Negative Network Effects
Distortion is a much-discussed topic in the context of U.S. culture and politics in 2019. Vast numbers of people on polarized sides of almost any debate seek to elevate victory to a life or death struggle. But why is there such urgency to win at all costs and to shape narratives so completely? And what are the reasons for the corrosive urgency?
Such fervency was common during the Soviet era when two powerful ideologies faced off to resolve profound philosophical differences that first emerged as ideas born in European coffee shops more than one hundred years ago. Our capitalist system, supported by a set of established values and beliefs that most Americans seemed to understand and collectively agree to, prevailed in a way that prevented what previously required world wars to resolve. Yet today, with all the winning chips in our favor, capitalism appears to have morphed into a “technology,” like social media, that is designed to find the clearing price for our values and beliefs. What was once a struggle against an external force now appears to be some form of necrosis.
Network effects is the popular economic construct applied to market concentration and increasing returns for strategies pursued by some leading tech companies. This dynamic economic agent is also known as demand side economies of scale. W. Brian Arthur, the economist credited with first developing the theory, described the condition of increasing returns as a game of strategic positioning and building up a user base to the point where “lock in” of dominant players occurs. Companies able to tap network effects have been rewarded with huge valuations and highly defensible businesses. And some of these companies’ products have impacted society in a variety of ways.
What if the same dynamic applies to the U.S.’s pay-to-play political industry where the government promotes or approves of something through a policy, subsidy or financial guarantee due to private sector influence. This is what I call negative network effects. Benefits accrue only to the purchaser of the negative network effects, and consumers, induced by the false signal of large network size, ultimately suffer from asymmetric risk and experience what I’m calling a loss of intangible net worth for each additional member after the “bandwagon” wares off. If this were the case, then you would see companies experience rapid revenue growth (out of line with traditional asset leverage models), executives accumulating huge fortunes and political campaign coffers swelling. But the most striking feature would be the anti-social outcomes, the ones not available without the instant critical mass of government-supported negative network effects, the ones that, at scale, monetize aspects of a society’s intangible net worth: housing, healthcare, education and food.
In essence, negative network effects are a mechanism for privatizing profits and socializing losses on a national level. In the case of strong negative network effects, the creators’ knowledge of a product and/or policy’s designed-to-fail nature obviates the need to bribe the government to get scale with distribution. The goal is to distribute the promise of advantage to the unsuspecting who then pay by becoming permanently disadvantaged.
In Washington, there is an odd logic promoted by lawyers and lobbyists to perpetuate this false promise of advantage: what’s legal is what’s ethical. But what if what’s legal is for sale?
Negative network effects come in to play when the effects are purchased through the campaign industry’s yoke of government and when the outcomes are anti-social. A quick summary of some metrics related to social cohesion and economic health suggest the impact of negative network effects at work: falling life expectancy, a spike in suicide rates, record levels of inequality, declining inter-generational economic mobility, record levels of wealth concentration and uneven distribution of income gains favoring the richest segment of society. Some products tied to these metrics include: prescription drugs, junk food (esp. targeting children), mortgages, diplomas, and social media (as a source of “news” and identity). Not to mention politicians themselves who are not more than just another product. A recent study by professor Gabiel Zucman suggests, “The bottom half of Americans combined have a negative net worth.” In fact, the levels of deterioration today are approaching those consistent with the destruction of tangible assets like crops and physical infrastructure that are commonly associated with periods of war. All of these declining conditions accumulated over decades and are not captured through the narrow prism of GDP growth because they are mostly linked to intangibles. When someone faces a setback with an intangible, it is often a lifetime of debt/despair, and on a national scale it tears at the fabric of society. This concept is intended as a companion diagnostic.
“The ethical dimension underpinning the whole system is this: what’s moral is what’s legal and what’s legal is for sale.”
Education
Higher education is a travesty characterized by the stripping of value from the intangible concept of education. This happens through price inflation and debt accumulation as a direct result of a toxic mix of government subsidized student loans and high-concept predatory marketing from schools that have no skin in the game when students default on loans. The incentive structure is designed to separate price and value in the equation of what to pay for an education.
The explosion of student loan balances corresponds with the madness associated with the mortgage industry prior to the Great Recession: government supported and government promoted for years before the greased wheels finally break down. It is abundantly clear that college diplomas have lost their scarcity value, yet total student loan balances stand at $1.5 trillion and carry a staggering 11% default rate for a commodity product with a luxury price (as of 2018). Vast numbers of students choose to acquire a mountain of debt only because the government sanctions it through the provision of lending, thereby reinforcing their choice.
