Bulletin – August 2013 Is the UK viable with only 10% of our GDP coming from manufacturing?

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August 1, 2013 by johnmillsjml

Exchange Rate Reform Group

BULLETIN   –    August 2013

 

Is the UK viable with only 10% of our

GDP coming from manufacturing? 

 

          The Problem

 During the two decades since the early 1990s manufacturing as a percentage of total world output has fallen from 21% to 17%. Some fast growing countries have much higher ratios than this. It is 34% in China, 25% in South Korea and 21% in both Singapore and Germany. At the other end of the spectrum there are a number of developed and diversified economies in the western world where the percentages are much lower. In the UK and France they are barely above 10%. Spain, the Netherlands, the USA and Canada are a little higher, all at about 13%. A crucial issue is whether any advanced economy is viable in world trading terms if manufacturing as a percentage of GDP drops as low as it now is in the UK.

Part of the reason why manufacturing has accounted for a reducing percentage of output almost everywhere is the result of a pricing effect. Whereas services have tended to rise in cost, the opposite has occurred in the case of most manufactured goods. A substantial part of the huge increase in productivity achieved in manufacturing has been reflected in falling prices as well as improved quality. As a result, there has been a very significant fall across the world in the ratio between the cost of manufactures in relation to their utility compared to services. It may be because of this that policy makers have regarded the especially steep falls there have been in manufacturing as a percentage of national output in countries like the UK as being of no particular consequence. This is, however, a major mistake.

To have manufacturing contributing a reasonably high percentage of GDP in any economy such as ours is critically important for three main reasons:

1.A     It is goods rather than services which are our main exports. Although manufacturing makes up little more than 10% of our GDP and services almost 75%, visible exports make up 60% of the UK’s exports and invisibles  only 40%. We have a trade deficit of just over £100bn per annum on goods, which is only partially offset by a surplus of £80bn on services. The only way in which we can close this gap – made much wider by other foreign payment we make each year – is to export more manufactured goods.

1.B     Productivity increases are far easier to obtain in manufacturing than they are in services. For example, although manufacturing contracted as a percentage of UK GDP between 1997 and 2012 from 14.5% to only 10.7%, it still contributed over a third of all the increase in Gross Added Value achieved by the UK economy over this period. Manufacturing was therefore more than three times better than the whole of the rest of the economy on average at increasing living standards as a result of increased productivity.

1.C    The massive increases in the disparities in income, wealth and life chances in the UK which we have seen in recent decades both geographically and socio-economically are very largely caused by the disproportionate growth in services in some areas of the country matched by the decline of industry in others. Manufacturing is far better at producing high quality blue collar jobs than services and it is the decline of industry in areas of the country which have traditionally been our industrial heartland which has caused most of the enormous disparities which now exist. Recent figures showed that the annual average Gross Added Value per worker in London was £35,638 compared to £15,842 in the North East, the poorest region in the UK. 

The problem with having only barely 10% of our economy coming from manufacturing is that, in consequence, we are unable to pay our way in the world. We do not have either enough goods to sell to customers abroad or the ability to make cheaply enough many of the goods which we buy in from overseas because it is so much cheaper to get them made elsewhere. The result is that we have chronic balance of payments problems, which ensure that we cannot run our economy at full throttle. The last year in which we had a balance of payments surplus on goods was in 1982 and we have not had an overall balance of payments surplus since 1983 – 30 years ago. It is because our economy is hobbled by our weak foreign payments position that we have such high unemployment, slow or non-existent growth, stagnant living standards, rising inequality, overstretched public services, excessive debt and relative if not absolute international decline.

          The Solution

 

There is only one solution to the problems now engulfing the UK economy. We have to get the proportion of our economy which comes from manufacturing back to somewhere around 15% from the barely 10% it is at the moment. This is the only way in which we are going to get our foreign payments position back into balance, without which there will be no long term solution to our present problems. It is because we have allowed the deindustrialisation of our economy to go so far that our current difficulties are so acute. Our history – reflected by the experience of all other countries which have allowed their manufacturing sectors to decline to similar extents to us – is that once the percentage of manufacturing to GDP declines much below 15%, foreign payment problems become inevitable and stagnation sets in. This is why we – and all the other economies in a similar balance of payments position to us – have to rebalance our economies in a major way both towards both more exporting and less importing, if years of very slow growth or stagnation are to be avoided.

