The Real Problem With The Economy: Misallocation Of Capital?

from the gov't-tinkering dept

Thu, Mar 11th 2010 6:06am — Mike Masnick

Andy Kessler has one of his standard thought-provoking opinion pieces discussing the economy of the past decade, suggesting that the real lesson learned from the past decade is the dangers of bad gov't policies leading to misallocated capital. Starting with bad telco regulations in the 90s that drove a bubble in unnecessary and misguided investment in infrastructure, some of which overflowed into a ridiculous dot com gold rush:

The late '90s Internet love fest was crazy enough, driven by former FCC Chairman Reed Hundt's misguided telecom reform that had the effect of keeping data rates artificially high. This created a gold rush to install fiber and build applications that didn't make economic sense (though electronic commerce, online banking, as well as wireless and broadband deployment would eventually prove productive over the next decade). Bad policy meant capital got overallocated and too quickly, as momentum mutual funds (momos) and day traders furiously drove up stock prices of every company with dot-com in its name for no fundamental reasons. Wall Street trading was broken.

But, he notes, there was a core of a good idea in there. What made the investment in the internet and new technologies make sense was that it actually did drive productivity. The proper use of such tools increased productivity, decreased costs and opened up new markets. But with the flood of misallocated money, a lot of that got obscured in chasing sock puppets selling pet food.

Following this, there was a combination of bad policy decisions -- Greenspan flooding the system with money out of fear of a Y2K problem, combined with Enron freaking people out and leading to Sarbanes Oxley -- and a new mess was created:

Instead of finishing what the dot-com era started to deliver--a productive, wealth-producing economy--capital was seduced into the financial lair of private equity and real-estate mortgages. Trillions were pumped into unneeded housing stock. Fannie and Freddie fanned the flames, and then fizzled and failed. And leveraged buyouts reigned. Even in 2007, one Blackstone private equity fund raised almost as much money as all of the venture capital industry.

The key point here is that venture capital tends to (though, certainly not always...) invest in real innovation, nurturing concepts from idea to market and beyond. Private equity, however, is more about just moving money around and looking for quick hit opportunities to get increasing returns. One grows the economy. The other does not. But, by punishing the capital markets that fund real innovation and company growth via Sarbanes Oxley, money that used to go to venture investment went towards the east coast private equity world, where it was shuffled around, rather than invested productively. And, tragically, it doesn't look like anything the government is doing is designed to fix this:

Today, we are still left with almost no initial public offerings. While private equity fund-raising was down 68% in 2009 to $96 billion, venture capital barely raised $13 billion.

Capital gains taxes are set to return to 20% on Jan. 1, 2011. And worse, investing is as uncertain as ever. No one wants to fund health care, medical devices or even much biotech if they can't figure out how they are going to be paid via reimbursements from ObamaCare. Energy investing is also a mess. And while "green" investing is booming, with few exceptions that is about efficiency rather than productivity. There's a big difference: You can make the Post Office more efficient while email makes us more productive and wealthier.

Big regulated oligopolists control our communications infrastructure. Startups are nowhere to be found. Few are willing to take the risk of true venture investing.

It's been 10 long years since the economy has created real wealth, as opposed to easy-credit induced real-estate or paper wealth. Amidst all the current confusion over health care and tax rates and energy and banking reforms, maybe it's time that the market transitions back to investments that drive productivity and increase living standards rather than just paper profits.

Reaching back to our economic parables, it's a question of whether or not our government has been making a giant broken window fallacy. It's not working on plans that fund actual productivity and economic growth. The government is focused, instead, on getting money moving around again, and all that means is it will move into another unproductive bubble, until we align the incentives properly again.

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Filed Under: andy kessler, economics

37 Comments

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yozoo, 11 Mar 2010 @ 6:25am

Huh?
"...with few exceptions that is about efficiency rather than productivity. There's a big difference: You can make the Post Office more efficient while email makes us more productive and wealthier. "

It’s obvious to everyone that this makes no sense right? Efficiency is certainly (and has always been considered as far as I know) a potential piece of increased productivity, for pretty obvious reasons. To take the authors analogy of the post office, if it is more efficient, it can move more mail, which makes it more productive. This pretty obvious crack in the author’s logic is bad enough that I doubt he knows what he’s talking about anywhere else either (although I agree over all that legislation drives investment, however this is as obvious as a blue sky and gravity).
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Mike C. (profile), 11 Mar 2010 @ 6:34am

Re: Huh?
I think this is open to interpretation though. Perhaps I'm adding words to the author's intent, but I read that line as:

