Stiff competition drives economies into high gear

In the 1970s and 1980s, when the Japanese economy was riding high, most commentators focused their attention on companies such as Toyota, Honda and Sony. These latecomers to the world market were running rings round their Western rivals, and there was much discussion of "lean production" and the other techniques that appeared to underpin their success.

Yet another side to the Japanese miracle was largely ignored - the chronic inefficiency of most of its non-manufacturing industries; retailing and construction were two notorious examples. Because these lagging sectors accounted for a much larger proportion of the economy than the few world-beaters, overall productivity was kept far below US levels. After the collapse of the Japanese bubble in the early 1990s, and the economic malaise that has persisted ever since, this weakness in the Japanese system is now more widely recognised.

What explains the dual nature of the Japanese economy? According to William Lewis, a McKinsey management consultant, the answer is simple: competition.

In the motor industry, six or seven firms had to fight for custom in a large competitive domestic market. In retailing, by contrast, "a combination of misguided zoning laws, taxes and subsidies have distorted competition and allowed the smallest, most inefficient retailers still to account for slightly over half of all retail employment". Whereas productivity in Japan's car industry exceeds that of the US, productivity in retailing is 44 per cent of the US level.

The importance of competition is the theme of this book, which is based on a series of industry-level productivity studies carried out by the McKinsey Global Institute (and published) over the past decade. Besides Japan, they cover 12 other countries. The value of these studies lay in the detailed identification of the various obstacles that were responsible for poor productivity in specific industries. In UK food retailing, for example, the consultants showed how planning restrictions, by holding back the construction of big stores, allowed large supermarket chains to charge higher prices than would have been possible in a fully competitive market.

Retailing figured strongly in the McKinsey studies, and for a good reason.

This sector plays a vital role in the evolution of a high-productivity economy. As Lewis remarks: "Retailers are the only businesses in the consumer goods chain physically and continuously in contact with consumers - they know exactly what consumers buy on a daily basis."

In India, where modern supermarkets account for only 2 per cent of the food retailing market, McKinsey's strongest recommendation to the Government was to allow unrestricted foreign investment in retailing. This was rejected, presumably because it would have upset too many vested interests. In Korea, the Government geared its industrial policy too narrowly to the manufacturing sector, often fostering "national champions" to the detriment of retailing and other service sectors.

The link between competition and productivity is not a new discovery, and Lewis sometimes claims too much for the originality of the McKinsey studies. It is hardly fair to say that the so-called Washington Consensus - a widely accepted set of principles aimed at improving economic management in developing countries - "profoundly underestimated the importance of a level playing field for market competition". On the contrary, most development economists (including the authors of the consensus) have stressed the need for openness to trade and inward investment and for strong domestic competition policies. Institutions such as the World Bank and the International Monetary Fund have put a great deal of weight on opening markets to new entrants, and countries that have gone down this path, notably China and India, have had considerable success in raising the living standards of their citizens.

Lewis also gives too little weight to factors other than competition that hold back productivity. He may be right to argue that economists have tended to overestimate the importance of formal education as a contributor to economic growth, at least in developing countries. He cites successful Brazilian industries to support his view that an ill-educated workforce is not a constraint on achieving high levels of efficiency. "The primary means through which workers attain the skills to perform at the economic frontier," he writes, "is through on-the-job training."

On the other hand, there is little doubt that in several countries, economic performance has been damaged by failings in corporate governance.

This is true of Korea's chaebol, the conglomerates that have dominated its industry for much of the postwar period. With their close ties to the Government, easy access to bank finance and limited accountability to shareholders, these groups were allowed to waste large amounts of money in unproductive investments. One consequence of the 1997-98 Asian financial crisis was to set in train necessary improvements in Korea's corporate governance arrangements.

In his eagerness to ram home a simple theme, Lewis risks oversimplifying some complicated stories. For example, he argues that Korea's car industry would have performed better if domestic companies such as Hyundai had been forced to compete from the start with Toyota and the other international leaders. Yet Japan, now the acknowledged leader in car industry productivity, also kept out foreign investment in the first two decades after the war. There was vigorous internal competition, but there were also barriers against inward investment. It is open to question whether the industry would have developed in the way that it did if Ford and General Motors, then the productivity leaders, had been allowed free entry into Japan in the 1950s and 1960s.

Lewis' aim is to provide an overview of the productivity issue for the non-specialist, and the use of numerous examples from the countries that the McKinsey team studied makes for a readable and often illuminating book.

Nevertheless, it would have benefited from at least a sidelong glance at other productivity studies that have come out of academia in recent years, and from bodies such as the World Bank and the Organisation for Economic Cooperation and Development. There are almost no references other than to the McKinsey Global Institute reports, and the list of recommended reading is short and somewhat eccentric.

Despite these weaknesses, the book's central argument is correct and important, and it has the great merit of steering attention away from the manufacturing sector towards services. Manufacturing now accounts for less than 20 per cent of the labour force in most industrial countries, and economic growth depends increasingly on raising productivity in services.

Measuring the productivity of the services sector is notoriously difficult; it calls for economic analysis of the sort carried out by British economists such as Mary O'Mahony at the National Institute of Economic and Social Research, and for detailed case studies. The latter are what consultants such as McKinsey are good at, and Lewis has provided a useful distillation of what he and his team discovered.

Sir Geoffrey Owen is senior fellow, Institute of Management, London School of Economics.