WILL Greece default on its debts and leave the euro? Will Britain decide to leave the European Union? Politicians in the two countries have threatened, implicitly or explicitly, to take these drastic steps if their European colleagues do not offer them inducements to stay.
Many people regard these threats as a bluff. They think that Greece does not really want to leave the euro, and that David Cameron, Britain’s prime minister, does not want his country to exit the EU. When push comes to shove, Greece will do a deal (see article) and Mr Cameron will persuade British voters to stay in the EU in his planned referendum. But there are risks that neither outcome will turn out as planned. In both cases, political leaders are making a risky bet.
The financial analogy is with writing (selling) an option. In the markets, an option is the right to buy (a call) or sell (a put) an asset at a given price; say shares of Apple at $130. In return for granting the buyer of the option this right, the writer receives a payment called a premium, rather like an insurance company receives a premium for protecting a homeowner against fire or theft. But if Apple shares do rise above $130, the buyer of a call option is likely to exercise it, to the writer’s cost; if they fall below it, the holder of a put option is likely to cash in.
Political leaders in Greece and Britain have in effect written an option on exit. The premium they receive is political popularity—for opposing the demands of international creditors, in the case of Greece, or for asserting Britain’s sovereignty, in Mr Cameron’s.
But in the financial markets, option-writing is a very risky strategy, unless the position is properly hedged. A lot of small profits can be earned from the option premia, only for all the gains to be wiped out when an option is exercised at an unfavourable time. Of course, the buyer of an option is most likely to exercise it when the cost to the writer is greatest.
For the political leaders of Greece and Britain, the difficulty is that they do not get to decide whether the option gets exercised. The other nations within the euro zone and the EU may decide to call Greece or Britain’s bluff. In Britain, the electorate also has the right to exercise the option of exit—which they might use in the referendum to protest against government policies in general rather than voting on the merits of EU membership in particular.
This leads to some complex calculations. Unlike Apple’s shares, the price of Grexit or Brexit at any moment is highly uncertain; political leaders cannot be sure what the costs and benefits will be. So this is rather like an option on one of the complex securities that proliferated before 2007—a collateralised debt obligation based on subprime mortgages, for example. The uncertainty makes it less likely that Europe will exercise the option and risk the departure of Britain or Greece.
If that gives the bluffing states an advantage, they also face a difficult trade-off. The more intransigent their demands, the more they may please their electorates (ie, the greater the “option premium”). However, such intransigence may make it more likely that the option will be exercised. European leaders may feel that making too many concessions to Greece or Britain will simply encourage other countries to make similar demands, and thus destroy the European project. In Britain, there may be a huge gap between the expectations fostered during the negotiating process and the reforms that emerge. This may create the impression that the government has failed, making the public more inclined to vote for exit.
This discrepancy between the high-flying nature of political promises and the mundane reality of policy outcomes lies at the heart of recent voter discontent. Promises may result in short-term electoral success but at the cost of increasing disillusionment in the long term. The most significant short-term influences on growth—the oil price, Federal Reserve policy, China’s success in managing its economic growth—are outside the control of European politicians. National leaders are, in effect, bluffing when they say their own policies can make much difference.
Europe’s failure to generate much in the way of economic or wage growth over the past decade means that voters are not just turning against the parties in power—they have lost faith with the mainstream opposition as well. The effect can be seen everywhere, from the rise of Marine Le Pen in France to the emergence of brand new parties like the Five Star Movement in Italy and Podemos in Spain. Years of short-term gains for the mainstream parties have resulted in a long-term loss.
Source: http://www.economist.com/news/finance-and-economics/21652362-when-political-leaders-turn-option-writers-economics-bluffing
Friday, May 29, 2015
Wednesday, May 27, 2015
Sewing up lower costs from falling commodity prices
In the past year the prices of many
commodities—including cotton and oil—have fallen 30 to 50 percent. That
should be good news for most apparel and footwear companies, since these
are key raw materials for the production of yarns and the synthetic
rubbers used in footwear. Companies are asking themselves how these
price falls will translate into cost reductions from their suppliers,
and how fast that will happen.
