capital spending, robots and “reshoring” of manufacturing to advanced economies

Blogging for the New York Times, Nobel laureate Paul Krugman recently referred to a Times article on the possible return to the US of manufacturing once outsourced (or “offshored”) to Asia.  In “Rise of the Robots,” Mr. Krugman suggests that much (all?) “reshored” manufacturing will be highly capital-intensive.  Factories will be run by robots, with only a few, highly educated, highly paid human supervisors finding being employed.  Therefore, he concludes, reshoring isn’t the job creation panacea some might think.

I have several comments:

1.  This is not new news.

For over two decades, tech businesses like semiconductor manufacturing have been very highly automated.  Component assembly is increasingly so.  In  the semiconductor case, only a few process engineers watch over $3 billion installations that may generate billions in annual operating profit.  Units of output are tiny and weigh next to nothing, so transport costs aren’t that important.  As a result, tax incentives for building and the rate of tax on corporate profit are the two main determinants of where a plant will be located.

One reason there aren’t more fabs in the US is that income tax rates here are relatively high.

2.  At least some of the current reshoring is either in response to political pressure or to creating a more favorable corporate image in the media.  AAPL, an example cited by the Times, has pledged to invest $100 million to make Mac computers in the US.

Sounds good, doesn’t it?

But $100 million is less than 2% of the company’s annual capital spending budget.  So it’s just a drop in the bucket.  If we pluck a number out of the air and say the investment will generate $1 billion in annual sales, which I think would be an awful lot, that wouldn’t amount to even 1% of the $160 billion or so in sales that AAPL will ring up this year.  Plunk! (=the sound of a drop hitting the bucket)

3.  Stuff that’s very heavy, spoils easily or that faces strong protective barriers against imports, normally must be produced in the same country where it’s sold.

4.  For a brief time I owned shares of Osaka-based manufacturer Sanyo Electric in my portfolios.  I bought it despite its collection of ugly business lines because at the time it was by far the dominant global maker of cellphone batteries.  That business was growing like a weed.  It alone was, in my view, worth far more than the entire market capitalization of the company’s stock.

Because Japan was a high labor cost country, Sanyo had created a highly automated operation.  For each 20,000 units of annual battery production, it had installed machines worth $1 million, which were  watched over by six employees making $50,000 a year each (these are not the real numbers, but that’s not important  for my point).

Business was great–until Chinese competitor BYD emerged.  If the name sounds familiar, it became famous years later when Warren Buffett “discovered” it.  BYD didn’t have the highly educated workers available to it that Sanyo did.  So it couldn’t use the highly automated machinery that its Japanese rival employed.  Instead, it bought simpler, locally made machines that were manned by a larger number of less skilled workers.  To produce equivalent output to Sanyo’s, it installed $500,000 worth of its simpler machines, run by 20 people being paid $7,500 a year each (again not the real numbers–like the real Sanyo figures, those are in notes which remained the property of my employer when I left) .

…and?

The really stunning thing about this example is that:

–BYD made its batteries with both less input of capital cost and less input of labor than Sanyo.  In the textbooks that’s not supposed to happen.  You’re supposed to have to choose between capital-intensive or labor-intensive production methods.  And you’re supposed to be able to compete using either approach, depending on your local labor cost structure.  Not here, though.

A little arithmetic–

Assume that we write the cost of the machinery off in equal installments over ten years.  Then Sanyo’s costs are raw materials + electricity + water, etc. + $100,000 in depreciation + $300,000 in salary.  That’s $20 for each battery + materials…, maybe $25 for each in total.

For BYD, the figures are raw materials etc. + $50,000 +150,000.  That’s $10 + materials… for each battery.  That’s maybe $14 in total.

True, the BYD batteries were probably only 90% as good as the Sanyo ones.  But they cost only a little more than half as much to make.

Lots of medium-tech stuff is like these batteries.  Note, too, that the Chinese salary I quote is less than half the minimum wage in the US.  So the Chinese business model won’t fly here.

