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The Triumph of Intangibles

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The Triumph of Intangibles

Risk Talking podcast June 2, 2022
Economy, finance, and budgets

Everyone seems to think that the world economy has taken a wrong turn, but nobody seems to agree on the reasons why. What if the culprit is the world’s hidden transition from tangible to intangible assets? In this episode of Risk Talking, Royal Statistical Society chief executive Stian Westlake joins Allison Schrager to define the intangible economy and explain how it affects the world around us. His new book, co-authored with Jon Haskel and called Restarting the Future: How to Fix an Intangible Economy, is out now.

Audio Transcript

Allison Schrager: Welcome to Risk Talking, a podcast about economics. I'm your host, Allison Schrager. And I'm delighted to be joined this week by Stian Westlake. Stian is the Chief Executive of the Royal Statistical Society. He is previously an advisor to three UK science and innovation ministers, and an executive director of the UK's National Foundation for Innovation, and a management consultant at McKinsey & Company. His newest book, just out and coauthored with Jon Haskel, is Restarting the Future: How to Fix an Intangible Economy. Thanks so much for joining me.

Stian Westlake: Thank you for having me.

Allison Schrager: So we'll jump right in, reviewing bits of your last book, which was very influential. What is an intangible asset, and how is it different from how we normally think of standard capital?

Stian Westlake: So most capital that we see in the economy, things that businesses invest in, are tangible. They're things that have a physical presence. They're something that you could stub your toe on as it were, if you accidentally trot onto it. Intangible capital is things that are, have an important long term economic value to a business, but are not physical. So let me give you some examples. If we think of research and development and the ideas that come forth from that, design of new products, relationships between businesses and their supply chains, where those are proprietary and generate value, or even things that are more expressive, like artistic originals, artistic rights, and branding and marketing, to the extent that those create long term value in the eyes of customers and markets, all of those things we would call intangible capital because you can't touch or feel them.

Allison Schrager: So you think this has become a bigger share of the economy, because to some extent, there's always been intangible assets in the economy?

Stian Westlake: So these things have always existed, but one of the things that my co-author's research work and the research of people like Carol Corrado over the years has done is really try to measure these things in a very systematic, rigorous way using business surveys, using historical data that have been repurposed. And what they've shown is that over time, in fact, really going back several decades, there's been a steady increase in intangible investment as a proportion of the economy. And that if you go back say 40 years ago, most investment in the economy was tangible, it was into things like machines and buildings and vehicles. Nowadays, the majority of investment being made by businesses in a country like the U.S., or in Europe, or in Japan, is intangible. And the premise of the book is that changes a lot of things in the economy.

Allison Schrager: Is this true in developing countries too, or just richer countries?

Stian Westlake: We're seeing the change everywhere where countries get richer. So there's been some really interesting work on intangible investment in China by people like The Conference Board. Typically a poorer country will have a smaller share of intangibles, because they tend to be associated with the services sector and with the advanced economy. But you see this growth everywhere the country is getting richer. So China definitely is seeing a lot of intangible capital deepening as their economy develops.

Allison Schrager: So is there also, in the meantime, a decline in more physical capital?

Stian Westlake: So we've seen a steady gradual decline in physical capital and perhaps 10, 15 years ago, those two lines were crossed. So the intangible investment as a share of GDP started to exceed on an annual basis, tangible investment as a share of GDP.

Allison Schrager: So in this new book, it seems that you're exploring the implications of that, and specifically why it's caused some problems and what we can do to fix it. So you come up with several of the issues that are bothering people now, both socially and economically, mainly inequality, stagnation, broken competition, fragility, and a general sense of inauthenticity. So, how does the rise of an intangible economy impact all of those?

Stian Westlake: So it's interesting when we, I think one of the things we observe when we are writing the book is that you see kind of across the political spectrum and across countries, this dissatisfaction with the 21st century economy, as you said, some of these things are very economic things to be upset about, whether that's slower growth than we had in the 20th century, or rising inequality. But some of them are more, almost more philosophical and more sociological like this nagging belief that the economy is somehow inauthentic, that we don't make real things anymore, or a kind of worry that there's something very dysfunctional about competition, not just between firms, but in among individual workers. And you see a lot of attempts to explain this. Some of them are very, what you might call moral conduct explanations. You see these both on the left and the right.

People on the left will say, "This is because we have too much neoliberalism, and the world used to be better when we have less of it." But equally, you'll see people on the right saying, "Well, this is because we've lost the urge to build. We're not as entrepreneurial, or as dynamic as we used to be." And then you get another group of explanations that you hear a lot of, which are kind of, "Well, this is just fate." So if we think of say Bob Gordon's very interesting work on the rate of innovation, he would just say, well, in the 20th century we were lucky. They were just all these amazing low hanging fruits on the tree of innovation that we could pluck. And those things don't exist anymore. So tough luck. You see those kind of arguments that say, well, this is something we can't control.