The basic estimates look promising. In a typical, mid-priced knit garment, raw cotton represents around 50 to 60 percent of the total cost of cotton yarns, yarn accounts for about 60 percent of fabric, and fabric for about 50 to 60 percent of the cost of a finished garment. Therefore, given the 30 percent drop in the price of raw cotton in the past year (Exhibit), a buyer might expect a 5 to 7 percent drop in apparel cost, depending on the complexity of the garment. The picture is similar in synthetics, with the price of PET1 dropping around 25 percent between March 2014 and February 2015.
Few apparel and footwear companies have captured significant commodity-related savings from their suppliers, however. Some companies don’t have a structured process in place to ask for supplier cost reductions when commodity prices fall; others don’t know what cost reduction to ask for when they do. Of those that do ask, many receive small reductions of 1 to 2 percent from some suppliers, while others receive no savings at all.
When pressed to offer commodity-related cost reductions, suppliers may argue that the effects of raw material prices on their own costs have been smaller than estimated, have been diluted by other players in the value chain, or have yet to trickle through to them. (In practice, changes in cotton yarn prices typically lag commodity prices by one to three months.) Without a deep understanding of the whole value chain and such facts at their fingertips, companies find it very hard to counter these points.
To claw back the full savings potential offered by commodity price drops, companies need to develop a detailed picture of the end-to-end value chains of their products, and of the way input cost fluctuations percolate through that chain. That is a complex business, requiring an understanding of the underlying chemistry of key raw materials, the structure of the industries that produce those materials, and the evolution of supply and demand over time. The sidebar below (“From oil to polyester”) describes some of the complexities surrounding the production of PET, one of the most important apparel inputs. A similarly complex value chain exists for many important polymers used in the footwear industry, like EVA (ethylene-vinyl acetate), PU (polyurethane) and SBR (styrene-butadiene rubber).
Companies that have taken such a fact-based and structured approach to supplier negotiations in the response to commodity price changes have been able to capture savings of 4 to 6 percent from their suppliers in a wide range of categories. One large apparel retailer did this by building a “rapid response system” based on detailed analysis of the effect of commodity price changes on the costs of different yarn and fabric types. Significant swings triggered assertive communications with its suppliers, asking for price adjustments within 30 days. The company was able to support subsequent negotiations with the data from its analyses.
There is also a significant opportunity for the apparel sector to make use of procurement best practices from other sectors. For example, the automotive and electronics industries for years have used advanced sourcing approaches such as Design to Value (DTV) teardowns, cleansheet “should cost” modeling and supplier collaboration. We will show in subsequent articles how these approaches can be adapted for apparel and footwear companies, and how leading players have driven 10 to 20 percent savings through their use.
Source: http://www.mckinsey.com/insights/operations/sewing_up_lower_costs_from_falling_commodity_prices
The basic estimates look promising. In a typical, mid-priced knit garment, raw cotton represents around 50 to 60 percent of the total cost of cotton yarns, yarn accounts for about 60 percent of fabric, and fabric for about 50 to 60 percent of the cost of a finished garment. Therefore, given the 30 percent drop in the price of raw cotton in the past year (Exhibit), a buyer might expect a 5 to 7 percent drop in apparel cost, depending on the complexity of the garment. The picture is similar in synthetics, with the price of PET1 dropping around 25 percent between March 2014 and February 2015.
Few apparel and footwear companies have captured significant commodity-related savings from their suppliers, however. Some companies don’t have a structured process in place to ask for supplier cost reductions when commodity prices fall; others don’t know what cost reduction to ask for when they do. Of those that do ask, many receive small reductions of 1 to 2 percent from some suppliers, while others receive no savings at all.
When pressed to offer commodity-related cost reductions, suppliers may argue that the effects of raw material prices on their own costs have been smaller than estimated, have been diluted by other players in the value chain, or have yet to trickle through to them. (In practice, changes in cotton yarn prices typically lag commodity prices by one to three months.) Without a deep understanding of the whole value chain and such facts at their fingertips, companies find it very hard to counter these points.
To claw back the full savings potential offered by commodity price drops, companies need to develop a detailed picture of the end-to-end value chains of their products, and of the way input cost fluctuations percolate through that chain. That is a complex business, requiring an understanding of the underlying chemistry of key raw materials, the structure of the industries that produce those materials, and the evolution of supply and demand over time. The sidebar below (“From oil to polyester”) describes some of the complexities surrounding the production of PET, one of the most important apparel inputs. A similarly complex value chain exists for many important polymers used in the footwear industry, like EVA (ethylene-vinyl acetate), PU (polyurethane) and SBR (styrene-butadiene rubber).
