productivity has grown too slowly. GNP per capita is determined by average
productivity, the average value of goods and services produced by each person.
In the long term meager productivity growth will be matched by disappointing
GNP growth. Unfortunately, our productivity growth has been mediocre,
despite, and perhaps because of, our adoption of purer free market policies. From
an average of 3% from the end of the Civil War through the Kennedy
Administration, our productivity growth is now struggling at just over 1%.
There are economists who insist that our productivity growth is better
than the official numbers. But careful research has not borne out such hopeful
claims. Professor Robert Gordon, a consultant for the Federal Reserve, recently
completed a comprehensive study on productivity. His results show that over
the past five years there has been no productivity improvement in the
manufacture of non-durable goods. For durable goods (except computers), there
has actually been a decline in productivity. Our entire increase in manufacturing
productivity has come from the computer-manufacturing sector, which
accounts for just over 1% of GNP.
But if we have adopted the most enlightened economic policies and if
productivity is so important, why is our productivity growth so low?
Economists have told us productivity growth depends on net business and
infrastructure investment, which in turn depends on savings. So our GNP
growth has been lagging because our productivity growth has been lagging. And
our productivity growth has been lagging because our investment has been
lagging. And our investment has been lagging because our savings rate has been
lagging.
This still fails to explain our mediocre productivity growth; it just redirects
the question upstream. If savings and investment are so important, why are our
savings and investment rates so low? In particular, what have we done to
increase our savings, investment and productivity?
Since 1980 we have tried two different approaches. The former approach,
adopted by the Reagan Administration, was a return to the strict orthodoxy of
laissez faire. Reagan’s team lamented that we had been deceived by the liberals
to worship the idol of big government. It claimed we were suffering the
consequences of our idolatry in lower savings and productivity and in slower
economic growth. If we wished to reap the full-flowing benefits of our economic
system, we would have to return to a pure faith in the free market.
One of the tenets of this faith is that it is the wealthy who generate savings.
Our lower and middle classes must spend all their income on the necessities of
life and have little left over to save. Only the wealthy have the capacity to save
and invest. But our oversized government has placed undue burdens on the
wealthy. Government has redistributed wealth, taking from the rich and giving
to the poor, who cannot save. It has also taken from the rich and given to
government bureaucrats to spend on their pet projects, unencumbered by the
market.
The Reagan program was designed to remedy these evils. If we were to take
after-tax dollars from those who need them and so are likely to spend them, and
give them to those who do not need them and so are likely to save them, we
would redirect consumption into increased savings, a higher level of investment,
greater productivity, and a better economy for all.
In addition, if we were to take money from government bureaucrats and
return it to the wealthy, they would save it and invest it in accord with free
market principles. These investments would now be regulated by the invisible
hand of market prices and no longer by the perceptions of bureaucrats. Because
the invisible hand automatically maximizes total wealth, at least in theory, this
transfer of capital must have a positive effect on the economy as a whole. Giving
more money to the wealthy would trickle down to everyone’s benefit.
In keeping with this picture painted by his economic advisors, the Reagan
tax cuts were geared entirely toward the rich. According to the Congressional
Budget Office, Reagan’s tax policies reduced the total federal tax rate (including
Social Security) for the top 1% while increasing it for the bottom 90%. A 1992
study by H & R Block showed that from 1977 to 1990 the total federal tax bill for
a person earning $50,000 a year increased 8%, while the tax bill for someone
earning $200,000 a year decreased 28%.
Many of those supporting the Reagan tax cuts pointed to the Kennedy tax
cut that reduced the top marginal rate from 91% to 70%. They claimed that this
was responsible for the halcyon economy of the 1960s. Wrong! Kennedy was
unable to get his proposals through Congress. The passage of his program had to
wait for Lyndon Johnson, and the tax reductions did not take effect until 1964
and 1965. So what happened?
These tax cuts did mark a major watershed. But — contrary to the claims of
apologists for laissez faire — it was a negative one. Real GNP growth declined
from over 5% in the first half of the 1960s to 3.3% in the second half of the 1960s
and 2.6% in the first half of the 1970s. The decades after these tax cuts have been
marked by slower growth, higher inflation, higher unemployment, higher
interest rates, and greater debt than the previous decades. After the tax cuts our
productivity growth, the most important determinant of long-term economic
growth, began to plummet. Long-term productivity growth declined 60% from
its levels prior to the Kennedy tax cut. (The other major pre-Reagan tax cut,
which reduced capital gains taxes by 30% in 1978, also marked a steep economic
decline.)
Despite this history, Reagan’s economic advisors, blandly confident,
assured us the Reagan tax cut would stimulate the economy and bolster savings.
They also assured us — at least until tax receipts plummeted — that the
economic growth produced by this tax rate cut would increase federal tax
receipts.
Contrary to these assurances, the Reagan tax cuts did not increase
economic growth, savings, investment or tax receipts. In light of the failure of
the Kennedy-Johnson tax cut, it should not be surprising that the effect of the
Reagan tax cuts was just the opposite of what his economic advisors had
forecast. Our savings rate, guaranteed to rise, did not even hold steady.
While our net savings had only rarely and briefly dropped below 6% of
GNP from 1950 to 1980, it has been declining steadily since the early 1980s,
decisively penetrating the 6% level. It has gone negative for the first time in 70
years. Even corporate investment, consistently our most positive investment
sector, has failed to improve. Despite heavy borrowing and large reductions in
corporate tax rates in the 1980s, corporate investment is little changed from its
levels of 50 years ago when the highest corporate income tax rate exceeded 50%.
