The services economy: Macroeconomic overview

The services economy: Macroeconomic overview

Phuah Eng Chye (12 August 2017)

The transition to an information society begins with the ascendency of the services sector. As output becomes increasingly intangible, the services sector supplants the manufacturing sector as the main contributor to the economy. The manufacturing sector then hollows out with its share of GDP typically shrinking to below 20%.

While it is widely accepted that the shift to services is an inevitable aspect of economic maturity, nonetheless there is considerable pushback against the loss of manufacturing activities. Binyamin Appelbaum observes “manufacturing retains its powerful hold on the American imagination for good reason. In the years after World War II, factory work created a broadly shared prosperity that helped make the American middle class. People without college degrees could buy a home, raise a family, buy a station wagon, take some nice vacations. It makes perfect sense that voters would want to return to those times.”

Considerable blame is often placed on globalisation in enabling firms to re-locate jobs from high to low-cost locations. The migration of jobs overseas has been blamed for causing the middle class to shrink and for wage stagnation. Hence, “American presidential candidates spent the better part of the 20th century promising to help family farmers in the face of urbanization. Now they promise to help factory workers in the face of globalization…Politicians of all persuasions have tried to turn back time through a wide range of programs best summarized as “throwing money at factory owners.” “They offer tax credits and other incentives; some towns even build whole industrial parks, at taxpayer expense, so they can offer free space for manufacturers. By and large, those strategies haven’t helped.”

But Binyamin Appelbaum suggests that “from an economic perspective, however, there can be no revival of American manufacturing, because there has been no collapse. Because of automation, there are far fewer jobs in factories. But the value of stuff made in America reached a record high in the first quarter of 2016, even after adjusting for inflation. The present moment, in other words, is the most productive in the nation’s history.”

Therefore, once economies achieve high levels of physical output, it is followed by a services phase whereby more sophisticated use of information increases dramatically the proportion of intangibles in the value of economic activities. This results in a contraction in the manufacturing share of income and employment even as physical output expands. The expansion of the services sector represents the initial phase of the transition to an information society.

I would like to highlight two interesting macroeconomic relationships accompanying the rise of the services sector. The first is the interesting dynamics between service sector growth, service costs, stagnating wages, inequality and fiscal policy that shapes an anorexic economy. The second are the important linkages between service sector growth, savings, debt and asset prices which are related to the emergence of the financialised economy.

On the first observation, services sector growth is typically driven by higher expenditures on healthcare, education, transport, housing, telecommunication and finance. Scott Alexander noted in the US, even after adjusting for inflation, “in the past fifty years, education costs have doubled, college costs have dectupled, health insurance costs have dectupled, subway costs have at least dectupled, and housing costs have increased by about fifty percent.”

The sharp rise in service costs can also be contrasted with the benign environment for inflation as proxied by the Consumer Price Index (CPI). It is interesting to understand why services such as infrastructure (network, transportation), social (education, health) and wealth (property) have been able to muster pricing power when the overall pricing environment for manufactured goods is weak.

The differing behaviours of service costs and manufacturing costs have revived interest in Baumol’s cost disease. In 1966, William J. Baumol and William G. Bowen made their famous observation that the playing time for four musicians to perform a Beethoven string quartet would always be unchanged. They noted that the limited scope for reducing labour in labour-intensive service industries such as the performing arts resulted in a “productivity lag” where wages would rise in line with other industries despite the absence of productivity gains.

In a later book[1], William J. Baumol explored the implications[2] of the cost disease. Production efficiencies would lower costs in manufacturing whereas costs in the low-productivity services sector would continue to rise. The outcome is that the GDP share of service sector would rise at the expense of the manufacturing sector. He extrapolated US healthcare expenditures, about 5% of GDP in 1960 and almost 18% in 2011, could reach about 60% in roughly a hundred years.

Scott Alexander points out rising service costs “is especially strange because we expect that improving technology and globalization ought to cut costs.” Despite the technological efficiencies, use of cheaper immigrant labour and outsourcing, “all of this costs ten times as much as it did in the days of punch cards and secretaries who did calculations by hand.” While service costs have risen, wages have stagnated. Many of the new jobs created in the service sector wages tend to be low-paying. The widening differential between rising service costs and stagnating wages undermines the validity of Baumol’s cost disease.

A competing hypothesis to explain rising service costs argues that as society becomes more affluent, the price of services increasingly becomes demand-driven. In this regard, Bowen’s law[3] suggests higher education institutions raise and spend as much money as possible to pursue excellence, prestige, and influence.

