The Betrayal of American Prosperity (Prestowitz)


Clyde Prestowitz

The Betrayal of American Prosperity
Free Market Delusions,
America's Decline,
and How We Must Compete
in the Post-Dollar Era


Here are several excerpts from the 2010 book
The Betrayal of American Prosperity:
Free Market Delusions, America's Decline,
and How We Must Compete in the Post-Dollar Era

by Clyde Prestowitz.
Emphasis is added.
The following uses suffixes
G = giga = billion = 109,
T = tera = trillion = 1012.


In a 2009 White House meeting,
a group of top American CEOs who have offshored much of their production
told President Obama that
to prevent retaliation against U.S. exports
he must avoid inclusion of any “buy American” provisions
in his economic stimulus package
even though the measures being considered
were all perfectly legal and permissible
under the rules of the World Trade Organization (WTO).
Moveover, at that very moment,
China, Japan, and most of the major European countries
that might threaten trade retaliation
were already implementing “buy domestic” policies of their own.
The CEOs were, in effect, arguing for
sending more of our stimulus money to help create jobs overseas,
while our trading partners were doing the opposite.

When I heard of this, I couldn’t help thinking of how
in the midst of the 1980s’ trade frictions with Japan,
then secretary of commerce Malcolm Baldrige had considered
initiating antidumping actions against Japanese semiconductor producers
illegally selling their computer chips below cost (dumping) in the U.S. market
and threatening the future of the whole U.S. industry.
Concerned about the impact of possible Japanese retaliation
on American multinational companies
as well as about the consequences for U.S. semiconductor users,
Baldrige sounded out a number of leading executives before deciding to act.
IBM Senior Vice President Jack Kuehler’s comments
had been particularly important.
When asked whether or not some action should be taken
Kuehler had emphasized:
“Not only should you act, you must act.”
Baldrige did act,
and the result was not only a halt of the dumping
but a deal that opened the Japanese market as well.

This shift in CEO attitudes has come about largely because of
where the big global companies are producing these days.
Increasingly, it is not in America.
Hence, we must be alert that
when American CEOs advise the president or lobby Congress today,
they may unwittingly be acting, in effect,
as emissaries of foreign governments.

In any case, we cannot be sure that they are speaking
on behalf of America’s overall prosperity.

So strong has the hold of this pro-globalization, free-trade orthodoxy become
that some of our most respected economists have argued that
it doesn’t even matter what we as a nation make
as opposed to what we import.

As one former chairman [Herbert Stein]
of the president’s Council of Economic Advisers told me,
“They’ll sell us cars and we’ll sell them poetry.”
Indeed, most of our economists argue that
we are moving into a postindustrial economy
in which we will do high-tech R&D, software, and services such as
consulting, travel and tourism, and design.

Chapter 1
The Real State of America

America is in danger of going down the tubes,
and the worst part is that nobody knows it.
They’re all patting themselves on the back [cf.]
as the Titanic heads for the icebergs full-speed ahead.
— Andrew Grove, former Intel Corporation head

The canary in our coal mine is the U.S. dollar.
Since the end of World War II,
the green back has been the world’s main currency
for carrying out international transactions.
Oil and virtually all other commodities and products in international markets
are bought and sold in dollars.
In addition, like gold in the nineteenth and early twentieth centuries,
the dollar is the main currency in which most countries
now hold their monetary reserves—
an arrangement that greatly favors the United States.
For example, in order to buy oil, people in other countries
must first produce and export something in order to earn dollars,
which can then be used to pay for the oil.
Americans, on the other hand,
have only to print more greenbacks to get their oil.
[It almost sounds too easy, too good to be true, doesn’t it?]
Nor does America have to worry like other countries about its trade balances.
If other countries import more than they export,
they must borrow dollars to pay for the excess.
But that can get expensive, and sometimes no one will lend to them.
So they are forced to get back into balance.
[Healthy discipline, in other words.]
In the case of the United States, however,
it is only necessary to print more dollars
to pay for an excess of imports over exports.

As long as the world will accept dollars,
there is no need for America to balance its trade.
This phenomenon is a crucial support of America’s global military deployments.
To pay for war in Iraq or Afghanistan
or for fleets to patrol the oceans of the world
or for troops in more than seven hundred bases around the world,
America has only to print dollars—
as long as the world will accept dollars in payment.

Recently and increasingly, however,
the world is showing some unwillingness to accept dollars.
In May 2007,
Kuwait stopped pegging its dinar to the dollar
in favor of a basket of currencies.
Since then, the members of the Gulf Cooperation Council
(Saudi Arabia, Bahrain, Oman, Qatar, and the United Arab Emirates)
have been debating whether to link their planned new common currency
to something other than the dollar.
Indeed, former Federal Reserve Chairman Alan Greenspan
has noted that the OPEC countries are
“already recognizing the value of shifting from petro-dollars to petro-euros.”
But it’s not just OPEC.
In the past few years, Russia, Thailand, Malaysia, and others
have also reduced the dollar ratio of their reserves.

More recently,
China, whose RMB is already a de facto currency
in parts of Thailand, Russia, and Vietnam,
and whose stash of dollar reserves now amounts to well over $2T,
has been calling for replacement of the dollar as the world’s reserve currency
by the International Monetary Fund’s special drawing rights (SDRs),
presently the unique internal currency of the IMF.
At the same time,
Beijing has been warning the United States against
allowing any depreciation of the dollar
and pressing Washington for a guarantee that
the dollar will not depreciate further.
China is also rapidly trying to diversify its holdings by using its reserves
to buy oil fields and other commodity production sites around the world,
to add to its gold stocks,
and to buy companies and other assets.

The dollar was also at the top of the agenda
at the October 2009 East Asia Leaders meetings in Thailand.
As the dollar fell to new lows against almost all currencies,
the new Japanese prime minister called for creation of an Asian currency
that would replace the greenback.
At the annual meeting of the World Economic Forum in 2010,
French President Nicholas Sarkozy urged a new global currency solution.

In tandem with these developments,
the September/October 2009 issue of Foreign Affairs
featured an article titled “The Dollar Dilemma” in which
UC Berkeley professor Barry Eichengreen discussed how, as he put it,
the world’s top currency faces competition.
He concluded that the role of the dollar will inevitably diminish in the future,
but that it will for some time remain first among equals
in a system of multiple national reserve currencies.
On the other hand, the UN special advisory committee on reserve currencies
chaired by Nobel laureate Joseph Stiglitz
is calling for creation of a new global reserve currency.

Section 1.2
Erosion of the Economy, Industry, and Technology

Subsection 1.2.3
What America Does Not Make

As a kid I often traveled by train from Wilmington, Delaware, where I lived,
to Philadelphia, where my dad worked.
Along the way the trains passed through
the then thriving manufacturing town of Chester,
which had proudly painted a sign in the railway station proclaiming that
“What Chester Makes Makes Chester.”
Today, Chester is a sad derelict of a city,
sunk in poverty and languishing next to
the broken down shipyards and factories that closed long ago.
Today, Chester doesn’t make anything, and there isn’t much left of Chester.

Unfortunately, Chester is a metaphor for the United States
and a pointer to many of the reasons for
the rotting of the country’s infrastructure
and the hollowness of its apparent wealth.
Like Chester, America doesn’t make much anymore.
it doesn’t manufacture the vast range of consumer and industrial goods
on which its wealth and power were originally built.
Like Great Britain before it, America has turned to
nontradable services, home construction, and finance to earn its living
as its manufacturing has migrated to other climes.

Keep in mind that manufacturing accounts for
about three-fourths of America’s corporate research and development (R&D)
and pays average wages 20 percent above those in service industries.
Manufacturing also has a job multiplier of 4 to 5,
meaning that each manufacturing job creates 4 to 5 other jobs in the economy,
as compared to a services industry job multiplier of 1 to 1.5....
And the sector enjoys productivity gains one third above the national average.
Even more important, it is the source of most of the economies of scale
that are the real drivers of wealth accumulation.
It is, thus, a very good thing to have a significant manufacturing sector
in your economy if you can.
Unfortunately, it increasingly seems that America can’t.

From 24 percent of GDP in 1980,
manufacturing has fallen by more than half
to less than 12 percent of GDP in 2010.
To some extent this is a natural development
as all developed countries tend to create larger service sectors
as their economies mature.
But the relative shrinkage of the U.S. manufacturing sector has been extreme
in comparison to countries such as
Japan (18.3 percent of GDP),
Germany (22 percent),
France (15 percent),
and even the U.K. (13 percent).
The U.S. decline has been particularly brutal in the past eight years,
during which it has lost about a third (from 17 percent to 12 percent)
of its share of GDP
as 40,000 manufacturing plants closed their doors.
For instance, the American steel industry that produced 97M tons in 1999
managed to do only 91M tons in 2008
even as Chinese production rose from 124M to 500M tons over the same period.
Between 2000 and 2008, 270 major U.S. furniture factories closed
as the industry lost 60 percent of its production capacity
and the market share of imports rose from 38 percent to nearly 70 percent.
The U.S. machine tool industry—
the backbone of any industrial economy and essential to defense production—
produced only $3.6G in equipment, less than 5 percent of world production,
down 30 percent from 1998, and only about half of U.S. consumption.
In contrast, Germany, Japan, and even Italy
produced more machine tools than the United States.
Chemical plants are another essential element of an industrial economy.
In 2008, 80 major plants costing in excess of $1G
were being constructed somewhere in the world.
None of them was being constructed in the United States.

There are many reasons for this long-running trend.

The one usually mentioned in popular commentary—inexpensive labor
is the least important.
Of course, that has played a role,
especially in industries like apparel that are very labor intensive.
But machine tools, steel, and chemical plants are not labor intensive,
and developed countries like Japan, Germany, and France
have managed to hang on to them.
These industries are leaving or have left the United States because

the dollar is being managed both in Asia and in America to be overvalued
versus many pegged or only partially floating currencies

like China’s RMB and Taiwan’s dollars.
Imports of products from these countries are thus artificially cheaper
than they would be under truly open-market conditions.

[But note the strong relation between "inexpensive labor" and "undervalued currency".]

The second major reason is
the tax holidays, capital grants, free infrastructure, labor wage agreements, and regulatory exceptions
that many countries use to entice investment by targeted global companies
and that the United States does not match.

The third reason is
political pressure from countries like China who make it clear that
if a global company wants to do business there
it had best demonstrate that it is a friend of China.

The fourth reason is
corporate tax rates.
U.S. rates are the highest in the world except for Japan’s.

The fifth reason is
onerous and complex U.S. regulatory procedures.

A sixth reason is
the difficult labor union-management situation in some U.S. industries.

Pure cheap labor is usually (not always) the last reason.

Thus, the key to global manufacturing dynamics lies
much more in the real of policy
than in the realm of economic fundamentals.

These dynamics have resulted in the dramatic loss of manufacturing jobs
and in a depression of manufacturing wages.
U.S. manufacturing wages that were tops in the world are now tenth,
and if we compare at nominal exchange rates,
U.S. wages rank sixteenth in the world.
Worse is the fact that this drop in manufacturing employment and wages
also depresses wages economywide.

Those National Institute of Standards and Technology
chief economist Greg Tassey has labeled
the apostles of denial among orthodox economists and commentators
have maintained that this is nothing to get upset about
and is just the natural evolution of a postindustrial economy.
Analysts like Michael Porter of Harvard Business School
and the Council on Competitiveness
insist not only that
the U.S. economy doesn’t need manufacturing,
but indeed, that
its decline is an indicator of success.
Thus, in one council report, Porter insisted:
“We have to stop this notion of believing that manufacturing is essential.
Such thinking is a real problem.”
Between 1998 and 2007, that argument seemed plausible.
First the dot-com bubble and then the housing bubble
masked the deterioration of manufacturing.
On top of that,
Wall Street’s share of GDP grew to match the lost manufacturing share.
[One should also observe the rise in health care’s cut of the economy.]
America, argued the orthodox apostles, was moving to “higher ground”
where its future lay in innovation, high technology,
and sophisticated service industries
like medical diagnostics and treatment, design, and investment banking.
Indeed, in recognition of this expected development,
a special category of U.S. trade statistics—
Trade in Advanced Technology Products
was designated in 1989 to demonstrate
how nicely the United States was shifting to a high-tech economic structure.

For the next twelve years, as expected, Advanced Technology trade statistics
showed a respectable (though not huge) surplus
even as the deficit in the rest of U.S. manufacturing plunged to new depths.
But then, in 2002, Advanced Technology swooned as well,
with a deficit of $17G.
By 2008, that had grown to $61G
as the dynamics of decline in traditional manufacturing
began to repeat themselves in high technology.

Subsection 1.2.4
High Tech Imitates Low Tech

Just as no chemical plants are being built in the United States today,
so only 2 percent of all new semiconductor fabrication facilities
under construction in the world in 2007
were under construction in the United States.
Thirty percent were being built in China,
25 percent in Taiwan, and
22 percent in Korea.
Japan, Korea, and Taiwan dominate the development and manufacture
of the liquid-crystal display (LCD) panels
that have become the world’s preferred viewing surface.
China’s BOE Technology Group and Korea’s LG Display Co. have both announced
they will locate new $3G-plus LCD factories in China,
and Samsung Electronics said it is considering a similar move.
There are no LCD plants in the United States.

America is also losing out in the latest generation (300mm, about one foot)
of the semiconductor wafers that eventually are sliced and diced
into the chips that go into your computer.
In 1999, 36 percent of global production of such wafers was in the United States.
By 2004, that was down to 20 percent and in 2010 it is around 15 percent.
Recently there has been much talk of “green industries and green jobs”
as part of the recovery from the economic crisis.
But there is only one American company
among the world’s top ten producers of photovoltaic cells.
German’s Q-Cells is the world’s leading producer,
while Japanese and Chinese producers each have
about 30 percent of the global market.
In the area of solar concentration and collection equipment,
the Germans dominate.

the only U.S. company among the ten largest in the wind energy industry is GE
with a share of only about 16 percent of a world market
that is dominated by Danish, Chinese, and German producers.
As for batteries,
a series of U.S. government grants was announced in August 2009, totaling $2G
to boost research by several U.S. battery producers.
But this looked less than impressive in the face of
an announcement by Toyota that
it was forming a consortium with Sanyo and Panasonic
not only to develop but also to produce advanced batteries.

Even more discouraging for those who have long argued that
America’s salvation lies in its [supposedly] unique innovative capacity
was a recent report by the Information Technology and Innovation Foundation,
which ranked the United States dead last among leading countries
in improvement in innovation capacity
and only fourth in absolute overall innovation capability.

A recent headline in Manufacturing & Technology News read
“America’s Oldest Printed Circuit Board Company Closes Its Doors.”
The story reports that after fifty-seven years,
Bartlett Manufacturing Co. can’t make it anymore.

