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but growing rapidly. When it comes to determining the long-run growth rate, it is the growth rates rather than the current levels of these three pillars that matter.

In fact, GDP per hour of work actually grew faster over the 25 years covered in Table 1 in several countries that have lower average incomes than the United States. For example, productivity in South Korea, Ireland, France, and the United Kingdom all grew faster than in the United States. Why? While a typical Irish worker in 1980 had far less physical and human capital than a typical American worker, and used substantially less-advanced technology, the capital stock, average educational attainment, and level of technology all increased faster in Ireland than in the United States.

The level of productivity in a nation depends on its supplies of human and physical capital and the state of its technology. But the growth rate of productivity depends on the rates of increase of these three factors.

TABLE 1

Productivity Levels and Productivity Growth Rates

in Selected Countries

		GDP per Hour	GDP per Hour
		of Work 1980	of Work 2005
		(as percentage	(as percentage	Growth
	Country	of U.S.)	of U.S.)	Rate
	United States	100	100	1.7
	France	86	99	2.3
	United Kingdom	71	85	2.4
	Spain	62	62	1.7
	Ireland	57	96	3.9
	Argentina	51	37	0.4
	Mexico	44	25	2 0.5
	Brazil	33	23	0.2
	South Korea	20	48	5.4

NOTE: All productivity data are measured in U.S. dollars. So countries whose currencies rise relative to the U.S. dollar gain on the United States, whereas countries whose currencies fall relative to the U.S. dollar lose ground.

SOURCE: International Labour Organization, Key Indicators of the Labour Market (Geneva: 2007), Table 18A (at http://www.ilo.org/kilm).

The distinction between productivity levels and productivity growth rates may strike

you as a piece of pedantic arithmetic, but it has many important practical applications.

Here is a particularly striking one. If the productivity growth rate is higher in poorer

countries than in richer ones, then poor countries will close the gap on rich ones. The

so-called convergence hypothesis suggests that this is what normally happens.

The convergence

The Convergence Hypothesis: The productivity growth rates of poorer countries tend to

hypothesis holds that

nations with low levels of

be higher than those of richer countries.

productivity tend to have

The idea behind the convergence hypothesis, as illustrated in Figure 2, is that productiv-

high productivity growth

rates, so that international

ity growth will typically be faster where the initial level of productivity is lower. In this

productivity differences

hypothetical example, the poorer country starts out with a per-capita GDP of $2,000, just

shrink over time.

one-fifth that of the richer country. But the poor country’s real GDP per capita grows

faster, so it gradually narrows the relative income gap.

Why might we expect such convergence to be the norm? In some poor countries, the

supply of capital may be growing very rapidly. In others, educational attainment may be

rising quickly, albeit from a low base. But the main reason to expect convergence in the

FIGURE 2

long run is that low-productivity countries should be able to learn from high-productivity coun-

The Convergence

tries as scientific and managerial know-how spreads around the world.

Hypothesis

A country that is operating at the technological

frontier can improve its technology only by inno-

vating. It must constantly figure out ways to do

things better. But a less advanced country can

Richer

country

boost its productivity simply by imitating, by

adopting technologies that are already in common

use in the advanced countries. Not surprisingly, it

is much easier to “look it up” than to “think it up.”

Poorer

country

Modern communications assist the convergence

Capita

$

10,000

process by speeding the flow of information

around the globe. The Internet was invented

per

mainly in the United States and the United King-

GDP

dom, but it quickly spread to almost every corner

of the world. Likewise, advances in human ge-

Real

nomics and stem-cell research are now originating

$2,000

in some of the most advanced countries, but they

are communicated rapidly to scientists all over the

world. A poor country that is skilled at importing

Time

scientific and engineering advances from the rich

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Levels and Growth Rates of GDP per Capita in Selected Poor Countries

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TABLE 2

	GDP
	per Capita,
Country	2005*
Belarus	$1,868
Russia	2,445
Ukraine	960
Peru	2,337
Haiti	434
Burundi	105
Sierra Leone	218

