WEBVTT NOTE Uncertainty, Asset Specificity, and Entrepreneurial Adaptation 1 00:00:00.000 --> 00:00:04.200 I should start off by saying this paper is very much a work in progress. 2 00:00:04.200 --> 00:00:10.600 In fact, as you can tell, there's been progress made in the last week or so 3 00:00:10.600 --> 00:00:16.600 because the schedule says the title of the paper is Uncertainty, Asset, Specificity, and Business Cycles, 4 00:00:16.600 --> 00:00:25.400 and I since came to the opinion that it would be better titled Uncertainty, Asset, Specificity, and Entrepreneurial Adaptation, 5 00:00:25.400 --> 00:00:29.800 although I still discuss business cycles in the paper. 6 00:00:29.800 --> 00:00:36.200 I started off looking at the impact, trying to look at the impact of environmental regulation 7 00:00:36.200 --> 00:00:41.200 on business cycles and I began to look at the particulars of environmental regulation 8 00:00:41.200 --> 00:00:48.280 and a lot of environmental regulation requires firms to install some specific kind of capital 9 00:00:48.280 --> 00:00:56.180 equipment such as a scrubber on a coal-fired power plant which is a hundreds of millions 10 00:00:56.180 --> 00:01:02.180 and the millions of dollars piece of equipment that might be as large as the generating facility itself 11 00:01:02.180 --> 00:01:08.180 and, of course, is a piece of capital that cannot be easily transferred to some other kind of production process. 12 00:01:08.180 --> 00:01:23.180 So as I began thinking about this, I thought, well, how do entrepreneurs adapt to uncertainty in the kind of capital they employ? 13 00:01:23.180 --> 00:01:39.180 So the main idea here is that the Austrian emphasis on entrepreneurial judgment and heterogeneous capital helps us to understand how uncertainty reduces economic growth rates. 14 00:01:39.180 --> 00:01:51.180 Entrepreneurship, most of you are familiar with the Austrian theory of entrepreneurship, but I'll briefly mention that it's the use of judgment under conditions of uncertainty. 15 00:01:51.180 --> 00:02:03.180 It's not merely probabilistic risk, and so it's not a matter of just looking at the statistics and figuring out what's the best course of action. 16 00:02:03.180 --> 00:02:14.180 We don't even know what the statistics are. As entrepreneurs, we have to use judgment and foresight, and it's really quite an art. 17 00:02:14.180 --> 00:02:24.460 Now, I would not have been able to put this picture up here until yesterday when I heard 18 00:02:24.460 --> 00:02:25.860 Mark Thornton's talk. 19 00:02:25.860 --> 00:02:32.700 I'm sorry, the top margin's cut off there, but Mark Thornton has argued that this is 20 00:02:32.700 --> 00:02:41.760 in fact Richard Cantillon and Cantillon's kind of our foundational figure for entrepreneurship 21 00:02:41.760 --> 00:02:43.620 theory in Austrian economics. 22 00:02:43.620 --> 00:02:50.220 And he said in 1755 that entrepreneurs work for uncertain wages, so to speak, and all 23 00:02:50.220 --> 00:02:56.280 others for certain wages until they have them, although their functions and their rank are 24 00:02:56.280 --> 00:02:58.380 very disproportionate. 25 00:02:58.380 --> 00:03:03.540 The general who has a salary, the courtier who has a pension, and the domestic who has 26 00:03:03.540 --> 00:03:06.620 wages are in the latter class. 27 00:03:06.620 --> 00:03:11.740 All the others are entrepreneurs, whether they establish themselves with a capital to 28 00:03:11.740 --> 00:03:17.900 to carry on their enterprise or are entrepreneurs of their own work without any capital, that 29 00:03:17.900 --> 00:03:22.900 would be like a plumber or furniture maker or something like that, and they may be considered 30 00:03:22.900 --> 00:03:30.300 as living subject to uncertainty, even beggars and robbers are entrepreneurs of this class 31 00:03:30.300 --> 00:03:40.020 and perhaps we should add to that politicians, or maybe that's redundant. 32 00:03:40.020 --> 00:03:50.620 Investment means the assessment of future prices of resources used in production and 33 00:03:50.620 --> 00:03:56.020 the prices of those final goods and services they hope to produce. 