By Leslie Pratch and Raj Alur
Economic disparity is what creates value because at every level there is an opportunity for arbitrage. I may have a particular way to leverage my status or technology to create a good, such as more economic wealth relative to someone else, on an average basis, not on an absolute basis. In emerging economies like India and China and in the past in America, this opportunity differs greatly from what we have in the U.S. today.
By stratification of wealth, we do not mean what happened under Communism, where a few, very few party elite lived like kings and almost everyone else had beans and water for dinner. What matters is a continuum with easy mobility upwards and a finite probability to jump across multiple layers. It is only capitalism that allows individuals to move up. The very rich and the very poor exist under capitalism and communism. We must look to the middle class, and its size and growth, to see the secret of capitalism.
Look to the middle class. That is the where the action is. In Czarist Russia, the number of levels was 1,000. The top echelon lived like kings and the rest of the nation starved. Mao Tse-tung starved tens of millions and lived a lawless and disgusting life well beyond the way anyone in the U.S. lives. Look to mobility. What we want is the chance to apply our talents. Give us the chance to move up!
China has decided to invest in us simply out of selfishness. We are among the best places to be right now for their money. If we continue to run peace-time deficits to the sky, as we presently are, that will change. Our worry is not that China will harm us; they want us to be able to pay them back. It is rather that our own Congress will harm us.
Milton Friedman did a wonderful study on wealth stratification (cited in Free to Choose, 1980). He showed was that way back when, wealth was far more widely spaced between poor and rich (and there were far more poor) and worst of all, the poor did not move into being rich, ever. Capitalism allows those, like you and me, who work very hard, to move up. No other system really does. “You cannot multiply wealth by dividing it.” And hence, capitalism was born.
Raj had a car driver in India who said that in 1958 he moved from a small village in the south into the same slum featured in Slum Dog Millionaire. There, he raised two kids. His oldest son is a civil engineer in Mumbai. His youngest son entered graduate school in electrical engineering and hopes to pursue a Ph.D. in the United States. Their father sold his property and made a large profit. But he still drives a taxi. This family has leaped across several wealth layers from abject poverty to middle class, all in one generation. This is the true story of Dharavi, the largest slum in the world.
If businesses in the U.S. cut salary and fringe costs by 35-65% (fringe costs consisting mostly of health care and dental, disability, life insurance), we will become a more competitive economy, especially compared to countries with an edge in information technology. We recognize we need to reflect on this issue and will do so in coming posts.
If in addition we also replaced “cash for clunkers” with “capital for entrepreneurs,” especially those pushing the boundaries on solar, vehicles, biological sciences, and computer sciences, we would create thousands of new enterprises and businesses across the country. These would generate more wealth, which would benefit not only the U.S. economy; it would also create a forward path for the rest of the world. The federal government should quit bailing out uncompetitive large industries and financial institutions and instead become a potent venture capitalist!
A fundamental macroeconomic factor that must happen is to bring down the cost of labor in the U.S. rather than enacting trade barriers. That is why it is important to visit places like India and China. The tax policies in India are far more progressive than in the U.S.; India’s social policies are also quite friendly. The socialist policies that existed in India during the 60s, 70s, and 80s are differ widely from what exists in today’s India. A true capitalistic tax system would be to have an inheritance tax. Taxing the wealth from one generation to the next is the answer. Unfortunately, the Bush administration changed that.
In India, the rise in taxation as one’s income grew used to be exponential. At the top levels of income, the tax rate was close to 99%. The result was an underground economy. Now the capital gain tax is a flat 15% (up from 10% a year ago) and the maximum individual income tax rate is 30%. India had policy makers who created a smart taxation policy. At the same time, the Indian government is involved in other socially beneficial programs. Our fear is that discourse in the U.S. has become so polarized that it will become impossible to enact the economic policy that will inspire entrepreneurial activity in the short- and medium-term and the correct socioeconomic policy for the long-term.
