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Piketty is wrong because he misses the capital destruction caused by capital efficient digital disruption May 9, 2014

Posted by Bernard Lunn in Globalization.
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Before Piketty’s famous book, Capital in the 21st Century, came out, his ideas and research had already influenced Occupy Wall Street. In 2011, I found myself sympathetic to the 99% and their story, but around that time I went to a meeting where I learnt why Piketty is wrong; his book is brilliant research and insight – looking in the rear view mirror.

The meeting that changed my perspective was at a Wealth Management firm whose mission was to preserve wealth for future generations. Looked at from the perspective of the barricades in Zucotti Park, these were the folks ensuring that the 1% won and that we drifted into Oligarchy.

The Wealth Management firm had put up a list of their highest conviction stocks. Right at the top of the charts was a mega big Global 100 type company that had just that day had some horrible story that had decimated their share price. Oops. When questioned they responded:

“Stuff like that happens, it’s impossible to predict that kind of thing where rogue employees run amok”.

Yes that is true and the rationale for putting that stock top of the charts based on financial metrics was impeccable. Yes, the problem that crashed the stock that day was a Black Swan event and they are by definition impossible to predict. The rogues were fired. Story over? No. Nobody could predict who would go rogue and when and in what form, but it was reasonably predictable that somebody would go rogue fairly soon in some way. It was an inevitable event even if it was not an imminent event where you could predict the timing. The reason that the employees went rogue was that their business was slap bang in the path of digital disruption. It was a great big firm, run by an awesome entrepreneur and yet it was roadkill in front of the digitization truck. The boss refused to accept this, they were the #1 winner dammit! So he piled on the pressure to hit the numbers any way they could. That leads to employees cutting corners and if they get caught it’s labelled as rogue behavior. Anybody who has toiled in the management ranks of big corporations will recognise this.

If you distrust anecdotal evidence, consider the trends about how fast companies are entering and exiting indices of bigness such as the S&P500 or the Fortune 500. Or look at the time taken to get to $100m in revenues for digitized consumer ventures. Look at how many now get t0 over $100m, in some cases nudging $1 billion, within 5 years. That is disruption at work. The pace of change is accelerating now that 50% of the 7 billion people on the planet have mobile phones. It’s no longer just book shops that worry about being Amazoned, it is now also WalMart heirs who have to worry about that as well. I am writing this on the day the Alibaba IPO prospectus loaded, so now Amazon has to worry about being Alibabaed.

What’s a poor trust fund kid supposed to do?

What does this have to do with Piketty? The simple concept is about what happens when R exceeds G. R is Return on Capital. G is GDP growth. His thesis is that when R exceeds G we drift to Oligarchy. That makes sense. If Capital gets 6% Return when GDP is 3%, then Capital gets a bigger share of a smaller pie, which leads to increasing inequality.

But what if R is only 3%? What if R cannot even keep up with inflation? What if the trust fund gets wiped out over time by inflation, fees from all those fund managers and tax? Plus the fact that the wealth managers will do the prudent thing that they are paid to which is to invest in those safe solid companies with wonderful financial metrics – some of which will be slap bang in the middle of the road waiting to be run over by the digitization truck. Those $ billions in revenue created by digital start ups do come from somewhere, it is coming from the big companies that are maladapted to digitization that the trust fund kid is invested in. This leads to “shirtsleeves to shirtsleeves in three generations”. That is as it should be. People should work for a living. It gives them self respect and a purpose in life. “Shirtsleeves to shirtsleeves in three generations” means we have something close to an equal opportunity society and we avoid the drift to oligarchy. I would not wish for my children to live isolated lives in compounds protected from poor people because they are rich enough not to have to work. I would wish for them to do work that is fulfilling to them, with peers that they like and respect, in a society where most people are doing the same.

The obvious answer for the trust fund kid is to put money into the start-ups that drive the digitization truck, to get the massive returns that go to backing the winners. There are three problems with that:

