(This essay was published in Hong Kong Economic Journal on 31 October 2018.)

Economic Challenges of Intangible Capital

 

Ideas can be embodied in human capital in ways that augment a person’s productivity. They can also be embodied in material capital, such as physical assets to boost productivity. But increasingly the most valuable forms of capital are intangibles ones that are not embodied in man, machine, or structures – they are disembodied. Successful economies and companies are now increasingly rich in intangible capital.

 

The intangible capital-rich economy is driven by ideas. Paul Romer, this year’s Nobel Laureate in Economics, made ideas the central element of his theory of economic growth. His thesis is that ideas are non-rival goods, which means when one person uses an idea it will not reduce its usefulness to others. Ideas can be used and reused, so their ability to increase productivity is not exhausted by use.

 

Ideas as non-rival goods can generate “spillovers”, meaning companies can copy the ideas and adapt their use to producing other goods. Ideas that can be used again and again without being exhausted are enormously “scalable” and can service large territories and huge populations. Furthermore, their use can be “synergistic” in the sense that they can be combined with goods and other ideas to produce new goods and new ideas.

 

Economies and companies that are successful in creating new ideas and adapting old ones can keep on producing new goods. They will thrive. Companies succeed by investing in new ideas and adapting old ones. Ideas are behind intangible capital. Experience in the past thirty years has shown that the most successful companies are those that have invested heavily in scalable intangible capital.

 

Globalization has also helped intangible capital-intensive companies to expand rapidly. Global supply chains have allowed companies to outsource fabrication processes to low-cost and business-friendly environments. Companies have grown by becoming connected with global supply chains and harnessing both new and old ideas. Globalization and intangible capital have together spurred the growth of the most successful companies.

 

While there is a huge upside to investing in ideas and intangible capital, there is also a big downside. Not all ideas are good or will work, very often good ideas may not work or be profitable for those who first created them. When ideas fail the investments are lost because unlike human and material capital they are difficult to redeploy or resell in secondary markets. They become “sunk” costs. This means such investments are more difficult to finance.

 

The combination of “spillovers” and “sunk” costs means societies will underinvest in intangible capital. Evidence has shown a clear tendency for intangible capital-intensive industries to be dominated by a small number of giant firms that are proficient at scaling up their own investments and gathering spillovers from others.

 

The profits and productivity of these industry leaders greatly outpace those of the laggards. This makes the laggards reluctant to invest in intangibles that may end up benefiting the leaders through spillovers. The leaders, in turn, may continue to invest, but not at a high enough rate to offset the laggards’ reluctance. The result is aggregate underinvestment, combined with a high rate of return for a small circle of industry titans.

 

There is therefore a role for government and private sector cooperation to overcome inadequate incentives for making such investments, especially for small and medium enterprises. The most important public policy actions to take are probably in setting standards, facilitating financial innovation, and reducing entry barriers rather than direct funding of investment, except as co-investment.

 

Innovations in institutional arrangements to promote an enabling infrastructure will matter greatly in an intangible capital-intensive economy.

 

Infrastructure in the Intangible Economy

 

A common theme among policy makers and economists is that a lack of investment in infrastructure impedes economic growth. The debate usually focuses on physical infrastructure – such as roads and airports – that benefits tangible capital-intensive industries.

 

Such infrastructure is also essential to intangible capital economies. In addition, these economies need certain forms of intangible infrastructure, like particular “rules, norms and processes” that recognize the unique properties of intangible capital – spillovers, scalable, synergistic, and are sunken investments.

 

Intangible infrastructure helps an intangible rich economy by providing an enabling environment conducive to the creation of spillovers and synergies. Such environments include innovation “clusters” in the mold of Silicon Valley that attracting talent to gather and converge. Barriers to the movement of talent have to be lowered. A number of governments around the world support development of such clusters, such as Israel’s Silicon Wadi.

 

The success of clusters depends on two other types of infrastructure: One consists of affordable housing and workplaces that are necessary to attract and concentrate entrepreneurs and skilled talents. The other is the spontaneous crisscrossing and layering of public spaces, artistic and cultural venues, transportation hubs, and informal meeting spots that make city life hospitable and promote a cross-fertilization of ideas.

 

Urban activist Jane Jacobs long argued that just such an environment is what gives cities their vibrancy. The recent government proposals to reclaim islands off East Lantau and initiate public-private partnership in land sharing schemes should be opportunities to build not only affordable housing and workspaces, but a vibrant urban environment for intangible capital-intensive development.

 

An intangible capital-intensive economy needs to provide the right “institutional infrastructure,” which includes properly-calibrated intellectual property rights, standards such as unfettered Internet connectivity and norms such as the practice of venture capital funding.

 

Perhaps the most intangible form of infrastructure is “trust” between companies and people, which encourages synergy-producing interactions and solidifies the rules that undergird intangible investment. Samuel Bowles in The Moral Economy (2016) argues that good incentives cannot fully substitute for good citizens.

 

Intangibles and Insecurity

 

The rise of intangibles might be a factor in the growth of various forms of societal inequality. When capital is made up increasingly of disembodied ideas rather than embodied human and material capital, many things become different. Successful companies are much larger and industries become more concentrated. Good jobs are paying much better, but they have also become fewer and are mostly found only at intangible capital-intensive companies.