34 00:03:56.020 --> 00:04:04.660 And as we see in several places in the Austrian literature, when entrepreneurs commit to a 35 00:04:04.660 --> 00:04:10.820 a particular course of action. When they make investments in capital, they are surrendering 36 00:04:10.820 --> 00:04:19.820 flexibility. In fact, Robert Mulligan, who's also, I believe, appearing later in this session, 37 00:04:19.820 --> 00:04:25.500 said that planners surrender flexibility whenever they commit liquid financial capital to a 38 00:04:25.500 --> 00:04:32.820 particular production plan. If business conditions change, production plans cannot be completed 39 00:04:32.820 --> 00:04:38.220 as originally anticipated. The removal of flexibility on the part of entrepreneurs can 40 00:04:38.220 --> 00:04:45.940 be thought of as the proximate cause of the business cycle. So as I looked at the existing 41 00:04:45.940 --> 00:04:52.380 mainstream literature on this, it seems that, and I've got a lot of it in the paper, I can 42 00:04:52.380 --> 00:04:56.500 send you a copy if you like, but a lot of that mainstream literature which I briefly 43 00:04:56.500 --> 00:05:01.500 seems to be focusing on the level of investment. 44 00:05:01.500 --> 00:05:10.500 It does not put a lot of emphasis on the heterogeneity of capital, 45 00:05:10.500 --> 00:05:15.500 and I think that that is a serious problem in the mainstream literature, 46 00:05:15.500 --> 00:05:21.500 and one which leads them, I think, to fail to see the connection 47 00:05:21.500 --> 00:05:51.500 There is some effort that I saw recently to try to measure asset specificity by looking at the saleability of assets across industries, and Kim and Kong, last year, produced a study in which they gave a kind of a numerical index of various industries in which they said 48 00:05:51.500 --> 00:06:00.020 said, well, here's the degree of asset specificity for coal mining and for electric power generation 49 00:06:00.020 --> 00:06:04.980 and for various services and distribution and so forth. 50 00:06:04.980 --> 00:06:16.100 And as I had expected, the extractive industries, the power generation industries seem to be 51 00:06:16.100 --> 00:06:21.560 near the top of that list, having the requirement of very specific capital. 52 00:06:21.560 --> 00:06:27.160 But of course, one of the problems here is that Kim and Kung are looking at the physical 53 00:06:27.160 --> 00:06:31.960 attributes of the capital and they're not looking at, you can't look at the judgment 54 00:06:31.960 --> 00:06:38.100 of the entrepreneur, which has a great deal to say about how specific capital is. 55 00:06:38.100 --> 00:06:43.620 So I think that it's under appreciative of the importance of entrepreneurial judgment, 56 00:06:43.620 --> 00:06:48.940 and the foresight. Without taking into account the foresight, you can't tell exactly how 57 00:06:48.940 --> 00:06:58.060 specific that asset is because you don't know all the possible uses of that asset. 58 00:06:58.060 --> 00:07:08.460 So I argue that lower rates of economic growth in the face of uncertainty are related to 59 00:07:08.460 --> 00:07:28.460 The defensive alterations in the capital structure that are undertaken to help entrepreneurs resist the effects of or be more resilient to changes in the political environment, the regulatory environment, and of course other sources of uncertainty. 60 00:07:28.460 --> 00:07:38.780 Ben Powell in 2010 noted that capital goods derive their value from entrepreneurs who 61 00:07:38.780 --> 00:07:45.380 bid on them with the aim of incorporating those capital goods into a specific plan to 62 00:07:45.380 --> 00:07:48.500 produce the final consumer goods of ultimate valuation. 63 00:07:48.500 --> 00:07:56.420 You can't separate the capital, the nature of capital from the entrepreneur's plan. 64 00:07:56.420 --> 00:08:02.940 And then, of course, I keep running into these people, Foss and Klein in the Austrian Literature 65 00:08:02.940 --> 00:08:03.940 and Entrepreneurship. 66 00:08:03.940 --> 00:08:07.700 You just can't escape running into these people. 67 00:08:07.700 --> 00:08:15.280 And of course, it has become Peter Klein's work and Nikolai Foss's work has become essential 68 00:08:15.280 --> 00:08:19.260 to the Austrian Literature and Entrepreneurship. 