comment breakthrough thoughts

The Productivity Riddle

Breakthrough Thoughts
Research finally links management skill to
macroeconomic growth.

by Glenn Hubbard

R
obert Lucas, a Nobel not in China or the Roman Empire,

Illustration by Lars Leetaru

laureate in economics, states brimming with technical
famously wrote that genius? Why did Hero’s contempo-
once one starts to raries use steam engines to wow
think about economic Roman tourists with magical toys,
growth, it is hard to instead of powering instruments of
think about anything production with them?
else. In other words, History proffers an intriguing
even slight increases in growth rates, answer. As a consequence of the
when accumulated over time, have Glorious Revolution of 1688 (when
an overwhelming impact on quality a group of nobles overthrew James
of life. Not just corporate profits, II and crowned William of Orange
but the livability and prosperity of as king), the British government
nations and regions depend on eco- committed itself to upholding pri-
nomic growth. Moreover, economic vate property rights, protecting
growth and the firm-level perfor- wealth, and eliminating arbitrary
mance that underlies it are not increases in taxes. These institu-
givens, but can be shaped. The most tional changes gave entrepreneurs
critical and overlooked factor is the the incentives they needed to make
quality of management. the most out of the technological
A peasant toiling on a farm in inventions of that time. Though
East Anglia in 1600 was not much China may have had a more sophis-
better off than his Druid ancestors. ticated economy then, it lacked the
But his descendants were. Eco- business institutions that would
nomic and social conditions began allow entrepreneurship to flourish.
to change dramatically when the In his article “The Good Life:
Industrial Revolution took hold How Managers Made the Modern
in England in 1750. But why did World” (Hermes, Winter 2004,
strategy + business issue 45

the Industrial Revolution begin www2.gsb.columbia.edu/hermes/

there and then, and not in 1650 winter2004/article_greenwald.cfm),
or even the year 50, when Hero Columbia Business School Profes-
of Alexandria developed a steam sor Bruce Greenwald puts the point
engine? And why in England and more crisply. The Industrial Revolu-
 comment breakthrough thoughts
tion, he writes, “appears to have both wireless and fixed, is also faster Glenn Hubbard
arisen largely from the application and more ubiquitous elsewhere. (rgh1@columbia.edu) is the dean and
Russell L. Carson Professor of Finance
of sustained management attention But if America’s greatest com- and Economics at Columbia Business
to everyday enterprise.” But econo- panies did not become more ef- School and a research associate of the
National Bureau of Economic Research.
mists and business analysts need fective simply by buying faster He was chairman of the Council of
to go further still and inquire why computers or networking their Economic Advisers under President
management matters. The reasons operations, what then is the answer George W. Bush from 2001 to 2003.

have powerful implications for to the productivity riddle? At first

business — and business education. glance, there is an obvious answer:
There were enough American com-
Productivity’s Hidden Effects panies in which leaders and man-
Let’s start with a “macro” perspec- agers knew how to integrate these
tive on one of the most interesting investments with new business
economies in the world today — models to raise their effectiveness. 2
that of the United States, where They also benefited from a distinc-
productivity is growing about a full tive economic context: The flexible
percentage point faster than it did a financial markets of the United
decade ago. This increase is the rea- States foster the celebrated resilience
son that, despite all contrary or neg- of its economy, in which entrepre-
ative economic indicators, corporate neurs can swiftly respond to external
performance and living standards shocks — from financial market
continue to improve in the U.S. It is downturns to disasters such as Hur-
important to recognize that this ricane Katrina — and to opportuni-
improvement is not the result of ties for innovation and expansion.
more labor or capital. It reflects the Individual entrepreneurs may
ability of American enterprise to succeed or fail, but when taken in
produce more output per unit of aggregate, this speedy and resilient
input each year than it did the year culture of entrepreneurship sup-
before. Moreover, the rate of pro- ports economic stability, if only
ductivity growth rose noticeably because those who succeed tend to
during the 1990s in the United learn from experience (and each
States and stayed high through the other). Twenty-five years ago, when
difficult early 2000s, even when a large firm had shortages or gluts
productivity growth in many other in inventory, it might have taken
major economies headed in the weeks to uncover the imbalance.
opposite direction. Companies responded to those
American productivity growth imbalances by buying or building
is often attributed to the effect of excessive stocks of inventory; then,
information technology. But those in downturns, they cut production
who chalk it all up to IT have spent much more sharply than would
too little time in Tokyo, Seoul, and have been needed had inventory
Berlin. Technology is more sophisti- knowledge been current. Today,
cated in many other countries than entrepreneurs and managers rou-
it is in the United States. Cell tinely apply information technology
phones and PDAs in Europe and to respond in real time.
Asia do things that American mo- Nowhere is this entrepreneurial
bile devices cannot; they pay for contribution to economic stability
goods and display far more informa- more evident than in financial ser-
tion. Broadband Internet access, vices. Deregulation, coupled with
comment breakthrough thoughts

