Britain's shrinking industrial base and stagnating output poses a long-term threat to economic growth. A different approach to industrial policy is needed, says Nigel Healey, to strengthen the incentive to research, invest and train invest and to train.
The 1980s were a heady decade. The economy boomed, output soared, unemployment tumbled. Only Britain's manufacturing sector missed the party. While overall economic growth touched Japanese-style highs, manufacturing output hardly increased at all, averaging a dismal 0.5% per annum. Over the same period, UK factories shed jobs relentlessly. Not even the wild excesses of the Lawson years could do more than temporarily interrupt the decline in the manufacturing base.
Today, the picture is bleaker still. Three years of recession have hit manufacturers particularly hard. During the exchange rate mechanism (ERM) era, high interest rates and an overvalued exchange rate hurt capital-intensive industrial companies and eroded their export competitiveness. With freedom from the ERM straitjacket coinciding with the collapse of key export markets in recession-hit Europe, no one is expecting an early pick-up in activity.
Views over the health and prospects of the manufacturing sector are sharply divided. Many argue that so-called 'de-industrialisation' is an inevitable stage of economic development and that public concern over the demise of smokestack industry reflects misplaced sentimentality. Critics retort that the speed and scale of Britain's de-industrialisation is uniquely and damagingly rapid, requiring urgent policy action to head off impending disaster. Like most well-worn controversies, clear thinking is clouded by a fog of misinformation, misconception and downright ignorance. That the issue deserves further attention is, however, not open to question.
'The "industrial base" is the "secondary" sector of the economy that produces tangible goods,' explains Professor Mike Hardy, consultant at Lancashire Enterprises. 'The so-called "primary" sector produces raw materials like agricultural goods and minerals and the "tertiary" or service sector produces services like retailing and distribution.' Hardy points out that, while the terms industrial base and manufacturing sector are often used interchangeably, the latter is technically a subset of the former. 'The secondary sector is dominated by manufacturing, but it also includes energy production and construction,' he adds. 'When people speak of de-industrialisation though, they are invariably referring to the manufacturing sector.' Table 1 shows the main categories of production within the manufacturing sector. It reveals that, in all cases, employment was sharply down between 1981-91, with only three of the 14 sectors (chemicals, electrical engineering and paper) matching the performance of the service sector in terms of output growth. Since the onset of recession in 1991, the labour shake-out has accelerated, while output has actually shrunk across the board.
The classification of companies as manufacturing, rather than services is, however, somewhat artificial. Manufacturing firms rely on a raft of in-house services (eg, accounting, marketing, human resource management) to profitably transform rubber, plastic and steel into finished products. Service companies frequently process tangible goods as part of their core business: the delivery systems of McDonald's and Kwik-Fit, for example, are designed to add value to frozen beef patties and car tyres. Indeed, most commercial activities are neither pure manufacturing nor pure services, but a seamless blend of the two.
This essentially arbitrary distinction between manufacturing and services is important because the organisation of production is changing rapidly, argues Peter Lawrence, chairman of Associated British Industries. 'Manufacturing companies historically employed ancillary workers, night watchmen, cleaners, maintenance men, costing and sales clerk and just "fat",' he says. 'The lean industry of the 1990s buys in all these services from professional companies selling security or janitorial services, leases on full maintenance trucks, cars and equipment, and under demand pressure, contracts in labour.' The result? In terms of both numbers employed and valued-added, the manufacturing sector appears to be shrinking, while the service sector is expanding. 'This tendency will continue,' warns Lawrence, 'as manufacturing is broken up into its component stages and sub-contracted out.' 'Recent corporate fads like outsourcing have undoubtedly accelerated the decline in the industrial base, but the phenomenon of de-industrialisation is much more than a statistical quirk,' declares Professor David Parker, a business economist at Birmingham University. He points out that the contraction of manufacturing began in the early 1960s. Manufacturing employment and manufacturing output as a share of GDP (see graphs on p39) have shrunk steadily since then, brushing aside swings in management fashion and industrial policy. 'De-industrialisation is a fact of British industrial life,' he concludes.
