How to Fix America

Which Tools Should Washington Use?

President Barack Obama's fiscal 2014 budget proposal. (Gary Cameron / Courtesy Reuters)

UNLEASH THE PRIVATE SECTOR
Edward Conard

In "Can America Be Fixed?" (January/February 2013), Fareed Zakaria argues that American democracy has grown increasingly dysfunctional since the 1970s and that "a series of lucky breaks" -- namely, the end of inflation, new information technologies, globalization, and excessive borrowing, which has allowed Americans to consume more than they have produced -- have covered up structural problems in the U.S. economy. He worries that these factors are now keeping unemployment high and wages low. In outlining his solution to this problem, Zakaria looks back to the 1950s and 1960s, when Washington spent lavishly on domestic investment and the economy "boomed." What the U.S. government needs to do today, he concludes, is establish "massive job-training programs" and a "national infrastructure bank" from which "technocrats" could allocate funds to public works projects based "on merit rather than . . . pork."

But Zakaria's argument is grounded in a misreading of history: although government investment in infrastructure in the 1950s and 1960s did contribute to economic growth, many other factors drove that growth as well. Moreover, it is unlikely that building new physical infrastructure would do as much for growth in today's knowledge-based economy as it did in the two decades following World War II. Finally, there is little reason to believe that politicians would allow technocrats to control infra-structure spending. And even if they did, it is doubtful that technocrats could choose investments effectively -- much less with the wisdom and efficiency of free enterprise. After all, private-sector investment and risk taking, not infrastructure investment, have driven U.S. economic growth over the last two decades, and they will likely continue to do so in the future.

INVEST FOR SUCCESS

Low inflation, information technology, and globalization do not fully explain the United States' economic success over the past two decades. Europe and Japan also enjoyed these things, yet their productivity growth fell to near-record lows, while the United States' soared to near-record highs. (Productivity, which measures output per worker, is the best measure of economic success, because it excludes population expansion, which adds to GDP without raising livings standards.) In fact, the contrast is even starker than it appears, because American innovation helped boost the rest of the world's productivity. It is thus difficult to conclude that a dysfunctional U.S. democracy slowed economic growth. 

Many advocates of government spending claim that productivity growth has not benefited the middle and working classes. Since the early 1980s, however, the U.S. economy has added 40 million jobs to the country's work force -- an increase of roughly 40 percent. France's and Germany's work forces have grown by less than half that amount, and Japan's, by even less. Indeed, U.S. job growth was so robust over the last two decades that it pulled 14 million new immigrants into the work force. Contrary to popular belief, the United States did not outsource jobs; it insourced them. Even if wages have remained flat (a disputable point), the United States still created an enormous increase in total middle-class income relative to Europe and Japan during this time. No other high-wage economy has done more for the middle class and the working poor.

Neither debt-fueled consumption nor borrowing can explain the United States' productivity surge or economic growth. Regardless of how it is funded, consumption does not increase productivity; investment and innovation do. Nor do borrowing and lending between entities in the U.S. economy -- which make up the bulk of the country's debt -- account for American economic growth. (Try borrowing from yourself and see if it allows you to consume more.) Moreover, the United States has borrowed far too little internationally to impact its growth substantially. The United States has achieved its impressive economic results not only by investing more than Europe and Japan but also by making riskier investments that produced innovation. The success of these investments accounts for the United States' stellar economic performance.

Furthermore, Zakaria's statement that "Americans have consumed more than they have produced" overlooks the full value of the assets produced by the United States. GDP measures the cost of investments -- but on the whole, U.S. investments have produced more value than their cost. This differential is largely responsible for driving up the value of the U.S. stock market from roughly 50 percent of GDP between the 1920s and the early 1990s to well over 100 percent of GDP today. To be sure, the U.S. government has sold a lot of one major asset -- government-guaranteed debt -- to foreign investors in order to fund consumption, but the U.S. economy has produced assets that are far more valuable than the assets it has sold abroad.

BRIDGES TO NOWHERE

Even though it was entrepreneurship that drove U.S. economic growth over the last two decades, Zakaria argues that infrastructure investment is now the key to jump-starting the economy. Public-sector investment in the 1950s and 1960s did contribute to the impressive economic performance of those years, but it is far from clear that the same types of investments would produce rapid growth today.

