The book examines the strategic implications of what de Kuijper calls "The Transparent Economy." How do companies make money in a world of perfect information, where everyone knows what everyone else is doing, and where competition is absolutely intense? She argues:

Profit power is economic clout--the ability of a company to hold on to the value it itself has created, as well as to extract a share of profits from its competitors, to create incremental value for itself and for its partners in business relationships, and to shape the risks it and others will take on....Being "the best" does not guarantee that your company can hold on to its hard-earned gains. Only profit power does that.

These are not the perfect information markets we learned about in introductory economics, where everyone makes the same profits. You have to have some edge (which she calls "power nodes") to ensure that you are not squeezed out by the competition.

The link between this book and the "The Big Shift" of the previous post should be clear. Hagel and company are concerned that American companies, on average, are losing ground because of intense competition, with some companies doing much better than others. de Kuijper is concerned with how to make sure your company is in the winning camp. (Her reasoning applies to careers as well)

Profit Power Economics is a very stimulating read, whether you are a business manager or someone trying to figure out the best career path. The book is a bit dense in parts, but well worth the trouble.

Now there's a new report out today from Deloitte's Center for the Edge which provides additional confirmation that the underlying problems extended well beyond the financial sector, and started well before the housing bubble.

Back in June, the Center--led by John Hagel III, John Seely Brown, and Lang Davison--released a report showing that U.S. corporate return on assets has fallen by 75% since 1965. They suggested this decline in corporate performance was driven by the "Big Shift"--a tremendous increase in competitive pressure, combined with the increasingly pervasive digital infrastructure.

At the time, I told Hagel that I didn't want to write about his "Big Shift" until I saw industry data, so I could understand which industries were driving the corporate performance decline. Well, the new report from the Center takes a closer look at nine industries, out of which seven show the same pattern of deteriorating corporate performance.

For example, here's the ROA chart for the tech sector.

As the report says:

And what about innovation? At least as conventionally defined and practiced, innovation may not help the trend. The Technology industry, known for innovation, experienced one of the steepest ROA declines of all the industries we studied. This suggests that while product and technology innovation may be necessary, they also are not sufficient.

There are two industries where corporate performance is still strong, according to Hagel & Co: Aerospace & Defense and Health Care. The report notes:

We do not believe it is an accident that two of the most highly regulated industries in the U.S.—Aerospace & Defense and Health Care—are outliers in a broader trend of performance erosion. The ever-more-powerful digital infrastructure increases the potential for competitive intensity and performance pressures, but public policy shapes the degree to which specific industries feel that pressure

I still have to chew through the report some more. But it's pretty interesting.

But here's something else. If we are to believe these numbers, the biggest financial crisis since the Great Depression has actually produced a productivity gain of 5.1% since the downturn started in the fourth quarter of 2007.

If you think that productivity has risen by 5.1% during the financial crisis, I've got a subprime bond to sell you.

Let me get this straight. We have a collapse of the housing and construction sector, massive layoffs in almost every part of the economy, a sharp downturn in consumer spending, and bank failures on an astonishing scale---and the numbers show an increase in productivity?

It defies common sense.

I suggest two reasons why the numbers are off. First, as in my recent cover, companies are cutting educated workers such as scientists and engineers who are not directly involved in the immediate production process. This means a drop in important but unmeasured intangible investments in R&D, product development, training, and advertising, which are not getting picked up by the GDP statistics.

Second, and this is relevant to the DC conference mentioned in the previous post, the statistics are being greatly distorted by globalization. Let's take a look at the computer purchases and supply, as reported by BEA.

According to the BEA's number, final sales of U.S.-produced computers has *risen* by 3.9% since 07IV, while imports of computers have *fallen* by 1.5%. Over the same stretch, employment in the computer industry has fallen by 12.5%. Being incredibly simple-minded, that would suggest that productivity in the U.S. computer industry has risen by about 19% in the downturn. Not bad, if true!