* In constant 2000 U.S. dollars.

			countries can achieve very rapid productivity growth. Indeed,
			when Japan was a poor nation, successful imitation was one of its
			secrets to getting rich. India and China are trying that now—with
	GDP Per Capita	Development	considerable success.
			Unfortunately, many poor countries seem unable to participate
	Growth Rate,
			in the convergence process. For a variety of reasons (some of which
	1990 – 2005
			will be mentioned later in this chapter), a number of developing
	2.0%	World
			countries seem incapable of adopting and adapting advanced tech-
	20.4
		SOURCE: World Bank, Indicators, 2007.	nologies. In fact, Table 1 shows that per-capita incomes in some of
	22.4
	2.3		these nations actually grew more slowly than in the rich countries
	22.4		over the quarter-century covered by the table. Labor productivity
	22.5		in Argentina and Brazil both grew much slower than that of the
	20.9
			United States, for example, while Mexico’s productivity (when

measured in U.S. dollars) actually declined. Sadly, this kind of decline is not all that unusual. Real incomes have stagnated or even fallen in some of the poorest countries of the world, especially in Africa and many of the formerly communist countries (see Table 2). Convergence certainly cannot be taken for granted.

Technological laggards can, and sometimes do, close the gap with technological leaders by imitating and adapting existing technologies. Within this “convergence club,” productivity growth rates are higher where productivity levels are lower. Unfortunately, some of the world’s poorest nations have been unable to join the club.

GROWTH POLICY: ENCOURAGING CAPITAL FORMATION

A nation’s capital is its available supply of plant, equipment, and software. It is the result of past decisions to make investments in these items.

Investment is the flow of resources into the production of new capital. It is the labor, steel, and other inputs devoted to the construction of factories, warehouses, railroads, and other pieces of capital during some period of time.

Capital formation is synonymous with investment. It refers to the process of building up the capital stock.

Let us now see how the government might spur growth by working on these three pillars, beginning with capital.

First, we need to clarify some terminology. We have spoken of the supply of capital, by which we mean the volume of plant (factories, office buildings, and so on), equipment (drill presses, computers, and so on), and software currently available. Businesses add to the existing supply of capital whenever they make investment expenditures—purchases of new plant, equipment, and software. In this way, the growth of the capital stock depends on how much businesses spend on investment. That process is called capital formation—literally, forming new capital.

But you don’t get something for nothing. Devoting more of society’s resources to producing investment goods generally means devoting fewer resources to producing consumer goods. A production possibilities frontier like those introduced in Chapter 3 can be used to depict the nature of this trade-off—and the choices open to a nation. Given its technology and existing resources of labor, capital, and so on, the country can in principle select any point on the production possibilities frontier AICD in Figure 3. If it picks a point like C, its citizens will enjoy many consumer goods, but it will not be investing much for the future. So it will grow slowly. If, on the other hand, it selects a point like I, its citizens will consume less today, but the nation’s higher level of investment means it will grow more quickly. Thus, at least within limits, the amount of capital formation and growth can be chosen.

Now suppose the government wants the capital stock to grow faster, that is, it wants to move from a point like C toward a point like I in Figure 3. In a capitalist, market economy such as ours, private businesses make almost all investment decisions—how many factories to build, how many computers to purchase, and so on. To speed up the process of capital formation, the government must somehow persuade private businesses to invest more. But how?

Real Interest Rates The most obvious way to increase investment by private businesses is to lower real interest rates. When real interest rates fall, investment normally rises. Why? Because businesses often borrow to finance their investments, and the real

