Alasdair Macleod – 28 February 2011
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.
[i] As measured by the US 13 week T-bill rate from 1971 to 2011.