March 2012

A PUBLICATION OF CHILTON CAPITAL MANAGEMENT

W W W.CHILTONCAPITAL.COM

Creating a Useful Bubble

THE MIDDlE ClASS MAlAISE

Samuel Rines

t appears we may lose a generation. One of the most economical bifurcated, under-employed generations in the history of the U.S. is becoming increasingly aware of their situation. The Wall Street protestors, having yet to make a coherent policy statement, are rightfully concerned about the current trajectory of U.S. policies. They have a point without making a point. The largest financial institutions were bailed out--given a new, albeit less profitable and more regulated, existence. Many struggling middle class voters saw this as a Fed lifeline to homeowners. Only to discover solvent banks and underwater homes, neither a conclusion that provided direct assistance to them. The middle income homeowner was betrayed in two ways by the financial crisis. Droves were laidoff or asked to accept a decrease in wages. Data from the Social Security Administration shows the middle class in American faced a decade of stagnating real wages. Predatory loans and their issuers were sued by States Attorneys repeatedly for offering these loans. But, there was little action on behalf of those duped into the loans, except to continually call bankers irresponsible. Although some of this may change soon, platitudes do not encourage foreclosed homeowners. Normally, a recession would end with a small housing boom, partially picking the economy out of the negative spiral. Housing is not likely to be

booming in the near future, and its usual status as a leading indicator is somewhat disheartening. The oversupply of workers employed for a decade, or more, building single family homes will continue to feel mired in a downturn. Recessions end, but the consequences of labor shifts can last an exceedingly longtime. This is especially true when applied to the lower skilled labor brackets whose skill sets are not easily transferable to another profession. You can be an accountant in the oil industry, or technology, or wherever, but you can only be a construction laborer in construction. The usual economics theorizes that, given enough time, these workers will migrate or learn new skills or both. It is the dismal science. In no uncertain terms, the last decade of U.S. economic growth and success was built on a housing bubble. But, the housing bubble was only a side-effect of a much more ominous issue facing policy makers. How to keep a middle class employed and prosperous in the midst of a radically shifting economic backdrop? Countries in Western Europe faced the problem with mixed success. The question is actually difficult to articulate with more clarity, but effectively asks how society transitions from competitive manufacturing to a greater proportion of services and technology while furthering the innovative spirit. At the most fundamental level the question is simple: How does the U.S. remain a competitive economic power? The Samuel Slater Moment It will take time for China to become comparable in technology and other knowledge based industries. Frankly, they have not stolen enough technology from the developed world, yet. This

idea irks the American CEO, but it is not unprecedented in our own history. We forget that Samuel Slater, the Father of the American Industrial Revolution essentially stole the technology from England. It was illegal to export the plans for mills or factories, so he simply committed as much to memory as possible and bought passage in a boat to America. Rhode Island industry was the beneficiary of his ingenuity. Young economies steal technology to help them grow. China was not the first to pursue such a strategy. China and India, rightly, see a successful growth path in stealing or copying other nations intellectual property.

process has so far manifested itself in the form of basic theft. The U.S. must construct a way to be part of the potential growth in the Chinese consumer, without the technology being taken. The U.S. ability to partner with the Red Dragon, and success in spurring innovation, will be a challenge. Avoiding a Samuel Slater moment is going to be difficult, until policy makers are able to build a mutually beneficial system of technology trade. Before the Bubble The world started to change for the U.S. sometime in the 1970s. Domestic manufacturing became relatively expensive, and Mexico provided a simplistic, close to home, outsourcing boost. Downward pressure was placed, not only on wages, on actual employment in manufacturing, especially in the South. Eventually, the Cold War warmed and from it emerged a resource rich Russia and a dynamic, if inefficiently complex, Brazil. Mexico grew from the proximity and a symbiotic relationship with the U.S. Russias growth is struggling to reach the next level because of an autocratic strongman and oligarchic economic system. Brazil has stalled, unperformed its growth potential, and inf lation refuses to subside. Brazil has made it almost cost prohibitive for foreign investors to place capital into their markets. Mexico accelerated to a definitional middle income country, and promptly stayed mired in a constant state of going forward to go backwards. This is largely the consequence of a wealth destroying, in both monetary and human terms, war against drug cartels. India, at some point, became the go to location for outsourcing of call centers and low technology trade. However, Indian inf lation is proving difficult to anchor, and terrorism is becoming an ominous specter. The lesson? The developing world is finding it challenging to join the developed world. China appears to be the exception to the above examples of the developing worlds issues. There appears to be no slowing its eventual economic supremacy. However, growth was from a base of near zero. According to the U.S.s Economic Research Service, Chinese gross domestic product per capita was $148 in 1970, by 2010 per capita income was $2,807 in 2005 U.S. dollars (IMF says $5,184 in local dollars for 2011). Keep in mind that constructing historic GDP figures for China is near impossible. Beware of Bureaucrats bearing numbers. The figures, however

