AIPIS 173 - Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong with Ed Conard

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It's my pleasure to welcome Ed Connor to the show. He is the former managing director and founding partner along with Mitt Romney of Bain Capital. He's author of the New York Times best selling book Unintended why everything you've been told about the economy is wrong and the new book that was Recently a top 10, the upside of how good intentions undermine the middle class. Ed, welcome. How are you?

Good, Jason. Thanks for having me.

It's good to have you and give our listeners a sense of geography. Where are you located?

I'm located in New York City.

Fantastic. So tell us a little bit about just before we dive into the books. Maybe, you know, I'm sure everyone would like to hear a little bit about Bain Capital and your founding and your work with Mitt Romney.

I was a manufacturing engineer before I went to business school. I came out of business school and went to work at Bain Consulting from Bain Consulting. I briefly worked on Wall street and then went to work at Bain Capital in the early 1990s where I worked until 2000, beginning of 2008 when I retired and then went off to write my first book. So I spent however many years that is.

15, 16 years working at Bain Capital, most of that time with Mitt, although Mitt left to run for governor of Massachusetts and eventually President of the United States. And while I was at Bain, I think it had about $50 million of capital under management when I started and when I left, it had about $75 billion of capital under management. Wow.

In what span? How many years was that?

It would have been the beginning of the 1990s until two.

Wow, that is an incredible growth story.

15 years, 16 years, yeah.

What do you attribute that to? I mean, $50 million to $75 billion. What was sort of the secret sauce of Bain and that kind of growth?

I think that Bain Consulting had a view about business, which Bain Capital adapted and used a great benefit. And Bill Bain used to say, we're selling dowers at a discount. We ought to be buying dowers at a discount. So we should buy employ the strategies that Bain Consulting had. And I think that's one of the things that were successful. And I'll tell you what that strategy was another was it just Mitt's commitment to integrity and doing what's best for the companies and investors and employees and the community. And then he surrounded himself with an extraordinary group of people who he was constantly challenging and pushing to be the best that they could be. I think the combination of those things ultimately resulted in the very high performance at Bain Capital. But I think the main investment insight was that if a company had a competitive all companies have a string of future investment opportunities. And if a company has a competitive advantage, those investment opportunities are more valuable and the market underestimates the value of those opportunities. So we were able to buy them perhaps more cheaply than the market valued them at. And then a second thing is that people are risk averse, managers are risk averse and they tend to underinvest invest in those opportunities. And so there's really kind of two types of opportunities. There's capital investment related opportunities and there's really management supervision related opportunities. Can you out think your competitors and people tend to they under invest in both of them, but on a relative basis they put more money into the capital investment because it's easier to manage and less money into the intellectual property, if you will, the clever ideas. And so we were able to put more resources into both of those and take greater advantage of the future investment opportunities that each of these companies had. And I think that just created enormous and continues to create enormous success at Bain Capital.

Very interesting. Can you drill down on that statement a little bit? This was Mr. Bain, I believe, who said it about selling dollars at a discount when you should be buying dollars at a discount. I think you alluded to that in what you just said. But I just want to make sure I catch the meaning and our listeners catch the meaning of that is that just apply to undervalued companies.

This insight that I gave you was really, I think it actually came from the Boston Consulting Group. This is where Bill Bain came from, by the way. And then he started Bain Capital and he had some other insights as well, which I can give you. But ultimately he used this strategy of taking more risk and making more investments and taking greater advantage of these future investment opportunities and recognizing that they were undervalued. And he would deliver, Bain would deliver this advice to companies and push them to make these investments and do these things that would create more value in these companies and I think Bill Bain's frustration was, gee, instead of selling our advice, and we used to say our advice was worth three to five times more valuable than the cost. And we try every year to prove to the companies that hired us this is the value that we thought we created and this is what the cost of Bain Consulting was. And Bill used to say we're selling Dowers at a discount and that we ought to do is own these companies and buy Bain consulting services and employ these strategies to make money for ourselves. When Bain Capital started way back in the 1980s, it was buying very, very small companies that couldn't afford to use Bain consulting services. And so when I joined, it was just investing $50 million it had under management. It was pretty small. It could only buy very small businesses that were way too small to hire Bain. But by the end, you were really able to buy very, very large public companies and put a tremendous amount of resources into those companies thinking about how to take advantage of all the opportunities they had to create value for customers.