There is a weak form of negative network effects at work in the government’s engineering of the overall higher education disaster. The for-profit education industry is example of strong negative network effects because it includes the starkest example of a template for socializing costs and privatizing profits: the dumping of stock among the senior executives before the reality of the product’s inferiority comes to light. In the last ten years, the for-profit education industry spent $67.1 million on lobbying in Washington as the industry reeled from multiple fraud prosecutions in at least 37 states and the resulting corporate bankruptcies. Prior to the collapse, a variety of for-profit education industry players went public. Many of these so called “free enterprise” companies booked more than 90% of revenue on government-guaranteed student loans, while they, “own every lobbyist in town,” according to one U.S. Senator. The University of Phoenix, for example, a nationwide school with more than 254,000 students, received over $2.75 billion in federal financial aid as revenue. And company executives received compensation in the millions through cash and stock; then they just walk away often by taking their for-profit entities thorough bankruptcy, an option not available to their student debt holders.
Food
Food’s transformation into junk food in a fashion similar to the “designed-to-fail” mortgage derivatives that were at least partially responsible for the decimation of the housing industry in 2008 and the resulting financial collapse. In 2013, I coined the term “metabolic donkey” to describe the methods junk food companies use to hoist bad outcomes (private profits, socialized losses) on consumers, often targeting children in the U.S. and abroad. Today, one in three children in this country is overweight or obese. Overweight children face a greater risk of developing diabetes, high blood pressure and asthma. For the majority of people, diabetes and fatty liver disease are a result of diet and lifestyle, as opposed to disease pathology. In fact the annual cost of the diabetes epidemic is $327 billion, including $237 billion in direct medical costs and $90 billion in reduced productivity, according to the American Diabetes Association. In the last ten years, the food processing and sales industry spent $288 million on lobbying in Washington. What is the purpose of such spending? One example is to continue counting tomato paste (in frozen pizza) as a vegetable in school lunches. Another is to protect SNAP recipients’ choice to prefer high-margin processed junk food over more healthy options. This particular issue attracts extreme vitriol. The perception is that targeting recipients of government food support is discriminatory if there is any suggestion of restrictive paternalism, even though SNAP diets are out line with Dietary Guidelines for Americans (USDA/HHS, 2015). Forget that such policies would be designed to reduce the negative health outcomes of a shortened, diseased life that junk food diets produce – and that the public treasury must underwrite the cost when the inevitable health disaster emerges from censored diets. If you are going to remove any dimension of morality from governance and instead rely on the rule of law, then what happens when those laws are for sale?
Finally, where in the national inflation statistics does the reduced nutrient density accounted for over the last several decades? Household food purchases made several generations ago contributed to health. Food purchases today – with a high contribution coming from processed food “products” – contributes to the reduction of intangible health.
Housing
It’s not difficult to conclude that a 33% nationwide real estate decline during the Great Financial Crisis of 2008/2009 (the worst since the Great Depression of 1931) transformed the concept of home into a lottery ticket. The houses remained physically in tact but, for millions of Americans, their intangible value as a home was destroyed. While the government spent about $16 trillion to prevent the collapse of the banking industry and to support other industries, the banking industry’s 2009 bonus pool topped $32 billion – while those banks had lost $81 billion during the crisis just one year prior. A recent Freedom of Information Act lawsuit initiated by Daniel Novack, First Amendment attorney based in New York City, reveals details of JP Morgan Chase’s involvement in mortgage fraud in the years leading up to the Great Financial Crisis. An excerpt includes, “By this action, the United States seeks to recover civil penalties” against JPMorgan Chase and its investment banking arm, “for a fraudulent and deceptive scheme to package and sell residential mortgage-backed securities,” that the bank, “knew contained a material amount of materially defective loans.” J.P. Morgan Chase settled the lawsuit for $13 billion in 2013. In the last ten years, the securities and investment industry spent $998.1 million on lobbying in Washington. The peak was $104.75 million in 2010 after a media frenzy over the excessive bonuses in 2009.
