Economy Suffers From Lack of Innovation- Christensen

I missed this article when it first came out some months ago, but the tenets still ring true.

Originally reported on CNN

Capitalists seem uninterested in capitalism, even as eager entrepreneurs can't get financing. Businesses and investors sound like the Ancient Mariner, who complained, "Water, water everywhere -- nor any drop to drink."

At the heart of this paradox is a doctrine of finance employing measures of profitability that guide capitalists away from investments that can create growth.

There are three types of innovations. The first are "empowering" innovations. These transform complicated, costly products that previously had been available only to a few people, into simpler, cheaper products available to many. The Ford Model T was an empowering innovation, as was the Sony transistor radio.

Empowering innovations create jobs for people who build, distribute, sell and service these products.

The second type are "sustaining" innovations. These replace old products with new. The Toyota Prius hybrid is marvelous -- yet every time a customer buys a Prius, a Camry is not sold. Sustaining innovations replace yesterday's products with today's products. They keep our economy vibrant -- and, in dollars, they account for the most innovation. But they have a zero-sum effect on jobs and capital.

The third type are "efficiency" innovations. These reduce the cost of making and distributing existing products and services - like Toyota's just-in-time manufacturing in carmaking and Geico in online insurance underwriting. Efficiency innovations almost always reduce the net number of jobs in an industry, allow the same amount of work (or more) to get done using fewer people.

Efficiency innovations also emancipate capital for other uses. Without them, much of an economy's capital is held captive on balance sheets, tied up in inventory, working capital, and balance sheet reserves

Industries typically transition through these types of innovations. The early IBM mainframe computers were so expensive that only big companies could own them. But PCs were an empowering innovation that allowed many more people to own computers.

Companies like Hewlett-Packard had to hire thousands of people to make and sell PCs. They then deployed workers to make better computers — sustaining innovations. Finally, the industry began to outsource its operations, becoming much more capital efficient. This reduced net employment within the industry, but freed capital that had been used in the supply chain.

The dials on these three innovations are sensitive, but if set in a recurring circle -- with empowering innovations creating more jobs than efficiency innovations eliminate, and the capital that efficiency innovations liberate being invested back into empowering innovations -- the economy is a magnificent machine.

The belt of circularity in America's economic engine, however, is broken. The 1982 recovery took the economy's usual 6 months to reach the prerecession peaks of performance. Getting back to the prior peak in the 1990 recession took 15 months. Our economic machine has been grinding for 65 months trying to hit prerecession levels — and it's not clear whether or how we're going to get there.

The reason? In America, Japan and Europe, the dials have gone amok. Efficiency innovations are liberating capital, but that capital is being reinvested into still more efficiency innovations. Our economies are generating many fewer empowering innovations than in the past.

The article and Christensen go on to argue that the reasoning behind the loss of innovative capital is because managers and businesses continue to act as if we live in a world of scarce capital. I take a different tack primarily, as I have seen how the process works first hand. The abundance of capital (thank you Federal Reserve, yes I had to work a knock of the Fed in here somewhere) has created a situation where financial 'innovation' and engineering produces gains at a more rapid and lucrative clip relative to creating a disruptive innovation. In many ways, it is simple math. 

Just think of the internal rate of return calculation. Imagine an investment scenario.Any scenario. Now dial back the cost of capital in conjunction with a reduction in the investable time period. Compare this to a similar scenario with a more uncertain stream of cash flows where capital is tied up for years if not decades. No wonder the economy remains locked in, as Christensen puts it, a capitalists dilemma.