How U.S. policy can promote higher economic growth
The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
In the past year, politicians from all bands of the political spectrum struck a common chord in declaring that the outlook for U.S. economic growth is unsatisfactory. They pointed out that economists both inside and outside the government predict growth in U.S. real gross domestic product per capita of only about 1 percent to 1.5 percent per year. They declared that the electorate should not be satisfied with this outlook for growth and argued that policy changes should be sought to improve it.
We agree. We should never be satisfied with modest real growth. And since policies are never ideal, there is always scope to change them in ways to promote more growth. The question, of course, is how to improve U.S. policy.
U.S. economic growth has depended primarily on growth in labor productivity, and by labor productivity we mean output produced per hour worked. Unfortunately, it appears that labor productivity growth has been very slow. It follows, then, that the less than optimistic forecasts of economic growth are essentially extrapolations of expected slow labor productivity growth.
Searching for higher economic growth, therefore, becomes a search for higher labor productivity growth. Labor productivity depends, in part, on the capital-both physical and human-employed per person in a country. Some argue that an increase in inputs, such as more physical capital (by encouraging higher savings rates) or more human capital (by encouraging higher education), is the answer. While these factors are important, for the United States they are expected to have little impact in coming years.
But labor productivity growth also depends on the available state of technology, which refers to the efficiency with which a given set of inputs is employed-this is what economists term total factor productivity. It has long been known that improvement in the state of technology, known as technological progress, is a key factor in growth in labor productivity. Our search then leads us to focus on technological progress.
So far, so good: To improve economic growth we need greater technological progress. As noted above, economists have understood this for some time. What has not been so clear, however, is the answer to the question: How can government policy promote technological progress?
Our view is that the state of technology in a country depends, in part, on the pool of world knowledge at a given time and, perhaps most importantly, on the country's institutions that promote or retard the use of this knowledge. Technological progress, therefore, depends on the rate at which world knowledge grows and on how a country's institutions evolve-whether they provide greater (or fewer) incentives over time for employing the expanding world knowledge. Government policy, then, can have its biggest impact by ensuring that it provides institutions with incentives to use and adapt world knowledge.
This view is based on theories that suggest that some countries have such relatively poor states of technology because groups in those countries erect barriers to the use of world knowledge. These barriers, like tariffs and regulations, serve to protect groups that stand to lose from the use of new world knowledge. Ultimately, such barriers serve to drag down the country's rate of economic growth. Recent evidence shows that the new theories have merit, that is, that the state of a country's technology is related to such policies as, for example, deregulation and openness to trade.
But do these studies, many of which are based on cross-country data, have any applicability to the United States? After all, the United States arguably has the "best" institutions as regards providing incentives to use new knowledge; the United States is already relatively open to new products and ideas. We argue that recent U.S. history strongly suggests that these studies do have applicability here. Recent policy changes (like deregulation in many industries), and continued commitment to certain existing policies (like keeping the auto and steel industries open to trade), have led to large gains in the use of world knowledge and gains in labor productivity.
Moreover, we argue that there are other potential changes that can further improve U.S. institutions, but in order for that to happen, U.S. policy must stay focused, generally speaking, on technological progress. Also, in an era of the so-called global economy, U.S. policy must not be swayed by arguments calling for the protection of U.S. industries-such policies are bound to retard economic growth.
The key to economic growth is labor productivity growth, which is driven by technological progress
Economic growth is about equal to the growth of labor productivity plus the growth of labor intensity. Labor intensity-essentially, a measure of how hard the population is working-is unlikely to contribute much to economic growth in the coming years, meaning that the fraction of people working and the hours they are working are already relatively high, and any further increases will add little to growth. For the United States, then, labor productivity has been, and will continue to be, the key. As described earlier, the less than optimistic view of future growth is based on expected slow labor productivity growth.
