If the gdp deflator is off, which financial investments should you make?

Many people suggest that we are under-measuring the benefits of innovation, and thus real rates of economic growth are much higher than we think.  That in turn means the gdp deflator is off and real rates of interest are considerably higher than we think.  Someday we will all realize the truth and asset prices will adjust.

Let’s say that view is correct (not my view, by the way), how should that change your investment decisions?

One implication, it seems to me, is that you should short the goods and services which are being produced so rapidly under this regime.  If that is hard to do, short their substitutes.  Say the new innovative growth is coming from the internet sector, and internet activity is a good substitute for collecting stamps (which seems to be true), well short stamps if you can.  At least get them out of your diversified portfolio.

Similarly, you may wish to invest in companies which produce goods not easily substituted for over the internet.  One observer has mentioned “perfume” to me in this connection, though I do not have the expertise to render a judgment.

More generally, if real rates of return are high, but not perceived as high by most investors (who are still victims of fallacious “great stagnation” arguments and the like), at some point those investors will learn.  With more rapid growth enriching the future, and with the realization of such, there will be a sudden demand to shift funds into the present, so as to equalize marginal utilities.  So bond prices will fall and that means you should short bonds and buy puts on bonds.

Don’t load up on land and public utilities.  Incumbent firms also may fall in value.

You also might fear this new technological progress will bring some fantastic but hard-to-afford new goods and services.  How about life extension or immortality but priced at $10 million?  The way to hedge that risk is to invest in life extension companies, but even more than their earnings prospects might dictate.  That is the best way to insure against life extension being too costly to afford.  Note that poorer investors should do this, but the very wealthy do not need to.

What else?

I thank B. and S. and Alex T. for relevant discussions connected to this post.


Who is John Galt?

Turns out we really did not need 15,000 pages to answer that question.

+1, TR hits it out of the park ;)


First +1 for Thiago

'Many people suggest that we are under-measuring the benefits of innovation'

Absolutely - the benefits of the GPL can be seen in its essential role in creating the World Wide Web, along with much of the software behind the Internet. Along with google and Android, of course. And one should not forget the Raspberry Pi as a tool available for a multiple of uses. limited pretty much only by the user's creativity and skill.

But oddly, though the GPL fosters innovation, it is concerned with sharing innovation to the benefit of all, and not for the profit of a few.

Makes measuring its contribution to growth difficult, or possibly even cancerous from one perspective.

Innovation is being greatly over estimated.

For example, why haven't housing components been standardized like electronics parts have?

Designing and building a house should be done with commodity parts that get popped into place and fastened quickly by shining a ligght or with ultrasonics. I started when assembly involved twisting and soldering wire leads was still common, with parts screwed to boards or suspended by their leads from terminal solder strips. The new method was parts inserted on boards "thru hole" and wave soldered, then plugged onto a backplane which was wire wrapped using automated loom technology. That was only a bit over a half century ago. Since then standards evolved so increasing numbers of parts became commodities that are both laid on a computer designed board or sheet photo processed similar to laser printing with chips laid on and joined with ultrasonic bonding, and the functional downloaded by software. All the wiring is standard and multiplexed for control and power.

For contruction, virtually nothing has changed in 50 years. For wiring, the biggest change is moving from knob and tube bare single wire to plastic insulated multistrand power wiring that gets screwed together with wire nut or an actual screw on the component. A big innovation was push to connect, but lots of power wires run from panel to switch to light or outlet, requiring lots of manual labor involving drilling holes and gthreading wire thru holes radially from a panel to now almost a hundred destinations. And if the initial design puts the switch in an inconvenient place, well that's forever.

Lots of talk for decades about smart building or homes, but they are like fads where on manufacturer offers their products that are incompatible with every other manufacturer, with only 50% of the components needed, and readily found based on the 1960s dumb standard.

Plumbing has gone through some innovation, but along the way have been some epic fails, like the aluminum wire fail, caused 90% by the idea construction is done by dummies.

Economists since the 70s increasing see construction as dummy work done by warm bodies off the street. Driven by the desire to get rid of unions, which come out of the guild system. 5 years as an apprentice working for a master, then at least a year as a journeyman until demonstrating to other masters you are competent to take on apprentices as assistants to train. Unions did update to formal classroom training and annual ongoing education, but like the guilds, tended to keep the training "secret".

