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Democratizing VC Investment Opportunities w/ James Kwan, VentureCrowd – EP197

Post author By Alec Krishna
Post date July 20, 2023
No Comments on Democratizing VC Investment Opportunities w/ James Kwan, VentureCrowd – EP197

Show host Gene Tunny chats with James Kwan, in-house counsel at VentureCrowd, about venture capital. VentureCrowd describes itself as “Australia’s leading equity crowdfunding investment platform, leveraging the power of crowdfunding for investments that back a better future.” Gene and James discuss how VentureCrowd is bringing venture capital investment opportunities to a wider audience through equity crowdfunding. Tune in to learn about the significance of venture capital in financing and supporting innovative ideas and businesses, particularly in the early stages when traditional sources of capital may be less accessible. Of course, listeners are reminded to do their own research and seek professional advice before making any investment decisions.
Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored.

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

What’s covered in EP197

James’ thoughts on venture capital and what he does at VentureCrowd. (1:31)
Initial thoughts on government policy towards VC (6:26)
The valley of death for startups (12:05)
What’s the range of funding for startups? (13:07)
Challenges in accessing the private capital markets. (17:29)
Crowdsourcing VC investment – example of success: Be Fit Food (19:50)
What is VentureCrowd’s pitch to investors? (21 :41)
ESG investments and societal values. (24:13)
What are the different ways people can invest through VentureCrowd? Is it based on specific startups? (25:54)
Tricky legal issues in VC. (27:01)
What’s the impact of blockchain on venture capital? (32:04)
Government assistance for entrepreneurs e.g. Breakthrough Victoria Fund (37:51)

Links relevant to the conversation

Venture Crowd website: https://www.venturecrowd.com.au/s/

Transcript:
Democratizing VC Investment Opportunities w/ James Kwan, VentureCrowd – EP197

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. The transcript was then checked over by a human, Tim Hughes from Adept Economics, to pick out any clangers that otters may have missed. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny 00:07

Hello, thanks for tuning in to the show. In this episode, I chat about venture capital with James Kwan. James is in-house counsel at VentureCrowd. VentureCrowd describes itself as Australia’s leading equity crowdfunding investment platform, leveraging the power of crowdfunding for investments that back a better future. In this episode, you’ll learn about venture capital and how VentureCrowd is trying to bring venture capital investment opportunities to as many people as possible. Nothing in this episode should be construed as financial or investment advice. Wherever you’re choosing to invest, do your own research and seek advice from a professional financial advisor if required. Okay, let’s get into the episode. I hope you enjoy my conversation with James Kwan from VentureCrowd.

James Kwan, welcome to the programme.

James Kwan 01:31

Great to be here Gene, longtime listener, first time guess, so

Gene Tunny 01:35

yeah, very good. Well, it’s I should have had you on earlier. I’ve recently discovered you, you’re the in house counsel at VentureCrowd, and you’re involved in venture capital and venture capitals has been an interest of mine for a while or as a as an observer of it, and is keen to get your thoughts on venture capital and what you’re doing at VentureCrowd. So if you’re happy to chat about that, that’d be great.

James Kwan 02:05

I’d love the opportunity. Look, can I just give a disclaimer, Gene? So yes, and I’ve loved you know, I’ve wanted to do this for a while so pilfered this from an American lawyer I listened to. Now what he says is, I’m VentureCrowd’s lawyer, obviously, I’m kind of swapping in a couple of different words, but I’m VentureCrowds’ lawyer, I’m not your lawyer. So anything I do say here, please don’t take it as legal advice. If you do need such advice, please solicit your own lawyer. So with that out of the way, I’d love to actually talk about venture capital.

Gene Tunny 02:34

That’s very good. Is that Jordan Harbinger? He says that on some of his podcast episodes, you know, the did you hear from Jordan Harbinger or from

James Kwan 02:43

He’s a bit of a new name. I think I’ve heard it from a couple of American lawyers speaking in the blockchain space. And we can talk about that as well, because that kind of feeds into the VentureCrowd vision, but it might just be an Americanism right?

Gene Tunny 02:57

No, it’s good advice, though. I mean, yep. I’m not your lawyer. So yeah, exactly. Get your own independent advice, professional advice. So and this is all for general information only. There’s no investment or financial advice in or legal advice in this episode.

James Kwan 03:12

Not even life advice, I think.

Gene Tunny 03:14

Okay. So James, to kick off with, could I just make sure I understand what we’re talking about with venture capital, we’re talking about financing for early stage businesses, typically startups they’re not they’ve got an idea. They might have a few employees, they’re looking to get some funding so they can can grow. What’s, how do you think about venture capital?

James Kwan 03:37

Yeah, look, the best way to probably explain it is that crazy uncle you’ve got in the garage, right? Who’s forever tinkering away on and, you know, a harebrained idea, they’re the people which you attract into the venture capital space, it is the idea, are the ideas which are crazy slash revolutionary, but really stand a chance at completely reforming, you know, how we think about doing life, because of the speculative nature of the ideas and the relative lack of business history behind a lot of, you know, these ventures, it’s very difficult for them to get funding from your traditional sources of capital, right? AKA, the bank. So what that leaves, for VC entrepreneurs really is four different options. You can go to your family and friends for a handout. Secondly, you could go to a benefactor with deep pockets, so high net wealth individual or their associated family office and the family office is just their army advisors to, you know, facilitate investments into the venture capital space. And lastly, I would historically have stopped at venture capital funds, so professional funds, who are looking to make an investment in a early stage venture on the prospect of a, you know, just hitting it out of the park in terms of you know, its financial performance five years down the track. VC funds do that on the understanding that, let’s say, the VC fund makes 10 investments, five of them go under, three of them break even and two of them really hit it out of the park. And I said, there are actually four options for VC entrepreneurs to go to for capital. And the fourth entrant into that are the government backed funds right? Now, the one people think about, I think, mostly in this space, just because it’s been so successful, is probably Temasek. Over in Singapore. So Temasek is Singapore’s sovereign wealth fund and they also have a ventures arm. But a little closer to home, there is an organisation a small organisation called Breakthrough Victoria with, I think, circa 2 billion funds under management. And they’re also looking to attract entrepreneurs in the VC space to the great state of Victoria. This probably because I know this is an economics podcast on that fourth source of venture capital, capital, probably a discussion to be had around whether or not that’s crowding out private investment, right. And to what extent you want the government maybe picking winners, but I leave it over to you as the host.

Gene Tunny 06:26

Yeah, exactly. Well, yeah. I mean, I mean, I’m not a great fan of government picking winners. And we might have to chat a bit later about how you think it’s crowding out. I mean, yeah, to the extent that the government gets involved in the deals, or does the financing rather than the private sector, then yeah, sure. I mean, that’s crowding out, I guess they would argue that they’re meeting, there’s a market failure, there’s not enough venture capital funding in Australia. And yeah, there wouldn’t be anyone else who would, who would fund it. Because I know, years ago, it was very difficult for startups in Australia, or people doing something innovative. So someone that Nick Gruen, and I both know, and I know you had a chat with Nick, recently, Anthony Goldbloom, who founded Kaggle years ago, he was at Treasury when I was there. And then he went to the Reserve Bank and he developed this Kaggle, the data science competition website, but he had to go over to the States to get the necessary financing. And you know, he ended up doing really well and selling to Google. So I think there’s been that view, historically, that we just haven’t had the the venture capital here in Australia. And if you want to get venture capital you for something that really innovative, really breakthrough, you need to go to the States to San Francisco to Silicon Valley to get it. What’s your take on that? James, do you think we’ve actually got an emerging private VC sector here?

James Kwan 07:51

I mean, it’s difficult to tell over the last decade, right, just because, I mean, on one interpretation over the last decade, there’s just been so much easy money, which is poured into, you know, people’s pockets, and it’s needed a home investment wise, right. So whether or not we have a working innovation framework in this country is probably something the jury’s still out. Right? There is, I think, good criticism, I think, and it’s, you know, was articulated by Kim Carr, who was the ex Minister for Innovation. And now, the, I think, believe the Chancellor of Victoria University, who says, in a nutshell, the innovation framework within Australia is just fragmented, right? It’s not that it’s nonexistent. But when you, you know, have to go to one arm of government to talk r&d tax incentive than another one to get something known as the early stage venture capital Limited Partnership, the tax incentives associated with that, that’s a particular structure, you can make VC investments through in order to obtain some sort of, you know, tax incentive. And then also litany of incentives. Like I said, you know, at the state level, think, Breakthrough Victoria, it’s very, very difficult for an entrepreneur who simply wants to build a business to tap into the government assistance in an aggregate way, right. So there is, you know, putting to one side, whether or not the existing architecture for innovation in this country is working, I think you could probably say, with a fair degree of certainty that it would substantially benefit from a degree of consolidation.

Gene Tunny 09:38

Right. Okay. Okay. So back to the, the startup. So you’re talking about what your uncle in the backyard garage or in the backyard shed, you know, as an example, I mean, are there any data or do you have a sense of who’s founding these startups? I know that, like the image of startup founders is that they’re all sort of just out Uni, they’re all sort of in their 20s, and if you don’t make it by 30, you’re a failure. But the reality is different. Is it? I mean, what what are you seeing in the startup space? Do you do have any observations on that, James?

James Kwan 10:13

Yeah. And look, I posed that early illustration of, you know, crazy uncle in the garage merely as an illustration. But really what I wanted to capture, and that was, the ideas which live and inhabit the VC space are just far fetched, right? They, you know, stand a minute chance to completely change the world and along the way to make an outsized financial return. But it is interesting that you touched on this. And I suppose to answer your question directly, I don’t actually have any data. But there is very much this dynamic, arguably perpetuated by Silicon Valley, which worships at the fountain of youth, right. So in order to be a entrepreneur in the VC space, you need to be somewhere between the ages of 18 to 35, you need to wear a black turtleneck. And I think, certainly from the VentureCrowd, side, we really want to expand people’s conception as to where great ideas can come from, because as we see it, VentureCrowd’s mission is simply to fund great ideas, and great ideas can come from anywhere.

Gene Tunny 11:23

Okay. So there are angel investors which are wealthy individuals who might give small amounts, I don’t know, whatever they give nowadays, bu you need a few angel investors, typically, to be able to get the funds, you need to scale up. And so they’re there. And then there are also the venture capital firms, so established ones, they might give you a bit more a larger amounts of funding. What are the different series of funding? Are you across that James, what they talk about?

James Kwan 11:55

Yeah, taking a step back from that, okay, I think some of the policy work, which has been done in this space to inform our innovation framework has identified something called the Valley of Death. And that’s simply a poetic expression policymakers have attached to that very early or infant stage in a company’s life, businesses life, which are very, very difficult to attract capital for the reasons we’ve just gone over, right? They don’t have a track record. And the idea is just far-fetched, it hasn’t been proven. So going to your question about you know, what do Series A, B, C, what does precede mean? These are essentially an effort by the venture capital industry to categorise that very infant stage in a company’s life. And they do that in order to introduce or inject funding in at defined milestones. So company would start a precede, there may be a couple of different stages before that before advancing to Series A, then to B, then to C. And then each stage at each progression, that the checks get bigger. And the prospect of a return gets hopefully more certain.

Gene Tunny 13:07

Right, gotcha. Okay. So so A is the first is that right?

James Kwan 13:12

Yes. So I think they call it following the alphabet in some circles. You would start off at A, well you would start off at precede nowadays and then you would go to A then to B, and then to C,

Gene Tunny 13:24

and is there any accepted understanding of what scale of funding is involved? I mean, so for precede, are we talking in the order of 100k? Or a couple 100k? Or under a million? Or what’s, is there an accepted range of funding term?
James Kwan 13:38

Yeah, look, that’s actually a really good question. It’s one I usually one I kind of leave up to our capital managers who might actually kind of slice that up. But really, they are kind of stages to know, you know, at what level or stage an early stage startup is at. And you know, that’s a way to, again, to kind of size the amount of funding investors would like to put into that company.

Gene Tunny 14:02

Yeah, I might look it up and see if there are any, any guides to that. Just interested. But I mean, one thing I’ve noticed is that, like, it’s so risky, isn’t it? Because one of the reasons banks don’t want to invest is because there’s, there’s not a lot of collateral there. I mean, banks want to lend against, you know, they want to lend you money to buy assets. So they’ve got something they can actually repossess, or foreclose on if, if you can’t meet the repayments. So yeah, startups are a really risky proposition, because you might end up with with hardly anything at the end if if everything goes wrong, if it …

James Kwan 14:39

absolutely. And yet we have this problem with lagging productivity, right. So you kind of you know, take that as a, you know, necessary ingredient to nurturing and expanding Australia’s economy into the future. These are the ideas which need to be funded in order to give that objective a real shot.

Gene Tunny 14:59

Right, Yeah, yeah, exactly, exactly. So it’s across, you know, it’s IT. It’s technology. There’s biotech. There’s I know that there’s a lot of discussion about medtech, biotech, particularly up here in Brisbane where I am medtech is quite popular, we’ve got the Olympics coming up. So everyone’s, sportstech too, I mean, there’s fintech, all sorts of things.

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker 15:31

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Gene Tunny 16:00

Now back to the show.

Could I ask you about Venture Crowd? Where do you fit in this constellation of venture capital, financiers or funders or however you describe it?

