The significance of manufacturing is one of those issues where it is difficult to extract the truth from thickets of nonsense, special pleading and excuses for failure. It should be obvious that, in principle, pounds 1m of income arising from services is every bit as valuable as pounds 1m arising from manufacturing. In this sense there is nothing special about manufacturing.
Yet there is a special association with manufacturing at the heart of Britain's economic predicament. The charts tell a story. In the first, the share of manufacturing in GDP is shown plunging. This can be presented as healthy. On the whole, the more developed the economy, the smaller the share of manufacturing and the larger the share of services in its GDP.
How difficult it is to distinguish fact from fiction] The evidence from the second chart suggests that the decline of manufacturing in the UK went beyond the stage associated with healthy economic development. British and world demand for manufactured goods has been rising: it is simply that this demand has increasingly been met by foreign suppliers, ironically often from countries more developed than ourselves - namely Germany and Japan, which ran trade surpluses in manufacturing.
Does the decline of manufacturing matter? Why not simply accept that we are not good at manufacturing and concentrate on services instead? Theoretically, we could set ourselves the objective of having better and better services and leave manufacturing to other countries. Much depends on the type of services that are developed. If they are internationally tradeable ones, one potential problem associated with the decline of manufacturing would disappear - the trade imbalance. Indeed, Britain has continued to do well from traded services, but not well enough. If the decline in manufacturing had been compensated for by the expansion of tradeable services, we would not now be running a substantial balance of payments deficit. Moreover, in the field of traded services the competition is growing stiffer. Britain's position is under threat from many of the same factors that undermined our position in manufacturing. Yet without exports, we cannot buy imports.
It is manufacturing that offers the greatest scope for productivity increases. Accordingly, a country that has a low share of manufacturing is likely to enjoy only a slow rate of economic growth. And, of course, much of the increased service output has not been tradeable. So we have ended up with a trade deficit.
But given that the switch from manufacturing to (mainly non-traded) services was freely chosen by business, pursuing profit opportunities, how can it have been against our national interests in principle? Do free markets not work? Part of the answer lies with the word 'chosen'. It was not so much of a choice as a forced retreat.
Manufacturing's relative decline reflects a higher level of exposure to international competition, which simply could not be withstood, particularly at the absurdly high sterling exchange rates between 1979 and 1981. As business withdrew from the areas where competition was stiffest, economic activity concentrated in the sheltered areas of the economy, where the competition was with other British producers who faced the same conditions and the same set of penalties and inducements.
The process was long established, but the particular economic conditions of the 1980s exacerbated the situation. A weaker exchange rate after 1981 improved manufacturing's profitability, but not enough. Given the technological gap that had opened up between Britain and the leading exporting countries, particularly Germany and Japan, the exchange rate would have had to be particularly competitive to give Britain any advantage.
The attitude of the Government was unhelpful. It seemed to be saying that there was little or no future for manufacturing in Britain and that it regarded the exchange rate as either irrelevant or as a tool for bringing inflation down. This left industrialists with the latent fear that the exchange rate could again be forced to uncompetitive levels as an act of policy. This discouraged investment in expanded capacity. As it happened, such fears were proved well-founded by the events of 1990-92.
Meanwhile, conditions in the economy favoured expansion in other areas. Consumer spending grew strongly. Although much of the demand resulted in increased imports, in the supply of both these and British goods, British business had no overseas competitors. So here was an area where British business could make money and where it seemed to pay to invest in high-street developments and out-of-town shopping centres. Financial deregulation led to an explosion of business opportunities in financial services and helped to sustain the boom conditions in the commercial and residential property markets, which created still more demand. Yet, if we are ever to equal the standard of living of our competitors in Europe, there will have to be a sustained recovery of UK manufacturing. What should the Government do to foster this?
One approach is to intervene directly in industry, directing funds and subsidising activities. But this has not worked well in the past, and there is no reason to think it would work well now. Rather, the Government's attention should be directed towards ensuring a suitable macro-climate for manufacturing. The first priority is a competitive exchange rate and the clear acknowledgement by the authorities that they are trying to keep it competitive, rather than using it as a crude tool of anti-inflation policy, as in the 1980s. For without confidence that the exchange rate will stay competitive, industry will not embark on the long-term investment necessary to enhance capacity. Equally, interest rates need to be kept low, consistent with this objective.
How then is inflation to be controlled? In this regard, the current economic situation could hardly be bettered as a starting point. For disinflationary forces are still very strong. The Government's new pay policy in the public sector is going to help. But the weapon the Government needs to apply to restrain inflation is fiscal policy. Not now, of course. But when consumer demand recovers, the Government must be prepared to restrain it by raising taxes. If the housing market threatens to get out of control again, the Government must tackle the favourable tax treatment of housing.
Yet to get the right response from industrialists and the lenders, the Government must make clear that it sees the revival of manufacturing as essential to our future. If the British economy is properly managed from now, the 1990s can be the decade in which manufacturing is the sector to make money rather than property or financial services. Given the experience of the last 13 years, the Government will have to help industry seize the opportunity.
The author is chief economist, Midland Global Markets. Christopher Huhne is on holiday.
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