W O R L D V I E W

Why businesspeople don't necessarily make great economists.

A Country Is Not a Company

by Paul Krugman

College students who plan to go I am not claiming that business- seem particularly inclined to make
into business often major in eco- people are stupid or that economists false analogies between countries
nomics, but few believe that they are particularly smart. On the con- and corporations.
will end up using what they hear in trary, if the 100 top U.S. business ex-
the lecture hall. Those students un- ecutives got together with the 100 Exports and Jobs
derstand a fundamental truth: What leading economists, the least im- Business executives consistently
they learn in economics courses pressive of the former group would misunderstand two things about the
won't help them run a business. probably outshine the most impres- relationship hetween international
The converse is also true: What sive of the latter. My point is that trade and domestic job creation.
people learn from running a busi- the style of thinking necessary for First, since most U.S. business-
ness won't help them formulate eco- economic analysis is very different people support free trade, they gen-
nomic policy. A country is not a big from that which leads to success in erally agree that expanded world
corporation. The hahits of mind that business. By understanding that dif- trade is good for world employment.
make a great business leader are not, ference, we can begin to understand Specifically, they helieve that free
in general, those that make a great what it means to do good economic trade agreements sueh as the recent-
economic analyst; an executive who analysis and perhaps even help some ly concluded General Agreement on
has made $1 billion is rarely the businesspeople become the great Tariffs and Trade are good largely be-
right person to turn to for advice economists they surely have the in- cause they mean more jobs around
about a $6 trillion economy. tellect to be. the world. Second, businesspeople
tend to helieve that countries com-
Why should that be pointed out? Let me begin with two examples
pete for those jobs. The more the
After all, neither businesspeople nor of economic issues that I have found
United States exports, the thinking
economists are usually very good business executives generally do not
goes, the more people we will em-
poets, but so what? Yet many people understand: first, the relationship
(not least successful business execu- between exports and job creation,
tives themselves) believe that some- and, second, the relationship be- Paul Krugmar} is a professor of eco-
one who has made a personal for- tween foreign investment and trade nomics at Stanford University in
tune will know how to make an balances. Both issues involve inter- Palo Alto. California. His last HBR
entire nation more prosperous. In national trade, partly because it is article was "Does Third World
fact, his or her advice is often disas- the area I know best but also because Growth Hurt First World Prosper-
trously misguided. it is an area in which businesspeople ity}" (July-August 1994).

