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The wealthy nations.

The wealthy nations.

The fundamentals of growth have been discussed elsewhere, as have some of the economic changes that are in train. This section is concerned with the changing relationship between the economies of the industrial world and the state and private sector which they have to support. Funding the state is addressed elsewhere.

The text covers two broad topics. One of these is the operating environment in which the economy has to perform. The nice balance that must be struck between stakeholder protection and economic liberalisation is discussed. Second, we consider the uncertainties in the accelerated cycle of erosion and renewal to which all advanced economies will be subject.

The operating environment.

Elsewhere, we have discussed the growing complexity of modern economies and the regulatory tangle that has grown up in order to manage this. In a related section, we have shown how the economy is embedded firmly in a network of structures which both enable and slow it down. The lesson of the recent past has been that the quality of these interfaces are critical for economic success.

This does not amount to marketising everything, however, as seemed appropriate in the Eighties. Markets will not invent the policy goals, but merely clear against the tools that have been put in place. There are two sets of considerations which differentiate high quality structures from those which hinder progress

It is, for example, a paradox that those countries with the strongest employment legislation have the highest levels of unemployment. Further, those which offer chronic support to unemployment tend to have the most of it. The Netherlands, with rates of unemployment that are low for Europe, has 'covert' support schemes, such as seldom-challenged disability allowances, which lead the OECD to estimate that levels of underemployment may touch 30% of the adult population. Only one German in three over the age of fifty works, perhaps consequent upon the support which removes the incentives to seek work, and the employment protection regulation which deters employers. Figure 1 gives a snapshot of the consequences of this on long term labour productivity growth.

Figure 1: Restrictive employment regulation appears to lessen the growth in labour productivity.

Such issues are generic. There is much to manage in a complex economy, and most states have made efforts to remove themselves from areas where it does not need to be - particularly in the actual delivery of goods and services - in favour of effective oversight and regulatory framing of these. Europe and Japan are particularly heavily regulated, and the state spends a relatively high proportion of all value added in the continental European nations. Figure 2 ranks growth in overall economic output against an OECD index of restrictive regulation

Figure2: Ranked European growth correlates strongly with restrictive or prescriptive regulation.

Refining the regulatory hand will be an ever-more significant task for government. As our understanding of economic and social fundamentals becomes stronger, so the scope of policy becomes more circumscribed, something we explore in depth elsewhere. As this is the case, the nature of policy may be become less significant than the means by which these goals are pursued. It is the managerial 'style' which may create the difference between competitive success and failure

An example of this is the increasing independence granted to central bankers by political leaders. Interest rates are a key variable which, at present, states can control. (But, as an aside, perhaps not for much longer.) They are the primary lever by which policy controls the pace of the economy, and they define the exchange rate of most currencies. The complex and intimate relationship between inflation and various capacity ceilings, fiscal balances and money velocity need management if cycles of boom and bust are not to develop.

This is a system which we understand well, which we can perceive through the collection of suitable data and which we can manage. However, the tools that we use need to anticipate with small movements rather than react with large once; politicians have a major interest in these matters and are inclined to intervene for party political reasons; and there is a major amplifier of events in place in the anticipation and arbitrage of capital markets. Coping with this by isolating a nucleus of expertise away from the political heartland - and giving it a duty to consult and to discuss it s views - seems a rewarding move. US and German initiatives of long standing have now been emulated by most industrial nations and, although at the time of writing this is far from a happy example, the Euro.

Complex regulation is here to stay. The key issue is how it can do its task well, and not to do tasks best left undone or to others. The answers to this may well vitiate the existing political institutions - by ceding power and policy choices to subsidiary organisations - and demand new skills of political leaders. But this is discussed elsewhere.

Erosion and renewal.

Two coupled systems operate in every economy. One of these is concerned with expectations of the future, and it follows swings of remarkable persistence. We tend to call this force 'market sentiment'. Figure 3 shows a measure of this (Tobin's q) for the US market since the great depression. (As an aside, the current very high level of positive market sentiment is reflected by very considerable deviations from the historical relationship between GNP and the Dow Jones, which had held steady from 1897 to 1987. We are in new terain, something reviewed below.)

Figure 3: Tobin's q swings for long periods either side of unity.

Figure 3 is best interpreted as follows. In the phases shaded red, market assets are worth more than the physical or other assets that they represent. In such a world, one should build factories and sell them. In the blue phases, assets are valued at less than their replacement costs: one would sell a new factory for less than it cost to build.

