Reindustrialization: The Capital Question
JUNE 01, 1981 by WILLIAM R. HAWKINS
Mr. Hawkins is a lecturer in economics and history at the University of North Carolina in Asheville.
Reindustrialization. The term is imposing. It conjures up the image of a devastated economy and of a rebuilding effort of massive proportions. Indeed, the effort has been likened to that of the Marshall Plan which helped rebuild Europe after World War II. It is also a term which is viewed with suspicion in some circles because of the ease with which politicians learned to use the term in an election year. Yet, the sudden popularity of the reindustrialization concept should be welcomed, for it indicates a new consensus as to the seriousness of the problems confronting the American economy—a consensus that cuts across ideological and party lines.
The obvious catalyst for this movement has been the wave of plant closings in the steel and auto industries which have cost tens of thousands of workers their jobs. But these two industries are only the most visible examples of a general decline in the strength of the American economy. The foreign penetration of the American market and the decline in America’s share of world trade are not due to any special attributes enjoyed by our European and Japanese competitors but to our own poor performance and mistaken policies.
The key element in any modern economy is capital investment. It is by this investment that workers are provided with more and better tools with which to work. This is the key to productivity. Productivity measures the amount of output produced by each worker for some time period. It was the great accomplishment of industrialization, and is the goal of reindustrialization, to boost this output.
Over the last two decades, the U.S. has lagged behind its foreign rivals in this effort. The myth that cheap foreign labor is the cause of our competitive lag is just that, a myth, at least as far as our European and Japanese rivals are concerned. Wage rates in West Germany and Japan are on a par with U.S. rates. It is not that each worker overseas is paid less per hour, but that each worker has been increasing what he produces each hour that has eroded the American position. Our competitors have been improving their productivity at a faster rate than we have because they have been consistently outspending us on capital investment.
U.S. Lags Behind
In the period 1960-1978, the U.S. spent 13.41 per cent of its Gross National Product (GNP) on new tools. This was half the percentage spent by Japan and significantly lower than the percentages spent by West Germany, Canada and France. Even England, long considered the “sick man” of Europe, invested more of its resources on tools than did the U.S. Table I shows the parallel between investment and productivity.
Beneath these averages lies a most ominous trend. American productivity gains are slowing. In the period 1968-73 annual gains were only 1.9 per cent. These gains dropped to only 0.7 per cent per year between 1974-79. For six quarters starting with the fourth quarter of 1978, productivity actually declined at a – 1.8 per cent rate.
Investment Productivity Gain
(% GNP) (increase in output per hour)
Japan 26.44 8.8
West Germany 18.43 5.4
Canada 17.45 4.5
France 16.85 5.7
England 14.69 3.3
United States 13.41 2.6
Source: American Iron and Steel Institute
There are many factors that have contributed to this recent poor record. The most central is the low rate of capital formation. An economy must generate capital before it can invest it. Personal savings, depreciation, and that portion of business profits retained for internal use are what combine to form the pool of capital from which investment must draw.
All of these sources of funds have diminished in recent years relative to the needs of the economy.
Throughout the 1970s, personal savings in the United States, as a percentage of disposable (after tax) income has been less than in the industrial states of Europe and Japan. Over this period only about 6 per cent of personal disposable income in the U.S. was saved as opposed to 20 per cent in Japan and 14 per cent in West Germany. The acceleration of inflation in 1979-80 further weakened savings dropping the rate to a mere 3.4 per cent. Inflation undermines both the ability and the incentive to save. As inflation increased faster than the average person’s income, many people cut back on savings in order to maintain their level of spending on consumer goods. Also, as inflation rages, the value of any idle funds, such as bank accounts, insurance and pension pro grams decline in real value. As the prices of things go up, the value of money goes down so it becomes smart to begin moving out of money and into goods. But what is smart for individuals in such a situation is harmful to the over-all economy. Money that flows into gold or works of art as a hedge against inflation is money that is not available for productive investments.
Tax policy has also hurt savings in a variety of ways. Inflation pushes people into higher tax brackets because of our progressive tax system. As the percentage of income going to taxes increases, the percentage left for disposable income diminishes. Taxes on the income from savings and investment are higher than on normal income, and the U.S. continues to be the only major industrial country to tax capital gains. The recent reduction in the capital gains tax rate had a profound stimulative effect on mobilizing money in the equity market and there is every reason to believe that further reductions or the outright abolition of the tax would have additional beneficial effects.
