Sunday, January 30, 2011

Drinking Tea with Elephants

President Obama, Republican responder Paul Ryan and rightward gazing Tea Party evangelist Michelle Bachmann all need a time-out. Together with their respective constituencies, the gross lack of awareness of structural deficits in both their diagnosis and proposed treatment for our economic ailments is reminiscent of the “nobody could see it coming” lunacy of 2008. And, before I waste more words – economies are built with customers exchanging value, not on investment. The next time you hear “access to capital” as an excuse not to succeed or as the treatment to enable success, realize that there’s no greater illusion in the global markets than the myth of private equity and venture capital carefully built over the past 45 years.

The siren song that venture capital is an integral component to stimulating an innovation economy has served to create a class of usurious despots, not economic efficiency. Despite its decades of existence, private equity in the form of venture capital has a hideous failure rate that is masked by those who have a few exceptional successes. Under the guise of “high risk”, funding failure rates in excess of 90% are not indicators of risk. Rather, they are indicators of a more problematic misconception and consistent, willful ignorance on the part of those who administer funds belonging to others. In short, not all innovations or technologies merit the creation of a business and, absent that merit, most fail along with the capital that supports them. No economy in the world has honestly and reliably developed the processes (or the courage) to recognize that an innovation does not a company nor an investment make. With over 95% of the world’s patents never associated with value accretion (most are useless and many others are defensive negotiating tools alone), the belief that patents and venture capital alone will create an economy is totally unfounded. These are among the many tools that can build value but they are not a prerequisite foundation. Missing from the calculus of economic promotion is the recognition that a customer, not an investor, is the key to creating enterprises. Every dollar of investment is a single dollar spent with subsequent investors often squeezing early investors out of the picture all together. The same dollar as a purchase can be leverage 3-10 times based on the form of capital sought by an enterprise. Governments who truly want to stimulate innovation economic development would be far better served by purchasing at a premium from local enterprises aligned with domestic innovation priorities rather than throwing investment dollars at everything that claims to be a company. Billions of dollars of wasted venture capital did not create IBM, Oracle, Siemens, or Sharp. Government procurement did and government procurement – often at premium prices – continues to be the lifeblood of many of the mislabeled equity successes of the modern economy.

When President Obama, Paul Ryan and Michelle Bachmann stand before the American public and the world and talk about fiscal discipline evidenced by decreased spending, they ignore the fact that the U.S. economy has been in a technical Depression but for the very spending they rail against. To be clear, if we didn’t have the public and private wars in Iraq, Afghanistan, and now Pakistan which support over 10% of our GDP and ALL of our national GDP growth, we would be pushing wheelbarrows full of worthless currency to buy loaves of bread. When the top five places the U.S. spends its money are ALL aerospace companies who deliver “shock and awe”, I find the government’s innovation mantra tragically ironic. The industry that we built on the minds of expropriated technologies from the Germans is the life blood of our economic life-support. Representing over $144 billion in market capitalization and over $112 billion in government expenditures last year, these five companies (Lockheed Martin: LMT; Boeing: BA; Northrop Grumman: NOC; General Dynamics: GD; and, Raytheon: RTN) are as much of the “too-big-to-fail” dynamics as their financial cousins that were bailed out in the last two years. We spend more government procurement money on private armies (KBR) than we spend on healthcare and medical technologies. And, for the record, let's remember that the last 4 years of the Bush - Republican administration (2005-2008)saw national spending rise by $1 trillion not counting the 2008 financial services bail-out set in motion by a lameduck President.

At the outset, we must understand that the last 30 years of Western economic development and hegemony have been built on several significant misconceptions leading many emerging economies into vast, inefficient policies and practices that fail to produce meaningful results. There are two fundamental misconceptions that we should examine.

First, we need to revisit the understanding of the mis-used term “innovation”. For the sake of loyal InvertedAlchemists, this is a reminder, for others, this is news. Without realizing it, this word has blurred the vital distinction between:

Invention: the process whereby something fundamentally new emerges from a flash of creativity and brilliance;
Innovation: the assembling of one or more components from prior existing knowledge for a new assembly or application that achieves a repurposed use not contemplated when any of the components were discovered or first assembled; and,
Incrementalism: the subtle modification of a thing for a particular market niche or the minute alteration of a good or service to impair a competitor’s activity.

Failure to distinguish between these three discrete concepts has lead to ruinous policy not only in the developing economies but has led to the wholesale failure of much of the private equity in the West. In the case of invention, a novel platform for highly diverse opportunities often emerges. However, invention infrequently serves as an ideal basis for a corporation as the enabled products or services are often much later in creation. Innovation, by contrast, often is integral to a successful commercial endeavor as innovators translate the creative work of invention into a context that people can use and consume. Incrementalism serves as no basis for entrepreneurial activity but rather is a tool for established businesses to defend or negotiate positions with the market place and modify pricing dynamics for consumers. Absent a clear process allowing policymakers to understand and differentiate these concepts, most economic development policy is grossly inefficient and capital deployment is wasteful. Neither the President nor the respondents following the State of the Union understand or animate responses with this awareness.

