Saturday, June 18, 2005

How Powerful Is Productivity?

TCS: Tech Central Station - How Powerful Is Productivity?

Editor's note: William Lewis is the director emeritus of the McKinsey Global Institute. His recent book, The Power of Productivity: Wealth, Poverty and the Threat to Global Stability, is based on extensive economic, political and sociological study of thirteen countries over a dozen years conducted by the Global Institute.

Through this research, Lewis and his colleagues examined some of the conditions that have led to the disparity between rich and poor countries. His findings about why some countries experience robust growth while others remain stagnant are surprising and insightful. He recently sat for an interview with TCS editor Nick Schulz.

NICK SCHULZ: Mr. Lewis, thanks for joining us.

Describe how you and the McKinsey Global Institute came to do the work that went into this book.

WILLIAM LEWIS: Well, it is unusual that a private sector firm like McKinsey would do this kind of work and so that story itself is interesting. The other aspect that is also relevant here is that none of us anticipated when we started the McKinsey Global Institute that 15 years later we would be looking at a book like this and that I would be talking to you about a subject like this.

The basic idea back in 1990 was that there were several big trends going on in the world, which were not very well understood. Globalization -- people were beginning to use the word globalization -- and it was not very well understood and nobody knew where it might lead. Secondly, there were other changes, maybe more in Europe than elsewhere, with the formation earlier of the common market and then the European Union. Then of course the fall of the Soviet Union coupled with a lot of other economic experiences had led to a wave of market reforms around the world. So the question was what does all of this mean and where is it leading? And for a firm like McKinsey, what are its implications for our clients? Our clients are people who can talk to anybody in the world. You name them and they can talk to them. But they weren't getting answers that were very satisfying and so they were interested in talking to us. But we were being drawn into discussions that we were not prepared to help with very much. We read a little bit more than our clients and we were feeding that back to them, but that only can go on for so long. So we faced the issue of either deciding to invest in this knowledge building that was differentiated from what others could do or getting out of the game. And McKinsey made the strategic decision to get into the game.

SCHULZ: What sort of specific work did you set out to do?

LEWIS: Well, it was a step by step process. I spent six months traveling around the world talking to my partners and to well-informed people of one kind or another, either academics or business people or journalists, about what we should do and didn't get a very clear picture from that. However, serendipitously, I happened to see one Saturday morning before I dashed off to play tennis those statistics in the Economist that are buried at the back that happen to show the latest results of GDP per capita using purchasing power parity exchange rates. What that shows (and this is back in 1990) was that the US still was well ahead of Germany and Japan by that measure. Of course, that was in conflict with all the conventional wisdom at the time. That basically, Germany and Japan had come out of the war with superior economic models and the US was going to have to change or fall behind.

What I realized when I saw those numbers was that if they were right, then the conventional wisdom was wrong. That would be a very, very important thing to get straight for all sorts of reasons. The idea quickly emerged in these discussions that if this is true, given that employment is about the same in many countries, it's got to be a productivity difference; and if the US has a productivity lead, it's got to be in services because everybody knew that US manufacturing had gone to the dogs. That was the conventional wisdom at that time.

SCHULZ: The title of the book came to be the Power of Productivity. Now how did productivity come to loom so large in what you studied?

LEWIS: Well simply because productivity is the best single measure of what leads to differences in economic performance. Even though GDP per capita is the all-encompassing measure, GDP per capita is determined primarily, almost entirely, by productivity. People basically work in order to have a place to sleep and something to eat and so on and so forth. The huge differences around the world are the efficiencies with which they work -- their productivity. So it is the power of productivity that determines what the global economic landscape looks like and because there are such differences, we have quite a number of severe issues that face us today.

SCHULZ: You say in your book that in order to really understand a country's economic performance, you need to conduct analysis at the level of individual industries and sectors. Why is that?

LEWIS: Japan is the best example of that, and I have devoted a whole chapter to Japan. I put Japan first because Japan is in many respects the most interesting country right now to study economically.

The paradox was that in the 90s stories on the front pages of the New York Times, the Wall Street Journal, and the Economist were all about how the Japanese manufacturing industries through trade were driving US manufacturing industries into the ground and virtually wiping them out. And of course that did happen in consumer electronics -- the US basically got out entirely in the consumer electronics business. And the steel industry and the automobile industry came very close to being bankrupt, although not all companies in those industries were in that shape. But the industries themselves as a whole were in very bad shape because of, in large part, competition from Japan, which was able to deliver high quality products at lower costs -- yet the GDP per capita numbers at purchasing power parity exchange rates show that GDP per capita in Japan was roughly 30 percent below the US. So how could this be? And the only way to understand that is to look at the productivity of individual industries in Japan.

What we found is that Japan has a dual economy. Yes, it does have some selected manufacturing industries that have high productivity, much higher than the corresponding US industries and in fact they have the highest productivity in their industries of any country in the world.

And yet, the traded part of an economy is always a tiny fraction of the total GDP. A rule of thumb is that it's roughly at most 15 percent of the GDP.

So what that says is that the standard of living is determined because the productivity of the country is determined by what happens outside these traded goods. Productivity of a country in total -- the average productivity -- is the average productivity of every single worker. So in that sense, every worker is equally important. If you have low productivity in the non traded parts of manufacturing and in the huge domestic service industry -- such as retailing and housing construction and so on -- you are going to have low average productivity even though you may have a handful of industries like automotive and machine tools and steel where you have the highest productivity in the world.

SCHULZ: So even though these may not be the sexiest industries and the ones that journalists especially like to focus on, they can be critically important. Now what did you find in the case of Japan?

