A Quick Fix Not Likely to Lead to Long-Term Growth

The U.S. economy is not doing well, but prospects will improve once defense cutbacks end. Economic growth in the four quarters ending in September was a sluggish 1.75%, about 1% below the average growth rate for the past 20 years.

The long-term average combines periods of expansion and recession, so the economy has to grow between 3% and 4% on average in years of expansion to make up for the losses in output during periods of recession. To get back on course, the economy has to about double its growth rate.

During the campaign, President-elect Clinton hammered on the record of slow economic growth during the Bush Administration. He often compared the economy’s performance under Presidents Bush and Hoover. Of course, he was careful not to point out an important difference: Output will rise about 4% during President Bush’s term; output fell nearly 25% during President Hoover’s term.

We are better off than candidates Clinton and Ross Perot claimed. Still, growth during President Bush’s term was slow compared to any administration since World War II. Worldwide disinflation and reductions in defense spending contributed to slower growth internationally.

Growth in Japan and Germany was slower than in the United States during the last four quarters for which data is available. Canada’s growth is less than half of ours for the same period, and in Britain’s output has fallen for two years or more.

September’s 7.5% unemployment rate for the U.S. compares to 11.4% in Canada, 10.2% in France, 10.6% in Italy, 9.9% in Britain and 6.8% in Germany.

Cutbacks in defense spending create temporary, not permanent, problems. In Southern California, southern New England and eastern Missouri, where defense contracts gave a significant impetus to industry, unemployment is above the national average.

These areas will begin to recover within a year, if growth rises, just as they did in the early 1950 and 1970s following the post-Korea and post-Vietnam defense cuts. With inflation now in the 2% to 3% range, and expected to rise a bit, we should soon see an end to the falling house prices that have reduced consumers’ wealth in many parts of the country.

The new Administration comes to office with part of an economic stimulus package already in place.

Last year, Congress and the Bush Administration agreed to spend $150 billion for transportation and highways spread over the next five years. This money will start to affect the economy in 1993. Also, the Bush Administration is spending $20 billion less for defense in 1992 than Congress appropriated.

Even without any additional appropriations, the economy will have new government spending equal to 1% of total gross domestic product or more when the highway and defense funds are spent. This is more than enough to get the economy up to speed. And, Clinton campaigned on the need to rebuild America, so more government spending for infrastructure seems likely. The Democratic platform calls for $220 billion of new spending in the next four years.

This type of spending will speed up the recovery, but it will not do much for long-term growth. Much of the highway program is pure pork barrel. There will be lots of waste. Such government spending can increase incomes and jobs during slack periods.

This spending won’t increase long-term growth because wasteful pork-barrel projects don’t increase productivity or add much value to the capital stock. And the higher taxes that Clinton promised will reduce saving.

The solution to long-term growth is to get productivity back to its upward trend rate of about 1.5% to 2% per year in the United States and other developed economies. This will not be accomplished if Congress and the new Administration choose taxes and pork barrel over productivity.

Some economists who advised Clinton during his campaign want to encourage investment in machinery and equipment. They argue that investment of this kind produces big returns by permanently raising the economy’s growth rate.

There is not much reason to believe their story. Experience with investment incentives here and abroad does not lend much credence to the idea that long-term productivity growth rate can be raised permanently in this way. But increased investment raises output and the productivity level, so living standards and incomes would rise.

I believe the most useful program to increase productivity would concentrate in two areas--improving the quality of education and reducing taxes on investment.

As a nation we spend heavily for public education but do not get good returns, except from higher education. One reason is that much primary and secondary education is remedial, repetition at a higher level of the training that was not learned earlier. Many educational reform programs want to increase incentives for learning by introducing competition between private and public schools. Clinton opposed that during his campaign.

There is much that competition can do to improve schooling, but schooling is not learning. Learning is what individuals do when they practice, drill and study. Improving the quality of education requires more discipline and greater incentives for students.

In many countries, a student’s scholastic achievement is important for getting his or her first job. This is less true in the United States, where school records are irrelevant for most jobs.

If students know there is little relation between schoolwork and jobs, they have fewer incentives to learn. But learning, and learning how to learn, is important for everyone, not just youngsters entering the labor force.

On the tax front, the government penalizes investment by taxing profits both when they are earned by the firm and when the earnings are distributed to investors. Depreciation allowances are not adjusted for inflation, so inflation lowers the returns investors receive. Lower returns have discouraged investment. As a result, firms have invested less, lowering their workers productivity.

Recent studies suggest the importance of low capital taxation to boost growth and living standards. Reducing the corporate income tax, which falls on invested capital, by 10 percentage points, it is estimated, would raise the long-run capital stock by 18% and the level of income about 6%. In today’s dollars this would add about $300 billion to aggregate income, or about $1,200 per person.

A new Administration and Congress is about to take office. The choices they make will determine whether the economy gets a short-term spurt from increased government spending or higher long-term growth through improved education and increased capital investment. The quality of the new Administration will be revealed by their choices--more pork barrel like last year’s highway bill--or a boost to productivity that raises living standards permanently.