Headcount Cuts vs. Compensation Cuts

California is on track to have 2.0 million people working for state and local government. According to 2008 U.S. Census data (ref. 2008 Public Employment Data, Local, and 2008 Public Employment Data, State) there are 1.85 million non-federal government workers in California today. It is becoming increasingly understood by voters and policymakers that a worker’s compensation is not adequately measured simply by referencing their annual salary or total annual wages. Overtime, sick time and vacation time payouts, health benefits, preferred access and rates for loans and insurance, transportation reimbursements, and more, are all examples of current year compensation that belong in any properly compiled estimate of a worker’s total annual compensation. And a heretofore arcane yet huge component of any worker’s total annual compensation is the current year funding requirements for future benefits – such as their retirement pension and their retirement health benefits.

In an analysis posted earlier this year entitled “California’s Personnel Costs,” the average total compensation for state and local government employees in California was estimated at $94K per year. In reality we feel this amount is still significantly lower than the true average because (1) public employee retirement pension funds are below the asset value necessary to ensure long-term solvency and therefore current-year payments into them on behalf of public employees will need to be further increased, and (2) assigning a value of $10K per year for the average current benefit package is probably too low, particularly when you take into account the extra vacation, other paid time off, and other reimbursements afforded public sector employees, and (3) the analysis did not take into account current-year funding requirements for any supplemental retirement health benefits. For these reasons, the default assumption on the interactive spreadsheet table below is an average total compensation for California’s state and local employees of $120K per year.

In the analysis below, the input assumptions are highlighted in yellow. These assumptions can be changed by any viewer, simply by clicking the cursor onto one of the yellow input cells and changing the number in the cell, then hitting the “Tab” key. The entire table will recalculate.

As the table is currently configured, 2.0 million workers making $120K per year would cost $240 billion per year – which is roughly 50% of California’s total state and local budgets combined. The remaining two assumptions on the spreadsheet allow the user to input percentage reduction scenarios both for the number of workers and the amount of average annual compensation. As can be seen, a 20% reduction to both the number of workers, as well as to the rate of compensation for the remaining workers, yields a total reduction of 36%, or $86 billion per year. This scenario is what I would like to call California’s “20% Solution.”

(enter new quantities in any yellow cell; to calculate, click cursor within any yellow cell, then move cursor off cell and click again)

If you consider what a solution like this would entail, it is important to note the cost should not include any draconian cuts to services, nor to the viability of earnings to employees who keep their jobs. Since most public employees have been getting nearly every Friday off, a 20% workforce reduction would simply mean that the remaining workers would have to work five days a week again. Reducing their generous holiday and vacation allotments incrementally – certainly not by 20% – would serve to easily build up worker attendance to a level sufficient to guarantee ongoing government services at the level they’ve been traditionally available.

Similarly, the 20% solution makes a reduction to compensation packages relatively easy to attain. Since public sector workers have already seen their direct compensation cut by virtue of getting nearly every Friday off without pay, all that is necessary is to put them back onto a full-time schedule without increasing their pay proportionally, then cut back on their benefits – current and future – enough to achieve the full 20% reduction in total compensation. The only area where a genuine hardship is inflicted is in the case of the workers who are laid off, which would be nearly 400,000 state and local government workers. But the question must be asked – if our state and local governments can continue to function with the actual labor hours lowered by one day per week – as the furlough Fridays has proven – then why should taxpayers continue to support these unnecessary jobs?

Using this interactive spreadsheet, however, one may input any variables they wish. Suppose you wanted to save $86 billion per year but didn’t want to lay anyone off? Then lower every state worker’s total compensation by 36% and you accomplish an identical level of savings. And you still have an average public employee compensation set at $77K per year, which is pretty good. For example, if you simply required public sector employees to collect social security and medicare instead of providing them pensions and supplemental retirement health care (that ordinary taxpayers have to become millionaires to ever hope to match), you could probably afford these reductions with NO reduction to any public employee’s current compensation. Alternatively, of course, some departments could be privatized, or eliminated selectively, ameliorating the hardship of headcount and compensation reductions elsewhere in the public workforce.

