Growthology

Insurgent Capitalism

Dane Stangler - growthology.org Guest Blogger - wrote up a typically deep and insightful essay over at Real Clear Markets:

The challenge is to orient regulation such that it protects access to entry—our economic policy must, in other words, become pro-insurgent. It must seek to maintain competition and help structure the economic playing field so as to give the widest scope to individuals and companies working at the margins to challenge existing ways of doing things.

BitTorrent, Harbinger of a Tech Downturn?

In this latest financial downturn, many market analysts have said that technology companies look to be okay. BitTorrent begs to differ, searching as it is for both a business model and a new mission. What are the implications?

From The New York Times's blog,

Today BitTorrent informed about half its employees, or 18 people, that they were being let go, according to a person familiar with events inside the company. That is in addition to a 20 percent staff reduction in August. In addition, a co-founder, Ashwin Navin, said yesterday that he was leaving the company, although he informed the board of directors of his exit in March.

A person with knowledge of BitTorrent’s plans also said the company would soon close its BitTorrent Entertainment Network, once conceived — and covered in the press — as a rival to iTunes. The company, with its remaining 20 employees, will focus on BitTorrent DNA, a content delivery network that helps media and video game companies distribute their products cheaply over the Internet.

It seems problematic for the company to actually turn a profit. Although the company has struggled to find its market niche, BitTorrent is actually used heavily. The Pirate Bay, a popular and semi-legal downloading site, now includes nearly 25 million peers.

Ashwin Navin, BitTorrent's former CEO, will be starting a start up incubator with several other Silicon Valley types from YouTube on down. Even as most pundits focus on the capital side of capitalism, the growth side of capitalism with its churning labor markets and innovative entrepreneurs continues unhindered.

Last month, my good friend (and GMU professor) Garett Jones surveyed the bailout mania rampant in Washington, DC and muttered the funniest line of the season: "Creative destruction, it was fun while it lasted." I tend to agree in spirit, but don't think mere national governments can stop human ingenuity. Oh, but they'll try ...

The Slippery Slope to Socialism

I learned yesterday that the presidential election has renewed a conversation in America about socialism. It is good that none of the candidates are embracing the moniker of socialism, but you would be surprised how easy it is for a people to slip into a socialist mindset, regardless of what we call it. Even the most hard-bitten capitalists might lazily think in such a way. Even a blogger you know ...

In my last post, for instance, I wrote "Look, if it is in the national interest to save these companies [GM and Chrysler], then taxpayers should have a say in how the money gets spent."

Minutes after publishing the post, it hit me how easily I had fallen into the trap.  Sounds a lot like socialism, doesn't it? 

In socialism's purest form, the government would take outright ownership of firms, manage them, establish wages, and so forth. Few would be so brazen. We instead need to be watchful for the slippery alternative form of socialism wherein the government acts as a "lender" rather than an owner. You might recall this was the approach suggested by Bernanke and Paulson, initially, until numerous voices suggested the taxpayer deserved some upside (e.g. a sliver of ownership) in distressed assets. Or warrants - a fancy way of getting ownership with upside. I'm afraid this mindset may have become a default consensus framework. But it is the next step is where we get into real trouble.

The next logical step following taxpayer's role as lender/owners of distressed firms (or indeed any firms that "voluntarily" accept government rate funds) is this: conditions. It is exactly the logic I followed earlier. Take public money = take public conditions on how your firm is operated.

The trouble hinges entirely on what conditions the government should, could, and will establish. For many people, conditions include limiting executive pay, minimum wages for each occupation (i.e. privatizing Davis-Bacon rules), mandates for health insurance, dental insurance, and so forth. If the federal loans are to banks, one would imagine these conditions would be extended to all small firms borrowing from those banks. FDIC insured lenders?  Sure, them too. How about rules that force firms to buy American components? -- very popular in some Republican as well as Democratic circles.

In the GM case, I think it is pretty clear that the conditions should involve bankruptcy-like realignment of unsustainable contracts with the unions -- including the infamous policy of paying workers to sit around and do nothing. In other words, the conditions I envisioned would lower costs, not raise them. But who is to say what policies will become part of the consensus rescure template?

Who is to say, indeed.

One final thought. You may notice that my initial statement calling for conditional lending included a qualifier. "... if it is in the national interest to save these companies  ..."

That is a very big if.  I will try to make it clearer next time.

American Dreaming

Uh-oh.  Some scientists have determined that the American Dream is actually impossible to achieve. The neuro-science is solid: people cannot achieve happiness through material abundance. Unfortunately, that science is being badly misinterpreted and then further misapplied as policy advice for reforming our economy. The problem is that many otherwise intelligent people don't have a firm grasp of either economics or history, specifically that the "American Dream" is not a culture of greed, but a culture of personal independence that stood in stark contrast to class distinctions in Europe.

