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The Institutional Risk Analyst

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The Interview: William Janeway on Capitalism and the Innovation Economy

“Political economy is not a science, it’s a clinical art, like medicine.”

Washington | In this issue of The Institutional Risk Analyst we speak again to an old friend, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. Our discussion with Bill back in 2009 (”New Hope for Financial Economics: Interview with Bill Janeway”) was one of the most popular discussions ever published in The Institutional Risk Analyst. He just published a new edition of his important book “Doing Capitalism in the Innovation Economy” We spoke with Bill over lunch at The Lotos Club in New York.

The IRA: Bill we loved your book when it came out half a decade ago, but the new edition is even better. Financial pros need to read the discussion of the remarkable series of deals and technologies you worked on over the years. With the benefit of time, talk about how you view the evolution of what you have called the “Three Player Game” between Markets, Speculators and the State? The role of the State seems to be diminished or, as you said, delegitimized as technology has created a new cadre of super corporations.

Janeway: As you’ll gather from the new conclusion to the new edition, the “dark side” of the Three Player Game, the play on words between the Three Player Game and the three body problem in physics is not an accident. The point about the three body problem is that there is no stable equilibrium. There are an infinite number of configurations in the Three Player Game, as well, and, post 2008, we have definitely shifted into a different one. There are several elements, and you can trace causal relationships without being mechanistic about it. One is clearly - always in tension - the spillover from the marketplace into the distribution of political power. I talk about this more in the new edition because it is so evident.

The IRA: Very clearly but nicely put.

Janeway: I refer a lot to the work of Larry Bartels at Princeton who has written a great book called “Unequal Democracy.” For the past two hundred years, since President Andrew Jackson, we have had the coexistence of two sets of institutions, the marketplace and an open political process. Each has certain claims to legitimacy in terms of allocating resources and distributing the return on those resources. It does appear that over the past 30 years we’ve had a shift in the balance of power of the Three Player Game. with the marketplace having a greater weight than the political process than any time since the 1920s or even the pre-progressive era, the 1890s. There is some great work being done in this area. I always like to provide reading lists.

The IRA: Would that there was more time to go through all of the wonderful footnotes in your book. You are very generous with your praise of good work. For example, in your book you have a wonderful quotation from Fernand Braudel: “Capitalism does not invent the market or production or consumption, it merely uses it.”

Janeway: The noted historians Naomi Lamoreaux and William Novak co-edited a great set of essays in a volume published by Harvard entitled “Corporations and American Democracy.” The book contains a deep history of the evolution of the 14th Amendment and goes through generations of Supreme Court opinions. The second focus of the new edition is the unanticipated consequences of the digital revolution that I talk about at length, for example, namely the rise of the giant, “superstar” digital firms. Here the reference is to the work led by David Autor at MIT, showing that across all of the four digit SIC codes across industries there has been a material increase in market concentration. The top four firms account for a larger share of the market, and this is accompanied by an increase in profit margins. Despite important questions about how we measure profits, the apparent markup enjoyed by these firms suggest that they are able to capture rents.

The IRA: Of course. We don’t enforce antitrust laws in the US, as evidenced by the banking sector. The largest banks grew after 2008, depositors and creditors saw their share of the interest earnings of banks cut by 90 percent thanks to the FOMC, and thereby fueled public anger and resentment against Wall Street that you describe in the book.

Janeway: David Autor’s biggest contribution may be showing a visible decline in labor’s share of revenues across SIC codes. And then you have to go back through the Game to look at the enormous impact over a long generation through the 1970s of the triumph of the Mont Pelerin Society as translated into economic theory and political prescriptions mostly at the University of Chicago. In the broad political domain, Milton Friedman's book and TV series “Free to Choose” translated into Ronald Reagan saying in 1981 that “government is not the solution…,government is the problem." These ideas were deeply reinforced and rendered not just intellectually legitimate but politically powerful. Like the rise of the efficient market hypothesis and the rational expectations hypothesis, which pervaded the economics profession, we accepted that markets would deliver a solution that is both efficient and fair, and also stable. So the message was that the only economic role for government is to screw up markets that would otherwise be fair and efficient and stable.

The IRA: Well 2008 seems to have refuted that idea pretty conclusively.

Janeway: From the perspective of the economics of innovation, the field I am most concerned with, the idea of a marginal role for the state is a recipe for at best stagnation and at worst a freeze-frame. Without an entrepreneurial role for a mission-driven government legitimized, to make investments, innovation suffers and so does economic growth.