In no uncertain terms, the last decade of U.S. economic growth and success was built on a housing bubble. But, the housing bubble was only a side-effect of a much more ominous issue facing policy makers.
China is rapidly urbanizing, and probably in the mid-stages of housing bubble as developers react to the demand of villagers moving from subsistence existences to metropolis manufacturing. Urbanization is one of the reasons for the incredible growth rates China has consistently seen, and it will slow significantly. The rush to the city brought housing prices and the incentive to build massive inventories to incredible heights. The search for new growth paths will be a challenge as China loses the low cost producer tag to countries on its periphery (Vietnam, Cambodia) and even reshoring to the Southern U.S. The lesson to heed here is simple; move quickly and nimbly between economic growth sources. China will likely look inward to domestic sources of growth and advocate a mechanism for domestic consumption. As the gains from urbanization and a housing boom dissipate, China will attempt to slowly shift from an export oriented economy to domestic consumption. Chinas growth over the next 20 years will be reliant on a lack of direct exposure to the developed world. Hence, the need for China to grow its intellectual property and technology based domestic economy. This

untrustworthy, reveal a country that has yet to actually deal with the difficult growth pains. The U.S. took advantage of the growth in the developing world to find new and intriguing ways of growing their domestic exports, and outsourcing the less human capital intensive industries. This buoyed the bottom line of corporate America, and the Clinton era buzz-line was to restrain the export of jobs. Most of this was kindly overshadowed by the unprecedented internet bubble. A teenager with a computer could achieve the American Dream by programming almost anything. America had already made the transition from a manufacturing hub to a knowledge industry hub. But it was not exactly that simple. Those previously employed in manufacturing were largely never retrained for the new services and technology driven economy. Policy makers never grasped how rapidly the world economic food chain was shifting. Capital f lowed into China and Mexico to build factories with cheaper labor costs. Capital moves quickly, people are educated slowly, and this creates a labor mismatch. This remains a concern today as recent data releases from Regional Federal Reserves show gapping distortions between the skills employers require and potential employees have acquired, especially computer skills, for manufacturing. The U.S. did not quickly develop into a 21st century economy. In the late 90s and early 00s, the world had only begun to grasp the consequences of rapid capital movements with shifts in the global manufacturing food chain. logistics needed to catch up, and the results of the technology boom and bust were everywhere. Wall Street was hit by the precipitous decline in the NASDAQ Composite, and capital was wary of moving back into Silicon Valley startups. The remarkable rise of the internet and the limitless possibilities of changing our daily lives had crashed. But, the results of the bubble were not devastating for long. The economy found itself revived, and money f lowed again into new ventures and the creativity they fostered. The American Silicon Dream was anything but dead. The tragedy of the internet boom was labeling it a bubble. It was a good, useful, almost necessary bubble. The employment boom in technology and nascent internet companies may have driven wages to an excessive level and been painful for some after the bubble burst, but the job market rapidly recovered. To be precise, the job market for skilled, educated labor recovered quickly, and

American manufacturing continued its decline. The economic recovery was deemed jobless, not entirely accurate, but not fully a misconception either. In many ways, the bubble caused incentives to shift towards technology innovation and higher education. The information age came of age with a massive burst and incubated the stalwarts of the new economy. The bubble facilitated their rise. All of this fits together in a mess of confusion. Somewhere in the late 20th century, the world began to realign. Knowledge-less jobs were pushed offshore to boost bottom lines, and consumers found a bastion of cheap, in both cost and construction, goods. The proclivity to offshore, in the U.S. and Europe, lead to the rapid economic development of China and other offshore hubs. In the U.S., laborers struggled against a throng of much cheaper international labor and lost. However, there is only so much to offshore. Much of the offshoring boost China and India enjoyed over the past two decades is waning. China is beginning to deal with its own version of outsourcing to the cheaper, neighboring Vietnam. Unfortunately for the development of a Chinese middle class, the reason for the rise of China was not a long-term economic tailwind. Chinas competitive advantage was and is cheap labor, and when wage pressure begins to seep into the system, the jobs will begin to creep away. Building the Next Bubble The U.S. has an economic moat in technology and research, manufacture of high end goods, and knowledge intensive industries. This does not mean that the U.S. should no longer participate in the manufacture of goods. While the American automakers were struggling, Toyota, Hyundai, BMW and others were moving into the South to

To be precise, the job market for skilled, educated labor recovered quickly, and American manufacturing continued its decline.
take advantage of, after a decade of stagnation, reasonable wages and talented workers. American businesses are also finding their way back to the US. The reshoring effect is beginning to find some traction in corporate America, and giants of

industry are slowly starting to reconsider where to base their manufacturing operations. The middle class in America has suffered incredible wage lethargy, but the good news is the wages seem to again be competitive in the global economy. To understand how to build the next bubble, the schematics of the housing boom should be scrutinized. A host of unreasonable policies aimed at promoting housing, created a housing boom, and painful speculative consequences became apparent in the aftermath. The end result of the housing boom was devastating, not because it evolved into a speculative bubble. It was disastrous because of those affected. The middle class prospered with the increase in their housing investment. The roof over their head became increasingly valuable, and the ability to borrow and spend against this increase seemed never ending. A mixture of tax incentives, federal subsidization, and financial innovation combined to create a perfect storm of boom and bust. Politicians should be proud of their accomplishment. They effectively spurred a massive allocation of capital to a relatively unproductive sector of the economy over a long time horizon. The current set of policy makers should be able to repeat this process. Not with housing, but a subset of the economy that is competitive and exportable. By looking at the recent past experience with the housing and internet bubble, we can move forward with creating the next big boom. Commentators are