But there's a problem. According to the BEA's stats, the price of imported computers has fallen by 9.6% since the end of 2007, while the price of computers to consumers has fallen by 22.2%.

That doesn't make sense. It's far more likely, as I argued here, that the import price stats are mismeasured.

If we assume that import computer prices really fell at the same rate as domestic consumption, that would mean import growth is really faster, and domestic output growth is slower, as is productivity growth. By my back of the envelope calculation, the effect on computer industry productivity growth is potentially huge (I'll give the details later after I have had a chance to check them). This sort of calculation extends to the rest of the economy, though less dramatically.

So for these two reasons, I am quite skeptical of the proposition that the financial crisis has increased output per hour.

Measurement Issues Arising from the Growth of Globalization

This is a very important conference as we try to figure what is *really* going on in the U.S. economy. I'll be writing more about it.

Is Buffett right that a bet on Burlington Northern is a bet on the economic future of the U.S.? Because if Buffett is right, we've got real problems.

Let's take a look at what Burlington Northern carries. Its major freight revenues (as of 2008) come from coal (23% of revenues); agricultural products (20%); international intermodal shipments of consumer products, which is probably mostly imports (16%); construction and building products (14%); and petroleum products (4%).

In essence, Buffett is betting that the next ten years will look a lot like the last ten: A lot of growth in imports, construction, energy and agricultural products. If he thought that innovation was going to be the driver of the next ten years--biotech, energy, and infotech--he wouldn't be buying Burlington Northern.

I'm not saying that Buffett is wrong. His skepticism about the tech sector in the late 1990s, and innovation in general, turned out to be right on the mark. Berkshire Hathaway stock over the past decade has risen by 84%, whil the S&P 500 is down by 18%.

But his "all-in wager on the economic future of the United States" paints a remarkably gloomy picture of where we are heading.

...reduced its Automotive structural costs by $1 billion in the quarter, largely driven by lower manufacturing and engineering costs, which included benefits from improved productivity, personnel reduction actions primarily in North America and Europe, and progress on implementing its common global platforms and product development processes.

So this leaves two questions: First, how much of these cost reductions came from cuts in intangible investments such as engineering, research and development?

The answer is: The earnings report doesn't tell us. R&D and product development are not broken out separately on a quarterly basis, even though Ford has had an enormous budget for these items ($7.3 billion in 2008, according to the 10K).

Second, is engineering, research and development money being shifted to Ford's overseas operations? Once again, the earnings report is mute on this point. The 10K says

We maintain extensive engineering, research and design centers for these purposes, include large centers in Dearborn, Michigan; Dunton, England; Gothenburg, Sweden; and Aachen and Merkenich, Germany

As Ford makes "progress on implementing its common global platforms and product development processes," it would be good to know the size of the ER&D spending cuts and where they are hitting.

Wow, when the chief economist at Businessweek is capable of writing a sentence like "if U.S.-based companies are doing their research and product development overseas and their production there as well, it's tough to see how ordinary workers in the U.S. will gain," it's easy to see why this magazine was recently sold off for almost nothing, around $5 million, or around $15k per employee as one article estimated. The ordinary worker gains because they can buy goods for cheaper, it's that simple.

Actually, it's not that simple. If one nation improves its capabilities while others stand still, there's nothing about the arithmetic of trade that requires that all nations benefit.

The simplest way to see this is to think about oil. Suppose that a very cheap substitute for oil was discovered in the U.S. Clearly U.S. standard of living would rise, and overall the average global standard of living would rise--but the standard of living in the oil producing countries of the Mideast would fall dramatically.

The parallel here--if China improves its R&D capabilities while the U.S. stands still, there is *nothing* about the arithmetic of trade in a multinational world that requires that Americans will benefit. Nothing.

I stand ready for people to argue with me.

P.S. Hopefully I'm not to blame for BW's sale!

