Tuesday, July 15, 2014

Risk & Valuations, Part 10: Risk Aversion and Demand for High Wage Labor in International Markets

I think one of the reasons my alleged inter-relationships between debt, equity, and labor in this series of posts sometimes seem counterintuitive is that there is a broad tendency to think of debt in terms of consumption time-shifting, so we tend to treat it as part of a narrative of greed, impatience, and risk-taking.  But, this is only fitting for unsecured consumer debt, which is a small portion of outstanding debt.

Most debt is simply an instrument of ownership, and represents risk aversion.  Debt is the product of risk trading, where asset owners buy local certainty (see Parts 1 through 9) while retaining ownership.  (Here, I am treating debt and equity holders as owners, since they are both claimants on the output of productive assets and are both sources of capital in an enterprise.  The difference is that debt holders buy local certainty from equity holders - receiving a fixed payout in exchange for an uncertain return with an expected premium.) More debt in this context represents a context where more owners wish to avoid manageable volatility.  Note that more debt would still create systemic risk, since it would push local risk onto a smaller portion of the economy's owners, but this risk comes from a surplus of risk aversion, not a surplus of greed.

I don't know how much this matters in cyclical analysis.  Here is a historical graph of US financial liabilities.  To the extent that there is a cyclical pattern, liabilities have risen when demand shocks led to sharp declines in equity values and pushed liabilities into disequilibrium, especially in the most recent two cycles when demand shocks were especially sharp.  Liabilities have returned to lower levels as the economy has recovered.

(I have been putting the idea forward that baby boomers are creating demand for local certainty, but the long term trend in liabilities as a proportion of financial assets does not reflect a unusually high demand for liabilities.  The tax effect that reduces corporate debt levels, the lower corporate leverage that results, and the coincident high equity premiums could lead to a context where the higher levels of equity mean that equity represents a less leveraged position on local volatility.  The demand for low risk might be accommodated with equity that, itself, represents lower risk as an alternative to debt which is in lower supply and which has very low returns.  Equity becomes less systemically risky as its share increases, whereas debt becomes more systemically risky as its share increases, so, possibly, markets naturally accommodate high risk aversion without leading to systemic risk by accommodating that risk aversion with less leveraged equity.)

So, we have a model where the motivating factor is the avoidance of local volatility, which is achieved through risk trading, where remaining equity holders take more of the manageable risk and debt holders and laborers enjoy more stable near-term contexts.  The counterintuitive result of this trade, facilitated by the tax benefits of debt and labor expenses is that relatively higher equity risk premiums and lower interest rates lead to lower levels of debt and labor utilization.

This relates to another topic where I would reverse the standard narrative - international capital flows and wage levels.  It frustrates me to see economists universally referring to the movement of production to low wage economies, when the opposite is true.  Sometimes when the earth revolves around the sun, it looks like the sun is circling the earth.  And, here, we have uncontroversial data that capital flows overwhelmingly to high wage economies.  In cases where capital flows change noticeably, it is usually where institutional improvements in a developing economy lead to an expansion in the productive basket of goods they can supply, and so capital flows there to accommodate the new production.  Because wages are generally low at an absolute level, it appears that production is moving to exploit low wages, but this is absolutely wrong.  The trigger for expanded production is also a trigger for higher wages.  Production doesn't move to where wages are low - it moves to where wages are rising.  This subtle distinction is so fundamental and so important to a proper understanding of international economics, and yet so universally misstated.

http://conversableeconomist.blogspot.com/2014/06/snapshots-of-foreign-direct-investment.htmlTimothy Taylor had a recent post on Foreign Direct Investment.  Here is a graph he posted, from UNCTAD.  Capital flows are much higher to developed economies, but flows to developing economies are increasing as those economies catch up.  Here is a table from UNCTAD of the major recipients of capital from the US, which are all high wage economies:

And, this idea happens to line up quite well with my counter-intuition about labor and debt levels.  Firms invest in economies with higher wages.

Of course, much of the wage differential reflects different levels of productivity.  But, if we think in terms of risk trading, some of the wage differential is a payment to equity capital from the risk trade with labor.  In developing economies with higher risk premiums, wages will capture a smaller portion of the producer surplus.  Again, this will appear as if corporations are exploiting low-wage economies in order to increase profits, but the higher profits are just a product of the higher risk posed by the foreign investment.  And, because we have a risk averse nature, owners will be enticed to move more capital to contexts with low risk premiums.

Here is another Timothy Taylor post - this one on labor share of national incomes.  He points to a global decline in labor's share of income.  To his list of reasons for the drop, I would add the global baby boomer demographic pattern, which is probably feeding the current decline in risk free interest rates and the high premiums on equity investments.  Here are three graphs he posts from an International Labour Organization Global Wage Report, which compare labor portions of income from several developed and developing economies.  The relationship between GDP and labor share is clear.  My risk trading paradigm argues that improving institutions leads to lower risk premiums and higher productivity.  Increasing wages come about due to both increasing productivity and decreasing equity risk premiums, which decreases the price of the risk trade labor tends to make with equity owners.  Investment is attracted to this high wage, low risk context.  Higher compensation shares come, in part, from lower equity risk premiums.  We are the 100%.

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