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CHAPTER 7	Economic Growth: Theory and Policy					139
interest rate indicates how much firms must pay for that privi-
lege. An investment project that looks unattractive at an interest		Produced
rate of 10 percent may look highly profitable if the firm has to			A
pay only 6 percent.
The amount that businesses invest depends on the real inter-				I
		Goods
est rate they pay to borrow funds. The lower the real rate of
interest, the more investment there will be.
In subsequent chapters, we will learn how government policy,		Investment
especially monetary policy, influences interest rates—which gives
policy makers some leverage over private investment decisions.
That relationship, in fact, is why monetary policy will play such a
crucial role in subsequent chapters. But we might as well come			Consumer Goods Produced
clean right away: For reasons to be examined later, the govern-
ment’s ability to control real interest rates is imperfect. Further-
					FIGURE 3
more, the rate of interest is only one of several determinants of investment spending. So
					Choosing between
policy makers have only a limited ability to affect the level of investment by manipulating
					Investment and
interest rates.
					Consumption

Tax Provisions The government also can influence investment spending by altering various provisions of the tax code. For example, President George W. Bush and Congress reduced the tax rate on capital gains—the profit earned by selling an asset for more than you paid for it—in 2003. The major argument for lowering capital gains taxes was the claim, much disputed by the critics, that it would lead to greater investment spending. In addition, the United States imposes a tax on corporate profits and can reduce that tax to spur investment as well. There are other, more complicated tax provisions relating to investment, too.3 To summarize:

The tax law gives the government several ways to influence business spending on investment goods. But influence is far from total control.

Technical Change Technology, which we have listed as a separate pillar of growth, also drives investment. New business opportunities suddenly appear when a new product such as the mobile telephone is invented or when a technological breakthrough makes an existing product much cheaper or better, as is happening with flat-panel TVs right now. In a capitalist system, entrepreneurs pounce on such opportunities—building new factories, stores, and offices, and buying new equipment. Thus, if the government can figure out how to spur technological progress (a subject discussed later in this chapter), those same policies will probably boost investment.

The Growth of Demand Rapid growth itself can induce businesses to invest more. When demand presses against capacity, executives are likely to believe that new factories and machinery can be employed profitably—which creates strong incentives to build new capital. Thus it was no coincidence that investment soared in the United States during the boom years of the 1990s, collapsed when the economy slowed precipitously in 2000–2001, and then revived again starting in 2003. By contrast, if machinery and factories stand idle, businesses may find new investments unattractive. In summary:

High levels of sales and expectations of rapid economic growth create an atmosphere conducive to investment.

This situation creates a kind of virtuous cycle in which high rates of investment boost economic growth, and rapid growth boosts investment. Of course, the same process can also operate in reverse—as a vicious cycle: When the economy stagnates, firms do not want to invest much, which damages prospects for further growth.

3 But any kind of a tax cut will reduce government revenue. Unless that revenue is made up by a spending cut or by some other tax, the government’s budget deficit will rise—which will also affect investment. We will study that channel in Chapter 15.

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SOURCE: World Bank web site, www.doingbusiness. org, accessed August 2007. The index is constructed by rating countries on transparency of transactions, liability for self-dealing, and shareholders’ ability to sue for misconduct.

5.3

5.0

5.0

2.3

6.0

5.7

8.3

8.0

7.0

6.0

9.3

8.3

Rating (0 –10 scale)

TABLE 3

Selected Countries Ranked by Level of Investor Protection

Property rights are laws and/or conventions that assign owners the rights to use their property as they see fit (within the law)—for example, to sell the property and to reap the benefits (such as rents or dividends) while they own it.

Brazil

Italy

China

Swaziland

India

Sweden

Canada

United Kingdom

Japan

Mexico

Singapore

United States

Country

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Political Stability and Property Rights There is one other absolutely critical determinant of investment spending that Americans simply take for granted.

A business thinking about committing funds to, say, build a factory faces any number of risks. Construction costs might run higher than estimates. Interest rates might rise. Demand for the product might prove weaker than expected. The list goes on and on. These are the normal hazards of entrepreneurship, an activity that is not for the faint of heart. But, at a minimum, business executives contemplating a long-term investment want assurances that their property will not be taken from them for capricious or political reasons. Republican businesspeople in the United States do not worry that their property will be seized if the Democrats win the next election. Nor do they worry that court rulings will deprive them of their property rights without due process.

