Chicago Booth Review Podcast Why the Economy Is Now Intangible

Amir Sufi: If you want to just boil it down to its essence, I think it used to be the case that the value of a company was larger than the value of the parts of the company if you liquidated and sold it.

Hal Weitzman: The value of the U.S. economy is increasingly accounted for by intangibles, things like intellectual property, brands, and customer relationships. How is that changing finance and business? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I'm Hal Weitzman, and today I'm talking with Chicago Booth's Amir Sufi about the rise of the intangible economy. Should advanced economies abandon the idea of reviving manufacturing and instead continue to chase intangible value?

Amir Sufi, welcome back to the Chicago Booth Review Podcast.

Amir Sufi: Thank you for having me.

Hal Weitzman: We are delighted to have you back to talk about... I feel like we've skirted around this issue several times, but now we're actually going to get into it in depth, hopefully, talk about intangibles. Things like branding. Like one time you came on and we talked about customer capital. Just remind us, what are intangibles? Why are they more important now than they used to be for the U.S. economy?

Amir Sufi: So the idea is when a company is producing whatever it's going to produce to try to earn revenue, it's got to rely on certain assets. And I think traditionally we thought companies relied on property, plants, equipment, land. Think about Henry Ford building cars, right? But this day and age, when you think about some of the biggest, most important companies in the U.S. economy, think about Alphabet or Amazon, a lot of what they're relying on is not so tangible. It's more what we would call intangible. It could be software, it can be intellectual property, trademarks, brands, patents. All of these kinds of more intangible types of capital are becoming more important because the industries that are growing most in the U.S. economy rely on intangibles in their production process much more heavily than, say, traditional manufacturing, which doesn't rely on intangibles as much.

Hal Weitzman: Why is that though? I mean, are we just more aware of how important brands are? I mean, why is it that those things... Is it about the companies themselves or is it about the way that we think about intangibles?

Amir Sufi: That's a million-dollar question for sure. I think in my view, it's part of what we... There's a literature in development macroeconomics called structural transformation. And it's the idea that as countries get richer and richer, their economies typically go from agriculture to manufacturing and then to more service-oriented. I think people used to think service oriented meant retail, going to the restaurants, but I think that's a misleading notion of what services means. It actually means more high-tech services like information services, like consulting, like professional services. There's a deeper question about why that happens. Why as countries get richer, they start to move towards those? I think that's kind of the million-dollar question that I don't think I can answer, but I think that it has been proven true across the world.

Hal Weitzman: But this is part of the extreme maturation of the U.S. economy-

Amir Sufi: Absolutely.

Hal Weitzman: ... is that we become more and more dependent on services.

Amir Sufi: Absolutely.

Hal Weitzman: And services are more about intangibles, so that's how they rise. Now, as you say, finance doesn't always find it easy to think about intangibles. Just explain what has that meant for banks, for financing operations with this rise of intangibles.

Amir Sufi: So if you think about the way banks will typically underwrite a loan for a company or even for a household, you can think about when you go get your mortgage, what's one of the first things the bank's going to ask? Well, what's the value of the home? And because the bank is kind of lending against the home in case you don't pay. And that's always been the traditional way in which banks have underwritten loans, is that they look at the tangible capital that they can grab if you were to default on the loan. And so they look at the machines, the property plants and equipment. It's not easy for a bank to grab customer capital or knowledge capital, and so they're not going to be as-

Hal Weitzman: But that's confusing because isn't it... I mean, imagine you're Acme Industrial. I can sell the chairs, the tables, the plants, the equipment. I can't sell the customer capital because by the time you go bankrupt, haven't you destroyed a lot of the customer capital anyway?

Amir Sufi: Exactly. Exactly. So what you said is exactly the problem with banking in this industry, is that banks are not well-equipped to take over the company before it gets to the point that that intangible capital is ruined, which is why they lend against the things that presumably won't be ruined like the chairs, like the property, like the plants, like the equipment. And so that's really where other financial intermediaries are better situated, that they could potentially step in if things are going badly and just take over the whole company and run the company as a whole.

