package0xxxx 4 S33 R Rbook>drdsUS Innovation at Risk.NP!bookBuilt with Newton PressAC! SAA9ۭ@UR+bookHA )Aa1Ii@UR/vversion@URiisbnۭ@URtitle@URIdata@URjɿ~contentsۭۭ@UR !styles@URohintsۭ@URbrowsersۭۭ@URߧwtemplatesۭ@UR0.renderingۭۭ@UR_String@URArray@UR㧦bviewFontۭ@UR2family@UR|face@URBƣsize@URiname@URLz@\listۭ@UR 97nColumnsۭۭ@URcolumn@URS6widthۭ@URtype@URIpageSizeۭۭ@URopagesۭ@UR+left@UR.topۭ@URǢright@URۡbottom@URJ0|templateۭ@URNblocks@URw>bounds@URCitem@UR,Ztabs@UR@III. - Executive Summary,A @`ۭCef1<@III. Executive Summary ,A @`ۭAX@ۭCfyff)@ America's manufacturing innovation process is vital to promoting economic growth, productivity gains and increased living standards. The most important components of this productivity-enhancing process include investments in worker education and training, investments in capital equipment and R&D and its "spillovers" - unintended benefits to other producers and society in general. A strong and vibrant domestic manufacturing base promotes those investments and keeps the innovation process functioning. Long-term U.S. economic growth and competitiveness in the global marketplace are at risk if recent trends in domestic manufacturing - and the innovation process it spawns - continue. There are five clear warning signs: * Manufacturing output since the last recession lags that of earlier economic recoveries - its 15 percent growth since the end of the recession is only half the pace averaged in recoveries of the past half-century. * Manufacturing capacity remains underutilized, slowing investment in new plants and equipment, an important avenue to introduce new, improved and lower-cost technologies. Since the end of the recession, total plant and equipment investment has risen at half the pace averaged in recoveries of the past half century. Manufacturing capacity has grown at less than one percent annually during this expansion (compared with five percent in the 1990s), reflecting a lack of investment in new facilities. * The U.S. share of global trade in manufactures has shrunk, falling from 13 percent in the 1990s to 10 percent in 2004. The U.S. share of global trade in some of the highest value-added export industries such as machinery and equipment is falling. Furthermore, the United States now runs a trade deficit in Advanced Technology Products, goods produced in the industries expected to lead U.S. exports in the 21st century. * The U.S. manufacturing workforce is highly productive; yet, the perception that manufacturing employment is unstable and lacks job opportunities discourages new workers from pursuing career paths in manufacturing. Manufacturing continues to pay better than many other industries, and it employs 25 percent of scientists and related technicians and 40% of engineers and engineering technicians - critical skill groups for the R&D process - yet the sector is experiencing a growing shortage of skilled workers. * America's long-standing leadership in R&D will be challenged. While the United States continues to spend more than any other country on R&D investment, U.S. growth in R&D has averaged only about one percent per year in real terms since 2000. And the United States is not keeping up with other countries in insuring a supply of scientific personnel: the portion of doctoral degrees awarded to citizens and permanent residents in the United States in science and engineering is falling, while the combined number of science and engineering graduates in China and India (1 million) now dwarfs those in America (70,000). * The United States invested more than $290 billion in R&D in 2003, or 40 percent of all R&D spending in the industrial world; the domestic R&D activities of manufacturers accounting for 42 percent of that total. But the United States cannot become complacent about this leadership position. The rapid growth in overseas manufacturing is creating new global centers with the critical mass necessary to build their own innovation machines. Meanwhile, the challenges faced by America's manufacturing base threaten to reduce the critical mass necessary for our own innovation process to work. It diminishes the size of the economic benefit flowing through the sector's high number of linkages that stimulate the rest of the economy. A slower pace of manufacturing production will lead to a weakening in R&D investment and a lack of skilled R&D workers will threaten the pace of innovation in the United States. * Gains in manufacturing productivity are key to overall U.S. productivity growth. If the innovation process goes offshore and the various wealth-enhancing aspects of that process are lost, a decline in U.S. long-term economic growth rate is all but assured. So the report closes with recommendations for economic policy changes to ensure a critical mass of production and a viable innovation process in this country. Among these policy changes: -- Emphasize accelerating production in the United States, and in particular encourage investments that enhance productivity, such as R&D investments, capital investments, and investments in education and worker training, encourage and nurture math and science education and talent. -- Focus on elimination of those workforce, investment and policy obstacles to domestic production and competitiveness that would provide the greatest economic return. o Increase federal spending on basic R&D and support of such R&D in U.S. colleges and universities. -- Encourage innovation clusters to increase spillovers, increase the productivity of R&D spending and spur hands-on development activities. -- Encourage improvement in the speed and efficiency of the transportation and communication infrastructures of the United States. -- Improve tax and intellectual property infrastructure needed to leverage investment in R&D. ,A @`ۭCg!2@IV. - Introduction,A @`ۭCI0@IV. Introduction ,A @`ۭA@@ۭC`@ This report complements and updates the 2003 publication, Securing America's Future: The Case for a Strong Manufacturing Base . It is prompted by the clear need to examine whether the threats to the U.S. manufacturing base identified in our first report have heightened since its publication. The current expansion of the U.S. economy is four years old. During this period manufacturing production has risen 15 percent, a little more than 3 percent per year.1 That is the slowest pace of any of the expansions that have lasted this long during the past 45 years. On average, those previous expansions showed a 30 percent increase in manufacturing this far (49 months) into the business cycle.2 One reason for the slower rate of growth is that the 1991 recession did not result in as deep a decline in GDP as some of the earlier recessions. But the slower rate of growth for the United States and its trading partners during the early part of the expansion was undoubtedly influenced by the increased uncertainty that followed the events of September 11, 2001. It was shown in the previous report that manufacturing activity has widespread consequences for the health of the U.S. economy. The most important consequence is manufacturing's impact (through its large multiplier effect on output growth) on investment growth, and on research and development spending, for which it is the major source of funding. Manufacturing's high-capital intensity translates into more plant and equipment spending than in other sectors. The results of manufacturing's R&D can be an endlessly renewable resource that improves the productivity of capital and thus adds to labor productivity. Those results improve the production process and add to the choices of goods and services consumers can enjoy. Productivity gains keep those goods and services affordable and they provide the foundation for increases in real wages. Such increases have been the driving force in the advance in the U.S. standard of living since the early days of our industrialization. All these linkages were explored in depth in the previous report and are further fleshed out with new and updated data in this one. That report suggested that successful R&D requires a certain critical mass. Since then, that premise has gained additional prominence. That is because the rapid growth of other global economies is generating considerable R&D activity abroad, some by U.S. companies. The United States is still the world's leader in R&D but, as its share of world manufacturing shrinks, that lead is at risk. As the manufacturing base in other countries gains ground, it begins to drive increases in their R&D, just as it has done here. One consequence is that the U.S. share of world R&D has been shrinking and that trend is unlikely to abate soon. This threatens our competitive edge in world markets and our lead among large industrial countries in real income per capita, a widely used indicator of the standard of living. This report has nine sections. The following section, Section V, describes the process through which manufacturing raises our standard of living and preserves our competitiveness in world markets. Section VI updates and enlarges on the set of data that depict the current state of manufacturing. Section VII details the benefits from manufacturing that are threatened, particularly R&D, plant and equipment investment, and the quality of labor. Section VIII draws together the conclusions of this report's analysis and Section IX provides a suggested bibliography of further reading on many of the topics explored. ,A @`ۭ4A 81lۭC)@V. - The Process by Which Manufacturing Raises the U.S. Standard of Living,A @`ۭC @V. - The Process by Which Manufacturing Raises the U.S. Standard of Living ,A @`ۭA(@ۭC@ The U.S. manufacturing sector should not be taken for granted. It is at the heart of a process that is critical to the health of the United States economy - the process of generating prosperity, i.e., wealth and real income gains. Because this process - basically an innovation process - is intensely interactive, its maintenance requires a strong, growing manufacturing sector. The innovation process not only drives the introduction of new products but is made more productive by the process itself. Manufacturers estimate that every two to three years over one-third of their revenue is generated from new product sales.3 Thus, a large percentage of today's manufactured goods will be obsolete within a few years. That makes innovation a necessity to merely maintain the status quo, and constant innovation is the only way to increase prosperity. It is perhaps easiest to understand this innovation process by tracing through the interactions beginning with an initial component, research and development investment. Basic R&D produces inventions. Spending on applied research and development spawns innovation - the process by which inventions are implemented.4 But this R&D-driven process does not stop there. It is magnified by "spillovers," channels by which an innovation in one area freely stimulates those in other