A Valley Divided: Do Startups Widen the Inequality Gap?
TheFamily Papers #012
By Nicolas Colin (Co-Founder & Partner) | TheFamily
Paul Graham dedicated one of his recent essays (and then a shorter version) to the sensitive issue of economic inequality. It triggered a controversy, as the essay was dubbed by many as the embodiment of everything that is wrong in Silicon Valley: technology-savvy, out-of-touch, self-centered millionaires trying to make sense out of the world, yet without the slightest consideration for the harsh realities of ordinary people’s day-to-day lives.
The stir around Graham’s essay could have remained a controversy led by professional polemicists such as Evgeny Morozov and others. Trashing Silicon Valley, after all, has become a prosperous industry in and of itself. But, especially in the context of the 2016 presidential election, economic inequality is also an ongoing public conversation involving many prominent figures from Paul Krugman to Bernie Sanders to John Oliver—and, yes, even Donald Trump.
What caught TheFamily’s attention is that Tim O’Reilly weighed in on the discussion, opening a rift between him and Paul Graham, two of Silicon Valley’s most prominent figures. It certainly challenges the allegiances of those of us who once had the comforting impression that they’re both on the same side and share the same values. But that rift is a good opportunity to discuss the issue as viewed from the European startup world. Here is our take on some of the reasons why the inequality gap is widening in the digital economy—and how startups can help tackle this unprecedented challenge.
Why the Narrowing?
Entropy is “the measure of the natural decay within a system”. It basically means that the more time goes by, the more disorder is looming in the system. The notion of entropy is at the heart of another longer essay that Paul Graham published the same day as the essay on economic inequality. In this other essay, titled “The Refragmentation”, he stresses the idea that the growing divide currently tearing our societies apart is not so much the result of new forces emerging as it is the consequence of old forces running out. The fact that people disagree and fight with each other is not because some outside influence has pushed its way into the system. Rather, it is because our society, just like any social system, is affected by entropy.
I’m not sure why he wrote two separate essays instead of merging them or cross-referencing them. He could then have better made the case that economic inequality is increasing as a consequence of the entropy that is currently laying our entire society to waste. Obviously “the erosion of forces that had been pushing us together” could explain why the rich get richer and the poor get poorer.
How did those eroded forces once contribute to narrowing the economic inequality gap in the most advanced economies? One story of inequality became an unexpected best-seller two years ago: Thomas Piketty’s Capital In the 21st Century. The cornerstone of Piketty’s book is the r>g formula. The economic inequality gap widens if the rate of return on invested capital (r) is superior to the rate at which the whole economy grows (g).
This is simple to understand. The value that the economy adds is distributed between those who provide the various factors of production: part of it constitutes the return on invested capital (ROIC), whereas the other part is the remuneration of work. If r > g, the share of wealth detained by those who own capital grows faster as a proportion of aggregate wealth as compared to the wealth of those who have nothing but their current and future labor to make ends meet. The resulting feedback loop contributes to concentrating wealth even more and to inequalities reaching new highs.
An r > g situation held for a long time until the first modern technological revolution. Before the 18th century, there simply was no economic growth, thus g was close to zero. Then the industrial revolution, followed by other technological revolutions (railroads, steel, oil), ignited economic growth, which contributed to narrowing the gap between r and g. And yet the inequality of wealth was so high at the time that income inequality kept on increasing (income, after all, is mostly derived from preexisting wealth). This was to the surprising point that, according to Piketty, at the beginning of the 20th century Europe was a more unequal society than the United States.
Then two phenomena contributed a great deal to reducing the gap between r and g—both of which Graham discusses in his essay on fragmentation, with economic inequality in the background.
The first phenomenon was war. So many things were destroyed or lost during the war that most rich people’s wealth simply vanished overnight. If they survived, they had to start again from zero. Entire countries had to be rebuilt from the ground up, which generated an extraordinary period of sustained economic growth that benefited the masses: as unemployment was very low, workers had more bargaining power to demand higher wages and more comprehensive social benefits.
