From Notting Hill Editions
Tom Kremer, the founder of Notting Hill Editions, says that what we desperately need is a new economic model, capable of predicting a crisis before it hits home.
In basic economic terms, asset is the counterpoint to expectation. It comprises all we possess. For individuals, this means personal belongings, property, skills and qualifications. Business assets are items that appear on a company's balance sheet, such as inventory, equipment, property, cash at the bank, money owed by debtors and items not recognised by auditors: production capacity, position in the market, reputation, intellectual property rights, expertise and a well-trained work force. The state owns what does not belong to individuals or companies in the country. Land, roads, buildings, infrastructure, the NHS, schools, police, armed forces, the judiciary establishment, the civil service... all belong to this category.
We will now differentiate assets in terms of their contamination by expectations. The extreme diversity of what is considered as an asset is bound to make such an evaluation difficult. I am making an attempt at a broad classification, not in the hope of discovering some elegant formula, but because even an imperfect model is helpful in gauging the strength and the soundness of any economy.
There are few pure assets, as there are virtually no pure expectations. The bulk of economic activity has within it both elements but in variable proportions. When it comes to assessing assets, their content is determined by the degree of their dependence on expectation. The more an asset is contaminated, the less solid it is. As a very rough guide, gold, minerals, commodities, property, land and what appears in company balance sheets as net asset value, are relatively less dependent on expectation. At the other end of the spectrum, sophisticated financial instruments, especially those of recent vintage, dependent as they are on future returns, are hugely expectation-biased. The value of this kind of asset is not only more fragile but also very difficult to assess. Toxic debt belongs to this category.
Gold is obviously an asset. It is a regular commodity, insofar as it is used in the manufacture of jewellery, but its significance lies in the handsomely-shaped ingots buried in the vaults of central and private banks. In that guise, gold is a solid asset, despite the oscillation in its monetary value, since its quantum does not diminish. It could also be said that it is a passive asset, not bearing interest and not taking a direct part in economic activity. At the same time, the ingots provide the most secure of securities against which money can be borrowed. Indeed, in past times, all paper money was nothing more than a government debt secured by its possessions of yellow and silver metal.
In stark contrast to solid and passive gold, the genius of a celebrated artist is an asset but one whose realisation lies wholly in the future. Any work of art as yet uncreated would most probably fetch a six-figure sum but the artist may suffer a fatal heart attack or simply cease working. The value represented by an unpainted painting I think deserves to be termed a potential asset. It is immediately evident that this category of assets reaches far beyond the spectacular individuals inhabiting the world of entertainment and the arts. Every scientist, teacher and surgeon - in fact, every professional and skilled worker - is part of the asset base of our national economy, so long as we keep in mind that these assets are strictly potential. In terms of our new conceptual structure, it is crucial to assess just how large an element of expectation forms part of any asset.
It seems fairly obvious that, all things being equal, the element of expectation in a surgeon "asset" is proportionally greater than the same element in a barber "asset", no matter how proficient or popular that barber might be. And this difference is twofold: it takes at least ten times the time and expense to train a surgeon than a barber and a surgeon is expected to deliver perhaps twenty times more value to the economy over his career. To quantify this difference, it is helpful to compare the cost of three haircuts per hour with the cost of an operation lasting twice that long.
People, on the whole, do not make career choices based on economic grounds alone, at least not in affluent Western democracies. Blue-collar workers and professionals diverge through aptitude, family tradition and opportunity, more than through sheer earning power. Nevertheless, we constantly make decisions based on the relationship between investment in effort, time and money on the one hand and of financial return on the other. And society certainly has to make this kind of calculation when apportioning resources between primary, secondary and tertiary education.
The same principle applies to industrial assets. A car-manufacturing plant carries an investment of what may be loosely described as set-up costs. Before a single car leaves the assembly line, a facility has to be built, equipped both with machinery and a trained workforce, let alone years of research and development. Once the shining new cars are ready to roll, the success of the entire enterprise resides in the realm of expectation. The production line may come to a grinding halt as workers strike for better pay, the particular model may be unpopular, demand for cars in general may plummet and unexpected environmental legislation may force expensive modifications. Any combination of these eventualities would play havoc with the original expectation at the creation of the car plant. The disappointment of expectation means that the whole enterprise diminished, rather than contributed to, the asset base of the economy.
Although industrial assets, comprising machinery, technology and know-how, have the more solid and quantifiable feel, human resource can have an equal, perhaps superior, track record. The kingdom of Hesse derived its main revenue by leasing out its army on a regular basis until the latter part of the 19th century, as did the Swiss before turning their mercenaries into universal bank clerks. An even better example is the success of Hong Kong, with an economy built entirely on the industry and enterprise of its people. In assessing the solidity of the economy, a more promising categorising of assets is along the lines of primacy.
