Improving Economic Growth

1

De LongView of Growth

A Short Review of Economic Growth: Theories and Policies

J. Bradford De Long

University of California at Berkeley, and National Bureau of Economic Research

December 1996

Version 2.0

Executive Summary

This essay provides a short overview of how different government policies might affect economic growth. It attempts to sketch out what are the are reasonable and unreasonable estimates of the boost to economic growth that could follow from different policy options.

The task is complicated because economistsÕ views on the nature and causes of the wealth of nations are, today, more than usually divergent.

As a result of a line of thought and discussion sparked by Stanford economist Paul Romer in the mid-1980s, the theory of economic growth today is up for grabs. A substantial minority of economists still hold to the ÒbaselineÓ vision of economic growth laid out by Robert Solow in the 1950s, which tends to lead to the conclusion that most growth is determined by extra-economic factors and does not depend strongly on economic policy, for the progress of science and technology depends little on monetary or fiscal policy. The Òvital centerÓ of the American economics profession today holds to an extended and reformulated version of the Solow framework, best exemplified by Gregory Mankiw, David Romer, and David WeilÕs ÒContribution to the Empirics of Economic Growth,Ó in which growth is more significantly affected by policies for two reasons: first, estimates of the social marginal product of physical investment are somewhat larger; second, because shifts in economic policy that boost production amplify themselves much more by inducing further investment in physical capital and, most important, in human capital via education.

A substantial group of economists, a group that looked as if it might be on the verge of obtaining intellectual dominance five years ago but that has lost some ground since, has become convinced by the Òendogenous growthÓ perspective attached to Paul Romer, and concludes that good and bad economic policies can have much more significant effects on growth. According to this perspective externalitiesÑwedges between the social returns realized by the economy and the private returns realized by investorsÑare pervasive. The advance of economically-useful knowledge and thus of total factor productivity depends urgently on the progress of other forms of investment.

This Òendogenous growthÓ perspective comes in a ÒnarrowÓ flavor, which emphasizes returns to research and development, and a ÒbroadÓ flavor, which stresses the many channels through which investment can influence the overall level of total factor productivity.

OneÕs conclusions about the ability of economic policies to affect economic growth depend crucially on which vision of economic growth one adopts. Three conclusions, however, appear quite solid:

• First, there is strong reason to believe that the American economy invests too littleÑthat the persistent budget deficits (which threaten to explode in the next decade whether or not the budget is brought into temporary formal balance in 2002) are damaging. Even if one holds to the baseline Solow framework in which policies to boost investment in America have little visible impact on time series of economic growth, such policies nevertheless have high benefit-cost ratios.
• Second, as one moves first to extensions and augmentations of the Solow model in which human capital plays an important role and then to the externality-emphasizing Òendogenous growthÓ perspectives, the case for tuning American economic policy in the direction of a budget surplus and low rates of tax on prospective investments becomes much stronger. The Mankiw-Romer-Weil model generates impacts of policy changes on economic growth approximately twice as great as the Solow framework; the Òendogenous growthÓ perspectives generate results that are greater still.
• Third, the stakes at risk in finding policies to spur growth are perhaps larger for the political left than for the political right. All have an interest in faster economic growth: faster growth empowers the American people to better achieve their endsÑwhether their ends are sitting on beaches sunning themselves, raising their children, protecting endangered species, or increasing their level of education. Those of us on the left have an additional interest in the preservation of the twentieth century social insurance state, which I think has done a good job at raising human welfare and making America a somewhat more equal place. In the absence of faster growth, the future of the social insurance state is easy to read: first Medicare and Social Security devour the rest of the Great Society and the New Deal; then Medicare and Social Security run up against their own funding constraints, and implode.

I. Introduction

Economic growthÑthe measured rate of increase of real GDP per worker, and of labor productivityÑhas slowed markedly in the United States over the past generation. In the 1950s and 1960s measured real GDP per worker increased at roughly 2.5% per year; since 1970 it has averaged less than 1.0% per year (see Jorgenson, 1988).

It is possible to see this glass as half-full. Measured estimates of real GDP growth in all probability understate true improvements in productivity and standards of living. Measured estimates suffer from the standard problems of index numbers, of which the most important is that they fail to solve the unresolvable problems of valuing the invention of new goods and new types of goods

It has become standard to guess (but it is only a guess) that ÒtrueÓ growth is one percentage point per year greater than ÒmeasuredÓ growth (see Boskin et al., 1996).

If this is indeed the case, then ÒtrueÓ real GDP per worker growth has averaged not 1.0% per year but 2.0% per year. 2.0% per year real GDP per worker growth is very large by long run historical standards, relative to any period but the thirty-year post-World War II boom. It is significantly faster than nineteenth or early twentieth century standards, and vastly more rapid than the millennia of near-stagnation in living standards that preceded the industrial revolution.