By contrast, in many less-well-organized societies, the rule of law is regularly threatened by combinations of arbitrary government actions, political instability, anticapitalist ideology, rampant corruption, or runaway crime. Such problems have posed serious impediments to long-term investment in many poor countries throughout history. They are among the chief reasons these countries have remained poor. And the litany of problems that threaten property rights is not just a matter of history—these issues remain relevant in countries as different as Russia, much of Africa, and parts of Latin America today. Where businesses fear that their property may be expropriated, a drop in interest rates of a few percentage points will not encourage much investment.

Needless to say, the strength of property rights, adherence to the rule of law, the level of corruption, and the like are not easy things to measure. Anyone who attempts to rank countries on such criteria must make many subjective judgments. Nevertheless, due to its recent interest in the subject, the World Bank currently ranks 175 countries on various aspects of their business climate, including their degree of investor protection. Some of their data are displayed in Table 3. The ranking of the various countries is roughly what you might expect.

GROWTH POLICY: IMPROVING EDUCATION AND TRAINING

Numerous studies in many countries confirm the fact that more-educated and bettertrained workers earn higher wages. Economists naturally assume that the people who earn more are also more productive. Thus, more education and training presumably

To Grow Fast, Get the Institutions Right

A few years ago, the World Bank surveyed the ways the governments of around 100 countries either encourage or discourage market activity. Its conclusion, as summarized in The Economist, was that “when poor people are allowed access to the institutions richer people enjoy, they can thrive and help themselves. A great deal of poverty, in other words, may be easily avoidable.”

The World Bank study highlighted the importance of making simple institutions accessible to the poor—such as protection of property rights (especially over land), access to the judicial system, and a free and open flow of information—as key ingredients in successful economic development. The Economist put it graphically:

If it is too expensive and time-consuming, for example, to open a bank account, the poor will stuff their savings under the

mattress. When it takes 19 steps, five months and more than an average person’s annual income to register a new business in Mozambique, it is no wonder that aspiring, cash-strapped entrepreneurs do not bother.

The Bank’s conclusion reminded many people of the central message of a best-selling 2000 book by Peruvian economist and businessman Hernando de Soto—who found to his dismay that, in his own country, it took 700 bureaucratic steps to obtain legal title to a house!

SOURCES: “Now, Think Small,” The Economist, September 15, 2001, pp. 40–42. Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books), 2000.

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contribute to higher productivity. Although private institutions play a role in the educational process, in most societies the state bears the primary responsibility for educating the population. So education policy is an obvious and critical component of growth policy.

A modern industrial society is built more on brains than on brawn. Even ordinary bluecollar jobs often require a high school education. For this reason, policies that raise rates of high school attendance and completion and, perhaps as importantly, improve the quality of secondary education can make genuine contributions to growth. Unfortunately, such policies have proven difficult to devise and implement. So the debate over how to improve our public schools goes on and on, with no resolution in sight. President Bush’s No Child Left Behind program is only the latest in a long list of educational reforms.

Finally, if knowledge is power in the information age, then sending more young people to college and graduate school may be crucial to economic success. It is well documented that the earnings gap between high school and college graduates in the United States has risen dramatically since the late 1970s. One graphical depiction of this rising disparity is shown in Figure 4. It shows clearly that the job market was rewarding the skills acquired in college ever more generously from about 1978 until about 2000. To the extent that high wages reflect high productivity, low-cost tuition (such as that paid at many state colleges and universities), student loans to low-income families, and other policies to encourage college attendance may yield society rich dividends.

Devoting more resources to education should, therefore, raise an economy’s growth rate. By suitable reinterpretation, Figure 3 (on page 139) can again be used to illustrate the trade-off between present and future. Because expenditures on education are naturally thought of as investments in human capital, just interpret the vertical axis as now representing educational investments. If a society spends more on them and less on consumer goods (thus moving from point C toward point I), it should grow faster. China, to cite the most prominent example, is doing that with great enthusiasm right now.

