FOOL ON THE HILL
Layoffs: Creative Destruction

Look around at the layoffs announced at U.S. corporations this year and it's easy to get spooked about the economy, but capitalism teaches that job cuts are a painful yet vital way to renew business agility and the economy. The economist Joseph Schumpeter called the process creative destruction: Old jobs must be destroyed to create new ones.

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By Richard McCaffery (TMF Gibson)
July 26, 2001

Look around at the layoffs announced at U.S. corporations this year and it's easy to get spooked about the economy.

Since January, total employment declined by about 1.1 million, according to the Bureau of Labor Statistics. That sounds like a lot of people, even though it represents less than 1% of the nation's 134.9-million person total employment level. Still, it's been a brutal year for many workers.

Company                       Announced Layoffs
Lucent (NYSE: LU)             More than 30,000
Nortel (NYSE: NT)                       30,000
Motorola (NYSE: MOT)                    26,000
American Express (NYSE: AXP)             5,600
Source: CBS Marketwatch. See story.

It can't be good for the U.S. economy when a company such as Lucent (NYSE: LU), a pillar of the telecommunications industry, cuts this fast and this deeply, right? Where do all those workers go?

Well, they go back into the economy in new jobs. It's not an easy process, or a neat one, but it is re-creative. The lesson capitalism teaches is that job cuts are a painful but vital way to renew business agility and the economy. The economist Joseph Schumpeter called the process creative destruction: Old jobs must be destroyed to create new ones. Word processors demolished the typewriter industry -- ask Smith Corona -- but the pain ushered in the PC era. The poet John Milton recognized the same vitalizing force at work in the literary process when he described creativity as inherently destructive.

Creative destruction is the market's invisible hand at work. The invisible hand moves entrepreneurs to produce products society wants, which companies do in pursuit of profits. They build the infrastructure to deliver these products. The invisible hand is merciless to these companies, however, when the winds change and a different or better product comes along. Then workers are displaced by the thousands. Sometimes they end up in worse jobs or unemployed because they lack the skills to find jobs in a changing world. It's ugly, but the turnover process is vital for the economy as a whole.         

We saw the big three automakers bull through creative destruction when Toyota rolled into America in the 1980s with better manufacturing processes. Japanese cars were suddenly better and cheaper than those made by Ford (NYSE: F), General Motors (NYSE: GM), or Chrysler -- now DaimlerChrysler (NYSE: DAJ). The solution, of course, was to make Detroit compete, not to protect the industry. American automakers had to get lean and innovate. It was a painful time for many in the manufacturing industry, but for the economy as a whole it worked out pretty well.

If you want a lesson about creative destruction from the past, check out the 1992 annual report at the Federal Reserve Bank in Dallas. (If you're interested in an educational, enriching tour of capitalism and the nation's economy over the last decade, by the way, take the time to read all the annual reports archived at the bank's website. You may not agree with everything these fed economists write, but the reports have a Warren Buffett quality -- at least in terms of subject matter and presentation -- and they have made the Dallas Federal Reserve Bank the place I'd most like to visit in Texas.)

At the time the 1992 report was written, GM had laid off 74,000 workers; Sears (NYSE: S) 83,000; 25,000 at IBM (NYSE: IBM); 27,000 at Boeing (NYSE: BA). The country was reeling, it seemed. At the same time, however, it went relatively unreported that companies like Wal-Mart (NYSE: WMT), Microsoft (Nasdaq: MSFT), and Dell (Nasdaq: DELL) were hiring by the thousands. (Actually, it didn't go unreported. It's just that headlines such as "General Motors Lays Off 74,000" have more impact than "Microsoft Busy Hiring." I don't blame the press for this, it's just the way we process information.)

I think part of what we're seeing in the economy now is creative destruction. Lucent's big circuit switches won't be as central to the world of telecommunications in the next 40 years as they were in the last 40. That much is very clear -- and this is big medicine for Lucent. Its world is changing fast and the company is struggling with more than technology as it tries to find balance.

At the same time, I think creative destruction, in the sense of new technology and processes, is just one part of the current layoff situation. The other part is the hangover effect of asset-price inflation -- what most people call the fallout of a burst bubble.

This is the danger of inflation, whether in the consumer products index or stock and real estate markets. The price we pay for a stock, a product, or a service, is much more than just a price tag; it's a vital piece of information that impacts the way we think about money, saving, and spending. You can bet Lucent's soaring stock price, from the time it went public in 1996 to its collapse in 2000, had a powerful influence on the way the company thought about capital allocation -- the way it spent money.

A soaring stock price colors the way companies think about access to capital, which colors the way they think about how big they can get, how many product lines they can support, how acquisitive they should be when chasing new technologies, how big a research and development division they can support. In short, it changes everything. It shouldn't; barring drastic swings it shouldn't change much of anything, but it can if you let it.

The economy is still growing even though certain sectors are contracting. The business world is righting the ship, and it will move forward healthier having shed its excess. That process puts today's companies in better position to compete tomorrow.

Have a great day.

Richard McCaffery, a writer at The Motley Fool, owns shares of Dell Computer. Unfortunately he didn't buy them in 1992. The Motley Fool has a full disclosure policy.