Jan. 24 (Bloomberg) -- Michael Porter, a professor at Harvard Business School, talks with Bloomberg's Tom Keene at the World Economic Forum in Davos, Switzerland, about the outlook for the U.S. economy and the state of credit markets.

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

TOM KEENE, HOST, ?BLOOMBERG ON THE ECONOMY?: It's ?Bloomberg On The Economy?; tonight from Davos, Switzerland. Hello everybody, I am Tom Keene.

In this hour, for the entire hour, Michael Porter, Lawrence University Professor at the Harvard Business School, competition in a time of financial crisis. Can C-class speak and listen to the risk guys in the same way ever again? Also, Porter, on the ultimate cluster China. We welcome the senior strategy advisor to the Boston Red Sox. Michael Porter. Welcome back to the program.

MICHAEL PORTER, PROFESSOR, HARVARD BUSINESS SCHOOL: Thanks, Tom.

KEENE: It's an annual visit. Pray tell, how did you get the World Series ring on the Boston Red Sox this year?

PORTER: Well, we had an incredible season and I can't take any credit for the on-the-field activities, but I like to think that the Red Sox also are truly the innovators in the -- all the surrounding things that go with the team.

KEENE: I remember the owner John Henry years ago, had -- he invented so much of trend-based mathematics in the management of risk. What do you say to an entrepreneurial smaller outfit like the Red Sox that's different than what you would say to General Electric?

PORTER: Well, I think you have to say that they are fortunately not exposed to much risk. But in the - they, we've got a sold out ballpark everyday; we have had it for years. Our problem is having to take advantage of the tremendous demand for our product and get enough revenue to keep up with the Yankees basically. That's the strategic issue facing the Red Sox.

And they've been enormously creative and imaginative in finding ways to -- through creating value to get new revenue streams, build out what seem to be a constrained ballpark into a much more attractive facility with more seats, find really new businesses.

The Red Sox now are a major player in NASCAR, as well as Minor League teams. And so, and they also have been an incredible citizen in the Boston community. They have really been an engine of development of the Fenway area which is just going through an incredible revitalization.

So, it is a very interesting group of people, Tom Werner and Larry Lucchino and John, and they work together really well, and so it is the kind of thing that I enjoy doing in my softer moments.

KEENE: Good. Section 30, Row GG, Seats 1 and 2; that's what I remember about the Red Sox.

PORTER: Yes.

KEENE: Let's get serious here. We are in a financial crisis, volatility more than doubled since a year ago, all of our listeners know about this. What is different this year at Davos?

PORTER: Well, I think there is a lot of sort of latent anxiety kind of hanging over the place like sort of -- some kind of a fog and I mean, what -- the kind of ironic thing about this is that I have been working for many years and intensively recently on the U.S. economy and the fundamental competitiveness of the economy.

On all really deep substantive metrics, we do very well and the country is -- as I travel the world and look at the way they are struggling in Europe and the way they are struggling in Japan and the way they are struggling in other countries, in some ways the U.S. economy and the U.S. position in the economic world is very, very strong.

Having said that, this uncertainty and volatility because people don't know where it will end, they haven't been able to get their arms around it, I think is leading to kind of a sort of a putting on the brakes of all kinds of activities. So, and people are consumed with it and distracted by it. So, I think it's just the expectations effect of people's concern is to me almost certain to lead to a material slowing of the economy and it is also spreading to other countries as well.

KEENE: If you're just joining us folks, Michael Porter of Harvard Business School with us from Davos, Switzerland for the entire hour. We spoke to Leo Tilman, the strategy guy at Bear Stearns in the previous hour about these challenges of the MBA-class, the C-class officers speaking to the risk guys within their group, or to their consultants in risk. Is that relationship forever changed with this crisis?

PORTER: I hope so. I think we have gotten into some very, very bad habits in this whole kind of financial engineering world and I am a bit of a outlier on this perhaps yet, but I hope that that will not be forever.

In finance to me, the really important issues are the underlying cash flows and that's what we ought to be worried about. Do we have a good, stable market position, so we have good, solid cash flows and if we don't, let's understand them and deal with them.