The United States in 2013 does not resemble the country it was in the two decades following World War II. In those days, government-built highways and television were just beginning to knit the U.S. economy together. Capital-intensive companies, such as General Motors and Procter & Gamble, raced to exploit previously unrealized economies of scale. Capitalizing on investment opportunities that had been postponed for two decades -- due to the Great Depression and World War II -- accelerated the economy, as did sending the most talented students to college, which the United States did before the rest of the world. Meanwhile, rapidly declining food prices and lower government spending (roughly 28 percent of GDP then, compared with nearly 40 percent now) freed up resources to fuel growth. But none of these factors is present today.

In the contemporary knowledge-based economy, innovation is the linchpin of growth, not physical infrastructure. The U.S. economy has grown sevenfold since World War II, whereas the physical inputs it consumes have grown only twofold. Japan raised government investment to six percent of GDP after its real estate bubble burst in 1990, and that figure remained substantially higher than the United States' until 2005, yet Japan's productivity growth slowed.

Even if infrastructure investment were the key to reinvigorating the U.S. economy, it is unlikely that technocrats, much less the political process, could identify the best investments. As with biological evolution, the U.S. economy is far too complex for any one individual or organization to understand which investments will succeed and which will fail. Free enterprise picks investments successfully by running millions of experiments, and the survival of a product depends on its producing more value per dollar of cost than other products do. Competition ruthlessly prunes products that fail to meet this threshold. The public sector works in the opposite way; it undertakes large investments with virtually no competition. To grasp the problem of entrusting the public sector with making large-scale investments, one need look no further than the costly wars in Afghanistan and Iraq, the unsustainable ballooning of U.S. entitlement programs, and the failure of large increases in education spending to boost American students' test scores.

CUT THE CHAINS

Today, two major factors are restricting economic growth. First, despite a worldwide abundance of unskilled labor, there are insufficient incentives for talented workers to get the training and take the types of risks that produce innovation. Although there is an enormous shortage of information technology experts in the United States, for example, some of the country's recent college graduates remain underemployed or unemployed. Many gifted students have chosen not to seek jobs in information technology because the salaries, despite being in the upper income brackets, are too low to motivate them to pursue these tedious and arduous careers. Raising taxes on high incomes to fund more infrastructure investment would further reduce the incentives for talented people to get the training and take the risks that produce innovation. It is hard to believe that such a policy would accelerate economic growth.

Second, despite a worldwide abundance of savings, there is a lack of equity to underwrite the risks that produce economic growth. Fortunately, the United States does have more equity per dollar of GDP than either Europe or Japan. As a result, its entrepreneurs have taken more economic risks and its economy has produced more innovation and has grown faster than those of Europe and Japan. Washington can tax and spend income that investors would otherwise invest as equity, or it can leave this money in the hands of the private sector. Historically, the private sector has chosen the risks that produced economic growth far more effectively than the public sector.

For the U.S. economy to reach its full potential, Washington should return to the policies that drove economic growth over the past two decades: lower federal spending and less onerous government regulation. It is important not to conflate the causes of high unemployment and slow economic growth after the 2008 financial crisis with the policies that have underpinned the U.S. economy's long-term success. A major cause of U.S. economic sluggishness over the past few years is that the private sector now recognizes that there is an enormous risk of damage from bank runs -- a risk that it thought government guarantees had mitigated after the panic of 1929. To compensate for this risk, the economy has dialed back both investment and consumption. Growth has slowed, unemployment has risen, and bank deposits and other short-term savings now sit unused. Growth is unlikely to reach its full potential until policymakers lessen this newly found risk and the economy subsequently redeploys these unused resources.

Although some argue that the government can stimulate demand in the short run by borrowing and spending idle savings, this policy is ultimately self-defeating. In the long run, deficit spending will permanently bloat the federal budget with additional interest expenses, and lawmakers will have to raise taxes to cover these costs. If they raise taxes on successful entrepreneurs, this will discourage the economic risk taking that produces innovation by socializing gains and privatizing losses. The costs of slower growth in the long run would overwhelm any benefits from fiscal stimulus in the short run.

Although reducing government spending today might contract the U.S. economy in the immediate future, doing so is necessary to finally return the country to economic strength. The private sector will gradually fill the void, as the public sector retreats. Raising taxes in the interim, moreover, would only slow growth further.

In order to recapture the United States' economic dynamism, President Barack Obama should reassert the prime objective of U.S. economic policy during the last four administrations: fostering private-sector investment. It was entrepreneurship, not government investment, that powered U.S. economic growth over the past two decades -- and if Washington grasps this fact, the same dynamic will likely continue well into the future.

