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On Global Business and Economics in Volatile Times
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Eternal Culture of Business in Shanghai?
When it comes to understanding another culture, I believe in the approach of the proverbial five blind man discovering an elephant: Everyone offers a different perspective that is very partial, yet together they offer quite a good understanding. So, when I travel, I have made it my habit to read on the plane a book - often bought at the airport - about the country I am travelling to. Not a tourist guide or a 'doing business in' type book, they are too boring. Rather, I like to read something more loosely related: a history book, a novel, or an autobiography.
This time, I found a particularly fascinating book; a book about doing business in China written in 1937. The author, Carl Crow had lived in China for about 25 years as journalist and as advertising agent. His writings illustrate deep insights into contemporary culture, though his forecast of a vast and growing market turned out to be premature: In 1937, the Japanese took over Shanghai, Crow had to flee the country and the economic boom took a break - for about fifty years.
In my mind Crow's observations raised issues of continuity of culture. In some ways, Crows observations seem to hold true for Shanghai 2010, especially culturally grounded mercurial behaviours, patterns of relationships, and trust in brands. In other ways, it has fundamentally changed, not just physically but also in the way business is done. In this way, Crow raises lots of suggestions that merit empirical testing - like any advise received from an old-China-hand or an academic study. It is always wise to form your own opinion rather that take the experts to literal; and with the passing of over 70 years, Carl Crow won't be loosing face if you disagree with him.
The Bundesbank-Affair in a Historical Perspective
The Deutsche Bundesbank used to be one of the most powerful institutions in Europe, being the guarantor of the Deutsche Mark - and thus all the other currencies linked to it by more or less fixed exchange rates. Its power has been greatly diminished by the introduction of the Euro - the big monetary policy decisions are now being taken by the European Central Bank (ECB). Yet, it was still an institution held in high esteem, until the recent Sarrazin affair: Essentially one member of the board of the Bundesbank made a series of provocative anti-immigration political statements, culminating in a book in which he implies a genetic inferiority of certain immigrant groups. This is - rightly - upsetting people in Germany, for at least two reasons.
Firstly, from a practical point of view, members of the board of the Bundesbank are appointed because of their competence in economics - and monetary economics in particular - to play a leading independent role in shaping economic policy. To ensure this political independence, they are appointed on fixed term contracts during which it is virtually impossible to fire them. If a member of the board uses this position to launch a political agenda that has nothing to do with economic policy, he is abusing the position, and, in my view, violating the spirit of his appointment, and in fact endangering the trust in the policies of the institution.
For the second reason, I need to start with a personal anecdote. My grandfather used to teach Biology to university and high school students - girls aged 17 to 18. Those teenage girls in their final year at school had figured out that "Herr Professor" was so easy to distract - just ask some question about his little son and he would go and tell stories for most of the session and forget about the textbook stuff they were supposed to study. What the girls did not know, and found out only years later, was that this distractedness of their professor was not by chance - the professor didn't want to talk about the material on the official schedule for the class.
This was in the late 1930s/early 1940s in Germany. The final chapter in the Biology textbook for high schools covered human genetics - with evidence for the supposed genetic superiority of the Arian (Germanic) race, and the supposed genetic inferiority of Jews in particular. When I first saw the textbook that my grandfather had to use for teaching, I was truly disgusted. The Nazis were not only using pseudo-scientific methods to provide a foundation for their ideology of racial superiority of one race over the other; they were using high school biology classes to propagate this ideology.
With this history of false genetics being used as ideological foundation for a racist policy, Germans are rightly sensitive to false genetics arguments being put forward in contemporary politics. Sadly, many younger people don't know about this aspect of European history, and fall prey to its demagogues.
Are there any more general lessons to learn from this affair? May be, this is another case of an economist knowing a lot about economic theory, but far too little of economic history (see March 2009).
Given my interest in election systems, it is fortuitous to observe the Australian elections first hand. For the election of the lower house of parliament, Australians use an 'alternative preference' voting system in which voters rank the candidates; the votes are then counted like in multiple run-off elections. Hence, to be elected, a candidate needs to obtain more than 50% of the votes including secondary preferences of candidates that did not make it into the top-2. Does this make any difference in practice?
