The Road To Poverty (Free Trade)

I was reading the WSJ today, as I do most every day, and I found a couple of very interesting articles that really compliment one another. This happens a lot, and when it does it makes for good blog fodder. The articles I am referring to are “Why The US Job Market Is Sagging In The Middle” which can be found here: http://www.careerjournal.com/salaryhiring/hotissues/20071012-wessel.html?cjpos=home_whatsnew_major&referer=sphere_related_content, and “The Burma Connection” which can be found here: http://online.wsj.com/article/SB119222553593857680.html?mod=hps_us_inside_today.

I must say that I found both articles to be very interesting and well done. The first article was in the Career Journal section, and it addresses the loss of good paying middle class jobs. These jobs are being replaced by personal service jobs, the demand for which is growing as those at the top demand more things like nannies, security guards, and so on. These are things that cannot be done anywhere else, so you can’t ship the jobs to another location to take advantage of lower wages or replace them with technology (not yet anyway). A bastion of safety from globalization and technology (unless, of course, you simply import the workers – some food for thought).

David Wessel, the author of this article, points to one possible solution to the widening wage discrepancy – unionize the service jobs to provide better wages thereby replacing the traditional middle-class factory workers with a new middle-class of service providers. I thought that was very interesting, and something the labor unions should grab on to (I’m sure this has not escaped them). They certainly are not winning many battles in their traditional strongholds such as the auto industry. Other possible avenues include further obfuscation of the tax code and trade restrictions, although Mr. Wessel correctly points out that many economists warn taking trade action would be costly to consumers (I assume here that he is referring to the increase in prices that would accompany a more restrictive trade policy). What I want to work through in this post is the globalization/trade restriction issue. This comes up a lot these days, including in the article about Myanmar, f/k/a Burma.

In the Burma article, author Andrew Higgins describes the tragic consequences for many residents of a planned economy, dictatorial regime, and economic sanctions. In particular, he explains the ordeal that many women go through each day crossing the Moei River into Thailand to work in factories for $4.30 per day (these are apparently the fortunate ones). This is the other side of the changing nature of the US work force and an important part, in my view, of the trade issue. These women living in abject poverty are working in textile mills making things such as braziers. The products ultimately end up on the shelves in our stores. Now, regardless of your political leaning, this is one of those facts that just cannot be reconciled with a national conscience grounded in freedom and fairness. OK, these are not people of our country, but so what? Something that results in these working conditions for these people and a product that we use is wrong and there should be a way to make it better, period. I am not claiming to know how.

We had circumstances in this country during the industrialization of our economy that left many workers in poverty. Now, I’m no expert on this point in history, but I have consulted someone who has read quite a bit about it. (I would like for him to do a piece on it, actually, and if I can convince him to there will be many more details to come). The very short upshot is that dreadful labor conditions led to revolt in the form of both violent and non-violent acts against industry and the political structure. Socialists, anarchists, and communists all gained popularity as workers were forced to endure these working conditions or go hungry. Ultimately, we altered the accepted rules of our society that had held labor could not bargain collectively. Originally (and today in many cases) collective bargaining was seen as collusion and inconsistent with a market based economy. Of course, with the deterioration of working conditions to the point of revolt, change was necessary. In this case laws were passed to allow workers the right to organize, thereby reducing the power of the business organization (yes, I use that term intentionally here) over that of the individual worker. If we had not done that, we may not have survived and thrived as we did. In fact, advancing workers’ wages turned out to be a good thing as we developed a strong middle class consumer population with a big appetite for goods and services. How did this happen?

I think it goes right back to basic economics. If the price of an input is dirt cheap, you will use that input over others. If the price of that input goes up, you will substitute another input for it. Now, there may be no absolute substitute for the labor of an individual, but if that labor gets more expensive, business figures out ways to compensate by innovating. This is the same argument for a minimum wage. It lifts people out of abject poverty (into just poverty) and it forces business to innovate. The innovation creates new job opportunities for those who are innovated out of a job, and the cycle continues. But if the cost of labor remains dirt cheap, there is no incentive to innovate around labor. It simply remains the low cost way to operate and workers suffer. This is also the argument for an increase in taxes on fuel.