Second, we should closely examine the national innovation economic models that have lead to both the successes and challenges of the past. For the purpose of this discussion, I would like to provide four case studies which are informative about these models which include: Build It; Leverage It; Serve It; or Option It. I will explain each model when it is being discussed.

Build It – the greatest modern example of this model is Germany between the First and Second World War. Germany was (and remains) a very proud country that sought to control its own industrial and economic destiny. As the world increasingly isolated Germany after World War I, the national resolve to build a strong national economy led to the wholesale alignment of public funding priorities in both education and commercial activities in an unprecedented fashion. During this period, German enterprises, supported by strong government procurement incentives, created unprecedented advances in Chemicals, Materials Science, Communications, Transportation, and Finance. The significance of this work is evidenced by the fact that, until the very recent past, all scientists were required to study German to read the foundational work in any basic science field. By balancing a commitment to education (which enables the mind to creatively think) and training (which allows for efficient industrialization), Germany avoided the pitfall that most countries since have fallen into – namely, the subjugation of creativity at the expense of free and creative thinking. The great German companies of today stand firmly on the foundation built almost a century ago. In a modern irony, this same isolation policy is leading the Islamic Republic of Iran – also a very proud and educated people – to many of the same outcomes. In fact, if you want to look at some of the best bioengineering, materials science, and natural resource processing technologies today, many truly inventive and creative ideas are emerging from Iran. Iran, like Germany eight decades ago, has struck a balance between education and training that could serve as a vital development model.

Leverage It – There is no country on earth that has done more to leverage innovation (both its own and that of the rest of the intellects of the world) than the United States. Supported by two, irreproducible events – the Bretton Woods conference in 1944 establishing the dollar as the global trade currency and the post war expropriation of both German inventions and innovators which fueled a majority of the U.S. science and technology imperatives – the U.S. had the ability to sell its debt to finance unprecedented expenditures in technology. Most Americans, including every State of the Union pundit and protagonist ignore the fact that Obama’s “Sputnik” admonition was one of many off-spring of the Allies’ reparations in which they distributed German technologies and scientists as spoils of war. It was German technology that built our aerospace and computer industries – not American ingenuity. We were the post-war beneficiaries of the intellects of others and we make a grave and irreversible mistake when we claim American ingenuity to support our aerospace, chemical, and information technology supremacy. We didn’t invent it – we innovated. And, unfortunately, nobody in Washington has a clue how to actually stimulate an “invention” fueled economy! Technology in the U.S., measured both as R&D funding as well as vast commercial incentives is aligned on a mortality imperative. We fund technology for war and healthcare. In an ironic sense, our major S&T priorities are to develop military capabilities for use on others and, at the same time, spending an irrationally disproportionate amount of money on end of life “health care”. Our institutions of higher learning, over the past 40 years have educated the world’s scientists and engineers but, what is often forgotten is that those students, many of them from India, Taiwan, China, and the rest of Asia, serve to stimulate the productivity of U.S. laboratories. The contribution of graduate students – often seen as merely the beneficiaries of our educational largesse – is ignored at our policy peril. Without our global currency attraction which provides ready cash and our military spoils – including our ability to control energy priorities by force – our S&T would be severely impaired.

Serve It – Singapore serves as the ideal study in serving innovation. Realizing that the small island nation needed to rapidly distinguish its economy from its neighbors, Prime Minister Lee Kuan Yew instituted an inducement-driven economic policy to attract foreign companies to Singapore to exploit what he viewed as Singapore’s greatest natural resource – its well-trained, low cost workforce. While ExxonMobil’s roots in Singapore date back to the 1890’s, the first major coup for his post-Independence effort was attracting Texas Instruments to set up chip-making operations in 1968. The “Singapore Economic Miracle” was a fortuitous union of a new technology – the integrated circuit – with a new country. Selected as one of the first manufacturing locations for this burgeoning technology, Singapore rode a tsunami of success with TI that went on to include over 2000 companies, the vast majority of which are U.S. corporations. Singapore and its Economic Development Board have attempted to manage a delicate balance. How, on one hand, do you continue to serve as an attractive location for foreign direct investment while, on the other, stimulating endogenous economic opportunity? How do you provide constant training for multinational corporation (MNC) servicing while creating a creativity-based educational system that relies on local innovation and imagination? Singapore’s greatest challenge is its entire dependency on one foreign economy and, as a result, its fortunes will rise and fall on the same as the country did not build a foundation for creative autonomy in its abiding commitment to serve the innovation of others. Recently, an exodus of firms from Singapore is the first indicator that the differentiator of well-trained, low-cost workforce is no longer the competitive advantage it was 40 years ago.