But education is not a panacea for all of an economy’s ills. Education in the former Soviet Union was outstanding in some respects. But it proved insufficient to prevent the Soviet economy from falling ever further behind the capitalist economies in terms of economic growth.

On-the-job training may be just as important as formal education in raising productivity, but it is less amenable to influence by the government. For the most part, private

		FIGURE 4
		Wage Premium for College Graduates over High School Graduates
of
State			50
The									Females
	2006–2007America,2007)Press,UniversityCornellN.Y.:(Ithaca,.	AdvantageWagePercentage
HeatherandAllegretto,SylviaBernstein,JaredMishel,LawrenceBoushey,			40
									Males
			30
			20
SOURCE:	Working		1973	1975	1980	1985	1990	1995	2000	2005
							Year

On-the-job training refers to skills that workers acquire while at work, rather than in school or in formal vocational training programs.

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businesses decide how much, and in what ways, to train their workers. Various public policy initiatives—ranging from government-run training programs, to subsidies for private-sector training, to mandated minimum training expenditures by firms—have been tried in various countries with mixed results. In the United States, mandates on companies have always been viewed as improper interferences with private business decisions, and they have been avoided. The government runs some training programs, though the biggest (by far) is the armed forces.

GROWTH POLICY: SPURRING TECHNOLOGICAL CHANGE

Invention is the act of discovering new products or new ways of making products.

Innovation is the act of putting new ideas into effect by, for example, bringing new products to market, changing product designs, and improving the way in which things are done.

Research and development (R&D) refers to activities aimed at inventing new products or processes, or improving existing ones.

Our third pillar of growth is technology, or getting more output from given supplies of inputs. Some of the most promising policies for speeding up the pace of technical progress have already been mentioned:

More Education Although some inventions and innovations are the product of dumb luck, most result from the sustained application of knowledge, resources, and brainpower to scientific, engineering, and managerial problems. We have just noted that more-educated workers appear to be more productive per se. In addition, a society is likely to be more innovative if it has a greater supply of scientists, engineers, and skilled business managers who are constantly on the prowl for new opportunities. Modern growth theory emphasizes the pivotal role in the growth process of committing more human, physical, and financial resources to the acquisition of knowledge.

High levels of education, especially scientific, engineering, and managerial education, contribute to the advancement of technology.

There is little doubt that the United States leads the world in the quality of its graduate programs in business and in many of the scientific and engineering disciplines. As evidence of this superiority, one need only look at the tens of thousands of foreign students who flock to our shores to attend graduate school—many of whom remain in America. It seems reasonable to suppose that America’s unquestioned leadership in scientific and business education contributes to our leadership in productivity. On this basis, many economists and politicians endorse policies designed to induce more bright young people to pursue scientific and engineering careers—such as scholarships, fellowships, and research grants—and worry that too few young Americans are choosing these career paths.

More Capital Formation We are all familiar with the fact that the latest versions of cell phones, PCs, personal digital assistants (PDAs), and even televisions embody new features that were unavailable a year or even six months ago. The same is true of industrial capital. Indeed, new investment is the principal way in which the latest technological breakthroughs get hard-wired into the nation’s capital stock. As we mentioned in our earlier discussion of capital formation, newer capital is normally better capital. In this way,

High rates of investment contribute to rapid technical progress.

So all of the policies we discussed earlier as ways to bolster capital formation can also be thought of as ways to speed up technical progress.

Research and Development But there is a more direct way to spur invention and innovation: devote more of society’s resources to research and development (R&D).

Driven by the profit motive, American businesses have long invested heavily in industrial R&D. According to the old saying, “Build a better mousetrap, and the world will beat a path to your door.” And innovative companies in the United States and elsewhere have been engaged in research on “better mousetraps” for decades. Polaroid invented instant photography, Xerox developed photocopying, and Apple pioneered the desktop computer. Boeing improved jet aircraft several times. U.S.-based pharmaceutical companies

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have discovered many new, life-enhancing drugs. Intel has developed generation after generation of ever-faster microprocessors. The list goes on and on.

