The Butterfly Effect: Only 3% Of What You Buy Is Made In China, But It’s The Most Important 3%

(Originally published at FastCompany.com on August 16, 2011.)

Resolved: “This house believes that an economy cannot succeed without a big manufacturing base.” This was the statement in question at an online debate between economist Ha-Joon Chang and Jagdish Bhagwati, hosted by The Economist last month. Chang, a student of industrial policy, defended the motion, while Bhagwati, an arch free trader, countered with dismissals of what he called the “manufacturing fetish.” Where does a nation’s prosperity come from, Chang asked rhetorically. “It has ultimately to come from productivity growth, which is faster in manufacturing, so a weaker manufacturing base means slower growth.” The debate wasn’t close—Chang carried the day with three-quarters of anxious readers’ votes. And the readers may have been right. As America has stopped manufacturing goods, it’s also sacrificed more than just simple, low-wage jobs. It’s sacrificed the know-how to think of new ways of manufacturing goods.

Whether causality or merely correlation, history proves Chang right. American manufacturing employment was indeed stagnant throughout much of what the economist Tyler Cowen calls “the Great Stagnation,” the current period from 1973 onward, in which productivity did not rise quickly (in some sectors, it even fell). During the same period, America’s median household income grew less than 25 percent after doubling in the era following World War II. And then, right around the peak of the dotcom boom, the U.S. began to shed a third of its manufacturing jobs—which The Atlantic’s Don Peck sees as a contributing factor in the culling of the American middle class. We know where those jobs went, right? China.

Not quite. In a much-discussed report last week, San Francisco Federal Reserve economists Galina Hale and Bart Hobijn pointed out that goods labeled “Made in China” make up only 2.7 percent of U.S. consumption. And less than half of the money spent on those products reflected the costs of the actual goods (the rest went to Americans for marketing and logistics). By and large, Americans already buy American. In fact, two-thirds of our consumer spending is on services rather than goods, which are 96 percent made in the U.S. Hale and Hobjin created the chart to make a point about inflation—pay no attention to rising Chinese wages, as they’ll have little or no effect on the prices of American goods—but the stats in it raise the question of whether America already has all of the manufacturing jobs it can support. America is still #2 in manufacturing output (behind China), and #3 in agriculture—though that industry employs only 2 percent of Americans. “American manufacturing looks to be heading down the same path,” Peck concludes.

But Chang’s point about manufacturing driving productivity growth isn’t about output or employment, it’s that it makes everything else—services included—possible. Apple’s lofty perch as the world’s second-richest company is direct consequence of this. Say what you want about the brilliance of its stores or its brand or the design of its products, but “in services like engineering and design, insights gained from the production process are crucial,” Chang argued. “Given this, a weakening manufacturing base will eventually lead to a decline in the quality, and exportability, of these services.” Just ask Apple’s lagging competitors in the tablet race. Not one designs its own products in-house, having long-ago outsourced even that task to Taiwanese OEMs. The reason Apple has a media, retail, and service industry empire and they don’t is because it could design an MP3 player, smartphone, and tablet when it needed to—and they couldn’t.

But Apple manufactures nothing of its own, of course, having outsourced most of those duties to Foxconn, another Taiwanese company. Given its separation from its production process, Apple may soon—like its table competitors—lose the ability to design innovative products, while Foxconn gains. This is how Foxconn—which recently announced it would add a million robots to its assembly lines to short-circuit further wage increases—was able to release a $100 knock-off of the iPad, the “iWonder,” a month before its release. (And how China’s counterfeit bandits pump out 250 million cell phones each year.)

The concentration of knowledge, skills, equipment and suppliers that are the key to innovative manufacturing, which, if Chang is right, is in turn the key to a healthy economy, is called the “industrial commons” by Harvard’s Gary Pisano and Willy Shih. The problem, as Pisano and Shih pointed out, is that we gave our industrial commons to China (and Japan, Taiwan, and South Korea) in the course of outsourcing the dull grind of manufacturing. As a result, American companies had simply lost the ability to innovate in field after field, ranging from glass for LCDs and CFLs to advanced ceramics and composites to lithium-ion batteries (one reason why GM chose LG Chem’s for the Chevy Volt).

Worse, America is in serious danger of losing its edge in the cutting-edge technologies many hoped would lift the U.S. out of recession: thin-film solar cells, windmills, and bio-tech. It was true that America had outsourced only a sliver of manufacturing to Asian companies, but it was the sliver that counted.  “New cutting-edge high-tech products often depend in some critical way on the commons of a mature industry,” Pisano and Shih wrote. “Lose that commons, and you lose the opportunity to be the home of the hot new businesses of tomorrow.”

How Taiwan ended up the locus of high-tech manufacturing was no accident. It has as much, if not more, to do with Cold War logic than short-term corporate decision-making. Washington wanted the island to be a “showcase of noncommunist development” just off the coast of Communist China, as the New America Foundation’s Barry Lynn explained in End of the Line.

The United States supplied Taiwan with economic and military aid, rewrote its regulatory framework and trade agreements to promote exports, paid for thousands of Taiwanese engineers to study at American universities, and arranged the transfer of cutting-edge military technologies to Taiwanese firms, all to prevent the breakaway republic from falling into the clutches of Mao. America supplied Taiwan with the makings of an industrial commons when growth seemed limitless. There was a lot more to go around then.