What our finance geniuses are focused on is not the underlying cash flows, they are focused on all these clever ways of squeezing a little bit more juice out of a particular set of financial instruments with all kinds of RAPs and derivatives, securities and slicing and dicing, and it gets to the point where nobody understands it. And even the folks that are doing this work are making assumptions that they don't understand and so this is kind of long-term capital again, except in a different zone of financial engineering.

So, I hope that the C-class starts to understand that this stuff may, you might seem smart because you can get another 0.002 percent higher return, but fundamentally this is a massive distraction to running the business and I think people are going to be much more cynical and much more prone to kind of dive in and understand what's really going on here. I think this was an area where most senior executives don't understand it, even people in the finance field.

KEENE: In just 30 seconds here, is the CFO going to be front guy on this. The CEOs got a strategic vision, he's got other responsibilities, here forward, is it a new CFO?

PORTER: I think CFOs are going to, all of a sudden are going to have a very, very high agenda item on their agenda and it is going to be this issue and never again, never again.

KEENE: He's Michael Porter. We are at Davos. Michael Porter, of the Harvard Business School. Coming up a number of themes to talk about in our next half hour; we will speak of -- we didn't talk about this last year, of clusters and the new take on building up regions and cities and this idea globally of clusters. I want to run into that in the next half hour.

But coming up, we will continue this discussion. Davos within the turmoil, the volatility, as Chairman Greenspan would say, the turbulence, of this 2008. From Davos, it is ?Bloomberg On The Economy.?

It's ?Bloomberg On The Economy?; I am Tom Keene from Davos. We continue with Michael Porter. There's a lot of fancy cars up and down promenade in Davos. Are the elite affected by this crisis? Does life going on for the crew at Davos?

PORTER: I would say so, yes. I think these folks are financially secure by and large, and I think the folks that are looking for bonuses in the financial services industry, it is going to be an awkward year for some of them. But, in general, I think the elites are going to go on and in some sense, the real world is going on.

I mean, this is playing itself out in some -- lot of lower-income mortgagers of that mortgage of the houses are going to -- are going through a period of anxiety, but in general the real economy is cranking on. I am on a number of corporate boards, public boards, and as I look at how those companies are doing, they are doing fine. These are companies in the industrial space, they are taking orders and making product, and yet we have this kind of turmoil going on in this one, if you will, niche of the economy.

We're not having defaults on corporate loans, we're not having issues with private equity deals failing. This is - it's funny how this corner of the universe, which was such a big corner because of the tremendous amount of real estate assets in America, has caused so much turmoil over the broader economy.

KEENE: Since I have seen you, Professor Porter, one of the highlights of the year was Thomas McCraw, his ?Prophets of Innovation,? which I read cover to cover, and just a magisterial effort on Schumpeter. And if Schumpeter's credit is the juice that keeps the system going, do you believe in this idea that the credit angst in that narrow area given global slowdown or U.S. slowdown could migrate over to credit angst in other parts of the economy?

PORTER: I think it could migrate wherever there was a sophisticated packaging of risk in these derivative instruments, because I think this is calling into question a lot of the underlying logic that was used to argue that those were actually very safe and secure instruments. And I think that again, most senior executives I know, and I know a lot of them, if you ask them about derivatives, they will kind of wave their hands a little bit.

And -- but they don't really know what they are, they don't know how to think about them, they don't know how to evaluate them, they don't -- so, I think what has happened here -- so, I think it would migrate that far. But, in terms of what you might call the bread-and-butter credit that greases the economy, I don't see it.

KEENE: Just in a minute and a half here, do you teach value at risk at the Harvard Business School?

PORTER: They certainly do in our finance curriculum. And -- but, you know, exactly how they are teaching it these days, I don't know. I am a strategy professor and what we focus on in strategy is the economic fundamentals, what gives a company competitive advantage, how to understand its potential profitability, the sustainability of that profitability, that is what we think about. But, again, we have this whole other field of finance that has somehow detached itself and gotten so complex that the people that are actually running companies don't understand.

KEENE: I want to come back and visit this, but just in a little time we have got left in this block, did we get into all of this because revenue streams and quality of cash flows in other traditional areas diminished, so they had to go searching for the marginal gain in derivatives?