areas. Innovations are diffused through the economy in a number of ways. The most obvious direct linkage is through the production of new goods, and quality improvements in existing goods. Successful R&D not only affects the kinds of goods that flow to consumers but also enhances the labor and capital inputs used to produce them. As capital goods are improved in speed, accuracy and quality, they rely on and often lead to new processes to make their utilization more efficient. Reaping the benefits of such improvements in manufacturing processes requires that human capital (labor skills) keep pace. This demand prompts investment in education and training. This process and the investment it promotes leads to productivity gains, the basis for higher living standards. Large and frequent innovations, the hallmark of U.S. manufacturing, require a certain mass of interconnected activities which, like a snowball rolling downhill, grows in size as it proceeds toward final consumers. The snowball effect requires substantial R&D, enough to be sure of significant successes after writing off failures. The successes must be frequent enough to keep the ball rolling by prompting interactions among the different parties to the process. As size and frequency of innovations rise, spillovers are magnified. The vehicles for the diffusion of new ideas and products along the supply chain are sales transactions, face-to-face discussion of ideas and needs, conferences and meetings of scientific professionals, scientific literature written in a common tongue, etc. All of those activities are nurtured by geographical proximity. Dr. Maryann Feldman, Professor of Business Economics at the University of Toronto, expressed this in a paper delivered at a National Academy of Sciences conference in January 2005. "Colocation facilitates knowledge spillovers by providing, often at less cost, opportunities for both planned and serendipitous interactions." Thus the process of wealth generation is most efficient when mass and proximity are wedded. What follows is a description of the method by which innovations become an integral part of the economic process and lead to widespread improvements in productivity and our level, or standard, of living. A simplified schematic of the innovation process is shown in Figure 1. R&D promotes economic prosperity through a multifaceted and complex process: o The first avenue is through direct benefits to firms from their R&D investments. Those direct benefits, or the need to balance the potential benefits a rival might gain from R&D, are the primary driver of firmfinanced R&D. o The second is through "spillovers" whereby innovations flowing from R&D performed by one organization benefit other organizations without direct compensation for the innovation. o The third is through the widely discussed multiplier - the effect of one industry's investment on other industries and the U.S. economy as a whole. o The fourth is the feedback from R&D and its spillovers to improve manufacturing products, processes and distribution networks. o Together these benefits produce productivity gains that lead to competitive prices and better paying jobs. In any economy, manufacturing is a major dynamo of R&D spending. Over the past 20 years, manufacturing has performed almost 60 percent of all R&D in the United States. The National Science Foundation estimates total R&D spending performed by private industry in 2003 totaled $204 billion.5 R&D performed by manufacturing industries totaled $123 billion, or 60 percent of total private R&D and about 42 percent of all R&D performed in the United States.6 Industry, dominated by manufacturing, also funded about 63 percent of domestic R&D in 2003. Manufacturing is estimated to have funded almost 60 percent of business sector R&D. The other funders of domestic R&D are government and nonprofit organizations such as colleges and universities. The forces of globalization are changing the face of R&D and investment. As manufacturing rapidly expands in other countries, their R&D base will expand as part of that general process. As R&D opportunities expand, U.S. companies will expand the geographic scope of their R&D as well. However, that does not lessen the need to maintain a strong and interactive domestic R&D base. To the contrary, R&D conducted in the United States must keep pace with the economy's growth. National Institute of Standards and Technology economist Gregory Tassey puts the importance of domestic R&D into its broader perspective: "Changes in competitive dynamics are altering the reward/risk ratio for R&D investments within and between technology life cycles. As life cycles compress, R&D at the company level no longer can exist in isolation of a supporting network. Corporations increasingly require access to R&D conducted by other firms in their supply chains and to the broader technology infrastructure provided by a national innovation system. If domestic R&D resources are not available, U.S. companies do not hesitate to form research partnerships with foreign companies, outsource R&D overseas, or directly invest in foreign research facilities. These research relationships often lead to follow-on foreign manufacturing relationships. Thus, the maintenance of an effective domestic R&D network is essential for attracting domestic and foreign R&D funds and subsequent manufacturing, which increases domestic value added and hence economic growth."7 R&D spillovers are an important factor in the benefits from the innovation process. Spillovers come about when parties derive benefits from the R&D without having to fully compensate the company conducting the research. Spillovers are often characterized in one of three ways, but these pathways often interact and increase their combined effect.8 One way is through "market spillovers," in which the marketing of a new product creates benefits to market participants other than the innovating firm. Often this is through a new technology that is embodied in products newly developed or improved by R&D. However, because producers cannot capture all of the value of the improvements in the prices they charge for those new goods, cost-free benefits accrue to competitors and customers, or are handed back to suppliers. The improvement in the speed and accuracy of machine tools is one example of such a market spillover. The introduction of numeric controls increased the number and complexity of items for which the use of machine tools was practical. Thus, at least one aircraft maker could make landing-gear bulkheads in two parts rather than 72 parts and reduce the number of fasteners used by more than 90 percent, which increased its productivity and cut its costs.9 A second kind of spillover is termed a "knowledge spillover." This is the transmission of knowledge from an R&D activity that can be used by other economic agents in a virtually cost-free manner. For example, academic papers and the information filed with patents provide the readers with information about the process or product being discussed. This cross-pollination of knowledge can spread ideas from one institution to another and from one industry to another with permutations of the ideas taking place at every step. The number of times that one patent is cited by other patents is one way that researchers trace knowledge spillovers. A third kind is a "network spillover." It occurs when R&D benefits are enhanced in value by the development of a related set of technologies. Thus, extra benefits may accrue to an innovation if related technological innovations also take place. The Internet is an example of a technology that has enhanced the value of communications equipment. The existence of a communications modem allows greater benefits to be derived from computers, and the more people with whom one can communicate on a computer network the greater those benefits. As mentioned earlier, the spillover effects are magnified - through sales transactions and knowledge transfers - if the parties are more interdependent and closer in their geographic proximity. A paper by Kansas City Federal Reserve Bank economist Michael Orlando discusses the importance of technological and geographical proximity to the spillover process in manufacturing. He finds that spillovers within a manufacturer's own very narrow sector tend to be much less inhibited by distance than are those from outside that narrow sector. In contrast, the impact from spillovers originating outside the manufacturer's narrow sector tends to decrease rapidly with distance.10 Perhaps this reflects the different paths taken to diffuse the ideas. Firms are more likely to benefit from spillovers when R&D takes place geographically near them than they are if it occurs on the other side of the world, especially with regard to the benefits from more generalized R&D. A recent study on pharmaceutical R&D finds that spillovers are more noticeable in the local geographic area surrounding where the research has taken place.11 This appears to be especially true of spillovers from public institutions.12 Since the federal government and academic institutions perform more than a quarter of R&D, geographic R&D centers with public and private institutions in close proximity can have significant spillover benefits. A recent report by the President's Council of Advisors on Science and Technology (PCAST) found "[l]ocations that possess both strong R&D centers and manufacturing capabilities have a competitive edge. Indeed, several major manufacturers told the PCAST panel that they decided to locate new plants in the United States, despite cost benefits of offshore manufacturing, due to the proximity of leading university R&D capabilities."13 One example of a company with a renewed interest in proximity is Honda. Always an innovator, it has renewed its focus on bringing R&D and production operations closer together. In a recent interview, Motoatsu Shiraishi, the head of Honda's R&D unit, explained, "[f]or example, when hybrid and fuel-cell cars become more common, it won't be enough to come up with a better product at the research level. We have to make it commercially viable when it's mass produced." Another advantage to the company is that R&D from dissimilar programs can be incorporated on the factory floor into a range of products. In that way Honda's technological know-how from R&D on robots and aircraft have been used to enhance the innovations incorporated into its automobiles. 