Companies that have taken such a fact-based and structured approach to supplier negotiations in the response to commodity price changes have been able to capture savings of 4 to 6 percent from their suppliers in a wide range of categories. One large apparel retailer did this by building a “rapid response system” based on detailed analysis of the effect of commodity price changes on the costs of different yarn and fabric types. Significant swings triggered assertive communications with its suppliers, asking for price adjustments within 30 days. The company was able to support subsequent negotiations with the data from its analyses.
The bigger picture
Beyond the specific opportunities related to a better understanding of commodity price effects, a procurement approach built on a deeper understanding of the whole value chain has the potential to offer more than just quick wins. It can also help the industry meet some of its most enduring challenges. For a decade or more, apparel companies have been fighting rising costs, driven by increasing labor, raw material and energy prices, as well as compliance costs in Asia. Their main weapon in this war against inflation has been to move production to lower cost countries and regions. But this strategy has many drawbacks: Supply chains must be reconfigured, and companies need to expend time and effort ensuring new suppliers meet the required standards of quality and environmental and social responsibility. Worse, by focusing so much on where their products are manufactured, these companies may not be paying enough attention to how they are made—and to the opportunities to reduce costs, manage risk and improve efficiency in their existing value chains.There is also a significant opportunity for the apparel sector to make use of procurement best practices from other sectors. For example, the automotive and electronics industries for years have used advanced sourcing approaches such as Design to Value (DTV) teardowns, cleansheet “should cost” modeling and supplier collaboration. We will show in subsequent articles how these approaches can be adapted for apparel and footwear companies, and how leading players have driven 10 to 20 percent savings through their use.
Source: http://www.mckinsey.com/insights/operations/sewing_up_lower_costs_from_falling_commodity_prices
Wednesday, May 20, 2015
Money for old folk: The relationship between ageing and inflation is not as simple as economists assume
WHEN it comes to the economic impact of demography, Japan is the wizened canary in the world’s coal mine. It has become older faster than any other big country: its median age went from 34 in 1980 to 46 today, and will continue rising for decades. But it will soon have plenty of greying company, from wealthy countries such as Finland and South Korea to developing giants, including China and Russia. Economists generally agree that the ageing of populations leads to slower growth, because a country’s potential output tends to fall as its labour force shrinks. They also expect heavier fiscal burdens, with governments providing for more pensioners from a smaller tax base.
Until recently, though, there had been little research into how demography affects inflation. The Japanese example of persistent deflation over the past two decades was seen as evidence enough that prices fall when countries age and their growth slows. Shinzo Abe, Japan’s prime minister, has sought to disprove that, espousing massive monetary easing to get prices rising. With inflation slumping far below the Bank of Japan’s 2% target in recent months, it is tempting to conclude that ageing is too powerful a force to overturn. But a new body of research* gives advocates of Abenomics a bit of support, at least on the demographic front. It shows that deflation is not the preordained outcome of ageing.
The problem lies not in identifying the possible links between ageing and prices, but in working out which way they cut. Consider the factors of production. When growth slows businesses rein in investment, so the cost of capital may decline. Yet wages ought to rise when the supply of workers falls. In the realm of fiscal policy, some indebted governments may make painful cuts as pensioners multiply, leading to slow growth and sluggish inflation. But others may opt to monetise their debt, pushing inflation up. (Some suspect this is the ultimate aim of Abenomics.)
How to disentangle these possibilities? In a recent working paper, Mitsuru Katagiri of the Bank of Japan and Hideki Konishi and Kozo Ueda of Waseda University distinguish between the ageing caused by a falling birth rate and that brought on by increased longevity. The main effect of fewer births would be a shrinking tax base; that might prompt the government to embrace inflation to erode its debts and thus stay solvent. But longer lives would cause the ranks of pensioners to swell; their increased political influence, in turn, would augur for tighter monetary policy to prevent inflation eating into savings.
In the case of Japan the authors estimate that the ageing process has led to deflation of about 0.6 percentage points a year over the past 40 years—a huge cumulative impact. That, they believe, is because the big surprise in Japanese demography has been ever-increasing longevity. Fertility rates are close to the levels projected in 2002, but the government has steadily revised up its estimates of lifespans. It is unexpected longevity, not simply ageing, that has been deflationary in Japan.
