Mind the Gap

THE PHRASE “mind the gap” can be heard or read in subways around the world, from England to Canada to Singapore. It originated with the London Underground, the world’s oldest and largest subterranean rail system, in 1969. Occasional sharp curves in the tunnels require station platforms to curve alongside, leaving noticeable space between the edge of the platform and the waiting carriage car. “Mind the gap” is thus meant to warn embarking and disembarking passengers, lest they lose a shoe, twist an ankle, or worse.

After nearly 40 years, “mind the gap” is internationally recognized as a London expression. (The Underground has capitalized on this fact by selling T-shirts.) It is typically offered as a gruff word of warning, on par with the American expression of “heads-up!” From our perspective, minding the gap is good advice regarding the challenges of globalization. In the West, there is a growing divide between haves and have-nots; this gap now threatens to become a gulf. In the developing world, there are rumbles of exploitation — a gap between mercantilist policies and social equity. And with political promises growing more expensive by the day, Western welfare states may soon find themselves swallowed up by the gap between income and expenditures.

Pollyanna vs. Doom and Gloom

Globalization is a polarizing topic by nature. The acceleration of outsourcing and offshore manufacturing trends have made it even more so. At opposing ends of the spectrum, there are two camps: those who see globalization as an unalloyed good, and those who view it as an unmitigated evil. We did not set out to caricaturize these viewpoints; as it turns out, vocal members of the camps have effectively caricaturized themselves. The popular defenses of globalization — particularly those that portray everything as rosy and America still in the catbird seat — tend to be cartoonish in their one-sidedness. The same applies in reverse to the anti-globalizers, however, who have it in their heads that things are going straight to hell.

Both camps offer valid points and glaring omissions; the reality of globalization falls somewhere in between the good versus evil extreme.

But covering all the bases is a lot to ask of one essay. So we shall begin modestly, with a piece of iconic technology.

Behold the iPod

Chances are there is an iPod in your family — perhaps more than one. If you do not own one, a younger-generation relative just might. The iPod is a wonderful invention; it has improved the musical quality of life for millions. As with other wildly successful technologies, those of us addicted to our iPods cannot imagine life without them.

Musical bliss aside, Apple’s manufacturing process is a testament to free trade realities – for better and for worse. With apologies to Blaise Pascal, the iPod is both the glory and the shame of globalization.

In a 2004 Wall Street Journal piece entitled “We Think, They Sweat,” ex-hedge fund manager Andy Kessler uses the iPod as a centerpiece for a pro-globalization, pro-technology, America-takes-all argument. Kessler calls Apple “the worst offender in the decline of U.S. manufacturing,” and means it as a high compliment.

On the back of every iPod, Mr. Kessler reminds us, the words “Assembled in China” are juxtaposed with “Designed by Apple in California.” The cost of labor and parts means that, by importing millions of iPods assembled in China, billions of dollars are added to America’s trade deficit. Yet Apple, an American company, reaps the lion’s share of profits, which, in turn, pass through to Apple’s stockholders.

Kessler thus uses the iPod to paint the trade deficit as a Chicken Little issue. After all, how can the sky be falling when U.S.-based companies are making money hand over fist on deals like these? Apple’s profit margin on iPods could run above 40%, based on production cost data from Wedbush Morgan Securities, whereas Kessler estimates the China-side profit to be in single digits, quite possibly below 5%. It is clearly much better, then, to “think” and profit handsomely…than to “sweat” for hardly any margin at all.

Sweating Ain’t Much Fun

There is a dark side to this heartwarming tale of profit. Apple makes big bucks in part because the laborers make close to nothing. The Daily Mail, a British newspaper, took a hard look behind the scenes in the summer of 2006. The following is an excerpt from its report, “The stark reality of iPod’s Chinese factories”:

“Zang Lan, 21, from Zhengzhou, in central China, has worked on the Apple assembly line for a month. Her 15-hour days earn her £27 a month – about half the wage weavers earned in Liverpool and Manchester in 1805, allowing for inflation.

“This is low, even for China, but Zhengzhou is a particularly poor region, so workers would accept even less.

“‘The job here is so-so,’ Zang Lan says. ‘We have to work too hard and I am always tired. It’s like being in the army. They make us stand still for hours. If we move, we are punished by being made to stand still for longer.”

To head off a looming public relations disaster, Apple launched an extensive inquiry not long after the Mail’s accusations were published. According to Apple, the most sensational of the paper’s claims were unfounded — though Apple did admit that factory work hours were “excessive,” that two of the open-air dormitories used to house workers “felt too impersonal,” and that two instances of standing at attention had been discovered, leading to a new “zero tolerance” policy in regard to cruel and unusual discipline.

Deplorable conditions or no, it clearly isn’t much fun to sweat…which is, incidentally, why China has no intention of sweating forever. Chinese politicians and business leaders understand the power of profit margin as well as anyone, and they are seeking to move up the intellectual property food chain as quickly as possible.

