Developing World Catches a Fresh IT Wave

Developing World Catches a Fresh IT Wave
Andy Xie


An IT-fueled shift to low-cost communications is revamping the services sector, to the benefit of developing economies

As cloud computing, optical fiber lines and mobile devices combine to form a much more powerful and accessible IT network, information and communication costs are falling to as low as zero. Some analysts consider this a third wave for the IT revolution, following the IBM mainframe of the 1980s and the advent of personal computers alongside the Internet in the 1990s.

This new wave has profound implications for how economic activities are organized. It’s destroying and rearranging economic structures in far-reaching ways. In particular, it strips away the need for multiple levels of white collar intermediaries whose services are at the core of a modern, developed economy. And it’s giving developing countries new avenues for growth.

The overall IT revolution has benefited developing economies enormously in recent decades by making possible an original equipment manufacturing model that’s powered trade growth. The revolution’s next stage may bring even greater benefits by decreasing costs for domestic demand growth.

Why? Because developing economies centered on blue collar-driven manufacturing now have a chance to develop services sectors around the latest technology and, hence, benefit from higher productivity without painful disruptions in existing structures. Higher productivity lowers prices, which lets developing economies transit from blue collar manufacturing to a white collar service economy earlier than they might otherwise.

IT has already reshaped the world’s economy by facilitating globalized manufacturing. Without IT, it would be hard to imagine a multinational company sourcing parts from so many countries for assembly in one country and sale in another. This is a major reason why trade has been growing twice as fast as the global economy. Developing countries have benefited enormously from this trend, employing surplus workers for export production. China is by far the biggest beneficiary.

Manufacturing services have been globalized to some extent. For example, logistics can be done far from a point of sale. When a product is picked up at a port and shipped to a shop, the documentation can be handled in a different country. In theory, only the truck driver and shop clerk must be local in the country where a sale happens. Manufacturing may be one-fifth of the global economy, but manufacturing services may be another one-tenth.

Some low-end services have been globalized. Call centers have been set up in India to provide product-after-sale services. For example, when a customer has trouble using a mobile phone, he can call tech support in India. Hotel booking and credit card services can be based in countries far from customers.

Alongside IT, globalization and aging are shaping the global economy. The first two forces enlarge the pie but change the way incomes are distributed among people, industries and countries. Aging makes the pie smaller. Eventually the pie may be bigger as the new IT revolution changes economies, even though the process will be quite painful.

Yet of all technologies, IT remains the most powerful force influencing the global economy. Green energy survives on government subsidies. We will not see a day when it will be more than a niche phenomenon. Biotech is constrained by a long gestation period for product development. The IT revolution, on the other hand, races forward at lightning speed.

Cloud computing is viewed by many experts as revolutionary. I agree because I see how it’s changing the real economy: It’s destroying some sectors, creating new ones, and reallocating incomes among people with different skill levels and across nations. Its effects will severely limit and change the impact of the macroeconomic stimulus plans that most economists are advocating to cope with the ongoing double-dip.

So far, IT has facilitated outsourcing. Jobs have become mobile and can be relocated in low-cost countries. The next IT wave may eliminate numerous jobs outright, change the nature of jobs that remain and create entirely new jobs. Thus, its power to destroy and create may be greater than previous IT revolutions.

Inefficiency Eraser

Services in a developed economy can involve shop clerks, restaurant waiters and bus drivers. But these jobs are not tied to “value-added” creation. High value-added services are found in the high-rise offices of administrators, bankers, lawyers, accountants and the like. What these people do is process information: They obtain information, process it, and pass a different form of the information to someone else. The information flows from one to another until someone acts on it. That someone could be a CEO or a truck driver.

A large organization with mainly white collar professionals is highly inefficient. An oft-quoted rule says 20 percent of the people do 80 percent of the work. This inefficiency arises from price mechanisms that don’t work properly during information processing; There is no end product to price.

One might tell which employees are more efficient than others, since these may be more likely to be promoted and receive raises. But that’s not always so. Where price mechanism stops, politics begins. A superior doesn’t always prefer the most efficient employee because she or he might threaten to take that superior’s job. Such complexities decrease incentives for employees to perform. Hence, large service providers are by nature inefficient.

Why do large service organizations exist? The main reason is precisely that one cannot price its product instantly. The quality of the product may take years to prove. A large organization provides the confidence to buyers through the reputation effect. If its previous customers are happy, it has incentives to protect its reputation. Hence, new customers also should buy from it with confidence.

A hospital, for example, fits this description well. A reputable hospital can charge a premium for its services, using revenues to purchase good equipment and hire good doctors. This sustains its reputation. A hospital with a reputation for bad quality, however, faces the opposite issue. Thus, unless one is willing to invest a lot to build a good reputation, it’s stuck in a vicious cycle.

