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» Feature Article

26th November 1998

Deindustrialisation, governments have been slow to recognise this trend

Deindustrialisation - It's only natural

John Dymond takes a look at the findings of research conducted by the International Monetary Fund (IMF) on 'deindustrialisation' and discovers they do not necessarily reflect current mainstream thinking in this area.

During the past 25 years, employment in manufacturing as a share of total employment has fallen dramatically in the world's most advanced economies, a phenomenon widely referred to as "deindustrialisation". Why this has happened, what it means for the world economy, and whether it is a good or bad thing are matters that have fuelled considerable economic and political debate during this period. Finally the International Monetary Fund has conducted some research in this area.

Falling employment in the manufacturing sector has been a major political, if not economic, concern of "advanced" economies for at least the last twenty years. In Australia in particular, it is considered in political parties as something that must be stopped, if not reversed. A whole new political party has sprung up which, amongst other things, wishes to increase employment in the manufacturing sector as a share of total employment through highly interventionist policies. The Federal Labour Party has recently unveiled a $1.5 billion dollar industry plan, and the Federal Coalition recently froze previously planned reductions in motor vehicle tariffs and increased assistance to the textile clothing and footwear manufacturing industry. Is the declining employment (relative to the whole economy) in manufacturing ("deindustrialisation") really a cause for concern? Or is it merely symptomatic of some other development which should be encouraged? How should the whole process be managed? Recent research conducted by the International Monetary Fund provides some interesting and very topical guidance.

The first point the research makes is that deindustrialisation is primarily a feature of successful economic development and that trade between advanced economies (with higher wage rates) and the developing world (with lower wage rates) has very little to do with it. Over the last 20 years, the IMF found that, adjusted for inflation, the amount spent on manufactured goods relative to total spending has been reasonably stable. Thus, deindustrialisation is principally the result of higher productivity in manufacturing than in services. That is, over the last 20 years or so the number of workers required to produce one unit of manufactured product has declined faster than the number of workers required to provide one unit of service. Looked at in this way, it becomes clear that the pattern of trade specialisation among the advanced economies explains why some countries deindustrialise faster than others.

The second point the research makes is that the rise in the share of manufacturing employment relative to total employment in most advanced economies until the late 1960s and subsequent decline, coupled with an increase in the share of services employment is explained by two factors. The first factor, affecting demand, is what economists call Engel's Law, which states that the relative amount of income that an individual spends on food declines as his or her income rises, meaning in practice that as economies industrialise, people spend proportionally less on food and proportionally more on manufactured goods and services.

The second factor, affecting supply, comes from the rapid growth of productivity in agriculture, as innovations make it possible to produce more food with ever fewer workers, leading to declining employment in the agricultural sector. The combined effect of these two factors is a shift of employment from the agricultural sector to the manufacturing sector. The overall proportion of employment in agriculture in the advanced economies fell from about 20% in the early 1960s to 11% in the early 1970s. From that point, it is logical to expect that any expansion in the share of services employment will subsequently be at the expense of manufacturing employment, just as the earlier shift to manufacturing took place at the expense of the agricultural sector.

The conclusion that may be drawn from the above two points is that deindustrialisation is an inexorable process based on changing spending patterns within an economy as the wealth of that economy increases and productivity growth within the agricultural and manufacturing sectors increases. Of particular note in this regard is the finding revealed by regression analysis (a statistical method of determining the relative importance of various factors contributing to a particular result) that over 60% of the fall in the share of manufacturing within the industrial world as a whole is explained by differences in relative productivity growth. If patterns of productivity growth revealed in the analysis continue, the share of manufacturing employment as a proportion of the workforce will probably fall from about 18% in 1994 to as little as 12% within the next 20 years.

The conclusion drawn above has profound implications for the future. It suggests a direction for future economic policy somewhat at odds with current popular perception. Some implications are:

» if more of the workforce moves into the services sector, productivity growth within the services sector will probably determine the outlook for living standards overall;

» if one accepts that the long term average rate of growth will be determined by the activity in which growth is slowest and that manufacturing is technologically progressive and services are, in general, less technologically progressive, the economy-wide growth rate in the long run will be determined increasingly by the growth of productivity in services;

» given that the manufacturing sector typically involves standardised modes of production and the services sector typically involves wide differences in the types of work available, countries that operate centralised wage-bargaining arrangements seem likely to face serious challenges, and it seems inevitable that appropriate wage differentials will be needed to compensate for the wide variation in skills and work intensity that the sheer diversity within the services sector implies;

» given the need for appropriate wage differentials amongst the myriad of different services provided, and the need to adequately recognise within the sector a range of service delivery modes, it would appear that any centralised wage bargaining system will inherently lack the flexibility and capacity for rapid change required to allow for innovations necessary to promote growth of productivity within this sector; and

» any interventionist approach aimed at slowing the process of deindustrialisation is likely to simply slow productivity growth in the services sector and thereby slow the rate of growth in economy-wide living standards which would otherwise prevail.

So, it appears that governments throughout the industrialised world have largely been trying to hold back the tide for the past 20 years or so. It would appear, based on the above findings, that such governments, and the communities they serve, would be better off if the inevitability of deindustrialisation were recognised, accepted, explained and planned for. The focus of governments of advanced economies around the world should be, it would seem, not the maintenance of the manufacturing sector but the expansion of the services sector, both in terms of capacity and productivity, and the adoption of new paradigms to cope with the new economic reality.

This article draws from material originally contained in IMF: Working Paper 97/42 "Deindustrialisation: Causes and Implications" by Robert Rowthorn, Professor of Economics, Cambridge University and Ramana Ramaswamy of the IMF's Research Department. Those interested in The original Working Paper may visit the IMF web site at www.imf.org.