Why We Can Grow Faster

From the early-nineteenth-century introduction
of steam power through the dawning of the age of the microchip
in the post-World War II era, real economic growth in America
averaged 3.8 percent per year. That meant economic output doubled
roughly every 19 years. Then after the 1970s, growth collapsed.
During the 1980s, growth averaged just 2.7 percent per year and
since 1989 only about 2 percent. At that rate, it will take nearly
36 years for gross domestic product (GDP) to double again.

Despite this performance at well below
historical trend rates, many mainstream economists and the journalists
who follow them have concluded that the new lower growth rate
is inevitable and more or less permanent. Economist Paul Krugman
suggests that we now live in an "age of diminished expectations"
and we had better get used to it. The Council of Economic Advisers
(CEA) forecasts 2.3 percent growth through 2002. Generally,
both the Federal Reserve Board and the Congressional Budget Office
agree with this assessment. Popularizing this theme, Jeffrey Madrick's
1995 book concluded that we had reached The End of Affluence.

This pessimism about future growth rates is predicated
on unassailable arithmetic but, as we shall see, questionable
assumptions. Mathematically, the rate of economic growth cannot
exceed the rate of labor force growth plus the rate of growth
in labor productivity—that is, total hours worked times output
per hour worked. This tautology sets the speed limit on how fast
an economy can grow; if we exceed the economy's growth capacity,
we will reap only inflation.

Typical forecasts of economic growth—the CEA's, for
example—predict that the labor force will grow at about 1.2 percent
per year at least through 2002 while productivity growth will
creep along at about 1.2 percent a year as well. Adding these
together (and subtracting a tenth of a point for the expected
slowdown in growth due to smaller government outlays and a smaller
farm sector) yields the "official" 2.3 percent growth
rate forecast that pretty much everyone has come to accept as
the most likely future scenario. Optimists predict that with a
little luck we could push it to 2.5 percent. The bridge to the
twenty-first century apparently is being built without a high-speed
lane.

Small differences in growth rates over a sustained
period yield huge differences in our standard of living. Whether
the economy can grow at 2.3 percent or, say, 3 percent a year
may seem a quibble, but that annual seven-tenths of a percent
is hardly trivial. Between now and 2007, the total difference
between these two rates is $3.1 trillion worth of GDP—an
average of more than $300 billion a year. That $3.1 trillion could
solve the Social Security "crisis," deal with the federal
deficit, and represent a large down payment on rebuilding the
cities and cleaning up the environment—not to mention what it
could mean for employment, wages, and family incomes. Misreading
the economy's speed limit has its costs. This is particularly
true if investors temper their own expectations of growth based
on "official" forecasts and limit their investments
in new technology and in new plants and equipment believing that
any larger investment will simply leave their capital stock idle
in the face of slow-growing demand.

It may seem prudent to "diminish our expectations,"
but there is the distinct danger that limiting our expectations
may become a self-fulfilling prophecy. In this article, we suggest
why. Instead of forecasting growth rates, the Federal Reserve
Board, the White House, the Congressional Budget Office, and the
economists on whom these bodies rely for advice may be inadvertently
setting growth rates. It would surely add credibility to the economics
profession if its slow-growth forecast turned out to be accurate—but
it would not be very good for everyone else!



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WHO WORKS, AND WHY

We think the economy can grow faster—provided
the growth prospects are not sabotaged. There is considerable
evidence that the mainstream forecasts of both labor supply
and output per worker are too pessimistic, given emerging
underlying forces in the economy. The supply of labor and the
potential growth of productivity are both more elastic than the
standard view admits. Moreover, the conventional wisdom relies
too heavily on an outmoded understanding of how technology and
growth are connected.

Consider labor supply. We may not like
all of the social consequences of an increasingly "overworked"
America, but more Americans are working, and they are working
longer hours. We are finding that the labor force is not tapped
out, but is ready to work more when jobs are there. The economist's
old homily, Say's Law, which says that "supply creates its
own demand," has been stood on its head. Now, increased demand
for labor coaxes out a new source of labor supply that can contribute
to faster growth. This ups the economy's speed limit a notch.

The increased labor supply shows up
in two forms. One is an increase in the labor force participation
rate—the fraction of the population that works or seeks work.
[See "The End of Unemployment?".] After growing
for decades, the labor force participation rate flattened out
in the late 1980s and early 1990s. Economists and demographers
took this to mean that with women's participation reaching a peak
and older workers retiring earlier, the overall labor force participation
rate had reached a plateau. Between 1989 and 1994, the rate was
essentially flat at 66.6 percent. But lo and behold, since 1994
the rate has been on the rise again. By March of this year, the
rate was up to 67.3 percent—adding 1.4 million additional workers
to the labor pool.

