Adam Smith is Still Right

A Review of The Power of Productivity, by William W. Lewis (2004)

This book was a big hit in 2004 when it was published. Over a decade later, the conclusions and lessons are still valid, surprising, counterintuitive (at least to some), and just as ignored as they were back in 2004.

William Lewis was a partner at McKinsey & Company, served at the World Bank, and founded the McKinsey Global Institute (MGI) for McKinsey & Company in 1990. He launched the McKinsey Global Institute with a project to answer the single question: How will globalization affect the world’s economies? That project consumed MGI for the next 12 years, and its findings are presented in this book, along with some entertaining descriptions of the actual founding and operation of MGI and challenges in answering the fundamental question above.

The shortest possible summary of this book is: Adam Smith is still right. The author often references relative productivity advantages and concludes that relative productivity is the ultimate driver of economic growth. Briefly, if a country (or company) A has a relative advantage over country (or company) B in producing products X and Y, country A may still gain an economic advantage by buying product Y from country B, if country A has a bigger relative advantage in producing product X, or if its resources are limited, or if product X has a bigger market, etc. In short, in a truly free market, a country (or company) will maximize its economic advantages.

All the fun is in the details of the MGI project, and it is sadly no surprise with how many different ways MGI discovered and documented governments and businesses actively distorting and sabotaging markets. Ever thus, perhaps.

The book very well organized. The prologue presents the findings and the structure of the study, which includes deep economic analysis of the 13 countries in the study, grouped as follows:

• Part 1 – Rich and Middle-Income Countries – Japan, Europe, United States, and Korea
• Part 2 – Poor Countries – Brazil, Russia, India
• Part 3 – Causes and Implications

The author has a breezy, engaging style. Even the chapter titles are entertaining.

Findings

The author develops ten conclusions from the project, which he presents as “Many people think that…. , but the reality is …” This format becomes very effective. These conclusions are quoted below, directly from the book.

“1. Many people look for the causes of poor economic performance primarily in macroeconomics.

An evaluation of economic performance requires an analysis at the level of individual industries, such as automotive, steel, banking, and retailing. This is the “sector” level. You must also look at the sector level for causal factors for economic performance.

2. Beyond macroeconomic policies, economic analysis usually ends up attributing most of the differences in economic performance to differences in labor and capital markets.

This conclusion is incorrect. Differences in competition in product markets are much more important. Policies governing competition in the product markets are as important as macroeconomic policies.

3. The Washington consensus of the 1990s argued that such elements as flexible exchange rates, low inflation, and government solvency are the critical factors in economic health.

One factor that was profoundly underestimated is the importance of a level playing field for competition in a country.

4. Many people believe that the educational attainment of a nation’s current labor force is responsible for the success or failure of its economy.

The importance of the education of the workforce has been taken way too far. In other words, education is not the way out of the poverty trap. A high education level is no guarantee of high productivity. The truth of the matter is that regardless of institutional educational level, workers around the world can be adequately trained on the job for high productivity.

5. Many people see access to capital as the determining factor between a productive growing economy and one that is not. Therefore they feel that if rich countries send capital pouring into poor countries, the poor countries would become richer.

The solution does not start with more capital. The solution, rather, is in the country’s productivity or the way it organizes and deploys both its labor and its capital. If poor countries improved productivity and balanced their budgets, they would have plenty of capital for growth from domestic sources and foreign investors.

6. Most people consider “social objectives” to be “good.” Import tariffs, subsidized loans for small businesses, government disallowance of layoffs, and high minimum wages are all examples of economic policies designed to achieve social objectives.

We can’t have it both ways. These measures distort markets severely and limit productivity growth, slow overall economic growth, and cause unemployment. Rather than support these measures, it is better to level the playing field, create a bigger economic pie, and manage the distribution of that pie through the tax code for individuals.

7. Most people don’t recognize the destructive power of big government on economic development.

Big governments demand big taxation. When part of the economy is informal and untaxed, the burden falls heavily on legitimate businesses. This is a burden today’s rich countries did not have when they were poor.

8. Many people think salvation is in the elites, the educational technocratic, political, business, and intellectual groups, who cooperate to manage economies through government.

The elites are responsible for big government. Particularly in the poorer countries, the elites license business activity, control international financial and material goods flows, promote unaffordable social welfare systems, and favor government-owned businesses. Too often, the elites reward themselves richly.

