How U.S. policy can promote higher economic growth
The views expressed herein are those of the
authors and not necessarily those of the Federal Reserve Bank
of Minneapolis or the Federal Reserve System.
In the past year, politicians from all bands of the political spectrum
struck a common chord in declaring that the outlook for U.S. economic
growth is unsatisfactory. They pointed out that economists both
inside and outside the government predict growth in U.S. real gross
domestic product per capita of only about 1 percent to 1.5 percent
per year. They declared that the electorate should not be satisfied
with this outlook for growth and argued that policy changes should
be sought to improve it.
We agree. We should never be satisfied with modest real growth.
And since policies are never ideal, there is always scope to change
them in ways to promote more growth. The question, of course, is
how to improve U.S. policy.
U.S. economic growth has depended primarily on growth in labor
productivity, and by labor productivity we mean output produced
per hour worked. Unfortunately, it appears that labor productivity
growth has been very slow. It follows, then, that the less than
optimistic forecasts of economic growth are essentially extrapolations
of expected slow labor productivity growth.
Searching for higher economic growth, therefore, becomes a search
for higher labor productivity growth. Labor productivity depends,
in part, on the capital-both physical and human-employed per person
in a country. Some argue that an increase in inputs, such as more
physical capital (by encouraging higher savings rates) or more human
capital (by encouraging higher education), is the answer. While
these factors are important, for the United States they are expected
to have little impact in coming years.
But labor productivity growth also depends on the available state
of technology, which refers to the efficiency with which a given
set of inputs is employed-this is what economists term total factor
productivity. It has long been known that improvement in the state
of technology, known as technological progress, is a key factor
in growth in labor productivity. Our search then leads us to focus
on technological progress.
So far, so good: To improve economic growth we need greater technological
progress. As noted above, economists have understood this for some
time. What has not been so clear, however, is the answer to the
question: How can government policy promote technological progress?
Our view is that the state of technology in a country depends,
in part, on the pool of world knowledge at a given time and, perhaps
most importantly, on the country's institutions that promote or
retard the use of this knowledge. Technological progress, therefore,
depends on the rate at which world knowledge grows and on how a
country's institutions evolve-whether they provide greater (or fewer)
incentives over time for employing the expanding world knowledge.
Government policy, then, can have its biggest impact by ensuring
that it provides institutions with incentives to use and adapt world
This view is based on theories that suggest that some countries
have such relatively poor states of technology because groups in
those countries erect barriers to the use of world knowledge. These
barriers, like tariffs and regulations, serve to protect groups
that stand to lose from the use of new world knowledge. Ultimately,
such barriers serve to drag down the country's rate of economic
growth. Recent evidence shows that the new theories have merit,
that is, that the state of a country's technology is related to
such policies as, for example, deregulation and openness to trade.
But do these studies, many of which are based on cross-country
data, have any applicability to the United States? After all, the
United States arguably has the "best" institutions as regards providing
incentives to use new knowledge; the United States is already relatively
open to new products and ideas. We argue that recent U.S. history
strongly suggests that these studies do have applicability here.
Recent policy changes (like deregulation in many industries), and
continued commitment to certain existing policies (like keeping
the auto and steel industries open to trade), have led to large
gains in the use of world knowledge and gains in labor productivity.
Moreover, we argue that there are other potential changes that
can further improve U.S. institutions, but in order for that to
happen, U.S. policy must stay focused, generally speaking, on technological
progress. Also, in an era of the so-called global economy, U.S.
policy must not be swayed by arguments calling for the protection
of U.S. industries-such policies are bound to retard economic growth.
The key to economic growth
is labor productivity growth,
which is driven by technological progress
Economic growth is about equal to the growth of labor productivity
plus the growth of labor intensity. Labor intensity-essentially,
a measure of how hard the population is working-is unlikely to contribute
much to economic growth in the coming years, meaning that the fraction
of people working and the hours they are working are already relatively
high, and any further increases will add little to growth. For the
United States, then, labor productivity has been, and will continue
to be, the key. As described earlier, the less than optimistic view
of future growth is based on expected slow labor productivity growth.
To better understand the potential role of policies to stimulate
labor productivity growth, it helps to adopt a simple conceptual
framework to identify the primary sources of labor productivity.
