Fostering Manufactures in Advanced Countries: Against the Secular Tide?

The Financial Crisis of 2007 resulted in massive losses of actual and potential output, accompanied by increases in unemployment unmatched since before World War II,  increasing by fourteen million in the OECD countries (four million for the Euro zone and almost seven million for the United States alone).  Still suffering from the effects of the severe financial dysfunction of the last decade, we now face the imminent possibility of a second banking disaster that could be even worse, prompted by mismanagement of Euro bond debt relief.

A famous cliché, repeating the same behavior with the hope of a different outcome is a definition of madness, accurately describes the fumbling attempts by US and European leaders to contain the excesses of financial misbehavior, which generate (degenerate, perhaps) a looming threat to global economic and social stability.  It is not surprising that several major European politicians, including the leader of the British Labour Party, call for a policy shift from finance to industry.  Those in favour of such a shift confront the challenge of first justifying it, then designing the policies to realize it.

Several prominent and progressive economists in Europe and the United States dismiss the need to influence purposefully the structure of output, in other words, “industrial policy”.  They argue that the essential problem is a runaway financial sector that must be radically reformed through severe curtailment of its functions – return banking to the dull business of lending.  If this is done, the argument goes, the structure of output can sort itself out.  For example, with the populations of Europe, North America and Japan growing older, it may be that these countries should focus their employment growth on the health-associated service sectors.

As superficially compelling as this argument may be – let the “young” countries produce and the “old” consume – it ignores the specific advantages of industry and especially manufacturing.  First and fundamental is what Thorstein Veblen called “the instinct of workmanship”, the creative potential of humanity through cooperative production.  Veblen argued that is in the process of collective work that people express and realize their imaginative and creative powers, which is obvious if one discards the obfuscating rhetoric of individualistic competition.  Manufacturing involves more than making commodities; it is the cooperative process of creation.  A society that abandons making things loses its creative potential.

More concretely, manufacturing has linkages than services do not, which integrates an economy both in the technical (input-output) sense and socially (through organizations of workers, employers and consumers).  The interaction between the technical and social linkages generates product and production innovation.  But, even if one accepts the advantages of manufacturing, a frequent objection to arguments for promoting manufacturing is that its declining importance in advanced economies is akin to a natural law.  The empirical work of two great economists, Simon Kuznets and Hollis Chenery, has been interpreted to imply that the secular decline of manufacturing is and will be observed almost without exception across countries as they develop.

However, the secular decline interpretation of the long run evidence does not imply the disappearance of manufacturing in the advanced countries.  This inference derives from the belief that absolute and relative wage costs dictate the relocation of production from more to less developed countries.  A moment’s reflection reveals this to be an extremely superficial and indefensible argument.  If wage costs play this determining role, then the relocation argument applies to all traded commodities, including services, which are typically characterized by a higher share of employment costs to total costs, as well as less skilled labor.  Thus, if the argument were true, there would be very little left that could be produced profitably in the advanced countries.

While it is beyond the scope of a short article to deconstruct the theory allegedly supporting the wage-cost relocation argument, a look at recent advanced country experience demonstrates its inadequacy.  The chart shows the share of manufacturing in GDP for four large advanced countries, Germany, Japan, the United States and the United Kingdom.  I selected the years 1995-2007 because in either years data for Germany would not be consistent, and during 1990-1994 the German statistics are distorted by the restructuring and closure of factories in the east.  The chart data end with 2007 because the Financial Crisis caused a sharp decline in the manufacturing sectors of almost all OECD countries.

The difference between Germany and Japan, with a slightly rising and almost stable share, and the United States and United Kingdom, with shares sharply declining, appears much too extreme to be explained by the same underlying “natural” process.  The differences arise from policies pursued in each country toward finance and “offshoring”.  Most important for the United States and United Kingdom have been policies that lower the cost of relocating to other countries, in specific those that facilitate escape from organized labor and de facto tax incentives (see K. Clausing & K. Hassett in the Brookings Trade Forum 2005, 457-490).

Manufacturing as a share of GDP, percentages, 1995-2010 (end year change given in legend)

The first step toward a purposeful and effective industrial policy would be to eliminate the implicit tax subsidies and statutory rules that facilitate the closure of production facilities in the advanced countries.  This in itself, creating the cliché-ridden “even playing field”, would substantially slow the decline of manufacturing in most countries.  Second, industrial policy should avoid the Mercantilist measures that have characterized some aspects of policy in Germany and Japan.  In the former case this has involved suppression of real wage increases, a primitive competitive mechanism that more rapid productivity growth would render unnecessary.  Further, governments in both countries have suppressed domestic consumption.  In Germany this could be tolerantly interpreted as a side effect of the inflation fears following the questionable decision to accept East marks at parity.  In Japan the domestic demand compression was notoriously conscious, implemented in part through price discrimination in favor of export markets.

Finally, when making comparison between the two pairs of countries one should not ignore that the growth of total GDP in the United States and the United Kingdom was almost double that for Germany and Japan during 1995-2007, three percent in contrast to 1.6.  An inspection of a larger group of OECD high income countries shows no relationship, positive or negative, between GDP growth and the manufacturing share.  Indeed, the slow Japanese growth is generally attributed to a dysfunctional banking sector.  In the case of Germany, its recovery from the deep recession of 2007-2009 has been faster than for any major country.

My interpretation of the long run statistics is that the systemic decline of the manufacturing share results from the complementary growth of finance and business-related services.  In the absence of anti-manufacturing policies, most large and medium advanced countries could sustain a manufacturing sector of about twenty percent of GDP.  The challenge for industrial policy is not to prevent further decline which is not difficult, but to maintain that twenty percent without wage repression or export promotion with its unavoidable Mercantilist elements.

As a final comment, the often encountered assertion that industrial policy would conflict with commitments in WTO agreements can be dismissed.  For good or for bad, the reality is that the World Trade Organization is a near-moribund body.  The main motivation for most countries to join it was to manage the arbitrary protectionist interventions of the US government.  This motivation has been fatally undermined by the US government pursuing bilateral agreements outside the WTO structure.  Rather than worry about the possible constraints of a hardly-functioning WTO, governments should base their industrial policy on long-standing principles of reciprocity and fairness.

This column is part of the Industrial Europe Online Debate jointly run by Social Europe Journal, the Friedrich-Ebert-Stiftung Rome and the Fondazione Brodolini

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