Tuesday, August 21, 2012

The widget illusion

The Economist runs a discussion forum titled The Economist By Invitation. In this, they recently setup a discussion about an opinion piece by Dani Rodrik about the future of manufacturing-led growth in emerging markets. I wrote a response there which is reproduced here.

The role of manufactures

I agree with a small element of Dani Rodrik's argument, but mostly for different reasons. Rodrik says:

Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization.

I have seen this kind of thinking among some policy makers in India also: that industrialisation is somehow special and good when compared with services. I would question this proposition, that I term `the widget illusion'. What matters to a country is having sophisticated firms that have a high marginal product of labour. We should not care whether this happens in services or in manufacturing. If anything, the opportunity to do it is perhaps better in services.

India is a good example of a country which embarked on its catchup by connecting into globalisation late: from 1991 onwards. It was probably the last country in the world to shed autarkic policies. This has given a remarkable growth acceleration. Sustained growth of 7 per cent is pretty good by world standards. These achievements have been significantly driven by services production in India within global supply chains (whether within production facilities owned by global MNCs who are operating in India, or contracted-out by global MNCs to Indian firms). If your null hypothesis was that industrialisation is essential to growth, then you would not have predicted what happened in India, where manufacturing was hobbled by an array of policy mistakes.

This illustrates the limitations of manufacturing-focused thinking, which seems a bit out of date in today's world economy where most output is services. Agriculture and manufacturing have wilted away in the consumption of the global representative agent: to succeed in the world economy today requires prime attention upon services.

Rodrik says:

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

As Rodrik points out, there are important gaps between the skills of the great unwashed masses in India versus China, where elementary technical training reached a larger mass of humans. In addition, China did better on core economic policy choices about (a) Removing protectionism; (b) Removing barriers to FDI; (c) Building hard infrastructure; (d) Labour law and (e) Rationalising taxation.

What policy advice would flow from this? India should not have have made these six mistakes in economic policy (low training for the masses, protectionism, barriers to FDI, weak investments into infrastructure, labour law and mistakes in tax policy). At the same time, this does not recommend a bias in favour of manufacturing. It is hard to discern a meaningful choice about emphasising services versus manufacturing in Indian economic policy. Participation in all global production is good. Governments should remove all barriers that inhibit global integration whether in goods or in services - e.g. the six mistakes in Indian policy sketched above.

A paragraph earlier, Rodrik says:

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden's institutions.

I would point out the contradiction: "A poor country can easily compete with Sweden in .. manufactures" but earlier it was asserted that the gaps in Indian skills inhibited India's ability to compete with Sweden in manufactures.

Doing things that push skills and institutional capabilities

I would go further to say that it is good to go after fields which require a wide array of skills and institutional capabilities.

I am reminded of Ricardo Hausmann's `Good Cholesterol' argument about financial globalisation as opposed to mere FDI. When a poor country operates in an institutional vacuum, foreign investors are uncomfortable, and the only thing that can happen is FDI. To obtain financial flows, the country has to build institutions: laws, regulators, property rights, and so on. This is a good thing! A country that gets to FDI and gets stuck there should ponder what is going wrong. In similar fashion, no country aspires to have low-wage production; every country wants to understand the secret sauce through which a part of the labour force can earn high wages by world standards.

As a country rises out of poverty, it is essential to build up skills and institutional capabilities. If policy makers hinder services and/or favour manufacturing, there is a greater chance of being stuck in low skills and low institutional capabilities. I am not proposing industrial policy in favour of services. I am only proposing the absence of industrial policy; we should avoid a `widget illusion' and foster more global integration without trying to push towards one industry or another.

In India, with 7 per cent growth, GDP doubles every decade. As a thumb-rule, I feel that a comprehensive transformation of skills and institutions is required across each doubling of GDP, which is roughly each decade for India. A country that is stuck in low-skill manufacturing will find it difficult to achieve the reinvention of this `soft infrastructure' of the mind. If policy makers tried to push a country towards doing low end grunge work, it would be harder to obtain these repeated transformations of institutions and the furniture of the mind, which would lead to growth decelerations.

As an example, in the article New wave of deft robots is changing global industry, John Markoff says:

Foxconn has not disclosed how many workers will be displaced or when. But its chairman, Terry Gou, has publicly endorsed a growing use of robots. Speaking of his more than one million employees worldwide, he said in January, according to the official Xinhua news agency: ``As human beings are also animals, to manage one million animals gives me a headache.''

The project of economic development requires sophisticated interactions between firms and workers. The laws, human rights and management practices that are required when dealing with humans are different from those required when running a firm with `one million animals'. I would hence argue that it is limiting for a country to focus on the political, legal and institutional requirements to produce a la Foxconn. It is better to confront the complexities of high skill, high wage production, and to build the environment for this to happen: in the political and legal system, in management practices of firms, and in the power structure embedded in a conversation between two citizens who are co-workers within a firm. Services production is a valuable learning ground where the complex management practices that involve high skill humans can be learned.