PORTER: I don't think so. I think it is just flat out greed. I think there is -- most companies have done well, corporate profits have been enormously high, the incremental benefits for these complex instruments are marginal compared to the core level of profitability. So, I think this was just kind of greed and Wall Street has a tremendous machine for driving out these products. They made a lot of money, they made their fees, their spreads, and it's like every other new financial instrument, it gets taken to excess.

KEENE: He's Michael Porter -- in excess we have him for an hour. Coming up, Porter, never talk to Professor Porter about his research years ago, the invention of it, I think 1990, on clusters. What is a cluster and is China the ultimate cluster? Tomorrow, on the program, the Senator from Texas A&M, Phil Gramm. We are in the middle of two hours of ?Bloomberg On The Economy.?

It is ?Bloomberg On The Economy.? I am Tom Keene in Davos. We continue with Michael Porter, our annual visit here at Davos. What was a cluster in 1990?

PORTER: Well, a cluster is a geographic concentration of a set of related companies and institutions in a particular field. A protypical cluster is Wall Street. We have an enormous number of entities all connected in a variety of ways to investment banking and financial markets, but it's not just the investment banks, it's the lawyers, it's the processing firms, it's the - there's a whole ecosystem of companies all co-located.

And what we find is that this cluster structure, which literally goes back hundreds and hundreds of years, has taken a modern shape in Wall Street, and in Silicon Valley, and in Boston in Life Sciences, and in Southern Germany in high-performance automobiles. And it is the engine of productivity and innovation in the modern global economy.

KEENE: When you overlay on that, Steve Roach's, and he was on the program last night, his labor arbitrage, the fluidity of labor flows and labor transfer, physical transfer of bodies within China, is China describing to us a new kind of cluster?

PORTER: Well, China is actually -- the economy is built on clusters. The Chinese economy has --

KEENE: And the culture is?

PORTER: The culture is, yes. The Chinese made a very, very smart either decision or they had a lucky break, and that is that the economy strategy of that country was de facto very decentralized.

Each city, each major region, the Shanghai area, the Beijing area, each area was given a fair amount of rope to kind of go out and do its own thing and decentralize. And so, in each of these areas, they've built up a series of clusters and they have kept attracting more players to that cluster.

And when you have a cluster, it gets just incredibly efficient to do business. Logistical times go down, the transaction costs go down, the access to anything you need is instantaneous. You can not only buy machines, but you can get the service man over to your location in 15 minutes if something goes wrong in your factory.

So, China actually was smart enough to build a decentralized economy in a very large country. That is the great secret of the U.S. The great secret of the U.S. is every state, every metropolitan region is its own distinct economy, it has a different mix of clusters and we have massive internal trade because of the internal specialization of the economy, we have massive internal trade.

Our international trade numbers don't look that great, but we have all the benefits of trade because Boston trades with Minneapolis and Minneapolis trades with Southern California, each with their own set of clusters that feeds productivity growth and innovation. Now, you know, and that allows the U.S. to keep upgrading and generating new stuff, as our less sophisticated activity moves abroad.

KEENE: When I look in your Web site, I don't see the nation of France among the 4,000 countries that you have consulted to and worked with their governments. We have got this attempted miracle in France, this change in France of capitalism. Can the clusters of France be successful given the overlay of decades and cultures of the certain different kind of capitalism?

PORTER: Well, it's going to take awhile for this new leadership to kind of strip away the barnacles that -- I mean France has some amazing clusters, I mean think of wine, I mean just what a classic case. But, if you get into the French wine cluster, which I happened to have for a variety of reasons because we have case studies in this field.

KEENE: Don't tell me the Boston Red Sox have leveraged into the wine business?

PORTER: No, not yet. Who knows, I mean if we can buy Roush Racing, we can get into French wine. But, in any event, in France, basically all the land is already classified in terms of is it -- what gradation is it, okay. So, it doesn't matter if you improve your quality, you have got a piece turf, it's rated x/y/z in terms of the packing order, that happened 200 years ago.

There is a tremendous rigidity in the French wine cluster. There is no way for it to innovate and regenerate. Whereas in Australia or in California, we have this continual innovation process going on where they change the way they plant the grapes and then the change the way they harvest the grapes and then they use different means of making the wine. In France, all of that is just frozen.

