Tuesday, 1 April 1997

Big is Flexible - New Patterns in World Investment

Introduction

The latest figures on the emerging pattern of global investment present a massive challenge to the next government. The likely future we can extrapolate from these figures will come as a shock to many, particularly those who subscribe to the theory of post-fordism which became fashionable in the 1980s. According to this thesis, the era of mass assembly line output, pioneered by the Model T Ford, was superseded. New forms, based on ‘flexible batch production,’ were playing the leading role in the economy.

A series of interrelated concepts were advanced linked to this — that a tendency towards small(er) scale production had replaced the huge units of output of ‘Fordism,’ that service industries were replacing manufacturing, that a ‘segmentation’ of markets had/was taking place etc.. In a typical formulation of the period: ‘The new terrain is that of high technology, of small firms, computers and information technology’. This concept led, in terms of rhetoric, to various views that the large scale economy of the manufacturing period was bypassed and instead ‘small is beautiful.’

This thesis was based on ripping individual aspects of the situation out of context, exaggerating them, and using this to destroy any quantified, precise or balanced consideration of reality, and thereby obscuring the real tendencies of development.

The real economic trends were, and are, the exact opposite of ‘small is beautiful.’ In the context of the issues discussed here, they might be termed ‘big is flexible.’

The most advanced sectors of modern production are, indeed, characterised by extraordinary flexibility — compared to the standardisation caricatured in Henry Ford’s famous ‘you can have it any colour provided its black.’ But this emphasis on the outward forms of flexibifity, segmentation, and individualisation obscures the underlying economic reality. The necessary precondition, and foundation, for the flexibility of ‘post-Fordist’ production is an historically unprecedented level of investment and associated scale of production.

This trend is evident not merely in direct investment within industry — i.e. the technology which makes possible flexible manufacturing, but in the processes necessary to co-ordinate extremely large scale production — telecommunications systems, transport, computerisation of stock control etc. These, in turn, require radical expansion of the educational system — the creation, on a new and unprecedented scale, of skilled labour which is the indispensable precondition for operating this new, more capital intensive, production.

The enormous concentrations of capital which make flexible production possible have a number of aspects. One, analysed by Socialist Economic Bulletin (SEB) in Fundamental Economic Implications of a Single European Currency, is that the necessary scale of production, of the most advanced industries, can only be carried out, on an efficient basis, on a scale which exceeds the nation state. It is this which is the ultimate root of globalisation — and why all attempts to pull production back into the scale of nation state are purely utopian.

This issue of SEB concentrates on a second aspect — that of the scale of investment required for modern production. This is considered from both an ‘extensive’ and an ‘intensive’ point of view. The ‘extensive’ is the spread of successively higher ratios of investment to GDP into the most successful contemporary economies. The ‘intensive’ is the penetration of high levels of investment into the new service sectors in the most advanced economies. This combination makes clear that what is being seen is not a retreat to the ‘small’ but a new upward twist in the role of large scale investment within the economy.

The implications of this for the U.K. are evident. Britain historically suffered from an inadequate level of investment — a phenomenon illustrated again here. But under 18 years of Tory government this chronic historic problem has become acute — with investment having now fallen to its lowest share of GDP for forty years. The material analysed below shows that far from the rise of the service sector leading to a lessening of the requirements for investment, it will raise them still further — together with the demand for an educated labour force capable of operating this investment.

The last 18 years of Conservative government have not corrected (he historical distortions of the U.K. economy, but deepened them still further. An emphasis on investment by the next Labour government is the essential precondition for tackling any of the problems which face the British economy.

Ken Livingstone MP

* * *

The historical rise in the proportion of the economy devoted to fixed investment is one of the most well established of long term economic processes. It will be illustrated below in considering the overall trend of fixed capital formation from the industrial revolution to the present. Current conjunctural trends, the development of very rapid economic growth in South East Asia, and the transformations within the service sectors of the most advanced economies, may then be clearly understood against this backdrop.1

The industrial revolution

While estimates for investment for early historical periods are extremely difficult to make, it is clear that at the time of the industrial revolution in the U.K., at the end of the 18th century, less than 10% of the U.K.’s GDP was allocated to fixed capital formation. To give an historical contrast, by the 1990s rates of investment had reached, in extreme cases, 35-40% of GDP. A rate of fixed capital formation of 30% of GDP, or above, is typical for Japan and the East Asian Newly Industrialising Countries (NICs) (Figure 1).