14 There are several examples of the benefits of geographic proximity in the United States. Innovators cluster in places like Silicon Valley, Research Triangle and Route 128 in Massachusetts, in part, to obtain spillovers from each other and often to obtain spillovers from academic research that is taking place nearby. The Regional Innovation project of the Council on Competitiveness studied which aspects of such clusters tended to result in increased standards of living of the inhabitants. Among its findings were: 1) "When members of a cluster are located in close proximity, they can capture synergies that increase productivity, innovative capacity and new business formation"; 2) "Commercialization of basic research is a difficult but important ingredient for generating entrepreneurship. Some regions have high levels of R&D investments and numerous specialized research centers, but still lag in terms of innovation output because knowledge is not effectively or rapidly transferred to companies"; and 3) "Above average economic performance measures are not enough to ensure regional prosperity. Maintaining, much less increasing, a region's standard of living requires the steady growth of productivity, which in turn requires innovation."15 While close geographic proximity seems to increase spillovers, knowledge transfers take place across geographic distance as well but the pathways may be different. Economist Lee Branstetter of the Columbia Business School has studied spillover impacts from Foreign Direct Investment (FDI) of Japanese firms in the United States. He found FDI is a channel for knowledge transfers between both parties to the investment. Furthermore, the spillovers to the Japanese investing firm increase when the American investment is in R&D or product development facilities. The flow from the Japanese firm to the American affiliate tends to be strongest through the new "greenfield" establishments where the investing firm is embedding superior technology and/or management practices into those facilities.16 The direct output of R&D consists, in concept, of the value of the new products, processes, etc. that result from it. However, that value is generally inferred by spending on the inputs used to conduct it. Obviously, the path from spending on inputs to the value of the outputs can vary considerably based on a wide array of factors and can be difficult to track since spillovers can produce value for participants other than the company spending the money. But, spillovers do help determine how far each dollar of spending can be stretched to create valuable outputs and are important determinants of the "productivity" of R&D spending. This suggests that R&D output can be increased without more spending if spillovers become more pervasive. Spillovers are not the only reason for maintaining a dynamic domestic R&D base. In a recent article on innovation Michael Orlando and Michael Verba identified two reasons for there to be higher rates of innovation in more densely populated geographic areas, such as large metropolitan areas.17 The first is the increased possibility for knowledge spillovers in areas where people have a greater opportunity to learn from one another. The second reason is what the authors term "thick markets" for the inputs to innovation. Their argument is that more populous places can support markets for the very specialized personnel and equipment that are needed for R&D, making them a more cost effective place for innovators to work. The authors make the further point that this is especially needed for new innovations because such research may take unexpected turns requiring the acquisition of new and different inputs than were previously needed. These thick markets for the inputs to innovative activities also require replenishment and growth of the types of inputs needed for R&D including technology and skilled personnel. Only ongoing funding and growth of R&D will continue to attract those necessary inputs. While R&D is the starting point for the innovation, recognition also must be given to the importance of plant and equipment investment to the process and to economic growth. Investment in new equipment provides each worker with more and better capital with which to work. This is often called "capital deepening" or an increase in the ratio of capital to labor. Capital deepening accounted for more than half the growth of labor productivity between 1995-2003.18 A thorough quantitative investigation of the relationship between manufacturing and economic growth was conducted in the early 1990s for the World Bank by academic economists J. Bradford De Long and Lawrence H. Summers.19 The study covered the period from 1960 to 1985, and looked at the behavior of a cross section of 61 nations at various stages of development. It confirmed the relationship and identified capital investment in equipment as a key contributor to manufacturing's importance as a growth generator. These findings have yet to be seriously challenged; the few subsequent research reports only confirm De Long and Summers. A more recent study by Tahir Abdi contains among its conclusions that "doubling M&E [machinery and equipment] investment could raise the TFP [total factor productivity] levels [in Canadian manufacturing firms] by about 20 percent and doubling non-M&E investment [defined as structures] could raise the TFP levels by almost 23 percent."20 It is noteworthy that a recent International Monetary Fund paper found that deceleration of capital deepening in the Euro area has been identified as the key factor explaining its slower growth in labor productivity during the 1990s when compared with the United States.21 Manufacturing firms themselves have been significant investors in capital equipment, in addition to producing a steady stream of improved capital equipment for other industries to use. Over the past 20 years, manufacturing industries have accounted for 20-30 percent of new investment in equipment and 10-17 percent of new nonresidential structures.22 ,A @`ۭA (0 t7$,0  t Dx ۭC ==@VI. - Manufacturing's Challenges More Critical Since Last Recession,A @`ۭC??@VI. Manufacturing's Challenges More Critical Since Last Recession ,A @`ۭA@ۭC?@@X@ Manufacturing generates a large share of American prosperity. While no one can determine its ideal size to sustain and grow the critical mass of innovation, the process by which those benefits are produced, described in Section II, clearly requires one. There are five signs that the process is endangered; perhaps its long-term health is more endangered than in 2003, when the previous report was written. Those signs are: (1) manufacturing output has continued to lag that of earlier economic recoveries; (2) manufacturing capacity remains underutilized so investment in new plant and equipment, particularly greenfield plants, has slowed; (3) the U.S. share of world trade in manufactured goods generally, and capital goods in particular, continues to shrink; (4) the sector's lack of job growth has discouraged new workers from entering the industry, which has serious implications for maintaining a skilled workforce; and (5) U.S. leadership in R&D is being challenged. The remainder of the section describes developments in these five areas. ,A @`ۭC@IQd@A. - The Measured Recovery of Manufacturing,A @`ۭCIJf@A. - The Measured Recovery of Manufacturing ,A @`ۭA@ۭCJIJJ&@ Manufacturing production is growing. Since the end of the recession, output has increased 15 percent. However, that is only half its average pace during earlier expansions over the past 45 years. That means the rest of the U.S. economy has not been receiving the charge from manufacturing typical of earlier economic expansions. That charge flows from manufacturing's multiple linkages throughout the economy. One measure of that is the multiplier for manufacturing. It is the highest of all the major U.S. industrial sectors. At 2.37 in 2004, its multiplier means that for each dollar of final demand for manufactured goods, $1.37 worth of additional goods and services is needed to support that demand. Those linkages stimulate activity in other parts of the economy. 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Pydy/#O AP/#l? OxxyO x? Z@O @O ? `yy j pO#y j p  j pA 0 @O#\ j p ? j pCy O% q j p qP j pC? O% q? 0O by / by0 OPDP `o 0 <` o @o0p0py @O 0po P `o `oP@y'O/`d @H 1d,(o`oLdH ɑ 0o4*@G gapdPt)*P /BE*bEI d F6PTEF02WTF@E I&@Dd@O-(FdFldOoF@7so@`(d`d@E Dpd/@t*(*bFad VF@F rW:d`G@\o/@,A(*o`oFd/`_&@p ot`@bO@@@`,Df @pD@  j@O@ @`, 'qDf PD@ CQ/@The lack of improvement in the trade deficit is partly because the decline in the value of the dollar comes mostly from its 25-percent depreciation against the seven "major" currencies of the world - those that are traded on exchanges outside of their own countries.39 But those countries only account for about 53 percent of U.S. exports and 45 percent of U.S. imports. If one looks at exchange rates applicable to the "Other Important Trading Partners" of the United States, as shown in Chart 7, it is clear that the dollar has changed little in value against them since February 2002, down barely one percent.40 Those countries supply 44 percent of U.S. merchandise imports, but they buy only 38 percent of U.S. exports. The differential for China is even larger. China bought four percent of U.S. exports in 2004, but was the source of 13 percent of U.S. imports; therefore, trade with China accounted for 21.9 percent of the 2004 U.S. merchandise trade deficit.41 The Chinese currency had been pegged to a precise exchange rate with the U.S. dollar for many years. In late July, China unpegged its currency from the dollar and instead began controlling its value against a basket of currencies.42 However, while this increased slightly the value of its currency against the dollar, the initial revaluation and the movement since then has been so small that it is unlikely to have much impact on the trade balance between the United States and China. Since some analysts estimate the renminbi (also referred to as the yuan) is overvalued by as much as 40 percent, there is significant pressure for a further revaluation. China has indicated some further upward revaluation, but not a free float, is in the offing. But it has also indicated it will diversify its foreign exchange holdings. 