The Heart and Soul of Capitalism: Innovation, Savings and Demand

Justice Litle reveals the three forces at The Heart and Soul of Capitalism.

Innovation, Savings, and Demand

“From a fishhook to the space shuttle, every material human advancement has been the result of a combination of technological innovation and capital savings. In other words, we are now building on the savings and innovation of our ancestors.”  — Victor Sperandeo, Trader Vic II: Principles of Professional Speculation

THIS PAST WEEK, the April issue of MIT’s Technology Review hit my desk. Its cover story this month is “World-Changing Ideas…25 Innovations From Around the Globe.” Among the more interesting:

What do these developments have in common? They are all focused on natural resources, and they highlight the intersection of three key forces that form the heart and soul of capitalism. What are those three forces? Drumroll, please…they are innovation, savings, and demand.

• Brazil is making a major commitment to biodiesel, an oilseed derivative with strong potential as a long-run alternative to fossil fuels.
  
•  In China, Shanghai’s Solar Energy Institute is focused on advanced solar technology. The ultimate goal: a home with 70% of energy needs met by the sun.
  
•  Chile hopes to increase its copper reserves substantially through genetic advances in biomining, a process that uses bacteria (rather than noxious heat or chemicals) to extract copper from the ore.

Let’s go over them briefly, because a proper understanding of these forces is imperative for investing success.

The Heart and Soul of Capitalism: Innovation

Innovation is perhaps the most intuitive of the three forces, but it is still overlooked or misunderstood. Through innovation, we become more productive and are thus able to reap greater output from the same or less input. In a rare instance of serendipity, the innovator is able to increase his wealth while increasing the productivity of others at the same time. The first fisherman to use a net would have had substantially greater numbers of fish to trade relative to his peers, without exerting greater effort. Once the idea caught on, greater quantities of fish would be available to the benefit of all. Alternatively, if greater quantities of fish were not desired, then fewer fishermen would be required to bring in the necessary catch, allowing some of them to pursue other productive pursuits. With every additional innovation, we are given the beneficial choice between greater levels of output or a surplus of resources available for alternative pursuits. And so we continue trading up to the present day, where the innovative fisherman’s descendants find themselves engrossed in solar energy and biomining.

Down through the centuries, innovations have shaped history and accelerated progress in sudden jumps. The plow led to agriculture-based societies rather than hunter-gatherer ones, which in turn created the locational stability required to build cities. Gunpowder led to the demise of feudalism and the first stirrings of democracy by bringing cheap weaponry to the masses. The printing press fueled the Protestant Revolution, which in turn sowed the seeds of Western-style capitalism.

This highlights another characteristic of innovation, namely, its incredible disruptiveness. When a promising new idea changes things for the long run, there are always vocal protesters in the short run. The term “Luddite” honors the memory of Ned Lud, a noted loser in the innovation process, who led mobs of workers in the destruction of British textile mills between 1811 and 1816 out of fear that they would destroy jobs. Ned has many descendants, in spirit if not in blood, and they are equally vocal today. Unfortunately for Ned and his descendants, the short-term pain of disruption is unavoidable, and in fact vital, in the pursuit of progress. In 1942, Joseph Schumpeter immortalized the concept by coining the phrase “creative destruction.”

The Heart and Soul of Capitalism: Savings

Savings are required to pursue innovation. Innovation is essentially an investment in future production, and one cannot make an investment without savings. This investment does not have to be in the form of money. It can be time, energy, education, other opportunities forsaken, or a number of other things. And like any investment, there is risk involved. When our intrepid fisherman first conceived of the idea for his net, he had to make a number of investment decisions. Was this idea worth pursuing in terms of energy and effort? Could he afford the time taken away from his regular fishing day? Did he have access and means to acquire the necessary materials? Would he have to budget time for trial and error as he tried different weaving patterns in the construction of the net? Was it worth the opportunity cost of foregoing other avenues of production? All these questions go back to savings (in the form of human capital rather than fiduciary), and a willingness to put a portion of those savings at risk. Without an available surplus of time, energy, and resources, the net would never have seen the light of day.

