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“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”– John Maynard Keynes, the father of macroeconomics, in “The General Theory of Employment, Interest and Money” (1936)
If you care about making money, you might be interested in Economics
Just as everybody has strong views on who should be playing in the Indian cricket team, most Indians have strong views on how the economy should be run. However, just as it is not easy to play cricket at the highest level, it is not easy to practice economics – whether macroeconomics (which pertains to how countries function) or microeconomics (which pertains to how companies function) – at the highest level. If you want to build more mental muscle regarding how economics informs decision-making (for companies and for nations), here are four super books which deal with questions like:
– Why are some governments able to run countries well whilst other governments send their countries hurtling towards ruin?
– What makes certain companies succeed spectacularly whereas other companies with seemingly similar characteristics fall by the wayside?
– Why are some companies able to monopolise industries where others are condemned to operate in the midst of intense competition?
Book 1: ‘Why Nations Fail’ (2012) by Daron Acemoglu and James A. Robinson
The overarching theme of ‘Why Nations Fail’ is the relevance of “inclusive economic institutions”. An inclusive economic institution is basically a combination of the state and the free markets working together, where the people’s voice is actively heard and acted upon by the leaders of the state. Acemoglu & Robinson believe that inclusive economic institutions encourage development, whereas an extractive economy can generate growth in the short term but ultimately ends up being poverty stricken as a tiny elite squeezes the juice out of the bulk of the population.
Looking at different pairs of countries such as Mexico vs America as well as North vs South Korea, the authors illustrate that institutional differences which have been put into place over the last couple of decades have set the precedent for the country’s development or lack thereof. For example, when looking at America and Mexico, the authors focus on a city named Nogales which lies partly in Arizona, USA and partly in Sonora, Mexico with pretty evident differences in average income, percentage of graduates, infrastructure as well as health of the population, even though factors like geographical location, culture, climate, etc., are more or less similar for the two halves of the city. The Mexico part of the city has an average income that is roughly 1/3rd of the American part. The authors explains that the root of this disparity is enslavement of Mexico by the Spanish colonialists. The Spaniards used slavery to their benefit to extract large amounts of gold and silver from Mexico and left behind a government which carried forward this legacy. The colonial elite was simply replaced by a Mexican elite which perpetuated the extractive institutions. Egypt, North Korea, Sierra Leone, and Zimbabwe are similar to Mexico in this regard.
In contrast, in countries like the UK, the USA, Japan, and Botswana, citizens were able to overthrow the elites and make their voices heard in the corridors of power. Hence political and economic laws and plans were fairer or less extractive in nature and catered to more or less the entire population (rather than a tiny elite).
The moral of the story is that rather than arguing about Capitalism vs Socialism or Left vs Right, countries need to focus on creating an environment where the Government is responsive to the citizenry – rather than ruling the citizenry – since this allows for the economy to be inclusive in terms of opportunity and thus fosters sustainable development.
If you are interested in understanding whether India has built inclusive economic institutions like UK and USA or extractive systems like North Korea and Egypt then read Arvind Subramanian on Why Nations Fail does not work for India and China and the authors’ response.
Book 2: ‘Other People’s Money’ (2016) by John Kay
In this searing critique of investment bankers, fund managers and other characters who hang around global capital markets, John Kay has succinctly captured the problems in contemporary financial systems and specifically why they have not been fruitful in terms of generating sustained economic growth.
Growing up in Edinburgh, he noticed that a typical male bank manager 50 years ago was meant to be skilful at chatting to clients on the golf course. Fast forward to today, says John, and these very managers are highly paid, smart alpha males and females. However, John finds that doing business at the 19th hole was far better than what is going on in British banks today. For example, today only 3% of British banks’ total assets are loans to entities engaged in the production of goods and services. The vast majority of loans are loans to other banks, thus showcasing the fact that the primary business activity of large-scale banks today is not financing and expanding the real economy but merely “exchanging bits of paper” with their fellow bankers.
