China’s Curious Growth Data

What significant economic news from Asia cheered the global markets last week? The Chinese central bank decided to permit many financial institutions to lend more of their cash deposits to borrowers, a move that is expected to stimulate their economy.

As a result, analysts estimate that 1.5 trillion additional yuan (i.e. approximately $242 billion in American dollars) will be placed into the hands of Chinese businesses. China clearly needs this economic stimulus, given that the nation may miss its annual economic growth target for the first time since 1998.

Oddly enough, though, no one appears to have stopped for a moment to ponder the meaning of an annual target that has not been missed in sixteen years. Indeed, most pundits appear to share the universal assumption that the Chinese economy has been enjoying a perfect winning streak of real growth during that entire period.

Of course, that is certainly possible. And yet, sometimes, entities only appear to achieve an unparalleled string of economic or financial success through the adroit manipulation of statistics. General Electric, for instance, used advanced “earnings management” strategies to generate an astonishingly smooth and consistent string of annual profit announcements during the final years of the twentieth century.

To be sure, Nobel Prize winning economist Paul Krugman and others have cast occasional doubts on the validity of China’s statistical announcements. Nevertheless, generally speaking, most Western news organizations simply accept these announcements at face value and repeat them for public discourse.

So what should we make of this sixteen year Chinese winning streak that suddenly appears to be in peril? If most news organizations are correct, and if the winning streak is a real one, then the sudden threat to its continuation is indeed a serious concern about an unforeseen slump in economic growth.

And yet if the streak is simply a product of an actively “managed” series of economic statistics, then the sudden threat may represent far more than a simple slump. Indeed, it may represent the government’s unwillingness to continue to “manage” its economic statistics, a new position that may portend a long term shift towards a more transparent (and thus a healthier) Chinese economy.

The Auto Bailout: Was It Worth The Cost?

Do you remember the great American bailout of the automobile industry? Following in the footsteps of the retiring President George Bush’s bailout of the financial industry, the auto bailout represented one of the first major decisions of the Obama Presidency.

A variety of reasons and reassurances have been offered by the President and his administration officials in defense of their decision to spend billions of dollars on resuscitating General Motors and Chrysler. They were saving thousands of American jobs. Iconic American firms would remain under American ownership. The federal government would (eventually) be repaid in full. And while under governmental control, the firms would aggressively support a socially desirable transition towards electric vehicles and renewable fuels.

Five years have now passed since the time of the bailout. How many of these four goals have been achieved?

On the one hand, General Motors and Chrysler continue to employ over 200,000 and 70,000 workers, respectively. Their networks of suppliers and dealers continue to employ thousands of additional workers as well. Many of these individuals would have undoubtedly lost their jobs if the firms had been permitted to fail.

In addition, when General Motors emerged from bankruptcy three years ago with an Initial Public Offering on the New York Stock Exchange, it resumed its historic role as an American firm with a corporate headquarters in the United States.

On the other hand, though, earlier this week, the Italian automobile company Fiat announced that it was completing its full acquisition of Chrysler. And last month, the federal government of the United States announced that it was closing the books on its investment in General Motors by writing off a $10.5 billion loss.

Furthermore, based on the 2013 annual vehicle sales totals that were announced this week, it appears that the American automobile industry remains as reliant on gas guzzling SUVs and pickup trucks — as opposed to fuel efficient small cars — as ever. Meanwhile, the General Motors electric Volt vehicle posts meager sales, struggling to remain ahead of electric vehicle competitors like the Nissan Leaf.

So how many of the bailout’s four goals (i.e. saving jobs, maintaining American corporations, getting repaid in full, and transitioning to renewable fuels) were actually achieved during the past five years?

Well, the first goal was certainly achieved via the bailout. The second can be deemed a partial success. But the third and fourth goals? It’s very difficult to declare victory about either one of them.

It’s impossible to know, of course, what would have occurred in the absence of the government bailout. On the one hand, 2012 Presidential candidate Mitt Romney may have been proven correct when he asserted that the free market would have continued to serve America’s need for motor vehicles. But on the other hand, it’s just as possible that Detroit’s total failure might have provided the “tipping point” to sink the global economy into a second Great Depression.

