Internet gains vs Wall Street innovations

People attend the annual 'Campus Party' Internet users gathering in Valencia on July 29, 2009. 'Campus Party' is a thirteen-year-old event where computer and technology fans gather gather from July 27 to August 2 to surf the internet, play, share information and technology.  

The Internet has turned 40. So much brain power has gone into creating this fascinating innovation. According to Internetworldstats.com, globally there are nearly 1.7 billion Internet users. The fastest growth rates have come from the Asian countries. China leads with 330 million, followed by the U.S. with 220 million. India has only 80 million users and a population penetration of a meagre 7 per cent. However, going by the trends, there are great opportunities for growth and investment.

Although it is hard to estimate the extent of job creation due to the Internet, it has made thousands of millionaires and billionaires. We must thank a number of researchers and scientists who made it possible. At least one person needs special mention for his contribution to making the Internet available to the masses — Tim Berners-Lee, currently a Professor at the Massachusetts Institute of Technology. He invented the World Wide Web (WWW) to serve the scientists at the European Organisation for Nuclear Research, or CERN.

What is even more important is that Professor Berners-Lee and CERN relinquished all intellectual property rights to WWW software and related technologies for the greater good. Had he chosen to patent and exploit the innovation for personal gain, he could be competing for the wealthiest person on earth.

Also, the adoption of the Internet and WWW would not have had the impact that it has had. The innovations in communication technologies and software would have been impeded. The demand for IT workforce in the U.S. and the rest of the developed world would not have skyrocketed. The massive demand for the IT workforce gave an incredible opportunity for Indian firms to tap the global market.

All those who condemn the role of governments should take a deep breath to acknowledge the role of U.S. and European governments and their research funding agencies for the new wealth. The long gestation period involved in bringing a commercially viable innovation into the market often requires some form of governmental support. The private sector by itself has little incentive to look several decades ahead to make investment choices.

All those entrepreneurs who made the Internet and WWW ubiquitous deserve praise as well. Entrepreneurs with ideas and perseverance toil for years in garages, living a frugal life, to make their dreams a reality. Many do not see success. Only one in 10 new ventures makes it big. Most of them die for lack of funding or competition or simply owing to bad timing. But many move on to the next venture to try again. So, as the Internet turns 40, it is time to acknowledge those entrepreneurs who toil to make their dream come true while creating jobs and wealth.

Contrast this with what goes on in Wall Street or investment banking all over the world. In 2008, John Paulson, the decorated hedge fund manager, walked away with $3.7 billion as the market imploded. He had bet on the financial sector to collapse under the enormous leverage and the comical financial engineering. He shorted (that is, borrowed stock from others, often without permission from actual owners, and sold in anticipation of buying back and returning the stocks once prices fell) financial stocks and hit the bull's eye as Lehman, Bears Stearns, Merrill Lynch, Goldman Sachs, Washington Mutual, Citi, and other behemoths died or had near-death experiences. Excessive shorting probably contributed to the rapid collapse in stock prices and a run on these banks. After the dust settled, mostly thanks to government bailout amounting to trillions of dollars, Mr. Paulson is back buying shares of any leftover institutions at amazingly low prices to ride back up again. He made his wealthy investors even wealthier and did an outstanding job of it.

But something is amiss when we contrast that to Professor Berners-Lee's contribution. Mr. Paulson's reward to some extent basically killed jobs and destroyed wealth in a dramatic fashion for a large number of people, while enriching a few.

The capital markets, the bedrock of capitalism, are about allowing human ingenuity to seek capital to create wealth and prosperity through greater employment. But the same market is being used to transfer wealth to a few, and destroy jobs and others' wealth along the way. The rewards are disproportionate to the value created to society or in comparison to those minds that enable wealth-creation.

