Is The US In A Phase Change To The Creative Economy?

Wednesday, February 1st, 2012

Steve Denning, Contributor Forbes

History is a record of exploded ideas.

- Admiral Fisher

In a stunning article in Vanity Fair, Nobel Prize-winning economist Joe Stiglitz asks the critical question: is the US economy going through a fundamental shift in the nature of the economy? Is the US economy is undergoing a phase change—a shift from one fundamental economic state to another?

The economic recovery that isn’t

Stiglitz shows that despite recent improvements there has been no “economic recovery” in the sense of any previous “economic recovery”:

  • Almost five years since the bursting of the housing bubble, and four years since the onset of the recession, there are still 6.6 million fewer jobs in the United States than there were four years ago.
  • Some 23 million Americans who would like to work full-time cannot get a job. Almost half of those who are unemployed have been unemployed long-term.
  • Wages are falling—the real income of a typical American household is now below the level it was in 1997.
  • A short-term stimulus, moderate in size, was put in place to tide the economy over until the banks could be restored to health.
  • Some of the money that bailed out the banks went to Wall Street bonuses. Little of it went to lending in support of the real economy.
  • A tripling of the Fed’s balance sheet provided large quantities of very cheap money to big business and banks.
  • The banks have recovered but the economy hasn’t—output is barely greater than it was before the crisis. In per capita terms, it is negative. The job situation is improving but remains bleak.
  • For the first time since the Great Depression of the 1930, four years after the onset of recession, unemployment has exceeded 8 percent  and economic output is barely greater.

Diabetes, not the flu

Why no recovery? The idea of the bailouts and the stimulus was that these measures would return the economy to where it had been before the crisis.

The striking part of Stiglitz’s argument is to say that this is indeed what has happened. The economy has gotten back to its former state. The problem, says Stiglitz, is that the former state of the economy was much worse than anyone realized. Getting back to where we were means getting back to a state of sickness, not to health.

Repairing the banking system didn’t fix the economy, because the economy was already in deep trouble, long before the financial meltdown of 2008. The boom years leading up to the meltdown were a mirage fueled by unsustainable debt. Although US firms were still leading the information-technology revolution, incomes for most working Americans hadn’t returned to their levels prior to the previous recession. The bottom 80 percent of the American population had been spending around 110 percent of its income. This level of indebtedness was enabled by the housing bubble, which the Fed helped the banks engineer. The arrangements were based on asset valuations “determined in part by mass delusion”.

Stiglitz might have drawn on the Deloitte’s Shift Index to support his case with the steady decline in the rate of return on assets and invested income of US firms.

The economy in the years before the current crisis existed in a bubble. The unsustainable consumption to which it gave rise, acted as life support. Without these supports, unemployment would have been high.

It was “absurd to think,” says Stiglitz, “that fixing the banking system could by itself restore the economy to health. Bringing the economy back to ‘where it was’ did nothing to address the underlying problems.”

The diagnosis of the situation was wrong, argues Stiglitz. It’s as if the economic doctors saw the economy as having a temporary disease, like a bout of the flu, when in fact it was suffering from a chronic disease like diabetes that will take years to deal with.

The analogy to the Great Depression

Stiglitz draws a striking parallel to the Great Depression, which is often attributed to a meltdown of the banking system. The conventional wisdom is that the Fed caused the Depression by tightening the money supply. If only the Fed back then had increased the money supply, it is said, a full-blown Depression might have been averted. This enduring belief among economists explains why the Fed is now massively expanding the money supply, i.e. “to avoid the mistake of the Great Depression.”

In reality, according to Stiglitz, the banking crisis of 1933 didn’t cause the Great Depression. The financial meltdown reflected a phase change in the economy from an agricultural economy to a manufacturing economy. The financial meltdown of 1933 was the consequence not the cause of the Great Depression. The joblessness of the times was a sign of the economic phase change already well under way.

Thus in 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. With better farming practices, fewer people were needed. At the beginning of the 1930s, more than a fifth of all Americans still worked on farms. A much smaller percentage was actually needed. Today, 2 percent of Americans produce more food than we can consume. The Great Depression, says Stiglitz, was about finding jobs for all those who were no longer needed on farms.

Thus the breakdown of the banking system in the Great Depression didn’t culminate until 1933, after the Depression began and after unemployment had started to soar. By 1931 unemployment was already around 16 percent, and it reached 23 percent in 1932. The underlying cause was a structural change in the real economy.

With accelerating productivity in the 1920s, farm output increased faster than demand. Prices and incomes fell sharply. Farmers then (like workers now) borrowed heavily to sustain living standards and production. A financial crisis ensued because the farmers couldn’t pay back what they owed and the banks that had lent them money became insolvent.

The economy stumbled along for almost a decade after the meltdown in 1933. It only recovered by accident, as a result of World War II.  Government spending unintentionally completed the necessary structural transformation, moving America, and especially the South, decisively from agriculture to manufacturing.

The crisis in the real economy

Stiglitz sees today’s problems of the banking sector, though bad enough, as a red herring in our search for real solutions. The real solutions are “rooted in the kinds of jobs we have, the kind we need, and the kind we’re losing, and rooted as well in the kind of workers we want and the kind we don’t know what to do with. The real economy has been in a state of wrenching transition for decades, and its dislocations have never been squarely faced.” A crisis of the real economy is the cause of the current Great Stagnation, just as it was the root cause of the Great Depression.

Stiglitz sees a strong parallel between the origin of the Great Depression and the origin of our current Great Stagnation. In the Great Depression, the economy shifted from agriculture to manufacturing. Today we are once again moving from one kind of economy to another.

Stiglitz notes the shift of jobs out of manufacturing. The decline in manufacturing jobs has been dramatic—from about a third of the workforce 60 years ago to less than a tenth of it today, as a result of greater productivity anda disastrous outsourcing of manufacturing overseas. The millions of jobless former factory workers of today are the modern-day equivalent of the Depression’s doomed farmers.

The transition to the Creative Economy

If the phase change in the Great Depression was a transition from agriculture to manufacturing, what is the transition to today? Stiglitz sees it as atransition from manufacturing to a service economy.

A service economy is certainly one looming possibility for the US economy, but a service economy per se is unlikely to be an American success story. If all American workers do is mow lawns, cut hair, export raw materials, and market and sell goods manufactured in other countries, the wealth of the nation is unlikely to be great. The US will in effect have become a Third World economy. It will be unable to support even the current standard of living, let alone an improving quality of life. In effect, a service economy with sharply lower incomes and standard of living for most people will be politically unacceptable.

Instead the needed transition is from a factory economy to the Creative Economy. The Creative Economy is one in which both manufacturing andservices play a role. It is an economy in which the driving force is innovation. It is an economy in which organizations are nimble and agile and continually offering new value to customers and delivering it sooner. The Creative Economy is an economy in which firms focus not on short-term financial returns but rather on creating long-term customer value based on trust. It is described in Chapter 3 of Richard Florida’s classic book, The Rise of the Creative Class (2003).

What must the private sector do?

Most large firms of today are ill-equipped to compete in the emerging Creative Economy, in which globalization and the shift in power in the marketplace from seller to buyer have put the customer in charge.   Most big firms still have a factory mindset oriented to economies of scale. They are focused principally on maximizing short-term shareholder value. They are not organized for continuous innovation. This way of managing is unable to mobilize the full creative talents of their employees. As noted above, the rate of return on assets and invested capital has been in steady decline for decades. Many firms are currently over-capitalized and yet unable to find productive uses for the money in a stagnant economy. Lending more money to these firms will do little to help revive the struggling economy. So long as these firms adhere to the goal of maximizing shareholder returns—which even Jack Welch says is “the dumbest idea in the world”—they will have great difficulty in operating effectively in The Creative Economy.

“We must shift the focus of companies back to the customer and away from shareholder value,” says Roger Martin, Dean of Rotman School ofManagement at the University of Toronto, in wonderful his book, Fixing the Game (2011). “The shift necessitates a fundamental change in our prevailing theory of the firm… The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.”

The Fortune 500 must master the management principles needed for continuous innovation that delights customers. The command-and-control management of hierarchical bureaucracy is inherently unable to delight anyone–it was never intended to. To delight customers, a radically different kind of management needs to be in place, with a different role for the managers, a different way of coordinating work, a different set of values and a different way of communicating. This is not rocket science. It’s called radical management.

Firms like Apple [AAPL], Amazon [AMZN] or Salesforce [CRM] are showing the way. Those firms that opt not to change won’t survive. The choice is clear: delight or die.

The Creative Economy will also be partly built on manufacturing. This is not about a shift out of manufacturing into services. In fact, although jobs were lost, manufacturing never died. Even adjusted for inflation, manufacturing output is near an all-time high. In real terms, we’re making more than twice as much today as we were in the early 1970s.

True, some manufacturing subsectors were lost due to short-term profit taking. In the foreign outsourcing of manufacturing, managers chased economies of scale, often overlooking the additional costs of transport, inventory management, quality control, sales, marketing and distribution of large production runs, as well the risks involved in such extended supply chains. They paid scant attention to the long-run costs of losing knowledge and the opportunity to learn.

Now the economics of large-scale production runs carried out overseas are being undermined by the possibility of making, selling and delivering millions of manufactured items one unit at a time, right next to the customer. Digital manufacturing is beginning to do to manufacturing what the Internet has done to information-based goods and services. Just as video went from a handful of broadcast networks to millions of producers on YouTube within a decade, a massive transition from centralized production to a “maker culture” of dispersed manufacturing innovation is under way today.

What must government do?

Stiglitz advocates “a massive investment program—as we did, virtually by accident, 80 years ago—that will increase our productivity for years to come, and will also increase employment now. This public investment, and the resultant restoration in G.D.P., increases the returns to private investment.” He suggests large investments in infrastructure, technology, and education for decades, as well as support for “small and medium-size companies, especially new ones, which are disproportionately the source of job creation in any economy, and they have been especially hard-hit. What’s needed is to get banks out of the dangerous business of speculating and back into the boring business of lending.”

Stiglitz asks: “Can we actually bring ourselves to do this, in the absence of mobilization for global war?” and replies: “Maybe not.” Clearly, when politics is dominated by issues such as whether the President is born in Kenya (he wasn’t), whether the country should repay its debts (it must), whether people should have affordable health care (they should), or whether the country should maintain its infrastructure (it has no choice), it is reasonable to wonder whether the country can muster the intelligence and the will needed for such a great effort.

Nevertheless, change will happen: the economic situation will continue to deteriorate until the pain becomes so great that action will have be to be taken. The question is whether we fight the phase change or facilitate it.

A huge opportunity awaits us

We have, Stiglitz suggests, misunderstood our situation. We are not as well off as we thought we were. The pain that we feel is the inevitable pain of a great economic phase change. Americans in general are coming to understand what has happened. What is needed now is a focus on the opportunities offered by the future. We need a clear understanding of the nature of the journey that we are negotiating and intelligent action to get through the transition as quickly and painlessly as possible. The Creative Economy is a huge opportunity that awaits us.

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