Following the news in the run-off to the election, it is hard to notice much difference to the UK: Most of the media coverage was focused on just two candidates representing the two major parties: Labour and the 'Coalition', which consists of two parties (Liberals and Nationals) that do not actually compete against each other in the constituencies. Only paying careful attention, news-listeners or readers will actually note that, firstly, the Green party regularly gets double-digit shares of the (first-preference) votes, and that independents are important in a number of rural constituencies. The media give the impression that neither of the top candidates are very popular (not to mention charismatic) and the parties are very close to each other on many key issues. The media just love battles between two heroic individuals rather than deep discussions on issues - no election system will be able to change that.
The AP system, however, induces candidates to court voters whose first love is one of the smaller parties. In the UK, the message might be 'don't waste your vote on the Greens', in Australia the message is, 'if you want to vote Green give me your second preference vote'. Moreover, it avoids outcomes where MPs are legitimized only by a third of the electorate because the vote is split between several candidates. The political dynamics within each constituency thus are somewhat different, reducing the chance of a candidate with polar views being elected due to split opposition - which is good.
The election outcome suggests that the media may have paid too much attention to the big two parties: Out of 150 MPs, 5 are independent or Green (with 3 constituencies still not declared), and they hold the balance of power as the big parties have almost equal numbers of votes. In fact - like in the UK - in 2010 Australia has the first parliament without overall control, and the first Green MP elected in a southern coastal city. Thus, voters around the world seem to be fed-up with two party systems, where to elites essentially shuffling power between them. However, both sides declare victory and try to convince the media that they deserve to govern (again, similar to the UK). Yet, it will be up to the majority in parliament to decide....
So, what can we learn for the UK? Nothing much, I am afraid. Australia has in most parts a two party system with the third party (Greens) being much weaker than the third party in UK politics (LibDems), not to mention, Plaid Cymru, Scottish Nationals and UKIP all of which received strong support in regional or European elections. Thus, the dynamics of second preferences in the UK would likely be much more complex. However, I have earlier predicted that the overall shares of seats in parliament is unlikely to change substantially if AP is introduced in the UK (May). Based on my observations in Australia, I stick to this prediction - apart from noting that we might have a handful of independents. Thus, I would not expect AP to boost the LibDems number of seats in Westminster!
Incentives to write a Sequel: Superfreakonomics
Bestsellers written by Economists are rare, but Freakonomics was a bestseller. Unsurprisingly, the authors, Steven Levitt and Stephen Dubner, couldn't resist the temptation to write a sequel. Both books are great fund to read - there are stories and anecdotes about prostitutes and terrorists, doctors and experiments. It is so entertaining that it is easy to overlook that both books actually contain a serious message:
People respond to incentives, but not always in the predicted ways. For most people trained as economists this seems obvious, if not trivial. The challenge, however, is what exactly the incentives are that people react to. Incomplete understanding of the incentive systems can lead to misleading inferences and bad policy advice.
Levitt and Dubner are essentially reporting applied microeconomics research. Levitt has done a great deal empirical research himself, and Dubner, a journalist, helps to communicate it. Together they trailed through vast amounts of other people's research, to come up with interesting empirical puzzles - and then try to explain the apparently puzzling human behaviour. Sometimes there are assumptions or jumps in the argument, but they are difficult to identify, and probably the authors are right on most points. The chapter on climate change is, however, less convincing as Levitt and Dubner turn to be rather technology-optimistic in a naive sort of way. May be the global climate is a bit 'macro' for microeconomists.
If you are invited to an economist-friend's garden party, this would be the idea gift to bring along. But consider the incentives carefully. Firstly, your friend's other friends may have the same idea. Secondly, the economist might enjoy it so much that he neglects attention to the BBQ.
Eucken's Competition-based Economic System
I have variously referred to German economist Walter Eucken's writings on the preconditions for a functioning market economy. As his books do not appear to be widely available in English, I am here summarizing his approach. In doing so, rather than using literal translations, I use concepts developed in more recent literature to explain his ideas and to facilitate linkages with contemporary discussions.
