US Economy: Is New Growth Economics the Cure?

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There are three major economic growth theories: Classical economic theory, Neo-Classical theory and New-Growth Economics.

Classical theory states that the output of a country depends on the capital available per worker. If capital per worker increased output would increase. The problem with this theory is that it does not account for important factors like technological change and the stock of knowledge. There are many African countries where capital per worker has increased in recent years due to the discovery of natural resources such as diamonds and oil. Nigeria and Sierra Leone are examples of such countries. Though oil was discovered in Nigeria in 1956, in 1998 Nigeria ranked 151 of 174 countries assessed under the United Nations Development Program’s Human Development Index. The majority of the population has the lowest living standards in Africa. Similarly diamonds were discovered in Sierra Leone in 1930; however, the United Nations listed the country among the World’s Poorest Countries of 2003. Thus when we apply the Old Classical theory to these countries, it is proved incorrect (i.e. though the capital per worker increased the output did not increase). This is because even though the capital per workers increased, there were no technological innovations in these countries. Moreover the capital fled abroad to escape instability at home

The Neo Classical theory tries to address some of the problems with the original classical theory. It states that economic growth is dependent not only on capital and labor but also on technology. Robert Solow isolated the sources of economic growth using a growth accounting equation. His contribution is to explain the sources of long-term economic growth. One problem with Solow’s theory is that it does not explain the reasons for the difference in economic growth rates between countries. Solow predicted that there would be convergence in the standard of living of all the countries of the world. This is because the growth in developed countries would stagnate because of the diminishing return to capital per worker and capital would flow to developing countries where there would be higher rates of return. Invested capital would in turn, lead to convergence between the developed, underdeveloped and undeveloped countries. However, in practice, the convergence predicted by Solow has not happened because growth in advanced countries continues to increase due to technical progress and also the capital does not flow to underdeveloped and undeveloped countries because of factors such as political instability and lack of institutional reforms. Conditional convergence occurs among countries with similar economies and cultures but not among dissimilar economies. Hence we find that both the classical and neoclassical growth theories do not adequately explain the differences in growth between various countries. The theories do not consider the fact that the wealthy and developed countries can improve upon their existing knowledge base and maintain the lead over the other countries due to technological innovation.

The New Growth Economics proposed by Paul Romer and Robert Lucas provides an explanation for the persistence of long run inter-country growth differences. These two economists from the University of Chicago proposed the theory in the 1980s. According to this theory, technology is endogenous (i.e. produced from within) and economic growth occurs from innovations that result from new ideas. New ideas come from many economic agents. These economic agents can be either privately or publicly funded. Some examples of the economic agents are the R&D department of a big corporation or a government funded entity such as NASA. These agents create new ideas from the pool of knowledge. The New Growth Economics can be represented as Y = f (K, L, H, A) where K is physical capital, L is labor, H is human capital, A is technological change and Y is output. The old classical theory concentrated on capital available for a country’s economic growth. Solow emphasized the importance of technical innovation for long-term growth, but his work did not account for the causes of technical change. Romer and Lucas, on the other hand, identified the causes of technological change in their New Growth Economics theory.

In addition to putting emphasis on technical change, New Growth Economics also proposed public policies supportive of economic growth. The public policies are listed in below:

  • Free Markets
  • Intellectual Property (IP) Laws and Enforcement
  • Support of R&D (due to knowledge Spillover)
  • Human capital
  • Rule of Law
  • Need for Openness (free flow of ideas, people)
  • Democracy
  • Political Stability
  • Government Spending (productive spending)
  • Concentration on Technical Innovation like IT

Source: Applied MacroEconomics – Olivier Blanchard

In order for innovations to flourish, Lucas and Romer state that a free market form of government is essential. The US economy is a perfect example of their theory, where free market capitalism generates the majority of the technical inventions and hence higher economic growth. Every major business cycle in the US economy has been made possible by new innovations. Examples of this include the dynamo, railroad, microprocessor, computer, Internet, etc.