Business Depreciation Allowances Inadequate
The other major sources of capital, business profits and depreciation have also become increasingly inadequate. As recently as 1965 business firms were able to provide 90 per cent of the funds they needed from their own internal sources. But by 1979 this internally generated capital provided only 52 per cent of their requirements. This has placed increased pressure on the external capital pool generated by personal savings at the very time that saving has declined.
Depreciation provides the largest part of these internal funds. The shorter the number of years required to recover the capital invested in plant and equipment, the easier it is to finance new and improved replacement equipment. Unfortunately, it takes twice as long, under U.S. tax laws, to write off an investment as it does in Japan and two to three years longer than in France or West Germany. This disadvantage is further magnified by the effects of inflation. Clearly, funds generated based on past costs are not going to be adequate to pay current or future costs.
There is widespread interest in liberalizing depreciation. Plans for basing depreciation on replacement costs rather than original cost, and adopting a 10-5-3 schedule for the number of years plant, equipment and vehicles, respective]y, can be written off have attracted the most support from business. In the past, when depreciation was liberalized, the result has been as expected: the amount of capital investment increased.
The other source of internal funds is earnings retained from profits.
Business profits as a share of GNP has declined from 13.3 per cent in the 1950s to 9.0 per cent in the 1970s. American business thus threatens to move into a vicious downward spiral. Lower profits generate less capital which slows productivity which loses markets to competitors which means a further lowering of profits.
Currently, the Federal corporate profits tax takes 46 per cent of what profits are earned. Money taken by this tax is, of course, not available for investment. William E. Simon, when he was Secretary of the Treasury, proposed reductions in the corporate profits tax and advocated eventual elimination of the tax as the easiest way to boost capital formation. While abolition of the tax is highly unlikely on political grounds, it is not beyond reason to hope that the tax can be reformed so that all or part of the profits that a firm would plough back into modernization or expansion of its operations could be made exempt from taxation.
Impact of Inflation
As if an inadequate capital pool were not enough of a problem, other government policies have had the effect of reducing the portion of that capital pool which is actually available for productive use. The Federal budget was in deficit every year of the 1970s. This deficit has to be financed by borrowing from the capital pool. Robert Dunn of George Washington University has appropriately called this “dis-saving.” Since the principal cause of increased Federal spending over the last decade has been income transfer programs, deficit financing has become a direct conversion of savings into spending. During the 1970s some $302.6 billion was so diverted from private domestic investors, according to the Federal Reserve Bank of St. Louis.
It might surprise many Americans to realize that our foreign competitors do not reside in countries that run deficits as large or as persistently as we do. Table 2 shows the relationship between government spending, deficits and economic growth.
Surplus budgets have the opposite effect of deficit budgets. Instead of absorbing capital, surplus budgets pump money into the pool of capital. By paying off past debts, funds are released from a non-productive use and made available for productive uses.
Increasing the pool of capital is the fundamental prerequisite for the reindustrialization effort. However,capital, once mobilized, must be free to flow to the uses which are most productive. This is not always allowed to happen.
Government Spending Budget (+ surplus Growth
(% GNP)* – deficit as % Rate
Japan 10.4 + 1.39 8.7
France 14.0 + 0.34 5.8
Canada 16.2 + 0.78 5.2
West Germany 20.4 – 0.30 4.1
United States 23.2 – 0.71 3.3
England 20.7 – 1.19 2.5
Source: Hudson Research Europe Ltd. from OECD data. ‘1961-71 average.
Misallocation of Resources
Governments at both the national and local levels have mandated a wide range of projects aimed at improving the environment and the safety of the workplace. These may be worthy goals, but during the 1970s inadequate attention was paid to calculating the full cost of such projects. Business had to divert billions of dollars of capital away from plans for modernization and expansion in order to finance pollution and safety equipment. Whatever the merits of these programs, they are not productive in the normal business sense of the term. They do not improve the competitiveness of American industry relative to its rivals.
If the government is going to mandate that scarce capital be invested in non-productive uses, it should recognize its responsibility to follow policies that will generate sufficient new capital to support such endeavors.
