Q2 ’07: The End of an Era
The disastrous world wars of the early 20th century were fought between largely self-sufficient industrial empires. Based on the bitter experience of those wars, generations of American leaders, beginning with Franklin Roosevelt, deliberately embraced a political framework and trade policy designed to promote global industrial interdependence as the best way to prevent future wars and thus guarantee national security. The early architects of this system would be in awe if they could see the fruit of their vision. Global industrial interdependence is now a reality. Whether the global production system will ultimately accomplish its primary goal of a sustained peace remains to be seen, but if it is to succeed in this noble purpose, the challenge ahead will be to make the system safe, stable and more equitable.
This quarter’s letter was inspired by the recent publication, “End of the Line: The Rise and Coming Fall of the Global Corporation” by Barry C. Lynn.
The title was most likely conjured up by the publisher’s marketing division, because the content of the book is not nearly as apocalyptic as the title. It does, however, point out features of our global production system that urgently require attention to forestall a global crisis. All investors should read this book and encourage their government representatives to do so as well. This is a book of economic wisdom, with a warning and prescriptions that I hope our policy makers will heed.
Author Lynn devotes 80% of the book to the policy, legal, market and technology developments, from the founding of America to present, that have led to the current form of the global outsourced corporation. In particular he goes into great detail, sometimes painfully so, in documenting the developments over the past twenty years that transformed the system of trade between national economies into the integrated global production system of today. He then spends the last two chapters zeroing in on the vulnerabilities of this system, and outlining policy changes needed on both government and corporate levels to stabilize it.
Lynn begins with the tale of a little known incident on September 21, 1999 – an earthquake in Taiwan — that brought the global electronics industry to a sudden halt. The one week shutdown of two critical chip producers in Taiwan (between them producers of the entire world’s supply of a certain chip used in virtually every electronic device) had repercussions that lasted well into the 1st quarter of 2000 and caused a 7% hit to global electronics production.
We were all lucky that the chip plants were not directly hit. If they had been destroyed, the consequence would have been a total meltdown of the global electronics industry along with their suppliers, financiers and downstream beneficiaries, and quite possibly the entire global economy with it.
There have been numerous events since 1999 that have highlighted the same issue: the SARS outbreak, 9/11, the 2002 West Coast dock strike, and others less well known. A recent earthquake (July 16th) in Japan immediately shut down 70% of that nation’s auto production when a critical parts supplier was damaged in the quake.
The main point of the book is that the concentration and hyper-specialization of each link in the global outsourced “just-in-time” supply chain of every major industry has made the entire system fragile at its core. As Lynn puts it, “Our corporations have built… the most efficient system of production the world has ever seen…a global production system that is so complex, and geared so tightly and leveraged so finely, that a breakdown anywhere increasingly means a breakdown everywhere…”
Lynn points out that the global production system is already a done deal, and that the policies that fostered its development and growth are not the policies needed to keep it stable and healthy into the future. “Our primary need is no longer to promote more global scale efficiency. These systems have already been made more efficient than is safe. The challenge now is to ensure their stability and their ability to keep growing.”
No one in charge. Government policy makers today embrace an economic orthodoxy defined by a blind faith in “the market” to solve all problems. This thinking took root in Washington with Reagan, was greatly expanded by Clinton, and has been given free reign by Bush II. This attitude means that even as the global economy has undergone unprecedented change, expansion and integration, making the entire world dependent on one integrated system (with power consolidated into the hands of self-interested top executives of massive global corporations), there is no-one overseeing the safety and stability of the system itself.
My response to the sentiment that the market will solve all problems is: yes, the market (nature) will solve all problems in the end, but the cost may be extreme in ways not foreseen or desirable, or even survivable. For those who are inclined to buy into the all-wise market argument: I suggest you go count the number of trees in Haiti. During a firewood crisis in Haiti, demand for firewood overwhelmed supply, and the failure of government to regulate the cutting of trees ultimately meant virtually no trees left, with severe long term consequences for the people of Haiti. Meanwhile, neighboring Dominican Republic remains nicely forested due to proactive government policies to protect their trees.
Relentless pricing pressure. “Once outsourcing begins to work its way through any industrial sector it often becomes nearly impossible for any one firm to stand alone against the pricing pressures that are unleashed. Absent government action to ensure that all companies around the world face the same costs of making their supply chains more secure, the marketplace tends to dictate one fact: Taking more precautions than your competitor is a good way to lose market share big time.”
