(mis?) measurement in financial services

One of the tidbits that came out of the Advancing Knowledge conference (see previous posting) was a nice example of how our current thinking inadvertently penalizes investment in intangibles. This is from Bob Hunt, a senior economist at the Federal Reserve Bank of Philadelphia:

The standard efficiency analysis for commercial banks is to examine some variation of the ratio of non-interest expense to average assets.

Bank expenses are divided into two large categories – interest expense and non-interest expense. Interest expense is the cost of borrowed funds (e.g. deposits), but the primary focus is on non-interest expense, which includes such things as the cost of buildings, etc.

One problem with this measure is that banks don’t amortize much of their investments in new products and services, or in reducing the cost of providing existing services. In particular, banks have no conception of investing in research and development. This is all expensed, and it appears in the non-interest expenses of the bank. As a result, a bank that is investing heavily in new products and services may appear less efficient than a bank that isn’t making these investments.

Yet, efficiency is an important measure of the health of a nation’s banking sector and a key economic goal of the financial regulations. It has become clear that financial institutions have been using technology and other innovations to become more efficient. But as Dr. Hunt points out:

Our accounting for this sector is rooted in a very static view of the industry even though there is ample evidence of financial innovation in the U.S. over the last 30 years.

We simply don’t have an accurate measure of R&D performed by the financial services sector. Some recent input-output tables performed by the Bureau of Economic Analysis suggests that this sector produced about $20 billion of software for its own use. Based on the conventional accounting, it appears that nearly all this effort was expensed.

NSF is now generating estimates of R&D in financial services in its survey of industrial R&D, but that is a very recent innovation and it is not exactly clear who is being surveyed and what is being measured.

Any new measure of innovation in the financial services sector would be a welcome step, but can not stop at simple estimated of R&D. As I have argued before, we need a survey of innovation, similar to the EU’s Community Innovation Survey – not just a measure of R&D. At best, R&D is a proxy measure of inputs to the innovation system. At worse, it is a misleading indicator of how well we are doing. We need to do better.

Brands – again

This may fall into the beating-a-dead-horse category, but this morning I picked up my latest issue of The Economist to find Samsung touted as the poster child of brand value in the digital age. Not one of those top US brands that PPI bragged about (see my posting yesterday) but the upstart from Asia.

Samsung was once best known for making things like cheap microwave ovens. In the past few years it has transformed itself into one of the “coolest” brands around, and is successfully selling stylish flat-screen TVs, digital cameras and mobile phones. After a record-breaking year, it is poised to overtake Motorola as the world’s second-biggest maker of mobile phones. And it is snapping at the heels of Japan’s Sony for leadership in the consumer-electronics business.

This would have seemed inconceivable a decade ago. But Samsung has proved that a combination of clever brand-building and well-designed, innovative products can work miracles. In such a competitive market, a brand without good products will quickly fade. But the real surprise is that the opposite is also true. The market is crowded with firms with a few snazzy products, but weak brands. To thrive and grow on the scale Samsung has achieved requires a strong brand, as well as innovative products.

In all fairness I must mention that the Economist also gives a tip of the hat to a US brand: Apple. But the point remains, strong brands alone are not enough to guarantee economic success. Yesterday’s second-string brand may become today’s powerhouse. And today’s health of a nation’s inventory of brands is no indicator of tomorrow’s prosperity.

