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Sorry Mr. Christensen, but there is no Capitalist’s Dilemma


Prof. Clayton Christensen of Harvard Business School and The Innovator’s Dilemma fame penned an article for Harvard Business Review June 2014 edition titled The Capitalist’s Dilemma. In it, he attempts to apply his strategic thinking to the question: Why aren’t businesses investing their capital in job creation? While the pursuit of an answer to such a question is laudable, given the current U.S. economic situation, the analysis and solution, sadly, are just wrong. I hope to explain why.

The article talks about three types of innovation with respect to their impact on jobs: performance-improving innovations which replace old products with new and better products; efficiency innovations which help companies make and sell mature, established products or services to the same customers at lower prices; and market-creating innovations which transform complicated or costly products so radically that they create a new class of consumers, or a new market.

The author maintains that performance-improving innovations have little impact on jobs, efficiency innovations eliminate jobs, and market creating innovations create jobs. As proof, he offers some examples. And herein lies the first flaw: mistaking correlation for causation. Ironically, he dismisses other theories for just that at the beginning of the article.

Jobs, Jobs, Jobs

Throughout the first part of the article, the author seems to revere jobs. There is no justification as to why adding to the jobs numbers is a worthy goal in and of itself. Let’s put this into perspective. There are quite a few unemployed persons in the US today. Now if only they all had jobs and plowed their paychecks into their local Wal-Mart, it would create more employment, which in turn will cause more spending, and round and round we would go until everything became all right again. That’s the battle cry of the economists. Create more jobs, spend more money, and everything will be hunky-dory.  But is this really true?

What if the government decided to grant everyone a “minimum wage” job for 29 hours a week? The workers would work in two shifts every day: in the first shift, they are given shovels and told to dig a huge, big hole in the ground. In the second shift, they are told to cover up the hole. The jobs problem is solved! Now let’s examine how this would affect the economy.

The shovel industry would surely benefit, as would the allied industries as they see the demand for their products going up. With their newly found steady income stream, the previous unemployed would now spend more money satisfying their wants. As the demand for these consumer goods increases, companies in this business see healthier revenues and rise in profitability. This positive effect would ripple across their supply chain, reinvigorating the retail trade. If jobs are the only metric by which success is measured, this measure has achieved quite an extraordinary success!

The Seen and the Unseen

“In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favorable  the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, – at the risk of a small present evil.”

– Frederic Bastiat, 1850 A.D.

We have seen the quite visible and immediate effect of what would happen if the government intervened to cause 100% employment in the above manner. Now let us examine the unseen effects, which we would do well to foresee.

There is a character in Greek mythology named Sisyphus, who as a punishment was forced to roll an immense boulder up a hill, only to see it rolling back down again, and to repeat this action forever. According to Greek mythology, this was King Sisyphus’ punishment. His actions would have zero lasting effect.

How exactly is that different from our example of digging holes and filling them back up? The effects of all their labour on the economy are nil, since they produce nothing of value to others. Yet, they consume things which others have produced and sold to them. These labourers take something of value from the real producers, while offering no production in return. Had they been unemployed instead, the real producers would have enjoyed the complete fruits of their production. Between these two scenarios, there is a clear transfer of wealth from the real producers working real jobs to the unproductive labourers. That’s an unseen effect.

By adding to the overall demand in the economy without adding to the supply as well, they cause prices to go up. This is basic economics of demand and supply. Thus, the real producers now have to suffer higher prices, and consume less than they otherwise would have been able to. That’s unseen effect #2.

There would always be people who prefer a secure, government job with no stress to the harsher, market-driven jobs which are demanding. Hence, there will be at least some migration from private sector minimum-wage jobs to this new source of employment. Companies would have to pay more for such positions. This would reduce their profitability. Or, they would curtail their production, decreasing the real production in the economy. The overall productive workforce will reduce, and whatever wealth these workers earlier produced will now not be produced. That’s unseen effect #3.

All this while, we have not even asked the most basic of questions: where will the wages for the unproductive labour come from? The government too needs to have a source of funds. Typically, government raises funds in one of two ways: taxes and debt. To fund this job spree, it has to either raise taxes enough to pay for all the labourer’s time and equipment, or issue debt and borrow money from the market, or a combination of the two.

Raising taxes would place a burden on the productive part of the economy. As it is, the first three unseen effects have been detrimental to them. This would cause more harm. They could borrow money from the market. But, this would divert capital from productive uses to wastage on fake jobs, starving good, sound enterprises of capital, causing them harm. Either way, the productive sector is harmed. Any means the government uses to raise money further hampers the productive economy. That’s unseen effect #4.

The more the real wealth in the economy, the longer the economy can bear the burden of such unproductive labour. In a rich society, these unseen effects will manifest themselves much later than in a not-so-rich society. The longer the duration for which wealth is destroyed, the more severely the losses manifest themselves.

