On economics and why what matters is material

Our imagination presumes that our world is driven by actors like Trump. Individuals who direct the course of history. Here is why the prime mover is more like an unguided invisible hand than a righteous avenger.

The public sphere is properly occupied with concerns around human survival due to environmental issues. Our current order has Environmental issues on the "left" side of the public debate or concerns about the survival of western civilization on the "right" side –but not the drivers of these existential concerns. Climate Change or the extinction of the Western Christian Man.

Pick your picket sign or pick your militia. For their partisans these concepts are satisfyingly simple. The end state apocalypse is clearly defined. Any action to negate that catastrophe is good. The underlying direction of material civilization is debated among elites but rarely in the public sphere.

The public debate goes on and remains focused on culture, All the while, food must be grown, children to be raised and work to be done. Behind the curtain of culture is the reality of economics. The prosaic, nuts and bolts of our reality reveal the direction that our civilization is moving.

Behind, driving, and in part driven by, culture is economics. In order for culture to exist it must rest upon a material reality.

That reality is ever-present when we buy groceries. Prices, income, and many other economic factors determine what people can afford and therefore what they will buy. This affects what types of products are most popular, and which ones become staples of society, thereby driving culture. Yet its underlying mechanics are largely unseen from a ground-level viewpoint.

But from a higher vantage point, the economic problem becomes clearer and forms a picture that we can strive to grasp. The economic problem: How does wealth get generated, spread out, and depleted in the world of perpetual scarcity and human frailty?

More powerful minds than mine have worked to understand the implications of the economic problem.

Below are a few observations to show the connections between the bigger systems from a variety of economists, philosophers and business executives. I am hesitant to credit any person with originating an idea, since they may either be the first to document the idea or merely the one remembered by history. In any event Adam Smith is credited with first identifying the phenomenon where competition drives long term profits towards zero.

"Smith's analysis of the falling tendency in the rate of profit is by far more complex than usually presented and that the intensification of competition is the result of the falling rate of profit rather than its cause which is the capitalization of the production process." (Tsoulfidis) Smith suggested that competition intensifies as a result of the declining rate of profit, rather than being the cause of it. This decline is caused by the introduction of production methods that involve the use of capital, such as machinery and technology, which increase the efficiency of production but also reduce the proportion of profits that can be made on each unit of output. So, the capitalization of the production process leads to a smaller return on investment and thus an overall decrease in the rate of profit.

Capitalizing the production process means investing in equipment, often with a view to save labor, either by employing fewer workers or making more products with the same number of workers. Reliance on labor will cause a business to suffer from low productivity relative to its potential productivity when it is augmented by equipment, organization, and other additions of capital. Otherwise it is like a car stuck in first gear--it can move but it won't go anywhere fast! The contradiction is that capital (machines, automation and equipment) does not provide its expected return due to competition. Marx argued that when businesses increase their capital investments, their labor costs become relatively lower, leading to higher productivity but also making them vulnerable to competition from other firms with similar levels of capital investment. This causes a tendency for businesses to enter into periods of crisis where they must either increase their capitalization or face bankruptcy. Ultimately, Marx argued that the rising ratio of capital to labor was the primary factor in both material improvement in society, as well as its periodic disruptions.This ratio is called the Organic Composition of Capital. Businesses measure Organic Composition of Capital (OCC) by calculating the total amount of capital in a business (fixed + circulating), and then dividing that by the labor cost of the business. The resulting ratio provides an indication of the amount of capital relative to labor in the business, and this helps to identify trends in the business's efficiency and potential for profitability. The higher the OCC, the more reliant the business is on capital and the more vulnerable it becomes to competition from other firms. The ever-increasing Organic Composition of Capital places businesses in a precarious situation, narrowing their margin for adaptation and potentially leading to their downfall.

