Piketty’s Missing Knowhow

Ricardo Hausmann

MAY 27, 2014
Newsart for Piketty’s Missing Knowhow

CAMBRIDGETheoretical frameworks are great because they allow us to understand fundamental aspects of a complex world in much simpler terms, just as maps do. But, like maps, they are useful only up to a point. Road maps, for example, do not tell you current traffic conditions or provide updates on highway repairs.

A useful way to understand the world’s economy is the elegant framework presented by Thomas Piketty in his celebrated book Capital in the Twenty-First Century. Piketty splits the world into two fundamental substancescapital and labor. Both are used in production and share in the proceeds.

The main distinction between the two is that capital is something you can buy, own, sell, and, in principle, accumulate without limit, as the super-rich have done. Labor is the use of an individual capacity that can be remunerated but not owned by others, because slavery has ended.

Capital has two interesting features. First, its price is determined by how much future income it will bring in. If one piece of land generates twice as much output in terms of bushels of wheat or commercial rent as another, it should naturally be worth double. Otherwise, the owner of one parcel would sell it to buy the other. This no-arbitrage condition implies that, in equilibrium, all capital yields the same risk-adjusted return, which Piketty estimates historically at 4-5% per year.

The other interesting feature of capital is that it is accumulated through savings. A person or country that saves 100 units of income should be able to have a yearly income, in perpetuity, of some 4-5 units. From here, it is easy to see that if capital were fully reinvested and the economy grew at less than 4-5%, capital and its share of income would become larger relative to the economy.

Piketty argues that, because the world’s rich countries are growing at less than 4-5%, they are becoming more unequal. This can be discerned in the data, though in the United States a large part of the increase in inequality is due not to this logic but to the rise of what Piketty callssuper-managers,” who earn extremely high salaries (though he does not tell us why).

So let us apply this theory to the world to see how well it fits. In the 30 years from 1983 to 2013, the US borrowed from the rest of the world in net terms more than $13.3 trillion, or about 80% of one year’s GDP. Back in 1982, before this period started, it was earning some $36 billion from the rest of the world in net financial income, a product of the capital that it had previously invested abroad.

If we assume that the return on this capital was 4%, this would be equivalent to owning $900 billion in foreign capital. So, if we do the accounting, the US today must owe the rest of the world roughly $12.4 trillion (13.3 minus 0.9). At 4%, this should represent an annual payment of $480 billion. Right?

Wrong – and by a long shot. The US pays nothing in net terms to the rest of the world for its debt. Instead, it earned some $230 billion in 2013. Assuming a 4% yield, this would be equivalent to owning $5.7 trillion in foreign capital. In fact, the difference between what the USshould be paying if the Piketty calculation was right is about $710 billion in annual income, or $17.7 trillion in capital – the equivalent of its yearly GDP.

The US is not the only exception in this miscalculation, and the gaps are systematic and large, as Federico Sturzenegger and I have shown.

At the opposite extreme are countries such as Chile and China. Chile has borrowed little in net terms for the past 30 years, but pays to the rest of the world as if it had borrowed 100% of its GDP. China has lent to the rest of the world, in net terms, over the last decade, about 30% of its annual GDP but gets pretty much nothing for it. From the point of view of wealth, it is as if those savings did not exist.

What is going on? The simple answer is that things are not made just with capital and labor, as Piketty argues. They are also made with knowhow.

To see the effect of this omission, consider that America’s net borrowing of $13 trillion dramatically understates the extent of gross borrowing, which was more like $25 trillion in gross terms. The US used $13 trillion to cover its deficit and the rest to invest abroad.

This money is mixed with knowhow as foreign direct investment, and the return to both is more like 9%, compared to the 4% or less paid to lenders. In fact, 9% on $12 trillion is more than 4% on $25 trillion, thus explaining the apparent puzzle.

Chile and China put their savings abroad without mixing them with knowhow – they buy stocks and bonds – and as a consequence get just the 4-5% or less that Piketty assumes. By contrast, foreign investors in Chile and China bring in valuable knowhow; hence the gross capital that flows in yields more than the gross savings abroad. This return differential cannot be arbitraged away, because one needs the knowhow to get the higher returns.

The point is that creating and deploying knowhow is an important source of wealth creation. After all, Apple, Google, and Facebook are jointly worth more than $1 trillion, even though the capital originally invested in them is a minuscule fraction of that.

Who gets to pocket the difference is up for grabs. Knowhow resides in coherent teams, not individuals. Everybody in the team is crucial, but outside the team each individual is worth much less. Shareholders may want to take the difference as profits, but they cannot do without the team.

