The Economic Food Chain Theory
The 'Economic Food Chain Theory' is a macro and micro economic theory developed by Steve Podmore over the last few years. In a graphical and easy to understand way, it seeks to explain why our local and global economies are increasingly defying natural and absolute laws, and how this has contributed to serious economic, social and environmental challenges.
With different characteristics but common regional themes, it explains and confirms where we need to focus our attention to address the largest challenges of modern times. The answer lies in how we use our financial, natural and human capital.
At its core, the theory takes a food chain in nature, or the level of biodiversity that is prevalent when our environment is healthy, and looks at our real world economies through the same lens. When any food chain becomes unnaturally unbalanced, and this sustains, the food chain is most at risk of collapse.
By examining where financial capital flows, and overlaying where jobs and innovation are shown to come from, one can view an inverse relationship with characteristics of serious and dangerous imbalance.
Looking into the detail of the capital concentration trends of our real world economies (visually alluded to above), and viewing them in a food chain or biodiversity context, the picture becomes a great deal easier to understand. In short, with business as usual, the implications of our increasingly imbalanced economic systems, with capital going to where empirical evidence indicates it is least efficient in the broader social and environmental context - are dire. This imbalance is not just damaging from a social and environmental perspective - but is catastrophic economically.
Nature can teach us some valuable lessons. A natural system has balance. For example, a forest has big trees, little trees and everything in between. It also has the nutrients and biodiversity that ensures everything has the right food to grow, and the natural remedies, pesticides and waste disposal systems to keep it all disease free. There are natural cycles and nutrient level recycling at all levels, but it is all part of a living, dying, living, breathing - healthy system. It’s all connected, and the big trees of the forest cannot survive for long without the nutrient rich biodiversity at the bottom.
Yet, if one contrasts this with what we have in our real world economies, capital is flowing at ever faster rates to speculative financial markets and into both the good and the not so good larger organisations. The big question is on balance, is the ‘financial services industry’ that fuels it all - serving itself - extracting more value than it adds, or is it serving society - adding more value than it extracts? And if the former - why?
As organisations increase in size, those who continue to do natural, thorough and diverse innovation - become fewer and fewer. While there are of course 'great' large organisations, scale gives challenges for most, which means as they grow, many organisations sweat assets and milk their cash-cows harder and harder. Clayton Christensen, the Harvard professor and noted author of ‘The Innovators Dilemma’ recently admitted as much, when at Davos 2013 he explained “for years he had been teaching executives of global corporations to do the wrong thing - hard wiring for efficiency innovation”.
The problem with efficiency innovation, is when the cash cows runs dry, without meaningful and diverse innovation pipelines, organisations find themselves in a weak competitive position. The larger they become, the harder they find it to innovate with the smaller stuff, and like an oil tanker - they then struggle to change course.
The ‘small stuff’ is the kind of innovation (in the broad sense) that all might add up, and might help them find the ‘next big thing’, but individually and without sufficient traction, does not ‘move the needle’ with a large enough potential impact on the bottom line.
It’s not that large organisations don’t innovate - the better ones of course do. It’s just that most don't do it sufficiently or thoroughly. To make up for the challenges in doing diverse innovation, many tend to engage more in the type of efficiency innovation that Christensen refers to - and this has financial engineering at it’s core.
The relentless pressure for returns - often results in larger corporations pushing legal boundaries (or moral obligations & social contracts) to legally avoid taxation.
In the more negative form of capitalism, jobs are said to be an inconvenience in the route to making money. Less responsible organisations thus strip out jobs if possible - deploying technology and ‘off shoring’ to do so. Many also ignore other critical externalities (economists speak for hidden costs) and while global corporations are powerful enough to do all this, governments are powerless to do anything about it.
If all corporations were responsible and ethical, and did all they could to understand and avoid hidden costs to others - it would not be so bad. Sadly that is rarely the case - and with some exceptions, plummeting levels of trust in global corporations, reflect this.
If different classes of investor into global corporations, also had effective and responsible governance, the picture would also look a whole lot different. However, the hypothesis contained within the broader economic food chain theory, details an inverse relationship between the percentages, speed and volume of securities traded in corporations - and the level and effectiveness of governance.