The value of an interactive spreadsheet is it defines and quantifies the immutability of the constraints we’re under. State and local governments have borrowed as much money as it is financially feasible for them to borrow. The Federal government can still borrow money to bail out the state and local governments, but that, too, is financially unsustainable and is encountering increasing resistance from concerned taxpayers. And speaking of taxes, it is ridiculous and futile to think California’s private sector workers are going to accept more taxes when Californians are already one of the most taxed states in the U.S., just so their public sector counterparts can continue to enjoy compensation packages that are, on average, at least twice as lucrative as these taxpayer’s own earnings in the competitive private sector. The choice is reduced to two hard variables – total headcount and average compensation. Hopefully these painful reductions will be made with humanity and wisdom.

U.S. Senate to Force Unionization of Police?

Within the next few days the U.S. Senate may consider Senate Bill 3194, the “Public Safety Employer-Employee Cooperation Act,” that will require states to grant collective bargaining rights for all public safety workers, including police, firefighters and emergency medical workers.

Residents of California have had a front row seat to witness the consequences of allowing unrestricted collective bargaining by public employees. It is increasingly arguable that the root cause of many of California’s most serious problems – the insolvency of the State and most local governments, and the mediocre public school system, to name two big ones – are because of the influence of public sector unions. And public sector union control over California’s State government, which most insiders will acknowledge is “absolute,” is matched by union control over California’s county and city governments. Now we’re going to export California’s problems with public sector unions to the rest of the United States?

A report written by Kris Maher for the June 17th, 2010 Wall Street Journal entitled “Bill Gives Public Workers Clout,” quotes the Executive Director of the 325,000 member National Fraternal Order of Police, Jim Pasco, who said “unions wouldn’t be able to negotiate wages and benefits that governments couldn’t afford.” It’s interesting to wonder how Pasco can justify this statement, because if history is any indication, the opposite is going to happen.

As documented in “The Price of Public Safety,” in California, it is already common to see public safety workers earn, on average, over $200K per year in total compensation. Much of this compensation has to be used to meet current year funding requirements for their future pensions, because these pension funds today are almost universally insolvent. California’s local government entities are cutting virtually all other government services, including road maintenance, libraries, and public health programs, in order to free up enough money to pay compensation and benefits for their public safety workers.

The fiscal crisis facing public sector entities isn’t merely because of unsustainable compensation and benefits being paid to public safety workers, however, it only begins there. Once the other public sector employees see the political clout and the financial compensation the police and firefighters are acquiring, they too will unionize, even if they haven’t already. At this point you are set to experience California’s plight – where nearly every government employee is overpaid, and consequently nearly every government institution in California is facing possible bankruptcy.

Without a strong set of regulatory checks, allowing public sector workers to unionize creates an unfair political environment, where public employee unions collect mandatory dues – paid for by taxpayers – to amass literally hundreds of millions of dollars to use for political activity. Public employee unions routinely outspend fiscal conservative reformers by ratios of 5-to-1, or even 10-to-1, or more, essentially using taxpayer’s money to advance their agenda, which is bigger and bigger government to create more union jobs, and higher and higher rates of compensation for unionized government employees. Unionized government results in government employees, through their unions, purchasing our elections and hence our elected officials, who then decide on policy matters affecting the compensation and benefits paid to government employees. For this reason, and for the reasons stated below, national legislation should aim at reforming public sector unions, not expanding them.

Why unionization of government workers is a threat to the solvency of America’s Federal, State and local governments, as well as a corrupting influence on the democratic process:

  • Civil service protections already available to government employees make union membership redundant.
  • Government employee unions collect membership dues, funded by taxpayers, and use it for political activity without the consent of the taxpayers and often without the consent of the individual government workers.
  • The automatic transfer of taxpayer funds – via membership dues – into union coffers gives public sector unions an unfair financial advantage in political campaigns.
  • Public sector unions have used their ability to buy elections and control politicians to negotiate financially unsustainable, over-market rates of compensation for public employees.
  • The effectiveness of public agencies has been compromised by work-rules negotiated by unions that prevent, for example, efficient allocation of worker hours or ability to terminate incompetent employees.
  • Private sector unions must, ultimately, negotiate in good faith with their companies, or they will destroy the competitiveness of the company. Public sector unions have no such constraint – and the results are already clear – unprecedented government deficits and debt.