innovative technologies, has fos- ences, collectively called “fixed ef- perceived as more beneficial.
tered the development of financial fects,” but merely attributed them If this theory is correct, then in
products, such as asset-backed secu- to variations in managerial quality a knowledge-intensive economy, the
rities and credit default swaps, that without exploring the effects of any firms with better practices for
make possible a much greater spread specific management practices on process techniques, goal setting,
of risk than was previously available. firm performance. It remained for performance evaluation, and hu-
Some observers have concluded business schools to identify the man resources management should
that this pace of productivity sources and examples of high- be found, by reasonably objective
growth is unsustainable. But con- quality management practices, and observers, to exhibit generally better
versation with many business lead- for consulting firms to conduct de performance. And indeed that cor-
ers suggests that there is still more facto “on-the-ground” experiments relation was found in recent re-
search by economists Nick Bloom

3
Those who attribute productivity of Stanford University and John
Van Reenen of the London School
growth to IT have spent too little of Economics. (Their 2006 paper,
“Measuring and Explaining Man-
time in Tokyo, Seoul, and Berlin. agement Practices Across Firms
and Countries,” is available at
room for productivity growth in implementing particular manage- http://cep.lse.ac.uk/textonly/people/
most companies. This is bolstered ment innovations. And it was only a bloom/papers/BloomVanReenen2.
by a body of recent economic small group of economic historians, pdf.)
research that finds large and persis- such as Alfred D. Chandler Jr. and Professors Bloom and Van
tent differences in productivity per- David Landes, who stressed profes- Reenen studied management prac-
formance across firms — within sional management as a key factor tices at more than 700 manufac-
and across countries. Consistent in the rise of U.S. industry, relative turing firms in the United States,
application of better management to that in France or the United the United Kingdom, France, and
thinking and practices will have Kingdom, in the early 20th century. Germany. They adopted a well-
important effects on business and Through the lens of economics, established survey of management
the economy. management is, at heart, a choice practice, in which they asked such
made by each firm. To alter that questions as, “How do you track
Choice and Competitiveness choice is costly; when a firm production performance?” and “Do
To truly understand the produc- changes management, it requires senior managers get rewards for
tivity riddle, we need to take a additional personnel, time, atten- bringing in and keeping talented
“micro” perspective and look, with tion, and other resources. The deci- people in the company?” Using the
an economic eye, at the behavior of sion makers who lead the firm must responses to their questions and
individual firms. We need to ask trade off these costs against the ben- publicly available data, they scored
why some gain in productivity con- efits they expect. That is why, if all the quality of management prac-
sistently while others do not. For other factors are equal, the new tices, grouped into four categories,
many years, economists have tried management practices most likely for each firm. Operations manage-
to attribute differences among to be adopted are those that promise ment practices included process
companies’ performance to workers’ the greatest cost reduction. In improvement, lean manufacturing
skills, information technology in- capital-intensive companies, these practices, documentation (the ways
vestment, or even the quality of tend to be those practices that most in which production problems were
available capital. But even after con- improve the efficiency of plant and exposed and fixed), and the use of
strategy + business issue 45

