Why Are We So Afraid Of Growth?Christopher Farrell
Can't we do better than this?
Ever since the U.S. economy powered ahead at a torrid pace late last year, the financial markets have feared that accelerating growth would send prices spiraling. To beat inflation to the punch by cooling off the economy, the Federal Reserve Board has already raised short-term rates in three quarter-point installments since early February. And Wall Street expects more rate hikes to come, even though the economy expanded at only a 2.6% clip in this year's first quarter.
It's beginning to look as though any surge in growth will be squashed in the interests of keeping the inflation nemesis under control. Most forecasters assume that economywide productivity growth will average some 1% a year. Add to that labor force growth of 1.3% or less, and the long-term growth potential of the economy comes to between 2.0% and 2.5% a year. Any pace faster than that, and the economy rushes headlong into production bottlenecks that ignite a wage-and-price spiral.
Certainly, the Clinton Administration "is comfortable with 2.5% as our long-run forecast," says Laura D'Andrea Tyson, chair of the President's Council of Economic Advisers. And Robert T. Parry, president of the Federal Reserve Bank of San Francisco, recently told a gathering of forecasters that "for the last two years, the rate of growth has been faster than the economy can sustain in the long run." No wonder every bit of good economic news gives the financial markets the jitters--sending bond and stock prices tumbling.
But the fears of the forecasters and the markets may be unfounded. "People are taking the last 15 years and just projecting them forward," says Richard Nelson, economist at Columbia University. The conventional outlook underestimates Corporate America's huge productivity gains, a historic wave of technological innovation, and the spread of capitalism around the world. "Productivity has dramatically improved compared with the prior two decades," says Bruce Steinberg, economist at Merrill Lynch & Co. "And improved productivity means the economy can grow more rapidly without triggering inflation."
Still stingy. True, the recent pickup in manufacturing activity is raising the specter of production bottlenecks. Yet in an increasingly global economy, many American companies can shift excess order flows to factories overseas. And with nearly one-fifth of all goods bought in the U.S. produced overseas, foreign competitors are eager to expand their sales should stateside companies aggressively raise prices. White-hot international competition puts a damper on the ability of U.S. companies to jack up prices.
Fed Chairman Alan Greenspan agrees that the growth prospects of the U.S. economy have improved. He believes the economy's underlying growth trend of productivity in both manufacturing and services has recently risen to 1.5% and that the noninflationary growth potential of the U.S. is certainly higher than the modest pace projected by conventional wisdom. "U.S. businesses in recent years have been investing in new capital and improving their use of capital in ways that are making the U.S. economy more productive," Greenspan recently wrote.
Still, the Fed isn't joining in any victory dance--at least not yet. Instead, it has been pursuing a tightfisted monetary policy as part of a campaign to convince the markets that it won't let inflation erupt.
And the markets, it seems, need a lot of convincing. They were seared by megabuck losses during the 1970s price spiral and won't risk trillions more until they have positive proof that higher productivity growth rates are here to stay and inflation will remain dormant. For example, consumer price increases are running at a 2.6% annual rate and investors are demanding a yield of more than 7% on 10-year Treasury bonds. By contrast, when inflation was this low back in the mid-1960s, investors only required a yield of 5%.
How good can growth get before the economy overheats? Perhaps a lot better than most people think. Over the past three years, productivity has been rising far faster than the rate assumed by the typical forecast--a 2.6% average annual rate, similar to the experience of the 1950s and 1960s.
In part, this reflects the typical productivity rebound that follows a recession. But with business equipment investment hitting 9% of gross domestic product, its highest level in the postwar period, the productivity surge is likely to continue. Tack on labor-force growth, and that means the economy's noninflationary growth potential could be as high as 3.5%--and not for two quarters or a year, but perhaps for the rest of the decade.
The gap between a growth rate of 3.5% and 2.5% may not seem like much, but it's the difference between eating fish eggs and caviar. The higher growth rate would cumulatively add about $1.2 trillion more, in 1987 dollars, to the nation's output by the year 2000. It would increase total business investment over the next six years by $170 billion. Per-capita income would rise to $23,600 instead of $22,250. The federal budget deficit would shrivel, and the U.S. could afford to spend plenty more on education, training, and scientific research, the seedcorn of future growth. Strong growth creates a powerful, self-reinforcing dynamic all its own.
