Structural Coherence and the Better Way to Make Cellphones

An interesting article in the Economist about the quagmire the Finnish cellphone giant Nokia finds itself in right now, lagging behind in the smartphone race against Apple and other phone makers. On the surface, this is an all too familiar story of creative destruction: the industry incumbent was too enamored of its own success, became tunneled-visioned, got caught off guard by the disruptive technology from new competitor(s), stumbled and fell... and the rest is history.

Of course the Nokia story can be told this way. However, this particular article raised a point that is not usually mentioned behind the success and failure of Nokia and its competitors:

"The first generations of modern mobile phones were purely devices for conversation and text messages. The money lay in designing desirable handsets, manufacturing them cheaply and distributing them widely. This played to European strengths. The necessary skills overlapped most of all in Finland... ... As microprocessors become more powerful, mobile phones are changing into hand-held computers. As a result, most of their value is now in software and data services. This is where America, in particular Silicon Valley, is hard to beat. ... ... the Valley boasts an unparalleled ecosystem of entrepreneurs, venture capitalists and software developers who regularly spawn innovative services."

In other words, Nokia used to be successful partly because its products and processes were "structurally coherent" to the economic fundamentals of its larger environment. Similarly, Apple and Google are successful today because their products and processes they invented are structurally coherent to THEIR economic environment. This is a piece of insight that lots of business narratives--mainly focusing on firms' innovative culture and visionary leadership-- largely ignored.

When I presented my research on structural coherence at various meetings, I told people that countries grow faster when the factor intensities of their industries are structurally coherent with the country's endowment fundamentals, and an industry has the best chance to grow if its production process uses the country's existing abundant factor intensively (see a previous post). Then I got asked the following question a lot: Ok, this may be true at industry level, but how about at firm level? Don't best firms succeed by innovating "ahead of the curve", thinking outside of the box, and not being constrained by existing "industry standards"? It seems that the formula for success at micro level is the complete opposite to that at macro level.

So is there a contradiction here? I don't think so. Of course there are countless factors that can determine a firm's fortune, but being structurally coherent with its larger economic environment, though not a sufficient condition for success on its own, is one of the basic necessary conditions. Nokia took advantage of the existing human capital in hardware engineering in its home country, applied it to the design & manufacturing of handsets and prospered. Apple tapped into the abundant resources in software design in Silicon Valley and flourished. The product strategies of both companies, at their best, are coherent with and fully exploit the fundamentals of their larger economic environments.

Of course, structural coherence alone doesn't make any single firm successful -- there may be tens of thousands of software companies in the Silicon Valley, but few achieved the same level of success as Apple or Google. Many factors play important roles in determining a firm's future. And some might say that such companies as Apple are successful because they are "innovative". However, although innovation is a much hyped word in our time, all innovations are not equal. The most successful innovations are "ahead of the curve" in terms of conceptualization of ideas and market judgment, but they are rarely ahead of the macro fundamentals of their economic environment. Just to the opposite, even the best idea can't fly high if its implementation demands inputs so different from what its macro environment can offer.

Therefore, structural coherence and product innovation are in fact complementary factors that make things happen. A country's specific factor endowment combination carries potential of success for specific types of firms and products, but this potential is only manifested in reality by firms' innovations that are structurally coherent with the environment.

Judging from this perspective, the best strategy for Nokia is to innovate on products and services that match its existing advantages and expertise, rather than trying to compete in a product (smartphone) that is more coherent with its competitors' environment. Unfortunately, it seems that the exact opposite is what they are doing.

Why Quantitative Easing Will Work Better in the US than in Any Other Countries

The Federal Reserve announced a month ago its plan to buy an additional $600 billion of Treasury securities in order to stimulate the economy. This second round of “quantitative easing” made some people cringe, for some very different-- even contradictory-- reasons. On the one hand it stirred inflation phobia in those that see excess liquidity as one of the root causes of the financial mess that we were (and still are) in. They argue that QE2 would only encourage another round of reckless financial speculation and bubbles, at a time that we least need it. On the other hand, pessimists about the Fed’s plan see no way that QE2 would accomplish the job that it is intended to, for mainly two reasons. First, the private sector is heavily in debt already and therefore has little capacity to borrow more, consume more, and invest more, not to mention that the financial intermediation sector itself is barely surviving. Lower policy rates are thus difficult to be arbitraged to the private sector’s benefit. Second, with the growth prospect in emerging markets much brighter than in the advanced economies, additional liquidity added to the system here will be quickly moved to, say, the other side of the Pacific, and ends up as emerging markets’ capital inflow and even higher foreign reserves.

While the inflation worry is still far-fetching given the currently depressed level of economic activities in this country, the skepticism about the effectiveness of QE2 seems justified. However, I’m going to argue that quantitative easing is probably more likely to work in the United States than in any other countries in the world, for two reasons. First, although the credit channel may be clogged, the policy-induced asset price increase will likely to encourage consumption through wealth effect. The asset price channel can be especially effective in the US because of the high percentage of stock ownership. Half of the US households own stocks, either through investment in individual stocks or through investment in mutual funds. This means that the wealth effect generated through higher stock prices can be far reaching, directly to half of the population and indirectly to an even wider range.

