Cheap isn’t Evil: Evil is Evil

China, Poverty, and A Framework for Practical Ethical Sourcing

Discussions of ethical sourcing tend to be very narrow, which is a problem because the ethics of production sourcing operate very differently in the macro versus the micro. On the micro, we obviously have a preference for sending business to factories that pay good wages, offer benefits, etc., but on the macro the competitive pricing of impoverished geographies with cheap labor attracts money that lifts entire populations out of poverty.

(Using 2011 PPP dollars, data sources at end)

To illustrate this point, I’m going to walk through bare-bones of how farsighted policymakers in China and global demand (especially US demand) for cheap production from 1990–2014 combined to form the largest movement of human beings out of poverty in history. Then, I want to briefly discuss how to merge the macro and micro picture of sourcing ethics to form a framework that I think leaves two routes for companies to approach “practical ethical sourcing”.

Macro Ethics: What China Did

Here’s a very simplistic account of what happened with China since 1990. The competitive advantage of cheap labor and production allowed Chinese businesses to grow massively, selling to other countries who outsourced their production to Chinese factories. This created a positive trade balance (how much more a country exports than it imports), which meant a large positive “current account” for China (trade balance plus a few other metrics of income from other countries).

Generally speaking, this kind of competitive advantage erodes in two ways:

Your currency gets more expensive, which raises production costs in foreign currency terms. This happens because exporters are selling goods in large quantities to foreign countries (let’s use US entities as the base case here). Those exporters get dollars for their goods, and then have to buy yuan with those dollars to pay production costs in China. Basically this means a whole lot of dollars being sold to buy yuan, pushing the price of the yuan up. Wages rise. This happens because export businesses see such good demand that they keep cropping up and keep hiring until all the cheap labor is basically hired, and then they start pricing the labor more competitively with each other and driving up labor costs (wages). Basically more demand for workers in China means higher wages in China.

Chinese policy makers knew this was going to happen, and thought “we don’t want a strong currency, we want a middle class,” so they began offsetting the upward pressure on the yuan by accumulating reserves — mostly dollar reserves. This meant that rather than being eroded through currency appreciation, the competitive advantage would be eroded through increasing wages (see “Appreciation Note” at end).

So how does this work? The Chinese government needs to sell a lot of yuan for dollars — enough to counter the buying pressure from all the export income being used to buy yuan.

The way this mechanically works is the Chinese government goes out and buys enough US government bonds to offset the the massive inflow. They sell yuan for dollars to buy US bonds, and the yuan stays flat against the dollar instead of rising. The Chinese government can make as much yuan as they want, so there’s no reason to bet that they’d run out of yuan to sell.

You’ll notice a few things in the chart below: the overall scale of both grows massively over the time period, and they grow roughly in line with each-other as reserve purchases offset the current account income. The reserve accumulation here is outpacing current account inflows in part because there are additional pressures to offset at times (foreign investment), and in part because I’m proxying it with an imperfect solution that will capture some appreciation of the reserves (see “Analytics Note” at end for explanations of this and some other important analytical choices like why this isn’t in GDP terms, etc.). You’ll also notice the picture gets a little messy in the post-crisis period, which makes sense as global demand constricted and capital flows got kind of wack.

(Data sources at the end)

In the early nineties, the Chinese government had unified the swap and official exchange rate, creating a 33% devaluation overnight, and then began to directly intervene in the currency’s value. Because the government was buying dollars (selling yuan) at the same rate that the exporters (and others) were buying yuan (selling dollars) the yuan avoided rapid appreciation. Instead, they allowed it to just make slow and steady gains over time.

(Data sources at the end)

The impact of this was that China retained a competitive advantage in the export market for longer than it otherwise would, and the advantage would only erode through rising wages. As continued demand for cheap production meant expansion of production facilities, new jobs, and demand for workers, wage competition took over and started to improve the income of Chinese workers.

(Data sources at the end)

This wage increase means more money every month for a previously impoverished segment of the world population — a massive impact in terms of human well-being.

(Using 2011 PPP dollars, data sources at end)

Nothing like that, on that sort of scale, has ever happened. But, things like that do happen on smaller scales in smaller countries all the time when competitive export pricing allows them to increase their wealth through global export markets and policymakers make good choices.

If you care about wealth inequality in a global sense, and about redistribution of wealth to poorer nations, then a lot of good is done by globalization of supply chains and demand for cheap labor (to the degree that this can ultimately translate to higher wages over time). Market dynamics distributing demand to geographies with cheap production can lift entire populations out of poverty. Today, the countries this most aptly applies to are the cohort of Bangladesh, Sri Lanka, etc.

Does this justify human rights violations?

No. It does not.

Were early industrial revolution coal mining towns that verged on slave labor “fair game” because they increased the wealth of the population over a few generations?

No.

That macro picture is all well and good, but as individuals who are decision-makers on these things, we have our own moral obligation to maintain a threshold of ethical treatment regardless of the optimization of profits. Pay attention to what your factories do, of course, and don’t work with people who dehumanize their workers.

The take-away of the macro picture is just this:

Cheap isn’t evil. Evil is evil.

So, how do we resolve this macro picture with obvious micro-ethical factors as we decide how to support better working conditions and avoid flagrant exploitation?

