How can firms and managers compensate for the gap between past understandings and future change? One way is to consciously investigate changes in the environment to understand which variables impact focal business processes. The goal of this article is first to illustrate how different worldviews evolved as the understanding of economic theory and reality changed. This will be done through a focus on the American experience. Second, emerging challenges to current worldviews will be identified and suggestions made as to how business practitioners can anticipate the future and plan accordingly.
Changing World Views
1776-1890: In 1776 Adam Smith published The Wealth of Nations arguing that the combination of individual choices made by consumers in a market economy without government interference produced the best economic outcomes for society as a whole. According to Smith, consumers would determine by their choices what products, and what quality of products, would be produced. Further, competition, which was assumed to be among businesses of roughly equal size, would keep prices in check. Businesses that didn’t meet market expectations would fail. The American economy of the late 18th century fit Smith’s model in many ways, and laissez faire became the dominant theoretical explanation of the time.
But, even then, reality was changing. Industrialization created the need for large-scale investment, leading to businesses of unequal size and economic power. It also led to attempts to eliminate competition in order to make investments more profitable. The 19th century saw many mergers, trusts, cartels, gentlemen’s agreements and, in time, monopolies. Business cycles came and went, but, in keeping with the laissez faire philosophy, the government stayed largely on the sidelines.
1890-Post WWII: A turning point was reached in 1890 with the passage of the Sherman Anti-trust Act. This act was not necessarily viewed as a repudiation of market control, but as setting “rules of the game” to make competition fair and to reduce monopoly power. However, the fines were too few and too small to be effective, making the act singularly weak. Numerous companies continued to buy and merge with competitors to avoid competitive pressures in the marketplace. Still appealing to laissez faire for justification, other laws were passed between 1890 and 1929 to limit anti-competitive behavior. However, since the general economy was doing so well, there was little concern to interfere further. The late 1920s saw a period of speculation and credit expansion. Unfortunately, in October 1929 the stock market crash demonstrated the weak credit structure on which the roaring 1920s were built.
In the aftermath, governments around the world raised tariffs in response to political pressures to protect domestic industries. At the same time, the accepted economic view remained that governments, like families, should always operate within a balanced budget. As a result, the overall world economy contracted sharply producing a worldwide depression.
Franklin Roosevelt, in spite of some criticism, believed the government needed to be directly involved in creating aggregate demand. Despite the lack of a macroeconomic theory to justify deficit spending, his administration created public works jobs and significantly counteracted the economic downturn via increased government spending. The U.S. economy did not really start growing, however, until the public accepted much greater deficit spending to support the war effort.
Post-WWII – 1950s: Americans were still skeptical about government involvement in a peace time economy. Pent-up demand from the 1930’s and war years fed the economy for most of the 1950’s without direct government intervention from the Eisenhower administration. The GI Bill helped by providing training and slowing the rate at which the economy had to absorb returning GI’s.
1960-1980s: Kennedy was the first president to take a macro-economic approach to the economy when he recommended a tax cut to stimulate the economy. The principles of macro-economics had been an academic topic since John Maynard Keynes’ work in the l930s but had never been applied as a part of public policy. Keynesian theory says that recession, defined as low employment and negative growth, is due to a lack of aggregate spending. A government can stimulate a recessionary economy by increasing government spending and/or lowering taxes to increase consumer spending. Conversely, it can cut back on spending and/or raise taxes and interest rates when the economy is overheating. The low inflation economic expansion following Kennedy’s new fiscal policy converted many to Keynesian economics, which later became the mainstream thinking.
New problems emerged in the l970s that challenged the idea that Keynesian theory had magically found a way to avoid economic problems. The U. S. entered a period of combined high inflation and slow growth, or “stagflation.” Simultaneously, the economy was shifting to a global focus, although few recognized the transformation at the time. By the mid 1970s, the American economy became more inflated and turbulent as other world economies also adjusted to compensate for the existence of world markets in oil, steel, and other products.
Reagan advocated a type of laissez faire economics as a cure to the volatile l970s. He pledged to reduce taxes, government spending, and government regulations. He was able to push through tax cuts and specific industry deregulation, but government spending still grew because of increased spending on defense and entitlements. The lower-tax, less-regulated economy did grow, but not fast enough to cover the increased spending, causing the federal deficit to grow. The Reagan period was a time of economic debate among post-Keynesians, monetarists, and supply-siders.
The emergence of global capital markets was another phenomenon of this period. The U.S. government was depending on international investors to finance the growing deficit, thus indirectly giving investors the potential to impact U.S. economic policy. For example, despite its laissez faire philosophy, the Reagan administration was pressured to keep interest rates and the value of the U.S. dollar high in order to attract foreign investors.
