Dharmendra Kanani: Good afternoon, everybody. A very warm welcome to Friends of Europe’s first #CriticalThinking Live of the year. Last January we woke up to a very different one than we did this year. We’ve had war, the energy crisis, and a crisis of livelihoods. People don’t know whether to eat or to heat. People are worried about what their future holds for them. Young generations are thinking, “The older generation has basically eaten up all the glory, and we’re left with a dud planet.” There are many people thinking, “In our generation we never imagined we would have this combination of factors, including a war in our neighborhood, the biggest energy crisis we’ve ever experienced, and eye-watering inflation figures we thought we would never witness again.” How do we make sense of this world, and what we can do?
I’m joined by Sven Smit, chair of McKinsey Global Institute (MGI) and senior partner at McKinsey, to provide his thoughts. He’s a big brain who has done a lot of deep analysis and has the aptitude, not to soothsay, but to provide us with guidance about what we might consider regarding what’s in the near term, and what we should think about into the long term. The basis for this conversation is a new discussion paper from McKinsey Global Institute, On the cusp of a new era?.
Sven, it’s a pleasure to welcome you. You’ve just come back from Davos, I believe, so you can also share some of your thoughts on what the crème de la crème of the world was thinking about in terms of global matters. But first, can you say a bit about why you call this period a “new era”? What’s the thinking behind setting out some of the dramatic elements of the report?
Sven Smit: Thank you for having me, it’s great to be with Friends of Europe.
When we think about movements through time, we’re used to thinking about a business cycle—like the dot-com cycle, the financial crisis, or COVID-19, which, of course, was recent and deep. Those cycles are demand cycles, and our pattern for getting through them is that we get afraid of something: all tech companies are going bust, the financial system is broken, our lives are broken because of COVID-19. When we are afraid, we stop spending and the economy gets a shock. The shock was deep in the first quarter, in the second quarter there was already some recovery, and in the third quarter we bounced back. Why? Because we got some signals of optimism. Not all tech companies closed, our money wasn’t lost in the financial crisis, and we found a way to live in lockdowns, even to spend and get our lives organized. Vaccines were made, and then life became basically back to how it was before.
It’s not perfect. We had to change things, re-regulate certain things, and we changed certain rules by which we live, but, basically, we went from fear to optimism. History has had bigger moments than this, and we’re suggesting that this could be just such a big moment—what we call the “cusp of a new era.” If we look back at the Second World War, there was a period from the war until the 1970s—the post-war boom—which was an era in which many actions were clear. Europe and Japan were deconstructed, the poverty in the rest of the world started to diminish, and people’s houses, cars, investment world, their fridge, and so forth were being rebuilt—and we were starting to achieve these actions in poorer countries. We had the supply of oil that we needed, and energy, and so on. The 1970s brought a supply shock. I would say that was the last time we had a similar supply shock to what we have now: global in scale, cuts in energy and food, with geopolitical dimensions, and challenges to world order.
That era lasted until the late 1980s or early 1990s, when the USSR dissolved and we entered what we have coined “the global era of markets.” For most leaders in the world, this global era of markets coincided with their entire time in leadership, and they’ve been conditioned to count on supply, energy, and some sort of geopolitical collaboration. Of course, there have been small wars and complexity, and business cycles that have come and gone, but at the moment we are dealing with a geopolitical set of questions at Davos. We are in a supply crisis on multiple dimensions. The demographics are no longer at tailwinds. Energy is in short supply and we want to transition to cleaner energy sources. The economics of the past 30 years—characterized by low interest rates, benign inflation, and so on—are also being challenged. It could be that it will all come down this year or next, and that it was just a business cycle, but the fact is that you have a congruence of geopolitics. You could hear it in Davos in every CEO conversation.
The list of issues is long and the answers are not clear. By the time we have the answers to the forks in the road that we face now, we may look back on the era and call it something different. In Davos, we had a session on this—there was a question put to me about what I would call this new era and I said, “Honestly, I think you name it in hindsight, not with foresight.” For instance, “the global era of markets” grew on us, rather than being defined at a distinct time. At the moment, where bigger shifts are occurring, I think we will give it a name at some point and call it a new era.