Entrepreneurship is created by less governmental intervention and lower capital gains taxes. It has been shown a hundred times. In the end, rising consumption in India will raise U.S. income levels. As an example, most Indians are used to income disparity. It is not that different income levels are bad; social and economic systems are not designed to give parity at the same time. Any economic system will say there must be a path to happiness. Either the system offers a path up or the individual accepts his or her station.
On October 15, 2009, the New York Times reported that the European Union and South Korea took a major step toward a free trade agreement aimed at generating billions of euros in new commerce:
With talks on global trade deadlocked and rising concern about protectionism, analysts said the deal could signal other nations to press ahead with their own bilateral pacts. After two years of negotiations, an agreement was signed in Brussels by the European trade commissioner and her South Korean counterpart. The pact now needs approval from the European Union’s member states, some of which face intense opposition to the deal from sectors like the automotive industry.
Under the agreement, the two sides will remove virtually all tariffs between their economies, as well as many non-tariff barriers, over a five-year period. The European Commission, the executive arm of the union, said the trade in goods between Europe and South Korea was worth about 65 billion euros ($97 billion) in 2008, and that the deal was worth 19 billion euros to European exporters alone. The European Union runs a deficit with South Korea in goods trade. A free trade agreement between the United States and South Korea, reached in 2007, has yet to be ratified and is stuck in Congress. Some American politicians oppose the deal over concerns it will harm automakers.
This furor over free trade versus protectionism is relatively minor compared to issues implicating a combination of a floating exchange rate system and the end of all currency controls and trade barriers, even “voluntary” export quotas.
As Paul Krugman points out, “Trade barriers are a minor issue for the United States today; even small wrinkles in health care policy, like overpayment to Medicare Advantage plans, probably matter more to public welfare than all the trade restrictions now in place.”
His point is well taken. Political discourse and policy making in the United States has become too myopic and insular. He also noted recently, “U.S. officials have been extremely cautious about confronting the China problem.” He believes China’s caution makes little sense. “Suppose the Chinese were to do what Wall Street and Washington seem to fear and start selling some of their dollar hoard. Under current conditions, this would actually help the U.S. economy by making our exports more competitive.” With the world economy in a precarious state, seeking economic policies by major players that worsen the problems of other countries cannot be tolerated. Something must be done about China’s currency.
In addition, we should keep a watchful eye on China’s increasing hunger for commodities and the implications thereof on commodity prices. Take for example, China National Offshore Oil Corporation (CNOOC). CNOOC is in talks with oil-rich Nigeria to buy large stakes in some of the richest oil blocks in the world.
In a research note dated October 19, 2009, Deutche Bank writes:
China has grown closer economic and business ties with emerging markets across the globe, raising its profile and enhancing its economic and political clout. Thus far, China’s interests have been driven mainly by its thirst for energy and commodities–in short, commercially-driven. It is pointless for traditional powers to try to stop China’s growing influence. It would be more productive if traditional powers responded to China’s emergence by enhancing their own positive engagements with EM regions.
China has grown closer economic and business ties with emerging markets across the globe, raising its profile and enhancing its economic and political clout. Given that nations are economically tied, it is hard for one nation to wage a differential war against another. We should become more cooperative and look at larger interests of humanity. Not that we would confuse that argument with entrepreneurship and the ability to make wealth.
Milton Friedman argues in Essays in Positive Economics that “current economic and political conditions make a system of flexible or floating exchange rates-exchange rates freely determined in an open market primarily by private dealings, and like other market prices, varying from day to day-absolutely essential for the fulfillment of our basic economic objective: the achievement and maintenance of a free and prosperous world community engaging in unrestricted multilateral trade. There is scarcely a facet of international economic policy for which implicit acceptance of a system of rigid exchange rates does not create serious and unnecessary difficulties.” “The sooner a system of flexible exchange rates is established, the sooner a system of unrestricted multilateral trade will become a real possibility.” (pp. 157-158).
If there is no major incentive to move up in the income strata, why work harder, unless I am motivated by altruism. One can either argue that spiritually it’s the right thing to do. Or one can adopt a rational argument: Every human being has the underlying energy to work and establish a differentiation between oneself and the rest of society.
