An exercise in first-level thinking

McKinsey published an interesting report on The Future of Work in America. On more than 100 pages, the report looks into the development of the workplace in the US on a county and city level. They looked at more than 3,000 counties and 315 cities in the US and split them into different categories depending on their economic performance, demographics and other factors. It is fascinating and worth reading for its elaborate detail. Take a look at the chart below. It shows the cities in the US and their different economic fortunes. High growth cities, mostly in the coastal regions and in big university towns have seen high GDP growth, have lots of high-paying jobs and young workers. Rural cities and counties, on the other hand, have been lagging dramatically in terms of economic growth. But they also tend to have a somewhat older and less educated demographic, which can partly explain the lower economic growth and the lower income earned in these areas.

The main challenge for the lower growth areas in the US will be to find jobs for the future. And this is where the problem starts. Digitalization and automatization have two main effects on businesses. First, they predominantly create jobs that require college degrees. Workers with lower educational attainment live predominantly in the rural mid-level cities that already suffer from low job growth and economic growth today. 

Second, the jobs that are most at risk of displacement from the technological revolution are jobs with a high degree of manual labour and low-skilled jobs. In other words, the jobs that are most frequently found in the American Midwest and rural areas. Thus, the report projects a double whammy for these regions where low growth areas will not only face a hard time growing jobs, but also the brunt of the technological displacement. As a result, McKinsey projects that the disparities between high growth cities and low growth cities will continue to widen until 2030.

There are, however, some areas of growth, that will be less affected by digitalization. Most importantly, the health care sector and other personal and professional services are likely to grow, simply because these services are hard to replace by robots and software. The bigger the human element of a job is, the more likely it is to survive over the next decade.

BUT: As I read through the report of McKinsey, I could not help to notice that it is very short-sighted. I don’t mean to pick on McKinsey. Reports like theirs are produced by every think tank in the world and they are useful to the degree that they provide insightful data for investors. So, let’s not get hooked on the fact that this example is from McKinsey but focus on a more general problem that reports like these have.

They are an exercise in extrapolating the past into the future.

The report effectively states that if the trends of the last five years continue, the disparities that emerged over the last five years will continue to widen. 

Duh! And it took you more than 100 pages to figure that out?

The entire report is an exercise in what Howard Marks calls “first-level thinking”. It is a simple and convincing story that explains what happened in the past and what may happen in the future. And as H. L. Menken so aptly said: “Explanations exist; they have existed for all time; there is always a well-known solution to every human problem — neat, plausible, and wrong”.

And as an investor, you should try to keep a healthy distance from these explanations. As Howard Marks puts it in his book The Most Important Thing: “First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in ‘The outlook for the company is favourable, meaning the stock will go up.’ Second-level thinking is deep, complex and convoluted.”

So, let’s engage in some preliminary second-level thinking on the problem of digitalization and its impact on the US economy – something that is almost never done in these “thought leadership” reports.

The way to think about the future of the workplace in the US is to think about the possible reactions to the trends of the last five to ten years. And here, I think there are several developments that may take hold in the coming years that are completely ignored in the report. 

First, we have already seen the political backlash against the growing disparities in the economic fortunes of the coastal and rural areas. A populist like Donald Trump would not have become President without the decline of the manufacturing sector in the American Rust Belt. Now, the politicians on the left propose additional populist measures to help the displaced workers at the expense of the high-skilled employees on the coasts. These measures range from higher taxes for high-income households and corporations to increased regulation of financial markets and businesses. All of these measures have good intentions and I agree with many of them, but it is clear that if these measures are overly restrictive (as is almost always the case when extremist or populist politicians design and implement them), then growth in the affected areas will decline rapidly. The history of economic policy making shows time and again that high-growth businesses eventually will be reined in by either increased competition or increased regulation. I would not be surprised to see public opinion swing so far against the technology companies that are so profitable today that they will eventually be regulated like public utilities. Demands for such regulation are already voiced by Democratic Presidential candidates Bernie Sanders and Elizabeth Warren. And the votes in favour of such regulation will be delivered by the cities and counties in the Midwest that suffer the negative consequences of this technological revolution.

Second, if increased regulation isn’t putting a stop to the continued growth of high-tech businesses, and the cities they are based in, then competition will. The Chinese competitors of Google, Facebook and Amazon are already expanding in South East Asia and in my view, it will only be a matter of time until they enter the US market. And with the cash flow from a protected home market, they will be formidable competitors to the local incumbents. This should drive down the profit margins of the FAANG stocks and others and lead to lower job growth and lower salaries. Competitive forces are a great leveller that should never be underestimated.

But there is potentially a third development that a second-level thinker needs to consider. As the rural areas of the US lag the rest of the country, salaries there stagnate. Meanwhile, the traditional outsourcing countries in Latin America and East Asia face rising wages for workers as Western businesses compete for increasingly scarce labour in their factories. And while there is still a large gap between the salaries of factory workers in the American Midwest and Mexico, the gap for service jobs that require good English language skills is much smaller. Thus, there might be an increasing trend to bring call centres and sales offices back to the US. 

In Europe, Ireland was one of the main beneficiaries of this trend since it provided relatively cheap labour and a large number of unemployed people who speak English as well as other European languages. In short, Ireland became a competitor to India for service jobs. In my view, the American Midwest could become the Ireland of the US over the next decade. And this, in turn, could create a new boom in these areas that narrows the disparities in the country.

None of these trends are examined in the McKinsey piece and think tanks usually are very bad at this kind of second-level thinking. Which is why their recommendations should be taken with a big grain of salt. Think tanks may be able to get away with first-level thinking, but investors certainly cannot. Thus, a thought leadership report can only be the starting point for your own work as an investor, but never the end point.

Economic and demographic developments in US cities 2012 – 2017

Source: McKinsey Global Institute.