New Directions in Manufacturing: Report of a Workshop (2004)

Michael E. Baroody

National Association of Manufacturers

Manufacturing took a particularly strong hit during the recent recession. However, manufacturing is extremely important to the economic competitiveness of the United States. Steps are currently being taken to reinvigorate manufacturing, stimulate more robust and durable growth, and increase employment.

Manufacturing is a critical contributor to the state of the economy. The National Association of Manufacturers (NAM) is the nation’s largest industrial trade association, representing 14,000 members, including 10,000 small and medium-sized companies. The recent economic downturn hit manufacturers much harder than the rest of the economy, both in terms of depth and duration. Manufacturers began slipping into recession in the third quarter of 2000, well ahead of the rest of the economy. And by the time that manufacturing output began to increase again in the beginning of 2002, industrial output had fallen by 8 percent over the previous 18 months. This is a significantly worse situation than that faced by the rest of the economy. Overall, gross domestic product (GDP) slipped less than half a percent during the first three quarters of 2001, the second-mildest recession in 50 years.

And while the overall economy grew a modest 3 percent last year, the increase for manufacturing output was only 1.7 percent. Thus, the manufacturing “recovery” is slower than the first year of any recovery over the past 40 years and less than one-fifth the average 10 percent growth during the initial 12 months of the past six expansions. Since July 2000, manufacturing employment has fallen by 2 million over the course of 30 consecutive monthly declines. By contrast, employment in the rest of the economy has grown by 954,000, with a brief, but sharp, drop in employment immediately following the events of September 11, 2001, sandwiched between months of modest employment growth.

During the manufacturing downturn that began in June 2000 and ended in December 2001, 1.4 million manufacturing jobs were lost. This 8 percent decline in the manufacturing employment rolls matches the average decline during the past six recessions. However, for 2002 overall, another 592,000 manufacturing jobs were lost. This stands in stark contrast to the average increase of 352,000 in manufacturing employment that has typically taken place during the first year of previous expansions. These figures clearly show that the recovery has thus far largely bypassed the manufacturing sector, which was hit hardest in 2001. The largest employment declines have taken place in the electronics and industrial equipment industries. Each of these sectors has lost more than 350,000 jobs. Together they account for more than a third of the manufacturing job losses since mid-2000.

Manufacturing was hit harder than the rest of the economy because the recession was

mainly caused by a collapse of business investment and exports, which declined by 9 percent and 11 percent, respectively, in 2001.¹ Recovery has evaded manufacturers for the same reason. By contrast, consumer spending has held up reasonably well, growing by 2.8 percent in 2001. In 2002, the recovery was largely driven by consumer spending, which accelerated modestly to a growth rate of 3 percent.² At the same time, business investment declined by 3 percent and the export of goods increased slightly, by 2 percent, remaining 8 percent below the level of 2 years ago. This stands in stark contrast to the 10 percent growth in exports during the first year of recovery following the 1990 to 1991 recession. Weak business investment and weak export growth have constrained the recovery for manufacturers. In short, the expansion to date has been narrow, unbalanced, and historically sluggish.

Despite historically low interest rates and the fact that a bonus depreciation stimulus package was passed last year, there remain significant inhibitors to economic growth. Some of the challenges facing manufacturers are long-term problems that need to be addressed to create a better environment for manufacturing in America. For example, manufacturers are competing in a deflationary environment, with pricing power falling at an average annual rate of 0.9 percent since 1995. By contrast, the inflation rate for the economy overall has averaged 2 percent since the mid-1990s. At the same time, heavy regulatory and legal costs are undercutting business competitiveness. Combined, a heavy regulatory and legal burden in 2002 cost U.S. firms $697 billion, or 6.7 percent of GDP.³ Manufacturers are especially hard hit by these burdens. The cost of regulatory compliance alone adds up to $8,000 per manufacturing employee. This is 67 percent higher than the average cost to business overall. In addition, manufacturers’ health-care costs rose at an average of 13 percent over the past year.

According to 80 percent of NAM’s membership, there was a moderate to serious shortage of qualified applicants in 2001. This signals that a persistent skills gap remains a problem for manufacturers. U.S. share of world manufactured exports has fallen from 13 to 11 percent since 1997 due to the rise in the value of the dollar. And while the dollar has fallen since its peak last February, it still remains 15 percent above its historic level. Businesses have also become increasingly uncertain about the short-term outlook, evidenced by the fact that the ISM business activity index dropped 9 percent from May to December 2002. This lack of confidence has curtailed investment spending, which is the main reason why the current recovery has underperformed when compared to past recoveries.