trolling for these factors, important equipment. In companies where dialogue among production teams.
and unexplained differences in pro- highly skilled workers are integral Targets as practices centered on the
ductivity performance remain. to a firm’s financial performance, choice of financial and nonfinancial
As far back as the early 1960s, practices related to incentives and goals; the survey asked about targets’
economists identified these differ- human capital will probably be reasonableness, transparency, and
 comment breakthrough thoughts
interconnection. Monitoring prac- business environment. When times that face competition and stay in
tices emphasized individual perfor- get tough — when the setting gets the game gain the ability to make
mance tracking and follow-up. more competitive — firms with bad better choices. And companies that
Finally, incentives as practices ad- management earn comparatively make better choices about manage-
dressed compensation, links be- lower profits and grow more slowly, ment practices, as they expand their
tween promotion and individual or even exit the scene. Under the scale and scope, are more likely
performance, and responses to poor same circumstances, the compara- to face the constraints of greater
individual performance. tive value of good general manage- competitiveness. In the end, in fac-
The study found that higher ment rises. ing either factor, the flexibility and
management scores were indeed Thus, the superior estimated quality of management matters.
associated with higher productivity, productivity performance of Ameri- Interestingly, in the work by
return on equity, and market capi- can firms relative to their non-U.S. Professors Bloom and Van Reenen,
talization relative to book value. The counterparts may be traced in these relationships hold even if one
researchers also found that low no small part to the disciplinary controls for CEO compensation (as 4
measures (all else being equal) corre- effect of the U.S.’s more competitive a proxy for the management ability
lated with the likelihood that the product markets. Within individual of people at the very top). In other
company in question had failed.
Moreover, the general management
approach, as set by the firm’s leaders, Naming a family member
was the dominant “management”
influence on performance. Intrigu-
as CEO tends to be a poorer
ingly, this research shed light on choice than recruiting an
international differences in firms’
performance. Companies in the outside professional.
United States and Germany had
persistently higher management industries, for instance, greater words, it’s the quality of manage-
scores than their counterparts in the competition spurs the necessity to ment throughout the company that
same industries in other countries. adopt best practices more quickly matters for firm performance, not
The authors concluded that this — or lose out. Likewise, when a just the quality of most senior exec-
strength derived principally from nation’s consumer goods markets utive leaders.
U.S. and German practices related are opened to international trade The results reported by Profes-
to targets and incentives (practices and capital markets are loosened, sors Bloom and Van Reenen will
that boosted flexibility and motiva- this openness tends to enforce the probably attract attention in
tion, for example). need to adopt better management economic circles. They suggest that
Another intriguing finding practices. To be sure, some compa- variation in management quality
concerned family-owned businesses. nies don’t adopt such practices, but “explains” many of the differences
When managed by members of they face higher costs, lower sales, in firm-level productivity. Such
the family, these companies tended and extinction in the competitive a striking correlation between
to score particularly poorly, as if to race. By contrast, when competitive management quality and produc-
reinforce the value of professional forces are weak, it becomes harder tivity raises questions about the
management. In other words, nam- to bring economic discipline to development of management prac-
ing a family member as a leader of bear; companies grow complacent, tices, the choices that managers
a company tends to be a poorer and fail to build the managerial make about practices, and the
choice than recruiting an outside capabilities that they will need in value of managerial talent in ex-
professional manager to do the job. more stressful times. ecuting these practices. It also sug-
According to Professors Bloom Managerial choice and econo- gests that the connections among
and Van Reenen, there is one mic competitiveness are not mutu- competitive conditions, manage-
other influence on management dif- ally exclusive. In fact, they tend to ment, and performance are highly
ferences: the competitiveness of the reinforce each other. Companies significant indicators of which
comment breakthrough thoughts