If you were the Chairman of the White House’s Council of Economic Advisors in 2009, and if you could foresee the results of the automobile industry bailout, would you have recommended it to the President?

A Holiday Gift From Mexico: Energy!

As Jose Feliciano’s classic song Feliz Navidad enters its fifth decade of holiday season popularity, people around the world are dashing from store to store, trying to find gifts for their family and friends.

There are times, though, when companies receive gifts too. As well as industries. And entire sectors of the global economy.

Last week, the Mexican government approved legislation that essentially delivered an attractive gift to the global energy industry. It’s quite possible that the gift will ultimately benefit the Mexican people, although one legislator literally stripped off his clothes in protest before voting against the measure.

The gift is a law that will permit private corporations around the world to develop Mexican energy resources, to own Mexican retail gasoline stations, and to operate other facilities and programs. For the past 75 years, prior to the law’s passage, the energy industry was a government monopoly led by the state owned Pemex.

For decades, the creation of Pemex was a source of immense national pride. During the Great Depression of the 1930s, Mexican oil workers went on strike against an array of foreign energy companies from the United States, Great Britain, and the Netherlands. President Cardenas, siding with the labor movement, seized all foreign energy assets and declared public ownership over them.

But over the ensuing decades, the often cash strapped Mexican government struggled to find the resources to maintain energy facilities and invest in new research and development activities. Mexico’s new conservative President, Enrique Pena Nieto, thus supported the drive to privatize his nation’s energy industry.

Congressman Antonio Garcia Conejo protested that the decision would strip the Mexican people of their natural resources; he literally stripped off his clothing on the floor of the legislature in protest. Nevertheless, the measure was signed into law last week.

Will the legislation prove to be effective? Will it benefit the Mexican people? Ironically, the answer to that question may not be determined by the global energy industry at all.

It is, indeed, likely that an infusion of private capital will lead to a wave of modernization and an increase in efficient energy production. And that, in turn, will likely generate more government revenue.

But in order to generate benefits for the Mexican people, the government will need to find a way to channel that revenue into programs that support social and economic growth at the grass roots level. In other words, the success of the privatization initiative will ultimately be determined by the capabilities of the government sector.

That’s quite ironic, isn’t it? Although the Mexican government is looking to the private sector to help the Mexican people, it will inevitably need to look to itself to ensure the success of the initiative.

Look Who’s “Committed” To American Manufacturing!

Can you guess which corporation hosted a summit last week to discuss its “commitment” to leading a renaissance in American manufacturing?

Boeing, perhaps? Or Exxon Mobil? Or General Motors?

No … it was Walmart! The world’s largest retailer gathered 500 suppliers and numerous government officials in Orlando to promote and coordinate its current “Made In America” initiative.

Can you detect any irony in Walmart’s announcement of this project? The retailer, after all, arguably bears more responsibility than any other firm for the shift of American industrial capacity to China, particularly in the consumer product sector.

It would be wrong to dismiss this conference as corporate propaganda, though. In fact, several global economic trends now favor a pronounced shift in production from China to the United States.

The first trend involves energy. America is poised to become the largest producer of energy on earth. Although the advent of fracking invokes significant environmental risks, a large and growing market of locally produced energy can dramatically reduce the cost of domestic production.

The second trend involves technology. Noteworthy advances in robotics and other industrial sciences have minimized the need for human labor in production processes. Thus, although American wages remain higher than Chinese wages, United States manufacturers are “getting by” with fewer and fewer labor hours.

The third trend involves labor supply. Whereas Chinese manufacturers are grappling with immense labor shortages that are driving up wages, American manufacturers are operating in a business environment with high rates of unemployment and stagnant wages.

Thus, although American manufacturers are “making do” with far less human labor and far more technology than in the past, the rate differential for the work hours that cannot be eliminated is narrowing between the nations.