The pricing pressure produced by global outsourcing has promoted ever increasing dependency on single sourcing, not only for individual corporations but also for industries as a whole. This has resulted in the dismantling of most of the redundancy and layers of management oversight developed from long experience to ensure the safety and stability of the corporate enterprise. These developments have exposed virtually every industry, and the system in its entirety, to potentially catastrophic risk. Without intervention to ensure the safety of the system, inevitably the day will come when some one event will cause a chain reaction that brings down the entire system.
Total dominance of global lead firms. Global lead firms such as Wal-Mart, Dell, Cisco, GE and Boeing have consolidated such power that they have managed the neat trick of shifting the business risk of manufacturing onto their suppliers (and in some cases customers) while extracting most of the profit from the business enterprise. With the implied and sometimes outright threat of taking their business elsewhere, lead firms retain dictatorial pricing power over their suppliers, which they relentlessly exploit. The suppliers in turn lean on their suppliers and employees in the same way. The system is devouring its own foundations. These global lead firms have for the most part outsourced all facets of the actual making of things and no longer own or maintain productive assets. Therefore, they have little incentive to plan and invest, or to attend to the wellbeing of the productive assets on which they depend. The function of the global lead firm has devolved from the creation, innovation and maintenance of the business enterprise to protection of market share and extraction of maximum short term profit. “Their power is mainly extractive, and increasingly destructive.”
Failure to innovate. Our global outsourced corporations are no longer engines of creativity and innovation. The relentless push for efficiency leaves no room for innovation. Despite endless, breathless corporate PR about innovation, the only real innovation that is going on in the corporate world these days is innovation in service to greater efficiency. Case in point – Six Sigma at 3M. See Business Week’s June 11th cover story, “3M’s Innovation Crisis.”
Excessive shareholder power. Ultimately a corporation must serve a social need in order to sustain itself over time. Today’s global outsourced corporations have no incentive for long term planning, investment in research, productive assets or employees, and no loyalty to community or nation. Huge CEO stock and option deals have aligned CEO incentives totally with the interests of shareholders (short term profit) to the detriment of all other interest groups impacted by corporate activity: suppliers, employees, customers, communities and society.
All of these problems are solvable with appropriate attention from government policy makers to set the ground rules and incentives for safety and sustainability of the system. With appropriate policy measures in place to put a stop to the industrial cannibalism, the system will be freed from the relentless downward spiral of outsourcing driven pricing pressure. Corporate policies and activities will quickly adjust and begin to create more balanced and sustainable policies, systems and structures.
Lynn offers a series of measures (pp. 256-257) to address these imbalances and vulnerabilities and to promote the long term stability and health of the global production system. These are all measures which have been used effectively and safely in the past, to bring the activities of the industrial giants of the early 20th century into line with the interests of society, and which can be enacted unilaterally by the U.S. without harming the interests of any other nation. These solutions are U.S. centric because the global system is the creation of U.S. corporations, and the U.S. is still by far the dominant force in the system.
- “Use anti-trust power to ensure that no global lead firm controls more than 25% of any American market.
- Limit how much of any key input any industry can source from capacity located in any single foreign nation, to no more than 25% of the amount consumed in the U.S.
- Require firms to double or even triple source all components and business process services, in real time, from suppliers in two or more different nations.
- Strengthen the ability of true manufacturers to counterbalance the price-setting power of global lead firms, by strengthening and enforcing anti-monopsony laws. (A monopsony is a market situation in which a single buyer exerts a disproportionate influence on the market.) This would allow true manufacturers to capture a greater share of the profit in the production chain, and thereby be able to invest more in the maintenance of their productive assets.
- Require managers to make public their sourcing and supply-chain relationships, to enable investors to shy from firms that take unnecessary risk.
- Enable workers to more effectively counterbalance the power of shareholders by giving them an absolutely equal right to act collectively within the U.S. economy. Practically, this would reduce the ability of large corporations to seek profits by mining the social infrastructure.
- Professionalize management of the U.S. corporation by compensating top management only in salary and not in stock or stock options. One result would be a very different assessment by top managers of risk within the production system and of the attractiveness of owning, developing and maintaining productive assets.
- Reconsider the nationality of the global-scale lead firm, even if it maintains its headquarters in the U.S. Practically, this would give Americans a much clearer sense of how to shape national and state-level policies, where and how to subsidize research, and how to employ the private sector to develop defense technologies.”
My comment: These measures will necessarily be inflationary, but we have before us a choice of continuing to chase short term gain in the form of marginally (from this point forward) lower prices until the system itself collapses from neglect, or we can accept a period of inflation while the imbalances in the system are normalized.