Are we following the public policies of New Growth Economics?

1. Free Markets – While the core of the free market principles are still followed some of the recent actions by the government such as the bailouts have prompted some folks to question if we are moving away from free market principles. In fact, there are some folks who say that things such as Social Security should not exist in an ideal free market. However I do believe that compared to most other countries the USA still has the best free market system in the world.

2. Intellectual Property (IP) Laws and Enforcement – The IP laws and their enforcement in this country are no doubt the best anywhere. For example, copying and distribution of music, movies, etc. are illegal and violators are taken to court by the IP owners. Similar rules are applied to companies for patents.

3.Support of R&D (due to knowledge Spillover) – The government and the private sector spend huge amount of their budgets each year on Research and Development. However it must be stated that some countries such as China are investing heavily in R&D to catch with the advanced countries. Knowledge Spillover occurs when a company files a patent. When other companies come to know of the patent they try to create better ideas.

4. Human capital – Some of the best and brightest minds in many fields live in our country. We continue to attract the best talent in the world.

5.Rule of Law – This is a country built on law and most of us follow the laws.

6.Need for Openness (free flow of ideas, people) – We encourage free thinking, free flow of ideas and we accept people from around the world no matter what their belief systems are.

7.Democracy – For a young nation, we have a highly successful democratic political system.

8.Political Stability – Compared to many other countries, political stability is not an issue in our country. For example in many emerging market countries such as India, Brazil, Chile political stability may not exist.

9.Government Spending (productive spending) – This public policy suggests that government spend its funds on productive projects. But what exactly does productive spending mean in modern times? Some may say even investments in infrastructure such as roads is not productive spending since it does not generate any additional return to the government.

10.Concentration on Technical Innovation like IT – Innovation can be one of the engines for growth. A few weeks ago Business Week had a cover story on how innovation is important for companies even when economy is in recession.

Questions to readers:

1. Should we follow all the public policies of New Growth Economic Theory to pull us out of the current mess?

2. Will New Growth Economics lead us out of this downturn?

3. Instead of encouraging bailing out banks and encouraging them to lend should the government increase its spending ?

4. Do we need to invest more in R&D and develop new products that we can export to other countries?

5. If we emphasize technical innovation as suggested by New Growth Economics or concentrate more on manufacturing and other high labor intensive industries?

Feel free to leave your answers in the comments section.

Three Australian Banks Offer Yields over 10%

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After the crash of the banking sector, the three Australian bank ADRs offer yields that are well above 10%. Just like any other bank that is cutting dividends or outright suspending them non one can be sure that these yields are sustainable.

However each bank is different and Australia is normal times is a stable country with a strong domestic economy. Australia is a regional powerhouse whose companies are heavily involved in many Asian countries. The country is heavily dependent on the commodity markets since it is a resource-rich country similar to Canada. These two countries are unique in a sense that they are both western style democracies, have developed economies and have stable political systems with an abundance of many natural resources.

The following are the three Australian Bank ADRs:

1.Australia & New Zealand Banking Group Ltd (OTC: ANZBY)
Current Yield: 12.67%

Many lawsuits have been filed against the bank recently due to not disclosing heavy losses sustained by the bank in its involvement with a failed brokerage outfit in Australia. One of the lawsuit says:

“The Company and its top executives violated the federal securities laws. The complaint charges that ANZ failed to adequately disclose the range of risks arising from its loans to Opes Prime Group Limited, an Australian stock brokerage firm that lent money to customers on margin. ANZ had lent hundreds of millions of dollars to this failed brokerage house, but without adequate disclosure of the risks the loans posed to ANZ. The day before the Company announced its losses stemming from exposure to Opes Prime, its stock (ADRs) closed at a high of $17.24. The following day, after ANZ’s announcement, ANZ’s stock price dropped to $14.57. ANZ’s stock is currently trading at $9.90.”