companies will succeed and which within companies, as managers investments are associated with
will fail. respond to sales results and higher financial restructuring, they may
competition spurs them to inno- have their greatest impact on pro-
Nondestructive Creation vate. As a consequence, productivity ductivity growth through the mana-
The idea that management matters differences will matter even for well- gerial changes that they put in place.
has broad implications. It suggests, established firms that last a long A separate avenue of inquiry
for example, that financial man- time in the marketplace. is “managing learning,” by which I
agement is important not so much Assessment of how “learning mean the systematic development
as a means of tracking and over- managing” occurs is a significant of management skills and knowl-
seeing individual companies, but topic for research. For example, edge, inside and outside business,
as a vehicle for improving their the delineation between the art and in society as a whole. Do tal-
productivity and performance. It of leadership (or, if you prefer, ented managers learn high-quality
also suggests that managers could
5 best improve their results, and
policymakers could best improve The quality of management
their economic climates, by focus-
ing on two management practices:
throughout the company — not
“learning managing” and “manag- just the quality of most senior
ing learning.”
By “learning managing,” I executive leaders — matters.
mean the conscious adoption of
methods, such as lean production general management skill ) and the management practices in business
or better human resources processes, science of management (or specific school or through interaction with
that deploy technology, financial management practices) may be some- other firms in the competitive
capital, and employees’ time more what artificial. The most important process? Are the most successful
effectively. The research I have al- distinguishing factor for U.S. managers generalists who adapt flex-
ready mentioned demonstrates that firms may be their flexibility in ibly to best practices, or specialists
the quality of a firm’s management identifying and capturing opportu- who apply a particular skill base?
can be adapted, most importantly in nities, which could result from Further study of data on firms and
that management quality improves either individual genius or training their managers and management
in the face of increasing competitive in operational capabilities. Recent practices over time would help
pressures. But the precise nature of evidence indicating that productiv- answer these questions. And it
how managers adapt to competition ity will increase along with the would also help inform regional and
requires further study. According to number of MBA holders in a firm national efforts to improve manage-
one important economic model of — MBA degrees presumably stress- ment skills, including those going
entrepreneurship and management ing broad flexibility and general on in emerging nations such as
(see “Selection and the Evolution of management abilities — is sugges- India and China.
Industry,” by Boyan Jovanovic, tive in this regard. Joseph Schumpeter’s theory
Econometrica, May 1982), business Another potentially significant of entrepreneurship (popularly
managers learn, through the course line of inquiry would be the links known as “creative destruction”)
of their transactions over time, how among three phenomena: corporate proposed that firm-level volatility
well their chosen management prac- governance (especially the competi- and aggregate productivity growth
tices adapt to a changing market. tion for corporate control), day-to- are positively correlated: The faster
They continually consider whether day management practices, and the companies come into and go out of
strategy + business issue 45

to remain in business; like species productivity of individual compa- existence, the better it is for the
succumbing to extinction, the poor nies. For example, what role do economy as a whole. But suppose
performers drop out. In a com- investments by private equity firms that better management has devel-
pelling extension of this view, best play in improving managerial qual- oped through a more evolutionary
practices also change over time ity? Although many private equity process — in which the greater
competition in product markets
leads to the gradual selection of
managerial processes that ultimately
increase productivity? Then restruc-
turing and experimentation may be
most important within large, rela-
tively stable firms. A decline in firm-
level volatility could turn out to be
associated with aggregate productiv-
ity improvements of the sort we
have seen recently in the United
States. A recent study by economists
Steven Davis, John Haltiwanger,
Ron Jarmin, and Javier Miranda
supports this view. (See “Volatility
and Dispersion in Business Growth
Rates: Publicly Traded Versus Pri-
vately Held Firms,” 2006, http://
ideas.repec.org/e/pja54.html.) The
study suggests that a kind of coop-
eration between managers, entre-
preneurs, and investors, with the
flavor of “nondestructive creation,”
would generate better performance
for many firms and for the economy
as a whole.
If management matters so
much, how do we foster better
management skills, avoiding hype
and focusing on the learning and
evolution of genuinely successful
practices? Economists have largely
ignored this issue in the past, as have
policymakers. And even business
managers have treated their own
skill sets as too much of a black box,
without fully investing time or
attention in improving their capa-
bilities. Management practice needs
a bigger spot on the agenda, not just
in business schools, but in board-
rooms and government councils.
That’s where the leverage may lie for
making productivity improvement
less of an ongoing riddle and more
of a deliberate and reliable aspect of
any enterprise. +
Reprint No. 06402