What is an “intangible asset,” and why are we investing so much in them? How are these so-called intangibles reshaping our economy, as well as our fundamental approach to economic concerns? Joining me today to answer these questions is Stian Westlake, the co-author of Capitalism without Capital: The Rise of the Intangible Economy. Stian is also the co-author of an important economic plan for the UK, entitled Reviving Economic Thinking on the Right, which we discuss as well.

Stian is a Senior Fellow at the UK’s national foundation for innovation, Nesta. He was also a policy adviser to the UK Minister of Science, Research, and Innovation. An Oxford and Harvard graduate, he is also the founder of Healthy Incentives, an enterprise focusing on healthcare initiatives.

What follows is a lightly edited transcript of our conversation. You can download the episode here, and don’t forget to subscribe to my podcast on iTunes or Stitcher. Tell your friends, leave a review.

Pethokoukis: I’ve been meaning to chat with you for some time about Capitalism without Capital, which you wrote with Jonathan Haskel. It’s a great book, but then I ran across a brief policy memo on the UK economy that you co-authored called Reviving Economic Thinking on the Right. This is the part that was really exciting to me:

“The right should be unashamed of the fact that it wants to make Britain boom again — to create good jobs, to enrich people in the places they live, and to give them the freedom and opportunity to lead better lives. Informed by the principles we’ve identified – the importance of productivity growth, agglomeration effects, intangible capital, and Britain’s persistently low levels of investment – the policies we set out below are a plan for creating prosperity in the UK.”

Now, this is about
the UK, but it seems to me that a good chunk of that mission statement, and the
paper in general, could easily apply to the American economy where productivity
and economic growth have been stuck at historically low levels.

And for some time I’ve been writing about the need to update economic thinking on the right. I sometimes think of the sarcastic joke from President Obama — there’s some truth to it: Too often on the right, the policy idea is, “Feel a cold coming on? Take two tax cuts, roll back some regulations, and call us in the morning.”

Instead of updating and expanding that agenda, what happened on the right was we turned backwards to focus on protectionism and economic nostalgia for the economy of the 50s and 60s. But a key thesis of Capitalism without Capital, which certainly informs your memo too, is that there’s been a fundamental change in the nature of advanced economies in recent decades.

So let’s talk about
that fundamental change which you write about in the book.

Westlake: This big change that’s been going on in the
economies of the rich world is about the nature of capital. The nature of what
businesses invest in.

Once upon a time, what businesses invested in was mostly
physical things — machines, factory buildings, vehicles, computer hardware —
things that, if you hit it with your foot, you’d stub your toe. That’s been
gradually changing for at least 40 years, and each year, businesses gradually
invest less in that physical stuff and more in in what we would call
“intangible assets.”

These are things that, like physical capital, have a long
term value. But they’re immaterial. Things like research and development,
designs, organizational capability, and even brands, marketing, and artistic
originals.

The reason why we think this is a significant change is that these intangible assets, from an economic point of view, behave differently to tangible capital.

How was this stuff
counted in GDP, and has that changed at all?

It has changed — this has been a big push by academics, national statisticians, and others over the last 20 years to record this stuff better. So people like Carol Corrado from The Conference Board here in the US really led the charge on this. They’re gradually introducing things like R&D, better measures of software and other things like artistic originals. So increasingly, probably about half of this stuff is now in GDP.

So previously, did
software not get counted, or it wasn’t counted as an investment?

It wasn’t counted as investment, but rather as an expense.
So it was treated like your paperclip bill for your business.

But obviously, as you and I know, if a business invests a
lot in proprietary software that creates all the value for the business in the
long term, that is an asset in the same way a machine or a factory is.

And so far in
advanced economies, generally we don’t count things like brand–building or
marketing.

And, you know what? To a certain extent, maybe some of this
stuff is impossible to count up or ultimately include.

If you talk to someone like Baruch Lev at New York University, he would say that when you look at company accounts, you can never really count this stuff. So in a sense, corporate accounts seem to be drifting further and further away from business realities in a way that you probably can’t fix.

