The thesis of this post is that it is pretty silly to base an economy, like that of the United States, on housing, finance, and government, which is what Wall St. and Pennsylvania Ave. seem to want to do.
Types of Industries
All organizations are constructed from three types of sub-organizations, which are within their domain. The Domains would normally be considered as political unit as per example, a city, county, state, or country. However, even in private organizations, these types of organizations exist, within the organization’s functions and departments. These organizational categories[i] are:
· Primary Industry – Organizations that are in an industry that creates a product or service that is exported beyond the boundaries of the domain within which it is produced.
· Secondary Industry – Organizations that are in an industry that enables and supports one or more of the processes of the primary industry within the domain it operates.
· Tertiary Industry – Organizations that in an industry that enable and supports both the primary and secondary industries by providing services that support the environment in the domain within which the primary and secondary industries operate.
As I demonstrate in my book, Organizational Economics: The Formation of Wealth, the primary industry (or industries) is the economic engine that forms the value of the organization for other organizations. Hamel and Prahalad called the turbine of this engine, the organization’s core competence.[ii] It produces the value for the organization. All other “industries” enable and support this engine. For example, the economic engine and primary industry for Detroit Michigan, has been and continues to be the automotive industry; in “silicon valley” it’s information technology, the State of Iowa is agriculture, and so on.
Secondary industries are sub-contractors and suppliers of hardware, software, and services to the primary industries. These industries would include auto parts suppliers, tool manufacturers, transportation within the organizational domain, and other organizations directly supporting the primary industry or industries.
Tertiary industries are organizations that enable and support the personnel, or the domain’s infrastructure. Schools, colleges, and universities, banks and other financial services, municipal services (e.g., electric, communications, roads and bridges, sewer, water, and so on), food stores, and other stores, hospitals and other medical services, restaurants, fast food outlets, and so on. In other words, the majority of economic activities within an organizational domain. Additionally, tertiary industries includes all types of construction. It also includes the defense (see Security a Mission of Government). These industries are where most of the economic activity of an organization occurs.
Types of Value
In the first chapter of Organizational Economics, I describe three types values, knowledge value, capacity value, and political value.
Knowledge value (see Knowledge Value) is value created by an increasing knowledge-base and includes research and development (invention and innovation), and knowledge transfer (education). Products based on new scientific discoveries and transferred into production are the most high valued. Unique user interface designs like the iPhone or innovative medicines are examples of knowledge value. Capacity value (see Capacity Value) is “more of the same” value. Once a product has been perfected and competitors have brought out versions, then what Adam Smith called “the invisible hand” starts to force reduction in cost of the product. Many economists refer to the as commoditization of a product, but its value is in capacity production—which produces capacity value. Political value (see Political Value) is of two types, mediating and exploitive.
· Mediating (or mediated) political value is created by reducing the organization’s internal process friction. Examples of mediating political value include contracts, laws, customs, codes, standards, policies, and so on. In the military, mediating political value (reduction in process friction) comes from “the rules of engagement” (e.g., don’t shoot your fellow military). The reduction in process friction is very often the difference between a process adding value and a process absorbing value. The regulation of markets (and the processes of markets, themselves) is such an example.
· Exploitive political value is indirect or “siphoned” value. It is caused by someone in the position of responsibility or authority using the position for the reaping of value to their own benefit; “The Lord of the Manor” is the archetypal example, those these include dictators, lobbyists, bankers, day traders, and many judges and legislators. Further, as I describe in my book, in many cases it includes various religious authorities.
Housing, Finance, and Government as Value creators
My thesis is that housing, finance, and government either do not create value or very little value. I base this on the understanding on how these fit within the dimensions described in the previous sections.
A house is worth a house. While that seems to be a tautology (and it is), too many people forgot that during “the housing bubble”. What that saying means is that the value of the house is only what value it imparts to the consumer of the house’s value. The house is never worth more than when it was built, unless it is maintained and upgraded. And even when it is upgraded the value of house begins to decrease as it is used (what’s being used, at the most abstract is its value). The problem, recently, has been that governments tend to inflate their money supply—money being a reserve of value. With the inflation of money (that is, the decrease in the value of money) the price of a house to increases—though its value remains the same; it’s worth one house. Likewise, when the housing market “goes down”, the price of the house goes down, but the value remains the same; one house.
House construction and remodeling is a tertiary economic activity. It produces some capacity value (more of the same value) for the builder and construction workers, but once completed and purchased, it starts loosing value. In giving the people of the organization a place to live, a house supports the secondary and primary industries of the organization.