Stunning pace. Of course, many economists remain convinced that America can't grow faster because it's a mature economy. The U.S., they say, has lost its economic and technological leadership in field after field to Asian and European rivals. To survive, companies are slashing costs by eliminating workers even entering the fourth year of recovery. The cold war's end, with the resultant cutbacks in the defense industry, is dampening growth, too. "Everyone hopes the rate of technical progress can pick up and the rate of productivity growth will pick up," says Gary Burtless, economist at the Brookings Institution. "But there is little basis for optimism."
But is the U.S. really stuck in mediocrity? "Economies have a way of defying expectations," says Alan Brinkley, a professor of history at Columbia University. For example, economists expected anemic growth in the U.S. in the wake of World War II. But for the following generation the economy grew at a stunning pace. How about the limits-to-growth panic of the 1970s? Oil, food, and other commodities once feared in short supply are now in cheap abundance. Says Robert Eisner, economist at Northwestern University: "Economists look at what has been happening and say that must be natural. Growth has been slow so it must stay slow."
What the slow-growth forecasters fail to appreciate is that the U.S. is in the throes of a transformation. Underlying the recent acceleration in productivity is a gathering web of technological and commercial innovations revolutionizing the economy, much as steam power did in the late 1700s and electricity did in the late 1800s.
The Industrial Era is giving way to the Information Age. "We are living through one of these fundamental and profound changes in the economic paradigm built around the transmission, retrieval, and analysis of data and falling transport and communication costs," says Richard Lipsey, an economist and fellow at the Canadian Institute for Advanced Research.
And the Information Revolution is only part of a much bigger innovation wave. U.S. patent applications have surged by a remarkable 35% over the past six years. The financial services industry keeps churning out new products tailored to meet the needs of a global economy. Pioneers in biotechnology and multimedia are building whole new industries. Old-line companies like General Electric, AT&T, and Alcoa are shedding bureaucracies and rigid hierarchies to foster responsiveness and creativity. "Innovation is the mother of all core processes, encompassing all levels and functions of a corporation," says Richard Foster, director at McKinsey & Co. "And U.S. companies are collectively the most innovative in the world."
Growth guru. Conventional economics falls short in dealing with the impact of such momentous upheavals. The kind of models that predict a 2.5% limit to noninflationary growth describe a world where the economy plods ahead at a rate determined by the amount of capital and labor employed, while fiscal and monetary policies are geared toward keeping the economy's fluctuations within a fairly narrow band. Of course, conventional models do an excellent job of describing how interest rates affect home buying or how higher taxes crimp consumer spending. But they are almost mute when it comes to measuring how new technologies affect growth.
To better grasp the relationship between innovation and growth calls for turning to an economic tradition championed by the late Joseph Schumpeter, one of the 20th century's intellectual giants. Schumpeter developed the idea of creative destruction, the process by which new technologies, new markets, and new organizations supplant the old. "Except for Karl Marx, Schumpeter was the only economist who placed strong emphasis on innovation and technological change as sources of economic growth," says Frederic M. Scherer, economist at Harvard University.
In recent years, Schumpeter has become a leading light to a group of economists struggling to answer the most basic question in economics: What drives growth? Like Schumpeter before them, these economists argue that innovation is the essence of capitalism. Knowledge and its application to real business problems count for more than capital and labor, the traditional factors of production. Entrepreneurs, industrial research, and knowledge are what matters (box).
The U.S. is not an aging, mature economy to the Schumpeterians, but rather it can generate almost unlimited possibilities of new goods and new technologies. "Knowledge doesn't face diminishing returns. It's an expanding universe," says Richard Baldwin, economist at the Graduate Institute of International Studies in Geneva. Adds Paul Romer, economist at the University of California, Berkeley: "We systematically underappreciate the potential for new things to happen."
It's easy to lose sight of the importance of innovation on growth because it doesn't have a straight-line impact. Picture this: a chart with an S-shaped curve. When a new technology is introduced into a company, productivity actually falls as workers and managers struggle to master different techniques and skills. But as more and more people move up the learning curve, the new technology begins to pay dividends, and productivity surges ahead. And sometimes innovations come in clusters, such as now with computers, communications, and other high-tech information systems. When that happens, the S-curve effect is magnified as each advancing technology feeds off the other.
History offers striking examples of the S-curve effect. Take electricity. Many of the critical advances came in the 1870s and 1880s. But it wasn't until two to three decades later that the productivity-enhancing promise of electrification was realized. Overall, U.S. productivity jumped to a 2.4% annual rate in the early 1900s vs. a 1.3% pace in the late 1800s, according to Paul David, economic historian at Stanford University.