Brands and trade

My friends at the Progressive Policy Institute sent me an email today with their latest Trade Fact of the Week contrasting two views:

The CIA’s National Intelligence Council last week, in a report on the possibilities of the world in 2020, noted the rapid growth of India and China and wondered about the possibility of an “Asian century.” One piece of evidence is the growing international appeal of Asian popular culture: Japanese anime and manga, Korean music, Chinese and Indian cinema, and so on.
On the other hand, Western business and entertainment brands seem still to be in pretty good shape. Since 2001, the consulting firm Interbrand has joined with Businessweek to publish an annual list of the world’s top 100 “brands,” defined as the likely future earnings of a company name. The brand values range from $67 billion (Coca-Cola) to $2 billion (Polo); they are distributed around the world as follows:

• Fifty-eight of the brands are American, including the top seven and 13 of the top 16. The diversity of the American list is striking: the top 20 U.S. brands range from high-tech businesses Microsoft, IBM, Intel, HP and Cisco; to diversified manufacturers GE and automaker Ford; Disney in entertainment; consumer-goods firms Coca-Cola, Marlboro, Gillette, and Pepsi; fast-food chain McDonald’s; and financial services providers Citibank and American Express.
• Thirty-four brands are European, among these Nokia leads in eighth place. The remaining 33 are split fairly evenly: nine are German, eight French, four and a half British (giving half credit for ownership of Shell to the U.K and half to the Netherlands), four Swiss, three and a half Dutch, three Italian and one Swedish. These are more nationally specialized than the American list: four of Germany’s nine entries are automakers, while Italy’s three members are high-end fashion firms Gucci, Prada, and Armani. The British entries, a bit more diverse, include the Hong Kong and Shanghai Bank, the Reuters news service, two energy companies and a liquor firm.
• Eight firms are Asian, led by Toyota at ninth place, Honda and Sony in 18th and 20th, and Korea’s Samsung in 21st. The other four are Japanese: Canon, Nintendo, Panasonic, and Nissan. No firm on the list is based in mainland China, Hong Kong, or Taiwan. Neither do India, Southeast Asia, Latin America, the Middle East, or sub-Saharan Africa have entries.

While I often agree with PPI’s point of view (and sometimes don’t), I have to take exception with their analysis. Brands are a very, very, very important intangible asset. But they are only part of the value equation. Brands are marketing devices – signals of quality, consistency, etc. As such, they allow a company to capture a higher portion of the value-added.

However, except for those pure service providers, there is still a portion of value in the intangible economy created by the tangible product itself. As our huge trade deficit attests, many of those things being sold under those American brands are made elsewhere, especially in countries that currently have no leading brands on the list (China, India, and Southeast Asia).

If history teaches us anything, it is that economies are not static. A number of those brands, both US and foreign, were not around or not as powerful 20 or 30 years ago. Simply because we lead in the number of brands today is no assurance that the scenarios outlined by the CIA are not accurate. We need to continue to build on our brand strength – not assume that it will carry us forward. As they warn in the financial markets, past performance is no guarantee of future success.

Advancing Knowledge and the Knowledge Economy

Last week I was at a fascinating conference on Advancing Knowledge and the Knowledge Economy. Held at the National Academy of Science main building here in Washington, it focused on the transformation of knowledge:

Knowledge assumes many forms and behaves in anomalous and unpredictable ways. Unlike the tangible resources of the industrial economy, there is little shared understanding of knowledge as an economic factor despite its immense importance in the global economy. Yet the knowledge-based economy, conventionally measured by the composition of the workforce, is in flux. It is plainly characterized by an explosion of data and codified knowledge, propelled by a revolution in information and communication technologies, but the changes go much deeper.
The generation of knowledge is traditionally conceived as a process internal to single entity. But it is increasingly a product of networked entities, often differently situated yet motivated to find new solutions to specific problems, needs, and circumstances – and, in many cases, to reveal these solutions to others. Enabled by technology, knowledge moves quickly within these networks – across firms, institutions, borders, and distances. While scientific research has long been characterized by unfettered circulation of discoveries and the ability to build instantly on these discoveries, distributed models are gaining importance and becoming essential to the larger fabric of the knowledge-based economy.

Abstracts are available at the conference website; the actual papers and presentations are not yet up, but should be available soon. The website also contains a link to a couple of relevant OECD papers (OECD being one of the major sponsors).
One aspect of knowledge very much in play at the conference was serendipity. Throughout the two days, I picked up little gems of insight and information that were not part of the speaker’s main message. Rather than try to summarize the presentations, I will be posting these tidbits over the next few days.