EDWARD CONARD is a Visiting Scholar at the American Enterprise Institute and a former Managing Director of Bain Capital. He is the author of Unintended Consequences: Why Everything You've Been Told About the Economy Is Wrong.

ZAKARIA REPLIES
Edward Conard claims that my solution for the United States' problems is more government spending, and that it is a bad idea. Actually, what I argue throughout "Can America Be Fixed?" is that Washington needs to shift its focus from tax hikes and spending cuts to "reforming and investing." I describe the kinds of structural reforms the country needs, such as junking its 73,000-page tax code, curbing its out-of-control litigation system, and streamlining regulations. But I also believe that Washington needs to make significant investments in the U.S. economy, as it has done historically.

In my essay, I highlighted the fact that since the 1980s, deficit spending, by both the government and private citizens, has fueled U.S. economic growth. But increasing consumption by maxing out on credit cards is not sustainable for the long run. Conard does not directly dispute this point but argues that the United States had higher productivity growth than Europe and Japan over that period, which allegedly proves that the low taxes and deregulation of the era were the cause. Although I agree that productivity growth is the elixir of economies, a closer look at American productivity growth over time tells a different story.

From 1891 to 1972, U.S. productivity grew at an average yearly rate of 2.33 percent, which is high, but then it dropped substantially, so that from 1972 to 1996, it averaged only 1.38 percent. In other words, the Reagan-era tax cuts and deregulation did not spur productivity growth, even allowing for a time lag. Then, in 1996, productivity spiked, and from 1996 to 2004, it averaged an impressive 2.46 percent. After that, it dropped back down to the rates of the 1980s, to 1.33 percent per year between 2004 and 2012. Notice that a sharp drop in productivity growth followed President George W. Bush's large tax cuts.

So the real question is what caused productivity to spike from 1996 to 2004. The economist Dale Jorgensen and other scholars at Harvard have persuasively presented research suggesting that information technology was the obvious cause. It would explain why the United States grew faster than Europe, since the information revolution started and flourished fully in the United States. But why did that revolution take place? Clearly, the private sector and its risk taking and innovation were crucial. But the story is incomplete without also mentioning government investment.

After World War II, the U.S. government made massive investments in the nascent field of computer science, both in research and in industry. In the 1950s, it bought almost 50 percent of all the semiconductors that were produced, thus driving down their costs until the private sector could afford to buy them. Spurred by Sputnik and the arms race, Washington spent lavishly not only on basic science but also, through the Department of Defense, on engineering. In fact, California had so many engineers in the 1960s because many defense contractors were located in that state. And it was the Defense Department, of course, that funded the programs that created the earliest incarnation of the Internet.

The United States is now headed in the opposite direction. Government funding for science has been declining for years and is set to drop even more sharply in the future. (As a percentage of GDP, it is now about half what it was in the early 1960s.) At the same time, countries such as China, Singapore, and South Korea are increasing their science budgets substantially.

Meanwhile, on infrastructure spending, Conard takes an odd position. He admits that it made a big difference in the past but argues that it cannot possibly make a major impact in the future. This kind of argument, which suggests that the United States has already built everything that needs to be built, is usually associated with left-wing types concerned about "the limits to growth" -- and it is ultimately unfounded. The United States needs to spend $25 billion to upgrade its air traffic control system, for example, which would allow many more planes to land at every American airport. That would translate directly into economic growth -- more trade and more tourists. The United States also needs larger ports, better roads and rails, and more reliable energy to ship goods across the country and to foreign markets. And to facilitate the next information revolution, the United States will need faster broadband and cellular infrastructure. Some of these needs can be met by the private sector, but without substantial government investment in those areas, the U.S. economy will not grow as fast as it could.

Conard compares the United States to Europe and Japan at the start of his argument, but he drops the comparison when he makes his case for lower taxes and less regulation. Compared with other rich countries, the United States has low taxes and light regulations, although, as I wrote, it does need major reform in both areas to keep its economy competitive. Nevertheless, the reality is that American entrepreneurs today are working in a pretty hospitable business environment compared with the Americans of the past and the Europeans and Japanese of the present. For example, taxes on capital gains and dividends -- crucial to Conard's risk takers and job creators -- were much higher in the Reagan years than they are now. What distinguishes the United States' economy today, both from those of other rich countries and from its own past, is not that it has high taxes but rather that is has low investments. That is another huge deficit that the United States should be concerned about.

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