The key to reviving productivity, part II

In part I of this research paper, we assessed the current macroeconomic environment with regards to productivity – we looked at the biggest drags on productivity and how innovation can revive it. We then defined innovation, making the crucial difference between updates, inventions and innovations and looked at some of the potential tools needed to measure innovation. To read part I click here.

In this part, we will assess the socio-economic elements that can block innovation. In addition, we will try and gauge how investors can position their portfolios to help revive productivity and reap the long-term potential benefits that new technologies bring.

What kills innovation

No matter how much spending goes into R&D, or how many great thinkers a society produces, the following elements can prevent innovation from occuring. They are in no particular order and are part of a non-exhaustive list.

A) Over-regulation

Rules of how we play the game (i.e. how live together on a planet with finite resources) are necessary for progress — there is no denial of this. However, just as there can be under-regulation (i.e. rules that are too loose, too vague or not existent at all) which can cause all kinds of excesses, of which there are plenty of examples in recent history, there can also be over-regulation. This can happen as a result of writing more rules in an attempt to prevent the past from repeating itself. Although this is in a sense admirable, it must be done in a balanced manner otherwise it will cost the economy a great deal — each new rule means additional resources that need to be deployed to satisfy it. In the US, for example, in 2018, the cost of regulation was about $1.9trn.

This cost burden is felt most heavily by smaller businesses, start-ups or “garage” entrepreneurs that see their financial resources suffocated by increasing regulation. The big players can deal with more compliance costs — they benefit from economies of scale or, in some cases, monopolistic / oligopolistic positions, that enables them to harvest resources and direct them towards complying with more rules (although, we should also question this practice in terms of efficient resource allocation. We could do so by looking at a cost-benefit analysis of the rules in question).

My thesis is that we have been living in an increasing regulatory environment, especially since the financial crisis which has the (unintended) effect of regulating big corporates into the market, creating monopolies and killing of small businesses. This isn’t good for the economy, or society, as smaller businesses like start-ups seem to be more likely to innovate (you can check out this paper from University of California at Berkeley for more details – although, “innovation” here is more in the sense of “think different”, to paraphrase Steve Jobs).

Looking at the US (as it still is the engine of innovation in our global society), the Ten Thousand Commandments Report has been recently published by the Competitive Enterprise Institute, stating that: “The Small Business Administration (SBA) last published an assessment of the federal regulatory apparatus in 2010, pegging regulatory compliance costs at $1.75 trillion for 2008, but that was discontinued and not replaced. The primary purpose of the SBA report series was not an aggregate cost estimate but rather to examine regulatory burdens on small firms, which have higher per-employee regulatory costs than larger ones. Earlier governmental assessments around the turn of the 20th century from OMB, GAO, and SBA also found aggregate annual costs in the hundreds of billions of dollars, some in excess of $1 trillion in today’s dollar…”.

Similar conclusions have been reached by the OECD in its SME and Entrepreneurship Outlook 2019: “…the complexity of regulatory procedures is still a major obstacle for SMEs and entrepreneurs. Costs of complying with administrative requirements remain comparatively higher for smaller businesses.”

These costs can prevent entrepreneurs from starting their own ventures which can stifle innovation and reduce productivity over time. Indeed, as the following point illustrates, we are already witnessing a phenomenon of market concentration in the United States (and elsewhere around the world).

B) Market concentration (e.g. monopolies)

recent OECD study illustrates that between 1997 and 2012 “most industries have seen a few large players account for an increasing share of the market”.

Source: OECD

The charts are from the study mentioned above and they show that since 1980s the role that small firms play in the American economy has declined, while larger players have become more dominant. This does not bode well for future prospects of increases in productivity.

The point is not that big firms are somehow, by their nature, unproductive or don’t look to innovate. However, larger firms seem to be driven by different kinds of inceptives. For example, their focus on delivering steady and increasing shareholder returns can be so great that it may act as a deterrent from engaging in more risky R&D.