43 While the direction if not the magnitude of the U.S. merchandise deficit has not been unanticipated, the conventional wisdom has been that as the U.S. economy shifted to services, service exports would compensate for weaker goods exports. But that has not happened. U.S. service exports grew 72 percent from 1994 to 2004 (and 45 percent in constant dollar terms), but they were still less than half the size of goods exports in 2004. And, the relatively small trade surplus in services has fallen by one-half over the past 10 years. The United States has competition in service exports as well as in goods exports. It is the largest exporter of commercial services to the world, accounting for 17-18 percent of the total during the 1990s and early 2000s. However, its share has fallen during the past three years and was down to 15 percent in 2004. In addition, the United States is both a major exporter and a major importer of some of the services with the largest total value, such as transportation and travel services. That will continue to be true. Consequently, the United States cannot depend solely on trade in services to offset a serious decline in goods exports. In addition, U.S. providers of business services are facing increasingly strong competition as foreign producers of services begin to staff U.S. call centers and provide programming services to U.S. companies. These jobs represent U.S. service imports and offset U.S. service exports. Consequently, the solution to the trade deficit is unlikely to be found solely with service sector exports. Based on the World Trade Organization's statistical database, the United States continues to be the world's leading importer of merchandise, accounting for $1.5 trillion or 16 percent of the world's merchandise imports in 2004, more than twice the value of the number two importer, Germany.44 Imports have been a positive force in the United States. The influx of inexpensive goods has helped keep prices down and encourage consumer spending among all income levels.45 However, when trade becomes too one-sided, it can slow economic growth and increase the potential for economic instability. To purchase these goods, large quantities of U.S. dollars flow overseas. So far, the countries receiving those dollars have frequently used them to purchase our Treasury debt, buy U.S. assets and purchase oil. However, if those choices were to change, as China has hinted, the resulting adjustment process could cause interest rates to rise in the United States and the dollar to fall significantly. Consequently, it is important for the United States to maintain its ability to produce new and better goods and services so that those dollars can also be used to purchase more U.S. exports. These trade developments have prompted some economists to revisit the assumption that the law of comparative advantage will cause all countries to benefit from free and open trade. They have pointed out the assumptions underlying that hypothesis may no longer be tenable in today's global economy.46 That "law" is based on the assumption that a country's labor, capital and technology do not move offshore. "If these factors move abroad to where cheap labor makes them more productive, absolute advantage takes over from comparative advantage."47 Even the first American Nobel Laureate in Economics, Paul Samuelson, wrote recently in a scholarly journal that nothing in the law of comparative advantage denies that "new technical Chinese progress in goods in which America previously had a comparative advantage can, all else being equal, permanently lower measurable per capita U.S. real income."48 But more fundamental to the outlook for the U.S. trade deficit is the reality that we have shifted from a producing economy to a consuming economy. Our ability to stay on that path depends, like a retiree, on how long our wealth will last. The potential adjustment processes to a more sustainable situation could be gradual or very rocky.49 However, the United States' ability to generate more wealth will be an important factor in its ability to adjust to the changes and manufacturing makes a vital contribution to that process. ,A @`ۭA(l   @ xۭCIb@D. - Impact on the Manufacturing Workforce,A @`ۭCd@D. - Impact on the Manufacturing Workforce ,A @`ۭA@ۭCa1@ Manufacturing has traditionally been a sector providing well-paying, full-time jobs, many that provide scheduled overtime as well. However, the availability of such jobs is shrinking. At 14.3 million workers, employment in manufacturing is at its lowest point since 1950 when U.S. GDP was about three percent of its current dollar size. 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O1ł *0p<  p@O Fo>*@*bDF 7A@t:*BDF =(`BFD@L P (bFFdD@=(`GFBD@FH  (bFFpD@=)@`DE F70 s )BDFE < ?`@O F.O@D '@@( HL@O ,` VB@/@O Z@O/@I, I/ wj0O1J/@  P@K@O#i`/I/H `\@O@II#/dhj``/I/H j`L@&/@iJD`/J/H0@H@O O,|@`//H,@)G 0  HO @ &`F f^7,DL,(D̤A$@ğϑ$DL o@ *0O9_f FtdDE_PDYy@H4`a\\`DE?% F * 9:OgaI󡢖&FV@h dE(DTDpz) @H$`aÁ£`pE(D78 F * 88 :O0dFFVfo,/D<(O!JD@H!;ƀ/D,'  \JϑxxD9_ doo"/d I Rd RS doCovs d Eqd Es@?dϑoBϑ, Ci @ In the major expansions of the 1960s, 1970s and 1980s, manufacturing employment had increased 10 percent on average after 49 months. The 1991 recovery was different, manufacturing employment showed less than a one-percent increase after the first 49 months of that recovery. That was one reason the early part of that expansion was referred to as the "jobless recovery." During the first two years of this recovery, manufacturing employment continued to fall, declining almost 10 percent by the end of 2003. In the past two years, those declines have leveled off but employment in this sector has shown little growth, registering positive gains in only nine months, and has declined by 10 percent since the recession ended. During the 2001 recession, overall employment declined by 1.2 percent while manufacturing employment declined 6.5 percent. Manufacturing jobs made up almost 70 percent of the total jobs lost during March to November 2001. However, manufacturing had already been losing jobs well before the recession started whereas the rest of the economy was generating employment growth. Manufacturing employment had fallen four percent from its high point during the 1991 economic expansion (March 1998) before the recession officially began.50 While this job loss has been painful, it also reflects one of the major benefits that manufacturing has provided to the economy as a whole: significant productivity growth. A comparison of Chart 2 and Chart 8 shows that the decline in manufacturing employment significantly overstates the impact on production in the manufacturing sector. That is because the productivity of the manufacturing workforce has grown significantly faster than has productivity in the economy overall. ,A @`ۭ$AۭC:GG3@3F  FFHHwwwwww ffffff UUUUUU DDDDDD 333333 """"""FFWP?p ?IO :0 b?`?p ?DO6  OP[ o O ?p o0? /p /p 0 O@_@7L?0P o5_@)7_@/ O@_/|ρ  ) O@?p  Oa1 ?`P_@4?/?pP /?p@_A /o0_OOA!  !   Eϑ P o?o  o /_D  O@o0_@ODo o : OP Oq ?@ E?p  /_E OI O@ _@OR 2?p0 /p ?`?q O  ?o   o /oD  _@O@ " /p/OP_@ ?/?p  /?p_@1Ao@(_@oO  !  OPPz@_@ Q?0  *@)G/'I@_@?/_ q0 O    pP  @0@2 OP ? U @ `02 OP@@ ?PF `/ /p0 2 o0?P ?P  ȠO L/@OP) o<0/t2 o5OSOA2  O ?P _zO/ ρOp+ "/OP/p/`oA /`o@@"0oA2# OP?P/o0_)OO?P |__@@/ ! 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Dc3j߂dY/#3d? l31^OP O@O /o@ , P  O@ @ϒ_@ , O HO o  o @ ,` `W /F 0v *JO  ``w v @* @ /F`` P/1 P: Y @Y Pw PX  uG OJ* fF O @D d u`a GXJ* @D CVuu f/ `:I  @ /, H  @/B@ O"  H,@/B ff @ JJ OdI /@ ,  @O ϟ  p,I H@O ff @tJJP/I`u  0/PHI 0  Ved@:I @t // t@w J  p,@ w @H   H/ tp,@ P: *@ @IP W u@ O@ /p /@  O)@  _ / HpO @   )@ `/` CH"@ As Chart 9 shows, labor productivity growth in manufacturing has outpaced that of the United States as a whole since 1992 and has grown significantly faster during this recovery. Since the recession ended, manufacturing labor productivity has grown at an annual rate of 5.8 percent. That compares to 3.4 percent for the non-farm economy as a whole, a rate which includes the results for manufacturing. This differential reflects the continuation of a longstanding trend. From 1991 to 2001, manufacturing labor productivity increased at an average annual rate of 3.7 percent and helped boost the productivity rate of the non-farm economy as a whole to 2.1 percent. This strong rate of growth in productivity has helped U.S. manufacturers stay competitive. Unit labor costs in the manufacturing sector have grown less than half a percent per year since the end of the recession in 2001. ,A @`ۭC| 1@<}  <}?<}HHwwwwww ffffff UUUUUU DDDDDD 333333 """"""<}<} | _ @ @*?`/pOO ?z/?0OP$ O B p O@oPO  /@zp yOP D 0 ``| p /@ OP @ Qp*L0__|`@,+AOP,+6P,+6P,+6P,+6P,+6P,+6P,+6P,+<"P,+? P,+? P,+? P,+? P,+? P,+? P,+C" P,+I  P,+I  P,+I  P,+T  P,=TO"j`  P==RO  P<*H,O\&O  P,*]|`  P,*]O  P, *R  P,*R  P,*R  P,*R  `,*X  `,*X  P,*X  P,*X  P,*X  P,*X  P,*X  P,*`fa 0P,*a  0P,*q:    P,*q\   P,*y" [   P,*z-͐[   P,*z+[ 0 P,*?@+[ 0 P,*Aj`"+[   P,*C+[   P,*vODOwO@/+[   P3OF_|`+[   P333OA+[    P333@+[   P333`+[   P333`+[   @333`+[  3?333f`+[  3?3?33D3 `+[  3?3?3333 `+[  3?3?3333 `+[  3?3?3333 `+[ 3?3?3?333 `+[ 3?3?3?33 `+[ 3?3?3?3 `+l 3?3 `,l  3 `MZ  DO3  `*Z 3?3 `*Z  `*Z  `*Z ?@ `*Z Dj` `*Z 3?FO/ p*Z 3?OFOOFO+ `*Z OD|`+@`*Z O@+ `*Z + `*Z " + `*[+ `.-+ ++&fa+\+[+ [=[=[+[[[[[m]j`O/_|`j`dd|`d k&@ pbR34@&@  pbDBC!F $|O|1L,/|1L,Ppϡ p@/1L9Ls?$ B @ p@ 2L9I?%Z3A r@HjTALRzĬD Dq@Dl|@%O@p)8jEBjAzĬB $`/ ,$\"@I>@VII. - Significant Consequences if Recent Trends Continue ,A @`ۭC?@?h@ Three main inputs are used to create a nation's wealth. The first input is a nation's stock of knowledge. R&D is the major ingredient for the growth of that knowledge. The second is its stock of tangible, physical assets such as structures and equipment. The third is its human capital - the nation's labor force and its level of training and education. Productivity links those inputs to output. Changes in the quantity of each input used and in its productivity determine the level of output. Manufacturing is a major producer and user of each of these three endowments. It creates knowledge by performing close to one-half of U.S. R&D. And it uses the R&D to create new products and productivity-raising processes. Its strong productivity performance significantly increases the output potential of the country. Manufacturing also produces and uses physical assets. Its ability to innovate and incorporate new ideas into manufactured equipment provides productivity gains to the workers in all the industries that use them. Manufacturers, as one of the major purchasers of equipment, are one of the major beneficiaries of those productivity gains. Since the end of the recession, labor productivity in manufacturing has grown at an annual rate of 5.5 percent per year, a major contributor to the 3.3 percent pace for the non-farm economy overall. This performance is the key basis of the U.S. competitiveness with other countries. Those improved, cost-competitive goods are sought by others and drive increases in U.S. high-tech exports. Last but not least, manufacturing provides job opportunities for two major components of the U.S. labor supply - production workers and scientists and engineers. It provides good wages and training to production workers and can foster stimulating work environments for its scientists. By this process, manufacturing has added to the nation's stock of human capital. Lately, the United States has not been building human capital as quickly as it once did.94 One of the worrisome aspects of that trend is that the quality of our primary education has slipped relative to other countries and that gives our students a poor base on which to build the highly proficient and skilled labor force the United States will need. In the previous section, recent trends in R&D, capital investment and labor demand were presented. In this section, the risks to the U.S. economy posed by developments in these three areas are discussed. ,A @`ۭ$ADhۭC?SySIX@A.