James Kwan 16:15

Good question. So go back to what I was saying, what I said a little bit earlier about VentureCrowd’s mission, because it has been around since I think 2013, has always consistently been to fund great ideas. And sorry, we’ll take the detour path to you know, the response to your question about where VentureCrowd kind of sits in the space. What we have seen as the two main hurdles to fund great ideas would be a lack of diversity of thought and imagination from the traditional sources of capital entrepreneurs would normally go to right. So if you can’t persuade a family office or a VC fund to fund you, I mean, you’re pretty much out of pocket in terms of, you know, getting someone to, you know, to back you. My boss loves giving the example of Airbnb, right, who faced rejection letter after rejection letter after rejection letter in Silicon Valley. One of those rejection letters, I think said, and I’m paraphrasing here, we just don’t think travel is a sexy idea. And yet, and yet, we know Airbnb is an eminently profitable commercial idea, because you see it everywhere, right? So entrepreneurs have had to contend with, you know, the biases in the people who they would traditionally go to for funding. On the investor side, investors have had to contend with challenges in accessing private capital markets. That’s happening in a context of companies, good companies staying private for longer, are not even contemplating listing at all. So what VentureCrowd want to do in this space is to really democratise access to founders, access to early stage startups for normal investors. And on the founder side, expand the investor base. So they actually have people with the right alignment of values, to really buy into the founders vision and to make it a reality. So where VentureCrowd sits, you know, in the constellation of VC funds, as you’ve put it is really, that idea of democratising access to private capital markets, both for founders and investors. It doesn’t have a particular mandate, although we have a number of products which align along those segments, which you just mentioned. So there’s a VentureCrowd Health Tech fund. But what we’ve seen is that investors, particularly in an area as speculative as venture capital, want to be able to invest not just in something which will make an outsize financial return, but also align with their values. And we’re actually seeing this in the suppose more conservative end of investments, right with the rise of ESG ETFs. We think the way to do this is by giving communities out there the tools to invest in a broader range of investment opportunities, which hopefully, engages that flywheel dynamic of more investment opportunities available for investors incentivizes more investors to come into this space, which incentivizes more entrepreneurs to come to VentureCrowd to seek capital raising activities through us. So that’s basically it in a nutshell. There’s a couple of nuts and bolts kind of sitting under that. I might just leave it at that.

Gene Tunny 19:43

Yeah, we’ll certainly delve into that. What are some of the successes so far James? Are you able to take us through any of those. I saw that you’ve got a there’s a meal prep business is there health.

James Kwan 19:54

Yeah Be Fit Foods is our one which we’re currently conducting a crowd source funding campaign for. So crowd source funding if you think Kickstarter, but for shares and equities, you’re basically right on the mark. So they’re doing really, really well over an established, you know, relatively new space for an established business. And the great thing about them seeking funding through the CSF, a crowdsource funding regime, is that really opens up the doors again to you know, the Mum and Dad investors I alluded to earlier.

Gene Tunny 20:27

So, yes, yeah, sorry, James, I’m just interested in that, because you’re talking about Mum and Dad investors. So normally, these type of opportunities would be for the wealthier individuals who could be angels or sophisticated investors, where you have to meet certain income or net wealth requirements. With Mum and Dad, are you talking about just ordinary people or people with which don’t, who don’t meet the normal, those requirements for sophisticated being a sophisticated investor or an accredited investor? Yeah,

James Kwan 20:58

Absolutely, I mean, there’s probably a kind of parallel conversation to this, right. But when you look at financial services regulation, you have that split between wholesale investors, and that includes sophisticated investors, investors with experience, investors with a certain amount of annual income, on the one hand, and everyone else who gets put in the retail basket. Now that’s fine from a regulatory perspective, if the objective is to have additional protections, which retail investors may avail themselves of, but increasingly what we’ve seen is the categorization of a wholesale investor actually allows you to access a broader range of investments. So go back to what I was saying about companies staying private for longer, and you know what that means in terms of, again, normal people being able to build wealth into the future. That’s really a big part of what’s motivating VentureCrowd to democratise access to these markets. Right. Because why should they be the purview of the already rich?

Gene Tunny 22:05

Yeah, look, I think I generally agree with that, that viewpoint and that philosophy, I mean, the the issue is, of course, that it is it is a risky, sector isn’t it and and I mean, potentially, there are much higher returns, but you don’t get that without taking on a lot of risk. So how do you explain it to investors? What’s your, what’s your promise? Or what’s your, yeah what’s your pitch to investors?

James Kwan 22:31

So the first thing probably to say is, and again, you know, not legal advice, not financial advice. But venture capital, probably, you know, again, because of its, you know, speculative nature, will probably only ever occupy a very, very small part of, you know, someone’s portfolio. But it’s interesting, you mentioned the riskiness of, you know, this area, and, you know, that is a deserved reputation. But when we look at, you know, the volatility in asset classes, which we’ve traditionally treated as less risky, and I’m thinking US Treasuries, right. I mean, as an economist, you’d probably be aware about the volatility that asset class has gone through over the last 24 months. So it’s interesting when we talk about, you know, these asset classes as having a permanent risk profile, and maybe that needs to be revisited. But parking that venture capital investments will, you know, tend to occupy a fairly small portion of an investor’s portfolio. It probably also engages that part of the investor, which, again, what I said earlier, wants to invest not just because of the financial value inherent within that company, but also the values which that company represents.

Gene Tunny 23:47

Yeah, do you find that, that is a, you know, people are really looking for that, that is something that, you know, that will affect materially affect people’s investment decisions.

James Kwan 23:58

I don’t think people can deny the fact that people bring their personal values to investments. I don’t think there’s any other way to describe the, you know, explosive growth in ESG funds over the last 12 to 24 months. I think as a society, we’ve just been, we’re getting less prepared to accept the cost to society, which traditionally had been externalised and separated out from the company’s financial performance.

Gene Tunny 24:25

Yeah, fair enough.

James Kwan 24:28

Yeah. I wouldn’t read into that, though. So the qualification there, Gene would be that I am not an absolute supporter of ESG. I think there are a number of important questions which need to be asked in terms of how you reconcile the values which ESG is intended to stand for on an internal basis. So how do you reconcile the E standing for environment with the S which is for social with the G right when those things come into conflict? And I certainly do think those values aren’t always in alignment. Certainly that broader proposition of people investing, because they see something which, you know, they see a value as in a social or an ethical value they want to advance, in addition to the financial value they hope to realise in the future, I don’t think anyone can really deny that.

Gene Tunny 25:18

Right. So how does this work at VentureCrowd? Do you have a specific investment vehicle or a specific fund that is making ESG investments? Is that what your, is that the case?

James Kwan 25:30

We don’t, and you’d have to ask the people developing products as to why we don’t. But what we do have, and again, getting going back to what I was saying about ESG, having a couple of internal inconsistencies, it’s perfectly fine to invest on the basis of your values, but it probably needs to be a little more specific than something as amorphous as ESG.

Gene Tunny 25:54

Yeah, good point. Yeah. Well, what are the different ways people can invest through VentureCrowd James, just interested in that you have specific funds? Or is it based on specific startups? There’d be a startup, and you, you were mentioning before you went and crowdsourced for Be Fit, was it? Is that right?

James Kwan 26:12

Yeah Be Fit Foods, so probably the best way to think about and I think this kind of applies broadly, is you can either invest into a single asset, or you can invest into a portfolio, right? A number of our investments right now would fall into the former basket. So investments directed into single company. But we do have and the example which I gave earlier being the VentureCrowd Health Tech fund, that would be one which grants people exposure to you know, a number of companies playing in a particular sub sector of the economy, namely Health Tech.

Gene Tunny 26:44

Yeah. Yeah, gotcha. Okay. Okay. Very good. And James, you’re a lawyer, aren’t you? You’re the in-house counsel.

James Kwan 26:53

For my sins, they never take me out of the dungeon.

Gene Tunny 26:55

Right. Yeah. So, I mean, what sort of, are there tricky legal issues involved in VC? I mean, what what are the, can you give a flavour of the types of issues that people in your sector or, you know, in venture capital have to think about please?

James Kwan 27:11

On any given day, you will have, I think this is the way I would describe it, you would have work which is driven by the broader economic climate. So when, yeah, when times are good, no one ever looks at the contract, but when interest rates are rising, and people are finding it difficult to put food on the table, you know, that’s when people actually, you know, start taking, you know, a magnifying glass to the investment contracts and seeing whether or not they can withdraw their money at a particular time noting that venture capitals, you know, tends to be a mid to long term investment. You have companies who you may have, you know, I’m not singling anyone out, in particular, I’m just kind of painting this sector in a broad brush. But you may have companies who, who you got along famously when you’re raising capital for them, but as soon as that capital is raised and transferred into their account, you no longer hear from them. So you having to chase them up. So there’s a lot of things of a transactional nature, which are driven by again, the broader economic climate. The other parts of my job, what really the other half of my job really would be dedicated to standing up the technology platform, which VentureCrowd wishes to move its financial services and financial products onto and that’s a way of engaging online communities to make investments. We think, within that the, so I again alluded to blockchain has been a bit of a part of the VentureCrowd strategy. And we think, so putting aside cryptocurrency, which is a particular, you know, use case of blockchain, we think that there is something within that technology, which neatly aligns with this idea of democratising investment, because what blockchain allows you to do is to represent ownership in a virtual context. And it allows you to do that as potentially as seamlessly as sending an email, you know, between you and I. So, we have, you know in the works, a development of a blockchain platform, which we hope to leverage to facilitate investments in a virtual slash digital context. And there’s a long list of items of a regulatory nature which we’ll need to tick off before we can do that in a compliant and safe way. So that’s probably the other part of my job, which is probably a little less applicable to other VC funds and more specific to the job I currently occupy right now at VentureCrowd.

Gene Tunny 29:54

Right, and so is this why you’re in, you’re based in Canberra aren’t you James and is this why because you have to talk to Treasury I guess and maybe APRA, the Australian Prudential Regulation Authority.

James Kwan 30:04

So APRA does actually have I think it’s a little known secret. But APRA does actually have a Canberra office. But you know, the headquarters are still very much ensconced in Sydney CBD.

Gene Tunny 30:15

Right, gotcha yeah,

James Kwan 30:16

I’m actually in Canberra, because I’m a born and bred local, so this is kind of in the personals. And, you know, it’s probably safe to say that, but for, you know, the broad based acceptance for remote work, which has happened over the last 12 to 24 months, because of COVID, I probably wouldn’t be where I am right now that, you know, we now live in a world where you can work in a, you know, industry where, you know, you are very much separate, except for a virtual connection with your employer, and pros and cons, but it’s working out pretty well, for me.

Gene Tunny 30:48

Ah very good. This blockchain platform sounds terrific. Would this be a first to the world? Do you know if anyone else is looking at this worldwide? Are there any examples of this sort of thing?

James Kwan 30:58

Yeah. So there’s a couple of people who, you know, have also twigged to the idea of blockchain being, you know, a potential, you know, next generational platform to make investments. So, you know, the effort to tokenize, they call it, you know, real world assets. But, you know, you could also include shares traditional financial instruments into that definition, definition of real world assets. And there’s definitely a couple of people doing that, again, over in Singapore, which, by the way, I should probably mention VentureCrowd’s also recently announced that it’s established a branch office over in Singapore, which is why I know about this. There’s a couple of companies, the one which comes to mind is ADDX, which is an exchange, which is hoping to tokenize a bunch of financial instruments and put them onto the blockchain. And it’s just, you know, again, there are certain efficiencies which you know, businesses see, which make developing, you know, a market exchange on that technology on the blockchain and attract a prospect.

Gene Tunny 32:04

Yeah, I’ll have to look more into that. I know, that wasn’t ASX looking at this. And then they had an issue that just didn’t work out for them. They blew a lot of, 200 million or something on investigating a blockchain exchange for the Australian share market. But you know, they had a go at it. I mean, you know, you may you’ve got your own tech guys and your own ideas. So yeah, I think it’s worthwhile looking at for sure.

James Kwan 32:28

The ASX post-mortem Gene is actually really interesting to read because blockchain at its heart is the idea that you can scale up peer to peer transactions, right, whereas the current model of financial services and financial transactions very much and the realm with which ASX sits in is very much based on intermediaries. So you know, how you reconcile a technology which promises peer to peer transactions with also the presence of intermediaries is somewhat difficult to reconcile. And I think that’s, you know, something which comes out in the post-mortem on a ASX chess replacement project,

Gene Tunny 33:09

I’ll have to have a look. So you were saying what they were trying to do if they, the way they were coming at it was never going to work? Is that what you’re suggesting? Because it was incompatible. There’s this incompatibility with their model and why would you use blockchain for that? Because they just, they didn’t want to surrender their role as the as the intermediary? Is that what you’re arguing?

James Kwan 33:31

I think that’s something which definitely kind of comes through quite clearly in the report, or at least if not quite clearly, and then reading between the lines, right, because ASX is, you know, an existing financial service has a number of stakeholders, which, you know, it needs to accommodate. And those, you know, stakeholders make money. You know, they have business in the existing financial system, which is predicated on money passing through different entities before it hits, you know, kind of, you know, the end investor.

Gene Tunny 34:03

Yeah you’re talking about the brokers as their stakeholders and the banks. Okay, gotcha. That makes sense. I’ll have a close look at that. I just thought of that then when you mentioned this, and just remembered ASX blew a, a whole bunch of bunch of money on that. But look, you know, there are going to be failures, in any when we’re innovating and before you get to the successes. I want to ask you about one thing you said before where there are concerns, sometimes the founders, they’ll get the money deposited, and then you don’t hear from them. But one of the things with venture capital, I mean, the way I understood it is that, I mean one of the benefits of this approach is that the the founders can get the benefit of these people who’ve been in venture capital like the or the angel investors have been successful business people, and they’ve got a lot of experience and the, and the venture capitalists have seen it before. And so they can provide them with the founders with the benefit of that experience. So will they sit on a board, they could be advisors, I mean, I know that someone like Tim Ferriss, you know, he would be an advisor to Uber or Shopify, and then they’d have an IPO and then, you know, make ridiculous amounts of money. Like, how does it work with VentureCrowd? Do you have a role in how the company runs day to day or the strategic direction?