This zeitgeist is being generated by Peter Whybrow, head of the Semel Institute for Neuroscience and Behavior at UCLA and author of American Mania: When More Is Not Enough. Whybrow's argument, to the extent not evident in the book's title, is that the American culture is founded on self-satisfaction, and worse, a strain of competitive consumption, fueled by irresponsible credit. WIRED summarizes the Whybrow critique thus:

Our built-in dopamine-reward system makes instant gratification highly desirable, and the future difficult to balance with the present. This worked fine on the savanna, said Whybrow, but not the suburbs: We gorge on fatty foods and use credit cards to buy luxuries we can't actually afford. And then, overworked, underslept and overdrawn, we find ourselves anxious and depressed.

You might agree with Whybrow. I certainly agree, and strongly, with some of his points. But not his conclusions. Whybrow is making a mistake of confusing the effects with causes. The American Dream is not material prosperity, but the system that gives people the opportunity to prosper. Miss that nuance, and you do not understand America. So when Whybrow confuses these two, he is contributing to 21st century cultural amnesia: Americans are forgetting who they are.

Historically, one could point to the Declaration of Independence as the origin of the Dream, which laid out the principles of equality and unalienable Rights, notably the Pursuit of Happiness. But as a phrase, "American Dream" was coined in the 1931 book Epic of America by James Truslow Adams. Adams wrote:

The American Dream is that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement. It is a difficult dream for the European upper classes to interpret adequately, and too many of us ourselves have grown weary and mistrustful of it. It is not a dream of motor cars and high wages merely, but a dream of social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position." (emphasis added)

So even at its first muttering, the idea of The American Dream was literally and pointedly not about materialism, but about the means of individual liberty, free of class, caste, and race. People who say otherwise are committing cultural libel. Seriously, if the American Dream is a fiction, somebody better tell my grandfather, because he must have been mistaken when he died happy (and poor) because he lived as a free man in a humble home.

Unfortunately, the wayward thinking doesn't stop there.  It just starts there.

Again, as summarized by WIRED:

The answers aren't easy, Whybrow cautioned — but they do exist. People can think creatively about jumping from the treadmills of bad jobs and unmeetable needs; and even if this isn't always possible, they can teach their children to live modestly and within their means. Urban engineers can design cities that allow people to live and work and shop in the same place. Governments can, at the insistence of their citizens, provide the social safety nets on which social mobility, stagnant for the last 50 years, is based. And we can — however much it hurts — look to Europe for advice.

Look to Europe for advice? Do they mean us to emulate Italy, where women don't want babies anymore or do you mean France where entrepreneurs face extinction because the labor laws are so extreme (and the lower classes riot in the streets because they cannot find jobs)? Europe is a diverse place, and the countries with the most economic freedom are the most prosperous. End of story.

Social mobility is stagnant? This is drivel. If it mean that the same percentage of people are going from rags to riches each decade, that is not stagnation.  It means social mobility is stable. Different adjectives.

Urban engineers? Right now, if people want walkable cities, they can move to them. Supply and Demand. And happily, this is happening -- the free market is already radically reshaping cities.

Bad jobs? Show me the evidence that people do not like their jobs in the U.S.! Sure, I like to mock cubicle culture as much as any Dilbert fan, but I bet mocking salt mine culture, serf/peasant culture, and hunter-gatherer culture were even more hilarious.

Living within their means. I am all for this, and it's where I find myself agreeing with Whybrow. The instinct for short-term gratification is too often indulged. And yet, the solution is not to erode America's long-term growth miracle embedded in property rights, free markets and trade, and democratizing finance. Whybrow seems to think that credit is the evil here, as if taking out loans causes overconsumption. Why not a cash economy?  Because giving poorer people access to credit is one of the great equalizers in U.S. (and world) history. We can all agree that predatory lending is bad, but to conclude that any lending is inherently bad is frankly pretty foolish. Has Whybrow not heard of microfinance?

Whybrow has an interesting interview on his homepage, and I think the most intriguing meme he is pushing is that the American people are not just culturally, but genetically distinct. The immigrants who moved here voluntarily, and those who thrived, were humans on the less risk averse side of the gene pool. He then draws numerous fantastical conclusions from this idea, suggesting that Americans are more prone to stock market bubbles (!), mental sickness, etcetera. I am inclined to agree that our culture is different, but two questions. Isn't cultural diversity a good thing inherently? Is it clear in any empirical research that Americans (or entrepreneurs) are more materialistic/greedy than others?

It just seems like Whybrow is telling Eagles they could be much happier without their feathers. 

Six Faces of Innovation

What is innovation, exactly? There is an unresolved tension whether the source of innovation comes from big firm R&D or small firm entrepreneurship. I'm particularly fascinated with the question whether breakthroughs or incremental innovations matter more to growth. And there are unresolved questions about what policies would enhance technology-based growth: industrial targeting or ecosystem optimization or research subsidies.