Business confidence has been undercut since the final quarter of the 2001 recession for a number of reasons. First, the attacks of September 11, 2001, and the entry of the United States into a war on terrorism have created an elevated degree of uncertainty overall. Second, the emergence of several major financial scandals in 2002 undercut consumer confidence and sent the Dow Jones Industrial Average plummeting 32 percent between March and October 2002. As a result, consumer confidence fell to a 9-year low by October 2002. Despite healthy growth in real incomes throughout 2002, consumer uneasiness deepened. This dichotomy has caused businesses to put on hold their spending plans for fear that expected demand may not materialize. Third, the war in the Middle East, and its possible effects on world oil supplies and prices, has further elevated both business and consumer uncertainty.

Simultaneously, some important fundamentals of the economy have improved and have primed the economy for faster growth once uncertainty dissipates. First, there has been a steady and strong acceleration in productivity and associated gains in real incomes in 2002. By the third quarter of 2002, business productivity growth was 5.6 percent higher than a year

earlier, the fastest quarterly growth rate in 36 years. This increase in productivity has, in turn, increased real wages. During the first three quarters of 2002, real disposable income grew 3.9 percent over the previous year. This is more than double the modest 1.8 percent growth in 2001 and is a solid foundation for consumer spending going forward once confidence improves.

Second, this rise in productivity has rapidly pushed down unit labor costs, which has, in turn, led to a recovery in profits. In fact, for the first time since 1949, the labor cost per unit of output has declined four quarters in a row beginning in the fourth quarter of 2001. As a result, corporate profits have begun to make a recovery. Manufacturing profits declined by $75 billion from the third quarter of 2000 to the first quarter of 2001. By the third quarter of 2002, nearly two-thirds of this decline was recovered. Similarly, after dropping $138 billion between the fourth quarter of 1999 and the third quarter of 2001, overall corporate profits have rebounded 60 percent. This recovery in business profits should prop up business investment spending and counter some of the general uncertainty that continues to exist in corporate America.

Third, the dollar has depreciated 9 percent since February 2002, although it still remains 14 percent above its 1997 value. This, combined with slightly faster expected economic growth abroad in 2003, should prop up an export recovery which, to date, has been very modest. Further depreciation is needed, however, for manufacturers to regain their international competitiveness. Fourth, after inventory levels reached a 5-year high in mid-2001, manufacturers aggressively worked off excess stocks over the past year. Manufacturers’ inventory-to-sales ratios are therefore near a decade low. These lean inventory stocks mean that firms will respond to stronger demand with increased production.

Increased uncertainty and an improvement in the fundamentals will work at cross purposes in 2003. While real income growth should keep consumer spending on track, this could be derailed by further shocks to confidence. As a result, businesses will continue to hold back spending plans. Therefore, an acceleration in the economic recovery is not likely to take place this year without significant fiscal stimulus to counter the threat of uncertainty. This has important ramifications for the manufacturing sector. Without a meaningful increase in business investment spending, further manufacturing recovery will continue to remain on hold.

NAM strongly supports the economic growth plan of President Bush. This plan offers a creative mix of incentives that will encourage aggressive investment in the stock market and new capital investment by business, which will, in turn, create more jobs. Specifically, the proposal to eliminate double taxation of dividends will boost business and consumer confidence, reduce the cost of investment capital, and encourage business to invest more in new plants and equipment. Small businesses will especially benefit by the proposal to increase the allowance for expensing capital investments from $25,000 to $75,000, indexed to inflation. This increased allowance will provide a powerful incentive for small manufacturers to increase investment and create jobs. NAM also endorses the President’s support of regulatory and legal reforms as a critical key to stimulating the economy and creating jobs. Removing unnecessary impediments to growth is as important as providing economic incentives.

U.S. manufacturing is innovative, productive, and efficient. For decades it has been the center of strength of the American economy and its prospects for future growth. With the best workers in the world, technologies that are on the global cutting edge, and research and development efforts capable of keeping it there, manufacturing has made the United States the world’s high-quality, low-cost leader in a wide variety of products and has made the United States the world’s largest goods exporter despite the most intense global competition in history.

Currently, manufacturing is at a crossroads. The industry lags behind the rest of the U.S. economy, and recovery from the recession is slow. This recession, unlike previous post-World War II economic downturns, has uniquely affected manufacturing and caused the loss of two million manufacturing jobs. Reasons include geopolitical uncertainties, the ongoing war on terrorism, and slow economic growth worldwide. However, other factors contributing to the manufacturing slowdown require policymakers’ attention. Addressing these factors could do much to reinvigorate manufacturing, stimulate more robust and durable growth, and increase employment. These factors are:

• The fact that U.S. manufacturing is at a distinct disadvantage in global competition due to unfair trade practices, export constraints, and artificially distorted currency values, such as in China, where the currency is undervalued as much as 40 percent;

• Intense foreign and domestic competition that makes it impossible for U.S. manufacturers to raise prices for their products, thereby fatally compromising their ability to meet rising costs associated with government regulations, runaway litigation, and employee health insurance; and

• Accelerating technological change that could make it increasingly difficult to achieve high productivity growth because of inadequate capital investment and workforce skill deficiencies.

