Saturday, October 17, 2009

Labor Shock - RealEconomy,org

Labor Shock and Its Role in the Economic Crisis

Commuters on their way to work in Bangalore's Electronic City
Bangalore, India, April 2009: Everyday Hosur Road feeds thousands of workers into Bangalore’s Hi-Tech Electronic City. Beside the roadway the ‘music of the streets’ is almost deafening; the drone of a 2-stroke 3 wheeled taxis is punctuated by incessant horn-beeping as workers pour into the city. It has an almost pleasant quality, it’s evocative of an India that combines the aggressive desire for modern growth and international stature with a people who have learned to live with whatever life deals them. It is a study in contrasts, magical and a little bizarre, where high-technology and poverty drive alongside one another on the way to work.
Phoenix, Arizona, U.S.A. April, 2009: Back in Phoenix, Arizona, we see a different picture; among the palm trees on the west side of town, the local strip malls surrounding one of the once-busy avionics engineering plants display 'For Lease' signs as does the once-busy avionics plant itself. The plant’s parking lot, once full of SUV’s and shiny new Honda Accords owned by legions of engineers, now sits empty. This plant location closed a couple of years ago, after many of its functions were moved to facilities in Bangalore, the Czech Republic and elsewhere. These high-tech jobs helped fuel Phoenix’s meteoric real estate appreciation in the bubble years, but recent events have been more unkind. Phoenix and Bangalore are poster children for this economic force we’re calling ‘Labor Shock’. This shock is happening because millions of new workers are arriving onto the world labor market, changing the relationship between supply and demand of labor, and drastically changing the societies on each side of that equation. Population, education, free flow of information, goods, and capital have all combined to intensify and accelerate the effects of the leveling of wages rates around the world.
The Economic Crisis Was Caused by Reduced Labor Income
This article argues that the bursting credit bubble is not the core reason for the advanced economies’ sudden reduction in spending. The credit bubble delayed that reduction, but can no longer prevent it. Rather, we assert that 1) the advanced economies are experiencing labor shock as they fail to adequately adjust to the changes in labor supply and demand, 2) that this shock is causing a severe wage income reduction in the developed economies, and 3) that the result of reduced income has been reduced demand from the West that is not being taken up in emerging markets, and therefore 4) that the reduction in developed economy labor income precipitated the credit collapse and is the fundamental cause of the current severe recession.
Global I.T. industry wages and supply 2006 - 2010 according to IBM Global Services Division
Global labor supply from export-oriented economies skyrocketed from 1980 - 2005
Shipping volume doubled in twenty years. Imagine what the information flow and financial transaction flow numbers look like!
In just twenty years, automation halved the number of workers required to manufacture a product in the U.S.
The Growth of Cheap Labor
Over the past few decades, the emerging economies have been furiously developing their labor forces in order to participate competitively in the world economy. Their efforts have paid off. The chart to the right (produced by IBM’s Global I.T. Services division in 2006) shows the enormous increase in I.T. workers in India and China and the huge disparity in wages between their wages and those of workers in the developed economies. To get a better picture of how effectively the emerging nations have targeted their labor development efforts, see the graph (supplied by the International Monetary Fund) that shows the growth of the labor supply that’s weighted (directed) toward exports. These emerging economies have done a magnificent job of aiming their strategic advantage (low labor cost) directly at the industries and labor categories in the advanced world which offer the greatest export earnings potential.
All that was needed was to increase the logistical capacity between the emerging and advanced economies, and the global income would come pouring in. The graph to the right, showing the doubling of sea-borne trade over the past twenty years, gives an index of how much the trade flows have increased.
The New Workforce is Highly Skilled
The skill level of the LDC worker has been growing very rapidly. In Bangalore, the engineers we visited are experts in their field. They run their software development organization at CMM Level 5, which is “world-class” by the standards of the Software Engineering Institute. These engineers are critical thinkers, challenging every assertion and filtering it through their knowledge and expertise. India has long had sophisticated defense and infrastructure capabilities, easily seen in such impressive facilities as the Indian Ministry of Information Technology building in Electronic City, which seems to sport more communications antennas than the Pentagon. India’s skill sets have not just come from free flow of information from the west. Considering their high skill level, the cost of labor here in India and from the other LDCs is a bargain. No wonder Western companies are flocking here to set up their software development operations.
Labor Shock: Not Only a Result of Increased Supply