Most everyone respects and appreciates the services performed by public employees, especially those working in public safety. Calling for reform of public sector unions is not personal, it a matter of restoring fiscal sustainability and the integrity of our democratic institutions. Moreover, concern over the unique dangers public sector unions present is not to take issue with unions in the private sector, which at least operate in a somewhat self-regulating environment. Finally, concern over the excessive power of public sector unions does not necessarily equate to an excessively libertarian ideology – many of us would like to see more government investment in our economy. But currently much of our federal deficit spending is being wasted to pay grossly over-market wages to government employees instead of being used for strategic investments that will yield long-term returns to society, such as scientific research, upgraded infrastructure, and military security.

Whether or not unions should be allowed to operate at all in the public sector is debatable. But at the least, if unions are going to be permitted to organize public employees, there should be curbs on their ability to (1) compel any public employee to join a union against their wishes, and (2) compel any public employee to allow any portion of their union dues to be used for political activity against their wishes. Unless checks of this sort, at the least, are part of the package, Senate Bill 3194 is a very bad idea.

The Price of Public Safety

There is nothing wrong with paying a premium to public safety personnel because of the risks they take. And while it is true there are other career choices that are riskier than public safety jobs, and while it is also true that on average, public safety personnel in California – according to CalPERS own actuarial data – have life expectancies that are virtually the same as the rest of us, it is still appropriate to pay public safety personnel a premium. After all, we never know when these people may stand on the front lines when something extraordinary happens – such as what occurred in New York City on Sept. 11th, 2001. People who work in public safety live with this knowledge every day, and they should be compensated appropriately for that.

The question is how much of a premium is appropriate, and how much of a premium can we afford as a society? Should a fire fighter make more than a medical doctor? Should a police officer make more than an engineer?

In order to get an idea of what public safety employees in California actually make, I obtained a roster that showed the total compensation paid to each employee of a Southern California city. Out of respect for the employees noted on this roster, I won’t identify the city, much less reveal the names of these individuals. And it is fair to state this city probably has a median income somewhat higher than the average for California. It would certainly be interesting as follow-up to obtain this sort of information for other California cities. But even taking all of these factors into consideration, the amounts these folks are making is startling – particularly when you adjust for realistic current year funding obligations for future retirement health and pension benefits.

In our example city, using actual data, the fire department has about 100 full time positions. The average annual compensation for these firefighters, if you include current benefits and current funding for future benefits, is $179K per year. But it doesn’t end there, because the pension funding percentage is calculated at 34% of earnings. As argued in “Maintaining Pension Solvency,” if you calculate pension funding requirements for a safety employee in California based on after-inflation returns of 3.0% instead of CalPERS official rate of 4.75%, you need to increase the pension withholding as a percent of payroll by 20%! Making this adjustment yields an average firefighter compensation of $202K per year. And even this figure probably fails to adequately account for current funding requirements for future supplemental retirement health benefits.

For our example city’s police department, using actual data, the police department has about 150 full time positions. The average annual compensation for these police officers, if you include current benefits and current funding for future benefits, is $174K per year. If you increase the pension withholding percentage by 20%, in order to reflect realistic rates of future pension fund returns, you will calculate an average police officer compensation of $197K per year – again, probably not including enough to fund future supplemental retirement health benefits.

It is important to emphasize these amounts – roughly $200K per year each – are not for senior management, or even senior employees. This is the average, taking into account entry level public safety employees as well as senior public safety employees.

It is interesting to note what the rest of the employees, the non-safety personnel, make in our sample city – making the same adjustments, their total compensation averages $118K per year. That is still quite a bit, considering many of these jobs are relatively unskilled. To put this in perspective, the average private sector worker in California averages $40K per year in compensation – one third what the non-safety workers average in our sample city.

Should a non-safety local public employee workforce, one including a large percentage of relatively unskilled positions, have an average compensation per employee of $118K per year? Should safety employees make, on average, $200K per year? Can we afford this?

What is clear over the past several years is that as pay stagnated in the private sector, public sector employees continued to receive regular cost-of-living increases. Over the past 10-15 years, public employees also received dramatic increases to their retirement benefits. And as housing prices soared, millions of Californians borrowed against their home equity, and many of them are now paying dearly for that mistake. There are undoubtedly many public sector employees who were caught up in the borrowing frenzy, and are now on the edge financially – but it is fair to wonder why they should be immune from the same cutbacks that have left so many people in the private sector unemployed, or under-employed, or compensated at rates that are a fraction of what they were during the bubble booms.