James Kwan 35:19

Again, good question Gene. So, ideally, the investment is tied also to some sort of ongoing engagement with the company. Right. And while that is the perhaps the ideal let’s say, it doesn’t always happen. And it really is kind of horses for courses right. Some founders, you know, may be reluctant to relinquish the control, which is represented by having, you know, an external person sit on their board. And it really is, I suppose, on investors VC funds, the onus is on them to actually persuade founders of the value of having a fresh set of eyes, an experienced set of eyes stewarding the company as it kind of goes through, you know, its various stages of maturity. And I suppose, where that doesn’t happen, right, where the company just, you know, takes the money and run that is, you know, a risk, which, you know, needs to be considered.

Gene Tunny 36:15

Yeah, I mean, just thinking about it, what I’ve seen with these, a lot of these startups is that it’s so long until they’ve actually got any significant amount of revenue, right. So for their first few years, they’re just burning cash. And they have a burn rate, don’t they? So they figure out oh, this is how much money we’re burning every month. And this means we can, you know, we’ve got to basically have the product up and running, earning revenue by this date. And, yeah, it’s, it can be tough that that sort of business. And if you’re investing in it, yeah, you’d have to, you really have to have nerves of steel, I suppose. Because a lot of it…

James Kwan 36:45

It’s not for the faint-hearted Gene

Gene Tunny 36:48

Yeah, that’s, that’s a good way to put it. Okay. Right. James, I should ask you about policy, you, you were talking about policy before. And Kim Carr, he was Industry Minister when I was in Treasury I remember. And he had an innovation review. And I think his idea was to try and connect everything up and have a more integrated system. And so he was Minister for Industry and Innovation for a while. So I guess he was probably trying to make, to improve the interconnectedness or whatever you want to call it when he was there, but you’re saying that there’s fragmentation? Is that, is that the case? You think that there are, that we could have better policy settings for venture capital here in Australia? Is that your view?

James Kwan 37:37

Yeah I don’t think I really have too much more to say, apart from you know, what I said earlier about fragmentation. But again, as I put it before, as an entrepreneur, right, your focus, the reason why you get up every day is to build a business. It’s not there to fill in a form. And so it is a little puzzling, that in order for people to access government assistance in this space, but it’s not just one form, it’s multiple forms. And those forms are Byzantine in nature. And you’ve got to deal with a host of government bureaucrats in order to access those those incentives, you know, those assistance packages, it may simply be, you know, a symptom of government being a complex creature, right. I mean, you would know that perhaps better than most people right Gene, but if that is the case, that the assistance is out there, it’s just not readily accessible. It’s not easily accessible, then perhaps one way of nurturing, you know, the venture capital industry in Australia, is to simply make it easier for entrepreneurs to do that on a personal basis with, you know, the least amount of friction possible in the least amount of time and attention taken away from building their own business.

Gene Tunny 38:55

Yeah, it sounds like what, is it about information, getting the information out there? Just trying to think how they can do that. Improve that accessibility? Maybe I’ll look into it and just see what the, yeah, I mean, I might have to try and connect with some founders and see what issues they’re, they’re facing moving. It’s, it’s a good point to, to make. I’ll also have to look at the break through fund and break through funding through Victoria, right BreakThrough Victoria. I’ll have to see how it’s gone. It’s, Ill have a look at its financial disclosures, and, gee, it’s risky for governments to do that sort of thing. And one thing that, it’s interesting it’s being done in Victoria, because Victoria, historically, I guess everyone’s forgotten it now but back in the late 80s and early 90s, there was the Tricontinental which was the merchant banking arm of the State Bank of Victoria. And it lost a lot of money on commercial real estate, if I remember correctly, and that basically led to the downfall of the State Bank of Victoria. And you know, huge issue at the time. So in, you know, venture capital’s arguably more risky than commercial property. So it’s it’s interesting that they’re doing that I guess they, if you’re upfront if you’re clear that you could lose money and it’s highly risky then, and they’ll argue that there’s a public benefit to it. Maybe you can, maybe you can get away with it if you limit your losses I suppose, limit yeah…

James Kwan 40:23

Yeah, what is it people say, Gene, don’t put money in to an investment which, you know, you’re not happy losing right, and I think that applies on the individual level. It probably also applies at the level of state governments.

Gene Tunny 40:34

Yeah, I think that’s a very good point James. Absolutely. Okay, James, anything. Any final points before we wrap up? This has been great. I’ve learned a lot about your business. And yeah, really appreciate your perspective, is there anything more you’d like to add before we wrap up?

James Kwan 40:48

No, I think you’ve done a pretty good job of covering everything. I’ve really appreciated the opportunity just to come here and have a bit of a chinwag. And you know, if there’s an opportunity to do it in the future. You know, who knows?

Gene Tunny 40:58

Absolutely. Okay, well, next time I’m in, in Canberra, and yeah, not during the winter, though. And it’s winter there at the moment. And I remember those Canberra winters, so stay strong, stay warm. Very good.

James Kwan 41:12

Thanks again for that Gene.

Gene Tunny 41:16

Pleasure. Thanks, James.

Righto thanks for listening to this episode of Economics Explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact@economicsexplored.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

42:04

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Credits

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Podcast episode

The Paradox of Debt w/ Richard Vague, ex-Sec. of Banking & Securities, Pennsylvania – EP195

Post author By Alec Krishna
Post date July 6, 2023
No Comments on The Paradox of Debt w/ Richard Vague, ex-Sec. of Banking & Securities, Pennsylvania – EP195

Economics Explored host Gene Tunny chats with Richard Vague, a prominent American businessman and investor, about his new book, “The Paradox of Debt: A New Path to Prosperity Without Crisis.” Richard, who has previously written about “The Case for a Debt Jubilee”, shares powerful insights into the benefits and drawbacks of debt, discussing how it can help grow household wealth while also promoting economic instability and rising inequality. He also offers thought-provoking ideas for helping households and businesses manage and reduce their debts.

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored.

Note: this episode was recorded in mid-June 2023, i.e. before the Supreme Court decision regarding student loan relief, which is why the decision isn’t mentioned in this conversation.

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

About this episode’s guest: Richard Vague

Richard Vague served most recently as Secretary of Banking and Securities for the Commonwealth of Pennsylvania. As the author of The Paradox of Debt (2023), The Case for a Debt Jubilee (2021), A Brief History of Doom (2019), and The Next Economic Disaster (2014), Richard Vague established himself as a clear and independent voice in the ongoing conversation about the role of private sector debt in the global economy.

What’s covered in EP195

[00:04:39] Debt and the global financial crisis.
[00:11:23] Debt always grows faster than the economy, Richard argues.
[00:12:53] Increased debt and higher net worth.
[00:17:23] Paradox of debt and inequality.
[00:23:01] Type one and type two debt.
[00:28:50] Regional banking crisis in the US.
[00:32:13] The paradox of debt: summary.
[00:35:10] Debt forgiveness in the private sector.
[00:41:43] Debt restructuring in banking.
[00:47:48] A win-win-win solution.
[00:49:53] Massive job training as something Richard would like to see.

Links relevant to the conversation

Where you can buy Richard’s new book The Debt Paradox: A New Path to Prosperity Without Crisis:

https://www.amazon.com.au/Paradox-Debt-Prosperity-Without-Crisis/dp/1512825328

Richard’s previous book The Case for a Debt Jubilee:

https://www.amazon.com.au/Case-Debt-Jubilee-Richard-Vague/dp/1509548734

Gene’s conversation with Allen Morrison about the Enterprise China model which he mentions this episode:

https://economicsexplored.com/2022/12/26/enterprise-china-what-western-businesses-need-to-know-w-prof-allen-morrison-ep171/

Transcript:
The Paradox of Debt w/ Richard Vague, ex-Sec. of Banking & Securities, Pennsylvania – EP195

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It was then looked at by a human, Tim Hughes from Adept Economics, to correct anything an otter might miss. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny 00:06

Hello, thanks for tuning into the show. This episode I chat with Richard Vague about his new book, The Paradox of Debt, a new path to prosperity without crisis. Richard Vague is a prominent American businessman and investor. He’s a former secretary of Banking and Securities for the Commonwealth of Pennsylvania. He sits on the University of Pennsylvania Board of Trustees as well as on the boards of other prestigious organisations such as the Institute for New Economic Thinking. As you’ll discover Richard has some powerful insights into the good and bad aspects of debt. He talks about how it helps grow household wealth, while also promoting economic instability and rising inequality. Richard offers some thought-provoking ideas for helping households and businesses de-leverage and get their debts under control. Richard’s book is definitely worth a read. So I’d encourage you to grab a copy of it after you listen to this episode. I’ll include a link to the Amazon page for the book in the show notes. Okay, let’s get into the episode. I hope you enjoy my conversation with Richard Vague on the paradox of debt.

Richard Vague. Thanks for joining me on the programme.

Richard Vague 01:54

Thank you so much for having me.

Gene Tunny 01:55

Excellent. Richard, I’m keen to speak with you about your new book The Paradox of Debt. Debt’s a huge issue around the world. I’ve had recent shows on the debt ceiling in the US and and also the, what they’re calling the emerging economy debt crisis, there’s been a lot of discussion about that. And it’s one of those things that seems to come back every now and then we have these, these debt crises in various places. And in your book, you’ve got, I think, a good description of historically what’s been happening in this, this process that we’ll talk about. Could I ask to start off with what made you want to write this book? What motivated you to write the paradox of debt?

Richard Vague 02:42

Well, thank you so much for asking. And thanks, again, for having me on your show. We had done a lot of work for a number of years about financial crises be it in the Great Depression, or the great financial crisis of 2008, and so forth. And really, all of those are tied up in private debt and really rapid escalations of private debt. And we wrote a book called A Brief History of Doom that chronicled the 43 largest financial crises in the world over the last 200 years. And as we went around and presented that folks would love what we had to say, but ask you know, what about the other side of the balance sheet? You know, what about the assets that these individuals have? And? And can you put this together with the government debt story that we normally spend more time on? So I after hearing that for a few years, I finally said, well, that those questions are legitimate, they’re productive. So let’s roll up our sleeves. And let’s get into it. Let’s look at the entire balance sheet of countries of the sectors within those countries. And that’s this book.

Gene Tunny 03:54

Okay. So you wrote a previous book, and you’ve been speaking with various different people about that. And this gave you the idea. You’ve had a distinguished career in business and public service. Are you taking lessons from that? Are there things you that you saw in your career that have helped inform this book that you’ve written?

Richard Vague 04:14

Absolutely, you know we were in the banking business. So I studied debt, from the context of being a president of a bank. For years and years and years. It’s all I did, but I didn’t think you know, when you’re CEO of a company, you really thinking about the results of that company, and you don’t step back and think about the equation as a whole. And so that’s that really changed in 2000 and 5,6,7, when we began to see this tsunami of mortgage debt in the United States that ultimately ended up being the great global financial crisis. So we I honed my ability to look at debt and my interest in debt over an entire 30 year career, but it took the GFC for me want to step back and look at it holistically.

Gene Tunny 05:11

Gotcha. Right. Okay. And you mentioned the balance sheet. So you wanted to look at all of the you want to look at the debt, you wanted to look at the, well the liabilities for the people who owe the money. But you also wanted to look at the the assets. So is that part of the problem is the problem that a lot of the money that was borrowed was spent on unproductive investments? Is that is that one of the issues that you’ve been looking at?

Richard Vague 05:41

Well, yeah, and I want to be careful with the word unproductive. There. But yes, when you see a great financial crises, as we’ve had in this country, many, many times, we had one in the Great Depression, we had one and the 1980s, we of course, had one in 2008. You see lenders lending too much. And really, what we see is they’re doing loans that in normal circumstances would be just fine, mortgage loans, commercial real estate loans, but they overdo it. They do too many mortgage loans, they do too much construction debt. And not just a little bit too much, an egregious amount too much. So let’s take the 08 crisis, mortgage loans in 2002, were 5 trillion in the US by 2007. They’re 10 trade. So they doubled in five years. Well, you had to be a blind man to miss that. Or you had to have economic theories that excluded debt as a variable. And that’s really the way the Mac, the Orthodox macro economics profession looks at the economy, then their models don’t even take debt as a factor. So if you were looking at debt, it was easy to spot. It was egregious. And clearly, it’s one of the things we study.

Gene Tunny 07:16

Okay, so a couple of things that I’d like to discuss, Richard, what do you mean by their models? Don’t consider debt is a factor is that you? Are you saying that they’re too short term that they’re not thinking about the longer term and debt is in the short term, maybe you can get away with a buildup of debt. But in the long term, there can be a reckoning. So I just want to understand exactly what you’re saying there?

Richard Vague 07:41

Well, it’s surprising. But what’s called the DSGE model, which is the core model used by the Federal Reserve and academic economists everywhere, simply does not have bank and other forms of debt as a variable in the model, period. And you know, as as a career banker, I find that shocking. I’m not sure how you can study an economy without studying debt. But that is, in fact, the case. And it’s pervasive in orthodox economics. And that’s the very simple, straightforward reason that, you know, in 2005, and six and seven orthodox economists, were absolutely sanguine about the economy. At the very moment, it was about fall apart.

