Reviewed in the United States on February 27, 2018
Capitalism without Capital provides a strong macro analysis on how intangible assets differ from tangible assets, why economies are shifting away from tangible assets, and how this is impacting economic performance. Intangible asset categories generally include: computerized information (software), innovative property (R&D), and economic competencies (trademarks, processes, and training), though they can also be contractual (non-competes), artistic-related (designs), and customer-related (membership programs, established relationships…etc.). The author begins by explaining the difference between tangible and intangible assets, highlighting scalability, sunkenness, spillovers, and synergies.
Sunkenness – intangible assets are more difficult to sell than tangible. They may be specific to the company that makes them or it may be difficult to strip one intangible asset from another (like workforce). Thus, investment in intangible assets tend to represent sunk costs, implying that there is less salvage value should things go wrong. Mass production and standardization has made many tangible assets of similar purpose homogenous, providing more salvage value. As a result, the secondary market for intangibles is much smaller than that for tangibles.
This makes financing intangibles with debt more difficult since collateral value is largely ambiguous. Further, a combination of the sunk cost fallacy causing managers to stick with bad investments and the lack of secondary market pricing could lead to overoptimistic investment, as well as more frequent and intense bubbles (no salvage value…). This is partially mitigated by option value created when investment in intangibles resolves uncertainty of similar potential future projects or future stages of the same project.
Spillovers – intangible assets generate spillovers, wherein unassociated parties find ways to replicate, and benefit from, the intangible assets that a private company developed with the intention of being its sole benefactor. For example, “knock-off” products can render long-term R&D less valuable, advertising can help entire industries, trained workers may leave for other firms…etc. This is an inherent characteristic of a non-rivalrous asset (an asset that can be consumed by one without preventing consumption by others), as opposed to a rivalrous asset that can only be consumed once or by one consumer. This is a logical extension from the fact that intellectual property rights are less protected than tangible property rights.
Spillovers may cause companies to invest less since they may not obtain the benefits, providing a role for government to invest in R&D that generates spillovers (government currently accounts for ~30% of R&D in the U.S.).
Scalability – Intangible assets are more scalable than tangible. If demand increases for, say, Coca Cola, bottlers would need to make significant investment in tangible assets to expand, but the owner of the Coca Cola intangibles (brand, recipe, licensing arrangements) need not invest more to benefit. Like spillovers, scalability is due to the non-rivalrous nature of intangibles. Ideas can always be scaled to increased tangible inputs to create more output since ideas can be used over and over. Intangibles also exhibit network effects more often than tangibles. Intangibles, however, are not infinitely scalable (the McDonald’s recipe changes from country to country after all).
Because of scalability, intangible-intensive businesses will grow very large, so rewards to intangible investment are high. As a result, firms will be encouraged to enter intangible-rich markets, leading to high competition at first but then discouraging further entrants. Over time, large winners will emerge and these industries will consolidate. This demonstrates the winner-take-all effect (if Google is better, why use any other search engine ever?).
Synergies – Intangible assets tend to have more synergistic combinations, akin to a truck and a loading dock, but think record label, licensing agreements, and design skills. Intangibles complement each other such that one raises the value of another. Thus intangible combinations lead to ladder externalities, meaning investment begets further investment.
Synergies incentivize companies to seek spillovers from other firms via acquiring start-ups, partnering in research, and undertaking joint ventures. Accordingly, a lack of general intangible investment can lead to individual firms avoiding intangible investment.
The above traits make intangibles more uncertain. If things go wrong intangibles are worth less, but if things go right they’re worth more. They also results in intangibles being more contested as firms and people vie for control.
While intangible assets have always existed in some manner, companies predominantly invested in tangible assets historically. Intangible investment began to surpass tangible investment around the year 2000 in the U.S. and around 2008 in the U.K. Mediterranean countries have more tangible than intangible investment, whereas the U.S./U.K./Nordics have more intangible. The rest of continental Europe is somewhere in the middle.