 

Economically, the middle class is thinning out and incomes are being redistributed more uniformly between the two ends of the distribution – the big hump in the middle is now less prominent. Over time, median incomes have stagnated or grown very slowly. The desire to escape from being in the bottom four-fifths of the distribution curve has intensified study and examination pressure. Disappointingly, the pursuit of formal credentials and licensing today is only able to guarantee employment, not upward mobility into the top-fifth.

 

The gap in revenue and efficiency between leading intangible capital-intensive companies and the rest results in unequal salaries for employees. Managing intangibles requires specific skills and knowledge. Companies seek people with these skills and are prepared to share company profits to attract and keep them.

 

Intangibles also help widen the wealth gap in two ways. First, because cities are fertile ground for intangible asset companies to collaborate, urban property values rise. The wealthy, the likely owners of this property, grow richer. Second, the portable nature of intangible assets has made governments hesitant about taxing them. Intangible capital-intensive businesses find it relatively easy to relocate to wherever they can get the most favorable tax treatment.

 

Before 1990, the middle class was by far the largest population segment in the developed economies. Its thinning out has created insecurity on a wide scale and loss of “esteem” and “social identity” for the single largest population group in society. This thinning of the middle class has created social and political dislocation and discomfort. The past tolerance for diversity and commitment to shared common values are eroding.

 

A breach is growing between the best educated who have the skills to flourish in an intangible economy, and those who feel “left behind” by societal and economic change and thus have become skeptical of elites and cosmopolitan urban values. This attitude has fueled populist movements in many parts of the world – localism in our own city. Xenophobic anti-immigration populist movements are clearly on the rise.

 

Implications for Public Policy

 

Governments, which have been slow to react to the rise of intangibles, should now pay attention to five areas:

 

1. Contestedness – Governments can address ownership and spillover issues surrounding intangible assets by strengthening patent and copyright laws. However, such an approach could produce the side effect of suppressing opportunities for synergy among intangibles, thus obstructing productivity. A better approach could involve pushing for “clearer” intellectual property laws and discouraging vague or expansive claims.

 

2. Synergies – Policy makers need to create the conditions for the cross-pollination of ideas and efforts. Effective tools for this goal include urban planning and land-use policies.  Regulators should not create too many obstacles to the construction of housing or workplaces. Urban policies should cultivate cities’ diversity and livability. Governments could also take steps to promote intangible methods for cooperation by investing in infrastructure for online collaboration and “distance working tools”, perhaps starting with the Greater Bay Area.

 

3. Financing – The current system of funding is not ideal for intangible capital-intensive businesses. Governments can help by devising tax incentives to support new forms of finance that make it easier to secure debt with intellectual property. Hong Kong is an international financial center, but it is less an innovative financial center. The need for enabling newer financial infrastructure is now urgent.

 

4. Low investment – Although large companies that excel at benefiting from spillover effects invest heavily in intangibles, they seem unlikely to compensate for the shortfall from other firms. Governments may need to take up some of the slack by investing in basic research, supporting emerging industries through procurement programs, and funding education and training programs.

 

5. Middle class insecurity – Insecurity is an especially steep challenge for governments, and no clear solution is in sight. Policies that encourage the growth of an intangible economy may also magnify the traits that help produce insecurity. Growing disparities in income, wealth, esteem and loss of social identity have all contributed to such insecurity.

 

Another connection between intangibles and worker earnings is the complementarity between particular worker skills and intangibles. This can also interact with intangibles’ scalability properties, creating superstar-type effects that can lead to skewed earnings distributions.

 

Interactions between intangibles and management practices are also related to productivity differences across firms, industries, and economies. How should management respond to the expansion and deepening of intangibles in firms? Complementarities will now take center stage: good management is more valuable in an intangible-laden corporate world.

 

The preferred organizational structure for companies depends on whether a firm is primarily a maker or user of intangibles. Makers of intangibles benefit from flat organizational structures that offer mid-level managers a lot of autonomy and only loosely monitored short-term performance metrics. The idea is to keep the creative juices flowing by allowing people and ideas freedom to flow through the company.

 

On the other hand, companies that are heavy users of intangible capital see greater benefits from having more rigid, control-from-the-top organizational structures, because the name of the game is coordinating the firm’s efforts to deploy its intangible assets to the uses that offer the greatest return at the moment.

 

One of the questions about productivity and management is whether it is simply management practices, or also managers, that make a difference. When it comes to intangibles, the latter is far more likely to be important. The role of morals and virtues of managers and management culture will matter to the success of the company.

 

It has often been argued that in a service economy where intangibles are important – and in contrast to a manufacturing economy – it is important to empower managers who have been inculcated with a strong corporate culture and strong morals and virtues. Competency in technical skills may not be the only factor that matters now; moral character and virtuous temperament will count more as Facebook and Uber have painfully learned. Education and family may well have a disproportionate role to play in the intangible economy.

 

Positive non-interventionism was a guide to policy action that counseled government to let the free and open market solve economic problems, and intervene only when markets were unable to resolve significant problems. But it also counselled that government should take up those actions necessary to enable markets to function properly. The intangible economy is such a case. It counsels government policy to take appropriate action to shore up markets where there are spillovers, synergies, and capital market imperfections.

 

It is very likely that the most difficult task we shall face in the future is not how to enable economic growth for an intangible capital-intensive economy, but how to make that growth inclusive. The social and welfare policy tools inherited from the past century may no longer be fit for purpose.

 

If the economic and social implications we have outlined are correct then there is much that we and our government must rethink.

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