Rita McGrath On The Future Of Capitalism In A Digital Revolution

capitalism noun: an economic system in which a society’s means of production are held by private individuals or organizations, not the government, and where products, prices, and the distribution of goods are determined mainly by competition in a free market.

This definition by Merriam-Webster summarizes what most accept as a pillar of democracy and life in America. Yet capitalism has evolved over the years, with government regulations intended to protect the public and preserve the intended free market. With dire warnings about artificial intelligence, repeated cybersecurity breaches, and increased focus on inequity and the environment, what is the future of capitalism in today’s digital age?

Best-selling author and Columbia Business School professor Rita McGrath has a few thoughts. Considered one of the top global experts on innovation, strategy, and growth, McGrath’s publications include Seeing Around Corners: How to Spot Inflection Points in Business Before They Happen and Discovery Driven Growth, co-authored by Ian MacMillan and praised by “godfather of disruptive innovation” Clayton Christensen as “some of the most important tools in management and strategy that have ever been developed.” As founder of strategy and innovation consulting firm Valize and with an upcoming book on permissionless organizations due out in 2024, McGrath’s experiences in both corporate America and academia provide a unique perspective on capitalism in the digital age.

McGrath sees America at the brink of an inflection point, similar to how the industrial revolution pulled people away from farms into cities, and the petroleum-fueled boom of the 1900s drew people to suburbs with increased mobility made possible by cars. The digital revolution is yet again changing the parameters of what’s possible, which may well change the way capitalism operates.

She points to the research of internationally recognized expert on the social and economic impact of technical change Carlota Perez, who asserts that when an old regime is at its peak performance, those with capital then look for a new regime, taking that capital with them. Once the bubble around that new regime eventually bursts, the money that’s trapped in what she calls the casino economy is then moved into investments in the real economy. This movement creates potential for a new golden age, in which resources are shared more broadly, and with less income inequality.

McGrath asserts that we’re at a moment where we’re questioning the way that capitalism has been run over the last forty to fifty years, and the generally accepted tenant of shareholder primacy being dominant. “We’re now seeing many organizations shifting, whether because they want to or because it’s being forced upon them, to really think about other actors who have a stake in the success of their firms. We’re in the middle of this giant reckoning because income inequality is at a level that it’s not been, and it’s not sustainable.” McGrath envisions a “democratization of capitalism, which is ironic because we are in a democracy, but perhaps with a more equitable sharing of resources moving forward.” The push for companies to consider environmental, social, and governance (ESG), and the backlash that followed, is another factor. Just as petroleum fueled the previous regime, data and the environment are likely to figure prominently in the way capitalism works in the future.

As one example of a company demonstrating an innovative interpretation of capitalism, McGrath points to Patagonia and its 2022 announcement that “Earth is now our only shareholder.” Another fascinating example is private equity firm KKR, which has embraced employee ownership in the companies they invest in, resulting in far more widely shared wealth when such a company enjoys an exit event. “Ordinary companies are now having to at least take broader issues into account. They’re being visibly measured on what they’re doing with the environment, how well their boards are balanced in terms of diverse membership, and more broadly, the prospect of an economic retrenchment has caused many companies to really rethink how they’re operating,” she says.

McGrath raises the criticality of innovation to the intersection of free markets and capitalism, and cites New York University economist William Baumol, who studied the rise in productivity, and the increase in wages that resulted even in industries with no change in productivity. “Baumol would argue that free market capitalism creates a condition for an innovation arms race so that companies are forced to innovate, and therefore innovation is actually the linchpin to a lot of the productivity growth that’s going to create whatever the future of capitalism is,” McGrath said. While it would be easier for companies to ride the wave of status quo and continue to make money on what they do today, they know they need to stay ahead of their competition through innovation or become obsolete. “There is this simultaneous reluctance to innovate but at the same time, recognition that you innovate, or you die. That’s really the key to what’s allowed so much productivity growth and improvement in basic human welfare to take place.”

To measure the value of innovation to a company, McGrath and Alex van Putten have developed what they call The Imagination Premium, or TIP. It breaks down the market cap of a publicly traded company into two measures: the value of operations, and what investors are willing to invest based on their view of the company’s growth prospects. Dividing the value of growth by the value of operations is that company’s TIP, which McGrath and van Putten view as a metric that provides a leading indicator of what investors think your growth prospects are. The TIP can also serve as a tool a CEO can use to gain support from the board for innovation investment intended to raise the market cap.