Financial products such as derivative instruments, which are based on market liquidity and complex structure, have helped the wealthy and educated business class while swift and efficient payment systems have helped the masses but not at the same scale. At its core, finance is an information business and therefore, those who are in the know of have, and always will be better off than those who are not.
The financial crisis of 2008, according to John, was caused largely due to the greed of a tiny self-interested elite. Earlier, bank managers or those in charge of approving any person to borrow had a personal interest in ensuring that the banks lent only to those who were able enough to repay the borrowed amount, in the sense that a considerable amount of their own money (bank managers’) was invested with the bank. In the case of a default, the brunt would have been borne by the managers of the bank too. Today however, this is not true. Bank managers (both retail and investment bankers) do not have to invest any of their own corpuses in the institutions that they work for. They mostly handle other people’s money and are thus incentivised to take greater risk with that money. Furthermore, the increasing dependence on asset backed securities, rather than focusing on actual physical assets (which ironically are crucial for the securities’ returns themselves) would pave way for the collapse of the global financial system in 2008. [By the way, John helped one of the authors of this note figure out in January 2007, a good eighteen months before Lehman collapsed, that the British financial system would blow up.]
This brings us to the core issue that John addresses in the book – profit in this sector is driven by self-serving antics such as fiscal, regulatory, and accounting arbitrage such as tax loophole games and financial reporting shenanigans. Simple financial products of the past such as online payment systems have increasingly given way to complex chains of transactions understood by few, benefiting even fewer. The more complex a system is made, the more ways are found by the stakeholders to circumvent the rules, sometimes even at the expense of their clients. This structure of finance and financial markets, according to John, is unsustainable in the long run.
Book 3: ‘Information Rules’ (1998) – by Carl Shapiro and Hal Varian
“Information Rules” by Carl Shapiro & Hal R. Varian (now Chief Economists at Google) is relevant even 21 years post its publication. Shapiro & Varian unravel how traditional economic concepts can be used to understand new technology and internet business models. Their book illustrates the difference between information and physical goods. In particular, information goods are typically more expensive to produce, and almost free to reproduce. Think of a code designed to use AI to detect places which would face famines. The software development might incur costs (hiring a coder, investment in technology, etc.). However, once the software is ready to use, subject to copyright, it is almost free to reproduce if the technology is available with the party hoping to replicate it. This makes it increasingly difficult to price such products, given that their subsequent costs of production are often zero or negligible. The authors suggest that information goods should be priced according to its value to the end user instead of its cost of production (reproduction or mass production).
This simple concept in turn leads to the first major strategy as espoused by the book: Price Discrimination. Using price discrimination, we can attempt to price the good in proportion to the propensity of the buyer to pay for the good. There are different ways of implementing differential pricing such as personalised pricing, group pricing or versioning (see below). In different cases, each type of pricing proves to be the most efficient and profitable to implement. A central aspect of building monopoly businesses is understanding which type of pricing to implement.
Versioning is a specific type of price discrimination wherein the company creates different versions of the same product at different price points, for example, a hardback, paperback and Kindle version of the same book. An important aspect of versioning is selecting aspects of the product that are more important to some users and less so to others. For example, when a major artist releases a new song, at first, they only release one song as a teaser. However, they make all their listeners purchase their album to listen to any of the other songs. This way they are able to attract more listeners and make money.
The second major business strategy espoused by the book is that of Network Effects – how the value of a network grows exponentially with the growth of the number of members. Shapiro & Varian explain how many industries use and enjoy the benefits of network effects. For example, in case of Facebook, the more people join the better is it for their friends. Facebook is only valuable to me when people I know are also using it. Hence the more valuable it becomes to its users, the larger its user base grows, the better it is for its owners (increased user base for advertisements equals increased revenue).
Linked to the preceding business concept is the third major business strategy highlighted by the authors: Switching costs.
