On depreciation, malinvestment and GDP as a gross number
If I could relate the concept of malinvestment to business administration I would do it using the concept of depreciation.
Depreciation is a term used in accounting and business to represent a writedown of a real asset on a company’s balance sheet to reflect its actual depreciation in value. If you build a building, it has a useful lifespan. You need to depreciate its value over that lifespan in order to make the balance sheet reflect this reality. In doing so, you encounter accounting-speak terms like depreciation guidelines, amortization schedules and depreciation methods to write down an asset. All of that is unimportant. What is important is the the end result, which is supposed to be that a balance sheet represents, not the cost of an enterprise’s assets, but their actual value today.
I used to work in the world of leveraged finance and this is the principal reason leveraged buyout companies use EBITDA (earnings before interest, taxes, depreciation and amortization) as a baseline metric for the earnings of any intended target investment. The goal is to get a realistic estimate of the GROSS earnings capability of the enterprise. To do so, you have to back out interest, taxes, and depreciation which can vary depending upon how and where the investment is financed.
When it comes to national income and product accounts, the numbers are already ‘grossed up.’ After all Gross Domestic Product is the name for the acronym GDP we all use to measure economic output. So, when we think about economic growth, we think of gross numbers, not net numbers. But net numbers are the ones that matter. We care about depreciation! As in any individual business, there is an economy-wide depreciation of fixed assets. And when investment resources are misallocated, this hidden malinvestment depreciation is not captured in the gross numbers.
What happens? Look at China for an example. Right now they are throwing hundreds of billions of dollars into the system. See my post “Construction in China’s Ghost Towns” for anecdotes on how crazy this all is. For example:
In Yingchuan, the capital of Ningxia province, 70 per cent of GDP growth last year was related to fixed-asset investment, according to the city’s officials.
"I can’t think of any economy where that rate of growth is sustainable," Bruce Richardson, an American businessman living in Yingchuan, said.
So, for the time being, all of this money is creating monumental increases in GDP in China. However, this huge investment in fixed assets in China also means massive amounts of asset depreciation. Roads and bridges need to be maintained too. That’s the reason you just can’t build to the sky. Eventually fixed assets need to be maintained and replaced. That’s why depreciation expenses exist. Unless all of these assets start earning an adequate return on investment, China will not be able to maintain or replace them and we are going to see China’s GDP slow dramatically at that point.
In the ghost town story, Patrick Chovanec, a professor at the School of Economics and Management at Tsinghua University, says many assets are not earning any return right now because they are sitting empty.
"I have seen houses and shops built in second and third-tier cities in Guangdong in 2005 that are still empty," he said. "Supply is much more than demand in these cities. Funding was easily available for developers, who went ahead and constructed, dis regarding demand.”
And you can see the same insane malinvestment in the videos in “Hugh Hendry: China – The Emperor has no clothes” and “China’s empty city: the emperor really has no clothes.”
Right now all of this investment is depreciating in China just as it has done in the U.S. I would argue the credit crisis in the U.S. was nothing more than a recognition of the malinvestment that was there all along but unaccounted for because everyone was thinking gross and not net. It was only when subprime imploded that the massive depreciation became real. Buildings need to be maintained, you know. Underneath the huge gross numbers were much less rosy net numbers. And at some point, this sort of thing catches up with you.
Please tell the Keynesians before we pay to dig more useless holes in the ground.
This is an interesting story that should be watched. Two years ago I took a short taxi ride on the second ring road in Xi’an the ancient capital of China and the capital of Shaanxi Province. My ten-year-old son started to count construction cranes on his side of the cab and I did the same on mine. The ride was about 20 minutes and we counted more than 150 cranes. Some of the construction looked so sloppy that even my son noticed and asked if the buildings were to code.
That said, the buildings will be filled even if the original owners go under and have to take a loss. The new occupants will come from very crappy housing that so many people currently live in. Their old residences will probably go to young people moving in from the countryside, where life is very boring and difficult.
While I expect a major contraction or two, I do not believe that the urbanization movement is over. We still have around 50% of the population in the countryside looking for a better life. And while there will be massive losses for most investors in the sector, the new capital that has been built up will still be useful to the Chinese. That would allow them to tear up the old and inefficient structures as they move into the modern world. Eventually life will become even better for the average Chinese worker than it is now.
Sadly, I cannot say the same about North America. Many or our factories are very old and not much better than the Chinese factories that will have to be shut down because more efficient ones have been built to take their place. Unlike the Chinese we do not have the savings necessary to build the new factories that are necessary to create employment and future demand.
And before we get on the China bubble bandwagon we need to look at the picture here. While we could see a fall in demand for base metals as China’s building activities slow, the nominal price may not fall by much, if at all, over the long term. The reason is the financial position of the US. With Obama proposing massive deficits that cannot be funded out of available ‘surplus’ savings and the looming bankruptcy crisis at the state and municipal levels we could see a major devaluation of the USD that leads to high inflation levels at a time when economic activity is in decline. How are we going to pay for the upgrades necessary for our roads, bridges, airports, ports, rail roads, etc., when there are no savings to pay for them? At least the Chinese built the infrastructure that they need before the crisis hit.