When this trend is magnified and spread across an entire system or society, it can result in a serious economic crisis and disruption of the status quo. The Minsky moment is a term coined by economist Hyman Minsky to describe a state of financial instability that arises from speculation and an abundance of debt. In such a situation, markets become overwhelmed by excessive speculation and speculation-driven debt, resulting in a dramatic collapse of asset values and a period of crisis. Additionally, when there is a structural imbalance of labor supply and demand with too many workers and not enough jobs, this can contribute to an economic crisis by creating a situation where businesses can no longer afford to pay their employees, leading to further economic disruption.

So is profit falling? Does capital yield a weak return? Is a falling return on capital a crisis? If so is it a business crisis (something for someone else to worry about, preferably someone wearing a suit) or is it a social crisis (something for you to worry about)? Overall profits in OECD countries have been falling since the start of the 21st century. This has been partially attributed to weak returns on capital investments, making it more difficult for businesses to generate profit margins that are sufficient to cover their costs.(OECD) If profits are falling why are the rich getting richer?

The reasons for why the rich are getting richer even with falling profits is complex, but could be linked to factors such as the increasing disparity in wages between different sectors, the rise of automation and technology-driven efficiencies, and the globalisation of capital markets which allows for greater access to investment opportunities. Additionally, many of the wealthiest individuals may be taking advantage of various tax loopholes or engaging in aggressive capital management strategies to increase their wealth. Thus, the appearance of great wealth in some sectors of the economy may not necessarily signify an absence of crisis, but instead simply mask it. Furthermore, the increasing inequality between the wealthy and the rest of society exacerbates this tension, as the elite can remain insulated from the effects of a worsening economic climate at least from their ground level vantage point.

Let’s explore some recent evidence. A prominent executive made a famous public speech where he identified the poor return on capital as the key driver for industrial consolidation. This executive showed a graph demonstrating how Return on Invested Capital (ROIC) is closely related to Enterprise Value Multiples (EV/EBITDA), which are measured as the ratio between a company’s market value and its operating income. As companies with higher ROIC generally generate more profit, they tend to have higher EV/EBITDA multiples, indicating that investors are willing to pay more for them. Similarly, companies with lower ROIC often have lower EV/EBITDA multiples as they generate less profit, leading to lower investor demand. This executive's prescription was industry consolidation. He later stated that anti-trust laws should not be used as a tool to prevent mergers or acquisitions that can create value. In his rejoinder to that speech, “The Downsides of Capital Junkie Economics,” Joseph Stiglitz argues that capital accumulation can have both positive and negative effects on an economy. He states that while it can bring greater efficiency and productivity, it can also lead to market distortions, a decrease in wages, reduced employment opportunities, and increased inequality. Stiglitz suggests that the real challenge is to find ways to mitigate the costs associated with excessive capital investments while still using capital to increase efficiency and productivity.

Deloitte published a study which elaborates on competition’s erosive power with regard to profit. The benefits go to consumers while the costs go to producers. The famous executive found that Investments in redundant technologies that do not drive any market differentiation but still cost enormous amount of money, are even more corrosive. In his view Research and Development was the more wasteful use of capital than the investments in assets. R&D in the same industry towards the same end in different companies amounts to an incredible duplication of effort, costing much but yielding little. Companies can reduce that burden by applying that Development cost over multiple products. Commonization serves to keep costs lower with no loss to the customer. This allows companies to reduce manufacturing costs and complexity, and use existing parts to create new models. It also helps to ensure that vehicles are compatible with each other and reduces the time and money needed to design and develop new parts and components. "Toyota requires a deviation from the CEO in order to make a change to the common Carhorn design found in ALL Toyota vehicles".(DELOITTE) This approach can help but ultimately he recommends consolidation. Only by reducing competition will capital provide an adequate yield. This may be a choice between two pillars of poison ivy: The Competition Crisis or the Stultifying Monopoly. Deloitte refers to this problem as the Big Shift. The "Big Shift" refers to the challenge of balancing competition and innovation within the economy. It describes how companies are shifting away from traditional models of volume-based profits towards more innovative, customer-centric approaches. This shift has been driven by advances in technology, changing consumer preferences, and increasing global competition. Companies must be able to identify and act on these changes if they are to remain competitive, or risk being left behind in an ever-evolving global marketplace.