In other words, several explicit economic trends are driving the new competitiveness of America’s manufacturing industry. As a result, although Walmart’s Made In America campaign may be immersed in patriotic overtones, it is actually based on a strong fundamental business strategy.

Hurricane Sandy: Debating Economics

Hurricane Sandy swept across the northeastern and midwestern regions of the United States last week, destroying thousands of homes and rendering more than eight million individuals without electrical power. The news might become even more grim this week, as a midweek storm threatens to dump several inches of snow on homes that still remain without any heat or light.

Although the immediate priority for government officials is the restoration of the existing power grid, long term planners are beginning to suggest innovative approaches to strengthen the region’s energy infrastructure. After all, such “storms of the century” are attacking the region with more regularity, with Hurricane Irene causing massive damage on August 27, 2011, and an unnamed nor’easter dumping over 21 inches of snow on New York State on Halloween Day, just two months later.

Some commentators attribute the recent onslaught of freakish weather to climate change that is caused by our own carbon omissions. Others believe that the region might be experiencing a naturally occurring shift in climate cycles. All would undoubtedly agree, though, that a new long term strategy may be needed to confront this meteorological threat.

Distributed Generation

During the past few years, government officials in Connecticut and New York State (as well as in California) have studied the possibility of developing innovative programs to address climate change. Connecticut, in particular, has aggressively launched a pilot program to develop clusters of microgrids at the local level.

Microgrids? What are microgrids? The term refers to relatively tiny power generation systems that serve very limited geographic areas. When a large region relies on many small microgrids instead of a single massive facility to produce power for its entire population, it is employing a strategy known as distributed generation to serve the needs of its citizens.

A few years ago, for instance, Toshiba developed a proposal to build and maintain a miniscule nuclear power plant for Galena, Alaska, a village with a population of 470 citizens. Although safety and other concerns led to the discontinuation of the project, such microgrids could nevertheless serve as back-up systems in the event of a massive regional power failure.

Economics: Theory Vs. Theory

Is this a good idea or a bad idea? Unfortunately, the discipline of economics does not offer us a clear answer to this question. Instead, it provides a pair of conflicting theories, one in support of each position.

On the one hand, the law of economies of scale would imply that a single large regional facility would be far more cost-efficient than a large number of tiny facilities. In other words, according to this law of economics, a widespread microgridding strategy might drive up the costs of generating power to unsustainable levels.

On the other hand, clusters of microgrid facilities would not necessarily focus exclusively on supporting the primary regional power grid during times of crisis. The small generation plants could produce power during times of normal operations as well. In fact, they could easily feed power into the primary grid on a continuous basis, and even compete with each other to sell energy to local customers.

A large number of small suppliers, competing on the basis of cost, service quality, reliability, and other factors? Classical economists would call such a model capitalism. Although each individual supplier may fail to achieve significant economies of scale within such a system, the “invisible hand” of market competition — as first described by Adam Smith in his classic text The Wealth of Nations — would nevertheless regulate the industry and produce optimal results.

From Banking To Health Care

In a sense, this “micro vs. macro” debate over energy production and distribution strategies is similar to policy disputes that are raging across many other industries. In the banking sector, for instance, many industry experts have noted that the Dodd Frank regulatory structures that were developed after the 2008 global financial crisis may have actu­ally punished relatively healthy regional banks, while the “too big to fail” institutions that precipitated the collapse have grown even larger in size.

Likewise, in the American health care sector, arguments continue to flare about whether the provisions of the Affordable Care Act (i.e. “Obama Care”) will save the system or destroy it. Whether or not the Act is implemented in its current form, hospital systems and insurance companies in the United States are likely to continue with their consolidation activities, hoping that the effects of economies of scale will outweigh the impact of diminished competition.

Regrettably, such economic debates will not benefit the victims of Hurricane Sandy, who are awaiting next week’s approaching snow storm with immense trepidation. Nevertheless, in consideration of their plight, our government officials may wish to consider a microgridding strategy as a means of building additional power capacity. After all, in this situation, the economic cost of service redundancy may be outweighed by the human (and humane) benefit of financing it.

