Good Morning Everyone.
In today’s piece we examine the relative structures of what bubbles up to form the US economy. Individual Contributors (ICs), Enterprise Value (EV), and Gross Domestic Product (GDP). As we have discussed in the past, there is sometimes friction between ICs and EV in what can manifest as the Principal-Agent Problem, or any number of micro-regulatory-capture or responsibility-moat-creation actions. It is, however (or is it?), this bloated middleware that makes up the purchasing power of the US and thus drives the increase in GDP each year. Also, there is a common theme of status signaling that runs throughout.
Let’s dive in.
ICs
From early on in our life we are told that the most favorable path to success is to get good grades in school so you can get into a good university, and ultimately start your career early so that your subject matter expertise compounds over time as you move up the corporate ladder with seniority/tenure. That is certainly a path, but it has become increasingly risky over time. Putting aside for a moment that the starting line for every child is different depending on the zip code of his or her birth, all participants run into a gamified system at every level. School administrators in K-12 have to secure taxpayer funding which requires student segmentation, teaching to standardized tests, or otherwise “juicing the stats” so that the money spigot stays on (which coincidentally leads to more school administrators per student). Students get prepared for a life where they are competing to get into a top university, but they are met with a few more issues: college acceptance is not based on merit, and in most cases is based on price tag. Since the ultimate goal is to land a great job, the employers of great companies can be hyper selective and only hire people from, say, Ivy League schools. Simple economics tells us that if the supply of Ivy League educations is restricted, demand is going to be very high, which increases the price. When money is the greatest determining factor, and all other merit based attributes get abstracted away, the quality of students at these facilities starts to diminish, and along with it the relative educational value of the institutions. Now, as we will see over and over, exceptional ability is not necessarily the prerequisite for landing a great job, it is the status symbol that is associated with these institutions. Status is an important theme that winds its way through all levels of the web of the economy.
So wealthy kids go to Harvard and land great jobs at law firms that only select Harvard grads, that’s nothing new. It is a microcosm of the greater forces at work and reflective of every other level of the status hierarchy. Middle class students get mid degrees and end up with mid job opportunities. The hiring structure of corporate America has adapted much more slowly than the Ivy League education pricing inflation has sped up. That is to say, corporations still rely more heavily on status signal than due diligence. As we have discussed before, the internet took the first big chunk out of the talent gap, democratizing knowledge, and AI is now becoming the second, commoditizing it. Without proper diligence, in every level in every organization, people are put into positions based on a piece of paper, a friendly recommendation, or a series of brief interviews. I get it, organizations need to hire people quickly, and they have to use all of the tools at their disposal, as archaic as they are. The problem that has compounded over time is that due to internal micro-regulatory-capture, responsibility-moats, or just old school politicking/nepotism/boy’s-clubbing, the people at the top of organizations don’t have the wherewithal or technical acumen to know who to hire or promote. This may have been fine 20 years ago when the breadth and depth of knowledge work was so narrow and shallow, but increases in technology have created exponential changes in talent gaps. The same way that corporations have been slow to adapt to the relative value of an Ivy League education, they have been even slower to adapt to the rapid increase in technological advancements. I wrote a few weeks ago that Brick and Mortar is the new Tech because of the vast opportunity in up-leveling available to that huge slice of the US economy.
People are now entering the workforce less and less motivated to do actual work. That is because the incentive to do actual work has degraded over time, correlated directionally with the material value of educations. Many have attributed this phenomenon to a generational divide where Millennials and Zoomers are “entitled” and don’t have the same drive as their predecessors, but I disagree. The talent level in each subsequent generation has increased in lockstep with technology, but the corresponding personal value capture for ICs is not commensurate, or even correlated in many instances. The effect is that people aren’t learning actual skills, they are learning how to convince an authority figure to advance them to the next level. Some cynics say this is by design, that schools purposefully teach obedience to sedate society. I don’t think anything so nefarious is going on. Occam’s Razor would point to the simple fact that incentives drive outcomes, and there are more economic incentives to be agreeable than to be effective. A great example of misaligned internal incentives leading to bureaucratic bloat is in this interview of George Hotz by Lex Fridman:
Hotz points out that Twitter’s internal promotion policy was based on an engineer’s ability to build a library and get other engineers to use it. Therefore the incentive was not to be more efficient, but to in fact be more complex. An engineer designs something superfluous and unnecessary, but because it ingratiates itself with the broader ecosystem, it gets recognition, and that person moves up the ladder. As Hotz states, the root cause of this issue is the lack of technical acumen in leadership to shoot down inefficient programs and the inability to identify real versus conjectured value. Clearly it is a cyclical problem that compounds over time as those individuals promoted via status signals and increased complexity end up in charge and making the same decisions.
