Airbus and Boeing are signing economic suicide pacts with Beijing

By Marshall Auerback

This article originally appeared on AlterNet.

Airbus is considering whether or not to shift the assembly process of its latest generation of A330 planes to China as part of a bid to increase its market share in the world’s fastest-growing civil aviation market.

The European multinational is following a trend started by Boeing, which recently opened a new completion plant in China. On the face of it, the decision by the two companies (which dominate the civilian aviation market) makes sense: build where your biggest customer lives, especially as China does not yet have a fully homegrown civil aviation industry ready to compete globally. The benefits are many, including the goodwill and esteem of the country that would be buying these planes. In the long term, however, that might prove to be a costly miscalculation. Based on its recent history (hereand here), it won’t take long for China to catch up and largely displace both companies domestically in Beijing’s home aviation market, as well as seizing a large chunk of the corporate duopoly’s global market share. Airbus and Boeing could therefore be making short-term decisions with negative long-term consequences for their future profitability.

Given China’s formidable economic advancement, none of this should come as a surprise to either Airbus or Boeing. Nor should it shock Western governments. The problem is that everybody has historically been guided by the naïve assumption that simply admitting China to organizations such as the World Trade Organization (WTO) would induce Beijing to, in the words of Philip Pan, “eventually bend to what were considered the established rules of modernization: Prosperity would fuel popular demands for political freedom and bring China into the fold of democratic nations. Or the Chinese economy would falter under the weight of authoritarian rule and bureaucratic rot.” China has unquestionably modernized, but its politically illiberal, dirigiste polity has, if anything, massively moved in the opposite direction, strengthened by that very modernization process that has done anything but falter. Furthermore, the country has many aims and goals that are antithetical to the long-term prosperity of Western companies and economies (as the European Union is beginning to recognize).

Boeing and Airbus might simply become the latest Western sacrificial lambs. Beijing has explicitly targeted wide-bodied aircrafts as one of its 10 new priority sectors for import substitution in its “Made in China 2025” document, so whatever short-term gains Airbus and Boeing receive in terms of securing additional orders from China could well be undermined longer-term. The resultant technology transfers and lower labor costs will almost certainly give Beijing a quantum leap toward competing directly and ultimately displacing both companies. Given the merger with McDonnell Douglas, Boeing will continue its march toward effectively becoming a branch of the U.S. Department of Defense, as its civilian market share crashes, but Airbus doesn’t really have the luxury of a military alternative, given the relative paucity of European defense expenditures.

As if Boeing needed any further problems, the 737 fiasco represents the latest in a series of setbacks for the company. Boeing’s 737 global recall, coming on the heels of the initial launch problems of the 787 Dreamliner some six years ago (where the “demoduralization” of production meant that Boeing “could not fully account for stress transmission and loading at the system level,” as Gary Pisano and Willy Shih write), together illustrate the dangers of spreading manufacturing too far across the globe: Engineers, notes CUNY fellow Jon Rynn, “need to ‘kick the tires’ of the new production processes they design. So while a market may be global, production and the growth of production take place most efficiently” in relatively close geographic quarters.

American companies such as Boeing consistently underestimate the value of closely integrating R&D and manufacturing, while underplaying the risks of separating them (as recent events have demonstrated again to the company’s cost). By deciding to expand its A330 production in China, Airbus looks poised to repeat Boeing’s error, a potential miscalculation that most European Union companies have hitherto largely avoided, because the EU has prioritized domestic manufacturing/discouraged offshoring more than its U.S. counterparts (in regard to the loss of U.S. manufacturing jobs attributable to China, the American Economic Review paper by Justin R. Pierce and Peter K. Schott specifically notes that there was “no similar reaction in the European Union, where policy did not change”).

Beijing itself has historically balanced its purchases from both major civil aviation manufacturers to ensure that it does not rely too heavily on one aircraft supplier, which means that Airbus will likely benefit from the void created by the 737 recall. All the more reason why the European conglomerate should be wary of following the pied piper-like expansion into China. (The 737 recall also complicates resolution of the U.S.-China trade conflict, which had appeared closer to resolution in light of Beijing’s proposal to buy an additional $1.2tn in U.S. exports over six years. Boeing aircraft purchases featured heavily on Beijing’s shopping list.)

But the longer-term challenges relate to China’s economic development path and its corresponding move up the high-tech curve, which have largely been characterized by mercantilist policies of protection and heavy government subsidy. In this regard, the Chinese state has followed a national development strategy first outlined in the mid-19th century by the German economist Friedrich List, who argued that the national government should play a crucial role in promoting, guiding, and regulating the process of national economic advancement.

