By Naji P Makarem, on 29 October 2015
Mainstream economics attributes economic performance to factor endowments; the characteristics of a national or regional economy expected to impact future output growth and wages. These can be understood as Lego pieces of various colours and shapes needed to produce lucrative products and services. According to this view of the world, the Lego set endowed to cities determines economic performance: Yellow blocks of human capital might be limited to lower educated two-pronged blocks in one region, and higher-educated 5-pronged blocks in another (usually proxied as educational attainment), can explain past or determine future growth and incomes. Factor endowments typically used in growth regressions include population size, the cost of housing, ethnic composition, the industrial structure (often proxied by the share of manufacturing and FIRE industries – Finance, Insurance & Real-estate), innovation (often proxied by patents per capita) and of course educational attainment. Carefully designed econometric models can explain and predict economic outcomes fairly well, given initial factor endowments. They only do so however ‘on average’, evident by persistently high residuals and numerous outliers.
There are two problems with this approach: First, regions and countries can change the composition of their Lego sets through unpredictable governance mechanisms that create characteristics which the market fails to create, such as by investing in education, infrastructure, changing migration policies and zoning laws. Second, there are much smaller Lego pieces excluded from the analysis, in the form of people, ideas, assets, experience, organisations and capabilities, which can be combined and recombined in a multitude of different ways. The industrial structure of two regions with seemingly comparable initial factor endowments at a given time can evolve and branch out into very different activities, despite initially comparable Lego sets. Their systems of governance can focus on different issues and tackle challenges very differently (as institutional economists and political scientists would argue), and they can combine and recombine smaller Lego pieces in very different ways. Both of these important dynamics are exogenous to econometric models, thus persistently large residuals and outliers in growth regressions.
Our in-depth historical case studies of the San Francisco and Los Angeles regions expose the limitations of the growth accounting and other mainstream economic approaches to explaining economic development. We found that given two seemingly very similar Lego sets back in 1970, and you might be surprised by the incredible similarity on so many fronts, the two regions developed their so-called factor endowments and combined their people, ideas, assets organizations and capabilities very differently: The ability of their regional governance systems to respond to major regional challenges and opportunities, through cross-jurisdictional coordination, diverged significantly around 1950; the perceptions and world-views of their business and political leadership vis-à-vis their regional economy and its role in a globalizing world with serious environmental challenges differed starkly since at least as far back as the 1980s; differences in their corporate practices with regards to attitudes towards failure, entrepreneurship, spin-offs and out-sourcing were starkly different; their civil movements organized and responded very differently to social and environmental concerns throughout the 1900s; and their high-end corporate social structures diverged significantly between 1980 and 2010.
The Bay Area’s social, relational and political contexts created fertile-ground, as our co-author Taner Osman would put it, for break-through technological innovations, start-ups, spin-offs and initiatives by robust actors to flourish. We show that even though these were abundantly planted in both regions, they had greater regional spillovers in the Bay Area, giving rise to an eco-system of world-leading firms and clusters. In LA however comparable events had negligent spillovers beyond the boundaries of large and highly successful vertically-integrated corporations, or the confines of the Hollywood entertainment complex. The culture and relational structure of the San Francisco region, evident in its long civic and political history and in its recent high-end corporate social structure, allowed the region to develop its Lego pieces and to combine and re-combine its smaller Lego blocks in response to economic, technological and environmental challenges and opportunities. Through this recombinatory process the industrial structure developed new innovative firms, products and services in response to the changing economic reality, carving new lucrative industrial pathways for innovators, investors and entrepreneurs. It is through this process that the industrial structure of the Bay Area evolved, branching out into new unchartered and highly lucrative industrial terrains, producing tremendous high-waged employment in the region. As a result, the Bay Area ‘won’ the New Economy, whereas the LA region missed it, for now. This has had important implications to social mobility, personal incomes and public expenditures in the two regions.
