The myth of intangible capital
http://www.youtube.com/watch?v=Mc6K58FCYTE&feature=youtube_gdata
As has been explained, intangibles now account for the majority of output and employment in advanced economies.
This alone constitutes sufficient grounds for economists to review their theoretical treatment of intangibles. The issue becomes even more pressing once the changing pattern of capital in advanced economies is taken into account.
At the end of 2019, the aggregate value of the balance sheets of the 10 largest companies listed on the London Stock Exchange was £3.23trn. The value of assets that are strictly tangible – property, equipment and inventories – accounted for just 16 per cent of the total1. A similar pattern can be found in all advanced economies. Contemporary capitalism is dominated by intangible capital, not tangible capital. This is a revolutionary transformation which, once again, economic theory has failed to deal with.
This chapter will deal with the concept of capital, how it’s created, the role it plays in conventional economic theory and the implications for theory and practice when capital in the form of intangibles becomes its principal form.
The characteristic of economies where tangible goods are dominant is that there is a sequential flow of things from sellers to buyers and a value-adding activity at each stage of manufacture. Iron ore, created by nature and time, is excavated, processed, transported, converted into steel, used in a final product and, ultimately, consumed over time. All tangibles involve a journey in which goods are bought and sold in technically-definable supply and value chains. In order for the system to be sustained and to grow, value must be extracted at each point in the value-chain to maintain machinery and other tangibles used in production and to expand its capacity to produce more and better tangibles.
But what of an intangible commodity, a good that has no physical characteristics? Is there a similar journey?
Let us examine the value-chain in teaching. A person starts life, like iron ore, as the product of nature and time. He or she learns to walk, talk and function from parents, guardians and members of the community of which he or she is part. In most advanced economies, formal education starts around the age of five. Usually, it ends with a final dose of training which is deemed to qualify a person to be a teacher. The teacher then spends his or her working life teaching others. Value-adding activity that is similar to that which occurs in transforming iron ore into motor vehicles can be discerned. The big difference is that, apart from the body of the person involved, no tangibles are involved. What is being transferred is knowledge mediated through the complex workings of the human brain.
No conventional economist will argue with this analysis. The problem is how do you reach conclusions about the role of human knowledge in economic development that can be used by government and business?
Through history, economists tended either to ignore knowledge, the essential ingredient of all service transactions, or to treat it as outside the scope of economic analysis because it was subjective, intangible and, inherently, unquantifiable. This position could not stand, particularly in view of the rise of knowledge-based services in advanced economies, and specifically because of growing government intervention in education and healthcare in North America and Western Europe after 1945. The British government created the National Health Service (NHS) in 1948 and effectively nationalised the entire UK healthcare industry. By doing so, it accepted the responsibility for deciding the right level of investment in primary, secondary and tertiary healthcare and the extent to which it should displace investment in public housing, public transport, national security and other recipients of government investment. Everyone agreed that a healthy population was better than an unhealthy one. But at what point should government investment in healthcare facilities and services be contained? Similar questions were asked about investment in education and other public services.
The response from conventional economists came in 1964 with the publication of Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education by Chicago University professor Gary Becker, a member of the hall of fame of neoclassical economics2. He argued that the return on investment in education could be valued in the same way as physical assets are. You calculate the market price that knowledge can earn over time and capitalise it by converting it into a net present value: human capital. That made possible the quantification of the return on investment in education and the internal rate of return in education compared with what could be secured by investment in other sectors.
For Becker, the theory of human capital, which allows knowledge to be converted into an asset, can be extended well beyond the areas that had been previously considered legitimately open to economic analysis. Family relationships, which are driven by knowledge, can consequently be capitalised as can the capacity to appreciate art, music and theatre. It was a conceptual breakthrough that opened up a new frontier for government intervention and profitable business.
The idea of human capital appears to solve the biggest problem conventional economics has with intangibles. Much as the theory of equimarginal choice allows the incommensurable desires of a single individual to be converted into a quantifiable demand schedule for many, the concept of human capital facilitates the translation of knowledge embedded in the brain and body of individuals into a tradable financial asset. This is conventionally understood as intellectual property in its various forms.
Human capital also allows conventional economists to elide the theoretical problems that microeconomic theory faces when applied to intangibles exposed above. How value is created and distributed is irrelevant so long as it can be expressed in a form that conventional economics considers valid. Human capital can be calculated and, in principle, traded like tangibles. It can therefore be priced1. Conventional microeconomic theory and practice is, as a consequence, applicable.
The idea of human capital, like the idea of the market-clearing price, has been widely accepted. Whether you consider education, healthcare, mundane social welfare programmes or the highest forms of high art, choices can be guided by working out the stream of benefits, which are not always in the form of cash, flowing from a particular service activity and converting it into a net present value. You don’t have to read far into government policy statements before you come across the idea of human capital, or a term that implies it. The role of human capital in business corporations is probably now the most important subject taught at the world’s leading business schools.
