Secular Stagnation

Secular Stagnation:The Plague of Our Age

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Secular Stagnation is a syndrome. It involves a situation where growthhas slowed to a trickle. Trickle is not a technical term, but one I amusing to describe circumstances where output and production are growing, but not at a pace sufficient to match productivity gains and population growth. The result is like a low-grade fever; unemployment remains uncomfortably high and individual earnings are stuck.

The syndrome is easily distinguished from pathologies like depressionsand recessions in that existing endeavors seem healthy and reasonably profitable. This vitality without growth is what underpins the defining attributes recognized by economists. On the one hand, income is sufficiently robust to enable a healthy level of savings. On the other hand, anemic growth creates few opportunities for profitable expansion. There is, therefore, no one to invest all of the money being saved. Economists try to reduce this imbalance into an analysis of markets and prices. They regard this syndrome as an instance where a price – the interest rate – remains too high for those who might come to the market to borrow funds. The reason that savers do not lower their price demands (interest rate) further is because they are already at 0%; what economists awkwardly call the zero lower bound. Itis scary when this price is too high!

This awkward characterization of the syndrome leads to a description which infers a very unhelpful cause. Hypothetically, lowering the price can lead to a market that clears; people wanting money to investin goods and services demand exactly as much as savers are willing to set aside given the offered rate of return. To get to an interest rateless than 0%, the saver needs to accept less cash back at a future date than they turn over to the borrower now. This isn’t going to happen.

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We are told not to expect a world where the best opportunities on the table are losers, let alone for this to turn into an unshakable syndrome, and for good reason. When there are enterprise that are sufficiently profitable to be savers, there should be opportunities tomake new investments that also make a profit. The opportunity may be in expanding one’s winning business or financing new competitors to successful ventures. This expectation is based on centuries of experience and is the essence of capitalism.

As such, you would expect greater interest in exploring and understanding the current syndrome which insinuates capitalism is faltering. Instead, public discourse tends towards defenses of one’s own models and launching attacks on competing theories, even as facts erode the foundations on all sides.

I am going to offer a different explanation for the syndrome. It is the fruit of decades of research, but research into a hypothesis that seems far afield from the syndrome. My hypothesis turns on what the proper relationship is between labor and overhead. A business that hastoo much overhead may not be able to generate enough revenue, no matter how productive labor is, to end up with a profit. Conversely, labor that runs high relative to overhead might indicate that labor isused in processes that are too unproductive in the circumstances; alsolimiting profitability. Cases studies in my cost accounting courses and my early public accounting experience suggested that a balance of about two dollars of overhead for each dollar of labor was the sweet spot. It was not too long though, before higher overhead rates startedto appear in profitable businesses. The inference was, possibly, that capital was being substituted for labor.

Labor represents the compensation of those engaged in the production process. Raise their pay or improve their methods and productivity andthe base figures change, shifting that ratio. Overhead includes other production costs. Benefits provided production workers as a part of their compensation are in overhead; workers not directly engaged in production – maintenance and stock room personnel, supervisors, etc. –are overhead; and capital and energy cost get allocated into the

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overhead factor. I want to emphasize the words and ideas behind ‘allocation’. Capital costs are incurred via an investment process that involves the commitment of a large chunks of money for a significant period of time. Moreover, this commitment to particular capital assets also commits the business to a certain type and rate ofenergy consumption, a minimal staffing level with people of a certain skill set. Decisions and commitment to a capital goods strategy is notmalleable and, hence, relates to planning on a very long time scale.

Early in the 20th Century, economists endeavored to understand nationalproductivity as a combined function of capital and labor. The core idea is that each factor leverages the other in producing a nation’s GDP. This model has its uses. It also has some political overtones forthe capital/labor dichotomy. The distinct time horizons upon which purchase decisions are made for labor and capital cannot be reconciled. A capital investment is also a commitment to a production process; building a coal fired power plant is a commitment to buy upwards of a billion tons of coal over the plant’s lifetime1. Given theeffectiveness of crystal balls, this tactic may or may not be prudent.Case in point, the efficacy of the U.S. transportation fleet circa 1970 suddenly seemed much worse as the powerful motors continued to guzzle no expensive gasoline. This fleet has continued to evolve, now consuming considerably less gasoline per mile driven – challenging a highway funding system that relies on per gallon user fees.

The middle decades of the 20th Century saw considerable productivity gains. Some of these were due to investments in equipment and processes; evolving with a fairly consistent pace of innovations. Someof this reflected the contributions of an increasingly skilled workforce and more effective organizations. Gains from both capital and labor supported the earnings potential and further investment in

1 A surprisingly large portion of U.S. power generating capacity is committed to a fuel type decided before the externalities of fuel type began to be understood at the production scales being built. Productivity gains on the consumption side – energy efficient machines and appliances – meant that the same old generators served more and more homes and businesses. This has been agood news/bad news outcome; less fuel has been required by the generators but there has not been demand for power sufficient to raze and replace outmoded technologies.