The American Economy: Good News and Bad News

Ben Bernanke, the Chairman of the Board of Governors of the Federal Reserve System of the United States, must be feeling a bit frustrated by now.

As soon as he observes a set of consistent signals that the American economy is strengthening, he’ll likely opt to restore interest rates to higher (i.e. relatively normal) historical levels. On the other hand, as soon as he observes a set of consistent indicators that the economy is weakening, he’ll probably opt to move even more aggressively to stimulate the financial markets.

But what will he do if he doesn’t observe any consistent signals at all? In other words, what if he continues to take note of signals that contradict each other?

That’s what happened to Ben last week, when mixed signals about American consumers were released to the financial markets. Good news was embedded in bad tidings, and bad news in good tidings as well.

It’s Good News, Or Is It?

What good news cheered the markets? It was the report that American household debt levels had climbed for the first time since the pre-crash days of early 2008. Although excessive debt is undoubtedly a worrisome situation, many financial pundits interpreted the increase as a sign that consumers are feeling more secure about their jobs and their futures.

On the other hand, some noteworthy concerns were embedded in this good news. Apparently, the increase was largely attributable to surges in student tuition and automobile loans. Although automobile purchases undoubtedly stimulate economic growth, student indebtedness has been “in the news” lately because of its debilitating effect on the work force.

In other words, the news about debt was generally good, and yet one of its underlying causes was cause for worry. That’s the type of “good news, bad news” data that tends to drive federal regulators up a wall.

It’s Bad News, Or Perhaps Not?

Meanwhile, the markets received some unabashedly bad news too. The median annual household income in the United States has fallen to its lowest level since 1995. In other words, a full thirteen years of economic progress in the late 1990s and early 2000s have been fully reversed by the past four years of deep recession and the ensuing tepid recovery.

Furthermore, even though economists claim that the recession of 2008 and 2009 ended some time ago, annual household income has fallen each year for the past four years. Although the national economy has begun to grow again, consumer wealth has continued to slide significantly.

What good news can be gleaned from this depressing statistic? Interestingly, both the Democrats and the Republicans appear to have found a political “talking point” in the data. The Republicans claim that the recent slide in household income can be blamed on President Obama’s economic stewardship. And the Democrats counter that the recession actually began during George W. Bush’s term in office, and that his eight years of service failed to generate any permanent wealth for American consumers.

Quantitative Easing, The Third Generation

These mixed signals have persuaded Ben Bernanke to announce additional actions to stimulate the economy, but to implement them at a scale that is unlikely to trigger massive growth. Skeptics like Nobel Prize economist Paul Krugman have noted that unlike President Teddy Roosevelt, who advocated that the American government should “speak softly but carry a large stick,” Chairman Bernanke appears to be adhering to the reverse strategy.

On the one hand, he has vowed to prioritize economic growth and the employment of American workers as highly as the goal of monetary stability. That’s a major step in a new direction for a government bank that has long focused primarily on maintaining the value of the American currency.

In fact, the Chairman has pledged to maintain low interest rates for the foreseeable future in order to encourage lending and investment activities. And he has expressing his intention to engage in a third round of quantitative easing, a technical term that refers to the injection of federal funds into the financial system through the purchasing of debt securities.

Nevertheless, many pundits have noted that such actions may only affect the American economy to a limited extent. More drastic actions, such as the large scale nationalization of all of America’s global banks, were once debated but are no longer under serious consideration in the United States.

Muddling Through

Although the American equity markets continue to demonstrate significant strength, most economists predict that the United States will continue to muddle through its financial quagmire. With Europe remaining in a banking crisis and Asia troubled with slowing growth and territorial disputes, it is difficult to anticipate any external positive surprises that may jolt the American economy towards renewed prosperity.

Chairman Bernanke might thus be advised to acclimate himself to the current condition of mixed signals. Although “one step forward and one step back” might be a frustrating sequence for any one who wishes to make definitive progress, the American economy appears to be stuck in that very rut for the present and the immediate future.

