I have written how the Great Recession will transform America by accelerating changes that are already happening but are slowed by incumbent industries with backing from government. We have seen in prior Depressions how the shock of the fall breaks the logjams that slow change by weakening incumbents and allowing newer industries to ride the new flood tide to great success. Simplified, canals gave way to railroads (1840s), Boston mill towns were swept away by the the great foundries of the Midwest (1890s), railroads were replaced by highways (1940s), and now the Internet is creating a digital economy (2000s).
The last time around, in the Great Depression, we shifted from largely agricultural to manufacturing, and saw a great migration off the farms and into the factories. This migration had started decades before, with Henry Ford's mass manufacturing process (1915), but accelerated during the '30s.
This time we are seeing a drop in core assembly-line manufacturing and a rise in value-added manufacturing, the layer of design, software and services above the assembly line that I call the Value-Add Layer. This change should not be feared but welcomed. The shift in assembly line work to China and base software to India should not be feared but applauded, as a third of the world is now joining the global system and will increase prosperity for all.
A simple look at how value flows to Apple for the iPhone should convince you that the value-add layer is a lot more valuable to us than assembly line manufacturing. Click on the sidebar thumbnail of a chart of value in the iPhone (courtesy GigaOm, sourced from Column Five Media). In sum:
- Apple gets $579 from the mobile operator
- Apple pays $179 to build it
- China gets $6.50 for core manufacturing
The assembly line manufacturing component is about 1c on the Dollar. Apple gets about 70c, and that does not include the service income from downloadable apps and music. Most the rest of the cost to build it is Intellectual Property (IP) frozen into chips and software. The mobile operator subsidizes the purchase by $351 and gets about twice that in data fees, even before including voice minutes and sms fees. A similar model applies to the new iPad (updated here).
The Value-Add Layer of IP and services is where the value is. Assembly-line manufacturing is no longer what "manufacturing" is all about.
You could argue that Apple is an outlier, but there are a myriad of similar companies in Silicon Valley, Redmond, San Diego, and elsewhere across the US. The web industry is largely centered in the US. The smartphone industry is almost wholly in Silicon Valley (Apple, Android, Microsoft's Danger division, Palm). The social networking winners are largely here as well. And of course the US and Europe have huge bio-tech and pharma industries.
It is passing strange indeed, then, that what passes for industrial policy in the US is to bail out car companies, enable huge profits in financial services, empower increased public sector union jobs, jawbone about green jobs - and continue to pluck apart the golden goose of innovation with:
- Sarbanes-Oxley, which has quadrupled the price of going public and at least doubled the cost of staying public
- Demonization of stock options
- Imposition (soon) of more expensive health benefits
- Imposition (likely) of increased taxation on small business
- Increase (likely) of capital gains tax rates
- Worsening (possibly) the tax treatment of venture capital
Certainly China is catching up, but a look at history shows that China is still a paper dragon. When the US went through its period of remarkable growth to become the China of its day back in 1900, US companies were the world innovators in both technology (telegraph, telephone, lightbulb, electric generation and transmission) and process (ruthless efficiency in oil, steel, transportation and retail). When Japan emerged as a world power, it too showed innovation, particularly in commercialization (VCR, walkman) and process (just-in time manufacturing, quality). As China has emerged, it shows neither. Its manufacturing prowess is more myth than menace, a story of cheap labor and rapid flow of capital.
This is all too apparent looking at Chinese profitability. The Chinese exporters are hanging on by a thread,with a profit margin of less than 2%. They are at huge risk of failure if the Chinsese currency rises. As an equity analyst noted:
2% margins on export-oriented businesses is not representative of any sort of real competitive advantage. A real competitive advantage when it comes to exporting would show double-digits profit margins.
Thus it is all the more appalling that pundits like Paul Krugman call for tariffs of 25% on China. If Krugman gets his way, the sort of assembly line manufacturing of China would not come back to the US. If the Chinese currency goes up 25%, or we throw on a tariff, the rise is from $6.50 on an iPhone to $8. US assembly line work would be multiples of cost above that. Instead, it would go to Vietnam or other low cost areas.
The bigger threat to the US is a continuation of bad industrial policy that hinders US innovation, while China makes great strides to move beyond cheap manufacturing to the Value-Add Layer. Already we see R&D moving to China out of the US. Several Chinese companies are gaining world scale and competitiveness with Western companies, such as Haier & ZTE in cellphones, Huawei in telecom infrastructure, Lenovo in computers, and Baidu in search. Despite some success, however, it may come as a surprise that China is having a hard time finding value-add jobs for millions of college grads.