Obviously, this is not an activity that enables and supports the formation of wealth for an organization. Consequently, basing an economy on housing, or at least a significant portion of an economy is foolish and silly. Yet, in the period from 1995 to 2007, that is what many Americans built the perceived wealth on, and what the United States did.
Finance includes two subtypes; banks and markets. The Wall Streeters, (e.g., bankers, hedge fund managers, stockbrokers, pension fund managers and so on) have forgotten that a bank is a value battery and “a market” is the transfer point for the value.
Banks dilute stored value of money through investments that increases risk and potentially increases the amount value through the implementation of discoveries and inventions as new products, systems, or services. In and of itself, investing cannot increase the amount of value only reduces it. Only when the money is invested in innovative ideas or the production capability (seeROI Vs VOI) does the value increase, so that, for example, loaning money for a house does not increase the value of the house or create value of any sort. However, if a bank loans money to a farmer to buy seed or farming implements, the bank has made an investment that does create capacity value—food. Consequently, banks are tertiary activities that do not produce an increase value, but they loan their repository of potential value (Money) to primary and secondary activities that do.
In the process of each transaction, the bankers siphon off some of the value as a “transaction” fee. This siphoning is converting potential value into exploitive political value; and exploitive political value is value that is quickly destroyed.
Markets have two missions. The first is to measure the value of a material, product, or organization. The second is to transform value from real to potential and back; that is trade materials or stocks for money (potential value) or money for materials and stocks. “Making a market” does both of these; and in this Internet age, anyone can do this. That is, the person can buy commodities, hold them, and sell them. In the process, the price of the commodity (be it materials, products, or stocks) converges on a price.
Again, market are tertiary activities that can convert knowledge and capacity value into potential value and the reverse. And, again, the “market makers” and “stock brokers” that siphon a percentage off, because they are “providing a service” (which to some degree they are), are converting some of the value and potential value into exploitive political value. Unfortunately, a good many Wall Streeters have turned the markets into legal mega-slot machines, gaming them through “day trading” and even “micro-second trading” to siphon off a much value as possible as quickly as possible, converting it into exploitive political value.
According to my Book, Organizational Economics: The Formation of Wealth, and as note above in this post, a government has three missions—security, standards, and infrastructure (see. Internal and External security, standards, and infrastructure are mediating political value and all three are tertiary activities, that is, necessary but not sufficient conditions for the growth of value within the domain of the organization. Further, the second and third activity can be Quaternary. That is activities, like the enactment of laws and determination of regulations, policies, and standards that enable the standards and infrastructure activities. These activities are very susceptible to manipulation for personal gain. The personnel that enact or fund the activities can enjoy an extreme amount of exploitive political value, as I describe in my book. In the past, it has been the lord of the manor, dictator, duke, king, emir, priest, shaman, rabbi, Imam, or other religious leader. Today, lobbyists must be included as they encourage the lawmakers to create uneven economic playing fields that favor one activity or one industry over another; this includes unions and other “not for profit” organizations as well as economic organizations. Consequently, mediated political value is at best much more easily converted into exploitive than either knowledge or capacity value, and is the catalyst for the conversion of these.
In this age, “Entitlements” are the single biggest place that creates exploitive political value. These safety nets drain value from the infrastructure portion of government. They are popular because the exploitive value goes into the pockets of the many rather than the few and popular with politicians because Entitlements buy votes. But, entitlements are unsustainable for any organization as Greece and Italy have proven, and like the United States is likely to prove, now that the population is addicted to Entitlements. For example, the occupy Wall St. movement feels that all college graduates are “entitled” to jobs (so what value is art history or black studies to an economic organization?).
The Net Result
Too much “unearned income” in too few wallets; too much “Entitlement income” in too many wallets. I think what I’ve shown is that having an economy based on housing, finance, and government, like that toward which the United States is heading, is a sure recipe for going out of business.
We still have time, but do we have the leadership?
[i]These categories of industries were generally accepted in the 1920s onward, as primary: mining, and agriculture, secondary, manufacturing, and tertiary, services—these definitions are outdated and don’t get at the underlying concepts. Therefore, I’ve redefined them for a more general meaning of the concepts. [ii]G. Hamel and C. Prahalad, Competing for the Future: Breakthrough Strategies for Seizing Control of Your Industry and Creating the Markets of Tomorrow, (Boston: Harvard Business School Press, 1994).