This is where the super-managers come in: they strive to pocket part of the value created by the team. Behind the growth of wealth and inequality lies not just capital, but also knowhow.

Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is a professor of economics at Harvard University, where he is also Director of the Center for International Development.

The Underpants Gnomes

By Grant Williams

May 27, 2014

“I think best in a hot bath, with my head tilted back and my feet up high.”

“Now, I want y’all to read a newspaper — or better still, watch television — and come up with something current to do a report on.”

“Business is all about solving people’s problems — at a profit.”

“A dream business that doesn’t make money is a living nightmare.”

“Profitable bookstores sell books. Unprofitable book sellers store books.”

This week’s TTMYGH will be a little shorter than usual (“Thank heavens!” I hear you cry) owing to my presence at the Strategic Investment Conference 2014 this past week and the travel time to and fro.


Due to the hectic schedule and the fact that there were so many interesting people in attendance, I had planned to spend my week dragging as much knowledge as I possibly could out of those who made the trip to San Diego rather than committing finger to keyboard; but a chance encounter with a delightful young lady initiated an engaging conversation which, in turn, led to my discovery of the Underpants Gnomes.

Those of you who have ever attended an event such as the SIC know full well how such conversations arise. Those of you who haven’t will likely think I’ve taken another step towards the light (and will wonder just what sort of a dialogue we engaged in), but allow me to elaborate.

I will spare the name of the young lady in question to protect her modesty, but if she happens to be reading this back home in Bath, my thanks for the inspirationeven though I find myself awake at 3 AM rather worriedly thinking about underpants.

On December 16th, 1998, Comedy Central broadcast the seventeenth episode of the second season of South Park. In the episode, written by Trey Parker and Matt Stone, Harbucks (a franchise coffee shop chain with no similarity to any real-life company) planned to enter the South Park coffee market, thus threatening the local business owners.

Through a rather convoluted series of developments, the boys (Stan, Kenny, Kyle, and Cartman), are tasked with writing a school report on the threat that corporatism poses to small businesses. The report mobilizes the South Park community to take action against the insurgent corporate behemoth.

In true South Park style, what starts off as an attack on the culture of greed surrounding corporate interests ends up taking a pot-shot at the work ethic and merchandise quality of the small business owner.

Somewhat surprisingly, the TV critic (and sometime Austrian economist) Paul Cantor referred to this particular episode as “the most fully developed defense of capitalism ever” — which simultaneously speaks volumes regarding both the South Park writers and all those who have at one point or another defended capitalism.

(If you’d like to watch the full episode, you can find it HERE. Ain’t the internet grand?)

So... those Underpants Gnomes.

In the middle of the episode, Stan, Kyle, Kenny, and Cartman finally manage to lay eyes upon a pack of mysterious gnomes and ask them if they know anything about business. The gnomes assure the boys that they do and lead them into the cave where the gnomes stash their contraband underpants.

Once there, the gnomes lay out their business plan... a thing of beauty and simplicity that has been emulated by many companies in the age of the Internet of Things (a phrase whose constant occurrence in recent years has never failed to get my hackles up, but one that has, amazingly, been in existence since the early 1990s).

Surprisingly enough, many investors seem to have bought into things that even Eric Cartman could see through. Ah well, there’s no helping some folks.

Behold, the Underpants Gnomes’ business plan in all its majesty:


Now, in the real world, during the first internet boom (which peaked the year after this episode of South Park aired), the business model of the Underpants Gnomes was commonplace, as scores of companies flooded the marketplace, sustained purely by the promise of future profits that would somehow magically appear.
It was the corporate embodiment of George Costanza’s yada, yada, yada”: “First we build a company... yada, yada, yada... we make billions.”

Of course, most of these companies went the way of the dodo; but remarkably, a mere 14 years after the bursting of the original internet bubble, there are signs of what Yogi Berra so beautifully referred to as “déjà vu all over again” — signs which some real heavyweight financial minds have recently highlighted:

(Seattle Times): Venture capital rising to levels not seen since 2001. Companies with no profits going public. Billions of dollars being paid for startups.

These and other signs that the tech boom may be taking an irrational turn are leading some notable investors to utter the dreaded wordbubble,” waking up the ghosts of an era many in Silicon Valley would prefer to keep buried.

Has Silicon Valley once again lost its collective mind?

Hedge-fund manager David Einhorn thinks so.

“There is a clear consensus that we are witnessing our second tech bubble in 15 years,” he warned in a note to his clients in late April.What is uncertain is how much further the bubble can expand, and what might pop it.”

