PDF Summary:Technological Revolutions and Financial Capital, by Carlota Perez

Technological Revolutions lays a framework for understanding the boom and bust cycles of disruptive technologies. The model is built on the history of the last five technological revolutions, from the industrial revolution to today’s information age.

Famed technology investors Marc Andreessen and Fred Wilson have cited this book as fundamental in their understanding of the tech industry. If you understand this book, you’ll have a better grasp of the 2000 tech bubble; where growth will occur in the next decade; and why explosive industries like cryptocurrency behave the way they do. You might even predict where the next technological revolution will be.

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The end of the previous revolution offers the gestational environment for new innovation.

At the dawn of the new revolution, the previous revolution has played out. Society has accepted the new common sense of the prevailing paradigm. Socially, these conditions cause inertia and exclude innovations that are incompatible with the existing framework. However, the previous revolution approaches the exhaustion of profitable opportunities. Core industries encounter market saturation and decreasing returns. Productivity and growth are threatened. Firms that have stagnated become receptive to radical innovations. An environment with decreasing returns brings idle capital looking for profitable uses.

Phase 1: Irruption

A technological breakthrough offers a visible attractor for investment, sparking the imagination of engineers and entrepreneurs and offering new cost-competitive possibilities in a sluggish landscape. New products and technologies arise that show future potential. The powerful firms from the previous revolution will use the innovation as a new lease on life and become testing grounds for the new technology. For example, the US auto industry (created in the previous revolution of the automobile and mass production) adopted Japanese production methods and microelectronics in both manufacturing and the car itself in the early 1980s.

Many innovators are likely to come from outside the prevailing paradigm. They don’t hold onto the past and so can explore new directions unfettered. The new revolution looks to have far higher profit-making potential than the prevailing paradigm. And so financial capital begins to court the emerging production capital: Old production capital has been facing diminishing returns since the last revolution’s Maturity, and financial capital flees from it. From the interactions with the new entrepreneurs, the financial world adopts the technology itself, and financial capital develops new risk capital instruments particular to the era. Financial capital thus enables and spreads the revolution.

At the same time, social tensions between the old paradigm and the new one cause resistance. Unemployment grows and inflation or deflation may occur.

Phase 2: Frenzy

In phase 2, irrational exuberance takes over. Financial capital, intoxicated by the perception that they’ve found an endlessly repeatable recipe for wealth, separates from production capital. Investors pursue profits without regard for fundamentals or even ethics. Innovations are rolled out without sufficient support. For example, canals were created in the 1790s from river to river with inefficient routing. Similarly, dotcoms were created in the 1990s with little evidence of underlying demand.

During a Frenzy, production capital has no choice but to adapt to the new rules set by financial capital. A phase of frantic investment occurs, usually typified by a stock market boom. Wealth is lauded, and individualism reigns. Financial capital thus generates a magnet to attract investment into the new revolution. Because of limited diffusion to the broader market, the real opportunities are relatively few, so financial capital develops sophisticated, speculative instruments to make money out of money, such as derivatives and junk bonds.

The gap between paper values and real values widens in a Frenzy. New millionaires appear, seeking to multiply their wealth at the same rate they made it, and so they redeploy idle capital with high pressure to generate profits. The newly rich hubristically believe it’s their own superior insight and intuition that led to growth, not the circumstances of the period. Participants refuse to recognize the delusion that the bubble might be inflated. The increase in the volume of transactions and number of actors involved attracts even more money and more actors into the game. These are self-reinforcing virtuous cycle effects.

However, a Frenzy also comes with social tensions. The regulatory framework is impotent to govern the new technology (for which there is little legal precedent), and is even seen as hindering the way to a successful society. Additionally, poverty is seen as a moral failure. As a result, people getting wealthy overlook ethics and due diligence. This leads to a permissive attitude conducive to corruption and illegal activities. Social resistance to unethical activities is less organized.

To avoid price competition, the new firms move toward oligopoly and cartel-type agreements. Income distribution becomes polarized, supply of the new technology outstrips demand, and income concentration at the upper end becomes an obstacle for mass adoption and full economies of scale. Excess money is poured into furthering the technological revolution. The leading countries that feel threatened by free competition often take protectionist measures.

Through all this, financial capital is unwittingly attracting the funds necessary to install basic infrastructure and facilitating social learning, paving the way for the full unfolding of the revolution during deployment.

Break: Turning Point

In Frenzy, financial capital separated from production capital and took on a life of its own. In the Turning Point, financial capital and production capital recouple. This recoupling is necessary for deployment and ushering in a golden age of more harmonious growth. The irrationally exuberant bubble bursts, causing a recession and social unrest. This is the trigger for regulatory and institutional change to adapt to the new revolution.

The significant failure of the bubble bursting is necessary for a regulatory change. Without these seismic shifts, financial capital would never abide by regulation. The power then shifts from financial capital to production capital, and consequently, the focus shifts from short-lived capital gains to long-term, dividend-producing capacity. This also shifts the tone of the economy to long-term growth and diffusion.

Institutions are set up to encourage diffusion of the new paradigm. The social values pendulum swings from individualism in Frenzy to collective well-being in deployment. Institutional choices will then shape the next two phases. With one set of choices, social cohesiveness, social safety nets, and income redistribution can happen—with another set of choices, selfish prosperity will continue.

Phase 3: Synergy

Using the infrastructure developed in Frenzy and the regulatory safeguards in Turning Point, the technological revolution spreads across the whole economy. A “good feeling” sets in with increasing coherence. Business is satisfied with its positive social role. Technology, and even finance, is seen as a positive force. Production capital is now recognized as the wealth-creating agent, with financial capital as the facilitator.