Note, however, that the magnitude of the productivity slowdown remains at least as large as, and possibly larger than, in standard measurements. Growth today is faster than official statistics suggest, but growth in the past was faster than official statistics suggestÑand possibly the gap was wider to the extent that the forces that generate measurement bias are correlated with the economic changes of productivity growth.

But on balance it is perhaps more important that the glass is half empty. The slowdown in productivity growth has left us with a social insurance system and government spending commitments that make sense only if output per worker, and thus the tax base per worker, grows at a measured rate of 2.5% per year on average. Promises made by presidents and congressional leaders in the 1960s and 1970sÑand 1980sÑabout future tax rates and benefit levels cannot be kept if measured output per worker growth remains at 1.0% per year.

At a true rate of GDP per worker growth of 3.5% per yearÑa measured rate of 2.5% per yearÑAmericaÕs real standard of living doubled every twenty years. At a true rate of 2.0%Ña measured rate of 1.0%Ñsuch a doubling takes thirty-five years. The productivity slowdown makes America a poorer country than it might otherwise have been. The resulting gap between how people are living today and how generation ago they had believed that they would be living today makes voters cranky. It turns politics into a search for scapegoats: corporate welfare recipients, individual welfare recipients, Mexicans who dare to stay in Mexico and produce goods for export to the United States, Mexicans who dare to cross the border and work in the United States, bosses who downsize companies, teachersÕ unions. The transformation of politics into a search for scapegoats does not lead to better public policy.

Reversing even a part of the productivity growth slowdown would pay enormous benefits, both in higher living standards and greater welfare directly and in changing the political climate in a way that would make better choices easier.

So what might be done to reverse this slowdown? Can anything be done to reverse this slowdown?

Some think that nothing or next to nothing can be done to increase economic growth. Others think that reversing the productivity growth slowdown is trivially easy. Both are wrong. Yet their arguments echo through our political system.

This essay provides a short view of how different policies could affect economic growthÑof what are reasonable and unreasonable estimates of the boost to economic growth that could follow from different policy options. The task is complicated because economistsÕ views on the nature and causes of the wealth of nations are, today, more than usually divergent.

As a result of a line of thought and discussion sparked by Stanford economist Paul Romer in the mid-1980s (see Romer, 1986, 1989, 1994), the theory of economic growth today is up for grabs. A substantial minority of economists still hold to the ÒbaselineÓ vision of economic growth laid out by Robert Solow in the 1950s (see Solow 1956, 1957, 1992), which tends to lead to the conclusion that most growth is determined by extra-economic factors and does not depend strongly on economic policy, for the progress of science and technology depends little on monetary or fiscal policy. The vital center of the American economics profession today holds to an extended and reformulated version of the Solow framework, best exemplified by Gregory Mankiw, David Romer, and David WeilÕs (1992) ÒContribution to the Empirics of Economic Growth,Ó in which growth is more significantly affected by policies for two reasons: first, estimates of the social marginal product of physical investment are somewhat larger; second, because shifts in economic policy that boost production amplify themselves much more by inducing further investment in physical capital and, most important, in human capital via education.

A fringe of economistsÑa fringe that looked as if it might be on the verge of obtaining intellectual dominance five years ago, but that has lost some ground sinceÑhas become attached to the endogenous growth perspective of Paul Romer, and tends to reach conclusions that good and bad economic policies can have much more significant effects on growth. According to this perspective externalitiesÑwedges between the social returns realized by the economy and the private returns realized by investorsÑare pervasive, and the advance of economically-useful knowledge and thus of total factor productivity depends urgently on the progress of other forms of investment. This Òendogenous growthÓ perspective comes in a ÒnarrowÓ flavor, which emphasizes returns to research and development, and a ÒbroadÓ flavor, which stresses the many channels through which investment can influence the overall level of total factor productivity.

OneÕs conclusions about the ability of economic policies to affect economic growth depend crucially on which vision of economic growth one adopts. Three conclusions, however, appear robust:

• First, there is good reason to believe that the American economy invests too littleÑthat the persistent budget deficits are damaging, and that especially in times of inflation the tax system is badly-tuned to provide incentives for investment and growthÑeven if one holds to the baseline Solow framework, in which successful policies have little visible impact on time series of economic growth (even if they have high benefit-cost ratios).
• Second, as one moves away from the baseline Solow frameworkÑfirst to the extended and augmented Solow model in which human capital plays an important role, and then to the externality-emphasizing Òendogenous growthÓ perspectivesÑthe case for tuning American economic policy in the direction of a budget surplus and low taxation on prospective investments becomes much much stronger. The augmented and extended framework of Mankiw-Romer-Weil generates impacts of policy changes on economic growth nearly twice as great as the Solow framework if one looks out at total cumulative effects twenty years in the future; the Òendogenous growthÓ perspectives generate results that are greater still.
• Third, there is a sense in which the stakes at risk in the task of finding policies to spur American economic growth are larger for the left than for the right half of the political spectrum. All have an interest in faster economic growth: faster growth empowers the American people to better achieve their endsÑwhether their ends are sitting on beaches sunning themselves, raising their children, protecting endangered species, or increasing their level of education. The left has an interest in the preservation of the twentieth century social insurance state, that I believe has done a good job at raising human welfare and making America a somewhat more egalitarian place. In the absence of faster economic growth than has been seen in the past two decades, the future of the social insurance state is easy to read: Medicare and Social Security devour the rest of the Great Society and the New Deal over the course of the next generation, and then two generations hence Medicare and Social Security run up against their own budget constraints.

