Depopulation: An Investor's Guide to Value in the Twenty-First Century

That's the title of a new short Kindle e-book by Philip Auerswald (@auerswald) and Joon Yun (@DrJunYoon). The book is, in part, a longer-form treatment of several of the main ideas from Auerswald's The Coming Prosperity, particularly Chapter 2: Demographic Dividends.

The book grapples seriously with Walt W. Rostow's observation that: "Up to this point, the conventional concern has been the adequacy of resources and the deterioration of the environment as new industrial countries move forward to technical maturity and beyond. These legitimate concerns give way in the next century to the quite different agenda of societies with declining or stagnant populations."

Naturally the book is strongly recommended, even if, like me, you have no intention to stop burying gold bullion in your backyard (the authors recommend real estate and health care investments as more appropriate alternatives.) You can find the book through Amazon--you do not need a kindle to read it.

Table of Contents

Introduction

Chapter 1: Why depopulation is all but inevitable
The population explosion: A dramatic exception in human history.
A unique characteristic of our historical moment: Depopulation coinciding with aging.

Chapter 2: Demographics and investment from pre-history to the present
The Agrarian Era (40,000 BCE-1800 CE): Riches through conquest
The Mercantile Era (~1200-2000): Fortunes through arbitrage
     The Industrial Era (~1800-present): Wealth through economies of scale

Chapter 3: The return of yield
Four core trends
    Depopulation and aging
    Depopulation and urbanization
    Depopulation and international migration
    Depopulation and price volatility
The return of yield

Chapter 4: How and where to invest in a depopulating world
Impact on Investment by Asset Class
    Equities
        Healthcare
        Human Resource Management
    Real Estate
        Residential real estate
        Commercial real estate
    Commodities
    Fixed income
    Alternative investments
Risk   
    Model risk
    Policy risk
    Threshold risk
    Asset-liability mismatch
    Expectational risk
summary

Chapter 5: "The future ain't what it used to be"
Culture
Politics
Technology
Public Policy

Conclusion

The Algorithmic Frontier

In our recent paper we introduce the idea of the algorithmic frontier to represent our current era of globalization. The idea of a frontier has a long history in American thought, starting with Frederick Jackson Turner’s seminal work, The Frontier in American History (1892). Frederick Jackson Turner wrote of the closing of the American frontier, but the physical closing of a land based agricultural frontier, which he described, marked the end of only one type of frontier. In Agwara et al. we summarize different dominant interpretations of the frontier over the past four hundred years of U.S. history: the agricultural frontier described by Turner (1610s-1880s), an industrial frontier typified by the Ford Motor Company (1890s-1930s), a scientific frontier following WWII (1940s-1980s), and the algorithmic (1990s-present).

The algorithmic frontier coincides with the latest period of globalization that began with the third wave of democracy, the reintegration of China and India into the world trading system, and most recently the end of the Cold War. Although the algorithmic frontier lines up neatly with the large scale resumption of trade, the focus of this paper is not with trade flows per se, but with the mechanisms that facilitated such activity; we are interested in the innovations that have led to our modern system of innovation based on global supply chains.

The primary difference between the algorithmic frontier and the earlier era of the scientific frontier is the rise of distributed networks of production and innovation (Auerswald & Branscomb, 2008). If we view these networks as the principal innovation demarcating the new frontier, then the current era of globalization is really a process of interdependence and interconnectedness (Acs & Preston 1997). The driver expanding the algorithmic frontier is the increasing reach of collaborative networks of all kinds—particularly production, but also research.

Shared standards and business practices have been a precondition to this process of economic integration. In contrast with the traditional multinational assembly of subsidiaries, the global enterprise is a flexible assembly of firms around the world, with skills and capacity that can be drawn upon for the most efficient combination of business processes. Firms traditionally relied on product and internal process standards but the rapid globalization and economic integration witnessed in recent years has created the need for standardization of management systems, which are essentially the interface layer between production subroutines. As then-CEO of IBM Palmisano wrote in 2006:

[S]tarting in the early 1970s, the revolution in information technology (it) improved the quality and cut the cost of global communications and business operations by several orders of magnitude. Most important, it standardized technologies and business operations all over the world, interlinking and facilitating work both within and among companies.This combination of shared technologies and shared business standards, all built on top of a global IT and communications infrastructure, changed the sorts of globalization that companies found possible.