The IRA: Just as banks do not fund risk investments, but instead this is the role for private equity, some investments like space exploration are too large for private capital, at least initially.

Janeway: The third related factor in the dark side of the Three Player Game is the institutionalization of the market. With the dominant portion of investment cash being managed by people on behalf of other people, who must hit at least the same performance as the broad indices, there is an endogenous tendency toward short-term herding behavior. Connected with that was the idea that we could address the “agency problem” between management and owners by turning managers into owners by giving them lottery tickets in the form of stock options. Back in the 1970s, we called it “Silicon Valley socialism." If you wanted to induce a senior executive or engineer or anyone else to leave the safe harbor of Hewlett-Packard, you had to give them tickets to the lottery. Most tickets to the lottery and most stock options are never exercised because they expire worthless. A startup is one thing, but giving stock options to the managers of stable public companies with secure market positions is, I believe, a crime against society. I have sat on enough public company compensation committees to know that the directors all look at one another and say “we have a great management team.” It is the Lake Wobegon phenomenon where everyone is above average.

The IRA: Get no argument from us. The agency problem is pervasive throughout American society. And the public shareholders or corporations have no effective way to limit executive compensation. But even large unicorns cannot escape from the law of cash flow. As your friend Fred Adler said: “Corporate happiness is positive cash flow.” But how are these changes affecting investment and thus innovation?

Janeway: We’ve currently got an Administration in Washington that has decided that science and the use of science to generate evidence is in no way concerned with public policy. Cutbacks in the flow of information and dollars to support scientific research will have a significant impact on future innovation. The other piece of this, which at team at Duke led by Wes Cohen and Ashish Arora have researched extensively is the shortening of research time horizons for American corporations. They track how company-employed researchers have shifted away from publishing in science journals to putting their work in trade publications as a proxy for development funding.

The IRA: So coming back to The Three Player Game, do you see any promising developments in the world of “artificial intelligence?” We have largely written off crypto currencies and blockchains as a dead end. We put quantitative models used in economics in the same bucket, but are fascinated by the particular. In your book, you alluded to using computers to do what computers do well, namely count, as opposed to trying to model human financial behavior or speech or whatever. Where is AI now vs when you began your work four decades ago?

Janeway: I have been a student of AI since the 1970s when I got involved with Xerox PARC. Since 2008, we have seen speculative capital focused on extending the digital domain, the digitization of all things, and machine learning techniques applied to what is genuinely unique, which are these very large data sets. This is really the third wave of computer techniques being hyped as artificial intelligence. First was the 1960s when DARPA funded some of the earliest AI research in an example of effective state support. Then came expert systems in the 1970s and 80s. Now we have Machine Learning based on “deep networks”. Clearly there are applications where it can be very powerful, but based on my research and discussions with many people in the field, AI systems seem to be very brittle. They are subject to the implicit and explicit bias of the people who set up the training set.

The IRA: That has always been the Achilles heel of search engines. Is it fuzzy and forgiving? Or does the search engine require a precise match? Obviously a huge area for military and intelligence research. What is AI good for commercially? This is not “simulated cognition” quite yet, is it?

Janeway: AI systems seem to be good at pattern recognition when they have been properly trained as to the pattern in question. They are good at playing games where the rules of the game are given exogenously such as in chess or go. They are good at that. But the games that really matter, like the Three Player Game, are those where we must co-invent the rules as we go along. For example, in any conversation, even with people you know well, you are constantly trying to understand the context of the words used by the other speaker and vice versa.

The IRA: Speaking of changing the rules as we go, how do you feel about the various unicorns in the market today that are violating Fred Adler’s rule about positive cash flow and happiness?

Janeway: While the unicorn bubble along with crypto-mania has absorbed animal spirits and speculative fever and more money than will of course be realized in due course by the investors, what is missing is the dynamics in this country of applying what we learned in the 1950s and 1960s about creating a new, low-carbon economy in response to climate change. When Richard Nixon declared “war on cancer”, he mobilized the same dynamic as in any war, the suspension of prospective cost-benefit analysis at National Institutes of Health. What matters is being effective, not efficient. The NIH grew by a factor of ten and the new industry flourished. The entire genetics, genomics and biotechnology revolution came out of President Nixon declaring war on cancer. There is a nation state with a legitimate government that has taken climate change as the next category for massive state investment, and of course that is China. The big question facing the US is whether another nation will take the mantle of innovation leader in the 21st Century, much as the US took the lead from Europe in the early part of the last century.

The IRA: Thanks Bill


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