  1. Venture Capital is a totally Darwinian game, the lion’s share of the returns go to a tiny number of Funds. These top tier VC Funds don’t need money from the trust fund kid, the partners invest their own money and tap a few investors who put money into their first fund and so have the right to put money into other funds.
  2. If you invest in a first time fund, you take a massive risk. If you invest in second tier funds you may, if you are lucky, make the same returns as an S&P Index Fund and quite likely you will lose money. If you invest directly in startups as an Angel you may get very lucky (the same is true in Vegas) and you may get non-financial benefits, but your chances of accelerating the destruction of your wealth is statistically far more likely.
  3. Digital startups are naturally capital efficient. That is why they are so disruptive. So they don’t need a lot of cash from the trust fund kid. That makes it really, really hard to make high R on large amounts of capital; it is far easier to get high R on small amounts of capital. If you are investing large sums you tend towards investing in big old companies that are roadkill in front of the digitization truck. Those big funds, whose managers make money on the amount of funds under management are the funds that our trust fund kid gets invited to invest in. Building a digital business is not like starting a factory or a diamond mine or some other 20th Century type enterprise. With smarts and hustle you can now reach billions of consumers directly. The cost of building the technology to do this is pathetically small. Its all about the smarts and the hustle (plus a sprinkling of luck). Founders of tech start-ups increasingly view capital as the least interesting ingredient in the cake they are baking. If asked could they have $50m or a co-founder like Steve Jobs, most would choose the latter because you cannot buy that kind of talent. That world – where talent is more important than capital – is not the world that Piketty is describing

It is not a coincidence that Piketty is French and his biggest fans are in America. When an economy is in slow growth mode, the people with the money use political power to grab an increasing share of pie. It is a diminishing pie that is based on the old 20th century businesses, but the pie is still very big.  The License Raj in India up to 1990 was the archetypal example of this.

The reason that this power grab cannot last long in the 21st century is that digital bits don’t stop at borders. The digitization tsunami amplifies the globalization tsunami and vice versa. India could hide behind the License Raj import substitution walls for decades and by doing this the people who were close to the political power became vastly wealthy while the rest of the people were relegated to poverty. This was a classic example that illustrates Piketty’s thesis – R was a lot more than G if you knew who to bribe in the License Raj.

However as governments learnt in the Arab Spring, you cannot turn off the Internet for long. If you turn it off or regulate to death the disruptive startups that use it, you kill the chance of the kind of wealth creation that you see in Silicon Valley and that other regions of the world want to emulate.

Piketty’s France is known for being run by a political elite. It is a slow growth economy where enough money is redistributed to keep voters happy. France today is similar to India in the License Raj days; it is only nominally a free enterprise society.

How can you see America in that context? America has nothing in common with socialist France and License Raj India, surely? Well in GDP terms, America is now a slow growth economy. And one can see a power grab by people with control of 20th century businesses like the Koch Brothers. That is why Piketty’s book is selling and being talked about so much and why Zucotti Park was crowded.

Yet America is also the home of innovation, the place where most of the digitization trucks get built. This is the real battle for the future of America. Forget about Democrats vs Republicans, that’s just a battle for who controls the spigots of the 20th century economy. The real battle is between 20th century America and 21st century America.

Ground zero in this battle for 21st century America is Stanford University. In 1999, two Stanford kids started Google. Ever since then, VC Funds (some of which are trying to make sure that the trust fund kid’s R is more than G) have camped outside Stamford dorm rooms waving check books. That has led to some embarrassing wealth destruction in ventures such as Color and Clinkle. Investing early in the great digitization winners is not a simple “wash and repeat” formula.

Who can blame parents for wanting to get their kids into Stamford? This is a return on education which is increasingly a return on capital since tax-payer funded education is in decline in America and many other countries. So once you get into Stamford you are made for life? Well no, not if you think you are made for life. That won’t make you work hard and will make you think like an insider when the disruption always comes from a well educated outsiders.

For this insight I am in debt to another book that covers similar territory to Piketty but in a very different way. This is Christina Freeland’s Plutocrats. She looks at where the first generation Plutocrats come from and that is very consistent all over the world. They come from smart, driven people who got a great education outside the elite centers of power. Yes there is an increasing return to education, but the results are better if that education is in a place where kids feel like outsiders who can only make it if they disrupt the existing order.

The poster boy for this is Marc Andreessen. Educated at Champaign-Illinois, in the midwest of America, he went on to found Netscape (and thus help start the digitization wave) and then started one of those top tier VC Funds (Andreessen Horowitz, where he coined the phrase that “software is eating the world”). He is now an insider in Silicon Valley, helping to build those digitization trucks that wipe out the inherited wealth invested in the 20th century economy. So it is significant that he shared his worry about the sense of entitlement at Stamford in a series of tweets (I am paraphrasing, check him out on Twitter, he is usually thought-provoking).

His tweets, inspired me to write this on a 12 hour flight from “old Europe” to “new California” without the distraction of Internet access.

Disclosure: I have NOT read Capital in the 21st Century. I am quite willing to admit that, I am no longer at College so I don’t need to prove to my Professor that I read the book. I got the “fundas”  by watching this Moyers interview with Krugman. I recommended it to all who have an interest in the subject but are too busy to read a 700 page book. I did read Plutocrats and highly recommend it (an entertaining read while also being very insightful).