Accounting is a wonderful tool for converting tautologies into useful information

Wednesday, January 25th, 2023

Accounting is a wonderful tool for converting tautologies into useful information:

Here, for example, is a tautology: when a company spends money, somebody receives that money. And here is a useful mental model that helps investors think about booms and busts, time industry cycles, and spot second- and third-order outcomes of news: one company’s expenditures are, very often, another company’s revenue.

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Higher returns to capital are a subsidy for reinvestment, and economies require a lot of reinvestment to keep going. Roads, railroads, ports, airports, power plants, factories, and homes are all long-lived assets with high upfront costs. For a country to have a lot of them, a smaller share of national income has to go to consumption so a larger share can go to investment instead. Importantly, shifting more returns to capital does not necessarily make all the capitalists rich (though it can have that effect!). It means there’s a race to identify good investments fast since there’s more money chasing them, and when this kind of policy continues for too long, the wave of capital looking for a return can end up subsidizing spending that simply doesn’t make economic sense. For example, in China circa 1980, pretty much any piece of physical infrastructure was probably worth either fixing up or tearing down and rebuilding entirely, so the country got good returns from holding wages down while reinvesting the proceeds of exports. Now that China is a richer country, with lots of infrastructure, it’s harder to find good homes for incremental money — but the money continues to flow.

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High-income workers tend to save more money, and their savings rate goes up when they experience windfall gains. Lower-income workers are usually scrimping, deferring some purchases, and missing out on things they’d like to spend on, so higher wages for them tend to increase consumer spending.

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When fab utilization is low, new demand just means that existing fabs need to run extra shifts. But when utilization gets high enough, it means the world needs more fabs, and needs more $200m-apiece EUV lithography machines to fill them.

This tends to be the big takeaway from looking at the world from a supply-chain perspective. When there’s slack in the system, or an ability to immediately respond to incremental spending, we see a pretty steady impact on every link in the supply chain: a surprise 1% increase in datacenter spending produces a 1% increase in spending on datacenter chips, which also leads the replacement of chipmaking equipment to tick up by about 1% — not because additional equipment was needed to increase supply, but because more is in use, which means more will need to be replaced.

But when there isn’t slack in the system, a small incremental increase in final demand can produce massive changes in total production capacity. The rough way to approximate this is to look at the useful life of the relevant investment, invert it into a depreciation rate, and then compare changes in demand to that depreciation rate. So if there’s some kind of asset that lasts for 10 years, another way to look at it is that in a given year, 10% of those assets are getting replaced as they wear out. A 2% increase in demand for whatever those assets produce, if they’re all being used at full capacity, means a 20% increase in demand for the assets.

Comments

  1. David Foster says:

    Something is messed up with the link.

  2. Isegoria says:

    Thanks, David. I don’t know how it went awry, but it’s fixed now.

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