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(The online version of this article appears in four parts. Click here to go to parts one, three, and four.)

Rule 3 Two routes other than radical technological change can lead to high-growth, high-rate-of-return opportunities: sociological disequilibriums and developmental disequilibriums.

ENTREPENEURS see sociological opportunities to change human habits. Starbucks persuaded Americans to replace their fifty-cent cup of coffee bought at a local restaurant with a $2.50 cup of coffee bought at a coffee bar. They turned a competitive commodity with widely distributed points of sale out of which no one made much money into a noncompetitive differentiated product, and created a rapidly growing industry with high rates of return from which great fortunes could emerge.

The cruise industry took advantage of a shift in demographics: the relative purchasing power of the elderly had doubled in two decades. Seventy-year-olds twenty years earlier had cash incomes 40 percent below those of thirty-year-olds; suddenly seventy-year-olds had cash incomes 20 percent above those of thirty-year-olds. Cruises, known at least since the days of Cleopatra, became the perfect vacation for the elderly: We move you; you don't move. Some owners of cruise lines have become billionaires by exploiting sociological disequilibriums.

The problem with wealth generated this way is that sociological disequilibriums usually reflect a transfer of existing wealth rather than the generation of new wealth. Those who were selling conventional cups of coffee now sell fewer of them, and thousands of mom-and-pop restaurants make less money. The extra two dollars a cup that goes to Starbucks is two dollars that isn't spent somewhere else.

deconstruction What might be called developmental disequilibrium exists whenever countries or entrepreneurs can replicate the activities of the developed world in the underdeveloped world.

A year or so before the hand-over of Hong Kong from Britain to China, I was sitting in the lounge at the Hong Kong airport eavesdropping on a conversation between two rich Chinese businessmen on their way to spend six months in Vancouver in order to get Canadian passports -- their insurance policy in case things went wrong in Hong Kong. They were complaining about having to stay so long in Vancouver, because they could see no way of using their time there to make money. To hear them describe it, Vancouver was an economic desert. Why? Vancouver, after all, is richer than Hong Kong.

The answer is to be found in the absence of developmental disequilibriums in Canada. In Hong Kong these businessmen had become rich by exploiting the differences between the developed world and poor, but now open, mainland China. They simply copied what was done in the developed world and replicated it in China. What were commodity operations with low rates of return and few growth prospects in the developed world were high-return, high-growth opportunities in China. These businessmen were skilled at replication and at knowing the exact time when mainland-Chinese conditions were ripe for any particular activity.

Vancouver held no replication opportunities. All the normal First World activities already existed there. To get rich in Vancouver one needed breakthrough technologies or new sociological concepts. The businessmen had neither. For them Vancouver truly was an economic desert.

Rule 4 Making capitalism work in a deflationary environment is much harder than making it work in an inflationary environment.

SYSTEMATIC deflation is not a certainty, but the third industrial revolution has made it likely enough that there's good reason to think about how standard economic operating procedures change when prices start to fall.

Globalization is forcing prices down. Production is being moved from high-cost to low-cost locations, and prices are falling as a result. Name any major product, calculate how much the world could produce if every factory were operating at capacity, subtract what the world is going to buy, and you'll find that the world's production potential exceeds expected consumption by at least a third. Cars, semiconductor chips, and oil are but three of many examples. With such an excess of production capacity, falling prices are no mystery. Firms have an enormous incentive to lower prices in an attempt to keep their facilities operating closer to capacity.

Globalization also brings pressure to bear to change work practices, to raise productivity, and to lower wages. BMW used its ability to set up a manufacturing plant in the United States as leverage with its unions to change work practices in Germany. Flexible shifts were introduced in Germany so that when demand was high, the plants could operate on weekends. This allowed capital costs to be cut by a quarter. BMW workers essentially have bank accounts in which their hours of work on weekends or after a normal shift can be deposited. When demand is low, workers who aren't needed can draw pay for the hours of work accumulated in their bank accounts. Overtime is not paid unless it is clear that total hours of work in a year will exceed the standard. The company is now spreading these practices to its Rover plants, in Britain. The British workers have been told that they must cut the productivity gap, of 30 percent, between themselves and the Germans. BMW does not have to threaten that if they don't, production will be moved elsewhere. Everyone knows that. With labor costs and wages down (the same pressures have been forcing down real weekly U.S. wages for the bottom two thirds of the work force at the rate of about a percentage point a year for the past twenty-five years), prices must eventually start to fall.