Where the excitement in Installation was in building infrastructure, much of excitement in deployment is building the application layer on top of the infrastructure. For example, during the installation phase of the auto revolution, the action was in building cars. In the deployment phase, the action was in the highway system, suburbanization, retail, and other second-order effects.

During Synergy, the new firms from the installation period are now giants. Paper values and real values are more closely aligned, so growth and dividends are more real than in Frenzy. Financial capital also creates instruments of credit that facilitate the new paradigm. For example, the second revolution in the 1830s saw joint stock for large projects and growth of capital markets, and the fourth revolution post-WW II saw personal banking services and consumer credit for consumption of mass-produced home goods.

This is also the phase when the paradigm spreads throughout society. Feedback effects reinforce growth. The raw labor and supplies are readily available, distribution networks are in place, new products are intercompatible, social acceptance increases, cost of inputs and infrastructure is reduced—all driving a flywheel effect for diffusion. For example, without roads, gasoline stations, and mechanics, people can’t use automobiles. Yet with a critical mass, enough automobiles are needed to make running a station profitable, thus making it easier to own an automobile, thus allowing more gas stations to exist, creating a virtuous cycle.

Social Adaptation in Synergy

During Synergy, culture adapts to the logic of the technologies. Consumers accept the progression of innovation as normal. For example, in the Information Age, there was rapid progression from home PCs to laptops to mobile phones to apps. The paradigm has spread and proven its power sufficiently to be installed in people’s minds as the new best practice.

This social momentum eventually becomes its own inertial force, rejecting innovations that disrupt the prevailing paradigm. This allows the full spread of benefits of the revolution and prevents kneejerk change for novelty’s sake. Employment rises steadily, and (depending on the institutional framework) there can be a shared feeling of an improving quality of life.

Phase 4: Maturity

Finally, the technological revolution begins to deplete its possibilities. Refer to Phase 0 above. This is the twilight of the golden age.

During Maturity, core industries experience market saturation and decreasing returns. To increase market share, the dominant firms concentrate through mergers and acquisitions, turning into oligopolies. Activities are migrated to less-saturated markets abroad, redeploying the prevailing paradigm. However, this exhausts relatively quickly because the knowledge gained in earlier phases accelerates the deployment in new markets.

Those who reaped the benefits of the golden age continue to believe in the virtues of the system. They insist on continuous progress of the current paradigm, in a complacent blindness. But promises of constant progress and social progress are not met, leading to labor and political unrest. The young and nonconformists stage rebellions and romantic protests.

Firms amass money without profitable investment outlets, creating idle capital. Financial capital begins separating from production capital again, seeking more profitable or exciting things. It supports investment in marginalized sectors and the periphery of the revolution. Bad loans are granted to weaker creditors, particularly internationally. Unorthodox practices like tax avoidance reign.

Radical innovations are demanded to propel further growth. During the Synergy phase, innovations that disrupted the diffusing paradigm were rejected. Now, they are sought after by firms desperate for growth, thus continuing the cycle.

Addressing Criticisms

Perez addresses a few arguments against her model of technological revolutions.

Criticism #1: The Model Doesn’t Apply to Every Situation

The four phases model is deliberately meant to be impressionistic. Each revolution has unique ideological, institutional, political factors that lead to particularities, but the general shape holds true. For instance, in the third revolution, madness in the US stock market occurred more during 1903 and 1907 during a “frenzied Synergy” in a strong drive to forge ahead.

Further, the Great Depression in the US after 1929 lasted especially long. Perez suggests that Roosevelt’s New Deal would have erected the structure for successful Synergy, but these were opposed for fear of socialism and inordinate state intervention in the economy. It took the military-industrial complex in World War II to teach how state and capitalism could coexist.

Criticism #2: The Model Doesn’t Show up in Metrics

Critics argue that this model should show up in economic analysis and in aggregate variables like GDP. However, there’s no expectation of neat upswings and downswings in aggregate metrics like GDP. Aggregate figures have a tendency to conceal what’s really going on.

Perez’s model argues for increasing differentiation within the economy. Some branches grow at very high rates while others are stagnating. Maturity of the previous revolution is occurring in the background of Irruption of the new one. Whether the sum of these trends shows up in aggregate metrics depends on the relative weights and relative growth rates.

Furthermore, many measuring attempts use money values, but there are really “two moneys” operating under one. Given the rapid improvement in technology, it’s hard to control the value of money across two periods. Even for the same good, the decreasing prices and increasing volume make measurement difficult. Finally, given the time lag of diffusion of the technology, the core countries in the revolution may be experiencing trouble at the same time that catching-up countries are reaching their maximum height.

Criticism #3: Cycles Must Be Simultaneous Worldwide Phenomena

Proponents of long-wave Kondratiev cycles expect worldwide progress coinciding in all sectors and geographies at once. In reality, diffusion tends to propagate in ripples, both across sectors and across geographies. Between sectors, the most closely connected industries form very high synergy and intensive feedback effects. This establishes the paradigm and lowers cost of adoption for an ever-wider circle, until it penetrates the whole economy.

Geographically, the process is similar. The paradigm spreads in the core country and then, as Maturity arrives and markets stagnate, propagates to the periphery. Through the life cycle of the revolution, the core country begins as a net exporter of the technology, then becomes a net importer as the paradigm reaches the periphery. Whether any particular country in the periphery adopts the new paradigm depends on its ability to take advantage of the opportunity.

Criticism #4: This Model Doesn’t Predict All Bubbles

While all technological revolutions have a bubble and a crash, not all bubbles are strictly connected with technological revolutions. Other collapses may have other causal chains.