Ten years ago,
U.S. makers accounted for 30 percent of the global market.
Today, that is down to under 8 percent,
and with the demise of Bartlett it will be substantially less.
In 2008, total U.S. PCB industry revenue fell to $4G, down from $11G in 2000.
Over that same period,
Asian output has climbed from 33 percent
to more than 80 percent of the global total.
Says Bartlett chairman Doug Bartlett:
“The U.S. industry has been crippled beyond repair.
Our kids are going to be fluffing dogs and doing toenails
while the Chinese are making leading-edge devices.”

In this, Bartlett echoes the concerns we saw expressed earlier
by former Intel chairman Craig Barrett.

What bothers Bartlett and Barrett
is what triggered the Defense Science Board to report that:
“Urgent action is recommended, as the industry (semiconductor)
is likely to continue moving in a deleterious direction,
resulting in significant exposure if not remedied.”
This only echoed
the 2003 report of the Pentagon’s Advisory Group on Electronic Devices (AGED)
that said
U.S. technological leadership “is in decline” and warned that
the offshore migration of semiconductor chip foundries “must be addressed”
because it “will potentially slow the engine for economic growth.”
It further emphasized that the Department of Defense
“faces shrinking advantages across ALL technology areas”
and noted that
as U.S. industry shifts its production offshore,
it “assigns those nations political and military leverage over the United States.”
It urged that the U.S. government needed to counter
the “massive financial and tax investments” being made by foreign governments
to lure U.S. companies to relocate their production away from the United States.
AGED chairman Thomas Hartwick told Congress that
“the structure of the U.S. high-tech industry is coming unglued
with innovation and design losing their tie
to prototype fabrication and manufacturing.”

This broken link
leaves inventions “on the cutting room floor
because they cannot be manufactured.”

Hartwick concluded that if dramatic action is not taken the United States
faces the “destruction of U.S. innovation centers.”

In 2004, the President’s Council of Advisors on Science and Technology (PCAST) sounded similar warnings,
noting that
the loss of production capacity will quickly be followed by
loss of research, development, engineering, and design capability as well.

Said the council:
“The continuing shift of manufacturing to lower-cost regions,
and especially to China,
is beginning to pull high-end design and R&D capabilities
out of the United States.”

It warned that
the “research to manufacturing process
is not sequential in a single direction,
but results from an R&D-manufacturing ecosystem consisting of
basic R&D, precompetitive development, prototyping, product development,
and manufacturing”
all operating in such a way that
the “new ideas can be tested and discussed with those working on the ground.”
locations that possess both strong R&D and manufacturing capabilities
have a competitive edge.
PCAST warned emphatically that “key elements of the innovation ecosystem”
were eroding rapidly and said that
only dramatically different U.S. government policies
could halt and reverse the erosion.

This warning was echoed again in 2006 by the National Academy of Sciences.
Its report—“Rising Above the Gathering Storm”—said the United States
could no longer afford research in areas like telecommunications
because it has lost its ability to compete in commodity products.
A final warning along these lines came in
a 2009 analysis of the defense industrial base
by University of Texas professor Michael Webber.
His conclusion is that
among the sixteen fundamental defense foundation industries,
the U.S. position is seriously eroded in thirteen,
holding steady in one, healthy in only two.

Section 1.3
The Services Myth

In the face of the decline of U.S. manufacturing and high tech,
many economists, business leaders, and policy makers
have embraced the notion that
America’s future lies in the service industries.

But the numbers just don’t work.
While it is true that the United States
had a services trade surplus of about $140G in 2008,
that made only a small dent in the goods deficit of $840G.
To get anywhere near a trade balance,
the services surplus would have to grow by more than five times.
But it isn’t growing at anything like that rate,
which brings us to the second point.
It is not at all clear that services won’t also go
the way of manufacturing and high tech.
Aside from travel, the big American service industry has been finance.
But, as I have said, that industry just [in 2008] blew itself up
and is going to have to contract as a percent of GDP.
The real trend here is that noted by
Federal Reserve board member and Princeton professor Alan Blinder,
who has forecast that as many as 29 percent of all jobs
could be outsourced over the next few years.
On top of that are the numbers we already have in hand
for job shifts taking place domestically.
Over the past ten years
there has been a massive loss of 8 million manufacturing jobs.
That has been accompanied by substantial job creation in the service industries,
but the bulk of the new jobs are in retailing and food services,
which pay far less with far fewer benefits than manufacturing.

The big news in services is India, not America.
I recently had a brain scan at Suburban Hospital in Bethesda, Maryland.
The radiologist was reading the scan from his offices in Bangalore.
The accounting firm that handles my taxes
recently moved its whole back office to Bangalore.
Reuters news has moved much of its editorial operations to Mumbai.
When you make airline reservations, chances are
you’re talking to someone in a suburb of New Delhi,
and that is definitely true when you call the help line
for assistance in fixing your computer.
Or let’s look at a comparison of IT services firms.
Infosys and Wipro of India both have sales of about $2G
compared to $25G and $15G respectively
for U.S.-based EDS and Computer Sciences Corp.
The Indian companies have profit margins of more than 20 percent
while the U.S. companies are in the 3 percent range.

In view of this, whose future do you think more likely lies in services?
in June 2006, IBM said India’s.
It held a meeting with Wall Street analysts in Bangalore,
where it announced adoption of the Indian offshore outsourcing business model,
explaining that it believed
the talent pool of India and other low-cost countries would continue to deepen.
IBM said it would be investing $6G to expand its Indian operations.
Its head count in India, which was 6K in 2003,
is projected to hit 110K in 2010.
This compares to a U.S. head count of 120K and falling.
In 2007, Accenture outdid IBM by actually increasing its Indian head count
beyond that of its U.S. operations.

Chapter 2
The Real Story of How America Got Rich

Manufactures are now as necessary to our independence
as to our comfort.
— Thomas Jefferson [3]

Thank God I am not a free Trader.
— Theodore Roosevelt [26]

Section 2.1
The Development of the American System

The historical quotes in section 2.1.0 below are all from pages 15-30 of
Opening America’s Market: U.S. Foreign Trade Policy Since 1776 (1995)
by Alfred E. Eckes, Jr.

The history of American tariffs is discussed in Wikipedia here.]



Alexander Hamilton,
with important support from George Washington [1],
argued that the new nation needed
a strong central government based on a firm financial foundation
which should foster the growth of manufacturing industries.
This would not only be the superior route to economic growth
but also would provide for the national defense.
Asserting that “a nation cannot long exist without revenue,”
he early called for a tariff on imports
that would both finance the state
and provide incentives to local manufactures.

One of Hamilton’s first acts
after he was appointed Secretary of the Treasury by Washington in 1789
was to propose a 9 percent general tariff,
which was duly passed and signed into law on July 4, 1789.
Though a plantation owner like Jefferson [3],
Washington felt strongly that
the new America needed a vigorous manufacturing base,
an attribute that undoubtedly reflected
his bitter experience during the Revolutionary War
when the American army lacked cannon, clothing, and shoes.
Thus in his first annual message, on January 8, 1790,
he emphasized that
a “free people ought not only to be armed but disciplined;
and their safety and interest require that
they should promote such manufactories
as tend to render them independent of others
for essential, particularly military, supplies.”

By way of example,
Washington ordered an American-made suit for his inauguration
and stated that he consumed no ale or cheese
“but such as is made in America.”
Thus, the father of his country underlined that
the government had a responsibility to promote and buy domestic goods.
he promised the Delaware Society for Promoting Domestic Manufactures
“to demonstrate the sincerity of my opinion
by the uniformity of practice,
in giving preference to the produce and fabrics of America.”

Vital to the support of American industry
was Article I, Section 8 of the U.S. Constitution,
which states that
“Congress shall have power ...
To promote the progress of science and useful arts,
by securing for limited times to authors and inventors
the exclusive right to their respective writings and discoveries.”
This article was put into practice by the Patent Act of 1790;
it was followed by Hamilton’s Report on Manufactures in December 1791,
which called for high tariffs to protect nascent American industry.
The act also offered support for agriculture in order to encourage more exports
emphasized the establishment of patents to encourage and protect inventions.
The report also called for Buy American policies
to ensure a favorable balance of trade
until domestically manufactured goods achieved
the quality demanded by overseas markets.
Finally, it foresaw allocation of substantial federal funds
for the building of roads, bridges, canals, and harbors
to facilitate both internal and external commerce.
[A side note: Note there was no federal support for health care at this time.]
Hamilton was following the English mercantilist model closely.

Free trade, Hamilton argued,
would be devastating to the young country’s economy.
With Britain using the Navigation Acts and a variety of tariffs and subsidies
to favor its industries,
the practical result of an American free-trade policy would be
continued British dominance
of all the leading-edge, rapidly developing new businesses.
Things might be different if Britain changed its policies.
“If the system of perfect liberty to industry and commerce
were the prevailing system of nations,”
said Hamilton,
“the arguments against a program of manufactures would have great force.”
But in the absence of equal treatment and reciprocity,
the United States could become a “victim of the system,”
and be led into “a state of impoverishment.”
Hamilton also believed that in the long run
a diversified economy
would be more likely to grow rapidly and productively
than would a narrowly specialized agricultural economy.

Hamilton countered the arguments of free traders
that tariffs would increase costs to consumers
by noting that
“the fact does not universally correspond with the theory.
A reduction of prices has in several instances
immediately succeeded the establishment of a domestic manufacture.”
Further, once established, a domestic manufacture
“invariably becomes cheaper,
being free from the heavy charges
which attend the importation of foreign commodities.”
[That argument seems less valid today.]
Thus, he argued that “a temporary enhancement of price
must always be well compensated by a permanent reduction of it.”
In this way,
Hamilton articulated what has since come to be known as
the “infant industry” theory.

The debate over these issues
continued in fits and starts for the next twenty years.
However sympathetic he was with Hamilton’s overall perspective,
Washington recognized that,
in view of the power of the Jefferson faction,
some of Hamilton’s proposals were politically premature
and so he held back on enacting many of them.
When Jefferson [3] was elected president in 1801,
the policy shifted toward his ideal of agrarianism.
Eventually, however, a number of key developments brought about
the hybrid mercantilist system that characterized the American economy
from then until the end of World War II.

One important event was Eli Whitney’s invention of the cotton gin in 1793,
for which he duly received a patent
under the strong new patent laws passed in 1794.
While the cotton gin was revolutionizing the American economy,
Whitney became bogged down in endless legal challenges to his patent
and nearly went bankrupt.
Eventually, however, he managed to finance the winning of his case
with a government contract for the production of 10,000 muskets.
In the course of fulfilling the contract
he also developed the concept of interchangeable parts
that, used in combination with power machinery and specialized labor,
revolutionized production and became known as
the “American System of Manufacturing
as it spread around the world.
This system was perhaps the first example of how
government contracting in combination with private enterprise
could be used to spur innovation and productivity growth

Another key factor was that British manufacturers
began dumping their products at far below cost into the American market,
a tactical maneuver to prevent U.S. manufacturers from gaining ground.
The British navy had also started boarding U.S. merchant ships
and impressing their sailors into service.
Objections to these practices precipitated the War of 1812,
and the war glaringly demonstrated
the limitations of the American economy
in defending against major powers with strong manufacturing industries.
As a result,
Jefferson [now out of office] did an about-face,
noting that the war experience had taught him
“that manufacturers are now as necessary to our independence as to our comfort.”
He promoted Buy American thinking and challenged free traders to
“keep pace with me in purchasing nothing foreign where an equivalent of domestic fabric can be obtained without regard to difference of price.”
[Cf. the 2012-07-25 report from Tom Ridge et al.,
New Report: U.S. Too Dependent on Foreign Suppliers in Crises”;
see also the Washington Post story
Reliance on imports leaves U.S. vulnerable to disasters”.]

Other leaders, such as
Madison [4], Monroe [5], John Adams [2], and his son John Quincy Adams [6],
echoed Jefferson [3],
and in 1816 the first really protective tariffs were imposed by Congress
with a 30 percent duty on iron imports
and 25 percent on cotton and woolens.

As president, in 1822 Monroe [5] called for more tariff increases,
noting that
“whatever may be the abstract doctrine in favor of unregulated commerce,
that doctrine rests on two conditions—
international peace and general reciprocity—
which have never occurred and cannot be expected.”
Leaders of another more populist and agrarian faction of the Democratic Party,
who might have been expected to take a different view, also agreed.
Despite his being from the cotton-exporting state of South Carolina,
John C. Calhoun called in 1816 for a tariff on cotton goods.
And Andrew Jackson [7] commented in the wake of the war
he contributed so much to winning
that “we have been too long subject to the policy of the British merchants.

It is time we should become a little more Americanized,
and instead of feeding the paupers and laborers of Europe,
feed our own,
or else in a short time,
by continuing our present policy [of laissez-faire]
we shall all be paupers ourselves.”

At the same time,
journalists and political economists took a more critical look at
the teachings of Adam Smith and his Wealth of Nations.
Among the most influential of these was Daniel Raymond,
who was recognized as the “first systematic American economist.”
Raymond opposed Smith’s preoccupation with the wealth of individuals,
that political and economic leaders should focus on
the welfare of the nation and the overall society.

He criticized Smith’s notion that
consumers should buy imports when they are cheaper than domestic products
because he saw such buying as
“destroying the unity of the nation
by dividing it into classes and looking to the interests of individuals,
instead of looking to the interests of the whole.”

Raymond further argued that individuals
“ought not to be allowed to afford patronage and support
to the industry of foreigners,
when their own fellow-citizens were in want.”
Unlike later-day economists,
Raymond did not assume that
the winners from trade in the country would compensate the losers,
or that a society was better off overall
as long as trade produced net gains
even if the gains were monopolized by a very few at the top of the society.

Thus, a new consensus emerged on the need for the development of
what became known as the American System [see also],
a concept best articulated and promoted by
Congressman Henry Clay of Kentucky.
It called for
free trade only in cases of “perfect reciprocity”;
protection and subsidization of America’s infant manufacturing industries;
extensive government-led development of
national roads, waterways, railroads, and other infrastructure;
expansion of the country’s borders;
removal of the Indians; and
settlement and development of the land.
In particular, tariffs were not seen as
a device for taxing consumers for the benefit of manufacturers.
Rather, it was believed that
tariffs would stimulate investment in the United States and eventually allow Americans to produce articles much cheaper
than they could be procured abroad,
by capitalizing on the economies of scale
that would result from substantial population growth,
thereby benefiting both American producers and consumers.