Also, a concentrated market tends to see diminishing competition — without competition there is no incentive to get better and without such incentives the chances to innovate fade away, decreasing the prospects for boosting productivity.

Smaller firms, especially the iconic “garage entrepreneurs” with which so many of us, especially millennials, have fallen in love with (the likes of Steve Jobs and Bill Gates of the past century) are not usually motivated to develop something new for the sake of shareholders or political support — they want to solve problems or to become part of a niche market that they hope to grow (like Jeff Bezos did with Amazon, Larry Page with Google and Elon Musk with Tesla).

A dynamic economy that supports a balanced selection of big and small firms has more chance to encourage and enable innovation. Also, as the global financial crisis of 2008 taught us, whenever something (a corporation, government etc.) becomes too big it also becomes inefficient (mostly due to bureaucracy and poor behavioural traits) and, as the timeless story of the tower of Babel shows us, what is “too big to fail” eventually fails.

C) Lack of patient capital

For investors, patient capital means financial resources deployed for the long-term. For the firm receiving the finance, it means stable financing and no pressure to rush things, which can lead to all sorts of technical, managerial and strategy mistakes.

There is already a lot of discussion within the financial industry about what long-term means. In my view, the range of years that we should view as “long-term” depends very much on the asset class we invest in and where we are in the economic cycle (i.e. the debt and the energy cycles). I won’t provide a detailed analysis of this for the moment. However, suffice to say that, in my view, right now leaving part of my own capital for 10 years in early-stage businesses that are operating in the five key areas mentioned above (education, healthcare, energy etc.), is reasonable for me. Of course, diversification (within the asset class, cross-assets and cross-geographies) is essential.

Providing patient capital to start-ups is not just an essential ingredient for economic development and (future) growth but it provides investors with several financial benefits. Locking in capital for several years means that investors will be able to collect a very healthy illiquidity premium, that they will have a first mover advantage in being on the share registrar of a potentially high growth companies and that they will not have to worry about price fluctuations (as most of these young companies are privately held).

For example, the UK benefits from some of the leading universities in the world, where some of the best scientific research is conducted. The country has developed over many decades (even centuries) a very strong network of academics, scientists, engineers and other very capable, intelligent and creative people. However, they lack appropriate vehicles that help them bring their work to market. They need funding platforms that lock in capital for years so their ideas, some of which may seem too crazy to be true, can become the products, services or processes of tomorrow.

D) Dogmatic thinking and making education political

I think it was Albert Einstein who said that “blind faith in authority is the enemy of truth”, or something along these lines. In other words, scepticism is not just healthy for our minds but necessary for progress.

However, dogmatic thinking disguised as scepticism is nothing but the blind faith in authority delivered in a PR fashion — to question the credibility or chances of success of something new because there are genuine technical items that need addressing and to do so while being open to change your mind once a satisfactory answer is provided is healthy scepticism; to question something just to defend the old way of doing things is a sign of dogmatic thinking.

A (popular) example of such rigid thinking surrounds fusion energy — it is true that it hasn’t been possible so far to bring this new form of energy to market and to scale it consumers. However, the criticisms that it attracted over the years almost completely wrote off the probability of this happening. This by no means should suggest that it will be impossible forever.

Meanwhile, education is what improves human capital; it is what ultimately encourages new ways of thinking and ideas. Therefore, in the same vein with dogmatic thinking, the danger of making education a political tool is, in my view, the greatest threat to our progress. Politics is the realm of appearances —  education should not be about promoting a political ideology or agenda.

Indeed, the most atrocious political systems of the last century, the totalitarian regimes of the Nazis and the Bolsheviks, both engaged in book burning and “re-education” procedures as their leaders thoroughly understood the power of unbiased education. Although these examples are of course extreme, they stand as eternal reminders that education should never be political. When it becomes so, people are no longer free to think and explore — they are being told how and what to think and this, obviously, diminishes the chance to innovate.