NAM recommends the policy agenda described below in 2003 to address the factors listed above, strengthen the economy, and encourage growth.

To encourage capital investment, productivity, and job creation, currency depreciation should be accelerated and taxes on dividends should be reduced. The tax relief enacted in 2001, including estate tax repeal, should be made permanent and the scheduled marginal rate cuts accelerated. The ongoing impasse with the European Union over the World Trade Organization (WTO) ruling on taxation of extraterritorial income (FSC/ETI case) must also be addressed, and further reforms in the international tax arena should be enacted to enable U.S. companies to effectively compete in the global marketplace. A permanent research and development tax credit to benefit the largest number of companies is also needed as well as pension reforms that encourage greater participation in the private retirement system. Finally, to ensure that these tax law changes benefit all manufacturers, action is needed to repeal the corporate alternative minimum tax, or the “anti-manufacturing tax.”

The United States must insist that foreign markets become open and that trade follow global rules. The United States should advance the WTO Doha Round, including the “zero-tariffs” proposal, the Free Trade Agreement of the Americas, and additional bilateral trade agreements. U.S. policy governing export controls and unilateral sanctions must be modernized, and an exchange rate regime should be promoted that is based on economic fundamentals and the free operation of markets. Given the rapidly rising importance of China in world trade, the Bush administration should seek a particular commitment from China to the market valuation of its currency.

Jobs in U.S. manufacturing are among the best jobs in the world. They are rewarding and increasingly demanding of skills. Both today’s workers and tomorrow’s workers now in school need improved systems of education and training through stronger implementation of the Workforce Investment Act, improved vocational education, and a strengthened, reauthorized Higher Education Act.

Most research and development is in manufacturing, the key technological and economic advantage of the United States. This advantage can be preserved and enhanced by improved tax treatment of research and development expenditures, stronger protection for intellectual property in a globally competitive environment, adequate funding of federal science programs, and a strong patent system.

Increased federal mandates and liability exposure for employers will raise costs and reduce insurance for workers. Policy makers should focus on lowering health care costs through improved quality and greater access to health care for all Americans. Medicare should be reformed in a way that allows addition of a prescription drug benefit to a strengthened program. Reform of medical liability law must also be a priority.

The current system on asbestos litigation is dysfunctional. It compensates individuals who are not sick at the expense of individuals who are, bankrupting companies in the process and threatening the jobs and retirement savings of hundreds of thousands of manufacturing workers. Medical criteria legislation, like that advanced by NAM’s Asbestos Alliance, is urgently needed.

Reform of the legal system is a durable priority for manufacturers that can be advanced in the 108th Congress. Prospects for class action reform and medical malpractice legislation, among others, can be furthered by widespread manufacturing participation in NAM’s Fair Litigation Action Group (FLAG) program, which is designed to enable member companies to inform and enlist their workers in the effort to hold members of Congress accountable for enacting needed reforms.

Enactment of a balanced, comprehensive, national energy policy is overdue and is essential to ensuring durable and sustainable economic growth in manufacturing and the broader economy. A reliable energy supply at affordable prices is essential, as well as increased efficiency, a strengthened infrastructure, and investments in research and development and new technologies. Greater cooperation in a North American Free Trade Agreement (NAFTA) energy alliance would benefit all three partners. NAM supports President Bush’s climate research and voluntary greenhouse gas reduction initiatives but opposes mandatory greenhouse gas reporting. NAM vigorously opposes the Kyoto Protocol and any

domestic actions leading to quotas or caps on fossil energy use by utilities or by industry.

The United States must continue to make environmental progress while maintaining economic growth in a competitive world marketplace. To achieve these dual goals, environmental policy must continue to evolve from decades-old command-and-control prescriptions to approaches that encourage innovation, investments, and partnerships. When environmental regulation is necessary, rules must be based on sound science and accurate data and must allow maximum flexibility to meet performance standards using the most cost-effective means. Specific priorities for the manufacturing community include New Source Review reform, sensible multi-emissions legislation, and science-based air quality standards.

Just-in-time operations are a vital component of modern manufacturing. Just-in-time is based on a reliable and satisfactory transportation infrastructure. NAM supports adequate investment in the national transportation infrastructure, especially improved intermodal connectors and facilities, as well as other improvements to make freight travel more timely and efficient.