5.  As the NYT pointed out in a follow-up, wages in eastern China have more than doubled since I owned Sanyo Electric–meaning that, all other factors being equal, BYD’s labor cost advantage has almost completely eroded.  I presume, but don’t know, that, if so, BYD has shifted production into western China, where wages are still low.

If this business follows the pattern of other industries I’ve followed, like the textiles, at some point the battery industry will shift out of China in search of lower costs.  Machinery will be shipped to another low labor-cost country, India?  Bangladesh?, where production will be resumed.  In fact, BYD may enjoy considerable local tax breaks for doing so.

But wherever the machinery ends up, it’s almost certainly not going to end up in the US.  That would just recreate the company’s situation of too expensive low-skilled labor.  Also, its plants may not be particularly welcome in a country where the firm has no political clout.  More than that, it could be that being Chinese-owned would make it a target of adverse political action.

My take:

This is a big issue, one without a clear solution.  Contrary to Mr. Krugman’s suggestion, I don’t think we’re seeing a reprise of the 19th century, when holders of large amounts of capital had a gigantic (unfair?) edge over people born into families of modest means.  Rather, the 21st century reality is that the market price of unskilled labor in an increasingly global world is under $10,000 a year.

A country can try to protect politically powerful but non-competitive industries, as Mr. Obama has recently done with tires, but that leads to disaster–enriching a small group of political favorites at the expense of everyone else (see my posts).

If all the good manufacturing jobs are robot-driven, then not all highly educated workers will find jobs there. That’s also not a great surprise, since the manufacturing sector in the US has been shrinking for decades.

But, of course, poorly educated workers will be excluded from manufacturing employment entirely.

In the service sector, where all the job growth has been in the US, the field seems to belong to highly educated, computer-savvy entrepreneurs.  Again, the poorly educated need not apply.

I don’t think that in the US a good education is a sufficient condition of personal economic prosperity, but it is a necessary one.

the latest Japanese election comes on Sunday

getting scared straight

Cable network A&E is now into its third season of Beyond Scared Straight. This is the latest iteration in the Scared Straight genre, created in the 1970s, in which budding criminals visit prisons and are supposedly frightened back onto the straight and narrow by Ghost of Christmas Yet to Come-like interaction with the inmates.  I’ve never had enough interest to try to figure out how much is real and how much is staged.

There is a real-life Scared Straight, though, for economics and public policy.  It’s called Japan.  Maybe we should send our elected officials in Washington for a visit.

Japan

The Japanese economy has been in neutral for almost a quarter-century, during which the standard of living for average Japanese citizens has steadily eroded. The workforce is aging (it’s actually been shrinking for about a decade) but Tokyo doesn’t allow immigration.  Weak management is slowly (sometimes, not so slowly) killing even iconic companies, but foreign turnaround specialists aren’t allowed to take control.

Worse, the government borrows heavily to spend on pork barrel “stimulus” projects that yield no economic return.  As a result, national debt now exceeds 2x annual GDP. That’s a Greece-like number. Perversely, because Japan is almost devoid of good new investment opportunities (small “counterculture” companies run by younger managers are an exception), citizens continue to plow their savings back into government bonds, even though they yield next to nothing–creating a continuing cycle of misery. The Diet has not been overwhelmed by the interest expense of its reckless borrowing, nor has it had trouble, so far, in raising fresh funds to squander.

There’s an election on Sunday, in which the hapless Democratic Party of Japan is likely to be replaced by the Liberal Democrats, who have been the dominant force in modern Japanese politics.  The DPJ was voted in a few years ago to change the patronage culture, but almost immediately lost its way in a frenzy of intra-party bloodletting.

why the election is interesting–and maybe important

Shinzo Abe, who will become the Prime Minister if the LDP wins, is running on a platform that includes dismantling the independent central bank.  If Mr. Abe gets his way, the bank will be forced to print money as fast as the presses can turn, until this action creates at least 2% annual inflation.

Wow!