Switching costs are those associated with moving a consumer from one product/service to another. Even small switching costs can have a large effect. Consider when people have to move to iTunes from MP3 or vice versa. They will only do this if the new service is going to be significantly better. Switching costs in turn lead to “standard wars” when two incompatible technologies clash. For instance, Android and iOS (Apple) can be seen as two operating systems that do not work well together. When one technology is incompatible it signifies a “revolution” strategy, against an “evolution” strategy when backwards compatibility exists. Winners of standard wars are those who can keep up with the growing and advancing technology, paying attention to one’s products, its complementary goods, and how these can be used to build a monopoly franchise.
In the Indian context the rise of Amazon, WhatsApp, and Facebook over the past ten years is almost like a copy book application of the strategies highlighted in the book (Price discrimination, switching costs, and network effects respectively).
Book 4: ‘Money and Government’ (2018) by Robert Skidelsky
The idea of the “invisible hand” as introduced by Adam Smith seldom comes into play in real life situations, as markets need some sort of guard rail to veer onto the correct path rather than correcting course by themselves. Robert Skidelsky’s ‘Money and Government’ is a survey of the main ideas driving macroeconomics over the last three hundred years, specifically how governments’ perception of the use of fiscal and monetary policy to steer the economy has changed over the last three centuries. Skidelsky primarily uses the example of the UK over the last three centuries primarily because it was the center of global power during those times, and hence many of the relevant schools of economic thought found expression there.
The central point of the book is Skidelsky’s opinion that recessions should be solved through a combination of the government using fiscal and monetary policy tools. These tools cannot be global, in the sense that no one size fits all, and they need to be tailored to a country’s specific requirements. The UK, for example, used Gordon Brown’s “golden rule”.The golden rule was used to establish a distinction between current and capital spending (opex vs capex). The purpose of the golden rule was to “create a bit more policy space for the New Keynesian Fiscal policy, against a background of relentless hostility to public expenditure”.
Another concern for Skidelsky is policy intervention that helps the elite rather than the masses. For example, Skidelsky takes the view that what the Fed did after the crash of the Lehman Brothers helped the American elite rather than the economy. Skidelsky says that quantitative easing by the major global banks proved to be a venture where little was achieved, besides the sharp increase in the prices of housing and financial assets which helped the rich become richer. Overall, quantitative easing has become a platform to bail out banks and enabling bankers to help reward themselves continuously.
Therefore, Skidelsky repeatedly reiterates in the book that using a clever combination of fiscal and monetary policy can help the masses, and not just the top tier of the population. “The Keynesian innovation was that the government should influence the level of total spending though the fiscal policy, with monetary policy made consistent with the aims of fiscal policy. By contrast, in new classical economics, monetary policy – keeping the economy supplied with the right amount of money – is the whole of macroeconomic policy, since fiscal policy cannot influence the total spending, only its direction.” (Source: Introduction, Money and Government – R. Skidelsky, 2018).
During the Keynesian heyday of the 1940s to the 1960s Skidelsky says there was a better balance between capital and labor. “Strong trade unions were able to push wages up in line with productivity; extensive government transfers kept up mass purchasing power. The commitment to full employment created a favourable climate for business investment, and hence improvements in productivity, and the state’s own capital spending policies maintained a steadiness of investment across the cycle. Consumer credit was restricted. As a result, business cycles were dampened, and economies enjoyed unprecedented rates of economic growth.” (Source: Chapter 10, Money and Government – R Skidelsky, 2018).
In the post-Covid world, Skidelsky’s work is more relevant than ever because what is really interesting is that in contrast to what was done after the 2008 financial crisis, post-Covid governments the world over have combined quantitative easing with fiscal largesse i.e. money transferred into the pockets of the public. If Skidelsky’s book is anything to go by, this should lead to an almighty economic boom over the next 3-5 years.
Saurabh Mukherjea and Nandita Rajhansa are part of the Investments team at Marcellus Investment Managers (www.marcellus.in). The authors would like to thank Amaya Chinai who as an intern provided inputs for this piece.