Hal Weitzman: So traditional banks just haven't got a way of thinking about this?

Amir Sufi: Well, I think they're regulated in ways that makes it very difficult. So for example, there were regulatory guidance from the bank supervisors that said, "We do not want you to take enterprise value of the company as your major type of collateral." And they argue just like you argued, "That enterprise value could diminish before the default, so we don't want you to do that." So banks are actually almost actively discouraged from betting on intangible capital because they're told the enterprise value of the whole company is not what you should be underwriting your loan on. And so that's where other intermediaries have been much more effective.

Hal Weitzman: Okay. So as you say, the U.S. has seen a massive rise in information services, what you call professional scientific and technical activities. So if we think about the economy, what does that mean for the value adding? How should we think about that and how that's changed?

Amir Sufi: Yeah. So I mean when you see the numbers, they're striking. So we're talking that these two industries, information services and business services... And just so make sure the listeners understand who that is-

Hal Weitzman: Yeah. Tell us what that means.

Amir Sufi: Information services is going to include household names like Meta, like Alphabet, like Microsoft, Oracle. That's all information services, some of the biggest companies in the economy. Professional scientific and technical service is a bit more nebulous, but it's definitely going to include almost all consulting firms like Accenture. It's going to include most of the huge law firms like Kirkland & Ellis. And so those are the kind of industries that we're talking about. And by the way, it's not just the U.S. This is kind of all, what we would call, the more high income countries in Europe, especially, have also seen their economies shift towards these industries over the past 30, 40 years.

In terms of your basic question, what does it mean for value add? It just means that in the production process and the value chain of the way companies act, people are willing to pay a lot to these companies for their services, right? And a lot of these are business to business services, not business to consumer services. So a business is willing to pay a software company. A great example would be legal software. Law firms pay legal software companies a great deal of money so that they can have very efficient software that manages their client flow that manages the legal documents, and that's just become a more and more important part of the U.S. economy over time.

Hal Weitzman: Now, in your research, you compare, as you say, it's all developing economies that have moved in this way and you present a comparison between Pakistan and the OECD, the often called club of rich countries. So what does your research tell us about how developing countries, developing economies, are learning from this changing industrial structure in high income countries?

Amir Sufi: Yeah. So part of the reason, I gave a talk, a keynote address in Pakistan, which is why I use Pakistan directly. But I think South Asia is so interesting in this regard because as I mentioned earlier, structural transformation usually goes agricultural manufacturing services. South Asian countries have actually kind of skipped the manufacturing phase. They've gone straight from agriculture to the export of high-tech services. And as you, probably, most of your listeners understand what I'm talking about, which is South Asian countries do a huge amount of work in tech,

In software for consulting companies in the U.S. So Pakistan itself, about 10% of its exports are in what I would call high-tech services.

Hal Weitzman: Wow.

Amir Sufi: Which for a country at its income level is amazing. They're punching way above their weight. And so a lot of the countries in the developing world are trying to figure out, "Oh, maybe we don't need to do this manufacturing stage. Maybe we can go straight to kind of software to business services and make more money that way."

Hal Weitzman: Okay. Now let's just define a few terms because that come up from your research. So we've talked in a prior podcast about customer capital, which is the value of the customer relationships you have, right? You've also researched knowledge capital. So just talk a little bit about these and how they've kind of changed what were the traditional investment decisions that businesses had to take.

Amir Sufi: Yeah. So if you think again back to this example I like to use of a legal software company, a legal software company is going to go out and try to get subscriptions by all the law firms to their product. And they're going to try to wrap them up into these five, six year long relationships. And the present value of those subscriptions we can think of as a kind of customer capital, that I have to go work to get these customers. Once I get them, they're part of my customer base. And then if another company comes and buys me, they're going to have to pay for those customers that I have.