The Findings

Clearly, a policy of paying people to dig ditches and fill them back up is an economic folly. It is a diversion of capital from wealth creation to wealth destruction. It has a very real negative impact-only, it takes place slowly and out of sight.

More broadly, we see that jobs per se are meaningless. For an economy to prosper, such jobs must be tied to wealth creation. It is the creation and accumulation of wealth that is the hallmark of a prosperous society, not creation of jobs. Job creation is a consequence of, not a cause of, wealth creation. And producing things which are in demand in the market is how a society creates wealth.

Sadly, the author has not bothered to distinguish wealth creation from job creation, and by observing the correlations between the two, has concluded that job creation would lead to wealth creation, and has gone on to outline policies for job creation. This idea of putting the cart before the horse is at the root of his mistakes, the second of which is the failure to distinguish between money and capital.

Capital in Superabundance

The author refers to a Bain & Co. report which points out that the total dollar value of all financial assets exceeds the total dollar value of all non-financial assets carried on balance sheets by a factor of two. The report also states that the dollar value of all financial assets is about 10 times global GDP. The author uses this to shore up his observation that capital is now cheap and that we can use it with abandon without any concerns.

The author connects capital superabundance with job creating innovation to make the point that now that capital isn’t scarce, companies should give less importance to efficiency innovations which reduce jobs and plow all their unused capital into market creating innovations which increase jobs. Capital is cheap, so why not take advantage of this to invest in job creating innovations? From this premise, he outlines the ways regulators can spur job creation by altering their tax policies. He also notes that business schools and their alumni can do their bit to wean companies off the efficiency focus and prod them towards a focus on job creation, using all the super abundant and cheap capital.

The Problem

Money is not capital. A financial asset is a claim on a non-financial asset. The value of a financial asset depends on the value of the underlying non-financial asset. The greater the disparity between the monetary values of non-financial assets and financial assets, the more the effects of volatility in the prices of the former on the prices of the latter. Simply put, if the value of the non-financial asset reduces by a dollar, the value of the financial asset reduces by three dollars.

Money is the medium of exchange, the unit of trade. Prices are expressed in monetary units in order to facilitate exchange. Money has value only for the purpose of exchange. Capital, while denominated in terms of monetary units, is valued for its ability to satisfy the demands of the market participants. While money may be in super abundance (thanks to the inflationary policies adopted by the Federal Reserve and followed suit by other central bankers all over the world), capital most certainly is not. Capital is scarce. Creation of capital involves the expending of resources: land, labour and other capital goods. While money supply can be increased on a whim with no effort and almost instantaneously, it takes time to build capital. Investors who undertake the task of building capital will not undertake them if they lacked economic rationale. In the current U.S. economy, there is no rationale for deploying massive cash reserves on long-term projects.

To understand why I make this claim, it is important to first understand the structure of production, and where capital creation fits in.

The Structure of Production

The economist Friedrich Augustus von Hayek, the winner of the 1974 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (to the layman, a “Nobel prize”, but it’s actually not) has used a simple illustration to explain the structure of production, which captures the essence for the purpose of our discussion:

The basic concept to understand is that all production takes time. Goods move through different stages of production before reaching the consumer. These different stages are separated in time. To produce a car, metallic ore has to be mined (early stage), the ore has to be refined, made into a component by the auto-ancillaries, assembled in the assembly line, distributed to dealerships (late stage) and then reach the hands of the end consumer. At each stage, capital has to be invested in the production structure. To sustain the flow of consumer goods, the capital invested in the production structure has to be consistently maintained. This capital, at each stage, is supplied by capitalists, who earn a return on their invested capital. They have to pay the capitalist of the previous stage, receive the unfinished good, process it, and pass it on to the next stage and receive payment. The late stage capitalist is paid directly by the consumer. Of course, I’m generalizing here, to keep our discussion simple while capturing the essence.

Deepening our understanding of the structure of production

For the sake of simplicity, let’s assume that the end consumer pays 100 ounces of gold for the consumer good, and that all stages of production take exactly one year. The capitalist at each stage has to invest, work on his unfinished good for a year, then sell it and get his return. Let’s target a 25% return for each capitalist. The following diagram captures the amount of capital that goes into the production structure:

Capitalist C4 pays 41 ounces of gold to capitalist C5, works for a year, and sells his unfinished good to capitalist C3 for 51 ounces of gold, who in turn works on it for a year and sells to capitalist C2 for 64 ounces, who sells to C1 for 80 ounces and finally, it reaches the end consumer who pays 100 ounces of gold to the late stage capitalist C1.