The great thing about this problem is that it is easy to solve! Free market capitalism self-selects for the best companies to thrive as new competitors enter the market. Every company has a score card where they measure success: dollars in the bank. When leadership makes a bad decision that compounds over time, the company simply stops making money at some point and changes are made. The unfortunate side note here is that government regulation often steps in to “slap” Adam Smith’s “invisible hand” that drives free market decisions. Individual Contributors can also choose to buck the system and build their own company rather than work for someone else. This is the obviously riskier option, and involves some luck, but making it in this way is much more merit based, and provides outsized returns. However, as we have discussed, getting access to capital to start something often devolves into the nepotistic arena, or to the institutional definition of what we just described as a “good candidate” i.e. the resume or university degree aka status. This makes the hurdle to create wealth for oneself even higher to climb because even if one has self-taught 10x developer talent, they still have to convince someone with 0x developer talent to give them money. Thus it goes back to the Twitter problem wherein the increases in technology (and with it actual talent) are outpacing the increase of technical acumen of leadership. This is the main reason why I think AI will have such a hard time displacing many jobs despite the upleveling of talent. The pushback from the entrenched within the responsibility moat will be too great.
What is a high performing IC to do? Not getting recognized from the top, or getting their radical ideas shot down (like George Hotz positing the idea that if Twitter refactor their code base they could run the company with 50 people) leads to all sorts of undesirable outcomes. It becomes an increasingly difficult task to search for a leader who recognizes and leans into true value when they see it. Ask any VC, who has to analyze whether a prospective founder is neurotic in a good way, or a delusional one. The job market, and economy writ large is about selling yourself, not about providing tangible value. Indeed these are first world problems, as Maslow’s hierarchy of needs is met up to level 3 for the majority of these people. Are levels 4 and 5 pure luxury?
This brings up an even deeper philosophical question: what is “tangible value” in the greater context of civilization? If the majority of our needs our met, what are the things that we are buying and selling? New cars, new clothes, CPG, entertainment, experiences. All could be defined as “superfluous” if we want to get philosophical. The game we play, at least in the US economy, and others where we export our culture, is one of status, or Level 4 on Maslow’s hierarchy. But what about those striving to achieve level 5?
Technology is inherently deflationary, and as all sorts of products become commoditized, the only reason a consumer is going to pay a premium on a product is for status. Is a BMW a better car than a Honda? Perhaps, if you like the features. Does a BMW do a “better job” of fulfilling its core purpose of getting you from point A to point B? Objectively not. Does a Gucci sweater keep you warmer than one from Target?
Are we still talking about people? Or have we moved into Enterprise Value? Hopefully you are starting to see the interchangeability between the two, in regards to the theme of status and value.
EV
One might ask themselves how organizations can make any money at all with all of this inefficiency happening. As the cost of ICs goes up relative to their tangible value, there is an obvious negative effect on Enterprise Value. And yet, we see over and over again in the market: as stock prices, earnings, and valuations soar, companies increase their headcount up to an appropriate bottom line. There are many factors at play: marketing, marginal cost, Pareto’s Principle, and of course valuations.
At the enterprise level, the same status games are being played. It is about how well positioned your product is to convince consumers to pay a premium. It doesn’t matter if you are Amazon drop-shipping a trinket you sourced from Alibaba, or a Chanel handbag. The seller must arbitrage cost versus value lest we fall into the black hole of Communism, where no risks are taken and incremental progress (however inefficient) drops to zero. Convincing one of another’s status is a sociological and psychological affair. Modern businesses rely on network effects to compound their user base over time. Social proof is so powerful that many are able to fake it with great success (purchasing followers on Instagram, etc.). However you need to get it done, you do it. We aren’t all going to just publish COGS plus OPEX as our pricing. There is a markup to extract a profit, and that markup is equal to the amount of status that you can display in society, either real or hypothetical. As the battle of AI and Authenticity rages on over the upcoming decades, the consumer will have to traverse those waters to find alpha with renewed scrutiny.
As financial markets become derivative, one man’s EV is another’s speculative vehicle. The company who is inefficiently running with a bunch of high priced Harvard grads but struggling to make a profit is at the same time selling shares (aka selling their EV) to investors. The same story plays out, that is, we must convince others that the underlying asset (whether IC or EV) is worth more than it perhaps is. Once a product hits the open market, supply and demand effects come into play, but it is all based on that initial status signaling. We can see this play out objectively with Crypto, VC valuations, and P/E ratios in the public markets, as all have skyrocketed over the past few years. NFTs are the perfect case study for such a phenomenon. Before the token even had utility or tangible value, buyers were bidding up the price so as to secure status. The status was inherently in how much they paid for it, intrinsically valuable to the consumer, if not inherently in society.
We also see a difference in competition from 50 years ago, as the barriers to entry in most markets have become astonishingly low that almost anyone can start any kind of company. Increased competition drives prices lower for the most part, but it bouys the signal of status for that overall sector of the economy. Think about it, if some new niche product is being sold by only one company, say electric vehicles, it can establish the the fact that there is any demand at all. Then, other market participants enter, and the status of the overall sector increases, creating further social proof and increasing network effects. Once some level of network effects are achieved, low marginal cost can take over and the enterprise (or on this case an economic sector) can grow in value.
Now what does that company choose to do with their profits? Well, if they are selling themselves as a derivative in any sort of way, they need to signal future value of growth, which can only be achieved via investment, usually in either R&D or headcount. But the point is that the internal investment itself is the signal. The same way that I invest in my education to signal status to an employer, that employer invests in me to signal status to the market.
