Subscribe to BrookesNews’ Bulletin
US economy, manufacturing and monetary policy
Gerard Jackson
There seems to be a degree of schizophrenia when it comes to manufacturing and services. When in 2000 it was clear that US manufacturing had slid into recession even as activity in services remained strong, particularly consumption, some commentators concluded that the US economy was experiencing a natural process of shifting investment from manufacturing to services rather than bearing witness to an impending recession.
Although the recession put a temporary end to this absurd rationalisation, many economists and economic commentators still argue that a shift from manufacturing into services is a natural process brought about by increased living standards. It should be noted that this view is merely an opinion presented as economic analysis. To say, as supporters of this shift do, that as people become richer they want fewer material goods and more services is to say very little.
This lackadaisical and somewhat patronising response is no real answer to the charge that the American economy can be hollowed out by manufacturers shifting production overseas to take advantage of so-called cheap labour. It’s not enough to point out that investing abroad in manufacturing is far from novel; that in the nineteenth century Britain invested massively in the US and South America, etc., and that in the 1950s and 1960s French intellectuals of all political stripes issued dire warning against American investment dominating Europe.
Though the old siren calls are almost forgotten the new ones do merit consideration because conditions are very different from the days when the gold standard ruled. The “hollowing out” charges should have at least alerted most economists to the possibility that such rapid economic shifts are not only sudden, in economic terms, but perhaps even unsustainable with respect to living standards.
(David Friedman is one of the few economists to question the profession’s complacent views on the manufacturing shift. [ Los Angeles Times , The Economy: The Neglected US Depression, 12 Augusts 2001]).
Notwithstanding previous criticisms of orthodox economics, it can still be used to explain to a considerable degree a “hollowing out” process without having to make lazy and grossly misleading references to so-called natural shifts in expenditure from the secondary sector to the tertiary sector.
Ordinarily an inflationary monetary policy will eventually drive down the exchange rate. However, where this process is temporarily halted or even reversed for a time it results in an overvalued currency which causes the role of prices to be perverted into misdirecting production and investment.
Therefore, what highly paid economics commentators should consider is that an overvalued currency amounts to exporting inflation to one’s trading partners. They should note that the effect of this process is to make imports cheap relative to domestic goods and services. The longer the overvalued currency is maintained the greater will be the distortions, i.e., malinvestments.
This is where an apparent hollowing out process makes its appearance. Because the overvaluation has distorted the price structure, domestic producers are encouraged to locate abroad while foreign manufacturers are encouraged to switch production from domestic use to satisfying the demands of its expanding foreign market.
In the meantime, the inflating country will find that its living standards are still rising, even as manufacturing is declining. Houses can get bigger as expenditure is directed towards more consumption, and the demand for other consumption goods can still be satisfied by increasing imports.
(One can also call this the consequences of a monetary inspired shift in the terms of trade, which will eventually be reversed).
Now there is absolutely nothing new or particularly Austrian in what I have just written. In 1970 Samuel Brittan, a well-known economist with the Financial Times and a Keynesian by training, was astute enough to spot this and wrote an excellent description of the situation:
If an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure while the surplus country becomes excessively export-oriented... This makes adjustment needlessly painful and difficult when it does come, and there is the risk of high transitional unemployment while resources are being transferred. Shop assistants in Britain cannot be transferred overnight to engineering establishments which do not yet exist while Volkswagen workers cannot move straight away into the German social services. These very facts themselves provide ammunition for those who oppose parity changes, and the eventual adjustments are all the more sudden and severe when at last they come.
There is nothing novel about this view. In his Three Lectures on Commerce and one on Absenteeism (1835) Mountifort Longfield drew attention to the possibility that a change in the pattern of spending could bring about an unfavourable change in the structure of investment.
He pointed out that if absentee landlords spent their rents on buying French dresses and lace for their girl friends instead of investing in their Irish farms this could alter the factorial terms of trade for Ireland. A little economic reasoning indicates that a loose monetary policy could have the same effect by artificially stimulating the demand for foreign consumption goods.
The world is a dynamic place and all things are never equal, even momentarily. What this means is that if the above analysis is valid then it might be possible for the “hollowing out” process to be offset by increased savings, regardless of the source, giving rise to increased investment embodying new technologies.
But then one could argue that in the absence of a loose monetary policy productivity and living standards would rise even faster. One could also argue that such a process has been offset in America by foreigners using their dollars to acquire US assets, including investments in production processes.
I think two lesson need to be learnt: a) money matters — a lot — and that ignorance of what inflationary policies can do to investment and manufacturing can have the most terrible consequences; b) that monetary policy is a lot more complicated than most economic commentators realise.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 28 November 2005