Another example of knowledge capital would be, well, maybe the software itself that the legal company creates is really quite unique and really quite valuable.

And so both of those would be kind of standard examples of intangible capital. And you can imagine getting a loan from a bank might be hard, but maybe getting a loan from a private credit fund or private equity might not be if that's the kind of capital that you have.

Hal Weitzman: And you've talked in previous podcasts about the loans from private equity and private capital to these emerging companies. So I understand why the banks can't do it because you said they've got all sorts of regulatory pressures. How come it's so much easier for private lenders to be able to do it?

Amir Sufi: I think at the end of the day, it boils down to one simple issue, which is they are willing to take over the companies as a whole and run them themselves. It's a very simple argument, which is a bank cannot run a legal software company. A private credit fund, if it has expertise, they can. There's nothing restricting them in any way from making a loan to a legal software company. If things go badly and they can't pay back that loan, they can just take over the whole company. They don't have to liquidate it for parts. And so that kind of simple distinction with being able to actually run the companies is a big reason why I think private credit is particularly well positioned to finance these intangible capital industries.

Hal Weitzman: I see. So with the growth of intangibles, with the growth of private, it's all moving together.

Amir Sufi: Yeah. And that's one of the things that I was showing in this presentation was that if you just look at the portfolio share of private equity and venture capital and private credit, relative to banks, those portfolio shares are much larger in precisely these two industries, information services and professional scientific and technical services. So those financial intermediaries, it seems like they have a comparative advantage in financing intangible capital, which I think helps explain why they've grown so much over the last 30 years.

Hal Weitzman: Right. But then what it means is we have... When it comes to finance, there's two tiers or two different worlds, right? There's a world that is comfortable and knows how to model these risks lending to intangible heavy companies. And there's the traditional model that doesn't want to.

Amir Sufi: Exactly.

Hal Weitzman: Is that right?

Amir Sufi: Yeah, exactly.

Hal Weitzman: What does that mean for the world of finance? It means that there's not a single market. There's really two markets?

Amir Sufi: Yeah. It's interesting because I think that is something we've seen is that banks have... If you look at the asset portfolio of banks, it has shifted dramatically away from commercial and industrial lending. It is much more heavy in residential real estate, in mortgages, and commercial real estate. And in fact, there was a nice paper by a group in Germany that showed that when banks are kind of flooded with more money because of central bank policy, that almost all of that money just ends up in real estate lending instead of kind of traditional commercial and industrial lending.

So as the business sector of the economy becomes more and more intangible capital-heavy, it seems like the only thing left for the banks is real estate. It's the one thing that they can lend against. And so you do see the portfolios of banks-

Hal Weitzman: Are we seeing that now?

Amir Sufi: Oh, absolutely. If you look... Even Gene Fama mentioned this to me 10 years ago. He said, "Look, when you look at the aggregate banking sector, they look like a hedge fund investing in real estate. They're taking deposits and putting those deposits in commercial real estate and residential real estate."

Hal Weitzman: So are we setting up the next financial crisis on the real estate front then?

Amir Sufi: That much real estate exposure is always kind of dangerous. And I think people have been looking at commercial real estate for a while, especially post COVID and the work-for-home dynamic. But I think from my perspective, you are starting to see this bifurcated financial system where banks typically have securities, kind of more boring vanilla securities, maybe bonds, and then they have a lot of exposure to real estate, but they're not doing nearly as much direct lending to kind of traditional commercial and industrial firms. And I think that's because those firms are becoming more intangible capital-heavy.

Hal Weitzman: But is the real estate, is that lending big enough to keep the banking sector going?

Amir Sufi: Real estate is a big part of the overall economy.

Hal Weitzman: Sure.

