Quarantine in an intangible economy By Jonathan Haskel and Stian Westlake

How might an intangible-intensive economy respond differently to a pandemic, and to the policies governments put in place to control it?
By Jonathan Haskel and Stian Westlake

As governments and businesses race to work out how to respond to the economic challenges of COVID-19, we thought it would be useful to set out how today’s economy might differ from the economy of a few decades ago when it comes to responding to a pandemic. What interests us in particular is how pandemic-response policy might work differently in an economy where most investment is intangible.

The intangible economy — a recap
We’re currently writing a book about the economic effects of the long-run shift to an economy where most capital is intangible, a trend we outlined in Capitalism Without Capital (2017).

Over the last 40 years, the nature of capital investment in rich countries has changed: whereas once most investment by businesses was tangible (that is, in physical things like machines and buildings), today most investment is intangible (that is, in things you can’t touch or feel: like ideas, brands, organisational knowledge and structures, or relationships).

Intangible investments have several unusual economic properties. Two of these are high spillovers (the benefit of an intangible investment often spills over to firms other than the one that made the investment) and high synergies (intangibles seems to be especially valuable when you combine them with other intangibles; they form systems and mutually reinforce one another.)

Intangibles and COVID-19

In the early weeks of the pandemic, much of the public debate focused on the tangible capital necessary to fight it. International observers were impressed with how fast China built a new COVID-19 hospital in Wuhan. We nervously wondered if Western countries could build new hospitals as quickly, and wondered if we had enough ventilators to meet peak demand and enough factories to produce protective equipment.

In fact, it turned out that many of these tangible capital issues were under control — the UK built its own new hospitals, and so far has thankfully not breached ICU capacity. But it is becoming clearer that the path out of the crisis actually requires massive intangible investment. We need software and processes to track, trace and quarantine people with the disease, and in research to develop effective drugs, treatment protocols and, ultimately, a vaccine against the disease.

The same is true for businesses, from a capital investment point of view (lack of demand is of course a bigger problem, but that is not the subject of this post). The immediate capital needs of most businesses involve investments in organisational, reputational and software capabilities — for example moving to online, remote and delivery models, not new tangible capital, much of which for the time being is lying idle.

Intangible investment also looms large in households’ experience of COVID-19, in particular for those socially isolating or able to work from home. Joe Wicks workouts and Zoom calls may not be perfect substitutes for the office or the gym, but the fact that they are possible at all for so many people is a sign of the proliferation of intangible capital over the last few decades. To the extent that intangible capital consists of knowledge, relationships and expressive content, it is possible to work with it remotely or consume its output remotely in a way that is not the case with tangible capital. (Of course, to deliver those services needed the very tangible investment in communications technology and infrastructure, but that is just to point out how e-infrastructure is a key platform upon which intangible investment can be made.)

Because intangible investment will be important to escaping the COVID-19 crisis, we are learning some hard lessons about the quality of our institutions for making and government intangible investment.
Drug development, for example, is plagued by a host of problems that seems to be making investment less effective. (Jack Scannell’s work is a good place to start.) The rules about how drug development is financed and how it is rewarded (e.g., through patent law) are complex and to some extent arbitrary. At the same time, there are many vested interests and achieving change is hard. Issues of intellectual property, rules and protocols also affect medical devices like ventilators. It will be interesting to see whether the urgency of fighting COVID-19 helps us find new ways of solving these problems.

    1. By the same token, remote work and remote socialising rely on a whole set of norms, rules and laws that are being tested and questioned like never before. Anyone who finds themselves drained and unfulfilled after a working day full of videoconferences might well reflect on what “remote-only” firms like Basecamp have learnt about the importance of making asynchronous communication a norm. (Though it could be worse: the role of seals in Japanese business is apparently a major hindrance to remote working in that country.) Zoom has had to juggle a set of thorny privacy and standards issues while at the same time achieving a phenomenal feat of scaling.When it comes to remote work, we could well be in the midst of an episode of intangible capital formation of epochal significant. Benedict Evans asked the following question about remote work:
      “How many processes in how many industries convert from in-person meetings and phone calls to Zoom, and how many convert to something like Rigup or Honor, or Figma or Frame.io — to tools, structure and workflow?”Turning face-to-face business interactions into “tools, structure and workflow” is an intangible investment in the same way that the re-design of factories to take advantage of electrification in the early twentieth-century was. Perhaps — if it results in the long-term increased uptake of remote working technologies — it could even have the same economic effect.Similarly if firms have to change how they operate, we may need to change rules and laws to let them. Most commentators were astonished to find that restaurants couldn’t repurpose themselves into take-aways since they did not have planning permission to do so.

