Arnold Kling  

Macro and the Organizational Capital Model

The Right Minimum Wage Questio... Hummel's Three Laws and WWII ...

Robert Shiller writes,

Consider this possibility: after all these months, people start to think it's time for the recession to end. The very thought begins to renew confidence, and some people start spending again -- in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

Shiller sees herd behavior a lot--it was he who coined the term "irrational exuberance," which was later made famous by Alan Greenspan. I would point out that in an affluent society, there is a lot of consumption that is deferrable. If everyone scans the headlines and sees "Great Depression," that could very well cause a drop in consumption. And if everyone scans the headlines and sees "recovery," they might spend more.

We could also observe herd behavior among producers. I have been talking a lot about Garett Jones' remark that today's work force produces organizational capital rather than widgets. It is time to elaborate on this notion.

In the 1970's, for two summers I worked in a factory. We assembled speakers that are used in buildings to provide what is known as "elevator music." My jobs included brushing coating on to the speakers, attaching padding to the coating, working a rivet gun to attach rivets to the speakers, and boxing the speakers with hardware for shipment. Our work load was proportional to the level of orders for speakers.

Since then, I have worked in two businesses, and in both cases the work force produced organizational capital.

When I worked at Freddie Mac, you could measure volume in terms of mortgages guaranteed or mortgage securities issued. But there was no assembly line where workers stood and stamped guarantees on mortgages or wrapped mortgages into pools to be shipped to buyers. The work involved developing better systems for pricing, managing credit risk, and hedging interest rate risk. The number of workers Freddie Mac needed varied with the scope of business, but not with the scale. That is, if we wanted to buy a new type of mortgage, that required new people. But buying more of the same type of mortgage required no new people.

At any given time, you could have run Freddie Mac with one quarter of the work force that we had. Perhaps another tenth of the work force was doing nothing useful at all. (Some people would have argued that this portion was considerably larger.) All the rest were working on ways to improve the business. For example, right before I left the company, a huge task force was put together to implement a change from human underwriting of credit reports to the use of credit scores. A classic example of investing to build organizational capital.

Next, I started an Internet-based business that evolved into a web site that offered information to workers who were relocating and earned revenue from advertisers of services to people who were relocating. Again, the scope of the business depended on the number of people, but the scale did not. The number of people it took to run the web site depended on the complexity of the business, not on the number of visitors to the site. One major project was to develop a calculator that would match a neighborhood in one city with a similar neighborhood in a different city, based on data supplied by a marketing firm on demographics and other factors. Another major project was to integrate our web site with that of a company with which we merged that had information on schools.

Thus, my experience fits very well with the notion that workers are needed in order to build organizational capital. In today's economy, the organizational capital often is embodied in a computer system of some kind. Those systems depreciate very rapidly, because of technological innovation and the evolution of business demands.

Other forms of organizational capital are embodied in human capital. For example, an airline needs to have an effective program for training its employees and for ensuring the quality of their work. If your flight attendants are surly, some of your customers will switch to a different airline next time.

The macroeconomic significance of all this is that the choice of when to invest in organizational capital is discretionary. If you read a bunch of headlines that say "economic downturn," you can cut back your labor force to just the number of people needed to keep today's business operating. If you read a bunch of headlines that say "recovery," you may become inclined to invest in projects that make your business more complex or more competitive.

Given this framework, a temporary government spending stimulus may not cause much of an increase in employment. Why build organizational capital to meet a temporary need? Instead, something like a payroll tax cut might increase employment at firms that are otherwise considering new projects, and it might reduce layoffs at firms that are trying to decide how much they need to reduce short-term costs in order to survive.

COMMENTS (8 to date)
david writes:

Might be even cheaper budget-wise to pay newspapers to publish optimistic headlines, given this theory.

Earlier this year, there was a lot of snark among the econoblogs that when an actual crisis occurs, macroeconomists just degenerate into armchair psychologists.

That was nearly a year ago, in fact. The lesson doesn't appear to have sunk in yet.

Felix writes:

I'm not sure whether "producing organizational capital" is something different from "producing information" or "producing knowledge" or whatever. It might be productive to figure out what these things are, really.

Be that as it may, I've noticed when producing organizational capital it's good to have a deadline. Call it an artificial constraint, but a deadline tends to cause better organizational capital to come out the end of the assembly line. A Goldilocks deadline, that is. Not too tight.