"For firms, the increasing number of channels to serve consumers can lead to a higher cost to serve each customer. In facility-intensive businesses such as retailing and process manufacturing, companies spend more to add capacity, they tend to generate lower profits over the life of the facility, and the useful life of the facility may be lower as a result of more rapid technological evolution.

As net incomes fail to keep pace with asset growth, that is returns on assets fall while the nominal enterprise values rise companies will continue to struggle. Focusing on income statement performance and accumulating financial assets on the balance sheet to manage short-term metrics will only exacerbate this struggle."

Organizations may try to increase their assets in the hopes of being able to keep up with changes in the economy, but this can often lead to poor yields and ultimately failure. As the economy shifts, organizations that have increased their assets will find it difficult to maintain profitability, leading to an amplification of their failure.

The inner workings of the economy are both captivating and critical - for each of us is crammed together in towns and cities by the millions, relying on a functioning economic system to deliver essential food and resources. Should it fail, all that any of us could do is pray - for without it, we would be unable to grow our own food, and without food, we would die. But if we take the time to understand the gears that make up the clockwork of our economy, we might yet have the power to act and change our fate.

Or we can opt for the easy path and just consume Entertainment, with no thought for the consequences and leaving the heavy lifting to someone else.

Some sources:

Success or struggle: ROA as a true measure of business performance Report 3 of the 2013 Shift Index series John Hagel (https://www2.deloitte.com/us/en/insights/topics/operations/success-or-struggle-roa-as-a-true-measure-of-business-performance.html?id=us:el:dc:dup505:awa:tmt) Corporate Governance, Incentives, and Industry Consolidations

Keith C. Brown, Amy Dittmar and Henri ServaesSource: The Review of Financial Studies, Vol. 18, No. 1 (Spring, 2005), pp. 241-270Published by: Oxford University Press. Sponsor: The Society for Financial Studies.

Stable URL: https://www.jstor.org/stable/3598072Accessed: 18-12-2019 01:40 UTC Euromoney Institutional Investor PLC How Do Private Equity Investors Create Value? A Summary of Findings from Ernst &Young's Extensive Research in North America over the Past Four Years

John VesterSource: The Journal of Private Equity, Vol. 14, No. 4 (FALL 2011), pp. 7-20Published by: Euromoney Institutional Investor PLC

Stable URL: https://www.jstor.org/stable/43503685Accessed: 18-12-2019 01:44 UTC Equity Valuation Using Multiples

Jing Liu, Doron Nissim and Jacob Thomas

Source: Journal of Accounting Research, Vol. 40, No. 1 (Mar., 2002), pp. 135-172Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,University of Chicago

Stable URL: https://www.jstor.org/stable/3542433Accessed: 18-12-2019 01:35 UTC Multiples Used to Estimate Corporate Value

Erik Lie and Heidi J. LieSource: Financial Analysts Journal, Vol. 58, No. 2 (Mar. - Apr., 2002), pp. 44-54Published by: Taylor & Francis, Ltd.

Stable URL: https://www.jstor.org/stable/4480377Accessed: 18-12-2019 01:35 UTC

The Concluding Volume of Marx's Capital W. Lexis The Quarterly Journal of Economics Vol. 10, No. 1 (Oct., 1895), pp. 1-33 Rethinking Marxian Investment Theory: Keynes-Minsky Instability, Competitive Regime Shifts and Coerced Investment James R. Crotty Review of Radical Political Economics, March 1, 1993 Revisiting Adam Smith's theory of the falling rate of profit Lefteris Tsoulfidis, Dimitris Paitaridis International Journal of Social Economics, 6 April 2012

Speech from unidentified Business Executive, 2015

Stiglitz, Joseph (2018). The Downsides of Capital Junkie Economics. Harvard Business Review, May-June. Retrieved from https://hbr.org/2018/05/the-downsides-of-capital-junkie-economics

Organisation for Economic Co-operation and Development (2020). OECD Economic Outlook: June 2020. Retrieved from https://www.oecd.org/economy/outlook/economic-outlook-june-2020.htm