Option It – Options are forward rights to purchase something that will have a differential value at a later date. The country that has optioned its innovation future in an unprecedented sense is the People’s Republic of China. In the latter part of the 1990’s, China instituted a policy of mandatory technology transfer, much to the chagrin of many MNCs. In addition to buying power generation, transportation, medical, or civil infrastructure technologies, corporations were required to sell the enabling proprietary know-how that underpinned the purchased technology. For years, the Chinese government was sorely abused as it had a problem (and still is impaired) in knowing whether such transfers were actually legitimate or complete. Many of them were not. However, over a decade, China has acquired options on vast innovation estates from many of the world’s largest companies. In addition, China elected to educate (in contrast to Singapore’s and India’s training focus) many of its citizens in basic sciences. Linking technical commercial know-how with basic scientists is an integral component of the long-term economic strategy of China, the first byproducts of which are emerging only recently. However, taking lessons from all historical models, the Chinese have the cognogenitive environment from which invention and innovation can organically emerge. Systemic challenges of establishing national S&T priorities in a country that is quite regionally governed presents obstacles in the short run and the emerging awareness of the degree to which China did not fully get what it thought it was buying in its technology transfer will impair the efficient execution of its strategy. However, it is reasonable to expect that with a growing population in a resource constrained and environmentally taxed world, China will achieve considerable breakthroughs as its survival and economy depend on it. In short, the Chinese government has acquired the world’s best technology and acquired, thereby, a series of innovation options at a very low cost. While the White House and Congress may wish that there was an innovation strategy that would save the economy from mismanagement, they’ve grossly underestimated the power of China, Brazil and other beneficiaries of technology transfer that propped up international business expansion over the past decade while no one was paying attention. Like the German technology expropriation at the end of the Second World War, the Chinese and others who were excluded by the superpowers at the Doha WTO meetings have exacted a more subtle revenge. They’ve optioned Occidental technologies and now they, not we, will control where growth happens next.

We are in a place no different from the foundational skirmishes at the birth of our modern economy. I find no modern public figure with the clarity of perspective rivaling James A. Garfield in his Congressional Address in 1866.

“Mr. Speaker, there is no leading financier, no leading statesman now living, or one who has lived within the last half century, in whose opinion the gentleman can find any support. They all declare, as the Secretary of the treasury declares, that the only honest basis of value is a currency, redeemable in specie, at the will of the holder. I am an advocate of paper money, but that paper money must represent what it professes on its face. I do not wish to hold in my hands the printed lies of the government. I want its promises to pay, signed by the high officers of the government, sacredly kept in the exact meaning of the words of the promise.”

“Let us not continue this conjurer's art, by which sixty cents shall discharge a debt of one hundred cents. I do not want industry, everywhere, to be thus crippled and wounded, and its wounds plastered over with legally authorized lies.”

And from his January 2, 1879 address to the Honest Money League of Chicago:

"Successful Resumption will greatly aid in bringing into the murky sky of our politics, what the signal service people call "clearing weather." It puts an end to a score of controversies which have long vexed the public mind, and wrought mischief to business. It ends the angry contention over the difference between the money of the bond-holder and the money of the plow-holder. It relieves enterprising Congressmen of the necessity of introducing twenty-five or thirty bills a session to furnish the people with cheap money, to prevent gold-gambling, and to make custom duties payable in greenbacks. It will dismiss to the limbo of things forgotten, such Utopian schemes as a currency based upon the magic circle of interconvertibility of two different forms of irredeemable paper, and the schemes of a currency, "based on the public faith," and secured by "all the resources of the nation," in general, but upon no particular part of them. We shall still hear echoes of the old conflict, such as "the barbarism and cowardice of gold and silver," and the virtues of "fiat money" but the theories which gave them birth will linger among us like belated ghosts, and soon find rest in the political grave of dead issues. All these will take their places in history alongside of the resolution of Varsittart, in 1811, that British paper had not fallen, but gold had risen in value, and the declaration of Castlereagh, in the House of Commons, that the money standard is a sense of value in reference to currency as "compared with commodities," and the opinion of another member, who declared that the standard is neither gold nor silver, but something set up in the imagination to be regulated by public opinion."

"When we have fully awakened from these vague dreams, public opinion will resume its old channels, and the wisdom and experience of the fathers of our constitution will again be acknowledged and followed."

"We shall agree, as our fathers did, that the yardstick shall have length, the pound must have weight and the dollar must have value in itself, and that neither length, nor weight, nor value can be created by the fiat of law. Congress, relieved of the arduous task of regulating and managing all the business of our people, will address itself to the humbler but more important work of preserving the public peace, and managing wisely the revenues and expenditures of the government. Industry will no longer wait for the legislature to discover easy roads to sudden wealth, but will begin again to rely upon labor and frugality, as the only certain road to riches. Prosperity, which has long been waiting, is now ready to come. If we do not rudely repulse her, she will soon revisit our people, and will stay until another periodical craze shall drive her away."

There was a time when public service and her stewards actually took the time to couch their analysis and recommendations in a context of reflected wisdom from the past. There was a time when Congress and the halls of power echoed with calls to accountability and integrity. It is time that, we the People, model such wisdom in our own practice and hold our leaders to the same standard. Otherwise, pull up a tiny chair in the playhouse and have an imaginary cup of tea with a forgetful elephant.

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Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave