Thoughts on Prosperity

I heard a joke the other day that the reason Michigan housing wasn't as badly affected by the recent economic downturn as, say, Arizona's, was that we never experienced the preceding upturn! With no real rise in prices, the fall was less precipitous.

While such a view might be looking at the glass half full, few of us would argue that we aren't mired in an economic malaise.

It's only natural that many think the answer is to focus on creating jobs. With real unemployment rates exceeding 20 percent in some counties of Michigan, the financial pain is real and finding a job seems like the best solution.

But focusing on jobs might not be the best approach to a prosperous future. Although many politicians believe differently, large companies arriving with thousands of jobs to save the unemployed is much like winning the lottery: It doesn't happen often and the benefits frequently don't endure.

The difficult truth is that Michigan's economic foundation has shifted beneath us. The large manufacturing companies are relocating, taking more than 2 million factory-floor jobs with them. Sure, a few will return, maybe as many as 30 percent. But this will never be enough to re-employ ourselves, our children, or our grandchildren.

But the news may not be all bad. In fact, it's often only when things get really bad that people are willing to take steps to implement changes that bring new prosperity. What many Michiganders have realized is that no one will be saving us. If there is saving to be done, we'll have to do it.

The way we'll have to do it is through innovation and entrepreneurship.

It's important that these two things go together. We don't need more small businesses for the sake of small business. What we need are new enterprises that do or produce something in new and innovative ways. We need to get our surfboard back on the wealth-creation wave before it either crushes us or just leaves us behind.

So how do we do this?

Fortunately, people are by nature entrepreneurial and innovative. They just need an environment that encourages such behavior. Taxes and regulations are simply costs to the bottom line. They need to be brought in line with the value they provide.

Laws regulating bankruptcy and foreclosure need to be modified so that penalties aren't so harsh that no one will "bet the farm" on progress (Did anyone know, for instance, it's impossible in Florida for a person to lose his main residence due to economic failure of any kind?).

Social institutions, such as labor unions, must adjust to a new reality where collective bargaining is less important than efforts to improve skills, foster "skunk works," and maximize productivity.

Innovation and entrepreneurship are the answers to our question of what will save Michigan's economy. But the more important question is whether we can modify our current institutions in such a way that will provide necessary incentives for people to give it a try.

As we speak the House and Senate have passed competing versions of a “stimulus” package—policies designed to kick start our free-falling economy. The approach, to spend close to a trillion dollars following on the heels of 700 billion dollars, will encourage banks to lend, people to spend, firms to quit laying off people and invest in new capacity, and a general return to confidence in our economy.

Not everyone, however, agrees with the plan. Nor should they. As I see it, there are two issues that not many are saying much about. One is the lessons of history, and the second, perhaps more daunting, is underlying economic fundamentals.

First, we seem completely unaware that historical efforts to spend one’s way out of economic downturns are not a quick solution. Many believe that a new “New Deal” will stimulate our economy and return us to prosperity in a short period of time. While 75 years of perspective seems to have convinced us such a strategy will work, we seem blind to the reality that 20 years transpired between the implementation of the New Deal and the impact we hope our current spending will have. Nor do we talk much of the social upheaval of war and displacement that happened in between.

Japan’s experience with economic downturn in the 1990s provides a similar lesson. Intensive government spending, to the tune of 181% of gross national product, contributed to economic turnaround in 12 years! To the extent that spending will work, it will probably not work quickly.

Yet the second problem gives rise to doubts that spending will work at all. Keynes’ perception of a “paradox of thrift,” where if people save and don’t consume then plants will shut down and people will be furloughed and then unable to save at all, leads our current politicians to equate spending with patriotism. But the problem is that American’s have nothing left to spend. Collectively we have a negative savings rate and our credit limits have mostly been exceeded.

I can remember as a young boy my Grandfather, who lived through the Great Depression, telling me to avoid credit and live within my means. Save for a rainy day. Build your business from your retained earnings. He sold chickens and eggs to make his living. When the chicken coop burned down, he had no insurance, he simply rebuilt and started over. He lived a hard life, but one that he could always afford and which was sufficient to send two boys to medical and business school and help his grandchildren with their schooling.

Now lest you think this is a “walk to school in the snow uphill both ways” story, I am not advocating that we use no credit or return to a less sophisticated financial system or time. But there are underlying fundamentals to which we must return if we are to create stability and confidence in our markets. And getting there won’t be quick or easy.

February 9, 2007

Dear Governor Granholm,

I listened with great interest to your state of the State address. I was pleased to hear you talk of investment, as indeed, investment is the ONLY variable correlated with economic growth and development over time. I was also pleased to hear you talk of encouraging high-tech, high-innovation business creation, since the type of investment also matters greatly. In short, I believe you have identified the key areas for success.

Yet despite moving in the right direction, I wonder if you really grasp the seriousness of our current situation and the height of the obstacles facing us. Historically, former economic powerhouses that fall from the top rarely, if ever, regain their former position. Two things prevent a recovery. First, the government assumes the entire burden of change. And second, (ironically) the government doesn’t do enough to change entrenched institutions and vested interests that would encourage the private sector to invest.

My experience in the United States as well as Thailand, Singapore, Malaysia, Indonesia, the Philippines, Korea, Taiwan, and Japan is that governments have a key role to play in economic development and growth. This role, however, is not to do everything themselves, but rather to release the entrepreneurial spirits of the private sector to invest productively. Some may lament our current economic vulnerability, but new research suggests that such vulnerability spawns creative responses that may in fact lead to long-term progress. Whether we release and channel appropriately our entrepreneurial spirits depends on policy and institutional choices we make now. I would suggest the following ideas.

Prioritize investment from a broad range of sources and in a broad range of activities. Your investment priorities, primarily in human capital, are too narrow and too state centric and ignore the importance of private-sector participation.

Refocus your economic plan on business creation rather than job creation. Focusing on jobs will lead you to make short-term decisions that may be detrimental to long-term growth. Focusing on jobs does not take into consideration externalities. In many cases the five person high-tech firm will be far better for our economic health in the long term than a 1,500 person transmission plant. I realize the latter is far better politically, but it is increasingly not better economically.

Emphasize and support entrepreneurialism and innovation. I applaud your willingness to "go anywhere and do anything" to bring businesses to Michigan. But the reality is that only a very small number of firms actually move locations, for any reason. The number is less than 6% per year. So, although this effort will be important, it is far more vital that we encourage entrepreneurship and innovation within our communities. We must create the new firms, just like Henry Ford did, that will power our economy into the future. As new firms form and naturally coalesce into industrial agglomerations, other firms will move into the state to join them. Medical equipment, insurance, financial services, pharmaceuticals, transportation R&D, and alternative energies are only a few of the industries that have begun to grow and might thrive in Michigan. The MEDC, universities, economic development agencies, smart zones, etc., should all be focused on generating innovation both in new firms and through expansion of existing firms.

Focusing on entrepreneurship also addresses a problem not touched upon in your address. Although we certainly need to improve the level of education for Michigan students, we are currently losing a large portion of our college educated 20-29 year olds every year. In my senior seminar I teach at James Madison College and MSU, every student for the past 3 years is leaving the state for employment reasons. The answer here is not to create cooler cities (like jobs, cool cities are an outcome, not a cause), but to create companies, and even better, help students create companies. What a great opportunity we have in our university system to not only provide an education, but to help in the application of the education to bettering our communities and society.

Next, quit playing the unfair trade card. While some of the accusations may be true, there is little we can do from a state perspective and, far more importantly, it matters very little for the industries of the new knowledge economy. This is also true for the criticism the political right often makes about labor, regulation, and taxation. All of these variables are far more important in the old economy than in the new and should be de-emphasized.

Now, that said, taxes are a direct incentive for industry. Fewer business taxes mean that more money can be invested. But it doesn’t guarantee that it will be. From my perspective, you should move as many of the taxes as possible to final consumption. Ideas for “service” taxes and “beer and soft drink” taxes for example, are an excellent way to generate income from consumption. Although we need consumption for our economic health, less consumption is not always bad, especially if the surplus is saved and invested. The key is to provide concomitant incentives to invest surplus. I would counsel you to lower business taxes while increasing consumer taxes and simultaneously providing incentives to invest surplus.

Finally, to return to our entrepreneurial roots will require significant reform of existing institutions. I mentioned above that regulation, labor, and taxes should be de-emphasized. But the institutions they have created should be dramatically reformed. Incentives that will help K-12 and university education cooperate with labor and business to improve skills, create knowledge, and then transfer and disseminate that knowledge will add to our competitive advantage.

Governor, I realize that the task ahead of our great state is a daunting one. But greatness never emerges in times of ease. I have been encouraged by the new direction you are taking and I hope you’ll make decisions that are more economically and socially correct than politically correct. But with challenge comes opportunity. As best exemplified by one of my favorite politicians, Harry Truman, now is the time to speak and do the right thing.

Sincerely,

Bryan K. Ritchie

Co-Director
Michigan Center for Innovation and Economic Prosperity
Associate Professor, International Relations
James Madison College 302 Case Hall
Michigan State University
East Lansing, MI 48824
(517) 353-8614
(517) 974-1353
ritchieb@msu.edu
www.msu.edu/~ritchieb

Labels: Economic Crisis Investment Innovation Michigan

A few months ago I suggested that saving, and even creating, new jobs in Michigan might not be in our best interest if they did not promote our transformation into a third-stage, upgrading economy. I’d like to push this assertion even farther by arguing that to survive, yes survive, we need to become a community of innovators.

How do we do this? It may be helpful to apply insights from the theory of evolution to the question. In a very simple form, organisms that adapt to new circumstances survive. Those that don’t, don’t. But some biologists suggest that in fact evolution is not a linear process. Instead, critical events lead to “punctuated equilibria” in which massive changes create entire new paradigms. Organisms that survive must change rapidly to survive. Then a period of stasis follows in which change happens primarily at the margins until the next critical event.

Economics might also work this way. Relatively long periods of stasis as one kind of economy gives way to another relatively rapidly. Interestingly, the period of stasis between critical events and the time it takes to move to a new paradigm have both shortened dramatically over time, putting increased pressure on firms, individuals, states, and countries to change ever more quickly.

We in Michigan are now facing just such a transformation. For almost an entire century we’ve benefited from a vertical agglomeration in a few industries, especially autos and agriculture. But then over a few short decades, the international economy changed. Oh, we knew changes were happening, but we didn’t really appreciate what they meant to us. Changes in consumer tastes, market access, technological capabilities, and foreign competitive capacity, among other things, have critically altered our system of wealth creation. So, what do we do next?

The answer is to strategically abandon our old economy and create a new one. Note the word strategic. We need to take our old, vertically integrated model of manufacturing and turn it into a new, horizontal model of innovation and capacity that can be applied to numerous industries and at numerous points in the production process.

In this new economy, value and wealth are created in the design and research phase. Agglomerations and linkages are based on talents, skills, knowledge, and capacity, most of it scientific. Centers of innovation emerge that produce knowledge applicable to numerous industries simultaneously. Industries are then linked horizontally: new generation automobile engines lead to alternative energy, which leads to advanced agriculture, which leads to pharmaceuticals, which leads to medical technologies, etc.

The same change can also be applied to humans. Global changes demand that unions remake themselves to be pertinent in this new economy. For example, in Singapore organized labor leads in training and skills development, recognizing that increased pay MUST be tied to productivity gains, not collective bargaining.

These changes undertaken in response to a shifting global economy will attract similar capacities, skills, knowledge, and capital. We must again become a capital, but one that produces ideas rather than cars.

A few months ago I suggested that saving, and even creating, new jobs in Michigan might not be in our best interest, depending on the type of jobs we were talking about. In that same article I suggested that we needed to upgrade our economy, and doing so would require us to change the way we think.

I’d like to now suggest how we do that. I’ll start by explaining two natural laws: the law of evolution and the law of attraction. Now I admit up front that I’m no biologist or physicist. However, I know enough of the properties behind these laws to suggest they have significant ramifications for our economics. First, the law of evolution predicts that organisms that don’t adapt to meet changing circumstances will eventually disappear. This has proven as true for dinosaurs and great civilizations (think Rome) as for the dodo bird and small communities (think of small farming communities in this and every other developed country). Second, the law of attraction says that similar things attract and that the more of a similar thing you have, the more it will attract.

Turns out we’ve been the beneficiary of both laws. In the early 20^th century, Henry Ford transformed the world economy with new production techniques that gave our state a special advantage in manufacturing, especially automobiles. As our expertise and success in auto manufacturing grew, we attracted companies, money, and talented individuals from across the world to come to Michigan to build cars. Because the economy at this time was constrained by limited technology, especially transportation and communication, new firms that supplied the auto industry, including steel, manufactured parts, plastics, and so forth, also set up shop in Michigan.

This arrangement worked well for almost an entire century. But almost imperceptibly, the rules of the international economy changed out from under us. Oh, we knew changes were happening, but we didn’t really appreciate what they meant to us. Changes in consumer tastes, technological capabilities, and foreign competitive capacity, among other things, all chipped away at our previously stable system of wealth creation until we now find ourselves in fairly critical circumstances. The 100K question facing us is what to do next?

The answer is to strategically abandon our old economy and create a new one. Note the word strategic. We need to transition current strengths into new activities. For example, we need to understand that it may not be in our best interest to continue to be the auto manufacturing capital of the world. But I would argue we should be the transportation technology capital of the world. Why not adopt the computer industry model? The production of hard disk drives, monitors, mother boards and chips are all highly commoditized processes. The significant value and wealth, however, is created in the design and research phase. I believe the same is true with automobiles. Moreover, focusing on value added leads us from autos to other complementary technologies, such as alternative energy, which leads to advanced agriculture, which leads to pharmaceuticals, which leads to medical technologies, etc. You’ll notice that these linkages are not the old vertical linkages we enjoyed for so long with automobiles. Instead, they are now horizontal agglomerations based on talents, skills, knowledge, and capacity, most of it scientific, rather than industrial structure.

The same change can also be applied to humans. We talk a lot in our state about organized labor. It would be hard to deny that our labor structure has been a tremendous asset to our automotive industry. But again, external changes demand internal ones. My challenge to unions is to remake themselves to be pertinent in this new economy. For example, in Singapore organized labor has taken the lead in training and skills development, recognizing that increased pay MUST be tied to productivity gains, not collective bargaining.

The payoff is that these new activities undertaken in response to changes in the global economy will attract similar capacities, skills, knowledge, and capital. Educated labor will attract more educated labor. Advances in automotive technology can encourage advances in other industries. Indeed, the most competitive economies in the world boast horizontal capacities, like precision engineering in Singapore, that can be applied to a host of industries, products, and processes. Success for these countries is not to create an entire vertical production chain in one geographic location, but instead to position themselves as an essential cog in a global production chain that is not bound by location.

As I hope you can see at this point, evolution and attraction will play an important role in any economic success we enjoy. However, there is one big difference in the economic sphere: Time. Whereas natural science counts time in billions of years, current economic change counts time in decades at the longest. The clock is ticking, it’s time to adapt and attract.

On April 19, 2006, Michigan announced its jobless rate rose again to 6.8%. At the same time, Utah’s jobless rate fell to 3.4%, close to an historic low. Why does Michigan’s jobless rate continue to climb while Utah’s continues to fall? Many, even among the experts, point to problems such as the single business tax and restrictive labor laws in Michigan as roadblocks to growth. But it’s not these “old economy” laws per se that are the problem. True enough, badly designed taxes and strict labor laws create perverse incentives that restrict growth, but the real problem is that Michiganians are mired in “old economy” thinking, second-stage economy thinking, to be exact.

The world economy has witnessed several critical economic transitions. The first was from agriculture to industry in the late 19^th and early 20^th century. The second moved from raw materials processing to final goods manufacturing, which took place in this country beginning in the early 1920s and continuing through the late 1980s. Michigan led the world into this second-stage upgrading phase. Breakthroughs in manufacturing processes, technological progress, facilities and infrastructure, and organizational management created the standard for the rest of the world to follow.

