Commentary: How Most Economists Missed The BoatBy
Celebrating victory in economics is dangerous. When the New York Yankees won the 1999 World Series, they could be confident that no statistician could go back and change the final outcomes. But in economics, the data are always subject to revision, and what seems to be true at one time may later turn out to be very different.
So when the Commerce Dept. released a major revision of the historical economic data on Oct. 28, it dramatically changed the score on the three-cornered economic policy wars of the 1980s and 1990s. The big winners are New Economy advocates--including BUSINESS WEEK--who now have much better evidence to support their claims that information technology can lead to much higher productivity growth.
ECONOMIC SHOCKS. The big losers are most economic forecasters and mainstream macroeconomists, who held the conventional view that growth mainly depends on building up the capital stock of equipment and structures. The new data undercut their argument--made consistently over the past decade--that the large government deficits of the 1980s and early 1990s would depress investment and doom the U.S. to slow growth for years to come.
And for supply-side supporters--including many Republican members of Congress, Presidential candidate Steve Forbes, and the editorial page of The Wall Street Journal--the new numbers are both good and bad news. The supply-side position, quite simply, is a belief that tax cuts are the best way to stimulate growth. The revised data show higher growth in the 1980s, making the Reagan-Bush era look better compared with the Carter Administration. On the other hand, the economy did very well in the aftermath of the tax increases of 1990 and 1993, something that the supply-siders would not have predicted.
This is not just ancient history. Today's debate between the Clinton Administration and Congress over what to do with the budget surplus--cut taxes, pay down the debt, spend on education and other investments for the future--closely reflects the different positions of supply-siders, conventional economists, and New Economy advocates, respectively. The same issues will also help determine what is done about Social Security.
To be sure, the U.S. economy has been hit by several shocks in the recent past that no one could have expected. The end of the cold war freed up resources by moderating defense spending, and opened up new global markets. And Japan's slump and the Asian meltdown held down prices for key commodities such as oil.
STEADY PICKUP. Nevertheless, the new numbers provide a much more coherent picture of the past two decades. The old data showed long-term growth in productivity, or output per worker--the key measure of the health of the economy--slumping to about a 1% annual rate in the mid-1970s and staying there well into the '90s. The low point for long-term growth--measured by the average productivity increase over the previous 10 years--was 1996.
The Labor Dept. will issue its official revisions of the productivity data on Nov. 12. But a BUSINESS WEEK analysis of the new data from the Commerce Dept. shows that output per worker started to grow faster under Reagan, then steadily picked up speed in the 1990s. The low point for long-term productivity growth is now 1982, not 1996.
Consider: Productivity growth from 1981, when Reagan took office, to 1989, when he left, was 1.6%, far faster than Carter's 0.8% rate (chart). Productivity rose at a 1.7% rate in Bush's term, and in the first four years of the Clinton Administration, it rose at a 1.8% rate before soaring by an estimated 2.8% in 1998 and 1999. By contrast, according to the old data, productivity growth in the first term of the Clinton Administration was actually lower than the Reagan gains, and Bush-era growth was lower still.
This steady pickup in productivity growth makes a lot more sense than the previous data. The beginning of the acceleration in output per worker now roughly coincides with the 1982 start of the long bull market. With the old data, it looked like the market rose by about 180% from 1982 to 1990 without any corresponding improvement in economic health.
The new statistics also give some evidence of the early impact of the Information Revolution. IBM announced its first PC in August, 1981, but the old numbers showed no productivity gains from the PC boom of the 1980s.
The supply-siders, too, benefit from the upward revisions in the 1980s data. Under the old data, conventional economists could argue that the massive tax cut signed by Ronald Reagan in 1981 had sent deficits soaring without lifting productivity. Under the revisions, the optimistic economic forecasts of the Reagan Administration--the so-called "rosy scenario"--turned out to be fairly accurate. The 1982 Economic Report of the President projected 4.7% gross national product growth from 1982 to 1987--and that's exactly what the latest data show.
More important for the supply-siders, the sterling economic performance of the 1990s destroys the central attack by conventional economists against tax cuts. They argued that the high budget deficits in the 1980s would give a short-term boost to output, but then the lack of savings would gradually eat away at the future long-run competitiveness of the economy.
In a 1988 book, Benjamin Friedman, a Harvard University economist and critic of supply-side economics, wrote: "Our prosperity was a false prosperity, built on borrowing from the future." Similarly, a 1987 BUSINESS WEEK column by Princeton University economist Alan S. Blinder argued that "no binge lasts forever. The drunk eventually sobers up. Sooner or later, America will awaken to the hangover of Reaganomics."
But these dire consequences of the tax cuts never came to pass. Instead, the economy accelerated in the 1990s. True, federal taxes were raised in 1990 and 1993 to help close the deficit. But even after these two increases, the share of personal income going to federal income taxes in 1995 was still only 9.4%, substantially below the nearly 11% share in 1979. Given how harshly they were attacked for undermining the future of the economy, it is only natural that the supply-siders crow about the boom.
NEW INVESTMENT. Nevertheless, the newly revised data favor the New Economy position more than the supply-side view. For one, productivity growth in the 1990s was revised upward by a full six-tenths of a percentage point, disputing the argument--made vehemently in the early 1990s by supply-siders--that any tax increase, no matter how small, would devastate the economy.
Moreover, the new data do nothing to back up the most extreme supply-side claims from the early '80s, that the Reagan tax cuts would generate enough revenue to more than make back the money lost. There is also still no evidence that the tax cut of 1981 produced a surge of business investment, as was the intention. According to the updated numbers, real business investment rose at only a 3.3% rate from 1981 to 1989. By contrast, spending on structures, equipment, and software has soared at more than a 10% rate under Clinton.
In the 1990s, at least, it seems that technology is more powerful than either taxes or deficits. No one is saying that the three are mutually exclusive. Lower interest rates from increased savings can encourage innovation. So can lower tax rates. But for now, the New Economy advocates get to take home the trophy.