What about the impact of ageing on financial assets? Economic theory—“the life-cycle hypothesis”—holds that people smooth their consumption over their lifetimes, going into debt when young, buying assets when their earnings peak and selling them to pay for retirement. That, in theory, should lead to lower asset values as countries enter their dotage, but the empirical record is mixed: house prices often fall, but stocks sometimes rise.
An important variable is whether assets sold by pensioners are domestic or foreign. Derek Anderson, Dennis Botman and Ben Hunt of the International Monetary Fund looked at the decrease in Japan’s net savings rate from some 15% of disposable income in the early 1990s to about zero in 2011. What stands out is that many of the liquidated savings had been invested in foreign assets. When Japanese pensioners sold stocks and bonds abroad and repatriated the funds, they fuelled an appreciation in the yen—a consistent problem until 2012. This in turn contributed to deflationary pressure, by lowering the cost of imports. But the researchers also reckon that strong monetary easing combined with a credible commitment to an inflation target would have been sufficient to negate the effect of ageing. In other words, they believe Japan needed Abenomics long before it got it.
Greyflation
A recent paper by Mikael Juselius and Elod Takats for the Bank for International Settlements offers a very different take on how ageing affects inflation, suggesting that Japan may not be typical after all. They look at 22 advanced economies from 1955 to 2010. Japan is, after all, not the only country to have experienced deflation. Sure enough, they find a steady correlation between deflation and demography, but just the opposite of what is commonly assumed. A larger share of dependents—both young and old—is associated with higher inflation, whereas having more people of working age is linked to lower inflation. Their explanation, albeit tentative, is straightforward. Countries with more people consuming goods and services than producing them are liable to have excess demand and thus inflationary tendencies. Those with more producers than consumers will, by contrast, have excess supply and a deflationary bias.
That raises the question of why prices in Japan have fallen for so many years, given its rapidly ageing population. There are several potential culprits: the damaged balance-sheets left by the popping of the asset bubble of the 1980s, say, or the hesitant monetary policy before Mr Abe. But if the paper’s thesis holds true, an ageing population could yet lead to rising prices in the coming years. As the Bank of Japan seeks to vanquish deflation, demography may turn out to be friend, not foe.
Source: http://www.economist.com/ageing15
Until recently, though, there had been little research into how demography affects inflation. The Japanese example of persistent deflation over the past two decades was seen as evidence enough that prices fall when countries age and their growth slows. Shinzo Abe, Japan’s prime minister, has sought to disprove that, espousing massive monetary easing to get prices rising. With inflation slumping far below the Bank of Japan’s 2% target in recent months, it is tempting to conclude that ageing is too powerful a force to overturn. But a new body of research* gives advocates of Abenomics a bit of support, at least on the demographic front. It shows that deflation is not the preordained outcome of ageing.
The problem lies not in identifying the possible links between ageing and prices, but in working out which way they cut. Consider the factors of production. When growth slows businesses rein in investment, so the cost of capital may decline. Yet wages ought to rise when the supply of workers falls. In the realm of fiscal policy, some indebted governments may make painful cuts as pensioners multiply, leading to slow growth and sluggish inflation. But others may opt to monetise their debt, pushing inflation up. (Some suspect this is the ultimate aim of Abenomics.)
How to disentangle these possibilities? In a recent working paper, Mitsuru Katagiri of the Bank of Japan and Hideki Konishi and Kozo Ueda of Waseda University distinguish between the ageing caused by a falling birth rate and that brought on by increased longevity. The main effect of fewer births would be a shrinking tax base; that might prompt the government to embrace inflation to erode its debts and thus stay solvent. But longer lives would cause the ranks of pensioners to swell; their increased political influence, in turn, would augur for tighter monetary policy to prevent inflation eating into savings.
In the case of Japan the authors estimate that the ageing process has led to deflation of about 0.6 percentage points a year over the past 40 years—a huge cumulative impact. That, they believe, is because the big surprise in Japanese demography has been ever-increasing longevity. Fertility rates are close to the levels projected in 2002, but the government has steadily revised up its estimates of lifespans. It is unexpected longevity, not simply ageing, that has been deflationary in Japan.
