Economists don't know margins

For some time it has been bothering me that when I look around there is a lot of prosperity but if you read the newspapers, it's all just a house of cards - all about to come down when the "kindness of strangers" has run its course. What I was seeing was not what those people who write about "twin deficits" were describing.

So finally, at long last, I came across somebody else who believes in "follow the money" - Andy Kessler whose book "Running Money" I have just finished. Although many of the things he writes in his conclusions I've had in my head for a while, I have certainly not been able to come up with as simple and self-evident examples of why the economists don't really get it.

The fundamental problem is that economists don't know (or don't care) about profits. As a consequence, they don't look at relative numbers such as a profit margin and instead look only at the absolute numbers such as imports and exports. The same is true of government bureaucrats and the only people who care about margins are investors / the stock market.

When an American buys a Toshiba laptop for $1,000 that is an import of $1,000. That laptop contains a CPU made by Intel which Toshiba paid Intel $300 for and a copy of Windows which Microsoft sold to Toshiba for $50. From the standpoint of national accounts, a trade deficit of $650 has just taken place.

What is missing from the above is the analysis an economist or the government is not interested in but the investor is. How much did Intel make on this deal and how much did Toshiba make? The processor that Intel sold Toshiba has a gross margin of more than 60% and therefore Intel registered a positive margin of $200 on a $300 trade. Laptop market being as competitive as it is, Toshiba is lucky if it made a $50 margin on its $1,000 laptop. If you look at it from the perspective of America and the rest of the world, which would you rather have - the $200 profit or the $50 profit?

A further point is that for commodities and even laptops (which are commodities by now), you can get an indistinguishable ton of steel from Brasil or a ton of steel from France or a laptop from Taiwan or a laptop from Korea. But there is only one place where you can buy CPU's either from Intel or AMD (even if the actual fabs are in Taiwan or elsewhere the profits accrue to the American company), there is only one place where you can buy Windows and only one place where you can buy a graphics card (Nvidia or ATI which is a Canadian company). These are unsubstitutable products which demonstrate the huge leverage of intellectual property.

So what then happens to the $1,000 we have just paid to Toshiba for their laptop? Some of it goes to buy U.S. products but whatever is left will get invested. It will get invested rationally and kindness has nothing to do with it. When looked at rationally, those investors will want to buy the bonds of the country that benefits the most from the leverage of intellectual property and they will want to buy bonds and stocks of companies that have the biggest margins. You put your money where it will make the most return at the least risk.

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