In particular, I translate Wirtschaftsordnung [literally economic order] as 'Economic System' to signal a similarity to the arguments in the Varieties of Capitalism Literature (Hall and Soskice, 2002); and I translate his konstituierende & regulierende Principien [literally constituting and regulating principles] as primary and supporting sets of institutions to allude to similarities of these concepts to the rules-and-regulations definition of institutions by Douglas North.
Eucken's basic argument is that competition based on prices is the best mechanism to ensure economic prosperity, yet such a market economy does need some sort of regulatory institutions because laissez-faire liberalism of the 19th century, if left unchecked, may deliver economic growth but not yield socially desirable outcomes. A strong state is necessary to ensure the functioning of these institutions. Yet, Eucken and his collaborators at Freiburg University in the 1930s and 1940s were pretty firm that the state should not directly interfere in economic activities. Most of today's main-stream economist would probably agree with this basic view. However, differences are in the details.
Eucken identified six primary and four supporting sets of institutions that need to be in place for competition to deliver the desired outcomes (see Figure). Three of the primary institutions are grounded in the legal system, and three concern the way the government is running the economy.
The supporting institutions aim to secure the sustainability of the system, and the generation of socially acceptable outcomes:
I find it useful to occasionally remind ourselves that the economic system that supports our prosperity did not arise spontaneously, but is subject to deliberate policy decision, and it is continuously evolving. It is constantly subjected to political pressures to change, some would improve it, others threaten to weaken its basic principle, the price mechanism of a competitive market economy.
Businesses - and individuals - have to take decisions over their future every day, many involving long-term commitments. They are used to facing uncertainty; no forecast can ever be perfectly reliable. However, businesses don't like uncertainty: The higher the uncertainty the less likely businesses are to buy new machines, build new factories, or make other commitments such as hiring people. Thus, even if the medium forecast remains unchanged - increased uncertainty reduces businesses activity now. Cash is held in the bank to wait for opportunities.
You would think that, based on this simple logic, governments would be concerned to dampen volatility in the economy, or at least not to add to it. Unfortunately, they often do the the opposite. The UK governments big stimulus, the temporary VAT reduction from December 2008 came with stark warning that not only would VAT increase a year later, other taxes would have to rise to make up for the gap - yet no-one knew which.
At the same time, at height of the crisis, while the (Labour) government was talking about it fancy stimulus programs, local business people were already feeling the stress of budget cuts. In the Bath area, we have a lot of small businesses that are directly or indirectly contracting with the Ministry of Defense. They were telling us of postponements of governments orders, and a lot of uncertainty of whether orders would be forthcoming as negotiated, or not. Thus, they were wondering how to keep their business afloat until the orders eventually come in - if at all. This uncertainty thus made it difficult for small businesses to invest, and made the crisis worse. And if one such company goes bust, the MoD has to re-start its procurement process - incurring added costs. Thus, government procurement policies actively created uncertainty for the businesses serving the government.
At a rare meeting of scholars and government officials in April 2009, I made the point that in times of a storm, the best that the government could do is to be a beacon of stability. But how do you convince a politician that the best to do is to do nothing when journalist up and down the country are calling for 'action'?
The new (Conservative-LibDem) government formed in May does the same mistake. They announced scarily huge budget cuts that they blame on the need to rectify imbalances created by the previous governments. The logic seems to be to give a lot of bad news now, such that people feel a sense of relief when things turn out better than predicted, and the next elections are approaching. In early July the new chancellor was supposed to announce specifics of budget cuts, but all we heard was were percentages of how much each department is supposed to save. But when and where? A lot of businesses, public sector entities (like universities) and individuals engage with the public sector in various forms of economic transactions. As long as the government keeps creating uncertainty rather than clarity, the government itself is inhibiting businesses and individuals from investing!