And new fields, like computer design and programminng was initially learn by experience followed by sale training, ie, the sales people taught customers the basics, eventually developing courses. The collegges, universities, then public schools developed general course from the manufacturer courses, generally by hiring people from manufacturers to start. After two generations, university instructors have little understanding of advanced product development or of customer application of the technology.

It recently it has been industry deciding standards are needed, generally to open up government business to competition. But before the 80s, government dictated industry develop standards, or government woulld, usually the military. In the US, that started with the revolutionary war, expanding with each major war.

By having standards creating known boundaries, innovation can take place at the component level, rather than requiring a complete start from scratch to build every component.

Innovation in ghe places where its most needed is really hard because so much must be dealth with due to lack of standards.

Self driving cars are easy using the stardard of 1890, after the "appliance" act of Congress which defined couplers and air brakes based on the winninng industry standard, as well as the 4ft 11.5 inch rail spacing.

Today, while interstates and highways have fairly specific standards, roads and streets don't and highways become streets, so self driving means teaching a car rules humans learn only after at least a decade as apprentice, then years as journeymen. At say 17, you test to become a master.

Innovation that is meaningful is hard and takes time on the order of decades, and thousands of workers.

Sears was innovative. Amazon started from a higher founddation, but has taken a decade for some significant innovation, which had parallels in Sears.

SpaceX has delivered some big innovations, but most of SpaceX is repeating what was done in 1970 better. But it has taken a decade to repeat, and a decade for each innovative advance, slower than NASA in the 60s, but with a fraction of the workforce.

Boring Co is trying to deliver a few innovations in a decade, but success will be recognized by economists only after two decades, if then. The Chunnel is a big innovation is how to accomplish a project of that scale which employed in projects in Europe, and Asia, but resisted in the US. Elon Musk is trying to do much better than that generation of innovation.

The Autobahn is an innovation that spawned the Interstate highways. The Interstates were built on the highways from both postal delivvery RFD and auto touring the national parks, built on the better roads movement driven by bicycle riders wanting paved bike paths on roads.

In many ways construction has moved to largely standardized parts. Particularly roofing trusses but also wall sections that interlock with one another. The limit to standardization is mostly personal preferences in overall flow of the house/building.

That said, I think we will see further moves in that direction until we have greatly improved industrial 3D printing technologies. Then it's back to just having standards for the "ink".

Lack of innovation in construction is real. Could it be like healthcare -- too much govt regulation and payment leads to complacency in the entire sector? Also personal tastes for high end run to custom desgins / details. You might find the podcast interesting on some construction innovation efforts. I am sure you heard some of these ideas 30 years ago. Arc of history bends toward ... efficiency? https://a16z.com/2018/06/15/construction-technology-building/

In the case of housing construction, cheap labor plays a part.

Also homes must vary by climate that they are in. I love block homes for Florida where I live in one.

If it is a serious suggestion, much more strongly standardized road widths and characteristics would certainly innovate frontloaded enormous costs for reconstruction and then ongoing structural costs of restricting land use and keeping up to code, probably far greater than any benefits of making computational problems for self driving vehicles simpler. As well as posing a huge hazard on payments (do people pay for all this through taxation for the benefits of self driving car companies?).

Probably politically impossible anywhere, to boot, let alone a country that can't even erect a fairly inexpensive set of steel slats that had the closest thing to a national mandate an infrastructure project is gonna get (and the least level of imaginable impact on anyone's daily life).

If you're going to make the utterly false statement that "innovation is greatly over-estimated," you should at least NOT back it up with the utterly false statement that this is proven by how cumbersome it is to build a house.

Have you ever been outside, or met anyone?

You might learn that houses go up with alarming speed. One day there's a forest, and a week later all the trees are gone a 4-bedroom house is for sale. And indeed, many of the (rather small) number of people who did the work are only lightly skilled. They even used standardized parts, such as 2x4x8 pieces of wood, and shingles, and doorknobs, from lands that are built in faraway exotic lands and imported on great iron ships.

You're an idiot.