The second phenomenon was that institutions were developed to mitigate risks and provide economic security to the majority of individuals. Wage contracts, social insurances, the banking system, organized labor, collective bargaining, progressive tax rates: this whole institutional system eventually gave rise to the middle class as we know it. It was somehow tied together by what Adam Davidson calls “the single greatest risk-mitigating institution ever: the corporation”. As he wrote in a New York Times article bound to become a classic:
The corporation managed the risk so well, in fact, that it created an innovation known as the steady job. For the first time in history, the risks of innovation were not borne by the poorest. This resulted in what economists call the Great Compression, when the gap between the income of the rich and poor rapidly fell to its lowest margin.
Paul Graham, too, points out why and how much the corporation contributed to narrowing the inequality gap:
Along with giant national corporations, we got giant national labor unions. And in the mid 20th century the corporations cut deals with the unions where they paid over market price for labor. Partly because the unions were monopolies. [10] Partly because, as components of oligopolies themselves, the corporations knew they could safely pass the cost on to their customers, because their competitors would have to as well. And partly because in mid-century most of the giant companies were still focused on finding new ways to milk economies of scale. Just as startups rightly pay AWS a premium over the cost of running their own servers so they can focus on growth, many of the big national corporations were willing to pay a premium for labor. [11]
As well as pushing incomes up from the bottom, by overpaying unions, the big companies of the 20th century also pushed incomes down at the top, by underpaying their top management. Economist J. K. Galbraith wrote in 1967 that “There are few corporations in which it would be suggested that executive salaries are at a maximum.” [12]
It worked for decades. Most of us grew up in a world where high inequality was a thing of the past, a vague reminiscence of the dreaded Gilded Age. Then at some point during the 1970s, the trend reversed and the economic inequality gap began widening again.
Why the Widening?
Economic inequality has been increasing for several decades. It is now common knowledge and it has even garnered consensus in the public debate. Less well understood, though, are the reasons why economic inequality has been steadily on the rise in every part of the global economy. The different economic arguments that have been put forward to explain this fall into three categories.
The macroeconomic argument insists on globalization and the rise of the financial sector. With globalization, added value becomes more and more distributed at a global scale, putting workers in an unprecedented competition with other countries’ workforces. The result is economic inequality rising within every country, when at the same time the gap narrows between middle class workers of different countries. As a result of globalization, the American middle class gets relatively poorer while the emerging Chinese middle class gets relatively richer. The appearance of inequality in developed countries overshadows an overall narrowing of inequality from one country’s middle class to another. This derives from what economists call the ‘Stolper-Samuelson Theorem’.
On top of that, as pointed out by Tim O’Reilly, a more global economy makes the financial sector more powerful. As the economic playground gets bigger, depth and liquidity increase exponentially on financial markets, making room for larger pools of capital, bigger bets, higher volatility, and more sophisticated financial products such as the infamous credit default swaps (CDS). This whole context provides the opportunity for a few players to reap an even higher share of extra income, to the benefits of both the richest, most sophisticated investors and the happy few working behind the large investment banks’ trading desks.
The microeconomic argument focuses on the reasons why the current situation on markets and within corporations puts such a high pressure on workers’ wages. In an article published by the Financial Times, Edmund S. Phelps makes the point that economic inequality is not so much an incentive for innovation (which is at the heart of Graham’s argument) as it is a consequence of the lack of innovation. As traditional companies have ceased to innovate, they convert to rent-seeking strategies that involve maximizing shareholder value and increasing the pressure on the weakest link in the supply chain—the workforce:
Losses of dynamism have tended to sharpen wealth inequality because it hits workers of modest means more than it hurts the wealthy. Developing new products is labour-intensive. So is producing the capital goods needed to make them. These jobs disappear when innovation stalls… [And] with less competition to fear, companies are emboldened to raise their mark-ups and profits. That lifts share prices and thus the wealth of already wealthy shareholders.