Vangel, your China cheerleading doesn’t square with your views. They are a command economy. Why do you look at them any differently?
I am not cheer-leading the central planners. I have simply observed that there is a large difference between the Party and the people. Actually, the Party even has a hard time controlling it own bureaucracy so I do not see how it will manage to call the shots economically as many are suggesting.
For the record, I was first steered towards Mises, Hayek and Rothbard when I worked in China. The people who were pushing them as the most competent economists best able to explain the real world were Chinese government economists. Sadly, most of the statist arguments being advanced came from my American and Canadian colleagues, who imagined socialism to be something that the Chinese knew to be false.
I think that you have misunderstood the accounting concept of depreciation. Even some accountants make the same mistake. To correct your sentence, depreciation is a term used in accounting and business to represent a writedown of a real asset on a company’s balance sheet to allow for the matching of the cost of the asset against the revenues to which it contributes. Imagine a computer system is bought for £1m that will run for 10 years and do more-or-less the same work at the same speed for 10 years. It will contribute more-or-less equally to revenues in each of the 10 years and so £100k of depreciation would be charged each year. The market value of the computer however would probably drop dramatically in the first year and probably be almost worthless in 3 years, but to reflect this valuation in the balance sheet would cause the income statement to show a big loss initially and then higher profits subsequently, thus giving a false impression of the volatility of the company’s profits. As it is the income statement that is critical to most users of the accounts, the correct matching of costs to revenues takes precidence over reflecting the actual value of the company’s assets in the balance sheet. So in practice a company’s balance sheet will not necessarily reflect the market valuations of its assets and is not intended to. Accounting for financial services is somewhat of an exception as financial investments would generally be kept at market value.
But I found your article really interesting because it drew attention to the differences between GDP and an accounting profit. As an accountant, my knowledge of the calculation of GDP is a lot shakier than my knowledge of the calculation of corporate profit. But it seems to me that the key difference is that a company’s profit has an external focus – it needs to bring in more from its external customers than it pays to its external suppliers. At IBM many years ago, where there were a huge number of intra-company sales, directors used to joke that they had been trying for years to find a way to make a profit without actually selling anything to an external customer. But of course they couldn’t. Whereas a country can in theory be self-sufficient, and globally, the economy is self sufficient because we have no trade outside the planet. A country can maybe make a ‘profit’ vis-a-vis an external country, but this could be minor compared to the economic activity going on within the country. So it makes more sense for a country to measure economic activity rather than the excess of revenues over costs. If a government spends £10 billion on road building in a year, and the building work is finished in that year, then it seems reasonable to me to count the £10 billion as part of GDP. There is no country-wide balance sheet to put the capital expenditure on or revenues against which to match the costs. For GDP, everything is a revenue to someone and a cost to someone else.
With regard to the depreciation in the non-accounting sense that you discuss (the reduction in value over time due to decay), then I would agree that the value-add of the GDP calculation is not currently reduced by a value-loss to represent natural decay, even though the value loss is taking place. Perhaps it would be slightly more accurate if it were, but I’m not convinced that the difference would be that useful. After all, infrastructure has always been decaying and GDP is useful more for comparisons over time or between countries than as an absolute figure of added value. Also, if the infrastructure wasn’t needed in the first place, then there is arguably less of a loss to its decay and it might not need to be replaced. In any case, it would have nothing to do with accounting depreciation, which, as noted above, is not there to reflect the decay in value of assets but to match the costs to the revenues to which they relate.
By the way, I love your blog, thanks for such interesting posts.
The balance sheet is supposed to reflect the real value of an enterprise – again real meaning economic value of all assets for the enterprise as a going concern not in liquidation.
So, I never mentioned market value. When I say actual value I mean the residual economic value the asset has at one specific juncture in time. The computer example you give is apt in that a computer’s ‘market’ value depreciates rapidly. However, it’s accounting value may not reflect this if you use straight line depreciation over five years – which assumes equal economic value in each of the five years over which it is depreciated.
Your larger point about GDP measurements is fair. Again, I wasn’t suggesting that GDP should be amended to represent depreciation value. However, I was inserting the depreciation concept into the conversation about growth to illustrate the point that not all growth is the same. Some assets have larger returns on others and some assets have higher depreciation/maintenance associated with them.
For example, if we produced an office building in a city with a 30% office vacancy rate, we should expect the return on investment to be lower than in a city with a 5% vacancy rate.
In both cases, the buildings have to be maintained and that diverts capital from other (potentially more economic) investments down the line.
In China’s case, you are seeing an enormous amount of depreciating assets built in a specific period of time. Unless these assets generate a sensible return, either they will not be maintained and fall into disrepair or future capital investment will have to be diverted away from more useful projects. Either way, this is a hidden cost – and that’s the point I am making here.