Clay Christensen warns CIOs that smart managers are doomed to fail

There is more than one way to disrupt the market. In addition to disruptive market-creating innovations, which succeed by offering products or services to a class of customer that previously didn't exist, there are sustaining innovations. These succeed by replacing good products with better ones (Prius for a Camry). Efficiency innovations, on the other hand, succeed by offering the same product at a lower price (Geico). Each plays a different role in the economy. Market-creating innovation requires capital and creates jobs. Sustaining innovation is "replacetive" in nature and, while making the economy more vibrant, does not generate a lot of jobs. Efficiency innovation eliminates jobs but frees up capital for other things. It's kind of a neat system, Christensen noted.

"As long as the market-creating innovations are creating more jobs than the efficiency innovations are taking out," he said, "and as long as the efficiency innovations are creating enough capital to fund the market-creating innovations, it is like a perpetual motion machine."

But since the 1990s, this nifty machine -- the envy of the global economy -- has been under assault from the "Church of New Finance," his name for the doctrine taught at places like the Harvard Business School, he said, that measure profitability by how efficiently a company uses capital. What the new ratios offer is two ways to achieve good results. Return on Net Assets (RONA) comes out just fine by either increasing the numerator or decreasing the denominator. "Either way RONA goes up," Christensen said. The same holds true for internal rate of return, the ratio that basically expresses how quickly one can get money out of an investment. Innovation is hard. Since those market-creating innovations that generate jobs often take five to 10 years to pay off, wouldn't it make more sense to invest mostly in efficiency innovations?

The end result of pursuing that strategy, however, is that profits accumulate but job growth declines. "That is why we are not getting out of the recession and why we are not creating jobs," Christensen said. And the doctrine makes no sense, he added, giving the audience a glimpse of the passion bordering on rage that fuels his pursuits. A scarce commodity when these measures took hold, capital is abundant today. The cost of capital is zero. America is awash in cash. Instead of hoarding capital, companies should be pouring it into innovations that create jobs. And yet, the management tenets of the Church of New Finance -- which protect capital at all costs -- "make it impossible for smart people to do what needs to be done to sustain growth in the industry," he said.

I've noted in the past that we've been entering an equilibrium (I say entering because it is at different stages around the world) where there are large pockets of people with needs, but no money - and small pockets of people with money, but no particularly unserved needs.

Economic analysis as operated by many economists breaks down at that point. SRW points to how you can analyse it... but in the end it becomes a political rather than economic problem...

There is, however, a second, much more fundamental inference from our argument which has a bearing on the future of inequalities of wealth; namely, our theory of the rate of interest. The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save. But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment. Thus it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of capital at which there is full employment.

There can be no doubt that this criterion will lead to a much lower rate of interest than has ruled hitherto; and, so far as one can guess at the schedules of the marginal efficiency of capital corresponding to increasing amounts of capital, the rate of interest is likely to fall steadily, if it should be practicable to maintain conditions of more or less continuous full employment unless, indeed, there is an excessive change in the aggregate propensity to consume (including the State).

I feel sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure. This would not mean that the use of capital instruments would cost almost nothing, but only that the return from them would have to cover little more than their exhaustion by wastage and obsolescence together with some margin to cover risk and the exercise of skill and judgment. In short, the aggregate return from durable goods in the course of their life would, as in the case of short-lived goods, just cover their labour costs of production plus an allowance for risk and the costs of skill and supervision.

Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital. Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce.

I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work. And with the disappearance of its rentier aspect much else in it besides will suffer a sea-change. It will be, moreover, a great advantage of the order of events which I am advocating, that the euthanasia of the rentier, of the functionless investor, will be nothing sudden, merely a gradual but prolonged continuance of what we have seen recently in Great Britain, and will need no revolution.

Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labour could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward.

At the same time we must recognise that only experience can show how far the common will, embodied in the policy of the State, ought to be directed to increasing and supplementing the inducement to invest; and how far it is safe to stimulate the average propensity to consume, without foregoing our aim of depriving capital of its scarcity-value within one or two generations. It may turn out that the propensity to consume will be so easily strengthened by the effects of a falling rate of interest, that full employment can be reached with a rate of accumulation little greater than at present. In this event a scheme for the higher taxation of large incomes and inheritances might be open to the objection that it would lead to full employment with a rate of accumulation which was reduced considerably below the current level. I must not be supposed to deny the possibility, or even the probability, of this outcome. For in such matters it is rash to predict how the average man will react to a changed environment. If, however, it should prove easy to secure an approximation to full employment with a rate of accumulation not much greater than at present, an outstanding problem will at least have been solved. And it would remain for separate decision on what scale and by what means it is right and reasonable to call on the living generation to restrict their consumption, so as to establish in course of time, a state of full investment for their successors.