Gasoline Prices: Driving Economic Prosperity?

The American economy has been stuck in a rut for a very, very long time. The unemployment rate, for instance, has been lodged above 8% since February 2009; it has remained there throughout President Obama’s term of office. And the Dow Jones Industrial Average has yet to surpass the 14,000 point level that it first reached in the pre-crash days of July 2007.

At first glance, last week’s news of a retail sales increase appeared to represent a rare signal of hope. But then it was reported that the increase was attributable, in large part, to a recent surge in the retail price of commercial gasoline.

The rise in the price of gas is particularly surprising, occurring in the post-Labor Day period when prices customarily decline as Americans return to work from their summer driving vacations. But is it possible that higher gasoline prices might actually help lift the United States out of its economic rut?

An Addiction To Imported Fuel

Traditionally, high gasoline prices have been detrimental to the American economy. The spike in energy costs during the 1970s, for instance, wreaked havoc on the financial security of the United States; it led President Jimmy Carter to declare that the development of a national energy policy represented the moral equivalent of war.

But that was a time when the American energy industry was focused on the importation of fossil fuels from foreign sources. Under such circumstances, any increase in the price of fuel would inevitably draw funds away from alternative domestic uses and fuel the profits of foreign providers.

For a while, America’s domestic nuclear power industry appeared to offer a home-grown solution to the nation’s addiction to foreign fuels. But the specter of nuclear disaster that was imposed on the nation’s psyche by the Three Mile Island crisis in 1979, stoked by films such as The China Syndrome that year, locked the American energy industry into a strategy of importation.

Energy Independence

So how has the American economy evolved during the past few decades? Why might higher fuel prices actually trigger an increase in domestic energy output, and ultimately lead to economic prosperity, today?

A primary reason, first and foremost, is that the United States is now producing a significant amount of energy resources to meet its own domestic needs. North Dakota has surged past Alaska to become the nation’s second largest energy provider, trailing only Texas. Pennsylvania, a major producer of crude oil in the late 1800s, is again producing energy resources with the use of fracking technologies and methods. And soon, the southern tier of New York State may begin doing so as well.

Furthermore, the Canadian province of Alberta has also recently become a major producer of fossil fuels. Given the extensive integration of the national economies of the United States and Canada, additional upstream energy activity in the Albertan region inevitably stimulates the economies of the northern American states too.

These developments have prompted Republican Presidential candidate Mitt Romney to declare that North America would achieve “energy independence” by his prospective eighth year in office, i.e. by the year 2020. Although some analysts believe that full energy independence may not necessarily represent an achievable (or perhaps even a desirable) goal, most do acknowledge that the emerging domestic energy industry is strengthened by higher energy prices.

A Gas Tax For The Deficit

High fuel prices generate indirect benefits as well. When the costs of fossil fuels are very high, the (generally always high) costs of renewable energy begin to represent competitive alternatives in comparative terms, and American consumers and businesses shift to these new “green” technologies.

The demand for solar panels, for instance, has increased in tandem with the recent spike in the costs of oil and gasoline. Although American panel manufacturers like the ill-fated Solyndra have yielded market share to Chinese producers lately, all panels (even those manufactured in Asia) require installation and maintenance in the United States, necessitating new jobs for the American economy.

Some well known commentators are actually advocating for higher retail taxes if the cost of gasoline drops back towards historical norms. Thomas Friedman, a global columnist for the New York Times and the author of the book The World Is Flat, has repeatedly called for an American taxation policy that imposes a retail gasoline surcharge of $1.00 and then applies all government revenues to reductions in the federal budget deficit. The United States, interestingly, has never paid a tax that is explicitly designed to reduce its accumulated debt.

Considering the aversion of America’s Republican Party to any new streams of taxation, it is unlikely that Americans will experience a national $1.00 per gallon gasoline tax at any time in the foreseeable future. Nevertheless, they shouldn’t be surprised if the recent surge in retail gasoline prices eventually produces some unexpected (and yet quite welcome) benefits for the American economy.