It is also fair to wonder why public sector employees should not be obligated to plan and prepare and save, if they want a comfortable retirement. For non-safety personnel in public service, it is fair to wonder – since they now make more, not less, than private sector workers for similar work requiring similar skills – why in their retirement they shouldn’t simply collect social security and medicare like the rest of us. And even if public safety employees should collect something better than social security in recognition of their role as first responders, it is fair to wonder why their retirement pensions should be literally five times more than the social security payments due retired private sector workers with similar salary histories. As documented in “Funding Social Security vs. Public Sector Pensions,” the fiscal crisis facing social security is trivial and easily solved, whereas the fiscal crisis facing public sector pensions is catastrophic and can only be solved either through massive benefit cuts or crippling new taxes.

It is difficult to dispute the contention that the price of public safety cannot be too high. It is difficult to overstate the appreciation anyone should feel for people who stand between us and chaos – the people who protect us, the people who rescue us, the people who save our property. But those people themselves should understand the price we’re currently paying is elevated because of collective bargaining and overwhelming political clout, and is dangerously out of touch with market realities. It would be helpful for everyone to consider the choices involved – cuts to pay and benefits vs. cuts to services, cuts to pay and benefits vs. crippling taxes and economic decline, cuts to pay and benefits vs. investments to advance our technology, our infrastructure, and our military security. All of these elements must be balanced, yet are currently grossly out of balance, because in one way or another, all of them may quite legitimately be described as issues of safety and security for California and the nation.

Logic and Emotion in Politics

Winston Churchill’s famous quote on this topic goes as follows: “If you’re not a liberal at twenty you have no heart, if you’re not a conservative at forty you have no brain.” Depending on your political persuasion this is not necessarily the most endearing polemic to lead off with, but it certainly frames the issue. Are fiscal liberals governed primarily by their emotions? Are fiscal conservatives governed primarily by their logic? There are countless ways to examine this – to wit:

Did the entirely valid emotional desire to see financially less-fortunate families become homeowners create the edifice of sand upon which the financiers of Wall Street built their derivatives house of cards?

Did the hyper-literate, ruthlessly logical calculations of economists and bankers – who thought they had mastered the art of risk management – completely backfire on them? Was the forest of fundamentals obscured by trees of logic?

In the above set of scenarios, emotion and logic both backfired, but a cynic would disagree with both assessments. A cynic would suggest policymakers knew perfectly well their attempts to sell homes to anyone regardless of their earnings or credit history was bound to fail, and that they pushed these manifestly irresponsible policies because they were taking money off the table the whole time. A cynic would make a similar claim against the Wall Street folks – that they knew the whole scheme was going to crash, but they collected their bonuses, bet against their own clients, concocted elaborate models that obfuscated the otherwise obvious financial chicanery of it all, and laughed all the way to the bank.

The point so far is perhaps this – logic is an amoral, bipartisan phenomenon that can be put to use for good or ill, and logic itself is no guarantee of accuracy, just an essential tool to help us hopefully be more accurate than we might otherwise be. And to the extent emotion governs politics, it is generally sincere, whereas logic is only an emotionless tool. Evidence suggests, overwhelmingly, that in a democracy, emotion is a far more powerful political weapon than logic. But sincere emotional appeals that aren’t vetted with logic can be dangerous. Our financial crisis that was enabled by a sincere emotional desire to empower poor families – and to embrace free market principles – is not the only example of valid emotional imperatives producing bad results.

  • We emotionally respond to the desire to help the poor, and instead create huge self-interested bureaucracies of overpaid taxpayer-funded unionized public employees, whose programs create a cycle of dependency and further harm the people they are supposedly going to help.
  • We emotionally respond to the desire to protect the environment, and instead tie all land development and resource development up in knots of regulations and lawsuits, undermining our economic growth and personal liberties.
  • We emotionally respond to the desire to provide health care to everyone, and instead create a new layer of government bureaucracy, drive capable doctors and other health practitioners out of the business in disgust, grossly increase rates of health insurance for people who can barely afford what they’ve already got, challenge the ability of medical device manufacturers to stay in business, reduce the amount of private research, and ultimately, slow the rate of growth and the rate of innovation across the entire health care industry.