Phelps’s charge against corporatism echoes Clayton Christensen’s argument as to how the ‘Doctrine of New Finance’ has diverted corporate focus from empowering innovation, which employs a lot of capital and creates many jobs. Instead, today’s corporate executives choose to favor efficiency innovation, whose main consequences are the freeing of invested capital (hence the record-high corporate dividends in the recent period) and a continuous increase in productivity that triggers massive job destruction. All in all, it is the fact that traditional companies prefer rent-seeking over innovation that explains part of the widening economic inequality gap.
Finally, the institutional argument leads directly to Graham’s conclusion: economic inequality is the result of the weakening of our political and economic institutions, both at the national and the international level. As a whole system of checks and balances unravels before our eyes, people are deprived of institutions, such as social insurance and collective bargaining, that long contributed to “spreading the wealth around” and sustaining inclusive economic growth. Those institutions were the pillars of economic Golden Ages such as the post-war boom. But as they falter, nothing is left to prevent inequality from rising again.
Organized labor is a good example of that destructive process. As explained by Kevin Drum in Mother Jones a few years ago, the “screwing of unions” may explain why Barack Obama has fallen short in substantially advancing the interests of the American middle class:
The relationship [between the Democratic Party and the unions] was symbiotic: Unions provided money and ground game campaign organization, and in return Democrats supported economic policies like minimum-wage laws and expanded health care that helped not just union members per se — since they’d already won good wages and benefits at the bargaining table — but the interests of the working and middle classes writ large… [But from 1978 onwards,] organized labor, already in trouble thanks to stagflation, globalization, and the decay of manufacturing, went into a death spiral. That decline led to a decline in the power of the Democratic Party, which in turn led to fewer protections for unions. Rinse and repeat. By the time both sides realized what had happened, it was too late — union density had slumped below the point of no return… There simply wasn’t an institutional base big enough to insist on the kinds of political choices that would have kept the momentum of 2008 alive.
Organized labor is not the sole institution whose demise we are witnessing. Austerity in most developed countries has forced governments to scale back social programs, thus exposing individual workers to a higher level of risk. Tightened regulations imposed on the banking industry have apparently kept banks from lending money to households, thus forcing people to tighten their belt even more. Progressive taxation has been damaged by decades of ‘trickle-down’ economics. As Karl Polanyi described in The Great Transformation, a new economic order always begins by imposing duress as it throws away most of what makes life in society sufferable; then the right institutions are eventually put in place to make economic growth inclusive again. But, as envisioned by James A. Robinson and Daron Acemoglu in Why Nations Fail, the installation of inclusive institutions is nothing but certain:
Political and economic institutions, which are ultimately the choice of society, can be inclusive and encourage economic growth. Or they can be extractive and become impediments to economic growth. Nations fail when they have extractive economic institutions, supported by extractive political institutions that impede or even block economic growth.
Voters Care for Security, Not Equality
In 1994, future British Prime Minister Tony Blair gave his first major speech as leader of the Labour Party. His goal was to affirm his position as the new Leader of the Opposition, but also to start the (not so) long road to making the Labour Party electable again.
Blair’s core idea was that his party should firmly hold to its historic values (those of inclusiveness and social justice), but that it should also radically innovate when it came to designing the policies inspired by these values. Since the modern economy was so different from that of 1945, it was useless, even repulsive, to stick to totemic, irrelevant policies that didn’t mean anything to voters anymore (nationalizing British industrial corporations is a good example). Instead, every public policy had to be revisited to try and imagine the new proposals that would affirm the British left’s core values and restore the public trust in the Labour Party at the same time. The rest, as they say, is history: the New Labour won three times in a row, making Tony Blair the longest-serving and arguably the most effective Labour Prime Minister in British history.