That the behaviour of government and business should be guided by analysis of the consequences for long-term human capital accumulation is almost undisputed. Even critics of conventional economic thought will turn to the idea of human capital. Anti-capitalists who argue in favour of government investment in education, health, social welfare and the arts will often attempt to prove that it produces measurable economic benefits. To do so, they will use calculations inspired by Becker’s theories.
The idea that practically everything in life can be converted into a tradable asset, or an analogue of a tradable asset, causes unease for practically everyone. We like to believe that our family relationships and friendships and creative and leisure activities are beyond cold economic analysis. The power of Becker’s arguments, however, force us to conclude that, here too, economics has something important to say that we can’t ignore.
And yet, the concept of human capital, or knowledge as a form of capital, is open to critical evaluation using logical analysis and not just because of ethical objections. It begins with an examination of the emergence of the idea of capital.
The history of capital
Capital is central to economic thought. Yet it is one of the most imprecise of all the concepts the discipline uses. The word originally denoted the principal of a loan in money. In the 12th-13th century, it was applied in Europe to describe a fund of money or portable property. What is considered to be mercantilist thought tended to define capital as money, which at that time took the form of precious metals and stones. Classical economists altered the definition and tended to see capital, with labour and land, as a factor of production. Marginalists and neo-classicists went further. Bohm-Bawerk in 1888 reported that there were no less than 10 definitions of capital as a concept in economics3. Alfred Marshall in Principles of Economics also had definitional problems. In the following extract, he uses almost 200 words to define capital:
“…the language of the market-place commonly regards a man’s capital as that part of his wealth which he devotes to acquiring an income in the form of money; or, more generally, to acquisition (Erwebung) by means of trade. It may be convenient sometimes to speak of this as his trade capital; which may be defined to consist of those external goods which a person uses in his trade, either holding them to be sold for money or applying them to produce things that are to be sold for money. Among its conspicuous elements are such things as the factory and the business plant of a manufacturer; that is, his machinery, his raw material, any food, clothing, and house-room that he may hold for the use of his employees, and the goodwill of his business. To the things in his possession must be added those to which he has a right and from which he is drawing income: including loans which he has made on mortgage or in other ways, and all the command over capital which he may hold under the complex forms of the modern ‘money market.’”
Chapter IV, Principles of Economics, Alfred Marshall
Historians of economic thought argue that classical and early neo-classical economists were focusing on capital used for short-term purposes only4. But the imprecision continues to this day.
Economics by Richard Lipsey and Alec Chrystal defines capital as follows:
“The capital stock consists of all those produced goods that are used in the production of other goods and services. Factories, machines, tools, computers, roads, bridges, houses and railways are a few examples. Because capital is a produced input, it is a renewable resource though technical changes over time mean that the characteristics of capital change over time. Here we are always talking about physical capital, such as machines, and not about financial capital. Clearly, the two are connected, as firms need to raise finance in order to purchase capital equipment. But our focus is on the equipment itself and not on the way it is financed.”
Page 251 Economics, Lipsey & Chrystal, 11th edition, 2007.
Lipsey & Chrystal’s definition is limited. It appears to exclude intangibles by stating that capital only comprises produced goods and the examples it cites are all of tangibles. The treatment of technology is imprecise. It implies that technology is exogenously determined and applicable to capital to alter its productivity. One more example might help highlight the confusion within economics about capital. In Price Theory (1962), Milton Friedman says this of capital:
“From the broadest point of view, capital includes all sources of productive services. There are three main categories of capital:
1) material, non-human capital, such as buildings, machines, inventories, land and other natural resources;
2) human beings, including their knowledge and skills, and ,
3) the stock of money.
The main distinction between human capital and the other items is that the existing institutional and social framework and imperfections in the capital market produce a different response of human capital to economic pressures and incentives than of nonhuman capital.”
Price Theory, Milton Friedman, Third Printing 2008, Aldin Transaction.
In view of Friedman’s reputation for concise argument, it is perhaps surprising that his definition of capital is so loose. By starting the definition with the phrase “From the broadest point of view,” Friedman implies that there is no agreed definition of capital at all. He describes three of the “main” categories of capital, which suggests there could be several more. The first is similar to everything encompassed by Lipsey & Chrystal’s definition of the entire capital stock. But Friedman goes further by adding land. The second category – knowledge and skills – is not even mentioned by Lipsey & Chrystal as being part of the capital stock. Friedman, however, includes human beings as part of the capital stock, which might come as a surprise to those who believed property in people was made unenforceable in Great Britain from the 1770s and illegal in the US from 1865. The third main Friedmanite category is the stock of money, something which Lipsey & Chrystal exclude.
Two further definitions will help highlight the problem. They are expressed in shorter and simpler statements that help us understand what modern economics think capital is. A discussion paper published by the IMF that examines the impact of intangible capital on economic growth provided the following definition of investment, or what is normally considered to be an increase in the capital stock5.
“…any use of resources that reduces current consumption in order to increase it in the future qualifies as an investment.”
