This article appeared in the Deseret News on June 28th, 2011.
In May, former Minnesota governor, Tim Pawlenty, declared his candidacy for the presidency of the United States. He also released a plan that is intended to lead to a revival of the US economy, which is in the middle of an anemic recovery. One of the key assumptions of this plan is that the economy can be coaxed and prodded into growing at an annual rate of five percent for a decade or more. As economist Donald Marron has pointed out, the US economy has grown at an average rate of 5% for ten years exactly once since the end of World War II. That was the period from mid-1958 to mid-1968. As he puts it, "Getting up to 5% over the next decade thus seems not merely ambitious, but almost unthinkable."
However, Stanford macroeconomist, John B. Taylor, argues that 5% is quite doable. One percent growth per year can come from growth of the population. Taylor argues another one percent can come from having a greater percentage of the population employed as workers. The remaining growth needs to come from increases in the productivity of capital and workers - what economists call total factor productivity or TFP for short. Since 1996 TFP has grown at an average rate of 2.7%, so the remaining three percent needed is not that hard to imagine.
When discussing growth it is important to distinguish between two different effects. The first is a levels effect. This occurs when something happens to permanently raise or lower the long-run productive capacity of the economy. For example, a one-time increase in the population due to a baby boom, or a relaxation of immigration constraints would give us a larger workforce and increase the amount of goods and services we could produce. Levels effects will cause the economy to grow in the short run as it adjusts slowly to incorporate these new resources. In the long run, however, the economy reaches a new higher level and then stays there without any further growth.
A second effect is a growth effect. This is a change that does not necessarily change the productive capacity of the economy immediately, but rather causes it to grow more rapidly over time. An increase in the rate at which new knowledge is discovered and turned into useful products would cause the economy to grow more rapidly over time, and these increases would continue for a long time without gradually petering out as level effects must necessarily do.
Pawlenty's plan calls for reductions in tax rates, balancing the federal budget, easing government regulation, and encouraging sound monetary policy. All of these are laudable goals, but they are also examples of levels effects. Eliminating burdensome regulation, for example, would allow firms to produce more efficiently and lead to increased production. It would also cause firms to hire more workers and invest in greater amounts of capital and machinery. However, once the firms have fully adjusted, there will be no additional economic growth.
If economic policies focus solely on these types of levels effects, then it might be possible to generate a decade's worth of growth in the neighborhood of five percent, but growth would not be sustainable at that level for much longer than that. To have long-lasting high growth rates, policy makers will need to focus on growth effects.
MIT economist Robert Solow won the Nobel Prize in 1987 for his pioneering work in economic growth. One his most important contributions was to show that much observable growth comes from increases in hard-to-measure intangibles that economists lump together and term "technology." Technological progress is now regarded as the primary engine of long-run, sustained growth. To raise the long-run growth of the economy, policy will need to focus on encouraging the expansion of technology.
Some countries, particularly developing ones, try to increase technology by government industrial policy. While this may be somewhat effective for economies that are catching up with the world technology leaders, it does not work well with economies that are already technologically advanced.
For countries like the US a much better approach is to put incentives into place that encourage the production of new ideas and technologies. Tax deductions or tax credits for research and development are one way to do this. Better enforcement of patents and other intellectual property would encourage firms and entrepreneurs to engage in more research and development as well.
Five percent growth for a decade is not an impossible goal for the US economy, but if it is to come about it will require careful consideration and implementation of policies that encourage investment in new ideas and technologies. A focus on policies like balancing the budget and reducing government inefficiency will make us better off, but by themselves are unlikely to yield the five percent growth that Mr. Pawlenty has in mind.
In May, former Minnesota governor, Tim Pawlenty, declared his candidacy for the presidency of the United States. He also released a plan that is intended to lead to a revival of the US economy, which is in the middle of an anemic recovery. One of the key assumptions of this plan is that the economy can be coaxed and prodded into growing at an annual rate of five percent for a decade or more. As economist Donald Marron has pointed out, the US economy has grown at an average rate of 5% for ten years exactly once since the end of World War II. That was the period from mid-1958 to mid-1968. As he puts it, "Getting up to 5% over the next decade thus seems not merely ambitious, but almost unthinkable."
However, Stanford macroeconomist, John B. Taylor, argues that 5% is quite doable. One percent growth per year can come from growth of the population. Taylor argues another one percent can come from having a greater percentage of the population employed as workers. The remaining growth needs to come from increases in the productivity of capital and workers - what economists call total factor productivity or TFP for short. Since 1996 TFP has grown at an average rate of 2.7%, so the remaining three percent needed is not that hard to imagine.
When discussing growth it is important to distinguish between two different effects. The first is a levels effect. This occurs when something happens to permanently raise or lower the long-run productive capacity of the economy. For example, a one-time increase in the population due to a baby boom, or a relaxation of immigration constraints would give us a larger workforce and increase the amount of goods and services we could produce. Levels effects will cause the economy to grow in the short run as it adjusts slowly to incorporate these new resources. In the long run, however, the economy reaches a new higher level and then stays there without any further growth.
A second effect is a growth effect. This is a change that does not necessarily change the productive capacity of the economy immediately, but rather causes it to grow more rapidly over time. An increase in the rate at which new knowledge is discovered and turned into useful products would cause the economy to grow more rapidly over time, and these increases would continue for a long time without gradually petering out as level effects must necessarily do.
Pawlenty's plan calls for reductions in tax rates, balancing the federal budget, easing government regulation, and encouraging sound monetary policy. All of these are laudable goals, but they are also examples of levels effects. Eliminating burdensome regulation, for example, would allow firms to produce more efficiently and lead to increased production. It would also cause firms to hire more workers and invest in greater amounts of capital and machinery. However, once the firms have fully adjusted, there will be no additional economic growth.
If economic policies focus solely on these types of levels effects, then it might be possible to generate a decade's worth of growth in the neighborhood of five percent, but growth would not be sustainable at that level for much longer than that. To have long-lasting high growth rates, policy makers will need to focus on growth effects.
MIT economist Robert Solow won the Nobel Prize in 1987 for his pioneering work in economic growth. One his most important contributions was to show that much observable growth comes from increases in hard-to-measure intangibles that economists lump together and term "technology." Technological progress is now regarded as the primary engine of long-run, sustained growth. To raise the long-run growth of the economy, policy will need to focus on encouraging the expansion of technology.
Some countries, particularly developing ones, try to increase technology by government industrial policy. While this may be somewhat effective for economies that are catching up with the world technology leaders, it does not work well with economies that are already technologically advanced.
For countries like the US a much better approach is to put incentives into place that encourage the production of new ideas and technologies. Tax deductions or tax credits for research and development are one way to do this. Better enforcement of patents and other intellectual property would encourage firms and entrepreneurs to engage in more research and development as well.
Five percent growth for a decade is not an impossible goal for the US economy, but if it is to come about it will require careful consideration and implementation of policies that encourage investment in new ideas and technologies. A focus on policies like balancing the budget and reducing government inefficiency will make us better off, but by themselves are unlikely to yield the five percent growth that Mr. Pawlenty has in mind.
