(This essay was published in the South China Morning Post on 26 September 2018.)
The Rise of Intangibles
From 1820 when the Industrial Revolution started in England to 1990, business investment centered on the acquisition of real, tangible assets, such as machines, tools, computers or office buildings. But since then investment in intangible assets — ideas, designs, research, specific human capital, client networks and the like — has been growing.
This change has far-reaching significance. Not only are the economic properties of the two different, but many statistical metrics do not take intangibles into account. As a result, analysts and policy makers lack the data they need to explain some current aspects of the economy.
Ideas and innovation and how they are organized and encouraged have become the new capital – intangible capital. This shift has arisen due primarily to the information and communications technology revolution, which has accelerated the process of globalization, enabled nations to export production capacity instead of manufactured goods, and facilitated the transmission of ideas across national borders.
What is new about today’s economy is not the role of ideas themselves, but rather that many of our best ideas remain disembodied. The idea is indeed valuable, but it does not take physical form.
This changes almost everything. Apple, the world’s most valuable company, owns virtually no physical assets. It is its intangible assets — integrating design and software into a brand — that create value.
Understanding this may help to explain some of the peculiar features of the modern economy, including rising inequality and slowing productivity.
Intangible investments have distinct characteristics in terms of accounting conventions, economic properties and business potential.
In company and national accounts, many forms of intangible investments are unmeasured. They may be expensed but not capitalized except in restrictive circumstances such as late in the development stage. They may be valued but depreciated, or if bought-in then valued as goodwill if the company is sold.
A consequence of all this is that firms making large intangible investments become fabulously profitable because they can realize huge sales with little capital. But if these intangible investments are not properly accounted for, then we undercount GDP and therefore could miss early signals of future output and productivity.
In terms of economic properties, intangibles are typically “sunk investments” that are difficult to resell, which makes it harder to secure bank financing. They tend to generate “spillovers” because competitors can copy nonphysical investments, such as production processes, with relative ease. They are “scalable” a firm can use an intangible asset in many places simultaneously, unlike a machine or an office.
They are also “synergistic” because they can interact with each other or with physical and human assets. For example, Airbnb combines its intangible assets — its network of housing hosts — with its material technologies such as computers and smartphones.
The business-related differences between tangibles and intangibles rest on several qualities. One is “uncertainty”. Intangible investments seem more unpredictable and carry more risk because if they go bad, recovering their value is difficult, although the upside potential is greater due to scalability and synergies.
Another quality is “option value” because even if a firm does not derive a marketable asset from its sunk costs, it can still extract valuable information from the process that it can use for future opportunities.
However, the rules associated with intangibles are also “contestable”, making it harder to protect ideas and knowledge. One outcome of this is that firms seek and reward employees who are skillful at extracting proprietary value from contested ideas.
Taken together, the characteristics and qualities of intangibles give them enormous benefits centered on their scalability – which in turn worsens the productivity gap between leading firms and laggards.
For tangible-intensive industries, the gap stays the same because they have constant returns to scale. Intangibles, on the other hand, promise increasing returns to scale. Successful companies that expand become progressively more productive than less successful ones.
Evidence of this effect can be found in OECD data from 2001-09. Labor productivity levels increased in manufacturing frontier firms by more than 30 per cent but only about 5 per cent for non-frontier firms, and in service frontier firms rose by more than 40 per cent versus virtually no change for the rest.
There is considerable evidence that frontier firms pay higher wages to all workers, both skilled and unskilled ones. This is due in part to the sorting of more productive workers into the frontier firms. But frontier firms also invest more in intangibles, which raises the productivity of their workers. To retain these workers, the firms have to share their profits with them.
The result is that intangible-intensive industries with such frontier firms become more concentrated and also increase wage inequality.
What implications does the rising intangible economy have for Hong Kong’s economy and public policy, especially positive non-interventionism? I shall explore these issues in my next column.