The Asian meltdown substantially increases the downward pressures on prices. Indonesia and Thailand have to export more, and can do so only by lowering prices. If their global competitors, mostly in the Third World, do not want to lose market share, they have no choice but to match the lower prices. In the developed world similar pressure comes from Korea and Japan.

New technologies, especially those affecting energy, minerals, and agricultural products, are also driving prices down very rapidly. Oil prices were at an all-time low early this year. Gold, that bellwether commodity, is also down dramatically from where it was just a few years ago. In every case new processes are dramatically cutting the costs of extracting value from nature.

Downsizing and outsourcing have also played a role in reducing prices. It is common in America for companies to have contracts with their suppliers that require annual price reductions. Auto-parts manufacturers, for example, have signed contracts with the major auto producers calling for price reductions of three percent a year. Outsourcing is largely responsible for these tough contracts, because it is easier to get tough with an outside supplier than it is with an inside supplier. If an outside supplier makes no money with the lower prices, that is his problem. But if an inside supplier makes no money, the corporation loses in one of its selling divisions what it gains in one of its buying divisions. It sees no gain in aggregate profits. Such practices led to a fall in new-car prices in the United States last year for the first time since the early 1970s.

In a deflationary world debt is to be avoided at all costs. Real interest rates (nominal money rates plus the rate of deflation) are very high and debts have to be repaid in dollars of greater value than the dollars that were borrowed. Those with debts want to repay them as quickly as possible, because debt burdens automatically grow larger in real terms over time. If prices fall by 10 percent, a $100 debt effectively becomes a $110 debt. And if debt reduction becomes the No. 1 priority, no one will invest in the things that cause growth.

Rule 5 There are no institutional substitutes for individual entrepreneurial change agents.

CAPITALISM is a process of creative destruction. The new destroys the old. Both the creation and the destruction are essential to driving the economy forward. Entrepreneurs are central to the process of creative destruction; they bring the new technologies and the new concepts into active commercial use. They are the change agents of capitalism.

The old patterns of powerful vested interests must be broken if the new is to exist, but those vested interests fight back. They are not willing to fade quietly into the pages of history. Entrepreneurs built the national companies that destroyed local companies at the end of the nineteenth century, and they are building the global companies that are destroying national companies at the end of the twentieth century.

History teaches us that it is only too easy to stamp out entrepreneurship. It is a fundamental human characteristic but, despite its creative and destructive powers, an extremely fragile one. Among most peoples in most times and most places entrepreneurs do not exist. The economic possibilities exist, but they are not seen, the energy to realize them is lacking, or the risks they involve seem too great.

When societies aren't organized so that the old vested interests can be brushed aside, entrepreneurs cannot emerge. Social systems have to be built in which entrepreneurs have the freedom to destroy the old. Yet destroying the old can too easily be seen as a step into chaos. Societies that aren't ready to break with the past aren't willing to let entrepreneurs come into existence.

Europe provides a good example of the importance of entrepreneurship. Europe saves and invests more than the United States, has a better-educated populace, and has a basic understanding of science that is just as good as that in the United States, yet it has created none of the new brainpower industries of the twenty-first century. Last year the production arm of the last indigenous European computer manufacturer, Siemens Nixdorf, was sold to Acer, of Taiwan. How can a region be a leader in the twenty-first century and be completely out of the computer business? The European entrepreneurs that should exist don't.

Sociology almost always dominates technology. Ideas often lie unused because people do not want to use them. The fact that something is possible does not mean that it will happen. Great persistence is needed to bring a truly new idea into the market. Steam toys have been unearthed in the archaeological exploration of ancient Greece, and the ancient Egyptians had steam-powered temple doors -- yet the steam engine did not emerge as a source of power for economic production until the eighteenth century. The right sociology had to be in place for revolutionary new products to emerge.

Continued...

The online version of this article appears in four parts. Click here to go to parts one, three, and four.


Lester C. Thurow is a professor of management and economics at the Massachusetts Institute of Technology. This article will appear in somewhat different form in his book Building Wealth: New Rules for Individuals, Companies, and Nations in a Knowledge-Based Economy which is to be published by Harper Business in June 1999.

Illustrations by Alison Seiffer.

Copyright © 1999 by The Atlantic Monthly Company. All rights reserved.
The Atlantic Monthly; June 1999; Building Wealth - 99.06 (Part Two); Volume 283, No. 6; page 57-69.