The rise of intellectual capital: creative destruction and its consequences

1. The rise of intellectual capital:creative destruction and its consequences Leonard Nakamura Federal Reserve Bank of Philadelphia* *reflects solely my opinions and not those of the Federal Reserve System

2. This moment… • Is a time of global risk and global opportunity • I am going to be talking about history of US creativity over the past half century • To help you interpret the present • To be better prepared for the future • Can be a great time to seek funds and invest

3. Talk outline • In the US, new product development accelerated in the 1980s as smaller firms were able to get creative profitably • Intellectual capital doubled in importance, one-third or more of US equity capital • This acceleration has slowed • New product development is now accelerating in rest-of-world • Consequences • More opportunity for smaller firms and less-developed countries • More risk for investors, employees, CEOs, nations • Need for better accounting, less hierarchy, more planning for failure

4. Global competition accelerated as the microprocessor came of age:1975-2000 • New products became central to private enterprises at all scales • Also known as: intangible investment, creativity, intellectual capital, knowledge creation • In the late 1970s, microprocessors gave a large boost to global innovation • By automating transaction processing, much easier for small and medium size firms to enter global markets and compete with giants • Microsoft (less than 5 thousand workers) in 1989 could compete globally with IBM (380 thousand workers)

5. Before 1980, large corporations dominated US private research and development (R&D) • Eighty percent of private R&D was performed by companies with more than 5000 employees • Only large corporations could sell large quantities of new products • Since 1980, firms no longer need a large bureaucracy to sell to the world market • And so small companies have accounted for almost all the growth in R&D

6. Since 1978, US nonfinancial corporations have doubled research and development spending

8. A crude estimate of intangibles • US businesses spend approximately $1 trillion in intangible investment • Including R&D, software, (re)organization capital, and advertising. • Of which more than 80 % is uncounted in U.S. GDP • Between 1977 and 2007, private intangible investment doubled as a percent of US GDP • Investment in new product development now as important as investment in plant and equipment

10. Other advanced countries have large investments in intangibles • UK: 9-10 % of GDP • Japan 8-9 % of GDP • Canada 8-9 % of GDP • Netherlands 7- 8 % of GDP

11. Crucial questions: • Is your firm – with its strategic partners– investing enough in intangibles? • Do you know whether your investment is profitable? • Is the profitability of your new products rising or falling? • Do you have the data to prove what you believe to be true?

12. Accounting: Corporate measures of intangible investment • In standard accounting investments in intangibles are expensed • Reduces taxes • Understates profits in the short run and capital formation in the short and long run • Expensing is often sensible as many projects fail • But, this makes it hard to know even ex post the rate of return to creativity • A problem for the firm, the industry, and the nation • With one-third of capital and one-half of investment coming from intangibles, this makes rational management more difficult

13. Creativity is risky • In markets dominated by new products, success is often winner-take-all or winner-take-most • A large fraction of all profits go to the top product in new product markets • New technologies can shake up entire industries • Picking strategic partners—rising risk and reward

14. Rising opportunities and risks to investors • Higher profits from investments = more return to stock market • $1 Trillion intangible investment = $5 Trillion intellectual capital • But: intangibles are risky assets • More risk at individual corporations: • Stock prices more volatile • Used to need 20 stocks to diversify most risk • Now need 50 stocks to diversify

15. Since 1980, individual stock volatility has risen sharply as intangibles heightened risk

16. Risks to CEOs and employees have risen since 1970s • CEOs are twice as likely to be fired • Outsiders are twice as likely to be chosen to run large corporations • Corporate succession and memory – knowing which workers have contributed and sacrificed in the past – has become more difficult • But remains valuable to long run corporate success

18. Employees are more at risk • Spells of employment with a given employer have become shorter in countries with weak employment protection (US) • Careers at one firm are shorter • Workers have to learn continuously • Spells of unemployment have become longer in countries with strong employment protection (Europe)

19. Investment in intangibles in US has leveled off • The evidence suggests that since the boom of the 1990s the proportion of US GDP going to intangible investment has stabilized • Proportion of workers in creative occupations has also leveled off

22. Risk and opportunity • Developing/adopting new products is both possible and necessary for every organization • Growth of new product development has slowed in the US 2000-present relative to 1990s • New product development/adoption has accelerated outside the developed countries

23. Decentralization • Decentralization with competition improves decisionmaking • Not just the private sector: • All sectors: public, private, and nonprofit can contribute to development of intellectual capital • But public and nonprofit sectors need to have genuine competition, not just subsidies!

24. Competitive Principles • Reducing hierarchy and increasing competition throughout the organization are key components of creativity • Organizations need to allow, not punish, risk and failure • No easy way to accomplish these goals • Important to plan for failure

25. Conclusions • Creating intellectual capital is increasingly the main form of wealth creation today. • Countries and businesses that foster creativity are likely to prosper • but creativity is risky. • Decentralization and competition are crucial. • Companies need to measure their innovation and its payoff. • From 1977 to 2000, US investment in intangible assets rose under the impetus of computerization. • But for the past eight years, intangible investment has not been rising as a proportion of output. • Current period is one of opportunity for many countries and companies.