69 00:08:19.260 --> 00:08:25.700 And in 2005, they pointed out that assets are heterogeneous to the extent that they 70 00:08:25.700 --> 00:08:31.300 They have different and different levels of valued attributes. Attributes may also vary 71 00:08:31.300 --> 00:08:38.180 over time, even for a particular asset. In a world of true uncertainty, entrepreneurs 72 00:08:38.180 --> 00:08:45.180 are unlikely to know all relevant attributes of all assets when production decisions are 73 00:08:45.180 --> 00:08:52.180 made. Nor can the future attributes of an asset, as it is used in production, be forecast 74 00:08:52.180 --> 00:08:57.580 with Certainty. Future attributes must be discovered over time as assets are used in 75 00:08:57.580 --> 00:09:03.060 production. Or to formulate the problem slightly differently, future attributes are created 76 00:09:03.060 --> 00:09:10.660 as entrepreneurs envision new ways of using assets to produce goods. So what I'm arguing 77 00:09:10.660 --> 00:09:18.660 here is that the poor long-term performance from sources of uncertainty results from the 78 00:09:18.660 --> 00:09:26.480 The difficulty of calculation, of course this has been frequently demonstrated by others 79 00:09:26.480 --> 00:09:34.300 that entrepreneurs can't calculate as easily when money markets and other markets are being 80 00:09:34.300 --> 00:09:39.580 distorted by changes in regulation by the Federal Reserve and other interventions of 81 00:09:39.580 --> 00:09:45.020 government, but also because entrepreneurs are making a trade-off. 82 00:09:45.020 --> 00:09:51.860 They're trading off, on the one hand, they want reduced exposure to economic uncertainty, 83 00:09:51.860 --> 00:09:58.300 and on the other hand, they'd like to be able to have a higher output, more roundabout production 84 00:09:58.300 --> 00:10:00.460 process. 85 00:10:00.460 --> 00:10:03.200 But they have to weigh these two. 86 00:10:03.200 --> 00:10:07.500 If they have a more roundabout production process, which might allow for some greater 87 00:10:07.500 --> 00:10:18.660 are long-term efficiencies, they have to give up some of that resilience to economic uncertainty. 88 00:10:18.660 --> 00:10:27.380 They have to expose themselves to a risk that a change in policy, a change in regulation 89 00:10:27.380 --> 00:10:32.080 could make their production process uneconomical. 90 00:10:32.080 --> 00:10:37.960 So uncertainty, I would say, reduces economic growth, not just by reducing the aggregate 91 00:10:37.960 --> 00:10:43.120 investment, and that's what the mainstream seems to be focused on, but also by changing 92 00:10:43.120 --> 00:10:50.520 the capital structure to increase resilience. 93 00:10:50.520 --> 00:10:57.080 Now there are four ways, at least, I point out four ways in which entrepreneurs may adapt 94 00:10:57.080 --> 00:10:59.080 their capital structure. 95 00:10:59.080 --> 00:11:09.080 The entrepreneur may change the placement of capital assets in the firm's production process, or they could organize the firm differently. 96 00:11:09.080 --> 00:11:18.080 They might merge with another firm, they might divest part of the firm, they could acquire another firm. 97 00:11:18.080 --> 00:11:23.080 In fact, often you see in the tech industry where a firm will make an acquisition, 98 00:11:23.080 --> 00:11:29.880 Not necessarily because they want the physical assets or maybe not even the human assets 99 00:11:29.880 --> 00:11:31.320 of that firm. 100 00:11:31.320 --> 00:11:38.460 They may want the knowledge or they may want some kind of IP that the smaller firm may 101 00:11:38.460 --> 00:11:41.560 possess. 102 00:11:41.560 --> 00:11:50.400 Secondly, entrepreneurs may move assets geographically to regulatory regimes that are more conducive 103 00:11:50.400 --> 00:11:52.040 to success. 104 00:11:52.040 --> 00:11:56.360 I teach at Wofford College, which is in Spartanburg, South Carolina, and Spartanburg, South Carolina, 105 00:11:56.360 --> 00:12:01.800 or not just Spartanburg, but South Carolina has been the beneficiary of this kind of geographical 106 00:12:01.800 --> 00:12:09.600 relocation. About 20 something years ago, we picked up a BMW assembly plant. It's one 107 00:12:09.600 --> 00:12:16.880 of the first major automotive assembly plants in the South, and I believe Alabama also has 108 00:12:16.880 --> 00:12:22.000 one or two. There's a Kia plant up the road near Columbus, and there's a number of others 109 00:12:22.000 --> 00:12:31.440 Now, why didn't they locate in Michigan, where there's a large number, I mean there's a 110 00:12:31.440 --> 00:12:37.200 clustering effect, right, there are a number of people there who know how to work on cars 111 00:12:37.200 --> 00:12:45.680 and a number of engineers and suppliers and all of these things have been attractive, 112 00:12:45.680 --> 00:12:51.960 but the regulatory regime in Michigan has not been conducive to success, so they moved 113 00:12:51.960 --> 00:13:06.520 Third, entrepreneurs may build up precautionary assets, which some, like Bischoff, have called 114 00:13:06.520 --> 00:13:07.520 putty capital. 