THINKING THINGS OVER
Volume I, Number 12 100811
By John L. Chapman, Ph.D. Washington, D.C.
The much-discussed but little-understood concept of entrepreneurship was in the news this week, especially as it relates to much-needed economic growth. Curiously, while even most elected officials are cognizant of the fact that virtually all net new job creation comes from newly-created or emergent firms, policy proposals surfaced this week from Senate Democrats, with explicit White House approval, to pursue a 5% surtax on incomes over one million dollars (of course that is on top of intended tax rate increases on households earning over $250,000 in income — and eventually, dear reader, you too will see your taxes raised, regardless of your current income). Because this surtax is in essence a direct tax on entrepreneurship — indeed, any tax on income is precisely this – and given that this was a week in which two great American entrepreneurs, Steve Jobs and Herman Cain, were much in the news, it is appropriate to think critically about the phenomenon of entrepreneurship, what we mean by it, and why it matters for growth.
What Is Entrepreneurship?
Entrepreneurship, said Ludwig von Mises, is the driving force of the market, that is to say, of civilized society. But while most people think they know what is meant when using this term, in asking any ten people for its definition, ten different answers may be proffered. Fortuitously, one of the foremost economists in the United States today, the University of Missouri’s Peter Klein, is also one of the world’s great experts on entrepreneurship, especially as it applies to corporate strategy, organizational design, and public policy (for those interested, Professor Klein runs the economics blog Organizations and Markets). Professor Klein has developed a very useful taxonomy and framework for thinking about entrepreneurship, and it can be employed as we discern its importance to economic growth.
Professor Klein distinguishes between three perspectives on entrepreneurship that should be kept in mind to help us understand its economic importance: occupational, structural, and functional. Occupational issues relate to the categorical choice of (1) self-employment, in which one acts as one’s own principal, versus (2) a full-time contracted, wage-based labor arrangement whereby one works “for” an employer, and can act as that employer’s agent. Structural issues pertain to (usually) small and usually newly-formed firms that may also compete in emerging industries: the whole phenomenon of mobile wireless application development for personal communication devices, for example, is only a decade old, and is often described as “entrepreneurial”, which also refers to a high level of industry dynamism. And finally, and most important for our purposes here, functional aspects of entrepreneurship refer to the term in its classic sense in the economics literature: as being a category of action in the market.
Even here, however, Klein reminds us that there are different emphases on its meaning: for Joseph Schumpeter, for example, the entrepreneur was a disruptive innovator, who literally “destroyed” existing configurations of resource usage by inventing new products or production methods that up-ended existing social and economic orders, on the way to new levels of wealth creation. As an example from Schumpeter’s time, the advent of the automobile had enormous (negative) consequences for breeders of horses and makers of buggies and buggy-whips. More recently, in telecommunications, there were 400,000 switchboard operators in the AT&T Bell system in 1970; today more than 99% of those jobs have disappeared, thanks to “disruptive” technologies.
Israel Kirzner, following F.A. Hayek, focuses less on innovation and more on the discovery of new, previously unexploited, opportunities in the marketplace. For Kirzner, successful entrepreneurs possess an alertness to such opportunities, and by discerning and acting upon them, they may reap entrepreneurial profit. The classic example of Kirznerian alertness is simple arbitrage: the economic agent discerns a resource or economic good which is mis- (or, under-) priced, and by reconfiguring its marketing, product attributes, or market positioning, can in turn increase the value of the resource or good by effecting a transaction at the higher (“correct”) price.
Beyond innovation (via, say, invention or new process development) and discovery (of exploitable opportunities for profit via improving existing economic or social arrangements), other functional interpretations of entrepreneurial phenomena focus on adaptation and learning in the face of change, and coordination of resources that are scarce, and usually not perfectly well-arranged or aligned in market-based activities. All of these are useful and appropriate for distinctive emphasis in given situations, but it is Professor Klein’s own formulation, of categorizing entrepreneurship as exercising judgment in the face of an uncertain future, that offers the best explanatory power for our purposes. And indeed, when thinking about entrepreneurship in terms of judgmental decision-making under uncertainty, the other aspects of entrepreneurial action (alertness, adaptation, coordination, discovery, and innovation) are all effectively subsumed.
For Professor Klein, entrepreneurial phenomena — and important aspects of economic growth — are best described in Frank Knight’s seminal 1921 book, Risk, Uncertainty, and Profit. Knight correctly described the economic problem as one in which actors confront the challenge of optimizing the use of scarce resources in the face of radical uncertainty. By “radical”, we mean that not only is the future unknown, but all the things that might happen are unknown, as are their respective potential (or probability) of occurring. If he had stated it colloquially, Knight would have said, “We don’t even know what we don’t know.” As Klein points out, in essence, then, there is an entrepreneurial element in all human action, because by definition, all action is taken with the prospective intention of improvement of one’s condition or situation while being ignorant of much about the future, and thus necessarily acting with “incomplete” information. All action is, by definition, future-oriented, and everything concerned with the future involves uncertainty.