This resurgence in part reflects an
apparent end to four decades of decline in labor force participation
rates among workers over age 55. With improvements in health and
changes in law that permit older workers to keep more of their
Social Security income while continuing to work, more older Americans
are choosing to remain employed in either full-time or part-time
jobs. Moreover, it appears that younger men who had "disappeared"
from the official labor force—as many as six million according
to Lester Thurow ["The Crusade That's Killing Prosperity,"
TAP, March-April 1996]—are beginning to reenter in response
to better job opportunities. In other words, faster growth and
more job opportunities coax out more workers; labor supply is
not fixed by demographics. Extra labor supply from these sources
will offset the projected decline in 25- to 34-year-olds over
the next decade, the legacy of the baby bust generation. Thus,
assuming adequate labor demand—something that macroeconomic policies
at home and coordinated negotiations among countries can promote—the
"graying of America" need not mean a decline in the
growth rate in labor force participation.

Even more important is the growth in
hours worked per worker—a factor that goes undetected in the official
labor force participation and employment statistics, since all
workers who work at least one hour a week are simply counted as
employed. From 1967 through 1982, the average annual hours worked
by prime-age workers (age 25-54) declined from about 1,975 to
about 1,840. This was primarily the result of women entering the
labor force in part-time positions. Since 1982, however, the trend
has reversed, so that by 1995 the average work year was back above
the 1967 level. Just since 1991, with the expansion of the economy,
average hours worked per employee have increased by nearly 3 percent.
That is the equivalent of adding 3 percent more workers to the
American labor force if the average work effort had remained unchanged
at its 1991 level.

That we have been able to drive the
unemployment rate down below 5 percent without igniting wage-led
inflation is testimony to the fact that there is a good deal of
labor supply in the pipeline when labor demand exists to employ
it. Because of its construction, the official unemployment rate
simply fails to capture it. Of course, at some point the typical
workweek and the fraction of the population that works reaches
a natural limit. But given healthier senior citizens, women's
equal participation in the labor force, welfare-to-work efforts,
and training programs for the conventionally unemployable, labor
supply should grow faster than population for some time.


A PRODUCTIVITY RENAISSANCE

The other component of growth—labor
productivity—has been the chief culprit in the growth slowdown
since the early 1970s. From 1870 through 1973, productivity increased
by an average rate of 2.4 percent per year. In the immediate post-World
War II era, productivity was absolutely booming—growing more than
3 percent a year. After 1973, productivity growth totally collapsed,
for reasons that most economists consider a mystery. (The OPEC
oil shock, the demise of the Bretton Woods system, and the high-interest-rate
austerity that followed are considered possible suspects.) For
a quarter century, productivity has been growing at barely 1 percent
a year—a pace even worse than that of the Great Depression. The
official projections for economic growth are based on a continuation
of this dismal record.

Yet there is good reason to believe
that we are on the verge of a productivity renaissance. This is
already evident in the manufacturing sector, where productivity
growth rates are back up to the levels enjoyed during the postwar
glory days. The recent drag on productivity has all been in the
service sector of the economy, where most of the growth in the
economy is now centered. But even here there is now evidence of
a turnaround. From 1989 through 1995, productivity growth for
the entire nonfarm business sector of the economy averaged only
0.9 percent per year. Since then, the rate has averaged 1.3 percent—a
sizeable improvement. Longer-term historical data suggest that
the productivity slump bottomed out in the late 1980s.

More
important perhaps than the actual recent numbers is the growing
awareness that overall productivity growth has a history of long
cycles based on the introduction of new technologies. This helps
to explain the productivity paradox of the information revolution.
The work of such economic historians as Paul David, Nathan Rosenberg,
Luc Soete, and Chris Freeman, shows that in every new technological
era—be it led by the introduction of water power, steam power,
or electricity—there has been a lag before productivity surged.
The decline in productivity growth rates often lasts two or three
decades, the time it has taken for each new technology to be "debugged"
and diffused.

The computer revolution very likely
follows the pattern. If so, we likely have lived through the downside
of a technological transformation and we are just about to receive
its benefits. For nearly two decades now, we have seen the rapid
introduction of new hardware and software as the technology revolution
moves toward greater maturity. Every time we have begun to become
proficient with new technology, newer hardware and software promises
even greater productivity. But it takes time to learn, and during
this time productivity growth is flat or even declines. For those
who have kept up with the innovations in computer operating systems,
think of the time and effort "wasted" in moving from
DOS to Windows 3.1 to Windows 95. Just as you were moving up the
"learning curve" with one operating system, another
one came along and you had to pause while you moved onto the next
learning curve. Over the long run, your productivity improved—or
will improve—but the process is filled with fits and starts.







What is our true position on economic growth and employment?
Are we really on a cliff by the sea,
poised perilously above the waves and the rocks? Or are we in
fact down by the beach, on a gentle slope of soft and agreeable
sand? What are the risks of another advance— injury and death,
or a little wetting of the feet? And if we do get our feet wet,
what will it take to get them dry again?