The new world of manufacturing

Rodrik correctly points out that manufacturing has become more sophisticated in recent years. This has some fascinating dimensions:

  • The rapid improvements in capabilities and declining costs of robots.
  • The rise of open source design coupled with 3-d printers. If a 3-d printer in the US fabricates a part close to its usage in an assembly line, while the labour-intensive design work ("services") that controls the 3-d printer is done in India, does this entail manufacturing or services work in India?
  • The world economy is likely to be in a low interest rate environment for a long time, which will encourage capital intensity worldwide (robots, 3-d printers), thus blunting the value of low wages.

Momentous changes are afoot, which challenge our traditional notions of manufacturing versus services. To some extent, we are even seeing some manufacturing go back to the US.

Things that might `go wrong'

Finally, Rodrik talks about reduced willingness in the West to tolerate unfair tactics like the Chinese exchange rate regime. I would generally consider this to be a good thing, both for developing countries and for the world. In any case, the Asian `Bretton Woods II' episode seems to be subsiding. As an example of the disenchantment with exchange rate distortions: From 2004 to 2007, India debated exchange rate rigidity, and walked away from it. The links between undistorted exchange rates and growth have not been adequately emphasised in the discourse. A developing country builds up inferior skills and institutional capabilities by exporting under a subsidised exchange rate: it is better to force firms to confront the market price and achieve the productivity required to participate in globalisation when facing an undistorted price vector.

He worries about a rise in protectionism in the West, but we have to admit that the 2008-2012 experience has been pretty good in this regard: by and large the West has not succumbed into protectionism. In 2008, all of us worried about Smoot-Hawley. Today, things seem to be be going well.

Conclusion

In summary, I would argue that we should avoid a `widget illusion'. There is nothing special about manufacturing or industrialisation: as long as people in India get high wage jobs, this is good. Getting there requries deep integration into the world economy, which includes policy battlefronts such as:

  • Openness to the Internet
  • Use of English
  • Inbound and outbound FDI
  • The array of cross-border financial services that are the enablers of complex globalised production of both goods and services
  • Globalisation-compatible tax policy on both trade and finance
  • The absence of either protectionism or mercantalism
  • Fostering high quality human skills, and
  • Infrastructure.

To the extent that globalised production of goods and services happens in areas which involve high skills and complex institutional development, this is a bonus, since any high growth country needs a rapid pace of reinvention of laws and institutions.

Most of this is the old orthodoxy. Policy makers worldwide are generally focused on these issues, as they should be. From the 1960s onwards, dirigisme has generally subsided, with the twilight of policies like fixed exchange rates, industrial policy, capital controls, protectionism, etc. These key lessons remain intact in the 21st century.

8 comments:

  1. As someone who has worked 30 years in manufacturing and seen his own manufacturing-based industry outsourced (>80% is in Asia now), I get the impression that you don't really understand anything about how manufacturing contributes to broader economic, what the US has lost or what would be required to recover it.

    3D printing WILL NOT magically solve anything - it has no economies of scale for volume production. It CAN speed prototyping but that's not the primary problem at all!

    It's this total disconnect from reality and fact that led me to move to Asia. They "get it"; Americans do not and apparently CAN NOT. Still have my US citizen... for now.. just a matter of time IMO.

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    1. Anon, I understand your points except when you say that prototyping is not the primary problem. Could you please elaborate? I thought design and prototyping is the primary problem and then assembly lines can be relatively easily created? You can probably tell that I don't belong to the manufacturing industry, but it would be nice if you would educate us on this point.

      Secondly, I found a very interesting stat on how people with less than a college diploma have faced the brunt of the recession and jobs for people with a bachelor's degree have actually increased since the start of the recession until now, in the middle of recovery. I remember that during the depths of unemployment in the last few years, unemployment in the US for those with a bachelor's degree was a not bad 4% as opposed to over 15% for those without a college diploma. As a whole, wouldn't you agree that this shift is good for the US economy in the long run? Ofcourse, there's then the issue of exploding student debt, but hopefully that can be thought of as good investment.

      The Value of a College Degree

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  2. Smoot Hawley was implemented by the US, who I think had themselves the most to lose from implementing it vs Europe in the 1930s. The parallel concern should be a reversion to protectionist policies by China and India, not by the West? We do know how much of a political case can be made in India for protectionism of our own industries.

    I would request you to write more about mercantilism as well. Its unclear where the fine line is and if there are any such issues in the Indian economy (as opposed to the China). While China's exchange rate is pegged, I wonder if India's disastrous self-selected economic policies which lead to a depreciation in the rupee can be termed a perverse type of mercantilism as well. Keep the domestic economy so screwed up, that there is always a favorable labor arbitrage vs other countries.

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  3. I think you are essentially arguing that people can be treated as widgets. While manufacturing looks for the cheapest, best quality widget, services looks for the cheapest, best quality people. We can discard widgets, move on to other types of widgets, but the question is, to what extent can that be done with people?