- R&D and Innovation Are Threatened,A @`ۭCSTZ@A.- R&D and Innovation Are Threatened ,A @`ۭA@ۭCTYTT'*@ In his book, The Free-Market Innovation Machine, William Baumol discusses the "three critical features of innovation that can, so to speak, magnify the contribution of technical change to the economy's GDP." 95 Those are: 1) the cumulative character of many innovations - called innovation breeding, where one new idea suggests another new idea; 2) the public-good property of innovation - often thought of as a spillover effect; and 3) the accelerator feature of innovation - the process whereby innovation produces productivity gains that allow the economy to grow at a faster pace. His analysis leads to the conclusion that any decline in innovation bodes ill for the continued growth of the U.S. economy. Weakening R&D investment and/or a lack of skilled R&D workers would threaten the pace of innovation in the United States. As discussed earlier, service sector R&D is unlikely to grow quickly enough to supplant manufacturing sector R&D partly because there are only a few areas of the service sector that are conducive to the types of R&D that drive major, economy-wide changes. The R&D intensity of services overall is relatively low because only a few sectors invest heavily. The intensity of R&D in the sectors that do extensive R&D, such as software, tend to be as high as it is in the sectors of manufacturing that are heavily focused on R&D, as much as 15-20 percent of sales in some years. However, large service sectors such as construction, finance, utilities and broadcasting spend less than 1.5 percent of sales on R&D. Further, as the OECD points out, service sector firms tend to be licensees of innovation rather than producers.96 Industrialization and a growing overseas manufacturing base are providing other global centers with the critical mass necessary to promote R&D growth. At the same time, the challenges faced by the U.S. manufacturing base, the traditional center of R&D strength, threatens to reduce the mass critical for the continued innovation process here in the United States. If concentrated centers of R&D are lost, the spillovers and growth derived from that innovative activity is lost. As this happens, a decline in the U.S. longterm economic growth rate is all but assured. Manufacturers' decisions to invest in R&D in the United States require a positive outlook about the industry. If the outlook is an encouraging one, the next issue is the availability of funding. The ability to fund new R&D spending comes largely from the profits that a company can plow back into its business. Thus, the available cash flow of manufacturing firms is closely linked to their ability to perform R&D work as well as make capital investments. Cash flow is driven by profits and depreciation charges. While manufacturing profits are cyclical, they are strengthened by strong productivity, a necessary ingredient. Depreciation charges are more stable over time but can be influenced by tax policy. Two other factors, longer term in nature, also temper private R&D spending. The first is the inability of producers to recover the fruits of all of their spending through the prices they charge for their innovations.97 It is widely agreed that firms doing R&D do not capture all or even most of their investment through the price mechanism. The existence of these essentially "free" spillovers means the social return from R&D exceeds the private return. That can lead to reluctance by firms to undertake some higher risk projects. The second circumstance of social returns being greater than private returns is related to the scope of the benefits from R&D. A single firm is unlikely to use the full scope of possibilities from innovations resulting from its R&D. This may be increasingly true as firms focus on producing results from their R&D that will primarily benefit their core businesses. A recent Booz, Allen, Hamilton study posits that while a company can suffer from too little R&D it may also be possible for it to spend too much on R&D. "These findings seem to suggest that at any given time there's only so much research that a company can nurture and commercialize. Beyond that, the company provides a public service - value to society perhaps, but not to its shareholders."98 While this philosophy promotes businesses using the best practices to make the most productive use of their R&D budgets, it could also result in a reduction of positive spillovers from R&D. In both the United States and other OECD countries government policies encourage R&D through direct funding of research and indirectly - largely through tax credits. Such tax relief is not only helpful but justifiable in recognition of the instances described above where social returns to R&D are higher than the private returns. While the amount of the tax credits that companies receive has been a very small part of their total cost of R&D, the credits should be continued to generate the broader social gains produced from the spillover effects of R&D. ,A @`ۭdA8p ۭCU!||Q@B.- Capital Investment, the Multiplier and Economic Growth Weaken,A @`ۭC}}@B.- Capital Investment, the Multiplier and Economic Growth Weaken ,A @`ۭA@ۭC}~~q@ As noted earlier, every dollar of manufacturing production for final sales stimulates an additional $1.37 in output once its impact has pervaded the economy. Manufacturing creates and consumes capital goods. It is a capital-intensive industry, as reflected by its high capital-to-labor ratio. Thus manufacturing has a positive effect on economic growth through the demand for intermediate goods and on final demand for capital investment. If the manufacturing share of output contracts, other things equal, its contribution to overall national stimulus will diminish. It also would cause the U.S. economy as a whole to become less capital intensive. Since capital deepening is an important source of labor productivity, that would have negative consequences for productivity gains. There are two ways such a loss could be offset: One is if manufacturing increases its capital intensity - the amount of capital it uses per unit of output - or the service sector makes up the slack by growing faster and/or increasing the capital intensity of its own production. Clearly those processes will offset the effect of the decline in manufacturer's share of output, but the extent of the offset is problematic. Thus any contraction in the manufacturing share of GDP can not be taken lightly. C. Well-Paying Jobs Will Continue To Be Lost Manufacturing jobs are always lost during recessions. However, during past recoveries, the number of jobs has generally grown. As Chart 8 showed, this expansion has not been like any other expansion. Job losses in manufacturing have continued and more downsizing has been announced by manufacturing firms. While the stellar productivity growth in manufacturing has partially offset that impact on the economy, it has still caused a painful readjustment in the structure of the U.S. labor force. One aspect of this rapid decline in manufacturing employment is the focus by manufacturers on core businesses. Business units outside those core areas of competence are spun off or closed, some become separate domestic firms (not all of them in the manufacturing sector) and others move to foreign locations, or the work is outsourced to a foreign firm.99 This "hollowing out" of industry can have significant impacts beyond the job losses. The movement overseas of manufacturers affects the entire industrial network. As manufacturers relocate overseas, suppliers all the way up the supply chain must evaluate such options as well. ,A @`ۭC~a@ This should be of concern to those who argue that good non-production jobs will replace lost manufacturing jobs. An alternative (and more plausible) scenario is that the resulting change in job mix will result in a lower overall real wage level for U.S. workers. The data discussed earlier, on the lowered wages of re-employed displaced workers across all industries, point in that direction. D. The Challenge to the U.S. Econom yFigure 1 (page 4) depicts the innovation process and how a vibrant domestic manufacturing sector makes its significant contributions to U.S. growth and standard of living. The chain of adverse results from a contraction of the manufacturing sector starts with a reduction in R&D spending. Since service R&D is not structured to pick up the slack, total R&D declines, which it has already begun to do when measured in real terms. Such weakness would also reduce the number of spillovers that generate their own innovative activities. The decline in the pace or absolute level of U.S. innovation weakens a major driver of the U.S. economy - capital spending - which itself is driven by innovation. Not only would that put productivity growth at risk but the production of capital goods would increasingly shift abroad, creating greater incentive for expanded R&D spending there. At a minimum, the extent of U.S. leadership in innovation will diminish as ever more countries devote a larger share of their GDP to such spending. Any contraction of the manufacturing base will also impact the U.S. labor market structure. Well-paid manufacturing jobs, as well as even better paid jobs in science and engineering will be harder to find. That will decrease the education and training manufacturers conduct for their production workforce. It will serve as an inducement for more foreign-born, U.S.-educated science and engineering students to return to their home countries and prompt some of our engineers and scientists to seek employment abroad, particularly in countries where English speakers are in short supply. This scenario, a quite credible one in our view, describes perhaps the most daunting challenge to the U.S. economy and U.S. economic policy we have yet encountered. Yet, to the extent that there is a parallel between current global competition and conditions of the early 20th century there could be a cause for some optimism. Then a progressive economic policy staunched some of the fears and laid the groundwork for our successes later in that century.100 ,A @`ۭ$A' ۭCY@ ,A @`ۭCh@VIII. - Conclusions - Promote U.S. Production,A @`ۭC!j@VIII. - Conclusions - Promote U.S. Production ,A @`ۭA@ۭCqA( @ The issues addressed in the paper concern economic growth, investment, exports, productivity, research and development, and well-paying jobs. All are related because they are "production" driven. Higher and faster growing U.S. production would impact all of these areas of concern in a positive way. If the United States is to have an economic policy, it should be one that focuses on and stimulates those factors that will make U.S.