The destruction of
industry by fluctuating interest rates
This is the second in a series
describing the disadvantages of inflationary policies.
The first concerning the effect on savings is
here
Keynesian and monetarist policies targeting price
stability have indirectly contributed to the demise of
industry in Western nations. This may be
counter-intuitive, given that most economists routinely
call for a weakening currency to give these same
industries a trade advantage, and industry itself
consistently supports these erroneous recommendations.
Yet the two post-war economies that most successfully
developed and retained capital goods manufacturing
industries, Germany and Japan, did so against a
background of strong currencies and a savings ethos. At
the same time, economies that had a weak currency and
declining savings saw the destruction of much of their
manufacturing industries.
The
world of manufacturing is competitive, with price and
quality being the main determinants of sales. To achieve
these objectives, a manufacturer has to seek economies
of scale, to ensure unit costs are kept as low as
possible, and to employ expensive machinery and good
worker skills to ensure quality. To be successful, he
has to invest and continually reinvest large amounts of
capital for long periods of time. This means that to
make profits over the lifetime of his investment he
needs stability in his production costs, especially in
the cost of capital employed. Without that stability, he
will find that the assumptions behind his investment
plans will be undermined. As he seeks to evolve his
product into new and improved models, the financial
returns may no longer be there.
The
yardstick for measuring these returns is obviously
interest rates; so low, stable interest rates are
paramount for the long-term success of manufacturing
businesses. Broadly, there are two ways interest rates
can fall to attractive levels for industrial investment:
either through an increase in savings at the expense of
consumption, or through central bank manipulation of
interest rates. The results are sharply different.
When there is a genuine increase in savings, it is at
the expense of demand for consumer goods, leading to a
relative fall in consumer goods values. Furthermore,
economic resources are released through this fall in
demand and so are available to be redeployed in any
business seeking to increase investment in
manufacturing. From the entrepreneur’s point of view,
lower interest rates, which are also proxy for the
hurdle on investment returns, make new manufacturing
processes profitable compared with an investment at the
consumption end of the manufacturing chain where the
returns have fallen, while at the same time the raw
materials and labour become available to him at stable
prices. In other words, the reduction in consumption
that results from an increase in savings releases the
capital, the labour and the raw materials required by
the manufacturer.
But
when interest rates are lowered by a central bank to
stimulate demand for money, consumption is not reduced,
but maintained or even increased. In this case, lower
interest rates arise from monetary and credit
stimulation, and not savings. The economic resources
necessary for a new manufacturing enterprise are not
released, and the entrepreneur finds he is in
competition for them. So the entrepreneur who considers
investing in production finds his cost of capital, and
therefore his return hurdle, will have dropped, but his
other costs have not.
The
entrepreneur may decide to invest in manufacturing on
the basis of lower interest rates, but to do so is a
mistake. His raw material and commodity costs begin to
increase as the inflationary effects of monetary and
credit expansion work through the system, and before
long the central bank is forced to raise interest rates
to control inflation. This rise in interest rates
inevitably kills the profitability and any remaining
logic of his manufacturing investment.
This description is a simplification of the effects of
monetary expansion on manufacturing, compared with
manufacturing financed out of increased savings. But
there are two principal points to appreciate. Firstly,
the expansion of money and credit ends up punishing
those that erroneously invest in production, because
inflation is the result and interest rates have to
subsequently rise. The second point is the timelines for
manufacturing very long, and profitability can be
disrupted by volatile interest rates many times over the
life of the capital investment.
Compare, for example, the establishment of a factory
designed to manufacture products for a minimum of twenty
or thirty years, with a retail operation that can easily
lay off staff and reduce stock levels as a response to
difficult times, knowing it can restock and rehire at
only a few weeks notice.
The
lengthy life of a manufacturing process in a declining
savings environment has to suffer many cycles of severe
interest rate volatility as a result of monetary
expansion. In the US, for the last forty years the
interest rate score-card is as follows: from 3% to 9% to
4.5% to 16% to 6.5% to 17.1% to7% to 10.5% to 5% to 9%
to 2.8% to 6.1% to 0.9% to 4.9% and to 0%[i].
In Britain, the swings have been generally greater. And
when a new manufacturing enterprise draws on outside
finance, its returns and losses, being geared, are
magnified in terms of the return on equity employed.
It
is therefore hardly surprising that over time businesses
have learned not to invest in production in an economy
plagued by credit-driven economic cycles. Instead, they
have moved their operations abroad to emerging
economies, where there is plentiful labour, and
factories and equipment can be up and running relatively
quickly. Labour there is eager to learn and work for the
prospect of a substantial improvement in their lives,
and the time-consuming government bureaucracy that is a
feature of the advanced economies is avoided. These
benefits taken all together can be more easily financed
due to the shorter time-scale to profitability.
As
if to prove the point, the exportation of manufacturing
activities is particularly noticeable in countries with
the weakest currencies, while manufacturing is retained
in the strong, when there is a strong savings ethos. In
Japan, the yen rose from ¥350 to the US dollar in 1971
to ¥128 in 1989, and in Germany, the mark rose from
Dm3.60 to the dollar in 1971 to Dm1.5 in 1991, offering
us strong evidence of the importance of a reliable flow
of savings to back investment, compared with the
supposed disadvantages of a strong currency.
Admittedly there were substantial swings in interest
rates in both these countries over the period, but they
were significantly less than those for the dollar and
pound and they were not enough to undermine a strong
savings ethos. Furthermore, both Japan and Germany were
certainly not free from errors in macro-economic policy,
but thanks to strong savings flows they did not destroy
their manufacturing bases as effectively as the
Americans and the British.
So
we can now see why American and British businesses have
had good reasons to relocate their manufacturing
elsewhere, and that the experience of the post-war
period confirms our reasoning. The increasing trend
towards service industries is also consistent with our
findings. Far from being symptomatic of an advanced
economy as often claimed, it is purely a result of
consumer focus and the destruction of manufacturing.
Service industries require little long-term capital
investment, in common with retailing consumer goods. So
long as a service-industry business is careful to
nurture its reputation, it easily hires and fires with
the business cycle. They are ephemera compared with the
heavy industries that depend on stable long-term savings
flows for their finance.
There can only be one conclusion: that weak monetary
policy, targeted at improving export competitiveness,
economic recovery, or whatever the problem of the day,
actually undermines the production structure of modern
economies. Remove this source of interest rate
volatility, encourage savings, and business can repair
itself. The source of our troubles lies in the Keynesian
mandates given to the central banks and in the central
banks themselves. Instead of achieving price stability,
their weak-money policies have managed to destroy
manufacturing, which is life-blood of a healthy economy.
28 February 2011
[i] As
measured by the US 13 week T-bill rate from 1971
to 2011.
