How the West Abandoned Manufacturing in Favour of a Service Economy, Causing a Decline in our Standard of Living

The British Prime Minister is fond of talking of the “global race”. It is an apposite if inane analogy, and it goes against the grain of the prevailing assumptions on international trade which have been held by many in the West over the past forty years. A race is a competitive thing; it has a winner. In a global race, countries must fight and scrap for custom, and their victory is implicitly at the expense of competitor nations.

This may appear to be a statement of the obvious. It is. But even so, it amounts to an insight which has eluded Western policy makers for some time. At a governmental level policy makers are squarely behind globalisation – the idea that increasing global economic interconnectedness will lead to increasing political connections under international umbrella bodies, and mutual economic gain. As it has been understood in the West, globalisation removes barriers to trade and has the consequent effect of allowing nations to specialise according to where their natural expertise lies. The modern multi-national corporation is a good example of this – its products may be designed in America, but they are assembled in China with parts made from materials extracted in Africa. It is inevitable, in this view, that countries develop specialisations, because foreign competition will overwhelm the domestic market in areas of weakness when not protected by a tariff structure.

Where the public in the West have expressed disapproval of this movement, it is usually couched in terms of concern for foreign workers in low-regulation, low-wage regimes. Unwittingly, these are arguments for more globalisation, not less. Only a universal labour market law would be capable of removing these distances, and such a law would almost certainly visit economic ruin on any emerging market country foolish enough to sign up to it. One of the reasons for the lack of success of the anti-globalisation movement in the policy space is that its big idea would serve to make everybody worse off – cheap goods disappear from the West, jobs disappear from the East, nations return to a state of non-competitive agrarian ignorance of the global market that has not existed since the time of the flood. This is to be regretted – a movement as deadly as globalisation deserves a better critique.

The specialist economy

That the UK has shifted towards an economy grounded on ideas, rather than on either agriculture or industry, is borne out by the statistics. Since 1964, ONS data shows that the primary (extractive) sector’s share of GDP has fallen from 5.8% to 3.7%, despite the success of North Sea oil. The secondary (industrial and manufacturing) sector’s share has slumped from 40.8% to 19.4%. The tertiary (services and intellectual property) sector has surged from 53.8% to 76.8%.
The British experience is an extreme variant of a movement which all Western economies (with the recent exception of Germany) have experienced in the last half century – moving away from extractive and productive industries and into the more ephemeral economic world of thoughts and actions. In no small part, the success of the West has been down to its ability to make things. No matter which industry, be it transport, medicine, telecommunications, or computing, the West has substantially improved people’s lives as a result of its physical innovation. In contrast, a great deal of the commercial focus of the West is now centred on intellectual innovation.

The shift from the physical world to the one of phone apps, computer programmes, and websites, is symptomatic of our inability to price properly. As an example, take the 2013 IPOs of two communications businesses. On the one hand, Twitter, which delivers 140-character messages electronically, priced at $17.4bn, with no substantial physical architecture, no obvious method of monetising the business model and a profit so far this year of…-$133.8m. In contrast, the Royal Mail, which delivers physical letters and parcels, makes a profit of £403m annually and has physical net assets of £1.4bn, was launched onto the stock market with a valuation of only £3.3bn. While there is a value in both companies, it is difficult to argue that the former deserves such a premium to the latter, or even that it offers a service which is half-way as useful. The exaggerated values which the West is placing on non-physical innovation, as seen here, will also have a deeper effect – investment in the physical architecture which countries need to flourish is set aside in favour of investment in programmes with lower overheads but larger re-sale values in frothy markets. It is no wonder that Britain currently faces an infrastructure gap worth £200bn – the investment capital which might have been assigned there is chasing meatier returns from restraint rating apps hailing from Silicon Roundabout.

Specialising in intellectual property won’t work without global standards

[pullquote]If innovative ideas can be copied and replicated when they are sent East, the West swiftly loses its competitive advantage.[/pullquote]But is there something fundamentally wrong with the idea that the West can focus on producing non-physical innovations while relying on the Rest to keep up the supply of physical goods? There is. At once, a truly tertiary economy requires both globalisation and a degree of homogeneity in regulations that globalisation is unlikely to provide. Think of it this way – without globalisation, it is impossible for the tertiary economy to survive – its workers require food and demand manufactured goods, these goods can only come from outside, and, as there is no significant domestic industry to protect, it is natural that there should be a desire for imports to have to pass through a low tariff barrier, as a high one would add to the cost of living and lower standards. On this reading, a tertiary economy incentivises country specialisation and free trade.

