Early Indications April 2008: Oil, Bits, and Steel

It used to be an economic commonplace that value was added in increasing amounts the farther one moved from raw material extraction. Farms, fishing villages, and mines have often created less affluent locales and involve dangerous work, while factories paid higher wages. Bankers fared better still. In today's information economy, that hierarchy bears revisiting.

Those who invest in the rise or decline of an asset class are still rewarded best of all, as the recent hedge fund salary report in Institutional Investor's Alpha magazine reveals: five individual money managers each made more than $1 billion in 2007. But even though the U.S. pure manufacturing sector no longer stands astride the global economy as it did 50 to 100 years ago, information’s role in international trade remains hazy.

Prices for goods from extractive industries have been soaring: copper has quadrupled in five years, and nickel went up a factor of five in just over four years, before dropping in the middle of 2007. Wheat soared, then has fallen 40% in recent months. Oil is visibly surpassing all-time highs. How much these increases relate to speculation, and how much to underlying demand, is difficult to tease out. Changes in diet, for example, contribute heavily: as developing nations eat more meat, more grain is needed to feed the livestock that feeds the people. Tariffs and subsidies, administered locally, have an enormous effect, especially when considered cumulatively. Corn’s use in ethanol shapes land use decisions from coast to coast, and beyond. One effect of powerful networks is to amplify noise: local distortions (corruption, protectionism, and subsidies) ripple farther, faster today than they did 100 years ago.

Whatever the impact of culture, Malthusian population pressure, and trade barriers, when capital is global and government (and therefore regulation) is not, money managers enjoy extensive leeway. When food shortages spur riots in several countries, however, the role of hedge funds in high grain prices should come in for scrutiny. As is so often the case, information about stuff is more valuable than stuff, and information about money is, as Walter Wriston opined, more valuable than money.

Away from investing, knowledge-intensiveness can add value but be difficult to monetize. In part, manufacturing is a victim of its own success: goods can be produced so efficiently, at such high quality, that margins often shrink. A descendant of the personal computer that sold for $2000 in 1992 ($3073 in 2008 dollars) can now be purchased for roughly $500. The Eclipse very light jet airplane is selling for only $1.5 million, compared to $3 million for a more traditional (and only slightly bigger) Cessna Citation Mustang. Refrigerators and other major appliances have dropped in price by 20% or more in industrialized countries - with a potentially decisive impact on women's participation in the labor force as a side effect. The reach of such manufacturing pioneers as Deming, Dell, and Ohno (father of the Toyota factory system) is broad indeed. (See Cavalcanti and Tavares, "Assessing the 'Engines of Liberation': Home Appliances and Female Labor Force Participation," Review of Economics and Statistics 90 (2008): 81-88)

Some manufacturers address this dilemma by increasing the content of manufactured goods. Automobiles have become a classic example. While the 1976 Honda Accord that launched this successful franchise was 162 inches long, the 2008 model is nearly 3 feet (32 inches) longer. Significantly, the 1990 Accord came with a 125-horsepower engine and got 30 miles per gallon in highway driving with a manual transmission. 18 years later, an Accord weighs 500 pounds more, has 177 horsepower -- and gets 31 highway miles per gallon under a tougher measurement standard. Honda is not alone as other manufacturers have made similar moves: a 2008 Ford F-150 pickup weighs 700 pounds more than its 1991 forebear, while a BMW 3-series sedan has added 455 pounds in 20 years.

Given how manufacturing has evolved in the U.S., it is not surprising that the status of the US economy in the world has changed dramatically. According to the U.S. Census Bureau's Foreign Trade Statistics, the U.S. has trade deficits with 13 of its top 15 trading partners. Only the Netherlands at number 10 and Singapore at 15 buy more from us than we do from them. It's noteworthy that the United Kingdom, the manufacturing empire from which the U.S. took the mantle, now sells the U.S. about $6.5 billion more than it buys – but North Sea oil rather than textiles is now the mainstay. Counterintuitively, the U.S. also imports more automobiles and pharmaceuticals from the U.K. than it exports back.

Canada was the U.S.’s biggest trading partner until just last year, when China took that spot. A close look at the figures reveals that the U.S. imports both extractive products (pulp and paper, metals, and energy comprising the big three, worth well over $100 billion) and manufactured goods, primarily automotive and aerospace. In return, the biggest U.S. exports to Canada are food, car and truck-related goods, and energy. Evidence of an information economy is hard to discern in the U.S. government statistics: motion pictures, patent licenses, and investment banking services do not appear. Even something as IP-intensive as pharmaceuticals was only about 1% of U.S. exports to Canada, and smaller in dollar volume than “toys, games, and sporting goods.”

The numbers with China tell an entirely different story. While U.S./Canada trade figures are close to being in balance (a gap of $64 billion, or about 20% of imports), the Chinese buy very little from the U.S., especially if raw materials and foods (including $4 billion in soybeans) are removed. Highlights include about $6.5 billion in both semiconductors and civilian aircraft, but these are dwarfed by the imports, starting with over $50 billion in computers and related equipment and another $50+ billion in apparel and footwear. The list goes on from there.

What are we left with? First of all, it’s clear that the record-keeping lags reality. How, if at all, are such real services as Bloomberg or Thomsen subscriptions, legal advice, or investment banking factored into trade figures? Services are far more portable than traditional economics reckoned them to be in the days when haircuts were invoked as the archetype: when every U.S.-based accountancy and every major law firm has Chinese offices, their work may not be an export in a technical sense, but it should play some part in the trade picture. Once again, the statistics presume a manufacturing-based economy that no longer employs a majority of Americans.

Second, America’s “dependence on foreign oil” is more complicated than the phrase suggests. According to the U.S. Energy Information Administration, here are the top seven importers of U.S. crude oil for the month of February 2008:

Canada 71.5 million barrels
Saudi Arabia 47.2
Mexico 38.5
Venezuela 32.8
Nigeria 29.7
Iraq 22.6
Russia 13.1

Note that only two Persian Gulf states are included; numbers one and three are our NAFTA neighbors. For the trade imbalance even to be dented, each country in slots two through seven will have to change its consumption patterns, and most likely central government, quite radically from what they are today. It’s difficult to see any information-based goods making a dent in those imbalances, in those countries. In just one month, those seven countries sold the U.S. over $25 billion of oil (assuming $100/barrel): that annualizes to $300 billion a year, a tough number to scale no matter how many MRI machines, bags of genetically modified seed corn, corporate branding campaigns, or copies of Grand Theft Auto we could sell in any of these countries excepting Canada. Rather than an “information economy,” we may well be more accurately defined by transportation.

In sum, there seems to be a “hollowing out” of many Western economies: extraction, whether of corn, copper, or oil, sits on one side opposite information/services (both of which are hard to capture statistically) on the other as the main drivers; manufacturing -- with some notable exceptions such as medical imaging and devices, excavating equipment, and aircraft -- appears to play a smaller and smaller role in export numbers. The Detroit-based automotive sector has become largely domestic, with imports and import subsidiaries gaining ground every year.

The next U.S. president will have many hard problems to address, but this series of hidden transformations in trade, as yet underappreciated by both statistics and policy, will be lurking in many of them: health care, the Iraq war, energy strategy, immigration, monetary policy, and taxation merely begin a long list.