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The Bear's Lair: What's That Sucking Sound?

US-based General Electric displays its new-generation industry system in Shanghai. GE has steadily been de-emphasizing its U.S. manufacturing, recycling more of its capital into the financial services business. In 2003 it announced that China, not the United States, was to become its global production center.
Washington DC (UPI) Dec. 13, 2004
In his campaigns for President, Ross Perot used to talk about a giant sucking sound of U.S. manufacturing jobs moving overseas. From a Korn Ferry/New America Foundation symposium Wednesday on U.S. manufacturing's decline, it's clear that the sound can still be heard. It would appear however that the fault may lie in our own actions - thus the sound may be more of a blow than a suck!

The question of how important it is to preserve manufacturing jobs is a difficult one. On the one hand, many defenders of manufacturing appear to regard any business that doesn't result in something you can drop on your foot as meretricious. This is an approach to manufacturing similar to the French 18th century physiocrat economists' approach to agriculture - it ignores the value added in the rest of the economy, and takes a distorted view of reality. The Conservative Trade Minister Michael Heseltine used to make speeches to this effect at Conservative party conferences in the 1990s; in Britain's case he was clearly trying to shut the stable door about 100 years after the horse had bolted.

Curiously, Joel Kutkin of the New America Foundation used Britain as an example of the dreadful things that might happen to the United States if it abandoned manufacturing. In my view, the British parallel is rather reassuring than otherwise; the country has retained a very reasonable level of prosperity, economic growth and productivity growth while specializing almost entirely in the services sector. What may happen to Britain in a downturn now that it's abandoned ownership of its treasured financial services businesses, is however a different story.

The United States has both positive and negative differences from Britain. Positively, it is a much bigger country, with far more abundant natural resources, much cheaper real estate (except in a very few areas) and a climate that most people appear to prefer. Negatively, it has five times as many mouths to feed (so must rely on a broader economic base, even in a distant future when it may no longer represent a quarter of the world's economy) and has an even greater tendency than Britain to pursue fiscal and economic policies that munch cheerfully through the seed corn and then wonder what's for supper.

There are also certain similarities. An international study published last week placed the United States 23rd out of 28 countries tested in high school mathematics - Britain at 19th was little better placed. Scott Kingdom of the executive search firm Korn Ferry complained at the symposium that U.S. education stressed too much the artistic and non-revenue producing side of life, and didn't focus enough on industry's needs. This is also a problem in Britain, where Cambridge University is closing its architecture department and Exeter University its chemistry department, while sociology and liberal arts courses remain oversubscribed. If business, in particular manufacturing, is not attractive to the nation's students, and they show less aptitude in technical subjects than those from foreign countries, then inevitably manufacturing will be forced to move overseas.

If you had graduated from a good college with an engineering degree in 1975 or 1980, you might well have looked to make a long term career at General Electric or Westinghouse, the two long standing, highly profitable, very stable titans of the electrical equipment industry. Bad decision! GE has steadily been de-emphasizing its U.S. manufacturing, recycling more of its capital into the financial services business, and in 2003 announcing that China, not the United States, was to become its global production center. Meanwhile Westinghouse also got into financial services, lost a bundle there in 1989-91, bought CBS, changed its name to CBS, split the company in two and sold the remainder of its engineering businesses to Siemens. Not a lot of job security for an engineer in either company.

GE's record of stellar financial performance, that made Neutron Jack Welch, its long-time Chairman, a stock market icon, was built on a 22 year bull market in bonds, which made GE Financial Services persistently profitable, and in the late 1990s, on raiding its employee pension funds. If and when bond and stock markets turn around, GE's financial services businesses may well go the same way as Westinghouse's, while unfunded pension liabilities cripple the cash flow of the engineering businesses. If you're still a senior engineer at GE, you'd better think about learning Chinese!

Another example of the hollowing out of U.S. manufacturing is Boeing, which recently filed a complaint with the World Trade Organization about Airbus' increasing dominance in the world aircraft industry, and the government subsidies it receives. Boeing has not introduced a major new product since the 777 in 1990; it's therefore not surprising that its market share has been slipping. Instead of spending money on developing new aircraft, Boeing in 1998-2001, at the peak of the stock market bubble, spent $9 billion repurchasing stock, no doubt making its option-rewarded top management rich in the process. It's perfectly simple; if you don't invest in a business, instead de-capitalizing it, your market share will quickly erode. Airbus' subsidies from the French and German government were initially huge -- of the order of $15 billion - but in recent years the subsidies have declined, to the extent that the company is now profitable on a stand-alone basis. Why shouldn't the subsidies decline? - Airbus no longer has serious competition, and is benefiting financially thereby.

Eventually, when giants of U.S. industry like GE, Westinghouse and Boeing outsource manufacturing, close it down or treat it as a Boston Consulting Group cash cow, students considering engineering careers think again, and either apply to law school if they're greedy or take up writing poetry if they aren't. It's not surprising therefore that, as Kingdom complained, the supply of new skilled employees for U.S. manufacturers comes largely from the immigrant community.