Secondly, higher asset prices are especially beneficial to the intangible-capital intensive industries and technology sectors, which in the long run drive the growth potential of the US. Partly because of the nature of their assets, intangible-capital intensive firms are more likely to seek finance through equity offering than borrowing from banks, as the latter normally requires tangible collaterals. Thus a depressed stock market is extra restrictive to the growth of high intangible sectors by making equity financing difficult. Moreover, the US has a much higher percentage of enterprises financed by venture capital and private equity firms than any other countries. Active venture investment is an important source of American innovation edge and long-run productivity growth. Venture capital firms typically exit from their investments in portfolio firms through selling their shares to other firms or to the public market. If the asset market is doing well, it’s easier for venture capitalists to exit and then invest in new firms. In contrast, when they can’t sell their existing portfolios, new start-up companies that carry productivity-enhancing potentials will be starving, too. Investing in long-term productivity and innovation is arguably the wisest thing a country can do during a downturn. But unfortunately, the funding constraints for long-run investments are most severe in the recession. People often neglect long-term goals when faced with immediate urgencies. To put things in perspective, the projected total investments in US new enterprises for 2011 is around $20bn (that’s already a significant increase from this year); in contrast, the auto bailout in the US cost $80bn, and that was only estimated in 2009.

Again, whether QE2 will be all that effective in stimulating the economy in the short run is debatable. But at least we know that if it is going to be of help, it will be most helpful here in the States. And even if it doesn’t have immediate effect on the economy, it will still have long-term benefit, though a lot of it may not be directly measurable.

What Can the Government Learn from the Structural Coherence Principle? (And Why It was Probably A Bad Idea to Bailout Detroit)

Structural coherence is the degree of alignment between a country’s factor endowments and the factor intensity level of the country’s industrial composition. For example, a country that has high capital endowment would be structurally coherent if the country’s industrial composition is dominated by capital-intensive industries; in contrast, if a capital-abundant country has an industrial composition that concentrates on labor-intensive industries, it would be structurally incoherent. My research found that the countries that have higher structural coherence level achieve higher economic growth. For a group of OECD countries, the differences in their structural coherence level explain about 25% of the variations in their economic growth.

Why should policy makers care about this? Because this result suggests that whatever can be done to maintain/increase the structural coherence level of a country would be good for its economy. In this light, government policies, investment decisions and regulatory reforms can be evaluated according to whether they help increase structural coherence or pull the economy away from structural coherence. And if the economy is in trouble, the government can think about what it can do to enhance structural coherence, either by bringing the capital intensity of the industrial composition closer to the existing level of capital endowment, or by changing the capital endowment level to meet the capital intensity of the present industrial composition, depending on which way is less costly. In general, the capital endowment of a country is probably slower and harder to change than the choice of industrial composition, though high capital mobility in today’s globalized world certainly makes it easier. That’s why it makes economic sense for the government to do whatever it can to help the industrial structure match the country’s capital endowment, instead of doing things the other way around. But we probably shouldn't take this as a rigid rule. The bottom line is: whenever there is incoherence, change whichever variable that is easier (less costly) to change.

Now let’s see how this principle can help guide the policy decisions. Let’s say there is a developing country. One day it got a large sum of foreign aid money, and it is supposed to invest the money in productive project(s) that help the country’s long-term growth. The government decides to invest in Project A: to build a factory producing electronic gadgets using the most advanced technology. The factory needs to employ local people to operate the fancy machineries. But since the country is very poor and the majority of its labor force uneducated, the government has to hire foreign experts to come train the local employees so that they become competent enough to handle the machines. Now what the government is doing here is essentially trying to marginally elevate the country’s human capital endowment in order to fit the human-capital intensity of its industrial investment plan. Can it work? Of course. Is it a good idea? Probably not. The government’s intention is a good one—to increase the country’s human capital through the investment project? (And don’t they all say human capital is important for growth?) But such a strategy is so costly to implement given the country’s original endowments that the profit level of Project A may turn out to be too low to make the investment even sustainable.

Now alternatively, the country can use the money to invest in Project B: to expand the country’s basic manufacturing industries, e.g., crafts& furniture, textile, food processing, that employ the country’s abundant manual labor but require relatively little physical and human capital investment; and at the same time to invest in infrastructures like roads and port facilities, which makes it easier for the expanding industries to transport and export their products. What the government does here is to bring the country’s industrial structure to match the country’s endowment fundamentals, by assisting the development of the “coherent” industries and removing the hurdles for these industries’ growth. By coherent industries I mean the industries whose factor intensity is in line with the country’s factor endowments. Since these industries are profitable given the macro fundamentals of the country, they can stand by themselves and generate savings for the country’s future development, which eventually becomes a virtuous cycle. This example is very stylized and the development puzzles in reality are often more nuanced. Each country has its own unique endowment and bottlenecks that need to be overcome. Yet the structural coherence principle as a guideline for policy and investment decision-making should hold in general.

