Understanding the US Economy 2015 (Part 2 of 2, Video)

Part One is here.

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Assistant: Mack Agbayani

Script:

Chicago: Education (continued)

We also believe that the liberal arts curriculum could be rationalized. Current debate centers around the validity of liberal arts, which offer development of critical thinking, versus vocational training, which offers skills necessary for performing a job. The US education system favours the liberal arts; on the other hand, many available jobs, including jobs for lower-income individuals, are out of reach for students because of lack of vocational training. This is known as the “skills gap” problem. Why not combine both for a cost-effective solution? For example: give liberal arts students the choice to pursue a rigorous study of business or other fields after they complete two years of a rigorous liberal arts education. That skips getting a two-year MBA and widens the number of job opportunities for these students. Using Massive Online Open Courses, or MOOCs for short, would also help. Cost rationalization for grad schools, the debt of which accounts for almost 40% of student debt, could have further benefits, such as helping reduce the cost of US healthcare, via lower costs of med school.

Going back to our discussion on US inequality, the fact that tuition continues to increase does not bode well for individuals from low-income backgrounds, as they most likely would need to take on debt for their education, given the vicious cycle of tuition increases we discussed. But the obstacles for such individuals run even deeper.

Grade schools are funded by local property tax, meaning that rich neighbourhoods immediately have access to higher quality education than poor neighbourhoods. Richer Americans can also afford test prep and extracurriculars, two factors that weigh heavily on college acceptance. It also doesn’t help that the most elite colleges benefit from rich alumni. The top 50 richest universities had a median endowment of $3.5 billion, compared to the median of all schools at $113 million. As a result, students in less wealthy universities have to pay more tuition than those in richer ones.

This might be defendable if many of the students at richer universities are not necessarily from rich backgrounds and got in on their own merit. Unfortunately, elite schools do have at least some biases in their selection process for children of alumni and professors, as well as “development cases”. So far from being a mitigator of class entrenchment, the US education system exacerbates it. Any moves toward cost rationalization would involve changing longstanding practices and potentially run up against entrenched interests.

Sounds like a tall order – is there anything else that could help reform education and mitigate class entrenchment? Let’s head West to look for our potential salvation – or ruin.

San Francisco: Technology and Productivity

I was born and spent my early years in San Francisco. I hadn’t been back in ten years. Some things look more or less the same, in a good way.

Some things have definitely changed for the better. The explosion of food trucks, an unexpected benefit from the Great Recession, has definitely led to some interesting culinary innovations. From our own observations, it’s interesting to note that while New York probably has more diversity of food options, San Francisco boasts a lot of fusion food – particularly between Asian and Latin cuisines, perhaps unsurprisingly, given California’s location. I also saw a lot of these guys specifically in SF. Is it me or is this a specific SF or West Coast look?

Okay, let’s go ahead and address the elephant in the room: The tech sector.

Twitter. Dropbox. Mozilla. They and many others have made San Francisco their home. And many others, such as Facebook, reside in nearby Silicon Valley. With big tech comes big money, driving up rent to a degree unreachable to many. Why don’t people want to live in Chicago? It’s cheap and cosmopolitan – probably the weather?

This is pretty cool. A dedicated laptop cafe where you can just pay by the hour. Makes sense in San Francisco where people can just code on their laptops. I would personally love to see this elsewhere around the world!

Anyway, expensive real estate is a drag on GDP. It pushes workers out of the city and into less productive jobs, or wastes their time with a long commute, both of which are drags on productivity (more on that in a bit). As an article in Quartz pointed out, you can remedy this in two ways. 1) Build more within the city (doesn’t sound feasible in San Francisco because the townhouses are cute) or 2) improve transportation to the city. Something to consider – but, given the fiscal issues of the government and divisive politics, such proposition seems difficult.

With the tech sector so big and squeezing people out of San Francisco, surely, in exchange, it must be truly adding value to the economy, right? Well, there is genuine value being created. For example, going back briefly to the issue of US education, tech startups such as Make School are working to bridge the “skills gap” by using software and a hands-on approach to teach vocational skills. Furthermore, big companies like Google, Apple and Facebook provide products on which everyone all over the world relies, and Uber and AirBNB are disrupting traditional industries, to benefit of the consumer. On the other hand, it’s… hard to justify some of these other apps.

