No Light at the End of the Tunnel

David Friedman, a contributing editor to Opinion, is a senior fellow at the New America Foundation.

If the U.S. economy is growing at anything like the 5.6% annual clip reported last quarter, why are U.S. stock markets sagging and economic confidence still shaky? Corporate accounting skulduggery and fear of terrorist attacks are commonly cited reasons. But the real problem is more fundamental: Nobody seems to know how the economy will generate new and sustained wealth. Currently, the most bureaucratic and least productive sectors--government, health-care, social and education services--are driving the economy, while entrepreneurial industries and manufacturing languish. In the absence of at least a plausible fantasy about the “next big thing” that will ignite the private economy, many investors are understandably uncertain about what the public sector’s accelerating expansion means for our economic future.

During the 1980s and early 1990s, the U.S. economy transformed itself from an aging, uncompetitive has-been into a beehive of industrial ingenuity as large companies split up into more entrepreneurial units. After the recession in the early 1990s, the Internet and the newly emergent “digital age” reinvigorated the industrial transformation. To be sure, new-economy hype and Wall Street excess eventually masked the nation’s more fundamental economic development. For years, however, U.S. entrepreneurial creativity and highly effective industrial reorganization were the engines of wealth creation. From 1994 to 1998, nearly 12 million jobs were created. About 4.6 million of them were in goods-producing sectors--manufacturing, construction, business services and trade. Government, health-care, social and education services added just 2.4 million jobs.

Virtually none of these trends, nor any newer, more promising ones, can be discerned in today’s economy. Over the last four years, wealth-producing manufacturing, business services, construction and trade industries steadily declined, losing more than 700,000 jobs. Manufacturing employment alone fell by 11%, the sector’s second-worst decline since 1939. Business services, which produced 2.3 million jobs from 1994 to 1998, rose by only 800,000 from 1998 to 2002, roughly matching the expansion in education, social services and health care.

But wealth-consuming sectors--government, state-supported social and education services, health care--grew even more rapidly from 1998 to 2002 despite the most recent recession. These sectors added more than by 3.2 million jobs, one-third more than from 1994 to 1998, and constituted 60% of U.S. total employment growth. If growth in retail employment is factored in, an astonishing 80% of total U.S. job growth since 1998 has been in wealth-consuming sectors, compared with just 35% from 1994 to 1998.


These trends show few signs of abating. In the last quarter, government and related services added 220,000 jobs, while manufacturing, construction and business services shed 300,000. So that first-quarter report of 5.6% annual growth is a bit misleading. Aside from the fact that such reports tend to magnify any one quarter’s performance, the nation’s seemingly robust growth mainly reflected the continuing expansion of public and closely aligned sectors.

All this undercuts more hopeful interpretations of some recent economic developments. The U.S. manufacturing decline, for example, is often downplayed as natural. As countries mature, goes the argument, they shift from making widgets to designing software. This change may inconvenience workers in the doomed sectors, but, over time, they will find more rewarding jobs and benefit from cheap, high-quality imports or products churned out by automated factories.

Such beliefs were plausible in 1994-1998, when business-service employment was booming. As millions of jobs in technically demanding work--programming computers, setting up communications systems, for example--were created, business services offset slower growth or job losses in manufacturing. Economists even debated whether such services should be reclassified to reflect their productive role in the economy.

But when manufacturing went into a tailspin in the later 1990s, the business-service growth that powered the healthiest phases of the decade’s boom slowed too. Rather than supplant manufacturing, business-service enterprises depended on healthy factories, which, after all, were among their biggest clients.


Worse still, service-sector expansion began shifting from the private to the public. In 1994-98, engineering, management, film and business services, all of which are private-sector wealth-producing activities, accounted for more than half of the growth in U.S. service employment. During the next four years, however, they generated just one-third of total service growth. Personal services, such as cutting hair, grew more rapidly instead.

It’s hard to imagine how service-sector expansion can play a role in wealth creation if growth in, say, manicurists exceeds that of engineers. Currently, growth in service jobs appears to be increasingly dependent on government spending, a connection not normally correlated with sustainable wealth creation.

The economy is also suffering from nervousness about the public sector’s fiscal solvency. The dramatic expansion of state and local government jobs and functions over the last few years has already produced billions of dollars of red ink. The federal budget may soon follow suit, depending on its response to last year’s terrorist attacks.

Government pump-priming during economic slowdowns is hardly new. But the current government spending spree is unusual in both its scope and longevity. Most states, like California, did little to limit spending even when the stock-market bubble that was financing their budgets had clearly popped. And they continue to create hundreds of thousands of government jobs, most of which are subject to stringent civil-service protections and strong representation by public-employee unions. Today’s public-sector expansion may be permanent.


Government planners hope that the private economy will soon recover, allowing tax revenues to rise and pay for all this public expansion. But what if it doesn’t? What if continued public spending, and possibly large-scale deficits, slow the recovery?

There are plenty of examples of public spending burdens crippling highflying economies. Japan’s high-growth period, for example, was once the envy of the world but stalled in the early 1990s when the nation’s real estate bubble abruptly burst. The Japanese government repeatedly tried to spend its way into a recovery, but only succeeded in amassing a huge public deficit. Remarkably enough, some analysts now worry that Japan, like Argentina and Russia, might even default on its debt.

No one has suggested that the U.S. economy is heading toward anything like a similar fiscal meltdown. Yet neither has anyone painted a picture of how growth in the public sector shall lead us into a new era of sustained prosperity when the manufacturing economy is rapidly declining.

Most of the potential new sources of economic vitality seem longshots, at best. Biotechnology, for example, seems years from making a significant commercial impact. Older, once-appealing theories of economic expansion are even less compelling. Few, for example, still openly tout, let alone believe in, the wild-eyed claims once made about digital-age prosperity.


Until U.S. economic growth is more balanced and its emerging public finance challenge more manageable, it’s likely that our economic prospects will fail to fire investors’ and consumers’ enthusiasm. An expanding public sector may be necessary at a time of global terrorism. We’ll soon learn whether it also can choke off the economic development necessary for sustained prosperity.