Now connect the dots. What is happening in the US is certainly connected to what is happening in Myanmar. Business seeks out the lowest cost anywhere on the globe today. Don’t blame business, it is supposed to do that and it is good for us that it does. The issue here is the set of rules that business must play by once they leave the US. There are lots of rules, and we keep hearing these days that those rules are why US businesses are losing competitiveness around the world (too much regulation, too many law suits, etc.).

OK, time for a thought experiment. What if, instead of exporting jobs to places like Thailand, we exported our rules? What if we said to other countries that we will not trade with them unless they protect their workers and pay them at least a living wage (defining “living” as something greater than survival)? Lets throw in a little environmental protection while we’re at it. Well sure, the cost of labor would stay higher, but does that mean that in the long run the prices of everything will go up? I for one am not convinced that this is the only logical long-run result. Didn’t the price of a car in this country steadily decline while labor gained much higher wages during the 20th century? And labor is a large part of automobile manufacturing. Oh, that’s right, it’s less so today. Why? Maybe it has something to do with manufacturers substituting technology for labor due to labor’s high cost.

As long as we export the jobs without exporting the rules, we are in fact importing the rules through the back door in the form of lower wages to the middle class. We begin living by the standards of other nations rather than our own. We may also be losing our advantage in innovation if we simply lower costs by moving from one area of cheap labor to another. Any change will likely cause short term pain making it politically difficult, but in the long run no change could be a lot worse. In the mean time, can we please figure out a way to help people like those women in Myanmar? If we don’t, we may be looking at our future.

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A Tale of Two Cities: New York and Detroit (Wall Street Competitiveness)

A Tale of Two Cities: New York and Detroit (revised)

The other day I wrote about the recent UAW/GM contract negotiations, and some commentary about the outcome. The bottom line of my piece is that US autoworkers are being forced down the standard of living scale by a shift in power from labor to business, and the main argument used to support this shift is competition from the global economy. Whether this is actually the case remains unclear, but it is certainly the reason given by business and the media in general for the decline in US manufacturing job compensation in Detroit. (For more on that see my post.)

I was reading an article in The WSJ Online edition today regarding Sen. Jeff Sessions promotion of a bill favoring financial institutions over accepted intellectual property rights, and I was struck by the way the rules are changed when the “victim” is an industry with very strong ties to the rule makers. (Of course, we all know there was gambling at Rick’s, but at least it was in the back room.)

Being interested in this example of the imbalance of power, I began to poke around a little, and came upon a recent report published by The Senate Republican Policy Committee which can be found at http://rpc.senate.gov/_files/061907competitivenessDK.pdf . The report (the “Senate Report”) is entitled Excesses Threaten U.S. Competitiveness, When Excess Damages Success: Have Litigation, Taxation, and Regulation Gone Too Far? This report, dated June 19, 2007 explains that US banks (Wall Street) are losing competitiveness to foreign markets. The conclusion of this report is:

"The declining competitiveness of the United States’ capital markets may be a canary in the coal mine of a much deeper problem. The trends of excessive regulation, litigation, and taxation in our capital markets are being replicated in other parts of our economy. Unless Congress, the Administration, and the business community create a clear and unified blueprint for maintaining our nation’s competitiveness, capital and jobs will continue to move overseas."

One of the major resources relied on for this finding is a report (the “McKinsey Report”) generated by McKinsey & Company for Mayor Blumburg of New York and United States Senator Charles Schumer entitled Sustaining New York’s and the US’ Global Financial Services Leadership which can be found at http://www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf . Citing this report, the Senate Report states that

“Regulatory and litigation burdens are two major drivers of declining
competitiveness for capital markets.

In a large survey of industry leaders, McKinsey & Company, a premier management consulting firm, found that about two-fifths of CEOs surveyed expected that New York City—and by extension the United States—would become less attractive as a place to do business. McKinsey found that what clearly dominated these views were fears that two factors would not be present: 1) a fair and predictable legal environment and 2) a strong but responsive regulatory environment.”

