Flexing Its Muscle: Why Manufacturing Is Bouncing Back

Published: January 20, 2010 in Knowledge@Wharton

Is the manufacturing sector getting more respect?

Although it represents a declining share of the U.S. economy, signs of a manufacturing rebound in the nation and around the world seem to be another indication that the global recession is coming to an end. At the same time, the near-collapse of the U.S. auto industry and last year's arrival of a Democratic president and legislature in Washington have prompted new thinking about the importance of manufacturing in the current recovery.

According to Wharton management professor John Paul MacDuffie, while some staunch free-market advocates were willing to let the U.S. auto industry die, the prevailing sentiment in the country favored salvaging this sector and others -- in part because manufacturing companies have traditionally provided well-paying jobs directly and indirectly through their many suppliers. Manufacturing is also viewed as an important sponsor of research and development, leading to innovative technologies that can give birth to whole new industries. Some experts believe "that if there were no U.S. car company, we, as an economy and a country, would not be as strong as we need to be," especially in the wake of the latest crisis, says MacDuffie.

On a global scale, "what we are seeing is a synchronized and significant recovery in manufacturing activity around the world," says John Ryding, chief economist at RDQ Economics in New York. "It has a long way to go before we get anywhere near back to normal levels -- or what was normal before the recession -- but the forces that produced this massive drop in output and collapse in trade volume appear to be reversing."

Others sound a more cautionary note. The rise in industrial production may be tempered by weakness elsewhere in the economy, notes Donald Norman, an economist and survey coordinator at MAPI, the manufacturing sector's education and research arm. "We are climbing out of the depths of the recession, but it has been a very slow climb. It's not a sharp bounce back."

Computers and Electronics

A surprisingly solid uptick in recent surveys that track the future prospects for manufacturing suggests that renewed strength in orders and declining inventory will lead to advances in industrial production and broader economic expansion in the months ahead. For example, the closely watched Institute for Supply Management's (ISM) purchasing managers index rose to 55.9 in December, the highest level since April 2006. Analysts had forecast it would be 54.3. Meanwhile, the quarterly Manufacturers Alliance/MAPI Survey on the Business Outlook found that its December index rose to 57 compared to 38 in September.

The ISM data, says Wharton finance professor Nicholas Souleles, has typically been a strong indicator of actual industrial production to follow. Industrial production, in turn, leads to expansion of the general economy and, finally, new jobs, as employers grow increasingly confident. In addition, the data tend to show that swift downturns in industrial production give way to sharply higher expansion once growth returns.

Manufacturing's role in the current recovery is subject to a number of conditions, notes Souleles. First, the sector is always highly cyclical in the short term, exhibiting wide fluctuations due to difficulties in tailoring the capacity of large factories, which take years to plan and build. Second, manufacturing plays a less important role in the overall economy. In 1953, manufacturing hit a post-World War II peak of 28.3% of GDP. That figure is now 12%. Industrial output has actually increased during that time, but rapid growth of the service sector has eclipsed manufacturing in terms of share.

Finally, the speed and severity of the downturn, which ultimately became the worst since the Great Depression, is also a factor in the current manufacturing rebound. "This time around, the dynamics are a little different," says Souleles. He cites two distinct phases of this crisis, beginning with "a normal cyclical downturn, more of a slow motion decline," that began a year before Lehman Brothers' troubles first surfaced. The next phase followed Leman's collapse "in the fall of 2008 when the timing was much more accelerated."

Marshall Fisher, professor of operations and information management at Wharton, cautions that while the recent manufacturing data indicate renewed strength, those increases are off an extremely low base. The decline in manufacturing output forecast by MAPI for 2009 is nearly 12%, three times more severe than the previous recession. "So while orders may be expanding at the fastest pace in more than three years, that is just the rate of change. When you have things fall that far, you can uptick quite a bit but still be way behind where you have been."

Fisher also notes that as manufacturers outsource production to contract facilities, they find it easier to adjust production to abrupt changes in demand. The electronics industry, in particular, carries little inventory. He recalls hearing a Nokia executive during the height of the crisis describe how the firm was adjusting. "He said they had been able to manage by doing 'the normal things,' so it struck me that they do, in fact, have a playbook for how to very quickly ratchet up and down."

According to Norbert Ore, who chairs the ISM survey, the most recent report shows varying levels of strength across the manufacturing landscape. The sector that held up best is computers and electronics, he says, because these companies had strong balance sheets going into the downturn -- having learned to conserve cash after they were badly hurt in the massive tech-sector restructurings following Y2K and September 11, 2001.

In all, the ISM survey examines 18 manufacturing industries, nine of which grew in the most recent reporting period. The robust overall results reflect strength in the sectors that were growing, but a recovery that leaves half the industries in decline is nevertheless worrisome. "That's less typical," says Ore, "but again, most recessions haven't reached the depth of contraction we [have experienced] this go around, particularly in the housing sector."

A broad-based manufacturing recovery, he adds, requires strength in autos and housing because they feed into so many other industries, from glass to plastics to steel. "Both of [these sectors] hit very low points in 2009," says Ore. "Autos now seem to be recovering faster than housing." In addition, he points out, capacity utilization -- a gauge of how much of the nation's plants and equipment are in use -- is just 70%, up from a low of 65% in May but below typical figures of between 80% and 85%.

