I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

I work for ThoughtWorks, the global leader in software delivery and consulting.

Friday, January 31, 2020

Lost Productivity or Found Hyperefficiency?

Labor productivity creates economic prosperity. Increasingly productive labor results in lower cost products (greater output from the same number of employees == lower labor input costs), higher salaries (productive workers are valuable workers), greater purchasing power (labor productivity allows households to keep monetary inflation in check), increasing sophistication (skill maturity to take on greater challenges), and higher returns on capital. The more productive a nation's workforce, the higher the average standard of living of its population.

In recent years, economists have drawn attention to low productivity growth in western economies as a key factor restraining economic growth and perpetuating low inflation and low interest rates. In particular, they cite the lack of breakthrough technologies - e.g, the emergence of the personal computer in the 1980s - to spur labor productivity and with it, more rapid economic growth. By traditional economic measures, things do not appear to be getting much better.

There is an alternative perspective that is far more optimistic: digital companies drive down costs through hyper-efficiency (speed, automation and machine scale) and price transparency. Algorithms are cheaper than humans and can be networked to perform complex collections of tasks at a speed, and subsequently a scale, that humans cannot achieve. Twined with the radical reduction of information asymmetry (particularly with regard to product price data), it stands to reason that there has been significant productivity growth in western economies: supply chains have never been so optimized, retail and wholesale transactions so price-fair and friction-free. This stands to reason: it is considerably less time- and energy-intensive to ask an Echo to order more Charmin toilet paper than it is to drive to a grocery store or pharmacy, walk in, price compare to justify those few extra pennies for softness, queue, pay, and drive home. The argument for this invisible efficiency is that economic models have simply failed to change in ways that reflect this phenomenon. The productivity is there, and will intensify with technologies such as AI and ML; the instrumentation simply doesn't exist to measure it.

In this definition, productivity through technology is a deflationary force that makes products more affordable. Even if real wages remain stagnant, the standard of living increases because people can afford more goods and services as they cost less today than they did yesterday. In theory, the increasing standard of living will occur regardless the cost of capital: because retail prices are going down, interest rates could move higher with no ill effects to the economy, juicing returns on capital. The bigger the tech economy, the better off everybody is.

There is truth to this. Consider healthcare: although medical costs are much higher today in nominal terms than they were in 1970, they are much lower in real terms when adjusted both for monetary inflation and medical-technological innovation. If medicine were still practiced today as it was 50 years ago, the cost of delivery would be lower in real terms, but the standard of care would be much, much lower than what it is today. Would you want to receive cardiac treatment at a 1970 standard, pulmonology treatment at a 1980 standard, or HIV treatment at a 1990 standard? Or would you rather be treated for all of these to a standard of care available in 2020? Technology is clearly a deflationary force that increases individual prosperity.

Still, there are three factors that should temper enthusiasm for an unmeasurable tech-led labor productivity bonanza.

The first has to do with the real price of and the real payers for tech-generated benefits. Ride sharing services have added driver/fleet capacity and accelerated speed-of-access for local transportation service. However, the individual consumer isn't fully picking up the tab; the ride is heavily subsidized by private capital. That makes the price affordable to the user. The question is, how sustainable is the price without the private-capital subsidy?

Economic subsidies are a common practice, typically sponsored by governments to protect or advance economic development. Sometimes a subsidy is direct, as is often the case with agricultural commodity price supports: if depressed crop prices drive farmers out of business, a nation loses its ability to feed itself, so in years of commodity gluts governments will offer direct assistance to make farmers whole. And, sometimes a subsidy is indirect. The United States was dependent on oil from foreign countries for much of the past 60 years. The price of petroleum products in the US did not reflect the cost of US military bases as well as having the Fifth Fleet patrol the Persian Gulf. The federal government prioritized energy security to guarantee supply and reduce the risk to energy prices of supply shocks. The immediate cost of that security and stabilization was borne by the US taxpayer; the policy was founded on the expectation that the federal government would be made whole over the long term through increasing tax receipts from economic growth that resulted from cheap energy.

There are subsidies that are sustainable and subsidies that are not sustainable. In theory the US projecting military power to secure Middle Eastern oil was a sustainable economic subsidy: containing energy prices while your nation gives birth to the likes of Microsoft and Apple and many other companies seems a good economic bargain (exclusive of carbon emissions, which did not historically factor into economic policy). By comparison, productivity in the Soviet Union grew in lock-step with direct government investment in industry (primarily steel production) through the 1950s and 60s, Trouble was, when the Soviet government pulled back investment, labor productivity growth flatlined. Labor productivity was entirely dependent on outside (e.g., government) financial injection. The lack of organic productivity growth translated into stagnation of economic prosperity of the masses. A standard of living that was competitive with the United States and Western Europe in the 1950s was hopelessly trailing by the 1980s. Turns out Maggie was right: eventually you really do run out of other people's money.

The investment case for the ride sharing companies is that there will eventually be one dominant player with monopolistic pricing power. A market for on-demand transportation is now established, so a single surviving ridesharing firm will reap the winner-take-all benefit of that market, giving it scale. Being the only game in town, the surviving firm will have pricing power. In theory, the surviving firm should have access to a larger labor pool spanning Subaru drivers to software developers, thus depressing wages, and thus the cost of service. Lower input costs twined with scale should mean a lower price increase is needed for the firm to become profitable.