And we, our book proposes a different explanation, which is in some ways a more optimistic explanation than either of these. And the argument that we make is that this economy based on intangible capital, we now find ourself in, needs different institutions, different rules, different norms to thrive. And that, because for the most part, we have not yet developed those norms. We are seeing all these problems arising. We're seeing stagnation because we're not seeing enough investment in intangible capital. We're seeing problems with competition because our competition regimes are designed for old economy where it was easier to measure things in particular ways.

And some of these things like the rise of authenticity is a cultural lag that we're just not used to the fact that jobs look different in an economy like this, and the color of our cultural expectations haven't caught up with the economic reality. So our belief is that not having the right institutions for the kind of capital stock that we now have explains a lot of these problems. And in the book we think about, well, what would the right institutions look like?

Allison Schrager: So I just want to dig into a couple of those. So for instance, broken competition, my understanding of the new economy is that one of the reasons, it seems like certain firms can't compete, and this also speaks to a lot of income inequality, is that we have the superstar effect, and you bring up intangibles are feeding this because it is, create a winner, take all effect, where it's just some firms and some people are just way more productive than the others. And once you end up with a defacto monopoly in your market. Is that right?

Stian Westlake: So you're absolutely right, that there's been this widely observed divergence between the best firms in any given industry and country and the rest, the leaders and the laggards. And it's something that the OECD has done some really interesting research on. Now, there's been a lot of attempts to try and explain this. And one of the predominant ways of explaining this, we see this in the, what are called the Neo-Brandeisian competition experts who are playing a very significant role in institutions like the US FTC or in the European Union at the moment. Their explanation, broadly speaking is, well, this is because we as the governments, have taken their foot off the gas, when it comes to enforcing competition policy. They've become more tolerant of monopolies. They've become more influenced by rent seekers and consequently things are getting worse.

Now we think that actually intangibles points you towards a different explanation, which is that intangible assets, they are very synergistic, they're very valuable when you combine the right assets together. And this means that, that in itself drives at least temporary monopolies, or quasi-monopolies in individual sectors. So, a company like Google has a lot of very valuable intangibles and when you combine them, it is pretty difficult to compete with Google.

And when you look at the underlying data, when you look at that gap between leader firms and laggard firms, indeed what we find is that, that gap is the greatest in sectors where intangible investment is highest. And I think the reason why this is important is because how you would want to respond to this, from a policy point of view, is very different if you think this is because governments have taken their foot off the gas, or got more influence, versus if you think this is a way that the economy is changing.

Allison Schrager: So is there a policy response? To some extent, is this just a Schumpeterian cycle of innovation? And this is just how new innovation comes out of the gate, or can policy actually restore competition?

Stian Westlake: I think the implication of this new type of economy is that the results of successful competition policy look really different. So, in the old economy where successful competition looked like a number of rival [inaudible 00:09:28] in any industry at any given time. And you could quite easily assess that, you can look at particular ratios, it's quite an algorithmic task to work out whether competition is working well or not. In this new, more intangible intensive economy in sectors where that really matters, successful competition will probably look quite different. You might for fairly significant periods of time, have markets dominated by a single organization that might be economically efficient for periods of time.

And consumers might actually do well from, for example, Google providing a range of services. But what you want is you want to make sure that there is contestability. And one of the things that we see with intangible assets, because it can be very quick to scale these things up. If a challenger business comes along and has the right offering, or if an incumbent becomes lazy, the tables can turn very quickly.

So you can have what maybe biologists would call a punctuated equilibrium where the one creature, the dinosaurs rule the earth for a period of time. And then suddenly they're replaced wholesale. That is more problematic for policy makers, because you need to look much more closely into what's going on in an industry. You need to look much more at the specific dynamics of new entrants, and you probably need a lot more technical savvy about the specifics of how technology is affecting new industries. So it's a challenge. It probably means you need to expend more resources on enforcing competition policy, but it probably pushes you against the situation where you're saying, well, this is simple. We just need to break up Google, or break up Facebook. That is probably not the answer.

Allison Schrager: That seems like a for regulators to have a sense. Is it possible to see when you actually have some firm actually being actively anti-competitive or just necessarily, or just better?

Stian Westlake: Well, you're absolutely right, that this is harder than simply looking at the number of industries in a firm and looking in a sector and looking at their market share. But it's something that increasingly regulators are gaining the ability to do. It requires hiring people who have more technical skills. It requires doing more regular reviews, and applying more finally grand judgment. But it also kind of raises an interesting question from a democratic point of view because the direction of travel for regulators and indeed some other institutions we talk about in the book has for the last 30 or 40 years been away from democracy and towards technocracy.

So we've sort of said, well, institutions, we want to just make sure they apply the rules. We don't want to get very political. This probably means if you want to do this, if you want to make these fine grain decisions, if you want to get enough resources to make these decisions, you probably need to have more political legitimacy for these for organizations as well. So this is a really important question for governments if they want to do this well.

