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Modern Capitalism’s Furnace

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Modern Capitalism’s Furnace
Skyscrapers in city financial and business district, downtown. Corporate work. Source: Zignox.

MEXICO CITY — Here´s a little secret about me. Although I spent the last 15 years of my life talking and writing about inflation, central banks, exchange rates and the like, I am at heart a microeconomist. Earlier in my career I was interested in the study of the firm and its nature, as well as of the environment in which it either thrives or fails. It didn’t take long into that route before I stumbled into the issue of technical progress. Why and how firms innovate? These are crucial questions if we really want to understand economic growth.

Joseph Schumpeter was arguably the first great economist interested in innovation. He originally associated this phenomenon with new firms entering an industry, with “disruptors”. Years later though, Schumpeter changed his view and argued that the R&D departments of large industrial conglomerates were the main conduit for technical progress: innovation as a corporate process. This appeared more in line with what the world experienced in the second half of the 20th century. However, so far in the 21st century, things appear to be moving back towards the original Schumpeterian view.

Innovation is nowadays associated to disruptors, and it is linked to a key concept: Venture Capital (VC). This is much more than mere financing. It is better described as the furnace where ideas are forged into business models that are then relentlessly tested by intense competition. Those who win this evolutionary game can reap substantial rewards: The Economist calculates that about USD18 trillion of value in public stock markets are explained by companies hatched by VC.

Thanks to the generosity of some good friends, I have been able to take a closer look to the VC world. The range of ideas as well as the dynamism of the sector is indeed impressive. But I have also found that some of the old rules of industrial organization still apply on innovation street.

Most projects in VC space involve the application of General-Purpose Technologies (GPT) to a range of activities and/or production processes. Thus, we have Artificial Intelligence, Cloud Computing or Distributed Ledgers for instance being applied to disrupt different sectors, giving rise to the proliferation of terms such as FinTech, PropTech, AgriTech and the like. A common feature of all these GPTs is that they can be used simultaneously by either one or many people but nonetheless can be protected by patents. Thus, economies of scale can be substantial, as the marginal cost of incorporating new customers is near zero while profitability is ensured by the rents generated by intellectual property rights.

Economists have long been aware that in these conditions, early success is self-reinforcing. Thus, instead of a landscape of firms of various sizes and different stages of developments, what we have is the emergence of a few juggernauts that aim at dominating an industry by radically changing the way it operates. The response of incumbents in these sectors is also consistent with what industrial organization would predict: buying out the innovator is often the best defense.

For industrial countries this raises new dilemmas in terms of competition policy. Regulatory clashes between tech tycoons and governments are bound to continue. A subtler, albeit more important policy challenge involves income distribution. VC firms are bound by the age-old principle of higher return being associated with more risks. As such, they offer opportunities to sophisticated, wealthy investors. Unless we find ways of democratizing these opportunities, the gap between the super-rich and everyone else will continue to widen.

For our region of the world the implications are equally far-reaching. Investment in Emerging Markets (EMs) have long been predicated on the idea of convergence: poor countries grow faster than rich ones. In contrast, the thesis behind VC is that the technological frontier keeps moving forward and that growth is associated with reaching that frontier first. As an asset class, VC might therefore could become the new EM.

It is a sobering thought. How can Latin America compete with VC for attracting investment? I believe the answer might involve combining the best of both worlds. The scope for efficiency gains in activities across the region is significantly larger than in industrial countries. Thus, potential gains from disruption and innovation are substantial. We already have several examples of challengers defying the status quo in industries ranging from retail, to finance, to transportation, often operating on a regional, rather than a national basis. In Argentina for instance VC is behind some of the recent stories of entrepreneurial success in an otherwise tepid business climate. Sao Paulo and Monterrey are devoting an increasing amount of their entrepreneurial capital to these possibilities.

In this regard, what can we do to foster this trend? I believe that paradoxically, we need more and less government. More because VC flourishes if we provide a strong legal framework that reduces contractual uncertainty. Less because we also need policymakers who resist the temptation to over-regulate. It is time for Latin American to heed the early advice of Schumpeter and unleash disruption.

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