To better understand the potential role of policies to stimulate labor productivity growth, it helps to adopt a simple conceptual framework to identify the primary sources of labor productivity. The framework, the aggregate production function, is widely used in economics. It assumes that total output depends on inputs and the state of technology. Inputs include labor, physical capital, such as machinery, and human capital, such as the education levels of labor. The state of technology refers to the efficiency with which a given set of inputs is employed. A common assumption is that if all inputs are increased by some percentage, that output also increases by the same percentage (this property is known as constant returns to scale). It follows from this assumption that the growth in labor productivity depends on the rate of technological progress and the rate of increase in capital intensity (capital per unit of labor).
In 1957, Robert Solow published an important paper in which he concluded that in the United States, for the period 1909-1949, "output per man hour doubled over the interval, with 87.5 percent of the increase attributable to technical change [technological progress] and the remaining 12.5 percent to increased use of capital" (p. 320). In other words, growth in labor productivity was driven primarily by technological progress and not by the expansion of capital inputs available to workers.
In brief, using available data on hours, capital intensity and output, Solow was able to derive a measure of the state of technology, and then to compute the contribution of both increases in capital intensity and increases in the state of technology (that is, technological progress) to economic growth. This accounting exercise for U.S. labor productivity growth has been repeated many times in the last 40 years. For some exercises, human capital has been added as an input. Refinements of Solow's exercise have not changed the basic conclusion that, in the United States, technological progress has played a major role in driving labor productivity growth (see King and Levine 1994 for review).
So, given the importance of technological progress for labor productivity growth, we turn naturally to seek its determinants. The next two sections will include a summary of some of the economic literature on this subject.
Some theories about the determinants of the state of technology and technological progress
Again, the state of technology gives us the level of efficiency with which a country employs a given set of physical and human capital inputs. What does this depend on? It depends, in part, on the state or pool of knowledge available in the world. But it also depends on the extent to which a country's institutions promote or retard its citizens from employing this knowledge. It follows that technological progress depends on the rate at which world knowledge grows and on how a country's institutions evolve-whether they provide greater (or fewer) incentives over time for employing the expanding world knowledge (see Parente and Prescott 1994). In what follows, we will focus on what determines the extent to which a country uses available world knowledge. We leave for others to discuss what determines the rate at which world knowledge grows.
Now, there are many "natural" reasons why a country may not fully use all world knowledge at a given time, even if a country's institutions are very well designed. Natural impediments can arise as new technologies are adapted to local conditions; for example, new agricultural technologies must be adapted to local climatic conditions. Another natural impediment is that the rate of diffusion may depend on the levels of other production inputs, such as human capital. As an example, although human organ transplant surgery is general knowledge, not all countries have the trained surgeons, professional staff and equipment to perform it.
Griliches' (1957) classic study of hybrid corn illustrates why the rate of diffusion of new technologies can differ across locations due to natural impediments. The new method of production had to be adapted to local area conditions because of climate and soil differences; hence, it hit some areas first and over time spread to others. Moreover, his study also demonstrated the complementarity discussed above: The rate the method diffused within an area was related to farmers' education levels.
While the importance of these natural impediments cannot be denied, these reasons are not sufficient, in our view, to explain why some countries employ so very little of the world knowledge pool at a given time. The culprit here is very often the policies and institutions that restrict citizens from employing world knowledge more fully. These restrictions on the use of new knowledge are constructed (with the help of government) by groups that stand to lose if the knowledge is employed.
Economic historians, in particular Mokyr (1990, pp. 209-272), assign a major role to these restrictions on the use of world knowledge in their attempts to explain differences in growth across nations. Mokyr (1990, p. 12) states:
In every society, there are stabilizing forces that protect the status quo. Some of these forces protect entrenched vested interests that might incur losses if innovations were introduced, others are simply don't-rock-the-boat kinds of forces. Technological creativity needs to overcome these forces.
Mokyr (1990, p. 16) also notes that technologically progressive societies are the exception. Usually, the forces opposing technological progress are stronger than the forces striving for change.