The potential to move up the wage ladder is what makes great nations. In order for the U.S. to keep a dominant world position, we need to be 10 steps ahead of the rest of the world. We need to propel the rest of the population up but by generating new wealth, by creating new avenues for wealth, rather than taxing everyone more. It is critical to have the incentive to move up the curve. Silicon Valley is an example. Overnight, entrepreneurs could jump up income levels radically, from making $200,000 to making $2 million after an IPO. The promise of wealth creation drives innovation. A government that takes away the potential to jump across brackets of income will not have sustained global influence.
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
Raj Alur is an entrepreneur and technologist born and raised in India, educated in the United States. Currently, he Investment and Strategy consulting in renewable energy and telecommunications. Recently, he marketed green energy solutions globally. Previously a venture capitalist with Vesbridge Partners and St. Paul Venture Capital, he has also served as a CEO of a Boston area wireless data startup and VP of Marketing at Lucent Technologies among others. He started his career as a software engineer designing operating systems and file systems. Raj holds an M.S in Computer Science from Boston University and an M.B.A. from Cornell.
By Leslie Pratch
I recently got an email from a friend who complained about lack of liquidity mechanisms into the U.S. economy. To quote my friend: “The market today is dominated by liquidity providers but the liquidity provision mechanism is broken. Unfortunately there is a presumption that that functional capitalism requires these dysfunctional liquidity providers (hedge funds, frequency traders, etc.).”
What did he mean?
Although I am not an economist, my impression, from trying to stay abreast of policy debates, is that since the 1930s, economists think that government should make policies that smooth out bumps in business cycles. To stimulate the economy during periods of low growth, the policy would take the form of government spending and tax breaks. To curb inflation during periods of high growth, the intervention would take the form of cuts in government spending and tax hikes. For a recent review of the theory, implementation,and effectiveness of Keynes economic policies, see this book.
Milton Friedman advocated the monetary policy view. He specifically advocated for increasing the money supply after getting into a position of stability. The economy would be stable if the government increased the money supply at a 3% annual rate. Friedman also said that if the Federal Reserve tightened the money supply too much, the result would be deflation. He said the Great Depression was caused by the fact that the Federal Reserve shrank the money supply by a third. The effect was terrible; it caused all kinds of misery. People were and are worried about that happening again. In my opinion, Ben Bernanke deserves several Nobel Prizes in a row for peace, medicine, and lesser-than-anticipated economic disruption because he has kept the economy stable. When the economy is stable, fewer people die.
Canada has been fine all this time. Canada has too-big-to-fail banks. Paul Krugman wrote a blog about it two months ago. People in the money business are looking for ways to make more money, like any people in business. Car makers want to sell more cars, doctors want more patients.
Good policy provisions can cause you to increase the whole assemblage of goods and services such as cars, medical supplies, and education. Bad policy can cause you to cut back on those goods and services. In many countries, taxes have gone up to give people public, social goods or private goods, such as subsidies to buy houses. But if you want a growing assemblage of goods and services and changes in taste, then the money supply should be the servant of that policy. Traders of financial derivatives would argue that the availability of these complicated liquidity instruments helps to manage the stability of these goods and services. Others would say that interfering with the money supply interferes with the fullest creation of real goods and services.
Milton Friedman said that the money supply consisted of demand deposits, plus currency, then added timed deposits. People have conventions about what the money supply is but it has not been settled. I think that money is a good thing to have. It serves as a store of value. Let’s think of money as a commodity that minimizes transaction costs. To put it simply, if we didn’t have it and I wanted a haircut, and the person who cut my hair wanted a car, we couldn’t do a transaction.
Where do hedge funds come in? What did my friend mean by the presumption that capitalism required dysfunctional liquidity providers? Liquidity is not about money itself. It is about the ability people have to transact goods and services without having to mark up or down the price much. People can buy and sell stocks or houses without much price increases or decreases. Hedge funds and frequency traders provide a readiness to buy and sell stuff in response to a proposition from the other side. Frequency traders make it possible to sell a stock at three times as much as it’s worth at a given time.
