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Can the public sector deliver growth if we have more active management?
Welcome to Known Unknowns, a newsletter that somehow manages to exist in a world where industrial policy is capitalism and index funds are communism.
More than 10 years ago, when I was at The Economist, a famous investor/philanthropist came to lunch. The world was still reeling from the financial crisis, and he remarked that he thought this proved that the Chinese had a better model. He argued the government’s heavy hand in markets meant that its citizens didn’t have to suffer the downturns that we did. (I should note that he was only making an economic argument—he was not defending their behavior on human rights.)
I summoned all of my neoclassical training and argued that their growth came from opening themselves up to the global economy and adopting existing technology that ultimately had made their labor force (and they had quite a large labor force) more productive. But the jury is still out regarding whether their model can produce new innovation, which is the only way that rich countries can lead and grow. And you can’t have growth without risk. The cost of the creativity and innovation that make the world better is sometimes in the form of recessions, financial crises, or innovations that aren’t great or else aren’t used property. But he didn’t buy it.
I was reminded about this conversation while watching Biden’s address about his new infrastructure plan. He spoke a lot about China, and how this massive infrastructure push/buy American policy was necessary in order to compete with them. Now, while I think a little nationalism can be good for morale, his view on the global economy as zero sum was disturbing. Normally I wouldn’t be too concerned, because this is how politicians talk, and we might need some nationalism to bring the country together. But the contents and philosophy behind this plan disturbs me, because there are shades of Chinese industrial policy embedded in it.
Obviously we’re not fully embracing their model—not even close. But there’s certainly an enthusiasm for their brand of industrial policy, as well as a belief that we need more of it in order to compete with them. And it’s not just Democrats. Industrial policy has become all the rage lately on the right, too. But there’s no getting around the fact that innovation is messy. Some people lose their jobs or businesses, and sometimes the biggest gains go to people who we don’t like. Sometimes we make bad investments, and sometimes the innovations that change the world happen by accident or aren’t what we expected. It’s tempting to think that it will be less messy if the government manages this process. And maybe it will, but that comes at a cost, because less risk means less growth.
Innovation is hard, and it’s risky by nature. And it seems that we’ve adopted a mindset that if the government is the primary innovator, then the risk goes away. But that’s not true. The risk just goes somewhere else, and the difference is that the people making the risky choices don’t bear the cost. And that’s important to note. Facing downside risk from an investment gone wrong is both how we make good choices and also how innovation thrives. Accurate prices are what allow innovators to test the market and see what works, and then move quickly in response.
Of course, there are examples of successful government-sponsored innovation, either through direct investment or through subsidies, like Operation Warp Speed or space travel. But obvious good investments are unusual. If picking winners were easy, no one would ever lose money.
There’s certainly a case for a nudge toward more green technology. It’s expensive, risky, and takes a long time to pay off. And we may not fully price the impact of climate change. But it feels like we’re going all in on certain technologies when we still don’t have great data. And some of these technologies, like electric cars, aren’t even all that great for the environment, and also aren’t pursuing green, efficient, but politically incorrect energy sources, such as nuclear power.
There’s clearly some room for government intervention, but it’s no free lunch, and the size of the plan is concerning, because our resources are finite and this a big shift from the private to the public sector. The few instances of industrial policy working tend to be in poor countries adopting innovations that have already been developed and have found success in the markets. Whether or not it works for already rich countries coming up with new innovation is unproven, at best.
Some of this innovation will be paid for with increased taxes on corporations, or we’re taking money from private sector innovators in order to fund public sector innovation or other corporations that get subsidies. Though we do need more tax revenue, and this is a start.
But raising the corporate tax rate isn’t the best way to raise revenue. First, the main reason that they lowered the rate in 2017 wasn’t more growth and innovation, though that can happen as a result. Rather, it was because it’s very easy to move profits abroad, and when we tax 35% and the average OECD rate is 23.5%, you create a big incentive to incorporate abroad. 28% makes us less competitive. I don’t see a minimum global tax working either, at least not in the long-term. I’ve studied too much game theory to believe that could ever be a sustainable equilibrium.
Also, it feels like this is more about signaling that we’re sticking it to corporations rather than adopting good tax policy. If we were really serious about increasing tax revenue, we’d keep the rate low and nix the gazillion deductions and loopholes that enable corporations to dodge the tax. A bigger rate isn’t about revenue—rather, it’s about pleasing the base, because it’s a simple, visible number that people understand that makes them happy that corporations are paying their share, even if they actually aren’t.
One thing is for sure, the return on risky investment is a lot more uncertain now that it changes with each administration.
I love index funds. I own them myself because I believe that diversification is important, and I don’t want to pay more than 10 basis points for it. In my opinion, index funds were one of the most important financial innovations of the 20th century. I understand the backlash from active fund managers, as it kills their business model. But the disapproval from left-leaning journalists is weird. Indexing is one of those cases where the little guy gets something of great value for cheap (an efficient portfolio), and the rich guy selling something that’s often a rip-off goes out of business.
Besides, we needn’t worry that there is too little active trading and that public firms are no longer accountable to investors or are accountable to too few of them. If we had 100% or even 80% indexing, then maybe we should worry. But that will never happen. Why? Well, lots of money in the market comes from institutional investors, and they will never go fully passive. If you run a pension fund, it’s your job to claim that you’re getting a higher return, and you can make a lot of money if you say that you do. But can you do that without taking a lot of risk? No, you can’t, but that’s not something that anyone has any incentive to admit. So pension funds and endowments will always put money in active funds, because picking the right active managers is one of the major ways that they justify their jobs. Even if the entire retail market went passive, which I think would be a great thing, markets will be fine, and we won’t end up with Marxism.
Until next time, Pension Geeks!