This is my cover story from last week’s Fund Strategy magazine. Note that, since I quote many people, not all opinions included in this article are mine.

In his March 2011 budget speech the chancellor of the Exchequer, George Osborne, put forward a vivid vision of how the British economy could return to growth. The new prosperity would be driven by the manufacturing sector and the export of goods abroad:

“We want the words: ‘Made in Britain’, ‘Created in Britain’, ‘Designed in Britain’ and ‘Invented in Britain’ to drive our nation forward—a Britain carried aloft by the march of the makers. That is how we will create jobs and support families.”

Osborne was echoing a call made by all of Britain’s main political parties since the emergence of the economic crisis in 2007-8. There is a broad consensus that the economy should be rebalanced away from financial services and towards the industrial sector.

That of course is not to contend that services, which account for about 77% of output, should disappear. The idea is that the British economy had become too heavily weighted towards financial services in particular. From this it follows that more emphasis should be placed on rebuilding manufacturing. An industrial renaissance is seen as key to the fortunes of the whole British economy.

Yet the economy has confounded this hope by going in the opposite direction since the crisis started to become apparent in early 2008. According to figures released in April by the Office for National Statistics the service sector was 0.8% above its pre-recession peak. Manufacturing, in contrast, was 10% below its high point.

These figures point to a peculiar paradox. The sector that was meant to lead the recovery is still languishing while the sector in which the crisis emerged has surpassed its previous best. If anything it is the servers who are marching forwards while the makers are in retreat.

Recent trade statistics underline this point. British still has a strong positive balance in its external trade in services. However, this is more than offset by a large deficit of its trade in goods, with no sign of recovery. Overall this leaves Britain with a yawning trade deficit.

This abject failure to bring about a manufacturing revival raises awkward questions about the British economy and its corporate sector. What is the character of the relative decline of manufacturing? Does it matter for the British economy as a whole and for its corporate sector? If so what can be done about it? The rest of this article will examine each question in turn.

Manufacturing decline

Decline is a deceptively slippery concept to pin down. It always begs the question of decline relative to what. There can be decline relative to some measures but increases relative to others. The tricky thing to work out is which metrics matter.

There is no doubt that Britain has suffered a long-term decline in its productive capacity relative to the rest of the world. As far back as 1860, at the height of the Victorian era, Britain accounted for about 20% of global manufacturing output. Today it accounts for a little over 2%.

Although Britain is still the ninth largest manufacturer, which makes it a sizeable player, it was once number one. It is also likely to be overtaken by several emerging economies in the coming years.

This shift away from a leading position does matter in relation to global politics. Historically economic power, particularly industrial might, has been closely tied to military and political influence. It is therefore not surprising that Britain long ago relinquished its record as the world’s pre-eminent power.

However, the particular form of decline does not necessarily matter in relation to economics. On the contrary, the world economy today, including the manufacturing sector, is vastly bigger than it was in the mid-nineteenth century.

Indeed in real terms Britain produces a lot more than it did back in then. It is just that Britain was the first country to industrialise and many have followed its path since. Britain is certainly a far more prosperous place than when it was the workshop of the world and Britannia ruled the waves.

Other forms of relative economic decline are more recent. Manufacturing has fallen sharply as a share both of employment and GDP over the decades.

Perhaps the most striking employment statistics relate to coal mining – strictly speaking not part of manufacturing although classified as industry. According to figures gathered by the National Coal Museum there were over 1.2m coal miners in Britain in 1920. These men were digging out coal with relatively primitive technology to fuel Britain’s manufacturing sector as well as associated areas such as transport. By 2004, in contrast, only 6,000 people were employed in coal mining.

Yet coal digging has become vastly more efficient over that period. Back in 1920 each employee dug up an average of 183 tons of coal compared with 4,500 tons per person in 2004.

There are no doubt several reasons for this shift including the closure of smaller and less efficient pits. But a key factor was the application of technology to make coal mining more efficient. Each individual can be vastly more productive thanks to the introduction of machinery. On top of that are the considerable health and safety benefits of not having to send vast armies of men underground.

This dramatic change points to a broader shift in British industry. It has become much more productive and capital intensive. Where there were once large armies of manual workers at many plants today there are far fewer. The number of people employed in manufacturing fell from about 5.7m in 1981 to 2.5m in 2011. In percentage terms that represents a drop from 22% of the workforce to 8%.

That is a substantial shift but it does not necessarily constitute an economic problem. Production can increase even though the number of employees falls. Indeed this rise in productivity – output per employee or per hour – is central to economic progress.

The shift away from manual work is more significant in social than economic terms. More people are involved in the services sector and far fewer are involved in producing goods. Arguably this change can also be associated with a cultural shift. It helps explain why nowadays people typically view the world from a consumer’s perspective rather than that of a producer. For most people the world of production is distant from their lives.