Figure 1


Sharp increases in investment

It is also clear from historical data that increases in the rate of investment do not occur gradually, but in (relatively) short periods that are frequently reflected in shifts in international economic leadership — i.e. such upward shifts in investment are ‘revolutionary’ rather than ‘evolutionary’.

Since the industrial revolution four such waves of sharp increases in the proportion of GDP allocated to investment have taken place — with, arguably, a fifth occurring at present. Using as titles the countries which provided the ‘leading edge’ of such periods of increased investment, these may be termed the ‘UK period’, the ‘US period’, the ‘West German period’, and the ‘Japanese period’. The fifth may be termed the ‘Chinese/South East Asian period’ — although it remains to be seen if this is a new higher phase, or a generalisation of the preceding Japanese one.

These periods will be considered in chronological order.

The UK rate of investment

Historical studies indicate that, following the industrial revolution, the U.K.’s domestic fixed capital formation was less than 10% of GDP and that no fundamental increase in the proportion of UK GDP devoted to fixed capital formation took place during the following century. While the U.K.’s savings rate became substantially higher than this level of domestic investment, the capital created was invested abroad. By the eve of World War I, U.K. annual overseas investment was larger than investment in its domestic economy — this tendency to substitute investment abroad for investment at home being one of the chief historical features of the U.K. economy, and substantially accounting for its weak character compared to its rivals. By 1885 UK fixed domestic capital formation was still only seven per cent of GDP.2

Only after World War II did U.K. domestic investment substantially rise as a proportion of GDP, and even then it remained lower than its rivals — while, simultaneously, its rate of investment abroad remained higher, in proportionate terms, than its competitors.

The US rate of investment

While the UK level of domestic investment remained fixed at under 10% for over a century, the U.S., by the period following the end of the civil war, had qualitatively surpassed this rate — to achieve an historically unprecedented level of capital formation of 15-20% of GDP. This rate of fixed capital formation, being double that of the UK, accompanied the establishment of the US as the world’s leading economy — replacing Britain in the period from the nineteenth century until the end of World War II. Furthermore, the U.S. did not become a substantial investor abroad until after the two world wars, and even then its accumulation of foreign investment remained proportionately lower than that of the U.K.

It is clear that the US has not succeeded in seriously raising this rate of investment since the period in which it was established. The post World War II US economy saw fixed capital formation still averaging 15-20% of GDP.

The West Germany rate of investment

Data for German rates of investment prior to World War II are, unfortunately, not available. There is no evidence they surpassed US rates. However, by the early 1950s, West Germany had achieved a new historical peak of fixed investment of 20-25% of GDP — for the first time achieving a level clearly exceeding that of the U.S..

This level of investment, due to the competitive power/example of the West German economy, became generalised throughout Europe during the period of post-war boom from the 1950s-70s — with the exception of the U.K, in which the rate of investment remained lower. This pattern of investment, at a ‘West German level,’ underlay the process of economic convergence in Western Europe in this period. The failure of the U.K. to achieve this level of investment explained why it fell behind its European rivals, and was, and is, unable to participate in their process of convergence.

On the international field, this new historically higher rate of fixed capital formation was accompanied by Western Europe achieving a more rapid rate of economic growth, and productivity increase, than the United States in the period from the 1950s to the early 1970s.

The Japanese rate of investment

From 1960 onwards Japan, which had commenced its post-war economic growth with levels of investment comparable to those of West Germany, achieved a new historical peak in investment rates — reaching levels of gross fixed capital formation of 30% of GDP and, at its peak, 35% of GDP. Such a rate of investment had, historically, only been previously seen once before — during Stalin’s period of rapid industrialisation of the USSR in the 1930s.

Japan’s rate of fixed capital formation has now been sustained for a quarter of a century indicating a new historical level in the proportion of GDP devoted to fixed investment.