Back in 1970 a person with a job in LA would have earned a very similar wage to his or her comparable counterpart in the Bay Area (same level of education, recent immigrants or not, and in the same industry and occupation); today there is a staggering difference in their wages across all these comparable groups, with the average person in LA earning 30% less than in the Bay Area. And this was achieved with comparable levels of population growth, openness to immigration and levels of inequality. The Bay Area produced its Lego blocks and combined and recombined its smaller blocks better in response to the challenges and opportunities brought about by technological change, globalization and the emergent New Economy.
How does all this apply to developing countries and cities? I propose the following transposition of ideas and insights from our study of the Bay Area and Los Angeles: Business-civic leadership can play an important role in both shaping the perceptions and world views of the broader business community (employees, entrepreneurs and investors), and in mobilizing public and private resources in response to economic challenges and opportunities. Their world views can either be narrow and conservative in nature, focusing on cutting costs by weakening labour rights, reducing taxes and diminishing social and environmental regulations, fearfully perceiving technological change and globalization as a threat, or they can be progressive, perceiving technological change, social and environmental regulation and globalization as an opportunity. Moreover, their regional perspectives can either be narrow in nature, focusing their attention on aspects of their cities that directly impact their business operations, such as access to land, services, connective infrastructure and red-tape, all very important albeit partial aspects of a functional business climate, or broader in nature, incorporating the entire urban system in which they operate, recognizing and valuing the potential gains from a functional agglomeration.
A functional agglomeration generates agglomeration economies which are the advantages firms and people gain from propinquity. These are namely the advantages of sharing infrastructure costs, the convenience and efficiency of geographically proximate suppliers and customers, the matching of jobs with specific skills and therefore the probability of finding the right job, and the learning from social interaction and people moving between firms. That is the economic rationale behind current high rates of urbanization – cities essentially reduce the transactions costs of all these activities. Business communities with strong and broad regional identities recognize and value the whole breadth of agglomeration economies which the city offers them, and the potential for unlocking its full agglomeration potential.
Progressive business leaders are aware of their interdependence with the region, and therefore they have a broad perspective of the business climate, which includes secure tenancies and the cost of housing, the quality and accessibility of education, congestion and accessible public transport, access to quality healthcare, sanitation, education and social safety nets for all citizens. Together these determine the quality of human capital, people’s access to employment, the quality of social interaction and the propensity for entrepreneurship and innovation, all integral to a functional urban agglomeration. Business-civic leadership in the Bay Area, as reflected in reports by the Bay Area Council and the Association of Bay Area Governments amongst others, have been concerned with broader regional issues such as the cost of housing, the environment and public transit over the past few decades. Progressive business people understand that their community is highly interdependent with the functionality of their urban system, and they mobilize public and private resources in response to urban challenges, with the aim of unleashing the agglomeration economies which they and their children will benefit from.
Economics and society interact in important and meaningful ways. This offers hope to people in urban economies who might otherwise feel locked-in to a path-dependent low-road trajectory of high unemployment, low wages, poor governance and weak public finance. It also raises community and business leaders to a broader sphere of regional social responsibility. How they think, organize and lead in response to regional challenges and opportunities is important: Their world views, social relations, association and leadership can have a profound impact on regional governance and organizational cultures and practices. As Douglas North argues, “[t]he dominant beliefs, that is, of those political and economic entrepreneurs in a position to make policies, over time result in the accretion of an elaborate structure of institutions, both formal rules and informal norms, that together determine economic and political performance” (North, 2003-p. 6).
The broadening of world views that transcend narrow conservative self-interest has long been the subject of intense research in the fields of psychology and philosophy (Wilber, 1996). Our world views, cultures, organizations (Laloux, 2015) and political and economic systems co-evolve towards greater levels of complexity, interdependence, creativity, compassion and shared-knowledge, and are doing so at a faster rate than at any other time in human history. Business communities have the power and responsibility to facilitate our journey towards more inclusive, just, wealthy and sustainable societies.
Laloux, F. (2014). Reinventing Organizations: A Guide to Creating Organizations Inspired by the Next Stage of Human Consciousness. Nelson Parker.
North, D. C. (2003). Understanding the process of economic change. In Forum Series on the Role of Institutions in Promoting Economic Growth: Forum (Vol. 7).
Wilber, K. (2007). A brief history of everything. Shambhala Publications.