What about the impact of ageing on financial assets? Economic theory—“the life-cycle hypothesis”—holds that people smooth their consumption over their lifetimes, going into debt when young, buying assets when their earnings peak and selling them to pay for retirement. That, in theory, should lead to lower asset values as countries enter their dotage, but the empirical record is mixed: house prices often fall, but stocks sometimes rise.
An important variable is whether assets sold by pensioners are domestic or foreign. Derek Anderson, Dennis Botman and Ben Hunt of the International Monetary Fund looked at the decrease in Japan’s net savings rate from some 15% of disposable income in the early 1990s to about zero in 2011. What stands out is that many of the liquidated savings had been invested in foreign assets. When Japanese pensioners sold stocks and bonds abroad and repatriated the funds, they fuelled an appreciation in the yen—a consistent problem until 2012. This in turn contributed to deflationary pressure, by lowering the cost of imports. But the researchers also reckon that strong monetary easing combined with a credible commitment to an inflation target would have been sufficient to negate the effect of ageing. In other words, they believe Japan needed Abenomics long before it got it.
Greyflation
A recent paper by Mikael Juselius and Elod Takats for the Bank for International Settlements offers a very different take on how ageing affects inflation, suggesting that Japan may not be typical after all. They look at 22 advanced economies from 1955 to 2010. Japan is, after all, not the only country to have experienced deflation. Sure enough, they find a steady correlation between deflation and demography, but just the opposite of what is commonly assumed. A larger share of dependents—both young and old—is associated with higher inflation, whereas having more people of working age is linked to lower inflation. Their explanation, albeit tentative, is straightforward. Countries with more people consuming goods and services than producing them are liable to have excess demand and thus inflationary tendencies. Those with more producers than consumers will, by contrast, have excess supply and a deflationary bias.
That raises the question of why prices in Japan have fallen for so many years, given its rapidly ageing population. There are several potential culprits: the damaged balance-sheets left by the popping of the asset bubble of the 1980s, say, or the hesitant monetary policy before Mr Abe. But if the paper’s thesis holds true, an ageing population could yet lead to rising prices in the coming years. As the Bank of Japan seeks to vanquish deflation, demography may turn out to be friend, not foe.
Source: http://www.economist.com/ageing15
Monday, May 18, 2015
Economists: Don’t leave home without one
As business leaders seek to stay ahead of the curve, they should ensure that somewhere in their range of view are the ideas of economists. Not forecasts or models or the dry parade of graphs and equations found in the typical introductory textbook, but rather economists’ insights and ideas, which sometimes have an enormous impact on the evolution of industries and also have been put to use in very practical and profitable ways by real companies. I am an economist, so this assertion may seem a bit self-serving. But I wouldn’t make it if there weren’t powerful evidence in its corner.
In this article, I’ll focus on one example: the Internet economy we know today would not have been possible, in scale or in speed of adoption, without an extremely important policy development of the 1970s and 1980s—the deregulation of transportation—in which economists played an important role. Nor would the business model of two of the Internet’s well-known players have been possible without the embrace of an idea—auctions—that has its roots deep in economics. I don’t think the Internet is an isolated case. I’ll close with an example of how a big economic idea could, in the future, have major implications for another major industry: pharmaceuticals.
Transportation deregulation
Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.
The deregulation of prices and of entry into the transportation industry—especially interstate cargo air traffic and trucking in the mid to late 1970s—is an exciting story in retrospect, but its importance would have been easy to miss at the time. As such, it is a useful reminder for business leaders of the value of keeping their ears to the ground when big economic ideas are playing out in policy arenas. That this particular dismantling of economic regulation happened at all is an amazing fact that contradicts one widely held notion of political economy: a policy benefiting large numbers of people and businesses in a small way is unlikely to be adopted if it imposes large harm on a small, concentrated number of other individuals and businesses.
Air cargo and trucking fit this description to a T. Economic regulation artificially suppressed competition and kept prices of freight (and passenger) traffic too high. But since freight costs represent only a small fraction of the costs of any retail operation and are not separately broken out, consumers paid only a little bit more than they otherwise might. Moreover, even if consumers knew this, they were too diffuse to oppose the concentrated lobbying efforts of the firms in the transportation industry (and its workforce), which would have been hurt greatly by additional competition. That was true even if the price for keeping it at bay had to be price regulation.
