The Capitalist’s Dilemma;
Like an old machine emitting a new and troubling sound that even the best mechanics can’t diagnose, the world economy continues its halting recovery from the 2008 recession. Look at what’s happening in the United States: Even today, 60 months after the scorekeepers declared the recession to be over, its economy is still grinding along, producing low growth and disappointing job numbers.
One phenomenon we’ve observed is that, despite historically low interest rates, corporations are sitting on massive amounts of cash and failing to invest in innovations that might foster growth. That got us thinking: What is causing that behavior? Are great opportunities in short supply, or are executives failing to recognize them? And how is this behavior pattern linked to overall economic sluggishness? What is holding growth back?
Most theories of growth are developed at the macroeconomic level—at 30,000 feet. That perspective is good for spotting correlations between innovation and growth. To understand what causes growth, however, you have to crawl inside companies—and inside the minds of the people who invest in and manage them. This article (which builds on a New York Times piece Clay wrote in late 2012) is an attempt to form a theory from the ground up, by looking at company experience.
About a year ago we invited the students and alumni of our Harvard Business School course “Building and Sustaining a Successful Enterprise”—who represent a cross-section of the corporate, entrepreneurial, and financial services sectors worldwide—to join us in this effort. (See “A New Approach to Research.”) Early on, we explored a wide range of reasons for the sputtering recovery, including political and economic uncertainty, the low rate of bank lending, a decline in publicly supported research in the United States, and the demise of innovation platforms like Bell Labs. (In a companion piece in this issue, our colleague Gautam Mukunda contends that the finance sector’s growing power is a major factor.)
Fairly quickly, though, the discussion focused in on what had first attracted our attention: the choices companies make when they invest in innovation. Unlike some complicated macroeconomic factors, these choices are well within managers’ control.
We’re happy to report that we think we’ve figured out why managers are sitting on their hands, afraid to pursue what they see as risky innovations. We believe that such investments, viewed properly, would offer the surest path to profitable economic and job growth. In this article we advance some prescriptions that could become the basis of an agenda for meaningful progress in this area.
In our view the crux of the problem is that investments in different types of innovation affect economies (and companies) in very different ways—but are evaluated using the same (flawed) metrics. Specifically, financial markets—and companies themselves—use assessment metrics that make innovations that eliminate jobs more attractive than those that create jobs. We’ll argue that the reliance on those metrics is based on the outdated assumption that capital is, in George Gilder’s language, a “scarce resource” that should be conserved at all costs. But, as we will explain further, capital is no longer in short supply—witness the $1.6 trillion in cash on corporate balance sheets—and, if companies want to maximize returns on it, they must stop behaving as if it were. We would contend that the ability to attract talent, and the processes and resolve to deploy it against growth opportunities, are far harder to come by than cash. The tools businesses use to judge investments and their understanding of what is scarce and costly need to catch up with that new reality.
Before we get to the solutions, let’s look more closely at the different types of innovation.
Three Kinds of Innovation
The seminal concepts of disruptive and sustaining innovations were developed by Clay as he was studying competition among companies. They relate to the process by which innovations become dominant in established markets and new entrants challenge incumbents. The focus of this article, however, is the outcome of innovations—their impact on growth. This shift requires us to categorize innovation in a slightly different way:
Performance-improving innovations replace old products with new and better models. They generally create few jobs because they’re substitutive: When customers buy the new product, they usually don’t buy the old product. When Toyota sells a Prius, the customer rarely buys a Camry too. Clay’s book The Innovator’s Solution characterized these as sustaining innovations, noting that the resource allocation processes of all successful incumbent firms are tuned to produce them repeatedly and consistently.
Efficiency innovations help companies make and sell mature, established products or services to the same customers at lower prices. Some of these innovations are what we have elsewhere called low-end disruptions, and they involve the creation of a new business model. Walmart was a low-end disrupter in retailing, for example, and Geico in insurance. Other innovations, such as Toyota’s just-in-time production system, are process improvements. Efficiency innovations play two important roles. First, they raise productivity, which is essential for maintaining competitiveness but has the painful side effect of eliminating jobs. Second, they free up capital for more-productive uses. Toyota’s production system, for example, allowed the automaker to operate with two months’—rather than two years’—worth of inventory on hand, which freed up massive amounts of cash.
Market-creating innovations, our third category, transform complicated or costly products so radically that they create a newclass of consumers, or a new market. Look at what has happened with computers: The mainframe computer cost hundreds of thousands of dollars and was available to a very small group. Then the personal computer brought the price down to $2,000, which made it available to millions of people in the developed world. In turn, the smartphone made a $200 computer available to billions of people throughout the world. We see this pattern so frequently that we’re tempted to offer it as an axiom: If only the skilled and the rich have access to a product or a service, then you can reasonably assume the existence of a market-creating opportunity.
