Inside Job

by Charles Ferguson

  The industries displaying this pattern in the 1970s and 1980s included cars, steel, telecommunications, mainframe computers, minicomputers, photocopiers, cameras and film, semiconductors, and consumer electronics. Together they formed the core of the American economy. They accounted for a major fraction of GNP, and they were among the wealthiest, most powerful industries in the US and in the world. They dominated US and often world markets, and were either regulated monopolies, oligopolies, or industries dominated by a single firm whose competitors lived in its shadow.

  In the car manufacturing industry, the Big Three (GM, Ford, Chrysler) dominated the US market and held roughly half the total global market. An oligopoly of a half dozen integrated steel companies, led by U.S. Steel, similarly dominated the domestic steel market. IBM held about two-thirds of the total global computer market, with smaller mainframe producers (the so-called “Seven Dwarfs”) and a half dozen minicomputer producers holding most of the rest. AT&T was a regulated monopoly that controlled over 90 percent of all US telephone and data services. Kodak dominated the film and camera industries; Xerox held a patent monopoly on photocopying for many years.

  The growing inefficiencies of these industries also affected their suppliers and customers. The stagnation of the American car industry contributed significantly to the decline of car parts suppliers and of the machine tool industry. By the late 1980s, Japan had definitively surpassed the US not only in the car industry but also in machine tools and robotics, as well as in their advanced use in a variety of manufacturing sectors. Similarly, Japanese excellence in producing commodity semiconductors and liquid crystal displays pulled along its semiconductor capital equipment industry.

  America’s largest industries had always wielded political influence, but for the first quarter century of the postwar period they did not wield it very aggressively, because they did not need to. They were naturally successful and profitable, with an almost leisurely dominance of both their domestic and international markets. Because their industries were mature, entry into their markets by small start-ups was for the most part impossible due to scale, capital requirements, and systems effects. In some cases, such as telecommunications, the media, and parts of financial services, new competition was legally limited or even prohibited. In a few cases (AT&T, IBM), antitrust actions were undertaken to limit the incumbents’ power. But for the most part American industry and the US government left each other to their own devices for the three decades following the Second World War.

  Over time, however, oligopoly and lack of competition led to complacency, which in turn led to inefficiency. By the 1980s, these inefficiencies were so severe that the productivity and product price-performance ratio delivered by the dominant firms in major US industries came to lag best practice by enormous margins—factors of two or more in productivity for traditional manufacturing industries, and up to an order of magnitude in the price-performance ratio of high-technology products such as computers.

  One of the most striking demonstrations of this occurred in Fremont, California. General Motors opened an assembly plant there in 1962 and then closed it as unprofitable in 1982, in part because the UAW-unionized workforce was regarded as unmanageable. By this time GM’s inefficiency was obvious, and it was facing intense competition from the Japanese. Under enormous political pressure from the US government, in 1984 Toyota agreed to form a joint venture with GM and to reopen the Fremont plant under Toyota management. The unstated but clear intent was to force Toyota to save GM from itself by teaching GM how to use Toyota’s “just-in-time” or “lean” production system. The result was a stunning indictment of GM. Using the same unionized workforce that GM had written off as hopeless, Toyota rapidly doubled productivity and sharply increased the quality of the cars that Fremont produced. But despite Toyota-organized tours of the plant for GM managers and videotaping of plant activities, the rest of GM learned very, very slowly.

  This was not an isolated situation. Careful studies conducted by MIT and Harvard in the 1980s and 1990s demonstrated that Japanese car companies were approximately twice as productive as their American (and some European) competitors in both design and manufacturing.2 Similar results were found when American integrated steel firms were compared with the Japanese industry and American start-up “minimills”. Even stronger results were found when comparing American to Japanese manufacturers in their use of robots and computerized flexible manufacturing systems (FMSs).3

  By the early 1990s, an even more remarkable situation held within the US computer industry. The price-performance ratios of microprocessor-based personal computers, workstations, and servers were twenty to fifty times superior to those of the mainframe computers and minicomputers that constituted the core business of IBM, the Seven Dwarfs, and most of the minicomputer industry. But in the case of the computer industry, the vastly superior challengers were predominantly American. The US venture capital industry and Silicon Valley are superb at creating new start-ups, and entry costs for companies based on new information technologies are generally relatively low. In those cases, the system largely self-corrected through domestic start-up entry. IBM deteriorated and most of the others went out of business. But in their place we got Intel, Microsoft, Compaq, Dell, and Apple. Alone among the earlier generation of firms, IBM was able to reform itself, after falling into a deep crisis in the early 1990s.

  But IBM was an exception; most of America’s declining giants failed to reform themselves. And in more mature sectors such as cars, steel, machine tools, photographic film, and photocopiers, start-up entry was and is impractical. To create a new competitor would require a gigantic, lengthy commitment. And the financial and industrial system, unlike those of Japan, South Korea, and China, is not good at creating new companies in mature industries that require large initial capital investments.

