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Economics: Is America Losing the Edge?
New York: December 20, 2004
By John R. Stephenson

A favorite saying on Wall Street is that you never want to bet against America. The reason? Well, for at least fifty years, it would have been a losing trade. America has long been considered economic nirvana by the rest of the world. For more than fifty years the United States has maintained an economic edge by constantly innovating and by being better and faster than any other country at inventing and exploiting new technologies. As well, the country has fully developed capital markets, favorable income tax treatment, the rule of law, market-based decision making and a large and affluent middle class that is consumption oriented. The country is also blessed with great geography and a system that rewards initiative.

So what's the worry? For starters, our economic house is not in quite as good shape as it was fifty years ago. Although the U.S. still generates 21% of the world's gross domestic product with 4.5% of the population, we are doing that largely because of the willingness of overseas lenders (mainly Asia) to finance our consumption binge. With a federal budget deficit of 3.6% of gross domestic product and a trade deficit (imports minus exports) of almost 6%, we are reliant on the goodness of strangers for our economic well being.

But why is this a problem? It puts us in a pretty weak negotiating position. With half of all tradable government securities being held by foreign sources (central banks and others) who could at any time reduce their enthusiasm for our financial assets (treasury bills etc.) sending the U.S. dollar spiraling down and interest rates rocketing upward. To date, these foreign governments have been willing to play ball and have in essence engaged in a massive vendor financing operation. These underwriters of our economic boom have been willing to support our vast consumption and carry all the risks of our currency devaluing and the potential for financial loss from rising interest rates because they wanted to keep the wheels of industry turning. They have kept the wheels turning by keeping their own currencies weak and subsidizing the U.S. consumer, while at the same time, deferring their own consumption and building their industrial base, increasing the size of their labor forces and obtaining market share. In short, they have become stronger while we have become weaker.

The forces of globalization have decimated the U.S. manufacturing base with just 12% of the U.S. non-farm workforce being employed in the manufacturing sector. Of course, there is still the service sector. But services are a lot harder to export than finished manufactured goods and other countries are rapidly developing their own service industries. The U.S. federal government is enormously indebted with not only its budget and trade deficits but also its unfunded liabilities for healthcare and retirement obligations for older Americans. According to author Pete Peterson, these unfunded entitlements range "between $45 and 74 trillion when the collective net worth of the country is only $42 trillion." The result of too little savings, too much debt and too little productivity? Sagging employment. While the U.S. economy is supposed to be back on track (average annual economic growth of 3.5%) we have added only 1.2 million new jobs since the current economic expansion began in 2001. The new jobs added represent less than half the growth in the U.S. labor force over that same time period.

Many observers suggest that the key to future U.S. prosperity lies with new technological developments that will ensure our prosperity. The United States has been the undisputed leader in scientific discovery for most of this past century with the majority of information technology and biotechnology patents being held by U.S. firms. But this is starting to change. More and more research, patents and innovation is starting to come from China, Singapore, South Korea and Taiwan. Indian companies are now the second-largest (after the U.S.) producer of applications services in the world, developing, supplying, and managing databases and other types of software for clients around the world. South Korea has made huge inroads in both the telecommunications area and in the manufacturing of computer chips. Through competitive tax policies, increased investment in research and development and government policies that favor science and technology personnel, Asian governments are improving the quality of their science and ensuring that they will be able to exploit future innovations.

In order to retain its leadership position, the United States must get better at fostering technological entrepreneurship at home. Yet U.S. government expenditures on R&D, while substantial ($132 billion in 2005), will be concentrated in the fields of defense, homeland security, and the space program. As well, privately funded industrial R&D, which accounts for over 60 percent of the U.S. total is also starting to slip as a result of the current economic slowdown. Private industry cut R&D spending by 1.7 percent in 2001, 4.5 percent in 2002, and 0.7 percent in 2003 -this at a time when 38% of all U.S. scientists and engineers holding doctorate degrees were born outside of the country. Many of these highly educated foreign students are now heading home or avoiding the U.S. altogether in part because of the booming economies at home and also because of the visa restrictions put in place after the terrorist attacks of September 11.

Figure 1: Global Growth Rates

Source: Morgan Stanley Research

So strong has been the push of Asian countries into the technologies that once were dominated by American firms that Craig Barrett of Intel has said that the Chinese are now "capable of doing any engineering, any software job, any managerial job that people in the United States are capable of." Companies such as Microsoft are increasingly turning to Indian companies such as Infosys and Satyam to not only do simple coding but also for more advanced software architectures. As the Asian countries continue to move from labor-intensive manufacturing to promoting technological innovation, they are increasing the expenditure on research and development for these areas. Japan and South Korea each currently spend 3 percent of GDP on R&D (compared to 2.7 percent in the U.S.) and China is trying to target 1.5% in 2005 (up from 0.6% in 1996). Asian countries are trying to take the lead in three technological areas that hold the most promise for the next wave of innovation: biotechnology, nanotechnology and information technology.

In order to ensure their growth in these technology areas, Asian countries are doing far more than dumping money into research and development. They are shifting from a top-down, state run approach to technology development to a more flexible, market-oriented approach that fosters innovation and entrepreneurship. As well, local governments are creating clusters of technology start-ups by using tax, education and fiscal policies more effectively. This is important because new firms are likely to be drawn to technology hubs that provide the concentration of ideas, talent and capital to fuel future growth.

America still dominates the world in the areas of technology development, but Asia is closing the gap quickly. Technology has been the driving force of world economic growth for the last twenty-five years and if Asia can establish the same sort of dominance in technology as they have in production, then things could look bleak for America. But America has many strengths that will be difficult to overcome. First and foremost the culture is one of Entrepreneurship with virtually no social barriers to success. There is a lot of available capital to finance ideas and ideas can be brought to market very quickly. As well, America is a land of immigrants which keeps the population base relatively young in contrast to the aging populations of Europe and Japan. While the era of American domination is not over yet, it certainly is somewhat less assured.


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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