Economic inequality was surprisingly absent from Blair’s reinvention effort, just as it was also absent from Bill Clinton’s own comparable version of a ‘New Covenant’ between government and its citizens. The left’s traditional support for economic equality was weakened, of course, by the power of the ‘trickle-down’ ideology. But mostly what innovative leaders such as Blair and Clinton discovered was that economic inequality didn’t resonate that much with their voters. People appeared concerned, even shocked, by the widening gap between the middle class and the wealthy. But they weren’t determined to vote for left-wing politicians who would only promise to cap CEOs’ bonuses and raise taxes on the rich.
A lot of people tried to explain that mystery, among them the late Philip Gould (once a senior advisor to Tony Blair) in his book The Unfinished Revolution, Thomas Frank in What’s the Matter With Kansas?, Frank Luntz while working as a consultant for Republican politicians, the cognitive linguist George Lakoff, Stanley Greenberg in his classic Middle Class Dreams, or Thomas B. Edsall and Mary D. Edsall in their landmark book Chain Reaction: The Impact of Race, Rights, and Taxes on American Politics.
The explanation is, in fact, very simple. In retrospect, voters tend to see the wealth gap as the symptom of a dysfunctional economy. But they’re not convinced that static measures such as raising the top rate of the income tax is enough to narrow the inequality gap again. That is because the vast majority of voters like to think of themselves as middle class and climbing up the social ladder. As a result, proposing higher taxes, even on higher tax brackets, means taxing those voters’ future wealth; and caring for the poor only means concentrating resources on a world that those same voters desperately want to escape (or at least refuse to be identified with). Simply said, middle class voters want politicians to focus on their problems, not the problems of the poor nor the wealth of the rich.
This doesn’t mean that economic inequality shouldn’t be tackled. Some successful progressive leaders did manage to narrow the inequality gap, and we can draw lessons from what they achieved. In every policy program designed to build an inclusive society in the long term, there are in fact three pillars. The first relates to the macro- and microeconomic measures whose purpose is to support Entrepreneurs and help the private sector create even more value. The second pillar consists in building the economic and social institutions designed to hedge individuals against critical risks such as getting sick, getting too old to keep on working, not having the means to afford higher education, or being unable to find affordable housing close to where the jobs are. The third pillar, which ties it all together, is the tax system designed to finance the whole effort. The Obama legacy is a good example of that systemic vision: there was the American Recovery and Reinvestment Act of 2009 and the JOBS Act of 2010 (pillar 1), the Affordable Care Act of 2010 (pillar 2), and the partial success in letting the Bush tax cuts expire (pillar 3).
Voters are not stupid (something that a lot of politicians tend to forget). They realize that simply building the third pillar (a more progressive tax system) is not sufficient to improve their day-to-day life. Rich people may pay a bit more taxes, which is fair enough, but ordinary people still need to find jobs and to be hedged against critical risks. This is why radical progressive leaders such as Tony Blair and Bill Clinton revisited the whole value system of the left and advocated a different view of social justice.
For them, implementing social justice was not only about wealth and income inequality at any given moment. In a more open and entrepreneurial society, what mattered was the dynamics of economic inequality — the fact that middle class people didn’t have the same opportunities as the creative class and were exposed to a looming, widespread economic insecurity. What makes us unequal is not so much the money we have at any given moment as it is our capacity to face critical adversarial events such as having cancer or losing one’s home (health and housing being the most important factors of inequality in advanced economies). The goal, as once declared by Pierre Laroque, the father of France’s modern welfare state, is to be freed from fearing the “uncertainty of the future”. It is no coincidence, after all, if one of the most important legacies of the New Deal was called the ‘Social Security Act’, not the ‘Reduced Inequality Act’. (On the ‘equality v. security’ discussion, read Michael Graetz’s True Security and Jacob Hacker’s The Great Risk Shift.)
