TheMarketForIdeas

One of the features of the modern Romanian economy is the rapid growth of the IT industry, along with a burgeoning prestige for such positions as being both intellectually demanding and well paid. The government has stepped in through various means to encourage the local implantation of foreign players and to enact fiscal privileges for IT workers. Some National champions are also steadily forming, with Softwin standing in the lead for size, sophistication and its development of a global brand. All in all, the IT industry seems to be a one of a handful of Romanian economic success stories, where competitiveness is mingled with high remuneration and prestige. But this article aims to present a brief dissent from the glorious IT future that various well-wishers predict for us and to argue that all that glitters is not gold, especially when it comes to the way the IT industry functions.

There is no doubt that the maintenance and employment of indigenous programming skills, along with the correlated competencies, are crucial to the wellbeing of our nation. For our society to modernize, our cyber infrastructure (physical and virtual) needs to be built and maintained, utilizing internal capacity wherever possible. It must also be protected, with cyber-attacks being an integral part of what is termed hybrid warfare, asymmetric warfare, fourth generation warfare and other such disconcerting novelties. While there is no hidden externality to the IT industry, like a pollutant that is unaccounted for, our decision to collectively encourage the assignment of increasingly scarce brainpower to this area presents us with significant opportunity costs in terms of the evolution of our structural economy and what it will be, as opposed to what it should be to meet our societal needs.

The production chain thesis

Since Romania is not at the current frontier of productivity and technological sophistication, it stands to reason that it, more than other countries we would like to emulate, needs to adopt a vision of synergetic development, where we not only create more added value, but we also get to keep more of the surplus and we do so in a manner that has positive effects throughout the economy.

For instance, a large factory making machinery or even cars, which are the principal large scale, high value added export in the world, will create and nurture an entire ecosystem of suppliers for parts or for tools, extending downwards towards the suppliers and processers of raw materials. In addition to the value creation and jobs represented by the particular factory, its subordinated production chain creates many times more value and jobs than the factory itself. Given the ease and low costs of international transport, some of this production chain will be global in scope, but countless examples, among which we find the Chinese, show us that there is strategic value and nimbleness in maintaining a production chain in close geographic proximity. Maybe it leads to incremental innovation, faster prototyping or reduced risks of shocks to supply integrity, but the fact is that such a chain will matter, and Romania possesses a part of such a chain for its Renault factory. What production does an IT company sustain? Aside from electricity consumption and capital investments in hardware and software, there is little depth and complexity to the economic interlinks an IT company will create, regardless of the high added value it may generate for itself. While profitability and productivity are nothing to sneer it, we should also show appropriate preference for the idea of business sectors that invariably create jobs and may be gateways to middle class lifestyles for a larger number of people. The acquired distaste that IT evangelists have cultivated for the real, physical economy is nothing more than an affectation without grounding in reality – factories can become increasingly automated and they may be extraordinary sources of innovation leading to competitiveness while still holding up a large segment of the economy.

The capture of value

Speaking of competitiveness, how much of the added value that the IT industry creates will be captured by the Romanian economy? Through a long production chain, it is possible for a National economy to capture a disproportionate amount of the economic value created by an enterprise. In the case of a foreign IT company implanted in Romania, the only sure capture of value is through the wages paid to the workers, which might be substantial by Romanian standards, but are not comparable to those abroad, which is an impetus for the initial implantation. Neither is the manpower requirement of the IT industry something extraordinary. Facebook and Google have large workforces, but still minuscule compared to their revenue and to their actual dominance in their fields. There is only one Google with a near monopoly on search engines and advertising. With no production chain to capture more value, no physical deliverable to subject to tariffs or to wring some money out of through transport and insurance services, the IT industry will necessarily rank lower than a factory for value captured (it will also find it easier to divest and to leave the country). A Swedish company with an office in Ireland can simply state that its Romanian operation, which creates the product itself, is a loss-making entity, while the Irish subsidiary that sells the actual product will also serve as the receptacle of the revenue. This may sound familiar because it is done all the time, by Microsoft, by Google and by Apple. To look at Microsoft, you would think it is composed mainly of a supremely inefficient facility employing thousands in Redmond (whom any good consultant would suggest firing to stop the hemorrhage of cash) and a highly productive office in Ireland that does all the work… but that is International tax arbitrage at work. If countries like Great Britain are claiming billions in unpaid taxes, then surely the Romanian government is losing out on its own cut of the created value. Therefore, IT companies have a lower tax footprint in Romania and fewer cumulative contributions to the state budget than a factory of equivalent gross revenue, such as taxes on salaries, value added taxes, corporate income tax etc.