Technology trends are also contributing significantly to the labor shock. Take a look at the Manufacturing Output per Labor Hour chart to the right. This chart shows that it takes only half as much labor to manufacture something in the United States as it did just twenty years ago. Half as many people! And that very same advanced manufacturing technology is being exported to China and the rest of the LDCs as fast as possible. What does that mean for future labor-demand growth? Technology is moving us toward the negation of the need for human labor across all industries and locations. More and more products and services can be generated without any increase in labor.
Enter the Platform Enterprise
In leveraging globalization, technology has also changed the structure and function of organizations. We now have an entirely new breed of world-wide economic actor: the “platform enterprise”. The Platform Enterprise is designed to leverage comparative advantage, to perform design, development, and manufacturing in the locale that’s best suited to deliver maximum value for each function across the entire supply chain from raw materials to finished product. A typical product development cycle might have the design and management team in one country, with engineering resources in another, lower cost location. Data can be shared worldwide, 24-7. When it comes time to manufacture, corporations today have raw resources such as steel, copper, or silicon wafers shipped from Africa or S. America to another part of the world to be molded, cut, or stamped. Foundries in Taiwan turn out chips that go into electronics built in Korea, Europe, the US, or anywhere else. The finished products are made available worldwide. The new platform enterprise exists to maximize their profits by arbitraging between global sources of material and labor. These platform companies accelerate the rate of labor shock by maximizing the speed and efficiency of flow between the global input suppliers.
Capitalism Responds To Globalization
Electronic City covers a vast 10-mile-square swath of Bangalore. Visitors are directed through the bewildering maze of streets by placards that list countless Indian firms and multinational giants. WIPRO, for example, is one of India's I.T. leaders. Passing its huge complex one can see the firm’s private fleet of busses which daily brings in workers. Electronic City has a 75,000 strong workforce that’s transformed itself into a world-class technology powerhouse. In the past decade, the IT and engineering skills concentrated here have become a part of a trend, whereby labor cost is a driving force in structuring businesses for maximum profitability. Simply put, if a region offers a competitive advantage, there’s a platform enterprise that will market that advantage to the rest of the world.
The realities of business in the 21st century have made this inevitable. When a business can reduce cost and increase margin, shareholders approve as profits increase. Investors allocate their capital where it can generate the highest returns. Today’s market trading technology and a hyperactive investment climate demands that capital allocations follow short-term results, and are not influenced by the effects of these investments upon the welfare of the workers in any particular region.
Labor Incomes Fall, Advanced Economies Contract
So the bottom line rules today’s global markets, and as the biggest expense for most companies is labor, the labor pool bears the brunt of cost cutting. Just because cheaper labor or the automated platform enterprise is available does not mean businesses have to use it. Businesses must make the choice to use this potential. However, in the business environment we have experienced the past few years, many have been forced to use this potential to stay afloat, and naturally, have responded with a vengeance. The increase in global trade patterns shows the extent to which non-raw materials have comprised an increasing percentage of trade. We have shifted to the platform enterprise, but the shift has had huge unintended consequences.
The term platform enterprise may excite Wall Street with dreams of ever-greater profits, but back in Phoenix, it has meant something completely different. Engineering jobs began to move offshore in the city’s avionics plants around the late 1990s. At first, the trend helped companies meet a constant demand for engineers. A few Indian engineers even began showing up in Phoenix from Bangalore, courtesy of H1B visas. Technical information flowed both ways. But gradually, as the aviation industry peaked, and times changed. Hiring freezes were put in place. New cost targets we established for software development which practically dictated that manpower could only be applied from offshore to stay within budget. Rates dropped in the local contract engineering community. Several rounds of layoffs in the past few years predated the current economic crisis. Now, as the economic storm has arrived in full force, the winds in Phoenix have been among the most severe. Hundreds if not thousands of qualified aviation engineers in the area now look for work alongside everyone else. A 10% across-the-board pay cut was recently announced at one company, and all contract engineers were let go on the same day. The collapse of the real estate bubble in Phoenix has been extreme, so that Phoenix leads the nation in home price depreciation and foreclosures. The effect of the Labor shock is stark and undeniable.
The Adjustment Process
The labor shift has been evident for over a decade now. It’s clear that the shift is good for Bangalore, but it’s hurting the people of Phoenix. Let’s take a look at what happens when a job is moved from an advanced to an emerging economy. The advanced economy must create not just a new job, but a new industry. If it makes sense to move one I.T. job to Bangalore, why not a million jobs? And that’s just what happens: a whole industry gets moved.