Of course, as we saw in 1998/9, there are plenty of people who believe in fairy tales, and they are happy to explain why THIS time is different:

Venture capitalists and entrepreneurs insist the Silicon Valley tech economy is not in bubble territory. Yes, they misjudged just how fast the Internet would change the world a decade ago and let things get a little bit out of hand.

But this time, they say, the revolution of mobile and cloud services justifies big, bold bets. And most of the companies going public are profitable, with real businesses that are transforming the way we live.

To some tech insiders, the region’s economy is in a “Goldilocksmoment. Not too hot. Not too cold. Enough of a boom to be just right.

Seriously?... Goldilocks? Again with that?


As you can see from the chart above, the Social Media ETF (SOCL) has fallen in almost a straight line since it peaked on Feb 19, 2014. Quite coincidentally, that was the day when $19 billion was paid for Whatsapp’s 450 million users.


The day that rationality returns to investing in technology stocks will be the day that we see some high-flyers (which had previously been given a pass on their poor performance because the promise of a bright tomorrow was just SO compelling) fall to earth in a hurry.

However, so as not to call out any specific companies, I am going to take the South Park approach and lay out a hypothetical fable about one such giant, high-flying corporate darling which has been embraced for its willingness to follow the Underpants Gnomes’ ingenious business plan.

The company has designs on becoming absolutely essential to all of mankind; and at that point, it has promised, it will figure out how to make a profit from the massive turnover that comes with ubiquity.

Let’s call this company... Spamazon.

(I should point out that Spamazon is an entirely fictional company. I offer no recommendation whatsoever, implied or otherwise, to either buy or sell the imaginary shares of this completely made-up entity.)

Spamazon was founded in 1994 in the mythical town of Beattle by an ex-investment banker and Harvard graduate named Jim Beeswax, a man with a passion and talent for engineering who had seen the internet wave swelling and wanted to ride it to the shore, where riches and fame awaited.

Supposedly, his first big idea was selling $100 bills on the internet for $99, but he was dissuaded from pursuing that plan by a friend who told him that while he would very likely build a HUGE business, it would be extremely difficult for the company to turn a profit. Also, the relative scarcity of hundred dollar bills at the time was an impediment to his strategy. Had Beeswax waited for the onset of QE, of course, he would have had more of a fighting chance, as the number of $100 bills in existence took a turn for the plentiful:


Ultimately, by the time Beeswax launched Spamazon, he had refined his thinking into what turned out to be a very simple business modelone the Underpants Gnomes would have been proud of.

Initially, the company would sell books online on the basis that there are millions of titles in print and they have a relatively low price point. From there it would expand by selling a ton of other stuff and, eventually, become the biggest company in the world.

Profits? Yeah... sure, profits too. Someday.


The company grew rapidly after being founded in Beeswax’s garage, and, from the sale of its very first book, Douglas Hofstadter’s Fluid Concepts and Creative Analogies: Computer Models of the Fundamental Mechanisms of Thought, it achieved phenomenal sales growth and most definitely caught the wave that Beeswax had seen coming.

The company’s strategy was clear and consistent; it was all about the future and the growth in top-line revenues. It was Eyeballs 2.0.

Beeswax’s plan to make customers happy and then figure out how to make money off of them was something investors were content to buy into; and over the years, despite testing the patience of his investors at various times, Beeswax stuck to his plan. Spamazon grew its revenues rapidly as consumers embraced the idea that they could sit on their couches and shop at lower prices than they would find at the store and save the time and trouble of driving to the mall.

If something they bought didn’t fit, then no problemo — they just sent it back at no cost to themselves or the company.

As word of Spamazon’s brilliant business plan caught the imagination of the market, it didn’t take long for investors to extrapolate the knock-on effects and, more importantly, who the chief beneficiaries would benamely Federal Express, who would be shipping stuff to EVERYBODY (and from everybody back to Spamazon if it didn’t fit/was the wrong colour/they’d had a change of heart).


The stock price of FedEx spiked nicely in tandem with the fictional stock price of Spamazon, but then came the popping of the tech bubble and both shares fell. Hard.

However, as hundreds of internet companies previously headed for the stratosphere crashed to earth like poorly maintained Russian satellites, Spamazon showed tremendous resilience and continued selling ever more stuff to more people at a loss; and as investors soon figured out, it didn’t matter whether Spamazon made any moneyjust as long as it kept getting bigger and collecting more underpants selling more stuff

FedEx shares almost quadrupled on the promise of all the additional business that would come once Spamazon’s dominance (as well as that of other fictional online retailers) was established. How much would Spamazon make from the additional shipping? Who cares? Certainly not FedEx.