The principle not only applies to the developing countries, but also to advanced economies. Take for example, the recent controversial bailout of several car manufacturers in the US. How do we evaluate the government decision from the structural coherence point of view? We know that the US is a capital-abundant country and also one of the largest recipients of foreign capital inflow in the world. Automobile industry used to be capital intensive, say, thirty years ago. But nowadays, despite the popular perception, car manufacturing has slid down the capital intensity ladder compared to the expanding industries such as pharmaceuticals and communication, (Note: higher fixed set-up cost, as in steel and automobile industries, should not be confused with higher capital intensity, though the two may correlate.) In fact, in the US, even agriculture industry is more capital-intensive than car manufacturing. (These rankings are, to be sure, highly country-specific, as different countries adopt different technologies in the same industry. Most countries’ agricultural sector is far less capital-intensive than that of the US.)

Now this leads to the question: is it a good idea for the government to artificially keep an industry alive that is no longer coherent with the country’s endowment fundamentals? The answer, according to the structural coherence principle, is obviously no. Simply subsidizing the incoherent industries won’t make them sustainable or productive; in the long run, this is a drain on government resources that can be better invested somewhere else. Then the next question is: is it an accurate description of what the US government has actually done? Sounds like so to me. But how about the employees of Detroit? If such a large industry collapsed, where would they go? Shouldn’t the government help them? Sure the government should help. And the government can do it in several ways: (1) hand them cash directly; (2) help them to relocate to profitable industries/thriving geographical areas; (3) provide trainings\continuous education to make them more employable in other jobs. All of these are probably more direct and efficient than trying to keep a dying industry alive. (This is related to the structural unemployment problem in the US right now. But that should be the topic of another article.)

But here is a caveat. Is it ALWAYS a bad idea for the government to prolong the life of an industry that is incoherent with the country’s endowment fundamentals? No, but for the bailout to work, it requires significant changes in the industry itself, which can be improbable in some cases. In other words, the temporary government assistance would only work if the incoherent industry finds ways to change and become coherent again. Following the car industry example, what should the auto makers do to save their own lives? The answer, according to the structural coherence principle, is deceptively simple. It’s not financial restructuring. It’s not negotiating with creditors. It’s not squeezing their suppliers. It is to FIND BETTER WAYS TO MAKE CARS AND MAKE BETTER CARS! Specifically, that means to survive in a capital-abundant country like the US, they need to change their input structure to use more of capital and human capital in the production process, and less of manual labor, which is way more expensive in this country than in its far-East competitors. It also means to reduce the scarce input the cars need themselves to function, in this case petrol fuels, the endowment of which is becoming less and less abundant globally. But both these measures require significant, if not revolutionary, changes in the technology US firms use to make cars. If these changes do not happen and status quo maintained, then any government subsidies will only save these firms temporarily, and more troubles will be coming. So an important question the government should be thinking about when making the bailout decision is: how likely are these changes gonna happen? If the government doesn’t ensure the implementation of these changes, then simply subsidizing the dying industries is a dead-end strategy. But again, how skilled are the governments in general when it comes to monitoring the direction of technological change?

Now I’ve argued that to maintain the structural coherence of the economy, the government should help bring the factor intensities of industrial composition closer to the levels of factor endowments. Are there situations where doing the opposite is advisable, i.e., to bring the levels of factor endowments into alignment with existing industrial structure? It will generally be far more costly, if not impossible, as mentioned earlier. But it can be a good strategy if given the following conditions:

1. The underlining industries are already profitable and expanding on their own;
2. The industries’ factor intensities are broadly in line with the country’s factor endowment levels, except for maybe one or two factors that is becoming the bottleneck for the industries’ future development;
3. It is possible and not overly costly (in terms of both resources and time) to change the endowments in these couple factors.

For example, the growing industries in the US nowadays are generally human capital and intangible capital intensive, industries like pharmaceuticals, computer services, and part of financial services, which require a lot of research and design work and technological supports. Some of these industries are faced with the shortage of domestic talents. Although the US is already human capital abundant, apparently the growth of US human capital is not catching up with the growth of certain industries. As a result, these industries are aggressively hiring immigrants and even from abroad, but it is not always easy due to administrative hurdles. Is it suggestible for the US government to do something to help increase further the human capital endowment of the country, so as to accommodate the need of existing industries? To answer the question we can check if the above three conditions are met. (1) Are these industries already thriving in the US? Yes. (2) Are they generally coherent with the endowment profile of the US? Yes, the US is abundant in physical and intangible capital, and other factors that these industries use heavily. But certain types of human capital are becoming constraining factors. (3) Is it possible and cheap enough to increase the human capital endowment of the US? Of course it is possible. All the government has to do is to change its immigration policy to allow more immigrants with high human capital. So it is doable and cheap in a pure economic sense. But of course, the political cost to the administration is another matter, which is how things often times start to deviate from the optimal state.

The Optimal Extent of Trading?

Back in April I was in a conference where George-Marios Angeletos of MIT presented a business-cycle paper that really caught my eyes. Basically the paper is a theoretical model saying that if information about production fundamentals is dispersed and there are market transactions across the economy, then business cycle fluctuations are inevitable even if there is very little "real" fluctuation in underlining productivities. One noteworthy aspect of the theory is that the business cycles in the model are not generated from any sort of inefficiency or market failure. They are unavoidable equilibrium features of the economy as long as there are market trading activities. And no government interventions can prevent them from happening as long as production information is dispersed among individual producers.