Dharmendra Kanani: The more important fundamental shift you describe is that we are no longer going to be in a boom-and-bust cycle. The fact is that the tectonic plates have changed so phenomenally that everything we knew, and have understood to be a cycle, is coming to an end.
You made reference to geopolitics. You’ve been at Davos, and we know that while there relationships between Africa, China, and India, have ricocheted. We know that post-Trump, we can take a breath and think, “A liberal order has been re-established,”—though we don’t know for certain because Trump may come back in a different guise. When we think about economic flows, and interdependencies, can you say a bit about how you see that going?
Sven Smit: We wrote a separate report to deep dive into that branch of a new era, talking about global flows and the degree to which we’re an interconnected world. A message from that is clear and should be the foundation for thinking about geopolitics—it is that no region can be an island. At least all regions have some material, energy flows, food flows, where they are more than 25 percent dependant on somebody else. Of course, there’s variance. The United States typically has more energy and materials than Europe. China is a large producer that uses material from the rest of the world. So, each region has different roles and the interdependency is significant. If you look at the materials sector, some materials essentially come from just three countries at the moment. Now, what we can do about it is design these materials out or make a new battery that doesn’t need to be that dependant, for example. That work is being done, but it takes time.
The big issue here is dependency. Perhaps you could become independent in 20 years, but the vital question is what do you do in the coming two years? How do you maintain collaboration if you wish to separate in ten years, while during these next two years you still need to collaborate? We think it’s going to be very hard and many benefits from these flows will be at risk. There are always two-sided benefits. Of course, the global era of markets with this interconnection brought the largest reduction in global inequality we have ever seen. In the discussion, the point was raised that the poverty line might not be the correct line to follow anymore.
Practicality or pragmatism would suggest that no matter what we do, we need to find a new way to collaborate. Does this mean going bilateral rather than open market? Does it mean quid pro quo across certain regions or circumstances? I hope—and that’s one of the forks in the road in the new era—that we don’t end up in a completely uncollaborative structure that basically cuts the flows, and that the ties that bind us get cut in a way that impedes everybody’s lives and prosperity. The arrangements for that will have to be adjusted and therefore most multinational corporations (MNCs)—and a very large proportion of these global flows are driven by MNCs—are considering dual sourcing rather than concentrated sourcing.
One of the biggest problems that we have in these flows is that many of them are highly concentrated. For example, Europe gets a lot of gas from Russia. We have found that 50 percent of the flows are super concentrated, but two-thirds are by our own choice. An answer here could be dual sourcing. I think that is the space into which people will move and what we would hope is that we find pragmatic pathways to keep the interconnected world together.
Dharmendra Kanani: Judging by the conversations you had in Davos with chief executives and governments, do you think they’re having the right kinds of conversations? Do you see a shift in thinking—that Europe needs to take a different approach to competitiveness, investment, and innovation? Do you think that company CEOs want something different and are they articulate about it?
Sven Smit: I think we are in a learning moment. Let’s take MNCs. Many MNCs have made public announcements saying, “We will build a facility outside China,” for example, in Vietnam or India. The recipients are positioning themselves as the “China-plus-one” location. What people discover, however, is that you build the facility but the ecosystem is not there, so initially and maybe even substantially, the costs are higher. This is because we’ve historically put measures in place where the comparative advantage was the best (to use an economic term). People are learning that it’s not that easy. Here I am referring to global flow connections. Governments are realizing that, too. I would say we have pragmatism.
“Competitiveness” was also a big discussion point. I would say it’s probably even more relevant for Europe. Canada and the United States have a significant portion of energy materials. On that spectrum, Europe is poorer.
Then you also have competitiveness around the technology battle. We want to achieve an energy transition, and I think the answer for Europe will need to be that the framework by which we do things will have to include competitiveness. This could mean that the input costs for companies are not so prohibitive that they can’t compete in global markets, because we will still operate in global markets.