This definition is so all-encompassing it is close to being otiose. Another definition has been suggested by Dr Meghnad Desai, previously a professor at the London School of Economics6.
“Capital can be physical, monetary, abstract-human capital, talent. But it has to generate an income.”
The most glaring problem with this definition is that it elides the distinction between capital and labour. Human talent, which is embedded in everyone and is essential to an individual’s capacity to exist, is classified as capital. The issue is exposed by asking the question: what is left of a human being if talent were extracted from him or her? The right answer is: nothing human.
The central challenge, which none of the economists cited acknowledge, is the handling of capital that is intangible, or the fruit of the human mind. Human knowledge operates on an economic system as if it were capital. It can be seen as a stock of productive capacity that lasts over several or many time periods. It can in principle be increased by investment in education and training. And it produces an income. But is it actually capital in the sense that economists should use the word?
About 80 per cent and more of employment in advanced economies is now due to services, but there is no evidence that conventional theories of capital have been significantly adapted to take this fact into account. The idea of goods and capital as intangibles has been absorbed into conventional economic theory with little comment. This is perverse. The idea of intangible capital constitutes an extraordinary divergence from what pre-mercantilist, mercantilist and classical economic traditions would have considered to be legitimate.
The point cannot be precisely located that marks the start of the journey that has been made in overturning embedded attitudes towards what can and cannot be treated as if it were capital. The creation of the joint stock company where individuals exchanged specie money in return for a legal claim over the assets of that company is one of the earliest forms of what can be called intangible capital: an asset that has no physical existence. Specie money, which usually took the form of gold coins, was placed at the disposal of the managers of the joint stock company. In return, the provider of the gold received a document that stated he or she would be returned the amount supplied plus a share of the profits generated by the activity in which the company engaged. In the 17th century, this would probably have been trade though plantation and natural resource exploitation activities were also among the activities such companies engaged in which involved the production of cash products: spices, precious metals and stones, tobacco, sugar, rice etc.
The document – in which the claim over the money advanced and a share of the profits was asserted – could be kept until it was redeemed at the end of the life of the business activity the company was engaged in. An alternative was for the holder of the document to sell it to someone else for money. Such transactions established the document as a form of capital that was not money but could be exchanged for it. The value of the document was not intrinsic. The document – conventionally called a share – was instead a written promise from the recipient of the original advance. So it was not money, but a derivative of money which was at the time defined as a real asset like land and tangibles. It was an expression of the commitments made between the parties to the original transaction. This was a decisive shift away from the concept of property as the possession of a thing to one where property could be an idea. Insurance was a more sophisticated form of the simple activity of reselling the original documentary promise. It helped facilitate trading in bills of trade and inspired the growth of a new market was based on intangible capital.
What did economics then make of such transactions? To the extent that early economists even considered such matters, they would have been bemused. Economics focused on the exchange of things: useful tangibles with a scientifically-measurable physical existence. But the trade in documents did not involve a tangible apart from paper with some ink and wax on it. The value it mastered was not embedded in the document. What was being bought and sold was a promise; an intangible asset. All financial instruments – loans, bonds, bills, notes and other forms of raising finance – are descendants of these original forms of credit.
Another form of intangible capital emerged from printing. Before the development of the mechanised printing press, books and other documents were produced by hand. This guaranteed that the capacity to copy an existing document was circumscribed. The number of literate people was limited and the cost of reproducing documents was extremely high. The prohibitive cost of producing books was reflected in the fact that most copywriting before the printing press was done in monasteries, definitive non-profit institutions.
Developments in the efficiency of printing eventually reduced the cost of producing books and documents to the extent that it became profitable to copy an original work. The original authors and printers lost income as a result. The original form of copyright protection was probably legislation enacted in Britain in 1662, though the motivation was at least partly to prevent the circulation of books and documents that the government disapproved of. Further legislation in 1709 more explicitly justified the restriction on copying by reference to the rights of authors. An expansion of the idea of state control over published works is found in Article 1 of the original US constitution of 1789. One of the most fervent advocates of copyright legislation and enforcement was Charles Dickens, who was exasperated by American publishers reproducing his works without payment. A further legislative breakthrough came in 1886 with the Berne Convention, one of the first international treaties. It stipulated that an author’s rights over his or her work were automatically established on creation. Copyright legislation created a new type of intangible capital. Copyright can be bought and sold and is often held by people other than the original creator of the works in question. What are covered are not the materials from which the books and other documents are made; it is the words and ideas expressed in them. Nothing could be more intangible and yet legislation converted them into the equivalents of tangibles, things that could be bought, sold, held, lent and stolen. In the US, copyright owners are now able to secure copyright that is enforceable for the life of the author plus 70 years. For works of corporate authorship, copyright can be claimed up for to 120 years after creation or up to 95 years after publication, depending upon which endpoint is earlier.