The international accompaniments of this ‘Japanese’ rate of investment are well known. During the 1960s and 1970s Japan achieved rates of growth exceeding that of not only the U.S. but also Western Europe.

The Chinese/South East Asian rate of investment

Since the beginning of the 1980s a rate of investment exceeding that of Japan has been achieved by China, and a number of the South East Asian NICs. Their levels of fixed capital formation have reached levels of 35-40% of GDP (Figure 2). If this is maintained it will, of course, represent a new higher period of rate of investment. However, this level has, so far, been sustained only for a relatively short period — a decade. It is, therefore, necessary to reserve judgement as to whether a new ‘plateau’ of investment, exceeding that of Japan, has been achieved or whether they will slip back to the Japanese level.


Figure 2


The consequences of such rates of investment are, however, clear. The four ‘Asian Tigers’ — South Korea, Hong Kong, Singapore and Taiwan — have been transformed from underdeveloped countries to advanced industrial states in a single generation. China is undergoing the most rapid sustained growth seen by any large underdeveloped country in history.

Successive rises in the rate fixed capital formation

Summarising the above data the four, possible five, historically characteristic periods of rates of fixed investment can clearly be seen. These were:

• the UK rate, from the industrial revolution to the late nineteenth century, with levels of fixed capital formation of 5-10% of GDP;

• the post-civil war level US with investment at 15-20% of GDP:

• the post-World War II West German level of fixed capital formation of 20-25% of GD?;

• the post-1960 Japanese level of investment of 30% of GDP;

• a possible Chinese/South East Asian level of investment of 35% of GDP.

‘Leaps’ in the rate of investment

It is evident that, at least in the modern period, such characteristic increases in the rate of fixed capital formation do not take place gradually but in relatively sudden spurts. The West German level of investment was achieved in ten years between the end of World War II and 1955; the Japanese level of investment was achieved in a rapid surge between 1950 and 1960; the Chinese/South East Asian rate of investment was achieved in the ten year period after 1980.

‘Extensive’ increases of rates of investment

It is, furthermore, evident that once a ‘leading country’ of a given period has achieved the new higher proportion of GOP devoted to fixed capital formation this rate is ‘sticky’ — i.e. it is hard to achieve a higher rate. Once the UK had achieved the level of fixed capital formation of the industrial revolution its level of domestic investment rose only slightly over the next 150 years — a substantial increase only occurring in the post-World War II period. After the US had achieved its post-civil war level of investment this did not significantly increase in the next 130 years. West Germany did not succeed in rising above its post-World War II peak of investment. Such ‘stickiness’ of the rate of investment evidently reflects the fact that the relations between social groups, established by a given investment rate, would require major political upheaval to modify that level of investment.

The result of such ‘stickiness’ is the ‘extensive’ spread of increases in the rate of investment. In each case the new, higher, level of fixed capital formation was accompanied by a shift in the geographical locus of the most rapid economic growth. This ‘leading edge’ of investment and growth rates passed successively from the UK to the United States in the late nineteenth century and the first half of the twentieth; to Western Europe, immediately after World War II; to Japan from the 1960s; and to China and the East Asian NICs from the 1980s onwards. A spiralling outwards from the first industrial countries occurred.

The rise of the ‘service economy’

The rise of, first, the Japanese and now the EastlSouth East Asian economies is, of course, a commonplace observation of modern economics — although its place in the systematic successive increases in rates of investment is not so widely appreciated. But what is involved in the second characteristic process taking place within the already advanced economies themselves — that of the rise of the service sector?

It is in this field, in particular, that the idea of ‘smallness’ is thrown up. The level of investment in a ‘Fordist’ car plant is evident in its sheer physical size. Does, therefore, the rise of the service economy represent a retreat to a new, lower, level of investment? To illustrate the actual processes, Tables 1, 2 and 3 [at the end of this article] show, for those sectors for which data exists, the percentage of value added that is constituted by consumption of fixed capital in the U.S., Japan and Germany — i.e. in the most advanced economies. Consumption of capital, as a percentage of value added, is the most appropriate measure of the capital intensity of production.