Given changes in communications technology, enabling consumers to link with alternative suppliers, expect to see

1. Greater elasticity of part time labor supply...Uber drivers, TaskRabbit, etc.

2. Greater competition between incumbents and new alternative entrants: Airbnb competing with hotels, making hotels less attractive or limiting price increases.

3. Declining auto sales as persons move to apartments in cities and forgo buying cars.

4. Acceptance of Obamacare as a way to provide healthcare in the independent contractor or gig economy.

Given the dependency on internet and communications technologies by short companies selling business disruption insurance or buy shares in companies offering computer security protection services. It's not if, but when, some actor is successful in disrupting internet services. Bet on satellite services that will create repairable or alternative distribution. You may have two internet service providers...one as a backup.

"3. Declining auto sales as persons move to apartments in cities and forgo buying cars."

Also, Declining auto sales because of ride sharing services, Uber and Lyft. It's far easier and cheaper to get along without a car in a lot of places than it was pre-Uber.

Do you see “ride sharing” as more than unregulated taxis + hyper efficient dispatch?

That nails it from my point of view.

Basically cheaper, faster and more flexible.

Technology could also help auto sales as it allows next methods of buying cars, such as fractional ownership. This would expand the market of potential buyers.

Agreed. But, its would depend on the mix of whether two persons would have purchased two cars, and now purchase one together, or whether a person who couldn't purchase a car can now purchase it with another person. When you consider used cars reach low price points, I think there will be net displacement.

The biggest potential is in used cars. While prices are lower than new, they remain out of reach for many. Many customers have to finance even a very cheap used car. You already have informal fractional ownership today, but retrofitting connected car tech creates a whole new market.

If real interest rates are actually much higher, that means Cowen's argument in favor of applying a zero discount rate in valuing the future is, well, more off base than first supposed. That "sudden demand to shift funds into the present" will greatly diminish the value of Cowen's argument.

To be clear, I agree with Cowen about valuing the future; I am just pointing out the ramifications of a higher real interest rate.

If real interest rates are actually much higher than believed, why would one sell bonds as Tyler has proposed?

Future human life valued differently than financial assets IMO.

Don't see how a high interest rate today would change my mind on the value of human flourishing in 100 years or 1000 years. Yes, from a financial standpoint it would suggest your discount rate is out of whack. But isnt TC's argument that using a discount rate to measure the far future of society is not relevant?

I think a better case can be made that the real "inflation" rate is higher. By that I mean the investor preference for relying on the returns from rising asset prices (as compared to the returns from productive capital) is based on a faulty premise: the returns from rising asset prices are being measured by assuming a low inflation rate when, in fact, the returns are much lower because "inflation" is much higher. Of course, the Fed is stuck in a continuous loop, as each time the Fed attempts to raise interest rates, investors express their disapproval by selling, causing the Fed to pull back.

You should probably stick to baseball posts.

Actually, every time the Fed raises the Fed Funds rate, investors have been buying bonds, flattening the curve. The flattening curve has made the Fed much more cautious.

Real interest rates are in reality high because excess, unmeasured productivity is leading to deflation. The cost of many marginal goods is zero, like Wikipedia or Bill Sharpe's RISMAT models. Prices aren't rising because we're not bumping into supply constraints because information is not conserved. As latency falls, capacity increases. We're in a 1/X economy.

This means high real growth produces low nominal growth. Interest rates will remain low, and even go negative. Technology disrupts both goods and services: ride-sharing disrupts auto manufacturing and Airbnb disrupts hospitality. Nothing is risk-free, not even currency, as deflation destabilizes the financial system.

Because data-driven marketing is a winner-take-all business, go long large software providers with massive data stores and short the also-rans. Go long companies with inefficient programs (Moore's law levels them) and short efficient, elegant coders. (In the future, all code will be ad-hoc and ugly.)

Deflation decays asset prices but leaves liabilities intact, so all levered institutions are at risk -- especially financial institutions. Financial disruption doesn't favor real assets, however, since deflation reduces their value as well.

Balance sheets matter. The best liability structure is 100% equity.

Monetary policy can correct for deflationary tendencies, and has been doing so for years.