On the flip side, we also need to think about affordability for consumers and citizens. There’s a long list of issues within the environmental, social, and governance (ESG) goals and the Sustainable Development Goals, including the energy transition. We will have to find a solution that satisfies competitiveness and affordability. I believe this is where there is a change occurring in dialogue, because it’s becoming apparent that we have to address energy prices. The pinch point here is Europe, because the Middle East is experiencing a rich period at the moment with these energy prices.
Dharmendra Kanani: We also have to consider Europe’s emerging new industrial policy. We have not heard much about the manufacturing, digital, and employment bases in terms of the digital industrial strategy that’s required. Do you get a sense that we are thinking about how we pull some of these pieces together, so that Europe can do better in the coming 50 years than it has in the past 50 years—especially since it created the fourth largest trading bloc, but now it’s actually whimpering? What would your advice be to the European bloc?
Sven Smit: We had many discussions on European competitiveness. It’s rich territory—we want an energy transition, we want to have a competitive technology industry, and we want to have proper innovation. The question is whether the mechanism that we already have can support these goals. I’ll start with a data point that we wrote in our European competitiveness report—if you look at the profitability of European companies versus US companies, on average, US companies are far more profitable than European. And that’s after European companies spend two points less on R&D. We’d like more R&D, innovation, and that profitability gap becomes bigger. How are we going to we solve the problem? Are we doing it with incentives?
Do we solve it with a directive that says, “Thou shall do this no matter what the profitability consequences are,” or with a stick that says, “If you do this, this is what you’re going to pay,” or something else? Along that spectrum, there are differences between Europe and the United States. For example, the US Inflation Reduction Act is more on the incentives side, and when you give incentives, there is a rapid reaction. It it’s a carrot-and-stick situation, you get a defensive reaction. So we need to decide: do we see companies (which, by the way, produce 70 percent of the value added globally) as the solution to these problems? They almost have to be—and not just large companies; this applies to the small and medium-sized enterprises too. Europe needs to think very hard about how to get this right.
Dharmendra Kanani: On that note, what are your thoughts about the role of government vis-à-vis the private sector? You have spoken about the approaches that can be taken and the role that government and industry can play. Do we need more or less regulation? What’s your thinking about the role of the public and private sectors as we think about this new era? In light of what you have said about the different cycle we’re in, what would you say the European Union should do vis-à-vis the private sector?
Sven Smit: An element that I’m nearly certain will feature in the new era for Europe, is that not all of these issues can be solved by individual countries. Technology, infrastructure, and so on, are much more global and regional in nature. The other point is that these bigger issues are very complex system issues and not ones that a company alone can solve. That means that the intention to collaborate has to be a lot higher to find out what the right answer is and, then, in the right framework. I hope the framework will start with something like, “We think it’s possible to achieve sustainable and inclusive growth,” and that’s an “and,” not an “or”.’ We know that the more you grow, the more people have a chance to get a piece of the pie.
It’s slightly counterintuitive on the sustainability side because you would think that sustainability will go down if you do more, because you are achieving a better emissions’ footprint. The reality is that the burden to switch to renewable energies and a cleaner world, from a financing perspective, is so big that every point of growth creates more capacity to do the transition, instead of creating additional problems on top of the stack of problems we still need to solve. One thing that needs to be in policy frameworks is that if transitions are done in a way that is not affordable, the transition will become non-inclusive. High energy prices are terrible for impoverished people and for large swathes of the population. We will have to add this affordability point to the framework, which can only be achieved if companies add their productivity to the solutions.
My sense is that in the mix of what we do, we will have to spend more time achieving affordability before we scale, rather than to scale not so affordably and as a result become less competitive and enter into a negative spiral. I have a feeling we will have to reset that balance in the global debate, but even more so in Europe. We need to make constructs so that it is possible for European companies to be competitive. Europe is equally concentrated at country level, but if you look at the regional level, it’s fragmented. Scale matters in these big decisions and so we will have to find a way to scale. It’s complex because you get the questions about who wins, who loses, where does the headquarter go etcetera. But we will have to get to the place that allows us to achieve solutions. It means very tight regulation, but it should be done in a way that it lands in the right place and achieves the proper incentives so people will do the work. Otherwise, we will carry on discussing targets and the work will not happen.
