Last Thursday, an article in The Atlantic argued that despite claims to the contrary, the United States government should subsidize the manufacturing industry. The author argues that the manufacturing industry is the most innovative of all industries and therefore deserves exceptional support from the US taxpayer. The article, however, falsely claims that innovation is the engine of economic growth and fails to give neither a clear explanation of exactly what innovation is nor how the government can increase it.

The author states that innovation is “the force that powers long-term improvements in our standard of living”. He proceeds to claim that the manufacturing industry is the most innovative industry in the U.S. economy. In support, he states that between 2006 and 2008, 22% of all manufacturing firms introduced a new product or service whereas only 8% of non-manufacturing firms introduced new products and services. Hence he deduces, “Because so much less is known about how to innovate in the services sector, an economy that loses its manufacturing base ends up sacrificing much of its ability to innovate at all. The consequence is slower growth in living standards.” [italics added] While I would be interested to know how the author obtained the statistics to compare innovation in manufacturing and non-manufacturing industries, his argument is off-base regardless of the validity of such statistics.

What leads to improvements in living standards?

The first point that needs to be clarified is that innovation, while beneficial to society, is not the force which drives increases in living standards. Rather, saving and investment is the engine which drives economic progress. Living standards can only be improved if individuals decide to put off consumption and thereby allow their resources to be invested into new and improved production processes. This increased saving and investment leads to a superior capital structure in which a greater quality and quantity of goods are able to be produced and enjoyed by people at lower prices.

What role does innovation play?

In the marketplace, entrepreneurs are constantly introducing new products or services which they believe will be highly desired by their fellow man. Innovations succeed when consumers deem the new products worthwhile by demonstrating that they value the products in purchasing them. If the innovations do not satisfy the most highly valued ends of individuals, they will sell poorly and eventually cease to be produced. Entrepreneurs attempt to anticipate what people will value most highly when deciding what to produce. When they introduce new products or services, there is always uncertainty about whether their innovation will be well received or not. In this way, the entrepreneur takes on risk. If he anticipates future demands correctly, he is rewarded with profits for providing goods which are highly valued by others. If not, he incurs losses and is forced to stop production of the new products.

While innovation is a characteristic of a healthy economy, it is not its driving force. The entrepreneur is only able to innovate because resources have been saved and furthermore invested into his production processes. Saving and investment allocates resources to the entrepreneur. Without them, he would not be able to innovate at all. This is an absolutely crucial point which is completely missed by The Atlantic’s article.

Does government subsidization encourage innovation?

The Atlantic article concludes that public policy should support the manufacturing industry because it is especially innovative and pays high wages. But what effect does government subsidization have on innovation? If a firm is subsidized, it is able to rely on a stream of income from the government. This decreases the monetary incentive for a firm to innovate. There is inherent uncertainty in bringing a new product to the marketplace. One cannot perfectly predict how his innovation will be received. If one’s innovation is successful, he will be rewarded with profits. The entrepreneur is not promised these profits, however, and takes on substantial risk in the process of innovating. If the government pledges a certain amount of money to a firm, that firm will have less reason to take the risk involved in innovating. The more the government subsidizes the manufacturing industry, the less inclined manufacturing firms will be to innovate as it becomes less imperative for them to increase their net income.

In summary, here are the critical points to understand which The Atlantic completely overlooks

Savings and investment is the driving force which leads to increased living standards. Entrepreneurs are able to innovate when resources are freed up through the savings and investment of individuals. Innovation is successful to the degree which entrepreneurs are able to accurately anticipate the demands of their fellow man. Government subsidization does not encourage innovation, it discourages innovation.

Sound economic analysis demonstrates that The Atlantic’s argument for government support of the manufacturing industry is based on false premises and therefore untrue. The author puts forth no legitimate reason as to why the government should bestow special privileges on the manufacturing industry instead of allowing the market exchange of individuals to determine the scope of U.S. manufacturing firms.