The framework, the aggregate production function, is widely used
in economics. It assumes that total output depends on inputs and
the state of technology. Inputs include labor, physical capital,
such as machinery, and human capital, such as the education levels
of labor. The state of technology refers to the efficiency with
which a given set of inputs is employed. A common assumption is
that if all inputs are increased by some percentage, that output
also increases by the same percentage (this property is known as
constant returns to scale). It follows from this assumption that
the growth in labor productivity depends on the rate of technological
progress and the rate of increase in capital intensity (capital
per unit of labor).
In 1957, Robert Solow published an important paper in which he
concluded that in the United States, for the period 1909-1949, "output
per man hour doubled over the interval, with 87.5 percent of the
increase attributable to technical change [technological progress]
and the remaining 12.5 percent to increased use of capital" (p.
320). In other words, growth in labor productivity was driven primarily
by technological progress and not by the expansion of capital inputs
available to workers.
In brief, using available data on hours, capital intensity and
output, Solow was able to derive a measure of the state of technology,
and then to compute the contribution of both increases in capital
intensity and increases in the state of technology (that is, technological
progress) to economic growth. This accounting exercise for U.S.
labor productivity growth has been repeated many times in the last
40 years. For some exercises, human capital has been added as an
input. Refinements of Solow's exercise have not changed the basic
conclusion that, in the United States, technological progress has
played a major role in driving labor productivity growth (see King
and Levine 1994 for review).
So, given the importance of technological progress for labor productivity
growth, we turn naturally to seek its determinants. The next two
sections will include a summary of some of the economic literature
on this subject.
Some theories about the determinants of the
state of technology and technological progress
Again, the state of technology gives us the level of efficiency
with which a country employs a given set of physical and human capital
inputs. What does this depend on? It depends, in part, on the state
or pool of knowledge available in the world. But it also depends
on the extent to which a country's institutions promote or retard
its citizens from employing this knowledge. It follows that technological
progress depends on the rate at which world knowledge grows and
on how a country's institutions evolve-whether they provide greater
(or fewer) incentives over time for employing the expanding world
knowledge (see Parente and Prescott 1994). In what follows, we will
focus on what determines the extent to which a country uses available
world knowledge. We leave for others to discuss what determines
the rate at which world knowledge grows.
Now, there are many "natural" reasons why a country may not fully
use all world knowledge at a given time, even if a country's institutions
are very well designed. Natural impediments can arise as new technologies
are adapted to local conditions; for example, new agricultural technologies
must be adapted to local climatic conditions. Another natural impediment
is that the rate of diffusion may depend on the levels of other
production inputs, such as human capital. As an example, although
human organ transplant surgery is general knowledge, not all countries
have the trained surgeons, professional staff and equipment to perform
Griliches' (1957) classic study of hybrid corn illustrates why
the rate of diffusion of new technologies can differ across locations
due to natural impediments. The new method of production had to
be adapted to local area conditions because of climate and soil
differences; hence, it hit some areas first and over time spread
to others. Moreover, his study also demonstrated the complementarity
discussed above: The rate the method diffused within an area was
related to farmers' education levels.
While the importance of these natural impediments cannot be denied,
these reasons are not sufficient, in our view, to explain why some
countries employ so very little of the world knowledge pool at a
given time. The culprit here is very often the policies and institutions
that restrict citizens from employing world knowledge more fully.
These restrictions on the use of new knowledge are constructed (with
the help of government) by groups that stand to lose if the knowledge
Economic historians, in particular Mokyr (1990, pp. 209-272), assign
a major role to these restrictions on the use of world knowledge
in their attempts to explain differences in growth across nations.
Mokyr (1990, p. 12) states:
In every society, there are stabilizing forces that protect the status
quo. Some of these forces protect entrenched vested interests that
might incur losses if innovations were introduced, others are simply
don't-rock-the-boat kinds of forces. Technological creativity needs
to overcome these forces.
Mokyr (1990, p. 16) also notes that technologically progressive
societies are the exception. Usually, the forces opposing technological
progress are stronger than the forces striving for change.
To give an idea of the type of restrictions that are imposed, a
clear example is the diffusion of new innovations in construction.