LEWIS: Well of course what it showed was that, yes in those industries, Japan had the highest productivity in the traded goods manufacturing sectors. In the rest, the productivity was very low. Say, in retailing, 50 percent of the US; in food processing about a third of the US. And food processing, although it's a manufacturing industry and it's not heavily traded, it has more employment than steel, automotive, computers, and machine tools added together. So it's much more important.

We got these results back in 1992 with our point of view about Japan very early. And this was while Japan was still on its bubble and the implied value of the land of the imperial palace in Tokyo was higher than the whole state of California. But now…

SCHULZ: And people talk about a housing bubble in the US now.

LEWIS: Oh yes now they have forgotten what a real bubble is like.

The way this now plays into the debate today is to say that all these sectors are in the same economy. And all the so-called Washington consensus factors are the same for these sectors -- the same exchange rate policy, same monetary policy, same rule of law, same set of governing institutions, same high quality education system, same infrastructure, same availability of capital. All the factors that the World Bank has said are so important over all these years -- up until Bill Easterly and a few others did some serious regressions on this -- are the same for these sectors, and yet there are huge differences in their relative performance that end up determining the standard of living in Japan, the GDP per capita. Therefore it is just necessarily true that there is something huge going on at the micro level that has to be taken into account when you try to understand a country's performance. Because the macro conditions -- the macro economic stability factors, the budget deficits -- all of those factors are the same for these sectors in Japan. You have to analyze the macro factors and make sure that's okay. But that's easy and people understand that now. But what they don't understand is that there is another equally important factor or set of factors at the micro level which are so very difficult for anybody to get at.

SCHULZ: How can there be such a disparity between the US and Japan in these sectors, such as retailing, in terms of productivity?

LEWIS: When you come to understand retailing, [you realize] that the industry of retailing has gone through its own evolution. 50 years ago or so, retailing was much more similar in the rich countries to each other than it is today in that it was primarily dominated by general stores of relatively small scale and mom and pop small shop operations. And what has happened over the last 60 years is that innovations have occurred in retailing and new formats of much higher productivity then these former formats have developed. The most obvious being the so called big box epitomized by Wal-Mart, which has productivity something like five times the productivity of a normal general store of the 1950's. And so the story in retailing is how many of these high productivity formats are part of the mix of stores in retailing and how much of retailing is still like it was in 1950. In other words, the evolution in retailing has progressed at far different rates in these countries around the world.

So in the US, the fraction of mom and pop general store-like operations that are left is under 20 percent of all employment. In Japan it's over 50 percent still. Even in France, it is down to about 30 percent. So when you put the mix together, you of course get a much lower productivity. So that's at the operational level. Why is productivity different? It's different because the nature of the retailing operations in the different activities of retailing is fundamentally different on a mix basis.

So then you get to the next level. OK, why haven't entrepreneurs and managers of capital and others that have invested in retailing and created businesses of operations and firms and actual formats in retailing [managed to do it] at the same rate? Why has it been different? And there you get into a huge area of micro rules and regulations and incentives on managers so that basically they end up doing different things.

In the US, there is much more level and free competition for the leading consumer's demands. So if Wal-Mart moves into an area, it sets up new operations. Because of its higher productivity, it is able to under price these much less productive operations. And consumers -- as nostalgic as they may be about Main Street and the small shopkeeper and the relationships they may have with those people -- the consumer has shown that he or she will go for the lower prices. So the consumer chooses the more productive format because the prices there are lower and so eventually the less productive format goes out of business and those people or their children end up working elsewhere and a lot of them probably end up working at Wal-Mart. Whereas in Japan, there all sorts of obstacles.

SCHULZ: What kind of obstacles?

LEWIS: In terms of the big operations, they have great difficulty in Japan getting hold of land. The local zoning authorities for a long time just outright banned big box stores, stores of over something like 10,000 square feet. That ban was put in place at the political influence of the small shopkeepers and others. The US objected to that and finally got that overturned, but it just got overturned into something almost equally ineffective which setup a lot of environmental and traffic and other kinds of potential obstacles, with the board determining whether to go forward dominated by local interest, local producer interest, local retailing interest.

So you get the case where I just read in the paper just the other day that Carrefour which is probably the most successful international retailer -- it has high productivity and it has been at the international game much longer than Wal-Mart and it is successful in most places around the world -- has actually just given up on Japan after trying for two decades to build stores and to create what they've been able to create most other places in the world.

At the same time, there are huge incentives for the mom and pops not to close down, to continue to limp along. They come from many directions. First of all, the mom and pops just simply get subsidized loans. And they have no trouble paying off those loans because they are sitting on some of the most valuable real estate in the world, especially during the bubble time. So basically when they die, their estate would have no trouble paying off the loans so they don't have a cash flow problem which they would have if they weren't subsidized in terms of loans. And then there is a strong incentive for them not to sell in the tax code in Japan in that capital gains taxes are very high in Japan and estate taxes are very low so there is a huge incentive for these mom and pops to hang on to their land and basically pass it on to the next generation. So those things are the main factors that have just lead retailing to stagnate in Japan compared to the US and compared even to Europe.

SCHULZ: Now I want to shift gears a little bit and just look at one or two things that you discovered that do not account for diminished productivity from one country relative to another. For example, one finding that might surprise some people is that the education level of the labor force isn't nearly as important for overall economic performance for a nation as commonly thought. You say in the book that importance has been "taken way too far."

LEWIS: Right.

SCHULZ: In other words that education is not the way out of the poverty trap. Now how do you reach that conclusion?

