A "Free Lunch" for the Economy

Part 1 of an excerpt from Michael Mandel's Rational Exuberance says during tech-fueled growth, gains can exceed any added investment

Rational Exuberance: Silencing the Enemies of Growth and Why the Future Is Better Than You Think

by Michael Mandel

Chapter 3: How Innovation Matters

(Part 1, click here for Part 2)

The difference between exuberant and cautious growth is not simply that one is faster than the other. Exuberant growth transforms the entire economy. In terms of the critical economic variables -- wages, jobs, international competitiveness -- the evidence is compelling that innovation-driven economies come out way ahead. Technological change also brings an excitement and wonder to our daily lives. The ability to travel to distant places, to communicate instantly with people in other parts of the country, to have online access to a vast array of information -- all of these capabilities open up new possibilities that capture our attention. In the absence of change, economies are not just slow-growing, they are boring and ultimately failures.

Pathways of Change

There are three main pathways through which innovation drives growth: the "ramp-up," the "spin-off," and the "free lunch."

Ramp-up: When the innovation first hits the market, and the demand grows very rapidly, there's typically a lot of investment in the new industry and new products. This can give a very big onetime pop to growth. That's what happened in the 1990s, when the advent of the Internet helped propel an enormous amount of investment in information technology and telecom companies and products.

Spin-off: As the innovation takes hold, it transforms other parts of the economy. In some cases -- such as information technology and electricity -- the effect is to increase the productivity of other industries. But that's not necessarily the only big impact. The automobile, for example, opened up new possibilities for spatial arrangements of work and living, creating the modern suburbs, and transforming the housing market.

Free lunch: Economists like to quote an old saying: "There's no such thing as a free lunch." The idea is that you usually only get what you pay for. In particular, future growth must be paid for by deferring current consumption, and putting it into savings and investment. But big technological breakthroughs violate the free lunch principle, giving a boost to growth and living standards that goes far beyond any added investment. Let's look at each of these in turn.

The ramp-up effect is like a shot of adrenaline to an economy. It pushes growth much faster than it would otherwise go.

The Ramp-Up

Almost every new innovation goes through three phases. When initially introduced into the market, the process of adoption is slow. The early models are expensive and hard to use, and perhaps even unsafe. The economic impact is relatively small.

The second phase is the explosive one, where the innovation is rapidly adopted by a large number of people. It gets cheaper and easier to use and becomes something familiar. And then in the third stage, diffusion of the innovation slows down again, as it permeates out across the economy. (This process is also known as the S-curve.)

During the explosive or ramp-up phase, whole new industries spring up to produce the new product or innovation, and to service it. For example, during the 1920s, there was a dramatic acceleration in auto production, from 1.9 million in 1920 to 4.5 million in 1929. This boom was accompanied by all sorts of other essential activities necessary for an auto-based nation: Roads had to be built for the cars to run on; refineries and oil wells, to provide the gasoline; auto dealerships, to sell the cars; and garages, to repair them.

Historically, the same pattern is repeated again and again with innovations. The construction of the electrical system required an enormous early investment in generation and distribution capacity. The introduction of the radio was followed by a buying spree by Americans that quickly brought radios into almost half of all households by 1930, up from nearly none in 1924.

During the 1990s, the arrival of the Internet ignited an even more impressive expansion in the info tech and telecom industries. Purchases of computers, routers, and cabling soared. Employment at software publishers and information technology consultants doubled, and then doubled again. A whole new category of retail computer stores exploded, flourished, and consolidated, leaving behind only a couple of survivors.

The ramp-up effect is like a shot of adrenaline to an economy. It pushes growth much faster than it would otherwise go. By how much? During the tech boom of the 1990s, from 1995 to 2000, business spending on information technology rose at a 21 percent annual rate (adjusted for inflation and increases in computing power), while consumer spending on computers and peripherals rose at an almost 60 percent annual rate (also adjusted for inflation and increases in computing power). Over the same period, the rest of the economy grew at only a 3.1 percent rate. To put that in perspective, that's below the average growth rate for the whole economy in the 1980s. Without the ramp-up effect, the New Economy boom would have been merely a little firecracker.