Is that something general? Is it best to have organizational capital producers always a bit under the gun? Could the quality of organizational capital being produced be measured, economy-wide? And, if so, does the quality go up during the hard times relative to when the living is easy? Or, similarly, does the quality go down when fat times are at hand and everyone is flying around producing self-importance instead of high quality organizational capital?

Businesses invest to produce or buy durable, intermediate goods that lower the cost of future production or to produce new products. Machinery, efficiency research, trained employees, more locations, product development, or better organization.

It is all lost money unless there are more customers at current or reasonably predictable prices.

The government is threatening to take a large, unknown, increased portion of production as more tax, on everyone in the US. Its spending guarantees that this will happen. Or, it will cause inflation, which will produce unknown distortions in what people will be able to earn and what they will want to buy. Who wants to invest under these conditions?

We are carrying out a great experiment, to see what the level of US production and employment will be under a vastly more intrusive government that takes much more tax. I don't think levels will be anywhere near what was normal under our prior, imperfect, freedom and lower taxes.

Businesses can no longer use prices and inefficiencies as a guide for investment. From now on, absent a change in government attitude, it is who you know rather than what you know that will determine business success.

Consider, do you want to invest in General Motors (government run), or in Ford (privately run, competing with government)? How can one invest in either one?

More simply put, do you want to invest with Tony Soprano, or against Tony Soprano? (Tony Soprano is the famous, fictional mob boss made famous by HBO).

fundamentalist writes:

My favorite explanation for the economy's recovery from a depression is Hayek's "Ricardo Principle." Modern Austrians ignore it, but I think it's still valid. For the most part, depressions occur in capital goods industries and those industries that support them. The recovery comes when high labor costs persuade businesses to invest in labor-saving equipment, such as computers and software, or new airplanes.

guthrie writes:

I. Hate. Elevator music!

Jowana Bissaif writes:

I disagree with the suggestion that "today's work force produces organizational capital rather than widgets". Only a very small percentage of the workforce is doing product development or organizational development. The data are available at the US Bureau of Labor Statistics (BLS.GOV). Arnold has quoted that remark from Garett Jones several times and still hasn't given any grounds for ascribing any truth to it.

He's also mistaken when he says "the choice of when to invest in organizational capital is discretionary". Most actual investments in the area are ongoing and continuous, and are not very volatile. The industry sectors that invest more are the same ones year after year.

fundamentalist writes:

Great post over at the Adam Smith blog: “From the Annals of Entirely Counter-productive Government Interventions “In reality, the evidence is overwhelming that the February stimulus bill has added at least two percentage points to the unemployment rate. If Congress and the White House hadn't tried so hard to stimulate long-term unemployment, the US unemployment rate would now be about 8 percent and falling rather than more than 10 percent and — rising.”

Steve Roth writes:

Arnold, thank you! Nicely (if anecdotally) explained.

In all the businesses I've built, what I really wanted my employees (including myself) to do was make themselves obsolete: build good systems and procedures that automated/streamlined what we did, so they and I could turn our creative attentions to more useful (and interesting) projects.

(The make-yourself-obsolete/build-the-machine message was not popular with employees, so I didn't use it much. But some were able and willing to understand that the goal was to give them freedom to do cool creative stuff--to all our benefit--instead of twisting widgets repeatedly.)

>a temporary government spending stimulus may not cause much of an increase in employment. Why build organizational capital to meet a temporary need? Instead, something like a payroll tax cut might increase employment at firms that are otherwise considering new projects

You're essentially arguing that a supply-side stimulus (with some demand-side effect) would be more effective than one on the demand side.

My experience (personal and observational): producers invest in organizational and other capital when they're 1. expecting or 2. experiencing an increase in demand. Otherwise they stick to their knitting and protect their downsides. (IOW, prefer liquidity.) So supply-side stimulus goes into the bank, not into organizational capital.

Neither type of stimulus can strongly influence longer-term expectations. There's just not enough leverage given the size of the economy. But demand stimulus can fire the "opportunity" neurons in producers despite the uncertain future, causing them to invest even if it's not really rational based on long-term prospects.

Likewise, I seriously question the received wisdom about the impact of credit on growth. Producers consistently tell us that lack of funding/investment capital is the very last thing on their list of business constraints.

There's great hew and cry about the difficulties at CIT, and how small businesses rely on them to make payroll.

These companies are taking loans to make payroll? Should they even be in business? (All hail creative destruction?) Is the easy opportunity to shift payments forward by a month or two really crucial to macroeconomic well-being?

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