Scott Alexander observes “where colleges expect people will pay whatever price they set, so they set a very high price and then use the money for cool things and increasing their own prestige…hospitals have switched from many-people-all-in-a-big-ward to private rooms…It’s almost as if industries have their own reasons for switching to more-bells-and-whistles services that people don’t necessarily want, and consumers just go along with it because for some reason they’re not exercising choice the same as they would in other markets.” He adds complexity also pushes institutions to “add extra layers of administration and expense not because they’re forced to, but because they fear being sued if they don’t and then something goes wrong.”

Hence, there are considerable differences in the cost-wage behaviours between the manufacturing and services sector. One feature of this different behaviour relates to how demand-driven pricing in the service sector aggravates inequalities. First, the rising share of the service sector seems to correspond with the falling share of wages as a percentage of GDP. This reflects the inclination of services sector to create low-income jobs and implicitly suggests much of the gains from services growth accrue to capital in the form of profits.

Second, employment in services is more vulnerable to “Winner-Take-All” effects and job polarisation. “Winner-Take-All”[4] effects are particularly prevalent in talent-based industries where the “winners” receive the bulk of rewards. Services also accentuate the features of a class system where a large percentage of the population work as servers to affluent patrons in the restaurant, hotel and healthcare industries.

Third, demand-driven pricing is efficient at maximising value extraction but this inevitably rations access to “premium services” (for medical, education and properties). In the meantime, the quality and availability of low-cost services suffer from under-investment as the poor returns deter the entry of investors and talent. The diminution of the quantity or quality supply at lower price levels can cause the middle and lower income class to feel disenfranchised.

The analysis of the relationship between the services sector and the economy is incomplete without considering the role of the government. The rapid growth of the services sector is usually underpinned by government intervention to broaden public access to education, housing, amenities and healthcare and policies favouring liberalisation, deregulation and privatisation.

These interventions created opportunities for the private sector to exploit demand patterns and arbitrage government expenditures and subsidies. Charles Hugh Smith notes how “cartels that have government backing can jack up prices at will, year after year, decade after decade, while wages have stagnated. Cartels have zero pressure to raise wages, while their immense profits fund vast propaganda/public-relations machines that translate into equally vast political influence.”

The buoyancy of service businesses benefitting from government largesse disguised anaemic growth in other sectors. As service costs escalated, a larger percentage of the population found they could no longer afford these services and they became even more dependent on the government to foot the bill. Therefore, government interventions in the service sector are a major feature of the anorexic economy.

The second interesting set of linkages are between service sector growth, savings, debt and asset prices which are related to the emergence of the financialised economy. Income growth in the services sector is characterised by the expansion of intangible output. Income that is saved is intermediated into investments or loans which results in the accumulation of financial assets. Excess financial capital usually gets diverted into two channels; one to finance borrowings for the consumption of services such as education, housing and healthcare. These consumer loans may be incentivised by government guarantees or subsidies. The other channel is investment in investible assets such as securities and properties.

Hence, services sector growth is characterised by excess savings which fuels debt expansion and demand for investible assets. This sets up a reinforcing relationship between economic growth, corporate profits, market liquidity and asset prices. Services sector growth is thus closely related to the financialisation process which tightens the linkages between the economy, debts and markets. My next article will review the developmental challenges posed by diminishing influence of manufacturing.


Binyamin Appelbaum (4 October 2016) “Why are politicians so obsessed with manufacturing?” The New York Times magazine.

Josh Russell (1 April 2015) “Alternative theories for rising college tuition: Baumol’s cost disease and Bowen’s rule.”

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society

Robert H. Frank, Philip J. Cook (January-June 2012) “Winner-Take-All markets”. Journal of Microeconomics Vol. 1 No. 1. Mind Reader Publications.

Scott Alexander (9 February 2017) “Considerations on cost disease”.

The Economist. (29 September 2012) “An incurable disease”.

William J. Baumol, William G. Bowen (1966) Performing arts: The economic dilemma.

Tags: information society, service economy, hollowing out, Baumol’s cost disease, Bowen’s law, demand-driven pricing, inequality, anorexic economy, financialised economy

[1] “The Cost Disease: Why computers get cheaper and health care doesn’t” (2012 – Yale University Press).

[2] The Economist.

[3] Attributed to Howard Bowen who wrote about the “revenue theory of cost” in relation to higher education. Sourced from Josh Russell.

[4] Robert H. Frank, Philip J. Cook

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