Who bears the cost? No one, yet..
In one of my first articles, we discussed how investors consistently get out over their skis by incrementally increasing EV valuations. We actually see the same thing happening with consumer credit. Consumer saving is way down and consumer credit is way up, the highest it’s ever been. We may only thematically be tying over-purchasing and status-signaling between ICs (who are the individual consumers in this equation) and EVs, but both of their behaviors are psychologically consistent. It is actual human ICs manning the helm of these EVs after all.
Many factors drive this increase in consumption. We can attribute it away to ZIRPs and quantitative easing, but there isn’t anything forcing investors to take loans from the government (except of course if you are given free money it would be rude to not take it). There is the psychological economic “ratchet effect” which claims that once a person reach a certain level of prosperity (aka status), they don’t typically reduce their consumption or quality of life voluntarily. There is also the factor of competition, in both EVs (many brands of consumer product options to buy, creating status hierarchies of brands), as well as ICs (what does purchasing X brand over Y say about me as a person?). The fact that competition yields hierarchy is no surprise, but the deeper the hierarchies go, the more FOMO is induced to the consumer. Billionaires don’t actually wear Louis/Gucci/Prada (or if they do, they don’t pay for it), those brands are reserved for the Millionaires, (and tbh probably majority Thousandaires and broke people alike) to status signal.
“Billionaires don’t wear chains”
The simple fact of our financial reality is that everyone is leveraged up to achieve growth, whether that be financing a Rolex in an effort to move up the social ladder, or taking a $1B loan at 5% interest to achieve a 15% rate of return on a risk asset. Einhorn is Finkle, Finkle is Einhorn. Growth is Status, Status is Growth.
GDP
At this point the concept of GDP should be obvious. It’s been said a thousand different ways in financial textbooks, differently than how I am describing it here. We simply have to keep growing otherwise we will die. Tomorrow’s profits must pay off yesterday’s contracts. Or rather, next decade’s profits must pay off last decade’s contracts. It’s not exactly a house of cards as it is Sandra Bullock in the movie Speed. If the bus slows down, it all explodes.
There is no reason to fear catastrophe, however. That is because there will always be something new to satisfy our urge to status signal. Another reason why I don’t think AI will ever send the economy into chaos due to a rapid precipitation in job loss. Firstly, which I have already stated, non-technical people who have created responsibility-moats will be able to effectively insulate themselves for at least several decades. Excel (released in 1985) isn’t even something that a majority of office workers have a good grasp of yet. Secondly, even if there was a monumental drop off in employment rate, the effects would be short lived. New products would be invented (necessary or not) that people with jobs (ICs) would consume, which would create more businesses, and increase EV and GDP. To prove this you can look at any point in history and never find a single time that technology (though it has been warned of many times) has lead to an aggregate decrease in employment. Technology is net deflationary which inherently increases the value of ICs, EV, and GDP. Any time we have had a stark fall off in economic growth has been due to a financial crisis. Namely, the same problem over and over throughout the history of money. Metal reserves turn into fiat currency, which turns into credit, which turn into derivatives. Whenever the underlying asset slips in value (or shows it’s true value), we get hit with a setback. See the Great Depression, the Savings and Loan Crisis, and the Great Financial Crisis. And every time, we print our way out of the situation, increasing the money supply, but the only way that it works is if people use that money to buy things. But when your base needs are met as a society, the only thing to sell is Status and Growth.
Could we tamper back the growth to become more resilient? Possibly, but more than likely the cat is out of the bag. Being accepting of less growth is more Lindy, less risky, saves gas on the Speed bus, is better for humanity (future generations), and dare I say it more moral? Some would argue that “growth at all costs” is the most moral thing to do, as it preserves the system that we have in place. More growth is always better because it allows more entrants into the arena, it increases the quality of life for more people. I can abide by these Milton Friedman-esque philosophies. The only argument against it is that we are putting future societies in financial jeopardy, as we don’t know if there will always be enough gas in the Speed bus (what happens if the whole world goes electric?). Are we leveraging 80% of future society’s quality of life to allow 20% more people to enhance their situation today? Maybe, and maybe it’s worth it. A bird in hand…
I have to assume that Popper would fall into the Friedman camp. Life is objectively made better by capitalism by any metric you choose to measure by. The fact that inequality increases with along with it is a nasty side effect, but it is often forgotten that the lowest parts of society are also raised by the success of the aggregate. Despite whether you think that trickle down economics trickles down enough, there is no contestation that there is, in fact, something trickling down which increases quality of life.
Often, the only difference between two stratas of the economy is status. Does the incremental restaurant outing, or logo on a shoe, or price of a t-shirt have a material effect on quality of life? Assuming the quality of one’s life is not dictated by how much status they wield, then no. Despite that, hundreds of millions of people around the world play that game, working for the better car, and the bigger house. And why not? It’s just a game anyways, and it has the added benefit of driving forward progress for all. So spend your money on something frivolous, and know that it is going towards someone who is going to spend it on something else, and before you know it, it will end up back in your wallet after having ratcheted up a whole slew of people’s lives.