SOTU: America's ‘Sputnik' Moment is a Sick Joke

In his State of the Union Address, President Obama dealt with a lot of major issues He offered a corporate tax cut, a retooling of the tax code and an end to pet spending projects. All good. The tax code has long been used as a political plaything by Washington's mounting corps of lobbyists and special interests, so it will be interesting to see how much resistance the President will encounter if he is serious about ending this insidious form of corporate welfare. The President also displayed his usual rhetorical flourishes, outlining what he called “a Sputnik moment” — a blueprint for spending in critical areas like education, high-speed rail, clean-energy technology and high-speed Internet to help the United States weather the impact of globalization and the challenge from emerging powers like China and India. “We need to out-innovate, outeducate and outbuild the rest of the world,” he said. He called the rising economic power of foreign competitors such as China and India “our generation's Sputnik moment”. What he was talking about was not just threats to U.S. jobs from emerging countries. He was talking about threats to the U.S. geopolitical position in the world. His proposals are a joke in the context of today's America. He gave priority to making the U.S. a leader in education. That may already be true at the level of higher education. But at the level of pre-college education the U.S. has fallen behind most countries in the world and keeps falling further. All the studies show that, especially in math and sciences, U.S. education performance is simply terrible. How do other countries outdo the U.S. in education? Through government intervention that allocates resources to the education process. After cutting taxes on upper incomes the U.S. Republicans, influenced by the Tea Party, want to reduce government support of education. Obama called for a doubling of U.S. exports by 2014. This is even more laughable. U.S. net business fixed investment is almost zero. Capacity has barely increased over the last three years. Our corporations choose to build new capacity in the foreign countries that are the big competitors to the U.S. in “our generation's Sputnik moment”. In China net business fixed investment is equal to two times that of Europe, Japan and the U.S. Net business fixed investment in the U.S. is the lowest of all four economic blocs. How is the U.S. going to increase its share in the global market for tradeables? It isn't as simple as the President indicates and, in any case, it's bad economic policy. It is becoming clear that not all countries can rely on exports to boost growth and employment; more than ever, they need to give greater attention to strengthening domestic demand. Competition in export markets often leads to domestic policy to keep wages and other costs low — both to fight the domestic inflation pressures (fueled in part by the processes just outlined) but, more importantly, to compete with other low wage developing nations. There's also a fallacy of composition argument. We can't all be exporting our output and China clearly has not evinced a comparable desire to turn into an "import superpower". The typical outcome of these dynamics is that the domestic population does not share in the economic growth that is generated by exports. Poverty and social unrest often worsens even as the economy grows. Is this really what the President wants? How has being an “export superpower” worked out for Japan the last 20 years? It is far better to increase a nation's competitiveness by taking the high wage-high productivity route as the Scandinavian countries have done. I'm not into the race to the bottom strategy – drive down employee morale and wages so that unit costs fall that way. It is the low productivity path and will never support significant increases in the real standards of living for the citizens. Obama once again identified the “green energy” sector as one slated for major expansion in the U.S. with a major contribution to future U.S. exports. Nothing could be more laughable. I have gone on and on about the growing Chinese dominance in solar power owing to Chinese government intervention in its industry. Consider the solar industry, which represents a perfect microcosm of the challenges the US now faces in regard to China. Beijing's command economy policy makers are piling subsidy on top of subsidy to make China's domestic market and domestic production the largest in the world. Its state-controlled banking system under government directive is financing capacity equal to a multiple of world demand on lending terms that make no sense for an industry with this much competition and flux. The Chinese solar industry has been able to drive down solar product prices to levels that are too competitive for the most automated U.S. producers using the most advanced technology. As a result, the U.S. solar industry, including Evergreen, upon which President Obama has placed such high hopes, is departing the U.S. for facilities elsewhere, including facilities joint ventured with favored Chinese companies. This encroachment by the Chinese into the global market for solar products is not occurring because China has especially low labor costs. It is not occurring because China has more advanced technology. It is occurring because China's command economy can force fixed investment in priority industries through a broad array of non-market means. Owing to depletion of China's well of underutilized rural labor, wage costs in China are now soaring. Sweat shop operators like Foxconn are looking to move their production platforms to lower wage economies. As a result, China is shifting its mega fixed investment more and more into higher tech industries, including capital goods industries. Armed with massive arrays of subsidies and a willingness to build unprofitable companies in order to reach the technological frontier and global market dominance, China is now entering a new phase in which its mercantilism threatens the last bastion of U.S. manufacturing expertise. Chinese objectives are as much geopolitical as they are economic. For the U.S., today's casualty is Evergreen Solar; tomorrow's may well be Boeing. That's the scale of the challenge we now face. Why is business fixed investment marginal in the U.S. and enormous in China? Because the U.S. private sector chooses to use its retained profits to build facilities abroad and buy in shares and pump up corporate stock prices. In China the government goes against the market and pushes vast amounts of resources into business fixed investment even if it's unprofitable in order to gain global market dominance. Obama called for investments in infrastructure. With government spending at the levels in the past U.S. infrastructure investment has been so low there's deterioration everywhere. Now the U.S. public has voted in the Tea Party which is going to constrict government spending at both the Federal level and indirectly at the state and local levels. Infrastructure cannot go unscathed. How does China build its infrastructure? With command economy mechanisms that have no regard for the market. That is how. Obama talks about the U.S. becoming a leader in high speed rail. It is preposterous that the President of the United States says such a thing. China now has 8500 kilometers of high speed rail. Europe has 6600 kilometers, and Japan has 2500 kilometers. The U.S. has a mere 360 kilometers. By 2013 China will have 20,000 kilometers of high speed rail. The increase between now and 2013 in the puny high speed rail system in the U.S. will be marginal. With such a massive high speed rail system China has the internal market to make the investments in the best high speed rail equipment in the world. China can outbid everyone in the global market for high speed rail systems. U.S. state and federal government budget restrictions will result in the U.S. purchasing all of its puny future high speed rail systems from the Chinese or other foreign suppliers. How do the Chinese do it? Through totally non-market means, which is an anathema to the U.S. political process. On one “sensible” Chinese high speed rail line from Beijing to Tianjin fares are set such that, even at 100% capacity utilization, this rail line will still be operating in the red. It is not possible to raise the fares because they are already so high that the population will choose lower fare ordinary rail service rather than high speed rail service. That's a “sensible” high speed rail link in China. The economics of the longer rail links into the interior are much worse. For example, a rail line from Wuhan to Guangzhou has a subsidized ticket price of 490 yuan. A passenger using the high speed rail line saves five hours compared to a conventional ticket which costs 400 yuan less. For the average Chinese the difference is equal to almost one week of salary. This rail line will be underutilized and, despite all kinds of subsidies, will also lose money. How do the Chinese build these rail lines? Through endless government intervention. The project is financed by China's Ministry of Railways and by local governments. The loans come from Chinese government directed commercial banks that provide loans at interest rates that do not reflect the financial risks. That is how. In the end all these uneconomic investments will create economic problems within China itself. But over the next few years China will make new incursions into higher tech more capital intensive global markets. None of Obama's goals will be approached. Rather the U.S. will fall ever further back in the global tradeables war. A trade war seems inevitable. The state of the union is not good. Marshall Auerback has 28 years of experience in the investment management business, and he is a senior fellow at the Roosevelt Institute. He is also an economic consultant to PIMCO, the world's largest bond fund management group. He writes a weekly column for Benzinga every Friday.