40 DRAWINGS BY CHRISTOPHER BING

 W O R t D V I E W

ploy, and the more we import, the ity to generate demand, from exports Needless to say, this argument
fewer jobs will he available. Accord- or any other source, but the level of does not sit well with business audi-
ing to tbat view, the United States unemployment that the Fed thinks ences. (Wben I argued on one busi-
must not only have free trade hut al- the economy needs in order to keep ness panel that the North American
so be sufficiently competitive to get inflation under control. Free Trade Agreement would have
a large proportion of the jobs tbat That is not an abstract point. Dur- no effect, positive or negative, on the
free trade creates. ing 1994, the Fed raised interest total number of jobs in tbe United
Do those propositions sound rea- rates seven times and made no secret States, one of my fellow panelists -
sonable? Of course they do. This sort of the fact that it was doing so to a NAFTA supporter - reacted with
of rhetoric dominated the last U.S. cool off an economic boom that it rage: "It's comments like that that
presidential election and will likely feared would create too many jobs, explain why people bate econo-
he heard again in the upcoming race. overbeat tbe econo-
However, economists in general do my, and lead to infla-
not believe that free trade creates
more jobs worldwide (or that its ben-
tion. Consider what
that implies for the ef-
Many people believe that
efits should be measured in terms of fect of trade on em- someone vs^ho has made a
job creation) or that countries that ployment. Suppose
are highly successful exporters will that the U.S. economy personal fortune will know
have lower unemployment than
those that run trade deficits.
were to experience an
export surge. Suppose,
hovs^ to make an entire
Why don't economists subscribe for example, that the nation more prosperous.
to what sounds like common sense United States agreed
to businesspeople? The idea that free to drop its objections to slave labor if
China agreed to buy $200 billion mists!") The job gains from in-
trade means more glohal johs seems creased exports or losses from im-
obvious: More trade means more ex- worth of U.S. goods. What would the
Fed do? It would offset the expan- port competition are tangible: You
ports and tberefore more export- can actually see the people making
related jobs. But there is a problem sionary effect of the exports by rais-
ing interest rates; thus any increase the goods that foreigners buy, the
with that argument. Because one workers whose factories were closed
country's exports are another coun- in export-related jobs would be more
or less matched hy a loss of johs in the face of import competition.
try's imports, every dollar of export The other effects that economists
sales is, as a matter of sheer mathe- in interest-rate-sensitive sectors of
the economy, such as construction. talk ahout seem ahstract. And yet if
matical necessity, matched by a dol- you accept the idea that the Fed has
lar of spending shifted from some Conversely, the Fed would surely re-
spond to an import surge by lower- both a johs target and the means to
country's domestic goods to im- achieve it, you must conclude that
ports. Unless there is some reason to ing interest rates, so the direct loss
of johs to import competition would changes in exports and imports have
think tbat free trade will increase little effect on overall employment.
total world spending - which is not be roughly matehed hy an increased
a necessary outcome - overall world number of jobs elsewhere.
Investment and the
demand will not change. Trade Balance
Even if we ignore the point that
Moreover, heyond this indis- free trade always increases world Our second example, the relation-
putable point of arithmetic lies the imports by exaetly as much as it in- ship between foreign investment
question of what limits the overall creases world exports, there is still and trade balances, is equally trou-
number of jobs available. Is it simply no reason to expect free trade to in- bling to husinesspeople. Suppose
a matter of insufficient demand for crease U.S. employment, nor should that hundreds of multinational com-
goods? Surely not, except in the very we expect any other trade policy, panies decide that a country is an
short run. It is, after all, easy to in- such as export promotion, to in- ideal manufacturing site and start
crease demand. The Federal Reserve crease the total number of jobs in pouring billions of dollars a year into
can print as much money as it likes, our economy. When the U.S. secre- the country to build new plants.
and it has repeatedly demonstrated tary of commerce returns from a trip What happens to tbe country's trade
its ability to create an economic abroad with billions of dollars in balance? Business executives, al-
boom when it wants to. Why, then, new orders for U.S. companies, he most without exception, believe
doesn't the Fed try to keep tbe econ- may or may not be instrumental in that tbe country will start to run
omy booming all tbe time? Because creating thousands of export-related trade surpluses. They are generally
it believes, with good reason, that if jobs. If he is, he is also instrumental unconvinced by tbe economist's an-
it were to do so-if it were to create in destroying a roughly equal num- swer that such a country will neces-
too many johs - the result would he ber of jobs elsewhere in the econo- sarily run large trade deficits.
unacceptable and accelerating infla- my. The ability of the U.S. economy
tion. In other words, the constraint to increase exports or roll back im- It's easy to see where the business-
on the number of johs in the United ports has essentially nothing to do people's answer comes from. They
States is not the U.S. economy's abil- with its success in creating jobs. think of their own companies and
ask what would happen if capacity