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  4. India's lack of manufacturing focus and faculties reflects amply not only in its crippled and inefficient mfg segment, but also in its inability to build a decent road network or power plants to meet the electricity needs or its ability to build high-rise residential and commercial real estate or its poor waste management capacities etc. We know the outcome of CWG games after spending thousands of crores of rupees. It's not just about corruption, it is also about the skill set to build, maintain, and operate physical assets efficiently that is utterly lacking as India aspires to grow at over 7% pace. A certain amount of skilled labor and wage arbitrage powering the outsourcing market cannot be confused to an overwhelming sign of strength or success in services either. The quality of government services or IT sophistication in the domestic private sector is a case in point.

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    1. Interestingly, a lot of the technology and expertise for the CWG was outsourced to foreign companies (many of them Australian), which we came to know after they complained about delays in payment. While India may claim national pride in hosting CWG, one needs to be aware of how much skilled labor is brought in from outside. IPL's production team is Australian. From what I can make out, we Indians are great at marketing and selling, but not so good at developing deep expertise and innovation - I guess the craze for MBAs points to the same hypothesis. I guess, gradually things will get picked up by us and then we'll re-export it back cheaply when the technology has been commoditized, but that by definition also means that whatever we do is not going to be high-tech but commoditized tech, just like IT services isn't necessarily high tech anymore. Even Microsoft is like a utility now. For true innovation, etc we need a critical mass of research labs, funding, vision, etc. That's unlikely to happen for another generation or two. When the leader of the country has to go outside the country for her treatment, it tells you all there is to know about "services" and skill level within the country.

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  5. Good article. One think which appears to be missing from discussion is need for external payments balance.

    Any geographical region or state or country should balance its sources and use of funds – for new investments as well as for expenses. Most countries will have some need for large scale import – e.g Japan for most energy and raw materials, India for most energy, Electronic components etc. The country needs to have inflow of funds from some others sources to support the payments for imports.
    It is believed that mass scale or high quality/precision manufacturing on expertise provides net export surplus which in turn allows imports (of goods and possibly services). Conversely it is believed, that lack of good manufacturing base leads to need for substantial imports of goods, thus requiring need to generate funds from some other sources.
    Services are believed to have less capability to generate funds from outside, as most services tend to be consumed locally by local people. This is obviously untrue of IT/ITES and Tourism & Travel services. India generates huge surplus inflow from IT/ITES, Thailand generates massive surplus from Tourism and Travel. Of course, the internally consumed services are a great distributor of wealth as it employs so many, who in turn become consumers. The internal service industry in India is very huge and well developed due to local entrepreneurship though probably not very efficient.
    Agriculture produce can be another source of such surplus, provided the country can afford to export the surplus in an organized and predictable manner. Most countries find this difficult to do, due to vagaries of weather, Government policies for agriculture and agriculture produce pricing. India, with tropical background and huge production of variety of foods, can actually do a far better job in agricultural exports, if it is able reduce wastage and follow rational agriculture policies.
    Capital inflows is another way in which countries support their needs for external payments. It is assumed that capital has to be paid back, but this is not necessarily true in all scenarios. E.g. A country with excellent living and working environment, or massive growth prospects, can draw capital inflows from people and companies who want to base part of their their wealth in that country – even if they want flexibility to take it out if needed.(e.g. US ). Such near permanent inflows, if they occur for large period and in large volume, can help leverage country up on development path. In Indian context, capital inflows will almost always come with expectations of payback whether as dividends, interest, principal repatriation etc., as we have yet to establish conditions for the near permanent type of inflows (though they do occur to some extent in case of NRIs).
    A very large country like India requires both manufacturing and services. Lack of efficient manufacturing will mean (i) loosing employment opportunity in manufacturing and (ii) substantial import needs. As we have seen so far (in terms of massive current account deficits), export of services alone does not appear sufficient to meet our needs of imports (goods, energy etc.), nor employment needs.
    Smaller countries may be able to do well by having one predominant over other (e.g. East Asian countries in Manufacturing, Singapore or Israel in services), because they can orient their smaller population base for success through one of the activity to meet needs of the nation and society.
    For India, increase in efficiency and innovation is also key in both sectors (and also in agriculture), as that will generate much needed employment, which in turn helps increase the velocity of money and sustain a virtuous economic cycle.
    So it is not a question of comparing which is better from manufacturing or services, but need to lubricate the internal economic cycle and balance the external payments.
    Paresh Vora / pareshvora@ovi.com

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  6. indias lack of manufacturing focus and faculties reflects amply not just in its crippled and inefficient mfg segment, but in addition in its inability out to build a decent road network or power plants out to fulfill the electricity wants or its ability out to build high-rise residential and industrial real estate or its poor waste management capacities etc. we grasp the outcome of cwg games once spending lots and lots of crores of rupees. its not merely concerning corruption, additionally it is in regards to the talent set out to build, maintain, and operate physical assets efficiently that's utterly lacking as india aspires out to grow at over 7% pace. a definite quantity of skilled labor and wage arbitrage powering the outsourcing market can't be confused out to an overwhelming sign of strength or success in services either. the quality of government services or it sophistication within the whole domestic private sector may be a living proof. Finance BLog

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