Where’s Genuine Economic Growth Going to Come From?

“We wanted flying cars, and they gave us 140 characters,” said venture capitalist Peter Thiel in 2011. He put his finger on a central dilemma of the New Economy: its innovations can make money (usually through redirecting advertising sales), but they add little or nothing to the overall stock of human knowledge or long-term happiness. Professor Robert Gordon postulated last year that we may have come to the end of the era of perpetual growth. His theory looked foolishly pessimistic, but as the current sluggish expansion limps on, it begins to look more plausible.

Innovation can be closely correlated with the destination of the smartest graduates. The natural optimism of the young leads them to congregate where the intellectual boundaries are being pushed fastest. Over the past 40 years, by and large the brightest graduates have tended to congregate around consulting and finance, a dispiriting observation. Both of those professions, to the extent they have innovated, have produced innovations that have added cost and overhead to the global economy rather than useful output.

In the early days of strategy consulting, in the 1960s and 1970s, the profession appeared truly innovative, producing analytical frameworks such as the Boston Consulting Group’s growth-share matrix that helped managers cope with disparate portfolios of businesses. However, the poor results produced by the 1960s conglomerates showed that disparate businesses should, by and large, be managed separately. The result, as we all learned in exhaustive detail during Mitt Romney’s presidential campaign, was the rise of private equity investing, in which portfolios of disparate businesses were assembled by an equity investor rather than within a conglomerate. The “funny money” era since 1995 has provided spectacular results to private equity investors, but the level of innovation or economic benefit from their activities must be seriously doubted.

The other area of consulting that has metastasized since the 1970s is that of software management: assisting companies to get their computer systems to work with each other, or indeed to work at all. In some cases, such as a medium sized company I came across in the 1990s which lost two years of operations and profit from trying to install an over-complex software system, these consultants also subtract value rather than adding it. Indeed, the consultants employed by Britain’s National Health System, or by the Obamacare designers, seem to have been completely incapable of getting the system to work properly. This is a very lucrative business; it can be made even more lucrative by designing the system to be as complex and time-consuming as possible. In a way, this is innovation; it is certainly not productive.

Financial services doubled their share of economic activity in the 30 years to 2008 as the derivatives revolution took hold and trading desks became automated and massively faster. However, while the ability to hedge income and liabilities was highly valuable in a few cases, in general hedging was a silly game played by corporate finance departments that had themselves been converted into profit centers. Just as it is questionable whether the gambling activities in Las Vegas truly add anything to the economy, but merely redistribute income from unfortunate punters to the gangsters and low-lifes controlling the casinos, so the true economic value of the vast derivatives sector must be doubtful at best. Like consultants, financial services have increasingly become rent seeking activities, in which a small number of people make extravagant incomes, but add nothing to the real output of the economy as a whole.

While consulting continues to act like “The Fish that Ate Pittsburgh” in terms of its absorption of national resources, financial services at least have begun to retreat since 2008. No longer is Wall Street the destination of choice for the best and the brightest. Instead, after a brief period when the advent of President Obama sent some of them into government (big mistake, guys!), the eyes of the talented are now firmly set on Silicon Valley and its various offshoots across the country. The only problem is that rapid progress in the tech sector requires engineering skills quite beyond the majority of elite job-seekers, who are much more suited to a life of designing consultancy flip-charts or selling dodgy derivatives to the dozier European and Asian banks.

At first sight, a rush by the talented into the tech sector ought to be good news. PCs, cellphones and the Internet may not have enabled our cars to fly, but over the last 40 years they have revolutionized our lives in ways we never dreamed of in 1970. If the Internet did not exist, I would either have to file this column by mail (and expect a team of unionized typesetters to put it into print) or would have to commute every day two hours into New York, my nearest major city. In practice, of course, I would have compromised, and bought a house within a half-hour train ride of midtown, but I would then have subjected myself to outrageous property taxes and probably relatively high crime in the sketchy neighborhood which would be all I could afford. So yes, tech sector, thanks for the Internet.