In the words of the great psychologist Jean Piaget, “Education, for most people, means trying to lead the child to resemble the typical adult of his society…but for me and no one else, education means making creators…You have to make inventors, innovators — not conformists”.

E) Rigid legal systems

Quoting again from the OECD’s SME and Entrepreneurship Outlook 2019: “Inefficient insolvency regimes limit the restructuring of viable firms and the second chance offered to entrepreneurs.” Having a flexible set of rules that enables entrepreneurs to take on risk and build something new is obviously important. For example, the US has (probably the most) flexible bankruptcy system in the world — this encourages risk taking, which is not always a good thing but, over the long-term, it is necessary.

Strong property rights and intellectual property rights are also key, and so are flexible contract rules, labour laws and finely tuned immigration policies that make it easy for talent to flow into the country. The latter is particular important in generating the crucial “network of ideas” which, when combined with access to resources, it is becomes fuel for innovation.

F) Inefficient resource allocation

Traditional monetary policy (i.e. setting short-term interest rates) acts as a lever on consumption and investment incentives in the economy.

The price of any investment asset is the present value of its expected future cash flows and the interest rate is the rate used to discount these cash flows. When central banks lower interest rates, the prices of assets rise because the present value of their discounted cash flows looks more attractive — the opposite is true when interest rates are increased. When interest rates are low, it encourages more spending (money and credit) on riskier and longer-dated assets (relative to cash, i.e. stocks and bonds) whose cash flows look increasingly more attractive.

If interest rates stay low for too long they can incentivise so much buying of these assets that a) they produce long levered positions and b) they eventually inflate the asset prices far beyond what their fundamentals would justify. Therefore, in the financial markets this can create bubbles whereas in the real economy it can lead to an ever increasing level of debt. As long as the cash flows needed to service the debt payments grow faster than (or at least in line with) these payments, the level of debt can be sustained.

However, as the economic cycle closes to an end (as signalled by little to no slack in the economy and debt levels that grow faster than GDP), debt is misallocated because there are fewer productive ventures that need credit financing. This misallocation of credit can last as long as monetary policy remains accommodative. However, I believe that going forward, what will signal the end of the current cycle will not necessarily be monetary policy tightening but a cap on cash flows imposed by the real economy itself. See Dalio’s piece on peak corporate profit margins for more details.

The main issue is that this misallocation of debt creates misallocation of natural resources. One of the (many) signs that this is happening is the rise of “zombie companies” — these are businesses that cannot cover debt service costs from current profits. These ventures weigh on economic performance and detract from productivity because they tie up resources inefficiently. The charts below illustrate the rise of “zombie firms” and it comes from the Bank of International Settlements.

Source: BIS

Lower interest rates also incentivise consumer borrowing. Consumers typically buy things which produce no return (e.g. a washing machine, a TV, an Xbox etc.). However, they also buy items that may improve their productivity — for example, someone may buy a bike on credit to cycle to work, reducing the cost and time of travel and getting more work done.

Therefore, as with any debt, consumer credit becomes a problem when the repayments are too much of a burden relative to cash flows (incomes and I would add savings too). Consumers across the developed world, especially the UK and US have seen stagnant real wages for the best part of the last 10 years and saved very little — for example, in the UK the annual saving rate of households was 4.2% in 2018, marginally better than 3.9% in 2017 which was the lowest since ONS records began in 1963. The bottom line is that unproductive credit spending fuelled by low interest rates incentivises resource consumption at the cost of long-term investment (savings).

Source: ONS, Quarterly % change

The inefficient capital allocation process blocks innovation by depriving the process of seeking and developing new things of the resources needed to do so.

Implications for investors

Google’s chief economist, Hal Varian, in a 2017 podcast with the IMFunderlined that if technology cannot boost productivity, ‘we are in real trouble’. As I see it, we can avoid being in real trouble if we a) invest in the areas where innovations can have the biggest positive impact on productivity and b) design policies which encourage and support innovation. Investors can help with a).

