While value investors may not devote too much attention to economics while doing analyses, their choices and the results they achieve all depend to some extent on economic forces. Everything from quarter-point changes in interest rates to international trade deals can have a profound effect on stocks and the stock markets.
Like investing, economics has jargon and assumptions that make it difficult to understand, to say the least. But, in his 2013 book, "The Little Book of Economics: How the Economy Works in the Real World," author Greg Ip promised a book that will help the rest of us understand the so-called “dismal science.” He is a veteran journalist with experience at several major newspapers, including The Wall Street Journal and The Economist.
In chapter one, he tackled what he called “The Secrets of Success” among nations: people, capital, and ideas. To begin, he compared the outlook for Japan and the United States in the late 1980s and the very early 1990s. Many no doubt remember that time, when it seemed Japan could do nothing wrong—especially in electronics, cars and steel. On the other hand, many Americans were depressed about the state of the country at that time; it was deeply in debt, its companies were being acquired by non-American companies and managers seemed obsessed with short-term profits.
Yet, by the time the decade of the 1990s ended, the positions of the two countries had dramatically reversed. What happened?
Ip pointed out that an economy needs both healthy demand and healthy supply. But Japan’s demand side slumped when overinflated stocks and real estate failed, saddling companies and banks with bad debt. At the same time, its ability to handle the supply side flailed because of three factors: population, capital and ideas.
People and population
Population is the source of future workers, but Japan had a low birth rate, an aging population and essentially no immigration. As Ip noted, the country made big investments in education and advanced technology in the decades after World War II, a thrust that began to falter in the 1990s. To move ahead, the country needed what Joseph Schumpeter called “creative destruction,” but Japan’s leaders balked. As a result, the next wave of progress, driven by the idea of the internet, was captured by the U.S.
Growth, according to Ip (and most economists), comes from two building blocks: population and productivity. The potential growth of a nation can be estimated by adding growth in the labor force and the growth of productivity. For example, a country that grows its labor pool by 1% per year and its productivity by 1.5% will achieve potential growth of 2.5%. This is the basis of economic growth.
In demographic terms, a country needs a birth rate of at least 2.1 babies per female to keep its population from shrinking. As we know, Japan had a low birthrate and it refused to allow meaningful immigration, so its economy ran into an inescapable headwind.
Looking to the future, Ip wrote that China is sure to run into a similar headwind, quite likely an even stronger one, because it’s one-child policy reduced birth rates and increasing wealth brought its birth rate to 1.6%. Ip added, “In 2026, China’s population should start to decline. It may be the first country to grow old before it grows rich.”
Comparing another pair of countries helped Ip make his point about productivity. The Philippines has 21 times as many people as Ireland—but their economies are roughly the same size. The difference? Productivity, the ability to make more things with the same or less labor.
Productivity, in turn, depends on two other factors, capital and ideas. Capital can make workers more productive by providing them with better facilities and better tools. Ip cited the example of a farmer who is given more land and a bigger tractor, allowing him to grow more food at a lower cost.
Capital
Capital is created when someone saves rather than spends, which means deferring their income or pleasures into the future. Saving originates in many places: households, businesses, foreign investors and even governments sometimes. He wrote, “The more a society saves, the more capital it can accumulate.”
There are, however, limits on saving. Using Ip’s example, a farmer’s second tractor will increase productivity less than the first tractor. Economists have a name for this effect: “the law of diminishing returns.”
Ideas
Ideas are the third determinant of national prosperity; this means combining labor and capital in new and different ways. For example, when DuPont (DWDP, Financial) discovered nylon in the 1930s, the textile industry became more productive: Nylon fibers could be spun with far fewer steps and at higher speeds than cotton or wool. That productivity increase led to cheaper and better clothes.
Ip wrote, “The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea can be reproduced endlessly for free.” For innovators, this can be a source of frustration, but for everyone else, it means higher productivity, leading to higher standards of living.
Ideas are many and diverse. Ip chose these examples of ideas contributing to greater productivity:
- Better business processes: The classic case is the one cited in Adam Smith’s book, “The Wealth of Nations,” in which an 18th century factory divided the pin making process into 18 different tasks. This allowed one man to make 4,000 pins a day, while he could make only one a day working on his own.
- New products: Internet browsers allow users to easily access and use the internet and are constantly getting better, despite the fact they are free. Another example: Eli Lilly (LLY, Financial) brought out Prozac in 1986, and soon after competitors began developing alternatives such as Zoloft and Celexa.
Although ideas can be patented or copyrighted, legal variations can be created once the initial idea finds success. Similarly, ideas can be plagiarized or pirated, as appears to be the case with some Chinese-made products. Both legal and illegal copying, as well as adaptation, can help nations immensely in their bid to modernize their economies.
While governments aren’t always welcomed in the business arena, they can take two types of measures that affect economic progress:
- Education: Human capital is enhanced when workers are well educated and trained. As Ip noted, “It’s no use equipping workers with the most advanced equipment in the world if they can’t read the instructions.”
- Rule of law: Investors need some confidence that the theft of ideas will not impair their capital, and so governments must offer transparent laws, impartial courts and the right to property.
There is also the issue of government integrity, meaning corruption is kept under control. Ip also took on the question of whether democracy is necessary for growth; he concluded it is more effective although not completely necessary. After all, many Asian countries with dictatorial powers rather than democracy have made huge strides in recent years.
In summary, Ip’s book, "The Little Book of Economics: How the Economy Works in the Real World," explained the importance of people, capital and ideas in growing an economy. To show the difference population makes, he compared Japan with the United States. Productivity begins with the act of saving and allows labor to multiply its effectiveness, while ideas are the essentially free yeast that makes people and capital more effective and societies more prosperous.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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