Every city has this good hospital-bad hospital phenomenon. But even good hospitals experience the 20-80 phenomenon. This same, inherent inefficiency can be found throughout large, white-collar service organizations.

Progress in IT cuts two channels for decreasing white collar inefficiency. First, output measurement becomes possible. For example, the progress of a doctor’s patients can be tracked at little cost. Data on every doctor’s efficiency and effectiveness could be available to each patient and hospital. Other professionals such as accountants, lawyers and bankers could be subjected to the same measurements.

Efficient output measurement leads to widening the price dispersion in compensation for white collar professionals and reducing the number of administrators needed to control them. Maybe the 20-80 phenomenon will remain, but 20 percent of the productive staff will be paid 80 percent of the total compensation while their bosses – the administrators – will get far less. In that way, the 20-80 phenomenon would not lead to inefficiency.

These changes may endanger the paradigm of a rich, developed economy with a middle class core. Inefficiencies in a service economy may even out income distribution, so that everyone earns about the same. But if output is measured accurately, the distribution gap may widen dramatically. The pie may get bigger, but many will be taking home less.

Second, collapsing communication costs can eliminate many layers of a supply chain. The travel industry, for example, is full of intermediaries. Ultimate suppliers are businesses that provide transportation, lodging and catering. With travelers so numerous and the supply side dispersed, it can be costly for service providers and consumers to find each other directly, so big travel businesses are often intermediaries. Even global hotel chains are management companies overseeing other people’s hotels.

The Internet moved some intermediation to online brokers who could operate more efficiently. The next step, I’m afraid, is to eliminate online intermediaries. Communication costs are becoming so low that small service providers can reach the world at almost zero cost, while any consumer can reach any small provider at zero cost. Airlines, for example, can now reach customers easily through mobile devices, offering perfect price discrimination in relation to buying times and locations. No intermediary could be so efficient.

Financial services providers are intermediaries by definition. They match buyers and sellers of stocks, bonds, commodities and other financial products. They fit perfectly the definition of information broker. They can still make a living by brokering among institutional investors who are, by definition, few.

But institutional investors are intermediaries, too. Why should savers give them money to manage? Not for superior performance: More than 90 percent of institutional investors underperform market indexes. The main justification is that they bring down costs of information acquisition and processing, as well as transactions. This justification looks shakier by the day. Any individual can have access to as much information as a fund manager at virtually no cost. I’m afraid the financial services industry is likely to decline structurally.

As financial services industry loses value-added to customers and the real economy, it is increasingly dependent on gaming the system and profiting from customer ignorance. This makes the industry and financial market more volatile and bubble-prone. In the last financial crisis, the financial sector survived by holding the real economy hostage.

Unless policymakers understand that the financial industry isn’t necessary for the real economy anymore, and that it should scale down dramatically, the sector will remain a gigantic parasite on top of the real economy.

Moreover, policymakers have wrongly responded to economic weaknesses tied to structural factors by releasing stimulus. That’s led to one bubble after another. Only smart investors profit by understanding the market implications of interactions between structural forces and policy mistakes.

Meanwhile, cloud computing, optical fiber lines and mobile devices are putting everyone in touch with everyone else at close to zero cost, destroying economic fundamentals for intermediary economies of scale. We are seeing the front end of a shock wave to established, white collar economies. This is a turbocharged version of Schumpeterian creative destruction.

This force will prolong the employment crisis. Globalization of manufacturing is the most important driver for a blue collar employment crisis in the West. The bubble covered up employment implications by creating bubble jobs. The crisis has exposed the employment crisis that should have been around a decade ago.

The destructive power of the ongoing IT revolution on the white collar labor force will make it extremely difficult for developed economies to decrease unemployment in the foreseeable future. The destabilizing force of the IT revolution could be similar to the fossil fuel revolution a century ago. Western countries may be entering a decade of instability.

Meanwhile, the developing world that’s benefited enormously from the PC and Internet could see its domestic demand development accelerate in the next IT wave. Lower intermediation costs could help the developing world enter domestic service demand-led growth earlier than otherwise.

Because developing countries do not yet have an intermediation economy for services, they can maximize the benefits derived from new technologies by making services and goods cheaper for domestic consumer demand, thus improving local consumption as a growth driver. And it could be coming just in time, as an employment crisis hurts overseas demand for manufactured exports.

The global economy has bifurcated into the weak developed world and the booming developing world. The contrast is partly due to liquidity from the former to the latter. When the current liquidity bubble bursts, the developing world may suffer a growth slowdown. But its cost advantages will sustain it with stronger growth performance.

The third wave of the IT revolution could amplify this outperformance. And if the world remains at peace, a convergence between what are now two worlds may occur this century.


Developing World Catches a Fresh IT Wave
Andy Xie,

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