The immutable relationship between savings and innovation is now clouded because there are so many hidden links in the chain. Thanks to the modern application of credit, it’s tempting to forget that savings are still required to innovate. After all, don’t entrepreneurs borrow money to start businesses every day? Indeed they do…but it is still someone else’s savings they are borrowing (and putting at risk), as well as their own time, energy, and opportunity cost. Ah, yes, but what about fractional reserve banking and the stimulative “easy money” activities perpetuated by the Federal Reserve? Even here, the circle remains closed. When excess liquidity is pumped into the economy, it only serves to devalue the real savings that previously existed, like a watered-down drink not worth the inflated price.

Coincidentally, America’s great hope is that we will innovate our way out of the current savings straits. In essence, bulls are betting the next long cycle of innovation will pay off big enough to cover the current tab. No matter how you slice it, savings are still required, be they already earned or mortgaged against the future. The only problem is we aren’t investing our borrowed funds in ideas, education, and means of future production; we are loading up on DVD players and SUVs while our next generation’s education rankings slip down the board.

The Heart and Soul of Capitalism: Demand

Demand is where the rubber meets the road. Without it, the innovations produced by way of savings have no benefit. In the case of natural resource development, demand usually comes first, spurring innovation through a sense of urgency or a clear long-range price advantage. When it comes to consumer innovations, like ATMs or iPods, the innovation usually comes first, with demand to follow once the value of the new technology or process is widely recognized. Either way, demand is the catalyst that ultimately allows the innovation to bear fruit. 

Demand is also important enough to stand on its own as an investment concept. As an investor, you can earn your keep simply by gauging fluctuating levels of demand properly. This, in fact, is how fortunes are made in commodity markets. By recognizing critical periods when demand is set to significantly outpace supply for a long period of time (or vice versa), it’s possible to make a great deal of money as prices wax and wane. The same applies to business expansion, in terms of applying a successful idea to a new city, region, or country. We don’t have to reinvent the wheel to make money; in fact, we don’t even have to improve on the wheel. All we have to do is uncover market opportunities where rising demand for wheels has not yet been met.

Of course, there are multiple factors that have to be taken into effect when considering potential demand. Among them are the level of competition, the economics of production, logistics of delivery, comparative substitutes, political risk, barriers to entry, potentially disruptive innovations, and so on. But when it’s all boiled down, the heart of the matter remains relatively simple. Economics deals with the allocation of raw materials and finished products that exist in limited supply, be they crude oil deposits, atomic physicists, or iPods. Demand is the root of the equation.

In part II of this series, we will take a closer look at innovations and economic factors in the world of natural resources. Through this lens, we will uncover some of the predictable ways in which innovation, savings, and demand tend to interact over the long cycle…and see how we can directly apply these observations in our relentless pursuit of profit. “The Death of May, 12 October 1949

And of course, comments and observations are sought with extra emphasis this time around, given my relative newness to the Whiskey & Gunpowder community. Let me know what you think – simply reply to this e-mail!

Justice Litle
March 23, 2005

“In the early summer of 1949 my daughter graduated from the Madeira School in Virginia, and shortly afterwards my wife and the children came to Switzerland, where we spent happy weeks at Pontresina and Saas Fee.  May said occasionally that she could hardly keep up with the children on walks; unfortunately, I paid too little attention to these remarks.  She was never ill, and I took that to mean that her health must be perfect.  In September she returned to Washington with the children, and I was to follow in November

“On 12 October, shortly after noon, May was stricken by a heart attack and died within a few minutes.  The two days that then followed must have been terrible for my children, who had been with their mother that morning; because of fog I was unable to arrive for two days.  I found the children grown up far beyond their years. 

“In my shock, I found myself questioning God’s will: why had my wife, who was so much younger than I, been torn away from me and the children?  Soon I came back to my senses.  Our marriage had brought me deep happiness in middle life.  I had to be grateful for that, bowed down as I was by present sorrow. 

“I pressed the children to me.  They tried to conceal their sorrow in order to comfort me.”