I live and work in California, and on Tuesday I witnessed two revolutions here. Both have very bullish long-term implications, and both present significant short-term risks.
The first revolution I’m talking about, of course, is the recall of California’s sitting governor, and his replacement by someone with no political experience whatsoever. But let me start by talking about the second revolution, which on the surface doesn’t seem to have anything to do with the first.
Tuesday morning I met the chief executive of a consumer-goods company listed on the New York Stock Exchange. He wasn’t speaking for the record, so I won’t embarrass him by revealing his name. His company is becoming dominant in its category by systematically buying up dozens of smaller public and private firms in the same space, and knitting them together into an efficient, modern conglomerate.
It’s an old strategy known as a “roll-up.” In fact, this CEO has done it before in another category during the 1990s, starting the decade with a tiny company with $17 million in revenues, adding over 200 acquisitions to it, and ending the decade by selling the whole ball of wax to another company for $8 billion. What’s different this time is the CEO’s manufacturing strategy.
He told me that the minute he buys a company now, he immediately dismisses all the factory workers, crates up the factory equipment and ships the whole kit-and-kaboodle to China. He said he has a staff of 55 people in Hong Kong who do nothing but build and staff factories in China to take over manufacturing processes that had formerly been done in America.
Why? He says that his average cost-per-day to employ an American factory worker is $135. In China, that cost is $135 per month! That cost difference is so vast, no little tweak in China’s currency exchange rate — like the kind the Bush administration is foolishly demanding — is even going to make a dent in it.
That means this CEO is buying companies, whose major cost is labor, at acquisition prices based on historical levels of profits that he has the power to instantly make vastly higher by moving jobs to China. That’s the obvious part, but it’s more than that.
He told me that when labor costs drop that dramatically, you have the power to use more labor than you would in the US, and that makes for better product quality. He says that in the US he can’t afford to do anything but take a product off the injection molder and drop it in a box and ship it. In China, after a piece comes out of the molder, a worker can spend hours polishing it and perfecting it. In the store, when those two products sit side-by-side, the Chinese-made product is going to win every time. Better price and better quality.
Now that’s a revolution. And if you are an American factory worker, it makes you an endangered species.
But what does it have to do with the revolution in California? More than you might think. Arnold Schwarzenegger hasn’t been terribly clear about exactly what he’s going to do as governor to get California out of the fiscal mess it’s in. But he has repeated one fundamental principle over and over, and if you think about it, it bears directly on the China manufacturing revolution.
Schwarzenegger’s clearest policy theme has been his commitment to make California a friendlier place for business to do business. Right now California leads the nation in rules, regulations and rigidities — which all amount to the equivalent of taxes, because they cost money for companies to observe. For example, California’s Paid Family Leave Act allows workers to take up to six weeks off — with pay! — in order to deal with family events. That means every new father gets to take a paid vacation for six weeks every time a new baby is born in California.
That’s a neat deal for dad. But someone has to pay — and that someone is the employer. That’s just one of a thousand similar reasons why no employer in his right mind would locate or expand in California if he had any choice in the matter. So businesses — and jobs — are leaving the state. Some are going to other states, others all the way to China. That neat deal for dad ends up being a pink slip. There’s no such thing as a free lunch, or a free vacation.
Even if Schwarzenegger can roll back all the anti-business, anti-job regulations in California, nothing is going to close the cost-gap between the US and China, at least not all the way. But that’s not really the point. America is never going to beat a country like China when it comes to competing on price for unskilled labor.
What America needs in order to deal with the China threat is the flexibility to rapidly develop new high-end industries that China doesn’t have the knowledge or the skill to compete with. That way we keep our people employed — in better jobs, by the way — and we get the benefit of cheap manufactured goods from China. Everybody wins.
And this is the kind of thing that California is especially good at. Or at least it used to be. Is there anywhere else in the world that has birthed more new technologies and new industries over the last 50 years than California?
But California has been inventing new rules, regulations and rigidities even faster. That means that there is lots of innovation that won’t get done in California. And that’s just what Schwarzenegger says he wants to fix. Workers won’t like it — at first — because it will seem like benefits are being taken away. But those benefits simply cannot be sustained. Those workers are going to end up with lots of benefits but no job unless something is done.
We’ve been here before. Remember the 1970s when US manufacturing was being crushed by Japan and Europe. Yes, hard to believe but there actually was a time when we were afraid of competition from Europe! But we worked our way out of it in the 1980s because President Ronald Reagan — another California governor who had formerly been an actor — held back the tide of excessive federal regulation, and allowed American industry to go through a decade of painful but ultimately very successful restructuring.
If Schwarzenegger can pull a Reagan at the California level, it will set a template for all of America to follow. If, instead, we retreat into fear and protectionism, then in 25 years America will be a second-rate economic power — and we will have done it to ourselves.
The message of the California recall revolution is that it doesn’t have to happen that way. If we are flexible and courageous enough to transform our economy — as we always have — we can meet the threat of the Chinese manufacturing revolution, and turn it to our vast advantage.
Good luck, Governor Schwarzenegger.
Originally published on SmartMoney.com.