At press time stocks are recovering somewhat from the recent sell-off, which has given pause to an otherwise pretty good year so far for the stock market. The sub-prime debacle has pricked the complacency bubble, causing a long overdue re-pricing of risk premiums in the credit markets. This has made investors nervous. But the rather dramatic spike in negative sentiment generated by this relatively minor sell-off (S&P down 6% from its highs) leads me to believe that while there is probably more to the downside in this move, it is not the end of the bull market.
I do, however, see some early signs of topping activity.
One such early warning sign is the Blackstone IPO. (See TheStreet.com’s analysis of this deal.) This is no ordinary IPO. Blackstone is one of the premier private equity companies and the Blackstone principals are masters of value — they buy cheap and sell dear. They buy companies that are “under-performing” for various reasons, “add value” by introducing operational efficiencies and technology, shutting down or selling unprofitable operations, outsourcing, off-shoring, and off-loading pension and health care obligations. These activities greatly increase the cash flow to the bottom line and to the shareholders, in this case the Blackstone principals and their investors. But that is not the end of the game. Increased profit and cash flow is very nice, but the big bucks are made when the transaction is completed.
Private equity companies complete the transaction and realize their profit by creating a “liquidity event.” This is either the sale of a portfolio company to another company, or the sale of the company through an IPO, in either case at a multiple of earnings. In this case Blackstone chose to offer shares in itself rather than offering the individual portfolio companies or the funds they manage. The fact that Blackstone has seen fit to do an IPO signals that the principals believe they have maximized the value of their portfolio and want to start cashing in. They are selling dear, and would not be selling if they thought their stock was anything other than dear.
If the Blackstone principals believe that they have realized the bulk of the value from their portfolio, that would indicate that valuations in general are peaking, and it also sends a signal to the dozens of other private equity companies which will now be looking for a liquidity event as well. In fact, KKR, another legendary private equity group, has also announced its intention to offer an IPO, as have numerous hedge funds. Others will surely follow. This new supply of stock will begin to put pressure on the market, a turnabout from the steady disappearance of stock caused by the de-listing of public companies during the buyout boom of recent years.
The private equity boom has been fueled by cheap money. Blackstone and other private equity companies, and public corporations as well, have been able to finance their acquisitions by selling junk bonds at historically low rates. That source of money is now starting to get more expensive as lenders, in the wake of the sub-prime meltdown, have suddenly realized that they are taking more risk than they are getting paid for. This will also begin a trend toward issuance of stock rather than debt as stock values are high and debt is now getting more expensive. So from various sources we will begin to see an increased supply of stock coming to market. Two excellent articles on the private equity business are the July 7th Economist cover article “The Trouble With Private Equity,” and Business Week’s July 2nd article, “Bashing Private Equity.”
President Bush’s intransigence on the war and his resulting spiral dive in ratings has finally begun to wear out the patience of his Republican supporters. In recent weeks numerous Republican Senators have publicly broken ranks with the President on Iraq and Senate Democrats are planning keep the pressure on with new votes on withdrawal. The President continues to reject all counsel but his own on this matter, and gives no indication he will alter his course regardless of political damage to his party.
The President’s commutation of Scooter Libby’s prison sentence has been a PR disaster for the White House, and for Republicans who have generally been unsympathetic and unyielding to the many thousands who have been sentenced to life destroying terms under the inflexible federal sentencing guidelines. Remarkably, the President’s rationale for commuting Libby’s sentence consisted of the very same litany of issues that defense attorney’s have been pleading since the onset of these guidelines: the sentence was too harsh, it will have an outsized effect on his innocent family, it failed to take into consideration all of his good works and character, and it failed to take into consideration any mitigating or unique circumstances.
The irony of this commutation is that it may well turn out to be a good thing for the country by opening up a debate on the harsh and inflexible federal sentencing guidelines and may over time yield changes on that score. “Law and order” Republicans who have stonewalled efforts to moderate these guidelines since their adoption in the ‘80’s will have a difficult time making their case after their support for (or failure to oppose) the Libby commutation. See “Bush Rationale on Libby Stirs Legal Debate” in the July 4th N.Y. Times.
The Mideast continues to dominate all geopolitical concerns. The situation is, in a word, hot.