In order to have liquidity, with substantial amounts being able to flow between buyer and seller, a number of things are required. You need a money supply but you also need a set of views on the part of the public that if I think my house is worth X, then I have to be able to sell my house in the next month or two. People live with that degree (a month or two) of illiquidity; perfect liquidity means you could sell it instantaneously. Hedge funds are additional buyers and sellers of stock. If I want to buy a house I want to be able to sell some stock to have the money to buy that house. I think we need much more sophisticated regulation of derivative securities, their creation and their trading because we got into deep trouble two years ago. We also had baloney going on with sub-prime mortgages. So yes, there has to be some careful monitoring of derivatives.
While I am on the subject, I was curious that this same friend then went on to propose a “return to the dividend payout model” as a method of valuing a company. Merton Miller and Franco Modigliani wrote about the dividend payout model. Essentially, the value of the stock depends on three things. It depends on the cost of equity capital for that enterprise, it depends on the growth rate of the company, and it depends on the return on capital that the company is able to earn. In this line of analysis, the company should keep money it has and invest in projects that return more than the cost of capital. If it doesn’t have enough money, then it should sell stocks to invest in projects that do provide a return on invested capital. The dividend policy growth and the valuation of shares has a fair amount of mathematics and algebra, with three factors essentially involved in valuing a company: the cost of capital, the return on capital, and the rate of growth. There’s no reason that dividends even have to be paid. If dividends are taxed more than capital gains, then wouldn’t you prefer stock buyback plans?
Thank goodness for Paul Krugman. It gets very complicated very quickly.
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
By Leslie Pratch and Raj Alur
In our first entry in this series, we wrote:
If businesses in the U.S. cut salary and fringe costs by 35-65% (fringe costs consisting mostly of health care and dental, disability, life insurance), we will become a more competitive economy, especially compared to countries with an edge in information technology. We recognize we need to reflect on this issue and will do so in coming posts.
Edward Hadas, Martin Huchinson, and Antony Curry do some of the analysis for us in their post, dated Nov. 11, 2009. Their journalism indicates that although the global wage gap is shrinking, wages in the U.S. for comparable products exceed those of foreign workers.
We in the United States must find a way to compete with lower-cost producers in Eastern Europe, Asia, and elsewhere without eliminating our legal system and other mechanisms that allow the U.S. economy to function in a more or less transparent and fair way, and which protect workers’ rights. We are not advocating slave labor, of which many readers accused us. We would all like to enjoy the prosperity of the 1980s and much of the 1990s. But we will not remain competitive in a global economy in which manufacturers can purchase equally safe, high quality, but less expensive components for parts used in manufacturing.
If workers in the United States leverage the higher productivity that makes our country richer, such as superior education and legal system, and access to capital markets, then their products will and should cost less in the long run. If the costs of sending goods overseas exceeds the savings, that is one factor that would reinforce the global wage gap. The other factor that might diminish global wage gap is the increased quality of such goods. As Hadas, Huchinson, and Currie point out, “Both measures point to a narrowing wage gap.”
What are the forces that push up productivity in emerging countries? They include: rapid development cycles; cheaper capital (especially in light of the tight and for many months, frozen capital markets in the U.S. during the past two years); and greater efficiencies in transporting goods across borders. Communication through the internet is virtually free and reduces myriad expenses, facilitating the trade of goods and services.
Messrs. Hadas, Huchinson, and Currie conclude, rightly, we believe:
The required cut may be smaller. But if US wages get stuck above the market-clearing levels, as in the 1930s, the result could well be something approaching 1930s levels of unemployment. Pretty well anything would be better than that. A combination of moderate inflation to reduce real wages and a further drop in the dollar’s real trade-weighted value might be an acceptable combination.
These are serious times and the U.S. faces serious threats. It is time to stick out heads out of the sand and get U.S. workers acclimated to the fact they may well have to tighten their belts on a permanent basis.
