Let's Get Something Straight!!

As you know, politicians are frequently willing to distort facts, and that is certainly the case with all the crap being spouted about Bain Capital.  Some of it is from ignorance (Perry) and some of it is plain deceit (Gingrich).


In any case, it is very, very important for you to know the facts, so here goes.  Every economy is constantly changing so the players have to change.  Some do it brilliantly, i.e., IBM, Dayton Hudson, while some do it slowly, Wal-Mart, Hewlett-Packard, and some fail completely, i.e. Kodak, Borders.


Some companies manage the change internally with existing managers.  IBM has done that brilliantly, first with outside managers, and then with carefully selected and promoted insiders.  But sometimes, the change management has to come from outside the company, and that is what companies like McKinsey, the Boston Consulting Group, Bain, et al. do.  Walter Bain decided it might be a good idea to buy into the company and then stay around to see the recommendations actually implemented.


And that is what Mitt Romney did to get extremely rich.  The idea of Creative Destruction is so important to understand that I included a number of examples in The Great Recession Conspiracy, and I am including that section of the book below.


While I am in complete agreement with the idea of change as important part of economic life, the question of who gets what is a separate question.  There is a concept in wide use called carry interest that is outrageously inappropriate, but is completely legal.  It is a section of the tax code that undoubtedly was created some special interests.  Carry interest is extremely complex and should be abolished.  And Mitt got a lot of his wealth from this tax dodge


So here is the economy really works.

New Industries: If the members of an economy are going to get richer (improve their lot) over time, then they must create more goods and services (GNP) with the same, or a lesser, amount of available resources.  That means there is a continuing need to experiment with finding new ways to do things.  Each successful new project means that it must dislodge an older way of doing things.  The economist, Joseph Schumpeter called this process, “Creative Destruction”, and that is a pretty good description, but a more accurate description might be “Creative Disruption”.  Airplane travel did not destroy travel by train, but it certainly disrupted it.  The Internet has not destroyed newspapers, but it has certainly have disrupted their business model.  So perhaps a better description might be “Creative Relocation”.

Creative Innovation: Here are three examples, one small and two large, of individuals finding a new way to do something better, and in the process, replacing an older method.

Encyclopaedia Britannica was a staple in American homes for 231 years.  The bound volumes were sold to families by door-to-door salespeople and the books cost about $1,250 a set.  In 1989, Britannica had a sales force numbering 2,300 and revenues of about $650 million.

In 1993, Microsoft approached Britannica about including the Encyclopedia in Microsoft’s Windows software.  Britannica turned them down flat, so Microsoft went to encyclopedia publisher Funk & Wagnalls and produced Encarta 99 Encyclopedia.  Encarta was given away free with every copy of Windows.

Today, Britannica has less than 400 employees and seems to be tip- toeing around bankruptcy.  Today, millions of families have access to an encyclopedia compared to a few thousand families in the past when Britannica volumes were the only game in town.  A greatly improved, less costly method of delivering information came into being and replaced an old, less efficient method.  Indeed, creative relocation at its best.

But there is more to the encyclopedia story.  In 2000, Jerry Wales and Larry Sanger had the idea for a FREE online encyclopedia.  They called it Wikipedia and it has been a rousing success. (Wiki for a collaborative effort and pedia as the obvious part.) It currently contains 2,756,219 distinct articles, all of which have been written by volunteers.  Wikipedia is now available in nineteen different languages besides English.  Wikipedia articles are continually update, something you can’t do with paper or plastic disk encyclopedias.  Just how successful has Wikipedia been?  In 2008, Wikipedia had 684 million visitors!  (And no trees were harmed in creating Wikipedia.)

Creative relocation usually replaces an old way of doing things with a newer, better method of doing the job.  And, as the encyclopedia story makes clear, it is an unending process.

The Swiss Watch Industry: Now let’s try a bigger example.  At the end of World War II, Swiss companies made about 80% of all the watches made in the world.  It was a very profitable and complacent business. But during World War II, the British government needed inexpensive, but accurate timing devices to use in aerial bombs.  You can understand the requirements; the timing devices had to be cheap since they would not be making a round trip and they had to be accurate because when the bombs exploded was critical to their successful use.

To do that job, the pin lever mechanism was developed.  It was inexpensive and accurate.

By 1950, U.S. Time Company was selling a watch with a pin lever mechanism.  By the 1960’s, one out of every three watches sold in the U.S. was a Timex, and the Swiss watch industry began a decline that lasted for decades.

However, traditional jewelry stores refused to handle Timex watches because they were seen as “cheap”.  Timex had to find other outlets for its products, and they did in a very big way.  Timex turned to mass merchandisers and other non-traditional outlets for watches.  By the mid 1970’s Timex watches were being sold in over a quarter million different outlets.

This is a clear example of a new technology replacing an old technology and Creative Relocation at its best.

But wait, there is more to the watch story.  In the 1970s’, some Japanese engineers were assigned the task of making the readout mechanisms in medical measuring instruments more legible in normal room lighting conditions.  Their work led directly to Light Emitting Diodes (LED) technology and the age of digital watches began.  Digital watches decimated the world watch industry.  Every watch manufacturer in the U.S., except one, went out of business.  Another example of Creative Relocation at work.

But there is even more to the world watch story.  By 1983, the Swiss share of the world watch market was less than 30%.  In a move born of desperation, the Swiss government forced the remaining two large Swiss watch makers to merge and bring in a new management as a condition for a government backed loan.

The new management re-defined what a watch is and decided that it was more of a fashion accessory than a time piece.  Thus, a whole new line of “fashion accessories” were designed, and the Swatch was born.  As you know, the Swatch has been a huge success.  The Swiss share of the world wide watch business is now around 60%.  So we have one more example of Creative Relocation at work and individuals inventing new processes to do a familiar job.

Be certain that there is pain and discomfort in this process of Creative Relocation just described.  People lost their jobs.  Investors lost their investments.  Governments lost tax revenues.  Companies went bankrupt or simply closed down.  There are real costs to Creative Relocation, but the idea is “No pain, no gain”.

Improved Productivity:  And one more story about Creative Relocation.  For hundreds of years, people bought books at book stores.  In 1995, a thirty-one year old man named Jeff Bezos incorporated a new company he called Amazon.com.  His purpose was to vastly improve in the business of selling books and do it online.  The success of Amazon.com has been huge.  In 2008, Amazon.com had total sales of $19,166 Billion, had 20,700 employees (all new jobs) and has averaged about 30% annual growth in the past three years alone.  It now serves 88 million customers.

By way of contrast, Barnes & Noble is the top selling book seller through 799 traditional book stores in fifty states.  In 2007, B & N had total sales of $5,411 Billion, had about 40,000 employees, and is currently teetering on the edge of bankruptcy.

To better understand the positive effects of Creative Relocation, consider this; an average employee at Amazon.com produces $912,000 in sales annually.  An employee at B & N produces about $130,000 annually.  Jeff Bezos has brought incredible efficiency to the book selling business and since his book “store” is open 24 hours a day, seven days a week, he has brought unprecedented convenience to all of his customers.  Joseph Schumpeter would surely be proud of Jeff Bezos.

But always remember that Creative Relocation has a down side.  If B & N goes bankrupt, there will be 799 stores standing empty and 40,000 people will have to find new jobs.  Yes, progress has a price.

In any event, you have now seen how the Expansion Phase of the Business Cycle creates new industries, improves productivity and creates new jobs.

AND THOSE ARE THE FACTS!!