Feature Stories | May 08 2006
By Greg Peel
GaveKal Research is an independent economic research house and consultancy created in 1999 in the US by Charles Gave and partners. GaveKal has a reputation for "original thinking". The following feature series is drawn from a GaveKal publication of 2005 entitled: Our Brave New World. This is Part III.
The twenty-first century has brought the rise of the platform company. A platform company is one which retains the high-margin design, marketing and sales elements of a product while outsourcing the low-margin, labour and capital intensive manufacturing process. In so doing the platform company makes the bulk of the profits (and these are within the "Western" industrialised nations), while the outsourced manufacturers receive very low reward for risk (emerging markets such as China).
Overcapacity in emerging markets has ensured that platform companies can quickly switch their manufacturing contracts to wherever the best price is offered, leaving competing manufacturers to fight over what little margin there may be. The whole process is deflationary, as prices are kept to a bare minimum.
As the platform company model becomes more prevalent, it is probably more correct to suggest that "Western industrialised nations" are no longer so, but more "Western post-industrialised nations" or perhaps "Western service nations". The emerging economies, such as China, India or Brazil, are becoming the new "industrialised nations". The West has outsourced its industry.
Because the West is making all the profits, while the emerging markets take all the risk, it follows that the rich are getting richer. But strangely, it’s also getting a lot more expensive to be rich.
If Western economies have been making all the money then one would expect this to result in inflation, as wealthier consumers can pay more for whatever they might want. However, inflation globally has struggled to breach a 2-3% level, even despite a significantly higher oil price.
The reason inflation hasn’t bitten is due to the deflationary effect of the great capacity boom in emerging markets, and the subsequent fall in price of manufactured goods. In Britain for example (as measured to 2005), clothing prices have fallen 42% in a decade, shoes are down 31% and consumer electronics are down 63%.
With such falls in these everyday items you would think we would actually have negative inflation, not low positive inflation. So using Britain as the example again, anyone who’s been to London knows it is one of the costliest cities in the world. Australians used to cheap-and-cheerful Thai meals for example, have heart attacks when trying to eat out – even simply – in London. The reality is, not everything has fallen in price.
The offset to the fall in price of manufactured goods is the equivalent rise in price of those goods or services that the emerging markets cannot deliver. Financial services, for example. Insurance, education, real estate. And any service industry such as holidays, hairdressing and indeed, restaurants.
In Britain over the past decade prices of such services have increased 30-60%. It is such services or goods, some of which might be called "luxury", that are making it a lot more expensive to be rich. But within those countries that can provide such goods and services – the post-industrial West – the providers are benefiting from the higher prices and thus getting richer. An upward spiral of sorts.
In the meantime, the booming emerging industrial countries such as China are producing goods at lower and lower prices and lower and lower margins which means less pay for workers. The wedge between the global "haves" and "have-nots" is getting wider. Surely there are ramifications of such a trend?
Let us consider firstly that there are more effects leading from the platform company model than just lower prices. The blue collar worker in previously industrialised nations such as the US is disappearing. This is not good news if you are a blue collar worker, or unionist, or political champion of the "working man". But either way there is a generational shift from a blue collar to a service industry workforce.
The industrial part of the production process – that which the platform company has outsourced elsewhere – is by far the most cyclical of the design, produce, sell process of industry. Something is invented or improved upon, it is highly sought after and attracts a high price, everyone opens factories or tailors factories to jump on the bandwagon, prices collapse. Workers are laid off.
The cyclicality of the process ensures volatility within the system – boom, bust, boom, bust. But under a platform company model, that volatility has been outsourced along with the production process.
If a company such as Ikea finds a particular line of furniture is no longer popular, it can contact its outsourced producer and say "I don’t need so many of those anymore". But the producer might say "But I’ve ordered all the wood and set up my factory to make them". To which Ikea can say "Well then you should be able to give me a good price on the smaller order then." In the meantime, Ikea develops a newer model that becomes popular, and so never suffers from overproduction and subsequent loss on inventory.
The producer, however, does suffer.
The volatility of production ensures volatility of wages, employment and profits. Over the past decade volatility in the US of these three elements has fallen substantially (and no doubt the same has occurred in Sweden, home of Ikea). This fall in volatility has an important flow-through effect.
If the employment market and wages are stable, an individual can be more confident in spending money, rather than feeling the need to save it just in case. To take it to the next level, an individual can be more confident in borrowing money to finance a new house or car, for example. The same is true at the corporate level. With a stable flow of profits, a corporation can more confidently leverage for the purpose of expansion.
Is it any great surprise then that the US has become the great consumer nation, running up vast amounts of debt? While wages, employment and profits have reduced in volatility, volatility of imports has greatly increased. In the meantime, the US has exported its volatility to the emerging world.
Many economists have despaired at the size of US debt, and its lack of savings, but strangely delinquency rates on loans in the US have also fallen – quite substantially compared to the booming 1980s. In past times an event such as 9/11 should have brought the US economy to its knees, but that has not been the case. The US economy has motored along, and the US consumer has been the "bedrock of the world economy".
It is in to the US and other long established economies that China has sold. Vast amounts of liquidity in China have encouraged productive capacity to provide goods for Westerners to lap up as they go further into debt. Many an economist has been expecting the big crunch, a natural outcome of the growing global imbalance, but to date it hasn’t eventuated. A lot of those economists are now tempering their views. The platform company model, it would seem, has contributed to the stability of a system which might previously have been unsustainable.
But while China can keep producing goods and the US can keep buying them the fact remains that Western economies have exported their volatility to emerging economies. It is the likes of China, India, Mexico and Brazil that will suffer booms and busts in specific products, collapsing profits and laid-off workers. The stability of Western economies may have supported the growth of emerging economies, and allowed many a Chinese or Indian to become far better off than they were previously, but at the street level there is plenty of room for poverty and unrest.
It is interesting to note that resources analysts are looking with some trepidation towards an upcoming round of mine-worker contract renegotiations across the globe. A lot of the current massive bull run in the copper price, for example, has been caused by supply disruptions due to industrial action in nations such as Mexico.
If further supply disruptions occur, then prices will only continue to skyrocket. This is all well and good for mining companies, but at some point price levels must have a dampening effect on demand. No one is sure at what point this will happen, as everyone has been surprised that demand, particularly in China, has held up this far. When it does happen there will be quite a shake out.
Perhaps the humble worker still holds the power. More in Part IV.
The ideas and examples put forward in this series are the work of Gave, Kaletsky & Gave: Our Brave New World, self-published, 2005. The writer has added observations as well.