But is Britain alone in contracting this wasting disease? Fred Strobel, an American academic who has made a detailed study of de-industrialisation in the US, doesn't think so. 'There's nothing special about de-industrialisation in Britain,' he says. 'All the advanced economies industrialised in the first place by scaling down their agricultural sectors. An expanding service sector and the run-down of manufacturing is just the next stage.' Professor Tony Thirlwall, a leading authority on de-industrialisation based at the University of Canterbury, rejects the argument that British industrial trends are mirrored in other countries, drawing a distinction between 'positive' and 'negative' de-industrialisation. While manufacturing employment is also falling in other major economies, he argues, 'this is because a high rate of growth of output is being outstripped by an even higher rate of growth of productivity'. Such positive de-industrialisation alters the sectoral pattern of employment, but is consistent with a strong, growing manufacturing sector in output terms. In Britain, in contrast, Thirlwall notes that 'falling manufacturing employment is the result of a low growth of output that is being exceeded by a mediocre rate of growth of productivity'.
British de-industrialisation is thus essentially negative - the decline in manufacturing employment reflects the weakness of the manufacturing sector, rather than buoyant productivity growth, and is associated with a shrinking industrial base and stagnating output. Table 2 illustrates the performance of manufacturing in the main Organisation for Economic Co-operation and Development (OECD) countries over the last two decades. It shows that, while Britain's productivity growth has been about average, this has been coupled with sluggish growth in manufacturing output. The result has been labour-shedding on a scale not experienced in other major economies (Table 3).
John Wells, a Cambridge economist, is also dismissive of the fatalistic, 'de-industrialisation-is-inevitable' view. He points out that this view is based on the underlying assumption that, as living standards rise, an increasing proportion of spending is channelled into buying services, with the result that relative spending (and so production) of manufactured goods declines. 'But when we look at the pattern of domestic spending,' Wells argues, 'there is no sign that Britain is experiencing a shift in the pattern of spending away from manufactures towards services.' He points out that over the 1980s, consumer spending on manufactures and services rose at almost exactly the same rate. The crucial difference was that, while spending on services was matched by a comparable increase in service output, says Wells, 'the increase in domestic spending on manufactures of roughly 26% contrasts with an increase in manufacturing output of just 8%'.
The implication is clear: consumption patterns are not switching away from manufactures towards services; British manufacturers are simply becoming uncompetitive vis-a-vis overseas rivals. The dramatic decline in Britain's share of world trade in manufactures supports this bleak interpretation of events (see graph, p39). Wells and Thirlwall are united in their conclusion that British de-industrialisation is not part of an inevitable, benign, global process, but a uniquely serious British problem.
Why does it matter that Britain has contracted such a uniquely negative strain of the de-industrialisation virus? Most concern attaches to the implications for the nation's trading position. The House of Lords Select Committee investigating de-industrialisation echoed this view, arguing that 'unless steps can be taken to enlarge the manufacturing base, combat import penetration and stimulate the export of manufactured goods, as oil revenues diminish the country will experience a grave threat to our standard of living'. The Manufacturing Trade Balance graph (not included) shows the development of the UK's current account. Historically, a surplus on manufactured goods plugged a deficit on other trade. Since 1982, however, the balance on manufactured goods has slumped into deficit. With oil revenues dwindling, the result has been that the decline in manufacturing has pulled the current account into an alarmingly large, structural deficit.