Agwara, Hezekiah and Auerswald, Philip E. and Higginbotham, Brian D., Algorithms and the Changing Frontier (October 1, 2013). GMU School of Public Policy Research Paper No. 2014-02. Available at SSRN: http://ssrn.com/abstract=2377168 or http://dx.doi.org/10.2139/ssrn.2377168

Algorithms and the Changing Frontier

That is the title of a new paper that we recently uploaded to SSRN. The paper was prepared for an NBER conference on the changing frontier in science and innovation - a retrospective on the world since Vannevar Bush's seminal Science The Endless Frontier. The abstract:

We first summarize the dominant interpretations of the "frontier" in the United States and predecessor colonies over the past 400 years: agricultural (1610s-1880s), industrial (1890s-1930s), scientific (1940s-1980s), and algorithmic (1990s-present). We describe the difference between the algorithmic frontier and the scientific frontier. We then propose that the recent phenomenon referred to as "globalization" is actually better understood as the progression of the algorithmic frontier, as enabled by standards that in turn have facilitated the interoperability of firm-level production algorithms. We conclude by describing implications of the advance of the algorithmic frontier for scientific discovery and technological innovation.

The full paper is freely available at SSRN.

How the Peer-to-Peer Economy Expands Opportunity

Testimony by @auerswald at the House Committee on Small Business hearing on "The Power of Connection: Peer-to-Peer Businesses." Other speakers included Dr. Arun Sundararajan (NYU), Ms. Beth Stevens, Assistant General Counsel, Sidecar Technologies, Inc., and Mr. Alan Mond, CEO, 1000 Tools, Inc. - the latter two are examples of innovative startups shaping the "sharing" economy described so well in books like The Mesh" and "What's Mine is Yours." An excerpt from Auerswald's testimony:

In more general terms, the bottom line is this: shared prosperity requires not only innovations that scale-up to create new wealth but also innovations that scale-out to create new opportunities.

Let me be very clear on this point. Much of my own work, as well as important research conducted over the past decade at the Kauffman Foundation in Kansas City with which I have been affiliated, is about the value to society of scale-up innovation—particularly via new entrepreneurial entrants. This research has demonstrated that the small proportion of new ventures that scale-up rapidly are responsible for a disproportionate share of value creation in the economy.

But here’s the problem we’ve run into: while some scale-ups create a large number of new jobs, many do not. Companies like Apple, Google, Facebook, Instagram, and Twitter have all achieved valuations in the tens and even hundreds of billions of dollars, but they directly employ far fewer people per dollar of revenue than their Fortune 500 counterparts did a generation ago. This is where peer-to-peer platforms come into play. By their very structure, peer-to-peer platforms scale-out success to reach tens of thousands, even hundreds of thousands, of people with opportunities to create viable livelihoods for themselves. They create new and enticing invitations to latent producers within the economy to employ their individual assets and talents to create new economic value.

The significance of peer-to-peer business models thus is not effectively measured by adding up the share of GDP they represent in terms of monetized transactions. These innovations in work are rushing in at the fringes of the advanced economies to fill the void left behind as large corporations continue to “lean up”—that is, to shrink their payrolls by employing algorithms and machines to perform routine tasks previously performed by people. As Gansky puts it, “We’re in a period of exploration. While we might be looking at a relatively small magnitude of overall economic activity now in the peer-to-peer economy, it’s happening at a time when all the tried-and-true industries are going through significant transformations.” Steven Straus, former managing director of the Center for Economic Transformation at the New York City Economic Development Corporation, looks at the same phenomenon from the standpoint of service providers: “We currently have about three job seekers for every available job and 11 million people looking for work—so the growth of the sharing economy isn’t surprising.”