In response to President Monroe [5]’s request,
Congress raised tariffs in 1824
and then raised them again in 1828
with the so-called Tariff of Abominations
under which rates on dutiable goods rose to 61.7 percent,
above even those that would later be imposed
under the notorious 1930 Smoot-Hawley Tariff Act,
so often blamed for worsening the Great Depression.
Over the next few decades,
tariffs declined from these punitive rates,
but were then raised again sharply during the Civil War
at the behest of Abraham Lincoln [16],
who might be called the Great Protector as well as the Great Emancipator.
Lincoln wholeheartedly embraced Clay’s American System thinking
and argued that
“the abandonment of the protective policy …
must produce want and ruin among our people.”
From the Civil War until World War I,
U.S. tariffs never fell below a 40 percent rate
as leaders such as Theodore Roosevelt [26]
emphasized their support of the catch-up effort by saying
“Thank God I am not a free trader.”

Subsection 2.1.3
The Effect of Britain Switching to Laissez-faire

The wisdom of the crafting of the American System
stands out in stark relief against
the developments in Britain over the same time frame.
In the 1840s British leadership
decided to partially abandon its long-time mercantilist policies
in favor of laissez-faire, nonreciprocal free trade.

Behind this fateful decision
were the arguments of a London banker named David Ricardo.
His 1817 treatise On the Principles of Political Economy and Taxation
laid out a case against mercantilism
and for nations adopting open markets and specialized production
that built on [Adam] Smith’s analysis and extended it in several ways.
The centerpiece of his contribution was
the concept of comparative advantage,
the notion that countries would optimize their welfare
when they concentrated on producing what they did best
and traded for the rest.
Smith’s argument for specialization was a step in this direction.
But Ricardo took it further.
His example of the trade of British woolens for Portuguese wine
would become a classic.

Rather than trying to grow grapes in Britain or raise sheep in Portugal,
both countries would optimize their benefits
if the Portuguese imported their woolens from Britain
and Britain imported its wine from Portugal.
Ricardo demonstrated that
even if Portugal could do both woolens and wine better than Britain,
the British were still better off by concentrating on woolens,
because they were less inferior in woolens than in wine making.
If they tried to take up wine making,
they would suffer worse losses overall
because their disadvantage in wine was so much greater.

Although it took time, this thinking, combined with
the rapidly growing dominance of British manufacturers and of British commerce,
led to the almost total abandonment of the mercantilist strategy
(with a few major exceptions I’ll discuss later)
and the adoption of the new doctrine of laissez-faire.
British leaders had come to the view that
as the leading producers, transporters, and financiers of the world,
they would automatically be
the low-cost and dominant providers in a world of open markets and free trade,
so switching to the laissez-faire model would be greatly to Britain’s benefit.
A number of initial tariff reductions were made in 1842 and 1845,
but the big moves came in 1846
when the Corn Laws protecting agriculture were dropped,
and in 1849 when the Navigation Acts were abandoned.
These moves were followed by
the unilateral removal of virtually all tariffs in the 1850s and early 1860s.

The new British ideal was a world in which
the United Kingdom would import grain and raw materials at the lowest possible cost from the rest of the world
and then export back to global markets
the high-value-added manufactured goods churned out by
the factories that had made Britain “the workshop of the world.”

Although the British argued passionately,
pushing the analysis of Smith and Ricardo,
that the rest of the world should also switch to laissez-faire,
the rest of the world absolutely did not embrace the new creed.
No more than the Americans had been
were the continental Europeans persuaded by London.
The German businessman and writer Friedrich List,
a onetime resident of the United States and fan of Alexander Hamilton,
wrote extensive critiques of Adam Smith and David Ricardo
along with proposals to apply the key elements of Hamiltonian thinking
to the German Customs Union.
List believed that Smith’s focus on the individual and the consumer
ignored the need to develop the entire national economy by expanding production.
He further believed that Smith’s emphasis on commerce and transactions
missed the need for invention, long-term investment, and
the potential for transformative shifts to dramatically better circumstances.
There was, he felt,
something terribly static about the Smith-Ricardian analysis.
List argued that the preconditions for wealth and democracy
are a diversified manufacturing sector subject to increasing returns to scale
rather than the constant or diminishing returns
of agriculture and raw material production.
(Today he would include knowledge-intensive services
in what he called manufacturing.)
Thus, List contended, as had Hamilton,
that a nation must first industrialize
by means of developing infant industries
and then engage in free trade with nations
on an equal level of industrialization.

The upshot of all this was that
the United States and the key European countries
all rejected British laissez-faire.
Germany introduced tariffs to protect strategic industries like steel in 1879.
France adopted higher tariffs in 1882
and then raised them again in 1892
as Sweden, Italy, and Spain joined the party.
Thus, by the last third of the nineteenth century,
Britain had become the world’s only fully free market,
and a highly asymmetric global economic structure was established in which
the world was half governed by free-trade doctrines
and half by strategic catch-up policies.

The British move to laissez-faire turned out to be an historic pivot point
after which,
as the American System drove the U.S. economy to ever new heights,
the British economy began a long decline.

Subsection 2.1.4
America Becomes Number 1

The mid-nineteenth-century golden age of British supremacy
was nowhere better symbolized than at the International Exhibition
at London’s Crystal Palace in 1851.
It was dominated by British machine tools, British locomotives, British textiles, and everything British.
At this moment, Britain was by far the world’s main industrial country,
accounting all by itself
for about 30 percent of total global industrial output.
It produced nearly twice as much as the next largest producer,
which by this time was the United States.
British ships carried more than half the world’s ocean freight.
As the increasingly troubled United States moved toward civil war
and Germany struggled to become a united country,
Britain’s economic supremacy seemed assured indefinitely.
Yet between 1870 and 1900,
America surged ahead of Britain
in virtually every sector of the economy.

The blueprint of the American System began to reap vast rewards.
The United States had evolved into an enormous, relatively unhindered market
that afforded American manufacturers unprecedented economy-of-scale benefits
which supported rapid increases in productivity.
The railroads were the lynchpin of astonishing economic growth.
Not only did they knit the regional markets together and by their own expansion create enormous demand for steel, coal, wood, and machinery.
They also became the first modern business enterprises,
and their model was copied to modernize one industry after another.

By 1870, America was laying track at the rate of 5,100 miles a year,
more than the rest of the world combined.
By 1896, there were 183K miles of rail,
not counting another 60K in sidings and yards.
This came to 40 percent of the world total
for a country with just 6 percent of the global land area.
The railroad system accounted for about 15 percent of national production,
more than all federal, state, and local governments combined,
and employed 800K men, or over 2 percent of the entire national workforce.

By 1880
the cost of traveling from eastern Europe to the American plains was $70,
and between 1866 and 1869 more than one million new immigrants
fled the poverty of Europe for the potential plenty of America,
particularly of the American West
where there was now accessible land for the landless.
By 1900 the number of American farms had tripled from 2M to 6M
while the area farmed doubled,
and production of wheat, corn, and cotton
outstripped the doubling of the population
to make the United States
the world’s largest exporter of agricultural commodities.

Part of this dramatic rise in production
was due to the increase in acreage,
but much of it was also due to the sharply rising productivity.
After 1860, widespread use of the mechanical reaper [Cyrus McCormick]
had more than tripled the acreage a man could harvest in a day,
and the new land grant colleges helped develop
new, drought-resistant seed strains and cures for animal diseases
that also vastly increased productivity.

Yet even as agricultural production soared,
it declined to less than half of total U.S. production
owing to a vast wave of industrial development
that has been called the Second Industrial Revolution.
The new farms and the rapidly growing population
needed more and more of the stream of newly invented machines—
the thresher, automatic wire binder, combine, husker, typewriter, electric lightbulb, telephone, and refrigeration car—
that emerged from America’s industrial inventors.
The railroads and the building boom drove demand for steel and wood,
and all producers needed the tools and equipment
that would allow mechanization and automation.

In 1870, Great Britain produced 40 percent of the world’s steel,
followed by Germany at 30 percent
and the United States at 15 percent.
By 1900, U.S. production had climbed to nearly 40 percent of the world total
with Germany second at 25 percent
and Britain trailing at about 20 percent.
By 1913, the U.S. share had increased to nearly half the world’s steel.

If we look more broadly at total manufacturing output
we find the same dynamics.
In 1870,
Britain accounted for about 32 percent of total world manufacturing,
with the United States second, at 23 percent,
and Germany third, at 13 percent.
By 1900, the United States was at 30 percent,
with Britain at 20 percent
and Germany at 17 percent.
And by 1913, the United States accounted for 36 percent,
Germany for 16 percent,
and Britain for 14 percent.
Most significant of all was the fact that by 1914,
the American population had become twice as large as Britain’s
and 50 percent larger than Germany’s,
greatly enhancing the U.S. advantages in economies of scale.

American GDP stood at $518G by this time
and was more than double that of Britain
and over three times that of Germany,
while U.S. per capita income was $5,307
as compared to $5,032 for Britain
and $3,833 for Germany.
America had become the richest country in the world.
And importantly,
it had reached this height
by using high tariffs and a catch-up strategy

that resulted in 4 percent plus annual rate of GDP growth
while free-trade, laissez-faire Britain
could not maintain even a 2 percent annual economic growth rate.
It had been argued in the old tariff debates that
protection of infant U.S. manufacturers
with initially higher costs than foreign producers
would impose higher prices on consumers
and inhibit the growth of the American economy.
In fact, as they rapidly improved quality
and exploited the potential for economies of scale,
American manufacturers were becoming the world’s low-cost producers
even as they paid the highest wages,
and American consumers were enjoying the lowest relative prices.

Not only did the domestic prices of American producers decline rapidly,
but their exports soared
as they undercut the prices of the higher-cost British producers.
From 1875 onward,
the United States had a trade surplus driven by rising exports of manufacturers,
and between 1870 and 1913,
U.S. exports grew at a compound annual rate of 4.9 percent
while those of Britain managed only 2.8 percent.
As the twentieth century dawned,
the United States completed the integration of its internal market,
built the Panama Canal, and acquired an empire.
American products seemed to be everywhere,
as Europeans and others fell in love with American typewriters, sewing machines, phonographs, autos, elevators, telephone, and lightbulbs.
Indeed, the English Daily Mail noted:
“there is hardly a workshop of any significance in the UK
that does not use American tools and labor saving devices.”
The British engineer Benjamin Thwaite went further to say that
“British soldiers and sailors open new highways of commerce,
but the American by his ingenuity is producing machinery
that will undersell the Briton in every part of the world.”

By the time of the Paris Exhibition of 1900,
there was no longer any question that Britain had lost its industrial and technological leadership.
British industrial output had fallen to only about 15 percent of the world total
while that of the United States had passed 30 percent.

Chapter 3
America Changes Course

The United States is organizing its own decline
— Geir Lundestad, Norweigan Historian

The structure of today’s global economy, with
its chronic trade imbalances,
its tendency toward financial crises,
its asymmetric economic growth policies, and
its continuous low-grade economic conflict,
was largely determined by the asymmetry between
America’s fixation on geopolitics and laissez-faire free trade and
the neomercantilist emphasis of the leading countries of Europe and Asia
on “catching up” and becoming competitive.
Conflict between these priorities was not apparent in
the first flush of the postwar boom.
But in later years,
under presidents Ronald Reagan [40] and George H.W. Bush [41],
bitter conflict arose as
the early signs of American decline began to appear.

Section 3.3
What Exactly Did Smoot-Hawley Do, Anyhow?

In a September 20, 2009, New York Times article,
ninety-four-year-old David Rockefeller
invoked the specter of the 1930 Smoot-Hawley tariff
to warn President Barack Obama against the imposition of temporary tariffs
on imports of Chinese tires.
Rockefeller stressed that the tariff had contributed greatly
both to the advent of the Great Depression and to the outbreak of World War II,
and suggested that Obama’s tire tariffs risked leading to a similar catastrophe.
This understanding of the apocalyptic consequences of Smoot-Hawley
has become deeply ingrained in the public mind over the past eighty years
and, as Rockefeller’s article demonstrated,
is regularly repeated at moments of trade tension
to prevent any deviation from pure laissez-faire unregulated trade.
it is repeated so often and in so many clearly noncomparable circumstances
as to have become almost trite.
Nevertheless, it has been and remains
the single most powerful rationale for
the orthodox laissez-faire unregulated trade doctrine and policy.

It all started in 1928 when then presidential candidate Herbert Hoover
promised struggling U.S. farmers to raise tariffs on agricultural commodities
if he were elected.
He was, and he duly proceeded to ask Congress to raise tariffs
on a number of agricultural products.
At the same time, however, he also requested
a reduction on a broad range of industrial product tariffs.
In the wake of the worsening economic situation
following the stock market crash of 1929,
the bill that finally came to Hoover’s desk for signature
called for dramatically increased tariffs across the board.
Hoover opposed most of the increases and agonized over what to do
as the likes of Henry Ford and [over 1,000 economists]
urged that he veto the bill.
But eventually, under enormous pressure from Republicans in Congress
and from some business interests,
he eventually signed it into law.

In the conventional version of the story,
the American action triggered
a wave of retaliatory tariff increases and competitive currency devaluations
by other countries
that cut world trade by two thirds.
U.S. imports also fell by two thirds,
exacerbating the economic slowdown in Europe
and triggering bank failures there
while a 61 percent decline in U.S. exports smothered American growth
and turned a stock market correction into the Great Depression,
which in turn created the conditions that eventually led to World War II.
The conclusion is, as David Rockefeller assumes,
that any deviation from unregulated trade,
even if it is fully in keeping with all international trade agreements and laws,
is an invitation to global cataclysm.

In the alternative version, while Smoot-Hawley was not a smart move
(because by cutting imports
it made earning the money
to pay off their loans to the net creditor United States
more difficult for the debt-laden European countries),
it was not the disaster of conventional mythology.

Yes, U.S. imports fell by two thirds,
but only about half the imports were dutiable.
The other half were duty free,
yet those imports actually fell a bit more than imports of the dutiable items.
So was it the tariff that stopped the imports and triggered the Depression,
or did the reduction of the money supply by the Federal Reserve
so squeeze credit that
neither businesses nor consumers could buy imports of any kind?
In just the past couple of years of economic crisis,
we have seen the U.S. imports fall dramatically
with no significant increases in tariffs
and an unprecedented increase in the money supply.
So maybe in crises, people just stop buying.
This possibility is only strengthened by the fact that
although the almost equally high Fordney-McCumber tariff of 1922
represented a greater percentage increase in the tariff rate
than the Smoot-Hawley tariff,
it was followed by the boom of the 1920s.

As for other countries’ retaliatory tariff increases,
some of them actually were imposed before the adoption of Smoot-Hawley,
and State Department reports from that time speak little of retaliation
and a lot about protectionist pressures from within individual countries.
The conclusion of this version of the story is that, while not helpful,
Smoot-Hawley was no more than a minor cause of the Depression
if for no other reason than the fact that
trade accounted for less than 10 percent of U.S. GDP.
Indeed, in perhaps the most sophisticated analysis of that period,
University of California, Berkeley, professor Barry Eichengreen concludes that
the tariff was probably mildly positive for the U.S. economy,
and mildly negative for the rest of the global economy.