2. National Australia Bank Ltd (OTC:NABZY)
Current Yield: 11.83%

3.Westpac Banking Corp (WBK)
Current Yield: 10.26%

Westpac is Australia’s second largest bank.

Recently it emerged that Westpac and ANZBY plan to issue samurai bonds backed by the Australian government. Samurai bonds are yen-denominated bonds issued by foreign institutions in Japan. Since the bonds are to be backed by the government, they would have the same sovereign debt ratings which would lower the financing costs for the issuers.

Multi-Year Chart:

As the economic crisis continues to unfold and commodity prices remain volatile investors can keep an eye on the Australian banks. If the Asian economies of China, Indonesia, Singapore, Thailand, Malaysia and other countries gets worse then Australian companies could be hurt more.

Singapore 2009 Growth Estimates Cut

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The tiny city state of Singapore is not immune to the global economic turmoil. Up until last year Singapore had strong growth and was even hailed as the “Switzerland of Asia” due to many international financial institutions having offices there. The government of Singapore rode to boom and even granted licenses to develop huge casino/entertainment centers to attract tourist dollars from the fast growing Asian countries such as China, India, etc. One of the casino operators invited to build casinos near the city center was the Las Vegas Sands Corp. (LVS) owned by Casino Mogul Sheldon G. Adelson.

However in the past few months, Singapore’s economy has been hit hard just like other Asian economies. Real estate business has slowed and many foreign workers have been laidoff. Being a small country this actually reduces the population of the country as the workers leave for their homeland.

On Wednesday the Singapore government’s Ministry of Trade and Industry (MTI) “revised GDP growth forecast downwards to -5.0 to -2.0 per cent, lower than previous estimates of -2.0 to +1.0 per cent. “

They also stated that “the weaker economic outlook is due to faster and steeper decline in the global economic activity, as well as spill over effects on key sectors of the economy from the last quarter of 2008. “

Singapore does not produce many goods on its own. Its economy is heavily dependent on foreign trade as the Singapore port is a major hub for shipments from Asia to Europe, North America.As the global trade slows ports like HongKong, Singapore are impacted heavily. Hence investors can avoid Singapore now. Since not many Singapore stocks are listed in the US, the iShares MSCI Singapore Index (EWS) was the preferred option to own Singapore companies. Currently EWS has assets of $730M and the dividend yield is 7.26%.

It is also important to monitor to performance of the two OTC-listed Singapore bank: DBS Holdings (DBSDY) and United Overseas Bank (UOVEY).

DBS Holdings Update:

Today(Jan 21) DBS its “S$4 bln rights issue was oversubscribed”

“Singapore’s DBS Group, Southeast Asia’s biggest bank, said on Wednesday a S$4 billion ($2.7 billion) rights issue to boost its capital had been oversubscribed.

“Acceptances and excess applications have been received for more than the total number of rights shares offered,” the bank said in a statement.

In December, DBS said it would offer shareholders one new share for every two existing shares at S$5.42 apiece, which was then a discount of about 45 percent. DBS shares were 57 percent above the rights issue price at the close of trading on Wednesday.”

Source: Reuters

The successful rights offering shows investor confidence in DBS Holdings.

Utility Stocks offer Nice Yields and Growth

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Utility stocks are one of the sectors that offer shelter during severe economic downturns. Utilities offer many advantages that make them attractive. Some of the notable points about utility companies are:

1. They are highly regulated and have fixed prices. However they usually apply for price increases and most instances get approval.

2. They are monopolistic in the territory they operate. For example, in many towns and cities there is only one electricity provider since they are licensed by regulators and hence there are no competitors.

3. Utilities such as gas, electricity are necessities of life. Hard to imagine a world without them.

4. They have consistent revenues and in most cases their customers pay the bills on time. For example, most people will pay their electricity bills when due and this offers the companies a steady, predictable revenue stream.

5. Many utilities pay a large portion of their profit as dividends to investors. This is especially helpful to investors who require decent dividend yields.