A May 2008 research paper (available at SSRN) written by Roger Miller and Marcel Cote titled The Faces of Innovation offers an exciting synthesis of many of the issues, and directly challenges the popular notions of "best practices" for business innovation and centralized public innovation polcies.

To be honest, at first glance this paper struck me as it may strike many of you - another glib mumbo-jumbo framework on innovation with buzzwords and checklists. On the contrary, the six-part framework is both insightful and well-organized. The authors define innovations along two axes: (1) market-creating versus in-market (MC and IM) and (2) the typology of product, process, or platform (my own abbreviations).  Here's a graphic showing the six faces or "games" (as the authors describe them) of innovation from the paper:

I've copied three interesting paragraphs from the paper, adding my own bolding:

[N]ew entrants displacing complacent incumbents and rendering old ways obsolete, is still a central theoretical tenet. There is also an almost mythical belief in the critical role of entrepreneurs as agent of rejuvenation, and by extension, in venture capital supporting them. But as Schumpeter argued late in his life, large firms with R&D are significant innovation agents, as scale matters when it comes to R&D. That view led to a strong association in public policy between R&D and innovation. Indeed, the most popular indicator of national performance on innovation seems to be Business expenditures on R&D as a percentage of GDP, (BERD).

...

A central feature of the synthesis that came out of the MINE survey is thus that innovation has many faces, each representing a distinct logic of innovation, requiring different strategies and practices. This view goes against the widely held belief that there are universal best practices to stimulate innovation. Indeed, the generalization of a unique set of "best practices" could trap entire sectors in negative-sum competition with low innovation, low growth, and low profit.

...

Government innovation strategies tend to focus on a limited number of areas strongly supported by special interests: university and industrial research, university-industry collaboration, intellectual properties, venture capital, etc... Looking at innovation from the perspective of the six games suggests different priorities, and more importantly, a much more parcelled approach.

Very highly recommended.

9/22 .... End of (Summer) Capitalism?

With news that Goldman Sachs and Morgan Stanley are ending the era of investment banking as of today, I could not help but wonder if today's date 9/22 will become a shorthand symbol as did 9/11.

The credit crisis is ongoing, but a new and unprecedented government bailout known as the Paulson Plan is being worked out in Congress. Every hour that ticks by reveals the typcial nasty partisan differences, introduces add-ons, but also allows experts to raise questions about deficiencies and unexplored alternatives.

I remain a skeptic for reasons that don't merit too much attention at a time when renowned financial experts are publishing very valuable insights. Here are four worth your time:

• Jim Hamilton, a seer if there ever was one
• Bob Litan, my colleague and a towering expert on finance
• Paul Krugman, in a welcome essay showing his wit and wisdom, rather than rancor
• Luigi Zingales, UofC professor who explains "Why Paulson is Wrong."

As for me, I would happily repeat what I have told all my econ students and countless people in casual conversation the simplest explanation for confidence: "There will never be another Great Depression." It can't happen for a handful of reasons, but perhaps the most important lesson is that the Great Depression resulted not from Wall Street's collapse, but from numerous wrong-headed responses to the crisis that unfolded over many, many years. At a minimum, the Fed will not fail to provide more liquidity, not less (as it did during the early 1930s).

New Business Cycle Theory

Step aside, RBC, it's time for NBC (New Business Cycle) theory, in a nice article in the WSJ today ...

In theory, output and income should go up and down together. If the economy is still expanding, why are so many households being squeezed?

One answer is that the business cycle itself is changing. Recessions in the past used to follow a predictable script. Business would slow or inventories would go up too much and catch companies flat-footed. As their own productivity dropped, they would belatedly respond by cutting back on workers. Then, as the process fed on itself, everything would go down together -- output, employment, income and productivity.

The 2001 recession changed the script -- productivity held up surprisingly well throughout. Companies cut back ahead of the business slowdown and kept doing it even after demand started rising again. The productivity they managed to squeeze out of existing workers bolstered output, even as it strained households.

The same thing seems to be happening again: To the surprise of many economists, worker productivity is rising, not falling.

Mathematically, a workforce contraction with relatively less GDP contraction gives off a signal of higher productivity. This is different: GDP is expanding while employment is contracting. I understand that the notion of GDP as a lagging indicator seems like the ultimate oxymoron ... because in fact it is. I refuse to believe the U.S. is in recession (and so should you) until it recesses. And yet, I can't get my head around an exploding unemployment rate (+0.4 percent in one month) in the context of a mere slowdown.

Recession or not? Yawn. Much more exciting question: How is the economy evolving?

America in Decline, Again . . . and Again . . . and Again . . .

