Innovation, Risk, and the ‘Most Hated Book of the Year’
By Nick Schulz
Wednesday, May 23, 2012
Edward Conard argues that in the wake of the commercialization of the Internet, the structure of our unrealized investment opportunities has changed dramatically.
Editor’s note: Edward Conard is the author of “Unintended Consequences: Why Everything You’ve Been Told About the Economy Is Wrong.” It’s a book that the New York Times has said might be “the most hated book of the year” for its blunt discussion of the role played by investment and risk-taking in driving innovation, economic growth, and income inequality. Conard is a retired partner of Bain Capital, where he ran Bain’s New York office. Below, he answers questions from THE AMERICAN’s Editor-in-Chief Nick Schulz about investment, risk, inequality, and more.
Nick Schulz: You argue that antiquated accounting obscures the link between investment and innovation. Can you give a specific example or two of what you mean and why this matters so profoundly? How does, say, Wal-Mart, Google, or any other firm account for something in a way that obscures how its investments yield innovation and growth?
Edward Conard: People create innovation by finding ways to make improvements and by implementing those improvements—both incremental improvements and major changes. These efforts extend far beyond science-related endeavors. For accounting reasons, the costs of people are largely expensed. Only recently, for example, have accounting rules allowed the capitalization of software development costs, an endeavor essential to the acceleration of U.S. growth. These costs are still largely expensed.
The book’s claims are based on the work of Corrado, Hulten, and Sichel, who conservatively identify and reclassify people-related investments both historically and across economies. They find people-related investments have risen steadily over time and that they accelerated following the commercialization of the Internet. By these measures, investment in the United States has significantly outpaced other high-wage economies.
We see the results of this increased investment in our output. The United States has grown significantly faster than other high-wage economies, the growth rate of the productivity of the U.S. workforce has returned to near-WWII highs, and the value of the stock market has grown relative to GDP. Increased consumption doesn’t produce those kinds of gains. Productivity gains have come largely from acceleration in the growth rate of know-how and not from acceleration in the growth rate of capital investment per employee or increased workforce training. We have not seen similar gains in other high wage countries.
Schulz: The economist Arnold Kling has argued that for certain innovative firms, the bright distinction between labor and capital is meaningless; instead, it is more useful to think that labor is capital. Do you agree?
Conard: Yes. After World War II, the United States largely grew by supplying efficiently manufactured goods to a newly created national market. We capitalized on the value of automobiles, for example. To do that, we had to build an enormous automotive manufacturing industry, pave millions of miles of roads, build a worldwide oil industry, and produce a fleet of 250 million cars (today). The scale of these endeavors was enormous. It left less room for the entrepreneurialism of individuals.
Today, 13 people can create Instagram and $1 billion dollars of value in two years with virtually no capital. In the wake of the commercialization of the Internet, the structure of our unrealized investment opportunities has changed dramatically. The importance of individuals, talent, and risk-taking have increased dramatically relative to the importance of capital.
Schulz: You point out that skill-biased technological change has driven rising income inequality. In your view, is there a point at which inequality should concern policymakers? If so, what’s the proper response?
Conard: We should grow concerned when further growth in income inequality stops being beneficial to the middle class and the working poor—if and when the rich somehow use, or I suppose even credibly threaten to use, their wealth to thwart further innovation or to take rightfully earned income away from the middle class and the working poor. We might find the middle class paying a disproportionate share of the taxes, for example. Today, we find the opposite. As the most talented Americans have grown disproportionally more productive relative to the rest of the world, they have paid a disproportionally greater share of the taxes. And where Europe has provided more government services, the European middle class has paid for those services with higher taxes. At the margin, it’s hard to see how the success of another Steve Jobs significantly threatens the middle class.
We might also grow concerned if we were paying talented people more money to create value than is required to discover and harvest the value of innovation. If, for example, there was a shortage of talent and it was able to collect unearned monopoly rent. But, again, today we see quite the opposite. We see a surplus of underutilized talent and a shortage of talented people willing to get training essential to growth and to take the risks necessary to produce it. It’s hard to see how talented risk-takers are collecting monopoly rent.
Along the same lines, some economists argue that the payoffs for successful risk-taking don’t motivate increased risk-taking—that Americans will take the risks necessary to produce innovation even though their colleagues in Europe and Japan stand in stark contrast. Wishful thinking has always been the scourge of critical thinking.
We might also grow concerned when a backlash to inequality threatens to dampen down the incentives for the risk-taking needed to produce innovation, which, in turn, threatens the benefits of accelerated innovation.
The optimal responses would depend on the circumstances, and the resulting effects would be hard to predict. For example, if the rich were truly able to close off opportunities to others, we would want to take action to make the political process more balanced, by restricting campaign contributions, for example. But one party would likely endeavor to restrict the other, no matter the optimality of the balance. If a shortage of talent was merely collecting rent, we might want to open immigration to the most talented workers. But other countries might make concerted efforts to steal our know-how and mitigate our competitive advantage. In the third case, we might endeavor to educate others about the benefits to them from innovation, which is the objective of my book and your organization, but there is no guarantee such efforts would work.
Schulz: You point out that the only way to support domestic unskilled wages in a world awash in unskilled labor is to successfully redeploy that labor to other sectors of the economy. What would those sectors be and how do you envision that happening?
