Five months ago during the early stages of the unfolding pandemic, Capital Flywheels published Recession of a Different Kind shortly after the market bottomed after falling 35% from all-time-highs. In the face of significant uncertainty, massive unemployment unseen since the Great Depression, and unparalleled economic collapse within recorded history…Capital Flywheels took a leap of faith to argue that things are probably fine.
The economy was (and is) suffering, but deep down, Capital Flywheels’ heart felt almost certain that the economy was more likely to undergo a convulsive metamorphosis rather than drop “dead as a doorknob” and enter Great Depression #2 as many pundits suggested:
The world may look like it is collapsing today, but the moment the wheel reverses, credit expansion will also lead to a positive feedback loop that will likely surprise people at the breadth and speed of recovery.
I don’t know when it will happen. It may take time. But the moment the world realizes that it is happening, it will be too late to react.
While the economy is likely to recover and demand is likely to recover, businesses and value creation may look very different. Capital Flywheels believes that this crisis will accelerate forces that have already been in motion for decades: More digitization/consumption of digital goods, more technology adoption even in lagging enterprises, and, sadly but surely, more consolidation of business within the largest companies over the smallest companies. This is an exercise in efficiency – the most efficient businesses (both from a labor and capital perspective) will gain, while inefficient businesses will decline. Efficient businesses tend to be large and technology-driven. Inefficient businesses tend to be small and/or legacy.Source: Recession of a Different Kind
That orientation allowed us to correctly position the Paper Portfolio to take advantage of a once-in-a-decade sell-off that we continue to benefit from even today.
Although Capital Flywheels continues to believe every single word written five months ago, Capital Flywheels now deeply regrets focusing the overall message so narrowly on investing and making money. We have made our money and will continue to make money from the chance we took and the assessment of the situation we were in, but the metamorphosis that the economy is undergoing will shake the foundation of our lives and Capitalism in ways that will only become apparent years from now. And how we make money then and how we live then, is not certain.
That’s what I want to focus on, specifically.
Because this is not just a recession in which the old is swept away to make space for the new.
This is not just a normal recession like every recession the world has faced in the last 100 years.
This is not just a recession in which one generation of brands and companies get replaced by the next generation of brands and companies.
This is not just a recession in which one generation of business people get replaced by the next generation of business people.
This is an economic recession and recovery that may (will?) accelerate the death of the economic models that dominated the 20th Century and will require Capitalism to evolve. And the world may not be prepared.
Despite the size, robustness, and complexity of the modern economy, its existence has been quite short. The modern economy we live in – one bringing together a fairly balanced mix of labor, capital, and “productivity” – is only a few hundred years old.
For most of human history, the economy was largely driven by only one factor – Labor. Every single economic activity largely required human hands. Countries with more labor, therefore had larger economies. Countries like China and India had the largest populations and, therefore, dominated economically throughout most of history.
However, this dominance meant very little. While China and India had larger economies than others, the economies were still driven by human hands. And even the most productive humans can only produce marginally more than the average global citizen. China and India were better off than other places for most of history, but unless you were the Emperor or Maharaja, your life situation was likely not that different from average (which is to say, pretty bad).
In this era of pure labor, countries had limited choices in terms of expanding their economy on a per capita basis. Some tried religion, hoping that prayers for more would be answered. More rain, more productivity in some manner…sometimes rain did come, leading to bountiful harvests. But, on average, prayers did not usually lead to different results.
Some tried technology and invention. This did work to some extent, but until the scientific process was formalized, technological progress was slow and uneven and too uncertain to invest behind. Most countries were just trying to get by and living barely above subsidence levels…devoting time and money towards uncertain technological progress was not a high priority.
The most successful strategy was often to take it from someone else. Large economies were backed by large populations. Large populations mean potential for large armies. Large armies can take economic growth and wealth (and labor, in the form of slaves) from smaller nations. Most of human history was therefore, violent. And per capita economic growth was largely a violent affair. By the time this era peaked, the world had consolidated down to just a few large empires.
Around 500 years ago, something magical happened. With the formalization of the scientific process, the world started to make scientific and technological discoveries on a more consistent basis. These discoveries led to the creation of machinery (capital) that dramatically expanded the economic output and potential possible with human hands. Humans could almost instantly produce what would have required tens or hundreds or thousands of hands previously.
