How does the economy work?


A colleague of mine in grad school once asked me to explain how the stock market works. I fumbled for a few minutes, tossing in phrases like “price to earnings ratios” and “returns to capital”, but it was clear he wasn’t being edified. (One of the best tests for whether you actually understand a concept is to try to explain it aloud, which is why being a lecturer, at least for me, can induce such anxiety.)

He then asked me, if I couldn’t explain how the stock market worked, why he should invest in it. If the stock market operates as a black box, with its inner workings occluded, then what is to say that the Rube-Goldberg mechanism that drives it won’t suddenly collapse (as has happened in the past)? In other words, why should we entrust our financial future to a system that seems to rely more on faith than on physics? Here, I thought I had a better answer. The reason for investing is inductive, not deductive. The stock market goes up, on average, at 4-5% per year, even after accounting for the occasional crash. This is an empirical fact, not the conclusion to a syllogism. Whether there are reasons for this behavior that I can explain is irrelevant; surely one does not need to understand the inner workings of the combustion engine to be able to trust that your car will deliver you from Phoenix to Los Angeles. And, even if the combustion engine obeys the laws of thermodynamics and there are no corresponding laws of capital accumulation: in other words, even if the stock market were a collective delusion, we will profit as long as we continue to be collectively deluded. This concept of the stock market is like the pragmatic theory of truth: it is a theory to guide our behavior, not to tell us how things actually “are” (if that is even knowable).

8 years later, I am no longer just investing in the economy; I am also part of it. If, as a grad student, I was observing only the black surface of the box, now, as an employee (or, at least, an erstwhile one), I can see the cams and pistons that its machinery comprises. The pragmatic theory of the stock market is much easier to justify is one is outside of the box, looking in, rather than inside, looking out. Ignorance truly is bliss.

I find it remarkable how many companies violate the laws of unit economics: their cost to acquire a customer is more than the profit they derive from that customer. (My former company is about to shutter because of this problem.) One example is Blue Apron, the meal-kit subscription company. Shortly after its S-1 filing (which is a financial form sent to the SEC by a company that seeks to go public), a professor at Emory University, Daniel McCarthy, published a pair of fascinating essays: 1) “Blue Apron’s IPO Filing Implies Troubling Customer Retention” and 2) “A Detailed Look at Blue Apron’s Challenging Unit Economics”. (They are relatively accessible even if you don’t have a background in economics or statistics.)

He writes, “virtually all the analysis [of Blue Apron to date] has focused upon traditional financial metrics such as revenues and net profits (e.g., “revenues and losses are both going up!”) or surface level analysis of their disclosed customer metrics (e.g., “average orders and average revenue per customer were down year on year!”).” McCarthy discovers that Blue Apron was likely stuck on the “acquisition treadmill.”. It would spend heavily on advertising to acquire new customers, at a cost of roughly $100 per customer. Each customer would make the company, on average, $25 in gross profit per month. However, more than half of those customers left after the first month of their subscription, and more than 70% abandoned the service after 6 months. The math, at this point, should be obvious. McCarthy estimates that 70% of its customers were unprofitable on a unit economics basis (i.e., before accounting for overhead costs). And it is almost certain that Blue Apron’s leadership was aware of these problems before filing for the initial public offering (IPO):

But what did the S-1 actually say about the true underlying propensity of subscribers to acquire and stay with Blue Apron? There has been far less written about this, because as Tren Griffin and PitchBook Data had noted, churn metrics were surprisingly absent from the filing (in stark contrast, for example, to the treasure trove of customer data disclosed in furniture e-commerce retailer Wayfair’s S-1)

In other words, Blue Apron chose to hide the evidence of poor retention, and it came to light only because McCarthy put together a statistical model to infer the retention curve from other data.

If someone were to ask me, “How does Blue Apron work?”, I would be of two minds. In the conventional sense, Blue Apron doesn’t work. They shouldn’t be in business because they lose money on most of their customers. After McCarthy’s analysis came to light, its stock price started a long slide from $10/share to less than $1/share, and its valuation decreased from more than $2 billion to close to $100 million.

In the pragmatic sense, though, Blue Apron worked for its initial investors. Here’s an excerpt from a CNBC article written a year and a half after the IPO:

Financial advisor Josh Brown of Ritholtz Wealth Management, who runs the Reformed Broker blog, didn’t mince words on Twitter earlier this week, saying, “One of the worst IPOs I’ve seen in the post-crisis period. Everyone knew this was an escape plan for insiders/VC. I can’t believe The Street sold this for them.”

Goldman Sachs, Morgan Stanley, Citigroup and Barclays were lead underwriters to its IPO.

Elliot Lutzker, a former SEC attorney who works with companies preparing for public offerings and on SEC compliance matters at the law firm Davidoff Hutcher & Citron, said a viable deal doesn’t mean a properly valued deal, or even close to it.

It is tough to construct a charitable explanation of this behavior, one that doesn’t indict the venture capitalists and big bank underwriters as guilty of deceptive and fraudulent behavior. They sold the public a pile of shit, made out with millions, and left asset management firms and pension funds with the losses. (If that reminds you of the last financial crisis, it should.). Funnily enough, even their IPO itself was a giant marketing stunt.

