The manufacturing sector has bled jobs for the last 20 years and everyone knows the story of how globalization has affected factory communities throughout the country. But is manufacturing coming back? This would be a great Rocky Balboa moment in the history of American industry if there was a resurgence of the manufacturing sector. There may be some evidence that this may be occurring but it also may be too early to tell.
The chart above shows how US manufacturing has performed in two periods: since 2000 and since 2008. Since 2000, real US manufacturing has been flat while imports have surged; imports are getting a bigger slice of the pie, so to speak. Something has happened in recent years though. US manufacturing and import growth are moving in lockstep; if there was a continued decline in the sector, you would expect to see imports continue to have a higher growth rate than the domestic production. This is just not the case. Some of this leveling out is driven by declines in petroleum imports; there has been more petroleum extracted domestically. However, the extraction of petroleum does not show up in US manufacturing; oil extraction is a category unto its own. Now I would not call this a robust "comeback" but it is a good sign from the US perspective especially because the economics of manufacturing are getting more favorable for US manufacturers; this will be discussed more below.
Further evidence supporting a basing thesis can be found in employment data below. The US actually added jobs to the sector for each of the last three years; before that, the US didn't add jobs to the sector since 1996. Every year was a decline. This might be a cyclical uptick after a big decline; however, taking into account the broader trend it might appear that the sector will be basing in the coming years and could possibly reverse course from a very long downward trend. The idea of a terminal decline in this sector is way overblown.
A little background is in order to see just how much this idea would buck the established trend. Consider the following, which is the same chart above with only a longer time frame.
Manufacturing employment peaked in 1979 and began to accelerate its downward trend in 2001. Since 2001, the year China entered the WTO and the US was in a recession, the manufacturing sector has shed over 5.2 million jobs. The sector never recovered and continued to bleed jobs year after year. The manufacturing sector can further be broken down per the chart below; you can see that some subsectors have been hit harder than others. It shouldn't be a surprise that textile-related employment has dropped the most as companies in this space have set up offshore.
The employment issue is one side of the issue. The total value added by the sector has actually ebbed and flowed over the last decade per the chart below. The reason for this inconsistency between employment levels and total value added is that there has been more automation and technology implemented at manufacturing firms, which has improved the productivity of the labor that remained. On a per worker basis, output has trended upwards.
The US has consumed manufactured goods that are imported and those that are produced domestically. See the chart below that shows the rise of imported goods year by year. Imports accelerated in many categories last decade and appear to be leveling off in recent years as mentioned above.
Reasons to Be Optimistic
There are a few reasons why the decline in manufacturing might stabilize and even turn upward. Labor costs in offshore countries, particularly China, have risen dramatically in previous years. Bunker fuel oil has also risen dramatically over the last decade; this is the fuel that powers tanker ships. Advances in automation equipment means that labor costs are becoming somewhat less relevant in the decision making process in determining where to locate a factory. Finally, as offshore economies develop and improve their productivity, their exchange rate with the US Dollar will likely strengthen.
There are many anecdotal stories of manufacturing coming back to the US. One such example is GE's reopening of its Appliance Park in Louisville, Kentucky that manufactures GE appliances. Jeff Immelt even wrote a piece in the Harvard Business Review, which can be found here, that is worth reading; it is summarized in an article here. Immelt says that outsourcing may have been a bit of a fad; there was a herd mentality that saving on labor costs was the only relevant decision point while executives did not consider other hidden costs, such as maintaining control of the supply chain or having a quicker time from assembly to distribution. These labor cost advantages have been diminishing over the years and companies are reevaluating their offshoring decisions.
The Economics of Globalization
A great primer on the wage rate component of globalization, specifically in China, can be found here; it was published by Accenture in 2011. Accenture considers three classes of manufacturing activity: Apparel, Heavy Equipment, and High Technology. The GE appliance example from above likely falls into the heavy equipment category.
The chart below shows the wage structure by class and how it has developed over time. Notice that each wage rate, as measured in USD, has more than doubled in only six years. This is driven by increases in the real wage rate and the strengthening of the yuan relative to the dollar. To put that into perspective, if wages were 50 cents an hour as they were a decade ago (as measured in USD), you could replace one American worker with 20 Chinese workers. Now, with Chinese wage rates up, you can replace one American worker with only just a few Chinese workers; this has a big impact when it comes to making the outsourcing decision.
The extent of the trend in rising wages (or rising transportation costs) needs to be put into the context of the cost structure. If these costs represent bigger portions of the cost structure, then they will have a bigger impact if they move higher. The goal for any manufacturer is to minimize their cost of goods sold (COGS); higher labor costs, wherever the product is made, will drive the COGS higher. The following graphs show the extent of labor costs within the cost structure of the various types of products.