Patents – exclusive rights granted by a sovereign state to an inventor or their assignee for a limited period of time in exchange for the public disclosure of an invention – can be traced back to Ancient Greece. The legislation upon much of future patent law derives was passed by Britain’s parliament in 1624. Today, the system constructed to protect patents is one of the most complex pieces of international law. The acceptance of the need for patent protection is a condition for membership of the World Trade Organisation (WTO). An extension of the ideas of copyright and patents is a trade secret. This is any confidential formula, device, or piece of information which gives its holder a competitive advantage so long as it remains secret. Trade secrets, which are generally not listed as assets in company balance sheets, cover, for example, the recipe used by The Coca-Cola Company to make Coke.
The next development was the brand. In the 19th century, manufacturers applied a mark or brand upon the goods they made to denote their superiority to similar products made by others. The brand was originally a physical mark on a tangible; an animal and – at times – on an individual to denote ownership or association. The skin of a grazing animal would be permanently scarred using hot metal. This could be recognised by people who could not read. Through history, slaves and criminals were branded in a similar way. Group associations would also be established through branding by tattoos. The first company to brand its tangible goods consistently is believed to be Bass & Company, a British beer maker. It printed a red triangle on bottles. Tate & Lyle, the British sugar refining company, was another innovator. It used colours – green and gold – to distinguish its products. American consumer good manufacturers, addressing the challenge of servicing a market spread over a vast geographical area, used brands – which took the form of words, colours and images – to establish that their products were better than locally-produced ones. This defined the essential characteristic of brands: they are instantly recognisable and seek to denote superiority.
The idea of the brand gained special significance in the US where huge distances separated farms and towns. It was a factor in creating a continental market in goods. Those with brands could be sold at a higher price than goods without one. This allowed accountants to project a future stream of revenues and profits that could converted into a present capital value of a brand. But for this to be possible, it was essential that the brand could only be exclusively used. Legislation protecting trademarks and brands is now an embedded fact in every advanced economy.
A further intangible that is significant in advanced economies is goodwill. This is an accounting concept that has allowed acquirers of a company priced at more than its reported book value to include that premium as an asset in their balance sheets. Accounting codes allow the present value of the projected income flowing from ownership of a brand to be capitalised and counted as an asset in balance sheets. Goodwill, in contrast, can only be counted as an asset when a company buys another one. Among its unintended consequences is that it provides an incentive for a company to buy another one at a price above the purchased company’s book value and is one of the main reasons why so many company take-overs fail to deliver the financial benefits forecast at the time the take-over was proposed.
Properly accounting for intangible assets, things that can’t be seen or touched, has puzzled the accounting profession for decades. In 2004, the Financial Accounting Standards Board (FASB), the organisation that sets financial accounting and reporting standards for US firms, issued new directives about the issue. It defined its goals as follows:
“The objective of this project was to establish standards that will improve disclosure of information about intangible assets that are not recognized in financial statements. Those unrecognized intangible assets include assets that are developed internally (such as brand names and customer relationships) and those that are acquired and written off immediately (acquired in-process research and development).”
Since then, the accounting principles governing intangible assets have been revolutionised and not just in the US. A decade ago, companies were obliged to write down the value of all intangible assets on their balance sheets as if they were tangibles. There was a fixed line depreciation rule which echoed the principles applied to land, buildings, machinery and equipment. The sole concession made to the idea that an intangible asset was materially different to a tangible one was in the term used. Tangibles depreciated. Intangibles, in contrast, were amortised.
As the value of intangible assets on most companies’ balance sheets grew, complaints increased about the validity of such an approach. How can an asset that has no physical characteristics degrade in the way a machine can? The answer is that it can’t. So if that is the case, what grounds are there for a rule that companies should on an annual basis reduce the book value of their intangible assets by a specified amount?
The result was a new and evolving approach to valuing intangibles. Instead of a fixed rate of depreciation to be applied to all intangibles, companies are now required to define those intangible assets that have a “permanent” value and to price those assets by applying a set of tests to help establish that price is fair. The new arrangements address the criticism of fixed-rate amortisation. But it has thrown up a host of other questions, including what constitutes a “fair” price.
One method is to benchmark an intangible against the market price of other intangibles. For example, if you have a Sunflower painting by Van Gogh and in the past 12 months another Sunflower painting by Van Gogh was bought and sold in a public auction, you could argue that that transaction sets a fair valuation of the painting you own. The main problem with this approach is that Van Gogh paintings aren’t sold very often. And the fact that a rich person was prepared to pay millions of dollars for one doesn’t mean there’s going to be another one prepared to pay a similar amount today or in the foreseeable future for another that is similar. Most intangibles are also non-homogenous. Your Van Gogh might be similar to the other Van Gogh, but that’s not the way an art connoisseur or a potential buyer might see it.
The result is that most companies can’t use a “mark-to-market” valuation for the intangible assets they claim to own. Instead, companies carry out a cash flow valuation exercise. This involves quantifying the additional revenue generated by a particular intangible, including a brand, projecting that additional revenue flow over a requisite number of years, applying a terminal value to the cash flow, discounting the projected cash flow and then aggregating the annual figures in into a present net value. Under accounting rules now applied in the US and the UK, this exercise must be carried out annually.