There is, however, a contradictory impulse inherent in the same model. A society which lives largely on intellectual property has a strong interest in seeing that property subject to fulsome protections wherever it is deployed. This is an idea which is inimical to the concept of specialisation outlined above, in which countries attempt to differentiate themselves from their competitors through adaption of the domestic market to best serve international demand. In other words – specialisation in the area of ideas cannot long persist without global protection for intellectual property. Deciding whether to extend that protection is a way in which economies can compete for investment. The only way to punish miscreant economies is with trade sanctions, and this is impossible because to do so would limit the access of the ideas economy to the finished goods it requires from less regulated, lower-wage peers. The impact of intellectual property theft globally is enormous. The United States estimates that theft of intellectual property by China alone is costing it around $300bn a year, while a study for the Cabinet Office in Britain found that the UK loses £9.2bn to intellectual property theft over the same period. Over the long-term, the effect of this movement is to effect a large-scale wealth transfer from the innovation-led West to the manufacturing-led East. The transfer of capital to build plants, machinery and equipment in the East has been on-going for at least two decades. The West’s ability to extract and remit profits based on the activities of these plants is a function of the quality of its ideas. If these ideas can be copied and replicated when they are sent East, the West swiftly loses its competitive advantage.

The de-industrialisation cycle

What is seldom recognised is that the wealth transfer which the West effected by switching its physical production Eastwards is a permanent one. Quite aside from patterns of consumer behaviour which will continue to both drive and be driven by innovators of thoughts as opposed to things, policymakers have proved over the course of the financial crisis that they are quite unable to re-shape Western economies even if we wished to.

The spiral by which the West imports goods from abroad, meaning that factories are mothballed and skills lost at home, results in even more production going abroad. The West is collectively haemorrhaging the industrial base which it needs if it is ever to make things again. This would not matter if the system above worked perfectly. Instead, it produces a cycle of national indebtedness which governments in the West belatedly attempt to rectify. The tools at their disposal do not work, because the effects of the globalised system already run so deep. This position has profound effects for Britain. Firstly, it is a drain on GDP. The country is losing 3.8% of GDP per year because of the balance of payments deficit, according to the latest ONS Pink Book. While reversing this drain would offer support to domestic producers and ballast to weak GDP figures, doing so has proved impossible. Part of this is thanks to the policy set open to the government. It is severely restricted in aiding manufacturers through fiscal policy, as its hands are bound in relation to other EU producers. Any allowance offered domestically has to be extended to companies resident elsewhere in the EU; likewise, the government has no control over its own tariff policy, which is determined in Brussels. Attempting to give a helping hand through monetary policy has been spectacularly unsuccessful, too.
The Bank of England’s policy of attempting to stimulate an export-led recovery by devaluing sterling through a mixture of low interest rates, Quantitative Easing and talking it down, has not had the effect which the models predicted – the current account has not rebalanced but instead the deficit is the worst it has been, as a percentage of GDP, since 1989. This is not only due to the simplicity of a model which supposes that economies all produce similar baskets of goods and can therefore compete with one another on a level playing field, gaining competitive advantage through devaluation. It should instead be ascribed to the simplicity of economists, particularly the Little Emperors of the central banks, unable or unwilling to dilute the purity of economic theory with even a couple of basic data points drawn from the reality of economic life.

Britain is not blessed with an enormous endowment of natural resources. There is a great deal of coal under Wales which climate change laws make it uneconomical to mine, there is still around 25% of the lifetime extractable oil left in the North Sea, while the country is dotted with small deposits of base metals and ancient woodland which for one reason or another we are forbidden to dig up. This means that in large part, the raw materials for our manufacturing sector are imports. The car industry accounts for 11% of British exports, and 70% of the parts in those cars are purchased from abroad. In short, the dependence of Britain’s industrial sector on extractive imports means that when sterling falls, input costs rise for the manufacturer. These are passed on to the end consumer, offsetting the effect of a fall in sterling on the currency markets. The net effect is not a thriving export sector, but simply to increase inflation at home when the end consumer does not benefit from the offsetting effect of buying in foreign currency. An example is the pump price of petrol rising while global prices fell thanks to sterling weakness and oil’s dollar denomination. These policy wheezes, while clever on paper, will likely always now be offset by the fact that the structure of the British economy, and its legal framework, no longer allows it to replace primary production from abroad with primary production domestically when the pound falls.
We have brought this collective crisis on ourselves. Capitalism, unencumbered by national sentiment and driven by a corporate incentivisation structure which prioritises result maximisation in the short-run, will always seek the cheapest possible manufacturing base. Where overheads are high, it will pursue high-margin, low-overhead businesses which offer ideas rather than physical products. These factors have driven so much of the West’s industrial base overseas. The sadness is the complicity of government – having watched their industrial heartlands wash away, governments throughout the West are now finding that they cannot be revived with a tweak to monetary policy. We have squandered a 200 year legacy for the sake of 20 years of additional margin. Our actions and motives are questionable; sadly the results are not.

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Image credits: banner; sewing; Post Office; magnifying glass; factory; oil rig.