Looking forward, there are some incipient innovations that could potentially produce a very large ramp-up effect. For example, a widespread shift to the use of hydrogen as a fuel, especially in automobiles, would cost hundreds of billions to retool the energy distribution system. Hydrogen requires a very different infrastructure for storing and delivering than does gasoline. Buried gasoline tanks might be replaced by hydrogen "sponges" -- solid materials that store hydrogen. Depending on how fast the shift took place, it could give a nice little boost to growth.

The ramp-up effect is usually ignored by economists, because it is only a one-time bump. Yet it is quite important, especially for the big innovations. The Western world has gone through several periods when innovation followed innovation in rapid succession. If each one gives the economy a little (or a big) jolt, that's enough to keep things moving forward. The Spin-Off

Any innovation pushes the production capabilities of an economy into new territory. But just as the discovery of a new continent doesn't tell you who will settle it or what kind of nation will evolve there, it's equally hard to predict what kind of impact a new innovation will have. The one that everyone thinks of first is increased labor productivity. However, labor productivity is not the only possible spin-off effect, and for many innovations may not be the most important one.

History suggests that the spin-off effects may take years or even decades to fully manifest themselves. Electricity was introduced toward the end of the 1880s, as Thomas Edison and George Westinghouse waged a great battle to determine whether the electrical system would run on direct current, as Edison proposed, or alternating, as Westinghouse wanted. The unprecedented use of electricity to light the 1893 World's Fair in Chicago was a marvel at the time. As Jill Jonnes wrote in her 2003 book, Empires of Light, the Ferris wheel

glittered in the sky, its gradual (electrically powered)

turning outlined with three thousand light bulbs....

The White City illuminated at night was a radiant

electrical vision long remembered by all who witnessed it.

Nevertheless, several economic studies have shown that it wasn't until the 1920s and 1930s that the use of electricity was widespread enough to boost labor productivity in the U.S., Britain, and Japan.

Similarly, it seems likely that increasingly widespread use of the Internet and Web-enabled businesses is a critical reason why productivity rose so fast in 2002 and 2003. A recent study from the Brookings Institution suggested that the Internet could boost productivity -- and overall growth -- by up to an extra half percentage point a year.

Innovations may also have a geographical impact that doesn't directly show up in the growth statistics. Before the introduction of the auto, suburbs were located mostly on train lines, with the jobs still in the center cities. But once automobiles became common in the 1920s, it was much easier to live anywhere, or to locate businesses and stores outside of the urban core.

On a slightly less cosmic note, the introduction and spread of air-conditioning is clearly connected with the rise of the Sun Belt states. Once again, there was a time lag between the original invention and the wider impacts. Willis Carrier received the first patent for air-conditioning in 1906, and formed the Carrier Engineering Corporation in 1915. Department stores began being air-conditioned in 1924, and home air-conditioning units followed soon afterward.

Not coincidentally, that marks the moment when the southern region of the country began to take off. Before air-conditioning became commonplace, in the first three decades of the 20th century the South's share of the country's population fell, as farmworkers headed north to the booming factories. Georgia actually lost population in the 1920s. But as air-conditioning made living and working in the South more attractive, growth picked up and hasn't yet stopped. (The ramifications of air-conditioning still persist today, making tropical and subtropical countries reasonable places to relocate factories.)

Innovations in health, especially for the elderly, are a boon for longevity and quality of life, but don't necessarily show up in the official economic statistics.

Innovations in health, especially for the elderly, are a boon for longevity and quality of life, but don't necessarily show up in the official economic statistics. GDP -- gross domestic product -- measures production, as the name implies. Imagine that the biotech revolution starts paying off, in terms of effective cures for major diseases. Longevity would rise significantly, but perhaps at a very large cost. There's no doubt that many people would find it worthwhile to divert money from other things -- such as housing -- to pay for more years of life. However -- and this is a big however -- those extra years of life would have almost no direct impact on growth, especially if the prime beneficiaries are older people who have already left the workforce.

In a less serious context, another example of a spin-off effect is Internet dating. The drive to meet a mate and start a family is one of the most powerful that we have. The widespread use of Internet personal ad sites dramatically increases the pool of potential partners, drawing from a wider range of geographical locations. Even within a local area, we are no longer bound by our friends and work partners -- the search can reach out and touch many different subgroups of society.