Evolutionary climb. Similarly, after a long lag, information technologies are just now living up to their economic promise. Says W. Daniel Hillis, co-founder of Thinking Machines Corp., a Cambridge (Mass.) maker of massively-parallel-processing supercomputers: "Society has to adapt around new technologies. That takes longer than developing the technologies themselves. The good news for the economy is we have a lot of stuff in the pipeline that will start paying off."
It's about time. For the past decade or more, the gale winds of "destruction" have been all too painful and apparent. Battered by vicious competition at home and abroad, companies have substituted information technologies for labor, eliminating millions of jobs. Corporate layoff announcements in the first quarter were up 11% from the same period last year, according to Challenger, Gray & Christmas Inc., an international outplacement firm. Delta Air Lines Inc. has just announced plans to eliminate 15,000 jobs in a mammoth restructuring, and overall unemployment levels are disturbingly high. The lethal combination of technological change and increased competition has slashed the real wages of low-skill and less educated workers, too.
Now, the signs of the payoff are finally here: Companies are becoming much more efficient. Anheuser-Busch Cos., the world's largest brewer, is replacing packaging equipment installed some 15 to 20 years ago with newer technology that requires fewer workers. Without adding any more workers, Mead Data Central, a leading electronic supplier of databases, is providing access to a lot more data. "We added 100 billion characters in 1993, and we'll probably add 250 billion characters this year," says Rodney L. Everhart, president of Mead Data.
Indeed, the rate of return on telecommunications investment is around 30%, including indirect benefits to the economy, says Francis Cronin, managing director at DRI/McGraw-Hill. And a recent study by Frank R. Lichtenberg, economist at Columbia University School of Business, found that one information systems worker can replace six other employees without affecting output.
Savvy companies are also discovering that breaking down the century-old command-and-control bureaucracies has an impact on innovation. For example, Toledo-based Dana Corp., a $5.5 billion producer of automotive and other industrial products, actively solicits ideas from employees at its 197 manufacturing plants scattered all over the world. "The power of that is incredible," says Southwood J. "Woody" Morcott, Dana's chief executive.
"Quite isolationist." Stitching together teams from engineering, design, finance, marketing, and production also seems to be boosting research and development productivity. As Rockwell International Corp. has shifted more of its R&d from long lead-time defense work to the fast-paced commercial market, it is tying its scientists to teams within the organization, according to Robert L. Cattoi, senior vice-president at Rockwell. Says John Seely Brown, head of the Xerox Corp.'s Palo Alto Research Center, better known as PARC: "We've moved from being quite isolationist to having a rich set of conversations with all parts of the company. [Yet now] we're probably bringing out more fundamental things than we ever have."
The benefits of the productivity boom are just beginning to boost worker incomes. Wages and salaries, after adjusting for inflation, are rising smartly for the first time in seven years. And a new study by North Carolina State economist Steven G. Allen shows that skilled workers in high-tech companies make more than their counterparts in less innovative outfits. "In industries with lots of R&D activity, you see a much more rapid growth of wages of college graduates," he says. And "it's not just scientists and engineers whose wages go up, it's everybody."
The official statistics fail to capture much of this productivity upturn. Productivity, an inflation-adjusted measure of output per unit of work, is relatively easy to calculate in the manufacturing industries. But when it comes to services or information technologies, which now account for more than two-thirds of the economy, the productivity measures are inadequate, says Zvi Griliches, economist at Harvard University. For example, more and more supermarkets have installed bar code readers in their checkout lines, making them faster and more accurate. Yet these gains to consumers do not show up in the government's numbers. With prices falling so fast in the high-tech market and quality improving so rapidly, the beancounters make mush of the productivity numbers.
What is clear, however, is that since it takes less money to buy better products, the productivity of capital is enhanced. For instance, computer users are accustomed to increasing their processing power by a factor of 10 every five to seven years at no additional cost. Overall, prices of computers and telecommunications equipment have plunged by 23% over the past five years. The government statisticians say that technological improvements and quality adjustments suggest that the consumer price index is overstated by some 0.5 percentage point--which would put it at a 2.1% annual rate instead of the posted 2.6%.