To me this paper has some very interesting implications concerning trade activities-- trades in real market and financial market alike-- that go beyond the conventional arguments. The traditional market advocates, going back to Adam Smith, emphasize the welfare-improving aspects of market trade, through specialized labor distribution, comparative-advantage-driven production, increased diversity of available goods, etc.

On the other hand, the opponents of market trade, especially in the recent years of massive globalization of economic activities, argue that the increased scope of trade is to the disadvantage of developing countries and contribute to environmental problems and the worsening economic inequality around the world. Some people also attribute financial market crashes, such as the one in the past two years, to extensive trading activities in the financial market.

However, it seems to me that most of the existing complaints against extensive market trade/globalization are either moralistic or reactive. First, what is "fair" in the distribution of trade gains depend on individual judgments and differ from person to person. Besides, certain negative side effects or coordination problems are not intrinsic of trade activities themselves, but rather are the results of poor judgments or human imperfections of market participants. Although this is mostly not what's happening in reality, theoretically speaking most of these complaints can be addressed through corrective actions from governments or any semi- "social planner".

In contrast, according to Angeletos' paper there exist certain intrinsic characteristics of the market institution that can be undesirable, even when the market is functioning perfectly. If we believe that business cycle fluctuations generate negative social welfare, which I think many people do, then there will be a trade off between the welfare gain from market trade activities and the welfare loss from excessive economic fluctuations. If both are increasing in the scope of market, then there shall probably exist at least one optimal scale of exchange activities. In other words, whether trade or (related) economic globalization is "good" is not an all-or-nothing question, but rather depends on the extent of the market exchange. This seems to me a more balanced and reasonable assessment of the question than either side of the conventional battle. But of course, what is the "optimal" extent of trading is a tough question and depends on a lot of factors, which can perhaps make an interesting (but difficult) topic for empirical research.

(Disclaimer: The opinions expressed in this article are purely my own and do not represent the viewpoints of GM Angeletos' research.)

SG&A and Management Quality

I kept thinking that I should mention this on my blog but kept forgetting. Now finally... Many people in my conference presentations have raised concerns about the validity of using SG&A (sales, general & administrative expenditure) as approximation of firms' intangible capital investment. I kept telling people that yes, the concerns are valid in that SG&A is not an exact measure of intangible investment. But the thing is that there exists no exact measure, given the current accounting practice, and SG&A is really not a bad one to get this job done.

Nick Bloom at Stanford sent me this. He did a regression of firms' management practice scores as in Bloom & Van Reenen (2007) on firms' intangible capital stock as approximated by the stock of SG&A using perpetual inventory. The regression coefficient turns out positive and highly significant. The following graph is a more visual presentation of the result.
The message is clear: management knowledge, which is an important and rising part of organizations' intangible assets, is positively associated with SG&A level. It is still a mystery to me how each penny of spending in SG&A is adding to firms' management finesse at micro level. It will be an interesting research project and can potentially inform the emerging practice of intangible capital accounting.

Global Economic Inequality: Why It Exists and How to Change It

In the new book I’m reading (see the previous post), the author John Perkins chastised multinational corporations such as Nike and Wal-Mart for exploiting workers in developing countries with extremely low wages and terrible working conditions. He also ask his readers, most of them citizens in advanced economies I suppose, to take consumer responsibility, stop buying from companies that earn enormous profits from their “sweat shops”, and shift to companies that pay workers “fair-trade” wages. Although the prices of “fair-trade” products are often way higher than that of their “sweat shop” counterparts, the author argues that consumers should realize that the price premium is an investment in the collective future of the humanity – buying products from socially responsible companies will help to create a just and safe world for future generations.

This is a beautiful and passionate argument, which I can see will win the sympathy of many well-educated liberals. Reducing global inequality and increasing living standards of third-world countries are important courses, to be sure. However, whether asking people to buy the more expensive products is a solution to this goal is a totally different question. It is not difficult to see why the approach won’t be effective. Even if buying fair-trade products is a collectively worthy investment in the future, any individual purchase will be too small and uncertain a contribution to the end goal, while the sacrifice at present is very tangible to the individual decision maker. On the other hand, every such purchase creates positive externality to the society, i.e., the person who made the purchase will not receive the full return of his “investment”, which almost certainly will render fewer such purchases than socially desirable in a society dwelled by mostly rational individuals. It is difficult to rely on people’s spontaneous sense of justice and innate altruism – though those virtues do exist -- to make social changes sustainable. Especially true when the going gets tough, our survival instincts and rational calculation will triumph. The fact that despite its poor record in human rights and social responsibility, Wal-Mart’s profit even increases with the economic downturn is just one more example to remind us of this simple truth. Therefore, asking people to act noble as if they can internalize the welfare of the whole society is probably not the best way to change the world. Our species just hasn’t evolved to that level yet. I believe that accepting this fact will create a more solid ground for any attempt to change the world for the better.