In the coming decades, the United States and other advanced industrialized economies will no sooner return to the routinized, manufacturing-centric economy of the 20th century than to the agrarian economy that preceded it. The issue is not whether new livelihoods based on peer-to-peer business models are better or worse than the Industrial Age jobs that are disappearing from large corporations. The real point is that when jobs are eliminated in the process of digital disruption, they will not be coming back in their old form. As that happens, we humans have no choice but to fall back on our fundamental social skill set: creating and sharing with one another. There is, however, one big difference: unlike our isolated ancestors of millennia past, Americans in this century are empowered by architectures of collaboration that allow for the creation of new and diverse livelihoods at unprecedented rates.

Therein lies the potential of today’s peer-to-peer economy.

A Call for Open Access

The Alliance for Taxpayer Access, a nonprofit coalition of organizations that support barrier-free access to taxpayer-funded research, issued the following call to action that might be of interest to our readers.

Call to action: Tell Congress you support the Bipartisan Fair Access to Science and Technology Research Act (FASTR)

Published Feb 14, 2013
Today (February 14, 2013), Senators Cornyn (R-TX) and Wyden (D-OR) and Representatives Doyle (D-PA), Yoder (R-KS), and Lofgren (D-CA) introduced the Fair Access to Science and Technology Research (FASTR) Act, a bill that will accelerate scientific discovery and fuel innovation by making articles reporting on publicly funded scientific research freely accessible online for anyone to read and build upon.

Every year, the federal government funds over sixty billion dollars in basic and applied research. Most of this funding is concentrated within 11 departments/agencies (e.g., National Institutes of Health (NIH), National Science Foundation (NSF), and Department of Energy). This research results in a significant number of articles being published each year – approximately 90,000 papers are published annually as result of NIH funding alone. 

Because U.S. taxpayers underwrite this research, they have a right to expect that its dissemination and use will be maximized, and that they will have access to articles reporting on the results.  The Internet has revolutionized information sharing and has made it possible to make the latest advances freely available to every researcher, student, teacher, entrepreneur, business owner and citizen so that the results can be read and built upon as efficiently as possible.

FASTR will make these articles freely available for all potential users to read and ensure that articles can be fully used in the digital environment, enabling the use of new computational analysis tools that promise to revolutionize the research process.
FASTR will accelerate science, fuel innovation, and improve the lives and welfare of Americans and those around the world. This is an achievable goal – today. Now is the time to push for this groundbreaking legislation, and let Congress know that the public deserves access to the research that they paid for.

You'll find the full call to action here.

South Africa's richest black man is giving away half his wealth

In case you missed it South Africa's richest black man, Patrice Motsepe, has announced he is giving away half his wealth to improve the lives of the poor.

Collaborative Manufacturing

One of the benefits of having workers and management on the same page is that innovation is more likely to occur in this model (basically the Toyota Way.) If we are actually going to experience a resurgence in manufacturing, as so many are today claiming, we will have to find a way to transform our firms into learning organizations that value the input of line workers and who create an opportunity for them to contribute productively with shop engineers and even with supervising managers.

A fascinating article in the Atlantic, "The Insourcing Boom," published earlier this month, features an incredible story about GE moving the production of water heaters in the U.S. from China. It's an inspiring story and hopefully a model for innovations to follow (The Atlantic):

So much has changed that GE executives came to believe the GeoSpring could be made profitably at Appliance Park without increasing the price of the water heater. “First we said, ‘Let’s just bring it back here and build the exact same thing,’ ” says Kevin Nolan, the vice president of technology for GE Appliances.

But a problem soon became apparent. GE hadn’t made a water heater in the United States in decades. In all the recent years the company had been tucking water heaters into American garages and basements, it had lost track of how to actually make them.