And follow they did. As early as the late 1970s Japan had begun to improve on U.S. manufacturing processes. By 1990 most Americans were afraid Japan would simply buy all of our assets. The common thought was that Japan had succeeded economically where they had failed militarily a few decades before.

But then a strange thing happened. Japan began to lose its manufacturing leadership to upstart countries like Korea, Thailand, Singapore, Malaysia, and Indonesia. More surprising, less than a decade later, these countries began to lose their manufacturing edge to China and India.

But not everyone stood around, wrung their hands, and wailed about saving jobs. In Singapore, the government recognized that wage rates had climbed far beyond those in the new manufacturing powerhouses of China and India. To compete head to head, Singapore would have to artificially restrict its wages, a move certain to create severe political problems. The answer? Move out of labor-intensive manufacturing. Begin the process, as quickly as possible, to third-stage industrial upgrading, a stage dependent on knowledge creation, science, technology, and innovation. To create the appropriate incentives, the Singapore government taxed low skill labor. Think about it. The government penalized businesses for every low-skill worker and job they hung on to. Compare that to Michigan. Governor Granholm argues that we’re “a community putting our foot down and saying we won’t lose any more [low-skill] manufacturing jobs to Mexico or China.” As a result, instead of penalizing low-skill firms, we give them incentives to stay: $43.9 million to be exact—a great example of being mired in “old economy” thinking.

What would “new economy,” third-stage thinking look like? Here the buzzwords include research parks, venture capital, one-stop business setup shops, technopreneurship and retention of knowledge workers. But isn’t everyone thinking about these things? The good and bad news is that these things are interrelated. One leads to the other. So where to start? In our federalist, highly politicized economy, the answer is probably not at the state level. Taking a cue from Singapore, Michigan should instead take its 13 “smart zones” and attach them, each with a specific industrial mandate (alternative fuels, homeland security, advanced automotive, etc.) and geographical boundary (a la research park), to one of the state’s universities. A public-private partnership should then be created as a local one-stop business creation shop to facilitate business entrepreneurship and relocation to the specific geographical site. Such a shop would also function to facilitate investment, especially zero-stage seed financing. This one-stop shop must have complete autonomy within its geographical area, including tax and labor considerations and incentives, unencumbered by city, county, or state oversight.

At the same time, a public-private R&D and innovation center could be formed between the university and private firms. The center would be the connection point for university-owned and created science and technology. Faculty and students would be assigned to the center from across the university and across disciplines, including business, science, politics, and technology. Students could be assigned early in their academic careers so that by later years and into graduate school they would provide value to member firms. Firms would become members by buying shares or interests in the center. Such interests would entitle firms to jointly created intellectual property and licensing rights, access to students (including the inside track on hiring the best and brightest upon graduation), and an ability to shape new academic research agendas. Such a configuration would keep smart students in Michigan, encourage investment, drive entrepreneurship, and facilitate the transfer and assimilation of newly created knowledge.

This is just one of many possibilities and it admittedly does not address all of our problems. But whatever we choose to do, the first step in figuring out how to transition from second-stage to third-stage industrial upgrading will be to think more about creating future possibilities than saving past triumphs.

One of the longest standing and most bedeviling debates among political economists is whether democracy leads to development, development leads to democracy, or neither. There is evidence for all of these positions. Japan, Korea, Taiwan, and Thailand have all grown economically and have transitioned, albeit slowly, to more democratic forms of government. On the other hand, countries like China and Singapore appear to have reached an equilibrium that allows illiberal, single-party governments to co-exist with tremendous economic expansion. Then there are the many non-democracies that have no growth and democracies that lag behind economically.

It is interesting to note that nowhere in this debate is the question asked whether democracy hinders economic growth. But if Brian Dickerson is right (Free Press 10/14/05) and the increasingly cantankerous exchange between democrats and republicans over who is responsible for Delphi corporation’s bankruptcy is a “glimpse of ’06,” then democracy, at least the partisan way we practice it, may not be helping Michigan compete.

The problem is, both parties have it wrong. The GOP’s contention that Michigan’s focus should be on Indiana and not India and that Governor Granholm should do more to protect jobs is shortsighted and unrealistic. At the same time, the Democrat’s obsession that globalization is ravaging Michigan jobs is pointless and irresponsible.