Yeah, fantastic. Very interesting, very interesting. Let's talk a little bit about your books. I love both of the titles, and I think I'm very much in alignment with your thinking about the Unintended consequences and the Upside of inequality and the Good Intention. But was it Karl Marx that said the road to hell is paved with good intentions? Certainly in the welfare state, I believe that is very, very true. Which one would you like to talk about first?

I'd probably start on the new book, the Upside of Inequality. And I think often what is the upside of inequality? Income distributed more evenly. And I'd say, well, you sure, we would if it had the economy. But both of the books really aim at the same thing, which is why has the United States been so much more successful than Europe and Japan have been at growing the economy economies, at increasing median wages, by increasing employment, and by producing innovation. And the argument I make in the Upside of Inequality is that you see in the United States a very deep pool of properly trained, highly motivated talent that's working longer hours, taking more entrepreneurial risks than their counterparts in other countries, and that those their successes have created what I'll call, for lack of a better word, institutional capabilities which make these workers even more productive than they otherwise would be. So they have opportunities to work at companies like Google and Facebook, to name the most obvious examples. They work in communities of experts like Silicon Valley, which have real synergistic value to them. They're able to work with venture capital investors who know the ins and outs of the technology that they're investing in so they're more effective investors. It raises the bar for success. So people are working harder to capture the status of success in the United States versus say, their counterparts in Europe. And a lot of the reason why they're doing this is because if I'm sitting in a cafe in Greece trying to think of the next high tech investment opportunity, what's the probability that I'm actually going to come up with a good idea and be able to implement my good idea, versus if I'm working at Google and I'm seeing really interesting ideas every day and I get a eureka moment and I go off with my friends who know how to program the computers, they know how to market the ideas, they know how to manage the startup company and build a team. I'm going to logically take a lot more risk because I have a much higher probability of succeeding and a much higher payoff because I have a better idea to begin with and a team of people that can see it through. So we logically are taking a lot more risk, entrepreneurial risk in the United States, which is producing faster growth.

Okay, so really you're just saying having a good network is valuable. I mean, can I. Is it fair to distill it?

Well, except that you can't accept that risk taking, it is successful risk taking that creates the network. And it's more than just the network, because you, even if you have a great network, if you haven't worked in a job that gives you the training that allows you to get the ideas and implement the ideas, all the network in the world won't help you. And so somebody has to take the risk that creates the company. Somebody has to get the training in school and then go work for these companies in their careers. And then you're going to coalesce into these synergistic communities of experts, Whether it's Wall street or the oil patch or the auto industry or.

Silicon Valley. It takes a lot of successful entrepreneurialism before you get these institutional capabilities. And what you look at in Europe and Japan is that there's been almost no entrepreneurial risk taking at all. Which is not to say that people don't start a donut shop. And I don't mean to demean small business. It's critical too, but it's not what grows the modern economy.

Yeah, right, right. No question about it. Well, okay, so there's been much written and much discussion on the issue of the concentration of wealth. This really is part of that issue because you have These people that are willing to take risk. You have certain governments that encourage risk taking and others that don't, and societal structures that do it. And. And the rewards are just dramatically higher for the people who are on the right side of the digital divide, who have the right networks, who are willing to take risk and live in countries that support and encourage all of these activities. Is that why wealth is becoming so concentrated? I mean, I guess you could debate whether or not it's even becoming more concentrated. That certainly is possible. But it is.

It seems like it is, but let's assume it is. Yep.