Gene Tunny 08:35

Yeah, yeah. I understand what you’re saying. And, and that’s true. So you’re talking about these DSGE models, these dynamic stochastic general equilibrium models of the economy. And yet you look at the macro models that the central banks run, and yeah, I mean, they’ve got a lot on inflation expectations on they’ve got their, their Phillips Curve and their Taylor rule. So they’ve got all of these traditional macro economic equations in them. But yeah, I have to look at what our RBA our Reserve Bank of Australia is doing here. But yep, I take your point and understand what you’re saying there. Now, I might have to have another look at that. And, yeah, I mean, I agree about in the lead up to the financial crisis. I mean, what was extraordinary about that I was in the when I was in the treasury at the time. So we were following it from the government perspective, also what was happening in the private sector, of course, because that was relevant to the state of the economy, government revenue, and what we’d have to borrow. But yeah, I remember just how much it did take a lot of people by surprise that suddenly everyone was talking about Hyman Minsky again. And someone who was considered a heterodox economist. And suddenly, everyone’s talking about the Minsky moment. So yeah, very, incredibly revealing time that one. So yeah, that’s more of a comment.

Richard Vague 09:56

Yeah, what I would say is, you know, I spent my career as a financial analyst, you know, as a as a bank executive, as a bank CEO, as in any of these capacities, you look at companies and industries, in the context of a balance sheet and income statement. And all any economy is, is the sum of the individuals and businesses and other institutions, primarily government institutions. In it, you just add those all up, and you have the aggregate balance sheet of the country. And so, you know, not coming up through a traditional economics route. I just took it as a given that the proper way to study an economy is the way I studied businesses and industries as a financial analyst. And this book, The Paradox of debt is that exercise, we just go in, and we look at it the way, you know, a financial analyst would look at it. And you’ll see for all seven of the largest countries in the world, we have assets, liability, income and expense, and we draw conclusions from that.

Gene Tunny 11:12

Okay. From that framework, Richard, what would you say are your key insights, and how that are different from the traditional way of looking at it?

Richard Vague 11:23

Well, one of the key insights is that debt always grows faster than the economy itself. And I spent decades in my banking career not even thinking about that. But to the extent I did, assuming that debt, you know, ebb and flow that it went up went down. But you know, over time, it was in a similar rein. That’s not even remotely true. Debt always grows faster than the economy. And we see that in the seven largest economies in the world that together constitute 60 plus percent of GDP. In the US, you know, circa 1980, debt to GDP, total debt, government debt, and private sector debt was 125% of GDP. Today, it’s more than double that level. So there’s no equilibrium, we are getting more and more leveraged as economic entities. So that’s the first thing that kind of hit you in the face, like a two by four, you know, we’re getting more and more leveraged. One of the other things that really is, you know, a central conclusion of this book, and again, was something that I hadn’t thought about, but is abundantly ever evident from the data is, the more debt you have, the higher the net worth of households go? So in 1980, at the time, you know, total debts 125% household net worth is about, let’s call it 350% of GDP. Here we are, you know, what is it 40 Something years later, debt has doubled. Net Worth, the net worth after subtracting debt of households is now almost 600%. So we should we actually demonstrate in the book that debt increased debt actually causes asset values to go up? And, you know, that’s good news insofar as it goes, but we also see show that it, it severely increases inequality, because the top 10% are the primary asset holders. So they’re seeing their net worth go up, you know, abundantly and folks kind of in the middle class and below, are not seeing increases in their net worth to GDP.

Gene Tunny 13:51

Gotcha. Okay. So yeah, a few things there. The so you talk about the tendency of debt to grow faster than the economy, and you’re talking about both private and public sector debt?

Richard Vague 14:03

The two added together.

Gene Tunny 14:06

Okay. And that you call this a debt staircase? Is that correct?

Richard Vague 14:11

Yeah, we’re very intentional about that, because most people call it the debt cycle. And while that’s, you know, somewhat accurate, it implies that debt returns to the previous level. Well, that essentially never happens. Debt will go up rapidly and then might come down, you know, a little bit it almost never comes down at all, frankly, and only in a calamity. And then it might plateau for a little while, and then it rapidly ascends again, to an entire new level. So we felt like debt cycle in a certain sense was misleading. So debt staircase really talks about we jump up to a new level plateau jump up in either higher level. That’s really been the history of debt in most countries.

Gene Tunny 15:05

Yeah. So I think this is that Ray Dalio, his idea of a debt cycle. I’m trying to remember who you are, I guess plenty of people, commentators talk about a debt cycle and leveraging

Richard Vague 15:16

it’s a natural tendency to think of things going up and down like a sine curve or something.

Gene Tunny 15:21

Yeah gotcha. Okay. Now, I want to go back to this, yeah, this tendency to go more and more into debt. And you mentioned that it does increase net worth. household net worth over time, and it’s increasing inequality. Yeah, I guess I’d probably Yeah, maybe I think too much in terms of the cycle. So I guess the story, many commentators or economists will tell us is the boom bust cycle. And there’s the exuberance, the over exuberance, and there’s too much lending, because there, there’s just too much optimism or frothiness, about the state of the economy and potential investments. And we see this time and time again, whether it’s railroads or whether it’s IT, whether it’s housing, there’s a there’s a new boom, and that’s when all the new debt gets created. So I’m just wondering, but it sounds like it’s not just a boom and bust phenomenon is it, you’re saying that this is something that actually has a there’s a trend increase in, in debt over time,

Richard Vague 16:30

you’re hitting the nail on the head, you know, I think that when people say boom, bust cycle, debt cycle, things like that, they kind of the unspoken implication is things return to the way they were previously. But that’s simply not the case. We instead, we have a boom, we have a bust, but we’re at an entirely new and higher level of leverage or indebtedness.

Gene Tunny 16:58

Hmm. Okay, I might ask you about this, what you call the paradox of debt. In your epilogue, you’ve got a really great summary of what this is. So I’ll just read this out, because I think this is really, really great. “This has revealed the paradox of debt, debt builds household net worth while also increasing inequality is essential for economic growth, and yet in excess leads all but inevitably to periodic economic calamity and stagnation. As a result, the paradox of debt portends the certainty of economic challenges and difficulties going forward, unless we are willing to get creative, and ambitious.” So I think that’s a really great summary of your of your arguments in this book, I want to unpack that I’d like to ask first, could you just explain again, how does this it builds household net worth, I get that because households are borrowing to invest in housing, but also in some other assets. But it also increases inequality. How does that work, Richard? How does it increase inequality at the same time?

Richard Vague 18:11

Well, this gets back to the relative distribution of stocks in real estate. Right now in the United States, household net worth is about $150 trillion. Let’s put that in perspective. Aggregate government debt is 31 trillion. So you can see household net worth really dwarfs anything else, it’s the biggest factor in any economy, and typically somewhere near 70%. So at least 60%, maybe near 70% of all household net worth is two things. Real Estate net of the debt to acquire that real estate, and stocks net of the debt to acquire those stocks. So your wealth really boils down typically, to those two things, your ownership of stocks and real estate. Well, the top 10% of households in the United States own 65% of all the stocks and real estate in the country. The bottom 60% That’s six zero % That’s surely most if not all of the middle class, collectively only own 14% one four % of all the stocks and real estate. So if stocks and real estate values go up, well then inequality by definition increases. And I think that is the fundamental equation in every developed economy. Debt goes up pushing asset values up. And since assets are held unequally, inequality widens.

Gene Tunny 20:04

And is it access to credit to then? And obviously the I guess the wealthier you are, the higher income, the more access, you have to credit. And that allows you to grow your wealth that way?

Richard Vague 20:15

Well, certainly that’s part of it. But even if we took the extreme example, where somebody in the top 10%, you know, had an asset had real estate, and a company selling goods, it is often the debt that the bottom 60% are accruing, or acquiring to buy the goods from the top 10% that contribute to this rising inequality. You know, famously, Apple didn’t really have much debt as a company and still doesn’t. But I guarantee you that the financing that’s provided to its customers, are what allow them to buy all the laptops and Macs and iPhones and, and other goods. I actually was a banker that provided some of that at one point in my career. So it’s the debt of the 60% that are buying the goods owned by from companies owned by the top 10%. That is part of this equation as well.

Gene Tunny 21:18

Right. And that’s, it sounds like that’s a sign that a lot of that is consumer debt. And so it’s not good debt, so to speak. So. Okay, what I want to understand which I’d love to know, your views on to what extent is this a good bet for the different players in the economy? So it sounds like so households seem to be on? Well, so far, they’ve Well, at least the the top 10% And maybe a larger share, they’ve done well out of this out of, you know, borrowing to invest? It’s, it’s been beneficial to them. I mean, that we’ve, you’ve had a housing crash, and you had one in LA, of course. So it’s not always, it’s not always smooth, but in general, have households benefited from it? What about business? I mean, clearly, some businesses have been able to access finance to grow, but then you do mention that, you know, this can lead to periods of economic stagnation. You talk about this debt, there’s a tax buyer, so the debt is favoured in the tax system in the states relative to equity finance. So how do you think about all of this in terms of is it rational to the whole debt? Or is it? How do you think about this? What about for business? And what about for government trying to regulate all of this, the central bank looking at it? I mean, to what extent should we be concerned about this growth of debt? There’s a lot there sorry, that I’m trying to understand the rationality, what your views are on that, please?

Richard Vague 22:52

Well, I would, what we do in the book is we divide debt, private sector debt into two categories. Type one debt and type two debt. And type one debt is debt for spending on new things, you know, and type two debt is spending to acquire an asset. Now, I’m being a little simplest, overly simplistic here. But, you know, from my perspective, if you borrow to go on a vacation, that debts a little bit more problematic, than if you buy you borrow to buy a house, or a company or something like that, you know, you might, you know, buy a small, you know, gift shop, or a retail store, you might borrow to buy a house or buy a rental property, those have a better chance of increasing your wealth, then the debt you incur to buy that motorcycle you’ve always wanted or go on that trip to Haiti, or what have you, and that that’s a little bit too simplistic, but directionally, I think, that would reveal the direction of our thinking about, you know, what debt we would encourage individuals to enter into and not.

Gene Tunny 24:17

Okay, so that’s for individuals, you mentioned this tax, this the tax system and how that works and how it favours debt finance. Is this part of the story? Is this does this mean that companies end up borrowing too much money and then to an extent, they can then invest in unproductive assets? Is this part of the story this, this tax treatment of the debt because of the interest payments are tax deductible and therefore, the other reforms? Is there any reform to that system that you see to the tax system that you you would propose?

Richard Vague 24:56

Well, you know, this is I think, is something that’s been debated endlessly for a long time. But you know, the, what we want to do, I think, and I think this would be true of all of us, I don’t think you’d find a lot of disagreement around this, what we want to do is we want to encourage stock ownership. And what we would like to somewhat avoid is the accumulation of too much debt. The irony is that the tax code would drive us in the opposite direction, because, you know, much of the interest we incur on debt is tax deductible. That’s a little less true than it was a generation ago. But it’s still, you know, broadly true. And at the same time, companies are double taxed, you know, on the stock side of things, so, you know, they’re taxed on earnings, and then the holder of the equity is taxed on dividends, but it’s famously referred to as double taxation. So, you know, I don’t think changing that changes the world irrevocably or radically, but I think at the margin, if we switch that around, you know, and made, you know, took away the tax penalty on the equity side and took away the remainder of the advantage on the borrowing side. At the margin, it would make a difference over time.

Gene Tunny 26:23

Okay, yep. So, so some difference, but it wouldn’t be the it wouldn’t completely solve this.

Richard Vague 26:29

It’s not the magic bullet

Gene Tunny 26:31

Not the magic bullet. Okay. Okay. Fair enough. Right. Well, I want to ask now about back to your, your summary of the paradox of debt. So “paradox of debt portends the certainty of economic challenges and difficulties going forward unless we are willing to get creative and ambitious” first, how bad could those economic challenges get? So when we were talking about risk, see you talk about how this debts leading inevitably to periodic economic calamity, calamity and stagnation? Are you seeing another financial crisis down the track for the US and the global economy?

Richard Vague 27:10

Well, we measure that by how rapidly the escalation in private debt to GDP is in a short period of time. And we do not see that as a problem in the US at the moment. It’s certainly a problem in China. You know, the Evergrande debacle that we all read about this past year was a direct result of an escalation in the equivalent of private so you know, there’s no private sector in China to speak up. But, you know, non government debt or the equivalent of private debt has shot up since 2008, in China in an unprecedented way. And I think one of the things you have there as a result is something on the order of 100 million empty dwellings, buildings were built in the interest of economic growth, that there are overcapacity, and thus, there are no buyers for so, you know, I think most western economies developed economies right now are not in danger of an imminent financial crisis. I think China’s got got its hands full.

Gene Tunny 28:23

Right, right. Yeah, yeah, absolutely. Good point about China. I had a guest from the business school in Arizona, I think it was on last year to talk about the enterprise China model where just the close links between the business in China and the the the administration over there, so you know, good, good point about that. What about the regional banking crisis in the US? Is that something you’re concerned about? Richard? That’s something that’s been talked about recently.

