Sunday, December 11, 2011

On The Future of Capitalism: Frontier Economics?

Brink Lindsey provides a glimpse at the future of the economy and capitalism in an article in The American Interest: Frontier Economics. Lindsey claims that the US and all developed countries have left one phase of growth and entered a new phase. This new phase is highly uncertain in terms of direction, hence the term "frontier economics." He provides a description of how we arrived at the place we are, and suggests what must be done to accommodate this new future that lies before us.

It is crucial to understand the phases of growth that occur as an economy matures.

"To begin with it is important to understand that economic growth comes in different forms. For present purposes, the key distinction is between growth as more of the same and growth as something new and different. Specifically, growth as more of the same can come from capital accumulation, the expansion and upgrading of the labor force, and the adoption of ideas developed elsewhere. Or growth can come from innovation—that is, the development of new products and new production processes. The former, or imitative growth, occurs within the existing technological frontier; the latter, or innovative growth, pushes that frontier outward."

There is a corresponding view of the accumulation of wealth that produces two phases. The first focuses on providing mass availability of the more fundamental needs of society.

"For present purposes, we will refer to these two phases as the transition to mass affluence, on the one hand, and mass affluence itself, on the other."

"During the transition to mass affluence, the central economic challenge is the development and servicing of mass markets for the obvious staples of life: food, clothing, housing (including home furnishings and appliances) and transportation. The focus is on exploiting economies of scale by producing relatively homogeneous goods of middling quality aimed at middling tastes."

This phase, in the context of developing countries, is best described as an "industrialization" phase. Lindsey describes it as one that is simple, in concept, for a developing country to follow given the numerous successful examples to follow and the ability to take advantage of existing technologies.

The next phase of development becomes quite different—more complex and more uncertain.

"....the second goes by a variety of labels. Some refer to the service economy, others call it the knowledge or information economy, and still others play it close to the vest and speak simply of the postindustrial economy."

We can think of this transition as going from a state in which the consumers’ needs and desires are understood, to one in which consumers’ needs and desires must be anticipated or created.

"What new products would people buy? What nuances of function or design or marketing would separate big sellers from duds? During the industrial era, investors could identify mass markets that weren’t yet saturated and know with reasonable certainty that the future would bring their further expansion. Now, however, the future is more obscure than ever."

Lindsey declares that the transition from the industrial phase to the post-industrial phase affects not only the way businesses operate, but it also changes the nature of the business-government interaction.

"....compared to rich countries, less developed countries can thrive with a distinctly different institutional mix between markets and government than that which prevails in more advanced countries. Because of the availability of catch-up growth, poor countries can reserve a larger role for government as both market regulator and market participant and still deliver excellent economic performance. In particular, the government can dominate decision-making over the large-scale allocation of capital—through state-owned enterprises, control over the financial sector, corporatist coordination and industrial policy."

The post-industrial era forces companies to think in terms of many more markets, but ones that are smaller and more specialized. This requires a focus on rapid innovation and quick turnover of products. This trend towards specialized or "niche" markets lessens the need for huge capital investments and provides an easier path for new companies to jump in with an innovation and seize or create a market. Given this environment, Lindsey insists that the role of government must be diminished in order to not impede this process. He does not deny that regulation is needed wherever abuses occur, but he believes it is critical that this creative construction and destruction process proceed unimpeded.

"Reduced market barriers to entry make government efforts to direct the course of economic development increasingly problematic. Such efforts typically take the form of funneling resources to existing producers through directed credit, restrictions on competition or outright subsidies. When market conditions are such that the status of leading producers in a given industry is fairly stable even without government intervention, such interventions can be relatively benign. Basically, what government does in these situations is to augment and accelerate investments that would happen anyway."

"When, however, the marketplace is considerably more dynamic, there is a greater risk that government intervention will misfire by propping up incumbent firms and thwarting the emergence of new firms with better ways of doing things. The opportunity costs of backing the wrong horse go up as well, as the possible trajectories of industries with and without intervention grow increasingly divergent."

Lindsey provides a compelling and insightful description of how the economy is evolving, but it is not a given that it will, or can, evolve in a satisfactory manner. What recent developments tell us is that the economy has become efficient at rapidly creating large concentrations of wealth, but very inefficient at creating jobs. That is not a viable long-term path. Lindsey’s suggestion of a highly uncertain business future might sound exciting to some, but uncertainty also suggests randomness. That does not appear to be an attribute of a stable society. One way or another we need an economy that can provide income for all of our citizens. There is no guarantee, or even a hint, that the "frontier economy" can provide this.

Tyler Cowen, in his book The Great Stagnation provides some insight into what the "new" economy provides us. Consider one of the "successes" of the new era: Facebook. This company is quoted as having a grand total of 1,700+ employees and a potential market valuation that has been estimated between $100 billion and $1 trillion. Compare that with General Motors of the old economy: 77,000 US employees and a market valuation of about $33 billion. Google provides jobs for about 22,000 employees, not a large number, but it can at least claim to be providing productivity gains for the economy. Facebook is probably an enormous productivity killer.

Cowen also targets Apple, the current darling of the industrial world. He quotes a study that indicates the revolutionary, highly innovative iPod created a net of 13,920 jobs in the US. Cowen points out that that number does not include all the jobs in the music industry that were lost when the iPod became popular. It is not clear that any net jobs became available. It is hard to create jobs when every time you purchase an Apple product you are siphoning money out of the economy and sending it elsewhere.

If these are examples of what the "frontier" economy holds in store for us, we are in big trouble. One could as easily argue that the conditions faced by the economy argue for a much greater involvement by the government.

Cowen’s book and his thoughts on capitalism and the economy will be presented in a subsequent article.

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