One thing is certain.
In the 1932 presidential election,
the Democratic Party, with the strong support of most professional economists,
targeted the tariff as a prime cause of
the unemployment and misery then prevailing
and helped themselves to the White House by blaming it all on Herbert Hoover,
who had never wanted the tariff in the first place.
Thus, regardless of the actuality,
Smoot-Hawley was cast for all time as the ultimate bogeyman of trade policy,
and by the late 1930s Cordell Hull had initiated a series of negotiations
to begin negating the act
by concluding deals for mutual tariff reductions
with several key U.S. trading partners.
Guided by the long-standing British philosophy that
unregulated free trade is always and everywhere a win-win proposition,
these talks were the harbingers of the coming conversion experience by which
America would replace Great Britain
as the high priest of free trade among nations.

Section 3.4
Miracles in the Rest of the World

Subsection 3.4.4
Japan Rocks the Boat

As pressure [in the early 1980s] mounted from
business, labor, and especially the Congress
for the White House to file unfair trade complaints with the GATT
and to declare Japan an unfair trader under then existing U.S. law,
debate raged between the national security agencies
(departments of State and Defense and the National Security Council)
and the economists at the Department of Treasury
and the Council of Economic Advisors on the one hand
and the trade negotiators
at the Commerce Department and the Office of the U.S. Trade Representative
on the other.
In this struggle, the majority of academic, media, and economic analysts
sided with the first group
while labor and much, but not all, of the business community
sided with the latter group.

The trade negotiators essentially wanted the White House
to give them some leverage.
There were no real protectionists among them,
but they wanted to initiate
antidumping, antisubsidy, and unfair trade cases
as a way of forcing the Japanese,
who were well aware of the divisions within the U.S. government,
to negotiate seriously
under a real threat of possible unpleasant consequences
if they rejected reasonable requests for market opening
and the halting of subsidies and currency manipulation.
the attitude of the diplomats and the military was essentially that
U.S. trade and economic interests should continue to be
subordinated to geopolitical considerations.

A good example was the case of the Japan Trade Task Force of 1984
headed by then vice president George H. W. Bush,
to whose service I was seconded for a while
from my post as counselor to the secretary of commerce.
In the midst of extreme trade tensions with Japan,
President Reagan designated Bush to head a team that would once and for all
resolve the long-running and debilitating trade frictions.
The expectation was that a final agreement would be crowned by
an official vice presidential trip to Japan announcing success
and a new era of mutual comity between the two countries.

Accordingly, the task force determined at the outset that
there would be no trip
without a satisfactory resolution of several key issues.
At a crucial meeting in the vice president’s office in March 1984,
the negotiating members of the task force,
including Deputy U.S. Trade Representative Mike Smith and me,
agreed that sufficient progress had not yet been made.
In particular, the issue of trade in semiconductors, a critical defense industry, remained problematic.
While access to the Japanese market continued to be limited
and patent and copyright protection difficult to assure,
Japanese producers were, with government backing,
aggressively dumping chips in the U.S. market
and had attained a more than 60 percent share.
Yet when Smith and I argued for more progress before any trip was scheduled,
Assistant National Security Gaston Sigur slapped the arm of his chair and said:
“We must have those bases. Now that’s the bottom line.”
Although there had been no indication
of any risk of our losing access to the bases
(indeed, if the United States had threatened to vacate the bases,
the Japanese would have been mortified),
that statement was decisive.
The trip was on.

Although the negotiations were declared a great success,
most of the issues were left unresolved.
Eventually a number of U.S. chip makers closed up shop,
and more than 100,000 Silicon Valley workers lost their jobs.
Even more significant,
the United States lost technological leadership in production of
several important kinds of semiconductor.

As for the economists,
rather than moderating their argument for unregulated unilateral free trade
in light of the obvious market distortions and disruptions,
they emphasized all the more the view that
trade is always and under virtually any circumstances
a winning proposition for an open-market country.
Moreover, they also insisted that
while corporations competed in the marketplace, countries do not.
These experts were completely unconcerned about
the structure of trade and of the domestic economy.
Whether the United States produced semiconductors or water conductors
or orchestra conductors
was a matter of no consequence.

America would always have a comparative advantage in some things,
whether they were wheat, or airliners, or wood chips, or dung.
It could always trade those to Japan for semiconductors.
Thus, the particular bundle of goods a country made and traded didn’t matter.

Often implicit in these discussions was the assumption that
America was transforming itself from an industrial into
a mainly service- and technology-driven economy
and that its workers would be
providing sophisticated, high-skill, high-wage services and
discovering new technologies.
There was no sense that maintaining an industrial sector might be important,
or any acknowledgment of a possible linkage between industry and
the ability to perform or develop certain services and technology.
For example, in 1984,
former Council of Economic Advisors member Herb Stein
told me with regard to the Japanese:
“They will sell us Toyotas and we’ll sell them poetry.”
Similarly in a 1984 White House discussion on whether to act against
illegal dumping of Japanese semiconductors in the U.S. market,
assistant to the president Richard Darman asked:
“Why do we want semiconductor industry?
If our guys can’t hack it, let ’em go.”
It was this attitude that led then Ford Motor Chairman Don Peterson
to lament in congressional testimony in 1985 that
“I wish someone would tell me that manufacturing is not un-American.”

Economists did acknowledge that there are some “adjustment costs”
for U.S. workers displaced from their jobs by imports.
But these were seen as small compared with
the large benefits for the much larger group of consumers
who could more than afford
to contribute to covering the cost of worker adjustment
from the savings they obtained by buying inexpensive imported goods.
They discounted the possibility that
the loss of employment might create downward pressure on all worker earnings
because they believed the government could always create full employment
through stimulatory fiscal and monetary policy.
That this power might be limited is now becoming increasingly clear,
but the arguments at the time assumed no limits.

The few exceptions to the laissez-faire orthodoxy
were usually linked to national security
or major unemployment/political considerations.
In 1979–80 when Chrysler was in danger of going bankrupt
and laying off scores of thousands of workers in the midst of a recession,
the U.S. government bailed out the company.
To address the U.S. semiconductor crisis,
Sematech was formed in the mid-1980s as
a 50-50 industry-government R&D joint venture.
The National Science Foundation also took over from DARPA
development of what would become the internet
and guided it toward commercialization.

But for the most part, the government exercised benign neglect
as one after another U.S. industry shriveled:
machine tools, consumer electronics, batteries, optics, flat panel displays,
printed circuit boards, and many others.
The argument that
“we don’t want government picking winners and losers”
became an article of faith,
and there was resistance to anything smacking of industrial policy
or of government intervention specifically to improve
the competitiveness of any industry.
In particular, as noted above, manufacturing was said to be passé;
America was leading the world into a postindustrial age.
The U.S. economy would be better off
specializing in finance, sophisticated services, and high technology.
As manufacturing moved to Asia, it was argued,
the U.S. economy would move to “higher ground.”

Chapter 4
Goldilocks and Bubbles:
The Faith in Efficient Markets

Section 4.5
The Truth Will Out

Subsection 4.5.3
Where We Are Now

American analysts often disparage Japan’s Lost Decade,
so I bet you’ll be surprised to learn that during the 1990s
Japan’s 1.4 percent GDP per capita growth rate was only slightly less than
America’s 1.6 percent.
You probably also don’t realize that
U.S. per-worker productivity growth of 0.9 percent
was actually behind Japan’s 1.2 percent.
Of course,
you know that Japanese auto companies continue to eat Detroit’s lunch,
and you know that all the computer games are Japanese,
and you may know that without Japanese silicon, tools, and chemicals,
many American production lines would shut down within weeks if not days.
But all you have heard is how much trouble Japan is in—right?

This is even more the case with regard to Europe.
How often have you read about Eurosclerosis
and how those poor Europeans suffer from low growth and high unemployment
in their high-tax, inflexible, anti-entrepreneur welfare states?
It is true that U.S. GDP has in recent years grown faster than EU GDP,
but (as noted earlier) so has U.S. debt.
Moreover, if you look at growth of GDP per hour worked,
Germany, France, and America are virtually tied.
How come?
Americans work a lot more hours.
Time with family doesn’t count in GDP, but Europeans think it’s important.
Further, one reason more Americans are working longer is because
over the past thirty years,
the bottom 20 percent of earners have become poorer
while the middle 40 percent have barely stayed even.
In Europe, the distribution has been much more even.
Take something fundamental—life expectancy.
In France it’s 81 while in the United States it’s 78,
despite spending of double the French level on health care.
Indeed, France is an interesting comparison.
If Americans know one thing for sure,
it is that America is a lot more competitive than France.
Except that in the wake of the crisis of 2008–9,
the French economy has been outperforming the U.S. economy
on virtually every measure.

This same willful blindness has applied to the question of
financial services, software development, and similar work.
For example, in 2004 Council of Economic Advisers Chairman Greg Mankiw
stated in the annual economic report of the president that
such offshoring was good for the U.S. economy
and no different in its economic effect
than similar activities done domestically
(like having a lawn service cut your grass instead of doing it yourself).
Though Mankiw’s argument ignited a firestorm of debate,
the economics establishment strenuously defended its conclusions.
Particularly influential was a study by the McKinsey Global Institute
that showed a benefit to the U.S. economy of $1.12 to $1.14
for every dollar of offshore spending.
The main problem with this analysis was that,
based on surveys from the late 1990s at the peak of the dot-com bubble,
it presumed 69 percent of workers whose jobs were transferred abroad
would find reemployment at 96.5 percent of their previous wage.
But the U.S. Census Bureau reported that, on average, in normal years
52 percent of job losers who are eventually reemployed
take a substantial pay cut.
Indeed, McKinsey itself had done another study in 2003 which showed that
only 36 percent of those displaced got new jobs at equal pay,
while 25 percent took pay cuts of as much as 30 percent.
So if McKinsey had applied the results of its own earlier study
to its offshoring analysis,
there would have been a big loss for the U.S. economy instead of a gain.


This willful blindness was never more glaring
than in the conclusion of a deal by U.S. negotiators
to bring China into the WTO in 2001,
and granting China
permanent most favored nation status in the U.S. market.
This will surely come to rank as one of America’s dumbest deals.
It extended the treatment
for truly free-trade, market-oriented countries
to an authoritarian country that not only was a potential rival
but also was clearly pursuing a neomercantilist, state-guided strategy
fundamentally at odds with the key assumptions of the WTO
and of free trade.
This deal was done
with only superficial analysis of its potential impact
on the U.S. trade deficit and international indebtedness

and with no assessment of the implications for U.S. world leadership
of China’s possible accumulation of immense dollar holdings.
in light of the American experience with Japan and the Tigers,
there was virtually no analysis
of what it might mean for China’s power
if it followed in their footsteps.

We enabled China to keep its currency undervalued against the dollar.
We made the U.S. market, with its huge economies of scale,
completely available to China-based producers
including U.S. companies that moved their factories to China.
And we did this
without gaining completely reciprocal access to the Chinese market
and its potential economies of scale.
We acquiesced in China’s pressuring of global firms to produce in China
as a condition of selling in China,
and we did this without returning the favor.
We acquiesced in massive patent and copyright infringement by Chinese firms.
Sure, we protested, but we did not take decisive steps to stop the practice.

We did these things for several key reasons.
The American big business lobby was panting to get into China
and to profit hugely by marrying
the immense demand and economies of scale of the U.S. market
with the cheap labor, tax holidays, and financial investment incentives
available in China.
This was as if the English of [David] Ricardo’s time
had put their textile mills in Portugal,
a thing Ricardo believed could never happen.
But American leaders didn’t read Ricardo,
they only parroted his win-win rhetoric.

Politics also played an important role.
Bill Clinton wanted to make history
by being the president who brought China into the community of nations
and set it on the road to democracy.
He strongly embraced the familiar syllogism that
free trade would make countries rich, and that
being rich they would become democratic, and
being democratic they would become peace loving.
He also embraced the notion that globalization and Americanization
are more or less the same thing,
and saw globalization as the way to make the Chinese more like us.
U.S. trade representatives Mickey Kantor and Charlene Barshefsky
also saw themselves as leaving a footprint in history
by actually negotiating the deal.
National Security Advisor Sandy Berger shared Clinton’s views,
and NSC China expert Ken Liebertahl promised him that
“over time the United States will shrink its [then $43G] deficit with China.”
Treasury Secretary Bob Rubin and his successor Larry Summers
also shared these views,
and saw the arrangement as good for Wall Street
and good for inflation and interest rates.
Finally, virtually everyone involved could see
a potential path to personal profit from the deal.

Virtually all the think tanks and the media
plugged the arrangement with China.

The Peterson Institute led the way,
arguing that full liberalization of trade and investment with China
would reduce the U.S. bilateral deficit
because U.S. exports to China would rise faster than
Chinese imports to the United States.
Peterson further emphasized that China’s dollar reserves, while large,
were not extraordinary and that
China was not a chronic trade surplus country like Japan because
“China’s markets were more open than commonly thought.”
The Peterson scholars dismissed as “absurd”
the estimates by the labor-oriented Economic Policy Institute (EPI)
of a major increase in the U.S. trade deficit with consequent big losses of jobs.
In a sense the Peterson argument was right.
While EPI estimated that the deficit would rise to $131G by 2010,
in fact it hit $240G in 2008.

I know all these people.
I have disagreed with all of them on various issues.
But I respect them,
and I don’t think any of them would do or say something
they did not believe was in the best interests of the United States.
But they all recommended and made a bad deal
that has reduced American influence and power
and constrained its future wealth-creating ability.
They did so because they believed in Ricardo
and that globalization is always a win for the United States
regardless of the circumstances.
They were all loyal disciples of a false faith.

Not surprisingly, the offshoring of U.S.-based production accelerated greatly
as a flood of American companies opened up shop in China,
and U.S. manufacturing fell to about 11 percent of GDP [q.v.].
Consequently, the trade (current account) deficit ballooned to $696G,
or nearly 7 percent of GDP.
We are now trying to recover from
the biggest economic crisis since the Great Depression
and not only owe Beijing $2.5T
but also have an annual bilateral trade deficit of over $200G.
And the U.S. industries that have moved production to China en masse
are not just textiles and labor-intensive low-tech stuff.
Intel just announced
a major multibillion-dollar semiconductor fabrication facility for China.
If you are an entrepreneur looking for venture capital,
you better have an R&D in China strategy.

As I noted at the start of this book,
China now holds power in its relations with the United States
that no other country has had since Great Britain
in the earliest days of the Republic.

By selling dollars,
China could force the U.S. military
to withdraw from its far-flung deployments
such as those in the Persian Gulf and Afghanistan.
China can use its dollars to corner markets of key commodities
like copper and molybdenum or soybeans.
And, of course, military might cannot be ignored.
China is using its wealth to build a blue-water navy with quiet subs
that will be able to counter the U.S. Seventh Fleet,
which would have to withdraw from the western Pacific anyhow
if the Chinese were to begin dumping dollars.