HARVARD BUSINESS REVIEW January-February 1996 41

 W O R L D V I E W

in their industries suddenly expand- mists hold; it is an unavoidable ac- spent on imported equipment for
ed. Clearly their companies would counting truism. Mexico's new factories. The rest fu-
import less and export more. If the So what happens when a country eled a domestic boom, which sucked
same story is played out in many in- attracts a lot of foreign investment? in imports and caused the peso to
dustries, surely this would mean a With the inflow of capital, foreigners become increasingly overvalued.
shift toward a trade surplus for the are acquiring more assets in that That, in turn, discouraged exports
economy as a whole. country than the country's residents and prompted many Mexican con-
The economist knows that just are acquiring abroad. But that sumers to purchase imported goods.
the opposite is true. Why? Because means, as a matter of sheer account- The result: Massive capital inflows
the balance of trade is part of the ing, that the country's imports were matched by equally massive
balance of payments, and the overall must, at the same time, exceed its trade deficits.
exports. A country that Then came the peso crisis of De-
attracts large capital in- cember 1994. Once again, investors
flows will necessarily run
A country that a trade deficit.
were trying to get out of Mexico, not
in, and the scenario ran in reverse. A
attracts a lot of foreign But that is just ac- slumping economy redueed the de-
counting. How does it mand for imports, as did a newly
investment will necessarily happen in practice? When devalued peso. Meanwhile, Mexican
exports surged, helped by a weak
run a trade deficit. companies build plants,
they will purchase some currency. As any economist could
imported equipment. The have predicted, the collapse of for-
investment inflow may spark a do- eign investment in Mexico has been
balance of payments of any country-
mestic boom, which leads to surg- matched by an equal and opposite
the difference hetween its total sales
ing import demand. If the country move of Mexican trade into surplus.
to foreigners and its purchases from
foreigners - must always be zero.' Of has a floating exchange rate, the But like the proposition that ex-
course, a country can run a trade investment inflow may drive up the panded exports do not mean more
deficit or surplus. That is, it can buy currency's value; if the country's employment, the necessary conclu-
more goods from foreigners than it exchange rate is fixed, the result sion that countries attracting foreign
sells or vice versa. But that imbal- may he inflation. Either scenario investment typically run trade defi-
ance must always he matched by a will tend to price the country's goods cits sits poorly with business audi-
corresponding imbalance in the cap- out of export markets and increase ences. The specific ways in which
ital account. A country that runs a its imports. Whatever the channel, foreign investment might worsen
trade deficit must be selling foreign- the outcome for the trade balance the trade balance seem questionable
ers more assets than it buys; a coun- is not in doubt: Capital inflows to them. Will investors really spend
try that runs a surplus must be a net must lead to trade deficits. that much on imported equipment?
investor abroad. When the United Consider, for example, Mexico's How do we know that the currency
States buys Japanese automohiles, it recent history. During the 1980s, no- will appreciate or that, if it does, ex-
must he selling something in re- body would invest in Mexico and the ports will decrease and imports will
turn; it might be Boeing jets, hut it country ran a trade surplus. After increase? At the root of the busi-
could also he Rockefeller Center or, 1989, foreign investment poured in nessperson's skepticism is the fail-
for that matter. Treasury bills. That amid new optimism about Mexico's ure to understand the force of the ac-
is not just an opinion that econo- prospects. Some of that money was counting, which says that an inflow