We began by suggesting that there were two interlocking systems at work in any economy. Market sentiment is one of these. The other consists of a balance between erosion and renewal. Renewal can occur in a number of ways: by starting completely new things or by regenerating old ones, by finding new customers in old markets or by entering new ones. Erosion - whose symptoms are obsolescence and declining margins - is less straightforward. What, after all, is being eroded?

A useful way of looking at business competition is that it is fought out around a series of key variables. One firm may be strongly positions versus another in respect of one or more variables - for example, speed to market and the capacity to exploit new technology - and this allows it to define a defensible position for itself. A whole jargon has arisen around these issues: the boundaries of the defensible position are known as 'rent barriers' and the processes which defend it are called 'key, distinctive, or defensible competencies.' The heartland is known as the 'core' or the 'core focus' and less than meaningful twaddle can be spun about the need to leverage our defensible competencies to ensure shareholder value', or the like. Life is never quite as clear cut as these ideas suggest, however, for two reasons.

First, competition is seldom as symmetrical or mono-dimensional as this suggests. Second, what determines profit is often more to do with sectoral cost profiles and so-called entry and exit barriers, rather than the efforts of individual firms. We shall touch on this in a moment.

These caveats aside, firms do find the grounds on which they stand become eroded. What was a world-beating product becomes emulated and supplanted over time. A wide range of factors are accelerating erosion, as discussed elsewhere. There is no reason to expect abatement and every reason to fear the intensification or these forces, based as they are on the pursuit of best returns, high quality goods, productivity and innovation. We shall legislate and agitate for more of them, despite some of the consequences.

Erosion strikes directly into the life cycles of products and processes, both of which become shorter. Managers have responded by streamlining what they do and outsourcing what is not - in the above terms - 'core'. In becoming more streamlined, a common technology base has been deployed and common data have been used (Re-engineering and bench marking.) These displaced large numbers of people from their jobs, cut costs thereby and so enthused the market. (We shall return to this in a moment.) The net effect has been both to raise the average performance and to close the gap between firms. They have all become very much alike as a result of these processes.

Firms have profits which are, obviously, set by the difference between their production costs and the price at which they can sell their goods. Cutting costs should, it would seem, increase profit. But only if prices stay the same.

What sets the price? Demand for the product, and the shape of the supply curve, which is defined by the cost profiles of the various suppliers. The marginal firms - the ones with the worst cost profile - will set the price, and the price will be equal to their marginal cost of supply. The will not manufacture for long when they lose money on each unit that they sell.

Figure 4 shows what happens after a period of re-engineering, downsizing and other commodity processes that can be bought off the shelf. On the left, a start-up industry has one major firm (ochre, left) and four progressively less effective companies. The weakest, the red firm, set the price. Industry profit is the area between the price and the cost of production, shown in yellow.

Figure 4: Commoditisation in an industry.

After a period of restructuring, the most effective firm has increased its market share and cut its costs, but all of the others have followed these down. The marginal firm (or in practice, the marginal units of most to the firms) set the price, as before, but this has fallen. Customers applaud. However, industry profit has evaporated.

This is called 'commoditisation', and appears much less in the consultant-driven literature than does the topics with which we began. Some 1600 US sets of competitors were tracked during the 1990s, and only a few of them were able to retain the rates of return on capital employed with which they began.

This second form of erosion may be the most grave. Product and process erosion can be handled on a relatively small scale: a new product, a better process. The so-called 'patchwork' strategies - or borrowing ideas, of setting up temporary alliances to bridge capability gaps - offers piecemeal upgrades whilst presenting no 'bet your company' great leaps into the dark. Such approaches have the merits of pragmatism, but may diffuse the organisation that does not know its own mind very well. However, sectoral erosion (and the turmoil in sectors, described elsewhere) is a much more problematic issue. It requires the fundamentals of the organisation to be re-thought.

The detailed means by which this is done are discussed elsewhere. The requirement that it be done is continual and urgent. No-one can step aside from this race without an end. In brief, however, the disciplines of clarity about what a company offers, and to whom, define the processes which that company needs. The processes, once defined, can be scrutinised for their adequacy and for their potential for outsourcing. Getting all of this right is a key set of skills, but nothing very revolutionary.