No, I’m not suggesting that China will do this,
nor am I trying to “bash” China.
It’s obvious that we could also inflict great damage on China.
So, as pointed out, before,
we have a kind of MAD (mutual assured destruction) relationship.
But there is no question that American power will be constrained
by the counterweight of China.
I don’t consider China a threat to America,
but the present relationship is not ideal from the U.S. viewpoint
and not what any astute American strategist would have planned ten years ago.

So how should the United States proceed?
Answering that question will be my concern in the remainder of this book.
The first step will be to break the mystique
of the efficient market, Washington Consensus ideology
so that we can reach a more sophisticated, realistic understanding
of the working of markets,
of the irrationality that can determine economic events, and
of the limits of the laissez-faire free-trade gospel
that has blinded our economists and leaders.

Chapter 6
Orthodox Free Trade:
God’s Diplomacy

Section 6.3
Other Problems with Conventional Free Trade

Subsection 6.3.4
Countries and Competition

This concern, of course, raised another traditional objection,
which was that while companies compete when it comes to trade,
countries don’t.
For them, trade was said always to be cooperative and mutually beneficial.
This argument has always seemed so obviously misguided to me
that I wonder why serious analysts aren’t embarrassed to articulate it.
Countries most definitely compete for power,
and power does not accrue to nations of taxi drivers.
China had comparative advantages under its old regime,
but it was poor and weak.
China is powerful today because
it changed the composition and structure of its economy,
and did so expressly in order to compete.
In fact, the whole notion that
we should not be concerned when certain countries gain an edge
in the production of certain products and in certain new technologies
is romantic in the extreme.
Do we care if China, or Russia, or Iran has leading-edge rocket technology?
Such technology involves leading-edge semiconductor, materials,
and processing technology.
Do we care if we lose those technologies, which is exactly what happens
when U.S.-based production and R&D close
and move to China or Singapore for better tax breaks or better engineers?
Of course we care.
Probably even some economists care.

As for the concern about special interests hijacking trade policy,
while justified,
it overlook the fact that foreign interests
also have powerful lobbies in Washington,
including sometimes leading U.S.-headquartered companies.
Washington can as easily be captured by lobbies for foreign economic strategies
as by lobbies for U.S. strategies.

Section 6.4
The Real Deal on U.S. Trade Policy

Subsection 6.4.1
Orthodoxy Keeps Its Grip

Though the debate over trade theory and its policy implications
became heated in the late 1980s and early 1990s,
it ultimately ended with a whimper.
Laura Tyson joined the Clinton administration,
which embraced simple free-trade-based globalization as America’s strategy
and concluded a series of Asian trade arrangements
culminating in China’s entry into the WTO.
As we have seen,
these arrangements were based on traditional trade and globalization theories
and have facilitated the movement of the production of tradable goods
and the provision of tradable services
out of the United States to Asia.
In 1996, [Paul] Krugman argued in a new book Pop Internationalism,
that it shouldn’t be a priority to teach undergraduate economics students
the innovative new trade theory arguments and wrote (page 125):
“The essential things to teach students
are still the insights of Hume and Ricardo.
That is, we need to teach them that
trade deficits are self-correcting
and that the benefits of trade do not depend on
a country having an absolute advantage over its rivals.
If we can teach undergraduates to wince
when they hear someone talk about ‘competitiveness,’
we will have done our nation a great service.”

And that is what they have been teaching.
Most economics textbooks focus on the conventional theory
and make little if any mention of
economics of scale, imperfect competition, and adversarial trade,
let alone of the fact that
cross-border flows of capital, technology, and people
tend to negate the concept of comparative advantage altogether.

The orthodox view also continues to dominate
press commentary on trade and globalization.
Just take the recent case of President Obama’s decision
to impose temporary tariffs on imports of Chinese tires....
The tariffs affect only a tiny amount of trade and will be lifted in 2012.
The United States has a $600G trade deficit
and nearly 10 percent unemployment,
while China enjoys the world’s largest trade surplus.
Yet the major U.S. media unanimously condemned the president
as a Smoot-Hawley protectionist
who was threatening to cause a trade war and possibly worse.
As I noted earlier,
David Rockefeller invoked the specter of another world war
in a New York Times op ed.
No one bothered to mention
the costly market distortions and damage to America
being caused by China’s mercantilism.

Chapter 7
Companies Without a Country

A corporation must consider
the impact of its actions on all,
from the shareholders to the society at large.

— Business Roundtable, 1981

Few trends could so much undermine our free society
as the acceptance by corporate executives
of social responsibility.

— Milton Friedman, 1970

[This thirty-page chapter is full of good insights,
but to save [my] time I only excerpt a few parts of it.]

[A 1981 speech by GE CEO Jack Welch at New York’s Pierre Hotel]
heralded a radically new philosophy or perhaps a return to an old one
for American business.
Under the new doctrine, the central concern of CEOs became
the steady accumulation of strong quarterly results in order to
increase the value of a company’s stock.
The notion that a CEO’s core responsibility is to the shareholders
has by now become such widely accepted wisdom
that it may seem always to have been the American business creed.
But that is not the case.
The view that had prevailed in America since the Great Depression was that
a CEO is responsible to the many people, businesses, and services
that have a stake in his or her corporation’s welfare—
to the society, that is, in which the corporation is embedded.

At about the same time as Welch’s speech,
in a manifesto on corporate governance,
the Business Roundtable, a group of CEOs of America’s major corporations,
perfectly expressed what has become know as the stakeholder theory:
“A corporation’s responsibilities include
how the whole business is conducted every day.
It must be a thoughtful institution which rises above the bottom line
to consider the impact of its actions on all,
from the shareholders to the society at large.

Its business activities must make social sense.”
According to this theory
the stakeholders in a company are defined broadly as
its employees, customers, and suppliers
along with the community in which it operates and the larger society.
But the Roundtable’s statement was a lagging indicator.
Welch had caught the new wave.
And the fealty to that new creed of shareholder value above all else
has by now been taken to such lengths that
a host of the most powerful American companies—
the companies most crucial to our economic well-being—
increasingly do not consider that they have obligations to America
or even that they are American.
Nor is this attitude limited to American CEOs.
The same could be said, although to a lesser degree, of many European CEOs,
and to a much lesser degree of some Asian CEOs.
The problem with this creed, as we have seen in the recent crisis, is that
when a company gets in trouble,
it turns to its domestic stakeholders, and especially to the U.S. government,
to bail it out.

Section 7.2
The Harvard Business School Creed

At the founding of the Harvard Business School in 1908,
Dean Edwin Gay said the purpose of the school
was to teach business leaders how to
“make a decent profit by doing decent business.”
That was McCabe’s creed
[Thomas McCabe had been head of Scott Paper and a mentor to Clyde Prestowitz]
and what thousands of future business leaders
learned at Harvard for many years.
But in 1970,
the University of Chicago’s Milton Friedman sounded a different note.
Said he,
“Few trends could so much undermine our free society as
the acceptance by corporate executives of social responsibility other than
to make as much money for shareholders as possible.”

This tune was quickly picked up and elaborated upon
by Harvard’s professors and especially by professor Michael Jensen,
who became the dominant American voice on corporate architecture
and the proper role of a board of directors and a CEO.

In a hugely influential 1976 paper and subsequently,
Jensen propagated Friedman’s doctrine as the sole purpose of the CEO.
His argument was grounded in the view that
the shareholder is the corporation’s final risk bearer
and therefore also its final claimant.
He added the notion that, as agents of the shareholders,
the corporation’s managers do not necessarily share
the interests of the shareholders.
Indeed, the managers and the shareholders may be at war
because the way for the CEO to maximize his/her private gain
may be at odds with maximizing shareholder gains.
For instance,
a CEO may like corporate jets or want to be part of the society scene,
but the costs of such indulgence may be a burden to shareholders.
Thus, the central problem is
how to align the interests of managers and shareholders
and to establish a monitoring mechanism that easily indicates
whether the managers are acting properly on behalf of the shareholders.

Jensen’s solution was to grant gobs of stock options to CEOs
and to evaluate their job performance by focusing on
the progression of quarterly earnings.
This is a single, readily available, objective number
upon which
a CEO can concentrate all [his] attention and which
the shareholder can readily use to determine
whether a CEO is working for him.
Jensen emphatically rejected stakeholder theories on the grounds that
giving a CEO multiple objectives would be confusing, distracting,
and make it impossible in the end to measure performance.

Of course, there were many counterarguments.
Is it true that shareholders are the residual risk bearers and claimants?
The shareholder does not own a corporation in the same way
he owns his house.
He owns only a right to the residual cash flow.
He doesn’t own the actual assets or business or a corporation,
which is itself a legal person.
Indeed, owning it would not be compatible with
the limited liability concept on which a corporation is founded.
Further, the value produced by a corporation
is produced by a combination of resources.
In addition to those of the shareholders,
there are also the workers, suppliers, customers,
public infrastructure and services,
the legal system,
and the society at large represented by the government.
So why should the distribution of value favor only shareholders?
Moreover, it is not clear that the shareholder bears more risk
than do other stakeholders.

Indeed, simply by selling shares
the shareholder can divest himself of risk more easily
than can any stakeholder.
Workers, suppliers, and communities
cannot so easily extract themselves from failing corporations.
Take the case of the recent bankruptcy of General Motors.
Many shareholders were able to sell out with relatively small losses
when they realized the company was in deep trouble.
But GM’s independent dealers, for example, weren’t so lucky.
With employees and cars in their showrooms,
suddenly they were told they were being cast off.
Or take the communities where plants are being closed.
Maybe the GM workers will get
some kind of reasonable severance and even a pension,
but the people who work in the coffee shops, machine shops, and other shops
that depended on that now closed plant
are all pretty much just out of luck.
Further, several empirical studies and examples have indicated that
stakeholder-oriented companies do better in crises and over the long term
than do those narrowly and intensely focused on shareholder return.
In a 1992 study,
John Knox and James Heskelt showed that
stakeholder companies had grown four times faster than
shareholder-driven firms.

But none of the objections stopped the momentum
that quickly developed behind the shareholder value theory.
The popularity of the new thinking was probably due in large part to
the fact that the focus on short-term earnings
made it so easy to quantify performance.
It also rationalized a lot more Wall Street merger and acquisition activity
and facilitated the quantification of business management theory
and the building of models
so that business professors could, like their economist colleagues,
present their discipline as a science.
The emphasis on the primacy of the CEO
was also, for obvious reasons, quite popular with CEOs,
and led eventually to the apotheosis of the CEO
as a godlike figure in American business,
credited with achieving near miraculous feats singlehandledly.
For example, the 1997-04-15 issue of Fortune magazine stated that
“in four years CEO Lew Gerstner had added $40 billion to IBM’s market value.”
Really? Did Lew do that all by himself?

In 1997, the Business Roundtable reversed its earlier views and pronounced:
“In the Business Roundtable’s view,
the paramount duty of management and of boards of directors
is to the corporation’s stockholders…
The notion that the board
must somehow balance the interests of stockholders
against the interests of other stakeholders
fundamentally misconstrues the role of directors.
It is moreover, an unworkable notion because
it would leave the board with no criterion for resolving conflicts
between interests of stockholders and other stakeholders
or among different groups of stakeholders.”
So fixed did this view become that eleven years later,
despite the intervening debacles of
Enron, WorlCom, Tyco, and Long-Term Cap[ital Management,
Jack Welch could still threaten his handpicked successor, Jeffrey Immelt,
with mayhem for missing his quarterly earnings target.
Said Welch in April 2008:
“Here’s the screw-up.
He promised he would deliver and now he misses three weeks later.
Jeff has a credibility issue.
He’s getting his ass kicked.
If it happens again, I will get a gun and shoot him.”

What Welch may not have realized is that
his stockholder value/quarterly earnings fetish had become a big gun
shooting a large hole in the competitiveness
both of corporations and of the United States.

The focus on short-term profits led to the slashing of R&D
and of investment in longer-term, more risky projects.
In short, companies were increasingly showing good short-term results
while eating their seed corn.

Section 7.3
U.S. Business Goes Global

Subsection 7.3.5
Winners and Losers

Not surprisingly,
the unlinking of the corporation from its national roots
has proved extremely profitable,
both for the corporation and for its top executives.
Over the past thirty years, the returns to capital have risen steadily
as have the profits of U.S. corporations as a percent of GDP.
At the same time,
compensation for CEOs and other top executives has skyrocketed.
In 1974, the compensation of the top 10 percent of the income distribution
was 20 times that of the bottom 90 percent.
In 2006, it was 77 times.
[But not all of that top 10 percent was corporate executives.
Consider the rise in income of doctors, lawyers, and other professionals.]

In 1979, the top 1 percent of earners garnered 34 percent of all capital gains.
In 2005, that number was 65 percent.
This dramatic shift, of course, reflected the fact that
globalization has diminished
the regulatory and social constraints on the corporation and its leaders

and given it much more leverage and flexibility to reduce costs
via the global supply chain.

[Please! Let’s not be disingenuous.
It also reflects
the decline in the influence of Christian principles on American society,
and the correlative rise in Jewish influence,
Judaism being a religion which specifically excludes
Christianity’s declaration of greed as a sin.]

Consumers also did reasonably well
as the flood of imports into the U.S. market helped to keep prices down
and inflation under control.
Walmart, for example, came all by itself to account for
9 percent of the U.S. trade deficit.

On the other hand, the vast bulk of working people
(who, of course, are also consumers) lost ground.
Between 1980 and 2005,
U.S. productivity rose 71 percent.
Yet real compensation (including benefits)
of nonsupervisory workers (80 percent of all workers)
rose only 4 percent.
In the tradable manufacturing sector,
productivity rose 131 percent
while compensation climbed only 7 percent.
This was in stark contrast to the period from 1950 to 1975
when worker compensation rose 88 percent
while productivity doubled.
Over the past thirty years, median real income has stagnated.
The median male 2007 income of $45,113 is actually less than
the $45,879 (in 2007 dollars) of 1978.
The stagnation was masked somewhat by the fact that
Americans increased their borrowing (helped by rising house values) and that
more women and children entered the labor force.
But the hard fact was that in the year 2000,
a new worker with a high school education had beginning earnings
that were $5,000 less than in 1970.
For a beginning worker with some college courses, the shortfall was $3,500.

Apostles of the conventional wisdom often dismiss such comparisons
as a problem mainly of unskilled workers and of education.
While there is some truth in that opinion, it is far from the whole truth.
This stagnation occurred
while those in the workforce with college degrees
doubled from 15 percent to 30 percent
and the share of high school dropouts fell from 29 percent to 10 percent.
the offshoring of jobs has now ratcheted up to jobs in R&D
that Americans had always assumed would be theirs.
The U.S. trade deficit in advanced-technology products
will reach about $56G this year.
As former Federal Reserve vice chairman and Princeton economist Alan Blinder
has warned,
“Tens of millions of additional workers
will start to experience an element of job insecurity
that has heretofore been reserved for manufacturing workers.
It is predictable that they will not like it.”

