I think there’s a deep structural shift, which is really important. That is that intangible capital has become more and more important in our economy. The nature of intangible capital is that it’s hard to measure it in financial reports.
To understand whether a particular software investment, for example, is worth a huge amount or, really, nothing, you need to understand what that software development within the company is doing. You need to be hands-on. You need to have the technical skills to evaluate that software project. The more that intangible capital rises as a share of new GDP creation, the more this venture-style hands-on expert investing is going to be valuable.
That was Sebastian Mallaby talking with Tyler Cowen. He has recently released a new book, Power Law: Venture Capital and the Making of the New Future.
This point is perhaps one of the most important things to understand about why industrial age reliance on financial metrics are increasingly irrelevant in modern business.
Think of how the revenues and income of a pharma company might depend on an expiring patent, and that the future of the company is in the success of a few drugs making their way through the FDA. Understanding whether that company goes to zero or grows 10x depends on the particulars of the drugs. The likelihood of a drug making it through regulations and then becoming a blockbuster cannot be estimated based on the dollar outlay of R&D.
In the world of intangibles, inputs do not have a direct correlation with outputs. There’s scalability, spillovers, synergies, and sunkedness. All that effort on a failed drug does not get stored up as “inventory” or get sold a fraction on the dollar. It’s zero.
However, the mRNA vaccine for Covid was developed in a matter of weeks. The enterprise tools and intellectual property can churn out a whole class of products at low marginal cost — meaning the price of any given output is arbitrary because the value is found in the intangible enterprise. The spreading of overhead on a peanut butter basis is, itself arbitrary and yet it is standard defense industry practice.
One point is that when DoD fixates on the tangibles, it can lead to higher overall costs. Consider the following example. Here’s Sebastian again from the podcast:
I think the lesson of Silicon Valley is that agglomeration effects and clustering effects are actually even bigger than economics as traditionally explained. In other words, economics . . . Just reading when I was writing my book about economic geography and that whole literature, the traditional story about why a cluster is a productive thing is that you get better matching between the skills of workers and the needs of companies when you have a very deep labor market.
So, if you’re talking about coding, and a company wants to hire a particular database engineer in a particular database software, in Silicon Valley, there will be the precise type of engineer that you want. Whereas if you’re in a less deep pool of labor, you won’t find that. The same argument goes for suppliers. If you want to have a supplier that provides a particular kind of bespoke semiconductor, you’re more likely to find that supplier locally and be able to go visit them if you’re in Silicon Valley than elsewhere.
The intangible point here is the agglomeration effects of the city. Congress and DoD are happy to spread out spending to maintain some equity — nobody wants a defense plant in their district closed. But you could imagine a world where there was more defense agglomeration, and that would result in less matching costs for employees and better mobility, and lower overall prices throughout.
The defense industry could also agglomerate on patterns from commercial clustering. That result would be expected if DoD were truly a “fast follower.” Similar to how Army Futures Command chose Austin, go to where the companies will be. Space Systems Command stayed in the Los Angeles hub, but there’s other space hubs like New Mexico, Colorado, Huntsville, and others. Balancing agglomeration economies, of course, is the logic of historical precedent and resilience of distributed production when at war.
Ultimately, I would never advocate for DoD to consciously agglomerate because of the high likelihood for error. I just think it’s interesting that the defense industry never agglomerated even though you tend to see it for other industries. Agglomeration is also a plausible thing that has all sorts of cost-benefit impacts, but because it is intangible, escapes the calculus. And thus, the defense industry optimizes so hard on the things it can measure, regardless of the on-the-ground costs they have.
Cost growth to baseline is the metric that only works when the intangibles involved are zero — when you have static production of a known item with known capital.
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