I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity…also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.