Q: Hey Ben,

People on both sides of the aisle argue that the decline in U.S. manufacturing is bad for the economy, even if this decline has been accompanied by an increase in the value of services we generate. Is there any truth to this, or is it really a disguised social argument about Wall Street versus Main Street?

A: Hi Travis. A great question that will draw strong reactions from both sides of the political spectrum as you mentioned. Many people point to the auto industry bailout as one of the deciding factors in the 2012 election. While I agree there is truth to manufacturing being “special”, I also believe this is a case of Wall St. versus Main St. After all, if everyone believed in the importance of manufacturing there would be no debate at all!

Manufacturing is an important development mechanism for any country. Virtually no country today developed without a strong manufacturing sector aimed at import substitution and export promotion. The middle class has for a long time been the cornerstone of the strong U.S. economy. This idea was driven home by Bill Clinton in a famous quote “if you just ‘work hard and play by the rules’ you should expect that the American system will deliver you a decent life and a chance for your children to have a better one”. A strong manufacturing sector is important for a strong middle class.

It also taps into a concept, brought to my attention by Paul Krugman, of “economies of agglomeration”. The basic principle is that “manufacturing plants don’t exist in isolation; [they] benefit a lot from being part of a manufacturing cluster, with specialized suppliers and a large pool of workers with the right skills close at hand” Many factors, including “transportation costs, economies of scale, and factor mobility”, make the sum of “agglomerated” economies greater than its parts. (Think of them as the modern day version of 19^th century “company towns”, except the workers are much better off because they are unionized / have better labor laws). This is one of the reasons why the collapse of the auto industry would’ve had such dire effects on the U.S. economy, and why Obama’s auto-bailout was so popular.

By the value of services we generate, I assume you are referring mainly to financial services. Capital gains tend to be realized by the upper-class of society–the 1% or .1%, if you will. Not only is there less of a shared benefit (as evidenced by Gini coefficients over time), but it diverts reinvestment away from the real economy to the financial sector. A combination of lax oversight (perhaps due to very high profits or “rents” and the subsequent corruption that follows), an implicit “too-big-to-fail” view of the mega-banks, and low capital gains taxes created an implicit subsidy to invest in the financial services industry. This holds true for both domestic and international capital. What you end up with is over-investment in a bubble (which inevitably pops), and under-investment in the real economy (manufacturing, infrastructure, education, healthcare, non-financial services, etc; the real driver of sustainable economic growth). When the bubble pops, we are left with a deep recession combined with a systematically under-investment-in real economy. Open capital accounts lead to “contagion”, and a domestic recession becomes a global crisis. Fiscal deficits make this worse; as people will be calling for expansionary fiscal austerity (which is a myth in the current context, austerity would be contractionary). Using the “Absorption Approach”, we can see how over-investment and low incentives to save money lead to large current account deficit, as we have here in America now.

This concept is illustrated below (model by me, click on the pic to see the model):