II. Wrong Answers

Look first at the wrong answers to the question of what might be done to spur economic growth. As examples of the first wrong answerÑthat it is easyÑconsider the views of those like Felix Rohatyn, mentioned as a possible candidate for Federal Reserve Vice Chair; and the views implicit in the arguments of StanfordÕs John Taylor, point man on economic issues for the recent Republican presidential campaign on the other. In the view of those like Felix Rohatyn, the only thing keeping the U.S. economy from growing at 4% or 5% per year is the Federal Reserve: let the Federal Reserve ease up on interest rates, and the U.S. economy will leap forward rapidly. In the view of those like John Taylor, relatively small changes in tax policies could easily boost the rate of economic growth by a full one percentage point per year or more (see Dole and Kemp, 1996).

As an example of the second wrong answerÑthat is impossibleÑconsider the views of Harvard economist Robert Barro (1996a, 1996b). Barro holds that rates of growth are ultimately determined by (a) an economyÕs technology gap vis-a-vis the worldÕs Òbest practiceÓ frontier, and (b) its politico-economic institutions: Òmaintenance of the rule of law and property rights... market distortions, the extent of political freedom and monetary/inflation policy.Ó Because the U.S. economy is at the worldÕs technology frontier and possesses relatively good institutions, annual growth in the low two percents Òis as good as it getsÓ (Barro, 1996a).

The easier monetary policy view is wrong because there is no evidence that looser monetary policy leads to significantly faster real GDP growth.

Over the twenty-three years since the 1973 Òoil shockÓ that tripled world energy prices and began our current regime of relatively slow economic growth, some eighty percent of the variation in year-to-year real GDP growth rates is accounted for by changes in the unemployment rate and changes in the rate of labor force growth: holding the unemployment rate constant, a one percentage-point increase in labor force growth over a year increases real GDP by an estimated 0.54 percent; holding the labor force constant, a one percentage-point decrease in the unemployment rate over a year increases real GDP by 1.67 percent. ÒBackgroundÓ growth in real output holding both the labor force and the unemployment rate fixed has averaged 1.57 percent per year.

(1)Real GDP Growth = 1.57% -1.676(Unemp. Ch.)+0.538(LF Growth)R2=.79 SEE=.010

(0.58%) (0.206) (0.308)

With the labor force growing at its current pace of approximately 1.0 percent per year, real GDP growth averages some 2.1% per year holding the unemployment rate constant. Looser monetary policy would accelerate economic growth, and labor productivity would increase: a one percentage point extra reduction in the unemployment rate boosts output not just by the 0.54 percent that is the marginal product of an extra worker, but by an extra 1.34 percentÑsome coming because lower unemployment means a higher average workweek, and some coming because more expansionary monetary policy is genuinely accompanied by higher productivity.

But the magnitude of the productivity boost from looser monetary policy is limited. 4% per year growth would, with the labor force expanding as current demographics allow, lower unemployment by 1.1% per year; 5% per year growth would lower unemployment by 1.7% per year. Five years at 4% growth or three years at 5% growth would lower the unemployment rate below zero.

Thus claims that looser monetary policy could boost growth to 4% or 5% a year over the medium term assume a major break in the structure economy: a large and unprecedented shift in the relationship between productivity growth and employment that there is no reason to anticipate.

Similarly improbable is the hope that relatively small changes in the tax code could trigger large increases in economic growth through improvements in productive efficiency. The tax law changes in 1981Õs ERTA , the flagship initiative of the Reagan administration, were designed to have as large a positive supply-side impact as possible: every dollar of notional revenue loss was spent reducing marginal tax rates for someone, and the reductions in marginal tax rates were larger the higher was the initial marginal rate of the taxpayer.

Yet even the largest estimates of the supply-side benefits from ERTAÕs tax reductionsÑthe estimates produced by Lawrence Lindsey and presented in his 1990 book, The Growth ExperimentÑfind that each dollarÕs worth of tax cut (defined in terms of the notional static revenue loss) triggered perhaps a dollarÕs worth of additional real GDP, some uncertain amount of which was not a true addition to production but a shift from unrecorded and untaxed to recorded and taxed economic activity.

Thus the (notional) one and a half percentage points of GDP reduction in income taxes as a result of ERTA triggered, on LindseyÕs estimates, a one-time one and a half percent boost to real GDPÑan increase in the real GDP growth rate of 0.3% per year over the five years after implementation.