Once again, the United States economy stands on the brink of historical irrelevance. That, at least, seems to be the consensus emerging from several books, reports, and public statements that have appeared in the last couple of years.

The din of the chorus has grown louder with the current economic turmoil. The latest salvo has come from Byron Wien of Pequot Capital Management, in the Financial Times a few days ago. Wien recounts the decline of American manufacturing, rising deficits, and our seemingly shoddy international performance in math and science. Wien has the facts right: yes, the U.S. has lost manufacturing jobs; yes, our debt and deficits have risen; yes, our students don't compare well to other countries.

The problem is that these are only numbers, and incomplete numbers at that. Declines in manufacturing employment are due in large part to productivity gains: China, remember, has also lost manufacturing jobs as its productivity has risen. Others have pointed to the danger of doing cross-country comparisons in test scores, as well as the possible explanations for discrepancies. In fact, I don't want to dwell on the general idea of decline here--others, too, have adequately covered that. (Here was a good response to Wien's column, and I hear Joel Kotkin is working on a book about persistent declinism in America.)

The most revealing thing about these periodic bouts of anxiety is that the proposed remedies are eerily similar. I offer two short book excerpts:

(1) "The National Innovation Council would be convened and led by the National Innovation Advisor. . . . This would be a 'guiding coalition,' setting direction and overseeing the innovation transformation process for our country. Its responsibilities would include adjudicating competing priorities, making useful exceptions, and orchestrating funding from multiple sources."

(2) "Solving our energy and growth problems demands that government gets more heavilty involved in the economy's major investment decisions. . . . To compete we need the national equivalent of a corporate investment committee. Major investment decisions have become too important to be left to the private market alone, but a way must be found to incorporate private corporate planning into this process in a non-adversary way."

(Wien's FT column echoes these.)

The last period of anxiety over the economic future of the United States was the late 1970s and early 1980s. One of the above excerpts is from 1980, the other from 2007 (answers below).  As Kauffman Foundation president Carl Schramm has chronicled (also explored in Good Capitalism, Bad Capitalism), the American economy in the last 25 years experienced a surge of entrepreneurship and growth driven by the confluence of a number of factors.

In 1967, for example, John Kenneth Galbraith published The New Industrial State. As Carl Schramm has written, "within a year of the first edition of The New Industrial State, Intel was founded out of Fairchild Semiconductor. The 1970s saw the appearance of firms such as FedEx, Microsoft, Apple, and Home Depot, and the expansion of companies such as Target and Wal-Mart, all of which became fast-growing parts of an entrepreneurial economy."

The rise of entrepreneurial capitalism began well before the economic troubles of 1980. By 1985, in fact, Peter Drucker was heralding the arrival of an "entrepreneurial economy." What happened was that far beneath the radar, the economy was transforming in a number of ways. The military, a major engine of the "bureaucratic capitalism" that grew up in the 1950s and 1960s, actually became a source of new discoveries and entrepreneurial opportunities. Thanks in part to deregulation, individuals and firms carved out new pathways of business in financial services and insurance. Some areas of manufacturing, even, enjoyed growth. (Take a look at the Inc. 500 list for 1983.)

It seems likely, in other words, that today the seeds of tomorrow's economic growth are being sown by individuals "out there" forging ahead, forming new firms, innovating, and seeking profit. We won't see them until they move onto the radar screen, but they're there for sure. I love analogies, and I have used this one elsewhere, but maybe we can think of this as the "dark matter" of the economy: we know it's there, expanding the economy, but we can't fully detect or measure it.

A side note: above I mentioned the military's role in in funding the research and development that helped give rise to entrepreneurial capitalism. That's not a new story. But what is often forgotten (or ignored) is the importance of the military in shaping what became Silicon Valley. When urban experts today discuss Silicon Valley and how other cities and regions can imitate it, they default to venture capital, research universities, and start-up firms. Those were all important, of course, but a very strong case can be made that the Pentagon was the sine qua non in creating Silicon Valley. You have to go back to about 1900 to see it fully play out, but the evidence is persuasive. I have yet to see, however, a mayor or urban planner propose the military as a strategic piece of economic development. (Although the Washington D.C. metropolitan area has certainly benefited from government contracting.) Anyway, this is turning into a separate topic--I'll leave it by saying that with thousands of returning veterans all over the country and the skills they are learning in the armed forces today, it is a rich but untapped resource for any city or region seeking a new avenue of growth.

Answer to book excerpts: (1) is from Innovation Nation by John Kao (2007); (2) is from The Zero-Sum Society by Lester Thurow (1980).

Just When You Thought We Were Out of Innovation . . .

Readers are undoubtedly familiar with the debates raging over American competitiveness and whether China or India or both will overtake the United States and consign us all to the dismal service sector tasks of burger-flipping, hair-cutting, and retail cashiering.

