WTF?: What's the Future and Why It's Up to Us

by Tim O'Reilly

These are noble goals. But they may have come too late. We are already in the thrall of a vast, world-spanning machine that, due to errors in its foundational programming, has developed a disdain for human beings, is working to make them irrelevant, and resists all attempts to bring it back under control. It is not yet intelligent or autonomous, and it still depends on its partnership with humans, but it grows more powerful and more independent every day. We are engaged in a battle for the soul of this machine, and we are losing. Systems we have built to serve us no longer do so, and we don’t know how to stop them. If you think I’m talking about Google, or Facebook, or some shadowy program run by the government, you’d be wrong. I’m talking about something we refer to as “the market.” To understand how the market, that cornerstone of capitalism, is on its way to becoming that long-feared rogue AI, enemy to humanity, we first need to review some things about artificial intelligence. And then we need to understand how financial markets (often colloquially, and inaccurately, referred to simply as “Wall Street”) have become a machine that its creators no longer fully understand, and how the goals and operation of that machine have become radically disconnected from the market of real goods and services that it was originally created to support.

“To model correctly one tranche of one CDO took about three hours on one of the fastest computers in the United States. There is no chance that pretty much anybody understood what they were doing with these securities. Creating things that you don’t understand is really not a good idea no matter who owns it.” In short, both high-speed trading and complex derivatives tilt financial markets away from human control and understanding. But they do more than that. They have cut their anchor to the human economy of real goods and services. As Bill Janeway noted to me, the bursting of what he calls the “super-bubble” in 2008 “shattered the assumption that financial markets are necessarily efficient and that they will reliably generate prices for financial assets that are locked onto the fundamental value of the physical assets embedded in the nonfinancial, so-called real economy.”

The guiding “fitness function” for Western economies thus became full employment. This worked well for a time, Blyth notes, but eventually led to what was called “cost-push inflation.” That is, if everyone is employed, there is no barrier to moving from job to job, and the only way to hang on to employees is to pay them more, which employers necessarily compensated themselves for by raising prices, in a continuing spiral of higher wages and higher prices. As Blyth notes, every intervention is subject to Goodhart’s Law: “Targeting any variable long enough undermines the value of the variable.”

In 1981, Jack Welch, then CEO of General Electric, at the time the world’s largest industrial company, announced in a speech called “Growing Fast in a Slow-Growth Economy” that GE would no longer tolerate low-margin or low-growth units. Any business owned by GE that wasn’t first or second in its market and wasn’t growing faster than the market as a whole would be sold or shuttered. Whether or not the unit provided useful jobs to a community or useful services to customers was not a reason to keep on with a line of business. Only the contribution to GE’s growth and profits, and hence its stock price, mattered. That was our Skynet moment. The machine had begun its takeover.

The Rise and Fall of American Growth, Robert J. Gordon’s magisterial history of the change in the US standard of living since the Civil War,

Stock prices are a map that should ideally describe the underlying prospects of companies; attempts to distort that map should be recognized for what they are. We need to add “fake growth” to “fake news” in our vocabulary to describe what is going on. Real growth improves people’s lives.

Despite these counterexamples, the idea that extracting the highest possible profits and then returning the money to company management, big investors, and other shareholders is good for society has become so deeply rooted that it has been difficult for too long to see the destructive effects on society when shareholders are prioritized over workers, over communities, over customers. This is a bad map that has led our economy deeply astray.

Mistaking what is good for financial markets for what is good for jobs, wages, and the lives of actual people is a fatal flaw in so many of the economic choices business leaders, policy makers, and politicians make.

The biggest losers, though, from this change in corporate reinvestment have been workers, whose jobs have been eliminated and whose wages have been cut to fund increasing returns to shareholders. As shown in the figure below, the share of GDP going to wages has fallen from nearly 54% in 1970 to 44% in 2013, while the share going to corporate profits went from about 4% to nearly 11%.

It isn’t Wall Street per se that is becoming hostile to humanity. It is the master algorithm of shareholder capitalism, whose fitness function both motivates and coerces companies to pursue short-term profit above all else. What are humans in that system but a cost to be eliminated?

