Private Equity and Consulting as Dengism with American Characteristics
Tyler Cowen and Ben Southwood have a great piece asking: “Is the rate of scientific progress slowing down?” To any student of headlines, the answer is “No,” but this essay is the exception that proves the rule: progress is slowing down. Probably.
But the meat of the essay is the “probably” part, because as it turns out, progress is extremely hard to measure.
The standard way to measure productivity growth is the Solow Residual, i.e.: once you account for changes in the labor supply and the quantity of investment, how much unexplained GDP growth is left? This turns out to be less straightforward than you’d hope, both because of what’s not measured (leisure time, quality time, and the value-add of home cooking are not incorporated into GDP) and because some advances in productivity show up as a change in inputs, rather than outputs. If a cheap new medicine reduces the number of sick days, that increases GDP, but the increase shows up as an increase in labor supply. It’s a productivity improvement that doesn’t affect measured productivity.
But the really interesting question in the essay is about the role of consultants: they point out that when a consultant shows up and tells a company how to get more efficient, it’s partly an increase in labor supply (the consultant), and also it’s an example of catch-up growth rather than a fundamental advance.
That last point is interesting. The usual narrative about US economic growth compared to East Asian exporters is that they were just copying advances that worked in the US, while we were advancing the state of the art. Deng Xiaoping didn’t need China to build new and innovative companies; he just needed China to be a good place for rich-world companies to offshore the most labor-intensive parts of the supply chain.
But it’s hard to deny that management consultants have gotten more common in the US since the early 1980s, and that private equity has gotten much bigger, too. And both of those professions involve taking templates that have been proven in one company and applying them, as carefully as possible, to another. Just like poor countries with ports, corporate America in the 70s had some low-hanging fruit:
- Management laziness: when marginal tax rates were high, it made sense to compensate executives with perks and status, rather than cash. (The three-martini lunch was always a tax arb: when you pay a 90% marginal tax rate but business lunches are fully-deductible, lunch meetings are a Happy Hour where the good stuff is discounted by 90%.)
- Cozy labor relations: when the US wasn’t especially exposed to global export competition, it made some sense for companies to have expensive workers in exchange for steady production. But, just as Deng and his successors broke up the agricultural collectives and work units, these mini-welfare-states centered around Fortune 500 companies weren’t nimble enough to compete globally. The labor deals big companies struck when they were racing to grow didn’t make much sense when manufacturing growth moved across the Pacific.
- Sunk costs in energy and manufacturing: for a long time, oil was a cheap and effectively unlimited source of energy for America (and only America! Nobody else had cheap oil and a huge industrial base). American workers were expensive, but close by; in any given year, it’s easier to accept a lower profit margin and certainty than to admit that you should have shut down a factory or oil power plant a decade ago. New managers are just as egotistical as old ones, but when you’re the new manager, ego compels you to shake things up rather than keep things steady.
Maybe the difference between MITI and McKinsey is the revenue model. Certainly the recruiting models were similar: both organizations set a very high bar for entry-level employees and implicitly promised a good corporate job at the end. Japan called it amakudari, or “descent from heaven,” when someone who had spent a few decades regulating an industry would spend the last five or ten years of their career as a senior executive at one of the same companies. I’m not sure what they call it at McKinsey, but the firm’s reputation as a CEO factory is well-deserved.
The private equity industry is too decentralized to map directly to industrial policy, but the parallels are striking: PE firms have a lot of capital, both equity and debt; their mandate is to acquire companies that are run inefficiently and streamline them for later sale. Usually step one is to fire lots of people, and that gets attention. But steps 2-N involve expanding whatever it is that the company is unusually good at. While countries with industrial policy have “policy banks” that make low-cost loans to strategically important industries, PE firms have another lever that gives them the same flexibility: when a company gets close to default, they can restructure rather than liquidate.
And while PE firms all compete with each other, they’re mostly stamped from the same mold. They hire out of the same set of business schools, underwrite through the same set of banks. If you tried to convince a policymaker from an East Asian country that America didn’t have an industrial policy, designed at Harvard/Stanford/Yale and implemented at JPM/Goldman/MS, you’d have a hard time.
This presents a novel possibility: rich countries could get stuck in a high-class version of the middle-income trap. How much of America’s productivity growth is new innovations, and how much is stuff that GE figured out in 1975 that didn’t make it to middle-market manufacturers until 1995? How much is better logistics and inventory management, and how much is the average retailer learning how Target and Walmart handle logistics and inventory management?
In one sense, this is productivity growth like any other; investing in human capital allows us to get more out of the same time and labor input, or, equivalently, the same output from less labor and more leisure. But it presents the worrisome possibility that productivity growth increasingly measures the extent to which American companies represent a managerial monoculture.
If you’re a pessimist, this is the best outcome: somebody has figured out the ideal way to run a company or a supply chain, and their practices slowly spread until they’re ubiquitous. But if you’re an optimist — if you think Keynes was right about the coming fifteen-hour workweek — it’s terrible. Instead of getting better and better, more of us are getting merely good-enough.