The production of food is perhaps the best example of a primary economic activity. Packaging, transporting and retailing it may be thought of as secondary, marketing and advertising it as tertiary, whilst applying health controls is more remote still. The same classification could apply to all products, with an increasing number, in the massive proliferation of choice, riding piggyback on others. If the car is considered a primary product then motorways, garages, fuel supplies and insurances are, to a varying extent, dependencies. The degree of interdependence, complexity and sophistication of an economy is not irrelevant to the solidity and state of its health. I am tempted to think that a high degree of vertical complexity is in itself an economic weakness.
The further society moves away from a historically primitive model, the more vulnerable becomes its economy. Our food production may be less exposed to the vagaries of the climate but our highly sophisticated economy is more susceptible to hundreds of other variables. One of the key features of our present predicament is the want of reliable measuring devices to keep pace with the complexities of a global economic system. We did not have any surefire indicators foretelling the severity of the crisis.
Perhaps, an even more pertinent distinction in the asset realm is what may be termed the expense element. Apart from the cost of keeping ingots safe in a bank vault, maintaining gold is expense free. Disregarding extraction and storage costs, much the same applies to non-perishable commodities in general. Human resources have a more serious expense element inasmuch as personnel do need to be kept up to speed in their speciality and face total replacement on retirement. As for machinery and technology hardware, the expense element is important enough to be written down in the company's annual balance sheet.
Taking a snapshot of the economy, assets, in terms of human resources, constitute partly past expectations realised and partly potential future output based on skills, knowledge and expertise already present. The economic equation is this then: how does past investment relate to current asset-enlarging output? If the result of the equation is positive, it means that past investments more than paid for themselves and the asset base of the economy grew. If the result of the equation is negative, it means that some of the expectations did not materialise and the asset base of the economy, at least in human resources, diminished.
But it is with public sectors, forming as they do part of the welfare state, that the expense factor becomes critical. The health service, the educational establishment, the police, army and the civil service, are essential to the fabric of our society. They are rightly considered assets. But we must bear in mind that they are expensive assets. To maintain, enlarge and improve them means a continuing and ever-increasing investment. As return on this investment, we expect an improved society: a more comprehensive health service, a better educational system, a fairer administration of justice, a more effective police force, a higher quality of social workers and whatever else public opinion desires. To what extent the returns on this on-going investment meets our expectations has become a statistical football kicked back and forth between political parties, with the whole exercise cheered on by the media.
You will tell me that all this business about barbers, surgeons, car plants and public services is rather elementary and you would be only too right. Sadly, if we aspire to have some understanding as to why the world's car manufacturing industry is near collapse, as to why we may be facing the woes of unemployment and social unrest on a scale not seen for half a century, we have to go back to basics. Especially so, since our leaders, in the public, private and academic sectors, are disinclined to do so.
The mantra of our economic life, for quite some time now, has been growth. Everything seems to have been growing: world population, production of goods, general prosperity, sophistication of the law, social justice, demand for resources, money supply and, above all else, expectation. In fact, the more the economy grew, expectation grew even more. Perhaps there is some truth in the belief that the more one has, the more one wants to have. Growth came to dominate our collective thinking to such an extent that we took its upward path for granted. And, more than that, we made growth the main, if not the only, criterion of the health and strength of our economy. And we have sanctified GDP as the sole measure of its extent.
Measuring the volume of an economy is not only insufficient, it is also misleading. It lulls us into believing that, because the economy grows, we are doing well. Ironically, if the quality of an economy is weak, the faster its rate of growth, the more grave will be the inevitable correction that must follow. The unfolding gravity of the crisis demonstrates that these weaknesses are most profound.
In sheer economic terms, the investment into national assets as against the improvements it brings, could never be quantified. It is obvious that the introduction of a cheaper and more effective drug represents a genuine asset gain. It is also evident that one biochemist or engineer is more likely to increase the national asset base than fifteen graduates in media studies. If Britain Plc, or any other national economy, were a publicly audited company, the profit and loss account and balance sheet would show the quantified result of investment, net loss or gain, as well as accumulated assets. Audits of national economies are less transparent. We have to be content with the overall yearly government revenue and expense. Annual GDP figures unfortunately tell us nothing about the economic quality of growth.
One of the few indicators that is relevant, if only indirectly, to assessing economic quality is the annually published statistic of the national budget deficit. This figure is supposed to be the measure of the difference between government income and expenditure. Government revenue has many sources and not all of them are helpful in measuring asset-positive against expense-loaded economic activity. For example, revenues derived from VAT do not distinguish between profitable and loss-making transactions. Taxes paid on company profits, on the other hand, do tell us something about the state of the asset base of a national economy. If, measured by GDP, economies have been growing steadily and company profits have not kept pace, the relative asset base must have shrunk. Thus, volume of economic growth with a preponderance of the expense element within its asset base would result in a weaker, more fragile real economy.