Allison Schrager: So I don't know if you're familiar with the work of [J Ritter 00:12:28] in Florida. He writes a lot about the economy, how I think this fits into your work, in that the economics of scope have changed, where if you want to compete in your industry, you have to scale up very fast, which just puts smaller firms at a disadvantage. And if you read his work, it does seem like he's talking about, that's just the nature of intangible capital. Do you think then that kind of inherently can... This sort strange paradox of our time and that we're creating so much stuff, it feels like. Whenever I talk to anyone, whether they're a sex worker or a bail bondsman, they all tell me that the job they do is completely different than it was five years ago, just because of technology. So our lives are changing so much more technology yet we complain [inaudible 00:13:16] that there's not enough dynamism. How do you square that?

Stian Westlake: It's a really interesting paradox. And I think part of the issue that we see here is that as the famous expression goes, the future is here already, it's just not evenly distributed. And I think if we come back to this question of, do we have the right rules? Do we have the right institutions for the intangible economy? We can see that there are summits of the economy where these things have effectively developed. So a classic example, if we look at the financial sector, which we talk about in the book, over a period of 40 or 50 years in California, and then in some other places, we developed a fantastic system of private risk equity capital to fund highly scalable, highly intangible, intensive businesses. And that is called venture capital. It took a long time to arise. It took a lot of money being wasted and lost on various things that didn't work out, but eventually it worked. Now, of course, venture capital is incredible and it's highly transformative to many aspects of the economy, but it's only relevant to a very small number of businesses.

And if we look at most businesses, most businesses rely on very traditional types of finance. The mobile business that has external finance gets a bank loan and bank loans work really well for tangible economy, for tangible assets. So businesses that have tangible assets, because you can take a charge on a tangible asset and the bank can sell the asset if the business defaults. They're pretty terrible for intangible intensive businesses, because those intangible assets are a lot harder for a creditor to recover. And interestingly, if you look at the empirical data, one thing that we see both in the UK and the U.S. is that a lot of bank lending to intangible intensive businesses is basically mortgage lending in disguise because the one tangible asset that banks can take a claim over are the houses owned by directors of businesses. And it turns out that the property value of directors is highly related to the access to finance in these intangible sectors.

So I think that phenomenon that you described of this kind of widespread feeling that culture is changing, but a lack of dynamism in places is kind of a function of the fact that we don't have the right institutions in so many parts of the economy. So there's this transition that is underway, but it's not being fully made.

Allison Schrager: Does this also explain the decline in IPOs? Because you talk a lot about debt, but I also wonder about what's changing the stock market too, is the stock markets institution's not conducive.

Stian Westlake: I think there's a number of interesting things going on with IPOs. Obviously, this is something that's highly cyclical. So there's a lot of noise in any data on IPOs, there are some substitutes. So we're seeing private markets getting better at supplying in later stage capital. So those are things that are kind of less worrying, but I know the UK public markets better than the U.S. public markets and in the UK public markets, I think we see big problems relating to IPOs, which is simply that are kind of group of institutional investors are less able to do the kind of due diligence that intangible businesses require. They are more obsessed with getting rapid cash flows, whether that's from buybacks or declared dividends and consequently, they are less willing to support the kind of businesses that you would want to be coming to public markets in this kind of economy.

The impression I get is that public equity investors in the U.S. are slightly better from this point of view, you've got a bigger and deeper market. So some of those effects may be relatively benign things like the fact that there are other ways of providing that later stage capital. But I think this does call for big changes in institutional invest in public equities.

Allison Schrager: How so?

Stian Westlake: So I guess, a few things. One thing, there's a big body of research that shows that more equity analysis pays off when it comes to intangible intensive businesses. So fantastic piece of work by [Brokled Fandu 00:17:13] U.S. academics that looked at the informativeness of company accounts and perhaps unsurprisingly, what that shows is as businesses get more intangible intensive, public accounts become less effective, a predictor of firm value. And that's kind of unsurprising because it's really hard to accurately account for intangible assets. And what they then go on to find is, well, this kind of generates a lot of activity for equity analysts, where you run into problems. There's two places where this cause problems, the first thing is equity analysis is a fixed cost for investors.

So if you have a situation where you have a lot of subscale funds, again, a problem that we see in a lot of countries, including the UK, subscale funds are less able to do the necessary due diligence. So they're less able to make these kind of investments. And again, work by people like Alex Edmond shows that actually constrains investment on the part of businesses. So it's bad for productivity as well as bad for individual people's savings.

The other interesting angle from a corporate governance point of view is, it kind of raise questions for our model of corporate governance, if you want more equity finance. And if you want more investment in kind of more inscrutable intangibles. I think it's fascinating that when we look at one of our most successful, one of the world's most successful intangible intensive business at the moment, Tesla, that Tesla's been described as a corporate governance's disaster. It's better now than it was before, but I've got a vivid memory of having a meeting with the former head of VP of investor relations there. And that was a guy with a hard job.

So the question of, well, what are the norms of corporate governance look like? How do you balance a kind of classic shareholder value management model with the fact that you are taking longer term bets on or intangible assets involved taking longer term bets, and it's harder to reveal information credibly and accurately to the public markets. I think that raises challenges. It increases probably the appetite for private capital. So that's another reason why you might see firms staying private for longer and it kind of puts an incentive on, it kind of creates a market where on the one hand there will still be a big market for totally passive equity investment, but it means that the premium for active investors is to be really smart. So there's a premium for cheap dumb money, a premium for smart money, but you get a really strong barbell effect from that.

