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Macro Scenario: The Demise of Manufacturing Is the Real Problem of the World Economy

Enjoy and learn from this discussion between Prof. Bruce Greenwald and Richard Koo at the CIGI conference: The Great Recession: Structural and Cyclical Causes

While Richard Koo is sure weak balance sheets are the issue, Greenwald disagrees and further elaborates on his thesis, the underlying problem is the demise of manufacturing.

I am always interested in comprehensive macro scenarios which I can use to test the business model of my investments or clients.

Manufacturers Suffered More from the Crisis Than Debtors

Greenwald, says that balance sheets are the problem in any recession, however now balance sheets are repaired (US, UK) the recession still continues. Evidence shows the countries that suffered most from the worldwide crisis were not the countries with a large bubble (UK, US), but countries with relatively sounds balance sheets.

He mentions:

  • Japan suffered a 7% drop in GDP while Japanese companies had very healthy Balance Sheets (significant negative debt)
  • and Finland (a 13% drop in GDP from 2008-2010, my add.)
  • Natural Resources countries also suffered, like Canada (My add. GDP drop -13%)
  • US (-2%) and the UK (-6%)

Is Manufacturing the new Agriculture?

Greenwald draws the parallel with agriculture. This industry suffered enormous productivity gains and limited increase in worldwide demand.

This same development is now happening in manufacturing.

And growing in a dying industry is an extremely difficult thing to do…

Screen shot 2013-01-06 at 11.19.33 AM

Agriculture as % of GDP development since 1960. I’ve included the countries mentioned. Source: Google, Worldbank. 

Greenwald says: productivity increases annually with 5-7%, however worldwide demand merely grows at best 2-3%. Capital expenditures (robots, technology, software) have come down dramatically the last decade, and so productivity improvements become less capital intensive…

Screen shot 2013-01-06 at 11.25.28 AM Manufacturing as % of GDP development since 1980. I’ve included the countries mentioned. Source: Google, Worldbank. 

Ok, ok what’s new you might ask…manufacturing usually declines as a % of GDP as a country moves up the income ladder and more and more countries move up this ladder…

Well there is something new, remember the earlier post on Greenwald’s thesis? The way out of the crisis and sustaining/increasing employment for manufacturing economies like Germany is selling the production surplus through exports.

However exports are a zero sum game between surplus and deficit countries…

Especially countries with a strong manufacturing base (read: labor unions, industry lobbies) are resisting the decline in jobs and revenues as hard as they can through exports, helped by politicians that aim to keep unemployments at bay.

The Spender of Last Resort Ran Out of Cash!

Now, what changed? Greenwald tells us US households have been eating the world surpluses up to 2008. Unfortunately they cannot finance a net deficit any longer through rising house prices and a zero savings rate. And if there is nobody in the world to eat the net export surpluses of manufacturing countries, the world economy will continue to have problems to grow until manufacturing countries make the explicit choice to change into a more service based economy.

This development has a chronic deflationary pressure on manufactured goods…

So the Remedy is a Focus on Services?

The remedy according to Greenwald is changing the economic structure of manufacturing surplus economies like Germany, China and Japan to focused (non-financial) service sectors like medical care, education. However this takes focus from government and bold decision making (read: confronting labor unions and industry lobbies).

Corroborative Inquiry: McKinsey on Manufacturing

Now all this sounds like a solid storyline from a highly respected (also by me) professor. But can we check some facts?

Very conveniently McKinsey’s Global Institute recently published a report named: Manufacturing the future: The next era of global growth and innovation, full of interesting statistics actually supporting Greenwald’s thesis.

Where McKinsey and Greenwald grow apart is the storyline on the future… So even though McKinsey draws similar conclusions as Greenwald from economic data, their overall conclusion (and productivity growth estimate) sounds less dramatic.

McKinsey explicitly mentions: Manufacturing is entering a dynamic new phase. As a new global consuming class emerges in developing nations, and innovations spark additional demand, global manufacturers will have substantial new opportunities—but in a much more uncertain environment.

Actually this conclusion sounds like manufacturing is set for a new growth spurt….not decline! Well let’s just use their facts.

Screen shot 2012-12-30 at 8.40.35 PM

Source: McKinsey Global Institute

So how does McKinsey’s data support Greenwald’s thesis?

McKinsey: “Manufacturing contributes disproportionally to exports, innovation and productivity growth.” Which is supported by Exhibit E2 and 13 as per above and below.

Per above we can see only 14% of employment (in advanced economies) is in manufacturing, whereas 37% of productivity growth comes from manufacturing (EU-15).

Per below we see most exports are still manufactured goods. According to Greenwald high productivity and high exports have a negative impact on manufacturers and jobs in manufacturing.

Manufacturing drives two third of exprts

Source: McKinsey Global Institute

So How Does the Future Look?

According to McKinsey, up to 2025 about 1.8 bln. people will enter the consumer class, which is about 140 mln new consumers per year or a CAGR of 3.8%. Not bad! However this is similar to the last 20 years.

Furthermore McKinsey estimates consumption will rise 3.54% so consumption per capita will actually fall from 16k to 15k per capita. Did they forget inflation? Or does inflation offset a decrease in overall income due to growth coming mainly from low income countries? Let’s assume the latter…

As the 3.54% is slightly above Greenwald’s 3% estimate, but far below the 7% productivity gain in manufacturing, the deflationary pressure still makes sense…or am I missing something?

Demand Shift

Source: McKinsey Global Institute

Now for the Productivity Gains? Are they Supported by Historical Evidence?

McKinsey mentions productivity gains have been at an average of 2.7% p.a. which does not tie in with Greenwald’s 5-7%.

However from the graph we can see a spread between US productivity growth and real value added of 1 – 4%. If this spread persists, this will probably impact pricing of manufactured goods.

Screen shot 2013-01-16 at 12.15.47 AM

Source: McKinsey Global Institute

This conclusion could be supported by exhibit 15: productivity gains were passed on to consumers through lower prices of consumer durables (refrigerators, cars etc.).

Screen shot 2013-01-16 at 12.25.49 AM

Source: McKinsey Global Institute

So could Greenwald be right? I don’t know. It sounds like a logical explanation. More important is to me…What can I learn from this?

I will have to think about the consequences for employees, companies and investors. Next to job losses of the lower skilled due to productivity gains, the multiplier effect of manufacturing could turn into a serious negative force following manufacturing decline, which will impact also service sector jobs and revenues.

As an investor I will have to look more critical at service sector companies and try to find out, whether the companies aren’t built too much around manufacturing clients. Who are the key clients? What is their competitive position? Will they still be clients in different manufacturing landscape? Why? Why not?

If I am investing in a manufacturer…I will not expect productivity gains to be passed on to me, the shareholder, but most probably to the clients. Overcapacity will also lead to a landscape for high end and low costs producers (e.g. think fashion and furniture): will my producers be stuck in the middle or are they already well positioned? Will capital expenditures be also lower in the future (deflation will also impact capital goods) or will companies have to spend more frequently to keep up with the productivity race.

Please let me know if I made mistakes, whether you disagree, or want to add to the scenario. Also read: Worse Than the Great Depression:  What Experts Are Missing About American Manufacturing Decline by ATKINSON, STEWART, ANDES, AND EZELL

Screen shot 2013-01-16 at 1.00.16 AMSource: McKinsey Global Institute

1 Comment

  1. […] two interesting articles on Manufacturing and Services. Thinking about the earlier posts on the Demise of Manufacturing this is yet another interesting development as mutual reinforcing multipliers (manufacturing […]

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