I guess the idea is to weaken the currency so that even arthritic export-oriented manufacturing companies will be able to make a profit.   There’s also the “advantage” that the currency markets, rather than the legislature, may take the blame for the immense loss of national wealth that would ensue.  At the same time, to the degree that the LDP is successful in creating inflation, it will also likely triple or quadruple the interest rate on new government debt–potentially making it impossible for Tokyo to service.  Scary.

Implosion isn’t imminent.  Mr. Abe hasn’t won yet.  Maybe he’ll change his tune after he’s in office.  Maybe the Bank of Japan won’t simply roll over and do what he says.  But, to mix metaphors a bit, that’s kind of like saying that the fuse to the dynamite that’s being lit is very long.  Japan could be an Asian version of Greece if a few years.

the really scary part for the US

In a nutshell, Japan’s basic problem is that since the early 1990s it has chosen to prop up the status quo, in the face of a changing world, no matter what the cost.  What’s really scary for an American is that Washington seems to be taking a turn down the same road.

the fiscal cliff: why not just raise income tax rates?

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.

won’t closing the Federal budget deficit be bad for stocks?

…after all, the only way the US will achieve budget balance will be through some combination of higher taxes and lower government spending.  The former will mean less income available for consumption; the latter will mean less stimulus from Washington for the economy.  On the surface, at least, both imply slower economic growth for some years–something that should be bad for stocks.

Yes, that’s right.  But it’s not the whole story.

For one thing, half the profits of the S&P 500 come from operations outside the US.  Their growth shouldn’t be negatively affected to any great degree, if at all.  Professional will tilt their portfolios toward foreign earners.

There’s also the question of the price earnings multiple applied to corporate profits, which in the case of the S&P 500 is currently relatively low.  Arguably, there are two reasons for this–both based on the idea that ordinary investors are much more savvy than pundits think.

1.  The current situation with government spending and taxation is economically unhealthy and ultimately unsustainable.  If deficit spending proceeds unchecked, some point lenders will lose confidence in the ability of the US to repay its obligations and demand, at a minimum, higher interest rates on new loans.  A two percentage point rise on $14 trillion in debt–which would come only slowly, as existing debt matured–would add about a quarter-trillion dollars to government debt servicing expense! And that’s by no means the ugliest thing that could happen (look back to the government bond buyers strike in 1987, for example).

Maybe the market PE would be 10% higher if the US weren’t slowly headed down this road.

2.  In investors’  imaginations fiscal contraction is almost certainly worse than the reality will be.  It’s even possible that more highly taxed citizens will demand better service from Washington than we get at present–maybe immigration reform to allow highly skilled foreign students to remain in the US, maybe shrinking the military so it’s not Washington’s largest expense, maybe finding out why Americans pay 2x what the rest of the world does for the same healthcare.  Who knows?  In any event, the elimination of uncertainty may be worth another point–or more–on the PE multiple.

In essence, I’m arguing that a reversal of bad fiscal policy won’t be a Wall Street disaster because the assumption of a continuation of that slow-motion train wreck is already depressing equity prices.  I don’t think, on the other hand, that prices will explode upward if Washington changes stripes.  A mild uptrend, with growth stocks outperforming?  Maybe Generations X and Y will begin to invest to fund their retirements…

it’s more than just the fiscal cliff

The fiscal cliff is only the first step in extricating the US from a fiscal mess created over the past decade.

a quick-and-dirty modern economic history…

…that is, my account of how the US got into the precarious position we’re in now

after WWII

The decades immediately after WWII were an extraordinary time for the US economy, for several interconnected reasons:

–the global war had been waged primarily in Europe and the Pacific, so American industrial productive capacity was virtually untouched.  Practically speaking, if anyone wanted a piece of industrial machinery or a consumer appliance, he had to buy from a US company.

–as part of its efforts to rebuild war-torn nations–through a mix of altruism and the desire to create useful allies against the Soviets–the US became banker to the world.  This gave Washington the ability to issue loans to itself without the same scrutiny that countries would normally be subject to.