See "Test the Limit," by James K. Galbraith

Moreover—and here is where mainstream
theory really misses the boat—Paul Romer, Richard Nelson, and
others have shown persuasively that the productivity dividend
from the introduction of any new technological paradigm is fully
realized only when all of its complements are in place. The hardware
has to work with the software. The skills of the workforce need
to be upgraded to utilize it. Old managerial routines that stand
in the way have to be replaced. This all takes time—and now appears
to be well along. A growing proportion of the workforce is now
computer literate. Investments in training are beginning to pay
off as more and more workers report that they are using computers
and related equipment on the job. The human process of learning
by doing is now increasingly routinized.

We have already seen this process flourish
in the manufacturing sector. With greater emphasis on user-friendliness,
and with the accelerated diffusion of the new easier-to-use technologies
in the service sector as well, the productivity promise of the
computer and related information-processing equipment is now on
the close horizon. This, we believe, helps to explain the bottoming
out of the productivity slump and heralds strong positive growth
in the near future.


FEEDBACK LOOPS AND SELF-FULFILLING PROPHESIES

Our estimates based on recent trends
suggest that we can claim another 0.3 to 0.4 percent growth annually
in the labor force over the next decade and another 0.3 to 0.4
percent growth per year in productivity. This means that there
is clearly room for the economy to meet a 3 percent annual growth
target—the amount necessary to garner that $3.1—trillion GDP bonus.

But we surely will fall short of that
goal if public and private policies sabotage growth. Here there
is much to unlearn from history. Though the Federal Reserve
Board has lately allowed unemployment rates to slip below what
it once considered a natural floor, there remains a powerful monetary
policy bias against faster growth [see "Test the Limit,"
James K. Galbraith].

In
the stagflation of the 1970s, many economists became convinced
that the natural rate of unemployment was an immutable law. But
in the 1980s and 1990s, the real trade-off between inflation and
unemployment has become more benign due to increased actual and
potential competition as a result of increased world trade, the
proliferation of offshore production sites (and producers), new
technology, changes in the nature of labor markets, and industry
deregulation. In fact, the recovery since 1992 has seen the unemployment
rate fall from 7.5 percent to 4.9 percent without any increase
in inflation whatsoever—a clear case where the facts inconveniently
trump received theory. The Fed is nonetheless poised to raise
interest rates in the near future if unemployment continues to
fall or simply remains below 5 percent.

Such action would not only sabotage
growth in the short run; it compromises the potential for long-term
growth because of an important feedback loop between monetary
policy, the investment climate, and future growth. For private
business to continually invest in new capital and new technologies,
firms must believe that the output created by the new equipment
will actually be sold. Here is another case where Say's Law operates
in reverse. If private business believes demand growth will be
slowed in the future, it will reduce its current investments accordingly—producing
the self-fulfilling prophecy of slow growth. If it expects, on
the other hand, that growth will be encouraged by policymakers,
then business will more likely make the investments that will
feed back in the form of higher productivity and faster growth.
The prospect of more demand for products produces the supply of
investment and innovation needed to make that prospect come true.
If the monetary authorities signal that 2.3 or 2.5 percent growth
is the most we can achieve, then that is what we are going to
get.

The demise of fiscal policy in the
service of balancing the budget at any cost also sabotages potential
growth. When deficits continue to rise without limit as a percentage
of GDP, there is no doubt a drag on economic growth. But targeting
a zero deficit is not necessarily good for growth either. Economic
expansion in a technological age requires continuous investment
in public infrastructure, in generic R&D, and in training
and education. If we continue to sacrifice these on the altar
of budget balance, we could undermine the very complementarities
that growth requires. A strong case can be made that we should
now be spending more on public investment, not less, if we do
not want to undermine the prospects for growth.

Industry too must consider all of the
complements to growth that need to be in place to assure a new
era of economic expansion. Continuing to build closer working
relationships with labor where both workers and managers are committed
to productivity, quality, and innovation is one area where much
is still to be accomplished. We must leave behind an economy where
workers are treated as expendable costs rather than the crucial
assets they are or could be. Expanding the level of employee training
throughout the enterprise, rather than (as at present) mainly
at the top, is another area where good business practice could
enhance national economic growth.


THE CASE FOR OPTIMISM

All of this suggests that faster growth
is possible—if we don't sabotage it. Changes in the labor supply
are providing one leg. The maturing of the information age is
providing the other. If we can make sure that fiscal and monetary
policy do not sabotage growth and if we can encourage businesses
to expand their investments in human capital to meet the investments
they have already made in their physical plant and equipment,
we will be on the road to faster growth. If we use that growth
dividend wisely, we can raise living standards, reduce the gap
between the rich and the poor, and help solve many of the pressing
social problems we face. We can repair many of the gaps in the
social safety net for both those who can work and those who cannot.

We may not be able to quite reach the
pinnacle of economic growth we enjoyed during the post-war glory
days, but we surely can do much better than the growth depression
we have endured for the past quarter century. Indeed, we might
have begun down this road a decade ago and avoided a great deal
of economic and social pain, if we had shed old resistances earlier
and adopted the appropriate pro-growth policies already.



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