To produce a consumer good in year 5, capitalist C5 has to start work 5 years in advance. For this production structure to maintain a steady output of consumer goods, capitalist C5 has to invest 5 years in advance and continuously re-invest every year to maintain his output. The same goes for the other capitalists, as they all have to start production before the consumer good makes it to market. For C4, 4 years in advance, C3 3 years, C2 2 years, C1 1 year. And each year, they have to make the decision to re-invest in order to produce an output for the next year.

To ensure a continuous supply of consumer goods, the invested capital should never leave the production structure. Thus, at any given year, capitalist C5 has to maintain his investment of 33 ounces of gold, C4 his 41 ounces, C3 his 51 ounces, C2 his 64 ounces and C1 his 80 ounces. The total capital invested in the production structure would be 80+64+51+41+33=269 ounces. It takes 269 ounces of gold in capital to produce 100 ounces of gold worth consumer good.

What does this tell us?

A couple of things stand out: demand for the unfinished good at each stage is directly dependent on the demand for the final consumer good, and early-stage capitalists have to be much more prescient in forecasting demand than the late-stage capitalists.

This also tells us that capital is simply never in abundance. If it were, there would be an abundant supply of consumer goods. We’d be living in paradise, with all our desires met by the abundant supply of goods available for our immediate consumption. There would be no need to work, save, and invest!

Capital, at each stage, has to be maintained just to ensure the same rate of consumption. To bring forth a new supply of consumer goods, more capital goods have to be created. As we have seen, the value of the capital goods to be created far exceeds the value of the final consumer goods they generate.

To create capital goods, capitalists have to save money and invest it in the structure of production, thus expanding the structure of production.

Capital and Money

In this happy land of production and consumption where gold is the unit of exchange, i.e. money, a thug with a gun steps in and declares that from thereon, all gold should be stored with him. In return, he will issue paper notes equivalent in value to the weight of gold represented on that note. He takes away all the gold, the people use these gold equivalents as money and life goes on under the watchful eyes of the thug. The prices are the same, but denominated in gold-equivalent paper notes.

Now, what happens if the thug suddenly triples the total supply of these gold-equivalent notes? Overnight, capital is in superabundance! The total money value of all financial assets exceeds the total money value of all non-financial assets carried on balance sheets. It is also far greater than the GDP, which is essentially the amount of money spent on consumption.

But, have things really changed? Is it really capital, represented by investments in the production structure, which is in super abundance? Or is it just that the basis of accounting, the monetary unit by which the capital is represented, that has changed? It’s clearly the latter since prices in terms of gold haven’t changed at all. All that has happened is that the monetary base in which goods are now forced to be priced has been changed by the rule of the gunman.

Seen from this perspective, it is clear that capital is not money. Money is merely a facilitator of exchange, and price is the ratio of capital/consumer goods to money. Having a lot of money reserves is not the same as having a lot of capital good reserves. Mistaking one for the other is a fatal flaw which totally invalidates Clayton Christensen’s analysis.

We live under a system of fiat money, where everything is forced to be priced in terms of a money commodity whose supply is controlled by a central bank which can increase the supply of money at whim. This distorts the structure of production as the monetary base capitalists use for their pricing and investment decisions changes rapidly without their awareness.

Since 2008, the money supply increases have reached such proportions that money prices have become far removed from market signals. We cannot be certain if the capital in the production structure has been maintained, invested capital has increased or decreased. The distortionary effects of the central bank’s activities are yet to be fully factored into prices in the production structure (which isn’t helped by the fact that the central banks distort prices more before the market can fully adjust to their prior actions).

Once the monetary base stabilizes, and prices work themselves out, we’ll be able to see the full effects on the production structure. This is why no new investments are being made in early stage production. The capitalists are waiting for prices to adjust, to reflect the amount of money commodity currently in the market.

Regime Uncertainty

Added to the pricing distortions caused by a shifting monetary base are distortions caused by changing government regulations affecting production decisions. The point has been illustrated well by the scholar Robert Higgs, who has studied its role in prolonging the Great Depression.

We are currently living through such a period.


Job creation, while correlated with wealth creation, is not synonymous with wealth creation. It is the creation of wealth which creates jobs in new lines of production made possible by the increase in wealth. A focus on job creation instead of wealth creation is a route which leads to wealth destruction and a lower quality of life in that society.

Capital is not the same as money. Capital is what is invested in the structure of production, and denominated in terms of money for the purpose of trade. A capital good is an actual asset used in production and capital, its money price. Distortions in the monetary base in which capital is priced creates distortions in the production structure, the full effects of which will play out only once the monetary base stabilizes and prices can adjust to the new monetary base.

Monetary base distortions are compounded by the shifting nature of government regulations, dealing a double whammy to any attempts by capitalists to converge on prices which reflect market realities. This is deterring investments in new lines of production, especially at the early stage production, due to heavy uncertainty over demand.


There is no capitalist’s dilemma. What the author observes happening is a natural consequence of the attempts of the central bank and government to interfere with the production structure through their regulations and changes in the money supply.

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