The solution to this issue is to have National IT companies that reap most of the value they create and therefore are more likely to spend it or reinvest it inside Romania. This would be the case for the aforementioned Softwin, the producer of the Bitdefender antivirus products, among others. But even if we emancipate our IT workers from foreign servitude, remarking on what Lord Byron said of the natural preference for one’s tyrants to at least be one’s own countrymen, we have another problem.

True comparative disadvantage

Leaving aside the issue of salaries, increasingly the way in which the most avant-garde companies (the ones everyone tries to emulate) make money is through increases in share prices, where profits are marked through the sale of shares. Many superstar companies struggle to turn a profit from their business model. Twitter comes to mind, with its extraordinary network effects and notoriety that it has never monetized properly. This is problematic for a number of reasons. What these companies and their venture capital backers hope for is that market optimism and recognition of some special company advantage will buoy share prices, letting investors cash out through market sales, buyouts or even buybacks. Even when they do make extraordinary piles of money, companies like Apple might prefer to keep them untaxed in some foreign account. To pay dividends marks you out like a dinosaur with no idea for future growth. The state gets nothing, but the shareholders supposedly benefit from value that they lock in the moment they sell. The piles of money get used for acquisitions (many overpriced) or as a war chest for intellectual property right disputes. Many investors realize that this deal is not to the advantage of the long term or strategic owner, who would benefit from locking in gains through cash payments along the way before liquidating his position in the company. Some, like Carl Icahn with Apple, have even sued trying to get some dividends. The true believers state that the effect on share price is worth it.

Unfortunately, unlike cold hard cash in your pocket, gains are locked in only when you sell the shares. These effects are subject to gross market manipulation, through reliance on the exuberance of a bubble, or market histrionics, or good management of optics until reality crashes down over their heads. The managers of the company keep their bonuses related to short term share price performance, while investors risk quite a bit.

The relevance to our discussion is that companies like Softwin or other theoretical Romanian IT champions also understand that the Holy Grail for cashing out on their worth is not living off of product sales, but being listed on the stock markets and trying to inflate their price as much as possible, with the connivance of the banker team preparing the Initial Public Offering. The problem with this is that it almost certainly means the Internationalization or the de-Romanianization of the company, which hinders the amount of value which the country can capture from its activity. In a globalized world, one can work from everywhere, but one only truly makes money in a few “Alpha cities” like New York, Los Angeles, London etc. This is why the supposed decentralization of work has not stopped Silicon Valley from experiencing a massive real estate bubble, where every company in the world tries to open an office and every start-up dreamer tries to relocate. The issue is not talent, though this is the explanation bandied around, based on the very real concentration of talent there. But there is plenty of talent in Romania, which globalization purportedly opens up for exploitation. Why go to Silicon Valley? The reason you go there is that the venture capitalists are there and there is a networking effect and a marketing cachet to being present in Silicon Valley. If you were to have hard data on buyout prices for start-ups, you would notice that economic calculations seldom factor into it, since a lot of the potential value of the company is contingent on how its business model will work out in the future. What has been noticed is that a start-up in Bucharest will be worth less than a start-up in Berlin, which is worth less than one in London or New York, which is worth less than one in Silicon Valley. This is a total comparative disadvantage of Romania when trying to capture the value of its indigenous IT industry. The incentives are too great for the company to go global and subsequently limit what the Romanian economy stands to gain from it in taxes, local spending, wages etc. or even in local stock market value. Just a few local examples – Softwin of Bitdefender fame and e-payment company GECAD have offices in Silicon Valley. The reasonable thing for them to do is to attract capital for growth and to pursue an IPO in New York. Another Romanian start-up, UberVU, specialized in analytics for social media, was purchased by American company Hootsuite. But if you look online, the foreign specialty press reports UberVU as being a London based company, which fits with my description above of the incentives for maximizing company value.

