Down is Still Down

So what if we become a nation of hamburger flippers? John Mauldin responds to a question put to him by Bill Bonner, while they were hanging out together on the back porch at Ouzilly.

"How can we," asked my friend and your editor, Bill Bonner, as we sat basking in the evening sun at his château in pastoral France only a month ago, "continue to buy goods if all we sell is services? Can we be a nation that just produces services and still maintain our way of life? How can we survive if our largest exports are jobs and the U.S. dollar?"

(Note: it is easy to ask such pessimistic questions while you bask in pastoral splendor at your château on the second bottle of wine.)

The numbers appear to confirm Bonner’s suspicions: "According to the Bureau of Labor Statistics," writes Bruce Bartlett of the National Center for Policy Analysis, "there were 14.6 million Americans employed in manufacturing in July, down from 15.3 million a year earlier, 16.4 million the year before that (2001) and 17.3 million the year before that (2000) – a decline of 16 percent in 3 years. The recent peak for manufacturing employment occurred in March 1998 at 17.6 million – about the same as it had been for the previous 15 years."

The stories are all over the press about how manufacturing jobs are being shifted to China, Mexico (think NAFTA) and (pick your favorite third-world country). They are the same stories, with different countries substituted, that I read in the 70’s. We read in those tough economic times that the U.S. was then at its zenith and moving into an era of low employment. Eventually, we would see Japan eclipse us as the pre-eminent economic power.

Bruce Bartlett: Declines in Manufacturing Employment

But "it is also important," Bartlett tells us, "to note that virtually every other major country has seen declines in manufacturing employment. Between 1992 and 2002, U.S. manufacturing employment fell by 3.7%. In Britain, it fell 4.7%, in Japan it fell 5.2%, and in Germany it fell 6.1%.

"…Industrial production [in the U.S.] has remained relatively strong. The Federal Reserve Board’s industrial production index is up 5 percent since manufacturing employment peaked in 1998, and down just 5 percent from the index’s peak in July 2000, despite a rather severe recession in the meantime.

"Looking at gross domestic product, real goods production as a share of real (inflation-adjusted) GDP is close to its all-time high. In the first quarter of 2003 – the latest data available – real goods production was 39.2 percent of real GDP. The highest annual figure ever recorded was 40 percent in 2000. By contrast, in the ‘good old days’ of the 1940s, 1950s and 1960s, the U.S. actually produced far fewer goods as a share of total output. The highest figure recorded in the 1940s was 35.5 percent in 1943; the highest in the 1950s was 34.9 percent in 1953; and the highest in the 1960s was 33.6 percent in 1966.

"In short, manufacturing output is very healthy. There is absolutely no evidence whatsoever that we are becoming a nation of ‘hamburger flippers.’ We are producing more ‘things’ than we have in almost every year of our history for which we have data."

The decline in employment is, in effect, a good thing, because it means that manufacturing productivity is very high. That is also a good thing, because it means that employers can afford to pay high wages to manufacturing workers while still competing with low-wage workers in places like Mexico and China. "Remember," says Bartlett, "what really matters for employers is not absolute wages, but unit labor costs – how much the labor costs to manufacture a given product. If a U.S. worker is five times as productive as a Mexican worker making one-fifth as much, they are exactly equal from the point of view of a producer."

Bruce Bartlett: Agricultural and Mining Output

Critics to this optimistic view note that Bartlett includes agricultural and mining output. My answer is, so what? Are not food and minerals part of the "stuff that so many say we’re not producing"? Agriculture and mining certainly produce exports and employment, which is the concern expressed by those worried about the collapse of U.S. manufacturing. Others suggest that the numbers reflect the fact that U.S. manufacturers are selling Chinese goods, which masks the problem.

Bartlett in a later column notes that this is not the case. "This is just a misunderstanding of how the gross domestic product is constructed. All imports are subtracted from final sales to calculate GDP. Therefore, imports from China or anywhere else can never raise GDP; they always cause it to be lower than if they were produced domestically. GDP measures only actual production on U.S. soil. In short, imports reduce GDP and exports increase it."

One final thought from Bartlett: much of the ‘decline’ in manufacturing employment is not real. Many manufacturing companies used to do everything in-house. Now many outsource as much as possible: janitors, accounting, data processing, sales, human resources, etc. Before, these jobs were counted as manufacturing because they were employees of manufacturing companies. Now, since the same jobs are part of an out-sourcing firm, they are considered service jobs.

As Bartlett notes, even if we are producing more stuff than ever, we are doing it with far less employees, and are doing so every year. Manufacturing jobs are indeed leaving the U.S. or being replaced by more efficient machines, but their demise is not voluntary: they are forced out by both productivity increases and price margin squeezes.