Why didn’t it all work? The main reason is that Blair’s and Clinton’s talent and charisma were not enough to achieve results on the second pillar—the one targeted at strengthening the social safety net and redeploying it to hedge against new risks (see the Foreign Affairs article I co-wrote with Bruno Palier on that issue). The Clinton administration’s attempt to create a national health insurance in 1993 failed as it faced massive opposition from key stakeholders and a growing skepticism from the public. And in the UK, Tony Blair’s efforts to reform the National Health Service and make sure that it could treat patients with a more customized service didn’t really change the game. Not only is economic inequality higher than ever, but the economic insecurity of the middle class has increased as well. And it will keep on doing so, at least for a while, in an economy in which technology plays a more central role.
Does Technology Worsen Inequalities?
The digital transition of our economy makes the situation even more complex. As argued by the recurring discussions inspired by authors such as Kevin Kelly, Robert J. Gordon, and Erik Brynjolfsson & Andrew McAfee, the digital transition supposedly destroys jobs. Our view at TheFamily is that the idea of the jobless future is merely explained by the rise of a massive transitional unemployment, which “will keep on increasing until the digital economy finally takes over and creates enough jobs so as to compensate for the amount of destruction.” You can read a previous issue of TheFamily Papers dedicated to that issue.
Beyond the question of jobs lies the fact that the economy’s digital transition amplifies globalization and its worsening effects on economic inequality. The main reason, as always with everything digital, is the law of increasing returns. The combination of globalization and of winner-takes-most explains why a few giant digital companies compete with each other to dominate the global economy. A substantial part of the value they capture is concentrated at the center and mostly benefits a few shareholders, executives and employees. This is the reason why Paul Graham once compared digital companies to McDonald’s: “A McDonald’s franchise is controlled by rules so precise that it is practically a piece of software. Write once, run everywhere”… and then reap the rewards of growing a global business that concentrates wealth at the center. Only if those companies create more value than they capture (to use Tim O’Reilly’s wording) does the periphery get a piece of the pie, under the form of lower prices and higher convenience.
This geographical concentration of value contributes to increasing economic inequality. Strained real estate markets are one factor. The digital economy concentrates jobs in a few large cities where Entrepreneurs, engineers, and venture capitalists collide, but in which real estate markets are unable to bear the consequences of clustering effects (a case made by Enrico Moretti in his book The New Geography of Jobs — and by Kim-Mai Cutler in this Techcrunch article). It is also felt everyday by those people who can’t afford housing in Silicon Valley anymore—a glimpse of what is bound to happen in every large entrepreneurial city in the world.
The power law that rules investment in the economy of increasing returns is another reason why the inequality gap is widening. The digital economy concentrates the return on invested capital in the hands of accredited investors that are able to invest in rounds before the companies go public. As IPOs happen later, if at all, the rise of the digital economy deprives the middle class of the opportunity to invest in fast-growing digital companies. As Andreessen-Horowitz’s Scott Kupor wrote:
We are quickly creating a two-tiered investment market — one for wealthy, accredited individuals and financial institutions and a second for the remaining 96% of Americans… If you are among [those] 96% of Americans that are not accredited investors, you can wait the 9.4 years that it takes for the average startup to go public and miss out on all of the price appreciation in the private markets that inures to the benefit of accredited investors.
So far we have been unable to tackle the challenge of higher inequality in a more digital economy. This is mostly because the inequality of our time has different causes from those which existed in an economy dominated by manual labor, factories, and mass consumption. This new inequality cannot be dealt with by the old, faltering institutions of the Fordist economy. Can the digital economy create its own institutions and make its growth more inclusive?
How Startups Can Help
We believe that the digital economy could be of more use than harm in the question of how to reduce economic inequality.
In his rebuttal against Paul Graham, Tim O’Reilly suggests that only startups who succeed at a large scale and get profitable, like Google, contribute to narrowing the economic inequality gap, whereas “in over-excited markets, it’s too easy for many startups to aim to cash out with “dumb money” while the getting is good with no real plan for ever delivering real revenues or profits.”
