Deindustrialisation and Financialisation: Two Sides of the Same Coin?

By Imad Moosa, Professor of Economics, Department of Economics, Kuwait University, Kuwait

Image Credit: Adobe Stock

Deindustrialisation is a process that involves economic and social changes caused by the erosion or dismantling of industrial capacity and activity, as manufacturing industry is replaced by services, particularly financial services. To be sarcastic, I would say that deindustrialisation involves the replacement of engineers with exotic dancers. The shift to financial services in particular amounts to the “financialisation” of the economy, which is indicated by the spectacular growth of the financial sector in terms of profits, size of institutions and markets, and also in terms of political influence and visibility.  

To those who believe in the absolute economic and moral superiority and supremacy of the West, China is the culprit when it comes to finding an explanation for the rapid deindustrialisation of the West. This explanation, however, is not based on sound economics but rather on blind ideology. Free marketeers, on the other hand, do not deny the shift away from manufacturing industry towards services, but they take attitude of “no worries” as this shift is allegedly “natural”, a phase of economic evolution.  In my humble view, both factions are wrong.  

Let us start with the evolutionary view expressed by some pundits who believe that financialisation (hence deindustrialisation) occurs naturally as the economy moves away from manufacturing industry to services. In an article published in The Economist in 2011, an eminent trade economist, Jagdish Bhagwati, expressed the view that those who call for reviving manufacturing industry suffer from “manufacturing fetishism”, arguing that the service industry is as good as manufacturing in generating jobs and boosting exports. However, manufacturing fetishism, which is the idea that manufacturing is the central economic activity and everything else is somehow subordinate, is not as bad as Bhagwati thinks. After all, advanced countries have become advanced and rich in large part because of industrialisation, which is the prime source of productivity growth (recall the industrial revolution).  

It seems that Bhagwati suffers from “services fetishism”, thinking that manicure and massage (and portfolio management) are as good for the economy as manufacturing industry. Rather than supplant manufacturing, business-service enterprises depend on healthy factories, which are among their biggest clients. Bhagwati is wrong because, as one observer puts it, “it’s hard to imagine how service-sector expansion can play a role in wealth creation if growth in, say, manicurists exceeds that of engineers”. An economist of Bhagwati’s calibre should know that while manufacturing industry lends itself to specialisation and economies of scale (hence, rising productivity) the service industry kills productivity because of the lack of potential for the exploitation of economies of scale and exports.  

Financialisation (hence deindustrialisation) has not happened simply as a “natural course of evolution”. Political decisions, or lack thereof, enabled the process to take off and accelerate beyond control. Policies formulated at the national and international levels encouraged activities and changes that provided the right environment for financialisation to move at full speed. Inaction, the deliberate decision to allow market forces to run our affairs, and refusal to intervene (even to regulate fraud or deal with destabilising forces) allowed the proliferation of parasitic activities that are commonly found in a financialised economy. In short, financialisation has not evolved naturally—rather, it is a product of public policy choices motivated by a race among the political elite to serve the financial oligarchy.  

The link between financialisation and deindustrialisation has been highlighted by a number of economists who observe the negative impact of financialisation on value added and employment in manufacturing industry. This link is conspicuous in reported data. For example, consider the annual data (displayed in the chart) on a measure of the financialisation of the US economy, which is the IMF’s index of “financial development”, and manufacturing employment, both measured as indices that take the value of 100 in 1980. Between 1980 and 2000, the financialisation of the US economy was running full steam ahead while manufacturing employment (the number of people employed in the manufacturing industry sector) was following a declining trend, with the usual cyclical ups and downs. Even though the pace of financialiastion has slowed since then (because there is a limit to the financialisation of the economy) manufacturing employment continued to decline. The (negative) relation between financialisation and manufacturing employment, as represented in the chart, can be seen more clearly by looking at the smooth trends of the two variables. Negative correlation is conspicuous: manufacturing employment has been shrinking at a diminishing rate, while financialisation has been rising, also at a diminishing rate.    

Those who reject the proposition that deindustrialisation and financialisation are two sides of the same coin (blaming deindustrialisation on China or otherwise) would suggest that what the chart shows is correlation, not causation. However, theory, intuition and observation of the facts on the ground tell us that the association between financialisation and deindustrialisation represents causation and not (spurious) correlation. Financialisation has a negative impact on manufacturing industry because of its adverse effect on capital accumulation. In a financialised economy, non-financial firms spend less on real capital accumulation. Financialisation imposes short-termism on management and curtails animal spirits with respect to real investment in capital stock, the outcome being increasing preference for financial investment to generate short-term profits from financial transactions that add no value whatsoever. It also drains the internal means of finance available for real investment purposes, owing to increasing dividend payments and stock buy-backs.  

By observing the profits and the potential increase of management compensation provided by financial transactions, non-financial firms shift from their primary activity of producing goods and services to financial activities for the purpose of making easy and quick “buck”. Financialised accumulation has implications for how the economy works. If companies can make more money by trading financial assets than by manufacturing products, they are unlikely to invest in new technology, opting instead to expand their finance departments to the detriment of other areas. This is why non-financial firms have become “financial rentiers”. We should not forget that the productive sectors of a financialised economy (including manufacturing industry) experience the adverse effects of the brain drain inflicted on them by the financial sector. Scientists and engineers leave labs and factories, take off their lab coats and uniforms, and rush (in suits and ties) to utilise their brain power in parasitic activities such as the pricing of “exotic” financial assets.  

An anecdotal “evidence” for the proposition that China has played a role in the deindustrialisation of American and the West in general can be found in a story told by Paul Krugman, a Nobel Prize winning economist, in a 2011 article in The New York Times. The story is about a Russian immigrant, an engineer by profession, who had just arrived in the US. The Russian engineer made the following observation: “America seems very rich… but I never see anyone actually making anything”. Krugman thought that the observation made by the Russian engineer became increasingly accurate over time, which led him to suggest (at the risk of being called a “Putin propagandist”) that “Americans made a living by selling each other houses, which they paid for with money borrowed from China”. This is an accurate description of the status quo as reflected in the trends displayed by the chart. Deindustrialisation and financialisation have not occurred naturally, and they are indeed two sides of the same coin.    

Financialisation and Manufacturing Employment in the US (indices, 1980=100)

Financialisation: Measurement, Driving Forces and Consequences
By Imad Moosa, Professor of Economics, Department of Economics, Kuwait University, Kuwait is available now.

Read the introduction and other free chapters on Elgaronline

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