I exaggerate. But this is a not-so-subtle subtext running underneath debates over the continued decline in manufacturing jobs, as well as the persistent exhortations from the scientific and policy establishments that we need to train more scientists and engineers.

There often appears to be a disconnect, however, between the public debate and what is going on in the American economy. Such a disconnect is nothing new, but I sometimes think we only dimly grasp the shift beneath our feet.

By sheer coincidence today, I came across this chart on The Big Picture, showing a growing gap between world GDP and oil production, and this Resilience Report from Strategy+Business about "digital oil fields." One way to jointly read these is with the expectation that digital oil fields will help boost oil production. Maybe.

The more interesting tale here is the transformation of the oil industry: facing a labor crunch and spike in demand, it's responding by developing a "new breed of engineer and technician." The oil industry is becoming, or already is, an example of a "service system." Our friend Jim Spohrer over at IBM has been a leader in developing the science of service systems, management, and engineering.

This type of evolutionary transformation is occurring across the economy, as old and new technologies, new knowledge, software platforms, and continuous learning keep coming together to create ever-greater levels of integration that require new approaches (entrepreneurship), new ways of thinking, and new forms of business.

In this sense, the steady drumbeat for 'more scientists and engineers' begins to appear a bit shallow. We need them, of course, but before simply recruiting more students into the existing disciplines, maybe we should think about restructuring those disciplines. In an odd way, the age-old story of specialization, increasing returns, and greater knowledge that continues to shape the economy, may push us toward an educational system that emphasizes integrative, consilient thinking.

More on Inequality

After the last post on inequality and different ways to look at it, I came across this entertaining post by Mark Perry on scoring inequality in the NBA. He also applies this method to Olympic medals and home runs in baseball.

Anyway, all this talk about inequality reminded me of something Hayek once wrote: "From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict which each other; and we can achieve either one or the other, but not both at the same time." (From The Constitution of Liberty.)

And that, of course, is reminiscent of Vonnegut's famous short story, "Harrison Bergeron," in Welcome to the Monkey House. (There was a thought-provoking essay on Vonnegut, by the way, in the Winter 2007 issue of the Claremont Review of Books.)

Inequality is not a simple issue conducive to Gordian solutions, and proves at least two things: (1) the once seemingly dead discipline of "political economy" is not dead, and (2) discussions of economics are perhaps inevitably informed by philosophy. Namely, why type of justice should we have?

In Defense of Consumption

Nearly four months ago, two economists at the University of Chicago released a paper purporting to show that much of the ballyhooed rise in income inequality in the United States actually closes when measured by prices and inflation across different classes of goods and services.

This paper has been written up in a few different places (see here and here), so I won't dwell on its counterintuitive yet completely common-sense conclusions, except to say that it (and other work on consumption as a better measure of relative inequality) confirms this observation made long ago by Joseph Schumpeter:

    "The capitalist achievement does not typically consist in providing more silk stockings for queens but     in bringing them within the reach of factory girls in return for steadily decreasing amounts of effort."     (Page 67 of Capitalism, Socialism and Democracy.)

Consumption is often derided as either wasteful or mindless or soul-destroying. (This, by the way, is not a partisan issue: you can locate various criticisms of consumption at any point on the spectrum of American politics.)

Such knocks, however, see only one stage of consumption: the actual purchase of a product or service or its actual use. They usually don't extend (necessarily) to what that consumption gets you. When you "consume" a cell phone, what you're really consuming is connection with other people. When you purchase a better refrigerator, you're consuming the ability to store food for longer periods of time than was available to most humans throughout history, thus raising the ability to improve nutrition. When you buy a drink from Starbucks, you're getting not only the drink itself but also the experience and interaction with others. (One of the original investment bets behind Starbucks, remember, was provision of a "third place" for people to get together.)

In other words, there is a great essay waiting to be written in defense of consumption. I'm not the first to observe this, of course--a couple of years ago Nick Gillespie had a brief but fantastic commentary on Marketplace. I won't venture into that perennial bugaboo of video games--there has been plenty of recent scholarly work on their cognitive and social benefits. See, for example, this interesting story in yesterday's New York Times, on the front of the Arts section no less. Also in the Times is Rob Walker's fantastic weekly column, Consumed, which provides an additional perspective on consumption and all its manifold uses and benefits. Walker has a new book out, too, which I look forward to reading.

Anyway, maybe the research paper with which I began this post will give us a new view of not only relative inequality but also consumption in general and its possible uses in, for example, international development.

(I am indebted to Kauffman Foundation president Carl Schramm for some of the insights and comments in this post.)

Prediction Markets in the innovations journal

Are you watching what the political prediction markets say about the presidential race? Ever since James Surowiecki published The Wisdom of Crowds, the public is becoming more comfortable with prediction markets …

So here’s an interesting paper (by Robin Hanson) from an interesting journal (innovations) about the demise of the U.S.government’s foray with the “Policy Analysis Market” (PAM).  The program was controversial, like many innovations, and it became a public relations fiasco, too.  Robin’s paper is a valuable bit of history on its rise and demise.