But in fact many more startups that never reach profitability, let alone find their business model, create more value than they capture and contribute to narrowing the inequality gap. Just like Edmund Phelps and Clayton Christensen, we’d like to make the case that more innovative, fast-growing startups contribute directly to narrowing the inequality gap, for reasons that sound familiar to everyone in the entrepreneurial world but are strangely missing from the discussion around Paul Graham’s essay. In truth, more entrepreneurial ventures in an economy structured around new institutions could ultimately help in narrowing the inequality gap again.
First, startups are significant job creators, in ways that other companies aren’t. As proved by the Kauffman Foundation or authors such as John Dearie & Courtney Geduldig, new businesses, not small businesses, create the many jobs that politicians and the public are desperately waiting for. Hence we’re not bound to live a jobless future if more Entrepreneurs create more startups and start their quest, successful or not, for a repeatable, profitable, and scalable business model.
Second, startups are willing to burn lots of cash to fuel their exponential growth. As they need to hire fast, they’re not usually as tough in negotiating wages as a mature company would be as it focuses its attention on cutting costs and reengineering its processes. In other words, even in the absence of unions, startup employees are better positioned for bargaining than employees of traditional companies will ever be.
Third, fast-growing startups are advancing the cause of empowering innovation as they create new products, build unprecedented assets and, even if they end up in failure (and most of them do), set an example for the next generation. It takes many failed search engine startups for a Google to succeed and finally “create more value than it captures”. Numerous founders built useless, forgotten social networking applications, and yet they paved the way for entrepreneurial successes such as Facebook and Instagram.
Finally, startups take an active part in the effort to replace old, irrelevant institutions with new institutions in line with how the digital economy creates value. From a static point of view, technology can help reduce the price of many goods and services, without imposing strain on the workforce. From a dynamic point of view, technology can help change the way we live our lives, thus contributing to providing economic security in ways that were unconceivable in the worlds of Franklin D. Roosevelt or even Tony Blair. In other words, innovation is the way to fight entropy.
In the first stages of every technological revolution, free market principles triumph and impose their excesses on the economy. Then, following terrible crises such as wars and economic depressions, governments take over and, in the best-case scenario, create the inclusive institutions that are needed to spread the wealth around. The Carlota Perez framework, described by Fred Wilson here, helps us understand the overall process.
What is interesting in the current entrepreneurial age is that digital technologies make entrepreneurship so much more powerful. Hence it could be up to the Entrepreneurs, as they form an alliance with hundreds of millions of users, to build those institutions and to solve problems at a global scale. The digital transition should be used as an opportunity to hasten the demise of the old paradigm and quicken its replacement by the new one. So even if governments are too slow and incapable of building the new institutions, they can facilitate the task for the ones that are ready to tackle their building.
All in all, supporting entrepreneurial ventures in any given country is critical because technology is an institutional remedy to the problem of inequality. So far, unfortunately, governments have acted merely as the defender of the old guard as opposed to becoming the allies of the new guard. In doing so, stifling innovation and preventing startups from growing, they contribute directly to the rise of inequality. Unless governments recognize that startups have a role to play in fighting economic insecurity, which demands that certain barriers be brought down, economic inequality is bound to widen even more.
Those of us who work at TheFamily are often accused of being laissez-faire hacks because our business is to help Entrepreneurs build scalable companies and advocate for their cause in the process. But when we vehemently protest against certain government regulations, it is not because we’re in favor of turning the economy into a no-holds-barred jungle. Rather it is because existing institutions are becoming irrelevant and favor vested corporate interests at the expense of innovation and the public interest.
Those crybabies who accuse us of being too radical simply don’t realize that sometimes it’s not enough to ask nicely. We’re convinced that we’re doing a better job than they are at fighting economic inequality—and we have no intention of pulling back from taking bold risks and implementing radical entrepreneurship!
(This is an issue of TheFamily Papers series, which is published in English on a regular basis. It covers various areas such as entrepreneurship, strategy, finance, and policy, and is authored by TheFamily’s partners as well as occasional guest writers. Thanks to Kyle Hall for reviewing drafts.)