However, the tech sector’s true boons to mankind were achieved before the best and brightest headed into that sector—not only before the recent influx, but before the first medium-sized influx which followed the unexpectedly bountiful Netscape IPO in 1995. The PC was invented by a couple of college dropouts at Apple, the Internet was invented by a government department and cellphones were developed within a large company that had specialized in car radios. Even the previous paradigm of “best and brightest” achievement in the tech sector, AT&T’s Bell Laboratories, was beaten to the cellphone by Motorola. (Although, admittedly, Motorola’s Martin Cooper had actually managed to graduate college, from Illinois Institute of Technology, a fine institution but currently ranked 109th nationwide).

In 1995-2000 (and even more since 2009) the crème de la crème flocked to the tech sector, as has an unimaginable tsunami of investor cash for any remotely plausible idea. The results so far have been distinctly unimpressive. Admittedly, the first wave of tech innovation produced Google and Paypal, two companies that have genuinely changed the way we operate, although arguably Wikipedia, founded around the same time on a completely uncommercial basis, has been even more pivotal. However this time round, the principal innovations have been in “social media,” a business enabling the less intellectually endowed to spend a high portion of their waking hours communicating the banal.

Most recently, $10 billion-plus valuations have been attached to social media companies, all of which hope to profit by accepting a portion of the finite pool of advertising dollars. Indeed, in today’s markets, profits and even revenues have tended to depress valuations. That’s because they allow investors to calculate a rational-appearing valuation, whereas “revenue-light” applications, which have as of yet penetrated only the free-user market, can triumph though the application of infinite hopes among investors and excellent marketing by the sponsors.

WhatsApp, sold to Facebook for $350 million per employee, appears only a precursor of a host of imitators that outshine among investors the solider, better-grounded companies that may actually be achieving something useful. Meanwhile, Apple and Microsoft, the daddies of tech innovation, content themselves with unveiling products largely identical to their predecessors with only a few extra features such as simply a different size.

The economic reality is that two decades of funny money, ending in six years of money that is positively hilarious, have funneled resources into hyped sectors and asset-growth scams, bypassing the sectors in which true innovation may be happening. A genuinely innovative development, such as the self-driving car, will take at least a decade to hit the road even if the regulators can be prevented from slamming the brakes on it. That’s far too long a timetable to interest private equity investors or the IPO market. Fortunately Google, like AT&T in the 1950s, is prepared to devote a portion of its profits to bringing this vision into reality.

Meanwhile, productivity grows more slowly than in any previous postwar recovery. This isn’t because Robert Gordon’s vision of a world without innovation has crept over us. Instead, sub-zero real interest rates have created an orgy of speculation through hedge funds, leveraged private equity funds and the Silicon Valley IPO industry. Such epic misallocation of capital inevitably makes the economy less efficient and starves legitimate innovation of funding and people. The mortgage securitizers of 2002-07 and the social media entrepreneurs of 2009-14 should be doing something useful. But participating in a wild, speculative bubble is much more likely to make them rich.

Innovation isn’t dead. It’s the force that will cause the U.S. economy to recover from the deep slump to which we are now heading. But for that to happen, fiscal, monetary and regulatory policies will have to be reversed 180 degrees from their current orientations.

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About the Author:  Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) which examines the British governments of 1783-1830. He was formerly Business and Economics Editor at United Press International. Martin’s weekly column, The Bear’s Lair, is based on the rationale that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. This article originally appeared on the economics website “The Prudent Bear” and is republished here with permission.

1 reply
  1. Fritz
    Fritz says:

    The author is right to focus on the misapplication of capital through low interest rates, but also by the picking of winners and losers by the Federal government and the unsupervised buildup of public funds now in the hands of the Federal Reserve and its member banks. This liquidity needs to get out into the marketplace. Why? Because it is capital, in company with entrepreneurship, that creates jobs for Americans. I think the emphasis on technological innovation is overdone in this article. Experience tells us that jobs can be created- lots of people have ideas for a new business. What is needed is the willingness to invest on the part of those who have money and want to grow it.

    Reply

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