42 HARVARD BUSINESS REVIEW Ianuar>--Ffbruary 1996

 W O R L D V I E W

of capital must - not might - be ac- theory of tbe corporation hut hy son's ability to spot opportunities
companied by a trade deficit. finding the particular product strate- and solve problems in his or her own
In each of the above examples, gies or organizational innovations business can be applied to the na-
there is no question that the econo- that work. There have been some tional economy. After all, what the
mists are right and the business- business greats who have attempted president of the United States needs
people are wrong. But why do the to codify what they know, but such from his economic advisers is not
arguments that economists find attempts have almost always been learned tracts but sound advice
compelling seem deeply implau- disappointing, George Soros's book about what to do next. Why isn't
sihle and even counterintuitive to told readers very little about how someone who has shown consistent-
businesspeople? to be another George
There are two answers to that Soros; and many peo-
question. The shallow answer is that ple have pointed out
that Warren Buffett
A corporate leader
the experiences of husiness life do
not generally teach practitioners to does not, in practice, succeeds by finding the
look for the principles tbat underlie invest the Warren Buf-
economists' arguments. Tbe deeper fett Way. After all, a fi- right strategies, not
answer is that tbe kinds of feedhack
that typically arise in an individual
naneial wizard makes
a fortune not hy enun-
by developing a theory of
husiness are both weaker than and ciating general princi- the corporation.
different from the kinds of feedback ples of financial mar-
that typically arise in the economy kets hut by perceiving particular,
highly specific opportunities a bit ly good judgment in running a busi-
as a whole. Let me analyze each of
faster than anyone else. ness likely to give the president good
these answers in turn.
advice about running the country?
Indeed, great business executives Because, in short, a country is not a
The Parable of the Paralyzed often seem to do themselves harm large company.
Centipede when they try to formalize what Many people have trouble grasp-
Every once in a while, a highly they do, to write it down as a set of ing the difference in complexity be-
successful husinessperson writes a principles. They begin to hehave as tween even the largest business and
hook about what he or she has they think they are supposed to, a national economy. The U.S. econo-
learned. Some of these books are whereas their previous success was my employs 120 million people,
memoirs: They tell the story of a ca- hased on intuition and a willingness ahout 200 times as many as General
reer through anecdotes. Others are to innovate. One is reminded of the Motors, the largest employer in the
ambitious efforts to describe the old joke about the centipede who United States, Yet even this 200-to-l
principles on which the great per- was asked how he managed to coor- ratio vastly understates the differ-
son's success was hased. dinate his 100 legs: He started think- ence in complexity between the
Almost without exception, the ing about it and could never walk largest husiness organization and
first kind of hook is far more suc- properly again. the national economy. A mathe-
cessful than the second, not only in Yet even if a business leader may matician will tell us that the num-
terms of sales but also in terms of its not he very good at formulating gen- ber of potential interactions among a
reception among serious thinkers. eral theories or at explaining what large group of people is proportional
Why? Because a corporate leader he or she does, there are still those to tbe square of their number. With-
succeeds not hy developing a general who believe that the businessper- out getting too mystical, it is likely

