On Incentives

"Never penalize those who work for us for mistakes or reward them for being right about markets. It will go to their heads, is counterproductive and, in any event, material compensation will not correlate with their ability to predict the future next time."

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An Open E-mail to My Son-In-Law Who is Concerned about the Loss of Decent Jobs for the Middle Class

The Cambodian Toy Maker
The Dirty Little Secret

The problem you have identified – the loss of decent paying jobs, particularly in manufacturing, in a country of 320 million is a fundamental one.  The dirty little secret:  the jobs are not coming back.  But of course that view cannot be even hinted at by political leaders.  Why am I so pessimistic other than my normal pathological temperament?  Let me set out the reasons for my concern and why globalization has fundamentally changed things:

First, low wage populations, almost two billion people, are now totally integrated in the world market for goods and services – particularly manufacturing.  And more to come.  Irreversible.

Second, 100 countries, once colonies exploited and controlled by the West, are now independent sovereign states who are not handmaidens to the West.  They will act in a way to further their best interest – not their previous landlords.  Irreversible.

Third, high tech is responsible for spectacular productivity which means fewer jobs.  The better the computer and information technology, the less the need for human labor to make things.  That is why our per capita GNP has only risen on average about 1.2% per year over the past 10 years.  Nor will it in the future.  Why not?  Consider the world before the advent of electricity, the telephone, the radio and the combustion engine.  And then consider the jobs created by the advent of these inventions.  The computer capacity to store data (and make it available) in milliseconds may drastically affect how we spend our time, but it has nowhere approached the hundreds of millions of new jobs created by inventions which brought us from an agrarian society to an industrialized one.  Indeed, I think that a case can be made that, so far, the recent explosion of high tech has reduced the number of jobs, not just in manufacturing but also in providing for goods and services.  That is the definition of productivity.  But that issue, so effectively spelled out by Northwestern University Professor Martin Gordon, in his latest book, “The Rise and Fall of American Growth,” I’ll leave to another e-mail!

Fourth, there has been a massive movement to the private sector of functions and infrastructure previously controlled by government.  The private sector decides – not the trade negotiators in Geneva.

Fifth, there has been a wide dispersion and integration of human, financial and natural resources across about 100 countries virtually without restriction.  For example, some innovative guys in their backyard garage in one country had an idea for a product; another eight countries manufactured the parts, another assembled the final product, another did the advertising, scores of countries provided the financing for the whole business, and of course the Computer and then the iPhone was sold around the world.

Another example.  Fifty years ago virtually every nation in the world restricted its citizens from making investments outside the nation’s own borders.  Capital was kept for domestic use only.  Brits for example were only allowed to bring 200 Pounds Sterling outside the United Kingdom when they travelled to other countries.  Now, in contrast, savings by individuals in Indonesia can be used to buy the bonds of Electrobras in Brazil with the proceeds used to purchase generators made in Switzerland or Korea.  That alone upsets 1000 years of restrictions on how and where the world’s wealth could be deployed.  That, too, is irreversible.  Just like computers have given access to information throughout the world, so too has the free flow of savings and finance throughout the world provided independence from government policy and constraints, let alone from those negotiating trade deals in Geneva.  That in turn means that if a country has tens of millions of people prepared to work at one dollar an hour but the toy maker in Cambodia doesn’t have the financial assets to expand its business, it simply goes to the world markets and borrows the necessary funding for its operations.  Now that’s revolutionary.  (I will take some credit for that one.)

Sixth, countries are now subject to the contagion effect, that is, because of links between countries (financial, water supply, energy, remittances, etc.) an adverse event – war, disease, earthquake, inflation, corruption, political instability, etc. – will have an almost immediate contagious effect on other countries that cannot immunize themselves from stuff they had nothing to do with, and worse, that can’t be insured against. Unpredictable events, unpredictable outcomes.  That is what globalization means: “the best laid schemes o’ mice and men Gang aft a-gley.”