Therefore, we find it again harder for Romania to expect that it may capture the value of the IT industry as fully as would have been possible in the case of a normal industrial operation.

Skipping stages

At the risk of being uncharitable, I think I know what lends the IT industry not just its local prestige, but also the disproportionate amount of attention it receives from our government to the detriment of export based growth and import substitution. One is the intellectual faddishness of it all – a hundred years ago, the American imagination was captured by electricity, and everything written at that time was electro-this and electro-that, persisting in the public consciousness through artefacts like the pulp literature of the time. Today, it is either e-this or cyber-that, to the very real neglect of the real economy, the one that literally puts the food on the plate and the car in the driveway, and not just skims off the top of economic activity through intermediation (which is still of real value, of course).

The second reason came to me when reading an article about how Kharkiv, the second largest city in Ukraine and one of the decayed industrial behemoths of the Soviet Union, was placing its economic hopes on a cyber-renaissance led by tattooed hipsters making apps. While not a bad idea in itself, it dawned on me that this is neither a workable solution for such a large economically blighted place, nor a sign of actual advancement. The whole point behind it was the low bar to entry that the field still possesses, along with high potential returns. To place your faith in it is to admit that you have no capacity to attempt greater efforts, to revitalize industry, bring investors, especially not with the civil war brewing in nearby regions. It is somewhat similar to Romania. An industrial renaissance for our country involves transport infrastructure, capital expenditures for investment, as well as efforts in transferring technology, in finding clients (including abroad), in ensuring standards and then bearing the risk of it not succeeding. For IT work, the minimum one needs are computers, reliable electricity and an Internet connection. We could be doing prestigious industrial work, like working with precision machinery to make producers’ goods (it worked for the Japanese), working with robotics, nanotechnology, advanced materials etc. But that would require active effort on behalf of the state to ensure infrastructure development and encourage strategic sector growth, while going for IT is the economic version of the “soft bigotry of low expectations”. Moreso since we have established that local champions are few and far between, and our country is basically exchanging IT worker labor for salaries. It is basically the 21^st century, advanced version of Jawaharlal Nehru’s vision of cottage industries in India.

Speaking of India, it was one of the first emerging economies to neglect other issues in favor of the siren song of the IT industry. While people were mocking the Chinese for making cheap plastic knick-knacks, India was praised for its stupendous IT industry development, which essentially involved low value added activities for foreign companies. It made a few people rich, and a lot of people comfortably well off, but just a few years later, China had all the infrastructure and leverage it needed to ensure both mass employment and advancing to the next stage of industrial added value that it can capture for itself, including in the IT industry. Compare this with India, whose License Raj and lack of infrastructure still strangle not just the economy, but basic living standards through poor hygiene and food and water insecurity. Just to give an example, its military needs are achieved through the world’s largest imports of arms, a capital hemorrhage that it is just now trying to solve through local development and production, hindered by the lack of a pre-existing infrastructure.

Conclusion

The IT industry is good to have, but bad to depend on for the development of the economy of a large country, such as Romania. Our breathless support of it is not just shrewd economic calculus, but a deafening indictment of our inability to promote other sectors of the economy with high added value creation capability, especially those that would support large scale job creation, the development of technical and technological expertise and the achievement of other strategic goals, such as military production capabilities, import substitution or export-based growth. Our capacity to capture the fruits of the IT industry’s operation is limited from the onset, and our tacit steering of talent towards this industry presents an opportunity cost in other fields. While talent or intellectual giftedness is not exactly fungible, a country has only a limited percentage of the population which can occupy cognitively demanding positions. With our severe brain-drain, our situation is even worse, since we need to steer talented people to medicine, government, research, industry and so on in a way that maximizes our development and national welfare. To be placed in a position where foreign companies arbitrage our low incomes to wow us with high wages (but not too high) which, with the collusion of government, induces a trend for talent to migrate to that respective field to the detriment of others, will cause us hardship in the long-term and waste our potential. Had we the capacity to do so, the same number of programmers who might have become engineers would have been a linchpin for the employment of thousands of their fellow citizens and of far greater and more certain economic gain in the long-run.