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Arbitraging wage rates

Arbitraging wage rates

Those who have worked in materials management have attended a seminar in which the speaker unfolded a fanfold computer printout products list that reached from the back of the auditorium to the podium. Then the speaker tore off half of the first sheet and said that it represented ninety-five percent of the revenues, which was where most of the materials management effort should be spent.

The concept of materials management is simple: You want to optimize the system to minimize either number or dollar value of stock-outs, whilst simultaneously minimizing safety stock costs. The further down the list you get from that torn-off sheet, the easier the management task is: When you open the last barrel of nails there is a note saying “re-order nails.” This approach works well in almost every area, and can be summarized as “Take care of the important things first.”

The problem is that it is hard for many to figure out what is important. You could see this in the recent American presidential election.

In the U.S. we have a plethora of problems with which we need to deal, but only a handful or two that are critical in the long term. During the campaign there was lip service (but no substantive discussion) given to the fact that nuclear proliferation should be any administration’s number-one priority.

It was terrorism that dominated the public discussion, albeit with virtually no discussion of why these bad things are happening. After all, while the psychological impact is great, the practical effect is minimal: More Americans will die from the flu this year – any year – than will people die from terrorism worldwide.

We care about terrorism (from a public policy point of view, not from an emotional point of view) primarily because the function of terrorism is to cause terror. Terror, because of its psychological impact, induces citizens to tell their government to take strong action to reduce the uncertainty that terrorism has induced. In turn, this has a tendency to cause governments to overreact over-broadly and over-repressively. From the terrorists’ point of view this is desirable because it causes citizens to force their governments to make political changes more favorable to the terrorists.

Therefore, in fighting terrorism, governments need to tread a fine line in dealing with both the practical and the emotional issues – preventing violence and criminal activities on the one hand, and assuring that the populace does not become fearful on the other – while simultaneously avoiding the temptation to impinge on hard-won liberties, or changing the essential character of society. Because this is a very fine line indeed, when dealing with terrorism it is critically important that every policy and measure be carefully evaluated by asking the five basic questions:

1. What problem is the policy or measure trying to solve?

2. How can it fail in practice?

3. Given the failure modes, how well does it solve the problem?

4. What are the costs, both financial and social, associated with it, and flowing from its unintended consequences?

5. Given the effectiveness and costs, is the policy or measure worth it?

While terrorism does not generally work out well for the terrorists, it sometimes does very bad things for the society under attack. If you look at the exemplar of the Tupamaros, you can see that they didn’t win, but did turn Honduras into a militaristic state. What do we learn from this? That we should pay attention to the cautionary epigram generally attributed to Benjamin Franklin: “Those who would give up ESSENTIAL LIBERTY, to purchase a little TEMPORARY SAFETY, deserve neither LIBERTY nor SAFETY.”1

While not relevant to this article, there can be many causes for terrorism, but they are generally based on some perception, by the terrorists, of oppression or mistreatment. The current wave of terrorism is based on an Islamic perception of being under attack, which we will discuss below, in the fifth article of this issue.

Since neither nuclear proliferation nor terrorism was ever actually discussed, this means that most of the most significant issues facing America were discussed with any seriousness during the campaign.

Let us look at one area, arguably among the most important, that was definitely under-discussed: The economy.

1            This is reputedly from a reply of the Pennsylvania Assembly to the governor, November 11, 1755, (The Papers of Benjamin Franklin, ed. Leonard W. Labaree, vol. 6, p. 242 (1963)).

We are given to understand that this quotation, slightly altered, is inscribed on a plaque in the stairwell of the pedestal of the Statue of Liberty: “They that can give up essential liberty to obtain a little safety deserve neither liberty nor safety.” We haven’t been to the Statue of Liberty since grade school, and can’t verify it.

No candidate discussed where the American economy is going, and what it should be based on in the future. That is to say, no candidate said, “In ten years the United States will have a population of 300 million. People will be working doing …, and we plan to do … in order to get us to the point where people can be doing that.”

What will we be doing in a decade? What will our children be doing? Because of NAFTA, our trade agreement with China, and current economic policy, neither we nor they will likely be involved in manufacturing on any great scale.