Perhaps one reason why the US tech industry is so dynamic is because, as we previously discussed, the tax regime is favorable to investment. In fact, this chart shows that the US leads the way in venture capital funds, which are funds that invest in startups. With the dynamism of the tech industry and a tax code favorable to venture capital, the US ranks as one of the most innovative countries in the world.

VC

The presence of so much money in this industry has led to proclamations that the tech industry is in a bubble. Let’s look at the factors underpinning this phenomenon.

Perhaps you’ve heard of the “unicorns” in Silicon Valley, which are tech startups valued at $1 billion or more. The number of unicorns is growing, even as many of these unicorns may not be profitable – to give you an idea, Uber, Snapchat, and Spotify are reportedly not making a profit, while AirBNB’s business model has been criticized.

So what’s leading to these sky high valuations? Well, here’s another vicious cycle. Private investors have been throwing money at tech startups, helping these firms hire more and build credibility. In return, these startups promise to pay these investors back the moment they go public. They also grant these private investors insurance in the form of free additional shares should a startup’s valuation be less favorable in a subsequent round of financing. The problem is that these PRIVATE valuations may not align with reality when the startup goes PUBLIC and the public gets to look the startups’ balance sheet.

bubblechart

Source: CB Insights; data analyzed by Funding Your Tech Startup

Regardless, as private valuations continue to rise, these privately-funded startups have caught the attention of non-private investors, such as mutual funds, who are supposed to invest in publicly-listed securities but are somehow investing in private ones. Does that make any sense to you? If we take a step back, this is just one more asset bubble that has been created as a result of the loose monetary policy (for reference, see our blog post on monetary policy) used to prop up the economy following the Financial Crisis. After all, all of these money managers need to put their cash somewhere to earn a return, right?

Nontrad investors

It’s difficult to say HOW and when EXACTLY the tech bubble will pop, but when it does, our concern is less about Main Street – as most of these companies are not public, retail mom-and-pop investors likely won’t be directly affected. Our concern is what happens to the sizeable portion of the upper middle class employed in this industry. Maybe some will find their way to other industries, but will others return to the controversial investment banking and consulting industries?

One unique feature about the technology industry is that it has a very decisive effect on GDP, beyond the production of goods and services. Technology produces advancement in productivity, which, over the long run, is an important input to a country’s standard of living. This is because productivity creates economic growth without higher inflation, meaning that firms can pay their workers more even as their own profits increase. Productivity is generally measured as the amount of GDP produced per hour of work. The basic idea is that the more value a worker can produce, the higher our standards of living. Technologies that enhance productivity also can also keep some specialized manufacturing jobs within the US in the face of globalization.

Historically, the system has largely worked. As Robert Lawrence of the non-partisan Peterson Institute for International Economics points out, if you look at wages of all workers – both high-skilled and low-skilled, and adjust to include benefits and make an apples-to-apples comparison between production and consumption, productivity and real compensation have grown more or less in tandem, meaning that “workers are rewarded for improvements in productivity.” This has been true up until around the 2008.

lawrence20150721-figure5

Why productivity growth has been outstripping real compensation for both low- and high-skilled workers since then is open to interpretation. Some reasons could be increasing globalization, with wages going abroad, or increasing automation which is reducing headcount or wages, or both. What we do know is that, despite an improving economy and hiring, wage growth has been constrained.

Labor Productivity

We also note that productivity growth itself has been slowing. Regarding the longer-term issue of productivity, two schools of thought have emerged to explain slow productivity growth. The optimists believe that, as most of the recent technological innovation has been software-driven, it is difficult to measure how much value recent technological progress has been adding to the economy – seemingly weak productivity growth may be understating an improvement in our standard of living.

Pessimists believe that all the low-hanging fruit of technological innovation have already been plucked. Think about how much recent innovation has been centered around the internet, versus the massive social transformations of previous innovation waves that affected multiple sectors from transportation to manufacturing to medicine. Combining relatively weaker technological progress with a smaller population, according to some, will lead to lower GDP and weaker job creation in the future.

We would add a long-term risk, or benefit, depending on how you see it: the advent of artificial intelligence. That AI is replacing human labor is not anything new, but the possibility of replacing substantial segments of high-skilled work looms on the horizon. Of course, the optimistic view is that AI will spur the human labor force to pursue more creative, higher value-add pursuits.

Technological progress and productivity gains are hard to predict, but are vital to the US economy. Let’s head back East and wrap everything up and see where the US economy stands in 2015.

