I wrote recently that UK company profits have become increasingly dependent on what the government and consumers do. Some people found this puzzling. This is because they often make a systemic error about economics: they often fail to see that what is true of an individual sometimes cannot be true for everybody. They lack a form of what US sociologist C Wright Mills called the sociological imagination.
It is true that an individual company can, with good management, increase its profits by well-judged cost-cutting, or getting its pricing right, or by good marketing. In these ways, its profits are at least partly under its control.
But what is true for any individual company is not true for all. In raising prices, it imposes costs on other companies thus depressing their profits; this is why increased monopoly power for a few companies doesn’t necessarily mean increased aggregate profits for all. If aggregate demand is set by macroeconomic policy, then one company’s increased sales come at the expense of another’s. And if the company lays off workers, it cuts their incomes and therefore spending and the revenues of other companies.
What’s good for one company, therefore, is bad for others. If all companies try to raise their profits, the profits of all do not therefore necessarily rise. It is for this reason that the share of profits in GDP is no higher now than it was 30 years ago, despite companies claiming to pursue shareholder value. And it was for the same reason that the great Polish economist Michal Kalecki wrote in 1935 that “a reduction of wages does not constitute a way out of depression”.
What’s true of the part is not true of the whole. Failing to see this is a common error.
One example of this is the desire that governments be fiscally prudent. Prudence might be a virtue for any individual. But if enough people practice it and rein in their spending, other people’s incomes fall and with it their spending and hence ability to save. This is the paradox of thrift. It is why fiscal austerity failed to reduce government borrowing as much as expected and has now been abandoned. Investors must be on guard against this error.
One danger here is liquidity risk – the risk of not being able to sell an asset quickly at an acceptable price. From the point of view of any individual retail investor, our holdings of unit trusts that invest in assets such as property or unlisted stocks seems reasonably liquid, as they are only a few thousand pounds. If you believe this, however, you are not asking the important question: what would happen if many people were to try to sell? The answer of course is that they couldn’t, as the trusts couldn’t liquidate the underlying assets quickly enough. Instead, they would simply block such selling – as we have seen recently with Woodford’s equity income and M&G’s property funds. As Maynard Keynes said, “there is no such thing as liquidity of investment for the community as a whole".
A second danger comes in riding bubbles, in holding onto assets you believe to be overpriced in the hope of selling them at a higher price to a greater fool. While any individual might be able to pull off this trick, we cannot all do so. And the things that would cause you to want to sell – such as a loss of price momentum or slightly disappointing earnings – would probably make others want to do so as well. Getting out at the top is a forlorn hope.
To see a third danger, imagine I were to give two of you each an envelope that might contain £5, £10, £20, £40, £80 or £160. You both open your envelopes and I then offer both of you the chance to swap with each other. Do you do so? Looking only from your own point of view at a low sum, you’ll be tempted. But if your counterparty is keen to do so, it’s a sign that he’s got little money and so you shouldn’t swap. Swapping cannot be in both your interests. Looking at the matter only from your own point of view can distract you from this.
This is no mere thought experiment. Investors have been making exactly this mistake for years around the world. One of the strongest patterns in share prices is that newly floated stocks tend to do badly in the months after coming to market. One reason for this is that investors make the same mistake they do in our envelopes problem. They fail to ask: if this is a good deal for me, why is the other fellow – who is more informed than I am – so keen to sell? The moment we look from other people’s point of view rather than our own, we immediately avoid the mistake of buying overpriced new flotations.
The point here is simple, even though it is so often missed by millions of people, and sometimes by governments. Very many economic phenomena – especially equity trades – should be seen as games, as strategic interactions between people. And as Avinash Dixit and Barry Nalebuff say in their book, The Art of Strategy, "the key lesson of game theory is to put yourself in the other player’s shoes". We make our best decisions when we see things from everybody’s point of view, not just our own.
It’s sometimes said that economics encourages us to be more selfish. Maybe. But it should also encourage us to become less egocentric.
