What the machine does to the future, the case that it’s fine, and the case that it’s not.
Garvin Jabusch | Co-Founder & CIO, Green Alpha Advisors dba Next Economy Investments | August 2026
Put a dollar into the stock market and roughly five dollars of market value appears. That is not a metaphor. It is the central empirical finding of Gabaix and Koijen’s “Inelastic Markets Hypothesis”, and it means flows do not merely reflect prices, they also manufacture them. Most of the market cannot lean against a flow: index funds must hold their weights, pension mandates must follow their policies, target-date funds must fall in line accordingly. So when money moves, prices move with it, multiplied.
Now aim that multiplier with a formula that directs the most new capital to whatever has already grown largest, and you have the machine described in The Yardstick That Ate the Market Part 1:a benchmark oligopoly paid by the assets tracking its products. Rather than for being right about anything, it is a yardstick that amended its own rules to admit SpaceX, with absentee owners who cannot sell and will not dissent. That was the anatomy. Part 2 is about consequences: what the machine does to the economy’s forward production function, meaning what we will actually be able to build?
It is also, deliberately, a note that argues against itself. The first half completes the prosecution: four mechanisms, each independently documented. The second half makes the case for the machine as strongly as its best advocates would, because an argument you haven’t tried to lose isn’t one you’ve won. Finally, I’ll show you where I think the defense of blind indexing breaks.
The forward production function: why this even matters
So what does it do to an economy when the marginal equity dollar is allocated this way? Four answers, all leading the economy in the same direction.
First: cap-weighting allocates capital in proportion to the past and calls it prudence. A capitalization-weighted index is, definitionally, a momentum machine pointed backward: it directs the most new capital to whatever has already grown largest. There is no mechanism inside it, none, that asks whether a company’s assets have a future. It is the industrialization of extrapolation.
Second: passive growth degrades the price signal everything else depends on. Grossman and Stiglitz showed in 1980 (“On the Impossibility of Informationally Efficient Markets,” American Economic Review), that prices are only informative because someone is paid to make them so; if nobody gathers information, prices can’t reflect it. Every dollar migrating from research-driven strategies to index-replication shrinks the aggregate budget for figuring out what companies are actually worth. Related work by Haddad, Huebner, and Loualiche (“How Competitive Is the Stock Market?”) finds that the rise of passive investing has made aggregate demand for stocks measurably less elastic, meaning fewer investors stand ready to trade against mispricing when it appears.
Third: in an inelastic market, the distortion compounds where the money lands. Return to the five-for-one multiplier that opened this note. Because most holders are constrained and cannot lean against the flow, the mechanical, cap-weighted routing of new money disproportionately inflates the largest incumbents, cheapening their cost of capital relative to challengers for reasons that have nothing to do with their prospects, fundamentals, or even what the company does. Flows became the fundamentals, and the incumbency collects the fees.
Fourth: universal ownership may be quietly softening competition itself. Azar, Schmalz, and Tecu’s Journal of Finance study found that common ownership by overlapping institutional investors was associated with meaningfully higher airline ticket prices, implied concentration increases ten times larger than antitrust authorities’ threshold for presumed market power. A firm whose largest shareholders also own all of its competitors faces blunted incentives to compete, invest, and disrupt. (This literature is genuinely contested; a 2022 Journal of Finance paper disputes the airline findings, and Azar’s own later work suggests economy-wide common ownership may cut the other way, but the mechanism is the kind of thing you’d want someone to be watching, and the watchers own the airlines.)
There’s a name for this arrangement, and it isn’t a flattering one. Peter Thiel built a worldview on the claim that “competition is for losers,” that monopoly is the natural aspiration of any serious business. His defense was that monopoly profits fund invention. The index complex has arrived at Thiel’s destination without his alibi: sixty-point margins on a sorting rule, distributed by an oligopoly of three, resting on an ownership structure that quietly holds Thiel’s thesis on behalf of shareholders who never had to adopt it, because when you own every firm in an industry, competition among them is just money leaving your portfolio. Thiel’s monopolism at least required a founder with intent. This one runs on autopilot, wearing Bogle’s humility as a costume.
Stack the four together and you get a coherent, uncomfortable picture: an allocation machine that funds the past at a subsidy, starves the price system that’s supposed to correct it, and defangs the ownership function that’s supposed to discipline it. For those of us who think the defining economic fact of this century is a once-ever transition in how civilization powers, feeds, moves, and heals itself, there’s a fifth consequence that follows from the first: a backward-pointed capital allocator will, by construction, keep funding the legacy economy’s capital expenditure until underlying reality (i.e. physics), not the index committee, forces the writedown. The index cannot see a stranded asset coming. Seeing things coming is precisely the function it deleted.
The case that index tracking is better
Everything above is the prosecution. Here is the defense, argued the way its advocates would argue it, because an argument you haven’t tried to lose isn’t one you’ve won.
The cost revolution was real, and it was enormous. Passive investing collapsed the toll on intermediating household savings from roughly one percent a year to a few basis points. Compounded across trillions of dollars and multiple decades, that is one of the largest peacetime transfers from the financial sector back to ordinary savers ever engineered. Whatever indexing costs the economy in allocative precision, it must be netted against what it returned to households in fees not paid. A cheaper pipe is itself a productivity gain.
Much of what passive displaced wasn’t price discovery, it was theater. The pre-index world was not a golden age of informed capital allocation. It was heavily populated by closet indexers charging active fees for benchmark-hugging portfolios. Passive didn’t kill research so much as it killed fake research, and there’s a respectable argument that this was a quality filter: the active management that survives cheap beta must actually differentiate to justify existing.
