UK: BACK ON THE MANUFACTURING SHIFT. - Manufacturing's contribution to GDP has been in decline for so long it appears to be irreversible. David Smith breaks two of his own rules by seeing signs of revival in some recent economic trends.

Last Updated: 31 Aug 2010

Manufacturing's contribution to GDP has been in decline for so long it appears to be irreversible. David Smith breaks two of his own rules by seeing signs of revival in some recent economic trends.

There are two important rules that should always be followed when assessing the British economy. The first is common sense, borne out by years of disappointment: never be too optimistic. The second is also sensible: don't assume, on the evidence of a relatively short period, that some fundamental shift has occurred. Those are the rules. I now propose to break them.

The decline of the relative importance of manufacturing in Britain's economy is such a long-established trend that it has become unremarkable, and apparently irreversible. Within a generation, as the chart shows, the contribution of manufacturing to GDP has dropped from more than 35% to under 22%. Only 4.25 million people, out of a population of 57 million, and a workforce of 28 million, can describe themselves as manufacturing employees.

The GDP comparison may be a touch unfair on Britain's manufacturers. One reason why manufacturing tends to decline as a share of national output is that productivity gains (and the ability to hold down prices) are greater in manufacturing, compared with most services, and certainly in comparison with public services. Therefore, even if manufacturing output is rising in volume terms, its value is unlikely to increase as fast as for other parts of the economy.

But the general point holds, and there is no shortage of explanations. Economies start off as agriculturally-based, moving to a second stage with the discovery and exploitation of minerals. Manufacturing then has its heyday, before services, reflecting the needs of a sophisticated and affluent population, take over. If Britain's manufacturing heyday was back in a pre-1914 golden age, it's not surprising that we have an economy dominated by services. What the US does first, Britain follows, and only 18% of the American economy is accounted for by manufacturing. There have been other explanations. The discovery of North Sea oil, it was said, meant that manufacturing was logically displaced, not least because the 'petrocurrency' effect on the pound made it difficult for the UK to compete in world markets.

Not everyone was happy with this state of affairs. In the mid-'80s a House of Lords committee took issue with the Treasury's neglect of manufacturing. Luminaries such as Lord Weinstock pointed out that Britain could not turn into a nation of Beef-eaters, showing tourists around the Tower of London. Nigel Lawson, the then Chancellor, was unmoved (having just reformed capital allowances to the long-term detriment of manufacturing investment).

By rights, then, we should be ready to hand over any pretensions we have to being a manufacturing nation to the tiger economies of the Far East, or to India and China. Instead a largely accidental combination of circumstances has given manufacturing a tremendous leg-up.

The first factor is that the unplanned post-ERM devaluation gave industry a huge competitive boost, which has been built upon by the strength of the Deutschmark, and therefore sterling's fall against it, this year. But, I hear you say, we have had devaluations before - in paricular in the 1960s and the early 1970s - without transforming industry's prospects. Then the gains were squandered in higher inflation, and in particular in a regular loss of control over wages. This time it has been different because it brought in a new, and lasting, pay discipline.

Second, some of the shift into service industries in Britain has been due to the overwhelming importance of the housing market. Not only did the perennial safe bet of investment in housing mean that a disproportionate share of savings was directed towards it, but a whole series of related businesses, from DIY retailing to mortgage-broking, blossomed around it. Some manufacturing industries, of course, rely on a healthy housing market. But plenty of others do not. And the main effects of a depressed housing market will have been on services, particularly financial services.

Third, manufacturing and exporting go hand in hand. Manufacturing may be only a fifth of the economy but it is hugely important for exports. The nature of the present recovery is one of relatively muted growth of domestic demand, against an export performance described by the West Midlands Chamber of Commerce as 'absolutely tremendous'.

Fourth, the Treasury neglect of manufacturing in the '80s has been replaced by a declared intent to frame policies that work to the benefit of industry. There is talk of manufacturing-friendly tax changes in the November budget.

There is good reason, therefore, to believe that manufacturing could begin to claim back some of its lost share of GDP over the next few years. David Kern, chief economist at National Westminster Bank, thinks manufacturing could rise from 21.9% to 22.9% of GDP between now and the end of the century. I think it could go further.

Something is happening in the labour market to suggest that the distribution of jobs between manufacturing and services will shift in a more subtle way. This is because service industries are now undergoing a change akin to that experienced by manufacturing in the 1980s. One reason for the decline in manufacturing employment was genuine, reflecting factory closures and rationalisation. The other was the tendency for firms to refine their employment policy, keeping core production employees on the staff, while contracting-out work, such as maintenance, delivery and catering. Service industries are now doing likewise. As service industry workers become self-employed, the gap between service and manufacturing employment narrows.

Economic shifts of the kind I believe we are seeing do not happen very often. But that is no reason to think they never happen. Good for manufacturing.

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