Connected Economics — The Threat — Part 1

Almost four years ago, I presented to Prime Minister Netanyahu and other Government Economic leaders the slides and insights which later became the basis for the 2010 Humus Manifesto. At the time, I argued to them that there would be increasing high tech unemployment from the older companies (Motorolla, Microsoft, Comverse, Ness etc) that were big employers in the system, that our reliance on Microsoft platforms was a problem, that we had a shortage of relevant engineers and that the Chief Scientist was investing our money poorly in companies such as Alvarion and ECI Telecom. Well, we are now after layoffs at many of the above companies and the ECI and Alvarion OCS investings…well…Additionally, we are now talking about the need for start up visas to bring foreign software engineers to Tel Aviv because we do not have enough nor have we trained enough of the right engineering talent here. And we still do not have a Chief Investment Officer for the country.

I have spent a lot of time in the last 18–24 months giving presentations to and talking to the good people at the Ministry of Finance about the changing economy and the threat it poses to Israel’s economic growth and employment. I think they can possibly be a big part of the solution. I now feel that it would be appropriate to put these in blog form much like the Humus Manifesto. The news of the last week that the budget deficit is larger than anyone thought is not a surprise. It is and was completely predictable in a system where populist politics has run amok and is incapable of keeping up with the changes in the global economy. It is symptomatic of a system that prefers fecklessly cutting a little from every ministry rather than deciding what to focus on and what to cut completely. It derives from a combination of political weakness of will and a grave misunderstanding of global trends and we need to solve it collectively or we will leave this country in worse shape for our children. Our children do not deserve that punishment because of our lack of will.

I am not an economist. I barely have a first degree in political science. Maybe that is a disadvantage, bordering onhutzpa, when talking about macro economic issues. Or, perhaps, it is an advantage because I am not shackled by well-known theories of economics and can look at it from outside the box. Judge for yourself.

One note: I will use examples both from the United States and Israel. The graphs and data from the US are much better so I will use more of them but they are basically equally applicable to Israel.

I would like to start this first post with a few basic premises that I view as self evident but I will endeavor to explain their impact:

1. The internet is massively deflationary

2. Labor has become global, as has employment

3. Connectivity, mobility and electronic productivity and innovation has replaced labor and, as a bonus, is killing commercial real estate and the financial institutions and employment that comes with that.

4. Capital is global

5. Government is too slow to keep up with the rapid changes

Why is the internet deflationary?

Allow me to start with a simple example. 15 years ago, you purchased goods and services locally or at a mall nearby. Your basis of price comparison was very difficult. You could compare a few department stores or supermarkets nearby but the price differential was insignificant. Enter Jeff Bezos, Amazon and comparison shopping and you could price compare immediately and buy at a lower price online. This has driven down the price of goods and services. It took over 10 years from Amazon’s birth plus the advent of smartphones to bring ecommerce to the near ubiquitous acceptance it has a achieved, and it is still only a small fraction of total retail. The price deflation Amazon has wrought on retail products and computing power, startups like oDesk, Elance and others are now driving into the world of labor. Using internet services, companies can source labor globally and at a dramatically lower cost than finding it locally. This is deflationary to wages. Every worker competes in a global market for labor and against the skills and talents of others around the world. If you do not have a unique skill, then you have zero pricing leverage. So computing generally and the internet in particular has driven pricing down. This is one of the reasons why despite massive money printing by the US Federal Reserve and the Bank of Israel, inflation is in check for now. As you can see from the graph below, if you plot inflation/deflation against Gold as a constant, we have had massive deflation. Only because of currency devaluations due to money printing has the CPI tended slightly up (I realize that Gold is not necessarily a constant and there is some speculation built in but the point remains).

Labor and Employment are Global. So What?

I mentioned above that internet services such as eLance and oDesk are making the labor supply global. This is not to be confused with outsourcing manufacturing to China, a trend that has happened over the last two decades. Services such as eLance, oDesk, Fiverr and others are advancing a flexible international labor supply. This has a few implications: First, if your job can be done by someone else, faster, cheaper and better and delivered over the internet, you are out of luck because your employer will find that person. This is already happening in fields as diverse as radiology, software engineering, marketing, legal and paralegal services and even party planning. Larger and smaller corporations are utilizing these flexible workers and workforces to reduce the size of their employment force. Using these flexible platforms and global workers, a company can convert payroll from a fixed cost to a variable cost. This then has the impact of reducing the size of large corporate workforces and will downsize corporate America (or large employers in Israel). Unionization or regulation will not stop this phenomenon because any company that cannot utilize flexible workforces to some level will lose their competitive edge. Ultimately, digitization and local manufacturing will accelerate this trend and will bring it to more industries and the ensuing disaggregation of the corporate world will accelerate.