Dharmendra Kanani: There are two big issues I would like to talk about. One is the role and purpose of money, and two, how we measure productivity. In your reports you’ve asked, “How do we come out of a period in which public taxpayers’ money is underwritten in society?” Holistically, for over 18 months in various parts, we have public debt at its highest and economists within governments thinking, “How am we going to square this circle because we have to make sure services are delivered but, on the other hand, we’ve got a massive debt?” So, do you just continue to print more money? What do we do about the money question?
Sven Smit: There are three thoughts here, and I will come at it from the microeconomic point of view, rather than the macro. You could make a point, some people will say, that the last period is modern monetary theory squared, because we were printing money and we had a lot of “loose” money. There was always a debate about whether the ’70s was a monetary issue—we just had too much money—or was it a supply issue? The answer is both. If you print a lot of money and you have no supply, the system can’t work. If you print money while there is supply, it can work. Let me give you an example that we all went through recently. I would say that putting a floor on the economy in the second quarter of 2020, when we didn’t know what was going on with COVID-19, was more than responsible because basically the supply was there but not the demand, and so we were not spending against a constraint.
I could make an argument that at later stages of this we knew the supply shortages were there. To then spend against a supply shortage, you get inflation. Now that inflation will help to debase the debt, but the issue is the pain distribution. You can talk long and hard about the level of debt, interest rates, and inflation. The reality is you can set them at different levels and the pain will go to different places. High inflation means that those who save experience pain, as well those who have small wages. High interest rates are maybe good for the savers, but bad for the people who need to buy a house. I could keep going but this, in the end, is also an equality debate. The one thing I know for sure is that productivity is going to be a medicine for all our predicaments. Why? Productivity gives us the growth that can cover the debt. If you grow, you’re solving the problem. I don’t expect we’ll ever pay down the debt; we will just debase the debt by growth.
Productivity will make things cheaper, which means that inflation goes down. Productivity will make things more affordable, which helps with the social contract at the bottom. Productivity will make it easier to deal with government deficits, and so forth. Productivity is always at the core of a healthy economy. I think we know from all the work that’s been done, productivity potential exists—to do twice as much, with the same amount of people, using forms of automation and AI. (One thing that surprised me at Davos was the talk about ChatGPT. We all talked about the standard issues of globalization, supply, on so on, but there were more conversations about ChatGPT). Productivity will have to be part of the bail out. But we have a productivity conundrum, which is that we can see all the benefits of automation everywhere except in the productivity statistics. That still needs to be worked out.
It does mean that you can’t spend money on productivity if you don’t get the proactivity energy to work and not constrain supply. If you release the brake at the money level, you also need to release the brake at the supply level. To me, that is the hard work.
Dharmendra Kanani: AI can potentially have the most disruptive influence on global economies, or have the most significant, positive impact. Do you think that it will require regulation?
Sven Smit: Yes, and that’s a fork in the road in the new era. The tech over the last three eras went from engineering post-war, to consumer electronics, to digital, and now we add AI, automation, and robotics at scale. We can deal with that in a way that will halve the number of people who have work and create high tension, or we can get twice the output with the same number of people in work, and the prosperity of the world will move on. That, of course, is the answer.
Dharmendra Kanani: You said that productivity matters, and you describe productivity as one of the most fundamental pillars of economic thinking and analysis, to a certain extent. We know it matters, but the past four years have taught us (or should have taught us) that we can’t take for granted what economic theory says because we are living in a new world. So how do you make sense of inequality? I’m enquiring that whether what you measure matters and what drives policies in governments, and where people decide where the pain is. Often, governments will say pain is required but we’ll protect the middle and the higher income earners, and the lower brackets will go through the pain or come out of it.
We know is that 60 percent of the global population currently is suffering much more than the other 40 percent because of where they live, where they work, and where they don’t work. Can you tell me a bit about whether the mantra of a free market and productivity is always going to be there, or could it be the basis for reducing the inequality gap? Could we have a different conversation about markets and money that addresses the world doing better; being happier, freer, and more peaceful if we had more inclusive growth?
