Thoughts on Economic Growth

Gary H. Stern
President
Federal Reserve Bank of Minneapolis

Fed Correspondents Association
New York City, New York
June 9, 1999

The overarching subject of my remarks today is economic growth: what we know about it, what we can make educated guesses about, what we don't know. Growth is a key economic issue from several perspectives. After all, the more rapidly an economy grows, the more rapidly its living standards rise given the path of its population, and rapid increases in standards of living are positive from virtually every perspective. Not only are people better off in material terms, but they also tend to enjoy greater economic security and greater opportunity in a rapid growth environment. To be sure, some worry that growth may be accompanied by degradation of the environment or by other undesirable side effects, but it is worth bearing in mind that the higher incomes growth creates are in the long run essential to preserving, and ultimately enhancing, the environment.

In my comments today, I will describe a theoretical framework with which we can think about growth, discuss what we know and don't know about the variables of the growth “model,” and speculate about the factors that influence an economy's receptivity to new technology, a key ingredient in growth. Implicitly, and occasionally explicitly, these ruminations will draw on “real world” examples as well as theoretical foundations. In the end, I conclude that healthy, sustained growth depends principally on the effective marriage of Adam Smith's “invisible hand” with provision of sound infrastructure and stabilization policies by government. This is, perhaps, not a startling formula, but it is nevertheless one many countries have had difficulty achieving.

Let me now proceed to try to make my case. A constructive way to start to think about growth is that it results from expansion of total hours worked by employees together with the increased productivity of those employed. That is, growth is a question of labor input and the productivity of that input. One might think that the quantity and the quality of an economy's capital stock would also affect growth significantly and they do, but in the framework utilized here their effects are captured in the labor productivity term.

In the long run, labor input is effectively determined by the size of the economy's labor force, assuming the economy does not run persistently below full employment, and the labor force, in turn, is determined by demographics. Changes in the labor force are the difference between those leaving to retire (or for other reasons) and those entering. The number of new entrants is largely predictable, absent a change in immigration policy, because at least for the next twenty years or so, these people are alive today. Looking at retirement patterns in conjunction with prospective entrants yields the result for the U.S. that the labor force will grow about one percent per year on average in the long run.

There is, of course, some short-run flexibility hidden by this calculation. For example, people may choose to retire later than normal or to enter the labor market earlier, but this flexibility is constrained by the fact that labor force participation rates are already relatively high. Similarly, people can choose to work longer hours, but average weekly hours worked is at a high level. The point is that on average over the long run, labor force demographics will prevail.

Labor productivity, the second important variable in the growth relation, is considerably more difficult to fathom. In fact, it is difficult to measure accurately, much less to forecast. According to the published data, productivity initially rose at nearly a three percent annual rate in the postwar period — from 1945 to 1973 to be precise. Its rate of expansion subsequently slowed to about one percent per annum over the 1973 to 1995 interval, before accelerating again to a two percent average increase over the past three years.

Economists and policymakers still can't explain the productivity slowdown that began in 1973 and persisted until the middle of this decade. Moreover, the debate about whether the recently observed acceleration in productivity is a cyclical or long-term phenomenon is unresolved. Meanwhile, business people and some analysts maintain that the available national statistics understate significantly the recent pace of productivity improvement, especially in service industries.

Wherever the quantitative truth lies, there is no doubt that arithmetically the pace of productivity advance matters a great deal. For example, if the recently observed increase — gains of about two percent per year — persists, then per capita income will double in about 35 years. But if annual productivity gains recede to their previous pace, then it will take about 70 years before per capita income doubles.

Ideally, we should be able to say something definitive about the prospective track of productivity, and therefore the trend of the economy, but this is not the case. In view of this limitation, a valuable step is to examine the factors that influence productivity performance over time, to see what they may imply about the future. What do we know about the determinants of labor productivity?

As noted earlier, the productivity of labor depends on physical capital, and on human capital as well — that is, the skills, experience, and education levels of the labor force, for example. And labor productivity also depends on the available state of technology, which refers to the efficiency with which a given set of productive inputs — capital and labor — is employed. It has long been recognized that improvement in the state of technology — technological progress — is an important factor increasing labor productivity.

If technological progress is central to productivity gains, hardly a surprising conclusion, then what determines the state of technology in an economy? In part, the state of technology depends on the pool of world knowledge at a given time and, more importantly, on internal institutional arrangements that promote or retard the use of this knowledge. Technological progress, therefore, depends on the rate at which world knowledge grows and on the extent to which a country's institutions and infrastructure provide incentives for employing the expanding world knowledge.