Citing the Philly Fed survey for August, Greg Weldon, editor of The Money Monitor, points out that twice as many firms were planning to cut employees in August over the previous month…even as 75% of these firms projected rising sales and improving business conditions.

Weldon slices and dices numbers as well as anyone I know, and he found a few devils in the details of the seemingly bullish report. The Philly Fed survey noted that prices paid for input material are up 16%, but prices received are up only 1.1%…meaning that sales margins are being squeezed. No wonder jobs are being cut, as costs are rising (in no small part due to energy costs), but the prices firms can charge are not.

Bruce Bartlett: A Classic Symptom of Deflation

Something has to give, and it is jobs.

This is a classic symptom of deflation. Indeed, all but one Fed governor was out in force this week talking about the ‘risks’ of lower inflation.

Second, Greg notes that expectations for improved business conditions are at a ten-year high. The last time they were this high, we headed into the 1991-2 recession. Not one firm reported a decline in expectations. It doesn’t get any better than that. It also means that perfection is ‘priced in’ to the expectations. Anything less will be disappointing.

A friend of mine in a high place has been keeping track of an interesting statistic: actual initial claims for unemployment. The number you see in the news is "seasonally adjusted." (That means seasoned and cooked by the government agencies that release them.) Even though the reported number was 386,000, the actual number was 307,000, which seems better in comparison. The key is the trend. Continuing claims are over 100k more in 2003 than 2002, using August 9 data (3,419,378 in 2003 versus 3,272,880 in 2002).

But for the first time in a long time in this cycle, week on week comparisons for last week showed a real drop of about 5% from one year ago. We are assured by all concerned that it had nothing to do with the blackout and people not being able to file.

Hopefully, this trend will continue. But maybe it won’t. Lay-off announcements usually increase after Labor Day (can you spell irony?), and they are running well ahead of last year. Challenger Gray reports an unusually high number of announced lay-offs for the month of July. 76,000 jobs went poof last week before last.

Bruce Bartlett: No Job Creation

The fact is, the ‘recovery’ is not doing the one thing recoveries are supposed to do: create jobs. Unemployment didn’t actually fall last month, as BLS reported to us. The authorities who count such things only count those who are actually seeking jobs as unemployed, which makes some kind of sense. But last month, they dropped around one half million of our fellow citizens from the unemployed ranks, not necessarily because they had found jobs, but because they had become so discouraged, they stopped looking.

The old line is that a recession is when your neighbor loses his job. A depression is when you lose yours.

Labor unions on the left and Pat Buchanan on the right are calling for trade barriers to ‘protect’ American jobs. The self-righteous vigor with which they decry the free markets borders on the religious frenzy of the tent revival meetings of my West Texas youth.

What they are really saying is that America should produce fewer goods with more workers, thus forcing American consumers to spend more for their goods and services. They want us to protect people from change. This type of ‘protection’ is as much a tax as is the income tax, and is just one reason why the Bush steel tariff policy is so wrong.

One industry after another, as it matures, becomes more efficient. Its products become more of a commodity. TV, electricity, cars, transportation…all are less expensive today than when they were first introduced. I write today looking at my new Dell plasma 19" monitor, which cost around $550. A few years ago, such luxuries were $10,000. In a short time, they will be only a few hundred dollars at most.

Should we force Dell to produce these in the U.S.? Should I be forced to pay $5,000? Of course, if that were the price, I would not buy, and neither would anyone else.

This is called the Law of Comparative Advantage, which was developed in the early 1800s by the great English economist David Ricardo. In short, this is a principle that states that individuals, firms, regions or nations can gain by specializing in the production of goods that they produce cheaply (that is, at a low opportunity cost) and exchanging those goods for other desired goods for which they are high-opportunity-cost producers.

This is a very neat and tidy law, and is true for all places and all times, in capitalist as well as socialist countries. But it has a caveat.

When that comparative advantage changes, those directly affected in the negative will not be happy. If it is your job that is lost to China or to a robot, you are the one who must find a new avenue of support.

If enough of your peers in your industry also experience ‘down-sizing,’ it will serve to drive down the wages of your profession. Think India and other educated third-world countries and what they are beginning to do to wages for technology-sector workers, especially software programmers.

You can only be protected from change for so long. Eventually, the Law of Comparative Advantage will exact its economic due, and the resulting change will be just, if not more, serious.

