Viewpoint -- Are We Destroying The Animal Spirits In American Manufacturing?

Duesterberg is President and CEO, and Meckstroth the Chief Economist, of the Manufacturers Alliance/MAPI, an Arlington, Virginia, association providing economic research and executive education to its 450 member companies.

The painfully slow recovery in manufacturing employment since the protracted recession and slowdown of 2001-2003 has engendered once again loose talk about "hollowing out" of this sector due to foreign competition and herd-like outsourcing of jobs by unscrupulous or traitorous corporate executives. While it is undeniable that competition from China, Southeast Asia, and India is taking market share in manufacturing, a close look at the data suggests that something more subtle and, in the long run, more insidious may be at work. A combination of forces, some economic, some purely political, seems to be sapping the creative or risk-taking energies that for generations have animated entrepreneurs in the goods-producing sector. Fortunately, many of these forces can be reversed with proper policy responses.

The goods-producing sector, which is much more subject to global competition than the services sector, is the very epicenter of the forces of creative destruction which define the modern economy. A focus on product innovation is one response to global competition: this sector is the source of two-thirds of all commercial research and development expenditures and 90% of new patents in the U.S. Manufacturing is likewise an innovator in business processes, with programs like Six Sigma, Lean, Just-in-Time, and integrated supply management helping drive much higher rates of productivity growth than in other sectors of the economy. New product development and productivity growth have allowed U.S. manufacturing production to grow at the same rate as the overall economy since 1919 and the United States to become the largest goods exporter in the world, while at the same time seeing its share of the workforce decline from 39% to approximately 11%.

The relentless forces of creation and destruction can be measured in the numbers of plant openings and closings over the past four decades. The following table shows the remarkable stability of both creation of new plants and their destruction between 1967 and 1997.

Survival Rations of New U. S. Manufacturing Plants, 1967 to 1997
(Percentage of plants surviving at five year increments)

The data show that roughly half of all new plants do not survive the five-year mark and two-thirds disappear after ten years. Startups, however, consistently outpace shutdowns. Between 1967 and 1997, the total number of manufacturing plants grew from about 310,000 to around 375,000.

However, since 1998, the constant churn has had a more negative tone, as more plants have been shuttered than opened. By early 2004, the total count of plants had dropped 9% from its 1998 peak. We do not have fully comparable data regarding plant openings and closings abroad by U.S. manufacturing firms. We do, however, know that between 1999 and 2002, the total number of foreign manufacturing subsidiaries of U.S. firms grew by only 250, while the number of plants located in the United States fell by over 20,000.

Moving plants abroad simply cannot explain the decline in domestic operating plants. The answer lies in the declining rate of plant openings since 1998. In 1998 (and prior years), we consistently saw about 52,000 plant openings annually, but in the new millennium the numbers dropped off to an average of 36,000 to 40,000 per year. Plant closings remained stable in this period. The number of new establishments in the nonmanufacturing sector grew by 848,000 since 1994, in sharp contrast to the loss of 23,000 manufacturing plants in the same time frame.

The manufacturing labor market shows a similar pattern to that of plant openings. The recession of 2001-2003 in manufacturing saw the worst job performance since the Great Depression. While about 2.7 million jobs were lost-since the recovery began only about 100,000 have been regained in manufacturing. It is the anemic rate of new hires, the counterpart to low levels of new plant openings, that explains the huge loss of manufacturing jobs. Despite a solid recovery to previous peak levels of production by late 2004, employment remains 15% below its level at the start of the recession, whereas we could expect a loss of only 4 % of manufacturing jobs in the average recovery.

What can explain this rate of new plant openings and jobs so far below historical patterns? Rapid productivity growth and working off excess capacity from the ebullient 1990s in the manufacturing sector certainly accounts for some hesitancy in new risk-taking. Import penetration has grown from 29 % to 35% of the domestic market since 1997. Nonetheless, in the midst of a global synchronized boom, a falling dollar, and strong global demand for capital equipment -- a U.S. strength -- other factors are at work to sap the willingness of corporate executives to assume the risks attendant to building new plants and hiring new workers.

Research by our colleague Jeremy Leonard has shown that a combination of cost pressures from energy, health care, tort litigation, corporate taxes, and regulation raises the base price of U.S. manufacturing by over 22% over raw labor costs alone, when compared to our nine leading trading partners. Such structural costs, when added onto already generous (by global standards) U.S. labor costs, greatly complicate the job faced by corporate executives in convincing their boards and their shareholders to put new money at risk. The cycle of corporate scandals, response by prosecutors, and new regulation from the Congress also works to discourage the same waves of creation witnessed in the 1980s and 1990s. Sarbanes-Oxley requirements not only take enormous time, money, and energy from senior executives and their boards, they also dangle the sword of Damocles over their heads with new criminal liability provisions. Prosecution of high profile cases, too, has emboldened and legitimized the trial bar to pounce on corporate leaders whenever a blip occurs in their firms' stock price.

In the face of relentless foreign competition, overzealous regulators and prosecutors, and difficult cost pressures (now magnified by high materials costs), the animal spirits of risk-taking in the manufacturing sector are themselves at risk, as witnessed by historic lows of plant and job creation. Fortunately, there are deep reservoirs of optimism among American executives, buttressed by the efficient creative genius of our best innovators and researchers. Moreover, the American legal, cultural, and business environment remains even today superior in nurturing the constant pursuit of innovation, change, and risk needed to succeed in the modern economy. These forces, however, urgently need assistance from our policymakers. A more rational tort and regulatory environment, better controls on health care costs, a pro-growth energy policy, more openness and less mercantilism in international markets, a tax structure that does not penalize domestic production and encourages research and investment, and a better educated workforce, all could contribute to a better environment for risk-taking and innovation. The rise of China and India represents the greatest challenge to manufacturers in recent memory, but also, with their enormous demand for new goods, the greatest opportunity for risk takers emboldened and properly incentivized to meet the challenge.