Brief Thoughts on Human Capital Investment

Recently, I had two stimulating conversations that converged on a share theme. Nick Schulz’s essay on “Human Capital in a Global Age” includes the following observation:

Economists have been trying to measure the importance of human capital in recent years. One estimate (see chart) pegs the total stock of human capital in the United States at over $700 trillion. That dwarfs the physical capital stock of $45 trillion.

Yet consider how we tax the income derived from investments in equities as opposed to debt as opposed to human capital. Returns to human capital are taxed as ordinary income. When weighing the size of the tax preference for capital gains, the case for which is entirely defensible to be sure, perhaps we should be more mindful of the fact that wage income can be understood as a kind of capital gain. Gary Becker and Kevin Murphy made an argument along these lines in The American back in 2007:

Higher rates of return on capital are a sign of greater productivity in the economy, and that inference is fully applica­ble to human capital as well as to physical capital. The initial impact of higher returns to human cap­ital is wider inequality in earnings (the same as the initial effect of higher returns on physical capital), but that impact becomes more muted and may be reversed over time as young men and women invest more in their human capital.

As Becker and Murphy go on to observe, however, the response to these higher returns has been “disturbingly limited.” We tend to think of this response primarily in terms of educational attainment among young people. The fact that high dropout and low college completion rates persist despite higher rates of return on human capital is widely understood to be a serious policy challenge, and with good reason. 

Yet there is another way of approaching this problem, which we’ve discussed in the context of Clayton Christensen’s critique of what he calls the New Finance:

The Republican intellectual George F. Gilder taught us that we should husband resources that are scarce and costly, but can waste resources that are abundant and cheap. When the doctrine emerged in stages between the 1930s and the ‘50s, capital was relatively scarce in our economy. So we taught our students how to magnify every dollar put into a company, to get the most revenue and profit per dollar of capital deployed. To measure the efficiency of doing this, we redefined profit not as dollars, yen or renminbi, but as ratios like RONA (return on net assets), ROCE (return on capital employed) and I.R.R. (internal rate of return).

The problem, according to Christensen, is that a focus on the internal rate of return can yield perverse consequences when capital is no longer scarce:

I.R.R. gives investors more options. It goes up when the time horizon is short. So instead of investing in empowering innovations that pay off in five to eight years, investors can find higher internal rates of return by investing exclusively in quick wins in sustaining and efficiency innovations.

In a way, this mirrors the microeconomic paradox explored in my book “The Innovator’s Dilemma,” which shows how successful companies can fail by making the “right” decisions in the wrong situations. America today is in a macroeconomic paradox that we might call the capitalist’s dilemma. Executives, investors and analysts are doing what is right, from their perspective and according to what they’ve been taught. Those doctrines were appropriate to the circumstances when first articulated — when capital was scarce.

But we’ve never taught our apprentices that when capital is abundant and certain new skills are scarce, the same rules are the wrong rules. Continuing to measure the efficiency of capital prevents investment in empowering innovations that would create the new growth we need because it would drive down their RONA, ROCE and I.R.R. [Emphasis added]

Moreover, Christensen argues that our efforts to building human capital endowments are counterproductive:

Our approach to higher education is exacerbating our problems. Efficiency innovations often add workers with yesterday’s skills to the ranks of the unemployed. Empowering innovations, in turn, often change the nature of jobs — creating jobs that can’t be filled.

Today, the educational skills necessary to start companies that focus on empowering innovations are scarce. Yet our leaders are wasting education by shoveling out billions in Pell Grants and subsidized loans to students who graduate with skills and majors that employers cannot use.

As I understand it, Christensen is suggesting that rather than take a static approach to human capital investment, in which we provide people with “yesterday’s skills,” we need empowering innovations that “transform complicated and costly products available to a few into simpler, cheaper products available to the many,” as empowering innovations like the automobile and the personal computer democratize economic life. In the context of medical care, for example, the “quantified self” revolution might allow a wider array of people to do things that could only have been done by skilled professionals in the past. 

The implications of Christensen’s thesis are, in my view, very deep. If he is right, we are approaching human capital investment through a self-defeatingly narrow lens. In Who Do You Want Your Customers to Become?, Michael Schrage offers a broader perspective, explaining how empowering innovations represent a distinctive kind of human capital investment that has gone largely ignored:

Perhaps the innovator’s most important assets “by far” aren’t its employees. Suppose its most important asset is its customers, and how it invests in its customers, how it treats its customers, how it raises the skill level of its customers. Maybe that’s a dominant factor determining whether this business is going to succeed. Yes, top employees matter enormously. They’re vital. But if Microsoft or McKinsey & Co. had their top-twenty clients taken away, they’d be less extraordinary firms. That’s true of a lot of other companies, too.

The human capital of customers matters. Increasing the human capital stock of customers and clients is as economically, financially, and strategically important as managing the human capital capabilities of the firm. Innovation generates a new wealth of human capital. Successful innovations are successful investments in the human capital stock of customers.

Nobel laureate economists such as Becker, Theodore Schultz, Robert Solow, Kenneth Arrow, Robert Lucas and Herbert Simon would surely consider innovation investment integral to human capital development. How different is educating undergraduates to solve Bayesian probability problems from training customers to effectively use a sophisticated Android statistics app? If retail innovators like Sylvan Goldman and Amazon’s Jeff Bezos teach people to shop in new ways, doesn’t that new knowledge create new opportunities for economic growth? To the extent customers and clients acquire new skills and new behavioral norms that make new value possible, they’ve enriched their human capital stock. Innovation makes them more valuable. Training workers and educating customers are simply opposite sides of the human capital coin.

Formal economic theory and empirical research have unfortunately underappreciated and undervalued the importance of the customer’s human capital in innovation success. That’s an oversight that deserves rapid remedy.

Successful innovators like Microsoft, Ford, Google, Apple, Amazon, and McKinsey have quantitatively and qualitatively increased the human capital stock of their customers and clients. The evidence strongly suggests they succeed because their innovations have made their customers more valuable. [Emphasis added]

One of the most interesting aspects about the kind of human capital investment Michael has in mind is that it occurs in a decentralized, competitive context, and it has a tremendous track record at upgrading skills quickly and cost-effectively. To use one of his many examples, consider how quickly millions of Americans have become adept “searchers” since the advent of Google’s search engine. 

This broader take on human capital investment suggests that we need new ways of thinking about our health system and our educational system, both of which depend heavily on scarce skills yet that arguably fail to leverage latent skills that are far more abundant. 

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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