Richard Vague 29:00

Yeah, it’s it’s a minor concern. It’s not a major concern. You know, there were some banks that broke the, one of the fundamental laws of banking. In banking, you’re supposed to match the maturity of assets and liabilities. You know, I entered banking as a young cub in the late 1970s. And, you know, I think one of the very first reports I was asked to prepare was the asset and liability matching report. So if it, you know, 5% of your assets, were at a 10 year maturity, then 5% of your liabilities were supposed to be at a 10 year maturity, and if 30% of your assets were at a, you know, one month or less maturity, you know, 30% of your liability, so, it matched so that if interest rates went up or down, the spread between the two would be relatively constant. What you didn’t want to have is a lot of long term assets, five year, ten year twenty year bonds, for example, funded by zero maturity liabilities, checking accounts, basically, or what we call demand deposits in the industry. You didn’t want to have that. Because if interest rates go up sharply, you’re screwed. That’s not a new concept. That’s banking 101. Well, what happened was interest rates were so low, and you had certain institutions like Silicon Valley Bank, who had way more deposits than they needed or should have had. And it was actually a penalty to them, because the yield on those assets was so low. Well, what you do to increase the yield on your excess assets is to buy long bonds. It’s the tempt, it’s like, you know, the forbidden fruit in the garden of Eden, you’re not supposed to do that. And everybody knows, you’re not supposed to do that. And yet they did it. And they did it in a huge way, they made a huge bet, has nothing to do with credit quality, has nothing to do with, you know, the fundamentals of the banking system as a whole. It represents their falling to the temptation in a in a gigantic way. And they weren’t the only ones. But it’s not so pervasive, that it’s a sustaining threat to the US banking system, it’s, you can go look at any banks, you know, call reports and other financial information. And we know exactly how much of this misbehaviour occurred and which institutions that occurred in and it’ll it’ll hurt, it’ll hurt a few and it’s hurting a few. It does not represent, you know, I’m gonna put a put a dimension on it. It’s a several 100 billion dollar problem in in an industry that has well over 2 trillion in capital, so it’s not a sustainable growth.

Gene Tunny 32:05

Okay. Okay. That’s, that’s fair enough. I’ll go back to your points on the paradox of debt. Yes, the creative and ambitious solutions you talk about, one of the things you talk about is a debt jubilee? Could you please explain what you mean by that, Richard?

Richard Vague 32:23

Yeah, this is, this is a hard problem. If as the evidence shows, debt always grows faster than GDP, You’ve almost got an engineering problem. You know, it’s as if you were designing an engine, and you found out after you had built it, that the temperature of that engine grows perpetually? Well, as an engineer, you could predict that that engine is going to explode from time to time. So you would introduce some kind of exhaust system or heat valve escape system to try to combat or overcome the perpetual increase in the temperature of that engine. I think we’ve got the same problem. You know, in modern developed economies, they always get more leverage. And so we’ve got, you know, put put your ideology aside put, you know, put all you’ve learned aside, you’ve got a problem here. And, and unless we solve it, we’re going to continue to have a couple of things happen, we’re going to have periodic crises. And we’re going to continue to have a slower and slower economic growth, as businesses and individuals get, you know, what I would call stultified by high levels of death. That leaves you with kind of only one solution, and that is ways of taking away debts that do not involve paying down that debt. Because paying down debt and aggregate just produces GDP, right. So we get into this quite a bit in the book. But there’s no easy way to do this. So I propose, you know, I kind of go out on a limb and try and propose some areas that maybe hopefully will provoke some thinking. So for example, student debt, which has gone from in the United States, a couple of 100 billion dollars to over one and a half trillion dollars really within a very short period of time. So you got all these students who graduate and then you know, lug around too much student debt for the next 20 or 30 or 40 years of their life. How about a programme where even I don’t support a programme of just forgiving all that debt, because it penalises the folks that were that did pay their debt. But I do think a programme whereby we let them do you know, a certain amount of voluntary community or civic work, you know, over, you know, five or 10 year period as a way to get relief on their student debt is something that we could consider. So, right now, if you graduate with student debt, and you enter government service, and you stay there for 10 years and you make 10 years worth of payments, you get whatever’s remaining of your student debt forgiven? Well, let’s, let’s create something that’s similar to that for the private sector. If you did 800 hours of community service, let’s say, after 10 years, the remainder of your student debt would be gone. That’s what I mean, when I say let’s get creative. Let’s try to think of ways to do this.

Gene Tunny 35:43

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker 35:48

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Gene Tunny 36:18

Now back to the show. So debt jubilee is about debt forgiveness in in some form or another and there might be some community service for two so people could reduce their student debt. What about a more broader programme of debt forgiveness? Is that what you’re proposing in the private sector debt banks forgiving part of the debt? How does it all work?

Richard Vague 36:44

Here’s another idea. Because like I said, I stopped short of just getting a magic wand out and forgiving everyone debt, which, by the way, is what in ancient civilizations, rulers would do. And I think, you know, guys like Michael Hudson and your countrymen, Mike, Steve Keen and others have have talked about, you know, this is Hammurabi, this is Ancient Egypt, this is even ancient China. We don’t have that luxury. So let’s get creative. And, you know, another possible programme would be, after the ’08 crisis, when, you know, it was probably on the order of 15 million mortgages in the United States that were underwater by 10% or more. How about kind of a debt debt to equity exchange, you know, if the lender would write the mortgage down to the new current market value, appraised value. So maybe you bought a house that was 300,000. And now it’s only worth 200,000, you’ve still got a $300,000 mortgage? If the lender will write it down to that new value, and write your payments down proportionately? Well, then you would, in exchange, give the lender certain ownership of the house, which would be realised only on the event of a sale of the house. So they would get the upside. And the way the government could facilitate that is by going to the lender and saying, if you do this, we won’t make you take that as a hit against earnings in the current period. We’ll let you amortise that over, pick a number 30 years. So it’s kind of a win win win at that point that the bank deals with problem loans, the individual gets a lower payment. And the lender has the potential upside down the road if the house is sold.

Gene Tunny 38:49

Okay. Okay. So you’re talking about something that is voluntary, you’re not going to compel banks or lenders to to forgive part of their loans or force them into restructuring your you want this voluntary, but there may be some policy tweaks that could facilitate this restructuring. Is that the argument that you’re making, Richard?

Richard Vague 39:12

Yeah, to make it real, legislatively realistic or feasible? You, you have to construct it. So it there’s something in it for everybody.

Gene Tunny 39:22

Gotcha. Gotcha. And I think one of the interesting points you make is that, look, debt’s a contract. Do you quote, Dave Graeber on this, if I remember correctly, and look, these things get renegotiated. Well, throughout history, we see various periods in which there’s restructuring of debt. I mean, what’s extraordinary is that, you know, some countries seem to the periodically defaulting or and then there’s restructuring and then the banks keep lend to them 20 years later, and then you go through the same thing.

Richard Vague 39:55

Yeah contracts are contracts, you know that you know, if you are a data servicing provider and somebody wants you to write a programme and have it done by August 1, and you don’t have it done by August 1, you haven’t done by the following February. That’s not a moral failure. And, you know, but somehow, and folks like Hudson would argue for good reason. People have conflated morality with performance in a commercial contract. So if an individual doesn’t repay their debt, that’s, that’s a moral flaw or moral moral failing. Well, in my career, I was in banking for 37 years and debt contracts with companies get renegotiated all the time, you know, the company, you know, was manufacturing XYZ product and a competitor came along selling for half of what XYZ was being sold for, and we all knew that this debt was never going to repay. And if we absolutely enforced that repayment, we would cause the company to fail and get zero of our money back. Well, instead, we restructured the note so that we get paid half of what we rode back, the country could company could survive and compete. So you know, a rational restructuring of debt goes on in the banking industry all the time, all day, every day. And I think the light bulb that went on for me was, you know, 10 years or so ago when David Graeber’s book, delightful book, you know, ‘Debt: The First 5000 Years’ and he, and he just says, you know, this is not a moral issue. This is a contractual issue.

Gene Tunny 41:43

Yeah, yeah. Want to ask, What about the policy changes? So you in a official position, you’re in a very senior position in Pennsylvania, but I imagine that this would require a federal change regulatory or legislative changes do have you thought about what, what could be done at a policy level to help smooth things to help make it easier to help make it easier for restructuring to to help households and businesses deal with this higher debt that that we’ve seen?

Richard Vague 42:19

I think the federal regulators in the Fed in particular have this ability. And there are a couple of famous instances of this. And to me, the most famous and applicable would have been in the early 1980s, when the New York money centre banks had been making lots of loans to less developed countries, the predominance of which were in South America. And, you know, they got to a point where the what were called LDC or less developed country debt was equal to, I think so, you know, well over 100%, of the capital of those New York money centre banks. So, you know, 150, 100, and the number that comes to mind is 170% was a big, big number, such that when things turn because of interest rates and the rising price of oil, if the regulator’s had come in and enforced their normal rules, all the New York banks would have failed, which, you know, by the way, would not have been a good thing for the country for, New York, for anybody. And so Paul Volcker, one of the giants of economic history came in, this was in the days before Twitter, and all those other ways in which information leaks, so porously, called those bankers into a room and said, We’re not going you know, you kind of put a fence around this, we’re not going to deduct these loans, from, you know, our analysis of your capital reserve adequacy. But you guys better get busy. And over the next several years, all your earnings ought to go towards building up reserves, again, so much of this as you can muster over the next few years. And then whenever you get a big enough cushion, we want you to write it down. That is exactly the kind of thing and by the way, they did this in a more structured and overt way relative to the savings and loan industry, which at that exact time had a very similar problem. That’s a way the regulators can step in the case of the LDCs. It was a regulatory matter. In the case of the same Solomons, it was actually a legislative matter. But those are ways you can do this. And sure enough, but I can I think it was 86 or 87 when Citibank announced a billion dollar write down of its LDC debt? Well, it shocked the world. But it related to a conversation that actually been held four years earlier. And for Citibank to do that was actually an announcement, they were now in good shape, rather than an announcement that they were in bad shape. They’d been forced do the same thing in 82 they would have failed. They had four years worth of earnings to cushion that. And it was it was actually a positive cleanup sign.

Gene Tunny 45:30

Yeah, yeah. So just, just to be clear, I mean, the reason I’m just just want to make sure I understand this properly in your, in your view as a banker, so what’s the, how are bankers looking at this when they do agree to a restructure or write down, they’re figuring that we can extend the term of the loan, or maybe we can cut the interest rate, or we take a haircut ourselves, we write down some of the value, they figure that well, this makes it more likely that they’ll actually be able to pay us back the full amount is that they’ll survive? Is that the logic from a bankers perspective?

Richard Vague 46:03

Yeah, if you’re the banker, the first thing, let’s just say it’s $100,000 write down, if you’re allowed to take that over 30 years, the hit to earnings this year is what? Roughly $3,000 instead of $100,000. You know, the second thing I would do in that case, is let them take the full deduction for a tax standpoint, because you know, most companies have regulatory accounting and tax accounting are two separate things. So they don’t have to take it, from a regulatory standpoint, they get to take it from a tax standpoint. So probably from a current earnings standpoint, at that point, they’re just fine. But in the meantime, the consumer who was struggling with their, you know, their loan now has a loan, they can make payments on adequately. So they they go from having a credit that is a troubled, questionable credit, to a credit, that is a solid credit. As it relates to the consumer, the household, they now have breathing room, they can go back to being kind of a regular participant in the economy, they now have a little extra money not only to make their payment, but to go on vacation and go out to restaurants and this that the other. And their give up is seven years down the road when they sell their house and they they get a gain of you know, $50,000 or whatever they might have give a third or a half of that to the bank, whatever they negotiated. So it makes it comfortable and possible for everyone. That’s why think of it is kind of a win win win.

Gene Tunny 47:50

Yeah. Okay. Very good. Richard, we’re coming to the end of our time. Any final thoughts, any additional thoughts on what other policy measures may be desirable? Or that you’re someone who’s concerned about the inequality in the US? And, you know, clearly that has grown over the last few decades? Are there any other policy measures you’d be recommending to address that?

Richard Vague 48:14

Well, I would make the observation that if the bottom 60% of the US population only holds 14% of the stocks and real estate, that you can probably afford to actually give tax incentives? You know, because we talked earlier about just modifying the penalties. But how about a tax credit, if you buy stock or a tax credit, if you buy real estate, for those, that bottom 60% It’s such a small number, that you have the room to do that without affecting the tax receipts of the government by much, if any, might actually be a positive there. So I make the point that there’s the latitude to create incentives for accumulating asset ownership among that group that we could be taking advantage of that will probably that we’re not. And there’s other things in that final chapter that we touch on too. And they may all be terrible ideas. Hopefully, some of them are good ideas. But, you know, having set up the problem in the first 90% of the book, we we take a stab at, you know, maybe some ways to deal with it in the last chapter.

Gene Tunny 49:29

Yeah, yeah. So, I mean, we talked about forgiveness or the debt jubilee as a possibility, renegotiations. Then you mentioned some, you’re trying to encourage asset ownership and then there are some others one other one or two that you you’d like to highlight.

Richard Vague 49:45

You know, it kind of kind of gets off the subject a little bit, but I put it in there anyway. I think there needs to be massive job training because if you want the bottom 60% to accumulate assets, you got to give them a little more income. We got a situation in the US that I think it’s parallel, at least to a certain extent elsewhere, that we’ve got a lot of jobs that need training that are going unfilled. We got a lot of under under employed people that don’t don’t qualify for that job that feels to me like a perfect place for government to step in, in conjunction with the private sector, and especially the companies and underwrite that, you know, I think it’s kind of the spiritual equivalent of, in the US what we call the GI Bill, where after World War Two, we underwrote college education for pretty much all the returning soldiers. And I think that helped fuel the increased size of the middle class and the 50s and 60s, I think there’s that opportunity here.