Seventh, there have been tremendous increases in education throughout the world and a significant drop of poverty in countries that, for a thousand years, were non-competitive.  No longer.  Remember, India and China with 2.5 billion people were basically “out of it,” invisible for 2000 years and then, after a long, long sleep, boom, they are here – almost overnight.  With the proceeds of their newly utilized advantage – low wages and a huge underutilized population – they were able to purchase the latest and most sophisticated high technology from the West.  And, given the difficulty, if not impossibility of enforcement, the patents, copyrights, intellectual property simply became a “free good” readily available to once “irrelevant” nations.  It became relatively easy for a factory making very high end handbags to carve out a corner of the factory, drop a few stitches, replace the leather handle with vinyl and produce as a sideline thousands of ‘knock-offs’ at a fraction of the retail cost.  Why make handbags in New England – or Florence?

Eighth, the “law of comparative advantage,” so basically enunciated by Ricardo, now operates unfettered, as each country uses and exploits whatever it has – cheap labor, high tech, raw materials, oil, timber, populations, etc. – to get a leg up with no fear they will be constrained or invaded.  Comparative advantage also means that if Boeing, Caterpillar or Ford wish to sell their product in China, China may insist, as it often does, that the manufacturing facility be located in Shenzen Province, not Seattle or Detroit.  So what is the CEO to do?  After all, Airbus and Toyota are waiting in the wings.

One final point.  Trade deals reflect leverage and reality.  They do not cause import or export imbalances.  Nor are they the cause of loss of jobs.  Trade agreements simply codify the realities set forth above.  Each country negotiates its comparative advantages, if it has any.  Some countries have leverage and advantage, others less so.  The negotiations don’t and can’t change that reality.

There is no such thing as “free trade;” nor is there any such thing as “no trade.”  Nor is there such a thing as a “level playing field.”  That’s just political rhetoric.  Everyone has advantages and disadvantages.  That’s the reality and is reflected in the trade agreements accordingly.  As to the trade negotiators in Geneva, they might not have noticed, but some Cambodian toy maker has already eaten their lunch.  The truth is that no one nation, no matter how powerful, can implement its preferences in trade negotiations.  No, tariffs will not work.  They will lead to a trade war causing both massive unemployment and inflation as each country will seek (fruitlessly) to protect its own economic base.  The truth is no one nation can by cleverness or carrot and stick, let alone by military prowess, impose their preferences, say protect their manufacturing jobs, given the factors set out above.  That is the dirty little secret.  It is tough to accept, let alone publicize, the loss of dominion and control over one’s own future.  What are we to do:  nuke our competitors?

Now, given those circumstances, what can a country like the United States do to help those caught in the middle of such an unprecedented transition.  Not much. Ask the Europeans.

So, let’s play a game.  Let us assume that our political leaders are prepared to act in bipartisan manner, put aside philosophical differences on the role of government and are prepared to have burdens borne in the present while the gains and credit, if any, would be taken by others in the future.  And are prepared to admit that their proposals, given all the forces at work, might fail and that they would be blamed.  I played that game over four years ago and laid out what I thought might be done.  The talk was entitled, “Uncertainty, Vulnerability and Risk: How Will Our Grandchildren Cope.”  Here is the relevant excerpt:

“So, how do we and our children and grandchildren cope?

“I do not claim the policies and interventions I suggest will “solve” the problem.  And I am not so naïve to believe that these initiatives are in the political mainstream.  Far from it.  But I do believe there are initiatives which can make a difference in providing opportunities for those who I believe are now at considerable risk.