The author offers several potential causes to explain this rise in intangible investment:
Baumol’s Cost Disease – increased productivity in manufacturing makes labor-intensive services more expensive relative to manufactured goods. Most tangibles are manufactured, while most intangibles are labor-intensive. This implies that tangibles investment is proportionally falling more so than intangible investment accelerating. This is somewhat offset by the fact that intangible costs can be nonrecurring.
Technology – many intangibles, like software, are IT related. Computers and tech are necessary preconditions for this investment. Conversely, some argue that tech evolved in response to the need for intangibles (firms desired mass advertising…etc.).
Industrial structure – service output is replacing tangible output in developed countries due partially to globalization, which forces further specialization (i.e. investment in intangibles like R&D and brand).
Deregulation – labor market strictness encourages tangible investment (machinery) to replace labor, while intangible investment inherently requires labor flexibility.
Free trade – due to the relative scalability of intangibles, increasing access to new markets incentivizes investment in intangibles.
There are some who argue that investment in intangibles is not investment at all, and should not be counted as such. The author describes these arguments and addresses them. Examples:
-Advertising is not net investment because it’s zero sum. The author explains that, while advertising by one firm may be damaging to competitor intangible asset value, it’s unlikely all firms advertising are exactly offsetting each other since advertising at one firm can increase product awareness that positively effects all firms in that industry (spillovers).
-Organizational structure (culture) is not an investment because it creates bureaucracy and busy work. The author explains this is unlikely to apply to market sector firm since worthless spending would eventually drive these firms out of business.
-Training is not an investment because it creates an asset owned by the employee, not the firm. The author addresses this by noting that, despite the lack of ownership, the firm nonetheless benefits. Also, training is often of limited use outside the firm doing the training. Non-competition agreement may make the skills non-transferable for a period of time as well.
The author adds that some intangible assets are formed without investment. This includes spillovers from other firms and learning by doing (i.e. simply improving from ongoing production experience). The public sector also invests in intangibles – software, training, marketing, faith in the rule of law, public officials…etc. Once he establishes that intangible investment is in fact investment, the question remains as to how to measure this investment in aggregate.
The author states that the cost approach to valuing intangible is inadequate when an intangible generates excess cash flows. In aggregate, much investment in intangibles also fails though, so it’s possible that on average aggregate investment in intangibles approximates aggregate value. One primary difficulty is measuring labor costs. Many employees, if not most, are dedicated to multiple tasks in any given day. The inclusion of salaries to employees tasked partially with unrelated work results in an unclear way to allocate work time to make the cost approach valid.
Measuring an asset also requires measurement of the depreciation of that asset. Economic depreciation is the year over year reduction in value. Intangible asset economic depreciation is primarily due to “discards,” where the value of an intangible falls due to competition from another intangible or the departure of a trained employee (as opposed to physical decay as with tangible assets).
As of now, GDP includes only productive activities, so pensions, transfer payments, capital gains…any reshuffling of wealth is not counted. Neither is household production, unless someone else is paid to do so. He provides a humorous quote from Samuelson, saying “when a man marries his cook, GDP falls.”
Next, the author attempts to explain how the rise of intangible assets has impacted economic performance. He starts with secular stagnation. Secular stagnation is defined by low investment coinciding with low interest rates (similar to a liquidity trap). At the same time, margins/returns are rising, the productivity gap between weak and strong firms is rising, and productivity growth in general is falling primarily due to a decline in total factor productivity growth. These characteristics, at least partially, could be explained by the rise of intangible assets. He notes the following:
-As discussed above, certain intangibles may not be counted by statistical agencies, suggesting under-measurement of economic performance.
-Scalability and spillovers have caused strong firms to pull away from weak, increasing profitability and productivity gaps. Empirically, intangible-intensive industries/countries exhibited the largest productivity gap and profitability increase. Consequently, investment behavior could diverge (strong firms continue to invest, weak firms don’t). With few leaders and many laggards, the net effect could be lower aggregate investment combined with higher returns on the investments that do get made.