When I interviewed Silicon Valley CEOs about their view of offshoring,
there was one CEO who had a nuanced answer, and that was Intel’s Craig Barrett,
with his worry about
how his grandchildren will earn a living,
as I quoted earlier
[in the Introduction, on page 5; the exact quote is:
“Intel can move wherever it must to thrive,
but I sometimes wonder how my grandchildren will earn a living.”
The biggest loser for the United States has been our productive base,
not just the factories and equipment,
but the skills and the ability for them to be passed on to the next generation
and to evolve.

We may still have universities on our campuses,
but we no longer have the “universities”
that were embedded in our factories and industrial laboratories.
[One may also think of the possibility of vocational training here.]

In an important recent article,
Harvard Business School professors Gary Pisano and Willy Shih emphasize that
with the bubble years behind us,
the United States will have to get serious about paying its way
and restoring the high-technology manufacturing base to do so.
Their concern is that in the quest for short-term earnings gains,
the shareholder-value-oriented, increasingly stateless global companies
have cut back so much on basic and applied research
and outsourced to offshore locations so many of
the critical production processes and their related skills,
that the United States has lost much of its ability
not only to produce current products and services
but to migrate from there to new products and processes.

These professors point out that developing or producing
the next generation of energy-efficient illumination
will be difficult or impossible in the United States
because not only are the critical light-emitting diode components
not made here,
but the skills to make them here have largely evaporated.
This true also for such things as advanced displays for
mobile phones, flat panael displays for computers, TVs, and handheld devices,
and for the carbon fiber components of the Boeing 787 Dreamliner.
Indeed, they enumerate a long list of items—
electrophoretic displays,
lithium-ion and NiMH batteries,
crystalline and polycrystalline silicon,
advanced ceramics, advanced composites,
hard disk drives,
and integrated circuit packaging—
that are no longer makeable in America.

Nor is it just a matter of hardware and manufacturing.
Pisano and Shih explain that
the capacity to create new high-tech products and services
is fundamentally affected.
For example, with the exception of Apple,
every brand of U.S. notebook computer is now not only manufactured in Asia.
It is designed in Asia.
[Both emphases were in the original.]
And the same is true of cell phones and many other devices.
Or to look at things from another angle,
although the United States invented the internet,
it ranks fifteenth among nations in high-speed internet deployment.
None of this is actually a new story.
Some of the names of the items have changed,
but this story was told in 1989 by
the National Advisory Committee on Semiconductors.
It was told at about the same time in my book,
Trading Places: How We Are Giving Our Future to Japan.
It was told yet again in 2005 by
the President’s Council of Advisors on Science and Technology,
which warned against the erosion of the U.S. innovation ecosystem.
It was told once more by the National Academy of Science
in its “Rising Above the Gather Storm” report of 2005.
And now to have the Harvard Business Review,
the citadel of Michael Jensen and shareholder value,
also say it
is an important step toward possible action.

Chapter 9
Competing in the New World

The big issue now is
how we can prevent the United States from
declining too quickly.

— Chinese Leaders

We did the opposite of what the American economists advised.
— Nachiro Amaya, Vice Minister,
Japan Ministry of
International Trade and Industry (MITI)

Section 9.1
The New Upside-Down World

Subsection 9.1.2
Losing the Industrial and Technological Commons

I stumbled across another kind of example
while speaking to the Association of Wood Office Furniture Manufacturers
a few years ago.
When I asked one of the CEOs what was selling,
he told me that he had a line of cherry office furniture
that was just flying out of the showroom.
Where do you make it? I asked.
Well, he said, the cherry trees are cut in West Virginia
and the logs are then shipped to Germany, where the veneer is peeled.
From there the veneer goes to China,
where it is glued to the furniture frame,
and then the furniture comes back to Wisconsin,
from where we market and distribute it.
Amazed, I asked why the veneer was peeled in Germany.
Surely, I thought, veneer peeling can be done in America.
After all, it is not rocket science, and
Germany has far higher labor costs than we do.
But the answer was that the Germans just do veneer peeling better;
indeed, enough better to warrant
the cost of shipping those logs and then the veneer around the world.
I’m still wondering why Americans can’t do veneer,
but somewhere along the line,
we lost those skills or didn’t keep them up to speed.

Another more significant example of the same thing
is Amazon’s Kindle electronic reader,
one of the 2009 Christmas season’s bestsellers.
The key innovation that makes this product possible is
the electronic ink invented and made in the United States
by Cambridge, Massachusetts-based E Ink Corporation.
Nevertheless, the Kindle cannot be made in the United States
because the special glass of the display,
and virtually all the other key components
like its semiconductor chips and its battery,
are made only in Taiwan, Korea, Japan, and China.
Thus, of the $185 total estimated manufacturing value added per Kindle,
only $40 to $50 is added in the United States,
and that may soon decline to zero.
Some analysts believe that E Ink’s production and R&D
will also soon be moved to Asia,
not because of cheap labor (the product is not labor intensive),
but because Asia
has a more friendly investment, tax, and regulatory environment
and offers various direct and indirect export subsidies,
including undervalued currencies.

This suggests that the most significant aspect of the above examples.
The next e ink is unlikely to be developed in America,
because we will lack the supporting components and skills
of the innovation ecosystem.
The special displays are made with lithographic equipment
originally used to produce semiconductors,
a technology that left the United States for Asia in the 1980s and 1990s
as Japan and then Korea and Taiwan
targeted the semiconductor and semiconductor equipment industries
for strategic development.
The battery technology that powers the Kindle left America
with the consumer electronics industry in the 1960s and ’70s.
Much of the glass technology also left with the consumer electronics industry.
As Silicon Valley entrepreneur, corporate director, and author
Richard Elkus says,
“Eventually, everything is related to everything else.”

These were not just losses of market share or of a few factories and jobs.
They were losses of what Harvard Business School’s Gary Pisano and Willy Shih call the “industrial commons.”
Like the common pastures and the fields of medieval times
or the common transportation infrastructure that supports modern life,
the industrial commons is
the collective operational capabilities
that underpin new product and process development in the United States.

Their loss represents not a relative shift but an absolute subtraction from
the total assets of the productive base of the economy.
Perhaps the most important loss of this type was signaled by the 2009-11-09 issue of Business Week,
which reported that employment of U.S. scientists and engineers had fallen by 6.3 percent over the past year
as opposed to a 4.1 percent decline in overall employment—
apparently a result of American corporations transferring more of their R&D to India and China.
For a country that says its future is in high technology and innovation
and that it is moving to “higher ground”
as India and China do the low-tech and mid-tech production,
this was a shocker.

the world is turning upside down,
with China and India doing the R&D
and America apparently moving to lower-tech endeavors.

Subsection 9.1.3
Services and Innovation

Of course, many U.S.-based producers
still maintain strong positions in a number of industries,
and new and innovative companies like
Google, Apple, and Human Genome Sciences, Inc.,
are creating whole new industries or industry segments.
But they are not creating enough in the United States to offset
the impact of the losses in other industries.
If they were, we wouldn’t have a trade deficit,
and there wouldn’t be any talk about
the days of the dollar’s hegemony being numbered.

Innovation is great, and it is a great American strength.
And, in my view, the greatest innovator of our time
is Steve Jobs and his company, Apple.
His latest hit, the iPhone, has revolutionized yet another industry
and created a huge profit stream for Apple.
Yet the iPhone is a big contributor to our trade deficit
and our mounting international debt
because it is made mostly outside the United States.
Like the cherry office furniture,
the idea and design are done here, as are the marketing and servicing,
but the parts and assembly are all done abroad.
So the more iPhones that are sold,
the bigger our deficit gets and the more we go into debt,
putting more pressure on the dollar.
The argument is often made that
the manufacturing aspects of the iPhone are low-margin operations
and that all the profit is in the design and marketing.
This may be true regarding labor-intensive iPhone assembly.
But we’d still be better off
if some of the components were made in America as well.

I’m not talking about trying to do the labor-intensive stuff here.
That clearly wouldn’t be sensible.
But the chips and the batteries and the displays aren’t labor intensive.
It’s not that Japan has some magic resources that we don’t have.
It’s that we have lost the skills and the economies of scale.
Further, we have seen in case after case that
design, engineering, and even marketing eventually follow manufacture.
This has happened most recently with laptop computers,
the design as well as the manufacture of which
have now migrated to Taiwan and elsewhere in Asia.
There is no reason why the iPhone can’t go the same way.
I’ll go into they whys and wherefores of this later,
but my point here is that
innovation may be a necessary but not sufficient answer
to keeping America near the top.
[Notice he says near the top.]

It is often argued that
just as agriculture shrank as a percentage of our economy
while manufacturing rose during the twentieth century,
so in this century will services grow to take over from manufacturing.
It is a credible argument because it has, in fact, been happening.
I have already noted the fact, however, that under current circumstances,
services exports are very unlikely to solve our trade deficit,
since provision of tradable services
seems to be going the way of the production of tradable goods—
So here I want to focus on another aspect of our situation.
Let’s look at upstate New York, which has a long tradition of manufacturing
in machine tools, air conditioning, furniture, auto parts, and appliances,
but also has a history of innovation and high technology
with companies such as Eastman Kodak, Xerox, and Bausch and Lomb.
The areas has been hard hit by competition from China and other parts of Asia
in virtually all of its manufacturing and technology sectors.
As a result, employment has shifted heavily into service industries.
From 1990 to 2005,
manufacturing employment declined by about 400,000 jobs.
So services took over nicely from manufacturing and high tech.
But here’s the catch:
the average salary for manufacturing jobs in New York in 2008 was $62K,
while for jobs in education and health services it was $46K.
This not to say that we can’t be prosperous
with the right combination of service and innovative technology industries,
but it is to say that we do not now have that combination—
and don’t seem to be on the road to getting it.
Indeed, we seem to be on the road to ruin.

Section 9.2
Two Views of the World

Our dire situation has come about in large part
because of two very different world views
the existence of which we have been painfully slow to recognize.
One view is ours, the other is that of
China, Japan, Korea, Singapore, Taiwan, Finland, France, Ireland,
and much of the rest of the world.

Subsection 9.2.1
The View from Washington

The view from Washington was well articulated at
a White House meeting I attended in the fall of 2009.
The subject was how to revitalize the Midwestern economy
that had been so hard hit by the economic crisis
and especially the failure of GM and Chrysler.
One idea was to foster green industries
as the replacement for auto and auto parts manufacturing.
Could wind turbines, batteries, and solar panels be made in old auto plants?
was one question.
But another was:
If not, can we just build new plants to produce the green products?
My answer was “yes” and “yes”
if you are prepared to jump-start these operations
with some tax breaks, free land, capital grants, and government orders.
That immediately sparked an intense discussion.
Most of the economists present objected that
such measures would constitute an industrial policy and
a breach of the sacred taboos against government “picking winners and losers.”
Moreover, they said, it would involve subsidizing production
that, initially at least, would have a higher cost
than in countries such as Denmark, Japan, Korea, and Germany,
where large-scale production was already taking place.
In other words, producers in those countries
have already achieved certain economies of scale
and coasted down the cost curve,
meaning that
even though U.S. competitors could equal or beat those costs eventually,
they couldn’t do so initially.
The argument of the economists was—
and remember that
these were officials trying to create jobs and reduce our trade deficit—
that we could buy the wind turbines, batteries, and solar parts
cheaper from foreign producers
[what’s the emoticon for a tear?]
and should do so
because to do otherwise would constitute protectionism
and misallocation of resources.
That response, of course, left unanswered the question of
how to revitalize the Midwestern economy
by doing something with the shuttered auto plants.
But it revealed perfectly the dream world in which
American policy has been made and promoted
for the past sixty-five years [since 1945].

In this world, the focus is transactional and short term.
One considers the price to be paid and the benefit to be obtained
only on an immediate basis
and only in terms of the narrow benefit to the consumer.
Foreign economies of scale are seen as something to be taken advantage of
in terms of obtaining lower buying prices.
But we never consider taking advantage of
the ultimate size of the American market
to achieve economies of scale for domestic production
by simply jump-starting a U.S.-based operation
or inducing foreign suppliers to produce in the United States.
Most important, global corporations compete in this world,
but countries do not compete economically,
and if they try to do so, they only damage their own economy.
A final key element is the view that
subsidies by foreign governments to their exporters
or dumping by the exporters in the U.S. market
are not so much to be frowned upon
as welcomed as a gift to American consumers.
If the gift happens to knock out a key domestic industry,
there is no reason to fret, because it doesn’t matter what we make
and the workers can easily find jobs in some other industry.
Finally, in this world,
the rules of the WTO and the IMF are seen to be based upon these premises,
and all the members of these two institutions are understood
to have embraced them upon joining.

Subsection 9.2.2
The View from Most of the Rest of the World

The statement by former MITI vice minister Naohiro Amaya in my epigraph,
which he made to me nearly thirty years ago,
perfectly expresses the view of most of the rest of the world.
When Japan and then Korea and Taiwan
embarked on developments of their semiconductor industries,
these countries either had no semiconductor products
or the ones they had were technologically behind
and had higher costs than the U.S. producers.
The Washington logic was for them to import from America
and export something like ladies’ blouses or kids’ tennis shoes.
The logic in Tokyo, Seoul, and Taipei, however was to catch up.
They thought they could become competitive
once they got over the initial learning stage
and could achieve economies of scale.
They were right,
and now each country has a big trade surplus in semiconductors
and has taken leadership away from U.S. producers in key sectors.
By the same token, the French, British, and Germans
didn’t forget about building commercial aircraft
because the Americans were way ahead.
They too decided to catch up,
and the catch-up story has been repeated
in many other industries by many other countries.
China is now repeating it.

The leaders of these countries believe that countries do compete.
They understand the huge importance of economies of scale,
of imperfect competition, of first-mover advantages,
and of the critical role of linkages between things like
consumer electronic batteries and new electric car batteries.
They use markets to achieve certain ends, but they don’t worship markets.
They are members of the WTO and the IMF,
but they don’t interpret the provisions of either body
as restricting their strategic promotion
of the long-term economic interests of their societies.

for them,
economic and technological development

are as important as
geopolitics and national security
are for the United States.

In fact, for them,
economic development is national security.