So when was the key
point where we saw intangible investment overtake physical investment?
Certainly to this day, you’ll hear a lot more about how businesses need to
invest more in machines and buildings. A lot of focus still seems to be on
that, so when did the handover actually take place?

The crossover when businesses in places like the US and UK
started to invest more in intangibles than tangibles was about the middle of
the 2000s. So, somewhere just before the global financial crisis.

Right, so I think
it’s profoundly weird at least in the US — I won’t speak for Britain — that so
much of the economic conversation is on the older side of that crossover. It’s
all about somehow restoring that economy of coal, steel, and mills from the 50s
and 60s.

I think there’s a good reason for that and a bad reason. The
good reason is that things like advanced manufacturing and advanced mineral
extraction are good for the economy. They create good jobs, they create value
added — that stuff is not made totally irrelevant by the intangible economy.
And indeed, an advanced manufacturing business uses a lot of intangibles as
well along with the factories.

That’s the good reason, but there’s a bad reason, too. You
might call it “policy nostalgia.” And sometimes, understandably, politicians like
to tell stories. Stories that voters and pundits often recognize are stories
about the past. Stories about what the economy was like in the days when
productivity growth was high, wage growth was high, nuclear families were
abundant.

You really have to ask yourself the question: Will harking back to the mode of production in those days get us the economic benefits that used to obtain then, or is this more of a cargo cult?

[laughs] Thank you for
putting “cargo cult” in there. And of course in the 50s and 60s there were some
unique, one-off factors that would be hard to repeat. That’s not even
mentioning that we have economies recovering globally from World War II.

That’s absolutely right. I think generally, particularly
because this dominant mode of production has changed because of intangibles
being more important, you can’t wind the clock back in the same way.

In the book, you list
the key aspects of the intangibles as the “Four S’s.” The first is they’re
scalable. What does that mean? They can get bigger?

If you’ve got a really invaluable intangible asset like,
say, the Uber algorithms that make the Uber application work, a little bit of
valuable intangibles can go a long way.

So, if you think about the Uber application — I use it in
London, I use it when I come to Washington DC, I go to Budapest and Hungary and
I use it. It’s the same algorithm.

Now, contrast that with a tangible investment like a
factory. You’ve got a factory, you have a limit to how much you can produce in
that factory before you need to invest in a new production line or even a new
building.

That’s the scalability of intangibles — it means that if you
own a really valuable one, that can be scaled across an often arbitrarily large
distance.

So it shouldn’t be surprising that we have these very big technology hubs where intangible investments are the core of what they do. I suppose it also shouldn’t surprise us that companies seem to have the ability to have little physical equipment or even employees and still get very, very big, like some startups.

I was trying to dig
up the quote: “In the past, it would take 500 employees five years to generate
sales of $5 million. Now you can have five employees generate sales of
$500,000,000 fairly quickly.”

That’s true, and that Silicon Valley dream that every
investor or startup–founder has is founded on the scalability of those
intangible assets.

Sunk costs seem like
another complicated economic concept, but how do they apply to intangibles?

The idea of a sunk cost is that if the business has an
investment that’s intangible, if the business fails for some reason, that
investment is what economists call sunk. It’s not very much use to someone else
who buys the asset or the business, nor to a creditor.

It’s not like a bunch
of bulldozers or forklifts where you could somehow sell the property itself, or
a building where you could recoup some of the cost.

Right. To take an example: Those of you with long memories
may remember Nokia, the mobile phone giant. Nokia had a bunch of intangible
assets — operating systems and so forth. They also had a vast research and
development campus in Helsinki, Finland.

That campus, a tangible asset, as soon as Nokia got into
trouble, was immediately sold. It was full of tenants, so now it’s a thriving
place, so that wasn’t a sunk cost. But while its operating system was bought by
Microsoft for $5 billion, within 18 months Microsoft realized it was worthless
and took the entire cost of that charge as a write–off. That’s what we mean by
intangibles being a sunk cost.

The other aspects are
the synergies and spillovers — things you get with intangible capital that you
don’t get with the traditional kinds. They make it helpful for these businesses
to be close together like in Silicon Valley.

Exactly right. The spillovers and the synergies have a
similarity in the sense that these assets are very good when you combine them
together.

