Calls to Boost U.S. Manufacturing Do Not Ignore the Gains Still to Be Made from Services

<Update (April 24, 2011): The Manufacturing Extension Partnership’s Manufacturing Innovation Blog picked up and elaborated on this post’s theme in a blog post called "Manufacturing and Services: Together Forever." The article cites recent data from studies on the express delivery industry and a report by Andy Neely, The Servization of Manufacturing, to reieterate the message of the inseparability of manufacturing and service industries, and the need for thoughtful strategies to bolster the success of both.>

An article in the April 2, 2011 issue of The Economist, “Cash Machines,” argues that “calls to boost manufacturing ignore the gains still to be made from services.” The article trumpets the views of those like Columbia University Professor Jagdish Bhagwati, who reckons that “those who argue in favor of boosting rich-world manufacturing suffer from a ‘manufacturing fetish’.” In terms of boosting job creation and economic growth, The Economist suggests that, “Increasing demand for non-tradable services should do just as well,” (e.g. “as boosting manufacturing”…so that we don’t need to worry about policies to support U.S. manufacturing).

But The Economist perpetuates a false choice. The United States needs both robust manufacturing and services sectors; it’s not either-or. Moreover, calls for policies to boost U.S. manufacturing simply recognize manufacturing for what it is—a vital component of the U.S. economy, the preponderant source of U.S. exports, and a major source of well-paying middle class jobs. Nor do calls to support manufacturing ignore the important role services play in the U.S. economy. (In fact, no one in Washington policy circles has been stronger supporters for services innovation than ITIF. I even co-founded a firm, Peer Insight, specifically dedicated to the study of innovation in services industries.)

Yet with manufacturing (as a share of total goods and services) accounting for 62 percent of U.S. exports, there is simply no way the United States will be able to balance its trade deficit without a robust manufacturing sector (though expanded services trade will also play an important role in balancing the trade deficit). Indeed, the principal reason to be concerned with the health of U.S. manufacturing relates to they key role it can play in ameliorating our unsustainable trade deficits. For the trade deficit represents a hidden tax on the next generation of Americans, who will have to pay off the debt in the form of reduced consumption of real goods and services and a future trade surplus. Manufacturing as a key source of U.S. exports is also important because exports lead to employment growth and support high-paying jobs. For example, economist Lori Kletzner finds that, within an industry, a 10 percent increase in sales due to exports leads to a 7 percent increase in employment, while a 10 percent increase in domestic demand leads to just a 3.5 percent increase in employment. Exports also contribute an additional 18 percent to workers’ earnings on average in the U.S. manufacturing sector, explaining in part why U.S. manufacturing jobs pay on average 9 percent more in wages and benefits than jobs in the overall economy.

Yet The Economist suggests that manufacturing is increasingly less important to developed economies as services take a larger share of GDP in many developed nations. The piece contends that manufacturing output as a percentage of GDP fell from 1991 to 2009 in Britain, Germany, Japan, and the United States, thereby suggesting that manufacturing is in uniform decline across developed countries. But that’s not the case. Over the last decade, Austria, Germany, the Netherlands, and Norway have all seen stable manufacturing shares (on an inflation-adjusted basis). Other nations have actually seen their manufacturing sectors grow as a share of their economy, by 5 percent in Switzerland, 13 percent in Finland, 39 percent in Korea, and 68 percent in the Slovak Republic. Other countries in which manufacturing as a share of GDP increased from 2000 to 2008 include Austria, the Czech Republic, Estonia, Hungary, Poland, and Sweden. So, contrary to The Economist’s suggestion, a declining manufacturing sector in a developed nation is neither “normal,” “inevitable,” nor even “desirable.” Simply put, manufacturing remains a vital component of healthy advanced economies.

