The City and the Digital Economy

FALL/WINTER 2000 STERNbusiness The City And The Digital Economy

The Rise of Silicon Alley Internet Business Models That Work The Brave New World of Telework Internet Shopping Estimates: Show us the Methodology! The Endurance of Brands: A History Lesson As the year 2000 races which teaches a financial toward a close, it is worth analysis of new economy looking back on the past companies and Data Mining decade. The year 1990 and Knowledge Systems, marked a nadir in the city’s which opens a new door into recent fortunes. The stock the consumer psyche gleaned market was stuck in neutral, from data related to behavior the real estate market was on the Internet. This fall, we mired in a slump, and jobs have introduced a new co- were leaving New York faster major in Entrepreneurship than Knick fans file out of and Innovation that will pre- Madison Square Garden when pare students to take an the home team is down 30 entrepreneurial role, whether points in the fourth quarter. in a startup firm or in an Such were the forces incubator within an estab- arrayed against the city that lished corporation. some began to question the Our ability to be in touch a letter fro m the long-term viability of our with the forces altering our dean economy. Of course, the economy can’t simply be doomsayers proved to be chalked up to geography, wrong. Indeed, New York although our location cer- proved to be one of the tainly helps. Rather, it’s as greatest beneficiaries of the much a matter of tempera- burgeoning digital economy. ment and worldview. We at And with the Dow near a the Stern School have always record high, unemployment prided ourselves on being part sliding to historical lows, and of the city, and thus part of the real estate market in the the world. Our campus is not stratosphere, New York is set off from the city by gates most definitely back. or walls. The heart of our Here at the Stern School campus – Washington we have literally been in the Square Park – is a public middle of it all. Throughout space. We are not only in the the 1990s, a new industry city, but of the city. STERNbusiness sprouted up, first to the The last decade has A publication of the Stern School of Business, New York University north of us, in the Flatiron brought tremendous changes District, and then to the to the campus and the city President, New York University ■ L. Jay Oliva south of us, around Wall we call home. The contents Dean, Stern School of Business ■ George Daly Street. Today, established of this issue of Chairman, Board of Overseers ■ William R. Berkley dot-coms and their younger STERNbusiness provide us Chairman Emeritus, Board of Overseers ■ Henry Kaufman sisters and brothers are tak- with a framework for under- Assistant Dean, Marketing and External Relations ■ Joanne Hvala ing root in every part of New standing how we got here, Editor, STERNbusiness ■ Daniel Gross York, from Long Island City, and where we’re going. Our Project Manager ■ Caren L. Piela Queens, to the western-most engaged – and wired – com- Design ■ Esposite Graphics, New Orleans reaches of Chelsea, from munity of scholars, faculty, 125th St. in Harlem to and students is looking for- Letters to the Editor may be sent to: Midtown office towers. ward to the coming decade. NYU Stern School of Business We’ve also been in the And we’ve got one of the Office of Public Affairs intellectual and strategic best seats in the house. 44 West Fourth Street, Suite 10-83 middle of this transforma- New York, NY 10012 tion. Stern has led the way http://www.stern.nyu.edu in developing courses related to the Internet and e-com- George Daly merce, such as FinDotCom, Dean contents FALL/WINTER 2000

The City and the New Economy

22 Forecasting Online Shopping by Joel Steckel

Cover and related articles illustrated by Dave Black 10 The Rise of 28 Stern Silicon Alley The Ultimate ChiefExecutive by Theresa K. Lant Capitalist Tool: Language Series by Michael Capek

Internet 38 Banking on 16 International Business Models 30 What History Financial Stability a Sternbusiness Interview Teaches Us about the by Paul Wachtel with Christopher Tucci Endurance of Brands Interviews with by Peter N. Golder Paolo Fresco, page 2 Blake Darcy, page 4 44 Endpaper by Daniel Gross 8 Location, Location, Location by Daniel Gross

18 The Brave 36 Supermarket New World of Checkout Roulette Telework by Larry White Illustrations by Dave Black, Tom Curry, by Roger Dunbar Robert O’Hair and and Ragu Garud Mike Caswell sternChiefExecutiveseries

Paolo Fresco is the chairman of Fiat, a diversified international automotive and industrial enterprise with 200,000 employees worldwide. A graduate of the University of Genoa in Italy, he practiced law and then joined GE’s Italian subsidiary in 1962. Over the next 36 years, he held a number of positions within GE, eventually becoming vice chairman and executive officer, a member of GE’s corporate executive office, and a member of GE’s board of directors. In 1998 he retired from GE and assumed his current role. PaoloFresco chairman Fiat ML: Welcome, Paolo, to the Things are fairly good in the DaimlerChrysler. When they portfolio and I saw a number of Stern School of Business. light truck business. If you look have a good year they will opportunities to become num- How’s business? at Fiat, you will see in general make five percent return on ber one or number two on a PF: Well, you know, 45 percent we find our specialization in sales. global basis. I believe that my of our business is automotive – smaller equipment – agricul- objective is to have a portfolio cars. Now, cars are picking up, ture, construction equipment, ML: Is that why you’re so of maybe six or seven or eight because we have a new prod- cars, or trucks. We are the cost eagerly apparently diversifying businesses where we have a uct that serves the low-end leaders. And we are doing very out of the automobile busi- leadership position. segment where we traditionally well. Now, unfortunately, in that ness? have been leaders in Europe area very often, the margins PF: Last year we spent about ML: Your operations are in and in the developing world. are a bit tighter. $10 billion in acquisitions – all many developing countries. Then all the other businesses outside of the automotive busi- Which of these many countries are doing well, or very well. We ML: Yes, but when you draw ness. And the principle reason do you think offer the best bought (U.S. agricultural up a bar chart showing the is that it is difficult to find an opportunities, the optimal equipment manufacturer) Case profit margins of, say General acquisition available in the opportunities for Fiat? during 1999. And today that Electric, at 18, 19 percent and automotive business. The real PF: Short term, our biggest portion is close to 20 percent you compare that with the total reason why, however, we are area will continue to be Latin of our total sales business. And Fiat, it looks like it’s unfair. strengthening these business- America. We are market lead- it is a real global company. The PF: I don’t think it’s Fiat, it’s the es is that I believe you have to ers particularly in Brazil, and market is very weak, particular- automotive business. You look be number one, number two or also in Argentina. If you look at ly in the States for agricultural at the results of Ford, GM, you have to do something the longer term, you have equipment. Toyota, Volkswagen, or about that. So I looked at my some two billion people that

2 Sternbusiness Marshall Loeb, the former managing editor of Money and Fortune, conducts a regular series of conversations with today’s leading chief executives on the Stern campus.

one day will need a car, if you know everything. And a lot of ference, again, is a systemic with this sort of thing? put together just India and people know very little and do difference. This country has a PF: Well, let me start with Fiat. China. So, obviously those two all the action. And the modern system that will favor entrepre- I thought I was working hard countries for the longer term way of working is spreading neurs. Venture capital is avail- when I was in GE. But in terms are extremely important. information. able. Until two or three years of hours of work, I work much If you had to take a percent- ago it was available three or harder in Fiat. I mean, I go in in ML: International trade is very age, you would see that four times as much as it is in the morning at eight o'clock important to you. Do you worry American companies have a Europe. Now last year I’ve just and at nine o'clock every- about perhaps a rise of protec- higher percentage of modern found out there's been catch- body's there, in the evening. I tionism in different parts of the companies versus European ing up. think that here (in the U.S.), world, and the anti-globaliza- companies. But when I went to people are better organized. tion movement? Fiat I found the same princi- PF: Yes, I do worry. I’ve seen ples, the same values – signs of anti-globalization, par- whether it’s creation of value, I thought I was working hard when I was ticularly in Europe. I didn’t see customer satisfaction, or in GE...I worked much harder in Fiat. it when I was living here. And I employee involvement – that I almost feel like the intelli- had in GE. Maybe I see more gentsia in Europe has been difference in the culture of the pretty leftist and want to have two countries: Anglo-Saxon ML: I came back last week So in, say ten hours a day of revenge against being proven versus Continental culture. I from the annual World work, they accomplish what wrong when they were sup- think the continental culture is Economic Forum meeting with you need twelve or thirteen or porting Communism. And if something about work being a firm impression that the fifteen hours of work in Europe. there is a chance to say capi- really punishment. (Laughter) Europeans are substantially The telephone system is better, talism does not work, they're all Well, think about when Adam behind the Americans in using the communications are better, very happy. and Eve were sent out from the the Internet for business and people are used to being Garden of Eden they were told, information technology. Do you crisper in meetings. I believe ML: Comment on what are you sinned and therefore agree? the biggest problem is govern- some of the things that you're going out and you're PF: I agree 100 percent and ment’s excessive regulation. I European business people going to earn your bread with my concern is that the think there are so many use- tend to do better than US busi- the sweat of your brow. Now Europeans are losing ground. less rules and nobody cancels ness people. And conversely, the Anglo-Saxon culture is – The Europeans are moving, but the rule because a new one what are some of the things work is the best way of self-ful- the Americans are moving so has been introduced. I remem- that American business people filling or manifesting yourself. rapidly, that rather than catch- ber when I was here and Jack may tend to do better than the And, you know, I always ing up at present, the gap, in Welch was complaining about Europeans? remember, in this country every my opinion, if anything, is the excessive number of rules PF: Rather than drawing dis- time that somebody asks widening. But, you know, I here. This is heaven. tinctions between the way the somebody else about his job, believe that that is not going to Europeans do business and the first thing they ask is, “Are last forever. European compa- ML: You work those long the way the Americans do you having fun?” I started to nies have a lot of highly trained hours. How do you bring bal- business you have to draw a say, “Are you having fun” in technologists, so there is no ance into your life? distinction between a modern Europe and people were look- reason why the same technolo- PF: Well, you go to the muse- way of doing business and an ing at me like I was crazy. gy should not be applied. um during the night. ancient, old fashioned way of (Laughter) No, listen, jokes doing business. And you have ML: Do you find that there is a ML: European industry is gen- apart. In Italy, we were trained examples of both on both spread of entrepreneurship in erally thought to be handi- to have a broader array of sides of the Atlantic. The Europe now? capped by very tough labor interests. You study art and you ancient way is highly hierarchi- PF: I think there are as many unions, by stern government study literature, you study his- cal. Very few people make all entrepreneurs in Europe as control, by high wages, and by tory and you do it very inten- the decisions and supposedly there are in the States. The dif- short hours. How do you cope cont’d. page 6

Sternbusiness 3 sternChiefExecutiveseries

Blake Darcy ceo DLJ Direct Blake Darcy is CEO of DLJ Direct, the online brokerage service of Donaldson, Lufkin, Jenrette Securities Corporation. He began his career as a retail broker for Lehman Brothers. In 1984, he joined DLJ, where he was soon chosen to form a new business unit at DLJ's Pershing Division. In 1988, he introduced DLJ Direct, originally called the PC Financial Network, one of the first providers of online discount brokerage services. Today, it has over 700,000 customer accounts and $14.2 billion in assets. In 1997, under Mr. Darcy's direction, DLJ Direct created a separate technology company, Onyx Technologies, that develops online solutions for financial organizations.

ML: Well, good afternoon. How an online brokerage system Interestingly, it was the day to have eight years of going did you get the idea for DLJ up. And they came to the of the crash when our first slow, to train people that could Direct and how did you man- Pershing Division of DLJ, meeting was due to be held do this sort of thing? age to start this company? because Pershing was known with Prodigy to get this project BD: You know, at the time it BD: The idea had come to us for having great brokerage started. And Prodigy called up seemed like it zoomed up. If through Prodigy. Prodigy at technology. at about 10:00 o'clock in the you're doing 50 trades a day that time was an IBM series So I was given the task of morning. I said, well, why don't and then you go to 200 trades, joint venture. They had building a business plan, to you call us in a couple of you feel like you just quadru- shopped around this idea, see whether it made any sense weeks. If we're still in business, pled everything. But in hind- doing online brokerage on their whatsoever to do this. I lis- maybe we can talk. I think we sight, nothing happened, really, service to a number of firms, tened to all the experts who were able to succeed early on until 1996, when the Internet including Charles Schwab and said it didn't make any sense. because we kept our costs low; came along. Fidelity. And at that point, prior And we said that we would do we kept very focused on what to the 1987 crash, nothing had it on a very low key basis, just we needed to do. And just ML: And how big now is the worked in the online world. to see if it would work. We got gradually, it began to take off. market? How many investors Schwab and Fidelity turned management approval. I think actually are online? them down. They weren't sure at that point it was about half a ML: In the early years, how did BD: I would say, probably about what they needed to do to get million dollars. your curve go? Did you have 30 percent of the transactions