The wheels are coming off of the U.S. effort in Iraq. Political support at home is collapsing, and while the “surge” is suppressing the overall level of violence in the short run, our troops are for the most part playing “whack-a-mole” with insurgents. Meanwhile, political progress in the Iraqi government is nonexistent. Having made zero progress on any of the critical issues it is facing, the Iraqi government has decided to take vacation for the month of August. The reality is that partition is the only viable option at this point. Turkey is ready…it reportedly has 140,000 troops massed on the Iraqi border.
Meanwhile, the Hamas coup in Gaza has upended the Israeli-Palestinian stalemate. Negotiations are suddenly going full tilt between Israel and Fatah in the West Bank to try to begin normalizing relations. We can all hope, but keep in mind that many Palestinians refer to Fatah as “the mafia” because of their well deserved reputation for corruption. Also, Hamas is not likely to sit idly by while peace breaks out between Israel and Fatah.
The big “known unknown” in the Mideast is Iran. Some feel that Iran is overreaching, and in the grips of hubris will trigger a regional war. The mullahs clearly feel that their star is ascendant. Their clients, Hamas and Hezbollah, have had big successes recently. They are working effectively with Syria to keep Lebanon destabilized. The U.S. is mired in Iraq. Their nuclear program is going full speed ahead. Iran is emerging from the neo-con era as the dominant force in the Middle East, and they feel this is their moment of destiny.
On the other hand, Iran is facing growing financial and domestic political problems. Despite sitting on the world’s second largest oil reserves, they are rationing gasoline. Two thirds of the population of Iran is under 30, and unemployment is very high among those under 30 — approximately 30%, and projected to reach as high as 50% in two years.
Terror Free Tomorrow recently conducted an unprecedented national poll of Iran, documenting the unhappiness (by wide margins) of the Iranian people with the policies and structure of their government. They would like a democracy; they would be happy to give up the nuke program, and they want to be open to the West. This information creates a delicate policy challenge for the Bush administration (unfortunately not known for its subtlety or nuance): an opportunity to mine this discontent to replace the existing regime without going to war and making enemies of those who desire to be our friends. I hope the Bushies are up to the challenge. See the July 11th Wall Street Journal op-ed, “What Iranians Think” by the President of Terror Free Tomorrow. Also, the Economist has an excellent special report entitled “The Riddle of Iran” in the July 21st edition.
At the same time Iran has pushed the U.S. about as far as they can without incurring a military strike. The Guardian recently reported that “The balance in the internal White House debate over Iran has shifted back in favour of military action before President George Bush leaves office.”
The U.S. has been building a public dossier of Iranian transgressions against American interests in Iraq and around the Mideast. The most inflammatory elements are repeated charges that Iran is directly supporting Iraqi insurgents by providing materials and training in IED’s, which are the #1 killer of U.S. troops in Iraq. When the time comes, this dossier will be used as justification for U.S. military action against Iran based on self-defense.
The grip of the mullahs will eventually start unraveling from the combined domestic and international pressures. The big questions are whether that will happen in time to satisfy George Bush, and whether it will happen before they develop nuclear weapons.
It remains my opinion that the primary opportunity these days is to prepare for the coming storm. Systemic risk is increasing, and the list of potential catalysts for a major crisis remains long. There is still time to pay down debt and reduce leverage.
Our government has long ago discarded any semblance of fiscal sanity, so long term the dollar has only one way to go. Gold, foreign currencies and assets owned outright are the counterweight to the dollar…but timing is everything. Economic and geopolitical disturbances can still cause a short term “flight to quality,” which can mean sharp rallies in the dollar. The cost of energy will probably continue to rise for the foreseeable future, but be prepared for serious volatility if you invest in this sector. There is a lot of interest in alternative energy but this is a nascent industry and it is very difficult to tell which technologies and companies are going to be the winners in the alternative race. Of course the best hedge against decline is your own debt free business, and on that score there seems to be more opportunity in the virtual world these days than in the physical. Here are some useful tips for newbie internet entrepreneurs. Also, one place to begin searching for on-line knowledge and inspiration is SreeTips.com.
Local food is gaining in popularity. I believe we are in a very early stage of a long term trend back to local agriculture. If for no other reason than the dramatically increased cost of flying and trucking food all over the globe, local agriculture is the future of the food business. A starting place for local agriculture resources is the USDA Alternative Farming Systems Information Center.
BCA Research recently ran an interesting piece about South American stocks. Apparently, while South Asia has been getting all the attention and most of the money, South American stocks have been outperforming South Asian stocks. You can check out South American indexes on Bloomberg and Latin American funds at Yahoo Finance.
South America has not come close to the economic performance of South Asia, but it is a lot closer to home, and many Americans are looking Southward for opportunity.