The forces holding inflation in check are also powerful. Labor costs are well under control and wage pressures almost completely absent. Unions have been sidelined, too. The number of workers covered by cost-of-living adjustments in major collective bargaining agreements is now lower than at any time in the past quarter century--from a high of 61% in 1976 to a low of 24% in 1993. The three-week strike by 75,000 Teamsters barely disrupted the economy in April. By contrast, when the Teamsters last struck, in 1979, the 10-day work stoppage caused widespread production disruptions.
glass cushions. The old rules of thumb about capacity utilization constraints and inflation flashpoints may no longer work, either. A lot of U.S. companies have plenty of manufacturing capacity abroad. When order flows substantially increase, companies can shift production runs to plants in Mexico, Canada, Asia, and other regions. Take Owens-Illinois Inc., the Toledo-based king of glass containers. Owens is running its glass plants at capacity, and the company is bringing in product from operations in Venezuela and elsewhere. Strong capital goods spending is quickly adding to the capital stock and raising capacity levels. Companies are increasingly adroit at boosting productivity and raising capacity, too. "It seems we get more creative each month," says Donald P. Hilty, chief economist at Chrysler Corp.
Even in those parts of the economy where prices are up, they aren't spiraling. Look at steel. Steel service centers, which purchase and distribute nearly 45% of all U.S.-made stainless steel, are shipping record volumes, and raw-steel producer plants are running near capacity. Over the past year, prices of flat-rolled steel have gone up from $310 a ton to $355, and scrap metal prices from an average of $97 to $147 per ton. But prices are leveling off with excess supply available from overseas makers. The price of scrap, used in minimills, has started to decline. When U.S. scrap prices surged, European buyers turned to cheaper Russian pig iron. "I don't think prices are going to go a lot higher," says F. Kenneth Iverson, chairman and CEO of Nucor Corp.
Disinflation is fast becoming the norm in the once inflation-prone U.S. economy. Producer prices are rising at only a 0.2% annual rate, and even medical-care inflation has dropped from an annual rate of more than 9% in 1990 to less than 5% currently. Economists often underestimate how long price trends can last, too. Over long stretches in history, inflation has been well-behaved. For instance, between 1860 and 1916, the annual rate of increase in the consumer price index was 0.3%, and it was 2.8% between 1960 and 1970. Says Stephen S. Roach, economist at Morgan Stanley & Co.: "With intense competitive pressures offering industry little alternative, there is good reason to believe that the fundamental break between the cost curve of the 1990s and those of the past will persist."
Higher U.S. productivity and technological innovation is a big competitive advantage in overseas markets too. Sure, the U.S still runs a merchandise trade deficit of some $130 billion a year, and worries about international competitiveness run deep. Japan and Europe are devoting huge private and public resources to nurturing science and technology. And the fast-growing economies of East Asia and Latin America are encouraging foreign multinational investment as a way of transferring manufacturing and management knowhow.
Altered positions. Nonetheless, U.S. companies are globally competitive in many leading-edge industries. The biotechnology industry, for example, was nearly nonexistent two decades ago and now has almost 700 active companies. The foundations of the Information Superhighway are being laid, despite the breakup of the mega-merger between Tele-Communications and Bell Atlantic. China's Guangdong province may be growing at 15% a year, but the Internet is expanding by 15% a month. Competitive high-tech goods are a key reason why U.S. export growth has averaged more than 9% a year over the past seven years--more than three times the gains of Japan and Germany. "And as consumers tap into the Information Highway, the competitive position of nations and industries may be further altered," says Steinberg of Merrill Lynch.
Indeed, in the U.S. there are fewer impediments to "creative destruction" than elsewhere. Regulatory burdens are fewer and market competition more intense. America is the only industrial country to have deregulated its airlines, financial services, telecommunications, trucking, and other industries. For instance, largely reflecting the competitive forces unleashed by deregulation, a blended measure of labor and capital productivity shows the U.S. telecommunications industry is as much as twice as productive as its counterparts in the major European countries, according to an analysis by McKinsey & Co. "What's important is that competition energizes new ways of doing things," says Donald McCloskey, economist at the University of Iowa.
Labor is highly flexible, too. And the nation's borders are more open. Research, development, and technological innovation are skills that are forged in the crucible of international competition. Most important, though, is America's entrepreneurial tradition. From Andrew Carnegie to Bill Gates, the incandescent lightbulb to spreadsheets, the U.S. has long been open to the ideas of innovators, mavericks, and immigrants. And these entrepreneurs have generated tremendous bursts of growth in the past. "What is our comparative advantage?" asks Zoltan Acs, economist at the University of Baltimore. "It is our ability to innovate."
Clearly, the U.S. economy is emerging stronger than it has been after two decades of turmoil. The nation is more productive and more competitive than at any point since the early 1960s. The biggest threat to the wellsprings of faster growth comes from the troubling combination of zealous restraint by policymakers and the inflation jitters of bond market investors. Both threaten to squander the economy's potential strength and all the jobs and wealth it would produce.
The U.S. can do better--but not if it continues to fear growth.