4 Sternbusiness that are occurring right now are occurring online. So, my guess One of the great things about the Internet is it’s a great would be maybe 20 million households trade online. place for people to find out who’s adding value and who

isn’t adding value. ML: Does that mean that most of those get online with a conventional broker? that their brokerage revenues the personal finance publica- the Asian economies an awful BD: There are certain people will go down sharply and so will tions, the television shows, the lot more.” And the beauty of the who have transferred all their their profits? books, magazines – all of these Internet is going to be that assets online. So when you talk BD: Well that's where the broker things have just proliferated. information is going to be right to our customer base, there's has to really prove its value to And individuals are taking much there at your fingertips. about a third of them. Another the consumer. One of the great more of a personal interest in third break it up into multiple things about the Internet is it's a managing their own finances. ML: Will I be able to get infor- sort of online accounts. A lot of great place for people to find But I think at this point, there's mation only from your DLJ ana- people still like the comfort of out who's adding value, who still a lot of people who want to lysts or will I be able to get infor- having a full-service broker. isn't adding value. A Merrill give it to someone else. mation from Merrill Lynch ana- About 75 percent of the U.S. Lynch broker who has 600 lysts and other analysts as well? brokerage assets are still in full- accounts right now, may talk to ML: Tell us some of the BD: Certainly there are going service organizations. 20 of those accounts per day. changes and advances that we to be the proprietary studies. So With the Internet, if they use it can expect in the future. The at DLJ Direct, that's where you ML: Well I've often wondered effectively as a communication 18-month future, the five-year go to get your DLJ research. At what distinguishes your compa- vehicle, they can communicate future, and the far distant future. Merrill Lynch, you'll get your ny from a full-service broker. You with every single customer every BD: What you're going to see in Merrill Lynch information. But we appear to be doing just about day at any hour of the day by the next 18 months is this issue already have other third-party everything that a full-service bro- using customized mass e-mails. of advice online. More and providers of information on our ker does, but at a small fraction There are all sorts of ways of more people being able to do site, where companies are of the price. using the technology to make sophisticated asset allocation, aggregating other brokerage BD: Well, that's the idea. And the brokers more effective. The investment selection online. I firms' information. the idea is to try to find all the bottom line, the broker will only think you're going to see much points of value that a full-service keep those customers if they're more in the way of use of broad- ML: Who are your biggest com- firm has. We can do it at a frac- adding value by improving the band. I think you'll see a lot petitors, or your toughest com- tion of the cost, because we performance of the investor in more in audio-video. I think petitors? don't have the high cost distri- the marketplace. you're going to be able to go on- BD: Well, right now Schwab is bution network of brokers. And line and I think you're going to clearly the best competitor in a you can scale the technology ML: What percentage of be able to see analysts having lot of ways. They have been in fairly easily. You're going to see investors should deal substan- conference calls with corpora- the business longer. They con- that online firms look more and tially or wholly online? Fifty per- tions, and talking directly to tinue to re-invent themselves as more like the Merrill Lynches cent? Seventy percent? management. times change. Clearly the big and the Morgan Stanleys. And BD: I've always said it was But you look out five years danger in our field are the peo- the Morgan Stanleys and the probably 50 percent of the pop- from now. Right now, in the U.S., ple like Merrill Lynch and Merrill Lynches are going to ulation probably would do it. you basically invest in U.S. Morgan Stanley and even look more and more like the And that percentage would go securities and some ADRs in Goldman Sachs, as they come online firms. up over time, as more and more foreign companies. But in the in and bring a lot of the people become very comfort- future, I think you're going to be resources that they have as ML: But then how will the Merrill able managing their own investable to say, “You know what? I traditional investment banking Lynches and DLJs be able to ments. If you looked back 20 don't like the U.S. market any- firms online. survive? Presumably that means years ago versus now as far as more; I really think I like some of cont’d. page 7

Sternbusiness 5 Paolo Fresco, Cont’d. being good at what you're at protecting people who Q: Given the declining doing. I hate golf because I already have a job rather than birthrate, the aging population sively. So you come out from don't know how to play golf. helping people find a new job. – not only in Italy but in other this school system – you're We, at GE, 10 years ago countries in Europe – how more prepared to enjoy the ML: How's the Italian economy bought a government company much concern do you have cultural life. doing this year? in Italy. The best technical talent about that? But in terms of finding the PF: It's trailing the European in the world, the best product in PF: I think there are two sides balance, I think it's the same economy, and the European the world, yet they had 20 per- to this coin. Today I think that thing. My father was a hard economy is trailing the cent of the global market and there are people in their sixties worker. But you know, at six American economy. So it's the American competition had or their seventies who can o'clock he was home, seven below two percent growth this 60 percent. This government make important work contribu- company was staying away tions. So let's look at the posi- from increasing the volume tive side of that and enjoy it They told me, you have to make one because they were afraid they and applaud it. Then there is contribution to Fiat...you have to have would undertake obligations the fact that you have less and that would last forever. I think less working strength because fun at what you’re doing. we are making progress in Italy people do not have children and we have now created part- anymore. The birth rate is time work, which is acceptable, going down. I think that o'clock he was home. He came year, but there are some signs and temporary work. And this is inevitably, in Europe, this will home for lunch, had a nap, that it's picking up slightly. going to reduce unemployment. be taken care of by greater and went back to the office at immigration. three o'clock. And he was con- ML: What's the problem? Q: A lot of people when they sidered a hard worker. So now PF: Well, I would say, “What is think of Fiat, they think of it as Q: When you describe Fiat's we have a different situation. the key to the U.S. miracle?” an automotive company. What current international thrust, you People take off on Friday. I can must be the real question, would be the main forte of Fiat revert to talking about the auto have all kinds of work in the because you never had an in the twenty first century? business. Are you going to try world, I take off on Friday and economy growing four or five PF: For a corporation, I think, to expand all your other busi- come back on Sunday night. percent without inflation. My you have to always ask your- nesses into the rest of the So there are two days a week impression is that now the self, what is my key competen- world? that I don't work. growth in productivity is heavily cy? What am I good at? And PF: Yes. I start speaking of dependent on the use of infor- no doubt Fiat has developed Fiat and of the beauty of all its ML: Are the other people hav- mation technology. I think as over a century competencies diversification, and then my ing fun in your office? soon as there is a utilization of in metal mechanical work. And mind in some of the answers PF: They told me, you have to information technology in somehow related to transporta- goes back to automotives. Let make one contribution to Fiat, Europe, I think you’ll be able to tion. So you look at trucks, you me tell you that we are much and maybe to the Italian work- get similar growth. look at agricultural equipment. more diversified internationally ing culture: you have to have You look at all these things. I in the non-automotive business fun at what you're doing. Now, Q & A with Students like the idea of expanding and than we are in the automotive in order to have fun, you must having a portfolio of business- business. Our agricultural know how to do it well. When I Q: Is Europe making any es which are leaders on a equipment business is the best speak with students, I tell demonstrable progress at global basis, and having these global company in the world in them, think of making an reducing double digit unem- businesses integrating their this respect. We are from Asia investment in your future hap- ployment by having greater competencies and their to the United States to Latin piness, because if you just do freedom and flexibility in labor resources together. America, to Europe, all over the right work, the right prepa- markets? the world. ■ ration, you're going to be good PF: The answer is, very little, in what you're doing and there very little. And the problem is is nothing more enjoyable than that the whole system is geared

6 Sternbusiness sternChiefExecutiveseries

Blake Darcy, Cont’d. Q & A with Students high quality research and infor- partnered with a Japanese firm mation analysis. We're position- and were able to get out as the Of course we're fortunate in Q: I was curious what you ing our brand as a high-end/ first U.S. broker online in being part of DLJ. We have all thought about the viability of sophisticated, serious brand. Japan. They helped us from a those capabilities right now. doing IPOs online and eventu- And you've not seen us use a regulatory standpoint, under- ally even disintermediating the lot of humor. We're trying to tell standing who to talk to. They ML: Is there going to be a investment banks? people to take this seriously. understand the cultural differ- shake-out in this industry? This isn't a game. ences which we would have no BD: What you've seen in this BD: There have been a num- Everyone says brand is clue about. I mean they stage is a vast expansion ber of companies who have everything on the Internet. It showed me advertising. I said, because everyone's making started off saying, we're going isn't. Longer term, the ultimate that's absolutely horrible, dis- money and everyone's doing to make this a democratic winners will be the ones who gusting, I'd never use it here. well. And the market is allow- process. We're going to bring have the best service with the And they say it's great, and ing there to be lots of players. in the individual. We're going to best value. they're always right and I'm When you start to see a down- get rid of the intermediaries. You look at Amazon. How always wrong. turn, and it's got to be some- And yet, all of those compa- much advertising did Amazon do to create Amazon.com? W: Where does DLJ Direct Next to zero. It had a great expect its new customer Everyone says brand is everything on product, a great positioning growth to come from? the Internet. It isn’t. The ultimate win- right from the start. BD: We're always happy to ners will have the best service with Ultimately it will get back to take them from our competitors who has the best product and in the discount world. But I the best value. the best service, and the best think we're going to probably value point. take them more from the full- what of a prolonged down-turn, nies look very much like a tra- service environment to a very then you're going to start to ditional investment bank when M: I'm with the faculty in man- large degree. Because they see more in the way of consoli- all is said and done. Because agement. Schwab and DLJ have higher assets, they're dation. And you're going to see the services that an issuer have taken rather different more in line with what we are some of the people who have needs aren’t just pricing. The approaches to partnering in looking for. We grab our assets made a lot of money, saying, piece that's big has to do with the Japanese market. Given from Schwab, from Fidelity, “Time to sell out.” making sure everything is set the rate of resources that you from Merrill Lynch, from Smith with due diligence and after- need in every single national Barney. And we continue to ML: If you were just graduat- market coverage. So I don't market that you anticipate pen- have success against those ing from business school, and think any investment banking etrating, how are you going to companies. you were thinking of building a firm is going to get disinterme- go about entering these markets? When you look at the new career in your field, where diated. BD: We have taken the people coming online, most of would you go? approach where, in most mar- those people are coming right BD: I think it always comes Q: What do you think the DLJ kets, we will partner in a joint out of college or business down to: Pick a business that brand is, and is brand more or venture with someone who school. They don't have a lot of you're going to be passionate less important now with the really understands the local assets, so they're not neces- about. Pick a business that you online brokers? markets. We knew that we sarily who we're targeting. think has a great operating BD: DLJ Direct is a brand real- would not be able to enter the We're targeting people with model. Don't worry about mak- ly started back in late 1997, Japanese market very suc- $100,000.00 or more in ing a fast decision. Don't when we renamed it from PC cessfully unless we had a very investable assets. ■ worry about dropping out of Financial Network. And our strong partner who put huge school and giving it all up attempt is to attach it to the resources behind it. So, we For more information on this because it's a bubble. DLJ brand which stands for lecture series and others, go to: http://www.stern.nyu.edu/lectures

Sternbusiness 7 Location, Location, Location

By Daniel Gross

ne of the many moved the business far-reaching north to North Sioux promises of the City, South Dakota. O Internet is that The company made the global neural system a virtue of its of modems, servers and remote location, fiber-optic cable has lib- taking advantage of erated individuals from low labor and real- geographical shackles. estate costs to get a After all, the Internet leg up on competi- allows a store in New tors. But Gateway Britain, Connecticut, to quickly outgrew its sell books to customers prairie digs. By 1998, in Great Britain, a tour it had 14,000 em- guide in Nepal to pitch ployees and sales of customers in Nebraska, $7.5 billion. And its and a magazine editor founders realized that in a New York apart- this Fortune 500 ment building to swap company needed to files with a magazine be somewhere else designer in New Orleans. to attract seasoned Today, in theory, executives. So in participants in the digi- 1998, Gateway moved tal economy can do busi- its administrative ness from anywhere. But headquarters to San in the Information Age, Diego. many businesses are For an increasing finding that location not number of companies only still matters – it like Gateway, cities matters even more. Last fall, I spent California had rejuvenated the have become more appealing. some time at Lincoln-Mercury’s new organization. During the Old Economy recession of headquarters in Irvine, California. Personal-computer maker Gate- the 1990s, the downtown areas of The executives rhapsodized about way 2000 is the prototypical New New York, San Francisco, and Los how leaving their historic home of Economy company. Ted Waitt and Angeles were written off as obsolete Detroit and joining the burgeoning Mike Hammond started Gateway in ghost-towns. But in the past several car-design center in Southern 1985 in an Iowa farmhouse and years, each has come roaring back,

8 Sternbusiness creating hundreds of thousands of fronting the Internet. down for a chat with Christopher new jobs. And in an unexpected nitially, many observers felt the Tucci, the co-author of a new text- twist, cities like New York have growth of online commerce book on Internet business strategy become among the biggest benefici- I would be a threat to cities like (p. 16). He provides some sugges- aries of the digital economy. New York. After all, New York is, tions for considering what types of Many observers have noted and among other things, the retail capital companies will make it here, and chronicled the growth of New York’s of the world. Millions of shoppers which may not. Silicon Alley. As a result, local read- annually flood into the city’s depart- One of the downsides of the ers are probably conversant with the ment stores and boutiques in search rebirth of many American cities has “whos” and “wheres” of New York’s of bargains and hard-to-find goods. been the concurrent growth in traf- digital epicenter. But until now, The rise of online retailers threat- fic. In urban areas like Atlanta, Los nobody has attempted to account for ened to disintermediate stores, from Angeles, and Washington, and, yes, the “how” and “why.” And that Armani to Zegna. And analysts and New York, hour-long commutes have makes Theresa Lant’s piece on the researchers hastened to issue hyper- become commonplace. Many compa- rise of Silicon Alley (p. 9) a perfect bolic predictions. In his timely piece, nies have sought to battle the scourge centerpiece for this issue. Lant Joel Steckel (p. 22) looks into the of traffic by having employees work weaves together the trends in tech- origins of today’s wildly disparate from remote locations. But this poses nology, politics, and the local econo- predictions about e-commerce, and challenges. And as Roger Dunbar and my with the career arcs of individual (politely) asks forecasters to show us Ragu Garud note in their forward- players. The end result is a com- the methodology! looking essay (p. 18), this new mode pelling narrative that explains the These days, as online retail pio- of working – “telework” – promises to unexpected rise of a thriving and neers like eToys and Amazon.com transform corporate culture. prosperous Silicon Alley from the continue to pile up losses, e-tailing To a degree, all of us have gloom of the downtown recession of has fallen out of favor. The original become teleworkers. Cell phones, the the early 1990s. Internet business model of selling low- Internet, and wireless devices now ne of the trends that continues margin goods seems to be on the outs, link us to our offices, and to one to propel the digital economy at least temporarily. Online retailers another, regardless of our location. O forward has been the belated had also justified such aggressive As a result, executives in all types of but steady move by established firms spending as necessary to build a last- businesses are being forced to con- onto the Internet. Metropolitan areas ing brand. But it is important for sider, and reconsider, the physical have also benefited from this trend. investors to consider that brands may location of their headquarters. New York-based bookseller Barnes not always stand the test of time. In hus far, the digital economy & Noble, for example, begat New his useful study (p. 31), Peter Golder has been a boon to cities. I York-based online bookseller digs into history to suggest why some T believe it will continue to be. Barnesandnoble.com. Toys’r’Us, leading brands survive for decades These days, you can start and run a based in suburban New Jersey, and why others don’t. business anywhere. But if you want spawned Fort Lee, N.J.-based toys- Online retailers have been the enterprise to live to its full poten- rus.com. And it made perfect sense replaced in the media and investors’ tial, you might have to physically for Donaldson, Lufkin, & Jenrette imagination by digital newcomers move it to a place where it can tap to base its online offering, like business-to-business firms, or into the best resources: technologi- DLJDirect.com, in Jersey City and on-line application service providers. cal, financial and human. And today, New York. Marshall Loeb’s insightful And next year, the pages of Business the richest deposits of these resources interview with DLJDirect CEO Blake Week and Fortune will probably be typically can be found in large cities. Darcy (p. 4) brings to light the chal- filled with talk of entirely new modes lenges and opportunities established of doing business. That’s why we Wall Street firms face when con- thought it would be useful to sit DANIEL GROSS is editor of STERNbusiness.