–efforts to help the rest of the world rebuild earned the US a huge amount of good will that lasted for a generation.  Europe humored us for a long while.  Japan, influenced by the guilt of having lost the war, twisted itself into a pretzel to accommodate the US far longer–until relatively recently.

For decades, then, the US maintained a substantial house advantage over the rest of the world.

Most Americans don’t regard this period as one of extraordinary good fortune.  We think this is normal–even though it isn’t.  We also don’t realize that this lucky era is already in the rear view mirror.

the Seventies/Eighties

This was a time of considerable GDP=boosting structural change for the domestic economy–the move to the suburbs, the rise of specialty retailing, the emergence of the computer, the revamping of many older, stagnant world trade-oriented companies in the Junk Bond era.

the Nineties

more structural change–mobile phones, PCs, the Internet–to boost GDP.

But this decade also marked the rise of China as an industrial competitor–hungry, fast-growing and without the warm feelings toward the US generated by WWII.  In a world where there previously had only been Michael Jordan (us), suddenly an Asian LeBron James appeared as a competitor on the scene.

today

The US opened the 21st century with a government budget surplus.  In fact, the Congressional Budget Office predicted that surpluses would likely continue as far as the eye could see.

For a number of years, Congress had been strongly encouraging banks to make mortgage loans, so more Americans would become homeowners instead of renters. It put Alan Greenspan, then the Fed Chairman, in charge of supervising this activity, but (so Mr. Greenspan now intimates) with strict instructions to do nothing to slow down lending.

Eyeing financial services as a new area for US economic expansion, in the late Nineties Congress had also repealed the Glass-Steagall Act, the Depression-era legislation that prohibited commercial banks from doing brokerage house trading.

So?

Washington spent the putative surplus right away by cutting income taxes, raising entitlement spending and attacking Iraq and Afghanistan.

A combination of too-low interest rates, rampant real estate speculation and reckless trading by the banks in toxic mortgage derivatives they created with their new freedom caused a near-collapse of the global financial system and the deepest economic downturn in the US since the 1930s.  Yes, we made out better than the EU, but that’s a cold comfort.

Washington has borrowed and spent over $5 trillion during the past four years in an effort to stabilize the economy, forfeiting its AAA credit rating in doing so.

where does the fiscal cliff come in?

The US can’t continue to borrow and spend a trillion dollars a year indefinitely.  At some point potential lenders will balk.  (By the way, that happened in 1987, when domestic lenders, not foreigners, refused to buy more Treasuries.)  So Washington devised a first step to begin to close the budget gap.  It has two parts.

Emergency tax cuts that boost consumer spending end on December 31st, unless Washington extends them.  Legally mandated cuts in Federal government spending amounting to $100 billion a year go into effect on January 1st.  Ben Bernanke termed this the “fiscal cliff” to convey his belief that the US is currently still too weak economically at present to take this fiscal contraction in stride.

the more?

Though the current budget deficit should narrow somewhat by itself as the economy eventually strengthens–through more tax receipts, less government assistance–it’s hard to see how the US will be able to grow fast enough for it to disappear entirely.  And then there”s the $5 trillion tab that the rescue effort has run up.  The fiscal cliff proposals are only a drop in the bucket–a big drop, maybe, but still…

The bet on banking as a new source of economic growth has gone badly wrong.  The emphasis on residential real estate has provided a lot of construction jobs and a ton of McMansions, but hasn’t helped to develop the highly skilled labor needed to justify customary wages in an increasingly competitive world. Nor has it added to our industrial manufacturing base. Neither housing nor defense (fully 1/4th of Washington’s spending) yields an economic return.

Washington doesn’t appear to have much of a clue, either about what to do about the problem–or perhaps even that it exists.  And, like Japan in the 1990s (and beyond), we continue to return the same inept players to office.   Part of the Washington problem is that until recently the patronage pie has been increasing every year.  It’s much more difficult to allocate who has to cut the most during an era of diminished resources.  But that’s the situation we’re in today.