9. Some people think that nations should protect their own industries but also ask outside nations for capital.

This is wrong. Direct investments by the more productive companies from the rich countries will raise the productivity and growth rates far more effective than sending them money. Poor countries have the potential to grow much faster than most people realize.

10. Many people think that production is all that is needed to create economic value. This is why government sometimes protects businesses, regardless of their performance.

They fail to make the link between production and consumption. The goods produced have value only because consumers want them. If they [consumers] don’t want them for some reason (such as the high price), the business producing those goods needs to die. Only one force can stand up to producer special interests – consumer interests. Most poor countries are a long way from a consumption mindset and consumer rights. As a result, they are poor.”

Country Examples

The examples of individual countries are very entertaining. Developed countries provide powerful examples of sectors with good economics as well as sectors that have gone astray. Poor countries offer a plethora of cautionary tales, which provide the foundation for the Findings above.

Why Does It Always Go Wrong?

Likely most of us would intuitively agree with some, if not many, of the author’s conclusions. Even where we disagree, we might read and respect the extensive research the MGI team did and the broad base of economic data and statistics they gathered and analyzed across thirteen countries that led to each conclusion. So, given that each of these conclusions probably has a very broad agreement and support, we must ask the question: Why does it always go wrong? Said differently, Why do we (nations) keep on making the same mistakes?

[Reviewer addition] One hint may lie in conclusion six. “Many people see “social objectives” as “good.”“ Not only do we see social objectives as good, we can often state the social objectives in a catchy “bumper sticker” format for easy consumption and forced agreement. With appropriate phrasing for the social good, agreement with the proposed solution becomes unavoidable. For instance.

• People need a living wage. Let’s raise the minimum wage.
• People need basic housing. Let’s build housing for the poor, and for teachers, and firemen, and for …. <other preferred groups>.
• People need education. Let’s provide free university education.
• People need cheap, good medical care. Let’s subsidize medical care, or even make it free.
• Older and poor people should not be thrown out of their houses for failure to pay property taxes. Let’s subsidize their taxes, or just waive those taxes.
• People need protection from unscrupulous businesses. Let’s require testing and licensing for barbers, hairdressers, certified accountants (CPAs), contractors, doctors, lawyers, realtors, and insurance salespeople.

We could easily extend the list above. While each of these social “goods” may in fact be good, each one comes with real social and economic costs. Better housing, higher wages, better medical care, protection from unscrupulous businesses, and tax subsidies may be good in some situations, but they are definitely not free.

[Reviewer Addition] So, why do we keep making the same mistakes? Consider five possible reasons.

1. Most of us want to do “social good” for people. Occasionally we may want to do social good for animals, historic buildings, or even specific natural areas, but mostly we want to do social good for people.

2. The benefit of “social good’ actions are visible and personal, and deeply satisfy our altruistic desires. No doubt you have heard these emotionally charged statements of social goods.

• Do it for the children.
• What if your mother or even your child was denied health care, basic housing, education, a mobile phone, or … <another good or service>.
• Don’t let this happen to your loved ones.

3. The benefits of social goods are highly focused. People who receive subsidized are highly incentivized to keep those subsidies and to increase them.

4. The costs of social goods are diffused across large populations. For instance, supporting Yellowstone National Park costs each taxpayer only $0.27 each year. Surely you can afford a quarter for Yellowstone.

5. We do not identify with the economy or business. Quite literally, the economy and business are faceless. We do not derive any sense of altruistic goodness from protecting the economy or business. In fact, we often identify the economy and business as evil actors in our human dramas.

All these specific reasons can be summed up as human nature, particularly the pleasure we derive from altruism and the unavoidable desire of every person to improve their own situation. Depending upon the lens of the viewer this desire to improve one’s own situation can be seen as reasonable and even beneficial, or just plain greedy.

In prehistoric times these human emotions may have motivated individuals to improve the survival and growth of the tribe, typically ten to fifty people, all related by blood—literally one extended family. Over time, starting approximately when humans shifted from nomadic hunter gatherer tribes to agrarian existence and accelerated with the average size of villages and cities, our individual fortunes and quality of life have derived progressively less from a local family and relatively more from faceless entities such as big business, the economy, and governments.

While our prehistoric emotions of altruism and greed have not changed significantly from nomadic cultures, our environment has changed dramatically. As a result, our emotions provide progressively less survival value for our tribe and progressively larger targets for external manipulation.