A Two-Track World

In a new book, Nobel laureate Michael Spence aims to help CFOs understand what growth will look like in a world where developed economies and emerg...
Kate O'SullivanMay 27, 2011

The U.S. economy continues to bump along unsteadily, and the eurozone countries are grappling with ongoing debt crises. Japan, already stymied by years of economic stagnation, has been sidelined by a natural disaster. Yet, while these developed markets struggle, opportunities abound in the developing world, where a faster recovery, rapid industrialization, and booming populations are driving demand.

In his new book, The Next Convergence: The Future of Economic Growth in a Multispeed World, Michael Spence — winner of the Nobel Prize in economics, a former dean of Stanford Business School, and currently professor of economics at New York University’s Stern School of Business — explores the history of these two segments of the global economy and examines the challenges and opportunities that will arise as the established economies converge with the new drivers of global growth.

Recently, he spoke with CFO about the key points for finance chiefs to consider as they think about growth and expansion in the ever-changing global market.

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What are some of the critical points in your book that you would relay to CFOs?

Twenty years ago, U.S. businesses would think of emerging economies as opportunities in the supply-chain sense but not necessarily in the market sense. That’s changing rapidly. These economies are getting very large and creating a huge amount of opportunity for those who can access them. So there’s a big opportunity in terms of corporate profits.

These markets are also shifting fairly fast, so my second observation is that one would have to be fairly fleet of foot in moving portions of global operations or supply chains around. China’s about to price itself out of lots of export industries where it appears to have been dominant in the past. So that economic activity will move to other countries.

Michael Spence

My third observation is that there is a huge investment boom coming in the global economy to sustain the growth in emerging markets. So, while it’s not a sure thing, it looks like the cost of capital is going up. I would say to CFOs that an efficient use of capital, focusing on access to reasonable-cost financing, should be a higher priority than it has been in the past 15 years in a very low interest rate, low cost of capital environment.

Because these emerging economies are moving up the value chain, they also represent a shifting pattern of competition in terms of our domestic activity. That affects so many industries differently.

If you’re a U.S. CFO with a U.S.-focused business, how will the growth in the developing world — and slowing growth in the developed world — affect you?
There are competitive challenges as well as huge opportunities in these markets. Domestic firms in our own country and a number of other advanced countries are going to have to transform themselves in terms of being capable to compete with other markets and establishing global supply chains. There’s a learning curve that goes with that.

Do you think the advanced economies will continue to be that, the advanced economies? Or will it reverse at some point?

I don’t think that at all. I think we’re going to have a lot of friends, a lot of company in the advanced-economy segment. If you look out to the end point of the century, there’s going to be a very different global economy that will probably be four times the size of the current global economy, with a whole range of countries and companies serving a gigantic market even by today’s standards. There’s no reason to think that we will not be a technological and business leader in that environment.

It’ll be a bigger economy and there will be more people participating in it. But it’s not a zero-sum game. We don’t have to lose when they win. In fact, we may win when they win.

That doesn’t always seem to be the prevailing mind-set.

There’s a tendency to think gosh, they’re going to knock us out of here. That may come from the postcrisis environment, or from the jobs situation. There is a possible overemphasis on risks and underemphasis on opportunities. And there are real risks. Asia is 60% of the world’s population, where almost all of the really large growth is going to occur. It contains two future economic giants, China and India, so if they become protectionist, [that’s a risk]. If China and India are irresponsible in discharging their responsibilities, some very bad things could happen and everybody could suffer, including us. But hopefully the new large players will exhibit the kind of responsibility that the U.S. has when it has been the dominant player.

Are there things the advanced economies should be doing to stay competitive?
Germany is a very interesting case. It’s doing rather better than the rest of us in the postcrisis period. Germany faced a very serious competitive and productivity problem around the year 2000. They had absorbed East Germany at a one-to-one exchange rate, and there was an enormous transition they went through. Then they went to work on it. They made the labor market more flexible and focused on employment. I suspect we’ll learn some things by looking carefully at what others have done and tried to do — and learn not just from their successes, but also from their failures.