- based production a viable and profitable business choice. Currently the U.S. economy and economic policy are consumption oriented. That stance is justified, not incorrectly, on the role of consumption in stimulating production. But there is growing realization that the production so stimulated will not necessarily take place in the United States. Thus the emphasis of U.S. policy must be placed directly on accelerating production here. This emphasis should induce the productivity-enhancing investment essential to increasing competitiveness and raising the U.S. standard of living. That emphasis will not hurt consumption because the cause and effect goes in both directions. Our argument here is simply that it will be more effective to emphasize stimulating consumption through production rather than the other way around. This difference on emphasis is vital. Many readers may ask if this emphasis on production is not merely another way to pose the need for saving and investment. If so, why not emphasize saving? The reason is that the relationship between savings/investment and production is translucent at best. And, because of their nature, savings and investment policies do not assure production here in the United States if other factors that directly support U.S.-based production are not in place. The elevation of the banner "U.S. Production" as the objective of our economic policy puts the emphasis where it is needed. Many pro-production policies, perhaps the most effective ones, do not require agreement with foreign countries to take effect. There is a wide scope for unilateral action by the United States. Pro-production policy need not be implemented by reversing any policies beneficial to consumption, investment and saving. Successful pro-production policies will cause consumption, savings and investment activity to fall into place as well. Promoting production here need not restrict U.S. direct investment broad. Producing abroad has clear advantages for some products, for some services, for some markets and for some host countries. The emphasis on U.S. production should focus on the margin at which the United States could be competitive and on insuring a thorough consideration by U.S. and foreign firms of investments here and on the development of new products uniquely appropriate for U.S. production. The United States cannot become complacent based on its historic central role in the world economy. All of its economic players must be at the top of their game to maintain the U.S. standard of living. What types of policies promise the most direct positive impacts on the innovative process and the U.S. production that drives that process? o U.S. manufacturers' productivity growth is enviable. It must remain so. But productivity growth depends on investment in knowledge and investment in equipment that embodies new innovations. o Along with increasing efforts to improve K-12 education, a special emphasis should be placed on improving the quality and rigor of math and science offerings at all levels. The problem-solving and critical-thinking skills those subjects teach will be vital for the U.S. workforce to compete in a global economy. o Support continued R&D investment by industry by renewing the R&D tax credit. Increase Federal spending on basic research with a focus on specific areas where social and private returns look most promising. Encourage and continue to fund basic research by colleges and universities and the spillovers that come from such research. But the "D" in R&D - largely product and process development - should be emphasized as well. Promote innovation clusters needed to spur such developments, to encourage thick markets for R&D inputs and to increase the productivity of each dollar of R&D spending. o "U.S. Production" should encourage workers to continuously pursue education and lifetime training so that they are more adaptable to improvements from innovation and to potential structural changes. New labor force entrants should be encouraged to take up the skilled jobs in which shortages are emerging and top engineering and scientific talent should be nurtured. o Focus on elimination of those workforce, investment and policy obstacles to domestic production and competitiveness that would provide the greatest economic return. o Encourage the improvement of the efficiency and speed of the U.S. transportation and communication infrastructures. o Improve tax and intellectual property laws and infrastructure needed to leverage investment in research and development by enhancing the environment for spillovers without needlessly facilitating technology transfers. ,A @`ۭCйF@IX. - Suggested Bibliography,A @`ۭCID@IX. Suggested Bibliography ,A @`ۭAh@ۭCё .@ Abdi, Tahir. "Machinery & Equipment Investment and Growth: Evidence from the Canadian Manufacturing Sector," Canadian Department of Finance Working Paper, 2004-4. The American Electronic Association. "Losing the Competitive Advantage? The Challenge for Science and Technology in the United States," February 2005. The Association for Manufacturing Technology. "Producing Prosperity - Manufacturing Technology's Unmeasured Role in Economic Expansion," September 2000. Audretsch, David and M. Feldman. "R&D Spillovers and the Geography of Innovation and Production," American Economic Review, Vol. 86, No. 3, 1996. Baumol, William. The Free-Market Innovation Machine, Princeton University Press, Princeton, N.J., 2002. Bloch, Erich, E. David, F. Press and F. Rhodes. "The Competitiveness of U.S. Research Universities," April 9, 2003. Branstetter, Lee. "Is Foreign Direct Investment a Channel of Knowledge Spillovers? Evidence from Japan's FDI in the United States," Columbia Business School working paper, June 2005. Broda, Christian and D. Weinstein. "Are We Underestimating the Gains from Globalization for the United States?" Current Issues in Economics and Finance, Federal Reserve Bank of New York, April 2005. Deloitte Research. "Mastering Innovation: Exploiting Ideas for Profitable Growth," 2005. Deloitte, National Association of Manufacturers, The Manufacturing Institute, "2005 Skills Gap Report - A Survey of the American Manufacturing Workforce," December 2005. DeLong, Brandford and L. Summers. "Equipment Investment and Economic Growth," Brookings Papers on Economic Activity, Fall 1992. Estevao, Marcello. "Why is Productivity Growth in the Euro Area So Sluggish?" International Monetary Fund Working Paper WP/04/200, October 2004. Freeman, Richard. "Does Globalization of the Scientific/Engineering Workforce Threaten U.S. Economic Leadership?" National Bureau of Economic Research Working Paper No. 11457, June 2005. Gallaher, Michael, A. Link and J. Petrusa. "Measuring Service-Sector Research and Development," Report for the National Science Foundation and the National Institute of Standards and Technology, March 2005. Jaffee, Adam, M. Trajtenberg, and R. Henderson. "Geographic Localization of Knowledge Spillovers as Evidenced by Patent Citations," Quarterly Journal of Economics, Vol. 108, No. 3, 1993. Jaruzelski, Barry, K. Dehoff and R. Bordia. "The Booz Allen Hamilton Global Innovation 1000: Money Isn't Everything," Strategy + Business, Booz Allen Hamilton, Inc., Winter 2005 Joel Popkin and Company. "Securing America's Future: The Case for a Strong Manufacturing Base," Council of Manufacturing Associations of the National Association of Manufacturer's white paper, June 2003. Jorgenson, Dale, M. Ho and K. Stiroh. "Will the U.S. Productivity Resurgence Continue?" Current Issues in Economics and Finance, Federal Reserve Bank of New York, December 2004. Leonard, Jeremy. "The Profit Squeeze for U.S. Manufacturers: A Close Look at Five Major Industries," The Manufacturing Institute of the National Association of Manufacturers, October 2005. McNeil, Lawrence and B. Fraumeni. "International Trade and Economic Growth: A Possible Methodology for Estimating Cross-Border R&D Spillovers." Paper presented at the NBER Productivity Meeting, March 4, 2005. Meckstroth, Daniel. "The Dynamics of the U.S. Manufacturing Sector: The Churn of Firms and Jobs," Speech to the National Economists Club, May 26, 2005. Moris, Francisco. "The U.S. Research and Experimentation Tax Credit in the 1990s," Info Brief, National Science Foundation, July 2005. National Science Foundation. National Patterns of Research and Development 2003, NSF05-308, Arlington Va., February 2005. Organisation for Economic Co-operation and Development. Science, Technology and Industry Scoreboard 2005, October 2005. Orlando, Michael. "Measuring Spillovers from Industrial R&D: On the Importance of Geographic and Technological Proximity," RAND Journal of Economics, Vol. 35, No. 4, 2004. Orlando, Michael and M. Verba. "Do Only Big Cities Innovate? Technological Maturity and the Location of Innovation," Federal Reserve Bank of Kansas City Economic Review, Vol. 90, No. 2, Second Quarter 2005. Porter, Michael. "Clusters of Innovation: Regional Foundations of U.S. Competitiveness," Council on Competitiveness, 2001. Pillsbury, Michael. "China's Progress in Technological Competitiveness: The Need for a New Assessment," Prepared for the U.S. China Economic and Security Review Commission, April 2003. President's Council of Advisors on Science and Technology. "Sustaining the a Nation's Innovation Ecosystems," January 2004. Prestowitz, Clyde. Three Billion New Capitalists: The Great Shift of Wealth and Power to the East, Basic Books, Cambridge, Mass., 2005. Roberts, Paul Craig. "The Harsh Truth About Outsourcing," BusinessWeek, March 22, 2004. Samuelson, Paul. "Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization," Journal of Economic Perspectives, Vol. 18, No. 3, Summer 2004. Tassey, Gregory. "R&D and Long-Term Competitiveness: Manufacturing's Central Role in a Knowledge-Based Economy," National Institute of Standards and Technology, February 2002. Tyson, Laura. "Those Manufacturing Myths," BusinessWeek, December 12, 2005. United Kingdom Department of Trade and Industry. "2005 R&D Scoreboard," October 2005. Vinas, Tonya. "Skilled Worker Shortage: It's Time to Fix the Kitchen Sink," IndustryWeek, November 1, 2005. Wolfe, Raymond. "Increase in U.S. Industrial R&D Expenditures Reported for 2003 Makes Up for Earlier Decline," Info Brief, National Science Foundation, December 2005. World Trade Organization. International Trade Statistics 2005, October 2005. Wyckoff, Andrew and M. Schaaper. "The Changing Dynamics of the Global Market for the Highly Skilled," Paper for National Academy of Science Advancing Knowledge and the Knowledge-Economy Conference, January 2005. ,A @`ۭCA@ ,A @`ۭCYi*@X. - Footnotes,A @`ۭC,@X. - Footnotes ,A @`ۭA8@ۭC)Y@ ,A @`ۭCj@1 The peak and trough months used as end points for measurements in this paper are determined by the National Bureau of Economic Research's Business Cycle Dating Committee. It identifies peak and trough months based on a few selected measures of economic activity for the whole economy; thus, manufacturing's experience may not match these dates. That Committee has determined that the peak of the last expansion, and thus the start of the most current recession, was in March 2001 and the trough was in November 2001. That trough marks the start of the current expansion. However, the peak in manufacturing activity was certainly earlier than March 2001 and its trough later. 