If we want growth to accelerate back to levels seen in the previous century (especially in the three decades following WWII), without drowning in debt, we need to invest in innovation — and this requires more than financial capital; it entails developing and maintaining a culture that encourages and enables innovation.

Here is a “back-of-the-envelope” analysis of the market opportunity that innovation can create. We will look at the US as an example.

Based on data from the Federal Reserve of St. Louis (Fred), between 1950–1980, US real GDP grew from $2.4 trillion to $6.8 trillion (chained to 2012 USD). This is an average annual growth rate of about 3.9%. If we assume that between 1980–2018 the US real GDP grew at an annual rate of 3.9% (not compounding rate, just tagging along at incremental increases of 3.9% on top of previous year’s growth), the 2018 number would have been $29 trillion. This is roughly $10 trillion above the actual figure recorded by the Fred. Also, when we look at what the US lost over the last 40 years or so, this amounts to about $116 trillion, or 6.2x the US real GDP in 2018.

Over the same period of 1950 -1980, the average labour productivity, measured as real output per hour in the nonfarm business sectors, averaged 2.4% per annum, while between 1980 -2018 it dropped to an average of about 1.9% per annum (after the financial crisis of 2008, the average annual labour productivity rate in the US declined to 1.3%).

We indexed US labour productivity to 2012 = 100 and found that, due to the drop in average annual productivity rate from 2.4% to 1.9%, the US lost a cumulative 293 index points of real output over the last 38 years. We arrived at this number by growing the index 2.4% per year between 1980-2018, taking the difference between the actual index figures and the modelled index numbers for each year and adding them up. This means that for every 1 index point of productivity lost, the US missed out on around $400bn of real GDP between 1980–2018, or c.$10.5bn a year (that is $116 trillion of missed US real GDP divided by 293 index points gets us about $398bn, which then we divide by 38 years to get the annual figure). Therefore, to return to the “old times of growth”, boosting average annual productivity by 52bps (i.e. 2.4% – 1.9%) is the base case must.

As one can see from the equations above, the financial returns from boosting productivity are immense over the long-term — investors can take advantage of this dormant opportunity by backing businesses in the key areas of energy, information processing, education, healthcare and transport infrastructure. However, the opportunity here is mostly amongst early-stage businesses, most of which are held privately.

That said, we need to acknowledge the risks that come with investing in early technologies and hedge against them — “we tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.”

Below are a few timeless principles for investing in new technologies from Nairn’s book.

1. Many big breakthroughs in new technology are initially greeted with hostility, even by experts

2. The investors and pioneers of new technologies are not always the best guide to whether it will succeed or not

3. Insiders usually make the best returns from new technologies

4. Over-promotion and new technologies always go hand in hand

5. The best technology doesn’t always “win”

6. New technologies do not, on their own, create financial bubbles — easy monetary policy, benign economic conditions and a general optimistic mood are more important ingredients for bubbles to form

7. Investing in new technologies is a high-risk endeavour

Finally, we’ve recently came across a superb research note from O’Shaughnessy Asset Management, which argues that value investing has outperformed after we transition from a technological wave into the next one. As the infographic below illustrates, we’ve just passed an inflexion point in terms of the latest technological wave (that of infromation procession) “settling down”.

Source: Second Machine Age or Fifth Technological Revolution? (Part 2)

Seeking opportunities through a value investment style is also consistent with the findings from Nairn’s book, which highlights that in the first part of a new technological wave investors are hyped by the growth stories that can come from the potential innovations. Meanwhile, the old-economy ventures tend to be neglected – this happened in the 2000s tech bubble which saw valuations of many traditional businesses dive into value territory.

However, as the dust settles and investors come to grips of how the new technologies will change the socio-economic order, the overhyped growth stories lose their panache and capital allocators seek to relocate their capital into opportunities which are cheap relative to the value of their future cash flows – i.e. money moves into value investing. As the O’Shaughnessy Asset Management paper suggests, we my be nearing that point right now: “eventually as the innovations move to maturity, value investing has also returned towards a longer-term trend of outperforming.”

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