Allison Schrager: So do you think that means then that most of the sort of huge returns would be more in private markets than going forward? Because it seems like public markets is really only going to be somewhere where a firm can be really mature and you wouldn't get the... sort of the everyday investors wouldn't benefit from the growth.

Stian Westlake: I think it's really interesting question. I think we don't quite know how it goes. I think it's totally true that there will be more and greater outsized returns in private markets. So this is great news for VC, but also for people who are looking at providing private equity in other area. So I think it's been really interesting to see how growth capital and those kind of areas have expanded. There is a sort of flood of less traditional non VC, private equity coming into markets, not driven by kind of just the sort of standard tax arbitrage model of LBOs, but driven by the desire to capture some of these harder to understand intangible rich businesses.

So I think there's definitely part of that. I think the interesting question about, well, where are then the opportunities in public equity? It probably suggests that there are still opportunities to have through really excellent analysis and really understanding stocks. But again, that is hard to do. And again, not everyone can get that alpha.

Allison Schrager: Although to some extent maybe it also increases risk. Because have you been watching the new show on WeWork?

Stian Westlake: Yes. Great example.

Allison Schrager: Well, it's sort of like when they actually had to do the IPO, really that's when they were really exposed this fraud.

Stian Westlake: Well, you're totally right. Because obviously that is the flip side of not having to present information in particular way. And of course, people often ask me, should we should accounting standards? So intangibles are more clearly reported and that's a really mixed blessing if you do that because they're more important. So you think, okay, well you want people to declare them, but it's much easier to misstate them. It's much easier to make arbitrary claims, not least because most intangible assets don't have a secondary market value. If you own a hundred tractors or a hundred swap bodies for trucks, it's fairly easy to know what they're worth because there's a big secondary market for all those assets. You can mark them to some kind of market, if you own a bunch of patents or a very, very large software system and some algorithms.

It's very hard to know whether your CFO is telling the truth to markets if he or she puts a on the balance sheet for those assets. So there's a real dilemma there about how you account for these things. And again, it means that there's a premium to being able to analyze these things correctly. But it's also, as you say, it's very possible to overvalue them and end up losing a lot of money.

Allison Schrager: It's not just easier to over value of them, but it boggles the mind how you would value them. When I think of value and capital, I think of the present discounted value of it, but you can have an intangible asset that's very valuable and then just one day it's value it seems like you could just go to zero.

Stian Westlake: The interesting example is, if we think about industries that have always been based on intangible assets, if you think of something like the pharmaceutical industry. So a long time ago, I was talking to an experienced pharma analyst about this and his take was, well, of course this is the way we've always analyzed a big pharma stock is to divide the business into dozens and dozens of individual DCFs. Each product line come up with quite a judgment based estimation based on kind of the market size for a drug, for a particular condition and the prospect of success, what that is. Then we discount all of those cash flows and we add up the number and then we add some option value on top and in a sense in an intangible economy, more and more equity analysis becomes like analyzing a pharma company used to be.

Allison Schrager: Although, I guess, in pharma you have some certainty of how long the product's going to be valuable because it's until your patent runs out.

Stian Westlake: That's true. You can bound things a little bit more from that point of view, but the flip side of pharma is that your drug may have a knowable shelf life, but [Jack Scandal 00:24:13], the farmer analyst famously called this the better than the beetles problem, to remain legal and to remain propose your drug has to be kind of best in class. And you may have several years of left on your pan, but if something else comes along, that is inevitably better than your product, the value of that product line suddenly collapses away quickly. So all that uncertainty, I guess, you see that written large in intangibles.

Allison Schrager: So how does intangibles contribute to, as you said, more fragility? Is the economy more fragile than it used to be?

Stian Westlake: Such an interesting question. I think when people look at the economy, especially in non economist, they see a lot of fragility around and they sort of say, "Well, you economists, you make these claims about growth and you make these claims, the world's getting better, but what about the dramatic effect of COVID 19 on the economy? What about the climate crisis that we face? Surely you can't get out of all that stuff with this new economy." And an interesting similar argument that they make is they say, "Well, surely all this stuff shows the importance of tangible capital of real things. And that kind of this intangible, this economy is actually not that important." And I think-

Allison Schrager: That would be my exact opposite takeaway from-

Stian Westlake: Really. Well, I agree-

Allison Schrager: I think RMNA was really sort of what brought us back. That was intangible.

Stian Westlake: In that case, I entirely agree with you. Your view is, in my opinion, the correct one, but it's the opposite from what most people who encounter us on intangibles typically say, I completely agree with you.

Allison Schrager: And I think it's a failure of communication that... I understand why people say that, but it's just sort of if you look objectively at the last two years, I feel like it's been such a great victory for intangible.