The GeoSpring in particular, Nolan says, has “a lot of copper tubing in the top.” Assembly-line workers “have to route the tubes, and they have to braze them—weld them—to seal the joints. How that tubing is designed really affects how hard or easy it is to solder the joints. And how hard or easy it is to do the soldering affects the quality, of course. And the quality of those welds is literally the quality of the hot-water heater.” Although the GeoSpring had been conceived, designed, marketed, and managed from Louisville, it was made in China, and, Nolan says, “We really had zero communications into the assembly line there.”

To get ready to make the GeoSpring at Appliance Park, in January 2010 GE set up a space on the factory floor of Building 2 to design the new assembly line. No products had been manufactured in Building 2 since 1998. An old GE range assembly line still stood there; after a feud with union workers, that line had been shut down so abruptly that the GeoSpring team found finished oven doors still hanging from conveyors 30 feet overhead. The GeoSpring project had a more collegial tone. The “big room” had design engineers assigned to it, but also manufacturing engineers, line workers, staff from marketing and sales—no management-labor friction, just a group of people with different perspectives, tackling a crucial problem.

“We got the water heater into the room, and the first thing [the group] said to us was ‘This is just a mess,’ ” Nolan recalls. Not the product, but the design. “In terms of manufacturability, it was terrible.”

The GeoSpring suffered from an advanced-technology version of “IKEA Syndrome.” It was so hard to assemble that no one in the big room wanted to make it. Instead they redesigned it. The team eliminated 1 out of every 5 parts. It cut the cost of the materials by 25 percent. It eliminated the tangle of tubing that couldn’t be easily welded. By considering the workers who would have to put the water heater together—in fact, by having those workers right at the table, looking at the design as it was drawn—the team cut the work hours necessary to assemble the water heater from 10 hours in China to two hours in Louisville.

In the end, says Nolan, not one part was the same.

So a funny thing happened to the GeoSpring on the way from the cheap Chinese factory to the expensive Kentucky factory: The material cost went down. The labor required to make it went down. The quality went up. Even the energy efficiency went up.

GE wasn’t just able to hold the retail sticker to the “China price.” It beat that price by nearly 20 percent. The China-made GeoSpring retailed for $1,599. The Louisville-made GeoSpring retails for $1,299.

Against Incumbancy

Over at HBR, Philip Auerswald has a good guest post on innovation and the role of entrepreneurs as change agents. He writes (HBR):

As the editor of the journal Innovations, I'm asked with some regularity, "So, what is innovation anyhow? How would you..."? (eyebrows usually furrow here) "... define it?" Since I don't particularly enjoy debating definitions, I usually respond by saying: "That's a difficult question. But one thing is for sure: If you're not pissing someone off, it's probably not innovation."

I like this response because, if it doesn't end the conversation, it usually shifts it from definitions to dynamics — which is what innovation is all about, after all. But I also like it because it captures one fundamental obstacle to innovation that all would-be disruptors must be prepared to face: the potentially hostile response of incumbents who don't want to see their market advantages threatened.

And then he ties this back to Schumpeter's writing. Here's Schumpeter, from Capitalism, Socialism, and Democracy (p. 132):

To undertake such new things is difficult and constitutes a distinct economic function, first because they lie outside the routine tasks which everyone understands and, secondly, because the environment resists in many ways that will vary, according to social conditions, from simple refusal either to finance or buy a new thing, to physical attack on the man who tries to produce it.

This doesn't, of course, have to apply to a lone individual working to change the world. Apple, at least in its current iteration, is clearly an innovative company. By that I am alluding to Auerswald's definition of an innovator as one who pisses people off. On the same day that Phil wrote his piece, there was a great example of the sometimes antagonistic relationship between Apple and AT&T, this despite the fact that around 60% of AT&T's phone sales in Q1 2012 were iPhones. Check out a few of the great quotes from AT&T's CEO, Randall Stephenson (i.e. the evil incumbent) at a recent conference (NYT):

Mr. Stephenson said he worried about services that could replace the company’s own offerings. For example, free Internet-based messaging services like Apple’s iMessage are eating into the company’s revenue from text messages.