There are potential pitfalls with such an approach. You have to agree the direct contribution to revenues flowing from a specific intangible, which is rarely straightforward. Unless you can completely ring-fence an intangible and then accurately measure its revenue contribution, this calculation will be misleading. As has previously been argued, an intangible asset can’t be accurately quantified because it is without physical characteristics and is nothing more than an expression of the subjective sentiments of an indefinable association of value-creating individuals.
Projecting expected revenue flows associated with that intangible over time presents further problems. Pricing an intangible involves dealing with the uncertainties about how an intangible might be viewed in the future. The right terminal valuation is a further issue. And finally, an appropriate discount rate needs to be applied, which is generally the base interest rate plus a risk premium.
Calculating the value of an intangible therefore involves four complex calculations: definition, which is almost impossible, cash flow-projection, terminal valuation and discounting. The conclusion is that valuing intangibles effectively is impossible in practice as well as in theory. The numbers going into a balance sheet will inevitably be misleading. That this is already obvious is reflected in the uncertain way that accounting bodies are dealing with this challenge. And yet, the valuation of most of the world’s largest companies using such methods has been accepted almost without question by investors and regulators.
You don’t have to reflect on this matter for more than a moment before you realise why this happened. For most companies, the balance sheet figures are the most important indicator of what they themselves are worth. Without balance sheets, very few would be able to raise finance from rational investors. Those with large aggregate balance sheet figures are able to borrow more and, consequently, expand more rapidly than those without.
It is a universal rule among corporations, whether they are privately or publicly owned, that the larger they are the higher the earnings and prestige of their managers. The system, therefore, has a built-in incentive for corporate leaders to expand their balance sheets. Since this can be done as well or better by altering the structure of corporate balance sheets, it is unsurprising that this happened. There has been almost irresistible pressure on accounting professions which are largely dominated by big corporations and parliamentary legislatures where big corporations are quietly but decisively influential for the way intangibles are defined and quantified to be relaxed.
The pace of change is beginning to quicken. Companies are increasingly dissatisfied by the restrictions on what can be classified as an intangible asset. The reaction is growing attention in parts of academia and in government agencies to what constitutes an intangible and the extent to which intangibles should be allowed to be counted as a balance sheet asset. In September 2013, the OECD published a report about the role of intangibles named New Sources of Growth: Knowledge-based Capital7. It included a table setting out what it considered to be knowledge-based capital (KBC), a term that encompasses all intangible assets that are or could be included in company balance sheets. This went well beyond any previous classification of intangible assets and included worker training. The list encompasses practically everything a knowledge-based company might actually spend money on. If the logic of the report is pursued, it would suggest that companies would consequently be able to classify all such expenditures as capital investment. This would have a twin-fold impact on their profitability and valuation. Most jurisdictions provide tax concessions for investment and few for expenditure; by reclassifying spending on training, for example, as an investment, the tax burden would fall. A direct conversion of spending on training into capital would automatically increase the balance sheet value of a firm.
The report includes “own organisational investment” as a form of KBC. This is deemed to be the value of the culture that a company has developed that facilitates output and employment. It would appear almost impossible to put a value on that, but the fact that the OECD has added this item to the KBC suggests that attempts may be made in due course to change accounting codes to make it possible for this to become a balance sheet asset.
A further incentive for companies to capitalise intangibles is taxation. A company with a factory has to locate it somewhere. And the country where a factory is – invariably — where corporate and other direct and indirect taxes like VAT are applied. The only coherent ways that taxation can be radically reduced is to persuade the tax authorities to treat a factory as either inherently special or because it is in a special area, for example in an area of high unemployment. An intangible asset in contrast can be located anywhere; it’s a balance sheet item with no material existence. An intangible asset can only produce intangible products and it’s impossible to say where an intangible product is made. This is one of the main reasons why media companies in the UK, in particular, have in the past decade relocated to low tax jurisdictions such as Switzerland, Dublin, Luxembourg and the Cayman Islands. Since their intangible assets only exist in their balance sheets, it is the equivalent to moving steel production from Corby to India, and a much less expensive manoeuvre. Examples of service companies that have successfully manipulated accounting and tax codes in the past decade include Amazon, Google and Starbucks.
The archetypal practitioners of this methodology, however, are hedge funds, a misnomer since that are in reality finance companies. They raise funds on wholesale markets or directly from wealthy investors and, consequently, they have no need for the physical network that conventional banks have. They are not deemed to be banks and, consequently, escape regulation. They are usually ultimately incorporated in low tax environments where the disclosure of the identity of the sources of funds is not required. And they often operate on a cross-border basis. The result is that most pay low or no tax.
It is unsurprising that owners and managers should enthusiastically support the constant growth in the number and range of intangibles that can be classified as balance sheet assets. The beneficiaries include some of the world’s fastest-growing corporations. It is, on the other hand, unclear why economists should do so to. And yet, there is practically nothing in recent economic literature that coherently addresses the rise of intangible capital, the most radical change in the structure and conduct of corporations since they first emerged.