Stian Westlake: It's been a triumph of intangibles. I think what was interesting is we were writing the book as COVID progressed. And I don't know if you think back to kind of February or March, 2020 in the very early days of COVID, there was very much what you could call a tangible economy panic, both in the UK and the U.S., and probably other countries as well. And it went something like this, it sort of said, "There's this big disease coming." We've got these very fragile international networks, but look at China, China is building new hospitals and they're putting new ventilators on street. This is physical stuff, and this is what you really to fight COVID. And there was this kind of, sort of sometimes unspoken feeling that, well, the [inaudible 00:26:35] will not be able to match up to this. We can't build new hospitals as quickly.

We don't have the capacity to deploy these ventilators. We won't be able to find enough personal protective equipment. And as you say, it turned out to be completely the opposite from that. It turned out that actually for the UK, for the U.S., Building emergency hospitals was a quite easy, but also kind of unnecessary. And that what really mattered was the R and D to develop vaccines, the ability to manage and track cases to persuade people to limit exposure to the disease. And it said, "It was one of these things where something that looked at first like a tangible story turned out to be deeply to do with getting the intangibles, right?

Allison Schrager: I guess maybe, and that speaks to the inauthenticity issue is it's just like any way, sort of intellectually that's true. People feel that less.

Stian Westlake: That's very true. And I think in some ways, culturally still cleave for an economy where people made things. And I think this is the idea that our cultural expectations to the economy are slow to adapt to how the economy really works. That shouldn't surprise us. Because that has happened in the past before. When I think of Thomas Jefferson debating with Alexander Hamilton about what the new U.S. economy should look like. And Jefferson had this vision of an agricultural economy where Americans would be kind of noble farmers. And this idea that industry and manufacturers were somehow demeaning and the cities were bad places.

That in a sense was a failure to update to how the economy and the kind of 18th and then 19th century worked. So perhaps it's not surprising that nowadays were still slow to catch up with how the economy works nowadays. So we see jobs that involve exchanging knowledge and coordinating things. As in the anthropologist, David Grave's phrase, "Jobs that aren't real, why do these jobs exist?" And the cynic would say, "Well, this is just because there's something kind of wrong with capitalism." But I think what our argument is this is just another example where an institution in this case, our cultural expectations to the economy, haven't adapted as quickly as they should do.

Allison Schrager: Well, it's a strange, another paradox this inauthenticity, because on the one hand we fetishize people who built things, but they are also seen as lesser in terms of our society knowledge, jobs have more prestige than say being a plumber. Anyway, plumbers probably make more than the average person with a knowledge job.

Stian Westlake: It's an interesting one, isn't it? Because there's a kind of strange bifurcation in how we think about status of knowledge jobs. There is a kind of a perception that some kind of knowledge, some white collar jobs are high status because they're in an office and some of them are very highly paid, but at the same time, there is a kind of feeling that somehow being a plumber or being a job that produces something physical, manufacturing jobs, for example, are in some sense, more real and more desirable. And I think people feel quite internally conflicted about that. Especially non economists. I think economists probably are more, more rational about it.

Allison Schrager: So because getting a into, I guess, institutions, which is a big part of this book of how the institutions need to change and I'm a big [Joe Milker 00:30:09] fan. So I'm very inclined to this argument. In fact, we just interviewed him last week. So, in reading this, it reminds me a lot of actually reading his economic history work of how people responded to moving from an agricultural to industrial economy. And I think people, now we don't appreciate what a messy and drawn out process that was too. And how growth maybe as fast and miraculous as it was made it be could have even been better or more inclusive if we had better institutions then. So, go ahead.

Stian Westlake: I think that's right. I think there is one reading of Joe Milker's work when he talks about how societies in places like England in the kind of 17th and 18th century, how those societies changed such that they were more willing to experiment, more willing to think about knowledge. Another way to describe the way we would describe that, the way we would describe the same thing is this is about the earliest institutions for a certain type of intangible investments.

So the scientists at the Royal Society in the 17th century or the people who were copying dying techniques from French artisans and these kind of things. This was all kind of institutions that were helping them work and the kind of critical mass of people combined with the rules and norms that helped put them in place. That was kind of the earliest phase of putting in place institutions for intangible investments and in a sense that the project that we think society needs now is a sort of a bigger version of that kind of 400 years later.

Allison Schrager: Well, a couple things Joe said that always stuck with me. One is that, the steam engine, one of the most important innovations that came out of that era was it took, he said more than a 100 years to show up productivity statistics, which is one reason I'm dismissive of when people say productivity is up but innovation is not. It's just, you never know how things are going to work. And the other is how he described how when you move people from being small scale artisans or agricultural workers to factories, how resistant they were and how actually it was the foundation of modern schooling or universal schooling that they realized that men couldn't go somewhere and be told what to do all day by people they weren't related to.

So they started universal education to essentially socially condition boys to sit still all day and be told what to do, which is, might be why people still, every so often meet these studies that boys aren't very good at sitting through school all day. It's like, yes, that was the whole purpose of it. So I guess, that was an example of an institution that had to change and we needed universal education to be an industrial economy. Do you think education needs to change for intangibles?