Of course some would argue that Mr. Paulson deserves his reward, and that shorting, in general, is a risk management tool. Some, including academic researchers, argue that shorting makes markets efficient and that prices reflect market information. This may have some support, but shorting existed for a long time and it has not prevented bubbles. While efficient market hypothesis sounds appealing, it does not explain how so many economists and financial "experts" missed the ridiculous leverage and lack of risk management. The unregulated market probably exploited the system for short-term gains that aligned with individuals' perverse incentive system.

Some pundits creatively term the financial carnage as creative destruction of old-time behemoths that have no business to exist in this modern complex business environment. The process of creative destruction — a term coined by the Austrian-American economist Joseph Schumpeter — explains that in a capitalistic system, by its very nature industries incessantly mutate with technological evolution and revolutions and with access to new markets and resources. During this mutation, existing players die and new ones are born. That explains why a large fraction of the industrial behemoths of the early 1900s do not exist now, but new ones thrive. At the same time, powerful players were brought to their knees. But it is a mistake to equate the highly leveraged, greed-driven decisions of investment bankers that put short-term rewards ahead of long-term benefits with creative destruction which naturally occurs in a capitalistic system.

It is hard to justify the reward structure of hedge funds and investment bankers vis-à-vis the human ingenuity that created the Internet that had such profound social benefits. It is of course dangerous to club all types of rewards in the financial sector as undeserving. For instance, huge rewards in private equity investments that support the process of mutation and drive innovations in a changing world can be justified for their role and risks. They do create efficiencies and job opportunities and drive economic growth. Investors taking a risk with new initial public offers (IPOs), participating in new equity, or buying corporate bonds that support operations of businesses also deserve rewards.

Capitalism thrives on access to capital and investors who provide the resources need to be rewarded. However, rewards such as those that Mr. Paulson got are mind-boggling since those gains do not support the foundations of capitalism. Maybe we have to coin a term "outvestment" rather than "investment" and have the process taxed differently. This digression from the Internet and entrepreneurs to the financial reward structure was deliberate, to make a comparison to highlight the contrast in the value systems. While so many entrepreneurs fail to have access to capital for innovative purposes, the financial markets have become a place for "fast money" and "mad money" rather than one to support access to capital for productive use. The so-called financial innovations that involve rapid trading, swing trading, excessive speculation, and shorting treat the financial markets as a giant gambling machine. The reward structure gives the illusion to the next generation that fast money on Wall Street is better than engineering and science where rewards take a long time and may not be guaranteed. There is increasing criticism that the best and the brightest are attracted to these quick rewards on Wall Street than to pursue other disciplines.

Like capital, greed is a key ingredient for capitalism to flourish. It is disingenuous to assume that greed can be eliminated with regulations. However, the incentive system and how governments tax gains must be revisited. Businesses and entrepreneurs that take risks to invest in R&D and create economic growth that benefits society must be rewarded, perhaps through incentives such as lower taxes. The entrepreneurial spirit must be rewarded even if a few individuals become obscenely rich. The good news is that many such billionaires have given, or are giving, most of their wealth back to society. Gains from investments to support the definition of "capital," as in new IPOs, new equity participation, and bonds, must be treated differently from gains made from "outvestment" and excessive trading that treat markets as casinos.

There will be many who will object to lower taxes even for businesses that invest in R&D and create jobs. But we should not equate tax incentives with reckless subsidies at the expense of the poor and the powerless. Rather than endlessly extending tax exemption to profitable companies, tax benefits should be based on new investments and job creation.

There are lessons to be learnt for India as it continues to prosper. The financial markets must be governed judiciously to avoid reckless behaviour from perverse incentive systems. Taxation should reward wealth creators and penalise those who treat the market as a giant casino. There needs to be greater fiduciary responsibilities for investment bankers, analysts and money managers when their advice leads to excessive losses.

(Prabhudev Konana is William H. Seay Centennial Professor and Distinguished Teaching Professor at the University of Texas at Austin, and can be contacted at pkonana@mail.utexas.edu)

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