Focusing on short-term efficiency gains can lead to long-term inefficiency. The work of Schumpeter provides an alternative that could lead to greater prosperity.
This blog is a version of a speech Patrick Kaczmarczyk delivered at the 30th Economic Forum in Karpacz, Poland in September 2021. His panel discussed the question of the necessity, usefulness and downsides to global supply chains. Further information about the Forum and Patrick’s involvement can be found here.
The Covid-19 crisis has exposed the fragility of the global supply chain system. Supply bottlenecks are causing delays in production and delivery of goods, at times including essential good like medical drugs. Policymakers are increasingly questioning whether the benefits of global supply chains still outweigh the risks.
It is important to put this question in a bigger context. The issue we are dealing with now is one dimension of what I refer to as the fallacy of efficiency. Guided by the belief that efficiency enhances overall welfare, government policy over the past thirty to forty years has been aimed at institutionalising a system that has rendered all objectives other than efficiency secondary. By that, it has created a system that becomes highly inefficient in the long run. That’s the fallacy in a nutshell.
The fallacy is a direct consequence of widely applied economic theories that take the world in which we live in as given. Their main concern is to allocate the given and scarce resources in the most effective manner. The best tool for that is the market. If governments ensure seamless market functioning, the production will adjust to the relative prices of labour and capital, until the economy is in equilibrium. It then takes again some external factor – whatever that might be – to disturb the equilibrium. A new adjustment process kicks in, and the economy adjusts towards a new equilibrium. In this stationary world, development is the transition from one equilibrium to another. Yet, this cannot even be taken as a way to simplify a complex reality, since it does not at all fit the messy and unpredictable experience of 150 years of capitalist development.
After 20 years of very weak development performance in Europe (as well as globally, except for China), it is time to start thinking in new, original and dynamic ways about the economy. One economist we should put back to the forefront in this regard is Joseph Schumpeter. Unfortunately, he is often reduced to buzzwords such as ‘creative destruction’ by people who have mostly never engaged with his work. It is the Shakespearian dilemma: often cited, never read. Yet, Schumpeter’s most important insight is that development and higher living standards are not a result of firms optimising their production but a result of firms innovating, of creating something new. In Schumpeterian terms, it is through a new combination of labour and capital that the pioneer gains a productivity advantage over their rivals in the market, who, in turn, must adapt to the new production method or product if they want to survive. This adjustment process entails a renewal of productive structures, which increases overall productivity and therefore real wages and living standards.
In his work, Schumpeter makes clear that there is a whole set of institutions required for innovation, including a low interest rate environment, government funding of independent and basic research, and appropriate wage policies, which force firms to invest to increase their competitiveness via higher productivity. As there are two ways of increasing competitiveness, one is lowering unit labour costs through higher productivity at the given wage level, the other is lowering wages at the given level of productivity, the Schumpeterian type of competition is the former. So, to be clear: to Schumpeter, an institutional framework that incentivizes companies to optimise, rather than innovate, is poison to achieving sustainable development. The same applies in certain ways to global value chains (GVCs), which are one dimension of such an optimisation-driven system, as companies merely outsource parts of their existing methods of production, to squeeze out a little bit more profit.
This is where the fallacy of efficiency kicks in: While most of the value added continues to be produced within regions, in optimisation-based competition regimes, tiny frictions at the other end of the world cause local crises. At the same time, there are few incentives for firms to invest in new technologies, as any inefficiencies turn into a competitive disadvantage that companies under pressure cannot afford. The creation of something new comes, by definition, with some trial and error, and only companies with a little breathing space can afford some wasting of labour and capital in the quest to increase productivity. Companies under pressure to deliver quarterly results, however, will rather outsource the existing production techniques or to try to push down the wage level in the domestic economy. It is easier and safer to do what one used to do simply with more cost-efficiency. Also at the government policy level, the obsession with efficiency leaves us with more inefficiency in the long run. As budgetary rules in Europe put pressure on public spending, education, infrastructure and the health system suffer. This lowers productivity and long-term prosperity.
We thus need to reconsider our economic approach away from an efficiency-fostering model to one that is more conducive to genuine development. It includes international cooperation on wage levels, exchange rates, and the application of the golden wage rule, also for foreign direct investments: nominal wages must follow the national inflation target and average productivity growth. But beyond that it requires a more fundamental rethinking of the role of the state, a rethinking of the role of wages, of innovation, and of the quality of competition that we want globally and in Europe. If the conditions for that can be created, there will be no need for value chains spanning the entire globe, and we might be more relaxed about giving developing countries more breathing space to catch up via their own industrial policies. The competition between nations, the useless and ruinous competition based on efficiency and costs alone would become a thing of the past. It will be a globalisation characterised by deeper regional integration, which will engender more prosperity whilst cutting the incredibly polluting transport emissions of GVC-trade. It might sound like a radical departure from what used to be the conventional way of thinking over the past 30 to 40 years. Yet, it would turn out to be a lot more efficient in the long run.