LEWIS: By sifting through evidence primarily from two directions. Interestingly enough, we got the first hint of this when we were studying the US relative to Japan back in the early 1990's when the Japanese were wiping out the US consumer electronics industry and threatening the steel and automobile industries. The conventional wisdom in the US was that it was true, and that was in large part true because the US labor force was so bad. There were many disparaging comments made in the US and maybe even stronger abroad, (and especially in Japan) about how the US labor force was getting what it deserved because it was lazy, uneducated and maybe even dumb. And of course, the Japanese then showed -- the really capable, competent Japanese manufacturing companies -- showed that was wrong by coming here, building their own factories, managing American labor and taking a lot of other local inputs and coming within five percent of reproducing their home country productivity.

So when we first came out with this conclusion, it just really staggered Bob Reich and others. Bob Reich was US Secretary of Labor and a great advocate at that time of the German apprenticeship system and felt like we just needed to train American labor better. And we showed that something like 40 percent of the unemployed in Germany had been through the apprenticeship system.

But more importantly, you can take the US workforce and train it on the job with sufficiently skilled managers to reach within a hair's breadth of the highest productivity in world in these industries. That pattern -- and of course that conclusion back then coupled with the fact that the US wasn't behind -- really got a huge amount of attention and really undermined the initial economic platform on which Bill Clinton was elected.

I am a Democrat, by the way, and I voted for Clinton, but he clearly was wrong about the health of the US economy in his first campaign and in the early days of his being president.

The great bulk of the evidence about education came from competent multinational corporations of any nationality. Showing they could go virtually anywhere in the world and take the local workforce and train it to come close to home country productivity.

And then, sort of the clinching evidence was we then looked at some other industries. We compared the construction industry in the US to construction in Brazil and found that in Houston, the US industry was using Mexican agriculture workers who were illiterate and didn't speak English. So they were not any different than the agricultural workers who were building similar high rises say in Sao Palo. And yet they were working at four times the productivity.


LEWIS: Just because people are not educated does not mean that they are incapable, which is a mistake educated people in the West often make -- and not just the West but probably in Japan as well. These people can be trained on the job to accomplish quite high skill levels and quite high levels of productivity. And that's basically good news because if the World Bank and everybody else had to wait until we revamp the educational institutions of all the poor countries and then put a cohort or two of workers through it, we are talking about another 50 years before anything happens. That's not acceptable and it's not necessary, thank God.

SCHULZ: That earlier comment about your politics leads into one of the next questions I want to ask. This might come as a surprise to some folks who work in development economics, but many people don't realize the destructive power that large government bureaucracies can have on economic development.

Now when I read your book, I did not detect any sort of anti-government ideology at work. And your comments about whom you voted for speak to that. So what are your experiences that led you to this conclusion about the role that the large government and government bureaucracies can have on productivity and economic efficiency?

LEWIS: That's an interesting story. I will try to make it short. We got the first hint of this in Brazil and then got conclusive evidence in Russia and of course found it to be absolutely true in India. And since then, some other works in other countries have shown it, particularly in Argentina.

The problem that we found was that basically the most productive multinationals in some industries were not going into these countries in the way that we expect them to; or they were not expanding in these countries nearly as fast as we thought they had the opportunity to do. And so we tried to get at why is that, because their productivity was clearly multiples of the domestic producers they would be competing against. And we did interviews with these people because thorough McKinsey we know these firms in a different way and so we could talk to them.

And I report about the interview with Carrefour in Russia. That was really a watershed interview because Carrefour said, "Well, we know all about Russia. We can handle most of the problems of Russia. We don't have trouble with red tape and bureaucracy. We can handle bribes. We know all about bribes. We even can worry and handle about any threat to physical security. We've been in tough situations and we can make our people feel secure. What we can't handle is not making money. And you can't make money in Russia." And of course that really left us puzzled. So we went away and we built up a model of their cost structure in Russia, of what it would be, and the cost structure of their competitors. And we found that by and large they were right. Their competitors were able to under price what Carrefour would have to price at in Russia in order to break even, let alone make money.

We found that their competitors were doing a number of things that Carrefour could not or would not do in their business practices. Imports were flooding into Russia and many of the local domestic producers in Russia were selling smuggled goods, on which they had not paid the import tariffs, and they also were selling counterfeit goods. McKinsey did a study of the vodka industry in Russia and found that 40 percent of the Vodka sold in Russia was not made by the company whose label appeared on the bottle -- so much for the value of the brand. And then we looked at the taxes, and taxes have to be collected in the sales price, the final sales price -- what the customer pays -- at the cash register. And Carrefour, as is the case with virtually all multinationals, they pay their taxes because they cannot afford to do otherwise. And it is not just profit taxes, it is in fact the other taxes that make the difference. The sales tax, the value added tax, the employment tax -- all of which were to be rolled into what the consumer pays Carrefour for any given goods or services. When you add all those up and compare it with what their competitors were doing -- who by and large were not paying these taxes -- Carrefour could not make money. So they were right.

That led to the question, okay, but this problem of competing with so-called informal firms, as these kinds of firms were known, has to have been true for rich countries at some stage of their development also. When they were poor, how did they ever get over this problem?

And so you think about it and say, well, I wonder if they got over this problem because it didn't matter. That the taxes were so low because the governments were so small that it didn't matter if there was this differential playing field. If they had productivity four times as high, they basically could make money even though they paid taxes and their competitors didn't because the taxes themselves were so low.

And so we did compare what the size of all governments in the US and France was when these countries were at the same stage of development roughly as Brazil and Russia are today. We found that whereas the poor countries are up in the 30 percent of total government as a fraction of GDP, the US and France were below 10 percent. So basically it didn't matter.

