Hamish McRae: Manufacturing is growing, but don't expect it to rescue the economy

Economic view

Manufacturing is back. Not only is output in Britain finally climbing, but we had data last week that suggested manufacturers were more positive about prospects than at any time since 1994.

At a time when concerns have been mounting that the economy faces a double dip, this is welcome news. Maybe the fall in the pound is doing what it is supposed to do: increase demand for UK exports and cut back our demand for imports.

Here we have an immediate issue and a longer-term one. The immediate issue is where demand will come from in the next stage of the recovery; the longer-term one is whether the country can successfully rebalance away from over-reliance on service industry exports and towards manufactured ones.

On the first, there are considerable reasons for optimism. You can see in the graph the huge dip that took place both in manufacturing output last year and, just ahead of that dip, the corresponding fall in optimism of manufacturers as measured by the Purchasing Managers Index. The PMI has in the past given a good feel for what might happen to output, and the two are plotted here beside each other by Capital Economics, a consultancy.

If you look at the individual components of the index, among the strongest items are orders, particularly new export orders, while one of the weaker items is employment prospects. This leads to the, albeit crude, conclusion that companies are cheerful about the amount of work that they have coming up, but are not likely to take on many additional workers to fulfil that demand.

If that proves broadly right, it is both good news and bad news. The pattern of development in all the advanced economies has been for employment in manufacturing to shrink, so we have not been alone in losing jobs during the recession. But manufacturing employment in Britain has simply gone down, over a long period, somewhat more swiftly than in most other countries.

Take another look at that graph. Right through the boom years, from 2002-2008, output in manufacturing quarter-on-quarter barely rose. As you can see, the line bounced around the zero point, spending almost as much time below it as above. All the growth in the economy that occurred during the boom was elsewhere.

That leads to the second and longer-term question: can we rebalance the economy? Here I think you have to be careful. It is easy for politicians and journalists to state that the economy is overly dependent on financial services and call for manufacturing to be built up to reduce that dependence. It is harder to see quite how to do that. The one policy we have tested to destruction over the past half-century is industrial policy. Hardly anyone still believes the Government is good at determining which parts of the economy should flourish and which parts should be allowed to decline. However, what governments can do is to remove roadblocks to all forms of economic activity.

So I suggest the issue is not so much whether we can rebalance the economy, but rather whether some areas of competitive advantage in manufacturing could be encouraged to flourish further which are currently being held back. We cannot know whether the economy can rebalance; all we can do is make sure no roadblocks stand in the path.

As a general management principle, the way to succeed is to reinforce success. Some areas of success are really quite sizeable. These include the aerospace industry, with British Aerospace and Rolls-Royce. They include the car assembly business, true, almost entirely foreign-owned. They include pharmaceuticals. And they include any form of manufacturing with a high level of craft involved.

But there are problems. One simple point is that manufacturing tends to be energy-dependent. So if we want to move to a lower-energy economy, which seems to be government policy, that will of itself mean a move to a smaller manufacturing sector. Yes, I know that the best manufacturers are working hard to reduce energy consumption, but it is naive to think that if you increase energy prices you won't damage industry.

Another point is that investment in manufacturing in recent years has largely been foreign financed. We have been remarkably successful in attracting inward investment until last year, when it plunged. One reason why it plunged was the feeling that Britain no longer wanted to attract such investment: the Government had suddenly turned anti-business. Bodies such as the CBI have been told by foreign investors that the case for investing in the UK, relative to other European countries, is much less attractive now.

A third point is tax. A trickle of UK companies, including some in manufacturing, have moved their headquarters abroad to more enticing fiscal environments. True, it has only been a trickle, but think of the effect this has on would-be inward investors. If British companies are moving out, why should they move in? In the past year, inward investment has plunged. I have not seen a breakdown of which types of investment fell most, but it cannot be good for the manufacturing sector.

Some positive things can be done. One is education. One fascinating idea is that we should recover the word "engineer" as a professional qualification. But big companies say "we will send an engineer" when they mean they will send a fitter. It will be tough to improve the status of engineers until that ends.

Another is more general support for small and medium-sized businesses, or "independent" businesses as they like to be known. Here lies a huge gap between rhetoric and reality. All governments profess to be in favour of independent businesses, but in practice they bully them with new regulations and more complex taxation requirements. Simple point one: large businesses quite like regulation because it is a weapon they can use against small businesses that don't have the resources to cope. Simple point two: all net additional job creation in the private sector comes from small and medium-sized businesses, for large businesses are net shedders of labour.

The big point here is that manufacturing can and will play a big role in economic growth in the next decade. I suspect we are quite close to the point where its long-term decline is coming to an end, or at the very least tapering off. But I don't think we should be starry-eyed about the possibilities and opportunities. It will be a slog. Manufacturing will help us along that slog, if it is allowed to do so. We should celebrate its present recovery, but we should not expect it to ride to the economy's rescue. The world is not like that.

If we get three Budgets this year, look for radical change in the last one

We still don't know the date of the Budget, though it is generally expected to be 24 March. I was fussing about how inconvenient it is, as the rest of us have to plan our work schedules, when a colleague pointed out that we might have three Budgets this year: this one, the emergency one after the general election, and then a third after the second election.

Well, we will certainly have two and maybe we should use these to have a thoughtful look at our taxation system. It is unreasonable to expect a new government to do more than patch things this year but it ought to be possible over the next four or five years to improve it.

There has been a lot of attention to one bit of harsh maths: no government for the past 40 years has been able to raise more than about 38 per cent of GDP in taxation, yet people want governments to spend something upwards of 40 per cent on services. Current spending is about 48 per cent of GDP but that will have to be tackled.

There is however another bit of harsh maths: the present tax take is only about 35 per cent of GDP, yet we feel overtaxed.

So we have two problems: a structural deficit and a poorly-designed tax system. Some thoughts on tackling the latter have just been outlined by the think-tank Reform, in a paper Reality check: Fixing the UK's tax system. The core of its argument is that we have to shift the balance of taxes from earning to spending. It argues that the tax system has to encourage economic efficiency; it has to be consistent; it has to be transparent; and it has to be fair.

Few would quarrel with that. The problem comes when you apply those principles. Reform says broaden the VAT base to include food and other zero-rated items but protect lower-income groups from the impact. And simplify income tax by changing the personal allowance system. So that people with incomes of below £17,000 would pay less tax and those above would pay more.

Well, maybe not an idea for the first budget or even the second – but the third?