All these companies and others have spent untold billions of dollars on R&D to discover new products, to improve old ones, and to make their industrial processes more efficient. Although many research dollars are inevitably “wasted” on false starts and experiments that don’t pan out, numerous studies have shown that the average dollar invested in R&D has yielded high returns to society. Heavy spending on R&D is, indeed, one of the keys to high productivity growth.

The U.S. government supports and encourages R&D in several ways. First, it subsidizes private R&D spending through the tax code. Specifically, the Research and Experimentation Tax Credit reduces the taxes of companies that spend more money on R&D.

Second, the government sometimes joins with private companies in collaborative research efforts. The Human Genome Project may be the best-known example of such a public–private partnership (some called it a race!). But there also have been cooperative ventures in new automotive technology, alternative energy sources, and elsewhere.

Last, and certainly not least, the federal government has over the years spent a great deal of taxpayer money directly on R&D. Much of this spending has been funneled through the Department of Defense. But the National Aeronautics and Space Administration (NASA), the National Science Foundation (NSF), the National Institutes of Health (NIH), and many other agencies have also played important roles. Inventions as diverse as atomic energy, advanced ceramic materials, and the Internet were originally developed in federal laboratories. Federal government R&D spending in fiscal year 2006 amounted to roughly $134 billion, more than half of which went through the Pentagon.

Our multipurpose Figure 3 (page 139) again illustrates the choice facing society. Now interpret the vertical axis as measuring investments in R&D. Devoting more resources to R&D—that is, choosing point I rather than point C—leads to less current consumption but more growth.

THE PRODUCTIVITY SLOWDOWN AND SPEED-UP IN THE UNITED STATES

Around 1973, productivity growth in the United States suddenly and mysteriously

slowed down—from the rate of about 2.8 percent per year that had characterized the

1948–1973 period to about 1.4 percent thereafter (see Figure 5). Hardly anyone anticipated

FIGURE 5

this productivity slowdown. Then, starting around 1995, productivity growth suddenly

Average Productivity

speeded up again—from about 1.4 percent per year during the 1973–1995 period back to

Growth Rates in the

about 2.5 percent since then (see Figure 5 again). Once again, the abrupt change in the

United States,

growth rate caught most people by surprise.

1948–2007

Recall from the discussion of compounding in

Chapter 6 that a change in the growth rate of

2.8

around 1 percentage point,

if sustained for

decades, makes an enormous difference in living

2.5

standards. So understanding these two major

events is of critical importance. Yet even now,

www.bls.gov/data.

reasons behind the 1995 productivity speed-up are

Yearper

some 35 years later, economists remain puzzled

about the 1973 productivity slowdown, and the

Laborofat

1.4

only partly understood. Let us see what econo-

Percent

mists know about these two episodes.

Department

The Productivity Slowdown,

U.S.

1973–1995

SOURCE:

1948–1973

1973–1995

1995–2007

The productivity slowdown after 1973 was a dis-

concerting development, and

economists have

NOTE: Data pertain to the nonfarm business sector.

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been struggling to explain it ever since. Among the leading explanations that have been offered are the following.

Lagging Investment During the 1980s and early 1990s, many people suggested that inadequate investment was behind America’s productivity problem. Countries such as Germany and Japan, these critics observed, saved and invested far more than Americans did, thereby equipping their workers with more modern equipment that boosted labor productivity. United States tax policy, they argued, should create stronger incentives for business to invest and for households to save.

Although the argument was logical, the facts never did support it. For example, the share of U.S. GDP accounted for by business investment did not decline during the period of slow productivity growth. Nor did the contribution of capital formation to growth fall. (See the box on growth accounting on the next page.)

High Energy Prices A second explanation begins with a tantalizing fact: The productivity slowdown started around 1973, just when the Organization of Petroleum Exporting Countries (OPEC) jacked up the price of oil. As a matter of logic, higher oil prices should reduce business use of energy, which should make labor less productive. Furthermore, productivity growth fell just at the time that energy prices rose, not just in the United States but all over the world—which is quite a striking coincidence. This circumstantial evidence points the finger at oil. The argument sounds persuasive until you remember another important fact: When energy prices dropped sharply in the mid-1980s, productivity growth did not revive. So the energy explanation of the productivity slowdown has many skeptics.