Do we need to help the poor, protect the environment, and reform health care? Of course – but we need to first ensure that sincere emotional motivation has not been hijacked by coldly logical cynics for personal gain, or has been passionately embraced by so many people that cautionary logic is swarmed under and insufficiently employed. Logic takes time. Logic is cold. Logic is heartless. But only logic can ensure a well-intentioned policy will have its intended effect.

In a commentary by Daniel Klein entitled “Are You Smarter Than a Fifth Grader,” published in the June 8th, 2010 edition of the Wall Street Journal, some interesting data on this divide between logic and emotion in politics was presented.

Klein cited a Zogby International survey that attempted to measure the economic literacy of the respondents, and then correlated their answers to whether or not they self-identified as either Very Conservative, Libertarian, Conservative, Moderate, Liberal, and Very Liberal. The poll had eight questions that tested the respondents understanding of supply and demand, free trade, and other basic economic concepts. In some cases, particularly with the two questions centered on free trade concepts, one may allow for some remaining debate on what might be the right answer, but the results nonetheless showed a sharp divide, with Conservatives and Libertarians scoring four times better than Liberals in terms of the number of answers they got correct.

Does such a test conclusively demonstrate that logic is more likely to inform the policy preferences of conservatives, and emotion is more likely to inform the policy preferences of liberals? If so, it would explain a lot. But asking such a question or making such a generalization is futile if, at the same time, the emotional dimension of enlightened altruism vs. cynical opportunism as the motive for a policy preference is not equally explored.

In an earlier post entitled “Fiscal Conservatism is Social Justice” this concept is developed further, and is summarized as follows:

The left has a rhetorical advantage because their policies are so easy to cloak in virtue. Does this advantage make the left the magnet for the sinners, the opportunists, those with no virtue – their ability to prevail politically merely because they can more easily tar and feather the right with the unjustified but easily applied stigma of having no altruism, no empathy? Ponder this need to redefine the perceived premises of left and right, before descending into the details of the debate. We all want the same things.

Without emotion, logic is rudderless and heartless. Without logic, emotion is a potent, capricious hydra, capable of utterly destroying productive institutions as often as it reforms or refines them.

Fiscal conservatives need to learn to express the altruistic heart that informs any policy they espouse, especially when they must otherwise depend on the financial literacy of their target audience. And perhaps fiscal liberals need to take classes in finance, and resist the all-too-normal tendency to become overwhelmed by the emotional appeal of their cause.

The China Bubble

With over a billion people and an economy poised to surpass Japan’s as the 2nd largest in the world, it seems everything that happens in China has an oversize impact on the rest of the world. So what if China’s economic growth turns out to be as reliant on inflated collateral and unsustainable debt as the Europeans or the Americans? Is there a China bubble?

A recent report on CBS “60 Minutes” provided visceral evidence that formation of a real estate bubble is undoubtedly already well underway in China. The report showed entire cities in China’s northeast that were newly constructed and completely unoccupied. This anecdotal evidence is backed up by other reports, such as noted by fund manager Jim Chanos in an interview on Charlie Rose on April 14th, 2010. In the transcript, “Jim Chanos on China’s Property Bubble: Charlie Rose Interview,” Chanos is quoted as saying “The fact of the matter is the game [real estate speculation] has to keep going…because so much of their GDP growth is in construction…50% to 60% of China’s GDP is in construction.”

The more you dig, the more it appears China is not just starting to inflate their real estate bubble, but that China’s real estate bubble is about to pop. China is doing almost exactly the same thing the Americans did – and the fact China has stricter regulations on mortgage lending, with between 30%-50% down payments required on real estate purchases – has not slowed the growth in real estate asset values, the rate of new construction, or the growth in residential and commercial vacancy rates. Go all the way back to 2007 for these statistics from The China Expat, in the report “China Housing Bubble Late 2007 Update:”

“Apparently, housing prices in Suzhou averaged about 500 RMB per square meter six or so years ago. Now, the average seems to be hovering around 7-8000. A rise of 14-16 times, which is even greater percentage wise than the increase in Shanghai housing prices… At the low point in the late ’90s, much of the prime real estate in Pudong [Shanghai] was selling for 1000-2000 RMB per square meter. Today, decent real estate in Pudong starts at 13,000 RMB per square meter. Residential apartments near the famed Oriental Pearl Tower goes for over 100,000 RMB per square meter.”