Sternbusiness 9 THE CITY AND THE DIGITAL ECONOMY

10 Sternbusiness The creation of

Manhattan’s $17 billion

Internet and New Media

industry was neither

inevitable nor an

accident. Theresa Lant

introduces us to the people

and forces that paved

New York’s streets with

entrepreneurial gold.

By Theresa K. Lant ILLUSTRATIONS BY DAVE BLACK BY DAVE ILLUSTRATIONS Sternbusiness 11 THE CITY AND THE DIGITAL ECONOMY

t was happening before the dot-com fever of 1999 shed light on the rise of Silicon Alley. and the April 2000 crash. Before anyone had heard What makes systems adaptive and complex? First, of Doubleclick or Jupiter Communications; before these systems have a property called aggregation. This I Razorfish was a multinational firm. In the mid- means that complex large-scale behaviors can emerge 1990s, a new industry was emerging in the lofts and offi- from the aggregate interactions of less complex agents. cer towers of downtown Manhattan. Of course, the larg- For example, the interactions of firms in the U.S. in the er world didn’t notice Silicon Alley until it had created aggregate result in the overall characteristics of the U.S. 250,000 full time jobs, revenues of $17 billion, and economy. An emergent aggregate property of the U.S. thousands of new business entities. But once venture economy is the gross domestic product. capital money started moving into the city in 1998, and Aggregate properties are the result of nonlinear the bull market triggered a rash of local dot-com IPOs in interactions among agents. So, for example, the pool of 1999, New York was on the New Economy map. And venture capital (VC) available to new firms in New York while many area firms have suffered in the recent cor- City is not just the sum of VC1 + VC2 + …VCn. Rather, rection, Silicon Alley is still a remarkably vital force. the decisions of venture capitalists to consider New York Why did Silicon Alley arise in Manhattan in the late firms and the amount they will invest is influenced by, 1990s? among other things, what other VCs are doing. Thus, VC There are compelling academic theories that account spending in NYC is the multiplicative interaction of dis- for the emergence of regional “hot spots.” Economists tinct variables, not the sum. note the proximity to resources and customers. Complex systems also require inputs of energy and Sociologists delve into regional cultures of entrepreneur- resources like cash, human effort, and raw materials. ship. But while these analytical tools can explain the The emergence of Silicon Alley depended on significant effort by individuals and the organizations The creation of hundreds of Internet- they created. As the tireless work of early related companies in a few square miles “evangelists” helped legitimize New York as a new media center, interest and resource of lower Manhattan was neither foreordained flows from consulting firms, law firms, and nor inevitable. venture capitalists followed. Once such resource flows interact, a complex system existence of regional clusters of similar firms, they neg- will often exhibit positive feedback effects, in which, for lect the complex dynamics that give rise to regional clus- example, investments in dot-coms produce ever more ters and their idiosyncratic characteristics. investment in dot-coms. My research focuses on how managers make sense of inally, complex systems are made up of different their “economic” world, and how this sense-making types of actors. The pioneers in Silicon Alley influences decisions about how to go about their busi- came from a wide variety of professional back- ness. In recent years, of course, a large number of people F grounds and industries, including advertising, in my NYU neighborhood seemed to be starting Internet- graphic design, publishing, digital technology, software related businesses. So I began to wonder why such clus- development, visual and performing arts, and journal- tering would occur when the businesses in question were, ism. As these people interacted, professional boundaries by definition, not constrained by geography. and definitions defined by traditional media and tradi- My conclusion? The creation of hundreds of tional industries began to fall away. Internet-related companies in a few square miles of lower Manhattan was neither foreordained nor inevitable. New York in the 90’s Rather, it was the product of a unique set of events and The stock market “crash” of October 19, 1987 individual characters, and the intricate, non-linear inter- plunged New York City, especially lower Manhattan, into actions between them. Indeed, Silicon Alley is what we a recession that lasted into the mid 1990s. In 1990, call a “complex adaptive system.” Understanding the Drexel Burnham Lambert went bankrupt, leaving its components and dynamics of such a system can help cavernous office building at 55 Broad Street empty. After

12 Sternbusiness Drexel’s departure, the Rudin family, which owns extensive properties in New York, discov- ered that the cost to modernize the building couldn’t be justified given the economic conditions at that time. By 1994, after all, the office vacancy rate in downtown Manhattan was 30 percent, with 25 million square feet lying fal- low. When Stern moved into its new quarters at 44 W. 4th street, the university was unable to find a buyer or tenant for its old offices at Nichols and Merrill Hall on Trinity Place. Fifty- five Broad Street remained empty for six years. n December 1994, Mayor Rudolph Guiliani introduced the Lower Manhattan Revitalization Plan. He formed a task force, I called the New York Information Technology District Commission (NYITDC), which included Deputy Mayor Fran Reiter, Con Edison, the New York City Partnership, the Alliance for Downtown New York, KPMG Peat Marwick, IBM, NYNEX, Brooklyn Polytechnic University, and Columbia University. The NYITDC conducted a study that rec- ommended the formation of a technology district and center in downtown Manhattan. The technology center required a building in which to showcase New York information technology. Regional economics, technological develop- In June 1995, Carl Weisbrod of the Alliance for ments, human resource characteristics, and Downtown New York called Bill Rudin and individual initiatives helped created an opportu- offered to do the project at 55 Broad St. Mr. Rudin, the scion of a powerful real nity space for Silicon Alley to emerge. estate family, was aware of the new media start-ups that were locating around the Flatiron and which new media start-ups thrived. But they did not Soho neighborhoods. The Rudins accepted the risky “cause” Silicon Alley to happen. For during the same project, which was announced in June 1995. It was not time, regional economics, technological developments, easy convincing new media tenants to move downtown. human resource characteristics, and individual initia- Most new media entrepreneurs viewed the Wall Street tives helped created an opportunity space for Silicon area as an unhip, starched-shirt ghost town. Nonetheless, Alley to emerge. new tenants were attracted by the cheap rents and excel- In the mid-1990s, there were significant numbers of lent wiring. In September 1995, online CD retailer N2K unemployed New Yorkers. Among their ranks were (now part of CDNow) became the first tenant at the new graphic artists from advertising firms as well as Wall Technology Center. And in October of 1995, Governor Street traders. Coincidentally, the Internet became acces- Pataki signed legislation for the Mayor’s plan in front of sible to large numbers of people with the evolution of the 55 Broad Street. The event, broadcast over the Internet, hypertext markup protocol, the tcp/ip protocol, and the was the first ever cyber-bill-signing. Web browser. In fact, Alice O’Rourke, the current presi- Local government and commercial property owners dent of the New York New Media Association, has sug- thus played a key role in creating the environment in gested that the preponderance of smart, creative, unem-

Sternbusiness 13 THE CITY AND THE DIGITAL ECONOMY

to 7,000 individuals representing 2,500 companies. NYNMA members work in such diverse fields as broadcasting and publishing, web site development, design, entertainment, education, and professional and financial services. Their firms range from one-person shops to Fortune 500 corporations. NYNMA formalized networking among new media participants by holding regular Cybersuds meetings at clubs such as the Roxy. Another group in the emerging community has been called the “Early True Believers.” They are, in New York magazine’s words, “the closest thing Silicon Alley has to an indigenous population…they’re brainy math-and-music types with impressive liberal-arts educa- tions, mostly upper-crust backgrounds, and birthdays in or around 1966.” Throughout the early and mid-1990s, this informal group held social networking events called “CyberSlacker parties.” Many of the friends and attendees went on to found Silicon Alley stalwarts such as MTVi, Feed, Razorfish, Pseudo.com, StockObjects, Nerve, and the Silicon Alley Reporter. Beyond social networking, these actors moved quickly to spread the word about the possibilities for new media business and about how and why New York was both different and “the place to be” Silicon Alley’s indigenous population? Brainy math- for new media. They sponsored and and-music types with impressive liberal-arts educa- organized “events” – conferences, semi- nars, parties, etc. that would draw both tions, mostly upper-crust backgrounds, and birthdays “true believers” and newcomers together. in or around 1966. In March 1997, the Global Community Sandbox opened at 55 Broad Street. The ployed people in New York apartments, with desktop image of a sandbox is that of converging and shifting and computers, phones, and time on their hands, helped trig- blurred boundaries among its components. This exem- ger the city’s dot-com boom. plifies the interaction among actors with different back- In 1994, Brian Horey, a local venture capitalist, grounds that meet at the Sandbox to share ideas. These founded the New York New Media Association interactions are also exemplified by advertisements for (NYNMA), a non-profit trade association – so that “we the Silicon Alley 1998 conference, which looks like a could stop flying to California every other week to do Venn diagram illustrating the interaction of different business.” Since 1994, NYNMA’s membership has grown “sets” of people and businesses.

14 Sternbusiness second vehicle was online publication and com- The manner in which information is communicated munication. In 1995, two entrepreneurs started by the media also influences the perceived “identity” of @NY – The New York Internet Newsletter, an Silicon Alley. Much of what is written focuses on what A online publication dedicated to news about makes New York new media distinctive. As the editor of Silicon Alley (atnewyork.com). It is important to note the the Silicon Alley Reporter put it in 1998: lexicon used in New York to refer to Internet based busi- “New York and Los Angeles are becoming the driv- nesses. New media (not e-commerce) means exactly that ing force in the Internet Industry for a very simple rea- – new forms of media. New York is a major media cen- son: They are the talent and media capitals of the world. ter, with a large number of media firms, ranging across Sure, content and community are going to take longer to the realms of publishing, entertainment, journalism, play out than the tools to make them. Right now, L.A. broadcasting, cable, and advertising. Thus, many of the and NYC may be on the bottom of the food chain by the first start-up businesses were media firms. This was par- Red Herring’s and Upside’s standards because we don’t ticularly significant for the growth of Silicon Alley because media itself is a vehicle for New York and Los Angeles are becoming the communication and information diffusion. driving force in the Internet Industry for a very Silicon Alley pioneers also used tradi- simple reason: they are the talent and media tional media to spread the word about new capitals of the world. media. In 1996, a local entrepreneur started a print publication to cover both business and social have the immediate revenues that make myopic venture aspects of Silicon Alley, called the Silicon Alley Reporter, capitalists drool. But there’s no place on the food chain which moved to nationwide distribution in mid-1998. In I’d rather be. Would you rather have made the camera December 1996, another pair of entrepreneurs launched that shot Citizen Kane, or make Citizen Kane?” a second print publication devoted to Silicon Alley, called Silicon Alley is unique, but the fundamental process- the AlleyCat News. es that have facilitated its emergence are not. Because Old and new media played an important role in facil- Silicon Alley is so close to home, it is a good place to start itating the legitimacy of Silicon Alley. New media adver- to learn about complex adaptive systems. The regional tising abounds on the pages of old media print publica- agglomeration we now know of as Silicon Alley is the tions and old broadcast media. Opinion leaders in the aggregate outcome of a wide variety of events and media also use their positions to shape the cognitive actions over the course of several years. The actors understanding of the emerging field. Each publication involved have been diverse, and yet have engaged in not only provides information, but also contributes extensive interaction and collaboration. The outcomes of frames of reference, interpretations, and evaluations. these interactions have been difficult to predict, howev- The information they provide is not “value-free.” The er. What if Brian Horey had not founded the New York choice of what appears in the publications and what does New Media Association? What if legislation to create a not, in and of itself, frames what is important and what business development district in downtown Manhattan is not. had not passed? What if New York had not been in a For example, many New York publications began to recession when the World Wide Web came online? What publish lists of Silicon Alley firms or people that they if local entrepreneurs had not gone out of their way to identified as being important or deserving of media evangelize the potential of New York new media? It is attention. Crain’s New York Business in 1997 published impossible to know what would be the same and what its “Top Cats” list of “players shaping Silicon Alley.” would be different. This is a key feature of complex @NY created the @NewYork.com 25, a group of compa- adaptive systems. Small changes in variables, even ener- nies “who distinguished themselves in some important or gy and enthusiasm, can yield large differences in the way innovative way in 1997.” The attention and legitimacy a system evolves. produced by these lists can be very powerful. And the publications have a great deal of discretion in deciding THERESA K. LANT is associate professor of management and whom to reward with such recognition. organizational behavior at Stern.

Sternbusiness 15 THE CITY AND THE DIGITAL ECONOMY

Internet Business Models an Interview with Christopher Tucci

Thus far, Internet companies have been known primarily for racking up astonishing losses. But some Internet business models will work, explains Christopher Tucci, co-author of a new textbook on Internet business strategy.