6. Utility companies are stable and offer slow but steady growth.

A 5-year chart (2004-2008) of Dow Jones Utility Average (DJI) is shown below:

One of the easy ways to invest in this sector is via an ETF. The iShares Dow Jones U.S. Utilities Sector Index Fund (IDU) is an option. IDU has a yield of 3.83% and an asset base of a $533M. The portfolio is comprised of 76.70% electricity and 26.06% gas and multi-utilities.

The Top 10 Holdings in IDU are listed below with their current yields:

1. EXELON CORP (EXC) – 3.83%

2.SOUTHERN CO (SO) – 4.80%

3.DOMINION RESOURCES INC (D) – 5.06%

4.DUKE ENERGY CORP (DUK) – 6.13%

5. FPL GROUP INC (FPL) – 3.57%

6.Public Service Enterprise Group Inc (PEG) – 4.17%

7. FirstEnergy Corp (FE) – 4.40%

8. Entergy Corp (ETR) – 3.89%

9. P G&E; CORP (PCG) – 4.15%

10.AMERICAN ELECTRIC POWER (AEP) – 5.05%

For exposure to global utilities, one can look at S&P; Global Utilities Sector Index Fund (JXI) which currently offers a 2.75% yield.

Disclosure: Long DUK, FPL

Anglo Irish Bank Nationalized – Equity Worthless

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Yesterday January 16, 2009 The Government of Ireland nationalized the Anglo Irish Bank. The shares were suspended from trading in all the exchanges. Anglo Irish was listed as a sponsored ADR with the ticker AGIBY. The ADR last closed at less than a dollar at $0.12.The Department of Finance of the Irish Government says:

“The Government has today decided, having consulted with the Board of Anglo Irish Bank Corporation plc (“Anglo”), to take steps that will enable the Bank to be taken into public ownership. This decision has been taken after consultation with the Central Bank and the Financial Regulator which has confirmed that Anglo Irish Bank remains solvent. Anglo Irish Bank is a major financial institution whose viability is of systemic importance to Ireland. Anglo has a balance sheet of some €100bn with a substantial deposit base which the State is determined to safeguard. The Government has made clear that it will ensure its continued viability. Anglo Irish Bank will continue to trade normally as a going concern, with appropriate Government support as necessary. All Anglo employees remain employed by the company.”

The government backtracked on its earlier proposals to bail out the plan. The authorities took the drastic action state take over of the bank since Anglo Irish was the most exposed to the commercial real estate market which collapsed with the downturn in the Irish economy. Officially the government statement said:

“The funding position of the bank has weakened and unacceptable practices that took place within it have caused serious reputational damage to the bank at a time when overall market sentiment towards it was negative. Accordingly the Government believes that the recapitalisation is not now the appropriate and effective means to secure its continued viability. Therefore the Government must move to the final and decisive step of public ownership.”

Until a few years ago the Irish economy was growing at an astonishing rate among the EU countries that it earned the nickname “Celtic Tiger” since the country grew from being one of the poorest in Western Europe to one of the most successful.

Anglo Irish’s reputation was seriously damaged when it was revealed last month that the Chairman Sean Fitzpatrick took loans of €87m from the bank secretly in the past eight years. He was forced to resign as well.

Hence the bank’s funding position and the chairman’s scandal which lead to the loss of confidence in the bank sealed its fate. The government decided that the best thing to do to protect the financial system was to nationalize the bank .

Incidentally Fitch downgraded five Irish institutions – Allied Irish Banks, Anglo Irish, Bank of Ireland, Irish Life & Permanent and Irish Nationwide Building Society on January 15th. Allied Irish Bank (AIB) and Bank of Ireland(IRE) ratings were dropped from AA- to A. The ADRs of AIB and IRE share prices are $4.05 and $4.07 respectively as of yesterday’s close. While each of these two banks are set to receive a bailout of €2bn each it is still very risky to invest in them at this time.