Another striking area of relative decline is in relation to output. Manufacturing output has fallen from about 25% of the economy in 1980 to 11% today according to World Bank figures. By this measure manufacturing has also become a lot less important relative to the economy as a whole.

The vast majority of British firms are not involved in manufacturing directly. They no doubt use manufactured goods, and perhaps supply manufacturing companies, but they are not goods producers.

It is therefore possible to identify at least three key areas in which British manufacturing has suffered a sharp relative decline. Its share of global output has fallen, far fewer people are employed in the sector and it accounts for a shrinking share of GDP.

These trends are common across the developed world. Britain, once the workshop of the world, has perhaps fallen further than others but it is not unique. Even mighty America does not enjoy the pre-eminence it had not that long ago. In 2010 China became the world’s largest producer of manufactured goods. Although American products were still, on average, more sophisticated the America lost the leading position it had since overtaking Britain to capture industrial pre-eminence.

Does it matter?

This all begs the question of whether the relative decline of the Britain’s manufacturing sector matters. Perhaps it is only the economy as a whole that counts. All the talk of the “march of the makers” might simply be a panic reaction to the financial crisis.

It might even be possible, in principle at least, for Britain to offshore all of its industrial production to the rest of the world. In any case it seems at least debate-able that there is a need for manufacturing to be any particular size.

Such conclusions should not be drawn too readily. Some indicators suggest that manufacturing is more important than its relative share in output and employment suggest. It is more than just another small niche.

For a start, manufacturing itself is fairly narrowly defined. Once production is defined more broadly, to include the likes of mining and infrastructure, its share of the economy becomes larger.

The boundaries between manufacturing can also be blurred. In many cases the division between manufacturing and services is not clear-cut. Rolls Royce, the power systems company, provides a classic example of what are sometimes called manu-services. A large part of its revenues comes from the services it provides as well as spare parts. For instance, it receives payments for engine maintenance and remotely diagnosing problems that occur.

But manufacturing is not just larger in size than the headline figures might suggest. It is also different in character. Typically manufacturing, at least in its modern high technology component, is far more capital intensive than the average services firm.

Despite the relatively small size of the manufacturing sector it accounts for over 70% of spending on business research and development. Manufacturing also accounts for a disproportionate share of trade with about 46% of exports and 55% of imports in 2011.

Splitting the difference

So far this article has talked as if manufacturing is one homogenous sector. Naturally the reality is more complex. It is widely accepted that the sector itself includes diverse types of firms.

Alastair Gunn, a UK equity fund manager at Jupiter, has extensive experience of visiting such firms. In broad terms he distinguishes between advanced engineering companies and firms that are trying to squeeze the most out of old facilities. The former are usually in the quoted sector – including listed companies such as Melrose, Rotork, Spectris and Weir – while the latter are generally privately held.

Gunn says that the manufacturing firms he invests in typically “have pricing power and what they are producing is incredibly valuable for the end customer”. Much of what they do cannot be easily replicated as it demands a high degree of skill and knowledge. Often such firms perform some of the more basic parts of the production process overseas.

Many industrial firms, in contrast, are not in such a fortunate position. “An awful lot of companies in this country are using 25-year old equipment in old buildings,” he says. For such firms, which are often competing with Chinese companies on price, there is little incentive for them to invest. “It does not make sense for them to do anything else as they are living in a world of constantly downward pricing”.

That is not to deny that such operations can be impressive in their own terms. But they are constrained in what they can do. “The live in a world without pricing power,” says Gunn.

The debate about whether sizeable economies always need a manufacturing sector remains to be resolved. But it is certainly the case that the headline figures about output and employment understate its continuing importance. Manufacturing remains an important area for the development of high technology and international trade.

What can be done?

The coalition government, and indeed the Labour opposition too, are keen on initiatives to promote the manufacturing sector. Although the days of “picking winners” have long gone there is a consensus that high technology production should be supported. Whether such initiatives will work is another matter.

This government has made several high profile announcements and launched numerous initiatives to support manufacturing. These include schemes for increasing university support for high technology, promoting training in manufacturing, support for regional growth funds and tax incentives.

Several government-backed bodies play a key role in attempting to promote the manufacturing sector. The Manufacturing Advisory Service, established in 2004, gives expert support to manufacturing firms to help them improves their competitiveness. The Technology Strategy Board, founded in 2007, overseas innovation centres and helps companies improve their supply chains.

However, there is a debate to be had about how much impact such initiatives can have. Many experts put much of the blame for the recent sluggish performance of British manufacturing on a lack of demand. This applies both to domestic demand, where households are clearly stretched, and exports.

From this perspective the weak performance of continental Europe, a key customer for British goods, inevitably caused trouble for exporters. Lucy O’Carroll, the chief economist at Swip, says: “The countries with which we do most of our export trade have been in a state of quite subdued demand since 2008. Giving them more of what we produce has been challenging.”