New York 2: Summary and Conclusion

Here we are, back where we started. We’ve covered a lot in our journey, so let’s sum everything up, with this chart.

Source: Art and Finance

Source: Art and Finance

As you can see, a lot of what occurs with the US economy, just like with any economy, is related to the current tax regime and how it influences and incentives human behavior. A relatively inefficient system of collection exacerbates the increasing deficit, which may lead to higher taxes or more borrowing. And regarding taxes, on the one hand, the tax system does exacerbate class entrenchment, such as through local property funding of schools. It also increases the level of inequality by favorable treatment of financial assets.

On the other hand, favorable treatment of financial assets has helped spur technological innovation. Over the short- to medium-term, the manufacturing sector may improve due to fracking, even helping employ some blue-collar workers. The same can be said for the tech sector, which is employing high-skilled workers. Over the longer term, technological innovation theoretically leads to a stronger economy and higher standard of living. Of course, this depends if each new innovation brings about the same level of social change that those before it have brought.

Looking at this chart, it appears that productivity enhancement is the only real factor that will benefit the US economy over the long run. That makes sense, as productivity helps increase society’s standard of living. While it’s difficult to forecast productivity enhancements, what Americans can do is mitigate the risks to their economy.

  • Clearly, one measure could be to reform the tax system.
  • Regarding employment, while tech and fracking are helping employ high- and low-skilled workers, these booming sectors are subject to the business cycle and may go bust at some point. For low-skilled workers, a national manufacturing strategy similar to what ITIF advocates may be beneficial.
  • Regulatory agencies have to be reformed to avoid regulatory capture, as is the case with education. But the problem of regulatory capture permeates throughout US business. Think of the arguably insufficient regulation of the Finance industry that helped lead to the Financial Crisis. Perhaps a much broader solution, then, is to apply what we call “The Singapore Argument” – basically, have an efficiently run government that pays highly-qualified civil servants competitive wages which helps incentivize them to combat negative activities of the various interest groups in the US economy.

Of course, these solutions are far from easy to achieve, and often require monumental cultural change. Not only that, but even getting a large part of US society to agree on the specifics of what needs to be done is an additional hurdle, to say the least. Over the long term, however, such changes may be necessary. While the US economy is currently recovering, with higher sales, more business spending, and more job openings, what happens when the next financial crisis occurs?

Maybe we’re looking too hard into the crystal ball, but, in the future, if the US is hit with a double-whammy of a major economic crisis and even higher amounts of inequality, we could see political instability. Sounds kind of far-fetched, right? Maybe not.

Some might argue that there have always been crises in the US and the country has managed to get through them, and any in the future would be no different. We would caution against projecting the past onto the future. This isn’t the 20th century anymore. As we’ve noted, productivity may not be increasing enough to offset the risks we’ve highlighted and keep the economy growing in a meaningful way.

While life has never been good for lower-income groups, and globalization without meaningful recourse is destroying the middle-class way of life, what’s interesting is how the US’ sizeable upper middle class has been acting in light of increasing inequality. As political commentator Chris Hayes noted, both the Tea Party on the right and Occupy Wall Street on the left during 2012 were largely upper middle class movements. If the upper middle class as well perceives that their lifestyle is disintegrating, the political risk becomes more real.

After all, this is the college-going group that is taking on student debt. With the rise of other economies like China, how would they be able to compete against job candidates who are just as qualified and relatively cheaper, given US workers’ comparatively higher student debt burden? You could argue that, given its dominance of university rankings, the US produces better-educated high-skilled workers, but a recent report from the Social Sciences Research Council shows that a significant percent of US students, including those at elite universities, fail to show significant improvement in critical thinking. If, in the future, the US upper middle class gets hit with increasingly higher tuition and lower-paying jobs, well – that could be a problem.

To our non-American viewers, the fate of the US economy has an impact on you, as well. Here is a non-exhaustive list of three reasons why:

  • The US is still the world’s largest economy, and it has a trade deficit, meaning that it imports more than it exports. If it goes south, so do a considerable amount of exports from other countries.
  • US military might is at least somewhat keeping relative peace around the world. What happens to their military if there is a major domestic political crisis?
  • The US dollar is the world’s major reserve currency. This means that other central banks hold a significant number of financial assets denominated in US dollars. Perception plays a major role in financial markets, and if the US is perceived as being risky, this perception could devalue US-dollar assets, potentially sparking another global financial crisis.