McGrath explains that a TIP of 1.0 signals a good balance between exploration and exploitation, with investors signaling they feel the company is generating good cash flows today, but also making sensible investments for the future. A low number demonstrates a view that investors don’t believe the company’s claims of innovation, and signals weakness to the possibility of a takeover or activist activity.

Yet a TIP that is too high signals fragility, with shareholders responding dramatically to the slightest bad news. Tech companies frequently fall into this description. “Tesla’s TIP right now is about 6.0, showing that investors are betting on future growth. For years Amazon’s was about 4.0, meaning only one quarter of its whole market cap was covered by cash flow from operations. Everything else was expectations for future growth, and for many years Amazon delivered on that.”

With regard to technology, particularly the advent of artificial intelligence, McGrath says, “we’re in this sort of ‘Netscape moment’ right now. When Netscape first became commercialized, that was the first time ordinary people actually had exposure to what the internet might be. There were apocalyptic predictions back then.” More recently, tech leaders recently warned that AI poses a ‘risk of extinction’ on par with nuclear war, yet she notes that the “AI bomb” is already embedded in society, and has been long before the highly publicized release and adoption of ChatGPT.

The rise of surveillance capitalism, or the commercialization of personal data, is a consideration in the future of capitalism in the digital age. “I think we need to have rules of the road. The reality of capitalism is that it’s policy agnostic – people make decisions based on market incentives,” McGrath said. “But capitalism doesn’t account for market failures and so we have these situations where the market doesn’t provide a good solution. Surveillance capitalism is a case in which institutions lagged behind reality and by the time giving away vast troves of personal information to third party players became both normalized and embedded, it is much more difficult to regulate in a sensible way. People didn’t realize the extent of this tracking, as evidenced by the conflict between Apple and Meta – once people had the chance to opt out of ubiquitous tracking, most do. The role of government and institutions is to create the guardrails.”

McGrath cites the Clean Air Act of 1970 as an example of these guardrails being put into place. “I remember as a kid I was carsick all the time because of the lead in gasoline,” McGrath said. “But then a whole consortium of players – government, industries, interest groups, regulators, policymakers, scientists – all came together and decided to set guardrails so that yes, you can operate for profit but within the range of a set of constraints. And that’s really the role of government, to define the box within which capitalism must operate.”

She also cites the factories of years ago, when laborers worked six or seven days a week for twelve hours a day or more. Ordinary workers were not even allowed to have timepieces. The only person in the factory who had a timepiece was the supervisor, who made sure they got as much labor out of people as possible. “Now you talk about that today and people think, ‘Oh my goodness, that’s ridiculous.’ But that was capitalism. That was capitalism without guardrails,” McGrath said. “It took decades and lots and lots of protests, hard work, and organizing before we finally settled on what we would regard as a fair day’s work for a fair day’s pay. And what we’re going to see is similar guardrails emerging around things like surveillance capitalism, the environment, and AI. That’s the role of government and policy.”

Yet the trouble with government and policy is that it tends to lag. McGrath points to a time before social media operated as it does today, and prior to digital companies’ pervasive ability to track people with their cellphones. “If you had asked somebody whether they thought it should be legal for a private company to be able to track your most intimate movements – going to a doctor’s office, seeking addiction treatment, or going to the liquor store – people would have been horrified. But nobody had the imagination to see where this was going.”

McGrath adds that the challenge with the lag in government and policy is the failure to foresee where these technologies and practices would and could go. “If we’d had the imagination to see where these things were going, we would have put preventative guardrails in place before they were allowed to become embedded,” she said. “The problem is that regulators and policymakers are not motivated to take a long-term perspective and have thoughtful negotiations in politics today.”

“I think the thing people don’t understand is that capitalism, left to its own devices, will go where markets tell it to go. And many of our issues as a society cannot be solved by market solutions,” McGrath said. She cites communities left behind when companies offshore work to China, and the environmental and health impacts of burning coal. “We’ve seen how market solutions don’t work when it comes to places where there isn’t a fair market, and when we don’t factor in the other intangible burdens that are placed on society.”

One thing is for certain, capitalism will need to evolve and innovate, in response to the innovations present in today’s digital world.

The conversation has been edited and condensed for clarity. Check out my other columns here.