Shale: the ‘IT bubble’ of the 21st century?

The dominant story about the American economy today is that if we could only look past Washington’s policy dysfunction in dealing with all those fiscal cliffs and debt ceilings, we would see that the underlying economy is really on the mend. The US is experiencing an ‘industrial renaissance’, we are told. The rise of ‘reshoring’ over outsourcing and the shale energy boom are both held up as evidence that things are improving. In the second part of his essay on US economic fortunes, Phil Mullan questions whether we’re witnessing the end of outsourcing, and sounds a serious note of caution about the shale bonanza. (Read the first part of Mullan’s essay here.)

Part 2: Reshoring doesn’t make a renaissance

In the first part of my essay, published yesterday, I argued that the starting point to any true ‘industrial renaissance’ in the US would have to be the rekindling of business and public investment to at least postwar boom levels. Yet that type of long overdue industrial renaissance is a far cry from what is being discussed today, in the widespread claims of an American manufacturing recovery. Even the reshoring trend, with more of America’s jobs and manufacturing now apparently being brought back within its own country rather than outsourced to other countries, is not quite as dramatic as its advocates make out. For example, a recent survey from Duke University’s Fuqua School of Business found that only four per cent of large companies had plans over the next three years for relocating jobs back to the US, despite increasing transportation and overseas labour costs.

And it doesn’t help to say we should perhaps reserve full judgment on reshoring and the industrial renaissance for another few years since it is still early days. There is little substance to the reasons being advanced for why reshoring and industry should be taking off.

Rising Chinese wages is both the most common justification for reshoring and for a revival of US economic fortunes, and also the most dubious. Although it is true that Chinese wages are rising considerably faster than those in the West, they still remain way below rates in the US. The latest analysis by the US Bureau of Labor Statistics says that in 2008 US hourly manufacturing pay was still about 25 times higher than in China. And although the productivity of Chinese workers in manufacturing is still lower than in the US, the gap is narrowing as Chinese productivity has been growing relatively faster, at about 10 per cent a year over the past two decades, compared to less than half that in the US.

It may also be true that some low value-added industries are already moving out of China as a result of rising wages – but very few are going back to the US. They are moving to places like Indonesia and Vietnam, where labour is even cheaper. James Crabtree, the FT‘s Mumbai correspondent, notes that ‘if China becomes too expensive there are plenty of other Asian countries to turn to, not least India, whose huge labour force is cheaper still, and whose government will eventually get its act together to support a viable mass-manufacturing economy’. Crabtree concludes that ‘most evidence fails to back up’ even the modest assertion that we are at the start ‘of a trend away from Asian manufacturing’.

Moreover, as even champions of reshoring recognise, labour costs account for a small proportion of a product’s manufacturing costs, so relative changes in them can hardly be the prime cause either of offshoring or industrial decline, or of reshoring and industrial revival. For example, although deemed a company secret, the labour costs of an Apple iPhone produced in China are estimated to be only between two and five per cent of the sale price. A change in this of a small proportion can hardly have such huge consequences as implied by the insourcing advocates. Even a relative doubling of wages is not going to make that much difference to retail prices or company margins.

What about the argument that America’s increased levels of shale gas exploration at home could tip it back towards manufacturing productivity? Here, too, the benefit to manufacturing of lower shale energy costs should not be overstated. Oxford Economics estimates that as ‘a share of industrial production costs, energy inputs comprised only eight per cent of value-added in 2010, with natural gas representing three per cent’. While this low share will partly reflect existing natural gas price declines, further price reductions due to shale developments would only reduce an input cost which is already a low proportion of overall costs. As Oxford Economics concludes, ‘The competitiveness benefits of low energy prices should therefore not be exaggerated’.

Placing faith in the competitive advantages of low energy prices to drive American industry’s revival also reflects a static belief that current energy price differentials will continue. Yet global market forces are likely to lead to the gap narrowing, if not equalising. It is rather quaint in our globalised world how it is thought that America can retain lower than world prices and this ‘competitive advantage’. Even if the US took a protectionist stance and were to continue to restrict export licenses, as some US manufacturers want, in order to try to limit downward pressure on world prices, global prices would still tend to equalise over time. As the US moves to self-sufficiency, lower US imports will take away significant global demand and see global prices falling and the difference narrowing for that reason instead.