Here are two valuable excerpts. The first is an impressive way of econometrically showing how the media coverage of PAM morphed:

Over the following days, weeks, months, and years [after the program was cancelled], more than 600 more media articles have mentioned PAM, many at first, and then gradually fading in frequency. Interestingly, the coverage gradually became more positive, and the most recent fifty articles on average give readers a positive impression of PAM. In a statistical analysis, eleven indicators of how informative an article is—including time from the events until the article was published, citing someone with firsthand knowledge, article length, a news or an editorial style, author anonymity, and the awards, circulation, frequency, and topic specialties of the periodical—individually predict that more informed articles give readers a more favorable impression of PAM.

The second excerpt is a nice summary of previous market creation failures:

The vulnerability of a market mechanism to such a political attack should not be too surprising: most familiar financial products, including stocks, insurance, futures, and options markets, were once prohibited by laws against gambling. It took a long time for the relevant industries to convince the public to see each of these products as not “just gambling.”

Of course, all of these products are ways to gamble, but, because they serve useful social functions, they have become politically and morally acceptable. Similarly, decision markets can also serve an important social function, especially when applied to government policy.

My analysis: I tend to lean Libertarian politically, but I can’t buy into the extreme libertarian mindset because I believe in market failure. And the most fundamental market failure is when a market does not exist. Governments have a role in creating and establishing markets in such cases: property rights, contract enforcement, and sometimes tradable permits for things such as fishing rights and CO2. The PAM failure is a failure for PAM to exist, and I suspect something like it will exist someday when it is no longer taboo.

Robin is an innovative economist worth watching. You won’t agree with him on many things, but you should admire his creativity. Fortune published a good article about him in late 2003:

Finally, while information markets can provide uncannily accurate predictions, they can also get things wrong. In lab tests of information markets, Plott has at times observed the formation of what he calls information "mirages," the equivalent of bubbles in asset markets. Hanson doesn't deny that markets can go bonkers--he says he pulled all his money out of the stock market in 1999 because it seemed wildly overvalued. He just thinks that, whatever their flaws, markets are better at sifting information and looking into the future than government bureaucrats or even corporate executives are. Despite their concerns, other experimental economists agree that killing off the exchange was a big mistake.

Venture Conversations, July 08

Business travel has taken me to San Diego and Boston recently, and I took the opportunity to visit with good friends in both cities who are venture investors: Ted Alexander (Mission Ventures) in California and Jim Matheson (Flagship Ventures) in Boston. Both firms seem to be doing well, but in separate conversations, they agreed the sector is changing dramatically and facing new challenges. For the record, my reflections are based on independent conversations, subsequent airline delays, lack of sleep, lost luggage, technical conferences, etc.

The interesting sidenote here is that America is a dynamic economy with lots of turbulence and churn and uncertainty. How strange that the sector devoted to capitalizing on the dynamism is itself being roiled by constant change. 

Public Capitalism? My first order of business was to call them out on what I thought was an embarassing doughut on the scoreboard in Q2: No venture-backed IPOs in the entire quarter, the lowest level in many decades. A lot of folks think that Sarbox is to blame, and both Jim and Ted agree it is a big factor. But they both also said it was probably not the dominant factor. Wall Street is in chaos right now. But there are some bigger forces in play worth considering. Hedge funds and fancy trading schemes are causing instability in the public markets, which is obviously bad for public sentiment, but not appealing to startup CEOs either. The need to focus on the short term in public markets is unattractive, and maybe getting uglier. The new schism between research and banking at Wall Street firms also has a possible downside of drying up research on young firms.

One other potential factor: booming M&A activity in the last decade has plucked a ton of older SMEs off the radar, making it a thinner public market. Venture firms can still enjoy liquidity events with large multiples via mergers and acquisitions. But the stagnation in public markets is a concern on many levels. At the most basic, a weak IPO market which leaves M&A as the only alternative, basically gives the M&A market a kind of monopsony pricing power, pushing down valuations.

I'm reminded of the line from A Man For All Seasons: "And if you cut them down, and you're just the man to do it, do you really think you could stand upright in the winds that would blow then?"

Abandoning the Seedlings. The venture sector has been criticised for abandoning seed-stage firms, and even A rounds, for higher ground. My sense is that if a venture firm tells you that it only wants to see companies that are already profitable, then they aren't really venture firms. The guys I talked to had differeing opinions on this one. It's useful to remember that Angel investors are big players, with available and active capital that is two to four times larger than all the venture funds combined. That angels are less visible does not mean they are less important. Angel networks are organizing and becoming more efficient each year. However, there is still a niche to be filled by an institutionalized venture investment vehicle. Incubators? Accelerators? Something as yet uninvented? Yes to all.