Practical Ethical Sourcing and Where you Have Impact

Despite the example above, you are not doing the world any particular positive good by choosing cheap factories. Unless you are in charge of manufacturing for a massive company that is a driver of the global market, your choices don’t move the needle on this dynamic. Whether or not you outsource your factory to a poorer country with cheaper labor, those large orders that do have an impact are driven by publicly traded companies whose decision makers, while not actually legally bound to maximize profitability, generally only have their job if they continue to do so. Demand will funnel to cheap production.

Does that mean that your choices have no impact at all?

No not necessarily.

To synthesize: there are functionally two ways to run a good, impactful business with “Practical Ethical Sourcing”:

Version 1: Go with a competitive production option, and make sure between comparably costed options you pick one that doesn’t have specific practices you find unacceptable (i.e. meets your threshold criteria for ethical practices). For example — refuse to work with factories that employ child labor (and make your own list of other practices you won’t tolerate). This is where most businesses who are primarily focused on product and producing value for customers, but also want to maintain ethical standards they are comfortable with, should operate. There is already pressure against most of the worst manufacturing processes, and by consciously avoiding giving evil factories your business you can participate in the process of “starving them out” of the global export market. You are having an impact through who you don’t give money to.

Version 2: Give your production orders to someone so ethically focused and otherwise non-competitive that orders coming from you are a needle-mover on their probability of survival. To really work it has to be the primary focus of your business and brand, such that you can target your branding materials toward the audience who is willing to spend the premium to cover the additional cost of your “super-ethical” production (or else it isn’t sustainable as a business). The basis of the impact here relies on the fact that the factory is uncompetitive outside of a willingness to pay an ethical premium, so you probably need to be non-competitively priced for retail to maintain margins — which means finding the consumers willing to pay that premium. As an example: T-shirts made form recycled tired tires might not be the best Ts, or the cheapest, but you can make it your business to find the people willing to buy them and generate income for the people who make them. You are having an impact by who you do give money to.

It’s usually a problem if a business is falling somewhere in the spectrum between Version 1 and Version 2. They run the risk of either being

More about storytelling than impact — maybe they advertise the fact that they produce in a high-wage geography (as though that is necessarily morally superior) or generally inflate the benefits of insignificant production choices (a lot of B Corps are like this; I’m considering writing an article about B Corps and how little that means), or A bad business that won’t sustain itself, and therefore wont have lasting impact — maybe they are trying to sell products with expensive, alternative, hyper-ethical production processes at competitive retail prices to the general market (possibly, in that case, funding a good brand and broken unit economics with VC money that will inevitably run out).

At r/MeritStore, we’re thinking through these problems in real time as we make sourcing decisions. For us, we think the best way is to set an ethical standard of practices we are unwilling to participate in, and then within those reasonable constraints source cost effective production. Looking at factories, we aren’t throwing out certain options simply because the wages there are low compared to the US.

We plan to make sure that we’re ethically comfortable with the factories we use to produce — for our own sake. We want to make a good business that brings great value to our consumers, and doesn’t compromise our ethics. I hope anyone interested in assessing the ethical promise of brands found value in this perspective, and I especially hope it is useful to anyone out there who is trying to navigate their own production sourcing decisions.

I know that this perspective doesn’t harmonize with some of the ethical “ra-ra”ing around certain brands. I’m trying to think this through with data, basic principles, and an eye towards the practical realities of running a business. I would love to hear your thoughts.

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If you’re interested, come join the discussion at r/MeritStore or pre-order our second version of the banded shirt at www.merit.store

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Data Sources:

https://www.ceicdata.com/en/indicator/china/gdp-per-capita

http://povertydata.worldbank.org/poverty/country/CHN

https://www.theglobaleconomy.com/China/

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Appreciation Note: You can make the contention that an rising yuan is equivalent to increasing wages, but in effect that is only true to the degree that the wage-earner is buying imports. Wage inflation through a tight labor market more effectively redistributes income share from business owners to workers, while currency appreciation simply has a deflationary impact through diminished import costs (and probably a more positive impact on large holders of Yuan denominated assets who are already wealthy enough to spend abroad).

Analytics Note: (1) I’m using YoY change in FX reserves incl. Gold as my “Reserve Accumulation”. This is not a perfect approximation of the flow I would ideally use (reserve purchases) because of reserve asset (especially non-dollar reserve asset) price movements. I think it’s a reasonable enough proxy for the purposes of this post. (2) I also don’t mean to totally ignore other flows and pressures, but won’t do the full balance of payments analysis needed to paint the whole picture — in this case most notably the rest of the capital account. It would only be to demonstrate why these are the important flows I’m talking about. I fear losing the reader’s interest going through why a bunch of other things aren’t the important thing. (3) In this case not doing in GDP terms because I also want to get across the point that the whole scale of the current account and the reserve accumulation is growing. (4) If anyone here has done BoP analysis they’re probably foaming about the fact that the outflows aren’t negative. I thought that might confuse some people, so I didn’t do it. (5) I’m focusing on 1990–2015 because in 2015 some of this dynamic shifted, as there was enough pressure of wealthy folks moving money out of china that the government actually started to sell some reserves (and devalued the yuan 1.5%). The fact that enough people in China had enough money to cause problems with outflows (as well as bust up some real estate markets like Vancouver and Sydney) actually shows that the policy worked.