To give an idea of the type of restrictions that are imposed, a clear example is the diffusion of new innovations in construction. One innovation in the industry occurred when engineers came to understand that wider spacing of wall studs would not influence the structural integrity of homes. With wider spacing there would be need for fewer materials and, of course, less labor. While this particular innovation was costless to introduce, it diffused very slowly. Oster and Quigley (1977) argued that it was likely construction workers, applying pressure on building code administrators, that blocked the adoption of this and other labor-saving technologies. They also showed that the procedures (that is, institutions) for choosing administrators influenced whether construction workers were able to restrict the new methods. Groups use many other means, in addition to regulations imposed by government, to restrict the use of world knowledge. Tariffs or, more generally, restrictive trade practices are a key method. With trade barriers, groups are able to continue producing with outdated methods by erecting barriers to imports produced with new additions to world knowledge.
Regarding theory, Olson (1982, especially chapter 5) has discussed how trade and factor mobility may limit the effectiveness of special interest groups.
Holmes and Schmitz (1995) have recently formalized these ideas about trade and resistance. They study a simple model where a special interest group can spend resources to block a new technology that threatens its privileged position. If there is no trade, the group may very well find it worthwhile to spend these resources. If, however, there is trade, so that the good can be produced elsewhere with new technology and shipped to the country, the special interest is likely to abandon its resistance (see also Parente and Prescott 1996 for recent models).
Recent evidence suggests these restrictions on use of knowledge, laid out in regulations (like those in the building industry) and supported by tariffs, have a large impact on the state of technology in a country. We now turn to this evidence.
Recent evidence supports the new views
There are large differences in the state of technology across countries, suggesting different countries access the world knowledge pool to varying degrees. While this has been known for some time (for example, Denison 1967 found this in his comparison of the United States and Europe; see King and Levine 1994 for a review of this literature), recent studies using many more countries find the same result. Three such studies are King and Levine (1994), Klenow and Rodriguez-Clare (1996) and Hall and Jones (1996).
Recent studies also find that the state of technology in a country is related to government policies. As mentioned, Hall and Jones calculate the state of technology for a large number of countries (for the year 1988). They show that variation in the state of technology is related to measures of policies and institutions. For example, their list of policies included measures of government support of production (including the extent to which government enforced private contracts), the type of economic organization employed (capitalist vs. statist) and openness to international trade. Hall and Jones find that differences in policy explain a large fraction of differences in the state of technology. In particular, openness to international trade is found to lead to much higher levels of the state of technology.
Hall and Jones' work supports the above view that differences in the state of technology are caused by differences across countries in restrictions on the use of world knowledge. By showing that openness to trade influences the state of technology, it lends support to the views above. The evidence is indirect, though. Openness to trade could be increasing the level of the state of technology through other mechanisms than the one we suggest, that is, by reducing restrictions on use of world knowledge.
Other research attempts to show through more direct means that restrictions on the use of world knowledge cause big differences in the state of technology. One example is Schmitz (1997), who studies a particular restriction on technology: the requirement that government, rather than the private sector, produce investment goods in a country. A number of countries have imposed this restriction, including Egypt, India and Turkey. He estimates that this restriction has had large impacts on the state of technology and labor productivity in those countries.
Other direct evidence is provided by McKinsey and Co., who have compared the labor productivity of various industries across the United States, Europe and Japan (these are summarized in Baily 1993, and Baily and Gersbach 1995). They find that productivity is often higher in the United States, and one of the reasons they give is that there are typically fewer regulations and restrictions on business practices in this country. For example, consider the retail sector. McKinsey argues that retail productivity is much higher in the United States than Japan. One of the reasons is that there are limits on the size of store that can be opened in Japan. These limits on store size effectively restrict some of the new retailing technologies, like better inventory management, since a larger store is better able to exploit this technology. These restrictions on size are maintained by lobbying and political pressure of small stores in Japan (such stores have had a rough time against such large retailers as Wal-Mart in this country).
Before turning to whether this has anything to do with the United States, we should mention that there are economists who, in trying to explain growth, do not place as much emphasis on how a country's institutions influence the incentives to use and adapt world knowledge. In particular, these economists have argued that the state of technology plays a minor role, if any, in explaining differences in output per worker across countries, and claim that varying levels of capital-both physical and human-explain differences in output. We are not persuaded by these arguments, based on two sets of studies: One set directly criticizes the research and the other takes its conclusion as an assumption-that is, that all countries have the same state of technology-and finds that differences in physical and human capital cannot account for unequal cross-country productivity levels.