Yet both parties also have it right. Democrats correctly point out our low-educated work force reduces incentives for Delphi and companies like it to stay. At the same time, a republican focus on reducing organized labor’s stranglehold on market incentives is vital.

The reality is that globalization and market forces are much more powerful than partisan politics. As Singapore, Malaysia, and Thailand have all learned, competing with China and India on low wages alone is a losing battle. But if, on the other hand, you can’t compete for high-skill manufacturing jobs, then you’re just stuck in a structural vice, the handle on which globalization is continuously tightening.

Rather than working so hard to lay blame at each other’s feet as a way to promote future electoral fortunes, democrats and republicans must cooperate with business, labor, and academic leaders to find ways to create market incentives for firms to not only to stay in Michigan, but also to upgrade their operations technologically. Steps must simultaneously be taken to absorb some of the pain for those who lose low-wage jobs due to market-induced transitions while they are being re-trained for new economic activities.

Powerful forces are reshaping the economic landscape. To survive and thrive in this new environment might require that we also reshape the political landscape. Otherwise, it won’t matter who gets elected.

By 1972 Singapore was in real trouble. Independent for just 13 years, it had failed to merge with Malaysia and, worse yet, the British Army, a major source of income, was going home. If something didn’t change dramatically, and soon, Singapore would cease to exist.

What does this have to do with Michigan? A few weeks ago I went to Detroit for the first time to see the Tigers play. My impression of Detroit was that it was in worse shape than many of the developing countries I had worked in as an executive for several different computer companies and now as an academic. To put it bluntly, Bangkok, Kuala Lumpur, Seoul, Taipei, Shanghai, and other Asian cities were rapidly eclipsing Detroit in terms of wealth and progress. Except for the area around Comerica Park, I saw mostly abandoned buildings, decaying infrastructure, and little if any sign of economic life.

Recent statistics reflect this general malaise. Michigan has the highest unemployment in the nation and Detroit the highest rate of poverty in a metropolitan area. The auto industry, the backbone of Michigan’s economy, seems hopelessly lost in an uncompetitive squeeze between unproductive labor policies promoted by out-of-touch unions on the one side and stale designs and tardy engineering fostered by unimaginative and risk averse executives on the other.

What can we do to reverse this slide and reclaim our position as an economic leader? Governor Granholm has suggested a classic Keynesian idea to invest $10 billion in our infrastructure to create jobs and demand that will jumpstart the economy. But if such infusions are not coupled with higher productivity and output over time, the result will be a one-time economic boost that will soon fall back into prior levels. Knowing this, the Governor plans attract high-tech firms and highly skilled people to “cool” cities. The problem, however, is the difficulty of matching supply and demand. Why do high-tech firms come if there are no well-trained people? And why to well-trained people remain if there are no firms? It’s certainly not because of Michigan’s mild winters, ocean beaches, or mountain skiing.

To solve this problem we need to take a page from the history books of successful developing countries. Last week I presented a paper on how Singapore simultaneously created highly skilled people and attracted high-tech companies. After my presentation, a well-known colleague inquired if I had ever applied my research to Michigan. To be honest, I had never considered it. But as he talked I saw the potential application: globalization and an increasingly complex and technical international economic system is driving the primary location of competition to the state level. Michigan is not competing only with other states. Michigan is competing directly with Singapore and every other developing country. If true, why not act like these other countries?

Singapore’s success in the world economy has come from a mixture of technocratic and bureaucratic professionalism, strong political leadership, and active private sector participation. And by participation I don’t mean simply consultation. Heads of companies, leaders of unions, and leading academics have all taken turns directing the entire public policy process in key economic areas including forming, implementing, monitoring compliance, and ensuring enforcement of policy. The key to making this work is tight coordination between the private sector and government—not government as a regulating force, but as a facilitating one.

In many ways Michigan is at the crossroads that Singapore was in 1972. The cash cow industry that we have depended on for so long is floundering. Our economy is overregulated, our workers underproductive, and our industries less than innovative. What we do next will determine whether we compete successfully in the global economy or whether we continue our slide into underdevelopment.