The larger implications of Internet dating are not yet clear. In theory, access to more potential partners will improve the quality of matches, which should lead to fewer divorces. At the same time, Internet dating should lead to more cross-country or cross-border relationships, which may be harder to sustain.

Or consider the field of entertainment, where video and computer games comprise a whole new mode of amusement that did not exist before. We can be more or less skeptical of the intellectual or moral value of such best-selling games as Grand Theft Auto: Vice City, but their appeal cannot be denied (especially to certain age classes). Amusement is an important human need, which is not generally captured by purely economic variables. The "Free Lunch"

One of the surprising things about innovation is that it emphatically breaks the link between savings and growth. A country or a company that makes better use of a new technology can potentially leap far ahead of one that saves and invests more. Innovation is, as was said above, the economic equivalent of a free lunch. In some sense, this goes against the values drilled into us when we are young. Traditionally we respect people -- and countries -- who save more. Putting money away for the future and then reaping the benefits later on seems like an admirable thing to do, even if we don't save ourselves.

In the end, bright ideas, risk-taking, and execution were more important than how much money we saved and invested.

In particular, in the 1980s, Japan, with a national savings rate in excess of 30 percent of GDP, was held up as a paragon of virtue. (National savings is computed by combining the savings of households and corporations, while subtracting the budget deficit of the government.) Meanwhile the U.S. with a national savings rate that only averaged 16 percent of GDP, developed a reputation, both domestically and globally, as a myopic, consumerist culture. Especially during Japan's boom years of the late 1980s, Japanese prime ministers would lecture the U.S. on the need to increase the savings rate. Fortune magazine wrote in 1988:

Since at least the Book of Proverbs -- "a wise man saves for the future, but a foolish man spends whatever he gets" -- saving has stood as a test of virtue. America looks to be flunking the test these days.... Moral fiber aside, persistent undersaving is a ticket to economic oblivion if a nation cannot invest in tomorrow's productive machinery and individuals cannot be sure of a good future.

The same year, Senator Lloyd Bentsen, a Democrat and later treasury secretary in President Bill Clinton's first term, called the savings rate "a disgrace." In 1989, both Democrats and Republicans on the Joint Economic Committee of Congress agreed that the nation's chief economic problem was a low savings rate. But it turned out that having a high savings rate did not prevent Japan from its slowdown in the 1990s, and having a low savings rate did not stop the U.S. from having a boom in the 1990s. In fact, despite being mired in a long slump, Japan still had much higher savings and investment rates than the U.S. throughout the decade. From 1995 to 2000, the national savings rate in Japan averaged 29 percent of GDP, compared with 18 percent in the U.S. That's a slightly smaller gap than in the 1980s, but there's no doubt that the Japanese were still better savers than the Americans, even during the New Economy boom years.

The free-lunch effect was stronger than the "virtue" of savings and investment. The U.S. leapt ahead because American companies and individuals were better able to apply the new innovations and ideas of the Information Revolution. In the end, bright ideas, risk-taking, and execution were more important than how much money we saved and invested.

Part 2 of this book excerpt discusses how jobs, wages, and competitiveness could jump with exuberant growth.

The foregoing is excerpted from Rational Exuberance: Silencing the Enemies of Growth and Why the Future Is Better Than You Think

, by Michael Mandel. All rights reserved. No part of this book may be used or reproduced without written permission from HarperCollins Publishers, 10 East 53rd Street, New York, NY 10022

Imprint: HarperBusiness; ISBN: 0060580496; On Sale: 05/11/2004; Format: Hardcover; Trimsize: 6 x 9; Pages: 224; $24.95; $38.95 (CAN)

Mike Mandell is Chief Economist at BusinessWeek, responsible for formulating BusinessWeek's coverage of economic policy. Prior to this, he was economics editor and played a key role in defining and popularizing the notion of the New Economy. In 1998, Mandel won the Gerald R. Loeb Award, the most prestigious prize in business and financial journalism, for his coverage of the New Economy.

Mandel's most recent book, The Coming Internet Depression (Basic Books), came out in September, 2000, and predicted the end of the tech-driven boom of the 1990s. His 1996 book, The High Risk Society, (Times Business/Random House) foreshadowed the New Economy by arguing that the coming decade would be marked by a combination of high growth and high volatility.

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