But then you say: well, the rich countries today have high taxes and big government. So why doesn't that matter? Well the reason it doesn't matter today is that everybody is formal. Informality fades out because as you go, the only way you get high productivity operations throughout the whole economy is to have it dominated by big firms of scale where there is substantial division of labor and high productivity and so on and so forth. And so that means that all firms pay these taxes so that the playing field is again equal because everybody pays the same fraction of taxes.

The no man's land that the poor countries have gotten into now is that they've gone to big governments before they can afford it and before informality has been phased out or driven out by high productivity operations, so they have both big government and informality. And that's a recipe for disaster for the reasons I have explained in terms of the competitive dynamics at the micro level. As a result you would predict, well, maybe informality is increasing. And sure enough when you look at it in Brazil, as I show in the Brazil chapter, there's a chart there [that shows that] informality has been increasing for the last 15 years in Brazil. Brazil is going in the wrong direction.

SCHULZ: What can a developing country like Brazil do to get out of that trap?

LEWIS: It is a problem because once you are there, as everybody knows from just simple kindergarten politics, it's very difficult to cut government services for people.

And we look for examples. All our instincts are to look and see who has done this before, rather than to theoretically try to think about how might this be done, how has this been done before? There are four relevant countries -- Ireland, Canada, New Zealand and Chile -- who have significantly cut their government. And actually, all of them have been successful afterwards -- to somewhat different degrees, but they have been successful afterwards. And not only because of cutting government, but because of other things that they have done as well. However Ireland, New Zealand and Canada were rich countries when they did it and they actually were forced to do it in large part by the bond market. The Canadian debt was approaching junk bond levels, so they were facing a crisis, a financial crisis, and they had to do it.

Chile is the only poor country that has done this and unfortunately Chile did it under a military dictatorship.

SCHULZ: Right.

LEWIS: But Chile did what needs to be done. Chile did what Brazil needs to do. Basically it went from where Brazil is today to where Japan was in 1950. Japan had a total government in 1950 of about 20 percent. And nobody has made the argument to me why any poor country needs to have a GDP per-capita -- a GDP for government fraction -- of more than 20 percent. Twenty percent ought to be enough and yet no poor countries come close to it except Chile.

SCHULZ: And the other problem is that we now have instances where the government itself is actively encouraging the informal sectors in some areas. Is that true?

LEWIS: That's certainly true and it gets all wrapped up in other kinds of efforts that are well-motivated but really not going to lead these countries out of their poverty trap, such as micro finance and property rights for squatters and this that and the other. All those things are worth doing but they are not going to solve the problem -- as long as the bigger conditions exist and are preventing the formation of the formal sector at a rapid rate where you can benefit from economies of scale and division of labor and training along particular functional skill lines and so on and so forth. That's the way countries get rich.

SCHULZ: We hear a lot about competition and trade distortions, subsidies and tariffs and that sort of thing. And certainly they exist in the US and Europe, and other developed countries. But another finding that I think might surprise some people is that, from the research you did, that distortions to competition are most severe in poor countries. Is that right?

LEWIS: Well, the distortions to competition in the great width of the economy are more severe in poor countries. As you go to progressively poorer countries, there is that sort of picture that shows up without any question. So yes, India probably has now the most distorted economy of any major economy in the world. Even more than the Soviet Union before. And you go to Brazil and Brazil has actually removed a lot of the market distortion like I described, even in Japanese retailing. Retailing in Brazil is probably close to being as productive as retailing in Japan. But Brazil has this huge problem of informality and so as a result, the more productive enterprises either can't enter or they cannot enter and grow nearly as fast as they have the potential to do so.

SCHULZ: And when you are talking about these more productive sectors and firms, a lot of time you are talking about large western multinational companies. You mentioned Carrefour. But a lot of these companies are perceived sometimes in the media, sometimes by NGOs and the like, as threats to developing countries. And indeed in Brazil for example, Lula sometimes uses rhetoric where he kind of bashes Western firms from the US and Europe. But you don't see them quite as a threat to these developing countries.

LEWIS: Well for the foreign direct investments, it's a win-win game - it's a win for the poor countries because they get capital to expand capacity and produce more goods and services. Because it's investment in the country, it employs local labor. And local labor is always 2/3 of the cost structure of any operation, so 2/3 of the value created by the new firms automatically and immediately goes to local labor through the salaries that are paid to local labor. And their productivity is so high they pay well relative to what you can make as an informal worker in those countries. That's how wages go up as a result of productivity improvement and that's how countries get richer. That's the growth dynamic; that's how growth actually occurs, it's for people to take more productive jobs that lead to higher wages that which then lead to more demand for things that people with higher wages want and that's how you grow - that's the growth dynamic. So that's the winner.

The reason it works is because the consumers in these countries end up getting a better combination of price and service and quality and convenience than they are able to get otherwise and they go to shop at these places. So the consumer is better off because the consumer gets a better deal.

Now that is not true in every case and obviously there have been some multi-nationals who have not done well and not succeeded. But for the last couple of decades the story of the results of foreign direct investment is a win-win story for everybody.

Populism is against this in many of these poorer countries. And one of the reasons that it is successful is because the secret enemies to globalization -- in particular to this foreign direct investment -- are the local domestic producers. And now multi-nationals have shown that they can go and invest substantial amounts of money with the benefits to the economy, the local economy that I have described, across the globe without any questions. And they can operate there at productivity significantly higher than the local producers and under price them and either drive them out of business or force them to improve in the way that the multi-nationals operate. And so, the domestic producers are against this because they don't want this in competition. I mean no producer -- no producer -- ever asked for more competition. So these domestic producers are really the secret enemies of globalization and they are having a lot of influence against it.