"...with few exceptions that is about efficiency rather than productivity. There's a big difference: If you could only invest in one area, you can make the Post Office more efficient while email makes us more productive and wealthier.
(emphasis for my interpretation)

As Mike was trying to point out, it's the allocation and where the scarce resource of capitol would actually influence the greater amount of improvement. Yes, I totally agree that a more efficient Post Office could be more productive. Counter that with a more efficient electronic delivery system and the return on capitol invested would likely be higher.
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heretic, 11 Mar 2010 @ 6:40am

Re: Huh?
To take the authors analogy of the post office, if it is more efficient, it can move more mail, which makes it more productive.
Not quite. It is you who is slightly confused. Pedantically applied, more efficiency does not necessarily lead to more productivity. More efficiency merely frees up resources; it is then up to the decision makers how the newly freed up resources are to be used.
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Mike C. (profile), 11 Mar 2010 @ 6:46am

ARGH!!! Paywall
While I would love to read the article in full, it's stuck behind a paywall. Oh well. Guess I can't comment further...
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Dark Helmet (profile), 11 Mar 2010 @ 6:48am

Re: Re: Huh?
"To take the authors analogy of the post office, if it is more efficient, it can move more mail, which makes it more productive."

Mike can correct me if I'm wrong, but I think you're both missing something:

If the post office is more efficient and moves more mail, that makes IT more productive, but not necessarily US the consumers. Email DOES make the USER more productive. Does a more efficient post office make the mail sender more productive? Perhaps a bit, but not at the exponential factor that the advent of email did.

Again, I think the mistake you both made is WHO is supposed to be more productive. It isn't the post office, nor the email system. It's US.

Thought that way, the analogy works just fine....
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Matt (profile), 11 Mar 2010 @ 7:02am

Re: ARGH!!! Paywall
Yes. Same for me. Search the article title in Google if you would like to read it.

Really hits home the point that WSJ is taking themselves out of the conversation when people can not share their articles.
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John Doe, 11 Mar 2010 @ 7:12am

Bad Government?
That government is best which governs least. You can quote me on that.
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Steven (profile), 11 Mar 2010 @ 7:15am

Re: Huh?
I agree that they are usually tied together, but there is a difference. Using the USPS analogy. If the USPS is more efficient then they are able to do the same amount of work with fewer resources. That may or may not mean they can increase the amount of output (productivity).
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Steven (profile), 11 Mar 2010 @ 7:17am

Re: Re: ARGH!!! Paywall
Wow. That is just the peak of annoying. The link from Techdirt runs me into a paywall, but the link from Google takes me to the full text. Must be because those darn Google people have found a way to hack and steal all that content. ;)
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Hoeppner, 11 Mar 2010 @ 7:21am

Why did you even bother with such a useless website?
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Steven (profile), 11 Mar 2010 @ 7:34am

TFA a bit weak.
So I got to the full text via Google and I must say the article is a bit weak. Don't get me wrong, it reads good and makes sense, but it has almost no substance (despite a pretty little graph). It reads as a good summary to what could be a fascinating research paper.
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Anonymous Coward, 11 Mar 2010 @ 7:40am

Re: Re: Huh?
"Not quite. It is you who is slightly confused. Pedantically applied, more efficiency does not necessarily lead to more productivity."

thus my use of the word "CAN" as in it has the ability too.
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Anonymous Coward, 11 Mar 2010 @ 7:48am

Re: Re: Re: Huh?
"If the post office is more efficient and moves more mail, that makes IT more productive, but not necessarily US the consumers. Email DOES make the USER more productive. Does a more efficient post office make the mail sender more productive? Perhaps a bit, but not at the exponential factor that the advent of email did."

This is where the authors analogy really rears its head, its the assumption that something "techno" is automatically better (as a wealth generator) then something thats not (which is not overtly stated I confess). The example of a post office that moves more mail does in fact make the economy more productive (and the individuals in that economy). Becuase, obviously, mail moves faster and in larger volumes making transactions that are dependant on mail happen faster and more frequently. This is exactly the same productivity improvement that email has (it allows things that are dependant on email to be done more quickly). Not all transactions can be done with email, so it connot increase effecniency for all transactions, the exact same thing is true for mail. However my bottom line arguments remains, improve the efficiency of mail (or email) and have the oportunity to improve the productivity of mail (or email).
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indir, 11 Mar 2010 @ 8:45am

indir
The key point here is that venture capital tends to (though, certainly not always...) invest in real innovation, nurturing concepts from idea to market and beyond. Private equity, however, is more about just moving money around and looking for quick hit opportunities to get increasing returns. One grows the economy. The other does not. But, by punishing the capital markets that fund real innovation and company growth via Sarbanes Oxley, money that used to go to venture investment went towards the east coast private equity world, where it was shuffled around, rather than invested productively. And, tragically, it doesn't look like anything the government is doing is designed to fix this:

Today, we are still left with almost no initial public offerings. While private equity fund-raising was down 68% in 2009 to $96 billion, venture capital barely raised $13 billion.
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Comboman, 11 Mar 2010 @ 9:17am

Re: TFA a bit weak.
Most of the concepts seem to come from "Crash Proof" by Peter Schiff, a great read if you're interested.
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Freedom, 11 Mar 2010 @ 9:28am

Re: Huh?
>> It’s obvious to everyone that this makes no sense right?

If you haven't read Steve Forbes' Book, How Capitalism Will Save Us yet, it is a great read and talks about the core ideas in Mike's post. (Here's an Amazon link if interested: http://www.amazon.com/How-Capitalism-Will-Save-Us/dp/0307463095) I won't pretend to be able to summarize it properly, but I'd be surprised if after reading SF's book that you still feel the same way about your question.

For what it's worth, I don't think anyone is saying that making the post office more efficient is a bad thing. Post Office efficiency is an admirable goal, but it doesn't have that life changing effect that will increase our Quality of Life in any meaningful way like a trans-formative innovation such as e-mail, etc.

Freedom
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ddbb (profile), 11 Mar 2010 @ 11:05am

VC vs. PE
"The key point here is that venture capital tends to (though, certainly not always...) invest in real innovation, nurturing concepts from idea to market and beyond. Private equity, however, is more about just moving money around and looking for quick hit opportunities to get increasing returns. One grows the economy. The other does not."

Really? How does private equity succeed, increase its investment or have a successful exit if it just moves money around? Turning around underperforming businesses is just as beneficial as investing in something new. Also, how many VCs are not looking for quick hit opportunities? How many VCs are not looking to increase returns? You hear this complaint constantly about the VC world.

If you actually look at what they do, I think you would find that VCs and PEs are similar businesses with similar objectives that might just be focused on different points of a company's maturity, and even that would be a gross over-generalization. There is far more overlap between VC and PE than you seem to realize.
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Suzanne Lainson (profile), 11 Mar 2010 @ 11:48am

Are IPOs the way to go for innovation?
I'm no expert on the history of technological innovation in the US, but was the dotcom boom actually creating all that many productive companies? I wrote about those companies for three business publications and a lot of the IPOs of those days were of the pump-and-dump variety.

Seems like this was a better model. Bell Labs
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Suzanne Lainson (profile), 11 Mar 2010 @ 11:59am

Re: Are IPOs the way to go for innovation?
Also, aren't IPOs often selling patented ideas in many cases (which is why many VCs get involved)? So wouldn't the average IPO work against the Techdirt philosophy?
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Mike Masnick (profile), 11 Mar 2010 @ 4:12pm

Re: Are IPOs the way to go for innovation?
I'm no expert on the history of technological innovation in the US, but was the dotcom boom actually creating all that many productive companies? I wrote about those companies for three business publications and a lot of the IPOs of those days were of the pump-and-dump variety.

Did you not even read the post, Suzanne? In it, I discuss how he covers why the dot com bubble got over inflated in a bogus way, and even discuss the ridiculous IPOs.

Typical of you to automatically jump to an extreme position which was already debunked in the article.
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Mike Masnick (profile), 11 Mar 2010 @ 4:13pm

Re: Re: Are IPOs the way to go for innovation?
Also, aren't IPOs often selling patented ideas in many cases (which is why many VCs get involved)? So wouldn't the average IPO work against the Techdirt philosophy?

What?!? IPOs and patents have nothing to do with one another. I'm not sure where you're even making the connection.
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Suzanne Lainson (profile), 11 Mar 2010 @ 4:32pm

Re: Re: Are IPOs the way to go for innovation?
This is what I saw in his article.

"Instead of finishing what the dot-com era started to deliver—a productive, wealth-producing economy—capital was seduced into the financial lair of private equity and real-estate mortgages."

I covered the dot-com era and I didn't find that many of the IPOs were for innovative companies. I consider Bell Labs to have been a more successful model.
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Suzanne Lainson (profile), 11 Mar 2010 @ 4:33pm

Re: Re: Re: Are IPOs the way to go for innovation?
What?!? IPOs and patents have nothing to do with one another. I'm not sure where you're even making the connection.