'De-industrialisation matters for trading nations like Britain,' says Professor Hal Williams, trade adviser to the governor of Ohio. 'Manufactures are internationally tradable in a way that services are not. Indeed, trade in services was historically so limited relative to manufactures that, before the present GATT talks, countries had not even attempted to regulate it.' He warns: 'Exports of services just can't fill the gap left by the run-down of industry.' Williams envisages a nightmare scenario if de-industrialisation is not arrested. 'If you want to know what happens when countries can't pay their way in the world, take a look at Latin America,' he cautions. When the international banks became tired of financing their trade deficits in the early 1980s, the flow of vital consumer goods and capital equipment to the economies of Latin America fell by a third, slashing living standards and stalling development. 'Britain is still a long way from this point,' Williams concedes, 'but de-industrialisation is creating a serious structural balance of payments problem which you guys want to address.' It is not only Britain's trade position which is at risk from de-industrialisation. Three decades ago, Professor Nicholas Kaldor spotted a disturbing link between the rate of economic growth and size of the manufacturing sector. Kaldor managed to successfully parlay this empirical observation into a cottage industry, securing himself a position as an economic adviser to the then Labour government and constructing a decade of industrial policy around the proposition that manufacturing is the main engine of growth.
Kaldor pointed out, with justification, that manufacturing is unique in the extent to which it benefits from economies of scale and experience. In contrast, productivity growth in the service sector is restrained by the much more intimate relationship between the number of service providers and the amount of the service produced. Productivity growth in the service sector has typically averaged less than 50% of that in manufacturing in the major OECD economies.
The implication is clear: the smaller the manufacturing sector, the slower the rate of overall economic growth. Casual observation supports this prediction. Table 4 shows that the economies with the largest manufacturing sectors (as a share of total output) have also experienced the fastest rates of economic growth - and have the highest levels of per capita income.
Establishing that de-industrialisation is a significant political problem is much easier than finding acceptable solutions. Most of the popular remedies have been tried and found wanting. Attempts to stem de-industrialisation by restructuring manufacturing under public ownership in the 1960s and '70s turned loss-making lame ducks into unwieldy, state-owned dinosaurs. Nationalisation became synonymous with negative rates of return, poor industrial relations and sluggish productivity growth. Government direction of R and D fared little better, resulting in hi-tech white elephants like Concorde. 'All too often in the past,' says Professor John Burton, former research director of the Institute of Economic Affairs, 'industrial policy meant governments having to pick "winners". And they invariably picked losers.' Nor have the policy prescriptions of the New Right halted the decline of manufacturing. Fourteen years of Conservative rule have seen a massive privatisation programme, the slashing of personal and corporate taxes and the introduction of new legislation to curb the power of overweening trades unions. While profitability and productivity in British manufacturing has recovered somewhat, the industrial base has continued to shrink.
The Opposition's Harriet Harman cites chronic shortages of the raw materials of industrial success - R and D, investment and skills training - as evidence that successive governments have failed to get to grips with the problem (see Table 5). 'You've only got to look at what successful economies are doing,' says Harman.'The average Japanese worker is backed by three times more capital than in Britain. And the Japanese worker is better trained.' But is greater taxpayer support for private sector investment, today's fashionable knee-jerk remedy, necessarily the solution?
There are two arguments in favour of greater state support for manufacturing investment. The first is that British companies are simply too weak, in profitability terms (see Rate of Return on Capital in Manufacturing graph) to break out of the vicious circle in which they are trapped. While overseas competitors plough back booming profits into product development, new plant and equipment and workforce upskilling, building upon their existing competitive advantages, cash-strapped British companies fall further behind. A transfusion of public funds is one way of helping British manufacturers break out of this low profitability, low investment, low productivity, low profitability circle.
Second, and more compelling, there are special features of the domestic economy that make it relatively less attractive for British firms to invest than their overseas competitors. The nature of the British capital market and the power of institutional shareholders force companies to keep a weather eye on their share prices, inhibiting long-term investment. In contrast, in Japan and Germany, hostile takeovers are an alien concept and institutional investors (mainly banks) are closely tied to companies, promoting risk-taking and a long-term perspective.