SCHULZ: Why are consumer interests so weak, and not just in developing countries but also in developed nations? You touch on this in your book when you talk about domestic producers and their political clout. But what if anything can be done to strengthen the relative status of the consumer to the governing elites and the producers in any country?

LEWIS: I tried to figure this out because the literature on this is actually very weak and there is not much of it. I did have a Yale law school graduate do some research here and I looked into the literature [to see] what had led to the pro-consumer rights laws and regulations in the US that are so different from almost any other country and certainly any poor country. And the startling thing that emerged from this at first was how long ago these laws were actually put in place in the US.

As I say in the book, the Sherman Act of 1890 probably had more good pro-consumer competition policy and direction than most countries in the world have today. And of course it took a long time for the Sherman Act to work its way through the US. It had to be followed by the Clayton Act and some other acts and then interpreted by the courts and the Federal Trade Commission. So it wasn't for two or three more decades until we really got in this country the pieces of the Sherman Act showing in actions of the court.

But certainly by the late 20s and early 30s when all the reforms occurred in US, we were seeing the benefits of this and the example I often give of this is that it was in the early 1930s that insider trading became illegal in the US. Insider trading didn't become illegal in Germany until five years ago. So most of the rest of the world has lagged.

So the question becomes why was the US so far ahead and why has it taken so long for other countries? Now this is all relative. Obviously Europe is much further ahead in many respects that Japan on this. And Japan and Europe are much further than most poor countries. But there, I went back to really the serious students of American history. Gordon Wood at Brown is one of the premiere students of colonial and revolutionary America. And Wood wrote this remarkable book, which I read at the time, called the Radicalism of the American Revolution. It came out in the early 90s I think. It's in my recommended readings list so if you want a reference to it it's there. What he showed was that at the time of the [American] revolution, consumerism exploded in the US. And it was associated with the fundamental notions of individual rights. That prior to that, at least in the feudal societies of Europe, consumption was viewed as a luxury to which only the land owning class was entitled. And everybody else was entitled to subsistence -- enough food and enough shelter to survive and that was it. And at the time of the revolution, because the revolution was so rooted in ideas of individual rights and equality of opportunity and equality of desire and equality of demand, everybody said, 'why not me?'

So you suddenly had a few million farmers beginning to view themselves as consumers. And that thinking didn't have much manifestation because we were primarily an agrarian society for the next 100 years. But certainly by the time the industrial revolution got started, the thinking in this country was so oriented towards consumption and consumers, relative to everybody else -- certainly nothing like it is today -- but relative to everybody else. That these laws naturally came into place when there began to be a need for them as a result of the industrial revolution and the issues that it raised over monopolies and special interests and influence on government and special privileges and this that and the other. And so basically the US was ready, and it was this political philosophy of individual rights that (of course is also in England; and competition law in England is probably further advanced than anyplace else and it may be that now it is as advanced as the US) was very important. And so it has spilled over to other places.

However, the other side of the coin, and the thrust, the modern thrust, that conflicted with this so strongly in the first half of the 20th century and even mid century, was the thrust of, I will call it, planning - the Soviet Union illustrating that to the greatest degree, with a fully centrally planned economy. It is interesting how many economists and how many intellectuals and how many other people really thought that was the way to create the superior economy because smart people could just figure out what should be done.

And I think I have in the book this great quote from Gunnar Myrdal right after he won the Nobel Prize. It must have been back in the 1950s. It said "what the poor countries or the developing countries need is super planning." And that kind of thinking just permeated the poor world, and also the developing institutions. There were vestiges of that thinking left in the middle 1970s when I was at the World Bank and it still echoes around in Delhi when we were there working on India. Nehru was a great admirer of the Soviet Central Planning System. He and the leaders in India thought, and in some respects probably still think, at least some of them are smart enough to figure out how all this should happen.

And of course the way you make a plan happen is by having a plan for production, not for consumption. There is no way you can plan or affect the individual choices that the people make as individuals when they buy things, but you certainly can affect strongly what they have to buy through production planning. And so this whole idea of the producer orientation was aided and abetted in modern times by the planning idea.

It's easy to see where it came from in feudal times -- that basically the people who owned the capital and the landowners could control what happens. They were the only ones who had the ability to do anything. So this whole battle between individual rights, political philosophies based on individual rights, and what immediately comes from those political philosophies -- namely ideas of consumer rights -- have permeated to a relatively small degree around the world.

And yet, as you can tell from my argument, that's the only way I can see for this lock of special interests and privileges that is holding back so many of these poor countries and some of the rich countries. The only way that can be overcome is through this consumer rights notion because democracy is necessary but not sufficient. It is necessary because it's the only way you can affect change of this kind, but it is not sufficient because, democracies have this theoretical weaknesses that lot of people have always recognized, that a majority or an effective majority can gang up on the minority and for short-term or medium-term gains can actually extract privileges or special benefits compared to what the other gets. And in Japan, the LDP [Liberal Democratic Party] is a great example of that, even in a democracy. For 50 years, it is governed from a coalition of small retailers -- the mom and pop shops, small farmers, the backward construction industry, the doctors and the lawyers and sets of other people -- [who] have really ganged up on, what I say when I talk about this, the Tokyo housewife, who really gets screwed as a result of this system. And it just gets worse if you go to poor countries.

So the thing that happens, the way to break that if you put any stock in the US example, is that politicians (in the conditions in the US) learn that they can be successful politically by campaigning on behalf of consumers. Those consumers are a majority. They are the other crosscutting majority. There is enough evidence in US political history, not just early but also through Franklin Roosevelt and even John Kennedy, that they had a clear consumer orientation. In fact, I have this quote from Kennedy in the book when he was campaigning for president when he said on national television something to the effect that "the consumer is the only person in Washington without a high powered lobbyist. I intend to be that lobbyist." And Roosevelt had a more eloquent, detailed quote that I had in there as well. So that's the reason I end up saying this business of becoming rich is not easy; it's amazing anybody does. And we are in for a very difficult 50-year period as a result of the complexity and the difficulty of doing better economically.