Secondly, however, there is a need for renewal that goes beyond chasing the coat tail of the best. Commoditisation will not go away. Here, the firm has to look to the vast tool kit of potential which the modern economy and its knowledge base represents. Its arrival at sensible new things to do will come a mixture of accident, propinquity and the recognition of a good thing when it presents itself, all informed by prepared minds. There may be many levels of research in train: about how to understand the operating environment, on how to comprehend and engage with technology, on who might be a partner and what might be done together, on where capital markets, target organisations and competitors, regulation, law, customers and partners might go next. Synthesised, this oversight creates prepared minds. Options, when they present themselves, trigger sparks. This is the core of the knowledge economy: finding good new options from out of complexity. This is hard work, and few senior management see the organisation of the opposite processes as their remit. It is also vaguely threatening, as it requires a much wider range of engagement, and gives potential power to people which is not reflected in customary hierarchies. Young technologists can stump middle aged generalists, and not always because they are right.

Capital markets do not know how to handle the knowledge economy. MIT analysis of data from 820 non-financial firms over 8 years finds that the financial markets value each dollar spent on capital investment in computing at about ten times the valuation placed on a dollar of conventional capital. Each dollar of property, plant and equipment (PP&E) is valued at about a dollar, and a dollar of other assets such as account receivables and inventories is valued at about $0.7. Strikingly, each dollar of computer capital is associated with over $16 of market value. The stock market imputes an average of $15 of "intangible assets" to a firm for every $1 of computer capital. Testing whether this was being confounded with other intellectual assets, it was found that R&D was not being mixed in, and was in fact relatively deprecated. Investment in software was rewarded, but not to the same extent.

Some of this may have corrected since the NASDAQ crash. However, market valuation of the economy has soared, as Figure 5 shows.

Figure 5: Universal growth in the value of stock markets as a percent of GNP.

There is, in effect, too much saving chasing too few projects - in one interpretation - or else there is an investment in an economy which conventional GNP measures cannot capture. The collapse in yields suggest that the 'surplus of saving' model has much in it, as does the migration of about US$ 1 trn of savings out off Japan annually. There is reduced confidence in the emergent markets - to put it mildly - and these had been soaking up capital. Nevertheless, there is a persistent sense in markets and amongst technologists that great things lie in the wings. We review technology elsewhere, and also consider the immense potential embodied in the world's human resource, also elsewhere.

Here, however, we have to note some of the negatives. Demographics will have a profound affect on European and Japanese - as well as some of the emergent - economies. Figure 6 shows the scale of this impact.

Figure 6: OECD estimates of the impact of demographics on regional growth.

Further, we have to be skeptical about the potential which markets see. The US would have to grow at about 2% over current rates to remunerate investment at current rates at historical levels of return on capital employed. There is scant evidence of major efficiency gains directly attributable to IT investments, although labour productivity has recently begun to rise very rapidly in the USA

There is a strong analogy to be drawn with the railway craze of the C19th. The first important railway project was the Liverpool & Manchester Railway of 1830. The core of the network was built by 1852, but railway lines continued to be added until by 1910 a total of 20,000 miles had been built. There was great initial excitement amongst commentators and investors. Railways were seen to be modernity embodied, and it was generally agreed that they would turn the world upside down. There might well have been talk of 'r-commerce' and the 'r-economy'.

The pace and scale of investment was huge, and market interest correspondingly immense. By 1870, the gross capital stock of the British railway network stood at 0.49 bn, a sum equivalent to half of all UK output at a time when Britain was the world's sole superpower.

This said, the enthusiasm of both the market and the theoreticians of the 'transport economy' had little fact to back their intuition. The social saving - the overall efficiency increase - that had been created by the railways by 1845 amounted to about 0.1 per cent of GDP. This is similar to current estimates of productivity gains resulting from B2B e-commerce in the USA, which were thought to amount to around 0.2% of GDP in 1999. By 1870, however, the social savings were much larger, at around 10 per cent of GDP. The social rate of return - the economic consequences to the society as a whole of the investment having been made - was about 15%. The private rate of return was, however, closer to 5%. By 1900, major rail projects were no longer paying their way. Nevertheless, the railway companies made up half of the FTSE in 1900: today, they amount to barely make 1%

The weak rates of private return, and market value inflated by hyperbole rather than a business model led to a collapse in railway company shares in 1845. They never recovered their value and many lost their persoanl savings as a result. Lewis Carroll has the Jabberwocky threatened with a railway share after they had been 'pursued it with pins and with hope'. This is not to say that railways were not useful, or that everything from the growth of the suburbs to the evolution of the novel was not affected by them. Military plans became predicated on them, colonial adventures ran upon their backs. The consequences of the new technology were indirect, non-proprietary and often unpredictable.

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