We can go even a bit further. Evidence shows that the state of technology of an economy is related positively to such policies as, for example, deregulation and openness to foreign trade. These results are interesting and merit further thought, for they are reminiscent of Adam Smith's thinking in “An Inquiry into the Nature and Causes of the Wealth of Nations.”

Smith's book, a classic in economic literature, extols the contributions of competition and specialization to material progress. And now we can begin to see connections between Smith's work and recent US economic progress. Deregulation and openness to trade enhance competition and specialization, as Smith knew, and apparently both contribute to technological progress. I would argue that it is competitive pressure, particularly, which encourages the adoption and adaptation of the new technologies essential to gains in the U.S. economy.

It thus appears that application of one of the oldest insights in economics helps to explain current developments. And as long as our commitment to competitive markets holds, I would think that the favorable path of productivity improvement could be sustained.

Let me elaborate further. In the current competitive, noninflationary environment, it has become clear to business that profits could be sustained only by restraining costs, a course of action vigorously pursued. Improved resource allocation, brought about both by technological progress and by the creative destruction that favors new industries, is at the heart of economic progress. Specialization, too, is promoted by foreign trade, and “outsourcing” is a domestic example of the phenomenon. Further, the US has permitted changes in industrial organization, through substantial merger and acquisition activity, to best exploit the new technology.

Given our performance, confidence in market-determined outcomes should be heightened. Despite occasional, and at times, significant disruptions, there should be little doubt that unrestricted flows of goods, labor, information, and financial capital are in the long-run interests of prosperity. Concern with international capital flows tends to rise when developing economies experience difficulties associated with capital outflows, but frequently such concern overlooks the constructive role foreign capital played in earlier development stages. Moreover, in the right institutional setting, market signals can curtail excessive risk-taking, thus helping to preclude outsized financial disruptions. I would go further, and argue that interference with market signals is frequently at the root of problems the unfettered market is alleged to create.

In heaping praise on Adam Smith and market forces, I do not mean to imply that there is no role for government in initiating and supporting economic prosperity. Indeed, government is important on two levels: that of macroeconomic policy and what I will broadly refer to as infrastructure. With regard, first, to macroeconomic policy, the objective should be to provide a stable financial environment in which the private sector can thrive.

For the Federal Reserve and monetary policy, this prescription implies a policy designed to achieve and maintain low inflation, not because low inflation is an important stand-alone goal but because it is the most significant contribution monetary policy can make to sustained growth and prosperity. For fiscal policy at the national level — that is, Federal tax and spending policy — the prescription, recognizing that the US is a low saving economy, is to run a budget surplus so that private saving is enhanced with public-sector saving. Interestingly enough, it appears that the private sector has thrived as monetary and fiscal policies have approached their respective goals.

As far as the government and infrastructure is concerned, I am not just referring to the provision of highways, airports, and so forth, important though they may be. Rather, the government has a responsibility to establish and maintain the infrastructure required for a successful commercial society. That is, the government is responsible for protection of property rights, regulation and supervision of banks, establishment of accounting standards, enforcement of the rule of law, maintenance of the integrity of the credit decision making process, and so forth. As we have seen in East Asia, Eastern Europe, and South America, when this infrastructure is lacking financial disruption is virtually inevitable, and economic progress usually stalls, and perhaps falters, while the necessary infrastructure is put in place. Unfortunately, such adjustments frequently are accompanied by significant reductions in living standards, at least for some segments of the population.

It would also appear that infrastructure of the type I am emphasizing is essential to sustained technological progress. For business to make substantial investments in new technology, it must have confidence that it will be able to retain at least some of the rewards, hence the importance of property rights, rule of law, accurate accounting, and so forth. But this is not to say that infrastructure, in and of itself, is sufficient for economic progress. The fundamentals emphasized by Adam Smith are essential, as is the stable macroeconomic climate discussed earlier.

In concluding, let me summarize these thoughts about growth. We have a reasonable framework for analyzing growth, one that appropriately emphasizes labor productivity. Unfortunately, we know far less about productivity and its determinants than we would like. We know, however, that productivity depends in part on technological progress and that such progress goes hand in hand with developments that enhance competition and specialization, namely openness to foreign trade, deregulation, and so forth. We also suspect that government—provided infrastructure, in the sense used here, is important to technological progress, as is a stable macroeconomic environment. If we have identified (at least some of) the ingredients correctly, the outlook is positive for sustained, and relatively rapid, productivity improvement in our economy.

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