So you can see from the above graphs that an increasing labor cost will affect each type of industry very differently because the labor cost makes up a different percentage in each one. The higher order technology goods will be most affected by rising labor costs followed by capital goods and then consumer goods. If this analysis is right, you will see high technology companies starting to come back to the US first. Examples that we see now may be Apple setting up a plant in San Antonio or Lenovo opening a plant in North Carolina.
The charts below shows the percentage increase in prices a company must make in order to maintain the same profit levels; the red circled number indicates the most likely scenario given current conditions. Once you see the COGS (and price) of goods rise, companies will start to find that their coordination transportation costs are no longer offset by labor cost advantages.
The above narrative is for China, which has seen the largest increase in real wage rates in the last decade compared to other emerging markets. The chart below shows the real wage rate increases of other countries. Vietnam is the leader on this list but India's real wage rate has actually been on the decline. Some analysts do not believe India to be a viable candidate as a large scale manufacturer because there is significant bureaucracy and poorer infrastructure to support large scale development in the sector.
Transportation costs, as mentioned above, also play a role in choosing to outsource. Transportation costs are driven by fuel costs. A recent Bloomberg article here estimates that fuel costs represent about 70% of tanker transportation costs. Bunker fuel oil, just like other petroleum products, has risen significantly in the past decade. Where the apparel-type category might have the lowest percentage of labor costs, it likely has the highest transportation costs relative to sales. These are lower margin products with high turnover.
A final economic factor affecting manufacturing is the value of the dollar relative to other currencies. The US dollar is the world's primary reserve currency. Therefore, there is a large demand for dollars around the world as a store of value; this strengthens the dollar. This is not beneficial for US exporters because it makes their products more expensive relative to the local currency. This trend is changing though. The world economy is growing faster than the US economy; this means that the world will have relatively more purchasing power over the years. The opportunity cost of holding the local currency goes up and drives the exchange rate to strengthen the local currency relative to the dollar. You can see the dollar index chart below that shows the weakening of the dollar relative to a trade weighted basket of currencies over time. Notice that the dollar strengthened recently during the crisis as there was a flight to safety. As foreign economies grow and foreigners diversify their holdings away from the dollar in favor of other currencies, you can expect the dollar to continue to weaken. This will be good for the US manufacturing sector.
Automation is the Critical Factor
The name of the game since the start of the Industrial Revolution has been automation. Automation and the implementation of technology makes economic processes more efficient; there are fewer resources (time, labor, costs) consumed in creating the same output. There are many innovations happening with automation technology. As one example, consider the meat processing industry. Since the invention of the knife, man has processed meat the same way: by having someone cut it. Now, because of visual recognition software, certain processes have become automated without the need for butchers. As a result, the industry has seen more output produced per worker in the industry.
It might seem counterintuitive to say that the US could gain jobs because of automation because automation helps to eliminate jobs. However, the jobs that would be created would eliminate foreign jobs in favor of Americans operating machines, so to speak. Labor costs become less of a concern and less of a percentage of the cost structure. Therefore, companies could relocate closer to end markets and economize on transportation costs given gains in local productivity.
Consider the graph below. The quantity index measures the difference in units produced where the labor index measures the differences in full time equivalent workers over the years. 2005 is the base year. Notice that the manufacturing quantity index has been rising while the labor index has been falling. In other words, there has been more output with fewer workers; manufacturing labor is getting far more productive.
The following two pictures tell the tale of automation being implemented in the auto industry over time.
There are quite a few economic forces in play that all point to improving US manufacturing. The labor cost advantage is less of an advantage than it once was and it will be less so into the next decade. There are rising transportation costs, which also add more cost into the cost structure of offshore manufacturers. The dollar is generally declining relative to foreign economies, which means that it will cost US buyers more dollars to purchase the same output from abroad. Finally, there is an increasing deployment of automated manufacturing in the US which makes the labor cost less important in the overall cost structure of products and US labor more productive.
It is a bold move to call an inflection point on a twenty-year trend; however, there are many economic forces acting in a way that favor an increase in US domestic manufacturing. There is a good chance that the US manufacturing sector will perform better in the next decade than it did in the previous decade.
Because of automation, US manufacturing will look much different than it did in different eras. Long gone are the days when manufacturers hired armies of workers to assemble products. Today, many of those jobs have been replaced by sensors, robotic arms, or automatic equipment. Workers in this industry require vastly different skill sets.
There has been a basing trend in US manufacturing output and employment in recent quarters especially relative to imports. It is too early to tell if this trend is structural or part of a cyclical uptick. A stabilizing US manufacturing sector would significantly help the US economy and offer more opportunities to the American worker. This is a trend worth paying attention to in the next few quarters to see how it unfolds.