I'm having trouble following the asset pricing argument. If investors have a required rate of return for a given level of perceived risk and are presently underestimating future returns (at current asset prices) then revising those estimates upward should, I think, result in increased asset prices.

If real returns have been higher than we think because of overstated inflation, the first order implication is that we are overconsuming, and we should shift more resources from consumption to investment.

As far as shifts "within" the investment decision, it seems to me the "real" Sharpe ratio graph just shifts upward (all boats rise), marginally favoring moves toward less risky investments.

Thanks. I'm still confused but perhaps more thoughtfully!

I don't understand why Tyler Cowen's set-up leads to *lower* bond prices per the original post.

Your thinking is that this marginally favours moves toward less risky investments, whereas Tyler Cowen suggests not loading up on land or public utilities.

It seems to me that Tyler is thinking that with the revised understanding of real returns that consumption will increase and investment decrease because of the richer future - contrary to your first order implication.

That's what I was thinking. I don't really follow the argument that if Google is undervalued, you should buy perfume.

Perfume is an example of the sort of product one would sample in a bankrupt Macy's store, then order on the internet. If you like the perfume, henceforth there's no reason to return to a physical store. This is the case with myriad goods. I recently visited a Sears store. Shelves were about half empty, and the employees were mostly young and looked hopeless.

I enjoyed watching you play defensive end for the Steelers back in the mid '90's, by the way.

I'm too ignorant (really) to understand the argument here. But last I heard, "value" is not an objective characteristic of an object or intellectual or abstract property. So, there's no reason why we (assuming none of us like to be wrong) will suddenly admit to being wrong, especially about something we have zero objective reason to re-evaluate. There's only market prices. And sure the "market" can be stupid and almost always exhibits herd behavior, but so what? Is the huge potential inflationary effect the Feds holding trillions of dollars as slush fund(s) significant here? Anyways, my main point is that while it is fun to argue viewpoints that you don't "believe in", there's little chance that you'll make the best, or even adequate, proponent of that pov. That's something we all learn as teenagers, although most of us seem to be OK with doing just that; hence the echo chambers that characterize our polarization today.

on the other hand i think its far more likely that inflation is underestimated. lowering real growth.

Sorry. Not an economist. But doesnt higher inflation actual *raise* the growth rate? EG, the GDP calculation today assumes your laptop that you purchased is worth $500. But because innovation is even more amazing than we think, a correct estimate is that the lap top is worth $600 compared to the lower feature version you bought a year ago. So inflation goes up, but so does GDP. There's already some of these "tech adjustments" in the GDP calc today. But i think the thesis here is that its under-shooting the real value. Could be wrong. I studied history.

If life extension becomes a thing shouldn't you short undertakers and sellers of annuities? Buy hearing-aid manufacturers.

Actually if life extension becomes a thing you could invest more confidently in Berkshire Hathaway.

"Actually if life extension becomes a thing you could invest more confidently in Berkshire Hathaway."

Only at the start before life extension becomes common. Early people will be selling off assets to afford the treatments. But (assuming the treatments are one time, or once every 50 years), they'll return to buying assets to create long term wealth to either retire or to save up for the next treatment in 50 years.

Of course all of the pyramid type pension schemes would collapse over time.

depending on the nature of the life extension one shorts or goes long assisted housing and similar old age related services and medicines. Similarly, one might want to go long food & beverage and the entertainment/leisure (VR?) space.

But some of that will depend on population growth -- if we live forever (or have a large probability of that) are we interested in children? If no one dies but we keep having kids here will be a much larger demand for all these over produced goods and services. Does that make it all a wash?

What if life extension treatment means just fasting for a week every three months?

Then nearly everyone would continue to die at the usual time.

It is amazing how little fat people and/or people with type 2 diabetes are willing to change to improve their unpleasant situation.

Fasting is one of these things that has undeniably more upside than downside, but very few people are willing to suffer for the first day of a 3 day fast or a 7 day fast. The hunger decreases a lot after the first day.

When you fast, you don't really live longer, it just seems that way! j/k

Is that a complete fast for a week or what? That seems like a long time to go without eating.

I used to fast regularly as an enthusiastic college student. Never found the much-vaunted “reduction in hunger” to be true for me.