Inequality in wealth distribution around the globe is a structural problem that can hardly be solved by such local, band-aid solutions as asking consumers in the rich countries to pay more for the welfare of workers in the poor countries. It is easy to blame big corporations for not paying their workers enough. However, it is more useful to ask: if not plan A, what would be other options? Are plan Bs and Cs actually better? The fact that Nike’s “sweat shop” is able to establish itself in Mexico and hire enough workers despite the extreme low wages says a lot. If the Nike factory is not there, the country will probably suffer from a higher rate of unemployment. Though the workers have barely enough food to feed their families right now, the alternative scenario would mean that they have nothing to eat at all! This doesn’t mean that Nike and other multinational corporations are the saviors for the poor people in third world countries. They are not. In fact, in some circumstances free trade and the introduction of foreign competition to local markets contributed to income inequality and unemployment in those countries. For example, the import of mass-produced, cheaper corns from US crushed small farmers in Mexico and made their original occupation extinct. They had to look for other ways to support themselves and probably ended up in a low-paying factory run by US corporations. The story is not unlike what happened to English farmers at the beginning of the industrial revolution 300 years ago, which led to clashes between classes and Marxism (but that’s another story). Conservative economics teaches that free trade is welfare-enhancing for both exporting and importing countries. After all, Mexican consumers get to buy cheaper corns. What international trade theory neglects is that this gain from trade is very unevenly distributed among the population. The world today is certainly very different than 300 years ago. For example, many countries have implemented or attempt to implement minimum wage laws. However, setting aside the loss of economic efficiency accompanied with these regulations, their effects are in many cases marginal in terms of improving living standards of low income population.

Again, inequality over the world population is a structural problem. Consider a pair of Nike shoes that cost $70 in the US. The wage of the workers in some third-world country shoe factory is $2.75 per hour. The gap is astonishing, I know, but there is a structural reason for that. The labor cost, together with material and machinery cost to make the shoes, constitutes around 20% of the shoes’ price. Then where is the additional 80%? The answer is that it is shared basically among three types of work: design, marketing and distribution. All these work are mainly done in US and generally require high human capital – likely college-graduated workers. Such intangible-capital intensive industries as research & design, sales & marketing, whole sale & retail trade have seen tremendous increases in both their size and price in the past 50 years in most developed countries. Costs associated with these industries have become the biggest chunk of value in almost all goods and services sold in an advanced economy, from shoes to computers to financial services. There are supply-side and demand-side reasons for that. First, as mentioned before work in these industries is generally more complex. Their value-added is not just labor but knowledge, information, creativity, which in turn requires expensive education input. Second, consumers’ demand for product sophistication generally increases more than proportionally with income. As a country gets richer, people seek to satisfy higher needs beyond basic necessities. While it is always true that a generic pair of sneakers is not as attractive as a brand-name product that is scientifically-designed to be more comfortable and carries aesthetic value, it is truer in an advanced economy where people’s basic needs are satisfied. The result of these structural factors combined is that the shoe factory worker will only get a negligible portion of the Nike shoes’ cost.

A structural problem requires structural solutions instead of well-intentioned band-aids. Since the extreme gap between manufacture workers’ wage and the product value is caused by both supply-side and demand-side factors, we can tackle the problem from both sides, too. On the supply side, invest in education and human capital accumulation in low-income population of third-world countries. The industrial revolution in the 20^th century is no different from that of the 19^th century except that knowledge is so much more emphasized in production process of the 20^th century. The fact that knowledge is accumulative and largely carried by the worker greatly shifted the balance of power between labor and capital. A most important way to elevate the manual worker out of poverty is to enable him to join the knowledge workforce, and that implies education investment. If as Perkins claims that buying products that pay workers higher wages is an investment in our future, I would argue that donating to education or training that applies the human capital already owned by the workers is a better investment, since it gives the workers more sustainable power. On the demand side, developing countries should expand local demand for locally-manufactured goods instead of solely relying on exports. Surely the manual workers in Mexico cannot afford a fair of Nike shoes. But as we discussed, the Nikes shoes that are sold at the high price in the US market contain a series of value-added that cater to the customers in developed economies. Enterprises should be encouraged to make products that cater to basic demands of local population. Products that do not involve extensive design and marketing are a lot more affordable to low income population and immediately serve local economy. (A side note: the enterprise Grameen Danone, a joint venture between Grameen Bank and Danone Group is a great example of enterprises catering to the local demand of low-income communities.) A diversified local market that has both volume and flexibility is the basis of economic independence for many third-world countries that heavily rely on labor-intensive exports and/or natural resource exploitation. It will also enable economic development to reach the vast majority of people instead of the privileged few.

Hoodwinked

I’m reading a new book called Hoodwinked by John Perkins. The book is on what Perkins called “predatory capitalism”, how the system has exploited the majority of global population to the benefit of a few, how it has caused the recent financial meltdown, how multinationals have seized control of worldwide resources and caused damages, and finally, how to change the world through enlightened activism. The book can be a very interesting read depending on who you are. The author is proficient in story-telling and weaving arguments and insights into stories. And the book is in no lack of passion and inspirations. However, the author has no interest in providing neutral and objective analyses of the topic with different sides of a controversy taken into consideration. Neither is he good at providing facts and numbers to support his arguments. So if you are the scholarly type who won’t buy into anything without sufficient hard-core proofs, or is easily annoyed by writers who call names or use emotion as a major tool of persuasion, you might be turned off by the book. My philosophy in reading any book is that I pick what I deem valuable and disregard the rest. Even if I dislike a particular style of the author or his opinions, I try not to let my judgment impact my ability to learn useful things from the book. It’s a waste of energy to indulge judgments on other people’s opinions. And they often blind us from receiving inspirations and valuable information. As for whether there is a better way to write the book, it is the author’s business. As a reader, my only task is to find if there is something useful in the book for me. If the answer is yes, then I consider the book a good one. In this sense, this is a good book and I recommend it to anybody that is interested in globalization, economics or social responsibility.