Transient ownership creates the conditions for absentee governance - with long term risks taken less and less into account. These are the same risks that organisations with negative externalities are increasingly exposed to. Short term market behaviour is bad from a sustainability angle, and therefore from a macro risk perspective too.
A market that is short term, will inherently favour organisations that ignore their externalities. Large organisations that ignore these costs will make more money in the short term, will be worth more, becoming even more powerful in the process - until they become seriously unstable. There is now a growing number of great organisations that are green, sustainable and their returns outperform their brown equivalents over time. In a resource constrained world, with a growing population, they are the future.
Paraphrasing J Edwards Deming, the famed American quality expert who was initially shunned at home but embraced in his adoptive Japan “quality will always cost less over time, and will deliver more, but in the short term it requires thinking, hard work and investment”. The same is true for sustainability.
Without doubt, being responsible and factoring in hidden costs (internalising externalities) will deliver more over time, but in the short term, additional investment is essential. It’s also harder to do - without methods of doing and funding diverse innovation. Funding the diverse innovation is the key, and even with the growing trend in ‘open innovation’ it just doesn't register on the radar of most larger corporations.
Then we look at the financial services industry itself, and look at the motivations, activities and tools available to the actors on the stage.
If one gets to the heart of the incentive for the legions of lawyers, accountants, traders, actuaries and assorted consultants, pension funds and other institutional investors, investment banks and other intermediaries, and the many suppliers of technology and support services (as one can also see in the graphic), the whole system automatically seeks larger deals, faster trades, liquid investments and high returns (always with the desire for ever lower risk). We call this ‘speed and weight of capital creep’ and as we will explain a few paragraphs further on, it is enabled by a system that over time has ‘removed the bulkheads’ from the ship.
Back to today. With all the pressure of a competitive and testosterone fuelled system, where ‘only the paranoid survive’ capital is directly or indirectly forced into a smaller relative number of larger corporations - via private or public placements, or traded debt or equities (for this discussion we will ignore the effects of trading in currencies, commodities and real estate).
Some of these organisations, because of the system pressure to do M&A activity, a relative lack of R&D, and the absence of thorough innovation as discussed - are increasingly weak. Partly because there is so little capital formation at the bottom (covered later), capital in the system therefore has less tangible opportunities at the top to invest in, and therefore a greater share of it ‘concentrates’ into traded activity.
The share of capital that is sucked into ‘high frequency trade’, for example - increases year on year. Yet it can be argued - financial instruments - traded by computers multiple times a second, are sucking up capital that could be used productively elsewhere - and rather than adding value to the system, they are extracting it. Again we’re not saying all financial trading and speculation is bad. Rather - it’s when it's done to the extreme and to the expense of the real economy - that problems occur.
Causes of capital concentration include deregulation, globalisation, the internet, and many questionable and hard to regulate financial innovations. It is all obscured by ever greater complexity which even insiders or so called ‘financial professionals’ find hard to understand.
When you take a 360 degree look at the financial system however, digging into detail as appropriate, and then going back to the umbrella view - providing you look with an open mind - it’s not too hard to unpack. While many actions make sense for individual organisations, it all adds up to a collective stupidity.
Just imagine a ship with the bulkheads removed (to use less material). In a stormy sea however, if there are any points of vulnerability where the water can get in, when it does - all the water can quickly slosh to one end, and the concentrated weight, critically destabilises the ship.
In our real world economies - and as the graphic also indicates, rather than sloshing to one end, financial capital concentrates upwards into a relatively small number of larger organisations, or as we have already said, into the metaphorical bubble of speculative trade.
While we use the nautical example of removing the bulkheads in a boat, the food chain example would be chopping down trees on a hillside, causing erosion, destroying the soil, and leading to floods, famine or in certain geographies - desertification.
There are many ways to look at this big complex system, but the lesson is that our financial systems need the diverse fabric and natural barriers for protection - just like nature or great engineering.
What many economists seemingly fail to understand, is that capital concentration away from the real economy and economic diversity - is the greatest threat to economic health. It is relatively simple maths too.
On average - financial trading strategies simply cannot outperform the inherent value created in an economy. Financial trading should be a facilitator of real world trade, not a replacement for it - and when the trading happens to extremes it’s time to get worried (take a look at the financial service industry rising relative contribution to tax revenue as a barometer for this).