Yeah. When you look at like CEO pay in the 90s versus now, the multiplier is dramatically higher than the typical worker at that company. The CEO pay versus the worker pay. And you know, Bernie Sanders likes to rail against this and so forth, but, you know, it's a very complex issue, no question about it. So your thoughts so.

Can address all of these things. You packed a lot in there. And remind me to come back CEO pay, because I think you'll learn some very interesting things about CEO pay. But I think there's two. I once had this conversation with Brian Greene, the famous physicist, about how do we know whether the universe is expanding or time is slowing down. And he said, well, there'll be telltale signs that'll be different if one is true or the other. And he went through and explained it in the universe. But here, if you say there's two ways that the wealth might be growing more concentrated, one is that people are earning it, that they're creating things like Google and Facebook and iPhones that are making the rest of the world more valuable. And they're probably capturing a dollar for every $5 of value they're creating for the rest of society. And it may be substantially higher than 5. Or they're simply competing with their cronies. They're negotiating faux negotiations with their cronies, giving themselves a greater and greater share of the pie. What would be the kinds of things we would see if they were simply negotiating a greater share of the pie? The first thing we would see is that we're misallocating about a trillion dollars of resources which are going to the 1% previously didn't go to the 1. We're misallocating resources on that level, we should expect to see US Growth slowing down relative to high wage economies that distribute their resources. More logically, we are seeing US Growth accelerate relative to those economies. Now, there could be other reasons why we're accelerating. We have the institutional capabilities and such, but we should also see other telltale signs. A good one would be we'd see an increasingly entrenched status quo. We see exactly the opposite. If you look at the Forbes 400, less and less of the Forbes 400 richest Americans inherited their wealth. 70 to 80% of them started a business and competed against competitors serving customers more effectively, and grew that business into a very successful business. If you look at the turnover in the Fortune 500, it has accelerated. Used to be in the Fortune 500 for about 65 years in the 1920s and 1930s, it's down to 10 to 20 years in the current situation. If you look at the cutting edge, where the turnover is in Technology, the top 15 most valuable tech companies in 2000, their value is down over 60% today. It'd be down even further if it wasn't for Microsoft, which is one of the only successful companies since 2000. Today there's a whole new set of competitors who have emerged in the last 16 years in technology. So we don't see the kind of entrenched status quo that you would expect. If we turn to CEO pay, which you raised, here's a couple interesting facts. The first thing we find, CEO pay has not risen relative to the value of the companies they've managed. Companies have gotten bigger. We've not seen CEO pay rise relative to private company CEO pay where people are negotiating with the owners of the companies, not with their cronies on the board of directors. And most interestingly.

The statistic that you cite where CEO pay has risen to 300 times the median wage, really looks at a small handful of Fortune 500 CEOs who work in companies with some of the highest paid employees. And I'll come back to that in a second. Relative to the median pay of all workers. So if you have a huge influx of low skilled Hispanic workers, for example, who are paid lower rate and they aren't working in Fortune 500 companies, that lowers the median pay relative to CEO pay. Actually, look at CEO pay.

Relative to the employees they manage. You find no rise at all within companies. All of the rise has occurred between companies. So what's happened is there's been lots of small companies created with low paid employees and low paid CEOs. And there's been a handful of very successful companies like Google and Facebook which have no blue collar workforce. They have a very high.

Employee pay and they have very high CEO pay because these companies have been very successful. Goldman Sachs would be another example of this. And so when you really look at the negotiating leverage of CEO relative to the workers who work for them. We've actually seen no increase at all, despite the fact that there appears to be this huge increase in CEO pay. So again, even when you look at the CEO pay data, you don't see strong evidence of CEOs increasing their negotiating leverage. Another example of this, if you look at CEO pay relative to the 0.1%, you don't see any increase relative to the 0.1%. And you have to recognize that we need really talented people to run companies. You got about a 1 in 100 chance, if you're highly talented of being a CEO, you probably have a 1 in 100 chance of succeeding in Silicon Valley. So the pay for taking those odds inside of a corporation have to be similar to the pay outside of the corporation, or you won't get the most talented people to run your key institutions, which are critical to the success of America. So you simply don't see a lot of evidence that the 1% has simply negotiated a larger share of the pie. Every time you look at that data, it looks like they've earned it.