2 That is, the increase in the Federal Reserve Board's Industrial Production Index for manufacturing from December 2001 through December 2005. This is based on manufacturing output as defined by the North American Industrial Classification System (NAICS) back through 1975 and manufacturing output as defined by the Standard Industrial Classification System (SIC) for the 1960s expansion. ,A @`ۭC H@3 Mastering Innovation Exploiting Ideas for Profitable Growth," Deloitte Research, 2005. 4 "The Competitiveness of U.S. Research Universities," a recent study by the Washington Advisory Group offers the following definitions of the R&D taxonomy on page iv: * R&D refers to both the conduct of research and development as well as R&D facilities. R&D is performed for the purpose of "increasing the stock of knowledge, including knowledge about humanity, culture and society." * Research is systematic study directed toward fuller scientific knowledge or understanding of the subject studied. The federal government categorizes research as either basic or applied according to the nature of the work and the outcomes. * In basic research, the objective is to gain fuller knowledge or understanding of the fundamental aspects of phenomena and of observable facts. * In applied research, the objective is to gain knowledge or understanding necessary to determine the means by which a recognized and specific need may be met. * Development is the systematic application of knowledge or understanding directed toward the production of materials, devices and systems or methods, including design, development and improvement of prototypes of new processes to meet specific requirements. ,A @`ۭ$A TۭC I@ ,A @`ۭCr@5 "Increase in U.S. Industrial R&D Expenditures Reported for 2003 Makes Up for Earlier Decline," by Raymond Wolfe, Info Brief, National Science Foundation, December 2005. 6 As will be explained later in the paper, this somewhat underestimates the R&D connected with the manufacturing sector. Firms classified in wholesale and retail trade perform an additional $20-25 billion of R&D related to their manufacturing establishments. ,A @`ۭCY@ ,A @`ۭC@7 "R&D and Long-Term Competitiveness: Manufacturing's Central Role in a Knowledge-Based Economy," by Gregory Tassey, National Institute of Standards and Technology, February 2002, p. 9. 8 "The Importance of 'Spillovers' in the Policy Mission of the Advanced Technology Program," by Adam B. Jaffe, Journal of Technology Transfer, Vol. 23 (2), pp. 11-19. ,A @`ۭC\@9 "Producing Prosperity - Manufacturing Technology's Unmeasured Role in Economic Expansion," The Association for Manufacturing Technology, September 2000, pp. 13-14. ,A @`ۭCy@ ,A @`ۭC@10 "Measuring spillovers from industrial R&D: On the importance of geographic and technological proximity," by Michael J. Orlando, The RAND Journal of Economics, 35(4), Winter 2004. 11 "Does Locale Affect R&D Productivity? The Case of Pharmaceuticals," by Margaret Kyle, Federal Reserve Bank of San Francisco Economic Letter, November 2004. 12 The author hypothesizes that this result may be for one of two reasons. First, published research by a competitor may signal a firm that they are too far behind in a certain area and cause that firm to withdraw its efforts from that area. Second, the author speculates that spillovers may require collaboration between researchers and that is less likely to happen between competitors. 13 Sustaining the Nation's Innovation Ecosystems, Report of the President's Council of Advisors on Science and Technology, January 2004. ,A @`ۭC &@ ,A @`ۭC'A'Q@14 "Honda on R&D To Keep Creative Edge," The New York Times, April 3, 2005. 15 "Clusters of Innovation: Regional Foundations of U.S. Competitiveness," by Michael E. Porter, Council on Competitiveness, 2001, pp. x-xv. ,A @`ۭC')a@ ,A @`ۭC))@16 "Is Foreign Direct Investment a Channel of Knowledge Spillovers? Evidence from Japan's FDI in the United States," by Lee Branstetter, working paper, June 2005. 17 "Do Only Big Cities Innovate? Technological Maturity and the Location of Innovation," by Michael Orlando and Michael Verba, Economic Review, Federal Reserve Bank of Kansas City, Volume 90, No. 2, 2005. ,A @`ۭC*,@ ,A @`ۭC-A-Q4@18 "Will the U.S. Productivity Resurgence Continue?" by Dale Jorgenson, Mun Ho and Kevin Stiroh, Current Issues in Economics and Finance, Federal Reserve Bank of New York, December 2004. 19 "Equipment Investment and Economic Growth: How Strong Is the Nexus?" by J. Bradford De Long and Lawrence H. Summers, Brookings Papers on Economic Activity, October 1992. 20 "Machinery & Equipment Investment and Growth: Evidence from the Canadian Manufacturing Sector," by Tahir Abdi, Canadian Department of Finance Working Paper 2004-4. ,A @`ۭ$AXۭC-21@ ,A @`ۭC2A2Q@21 "Why Is Productivity Growth in the Euro Area So Sluggish?" by Marcello M. Esevao, International Monetary Fund Working Paper WP/04/200, International Monetary Fund, October 2004. 22 Investment in Private Equipment and Software by Industry and Private Fixed Investment in Structures (table), Bureau of Economic Analysis, U.S. Department of Commerce. ,A @`ۭC25ix@23 Multipliers are based on current dollar relationships and therefore include the effects of changes in quantities and changes in relative prices between one period and the next. ,A @`ۭC57)@24 This gave rise to the expansion's characterization as a "jobless recovery". ,A @`ۭC7q8!@ ,A @`ۭC8i8yH@25 These decade averages include both recessions and expansions. 26 This calculation is done on a Standard Industrial Classification (SIC) basis because the Federal Reserve calculates the manufacturing index excluding computers, semiconductors and communications equipment using an SIC definition for manufacturing. For the most part, the SIC and NAICS definitions for manufacturing vary by one major industry, publishing. In the SIC definitions that was part of the manufacturing sector, under NAICS it is part of the information sector. ,A @`ۭC8= @ ,A @`ۭC=Q=a@27 While the weakness of the manufacturing sector has been a contributor to this outcome, the productivity of manufacturing capital may have been another factor that has influenced this decline. Between 1992 and 1999 (the last full year before the manufacturing recession began), the productivity of manufacturing capital grew about one percent per year. At the same time, capital productivity for the overall nonfarm economy was virtually unchanged. To the extent manufacturers use their equipment more efficiently than other sectors of the economy, less investment is needed to support their output. ,A @`ۭC=Bq@28 "The Dynamics of the U.S. Manufacturing Sector: The Churn of Firms and Jobs," Speech by Daniel Meckstroth, chief economist of The Manufactures Alliance, to the National Economist Club, May 26, 2005. 29 "Bottleneck Inflation and Growth," by Joel Popkin in The Rising Tide edited by Jerry Jasinowski, John Wiley & Sons, 1998. ,A @`ۭ$A4ۭCBEEa@ ,A @`ۭCEEv@30 "Operations in the United States, by Primary Activity, 1978-2004," U.S. Mine Safety and Health Administration. 31 "Mineral Commodities Summaries 2004," U.S. Geological Survey, p. 5. 32 "Advance Summary: U.S. Crude Oil, Natural Gas, and Natural Gas Liquids Reserves 2004 Annual Report," from the U.S. ,A @`ۭCF)H@33 Federal Reserve Board Industrial Production Database, capacity by stage of process. ,A @`ۭCHI@34 China Statistical Yearbook, 2004, National Bureau of Statistics of China, Tables 6-9 and 6-10. 35 Index of Industrial Production Report, Central Statistical Organisation, Ministry of Statistics and Programme Implementation, July 12, 2005. ,A @`ۭCIK.@35 Index of Industrial Production Report, Central Statistical Organisation, Ministry of Statistics and Programme Implementation, July 12, 2005. ,A @`ۭCL1MaL@ 36 WTO world trade database. ,A @`ۭCMM@ 37 Goods imports equal more than 13 percent of GDP during the first half of 2005, up from about 10.5 percent in 1997. ,A @`ۭCNAOA,@ 38 Advance Technology Products are defined as those in the following areas: biotechnology, life sciences, optoelectronics, information and communications, electronics, flexible manufacturing, advanced materials, aerospace, weapons and nuclear technology. These are areas where the United States has made significant R&D expenditures and where many innovative processes and products are developed. ,A @`ۭCOR @39 Major currencies are defined as the Euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar and Swedish krona. The Federal Reserve Board's "Other Important Trading Partners" index is made up of the currencies of China (including Hong Kong), Mexico, South Korea, Taiwan, Malaysia, Singapore, Brazil, Thailand, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Columbia and Venezuela. 40 Many of the currencies in this index are pegged to the dollar and the exchange rate for those currencies show little month-to-month variation. The other currencies in the index tend to devalue against the dollar. 41 While China bought a relatively small share of U.S. exports, China's total imports have boomed over the past three years, growing 32 percent per year on average, much faster than the nine percent per year increase in U.S. imports. In 2004, China imported $561 billion of merchandise, about one-third of the value of U.S. imports and Hong Kong imported an additional $273 billion of merchandise (although some of those imports are undoubtedly transshipped to other parts of China.) 42 "China Revalues Yuan," CNN, July 21, 2005. 43 China is a major holder of U.S. Treasuries, and as it acquires more dollars through trade it buys more Treasuries. That is a logical outcome when its foreign exchange activities are focused on holding its currency in a strict relationship to the dollar. However, if its foreign exchange activities are more wide ranging (such as using a basket of currencies including the euro, yen and won, as well as the dollar, in its foreign exchange activities) China may decide to hold a larger percentage of its assets in bonds valued in different currencies. ,A @`ۭCS`@44 Part of the growth in the merchandise trade deficit can be attributed to the growing purchases by U.S. "Original Equipment Manufacturers" (OEMs) of foreign-produced parts and components for their products. A measure of this hollowing out of the supply chain can be found in the statistics on "related party trade" - that is, imports to the United States from U.S.-owned foreign affiliates or from foreign companies to their U.S. affiliates. In 2004, the Department of Commerce estimated that $698 billion, or 48 percent of all U.S. merchandise imports, fell under this category of trade. ,A @`ۭCae8@ 45 In a recent article titled "Are We Underestimating the Gains From Globalization for the United States?" Broda and Weinstein posit that U.S. consumers have also seen significant welfare gains from the expanded variety of goods that have become available through international trade. In Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol. 11, No. 4, April 2005. 