China and the New American Manufacturing Paradigm

"Mercantilism works" - Paul Krugman

Krugman's call for 25% tariffs on China are based on a profound misunderstanding of how the Great Recession will transform US manufacturing. The US is rapidly moving to a higher-value and sustainable position in global production from an older model of unskilled labor gaining a middle class salary on the assembly line. The greatest threat to this repositioning comes not from China but from within, from policies that hinder innovation and burden production. 

I have written how the Great Recession will transform the West by accelerating a drop in core manufacturing and replacing it with high-value jobs in the layer of design, software and services that I call the IP layer (for Intellectual Property). A simple look at how value flows to Apple for the iPhone should convince you. 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 $. 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 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. 

The IP and Services layer is where the value is. Traditional manufacturing of the sort Krugman wrings his hands over 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 bailout car companies, enable huge profits in financial services, empower increased public sector union jobs, jawbone about green jobs - and continue to pluck 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 (potentially) 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. Instead, it is 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.

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. 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 IP 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 ZTE in cellphones, Haier in telecom infrastructure, Lenovo in computers, and Baidu in search. 

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. 

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. I don't know if this is quite accurate, but 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 IP 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 IP layer: 

 

As with farming, we can promote innovation, or starve it. Right now the punditry seems intent on starving it. The most astounding fount of bad policy is the Economist Who Wants To Be Taken Seriously but says really dumb things - Paul Krugman. In a recent post in his NYT blog, he 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 force 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 much more 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 whole hurting the US consumer. 

In spite of poor US policies, I see a tremendously exciting and lucrative future for the US in remaining the leader in the IP layer above manufacturing. We have already vastly increased the size and scope of our college-educated workforce, and the IP layer can absorb college graduates just as the assembly line absorbed unskilled labor off the farms. The speed of change and innovation in engineering, design and marketing mean 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 Destruction of Capitalism, rather than fall into the politically expedient trap of intervening to forestall the change. 

Comments

[Eventhorizon]

How does everyone interpret the concept of a "service economy"?

Duncan, you keep putting forward this theory that erst-while factory workers are going to be creating IP. How? More education? Education doesn't make a stupid person clever. Someone who, say dresses chickens, is now going to write software?

If you mean waiting tables, cleaning IP worker's houses, cars and clothes, flipping their burgers, etc I can see it. But is that any better than working in production? I don't think it is better or worse.

I am absolutely 100% against pointless efforts to preserve the status quo, the economy is going to go where it is going to go. It is global, better deal with it.

But sooner or later we are going to have to confront the issue of what the majority of the population is going to do with their time. As was pointed out above, machines and 'puters can do any repetitive / routine task better than any human. The corollary is that nearly every job can be engineered to be routine and repetitive. So what exactly are we going to do to provide some semblance of a fulfilling life for those who would otherwise likely resort to torches and pitchforks?

[Aldous Huxley]

So what exactly are we going to do to provide some semblance of a fulfilling life for those who would otherwise likely resort to torches and pitchforks?

One word: Soma.

[nmelendez]

You know what's really funny? Your comment on govt. workers. I am a govt. employee. When i came in there were 145 employees in my Division. Now we are 3 work centers with a total of 38 employees. We still have the same old equipment PLUS they have added other equipment and loaded us up with the responsibilities for logistics, coordination, contracts, etc, etc. My job used to be technical (repair). Now it's turned to technical managerial administrative. Believe it or not the increase in govt employees has not been on the GS side but on the contract side. I coordinate various groups of contractors. Maybe you should do further research because it's a common misconception that all Govt. employees are the regulars.

[yelnick]

Event, it is really the other way around: clever people who create IP can then drag with them a lot of other employees. But the majority will not be unskilled workers off the farms, whether in Kansas or Juarez MX. They will be college educated filling engineering, marketing, design, business development, PR, etc. types of jobs. Think of who works at Facebook, or Google, or Apple.