Stian Westlake: I think there are certainly a number of issues. There are some skills that are obviously directly soil intangible economy. So proverbially, it becomes more useful to be able to code, for example, in an economy where more people are producing code and code is more important. It's more important to be able to do statistical analysis or do data science. That is kind of, I don't need to tell anyone that's very obvious. What I think is maybe more interesting and less obvious is that because there's now such a premium to combining intangibles in the right ways or to negotiating the spillovers between intangibles when it comes to things like intellectual property or ideas, a lot of social skills become really important as well.

So the ability to negotiate claims, the ability to analyze and make legal arguments, a lot of these things that people sometimes call symbolic analysis tools, all become pretty important when it to the economy. So it's not just science, technology, engineering, maths, those obviously are important, but actually a whole host of social skills, of integrative skills of bringing things together. I think all of those become particularly important.

Allison Schrager: Do you think that means more people need to go to university or the same amount or fewer?

Stian Westlake: So I think the challenge here is it probably also increases how much the quality of university education matters as well as the quantity. So because there is a lot of synergy between the right skills and other intangible asset, it probably really matters not just that people go to university, rather not going to university, but they go to university in the right way and learn things. So I'll give you an example from some research that I was involved in several years ago. As you probably know in the UK, when you go to university, you kind of choose your major at the beginning. You don't choose it as you go. And we were looking at courses in the UK in video game design. So you can go to a bunch of universities in the UK, you can study video game design, which is a bunch of a combination of computing and kind of more practical hands on stuff related to game design.

What was really interesting is we found that, of universities that offered these courses, there were a handful of universities where course was fantastic. The people got jobs in video game design. It was very rewarding. It was kind of a great experience for people who studied that course. These weren't necessarily at highly elite universities, either. But there were a few, had this characteristic. And then there were a bunch of courses where this degree was a terrible degree to take, people ended up getting non graduate jobs. You'd be more likely to work in a store selling video games than you were to end up ever programming or designing a video game.

And the difference between the courses was that the ones that got people jobs in the sector that people kind of got a positive return from were ones where there was a lot of integration between the and the business itself and the industry. So people were working with up to date software tools. They were able to talk to people in the industry. So they learnt about the kind of the softer side of what went on and built social connections. And that meant that they were learning stuff that was genuinely valuable and making more connections.

So it was really interesting if you sort of said, well, if you want to develop a thriving video games sector, it's not a question of saying, well, we just need lots of people studying video games, design skills in universities, but you need them doing it in the right way. And I think that increases the onus for our kind of post 18 education system to really think about quality as well as quantity.

Allison Schrager: Well, and it sounds like as well being, I actually went to a British university for undergrad and I had a great education there, but it was pretty disconnected I think, from industry. So I think maybe it's also thinking, making things more education, in some ways more like apprenticeships.

Stian Westlake: Building those connections, I think is really important. And that doesn't mean that you can't have a very rigorous academic grounding. It's about kind of porosity and integration. That has implications for academic careers as well. It means probably, the model academic is extremely incentivized to publish and publish and publish, and has very little time to think about other things, probably suggest you want to give academics a little bit more freedom from that so that they can be more broadly involved.

Allison Schrager: So another institution that changed an industrial revolution was people engaged before more home production, and then they moved to factories. With the pandemic, people sort of in some ways move back to that original model, doing more home production are now insisting they never want to go back to the office. Do you think we can have a thriving intangible economy if people are largely working from home?

Stian Westlake: Well, this is a really big question. And I think one thing that we know is that spillovers and interactions between workers really matter in the intangible economy and clusters dynamic places like Silicon Valley become more important because as far as we know, these interactions happen most effectively face-to-face. So that would suggest that if we did see a very big move to very significant amounts of home working, that would probably be bad and it's pretty interesting to see that quite a lot of intangible intensive businesses are gradually making more of a move back to in person working. I think that's an interesting factor.

However, there is still some uncertainty here. It's not impossible that one day it will be possible to have the kind of meaningful social interactions that generate serendipity, that generate kind of water cooler moments remotely. I know people are getting more and more comfortable with doing that. People are conducting more of their social lives online, and people are coming up with ways of loading online communication with more meaning with more emotional resonance and more casualness.

So at some point, I would think that some of these effects will be achievable at scale. And when that happens, that'll be highly transformative. It'll affect real estate markets, it will affect regional mobility, it will affect the international ability to work. So I think if I'm saying what's going to be a really big and uncertain economic development in the next 10 to 20 years, I would say, if the death of distances sometime called ever partly happens, and COVID, the experiment of COVID may help us understand that more, that will change a lot.

Allison Schrager: So another institution you write about is the role of government in innovation. And I think one thing I felt like I took away from the last couple hundred years is, like many economists, I'm incredibly skeptical of industrial policy. And think ultimately the best innovations come from individuals and free markets. But there is a case to be made that with intangibles because there's a high fixed cost and higher probability of failure. And it can take a very long time for an investment to pay off. Does that create more a role in industrial policy and do governments like China show a different alternative that's viable?