Jobs were moved from manufacturing to credit-bubble industries like retail, home construction and hospitality. Look at the anemic job growth in I.T. - the sector that was supposed to drive job formation for decades. Not!
Let’s take a look at how the U.S. coped with the loss of manufacturing and then I.T. jobs over the past decade. The table to the right shows the job losses in manufacturing, the anemic job growth in I.T., and the moderate job growth in health care, state and local government, home construction, finance and real estate, the hospitality industry, and retail. The only bright spot was the modest increase in technical service jobs. Health care is arguably consumption, state and local governments are consumption, and the finance, real estate, home construction, hospitality, and retail industries are substantially dependent upon credit, which has crashed. Because labor income is falling, consumption across the board is, and will continue to fall. The advanced economies have not generated new, defensible, wealth-producing industries at the same pace that their mainstays are moving to lower-input-cost regions of the world.
Won’t the Emerging Economies Make Up the Demand?
So as the advanced societies struggle to adapt, what of the LDCs who are gaining the jobs? Won’t their consumption increase to offset the demand drop in advanced economies? Economists, almost to a man, pin their hopes on increasing demand from LDCs. Look to the east, we are told, for they will lead us out of the downturn. This may happen, but it will not happen fast. To answer why, we can again return to the streets of Bangalore.
We discussed the challenges facing India today with an engineering manager for an avionics outsource company. He manages several dozen employees, the equivalent of a senior manager in a US company. He is proud of his Maruti hatchback, a small subcompact equivalent to a Chevrolet Aveo. Most of his engineers ride scooters and motorcycles, as they are much more affordable and bettter suited to commuting than cars. Average Indians (as opposed to Mumbai’s jet set as depicted in ‘Slumdog Millionaire’) are not prone to western style debt levels, so will consume only what they can afford. And this is much less than their advanced-economy counterparts.
Another factor limiting India’s consumption is the infrastructure. In many instances, the streets are relics of the distant past, with few signals, dirt patches, potholes and a wide array of obstacles such as pedestrians, bicycles, vegetable carts, and of course cows. India has the desire to put more automobiles on its roads, but the reality is they will struggle to do this. Another limiting factor is energy. Rolling blackouts plague Bangalore, including Electronic City, its economic flagship. India has nowhere near the power generation capacity required for its vast population. India simply can’t consume anywhere near the pace of an advanced economy; the infrastructure can’t deliver the necessary inputs. It’s going to be several decades before the developing economies can supply enough demand to compensate for the falling demand from the West.
Meeting the Challenge
The falling incomes in the advanced economies that result from Labor Shock pose serious challenges. While supply and demand imbalances have existed before, the scale and rapidity of the phenomena is daunting, and may well be unprecedented. Never before has it been possible for man’s labor to be so mobile and so sensitive to global wage and cost structures. The inevitable result of this would appear to be extreme deflationary pressure on wages, with severe ripple effects across the advanced economies, and coupling effects into the developing economies.
At some point in the future, global labor prices will reach near-parity. But the process of equalization is going to be painful. The question in many people’s minds is no longer “what’s happening”. Many of us have rejected the idea that turning on the credit spigot is the answer. We’re looking at incomes, specifically incomes from labor, and alternatives to labor income for those that made their living selling labor into this increasingly globalized market.
Alternative strategies for workers and affected businesses are not only possible, they are probable and are needed now. Look at what the emerging economies have accomplished in just the past twenty years. Why can’t the advanced economies develop and promulgate new industries, just as the emerging economies did?
There is certainly a big difference between moving some jobs between locales and creating a brand new industry. But that is the task that confronts the advanced economies: to create new industries faster than they’re being lost to wage arbitrage and automation. So far, we’re losing the race, and that is the fundamental reason that we’re in a recession.
Change From the Bottom
It is highly unlikely that the innovation and entrepreneurship that creates industries can come top-down. This is why Washington and Wall Street, and the investor-class in general can’t solve what ails the advanced economies. At RealEconomy.Org, we think the solution will come from the bottom up, and will take the form of massive peer-to-peer collaboration directed toward business formation and entrepreneurship.

This article was a collaboration from RealEconomy and authored/edited by contributors there including ex VRWC

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