So, a product like the iPhone is based on the synergies of
lots of intangibles, like the design, the structure of the App Store, and the
R&D for the product.

The spillovers, on the other hand, mean that very often if you invest in intangibles as a business, you can’t be sure that your business will get the benefit rather than a totally different business. The classic example here is how Xerox PARC developed a lot of the technology behind WYSIWYG [What You See Is What You Get editing software] and graphical user interfaces that Microsoft and Apple then commercialized.

In a way, having
businesses with employees that transfer between businesses and start new
businesses with knowledge or know how from some other company is important.

For the intangible
economy, you need those hubs — and every mayor, governor, or even president
would love to create these tech hubs for good reason, as your saying. Those
hubs are really important if you want to have a productive economy going
forward.

And because intangibles are becoming more important, those hubs and the so-called “agglomeration effects” are getting more important. That creates a challenge if you’re a mayor of a left-behind place — your disadvantage is growing and growing.

The other side that
you write about is that this generates a natural inequality, where you have
regions or even certain companies which do very well while others fall behind.
That’s exactly what we’re seeing in the economy.

There’s been a lot of
concern about companies not investing enough, but that’s really just some
companies. Some of them are investing a lot, and some companies’ employees are
doing fantastically. And to some degree, when we talk about inequality, we’re
not talking about the differences between the CEO and the lower-paid employees.

You’re really talking
about all of the employees of one
company are doing much better than all of the other employees at a company somewhere else that’s not doing well.
That’s the real inequality problem.

That’s exactly right, and I think some of the research we’ve
seen in recent years using both US and Scandinavian data where there are good
data sources shows that this accounts for the majority — something like 75 or 80
percent — of the increase in income inequality we’re seeing. We think that’s
really driven by this gulf in intangibles.

So that’s the broad
outlook of what all this means. Now let’s look at some of the key issues. I’ve
read a lot about the Trump tax cuts in the US: One thing they were meant to
boost was business investment.

Business investment
has been weak for a number of years, and indeed, in spite of these tax cuts
including one to the corporate tax rate investment is still weak. What does
your research tell us about that? Is there something else going on with
business investment that perhaps cutting the corporate tax rate won’t fix?

We think there is. In this new world of intangibles, a lot
of investments with aspects like synergies and spillovers are really worth
making if you’re Google — if you’ve already got valuable intangibles and can
take advantage of the scale. But if you’re a less-favored firm that can’t
benefit from those, the winner-takes-all effect will in fact discourage you
from making those kind of investments.

So if you think about what that means, it means that there’s
a stronger case for greater incentives to do things like R&D, looking
carefully at competition policy, and trying to make sure that, wherever
possible, we create a dynamic market. A market where small attacker firms can
also scale rapidly and won’t be crushed by incumbents.

Part of the issue, then, is that if you’re at a firm that’s already doing well with lots of smart people with PhDs from the best business schools, you can take advantage of the latest advances in robotics and AI rather quickly.

Other companies may
eventually catch up, but it may take a while, or they may say, “We can go buy
this stuff, but we’re never going to get a good return. We just don’t know how
to use it well in our business.” So they won’t make those investments.

And if those
investments are becoming more important, then maybe we shouldn’t be surprised
right now that we’re not seeing an explosion in business investment just
because of a tax cut.

Right, we think this helps explain this effect of secular
stagnation, where there’s a combination of what seems like a fantastic time for
technology, a time where some companies seem to be posting incredible results
for ROI in companies like Google, but the aggregate levels of investment are
still low. We think that bifurcation helps explain that.

An alternate
explanation has been that the problem is with corporate governance. That you
have these CEOs under a lot of pressure from shareholders to generate good
returns over the next quarter or two.

Because of that
short-term mentality from “Shareholder capitalism,” these companies just aren’t
investing. How much merit does that alternate explanation seem to have, if any?

So I spent a long time talking to CFOs and sell-side
analysts about this question over the last 10 years, and one of the things I
think comes across is that analysts are trying to work out which of those two
categories a given company falls into.

Are they in the category of companies that you can trust to
make risky intangible investments because they can internalize the benefits and
spillovers? Or are they in the “also-ran” category — the category that can’t
benefit? And you see that if you’ve got a company that’s seen as a growth
prospect, they often have remarkable leeway from corporate governance to make
investments.