If you run the numbers, a 14x appreciation in the six years between 2001 and 2007 equates to a 55% increase every year. Fast forward 2.5 years to the present – how much more appreciation has occurred?

In a USA Today report from April 24th, 2010, entitled “If hot China real estate market stumbles, will USA get bruised?,” here is evidence that China’s real estate asset appreciation hasn’t begun to slow:

“Real estate prices have risen for nine consecutive months in China, making home purchases unaffordable for a growing number of white-collar workers. Among large cities, commercial and residential prices in Shenzhen — known as much for its wealth as its seemingly boundless growth — have gained the fastest, rising nearly 21% in the 12-month period ended in February. Overall, the most dramatic jumps are in Sanya, a resort city in southern China where property prices were nearly 50% higher in February than a year earlier, according to the National Bureau of Statistics. Analysts believe that China’s official data likely understate the price increases.”

The same USA Today report also has some good information on what prices actually are for real estate in China, as well as information on vacancy rates. Consider these nuggets:

“At the Curio — one of the most expensive new buildings in the city [Shenzhen] — buyers can purchase a nearly 2,400-square-foot apartment for $1.9 million. In the USA, that amount would buy a 2,400-square-foot beach house in Santa Cruz, Calif., a 12-acre New England farm in Sharon, Conn., or a four-bedroom pad near New York City’s Central Park.

In Shanghai and Guangzhou, the commercial vacancy rate exceeded 15% at the end of 2009. Meanwhile, in Beijing’s central business district, the commercial vacancy rate was 29.2%, while the citywide vacancy rate was about 20%, according to real estate broker CB Richard Ellis.

A healthy vacancy rate for Beijing would be around 10%, says Jack Rodman, president of Beijing-based Global Distressed Solutions, a property consultant. But he believes the city’s actual commercial vacancy rate is closer to 50%, after taking into account office space that’s been completed but isn’t on the market. To get back to a normal occupancy rate could take 15 years, he estimates.”

In a MoneyLife report entitled “The China real-estate bubble,” dated today, June 8th, 2010, the following data was provided:

“Depending on whose numbers you believe, real estate in 70 Chinese cities has risen between 12.8% to 18% over the past year and 95% in Beijing. To buy an apartment in Beijing would cost the average wage earner 17 years’ income.

To pay for these skyrocketing prices the amount of mortgages as a percentage of GDP has exploded from an average of 10% from 2005 to 2008 to 16%, while the amounts have tripled from 500 billion yuan to 1.75 trillion yuan. But is this a problem?”

This is a huge problem. If 50% or more of your economy is construction oriented, and real estate values have appreciated at 3-5x the rate of GDP growth for a decade, and GDP itself is tied to construction activity, this is indeed a huge problem. The large down payments required in China, 30-50%, are about as useless as minimal down payments or zero down payments, if the property suddenly begins to depreciate for more than a year or two at the same rate it once appreciated. So what if you have put 30% down, if your property has appreciated 50% in the year before you bought it?

As noted in the post “The Razor’s Edge – Inflation vs. Deflation,” collateral is wealth; collateral is currency; the ability of collateral – asset value – to create purchasing power simply dwarfs the impact of national fiscal and monetary policies – especially in the short run. Think of a nation’s fiscal and monetary policies as the helm and the rudder of a giant ship. Think of collateral as the ship itself. Point the ship at an iceberg for a thousand miles, and try to stop the collision when the ship is on a direct heading and 1,000 feet away. It can’t be done.

The United States experienced low double-digit rates of real estate appreciation for about five years, and is paying an awful price. The Chinese have now experienced mid double-digit rates of real estate appreciation for nearly twice as long. There is no doubt their real estate market will correct – to put it mildly. What does this all mean?

First of all, there will have to be some triggering event. In the U.S., the triggering event was basically when the buying frenzy began to slow down. Once prices stopped getting bid upwards, the searing light of day began to shine onto Potemkin Villages of overpriced and empty buildings from Miami to Las Vegas, and the party ended. Sooner or later, the Chinese are going to experience exactly the same thing.