So let me be clear: this is NOT a transition of existing factory workers into a new jobs. Fortunately, the transition down of them has been occurring for quite a while, a lot of US manufacturing jobs are highly-skilled positions. Let me put it this way: the auto industry south of the Mason Dixon line is doing much better than the unionized shops in Detroit. They make decent wages albeit their comp runs about 50% of the union comp all in. They build cars every bit as good as Detroit, and as a bunch are gaining share of autos vs Detroit.

What is driving autos these days is the value added layer: hybrids, more electronics inside, better safety, etc. Those jobs are still in the US, especially design shops in LA that design for the Japanese, or the many machine shops across the Midwest that do components; and of course the electronics makers that go into cars, like Bose systems.

The transition to value-added manufacturing started a long time ago. The Great Recession will accelerate it. Govt bail outs slow it down.

I added a new page to the left sidebar called Creative Reconstruction to let me expand on the them of this China post. I have changed the "IP LAyer" to "Value Add LAyer" since I think readers take a much more narrow view of IP than I do.

[Anon]

I found the fiscal insanity evidenced by a 61 year old woman in this article to be beyond comprehension. http://tinyurl.com/ygxkqtv

She would have been better off buying a Ferrari Enzo - at least it's a limited availability, collector's item.

[yelnick]

nmelendez, you make a very good point. I think we have lost 2.7M jobs since Obama took over and gained only 100k govt jobs of the GS sort. It is not the govt job per se that I worry about; I would say a lot of govt positions are the type of value-added work that the new manufacturing paradigm requires. It is the govt interference in the private sector, and burdening of innovation, that concerns me. 

[yelnick]

Oracle, it turns out some enterprising Chinese have already begun your concept of open source from there! No reason they shouldn't, and it might benefit the US if they succeed. To repeat a clarification I mentioned in a prior comment, think of the IP Layer as not merely the creation of IP, but the whole slate of value-added work required in a place like Apple or Google to innovate, market and deliver the new products and services.

[yelnick]

Newbie, actually, the Food Processing layer can make a lot more money selling a family of preparations of pork than the pig farmer. And they do! The value is in the higher layer, not the farming.

[P3 Dude]

What is Hochberg saying tonight?

[Glenn Loser Neely]

The neely shill DG...(aka neely's bitch).

"Contrary to what they seem to think, nothing they say bothers me."

Yea right...that is why he ALWAYS answers.. also... a person that anwwers "Go F@@@CK yourself" is because it is mad...

Again DG is liar and and idiot..and this is the proof.

GLN

[yelnick]

P3, a three wave zigzag up from Feb lows, first wave done, now in the B, might break as a running triangle or expanded flat - then pop higher.

[DG]

Yea right...that is why he ALWAYS answers.. also... a person that anwwers "Go F@@@CK yourself" is because it is mad...

You're assuming that the reasons you would do those things are the same reasons I do those things. Wrong.

[Glenn Loser Neely]

Neely's gay bofriend said:

"You're assuming that the reasons you would do those things are the same reasons I do those things. Wrong"'

Yes you are correct, you are not normal. You have mental problems and you are lonely gambler, who comes to this blog to get a life.

I can see you waiting every day for your boyfriend neely to post his neo garbage... like a dog waiting his master.

As long as there is people like you in the market, there will be people like me taking your money..... legally of course because...We need idiots like you!!!

See you tomorrow DG (Dog Neely?).. I have to run because I have a date with your mom.

[Hockthefarm]

Definitely one of your best Yelnick and I agree with just about everything you are saying. In fact I think it is our only path forward and we will go there even if it is with a lot of kicking and screaming.

Looking at the factors of production, China has created a huge global change to the labor component. The way to compete with that is to continuously move higher up the chain.

The chink (no pun intended) I see to all of this is this statement you made:

"We have already vastly increased the size and scope of our college-educated workforce, and the IP layer can absorb college graduates just as the assembly line absorbed unskilled labor off the farms."

I think you have over simplified here, and the reality is that vast segments of our population will never be productive again. The transition you talk of today is vastly different than past ones.

It would have made things a lot easier if we had run surplusses rather than deficits since 1980. Sadly, we are further from surplus than we have ever been.

