Recessions end. And corporate executives and consumers alike are finding reasons for cheer in the latest upbeat economic numbers. Yet even as recovery begins to take hold, it's hard to shake a deep-rooted worry: that the American economy has lost its edge.

Whatever the causes, and there are many, the economy has turned in a dismal productivity performance for two decades. Consider this: Since 1973, output per worker has risen at only a 0.8% annual rate, compared with a 2.5% rate over the previous 25 years. Had productivity kept up with its earlier pace, today's median family income would be $47,000 instead of its current $35,000. At the same time, other industrial nations have been enjoying rapidly improving living standards. And these countries, especially Japan, have been laying the groundwork for even better times ahead by investing heavily in future productivity growth (chart, page 7246).

Stagnant incomes and low productivity growth have dogged the U.S. economy for years. What's new is the waning of the cold war and the prospect of wholesale defense cutbacks, a combination which will knock a powerful prop out from under America's industrial base. But freed-up resources also offer a historic opportunity to get the economy back on a fast-growth path. That is why the cold war's end raises anew one of the most contentious questions in recent political history: Should the U.S. have an industrial policy to nurture and promote technology and industry?

The answer is "Yes." If the words "industrial policy" set off alarm bells, call it a technology policy, a competitiveness program, or a growth agenda. Whatever the label, the U.S. needs an economic vision geared toward the global economy of the 1990s. Competitive advantage no longer belongs to the biggest or those blessed with abundant natural resources or the most capital. In the global economy, knowledge is king. And those nations that excel at creating new knowledge and transforming it into new technologies and products will prosper in years to come.

Government can become a key player in the knowledge economy. It should boost research spending across a wide range of technologies and offer hefty financial support to the next generation of scientists and engineers. The U.S. needs tax laws that make it a lot cheaper for the private sector to invest in research, development, and new equipment. Smaller companies should get technical assistance to learn the latest manufacturing techniques. The government can enhance productivity by building up the infrastructure, especially by encouraging the development of high-speed communications networks. And trade policy can focus on opening up foreign markets while resisting protectionism at home.

PAST GLORY. To some, adopting an industrial policy would be a colossal mistake. "We don't have any confidence in government policy that reallocates resources from one sector to another," says David M. McIntosh, executive director of Vice-President Dan Quayle's Council on Competitiveness.

But this growth policy has deep roots in U.S. history. In the 19th century, the federal government backed the development of a transcontinental railroad by ceding huge tracts of land to get the job done. The government also sponsored a network of universities, extension services, and research to help U.S. farmers successfully reap the riches of a fertile land. And in this century, government funds nurtured such infant industries as airlines and electronics. Even the Reagan Administration pursued an ad hoc industrial policy, shoveling huge tax breaks at the real estate industry and laying the groundwork for such high-tech industries as biotechnology by funding basic research.

A knowledge-based growth policy doesn't call on government to pick winning and losing industries. Nor does it create ponderous bureaucracies or shelter stumbling companies from tough foreign rivals. And while the government may sow a lot of seed corn, it will be up to the private sector to risk its own money to develop commercially valuable ideas. It's the market that picks the winners and losers, not government.

This kind of policy builds on the cornerstone of American economic growth: individual achievement. U.S. science and technology have been propelled by the immigrant, the entrepreneur, the maverick thinker unwilling to wait for a consensus or committee assignment. But superachievers do not stand alone. They can be successful only if the U.S. backs their research and ideas, as it did in the decade after World War II. "The best contribution government can make is to support institutions which help support the creation of ideas," says Paul Romer, a leading theoretician of economic growth at the University of California at Berkeley. "There is a collective stake in the production of ideas."

Here are the elements of a knowledge-based growth policy:

-- Spurring cutting-edge technology. America's high-tech industries, such as biotechnology, computers, and chemicals, are among the best in the world. Last year, the U.S. ran a $37 billion trade surplus in advanced-technology goods, even as the rest of the manufacturing sector suffereda $105 billion deficit. Better yet, high tech pays well. For example, in 1989, average annual compensation in high-tech industries was 22% higher than the average for all manufactur-ing, calculates Laura D'Andrea Tyson in her forthcoming book, Who's Bashing Whom: Trade Conflict in High-Technology Industries.

But there are worrying signs. If you take away aerospace, the high-tech trade surplus fell by 11% from 1990 to 1991 (chart). More troubling still, the U.S. has been spending only 1.9% of gross domestic product on nondefense R&D, both public and private, compared with 3% for Japan.

America's technological edge is melting away as other nations invest heavily in science and engineering. The competition for new ideas, products, and markets has never been more intense or important. "The growth in jobs and the standard of living tend to be governed by industries that have relatively high rates of research, development, and capital investment," says Jerry R. Junkins, chief executive of Texas Instruments Inc. Adds John A. Young, chief executive of Hewlett-Packard Co.: To boost technology, "what we need is something like a Desert Storm."

Technological breakthroughs are what really spur growth. Without major advances, even doubling net investment in plant and equipment raises the growth rate of real income by less than half a percentage point a year, according to most estimates. But throw in a jet turbine, a spliced gene, or a touchstone software program, and suddenly new markets, jobs, and opportunities open up. "In the long run, it's clear that it's ideas that drive growth," says Romer.