The world is changing at an ever-faster pace. It is quite unsettling to many workers, yet that is the reality with which we are faced. Sometimes the changes will force people into a lower life style. Sometimes it makes them become creative and start new companies and whole new industries, creating the demand for far more workers.

Thus, I can with one breath say that the United States will do just fine during this period of change, and yet acknowledge that the head winds of change will create significant problems and require substantial adjustments.

It is entirely consistent to suggest a 30% real GDP growth for the U.S. economy over the next ten years (which is still well below trend and potential growth), and also suggest that we will see at least two recessions as we resolve the U.S. imbalances in the trade deficit and the imbalance in the world of U.S.-centric global trade.

Readers of my weekly e-mail know I have come to call this the Muddle Through Decade. It refers to a long period of below-trend growth in which we must come to terms with all of the imbalances created by the last boom. It will be far more like the 70’s than the 90’s.

Cataclysmic changes are rare events for free market economies. They usually come as a war or revolution, and not because of a shift in comparative advantage. While economic shifts can be far-reaching, in a free market world, the changes can be dealt with individual by individual.

Warm regards,

John Mauldin,
for The Daily Reckoning

August 26, 2003

P.S. In 1532 Juan Pizarro met a force of 80,000 Incas along with their God-Emperor Atahuallpa at Cajamarca. He had a ragtag group of 186 soldiers. It was no contest. Pizarro captured the Emperor, through deceit and other infamous acts. This produced a cataclysmic change for the Incas.

Think of many modern economic changes which produced changes no less significant for the world economy, but which worked themselves out in a more reasonable manner.

Gary Shilling notes in his book that the construction of the Erie Canal precipitated a serious drop in the price of wheat. Think of the changes that wrought upon the farmers. New markets became available, but at much lower prices. Not everyone liked the new world order, or praised the canal. But from the time advantage of our perspective, we see the canal as a positive move forward.

What will future historians say about our time? That we were met with challenges and did just fine, thank you. Did some groups do better than others? Yes.

There can be no insurance for change, no policy that protects. You just have to deal with it. I see no reason why we should not deal with change as well in the future as we have in the past.

John Mauldin is a prolific investment writer and analyst and president of Millennium Wave Investments. He is a frequent contributor to The Fleet Street Letter and Strategic Investment, and is currently writing a book entitled "Absolute Returns."

The U.S. federal deficit is now expected to hit half a trillion dollars next year, according to a congressional committee. John Spratt, a S.C. Democrat, says the deficit pile-up over the next 10 years would total about $3.7 trillion.

A half a trillion is also the amount of capital that the U.S. needs to import from overseas to make up for the trade deficit.

How can these deficits be financed? Consumer savings rates are near zero. Corporate savings, or retained earnings, are actually negative. The money must come from abroad.

Still, many economists say these deficits are signs of health. The federal deficit helps stimulate the economy, they say. The current account deficit just shows how much foreigners admire us; overseas investors buy up our stocks and bonds because they know we have the most dynamic economy in the world. Besides, what else can they do with the money?

Thus, we have one of the goofiest ideas of modern economics: that the world’s creditors are at the mercy of its biggest debtor.

The idea is absurd; our intuition tells us so. Does it not say in the Bible that "the borrower is slave to the lender"? In a meeting of banker and borrower, is it not the former who swaggers and the latter who grovels?

And yet, from Federal Reserve governors to university economists to TV presenters runs the notion that China and our other major trading partners must reinvest their trade surpluses back in the U.S., no matter what.

These foreign investors have already lost trillions – first when the dollar fell against major foreign currencies over the last 12 months…and then when U.S. bond prices collapsed this past summer. We do not doubt that overseas investors are no geniuses. But even a Social Democrat eventually figures out how to stop losing money.

‘Yes, but we’ve got them over a barrel,’ say the economists. ‘If they don’t re-invest in the U.S., the dollar will fall even more. Then, they won’t be able to sell so much of their production on the U.S. market. In fact, without the U.S. deficits, the whole world economy will go down the drain.’

The U.S. might be likened to a company that sets up in a small town…and becomes its biggest business. Soon, the whole town depends on it. It is the major buyer at the hardware store. Its employees are the biggest spenders at the grocery store. Its executives are big spenders at the local bar…and the biggest borrowers at the local bank. Its owners give the nicest parties and are accorded a special unspoken rank at the local Presbyterian church, where they are the biggest givers.

But The Company loses money each year. So, it goes to the bank and to the merchants and says: give us more credit, or we stop spending. More and more credit is extended, because each merchant wants the business. The tavern owner allows the bar tab to grow. The banker increases the company’s line of credit. Even at church, the minister might want to give an especially warm handshake to the owner.