Inadequate Workforce Skills Could it be that the skills of the U.S. labor force failed to keep pace with the demands of new technology after 1973? Although workforce skills are notoriously difficult to measure, there was and is a widespread feeling that the quality of education in the United States has declined. For example, SAT scores peaked in the late 1960s and then declined for about 20 years.4 Yet standard measures such as school attendance rates, graduation rates, and average levels of educational attainment all continued to register gains in the 1970s and 1980s. Clearly, the proposition that the quality of the U.S. workforce declined is at least debatable.

A Technological Slowdown? Could the pace of innovation have slowed in the 1973–1995 period? Most people instinctively answer “no.” After all, the microchip and the personal computer were invented in the 1970s, opening the door to what can only be called a revolution in computing and information technology (IT). Workplaces were transformed beyond recognition. Entirely new industries (such as those related to PCs) were spawned. Didn’t these technological marvels raise productivity by enormous amounts?

The paradox of seemingly rapid technological advance coupled with sluggish productivity performance puzzled economists for years. How could the contribution of technology to growth have fallen? A satisfactory answer was never given. And then, all of a sudden, the facts changed.

The Productivity Speed-up, 1995–?

Figure 5 shows that productivity growth speeded up remarkably after 1995, rising from about 1.4 percent per annum before that year to about 2.5 percent from 1995 to 2007. This time, the causes are better understood—and most of them relate to the IT revolution.

Surging Investment Bountiful new business opportunities in the IT sector and elsewhere, coupled with a strong national economy, led to a surge in business investment

4 The SAT was rescaled about a decade ago to reflect this decline in average scores.

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Growth Accounting in the United States

In this chapter, we have learned that labor productivity (output per hour of work) rises because more capital is accumulated, because technology improves, and because workforce quality rises. The last of these three pillars is quantitatively unimportant in the modern United States because average educational attainment has been high for a long time and has not changed much recently. But the other two pillars are very important.

The table breaks down the growth rate of labor productivity into its two main components over three different periods of time. We see that the productivity slowdown after 1973 was entirely accounted for by slower technological improvement; the contribution of capital formation did not decline at all.* Similarly, the productivity speed-up after 1995 was entirely accounted for by faster technical progress, not by higher rates of investment.

* Changes in workforce quality are included in the technology component.

		1948 –1973	1973 –1995	1995 – 2006
	Growth rate of Labor
	Productivity	2.8%	1.4%	2.7%
	Contribution of	0.9	1.0	1.0
	capital formation
	Contribution of	1.9	0.4	1.7
	technology

SOURCE: Bureau of Labor Statistics at www.bls.gov/data.

spending in the 1990s. Business investment as a percentage of real GDP rose from 9.1 percent in 1991 to 14.6 percent in 2000, and most of that increase was concentrated in computers, software, and telecommunications equipment. We have observed several times in this chapter that the productivity growth rate should rise when the capital stock grows faster—and it did in the late 1990s. But then investment fell when the stock market crashed, beginning in 2000. So, over the entire 1995–2006 period, the table in the box above shows the same contribution of capital formation to productivity growth in 1995–2006 as in 1973–1995. So investment cannot be the answer.

Falling Energy Prices? For part of this period, especially the years 1996–1998, energy prices were falling. By the same logic used earlier, falling energy prices should have enhanced productivity growth. But, as we noted earlier, this argument did not seem to work so well when energy prices fell in the 1980s. Why, then, should we believe it for the 1990s? In addition, productivity continued to surge in the early years of this decade, after energy prices had started to rise.

Advances in Information Technology We seem to be on safer ground when we look to technological progress, especially in computers and semiconductors, to explain the speed-up in productivity growth. First, innovation seemed to have exploded in the 1990s. Computers became faster and much, much cheaper—as did telecommunications equipment and services. Corporate intranets became commonplace. The Internet grew from a scientific curiosity into a commercial reality, and so on. We truly entered the Information Age.

