×

Can Donald Trump stop jobs going to Mexico? Indiana is a key test case

Jabin Botsford | The Washington Post | Getty Images

Working over the Thanksgiving weekend to keep 1,400 jobs from leaving Indiana for lower-cost production sites in Mexico, President-elect Donald Trump has begun his difficult mission to revive the sluggish economy and to stem America's soaring foreign debt.

The jobs at Carrier Corp. are on the way to Mexico because the company concluded that it could not stay competitive and reward its shareholders unless it took advantage of lower production costs south of the border. Things are as simple as that, and the man who made billions of dollars in his businesses needs no coaching in cost accounting.

But this particular case raises much broader economic policy issues the incoming administration will have to address with the same sense of urgency showed by America's new chief executive.

So, let's see how this nickels-and-dimes story leads to core problems of American economic growth.

Here are the key variables to consider. Profits – revenues minus costs – are the central issue in Carrier's case. Revenues are a product of prices times the quantity of goods (or services) sold. Costs consist of labor compensation, non-wage costs, materials used in the production process and various other items.

Productivity is a cost killer

Mexico beacons because of its lower labor costs – an outlay that generally represents three-quarters of all production costs, and possibly much more in highly labor-intensive industries.

The counter-intuitive idea is that Indiana could still beat Mexico. How? Easy, because hourly wage and non-wage labor costs can be offset by higher labor productivity – a simple concept (but a black box for economic theorists) that measures how many units of a given product (or service) a worker produces per hour. That difference(labor costs minus productivity) is called a labor cost per unit of output and serves as a dominant variable in the profit equation of revenues minus costs.

To illustrate the point, here is what a great star of the business world had to say about that.

Some years ago, when China and a few other places in East Asia were the promised land of cheap manufacturing, a famous "cost and keiretsu killer" is reported to have said that it was still more profitable for him to produce cars in Japan. That was possible, the story went, because it took much less time for a highly trained Japanese labor force, working with sophisticated technology, to turn out a product of superior quality. In other words, higher productivity gains were (a) offsetting the enormous wage differential, (b)protecting the pricing power and (c) generating a profit.

The message was not lost on China. Cheap sweatshops were no longer to be the mainstay of the world's manufacturing hub. China's beaming Prime Minister Li Keqiang could be seen standing next to the German Chancellor Angela Merkel extolling the Sino-German "Dream Team." Beijing was working with Berlin to replace its primitive smokestack factories with the state-of-the(German) art, IT-driven manufacturing processes.

You can easily imagine how many more widgets these gleaming new factory floors could produce per unit of labor input, compared to low-cost sweatshops. That's smart and sustainable cost-cutting and profit generation through productivity growth.

But all that was not a manna magic bestowed upon the Celestial by technology transfers from eager German traders. China had to leap into the world of best-practice manufacturing, and to train its labor force to operate complex production management techniques.

Heed the Sino-German lesson

And, speaking of Germany, here is another example. Germany became the world's export champion even though the revered Deutsche mark kept soaring from 4.17 to 1.76 per dollar between 1960 and 1998 (the euro was launched on January 1, 1999), while the sloppy cost and product management in other European countries was causing unending devaluations and financial crises.

To this day, Germany remains an export powerhouse, with $300 billion in annual trade surpluses (a whopping 9 percent of GDP), on account of productivity gains, product innovation and rigorous cost management.

That's intriguing, isn't it? One wonders what would happen if Carrier upgraded its technology, came down on its costs and retrained its labor force.

That would be just a tiny piece of a broad policy action Mr.Trump needs to rev up the economy from a lethargic 1.5 percent growth rate in the first three quarters of this year – a sharp slowdown from a 2.8 percent growth in the same period of 2015.

Surely, a quick boost to economic growth is technically possible, but that would just be a flash in the pan. Why? Because even at a slow pace of 1.5 percent the economy is bumping against physical limits to growth. As a result, the core inflation rate of consumer prices is pushing well beyond 2 percent and, more importantly, unit labor costs (aka, a floor to general price inflation) are accelerating to 2.4 percent.

The question is: How do we remove that speed bump, or, if you prefer, how do we relax that binding policy constraint?

The answer is: We need to revive and accelerate productivity growth. That is how the Carrier's problem becomes emblematic for the economy as a whole.

A faster productivity growth would push out the current limits to labor and (physical) capital resources, and it would lead to the increasing potential (and noninflationary) growth of the economy. The economy could then run faster and create more jobs in an environment of price stability, generally defined as an inflation rate of 0-2 percent.

That's a far cry from what we have now. Over the last five years, the potential growth rate has been estimated at about 1.6 percent, almost exactly one-half of the average growth potential recorded during the 1990s, and well below the 2.3 percent rate in the first ten years of this century.

And here is what the incoming administration has to work with: There was zero growth of labor productivity in the nonfarm business sector during the first nine months of this year. Over the same period, the labor force growth was about 1.6 percent.

Taking the sum of labor productivity and labor force growth gives a rough approximation to the economy's growth potential. That sum shows that the new economic strategists are looking at a noninflationary growth limit of 1.6 percent.

Investment thoughts

The Fed is poised to begin an overdue process of monetary tightening to safeguard price stability. The speed limits to economic growth are so low that unit labor costs and consumer prices are accelerating despite the slowing pace of aggregate demand.

Bond prices are falling on prospects of the Fed's action and on expectations of a substantial fiscal easing by the next administration. The costs of consumer credit and mortgage finance are rising. That is hitting nearly 80 percent of the economy, consisting of private consumption, housing and some segments of business investments. The upshot is that the planned fiscal stimulus could be substantially offset, or completely erased, by the slowing interest-sensitive GDP components.

Mr. Trump can do a lot to improve the business climate by adjusting the corporate tax system and by evening out the playing field for American companies in overseas markets. But he may also wish to remind the captains of U.S. industries that it would be better to generate profits through productivity growth (i.e., technological advances with a highly trained labor force) and a rigorous cost management instead of relying on price hikes and off-shoring.

The Carrier's operation in Indiana could be a significant test case of such a policy.

Investors should be watching that and rooting for Indiana. If Mr. Trump can help to keep profitable businesses and viable jobs at home, he would greatly increase his negotiating leverage with countries that are currently living off their huge trade surpluses with the United States.

Follow CNBC International on Twitter and Facebook. For more insight from CNBC contributors, follow @CNBCopinion on Twitter.