Seen in this “Kleinian” formulation, in which judgment about an uncertain future is the crucial focal point for analysis of entrepreneurship, several important conclusions follow:
- Ownership matters. It is the command of resources — of capital — that empowers (and defines) successful entrepreneurs. This in turns matters for (and implies a specific) policy formulation: the owners of capital or those tasked, in a derived sense, to control use of it, make decisions about the unknown future. It is in their interest, and indeed they have every incentive, to economize on the use of this scarce capital, that is, to protect and grow it. They therefore have every incentive to understand and acquire knowledge, both through trial-and-error and through research, about future conditions in the market, in order to optimize their capital. Government actors, by contrast, do not have the same incentive, nor the same ability, to acquire such useful and relevant knowledge.
- Uncertainty, and the imperative to exercise judgment, are irrevocable, in this world of space and time. Much in the way of policy developed out of Washington, D.C. seeks to replace the vague unpredictability and uncertainty about the future with bureaucratic diktat that allegedly makes life easier for citizens. Many elected officials will say their purpose is to remove, as it were, the uncertainty itself. And the assumption is always implicit in Beltway-based action that the government actors – somehow — know more than citizens do, and that the course of action taken by government will turn out as they intend it to, and will successfully improve conditions for the intended citizen beneficiaries. Professor Klein’s extensive body of work shows that this is folly. Radical uncertainty is a pervasive and permanent feature of life in this world; the operative question is how best to mitigate it. Entrepreneurs, again, have every incentive to discern the best uses of current capital resources as applied against future prospective conditions, and to organize activity around profitable possibilities emanating from these future (currently unknown) conditions; government actors, conversely, whether elected or permanent civil service, have no such similar incentive. And indeed, the knowledge the government actors have about what are often locally-based conditions — that is to say, from the vantage point of the government actor, geographically and contextually distant – is almost always inferior to that garnered by profit-seeking entrepreneurs who are responding to market signals. Further, for Klein, the trial and error process itself is what generates the knowledge that is useful, relevant, and indeed, critical, in order to make the best decisions about deployment of scarce capital to make the future conditions better than they are at present. No amount of government resources or intervention can somehow supersede this knowledge-generating process by effectively abrogating the trial-and-error that is its critical essence. And this trial-and-error process is none other than the market process itself; that is to say, the buying and selling that takes place in markets and generates useful price signals that are effectively co-opted by entrepreneurs, as primordial sources of information and insights about the uncertain future.
- Entrepreneurship, as the driving force of the market, is a necessary institutional condition for optimal economic growth. Because radical uncertainty cannot be revoked, and because capital resources are both scarce and depreciating, action is required in order to maintain (and protect) one’s current standard of living, and achieve a higher standard of living in the future. Entrepreneurship, which at its essence permits both the creation and salutary exploitation of knowledge about how to best employ the scarce resources of society for profit — that is to say, for the creation of wealth — is absolutely critical to economic growth and human progress.
This is seen, most easily and simply, by observing that the most entrepreneurial cultures and societies are also the wealthiest — this is, indeed, a universal phenomenon. Conversely, where entrepreneurship has been stifled or eradicated (e.g., the U.S.S.R., North Korea, Cuba), the flourishing of human life has been stunted as well. Other factors are often at play: confiscatory taxation, lack of property rights, lack of sound money, and so on can also ensure a society of poverty. But these other institutional conditions are themselves related to entrepreneurship and its promotion — there can be no entrepreneurship in a society that constricts ownership of property, for example. Still, this is a matter of degree: even in the societies across the Eurozone, where property rights, relatively sound currency, and the rule of law exist in Westernized fashion (e.g., Denmark, France, Italy), the significant gap in the per capita standard of living between them and the United States is largely explained by the lack of support for entrepreneurship there, versus a vibrant and dynamic entrepreneurial culture that, for many non-U.S. citizens, is the very definition of what it means to be American (as an example of this, the venture capital and private equity sectors in most all of Europe and Japan are, if not moribund, then anemic, compared to the U.S.).