Jackie Chan and the Secrets of Chinese Business
July 17, 2010
Friday night, I was watching Jonathan Ross' chat show on the BBC, where he was talking with Jackie Chan - famous for karate and action movie stunts - about his latest movie. Along the way they were talking about the differences of making a movie in the US and in China (which presumably meant 'Hong Kong').
Why does Jackie no longer do his stunts himself? The answer is not fading health, nor government regulation - but insurance. Apparently, he can't get insurance for action movies in Asia, while in the US he could get insurance, but then the insurance inspector would monitor and risk-assess his every move. He visibly was missing the good old times when they would just do it and worry later: "roll, jump, cut - hospital", which is his way of saying, we just did the stunt - if it was in the camera it was a success - injuries happen, so what?
While things are no longer that easy, for good reason, he still prefers casting movies in China: In the US every scene is planned three months in advance, while in China the actors and producers would have much more flexibility to improvise and use their creativity on the spot. In other words, excessive planning (in part presumably because of all sorts of risk assessments) kills the spontaneity in the creative arts.
I believe this anecdote contains a few lessons for understanding why Asian businesses are doing better than American (or European) businesses. The general attitude of businesses, like movie makers, is to 'get things done', an attitude that was characteristic of the USA in the 19th century but that may have been been lost over the years. Why? In Europe, we would presumably (rightly or wrongly) blame excessive government regulation and interference.
In the USA (and the UK), it is more subtle. The rules and regulations that business have to follow are to a large extend created by businesses themselves. Insurance is a good example: if businesses want to insure their staff, the details of the insurance contract dictate what staff may or may not do - far more detailed than even the most interventionist governments would consider. Similarly, large businesses want to protect themselves against all sorts of legal claims, and thus impose strict rules and reporting requirements on their staff. Naturally, staff act exactly within those rules and stay away from anything unconventional as the costs (in terms of "time to convincing the bureaucrats higher up") are just too high. In consequence, entrepreneurial initiative dies out, and businesses become stale and inflexible. Most new rules make sense on their own, but together they can bring down the economy.
Institutional Voids as a Lens for Emerging Economies
July 8, 2010
Tarun Khanna and Krisha Palepu have over the years developed the concept of ‘institutional voids’ to explain the difficulties of doing business in emerging economies. Essentially, they are asking, what institutions are missing that inhibit the efficient functioning of markets? The basic reasoning is that a market economy works best if markets are efficient; yet such market efficiency depends on institutions – rules of the game and specialist intermediaries – that are not in place in emerging economies. This line of argument is curiously similar to the thinking of Walter Eucken in the 1940s/50s, whom I was blogging about a few weeks ago (May, January). Of course, Eucken was an economist thinking about how to ensure that a market economy generates socially desirable outcomes, while Khanna and Palepu take a firm perspective. Yet, they are working in a long tradition – that also includes Nobel Prize winners Ronald Coase, Oliver Williamson and – most importantly – Douglass North.
Khanna and Palepu’s new book, Winning in Emerging Economies, uses institutional voids as core perspective for managers to help developing strategies for emerging economies. While I am not sure it is that easy to exactly pinpoint such voids, the concept provides a useful way of framing the challenges businesses may face. However, I have one concern regarding the use of this concept that I may best illustrate using an anecdote:
A professor from a Nordic country is contemplating a job offer from another country. Looking beyond the job, he was considering transactions of daily life in the country:
The professor was thus considering how much of a pay rise he should ask for to cover the (transaction) costs of these institutional voids. You probably guessed it, the country I am talking about is the USA.
My point here is this: Institutional voids exist in all countries. Unfortunately, some uses of the term seem to imply a hierarchy of market efficiency seeing the USA at the top, and a void being defined as difference to the US system. Khanna and Palepu themselves are clear that they see institutional voids everywhere; they in particular attribute the financial crisis of 2008 to institutional voids in the US mortgage banking sector (page 25). However, they argue that institutional voids are more prevalent in emerging economies, making a focus on institutional voids essential in emerging economies.