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the other. This dynamic created stability in the relationship between the two main productive factors. A sustaining steady state allowed certain basic measures of a nation’s economy to be stylized as constants: Kaldor Facts2. These Facts supported the notion that what was good for capital investment was good for workers and vice versa. The economic forces at work are the same influences that tended to keep the ratio of labor to overhead fixed. When the ratio changed, a couple of the Kaldor Facts lost their legitimacy. This is serious stuff since these Facts are economic identities underpinning some of the most potent beliefs about capitalism.

Work is done through the expenditure of energy. Both labor and capitalare capable of doing applying force. Labor is pretty limited as to theamount of work that can be done, but the level of effort can also be modified quickly by hiring or firing people. Capital goods are capableof work at a far more massive scale, but, once in place, it is far more difficult to make a large change in the capacity of a particular investment. Large shifts in the cost of a particular energy source will alter, at the margins at least, the costs associated with capitalresources. Consider, could the energy shocks of the ‘70s have tilt thebalance from costly domestic capital production to cheap foreign laborsources? Productivity gains had been cutting both these costs over theprior decade. For the moment, let’s only say that this is plausible.

Joint progress – inventions, innovations, and increased skills – of labor and capital improved productive capabilities as well as productive capacity. Product design and engineering require labor, butlabor that is indirect or overhead labor. This increased the ratio. Historically, manufactured products went from one-off items produced by skilled craftsmen to assembly-line produced goods conceived once yet produced by the thousands. Such assembly might require less skill,but the fabrication of inexpensive, standard parts involves tools and equipment dedicated to a single task; such tools requiring their own designs and production. Decade by decade, products changed in the materials from which they were made and the precision with which they 2 These were developed by Nicholas Kaldor and published as Kaldor, N. (1967). Strategic Factors in Economic Development. New York: Ithaca.

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were fabricated. Electronics went from lights and motors to circuits with transistors to perform logic and devices with more refined measurements, analysis, and computations. These enable devices to replace people. More and more knowledge, ideas and information are being embedded in the equipment under each worker’s purview.

The economists’ convention has been to include costs of new technologyincorporated in the production and operation of capital goods as part and parcel of that good. There is no obvious way to separate a tool from the ideas that went into the tool, nor any compelling reason you would want to do so. There is the trend, though, of more and more ideas are going into products (a/k/a technology). Differences in the dynamics of ideas integrated into a good or service and the other costelements will be increasingly significant to the economic nature of capital. Capital goods are constructed for a use and then used over and over for that purpose until it is worn out used up. All of its cost must be recovered within this span of use. Labor, too must be recovered through the results of its use, but labor tends to be paid only during the period it is being used. Ideas do not wear out and arenot transient like labor, but also must be fully formed and debugged before they are useful. Once operational, most ideas – designs, systems, protocols, programs, etc. – can be used again and again, gainvalue with exposure as the use of them is learned and new applicationsdeveloped.

What got my attention was the doubling and, in some cases, redoubling of ratios of overhead to labor. The root was not one thing but a wide range of factors and forces in play. These were the early manifestations of the Secular Stagnation Syndrome. While it came to myattention as a feature of overhead burden, it turns out to be something distinct with far wider implications:

The essence of the issue is in the nature of what economists refer to as non-rival goods. A thing is non-rival if my use of itdoes nothing to preclude you use of it. For example, I can use the Pythagorean Theorem even though you are using it, too. I havebeen using words like ‘idea’ in this discussion, but information

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of all sorts can be copied and communicated and fit this category:

Programs Patents and copyrights Blueprints Systems and processes Performances Innovations Games Formula Algorithms Music and movies Texts & tweets Blogs

The value can only be derived from non-rival goods when the good is complete. A software program that is not complete; that does not accept the necessary inputs and provide the desired output is not useful.

The creation and preparation of non-rival goods requires advancedinvestment until the product is finished. A movie needs to be shot and edited before tickets can be sold. A book must first be written. Software must be programmed and debugged. A professionalsports team must be assembled – formal contracts, a coaching staff with their philosophy of the game, stars who hint at amazing play and a chance to win, and other components – even though ticket revenues (and TV, merchandise, etc.) arrives beforethe entertainment is delivered. Non-rival goods, in short, involve a temporal framework that is in direct conflict with the precepts of Marshall’s economics. While it may be possible to develop proxy costs, a product with a meaningful non-rival element lacks a defined cost.

A producer is naturally averse to selling products for less than their cost. When they do, they are regarded has having incurred aloss. When products do not have unit costs, they are not constrained or even guided by this stricture.

This is a big, big deal because it means that the principles of free market principles are out the window. Entrepreneurs have newmodels which serve them well – only not price equilibrium seeking. Nearly all of the virtues of free market capitalism havetheir foundation in the expectation that prices are tending toward some equilibrium which will result in an ideal allocation

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of the dear resources of society. The lack of such a mechanism isa profound change. Products with a meaningful non-rival components just doesn’t work this way. Strikingly, a lot of voices are raising an alarm at the transition.

Matters have progressed to the point that prominent economists have proposed New Kaldor Facts. Central to their exposition is the expanding role non-rival goods are taking in the global production system. China has, as an example, massively adopted Western production technologies – virtually all of this non-rivalgoods (ideas and technology) – thereby attaining an exponential growth rate. GDP growth was accomplished with more labor productivity for their huge labor force. In analytical terms, China made a push towards the technological frontier where, according to the New Kaldor Facts, incomes are higher.