HARVARD BUSINESS REVIEW January-February 1996 43

 that the U.S. economy is in some tion: consistent accounting, clear or she does not understand, such as a
sense not hundreds but tens of thou- lines of responsibility, and so on. chemist who decides that he is an
sands of times more complex than But many husinesspeople have trou- expert in medicine or a physicist
the biggest corporation. ble accepting the relatively hands- who decides that he is an expert in
Moreover, there is a sense in off role of a wise economic policy- cognitive science. The same syn-
which even very large corporations maker. Business executives must be drome is apparent in some husiness
are not all that diverse. Most corpo- proactive. It is hard for someone leaders who have been promoted to
used to that role to real- economic advisers: They have trou-
ize how much more dif- hle accepting that they must go hack
ficult - and less neces- to school before they can make pro-
The U.S. economy is the sary-this approach is for nouncements in a new field.
ultimate conglomerate, national economic policy.
Consider, for example,
The general principles on which
an economy must be run are differ-
vs^ith tens of thousands of the question of promot- ent - not harder to understand, but
ing key business areas.
distinct lines of business. Only an irresponsible
different-from those that apply to a
business. An executive who is thor-
CEO would not try to oughly comfortable with business
determine which new areas were accounting does not automatically
rations are built around a core com- essential to the company's future;
petence: a particular technology or know how to read national income
a CEO who left investment deci- accounts, which measure different
an approach to a particular type of sions entirely to individual manag-
market. As a result, even a huge cor- things and use different concepts.
ers running independent profit cen- Personnel management and labor
poration that seems to be in many ters would not be doing the job. But
different businesses tends to be uni- law are not the same thing; neither
should a government decide on a list are corporate financial control and
fied by a eentral theme. of key industries and then actively monetary policy. A business leader
The U.S. economy, in eontrast, is promote them? Quite aside from who wants to become an economic
the ultimate nightmare conglomer- economists' theoretical arguments manager or expert must learn a new
ate, with tens of thousands of utterly against industrial targeting, the sim- vocabulary and set of concepts, some
distinct lines of husiness, unified on- ple fact is that governments have of them unavoidably mathematical.
ly because they happen to be within a terrible track record at judging
the nation's borders. The experience which industries are likely to be im- That is hard for a business leader,
of a successful wheat farmer offers portant. At various times, govern- especially one who has been very
little insight into what works in the ments have been convinced that suecessful, to accept. Imagine a per-
computer industry, which, in turn, steel, nuclear power, synthetic fuels, son who has mastered the complexi-
is probably not a very good guide to semiconductor memories, and fifth- ties of a huge industry, who has run
successful strategies for a chain of generation computers were the wave a multibillion-dollar enterprise. Is
restaurants. of the future. Of course, businesses such a person, whose adviee on eco-
How, then, can such a complex make mistakes, too, hut they do not nomic policy may well be sought,
entity be managed? A national econ- have the extraordinarily low hatting likely to respond by deciding to
omy must be run on the basis of gen- average of government because great spend time reviewing the kind of
eral principles, not particular strate- husiness leaders have a detailed material that is covered in freshman
gies. Consider, for example, the knowledge of and feel for their in- economics courses? Or is he or she
question of tax policy. Responsible dustries that nobody-no matter how more likely to assume that business
governments do not impose taxes smart-can have for a system as com- experience is more than enough and
targeted at particular individuals or plex as a national economy. that the unfamiliar words and con-
corporations or offer them special cepts economists use are nothing
tax hreaks. In fact, it is rarely a good but pretentious jargon?
Still, the idea that the best eco-
idea for governments even to design nomic management almost always Of course, in spite of the examples
tax policy to encourage or discour- consists of setting up a good frame- I gave earlier, many readers may still
age particular industries. Instead, a work and then leaving it alone believe that the second response is
good tax system obeys the broad doesn't make sense to businesspeo- the more sensible one. Why does
principles developed by fiscal ex- ple, whose instinct is, as Ross Perot economic analysis require different
perts over the years - for example, put it, to "lift up the hood and get to concepts, a completely different way
neutrality between alternative in- work on the engine." of thinking, than running a husi-
vestments, low marginal rates, and ness? To answer that question, I
minimal discrimination between Going Back to School must turn to the deeper difference
current and future consumption. In the scientific world, the syn- between good business thinking and
Why is that a problem for busi- drome known as "great man's dis- good economic analysis.
nesspeople? After all, there are many ease" happens when a famous re- The fundamental difference be-
general principles that also underlie searcher in one field develops strong tween business strategy and eco-
the sound management of a corpora- opinions about another field that he continued on page 48