What, if anything, does the new evidence have to teach the United States?
In some important ways the U.S. economy is unlike many economies in the cross-country studies that provide much of the new evidence. First, it already has relatively good policies and institutions. Most observers would probably rate the United States as having the best institutions in regards to promoting competition among businesses. Second, the United States economy contributes much to the world knowledge pool. It is a major spender on research and development, which is one key to growth in that pool. Though both these facts suggest the United States has little to gain from policy changes, and little to learn from the recent studies, we argue that recent U.S. history strongly suggests otherwise. U.S. policy changes have indeed led to large gains in access to world knowledge. And there is more to do.
Openness to technological progress has led to substantial labor productivity gains ...
Recent U.S. history suggests that policy changes, and continued commitment to existing policies, have led to large gains in the use of world knowledge and gains in productivity. One important area of change has been the large number of industries that have been deregulated over the past two decades. These include airlines, trucking, railroad, the securities industry and long-distance phones. As a result of deregulation and increased competition, these industries have experienced rapid drops in prices and strong gains in productivity (see, for example, Winston 1993).
A study by Olley and Pakes (1996) of the U.S. telecommunications industry suggests that labor productivity growth spurted after the industry was deregulated and that the growth was fueled by the introduction of new technology. It suggests that the state of technology had been stifled by regulation.
There have been other changes, for example, in the area of trade policy. (See Miller 1993 on the relationship between trade policy and economic growth-including the references therein.) A high-profile case has been the lowering of trade barriers associated with the North American Free Trade Agreement (NAFTA). Other negotiations to lower trade barriers with South America are under way.
While these changes are important, so, too, have been the battles fought to continue existing policies that foster growth. Regarding trade policy, in many markets, like steel and autos, the United States maintained its commitment to open markets. There was great pressure to limit trade in these markets and there were some programs that did slow imports. On balance, however, the markets were kept open. As a result, the United States more quickly adopted new methods than, for example, its European counterparts (as the above ideas suggest). U.S. car producers adopted Japanese "lean" production well before its more closed European rivals (see Holmes and Schmitz 1995).
In the steel industry and, in particular, the iron-ore industry, the United States also kept its markets open in the face of increasing international competition. As a result, as the international price of taconite fell in the early 1980s, the Minnesota industry was able to double its labor productivity in a fairly short period. This was accomplished not with new machines and the like, but in part by changes in work practices.
... but there's more to do
While much has been accomplished, there is still more to do. For example, deregulation has begun in telecommunications, but much remains to be done; reform of the electricity industry has just started; and there is also the recent drive to end "corporate welfare," including subsidies to producers. Important areas under study are: tort reform, liability reform and increasing competition in primary and secondary education.
This is not to say that reform is not difficult. Even if a policy change would lead to large productivity gains, it still, most likely, would harm some groups. These groups may well seek access to the political market to block reform. Recognizing this, the current administration has developed some programs to help defray the costs borne by groups so affected. Their policies of retraining workers who lose jobs due to NAFTA is one such program.1
Breaking down the barriers
At first glance, the policy prescription advocated in this essay-open trade, deregulation and increased competition-seems merely like a reiteration of well-accepted economic principles. However, these principles are more often preached than practiced, and many policy-makers are not necessarily convinced of their wisdom. Governments are often tempted to engage in policies that, for example, protect certain industries from foreign competition or, in the case of internal markets, make it difficult for innovative companies to compete in established industries.
Recent U.S. history strongly suggests that the lessons being learned from cross-country comparisons of labor productivity and growth apply to the United States. In brief: Technological progress is a key element of economic growth, and to encourage technological progress, the United States must constantly refocus its efforts on policies that reduce resistance to technology and increase the use of world knowledge.
1/ Most of the reforms we have discussed involve less government. We do not want to tip the balance too much here. Government must play an important role in ensuring a productive economy. For example, antitrust is an important role for government. Just as trade ensures open markets across borders, antitrust can ensure that monopolization doesn't reduce competition at home.