Non-rival goods are widely regarded as property. The owner’s interest is protected by patents or copyrights granting exclusiveuse for a set period and circumstances. The Chinese push to the frontier sometimes ignored these owner’s rights. However, most ofthe adopted technology was and is freely available. Other nationshave made similar pushes – Japan and South Korea being quite notable, but all non-U.S. Western nations have made a post-WW II push towards the leader, the U.S. The quality of the central government in these nations is seen as central to the timeliness and effectiveness of the push. The argument has often been made that a liberal democracy is critical to any advance on the technological frontier. The Chinese example suggests that the principles of constitutional government are more flexible in how they can support technological change. Chinese reforms allowed some freedom across civil society without all of the political reforms of a liberal democracy; adopting only some of the models and products of the economies it is chasing.

It is time to put this turn into the big picture. To do so, let’sstart with the prevailing, quasi-utopian model. It is referred toas the Virtuous Cycle because, when money is spent, it is presumed to go for capital or labor. That is, the purchase of goods or services goes to a business that pays workers (or their supplier who pay workers) or to buy equipment and other capital

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goods. The workers earn wages and the businesses generate a return for their owners for the investment to purchase of the capital goods. This is investor income that can be spent. Broadly, revenues generated by production are income allocated tocapital and to labor. These respective segments then have money with which to make their own expenditures. Income enables expenditures which provide income. Now, earners don’t always spend all of their income and purchasers do not always have all of the income needed for their spending level. There is a tendency for those who spend less than their income to match those who spend more and to offset one another. Production using substantial non-rival resources doesn’t follow this pattern. A non-rival good must be finished before it can be used and sold – much like capital goods. Labor gets income for this effort duringa period leading up to when revenue comes in. Once the non-rival good is finished and ready for sale, the level of labor required must be relatively nominal compared to the revenue stream. There is an allocation process, as with capital goods, between current labor, past labor, and investors funding creation of the non-rival good. Once all of these interests are paid their full share, the non-rival good often still keeps producing revenue. The simple observation is that sales and consumption of non-rivalgoods can continue long after its production is over and done (asto a need for resources). Laws like patent and copyright protections enable creators of the ideas to capture a share of the income stream during this tail. Producers retain this revenuestream after labor is paid, after capital is returned, after inventors and creators get their share. Whatever fairness this

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may entail3, this disrupts the Virtuous Cycle. That is a problem.It is the cause of Secular Stagnation.

Secular Stagnation occurs when the expenditure side of the Cycle hasmore activity than the income side. There can be an imbalance because spenders can borrow to supplement their earnings. Historically, those who borrowed were balanced by those who saved. What has tilted the scale in this Age of Stagnation is the fact thatthere is spending that doesn’t become income; earnings of workers, of investors, or of creators. These earnings may be considered to bethe return on Old Ideas. After Pythagoras were Descartes, Einstein, Heisenberg, Turing, Shannon, Bardeen, Brattain, and Shockley (inventors of the transistor), Edison and Tesla, Crick and Watson, Pasteur, Fleming, Borlaug, and so on. Their insights continue to generate billions of dollars of earnings. They have become trillionsof dollars on corporate balance sheets – basically unspendable.

Now, prudent borrowing contemplates future income, which, combined with reduced expenses, enables borrowers to repay debt. This expectation – and this is really, really important – is based on nominal dollars. Today, I am borrowing because I do not have enough income to support my spending AND I expect my future earnings to be greater than my future expenditures by enough to pay the money back.Experience has taught two reasons for a rise in future earnings: 1) Greater productivity, and 2) Inflation.

I know I will soon need a new car. The model I desire will cost me $30,000 if I go ahead and buy it now, but $35,000 if Iwait until my current car has gone its last mile. If I go

3 To be clear, this is not a challenge to authors and inventors to the right to income from their creation. Rather, it is a recognition that once discovered, and idea stays discovered. Paying Pythagoras won’t get him to develop a second theorem. Up until now, it has made sense to pay people who learn Pythagoras’ Theorem a bit more for that effort of learning it, but with machines taking over the computations, it is not clear how to benefit society by paying someone for this element of a product. Further, while products a century ago or even some decades ago incorporated just a few such insights, modern products include so many such bits of knowledge that they comprise mostof the value of an item.

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ahead and buy the car, I will spend 5 months’ worth of currentincome. However, I may borrow this same amount of money knowing that, like the price of the car, my income will be rising and that only 4 month future income will be used to payfor the car. Inflation provides a scenario where I can spend valuable dollars now by returning cheap future dollars.

If my hypothetical purchase involves a non-rival good, I may reasonably expect that the producer of this good is trying to recover production costs as quickly as possible. What they arenow charging $300 for may cost $100 not too far down the road and when I really need it. Granted, it is likely that, by then, this same producer has added valuable new technology to a similar product and costs the familiar $300. The value of the improvements may lead me to pay this higher price, rewarding the producer’s investment in the technology upgrade.

An enterprise, which has been able to accumulate a cash balance due to the improved productivity of capital or labor, or to continued earnings on non-rival productive factors, lacks motive to seek out new uses for the accumulating cash. True, it will continue to spend on productivity enhancing technology and non-rival upgrades. This is only enough to maintain the status quo, not to add jobs and expand the economy, leaving cash deposits growing. This is the situation,in spade, for a few companies but is also, in the aggregate, the emerging situation for commerce broadly.