In short, the bill of goods we were sold is worthless. The Reagan
Administration proclaimed that if our tax policies were tilted to favor the rich
then savings and investment would rise and everyone would prosper. But
contrary to the glowing promises of progress and prosperity for all, our
economic growth slowed, our savings rate declined, our debt rose sharply, and
all but the richest lagged.
Had we considered the effect of the Kennedy-Johnson tax cut, we might
have hesitated to swallow whole hog the laissez faire revivalist message of
Reagan’s economic advisors. Had we looked at Western Europe, where the ratio
of tax revenues to GNP is 30% higher than ours, but where savings exceed ours
and productivity and standards of living are rising faster, we might have
reconsidered. Had we even examined our own historical correlation between
reducing marginal tax rates on the highest incomes and slower economic
growth, we might have had second thoughts about sharply cutting the top
marginal tax rates.
Why did we not look at the historical evidence and decide — at the very
least — on a more gradual approach? Why did the attraction of free market
ideology overwhelm the lessons of history? For an administration that described
itself as conservative, this is astonishing, for central (if not defining) themes of
conservative thought have been the precedence of history over ideology and a
worry about what could go wrong with radically new policies.
From a truly conservative perspective, considering the previous failure of
similar policies, the failure of Reagan’s policies was no surprise. Surprising or
not, that failure left us with declining savings, stagnant investment, mediocre
productivity improvement, and slowing economic growth.
Our more recent attempt to deal with low productivity growth stems from
the Clinton Administration of the 1990s. It reflected a different philosophy: if
you can’t hit the target, move the target. In the spirit of this philosophy, we
introduced a new variable to the measurement of productivity and economic
growth. This is the hedonic deflator, which is applied to the computer industry
and adjusts the price of an item for improvements in quality.
No other major economy uses the hedonic deflator, which has been
challenged as inappropriate by European economists. Our use of this measure for
the past several years renders meaningless comparisons of our economic growth,
productivity growth and inflation with those of other countries or our own past.
Yet the hedonic deflator is a superficially plausible measure. If the quality
of an item improves, then a commensurate price increase provides the same
value. What appears to be inflation — a higher price — really is not. Why, then,
do other countries reject this measure?
They can make a powerful case. Suppose the hedonic deflator had been
introduced in 1980. Since then, three years after the Apple II was marketed as the
first personal computer, the amount of memory in personal computers has
increased several million-fold. The power of microprocessors has grown ten
thousand-fold. Software that comes with the computer makes it far more user
friendly. Modems and the Internet dramatically widen the range of tasks
computers can perform.
Today’s computer is at least 500 times more valuable than the 1980
computer. The 1980 computer sold for $2,000. So our modern computer has a
real value of $1 million ($2,000*500). Presently, 15 million computers are sold
annually. The real value of those computers is $15 trillion ($1 million * 15
million).
Thanks to this contribution, our annual real GNP growth since 1980 would
approach 10% even if the rest of the economy had not grown at all. How
remarkable, when no developed country has ever managed to sustain real GNP
growth of more than 5% per year and when our Federal Reserve warns that
prolonged growth above 3% would stimulate inflation.
Even better, we have had 20 years of deflation. Our real GNP, including $15
trillion just from computer sales, exceeds $15 trillion. Our nominal GNP is only
$10 trillion. If real GNP grows faster than nominal GNP, that must be because of
deflation.
Note how misleading a picture this is of our, or any, economy. That is why
other countries reasonably reject such a measure. We adopted it primarily
because it makes us look better without having to take action to improve our
savings rate, investment or productivity. While this may make us feel better in
the short term, sub-par productivity growth in the long term has always been
debilitating.
Productivity growth, investment and savings are not merely academic
issues. While our economy did grow in the 1980s and 1990s, much of this growth
— meager as it was — was financed by trillions of dollars obtained from
borrowing and from the sale of assets. By recycling capital from our trade
deficits, foreign interests have come to own an enormous amount of not only our
debt (a record 44% of liquid Treasuries plus 20% of corporate debt), but also our
corporate assets (10% of our total corporate stock) and our commercial real
estate (one half of the commercial real estate in downtown Los Angeles, onethird
in Houston and Minneapolis).
Because our trade deficits have been financed by the purchase of our bonds,
real estate and capital stock, they have had little adverse short-term impact. It is
the long term that is worrisome. Throughout history, and not only in the West,
persistent trade deficits have been destructive. “Even when the situation was not
so dramatic, if deficit became a permanent feature it spelled structural
deterioration of the economy sooner or later. And this is precisely what
happened in India after 1760 and in China after about 1820-1840.” (Braudel, The
Wheels of Commerce, p. 219.)
Our policies derived from our free market theology, though painless in the
short run, have compromised our long-term health. As Warren Buffet put it:
“We are much like a wealthy family that annually sells acreage so that it can
sustain a lifestyle unwarranted by its current output. Until the plantation is
gone, it’s all pleasure and no pain. In the end, however, the family will have
traded the life of an owner for the life of a tenant farmer.” (Fortune, May 1988) In
the same spirit, “In Trading Places, former Commerce Department official Clyde
Prestowitz referred to the U.S. as ‘a colony in the making.’” (Philip Mattera,
Prosperity Lost, p. 170.)
The irony is the extent to which we have positioned ourselves to be the
principal agent in our downfall. In the immortal paraphrase of John Paul Jones
by Walt Kelly (Pogo): “We have met the enemy and he is us.”
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