How then did things change in the United States? The starting point was congressional hearings organized by the late Senator Edward Kennedy and his chief staffer on these issues, Stephen Breyer (currently a Supreme Court Justice). The hearings featured economic research that made clear the large price cuts to be expected from dismantling price and entry controls in the airline industry. When Jimmy Carter was elected president, he joined forces with Kennedy (and senators whom Kennedy recruited to the cause) to push deregulation. Carter started with the appointment of two prominent economists, the late Alfred Kahn (as chairman) and Elizabeth Bailey, to the Civil Aeronautics Board, which oversaw the airline industry.
Airline deregulation passed Congress in 1978. Once the deregulation ball was rolling, it next went to the trucking industry, whose prices and routes were just as strictly controlled, even though there were thousands of firms in the industry. Trucking deregulation came in 1980, with the help of some heavy pushing along the way by the Interstate Commerce Commission, headed by another highly regarded economist whom Carter had appointed as chairman (on Kahn’s recommendation): Darius Gaskins. The bottom line is that neither deregulation success would have been possible without many years of prior economic research and, most likely, without articulate economists such as Kahn, Bailey, Gaskins, and the economists they appointed to key regulatory positions. When the stars align in this way, it’s worth paying attention.
Auctions
Economists and their ideas also have had an important impact on the evolution of the Internet directly, not mediated by policy changes, through their championing and theorizing about auctions. In the early 1900s, the whole notion of how prices are set in a market economy was analogized to an auctioneer, since frequently referred to as a “Walrasian auctioneer” in the academic literature. The auctioneer conducts continuous auctions for all kinds of commodities, not just those in scarce supply, to which it was once commonly thought that auctions would be limited.
Auctions played a role in the rise of mobile telephony, which has become deeply intertwined, through smartphones, with the Internet itself. (Economist Ronald Coase proposed auctioning off segments of the electromagnetic spectrum in the late 1950s, an idea that was not adopted until the 1990s.) And auctions also played a direct role in the growth of two well-known Internet companies.
One example is Priceline, launched by Jay Walker, who studied economics at Cornell as an undergraduate and learned his lessons well, especially the lectures and reading materials relating to demand curves, which are constructs in economic textbooks but not directly observable in the real world. Shortly after the Internet’s commercial possibilities became evident, Walker and his colleagues came up with the idea of “name your own price travel”—essentially reversing the typical process, in which firms set prices and then hope that consumers pay them. But Walker’s idea was not just to have consumers offer to pay their own prices: if it had only been that, travelers would have bid a dollar or two, and the airlines and hotels he was seeking to participate (TWA and America West became the first) would have refused. No, Walker’s clever innovation was to require consumers to pay the price they bid if the airlines and hotels on Priceline decided to accept it. That condition made travelers think hard about their bids and induced them to make serious offers.
Priceline is an example of a company founded by an innovator with a background in economics. Another company where economic principles later proved to have importance is Google. The search-engine pioneer generates most of its revenue through an auction-based system of selling ads. The system was developed by two engineers but validated by Google’s chief economist, Hal Varian, who was also the first dean of the School of Information at the University of California at Berkeley.
It’s worth mentioning as a side note that Varian has since overseen the hiring of a large corps of statisticians (mostly) and economists who developed other innovations for the company. Google Trends, for example, tracks search-term volumes, which can be helpful in predicting various real-world events, such as the progress of the flu or forthcoming official unemployment statistics. Indeed, the big data revolution ushered in by the ease of capturing, storing, and analyzing large bodies of data has generated new demand for economists and statisticians. High-tech companies like Amazon, Google, and Yahoo! now employ economists to sift through all kinds of data—retail transactions, browsing patterns, mobile-phone usage—to fine-tune their product offerings, pricing, and other business strategies. While teasing out relationships from masses of data can be helpful, correlations found in them often speak to the past and have limited forward-looking utility. Data mining is likely to be more useful if guided by underlying theories, which is what economists can do.