Once this happens, China’s construction industry is going to shrink dramatically. With commercial and residential real estate nationwide already at 25% vacancy rates, there is no other option. And unlike the United States, where construction barely exceeded 10% of GDP even during the bubble, China’s construction industry is estimated to be at least 50% of their GDP. When construction falters, China is going to experience massive unemployment.

As China’s economy enters its version of the great recession, how the rest of the world adjusts is difficult to predict, but the effect may not be as dire as one might imagine. China has only in the past quarter become a net importer after years of massive trade surpluses, so few countries – certainly not America – are overly reliant on exports to China. And China’s GDP, despite having experienced miraculous (and unsustainable) expansion over the past 10+ years, is still only tied with Japan’s at around $5.0 trillion per year, compared with the U.S. and the European Union who both are about triple that size. China’s GDP only represents about 8% of the global economy. Given the economic turmoil that has already erupted in the U.S. and the EU, it is possible China’s economic slowdown will not catalyze further economic difficulties elsewhere. It will certainly take pressure off energy prices. The biggest risk is a China crash will contribute to global deflation, which remains the most terrifying bogeyman of all.

In America, unfunded liabilities and expanding debt present financial policymakers with a potentially ominous future. But America is watching the Europeans grapple with a debt-fueled meltdown at least as severe as America’s, because it is exacerbated by problems America doesn’t have – a strained integration of previously independent national economies, an entitlement-driven statism that America, at least so far, does not match, and a population aging far more quickly than America’s. And China also faces an inverting age demographic that is going to challenge them economically within the next 10-20 years.

China’s asset bubble going to burst, throwing them into a financial crisis and raising anxieties around the world. The real question is will America adapt and learn from the economic carnage witnessed elsewhere? America’s response in this scenario, where sudden economic downturns in China and the EU underscore America resilience, is an opportunity that cannot be missed.

The biggest risk of America reemerging economically amid relatively worse economic problems in the rest of the world is that their good fortune will be squandered, as structural reforms to America’s economy are deferred or abandoned in the face of a deceptively positive economic performance. America will still be able to print currency at will, borrowing additional trillions because even as a nation dealing with unprecedented debt, she still has the most diverse and secure economy on earth. Most crucially, America may delay reforming her public sector, using her ability to persist in massive federal deficit spending only to indulge in overpaying public sector bureaucrats – a hideous waste of deficit spending, which is properly used on infrastructure projects and technology initiatives that yield long-term strategic returns on investment.

America can use this coming decade of economic reprieve, purchased by more severe economic challenges in China and the EU, to make deficit-fueled but genuine investments that will secure her future economically, or America can use this opportunity to simply spend another decade printing borrowed money to pay excessive compensation to unionized public employees. Such a feckless act will inflate the mother of all bubbles, an American debt bubble of unprecedented and ever burgeoning magnitude that will progressively induce investment to gravitate to chastened, reformed and recovering foreign shores. A bubble fueled by irresponsibility and corruption, and ignored 2nd chances, whose cataclysmic burst will signal the end of the America era.

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Sustainable Economic Returns

John Maynard Keynes, in his General Theory of Employment, Interest and Money, advocated deficit spending during economic downturns to maintain full employment. It is fair to say the theories of Keynes have been embraced by U.S. economic planners, and Presidents, for several decades – and each decade seems to have outdone the preceding one. But what sort of government deficit spending? During the 1930’s we built dams and power plants. During the 1950’s and 1960’s we built the interstate highway system and sent astronauts to the moon. During the 1980’s we invested in our military and won the cold war. These programs delivered a temporary stimulus to the economy, but they also yielded lasting benefits. The physical infrastructure, the strategic dividends, and the technological spinoffs outlasted the spending programs. There was a return on investment beyond the temporary stimulus – and this is the crucial difference between what we’ve done before, and what we’re doing now.

A good example of where deficit spending should go, but isn’t, is the F-22 Raptor, a fifth generation fighter that development began on over 20 years ago. Originally the F-22 was intended to replace the F-15, America’s current air-superiority fighter, and at least 750 of these advanced aircraft were supposed to be built. Today, with only 186 planes built, President Obama has canceled the F-22 program and their assembly lines are scheduled to be dismantled.