Grossman-Stiglitz describes an equilibrium, not a death spiral. As the passive share grows, the reward for genuine information gathering rises, because the remaining informed dollar has more price-setting influence. On this view the market doesn’t need more active managers; it needs fewer, better ones, properly paid by the inefficiencies indexing creates. (You will notice this argument is structurally flattering to concentrated, high-active-share fundamental investors. I noticed too. It being convenient for me doesn’t make it wrong, but you should know I checked.)
The secondary market may matter less for real investment than the critique assumes. This is the best arrow in the defense’s quiver, so take it seriously. Corporate investment is financed overwhelmingly from retained earnings and debt, not from issuing shares; net equity issuance in the U.S. nonfinancial corporate sector has been negative for roughly two decades, as buybacks exceed new issuance. Meanwhile the primary markets that actually form new capital, venture, growth equity, project finance, credit, remain intensely – sometimes pathologically – active. If public cap-weighting mostly reshuffles ownership claims on existing assets rather than directing new investment, its damage to the forward production function is second-order.
And broad, cheap ownership has a return the efficiency ledger doesn’t capture. Index funds put tens of millions of households on the right side of the capital share of income for the first time. In an era when the gap between asset owners and everyone else is a live civic wound, that’s not nothing. It may even be load-bearing for social cohesion, which, if you’ve read anything else I’ve written, you know I consider an input to the economy, not a decoration on it.
That’s the honest best case: indexing as a massively cheaper pipe that purged the pretenders, concentrated the rewards for real research, left true capital formation to markets it doesn’t touch, and broadened ownership of the productive economy along the way.
Where the defense fails
It fails in one place, and the place is load-bearing: secondary-market prices are the signal every other market steers by.
Concede the whole net-issuance point. Concede that companies fund capex from cash flow and that venture capital forms the new stuff. Every one of those decisions still navigates by public prices, and here is what that means in practice. The venture partner deciding whether a battery startup gets its next round is underwriting to public comparables that mandate-driven flows helped inflate somewhere else. The board approving or killing a decade of grid investment is discounting it against a cost of capital the multiplier helped set. The executive with eight figures of stock compensation is steering the company wherever the ticker points, and the ticker points wherever the flows went, and the flows went wherever the formula sent them, and the formula asked nothing. Follow the chain far enough and it always ends in the same place: someone’s retirement, wired on autopilot into a price that no one, anywhere, was paid to doubt. The corruption is not contained in the secondary market. The secondary market is the map the rest of the economy uses to navigate, and the defense has merely proven that we are driving into the ditch because the cartographer is blind, not because the engine is broken.
Likewise the cost argument, which is true and incomplete in the way a receipt is true and incomplete. The fee savings are real, countable, printed on every statement, celebrated annually. The costs never appear anywhere. There is no line item for the challenger that stayed capital-starved while its incumbent competitor borrowed against an index-inflated valuation. No statement records the capex that flowed into assets a decade of reality will strand, or the competition that softened once the same three shareholders owned both sides of every rivalry. The savings are visible because they were subtracted from a bill. The costs are invisible because they were subtracted from the future.
And we have run this exact experiment before. In the 2000s we outsourced judgment to an oligopoly of licensed measurers, paid by volume rather than accuracy, embedded their output in every mandate, and told ourselves the system was safe because the yardstick said so. In 2008 the yardstick’s word came due, and ordinary people paid it in foreclosures and lost decades. The index oligopoly has better margins than the rating agencies ever did, a bigger book, and the same alibi.
So the steelman, while real, narrows my claim but does not defeat it. The refined claim is this: indexing’s efficiency gains are real and were captured in its first act; its allocation costs compound in its second act, and they compound fastest precisely when the economy needs to reallocate most. In a static economy, a backward-looking allocator is merely inefficient. In a fast changing, innovative economy in mid-transition, where energy, materials, transportation, water, and biology are all re-platforming at once, a backward-looking allocator is a bet against the transition, made with other people’s retirements, collecting licensing fees all the way down.
What follows
I won’t insult you with a pitch; you can see where I live. But three conclusions seem to me to survive contact with the strongest counterarguments, and they’re actionable whether or not you ever own an active fund.
- Know who’s allocating your capital. If your equity exposure is cap-weighted, your investment committee is an index committee: unelected, unaccountable, paid by the total volume of assets in the products tracking the index, and structurally indifferent to whether the economy it’s funding can persist, much less thrive. That may still be a trade you want. It should at least be a trade you know you’re making.
- Separate the vehicle from the driver. Everything indexing genuinely got right – the low cost, the broad diversification, the tax efficiency – is a property of the vehicle, and the vehicle is a triumph. Keep the vehicle. The problem is the driver: a decision rule that steers tomorrow’s capital toward yesterday’s winners, in proportion, automatically, a driver that only ever looks in the rearview mirror. The two feel inseparable because they are always sold together, but they are not welded, they are bundled. Cheap, diversified, forward-weighted exposure is not a contradiction in terms. It is simply not what the oligopoly is licensed to sell, because the oligopoly gets paid the same whether the driver watches the road or not.
- Price the assumption. Every cap-weighted dollar embeds a forecast, whether its owner knows it or not: that the companies which dominated the last economy will dominate the next one, in proportion. That is not a neutral, riskless default. It is the single largest active bet in the world, and it’s simply the only one that never has to justify itself, because the yardstick that would measure it is the one making it.
In the essay that provoked Part 1 of this piece, Cory Doctorow calls Google a Bizarro-world Spider-Man: great power, no responsibility. He was writing about the internet’s absentee landlord. He could have been writing about ours. Nobody rigged anything. Nobody had to. We simply let a measurement instrument compound into a sovereign, kept calling it passive, and agreed not to notice that the thermometer had been setting the temperature for years.
The market still needs a scoreboard. It just needs a scorekeeper who doesn’t take a cut of the points.
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