Olympics: Economic Winners and Losers

Each Olympic Games produces its share of sporting winners and losers. Each winner experiences the pleasure of mounting a podium and receiving a glittery medal, while each loser takes solace in the knowledge that (s)he has competed against the world’s greatest athletes.

But the cost of staging the Summer Olympics has soared beyond $15 billion dollars. With that much money at stake, each Games inevitably produces economic winners and losers as well. So how can we distinguish the winners from the losers? And what can we learn from them?

The Winners

Athletes who win gold medals often advance to careers of fame and fortune. From Norwegian figure skater Sonja Henie to American decathlon athlete Bruce Jenner, Olympic champions have frequently become global media celebrities in Hollywood films, Madison Avenue marketing campaigns, and other commercial endeavors.

Global corporations often emerge as winners too. The upcoming James Bond film Skyfall undoubtedly profited immensely by the Opening Ceremonies of the 2012 Olympiad. The event featured a parachute jump — indeed, a literal “sky fall” — by characters portraying the British spy 007 and Queen Elizabeth II.

The East End of London will also benefit by hosting the main Olympic Stadium and several other facilities. In fact, Olympic organizers convinced an initially skeptical public to support their plans because the new venues would rejuvenate a neighborhood in need of development funds. Soccer star David Beckham, who spent his childhood in the East End, has been widely praised for working vigorously to bring the Olympiad to his boyhood home.

The Losers

On the flip side of the roster of economic winners, of course, reside the economic losers of the Olympiad. First and foremost, every losing athlete who dedicated years of hard work to physical training would have been better served, in retrospect, by engaging in more financially productive endeavors.

The same principle applies to the government of the host city. In order to minimize construction costs and post-event maintenance expenditures, many of London’s Olympic events have been scheduled in temporary structures that will be torn down or dramatically downsized at the end of the Games. In fact, the basketball arena was even offered to be shipped to Rio de Janeiro for use during the 2016 Olympiad!

Although the use of temporary facilities may minimize costs in the short term, it may nevertheless result in the loss of rental and tourism revenues in the long term. Unlike Montreal, which recouped some costs by renting its Olympic Stadium to the baseball Expos for over 25 years, and Beijing, which now sells tours of its iconic Bird’s Nest Stadium, Londoners will be unable to enjoy any Olympic facilities that are torn down or sold off.

London vs. Athens

The primary question, of course, is whether Britain would have been better served if its leaders had dedicated a decade of planning time and billions of British pounds to other endeavors. Considering the British government’s commitment to an austerity oriented fiscal budget, as well as the recent slide of the national economy into an extended economic recession, it is reasonable to believe that the Olympic expenditures are inappropriate in nature.

Of course, Olympic supporters can retort that the global visibility of the Games could not have been achieved by any other means. They can also assert that, as a one-time only event, the Games do not require the type of long term spending commitments that would otherwise have been necessitated by massive expansions of social service programs.

Nevertheless, with economic conditions in Greece deteriorating so soon after its government’s massive fiscal commitment to host the 2004 Olympic Games, one cannot help but wonder whether Britain has placed itself at risk of experiencing a similar fate. Although London possesses incomparably greater financial resources than Athens, it is not immune to the vicissitudes of the global economic markets.

The Big Apple’s Experience

Meanwhile, across the Atlantic Ocean, a city that lost its own bid for the 2012 Games may now consider that defeat to represent a victory in disguise. New York City, after all, had (like London) developed a proposal that featured massive construction projects in neighborhoods that needed such funds.

But those Big Apple neighborhoods have been growing more prosperous as a result of private initiatives that emerged in the wake of the failed Olympic bid. The Far West Side of Manhattan, which would have served as the site of New York’s Olympic Stadium, has been revitalized by the renovation of the High Line elevated linear park. And the East River waterfront, which would have hosted the Olympic Village, has experienced gentrification in neighborhoods such as Long Island City in Queens and Williamsburg in Brooklyn.