For Spamazon, the profits, like Christmas, would come (except not like Christmas, which comes once a year).

The spottiness of those profits led to a somewhat overinflated P/E ratio, something that people argued back and forth about for hours on the internet (whilst shopping, presumably); but it was hard to argue for such a lofty valuation from a pure value perspective when the world could look at Apple, a former growth stock that made the transition to a value stock with the grace of a prima ballerina, or Walmart, which also sold everything to everyone (though it was most definitely a victim of the spread of Spamazon’s tentacles).


Over the past decade, Apple has watched its P/E ratio fall from 90 to a far more respectable level in the teens as it has delivered spectacularly on its promise of outsized growth. Meanwhile, Walmart, with steady sales of everything to everyone, has maintained very stable multiples, as one would expect.

However, the fictional company Spamazon needs a chart all of its own, because if I put it in the same chart as Apple and Walmart, the scale on the Y axis would have to be extended so far that the changes in the P/E ratios of the two REAL companies would be completely indiscernible.

I guess I could have just plumped for a different fictional P/E that fit better on the above chart (seeing as how Spamazon is a fictional company and all), but that would have made the story less compelling, so I’ll stick to my guns and keep the numbers as they originally were (you know, in my head):


Elsewhere in the fictional world of Spamazon, things were looking equally shaky as fictional margins and sales growth fell steadily as the number of fictional employees on the fictional payroll soared:

But is there any point in going over the fictional metrics of a fictional internet behemoth just to belabor a point? After all, it’s not as though it actually matters in the real world. And it’s not as if Spamazon is the ONLY fictional company purusing the Underpants Gnomes’ business playbook.

Take Flutter, for example.

(For the sake of clarity, I should point out that Flutter, too, is an entirely fictional company. I offer no recommendation whatsoever, implied or otherwise, to either buy or sell the imaginary shares of this completely made-up entity.)

The fictional premise behind Flutter’s completely fictional business proposition is simple: millions of users sign up and gain the ability to “flutewhatever they happen to be thinking at the moment although the length of thoseflutes” is restricted to a handful of characters.

Essentially, this is the ideal way for fictional celebrities to engage with their audience and fanbase, for angry fictional men and women to let the world know what ails them, and for millions of ordinary fictional people to demonstrate to anyone who will listen to them just how smart/funny/erudite/witty/desperate/misguided/batshit crazy* they are.

*delete where fictionally applicable

The Flutter business model is eerily similar to that of Spamazon:


After its fictional IPO, Flutter’s stock soared 70% on the promise of Phase 3, despite the fact that it lost more money in 2013 than it did in 2012. In fact, those fictional losses increased five-fold.

Fast-forward to April of 2014, when Flutter announced that it had doubled its fictional revenues... oh, and managed to lose four and a half times as much as it did in the comparable quarter 12 months prior. Not only that, but its fictional user growth had slowed enormously. The only good news was that it had lost less in Q1 2014 than it did in Q4 2013, when it racked up over half a billion dollars in fictional losses.
The fictional stock took a very real 10% beating.

This surge in companies being awarded huge valuations based solely on the fact that, like the Underpants Gnomes, Phase Three of their business plans calls for gargantuan profits has reached a level seen only once before.

Can you guess when that was?


Yep... the share of companies coming to market with negative earnings reached 74% in early 2014, a level surpassed only in........ drumroll, please........ February 2000.

(Fox Business): According to CB Insights, 600 startups in the IPO pipeline have raised more than $55 billionthat’s nearly $100 million apiece. And 47 venture-backed companies — including Palantir, Pinterest, Box, Spotify, Fab, and Square — are valued at more than a billion dollars.

And THOSE companies aren’t even fictional.

And then there’s BookFace.

(OK... last time: BookFace is also an entirely fictional company. Just as with Spamazon and Flutter, I offer no recommendation whatsoever, implied or otherwise, to either buy or sell the imaginary shares of this completely made-up entity.)

BookFace is a fictional social network that allows people to post pictures of meals they have eaten, amusing cat videos, photos of themselves in copper bathtubs wearing sunglasses, inspiring messages about what a wonderful place the world is, and joke posters about what wine means to women.

It’s an absolutely invaluable service.

It also has a business model the Underpants Gnomes would be proud ofone that takes the plans of the likes of Spamazon and Flutter and adds a unique and compelling twist:

Mobile, people. M-O-B-I-L-E.