Looking forward
What do these stories of economic ideas have to do with business leaders today? I’d suggest that, every now and then, economic concepts are likely to make their way forward in surprising places, creating real opportunities for watchful executives and threats for unsuspecting ones. Here’s an idea, developed by economists at MIT, that I believe has promise: the securitization of research and development for pharmaceuticals or medical devices.1
The notion here is to pool the R&D expenses of many different research endeavors, most likely ones that have passed some preliminary vetting (for example, Phase 1 clinical trials mandated by the US Food and Drug Administration). I know that the mere word “securitization” has a bad name in the wake of the financial crisis. But the notion itself is not bad; it’s what’s inside the pools of securities and the completeness of disclosure for investors that matter. Structured the right way, pharma R&D bonds could be not only attractive for investors but also a potentially important way to bring more capital to support research for drug therapies and medical devices that both extend and improve the quality of life for millions of people.
When and how this kind of securitization will happen I don’t know. But I do believe that pharmaceutical researchers and leaders should keep an eye on the potential for it, and I will be surprised if, at some point, economic and financial value don’t shift in surprising ways as a result. Business leaders are unlikely to catch signals like these, though, if they limit their focus on economics to one-off situations—listening periodically to the forecasts of economists, hiring them as experts in lawsuits, or seeking their assistance in very specific projects, such as how best to bid in upcoming federal auctions for the electromagnetic spectrum.
I believe economists have a broader and more ongoing usefulness for business. John Maynard Keynes, one of the most famous economists of them all, surely was right when he observed that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The one qualification I would add is that the originators of the ideas need not be defunct; economics is a living field whose generation of ideas with business relevance bears watching all the time.
Source: http://www.mckinsey.com/insights/economic_studies/economists_dont_leave_home_without_one
In this article, I’ll focus on one example: the Internet economy we know today would not have been possible, in scale or in speed of adoption, without an extremely important policy development of the 1970s and 1980s—the deregulation of transportation—in which economists played an important role. Nor would the business model of two of the Internet’s well-known players have been possible without the embrace of an idea—auctions—that has its roots deep in economics. I don’t think the Internet is an isolated case. I’ll close with an example of how a big economic idea could, in the future, have major implications for another major industry: pharmaceuticals.
Transportation deregulation
Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.
The deregulation of prices and of entry into the transportation industry—especially interstate cargo air traffic and trucking in the mid to late 1970s—is an exciting story in retrospect, but its importance would have been easy to miss at the time. As such, it is a useful reminder for business leaders of the value of keeping their ears to the ground when big economic ideas are playing out in policy arenas. That this particular dismantling of economic regulation happened at all is an amazing fact that contradicts one widely held notion of political economy: a policy benefiting large numbers of people and businesses in a small way is unlikely to be adopted if it imposes large harm on a small, concentrated number of other individuals and businesses.
Air cargo and trucking fit this description to a T. Economic regulation artificially suppressed competition and kept prices of freight (and passenger) traffic too high. But since freight costs represent only a small fraction of the costs of any retail operation and are not separately broken out, consumers paid only a little bit more than they otherwise might. Moreover, even if consumers knew this, they were too diffuse to oppose the concentrated lobbying efforts of the firms in the transportation industry (and its workforce), which would have been hurt greatly by additional competition. That was true even if the price for keeping it at bay had to be price regulation.
How then did things change in the United States? The starting point was congressional hearings organized by the late Senator Edward Kennedy and his chief staffer on these issues, Stephen Breyer (currently a Supreme Court Justice). The hearings featured economic research that made clear the large price cuts to be expected from dismantling price and entry controls in the airline industry. When Jimmy Carter was elected president, he joined forces with Kennedy (and senators whom Kennedy recruited to the cause) to push deregulation. Carter started with the appointment of two prominent economists, the late Alfred Kahn (as chairman) and Elizabeth Bailey, to the Civil Aeronautics Board, which oversaw the airline industry.
Airline deregulation passed Congress in 1978. Once the deregulation ball was rolling, it next went to the trucking industry, whose prices and routes were just as strictly controlled, even though there were thousands of firms in the industry. Trucking deregulation came in 1980, with the help of some heavy pushing along the way by the Interstate Commerce Commission, headed by another highly regarded economist whom Carter had appointed as chairman (on Kahn’s recommendation): Darius Gaskins. The bottom line is that neither deregulation success would have been possible without many years of prior economic research and, most likely, without articulate economists such as Kahn, Bailey, Gaskins, and the economists they appointed to key regulatory positions. When the stars align in this way, it’s worth paying attention.