      Intangibles and the cost of lock-down
      Another big economic question of COVID relates to the lockdown — in particular, its costs and how to manage them. Governments and economists are trying to work out how to manage the lockdown in a way that causes as little as possible long-term damage to prosperity and to people’s livelihoods. There is an interesting intangible angle to this question: specifically, the effect of lock-down on intangible-intensive firms and intangible-intensive economies may be different from the effect on more tangible-intensive firms.

      We can think of three reasons:

      1.Furloughing prevents certain types of intangible investments being made
      2.Social distancing makes certain types of intangible investment less effective
      3.Business failure destroys intangible capital

Let’s consider each in turn.
1.  Mothballing and furloughing reduce the stock of intangible capital
Consider two businesses: a fully-automated factory full of large machines producing a generic product and a consulting firm. The factory is almost certainly more reliant tangible capital (its building and its machines), the consultants on intangible capital (the know-how, relationships and proprietary practices of their staff).

One way in which these stylised firms differ is that the consulting firm is building intangible capital by virtue of doing business: every novel project it takes on, every new client it works with marginally increases its know-how and, in due course, the profitability of its business. In the automatic factory, this is happening to a much lesser extent*. This is the subject of Jim Bessen’s excellent book Learning By Doing — and we think we would expect to see more of it in intangible-rich firms and economies than in tangible-rich ones.

What’s more, intangible capital is harder to mothball; to put it another way, if it is not used, it degrades. This is the opposite of most tangible capital, which typically suffers wear-and-tear from being used: if your business owns a van with a useful life of 100,000 miles, not driving it for six months will extend its life. But an intangible asset like a brand or a supply chain or the organisation practices of a business: being out of commission for six months makes it less valuable. The “cost of desuetude”, to coin a phrase, is higher for an intangible-rich firm.

The implication of this is that the capital stock of an intangible-rich firm would suffer more from a period of furlough than that of a tangible-rich one, since in an intangible-rich economy, business as usual creates or refreshes the capital stock and disuse reduces it. Multiplied across the economy as a whole, this means the cost of lock-down is higher for an intangible-rich economy.

2. Social distancing makes certain types of intangible investment less effective
We mentioned earlier that intangible assets exhibits spillovers and synergies: that is to say, their benefits often spread beyond the firm that owns them, and they’re unusually valuable when you combine them with other intangibles.

Humans being social creatures, these spillovers and synergies often arise from face-to-face contact. That’s why clusters and “agglomeration effects” (the economic advantage of big dynamic cities) seem to be especially important in an intangible economy.

If social distancing prevents these activities from happening, it would also reduce capital formation in the short term, meaning future economic growth is lower.

For an example of what happens to intangible investment when you enforce “social distancing”, we can turn to an fascinating recent working paper by Michael Andrews looking at the effect of Prohibition in the US on patenting (patents being one output of R&D, which is a type of intangible). Remarkably, closing down bars and saloons, where researchers would congregate after hours, turns out to have significantly reduced patenting in the areas that it took place. Distancing outside the workplace also reduced innovation within the workplace.

We suspect this applies more broadly. A disciplined software engineer or a researcher may be able to work productively at home if their output is measured purely in terms of lines of code written or papers published. But if they can’t attend conferences or have unstructured, serendipitous chats with coworkers, customers or even just interesting acquaintances, the value of their output may end up being much lower.