Section 9.4
The New American Way

As I have explained,
the United States in the past thought and acted
pretty much like China, Finland, and Taiwan.
But for the last half century,
and especially since the presidency [40] of Ronald Reagan,
we have not only turned away from the notion of an economic strategy
but also have actively condemned it.
In making our own policies in international institutions and negotiations,
we have considered government guidance
or support of economic strategies and industrial policies
as not only wasteful and counterproductive
but also as downright bad.
Our view was well described by Reagan’s famous comment noted in chapter 1—
that far from being a solution, government is the problem.
So we have apotheosized the pure free market, the business CEO,
and, above all, the entrepreneur.
We have attributed all of our economic successes to these factors
and all of our setbacks to misguided government intervention.
So deeply ingrained is this attitude that
a sure laugh line for any public speaker is to say to the audience:
“I’m from the government and I’m here to help.”
Ha, ha.
No one in the audience believes
the government can do anything except screw up.
So we pride ourselves on not having and not wanting any economic strategy,
and heaven forbid that anyone should allow the words “industrial policy”
to escape their lips.
Our mantra has been that competition and market forces
are the great drivers of economic and technological progress.
But is that in fact true, and is it really the case
that we don’t have an economic strategy and industrial policies?

[Skipping over three pages and seven paragraphs of examples, we come to:]

[B]tween 1979 and 2006,
federal spending on the National Institutes of Health (NIH) and medical research
nearly quadrupled.
Especially in the area of biotechnology (as in the area of national security),
the United States now spends more than the rest of the world combined.
Is it then a coincidence that we are by far the world leader in biotechnology
and in the commercialization of biotechnology?

I could go on, but I think several points are clear.
Although the United States eschews a formal economic strategy
and any kind of stated industrial policy, we have such policies.
Indeed, we can’t avoid them.
The FCC must choose how to regulate telecommunications.
The choice of focusing on competition (a process)
rather than on deployment (a result)
is a form of industrial policy—or perhaps of antiindustrial policy.
The same holds for treatment of DARPA, ARPA-E[nergy],
and the NIH and for many other agencies and programs.
The U.S. government is very large, spends an enormous amount of money,
and sets standards and regulations that have an enormous impact
on the business environment, on the shape of various industries,
and on the conditions of consumer life.
We cannot avoid having a de facto economic strategy
and de facto industrial policies of all kinds.
So let’s take a quick look at out de facto strategy.

Let’s start with agriculture.
Despite all our talk of leaving things to the private sector,
the last thing we will ever do is get rid of the agricultural subsidies
that now cost us $50G annually and that provide, for example,
about $160K per U.S. cotton farm,
despite the fact that America is the high-cost international cotton producer.

As noted above, we also highly subsidize medical research
and are not likely to stop.

We have long subsidized home buying and home construction
through the lending of Fannie Mae and Freddie Mac
and, of course, with the mortgage interest tax write-off.

Our low taxation of gasoline
and public provision of roads, skyways, and airports
have favored driving and flying over taking the train,
and, of course, have been a great boon to the oil companies.

Our taxation of savings and dividends penalizes savings,
while the home equity loan, with its mortgage write-off, subsidizes consumption,
particularly of consumer durables.
This, coupled with our tolerance of dumping, currency manipulation,
and other trade-distorting activities by our trading partners,
has favored the offshoring of U.S.-based production,
as have the asymmetrical trade agreements
we have concluded for geopolitical reasons.

Most striking of all is
the extraordinary support we have given to one industry
over the past thirty years.

It is so striking that I fear we must call it for what it has been—
a clear industrial policy to target
development of the financial services sector.

Consider that from 1929 to 1988,
the profits of the U.S. financial sector averaged annually 1.2 percent of GDP
and never rose above 1.7 percent in any year.
From 1988 until 2005, they averaged 3.3. percent of GDP.
In 1980 the financial sector’s share of business profits was 6 percent.
By 1990, it was 30 percent,
and by 2005 it had soared to 40 percent,
although it fell back to 30 percent in 2007
as the crisis began to break upon us.
Even more striking is the pay per worker in the finance sector.
In 1948 it was 105 percent of average worker pay.
That proportion, though unchanged in 1980, was, by 1990, 130 percent,
climbed to 165 percent in 2000, and soared to 185 percent in 2007
as Wall Street sold trillions of dollars of securities backed by “ninja”
(no income, no jobs, no assets) mortgages.
As former IMF chief economist Simon Johnson has emphasized,
measures such as regulation of derivative instruments
that could have stopped the 2008–9 economic crisis
but would have limited financial sector profits,
were prevented.
Hedge fund managers who made literally billions of dollars
benefited from special income tax breaks.
The Glass-Steagall Act and virtually all other bank regulatory acts
were abolished or weakened.
Indeed, as I write, Federal Reserve Chairman Ben Bernanke is saying that
lack of Fed oversight of the banking industry caused the crisis.
Just as an example, in 2004 the SEC changed its net capital rule
that a bank had to have $1 of capital for every $12 of liabilities.
Under the new rule,
any bank with assets of more than $5G could use its own model of risk
to determine an appropriate ration.
Bear Sterns, for one, went from $1 of assets to $33 of liabilities.
That, of course, is what broke the bank.

So why did finance become so favored?
A couple of numbers tell a lot.
From 1998 to 2008,
the finance industry spent $1.8G on political campaign contributions
and another $3.4G on lobbying.
As Simon Johnson says,
the Wall Street-Washington corridor is rich and crowded.
The writer Pat Choate has even coined a new name for the United States:
Goldman Sachsony.

In this light,

America’s economic strategy is clear.

It is to overconsume, and to promote
weapons research and production, financial services, construction,
medical research and services, agriculture,
and oil and gas consumption and production.

Further, it is both
to offshore production and provision of
all tradable manufacturing and services
as well as, increasingly, high-technology R&D,

to expand the domestic
retail, food service, and personal medical services industries.

At the macro level, the strategy is to
run up massive debt
and borrow as much and as long as possible.

In terms of international competitiveness,
the United States benefits from its fundamental nature.
It has
a very stable political system, a real rule of law,
a relatively low level of corruption,
a high average level of education,
strong incentives for entrepreneurial activity,
lots of second-chance opportunities,
leadership in many technologies and industries,
and a diversified economic base.
But these factors are offset by some surprising negative.
For instance, while we think of Scandinavia as the citadel of high taxes,
the United States, in fact,
has higher taxes on business than do the Nordic countries
and, indeed, than almost all other countries.
As already noted, America’s advanced infrastructure is lagging,
and even its legacy infrastructure is deteriorating.
The fact that there are no investment incentives at the national level
and only small ones at the state level,
coupled with a strong dollar relative to manipulated Asian currencies
and the high business taxes,
makes America unattractive for investment.
So the funny thing is that while America should be very competitive,
it is not and is becoming less so.

Section 9.5
The Dynamics of a World That Is
Half Free Trade and Half Mercantilist

So you see, to paraphrase Abraham Lincoln,
the world in which we live is half free trade and half mercantilist.
Half or more of the countries
have a clearly defined national economic interest,
an economic strategy focused on export-led growth,
and a series of industrial policies to fulfill the strategy.
The rest, mostly us and the Brits, have
no defined national economic interest, no formal strategy,
and a bunch of de facto industrial policies
that are uncoordinated and often contradictory.
This is significant especially in
the arena of trade negotiations and globalization.

Consider the Doha Round of WTO multilateral trade negotiations
or the U.S.-Korea Free Trade Agreement negotiations.
Before these talks begin,
the foreign negotiators already have an economic strategy
and a series of industrial policy objectives
that define their objectives for the talks.
They are not looking for something vague like “open markets.”
Rather, they are looking for specific, concrete results in terms of
lower tariffs or lifting of regulations in sectors like autos or semiconductors,
which they have targeted for development because of a belief that
those sectors will lead to higher productivity, faster growth,
and more extensive technological advances.
So, for example, Korean negotiators will want both
to get lower U.S. tariffs on autos and
to shield their producers from U.S. prosecution
for theft of intellectual property.
Of course,
the foreign negotiators will have consulted with
their industries and labor unions,
but they will have done so
on the basis of a governmentally defined national economic interest
and not on the basis of which interest group shouts loudest.

In contrast, the American negotiators
have no governmentally defined national economic interest
and have done no analysis of what negotiating results might lead to
the greatest increase in American exports
or the greatest decrease in the U.S. trade deficit
or to any other particular benefit for their country.
Their negotiating agenda will have been largely determined by
the wish lists they have received from various industries and members of Congress
and the negotiating priorities by
how politically influential the presenters of the wish lists are.
So, for example, in the talks with Korea,
getting the Koreans to reduce their tariffs and quotas on U.S. beef exports
have been a high priority—
not because beef exports add much in any way to the United States’ economy
but because Senator Max Baucus of beef-producing Montana
is chairman of the Senate Finance Committee,
which has jurisdiction over the ultimate Senate approval of any free-trade deal.

It’s against this background that
I recently had a conversation with an old Korean friend
who has also been one of his nation’s trade policy makers.
He knew that I was skeptical of the value to America
of the proposed U.S.-Korea Free Trade Agreement
and tried to persuade me to favor it by emphasizing
the big concessions that Korea had made,
especially in the area of auto tariffs and intellectual property protection.
I agreed with him that Korea had indeed been unprecedentedly forthcoming
and had gone a long way to meeting the U.S. requests.
But I asked:
“Do you honestly believe that
this deal will significantly increase U.S. exports to Korea
or reduce the U.S. trade deficit with Korea?”
He replied:
“Frankly speaking, no.”
Indeed, we both knew that, if anything,
the deal would increase the U.S. deficit.
Yet the American negotiators
have been calling the proposed agreement a great negotiating victory
because they think they have been procedurally successful.

Subsection 9.5.1
The Dynamics

Dynamics similar to these operate in all the neomercantilist markets.

The structure of our present globalization is such that a combination of
currency undervaluation,
explicit or implicit requirements and incentives
to invest and transfer technology
as a condition of market access,
and explicit industry targeting policies
exists in most of the major markets—especially in Asia—
to a greater or lesser extent.
This important fact
negates all the remedies
normally proposed by American conventional wisdom
for regaining our competiveness,
especially the two major ones:
improved U.S. education and more and better innovation.

While both of these aims are highly desirable,
they alone cannot reverse the current dynamics of globalization.
While the American education system has many flaws,
which we have already discussed,
the American workforce is still the best educated workforce in the world.
Very interesting is the fact, noted earlier, that
the share of the workforce with a college degree
doubled from 15 percent to 30 percent between 1973 and 2005,
while the high school dropout rate over the same period
fell from 29 percent to 10 percent.
That is a huge improvement in education.
It is difficult to imagine a greater improvement.
Yet it is precisely during this period that our trade deficits
and the erosion of our technological, industrial, and R&D leadership
have accelerated.
Do we need better education?
Of course, but will it solve the problem by itself?
Absolutely not.

By the same token, neither will innovation.
Recent studies have shown that
80 percent of engineering tasks in product development
can relatively easily be offshored.
And that seems to have been confirmed by the report in Business Week noted earlier that
unemployment among U.S. scientists and engineers
has risen more rapidly than general unemployment
during the recent crisis,
as American compnies sent more of their R&D to India and China.

Section 9.6
Who Stands for the Average American Family?

The answer to the above question in terms of the national economic interest
is pretty much “no one.”
This is largely due to the assumption of economic orthodoxy
that countries don’t compete economically.
Consequently, the economic decisions that in most countries are made based—
like our national security and geopolitical decisions—
on careful consideration of the objective national interest
are, in America, made largely on the basis of lobbying.

Among the lobbies, the one that comes closest
to articulating the interest of the average American family
and thus the objective interest of America
is organized labor.
The reason is obvious.
Union members are American workers,
and American workers mostly can’t go offshore for jobs.
Since they have to work for a living and have to work here,
they have a primary interest in
the competitiveness of the United States in producing products
and providing services for the domestic and international markets.

We need to understand that
the interests of Wall Street,
and therefore of much of Washington,
have not been and will not be those of Main Street.
Wall Street

  • doesn’t care about trade deficits,
  • has bought into the idea that making things is passé
    as we move to the “higher ground” of services
    (especially financial services),
  • abhors taxes,
  • thinks the growing gap between rich and poor
    is a sign of the strength of the U.S. economy.

Section 9.7
The Trap

As a consequence of all these factors,
the United States, and indeed, the world
find themselves in a nasty trap.
Even at its current reduced level of about $500G, or 3 percent of GDP,
in the wake of the Great Recession,
the U.S. trade deficit is problematic
and will likely become more so with any kind of economic recovery.
Its financing already requires a daily inflow to the United States
of $4G to $5G of foreign capital a day (i.e., about $1.5T/year),
a number that could easily pop to $8G.
China and other big holders of U.S. debt
are expressing increasing unease over holding too many dollars
and are even calling for a new global currency,
as most analysts admit that
the present situation is clearly not indefinitely sustainable.
the U.S. federal budget deficit and national debt
are racing into uncharted waters
and obviously must be brought under some kind of control
to avoid ultimately unsustainable interest costs,
but also because the federal deficit reduces net national saving
and exacerbates the trade deficit.
Yet unemployment is high and threatens to remain so
despite huge federal deficit spending.
Indeed, further spending to help reduce unemployment is probably not possible.

To add to this mix, U.S. geopolitical concerns cost a lot of money
and take priority over economic issues.
So spending on them will further constrain economic stimulus spending.
Just to complicate matters a bit more,
despite its unilateral defense of key allies
and huge buying from potential adversaries,
America’s national security policies work to accommodate
the economic strategies of both our friends and our possible adversaries
while undermining our own productive and technological base.
If the trade situation gets bad enough
to really cause a shift away from the dollar,
our ability to maintain our far-flung deployments will collapse
because we have no means to export enough
to earn the foreign currency necessary to pay for them.
[Frankly, when (not if) there is a shift away from the dollar,
the inability of America to maintain its current excessive overseas commitments
will be the least of America’s worries.]

Finally, our increasing reliance on imported oil means both
higher trade deficits with economic recovery
and higher trade deficits
just with the passage of time as our own production declines.
In any case,
none of this adds to employment or to our grandchildren’s livelihoods.

The key to solving all these problems is
to reverse the dynamics of our present form of globalization
and, in particular, of the U.S. trade deficit.
If we can start running a trade surplus, or even a lot smaller deficit,
we can create employment without the need for federal deficit spending.

We can thereby help increase savings and further reduce the trade deficit.
The new jobs will generate tax revenue and further reduce the federal deficit.
The dollar will strengthen and talk of alternatives will cease.
Then we can play a more robust geopolitical game.
Sounds simple, but there are a few problems.