In other words, the problems causing New York banks to lose market share are taxes, the lawyers bringing too many frivolous lawsuits against companies in the US, and over-regulation of US companies. This is causing companies to go overseas and sell their stock in foreign markets. Now, to be fair, there is some merit to these claims, and I am all for rationalizing our regulatory systems. There is a price to be paid, however, for transparency and safety and I do not believe we should go too far. (This is the stuff of a future blog piece.) All of this got me thinking about the competitiveness issue for investment banks. Being a former analyst and having just written a piece regarding global competition, the first question that came to mind was how much of this competitive loss is being caused by these factors as compared to good old competition from lower cost global competitors?

Well, I reviewed the McKinsey Report (though I will admit I did not read all 142 pages of it in its entirety), and was startled at what I did not find. What I did not find in all of the 142 pages of the McKinsey Report was a material discussion of the impact of lower fees charged by banks in other countries having an impact on the competitiveness of New York banks. Not to digress, but how can one of the premier consulting firms on the face of the Earth, engaged by The City of New York and the United States Congress, produce a report that purports to study why US Banks are losing competitiveness to banks overseas not consider the prices being charged by overseas competitors? Either the researchers were instructed to report only on select issues, or the research is completely flawed. You be the judge. Here is what they had to say about the fees:

“Another explanation put forward by some commentators as to why international issuers are staying away from US equity markets is the fact that the underwriting fees charged by investment banks are significantly higher for US listings than in competing markets. One study reveals that underwriting fees for non-domestic listings were 5.6 percent and 7.0 percent on the NYSE and NASDAQ, respectively, compared with just 3.5 percent on London’s man market. But while such figures may seem significant when looked at in isolation, their importance relative to the overall value of an IPO s fairly low, and easily outweighed by the benefits of a more liquid market and superior execution. Surveys conducted for this report corroborate this thesis: when asked to rate the importance of underwriting fees in the overall process of listing a company on the public equity markets, survey respondents ranked underwriting fees last among seven factors, with just 4 percent judging the issue ‘very important.’” (See pg 49 of the McKinsey Report.) (Note that they did not site the LSE Report discussed below here, as that would show a larger fee discrepancy.) Who are these respondents who deem it not important that the fees charged are almost double? “… a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 75 additional global financial services senior executives through a separate on-line survey.” (See McKinsey Report pg 8.) So the people who say the vast differential in the fee is not important are the very people running these businesses and charging these fees. Sounds conclusive to me.

As it turns out there has been a study that identifies the fee differentials between international markets for investment banking services. I found it in a footnote to the McKinsey Report (so they looked at this report). You can find the report (the “LSE Report”), published by The London Stock Exchange, here http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .

The LSE Report finds "Gross spreads of IPOs on the US exchanges are found to be highest, averaging 6.5% for the NYSE sample and 7% for Nasdaq IPOs. In comparison, median spreads of IPOs on the LSE’s Main Market are 3.25% and those on AIM somewhat higher at 4%. Thus, there is a cost saving of three percentage points for a UK transaction compared with a US transaction." (See pg 18 of the LSE Report.) How much is 3%? Well, for the over $4 billion Blackstone initial public offering, that would be at least (.03X4,000,000,000) $120 million! That's just the excess of US over other markets. How does this compare to the first year’s cost of compliance with Sarbanes-Oxley? That cost is estimated at $4.4 million according to a 2005 survey cited in the LSE Report (LSE Report pg. 33).

So let’s review. The fee charged is by far the largest component of the cost of issuance in the US, and fees in the US are by far the largest among international competitors. This fee differential is not, however, why US banks are losing competitiveness. The reason is the cost of these darn law suits and regulations that companies in the US must put up with. That’s the New York tale. The Detroit tale? US workers at GM, Ford, and Chrysler must reduce their standard of living because we cannot compete with lower cost labor from foreign competitors. My conclusion? Perhaps Wall Street should lower the standard of living of its employees so that it can better compete with the foreign competition just like those on main street in Detroit are doing. Otherwise, stop spending my tax dollars on stupid reports that ignore the most obvious issues. Now don’t get me wrong. I am all for US competitiveness. We need to continue to study our competitiveness and actions we should take to ensure our future. I, however, would prefer to do so with full information applied across all of the US constituents rather than targeted reports used to influence the rule making process for the benefit of those in power (which is my interpretation of the McKinsey Report).

PS – if you think the higher fees charged by the New York banks has to do with the cost of living in New York, forget it. The studies show that is not the case.

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