Amir Sufi: Yeah. I mean, yeah, I think they have a big exposure in both... Now again, they don't even sometimes make the mortgages themselves. They buy mortgage backed securities from Freddie Mac and Fannie Mae and from other private label issuers. But I do think that you should, as a whole, think of banking in large part by their exposure to real estate.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show you should check out. It's called Big Brains. Big Brains brings you the stories behind the pivotal scientific breakthroughs and research that are reshaping our world. Change how you see the world and keep up with the latest academic thinking with Big Brains, part of the University of Chicago Podcast Network.

Amir Sufi, in the first half we talked about your research on intangibles and how you're thinking about this growth of this phenomenon where so many companies, such a huge part of the economy is dependent on things that cannot be repossessed by a lender, right?

Oliver Heart, the Nobel Laureate economist proposed that creditors will only lend up to the value of the assets they can seize. And I guess, you can't really seize, as we talked about in the first half, customer relationships or brands, so that makes it hard for banks to think about lending to these kinds of companies, which has all come with the growth of private lending, which you and I have talked about many times before.

So there's this connection between all these different phenomena that we've been talking about. One is the growth of intangibles. One is the growth of private equity. The other one is the kind of decline in traditional commercial bank lending, right?

Amir Sufi: Right, right. And I think if you want to just boil it down to its essence, I think it used to be the case that the value of a company was larger than the value of the parts of the company if you liquidated and sold it, but not by that much, right? So I think that's what the real core difference is. It used to be that if you lent to a heavy machine equipment company in Illinois, that if you were to have to foreclose on that, the underlying assets that were being used were worth maybe not as much as that whole company was worth, but somewhat close. But now this day and age with intangible capital firms, the gap between what the company's worth as a whole and what it would be worth if you liquidated has gotten larger and larger and banks are just not going to be well positioned to make loans to those kinds of companies. But that's a phenomenon that's happening everywhere, and that's just a phenomenon we have to deal with in the financial sector.

Hal Weitzman: And we talked about Pakistan and other developing countries and how there might be this possibility... I mean, I used to live in Latin America and I know that they've been talking forever about, "Let's actually not just extract stuff, let's try and build stuff. And now as you say, they say, "Forget about that. Now we need to do professional services." So there's this opportunity perhaps for countries like India or Brazil to leapfrog and to go straight to this, which is very exciting, to this service thing, which would be a challenge. Does that mean that the economic competition such there is in the global economy is really for intangibles?

Amir Sufi: Well, it's interesting because there's this argument by a scholar named Richard Baldwin that he calls the supply chain smile where he basically says, "Look, the real value add in producing in the supply chain is at the beginning when you do the design and at the end when you do the sales and marketing, that's where the real value is." And in the middle where you actually make the things-

Hal Weitzman: Right.

Amir Sufi: ... it's actually not that valuable.

Hal Weitzman: You may think of Apple designed in U.S.

Amir Sufi: Exactly. That pretty much defines the U.S. economy at this point, is I think it's mostly a design economy and a sales and marketing economy. Now it's still the case that, for example, China and some of the other East Asian countries have chosen to put themselves in the middle and build and build and build and they're doing manufacturing like crazy. South Asia, which we mentioned before we broke, they're kind of an exception in that they're kind of skipped manufacturing. And in fact, when I told some of my colleagues when I was looking at the data, they said, "Well, how do you know South Asia really is just better at doing business services?" Or maybe it's just they've decided they can't compete with China, so why even try and so they have to find something else to do." I do think-

Hal Weitzman: But they also have a heritage of English.

Amir Sufi: Yeah, that's true.

Hal Weitzman: Which makes a difference. But that makes me think that with AI, maybe you don't need a heritage of English, maybe that's irrelevant.

Amir Sufi: When I was there, that was a big question whether AI is going to help the software companies in Pakistan or hurt them. One argument was it's actually going to help them because it's going to eliminate jobs in the U.S. and make their jobs better. But the other argument was, no, it won't eliminate jobs in the U.S. The AI is actually going to be able to do exactly what the Pakistani software developers are doing. So that's an open question.