The payoff from boosting civilian R&D could be huge. Economic studies suggest the rate of return on R&D spending runs as high as 50% a year, if you include indirect benefits to the economy. For example, Xerox Corp. made little money from the pioneering computer work done at its Palo Alto Research Center in the 1970s. But out of that division came an entire generation of "user-friendly" computer technologies that made millions for Apple Computer Inc. and others.

The Bush Administration is beginning to recognize the economic importance of new technologies. Its 1993 budget proposes increasing nondefense R&D spending by 7%, to just over $30 billion. The Administration is also pushing national weapons laboratories, such as Los Alamos and Lawrence Livermore, to focus more on commercially relevant research. But the funding increases are modest, and companies haven't yet been able to generate many commercially viable products based on technologies developed at the national labs. And aBUSINESS WEEK/Harris Poll shows that the American public strongly supports redirecting military research money into civilian R&D.

That's why Congress and the Administration should give a big funding boost to the National Science Foundation, the National Institutes of Health (NIH), and similiar sci-tech outfits. The additional funds should be spread over lots of different ideas at the expense of such current big science projects as the $40 billion-plus space station. The policy would rely on the well-established decentralized decision-making system of the scientific community, one of peer review. And because these agencies fund science in academia, any increases would feed more money into America's top research universities. In this way, the government diversifies its spending across a variety of technologies, like putting together a growth stock portfolio.

The NIH is a good model. The research it supports has brought an explosion of knowledge about biology and disease, spawning powerful drugs and an entirely new industry, biotechnology. Yet most of the spin-offs of this taxpayer-funded science were unforeseen. "Every single thing in biotechnology can be traced back to basic research that didn't have any applications at the time," explains molecular biologist Russell F. Doolittle of the University of California at San Diego. That's why Doolittle firmly believes that the government must keep stoking the fires of invention. "If we don't, we won't have anything new 20 years from now," he warns. "We have to keep putting coal in the furnace."

-- Diffusing new technology. More R&D spending is but the first step in a growth strategy. The government must also speed diffusion of technical knowledge and new manufacturing techniques, especially to the nation's smaller manufacturers. Some are among the most technologically advanced companies in the world. But far too many of the 350,000 small manufacturing companies lag behind. To some experts, outdated manufacturing practices are pervasive and account for about "85% of the problems of American firms," says Charles F. Sabel, a political scientist at Massachusetts Institute of Technology.

To help small companies, 23 state governments are spending a total of $50 million a year supporting 27 technology extension centers. The federal government is pitching in with several million more. That pales, however, next to the $500 million that Japan spends backing 185 technology extension centers across the country, according to the federal government's Office of Technology Assessment (OTA).

To do more, the U.S. needn't look overseas for guidance. History offers an incredibly successful example: the agricultural extension service. The federal government upped its support of farming with the 1862 Morrill Land Grant College Act. Almost half a century of increasing support led to the creation of the cooperative extension service in 1914. At that time, the U.S. trailed Europe in farming techniques. But a generation later, these investments paid off in enormous gains in agricultural productivity.

A few of the state industrial extension services are showing results. Georgia Institute of Technology, for example, has helped almost 3,000 companies over the past five years solve manufacturing-process problems. "We're trying to modernize Georgia manufacturing," says David H. Swanson, director of the Economic Development Laboratory at Georgia Tech. Pennsylvania's industrial research centers have been successfully honing the technical skills of its many Rust Belt manufacturers.

But the state programs need more federal support to expand. The OTA estimates it would cost up to $480 million a year to run industrial extension services similiar to Georgia's in all states. By contrast, the agricultural extension program now costs about $1.2 billion. Such extension programs are the logical place for helping manufacturers upgrade the skills of workers and for offering smaller companies low-cost loans for new equipment.

The federal government is also a splendid bully pulpit. For example, the Commerce Dept.'s Malcolm Baldrige National Quality Award, which was set up in 1988, has been extraordinarily successful in spreading the quality-management revolution. Whenever possible, the government should "press and prod industry to move to a higher plane," says Michael Porter, a professor of business administration at Harvard business school.

-- Creating a new infrastructure. Take a drive around New York or Los Angeles, and it won't come as any surprise that the U.S. has neglected its infrastructure. Public infrastructure spending is down from 2.3% of gross domestic product two decades ago to 1.3% in the 1980s. The cost isn't just in lost tempers and missed appointments. It affects the bottom line. According to estimates by David A. Aschauer, an economist at Bates College in Maine, approximately 50% of the falloff in productivity growth--from an average of 2.8% a year from 1953 to 1969 down to 1.4% from 1970 to 1988--can be blamed on a lower rate of public investment.

Clearly, government needs to refurbish decaying roads, harbors, and bridges. But in the 1990s, building up a communications infrastructure that can support the information-intensive industries of the 1990s is critical. A communications conduit made up of fiber-optic cables and high-speed digital switching equipment, which is being developed by such companies as Bellcore, the research arm of the Baby Bell phone companies, could have an economic impact such as the interstate highway system did in the 1950s and 1960s.