SCHULZ: What are you working on now? What are areas that you think where further study or inquiry are required to round out that picture of the path to development and wealth?

LEWIS: Well let me just say first that I don't think additional countries in the sample are necessary. I don't think they will add anything to the fundamental pattern that showed up.

What I am mulling over in the back of my mind is of course where the book left off. Namely, how do you break through the special interests that are holding back development in the poor countries? And if it is rooted, as I argue, in political philosophy, how do you get the spread of this old idea in the West (and in particular in the US) of individual rights and the implication of those rights for consumer rights. How do you get this idea spread around the world better than it has been spread so far? And that's not an economic question. It's a political economy, sociological, political philosophy, almost anthropological question.

And you know, I am not tying it to anything today yet. But you know, the notion that for the US president to come out and say we think democracy around the world is really important. That's probably right. But I think it is naïve because as I said earlier, democracy is necessary but it is far from sufficient. And getting a working democracy that is not captured by special interests is the problem. It is not getting democracy established. And so far we haven't had an American president who talks about the complexity of creating a democracy that is not captured by special interest.

SCHULZ: And just in terms of what you are working on right now, what sort of research are you doing?

LEWIS: I am not doing any new research. The Global Institute, since I retired, has gone to working on things that are more directly associated with our clients and their problems of today. They are not really doing any more country studies. This was a one time event that McKinsey probably will never do again nor will probably any private sector institution do again. And that's the reason every time I speak at the World Bank I say you guys have got to pick this up. You are the right institution; you have the resources; you have the access and you have the charter so you really need to do this.

SCHULZ: I hope Paul Wolfowitz will be giving you a call.

LEWIS: I got Jessica Einhorn, the Dean of SAIS, who succeeded Paul as the Dean of SAIS, to send him a copy of my book, so I hope he does pay attention to it.

SCHULZ: Excellent. Well I think he is the kind of person who might be receptive to these ideas. And I do think they are absolutely critical. I want to thank you for talking to us today.

LEWIS: Thank you.

Saturday, June 11, 2005

Roubini Global Economics (RGE) Monitor

Roubini Global Economics (RGE) Monitor

Is the Euro just a Bull Market Phenomenon?

Marshall Auerback

“We lost a lot of our influence. We went too quickly on enlargement. It was a big mistake. The people voted against it last Sunday. Now we have lost our credibility too.”
– An unnamed French diplomat, quoted in London’s Sunday Times in the aftermath of the French EU constitutional referendum

The dual rejection of the European Union’s proposed constitution by the Netherlands and France has been described as a political earthquake. The analogy is appropriate: the underlying edifice holding together the EU has suffered serious structural damage, the extent of which is still unclear. And there is also the possibility of further aftershocks which may ultimately lead to nothing less than the demise of the euro itself.

The tea leaves for Europe’s policy makers have been evident for some time, if they only chose to read them. The EU and its attendant institutions have long been characterised by a huge democratic deficit, which has led to an increasing sense of political alienation of the part of much of the population. Even before the respective French and Dutch referendums, there had been enough hints by the electorates of various member states in a sufficiently large number of national elections to give Brussels a sense that something was amiss. Results across the continent repeatedly reflected the rise of populist, anti-EU parties and a concurrent sense of dissatisfaction with its existing leaders. All of this has occurred against an economic backdrop in which continental European living standards have plunged, national pension plans veer toward insolvency, unemployment remains in double digits and national pride is turning into embarrassment and even shame.

Even when things have apparently gone well, it has not redounded to Euroland’s credit. The appreciation of the euro over the past few years has been widely hailed by the continent’s policy makers as symptomatic of the currency’s growing credibility as a genuine store-of-value alternative to the dollar. But the ultimate impact of such appreciation has been to price European manufacturers out of global markets, if one is to judge by the wretched performance of the export-dependent Italian economy (now in recession), as one significant example. This is a particularly worrisome trend, since EU-wide exports were widely deemed responsible for last year’s economic recovery, given the persistent sluggishness of domestic consumer demand.

Amazingly, the underlying problems have continued to be ignored by the European Union’s leading officials, which in turn has stored up additional trouble for the future. No change in the Commission’s operating procedures have ever taken place in spite of numerous political warnings. Euroland, as a consequence, has continued to function in a huge political vacuum. Indeed, the whole “European project” is increasingly characterised by growing institutional inflexibility, policy paralysis, and tenuous political legitimacy. Today, the whole movement toward an “ever closer union” appears dead and the notion of a “United States of Europe”, standing as a serious political counterweight to the US, risible.

The more relevant question might be: is the euro itself salvageable? The FT’s Lex column lays out the stark alternatives ahead for Euroland:

“[M]arkets are leaning toward the belief that a vicious cycle is taking hold. This will see a weaker euro on the back of a worsening eurozone economy, political uncertainty and higher US interest rates. The European Central Bank, convinced that economic weakness has structural rather than monetary causes, will refuse to lower rates as imported inflation rises. Fiscal laxity as governments try to placate electorates could actually result in rate rises, depressing growth.

But those searching for a chink in the clouds could paint a much sunnier scenario. Elections in Germany this autumn, and the discrediting of the lame-duck French government, could result in a more pro-reform core Europe, which would work more harmoniously with the UK. Italy’s economic meltdown would continue, its debt burden finally forcing it out of the euro. A few years down the line, a leaner, meaner EU, focused on trade rather than political and social integration and expansion, could drive through aggressive structural reform and set the region on the high growth low unemployment path. An EU that regained the characteristics of a free-trade zone, focussing on competition and financial regulation, could more comfortably accommodate Turkey and other new members.”