While some US companies are relocating back home, it is naive to believe that the decision about where to locate production is a simple matter of ‘input’ costs, whether labour or energy. As the consultancy McKinsey correctly explained in a recent review of global manufacturing’s prospects, when it comes to location decisions, ‘companies must look beyond the simple math of labour-cost arbitrage to consider total factor performance across the full range of factor inputs and other forces that determine what it costs to build and sell products— including labour, transportation, leadership talent, materials and components, energy, capital, regulation, and trade policy’.

McKinsey describes, for example, how ‘many energy-intensive processing industries such as steel tend to be located near demand, and their footprints are “sticky” due to high capital investments and high exit costs. In many industries, market proximity, capital intensity, and transport and logistics matter as much as energy and labour costs’. From this perspective, McKinsey’s analysis finds something rather deflating for the shale energy champions of industrial renaissance: the most energy-intensive areas of manufacturing tend to be also among the least internationally traded.

Among the energy-intensive industries where proximity to the big expanding markets of the developing world matters more, McKinsey includes metals, petrol refining and other resource-related products. As Sebastian Mallaby noted in an otherwise bullish assessment of American industry’s prospects, ‘The industries that are most energy-intensive are not actually very trade-intensive. US paper mills and oil refineries will enjoy the cheap gas bonanza but not much production in these sectors is likely to shift to US shores.’

One of the few industries McKinsey assesses as being both energy-intensive and trade-intensive is chemicals, which no doubt accounts for why this industry is so often referenced as illustrating the reshoring trend in the US. However the chemical industry represents only about two per cent of all US value-added, so even if it were to double in size due to cheaper energy over the next few years, the total US economy effects will be tiny.

We can conclude that changes in relative labour costs (rising Chinese wages), or in relative energy costs (from US shale resources), are never going to be as decisive on their own in determining where to locate production as much of the contemporary discussion seems to assume.

When it comes to the prospects for US industrial revival, the more important point is that the US economy is not in its current predicament due to input cost factors, or anything else, driving some production abroad. A little bit of historical perspective reminds us that the decline of US economic dynamism was never caused by offshoring in the first place. Outsourcing overseas has been a consequence rather than a cause of US productive decay, which long preceded the take-off of outsourcing. As I noted in the first part of my essay, the US trade deficit has been growing continuously since 1983, well before anyone had heard of ‘offshoring’. Revitalising US production requires a lot more of an economy shake-up than turning the clock back a little. In fact, what matters is almost the opposite: not protecting and holding on to or restoring old businesses and jobs, but for new areas of business to take off to replace them.

Illustrating this, McKinsey estimates that for the US, ‘trade and outsourcing explain only about 20 per cent of the 5.8million manufacturing jobs lost during the 2000-2010 period’. It concludes that more than two-thirds of job losses are attributable to continued productivity growth. The problem has been less the pace of manufacturing productivity per se than the lack of new productive jobs for the ones lost.

Moreover, US economic decay is a much broader phenomenon than the declining share of manufacturing either in total employment or in total value creation. We should recognise, for example, that trends in manufacturing employment are not a direct measure of an economy’s underlying health. In fact, the absolute and relative decline of manufacturing jobs in an advanced economy can be a positive sign of the sort of rising productivity that McKinsey mentions. Rising productivity means that rising output can still be achieved with falling employment. The US record of employment decline (see the chart in Part 1 of this essay) is quite consistent with the fact that manufacturing output hit an all-time high in 2007, before the latest recession began.

We should not fetishise manufacturing, either. Services can be just as value productive as manufacturing, while the distinction between the two has become increasingly blurred anyway. With the rise of the East, it is likely that as the balance of global consumption shifts to the emerging markets, the production location for the less traded manufacturing segments will follow suit. McKinsey estimates that by 2025, developing economies could account for nearly 70 per cent of global demand for manufactured goods.