It is evidence that corporations are well ahead of economic theorists in grasping the contemporary power of intangibles in general and of intangible capital in particular. It suggests intangibles should now be treated with greater rigour.
Critiques of intangible capital
Despite the fact that economics accepts the existence and validity of intangible capital – and all major companies now count them in their balance sheets as if they are identical to tangible assets – the rationale supporting their widespread acceptance is not located within economic thought. There are two principal ways of defending intangible capital8:
- Natural rights arguments. These assert that creations of the mind are entitled to protection as much as tangibles because they are the product of a person’s labour and a person’s mind.
- Utilitarian arguments. These claim that ownership of ideas should be allowed if that leads to a higher level of wealth and income.
Both arguments are flawed. Natural rights in ideas are invariably applied only to some of them. For example, almost no one suggests that a person who developed a new word should be entitled to be paid every time it is used. The distinction between ideas that can be protected – and therefore owned – and those that cannot is, therefore, arbitrary. Patents can only be secured for “practical applications” of ideas but not abstract and theoretical ones. The distinction between creation – deemed to be the source of ownership – and discovery, which is not, is also unclear in ideas.
Economists are familiar with criticisms of utilitarianism. These include the immeasurability of utility and the invalidity of interpersonal utility comparisons. Even if these are set aside, there is no conclusive evidence that the net gains produced by establishing ownership of ideas outweigh the costs.
Economists, consequently, are forced to return to first principles. The fundamental validation of a person’s right to ownership over anything is that it peacefully deals with scarcity. Without the allocation of exclusive ownership of scarce resources to individuals, there would be perpetual conflict and the distribution of property to the winners. Property rights can only work, however, if they are visible and just.
“…in order for individuals to avoid using property owned by others, property borders and property rights must be objective; they must be visible. For this reason, property rights must be objective and unambiguous.”
Against Intellectual Property, N Stephan Kinsella, published by the Ludwig von Mises Institute, 2008
Using this argument, property rights can only apply to resources that are both scarce and objectively definable. Intellectual property and intangible capital (the economic form of intellectual property) are neither. An idea is infinitely reproduceable since it can be copied without the need to use scarce resources. For example, you might invent a new way of cooking an egg. The fact that someone copies that method in no way reduces the scarce resources (eggs, pans, cooking oil) that you own. Establishing property rights over the method of cooking you’ve developed will artificially create scarcity, probably reduce aggregate welfare and, in effect, establish your right to determine the way everyone else uses eggs they own. The most compelling counter-argument is that unless people can assert property rights over inventions, they will have no incentive to develop them in the first place. Champions of this approach say that the lack of enforceable intellectual property rights is one of the reasons why human societies were so slow to capitalise on brilliant intellectual breakthroughs. One example cited is that of birthing forceps which help ease childbirth. The original set was developed by the French Huguenot Chamberlen family in the 16th century. It was a medical breakthrough that could have saved millions of lives but was kept secret for 150 years, apparently because the Chamberlen’s couldn’t commercialise the idea.
There is some truth in this argument but it ignores the fact that human beings were inventing things before intellectual property rights were defined in law. The profitable exchange of ideas is possible without intellectual property rights. An individual who develops an idea can share it in a single transaction for which a payment is received. Musicians are paid for a single performance and will have to perform again to secure a further payment. An inventor can sell an invention in a single transaction for which he or she is paid in the way a manufacturer of a tangible would manufacture and sell a product. This provides an incentive for creation and trade without the application of intellectual property rights or the existence of intangible capital.
There is as yet no consensus about the treatment of intellectual capital and this should encourage economists to think more deeply about how they treat the concept. But, as practically all economic text books show, economics has treated intangible capital as if there was no debate and that it is a product rather than a novel construct that has developed as the result of legislation and adjustments in accounting codes.
The reason why profit-making organisations count intangible assets and capital as equivalent to tangible assets and capital is comprehensible: it is to increase both the profits and the economic worth of their organisation in accounting terms. When treated as equivalent to tangible capital, intangible assets and capital raise the wealth and income of the managers and owners of such organisations. Intangible assets can be used as collateral for debt-raising, just like tangible assets. Whether it is right for economists to treat intangible assets and capital as identical to their tangible equivalents is, however, debateable.
A familiar objection rooted in economic thought to treating categories of intangibles as assets is that copyright and patents grant monopoly power to their owners. They increase their income and wealth but these are transfers, at best. More robust critics of copyright and patents argue that copyright and patents suppress innovation and risk-taking by other individuals and organisations. They argue, for example, legal protection of the recipe used to make Coca-Cola discourages more efficient makers of carbonated drinks. A more serious criticism is of patents in pharmaceuticals. Anti-AIDS medicines have been made more expensive and effectively unavailable to millions of sufferers as a result of patents laws. Companies making low-cost copies of such medicines can be, and often are, subject to litigation. The argument that intellectual property always leads to economic inefficiency lacks evidential support, but defenders of intellectual property, nevertheless, have a case to answer.