44 HARVARD BUSINESS REVIEW January-February iy96

nomic analysis is this: Even the In this case, each individual com- move into trade surplus; and, as we
largest business is a very open sys- muter constituted an open system: have already seen, a country tbat
tem; despite growing world trade, He or she could find a parking space runs a trade surplus is necessarily a
the U.S. economy is largely a closed by arriving early. But tbe group of country that exports capital. A little
system. Businesspeople are not used commuters as a whole could not do arithmetic tells us that if the average
to thinking about closed systems; the same. If everyone tried to get a U.S. company were to expand its
economists are. space hy arriving earlier, the garage share of the world market by as little
Let me offer some noneconomic would only fill up sooner! Com- as five percentage points, the United
examples to illustrate the difference muters as a group constituted a States, which is currently a net im-
hetween closed and open systems. closed system, at least as far as park- porter of capital from the rest of the
Consider solid waste. Every year, the ing was concerned. world, would have to become a net
average American generates about What does this have to do with exporter of capital on a scale never
half a ton of solid waste that cannot husiness versus economics? Busi- before seen, if you think this is an
he recycled or burned. What happens nesses - even very large corpora- implausible scenario, you must also
to it? In many communities, it is tions-are generally open systems. believe that U.S. companies cannot
sent somewhere else. My town re- They can, for example, increase em- increase tbeir combined share of the
quires that every resident subscribe ployment in all their divisions si- market hy more than a percentage
to a private disposal service hut pro- multaneously; they can increase in- point or two, no matter how well
vides no landfill site; tbe disposal vestment across the board; they can run they are.
service pays a fee to some other com- seek a higher share of all their mar- Businesspeople have trouble with
munity for the right to dump our kets, Admittedly, the borders of the economic analysis because they are
garbage. This means tbat tbe garbage organization are not wide open. A accustomed to thinking about open
pickup fees are higher than they company may find it difficult to ex- systems. To return to our two exam-
would be if the town set aside a land- pand rapidly because it cannot at- ples, a businessperson looks at the
fill site, hut the town government tract suitable workers fast enough or jobs directly created by exports and
has made that choice: It is willing to because it is unahle to raise enough sees those as the most important
pay so that it won't have an unsight- capital. An organization may find it part of the story. He or she may ac-
ly dump within its borders. even more difficult to contract, be- knowledge that higher employment
cause it is reluctant to fire good em- leads to higher interest rates, but
For an individual town, that ployees. But we find nothing re-
choice is feasible. But could every this seems an iffy, marginal concern.
markable in a corporation whose What the economist sees, however,
town and county in the United market share doubles or halves in
States make the same choice? Could is that employment is a closed sys-
just a few years. tem: Workers who gain johs from in-
we all decide to send our garbage
somewhere else? Of course not creased exports, like park-and-ride
By contrast, a national economy-
(leaving aside the possibility of ex- commuters who secure parking
especially that of a very large coun-
porting garbage to the Third World). spaces by arriving at the garage early,
try like the United States-is a closed
For the United States as a whole, must gain those positions at some-
system. Could all U.S. companies
the principle "garbage in, garbage one else's expense.
double their market shares over the
out" applies literally. The country next ten years?' Certainly not, no And what about the effect of for-
can make choices about where to matter how much their manage- eign investment on the trade bal-
bury its solid waste but not about ments improved. For
whether to bury it at all. That is, in one thing, in spite of
terms of solid waste disposal, the growing world trade,
United States is more or less a closed more than 70% of
Will a business leader
system, even though each town is an
open system.
U.S. employment and vs^ant to revievs^ material
value-added is in in-
That's a fairly obvious example, dustries, such as retail taught in freshman
trade, that neither ex-
Here is another, perhaps less obvi-
port nor face import
economics courses?
ous one. At one point in my life, I
was a "park-and-ride" commuter: competition. In those
Every morning, I would drive to a industries, one U.S. company can in- anee? Again, tbe business executive
large parking garage and then take crease its market share only at the looks at the direct effects of invest-
public transportation downtown. expense of another. ment on competition in a partieular
Unfortunately, the garage was not In industries that do enter into industry; the effects of capital flows
large enough. It consistently filled world trade, U.S. companies as a on exchange rates, prices, and so on
up, forcing late commuters to con- group can increase their market do not seem particularly reliable or
tinue driving all tbe way to work, I share, but they must do so by either important. The economist knows,
soon learned, however, that I could increasing exports or driving down however, that the balance of pay-
always find a parking space if I ar- imports. Any increase in their mar- ments is a closed system: Tbe inflow
rived by about 8:15. ket share would therefore mean a of capital is always matched hy the