Secular Stagnation is a syndrome first diagnosed in seemingly different circumstances; the onset of the Great Depression, with markedly different economic drivers. The social conflicts and tensions that then emerged were resolved through mechanisms neither desirable nor currently plausible [mass migration or world war]. Given the manner in which society continues to evolve, it is not clear that any resolution is foreordained. Of much more consequence,though, are the implications this re-emergent syndrome has any “remedy” is but a temporary palliative. Our current debates and disputes are a rehash of those of the last century; a worrying sign that things never got “fixed”.

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IIThe diagnosis of the Secular Stagnation Syndrome has been impaired by a blind spot in the analytical toolbox of economists. This is notjust for today’s thinkers, but afflicts more than a century’s worth of development. We could attribute the problem to Marx and his juxtaposition of workers against owners; labor against capital. Thisis frequently presented as the dilemma faced by policymakers trying to advance the general welfare. This dilemma is often presented in zero-sum terms. It was, for example, the context in which laissez-faire government policies were advocated. While economists have longtreated labor and capital as complimentary, this balance is a bit beside the point if other resources are a part of the story. And notonly are there other essential resources, these other factors often drive the outcomes.

I have upgraded the old two-factor model to eight. This model, whichserves as the foundation for this book, is based on a simple premise– that a producer is required to exchange for all of the resources needed to produce a good or service. However, the bargains with resource providers vary widely in the way that quantities, risks, timing and proportions of the parties’ respective benefits are incorporated into a deal. The constraint is that each party is acting in the expectation that the deal will be to their advantage. To use a common metaphor, the producer must come up with a recipe for a pie while simultaneously negotiating what share of the pie is to go to the providers of each ingredient. Every ingredient providermust be satisfied with the size of their piece.

The expectation that they will be satisfied by the exchange implies that they have a stock or inventory of whatever ingredient it is they agree to give up and want a stock of that which they are to receive such that they are better off when they give up some of the first and get some of the second. For some producers and some customers, the prospects that selling the same amount at the same price is identically advantageous, is very situational. For most businesses, the expectation that workers will have a stock of hours and suppliers a stock of materials that they can get is all but given. In these simple transactions, the parties may have a pretty

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clear, immediate idea of how their situation will change in a deal. Much of economics is built on the assumption that such repetitious transactions are universal.

Some resources must come from parties whose situation is not so stable. Customers, for example, may have their need satisfied for anextended period after they make a purchase. Investors may need to berepaid or be able to sell their investment before too much time passes.

Classical economics is based on obtaining resources in free markets at competitive prices. If I need more sugar or flour for my pie, I can get it on the same basic terms (I may have to pay marginally more if I bid the price up). Today’s entrepreneur is trying for a unique pie that requires unique ingredients. Not only do such ingredients not trade competitively, the entrepreneur must be scouting and recruiting a very specific capacity to provide a uniqueingredient. The whole thrust of commerce and society for a century and more is to stop dealing in commodities and deal in novelties. This effort has been an unabashed success!

In the model presented here, an endeavor is a social construct whichconverts some set of resources into a more useful form. It is the social construct which serves up the rules by which the benefits that come from the transformation of ingredients into pie are allocated back to the resource providers. The endeavor as a separateentity does not profit or gain through its activities. It is always someone who has provided something of value. Nor does it incur losses for that matter. Each deal with one provider increases or decreases the benefits allocable to the other resource providers. The customer is one of the resource providers (usually contributing cash) who must be satisfied with their slice of the pie (typically, the product).

This model allows for non-standard situations. In some business models the customer ‘pays’ for the product with their attention, which the producer then deals to advertisers for money. Perhaps the most rapidly expanding segment of the economy is that where a good or service is “free” to the consumer; in fact, there is a

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nonmonetary quid pro quo involved and the freebie has near zero marginal cost. Today’s free media – broadcast and internet – had print precursors –newspapers, magazines, and mail order catalogues that had some cost to print and distribute, but were still very costeffective ways to broadcast large amounts of information. Todays’ big data, where a consumer reveals information about themselves in exchange for the freebie is more of an innovation. ’Free’ doesn’t show up in GDP, just the derivative value to the third party sponsorand what they pay.

There is no owner in this model. Instead, it recognizes that certainresource providers get the residual after the deals with other resource providers have been settled. That is, someone gets the lastpiece of the pie; what is left after all of the other pieces are doled out. Historically, it has been the providers of the most patient financial resources who have obtained this position. These are commonly referred to as stockholders. Where intellectual property provides significant value, the artist, author, or inventormay retain this residual. In the entertainment field, there is a competition for this position between the stars and the studios (or owners in the case of sports.)

As the scenarios whereby resources are accumulated and benefits delivered and/or are allocated have evolved, the entrepreneurs who conceived and implemented new businesses have managed to retain the last piece. Through the generations, there are the founders of new industries – railroads, steel, oil, personal computers – whose entrepreneurial founders have become massively wealthy. More recently, management of businesses that trade on information (a category to be uncovered in this book) have managed to arrange for alarge share of the earnings – the last piece of pie -- to be paid out to themselves. Governments have managed to exercise political power to gain this position, independent of the fact that there are situations where the community may be best served when government takes this role.