Spiritual Capital

I was flipping through the Light of Consciousness magazine and came cross an article by Swami Amar Jyoti. I didn't know about this author. But I like the article. Here is a quote from it:

"The higher you go, the less dependent you are upon material needs. And because you depend less on these, the less you have to spend, which means you don't have to earn as much. And if you do not have to earn as much because you are now depending upon higher principles, the less you have to work for money, the finer your consciousness becomes and the more satisfaction you will have. I am not teaching poverty. On the contrary, I am trying to convey how to get rid of dependence on gross needs so that you could enjoy and have a more fulfilling life. It is only then that you can grasp and experience pure love."

It is an interesting passage. Now this may sound crazy to you -- it appears to me that the author was actually describing the economic logic of a type of intangible wealth. I would call it -- excuse me for the lack of imagination -- "spiritual capital". You can think of it as the level of spiritual consciousness in a person, or the degree of awareness / enlightenment, or whatever term that makes spiritual sense to you. If you think about it, spiritual capital fits the common definition of "capital" very well:

First, it is a production factor, that is, it can be used to produce other goods, except in this case, the "goods" produced are intangible, too. We can call them "blissful experiences", which certainly are valuable and consumable (for an extensive discussion of experience as commodity, see The Experience Economy, by Joseph Pine and James Gilmore). In Jyoti's words, spiritual capital helps produce certain experiences so that other things equal, "you could enjoy and have a more fulfilling life".

Second, spiritual capital is produced, not a pie from the sky. Spiritual traditions around the world teach people that spiritual capital can be produced in various ways -- meditation, yoga, prayer, selfless actions, for example. In other words, you have to "work" (read: spend time and energy) to get to a certain level of spiritual consciousness. Though the investment in spiritual capital has uncertain returns and different individuals achieve different levels of efficiency in its production, it certainly requires human inputs. And the time and resources spent in producing spiritual capital are very likely exclusive. For example, with the time one spends on meditation, one could have fixed himself a lunch sandwich (read: consumption goods production) or engaged in other productive activities.

Third, spiritual capital is a stock variable, i.e., it is not used up in a single period but instead, can be accumulated and benefit multiple future periods. One's spiritual capital may also depreciate over time due to neglect and lack of practice.

Now here is what's really interesting about the quote from Swami Amar Jyoti's article: it argues that spiritual capital is exchangeable with other goods. "The higher you go, the less dependent you are upon material needs". In economic terms, the level of human utility that can be generated by the consumption of 2 sports cars and 10 brand-name suits can be produced by x level of spiritual consciousness, too! This exchangeability, if true, brings spiritual capital one step closer to the mainstream market economy. Since if the value of what spiritual capital produces is comparable and exchangeable with the value of other goods, then spiritual capital can have a market price. And if this is true, I believe that it will eventually help to transform the market economy itself, along with other types of intangible goods.

There is another essential characteristic required for any goods to be integral part of a market system: interpersonal transferability, otherwise the good cannot be bought or sold. So is spiritual capital trade-able? I think the answer is to a large extend yes. Though the direct transfer of spiritual capital from one person to another is not possible (well, not until we invent technologies of brain data downloads), still individuals can buy and sell services (and also tangible goods in some cases) that facilitate spiritual capital production in the buyer. For example, we've seen in recent years rapid expansion of spirituality-oriented continuous education and health care industries, in the form of yoga education, life coaching, spiritual counseling businesses and non-profits, and in spirituality-related exhibition and publishing industries. They are all inputs to spiritual capital production. Though eventually it still depends on the seeker himself to produce and accumulate spiritual capital in himself, those inputs may increase the productivity tremendously. In this sense, spiritual capital can be a market product just like products of other education industries.

Imagine a time when the spiritual capital industry and other intangible goods industries become the major growth engines of our economy (like steel and automobile industries in the 20th century), and a large percentage of society members following the consumption pattern described in Jyoti's article. Imagine how different the world would be!

The Price of Free Market

I'm standing in front of the blackboard looking at about 30 undergrad students in the classroom -- my first recitation class for this semester's Microeconomics Principles course. I'm supposed to go through some textbook examples about the concept of comparative advantage, opportunity cost, and how market exchanges or trade activities increase welfare for everybody involved.

Here is one of the examples, simple but illustrating. Suppose that in an economy there are only two goods produced, bread and milk. In the scenario without market trade, every household has to produce both goods. Naturally, their capabilities for the two tasks vary. Now suppose you and I start trading. Then each of us can just produce the good we are relatively better at and exchange a portion of our products with each other. The labor distribution improves the efficiency of our time allocation. There will be more bread and milk produced in the economy and both of us better off. In addition, by focusing on making milk and not getting distracted with other activities, my milk-making skill is likely to improve faster, so is my trade partner's bread-making skill. The conclusion is that trade, no matter whether it is between individuals or between countries, makes everybody happier.