Discussions I've had with VCs.
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Suzanne Lainson (profile), 11 Mar 2010 @ 4:46pm

Re: Re: Re: Are IPOs the way to go for innovation?
With the emphasis on appeal to investors, the IPO model may not be the best way to encourage innovation. I'm one who is concerned that the stock market tends to favor short term results.
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Mike Masnick (profile), 11 Mar 2010 @ 5:00pm

Re: Re: Re: Are IPOs the way to go for innovation?
This is what I saw in his article.

And you missed this: "Bad policy meant capital got overallocated and too quickly, as momentum mutual funds (momos) and day traders furiously drove up stock prices of every company with dot-com in its name for no fundamental reasons."

I covered the dot-com era and I didn't find that many of the IPOs were for innovative companies. I consider Bell Labs to have been a more successful model.

You do know that Andy worked at Bell Labs, right?

Yeah, Google, eBay, Amazon. No innovation at all.
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Mike Masnick (profile), 11 Mar 2010 @ 5:01pm

Re: Re: Re: Re: Are IPOs the way to go for innovation?
Discussions I've had with VCs.

And they said *what*? I can't think of an IPO that has anything to do with patents. Please help me here.

Yes, lots of tech companies have patents, because the system requires them to get them. But that's got nothing to do with their IPO.
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Suzanne Lainson (profile), 11 Mar 2010 @ 5:06pm

Re: Re: Re: Re: Are IPOs the way to go for innovation?
Yeah, Google, eBay, Amazon. No innovation at all.

Actually no. Not compared to these from Bell Labs:

1937 Clinton J. Davisson shared the Nobel Prize in Physics for demonstrating the wave nature of matter.

1956 John Bardeen, Walter H. Brattain, and William Shockley received the Nobel Prize in Physics for inventing the first transistors.

1977 Philip W. Anderson shared the Nobel Prize in Physics for developing an improved understanding of the electronic structure of glass and magnetic materials.

1978 Arno A. Penzias and Robert W. Wilson shared the Nobel Prize in Physics. Penzias and Wilson were cited for their discovery of cosmic microwave background radiation, a nearly uniform glow that fills the Universe in the microwave band of the radio spectrum.

1997 Steven Chu shared the Nobel Prize in Physics for developing methods to cool and trap atoms with laser light.

1998 Horst Stormer, Robert Laughlin, and Daniel Tsui, were awarded the Nobel Prize in Physics for the discovery and explanation of the fractional quantum Hall effect.

2009 Willard S. Boyle, George E. Smith shared the Nobel Prize in Physics together with Charles K. Kao. Boyle and Smith were cited for the invention of an imaging semiconductor circuit – the CCD sensor.
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Mike Masnick (profile), 11 Mar 2010 @ 5:13pm

Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?
Actually no. Not compared to these from Bell Labs:

Heh. Ok. You're like one of those people who argue "the music was better in my day."

Different times, different innovations. And you're talking about scientific breakthroughs, which are entirely different than innovations which help the economy. Certainly the transister became an important innovation, but tellingly NOT FROM BELL LABS. It took Shockley to go off on his own... and *then* to have his best engineers go off on *their* own to build a real market.

And you know how they funded that? With IPOs.

I mean, if you're at it, why not talk about PARC as well? There are lots of research labs that have done and still do scientific research.

But making that research useful in the market is entirely different.
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Suzanne Lainson (profile), 11 Mar 2010 @ 5:21pm

Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?
The point of the article was talking about a lost decade in terms of capital allocation and why the economy doesn't work.

I don't see that his ideas would help some of the more fundamental problems we are facing because I don't think capital would automatically go toward correcting them. Facilitating more IPOs and eliminating economic problems don't necessarily go hand-in-hand.
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Suzanne Lainson (profile), 11 Mar 2010 @ 5:24pm

Re: Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?
I mean, if you're at it, why not talk about PARC as well? There are lots of research labs that have done and still do scientific research.

Actually I was thinking about PARC as well.
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Mike Masnick (profile), 11 Mar 2010 @ 5:35pm

Re: Re: Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?
Actually I was thinking about PARC as well.

The place where they invented the future and monetized none of it?

Right.

See, that's the difference we're talking about here. The difference between *innovation* and *invention* or *scientific breakthrough*.

You're talking about the latter two things. I'm talking about the former. I don't care about people who invent stuff or discover stuff and can't do anything with it. I want the people who can do stuff with it.

Which is what happened with the transistor, where Bell Labs failed to take advantage, but others figured out how to make it useful and how to change the world.
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Suzanne Lainson (profile), 11 Mar 2010 @ 5:55pm

Re: Re: Re: Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?
Which is what happened with the transistor, where Bell Labs failed to take advantage, but others figured out how to make it useful and how to change the world.