Market-creating innovations have two critical ingredients. One is an enabling technology that drives down costs as volume grows. The other is a new business model allowing the innovator to reach people who have not been customers (often because they couldn’t afford the original product). Think of it like this: An efficiency innovation pointed in the right direction—toward turning nonconsumption into consumption—becomes a market-creating innovation. Ford’s Model T, for example, brought automobile ownership within reach for most Americans, because of both its simple design and the revolutionary assembly line that brought scale to the enterprise. In the same way, Texas Instruments and Hewlett-Packard used solid-state technology to bring low-cost calculators to millions of students and engineers worldwide.
Companies that develop market-creating innovations usually generate new jobs internally. When more people can buy their products, they need more employees to build, distribute, sell, and support them. A great deal of related employment growth, though, occurs in the innovating companies’ supply chains or in partners whose own innovations help build a new platform. A classic example is the Bessemer Converter, patented in 1856, which made it possible to manufacture steel inexpensively for the first time. Andrew Carnegie used its revolutionary cost-reduction potential to build the Thomson Steel Works, but the railroad companies used the cheaper steel to create a new industry. U.S. steel employment quadrupled in the last quarter of the 19th century, reaching 180,000 by 1900, and railroad employment reached 1.8 million a scant two decades later.
The combination of a technology that drives down costs with the ambition to eradicate nonconsumption—to serve new customers who want to get something done—can have a revolutionary effect. A decade ago, Apple’s managers were on the lookout for a device that could enable convenient, affordable storage of a consumer’s music library, with anytime, anywhere access. They saw in Toshiba’s development of a 1.8-inch hard drive the opportunity to fulfill this job, which triggered the development of the iPod/iTunes business model. And if companies such as Corning and Global Crossing hadn’t innovated to create and lay ample low-cost dark fiber capacity, Google, Amazon, and Facebook wouldn’t exist as we know them today.
Market-creating innovations need capital to grow—sometimes a lotof capital. But they also create a lot of jobs, even though job generation is not an intended effect but a happy consequence. Efficiency innovations are at work 24/7 in every industry; that very same efficiency, if targeted toward making a product or a service more affordable and accessible, can create net new jobs, not eliminate them.
The mix of these types of innovation—performance-improving, efficiency, and market-creating—has a major impact on the job growth of nations, industries, and companies. The dials on the three types of innovation are sensitive, but if the capital that efficiency innovations liberate is invested in market-creating innovations at scale, the economy works quite well. However, that’s a big “if,” as we shall see.
The Orthodoxy of New Finance
So, to come back to our central question (phrased in a new way): Why do companies invest primarily in efficiency innovations, which eliminate jobs, rather than market-creating innovations, which generate them? A big part of the answer lies in an unexamined economic assumption. The assumption—which has risen almost to the level of a religion—is that corporate performance should be focused on, and measured by, how efficiently capital is used. This belief has an extraordinary impact on how both investors and managers assess opportunities. And it’s at the root of what we call the capitalist’s dilemma.
Let’s back up to see where this assumption came from. A fundamental tenet of economics is that some of the inputs required to make a product or service are abundant and cheap—like sand. We don’t need to account for such inputs and can waste them, if need be. Others are scarce and costly and must be husbanded carefully. Historically, capital was scarce and costly. So investors and managers alike were taught to maximize the revenue and profit per dollar of capital deployed.
While it’s still true that scarce resources need to be managed closely, it’s no longer true that capital is scarce. A recent Bain & Company analysis captures this point nicely, concluding that we have entered a new environment of “capital superabundance.” Bain estimates that total financial assets are today almost 10 times the value of the global output of all goods and services, and that the development of financial sectors in emerging economies will cause global capital to grow another 50% by 2020. We are awash in capital.
Because they were taught to believe that the efficiency of capital was a virtue, financiers began measuring profitability not as dollars, yen, or yuan, but as ratios like RONA (return on net assets), ROIC (return on invested capital), and IRR (internal rate of return). These ratios are simply fractions, comprising a numerator and a denominator, but they gave investors and managers twice the number of levers to pull to improve their measured performance. To drive RONA or ROIC up, they could generate more profit to add to the numerator, of course. But if that seemed daunting, they could focus on reducing the denominator—outsourcing more, wiping more assets off the balance sheet. Either way, the ratio would improve. Similarly, they could increase IRR either by generating more profit to grow the numerator or by reducing the denominator—which is essentially the time required to get the return. If they invested only in projects that paid off quickly, then IRR would go up.
All of this makes market-creating innovations appear less attractive as investments. Typically, they bear fruit only after five to 10 years; in contrast, efficiency innovations typically pay off within a year or two. What’s worse, growing market-creating innovations to scale uses capital, which must often be put onto the balance sheet. Efficiency innovations take capital off the balance sheet, however. To top it off, efficiency innovations almost always seem to entail less risk than market-creating ones, because a market for them already exists. Any way you look at it, if you measure investments using these ratios, efficiency innovations always appear to be a better deal.