The townspeople may even get together and decide to back The Company ‘for the good of the whole town’…even going so far as to contact their legislators in the state capitol or Washington in an effort to get the company special favors or extra loot.

But as The Company goes deeper and deeper into the hole, eventually, one by one, the townspeople begin to feel like fools and patsies. ‘When are we ever going to get paid,’ they ask. ‘How,’ they want to know. ‘It may be in the interest of the whole town to have The Company spending money,’ says the barkeep to himself, ‘but I’m tired of giving away good liquor.’

Finally, they all turn on The Company…dump its I.O.U.s at whatever prices they can get for them…and forget to invite the owner’s wife to tea.

Someday, we remind readers, foreigners will turn on the dollar. What day? We don’t know…

In the meantime, here’s Addison with the latest news:


Addison Wiggin writing from Paris, France…

– "It is too early to suggest it is a total turnaround," Intel’s CEO Craig Barnett said yesterday. You think so, Craig? The Dow apparently agreed; it continued the sell-off it began on Friday. The Dow dropped 31 points to 9317. The Nasdaq fell but a point to 1764.

– Gold lost 70 cents…and rests at $360.

– It’s the end of summer, and the living is still easy. And you are fortunate, dear reader; this is an historic time to be alive and a spectator of the financial markets. Why? Well, for starters, new house sales hit another record in July, with the median house selling for 12.1% more than a year ago – the biggest gain in more than 20 years. In the meantime, as we reported yesterday, Freddie Mac’s chief executive, Greg Parseghian, was chased out of his post by a meddling Fed regulator. How are these two news items related? If you have been following along you probably already know the answer. Your meddling editors, at least, suspect they signal the opening salvo to one of the greatest spectacles ever to unfold in financial history.

– The Daily Reckoning began life as an awe-struck witness to a dazzling run-up in the stock markets, most gloriously exemplified by the Nasdaq topping out at 5048. Your editors were cranks who just didn’t ‘get it.’ It was a hoot. (If you’re a long-time reader, you’ll recall we enjoyed a remarkable stretch of schadenfreude while the Nasdaq was getting splattered all over God’s green earth.)

– While doing research for "Daily Reckoning: The Book" ("Financial Reckoning Day," John Wiley & Sons – due to bookstores soon), we noticed that even far back in the recesses of history – all they way back to John Law and the Mississippi scheme – exploding financial bubbles usually get some of their goo on the real estate markets…which voraciously gobble it up…until they, too, go boom.

– "If you want to be successful," Jimmy Rogers writes in the foreword to our book, "you’ve got to understand history. You’ll see how the world is always changing. You’ll see how a lot of the things we see today have happened before. Believe it or not, the stock market didn’t begin the day you graduated from school. The stock market’s been around for centuries. All markets have. These things have happened before. And will happen again.

– "As [Financial Reckoning Day] demonstrates, artificially low interest rates and rapid credit creation policies set by Alan Greenspan and the Federal Reserve caused the bubble in U.S. stocks of the late ’90s. Now, policies being pursued at the Fed are making the bubble worse. They are changing it from a stock market bubble to a consumption and housing bubble.

– "And when those bubbles burst, it’s going to be worse than the stock market bubble, because there are a lot more people that are involved in consumption and housing. When all these people find out that house prices don’t go up forever, with very high credit card debt, there are going to be a lot of angry people."

– By the way, Jim Rogers will be speaking at the upcoming New Orleans Investment Conference, alongside Bill and your New York editor, Eric Fry. If you’d like to catch them, you can sign up to attend below…

– The fact that new house sales reached an all-time high just about the time the Federal spooks started hunting for heads at Freddie Mac, we’ll take as an ignominious sign that the housing bubble is about to blow. Not to mention the fact that long-term rates began rising in June, despite the best efforts of Mr. Greenspan and his band of cronies at the Fed.

– Our friend and colleague Gary North, following the housing bubble saga closely, has noted that even the mainstream press has been getting edgy over Fannie and Freddie’s frolicking in the credit markets. An article in the New York Times on August 8th noted that Fannie Mae "faces much bigger losses from interest rate swings than it has publicly disclosed."

– "At the end of last year," the Times piece goes on, "[computer models] showed that Fannie Mae’s portfolio would have lost $7.5 billion in value if interest rates rose immediately by 1.5 percentage points…" That’s a sum equal to half its market value. "With $923 billion in assets under management, the Times also reports, "Fannie Mae is the second-largest financial company in the United States, trailing only Citigroup." The implications of a collapsing mortgage market extend far beyond these erstwhile GSE’s…

– Gretchen Morgenson, also writing in The NYTimes, and citing the work of Jim Bianco’s research firm in Chicago, notes that "the last time interest rates moved up – in the mid 1990s – the mortgage-backed securities market was much smaller and more manageable. ‘Back in 1996, the mortgage market was roughly half the size of the Treasury market’, Bianco says. ‘Now it is 125 percent of the Treasury market.’"