The conventional prescription here is for
the Chinese, Japanese, Koreans, Southeast Asians, and Germans
(the major non-oil producing trade surplus countries)
to save less, export less, and consume more domestically
while at the same time the United States
saves more, produces more, exports more, and consumes less.
However elegant as a theoretical solution,
it is not going to happen through enlightened self-interest and sophisticated negotiation. [!!!!]
Just for starters,
the Germans do not at all believe that they need to consume more.
I was in the room in 1984 when Japan’s Prime Minister Nakasone
promised that Japan would become an importing superpower.
Well, twenty-six years later, Japan is still dependent on export-led growth.
The Chinese are not going to change their currency policy in any significant way, nor are they going to abandon their currency policy in any significant way,
nor are they going to abandon their industrial catch-up policies [neomercantilism],
and even though they recognize the need to stimulate domestic consumption,
it will be hard to do because of
the deep structural and political problems of their economy.
As for us Americans, while we are actually saving more and consuming less
as a result of the Great Recession,
we are not changing the fundamental production and export-import dynamics.
The only way to do this is to
produce more of what we consume and export more of what we produce.
Further, we will simply have to produce and export more manufactured goods.
The trade deficit is so big in manufactures
that we simply will not be able to overcome it with services and R&D.
But an export-led growth policy of our own
puts us on a collision course with China, much of the rest of Asia,
and even possibly with the EU.

Above all, we need to create jobs, and as both Columbia University’s Jeff Sachs
and U.S. News and World Report’s Mort Zuckerman have recently said,
“jobs just don’t happen.”
The free market by itself is no longer, if it ever did,
going to produce those jobs.

In the face of the difficult dynamics of globalization,
of the division of the world into half free trade and half mercantilist,
and of the present collision course of ourselves and most of Asia,
we need to explicitly define our national economic interest
and to devise a strategy to further it.

Chapter 10
Playing to Win

[Here Prestowitz presents his prescriptions
for restoring America’s economic competitiveness.
I mainly just list his section and subsection headings,
however in a few cases I give at least part of his text.]

Section 10.1
The Tyranny of Orthodoxy

Subsection 10.1.1
The Role of Government

Subsection 10.1.2
Turn Away from False Gods: Teach Reality

One positive result of the recent Great Recession is
the blow it has struck to the efficient-market hypothesis (EMH)
and rational expectations (RE) school of thought.
In the wake of the crisis, many prominent economists and commentators—
such as Paul Krugman, Justin Fox, and Warren Buffett—
have echoed Robert Shiller in his prescient critiques of the theory,
and there are now many efforts under way
to achieve better oversight and regulation of financial markets
in recognition of the failure of so-called efficient markets.
They may abandon at least this false god in favor of
dealing with harsh, complex reality.

But the efficient-markets god was linked to
the gods of shareholder value, industry nonintervention, and
laissez-faire globalization

in a broader market fundamentalist faith.
These other gods may have been a bit damaged by the fall of EMH,
but they have not been displaced.
If the American Dream is to survive, they too must go.

Surely the Great Recession has demonstrated
the emptiness of shareholder value
as the sole guiding principle for CEO decision making.
As we noted in chapter 7, when the going got really difficult,
it was not the shareholders but the stakeholders of troubled corporations
who bore the ultimate risk
and who were called upon to serve as economic rescuers.
This is not to say that shareholders don’t count.
But a sole focus on increasing shareholder value too easily becomes, in fact,
a focus on increasing shareholder value in the short term …

Similarly, the doctrine that
government should refrain from industrial policy intervention in the economy
because it “cannot pick winners and losers”
fails to stand up under close examination.
Again, the history of the United States that I’ve reviewed
demonstrates the key role government has played in picking winners like
the telegraph, the interchangeable-parts assembly line, aerospace, RCA, the transistor and semiconductor, computers, GPS, the internet, and much more.

Indeed, in view of the fact that
private industry’s record of picking winning new products and systems
is no better than 10 percent,
the record of the government seems to be at least as good and perhaps superior.
But that is the wrong way to look at things.

For starters, the government doesn’t decide what wins or loses.
The market does that.
Government makes choices about investing in various lines of endeavor,
and it is compelled to do that.
The government has a budget that it has to spend.
It can’t spend on everything.
So just like any person or company,
it has to make choices about what it spends on.
Take, for example,
the budget of the National Institutes of Health (NIH) at $30.5G.
The NIH has to decide whether to spend on biotech research,
and if yes, then on which projects.
Likewise, the Defense Department has to decide
which kinds of new metals or nano-tech processes to develop
and which research groups are most likely to get results.
The Federal Communications Commission has to decide how to allocate radio bandwidths and for what purposes.
None of these choices can be avoided, and whether they are so labeled,
they are, in fact, industrial policy decisions.
They will shape the structure of industries and of the entire economy.

The truth is that the government cannot avoid industrial policies.
The only question is whether such choices and policies
will be guided by some overarching strategy and principles
or solely by idiosyncrasy and political trade-offs.
It is imperative that our thinkers, leaders, and media make clear
the necessity of such industrial policy choices.

Laissez-faire globalization
is the false god that will be most reluctantly abandoned.
Even as experts and pundits have turned on the efficient-markets god
and, to some extent, on the tyranny of shareholder value,
they have rushed to reaffirm laissez-faire globalization.
Any U.S. antidumping or other unfair trade action
inevitably elicits stern warnings against Smoot-Hawley protectionism,
and every debate over whether to conclude a free trade agreement
is said to be a “test” of the government’s commitment to free trade.
This is strange in view of
the general abandonment of the efficient-market notion;
because the laissez-faire globalization doctrine also rests on
the notion of the automatically optimizing and self-adjusting market
and is thus merely a special case of the efficient-market hypothesis.
Thus, if the efficient-market hypothesis is flawed,
so also must be the laissez-faire globalization notion.
And, indeed, we have seen that it is flawed.
For one thing, it is often discussed under the rubric of free trade.
This discussion has its own difficulties because as we have seen,
neoclassical free trade is only fully valid as a doctrine
under very narrow and increasingly unrealistic assumptions such as
perfect markets, the absence of economies of scale,
and international immobility of capital and technology.
But even more important is the fact that
globalization involves far more than trade.

globalization is really more about
investment and technology transfer
than it is about trade.

To imagine that a U.S. policy of laissez-faire globalization
will optimize global investment flows and technology transfers for America
is truly to be capable like the White Queen in Alice in Wonderland
of imagining six impossible things before breakfast.

Section 10.2
Have a Vision:
The Goals of Competiveness

Maybe we should revisit the vision put forth
by John Young’s Council on Competiveness in 1986.
Recall that the council called for the United States
to be a competitive country, defined as
“a nation which can under free and fair market conditions,
produce goods and services
that meet the test of international markets
while simultaneously maintaining or expanding
the real incomes of its citizens.”

But of course, more is required.
Not only must the president and Congress articulate a vision,
there must also be a process for realizing that vision.
A long time ago,
the congressional Office of Technology Assessment did a spectacular job
of assessing the technological capabilities and trends of the major countries.
It was abolished in 1995. [I.e., by the incoming Republican Congress.]
To replace it now, Congress should establish an Office of Competitive Assessment
to provide a nonpartisan, expert view of
the relative capabilities, strengths, and weaknesses
of the world’s leading economies.
In addition, the National Economic Council should be charged with
developing and articulating the national economic vision
and with realizing legislative and policy proposals
with regard to their likely impact on the realization of the vision.

Subsection 10.2.1
Save and Invest

The key macroeconomic weaknesses of the United States are overconsumption and low rates of saving and investment.
To make the United States more competitive again
we must institute tax reform to increase government revenue.
Of course, spending must be kept under control,
but there really is no way to fix this problem without adjusting taxes....
A good place to start would be by
greatly restricting the tax deduction on home mortgages.
We should limit it to one house per taxpayer
and to only a portion of the loan,
with wealthy taxpayers and big mortgages getting a smaller eligible portion
than poor taxpayers and small loans.
Taxing employer-provided health benefits would be another sensible step.

[Skipping over his idea for a “reverse income tax”, we come to:]
So let’s go to a more practical solution—a value-added tax (VAT).
Virtually every major country except the United States has something like this.
It is essentially a sales tax
that is collected at each step of the production of a product or service.
It is easy to collect, difficult to evade,
and generates a lot of revenue while encouraging thrift.
In addition, the tax is rebated on products and services that are exported.
At the moment, foreign producers have a great advantage because
their taxes are rebated on their exports to the United States.
But because we have no VAT and corporate income taxes are not rebated under international trade law, U.S. exporters get no tax break on their exports.
Moreover, when those exports enter a foreign market,
the foreign government levies the local VAT upon them.
Adoption of the VAT would also enable the abolition of the tax on dividends
so that corporate earnings would be taxed only once,
as they are in every other major country.
In addition, it could enable a reduction of U.S. corporate tax rates,
which are now the world’s second highest.
These measures would, of course, encourage investment
and make the United States more competitive as a location for global production
and the creation of globally oriented jobs.

Consumer credit should also be much more tightly restricted,
and home equity loans for purposes of anything but home improvement
should be abolished.
I know this may sound tough, but if we want to be competitive,
we must understand that countries like Germany and China,
who are serious about competing, don’t engage in such nonsense.
On top of cutting back on easy consumption credit, however,
we should do all we can to encourage investment.
We could revive the old Kennedy investment tax credit....
We should get rid of the tax on interest earnings
and make saving attractive in every other way possible.
Our objective should be to get to
a national savings rate of 20 percent of GDP
and a national investment rate of about the same.
If we did nothing more than this,
we would greatly reduce our trade deficit
and become much more competitive.

Section 10.3
Smart Globalization

Subsection 10.3.1
Normalize the Dollar

Subsection 10.3.2
Trade Deals Pause

No matter what one thinks is the core problem of our exploding trade deficit
(e.g., low savings, currency distortions, trade deals, skill deficiencies,
the tax code, foreign mercantilism),
the reality of America’s present condition is that
we have no trade strategy and the more trade deals we do,
the less competitive we seem to become.
Thus, the knee-jerk promotion of more trade agreements
before we address the flaws in our system
simply exacerbates our problem.

The first step therefore is to do no further harm....

Subsection 10.3.3
Match Targeted Financial Investment Incentives

Subsection 10.3.4
Reform the WTO

Section 10.4
Domestic Issues

Subsection 10.4.1
Rebuild the U.S. Productive Base

The Department of Commerce was created precisely to be
on top of this kind of thing.
But an important consequence of the rise of
the notion that the government is the problem
has been the evisceration not only of
the Commerce Department’s industry analysis and promotion capabilities
but also of those capacities throughout the government.
They need to be re-created and enhanced.
The U.S. government needs to
systematically analyze every important industry sector
and determine in which ones and under what circumstances
U.S.-based production could be competitive in international markets.

In order to bring all the relevant policy entities under one roof
we should establish a Department of Competitiveness,
which would include the departments of Commerce, Energy, and Transportation
along with the office of the United States Trade Representative, DARPA,
and NASA.
This department would be among the first rank in the cabinet
along with the departments of State, Treasury, and Defense.
It should develop a vision of
the future United States economy and policies
necessary to achieve and assure
broad-based American leadership
in key industrial, service, and technology sectors...

Subsection 10.4.2
Energy Independence

Subsection 10.4.3
Align Business Interests with America’s Interests

Washington must give serious thought to
measures that better align the interests of global corporations
with those of the United States and its citizens.
A good place to start is the corporate charter.
Few people realize that corporations are chartered by the state,
not by shareholders.
Indeed, the state confers enormous benefits on corporations,
including most importantly
its shareholders’ limited liability for losses.
Without such limited liability, each shareholder would be responsible for
the entirety of any losses the corporation might incur.
Such a prospect would severely limit investment in corporations.
The state extends this privilege because
it believes the corporation will produce benefits for the society.
Let me repeat that—for the society.
The society includes but is not limited to the shareholders.

The modern corporation is a creature of the state
meant for the benefit of the entire society
or what we might call the stakeholders.

Since it is a creature of the state,
a corporation can be required by the state to act in certain preferred ways
or for the attainment of certain preferred objectives.

A problem in the United States is that
American corporations are literally chartered by the various state governments
rather than by the United States federal government—
a situation that produces a race to the bottom in the sense that
the states vie with each other to be the incorporating state
and get the resulting state revenues.
However, the competition is in the form of
offering the most nondemanding conditions for incorporation.
My home state of Delaware seems to have mostly won the competition,
and I am sorry to say that it has done so
by demanding little in return for the benefits it confers.
As a result,
the formal responsibility of a CEO really is primarily to the shareholders—
the stakeholders be damned.
In virtually every other country in the world,
corporations are chartered nationally
and there are quid pro quos in terms of
organization, responsibility, and performance.

Germany is the best example.
There, the corporate charter establishes a supervisory board on which
stakeholders representing labor, shareholders, the community, and other groups
by overseeing the company’s management and its broad strategic goals.
This structure is very effective
in ensuring both attention to stakeholder interests
and alignment with broad national interests.
Many German companies are quite global,
but they also feel an obligation to keep the interests of Germany in mind.
Other countries, such as Japan, France, Finland, and Singapore,
have similar arrangements.
The United States needs to have them, too.
Congress should compel all corporations operating in the United States
to be chartered by the federal government.
Whether in addition to or in place of individual state charters,
there needs to be a federal charter.
And this charter would establish a board structure and membership
that would compel serious consideration of stakeholder interests
while also enabling effective pursuit of profit and shareholder interests—
just as German and Japanese companies manage to do
while remaining quite competitive at the same time.

In addition to the earlier mentioned
war chest for matching foreign investment,
the U.S. government should offer a tax credit,
like the R&D tax credit for investment that results in the creation of
certain categories of desired jobs or certain desired levels of production.
At the same time, the burden of social costs must be relieved.
In virtually all other major countries,
health care insurance is provided by the national government,
not by corporate employers.
European, Japanese, and Chinese companies do not bear a cost comparable
with that for the health care benefits provided by U.S. corporations.
Therefore, to offset this competitive disadvantage,
the U.S. government should provide a compensating tax credit or tax rate reduction or some other equivalent payment.
In short,
every effort must be made to make the United States
a desirable location for investment
by both American-based and foreign companies.

By the same token,
federal support of R&D and innovation should be at least doubled.
But in the present global economy,
simply providing funds for companies, universities, and research centers
can easily be counterproductive, because
the resulting products and processes
are increasing likely to be
produced in other countries.

Not only have American firms become global, but so have universities,
with partnerships and subsidiaries around the world.
Harvard, for example, now refers to itself as a “world university.”
In the global economy, ideas cannot and should not be stopped at the border.
By their very nature,
research and innovation need to be free of bureaucratic restraints.
But we also need government policies that increase the chances that
research and development will be channeled to production in the United States.
Thus, if government is funding research,
there should be some obligation for domestic commercialization
of whatever results are produced.

Subsection 10.4.4
Save the Environment, but Not at Producer Expense

Subsection 10.4.5
Training and Education

More and better education is often prescribed as
the main medicine for our competitiveness ills.
Actually, it is not.
But it is important and is an area in which, as I note earlier,
we are doing poorly.
The analysis and answers would fill several more books.
Indeed, they already have.
But there are four major elements that I want to emphasize here.
First is the simple matter of the length of the school year.
The American school year is at least a month shorter than
that of any other well-educated country.

Section 10.5
Political Reform

Labels: , , ,