Gene Tunny 50:47

Okay. Well, Richard, thanks so much. And I’ll put a link in the show notes to your book. And yeah, I’d encourage people to buy it and read it. So it’s published by the University of Pennsylvania Press.

Richard Vague 51:16

Yes.

Gene Tunny 51:18

Very good. So very distinguished publisher, and yeah, well researched, and lots of lots of good facts and figures. And yeah, very interesting analysis. And, but very good. But Richard, thanks so much for your time. I really appreciate it. And good luck with the book sales. Yes. And I hope you, you get a lot of a lot of readers and a lot of people are engaging with you on the issues, and I certainly enjoyed our conversation. So again, thanks so much.

Richard Vague 51:29

It’s a privilege and I’m all thanks go to you.

Gene Tunny 51:32

Very good. Thanks, Richard.

Richard Vague 51:36

Bye bye

Gene Tunny 51:39

Righto, thanks for listening to this episode of Economics Explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact@economicsexplored.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

52:23

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Tags assets, bank, book, business, company, debt, economics, economy, financial crisis, household, increase, inequality, liabilities, loans, people, restructuring, richard, talk, tax, years

Podcast episode

Using Coase’s 1937 theory to explain Hutchies doing its own concrete formwork – EP181

Post author By Alec Krishna
Post date March 31, 2023
No Comments on Using Coase’s 1937 theory to explain Hutchies doing its own concrete formwork – EP181

Why do firms do some activities “in house” and contract out others? British-American economist Ronald Coase gave a cogent explanation in a classic 1937 paper on the nature of the firm. Show host Gene Tunny explains to his colleague Tim Hughes how Coase’s insights (e.g. the concept of transaction costs) can be applied to understand the actions of an Australian construction firm Hutchinson’s deciding to employ people to do concrete formwork rather than relying on subcontractors.

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored.

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple Podcasts, Spotify, and Stitcher.

What’s covered in EP181

Episode topic: What determines what activities a business does in house? [0:06]
What is formwork and why does it matter? [3:29]
Hutchinson’s moves to bring formwork in house [8:54]
When is it important to have an in-house workforce in your firm [14:42]
Why you don’t always contract out [20:00]
What’s done in house and what’s outsourced? [25:03]
Gig economy platforms (e.g. UpWork) [33:02]
A closer look at The nature of the firm by Ronald Coase [40:56]

Links relevant to the conversation

Courier-Mail article on Hutchinson’s decision to do its own formwork:

https://www.couriermail.com.au/business/citybeat/hard-labour-hutchies-plan-to-survive-building-crisis/news-story/e3b8acc34728e49cc04d0c4b88bafc8d

Ronald Coase’s classic article on the nature of the firm:

https://onlinelibrary.wiley.com/doi/full/10.1111/j.1468-0335.1937.tb00002.x

American Express article on pros and cons of hiring versus outsourcing:

https://www.americanexpress.com/en-us/business/trends-and-insights/articles/pros-cons-hiring-house-vs-outsourcing/

Transcript:
Using Coase’s 1937 theory to explain Hutchies doing its own concrete formwork – EP181

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny 00:06

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist and former Australian Treasury official. The aim of this show is to help you better understand the big economic issues affecting all our lives. We do this by considering the theory evidence and by hearing a wide range of views. I’m delighted that you can join me for this episode, please check out the show notes for relevant information. Now on to the show. Hello, thanks for tuning into the show. This is episode 181 on the boundaries of the firm, what determines how many activities a business does in house rather than relying on suppliers? In this episode, my colleague Tim Hughes and I begin with a real example in the Australian construction industry. And I’ll talk about how it illustrates the principles from a very important paper from 1937. That paper is the nature of the firm written by Ronald Coase, who won the Nobel Prize for Economics in 1991. Okay, let’s get into the episode. Tim, here is good to be chatting with you again, Gene Tunny, good to be here. Excellent. Tim. Tim, I thought today we could chat about the theory of the firm. And this conversation was prompted by some news about one of the major construction companies in Queensland, which is the state of Australia that we’re in. And indeed, I just walked past one of their building sites on Brunswick Street forward to valley a bit earlier before we call it up. And I think they’re 100. I think they’ve had their 100 and 10th anniversary or something like that recently. It’s a big company. Yeah. Huge company that’s passed down through the generations. So yes. But it’s experiencing challenging times as a number of building companies are in the current environment due to rising cost of materials. And also, I think, probably challenges getting the skilled labour that they need. So this is Hutchinson’s? Yeah. Yes. Yeah, that’s right. Didn’t know I’m done. I should have mentioned that upfront, but I didn’t think so. But there we go. Excellent. So it’s definitely Hutchinson’s and I saw this report in the Courier Mail. So that’s the paper here in Brisbane a few days ago. So we’re recording this on Friday, the 10th of March 2023. And there was a report Hutchinson builders reveals plan to hire trainees in house. So if you’re listening internationally, tradies is our word for tradespersons for carpenters, and bricklayers and plumbers, etc. Construction giant Hutchinson builders is taking drastic measures to survive in an increasingly cutthroat industry, forming his own in house team of tradies to keep its high rise projects on schedule. Hutchinson builders, Chairman Scott Hutchinson said a team of 106 concrete form workers had been established from former employees of subcontractors who had gone into liquidation.

Tim Hughes 03:29

Tim, you’ve worked in construction and you have at different times. Yeah, yeah. Are you able to explain what formwork is? Yeah, formwork is basically putting up wooden surrounds, I guess, to then be the boundary for a concrete pour. If you’re doing if, say, for instance, a floor is gonna have formwork around for the edges of where the concrete is. And then you’d have reinforcing etc, throughout. But yeah, basically, it’s, it’s whatever is there to contain the concrete. So that once it’s set, the formwork gets taken away, and you’re left with the structure.

Gene Tunny 04:04

Okay, and so you need this in place. Do you before you pour the concrete? Yeah. Yeah. So this is, so what’s going on here, it appears is that Hutchinson’s is bringing that in house. So rather than sub contracting that out there, making sure they’ve got the people on hand, that they’re employing them permanently, as you know, in their workforce to make sure that they’ve got the skilled labour that they need, when they need it. So that I guess, so they don’t delay a job. So because that’s on the critical path of the job, isn’t it getting there? Getting the formwork done, so then you can get the concrete poured?

Tim Hughes 04:42

Yeah. And one of the typical issues with any building project is that, you know, all the subbies have their different schedules that they’re trying to keep in they always have more than one job. And so, it becomes this issue of, then servicing different jobs at the same time, in general. And so it becomes this catalogue of finger pointing quite often, where somebody doesn’t do something because somebody else hasn’t done something. And so there’s a chain of events or a sequence of events, you know, for instance, you can’t pull the concrete, for example, unless the form where it’s been done, you know, yeah, if you know that has to follow, everything’s sequential, or largely sequential. Certainly, once you’ve got the roof on and everything like that, then there are different things that can happen at the same time. And you might end up with an electrician, Spark is chippies, carpenters, etc, they can work in the at the same time because the roofs on the site is watertight or secure. But there’s always that sequence of events. And it’s a strong like, it’s a confident move. And a smart move from Hutchinson’s from what I can see because they’re secure in the workforce. Because one of the problems at the moment is now trying to make sure that you can line somebody up and be certain that they’re going to be there when you need them. So it’s a confident move, but obviously, with having permanent workforce, then you’re taking that point that you can keep them working, you know, obviously, nobody wants to have somebody on the books and not enough work coming in.

Gene Tunny 06:15

I guess if you’re a big company like that, yeah, then well, I mean, they’re expecting they’re gonna have plenty of work for him and for them, and if they don’t, then they’re willing to bear the cost of that under utilisation, to an extent because there’s such a benefit from having them on hand, because the cost of the alternative is just so high for them, not having the people they’re not having the formwork done, and then the delays to the project, the costs associated with that, and not being able to get the work done and then be able to invoice for it.

Tim Hughes 06:49

Yeah. And it’s obviously been a well thought out move. But it’s good to see I mean, because there are, you know, they’ve done a lot of great work around Brisbane, for instance, certainly in the entertainment industry. And now Scott Hutchinson has been played a big part in keeping, for instance, the Tivoli, which was a den danger of being lost to development knocked down. And the same with the princess Theatre in Berlin, GABA, you know, to beautiful music venues, which historically, there have been some great venues lost in Brisbane, you know, in the 80s. Just being knocked down in the middle of the night, like Cloud lands, for instance. Yeah. You know, so it’s great to see a building company, Scott Hutchinson, I know, he’s led a lot of that with the music venues, it’s great to see them having this confidence. So yeah, yeah. Because well for them.

Gene Tunny 07:37

Yeah. I mean, they’re having to do it because of the conditions in the industry. And I think, I mean, they probably would rather not have to do it, then historically, they haven’t. So we might just go over their justifications for other reasons. And then I want to go on to the micro economics of it. So how would economists think about it? Yeah, sure. Because when I read that article, it made me think of a famous theory put forward by a British American economist, Ronald Coase, who was a Nobel Laureate. So Coase was at University of Chicago, toward the end of his career. 1910 to 2013. He had an incredible life. Yeah, that’s a good clip. 103 year. I think he got 202 102. Yeah, pretty good. Yeah. Yeah. Pretty impressive. He obviously managed stress well, and lived well or lived moderately. Differently, give into temptation.

Tim Hughes 08:39

I know, there’s another story that for sure, it’d be interesting to know. The secrets were

Gene Tunny 08:44

Yeah, I may learn that today. When I was preparing for the podcast. He lives so long. I’ll have to try and find out what it is. There’s got to be a story there. Yeah, absolutely. Okay. So we’ll get on to his theory in a moment. The moves so they’re talking about the Hutchinson’s moves to bring this formwork in house. Yeah. So rather than subcontracting, bring it into the business bringing it into the firm. And the article continues. The moves come as major national building company PBS building group collapsed, leaving at projects unfinished and owing $25 million. Due to the instability of the market, through insolvencies, we have had to sell sorry, we have had to self perform a number of the tradies we would otherwise subcontract out like formwork ceilings and partitions Mr. Hutchinson revealed in the company’s in house newsletter, hutches truth. We have to get subscribed to that, Tim Yeah, for sure. A looming threat to our business was a shortage of formwork contractors to build slabs and columns, which are vital to keep high rise projects on schedule. Okay, so that’s pretty much what we were talking about before.

Tim Hughes 09:57

Yeah, some that’s a good sign, you know? Like, because the last few years have been so interrupted with the whole pandemic and the supply chain being disrupted. The knock on effect is still going on and will do for some time. Now, there’s been a lot of a lot of companies and subbies subcontractors who have gone under, it’s been very, very challenging times.

Gene Tunny 10:21

Yeah, yeah. Now, as I mentioned, this story made me think about this important theory in economics, this very important paper from the 1930s, the nature of the firm in 1937 paper published in economics, which is one of the well, it was a major economic journal, I think, I think it comes out of LSE. I’ll have to check though. So this article, the nature of the firm, and what Coase was trying to do there was to think about, well, how do you define the firm the business? What are the boundaries of the business, because economics tells us that the market is efficient, the market competition brings benefits, there can be benefits from participating in the market and taking advantage of the competition amongst potential suppliers. But we know that their businesses exist. And in businesses, there’ll be some control there’ll be Well, I mean, they’re almost like a command economy inside a business. They’re not run. It’s not as if they’re bidding. In my business, I don’t have to bid all the time for the people working for me to do a particular job. I don’t have to put out a request for for quiet and get them to the bid for the work. Or I’m not having them compete against each other I’ll I will be determining who does what jobs. So there’s a there’s a socialist or a command element within a firm itself rather than a competitive market element. Right. And so the question is, how do you determine the boundaries of a firm? Why do firms exist? What determines what size they are? So? So for example, for a consultancy business? I mean, we talked about hutches before and we talked about the formwork and what they brought in, but they were bringing that in house well, for a consultancy business. consultancy businesses will typically they’ll have employees who do the jobs. But one option is just a subcontract every time so you could just hang out a shingle and you may not even need a physical office and there are some consultancy businesses that will do this. And they will subcontract, you know, a particular expert to help them out on a job as it comes in.

Tim Hughes 12:48

hang out a shingle.

Gene Tunny 12:50

Isn’t that what you say? Don’t know. Actually, if you don’t have an office, you probably don’t hang out a shingle?

Tim Hughes 12:55

I haven’t heard that term before. Okay. I’m not sure if it’s legal. But um, yeah, I get the gist of it. Yeah.

Gene Tunny 13:08

I think you do put out a hang out a shingle. I think that’s what the term is. Do I get the gist of it, though? Yeah. Okay. Very good. It was not the right term. I’ll cut this out. So there’s this issue about what determines the size of the firm, what activities should be done in house where there’s not a reliance on the market mechanism within the within the business, there’s somebody directing things, what should be done in house in a particular business versus what should be done through the market? So it could just be I mean, there could just be one entrepreneur, and then for every job that their business needs to do they just contract out every time they just get someone to supply the services. And then there are things that I’m contracting out in my business. I mean, I’m contracting out the website, design, the website management, or the podcasts. Yeah, the editing. Yeah, podcast editing. Because, I mean, that takes time. And I can’t do it as quickly as someone else. And not as skillfully. So that’s something that I’m happy to contract out. And now because of things like Upwork, and free, what’s the other one? Fiverr it’s so much easier to find people to do stuff to contract out. So the lower cost of contracting now that’s going to mean there should be more of it. So it should mean that yeah, there’s maybe you do have fewer people in your business than otherwise, because you can contract out so much.