Conard: It’s not something I envision happening; it has already happened! U.S. manufacturing employment is now only 11 percent of overall employment, less than other high-wage economies. Steep declines in the cost of food drove growth in manufacturing in the 1950s and 1960s. Today, productivity gains in manufacturing drive growth in domestic services—doctors, nurses, schoolteachers, truck drivers, and salesclerks. Because of this successful transition, long-term growth in the United States has been substantially higher than other high-wage economies.
It is near impossible to predict which sectors will grow and decline. If we knew that, we would all be rich! And we wouldn’t need to pay successful entrepreneurs to take the risk necessary to find new growth opportunities for us. Instead, the economy must run millions of experiments. These business experiments compete fiercely with each other for customers and capital. Competition prunes away all but the most valuable—by my estimate, companies that probably produce 20 times more value for customers than the cost of their products. Before the fact, entrepreneurs face near certain failure. After the fact, they only earn a dollar more than the next-best alternative—a small and uncertain share of the value they create for us. If there is a better way to find growth, no one has found it.
Schulz: Why do you think offshore savings (in, say, Europe and Asia) are so risk-averse (e.g. preferring U.S. Treasuries)? Are there offshore exceptions to this general rule?
Conard: A country can’t run a trade surplus unless their workers save money and buy assets instead of goods. If they bought goods, trade would be balanced. No surprise, surplus exporters—namely Germany, Japan, and China—are all nations with high savings rates.
Deferred consumption by middle-class workers, both here and abroad, tends to produce risk-averse savings. They save for homes and retirement and can’t afford large losses. Successful innovation produces equity, which underwrites risk. Equity owners can often tolerate more risk because they have more assets.
Most of the innovation has occurred in the United States, no matter the reasons. Manufacturing-based exporters have tended not to be innovative leaders. It’s hard to be competitive at one thing, much less two. We have a much bigger stock market relative to GDP than Europe and Japan. In part, that leads to a greater tolerance for the risks necessary to produce innovation.
The United States is the exception.
Schulz: How should the public and policymakers think about asset bubbles (e.g. the dotcom/telecom bubble of 1999/2000)? Obviously there’s lots of capital that, in hindsight, is misallocated. But, in your view, there are unappreciated aspects of bubbles, correct?
Conard: I believe there is no systematic way to identify asset bubbles. If an individual or group of individuals has an opinion that differs from the market, they are almost always in error, not the market. And even if some hedge fund managers have found a way to beat the market, I wouldn’t trust them with my freedom regardless.
We simply can’t let someone have the power to determine whether we can buy a legitimate good or asset for a price we are willing to pay. At the end of the day, institutional buyers have to take responsibility for themselves. There is simply no other way for the free market to work.
This is why the Financial Crisis Inquiry Commission went out of its way to avoid blaming buyers for the crisis. Were it to have done so, it would have produced questionable grounds for increased regulation. Although markets will make mistakes from time to time, there’s no way we can trust any group in government to monitor bubbles and take action; the mistakes they make will be much worse than the mistakes markets make.
Schulz: How do we know that it is consumers and wage earners who capture the vast majority of value created from investment, and not investors themselves?
Conard: Wage earners have consistently captured 70 percent of GDP over time and across economies, no matter the amount of capital invested per worker. While GDP is measured at the price of goods, consumers buy goods because they are worth more than they cost. Google, for example, costs users a small loss of privacy for an enormous increase in their productivity. Economics calls this buyers’ surplus. I conservatively estimate the value of products at two times their price, but show several micro and macro examples that indicate the value is probably closer to 20 times the price on average. Because all products compete against each other for the customer’s incremental dollar, it is logical that some common ratio of value-to-price drives their success and failure even though markets may be inefficient. If wage earners capture 70 percent of half the value of production, and consumers capture 100 percent of the other half, then non-investors capture about 85 percent of the value of production. The middle 40 percent of income earners capture about a third of that value.
Schulz: Who are your intellectual influences?
Conard: Bruce Greenwald at Columbia, my close friend, taught me economics, issue by issue, over 30 years. His early work on equity as the binding economic constraint played a major role in my thinking. His later work on trade, in both the long and short run, changed my views.
Ricardo Caballero at MIT showed me that trade was driven by many factors besides competiveness. His work on the financial crisis gave me confidence to propose strengthening government guarantees of liquidity.
Gary Gorton at Yale showed me a run on the banks, not loans losses, caused the financial crisis. Paul Roemer opened my eyes to the changing structure of unrealized investment opportunities. Mario Giampietro gave me a glimpse of the big picture—a nested hierarchy of positive feedback loops.
Bill Bain taught me how business really works—competition forces competitors to deliver more and more value at lower and lower costs; customers capture most all the value created by investors; investors only capture their advantages relative to competitors; and those advantages are fragile and quickly eroding.
Allan Bloom opened my eyes to the importance of communitarianism and that talented people have a moral obligation to maximize their contribution to society.
FURTHER READING: Nick Schulz interviews more authors in “The Life and Death of Great American Cities,” “America Is Out of Control,” “Want to End Poverty? Legalize Freedom,” and “The Most Important Start-Up.” Kevin A. Hassett and Steven J. Davis say “Private Equity Is a Force for Good.” Arthur C. Brooks contends “True Fairness Means Rewarding Merit, not Spreading the Wealth.”
Image by Rob Green / Bergman Group