Christopher Tucci, assistant professor of Entrepreneurship SB: Many Silicon Alley companies either depend on and Innovation at Stern, is co-author, with Allan Afuah of advertising or are involved in creating online advertising. the University of Michigan, of a new textbook: Internet How does this conclusion impact them? Business Models and Strategies: Text and Cases. CT: Online advertising is growing and is going to be Published in August by Irwin/McGraw-Hill, the book is around forever. So New York companies like the first geared toward MBA students that deals with DoubleClick, or 24/7, which are providing the technolo- Internet strategy. Last summer, STERNbusiness sat down gy and service for advertisers, will be around. The com- with Tucci to discuss the lessons that can be learned from panies that are depending on advertising as their sole the last several tumultuous years in e-business. source of revenue will have a tougher time. If you look at the long-term trend, advertising prices have been declin- SB: How did you get interested in the business aspects ing for the last few years. And the massive companies – of the Internet? the AOLs and Yahoos – are always going to get a premi- CT: I’ve been working on Internet topics since I gradu- um. But as soon as you drop off the list of the top few ated from college, about twenty years ago. I started doing companies, it becomes very difficult to attract significant work in computer science research in California, and was advertising revenues. very involved in working on Internet protocols. Then I got interested in the business aspects of how companies SB: Can we say that some of the models or modes of manage their research and development. And for my dis- doing business on the Internet do work? Or don’t work? sertation, in 1995-1996, I did one of the first academic CT: It’s still too early. In the book, we describe ten dif- surveys conducted over the Internet. ferent segments. Some of them are getting harder and harder to enter. If I had to pick one that was going to be SB: What surprising or important conclusions emerge a tough business, it would be content aggregation. It’s from these cases? not that there’s no way to make money in it, it is just that CT: First, it turns out that customer value is one of the probably only the top companies are going to make most important components of the business model. money in the long run. Companies that deal in financial Whoever you are, you’ve got to find something that cus- content and entertainment, and those that successfully tomers love. A second point is, that if you’re a start-up, add value are going to be around for a long time. you should take care to locate your place in the value network. Managers shouldn’t just jump in and say that SB: Amazon.com set the tone for retailers: Offer low mar- because the business-to-business area is exploding they’re gins and great customer service, and spend lots on market- going to start a B-to-B exchange. A third point is that the ing. For a few years, the market seemed willing to ignore critical piece is sources of revenue. At this point, it is the fact that these goals created huge losses. Now, however, becoming obvious that the advertising model is not going many e-tailers are suffering, financially and in the stock- to really sustain a huge number of businesses out there. market. Has that business model been discredited?

16 Sternbusiness CT: A lot of this was actually driven by AOL. Many ness, iBaby, about a year after acquiring it. Are such years ago, when AOL blanketed the country with disks, abrupt changes warning signs or good signs? critics said it was a lousy business plan, and they were CT: iVillage is a great case, because they have this com- spending too much on marketing. But in the meantime, munity, which is a real thing. But the problem is that its they were building this powerful network. And in the original advertising-supported model was not sustainable end, they ended up making money and doing quite well. by itself. So they were looking for additional revenue That encouraged people to think, I don’t want to miss sources. E-commerce was one idea. But competencies like out on an opportunity like that. So retailers that can order fulfillment and order taking were not necessarily build a network of reliable and loyal users might be in what they knew best. And there’s nothing wrong with the game. As far as I’m concerned, the pure low-margin thinking something through, and saying, this isn’t going retailer that is simply going to compete on cost will have down the right road. The case also really shows the ten- great difficulty. I think you’re going to see a lot of the sion that once you’ve built up a community, it’s a sen- smaller on-line retailers come and go. sitive issue how you manage these other revenue sources. How that transition is managed is what’s going SB: Aside from technology, what will help com- to separate the successes from the has-beens. panies become profitable? CT: What a lot of people have shown is that SB: These days, the market isn’t the complementary assets, when they are placing a particularly high value tightly held, can be a very powerful tool. on New York-based community Complementary assets could be your logis- Internet companies like iVillage and tics, or your customer base, your brand or TheGlobe.com. Are there other ways for corporate reputation, or your existing their managers to monetize their assets? network of bricks-and-mortar stores. CT: It is possible that someone else Pure online companies must spend might be able to monetize them better loads of money to build such comple- than they will. We’ve seen cases where mentary assets. Compare Barnes & large companies buy small companies with Noble and Borders’ reaction to little or no revenues but large numbers of Amazon. Barnes & Noble really users because they think they can monetize embraced the Internet, and began competing them. America Online paid $300 million for head-to-head by setting up barnesandnoble.com as ICQ, the company that created instant mes- a separate entity. The company has used its complemen- saging technology. Excite@home acquired tary assets – namely its brand name and network of Bluemountain.com, a free online greeting card company, stores – to help grow business at barnesandnoble.com. which also had no revenues. The time to make these The two firms share advertising and promotions, and transitions is when you’re flying high. If you wait too you can return books ordered from barnesandnoble.com long, once the market sort of starts souring on your busi- at stores. ness plan, it becomes more difficult.

SB: Internet companies seem to change their business plans SB: Some of the cases in your textbook are written by rather frequently. Is that a danger sign? students. How would you rate their level of interest in CT: It is true that online business plans evolve more and sophistication about how these companies work? quickly than in the manufacturing economy. When you CT: It’s phenomenal. The cases are very high quality. We build a plant, you have huge sunk costs, so once you’ve have a case series here in the Berkley Center, and we’re got it, you’re sort of stuck with it and you want to milk making these cases that the students have written – I it in some ways. Online companies are less wedded to probably have 40 or 50 – available for use inside and their original plans. Yahoo is an example of a company outside Stern. And it gives us a nice base of up-to-date that has changed its value proposition quite a bit in high-tech cases. terms of the specific products and services that it offers. And they’re making money on things other than adver- More information can be found at: http://www.mhhe. tising, such as auctions. com/catalogs/0072397241.mhtml

SB: One of the cases deals with iVillage, the New York- CHRISTOPHER TUCCI is assistant professor of entrepreneurship, based network of women’s sites. The company recently innovation, & operations management at Stern. announced it was getting out of its online retailing busi-

Sternbusiness 17 THE CITY AND THE DIGITAL ECONOMY

Telecommuting? That’s so last century. The explosion in bandwidth and networking power is forcing companies to adapt to a new mode of managing workers in remote locations.

The Brave New World of

The advent of portable computing and the Internet has rapidly opened up possibilities for a new mode of work: teleworking. This new workstyle is more flexible and dynamic than telecommuting, which has typically simply meant working from home. Under telework, employees are based wherever their work happens to be. But the growth of telework is a double-edged sword. The upside? Employees are able to work from their cars, hotels, or airplanes, and out of other firm’s By Roger Dunbar and offices, and from their homes, and on weekends and at night. The downside? Raghu Garud Employees may be expected to work from their cars, hotels, or airplanes, and out of other firm’s offices, and from their homes, and on weekends and at nights. Telework presents challenges to both management and workers, and their relations with one another. After all, most corporate work cultures are designed to support face-to-face work activities at the office. And while some employees find the teleworking notion natural and attractive, others find the idea of working continually untethered and off-site disconcerting. Under the right circumstances, of course, telework can lead to that great desideratum: improved quality of life. And yet some employees will fret about the meaning of corporate membership if they have no physical corporate office they can call their own. Telework also terrifies some managers. After all, how do you motivate and supervise employees you rarely see?

18 Sternbusiness But the local laborers, accustomed to working at their own rhythms, chafed at the new behavioral con- straints. Mr. Wedgwood’s response would have made Chainsaw Al Dunlap proud. He imposed stiff fines for transgressions and created a supervisory career structure that rewarded those who followed the rules with easier work and higher pay. Eventually, Mr. Wedgwood attracted a work force willing to play by his rules. The new work culture was epitomized by the idea: “You are paid to do, not to think.” Such managerial impo- sitions curtailed human creativity. But they also harnessed machine productivity and forged a new industrial culture in the 19th century. Encouraged by productivity gains, the architects of industrializa- tion continued to explore how a work logic based on ever more refined divisions of labor could further increase productivity. Eventually, much mass production work ILLUSTRATION BY DAVE BLACK became completely mean- ingless to the workers and anaging in the culture of telework requires many viewed it as exploitative. executives and workers alike to cast off long- The mass-production culture bore fruit: think Henry M held beliefs and adopt new ones. For tele- Ford’s Model T. But it also wrought strikes, violence, and work, by its nature, transforms the way a company lives sabotage. The crisis it imposed ultimately shifted power and breathes. It alters the very genetic make-up of an from management to labor unions, and required man- organization. Rather than being stable and revolving agers to reconsider the meaning of work. In response, a around the workplace, telework is highly dynamic and new management culture slowly emerged based on the centers around the work people do. notion that more meaningful work experiences would Wrenching a company around to accommodate tele- improve work performance. This led to recommenda- work is a process – more like turning around a battleship tions that increased worker participation and to exten- than clicking a mouse. It takes time. And throughout his- sive redesign of factories and offices. tory, changes in corporate culture have rarely come easi- The advent of information technologies in the late ly or without pain. 20th century has set the stage for the next round of cul- Back in the 1760s, Josiah Wedgwood tried to bring tural change. In the past, managers and entrepreneurs the techniques of mass production to his pottery factory. sought to boost efficiency by manipulating structural

Sternbusiness 19 THE CITY AND THE DIGITAL ECONOMY

designs – devising a better assembly line or installing air- a shared identity based on daily personal contact. It is conditioning. But telework technologies extend the solid. You can see, touch, and feel it. As a result, it is more human mind – they liberate rather than limit or con- likely to produce an enduring organizational identity. strain thoughts and ideas. As a result, the great work- The telework culture, by contrast, is built upon the place slogan of the 21st century may be: “You are paid ground of individuals with computers working intensive- both to think and to do.” ly on assigned tasks. It’s more amorphous. The values, omputers – and the networks that link them – norms, behaviors, and symbols that it forms around are have changed the very locus and mode of work. associated with ongoing computer work performance. The Internet allows people to be in constant In a teleworking culture, employees interact different- C contact with others who think in different ly with one another. And that changes everything. ways. And as new information becomes available, they may Indeed, the use of e-mail – simple as it may sound – think about work matters differently. Historically, the con- becomes an enormously important component of culture. tent of a work culture has been centered on specific tasks. As any computer user knows, chatting by e-mail is far In the wired economy, however, participants continually different than talking in person. E-mail is far more dynam- renegotiate and redefine the system of meaning – the very ic than real conversation. It requires high user involve- nature of work. As a result, telework tends to evolve and ment and interaction, but is also easy to use. It takes little change quickly in unexpected ways. effort to turn on a computer and send an e-mail – to one Indeed, telework makes it more difficult to identify person or to forty – and there is no need to be physically and define corporate cultures. Generally, organizations and temporally co-located with others. Electronic and have relatively identifiable, phone messages await teleworkers, which allows tele- stable cultures. The mem- workers to be truly distributed over time and space. Telework techniques bers share norms, beliefs, Teleworkers tend to rely on e-mail to communicate extend the human mind and behaviors that develop with one another. As a result, the overall emerging net- – they liberate rather over time as a result of work content – the overarching conversation among face-to-face interaction employees – reflects a combination of individual user ini- than limit or constrain and shared experiences. In tiatives acting in conjunction with other interactions. A thoughts and ideas. many instances, managers person might send an e-mail that contains a link to a lay down the infrastructure website, or an attached file, or a photograph. A second of corporate culture. person can pass the message – or part of it – along to one When they introduce person, or to an entire group. In this way, the content of telework, managers must be aware of the way it can the conversation is continually being influenced but affect corporate culture. If the organization portrays the never controlled by individual teleworkers. arrangements simply as a cost-reduction measure, the Teleworkers’ culture – their values, norms and beliefs telecommuting assignments may involve routine work. – are continually emerging through a constant process of Technology may be used simply to send and return negotiation among the members of open and burgeoning assignments. Those who continue to work in the office e-mail networks. Telework culture is thus composed of are likely to feel they have a preferred status while those the partial and temporary set of agreements members working outside are likely to feel they have been trans- reach about a network’s current values, norms, and formed into a source of cheap, out-sourced labor. If tele- beliefs. It offers a common ground to foster interactions workers view the firm’s actions as isolating, alienating, among the various team members involved in a particu- exploitative, and devoid of human sensitivity, an lar project. By using e-mail, groups of workers can easi- unhealthy culture will develop. ly add members. This attribute generates an acceptance In contrast, if the organization makes telecommuting and expectation of fluid memberships. assignments with the intent of developing the firm’s orous boundaries are a corollary to fluid mem- human capital faster, telecommuters may be seen to be bership. Members can jump in and out of chat- among the privileged elite. And as teleworkers anticipate rooms after they have made their contributions. and enjoy their relative independence and flexibility, P And at any point in time, teleworkers may in fact they may feel empowered and develop unique cultures be members of several groups. A chief financial officer supportive of their work activities. may simultaneously be teleworking with a company’s A teleworking company will differ, by its very nature, treasury staff on the budget and sitting in on a branding from a traditional organization company. Organization strategy meeting. Consequently, teleworkers’ experiences culture is built upon the ground of specified locations, from one work group impact processes in other groups. determined tasks and bounded social units. Members build The same individual may be running one task group and

20 Sternbusiness merely observing another. Best practices gleaned from one porate networks. As situations arose, they sought help group may be tried out in another. And so the culture from across the company. Members of Verifone who had changes yet again. worked at other corporations were frequently astounded E-mail also generates content in its very use. As tele- at the response speed created by these arrangements. workers exchange messages, information about their inter- But the speed also generated tension and misunder- actions and relationship is recorded. And since these infor- standings. And it quickly became apparent that face-to- mation threads are frequently accessible, the e-mail record face interactions were necessary to complement e-mail becomes a trace of evolving understandings, with people messages. As a result, one third of Verifone’s employees applying their own perspectives and interpretations. were always on the road having “off-line” meetings. This mode of working can have its downsides. At In traditional groups, indi- some point, most networks need to develop ways to sum- viduals are likely to identify marize, simplify, and clarify the understandings they strongly with specific group As the numbers of have accumulated. This task becomes more difficult in a values. In telework groups, people involved in a telework culture. And as the numbers of people involved where employees are likely to conversation in a conversation expands, the whole process can become be members of more than one overwhelming: a Tower of E-Babel. Norms of interaction, practice community at the expands, the whole designed to maintain work focus and control, may over- same time, employees can shift process can become load. These norms may include rules for how and when their identification from one overwhelming: to respond to e-mails, the topics that may be raised in a group to another depending particular group, membership issues, or the use of sig- upon the specific group that A Tower of E-Babel. nals to communicate message urgency. They may also they are operating in at any include cultural understandings as to when to send an e- particular time. So instead of mail, or when to phone. Or when a face-to-face meeting regarding themselves as mem- might be in order. bers of stable organizations, workers will see themselves as ven as norms evolve, there is still no possibility affiliates of several constantly evolving entities. that a stable cultural state will emerge. In the past, executives and experts viewed culture as Consider what happens when a new member is stable content. But like evolution itself, telework culture E added to an ongoing e-mail exchange network. is a process always in-the-making. Every day, individu- The new member can get up to speed by examining the als with different interpretive schemes show up for work records and asking questions of clarification as needed. – wherever that may be – and negotiate the meanings But once this happens, she will immediately begin to add associated with the information they exchange. her own perspective and insight to the conversation. And that’s not the only tension created by the growth How do collective values shape these fluid processes? of telework. In centered organizations, there is often In traditional work groups, values – think quality, excel- widespread agreement about the norms of interaction. lence, diversity – are often considered to be stable. But But as organizations grow more decentralized, interac- the members of a telework group are often not sure what tion norms become subject to continuing negotiation, is going to emerge from their efforts. So they only evolve and conflicts between member beliefs, organization to an understanding of what is not acceptable to the col- norms, and even its values may emerge. lective based on what is inviolate at an individual level. Given such tensions, managers seeking to institute a This issue is apparent in the way Hatim Tyabji, the new culture may face the same type of resistance that Mr. CEO of Verifone, Hewlett-Packard’s e-payment solutions Wedgwood did back in the 1960s. But the modern-day unit, governed his virtual enterprise. In defining his process is likely to give rise to new challenges. Instead of organization culture, Mr. Tyabji suggested that Verifone inviting the crisis of alienation and meaninglessness that would “create and lead the transaction automation mass production brought, telework may spawn bound- industry worldwide,” and his firm would be close to cus- arylessness and burnout. In our 24x7 world, after all, tomers and respond quickly to their needs. distinctions between work and play inevitably blur. And To achieve these broad goals, Verifone mobilized that may yet prove to be the Internet’s great contribution many cross-functional teams, many of which had mem- to commercial culture. bers in different locations relying on e-mail. While team tasks were defined, the methods by which they would achieve those tasks were usually left undefined. Members ROGER DUNBAR is professor of management and organizational relied on each other’s ideas to determine what should be behavior at Stern. RAGHU GARUD is associate professor of manage- done. Teams posted both progress and problems on cor- ment and organizational behavior at Stern.