That is fascinating. I mean, you cited, that's a lot of a wealth of information there, but you debunked a lot of the stuff that, say, Lou Dobbs talks about. Because when you slice and dice that a different way, and when you look at, I mean, fascinating comments about the turnover in the Forbes 400, you know, wealth is being spread and more people, there's more mobility into these extreme levels of wealth than there ever has been in history. And so, you know, it's not the dynasties, not the inheritance. People really can do this. But the interesting thing, the especially interesting thing that you did not mention that I took from it, and I talk about a lot, is the regulatory climate. And it's interesting because you talk a lot about technology, but you're also a Wall street guy, okay, In a way. And I argue that regulation is what limits the spreading of the pie. I argue this constantly because when you look at like the Wall street environment, there are very few new entrants that, I mean, nobody's really going to compete with Goldman Sachs, okay? But lots of people can compete with even huge companies like Facebook, for example.

Snapchat.

Yes, Snapchat, exactly. I would argue that's a great example. I would argue that the reason for this is because the world of technology is extremely unregulated. Nobody is telling Facebook where to put the buttons, what color to make them, any big barrier to entry to creating a software company. Now, there are barriers to Entry in terms of taking it public and you know, all this massive regulatory compliance burden. But now you can crowdfund so you can at least get, get a hand up that way. And this is one of the reasons that in the world of technology it's beautifully like the wild west, anybody can jump in and play, but in the world of the banking world, you can't because of the regulations. Do you have any comments on the regulatory impact of the spreading of the pie?

So, two things. I agree with what you're saying strongly. I would also point out, by the way, that the real effective tax rate in the tech industry is about 15% versus 35% in the rest of industry. So they actually had much lower taxes in the tech sector, which has probably allowed them to also accelerate their growth. In the book I called for reducing corporate taxes to 15% across the board. I do agree with you that very importantly, although I think it's harder for me to quantify as an economist trying to quantify everything, as you could tell by my last answer, but you have laid this web of regulation over the economy and every year you make that web thicker and thicker and thicker and increasingly complex and more far reaching. And that's going to slow down growth because you constantly have to push against that web of regulations to try to increase growth. But the second thing that it does, which is very worrisome, is that you can, if you can afford it, get lawyers, find loopholes, find places where you can get a competitive advantage by knowing more about the regulations and using them to your advantage. And that's precisely the place where we don't want people to get a competitive advantage. We want people to go out and create Google and Facebook and Snapchat and iPhones, which are valuable to everybody else, and compete head to head to try to create more value for customers than the competitors have. What we don't want them to do is get a tax loophole. We don't want them to find a regulatory loophole that gives them a competitive advantage and allows them to compete more successfully without serving customers. And the more complex we make this web, the easier it is for people to find these loopholes. And it's only the biggest competitors who can find those loopholes. So I agree with you in the tech sector, where a company with a good idea can scale up to industry wide success without needing any capital at all in today's knowledge based economy makes it a much more competitive space. And you saw that in the turnover of just the top 15 tech companies over the last 15 years. The level of competition is extraordinary in that sector relative to what we see in the rest, in the rest of the economy. I will say this, though, that what you do find in the rest of the economy, and I do quote these statistics in the book, the rise in profitability in the tech sector has been extraordinary. I think it now accounts for about 30% of all the profitability.

In business in the United States. So we have seen a rise, and the economics are very different there, where the incremental cost of adding one more customer is almost zero. So anybody who can scale up will become enormously profitable because they have almost, almost no cost to scaling up. Meanwhile, though, we have seen squeezing of profitability and an evening out of profitability, which is an indication of competitiveness in the rest of the economy. So often you hear about how corporations have grown more profitable, how the.

