Month: January 2019

Funding Strategies in a Rising Interest Rate and a Flattening Yield Curve Environment

Funding Strategies in a Rising Interest Rate and a Flattening Yield Curve Environment

In our third article Special Issue on Growth and Innovation Niso Abuaf suggests that an optimal corporate funding strategy may be a “barbell” that combines short-term borrowings (to exploit still low short-term rates) with some long-term borrowing to lock in historically low interest rates against the possibility of rising inflation and interest rates. Abuaf shows that a “barbell” funding strategy is on the “efficient frontier” of corporate liability structure, i.e., the curve tracing the lowest cost and lowest standard deviation points. Such strategies consist of a barbell with occasional medium-term borrowings, but with some “rollover” or funding risk attached.

Once the efficient frontier has been delineated, the chief financial officer can use breakeven analysis to choose the optimal maturity mix. The choice between fixed and floating interest rates will depend upon management’s tolerance for earnings fluctuations resulting from moves in short-term rates.

While most of the existing literature predicts that a lot of short-term debt leads to early default, Abuaf sees that an upward sloping yield curve can easily make short-term debt cheaper than longterm although it comes at the cost of higher volatility. It follows that in a flatter yield curve environment, longer maturities may be more attractive. If a company’s revenues are highly correlated with short-term rates, it should keep maturities relatively short, however.

If, as Abuaf thinks most likely, that interest rates increase 100 basis points across the curve, CFOs should lengthen maturities now.

Authored by Niso Abuaf, Pace University and Samuel A. Ramirez and Co.

Management’s Key Responsibility

Management’s Key Responsibility

In our second article Special Issue on Growth and Innovation Bartley Madden, a leading management consultant and author, follows up after Edmund Phelps’ leading article on innovation and mass flourishing with specific recommendations for business managers.

Madden identifies a firm’s knowledge-building proficiency as its most important capability in order to survive and prosper over the long term. Even a firm’s competitive advantage and intangible assets are best understood as the result of its ability to build knowledge.

Along with a firm’s organizational structure, knowledge-building proficiency coordinates and improves work, innovation, and resource allocation.

Madden is very critical of much of the current academic finance research that, while ostensibly focused what creates “excess shareholder returns” (i.e., economic profit or economic value-added), is actually irrelevant to a fundamental understanding of what creates long-term value.

Academic studies are usually just statistical factor analyses. Even when economists study individual firms, they usually do so by modeling them simply as production functions: management is assumed to coordinate factors of production to make and sell products until marginal costs equal marginal revenue and profits are maximized. Such a firm is assumed to have clear boundaries and its management tightly controls the work of employees and the accumulation and allocation of its physical assets.

Instead, Madden proposes a new and more sophisticated concept of the firm to position human capital, in general, and knowledge-building proficiency, in particular, at the center of value creation. In this connection he offers two business exemplars: the American retailer Walmart and the Chinese Haier Group that makes consumer electronics and home appliances.

Authored by Bartley J. Madden

Toward a Theory of Indigenous Innovation

Toward a Theory of Indigenous Innovation

In the first article from our Special Issue on Growth and Innovation 2006 Nobelist Edmund Phelps expands upon the ideas about innovation and creativity he introduced in his 2013 book Mass Flourishing. Phelps argues that while economies have continued to evolve, the concepts in economics have lagged behind.

Western nations that have gone from brilliance to very slow growth have little idea of how to redevelop the old élan of their best decades. With only the standard toolkit, economists may offer relief from some of the symptoms of the illness, but not a cure. Standard economics cannot cure the illness because it cannot know the causes.

In standard economic models, the reward for work is fundamentally the market wage. There is no room for any human agency by which a person might gain rewards other than the going wage. Thus, standard models miss the character of a modern economy.

The treatment of “innovation” is especially lacking. Standard economics uses the word “innovation” to denote a shift in a “technology” parameter. Yet these parametric shifts are exogenous to the economy—not new products or new methods conceived in the economy, thus endogenous to the economy.

Western nations that have gone from brilliance to very slow growth have little idea of how to redevelop the old élan of their best decades. With only the standard toolkit, economists may offer relief from some of the symptoms of the illness, but not a cure. Standard economics cannot cure the illness because it cannot know the causes.

The critically missing element in standard economics is indigenous innovation. This refers to new ideas not just to adaptations.

A great many businesspeople take the view that a company “innovates” when it detects and acts on a new opportunity—one that fills a need. But the concept of an indigenous innovation—a new idea that brings new practice—is miles away from the concept of detecting and acting on an opportunity that brings new practice.

Indigenous innovation, where it occurs, is driven by people’s creativity. Innovators use their imagination to conceive of new products or methods and their ingenuity and savvy to implement the new product or method, that is, to make it and market it.
New ideas are not the same thing as science. Science does not tell us whether there will be a market for any of the new possibilities; business knowledge is indispensable here. Even in Western countries, myriad business discoveries may have led to as many new products and methods as from scientific discoveries between the 1820s and 1960s.

Phelps believes the “spirit” of dynamism derived from modern ethical values including individualism, vitalism, and self-expression. They also include what Phelps calls “visionaryism” or the desire to create entirely new things.
Modern societies developed as the result of these modern values. And where these values reached a critical mass, modern economies sprouted up which brought mass innovating and thus rapid economic growth. The dynamism also enriched work. Ordinary people had engaging employment and most of them prospered and many flourished.

Phelps sees several causes for the loss of dynamism, particularly regulation and what he calls “social protection.” He is not referring to social security but to efforts to inhibit change. Not only does social protection stymie potential agents of change on the outside (e.g., by blocking potential startups) but CEOs who might have been innovators are reduced to being lobbyists and rent seekers. He thinks the private sector may also suffer from “decadence” including corruption, weak governance, and short-termism.

Phelps refers collectively to the old values opposing modern values as “corporatist values.” Now pervasive in all the nations of the West, corporatism is behind the self-serving vested interests, clientelism, and cronyism.

Two propositions follow from this assessment:
1. Nations that lack the dynamism for mass indigenous innovation will not achieve the prosperity of which modern economies are capable. “Reform” will be fruitless without the right culture. It will be necessary to bring back into schools and the home the literature of adventure and exploration.

2. The once-dynamic nations of the West cannot regain the stunning indigenous innovation of the 19th and 20th centuries without first doing battle with corporatist values. Western nations will have to reassert the modern values.

Authored by Edmund Phelps, Columbia University