One would think the lessons learned during the Cold War – that deterrence depends on fielding an equal or greater military capability than your rival, or that national rivalries are real and enduring even into this age – would be remembered and acted upon. One would think the hard lessons of appeasement gone awry – such as when Chamberlain gave up the Sudetenland in 1938 and proclaimed “peace in our time” to the world – would also be remembered. One would think the benefits of investing in our high-tech military – the countless industries and amenities we have produced using technology that was once purely defense-related, from advanced composites to the internet – would be remembered. But apparently memories are short in Washington these days.

If you want to better understand what an amazing piece of technology the F-22 represents, an outstanding source of information is the article “The Sixth Generation Fighter,” written in October 2009 by John A. Tirpak, Executive Editor of Air Force Magazine. In this comprehensive summary of what the F-22 can do, Tirpak describes the generations of fighter development from the 1st generation, such as the German ME-262 which was the first operational jet fighter, through today’s advanced 4th generation fighters, which are actually characterized as Generation 4, 4+, and 4++. Today’s F-15SE fighter is considered a Generation 4++ fighter, and ranks with the Russian Su-35 as the most advanced fighter in the world. But the 5th generation F-22 offers more capability than 4th generation fighters in several important ways.

The F-22 has “all-aspect stealth,” meaning it has virtually no radar signature. All its weapons are internal, only deploying outside the skin of the aircraft when they are being launched or fired. It has extreme agility. It has “full sensor fusion,” providing the pilot with total awareness of the battlespace in all directions, and the ability to engage multiple threats simultaneously. It has “integrated avionics,” allowing a formation of F-22s to, for example, each shoot several missiles at targets and have the missiles interact to each identify a separate target. It can “supercruise,” which means it can fly for extended periods of time at supersonic speed without requiring afterburners.

If you want to learn more about what America’s failure to invest in the full complement of 750 F-22s means, read “The Fate of the Raptor,” originally published by Mark Helprin in the Claremont Review of Books in the Winter of 2009/10 and later appearing under a different title in the February 21st, 2010 edition of the Wall Street Journal. Abandoning the F-22 in order to produce the marginally cheaper F-35, a multi-use, far less sophisticated fighter that barely qualifies as a 5th generation aircraft, is a decision that is almost inexplicable. An Air Force source told me the real reason Washington chose the F-35 was political – the parts for the F-35 are manufactured in nearly every State, meaning a lot of Congressmen and Senators protected jobs in their districts. But the gains to a broader assortment of local economies is more than offset by the overall loss to our national economy, as we deploy an inferior weapons system, and regress technologically as we dismantle the F-22’s manufacturing lines.

When discussing preferable ways to engage in deficit spending, of course, this isn’t just about the F-22. This isn’t even just about strategic military spending – although our government’s failure to deploy the F-22 in numbers, and our failure to-date to launch a long-lead 6th generation fighter program, is an egregious case of missed opportunity. But missed opportunities abound. Along with 5th and 6th generation fighters, if we are to legitimately embrace Keynes during this economic downturn, we should be sending humans back to the Moon, and launching a manned Mars mission. The benefits to our technological prowess and industrial base alone justify these expenditures.

Back down on the earth, if deficit spending is indeed our economic elixir, we should be engaging in responsible development of domestic fossil fuel reserves and building nuclear power plants. We should be constructing desalination plants, canals and reservoirs (above and below ground), and we should be building and upgrading our bridges and freeways. All of these projects could be public-private partnerships, and could rely on deficit spending. But along with the temporary economic stimulus they would bestow, they would provide sustainable economic returns in the form of effective military deterrence, ongoing technological leadership, and assets of infrastructure that would yield permanently cheaper energy, water and transportation.

Instead, today we have interpreted Keynes at his worst, perverting his principles to justify massive deficit spending only to allocate money to public sector employee paychecks and pensions – borrowing and taxing and running up trillions in deficits not to invest in our future and our security, but to perpetuate their over-market, unsustainable compensation packages. If someday the U.S. can no longer deter her rivals, and faces another catastrophic war of uncertain outcome, remember 2009, the year the U.S. President killed the F-22 program to instead use Keynesian debt to pay government workers to live the life to which they had become accustomed. Similarly, when these never-ending, ever-expanding debt bubbles burst and utterly refuse to reflate, remember what returns might have accrued if we had invested those deficits to rebuild our nation, our technology, and our security, instead of feeding the insatiable maw of a unionized government.