This is a constant argument between CFOs and analysts at
companies like Google, or Tesla, more notoriously. But when you convince
analysts that you’re in that category, a lot of these “short-termism”
criticisms don’t apply, and you see companies making long-term investments.

But in some sense, analysts are responding quite logically
to this new economic reality.

So if an analyst or
investor thinks, “You’re the kind of company that hasn’t shown a great ability
to incorporate acquisitions or new kinds of intangible investments in the
past,” then they’re going to give you a short leash. “Perhaps you should be
focusing more on cutting payroll, becoming more efficient, or other things.”

Right, focusing on your core business and giving money back
to shareholders.

“You can’t be trusted
to do this.” So it’s almost like we’ve confused this. It’s not like corporate
America isn’t investing. Certain parts are, especially these big tech
companies.

I think that’s correct, and the bigger problem is not with
public equity in the stock market, but with debt markets. Which is obviously
the source of most external finance for businesses.

This comes back to the fact that these intangibles represent
sunk costs. If you’re an equity holder and the company you’ve invested in goes
bust, you get nothing. So you don’t care whether the investments are sunk costs
or not — you have no recourse.

If you’re a lender, a bondholder, or a bank, you care about what you get in the case of business failure. And this has been called by people like Stephen Cecchetti “the Curse of Collateral.” In an intangible economy, because these assets don’t represent collateral, if we depend mostly on debt finance for our economy then what Keynes called “The capital development of the economy” will be ill-served.

Much of what we’ve
just discussed informs your policy memo, so let’s just go through a bit of it.
One of the areas you’re talking about in this is housing. That fits very nicely
into what you were just saying, because in Capitalism
without Capital, you talk about the importance of tech-hubs which do very
well with property values that go up a lot more.

People who live there
are going to have a big jump in wealth inequality, and to a great deal this
explains the growing disparity in wealth that has been a big issue. Talk a
little bit about what you’d like to do for housing — granted, this is
recommended for Great Britain, not the US, but what should policymakers
generally think about regarding housing and the importance of having regions
with these synergies and spillovers?

If you look at places around the world where the intangible
economy is thriving, these tend to be dynamic cities or dynamic suburbs like
Silicon Valley. But in all of these places we’ve seen skyrocketing property
prices. As people like Enrico Moretti point out, this is bad for the
development of the knowledge economy, and it’s also bad for ordinary working
peoples’ wages.

When the housing market works well, you can move from a poor
place to a better-off place and earn a high salary even if you’re not in a
glamorous high-tech job. You’ll still earn more by making coffee, or cutting
hair, or being a builder there. But if all of that is being eaten up by your
rent, or your housing cost, or your mortgage, then there’s no benefit and the
economy doesn’t thrive from that.

So the thing we’ve been recommending is planning,
deregulation, making it easier to build houses so that more people can take
advantage of benefits to the intangible economy, and the economy itself can get
better.

That policy
recommendation is a beautiful, elegant, obvious thing. It’s very easy to
understand, because it’s basic supply and demand. The politics, though — very
hard in this country. I don’t know that they’re any easier in Britain? [laughs]

You’re absolutely right, and this is where the detail really
matters. What we proposed in the report is a way of getting around the
political objection to deregulating and planning. This is what we call “street
votes,” or as it’s sometimes called, street-by-street zoning.

The idea is this: at the moment, zoning decisions are
decided on a city level, neighborhood level, or even, in the UK, at a national
level. And in most cases, if ask people, “Do you want to make it easier to
build housing?” generally people say “No.” They don’t trust the government on
these issues, they value green space, they value low-density.

But the way around this is to say, “Let’s push this decision
down as much as we can. Let’s make it not to be done at a national or city
level — let’s give people the right to make these decisions at a street or
neighborhood level.” What that means is that if you get a majority of people on
a street who want to make it easier to densify their street, within limits, it
can happen. You can change the zoning.

And many, many places will no doubt decide, “We don’t want
to do this.” But the fact is that some places will decide to do this.