Underestimating savings

While the account profession continues to resist counting research and training as an investment, there is some slight movement at the level of macroeconomic statistics. Recently, the Bureau of Economic Analysis (BEA) and the National Science Foundation (NSF) announced a new project to look at the issue. The project would create a “satellite account” for the R&D portion of the GDP numbers — including looking at the issue of treating R&D as an investment (i.e. capitalizing the cost over a number of years, similar to what is already done with plant and equipment, rather than expensing it). According to research by BEA economists, our current treatment of R&D as an expense underestimates our national rate of savings by approximately 2 percentage points.
As Michael Mandel points out in a recent column in Business Week, this underestimation distorts our policy debates and focuses attention on the wrong priorities:

The coming debates over tax reform and private accounts for Social Security are going to be framed in terms of the savings rate as well. All the proposals for overhauling the tax system are geared toward putting more of the weight of taxation on consumption, and less on savings and investment. And many supporters of Social Security privatization claim that the current system lowers savings, because Americans rely on the government to fund their retirements rather than putting money away themselves.
In the end, what will propel growth is human capital and innovation. It’s the hidden savings rate that deserves the attention, not the official one.

This mirrors an argument that Baruch Lev has repeatedly made about the expensing of corporate R&D. It has always surprised me that the high-tech community has focused exclusively on the issue of stock opinion and completely ignored the issue of capitalizing of R&D. Part of the problem has been accountants’ concern over the validity of the procedure. The movement by the economists in charge of macroeconomic statistics toward capitalization of R&D in the national accounts may give a new push to the business accounting issues. After all, these folks are hardly a radical bunch. And if they say this is the right thing to do for the national accounts, it is going to be harder for people to say it can’t be done at the firm level.

Inclusion in the Intangible Economy

The Martin Luther King, Jr. Holiday is more than just a day off. It should be a time to reflect on where we are in meeting Dr. King’s Dream and the American goal of an inclusionary society. An inclusionary society is absolutely necessary for the functioning of an intangible economy. As Richard Florida and others have pointed out, creativity thrives where there is diversity and tolerance. In this intangible economy, we can not afford to exclude any human assets.
The intangible economy is also the networked economy. Metcalf’s Law roughly states that the value of a network increases exponentially in relation to the number of participants. The same is true for that network of productive activity we call the economy. By leaving some behind, we impoverish not only those individuals; we also impoverish ourselves. By empowering and embracing others, we also empower ourselves.
Let us continue to keep this in mind, not only today, but always as we strive to build an inclusionary intangible economy.

Trade in intangibles

This morning’s trade figures have some good news and bad news concerning trade in intangibles. For our purposes here, I’m defining trade in intangibles as the sum of “royalties and license fees” and “other private services” (see the official BEA/Census definitions of these two categories below). The good news is that our balance of trade in intangibles is holding steady over the past three years at between $6 and $6.5 billion monthly. Imports of intangibles have steadily increased over the past three years from $7.5 billion to almost $10 billion. But exports have increased as well.
The bad news is that our balance of trade in intangibles is holding steady at between $6 and $6.5 billion monthly. Intangibles are not offsetting our large deficit in goods. If we are to get our trade deficit under control, we have to pay more attention to goods and not rely on the myth that “services (intangibles) will save us.”
As I have often argued, much of the power of intangibles is how they operate within all sectors of the economy – not as a separate sector. We need to harness our intangibles to re-invigorate our goods trade as well as rely on our “intangible trade.”
Intangibles trade 1.gif
BEA/Census Bureau definitions:
Royalties and License Fees – Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term “royalties” generally refers to payments for the utilization of copyrights or trademarks, and the term “license fees” generally refers to payments for the use of patents or industrial processes.
Other Private Services – Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term “affiliated” refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise’s voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.