Sternbusiness 21 THE CITY AND THE DIGITAL ECONOMY

Stormy Weather? The Art and Science of

By Joel Steckel

Readers of both the popular and trade press are regularly

bombarded with high expectations for online consumer shop-

ping and buying. For as they seek publicity, research suppliers

rush to outdo one another by broadcasting key optimistic find-

ings. Forrester Research predicts that by 2004, 49 million U.S.

households will spend $184 billion dollars online. e-Marketer

predicts 67.2 million Americans will purchase goods and serv-

ices on the Internet by 2002. Jupiter Communications foresees

that 85 million Americans will spend $78 billion online in 2003. ILLUSTRATIONS BY DAVE BLACK

22 Sternbusiness Sternbusiness 23 THE CITY AND THE DIGITAL ECONOMY

n addition to being large – as a reference point, assumptions. Methodologies, data, and assumptions can Forrester estimated that just 17 million households vary in numerous ways. bought online in 1999 – online shopping estimates Judgmental methods – like expert judgment – are I and forecasts vary greatly. The Boston Consulting probably the most common forecasting methods in use Group estimates that 1999 U.S. consumer online rev- today. Experts know a tremendous amount about a spe- enues totaled $36 billion. But the Direct Marketing cific market and bring all their cognitive resources to Association pegged the same quantity at about 11 per- bear on the problem at hand. Of course, each expert has cent of that total: $3.9 billion. an idiosyncratic set of experiences and attitudes. One Why do the forecasts of different research vendors may be more familiar with online book sales; another vary so much? And what must happen in the business may be more familiar with online travel. One may have and consumer environment for these extraordinary a tendency towards optimism; another has a tendency growth projections to be realized? towards pessimism. (Viewers of financial news networks Some of my recent research has been directed at like CNBC will recognize certain pundits as congenital answering these two questions. I’ve found that variation bulls or as perpetual bears.) As such, comparing the in forecasts can be attributed to variations in the news releases of different online experts can be akin to approaches used to obtain them. However, analyzing comparing e-apples and e-oranges. these differences is very difficult, since suppliers do not any market analyses are made via customer always provide details about how they obtained their surveys. These surveys are centered on a ques- forecasts. Furthermore, I believe that the extraordinary tion of the form “Do you intend to….?” While growth projections cannot simply be achieved with a M it is likely that a plurality or majority of peo- continuation of existing trends. ple responding in a positive manner to such a question is indicative of a bright future for the concept, research has Why do the forecasts of different research shown that people are notoriously bad at predicting their vendors vary so much? own future behavior. So when research suppliers use Analysts produce forecasts by applying a specific intentions data to make precise forecasts, they are likely methodology (or a group of methodologies) to a set of overestimating true results. data under a certain set of Time series analysis involves the extrapolation of historical data. However, forecasting The wildly optimistic the adoption of a phenomenon as new as online shopping is very dif- online shopping fore- ficult because historical data are very sparse. casts probably Causal methods express demand as a function of a set of do not take potential causal factors. Under into account these methods, data are plugged into statistical procedures, which the impending produces a forecasting model. Such a model can then be used to plateaus of PC forecast demand if the future values of the causal factors are either and Internet usage. known or could be forecasted in another way. Obviously, different methodologies can lead to different forecasts.

24 Sternbusiness In addition, practitioners employing different meth- A significant feature of odologies may use different means of processing online buying is that it data. After all, research suppliers generally do not is contingent on other open their methodologies to public scrutiny, present- innovations. One ing another problem for objective analysts. Some cannot buy online may provide a flavor in without being online. their web sites and promo- tional literature. For example, Forrester describes its methodology as being based on interviews with consumers and business execu- any tives. eMarketer claims to enter data from a wide variety forecast to be of published, publicly available sources into a propri- credible, the methodolo- etary aggregation model. Other companies, including the gies, data, and assumptions behind Gartner Group’s DataQuest division, are much more it must be beyond reproach. Unfortunately, clients and secretive. Repeated telephone calls to Gartner failed to investors have not made these firms accountable. produce an informative response. nsatisfied with the forecasts provided by the These companies argue that their competitive advan- usual suppliers, I decided to develop model- tage depends on their methodologies remaining propri- based five-year “forecasts” of online shopping etary. This is unfortunate, for it is impossible to evaluate and buying. My forecasts are not based on a forecast without knowing the methodology and any U what people say they will do or on some secret assumptions it harbors in detail. Even those companies proprietary model. Rather, I applied standard time-series- that hint at their procedures do not give sufficient detail. based marketing methodology to U.S. Census data and Forrester does not explain how it arrives at a projection survey data collected from people who describe what of $184 billion spent online in 2004. e-Marketer does not they have already done. post its proprietary formula. Gartner tells us nothing. I further focused on forecasting the number of people Do companies need to keep their methodologies con- participating in online shopping, as opposed to sales rev- fidential to be credible? Not really. Even if a methodolo- enues, for two reasons. First, sales revenues comprise the gy were to be completely revealed, a competitor would number of people and how much they spend. By focus- still need the raw data used by the research supplier in ing on a simpler construct – the number of people – I order to duplicate the supplier’s forecasts. Research sup- have a better chance at success. Second, marketing pliers can produce proprietary forecasts by maintaining scholars have a standard time series-oriented technology proprietary data. for forecasting the number of people who have adopted There’s another reason why suppliers should explain an innovation: diffusion models. their methodologies more fully. Most suppliers have an Diffusion models produce a lifecycle curve for a partic- economic interest in making optimistic forecasts. These ular innovation – be it the microwave oven, the cellular firms all either sell other research or provide consulting phone, or the Internet. The premise behind these models is services to Internet commerce companies. Forecasts of that an innovation is adopted by a small, select group of huge volume and high growth not only attract attention, adopters in the population based on mass media commu- they may recruit new players into Internet commerce and nications. These adopters, called innovators, then influ- hence increase the universe of potential clients. But for ence others to adopt via word-of-mouth. As time goes on,

Sternbusiness 25 THE CITY AND THE DIGITAL ECONOMY

and more people adopt the innovation, all non-adopters are subject to the same type of word of mouth. This process continues until all members of the population who will eventually adopt the innovation have done so. significant feature of online buying is that it is contingent on other innovations. One cannot buy online without being online. A Furthermore – recent technological developments notwithstanding – one generally cannot have access to the Internet without having a personal computer (PC). The diffusion approach allows for interrelated innovations. The models I developed allow for each of the variables – PC access, Internet access, and online I have a challenge for research shopping – to impact and to be impacted by each other. The data I used come from two sources. The U.S. suppliers whose projections are Census Bureau captures data on PC and Internet access. even more optimistic than mine: (See: www.census.gov) A private Internet marketing “Show me the methodology!” research firm, Cyber Dialogue, provided data on PC access, Internet access, and online shopping. Cyber ing. But my number significantly lags the Gartner Group Dialogue’s methodology, in contrast to other suppliers, is estimate that online purchasing will rise from $20.5 bil- described in complete detail on its web site (www.cyber- lion in 1999 to $147 billion in 2003 – a 600 percent dialogue.com). It involves multiple, random-digit-dialed increase in four years! surveys per year. As such, the company surveys both The third conclusion – that Internet and PC penetra- users and non-users of the Internet. Its data on PC access tion may be plateauing – is very informative with respect and Internet access are remarkably consistent with those to the future of online shopping. For without a corre- of the Census Bureau. sponding increase in PC and Internet users, the growth in So what did I find? Well, my study produces the fol- the number of online shoppers is limited. The Census lowing generalizations: Bureau data are very clear on this. The number of new 1. By the year 2004, at least 60 percent of those U.S. PC and Internet users each year is now decreasing. The residents having access to PCs will have bought over the Census Bureau estimated that in September 1999, 59 Internet. million Americans used the Internet at work or at home. 2. Online consumer purchasing in the U.S. will grow ot surprisingly, other research suppliers have about 1/3 over the next year or two and 20 percent for a published substantially higher estimates. year or two after that. This amounts to a 150 to 200 per- Nielsen/Netratings estimated that 118.4 mil- cent increase in the number of online buyers within five lion Americans had Internet access in years. N December 1999. This figure seems unusually 3. Personal computer and Internet access are high. And a search of Nua Internet Survey’s collection of approaching plateaus in the United States. “How Many Online?” studies confirms that the top five 4. Within five years, 90 percent of the population estimates all belong to Nielsen subdivisions. The vast with PC access will have Internet access as well. majority of estimates are in fact much lower – in the 50- The first generalization above suggests that more and 75 million range. more Internet users will use the medium for shopping. The second generalization suggests that this growth will Can the Optimistic Forecasts be Achieved? indeed be considerable. It is in line with Forrester’s pro- The wildly optimistic online shopping forecasts, like jected growth for the number of households participat- those of the Gartner Group, probably do not take into

26 Sternbusiness account the impending plateaus of PC Look. It’s likely that both they and I are wrong. That’s and Internet usage. Many in the indus- the nature of the forecasting game. But executives and try simply take for granted the continued analysts need to know which e-commerce forecasts are galloping growth of Internet access. For the most reasonable to use for business planning. And example, Nielsen/Netratings last December the reasonability of any forecast depends on the credibil- claimed that between October 1999 and November ity of its assumptions, integrity of the data, and sound- 1999 the number of Americans with Internet access ness of the methodology used. rose a stunning 5.4 million. But a recent Cyber Dialogue I’ve posted my major assumptions and the details of report found that one third of U.S. adults believe they my methodology on Stern’s web site – at www.stern. have no need at all for the Internet, and that a significant nyu.edu/Faculty/workingpapers/papers/steckel2000. number (estimated at 27.7 million) have tried the Anyone who finds my assumptions and/or methodology Internet and found they have no use for it. The Census unreasonable is free to reject my forecast. Bureau data support this latter assertion. ut the usual suppliers provide no such oppor- So if the optimistic forecasts are to be achieved, some- tunity. What is their methodology? Do they thing must change in the pattern of Internet access. project increased purchasing per customer? If Possibilities include: so, how much? Will Internet access trends Everyone who purchases over the Internet does B revert from declining growth rates to increas- ALL of his or her buying online; ing ones? And if so, will they come through a medium Some discontinuity has to occur to expand the pop- other than the PC? ulation that has Internet access; or The suppliers of the data consumed so willingly by the A vehicle other than the PC will have to be used to media and the business community do not attempt to access the Internet. answer such questions. They provide a number and a The first of these possibilities is very unlikely. After mysterious black box, and ask us to take their results on all, there are a significant number of goods that con- faith. And they are slow to alter their projections. In sumers must experience before they buy them; tailored response to questions from a Wall Street Journal reporter, clothing, fresh fruit, and antique furniture will be very the Gartner Group indicated that it was lowering its online difficult to sell over the Internet. The second possibility shopping revenue forecast by about 35 percent through would require the Internet to penetrate the lower income 2003 because research had revealed an unanticipated strata of society. Thus far, however, the lower cost of pullback in venture-capital funding for Internet retailers. computers and free-PC model have yet to accomplish The Wall Street Journal article appeared on May 25, that goal. Finally, firms like Nokia are forecasting that 2000. Yet on September 15, 2000, Gartner still displayed five years from now, most Internet access will take place its original optimistic forecast on its web site. through handheld devices, such as the Palm Pilot or cell The Internet has empowered consumers of everything phones. The question remains as to whether such devel- from airline tickets to stocks by improving disclosure. opments will expand the Internet user base or simply Today, an immense amount of previously hard-to-get shift usage from one medium to another. (I believe the information on everything from corporate finance to latter is more likely.) government operations is now available gratis on the Internet. And with every passing day, more data is avail- A Challenge to Research Suppliers able to businesses and consumers. Indeed, the more one crunches the numbers, the more Given these developments, it’s more than ironic that difficult it becomes to square the sunny projections of some of the biggest boosters of e-commerce continue to research suppliers with more objective analysis. So I have operate behind a cloak of secrecy. a challenge for research suppliers, such as the Gartner JOEL H. STECKEL is chairman of the marketing department at Group, whose projections are even more optimistic than Stern. He acknowledges the assistance of Jill Grummert of Cyber Dialogue, mine: “Show Me the Methodology!” Inc., and of Stern Professors Yannis Bakos, Sergio Meza, and Lee Sproull.