And this led to a dramatic shift in the economic fabric of the world. In the prior era, people were chiefly responsible for their own output. Everyone’s hands could barely produce what was enough for their own consumption or could barely produce what was enough to trade for the basic necessities of life. Few people other than kings and queens could live on the output of others (more than partially enabled through force). But with the creation of machinery and capital, suddenly human hands could consistently produce surplus.
But more importantly, the creation of machinery and capital allowed the full emergence of business people and the Capital class in a way that was not previously possible on a wide scale. In the labor era, people could only live off the output of others through force with the extreme form being slavery. But with the creation of machinery and capital, business people and Capitalists could live off the output of others through ownership of machinery rather than people. No longer did one have to coerce or enslave someone to take control of their output…you just have to own the machine that the person requires for their output.
Of course, I am dramatically simplify history, but the long arc of history is better understood in broad strokes.
The emergence of machinery and capital transformed the economies of the world and ultimately led to the philosophical emergence of Communism. As originally proposed by Marx (rather than the bastardized versions of Communism that were later carried out by various authoritarian governments around the world with extreme command-and-control tendencies), Marx’s Communism mainly concerned itself with the question of who should own the “means of production” (e.g. machinery) because the economic world that emerged from 500 years of scientific progress led to an unstable situation between labor and capital.
While machinery and capital was responsible for dramatic improvements in economic output, the machines still need to be operated with human hands at the end of the day. What the Capitalists owned were machines, not robots that can do things on their own. Capitalists own the machines but ultimately without labor and human hands, the machines are useless. And it is through ownership that Capitalists reaped almost all of the rewards of the improvement in output. Marx and Communism, ultimately, viewed that split of the spoils tended to be unfair. Without labor, Capitalists would have nothing. Perhaps labor should receive more than they were receiving.
The last two centuries, from a philosophical perspective, have been primarily about the struggle between Labor and Capital over the ownership of machinery.
And, increasingly, I think the world will emerge from this pandemic facing an entirely different struggle altogether – What happens when we live in a world where neither Labor nor Capital are needed?
Up until 1994, the world needed both Labor and Capital. The question was how to split the economic gains that have been enabled through the interactions of Labor and Capital.
But with the emergence of the internet and the digital economy starting in 1994, the world has increasingly trended towards a future where neither Labor nor Capital is needed. The digital economy is materially more scalable and more efficient than the non-digital economy. And as we increasingly consume digital goods such as character skins within games (e.g. clothes that do not require human hands to sew), the need for Labor continues to decline.
That is likely not news to anyone by now. (Though Capital Flywheels remains confident that humanity will never be satisfied and will continue to invent ever more intricate ways to keep ourselves busy.)
But what I think is likely news to most people is that the digital economy also does not require the Capitalists, either. The scalability and efficiency of the digital economy also means that the companies that enable and thrive in the digital economy are increasingly extremely cash flow generative and hardly need any machinery or financial capital contribution from the Capitalists.
And we are 10 steps closer, instantaneously, because of the pandemic. The pandemic has jumped us forward 10 spaces to pass Go. And we are passing Go into a fully digital future.
When we emerge from this pandemic, the world might be different.
Similar to how the proliferation of machinery enabled the creation of the Capitalists / Capital class, the world is possibly seeing the emergence of a new class to reckon with. These are people that need neither labor nor (machinery or financial) capital and are purely limited only by their imagination.
And the most dangerous question is what happens when this class recognizes that they do not particularly need Labor nor Capital? In the prior era, the equilibrium between Labor and Capital was unstable but Labor and Capital absolutely needed each other. It was just a question of how to split the economics. In this new era, we are increasingly living in the (digital) worlds of the Imagination class that don’t need us, whether we are Labor or Capital.
As a laborer, I already have no part in these digital worlds. I am not a coder. I do not work in tech. My labor has no value in this brave new world.
But I do currently participate as a Capitalist. I own stocks in companies that are pioneering this future. And lucky for us, the Paper Portfolio owns a large number of companies that are benefiting from the accelerated metamorphosis of this world. But increasingly many companies do not need Capital. How long before even Capitalists are not allowed to participate?