Little Push. Consolidation and shake-out are realities in the venture industy, and my takeaway is that it is not healthy for too much money to be chasing too few deals. It would be nice to believe that investment causes economic growth, but there's not much evidence for it. Nations would like to accelerate their development, and there are countless failed efforts to push investment dollars as a growth engine, by governments themselves and by international development agencies. The same mindset of engineering an economy is common among governors and mayors and city councils all across the U.S.

Talking to Ted and Jim made me realize that we need to really rethink how innovative economies grow. I think economists understand that the most politics can do is to let (not make) an economy grow, but it absolutely cannot engineer an economy to be bigger. That's as true in Independence, Missouri as it is in Iraq.

P.S. For the record, this was my first ever trip to Boston, and it is an amazing city. Amazing! If I had to choose one city over the other (and I lived for many years in San Diego), I might actually choose Boston. Would I make the same choice come January? Ha!

If Schumpeter could talk to Larry Page ...

FORTUNE has a great interview with google co-founder Larry Page in the recent "best advice" issue. Lots of good stuff in there, but I appreciate his distinction between invention and entrepreneurship:

You don't want to be Tesla. He was one of the greatest inventors, but it's a sad, sad story. He couldn't commercialize anything, he could barely fund his own research. You'd want to be more like Edison. If you invent something, that doesn't necessarily help anybody. You've got to actually get it into the world; you've got to produce, make money doing it so you can fund it.

It's exciting to see smart guys like Larry make it big because I tend to believe they will use their fortune to great effect, i.e. huge positive externalities. Larry's fascination with automated cars is a case in point if you are, like he is, bothered by the 40,000+ car crash deaths annually in the U.S.

If Schumpeter had lived to see the development of the IT revolution, the Internet, and google, what would he have thought? He probably would be incredibly encouraged to see the acceleration of innovation and the constant re-spawning of innovative small firms. This is the start-up culture, and my sense is that it is the one big idea Schumpeter missed. It goes without saying that Karl Marx missed it. But the painful thing about creative destruction is that even a great company like google cannot help but face talent defection.

Again, FORTUNE has the story on the brain drain at Larry & Sergey's huge, young corporation. This has long been happening to Microsoft. And for all the blather about strategic plans and mis-steps made by these new gaints, the real story might simply be that there is only so much equity to go around. Best line:

Google was like that too, about eight years and 18,000 employees ago.

The story is somewhat anecdotal, but it raises an interesting challenge. What can a company do to keep innovative employees from leaving? The dominant model decades ago was for a major industrial firm to establish a corporate R&D lab - At&T and Xerox come to mind. This is the model Schumpeter expected to dominate the future on the theory that future innovations require integration of more and more knowledge, requiring larger and larger teams of researchers to push the envelope. History proved him wrong. (And history was named Noyce). The updated model has big firms shedding internal R&D in favor of M&A. They buy innovation and revenue growth through acquisistions - Cisco comes to mind. But the new model that google is wrestling with is to allow almost all their employees to be entrepreneurial.

I don't think any one of these models is always right or always wrong, because they are all contextual. Too often, commodity organizations buy into faddish management theories and try to empower all their workers. Nice in theory, but sometimes you just need the architect to draw and the sales team to sell. Regardeless, we can be confident the corporation is not done evolving. Companies face brain drains, and the question is how to stop them - or more properly - take advantage of them.

The smart companies will do what universities aren't doing very well yet - offer maximum flexibility to their innovative employees while retaining a minority stake in the offshoots. If google really wants to keep talent in-house, it might need more than google stock options and free food. It might need to create a new turn-key subsidiary framework - a kind of reverse M&A where employees can apply to start internal divsions using company capital in exchange for partial ownership of the future revenue stream.

What does this mean? Labor is more than labor. Modern labor is human capital, and it wants more than a paycheck, a pension, profit sharing, and, even more poignantly, aggregated risk capital returns. I think human capital wants a balance of individualized risk returns and security. Sorting out that balance is the true search function of modern capitalism.

Thoughts?

The Blogging Manifesto

So here I am launching a blog, and pondering its implications. There is blood on my hands. Ink, rather … Venerable newspapers face extinction (from the May 1, 2008 issue of the Economist):

THE New York Times once epitomised all that was great about American newspapers; now it symbolises its industry’s deep malaise. The Grey Lady’s circulation is tumbling, down another 3.9% in the latest data from America’s Audit Bureau of Circulations (ABC). Its advertising revenues are down, too (12.5% lower in March than a year earlier), as is the share price of its owner, the New York Times Company, up from its January low but still over 20% below what it was last July. On Tuesday April 29th Standard & Poor’s cut the firm’s debt rating to one notch above junk.