Sternbusiness 27 LANGUAGETHE ULTIMATE CAPITALIST TOOL: What’s the ultimate capitalist tool? Some executives say it’s the Internet. Others place their faith in junk bonds. For the privileged few, it’s a Gulfstream V jet. All are important. But Michael Capek says the real answer is something we all can afford: language.

anguage con- anywhere else. By the mid- stitutes the 1980s, Japanese car man- foundation of ufacturers had captured a human inter- big chunk of the American Laction and advance- car market. Having taken ment. It is the medi- their cue from American um in which we quality guru W. Edwards exist, survive, and Deming, they developed thrive. It is what systems of building cars of has allowed us in of superior quality. the space of a few Indeed, it was reported thousand years to at the time that the travel from margin- Japanese had fundamen- al nomadic exis- tally redefined and expand- tences to the moon. It ed the concept of quality. In is the means by which Japanese atarimae no we get the useful hinshitsu means ordi- material trapped in nary quality, quality of a our heads into the type that is “taken for minds of others. granted.” The new, expanded In today’s business concept, called miryokuteki na culture, effective communica- hinshitsu, translates into “things tion skills are regarded as a sine qua non gone right” – indicating a breadth and depth of for success. But comparatively few people real- quality beyond what the consumer expects or can even ize that language remains, at root, a tool. Indeed, language imagine. One of the reasons Japan produced cars of superi- is as critical a prop for road warriors and global executives or quality has to do with language. For the Japanese today as jawbones, flints, and wooden clubs were to our less- miryokuteki na hinshitsu constituted reality, and it found evolved ancestors eons ago. embodiment in Toyotas and Hondas. Language is the bridge between material fact and mental Most of us are comfortable with the thought that lan- abstraction. But it’s even more powerful than that. As guage is a means of communication. But we are less aware management guru Peter Senge has written, “the alternative to that language is our primary tool for representing reality to seeing language as describing an independent reality is to rec- ourselves and to others. It enables us to suspend our ognize the power of language – to bring forth new realities.” thoughts in air or capture them on paper, or on a computer In fact, reality shows up in language before it shows up screen, or store them on a hard drive, so that our thinking

28 Sternbusiness can be seen, examined, and modified. And in a very real their roles have undergone a fundamental change.” sense, business is language. Business is analyzed and talked Similarly, GE’s Jack Welch used the phrase “boundaryless about in language, business takes place in language, and corporation” to help legitimize what he saw as the essential virtually all breakdowns in business are either breakdowns egalitarian nature of organizational success. in communication or are accompanied by breakdowns in Because our core vocabulary has multiple meanings, communication. Recognizing this seemingly innocuous pre- there is always a certain amount of slippage between how sumption is important because it enables a different we perceive things and represent them to ourselves, conversation about business and business and how we are able to describe those problems. And it leads us to the conclu- Words things to others. Thoughtful, intelligent sion that the very language we use do not contain meaning employees can be communicating at can profoundly influence outcomes. their best, but a company may or example, there at all. Rather, words have continue to lose market share. are times when Why? Part of the reason may be articulating a sin- meaning attributed to them a gap between perception and gle phrase can by people. Many successful reality, a failure of language. produce dramat- Consider one of the most ic results. When business leaders seem to grasp frequently used terms in busi- Ffamed banker John Reed first ness: problem. The process of arrived at what was then First intuitively that one of the identifying problems sounds National City Bank, the most important things simple. But as every businessper- Operating Group, one of the son knows, gaining consensus bank’s six divisions, was experienc- they manage is about exactly what constitutes a ing breakdowns of a magnitude that problem – or ‘the’ problem – can be a threatened the entire entity. At the time, the meaning. challenging undertaking. We can point to, Operating Group was viewed simply as a mechani- see, and sit on a chair. And even when chairs are not cal support function for the customer contact offices. physically present we have no difficulty communicating Reed, who would later rise to become CEO of Citicorp, about them. But we normally cannot ‘see’ a problem. A was not the first to view the Operating Group as an inde- problem is an abstraction from the outset, and herein lies pendent, high-volume production operation. But he was the part of the difficulty. In fact, ‘problem definition’ has first to insist on calling it a “factory – which designed and become an industry. Consulting firms make millions by tak- controlled its own processes and products in the style of a ing on this process for client companies. At a time when manufacturing organization.” This ‘naming’ allowed some- many industries are undergoing profound change and new thing quite remarkable to happen. Once that fundamental industries are developing willy-nilly, the ‘sense-making’ shift in perception took hold, the bank installed the appro- ability of managers is all the more critical. priate personnel – professional production management – he other major barrier limiting our ability to use and they managed to resolve the systemic difficulties that language effectively to achieve business goals is had plagued the Operating Group. The point here is that the the tendency to believe that our perceptions are a importance of language in business goes beyond good com- T description of what reality actually is. Indeed, the munication skills. It goes to the heart of understanding your trick to communicating effectively is to distinguish what we business and what makes it work. are getting from outside versus what we are getting from Using language as an effective business tool is compli- inside our heads. This is a prerequisite for then being able cated by the fact that words are not like Morse Code, in to put into words the ‘meaning’ of what is going on exter- which there is a fixed meaning for each symbol. In fact, nally, in front of our eyes. words do not contain meaning at all. Rather, words have To be sure, this process is among the most complex and meaning attributed to them by people. Many successful least understood of all human activities. But by becoming business leaders seem to grasp intuitively that one of the aware of the tool-like nature of language, we can become most important things they manage is meaning. Part of Jan more aware of our capacity to create meaning and to lever- Carlzon’s success in turning around the airline SAS was his age our ability to manage effectively, as well. emphasis on front-line workers – those who keep business More information available at: http://www.stern.nyu. customers happy. Early on he declared that henceforth they edu/~mcapek/mginglng.html would be known as managers: “It may seem like a mere word game but I use the term to remind my staff – and per- MICHAEL CAPEK is clinical associate professor of manage- haps mostly those at upper levels of the old pyramid – that ment communication at Stern.

Sternbusiness 29 30 Sternbusiness "History is bunk" – Henry Ford

In general, most marketing experts have agreed with Ford’s conclusion. While some researchers have advocated using historical or longitudinal approaches to study marketing phenomena, others have dismissed the vast field of history as inherently subjective and hopelessly unscientific.

Brand New or Brand Old? What history

believe the his- teaches us about the cluded that “even when torical method looking at prolonged is well suited to periods of time, market address strate- shares tend to be in a gic issues in endurance long-run equilibrium Imarketing. After all, position.” it’s an endeavor in of brands But there’s a prob- which relationships lem with these asser- must be examined By Peter N. Golder tions. The first two over a long period. cited above seem to be And I have found it to drawn from a 1983 be of particular use in Advertising Age study. asking the question: The Advertising Age How stable are the market shares of leaders in 1923 were still the market study claims to show that long-term leading brands over prolonged peri- leaders in 1983, sixty years later.” success is due to well-managed pro- ods? Based on these assertions, main- motions and contemporary graphic Research has found evidence of taining market leadership must be presentations. Makes sense. But my strong and stable product-preference surprisingly common since over 75 investigation into the data used in patterns due to product differentia- percent of leaders maintained their that study leads me to quite a differ- tion advantages of established brands. leadership for at least 60 years. More ent conclusion. Gregory Carpenter and Kent recently, the concept of stable or sta- he Advertising Age results relied Nakamoto in 1989 reported that tionary market shares has been found on a book published in 1923 by “leading brands outsell their rivals for to be an empirical generalization. T two New York University pro- years and sometimes decades.” And Based on a database of over 400 prior fessors, George Burton Hotchkiss and Philip Kotler in 1997 found that “19 analyses, Marnik DeKimpe and Richard B. Franken, entitled The out of 25 companies who were market Dominique Hanssens in 1995 con- Leadership of Advertised Brands.

Sternbusiness 31 Brand Endurance

Table 1 is the proper estimate of long-term leadership? And how stable are the Sample of Leading Brands in 1923 and 1997 market shares of leading brands over Product Category 1923 Leaders 1997 Leaders prolonged periods? By comparing the leading brands Single Dominant Brand in 1923 (well-known categories) in 1923 with the leading brands Cleanser Old Dutch (744) Comet, Soft Scrub, Ajax today in all 100 categories, I have Chewing Gum Wrigley (664), Adams (97) Wrigley’s, Bubble Yum, Bubblicious determined that the actual percent- Motorcycles Indian (564), Harley-Davidson (156) Harley-Davidson, Honda, Kawasaki age of former leaders that have Single Dominant Brand in 1923 (less well-known categories) maintained leadership is actually far lower. In addition, I’ve been able to 5-Cent Mint Candies Life-Savers (436) Breath-Savers, Tic Tac, Certs consider the market share stability of Peanut Butter Beech-Nut (435), Heinz (140) Jif, Skippy, Peter Pan leading brands over this period. Razors Gillette (396), Gem (87), Gillette, Bic, Schick Ever Ready (50) First, however, we have to go back to the original data. The NYU Single Leading Brand in 1923 professors collected data in 1920 Soft Drinks Coca-Cola(353), Cliquot Club(85) Coca-Cola, Pepsi, and 1921 from 512 males and 512 Bevo (75), Hires (51) Dr.Pepper/Cadbury females at a representative sample of Coffee Arbuckle’s Yuban (224), Folger’s, Maxwell House, Hills Bros. U.S. colleges. Most were in the White House (100), Hotel Astor (56) Northeast and Mid-Atlantic states, George Washington (55) with some colleges from the South, Laundry Soap Fels Naptha (192), Octagon (93) Tide, Cheer, Wisk Kirkman (83), Ivory (82) Midwest, and West included as well. Babbitts (51), Crystal White (51) Subjects were given a list of 100 categories and asked to write the brand Brands Sharing Leadership in 1923 or manufacturer they first thought of Typewriters Underwood (394), Remington (265) Smith Corona, Brother, Lexmark for each category. The analysis of Oliver (100), Corona (53) these data considers all brands men- Cigarettes Camel (256), Fatima (156) Marlboro, Winston. Newport tioned by at least 50 people. The Pall Mall (90), Murad (72) Lucky Strike (64) only exceptions are four categories where the leading brand is included Hosiery Holeproof (180), Onyx (156) L’Eggs, Hanes, No Nonsense Phoenix (66), Luxite (60) even though it was mentioned by fewer than 50 people. Leading Brands in 1923 do not have Pronounced Leadership he data collected in 1997 Shoes Douglas (146), Walkover (120) Nike, Reebok are the leading brands in Hanan (52) T each category based on Candy Huyler’s (144), Loft (94) Hershey, M&M/Mars, Nestle market share. Data sources used to Page & Shaw (91), Whitman (89) compile this include Gale’s Market Jelly or Jam Heinz (62) Smucker’s, Welch’s, Kraft Share Reporter, Simmon’s Study of Media and Markets, trade publica- A fresh look at the book reveals that covered 100 categories, not 25. tions, and multiple sources refer- the commonly referenced data that Advertising Age plainly chose the enced in the Business Periodicals “19 out of 25” market leaders main- sample of 25 selectively to demon- Index, Readers’ Guide to Periodical tained their leadership for at least 60 strate long-term leadership. Literature and Lexis-Nexis. Reports years is based on a biased sample of Given that this conclusion is mis- of market share are primarily based companies. The original 1923 study leading, the questions remain: What on 1996 sales.

32 Sternbusiness Table 2 Table 3 Long-Term Success Rate of 1923 Comparison of Starting and Ending Market Share Positions Market Leaders Ending (1997) Starting (1923) Later Market Share Rank Sample Size No. 1 No. 2 No. 3 Top 5 Top 10 >10 Failed Current Knowledge New Findings Number 1 Brand 97 23% 8% 9% 8% 7% 16% 28% (based on biased (based on com- Group 1 19 42% 5% 11% 5% 5% 5% 26% 1983 sample) plete 1997 sample) Group 2 11 18% 18% 18% 9% 9% 0% 27% Group 3 25 24% 8% 12% 12% 8% 20% 16% Number 1 76% 23% Group 4 15 13% 7% 7% 20% 13% 20% 20% Number 2 16% 8% Group 5 27 15% 7% 4% 0% 4% 26% 44% Number 3 4% 9% Number 2 Brand 70 11% 9% 3% 4% 9% 26% 39% Top 5 4% 8% Number 3 Brand 43 5% 7% 2% 5% 9% 14% 58% Top 10 0% 7% Number 4 Brand 26 4% 4% 4% 4% 8% 42% 35% Below 10 0% 16% Number 5 Brand 12 0% 0% 25% 0% 17% 42% 17% Number 6 Brand 5 0% 0% 0% 0% 20% 20% 60% Failed 0% 28% Number 7 Brand 1 0% 0% 0% 0% 0% 0% 100% After investigating these 100 categories, five no longer seem relevant Table 4 for today’s consumers. Independent Comparison of Starting and Ending Market Share Positions for Durable Goods Ending (1997) Starting (1923) public reports of market share were available for 85 percent of the Sample Size No. 1 No. 2 No. 3 Top 5 Top 10 > 10 Failed Number 1 Brand 45 16% 4% 13% 7% 2% 16% 42% remaining categories. Market shares Number 2 Brand 28 11% 7% 0% 0% 11% 25% 46% for the remaining categories are esti- Number 3 Brand 17 6% 6% 0% 6% 6% 6% 71% mated based on (i) company reports Number 4 Brand 8 13% 0% 13% 13% 13% 38% 13% Number 5 Brand 4 0% 0% 50% 0% 25% 0% 25% and (ii) visits to multiple stores in Number 6 Brand 2 0% 0% 0% 0% 0% 0% 100% New York City and Los Angeles. Number 7 Brand 1 0% 0% 0% 0% 0% 0% 100% Table 1 presents a sample of the 100 categories and the leading Table 5 brands in 1923 and 1997. These 15 Comparison of Starting and Ending Market Share Positions for Non-durable Goods categories are grouped according to a Ending (1997) Starting (1923) classification from the 1923 study. Sample Size No. 1 No. 2 No. 3 Top 5 Top 10 > 10 Failed The numbers in parentheses beside Number 1 Brand 51 29% 10% 6% 10% 12% 18% 16% the 1923 leaders are the number of Number 2 Brand 41 10% 10% 5% 7% 7% 27% 34% Number 3 Brand 25 4% 8% 4% 0% 12% 20% 52% respondents mentioning that brand. Number 4 Brand 17 0% 6% 0% 0% 6% 47% 41% Table 2 compares marketing’s Number 5 Brand 7 0% 0% 14% 0% 0% 71% 14% current knowledge (which is based Number 6 Brand 2 0% 0% 0% on a biased sample) with the new findings based on the full sample of (durables last for many uses while remained among the top five brands. categories. non-durables do not), Tables 4 and All of which leads us to believe that The difference in the findings is 5 present findings for these two market shares over this prolonged striking. It turns out leading brands classes of goods. period are simply not stable, and, as maintain their leadership at a rate The data can be mined for other a rule, decrease over time. However, less than one-third of that currently important conclusions. It turns out, the long-term success or failure of believed! Table 3 presents a broader for example, that more of the leading brands is proportional to the set of findings based on these data. brands in 1923 failed than remained strength or weakness of their Since there may be differences leaders. In addition, more of the top starting positions. between durables and non-durables three brands in 1923 failed than What kinds of brands last? As a