I'll agree with you there. If you have an invention that no one uses, it doesn't benefit anyone.

However, I'm not sure I see capital flowing to breakthrough technology even if we have more IPOs. Being accountable to investors on a quarterly basis tends to skew decision-making. Some problems will likely take decades to solve and most companies aren't focused that far out. It's so much easier to fund something that will bring in an immediate return.
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Mike Masnick (profile), 11 Mar 2010 @ 6:19pm

Re: Re: Re: Re: Re: Re: Re: Re: Re: Are IPOs the way to go for innovation?

However, I'm not sure I see capital flowing to breakthrough technology even if we have more IPOs. Being accountable to investors on a quarterly basis tends to skew decision-making. Some problems will likely take decades to solve and most companies aren't focused that far out. It's so much easier to fund something that will bring in an immediate return.

Hey, we agree on something! :)

I've written how I think that quarterly reports and such are a problem and do lead to bad decision making as well:

http://www.techdirt.com/articles/20081113/0321092822.shtml

But that's a separate issue. Don't blame IPOs for public reports. Having a good capitol market that can support innovation is important. That's what's blocked and that's what Andy's talking about. Separately, we should also look at then improving financial disclosure systems so that we can encourage more long term thinking.
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Anonymous Coward, 11 Mar 2010 @ 6:27pm

I imagine some in Private Equity will wait until ACTA is passed, then find a bunch of startups to fund in India or China. I know that's what I would do.
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Dale B. Halling, 12 Mar 2010 @ 7:12am

Misallocation of Capital
Excellent points. The telecom deregulation was poorly thought out and only a bureaucrat would have thought it represented deregulation. However, the recessionary bump that the telecom bill and Greenspan’s Y2K pumping of money caused would have been minor but for the over reaction of Sarbanes Oxley and other little known bad policy decisions. Technological innovation is the only way to increase real per capita income. Unfortunately, since 2000 we have passed a number of laws and regulations that are killing innovation in the US. (see www.hallingblog.com) The incredible innovation of the 90s was based on technology start-up companies built on intellectual capital, financial capital, and human capital. All three of the pillars have been under attack since 2000. Our patent laws have been weakened reducing the value of intellectual capital. Sarbanes Oxley has made it impossible to go public reducing financial capital for start-ups and the FASB rules on stock options have made it harder to attract human capital to start-ups. The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation http://www.amazon.com/Decline-Fall-American-Entrepreneur-Regulations/dp/1439261369/ref=sr_1_1?ie=UTF 8&s=books&qid=1262124667&sr=8-1, explains these problems in more detail.
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Brandon Seller, 21 Apr 2010 @ 1:26pm

Huh?
I really don't understand anything.
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Sandy (profile), 21 Jun 2010 @ 11:25am

Misallocation of cause
I completely agree with the authors contention that the big problem with the economy is that we stopped capitalizing innovation - and too much of our captial was diverted to "get rich quick" private equity.

I completely disagree with his focus on government over-regulation (and over-reaction) being a (primary?) cause of that slosh.

If one were to look for a foundation block for the shift from innovation to equity it would likely begin with the multitude of deregulations during the Reagan era. Specifically, from 1980 to 2000, the government chipped away at the financial regulations that had been imposed after the Great Depression. The HEIGHT of the American industrial climb and innovation run amok was precisely when these regulations were in full effect.

The HUGE problem is that given a *choice* between "get rich quick" (equity) or "get rich slow" (innovation) - QUICK is going to trump slow 98.6% of the time. The damage was done with the tearing down of the wall between investment banking and commercial banking. The death of Glass-Steagall was just the final straw.

When it will take 30 years to make your profits on a mortgage, it's in YOUR best interest to make "reasonable" loans. If you can magically turn ANY mortgage into a security and resell it instantly, all prudence goes out the window, because a worthless $800K mortgage is actually much more profitable than a solid $160k.

SOX was probably the wrong over-reaction to WorldCom and Enron and Tyco - but clearly there needed to be a reaction. *CONFIDENCE* in the solidity of an economic entity has gigantic value. Why were mortgage backed securities soooooo attractive? Because they were practically gold in terms of performance over nearly 100 years. You KNEW that American mortgages were 99% solid. Why? Because American banks were REQUIRED BY LAW to very exacting, (and annoying, and expensive) standards. And the solidity of the market died the day the banks managed to get most of those minimum standard thrown out.

The market NEEDS both commercial and investment banking. But, the market showed back in 1929, and again in the first decade of the 21st century, that the two do NOT mix.
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