There can be little doubt that this is precisely what has happened over the last decade or so. Despite the self-deluding boast of a chancellor who believed he was the master of the economic universe, our economy was neither sound, nor healthy nor resilient. There is a wealth of evidence pointing to our economy, much like other national economies, suffering from a variety of dangerous imbalances. Expectation and assets with a built-in element of expense far exceeded the growth of material assets with a solid, reliable base.
If Gross Domestic Product is a measure of total turnover, then I propose that Net Domestic Product (NDP) should be a measure of asset enlargement activity. The rough guidelines of qualifying for inclusion in the NPD centre on the creation of assets. Thus money derived from outside the economy, whether brought in by visitors, foreign investors or exports, naturally represents an increase in the national asset base.
Correspondingly, native money transferred abroad, whether spent on leisure, imports or investments does not qualify. Income produced by investments abroad does count when repatriated. Manufacturing, along with agriculture, mining and quarrying are obviously included since they produce goods that were not there before. The service sector, in the greater part, is excluded since, vital as it is, it maintains what is there without adding to the asset base.
However, services strongly linked to production, such as transport, storage and communication, as well as research and development, could count towards asset generation. Additions to the national housing stock, property construction and transport infrastructure in general have to be included. I am inclined to treat the building of new schools and hospitals in the same way, although they will hardly produce any revenue and, throughout their lifetime, they will cost the national economy a great deal of money.
In modern mixed economies, the state tends to provide the essential conditions for a society to maintain itself. This means looking after the people's health, education, social welfare, defence and security. Comprising the public sector, this involves a massive use of human and material resource.
So, for the purposes of the distinction we are drawing, this vast sub-economy represents a drain. It cannot form part of the NPD. We all want a superb universal health care system but, with people living longer and ever-improved treatments available, this costs more and more money. We depend on skilled and well-educated future generations but, while they are schooled and trained, they are a burden. We are striving for a more refined justice system accessible for all, but administration and enforcement of the law is very, very expensive. The legislation 'industry' has never been more productive and never as oblivious to the cost of each additional right, each additional bit of legal protection and opportunity to engage in litigation. We are keen to extirpate any and every conceivable discrimination, but has anyone ever calculated the associated cost? Compensation paid by an NHS primary trust in case of medical negligence, and the legal and administrative costs involved, are transactions that swell the GDP figure whilst diminishing the economy. This is why we need to distinguish systematically, on an ongoing basis, between asset-enhancing and asset-using activities on a national scale.
These analytic proposals aren't a general attack on various aspects of the welfare state. Efforts to improve the lot of our society are generally desirable and the resource devoted to each single implementation of it may well be justified. But we have to know how much of it, in total, we can afford while we maintain, or improve, the balance of the economy. This is especially critical in a crisis when the measures administered are a general stimulus to the broad economy, measured, as usual, in terms of a percentage of the sacrosanct GDP. To determine affordability, it is not enough to calculate the money available for the Treasury at budget time. It is critical that we assess the quality of the economy as manifest in the balance between assets and expectations, between revenue-yielding and revenue-spending sectors, between hard and soft assets.
To evolve a quantifiable formula for the Net Domestic Product will not be easy. It will require a much closer analysis of the middle ground stretching between obvious asset production and sheer, non-investment, expense. It will have to distinguish between investment into human resources likely to produce future revenues and investment likely to improve the quality of life at additional cost. It will have to take account of factors like levels of primacy in the production process and the future growth potential of individual industrial sectors. But no matter how imperfect the first formulation of the NDP definition turns out to be, it will be the only tool to meaningfully assess the state of a national economy.
Once we have a figure for the NDP, its relative proportion to the GDP will yield a numerical coefficient to tell us what kind of economy we are assessing. If the NDP is 90% of the GDP, the coefficient is 9, if it is 10%, the significant figure is 1. Neither case is practically possible, of course. A primitive agrarian economy is likely to have the highest coefficient, with an oil-rich sheikdom coming a close second. For the lowest coefficient we would have to look at advanced economies leaning heavily on social-democratic models. My guess is that Western economies would range between 2 and 4, with the majority around 3. I do not think there is an ideal coefficient guaranteeing a perfect balance. But there are limits, and breaching those leads inevitably to economic crises, or social upheaval, or both. The greatest danger, however, lies in relying on GDP and ignoring how much of it nets down to a sustainable economic base.
I do not know what calculations are currently used by central banks in the US , UK and Europe to determine the rate of money creation. I suspect it has to do with GDP yet it seems obvious that economies with higher Net Domestic Product coefficients could afford larger monetary expansion than those with lower ones. If currencies are based on the economies they serve - and, with gold gone, there is nothing else in the offing - the balance of the economy, and not just its size, should be reflected in the relative strength of any currency. In addition, when contributions to the EU and other international bodies are allocated, NDP should be part of the equation if that system of proportional contributions is to survive.
All this now becomes apparent with all the simplicity and clarity of hindsight. What we desperately need is an economic model that is capable of predicting a crisis before it hits home.