This is literally the
opposite of the theory in the US, which is, “You can’t trust cities or the
neighborhoods, we need to push this up
the ladder and have governors decide. They can look at a whole state like
California.”

So, will neighborhoods
decide to do that? It just seems very counterintuitive.

Well, here’s the incentive: If you are a property owner on a
street that chooses to densify, that immediately means that your property that
you own becomes considerably more valuable — maybe increasing the prices by 3
or 4-fold.

If you’re talking like we do in the book like some areas of
London that are very dense at the moment but are very well served by public
transport, you’re offering a potentially enormous windfall to your property in
the city. Now, as you say, there will be some neighborhoods where people say,
“I don’t want to be a millionaire, I just want to keep my street as it
is.”

Right, you don’t want
to hurt the “character” of the neighborhood.

But there are a lot of streets in a city like London or San
Francisco, and you don’t need many streets to change their mind on this issue
to cause a very significant increase in density.

The idea of pushing this decision up — as a Brit, I guess I’m skeptical because we make these decisions at a national level, and the NIMBYs, as it were, the special interest groups, find that they can operate more efficiently at a national level than a local one.

We mentioned taxes
earlier: What should the tax code look like? We had this big reform in the US
that cut corporate rates, and we tried to encourage more long-term investment
through expensing provisions. Some of that is a good idea.

Yes, we are big fans of full expensing proposals in the UK.
This cuts slightly against the intangible message.

A lot of that is
going to be in actual stuff.

The tax code is actually pretty favorable to intangible
investment in the UK, because pretty much all of that can be treated as 100
percent expense in the year it’s incurred.

We have a strange situation in the UK where for the last
decade or so we’ve disfavored tangible capital investment, because we used to
give capital allowances for it. We got rid of a lot of those allowances. So in
a sense, what we’re proposing is that the UK should emulate the US’
full-expensing policies.

You also talk about infrastructure. Again, there are different challenges in the UK, but would you recommend to an American policymaker that we should build a lot of high-speed rail in this country? Because a lot of infrastructure ends up being like that — people are bored by fixing roads and bridges, but a high-speed rail or a Hyperloop is very exciting.

What do you think
about those ideas for the US?

I think that the key goal with building infrastructure comes
back to this idea of agglomerations. In an intangible economy, you want to
create big areas where people can travel for work.

Now, in some cases, you may achieve that through high-speed
rail, but more important is good, quality, local transport that allows people
to get from their home to their jobs.

Like buses?

We love buses!

But isn’t this the
old way of thinking? Doesn’t the technology need to be updated?

I’m a big admirer of Elon Musk, so I’m also excited about
Hyperloops. But I think the question with buses is: How do you make a bus
something reliable, that people want to commute on?

It’s partly about making sure you have more dedicated bus routes. It’s partly about having reliable buses so you’re not sitting there thinking, “Ah, no! I missed my bus, I’ve got to wait 17 minutes and I’m going to be late for my job.” It is about making buses more like trains, or for that matter, more like Hyperloops.

I thought it was
interesting that in the section about public research funding, you like some of
the things we do in this country. Maybe we should be spending more, but you
like things like DARPA, where you have these quasi-independent agencies that
are doing cutting-edge research.

Do you like that idea
better than these “grand challenge” kind of competitions, where companies have
these big goals, even though DARPA has used some of those? What’s your idea
about how to do public research investment in an efficient, productive way?

What I like about organizations like DARPA is that, because
they’re focused on getting stuff done, they nicely bridge the gap between more
academic research and more applied research. That is a huge advantage.

I am more skeptical of what some people call “mission-oriented
innovation,” these grand challenges. I think it can be a useful red herring, a
useful way of crowding people in. What I’m more skeptical about is that
government or other great figures can effectively say, “Right, the goal is
going to X, and that will generate some advantage.”

Climate change seems
to be about that — setting some big, mission-oriented goal, where we’re not
going to generate any carbon emissions by a particular year.

That seems to be
driving a lot of the thinking, at least on the left, because on the right we
seem to not think about it at all in this country. It’s thinking, “This needs
to be a new Manhattan Project, or a new Apollo mission,” and that we’ll deal
with climate change that way.