Stian Westlake: I guess, it's probably first of all, worth sort of defining what we mean by industrial policy, because I think there's a fairly incontrovertible case for public investment in R and D because it's something R and D has spillovers and therefore the private markets are likely to under invest in if there's no either government [inaudible 00:40:42], government direct promotion of things like basic research. Now, obviously, that's not necessarily the same as industrial policy. And when people talk about industrial policy, they often mean something more directive. So it's not just the government funds R and D, but they say, we're going to fund R and D and it's going to be on batteries or something like that.

And I think this is kind of an interesting question, because I think you're absolutely right, that there is a big kind of government failure mode that you can get into when government starts to do this. I saw it with my own eyes. I was a government advisor. I was very involved in the UK's industrial strategy in kind of 2017, 2018. And there is a sense in which as soon as government people take control of the agenda, it can get rapidly quite removed from business concerns, or it can get very captured by incumbent businesses that are better at working with government so there is a big risk there.

But I think if we want to make a more modest defense of what could get called industrial policy, something I've noticed that is quite helpful about research that is directly performed by government in places like government labs, as opposed to universities is that university research has quite a lot of perverse incentives. As we were saying before, if you're an academic, you've got to write papers and writing papers has very specific requirements, not all of which are related to having a lot of impact in the wider world.

If for example, you've got a different challenge. If for example, your job is to create a working nuclear fusion reactor. So there's a nuclear fusion lab in the UK near Oxford called JET, the Joint European Tourists and their job is to try and produce a kind of working fusion prototype reactor. And what's interesting about that because their primary incentive is not to produce highly cited papers. They are arguably a bit more into applied research. They're more into fixing practical problems. They're a lot of really interesting spin off, so there's some really interesting space propulsion technology that's come from that fusion reactor.

There's some interesting self-driving car technology that's come from the robots they used to fix it. So there's a sort of sense in which not for the reasons you'd expect, that industrial policy can sometimes be helpful because it tries to fix a different disincentive, which is the disincentive of academia. But I guess, that's not the same as saying that government should just pick what it wants to happen. And it will happen, which I share your skepticism off.

Allison Schrager: So you reckon that the way, maybe there's more of a role for government in R and D, but markets are still best for taking products to market.

Stian Westlake: I think markets are great for the taking products to market. Markets are also great for the quality of innovation. So if what you want is the quantity of R and D, you'll probably need taxpayer subsidy because businesses won't invest all that you want. So if you want to do something like the Apollo program where you just need to spend an awful lot of money on propulsion, R and D and semiconductor R and D, and that kind of thing for it's very hard to do that without some public involvement, whether that's the direct public funding we saw in the Apollo program, or the role of NASA as a kind of lead customer in El Musk, more recent SpaceX ventures. The government, I think, had a role to play in both of those.

Stian Westlake: If we take a different type of innovation, something which is much more about just combining the right thing. So something we talk about in the book is the famous example of the invention of the roller board, the wheely suitcase to take on planes. That was not about deploying a huge amount of R and D capital. That was about coming up with a precisely right combination of two existing inventions. And I think markets are great at doing that particular. And if you want successful innovations, you probably need a mixture of those two. So you need some role for states and some role for markets.

Allison Schrager: So we're at the 45 minute mark, although I feel like we didn't even get into the meat of a lot of your institutional recommendations.

Stian Westlake: I've got more time if you do. That's great.

Allison Schrager: Okay, great. So okay. What about monetary policy? Right now, monetary policy is a, I think a bit of a crossroads with inflation and whether or not it's going to have to increase rates as you bring up in the book year, years, and years of very low rates that were partially structural. How does an intangible economy really change the scope of monetary policy? And should it operate differently or use maybe different tools or maybe of a different intellectual framework?

Stian Westlake: I think it creates a lot of challenges, particularly because as we're saying, because bank finance is less useful for intangible intensive businesses, that channel, the central banks have traditionally relied on of raising or lowering interest rates. And then that being communicated to firms, therefore the firm investment through bank lending becomes gradually less useful. So I think that is a sort of long term challenge for central banks. I guess, the other angle that's important here is this sort of financial stability angle. Because, again, if you've got a situation where your business sector owns a lot of tangible assets that have secondary market values, that can be sold if there's a failure, you have a sort of stock of capital adequacy there if necessary.

And I think the problem comes in an intangible economy, that if you have a collapse, suddenly a lot of your assets can that a lot of the assets in your business sector can be marked to zero particularly quickly. And the flip side is that we see that banks loan books get more and more taken up with residential property from that point of view, which again, increases the sensitivity of the economy to rises and falls in housing prices. So it does make everything a little bit more sensitive and makes the role of central banks more judgment based.

Allison Schrager: Do we have to rely now more on fiscal policy for that reason?

Stian Westlake: Broadly speaking, I think we do. Obviously, that's some ways an unhappy place to be because we'd kind of gotten quite happy with the idea of somewhat independent central banks being able to set policy quite straightforwardly through inflation targeting. I think a world where you do more through fiscal policy, again, like we were saying before, becomes more reliant on you need more democratic legitimacy to do that. And it increases the risk of more arbitrary behavior by governments.

