Competitiveness: Complexity is the Key
Jennifer Blanke, Senior Economist, World Economic Forum & Professor Xavier Sala-I-Martin, Columbia University (Co-authors of the Forum’s Global Competitiveness Report 2007-2008)

In economics, things are usually more complex than they first appear. This is probably the most important lesson in economics … and the most widely ignored. After all, pundits, analysts and experts continue to offer simple formulas that are supposed to guarantee a country’s economic success: from debt relief to international aid, from undervalued exchange rates to government-led industrial policies, from more education to better infrastructure, from more public sector programs to less government intervention.

The origin of the problem is that, in order to focus on a particular factor, economists use models that purposely assume a world that is a lot simpler than reality: for example, when researchers study the effect of aid on economic development, they usually use a model in which many important factors (such as education or innovation) are purposely excluded; the only factor that matters is aid. Researchers don’t do this because they believe that only aid matters. They do it because it is easier to study economic phenomena in isolation. Naïve users of these simple models, however, will reach oversimplified conclusions and offer misleadingly straightforward magic formulas.

But most researchers are not naïve. Indeed, they know that their models are open-ended. That is, they understand that their theory and many other theories can be true at the same time: The fact that aid can affect growth does not mean that education or innovation are irrelevant. In fact, when researchers test their hypotheses with actual data, they always allow for multiple additional factors to matter.

Over the past three decades, the World Economic Forum has been undertaking the difficult task of analyzing and measuring the set of factors, policies and institutions that determine the level of productivity of a country for a large number of countries  a phenomenon that we call competitiveness. Understanding the efficiency by which economies transform their resources into useful outputs is important because this efficiency determines both the material well-being of their citizens and the rate of return of investments and, therefore, the potential growth rate of incomes.

Our index is built on three principles. The first principle is, of course, that competitiveness is complex. We capture this complexity by measuring a large number of factors that we group in 12 different areas: institutions, infrastructure, macroeconomic stability, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market sophistication, technological readiness, market size, business sophistication and innovation.

The second principle is that different factors affect different economies differently. The reason is that economies move through the process of economic development in stages and the nature of competitiveness moves with them. Advanced countries, for example, can only compete if they innovate or if they improve the degree of sophistication of their corporations. On the other hand, less developed countries may have to put more emphasis on basic factors such as infrastructure or public sector transparency.

The fact that advanced economies need to focus their attention on innovation and modernization of their business activities does not mean that they should ignore the institutional environment or the efficiency of the financial sector because many of the factors, institutions and policies that affect the level of their productivity are interrelated. The third principle is that many determinants of competitiveness are interconnected and tend to reinforce each other. For example, innovation is extremely difficult if the institutional environment does not guarantee intellectual property rights, cannot be performed in countries with a poorly educated and poorly trained labor force, and will never take place in economies with inefficient markets. Another example, a good educational system is of no use if students have no incentive to study because labor market opportunities after school are nil.

The World Economic Forum’s recently published Global Competitiveness Report evaluates the competitiveness of 131 countries using these three principles. We find that the most competitive economy in the world in 2007 is the United States followed by Switzerland, Denmark, Sweden, Germany and Finland. The United States gets its leadership position through a winning combination of highly sophisticated and innovative companies that operate in very efficient markets. This is buttressed by an excellent university system that works closely with business, a very flexible labor market and a financial sector that supplies the needed capital for risky innovative ventures. These strengths allow the United States to overcome weaknesses in its public institutions and its well known macroeconomic imbalances.

The leading northern European economies, on the other hand, offset the negative effects of their burdensome tax systems and their relatively inflexible labor markets through very efficient institutional environments, superior education systems, and sophisticated and innovative corporations (contrasting with their southern European counterparts who have equally burdensome tax systems and equally inflexible labor markets but inferior institutional frameworks, educational systems and innovative capacity).

Those who believe that the key to competitiveness is something as simple as the “size of the government” will be puzzled by our findings. After all, the United States has a very small government whereas the northern European economies that follow have relatively large public sectors. The evidence suggests that size alone does not really matter. In fact, it also suggests that no factor alone really matters. The central lesson is that for competitiveness, complexity is the key.