Sternbusiness 33 Brand Endurance

rule, for durable goods, the rate of Meanwhile, in the food and beverage raise doubts about the currently maintaining leadership is lower than sub-group, 39 percent of the 1923 accepted empirical generalization that the overall average and the rate of brands maintained leadership and market shares are stable over pro- failure is higher than the overall only 21 percent of former leaders longed periods. While market shares average. For non-durable goods, the failed. Brands that consumers eat may be stable over shorter periods, rate of maintaining leadership is and drink constitute brands that are they are clearly not stable in these cat- higher than the overall average and plainly built to last. egories over the period considered. the rate of failure is lower. None of The findings from this analysis Many historians believe that a the members of the clothing sub- show that the rate of long-term lead- reasonable outcome of historically group maintained leadership and 67 ership is much lower than currently generated knowledge is being able to percent of the 1923 leaders failed. believed. In addition, these findings manage better in similar situations.

n 1923, Wrigley’s had “Remember this Wrapper.” The second factor in even though Warner-Lambert become the established After the war, sales soon sur- Wrigley’s long-term domi- and Squibb had acquired its I brand leader through passed the pre-war level. nance is the firm’s unrelent- major competitors. As a sin- extensive advertising. Its main More recently, Wrigley ing focus on chewing gum. gle-product company, Wrigley competitor, American Chicle – has continued to manage its Even though the company has continued to grow and also known as the chewing brand equity carefully. When owned the Chicago Cubs prosper, domestically and gum trust – tended to maxi- sugarless gum and bubble baseball team for many internationally. Over the last mize profits by skimping on gum became popular in the years, the team was a side- 10 years, dollar sales have marketing. Since 1923, 1970s, Wrigley did not line to the firm’s main busi- grown nearly 10 percent per Wrigley’s continued suc- year in what is considered cess has been primarily A Non-Durable Leader That Endured: a mature category. based on three factors: The third factor con- maintaining and build- Wrigley’s Chewing Gum tributing to Wrigley’s ing strong brands, long-term dominance is focusing on a single the fact that chewing product, and being in a gum has changed very category that simply has little over the years. In not changed much. some ways, the market In 1927, Wrigley’s has simplified. In the was an early sponsor of 1920s, at least 25 flavors national radio. By of chewing gum were some reports, the firm available. Today, only was the largest, single- mint-flavored gums dom- product national advertiser reflexively extend its brand. ness. For over 100 years, inate sales. These minimal in the 1930s. Wrigley’s also Several years after the sugar- Wrigley has been run by changes have made later showed a great commitment less gum market had taken three generations of entry very difficult. In fact, to its brands throughout off, it introduced a product, Wrigleys. Collectively, the Beech-Nut (now part of World War II. Due to scarce but under the same brand it family still owns over 40 Nabisco) was the last major supplies of the ingredients had used for the World War percent of the company. chewing gum company to crucial to its normal quality II-era sub par gum. It wasn’t In the 1960s, the family enter, way back in 1911. gum, Wrigley’s pulled its tra- until 1984 – with “extra” – chose not to expand into Although chewing gum has ditional brands and intro- that Wrigley committed to other businesses and referred changed relatively little, duced another brand. At the the sugarless gum market. to diversification as a dirty Wrigley maintains a serious same time, Wrigley contin- Meanwhile, in bubble gum, word. Management rejected R&D effort to improve its ued to advertise traditional Wrigley used a subsidiary to joining a conglomerate, products and packaging. brands with the slogan introduce Hubba Bubba. American Home Products,

34 Sternbusiness Everybody knows Santayana’s line example, we have precious few More information can be found at: about those who don’t remember the antecedents to guide our under- www.stern.nyu.edu/Faculty past being condemned to relive it. standing of the current situation. /workingpapers/papers/golder The same holds true for brand man- Therefore, the tools and techniques agers. Understanding how and why of history can act like torches simul- brands succeed and fail over time taneously illuminating the path PETER GOLDER is associate professor of marketing at Stern. This article is can help executives and marketers we’ve already taken and the road adapted from research was published in do their jobs better. There may be ahead. To understand where we are the May 2000 issue of Journal of Marketing areas of inquiry where history, today – and where we may be tomor- Research. indeed, remains bunk. When study- row – it can never hurt to know ing the Internet and e-commerce, for where we were yesterday, or in 1923.

nderwood was the acquired only tiny Electronic lacking the necessary techni- duced proportional letter leading typewriter Computer Corporation of cal expertise. spacing. In 1961, Big Blue brand in 1923. Brooklyn in 1952. After a few more unprof- introduced the Selectric type- U Over the next three In 1956, several factors itable years, Underwood was writer with the “golf-ball” decades, Underwood was exposed Underwood’s weak- acquired by Olivetti. While typing element. In 1964, the profitable. But instead of nesses. Lower-priced foreign Olivetti’s U.S. subsidiary company introduced an auto- innovating, Underwood competitors’ share of manual returned to profitability from matic typewriter that stored sought to collude with its typewriters began a five-year the mid-1960s until 1970, it information on magnetic competitors. According to a increase from 15 percent to lost money throughout the tape. These advances and 1939 federal antitrust indict- 40 percent. Outdated manu- 1970s and early 1980s. The others enabled IBM to domi- ment, the four largest type- facturing facilities became too Underwood name was phased nate electric typewriters writer manufacturers, who through the late 1970s. together set prices and cor- A Durable Leader That Did Not Endure: More important than suc- nered 90 percent of the mar- ceeding in typewriters, IBM ket, met to coordinate activi- Underwood Typewriters leveraged its strong position ties as early as 1930. One to become the dominant firm year after the indictment, in computers. During World Underwood and the other War II, IBM developed the three manufacturers agreed to Mark I computing calculator. a consent degree that prohib- The company sold its first ited their monopolistic prac- computer to the government tices. research facility at Los During World War II, Alamos, New Mexico in 1953 many companies developed and soon afterwards captured technology that would be use- market leadership. IBM’s ful after the war. But not leadership in important seg- Underwood. The company’s ments of the computer indus- profitability from 1945 to try continues today. 1955 was due to pent-up, Underwood’s demise post-war demand for type- costly, and electric typewriters out, and today, Olivetti is demonstrates the importance writers, a growing economy, became more competitive, only a very small part of a of continuous innovation. At and sales from the Korean eventually surpassing sales of relatively unimportant least up until the mid-1930s, War effort. During this peri- manual typewriters in the category. Underwood was well posi- od, Underwood continued to early 1960s. These conditions Underwood’s lack of inno- tioned to be the dominant pay high dividends rather led to increasingly large losses vation stands in stark con- firm in office automation. Its than invest more in product and failed efforts at new trast with IBM. IBM bought revenues were about equal to development and manufac- strategic directions. Electromatic Typewriter in IBM’s in 1937. But by 1957, turing. While other compa- Underwood spent $12 million 1933 and introduced the first IBM’s revenues were about 15 nies invested heavily in com- to diversify into computers, successful electric typewriter times those of Underwood! puter technology, Underwood but gave up after 18 months, in 1935. In 1941, IBM intro-

Sternbusiness 35 SUPERMARKET CHECKOUT ROULETTE These days, New York is one of the safest cities in the world. But there are some places that remain remarkably treacherous: supermarket aisles. Larry White guides us through the Express Lane.

ife in modern New York engenders a great deal of of us and wonder whether we should challenge the man uncertainty, even anxiety. For many residents of who clearly has thirteen items in his basket. Does the L Gotham, the basics of everyday life are frequent- “two cans for a dollar” special count as one item or two? ly a question of chance: finding an affordable apartment, How about two six-packs of Sprite? Do they comprise hailing a taxi during rush hour, getting a reservation at two items or twelve? And while barcode scanners at that hot new Asian/Italian/Peruvian restaurant. And checkout counters have been beneficial, they haven't every day, hundreds of thousands of New Yorkers invol- really eliminated the roulette game. untarily take their chances in another game of chance Of course, this is one area of retailing in which New they surely would prefer not to play: supermarket check- Yorkers can comfort ourselves that we’re not at a disad- out roulette. vantage. Supermarkets throughout the country have per- When shoppers load up their carts at D’Agostino’s or sisted in this entirely archaic checkout system for the Food Emporium, and head down their final aisle, a decades. series of questions pop up: Which is the fastest checkout ut there is a better way – and one that is based on line? How many people are in which line? How full are sound economic principles. For at least thirty their shopping carts? Which checkout clerk is the speed- B years, many banks and airlines have served their iest? Will the woman in front of me decide to write a customers through a system of “one line serves all.” All check? Or ask for a price verification? Will the store customers form a single line and then proceed to the next manager have to come over? open teller or clerk, whether they are cashing twenty-five To top it all off, we risk being flattened by speeding checks worth $500,000 or depositing two rolls of quarters, shopping carts when a new checkout line suddenly whether they are buying a ticket to France or vainly opens. Indeed, the traffic jams of maneuvering carts fre- attempting to get a better seat. Even the legendarily logy quently rival those of the approach to the 59th St. Bridge Post Office has adopted this system. And the “take a num- at rush hour. ber” system employed by bakeries, butchers, and deli- In recent years, the supermarket industry has intro- catessens is partly designed to accomplish the same end. duced some wrinkles that it plainly believes will improve Now, as any management expert could tell you, the shoppers’ odds. But while well-meaning, these efforts one-line-serves-all method doesn’t speed customers have largely failed. The “ten items or fewer” line doesn’t through service lines any faster – on average. But it does really solve the problem. Our anxiety levels are just as have the salutary result of reducing variance and the ele- high when we scrutinize the baskets of the people in front ments of luck. And as any psychologist could tell you,

36 Sternbusiness that surely reduces anxiety. happened yet. For New Yorkers, what And this state of affairs could be of greater value? can’t be a problem of “net- So, why haven't the work economics.” Unlike supermarkets followed the the prevalent and highly lead of their counterparts efficient barcode/scanner in banking and airlines? technology, which required Could this all be a conspira- group action and coopera- cy by the tabloid publishers, tion between manufacturers, who want shoppers to linger distributors, and retailers, in line and buy their latest the rearrangement of a alien revelations? But the supermarket floor layout current system isn’t any to accommodate one-line- slower on average; it just serves-all could be under- increases variance and anxi- taken by a single actor. All it ety. So, the tabloids could would take is one brave still have the same average supermarket. But, again, it shot at you in that single hasn't happened. waiting line. Tempting as it It is this economist’s is, we can not collar them as humble opinion that we the villains. need to explore more n its defense, the sociological dimensions. supermarket industry Supermarkets, after all, are would probably com- a relatively old industry. I plain about the scarce (They date to the 1930s.) (and expensive) square feet And it is one in which tech- of selling space and the nological change – or even extra problems of shopping any kind of change – does carts. But this would just not happen often. The last

be an alibi to cover their ILLUSTRATION BY DAVE BLACK major innovation in super- sluggishness. Space is markets (aside from the scarce for every retailer in New York, and shopping bulk-food sections) was the bar code/scanner technology, carts are simply an extra complication, not an insuper- which is now over 20 years old. We have to go back to able barrier to change. Anyone who wants to see how the 1950s – and the cash register that automatically the one-line-serves-all system could be successfully calculates and dispenses change – to find another leap adapted to similar retailing should pay a visit to any forward. Old Navy store. One major innovation every 20 years seems to be the Supermarkets may also pull out a trump card: tech- norm for this industry. And if the hand-held checkout nology. After all, we have been told that customer-held computer is the current focus of industry attention, then checkout computers, which will eliminate unpredictable I fear we may have to wait another 20 years before one- lines and hence anxiety, will appear imminently. With all line-serves-all is even considered. In this age of rapid due respect, people who believe this claim have been technological improvement, surely the supermarket reading too many of those tabloids while waiting for the industry can do better than that. store manager to verify the price of asparagus. Ralph Waldo Emerson told us that the world would Can the academic business literature help explain why beat a path to the person who invents a better mouse- the supermarket industry has been so slow? trap. I'll settle for a better supermarket checkout system, Unfortunately, standard microeconomics is not much and I will be eager to take my business to the chain that help here. There are enough supermarket chains remain- develops it first. ing in this country so that at least one of them would have experimented with one-line-serves-all. But it hasn't LAWRENCE J. WHITE is professor of economics at Stern.

Sternbusiness 37

B On Internationalanking Financial Stability

In their search for the root causes of international financial meltdowns, politicians and bureaucrats have been looking in the wrong places. The best defense against economic crises is good, solid banks.