This is on top of the fact that many jobs previously done by humans are being done by machines. This has been true in manufacturing for a while as robots take on ever more human tasks. Anybody who has been to Iscar in northern Israel which is now owned by Warren Buffet immediately notices the dearth of people and plethora of robots and yellow robot paths. Now, farms in Israel are replacing Thai and Israeli labor with mechanized agriculture. That drives employment down.

There is good news in this too. If you are a capable, skilled person with a go-getter attitude, you can be employed by anyone anywhere in the world so more opportunity will come your way (as Reid Hoffman has pointed out and I will expand on in a future post). It also means that we need higher skilled and therefore higher paid workers to manage mechanization but, as I said, we need less workers.

This has another implication as well. Over the last 100 years, the economy has gotten used to the notion of a middle class. This is actually an invention of the industrial revolution and “Corporate America.” The middle class is made up of good people who started working at a company or a firm at the lower levels and through service, loyalty and good work, he/she advanced up the corporate ladder of a bank, an insurance company, a law firm or a supermarket chain. However, as labor disaggregates and the big companies disaggregate corporate functions through flexible workforces, those chances of advancement become available to ever-fewer people. In Israel, there is a ritual annual meeting between the government and the “Economy’s Large Employers.” The government spends lots of time on these “Large Employers” thinking that they will hire more and more people. This is complete folly. These large employers are on a diet and they are laying off people in droves. Just look at the Israeli cellular carriers like cellcom and we are just at the beginning of this phenomenon. As I mentioned, we are at the early stages of the disaggregation of the corporation and the rise of global individual employment yet our government is focused on exactly the wrong people and employers. Current government focus and policy will result in what economist Umair Haque calls Neo-Feudalism. I think he is right.

Global Connectivity and Internet Driven Productivity is accelerating the vaporization of employment

For 100 years, the corporation has served as the glue that binds employees together into a business. Concurrently, we have a lot of business that have been built on non-digital models that employ lots of a people in supply chains. Both of those are being dismembered at the same time and this is causing massive disruption in employment, all while productivity is increasing and GDP is growing! Let me give some examples. The Yellow Pages was a $112 Billion (about 400 Billion Shekels) in 2006. Today it is less than half of that because it has all moved online. That means that $60 Billlion of analog advertising dollars and the jobs that went with them are gone. That means that the people who operate the printing press have gone home. It means the people who delivered the Yellow Pages are not needed. It is all growing fast online with fewer people. How about other examples like self-checkout from the supermarket that replaces the workers who sat all day at the cash register? How about the taxi dispatcher that is replaced by a cell phone app called Uber. Enterprising Individual taxi drivers make more money using Uber and it is a fairer system than dispatchers. That is good. But the taxi dispatcher will need to find a new job.

As Smart Phones have become ubiquitous, more and more services will disintermediate the coordination function of corporations and dispatchers and give more opportunity to single practitioners and enterprising workers. This will send people that are currently working in many corporate functions such as HR, Marketing etc to unemployment or more hopefully individual entrepreneurship. There are hundreds of examples of smartphone applications replacing people in industries as diverse as newspaper distribution and printing, renting a car, data collection, etc. My partner Matt Cohler has pointed out that mobile phones have become the remote control for my life. You push a button and something amazing happens in the real world. Most often, that something amazing requires less employees than it did 24 months ago and it turns everything into a spot marketplace (more on that in a future post)

Look at this critically important graph of what happens to the labor force when always-on, global connectivity reaches ubiquity.

What you see above is that in the United States, Labor, Employment, Income and GDP growth went in lockstep until the early 90s. That is when personal computers began to go ubiquitous. As the Netscape browser was introduced in the mid 90s and connectivity accelerated with cellphones, we see a massive decoupling of Labor and Income on one had vs. Productivity and GDP on the other. Simply put, this is machines or software doing the job of people better, faster and cheaper. Stated in a more complex way, the internet had a deflationary impact on wages and labor both through replacement, substitution and global flexibility as described above. At the same time, the economy got more efficient and could sell more stuff to a more global market. This is the story of the increasing income and skill gap between the “haves” and the “have nots.” The global creative class has adapted to the new way of business and small entrepreneurial types are thriving . But typical corporate labor and those in low skilled or unskilled jobs are suffering. Remember that the industrial age was all about making people replaceable in the jobs they do. The process was more important than the people. Now that computers, software and global labor can do the job, that replacement is happening quickly.