A number of features stand out in this data which are not connected to the rise of the ‘service economy’ — in particular the extremely capital intensive character of the extractive industries (oil, gas, coal, mining in general etc.), and agriculture (which in all three economies has a higher capital intensity than the average for the economy as a whole). But the most striking feature, for present purposes, is that in all three economies the level of capital intensity in manufacturing is lower than the average for the economy as a whole — i.e. manufacturing does not represent a peak level of investment, from which a decline then takes place. Other things being equal a shift out of manufacturing would be associated with a rise in the level of capital intensity, not a fall.

Distinctions within the service sector

The process involved in this striking fact that manufacturing represents a sector of lower than average, not higher than average, capital intensity may be seen clearly by examining the service sectors in Tables 1 to 3. Certain service sectors have a low, common, capital intensity in all three economies — indicating that these are sectors that, at least at the present stage of economic development, are less capital intensive than manufacturing. These are notably the wholesale and retail distribution system and provision of government services. But considering the U.S. economy, that is the most advanced in the world, a whole series of service sectors have capital intensities significantly above the average — and substantially above those for manufacturing. These include communications and telecommunications, hotels, recreational and cultural services, finance, non- dwelling real estate and transport.

These named service sectors are, however, precisely the core of the expanding areas that form the base of the modern ‘service economy.’ That is, the movement of the U.S. economy out of manufacturing, and into services, is not a shift into sectors with a lower capital intensity than manufacturing, but into those with a higher capital intensity.

Some of the reasons for this trend are evident. These U.S. service sectors, which are the most advanced in the world, have undergone a massive process of computerisation in almost all areas. This process of computerisation has interlinked with that of telecommunications — the necessary precondition of efficient organisation of very large scale, including ‘globalised,’ production. Whole service sectors, such as finance, transport, and hotels, are now entirely dependent on such systems.3 These trends, together with others, result in a situation, as illustrated by the data, whereby the capital intensity of these service sectors actually exceeds that of manufacturing.

The process of rising capital intensity, in the most advanced service sectors, can be seen clearly by making a comparison of service sectors where capital intensity in the U.S differs sharply from the other economies noted — particularly for Germany, for which more comprehensive data is available than for Japan. In Germany, sectors such as communications and transport have high capital intensities — as in the U.S. But sectors such as financial institutions and restaurants and hotels do not — as is also the case for the U.K., Norway, Sweden, Finland, Austria and New Zealand for which OECD data are available.4 The higher level of capital intensity of these sectors in the U.S. is, evidently, linked to their more advanced development.

Increasing scale of production

A feature accompanying this rising capital intensity in the service sector is its increasing scale of production — the bringing of the service sector under the sway of large scale concentrations of capital. The process of creation of such concentrations in banking, entertainment, music, sport, broadcasting etc., is now on a scale equaling that in manufacturing. It was accurately described in Business Week:

‘Almost without warning, the U.S. has entered a new era of bigness... Chase-Chemical, Disney- ABC, Time Warner-Turner - these are just the tip of an economy wide move toward combination and consolidation.

‘Today’s deals are not the financially driven hostile takeovers and leveraged buyouts that dominated the 1980s. No raiders are carrying out bags of cash this time around. Now it’s the corporate leaders of America... Their goal: to acquire the size and resources to compete at home and abroad, to invest in new technology and new products, to control distribution channels and guarantee access to markets. “We are moving toward a period of the megacorporate state in which there will be a few global firms within particular economic sectors,” says Steven Nagourney, chief investment strategist for Lehman Brothers Inc.’s private client group.

‘That’s certainly true in the media industry, where the race to lock up key distribution channels such as television, and cable networks just got more frenzied. Market dominance is also driving such mergers in the drug industry, Merck’s & Co.’s purchase of Medco Containment Services Inc. ‘As your competitors get bigger, you’re almost forced to get bigger to stay equal’, says Norman S. Selby, Head of McKinsey & Co.’s pharmaceutical practice. ‘It’s a continual game of catch-up’.

‘Other deals are driven by a need to bulk up as U.S. companies take on global competitors. The Chemical-Chase merger produces a bank that’s No 1 in the U.S. but only 21st in the world, by assets. And the combination of Upjohn Co. and Sweden’s Pharmacia, announced on Aug. 20, will create a titan that only ranks about ninth in sales among drugmakers worldwide.