I would however want to go further. Institutional voids depend on your own perspective: If you know how to deal with the US legal, health care and income tax systems, you don’t perceive major problems of operating within it. Likewise, if you are used to drive a car for every basic transaction (like buying groceries), you won’t miss trains and busses, safe foot and cycle paths, or in fact local corner shops. In other words, the costs of dealing with institutional voids depend not only on the local context, but on the experiences and competences of the individual (or firm) wanting to do business in that context.
Football and Management: 11 Friends
June 30, 2010
Sepp Herberger, the manager of the German team that won the football world cup in 1954, is credited with the insight “you have to be eleven friends”. In other words, everyone has to play for the team – and not for themselves. AT this year’s cup, the French team has in particular illustrated that a football team is more than the sum of the individual talent – and if that “team spirit” goes, the team goes out. Some small nations have at times had great teams that won major championships, like the European champions of 1992, Denmark, and of 2004, Greece. At the same time some highly fancied teams with star players have failed in tournaments because they did not coalesce into a team.
The world has changed since 1954. “Team spirit” is still essential, but the pride of playing for the nation seems diminished, and footballers have become far more individualistic. They have become stars in their club teams – highly paid and highly revered. May be, the club team is even build around the start player in that others provide the passes that the star striker converts into marvellous goals. Yet, getting highly successful individuals to integrate in a team is a major managerial challenge – for football teams as well as for businesses that are run by bringing together highly talented individuals, from professional service firms to universities.
The French experience of the world cup 2010 illustrates that an autocratic leadership style does not work well to motivate highly skilled and talented individualists. Not in football, and not in business. Nor in universities.
June 27, 2010
Some wise man once stated that the only difference between state and private monopoly is that one of them doesn’t have a bad conscious. Unfortunately, I can’t remember which one. Dependent on their practices, both may have reasons for a bad conscious.
Most people agree that monopolies are bad the market power of the monopolist is invariably abused in some way. However, there are some industries, where a quasi monopoly is unavoidable. Take the railways for example. The companies may argue that they are competing with cars, aircraft and coach services – but in reality few customers actually face this choice for the specific journey they want to undertake – say travelling from Bath to London. So what can economic policy do?
In the early 20th century, countries across Europe nationalized their railways and ran them as state-owned companies – or as a public sector administration. The logic was clear: Putting monopolies under control of the state – and thus the elected representatives of the people – should facilitate coordination between different train lines and investment projects, while designing services and setting prices in the best interest of society. The problem was (and continues to be in many places) that democratic oversight over state companies is not very effective: governance structures tend to be opaque and interest groups are able to pursue their particular interests.
In consequence, the past two decades have seen a drive to privatize railways. Maggie Thatcher led the way, and to this day, her example is followed. The idea is that private ownership would focus managers’ minds on costs and benefits, and thus reduce the waste that supposedly bogs the railways system. Yet, how to make sure the private operators don’t abuse their market power? Regulate them: Specify specific prices, performance criteria, and fines that create the right incentives for companies to deliver value for money.
Sadly, as any regulars on the British railways can tell, it doesn’t work in practice. Britain has both the most expensive and the most unreliable train system that I have ever travelled on. Why is that? Lots of reasons can be heard among those waiting on the platform, but in my view the problem burns to a mega principle-agent conflict.
Regulation is like a contract that specifies exactly what service is to be delivered at what price, and how much users can be charged for standard services. However, railway operators maximize profits – and their true customer is the regulator. They have few incentives to really care about customers. They deliver exactly what is required, but they cut corners on issues not explicitly specified. Hence, prices for un-regulated services are sky-high, and whenever there is a disruption that can be blamed on someone else, the railway companies feel no obligation to compensate those who got stuck on the trains (or to develop appropriate contingency plans to react to “signalling failures” and other common events, or to invest in infrastructure needed in the future). The regulators have few tools to react – if they change the rules the operator will request compensation for breach of contract, and penalties will invariably result in higher prices rather than lower profits. The costs of disruptions for the British economy are huge.
Privatization is a good idea in principle. But not always and everywhere, and not the way it was done in the British railways.