Protectionism, List argued, should play a role here as well during the country’s “catch up” phase of technological development. List wrote the analysis against a historic backdrop where Germany was beginning to challenge the dominant economic power of its time, the United Kingdom. So the defenders of Beijing might well point to his work to show that there is nothing new about using the state as a principal instrument to accelerate economic development and innovation.

However, List was analyzing two capitalist economies operating within the context of a 19th-century gold standard global financial system, which invariably circumscribed the scope of state involvement (the finite availability of gold reserves limiting fiscal policy options). By contrast, today the global economy operates under a fiat currency system, and what therefore distinguishes China’s economic domestic development from its 19th century predecessors is the sheer scale of fiscal resources it can deploy in the furtherance of its economic (and military) objectives. Some of these objectives might not be so benign to the West longer-term.

Which points to another consideration for the West: for all of its supposed embrace of capitalism, China is still primarily a state-dominated economy, which eschews the disciplines of a free market economy. This means it has the capacity (and ideological predisposition) to use the national fiscal policy as a loss leader, absorbing losses well beyond what would be tolerated in an economy dominated by private enterprise (private companies, of course, can go bust). Beijing underwrites its designated national champions by relying on a combination of subsidies (some disguised, as they flow through state-backed investment funds and the financial sectors) and “Buy China” preferences to develop Chinese products, even though these policies are contrary to the rules of WTO membership, which China eagerly joined in 2001. As the economist Brad Setser argues, “various parts of the Chinese state compete, absorb losses, and then consolidat[e] around the successful firms. Other countries… [might] worry about the [scale of the cumulative] losses,” notes Setser, but not the Chinese government, which simply socializes the losses at the national level, and writes them off.

In this regard, Boeing and Airbus would do well to consider China’s experience in the solar industry. Designating this as another strategic sector for growth in the 1990s, Chinese solar companies, with the explicit backstop of the state, ultimately raised enough funding via debt to build sufficient solar capacity for the world three times over. The overinvestment ultimately killed the cash flows of major Western competitors and knocked them out of the business, leaving the market free for China to dominate. Commenting on the trend, Scientific American highlighted that“between 2008 and 2013, China’s fledgling solar-electric panel industry dropped world prices by 80 percent, a stunning achievement in a fiercely competitive high-tech market. China had leapfrogged from nursing a tiny, rural-oriented solar program in the 1990s to become the globe’s leader in what may soon be the world’s largest renewable energy source.”

Here was a classic case of state-guided/supported commercial companies receiving benefits that went far beyond anything in, say, Korea or Taiwan, or even Japan in the earlier part of their development. Now this trend is manifesting itself across the entire spectrum of the Chinese guided economy, including agricultural equipment, industrial machinery, telecommunications, AI, computer chips, and civil aviation. In another disturbing parallel that Boeing and Airbus would do well to consider, “[t]he timeline of China’s rise began in the late 1990s when Germany, overwhelmed by the domestic response to a government incentive program to promote rooftop solar panels, provided the capital, technology and experts to lure China into making solar panels to meet the German demand,” according to Scientific American. Much like the German solar companies, which shipped valuable manufacturing and technological expertise to China, to sustain demand, Boeing and Airbus could well be signing their economic death warrants by agreeing to offshore increasing amounts of production in China to sustain their global market shares (aided and abetted by their more market-oriented governments, which frown on the idea of national industrial policy).

The same thing is happening in wind power in China, which is expected to see offshore wind capacity grow from 2 gigawatts last year to 31 gigawatts in the next decade. China’s expansion here has already forced Siemens and Gamesa to merge to cope with the rising competitive challenge. As far as aviation itself goes, Setser makes the point that “China may cut into the United States’ future exports by building its own competitor to the 737 and also cut into Europe’s future exports if Airbus decides to build the A330 in China and China buys ‘Made in China’ Rolls-Royce engines for the C929 and the A330.” Even if this allows the duopoly to maintain its dominance in global civil aviation, it is hard to see how shifting manufacturing production of aircraft components to China to get orders constitutes a “win” for the U.S. or European workers who are already being displaced. And Boeing’s weak-kneed response to the 737 crisis will likely exacerbate the company’s problems going forward.