This argument for free market exchange is one of the crown jewels of modern economic thinking. It is powerful and elegant, and economists have been using it to advocate for free trade and globalization since the time of Adam Smith. Many years ago, when I first learned about it in my undergrad Econ class, I was immediately hooked and felt so excited as if I had been given new eyes to see the world. From then on, anybody who questioned the expansion of free market would look either crazy or downright stupid in my point of view.

But today when I was supposed to teach the same brilliant theory to my students, I suddenly found it a very frustrating task: the real world is so much more complex than described in those elegant textbook examples, and I'm not sure that I'm offering those young minds a "better" way to see the world by simply presenting them some over-simplified cases.

When the scope of market is small, everyone in the economy needs to basically be self-sufficient. One juggles across different activities throughout the day, his goal to allocate time spent on each kind of work to maximize the total value of his production, according to the implicit prices he assigns to different products. He won't spend all his time doing a single kind of work -- he won't be able to meet his various needs in life that way. In Economists' Language, the marginal value of one activity goes down quickly with more time spent on it. Though probably not the most "efficient" arrangement, the keyword for such a lifestyle is "balance", something that the citizens of modern society long for but find hard to achieve, for reasons I will specify below. But surely the aggregate goods produced in this society would be less than in the scenario with active and large-scale market trades.

In contrast, when the market is sufficiently developed, most people are specialized in only one kind of work -- we are doctors, farmers, or barbers, but not all of those. Our production goal is very different from that in the previous case. Now as an individual one needs to rely on other members of the society to give him everything his needs in life except the one thing he himself produces. And the way he can convince them to do so is to exchange his own product with theirs through a monetized market system. But his can be a very vulnerable position. As an individual producer he is not likely to have a perceivable impact on the market price of his product, and whether he will prosper or starve tomorrow completely depends on the whim of market conditions. If absolute specialization of production is imposed, then what an individual can do to ensure survival is straightforward -- to produce more of his product. With the market system, one's consumption maximization problem across different goods is completely separated from one's production decision. The production decision is now much simpler and much more "single-minded", to work as much as he can, to produce as much as he can, so that he will have more to trade with other people. Here comes also the dichotomy of "work" and "life": the ONE thing we do for market exchanges and the rest of who we are. The kind of dichotomy that didn't exist before the emergence of modern market economy.

Ever wonder why the advancement in technology and production efficiency has not significantly reduced working hours? Why is the life pace in New York City, where commerce and trade is highly developed, so much faster than that in, say, some remote village in China? Why is there so much stress and competition pressure in modern society? Our very specific maximization goal developed through the extended market exchange system largely contributes to these phenomena.

The institution of economic exchange came into existence with many blessings. It improved the diversity and efficiency of goods and services production in an economy. But it has its own trade-offs. For one thing, the nature of human physical and mental system favors balance. Our well-beings benefit from variation in activities, freely-expressed creativity and diversified pursuits. But these are the direct opposite to what a highly specialized labor distribution system can bring us. It is true that if I produce only milk and let my neighbor produce bread, both of us will probably have more milk and bread to consume. But can the increase in goods consumption more than compensate for the boredom I endure in working on the same task day after day, for the competition pressure I feel in having to compete against other milk makers for my neighbors' favor, for the constant worry about not making enough milk to exchange for the necessary amount of bread? Those are the intangible welfare losses that are hardly quantifiable and never entered economic models.

Economics see human beings as single-dimensional creatures, whose only purpose on earth is to maximize consumption and that is the only source of values. But it doesn't mean that other values and purposes do not exist in reality. Just to the opposite, the deprivation of "intangible" values and purposes has been a major cause of many psychological and social problems in modern life. Free market institution is really not free. It comes with a price. The issues faced by countries in a globalized economic system are analogues to the issues faced by specialized individuals, especially for small developing countries who are not diversified in the global allocation of production tasks.

When the idea of labor distribution and market exchange was first invented, its consequences, both positive and negative, were probably mostly unforeseen. Over the course of market development at both local and global levels, the human society has more and more come to realize that the increased economic efficiency through market exchange does not come freely. And people are making choices to limit the degree of specialization and the scope of market. That's why "localization" is becoming a new economic trend of this century, alongside the seemingly unstoppable force of globalization. At first sight, the localization trend might seem to go against the economic logic of rational decision maker and utility maximization. But the choice of more self-sufficiency and limited market can actually be a very "rational" choice, if we are willing to see humans as multi-dimensional beings, capable of appreciating and making trade-off among a sophisticated set of values, instead of some sort of consumption-maximizing machines.

Is a New Growth Model Possible?

I just came back from a trip to Shanghai. The city is changing fast by any standard. I could hardly recognize many of the places I had been to only two years ago. What is changing even faster than roads, buildings and shops is the city’s mentality. It seems that the accumulation of material wealth has bypassed any other concern and is becoming more and more the central focus of life in this city. The media is filled with money-making tips and newest consumer products information. The conversations with friends and family frequently involve cars, houses and memberships of department stores. The modern American culture has often been seen as a culture of mass consumption and materialism. But now I feel that China has already bypassed the US in its fascination about material wealth, at least for some part of China.