As the paper concedes, this latter scenario appears unlikely, especially in light of the immediate response to the results in France and the Netherlands. It is worth noting that these two countries are core founding members of the European Union, not traditionally euro-sceptical nations existing at its periphery such as the United Kingdom or the newly accepted nations of Eastern Europe. And the latter are feeling fairly aggrieved at this juncture because the No votes were said to be fuelled by fears over jobs being lost to cheap workers from the east and immigration. Resentment is, therefore, building in the new members that they have been made scapegoats for the economic and social ills of old Europe.

So does “Old Europe” get it? Even before the results of the French referendum were official, Jean-Claude Juncker, the Luxembourg Prime Minister, insisted that the ratification process for the constitution continue until all countries delivered the “right” answer, which is essentially what was tried following the Danish referendum on the euro and the Irish rejection of the Treaty of Nice.

Jean Luc Dehaene, a former Belgian PM, exhibited comparable contempt for popular opinion: In a BBC interview last Monday, Mr Dehaene made the extraordinary remark that the results in France were meaningless because the electorate was not voting against the constitution, but against the French government. Common sense suggests that on the contrary, they were voting precisely against the constitution, a project of politicians such as Dehaene who are determined to pursue an unpopular agenda with or without popular consent. This notion also appears to be confirmed by the British newsmagazine, The Economist, which noted that five of the top 10 best-selling non-fiction books in France were about the Constitution. Millions of people watched television shows discussing it. A huge percentage of respondents in public opinion polls were familiar with its content. There was huge voter turnout (70 per cent) and people had a very good idea of what the issues were.

This obliviousness to public opinion has been the flaw at the heart of the whole "European Project" right from the start. It is scarcely remembered now that France only barely ratified the introduction of the euro in a vote so tight that its adoption by a few tenths of a percentage point gives lie to the word, “democracy" that lifts so carelessly off the lips of the most undemocratic of politicians.

But have France, let alone the rest of the EU, taken on board the message? In the immediate aftermath of the French Non, President Chirac announced a new and strong impetus to government policies, but chose his “political son”, Dominique de Villepin, to be France’s new Prime Minister, rather than someone identified closely with further economic reform, such as Nicolas Sarkozy. De Villepin (best known to Americans for his outspoken opposition to the US-led invasion of Iraq when he was France’s Foreign Minister) is viewed by the markets as fundamentally hostile to “Anglo-Saxon liberalism”, and determined to retain France’s unique “social model”.

“He’s got class and he can recite poetry,” said Jean-Louis Martin, a 59-year-old engineer who lost his job in 2003 when the local metal smelting factory shut down. “But I don’t see what hope it brings us. The people voted for a change — not a return of the nobility, the old regime. This is a joke.” This quote from the London Sunday Times reflects a commonly expressed sentiment. The euro lost a cent against the dollar in the immediate aftermath of the announcement of De Villepin being named French Prime Minister because the markets interpreted his appointment as a sign that France has set its face not just against the European project but against further economic liberalisation and reform. This is not euro bullish.

On the plus side, the contradictory impulse toward both widening and deepening the European Union (and, ultimately, the euro zone), has been demonstrably established as futile. The British belief that more widening of the EU would mean less deepening has essentially been vindicated.

There is little question that for a monetary union to operate successfully, there has to be a high degree of economic and political convergence. But this runs up against the tide of history: Pooled political sovereignty and a concomitantly more cohesive supra-national fiscal policy are far more difficult to implement in a larger currency zone with countries at disparate stages of economic development and correspondingly different political/historical traditions.

Most single-currency zones involve a central or federal government with a tax and public expenditure program of substantial size relative to national GDP and the ability to run significant deficits. A tax and public expenditure program generally involves redistribution from richer regions to poorer ones, whether as an automatic consequence of a progressive tax and social security system or as specific policy acts. The redistribution also has to be sufficiently large in scope to act as a stabilizer with negative shocks, leading to lower taxation and higher social security payments in the region that is adversely affected. The EU’s current budget is a pittance and there is little inclination for member states to pool further fiscal resources in the current political climate. But there is a need for the development of a larger EU tax base and redistribution of tax revenue from richer regions to poorer ones in order to have a genuinely proper functioning fiscal policy at the supra-national level. This is clearly more feasible with a smaller zone of nations with common economic and political philosophies.

In the absence of such a mechanism, it could be expected that economies would adjust to differential shocks and uneven economic performance through a variety of other routes, such as currency devaluation.

With the existence of the euro, that is not an option, but even that is coming into question: In the aftermath of the recent referendum results, issues hitherto considered politically sacrosanct, such as the actual withdrawal from the euro zone, have begun to creep into the public domain. This must surely constitute the ultimate Pandora’s Box for euro enthusiasts.

Of course talk of withdrawing from the euro zone is dismissed as completely unrealistic by EU officialdom. But recall that when the first stirrings of doubt were expressed by Germany back in 2001 about the Stability and Growth Pact, this too was met by a hail of denial. Just four years later, the Stability Pact is all but dead, denuded of any kind of meaningful enforcement mechanisms in the face of persistent violations.

The issue of euro withdrawal has been broached in Italy, of all countries. Ironic, because Rome has effectively had a free ride in the eurozone’s integrated bond markets for years, obtaining Germanic levels of interest rates (as a consequence of Germany’s historic record of fiscal prudence), despite maintaining historically retaining profligate levels of public sector expenditure and debt to GDP ratios well in excess of most of the other founding member states in the monetary union.