Auctions
Economists and their ideas also have had an important impact on the evolution of the Internet directly, not mediated by policy changes, through their championing and theorizing about auctions. In the early 1900s, the whole notion of how prices are set in a market economy was analogized to an auctioneer, since frequently referred to as a “Walrasian auctioneer” in the academic literature. The auctioneer conducts continuous auctions for all kinds of commodities, not just those in scarce supply, to which it was once commonly thought that auctions would be limited.
Auctions played a role in the rise of mobile telephony, which has become deeply intertwined, through smartphones, with the Internet itself. (Economist Ronald Coase proposed auctioning off segments of the electromagnetic spectrum in the late 1950s, an idea that was not adopted until the 1990s.) And auctions also played a direct role in the growth of two well-known Internet companies.
One example is Priceline, launched by Jay Walker, who studied economics at Cornell as an undergraduate and learned his lessons well, especially the lectures and reading materials relating to demand curves, which are constructs in economic textbooks but not directly observable in the real world. Shortly after the Internet’s commercial possibilities became evident, Walker and his colleagues came up with the idea of “name your own price travel”—essentially reversing the typical process, in which firms set prices and then hope that consumers pay them. But Walker’s idea was not just to have consumers offer to pay their own prices: if it had only been that, travelers would have bid a dollar or two, and the airlines and hotels he was seeking to participate (TWA and America West became the first) would have refused. No, Walker’s clever innovation was to require consumers to pay the price they bid if the airlines and hotels on Priceline decided to accept it. That condition made travelers think hard about their bids and induced them to make serious offers.
Priceline is an example of a company founded by an innovator with a background in economics. Another company where economic principles later proved to have importance is Google. The search-engine pioneer generates most of its revenue through an auction-based system of selling ads. The system was developed by two engineers but validated by Google’s chief economist, Hal Varian, who was also the first dean of the School of Information at the University of California at Berkeley.
It’s worth mentioning as a side note that Varian has since overseen the hiring of a large corps of statisticians (mostly) and economists who developed other innovations for the company. Google Trends, for example, tracks search-term volumes, which can be helpful in predicting various real-world events, such as the progress of the flu or forthcoming official unemployment statistics. Indeed, the big data revolution ushered in by the ease of capturing, storing, and analyzing large bodies of data has generated new demand for economists and statisticians. High-tech companies like Amazon, Google, and Yahoo! now employ economists to sift through all kinds of data—retail transactions, browsing patterns, mobile-phone usage—to fine-tune their product offerings, pricing, and other business strategies. While teasing out relationships from masses of data can be helpful, correlations found in them often speak to the past and have limited forward-looking utility. Data mining is likely to be more useful if guided by underlying theories, which is what economists can do.
Looking forward
What do these stories of economic ideas have to do with business leaders today? I’d suggest that, every now and then, economic concepts are likely to make their way forward in surprising places, creating real opportunities for watchful executives and threats for unsuspecting ones. Here’s an idea, developed by economists at MIT, that I believe has promise: the securitization of research and development for pharmaceuticals or medical devices.1
The notion here is to pool the R&D expenses of many different research endeavors, most likely ones that have passed some preliminary vetting (for example, Phase 1 clinical trials mandated by the US Food and Drug Administration). I know that the mere word “securitization” has a bad name in the wake of the financial crisis. But the notion itself is not bad; it’s what’s inside the pools of securities and the completeness of disclosure for investors that matter. Structured the right way, pharma R&D bonds could be not only attractive for investors but also a potentially important way to bring more capital to support research for drug therapies and medical devices that both extend and improve the quality of life for millions of people.
When and how this kind of securitization will happen I don’t know. But I do believe that pharmaceutical researchers and leaders should keep an eye on the potential for it, and I will be surprised if, at some point, economic and financial value don’t shift in surprising ways as a result. Business leaders are unlikely to catch signals like these, though, if they limit their focus on economics to one-off situations—listening periodically to the forecasts of economists, hiring them as experts in lawsuits, or seeking their assistance in very specific projects, such as how best to bid in upcoming federal auctions for the electromagnetic spectrum.
I believe economists have a broader and more ongoing usefulness for business. John Maynard Keynes, one of the most famous economists of them all, surely was right when he observed that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The one qualification I would add is that the originators of the ideas need not be defunct; economics is a living field whose generation of ideas with business relevance bears watching all the time.
Source: http://www.mckinsey.com/insights/economic_studies/economists_dont_leave_home_without_one
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