Would London’s East End have experienced such development without a victorious Olympic bid? Perhaps you may find it difficult to envision such an outcome. And yet no one could have predicted that Brooklyn’s real estate values would ever rival those in Manhattan … as they now do.

The Michelin Man In Dixie Land

Where would you expect Michelin, the French manufacturer best known for its Michelin Man mascot and its global travel guides, to build new capacity to produce automobile tires?

“The industrial heartland of France itself” might be your first guess. Perhaps “eastern Germany, or the westernizing European Union nations of Bulgaria or Romania” might be your second guess. And perhaps “an Asian nation, such as China, Indonesia, or the former French colony of Vietnam” might be your third.

Most likely, the American state of South Carolina wouldn’t even make your Top Ten list of guesses. And yet that’s where Michelin is placing its newest tire plant, a development that will transform the state into the tire manufacturing champion of the United States.

It may not be surprising that Michelin and other tire manufacturers would prefer to do business in South Carolina than in the rust belt states of Indiana or Michigan. And yet why would they want to manufacture their products in America at all?

From Snow To Kudzu

Ironically, the most recognizable tire in the United States represents a brand that is actually now owned by Michelin; it’s the gigantic Uniroyal Tire that sits at the side of Interstate 94 just outside of Detroit. The eight story tall billboard was originally used as a Ferris wheel for the 1964 New York World’s Fair, and now serves as the symbol of the Motor City. Uniroyal, however, was acquired by Michelin in 1990; it no longer operates as an independent American company.

Nevertheless, the tire industry hasn’t fully closed all of its American tire factories; instead, it has simply moved south and traded the snowy climes of Michigan for the kudzu-festooned environment of the Palmetto State. Last week, Michelin announced that it would join Bridgestone and Continental Tire by greatly expanding its manufacturing base in South Carolina.

For decades, pessimistic economists have predicted that the American manufacturing sector would continue to dwindle in the face of competition from other nations. Steve Jobs himself, in fact, once told President Barack Obama that high technology Apple manufacturing jobs that have been lost to China aren’t coming back to the United States. And yet Michelin, a European company with no historical ties to the American nation, decided to produce tires — a product far less technologically advanced than iPhones or iPads — in the United States.

That clearly raises the question: why would they decide to do so?

Simple Economics

The answer to that question is a simple function of economic competitiveness. Although many other nations maintain far lower labor costs than the United States, and although China surpassed the United States as the world’s largest automobile market two years ago, the American economy remains the largest in terms of Gross Domestic Product (GDP).

Thus, any tire company that wishes to do business on a global level must develop a strategy to produce and sell its product to American consumers. In order to do so, it must inevitably choose between a pair of options: (a) to both manufacture and sell its tires within the United States, or (b) to manufacture its tires outside of the nation and then import them into it.

Although the second option remains a feasible one, it is burdened by the weight of skyrocketing fuel expenses that drive up the cost impact of transporting finished goods across national borders. When we also consider the effect of a weakening United States dollar and a strengthening Chinese reminbi, as well as the recent willingness of the American labor force to accept lower wages and benefits in the face of high rates of unemployment and continuing economic weakness, we can understand why simple economics makes South Carolina an attractive locale for tire manufacturers.

Growing Old Before Growing Wealthy

Of course, although the United States has maintained an industrial base in tire manufacturing, we cannot assume that America will soon reclaim all of the plants and factories that have been lost to China since President Richard Nixon visited the Communist nation in 1972. Nevertheless, China’s inability to woo tire manufacturers away from the American South does give the United States hope that it will be able to compete with the Asian nation for future manufacturing plants.

The Chinese economy itself is burdened with many handicaps. Its economic growth rate is slowing, its population is aging, and its labor force is demanding wage increases and improvements in working conditions. These demands will inevitably erode its labor cost advantages.

In fact, if its economy hits a wall as Japan’s did during the final decade of the twentieth century, the Chinese government may discover that its population has grown old well before the nation has grown wealthy. Should such a scenario emerge in the future, the American manufacturing industry and its skilled labor force may remain highly capable of competing against their global rivals.

Pension Assumptions and Circular Logic

One quarter of one percent.

