What Matters: December 2008
Today's Economic Gridlock Demands Innovation
By Kay Plantes PhD '79
A perfect storm of forces has gathered to lock the U.S. economy in a Gordian knot. Which policies might slice through it to get our economy back on track?
A global excess supply of investment funds found its way into U.S. mortgages, courtesy of financial innovations that bundled mortgages and, through insurance, made them into liquid, secure, and tradable assets. Two other factors—a low-interest environment and a U.S. Congress vested in expanding home ownership—joined to create the housing bubble.
Housing is like farming. When crop prices rise, farmers plant more. Thus, when home prices rose, contractors built more housing units—six million more housing units than new households formed. That overproduction became the needle that burst the bubble. Housing prices fell, borrowers defaulted, and prices and liquidity of mortgage assets fell, reducing banks' capital and confidence. Soon, banks decreased lending to each other or anyone else, and, because so much of our economy runs on credit and housing, our economy stalled.
We're now in a vicious cycle in which bad economic news follows bad news, and the Federal Reserve's favorite policy tool—lower interest rates—fails to yield its intended pump-up-the-economy result.
What can policy makers do?
To answer this question, we must understand commoditization, a process in which price determines who wins or loses because customers see competitors' offerings as essentially equivalent. Since all purchase decisions are based on value (i.e., perceived benefit minus cost), the lowest price signifies the highest value. Commoditization of financial products was a critical root cause of the recent financial sector meltdown.
As price becomes more important, companies may respond by becoming more efficient. In a drive for efficiency, industry consolidation and outsourcing can occur, which is what happened in the financial sector, driving earnings growth since the 1990s.
Financial institutions have one other earnings strategy for dealing with commodity pricing: they can make riskier lending decisions and increase their leverage—the ratio of loans to capital. Financial institutions did both in recent years. Regulators ignored the higher risk, resulting in the housing bubble.
Financial institutions aren't alone in facing commodity-like markets. Many U.S. industries beyond the financial sector have matured, creating a drive for efficiency. Because the lowest labor costs are located in Asia along with the fastest-growing consumer markets, more jobs in more industries will move or be created overseas, absent change.
While tax cuts and printing money may provide short-term stimulus, they won't increase real wages and stabilize housing. The right policies for the U.S. economy are those that help existing companies escape commoditization through innovation and, at the same time, increase start-ups of innovative businesses.
What would an innovation agenda for our nation look like? There are many viable options. Here's my list.
- Redirect federal government spending to rebuild our non-defense research enterprise, which fell precipitously under George W. Bush.
- Adopt a carbon tax and other policies that accelerate the greening of materials, productions, and products. Environmental innovation, including new agricultural approaches, is the low-hanging fruit for rejuvenating our industries.
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Fix health care. We pay a high financial and health penalty for our broken healthcare system. New policies must expand insurance, but also lead insurers and providers to compete on the basis of keeping healthy people healthy and offering the most cost-effective, high-quality care for chronic and acute conditions.
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Reinvent how we educate our most gifted and most needy youth by scaling up proven models. Major U.S. cities have four-year high school graduation rates in the 30th percentiles, and even our best public school districts consistently fail poor students. An innovative economy needs a stronger school system, especially in the sciences and math.
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Invest in infrastructure improvements. Our infrastructure is woefully behind that of other developed nations, which weakens our productivity.
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Create a more entrepreneurial culture. Require all high school and college students to take classes in the three Cs (commerce-economics, collaboration, and creativity-innovation), not just the three Rs. Silicon Valley's success proves the value of opening our immigration gates to international students and professors.
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Create a tax structure that encourages more investment and less consumption. A flat tax based on consumption, with adequate protection for the poor, would increase savings, creating investment funds that our country needs to fund private and public innovation.
- Create more forward-looking companies. Leadership's most important role is strategic—building hard-to-copy business models that bring unique benefits to target markets. Boards of directors should hold CEOs accountable for more durable long-term strategies.
We will not retain our economic strength without different federal policies, more forward-looking corporate leadership, and innovative educational approaches. Einstein had it right—doing the same thing, while expecting a different outcome, is the definition of idiocy.
What are your innovation agenda items for the nation's economic crisis? Share your ideas on the Discussion Network.
About the Author
Kay Plantes' book, Beyond Price: Differentiate Your Company in Ways that Really Matter (Greenleaf Book Group, 2008) provides leaders with a pragmatic, eight-step business-model innovation process to build winning market positions. After earning a PhD at MIT in 1979, she was an executive in a global medical products company and then started Plantes Company, which offers business strategy consulting.
What Matters is a guest opinion column written by a different MIT alumnus or alumna. The views expressed are entirely those of the author and do not necessarily represent the views of the Alumni Association or MIT. Interested in writing a column? Email whatmatters@mit.edu.
