A corollary to Upton Sinclair’s famous saying, “It is difficult to get a man to understand something if his salary depends on his not understanding it” is “People promote ideas that help them secure or preserve a privileged position on the totem pole.”

A glaring example of these observations came in an op ed in the Sunday New York Times by Steve Rattner, former Lazard mergers & acquisition partner, later head of the private equity firm, Quadrangle Partners. He is best known as the chief negotiator in the auto bailouts (and he was criticized for not involving any auto industry experts). He paid $10 million to settle a kickbacks investigation and agreed not to work for a public pension fund in any role for five years. I happened to see Rattner on a panel at a Financial Times conference earlier this week and he elaborated on some of the themes in this piece, “Let’s Admit It: Globalization Has Losers,” which reader Brett asked me to debunk line by line. I’ll spare you and focus just on the most critical and bald-facedly dishonest bits.

Let’s start at the top:

For the typical American, the past decade has been economically brutal: the first time since the 1930s, according to some calculations, that inflation-adjusted incomes declined. By 2010, real median household income had fallen to $49,445, compared with $53,164 in 2000. While there are many culprits, from declining unionization to the changing mix of needed skills, globalization has had the greatest impact.

Apparently the NYT fact checkers give guys at Rattner’s level a free pass. This is false. Where was Rattner in 2007 and 2008? Real median income peaked in 2007, and that was modestly higher than in the last cyclical peak, in 1999. The decline in income (nominal, not just inflation adjusted) is the direct result of the global financial crisis, not inflation. So his entire piece is based on an inaccurate claim which has the effect of diverting blame from bankers like him.

This next bit is sneaky but worth pointing out:

The phenomenon that free traders like me adore has created a nation of winners (think of those low-priced imported goods) but also many losers.

We don’t have a system of free trade. It’s managed trade. As William Greider has pointed out, most other countries play the game in a way to produce better national outcomes (fewer lost jobs and trade surpluses). We seem to be running our trade policy not to optimize our national interest, but that of large international corporations, which is far from the same thing.

The next bit is pure reductivism:

A typical General Motors worker costs the company about $56 per hour, which includes benefits. In Mexico, a worker costs the company $7 per hour; in China, $4.50 an hour, and in India, $1 per hour. While G.M. doesn’t (yet) achieve United States-level productivity in China and India, its Mexican plants are today at least as efficient as those in the United States.

American management is also more expensive than management in Mexico or China or India. And I think you’d be hard pressed to say American management is better than management, say, from Sweden or Australia, where CEOs are vastly less well paid than here. So shouldn’t we expect CEO and upper management wages also to fall?

And remember, as we have said in other posts, the evidence is overwhelming that not only is CEO pay in the US not correlated with performance, it is negatively correlated with performance. The best paid CEOs deliver the worst results, and the leaders of Jim Collin’s stellar performers in Good to Great all paid themselves modestly.

We need to peel back several layers to debunk this notion that labor costs trump everything. First is that Rattner is implicitly arguing that the world is frictionless. But that is misleading. The US is a big market, and there are advantages in being close to the customer, in terms of rapid response, carrying smaller inventories (and thus having smaller losses when you get it wrong), lower shipping and financing costs. IKEA, which is in a low end manufacturing business, has its manufacturing for the US located in the US.

Second, he is also assuming that all products are more or less commodities. But the job of management is to find a way to gain competitive advantage, and being a low cost competitor is one of many options. I’m sure you’ve paid a big premium to buy food or a drink at a convenience store now and again. They are competing on location, not cost. Similarly, I’m always amused at techies who hector Apple product users in comments. They seem angry that consumers will pay a big premium for ease of use or maybe just sheer coolness (and I have to say, as a Manhattan person, being able to see a live person at 3 AM and get something diagnosed and fixed is worth a lot to me). So a fixation on costs too often reveals a management lacking in imagination and gumption facing increasingly competitive and mature markets.