In spite of its low cost of capital, the country’s Welfare Minister, Roberto Maroni, told La Repubblica daily Italy should hold a referendum to decide whether to return to the lira, at least temporarily. He also said European Central Bank President Jean-Claude Trichet was one of those chiefly responsible for the “disaster of the euro”: The euro “has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis,” Maroni said.

In this situation, Maroni contended that the answer was to give the government greater power to defend national industry from foreign competition and “to give control over the exchange rate back to the government”, and specifically cited Britain as a virtuous example of a country whose economy “grows and develops, maintaining control over its currency.”

The dirty little secret of European Monetary Union is that there has never been a proper debate on the pros and cons of the single currency union within the member states. Like so much else in regard to the EU, it was imposed from above. Yet this is a debate that must occur because the European Monetary Union and its attendant institutions, such as the European Central Bank, ultimately cannot succeed in the absence of open, public discussion and acceptance, in lieu of bureaucratic imposition.

It is said that politicians in particular and the democratic process in general cannot be trusted with economic policy formulation because they lead to decisions that have stimulating short-term effects (for example, reducing unemployment via higher government spending) but are detrimental in the longer term (a notable example is a rise in inflation). But comprehensive rejection of the constitution has proved to be an outlet for discontent extending well beyond this particular issue; French and Dutch voters have now shown us the limits of pure technocratic economic management in an environment divorced from political reality.

On the other hand, to debate the appropriateness of a single currency union at this juncture may engender unintended results. It is extraordinary to consider, for example, that the German people never had the opportunity to express their views in a referendum as to whether they ought to abandon one of the most successful post-war monetary regimes in favour of an untried and untested currency. Even if one makes allowances for Germany’s traditional post-war phobia of being perceived as “bad Europeans”, it is almost certain that most would have voted to retain the D-mark, had they been given the opportunity to express themselves in a proper democratic forum.

Already, there are stirrings of euro discontent emerging at the margins in Germany as well as Italy. The referendum results in France and the Netherlands appear to have lit a match on a tinder box of huge continent-wide disenchantment. Consider what is happening to the now discredited EU constitution in the wake of the French and Dutch referendum results: Four separate polls in Denmark and a survey in the Czech Republic indicated the two countries could both vote No in referendums on the constitution. Bild, a leading German tabloid, showed overwhelming hostility in Germany to the constitution. Of the 390,694 readers who responded, 96.9% said they would vote no if a referendum were held there. Now imagine if this discontent were to extend to the monetary union itself.

Increasingly, the euro appears to be nothing more than a bull market phenomenon. Its enthusiasts have over promised and under delivered. In the words of London Times’ correspondent, Anatole Kaletsky:

“The relative economic decline of ‘old’ Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years.”

Could the euro, therefore, suffer from the same sort of conflagration of discontent, as is now manifesting in the constitutional ratification process?

How would one re-establish national currencies, given that there exists no mechanism to re-establish them in lieu of the euro (at least none that have been publicly disseminated, for obvious reasons)? Indeed, France and Germany have only recently issued 50-year euro-denominated bonds. The euro itself is becoming an increasingly large component in the reserve portfolios of other central banks, particularly Asia. The prospect of chaos in the bond markets, and consequent severe economic dislocation, cannot be ruled out if this movement to restore national currencies were to gain sufficient political momentum on the back of this current outbreak of anti-EU populism.

What to do in that sort of context? In the past we have described the problems of the US economy ad nauseum. We have also highlighted the problems of the yen and the structural problems inherent in the existing European Monetary Union. Although the euro zone as a whole suffers less from the debt disease prevalent in both the US and Japan, it has largely “earned” its spurs on the foreign exchange markets as a consequence of being the least bad major paper currency alternative. Its acceptance has, until recently, continued unabated, largely by virtue of not being the dollar, as opposed to any intrinsic merits.

Generally speaking, most currency choices faced by market practitioners today are comparable to Keynes’s notion of market speculation: to paraphrase Keynes, one is not seeking to adjudge the most beautiful currency in absolute terms, but merely seeking to guess what the market’s will judge to have the best relative merits . In other words, paper currencies are only “relatively” attractive vis a vis each other and not genuinely attractive as ultimate stores of value. The current problems of the euro (as well as the longstanding problems of the dollar) illustrate that phenomenon.

This points the way toward a potential major paradigm shift in relation to gold, long viewed simply as another variant of the “anti-dollar” theme. Symptomatic of this shift in thinking is the Financial Times, a publication which has usually been viscerally hostile to gold as a legitimate reserve currency asset. In an editorial last April, however, the FT came to a fairly stunning conclusion:

“In truth, there are good reasons for selling all three of the world's main currencies. But could they all fall? Yes, against either gold or the Chinese renminbi. In recent years, gold has been a useful hedge against the dollar, but not against the euro or yen. Meanwhile, the U.S., Japan, and the EU would all like to see the renminbi revalue, but so far, the Chinese are not playing."

The current travails of the euro may change the perception of gold as a barbarous relic from a bygone era For the FT, which has been known as a very anti-gold publication, to come to this conclusion means that many people who have long viewed bullion as economically irrelevant are likely reassessing their viewpoint. This could well point the way forward for gold, notwithstanding the many travails its holders have experienced over the past two decades. Often, seismic shifts in thinking unfold in slow-motion, and are often masked by other “noisier” events, such as the French and Dutch referendums. The “noisier events”, however, could well be catalysing a far more profound change in financial thinking. The rejection of the EU’s constitution in France and the Netherlands, therefore, may well have initiated something well beyond the control of today’s paper currency custodians, much to their ultimate horror no doubt.