The assumption behind the trade agreement was that China had a huge population that could buy our products. Today, even with a significant increase in standard of living in China, a skilled Chinese factory worker earns between $0.25 and $0.50 per hour, making it unlikely that the majority of the population could buy anything we make (although the still-substantial rich could do so). Given a roughly equivalent productivity, this in turn means that, with current economic policy, in order to be competitive based on wage cost, an American manufacturer of any size must either convince his workers to take a pay cut down to, say $0.75 per hour, or close domestic manufacturing facilities and manufacture abroad. The case with NAFTA is similar, although the wage disparity is not quite so extreme.

Due to this ability to arbitrage wages, it is safe to say that within a relatively short period of time only a few specialty items will be able to be cost- effectively manufactured in the U.S. And that if you are now manufacturing here, you could well be either out of business or outsourcing.

This has allowed the expansion of retailing, following, more or less, in the footsteps of Henry Ford. Ford, if you will remember, paid workers on his assembly lines an above-average wage, which allowed them to buy his cars.

Retailers have done much the same thing as did Ford, only in reverse. In the past a retailer doubled the cost of his merchandise, so that an item that cost him $10 sold for $20. By manufacturing in countries with very low wages, this $20 item costs the retailer $4. This moves revenues from wages to profits and management benefits. It also leaves large numbers of people out of work, and with the likely possibility of never working again at a level that will allow them to sustain the American dream. This means that many people cannot afford to shop at former retail prices, and need the deeper discounts available at retailers whose products are manufactured with essentially no labor costs.

We do not wish to give the impression that there is, in a cosmic sense, anything wrong with this. A case can certainly be made that, in a global economy with inexpensive transportation, wages must adjust to the lowest common denominator. It may well be that manufacturing simply needs to be where labor costs are lower. And, after all, we have intellectual work, like computer programming and engineering, which can be even more valuable.

So let’s look at programming. In the 1970s American programmers were earning about $40/hr. By the 80s this was up to $60 an hour. By the 90s this was up to $80, and, by the beginning of the Millennium in 2001 it was around $100 an hour. And today, as we enter the fifth year of the new millennium, a good programmer is again being offered about $40/hr. However, you can get a highly skilled programmer in India for about $15/hr, so it is fiscally irresponsible to hire American programmers. How about engineering design work? Frequently outsourced. It may well be that, given roughly equivalent productivity, intellectual work, like manufacturing, simply needs to be where labor costs are lower.

How about clerical work? When your federal taxes are checked, they are checked by someone in India, as are some health care records and corporate accounting records. Customer support centers? Outsourced. Call centers for marketing? Outsourced. Agriculture? Well, putting aside the issue of China going into agribusiness, we don’t really foresee America returning anytime soon to a non-mechanized, labor intensive, agricultural society.

Is it possible for us to have a positive trade balance with China? Sure, lots of countries do it: Just look at the number of Mercedes on the streets of Beijing. And even if ninety percent of the Chinese were too poor to buy American products, that still leaves a lot who could buy our products.

Do we blame companies for firing large numbers of people, transferring revenues from wages to profits and executive compensation? Absolutely not. Fiscal and economic policy is determined by the government, which should balance the needs of the expanding U.S. populace with the needs of the world at large. (Third world nations who have widespread manufacturing tend to be more politically stable, and less of a threat to us. Nations that have a good income spread rarely have revolutions. In fact a good indicator of revolution is when there are 70 persons in the bottom 10% for every one person in the top 10% of income for the country. An economically stable county with a strong middle class is a very stable country.) Fiscal and economic policy decisions are designed to induce – even force – the economic drivers along specific paths. Thus, when a decision was made that Americans didn’t save enough, and that $2,000 could be put, tax deferred, into an IRA, a lot of people saved $2,000 a year. When fiscal and economic policy rewards businesses for firing employees and manufacturing abroad, it is to be expected that companies will fire their employees and manufacture abroad.

Whether or not this is a good idea depends on a number of issues. The most obvious is whether you are the person doing the firing or the person being fired. (If you fire 40 people earning $25,000 a year you can add a million dollars to your benefits while keeping shareholder return where it was. Instead of operating a lathe, you can retrain for some other job – if there is a policy initiative to create new classes of jobs).

Economic policy is an issue of great significance to both companies and individuals. It affects corporate bottom lines, and the jobs and lives of many individuals. It should help deal with the fact that as products become commodities they become cheaper to produce, and bring in less revenue per unit. No matter where you are on the economic food chain, economic policy affects you, and should be discussed openly and fully.

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