Third, his focus on direct factory labor is disingenuous. Direct factory labor is typically just north of 10% of the cost of most manufactured goods; for cars, we are told it’s 13%. Even if you can extract meaningful savings there, you have significant offsets: the upfront cost of re-orgainzing production (which in the outsourcing scenario include hiring costly outsourcing “consultants” and paying attorneys to paper up the deals), higher ongoing managerial costs, higher shipping and related inventory financing expenses. Yes, there are cases where outsourcing and offshoring have been a big success, but there are also others where the benefits have been underwhelming and have come at considerable costs to US workers, communities, and the economy (see a very good long form discussion by Leo Hindery).

And in many cases where big multinationals come out ahead, it isn’t due solely to labor cost savings. As Greider pointed out:

At IBM back in the 1980s, [Ralph] Gomory watched in awe as Japan and other Asian nations captured high-tech industrial sectors in which US companies held commanding advantage. IBM invented the disk drive, then dropped out of the disk-drive business, unable to compete profitably. Gomory marveled at Singapore, a tiny city-state, as it lured American manufacturers with low-wage labor, capital subsidies and tax breaks. The US companies turned Singapore into a global center for semiconductor production.

And this sort of thing continues. I discussed long form the fate of a world class coated paper mill in Escanaba, Michigan. The main culprit in its demise was overleveraging and excessive compensation to executives who knew bupkis about the paper industry. But another factor I did not include in my getting-to-be-too-long post and was pointed out by readers in comments were the considerable subsidies given by the Chinese and Indonesian governments to their papermakers.

Consider the implications: if the only factor at work were factory labor, as Rattner implies, you’d see far fewer jobs ceded to foreign markets (put it another way: if the labor cost differential were a sufficient inducement, foreign governments wouldn’t need to offer such generous subsidies).

To put it another way, the argument that Rattner is making is basically that of the Stopler-Samuelson theorem. Let’s turn the mike over to development economist Dani Rodrik:

The Stolper-Samuelson theorem is a remarkable theorem: it says that in a world with two goods and two factors of production, where specialization remains incomplete (plus a few more technical assumptions), one of the two factors–the one that is “scarce”–must end up worse off as a result of opening up to international trade. Not in relative terms, but in absolute terms. But the theorem is also quite limited in its applicability. It applies only to a case with two goods and two factors, and so its real world relevance is always in question. But there is a version of the theorem that is remarkably general and powerful. It says that regardless of the number of goods and factors, at least one factor of production must experience a decline in real income from trade as long as trade induces the relative price of some domestically produced good(s) to fall (and as long as the productivity benefits from trade are restricted to the traditional, inter-sectoral allocative efficiency improvements, about which more later). All that this result requires is a very mild assumption, namely that goods be produced with varying factor intensities (i.e., use different combination of factors). The stark implication is that someone will lose, even if the nation as a whole becomes richer.

So to give an example: Let’s say that as a result of globalization, the wholesale price of a car falls from $20,000 to $15,000. Let’s further assume that materials costs were $6000, direct factory labor was $3000, factory overheads were $2000, shipping is $1000, marketing is $2500, other management costs (top brass, IT, legal, accounting) were $2000, interest cost are $1000, and $1500 is for capital investment (as in repairs and replacements), with a target profit of $1000. Per Stopler-Samuelson, something has gotta give to get the manufacturing price down to $15,000.

But it does not have to be worker wages. For instance, over the years, we’ve seen manufacturers of all sorts get smarter (and in some cases, just stingier) in their use of raw materials. And all bets are off if you increase productivity. That means you can use fewer workers, but maintain their pay levels. As Rodrik continues by discussing a paper by Broda and Romalis that found that trade with China reduced income inequality in the US. Huh? Per Rodrik:

The puzzle here, at least on the face of it, is that one would expect China’s trade to have had the largest price impact on labor-intensive goods. And if so, wages of unskilled workers must have fallen even more, along the lines of the Stolper-Samuelson logic sketched out above. Can we still say that trade with China has helped reduce U.S. inequality? The first thought that comes to mind is that Broda and Romalis are talking about consumer prices, and Stolper-Samuelson effects depend on changes in producer prices–i.e., prices of goods that are actually produced in the U.S. If nobody in the U.S. produces the garments and toys that China exports to the U.S., then it is conceivable that the relative price of labor-intensive goods will fall without hurting real wages. But then this is unlikely, given substitutability between Chinese- and U.S.-made goods. And indeed another paper, by Raphael Auer and Andreas Fischer, employs a clever technique to document a sizable negative impact on U.S. producer prices from trade with China and other labor-abundant countries. So the benign effect of Chinese exports, if any, is not due to the fact that the U.S. no longer competes head-to-head with that country in similar products. What gives? The Auer and Fischer paper underlines another important result. What lies behind the decline in U.S. producer prices in trade-affected sectors is not wage or other input price reductions but mostly increases in total factor productivity. So perhaps what is going is that the Stolper-Samuelson logic is defeated by increases in sectoral productivity induced by import competition. The mechanical link between prices and factor costs–which I appealed to above in the proof of the generalized S-S theorem–breaks down whenever there is productivity change. After all, if TFP increases, employers can afford to pay unchanged wages even if the prices they face decline.

So this is where the misdirection by Rattner is crucial. Until the 2000s, in every economic expansion, labor got the bulk of the increase in GDP, typically over 60%, via more jobs and increased pay. Post 2000, there was an astonishing change, a shift from labor share, which fell to below 30%, and a massive increase in corporate profits. In other words, there was huge shift away from labor to capital. This has little to do with globalization and much to do with the weakened bargaining power of US workers. As much as it has become fashionable to look down on unions (and their corruption and short-sightedness hasn’t helped), having well paid blue collar workers helped the negotiating position of non-unionized white collar employees.

Rattner also conveniently fails to discuss how the rapacious tendencies of private equity firms made matters worse. An unduly candid investor described the business model in Confidence Men: pile debt on the acquisitions, and if only one of ten made it (meaning survived!) you still made a good return for investors. So many companies in Europe have gone bankrupt thanks to the tender ministrations of PE pirates that the officialdom has read them the riot act. PE firms have to register, and they cannot either buy companies or raise money in the Eurozone unless the conform to regulations, which include strict limits on leverage.

Rattner argues in his piece that we should imitate Germany and focus on high skill manufacturing. But Germany’s population is roughly 1/4 ours and they already dominate certain niches. Rattner at the FT conference called for the US to start producing more engineers, which readers will laugh out of the room. Engineers don’t get paid enough for more people to want to seek out that career path; many of you have told me the only way to make a good living was to get another degree, like law, and go into another line of work.

And even if copying Germany might be a viable approach, it would take something like industrial policy to get there. Note the US already has industrial policy by default, with banks, the mortgage-industrial complex, military contractors, agriculture, and Big Pharma among the favored groups. But no, Rattner pooh-poohs the whole idea. Better to have industrial policy determined by lobbying effectiveness than a more thoughtful process:

The prospect of Washington lurching into the private sector is terrifying, as illustrated by the debacle of Solyndra, the solar energy company that failed with $535 million of taxpayer loans. While countries like China have put large resources behind industries they want to nurture, we should resist the temptation to plunge deeply into industrial policy.

I wish I had the space to discuss Solyndra in depth, but the sort form is that the failure of that deal is not an indictment of the overall program. If you are a VC investor, you expect a certain percentage (actually a pretty high percentage) to come a cropper. Solyndra was only a bit over 1% of the portfolio, and it appears to be the only loss. This looks like a classic “shit happens” deal failure: the investment looked sensible at the time, silicon prices collapsed, which had a direct, negative impact on competitiveness. Even so, a later-stage independent investor provided funding, which further confirms the original investment was not misguided (you’d get no rescue investors coming in if it looked like a hopeless turkey).

Rattner apparently missed a different Rodrik article, a Financial Times op ed, in which he warned:

If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens.

Yet an unfettered system is precisely what Rattner is promoting, no doubt because it works to his and his fellow rentiers’s advantage.