Source: Forbes

The malaise that we have started to notice in the world around of the protracted recovery from the 2008 financial crisis will stay if we don’t dramatically change our perspective of the economic world. I had written about the article that Clay Christensen wrote in New York Time a week back, I think once again he is spot on in terms of what is causing this painfully long recovery from the recession. Dr.Christensen talks about 3 types of innovation, they are:

  1. Empowering Innovation
  2. Sustaining Innovation
  3. Efficiency Innovation

In my opinion most Startups should fall in the Empowering Innovation category because they should be actually solving a problem that current businesses are not able to solve, therefore they generate new jobs and as Dr.Christensen says:

These transform complicated and costly products available to a few into simpler, cheaper products available to the many.

The Ford Model T was an empowering innovation, as was the Sony transistor radio. So were the personal computers of I.B.M. and Compaq and online trading at Schwab. A more recent example is cloud computing. It transformed information technology that was previously accessible only to big companies into something that even small companies could afford.

Empowering innovations create jobs, because they require more and more people who can build, distribute, sell and service these products. Empowering investments also use capital — to expand capacity and to finance receivables and inventory.

Unfortunately, many in the investor groups are stuck in the Sustaining and Efficiency innovation mindset and that is the main reason why it is extremely hard to get capital allocated into the empowering innovation cohort even though we have plenty of capital and more being pumped into the economy every day by the Federal Reserve and Central Banks of the world. How simple it would be if our central bankers understood this dynamic. We are stuck in thinking about investment in IRR or ROIC terms. When you are investing in empowering innovation you dont usually know the transformative power of the technology or the innovation and it is hard to measure the IRR or ROIC on them. This is typically the Venture Capital space. We have misaligned our understanding of Risk to say that these investments are risky, I beg to differ. We thought banks were safer investment but it turned out that they were only safe for those working in the banks not for the shareholders.

Coming back to the discussion of jobs, I really like the structural reason that Clay Christensen outlines as the symptoms and recovery of the recessionary periods:

Ideally, the three innovations operate in a recurring circle. Empowering innovations are essential for growth because they create new consumption. As long as empowering innovations create more jobs than efficiency innovations eliminate, and as long as the capital that efficiency innovations liberate is invested back into empowering innovations, we keep recessions at bay. The dials on these three innovations are sensitive. But when they are set correctly, the economy is a magnificent machine.

After the financial crisis in 2008, these dials have been broken by the capital misallocation problem because of the amount of capital that was wasted and had to written off because of the crisis. Adjusting the economy to accomodate that is going to take time but it behooves everyone to understand the above dynamic. We need to dramatically change how we allocate capital, train ourselves and our workforce, disrupt our education system to prepare our next generation to take on these challenges etc. I like all the ideas that Clay Christensen recommends, if implemented I think we will solve a huge incentive problem for the investment community.

CHANGE THE METRICS We can use capital with abandon now, because it’s abundant and cheap. But we can no longer waste education, subsidizing it in fields that offer few jobs. Optimizing return on capital will generate less growth than optimizing return on education.

CHANGE CAPITAL-GAINS TAX RATES Today, tax rates on personal income are progressive — they climb as we make more money. In contrast, there are only two tax rates on investment income. Income from investments that we hold for less than a year is taxed like personal income. But if we hold an investment for one day longer than 365, it is generally taxed at no more than 15 percent.

We should instead make capital gains regressive over time, based upon how long the capital is invested in a company. Taxes on short-term investments should continue to be taxed at personal income rates. But the rate should be reduced the longer the investment is held — so that, for example, tax rates on investments held for five years might be zero — and rates on investments held for eight years might be negative.

Federal tax receipts from capital gains comprise only a tiny percentage of all United States tax revenue. So the near-term impact on the budget will be minimal. But over the longer term, this policy change should have a positive impact on the federal deficit, from taxes paid by companies and their employees that make empowering innovations.

CHANGE THE POLITICS The major political parties are both wrong when it comes to taxing and distributing to the middle class the capital of the wealthiest 1 percent. It’s true that some of the richest Americans have been making money with money — investing in efficiency innovations rather than investing to create jobs. They are doing what their professors taught them to do, but times have changed.

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