Why don't economists get it on manufacturing?

Casino chips, computer chips, what's the difference? They're all chips, right?

That seems to be what Berkeley's Christina Romer, the former Chairwoman of President Obama's Council of Economic Advisers thinks, and in that she faithfully reflects orthodox economic wisdom.

Writing in yesterday's New York Times, Romer debunks the present wide concern over the decline of American manufacturing and the call by many, including the president in his State of the Union address, for tax breaks and other policies to help shore up manufacturing. She first notes that services industries are as valuable to the U.S. economy as manufacturing, emphasizing that consumers value haircuts as much as hair dryers and that earnings from exporting architectural plans to Shanghai are as real as those from exporting cars to Canada.

This sounds good because all industries have their value and no one wants to denigrate a particular industry or type of respectable work. But it's just not true. Consumers may not value haircuts less than hair dryers but economists should. Production of hair dryers can be done in large factories that produce economies of scale. Such scale economies lead to lower prices, lower inflation, higher productivity and thus higher wealth creation for the whole economy. In addition, producers of hair dryers invest in research and development to foster innovation of new, more efficient, less energy using, and easier to produce dryers.

Now don't get me wrong. I love my barber and want to be sure she stays in business, but her work doesn't yield any of these benefits to the economy. It doesn't have economies of scale, falling costs, rising productivity, or investment in R&D. So while I don't want to lose my barber, I also don't want to lose my hair dryer production unless it can be replaced with something that contributes equally or more to wealth creation. And I don't see retraining the hair dryer workers to be hair dressers as a gain for the economy.

The truth is that manufacturing underwrites about two thirds of all the R&D done in the United States and contributes heavily disproportionately to increases in productivity in the overall economy. That makes it economically more valuable than most (but not all) service industries.

Next, Romer claims that the benefits of such things as the spillovers of clustering and of the acquisition of skills that are broadly transferrable are overstated as are concerns over the viability of the U.S. defense industrial base. She cites a couple of studies by professors at Harvard and M.I.T. along with a semiconductor industry study to support her view.

Well, maybe, but I've been involved in studies and the National Academy of Science and the President's Council of Advisers on Science and Technology have done studies that seem to support the importance of the innovation and production ecology. So we have warring studies. What I can say is that in interviewing I have personally conducted of deans of engineering schools, I hear again and again that the reason for the fall off in U.S. science and engineering graduates is that as a result of the decline of manufacturing there are no jobs for those graduates. The kids are not stupid. They see that and decide to study finance or communications or design or medicine where they can anticipate having employment.

Next, Romer argues that America's present high unemployment rate is not due to any decline of manufacturing but rather to a "profound shortfall of demand" that should be remedied not with aid to manufacturing but with further tax cuts and  macro-economic stimulus measures.

This argument baffles me. In the first place, given the present level of U.S. debt and the present political line-up, I don't know how Romer can imagine that she can get further macro-economic measures that will increase the budget deficit. But, more importantly, I don't know how anyone can say we have a shortfall of demand when our trade deficit is over 3 percent of GDP. That means that we are consuming and therefore demanding 3 percent of GDP (about $500 billion) in excess of our own production. The problem is not that we don't have enough demand. It is that much of our demand is supplied by imports. If the demand currently supplied by imports was entirely supplied by domestic production we'd have an additional 5 million jobs and unemployment would be 4 per cent instead of 8 percent. Our problem is not too little demand. It is too little domestic production. And since our trade deficit is overwhelmingly in manufactured goods (which any conceivable growth in services exports cannot balance), our problem is really too little production of manufactured goods

Just to drive the point home, let me cite a study by the U.S. Government Bureau of Economic Analysis in 2007 which shows that $1 of final demand in manufacturing generates $1.41 in additional intermediate demand. This is far about the next greatest demand generator which is the information industry at $1.14. By contrast retail industries generate only $.58.

Finally, Romer argues that whereas in the past manufacturing paid above average wages and was one of the few sources of well paying jobs for less educated workers this is no longer as much the case.

Okay, so it's not as much the case as it was thirty or forty years ago. But it's still somewhat the case. The average manufacturing wage is still above the general average wage. Yes, it's true that manufacturing jobs today require on average more education than in the past and that factories now operate with a lot fewer workers per dollar of production than twenty years ago. But that's no reason not to want as many of them as we can get. Don't forget that the wealth they create will be necessary to sustain demand for all those service jobs at good middle class wages.

Finally, the worst Romer error is her assertion that manufacturing is asking for special help and subsidies and that we have to choose between manufacturing  and services. This is a false choice and a kind of a straw man argument from Romer. What's really going on is that U.S. manufacturing has been the main target of industrial policies in Asia and Europe. Thus, for example, the semiconductor industries of Japan, Korea, and Taiwan have been heavily subsidized and protected and on that basis have taken a large part of the world's production away from the United States. At the same time, countries like Ireland, Israel, and Singapore have offered tax holidays, free land, cut rate utilities, and capital grants to induce U.S. and other global semiconductor makers to locate production facilities in their countries. They do this because, contrary to Romer, their economists and industrial planners think the spillovers and clustering and productivity gains are enormous. None of these pressures and inducements are being applied to services industries by foreign countries. Thus, U.S. proponents of manufacturing are not asking for special treatment or support that discriminates against services industries. They are merely urging that steps be taken to offset the market distortions being caused by the foreign industrial policies. If such distortions were being generated in services industries, they should also be offset.

The point is that we should not have to make some false choice between manufacturing and services. We should be able to have both in those industries in which America can be competitive on the basis of prevailing market forces. I don't understand why, instead of bashing American manufacturing, Romer and her colleagues don't bash the mercantilists and strategic industrial policy and trade regimes of much of Asia and Europe in defense of truly operating global markets.