The global industrial arms race is just what we need

The writer, an FT contributing editor, is chief executive of the Royal Society of Arts

A global arms race to reindustrialise is under way, reversing long-established trends in many advanced economies. The forces driving this race — decarbonisation, deglobalisation, remilitarisation — are likely to have lasting implications for the global macroeconomy and may even help it break free from secular stagnation.

Manufacturing has been in secular decline in many advanced economies. At its peak, manufacturing accounted for almost half of output and employment in the UK. Today it stands at less than 10 per cent. Manufacturing in the US peaked in the 1950s at about 28 per cent share of the economy, but has since fallen to little more than 10 per cent. Even in Europe’s manufacturing powerhouse, Germany, the manufacturing share of the economy fell from 25 per cent to 19 per cent between 1991 and 2022.

Underpinning this shift has been a relocation of manufacturing production from west to east and an accompanying reconfiguration of global supply chains. This was made possible by successive waves of trade liberalisation, culminating in China’s accession into the World Trade Organization in 2001. These trends were then amplified by the activist industrial policies pursued by countries such as China and Singapore, policies typically not matched in the west.

These shifts in the sectoral and spatial pattern of manufacturing have shaped the global macroeconomy in important ways. In the west, they contributed importantly to low and falling rates of inflation, growth, productivity and interest rates in the first two decades of the 21st century. As cheaper imported manufactured goods from the east depressed price levels in the west, inflation fell, in the US and EU to below target levels, with short-term interest rates following suit.

Manufacturing companies have higher investment rates, especially in R&D, and higher rates of measured productivity than those in the services sector. The loss of manufacturing thus contributed to falling rates of investment, productivity and economic growth in the west too. Falling investment also widened the imbalance between global savings and investment, lowering global long-term interest rates by 3-4 percentage points.

The past few years, however, have seen a new industrial age beginning to take shape, with global manufacturing undergoing a revival, in particular in the west. This has been underpinned by three distinct global arms races.

The first centres on green technologies and industries, a race to decarbonise. China has stolen a march in technologies such as solar and battery manufacture. Latterly the west has stirred, led by the US Inflation Reduction Act’s blockbuster package of subsidies and incentives. The EU is now escalating its own efforts. With an extra investment of around 2-3 per cent of global gross domestic product per year in green technologies needed to hit net zero, this race has a distance to run.

These initiatives have drawn criticism on the grounds they amount to a subsidy race. But an arms race to invest in decarbonising technologies is in fact exactly what the world needs to tackle two global externalities — the climate crisis and the investment drought. The theory of the second best tells us that, faced with an externality, subsidies can help us achieve the best attainable outcome.

The second global arms race under way is remilitarisation. After a period of decline, heightened geopolitical tensions, amplified by the war in Ukraine, have caused governments globally to reinvest in defence. Global defence spending rose sharply last year to well over $2tn and is set to rise faster still this year. This arms race, while decidedly less benign, is reigniting manufacturing in both east and west.

Third, there is an ongoing global race to re- or on-shore manufacturing. This has been motivated by the need for greater supply chain resilience in the wake of Covid-19, but also by a desire for local job re-creation as the economic and social costs of the loss of many millions of manufacturing jobs in the west have become transparent. This has led to the activist industrial policies long since in place in the east now being adopted in the west — witness the US’s Chips and Science Act.

These arms races are beginning to transform the contours of global policy and the global economy. Many countries are now targeting advanced manufacturing in their growth strategies, with subsidies and sweeteners to attract frontier technologies and businesses. Encouragingly, these new industrial hubs are often located where land and labour are cheap and local growth most needed, in places such as Cincinnati and St Louis in the US and Sheffield and Manchester in the UK.

This new industrial age is also beginning to reverse some of the secular macro trends of the past. Fractured supply chains are raising global prices, causing inflation targets to overshoot and interest rates to rise. Public and private money is flooding into manufacturing projects, irrigating firms dehydrated by the investment drought. Higher investment plans are also helping absorb the global savings glut, with global real interest rates rising by over 1 percentage point so far.

Most arms races leave no one better off. Today’s race to reindustrialise is different. It may be just the impetus the world needs to break free of its economic and environmental torpor.