An example of the dimensions of the problem, in regard to both capital availability and use, is the troubled steel industry. The average age of American steel producing facilities was 17.5 years in 1979. This means that the bulk of the American industry has not been able to incorporate the technological advances of the last two decades. During the 1970s, the industry invested $2.9 billion per year. To reindustrialize, the American Iron and Steel Institute estimates that the indus try will have to invest $7 billion annually in the 1980s. Of this money, 11.4 per cent will go to meet environmental and health standards. Given current tax laws and a moderate rate of inflation (5 per cent) the AISI estimates that the industry will fall short of its goal by about $25 billion over the decade (in constant 1978 dollars). Higher inflation or higher taxes will cause this short fall to be even larger.
Impact of Tax Reforms
Six times over the last twenty years (1962, 1964, 1967, 1971, 1975, 1978) there have been minor changes in the tax laws that have been beneficial to capital. After each one, investment increased and the economy enjoyed real economic growth. But three times the “reforms” went the other way (1966, 1969, 1976) increasing the tax burden on capital and slowing its formation and use. If the country is serious about revitalizing the economy, it will have to consistently reduce the obstacles to investment contained in our tax system.
There is a push to do more than this by having the government directly intervene to allocate re sources to specific industries. This may be useful in certain cases where an industry is in a transition period and the process needs to be speeded up so that the industry can become competitive again before it loses too large a share of its market. However, such programs must be approached carefully. Whenever government becomes directly involved in an issue, it politicizes that issue. Direct aid programs attract special interests. We do not want an American reindustrialization program to become another exercise in “lemon socialism.” Lemon socialism is when resources and capital are poured into lost causes in order to please politically powerful groups. Such practices only create industrial welfare cases which are forever dependent and a drain on the economy. Reindustrialization is meant to strengthen the economy and it can only do this if resources are allocated efficiently to those projects that have the best chance of success.
Business and Labor Bear Share of Blame
Of course, government policies cannot be blamed for everything wrong with the U.S. economy. Business and labor must bear their share of the responsibility as well. The steel industry in the U.S. waited too long to adopt the basic oxygen furnace while there was no such hesitation on the part of the Japanese. The auto industry failed to realize the long-run effects of high-priced oil on the market for large cars. Corporate management has gradually lost much of its entrepreneurial aggressiveness. The corporation, that genius of American business, the institution that allowed earlier generations to mobilize capital, penetrate markets, develop mass-production technology and engage in long-run planning has proven as vulnerable to bureaucracy and its stagnation effects as every other institution.
Labor, for its part, has pushed for wage increases that have outstripped productivity, thus adding real costs to American products. These costs have to be reflected in higher prices. Labor has also resisted automation, one of the most promising ways to boost output. Labor fears the loss of jobs to the machine, but has overlooked the greater loss of jobs that results when plants close because they can no longer compete.
Historically, increased capital investment has increased employment. This is for the very logical reason that an expanding economy needs more workers than a contracting economy. That is why mass unemployment is associated with depressions and not with periods of prosperity. And since improved machinery is the only way to increase productivity it is also the only sound way to increase a worker’s pay.
There may be a short-term displacement of workers from automation, and every effort should be made to provide retraining for any worker so affected. This is the practice in Japan where the goal is to eliminate all unskilled labor. Japanese firms are willing to take the time to retrain their people, and with the benefits of advanced technology they can afford to do so as well. The United States should do no less.
Prospects for Recovery
The United States economy has great residual strength. The U.S., though facing a serious energy problem, is far less dependent on OPEC oil than is Europe or Japan. A serious program to develop alternate energy sources, which should be a part of any reindustrialization scheme, gives the U.S. a realistic chance of solving its problems and opening a competitive advantage on its rivals who cannot do the same.
American technology is still the world’s leader, even if it does not enjoy the complete dominance it once did. Nuclear and solar technology, aerospace and the revolutionary world of microelectronics are only the vanguard of the American scientific capability. Behind this stands a highly educated population and an educational system which spends billions of dollars annually developing the “human capital” of knowledge.
The framework thus still exists for reindustrializing the country as, indeed, it was industrialized in the first place. What is needed is a more enlightened allocation of resources to support the effort and a determination to see it through.