46 The hypothesis never claimed a country could still hold on to its share of a growing pie. 47 "The Harsh Truth About Outsourcing," by Paul Craig Roberts, BusinessWeek, March 22, 2004. 48 "Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization," by Paul A. Samuelson, Journal of Economic Perspectives, Vol. 18, No. 3, Summer 2004, pp. 135-146. ,A @`ۭCel1@ ,A @`ۭClyl^@49 For some possible scenarios, see Three Billion New Capitalists: The Great Shift of Wealth and Power to the East, Clyde Prestowitz, Basic Books, Cambridge Massachusetts, 2005, p. 193 and "Counting on a Miracle With U.S. Debt," David Wessel, The Wall Street Journal, September 29, 2005, p. A2. ,A @`ۭClo1@50 The number of manufacturing firms declined by about 6.5 percent in recent years. Between 1998 and 2002, the U.S. Census Bureau estimates that the number of U.S. manufacturing companies declined from 318,537 to 297,873. ,A @`ۭCoyqI@ ,A @`ۭCqq@51 The reason for plant closures cannot be identified in these surveys. Consequently, all of these job displacements cannot be linked to outsourcing overseas. However, many of the industries with increasing import penetration shares are also industries in which a large percentage of the job losses are due to plant closures. 52 Displaced Workers Survey, Bureau of Labor Statistics, U.S. Department of Labor. 53 These rates cover workers who lost their jobs due to plant closures, lost shifts or slack work. Consequently, the rates of re-employment among workers whose jobs were lost due to plant closures is undoubtedly somewhat lower than these. 54 Employer Costs for Employee Compensation, Bureau of Labor Statistics, Department of Labor. Benefits are calculated per hour worked and therefore include leave benefits and premium pay as well as insurance and retirement benefits. ,A @`ۭCqx@55 Full-time workers are much more likely to be eligible for benefits than part-time workers in all industries. 56 Employer Costs of Employee Compensation, Bureau of Labor Statistics, U.S. Department of Labor. 57 In 2004, about $.59 cents of the average hourly benefits were related to paid overtime. 58 Current Population Survey, 2004, Bureau of Labor Statistics. ,A @`ۭCy1|)@ ,A @`ۭC|q|@59 "In Search of Skilled Employees for America's Future," by Jerry Jasinowksi, May 24, 2005. ,A @`ۭC|},@ 60 "The 2005 R&D Scoreboard," United Kingdom Department of Trade and Industry, October 2005, p.9. These data are compiled from "company annual reports & accounts" and the lack of such standardized reporting mechanisms in some countries may account for the DTI finding "no evidence of substantial R&D spending in Chinese or Indian companies." 61 Science and Engineering Indicators - 2004, NSF, 2004, Appendix Table 6-5 identifies the four major factors as: 1) National orientation; 2) Socioeconomic Infrastructure; 3) Technological Infrastructure; and 4) Productive Capacity. The United States leads in all but national orientation where it is fourth. ,A @`ۭ$A`ۭC}A@62 "Does Globalization of the Scientific/Engineering Workforce Threaten U.S. Economic Leadership?" by Richard B. Freeman, NBER working paper No. 11457, National Bureau of Economic Research, June 2005, p. 19. 63 Freeman, p. 21. 64 Science, Technology and Industry Scoreboard 2005, Organisation for Economic Co-operation and Development, October 2005. ,A @`ۭCY@ ,A @`ۭCj@65 One reason for China's R&D record is apparent in Chinese manufacturers' responses to a recent survey by IndustryWeek. When asked to identify the focus of their marketing strategy, the second most frequent response was innovation, preceded only by high quality, itself enhanced by innovation. U.S. manufacturers, when asked the same question, put innovation much further down the list (at number seven). "Manufacturers Like Us," IndustryWeek, November 1, 2004. 66 This includes the federally funded research and development centers that are managed by private industry. 67 "Increase in U.S. Industrial R&D Expenditures Reported for 2003 Makes Up for Earlier Decline," Raymond Wolfe, Info Brief, NSF06-305, National Science Foundation, December 2005. 68 There are three reasons why manufacturing-related R&D may not have fallen as sharply as the data indicate. The first is that a substantial portion of funding in the trade sector is actually being done for manufacturers. Companies that manufacture goods do not always show up in these statistics as manufacturers. In some cases, because their workforce is more heavily weighted toward their marketing and sales functions, a company may be classified in the trade sector when its R&D activities are primarily focused on its manufacturing activities. NSF has determined that the bulk of R&D in the trade sector in 2001 reflected research done for the manufacturing part of those firms. Secondly, the publishing sector was removed from the manufacturing sector in 1999 because of the change to the NAICS based industrial classification. While publishing was not a major funder or performer of R&D, its removal from manufacturing does impact the manufacturing share by close to half a percentage point. The third factor is an increase in the amount of R&D done by specialized R&D companies that are classified in the business services sector of the economy. Many of those companies are providing their services to manufacturing businesses. Due to the method by which the statistics are generated, the funding for this R&D does not usually show up as coming from the manufacturing sector even though much of the work seems to be produced for the benefit of that sector. ,A @`ۭ$A!@ۭCi@ ,A @`ۭC@69 The latest data on federal R&D funding indicates that the share of total federal R&D expenditures that are spent on defense have increased from 54 percent in 2000 to 59 percent in 2005. 70 "President's FY2006 Budget Requests Level R&D Funding," by Ronald Meeks, Info Brief, National Science Foundation, October 2005. ,A @`ۭC1@ ,A @`ۭC!@71 In 1990-93, manufacturing (excluding publishing to make it more comparable to a NAICs definition) was paying out more than 26 percent of all corporate dividend payments to shareholders in addition to retaining enough earnings to fund its investment programs. Manufacturing's share of dividend payments declined to 19 percent of the total corporate dividend payments in 2001 but has improved to about 22 percent in 2004. Bureau of Economic Analysis, U.S. Department of Commerce. ,A @`ۭCi9@ ,A @`ۭC@72 In 2003, motor vehicle R&D accounted for about 15 percent of total manufacturing R&D. 73 Annual reports of GM, Ford, Daimler-Chrysler. 74 "Company and other non-federal funds for industrial R&D as a percent of net sales of companies that performed industrial R&D in the United States," Table 27, National Science Foundation, December 2005. ,A @`ۭC@75 "Company and other non-federal funds for industrial R&D as a percent of net sales of companies that performed industrial R&D in the United States," Table 27, National Science Foundation, December 2005. ,A @`ۭCD@77 Digest of Education Statistics, 2004, U.S. Department of Education, Tables 250-252. 78 "Labor Force Characteristics of Foreign Born Workers in 2004," Bureau of Labor Statistics, May 12, 2005. 79 Science and Engineering Indicators, 2004, National Science Foundation, May 2004. ,A @`ۭC)j@80 "Full-time equivalent R&D scientists and engineers in companies that performed industrial R&D in the United States," Table 41, National Science Foundation, December 2005. ,A @`ۭCq@ ,A @`ۭC)9@81 "Going Global U.S. Colleges and Universities Head to Distant Lands, and Approach the Challenge in Remarkable Different Ways," by Elizabeth Gardner, University Business, October 2003. 82 It should be noted that many job opportunities associated with U.S. teaching and research facilities are likely filled from the local labor market. 83 "The Changing Dynamics of the Global Market for the Highly Skilled," by Andrew Wyckoff and Martin Schaaper, OECD, paper prepared for the National Academy of Science's Advancing Knowledge and the Knowledge-Economy Conference, January 2005. ,A @`ۭC!|@84 "China Luring Scholars to Make Universities Great," by Howard French, The New York Times, October 28, 2005. 85 "America Isn't Ready," by Geoffrey Colvin, Fortune, July 25, 2005, p. 72. 86 Science and Engineering Indicators, 2002, National Science Foundation. 87 OECD Science, Technology and Industry Outlook 2004, OECD, 2004, p. 12. 88 "R&D Tax Credits Progressive with Incentives for R&D," Business Voice, CBI, www.cbi.org.uk. ,A @`ۭCi@ ,A @`ۭC1A@89 As of mid January 2006, they had not been reinstituted although Congress was considering a one-year extension of the credits. 90 "The U.S. Research and Experimentation Tax Credit in the 1990s," by Francisco Moris, Info Brief, National Science Foundation, July 2005. 91 BEA data also show that about eight percent of service imports are for U.S. expenditures to license foreign intellectual property. 92 "U.S. Patent Statistics, Calendar Years 1963-2004," U.S. Patent and Trademark Office, May 2005. ,A @`ۭC@93 "Patenting by Organization, 2004," U.S. Patent and Trademark Office, p. B1-1. ,A @`ۭC@94 "America Isn't Ready: Here's What to Do About It," by Geoffrey Colvin, Fortune, July 25, 2005, p. 72. 95 The Free-Market Innovation Machine, by William Baumol, Princeton University Press, 2002, p. 51. ,A @`ۭCL@96 OECD Science, Technology and Industry Outlook, OECD, page 15. 97 "The Search for R&D Spillovers," Zvi Griliches, NBER Working Paper No. 3768, July 1991. ,A @`ۭC!f@98 "The Booz Allen Hamilton Global Innovation 1000: Money Isn't Everything," by Barry Juaruzelski, Kevin Dehoff and Rakesh, Bordia, Strategy + Business, Winter 2005, p. 9. ,A @`ۭCi@ 99 The number of jobs literally moved overseas by U.S. manufacturers appears to be small. BEA's data on multinational companies show that employment by manufacturing parent firms has declined by about 480,000 or 6 percent between 2001 and 2003. However, employment of those firms' majority-owned affiliates has declined as well, by about 48,000 or one percent. Employment in majority-owned affiliates in China and Hong Kong have increased by about 38,000 but at the same time employment in India, the rest of Asia and Latin America has declined. The data only measure the employment in affiliates of the U.S parent and do not measure employment changes that take place by contracting the work to a non-affiliated entity. ,A @`ۭ$A |ۭC@ ,A @`ۭCAQ@100 "The Era To Bring Back," by Joel Kotkin, The Washington Post, October 9, 2005, p. B1. ,A @`ۭAl`ۭCęő@ ,A @`ۭC (@Copyright 2006 by Joel Popkin, Kathryn Kobe, The Manufacturing Institute and Council of Manufacturing Associations. 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