The Great Pessimism
“Unless developed countries learn how to increase the productivity of knowledge workers and service workers, they will face economic stagnation and severe social tension” – Peter Drucker in ‘The Post-Capitalist Society’
The year 2008 saw one of the worst recessions after the Great Depression in the 1930s. Hundreds of millions of people even in the so called ‘Developed World’ were affected. Fast forward to 2016, the case can be made that there has been a recovery but an insufficient recovery.
The return to pre-recession employment was inordinately long (See Figure 1).
There are signs of a dangerous pessimism about the economy and the future. Interest rates in the United States have been rock-bottom near-zero for six years now. In fact, we may have the lowest interest rates in history! (See Figure 2)
Despite having the lowest interest rates in history, every time there is a signal that the Fed is going to increase interest rates, the market reacts wildly, implying very low confidence in the economy.
As of July 2016, there are more than 13 trillion in Negative Yield Bonds. That number was only a few tens of billions as recently as 2014. Investors will be essentially paying Governments for the ‘privilege’ of holding these bonds. In other words, investors feel they will be losing far greater money otherwise.
One thing is clear – there is Great Pessimism about the future.
Low confidence in the Government is at record breaking levels. Only 14% of citizens in United States approve of Congress (See Figure 3).
The good electoral performance of Donald Trump and Bernie Sanders (fringe candidates in any other era); Britain leaving the EU; Right-wing and Left-wing fringe parties (both having the commonality of being protectionist) performing very well against Centre-Right and Centre-Left parties in Europe; All of these illustrate this Great Pessimism. This Great Pessimism is a direct consequence of low growth for many years and the fact that the middle class has been struggling for decades (median wages that are stagnant since 1973) (See Figure 4).
There have been some very good attempts at explaining why we are stuck and frozen in slow growth. Larry Summers has proposed that we are in an Age of Secular Stagnation. He thinks that there has been an increasing propensity to save resulting in a drag in demand.
Robert Gordon seeks to explain this from the supply side – Innovation has slowed down. In his fantastic book, “The Rise and Fall of American Growth”, he argues that the years 1870-1970 were some sort of a special ‘century’ where we luckily ended up with miraculous Innovations. Compared to that period, Gordon is not impressed by the innovations post 1970 (most of which were in the area of computing). The visual argument is if you time-travel to 1940 from 2015 you wouldn’t be really shocked by the standard of living. But if you time travel from 1940 to 1870, you will be truly shocked at the quality of life even in a relatively rich country like the United States. There was no indoor plumbing, no leisure, men were expected to work in the fields since the age of 15, women had their entire time consumed with household chores, food was expensive, horses ate one fourth of the food, no one travelled outside the city for vacations, high infant mortality rates and so on.
Gordon explains with the help of Total Factor Productivity which has taken a dive, the slowdown in Innovation and in turn Growth. (See Figure 5)
Gordon points out that unless there is a major technological revolution, growth is doomed and he leans towards the possibility that the chances of such a major revolution happening is minuscule. And Innovation is desperately needed to offset the headwinds like demographics, debt and inequality which further drag down growth.
This is how growth looks like today in the advanced economies (See Figure 6):
An even more alarming statistic would be that Growth would have fallen short of projections even without the financial crisis (See Figure 7).
Rules of the Game and The Great Misallocation
But both the Secular Stagnation theory and the End of Growth Theory have some uncomfortable assumptions. Larry Summers argues that the cure for Secular Stagnation is a massive expansionary fiscal policy by the Government and growth would be restored. But what if it does not address the root cause of stagnation whatever it might be and you end up with high inflation and not much to show for it? And Gordon’s End of Growth theory assumes that new technological revolutions are not possible.
Bain Capital notes in its 2012 report, “A world awash in money” that the total size of financial assets will grow from $600 Trillion in 2010 to $900 Trillion in 2020. Meanwhile the total GDP in 2020 would be only $90 Trillion – fewer opportunities than money available for investment (See Figure 8). Yet, growth is languishing.
What if Gordon is right about the part that Innovation has slowed? Peter Thiel, legendary investor and co-founder of Paypal laments, “We were promised flying cars and instead we got 140 characters”.
I strongly believe, we will indeed not have massive tech innovation – with the current ‘rules of the game’. I believe Innovation can be supercharged if we change the rules in the system and incentives are redesigned.
William Baumol notes that entrepreneurs, highly talented individuals and innovators can be involved in productive or unproductive entrepreneurship activities.
What are productive activities and unproductive activities? Productive activities can be thought of activities that are highly beneficial to the society while also simultaneously enriching the entrepreneur/innovator. Unproductive activities enrich the entrepreneur without being beneficial to the society.