China can find plenty of inspiration from its neighbors in this regard. Japanese cars and electronics have been top of the line for so long it is hard to believe that anything “made in Japan” was considered junk 50 years ago…yet it was. It is perhaps even harder to believe that Toyota, now the most respected and profitable car company in the world, once took its quality-assurance cues from Ford. In South Korea, Samsung Electronics made a stunning transition from low-quality, commodity-level parts supplier to high-quality, high-margin innovator. The list goes on. Perhaps smug Western companies should be sweating a little. (More on that later.)

Make Like a Banana and Split

The iPod is the piece de resistance of Kessler’s “margin surplus” theory, first advanced in 2004 in his book Running Money. The margin surplus theory focuses on the hugely profitable implications of the design/manufacturing split, in which the intellectual property reaps in big bucks relative to effort (hence the profit margin “surplus”) while the low value-add manufacturing side of things does the opposite. Because profits are Wall Street’s first love, any move that increases overall profitability — like, say, outsourcing manufacturing operations to the lowest-cost provider who can get the job done — is generally applauded. Kessler elaborates:

“We can and should own stocks of the high-margin companies that benefit from this design versus manufacturing divide. As we move to an intellectual property economy, our wealth will come from exporting our profitable designs and importing more finished goods. It’s higher salaries and our stock market that balances all this out as those dollars flow back in. Of course, bean counters can’t find the money that flows back into the stock market, it is just bean dip.”

For those inclined to this way of thinking, a booming stock market can explain why the trade deficit is no big deal. By definition, all trade deficits are made up for in the current account — shortfall on one side of the ledger is balanced out by the other. (A simple way to think about this is to imagine borrowing $500. If you go into debt for exactly $500, that means someone, somewhere, has lent you exactly $500.) Because “money chases profits,” in Kessler’s terms, all the deficit dollars inevitably find their way back to America — home of the fattest profit margins in the world — as foreign investment in U.S. stocks, bonds, and real estate.

A Classic Fallacy

The concept has merit. Kessler has his reasons for waving off the trade deficit as a mere “economic construct.” It’s true that accounting for costs but not profits is a bit loopy, and that there are real problems with the way the trade deficit is put together and presented.

That said, there is a serious problem with the “What, me worry?” approach to global trade. The margin surplus argument is shared with such confident zeal, it becomes a handy excuse to ignore the trade deficit completely. Thanks to the margin surplus phenomenon, they tell us, the bluebird of prosperity has a permanent perch on America’s shoulder. So who cares how ugly the numbers get? We do, for one. Reality is just not that simple.

iPod profits aside, the “what me worry” crowd has a fatal flaw in its reasoning. It’s snared by a classic logic trap: the fallacy of composition. The fallacy of composition arises when something that is true of the part is wrongly assumed to be true of the whole.

In this case, margin surplus theory could certainly explain part of the trade deficit. As intellectual property-based companies get leaner and meaner, more of the capital-intensive, low-margin work is sent abroad, while high-margin activities stay in the U.S. But this phenomenon certainly doesn’t explain all of the trade deficit — and likely not even the bulk of it. Whither the hundreds of billions of dollars spent on the Iraq war, for example…or the hundreds of billions frittered away by Congress…or the hundreds of billions in skyrocketing energy costs…or the hundreds of billions in homeland security bills…or the hundreds of billions in mortgage equity withdrawals, largely spent on “stuff” that will never show a penny of long-term investment return…you get the idea. It is disingenuous to sweep all that under the carpet.

Stimulus and Incentives

The other dubious element of margin surplus theory is its questionable method of validation. The way to tell whether the theory holds, Kessler seems to argue, is to look at salaries and the stock market. In order for the magic to happen, the deficit outflows that fund offshore manufacturing should be recycled back into U.S. assets — and not just any assets, but particularly the stocks of these high-margin companies that are doing so well. With the companies doing well, executives should then do well too.

This leads to two immediate questions. First: Even if the stock market has been going up these past few years, how do we know why it was going up? Second: If foreign interests are recycling their dollars back to the U.S., but they are buying a lot more Treasuries than equities, is that really such a bullish thing?

To expand on the first inquiry, it is possible the bullish hubbub was actually tied to a massive external factor: the liquidity flood of biblical proportions unleashed by the Federal Reserve. Following the demise of the multitrillion-dollar dot-com and telecom bubbles, Alan Greenspan called forth the most awesome display of stimulative financial force in the history of man. Could this have had a little something to do with the rise of equities, the echo bubble in executive compensation, and the insanity of the real estate bubble just experienced? We think so. Given that most high-profile technology companies have not outperformed the rest of the market — with Apple a possible exception — Greenspan is a far more realistic culprit than margin surplus theory.

Regarding the second inquiry, on Treasuries, it is clear that America’s trading partners have had strong incentives to keep the party going. China has been willing to forego profits in pursuit of mass employment and rapid economic expansion. On the energy front, the oil exporters of the world have had every reason to extend America’s credit line, considering what a killing they’ve been making on oil sales (talk about high margins!). Is it any surprise, then, that as the dollars pile up for Asian manufacturers and the world’s oil exporters those dollars would get plowed back into U.S. Treasuries? Is this dollar-recycling phenomenon really a shiny happy vote for America’s future, or is it more a calculated decision to keep the big customer happy and interest rates favorably low? The margin surplus theorists do not even ask the question.

Regards,
Justice Litle
November 9, 2006