For that matter, why would you provide the best goods or services if you could improve profits by cutting corners? This is the era of what business strategist Umair Haque, director of the Havas Media Lab, calls “thin value, profit extracted through harm to others.” Thin value is the value of tobacco marketed even after its purveyors knew it contributed to cancer; the value of climate change denial by oil companies, who have retained the same disinformation firms used by the tobacco industry.

Economists George Akerlof and Paul Romer fingered the nexus between corporate malfeasance and political power in their 1994 paper “Looting: The Economic Underworld of Bankruptcy for Profit.”

As I remember the talk, its central argument went something like this: “I’m a successful capitalist, but I’m tired of hearing that people like me create jobs. There’s only one thing that creates jobs, and that’s customers. And we’ve been screwing workers so long that they can no longer afford to be our customers.”

Who is the market? It is algorithmic traders who pop in and out of companies at millisecond speed, turning what was once a vehicle for capital investment in the real economy into a casino where the rules always favor the house. It is corporate raiders like Carl Icahn (now rebranded as a “shareholder activist”) who buy large blocks of shares and demand that companies that wish to remain independent instead put themselves up for sale, or that a company like Apple disgorge its cash into their pockets rather than using it to lower prices for customers or raise wages for workers. It is also pension funds, desperate for higher returns to fund the promises that they have made, who outsource their money to professional managers who must then do their best to match the market or lose the funds they manage. It is venture capitalists and entrepreneurs dreaming of vast disruption leading to vast fortunes. It is every company executive who makes decisions based on increasing the stock price rather than on serving customers.

This is what financial industry critics like Rana Foroohar, author of the book Makers and Takers, are referring to when they say that the economy has become financialized. “The single biggest unexplored reason for long-term slower growth,” she writes, “is that the financial system has stopped serving the real economy and now serves mainly itself.”

The system is rigged. Companies are forced to eliminate workers not by the market of real goods and services where supply and demand set the right price, but by the commands of financial markets, where hope and greed too often set the price. Most people unthinkingly use the term the market to refer to these two very different markets. Recognizing that they are not the same is the first step toward solving the problem.

I’m not convinced. If Uber had the courage of its convictions, it would be deploying demand-based pricing (including surging prices in a negative direction, below the base price) all the time, much as Google sets ad prices with an auction. Why don’t they? Because they believe that both drivers and customers are more comfortable with a known base price. That is, the difference between theory and practice is greater in practice than it is in theory.

Here’s the rub in the real world: Uber isn’t just satisfying the two simultaneous demand curves of customer and driver needs, but also competitive business needs. Their desire to crush the incumbent taxi industry and to compete with rivals like Lyft also affects their pricing. And under the rules of the venture-backed startup game, in order to satisfy the enormous prospective valuation placed on them by their investors, they must grow at a rate that will allow them to utterly dominate the new industry that they have created.

“Between the end of World War II and 1968, the minimum wage tracked average productivity growth fairly closely,” writes economist John Schmitt. “Since 1968, however, productivity growth has far outpaced the minimum wage. If the minimum wage had continued to move with average productivity after 1968, it would have reached $21.72 per hour in 2012—a rate well above the average production worker wage. If minimum-wage workers received only half of the productivity gains over the period, the federal minimum would be $15.34.” Instead, as we have seen, the bulk of the value created by increasing productivity has been allocated to corporate shareholders.

As Nick Hanauer pointed out, in general we have forgotten the hard-fought lessons of the twentieth century: that workers are also customers, and that unless they receive a fair share of the proceeds, they will one day be unable to afford the products of industry.

As Nick Hanauer, who got his start with his family pillow business, put it in the documentary film Inequality for All, “The problem with rising inequality is that a person like me who earns a thousand times as much as the typical worker doesn’t buy a thousand times as many pillows every year. Even the richest people only sleep on one or two pillows.”

In The Marriage of Heaven and Hell, written during the most hellish days of the first industrial revolution, the poet William Blake issued what might well be a rule as certain as those issued by any economist: “The Prolific would cease to be Prolific unless the Devourer, as a sea, received the excess of his delights.”

It has been estimated that the total public subsidy to low-wage employers amounts to $153 billion per year.

Nick Hanauer calls it the fundamental law of capitalism: “When workers have more money, companies have more customers and then hire more workers.”