One innovation in the industry occurred when engineers came to understand
that wider spacing of wall studs would not influence the structural
integrity of homes. With wider spacing there would be need for fewer
materials and, of course, less labor. While this particular innovation
was costless to introduce, it diffused very slowly. Oster and Quigley
(1977) argued that it was likely construction workers, applying
pressure on building code administrators, that blocked the adoption
of this and other labor-saving technologies. They also showed that
the procedures (that is, institutions) for choosing administrators
influenced whether construction workers were able to restrict the
new methods. Groups use many other means,
in addition to regulations imposed by government, to restrict the
use of world knowledge. Tariffs or, more generally, restrictive
trade practices are a key method. With trade barriers, groups are
able to continue producing with outdated methods by erecting barriers
to imports produced with new additions to world knowledge.
Regarding theory, Olson (1982, especially chapter 5) has discussed
how trade and factor mobility may limit the effectiveness of special
Holmes and Schmitz (1995) have recently formalized these ideas
about trade and resistance. They study a simple model where a special
interest group can spend resources to block a new technology that
threatens its privileged position. If there is no trade, the group
may very well find it worthwhile to spend these resources. If, however,
there is trade, so that the good can be produced elsewhere with
new technology and shipped to the country, the special interest
is likely to abandon its resistance (see also Parente and Prescott
1996 for recent models).
Recent evidence suggests these restrictions on use of knowledge,
laid out in regulations (like those in the building industry) and
supported by tariffs, have a large impact on the state of technology
in a country. We now turn to this evidence.
Recent evidence supports the new views
There are large differences in the state of technology across countries,
suggesting different countries access the world knowledge pool to
varying degrees. While this has been known for some time (for example,
Denison 1967 found this in his comparison of the United States and
Europe; see King and Levine 1994 for a review of this literature),
recent studies using many more countries find the same result. Three
such studies are King and Levine (1994), Klenow and Rodriguez-Clare
(1996) and Hall and Jones (1996).
Recent studies also find that the state of technology in a country
is related to government policies. As mentioned, Hall and Jones
calculate the state of technology for a large number of countries
(for the year 1988). They show that variation in the state of technology
is related to measures of policies and institutions. For example,
their list of policies included measures of government support of
production (including the extent to which government enforced private
contracts), the type of economic organization employed (capitalist
vs. statist) and openness to international trade. Hall and Jones
find that differences in policy explain a large fraction of differences
in the state of technology. In particular, openness to international
trade is found to lead to much higher levels of the state of technology.
Hall and Jones' work supports the above view that differences in
the state of technology are caused by differences across countries
in restrictions on the use of world knowledge. By showing that openness
to trade influences the state of technology, it lends support to
the views above. The evidence is indirect, though. Openness to trade
could be increasing the level of the state of technology through
other mechanisms than the one we suggest, that is, by reducing restrictions
on use of world knowledge.
Other research attempts to show through more direct means that
restrictions on the use of world knowledge cause big differences
in the state of technology. One example is Schmitz (1997), who studies
a particular restriction on technology: the requirement that government,
rather than the private sector, produce investment goods in a country.
A number of countries have imposed this restriction, including Egypt,
India and Turkey. He estimates that this restriction has had large
impacts on the state of technology and labor productivity in those
Other direct evidence is provided by McKinsey and Co., who have
compared the labor productivity of various industries across the
United States, Europe and Japan (these are summarized in Baily 1993,
and Baily and Gersbach 1995). They find that productivity is often
higher in the United States, and one of the reasons they give is
that there are typically fewer regulations and restrictions on business
practices in this country. For example, consider the retail sector.
McKinsey argues that retail productivity is much higher in the United
States than Japan. One of the reasons is that there are limits on
the size of store that can be opened in Japan. These limits on store
size effectively restrict some of the new retailing technologies,
like better inventory management, since a larger store is better
able to exploit this technology. These restrictions on size are
maintained by lobbying and political pressure of small stores in
Japan (such stores have had a rough time against such large retailers
as Wal-Mart in this country).
Before turning to whether this has anything to do with the United
States, we should mention that there are economists who, in trying
to explain growth, do not place as much emphasis on how a country's
institutions influence the incentives to use and adapt world knowledge.
