The digital subversion of classical capitalism won’t last

The Nasdaq stock market index that is based on a portfolio of technology stocks exhibited a three-fold increase in just 19 months spanning August 1998 to March 2000.  (Bloomberg)
The Nasdaq stock market index that is based on a portfolio of technology stocks exhibited a three-fold increase in just 19 months spanning August 1998 to March 2000. (Bloomberg)

Summary

  • Sustainable digitalization calls for a return to principles of capitalism under which profits matter.

Byju’s, once the darling of India’s digital economy with a valuation of $22 billion in late 2022, is attempting to raise money at a valuation that’s a small fraction of that today. Through its roller-coaster ride, one thing has remained constant: in its 13-year history, it appears to never have been profitable. This is standard for internet companies. Amazon did not make profits in its first 6 years. How have we arrived at this model of ‘digital capitalism,’ a system where valuations are independent of firm profitability for long periods of time?

Many would ascribe the phenomenon to the internet being characterized by network economies, the phenomenon of benefits to users increasing with the addition of new subscribers. For instance, a social network such as Facebook becomes more valuable for each user with an increase in the number of users on account of the increasing number of people that can be reached. Therefore, the argument goes, competition on the internet must inevitably resemble winner-takes-all contests, with each firm trying to achieve a critical mass of subscribers in the earliest possible time.

But social networks and e-commerce platforms are not the first examples of industries with network externalities. The plain old telephone service also became more valuable for each subscriber with every new connection. Similarly, the traditional video-tape industry also exhibited this property; the triumph of the VHS format over Betamax resulted from an earlier attainment of critical mass, not a superior technology. Why did the business model of telephone or video-cassette recorder companies never get decoupled from earnings in the way the businesses of internet companies has?

This is the story of a liberal consensus, a phase of market-led growth which began in the 1980s, helmed by the charismatic figures of Ronald Reagan in the US and Margaret Thatcher in the UK. A rightward political shift, growth of automation and outsourcing of jobs to China led to a weakening of the labour movement in advanced economies. In parallel, multinational corporations (MNCs) had a dream run of 25 years, during which the contribution of corporate profits increased from 7.6% to almost 10% of global gross domestic product (GDP).

This phase created an enormous amount of private wealth, driven by sharp spikes in the valuation of corporations and residential property, and the mushrooming of off-shore tax havens. Starting from 1979, while incomes of the top 1% in the US more than tripled, those of the next 19% increased by less than two times. There was a remarkable difference even within the top 0.1%, with the top 0.01% doing far better than the next 0.09%. Thus, by the 1990s, the US possessed a small cohort of extremely wealthy people.

These people wanted to stay in touch with new developments and provide mentorship as technology boomed with a new generation of entrepreneurs at the helm. And, of course, they wanted to keep multiplying their wealth. Hence, vast sums of wealth were channelled through angel networks and private equity firms to enterprises in the ‘new economy.’ This kind of wealth was not available back in the days of the plain old telephone service.

Proponents of these developments characterized this inflow as ‘patient capital’ that did not require firms to show profits or even revenues in the near term. However, while startups were given long lead times for profitability, the investors themselves did not have to exercise much hermetic patience. As the liberal consensus led to a relaxation of the rules put into place after the Great Depression to curb speculative investment, the stock market boomed. The Nasdaq stock market index that is based on a portfolio of technology stocks exhibited a three-fold increase in just 19 months spanning August 1998 to March 2000. There was a spate of Initial Public Offerings (IPOs) of technology companies. In November 2015, Facebook crossed $300 billion in market capitalization, overtaking the 123-year-old GE after only 11 years of existence. Early-stage investors cashed out from these IPOs if they had not already cashed out in funding rounds (usually 3 to 4 in number) that preceded the IPO. The vast wealth accruing to angel investors and tech entrepreneurs generated a fresh flow of capital for digital startups, thus creating a self-perpetuating cycle.

The consequence of this model of digital capitalism is the creation of winner-takes-all markets characterized by extreme competition and volatility. The dotcom bust of the 2000s and the churn experienced by companies like Byju’s are prime examples of the new nature of competition.

Of course, the consumer who gets access to a raft of digital goods and services is not complaining. However, ordinary citizens suffer in their roles as workers or entrepreneurs. As digital businesses take over traditional brick-and-mortar industries like retail and education, only firms with deep pockets can survive. As global investors set up digital firms, local small businesses lose out. In 2021-22, foreign direct investment in India was 2.7% of GDP, nearly 24% of it in computing and software services. Such developments spell good news for Indians as consumers, but less so for Indians as productive members of the economy. Sustainable digitalization requires a return to classical principles of capitalism under which profits matter.

Of course, in the Indian context, we also require a competitive telecom industry. But that’s a story for another day.

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