The net result we’d expect to see at the level of the economy would be that the efficiency of intangible investment would fall: a dollar spent on an intangible investment like R&D, software development or marketing would produce less than in would do in normal times.

3. Business failures destroy intangible capital
A major topic for debate among governments and economists is to what extent it makes sense to subsidise businesses that are losing revenues because of the lock-down.
One important question in this debate is how much real economic value is destroyed if a business is liquidated. If the assets of a business can be quickly reallocated to other businesses who can make productive use of them, the costs of widespread business failure might be surprisingly low. This would weaken the case for governments to intervene to save firms (relatively to other policy choices, like paying citizens directly in the form of benefits or basic income).

It seems to us that intangible capital is, on the whole, harder to reallocate in the event of business failure than tangible capital. It is often firm-specific, having strong synergies with other intangible assets owned by the same firm (consider the synergies between Apple’s design repertoire and its product R&D). And it is often not instantiated in a way that makes it easy to transfer in any case (such as a set of organisational practices and norms).

This suggests that the economic costs of letting businesses fail are higher in an economy with lots of intangible assets than in an economy based mostly on tangibles — and it strengthens the case for governments to direct subsidies to businesses.

We can get some sense of the possible losses due to business failure by looking at the literature on the wage losses when worker-firm matches break up. Fujita et al report on US studies that compare workers who lose their jobs but are recalled back to their employer (where you might imagine that match capital is maintained) with workers who are not recalled (for whom match capital would be lost). The latter have wage losses of between 2% and 12%. For the UK, Richard Upward and Peter Wright used a long panel of UK households to compare employment spells that involved moving to another job with those where the (like) worker was made redundant and was unemployed. Those workers who were unemployed for at least a year, even if they got another job, suffered a long-term reduction in the wage of approximately 10%. Now, of course, it might be that displaced workers are less good workers and the firms for whom they work less good firms and so their wage loss merely reflects a market signal of lower value. These studies however, do attempt to control for host of characteristics of those workers, such as their age, skill, region etc. Now, if 10% is a very rough estimate of average “match specific” capital in the employment relationship. If the UK’s job furlough scheme is preserving matches of 25% of the workforce, with a labour share of 70%, the scheme is therefore preserving around 1¾ % of GDP.
The possibility of system change?
There is, however, a caveat to the argument that the costs of business failure are higher in an intangible economy.
We talked earlier about the popular idea that a period of “social distancing” might give rise to new ways of working remotely, which could over time raise productivity, maybe significantly. This is a specific instance of a more general phenomenon, of the disruption of ways of doing things creating space for new and better ways of doing things to arise.
Why does this sometimes happen? One way of thinking about it is that a concept like “successful remote working” is a bundle of practices, ideas and common knowledge that, once you hit on the right combination, has transformation results — or to put another way, a combination of intangibles that have synergies with one another. The synergies between the intangibles make it hard to change just one element, even if it might theoretically be an improvement. (This is Paul David’s story of how it required 40 years of innovations to move from the steam-powered factory to factories powered by electricity — a vast number of ideas, designs and practices had to devised and put in place to make the change worthwhile.)
A recent paper by Matt Clancy of the University of Iowa proposes a model of remote working along similar lines: employers choosing whether to allow employees to work remotely face not just a trade-off (does remote work generate more productive work for a given level of pay?) but also a fixed cost of moving from an office-based set-up to a remote one. One way of thinking of this fixed cost is representing the difficulty of making a systems change.

In an intangible-rich economy, these sorts of interlocking systems of know-how and practices are probably more abundant and important. And if so, they are perhaps more prone to getting stuck, or locked-in.

One implication for economic policy is that governments need to create as much opportunity as possible for good new businesses and ways of working to thrive. Another implication is that we ought if possible to avoid structuring subsidy schemes so that large numbers of businesses that would have failed absent COVID-19 survive.

The $64,000 question then is to create a set of policies that as much as possible supports existing businesses, to preserve bundles of know-how and practices together in existing firms, but also to create the space for new ways of doing things to arise. Striking this balance is clearly very hard, but is more important now than ever.