“First, government Research and Development Institutes, similar to our National Research Laboratories, the Oak Ridge experience in the Second World War and the Space Program, where government supports and finances, partnering with the private sector and universities.  These institutes might focus, for example, on energy alternative research, aeronautics, materials science research, water salinization, shipbuilding, food protection, genetics, biotech, medical diagnostic equipment.  The output of such government-financed Research Institutes would be available to the private sector.  Yes, it would be financed by tax payers.  It would create jobs and result in findings which will add to employment potential.  No, the private sector will not do this alone.  The private sector does not have the resources or inclination to do costly, uncertain long-term research and development.  The outlays for such research would be borne immediately with outcomes, at best, perhaps a decade later.  The private sector is not in that business.  No CEO would dare to take the chance and no private bank would finance it.  Indeed, the Board of Directors of public companies would consider it a serious breach of fiduciary duty to their shareholders to borrow funds or raise capital for uncertain outcomes way in the future.  Neither stockholders nor bondholders can or will do it.  Keep in mind, our vaunted expertise of innovation may be great for stockholders but of very uncertain benefit for workers, as the private sector, with little hesitation, move its plants to China or India where 14-year olds live in crowded dormitories to make a few dollars an hour assembling our iPhones.  The private sector does not look to creating jobs as part of their mission statements.

“Second, tax incentives for foreign companies to bring their factories here rather than China, India or Southeast Asia.  After all, we have a great legal system, excellent marketing and a huge consumer base.  Provide incentives for the Dutch, the Germans, the Japanese, the French, to bring their plants here. 

States do it.  Why not the Federal Government?

“Third, expansion of government-financed health care benefits so it's low or zero cost to the private sector.  It makes no sense to have an enormous cost burden for health care on corporations when they are on the brink of deciding whether to build their plant in Ohio or Bangladesh. 

“Fourth, An expansion of apprentice programs with the private sector primarily with community college programs.  We should stop all this nonsense of claiming there is a great shortage of U.S. trained Ph.D. engineers and scientists.  There is not.  When businesses complain they can’t find qualified scientists and engineers, what they mean is they can’t find them at the wages they prefer to pay.  Or, in some cases, the scientists and engineers have chosen to work outside their field.  Over 1/3 of the undergraduate scientists in the U.S. are not working in their field; 50% of the graduate scientists are not working in their field.  For many, they can do better, they think, by going into investment banking.   Far more jobs are available at a lower level but requiring very specific technical skills. 

“Fifth, massive infrastructure building:  railroads, ports, highways, light rail, dams, bridges, schools.

“Sixth, permit Social Security to be invested in an index of say 50,000 stocks all over the world with a guarantee that the recipient will never get less than what they would have received under the old system.

“Seventh, substantial affirmative action based on income and race – assuming the Supreme Court is willing.

“You will ask how to pay for this: 1) get rid of preferential rates for capital gains and interest; make it ordinary income. 2) raise the marginal tax rate for those who make $500,000 a year to 40% and 50% for everyone making over $1.0 million per year.  3) substantially reduce the defense budget.  And borrow – stimulate.  And for those who say we are drowning in debt, I would only point to the fact that the huge increase in debt over the last twenty years has not at all damaged our currency or reputation.  There is a market test.  Short term interest rates have fallen to near zero.  The best test of whether there is market concern about the amount of debt are long term interest rates which reflect market concern about inflation, default risk, or currency de-valuation.  Those rates are at 100-year lows.

“And for those who simply don’t want government intervention, I would simply ask you whether BP/Exxon would be your best choice to provide research breakthroughs for alternatives to oil as an energy source.  It’s like asking Gillette to be responsible for research on razor blades which never lose their sharpness.

“I know these initiatives are not politically popular to say the least but my instincts and background suggest that there are few alternatives.  I believe we must use the power available only to governments – to tax and yes borrow – stimulate – to help cope with the challenges that have occurred in the world.  One final point – it might be wise to understand that thwarted expectations produce pain.  We might try to change our perception which we pass on to our children and grandchildren, that they can be immunized from the matters I have described.  We all might benefit by realizing that only 1% can be in the upper 1%.  And that even they will benefit if we can give the 99% a fighting chance – but only if we implement some rather far reaching initiatives.  I hope it is not too late.”

Gene Rotberg, Former Vice President & Treasurer, The World Bank