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
Raj Alur is an entrepreneur and technologist born and raised in India, educated in the United States. Currently, he Investment and Strategy consulting in renewable energy and telecommunications. Recently, he marketed green energy solutions globally. Previously a venture capitalist with Vesbridge Partners and St. Paul Venture Capital, he has also served as a CEO of a Boston area wireless data startup and VP of Marketing at Lucent Technologies among others. He started his career as a software engineer designing operating systems and file systems. Raj holds an M.S in Computer Science from Boston University and an M.B.A. from Cornell.
By Leslie Pratch and Raj Alur
Just as a reminder to the reader: We expect our remarks will generate some debate. Please tell us what you think by commenting in the Comments Box below. We will reply as soon as we can.
Fair taxation is the only true driver for an equitable and stable society. Excessive corruption within government and lobbying have made the U.S. tax code both unwieldy and unfair, serving only those tax payers with enough money to exploit the loopholes. The simple answer is to scrap the code completely and replace it with a sliding scale of tax on everyone with no exceptions, no special interest groups, no trust funds to protect the rich – and the only groups eligible for exemption are charities.
But wouldn’t a simple sliding scale destroy businesses and kill innovation? Surely not! There is always room for true entrepreneurship. The discovery of a useful drug that could heal where others could not deserves to earn a premium. A sliding scale on income tax would not destroy innovation. It would merely even the field all around. Remember: Our country was founded was a fair playing field and competition.
Do we really need trust funds? The wealthy have enough money to provide for their children (which includes the cost of education). A trust would then serve only to reduce the tax or to protect one’s assets in case one goes bankrupt. Neither of these reasons is acceptable for the creation of trust funds. The super-wealthy could create scholarships for fatherless but promising youngsters in war-torn regions outside the U.S. or urban ghettos. In both cases, the chances of that young person becoming a productive adult are slim compared to the effects of higher education and mentors when they’re needed.
These kinds of scholarship and mentoring programs are a far better use of surplus income of a wage earner that turning that money into a trust fund for a kid who would as easily blow it all away on a cocaine habit (or compulsive shopping.) A virtuous cycle beginning with directing a financial surplus from the core family unit (once basic legitimate expenses are covered for the rest of that family unit’s life) is an example of creating a social good.
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
Raj Alur is an entrepreneur and technologist born and raised in India, educated in the United States. Currently, he Investment and Strategy consulting in renewable energy and telecommunications. Recently, he marketed green energy solutions globally. Previously a venture capitalist with Vesbridge Partners and St. Paul Venture Capital, he has also served as a CEO of a Boston area wireless data startup and VP of Marketing at Lucent Technologies among others. He started his career as a software engineer designing operating systems and file systems. Raj holds an M.S in Computer Science from Boston University and an M.B.A. from Cornell.
By Leslie Pratch and Raj Alur
Political pundits talk about deindustrialization in the United States. These days practically any unfinished product can be made in India and China. Where education fits into this mix is important.
The Chicago Public Schools (CPS) is the third largest public school system in the United States. The split between Black and Hispanic kids in the inner city schools is appalling; the gang problem, horrific. There is talk is of putting semi-authorized veterans as guards in schools, to make a school a community center.
On October 27, 2009 Juvenile Court officials, police, and school officials met to discuss ways to share information to ease the violence against Chicago students. One question was whether court officials could share information on court-involved youth with educators to prevent violence or deal with its aftermath. The statistics exist to predict which students are more likely perpetrate violence and which are likely to be victims, but civil liberties’ laws prevent the police from sharing such information with educators.
In January 2009, Ron Huberman became the CEO of CPS. Huberman oversees a budget of over $6 billion. When his term commenced in January 2009, he promised to focus on safety, performance, mentoring, a reduction in teacher turnover, and a safe place for kids to go at night. But what he describes is more management. He will be waving his arms and hoping to catch mosquitoes. We wish him luck. As a strategy professor at the University of Chicago put it: “Good management with a bad strategy is almost always a loser. We in the U.S. need to win on the public schools. It is vital to our country. That’s why so many are passionate on charter schools: They work. I have asked every person who is against them why, and I’ve rarely heard a reasonable response yet. One of the best answers I have heard is ‘the teachers unions elected me and I promised I would protect them.’ That makes sense. Let’s ruin the country but protect a union.”