Now lets follow this through to the next level. If workforces are becoming more flexible and commerce is moving online, the spaces that corporations and retailers occupy are becoming oversized. Jeff Jordan did an incredible job of analyzing this in a post entitled “Why Malls are Getting Mauled.” Here is the money quote.

“This declining retailer health is directly impacting malls and shopping centers in the form of very high vacancy rates and sluggish rents — exactly what you’d expect to see where supply exceeds demand. Both factors deteriorated quickly during the economic crisis of 2008–09, but they’ve shown virtually no improvement since in spite of improved economic conditions. The recession was the catalyst, but competition from online retailers can only be the continued driver. The mall business isn’t very healthy either.”

If malls are cratering (please read Jeff’s entire convincing post), think of all the service jobs in malls that will disappear. Online commerce does not need cleaning people but malls do. You do not need store attendants online. I can keep going but you get the point that this is all net negative for employment and median household income and it does not matter if you live in the United States or Israel. The result will be the same.

The same analysis Jeff applies to malls is true for office space in a world of flexible employment. As corporations of all kinds downsize, they need less space and they will want it more flexibly. Expected rents will come down as occupancy goes down and since financing by the banks is typically predicated on these long lease big tenants, that financing is going to come under scrutiny. This will have a further impact on the stability of banks and their financing role and will likely have a negative impact on corporate and income taxes (more on this later).

Capital is Global

Everyone knows this so I will not spend time on it. However, it is important to note that countries must compete on capital in the same way they compete for competitive advantage. Capital seeks large opportunity, low impact regulations, moderate tax rates, stable and predictable judicial systems and highly skilled workforces. And money is what makes the world go round, or at least the economy. If you are not competitive on all five of these fronts, not only will investment capital not come to your country but it will flee your country. Let me use a couple of recent examples from Israel and the USA to highlight how fragile this point is. The Israeli Supreme Court issued a somewhat ambiguous ruling last week stating that employees of a company can sue to get royalties on IP that they create while at the company. This would be true even if they are signed on an invention assignment agreement. As proprietary IP becomes more and more important, what company in their right mind would domicile their business in a country where it is unclear whether you own 100% of the IP that you invest to develop? Look at the argument in the USA and Israel around repatriation of funds locked across the globe. Companies leave that money in foreign jurisdictions for tax reasons. Under a moderate tax regime, that money would flow back to the country of origin but it flees or stays trapped in other markets because of taxes. It is politically unpopular to attract capital to markets because it necessarily means lighter regulation and moderate taxes but it is necessary for employment and growth, especially today. Since capital and labor is global, we need to stop looking at government income and distribution (re-distribution) as a Zero-sum game. Smarter countries, will attract an unfair share of global capital and creative labor, provided they answer to the five criteria above. This will increase the size of the pie. However, this requires a global view, something most politicians and bureaucrats lack.

Government is too slow to keep up:

The economy has changed dramatically in the last two decades yet it is hard to point to something in public service and government that has changed this dramatically. Ergo, government forecasts for revenues in Israel have come up way short (as they have in the USA). Our government institutions have gone online, kind of. But have they changed for an online world? Have the government ministers responsible for financial management (mis-management) of our country adapted to these new realities and what that means for our budgeting. More importantly, what INVESTMENTS (not spending) are we making and must we make for the future? Have the stewards of employment thought about the divide in skills and cognition between the “haves” and “have nots?” What is our policy response to that and the disaggregation of the corporation? How have we changed the way we look at employees and employment in the face of sweeping global change? Whether politicians like it or not, these changes are happening and they are happening quickly and our competitive advantage is at risk.

Here is the bad news: The deficits, unemployment and income gaps are not going away until we address these issues systematically and systemically. They will not go away until we fundamentally address the changes in the economy. But here is the good news: Israeli is a tiny country where change can come quickly if we want it to and if we apply resources to the problem. We are in a better position than most to emerge from this economic chasm even more globally competitive. I will expand on this in my next post.

[Originally published on 18th January 2013 by MIchael Eisenberg]