‘Besides adding sheer size, acquisitions can provide an instant presence in foreign markets. Scott Paper Co. was acquired by Kimberly-Clark Corp., in large part, because Scott had strengths in Europe that Kimberly lacked....

‘Companies are taking advantage of deregulation to make ever- larger combinations. New rules lifting barriers on interstate banking set to take effect in September, for example, will ignite a new round of cross-country mergers. And the proposed elimination of the Interstate Commerce Commission, which reviews railroad mergers, may spark more combinations among real carriers. One possibility: a Norfolk Southern Corp., takeover of Contrail Inc.

‘The passage of the telecom deregulation bill, expected this year and next, may be the signal for some of the biggest mergers of all time, especially if the old Bell system starts reassembling itself. ‘It’s not unreasonable to see several (regional Bell operating companies) merging over the next several years’, says Daniel Rein gold, vice-president at Merrill Lynch & Co. The most likely candidates: Bell Atlantic Corp. and Nynex Corp., which already jointly run a cellular service...

‘Inevitably, some once-mighty players will be trampled in the stampede for market dominance. Apple Computer Inc., with only about 10% share of the personal- computer market, may find that software developers opt to concentrate their efforts on the much larger Windows market.’

As Business Week noted, even in ‘classical’ service sectors:

‘Entertainment — just about everyone is trying to dominate this very hot U.S. export. Reason: vertical integration is supposed to yield clout in the Information Age. Result: Disney, Seagram and Westinghouse are all doing huge deals. Now, Time Warner is wooing Turner Broadcasting. Financial services — the goal here is to squeeze out costs and earn economies of scale. That’s a big reason behind Chemical’s $10 billion merger with Chase and First Union’s $5.4 billion acquisition of First Fidelity Bancorp.’5

The Wall Street Journal noted precisely the same trend driving the process of mergers which now extends well into the service sector:

‘The deals come tumbling out, one upon another. Chase/Chemical. Sandoz/Ciba-Geigy. Bell Atlantic/Nynex. British Telecom! MCI. Boeing/McDonnell Douglas. Morgan Stanley/Dean Witter.

‘It is a merger boom the likes of which the business world hasn’t seen since 1960s, when assembling conglomerates out of dozens of smaller companies was the rage. Except that it isn’t really like those eras. It is bigger, for one thing. And the forces behind it are different.

‘First, a few figures. The volume of mergers and acquisitions done world-wide last year added up to $1 trillion. That included 10,000 transactions in the U.S. alone, worth more than $650 billion — nearly twice the dollar volume and the number of deals for the peak year of the 1980s.

‘Many have been huge: Six last year topped $10 billion. Indeed, one-fifth of last year’s total dollar volume was squeezed into just 10 mega-mergers. The year saw more than 100 billion-dollar-plus transactions, a record...

‘This year there is no letup: 26 billion-dollar announcements so far and already a few giant ones, such as Morgan Stanley/Dean Witter and Banc One /First USA. It is the fastest pace since the current merger boom began...

‘Some of the causes aren’t far to seek... Above all, a globalizing economy in which companies often find they must become big to compete, either by acquiring or by being acquired. “There are all kinds of related factors, but the fundamental determinant of the overall level of activity is the expansion of the global economy,” says Scott Lindsey, co-head of mergers at Credit Suisse First Boston Corp.

‘As these elements suggest, the mergers of today are overwhelmingly being done for strategic business reasons. Thus, this merger boom differs from that of the 1980s, when some buyers were financial types simply angling for undervalued assets that could resell, and also from the conglomerate era that began in the early 1960s...

‘At its most fundamental level, today’s merger wave is about efficiency and market clout. Look at the union last year of Chemical Bank and Chase Manhattan. Where there had been two banks, with two. chairman, two corporate-loan departments, roughly 600 branches and over 75,000 employees, there is today just one bank. One chairman. One loan department. Eventually 100 branches will be shuttered, and 12,000 jobs will be eliminated...