  In contrast, the Japanese (and later, South Korean and Chinese) did finance new entry into these industries. This was because the Japanese business sector was dominated by six diversified, vertically integrated financial-industrial complexes (keiretsu) that could create new companies even in mature industries. Japanese industry also engaged in large-scale technology licensing, copying, and intellectual property theft, aided by Japanese industrial policy. South Korea had a similar system (based on the chaebol). In China the central government, the People’s Liberation Army, provincial governments, and state-owned enterprises are now playing a similar role in technology extraction, financing of new domestic entry, and protection of the domestic market from uncontrolled foreign competition.

  The comparative ability of different national economic systems to generate new competition in large, mature industries is a subject that the economics discipline has mostly ignored. But the inability of the system to create major new competitors in mature industries is extremely important, because it means that the US faces a very limited set of options when large companies and concentrated industries go into decline. If start-up entry is feasible, as in most IT and Internet markets, American industry renews itself and remains healthy. But if start-up entry is not feasible, then there are only three possibilities. They are:

  • The US government acts to restore competition and/or reform corporate governance; for example, through antitrust action that breaks up the largest firms.

  • Foreign competitors take over, with some resultant loss of US economic welfare.

  • If no foreign competition appears, the US industry goes into uncontested decline, imposing the costs of its inefficiency on the American economy and population.

  The result has usually been some combination of the second and third options. Since the 1970s, in case after case—GM, Chrysler, most mainframe and minicomputer companies, major steel companies, nearly the entire consumer electronics industry—the failure to adjust has eventually led to wrenching crises, downsizings, bankruptcies, or acquisitions at fire-sale prices. Whether the challengers were foreign or domestic, the incumbents generally resisted change as long as they could, often t
hrough political activities, and consequently suffered even more severely when reality could no longer be denied. In many cases, including cars, steel, and telecommunications, incumbents were able to retard both competition and reform sufficiently that they imposed major costs on the American economy. And now, to those costs we must add the impressive damage caused by powerful predatory industries—especially financial services.

  Indeed, seen in the context of broader industrial decline, the financial services industry is not entirely exceptional. While much of the damage it caused was rationally, amorally predatory, some of it came from the same kind of managerial decadence that ran GM and Chrysler into the ground. Jimmy Cayne, Stan O’Neal, Chuck Prince, Richard Fuld—these were people way above their rightful pay grade, kept there by complacent boards of directors, just the way things worked at GM, Chrysler, U.S. Steel, Kodak, and IBM before 1993. The principal difference was that finance can be really dangerous. In contrast to the car industry, people in finance were able not only to loot their companies but also to bring the global financial system to its knees.

  The rise of China, India, and other Asian nations had another effect on the calculation of industrial executives, of course. It provided a gigantic new pool of extremely low-cost labour to their multinational firms. This meant that even a very efficiently run company (in fact, perhaps especially a well-run company) no longer needed, or even wanted, high-cost local workers for many low-skill jobs, ranging from manual labour in manufacturing to call centre personnel used in routine customer service. Outsourcing and offshoring were much more effective.

  Such changes mean that a nation can only remain economically healthy, and provide high-wage employment, if it radically improves the education and skills of its population, as well as its attractiveness as a location for high-technology activities. In fact, the reverse has occurred. As a result, manufacturing has all but disappeared from the US as well as the UK and similar economies; it now accounts for 12 percent of GDP in America. High-skill custom manufacturing (such as for machine tools) is dominated by Japan and Germany, while labour-intensive mass manufacturing is dominated by China, Vietnam, Bangladesh, and other low-wage nations. This has rendered an enormous number of workers all but unemployable, except in minimum-wage service occupations.

  But how and why was all this permitted to occur? It’s complicated, of course. But a very big part of the answer is that an effective response to internal industrial decline and foreign challengers required major changes in government as well as industry. It required major improvements in the educational system, aggressive pressure to force incompetent industries to reform, deployment of advanced broadband infrastructure, and a variety of regulatory changes.

  But those measures had no focused, powerful, well-financed interest group to lobby for them. There is no wealthy, powerful industry that has an urgent, immediate need to improve the education and skill levels of the bottom half of the American population. In contrast, there were many other things that powerful, well-financed groups did want, and started to lobby for. When faced with internal decline and global competition, the executives in charge of large, concentrated industries decided to start using money to get what they wanted. But only what they wanted, individually—not what the country as a whole needed. Indeed, what was good for their company’s profits was quite often bad for the nation. If the CEO and senior management were lazy, outdated, and incompetent, then they wanted protection from antitrust policy, proper corporate governance, and competition. If the company and its industry were run by competent but predatory management, then additional lobbying goals might include evisceration of regulatory oversight and white-collar law enforcement.

  And once they started down this path, executives in incompetent companies discovered that corruption was a brilliantly easy, effective way to forestall, or at least delay, their personal day of reckoning. Later, their highly predatory friends in financial services realized that the same techniques would enable them to rape the entire country, even the entire world. And the rest of us have been paying for it ever since.