For example, finding a low cost drug for a certain type of cancer will be a productive activity. The society benefits and the entrepreneur with a patent on the drug can also be enriched by solely manufacturing it. On the other hand, an unproductive activity will be if an entrepreneur decides to buy a company having patents on life-saving drugs and increase the price of the drugs unilaterally. The entrepreneur becomes rich but the society is worse off than before. This is not a fictional example. Turing Pharmaceuticals bought an important 62 year old drug called Daraprim and raised the price from $13.50 to $750 a tablet. The efficacy of the drug remains same though the price went up by 5000%. This is not an isolated example and not an isolated price gouging experience. New York Times called it a new business strategy in pharma – “acquiring old, neglected drugs, often for rare diseases, and turning them into costly “specialty” drugs.
Entrepreneurs and innovators allocate their time, effort and ingenuity to productive or unproductive activities depending on the rules and incentives in the system.
A simple way to illustrate this is by the following matrix (See Figure 9):
Highly Talented Individuals engaging in Productive Entrepreneurship Efforts will have a positive impact (A). And Highly Talented Individuals engaging in Unproductive Entrepreneurship Efforts (or Destructive Efforts) will have a negative impact (B). When Capital and Talent flow towards unproductive economic activities rather than towards productive ones, I call it the Great Misallocation. The Great Misallocation happens when payoffs in unproductive activities is greater than productive activities.
In my opinion, in most other systems other than capitalism, B will be far greater than A. Talented individuals opt to participate in unproductive activities rather than productive activities. Before 200 years, that would mean, becoming a bureaucrat at best or waging wars. Capitalism and free markets provide the opportunity for A to be far greater than B. Joseph Schumpeter noted in his famous theory of Creative Destruction that capitalism, “…incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one” and this innovative element of capitalism is what made it the best system according to Schumpeter.
But here is the key thing. Capitalism provides opportunity for A to be far greater than B. But it does not guarantee it and sadly often does not self-correct. The rules of the game are important and under perverse rules, this Great Misallocation of talent will take place and may end up undermining capitalism itself. Schumpeter in his chapter, ‘Can capitalism survive?’ in his seminal book “Capitalism, Socialism and Democracy” begins with an ominous answer – “No. I do not think it can”.
To secure the future, we must ensure that Capital and Talent:
1. Must flow to productive activities
2. Must not flee from productive activities
3. Must not flow to unproductive and destructive activities
Sadly, however, increasingly the reverse is happening. A lot of capital and high quality talent is flowing towards unproductive (and potentially destructive) activities. Why? Because the payoffs of engaging in unproductive activities have become extremely attractive. And we have prioritized short term rewards over long term miracles.
Peter Drucker sounded the alarm on short-termism and bad incentives way back in 1993 in ‘The Post-Capitalist Society’:
“Instead of being managed “in the best balanced interests of stakeholders,” corporations are now being managed exclusively to “maximize shareholder’s value”. This forces the corporation to be managed for the shortest term and damaging the wealth-producing capacity of the business. It means decline, and fairly swift decline. Long-term results cannot be achieved by piling short-term results on short-term and long term needs and objectives.”
Only 15% of capital coming from financial services today is used to fund business investments, whereas that would have been most of what banks did in the 20th century. In other words, the role of banks and capital markets in making new investments is decreasing. When most of the capital is not going to new business investments, new jobs are not going to be created as well. And that is exactly what has happened. Most of the new jobs have been low-paying jobs. (See Figure 10)
S&P 500 firms are spending $1 trillion each year on share buybacks and dividends. That represents 95% of their net earnings and a paltry amount goes into research and development and towards the long term? Why? Because the rules and incentives of the game direct this behavior. CEO compensation is tied to yearly performance of the stock and in the short term the best way to increase the stock price is through buybacks.
IBM and Pfizer have spent $157 and $139 billion respectively in buybacks and dividends since 2005 and only $111 billion and $100 billion respectively in capital spending and R&D. Let us digest that for a second. A tech icon and pharmaceutical giant basically acknowledge that they will succeed in short term value creation than in exciting long term possibilities of innovation. Or they are being incentivized to ‘forget’ the future.
A Stanford study finds out that innovation slowed down by 40% at tech companies after they went public – mostly because of expectations from the public market. Which is shocking because going public allows companies to raise cash that they can plow into more R&D. And they are incentivized not to do it!
There are signs that the misallocation of capital (and talent) might be increasing. Legendary investor Stanley Druckenmiller in the Sohn Conference this year presented a couple of charts that showed this great misallocation. (See Figure 11)
“And if this wasn’t disturbing enough, take a look at the use of that debt in this cycle. While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. This is very clear in this slide. The purple in the graph represents buybacks and M/A vs. the green which represents capital expenditure. Notice how the green dominates in the 1990’s and is totally dominated by the purple in the current cycle.”
Unless we solve the Great Misallocation problem, capital and talent will be stuck in unproductive and destructive activities and the world in turn will be trapped in low growth and in a zero-sum economy where someone has to lose for someone to gain.
How do you solve this Great Misallocation problem? Hope to write about it in another post soon.