Therefore, it’s in everyone’s best interest that the US avoid political instability. But it is the American citizens that have the power to change things. Similar to Japan, the US is a democracy. Citizens can vote for change. And this is perhaps the greatest strength of the US economy. Similar to other developed Western nations, the judicial system is relatively independent, and citizens can exercise their rights. Remember, this is a country that once impeached the most powerful man in the world. There can be change without instability. If you are a US citizen, we hope this video can help you make educated decisions when you vote. The country, and maybe even the world, depend on it.

Thanks for watching, and we hope this video was helpful. Just to remind everyone, there won’t be a new Youtube video for a while as we are busy expanding Art and Finance – but please do visit our site! artandfinance.net. You can follow us on Facebook and other social media, which you can find in the description. You can also buy merchandise and artwork, also in the description. Thanks and see you again soon!

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Art and Finance

Sources/Further Reading:

Chicago: Education

“That ‘Useless’ Liberal Arts Degree Has Become Tech’s Hottest Ticket” (Forbes)

“Liberal Arts Majors Are Screwed” (Business Insider)

“Lack of vocational education stifles US mobility” (Financial Times)

“How Liberal Arts Colleges Can Stop Fueling the “Skills Gap”” (Harvard Business Review)

“Grad-School Loan Binge Fans Debt Worries” (Wall Street Journal)

“America’s new aristocracy” (The Economist)

“There are two Americas for kids now, thanks to income inequality” (Quartz)

“Why does a college degree cost so much?” (CNBC)

“Why Elites Fail” (The Nation)

San Francisco: Technology and Productivity

“Five Facts About Housing That Will Make People In New York City and San Francisco Depressed” (Bloomberg)

“How cheaper housing can boost productivity” (The Economist)

“New York and San Francisco’s insane housing prices are dragging down US growth” (Quartz)

“Make School Wants To Build The Product University For The Masses” (Tech Crunch)

“Which countries have the most venture capital investments?” (World Economic Forum)

“The Bloomberg Innovation Index” (Bloomberg)

“Welcome To The Unicorn Club, 2015: Learning From Billion-Dollar Companies” (Tech Crunch)

“The Tech Industry Is In Denial, But The Bubble Is About To Burst” (Tech Crunch)

“Here Are the Internal Documents that Prove Uber Is a Money Loser” (Gawker)

“Snapchat Lost a Ton of Money Last Year” (Gawker)

“Spotify tripled its losses in two years. Is music streaming over?” (Mashable)

“Sharing economy disruption, maybe not so disruptive?” (Financial Times)

“The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies” (Bloomberg)

“Is there a bubble in Silicon Valley?” (Financial Times)

“Here’s The Evidence That The Tech Bubble Is About To Burst” (Business Insider)

“Financial sector in advanced economies is too big, says IMF” (Financial Times)

“House of Lies: How Management Consultants Steal Your Watch and Then Tell You the Time” (Amazon)

“Why Your Wages Could Be Depressed for a Lot Longer Than You Think” (Bloomberg)

“Labor Productivity” (Investopedia)

“Globalization and Unemployment” (Foreign Affairs)

“The Growing Gap between Real Wages and Labor Productivity” (Peterson Institute for International Economics)

“Guess What’s Destroying the Middle Class?” (Bloomberg)

“Robots Versus the Middle Class” (Bloomberg)

“Sputtering Worker Productivity Vexes Economy” (Wall Street Journal)

“Goldman: How ‘Grand Theft Auto’ Explains One of the Biggest Mysteries of the U.S. Economy” (Bloomberg)

“Beyond the Internet, Innovation Struggles” (Wall Street Journal)

“JPMorgan Economist: Get Ready for the Economy to Produce Way Fewer Jobs in the Future” (Bloomberg)

“Robots Versus the Middle Class” (Bloomberg)

New York 2: Summary and Conclusion

“Banks’ World Under Dodd-Frank Takes Shape With Volcker Rule” (Bloomberg)

We should pay politicians a lot more: Freakonomics author (Yahoo)

“GDP Numbers Reveal Underlying Momentum, Possible Headwinds for U.S. Economy” (Wall Street Journal)

“US employers post record job openings” (Financial Times)

“Twilight of the Elites” (Google Books)

“Improving Undergraduate Learning: Findings and Policy Recommendations From the SSRC-CLA Longitudinal Project” (Social Science Research Council)

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