It’s kind of interesting: when we look at some of the
examples of mission-oriented innovation often used to justify the Green New
Deal-style innovation, people often talk about historical DARPA innovations.
So, for example, the development of the internet.

But it’s interesting, because if you look at the history of
IPTO, the DARPA programs that developed these breakthrough computer
technologies, they were the opposite of these highly politicized, high-profile
grand challenges. As far as I can see, they were a bunch of very strange,
eccentric guys being allowed to do things that the public in the late 1960s
would never have given license for.

If you’d asked the public what they wanted in the late 1960s from their innovation system, they would’ve presumably said something like Nixon’s War on Cancer, which was a failure. Rather than, “We want some guys to create an internet so that I can use Tinder,” or something like this. This was a totally oblique, serendipitous discovery.

And even the
government funding was very decentralized, just pushing the money out there for
companies to take advantage of. It wasn’t a very centrally-commanded, prescribed
thing.

Exactly, so it was mission-oriented to the extent that there
was a great demand to make it practically applicable, which is what I think is
the good thing about organizations like DARPA. But I guess what it wasn’t was
getting a bunch of high-level politicians around a table and getting them to
agree to a target.

Let’s get into your
mention of secular stagnation. We have this weird situation where we have very
low interest rates, but also very low investment and productivity is weak.

We talked about it a little
bit with how it works with the intangible economy. So, if you’re worried about
secular stagnation and continuing low investment and productivity, are your
policy recommendations what we need to do? Are there any additional things?

Those are really important, but I think the number one
problem behind secular stagnation is that when you look at investment in
intangibles something strange has happened for the last ten years. This
long-term increase in intangible investment has started to slow down.

That seems really
important.

It is, and we talk about it in our book, but when we wrote
it a couple of years ago we were still just checking the data. Now, it looks
like it’s a pretty clear trend.

How could that be?
This is supposed to be more important than ever — I’d think it would be
skyrocketing.

You would think so, but I guess the first thing is that the
secular stagnation is really showing up in total factor productivity — kind of
a measure of innovation in the economy. And that’s exactly what you would
expect to fall away if intangible investment is falling away, because of the
spillovers.

And I would speculate — this is the subject of my next book
with Jonathan Haskel —

Good, we got you to
push the product.

I’d speculate that this is about us running up to the limits
of what our current institutions allow us to do when it comes to intangibles.

We talked earlier about the problems of things like debt
financing and competition policy. I think this means that if we really want to
solve the secular stagnation problem, we’ve really got to up the ante on making
sure we have the right policies in place.

Any sneak previews on
those policies, if they’re any different than what we’ve talked about?

Some of them are definitely to the point: Clusters,
financing, getting the right kind of financial institutions, and getting the
right competition policy. Those are on our wishlist.

Are you worried that
these big tech companies like Amazon and Google — even though they’re
innovating and spending on R&D — are a problem?

I’m a big fan of tech platforms. I think what they do is
make the job of being a regulator, for example, of competition, much harder.

They make it less rules-based, and more about applying ad hoc judgement. Which is really tough, because we spent a long time — with AEI and others as foot soldiers in this war — going from a judgement-based way of regulating to a rules-based form, with RPI-X methods of pricing and all of that.

But in this new platform-based economy — and I certainly
found this working in my government brief on things like IP and copyright
policy — you actually find that you’re judging many more one-off debates
between Google, YouTube, and rights–holders, for example.

And that creates a really big challenge for governance
because it has to be really ethical and honest. It creates a political problem
because it’s much harder to have depoliticized technocratic regulators if
you’re expecting them to exercise the Wisdom of Solomon every few weeks.

Indeed, I think one
concern in this country is that you’re going to have the FDC and the Department
of Justice glaring at these companies at the same time that you have the
president tweeting attacks to them, saying, “Break them up!” To have
depoliticized judgement seems especially difficult.

In many countries political norms are being undermined just
at a time when, from an economic point of view, we need them to be really
strong. I wish I had a solution to that, other than just saying, “Norms are
good.”

We’ll be looking
forward to that book, and we’ll have you on then. Stian Westlake, thanks for
coming on the podcast.

Thank you.

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