This change in social mentality shouldn’t be a surprise. It is simply an eastern rendition of Max Weber’s “Spirit of Capitalism”, probably an inevitable aspect of any society’s transition into market economy. The focus on wealth, production and consumption serves as a fertilizer to economic growth, which ideally leads to the prosperity of society and better life for everybody.

However, what I experienced in Shanghai was not just the merry spirit of economic growth. My Washington DC – trained respiratory system had a hard time working in the polluted air of Shanghai. I felt almost difficult to breathe no matter where I went. I could sense that my hair and nose were filled with dust and particles even after only 2 hours’ walk in the downtown streets. (I once lived in this lovely city for ten years. Talking about change!) Private ownership of cars has soared in recent years. The roads of Shanghai boast the newest models of every famous international car makers. But another increase that is equally obvious is the level of traffic congestion and sound pollution. By some calculation, China’s carbon emission level had already bypassed the United States in 2006. And we are talking about an economy whose per capita GDP is still only about one tenth of that of US. Imagine the day when every Chinese would own a car!

The government is well aware of the problem, to be sure. And China, like many developed countries, has made positive efforts to reduce carbon emission and to resolve other sustainability-related issues. However, most of those policies are only short-term solutions and feeble compromises. The fundamental reality that most of us has been refusing to see is that the prevailing model of "economic development" is not a feasible one anymore. Our planet simply does not have enough resources to sustain every country on the earth as a "developed" or "industrialized" society in those words' commonly conceptualized forms.

Luckily, it may not be necessary for every country to go through a heavy industrial phase when the production and consumption of such goods as steel, autos and machinery are emphasized, to become a well-off society. After all, it has only been in the past two hundred years that these industries become the major embodiment of national wealth. The Auto shipment index was seen as an important indicator of business cycles only after cars became a major household consumption in most advanced economies, which, if you think about it, is only a pretty recent phenomenon in the world economic history. It is temping to think, as macroeconomists often do, that the economic growth for less-developed countries is always a "catching-up" process, and those countries have to follow step by step the road traveled by countries with higher GDPs. However, what embody value and wealth have always been changing, with the shifts in technology, culture, preferences and living environment of the communities.

The consumption of industrial goods from plastic bags to electronic appliances to automobiles, has become the standard way to live in a modern society. These goods surely contain values and generate utility for the consumers. And the mass-produced manufacturing products have also been the major carriers of the state-of-art technologies since the 19th century. That's why we count the new goods produced as a major part of GDP, the national wealth generated every period. However, the manufacturing, consumption and disposal of these goods also generate negative values -- depleted natural resources, polluted air and water, for instance. Yet unfortunately, these dis-values are never subtracted from GDP in the national wealth accounting. This is of course due to a lot of reasons. The dis-values may be intangible, too hard to count; their effects may be long-term, too hard to foresee; the dis-utilities are mainly in the form of negative externality, difficult to be revealed in the pricing of products. But despite all these barriers in calculation, it is still undeniable that the increased production of industrial goods is NOT equal to the generation of more national wealth. In some cases it is simply the opposite.

The good news is that the industrial structure is already changing, for most developed countries and many developing countries as well. Partly because of the IT revolution in the latter half of the 20th century, the cutting-edge technologies are no longer only embodied by tangible products, but more and more carried by softwares, designs and human resources. The structures of both consumption and investment in a modern society are shifting towards "intangible" products. Intangible capital investment -- R&D, design, marketing, management, training -- in the US is already larger than physical investment, according Corrado, Hulten & Sichiel (2005)'s calculation. On the consumption side, almost every goods or service in today's economy contains an intangible, conceptual part that constitutes a considerable part of, if not most of the product's value. This change in the structure of economy is also apparent in the rising share of high-intangible service industries in the total national outputs (Che, 2009).

Imagine an economy where most of "wealth" and economic values of society are embodied in intangible or conceptual goods, and the major household consumptions are intangible products instead of automobiles and electronics. In such an economic model, there will be no conflict between economic growth/increase of consumption and the sustainability of development, since the creation and consumption of wealth does not depend on natural resources or impose negative effects on the environment. Is such a consumption model too much of a fantasy? I don't think so. Just think about how much a typical American household has already spent on such goods as education and health care, which are basically intangible goods. And the advancement of technology is often way beyond our imagination and takes the value system of society on unexpected adventures. (Even the most brilliant minds in the 19th century couldn't have foreseen the major industrial inventions of the 20th century and how they would transform people's lives.) Maybe by the 2nd half of this century, we would be able to consume most of the consumer products we enjoy now in their virtual forms. Who knows?

But this new path of economic growth won't unfold by accident. It requires a shift in the concept of economic growth and development for all of us, from government to academia to business sector, so that we will work to explore this new vision through policy-making, scholarly research and entrepreneurial endeavors. And given the enormous changes we've already experienced since the beginning of this century, I don't think this shift would be too drastic in comparison.