This being the 4th of July weekend, I decided that the week would be dedicated to a “Don’t Count America Out Yet” series. In that light, I went back to examine the NY Times articles from the late 1980′s admonishing American managers, praising Japanese manufacturing and long-termism thinking, and worrying over the purchase of American assets by the Japanese. In hindsight, it turns out that American business sold to the Japanese at the top and were able to buy back the assets on the cheap only a few short years later. It wasn’t, however, without pain. The US went through a severe recession in the early 1990′s, with high seemingly structural unemployment, banking crises in the form of S&L’s, a mideast war, and currency fluctuations (many would point in hindsight to the currency markets providing a key signal prior to the 1987 crash – although their predictive value a priori is questionable, at best). Yet the US, contrary to popular fears, was able to withstand the structural and economic challenges.
The natural question arises of “why?”. Was the US recovery predictable? Which factors led to our recovery? Are those factors in place today? Etc.
To answer the questions, I looked to the academic literature examining the comparative development of colonies, countries, and, more importantly, divergent economic structures. What I found was simultaneously encouraging and worrying. . .
One of the best articles I found was by Acemoglu, Johnson, and Robinson, titled Institutions and Economic Development.
In this paper, we discuss how and why institutions— broadly, the economic and political organization of societies— affect economic incentives and outcomes. After briefly surveying a number of theories of institutional differences across countries, we focus on two questions: why societies may choose institutions that are not good for economic development, and why institutions, even bad institutions, persist.
So what made me hopeful after my surveys? The papers I read mentioned two factors which, when applied to the US, should give us hope. First is the establishment of certain institutions. The most important of these are institutions which foster and protect property rights. Luckily, the US still retains its vast institution framework dedicated to property rights, the foundation for the efficient allocation of capital. Under the rent-seeking theory, protecting property rights is the main driver of political power struggles, and only through the establishment of clear procedures for transferring and maintaining property rights can business people make investments and can society encourage production. The second factor is the inertia associated with institutions. Once institutions are established, they are dificult and costly to change. Namely, once a country is on an inefficient path, the strucutural changes become increasingly difficult to shift. Again, since the US started on a path of property rights, representative democracy, etc. in the modified neoclassical tradition, the main foundations for the allocation of capital and resources have not changed.
In light of these surveys, our institutional foundation should provide a certain predictive value to the US weathering the current recession. However, a few notable should already come to mind. Said property rights are under ever-increasing threats. The GM bondholder saga is a manifestation of the expropriation of property by the government. Other examples abound; for example, the forced renegotiation of mortgages, forced mergers, and politically motivated infusion of equity capital. In this vein, the devaluation of currencies is a stealth tax, or a stealth expropriation of wealth by the government. The tide seems to continue. Everything from government-rationed healthcare, to ever larger ineffective regulatory bureaucracies (think Office of Homeland Security and a revamped financial regulator). The obvious second concern, is that once these institutions will be in place, they will be increasingly difficult to reverse. A quick example is Medicare, the US government mandated health care system. In this system, everyone over the age of 65 is covered, yet the bureaucracy is crippling and the system is bankrupt by all normal (read, non-governmental) measures. However, there is little political ability to reform the system, let alone start from scratch. The fear is that the new institutions and precedents will take us further down the wrong path.
Again, this being the 4th of July, I’ll focus on the positives. The preceding paragraph was pointing to some worrying signs, but should not be in and of itself discouraging. The US citizenry has not consented and might not allow the expropriation by the political elite. Certainly, it does not appear that everyone is on board to change the healthcare system so quickly. Second, our main focus here is on the investment front. In that light, investments are always relative to other alternatives. From that perspective, the US still remains a better long term protector of property rights than, say, China or Russia. Might these countries surpass the US in the near future on certain metrics? Of course. Yet, as an investor, I still contend that the risk premium offered by emerging markets debt, for example, is not adequately compensating me at this stage for the risk of expropriation of my capital (either directly or through the respective country’s own currency debasement). 4-10% risk premium over Treasuries? Hmmmm. Maybe at the high end it’s enough of an incentive for some shorter term investments (i.e. bonds, currencies) but I’m not taking that risk for the next decade of two for only a few percents. So the US, in my mind, still retains at least one competitive advantage: institutions. Flawed, but still the world leader.
Academic, Strategy/Allocation | Yaron Sadan | 
December 8, 2009 11:36 am | 
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