The U.S. has started such an information superhighway to make it easier to manipulate and transfer huge amounts of data at high speed. But so far, only $400 million has been budgeted for constructing high-speed data links between universities and government research labs. That isnot enough, especially since many small companies won't get any benefits unless the government offers telephone companies and their competitors incentives to expand the data superhighway.

-- Technology education. What America's college graduates do will determine in large part how fast the U.S. economy grows. The more young people who pursue careers in science and engineering, the better the odds that society will develop technologies and products that fuel economic growth. And in our entrepreneurial economy, a lot of the innovators will end up building their own companies, creating jobs and incomes. One study, by economists Andrei Shleifer, Kevin M. Murphy, and Robert W. Vishny, estimates that if an extra 10% of university students went into engineering--a doubling of the current engineering enrollment--the growth rate of the economy would rise by 0.5% a year. By contrast, if law school enrollment doubled, the growth rate would fall by 0.3% annually.

These days, the U.S. economy isn't "graduating enough scientists to fill the need of the coming decades," frets Charles C. Leighton, senior vice-president for administration, planning, and science policy at Merck & Co. "That's a real concern." The government should address the glaring weakness in science and math in primary and secondary schools. It should also subsidize the education of more engineers and scientists. As companies and government hike research, development, and investment spending, the demand for these graduates will soar.

-- Free trade at home and abroad. A country that is taking care of business at home has little to fear from free trade. Despite intensifying foreign competition, the government should ignore calls for protectionism. Indeed, the past five years have seen the beginnings of an important transformation in the U.S. economy: Overseas trade has contributed about 30% of real growth in the economy since the trade deficit peaked in 1986. The collapse of communism in Eastern Europe and the Soviet Union means many more potential customers over the next decade. The proposed North American Free Trade Agreement would create enormous opportunities for U.S. companies, too. "And free trade keeps the pressure on domestic industries to innovate and create a productive economy," says Porter.

But it's a two-way street. The U.S. should help companies gain access to foreign markets. For one thing, it can provide more small companies with cheap financing from the Export-Import Bank in Washington. In addition, the government can spend more time and money pro-moting American exports by expanding its trade missions overseas. The U.S. spends only around 50 per capita on export promotion, compared with $4 in France and $5 in Japan, according to the National Association of Manufacturers.

While the U.S. has dramatically improved its trade balance with Europe, the deficit with Japan has started growing again. The record clearly shows that the world's second-largest economy is inhospitable to too many American companies. For example, Giddings & Lewis Inc., now America's largest machine-tool builder and a fierce competitor, hasn't sold a major machine in Japan since 1974. And it's not for lack of trying, says Chairman William J. Fife Jr. The Administration, its trade negotiators, and Congress should keep on pushing, nudging, and bashing for ever more market access, playing hardball when needed. "We absolutely have to succeed in terms of securing reasonable trade with Japan," says Richard W. Heimlich, director of international strategy for Motorola Inc.

-- Investing in new technologies. In the past, U.S. companies have been slow to take advantage of new technologies coming out of labs. "All this crap in Washington about industrial policy and funding generic technologies makes no difference if CEOs don't make a commitment to bringing new technologies to market," says Donald N. Frey, professor of industrial engineering and management sciences at Northwestern University and former chief executive of Bell & Howell Co.

But as the economy moves from recession to expansion, the climate for investment will be better than it has been in decades. U.S. companies are no longer hobbled by a higher cost of capital than their foreign rivals. U.S. hourly labor costs are among the lowest in the industrialized world. To speed both innovation and investment, government should make permanent the research and investment tax credits. This way, the private sector assumes the greatest financial risk, but the government also lends a helping hand. Says Intel Corp. Chief Executive Andrew S. Grove: "I'mnot looking for a handout, but aturbocharge."

The new growth agenda will not come cheap. Done right, the cost could add up to billions of dollars, which won't be easily found at a time of gaping budget deficits. But unlike mther federal spending, over the long run, this industrial policy will boost productivity and living standards, generating plenty of tax revenues to more than pay for itself. It's the best investment America can make.

       -- Boost federal spending on civilian, nonspace R&D from its current $20 
      billion a year. Support a wide range of projects, from basic research to new 
      manufacturing technologies. Cut defense R&D from its current $43 billion a year
       -- Increase federal funding for state industrial extension programs to help 
      smaller manufacturers adopt up-to-date technologies and production methods. 
      Provide training grants and low-cost equipment loans
      Improve data collection on R&D and manufacturing practices of foreign 
      competitors. Continue to identify emerging critical technologies that need 
      Rebuild existing infrastructure, such as roads and bridges. Increase funding 
      for new types of infrastructure, such as high-speed data networks, to encourage 
      new high-tech industries
      Expand the Export-Import Bank to make export financing easier to obtain for 
      creditworthy small and midsize exporters. Boost export promotion efforts for 
      nonagricultural products
      Raise funding for all levels of science, mathematics, and engineering education
      Make the research and investment tax credits permanent, so companies can do 
      long-range planning
      DATA: BW
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