R and D and training are, moreover, plagued by problems of retaining ownership. 'Me-too' companies can compete away the potential benefits of expensive product development. Rival firms can poach staff after they have been trained. The perceived benefits of such investments by the initiating company appear low. The result? A dearth of commercial R and D and widespread skill shortages. In Japan, the keiretzu system of interlocking corporate ownership enables companies to share the cost of basic technological advances without degenerating into the cartelisation of product markets; and in both Germany and Japan, cultural and legislative factors militate against workers switching companies after training, guaranteeing that companies which train will reap the benefits of such outlays.
'Some form of legislative or tax-financed innovation is essential to level the playing field for British manufacturers,' says Mark Cook, author of Growth and Structural Change. 'Of course, governments can't undo national cultural differences or change institutional structures overnight, but at least some of the traditional approaches to industrial policy, like investment grants and training levies, balanced things up a bit. Without more state support for investment, British manufacturers are fighting a losing battle.' Walter Eltis, economic adviser to the president of the Board of Trade, Michael Heseltine, believes that, even without direct intervention, governments can do a great deal to assist British manufacturing. He argues that the Government should recognise that macroeconomic instability is exacerbating manufacturing's problems. 'Given the lowliness of average profitability in UK industry, the predictability and stability of the prospective cash flows from investments are especially important,' says Eltis. 'If profits are as low as 10%, an unfavourable exchange rate movement of 10% can wipe out profits.' He notes that the fluctuations in inflation, interest and exchange rates faced by British companies have been much more violent and disruptive than those suffered by their competitors. He is particularly critical of the Government's inflation record. 'With inflation, companies have to find more cash to pay interest,' he warns. 'If companies face a recession, they will find it difficult to pay interest to their bankers. That is why each 1% addition to the inflation rate has added almost 6% to the number of company insolvencies in the UK.' Paul Geroski, of Southampton University, agrees that modest state subsidies for investment and greater macroeconomic stability would make a valuable contribution to strengthening British manufacturing. But he feels that fashionable diagnoses of industrial malaise miss a crucial factor. 'The root cause of the industrial crisis is that firms have been too slow in initiating and responding to change,' he says, pointing out the need for vibrant, competitive product markets to ensure that firms stay on their toes. The Japanese product market, for example, is the most cut-throat in the world. Only the toughest, most agile players survive. Having clawed their way to domestic success, such survivors make fearsome opponents in the cosier, slower-moving markets of Europe and the US.
Geroski urges a new twin-track approach, which provides for a more supportive investment climate, coupled with policies that promote product market competition. 'Policy must aim to enhance market flexibility, reduce barriers to mobility, and stimulate adaptability within large corporate bureaucracies,' he declares. 'Policy may include the familiar tools of industrial policy - tax credits, accelerated depreciation allowances, R and D incentives and so on - but it must go beyond it.' Several stark conclusions emerge from this audit of the British manufacturing sector. First, the speed and scale of Britain's industrial decline is much more rapid (and negative) than in other, more prosperous OECD nations, casting doubt on the view that our present rate of de-industrialisation is inevitable.
This is confirmed by evidence on consumer spending patterns, which does not support the notion that increasingly affluent households are turning away from manufactures towards services. In fact, the more disturbing conclusion is that de-industrialisation appears to reflect the declining international competitiveness of the manufacturing sector. With de-industrialisation now highly advanced, the country faces a severe structural balance of payments problem and a possible long-term threat to economic growth.
Deepening and enlarging Britain's manufacturing base is essential to the country's long-term economic success. Cloying state intervention has been tried and discredited. Free market liberalism has failed to reverse the trend. These past experiences, and the lessons from more successful manufacturing nations, suggest a new approach to industrial policy which eschews direct state involvement, but splices together various strands of public policy to strengthen the incentives for the private sector to research, invest, train and build competitive advantage in the international marketplace. How might a political agenda for the reconstruction of British manufacturing look?