Hock

[yelnick]

Hock, appreciate your kind words. on the oversimplification, perhaps, but I think you would find if you could review the farm migration that it was largely made up of the young and healthy. It didn't happen overnight, altho it accelerated in the '30s due to people losing their farms and the dust bowl (global warming back then!). The problem we have now is with the over 50 workers. We went thru a steep downsizing of steel in 1979, and then a similar downsizing of aerospace in 1991, which in both cases had over 50 workers hit hard. The 30-somethings are more able to adapt and retrain.

[Yleen_nnelg]

Neely said in July of 2009 that he would bet hiss career on 666 not holding and being the low. 4-5 months later he called for some wacky triangle. You need to know that he has "expanding triangle with contracting lines".

Is that in a press release?

[trendlines]

Hi Yelnick,

Here's a short-term analysis of Shanghai Composite:
http://trendlines618.blogspot.com/2010/03/shanghai-composite-short-term-following.html

Technical view -
Short-Term: Neutral, Medium-Term: Bullish, Long-term: Bearish

[bob m]

Did I just wake or something? I think what happened was that TARP and the stimulus were nothing but bold face robbery. Then this sort of legislation was passed taking a giant chunk out of the constitution. But now all that stolen money will be used to launch the stock market because we all know America will ignore losing its liberty as long as their IRA is growing.

[Mamma Boom Boom]

You can put me in with those that think 'you can't eliminate entire segments of economics (manufacturing) and have a successful society'. The absolute proof is the USA, today.

We are now a banana-republic.

[bob m]

Gold accelerating to the downside. Something has to give. Gold needs to start to follow stock or stock will stop and decline with gold.

[Mamma Boom Boom]

By PAUL CRAIG ROBERTS

"As an economist, I am astonished that the American economics profession has no awareness whatsoever that the U.S. economy has been destroyed by the offshoring of U.S. GDP to overseas countries. U.S. corporations, in pursuit of absolute advantage or lowest labor costs and maximum CEO “performance bonuses,” have moved the production of goods and services marketed to Americans to China, India, and elsewhere abroad. When I read economists describe offshoring as free trade based on comparative advantage, I realize that there is no intelligence or integrity in the American economics profession."

Right-On! Right-On!

[Hockthefarm]

Yelnick:

"The 30-somethings are more able to adapt and retrain."

Agreed. and while the 30 somethings may not lead, they can definitely follow and contribute. And it is not as if we must eliminate labor. We can marry it to technological advancement, such that its costs become benign. Boeing comes to mind here. Composite planes that require 1/3rd of the pop rivits. You can still do the pop riviting in Seattle because it has a much smaller impact on overall price.

But the world has changed. In 1970, one union produced 87% of the cars driven in NA. It was a feast for the high school dropout.

My concern is that you can lead a donkey to water, but you can't turn him into a horse. It's one thing to move a person from a field to an assembly line, but to move him from there to a cubicle, well good luck with that. And speaking as a chemical engineer, I'd go absolutely bonkers if I sat around and wrote code all day.

Hock

[Anon]

Anyone have a site that reports the TED Spread in delayed or real time? Bloomberg just pulled their feed for some reason (just when it was starting to look interesting). Coincidence?

[bob m]

Gold needs to fail here or I would expect it AND stocks to rally.

[yelnick]

bob m, an even bigger bank robbery happened from the 2002-08 bubble. Greatest Bank Robbery in History?

[yelnick]

Hock, the good news for you is the routine software is moving offshore! These new 'value added' jobs are much better work than the interminable routine of an assembly line. And the US college system with all its politically-corrct weaknesses produces much more creative and adaptive thinkers than the French or Asian cram systems.

[DG]

"And the US college system with all its politically-corrct weaknesses produces much more creative and adaptive thinkers than the French or Asian cram systems."

Someone once said that the US has "the world's worst 18-year olds and the world's best 30-year olds".