-A slowdown of intangible investment post-2008 coincides with the observed decline in total factor productivity growth. A logical consequence of a slowdown of intangible investment is fewer spillovers.
-Concentration in intangible-intensive industries has caused less intangible investment as leading firms narrow their focus and laggard firms become less effective at absorbing spillovers.
-Intangible investment may have negative externalities and be zero-sum (rent seeking via patent protection from competition…etc.). It would still count as investment but would not produce new output, instead just redistributing existing output. This would make [total factor] productivity growth stagnate. It could also exacerbate the gap between leading and lagging firms.
The author then moves to inequality. He starts by providing the traditional explanations of inequality:
Technology – labor replacing machines…this is perhaps the oldest argument around, though evidence suggests it may impact the middle class most.
Globalization – the workforce of the global tradable economy doubled in the ‘90s from China/India industrialization, increasing the supply of low-skilled workers and driving wages relatively low.
Natural – Piketty’s r>g explanation wherein capitalists take growing pieces of the pie unless some force suppresses return on capital.
The author is ultimately either unconvinced by these arguments or believes intangible assets play a role within the traditional explanation. He states:
-Technology tends to reformulate jobs, not eliminate them. Tech may only replace other tech, providing benefit with limited cost. Tech also allows for business expansion (requiring new staff) and raises marginal productivity (thus increasing wages). Each of these points are empirically supported.
-The gap between skilled/unskilled has steadied, with the new growing gap being that between the top 1% and everyone else. This discredits skill-biased technological change as the primary cause of inequality.
-A material portion of Piketty’s inequality reflects housing wealth (paper wealth). The author returns to this point later, arguing that this is attributable to the rise of intangible assets.
-Two-thirds of inequality is across firms, and only one-third is within firms. Leading firms are paying more to top and bottom employees relative to non-leaders. Also, people joining high paying companies tend to be highly paid already, termed “sorting.”
This last point is important, as it requires answers to a whole new set of questions. To explain this fact, the author provides the following logic.
-Superstar performers may have exclusive access to scalable intangibles.
-Leading firms want employees who can contest intangibles in order to appropriate spillovers or coordinate synergies, and are willing to pay well to attain them.
-Investment in organizational structure continually leads to reorganized divisions of labor, separating companies providing higher and lower cost services and employing different staff. This leads to more inequality across firms. In other words, firms offering multiple services with differing price schedules will divest divisions and refocus on more narrow service offerings. The firm focusing on the higher value service will become more profitable than the firm that breaks off to focus on the lower value service, likely hiring the lower value service firm at a market price rather than hire staff for the lower value services.
-Attribution error leads firms to overvalue executive positions.
These explanations may provide viable explanations contributing to income inequality, but not necessarily wealth inequality. Regarding wealth inequality, the author states:
-Spillovers and synergies across industries (ladder externalities) are more likely to occur in “unplanned” cities with a plethora of active industries, encouraging migration to cities. This, combined with zoning and NIMBYs, could explain the rapidly rising value of home prices, which makes up a material portion of rising wealth inequality.
-Taxing capital gains normally causes capital to shift to more favorable regimes. Intangible assets are more mobile than tangible assets. This means tax competition could intensify, keeping taxes on capital lower and inequality higher.
This leads into market predictions and policy recommendations, specifically how to steer policy through an emerging intangible economy. The author starts by addressing the desirability of industry clusters, which can be expected to result in synergies. Encouraging industry clusters in a city requires housing and public areas where individuals can interact. While deregulating NIMBY laws can help create housing, it can also lead to interactive areas being replaced by housing. Further, it’s unclear whether to encourage clusters that are already forming, clusters that are dying, or totally new clusters. Accordingly, matching appropriate infrastructure to a growing intangible economy faces several challenges. Speedy technological changes may make infrastructure investment obsolete quickly. At the same time, infrastructure is most useful in conjunction with complementary infrastructure, and may even be useless without it.