The end result of the housing boom was devastating, not because it evolved into a speculative bubble. It was disastrous because of those affected.
calling the current social media revolution a bubble, and they may be correct. But, Facebook and linkedIn would never spawn out of Chinas closed economy, and two companies and a Groupon do not constitute a bubble. Social media is a competitive advantage for the U.S. Hopefully, it will become a bubble. We may never return to having low-cost manufacturing, but we can compete in our ability to innovate freely. Our capital markets, however costly at points, are some of the most developed, and venture capital

is capable of taking an idea from nascent theory to commercial success. The U.S. needs to realize the world changed, and come up with a method of actually developing more than Silicon Valley and Route 128. Rewards still await those willing to bring technology to market. This needs to be communicated more effectively and encouraged more directly. There is no great rule against promoting a different picture of the future U.S. economy and articulating the great shift. Politicians have instead opted for infighting and incredibly complicated regulations. There is no problem with properly regulating the economy. But the uncertainty generated by incoherent policies, constant churning of opinions in Washington, and unwieldy regulatory outcomes will hamper the development and competitiveness of the economy. The inability of the U.S. Government to effectively legislate is evidenced by the perfectly ineffectual debt ceiling debate. At the turn of the 20th century, the U.S. was ahead of the curve with the philosophical notion of pragmatism. C.S. Peirce, John Dewey, and William James thought ideas should be applied to actual actions. The pragmatic ideal no longer applies to U.S. policies, economic or otherwise. A return to something similar to their thinking may be the best way for the U.S. to construct a set of policies that are coherent with the new economy. But, it is a pipe dream to believe Policy Makers and Politicians, not always the same, will take a pragmatic approach to creating a better education system to promote technological development and foster competitive advantage. After all, one of the consequences of increasing income inequality is a decline in effectiveness and fairness of the democratic process. Big money buys big toys. Political action would be a sacrifice of re-election chances for the actual benefit of their constituents. Pragmatic solutions to our problems are rendered literally impossible by the current bicameral bifurcation. The approach of fiscal stimulus towards unskilled labor is an erroneous long-term approach to creating a competitive and thriving U.S. economy. The reach backwards to the old economy is stif ling the possibilities for the future. We are genuinely talented at creating bubbles. Now, we need to begin spurring useful bubbles. Bubbles Matter Occupying Wall Street is a statementnot towards bankersabout the incoherence of

policy towards an economy of the future. If the U.S. were paying for the education of the future and could point our finger towards what we were trying to become, there would be no great complaint. Americans are acquainted with change and adjust remarkably well. However, there has been no consistent policy of fundamentally adjusting the economy to the 21st century. Instead, there is debate about ensuring jobs stay onshore, but never articulation concerning how to promote the next generation of innovation. The U.S. middle class feels left out, not solely due their wages stagnating, because there is nothing to stimulate the next generation of American dreams. Job creation is lacking because the U.S. has failed to appropriately incentivize education in competitive industries. The U.S. must formulate new bubble policies to spur the next great recovery, and maintain its place in the economic hierarchy of the world. China is nothing but a lower middle income, manufacturing hub that is beginning to lose its competitive edge. The U.S. needs to seize the moment. Otherwise, we could find ourselves falling into a spiral of looking backward, promoting old, less competitive industries, and fighting a trade war with China. There is no reason to fall into this spiral. China cannot compete with the U.S. in technology development and services. The U.S. is still an economic juggernaut, but we need to not keeping glancing backwards. By developing and promoting a strong future that refuses to look backwards, the U.S. can create prosperity for all income brackets, and have an answer to those who feel left behind. At some point in the economic development of every nation, there is a necessary economic transition from relatively low value manufacturing towards services and knowledge intensive industries. This is well known to economists, but obviously not policy makers. The fate of the U.S. economic and political hegemony rests on the understanding the world has changed, a creative economic bubble must be encouraged, and the confidence of the American people can be restored. The middle class in the U.S. may have been largely left behind economically in the past couple decades, but with time a new creative bubble can be formed. The emerging world would find it difficult to compete directly with an economy built around technology and innovation, and the next generation of dreams can be nurtured and the American middle class put back to work.

SAMUEl RINES is an a nalyst and Economist at chilton capital m anagEmEnt in houston, tExas. dirEct quEstions or commEnts to: srinEs @chiltoncapital .com ZACH BECK is thE E ditor of chilton currEnts and an opErations spEcialist at chilton capital m anagEmEnt in houston, tExas. for furthEr information on chilton capital m anagEmEnt stratEgiEs and sErvicEs, plEasE contact christophEr l. K napp, cKnapp@chiltoncapital .com for rEprints contact srinEs@chiltoncapital .com www.chiltoncapital .com/currEnts