Created: 2000-04-15
Last Modified: 2000-04-21
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Comments on Hall, on Hobijn and Jovanovic, and on Jovanovic and Rousseau

J. Bradford DeLong

April 2000

"Irrational Exuberance"? Federal Reserve Bank of San Francisco Conference, April 21, 2000

Robert E. Hall (1999), "The Stock Market and Capital Accumulation"

Bart Hobijn and Boyan Jovanovic (2000), "The Information Technology Revolution and the Stock Market: Preliminary Evidence"

Brian Jovanovic and Peter Rousseau (2000), "Vintage Organization Capital"

I'm lucky here, even though I'm a discussant of two very different papers. I'm lucky in that they do share a common theme. Each of them tries to take the stock market very seriously, and assumes that the stock market has a lot to tell us about the productive economy. Bob Hall employs his patented method of taking some piece of economic theory very seriously, letting something usually taken as fixed--in this case dY/dK--swing wildly, and wind up by resolving one puzzle while creating two or three larger, deeper, puzzles. Boyan Jovanovic uses the stock market to try to say things about creative destruction.

Let me start with Bob Hall, who assumes that the value of corporations' stocks and bonds tells us what the quantity of corporate capital is in the economy.

We know more or less what the replacement cost of corporations' plant and equipment capital stock is. And we know that what Hall calls the total quantity of capital varies from a low of 0.7 times the replacement cost of plant and equipment in the second half of the 1970s to a high a couple of months ago of 1.8 times the replacement cost of plant and equipment. Hall wants to identify the extra 0.8 times the plant and equipment stock that is valued today as the corporate sector's aggregate "intangible capital"--the organizational patterns and processes and the business-created consumer attitudes that were expensive to create and that are a key part of productive efficiency.

The story of the post-WWII evolution of the stock market and the corporate sector as Hall tells it is as follows: On average since 1945 the after-corporate-tax return on corporate capital has been 10%. Of this 4% has been paid out to shareholders and bondholders, and 6% has been reinvested. Between 1945 and 1968 this process of compounded reinvestment--accompanied by "noise" in asset market valuations produced by various factors--boosted the value of corporate capital from $800 billion to $4 trillion 1998 dollars. Then something odd happened: in spite of substantial cash flow devoted to reinvestment, 1972 saw the real value of corporate capital unchanged from 1968: some $1 trillion on net had been invested in expanding America's corporate capital, and an equivalent $1 trillion of the old corporate capital had vanished over those four years. Things got worse: in 1978 the value of corporate capital was only $3 trillion, instead of the $8.1 trillion that one would have obtained by extrapolating the 1945-1968 experience in reinvestment patterns and returns on reinvestment: some $5 trillion of corporate capital had gone missing.

Conversely, at the start of the decade just past the U.S. had some $5 trillion of corporate capital--an amount that should, given the 4% average net reinvestment rate that prevailed from 1945 to 1990, have compounded to $7.5 trillion of our dollars by the start of 2000. Yet by the start of 2000 we had $12 trillion. An extra $4.5 trillion of corporate capital had been created, largely in the second half of the decade just past.

This destruction and creation of capital show up in Bob's framework as fluctuations in the productivity of capital: 8% per year in the 1960s, 2% per year in the 1970s, 13% per year in the 1980s, and 17% per year in the 1990s--but if one broke the 1990s in half, one would find a productivity of capital of some 24% per year for the last five years. That's what you need in Hall's framework to explain the sudden creation and destruction of large amounts of organizational capital.

So one way to look at it is that Bob has replaced the puzzle of the extraordinary volatility of the stock market's valuation of Lucas trees with a puzzle of the extraordinary decade-to-decade volatility in the productivity of capital. I don't know which puzzle we are likely to find more difficult to solve.

Boyan has an ingenious and interesting story for where these episodes of capital destruction and capital creation come from: the development of our new general-purpose information technologies. And to support this story Boyan has the nicest model of creative destruction that I have yet seen.

Boyan's story is that old vintages of capital are always under threat because established organizations have a hard time reconfiguring to take advantage of new technologies and processes. In particular, in the 1970s old capital lost its value when it was clear that the information technology revolution was coming, and that it was about to face competition from a vastly more efficient new vintage of capital-- organizational, physical, technological. New capital has acquired its value as it has become clear exactly which new firms are best at using new this new vintage of capital based on modern general-purpose information and communications technologies.

