25 November 2011 at 13:50 GMT
Focus on framework for entrepreneurship instead of more regulation and solidarity policies
On a quiet day with the Americans only at work for a half day and Europe being more of the same, it seems more prudent to discuss the most important question today - namely what fosters economic growth?
Well basically two answers have been given in history; one following the Adam Smith (later developed by Schumpeter and Kirzner) and the other following the ideas of David Ricardo. Adam Smith was interested in the wealth-creation process leading to his treatise of division of labour, whereas David Ricardo had the vision of economic output as a function of the inputs of land, labour and capital.
The Ricardo ideas translated perfectly into the post-WWII production-function approach due to its ability for mathematical modelling as economics went from deductive human science to inductive applied science. This revolution lead to glorious growth models leading to mechanically advise nations to focus on inputs such as human capital (more education), consumption (due to Keynes' ideas), capital growth which all completely due to the models ignored the underlying institutions supporting economic growth. The country taking this production-function theory to the extreme was the Soviet Union which lead it to invest heavily in education (human capital) but the economic growth was pathetic because the country lacked the institutions and frameworks that foster economic growth.
Contrary to the mechanical Ricardo idea, Adam Smith's ideas of wealth-creation lead Schumpeter and then later Kirzner to develop a much more enlightened and compelling theory that links economic growth to entrepreneurship. Schumpeter saw economic growth as a spontaneous, revolutionary and discontinuous process leading to the idea that entrepreneurial activities are dis-equilibrating forces. According to Kirzner, entrepreneurship is a process of acting upon a previously unnoticed profit opportunity. The key is that entrepreneurial opportunities are not just exogenously delivered to an economy; in large part they are produced by entrepreneurial activities in the recent past. Entrepreneurship is a black box in modern growth theories, but following Kirzner's theory it becomes apparent that the engine of economic growth is entrepreneurship, not technological advance or investment in human capital per se.
Understanding that entrepreneurship drives economic growth, policy makers should focus on transforming the current framework to be more stimulating for entrepreneurial activities. This includes lower income and corporate taxes, a 95 percent reduction in regulation, less subsidisation of industries, focus on entrepreneurship in schools, labour market reforms, complete privatisation of education (our current investments in education give a poor return because the necessary institutions for entrepreneurial activities are being destroyed) and most importantly more emphasis on private property rights (which mean no bailouts of banks and sovereign states).
Stocks head south in tandem with Italian bonds
Markets are still very dominated by a risk-off sentiment with surging Italian 10-year bond yields trading at 7.3 percent as the best prevailing barometer and the Euro STOXX 50 Index down 0.7 percent. Another indicator of risk-off is the billions of dollars flowing out of emerging markets - with Russia as probably the scariest example; investors are unwilling to pay more than five times earnings on Russian companies as a whole!
Yesterday's 35 percent shortage on the German bond sale is another beacon that we are heading towards a discontinuity of the present system. What will happen and how it will play out is impossible to predict but if one had to guess it would be the Euro exists of several countries.
The best way to position yourselves is probably to take your portfolio to a net neutral or slightly net negative (more short than long) exposure through futures or index ETFs; this strategy is more preferred over buying puts as insurance premiums on stock declines are climbing fast.
US cannot escape the European debt vortex
Contrary to the belief in the US that it will not be hugely affected by the events in Europe, the St. Louis Fed Financial Stress Index tells another story. The index is trending up and is currently sitting at levels indicating that financial stress is one standard deviation above its historical mean; to put it in more human terms the index is showing more stress than what we saw during the double dip recession concerns back in the summer of 2010. Or described even clearly, the index is at the same level it was at just a few months prior to the Lehman Brothers' bankruptcy.
Source: Bloomberg
What the chart tells us is that the US financial system will not be able to escape the European debt vortex if we enter into an even more distressed period going into 2012. The implications for the real US economy can only be guessed at but believing that the world's largest economy can isolate itself is a fantasy due to the interlocking of global commercial banks.