The purpose of the social construct is to use as few resources as possible to deliver as much benefit as possible. What constrains

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this simple proposition is that each and every participant in the process must find it to be to their independent benefit to join in. Any scheme of allocation which satisfies this constraint can be saidto be fair.

However, schemes that are thus fair may not serve the community well. Specifically, even though every provider has accepted the value of their share of the pie, the community gains when more goes to those who, if you will, spend it well. This may mean reinvesting a part of the share to expand capacity or to create new and better products. It may mean consuming locally with one’s income. This may mean adding jobs, helping suppliers or lending locally.

I offer this proposition, that it is preferable for an allocation scheme to be one which encourages the community to allocate more resources to activities that create greater net benefit while it discourages the allocation of resources to endeavors which produce marginal benefit.

This proposition presupposes that an ideal allocation exists. For reasons that will become clear as the model is developed, this may not always be the case. The model itself is just an observation thatevery endeavor or enterprise has an allocation scheme but is neutralon questions of fairness or efficacy. That said, matters of pricing,compensation, risks and return, and several other quid pro quo issues do come under the pie slicing process.

This new model may provide insights into historical controversies and raise new questions in areas of economics that have generally been regarded as settled. This potential will be left aside for the moment. Critically, though, every bargain between the endeavor and aresource provider involves an exchange of two or more resources and is explicitly synergistic among resource providers – it is fashionedso as to increase the benefits produced for the resources used – themargin between cost and benefit – that is the subject of allocation.Every deal increases the size of the pie and, even though often trivially, each participants slice, too.

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It is useful to presuppose that the negotiations over how the benefits generated by an enterprise get allocated involves output over the full production cycle. This, however, requires that all of the resources that must be acquired are fully used up in the production of goods and services. In a full cycle, goods and services are completely sold and revenue all collected. This situation rarely, if ever, exists in the real world. In the idealized cycle, the endeavor would have delivered all of the piecesof pie, retaining no resources. Some of the resources acquired though are long-lived assets. These must be in place before production can take place. Other assets take a more transitory role in the production process and are only acquired as needed. There is no requirement that the full set of resources that will be needed orthe terms on which they will be acquired be known when starting a business. It is sufficient to understand that things of the kind needed are available and to be able to generally anticipate the terms typical of the expected deal. Those who commit resources earlyneed to understand the uncertainty implicit in these still hypothetical/essential exchanges and for the organizer to buffer theallocation scheme should actual deals prove to be lesser than or greater than first envisioned. It is best to understand that failures to fit expectations are the norm and that it is continuously necessary to renegotiate, implicitly or explicitly, thegrand allocation scheme. The theoretical ideal of a revised scheme that better supports a societally ideal allocation of resources is usually defeated by timing issues; exchanges that merit a smaller orlarger share of the pie have already been finished when the way in which reality differs from expectations comes to light.

This model requires a resource that was already labeled ‘entrepreneur’, above. The entrepreneur anticipates a benefit that can be generated through a production process, the full array of resources that will be required in this process, the manner in whichthe required resources and process may be assembled, and an allocation scheme that should prove acceptable to the various parties offering the needed resources. One way of delimiting this resource is to see it as completing its function when the endeavor is able to go through a full production cycle, delivering a product

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that generates benefit shares that meet or exceed the needs and expectations of all resources providers (or does so well enough to continue on to another cycle.) A more comprehensive understanding has the entrepreneur continuing to strive to increase the benefit generated, decrease the resources required in the process, and to improve the terms of exchange for all of the parties so as to increase their respective perceived advantages.

The entrepreneur is a sort of heroic archetype who comes to market with a new product, forming an enterprise that adds new jobs, and becomes a good customer for existing businesses. The entrepreneurialfunction also exists within companies, working to improve products and services, to lower prices and offer more flexible terms to current customers, and to open new markets. The same function also evaluates changes to systems and new technologies that may be used to improve the production process. Such changes may be implemented by the enterprise, but upgrades may also be implemented by suppliers– the resource providers who support the company. These innovations impact the exchange-to-advantage between the supplier and producer even if the nominal terms at which the exchange is made remain unchanged. Even if it appears that all of the benefit from the change accrues to the supplier, the long-term scenario is always dynamic. Gains by the suppliers set the stage for that supplier to make further changes, enjoy more gains, and provide the basis for greater synergies and improved terms of exchange for the user. This suggests we downplay prices – immediate terms of exchange – in favorof fundamentals that best support delivery of the optimal resource required over the long-term. The fundamental drive behind this function is toward more benefits from fewer resources. Therefore, while the heroic entrepreneur may be offering new jobs; at scale, their more benefits from fewer resource thrust means fewer jobs and less demand for the raw resources. For broad sweeps of time, the improving advantage for the enterprise manifests in the marketplace as lower prices and affordability for more customers. The increasingmarket grows demand at a pace that adds jobs for those employers that innovate best.