An encapsulation of the problem with the path we are on is that government workers now surpass goods-producing workers in the US.
The last time a transformation of this magnitude occurred in the 1930s when workers left the farms and went to the assembly lines. Farming dropped from 40% of the workforce to a few percent, and yet farm production kept increasing. We had huge gains in productivity, and after WWII were able to absorb those new workers into manufacturing.
Yet the government continued to pile on bureaucrats as if nothing had changed. Huge farm subsidies enacted as emergency measures in the 1930s live on today when we have neither shortages of food production nor collapses of food prices. We have gotten to the point where the number of public employees in the Agriculture Dept is said to rival the number of core farmer workers. The joke is, why was the Agriculture employee crying? His farmer had died.
Yet that old saw misses a deeper and more important observation: while the number of core farmers has decreased, the workforce in the layer above farming - call it Food Processing - has grown dramatically, and adds a lot more value than farming itself. Food processing and the food service industry to deliver it to supermarkets and restaurants has proliferated an incredible assortment of food products. In many respects this is equivalent to the Value-Add Layer above the assembly line, and has its own intellectual property in genetic engineering, flavor enhancement, organic products, preservation, packaging and distribution. Sadly, it too is being starved of innovation, and hampered by fears of genetic modification of seeds, while China is moving ahead.
Similar to what happened in the '30s, as core manufacturing has declined, manufacturing output has not, and the jobs have shifted to the "manufacturing processing" layer above, the Value-Add Layer. US manufacturing as a percent of GDP has been stable since 1947, when we all thought we were a great manufacturing powerhouse. GDP has gone way up, and so has manufacturing output. With many fewer workers, we produce the same percent of GDP in manufacturing today as we did in 1947:
Let's not confuse a drop in assembly-line workers with a drop in manufacturing. We have been changing our economy for decades, rotating into new products and high levels of value-added features. You are witnessing the process of Creative Reconstruction, as we constantly rebuild our economic base.
As with farming, we can promote innovation & productivity, or starve it. Right now the punditry seems intent on starving it. Paul Krugman, in a recent post in his NYT blog, actually said that "mercantilism works". Adam Smith wrote Wealth of Nations to show the mercantilist fallacy, that the "beggar thy neighbor" policy lowers overall trade and hurts the mercantilists' citizens. The victory of Capitalism over Mercantilism was decisive, to say the least. The errors in Krugman's argument are dissected here and here. He wants us to become China. He says things this dumb:
- Virtue becomes vice: attempts to save more actually make us poorer [comment: tell that to the Japanese and Chinese, who incent their citizens to save at high rates]
- Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster [comment: tell that to the Chinese, who are now deathly afraid of inflation scuttling their miracle]
- Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense [comment: really? we grew a whole China in GDP from 2004-7]
- For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies [comment: only in an academic fantasyland]
A sophisticated discussion of the topic comes from Professor McKinnon of Stanford, who points out that as long as the Chinese currency is not accepted as a widely-tradeable reserve currency (like the Yen, Dollar or Euro), it cannot be floated without severe internal consequences to China. Simply put, it would rise without much to limit it, as the Chinese themselves would be loathe to recycle their savings by investing in Dollar assets since the rising RMB means their Dollar investments drop. It should come as no surprise then that mercantilist economies tend to force their citizens into huge savings while restricting their ability to spend outside the home market, since that spending would unwind the beggar-thy-neighbor cheap currency. All of this means that the clumsy Krugmanian solution (of the US becoming a mercantilist like China) would fail to change China and would lower global trade while hurting the US consumer.
Another risk we run is the government using coercion to try to pick winners/losers. Governments will tend to reward incumbent industry structures over new ones, since that is where they find the most votes and can shakedown the most campaign money. The process of Creative Reconstruction requires instead the promotion of new industries.
In spite of poor US policies, I see a tremendously exciting and lucrative future for the US in remaining the leader in the Value-Add Layer above core manufacturing. We have already vastly increased the size and scope of our college-educated workforce, and the Value-Add Layer can absorb college graduates fresh off campuses just as the assembly line absorbed unskilled labor fresh off farms. The speed of change and innovation in engineering, design and marketing means that training for specific jobs is less valuable than being broadly skilled in learning, creativity and adaptation, all areas in which the US culturally excels.
We need the patience to ride out the Great Recession, the forebearance to let the transformation work its way across industry, and the wisdom to accept the Creative Reconstruction of Capitalism, rather than fall into the politically expedient trap of intervening to forestall the change.