Tim Hughes 14:42

Yeah. And I guess because that I mean, it’s part of the gig economy, like Yeah, and it makes a lot of sense. So that’s something we’ve talked about before is, you know, being agile being able to scale up or down quickly, which is something for instance, like there’s a an office at WhatsApp ended just moved to a larger office. So it’s like a, like we share, or we work rather, it’s a workspace. And so it allows you to be agile and sort of move around and go up and down and expand and contract. And I guess that’s we’re not contracting, but not contracting, there’s no going back. But is that thing of like? Obviously, it’s like paying casual rates, etc. So you pay a little bit more when you when you saw something, you know, occasionally, etc. Whereas, like, using hutches, for instance, as an example, that will be paying the guys doing the formwork, a little bit less than they would do for subcontractors, because they’re on the books, you know, and they would have then holidays and all that kind of stuff. I would imagine. I mean, I could be wrong there. But it was suggested in a normal traditional situation, that’s what would be happening.

Gene Tunny 15:50

Yeah. And I think that’s because when you’ve got people on in your firm, to some degree, they will be. I’m just trying to think through this. If they’re a subcontractor, yep, they’ve got all of their overhead costs as well. Yeah, if they’re in your firm, you’re paying the overhead costs yourself. But when you subcontract out, you have to pay for the overhead costs of the subcontractors. And as well as their you know, what they need to do the job. And then there’s also the fact that they’re possibly more specialised, and they’re going to get the job done. Now, they’re really motivated to get the job done if they’re a subcontractor.

Tim Hughes 16:36

Yeah, I mean, I guess that would be a question for Hutchinson’s really like it would be, it’d be great one day too. If I, Scott, I shouldn’t listen to the podcast, and pick his brains. Because, yeah, I wouldn’t know about that. But you can imagine that that would be the case, for sure.

Gene Tunny 16:52

Well, I think that might be one of the motivations for contracting things out. Because you can specify the job, you can have the the scope of work, and you can say, I need this by this demand, and you’re paying more, and there’s an expectation it gets done by that day. And

Tim Hughes 17:11

the responsibility lies with the subcontractor to say that on one of the things, though, as well to consider is having your in house workforce, if you like, would give a lot of confidence, I would imagine to people who are giving up projects, you know, if you’ve if you’ve got a project someone is bidding for, and they’ve got a large in house workforce, that gives a lot of confidence that, you know, that aren’t maybe the issues that may be around with other developers and builders that have to rely on the subcontractors to be available for when they need them. So there’s a level of confidence so that that would, you know, maybe attract or give them a better chance of winning different, different contracts?

Gene Tunny 17:50

Yeah, so certainly in the current market environment where it’s been hard to get those skills, because there’s been a lot of work on and there’s a lot of competition for skilled labour. Yeah, that could make sense. Yeah. Okay, so I should get back to COEs did my explanation of the problem the intellectual issue, the what Coase was trying to address the the question he was trying to answer. Did that make sense about the nature of the firm? Why should you have a business at all? Why should you have a business that employs people rather than just say, a single entrepreneur? No, it didn’t make sense.

Tim Hughes 18:30

Not to me, but I mean, it’s funny, because I did quickly read it beforehand. And for that, for me, it didn’t jump out at me as being one of the things that, for instance, myself, can take on straightaway, I think I’d have to absorb that over a period of time and really take a bit more time. Because I understand the premise of a business, but I don’t fully understand what the nature of the firm is addressing or talking to. But that might have just been me. And my,

Gene Tunny 19:01

I guess it’s a it’s a rather subtle thing, isn’t it? So he’s asking the question, Why did firms exist at all? Okay, let me see if I can find,

Tim Hughes 19:15

I mean, by firms, it’s business, yeah, business, any business or company. And I guess they exist to make money. I mean, that they’re set out to be profitable, and to serve a purpose and solve problems, you know, builders, build places, you know, everybody has a job to do kind of thing. And if you’re going to build a business, the idea would be to be a profitable one, I would imagine.

Gene Tunny 19:39

Yeah, I mean, this is an article that has been very influential, and it was identified as having solved that problem of how do we justify the existence of a business that employs people and has this long term relationship with employees rather than just sub contracting? All the time to get the services that it needs. So to me it, it’s an important article because it it highlights the relevant considerations and it’s all about minimising the transaction costs. So the reason why you don’t just always contract out so why Hutchinson’s for example, why did it actually employ some people? And it’s not just contracting now for everything so Hutchinson’s would have its own project managers, I suppose, or, you know, people in the head office. And so it’s not going to contract out every time to get someone to come in to, I’ll have to be careful here, because I can’t say I’m totally familiar with their business. But say their accounting, I mean, they, they will have a dedicated, Chief Financial Officer. Yep. I’m pretty sure that have that. So each time they they need some financial analysis, or they need the someone to sign off on their books, they won’t just they won’t contract out that every time they won’t go to the market to try and get that done, they’ll probably have someone who does that, that they’ve employed. And they’ve worked out that that’s the least cost way of getting that thing done. Over the longer term, is if they contracted it out, then they’d have to pay a bit more, presumably. And there’s always a cost in trying to engage with the market. So trying to find out who the people are, who could supply the services, what the cost of the services are selecting the best person?

Tim Hughes 21:38

I mean, I guess like for me, I don’t truly understand the question behind it, because I just thought it would be clear that a business grows or bills, deer to be profitable. And so the decisions that you make along that way would be, well, if it’s more profitable to have in house people for this department, it was something rather than something that out, then that would be an economic or financial decision to be more efficient and save money. And so it’s all about, you know, making money at the end of the day. And then obviously, there are there are quantum leaps taken at different times, which might be a bit of a pun, and they either work or they don’t, but they’re the best guess at the time. But it’s all about growing safely to increase profits. I mean, that isn’t at the foundation of any any business in terms of supply and demand. And, you know, the market in that regard. Yeah, exactly. Competition, etc.

Gene Tunny 22:33

Yeah. So I guess what Carlos was trying to do was to provide a solid intellectual foundation for what you were saying there, which is rough, you know, roughly what he’s driving at. It’s about finding the way for the business to be profitable to be most profitable as as it grows. And so yeah, I think, yeah, maybe it’s a case of over analysis. But it has been an important paper in economics. And I mean, yeah, I guess I might have explained it very well. Why it’s an important paper.

Tim Hughes 23:07

That’s the thing. I’m sure there’s more to it, but like, it seems like a clear question, as to I mean, there’s there’s obviously more.

Gene Tunny 23:14

Yeah. So we’re, I guess where it comes from, is that economists talk a lot about supply and demand and the market and the virtues of the, what they call the price mechanism, which is the fact that, well, we don’t need someone who’s responsible for the control of the supply of bread to the City of London, for example, because the market sort of set out, okay, don’t need someone to allocate that. You’ve got people wanting to supply businesses wanting to supply because there’s, there’s a demand there. And so I might read from coasters papers, because I think this, hopefully, this is illuminating, and it resolves this, an economist thinks that the economic system has been coordinated by the price mechanism and society becomes not an organisation, but an organism, the economic system works itself. This does not mean that there is not planning by individuals. These exercise, foresight and choice between alternatives. This is necessarily stuff there has to be order in the system. But this theory assumes that the direction of resources is dependent directly on the price mechanism. Indeed, it is often considered to be an objection to economic planning that it merely tries to do what has already been done by the price mechanism. Yeah, so what the issue is, is, what’s the limit to a firm? I mean, I clearly there’s reason for many firms to have more than just the the entrepreneur or the the owner manager, they will hire people in rather than just contract out each time to get the services that they need. Where’s the limit to that? I mean, why don’t we just have one big Corporation. Yeah, that does everything or one. So I guess that’s what?

Tim Hughes 25:05

So is it like, for instance, whatever widgets you might be selling, at some point, you have your own delivery drivers or Exactly, yeah, you outsource it to the the post service, etc. So at some point there’s a parameter to what’s in house and what’s outsourced or

Gene Tunny 25:23

exactly. That’s what is driving it. Right. Okay. Yeah,

Tim Hughes 25:26

I get that. Because yeah, there’s so there’s a, there’s a limit, or there’s a wall, if you like to, you know, what you do in house? Exactly. Yeah. And that would be, then back to those things we talked about, like, you know, well, is it efficient? Is it profitable, you know, what risk is involved, etc. And I guess that’s when those decisions, come to the fore and drive where that wall is?

Gene Tunny 25:48

Exactly, yeah,

Tim Hughes 25:49

I get it. Yeah.

Gene Tunny 25:52

Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny 26:27

Now back to the show. The fundamental concept that Coast introduced, which is then had been widely applied in economics is this idea of transaction cost of the fact that there’s a cost of transacting in the market, right? There’s a cost of trying to find, you know, issuing a request for quiet and you know, sorting through those and and then contracting them in particularly like if you need a lawyer to, to write a contract for you. I mean, that’s an additional cost.

Tim Hughes 26:59

Well, that’s a good point, actually. Because I guess you get to a critical point or a critical mass where you have your own in house legal department. So I guess there are certain sizes of you know, the need for those different services, professional services, whereby at some point, you then have your own department in the company. You know, that your own legal department, for instance? Yeah. Marketing, yeah, marketing department, etc.

Gene Tunny 27:23

Exactly. If you’ve got enough work for them. Yeah.

Tim Hughes 27:27

So I mean, so going back to Hutchinson, for instance. So that’s, and you would have to say, in every instance, it’s a sign of confidence, of expansion or of growth, to have that in house, because that’s obviously a commitment and a cost. That wouldn’t be easily withdrawn, because it’s expensive to, to let people go, you know, there’s a cost with everything. I guess

Gene Tunny 27:50

there’s positive in in that sense that they expect that we’ll be able to keep these people employed doing formwork? Yeah, they’ve got to, they’re confident they’ve got enough work to do that. But I mean, it looks like it’s a defensive measure to me, they wouldn’t be doing this if it weren’t for the the challenging conditions in the industry, the difficulties of finding people the the challenges of, you know, what you don’t know whether the subcontractor, you engage with whether they’ll survive, and no, because they could let you down mid job?

Tim Hughes 28:23

Yeah. So I see what you mean. And I think you’re absolutely right. Like, it wouldn’t necessarily have been done if the certain situations weren’t around, and maybe other people will follow suit.

Gene Tunny 28:34

I mean, how cheese can do it? Because it’s a reasonably big company. So it’s got the, the real, I mean, you need some, some cash on hand to be able to finance this. Yep. And they’re able to do it. Yeah, some other businesses may not be able to, but it could give them a as I think you were suggesting this before it could give them a competitive advantage in the market, because the purchases are the people wanting the work done. They’ll see how Jesus got this capability. And that reduces the risk.

Tim Hughes 29:08

Yeah, I can only imagine via that it gives them an advantage. Going for contract. Yeah. You know, and also, depending on Well, if they’re taking skilled workers from the labour force, and who are fewer to go around for the other potential competitors.

Gene Tunny 29:26

Yes. Mm hmm. Yeah, it could be a cunning plan or something suggesting to

Tim Hughes 29:32

plan would be proud, very good.

Gene Tunny 29:35

Guy. So might, I might read Ronald Coase as explanation. I’ll put a link in the show notes to the nature of the firm, which I think is one of those. Just one of those outstanding

Tim Hughes 29:46

sisters 1937 Yeah, so he was 27 years old. Yeah.

Gene Tunny 29:51

Pretty impressive. Yeah. Yeah. Yeah. And it well, and then he followed it up with another famous paper and economics. So he won the Nobel Got a prize in 1991? For the essentially for this paper and another paper in the early 60s called the Theory of social cost. Both of them were hugely influential. Yeah.

Tim Hughes 30:12

That’d be interesting to do another episode on that paper.

Gene Tunny 30:17

Yeah, we could. Yeah. It’s, it’s about how you manage pollution and things like that. And yeah, so maybe we could talk about that.

Tim Hughes 30:27

Well, that’s topical all the time, but never more so than right now.

Gene Tunny 30:32

It’s a controversial paper, because some critics of it argue that what Carlos was talking about was a very special case. And it’s been interpreted as saying, Well, you don’t have to worry about pollution, because people affected by it will. They’ll do some deal with the people doing the pollution, and it’ll be resolved somehow. So that’s a simplistic way of describing it. But it’s a controversial paper, there’s Coase was, it looks like he was talking about a special case. And it can be interpreted as saying, well, we could just leave things to the market, we don’t necessarily have to have regulation, which wasn’t really what he was saying. So it’s controversial. I think we’ll have to cover that in another episode be interesting to have a look at that. Yeah, it’s another famous paper. Yeah, so 1937 27 years of age. I mean, he might even been 26, when he wrote it. So he did well, he writes, the main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism. The most obvious cost of organising production through the price mechanism is that of discovering what the relevant prices are, these costs may be reduced, but it will not be eliminated by the emergence of specialists who will sell this information, the cost of negotiating and concluding a separate contract for each exchange transaction, which takes place on a market must also be taken into account. And I think that’s, that’s going to be one of the major ones, isn’t it? And, and also the delays in finding people. So I think about why I would want to have a, well, if you think about the choice between, say, a permanent person, a full time person and a casual person, for example, then it’s good to have a permanent person, because they’re on hand, they can deal with a variety of different issues, which, whereas with the casual person, you’re not always sure if they’re available. And if you want to contract out, if you want to get on up work, then the people that you might have used previously might be busy doing something else. And you don’t always know what the other person on the other end is what they’re telling you is that right? I guess without work, there’s an advantage in that platforms like that as a rating, and there’ll be some feedback. But still, if you haven’t worked with them before, it’s hard to know how they’ll, they’ll go.