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There are limits to expansion, whatever the market. In what is, no doubt, a statistical anomaly, one U.S. agency reports that there aremore households with television sets than a separate agency comes upwith for total households. Since there are those households that deliberately avoid televisions, one is forced to conclude that television manufactures will not enjoy demand by further penetratinginto existing homes. Similarly, while the U.S. Department of Agriculture has reported a double-digit rate of increase in the average calories consumed, this trend is not only unsustainable, butone that many people are hoping to reverse. The success of the entrepreneurial function and the limits of the markets they seek to serve set the stage for a tension within societies that is inevitably disruptive. This is covered in Modern Market Theory.

The entrepreneurial resource has to be distinguished from the category of management. Managers may contribute to entrepreneurship in some organizations but, as we consider the production cycle, it becomes clear how management of the cycle is at odds with efforts toimprove the process. The production process can be complex and, given the benefits of economies of scale, the advantages of long-lived assets, and established organizations, activities that are challenging just to keep on task and on plan, managements’ focus is on conservation of the status quo. Managers at all levels must constantly fight the laws of entropy. Management fits the category of labor with this its task. Conservatism may be institutionalized as the means to sustain the current design. For the managers whose responsibilities are mostly to constrain change, implementing targeted changes can be a struggle. Organizations that do not find abalance between top current performance and a capacity to innovate will find themselves at a disadvantage versus those that manage performance and entrepreneurial change.

IIIA production process may be considered as a cycle, but only in abstraction. Some resources must be acquired early in the formation process and then need to be used regularly to generate revenues overa long lifetime; the long steam of revenues needed to complete the bargain implicit in its acquisition. Other producing resources may

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not need to be acquired until the last minute and their cost is recovered quickly. The cycle of ‘acquire resources’, ‘produce products’, ‘sell products’, ‘repeat’ doesn’t have any neat cur-off. With the industrial age, the need to pay for expensive factories andequipment gave rise to the financial innovations that get called capitalism – conflating capital as long-lived assets and capital as the funds to pay for these assets.

The long-lived resources may be generalized as assets that deliver economies of scale and therefore important to a profitable business.The size of these assets can make their purchase a similarly large challenge. Innovations that are enabling a business to acquire such a resource on terms more congruent with operations are having an unseen but profound impact. There is a revolution in how people and businesses work with one another that is freeing entrepreneurs to dothings never before considered. A general principle might be that every social innovation that gives entrepreneurs and resource providers more flexibility in crafting exchanges to advantage has animpact that changes society.

ExamplesIt takes assets with values in the billions of dollars to operate anairline, but entrepreneurs with mere millions start one every few years. They can do so because these various assets can be obtained on terms that can be aligned with revenues generated. An airplane may be owned in parts, with one owner leasing the airframe on one set of terms and the engine owner selling hours of operation on a usage based rate. Facilities for arrivals and departures at airportsare critical for the airline that wants to serve a city and their acquisition may involve multiple agreements with a commission and other operators at the airport.

The world of computers was once an area where an investment in hardware and software could be significant for a start-up. If the start-up was a success, it wasn’t long before it was time to upgradethe IT systems. The cloud has emerged as the place to get the computational resources you need. As business grows, this resource can scale right along with the company’s needs.

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Transformations are disruptive with real winners and losers. Historyis largely the stories of successes, so innovations are generally regarded as positive, but this is not necessarily the case. Aspects of this model raise important questions. For the moment, I want to focus on the mechanisms that enable the entrepreneur to span the mismatch in time between when resources are required and benefits are subsequently realized.

There is one innovation behind many important innovations; money4. Iwant to spend a moment on money as it is often misunderstood. No oneneeds money. What one needs is the resource(s) that can be purchasedwith money. An enterprise wants money so as to be able to pay for resources. Finance is an innovation that enables the enterprise to get money in exchange for money. More precisely, the enterprise receives money now as a quid pro quo for promising to pay money in the future, usually under specific terms and conditions. While this may be easy to understand in the limited case where the promise is for return of more money in the future, it is important to build a greater understanding of how this is an exchange to advantage. For example, if the enterprise is in need of money now, how does it promise to return money in the future in a way that is credible?

It is helpful to develop a full understanding of the universal aspects of a production process to properly address this and relatedissues. A full exposition requires a foundation be laid of the full array of resources included in the model being presented here. For purposes of this discussion, I will outline what I hope are some

4 Money is sometimes regarded as being valuable in its own right – a precious metal – independent of a social contract that says others will take it in exchange for goods and services. As money has gone from the Gold/Silver Standard (where a government promised a metal in exchange for paper they issued) to paper to checks to plastic cards to binary code, money has become asocial contract, pure and simple. It should be noted that governments that issue currency require the payment of taxes in that currency, compelling one important use. Governments are also big consumers, a second reason to honor a currency as valuable. Governments can use this position of money issuer to generate revenues in an alternative to taxes; seigniorage. There is an arbitrary creation of value of sorts in the way that central banks now introduce money into the banking system, but who and how this may hurt or helpanyone is much in dispute.

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fairly intuitive scenarios for which the implicit value of traditional resources is obvious.

An enterprise is producing output at a level below capacity but could reach that capacity with the acquisition of a relatively small amount of a particular resource. A small allocation of the pie is all that is required to substantiallyincrease the pie.