115 00:13:07.520 --> 00:13:14.360 It's an unformed capital, it's liquid, and then fourth, entrepreneurs may shift from 116 00:13:14.360 --> 00:13:21.320 large time-consuming capital investments to smaller projects that have shorter lead times. 117 00:13:21.320 --> 00:13:27.040 Much of this has been established already in the literature simply pointing out that these 118 00:13:27.040 --> 00:13:31.840 are methods by which entrepreneurs may adapt. 119 00:13:31.840 --> 00:13:38.240 We see some of the mainstreamers in this, like Pendike, says that capital asset specificity 120 00:13:38.240 --> 00:13:43.280 may lead to inertia in industries that are not very well adaptable. 121 00:13:43.280 --> 00:13:47.200 He says we may get greater malinvestment in energy. 122 00:13:47.200 --> 00:13:48.200 We may get malinvestment. 123 00:13:48.200 --> 00:13:52.400 Malinvestment, I don't think he uses the term malinvestment, but there's greater malinvestment 124 00:13:52.400 --> 00:13:56.580 in energy and other industries that have a higher level of specificity. 125 00:13:56.580 --> 00:14:01.360 Bernanke mentions bunching of investment projects over time. 126 00:14:01.360 --> 00:14:06.800 Bloom also mentions the delays of investment and hiring. 127 00:14:06.800 --> 00:14:12.280 But many of these neglect the heterogeneity of capital. 128 00:14:12.280 --> 00:14:22.080 I noted that we ought to see a shift, a smoothing really of the business cycle as we've seen 129 00:14:22.080 --> 00:14:26.220 a shift toward services because the service industry has typically a lower level of capital 130 00:14:26.220 --> 00:14:28.100 asset specificity. 131 00:14:28.100 --> 00:14:33.400 So the shift from manufacturing and extractive industries toward services ought to smooth 132 00:14:33.400 --> 00:14:39.300 out the business cycle over time somewhat, other things being equal. 133 00:14:39.300 --> 00:14:42.060 And so why haven't we seen that? 134 00:14:42.060 --> 00:14:48.580 Also we see that moving assets geographically seems to have gotten easier as transportation 135 00:14:48.580 --> 00:14:50.740 costs have dropped. 136 00:14:50.740 --> 00:14:53.980 So why haven't we seen less severe, less frequent business cycles? 137 00:14:53.980 --> 00:15:00.660 If you look at Seljand's work and some others well known to you, we have not seen a real 138 00:15:00.660 --> 00:15:04.960 improvement in the severity of business cycles lately. 139 00:15:04.960 --> 00:15:19.280 And so if we see entrepreneurs being prevented in some way from adapting, that is going to 140 00:15:19.280 --> 00:15:23.640 have a similar effect to an increase in overall uncertainty. 141 00:15:23.640 --> 00:15:30.320 And we probably have seen an increase in uncertainty as well, at least in the short run. 142 00:15:30.320 --> 00:15:34.680 And so we've seen limits on mergers and acquisitions, we've seen restrictions on capital mobility 143 00:15:34.680 --> 00:15:39.800 to some extent across political boundaries, and then if you look at some recent commentators 144 00:15:39.800 --> 00:15:45.020 like John Taylor, he says we've seen both increased regulation and increased policy 145 00:15:45.020 --> 00:15:51.320 uncertainty that have been holding the economy back, preventing entrepreneurs from adapting. 146 00:15:51.320 --> 00:15:56.240 Taylor points out we've seen a higher number of full-time equivalent federal employees. 147 00:15:56.240 --> 00:15:58.720 We've seen a less predictable tax code. 148 00:15:58.720 --> 00:16:04.040 All of that may increase uncertainty and make the entrepreneur's job more difficult. 149 00:16:04.040 --> 00:16:10.380 So while the mainstream approach does not see capital asset heterogeneity as a function 150 00:16:10.380 --> 00:16:17.340 of entrepreneurial judgment and foresight, it misses the link between limiting entrepreneurial 151 00:16:17.340 --> 00:16:25.880 freedom to adapt and worsening of business cycles and slower long-run growth rates. 152 00:16:25.880 --> 00:16:30.920 So I would suggest that if you want to see improvements in growth and you want to see 153 00:16:30.920 --> 00:16:42.520 Business cycles moderate instead of becoming more severe, and perhaps we ought to seek not only to reduce uncertainty, but also make it easier for entrepreneurs to adapt to the existing uncertainty. 154 00:16:43.520 --> 00:16:50.320 I'll stop here. My contact information is here, and if you would like a copy of the paper, please feel free to email me.