That’s all it took to set off alarm bells in the state of California. Calpers, the organization that manages the pension plans of the Golden State’s public sector employees and retirees, decided to reduce its estimate of the future rate of return on its investment portfolio by one quarter of one percent.

Calpers asserted that the reduction decision was, in essence, a necessary response to the relatively slow growth environment, with exceedingly low inflationary conditions, that is expected to persist in the United States and around the world for the foreseeable future. But commentators worried that their decision might contribute to the very economic sluggishness that Calpers cited as the justification of its action.

Huh? How can a simple arithmetic decision contribute to its own causal justification? That’s the type of circular logic that makes eyeballs glaze over when conversations gravitate to pension accounting. Nevertheless, the issue is a serious one, with echoes that reverberate throughout the global economic system.

An Arithmetic Necessity

Any pension system can be conceptualized as a collection of promises to pay a fixed annual amount to each employee after (s)he retires and as long as (s)he remains alive. In each year that an active employee is earning (or “vesting”) this benefit, an employer is expected to put aside a sufficient dollar amount to fund this future obligation.

There is uncertainty, of course, over the length of time that any employee will remain alive. With medical technology improving each year, life spans and thus pension obligations are increasing continuously. But average life spans tend to creep up over many decades; thus, although they have placed some pressure on pension funding assumptions, they haven’t wreaked havoc on them.

Rates of return, though, are a different story. As the global investment markets grow increasingly volatile, rates of return grow more volatile as well. If pension systems like Calpers believe that market crashes (such as the decline of more than 50% in the equity markets that slammed investors in 2007 through 2009) are more likely to occur in the future, they will inevitably modify their arithmetic assumptions by reducing their estimates of future returns.

Then why are critics complaining about this arithmetic? And where is the circular logic?

Plugging The Gap

Their concern is, essentially, a function of cause and effect. When Calpers decides to reduce its estimate of future returns, its decision represents an explicit acknowledgment that its current investment portfolio will not be sufficient to cover its future payment obligations.

So what does Calpers do? Well, it must add money to its current investment portfolio to “plug the gap” and compensate for the reduction in future returns. Let’s assume, for instance, that Calpers is obligated to pay $10,000 to a retiree in the year 2013. If the pension plan expects to earn 10% on its investments in the year 2012, it would only invest $9,091 in its portfolio in 2012 with the expectation of earning an additional $909 (i.e. 10% of $9,091) during the year.

But if the pension plan slashes its earnings expectation to 5%, it would need to increase its current investment from $9,091 to $9,524 in 2012 to account for the expected reduction of earnings to $476 (i.e. 5% of $9,524) during the year. In other words, instead of relying on the market to “grow” a $9,091 fund into a $10,000 balance with a robust $909 return, Calpers would only rely on it to grow a $9,524 fund into a $10,000 balance with a meager $476 return.

Okay … but this is still just a matter of simple arithmetic! So where’s the circular logic?

Too Big To Fail

Calpers isn’t a typical pension plan. It’s the California Public Employees’ Retirement System, a gargantuan entity that manages pension and other plans for more than 1.6 million individuals. Its investment portfolio held almost $250 billion as recently as 2007, and rebounded to hold $225 billion at the end of last year.

How does any pension plan, including Calpers, find funds to add to its portfolio when returns are expected to be insufficient? Inevitably, it must turn to its employer sponsor to request the additional funds. At Calpers, the employer is the State of California and its affiliated entities, and the amount that Calpers now requires equals tens of billions of dollars.

So where can the State of California find tens of billions of dollars to give to Calpers? At a time of fiscal austerity, the state must increase taxes or slash government spending to produce such prodigious amounts. And that inevitably slows the economy, thus depressing rates of return, hence causing the future rate reductions that justified Calpers’ decision to begin with!

Like many global banks or European nations that have grown too big to fail, Calpers itself has grown to a size where simple arithmetic business decisions can damage the entire economy. That’s why the critics are worried about its recent decision, and that’s why we should all be concerned as well.