But I have a hard time making Boyan's story work quantitatively as an explanation of what has happened to U.S. equity values since 1970. The $5 trillion of corporate capital that vanished beween 1968 and 1978 is, presumably, the result of people between 1968 and 1978 looking forward to 1998 and suddenly seeing the reduced value of old pre-IT capital--for there was little IT capital (outside of airlines and insurance companies) back in the 1970s. But given the high real required rate of return on the market, a dollar of wealth lost in 1998 has a low present value in 1973: seventeen cents (if you use the 7% real required rate of return I carry in my head) or eight cents (if you use the 10% real required rate of return that Bob Hall carries in the back of his head). To have the shadow of competition in 1998 and thereafter destroy $1 trillion of market value in 1973 would require that in the absence of the the new vintage of capital the old capital would have been worth an extra amount of between $6 and $12.5 trillion in 1998. And to have the shadow of competition from 1998 destroy $5 trillion of capital value in 1973... I cannot match up the capital-destruction episode characterized by Bob Hall to a plausible effect of Boyan's model.

Moreover, even in the middle of the 1970s it was not at all clear that old corporations would fail to profit from new information technologies. The core of the internet today is technology--UNIX--that was the undoubted intellectual property of AT&T in the 1970s. The greatest profits earned from IT in the 1980s accrued to IBM. And if you look at analysts' reports from the 1970s for Xerox--one of the niftyest of the pre-1974 "nifty fifty", selling for 50 times earnings or more--they stress that Xerox has a bright future in large part because of the technologies being developed at Xerox's Palo Alto Research Center. And, indeed, the market capitalization today of Xerox PARC's technologies is remarkable. Ethernet walked out of PARC inside Bob Metcalfe's head: 3COM. Postscript walkied out of PARC inside John Warnock and Charles Geschke's heads: Adobe. Microsoft Word walked out of PARC inside Charles Simonyi's head. When Steven Jobs was (apocryphally) yelling at Bill Gates for "similarities" between Windows and Macintosh, saying that it was like Gates breaking into Jobs's house and stealing his TV set, Gates (apocryphally) responded: "That's not true. It's like we both had a rich neighbor named Xerox, and you just happened to steal his TV set first."

One of the most interesting--and least well-explained--pieces of economics is the remarkable failure of companies to keep hold of and profit from IT research and development done at their own facilities. Ever since the invention of the modern corporation with its research lab companies had been pretty good at keeping hold of and profiting from their intellectual property: think of Alfred Nobel's dynamite company, or DuPont, or General Electric, or Boeing.

One final thought: perhaps when we look at the magnitude of the capabilities made possible by our general-purpose information technology, and try to match it up to a large profit flow that supports high stock market valuations, we are looking in the wrong place. It is far from clear that rapid technological change with major effects on social welfare maps clearly and transparently into lots of profits for enterprises. New technologies create large, permanent profits where they can be transformed into powerful barriers to entry. And it is not clear to me that this is the case: I tend to be an optimist about the social impact of the technology, and a pessimist about the profits of dot-coms.

Why? Let me tell a story--the story of the collapse of the encyclopedia market. Two decades ago I was thrilled to get my paper Encyclopedia Britannica--a market value of $1500. It seemed worth every penny (even though I didn't pay for it). For a while I would go down and look at it every day, running down a reference or flipping through random pages. It was still the resources that I went to when I ran across something unfamiliar until last year--until the coming of to the internet.

And now my paper copy is gathering dust. It has been replaced. Reading on a screen is hard, but so is reading small print. On my computer I can make's print as large as I want, so it is actually easier to read on the screen than in the book. And the search engines! You need a flat place to open at least five volumes if you are going to do a comprehensive job of searching the paper encyclopedia. By contrast, the first search brings up all the references in the whole encyclopedia text on the very first screen. is a superior intellectual product.

And it is free: intellectual capabilities that were expensive--to the tune of $1500--fifteen years ago are now effectively free to anyone with an internet connection, and a web browser. For most people access to the Encyclopedia Britannia is not worth the $1500 it used to cost: we know this because most people did not buy the Encyclopedia Britannica. Still, it is worth something. If it is worth an average of $50 per household to Americans, than we all are now $4 billion richer as a result of the decision to put online and its competitors online.

And is anyone going to profit from this creation of $4 billion in wealth? It is hard to see how. Amazon, for example, started out thinking that it would make money by having the best front-end computer interface in the world to Ingram, the U.S.'s largest book distributor. It has now decided that it will try to make money by integrating backward--by being the best distributor of books and other stuff. So if you look at the bulk of Amazon's assets today, they aren't made up of new-technology goods like servers and RAID disks and Oracle tables and Cisco routers and Uniphase fiber. They are made up of warehouses and forklifts: think Sears. Now maybe Amazon truly does have extraordinary organizational capital--is much, much better at the warehouse-and-forklift business than Walmart or Ingram, and has an advantage that others will not be able to copy. Organizational capital is truly valuable only when it is expensive or impossible to copy. And I don't see how...

So perhaps there are limits to how far we can go by starting from the premise that we should take asset market valuations very seriously...

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Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
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