The bottom line is that both Western governments and Western corporations have persistently underestimated the power of China’s economic development model, and the corresponding economic threat that it poses to the West’s own affluence. The usual criticism leveled against the Chinese growth model is that a country that subsidizes its industries ends up with inefficient industries, because heavily protected local firms are shielded from global competition, ultimately leaving the country that resorts to protectionism with inferior products. The idea of national champions, built up via state dirigisme, according to classic liberal economic doctrine, ultimately ensures that economic efficiency and commercial considerations get squeezed out. Rent-seeking and corruption become institutionalized, goes the argument, so these national champions ultimately will not be able to compete in the global marketplace. That was certainly the assumption of Milton Friedman, who called the Chinese Communist Party’s state-driven strategy“an open invitation to corruption and inefficiency.” By contrast, according to Defense and the National Interest, the governing assumptions of capitalist economies is that “[t]he discipline of the ‘marketplace,’” not the state, is better suited to choose winners and knock out losers “who cannot offer the prices or quality or features of their competitors.”

China represents the ultimate repudiation of these seemingly ironclad economic laws. The country’s success has come across a slew of industries: clean tech, notably wind and solar power, internet companies (despite overwhelming censorship, China has corporate behemoths, such as Alibaba, or Baidu, which rival Google in scale and scope), and more recently, in the telecommunications sector (where Huawei has clearly benefited from “Buy China” preferences created by the state via its state-owned telecommunications enterprises and now is considered to be the global leader in 5G telephony). In practice, therefore, there is no reason why the same model cannot work with regard to civil aviation even as Airbus and Boeing eagerly provide the rope with which they may hang their respective companies in the future.

Marshall Auerback is a market analyst and commentator. This article was produced by Economy for All, a project of the Independent Media Institute.

US curve inversion worsens as the Fed acquiesces to market sentiment

Yesterday's climbdown by the Federal Reserve on both interest rate policy and balance sheet reduction was not enough to satisfy the market's disquiet about the US economy. Equity markets sold off and US Treasury yields rallied as the inversion in the middle of the yield curve steepened. What's driving this is renewed concerns about the real economy. And ultimately, the Fed may have not proven itself dovish enough yesterday. Some thoughts below

The real economy

The big question now is whether the US economy has bottomed. And while I don't think we can answer that question until April, some of the recent data have been positive on that score. But the data are mixed at best.

For example, today's jobless claims number showed a 4-week average of 225,000, bang inline with the year ago levels. So, while the claims number is flashing red, by showing elevated numbers versus year-ago levels, it has stabilized. That is positive. The unfortunate bit here is that continuing claims comparisons continue to show weakness, as the 4-week average differential has narrowed to just over -100,000 from over -200,000 4 weeks ago. Soon, the continuing claims number could be flashing red as well. And that's a big problem.

Another example comes with the March 2019 Manufacturing Business Outlook Survey from the Philadelphia Fed that just came out this morning:

The index for current manufacturing activity in the region increased from a reading of -4.1 in February to 13.7 this month. The index nearly recovered its decline from last month, when it dropped to its first negative reading in almost three years (see Chart 1). Both the new orders and shipments indexes also increased this month. The current new orders index improved modestly, increasing from -2.4 in February to 1.9 in March. The current shipments index increased 25 points to 20.0.

That's good. But look at the chart they produced.

March 2019 Philly Fed

Notice that the six-month forecast is still in a downtrend. That's the line we need to pay attention to. And so, while we see a rebound and the forecast is good, the trend is bad.

And of course, we know that the GDPNow number is still running at a measly 0.4% for Q1.

The Fed's decision

So, I would argue that the Fed was forced to cede ground. The numbers are just too weak for hawkish rhetoric. Most Fed officials now expect no rate increases in 2019, just a single one in 2020 and none in 2021.

Dot Plot Mar 2019.png

That's dovish. I don't see how the Fed can reasonably be more dovish than that. Talk of the Fed cutting is premature and unreasonable.

Moreover, the central bank also said it will begin to taper quantitative tightening in May, and will end the program in September. Again, that's about as dovish as you can get. And it's what I told you the market wanted.

But the market didn't like the outcome. In fact, if you look at the yield curve it is incredibly weak:

  • The US 6-month Treasury yields more than the US-7-year Treasury

  • The US-Treasury curve is now fully inverted from 6-months to 5 years, with a inversion differential of 16 basis points

  • The 2-10 year spread is down to 12 basis points

  • The 10-year yield fell to the lowest in more than a year after the rate decision

All of this says that it was the Fed's economic outlook driving the market moves.

My view

The Fed's policy move and messaging in December was all wrong. It simply did not recognize the dangers and pivot fast enough. But it has done now. And we simply have to wait to see whether it will be enough to prevent further weakening and recession. I think there is a reasonable possibility that the US economy re-accelerates from here, just as with the global economy. Brexit, in particular, could be an exogenous shock that disrupts any momentum though. So, it is too early to know. In April, I think we can begin to decide where this is headed. But, for now, the risk-on mood since December seems to have taken a knock.

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