48 HARVARD BUSINESS REVIEW January-February 1996

 W O R L D V I E W

trade deficit, so any increase in that effects of the growth of one part of pulls resources of capital and labor
inflow must lead to an increase in the company on the success of the away from other industries.
that deficit. other are both ambiguous in princi- There are, in fact, examples of pos-
ple and hard to judge in practice; itive feedbacks in economics. They
Feedbacks in Business and feedbacks among different lines of are often evident within a particular
Economics business, whether they involve syn- industry or group of related indus-
Another way of looking at the dif- ergy or competition for resources, tries, especially if those industries
ference between companies and are often elusive. are geographieally concentrated. For
economies may help explain why By eontrast, consider a national example, the emergence of London
great business executives are often economy that finds one of its major as a financial center and of Holly-
wrong about economics and why exports growing rapidly. If that in- wood as an entertainment center are
certain economic ideas are more dustry increases employment, it clearly cases of positive feedback
popular with businesspeople than will typically do so at the expense of at work. However, such examples
other industries. If the country does are usually limited to particular re-
others: Open systems like eompa-
not at the same time reduce its in- gions or industries; at the level of
nies typically experience a different
flows of capital, the increase in one the national economy, negative feed-
kind of feedback than closed sys-
export must be matched by a reduc- back generally prevails. The reason
tems like economies. should be obvious: An individual re-
This concept is best explained hy tion in other exports or by an in-
crease in imports because of the gion or industry is a far more open
hypothetical example. Imagine a system than the economy of the
balance of payments accounting dis-
company that has two main lines of United States as a whole, let alone
cussed earlier. That is, there will
business: widgets and gizmos. Sup- the world economy. An individual
most likely be strong
negative feedbacks from industry or group of industries can
the growth of that export attract workers from other sectors of
Even the largest business is to employment and ex- the economy; so if an individual in-
ports in other industries. dustry does well, employment may
a very open system; Indeed, those negative increase not only in that industry
a national economy is a feedbacks will ordinarily but also in related industries, which
may further reinforce the success of
he so strong tbat they
closed system. will more or less com- the first industry, and so on. Thus if
pletely eliminate any im- one looks at a particular industrial
provements in overall employment complex, one may well see positive
pose that this company experiences or the trade balance. Why? Because feedback at work. But for the econo-
unexpected growth in its sales of employment and the balance of pay- my as a whole, those localized posi-
widgets. How will that growth affect ments are closed systems. tive feedbacks must he more than
the sales of the company as a whole? matched by negative feedbacks else-
Will increased widget sales end up In the open-system world of busi- where. Extra resources pulled into
helping or hurting the gizmo busi- ness, feedbacks are often weak and any one industry or cluster of indus-
ness? The answer in many cases will almost always uncertain. In the tries must come from somewhere,
he that there is not much effect ei- closed-system world of economics, which means from other industries.
ther way. The widget division will feedbacks are often very strong and
simply hire more workers, the com- very certain. But that is not the Businesspeople are not accus-
pany will raise more capital, and whole difference. The feedbacks in tomed to or comfortable with the
that will be that. the business world are often posi- idea of a system in which there are
The story does not necessarily end tive; those in the world of eeonomic strong negative feedbacks. In partic-
here, of course. Expanded widget policy are usually, though not al- ular, they are not at all comfortable
sales could either help or hurt the ways, negative. with the way in which effects that
gizmo husiness in several ways. On Again, compare the effects of an seem weak and uneertain from the
one hand, a profitable widget busi- expanding line of business in a cor- point of view of an individual com-
ness could help provide the cash poration and m a national economy. pany or industry - such as the effect
flow that finances expansion in giz- Success in one line of husiness, of reduced hiring on average wages
mos; or the experience gained from which expands the company's finan- or of increased foreign investment
success in widgets may he transfer- cial, technological, or marketing on the exchange rate - become cru-
able to gizmos; or the growth of the base, often helps a company expand cially important when one adds up
company may allow R&D efforts in other lines. That is, a company the impact of policies on the nation-
that benefit both divisions. On the that does well in one area may end al economy as a whole.
other hand, rapid expansion may up hiring more people in other areas.
strain the company's resources, so But an economy that produces and What's a President to Do?
that the growth of widgets may sells many goods will normally find In a society that respects business
come to some extent at the gizmo negative feedhacks among economic success, political leaders will in-
division's expense. But such indirect sectors: Expansion of one industry evitably - and rightly - seek the ad-