Blue Apron isn’t an isolated case. There are dozens of “direct to consumer” companies with the same problems of high cost of acquisition and poor retention. One recent example is Casper, which is valued at over $1 billion.

“We have a history of losses and expect to have operating losses and negative cash flow as we continue to expand our business,” Casper said last week in its financial filings. The mattress maker’s sales increased a cumulative 20% in the first three quarters of last year, down from growth of more than 40% in each of the previous two years.

Faced with the dismal unit economics of mattresses (i.e., the fact that repeat purchases are highly unlikely), Casper has fallen back to Gwyneth Paltrow-inspired mumbo jumbo about its business:

“We believe that sleep consists of more than just the act of sleeping, and instead, includes the entire set of human behaviors that span from bedtime to wake-up and affect sleep quality,” Casper said in the filing. “This is what we refer to as the ‘Sleep Arc.’”

The company boosted spending in developing sleep products by almost 90% to $12.3 million in 2018. It now has novelties such as the experiential “napmobiles” — mobile pods that let people test its mattresses. The company has developed and now sells a product called Glow Light, a $129 lamp that brightens and fades “with the body’s circadian rhythm.”

Another instructive case, when talking about unit economics, is Uber. Hubert Horan, a transportation expert, published a long peer-reviewed article about the economics of Uber. It’s well worth a read, but here is the key conclusion:

An examination of Uber’s economics suggests that it has no hope of ever earning sustainable urban car service profits in competitive markets. Its costs are simply much higher than the market is willing to pay, as its nine years of massive losses indicate. Uber not only lacks powerful competitive advantages, but it is actually less efficient than the competitors it has been driving out of business.

Uber’s investors, however, never expected that their returns would come from superior efficiency in competitive markets. Uber pursued a “growth at all costs” strategy financed by a staggering $20 billion in investor funding. This funding subsidized fares and service levels that could not be matched by incumbents who had to cover costs out of actual passenger fares. Uber’s massive subsidies were explicitly anticompetitive—and are ultimately unsustainable—but they made the company enormously popular with passengers who enjoyed not having to pay the full cost of their service.

Starting in 2015, Uber eliminated most of the incentives it had used to attract drivers and unilaterally raised its share of passenger fares from 20 percent to 25–30 percent. Almost all of Uber’s margin improvement since 2015 is explained by this reduction of driver compensation down to minimum wage levels, not by improved efficiency. These unilateral compensation cuts resulted in a direct wealth transfer from labor to capital of over $3 billion. Comparable cuts at Lyft resulted in a labor-capital wealth transfer of $1 billion.

The story of Uber is astounding, when you think about it. Not only does it rely on anti-competitive practices to squeeze its drivers’ earnings to unlivable levels, but it simultaneously manages not to make a profit while doing so. It would be as if the owners of the Triangle Shirtwaist Factory were burning their own money, not just their workers. (I thought the point of exploitation was to make a profit?)

In a story akin to that of Blue Apron, though, some investors in Uber have made out like bandits.

Goldman Sachs sold its entire stake in ride-hailing giant Uber in the fourth quarter [of 2019], according to a person with direct knowledge of the move.

The sale, which likely resulted in a large gain for the early investor in Uber, helped the bank beat analysts’ expectations for revenue in the period.

It appears that Goldman, which reported earnings Wednesday, sold at the earliest opportunity: Uber’s post-IPO lockup period for share sales ended in early November.

I’m sure that I’m guilty of taking too many anecdotes and thinking that, collectively, they constitute data. But it is unnerving how many companies seem to be guided by this Ponzi scheme mentality. A fundamentally unsound business model is supported by gobs of venture capital. That capital is used to acquire customers, at an increasingly dizzying pace and at ever increasing costs. (If you want to know how Google and Facebook obtained market capitalizations in the realm of a trillion dollars, this is it.) The inadequacies of the business model are explained away by business school bullshit about synergies and disruption and new modes of buying and living (the “Sleep Arc”, for instance). With its spending on advertising, the company’s image is burnished in the minds of the public — after all, would a failed business be able to blanket the subway with clever copy? —, who are the ultimate marks in this con. And the purpose of the IPO is to transfer the risk (and, to be clear, with Blue Apron and WeWork and Uber and Casper, it’s all risk) from sophisticated capitalists to the unsuspecting public. Meanwhile, everything looks rosy to the law and economics crowd, because customers are getting mattresses delivered to their door, cheap rides around town, meals that they can prepare in their rapidly diminishing supply of free time, and co-working spaces that will house them as they power the next generation of fraudulent fads.

As bleak as it sounds, it seems that the only way, as a laborer and not a capitalist, to make it in this economy is to swallow our doubts and engage in the collective delusion: to have a “pragmatic theory of labor”. I invest my money in the S&P 500 without believing that many of its members are legitimate, with the knowledge that it will work out to 4-5% in the end, somehow. (As Keynes said, “The market can remain irrational longer than you can remain solvent”) Perhaps I should also invest my time working for companies that I know are not legitimate, with the knowledge that as long as I’m being paid 6 figures, it doesn’t really matter where the money is coming from or how it got there. I’m reminded of my friend, a software engineer, who has gotten severance at three of his last four employers, and seems remarkably unperturbed by that fact. Here’s to four out of five, I guess.


4 thoughts on “How does the economy work?

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