In particular, these economists have argued that the state of technology
plays a minor role, if any, in explaining differences in output
per worker across countries, and claim that varying levels of capital-both
physical and human-explain differences in output. We are not persuaded
by these arguments, based on two sets of studies: One set directly
criticizes the research and the other takes its conclusion as an
assumption-that is, that all countries have the same state of technology-and
finds that differences in physical and human capital cannot account
for unequal cross-country productivity levels.
What, if anything, does the new evidence
have to teach the United States?
In some important ways the U.S. economy is unlike many economies
in the cross-country studies that provide much of the new evidence.
First, it already has relatively good policies and institutions.
Most observers would probably rate the United States as having the
best institutions in regards to promoting competition among businesses.
Second, the United States economy contributes much to the world
knowledge pool. It is a major spender on research and development,
which is one key to growth in that pool. Though both these facts
suggest the United States has little to gain from policy changes,
and little to learn from the recent studies, we argue that recent
U.S. history strongly suggests otherwise. U.S. policy changes have
indeed led to large gains in access to world knowledge. And there
is more to do.
Openness to technological progress has led
to substantial labor productivity gains ...
Recent U.S. history suggests that policy changes, and continued
commitment to existing policies, have led to large gains in the
use of world knowledge and gains in productivity. One important
area of change has been the large number of industries that have
been deregulated over the past two decades. These include airlines,
trucking, railroad, the securities industry and long-distance phones.
As a result of deregulation and increased competition, these industries
have experienced rapid drops in prices and strong gains in productivity
(see, for example, Winston 1993).
A study by Olley and Pakes (1996) of the U.S. telecommunications
industry suggests that labor productivity growth spurted after the
industry was deregulated and that the growth was fueled by the introduction
of new technology. It suggests that the state of technology had
been stifled by regulation.
There have been other changes, for example, in the area of trade
policy. (See Miller 1993 on the relationship between trade policy
and economic growth-including the references therein.) A high-profile
case has been the lowering of trade barriers associated with the
North American Free Trade Agreement (NAFTA). Other negotiations
to lower trade barriers with South America are under way.
While these changes are important, so, too, have been the battles
fought to continue existing policies that foster growth. Regarding
trade policy, in many markets, like steel and autos, the United
States maintained its commitment to open markets. There was great
pressure to limit trade in these markets and there were some programs
that did slow imports. On balance, however, the markets were kept
open. As a result, the United States more quickly adopted new methods
than, for example, its European counterparts (as the above ideas
suggest). U.S. car producers adopted Japanese "lean" production
well before its more closed European rivals (see Holmes and Schmitz
In the steel industry and, in particular, the iron-ore industry,
the United States also kept its markets open in the face of increasing
international competition. As a result, as the international price
of taconite fell in the early 1980s, the Minnesota industry was
able to double its labor productivity in a fairly short period.
This was accomplished not with new machines and the like, but in
part by changes in work practices.
... but there's more to do
While much has been accomplished, there is still more to
do. For example, deregulation has begun in telecommunications, but
much remains to be done; reform of the electricity industry has
just started; and there is also the recent drive to end "corporate
welfare," including subsidies to producers. Important areas under
study are: tort reform, liability reform and increasing competition
in primary and secondary education.
This is not to say that reform is not difficult. Even if a policy
change would lead to large productivity gains, it still, most likely,
would harm some groups. These groups may well seek access to the
political market to block reform. Recognizing this, the current
administration has developed some programs to help defray the costs
borne by groups so affected. Their policies of retraining workers
who lose jobs due to NAFTA is one such program.1
Breaking down the barriers
At first glance, the policy prescription advocated in this
essay-open trade, deregulation and increased competition-seems merely
like a reiteration of well-accepted economic principles. However,
these principles are more often preached than practiced, and many
policy-makers are not necessarily convinced of their wisdom. Governments
are often tempted to engage in policies that, for example, protect
certain industries from foreign competition or, in the case of internal
markets, make it difficult for innovative companies to compete in
Recent U.S. history strongly suggests that the lessons being learned
from cross-country comparisons of labor productivity and growth
apply to the United States. In brief: Technological progress is
a key element of economic growth, and to encourage technological
progress, the United States must constantly refocus its efforts
on policies that reduce resistance to technology and increase the
use of world knowledge.