I recall a conversation I had with an Indian colleague back in the early 2000's. I was working in the technology sector and it was clear that many of the coders were Indian and the project managers were whites. He said to give it a couple of decades and that would change. He was a very sharp individual and I think he's right. One of the main reasons I got out of technology was because of the downward wage pressure on even the highest-level skillsets, due to the emergence of the global technology labor pool.

[bob m]

Yelnick yeah I agree. But I think THAT was for greed. I think THIS one is for power and control of US sheeple.

[bob m]

By the way - THANKS GOLD!!! Love the effort!! Let's see some follow thru!!!!

[Michael]

Huge shift by asset-allocators out of Bonds the last few days and into US Equities.

[Chabazite]

Yelnick - 'The Fed is already easing out of QE, and if they really end it, the markets can then reverse.' That will surely happen only when the Fed starts to draw money back out of the system. What if they just leave it there - status quo of inflated prices remains, and no P3 (at least until the next crisis)!

[yelnick]

Chab, if the upwards pressure eases, the market will drop, not hover. Think of it as a rate of change machine. Things will not stay constant. Money will rotate out. The market will chase yield.

Right now Michael noted how we seem to be in a movement out of bonds and into other assets, including stocks. Yields are spiking, the Euro is dropping, and the Yen appears to be next to fall. My next post will be on this topic.

[Chabazite]

Yelnick - very many thanks. When you do your next post, would it be too much to ask if you could build upon your comments of 'high yields', 'dropping Yen', 'fed raising the discount rate' etc to outline the perceived milestones to this process. It would help if we had some kind of road map if you have one in your mind. Chab.

[Mr. Panic]

Wow, market might not finish in the positive. Apple and Baidu both reversed down into the negative after making 52 week highs. We've had enough divergences in the new highs and RSI levels to get me bearish again. The last three days are the type of patterns I look for a top, that is if the market still stays positive by the close (forming massive shooting star--pattern at the $ndx top of March 24,2000----10 years ago when $ndx made a new high unconfirmed by qqqq/overall nasdaq index and $rut.) This three day pattern is evident in the smaller ballistic indices like the biotech and $rut indices. XLF 29 straight closes above the close four periods earlier. Nasdaq with 13 TD combo sell signal (the strictest and shortest of the TD sell signal which admittedly haven't been working but they are interesting to use to measure the market). McClellan Oscillator will be negative if breadth finishes negative. One of my favorite sell setups is the market making a new high with a negative McClellan Oscillator.

[Chabazite]

Labour (socialist) governments have a habit of ending like this ...

Thousands of public servants in Wales on 48-hour strike http://news.bbc.co.uk/1/hi/wales/8553262.stm
Scots civil servants join first Budget Day strike http://news.bbc.co.uk/1/hi/scotland/8583879.stm
Rail unions announce strike dates http://news.bbc.co.uk/1/hi/uk/8586422.stm
British Airways boosts flights for next strike http://news.bbc.co.uk/1/hi/uk/8583276.stm

In Greece they get out on the streets and throw rocks. In Britain we go home and sit on our asses!

[Mr. Panic]

Breadth finished negative. $rut was never up big so breadth must have been narrowly positive when $indu $ndx and $spx were up big earlier. Breadth and up volume had been lessening on all of the big up days the last week or so another type of divergence.

I had been thinking that a sure sign of the market top would be when Dan Zanger ads would start appearing on the hard core E Wave sites. I had seen some of the ads on some general trading/TA sites during the last week but low and behold I saw not one but two DZ ads over at Daneric's site yesterday not to mention a penny stock advisory one also.

[Barood]

13 days from Jan high to Feb Low.
34 days from Feb Low to today.

Ratio(34/13) = 2.61 - Phi = 1. Whole is complete.

[Michael]

"McClellan Oscillator will be negative if breadth finishes negative. One of my favorite sell setups is the market making a new high with a negative McClellan Oscillator." - Mr. Panic

I love sticking with the classical technical indicators like the cumulative A/D line, which actually has been (finally) getting a bit "sloppy" up at these levels. The MACD on this classic technical indicator gave a BUY signal back on Feb. 16th and has kept you LONG all the way until today.

Ka-Ching!