  Economic Decline and the Rise of Money-Based Politics

  LET’S BEGIN WITH a case study: broadband infrastructure.

  As noted above, the US has fallen far behind other nations in broadband deployment. Broadband service in much of Asia is now vastly superior to US services in speed, cost, and universality; the same is true for parts of Europe, as well. To cite just one example among many, as of early 2012, 60-megabit per second Internet access was available in Taiwan for $30 per month, and by the time this book is published in mid-2012, 100-megabit per second service will be available for the same price.4 Japan, South Korea, Singapore, and even portions of mainland China now have far better broadband service than most of the US. America, home of Silicon Valley and inventor of the Internet, does not have universal broadband access, for either landlines or Wi-Fi, and its services are slow, unreliable, and expensive. This situation has now existed for over a decade, and the lag relative to Asia and Scandinavia is if anything worsening. Why?

  The reason is that both the traditional telecommunications and cable TV industries are tight, powerful oligopolies deeply threatened by high-speed Internet services. They view as particularly dangerous a nationwide infrastructure of universal high-speed Internet service combining both wireline and Wi-Fi access. This would sharply reduce the cost of data services; it would also enable universal, inexpensive Internet telephony and streaming Internet video that would render traditional telephone service, cable TV, and broadcast television completely obsolete. In the case of AT&T and Verizon, this would destroy the majority of their current revenues. In the case of the cable TV companies, advanced Internet infrastructure would also threaten them by allowing new competition in video content production and distribution.

  While there exists some real competition between AT&T, Verizon, the cable industry, and smaller competitors such as Sprint and T-Mobile, the competition is very limited. After the breakup of the AT&T monopoly in the 1980s, there were about a dozen major telecommunications companies in the US. There are now two; instead of competing with each other, they merged. They are still trying to consolidate further. The American phone company AT&T recently tried to acquire T-Mobile; the acquisition was blocked by the US Justice Department, the one and only time in the last decade that the department has halted the industry’s consolidation, which is still continuing. In late 2011 Verizon signed a major deal with America’s three largest cable TV companies, allowing them to cross-market each other’s services.5

  Despite very rapid progress (50 to 100 percent per year) in underlying digital technologies (routers, fibre-optic cable, software, digital wireless systems), the industry exhibits very low rates of improvement in its price-performance ratios. The US now lags behind Scandinavia, Japan, and South Korea by a factor of ten or more.

  The reason is money and politics. Lobbying is this industry’s real core competence. It spends more on lobbying, political contributions, and other political activities than it does on R&D. For example, the incumbents have successfully lobbied for state laws prohibiting municipalities from constructing their own fibre-optic networks, and they are probably the largest industrial users of antitrust “consulting” from academic economists.

  A decade ago, my last project while a senior fellow at the Brookings Institution in Washington, DC, was to write a book about this issue. As a condition of publishing the book, Brookings censored my manuscript in exactly one place: the passage in which I had named the academic economists who had consulted for the telecommunications incumbents—including Brookings’s own Robert Crandall, as well as Laura Tyson, Peter Temin, Daniel Rubinfeld, Rich Gilbert, Jerry Hausman, Carl Shapiro, and the Law and Economics Consulting Group.

  The industry’s political connections are superb. Laura Tyson isn’t just on the board of Morgan Stanley; she’s on the board of AT&T, too. In May 2011 Meredith Baker resigned as one of the five members of the Federal Communications Commission to b
ecome the chief lobbyist for the media conglomerate NBC-Universal, four months after voting to approve its merger with Comcast. Verizon’s board includes a former chief accountant of the SEC, a former secretary of transportation, and a former Treasury secretary. And Bill Daley, who replaced Rahm Emanuel as chief of staff in the Obama administration from 2011 to 2012, was formerly the president of SBC, one of the regional phone companies acquired by AT&T. The political situation is further worsened by the fact that the industry’s trade union, the Communications Workers of America, has consistently sided with the incumbents in opposing antitrust actions and other measures to improve competition and technical progress.

  As a result, the total cost of using Internet services, smartphones, tablets, and personal computers in the US is dominated not by hardware or software costs, but by the high cost of data services. The economic consequences of this situation are enormous. In economic policy debates, nearly all discussion of “infrastructure” concentrates on modernizing highways, airports, bridges, sewage systems, electric power, and the like. Those things are important too. But future economic welfare depends heavily on competitive broadband infrastructure. Education and Internet technology are the two principal drivers of productivity growth in advanced economies. Improved broadband services could also play a major role in reducing greenhouse emissions and dependence on fossil fuels through telecommuting, videoconferencing, and intelligent energy management systems. Moreover, universal broadband deployment would be an enormous physical construction project, an ideal stimulus for the economy in its weakened state. And finally, competitive broadband services are important to both the quality and the affordability of distance (online) education.