‘A common theme in modern mergers is sheer size. Size is advantageous in many ways. Tyco international in Exeter, New Hampshire, by buying a packaging maker called Carlisle Plastics and wrapping it into its own Armin plastics, has doubled the volume of its purchases of low- density polyethylene film and gained new clout with suppliers. Banc One, by buying credit-card issuer First USA and its U.S. portfolio of 16 million card holders, gains a national platform in a key business.

‘And British Telecommunications’ $21 billion purchase of ‘MCI can now aggressively pursue a local strategy without worrying about near-term earnings impact,’ notes Salomon Brothers analyst Jack Grubman...

‘Size also matters in trying to capture as much business as possible from a given client. Companies like to offer customers “end- to-end solutions”. So Duke Power bought gas-pipeline giant PanEnergy, creating one the biggest energy suppliers in the U.S. Citing Duke’s contract to manage First Union’s energy needs over its entire 12-state network. Duke Chairman William Grigg says:

“Customers want companies to manage their whole energy requirements.”

‘Mergers are happening even in technology, historically an industry devoted to creating new products and services in-house. Cisco Systems, whose stock has been one of the great performers of the 1990s, last year spent a speck of it for a little-known company called Granite Systems Inc. Granite had no revenue, only a great idea: a promising switching technology, a crucial piece of the puzzle for networking companies. Like Duke, Cisco wanted to be better able to provide end-to-end solutions. And it wanted to do so fast.

‘For Cisco, with a $40 billion stock-market value, ‘to pay $200 million and potentially ride the next wave is a trivial insurance policy if it works,’ says Charlie Federman of Broadview Associates, a technology-oriented investment bank. “Time-to-market is absolutely critical, and you can’t be one or two months late.”..

‘The Clinton administration and the Republican Congress enacted the Telecommunications Act of 1996, opening up the long- distance phone business and the TV and radio markets, That helped spawn some of the biggest combinations ever, such as the $22 billion pending Nynex-Bell Atlantic merger and WorldCom’s $14 billion acquisition of MFS Communications. Westinghouse’s purchase of Infinity Broadcasting, combining Nos. 1 and 2 in the radio business, couldn’t have happened without the same legislation.’6

This scale of concentration of capital, now spreading far into the service sector, is simply a counterpart of the increased capital intensity of production — reflected in the figures for the most advanced service sectors.

Summary

Considered from a fundamental point of view three of the most striking features of the new world economy — globalisation, the explosive growth of the Asian economies, and the rise of the service economy — are merely different manifestations of the same process — the continuing sharp rise in the proportion of the economy devoted to investment, and the scale of production which results from this. In its outward form flexible production appears small and precise — involving ability to produce smaller runs of differentiated products and utilising physically smaller units of production as parts of large concentrations of capital. But this physical aspect is merely the outward form. The underlying reality which makes such ‘flexible production’ possible, its precondition, is levels of investment, and a scale of production, on an unprecedented level.

The implications for the U.K. are evident. The fact that Britain’s is a mature economy, which must rest on the most advanced spheres of manufacturing and on services, does not obviate its need for investment — or lessen the crippling effects of its historical inadequacy in this field. It merely gives this problem unprecedented acuteness.


Table 1

Table 2

Table 3

Notes

1. An earlier analysis of part of this material was given in ‘Behind the Threat of a Global Credit Crunch’, May 1991. This article both updates these international trends and considers the situation within the service sector of the advanced economies.

2. All historical figures, unless otherwise stated, are from One Hundred Years of Economic Statistics, Economisy publications, London 1989. Where more recent data is available from the OECD this has been used.

3. This process of cornputerisation of transportation has affected no simply obvious areas, such as civil aviation, but also lies behind the revival of the U.S. railway system. For an excellent analysis of this see Barnaby Feder, ‘What drives U.S. rail rebirth,’ International Herald Tribune 2 November 1996.

4. The only exception to this is the hotel and restaurant sector in Sweden, the capital intensity of which is above that of the Swedish economy as a whole.

5. Michael Mandel, Christopher Farrell, Catherine Yank, ‘Land of the Giants,’ Business Week 11 September 1995.

6. Steven Lipin, ‘Corporations Dreams Converge on One Idea: Its ‘lime to Do a Deal.’ Wall Street Journal 26 February 1997.