So if an economy is getting weaker, where consumers cannot consume because their cost of living rises but where wages stay the same or drop; or if consumption is fuelled by debt and not by productive value added or exchanged; and if energy costs more to harness or transport, and clean up costs or consequences increase; or if less jobs are created in an economy than are lost - then all the trading activity is just dividing up the spoils of an ever smaller pie (a pie that appears much larger).
The Economic Food Chain Theory perspective - is that the capital concentration so described creates a perfect macro economic storm. Governments have more costs, more dependents and less cash to pay them all.
Furthermore, with so many of the players in the financial system profiting from what amounts to the collective stupidity described, the markets miss this truly important and absolute law of diminishing returns. As Upton Sinclair said and Al Gore quoted - “It is difficult to get someone to understand something, when their salary depends on not understanding it.”
With all actors in the economic system allowing capital concentration, and not working to thoroughly reinvent finance at the other end of the spectrum, we have done the equivalent of cutting off the oxygen supply (financial capital) to what we call ‘The Plankton of The Economic Food Chain’ (Infrastructure / SME’s / start-ups etc).
As a result of the drivers explained above, early stage investment, which is widely understood to be the lifeblood of our economies, is fully ignored by most institutional investors! It’s a hassle - not an essential.
If one looks at the numbers, of the institutional capital pool, only about 0.05% - 0.5%, ($1 in $2000 - $200) (source - derived from IMF asset allocation report and related material) is invested into the part of the market that in a developed world country like the UK or the US, is widely accepted to be responsible for 60% + of all innovation (source - from UK perspective - Respublica).
Yet - reinforcing the earlier comment, and as shown by recent news, a great many corporations do everything possible to ensure they pay the minimum in taxation, and often hold unproductive capital offshore as a result.
On the other hand, small but growing companies at the bottom of the economic food chain pay proportionally more tax to support public services and society at large.
The type of dynamic, lean and profitable organisations where innovation is rife spring from anywhere and include people with an idea, kids in college, start-ups, to medium organisations of 250 employees or more.
They are also known to be home to, and creation engine of the largest number of jobs (50% + in the emerged markets - up 80% or more in emerging markets (source - International Labour Organisation).
The numbers and nature of innovation can be debated for a long time and we are not saying no innovation comes from large organisations. Of course it does, and scale is sometimes a very good thing. But the nature of large organisations - is the majority slow down and stifle critical innovation more often than not.
For example, it was Microsoft that commercialised DOS and Windows - not IBM. Google created and monetised search in a sleek way that resonated with the world - not Microsoft. Facebook worked out how to do social networks - not Google. And Amazon worked out how to sell a huge offering of books in physical and Kindle format - not Borders or Waterstones. The list goes on.
However great an organisation might be, staying great, lean and innovative through the stages of growth is the greatest challenge of all.
Knowing this, once they have it, many will do everything possible to reinforce their power and monopoly. When they do however, arrogance and disfunction quickly follow. Shortly behind are significant strategic missteps, which for large or global corporations, can be fatal. When they are - significant shareholder (e.g. pensioner) wealth disappears in a puff of smoke - but what is lost is often obscured by a fog of financial engineering.
The point is, aside from whether it adds or subtracts value on a societal level, capital deployed at the top of the economic pyramid, in huge quantities can be lost in the blink of an eye - yet no-one bats an eyelid.
However at the other end of the scale - gaining access to capital is like getting blood from a stone, and capital that can be raised routinely comes from disjointed sources, and is invested in ways that contributes to failure rather than nurturing and enabling success.
Now lets get a contextual reset. Even if the part of the market that is currently ignored by the financial world only came up with 40% or even 20% of innovation, and created only a similar number of new jobs, does it really warrant putting in less than 1%, (or even less than 5%) of all institutional capital?
How many more jobs would be created, and solutions generated for important social and environmental issues, if bottlenecks could be removed to unlock capital and support in the famed ‘Valley of Death’, and other key risk areas - and do so at adequate scale?
The inverse relationship between levels of capital invested, versus sources of job creation and innovation, is a global phenomenon with serious consequences.