How can this be done? For those who recognise that there is a problem – which is far from everyone – the solutions proposed tend to be a whole variety of supply side remedies. These include improving our infrastructure, better education and training, subsidies to try to increase investment, making the planning system more reflective of industrial requirements, encouraging closer links between universities and industry, and making access to finance easier for expanding companies. All these approaches have varying degrees of merit and might well be worth pursuing in an appropriate environment. The problem is that no combination of these approaches, on their own, has the slightest chance of getting manufacturing back to 15% of GDP. For this to happen, there has to be a radical change in the relative profitability of exporting compared to importing. The Economist recently published figures showing that the return on capital in manufacturing was about 5% whereas elsewhere in the economy it was around 15%. Until this changes, we will never solve our balance of payments problems.

The only solution which is going to work is to use the exchange rate to achieve the scale of change we need. This is the only economic policy tool available to the government with sufficient power and leverage to make this happen. It is the scale of the problem which also determines how big the exchange rate change would have to be – and it would have to be very significant. IMF studies on the sensitivity of both exports and imports to price changes provide the basis for calculating how much lower sterling would need to be not only to halt but very substantially to reverse our deindustrialisation. These show that we would need an exchange rate about one third lower than it is now – i.e. with £1.00 equalling little more than $1.00 or about €0.80.

Why would this make exporting so much more profitable than it is now and importing correspondingly less so? Here is the maths. For typical manufacturing operations about 20% of total costs are raw materials and 10% is depreciation of plant and machinery. For this 30% of costs there are world prices. Almost all the remaining 70% of costs, however, are incurred in local currency – in our case sterling. Most of these costs are ultimately labour costs but not all. Others include rent and interest. Taxation is also a major factor. But all these costs could fall by a third to foreign buyers if sterling was devalued by a third. 33% x 70% means that a reduction in price of almost a quarter to world buyers would be possible. This would then need to be split between making exporting much more profitable and increasing market share by taking advantage of the lower prices which could be charged.

Not only would exporting become much more profitable, importing would become much less attractive for all the same reasons in reverse. Indeed, because IMF studies show that the sensitivity of imports to price changes may be even greater than it is for exports, there may be even more to be gained from import substitution – making goods and providing services in the UK which would otherwise have been imported or, like tourism, consumed abroad  – than there is from increased exports.

Why then don’t we go for a much lower exchange rate to get our economy moving again? There are five main reasons which are regularly advanced – none of which bares close examination. These are:

2.A     Devaluation is believed always to increase inflation. All the evidence, however, shows that this does not usually happen. On the contrary, inflation often goes down, as it did when we left the ERM in 1992 and devalued by nearly 20%.

2.B     It is believed that devaluing the pound must make everyone poorer. This is completely the reverse of the truth. If the economy grows more quickly than it otherwise would have done, output per head must go up and not down.

2.C    Other countries might devalue too. One or two might but our share of world trade is now so small – at less than 3% – that what we do is largely irrelevant to the rest of the world, as it was when the pound came down from $2.00 to around $1.50.

2.D    Devaluation has been tried before and does not work. This is not the case. Every time we have devalued the outcome has been better than it would have been without the pound coming down. Our problem is that for many decades we have had higher rates of inflation than other countries, making depreciation inevitable. We have always reacted by doing too little to late, however, which is why our export costs have been much too high for so long.

2.E     It is impossible to change the value of the pound which is fixed by market forces over which the Bank of England and the government have no control. This is also completely untrue. There are numerous examples of countries changing their exchange rates, the most recent being Japan which since last autumn has reduced its exchange rate against the US dollar from 75 yen to over 100 – a devaluation of more than one third.

The real reason why there is so much reluctance to recognise how important it is to get the exchange rate right is that for many decades nearly all UK politicians, civil servants, commentators and the academic world have been fixated on inflation targets. Low increases in prices and low interest rates, however, are not the lodestones by which economic policy should be judged. Making sure that our exchange rate is competitive is infinitely more important. Until this is realised, years of anaemic or negative growth, stagnant living standards, rising inequality, increasingly unmanageable debt and declining national significance unfortunately lie ahead. None of these outcomes is inevitable. They could all be avoided if the reasons for them being so likely to occur were more clearly understood. Our currently dire economic prospects lie in mistaken policies – not their inevitability.

__________________________________________________________________

 

Published by the Exchange Rate Reform Group

JML House, Regis Road, London, NW5 3ER

Tel: 020 7691 3833 * Fax: 020 7691 3834

E-mail: john.mills@jmlgroup.co.uk  *  Website: http://www.johnmillsblog.co.uk

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