“You lie awake at night worrying about what is that which will disrupt your business model,” he said. “Apple iMessage is a classic example. If you’re using iMessage, you’re not using one of our messaging services, right? That’s disruptive to our messaging revenue stream.”

Now, if you're a shareholder of AT&T, you'd probably be pretty happy knowing that the company is actively looking for ways to retain their core profit streams. On the other hand, if you're a consumer, you're pretty happy that Apple is doing what it can to improve its customers' experience. Along the way, innovators like Apple improve consumer surplus by challenging the status quo. The lesson is that incumbents worry about potential disruption while innovators (entrepreneurs/social entrepreneurs/change agents...) lie awake at night worrying about how they can create value and change the world.

The gains to consumer surplus from increased competition are far higher than the gains to incumbents, but we spend most of our precious political capital protecting incumbents. It's time to move beyond left and right - the real debates of the 21st century revolve around how we can better enable entrepreneurs to create value and find solutions to global problems.

An Economics and Evolutionary Biology Reading List

You'll find it here, via MR. I find it to be a fine yet incomplete list. A few additions. In terms of popular books, one commenter added Eric Beinhocker's Origins of Wealth. In my mind this would be the place to start. It's great and I recommend it strongly. It seems to me that evolutionary economics offers a less complete vision than complexity theory, and you get a lot of that in Beinhocker as well. Melanie Mitchell's book, Complexity: A Guided Tour, is a good companion to Beinhocker, though off our current topic.

If you want something on the academic side, works by Stan Metcalfe (1, 2) should be included and the Nelson/Winter treatise is canonical, yet missing. Really everything by Nelson. Start there, and then read Baumol's Microtheory of Innovative Entrepreneurship, or perhaps the gentler, The Free-Market Innovation Machine.

I am less qualified to offer recommendations on the biology side, though I found Stuart Kauffman's work to be uniformly excellent. His At Home in the Universe is an easier read than Origin of Order, but both are great and highly recommended. Not all of the conclusions are universally accepted, though epistasis and fitness landscapes (and Kauffman's NK model) should be important concepts in the social sciences. Ernst Mayr's What Evolution Is, is a fine introductory book written for non-specialists.

This is all tip of the iceburg of course, but it's nice to see so much new work in this field. Most of this remains outside the mainstream of economics, with the partial exception of Nelson/Winter and Metcalfe. In part this reflects a general wariness of evolutionary concepts, which have been grossly misused in the past. But it also reflects a desire by economists, in particular, to maintain their focus on equilibrium and optimization analysis, their two primary tools. An evolutionary perspective can be made to fit these tools, but it does present a challenge to them as well.

And it should go without saying that I'd recommend reading lots and lots of Schumpeter.

From Reset to Prosperity

The recent financial crisis and subsequent recession have left many of us reflecting on our prospects for the future and even revived earlier debates about whether we should have come down from the trees in the first place. 

In “Reading About the Financial Crisis” (JEL, gated |ungated |NPR story), financial economist Andrew Lo attempts to make sense of the first wave of scholarship on the crisis. Unfortunately, according to Lo, academic economists, policymakers, and journalists have been unable to even reach agreement on the basic facts of what went wrong.

While the financial crisis still resonates because of its immediacy, several scholars have begun to make the case that the downturn occurred for systematic reasons representing broader forces. Three recent books from George Mason University (GMU) faculty, and one from a former professor at the School of Public Policy (SPP), attempt to put the recent downturn in broader perspective.

In Tyler Cowen’s provocative treatise, The Great Stagnation (2011), written for the Kindle (and only later published in hardback), we learn that the downturn is only the latest example of a broader and more  fundamental slowdown in our potential rate of growth. This slowdown arose, according to Cowen, because the costs of innovation have risen as we picked all of the low-hanging fruit. New innovations become more reliant on greater specialization and higher rates of knowledge accumulation and as a result become more difficult to produce. Since I talked at fairly great length about Cowen’s work in this earlier piece, I’ll leave it there for now.

