Hamish McRae: Yes, it's services with a smile

What should we do about our two-speed economy?

What should we do about our two-speed economy? There is an immediate policy dilemma facing the Bank of England. Consumption is racing ahead and, in an ideal world, it needs higher interest rates to curb it. Yet manufacturing is in recession and, in a perfect world, it needs lower interest rates to boost it. But of course you cannot have different interest rates in different parts of the country any more than you can have different interest rates in different parts of the eurozone.

Setting interest rates has inevitably to be an unsatisfactory compromise. There has been considerable concern about the disadvantages of the "one size fits all" interest rate in Europe but the same worry persists here: one size does not fit all in any comfortable manner.

So what's to be done? Wring hands? Try to offset the effect by bringing in other policies to support industry? Or accept it and recognise that this sort of pressure is exactly what is needed to make the economy more productive?

The answer is number three. A bit of hand-wringing may be in order because whenever there is strong pressure on part of the economy, good companies and good people will be hurt. There is also a case for finding out if there areregulation or infrastructure problems damaging manufacturing industry that local and central government could do something about.

But ultimately the shift out of manufacturing and into services is a natural and inevitable aspect of countries getting richer. To try to slow the process down would be to slow the creation of wealth.

The graphs show three aspects of this transfer. On the left is the change in employment in the US over the past 30 years. Despite the resurgence of US manufacturing during the Nineties the proportion of people employed has continued to fall and is around 16 per cent of the workforce. The proportion of people in the services industries has correspondingly soared. That 35 per cent figure is on the narrow definition of the US Bureau of Labor Statistics (BLS). On wider definitions, which include the public sector and other service industries separately classified by the BLS, the proportion is double that.

If you look at the proportion of service industries in the GDP in G7 countries (middle graph) there are two striking features. One is that all the lines go up. The other is that, with the exception of Japan, the higher the proportion of services in the economy the higher the GDP per head. The US is at the top, followed by the UK (yes, our GDP per head is now higher than France and Germany, at least in money terms). Then at the bottom comes Italy. Allow for the over-valuation of the yen, now being corrected and maybe even Japan fits in. A correlation does not mean a causal relationship, but the US position in particular surely tells us that rich economies will inevitably have smaller manufacturing sectors. You can even catch a glimpse of this process in the "tigers" of East Asia. Just after the 1996 Asian crash, the IMF produced a chart showing that manufacturing employment in East Asia was falling even before the crash (see right-hand graph). As you can see, the decline was most dramatic in Hong Kong, which for a generation had been outsourcing its manufacturing to the mainland. But Taiwan, South Korea and Singapore were also downsizing their manufacturing workforces from the mid-Eighties onwards. If you are successful at manufacturing your wages go up and you start to price yourself out of the market.

So what are the messages for us? The tough one first: we must assume that manufacturing employment, about 20 per cent of the workforce, will fall to perhaps 10 per cent over the next 20 years. This is inevitable. The proportion of output will not fall as fast as manufacturing productivity will continue to rise. One reason why it will rise is the strong pound: as the US, Germany and Japan all showed in the past, a strong currency forces more efficiency on to the traded portion of the economy. Companies both find ways of using labour more effectively and developing their products so they can justify higher prices.

The encouraging message is the flipside; that we have a comparative advantage in services, so the more we can shift our output in that direction – the faster we are forced to de-industrialise – the richer we will become. How do we know we have a comparative advantage in services? Look at the export figures. In 1999 (I don't yet have the IMF comparable figures for 2000) the UK was the world's fourth biggest exporter of physical goods, with 5.38 per cent of the world market. But it was number two behind the US in exports of services, with 10.46 per cent of the world market. The more international trade moves from shipping goods around to shipping services around, the more this plays to our strengths.

To many people this will seem odd: you often hear people say the manufacturing sector is the wealth-creating part of the economy while the service sector spends that wealth. But that is misleading. Simple example: this newspaper is a manufactured product. If instead you got information and ideas from a TV programme or the net, you would be buying a service. I'm glad you are reading a newspaper because I think that at their best they are wonderful, worthwhile endeavours. But I would have to admit that the newspaper industry, for all its innovative efforts (including the work of this group), is losing market share to newer media.

This may not be any comfort to those in manufacturing who will be losing their jobs. But we do have to recognise that society as a whole benefits from the shift, even if many individuals suffer.