However, “one reason for the fascination with manufacturing” The Economist dismissively contends, citing Bhagwati, “is the mistaken belief that it is more technologically dynamic than services industries.” Bhagwati also argues that a second assumption of the so-called ‘fetishists’, “that manufacturing is better for job creation” is fundamentally flawed. Now to be sure, the article rightly notes that many services firms and sectors (e.g. Wal-Mart in the retail industry) have aggressively and effectively used technology to raise productivity and create novel business models. And there’s no doubt that the services sector has been critically important for job growth. But while these points are valid, they utterly fail to prove either: 1) the dispositive, that the services sector is more “technologically dynamic” than the manufacturing sector and a better source of high-paying employment, or 2) that just because services are important, that this means that we should feel comfortable ignoring the health of the traded manufacturing sectors of our economy. That is, just because services are important, doesn’t mean that there’s a corollary that says that manufacturing is unimportant. While Bhagwati may be correct that some focus too much on manufacturing and not enough on services, he is guilty of the opposite fallacy, focusing too much on services, and not enough on manufacturing.

Moreover, to argument #1 above, it’s important to note that manufacturing firms account for 70% of the U.S. economy’s R&D. This means that manufacturing R&D remains the dominant source of service-sector technologies. At the same time, the National Science Foundation’s 2008 Business R&D and Innovation Survey (BRDIS) found that on average 22 percent of U.S. manufacturing firms reported being active innovators, while only 8 percent of U.S. non-manufacturing (mostly services) firms reported being active innovators. So there is some evidence that U.S. manufacturing firms may actually be more innovative than its service firms. But the reality is that it shouldn’t be a contest. Rather, the manufacturing and services sectors of an economy are inseparable and complementary; their health goes hand-in-hand.

Although some argue that U.S. manufacturing is quite healthy and that recent job losses in manufacturing are due to superior productivity performance, the reality is that output growth in U.S. manufacturing has been overstated by flawed statistics and that manufacturing job loss has stemmed also from a decline in output and competitiveness. In fact, from 2000 to 2008, fifteen of nineteen U.S. manufacturing sectors (representing 72 percent of manufacturing output) saw absolute declines in output. Moreover, manufacturing lagged overall economic growth over that time period, as total manufacturing realized a 5 percent increase in real-value-added while U.S. GDP increased 18 percent. We argue this merits a serious policy response.

But for neoclassical economists, whatever outcome the “market” produces is by definition the proper outcome. Thus, if U.S. manufacturing is doing fine, there’s no need for proactive public policies to support it. But if U.S. manufacturing is faring poorly, then the market is simply saying that manufacturing is no longer as important to the economy, so again there’s no need for intervention. Inherent in this is the assumption that unbridled, untrammeled “market forces” are producing these outcomes, and not in part the effects of foreign government policies—whether fair or unfair—to shift comparative advantage in key manufacturing industries to their favor. As ITIF explained in its report, The Good, The Bad, and The Ugly of Innovation Policy, such “fair” policies include measures to support scientific research, develop talent, and deploy digital technology platforms, while “unfair” practices include mercantilist policies such as currency and standards manipulation, IP theft, or forced transfer of IP as a condition of market access—policies designed to gain unilateral advantage to the detriment of other nations’ firms and industries.

The Economist dismisses the idea that America should explicitly target some public-sector investment toward technologies that could expand the scope of the tradable sector, arguing that, “It is far from clear whether, and how, such a policy might work…And many would question the need for this sort of industry policy in the first place.” But having a national manufacturing strategy is not tantamount to having a heavy-handed industrial policy that picks specific firms as national champions in winner industries. Rather, a number of countries—including Brazil, Canada, China, Germany, India, Japan, Korea, Singapore, South Africa, and the United Kingdom (amongst others)—have moved beyond this shallow red herring to articulate national manufacturing strategies. These countries’ manufacturing strategies offer a coherent set of policies around the “4T’s”—tax, trade, technology, and talent—designed to bolster the competitiveness of their manufacturing firms and industries. And the United States will likewise need a coherent manufacturing strategy if it wants to stay competitive with these countries and to restore U.S. manufacturing to a world leading position, as ITIF will explain in further detail at an event on Tuesday, April 26 when it releases a new report entitled The Case for a National Manufacturing Strategy for the United States.