Healthcare
Health is looking like a similar intangible asset that is being stripped of value for profit. If the U.S. healthcare industry were a country, it would be the fifth largest GDP in the world. Yet the health outcomes the industry produces are the worst in the industrialized world. The opioid epidemic represents the most striking example of “lock in” for a group of patients seeking pain relief but instead were victims of a corporate strategy to achieve negative network effects with a highly addictive drugs. Overdoses involving opioids killed more than 47,000 people in 2017, and 36% of those deaths involved prescription opioids. In the last decade, the pharmaceutical industry has spent more than $880 million at the state and federal level to fight regulations that would limit the availability of powerful opiods such as OxyContin, Vicodin and fentanyl in the U.S., according to an investigation by the Associated Press (AP) and the Center for Public Integrity. According to the AP report, prescription opioids are the cousins of heroin, prescribed to relieve pain. Sales of the drugs quadrupled from 1999 to 2010, rising in tandem with overdose deaths. In 2015, the U.S. doled out 227 million opioid prescriptions by legal physician advice, enough to hand a bottle of pills to nine out of every 10 American adults. A recent filing in Massachusetts, Attorney General Maura Healey is pursuing Purdue Pharma, the maker of OxyContin. Her office has exposed how Richard Sackler, then Purdue’s president and part of the Sackler family that owns Purdue, was personally involved in efforts to hide the drug’s deadly addictive quality in marketing materials targeting physicians. From 2007 to 2018, the Sacklers paid themselves more than $4 billion from opioid sales. These drug dealers bribed the government (federal and local) to first approve opioids and then ignore the addictive outcomes even as the number of opioid deaths climbed for more than a decade before acting in any definitive way.
Take the case of Facebook, a company considered to be a textbook case of massive value created with network effects that now appears to be transitioning to negative network effects through the purchase of political influence. There are persistent questions about Facebook’s impact on society. One data point to consider concerns leaked documents that describe how the social network shared psychological insights on young people with advertisers. According to reports dating back to 2016, Facebook told Australian advertisers it can identify teens feeling “insecure” and “worthless” stemming from such things as body confidence and weight loss. In the marketing world, this segment is called vulnerable narcissists – and these are among the most emotionally vulnerable in society including, “high schoolers, college students and young working Australians and New Zealanders.” Facebook is described as having the capacity to monitor posts and photos in real time to determine when young people feel “stressed”, “defeated”, “overwhelmed”, “anxious”, “nervous”, “stupid”, “silly”, “useless” and a “failure.” Exploiting emotional vulnerability for profit can certainly be considered a sociopathic targeting of intangible mental health. Consider this: A New, More Rigorous Study Confirms: The More You Use Facebook, the Worse You Feel. 2011 was likely the year Facebook realized a hidden truth: when a user’s life becomes measured through the narrow lens of envy and narcissism the result is a spike in suicide rates, especially among society’s most vulnerable ie. among teen girls who exhibit addictive behavior on the platform. When a company like Facebook bribes the government to gain advantage, who are the losers in the shifting landscape of advantage peddling? The company has no competition, so it must be its users.
Source: OpenSecrets, as of May 2019
Negative network effects ultimately fail, but when the government provides the scale and the moat, the outcomes become a tragedy: social decline, massive government debt and record levels of wealth concentration among a narrow segment of society. Americans will have to come to terms with a government that fails to protect. The state of polarization likely precludes any changes to the political industry. In fact, buying network effects from the government thrives when polarization dominates the narrative about solutions.
There is a real possibility that the private sector will take over the basics like healthcare, home security, education and food (supply and prep), water and Internet infrastructure for a large segment of society. Home ownership is already part-way down this path, with home ownership in a long-term decline as private corporations buy trillions of dollars worth of single family homes.
Idea: Real food will never attract capital like the junk food industry because of low margins. A shortened diseased life is not price enough to alter consumption habits when negative network effects shape consumers’ identities (Snickers: “You’re not you when you’re hungry”) at scale. There will be a company that realizes food quality is a vital input to poor and declining health, and subsidizing high quality food is the best way to control healthcare costs, measured over decades. Yet today, the government actually subsidizes the junk food industry in a variety of ways and is captured by the industry.
For investors, there are opportunities to profit from companies able to offer solutions. SodaStream built an at-home soda making business based on the merits of consumers’ producing something (by hand) and reaping the rewards of conservation through the use of one’s ability to reason that a beverage can be as good or better with half the sugar, sodium, calories and cost. Another company to consider is Teladoc (TDOC). In the area of care delivery, telemedicine is positioned to be a novel first access point into the healthcare system of the future. The only pure-play, publicly traded company in this space is TDOC.
Articles and links related to negative network effects:
Facebook’s Conduct Shows Not All Network Effects Are Positive
Why U.S. Political Risks Should Be A Factor In Portfolio Risk Budgets
Two Intertwined Dynamics Are Transforming the Economy: Technology and Financialization