Tim Hughes 33:02

I mean, the costs of doing business on those sort of platforms is has gone up from what it started out as, but it’s still relatively inexpensive compared to outsourcing locally, certainly, I mean, because one of the benefits of this is you can get work done from anywhere in the world. And that’s one of the technological advances that we have at our disposal for sure. It’s cheaper than it used to be 1520 years ago.

Gene Tunny 33:28

It is. So there’s that arbitrage, again, that geographical arbitrage you can take advantage of you could employ someone to, to do a job that you’d have to pay more for here in Australia in the US, and you might be able to find someone who can who’s really good who can do it. And they might be living in India, or Pakistan or somewhere like that. But generally, I think what you find is that the more skilled, well, the higher the rate they charge, generally, the more productive they are, and you get what you pay for, ultimately, so that geographical arbitrage isn’t as or that opportunity to get lower cost. Labour in other countries is not as great, I don’t think it’s as great an opportunity is, as some might think, oh, at least that’s my that’s my experience,

Tim Hughes 34:20

I guess, with increasing any workforce within the company. The nightmare for any employer is to have people twiddling their thumbs and not earning money for the company. So you have to keep that source of work coming in, you have to and also to make sure that people are working efficiently, you know, because the bigger everywhere becomes then I mean, you know, I haven’t had huge experience in this, but I’ve worked with so many people at different levels of management and you know, it’s clearly not straightforward in the bigger companies as to how the hierarchy works. And there’s always people unhappy with how things are the in those really big companies, but yeah, It seems to be there. They take on a life of their own these big companies with all the departments and the hierarchy. And it’s an interesting human experiment. I think, having these insights into these big companies that, obviously, some do really well, some do do not so well, but they become their own living, breathing thing that is clearly difficult to manage, you know, but at every level, the bigger it gets, it comes with a whole different problems for Yeah, just managing the sheer size of something.

Gene Tunny 35:32

And that’s why they’re often Outsourcing Things or something, sometimes they asked us and they bring back in because they had sorted didn’t work out too well. But in terms of outsourcing, look, cuantas. And, and that’s, that’s possibly a good example of the one of the trade offs there. So quite as, as you remember, when they outsource their baggage handling. And they did that to save money. And I mean, they just had a record profit didn’t know. So obviously,

Tim Hughes 35:59

it was very controversial. And I do have a friend who has a lot to say about this particular thing, because he used to work at quantas. And, and so he has insights that far, closer than anything I know. Yeah. But it did appear certainly, from what I understand that like, that didn’t seem to be a great thing. And I’m just going from what I’ve read in the news with this. And, you know, clearly it’s a skilled job, you know, that could that kind of thing where there’ll be problems all the time with baggage handling, as an example that always be these issues with that will come up and experience in any job. And using that as an example, experience wasn’t there with a new workforce, to be able to sort out the issues as they came up. And you can imagine that with pretty much anything, you know, if you change the workforce, and you don’t have that experience of what can go wrong, and what you do to fix it, there’s going to be issues, and that clearly seems to be the case with the baggage handlers. And as to how fair it was or unfair. You know, there’s plenty of commentary on that. But just losing that experience base yourself was, you know, that’s, that’s a difficult thing to replace, it takes time to build. And it’s, it’s clearly clearly was an issue anyway, at the time.

Gene Tunny 37:13

And I think the people who worked for cuantas, as baggage handlers were better motivated, they had better morale, they cared about the image of cuantas. And so they weren’t just throwing pegs around. Well, we’re human

Tim Hughes 37:24

at the end of the day, yeah, there’s that thing of like, whatever job you have, if, if there’s pride in it, and if, you know, I think when people talk about culture in a in a company, you know, this is, this is the reality of it, you know, you can’t just do broad sweeps here and there, and expect everything to maintain some level of pride in the work, for instance, you know, and all of you know, there are very human things that we all sort of respond to, and taking pride in your work, for instance, will be one of them, no matter what your job is, you know, and so I think, yeah, I guess I don’t know enough about that particular thing. But I know, there’s a lot of commentary that has gone on, and it didn’t appear to be a very popular outcome.

Gene Tunny 38:04

No, no, exactly. And I think that’s why, you know, occasionally I have to try and find an example of a company which is outsourced and then brought something back into the company is don’t know any off the top of my head, but I’m sure it’s occurred, brought something back into the company. Well, because there’s what I’m driving at is that, I mean, you’re talking about companies and they can serve, you know, they can grow and you know, you can end up with all of these different departments. But then when they get into financial trouble, that they might realise, oh, we have to rationalise or we have to do things better, and they’ll outsource various different parts of their business. Yeah. And, you know, the baggage handling was one example. I’m thinking, where’s an example where there’s something that’s been previously in house has been outsourced, and then it’s been brought back in house? If you’re in the audience, and you if you know, of an example, please let us know. I’ll try and dig one up and put it in the show notes. But you know what I’m driving it.

Tim Hughes 39:05

I think every scenario that you can imagine must happen, some of has happened. But yeah, for sure, that would have happened.

Gene Tunny 39:12

Yeah, yeah, definitely. Okay, so we might get toward the end of coasters, or his summary of his argument. And then I’ll just go over a couple other things. Chris writes, we may sum up this section of the argument by saying that the operation of a market costs something and by forming an organisation and allowing some authority and entrepreneur to direct the resources, certain marketing costs are saved. The entrepreneur has to carry out the function at less cost taking into account the fact that he may get factors of production at a lower price than the market transactions which he supersedes because it is always possible to revert to the open market if he fails to do this. That’s just saying that yeah, I mean, you’re only going to hire someone if it ends up being cheaper than going out to the market each time. Yeah, to subcontracted out the question of uncertainty as one, which is often considered to be very relevant to the study of the equilibrium of the firm, it seems improbable that a firm would emerge without the existence of uncertainty. And I think that’s an important point, what is driving out there is uncertainty is one of the major reasons why you have a business, you know, that the Will you hope that people are going to turn up to work. And you know, they’re going to turn up, it provides some certainty, whereas in this is the situation Hatch’s was facing, or has been facing, it’s concerned about the uncertainty of whether it will get the formwork the people with the form working skills to make sure the form work gets done the so that the concrete can get poured, and the building projects can go ahead on shedule.

Tim Hughes 40:56

It’s interesting, actually, because some it’s just formwork is that they’ve taken on just thinking about it a little bit more. And it’s the big guts of the building, you know, concrete pour. From that point, everything else can sort of happen. I mean, there are still things that happened before a concrete pour. But it’s, you know, it allows everything else to sort of go. So it’s one of the first you know, it’s an ongoing thing, depending on the structure of the place, there’s going to be more than one pour. But yeah, it means all those other things can then happen, you know, so for instance, yeah, it’s different than having a whole team of electricians or a whole team of carpenters, chippies, whatever it may be, and I’m sure they’re building companies that do maybe hajis to have some of those guys on board too. But because it’s the formwork, it’s like, yeah, they need that at that very, you know, the putting the skeleton, the bones of the place together so that all the the rest of it can happen. I think

Gene Tunny 41:53

in project management, you would say it’s on the critical path. Yeah, yeah. Yeah, exactly. Okay. So many questions or any thoughts on on that the theory of the firm the the nature of the firm by Ronald Coase,

Tim Hughes 42:08

it’s interesting, I can’t say I fully get it. But that’s what I enjoy about these conversations. I come in as a layman and get exposed to these different things. And it’s always interesting. And I have to add, there was another venue, of course, the first value musical that The Hutchins centre Scott Hutchinson was involved

Gene Tunny 42:27

in service when I saw the Johnny Cash tribute concert. Yeah, it was that textbook and no, that was another one though. It was someone else. It wasn’t textbook, it’s unfortunate textbook.

Tim Hughes 42:37

And yeah, if you get a chance, hello.

Gene Tunny 42:41

Okay, so in the shownotes, so as well as linking to that story about Hutchinson’s and the the nature of the firm by Ronald Coase. I’ll link to a really good article on the American Express website, the pros and cons of hiring in house versus outsourcing. And yeah, I thought it went over a lot of the relevant considerations. Things like one of the best things about having people in house is you get the face to face conversations, you build the relationship, you learn how to work together. So there’s benefits from that. Possibly, you can get a sense of whether people are ethical and honest. I mean, I guess one of the challenges and one of the problems with issues with contracting out is that sometimes you could get ripped off, right? It’s

Tim Hughes 43:29

definitely I mean, it’s an interesting point, like, certainly, I’ve heard from friends in the creative industries like architecture, where a lot of the benefits were lost during the lockdowns and working from home was in the collaboration of different ideas. And that yeah, that sort of thing, where you just sort of organically go and check in with someone and someone else might. I mean, of course, there’s, you know, people can waste time, but with creative industries or creative work, that collaboration is really important to be able to share ideas organically as they come up, and it is different face to face as it would be on the screen, you know, like so. It was it was good seeing the respect and the sort of benefit for those kinds of face to face interactions, you know, which I think people have valued since the pandemic and it’s like yeah, that’s something worth holding on to.

Gene Tunny 44:26

Yeah, for sure. The other pros have in house are in that they talk about intellectual property may be more likely to remain confidential. You don’t have to worry about some supplier coming in and learning about your business and ripping off some of your IP so perhaps that’s an issue. However, there are cons of in house hiring could be well it can be difficult finding the right people. There, there might be others. is no benefits you have to pay them. So medical and dental benefits. So that’s more of an issue in the states where the employers have to cover that. And finding, interviewing and negotiating can take time. And then if someone leaves, you have to find them again. So there can be there’s a cost of onboarding people. Yeah. There’s a cost associated with trying to get people to get suppliers in through the market. There’s also and there’s also a cost of trying to get people to work for you.

Tim Hughes 45:28

I guess it’s building trust as well. I mean, what yeah, of course, isn’t exclusive to it working out if it’s in house, you know, look in the house or outsource to the seller level of trust, that takes time to build up which has value.

Gene Tunny 45:45

Yeah. Pros of outsourcing. Most freelancers are pros at a very targeted discipline. So you can get really good people. Outsourcing can be ideal for short term projects in which talent is only needed for the completion of a one off project. Yeah, so the so I’m going to outsource the design of my website every few years or so there’s no point me having a dedicated web designer. Yeah. In the firm, obviously, not yet. Not yet. Yeah, so cons of outsourcing. Near the IP issue. Fake freelance profiles can exaggerate talent. Yeah, there could be different different styles, you may not be used to how the Freelancer works, or the can the person you outsource to, there may be some cultural differences. For example, there can be communication gaps. And yeah, freelancers can get quite expensive. Yeah. So I think that’s quite a good list of pros and cons of in house hiring and pros and cons of outsourcing. So I’ll put a link in the show notes. Okay, I’ll have to have a another read of the nature of the firm when I get a chance, and maybe I’ll have to come back to it and and try and illuminate it a lot better than that. But I was hoping that, at some, at least some of the core principles are clearer.

Tim Hughes 47:17

Yeah, I certainly have a better understanding of it from my first overview of that, again, but it’s, you know, it’s that thing of like, it’s interesting seeing it put down in a single paper, you know, like, I guess, in many ways, I’ve got to the point where I’ve taken it for granted, that kind of outlining, and, and formed my own opinions as to why it has happened. And so it seems like, you know, I’m sure there’s more to it than what I originally saw, you know, which we wish we got to in the in the conversation, but I’d be very interested in having a chat about the other paper whose it was the theory of social cost. Yeah. And with the pollution and everything, that would be good. Yeah. And also to find out what his health regime is, I mean, he got 102 That’s probably fine. It was a chain smoker and drank lots of whiskey, you know, but if it works, it works.

Gene Tunny 48:10

That’s right. I mean, that’s that’s funny, isn’t it? When they asked the 109 year old woman, what was that? What was the secret fear of longevity? I had a brand new every day.

Tim Hughes 48:20

There’s always some French farmer who lives 114 And he’s a chain smoker with colour wise and he drinks red wine for breakfast. These are outliers in the genetic field. So yeah, all power to them.

Gene Tunny 48:34

Good. Save any any other thoughts or any anything else that’s on your mind?

Tim Hughes 48:38

That probably is gene but I think we should probably leave it at that and I look forward to the next one. Okay, thanks to Jeremy.

Gene Tunny 48:50

Okay, have you found that informative and enjoyable? Ronald Coase, his article on the nature of the firm is one of my favourites in the economics literature. It’s highly readable and incredibly insightful. The paper was probably so good because it was based on extensive fieldwork by coasts is a great 9097 reason interview with coasts in which the story is told about how he wandered around the US Heartland in the 30s talking to business owners about how they organise their firms. Based on that field workers concluded that business people were well aware of the relevant trade offs, trade offs that Tim and I talked about in our conversation. Unfortunately, I’ve been unable to get any insights into how COAs lives so long 102 is an impressive run. If you know anything about rollercoasters health regime, then yes, get in touch and let me know and they’ll share it with other listeners. Also, let me know what you thought about my conversation with Tim. As always, feel free to email me at contact at economics explore.com Thanks for listening. rato thanks for listening to this episode of economics explored you Have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explore.com Or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week.

50:42

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Credits

Thanks to Obsidian Productions for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au.

Tags building, business, company, contract, contracting, cost, cuantas, economics, firm, guess, house, hutchinson, instance, job, market, outsource, outsourcing, paper, people, projects

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