So, the problem with France is that there's this attempt to freeze the status quo, which is great for the people that happen to have a job in that system, but it's just -- France has just lost its dynamism. It has it in a few fields, in fashion and so forth. But France has got to pull off, it has to pull off this -- these barnacles, as I said earlier and just let the French -- French are incredibly bright, they are very well educated, they are very scientifically capable, they have terrific engineers, but they have been stifled by the system.

KEENE: What are you working on right now, I've just got a minute here, what are you working on right now? What's the major focus of Michael Porter?

PORTER: I am working on how to totally rethink and restructure the way we deliver healthcare globally.

KEENE: Are you advising to any of the candidates?

PORTER: I am in contact with virtually all the candidates. I am personally advising Governor Romney, who is a dear close friend and, but we have a tremendous opportunity and a tremendous need to actually change the way we think about health care and delivering of health care. So, that's my passion at this particular moment.

KEENE: Wonderful. Michael Porter with us, of Harvard Business School. Coming up folks, final thoughts from Professor Porter and I don't know, we are going to drag him, kicking and screaming to Chicago to look at the microeconomics of one of the great themes of the American economy as we go through.

And one of the underlying themes here at Davos, quietly through seminars on the economics and the future of our food economy, our food inflation. We are in Davos, ?it's Bloomberg On The Economy.?

It's ?Bloomberg On The Economy.? I am Tom Keene at Davos. We thank you for listening on the Sirius XM Satellite Systems at Bloomberg.com and thank you for listening on our podcast at iTunes and at Bloomberg.com this year.

This has been the great innovation of ?Bloomberg On The Economy,? out of nowhere came these podcasts. The ability, and I was with Chad Hurley last night of YouTube for a good hour, just talking about America. Is there any place else that's going to compete with us for just ideas?

PORTER: No way. We just have a tremendous deep system for generating ideas and by the way, it's not just the research. See, if you go to Europe, where I was earlier this week elsewhere besides of course --

KEENE: Professor, we are in Europe, right?

PORTER: We're here. When I was in Europe at a meeting of Europeans, talking about innovation and the way they think about it is investment in R&D and investment in science and of course, we do that in America, we have got to do that.

But, what makes the American R&D machine and idea machine so potent, is that it really draws on the much broader set of factors that truly drive innovation, starting with very sophisticated customers who will buy the new stuff, who will try the new technology. It starts with a tremendous amount of competition, and no impediments to that competition. It is a very fluid market for human resources, people moving around different companies.

There's -- and there is a lot of clustering in the economy where you get a bunch of companies in Silicon Valley or a bunch of companies in Boston or a bunch of companies in Minneapolis doing heart-related stuff and the ideas fly and the sparks fly. So, it's an amazing machine.

KEENE: Just because of time, I want to get to this. The theme of the program this year is that economics of food. We have this new constraint into the system in ethanol. Within -- away from your strategy and competition study, what do you think of the impulse of ethanol economics into our food systems, sky-high corn prices, soybean prices? Is this a case of unintended consequences?

PORTER: I think so. I don't think -- thinking back, I don't think anybody really thought this through and it really is having quite a ripple effect across many companies and many industries, and including ones that are outside of the food space. I mean it turns out that agricultural inputs are actually rather broadly used in other industries as well.

So, I don't think we understood this. I am convinced that with a little bit of time, the American production system will be able to substantially improve its productivity. We have been taking land out of farming and we have been reallocating our resources.

So, at least in America, there will be I think a response over time. I don't think -- there is no need for big breakthroughs here in technology like there is in energy. But, this has just caught everybody by storm. This is probably the biggest issue that I hear corporate leaders talking about, is rising input costs.

Part of it and a big part of it is these food costs, but also this is true in all kinds of inputs. We sort of took for granted that you could buy copper and metals and all this stuff for a very low cost, that people were lulled to sleep on the input side, on the raw material side.

KEENE: Right.

PORTER: It's dealing with raw material escalation that is one of the kind of big strategic themes that (inaudible).

KEENE: So, I made the right choice looking at the economics of food?

PORTER: Absolutely.

KEENE: Good. Well, glad I did something right. Folks, Michael Porter, a generous hour, thank you on your schedule for meeting with us in Davos.

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Last Updated: January 24, 2008 15:31 EST