Intangible investments, tangible wealth

In the intangible economy, wealth is still mostly tangible and rising equity and real estate values are drivers of increased global wealth – not savings and investment.

Late last year McKinsey Global Institute (MGI) put out a report on The rise and rise of the global balance sheet: How productively are we using our wealth? which revealed an interesting feature of the intangible economy: while investment is increasingly in intangibles, wealth is overwhelmingly tangible. Intangible account for only 4% of real global assets as of 2020. Real estate (land and structures) account for 68%. The remainder is made up of other tangible assets such as infrastructure, machinery & equipment, and inventory.

Looking more broadly at the global balance sheet, the value of these real (aka non-financial) assets account for roughly a third of total global assets. The other two-thirds of wealth are financial assets held by financial corporations (the financial sector) and financial assets held by households, governments, and nonfinancial corporations (the financial system). Analysis of the growth in these global assets reveals a worrisome fact. Over the past two decades asset growth has been largely due to rising prices (valuation) for equities and real estate. Increased savings and investment account for just over a quarter in wealth creation.

I have two take-ways from this report. My main take-away is about the difficulty of measuring the value of intangible assets as assets. The report uses data from existing System of National Accounts framework. In the US data, the only intangibles included are intellectual property products which include only software, research & development, and entertainment, literary & artistic originals.

It should be noted that the authors of the report are well aware of the importance of intangibles as a factor in production (see MGI report Getting tangible about intangibles: The future of growth and productivity?.  For comparability’s sake they used the globally accepted framework.

However, as part of their sensitivity analysis, they modified the treatment of intangibles. They first expanded the list to include additional intangibles from the INTAN-Invest project database such as organizational capital, training, and brand investments. Adding these doubles the value of intangibles. Next, they removing the standard accounting practice of depreciating IP on a 5-year schedule. This quadruples the value of intangibles.

Admittedly, these modifications result in only minor changes in the relative size of intangible assets compared with total. But they do illustrate the difficulty in using intangibles as a store of value.

[Note there are other frameworks as well. For example, World Bank’s Changing Wealth of Nations series includes human and natural capital in its analysis. It should be pointed out however that measuring human capital and natural capital is a work in progress.]

My second take-away is more of a macroeconomic concern about the relatively small contribution of saving and investment to overall wealth creation. To the extent that additional wealth created by rising asset prices is channeled back into the economy in the form of savings and investment, this can be a positive spur to economic growth. However, this is not necessarily what happens. As the report states, the process could “encourage investors to seek asset price increases rather than more traditional benefits from operating assets.” In other words, create an asset bubble.

The report discusses to role of low real interest rates, among other factors, in fostering this situation. If we are moving to an era of higher interest rates (as it appears that we are), the future growth of the economy may be more fragile than we thought.

For this, and other, reasons, the report concludes that we need to find “alternative long-term stores of value.” However, it also lays out the case as to why it is difficult for intangibles to play that role:

“Although intangibles have attracted plenty of investment, they have not served as a long-term store of value at scale. Measured using current assumptions for their value rather than the broader societal value they might bring, they constitute only a tiny part of total net worth. But these assumptions and the amount of private value intangibles can hold depend on the economic and competitive context. Most intangibles can be scaled at near zero marginal cost and are not “used up” in production. That means the returns on intangibles investments can flow to a variety of stakeholders. At one extreme, if competition is strong and IP protection light, all value of intangibles investment will quickly pass to consumers as customer surplus, increasing real income and standards of living for all but not serving as a long-term store of value for those making the investment. At the other extreme, the policy and competitive environment could allow companies investing in intangibles to protect—and scale—the value of those investments ad infinitum, through IP protection, protection of trade secrets, sustained advantages of scale, barriers to entry, or not containing monopoly power. In such a setting, intangibles investments could become long-term stores of value for savers and increase the value of their investments over time, but at the expense of competition and consumers. What policy mix is needed to extract more value and return from intangibles investment and yet also preserve customer surplus and strong competition? And what might then be the right way to measure intangibles at a company and societal level?”

For all these reasons, I am beginning to believe that we need to modify our view intangibles. We need view intangibles as an “asset” in the sense of something useful (using the Merriam-Webster’s definition of an asset as an advantage or a resource) – not an asset as in a store of value. In other words, focus on intangibles as input to the production process. As such, we need to focus measurement on investment metrics, rather than valuations.

More on this to come.

BEA data shows strong growth in knowledge-related business investment in 4Q 2021

Growth was led by increased investment in information processing equipment but all other nonresidential fixed private investment actually declined, with investment in transportation equipment taking a big hit.

This morning’s numbers for US GDP for the 4th quarter of 2021 and-year-2021-advance-estimate are looking good. According to BEA, GDP rose at an annual rate of 6.9% in 4Q and by 5.7% for the year.