The barriers to fresh thinking are even higher in politics than in business. The Overton Window, a term introduced by Joseph P. Overton of the Mackinac Center for Public Policy, says that an idea’s political viability depends mainly on whether it falls within the window framing a range of policies considered politically acceptable in the current climate of public opinion. There are ideas that a politician simply cannot recommend without being considered too extreme to gain or keep public office.

If there were no income tax, what about replacing it entirely with so-called Pigovian taxes, taxes on negative externalities? A carbon tax is one of those ideas. A financial transactions tax or other form of tax on the massive redirection of corporate profits toward financial speculation and away from investment in people and the real economy might be another.

“Only around 15% of the money flowing from financial institutions actually makes its way into business investment,” says Rana Foroohar. “The rest gets moved around a closed financial loop, via the buying and selling of existing assets, like real estate, stocks, and bonds.” There is some need for liquidity in the system, but 85%?

Here is one of the failed rules of today’s economy: Human labor should be eliminated as a cost whenever possible. This will increase the profits of a business, and richly reward investors. These profits will trickle down to the rest of society. The evidence is in. This rule doesn’t work. It’s time to rewrite the rules. We need to play the game of business as if people matter.

Over the years, it became clear to me that many of the companies in the technology industry we are part of were playing by very different rules. They were not getting paid by exchanging goods and services with customers, but by persuading investors to give them money. Perhaps customers would come along eventually, but as long as the company could find investors to finance their next round, perhaps all the way to an IPO or acquisition, a company could just have “users” instead of customers. Early in my career, venture capitalists still funded entrepreneurs in the hope that they would build companies with real revenues and profits, but in the years leading up to the dot-com bust, it seemed that the game had changed. Entrepreneurs were not creating true companies but a kind of specialized financial instrument, a financial bet not that dissimilar to the CDOs that bedeviled the banking industry in the years leading up to the 2008 financial crisis a decade later. I see much of the same misdirection of entrepreneurial energy in today’s overheated Silicon Valley boom. These companies, often sold for billions of dollars, are valued not based on some multiple of their sales, profits, or cash flows, but for expectations of what they might become, promoted like fake news in a market of attention. This effect is central to understanding the hypnotic allure of financialization.

The ratio between a company’s revenues, cash flow, or profits and its market capitalization is one of many imaginary numbers that make up the world of financial capital. In theory, the intrinsic value of owning a stock is based on the net present value of its expected future profits. In practice, it is that net present value times the expectations of millions of potential buyers and sellers.

The price-earnings ratio of a stock is the difference between the actual net present value of a company’s future profits and its market price. Amazon’s P/E ratio is 188 at the time I’m writing. Facebook’s is 64, Google’s 29.5. The ratio for the entire S&P 500 is about 26. That is, for every dollar of profit it makes today, Amazon gets $188 in stock value, Facebook gets $64, and Google gets $29.50. For a company like Uber, which has no profits yet but is valued at $68 billion by investors, the ratio is essentially infinite. That leverage makes stock an incredibly powerful currency, which swamps the purchasing power of the ordinary currency used in the market of real goods and services. Amazon’s profits in 2016 were just shy of $2.4 billion, and its book value (the actual value of its cash, inventories, and other assets less its liabilities) $17.8 billion, yet its market capitalization at the end of the year was $356 billion. George Goodman, a financial writer who published under the pseudonym Adam Smith, calls this “supermoney.”

A company that has been financialized—that is, is valued in supermoney—has a huge advantage over companies that are operating solely in the market of real goods and services.

If all you have to pay employees with are actual earnings from your business, you are limited in how rich you can make them. If you can pay them in supermoney—especially in the super-supermoney represented by stock options (the right to buy a stock at today’s price but with no obligation to do so until it has appreciated in value), even more so if it is in supermoney cubed (pre-IPO stock options at 90% discounts from what even the venture capitalists are paying) you can hire the best talent. If you have access to supermoney, you can operate for years at a loss. This is one reason—not just the superior customer benefits and economic efficiencies of their technology or business model—that Internet companies can disrupt older, less highly valued companies.

If you are paid in ordinary money, you may still be able to buy a home, but perhaps you have to move to a less attractive location to do so. If you are paid in supermoney, you can afford to pay higher rents, or spend more to buy your home, driving up prices and even further increasing the distance from those working in the ordinary marketplace of goods and services. Not only that, if you are paid in supermoney, you can convert some of it into ordinary money and become an investor—placing bets in other new companies, in the broader stock market, in real estate—multiplying your wealth still further.