An enterprise experiences seasonal demand for its output and needs to acquire a standard slate of resources to be able to operate at capacity through the peak interval, after which it can pull back to much lower levels. The acquisition of the short-term burst of resources requires an allocation of benefits that mirror the bargains made for such resources whendemand is lower; the synergies and the gains produced are typical of the rest of the year.

An enterprise is regularly at or near full capacity but could create products delivering greater benefits to customers. Whatis needed is a long-lived asset which will take some time to generate enough additional benefit to cover its cost. The purchase price is needed now even though the larger slice of the pie is an on-going proposition.

An enterprise has operated successfully for a period of time, generating large benefits with respect to the portions of resources used in the process. However, it has come to possesssignificant stocks of resources that it doesn’t need in its current operations and, more centrally, cannot be allocated orexchanged in a way that increases the size of the pie.

The four scenarios differ fundamentally in the types of synergy thatbecome available with the addition of particular resources. If we assume that the resources in each scenario can be acquired through acash purchase, each differs in when and how much cash will be available as a result of the gains implicit in the opportunity and, thus, how much money can be promised for the money. Not all of the gain is likely to go in the promised return of money, the remainder goes to increasing the slice of at least one other participant.

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Familiarity with the daily activities of business leads to the realization that the need for money and the availability of money changes daily. The assessment of the stock of money at hand also appears quite different in the context of short, intermediate, and long-term opportunities/ obligations.

I submit that the value of money has nothing to do with accounting entriesand everything to do with the benefit the resources to be purchased bring to

the operation in its current context.

Accountants and economists treat a dollar as though it always contained a fixed quantity of value. Yet a person puts time and effortinto a transaction so that they gain the maximum possible advantage for their money. Deals follow only if all parties are very clear that they are better off after the transaction. This judgment gets ignored.Even if there is concrete, objective information about the degree of actual advantage or gain from the transaction is ignored. There are difficulties in measuring gain and such gains may disappear quickly asthe resource is consumed. Neither of these considerations justify, however, the development of theories and formulation of policies that presuppose that these gains do not exist. Ignoring gains that are too hard to measure is less problematic when comparing two quantities thatare otherwise similar, but is downright misleading if the comparison is apples to oranges.

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We can use a utility curve to describethe value money brings to an enterprise.Utility is the combined advantage of allof the participants in an enterprise.This utility comes from the gains andsynergies not available to the partiesbut for the money made available for theexchange. I submit that this curve is astair-step function, the need for someadditional resource(s) a conditionalfunction of the enterprise’s state:

I Crisis mode – A dire need for a small amount of resources of great significance gives money a very high value.

II Opportunistic mode – Additional money enables an enterprise operating below capacity to get afew resources enabling it to produce much greater throughput relative to the money required.

III Seasonal mode – Money enables a producer to ramp up production and build inventories for a demand peak; demand varying by season or another cyclical driver.

IV Operating buffer – Even at times when there is no immediate need for resources, a cash buffer is valuable to be able to meet unexpected expenses or opportunities.

V Investor mode – The enterprise has no anticipated needs for further money: Short-term, Long-

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Marginalist PrinciplesOne of the foundational principles of economics is that economic actors will choose to act if and only if doings so would leave them better off. This analysis is done at the margin; one more unit or if the price is this high (for a seller) or low (for a buyer, one more customer, etc. The crux is “Can I make a little more profit?” Its application is usually in some form of supply and demand situation. For example, if a price is marginally higher, how much more will producers being willing to sell versus how many fewer buyers will there be. Where the quantities offered in supply balance those for which there is demand, the price is said to be in equilibrium. Economics is often a study in the allocation of scarce resources so that there is a tension between two options where a balance between them is optimized ‘at the margin’. At such an equilibrium point, the marginal increase for one/decrease for the other is very small. And it is very hard to objectively measure. Given its small size and hard measurement problems, the adopted convention became “Ignore it”.Times change. Take a 19th Century supply and demand curve. Fast forward 100+ years. The average consumer is a lot more affluent. The producers are a lot more efficient. Inevitably, there comes a point at which producers are willing to meet the demand of everybody and/or everybody can afford to pay the price producers need to cover costs. A growing number of products have zero marginal cost – they are profitable at any price. This means that any price has a significant gain at the margin; something ignored at the peril of erroneous conclusions.

term, or Exploratory. The endeavor is left with the optionsof holding the cash on the chanceof some benefit, investing the cash with a separate party in exchange for their promise of a future return plus a premium, or distributing it to participants in accord with the existing allocation scheme (such distribution serving as a revision of the scheme.)

These categories represent conditions or states in which businesses operate. Any money obtained while in a particular state can be used intransactions with similar anticipated benefits so that different amounts of money within a range offer similar potential, up to the point all similar needs are met and a new state is reached. Then the per unit utility drops to that of the new state. For example, a retailer may be willing to borrow money at one rate to prepare for Christmas sales, but not to borrow an additional sum that may or may not be needed.

There are some simple observations that not only explain the emergenceof finance as a force in modern commerce but also how the financial sector has continued to innovate. Additionally, these serve to explainthe role modern financial practices have and will continue to play in cyclical financial crises.

First, there exists and opportunity for a mutual exchange to advantagebetween entities where those at Level V are on one side and those at Levels I – IV are on the other.

