During the first decade of this century, U.S manufacturing employment fell sharply. Prior to 2000, employment fell as a share of total employment but managed to stay around 17 million strong for a couple of decades. After 2000, it crashed.
What was its cause? Technological change, the impact of trade, or something else? Productivity growth in the five years after 2000 was no higher than the five years before 2000, so one can dismiss technology as a potential cause.
Those making the case for trade point to the increased trade deficit during this period and link it to China's accession to the World Trade organization in 2000. Others blame the glut of savings in China and other East Asian countries for the increase in the trade deficit.
Both the overall trade deficit increased as well as the ex - petroleum deficit. From Calculatedriskblog.com
However, the way excess foreign savings are meant to produce a bigger trade deficit is by boosting the value of the exchange rate. But the dollar fell in value during this period (early 2002 - middle of 2005) rather than increasing.
So the actual puzzle is not why manufacturing was hit as hard as it was, but to explain why both the dollar fell and the trade deficit increased. There are a couple of ways this can occur:
If the price of imports falls and the induced demand for imports increases enough that the dollar value of imports increases, not just the quantity. In that scenario, the trade deficit expands, and since foreigners will see their dollar holdings increase they will attempt to diversify away from the currency, pushing its value downwards.
The second way the trade deficit can accompany a falling dollar is if Americans decide to go on a spending binge. This results in a higher deficit and a falling dollar, but if Americans are spending more and saving less then this should push up domestic real interest rates vs other economies. American real interest rates though were lower, not higher, as you can just about see in the chart below.
So what economic forces can give rise to the combination of expanding trade deficit, falling exchange rate, and lower interest rate differentials?
There is a straightforward way for this to occur. Consider what happens when a U.S firm is outcompeted by a foreign firm in either domestic or foreign markets. Suppose for example the foreign firm is a car manufacturer and releases a new design that is better than rival designs by U.S auto companies. U.S consumers will then shift some of their spending to the foreign firm. The loss of sales to the U.S firm results in a loss of income to the U.S as a whole. U.S households then reduce their consumption and due to the higher propensity to spend on domestic goods vs foreign, the net effect is for imports and the trade deficit to rise. The rise in the trade deficit in turn results in a declining exchange rate. How do interest rate differentials come into play? With households cutting their spending the economy suffers a loss of aggregate demand. In response, the Fed cuts interest rates1 to stimulate the economy.
To generate the economic picture of the early 2000's just assume that one U.S firm after another was out-competed by foreign firms. Either foreign firms were doing something very good or U.S firms something very bad. Supposing the latter, what defect or flaw could affect all those U.S products? Garish color schemes? Confusing instruction manuals? The only flaw that could afflict such a large swathe of products is if these products didn't exist.
Put more plainly, starting in 2000 and lasting roughly half a decade, American companies erroneously exited numerous market segments, leaving the field clear for foreign competitors. What made them do this?
Early on in the decade, the high Asian savings rate had driven up the value of the dollar and pushed down interest rates. The strength of the dollar meant U.S firms now struggled to compete with foreign firms. Many market segments, especially commodities, were unprofitable and American firms would and should have exited these markets. However, there also were markets where U.S firms enjoyed more pricing power and in these market segments, profitability would have fallen but because firms' cost of capital had also fallen, these firms were still earning returns on capital in excess of firms' cost of capital. Firms should therefore keep operating in these particular segments. But as I noted in my previous post, firms (not just American ones) have not responded to lower interest rates. They stubbornly still want to earn the return on capital they have achieved historically.
This dynamic of U.S firms abandoning market segments was initially caused by an elevated exchange rate. Once the dollar drops down to a more normal level this effect should cease. However, the dollar kept falling during the early 2000s. And that's because there was another factor pushing firms to abandon markets that was also in operation during this time.
That factor was slowing economic growth. What is the connection between that and U.S firms exiting product markets? To give some context, it's helpful to know that firms constantly exiting markets in part due to foreign firms climbing up the value chain. E.g., textiles used to be manufactured domestically but have long since been offshored. In the 2000s China plus other economies like South Korea were becoming more capable manufacturers and were taking market share in a whole bunch of product categories, just as they had done before in lower-valued market segments prior to 2000.
What was different was that before 2000, economic growth was higher and so foreign manufacturers were taking a bigger slice of a rapidly growing pie. Post-2000, the size of advanced economies' markets was not growing as quickly and the market share inroads made by developing world manufacturers had a bigger bite.
What should domestic firms do in this situation? In many cases, profits would decline so much that the optimal choice would be to exit the product segment. But in others expected profitability would only see a modest decline and since slower growth leads to lower interest rates, firms would still be able to earn a return on capital that is above the firms' cost of capital. Unfortunately, as I pointed out before, firms were not settling for lower returns on capital. Thus firms chose to exit.
Now, this logic should apply to firms in all developed economies, not just the U.S. So why did U.S firms exit more than firms elsewhere? When a firm exits a market segment it has to shut down production and therefore the firm will have to lay off workers in factories (if it still has them) as well as in R&D and marketing etc. But in many countries, the costs of laying off workers are high, either financially (severance payments) or because of unions and pay agreements that usually stipulate a maximum number of layoffs. In these countries, firms would be better off either continuing production or refreshing the product line with a new design. Ironically, the influence of unions and other regulations would make firms in these countries choose the profit-maximizing course of action.
To come back to our original question. What was responsible for the fall in manufacturing employment? The shock of cheap Chinese labor would have had an impact on the manufacturing sector, if not on the trade deficit. The savings glut that initially pushed the dollar higher would be another factor. However, it was the abandonment of markets that led both to a fall in U.S manufacturing employment and a reduction in American living standards.
With lower real interest rates, holders of dollars require the dollar to appreciate in compensation. But the U.S high trade deficit implies a steady depreciation in the dollar. What then must happen is that after interest rates are cut the dollar must sharply ("instantly") depreciate below its long-run value so that it can then steadily appreciate in value. This overshooting explains the violent fall in the value of the dollar during the early to mid-2000s.
The America Shock
"Ironically, the influence of unions and other regulations would make firms in these countries choose the profit-maximizing course of action." - not ironic, only contrary to dogma. Any smart union does this, and so do good regulators. Neither has the compulsive interest in short-term profits too often seen in employers.
Isn’t big factor just making mfn permanent. https://slate.com/business/2016/09/when-china-joined-the-wto-it-kick-started-the-chinese-economy-and-roused-a-giant.html