A specter is haunting 620 8^th Avenue in Manhattan – it is the ghost of the great economist, Joseph Schumpeter. It is also haunting newspapers large and small all across America. For those who don’t know him, Schumpeter’s ghost is a balding, German-accented fellow that few would recognize, but he is haunting them all the same. While alive, Schumpeter championed capitalism, while predicting its ultimate demise. Presumably the specter of Schumpeter is pleased that the corpus of Schumpeter erred in his prediction.

All the powers of old media have entered into a holy alliance to exorcise Schumpeter’s theory: media mogul and rock star, publisher and studio head, opinion-editing elitist and radio-spittling populist.

In 2001, the humbling of the “arrogance and hubris” of the Stanford MBAs and their new economy faith was welcomed with smug chuckles of the old guard. They still call it the Internet “bubble” – implying with certain confidence that inside the stock valuations of oh-so-many companies was nothing but air. Schumpeter’s ghost is now chuckling, as the incessant information technologies are continuing to unfold with much more force than bubbles, like some accelerating fire scorching existing businesses and business models

Some are smugly suggesting that the newspapers are in duress because they failed to plan ahead. The newspapers will fall regardless whether their owners plan or not. But those who see ahead see that the newspaper business has nothing to do with paper and everything to do with news.

The future is all about information. It is a future ripe for editors and writers whose life’s work is the manifestation of information. The packaging is what the old business model represents, and that packaging – a few hundred pages of cheap pulp smeared with a quarter-cup of ink – will not see the end of the next decade

It’s no secret that, as the Economist notes, “this decline is being blamed on the rise of the internet.” But what about the Internet, exactly? One cause is surely the loss of classified advertising to craigslist.com and eBay.com. Another cause is simply speed – why wait 24 hours to learn “breaking” news? A third cause is money, namely the high costs of physical production of a newspaper. And yet, the more important phenomenon that I see is disaggregation. A better way to think of this is personalized aggregation, something that can be done digitally with ease.

Why bother reading the six or seven political experts assembled by the Times, when I only enjoy Kristoff, Krugman and Kristol (okay, I’ll admit it … and Dowd)? Alternatively, I can use an RSS feed to get seven (or twenty) of my favorite writers piped directly to me at bloglines?

What is under siege is the business of mass-market aggregated news. I do not know if it can survive, but I do know that – as a blogger – I have its ink on my hands.

Jacobs' Three Product Stages

I borrowed a book from Dane Stangler without his permission, and couldn't resist because I have wanted to read this book for such a long time: The Economy of Cities by Jane Jacobs.  Written in 1968, the year of riots that radically altered the shape of Detroit and other great cities, the book is amazingly insightful.  Consider this, which I call the Lesson of Three Product Stages:

Garment making, I think, affords an interesting clue to future manufacturing because it exemplifies manufacturing of three distinctly different kinds.  The oldest is craftwork.... The second is mass production.... The third method of garment manufacturing has arisen chiefly during this [20th] century, has grown much more rapidly than the other two, and has become the dominant form.  For lack of any present generic name, let us call it differentiated production.  This method produces relatively modest amounts of each item as compared with mass production, yet it is not craft manufacturing either.... Thanks to this third kind of garment making, one can look at a crowd of thousands of persons in a large city park on a fine day or gathered to watch a parade, and be hard put to find two women or two children dressed in identical outfits. (Chapter 8)

From what I can tell by googling "differentiated production," this concept is underappreciated and sometimes mischaracterized.  Craft products are made by artisans, mass products are made by one-size-fits-all factories, and “differentiated” products are made by modernized assembly processes.  I think the problem is that the word differentiated describes the output, not the process.  Both stage 1 and 3 yield differentiated output, but stages 2 and 3 use mass production.  I am tempted to call stage 3 something new.  Customized? Personalized?  Micro-mass?

Maybe Jacobs Three-Stage Theory is canonical among city scholars, which is entirely likely.  But here's why it matters to me: I have seen the Three Product Stages occur in products that were not invented when I was born.  Key Example:

Personal Computers
Stage 1. 1973-76           Apple I (in a wooden box!)
Stage 2. 1977-81           Apple II, IBM PC
Stage 3. 1985-present    Dell custom-ordered components

So what products are in Stages 1 and 2 today?  And how soon do we think they will get to Stage 3? I can think of a few things in stage 2 (or 2.5) ... houses, game consoles, iPods, digital book readers.  But the most things that are stuck in stage 1 (or 1.5) are major capital infrastructure things like highways and skyscrapers and jumbo jets.  Does anyone doubt they will get to stage 2-3 this century?

Isn't the most interesting irony of Jacobs describing this 3-stage pattern in a book about cities is that it is not too hard to imagine whole cities moving from stage 1 to stage 3?  I keep thinking of all these City 2.0 retirement communities popping up in Florida, Arizona ...