Mr. McGuire may have been right when he told Benjamin Braddock that there was a great future in plastics, but time has yet to tell whether BookFace’s omnipresent fictional CEO Dirk Puckerberg’s assertion that mobile is the “plastics” of the 21st century is indeed correct and, if he IS right, whether BookFace can continue to keep a choke-hold on its fictional subscriber base without spending billions on what might seem at first glance like desperation purchases of fictional messaging apps, for example.

BookFace paid $42 per fictional user when it recently splurged on fictional messaging app WhataSap?
Now, BookFace actually DID eventually manage to make some fictional profits; but even then, there was a little creative accounting involved, so that the fictional non-GAAP numbers were actually double those reported under GAAP between 2012-2014.


I don’t want to dig too deeply into BookFace’s imaginary numbers because I promised you a short-than-usual read this week. Whichever way you cut it, though, I am afraid we are back in the same neighborhood where we found ourselves in 2000 when the first great internet bubble caught so many people off guard. The promise of future profits has been enough to drive insane valuations — even if just in the fictional world of Spamazon, Flutter, and BookFace.

Stepping away from all these fictional companies, there are a few real ones that defy explanation, too (unless you apply the Underpants Gnomes’ business plan):

(Jonathan Weil): This is one of those days where I realize I don’t understand anything about finance or capital markets. I’m a dinosaur. I don’t get it. People are saying things likethis time is differentagain in news articles about initial public offerings by Internet companies, and they mean it. All I can do is watch, dumbfounded.

What was it that made Jonathan question his own intelligence


Coupons.com, with Goldman Sachs as its lead underwriter, raised $168 million, selling 10.5 million shares for $16 each. And the stock rose as much as 103 percent to $32.43, making it today’s biggest gainer by far. If that doesn’t remind you of 1999, then you probably weren’t following the stock market back then.

The company has about a $2.3 billion stock-market value, which is more than 13 times its $167.9 million of revenue last year, when its net loss was $11.2 million. But like so many other companies in these golden times, Coupons.com simply told investors to exclude about $13 million of normal everyday expenses and, abracadabra, it claims to be profitable on a nonstandard, cockamamieadjusted Ebitdabasis. It’s all part of the show.

Coupons.com is a real company that takes the Underpants Gnomes’ business plan and cranks it all the way up to 11.

BookFace, Flutter, Spamazon, and other fictional companies we just don’t have time for this week (fictional companies like Mynga, HoodwinkedIn, and Ponedora) have all benefited from the suspension of traditional investing practices in favor of promises of good things to come.

All of them currently find themselves in Phase 2 of the Underpants Gnomes’ ingenious business plan, and they do so juuuuust as reality begins to dawn on a few people — and that has led to some nasty corrections in recent weeks.

How potentially dangerous could this be? Well, you may be surprised by the identity of one man who fears that this may be only the beginning of the bad times for these stocks.

Step forward Jim Bear-Stearns-is-FINECramer:

(CNBC): [W]hat matters here is that the selloffs in momentum stocks have been significant, and Cramer knows you may be wondering how much more they should decline before they rebound.

Considering the declines are significant, shrewd investors may even be wonderingshould I buy the dip?”

If you’re asking yourself that question, I’m afraid you’re not going to like the answer,” Cramer said. If history is any guide, then the high-flying biotechs, Internet plays, and of course the cloud-based software-as-a-service stocks could still have a long way to fall.”


If we’ve reached the point where even Cramer has spotted that this bubble may have burst, then we must already be pretty far advanced in the process.

Hell, CNBC have even given the recent move a catchy alliterative name: “the Momentum Meltdown.” We must be close.

We never did find out how the Underpants Gnomes’ business plan worked out for them, and South Park has yet to revisit them. Perhaps another boom in the underpants-gathering business has been gathering momentum, and perhaps the Gnomes have been successful raising money based solely on their three-phase model. (Let’s face it, theirs certainly isn’t the MOST ludicrous model ever devised.)

However, I suspect their business plan as applied by fictional companies like Spamazon, Flutter, and BookFace will end up a colossal failure.

The only question is, when?

Eventually, momentum based upon future promises will cease, and when it does (or if it has) then anybody taking a long hard look at the stocks they bought during the mania will find only one word to describe the quality of many of those companies:


(Neither I personally nor Vulpes Investment management hold any positions in any of the companies — either real or fictionalmentioned in this week’s Things That Make You Go Hmmm... We make no recommendations about any of them.)