A more comprehensive attack on the argument that intangible assets and capital exist as economic categories and should be accepted by economists broadens the target to include brands and goodwill. Originally, brands were physically embedded in the thing over which ownership was asserted: for example on an animal or a bottle. The idea of superiority attached to a brand was a subsequent development.
Critics argue that advertising designed to establish in the mind of consumers that a branded good is better than a non-branded or generic equivalent undermines competition and leads to socially and technically-inefficient outcomes.
Defenders of brands say consumers will through experience decide whether a brand merits a premium or a discount. Failure to deliver on a promise of quality implied by a brand leads to profits falling to the level enjoyed by the manufacturers of generic and non-branded alternatives. Ultimately, the defenders argue, advertising will fail if that promise is unfulfilled.
The legitimacy of recognising brands applied to tangible assets as real assets is, nevertheless, open to challenge. It is even more questionable when brands are applied to intangibles such as healthcare, education, consulting and entertainment. It is impossible to apply a brand on a thing that has no physical existence. In fact, it is impossible to define what an intangible is. All intangibles are by definition things that only exist in the minds of those involved in an intangible transaction. How then can a brand association ever effectively be applied to an intangible? This is another legitimate subject for economists to study.
These are technical issues. But the concept of an intangible being effectively identical to a tangible is open to further logical deconstruction. The value created in the interaction between a hotel guest and a receptionist and a patient and a doctor is simply beyond resale. Would a guest say to a receptionist: “I would like to pay you for the service you are about to provide but I don’t want to consume it myself. I want to sell it at a higher price to someone else who will arrive sometime in the future. I’d appreciate it if you treated him or her in exactly the way you might have treated me or I’ll have to pay compensation.”
Would the patient leaving with the doctor’s guidance sell it to someone else who believed he or she had the same symptoms? The answer is: it’s possible, but so unlikely that it can be effectively eliminated as a practical option.
And can the value in an intangible transaction be effectively stored? Consider once more our hotel guest. He or she captures value in a constructive interaction with the receptionist. Can this value be stored in the way that the value stored in a car is? Can the guest the next day get up and retrieve the residual value of the interaction and, figuratively speaking, go for a drive in it?
The answer is no, or at least not in the way that the value in tangibles can be. The interaction at the reception desk the previous night that delivered value to the guest lives only in that guest’s memory. It’s not disappeared as if it never happened. But it’s gone in every way that an economist would understand. The idea of depreciation that scientifically measures how a durable tangible degrades, or is used up, over time also has no validity in services. Whether participating in a relationship today is better than waiting until some future date is itself a subjective issue over which the market-clearing price has limited traction. If that is the case, then any method of valuing intangible capital including human capital will produce wrong and misleading results.
The role of the process
Those following this line of argument will point out that the amount of money paid for a service also must take into account the cost of providing the tangibles used in hotels and health clinics. There are buildings and equipment. If they weren’t there, there could be no service transaction and no consequent value creation.
This is beyond argument. Tangibles are invariably essential for a successful service transaction. But their role is to facilitate the value created in constructive human interaction. The bed in the hotel room used by the guest does not add value; it makes value-creation possible because the guest wouldn’t get a good night’s sleep without a bed. Doctors and patients need equipment, teachers and pupils need schools and English premiership football teams and spectators need football stadiums. Most of the things that facilitate value-creation – the processes – degrade over time. It is, therefore, possible to establish a quantifiable connection between the productivity of having it now or in the future. This will establish time-preference based and opportunity cost options for all process investment choices.
But they will be subordinate to the subjective assessment of the impact on relationship value-creation of deferring or advancing a service interaction. Objective cost factors play a role, but the investment decision about intangibles supporting a service transaction will be driven by service relationship priorities.
The analysis of a service described above, therefore, entails dividing it into a relationship component, where value is made, and a process component that facilitates its creation and distribution. It consequently divides the amount paid into two elements: a cost-covering part, which deals with the tangibles used in service delivery, and a gift-exchange part governed by subjective factors.
The distinction between the relationship and process components of a service transaction is imprecise. Relationships exclusively involve people. But the process also encompasses the work of people that operate and maintain the tangibles supporting service transactions. The process is therefore not only physical infrastructure. It includes human activity required to keep the physical infrastructure in operation. One way of separating the part of the human activity involved in a service transaction where value is created and the part that maintains the requisite tangibles is to define the activities that could be automated. If a machine can do the work of a person, then it’s a process. Examples drawn from the past include accounting work that is now done by computers.
For the purposes of effective theoretical analysis, the process or processes can be treated in line with the market-clearing price model originating in the Marshallian synthesis of 1890. The relationship where value is created in services, however, falls outside the scope of scientific analysis as we know it. It depends upon human interaction underpinned by obligations. These are essentially intuitive and can be said to be irrational. And yet, they are essential to the well-being of every rational person.
