“In order to find good predictors of non-financial sector performance, and GDP growth generally, we look to the non-financial sector itself. One of those predictors is the profitability of non-financial capital, or the “marginal product of capital” as we economists call it. The marginal product of capital after-tax is a measure of how much profit (revenue net of variable costs and taxes) that each unit of capital is producing during, say, the last year. When the marginal product of capital after-tax is above average, subsequent rates of economic growth (and subsequent marginal products of capital) also tend to be above average.
Since World War II, the marginal product of capital after-tax averaged between 7 and 8 percent per year. During 2007 and the first half of 2008 – exactly the time when financial markets had been spooked by oil price spikes and housing price crashes – the marginal product had been over 10 percent per year: far above the historical average. Compare this to the marginal product of capital in 1930-33 (the years of Depression-era bank panics): 0.5 percentage points per year less than the postwar years and significantly less than in 1929. The marginal product of capital was also below average prior to the 1982 recession (in this case, far below average) and prior to the 2001 recession. Thus, the surprise was not that GDP continued to grow 2007-8 despite the bleak outlook from Wall Street’s corner of the world, but that GDP growth failed to be significantly above the average. More important from today’s perspective is that much capital in America continues to be productive, and that this will likely permit Americans to advance their living standards as they have in years past. The non-financial sector today looks nothing like it did in 1930. “
Casey B. Mulligan, “Wall Street will drown alone”, Supply and Demand Blog (28 September 2008).
http://caseymulligan.blogspot.com/2008/09/wall-street-will-drown-alone.html
Professor Casey Mulligan is a faculty member at the University of Chicago's Sloan Center on Parents, Children and Work. His interests include intergenerational mobility and non-pecuniary incentives for behavior.
There is of course plenty of bleak news on the financial crisis and it would be easy to find a Tdj that can tell us how bad Paulson’s Pig is and how it portends the end of free enterprise and will bring on “the end of the world”. I have pontificated elsewhere that it is inevitable we suffer a recession, and a steep and prolonged one at that. I also see the world economy as entering a period of slow and halting growth, with recessions in Europe and Latin America. I have said this even though I do not believe the financial crisis, by itself, is all that bad. To my mind, when all is said and done, at most 10 or 20 per cent of the mortgages in the U.S. will provide to be non-performing and while this is certainly not good, it is not a disaster deserving of the attention it is now getting. The Fed and the Treasury, I would guess, overreacted, and now the financial sector of the U.S. is being radically revamped for reasons we’re not quite sure of. We no longer have investment banks, many securities firms have morphed into bank holding companies, and many firms on Wall Street have closed their doors. I wonder whether all this was really necessary, especially since much of the sub-prime problem can be laid at the door of the Congress, and the loss of financial diversification on Wall Street now underway lowers the ability of the financial system to absorb shocks. To be sure, the financial sector had to shrink and shrink significantly. But given the shocks of recent months and the sudden deflation of capital asset values, what could have been an adjustment spread over many years has now come upon us in a moment, and is being spurred on by the sledgehammer of government intervention.
Fortunately for the U.S. and the world, when it comes to forecasting the future of the economy, I am often wrong. Casey Mulligan is optimistic and he may well be right. As I have said elsewhere, the strength of the real economy in the midst of this financial storm surprises me. Capitalism, as Schumpeter reminds us, is a tremendously adaptive economic system spurred on by the smell of profitable opportunities. If the marginal productivity of capital is on the rise, as Mulligan tells us, nothing -- not a financial crisis and certainly not the hopelessly uninformed attempts of the political class to hinder determined entrepreneurs -- will prevent the economy from expanding or at least holding its own. Profit, after all, as Marx knew (“The magnitude of the profit whets his [the Capitalist’s] appetite for more profit”), is the driving force of Capitalism and the sure spur to its continued growth. If beyond our ken there are developments in the economy we can neither see nor predict, as Mulligans work suggests, the economy will surprise us.
If it does surprise us, let us pray it surprises us for the better.
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