50 HARVARiD BUSINESS REVIEW January-February 1996

vice of husiness leaders on many is-
sues, particularly those that involve
Forget EPS, ROE and ROI.
money. All we can ask is that both
the advisers and the advisees have a
proper sense of what business suc-
cess does and does not teach about EVAls What Drives
economic policy.
In 1930, as the world slid into de-
pression, John Maynard Keynes
called for a massive monetary ex-
Stock Prices.
pansion to alleviate the crisis and
pleaded for a policy hased on eco-
nomic analysis rather than on the
advice of hankers committed to the
gold standard or manufacturers who
wanted to raise prices by restricting
output. "For-though no one will be-
lieve it - economics is a technical
and difficult subject,'" Had his ad-
vice been followed, the worst rav-
ages of the Depression might have
been avoided.
Keynes was right: Economics is a
difficult and technical suhject. It is
no harder to be a good economist
than it is to be a good business exec-
utive, (In fact, it is probably easier,
because the competition is less in-
tense,) However, economics and Look what happens whm a compcm)' adopls EVA
business are not the same suhject,
and mastery of one does not ensure
comprehension, let alone mastery, EVA® — Economic Value Added — is a to guide their decision making. If you're not
of the other. A successful business financial tool that tells you how much your using EVA to help you decide whether to buy a
leader is no more likely to be an company is beating the total cost of capital, competitor, sell a division or build a new plant,
expert on economics than on mili- and what to do about it if you're not. then how can you be sure your decisions are
tary strategy. EVA is also a performance measurement maximizing your shareholder value?
The next time you hear husiness- tbat best accounts for changes in share Wovt am you be sure?
people propounding their views value. Why? Because what drives a compa- You can turn to the corporate advisory
about the economy, ask yourself. ny's share price is the amount by which firm that developed EVA, Stern Stewart & Co.
Have they taken the time to study earnings, properly measured, exceed or fall can do for you what we have done tor dozens
this suhject? Have they read what short of the cost of the capital required to of Fortune 500 companies and scores of oth-
the experts write? if not, never mind produce those earnings. That's precisely
how successful they have been in ers. Our EVA'' financial management service
what EVA shows you. can give you the tools and training to inte-
husiness. Ignore them, because they
probably have no idea what they are •'We calcukited our EVA hack to 1984 grate an EVA management framework into
talking ahout. and found an aln?ost perfect correlation your corporate culture.
uitb stock price." siiysJmiK'^Uiienim.CFO oi Just measuring EVA isn't enough. You
1. There are actually two tecbnical i Communications Services at AT&T. need to adopt it. EVA brings a new kind of
tioos to this statement. One of them involves
what are known as "unrequited transfers": EVA is your company's after tax profits financial discipline to companies, it encour-
gifts, foreign aid, and so {)n. The other involves from operations less the cost of all capital ages managei^ to act like owners and boosts
profits and interest payments from past invest-
ments. These qualifications do not change the employed to produce those profits: not just shareholder fortunes in the process,
main point. the cost of debt, but the cost of equity capi- EVA® — The Real Key to Creating
2. Strictly speaking, one should talk of compa- tal as well. When EVA is used as part of a Wealth'"' For more information, contact
nies that produce in the United States. It is cer- total financial management system, it can AlEhrbar at (212) 261-0748.
tainly possihle for companies based in the
United States to increase their world market help shape ever\' corporate decision, from a
share hy acquiring foreign suhsidiaries. company acquisition or divestiture to proj- •••'-j',i
3. "The Great Slump of 1930," reprinted in ect budgeting, product development..,even
Essays in Permasion (New York: Norton, 1963). incentive compensation.
Reprint 96108 More and more companies such as Stern Stewart & Co.
Equifax and Briggs & Stratton are using EVA THE EVA''COMPANY

e All ri^Lsre*rwdforStem Sitwart S (ji. KVA* a 3 ivgislmid trademaA nf Stem Stewan & Co, jn the I^S and Moxi