By Paul Wachtel

For much of the past decade, government officials, officials of international financial institutions and international bankers have hopped the globe like firefighters – dousing conflagrations in far-flung economies. The Mexican crisis in 1994-95. The enduring Japanese depression. The meltdown in the Asian economies in 1997. The collapse of the Russian economy in 1998. Each of these wildfires burned the local economy and threatened to torch the world’s financial infrastructure. ✄ In each instance, observers searched for cul- prits. The usual suspects include government fiscal policy, currency speculators, unpredictable changes in the tide of capital flows, overzealous Western investment banks, and corrupt local governments. ✄ In each episode, however, one important factor was often overlooked: the banks. ILLUSTRATIONS BY TOM CURRY ILLUSTRATIONS Sternbusiness 39 ntil recently, macroeconomists paid compara- which were backed by central banks and sometimes tively little attention to banks and other finan- aided by international financial institutions, led to cial institutions. The analysis of monetary poli- resource misallocations. Specifically, banks failed to cy has tended to rely on the study of interest develop risk management skills because they expected Urates, credit availability, and government policy. The the central bank and the international community to be unique role of banks as a link between monetary author- a lender of last resort. ities and the economy was often overlooked. However, The failures of many of these banks led to increased today, in developing countries and emerging markets, focus on efforts to design and implement appropriate financial intermediation by banks and the existence of regulatory structures. As a result, it is now generally sound domestic financial institu- accepted that sound domestic tions are accepted as necessary In developing countries and market-oriented financial insti- conditions for economic growth. emerging markets, financial tutions will enhance the stability The greater appreciation of intermediation by banks and of the international financial sys- the role of banks is partially due tem. Such banking systems, to the transition economies of existence of sound domestic however, must meet three essen- Eastern Europe and the former financial institutions are tial criteria: (1) independence Soviet Union. After all, Soviet- accepted as necessary con- from political influence with or era planned economies did not without private ownership; (2) have modern banking sectors. ditions for economic growth. market competition or at least Eastern bloc banks were merely contestability; and (3) credible payment agents for government bureaucracies. As a and effective regulation. result, the transformation of the various state mono- banking systems into systems composed of a central Independence. In more than a few countries, many bank and commercial banks was frequently one of the banks are private in name only. Extensive government first steps of modernization. Indeed, in countries such as ownership is common. Even where banks are privately Hungary and, more recently, China, the transformation owned, government-bank links are frequently very strong. started before political liberalization. Moreover, foreign ownership of banks or allowing foreign Since banks were established before other economic participation in the financial services industry is often reforms or structural changes were enacted, they contin- proscribed. Such insulation from international markets is ued to function as sources of credit to state-owned enter- a destabilizing influence, and the lack of independence prises. As a result, these newly established banks did not from the state deters sound banking. develop lending skills, easily became overextended, and Privatization is usually viewed as the way to create had to be recapitalized. The existence of weak banks, market-oriented banking sectors in transition economies.

40 Sternbusiness Indeed, market-oriented banking requires the state to unwilling to monitor company behavior. An independent disengage from direct governance of banks (whether they bank is able to shed its unprofitable customers without are state-owned or privatized) and to develop an effec- state interference or the influence of managers. tive regulatory framework for the banking sector. Governments thus face the tricky maneuver of simulta- Competition. The second element of market-ori- neously getting out of the banking business and getting ented banking is competition or contestability. into the regulatory/supervisory business. Competition can be introduced by easing the entry of Managing these two seemingly contradictory tasks new entities into the local banking scene. However, an is often difficult. Successful regulatory policy requires increase in the number of banks is problematic for at the state to assume an arms- least three reasons. First, the cre- length role as banking sector Competition in banking does ation of a bunch of inefficient regulator and supervisor without not require a large number of and poorly capitalized banking any direct involvement in institutions may not improve the the conduct of the banking banks. The situation in the efficiency of financial intermedi- business – even if it remains a U.S. – with thousands of ation. Second, poorly capitalized passive shareholder in certain banks that undertake risky institutions. banks – is the exception activities have systemic implica- n independent bank- and not the rule. tions. Third, since bank licensing ing sector also requires is often subject to political influ- entities that are independent of control by ences, the managers and owners of new domestic banks insiders. The inherited legacies of planning are often poorly chosen. mechanismsA (in transition economies) or economic Competition in banking does not require a large num- oligarchies (in many non-democratic developing ber of banks. Many countries (both small and large) have economies) encourage a continuation of directed credit relatively few banking institutions. The situation in the allocation that is not based entirely on strict commercial U.S. – with thousands of banks – is the exception and not conditions. For example, the Czech banks continue to the rule. In other countries, competitive pressures come support large firms with massive loans and Indonesian from the structure of the financial system generally and banks were responsible for the diversion of assets to the the extent to which other non-bank financial institutions President’s family. Interlocking arrangements between compete with the banks. bank insiders and clients often result in excessive accu- The possibility of the entry of foreign banks and the mulation of bad debt in hostage-like situations. Due to a provision of banking services by other institutions make combination of political interference and a lack of the financial services market contestable. Contestability expertise, bank personnel are often incapable of and can lead banks in even a highly concentrated, seemingly

Sternbusiness 41 Banking

protected market to stitute for the salutary operate as they would effects of market disci- under pure competi- pline but as a comple- tion. And it can create ment to it. In New a competitive frame- Zealand, regulatory work for banking with- authorities are intro- out increasing systemic ducing a system where risks. conventional bank regulation will be aug- Effective regu- mented by market lation. The third ele- discipline. The government of an independ- ment will not provide ent banking system is deposit insurance and an effective bank regu- banks will be required latory structure. The to publish information regulatory structure on their condition reg- must remain independ- ularly. We are likely ent of any residual to see other countries state involvement in experimenting with the banking business; such market-based reg- the credibility of bank ulatory mechanisms. supervisors and regula- International stan- tors must be unques- dards for regulatory tioned. This is not a oversight are impor- simple matter of put- tant because central ting legislation and bureaucracies in place. Rather, it banks can sometimes find themselves with conflicting entails the development of institutions that can provide goals. For example, the central bank may be reluctant to credible regulatory threats to the banks. take regulatory actions that might lead to increased There is no clearly appropriate design for bank regula- demand for central bank loans if, at the same time, macro- tory structures. The mechanism can be run by the Finance economic policy dictates that it tighten the money supply. Ministry, a central bank, or by some other entity. Where it And if the central bank does not provide liquidity to a is located is less important than how it operates. troubled banking institution, another regulatory struc- ecent large country experiences have illus- ture must be in place to oversee the troubled institution’s trated the importance of these issues. In the needs. That is, there needs to be an independent regula- United States, an inadequate regulatory tor, such as a powerful deposit insurance agency, that can structure was not, in all likelihood, respon- either close down or sustain failed banks. sible for the crisis in the thrift industry in Since it is almost impossible to envision a deposit the 1980s. However, the inadequacies of insurance fund that is sufficiently well capitalized to pro- Rthe regulatory response probably aggravated the crisis. A vide insurance against all risks, the deposit insurance similar argument can be made regarding the ongoing cri- agency should have sufficient power to minimize the sis in Japanese banking. Although a regulatory structure calls on the insurance funds. Thus, the deposit insurance is in place, it has not responded in a sufficiently timely agency should also have extensive regulatory powers fashion. over banks. A regulatory structure that responds quickly is an he rules regarding the deposit insurance scheme important tool in avoiding the international exposure of should be as transparent as possible and should both banks and firms with excessive risks. The Asian cri- be uniformly and consistently applied. Any sis of 1997 showed clearly that international financial T deviation from specified rules will create the stability is threatened when both domestic and foreign expectation that the government is willing to guarantee institutions rely on lender of last resort promises and the continued existence of banks. The efficacy of bank inadequate supervision. These experiences suggest that regulation is undercut when all the players – bankers and conventional forms of bank supervision may not be able government officials alike – believe that the government to stem bank failures in all situations. will provide support in the event of any bank failure. The regulatory framework should not serve as a sub- Coordination of regulatory authority is particularly

42 Sternbusiness • important when banks may be viewed as being too big If we have learned anything from the cascading crises to fail. In such instances, regulatory action must be of the past five years, it is that traditional macroeconomic timely because closing the bank with or without analysis of external sector fundamentals is not always an deposit insurance guarantees may be impossible for adequate indicator of vulnerability to exchange rate crises. any of several reasons. Indeed, understanding the crucial role of banks and finan- n some cases, bank closure may simply be cial institutions should lead analysis into an incisive new politically unfeasible. direction. For in addition to the Or regulators may fear Domestic banking crises traditional macro fundamentals – systemic economic con- inflation, growth, fiscal deficit, sequences. If closure is are more often than not external debt, current account, precluded, then effec- precursors to exchange and exchange rate – we must now tive regulation takes the rate crises. monitor the new fundamentals form of examining and disci- that relate to the financial sector. pliningI the bank’s activities. These new fundamentals include Regulators should have a clear understanding of the the strength of the banking system, quality of bank super- types of sanctions – a forced sale, merger, recapitaliza- vision, exchange rate exposure of the financial sector, and tion, or limits on activities – that can be applied to a trou- the adequacy of the legal and financial infrastructure. bled bank prior to closure and they should be applied nderstanding and monitoring these new funda- promptly. mentals may help ward off international financial In many countries, authorities are beginning to recog- crises, for domestic banking crises are more often nize the need to ensure independence, contestability, and U than not precursors to exchange rate crises. An credible regulation in domestic financial services. Sound important implication of the relationship between finan- banking is a necessary complement to the sound fiscal and cial fragility and international crises is that financial liber- monetary policies that have been the focus of macroecon- alization and the development of sound financial institu- omists in the past. tions and regulatory structure should be carefully Frequently, the introduction of foreign banks or foreign sequenced. owners has helped push the development of sound bank- In the end, the best protection against exchange rate ing forward. Nevertheless, there is still a persistent and crises may be a sound banking system. Moreover, the puzzling resistance to foreign entry. integration of financial systems that comes with open Countries as disparate as Brazil, France, and Poland financial markets, international banking, and foreign have been loath to let the national financial system become bank ownership provides a clear incentive to maintain a subject to foreign influence. And foreign ownership of the sound banking system. Poor banking practices and poor banks seems to convey the appearance of foreign control. banking regulation invite destabilizing capital flows and But there are many fundamental reasons why foreign unsound financial decisions. A closed banking sector that strategic investors are important to the banking industry. is protected by government ownership or regulatory Even when foreign banks enter with little capital at risk, weaknesses leads to moral hazards. An independent and they are placing their international reputational capital at open financial system on the other hand will have self- risk. Foreign ownership helps clarify private sector control interest in avoiding destabilizing transactions. that is independent of the government. Foreign banks are It is no surprise that international financial institu- able to transfer modern banking technology easily. And tions like the International Monetary Fund have begun to such ownership reduces the potential for politicization of pay more attention to the financial sectors in their bank lending and increases the international integration of regular country evaluations. As we strive to head off the financial markets. next international financial crisis, it may be more Most importantly, foreign bank ownership may reduce important to evaluate the financial sector than to moni- the likelihood of financial crises. Indeed, it would have sig- tor traditional macroeconomic indicators. nificantly reduced the seriousness of the recent financial More information can be found at: http://www. crises in Asia. Making foreign investors – the bank owners in stern.nyu.edu/~pwachtel/research.htm emerging markets – responsible for the consequences of their lending practices creates a disincentive for damaging specu- PAUL WACHTEL is research professor of economics at Stern. lative short-term financial flows. Foreign banking interest is a genuine market test of the value and soundness of domes- This article is based on a paper delivered to: The International Monetary tic banks. So it is a useful signal when local financial mar- System: Current Situation, Perspectives and Reform Proposals, A Conference kets are too thin or too small to draw such attention. in Memory of Rolf Mantel, Buenos Aires, Argentina, August 11-12, 1999.

Sternbusiness 43 endpaper By Daniel Gross City Slippers

N ew Yorkers are Once the industrial revo- not alone among urbanites lution caught hold, however, in thinking their city to be Western cities experienced the center of the world. If massive population and eco- you spend any significant nomic growth. By 1900, the amount of time in London, world’s largest five cities or Paris, or Beijing, or were all in either Europe or Madrid, you will realize the U.S. One of the newcom- that the locals believe that ers to the 1900 list was our their hometown stands at home – New York. the geographical center of Indeed, the self-pro- all that matters. fessed financial, media, It has always been thus. fashion, and advertising The residents of Rome, the The World’s Largest Cities In... capital of the world is a rel-

world’s largest city about 100 A.D. 1925 ative neophyte onto the 2,000 years ago, liked to Rome 450,000 New York 7,774,000 world scene. In 1,700, when Loyang, China 420,000 London 7,742,000 note that all roads led to Seleucia, Persia 250,000 Tokyo 5,300,000 Yedo, Japan, counted Alexandria 250,000 Paris 4,800,000 their metropolis. Antioch 150,000 688,000 souls, Gotham was Berlin 4,013,000 But for the great cities 1000 A.D. nothing more than a warren of the world, fame can be Cordova, Spain 450,000 1950 of streets in southern Kaifeng, China 400,000 New York 12,463,000 fleeting. Rome, the eternal Constantinople 300,000 London 8,860,000 Manhattan and some farms. Angkor, Cambodia 200,000 Tokyo 7,000,000 city, lost its status as the Kyoto, Japan 175,000 Paris 5,900,000 And New York’s reign Shanghai 5,406,000 world’s largest about 1,700 1500 A.D. at the top has been relative- Peking 672,000 years ago. And some of the Vijayanagar, S. India 500,000 1975 ly brief, in historical terms. members of the global top Cairo 400,000 Tokyo 23,000,000 Today, the New York Hangchow, China 250,000 New York 17,100,000 five in 100 A.D. don’t even Tabriz, Persia 250,000 Osaka, Japan 15,500,000 Metropolitan area sits a dis- Mexico City 11,300,000 exist any longer. 1700 Moscow 10,700,000 tant second behind Tokyo. Constantinople 700,000 The shifting fortunes Yedo, Japan 688,000 2000 (estimates) And when a global census is of the world’s largest cities Peking 650,000 Tokyo 28,000,000 taken in 2020, it is likely London 550,000 speak volumes about the Paris 530,000 New York 20,100,000 the Big Apple will be sur- Mexico City 18,100,000 vast economic, technologi- 1900 Bombay 18,000,000 passed in size by the likes of London 6,480,000 Sao Paulo, Brazil 17,700,000 cal, and social trends that New York 4,242,000 Mexico City and Bombay. have swept the world Paris 3,330,000 Source: "4,000 Years of Urban Growth: As the Romans might Berlin 2,707,000 An Historical Census," Teritius Chandler throughout the last two Chicago 1,717,000 (St. David’s University Press, 1987) have put it, sic transit gloria. millennia. Well into the Middle Ages, Asia was frequently more advanced in many DANIEL GROSS is editor of STERNbusiness. areas than Europe. As a result, it was home to some of the globe’s largest concentrations of population.

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