The negative impact on the real economy doesn’t end there. Investors focus on companies that will have huge “exits”—that will return at least 10x their investment. This quest for outsize winners has the perverse effect of starving ordinary businesses of capital. A company that may deliver real value but grows slowly and may never achieve global scale is simply uninteresting to investors.

He believes deeply in building real businesses, using the same philosophy as Warren Buffett, the value-investing genius of public markets, that valuing a company based on positive cash flow is the secret to successful investing. His own mentor, Fred Adler, had a saying that Bill passed on to me: “Corporate happiness is positive cash flow.”

If they are to break free from the mistakes of the failed philosophy of current financial markets, which too often hollow out the real economy and increase inequality, these platform companies must commit themselves to the health and sustainability of their partner ecosystems. This is not just a matter of idealism. It is a matter of self-interest. When platforms take too much of the value for themselves, they lose their way.

“If you take down your clothesline and buy an electric clothes dryer, the electric consumption of the nation rises slightly,” Baer wrote. “If you go in the other direction and remove the electric clothes dryer and install a clothesline, the consumption of electricity drops slightly, but there is no credit given anywhere on the charts and graphs to solar energy, which is now drying the clothes.” The Clothesline Paradox is a tool for seeing the economy with fresh eyes, essential if we are to correctly rewrite the rules. It is another of those general-purpose concepts that is an aid to seeing what others are blind to.

The Clothesline Paradox is a great way to understand the value of investments in basic research, and in particular, open science, where information is freely shared. Much of the basic research that pays such enormous dividends is funded by taxpayers, yet when government makes a claim on those dividends in the form of corporate or capital gains tax, far too many of the beneficiaries complain or seek to avoid it.

Nick Hanauer once said to me, “Prosperity in human societies is best understood as the accumulation of solutions to human problems. We won’t run out of work until we run out of problems.”

Jeff Immelt, Jack Welch’s successor as CEO at GE, has rejected the purely financial calculus of the old GE, and has recommitted the company to “solving the world’s hardest problems,”

“We need to be investing in this next generation of who’s employable and what skills they need. And that’s the purpose of companies just like it is of schools.” That is, good jobs, not just profits, or even great products, are one of the key outputs of a great company.

Education is another way that we effectively reduced working hours. Young children once went to work; in the nineteenth century, we sent them instead to school.

I asked MIT labor economist David Autor whether there were any natural experiments in universal basic income, and what they teach us. He cited the contrast between Saudi Arabia and Norway. Both countries have enormous oil wealth, he noted, but in Saudi Arabia, the bulk of the wealth goes to a small percent of the population. Much of the work of everyday society is looked down on and is done by an underclass of low-paid “guest workers” while an elite works at sinecure jobs or enjoys idle pursuits. In Norway, by contrast, Autor said, “All kinds of work are valued. Everybody works, they just work a little less.” The generous redistribution of oil profits and a strong social safety net funded by the wealth that is understood to belong to all makes Norway one of the happiest and wealthiest countries in the world.

“There may need to be two kinds of money: machine money, and human money. Machine money is what you use to buy things that are produced by machines. These things are always getting cheaper. Human money is what you use to buy things that only humans can produce.”

Paul believes that the right name for what many are calling “universal basic income” should be “the citizen’s dividend,” the name given to it in Thomas Paine’s Agrarian Justice.

Back in 1950, who would have guessed that in 2014 there would be nearly 300,000 “fitness trainers” in the United States? If you look at the current shape of the economy, there are huge and growing numbers of service jobs of this kind.

On-demand technology has promise for growing the market even further. Seth Sternberg, founder of Honor, a service making it easier for older adults to remain in their own homes, pays its caregivers as full-time employees with benefits, but uses on-demand technology to make care more flexible and affordable for consumers.

The economic problem is that caregiving is insufficiently valued in our society. If there were ever a case to be made for the Clothesline Paradox, this is it. Why is it that work that is so valuable to society is expected to be provided for free, or when paid, is paid so poorly? If we are working from a new map, in which our objective is to value human effort, not to dispense with it, we surely must start by assigning an economic value to caregiving.

(The United States is one of only two countries in the world that don’t mandate any paid maternity or paternity leave; the other is Papua New Guinea.)