What is much more important for future prosperity in any country is the ability not to retain old sectors and jobs but to develop new areas of value creation and jobs, whether in manufacturing, in other industries, or in services. This is where the US and other Western economies have become dysfunctional.

The growth in public-sector jobs – financed by increasing government debt – has obscured this to some extent. Government employment in America rose continuously from 14million in 1973 to 22.5million at its peak in 2008, disguising the decaying dynamism of the private sector. However, when we look just at the pace of private-sector job gains, the long-term economic decline is more obvious (see chart below). Although this data series from the US Bureau of Labour Statistics only goes back to the early 1990s, the ebbing of the creative powers of the US private sector are evident well before the latest recession hit. This is the inevitable consequence of that sorry picture of long-term falling business investment.

Annual private sector gross job gains
and gross job losses, as a per cent of employment
March 1994 to March 2012
Source: US Bureau of Labour Statistics
Note: Shaded area represents recession period

So what is important, then, is not the earlier relative decline of manufacturing, or offshoring, or its partial reversal. What matters is the need for massive investment in new areas of production – led by the state and executed in some form of partnership with the private sector.

Shale energy: boon or curse?

After four years of sluggish recovery, President Obama’s goal of an industrial renaissance, of an ‘economy built to last’ based on production and earnings instead of debt-funded consumption, is certainly a worthy one. But realising it will need a lot more than a belief in reshoring. This is where recent developments, and especially the shale energy boom, may actually be counterproductive.

The shale oil and gas boom is real enough. The danger is that investment in fracking could become the ‘IT revolution’ of the 2010s – the exception that proves the rule. While the internet, and information and communication technologies more widely, expanded in the 1990s, most else of US production continued its long-term decay, disguised by state intervention, including the financialisation boom and by the subsequent dual credit and housing bubbles. Today, similarly, apart from fracking investments, most other major infrastructure and production investments are pretty paralysed.

It’s long been recognised that for a developing economy, having energy or other natural resources can counterintuitively turn into a distraction from economic development and progress. Capital – domestic and foreign – often focuses on this resource sector alone, at the expense of broader economic development. This can produce the paradox that countries and regions with an abundance of natural resources tend to have less economic growth and worse development outcomes than countries with fewer natural resources. Because of a nation’s resource wealth, other sectors seem to have less incentive to pursue productivity improvements. This has become known as the Resource Curse (or the Paradox of Plenty, or the ‘Dutch disease’, a term coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field in 1959).

Given the four-decade track record of the elite in the US in evading addressing the seriousness of its economic challenge, the danger is that the shale energy boom becomes America’s version of the ‘resource curse’. The belief that things are ‘on the mend’ takes the pressure off addressing the deeper economic challenges. Ironically, the fact that the US is genuinely experiencing an energy renaissance, which could continue for many years, might be a bigger problem than if it were a mirage that soon evaporates. Just as Britain’s North Sea oil boom in the 1970s and 80s disguised how far the underlying British economy had sunk, so US shale energy could hide from view the pressing need to restructure radically America’s productive base.

Maybe partly influenced by his roots, South African Michael Edwardes, then the chief executive and chairman of Britain’s ailing motor giant, British Leyland, presciently but controversially spoke to the CBI Conference in 1980 about the dangers from Britain’s own resource boom: ‘If the [government] cabinet do not have the wit and imagination to reconcile our industrial needs with the fact of North Sea oil, they would do better to leave the bloody stuff in the ground.’

He was ignored, of course. North Sea oil came and went, and Britain continued its own economic decline. The American elite could do with remembering that lesson and, instead of hoping for cheap energy to perform miracles on its own, develop the ‘wit and imagination’ to initiate the long overdue restructuring, renewal and revitalisation of the US economy.

Read Part 1 of Phil Mullan’s essay here.

Phil Mullan is the author of The Imaginary Time Bomb: Why an Ageing Population Is Not a Social Problem, IB Tauris, 2000. (Buy this book from Amazon (UK) or Amazon (USA).).