“We know how to better the education system in the United States. It is very simple and being tried with great success now: School Vouchers. It works wonders, absolute wonders. Ask your Congressperson why it isn’t the law of the land. The Greater Chicago School System will not improve without outside competition.”
Vouchers are subsidies that grant limited purchasing power to a student to choose among a restricted set of private schools. In the traditional school funding configuration, public funds for public schools flow from national and state governments and local communities, directly to school districts. A family wishing to send its child to a private school must do so with its own funds. A large-scale voucher plan would allow families wishing to enroll their children in private school have the tuition partially or completely covered by tax-levied dollars. The role of the government would be limited to ensuring that schools met certain minimum standards, such as the inclusion of a minimum common content in their programs.
In Capitalism and Freedom Milton Friedman advocates vouchers, which students may use for education at a private school of their choice. He believed that in a democracy, to be a citizen, everyone needs a basic education. Thomas Paine also advocated a voucher system because he felt that compulsory education violated individual conscience. He, in turn, followed John Stuart Mill, who believed that state-sponsored education instilled conformity.
Recently, a friend of Leslie’s moved to Seattle. The public education available his daughter was so inadequate that he and his wife—both Presbyterian—enrolled their daughter in a Parochial school. He was impressed that the school required parents to serve a certain number of hours on behalf of the community. This practice is reminiscent of the Corvée taxes in Medieval Europe, where serfs owed a certain number of hours on the roads in the feudal domain. The Corvée was a certain number of days a year devoted in labor. If we are required to get a license to drive a car, why not require service for education? It is a reasonable experiment as an alternative to purely government-levied taxes.
Moreover, the voucher system misses the nature of schooling. Schooling involves teaching the curriculum. Parochial schools do maintain discipline. The voucher advocates presuppose that parents know what they want from the school. But do they? Do parents know what they mean by education? Is it etiquette? Is it getting the kids out of their hair so they can go to work? Is it education? Is it all three? It is not clear that vouchers would improve education because it is not clear that parents know what they want out of education. They may want kids who do not talk back. Education teaches children to talk back.
Reviewing the above, were are struck that of the critique focus on obvious, peripheral issues such as:
- Education is necessary for democracy to work (Friedman, Paine, John Stuart Mill);
- Moaning that public schools are not providing good education;
- Competition (parochial, private, versus public). This argument assumes that by injecting competition, public schools will improve. How many public institutions have improved purely because of increasing competition? Competition works if by beating the competitor yields tangible material and monetary benefits. FedEx earns more EPS and management, shareholders, and employees share the loot if they gain market share over UPS. The US Postal Service’s success, however, is not measured using the same metric.
We have some ideas.
- How about focusing our dollars on teaching methodology, on pedagogy, and on a variety of pedagogical techniques. Whether it be public, private, parochial, or charter, we are not close to leveraging computing and communications technology to the hilt.
- How about getting Google, Apple, Microsoft and the Gates Foundation involved in how to bring a laptop to every kid in public school?
- How about videotaping the “best teachers” from across the country/globe teaching everything from Algebra to U.S. History and delivering it to each desktop?? How about interactive group classrooms, etc, etc???
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Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com or visit www.pratchco.com.
Raj Alur is an entrepreneur and technologist born and raised in India, educated in the United States. Currently, he is in Investment and Strategy consulting in renewable energy and telecommunications. Recently, he marketed green energy solutions globally. Previously a venture capitalist with Vesbridge Partners and St. Paul Venture Capital, he has also served as a CEO of a Boston area wireless data startup and VP of Marketing at Lucent Technologies among others. He started his career as a software engineer designing operating systems and file systems. Raj holds an M.S in Computer Science from Boston University and an M.B.A. from Cornell.