Wharton professor of operations and information management Richard Lai is also cautious about reading too much into the recent numbers. Manufacturing, he notes, is subject to wild swings in demand that can wreak havoc on the entire supply chain -- from the manufacturers on through to wholesalers and retailers. "Like the children's game in which one child whispers gossip to the next, by the time order information gets from retailers to manufacturers, the manufacturers' information is distorted."

On the positive side, adds Norman, consumers are in the process of improving their balance sheets, debt is declining and the personal savings rate is higher. Yet while these changes are healthy for the economy long-term, he notes, the short-term effect is that consumer spending -- which accounts for 70% of GDP -- is not going to grow as fast as it has in the past, thereby making GDP slow to rebound.

The Role of Government

MacDuffie predicts that government policy will continue to play an important role in manufacturing. About a year ago, it would have been hard to imagine that the U.S. government would control General Motors. MacDuffie notes the appointment of Ron Bloom -- senior advisor to the Secretary of the Treasury assigned to the President's Task Force on the Automotive Industry -- to a new position as an advisor on manufacturing policy. The Obama administration also appointed Ed Montgomery, a member of the auto task force, to the position of Director of Recovery for Auto Communities and Workers.

In addition to the severity of the recession, MacDuffie says new attention to manufacturing is to be expected with the arrival of a Democratic administration which typically has strong support in regions of the country where manufacturing is strong. The Obama administration, he adds, is exploring many ways to retain and expand domestic manufacturing by tapping existing plants and expertise -- in hard-hit regions of the Midwest and elsewhere -- to play a role in the development of new industries, particularly alternative energy or other "green" sectors.

The administration, however, will also be cautious about coming up with a clear-cut industrial policy that would most likely provoke a virulent response from business people fearing that the government has overstepped its bounds and will choke off free-market innovation. MacDuffie notes that other countries already have policies that give their native industries advantages over competitors around the world. "Nobody wants to interfere with trade, but if you look at most other advanced economies and developing economies that have manufacturing, they all support their industries in one way or another," he says. "If you decide not to in the name of free-market ideology, then you may be mischaracterizing the basis of the competition that is actually out there."

The French government, which owns 15% of the carmaker Renault, has objected to the company's plans to produce a new car in Turkey instead of at a plant outside Paris, as initially planned, he says.

As for global manufacturing, the improvement noted in the U.S. is mirrored elsewhere. In Europe, manufacturing grew in December at the fastest rate in 21 months, according to Markit Economics in London. In the same month, an HSBC Holdings survey of Chinese purchasing managers reflects the fastest growth in five years. In the U.S., MAPI forecasts GDP growth of about 2.4% in 2010, but faster growth of manufacturing output at 4.6%

The improvement in global manufacturing, despite continued weakness in other parts of the economy, is a reflection of the importance of global trade, which is only now beginning to be fully understood as statistics come in about the recession, says Ryding, adding that it is becoming clear that trade itself is an important mechanism for driving economic ups and downs along with demand and supply. The abrupt drop-off in letters of credit as a result of the panic in financial markets shows that a decline in exports and imports has an important effect on global recession and recovery, he notes. And while the collapse in U.S. housing markets was a prime cause of the recession, Japanese companies had little or no exposure to those problems. Nonetheless, he says, they suffered a sharp decline in business as the recession rippled out through financial channels. Now, the opposite is occurring.

The importance of the link between maintaining a domestic manufacturing base and continued advancement of research and development is also drawing new attention, says MacDuffie. With improvements in telecommunications and a decline in trade barriers beginning in the 1980s, many multinationals have outsourced production to low-cost nations. However, they planned to keep research and development in the home country or developed countries with a strong educational system.

Now, however, many countries are able to field their own research and development operations, MacDuffie notes, adding that much of the science that goes into laptops has migrated from the United States to Taiwan, where production is based -- because insights into the manufacturing process help drive new ideas in research. A similar pattern is developing in mobile phones. HTC, the Taiwanese maker of the new Google Nexus One and other Android-based cell phones, was initially a contract manufacturer, but now is a full-blown manufacturer and marketer.

MacDuffie says manufacturers eventually find it difficult to keep research and development separate from production facilities. "For a couple of years, the contract manufacturing path has a lot of appeal for a big company because it's not as messy and you can focus on innovation," he says. But the attraction of contract manufacturing "might not last that long, and you could end up finding out that your contract manufacturer has become a direct competitor."

Meanwhile, the U.S. government has reduced its emphasis on research that might benefit industry. Federal funding for physical sciences has declined as a percent of total federal support for basic research from the era of the Apollo space program in the 1960s, when the U.S. spent 2.5% of GDP on basic research. Now, the total spent on basic research is 0.3% of GDP.

According to Souleles, despite all the economic advantages that come with maintaining a strong manufacturing base, services also play an important role in the U.S. economy and are part of a natural evolution as nations advance beyond a society based heavily on manufacturing. "It's not surprising that as a country gets wealthier, people spend a larger fraction of their budget on services," he says. "We have lost a lot of jobs in manufacturing; over the long run that's a concern, but we don't want to go too far the other way and say the increasing role of services is not of value."

Souleles adds that each country must focus on what it does best to maintain or establish its place in the competitive global economy. "There's nothing wrong with a country focusing on the areas in which it has a comparative advantage. Technology is always changing, but the important thing is that the U.S. has a niche and an educated workforce that can shift into the new high-value-added areas."

This article is provided courtesy of Knowledge@Wharton.

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