More emphasis will be placed on defining property rights, particularly for highly contested intangible assets. Property rights (tangible and intangible) and norms (intangible infrastructure) help mitigate uncertainty in production (norms within industries, across industries, in M&A…etc.).
Private finance will experience significant changes, as the sunkenness of intangibles makes bank lending more difficult. Lending on intangibles requires higher levels of regulatory capital reserves. Government could guarantee or make more loans, but as the economy becomes more intangible, they will become increasingly necessary. Government could deregulate interstate banking, as more competition encourages lending on intangibles.
Companies may shift to increased equity financing, but most financial institutions don’t provide equity financing. Eliminating tax benefits on debt would be a helpful start. However, equity markets create short-term incentives (cut R&D when options are vesting…etc.), which may be incompatible with the inherently longer-term nature of intangibles. Having institutional investors (or concentrated ownership generally) tends to encourage longer-term intangible investment, and being listed on an exchange tends to result in greater institutional investment. Empirically, public company managers have focused on more successful/higher quality intangibles due to the need to “signal” to shareholders.
Venture capital is suited to intangible investment due to the need for potentially large winners to offset frequent losers. Scalable intangibles create the potential for large winners more than tangible assets. VCs will focus on creating synergies (network) to increase potential. Spillovers are a concern. A thriving VC sector takes time, so encouraging venture capital in developing countries should not be a short-term policy goal.
-Debt financing will fall and equity financing rise.
-Ownership will concentrate and institutional ownership will rise (regulation permitting).
-Public ownership may fall as concentrated/institutional owners see less benefit to being public.
-Widespread industry investment may become more popular as firms attempt to increase beneficial stake in spillovers. The author notes this is a contradiction, however, as it is the opposite of concentration. Investors wish to diversify to capture spillovers, but intangible spillovers are most likely to be generated when more intangible investment occurs (i.e. with concentrated ownership).
In addressing the role of management in an intangible economy, the author starts by highlighting the role of prices in signaling production. He explains that managers are needed as figures of authority, as Coase argued it’s more efficient and less costly than discovering market prices and negotiating contracts for every “inter-company” transaction. This is especially true when investments are sunk (as with intangibles), giving more bargaining power to certain employees (the “hold-up” problem). IT enhancements and organizational development may lead to less authority via lower information prices, but it also makes monitoring more efficient. This encourages monitoring to be substituted for autonomy, so there’s theoretically less need for managers. Consequently, this may allow firms to grow larger, which is desirable if searching for synergistic intangible combinations.
Managers with strong organizational knowledge are more difficult to hold onto than physical assets since managers can choose to leave of their own accord. This may result in higher pay to managers. Good management tends to mean setting stretch targets, tracking performance, and promoting high performing workers (instead of basing promotion on tenure). This, however, is not always true for longer-term employees due to the ratchet effect (workers work less hard initially knowing that outperforming short-term targets will result in higher future targets). The ratchet effect can be mitigated by setting long-term targets, not day-to-day, and by avoiding target adjustments and rewards in response to short-term employee lobbying. Intangible producers should strive for a free flowing open culture without stretch goals. Intangible users should have more strict hierarchies and targets.
Regarding investment management, since intangibles generally only show up on balance sheets post-acquisition (except for some capitalized R&D or software), book value has become increasingly irrelevant for predicting earnings as intangible investment increases as a proportion of expenses.
I was somewhat disappointed that there was so much focus on the need for government in the intangible-rich future. Theorizing about the impact of intangible assets is relatively new in the field of economics. Appealing to the need for vague government action is a bit of a cop-out. It’s unclear what kinds of budding entrepreneurship will emerge as the rise of intangible assets continue, but equally unclear are the externalities of Federal, State, and local legislation/regulation aimed at managing this dynamic process.
Overall, I highly recommend this book to anyone working in finance or economics at a micro or macro level. As an intangible asset appraiser, I found much of the above information relevant and practical. Very much worth the read.