But there are a lot of variables in play here. Ridesharing firms are carrying billions of dollars of losses they accreted over many years that they need to make up for their investors to be made whole; that will create pressure to raise prices. There are other industries competing for the labor of these firms (especially those software developers), so input costs will not necessarily decline. Because drivers work for multiple ridesharing services, their utilization is already high, meaning economies of scale that will temper price increases passed on to consumers.

If or when a monopolistic competitor triumphs, prices are going to rise and individual consumer's "productivity" will be impaired by the withdrawal of the price subsidy. Consolidation and scale will not perpetuate the subsidy, so the price of service is going to rise. The subsidy is only sustained if a new entrant with deep-pocketed backers emerges to challenge what will by then be a "legacy" incumbent; in essence, the cycle of subsidy regenerates itself. Don't rule it out: it isn't out of the question as long as capital is cheap. While it's reasonable to assume the industry will run out of greater fools, there has always been a high degree of correlation between "minutes" and "suckers born". The WSJ reported today that Softbank is pumping cash into multiple meal delivery services operating in the same markets and therefore competing directly with one another, each firm engaged in an arms of subsidies with one another to sign restaurants, delivery labor and customers. It is difficult to fathom the logic of this.

The second factor is the implicit assumption that the tech cycle has triumphed over the credit cycle. There is a popular theory that technological innovation has become more important than capital in setting prevailing economic conditions. The evidence of this is the shift in economic activity steered by emerging technologies in areas such as ecommerce and fintech. A technology-centric business benefits from lower costs for facilities, lower inventory carry costs, and lower network (transaction) costs, and therefore has an intractable competitive advantage over incumbents. As I've written previously, unfortunately the evidence doesn't entirely support this yet. Plus, deep-pocketed incumbents can raise capital to acquire, compromise or corrupt the business models of would-be disruptors, not to mention that would-be disruptors are finding themselves engaged in technological arms races not with incumbents, but other would-be disruptors. This distorts the playing field, making it much more about capital than tech.

It's curious that contemporary strategy among big tech firms is to burrow into the existing economy as un-metered, un-regulated, subscription-based utilities, as opposed to betting on ever-accelerating revenue from their intrinsic value-generative nature. Consider entertainment streaming services: by selling subscriptions, they are willfully exchanging the potential for sky-high equity-like returns from the value of the content they produce (which is how movie studios used to operate) for more modest debt-like returns from the utility that subscribers will pay for access to a library where they can find something they can tolerate just enough to pass the time (which is how cable companies operate). While streaming services are engaged in a long-running competition for content and tech, they have concluded they are not going to win by out-tech-ing or out-content-ing one another. Streaming entertainment is not a value proposition, it is a utility proposition. A utility business model is one that is explicitly (a) not leading with tech innovation and (b) seeking immunity from the credit cycle.

What this tells us is that the tech cycle is not the dominating economic force. As it stands today, more people suffer economically when the credit cycle turns than when the tech cycle turns (e.g., a dearth of innovative new technologies). A turn in the credit cycle contracts business buying which creates layoffs. A turn in the tech cycle makes means there will not be a still more convenient way to get a ride from The Loop to O'Hare or food delivered from a Hell's Kitchen restaurant to an apartment in Midtown. While it may happen some day, we are still not yet at a point where the tech cycle is triumphant.

The third factor goes to the question of labor capacity versus labor productivity. Labor productivity and labor-saving efficiency are really measures on the same axis: less time, effort and energy necessary to complete a task and ultimately achieve an outcome. A different but equally important dimension is labor capacity: the more people engaged in gainful employment, the greater the level of household income, the more individual households reap economic benefit.

Labor participation in the United States took a direct hit in September, 2008, and hasn't recovered. After hovering above 66% for over 18 years, it went into sharp decline, bottoming at 62.5% in 2015 and recovering only to 63.2% today. To put it in absolute terms, there are 20 million more jobs in the US today than there were in 1999 (peak labor participation), but the US population has grown by 48 million more citizens. Job growth hasn't kept pace with population growth. This suggests that the economic benefits of productivity gains (through organic labor productivity or technology) are concentrated in fewer hands, implying that the economic benefits of technology gains are asymmetrically distributed.

Yes, labor capacity is a measure, not a driver. From 1950 to 1967, the labor participation rate hovered in the 59% range. And even with a growing population, technological advances can create price deflation that raises the standard of living for everyone: many and perhaps most of those 48 million additional US citizens since 1999 have smartphones, which none of the 279 million Americans had in 1999. Still, there is asymmetric benefit to those technological advances: those not working are not enjoying the totality of economic benefits of increased productivity described in the opening paragraph. As much as proponents advocate that technology improves labor productivity, that same tech is also increasing in the Gini coefficient.

Does technology improve productivity? Undoubtedly. But before hailing any technology as an economic windfall on par with traditional measures of labor productivity, best to scrutinize how it organically it achieves it, how resilient it is, and how widely its benefits are spread around the work force. Technology may eventually change traditional economics, but there is one thing even the best technology cannot overcome: there is no such thing as a free lunch.