Added November 3: Novartis announced that it is going to invest $1 billion over the next 5 years for a new R&D facility in China. Just a few days earlier, the company announced that overall R&D expenditures were down by 6% over the previous year. You draw your own conclusion about the future path of spending.

If you care about R&D, product design, worker training, or any of that other good stuff, you might want to look at my new cover story. I’ll be adding to this over the weekend.

The rate of job cuts for production workers in manufacturing has slowed dramatically in the past few months, as companies start to rebuild inventories.

However, they are still aggressively slicing their nonproduction workers--engineers, managers, sales staff, and the like. Over the last three months, employment of manufacturing nonprod workers is falling at a 7.6% annual pace, compared to a 4.2% pace for production workers.

Good news for the U.S.? Nope. Remember that the U.S. manufacturing productivity stats are not adjusted for offshoring. That is, when a U.S. manufacturer starts buying or making parts overseas, rather than making them at home, domestic factory employment drops. However, the BLS stats can still report the same output. The result? A reported rise in productivity.

[Added 11/1/2009: As David Martin correctly points out in his comment, the international manufacturing productivity comparisons from the BLS actually use the BEA value-added measure. My mistake, my apologies. However, in two cover stories and various other stories, I've spent a lot of time explaining why the BEA manufacturing measure *also* significantly understates the impact of offshoring, because import prices are mismeasured.]

I ask you--with manufacturing productivity dropping around the world, is it more likely that the U.S. is one of the few countries where manufacturing productivity is rising? Or is it more likely that our view of the U.S., with the biggest goods imports in the world, is being warped by a statistical mirage?

2008 increase in manufacturing output per hour
U.S. 1.2%
Korea 1.2%
United Kingdom 0.3%
Germany -0.1%
Japan -0.2%
Taiwan -0.5%
France -0.8%
Canada -2.6%
Sweden -3.7%

Thanks.

So I've spent the past few hours reading up on Ostrom and Williamson's work. The two of them share a common thread: They have both spent their careers studying alternatives to markets and government. Williamson focused on a simple question: If markets are so good, why is so much economic activity organized within businesses, which are run as hierarchies?

Ostrom focused on a more subtle question--if you have a shared "common-pool resource" like a forest or the ocean, what is the right way to manage it? Typical answers have focused on either collective management (i.e. government control) or effective privatization (i.e. fishing permits). But Ostrom has argued that all sorts of other institutions can grow up over time that give good results.

Her principles for good management of collective resources include:

(i) rules should clearly define who has what entitlement,
(ii) adequate conflict resolution mechanisms should be in place
(iii) an individual’s duty to maintain the resource should stand in reasonable proportion to the benefits.
iv) monitoring and sanctioning should be carried out either by the users themselves or by someone who is accountable to the users.
vi) governance is more successful when decision processes are democratic in the sense that a majority of users are allowed to participate in the modification of the rules
(vii) the right of users to self-organize is clearly recognized by outside authorities

The political implications of this year's Nobel prize are clear. In the aftermath of the financial crisis, people are experiencing a revulsion against markets. However, turning the economy over to the government is not palatable either, since no one really believes the politicians and bureaucrats will do a better job. The same two-sided distrust of markets and government is shaping the healthcare reform and climate change debates.

From that perspective, the Ostrom/Williamson prize may come at exactly the right time, since it shows that there are credible alternatives to the dueling poles of market and government.

Added: The Ostrom prize was a surprise to many, if not most, economists. The Economics Prize Pool at Harvard tabbed Williamson as one of the favorites, but did not mention Ostrom.

I'm going to find out if she was on the reading list for environmental economics courses. If not, there's a problem.

That's not a good thing. It means that the fundamental imbalances in the global economy are reasserting themselves.

What's worse, our trade deficit in advanced technology products is actually worse than it was a year ago, before the crisis hit. That's a sign of a fundamental problem in what should be a U.S. strength.