There is another problem facing U.S. manufacturing, and it is one for which Korn Ferry and the other headhunter executive search firms are largely responsible: the remuneration of U.S. top management. Before the modern executive search business was formed in the 1960s, if a top management vacancy arose, the company advertised the job, recruited through a trade association, through personal contacts or through the college or business school that senior management had attended. It was a relatively open process; there were many ways in which you could acquire the skills and experience that would qualify you for top management.

In the 1960s and 1970s this changed. Equal opportunities legislation made it impossible to justify an informal recruitment process through personal contacts. Business life became more mobile, so the need to recruit senior management arose more frequently, lessening the chances of filling vacancies through personal contacts. The long bull market of the 1960s increased the vogue for celebrity managers; it became clear that you could increase your stock price by hiring a top manager with a gunslinger reputation. All these factors caused a demand for a service that would recruit top management from competitors, professionalizing the hiring process.

For the headhunters, the motivation was clear. Headhunters make money (generally one third of first year's salary and benefits) by executive transitions. Therefore it became in their interest to provoke executive transitions and to seek to drive up executive salary packages.

Initially, the normal willing buyer-willing seller relationship operated. The board of directors selecting the new CEO wanted to keep the cost down, the headhunter wanted to raise it; they were in an appropriate arms-length relationship.

However, as the market share of headhunters in top management searches increased, a new dynamic came into play. Top management had increasingly itself been put in place by headhunters, and was reliant on headhunters for possible future opportunities. The headhunter who hired you, of course, couldn't take you out of the company they'd put you in, but other headhunters could, and you in turn could cement your relationships with headhunters by recommending your friends and thereby adding to their database of appropriate executives. The relationships became much closer.

The headhunters began to act as gatekeepers. Instead of screening the universe of all possible candidates for a position, they screened only those who were already in similar positions, justifying their narrowing of the selection pool by the need to get the choice absolutely right. After all, from the headhunter's point of view if they recommended somebody unconventional and he didn't work out, their reputation was damaged, whereas nobody (except the shareholders, who didn't matter) was damaged if sticking to a restrictive pool of conventional candidates meant their choice was far more expensive than he needed to be. The unconventional candidate might be unconventionally good at the job, but if he was, it was mostly the company that benefited and not the headhunter who found him.

From the board of directors' point of view, there was the never get fired for buying IBM factor - you were unlikely to face a successful shareholder lawsuit if you hired someone recommended by Korn Ferry or another top headhunter. Thus an open selection process became a closed one. The option of paying much less for a CEO outside the magic circle of those considered appropriate by headhunters disappeared, and top management, which had been fairly open, became a closed profession, in which in order to be a big company CEO you had to have a top management track record with a competitor or a company in a closely related industry.

The result has been a dramatic escalation in CEO and top management pay. In 1968, after a decade of boom, the highest paid executive in the United States, James P. Roche, Chairman of General Motors, earned $795,000, or 142 times average worker pay. Thirty years later Michael Eisner, of Disney, made $575.6 million, nearly 1,000 times as much as Roche and 25,052 times average worker pay. Remuneration declined somewhat after 2000, with the decreased profitability of stock options and the intrusiveness of Sarbanes-Oxley legislation, but even in 2003, a year following a deep recession, 90 of the Forbes 500 top CEOs made more than $10 million, 350 times average worker pay, or 2.5 times as much relative to the workforce as Roche.

Compared with Europe or the wealthier countries of Asia, U.S. executive compensation is orders of magnitude higher. Further, management overcompensation extends far down the pecking order - median total compensation in 2003 for starting graduates of Wharton Business School was $158,000, compared to the average starting salary for those with masters' degrees in engineering of $57,000. Consequently U.S. companies are burdened with additional costs not from worker compensation (only moderately high, and flat in real terms over the last 30 years) or from pensions and healthcare (often lower than in Europe, except for some special case companies with geriatric workforces and final salary pension schemes) but from the top management cadre, which in total absorbs a multiple of each year's profits. However, this is the one cost that top management doesn't seek to cut!

The solution to the problem is to let nature take its course, and hope it does so quickly. Eventually, bond yields will rise and stock prices decline, so the funny money profits from financial services (29 percent of total corporate profits in 2003, compared with 15 percent in 1975) will disappear. Eventually, Wall Street and the consultancy business will go into recession, which will cause redundancies and pay cuts, which after a lag will affect the study and career choices of undergraduates.

Two political/economic factors will help: a decline in the dollar against other currencies, which will improve competitiveness, and the post-9/11 tightening in immigration restrictions, which is already chilling foreign applications to U.S. colleges. Reducing the number of foreign students graduating in engineering and science from U.S. schools both increases the reward/risk ratio for those Americans thinking of studying engineering or the hard sciences, and slows the transfer of U.S. technical know-how to Asian competitors through foreign graduates returning home. Free trade is advantageous to the U.S. economy and the U.S. workforce, free immigration, which brings foreign competitors into much closer competition with the U.S. workforce than mere free trade, is a very different matter.

The problem of disappearing manufacturing is a real one, and it won't go away quickly. But in the end, as with most problems, it is our own fault.

The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of sell recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

All rights reserved. � 2004 United Press International. Sections of the information displayed on this page (dispatches, photographs, logos) are protected by intellectual property rights owned by United Press International. As a consequence, you may not copy, reproduce, modify, transmit, publish, display or in any way commercially exploit any of the content of this section without the prior written consent of United Press International.

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