Second, it probably took American businesses some time to learn how to use the computer and telecommunications technologies that were invented and adopted between, say, 1980 and the early 1990s. It was only in the late 1990s, some observers argue, that U.S. industry was positioned to reap the benefits of these advances in the form of higher productivity. Such long delays are not unprecedented. Research has shown, for example, that it took a long time for the availability of electric power at the end of the nineteenth century to contribute much to productivity growth. Like electric power, computers were a novel input to production, and it may have taken years for prospective users to find the most productive ways to employ them.

In summary:

The biggest pillar of productivity growth—technological change—seems to do a credible job of explaining why productivity accelerated in the United States after 1995.

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PART 2

The Macroeconomy: Aggregate Supply and Demand

According to the cost disease of the personal services, service activities that require direct personal contact tend to rise in price relative to other goods and services.

PUZZLE RESOLVED: WHY THE RELATIVE PRICE OF COLLEGE TUITION KEEPS RISING

Earlier in this chapter, we observed that the relative prices of services such as college tuition, medical care, and theater tickets seem to rise year after year. And we suggested that one main reason for this perpetual increase is tied to the economy’s long-run growth rate. We are now in a position to understand precisely how that mechanism works. Rising productivity is the key. The argument is based on three simple ideas.

IDEA 1 It stands to reason, and is verified by historical experience, that real wages tend to rise at the same rate as labor productivity. This relationship makes sense: Labor normally gets paid more when it produces more. Thus real wages will rise most rapidly in those economies with the fastest productivity growth.

IDEA 2 Although average labor productivity in the economy increases from year to year, there are a number of personally provided services for which productivity (output per hour) cannot or does not grow. We have already mentioned several of them. Your college or university can increase the “productivity” of its faculty by increasing class size, but most students and parents would view that as a decrease in educational quality. Similarly, a modern doctor takes roughly as long to give a patient a physical as his counterparts did 25 or 50 years ago. It also takes exactly the same time for an orchestra to play one of Beethoven’s symphonies today as it did in Beethoven’s time.

There is a common ingredient in each of these diverse examples: The major sources of higher labor productivity that we have studied in this chapter—more capital and better technology—are completely or nearly irrelevant. It still takes one lecturer to teach a class, one doctor to examine a patient, and four musicians to play a string quar- tet—just as it did 100 years ago. Saving on labor by using more and better equipment is more or less out of the question.5 These so-called personal services stand in stark contrast to, say, working on an automobile assembly line or in a semiconductor plant, or even to working in service industries such as telecommunications—all instances in which both capital formation and technical progress regularly raise labor productivity.

IDEA 3 Real wages in different occupations must rise at similar rates in the long run. This point may sound wrong at first: Haven’t the wages of computer programmers risen faster than those of schoolteachers in recent years? Yes they have, and that is the market’s way of attracting more young people into computer programming. But in the long run, these growth rates must (more or less) equilibrate, or else virtually no one would want to be a schoolteacher any more.

Now let’s bring the three ideas together. College teachers are no more productive than they used to be, but autoworkers are (Idea 2). But in the long run, the real wages of college teachers and autoworkers must grow at roughly the same rate (Idea 3), which is the economy-wide productivity growth rate (Idea 1). As a result, wages of college teachers and doctors will rise faster than their productivity does, and so their services must grow ever more expensive compared to, say, computers and phone calls.

That is, indeed, the way things seem to have worked out. Compared to the world in which your parents grew up, computers and telephone calls are now very cheap while college tuition and doctors’ bills are very expensive. The same logic applies to the services of police officers (two per squad car), baseball players (nine per team), chefs, and many other occupations where productivity improvements are either impossible or undesirable. All of these services have grown much more expensive over the years. This phenomenon has been called the cost disease of the personal services.

5 However, some people foresee a world in which some aspects of education and medical care will be delivered long distance over the Internet. We’ll see!

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