I think our economy has great strengths. We have a flexible economy. We have an innovative economy. I think most of the heavy lifting is going to have to be done on the government/public sector side. I think we’re underinvesting in total, and we’re going to have to improve our performance in education, improve our infrastructure, have an energy policy that makes some sense, and a tax system that makes some sense that doesn’t have oddball incentives in it to invest abroad rather than at home.

We have been overconsuming and underinvesting for an extended period of time, and we’re going to have to reverse that pattern to be as effective as we can be.

Is there a risk that the developing world will stall out?

There’s a serious risk of that. The common point to stall out is the so-called middle-income transition, the growth of a middle class. The transition from $4,000 in per capita income, which is where China is now, up to about $10,000 in per capita income. By the time you get to $10,000 in per capita income, the economy is starting to look like ours. The market is driving more of what happens and the government less.

There’s nothing inherent that prevents [that transition] from happening, but governments can make mistakes. They can hold the exchange rate down, or they don’t invest heavily enough in the human-capital base of the economy to sustain more-innovative work, or they subsidize the wrong things.

When you look at it, there are really only five countries that we’re aware of that have kept the growth up and made the middle-income transition. [They are Japan, Korea, Taiwan, Hong Kong, and Singapore]. China’s entering it right now, and it remains to be seen whether they’re going to be the sixth country to do so.

Most of the Latin American countries and a number of the Asian countries slowed down significantly. The middle-income transition has never been made at the scale of an economy the size of China. So we’ll see. I think they’re working on it hard. They have a five-year plan that has most of the moving parts in focus. Now it’s an implementation question.

Talk about the impact of population growth on the global economy.
You have aging populations in virtually all of the advanced countries. Japan, Europe, then the U.S., and then China not long after us. There’s a serious question about what that will do to growth. An aging population doesn’t necessarily have to slow down growth, but it may be unlikely that we can make all the necessary institutional changes — to the length of a person’s working life, for example — to keep up.

Then you have countries that are going to have high population growth, and that’s a problem for them. They tend to be poorer countries, and high population growth doesn’t help at all.

There’s also a more subtle issue in that countries differ in what they regard as areas in which people are allowed to exercise freedom of choice. Typically, the number of kids you have has been one, with China the obvious exception. But there are questions like how you build a city, how many cars you have, how much fuel you consume, that have fairly large external effects. One of the things coming down the road in the U.S. is a set of fairly fundamental questions as to where we view the line of individual freedom and constrained choice when it comes to the impact on natural resources and the climate.

Trying to tell people that they can’t buy SUVs is going to be a hard sell.

Right. But we may be able to address that with a price system.

The growing demand associated with substantial growth in the world economy is having an impact on commodity prices in agriculture, in energy. There’s considerable concern about minerals and whether or not there are substitutes or whether we’re just going to run out of them.

Prices will go up, and then people will start economizing on the use of these things by virtue of their own choices. There will be big incentives to develop technologies that economize further on them. That will all be helpful. That’s really the market mechanism working well, maybe with an assist from the government in terms of providing certain incentives.

It may be a bumpier journey than is ideal. The whole thing is going to be a bumpy journey. One of the themes not just of my book but also of other books is that the integration of the global economy and global financial system is well ahead of regulatory integration on a global level, and there will be a lot of volatility. I don’t think it’s going to go away, even if Europe and America solve their current fiscal challenges.

What can CFOs do to manage in such a volatile environment?

In this environment, companies are already hedging in different ways. They’re building up big piles of cash. CFOs should be thinking about lowering the debt level, anticipating a higher cost of capital, maintaining cash and liquid reserves to handle both business and financial volatility, and economizing on the use of capital because of the probability of the rising cost of capital. We’re exiting QE2 [the Federal Reserve’s second round of quantitative easing], but that doesn’t seem to be having a major effect. But on a three-to-five-year time line it will start to feel like we’re in a different cost-of-capital and fiscal environment than we have been for a long, long time.