Unexpectedly Intriguing!
November 5, 2009

In the cover story for this week's edition of BusinessWeek, Michael Mandel offers an intriguing hypothesis. He suggests that the impact of recession-driven cuts in corporate spending supporting activities that are directed toward future business growth opportunities, such as research and development, product design and employee training, is not being communicated through today's economic statistics. As a consequence, those measures are therefore overstating the true health of the economy, at least as measured by the growth in the nation's GDP. Here's the key passage from the article:

While the statistics don't account for it, there's good reason to suspect intangible investments are falling. Companies are under pressure to cut costs by reducing R&D expenditures and deferring other crucial intangibles, notes Hulten. "Because these are expensed, it looks like a pure win," he says. "You are not seeing the benefits of the intangibles in the financial statements—only the costs."

But Mike Shedlock (aka "Mish") isn't buying that hypothesis, at least not where the present is concerned:

I have met Mandel. He is a smart guy. However he is counting chickens before they are hatched, better phrased as counting production before there is any. Research may pay off, or it may not. When it does pay off it may be 5 years from now or 20 years from now. It may pay off a little or it may pay off a lot.


Mandel is correct in one aspect: That cutbacks in R&D are highly likely to affect future GDP. However, one just does not know when or by how much or even what country will benefit.


Let's now answer Mandel's riddle "If a scientist or engineer is laid off, does it affect gross domestic product?"

The answer by now should be clear: Is does not affect current GDP but it may affect future GDP in an unknown, impossible to predict way, in terms of the time it will take to see any products, as well as the present and future value of those products.

While Mish's main focus in his post is upon the shortcomings of Gross Domestic Product (GDP) as an accurate measure of economic activity, we can summarize his arguments this way: "GDP isn't a price." Prices, when free of artificial constraints, represent the approximate net present value of the sustainable portion of the profit that might be realized from the expected future unit-level production of a product or the provision of a service. As such, they automatically communicate information about the expectations for present and future values.

Coincidentally, that difficulty in using GDP figures to determine the impact of a change in intangible investments (like corporate research and development) is also the essence of Michael Mandel's argument, although he would appear to be basing it more directly upon the role of gross investment in determining GDP:

GDP = Private Consumption + Gross Investment + Government Spending + (ExportsImports)

Mandel describes the potential significance of how a change in the intangible investment in future products might affect GDP:

Measuring intangible investments such as business R&D and worker training isn't easy—which is one reason why government statisticians haven't yet done it. But including such expenditures could make a big difference in the way companies, investors, and others understand the economy. Let's do a back-of-the-envelope calculation. In the four quarters ended last June, business spending on tangible investments—equipment and structures—as reported by the BEA dropped by about 20%. If intangible investments had dropped at the same rate, it might have knocked an additional 1.5 percentage points off the -3.8% GDP growth rate. If intangibles fell by only 15%, that might have taken 1 percentage points off GDP growth. (These calculations require making heroic assumptions about price changes and other difficult-to-observe figures, so they should be treated as very rough estimates.)

Research & Development - Source: Fremont, CA We're now going to contradict Mish and agree with Mandel regarding the immediacy of the impact of cuts in corporate R&D and other venues for transforming intangible assets into real assets. In answering Mandel's "riddle", Mish observed that current GDP would not be affected by the layoff of a scientist or engineer (or really, anyone involved in new product development or process improvements), but that future GDP would be, in unpredictable ways.

In practice though, when a company anticipates that it will not be able to afford its current level of new product development into the future, its management will begin a process of winnowing the list of research and development projects that it is willing to develop. That process occurs well in advance of the layoffs of the people who actually carry out the work involved with them.

Development projects are often reviewed and ranked according to their prospective return on investment (ROI) in that process. Here, projects that fail to meet a certain ROI threshold are discontinued, with the people engaged in those projects initially reallocated to other projects. In addition, the company's management may also kill a high ROI project, should they judge it to involve too much risk to continue developing in the fading economic climate it foresees.

Unemployment Line, January 1938 (flipped) Following this phase, the company's management evaluates its staffing needs to support the "winning" projects it will continue and this leads to the resulting layoffs of its creative staff. Then the process repeats until whatever cost reduction target the company's leadership has set for its intangible investments has been met.

Before those layoffs occur however, it is the termination of the low ROI and high risk projects that negatively impacts GDP in the current timeframe, since the cancellation of the projects also terminates the relationships established between the company and its suppliers, vendors and customers to support them.

That change then ripples into the larger economy and also into the future, as the parties involved in these projects alter their own efforts to compensate for the loss. This contraction of economic activity then only subsides once sufficient new work makes it possible to reverse the process.

And from there, it's a question of whether those laid off have the skills needed for the new economy that forms. If there's a massive mismatch between the skills of the creative people who were let go and the opportunities available to them, the downturn for them can drag out for a very long time, especially for those employed in the industries that went from being the most high-flying to the most distressed.

Update: Part of the text in the post above has been edited to better clarify the role of prices in communicating information about present and future expectations, as well as the difficulty Michael Mandel observes in using GDP to divine the impact of changes in corporate research and development investments.


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