Industries have grown more concentrated. If you really get down and look at that data, what you find is, yeah, it's true, the airline industry has gotten more consolidated, but it's highly, highly competitive. The restaurant industry has grown and retail's growing more consolidated, but it's still highly, highly competitive. The profits are being squeezed out of those sectors. People are basically earning the cost of capital. And all of the shift has been into where you see much wider variation in profitability. Much higher profitability, on average is in the tech sector, where the incremental costs are basically zero and the competition is much fiercer.

Yeah, and you talked a lot about the. The benefits to the company and the entrepreneur with the idea and how when you don't have big regulations, the pie spreads and the wealth spreads and it's just better for everybody. You didn't even have to mention, though, but there's a huge benefit. The benefit to the public and the customers who get to use all these services. They're so inexpensive. I mean, the advent of all these SaaS, software products that help businesses run, whether they be Google Docs or even the small little ones like appointment scheduling softwares that call cost 8 bucks a month has made the cost of starting a business almost nothing. It's truly an amazing time to be alive. And there are so many just incredible, wonderful things going on. We just got to keep the regulation to a minimum so that this kind of stuff can continue to thrive. You've got some fantastic charts in your book. I'm now referring to the Unintended Consequences book where you compare the 1980s to 2005 percentage of workers. You talk about the savings rate. I know we've got to wrap it up, but there's just so much interesting content here and, you know, real net worth of US Households, I guess, maybe. Ed, I'd like to just ask you, as we wrap it up, what are your thoughts about the future? Where are we going? I mean, are we on the brink of another economic disaster or should we expect prosperity? It's a big question obviously, but.

Well, I do think we, we potentially are heading towards a divided society where you have one group which is benefiting enormously from this technology. It's making them way more productive and there's near, I think, unlimited opportunity in terms of finding value. It's like mining for gold, finding value in that area. I worry a little bit that that group starts working for itself, making its more and more productive. And I do think it creates products like iPhones and stuff which are used by everybody else. You have to worry sometimes that those iPhones are largely used for entertainment, which is great, but they're also, the iPhone is being used by the most talented workers to make them way more productive than they were before. And so we will see a widening of income inequality on the other side of the equation. I think we have been kind of insensitive to what has slowed middle and working class wage growth. And I think we, you know, I always tell this story, which is, I was an engineer at Ford. We take a plant, we move it to Mexico. We tell the workers, don't worry, the entrepreneurs are coming. They're going to compete with each other. They're going to put you back to work and drive your wages up to where they were before. And that worker looks and sees. The entrepreneurs moved to California and they outsourced their blue collar work to China. And meanwhile the smart engineers who are back in their hometown are designing products and factories that put Mexican workers to work and not local workers to work. And when we look at what's happened to the wages in those communities, the wages have stagnated for decades, actually have been depressed for decades. And I think we economists on the left and the right have been quite insensitive to that. And because we haven't put forth either a theory for what's happening or a solution to how to fix it, it leaves wide open the argument that no, it's the success of the 1% which is really causing the stagnant wages of the middle and working class. I don't believe it's the success of the 1% at all. I think there are other forces at work that we have been insensitive to because we want to make the argument that there's an unlimited supply of talented workers and risk takers and entrepreneurs that are going to opportunistically put all the workers back to work and raise their wages. I don't think that's true. I think that, as I argue in my second book, properly trained talent and our willingness and capacity to take risk are the binding constraints to growth in this new economy. And it has far reaching consequences that I think my brothers in the economics profession haven't fully appreciated yet.

Fascinating, fascinating, fascinating stuff. Ed. This is an incredibly fascinating discussion. Please give out your website or a Twitter handle or however you want people to find you. Of course the books are available in all the usual places, but any other information you want to share?

Sure. It's www.edwardconard.com. that's C O N A R D and EdwardConard on Twitter and also on Facebook.

Ed, thank you so much for joining us. Really interesting insights. It was great talking with you.

Thanks for having me. Jason.

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