So in food chain or biodiversity terms - we have tried to survive off economies that have more than their fair share of big tree equivalents, and we have failed to see the enormous value the rest of the vegetation and biodiversity delivers (innovative, high growth and diverse real economy SME’s, and everything else).
The most important innovation society needs, is in the forms of finance which can unlock a vibrant mix of positive economic activity, and at a much faster rate.
A key problem that has so far prevented this, is the perception of risk in early stage investing is high - and the lure of short term ‘established market’ investing gets ever higher. There are powerful sales and marketing and inertia forces at work. This further compounds the problem of imbalanced capital flow and reinforces negative perceptions held by institutions of investing at the earliest stages - and has stalled the kinds of financial innovation we badly need.
A big part of why capital does not flow more effectively to where it is needed for healthy economies - is due to how funds are structured and raised. This leads to challenges in how these funds are invested.
Generally, funds for investing in areas which are viewed as risky, or into entities which are small and require aggregation (such as those required to create jobs, feed a growing population, and provide water and clean energy for all), where more work is required for success, are 100% equity - or risk money. Often this capital comes from investors who seek to maximise financial return, and funds are mostly structured to last 10 years.
For many reasons, these funds are incredibly inefficient, but remarkably this basic fund structure (the 100% equity - 2 : 20 - 10 year model - commonly used in VC or PE) has seen little innovation in 40 years.
In this out of date structure, with typically one class of investor, returns sought to compensate for the real or perceived additional risk, actually prevent the funds investing into the type of enterprise that most require capital. Ironically these are where decent aggregate returns could be found if a little more thought was given to the structure and system of investing (the many related inefficiencies in how capital is raised and deployed - will be explained in the forthcoming book).
As a result of falling early stage venture or similar performance, and with pressure from institutions, in a weak attempt to reinvent and de-risk, the early stage funds that do exist have become smaller, more narrowly focussed, and increasingly invested into digital only opportunities. But this is a damaging false economy.
High return expectations, means decent help and support alongside investment is just not possible, and funds rarely posses critical mass which in turn would enable better systems and efficient investment portfolios. Worldwide, there are very few funds that at scale, provide angel and seed money on fair terms along with the necessary help and support these young companies and their founding entrepreneurs so often need. Nor are there connected funds to provide the follow-on capital they then need to succeed (assuming there is not a liquid and vibrant investment market to provide it instead). So virtually no institutional money goes to the very earliest stage. This is the case in mature markets - and it is much worse in the rest of the world.
There are innovations such as crowd funding and peer to peer lending, and even barter platforms springing up, but they are still nascent industries and are a relative scratch on the surface of what is needed. Peer to peer and crowd-funding is also direct from the individual, when the point should be, institutions that hold capital (asset owners), on behalf of the individual should be placing that capital more effectively into the real economy where most productive value could be added.
Also - direct from individual investments however they are facilitated are not suitable for larger investments or infrastructure - where there are significant funding gaps around the world. Tackling capacity building or risk capital - and filling these gaps is of upmost importance.
When governments try and fill these gaps, the institutions they create, and the direct and indirect stimulus packages, are often blunt instruments. Unwieldy, disjointed and not fit for purpose.
However, the key to addressing these challenges, is figuring out how to help governments, who do have a role to play, connect more effectively with institutional investors, philanthropists and other key actors, ironically including, motivated - innovation seeking corporations!
Economic and environmental recovery will only come from better systems to efficiently deploy capital to the areas of our economy which are most vibrant, create the most jobs and deliver the most innovation as per the right thicker yellow line in The Economic Food Chain Theory diagram - and the pooled funds it can populate.
Put simply, less investment (and less intelligent investment) at the bottom of The Economic Food Chain, means less and lower quality of organisations and returns at the top. For the environment and society as a whole, with a growing population in a resource constrained world - we are currently going in the wrong direction.
Underutilising our Human Capital, over-utilising our Natural Capital, and with an elite few at the controls of a complex system - misappropriating or misdirecting our Financial Capital as a primary cause.
So in summary - if you only support and feed the largest of your dominant predators (monopolists), and you cut off the oxygen supply or suppress the conditions in which the plankton and smaller fish can thrive, then it is only a matter of time before the big fish go hungry. However If the food chain is re-balanced, everything works. Each part of the chain relies on the other, and the food chain can strengthen and self correct over time.