– Mr. Bianco, apparently, fears that "the size of the market" and "the fact that so many players are heavily leveraged make a disaster almost inevitable."

– "Because of the threat to the American bond market that mortgage lending institutions pose," North elaborates, "I don’t expect the Fed to allow long-term rates to rise to double-digit levels. But, before the Fed panics and starts buying T-bonds to force down long rates, I do expect mortgage rates to rise at least back to the 7% to 8% range. This will have negative consequences for the following: 1. The supply of people who can qualify for loans; 2. The retail prices of homes that prospective buyers can finance with their existing incomes; 3. The home equity that existing buyers now possess; 4. The liquidity of the housing market; 5. The monthly disposable income of people who bought homes using Adjustable Rate Mortgages.

– "In short, pop goes the bubble." It hasn’t happened yet, but when it does, there are going to be a lot of angry people.


Bill Bonner, back in Paris…

*** China’s economy is growing 3 times as fast as the U.S.’s.

"With an expected annual GDP growth rate of 7% this year," writes James Boric, editor of Penny Stock Fortunes, "China is growing faster than any other large country in the world."

In particular, Chinese manufacturing is enjoying a season in the sun. If the ’80s were the hey-day of China’s farmers, subsequent years have glorified its producers. Thousands of empty containers have piled up in New Jersey (they came full, but there is nothing to ship back in them) and trillions of dollars have accumulated in overseas bank accounts. These are the silent witnesses of China’s manufacturing revolution.

But it’s not only exportable gadgets and gee-gaws that China makes; the country must provide for its growing internal industry, too.

"Today, there are about 160,000 kilometers of paved roadways in China," continues James Boric. "That’s significantly more than in 1985, but still very low for such a large country.

"There is a ton of room for growth in China. Billions of dollars still need to be spent on new roads, cars and engines. And now that China is opening its borders more to the rest of the world, you can bet it will go the extra mile to improve its infrastructure, make new cars and bolster its public transportation system."

*** Americans expecting an economic recovery are destined to be disappointed. Samuel M. Robbins explains why:

"There is no longer the pent-up demand that followed WWII. There is no shortage of cars or houses or computers. Thus, consumer demand, once thought to be the mainstay of the domestic economy, is unlikely to hold up the economy…. After all, the consumer has already borrowed and spent all he can. Consumer debt has risen twice as fast as consumer income. At some point, debt service will take priority over consumption. One can hardly expect manufacturers to expand their domestic production when they are already operating at 75% capacity. Thus the ingredients of a boom or a recovery do not exist…"

*** We spent yesterday enrolling Jules, 15, in the American School of Paris. Jules has been in French schools for the last 6 years; the American school is a new experience.

"We know some of you are nervous," said the principal to the new recruits. "There may be some of you who are not too happy about being here. We know that many of you are here because your parents were transferred to Paris for business reasons, for example. And you may not even like being here.

"But our job is to make you comfortable and make sure that the year you spend with us is one of the best learning experiences you ever have."

So pleasant with their mid-western accents. Everybody smiled. Everyone was so up-beat and positive. So relaxed.

This was very different from our encounters with the headmasters of St. Jean de Passy or the Institute de la Tour. They would not waste a minute trying to make students or parents feel at ease.

At St. Jean, for example, the principal is a man with a white-bearded face like Victor Hugo and the demeanor of a whaling captain. Each year, instead of warmly welcoming the children and parents, he calls them together and delivers a chilling 45-minute lecture…warning that if any student comes to school late, or unprepared, he will hold the parents personally responsible. He gives this warning while pacing back and forth on the stage with what looks like a harpoon in his hand, practically daring the parents to ask a question or raise a doubt. The parents, two per child, and many of them former students, sit as still and mute as dead fish. Back home, they immediately set upon their children with rigid homework schedules…and tutors in French, history, math, and Latin. More math…more literature…more languages…more history. Day and night, the parents push and prod…tempt and torment…trying to get their children to do better. The last thing they want is to face the headmaster in a private conference…or worse, have their children sent away from St. Jean.

"Well, Jules, what do you think," asked his father after a day at the American school.

"I don’t know…it will be a change…I’m taking a course in pottery…"

The Daily Reckoning