11 April 2018

The false promise of manufacturing

by Oliver Wiseman

Originally published by CapX.

The lament that we don’t make things any more is a common refrain in most developed economies. Ever since the financial crisis, a preference for real-world production lines over high-finance funny business has become de rigeur. It is one of the few things that populists and centrists can agree on. Donald Trump has promised a return of factory jobs to down-at-heel parts of America. Politicians on the centre-left and centre-right promise to do the same by different means. Recall, for example, George Osborne’s abortive “March of the Makers”.

But, according to new research by the IMF, this fondness for manufacturing has gone too far. And policymakers scratching their heads trying to revive the sector have been wasting their time.

The pro-manufacturing bias long pre-dates the financial crisis. In fact, its pedigree could hardly be better. In The Wealth of Nations Adam Smith dismissed the labour of those who work in the services as “unproductive of any value”: “Like the declamation of the actor, the harangue of the orator, or the tune of the musician, the work of all of them perishes in the very instant of its production.”

The desire to boost manufacturing is about more than a vague bias against intangible economic activity. Developed countries that have a thriving manufacturing sector tend to be more equal than those that don’t. Manufacturing is generally thought to be the engine of productivity growth and a part of the economy where workers can earn higher wages than they would be able to elsewhere. And so, the decline of manufacturing has, the argument goes, made us less productive than we would otherwise have been and hollowed out the middle of the income distribution in economies like Britain’s.

The policy implication is that if you want the right kind of growth – the kind that delivers high wages and stable jobs – then government should do what it can to encourage the re-emergence of a thriving manufacturing sector.

But, according to the IMF economists, there are several problems with that theory. The most important is that the link between manufacturing and productivity growth has been overstated. In fact, they argue, “there is a sizable overlap between productivity growth among the service and the manufacturing subsectors.” Some parts of the services sector are more productive than manufacturing. Others aren’t. And, contrary to what many might assume, the shift from manufacturing to services hasn’t weighed on productivity growth.

As for the link between income inequality and the decline of manufacturing, the IMF report finds that while wages do tend to be higher and more evenly distributed in manufacturing than in services, “the key drivers behind greater pay inequality over time seem to be the dislocation of middle-skilled workers through technology and trade – and the resultant downward pressure on wages for medium- and low-skill jobs – rather than shifts in the relative size of employment between industry and services.”

Arguments against government efforts to rebalance the economy by incentivising the re-emergence of manufacturing tend to focus on the impossibility of that task. But, if the IMF economists are right, such policies aren’t just ineffective but basically pointless.

In her excellent new primer, The Great Economists: How Their Ideas Can Help Us Today, Linda Yueh asks whether Adam Smith – who evidently didn’t think much of the services sector – would support modern governments’ efforts to rebalance the economy.

Yueh’s answer is no. Smith’s view of services was largely a product of his time. He wrote The Wealth of Nations at the dawn of the industrial revolution, and so his focus on making stuff is understandable. Moreover, the technological advances of the last few hundred years mean the tune of a musician, to take Smith’s example, is no longer ephemeral.

But more importantly, his confidence in the power of the invisible hand trumps all else. He may not have thought much of musicians, orators and actors, but it was for the market to judge their worth. Were he around today, Smith would have argued that efforts to promote manufacturing ahead of services introduce distortions that ultimately make us all poorer. According to Smith, “Upon the whole… it is by far the best police to leave things to their natural course.”

Such warnings against government overreach do not mean that government should do nothing. Rather they are a reminder that the government’s focus should be on delivering the stability and openness that creates a broadly business-friendly environment, rather than prioritising one part of the economy over another.

That is especially true when the line between manufacturing and services is becoming ever more blurred. As Yueh points out, Rolls-Royce is seen as one of the few British manufacturing success stories, but they “make more money servicing and maintaining their engines than selling the engines themselves”.

The fetish for manufacturing hasn’t just led to costly and largely pointless policies across the developed world. It’s also taken policymakers’ eyes off things that could make a real difference. In particular, if the IMF is right that services can be as good a source of productivity growth as manufacturing, then the economic rewards of further liberalisation of trade in services could be much bigger than has been anticipated.

It’s not hard to see why manufacturing’s decline has preoccupied governments across the developed world. The way in which it has left formerly prosperous places with very little in the way of economic activity has often devastated the communities that are left behind, creating deep social problems and considerable political anger. But the job of government should be to manage that process, not reverse the tide of economic history.