Azad Zangana, an economist at Schroders, shares this view. It follows, if the argument about demand is right, that a eurozone recovery should boost manufacturing. “Later this year, and certainly next year, we should see better growth coming out of the eurozone,” he says. “That should feed through into better export performance and better numbers for the manufacturing sector in the UK”.

But arguably a dynamic manufacturing sector should be able to prosper even with a poorly performing eurozone. Strong firms should be able to take advantage of rapidly growing emerging economies to find new customers. German firms, for instance, are shifting the balance of their exports away from the region. Three of Germany’s top five export destinations – America, Britain and China – are outside the eurozone.

Swip’s O’Carroll recognises the potential of shifting more towards emerging economies but argues it is a difficult task. “It is not an easy thing to do”, she says. “The challenge was perhaps underestimated.”

Schroder’s Azanga agrees that such a shift is starting to happen. He says success by British exporters to China constitutes a “phenomenal story”.

An alternative, although also complementary, explanation of relative decline is that a structural change is underway. Western firms are retaining the most sophisticated elements of their operations at home while outsourcing routine operations abroad. This can take the form of setting up lower technology manufacturing facilities overseas.

Some companies, including the likes of Apple and Nike, outsource manufacturing to other firms. The American firms are responsible for design and marketing but others generally carry out production.

Such arrangements do not show up clearly in the national trade statistics. If a British firm produces goods overseas they are not counted as British exports.

Low levels of investment are perhaps the final part of the puzzle. Manufacturing investment accounted for only 12% of business investment in 2011 compared with 22% in 1997.

The difficulty here is untangling cause and effect. For Andrew Milligan, the head of global strategy at Standard Life Investments, low investment levels are mainly a response to the low levels of demand.

Even those companies that are performing well are not generally close to full capacity. As a result they have little incentive to invest to increase their output.

Despite the frequent complaints about access to finance it is not generally a problem for sizeable firms. Milligan, who is also an adviser to the TSB, says: “Large companies have no difficulty in accessing finance.”

Britain’s manufacturing sector looks set to become smaller still as its less efficient firms struggle to deal with ever-fiercer competition. The big question is whether its engineering champions can retain their edge against existing players and ambitious newcomers. A tough fight lies ahead.

[BOX] A new industrial revolution?

Except for a handful of seasoned fund managers, few have had such privileged access to manufacturing firms as Peter Marsh. The former manufacturing editor of the Financial Times estimates that in 29 years on the newspaper he visited about 5,000 companies in 30 countries.

He pulled together the results of his research in The New Industrial Revolution, published last year. As an international study covering more than 250 years of industrial history, the book has enormous scope. According to Marsh, the new industrial revolution, which he says started in about 2005, has some defining characteristics:

Technology. The more technology there is in the world the greater the scope for yet more new ideas to emerge. Technological development should be seen as an ongoing process with one breakthrough making future innovations ever more likely.

Choice. For Marsh the new era will be one of “mass personalisation”. While the mass production of the early 20th century was based on standard products the current trend is towards providing enormous variety. Standard components can be combined in numerous ways to provide an almost bewildering range of choices for consumers.

Value chains. Companies will be linked to each other in new and innovative ways. Those firms that are most adept at developing such connections will have an advantage.

Niches. The global scale of production gives more scope than ever for companies that inhabit highly specialised niches.

New manufacturing nations. Connections with China in particular will play a key role in shaping the new industrial landscape.

Clusters. Regional concentrations of expertise will be able to prosper by exploiting global connections.

Not everyone agrees that combining these developments, even if each transpires, will constitute a genuine revolution. James Woudhuysen, professor of forecasting and innovation at De Montfort University, Leicester, points out that the industrial revolutions that occurred after 1750 and in the decades preceding 1914, were made of more substantive and more obviously interlocking innovations. The late nineteenth century department store was revolutionary in that it combined safety lifts, plate glass and electric lighting. It also made the most of the refrigerated railroad car, the telegraph and the mail-order catalogue.

He adds that in the two earlier epochs, society had every confidence in future progress, giving it the will to introduce radical innovations. Today, he says, “that can-do attitude towards the future is notable by its absence”.

Indeed negative attitudes towards industry are widespread. It goes much further than a failure to embrace production. Industry is presented as guzzling scarce resources, generating harmful waste and even threatening the future of the planet. The aspiration to use industrial development to help create a better and more prosperous world is, sadly, lacking.

[BOX] Key sources on manufacturing

Commons Library Standard Note – Manufacturing

Department of Business, Innovation and Skills (Bis)

EEF (formerly the Engineering Employers’ Federation)

Manufacturing Advisory Service (MAS)

Office for National Statistics (ONS )

Technology Strategy Board (TSB)