Second, an enterprise will move between levels with the passage of time. Indeed, with the available response time of financial institutions, a business will cycle between being a source of cash anda “needer” of cash on daily, weekly and monthly basis.

Third, there is an element of risk, given the situations in which entities at the lower levels find themselves, as to when and if the promise to repay money can be fulfilled. The ability to correctly

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Marginalist PrinciplesOne of the foundational principles of economics is that economic actors will choose to act if and only if doings so would leave them better off. This analysis is done at the margin; one more unit or if the price is this high (for a seller) or low (for a buyer, one more customer, etc. The crux is “Can I make a little more profit?” Its application is usually in some form of supply and demand situation. For example, if a price is marginally higher, how much more will producers being willing to sell versus how many fewer buyers will there be. Where the quantities offered in supply balance those for which there is demand, the price is said to be in equilibrium. Economics is often a study in the allocation of scarce resources so that there is a tension between two options where a balance between them is optimized ‘at the margin’. At such an equilibrium point, the marginal increase for one/decrease for the other is very small. And it is very hard to objectively measure. Given its small size and hard measurement problems, the adopted convention became “Ignore it”.Times change. Take a 19th Century supply and demand curve. Fast forward 100+ years. The average consumer is a lot more affluent. The producers are a lot more efficient. Inevitably, there comes a point at which producers are willing to meet the demand of everybody and/or everybody can afford to pay the price producers need to cover costs. A growing number of products have zero marginal cost – they are profitable at any price. This means that any price has a significant gain at the margin; something ignored at the peril of erroneous conclusions.

evaluate this risk is important in every situation, accompanied by a need to structure and set terms for the agreement to exchange money for a promise that maximizes the prospects for the return of cash.

Fourth, a party which, while at Level V, exchanged cash for a promise of future returns of cash, may find itself at some lower level before the promised cash is returned. When this situation arises, there may be another party experiencing the reverse transition, now holding Level V cash, seeking an exchange of that cash for an opportunity for future cash plus a premium. There may be a mutual benefit for these transitioning parties to trade the existing promise of future cash forcash, essentially swapping positions. The prospects for benefit are enhanced if the new buyer can reasonably expect to find a seller when it needs cash again. Herein is the value of stock and other financial markets.

Finally, Intermediaries can accumulate information about parties either having cash needs or having cash available which enables fast and accurate evaluation of potential promises to repay cash, the ways to minimize and mitigates risks of promises going unmet, and when a party willing to give-up cash now needs to get it back in the future.

These few, generalized facts show there are nearly universal opportunities for intermediaries to create mutual benefit by appropriately connecting parties at Level V with those at Level II or III, generally, and, more narrowly, with those at Levels I or IV, where the risks are greatest or the rewards smallest. The crux of all such transactions is that the borrower is able to generate a greater return with the advantage of cash which it can then share with the lender, along with the return of money. A slice of this goes also to the intermediary as payment for their gathering and using information to make a proper match between money source and money user.

There is a tendency to conflate the source of the money and the intermediary as the ‘lender’. In reality, taken both from the perspective of the borrower and the investor, the intermediary is the face of the counter-party and seen to be the source of or user of the money involved. A customer depositing money in the bank, for example, does not see this as going to make loans to people who are buying

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houses or cars. The substance of the matter, though, is that the intermediary is a matchmaker whose raw material is information; information about the two parties and, of greater importance, about portfolios of parties in each category that they can balance. Using information, the financier can match the investors’ objectives for thereturn of cash to, not one, but a portfolio of promises to repay the cash with a fairly accurate read as to the uncertainties surrounding these promises. The financier typically aggregates multiple groups of promises so as to mute, mitigate, and offset the risks and uncertainties inherent in the individual promises. Essentially, this process involves averaging cash payments and setting up offsetting deviations, so that the aggregate payment stream is low risk. This process is effective when it comes to anticipating and managing individual risks, it tends to fail when systemic risks have an impact that is correlated across a large portion of a portfolio.

The financial intermediary is a business operating by processing information, often in very large volumes and using standardized formats. As the industry has grown increasingly sophisticated, it has created products that fit ever more specific situations and to anticipate and manage changes within groups that tend to correlate. There are invariably limits to what these tools can accomplish. The lesson of history is that, when these limits are reached and exceeded,the consequences then cascade through the financial system, voiding many of the protections that had been put in place for smaller risks and failures.

The financial markets and the complex systems used by financial intermediaries are based upon marginal principles. For example, assetsare typically used as collateral on loans made for their purchase. If there is a buffer, say a 10% down payment, then repossessing and selling the asset should ensure recovery of the loaned amount. [The amount of buffer needed to give reasonable assurance varies by type ofasset, of course.] Per Marginalist Principles, a small decrease in price is sufficient to grow demand, allowing the lender to sell the collateral and recover on the promise. While this works fine most of the time, there are too many very dramatic examples of where it doesn’t.

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The financial system is a major part of modern commerce. It is a system built upon protections and fail-safes. It is secure up to the point that it is not. The Secular Stagnation Syndrome leads to the very kind of system shifts that the financial system cannot withstand.If future income is not greater or expenses lower, new debt will not be incurred nor old retired. Crash!!!

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