To successfully reverse decades of decline, the Government must do the following:
- Recognise the importance for manufacturing (and business generally) of low, stable inflation and interest rates and a predictable exchange rate. End decades of damaging 'stop-go' policies by making the Bank of England independent of political control and charge it with a statutory duty to maintain price stability.
- Increase government funding for basic R and D (eg, in universities and private sector research agencies). Use public money to leverage more university-linked science parks. Avoid any temptation to 'pick winners', but use public resources (eg, universities) to support co-operative R and D ventures between private sector companies.
- Accelerate writing down allowances for manufacturing investment. Consider the introduction of a cumulative allowance in excess of the value of the original investment, to offset the damagingly high 'hurdle rates of return' demanded by companies as a result of Britain's capital market structure. Alternatively, offer tax relief on manufacturing investment at a higher rate than the standard rate of corporation tax.
- Extend the tax relief on vocational training, providing tax credits in excess of the cost of training (or tax relief at a special, higher rate). Training provides benefits to the wider manufacturing sector over and above those to the companies paying for the training. Fairly compensating the latter is the best way to increase the incentive to train.
- Use the educational funding bodies to encourage alliances between companies and educational institutions to develop joint, integrated training schemes, which can be externally validated and certificated.
- Revise unfair dismissal legislation to place a much greater onus on companies to retrain staff, rather than dismissing those with obsolete skills and hiring those with the new skills.
- Work with other EC members to ensure that the EC remains receptive to inward. investment, but co-ordinates policy in order to maximise the 'technology transfer' from companies like Nissan and Toyota.
- Use anti-trust, merger and trade policies to promote product market competition and industrial change more aggressively. A fiercely competitive home market is the best way of spurring UK manufacturers to take advantage of any increased incentives to invest and train. Attack cartelised industries in Britain and the EC (eg, brewing, automobiles) and work for a successful conclusion to the Uruguay round of the GATT talks on trade liberalisation.
Nigel Healey is lecturer in economics at the Centre for European Economic Studies, University of Leicester.
TABLE 1: THE MANUFACTURING SECTOR
Change in Change in
1981-91 (% pa) 1981-91 (%)
Metals 1.4 -17.3
Other Mineral Products 1.0 -49.1
Chemicals 3.3 -24.8
Man-made Fibres 1.0 -24.8
Metal Goods 0.5 -13.8
Mechanical Engineering 0.3 -14.3
Electric. + Instrument 4.0 -37.8
Motor Vehicles and Parts 1.5 -36.3
Other Transport Equip. 0.2 -41.4
Food 1.0 -19.2
Alcohol and Tobacco 0.4 -19.2
Textiles -0.8 -50.1
Clothing 0.1 -23.2
Paper, Printing and Pub. 2.8 -3.7
Total Manufacturing 1.9 -22.5
Total Services 2.4 +16.9
TABLE 2: MANUFACTURING PERFORMANCE, HOME AND ABROAD
productivity growth output growth
1973-90 (% pa) 1973-90 (% pa)
Britain 2.8 0.5
France 3.9 1.6
Germany 2.0 1.1
Japan 3.9 4.7
US 1.1 2.9
TABLE 3: LEADER OF THE DEINDUSTRIALISING PACK
TABLE 4: MANUFACTURING, ECONOMIC GROWTH AND PROSPERITY
Manufacturing GDP Growth Per Capita
as % GDP 1973-90 GDP
1990 (% pa) 1990 (ecu)
Britain 19.8 1.6 13,354
France 21.1 2.2 16,607
Germany 30.4 2.3 18,834
Japan 31.3 3.9 18,827
US 22.5 2.4 17,179
Source: UN, OECD, EC Commission
TABLE 5: BOTTOM OF THE CLASS
R+D Expenditure Investment 18 year-olds
1990 1986-91 in f/t
(% of GDP) (% of GDP) 1988 (%)
Britain 2.21 17.6 33
France 2.40 22.2 66
Germany 2.81 20.8 81
Japan 2.88 26.8 87
US 2.80 14.2 88
Source: CSO, OECD.