Business (non-residential fixed) investment in knowledge-related areas grew at an annual rate of 14.2%. This grow was due to a 22.7% increase in information processing equipment (which had declined in the previous two quarters). Investment in software was up by an annual rate of 12.2% and R&D spending up by 6.5%.

Total business investment in all other areas declined by an annual rate of 14.6% — driven in large part by a drop in investment in transportation equipment of 45.3%. Investments in non-residential structures and in “other equipment” were down by 11.9% and 11.7% respectively. Investments in non-residential structures have declined in 8 of the past 9 quarters (1Q 2021 being the one exception). The continuing declines in investments in non-residential structures and transportation equipment are especially worrisome.

In my earlier posting on 3Q 2021 I expressed concern that the decline in investment in information processing equipment in 2Q 2021 and 3Q 2021 may be a reflection of the ongoing semiconductor shortage. Hopefully the rise in investment in information processing equipment in 4Q 2021 is due to steps to alleviate that shortage.

As I also noted in last quarter’s posting, knowledge related business investments did not suffer as great a cutback as other business investments in the COVID-19 slowdown and have been growing since 2Q20. They now account for 59% of total business investment (up from 50% in 3Q19). Looking at only the two digital-related investments of information processing equipment and software, this subcategory makes up 42% of business investments.

[Note: I define knowledge-related investment as the combination of investment in Information Processing Equipment, R&D, and Software. The first of these three categories is reported in the GDP data as a subcategory of Non-residential Fixed Investment: Equipment. The latter two are reported as subcategories of Non-residential Fixed Investment: Intellectual Property Products.]

Intangible assets v. intangible assets

We generally think of intangible assets in discreet categories. Depending on which framework you choose, these include worker skills and know-how, innovative work organizations, business methods, brands, and formal intellectual property, such as patents and copyrights (see my earlier paper Intangible Assets as a Framework for Sustainable Value Creation). Increasing we see descriptions and analysis of asset complementarities and the interactions among intangibles. For example, there are clearly synergies among knowledge creation, human capital (workers skills), and organizational features and capabilities.

However, there are times when the development of different intangible assets can be at odds with one another. The following insight on enforcement of patents from Stephen Miller (What Do Patents Mean? in Issue in Science and Technology) is a case in point:

“Another reason a company may take no action against a likely infringer is that the company already has an existing or potential relationship with the infringing company, often in another sector or sectors of business, as a partner, a customer, or a supplier. If the real or perceived value of that relationship is greater than the estimated value of the invention, which in its early stages is usually quite uncertain, then the patenting company may choose not to go after the infringer. I saw this happen at a time when my company was negotiating a business deal with another company that I was confident had been infringing one of my patents. Our management decided the value of the deal being negotiated was greater than the value of the technology under my patent, so they refused to try to enforce it.”

So, the goal of maintaining relational capital was in conflict with the protection of intellectual property (and ultimately with the R&D investments made to produce that intellectual property). Are there any other examples where intangibles might work at cross-purposes?

By the way, Miller’s article is a straightforward discussion of how patenting works in the real world. If you want to understand How companies really use patenting and (one of my pet peeves) why patents are problematic indictors of innovation, read this article.

December employment growth slows in intangible producing industries

Employment growth slowed in December according to the BLS data released this morning.  Nonfarm payrolls were up by only 199,000 employees, compared to 249,000 in November. By contrast, employment grew by 648,000 in October, 379,000 in September and 483,000 in August.

Both tangible and intangible producing industries grew by lower amount in December but the slowdown was more pronounced in intangible producing industries. Employment in intangible-producing industries grew by just 58,100 – a marked decline from November’s disappointing increase of 97,400. This compares to increases of 187,500 in October, 132,800 in September and 310,800 in August. Employment in tangible-producing industries was up by 140,800 in December, close to the 155,900 increase in November.

The biggest slowdown was in intangible Professional and Business Services, which grew by only 34,400 in December compared to 61,500 in November and 112,800 in October. Arts, Entertainment, and Recreation also saw a sharp decline in employment growth, rising by only 7,000 compared to growth of 10,200 in November. The sector had been growing at an average rate of 54,000 in the 3rd quarter of 2021 and a much higher rate than that earlier in the year.

The bright spot in the tangible producing industries was in Accommodation and Food Services, which grew by 52,600 in December compared to only 31,000 in November. Employment in this industry is very volatile however. For example, it grew by 352,400 in July but only 7,500 in August.

As I have noted in earlier postings, the labor market seems to have settled back into the post-Great Recession, pre-pandemic pattern of relatively equal growth in tangible-producing versus intangible-producing industries – but at a slower rate. The COVID-19 pandemic has done little to disrupt to dramatic shift in the tangible-intangible structural balance that emerged after the Great Recession.

For more on the categories, see my explanation of the methodology in an earlier posting