Alex Tabarrok's Launching the Innovation Renaissance (2011) is an almost perfect companion to Cowen’s work. Tabarrok, Cowen’s co-blogger at Marginal Revolution, jumps off from the great stagnation, and then asks how we might reform our current policies to reinvigorate our innovative capacity. Tabarrok’s suggestions range from reforming our patent system, to increased reliance on prizes and other incentive mechanisms, to rethinking education and transforming our immigration system. Taken together, these two works provide a coherent view of what’s gone wrong, and one possible set of reforms we could make that would help us get back on track. In terms of "bang for the buck" you get a lot from Cowen and Tabarrok's works. Two recent books build on these themes, but devote more space and depth to their topics.

Richard Florida, a former Hirst Professor of Public Policy at SPP (and now Director of the Martin Prosperity Institute at U. Toronto) frames the recent downturn as a “great reset.” In The Great Reset (2010), Florida writes that our current recession is reminiscent of earlier severe downturns in the economy, such as the Great Depression and the Long Depression of 1873. These earlier crises are notable not just for their severity, but also because they launched new ways of thinking about the world and spurred long periods of inventiveness. These resets purge what is not working and reinforce positive trends that are leading to growth.

Throughout Florida’s narrative, we learn that our economy is currently moving through a such a reset, as we shift from a managerial economy, epitomized by General Motors, into a knowledge driven economy that relies on individuals in cities as the central unit of organization. In an interview for the Atlantic, Florida states (The Atlantic):

There are two tendencies in the world economy. There is a great tendency for low-cost, fairly standardized stuff to spread itself out, and that’s where people say, “Oh my God, the world is flat.” But there’s also this counter-tendency for things to concentrate—to take advantage of these forces of agglomeration and human capital. So what I tried to argue is that that second tendency is very important.

[…] What I tried to do in this piece is say, “I don’t think this great crisis—or great ‘reset,’ as I like to call it—will change this trend. In fact, my hunch is that, coming out of this crisis, our geography will end up more concentrated than it was before.”

One promising trend that Florida cites is the growing concentration of human capital around cities and “mega-regions” like the Boston/New York/Washington corridor. The challenge will be for isolated cities like Pittsburgh to connect to these broader networks. Connecting people in ever-denser networks has become the fundamental challenge in the 21st century.

Finally, Auerswald’s The Great Prosperity (2012) ties together these disparate themes and extends the analysis to the global economy. Auerswald sees entrepreneuers as the primary force driving the outlook and the book focuses on the remarkable actions entrepreneurs are taking to address global challenges. Like Tabarrok, Auerswald also sees incredible potential from immigration and the spread of ideas, but frames the discussion in the broader context of a growing population, which is often portrayed as a coming threat. Unlike earlier theorists like Malthus and Ehrlich, Auerswald, channeling Michael Kramer, explains how new people create new ideas and fundamentally reshape our approach to existing challenges. As in The Great Reset, we learn of the fundamental importance of creating value through connection and collaboration.

In an excellent review of Why Nations Fail, Auerswald reiterates this point (growthology, see also Fukuyama’s review for a similar take). Fundamentally the story of how institutions and economies evolve is a story about people and how: “actual people, or groups of people, acted at particular points in time to push back against incumbent interests, change institutions, and in so doing move the arrow of history."

Through case studies of disparate entrepreneurs, ranging from a mobile phone revolution in Afghanistan to Victoria Hale, who has successfully utilized “orphan drugs” to address issues of global health, Auerswald demonstrates that historically intractable problems can be solved through entrepreneurial solutions.

Our current myopic focus on the past decade and the two most recent recessions and "jobless recoveries" misses the broader and fundamentally promising trends currently underway. Florida and Auerswald both provide excellent maps of our changing terrain, and Tabarrok provides one potential path for the U.S. to escape its current malaise.

The contemporary works that Andrew Lo cites will be crucial to future historians as they reconstruct what went wrong and how we can learn from this experience. But if you're trying to get a sense of where we're headed, and why, you could instead read these two short monographs and two books. Even better, if you actaully want to participate in changing the future, these books serve as important blueprints.