For the purpose of helping you decide whether you want to read more than the first page of this book, I am listing here my ten main conclusions.

One, many people look for the causes of poor economic performance primarily in macroeconomics. An evaluation of economic performance requires an analysis at the level of individual industries, such as automotive, steel, banking, and retailing. This is the "sector" level. You must also look at the sector level for causal factors for economic performance.

Two, beyond macroeconomic policies, economic analysis usually ends up attributing most of the differences in economic performance to differences in labor and capital markets. This conclusion is incorrect. Differences in competition in product markets are much more important. Policies governing competition in the product markets are as important as macroeconomic policies.

Three, the Washington Consensus of the 1990s argued that such elements as flexible exchange rates, low inflation, and government solvency are the critical factors in economic health. One factor that was profoundly underestimated was the importance of a level playing field for competition in a country.

Four, many people believe that the educational attainment of a nation's current labor force is responsible for the success or failure of its economy. The importance of the education of the workforce has been taken way too far. In other words, education is not the way out of the poverty trap. A high education level is no guarantee of high productivity. The truth of the matter is that regardless of institutional educational level, workers around the world can be adequately trained on the job for high productivity.

Five, many people see access to capital as the determining factor between a productive growing economy and one that is not. Therefore, they feel that if rich countries sent capital pouring into poor countries, the poor countries would become richer. The solution does not start with more capital. The solution, rather, is in the country's productivity or the way it organizes and deploys both its labor and its capital. If poor countries improved productivity and balanced their budgets, they would have plenty of capital for growth from domestic savers and foreign investors.

Six, most people consider "social objectives" to be "good." Import tariffs, subsidized loans for small businesses, government disallowance of layoffs, and high minimum wages are all examples of economic policies designed to achieve social objectives. We can't have it both ways. These measures distort markets severely and limit productivity growth, slow overall economic growth, and cause unemployment. Rather than support these measures, it is better to level the playing field, create a bigger economic pie, and manage the distribution of that pie through the tax code for individuals.

Seven, most people don't recognize the destructive power of big government on economic development. Big governments demand big taxation. When part of the economy is informal, and untaxed, the burden falls heavily on legitimate businesses. This is a burden today's rich countries did not have when they were poor.

Eight, many people think the salvation is in the elites, the educated technocratic, political, business, and intellectual groups, who cooperate to manage economies through government. The elites are responsible for big government. Particularly in the poorer countries, the elites license business activity, control international financial and material goods flows, promote unaffordable social welfare systems, and favor government-owned businesses. Too often, the elites reward themselves richly.

Nine, some people think that nations should protect their own industries but also ask outside nations for capital. This is wrong. Direct investments by the more productive companies from the rich countries would raise the poor countries' productivity and growth rates far more effectively than sending them money. Poor countries have the potential to grow much faster than most people realize.

Ten, many people think that production is all that is needed to create economic value. This is why government sometimes protects businesses, regardless of their performance. They fail to make the link between production and consumption. The goods produced have value only because consumers want them. If they don't want them for some reason (such as high price), the business producing them needs to die. Only one force can stand up to producer special interests—consumer interests. Most poor countries are a long way from a consumption mindset and consumer rights. As a result, they are poor.

These conclusions come from the studies conducted by the McKinsey Global Institute over the past twelve years. This work is based on how individual businesses—from state-of-the-art auto plants to black-market street vendors and everything in between—actually behave and perform on a daily basis. The understanding of an economy comes from the ground up rather than the top down; a grassroots view versus a bird's-eye view. This book is going to provide the evidence and the arguments for my conclusions listed above.

How Did I Get Here?

In August 1990, I flew from Washington D.C. to Bangor, Maine, and drove a rented car to Bar Harbor. Meeting me there in his boat was Marvin Harris. I had run Marvin down a couple of weeks earlier through the University of Florida, where he was a partially retired research professor. Marvin had formerly been chairman of anthropology at Columbia and was a past president of the American Anthropological Association.

I had wanted to see Marvin because, by chance, one of the first things I did after learning that I would be the founding director of the McKinsey Global Institute was to read Marvin's recently released book, Our Kind. I had read the book while holed up in a cabin in the West Virginia Mountains over a rainy three-day Memorial weekend. Our Kind was a marvelous anthropological history of our species. It convinced me that Marvin's approach might help me some in setting direction for the McKinsey Global Institute.

McKinsey had created the McKinsey Global Institute in June 1990 to develop a better understanding of where the world was going. The specific issue on the minds of many was a phenomenon coming to be called "globalization." Globalization seemed to be so powerful that it could affect the evolution of human society. Thus, it was potentially of anthropological scale.

I had gotten all sorts of advice from many quarters about the factors that were causing and constraining globalization. Culture, religion, ethnicity, climate, and politics were all thought to matter. I needed help in sorting out the relative importance of these factors. I thought Marvin could do it. I was right.

Marvin and I spent several hours sitting in the sun at his summer house on one of the islands in the waters off Bar Harbor talking about my problem. Over a wonderful cold salmon lunch, Marvin and I agreed on the outline of a research project to sort out these factors. What I did not know at the time was that Marvin's lifetime research had already worked out the answer I needed.

During the course of the next six months, Marvin educated me about his theory of Cultural Materialism. Cultural Materialism says that there is a direction in the evolution of our species. That direction is that societies with higher productivity inevitably replace societies with lower productivity. Marvin validates his theory with a large number of case examples. In these case examples, Marvin digs down deeply to the productivity roots of things. The examples range from sacred cows in India to prohibitions against pork in Muslim countries. These case examples explain why many aspects of human behavior considered to be cultural or ethnic or even religious have been adopted because they make societies have higher productivity.

Societies with higher productivity have overcome to a greater degree whatever cultural, religious, ethnic, climatic, and political barriers have constrained productivity. These higher productivity societies have been successful in competition with lower productivity societies. They have been successful either through conquest or through simply surviving the hardships of nature.

In more recent times, this competition has often been commercial. This competition has led to the adoption of higher productivity practices by lower productivity societies. Globalization, through the transfer of higher productivity practices, might be the current method through which lower productivity societies achieve higher productivity. Thus, understanding productivity differences around the world and barriers to the transfer of higher productivity practices might reveal how globalization would proceed.

Initially, I had no appreciation of the huge differences in productivity around the world today. These differences mean that more productive societies have replaced less productive societies to a much greater degree in some parts of the world than in others. I had no idea that understanding the reasons for these differences in productivity would be the central theme of a twelve-year research program. Such a program held the potential for revealing how less productive societies could accelerate the process of becoming more productive. I, of course, did not see this potential then. However, Marvin Harris's research got me started off in that direction.

I could get started because I could connect productivity to the business world in which my colleagues in McKinsey and I had significant experience. If the most important factors in the evolution of societies were cultural or religious, then neither McKinsey nor I would have much basis for understanding where the world was going.

Productivity, on the other hand, is the most important objective that businesses and their management try to improve all around the world. The reason, of course, is that productivity is very closely connected to profitability. Productivity is simply the ratio of the value of goods and services provided consumers to the amount of time worked and capital used to produce the goods and services. If a firm produces more goods and services for the same effort or it produces the same goods and services for less effort, its profitability increases. Such a firm is likely to invest the funds from its increased profits in building a bigger business. The firm then makes even more profits. This process continues until other firms note the success of the more productive firm and copy its more productive ways. The profitability of the innovative firm returns to normal. However, the productivity of all firms is increased. Since the productivity of a society is simply the average (weighted) of the productivity of all the firms operating within it, understanding the productivity of firms around the world must be important. Why are firms in some societies more productive than firms in other societies? The answer has got to help us understand where the world is going.

Buried Statistics

Back in 1990, the most important question about where the world was going was whether the U.S. economy was going down the drain. Conventional wisdom both in the United States and abroad held that Germany and Japan had emerged from World War II with a superior economic model. The United States was either going to have to copy that model or fall behind. In fact many people assumed that Germany and Japan had already passed the United States in economic performance. At that time the most widely used measure of economic performance, GDP per capita, was calculated using market foreign exchange rates to convert GDP from one currency to another. At the market exchange rates prevailing at the time, it was true that the GDPs per capita of Germany and Japan exceeded that of the United States.

Shortly after visiting Marvin Harris, I picked up that week's Economist one Saturday just before going to play tennis. After a quick reading, I glanced briefly at the economic statistics buried at the back of the magazine. There I saw the current Organization for Economic Cooperation and Development (OECD) statistics for GDP per capita using purchasing power parity (PPP) exchange rates. By this measure, the GDP per capita of the United States was still some 20 percentage points above that of Germany and Japan. Purchasing power parity exchange rates, although subject to data gathering and statistical analysis difficulties, are conceptually the right way to convert GDPs from one currency to another for comparison purposes. I thought immediately that if this result is right, then conventional wisdom is wrong. Moreover, if the result is right, why is it right? Conventional wisdom included many explanations of why economic policies and practices in Germany and Japan were superior.

In October of 1990, I convened a meeting of five people including Marvin Harris and Tom Shelling, formerly chairman of economics at Harvard and then at the University of Maryland. The meeting was to discuss what topics the McKinsey Global Institute should study to contribute to an understanding of where the world was going. At that meeting, I showed the latest OECD statistics based on purchasing power parity exchange rates. I had found that the OECD buries these statistics in an appendix of their international comparisons report.

Tom confirmed that using purchasing power parity exchange rates was the right way to do the comparisons. I allowed that if these numbers were right, then most of the assertions in the debate in the United States about economic performance were wrong. To Tom's credit, he reflected and said, "I don't think my colleagues and I have a good handle on the health of the U.S. economy." I said, "Tom, what do we do about that?" Tom responded that we should get a group of his friends together and talk about it. I asked him who his friends were. He said Bob Solow, Francis Bator, and a couple of others. Bob is a highly regarded Nobel Laureate and Francis is one of the leading macro economists. Tom then helped me organize a meeting that included Bob and Francis to discuss the health of the U.S. economy. That meeting took place in February 1991.

Research Strategy

That February 1991 meeting ended with the idea that shaped the work of the Global Institute over the next ten years. The idea was to do case studies of a sample of economic sectors to determine differences in productivity across countries and the reasons for those differences. We got to that idea by first confirming the importance of resolving the apparent contradiction with conventional wisdom in the OECD statistics. Clive Crook, economics editor of the Economist, and Bob Bartley, editor of the editorial page of the Wall Street Journal, were in the meeting and helped us to reach this conclusion.

Second, we felt that the differences in GDP per capita should show up in differences in productivity across countries. The reason for this assumption is that in most countries the fraction of people who work is about the same. GDP per capita is simply the product of the fraction of the population that works and average worker productivity. Thus differences in GDP per capita should reflect primarily differences in productivity. We learned over the twelve years that this is true broadly around the world.

In our meeting, we reviewed the structure of modern economies and saw that service industries now dominate. In developed economies, employment in service industries accounts for 70 to 75 percent of all employment. Manufacturing accounts for 20 to 25 percent, with agriculture at less than 5 percent. The productivity of any economy is simply the average of the productivity of each individual worker. Thus if there were differences in productivity across the advanced economies, there had to be differences in productivity in the service industries because of their sheer size. Thus we concluded that if we were to tackle the conventional wisdom question, we would first study service industries. Since there would be no hope of studying all service industries, the idea was that case studies of productivity differences in a sample of service industries might reveal whether conventional wisdom was wrong, and if so, why.

The February meeting was followed quickly by a Saturday-morning meeting at Francis Bator's house in Cambridge MA. In addition to Francis, Bob Solow and Tom Schelling were there. We organized the first project of the Global Institute. A team of McKinsey consultants would study 5 key service industries in Japan, Germany, the United Kingdom, France, and the United States. We ended up choosing airlines, telecommunications, retail banking, retailing, and restaurants.

The project took a year to complete and ended up confirming the OECD statistics that the GDP per capita in the United States was significantly higher than in the other advanced economies. In all the case studies, the productivity in the United States was higher. In some cases, it was dramatically higher. For instance, the productivity of retailing in Japan was only 44 percent of retailing productivity in the United States. Productivity of telecommunications in Germany and the United Kingdom was only about 50 percent of the productivity in the United States. Productivity of retail banking in Germany and the United Kingdom was only about 65 percent of productivity in the United States. In countries where capital is freely available, where the workforce is well educated, and where technology and other business innovations are readily available, it was amazing that such large differences in performance existed.

Because the productivity results contradicted conventional wisdom, it was crucial to determine the reasons for the results. We started at the bottom within individual businesses. The productivity of an economic sector is simply the average (weighted) of the productivities of all the firms in the sector. Differences in the services delivered and in the way those services are delivered in each firm have to explain the differences in productivity. For instance, much of Japan's retailing services are delivered by small, unproductive mom-and-pop retailers. In contrast, retailing services in the United States are dominated by large, highly productive supermarkets and discount stores. Moreover, with similar telecommunications infrastructure, U.S. businesses make far more telephone calls than their counterparts in Germany and the United Kingdom. Thus the capital invested in the telecommunications industry in the U.S. is used more productively. The burning question was what causes these differences. Why have business managers and owners made decisions that have led to such differences in business operations, with their very different productivities? Fortunately, unlike many efforts in this area, we had the resources and experience to tackle such questions on a large scale.

Manufacturing Wrong Too

Another reason for our working first on service industries was our assumption that the United States had to be behind Japan and Germany in manufacturing. After all, in the early 1990s the newspapers were full of stories of how Japanese manufacturers were flooding the U.S. market with their products and wiping out U.S. companies and jobs of American workers. The automotive and steel industries got the most attention, but other industries including machine tools and consumer electronics had similar results. My assumption was that U.S. superiority in the much larger service industries was overcoming U.S. shortfalls in manufacturing.

Towards the end of our service sector project, Martin Baily, one of the economists on the committee reviewing our work, mentioned that some rough work in the economics literature suggested that the United States still had a significant lead in manufacturing productivity over Japan and Germany. Given our success in conducting case studies in service industries, I decided that we would conduct a similar project in manufacturing. Beginning in October 1992, we conducted nine industry studies in manufacturing over the next twelve months. We studied automotive assembly, automotive parts, machine tools, steel, computers, consumer electronics, food processing, beer, and soap and detergents in Japan, Germany, and the United States.

The most important thing about our results was that they explained Japan. We saw clearly that Japan had a dual economy. Sure enough, in automotive, steel, machine tools, and consumer electronics, Japan had the highest productivity in the world, exceeding the United States by 20 percent in automotive and 50 percent in steel. Japan's high-performing industries corresponded exactly to the industries in which Japan was having extraordinary success in trade. However, there was another Japan that was not involved in trade and was hidden from the global view. In food processing, for instance, the productivity of Japanese workers was only one-third of that in the United States.

Food processing is a huge industry in virtually every modern economy. In Japan, there are more workers in food processing than in steel, automotive, consumer electronics, and machine tools combined. Since the productivity of the whole manufacturing sector is the average of the productivities of each individual worker, the very low productivity of the large number of Japanese workers in food processing pulls the Japanese average down below the U.S. average. Thus we found Japan's economy to be composed of a few manufacturing industries with the highest productivity in the world alongside manufacturing and service industries with much lower productivity than in the United States.

Our results for Germany were not as dramatic as for Japan. In all but two cases, productivity in Germany was lower than in the United States. In machine tools and steel it was about equal to the United States. In automotive, productivity in Germany was about 70 percent of the United States figure. U.S. productivity was higher in automotive because of direct competition with the more productive Japanese industry. Japanese car makers not only exported to the open U.S. market but also built automotive plants in the United States that operated at close to Japanese productivity. Japanese cars accounted for about 30 percent of the U.S. market but only about 15 percent in Germany. The more intense competition in the United States with global best practice forced U.S. automotive firms to improve faster than automotive firms in Germany.

Payoff

I was surprised at how clear a picture our service and manufacturing results gave of the world's leading economies. The clarity of the picture clearly came from the industry studies themselves. The industry studies allowed us to relate our economic results to everyday circumstances, such as the large number of Japanese cars in the United States and the very high prices of retail goods in Japan. At the same time, it seemed miraculous that our industry study results and the overall OECD results were consistent. After all, they were developed in totally different ways. The OECD results came from adding up all the sales to final users in each country's currency to get GDP and then converting the totals to a common currency using purchasing power parity exchange rates. These exchange rates are calculated by finding the prices in local currencies of a large sample of the same items in different economies and using these price relationships to convert the GDP numbers to a common currency. Thus the OECD results came from two huge data-gathering and statistical analysis operations. On the other hand, our industry studies were based on counting physical products such as cars and tons of steel and then adjusting the physical counts for relative quality and other characteristics of value to consumers. That the two totally independent approaches gave the same results was deeply reassuring about our conclusions.

Outside Reaction

The outside reaction to our results was also surprising. They immediately became news stories. Sylvia Nasar, who at the time was writing economics columns for the New York Times, wrote about our results on the first page of the Times business section. She called our results "the most authoritative comparison to date" of country economic performance. News stories also appeared in the Wall Street Journal, the Economist, and the Financial Times. Such attention indicated a deep public interest in the real health of the U.S. economy and the importance of a satisfying explanation of why the conventional wisdom was wrong.

Our first service sector report was issued in the middle of October 1992, some three weeks before the 1992 presidential election. Of course Bill Clinton had campaigned that the U.S. economy was going down the drain and needed fixing. On the day of the release, Nasar's column appeared. By 10:00 a.m. that morning, I had received a half-dozen phone calls from Little Rock as the Clinton campaign tried to figure out what was going on. I of course made all our results available to them immediately. At the same time, some of my Republican colleagues immediately recognized the significance of our results for the presidential campaign. They tried very hard to bring these results to the attention of the Bush senior White House but were unsuccessful. The only reference to our results on the Republican side came from Barbara Bush on one of the morning talk shows. Needless to say, the Democratic side kept quiet.

Once elected, Clinton appointed Laura Tyson as chairman of his Council of Economic Advisers and Robert Reich as his secretary of labor. Tyson was an advocate of managed trade and believed that much of Japan's success came from emphasis on strategic industries. She thought the United States should copy Japan in this regard. Reich, on the other hand, was an admirer of the German labor market and thought the United States should copy a substantial part of it. Our results showed that the U.S. model actually worked better than the German and Japanese models. Thus, U.S. economic policy should focus on making the U.S. model work better and not on copying the Japanese and German models.

Fortunately for the country, economic policy proceeded along this line. A former Clinton administration official, who later came to work at McKinsey, told me that our work had contributed substantially to their abandoning their initial policy direction on trade and labor. Clinton had clearly been wrong about the health of the U.S. economy. Adam Meyerson, a former editor of the "Manager's Journal" column in the Wall Street Journal, remarked to me one morning on the Washington subway that our productivity studies had changed the economic debate in the United States.

The reaction in Japan and Germany to our results about the health of the U.S. economy was strong. In Japan there was complete denial. The Japanese were understandably highly proud of their economic recovery after the war. Moreover, Japan has been the only country in the world to go from being a developing country to a developed country within the past hundred years. Even in 1950, 50 percent of the workers in Japan worked in agriculture. By 1990, that fraction had declined to less than 10 percent and was in line with other developed countries.

On the other hand, the Japanese had been misled by their success in international trade, and by the extraordinarily inflated values of their stock market and their real estate. At the beginning of the 1990s, the Japanese stock market index was five times its current value, and the paper value of the Imperial Palace grounds in central Tokyo was equal to the value of all real estate in California. The Japanese themselves missed the fact that they had a dual economy. Their overall productivity was only about 65 percent of that of the United States, and much of Japan's impressive economic growth had come from the massive application of labor and capital. However, with the exception of about half its manufacturing sector, that labor and capital had been applied relatively unproductively. Of course there are limits to how many people can work and to how many hours each worker works. Moreover, there are only so many pieces of equipment that a worker can use. The Japanese stock market and real estate market behaved as if this input-intensive growth could go on forever. In the early 1990s as Japanese workers achieved shorter, not longer, working hours, and as much of the massive investment of the late 1980s remained unused, Japanese growth stalled. It has remained stalled for the past ten years.

Not only were the Japanese proud of their economic success, but many other parties in Asia were also proud of the Japanese success. After five centuries of Western leadership in economic progress, finally an Asian society was perceived to be the leader. In early 1994 at a conference of business leaders in Taiwan, my results were met with disbelief. One gentleman remarked that he knew I came from a reputable firm, but my results were nonsense. He said there was no way I could have adequately taken into account the far superior quality of Japanese products. I responded as calmly as I could that the products of most of the leading Japanese manufacturing companies were sold in the U.S. market. U.S. consumers do pay a price premium over U.S. products when the quality of Japanese products is higher. That premium is the additional economic value to consumers of the higher quality of Japanese products. So when we counted the number of midsized cars produced in Japan, we increased the count by the ratio of the price of a Toyota Camry to the average midsized car produced in the United States. I doubt if I convinced that audience in 1994 that I was right. However, one member of that business community told me within the last year that he still remembers that I was the first person to explain Japan to them.

The reaction in Germany to our results was similar in many respects to the reaction in Japan. Germany also was understandably proud of its economic recovery after the war. Of course, in the early 1990s, even though Germany had already been reunified, when we talked of the German economy, everybody really had the West German economy in mind. Germany viewed itself as the strongest manufacturing economy in the world and had little regard for the importance of service industries. Moreover, West Germans had been misled by their success in competing with the rest of Europe once the European Common Market had been formed.

At a conference of global business leaders in Washington in 1992, I presented the results of our service sector case studies. The CEO of Siemens at the time, Karlheinz Kaske, said he was puzzled about the role of service industries in an economy and wondered why we paid so much attention to them. I showed the group some recent results from our analysis of the interconnectedness of the U.S. economy. We had found that for the economic value reflected in the sale price of a consumer good, two-thirds of that value was created by the consumer good manufacturing firm and one-third of the value was generated by the transportation, wholesaling, and retailing functions that got the good from the manufacturer's loading dock to the hands of the consumer.

Moreover, of the total value produced by the manufacturing firm, one-fourth of that value was created by accounting, banking, legal, consulting, janitorial, and other business services. Thus, services accounted for one-half of the value to a consumer from the purchase of a good such as a CD, a can of beans, or a car. On top of this, one-half of all services are delivered directly to consumers and not to firms. From this light, it's easy to see why services make up about 75 percent of the total value created in an economy. Germans were not taking their performance in service industries into account in forming their perception of the performance of their economy.

Employment and Growth

In the early 1990s, as we were finishing our productivity work on manufacturing and services, the most serious economic issue in Europe was not productivity but high and rising unemployment. Every time Europe had a business downturn, unemployment rose. Every time there was a business upturn, unemployment stayed constant. The net result was that unemployment rates in Europe were two to three times as high as in the United States. At the urging of my colleagues in Europe, we decided to see whether our industry study approach would yield new insight into the reasons for the differences in employment performance.

We quickly found that in the decade of the 1980s the United States had created far more new jobs relative to the growth of the working-age population than in Europe. The question was why. We started with the relationship that employment levels are the result of dividing the overall level of production of an economy by the productivity of the workforce.

This simple relationship has led to one of the most serious public misunderstandings about how economies work. It is tempting to conclude that if productivity increases, then employment must go down. After all, if the workforce works more efficiently, then fewer workers are needed. This line of thought stops too soon. It fails to consider what happens after productivity is improved and workers are available to be redeployed somewhere else in the economy. It assumes incorrectly that the amount of business activity in an economy is fixed. In fact, if workers are available, entrepreneurs can match them with new business ideas and investment capital and thus increase the total amount of business activity in an economy. The production of goods and services thus increases, along with the productivity increase, and employment levels do not have to decrease.

After all, 200 years ago virtually all people who could work worked in agriculture. Since that time, productivity in agriculture has increased tremendously. Now in the advanced countries, less than 5 percent of the workforce is able to feed their entire population and then some. However the remaining 95 percent of the potential workers are not sitting around simply eating what the 5 percent produces. Obviously, over time these workers had been redeployed to new business activities that produce the huge variety of goods and services that characterize all advanced economies. This change is the natural evolution of all economies.

By this time in our work, it was clear that we were venturing far beyond simple productivity comparisons. We were looking at the fundamental forces that determine how economies grow and the employment consequences of growth. Economic work on these questions long ago pointed out quite logically that growth depended on an increase in the amount people work and the amount of equipment they use and on an increase in the efficiency with which people work and the capability of the equipment they use. Somehow in Europe, the efficiency of the workforce was increasing but the available labor was not being matched with new business ideas and additional equipment to create growth and employment. The natural evolution was proceeding differently in Europe from the United States.

We looked at the structure of the European and U.S. economies and found that the employment distribution was quite different. The U.S. had far more people working in services than Europe did. In fact, the biggest differences were in residential construction and retailing. We asked why this is so. What we found is that many of the factors that distort the nature of competition and result in lower productivity also limit the production of more goods and services.

I did not realize it exactly at this time, but by enabling an understanding of productivity, growth in goods and services, and employment, our industry study approach provided a new way to understand country economic performance.

Country Economic Performance

In the spring of 1994, I was meeting with Christian Caspar, my McKinsey evaluator. In McKinsey, European partners evaluate the performance of U.S. partners and vice versa. Christian is Swedish and was the partner in charge of our Scandinavian offices. In reviewing my work on manufacturing and service productivity and unemployment, Christian asked if I would add Sweden to the cross-country comparisons. Christian may have thought he had a little extra leverage on me at the time. I reflected for a second and replied that if we added Sweden to all the productivity and employment performance comparisons, we would really have a picture of Sweden's fundamental economic performance as a country. I asked Christian if he was prepared for me to come out with a point of view about Sweden's performance. To his credit, he said yes.

This was the starting point of a series of thirteen country studies covering all the major economies in the world, with the regrettable exception of China. The initial three years addressed OECD countries, where McKinsey's practice had been well established for a long time. As soon as we had confirmed that our industry study approach was going to work in Sweden to yield a point of view about that economy, we immediately started a similar project in Australia. That was followed by a joint study on France and Germany at the same time. Then came Japan and our first real stumbling block.

In 1996 we attempted to do a similar country study for Japan. At that time in Japan, there was some concern about Japan's economic performance. Japan had grown very little since the stock market and real estate bubbles had burst in the early 1990s. However, most of the country was still in denial. The conventional wisdom was that the old input-led growth strategies would lead Japan forward. I found virtually no acceptance of the view that productivity was the fundamental engine of growth. As a result, I was unable to persuade my Japanese McKinsey colleagues to start at the beginning with productivity. As a result, we conducted a project that devoted most of its effort to thinking of new, interesting products that current Japanese companies could add to their production.

My academic advisory committee for that first Japanese project included Masa Aoki, a highly regarded Japanese economist in the Stanford Economics Department. Masa suffered through that first project without complaining, even though we did not get down to the real issues of Japan. By 1999, the no-growth picture of Japan was inescapable to all observers. At that time, the Global Institute had a worldly young Japanese consultant who could lead a second try in Japan to get at the real issues. That person was James Kondo. James was a graduate of Harvard Business School who liked the work of the Global Institute so much that he'd already had two stints with me. James was a true Global Institute veteran, having spent six months working on our projects on capital productivity and on France and Germany, and then a full year on our project in Russia. James knew how productivity was the key to economic performance. Near the end of the second project on Japan, Masa made the remark to James in Japanese that the second project seemed much better than the first.

Within the OECD countries, I had not yet dealt with an apparent paradox. Every time I discussed my results with Continental Europeans, I got one retort I could not handle. That retort was that if the U.S. economy is so great, how come the United Kingdom, the other "Anglo-Saxon" economy, is doing so poorly. This was clearly an apparent paradox. The universal perception was that Margaret Thatcher had deregulated the UK economy to make it similar to the United States. Yet the UK GDP per capita was only 70 percent of the U.S. figure and somewhat behind France and Germany. What I knew was that Margaret Thatcher had deregulated the UK capital market and labor market, but I knew nothing about the industry level restrictions governing the conduct of individual businesses and therefore determining the nature of competition in the United Kingdom. My hypothesis was that the United Kingdom had to have significant industry level market distortions. However, I had no evidence, and I found little interest among my UK colleagues in resolving the paradox.

My opportunity came when the Labor government took office in 1997. Shortly thereafter, Gordon Brown, the new chancellor of the exchequer, contacted me through Adair Turner, a former partner of mine who was then head of the Confederation of British Industries. The chancellor was anticipating the British assumption of the rotating chairs of both the European Union and the G-7. He was concerned about the economic performance in the rest of Europe and wanted to use this opportunity to improve Europe's performance. He said that during the UK election, our study of France and Germany was the best economic analysis he had read. I replied that he would not be able to lead economic policy improvement in Europe without a diagnosis of the UK economy also. He agreed and offered to pay something for a UK study. I declined the money because the results of a study even partially financed by one political party would be suspect. Thus I got my chance.

Of course what we found was that whereas the United Kingdom had Anglo-Saxon capital and labor markets, it had a "Continental" product market, the market where goods and services are bought and sold. Moreover, UK firms adhered to the regulations to the letter. Competition was severely distorted in many sectors. In particular, the development of the retailing and hotel sectors was severely constrained by planning regulations. These regulations, for instance, made it torturous to attempt to improve any property with a structure on it over one hundred years old. The paradox of the UK economy was resolved, and Gordon Brown got a plateful of improvements needed at home.

The Rest of the World

After finishing our country study of France and Germany in early 1997, I was confident that we could do country studies of OECD countries. Of course, we did subsequently conduct country studies of the Netherlands, the United Kingdom, and Japan a second time. However, with the economic reforms around the world of the early 1990s, substantial interest had arisen in "emerging markets" economies. Since McKinsey's practice was growing rapidly in these markets, it seemed possible that the Global Institute could conduct country studies in developing countries.

Korea and Brazil were the obvious first candidates to study. Korea was one of the few middle-income countries, with a GDP per capita at the low end of the range of the OECD countries. In fact, Korea was joining the OECD as we conducted the study. Korea is the largest of the "Asian Tigers," with the most comprehensive economy. Brazil was at the top of the poor countries, with a GDP per capita about 25 percent of that of the United States. Brazil has half the GDP and half the population of all of South America.

Korea

Our work in Korea turned out to be very similar to our work in Japan. This is because we found that Korea was following the Japanese development path almost exactly. Koreans worked extraordinarily long hours and invested enormous sums in plant and equipment. This led to substantial growth in GDP per capita but at relatively low productivity. The one difference with Japan was that Korea had borrowed substantially from other countries to finance its investment. Therein lay the seeds of its financial crisis, which occurred in late 1997 as we were conducting our study. The capital productivity of Korean firms in such sectors as automotive, semiconductors, and steel minimills was so low that they were unable to meet the debt service requirements of their loans, which were at international interest rates. Foreign lenders were unwilling to extend additional loans and the crisis was precipitated.

The IMF of course prescribed its traditional remedies of reforming the banking system and opening the country to trade. Our work showed that these remedies would leave Korea vulnerable to another crisis. This was because the much larger domestic sector also needed drastic reform in order to create jobs to replace those that would be shed in the manufacturing sector because of the IMF remedies. Reform of zoning laws was especially needed to allow for shopping centers and large-scale single-family housing developments.

Brazil

Brazil turned out to be the first truly developing country we tackled. The issue was whether we could gather sufficient data to conduct industry studies. In Brazil many businesses operate and many people work on an unofficial basis. This means they don't pay taxes, government regulations don't apply, and they don't show up in the national economic statistics. In retailing, for instance, about half the people work in this "informal" way. We found that studies in Brazil had analyzed a large enough sample of this informal activity that we could piece together a good enough picture of the microeconomic dynamics of individual industries. We had to supplement this information with extensive interviewing of individual businesses.

For instance, one of our young consultants spent two days recording everything that went on in a small cardboard-constructed retailing business in the middle of one of the huge slums that surround Säo Paulo. The consultant also provided day care services for the child of the woman who was running the business. This service probably improved her productivity above what it normally was. Even then, it was only 8 percent of the U.S. retailing average. Thus, in Brazil, we first came into contact with perhaps the most fundamental change needed for much higher living standards in poor countries. That change is the evolution of workers from low-productivity jobs in informal firms to much higher productivity jobs in formal firms.

Russia

Having shown that we could obtain results in Brazil, I decided we had to try Russia. The failure of the Russian economy was viewed in the late 1990s as perhaps the most serious economic problem in the world. The replacement of the centrally planned economy in the Soviet Union with a "market economy" in Russia had resulted in a drop in GDP per capita of an amazing 20 to 30 percent. Russia had shown that a market economy could clearly perform much worse than a centrally planned economy. We had to find out why. What we learned is that it is possible to distort the competition in a market economy sufficiently so that the outcome is worse than from central planning. Some firms not paying their taxes and energy bills while others do is just one example of these distortions.

Poland

In the course of our work in Russia, I took notice of how the other countries formerly in the Soviet sphere were performing economically. Poland clearly stood out. Most of the former Soviet sphere countries had dropped in GDP per capita since 1990. Poland was the only country where GDP per capita was higher in 1999 than it was in 1990. Poland was up by about 20 percent. Thus as part of our Russia study, we began to investigate why Russia and Poland had gone in opposite directions from roughly the same starting point in 1990.

Out of the blue one day I got a telephone call from the executive assistant to Leszek Balcerowicz, the deputy prime minister and finance minister of Poland. Balcerowicz was the legendary reformer responsible for Poland's success. The assistant said that Professor Balcerowicz had read about our study of the United Kingdom in the Economist and that he wanted us to do a similar study on Poland. Even though the McKinsey practice in Poland was not well enough established to support such a study, I could not turn down a request from Balcerowicz for some help.

In Poland, a quick survey indicated Poland had done many things right. Its macroeconomic policies seemed consistent with current best thinking, including having a flexible exchange rate. As a result, Poland had been affected very little by the "Asian financial crisis" that swept around the world in 1998, plunging many developing countries, including Russia, into economic chaos. Poland did have naggingly high unemployment, ranging from 10 to 15 percent. The source of this problem was at the core of Poland's domestic economy, in residential construction and retailing. These industries are the most difficult for any country to get right. Poland's failure to privatize urban real estate and end subsidized rents was preventing the retailing and housing construction industries from growing and creating jobs. Moreover, zoning laws were preventing suburban development from taking off.

India

Even after studying all these countries, we still had not addressed economic conditions under which most of the people in the world live. Brazil, Russia, and Poland all have GDPs per capita of 20 to 25 percent of that of the United States. Even though they still have 20 to 30 percent of their employment in agriculture, their structure looks roughly similar to the most developed countries. Manufacturing employment accounts for 20 to 30 percent of all employment, and employment in services is already higher than in manufacturing or agriculture. The structure of economies however, changes dramatically as GDP per capita goes below this level. The majority of the world's people still live in economies where agriculture accounts for at least 50 percent of all employment. Thus in order to understand today's global economy, we had to study at least one of the world's poorest countries.

Of course, the two strongest candidates are obvious: China and India. My choice had to be India. McKinsey's practice in India was well established, we could work in English, and India had a number of well-trained and globally respected economists with whom we could work. One of my two serious regrets from the past ten years of work is that we have not done China. However, within the next ten years India is likely to become the world's most populous country, and it has a GDP per capita of only 6 percent of that of the United States. India is clearly a major anchor point for understanding the economies of the world's poorest people. (The second regret is that we did not study South Africa and thus have learned nothing about a whole continent. However, India alone has 200 million more people than the entire African continent.)

Starting in December 1999, I thus undertook a study of India. It turned out to be the largest project we conducted over the last twelve years. It took eighteen months to complete and we studied fourteen separate economic sectors. The highest number of sectors before had been ten in Russia. In India we had no choice but to study agriculture for the first time. As a result, we conducted sector studies in dairy and wheat. We found that dairy in India had the largest employment of any sector anywhere in the world in absolute numbers of people. Indians get much of their protein from milk and not meat.

We found that India had created a development trap for itself. Farmers have no incentive to further invest in mechanization. The farmers are not dumb. There are so many workers in rural areas with no alternative but to work in agriculture that rural wage levels are incredibly low. They are so low that farmers are better off employing these workers than in further investing, for instance, in combines for wheat harvesting. Thus agriculture in India will not move much further until enough jobs are created in manufacturing and service industries to drain the excess workers out of agriculture. Then, rural wages will increase and farmers will have the needed incentive to invest and thereby improve their productivity. However, India has by far the most restrictions and barriers on the development of the manufacturing and service industries of all the countries we have studied. Restricting the manufacture of 836 products to small-scale industries and prohibiting investment in India by the world's most productive retailers from France, the United Kingdom, and the United States are just two examples.

U.S. New Economy?

As the 1990s drew to a close and we were finishing our work on India, the newspapers were full of stories about how our starting point, the United States, had a "new economy." Thus to close my survey of the global economy, I concluded that I needed to loop back and revisit the performance of the U.S. economy.

The new economy stories threw in everything: a never-ending rise in the stock market; paper shares in information technology companies that traded for real money without the companies having ever made a profit and sometimes without having any revenues; computers found everywhere all connected by the Internet; computer scientists and MBAs being lavishly recruited and with starting salaries that approached the salary of the president of the United States, etc. However, in economic terms, there were only two dimensions in which the United States might have a new economy. The first was that the United States was having the lowest unemployment rate since the war and at the same time the lowest inflation rate since the war. These two factors are thought to move in opposite directions not the same direction. Second, after 25 years of productivity growth of about 1.5 percent per year, starting in 1995 the productivity growth rate accelerated to an average of about 2.5 percent for the period 1995 to '99.

The unemployment and inflation paradox was not something that the work of the Global Institute was likely to help resolve. On the other hand, we had learned a lot about productivity over the past ten years. Moreover, Alan Greenspan was making the argument that the productivity acceleration explained the unemployment and inflation performance. He believed that because the productivity acceleration caused an acceleration in real wages, workers were less inclined to press for additional wage increases as the labor market got tighter. Thus it seemed clear that we should tackle the causes of the productivity acceleration.

Needless to say, the idea of investigating the productivity acceleration occurred to many economists. At the time we began our work in September 2000, several points of view were already on the table. At one extreme, Bob Gordon at Northwestern concluded that all the productivity acceleration came from the increased performance of the computers we were producing and from "cyclical" factors that were part of the normal fluctuation of an economy and which would not persist. At the other extreme, the Economic Report of the President issued in January 2001 concluded that a fundamental change associated with the widespread application of information technology had indeed occurred in the U.S. economy in the 1990s. Alan Greenspan's justification for not tightening monetary policy and for letting the economy roll seems to have been based on agreement with the view expressed in that last Clinton economic report.

All these conclusions were based primarily on extremely complex, data-intensive "regression" analyses standard in economics. Regression analyses always have great difficulty explaining causality in an understandable and satisfying way. Our hope was that our traditional approach of industry studies would allow us to identify exactly where the productivity acceleration had occurred and what businesses had done to cause the acceleration.

In the end the industry study approach worked. We found that the United States did not have a new economy nearly to the extent that Clinton and Greenspan claimed. Sadly, this result has been validated by the disappearance of vigorous economic growth and huge budget surpluses.

The revisiting of the U.S. economy was a good way to end my journey through the global economy. It reconfirmed the role that competition plays in stimulating innovation and productivity improvement. In every sector in which productivity accelerated in the United States in the second half of the 1990s, competition intensified. Sometimes the increased intensity was triggered by regulatory changes, as in mobile telephone services and the reduction of the price per trade in securities. Other times, it came from business innovation like Wal-Mart's. Information technology was just part of the story. The bigger story was competition causing more productive business enterprises to replace less productive ones. This conclusion is of course reassuring to those worried about the health of the U.S. economy. However, it provides even more reason to worry about all the people living in economies where protection and distortion of competition allow unproductive enterprises to persist and cause these people to fall further behind, but even more importantly, to remain in poverty.

 

Copyright notice: Excerpt from pages ix-xxxi of The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability by William W. Lewis, published by the University of Chicago Press. ©2004 by William W. Lewis. All rights reserved. This text may be used and shared in accordance with the fair-use provisions of U.S. copyright law, and it may be archived and redistributed in electronic form, provided that this entire notice, including copyright information, is carried and provided that the University of Chicago Press is notified and no fee is charged for access. Archiving, redistribution, or republication of this text on other terms, in any medium, requires the consent of the University of Chicago Press.

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William W. Lewis
The Power of Productivity: Wealth, Poverty, and the Threat to Global Stability
©2004, 370 pages, 37 line drawings
Cloth $28.00 ISBN: 0-226-47676-6
Paper $14.00 ISBN: 0-226-47698-7

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