The 1990s: The economy had begun to slow during the second half of the Bush presidency, but this was not a typical business cycle slowdown created by inflation followed by high interest rates and a dampening of aggregate demand. Although there is controversy about why the second half of 1990 was so weak, many believe that U.S. consumers had simply over-extended their credit limits. In addition, the government’s debt level was so large that it was neither politically nor economically feasible to increase government spending or cut taxes to stimulate the economy.
Decreased consumer demand, as a result of the July 1990-April 1991 recession, led to lower interest rates. Consumers, business, and government were all able to refinance, freeing potential credit for new spending and ending the recession in the early part of Clinton’s term. At the same time, the impact of corporate down-sizing and global competition kept wages and inflation in line. In addition, information technology began to positively impact productivity creating new categories of employment and spurring the economy without the typical inflation concerns.
Today’s Changing World
Keynes Revisited: What does the above say about how a businessperson should make decisions today? First, change is occurring much faster and is more radical than most of us realize. While the fundamental principles of economics still hold, the dynamics of analysis have changed. Nation-states no longer have the degree of autonomy they once possessed. For example, European countries have had to modify their domestic polices to ensure admission to the European Community. A common currency will likely unite the European Community even further and may limit the ability of individual countries to use macro-economic tools internally.
Second, the belief that national economic swings can be manipulated by government spending and changes in tax rates requires re-evaluation. Countries whose currencies are traded, including the U.S., need to consider the impact of currency traders looking to exploit discrepancies between the domestic economy and the international value of the currency. As the recent turmoil in
Asia has demonstrated, policy choices need to include consideration of the potential for a run on any nation’s currency.
Ricardo Revisited: As globalization proceeds, traditional rules of the economic game are being challenged. New rules, such as modification to the anti-trust laws, are being crafted for domestic and international markets. In a provocative analysis, Lester Thurow suggests that the game itself will be much different. Previously, successful nations developed different economic niches based on their natural resources or some other advantage in the Ricardian world of strategic differentiation. While that world had the potential to be a positive-sum or win/win game, Thurow argues that the new game is more likely to be zero-sum as nations compete for the desirable, high-paying, less-polluting industries such as materials science, software development, biotechnology, and robotics. Competition in these emerging industries will be based on brainpower and education. Unlike natural resources, brainpower is not geographically-specific. Thurow argues that nations that are able to educate workers and mobilize resources to be the low-cost producers in these new industries will become dominant powers and may be able to influence the definition of the new rules to their advantage.
New Rules: The rules are evolving even as we ponder what type of environment will allow America to remain economically competitive. Many as-of-yet unanswered questions surrounding mergers such as that of Chrysler and Daimler-Benz will set precedents in the new global theater. On which stock market will they be listed, and therefore which accounting and disclosure rules will they have to obey? How will differences in environmental, anti-trust, or contract laws be resolved? Can any nation-state really control a transnational company? If not, what are the implications?
Some things about the new order are fairly certain. The new future global marketplace is unlikely to be dominated by an Anglo-Saxon hegemony or any one nation-state for that matter.
While the concepts of market economics and democratic participation will probably spread globally, what this means is unclear. China is likely to make the transition to a truly market economy faster than some other nations because of its long history of entrepreneurship prior to the communist experiment. However, the Chinese version of a market economy may be much more protectionist or have greater government involvement than western versions. The term “market economy” may not be synonymous with the American definition of “capitalism.”
Developing countries will demand their perceived fair share of natural resources and “pollution rights.” The population of the world is still growing, but the age distribution will shift. The median age of the population, and the proportion of the elderly, will rise in developed countries since people are living longer and birthrates have declined. Consequently, promises made regarding social security and health care must be renegotiated so that subsequent generations can survive.
Decision-Making in the Changing World
The above discussion has a direct relationship to business decision-making. First, business practitioners need to accept that change is often unpredictable, whether domestic or international. Thus making future decisions based on the traditional considerations becomes a dangerous decision premise. Variables that impacted prior quarters may be different from those that will influence future financials. In the past, external conditions were considered a constant, and internal factors were used to predict organizational performance. Today, the opposite is true for most companies. Organizations should be constantly aware of external changes, including changes in global, national, state and regional policies and economic trends. The crisis in Southeast Asia has altered money and capital markets world wide, directly influencing business decision making within the U.S. El Nino related losses have impacted commodity prices and the cost of doing business. The formation of the European Community may alter the openness of markets and production. Immigration will affect the availability, and cost of labor, as well as productivity.
Understanding which variables are most likely to impact performance is an important step in anticipating how these factors can influence decision-making. Making this determination is not necessarily obvious and empirical analysis may help. One such decision-making tool involves determining the relationship between key company ratios and macro-economic variables over time. An example, using actual company data, can be viewed by clicking below. There is also a downloadable Excel spreadsheet that will let you experiment with some of your company information.
These are interesting times. Executives can be proactive and develop policies that will help their firms remain competitive in a changing world where economic power will likely be internationally disbursed. Or they can choose to be reactive and do “business as usual.” In that case, they should not be surprised when “business as usual” isn’t!