The Mind of an Independent

In a recent letter to investors, Bill Gross writes about a $15 trillion overvaluation of assets. This overvaluation represents an astonishing 100% of nominal GDP, which suggests that our assets appreciated beyond our actual production, creating expectations of asset growth that were unsustainable. While economies are run in large part on confidences (see Schiller’s compelling ideas of “Animal Spirits”) when over half our economic production is underpinned by a confidence game, I’d say we’ve got to watch out.

This crisis began because incomes simply could not keep up with asset appreciation. The crisis metastasized in large part due to the securities that were created on intricate spreadsheets using asset appreciation assumptions, rather than real income assumptions (there no income growth, so why assume). When these assumptions failed, so did the securities, setting off a viscious confidence crush that led to the demise of financial institutions which formerly looked unimpeachable. Now the entire ecosystem of asset creators and amplifiers stares blankly (though talks optimistically and lobbies vigorously) at a world growing decidedly more asset poor. With dwindling real assets to securitize and little real risk capital we’re left creating securities based on assumptions of our mortality (check out the latest life insurance securitization which pays off for investors if you die before your life insurance pay out. Life and death arbitrage, sweet!!). While I acknowledge that we’re in the midst of a carry trade fueled asset boom, in the long term the real growth must once again reside in the productive REAL economy, if for no other reason than to create a larger real economic base for the securitizers to plunder again.

Income growth and product development require experimentation, without experimentation the data to grow a business cannot be generated.  The problem with experimentation is that it does not produce linear growth over short time periods. This lumpiness is why we adore the derivatives and off balance sheet vehicles that allow us to use asset management to smooth earnings. This market culture, which demands linear quarterly earnings growth, had roots with GE’s stunning earning’s consistency and reached its apotheosis with Bernie Madoff’s 10% a year returns.

Let’s face it, there is significant correlation between risk and return. The higher the risk the higher return. However, massive returns with little visible risk is indicative of a structural problem, not a stroke of genius. Structural problems build beneath the surface till eventually they crack the foundation, causing catastrophic failure to the structures above.

The industrial market economy with its demands for linear quarterly earnings, massively scaled products and super efficiency has created processes which have and will continue to destroy our ability to generate real value. However, there is a path forward. In an industrial economy eliminating risk is part of improving efficiency; the most efficient process is a product of winnowing down.  Winnowing down uses data to guide decision making around the most effective path from raw to finished product. Use of data is the continuity between the industrial and network economies and what we must focus on as we embrace the rapid product and business model innovations taking place in our rabidly Schumpterian marketplace. 

In the network economy managers must constantly take product risk because their product advantages are so short term (see Doctorow’s The Makers). In fact a good network manager would encourage destructive forces within her own organization. In the network age the efficiency driver is not found in the process (input) stage, it’s at the product (output) stage. The value add of process efficiency is diminishing (Six Sigma is a commodity) and in its place is the value add of product creation efficiency. The scary part for current managers of product creation efficiency is that you can’t hide!  The only way to iterate quickly enough is to deliver a product to a customer, warts and all, and listen to their feedback. That feedback may often be negative and your work product in a traditional sense will have failed, but in a network sense you’ve simply winnowed down your options and added a new data point to guide your next product iteration. In addition and perhaps most importantly you’ve shown your customer how important they are to your success, through honesty and humility you’ve established a long term relationship.

So to get back to where we started. Bill Gross recognizes that asset appreciation has untethered from our real production levels and created a massive levered bubble. That bubble popped (we’ll see how long this commodity bubble lasts) leaving us with an economy that must grow differently. Unlike the past 30 years it cannot grow through asset appreciation, but through real goods and services production. We are mechanically ready for this change. I’m just not sure that we’re organizationally ready for this change. Taking the lead from Apple, Amazon, Etsy, Threadless, Ford, Google and others, lets buckle down and blow the New Normal out of the water with incredible productivity built on honesty, competitiveness and intelligence.