Hal Weitzman: Right. And not to mention that a lot of the professional services is call centers and other things.

Amir Sufi: Absolutely.

Hal Weitzman: Which there's, I imagine, a huge question mark over the future of those businesses.

Amir Sufi: Yeah. Absolutely.

Hal Weitzman: Right? Now you've said that institutions matter even more when capital is intangible. Why is that?

Amir Sufi: So that's a point about why is it that it's easier to lend against hard assets from an institutional legal perspective? It's because I don't really have to know much about the business to come in and liquidate it and take the parts and sell it. But if you're going to have a successful bankruptcy system that allows me as a lender to come in and take over the company while preserving the value, you have to have a very excellent kind of reorganization Chapter 11-like system. And the U.S. has excelled at that. I mean, I do think the Chapter 11 system in the U.S. is probably the best in the world at preserving what we call going concern value, even though the company technically is in default. But I think that's very difficult to do.

And so other countries of the world that may have less of a developed financial system, it's going to be very hard for them to have bankruptcy systems that preserve that continuation value, going concern value, through a bankruptcy because the instinct is almost like a run, right? The instinct when there's a default is for all the creditors to just try to grab the collateral and sell it for whatever they can to recover what they can. Going concern value lending requires patience. It requires good institutions to kind of slowly go through the system to transfer the ownership from the old equity holders to the new equity holders, which were the old creditors, and that requires a very sophisticated legal system to do that.

Hal Weitzman: Okay. So in that sense, U.S. is maybe more under pressure from intangibles, but it may be in better situation because of the rule of law?

Amir Sufi: Absolutely. And I think that's part of the reason, for example, Singapore has made a huge effort to try to become the kind of Delaware... To plug your book a little bit, to try to become the Delaware of the world, because they understand that this legal regime of preserving continuation value at a global scale has to be able to be done somewhere, and they're trying to market themselves as the place where it can be done.

Hal Weitzman: Fascinating. So intangibles have come to define the U.S. economy in many ways. What's the future, do you think? Are we just going to be an intangible economy in the U.S?

Amir Sufi: Yeah, it's very interesting. I mean, I do think that one of the most fascinating things about artificial intelligence for me is that, at least in my professional career, it's the first time I've seen a technological breakthrough that really threatens industries that are primarily focused on intangible capital. So to see software companies under threat, legal companies, like all the kind of traditional information services, professional scientific and technical services companies, are now under threat from AI. But of course under threat is kind of a funny way to put it because AI obviously will be beneficial to somebody in that world. It's just who? Who's going to end up benefiting in the intangible capital parts of the economy. Presumably, but I think some companies will figure out better how to use it and better create-

Hal Weitzman: But maybe the value of that... I mean, legal services is so expensive. Maybe the value of that will decrease.

Amir Sufi: Yeah, exactly. And so maybe we'll just get good productivity growth, cheaper prices, and more efficient allocations. I totally think that could happen. But it's kind of interesting because you and I have lived in a world in which everyone's, "Oh, manufacturing's gone to China. Manufacturing is getting destroyed. Manufacturing's..."

Hal Weitzman: Well, we have a government in the U.S. that wants to boost manufacturing here, even though it's against the tide of everything you've talked about.

Amir Sufi: Of course. Of course. I mean, that's the kind of funny thing, is like, people have said, like if you talk to people, the elite party leaders in China, they're like, "What are you talking about? We want to be more like the U.S. We don't want manufacturing. We want these very high value add service industries, like we talked about the design stage and the sales and marketing stage." But I do think both the design stage and the sales and marketing stage really could be radically transformed with AI. So I think that's part of the reason I find it so fascinating.

Hal Weitzman: Excellent. Well, we're going to continue to follow this, so we will look forward to having another conversation with you about this. For the moment, thank you so much for coming back on the Chicago Booth Review podcast.

Amir Sufi: My pleasure to be here.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis and insights, visit our website, chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe. And please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.