As politicians argue about how to rescue economies in recession while tackling rising budget deficits, the role of the state in the economy has been a focal point of criticism. In this discussion, two quite different forms of state involvement are often mixed up: the state as owner, and the state as regulator. These two roles have quite different effects. In the middle of the 20th century, the state has in many countries become directly involved in economic activity: from running railways and hospitals, to building highways and industrial enterprises (the latter especially in developing countries trying to catch up). Most of the recent state involvement is around regulation: regulating privatized enterprises that still have a monopoly (like the railways in the UK), regulating banks to prevent another crash, or regulating health private health care (in the US or Germany).
I suggest the following matrix to illustrate the different forms of state involvement (click for enlargement):
To understand the matrix, lets look at the polar cases first.
The matrix allows representation of countries' economics systems in comparison, and their changes over time.
I suggest this matrix as anchor to clarify various arguments in the public discussion. Of course it can be further refined, for example by including 'redistribution of income' through progressive taxation and social welfare as a third dimension.
Not only the British discuss the flaws of the first-past-the-post electoral system, so do Californians. In fact, they get to vote this Tuesday on "Proposition 14", which suggests that primary elections (when the parties select their candidates) be substituted by an open election where everyone can vote for all candidates. The first two candidates would then go forward to the actual election.
The primary elections are a critical difference between the US and British electoral systems: It gives voters associated with either of the main parties the chance to select whom the want to send into the actual election. Thus, voters have power than in the UK where the candidates are selected from a shortlist vetted by the national party leadership.
Californian politics has become highly "partisan". Most constituencies are 'safe seats' where either party can be practically sure to win. This is because the socio-demographic structure is so different between the coastal areas and the farming areas inland. In consequence, for many state senators winning the primary in the own party is more challenging than winning the actual election. Hence, most of them are more concerned with pleasing their own local party than working with others to make compromises that the state needs. Hence, paralysis is normal in Californian politics.
Supporters of Proposition 14 expect that "open primaries" with the first two candidates going through - even if they belong to the same party - will strengthen moderate candidates relative to hardliners, and hence create a parliament that actually works. The system would resemble a little the French system of run-off elections between the leading candidates, and have similar effects as the 'alternative preference' system currently being discussed in the UK (see May 11). If Californians pull through with this reform, it could have dramatic effects on the political culture not only in California, but throughout the USA. The adversarial nature of US politics could be - just a bit - mellowed.
Illusion of Competition at the Train Station
On my frequent stopovers at England's second busiest train station, I often buy a coffee, a sandwich, or both, at one the outlets of Upper Crust, Costa, WH Smith or AMT. Separated from the outside world by the ticket barrier, this makes for a nice little microcosm to study competition, you would think. This high and recently sharply rising prices, however, point in a different direction.
But alas, it is not. The other day, I was getting my sandwich at WH Smith, when I was served by the gentlemen who usually sells baguettes at Upper Crust. "What are you doing here?" I asked. "I am just helping out," he replied and then explained that all these shops are owned by the same franchise taker, "there are seven of us here at the station!". Thus, while the franchise chains may be competing nationally, here at the train station they form a local monopoly.
If this happened on a national level, the competition authorities would certainly intervene, but in a confined space - a train station managed as private property - it is perfectly legal. The owner of the station (I believe it is National Rail, a de facto state company) can maximize revenues by contracting with a single service provider rather than encouraging competition. The contractor could just offer one service and charge monopoly prices - with the main competition arising from travelers buying the breakfast before entering the train station. However, using different brands, the franchise taker can segment the market, and disguise the monopoly that customers might resent.
Curiously, the cheapest coffee (after a drastic jump of prices at Upper Crust) was not available on three of my last five stopovers. The coffee machine kept braking down. Thus, I - like other travelers - faced the choice between paying 35p more for a coffee, or not having no coffee at all. Weather deliberate or not, this broken coffee machine should provide a wealth of data on customer behaviour, notably their 'price elasticity of demand', and thus allow the franchise taker to optimize revenues. With a bit of economic analysis, it should be possible to determine when the coffee machine should brake down (presumably in the mornings when people are desperate for coffee and willingly pay a higher price).
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