I do sporadic fast. For the overweight people fasting can give amazing results. But the effects are temporary and if you are not overweight the benefits are lower. And for sure it will not increase the maximum lifespan. Probably, give 10-15 years more for the average American coach patato..

Seems like investing style might matter. Top-down versus bottom-up I would think are effected differently. I would also think those focusing on index type vehicles rather than the specific companies might make more adjustment.

The markets are already priced as though manufacturing of most consumer goods is a low value commodity business and branded prestige goods and specific, non-substitutable services will eat up more and more of GDP. Also note that many of these escalating costs, like health care, will not necessarily reflect in the market value of public companies, which greatly limits investor's ability to trade on this information.

But in general, just because the experts producing the statistics are providing a measure of inflation that is most likely wrong (but by what magnitude is really the question), it doesn't mean that the market price implications of the actually correct rate have not already been captured in public markets. This is what you would expect if you believe in the EMH. I am generally skeptical about the EMH, but I think this is very much an area I would expect it to apply.

The profits from innovation are competed away as quickly as they are created. The returns on the investment are not growing in some unnatural way, they remain at a stable risk-adjusted long-run rate of return. Assets are not mispriced. Interest rates reflect in part the demand and price for capital and are also not mispriced. Opportunities are created, substitutes are created, free markets are dynamic, and risk-adjusted rates of return remain stable. If one sector is making above market rates of return competitors enter to compete for those returns away. The cost of getting a haircut adjusts to reflect the returns that a barber must get to be in that business. Somehow the market has adjusted and supplied barbers for hundreds of years.

All of these insights are obvious and therefor likely already incorporated into security prices (and if they weren't yesterday before this was published they are today) so I wouldn't make investment decisions based on them. I am no economist but i am not aware of any economic theory showing that you can earn an excess return from investment decisions based on the obvious rather than information that no one knows.

The other theory says we are close to the Moore's Law limit, and innovation will pause for sometime. I have no idea, actually, few of us do.
So we get watched pot effect, what if the conclusion about Moore's law is due in two years, how do you hedge until we know for certain?

Most experts think Moore's Law in its most basic form is already quite dead.


The last time I bought an AC system, about 10 years ago, I chose the highest efficiency unit. Capital cost was about 2x the lower efficiency unit, but electricity usage is about 40-45% less than the lower efficiency unit.

It was in part an attempt to protect against higher future electric rates, mostly driven by fuel prices, but I also considered inflation. In fact, lower nat gas fuel costs and relatively low inflation have meant a very long payback on this investment.

I wonder, in the real world, how sensitive efficiency related capital investment decisions are to inflation expectations?

seeing as how you had tax incentives at the time that also probably affected your decision. you paid to lock in lower consumption, you insured against future risks, you must be rather risk-averse so you paid a rather high rate to insure against a possible bad event. a firm that is highly sensitive to future unknowns may want to hedge risks. A food company may lock-in commodity prices for next year to reduce risks. An airline may lock in fuel prices to avoid unexpected price changes. A real estate developer may lock in an interest rater for a large project. etc. These firms are probably better at using hedging strategies to reduce risks at a low cost. It goes on every day.

What about regulated utilities who are allowed to increase prices with inflation?

If real rates of return are too high, and investors realize it, they will respond by.... pushing yields on bonds higher?! Hmm.

I think he meant prices higher / yields lower. Ask Bill Gross.

From the post: " With more rapid growth enriching the future, and with the realization of such, there will be a sudden demand to shift funds into the present, so as to equalize marginal utilities. So bond prices will fall and that means you should short bonds and buy puts on bonds"

His argument is clearly that people should start preferring money in the present to money in the future so that they can smooth their welfare over time (i.e. the world is getting more wonderful and amazing so much faster than i thought, i'll be happy in retirement on less money, let me spend more now). This is an argument for bond prices going down and yields going up. I just think it is not a very good one.

"...considerably higher than we think. " isn't that like asking what if people are taller than we think? We'll only know when the incidence of dunks in basketball significantly increases. Without an agreed upon unit of measurement, what's the point of the comment. If the point is about our current measurements, shouldn't you be able to identify where the mistake comes from? It sounds like a dressed -up ideological remark, and I'm not wearing it.

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