The principles guiding value creation in services that have been explained can now be used to reconceptualise the changes in the economies of advanced countries in the past century. By stimulating the accelerated production of tangibles, the idea of the market-clearing price freed human beings from the struggle to survive. There were increasing amounts of time to devote to constructive interaction within value-creating relationships expressed in the form of the services which now account for the majority of output in the world’s most advanced economies. Initially subordinated to the tangibles they enhanced, services have turned the tables on their previous master to dominate value creation itself. Technology, the fruit of constructive human interaction in science, has liberated value-creation from the tangibles that had previously imprisoned it. Process and relationship are dividing with profound implications for the future.
An example, among many, can be found in the changes in the media industry. In 1977, when the author started as a junior reporter at Reuters in Fleet Street, the relationship elements of media service production were to be found in the same place as the process elements. Journalists and the advertisement and marketing teams – the relationship specialists in media firms – were located in the same building as the printing press. This was not an accident or a mistake. It was because that was all the technology of newspaper production at that time allowed.
Technical change in general, and the rise of digital communications in particular, has radically changed what is possible. Today, reporters don’t have to be in the same continent as printers, let alone in the same city. Price has encouraged the automation of newspaper manufacture that has reduced average costs and freed resources to increase the service component of what is made. It has also encouraged the export of the process component of production to places where such costs are lower whilst allowing the relationship component to stay close to the consumers, the essential counterparty in service value-added creation.
The separation of process from relationship in services, which has allowed the boom in services, is the supreme achievement of the idea of the market-clearing price. But it is also its undertaker. The growth of services, and the technologies that separate process from relationship, mean that the market-clearing price can only affect the first. As the figures that cited at the start of this chapter, this is becoming increasingly insignificant for output and employment in advanced economies. Technical change promoted by price will continue, thereby driving down process costs further and releasing resources for the increasingly dominant relationship component of the service sector. As the proportion of total service activity accounted for by relationship activity grows, price’s traction will steadily decline.
The most compelling example of the separation of relationship from process and the rise of spontaneous, horizontal, unmanaged and unstable communities can be found on the worldwide web. The internet is the most dynamic process the service era has so far produced. It is facilitating unmediated and spontaneous human interaction on a scale and of a nature that has no parallel in history.
Through the web, the concepts developed in this chapter have become a daily reality. It proves that the separation of process from relationship is happening with beneficial effects. It is an environment where price is largely irrelevant and the desire for people to interact constructively and on a global basis is dominant. And it’s a model that is increasingly determining the behaviour of the state and the business corporation.
But how should we respond to the process-relationship divorce caused by the dynamic but increasingly redundant role of the idea of the market-clearing price? This question will be addressed in the following chapters. But this one closes with the market-clearing price deposed as the master of economic thought and practice. Subjectively-perceived value, the product of interactive relationships within intuitively-defined communities, and objectively-measurable cost, which measures the efficiency of the service process, have been restored as concepts that economists once again have to consider separately and seriously.
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1 The 10 largest companies quoted on the LSE on 31 December 2019 in terms of market capitalisation were Shell, Unilever, HSBC, Astrazeneca, BP, GSK, BHP, BAT, Diageo and Rio Tinto. HSBC’s intangible balance sheet assets accounted for 99 per cent of the total. The fastest growing companies of the modern era have generally been those with the highest proportion of intangibles in their balance sheets: Microsoft, Google and Facebook.
2 Gary Stanley Becker (1930-2014) was a professor of economics and sociology at the University of Chicago and a professor at the Booth School of Business. He was awarded the Nobel Memorial Prize in Economic Sciences in 1992 .
3 From Book I, Chapter III of The Positive Theory of Capital by Eugene Boehm-Bawerk, published in 1888.
4 “The history of capital theory after Ricardo, through Boehm-Bawerk and up to Wicksell, was confined…to the examination of working capital not fixed capital…” Economic Theory in Retrospect, Mark Blaug, 5th Edition, Page 93. “…capital is an input whose use necessarily involves the passage of time and, conversely, that any output whose production takes time must necessarily employ capital as an input as a direct consequence of the time-consuming character of the production process.” Economic Theory in Retrospect, Mark Blaug 5th Edition. Page 489.
5 From Intangible Capital & Economic Growth by Carol Corrado, Charles Hulten and Daniel Sichel. The authors were then employed by the Federal Reserve Board, the University of Maryland and the NBER respectively. The report is one of a growing number that argues that intangibles are an economic concept and that more should be done to make it possible to create intangible capital.
6 From private correspondence with the author in 2011.
7 New Sources of Growth: Knowledge-Based Capital. Key Analyses and Policy Conclusions. Synthesis Report. OECD. September 2013. A copy of the report can be downloaded at http://oe.cd/kbc.
8 The discussion of intangible capital is based on Against Intellectual Property by N Stephan Kinsella published by the Ludwig Von Mises Institute in 2008. It can be downloaded from the Institute’s website.