Allison Schrager: In a more intangible driven economy, assuming we even had better institutions, can we expect more volatility?

Stian Westlake: I think in a number of ways we can. I think one thing that's really interesting is if you think about this from the point of view of firms, we talked earlier about how intangible intensive firms, you see more of a divide into leader and laggard firms. Now, to think of a tangible economy, in a tangible economy you can rely on mean reversion to a certain extent in any given sector. So if the success of your business depends a little bit on your business model, a little bit on your tangible capital stock.

If you're the best business in one year, it's not too hard for someone to try and emulate your business model, they can take out a bank loan and buy better capital stock. You would expect over time there to be quite a lot of mean reversion, today's best business will not necessarily be tomorrow's best business. In an intangible economy, the opposite happens because these intangibles are so valuable when you combine them in the right way. It not only means that if you're a firm, that's got lots of really great intangibles and a great business model based on them, it not only means that you're more likely to be in the lead in year one, but it means that the incentive to invest more because you get more synergies with your other assets is even higher.

So there's an even bigger advantage to your behavior in year two. And that kind of world where you see that kind of division, I think is a world of greater volatility. Mean reversion is a very comforting thing when it applies. If we see less of it, the world will feel more random.

Allison Schrager: Although, I guess, maybe in some ways less. So maybe it'll be more churn of firm, but fewer downsides, maybe? Do you think we could expect more recessions, more [crosstalk 00:48:57] recessions?

Stian Westlake: I guess, the upside is that because intangibles scale fast, when things go wrong it can be easy to put them right. Or it's easier to kind of grow new firms. And there is one model of stability, which is kind of the old firms carrying on and doing well. I guess, there's another model of stability, which says you have a lot of churn, but so long as your new champions are being created as fast as your old ones are being destroyed, that the level of the economy that might all feel fine. So I think that's so long as you get your policy right, so long as you maintain a dynamic economy, an intangible economy can feel like a comfortable place, but it means if you don't, that makes it more problematic.

Allison Schrager: Because it seems if we could get the institutions in place, in some ways we could have an economy that's more resilient than before because physical capital was never very stodgy. It wasn't really resilient.

Stian Westlake: Absolutely. And one way to be resilient, it's kind of like a tree that bends in the wind is more resilient than a brick wall that blows down when there's a storm.

Allison Schrager: As I said, just look at the pandemic. I think people have to take stock that pandemics happen. They've happened throughout human history, but we've never gotten out of one so quickly because of the intangibles.

Stian Westlake: Exactly. That's a really good point.

Allison Schrager: It made us a lot more resilient as a world.

Stian Westlake: The ability to respond quickly.

Allison Schrager: So I say you have a laundry list of institutions that need before. If you were king for one day and you got to reform one institution in the UK and the us, let's just say you could do both in one day, what would it be? What do you think is the most important one to change and change as soon as possible?

Stian Westlake: So I think the really big thing and this is a big, gnarly political battle to fight. But if I had a magic wand and could just change it straight away would be the bias against equity and towards debt and our financial system, that requires a lot of changes. So the kind of the most straightforward, even though this would be very difficult to change is the tax bias. Obviously, debt is tax advantaged over equity. And there's a long tradition of economists making recommendations to change that, but they face a big political uphill struggle. I think if I could change that. And then at the same time, just to make it even more difficult, put in place more institutions that are good at providing equity finance.

And I think, as we said before, it took 50 years to work out a way of putting in place institutions to provide equity, private equity, to high growth tech firms in the form of venture capital. But I think we would want to see institutions that work for the rest of the economy in the same way. So classic example, German banks will typically take warrants alongside business loans, which gives them some kind of equity upside in businesses they lend to. And as a result, they do more due diligence. They're more aware of the upside of businesses and debt finance has a slightly more equity-like character.

You'd probably want alongside equalizing the tax stream, you'd also want to make it easier for businesses to raise equity and to be more institutions willing to do that. And I think if you change that, that would be an incredibly significant step. It would be very hard work, but if you're saying I'm keen, if I've got a magic wand, that's the thing I would do.

Allison Schrager: Do you think [inaudible 00:52:22] no longer hold?

Stian Westlake: That's a good question. I guess, the problem that we have from a [inaudible 00:52:29] point of view is the question of recourse. So [Steve Chiketi 00:52:36], U.S. economist looked at this and he called this The Curse of Collateral, which is that if you're a debt holder, there is still at a micro level, perhaps not at a macro level, there's still a sort of significant advantage for a debt firm in having collateral. And I think if you see a big shift in the collateral liable assets in the economy, then that does change things. I guess, this is always the challenge with [inaudible 00:53:12] is how it interacts with actually observable finance decisions.

Allison Schrager: Okay. Well, thank you so much. And I said, I'm so excited about this book. Congratulations.

Stian Westlake: Thank you.

Allison Schrager: [inaudible 00:53:21], do let us know when you're going to be passing through the New York.

Stian Westlake: I will do that. It'll be really good to catch up in person.

Allison Schrager: Wonderful. Thank you. Good luck.

Stian Westlake: Thank you so much. Speak soon.

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