Response to Finance and Manufacturing

Suzanne Berger makes a compelling case that manufacturing is crucial to innovation and the health of the U.S. economy, that the sector is in trouble, and that the financial system bears much of the blame.

Official statistics actually point to a relatively healthy manufacturing sector: for many years, growth in U.S. factory production has outpaced overall GDP growth, except during recessions. Likewise, productivity growth in manufacturing has greatly exceeded that in the rest of the economy, leading economists and policymakers to argue that the steep employment decline—30 percent since 2000—is the result of productivity gains from automation.

That reading of the numbers, however, is incorrect. For arcane technical reasons, virtually all of the apparent growth in U.S. manufacturing is attributable to the computer and semiconductor industries, even though these make up a tiny share of the dollar value of U.S. manufacturing, and much of their production has shifted to Asia. Without these industries, production in U.S. factories is no greater today than in 2000, and labor productivity growth is no higher in manufacturing than in the economy overall. With modest productivity growth in most of the sector, automation is an unlikely explanation for recent large losses of manufacturing jobs.

What then has caused the sharp decline of U.S. manufacturing employment since 2000? Clearly trade and the shift in production to low-cost emerging economies have played large roles. Research by Daron Acemoglu, David Autor, and other economists suggests that Chinese imports are responsible for many if not most of the job losses.

Yet, as Berger points out, imports are not the sole cause of American manufacturing’s decline. Economists predict that as product designs mature and goods become commoditized, their production will shift to low-cost developing countries. But through innovation, developed economies such as the United States should be able to specialize in new, advanced products with complex manufacturing requirements for which the colocation of research and production is important. The problem, then, is not simply that the manufacturing of established products is leaving the United States, but also that the rate at which new products replenish the old is too slow.

Here, Berger points to a homegrown threat to American manufacturing: the financial system. The growth of institutional investors since the 1980s has led to the breakup of vertically integrated companies and a focus on quarterly earnings and stock prices. This change has come at the expense of R&D investments that are expected to yield returns over long time periods.

What is the market failure? Why won’t anticipated future returns from such investments be reflected in a company’s stock price today? To some degree they are. However, institutional investors, whose focus is on company performance over the next six months, will heavily discount returns on investments expected five to ten years in the future. Investments with payouts expected far into the future also are intrinsically risky and more difficult for investors to evaluate. And long-term investments can be expensive and reduce short-term net earnings. Investors may see such R&D expenditures as an excuse senior management makes for failing to meet short-term earnings targets. Furthermore, if CEOs and other senior management don’t meet their quarterly targets, they may be terminated. CEOs of large American companies, who typically have tenures of seven or fewer years, are unlikely to be around to see the benefits of long-term strategic investments. Instead of plowing earnings into employment and long-term investments, corporate executives have spent billions on stock buybacks to boost short-term stock prices. Because executive compensation often takes the form of stocks or stock options, such short-term manipulation also may enrich those executives.

Public policy can play an important role when private markets fail to support R&D and farsighted planning. Berger points to recent initiatives by the Obama administration to create public-private partnerships in advanced manufacturing. Such initiatives will help fill gaps in investments and in the industrial ecosystem left by domestic manufacturing’s decline. But these initiatives need to operate at a much larger scale than the current federal budget supports. Another option is regulation, which may help stem some abuses in the current financial system. Economist William Lazonick, for example, has championed restrictions on stock buybacks.

Even if domestic R&D is significantly increased, there is no guarantee that the resulting products will be manufactured in the United States. Any effective policy to revitalize American manufacturing must make the United States a more competitive location for production. The U.S. dollar is significantly overvalued relative to the currencies of our major trading partners, harming U.S. manufacturers and contributing to the large trade deficit. High U.S. corporate taxes are another deterrent to domestic production and investment. Bipartisan proposals in Congress to lower corporate taxes in a revenue-neutral way by eliminating deductions and loopholes therefore are critical to revitalizing the sector.