Creating the Next Economy

In my last post, I wrote about where the capital is that is necessary to create the next economy.  It is in private hands--those of banks, institutional investors and, as the New York Times echos today, corporations who are now sitting trillions in cash.  There is no guarantee this money will go to work anytime soon or that it will all stay in the Untied States.  Government's role post-crisis must be to coax it out of hiding by reducing uncertainty while investing in education and infrastructure--two local factors in growth where there is no substitute for government leadership--to make the US attractive to investors.

But when capital comes out of hiding, what will the next economy look like?  Today I will describe four economic trends that will shape the next economy.  The Great Recession did not reverse these trends; rather it was failure to adjust to them that precipated the crisis. 

First, small continues to beautiful as economies worldwide continue to decentralize.  Continuing a trend that began in the 1970s, over the last decade, Fortune 500 employment has been flat though their sales and profits have jumped evan allowing for the Great Recession.  Not only only do small businesses create about two thirds of US jobs as we often hear, small and medium size businesses are providing a higher percentge of jobs as the Fortune 500 continue to outsource functions and some old companies disappear.  We may regret the passing of high paid lifetime jobs at blue chip companies but that day is gone.  Overseas the dynamism in China, Vietnam and elsewhere is occurring not in large monolithic companies but in networks of smaller firms with a strong regional focus.  Chinese economic dynamism on in Guangdong province and coast, for example, appears to be yet another example of the regional development fueled by local spillovers described by Michael Porter (and decades earlier by Alfred Marshall) following liberalization.  We should not confuse liberalization with what remains of command and control.

There is a solid economic reason for this trend.  Firms grew large in the 20th century, as Nobel Laureate Ronald Coase first observed, not because of economies of scale which can exist over a keiretsu of companies or region (such as the Garment district in New York) but rather to avoid the transaction costs of contracting with outsiders.  In recent years, those transaction costs have collapsed due to email, database integration and other technologies.  During the recent crisis it was firms that remained highly vertically integrated such as GM that suffered whereas those that embraced collaborating such as Ford survived. Similarly, large bank like Citi suffered.  And, of course, it was bailing out the large companies that created the largest chore for government.

Second, and related to the first, technologies have dramatically empowered the individual--or perhaps more accurately the crowd--at the expense of elites.  From the Barack Obama campaign to political movements in other countries to the tea party insurgency within the Republican parth this summer, groups of people have allied quickly and unexpectedly at the expense of incumbents, helped by new technologies.  Accustomed to this democracy in most parts of their lives, people expect to see it in the economy.  For this reason, the bailouts of large companies, however, necessary following the financial crisis, created a cognitive dissonance that the Administration needs to escape.  There is no way we are going to redo the 1930s in the age of Twitter.  The next economy will be bottom up and leverage new technology.

Third, the next economy must leverage innovation.  The US can (and should) not compete on cheap labor.  To do so would be at best a race to the bottom that we would lose.  Nor can we compete on cheap land or raw materials--because our exchange rate prices those things equal to or greater than equivalents elsewhere.  We can compete, however, on knowledge and productivity where we excel.  No country conducts better research or has better unversities.  And no country can convert an idea into a business better than the United States.  The next economy must leverage that knowhow.  The US economy received a huge boost from our leadership in Internet technology and we need similar boost in new sectors if we are going to retain global economic leadership.

Fourth, the next economy will follow changes in laws.  The sectors where we reform regulation will be those that upgrade plant and equipment as capital flows toward new opportunities. 

Ironically, post financial crisis, one sector that has been granted a new set of rules is the financial one.  Early indications are that financial regulation while curtailing some businesses will create vast new ones.  For example, the derivative clearing houses created in the regulation are likely to spawn a whole new growth industry on Wall Street.  There is nothing wrong with a new industry per se and it is too soon to know whether Congress got it right or perhaps created a new moral hazard.  But clearly, it will form part of the next economy.  Similarly, the healthcare sector will adjust to new rules, however, it remains to be seen how a reduction in medicare and increase in medicaid will impact healthcare practice.

Perhaps the key sector in need of reform that has yet to get it is the energy sector.  Silicon Valley and savvy investors have identified clean technology and, in particular, the smart grid, electric transportation and electricity sector as one rife with opportunities.  However, the technologies fermenting in laboratories will go nowhere without meaningful reform of the electricity sector that provides virtually no way, currently, to monetize new technologies.  Reform is complicated by the large state role in electricity regulation.  (The telecom and financial sectors which boomed in recent decades solved this problem by carrying out reform at the federal level.)  Climate change legislation would have sparked a surge in energy investments, but didn't happen.

For the energy sector to become a driver of wealth and job creation, the Adminsitration needs to get behind a major bipartisan effort to upgrade our nation's outdated energy regulatory architecture.  NDN launched this drive with our Electrcity 2.0 initiative and we are glad to see more and more groups beginning to embrace what must become a central economic policy project of the next year. 

So what will the next economy look like?  It will be underweighted in housing and consumer spending reflecting the overhang of the housing crisis.  It will include a financial services component.  Ant it  will rise or fall on its embrace of innovation.   But to achieve its full potential and engage the trillions in private capital now sitting on the sidelines--money that could easily go to China or Vietnam, it will require upgrading our energy regulation.