Sven Smit: I think the stories are slightly different for the Western world and the emerging world, because of the poverty difference. We know that inequality in emerging markets has significantly changed, relative to the Western world. Growth will help, but it doesn’t change the inequality. However, growth will help all, and sustainability too, if it’s affordable. This affordability point is more fundamental. I see two metrics. You could say, “Let’s measure happiness,” but we need to have something a bit more tangible for which to work. The work we did on social contracts shows very clearly that, even while the bottom tier in the Western world has had a slightly higher income increase than the middle class, the middle class is squeezed on income while the bottom is squeezed on affordability. Their incomes don’t rise fast enough to keep up with price rises. This current inflation situation makes that worse.
What is it that they can’t participate in? They can’t participate in affordable housing, healthcare, and education of high quality. Affordability has to become part of the solution as a metric. Then the second way to measure that is to say, “What’s the income in different countries that doesn’t get you just to the poverty line,” which just means you have access to food most of the time. There’s good research that shows that people become empowered once they have an income level that is at the level of having food, having access to health, to education, and to affordable housing—as basic as they might all be in different countries. That level is not $1 a day (that we also want to move away from), but in poor countries it might be $10 or $12 to start with, and in richer countries it might be higher.
I don’t want to pick the number now; I want to discuss the concept because the research has shown that an empowered person can move on in society. A person who is only focusing on getting food and healthcare can’t get to education because they don’t have the time for it. It’s basic Maslow’s theory. Once you have achieved those lower levels, you can be empowered to start participating in society and enhance your education. It sounds quite economic, but we know that people who are empowered are happier.
Sven Smit: Okay, dear governments, if you have this many people coming into your country, you need to give them this much land at a reasonable price, otherwise they will not be part of affordable housing. Maybe a solution might be more in that area than a redistribution of money because that just raises the price of what is already in short supply. The affordability crisis might not get smaller if you just give people money for something that’s short. It’s almost the same as when we talk on the macro level. You can’t grow money if there is no supply, and we need to have affordable supply.
Dharmendra Kanani: Do you feel the empowerment gap would also incorporate the sustainability factor? There’s been a lot of discussion about how we make sure that the auditing frameworks for governments and the private sector have a sustainability aspect, in component or in fundamental look. Do you see the empowerment gap as part of that same narrative?
Sven Smit: Yes. We have a paper out on sustainable, inclusive growth, which shows the squaring of the circle. It depicts that you can have the growth, every point higher is better, and that requires productivity. You have to have sustainability but to achieve it, it has to be affordable, otherwise it’s non-inclusive and also large spots of the world can’t be involved in it. And to have inclusion, we have to address it as part of the empowerment gap, not the poverty line. If you look at it that way, empowerment might be a slightly bigger issue than sustainability, and they are both very big next to the growth that is needed to fund it all. We need to have a whole systems approach, not just individual issues. For example, we say, “Let’s solve sustainability, set targets; it doesn’t matter what it costs.” “Let’s solve empowerment, take the money there, but then kill the golden goose of growth.” “Let’s do growth and forget inclusion and sustainability.” None of those work. The world is a system and that’s the puzzle that government and society need to solve.
Dharmendra Kanani: When we think about the European Commission, there isn’t one person you could say who has economic growth in their job description, who would think, “What do I do about markets? What do I think about every day to help add value to member states?” Sven, imagine you’re in the room right now with that person, what are the couple of messages you’d say?
Sven Smit: The first is that perhaps we shouldn’t have one person, but rather that all the people should have the flipside of the coin. You can’t just put out the carrot and the stick and say, “Thou shalt not do that, or now do this,” and not have the consequences on growth and affordability in the room. I think it would detrimental to pursue a single issue at a target level without understanding the deeper system issues. Then maybe the sum total as a team could produce the growth. Maybe initially you would have to have a person in there who pulls it out and clarifies it. That person might look at sustainable, inclusive growth but if they don’t do it with affordability and with companies ensuring competitiveness, you’re basically going to throw out the baby with the bath water. That is what we need to prevent.
Dharmendra Kanani: Thank you, Sven, it has been a pleasure and illuminating.