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Symposium 2013

Proposal - Hedging against Ignorance

The Challenge

Innovation as the foundation of economic dynamism and prosperity is a complex process involving contributions from various players. In particular it deals with the transformation of basic science into ...

Innovation as the foundation of economic dynamism and prosperity is a complex process involving contributions from various players. In particular it deals with the transformation of basic science into rival proposals that improve the well-being of mankind. For more than 200 years technological innovation has driven economic development. All growth is based on innovation. The process of innovation involves complementary contributions from science, from entrepreneurs, from the financial markets, from the investment community and from government.

Investment in science and technology at the frontier of knowledge necessarily requires acceptance of fundamental ignorance about future economic and social value; is it possible to hedge this inescapable ignorance?

Forty years of practice as a venture capitalist operating at the intersection of technological innovation, commercial promise and financial speculation inform these remarks. Early in my career I learned how right Keynes was when he wrote in The General Theory:

By “uncertain’ knowledge” . . . I do not mean merely to distinguish what is known from what is merely probable . . . The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

Is it possible for the funders of a start-up venture to construct a financial hedge against the ignorance in which they are necessarily investing? From a pre-2008 point of view—but definitely not from a post-2008 perspective—it is tempting to imagine a derivatives market in which venture capitalists can purchase hedges. In neoclassical economic theory, the central notion of general equilibrium depends on the existence of just such a market. In that fantastical virtual space, rational agents protect themselves from the ontological uncertainties of life by trading Arrow-Debreu securities, conceived to provide exactly the state-contingent insurance for which all of us yearn. Markets for goods and services and assets are made complete by the supposition that at any point in time, one can buy and sell insurance over every possible future state of the world.

In the spirit of Arrow-Debreu, is it possible to imagine that this market could extend to start-ups? Even at the peak of the credit bubble in the first half of 2007, there were only a limited number of corporations against whom it was possible to purchase single-name credit insurance. Any institution prepared to write a contract on an early stage technology venture would either have had to charge a premium so huge as to make the hedge uneconomic on its face or would itself have been so obviously incapable of evaluating and pricing risk as to be utterly unreliable as counterparty. In other words, a market mechanism for hedging the sort of ontological uncertainties that proliferate where entrepreneurial innovation meets emerging commercial opportunity has never existed, is unlikely ever to exist, and will not persist if someone is foolish enough to create it.

Where theory fails, practice offers an alternative. As a venture capitalist, I learned how to construct a two-edged retrospective hedge against unanticipated adversity. My term for this tool is: Cash and Control. I mean unequivocal access to sufficient cash to buy the time necessary to understand the dynamics of the crisis and sufficient control to change the parameters of the problem. In the micro-world of the individual venture capitalist, this means the ability to restructure operations, redirect strategic priorities and/or force a sale of the venture…and it often turns on the ability to fire the CEO.

My discovery of how to construct defenses against the vagaries of living in this uncertain economic world is far from unique. The most successful venture-backed companies typically hold cash reserves far in excess of what conventional economic theory can rationalize as “efficient.” To pick a nonrandom four companies, as of mid-2013 Apple held $42.6 billion in cash and short-term investments, plus no less than an additional $104 billion in long-term investments; Cisco held $50.6 billion; Google held $54.4 billion and Microsoft held $76 billion. Having accepted radical technological risk in the development of novel products and services, along with radical market risk to discover whether there are customers for their inventions, even the most outstanding winners in the Innovation Economy understandably choose to accept no financial risk whatsoever.

Although the context was different, the same strategy expressed itself in the fortress balance sheet that Jamie Dimon constructed at J.P. Morgan Chase in anticipation of the Crisis of 2008. At the global level, the turn toward aggressively mercantilist policies by the nation-states of East Asia, led by China, in direct response to the destruction wrought by the International Monetary Fund (IMF) in the late 1990s, has the same pragmatic motivation. To avoid the threat that the IMF would again impose severe spending reductions and tax increases, thereby accelerating and deepening the contraction of their economies, these nations were determined to achieve the autonomy that Cash and Control ensures.

At the national level there is a reason why policies aimed at accumulating cash and ensuring autonomy of action are termed “protectionist,” whether they are implemented by way of an undervalued currency or legislated tariffs and subsidies. Of course, political leaders in these instances are also serving the economic interests of those in the market economy who export and thrive on protectionist policies at the expense of the mass of consumers who suffer at the margin from the adverse shift in the terms of trade with the external world. And, of course, the intensely focused interest of the few whose wealth buys access to those in power always tends to trump the diffuse interests of the many.

However, only nations that are the most competitively productive and that hold substantial net balances of international assets can afford to implement the pieties of free trade without fear—think Great Britain in 1846 or the United States in 1945. Friedrich List put it succinctly some 170 years ago: “Any power which by means of a protective policy has attained a position of manufacturing and commercial supremacy can (after she has attained it) revert with advantage to a policy of free trade.” All other participants on all the fields on which the economic game is played are on notice to develop their own strategies of self-insurance, their own path to Cash and Control.

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