Exemplars of Entrepreneurship in Action: Steve Jobs and Herman Cain
The application of the foregoing can be seen in the lives of two men in the news this week: Steve Jobs and Herman Cain. Mr. Jobs, the legendary founder of Apple (AAPL) was a giant of American business, cut down at the way too young age of 56. Worth over $7 billion personally, Mr. Jobs led Apple from near extinction in 1997 to its place now as the second most valuable corporation in the world in terms of market capitalization (trailing only Exxon-Mobil [XOM]). Mr. Jobs was a classic entrepreneur at every stage of his career, and indeed, exhibited and lived through all the “categorical constructs” mentioned above. But the key learning for our purposes was his continual sense-and-respond ethic and modus operandi. First with the Apple I-II, then the Mac, and in turn iPod, iPhone, iPad, and hyper-successful retailing operations along with the Mac-OS software architecture, Mr. Jobs peered into the unknown future and saw in it profit opportunities based on resource deployments far different from the then-present. Other than the possible exception of the iPod and iTunes store, he was not “first entrant” into any of these markets (though a very early player in personal computing), but he observed existing offerings and matched them with what he estimated would be desired services offered in an enhanced way. Like any entrepreneur, he was not always correct in his estimates of future demand (e.g., the Lisa product line, NeXT hardware), but through trial-and-error came to be legendary in his ability to create value where no others saw opportunities.
It is important to note as well that the character traits possessed by Mr. Jobs were, while uniquely what made him who he was, not at all required parameters of entrepreneurial behavior or success. For example, Mr. Jobs was both ill-tempered and secretive, almost in a paranoid way (this latter trait being counter to the “textbook models” of modern-day inclusive managerial decision-making), but these do not define entrepreneurial success any more than a perpetually placid demeanor and an open and collaboratively-inclusive style would.
Like all people touched by entrepreneurial greatness, however, Mr. Jobs had one core trait they all share: intense passion for what he did; belief; and, a burning desire that fueled his drive to success. This, in fact, feeds the trial-and-error process that generates exploitable knowledge, and may be one explanatory variable underlying Apple’s rebirth. The comeback part of his story — he had been fired from Apple in 1996, in large part via the directive of CEO John Sculley at the time — is the best part of his career and life’s narrative. Apple was in deep trouble by 1996, losing over a billion dollars per year, and on its 3rd CEO in as many years (Gil Amelio). (In a testament to his intensity, Mr. Jobs would not speak to Sculley when he was fired, and never spoke to him again. He also was unusual in that founding entrepreneurs and visionaries who return to lead their companies, especially after they become well-established organizations, are unheard of.).
Similarly, former Godfather’s Pizza CEO Herman Cain, currently a candidate for the U.S. Presidency, has been a highly successful entrepreneur on many occasions across his career. Most notably, in 1988 Mr. Cain executed a management buyout of the Godfather’s Pizza chain from parent Pillsbury Corp., not long after the pizza company was an unprofitable division. Drawing upon extensive experience and knowledge of current conditions in the quick-service restaurant sector, Mr. Cain drew up a plan for national reconfiguration of the Godfather’s system, closing some stores and opening new ones elsewhere. His own capital and that of his investors was heavily at risk in what is a notoriously competitive industry sector, but his estimates of demand proved largely correct, as he created enormous value for his investors, employees, and customers.
What is the Lesson Here?
Entrepreneurship drives the market economy in what Schumpeter labelled a process of “creative destruction.” Vibrant and dynamic entrepreneurship, if permitted to flourish, is a necessary and near-sufficient condition that ensures strong economic growth, because it engenders the rapid flow of resources to their highest and best uses — that is, to their most value-creating deployments. Equally important, entrepreneurship helps correct prior errors in resource deployment, as the competitive process of profit-and-loss induces those enterprises earning losses (and the entrepreneurs who run them) to give way to those who are earning profits, and from whom society clamors for more while rewarding them.
As such, not only will the millionaires’ surtax fail to work, it is sure to lead to higher unemployment, especially in the case of small business proprietors who run their business affairs concurrently through their personal lives. One of the tragedies of the Obama Administration has always been its stunning lack of business experience and real-world acumen among its key personnel now in residence in Washington. As such, a continual stream of legislation and new policy proposals that are at best unhelpful and in many cases wholly destructive of entrepreneurial pursuits have been a hallmark of Mr. Obama’s tenure (e.g., ObamaCare, Dodd-Frank, attack on Boeing, take-over of Chrysler and GM, nationalization of student loans, stultification of trade agreements). There is no question that however well-intended, these anti-entrepreneurship policies have significantly aggravated the unemployment problem in the U.S., and deepened the misery of the current era for many Americans. Perhaps in the fullness of time, Mr. Cain will be granted a shot at showing what a pro-entrepreneurship President would mean for America and the world.
Disclosure: Alhambra Partners currently has long positions in AAPL.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at firstname.lastname@example.org.
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Appendix: The fascinating career of Steve Jobs is summarized in a graphic here below from Reuters, and note the rising stock price after his return to Apple in 1997: