Economics One

What’s the best way forward for American economic policy? On Independence Day it’s natural to look to the country’s founding principles—political freedom and economic freedom—for an answer. 1776 was not only the year when Thomas Jefferson wrote the Declaration of Independence, it was the year when Adam Smith wrote the Wealth of Nations. We can learn what to do by studying the alternating periods in American history when careful attention was paid to these principles and when they were recklessly neglected.

From the perspective of today’s dismal economic performance—high unemployment and a nearly non-existent recovery from a devastating recession—the final two decades of the 20th century are particularly relevant for they stand out as unusually good economic times. With lessons learned from the 20th century’s tougher decades, including the Great Depression of the ‘30s and the Great Inflation of the ‘70s, America entered a period of unprecedented economic stability and growth in the ‘80s and ‘90s. Not only were 47 million jobs created, economic growth was more stable than ever before in American history.

Economic policy in the ‘80s and ‘90s was less interventionist in comparison with earlier 20th century decades. Attention was paid to the principles of economic and political freedom: limited government, incentives, private markets, and a predictable rule of law. Monetary policy focused on price stability. Tax reform reduced marginal tax rates. Regulatory reform encouraged competition and innovation. Welfare reform devolved decisions to the states. With strong economic growth and control of government spending the budget moved into balance. As the 21st century began many hoped that applying these same principles to education and health care would create greater opportunities and better lives for all Americans.

But economic policy went in a different direction. Some public officials found the limited government approach to be a disadvantage; they wanted to do more—whether to tame further the business cycle or increase homeownership. Others took the good economic performance for granted, forgetting that good economic policies made that performance possible. Still others forgot the earlier lessons that interventionist policies frequently made things worse. Complacent about the success in the ‘80s and ‘90s, they let down their guard against political pressures that thwart good policy and lead to reckless ones.

So policy moved in a more interventionist direction. The result was not the intended improvement, but rather an epidemic of unintended consequences–a financial crisis, a great recession, and the high unemployment and wasted resources we see now. The change in direction did not occur overnight. We saw increased federal intervention in the housing market in the late 1990s. We saw a countercyclical fiscal policy in the form of rebate checks in 2001, and then a failure to control of government spending growth from entitlements to defense. We saw monetary policy moving in a more activist direction in 2003-2005, and interventionism reached a new peak with the bailouts before and after the panic in 2008. In the past three years Washington doubled down on the interventionist approach, and deficits and debt have exploded. With high unemployment and fears of a secular American decline, there is now an urgent need to get back to the principles of political and economic freedom put forth in the Declaration of Independence and in the Weath of Nations. The good news is that it’s not too late.

Some skeptics have complained about the 5% national economic growth target put forth by former Minnesota Governor Tim Pawlenty in his speech this week about his economic plan. They say it can’t be done. But I think the goal makes a great deal of sense. It would focus policymakers like a laser beam on the great benefits that come from higher growth and on the pro-growth policies needed to achieve it. As with any goal, if you take it seriously, you’ll choose policies that work toward that goal and reject those that don’t.

As stated in the speech, “5% growth is not some pie-in-the-sky number.” One way to see why is by dissecting the number into its two parts using basic economics. As we teach in Economics 1, economic growth equals employment growth plus productivity growth. Productivity is the amount of goods and services that workers produce on average in a given period of time. Thus, higher economic growth can come from higher employment growth or from higher productivity growth. Now consider some examples of average growth rates over the next ten years.

First, look at employment growth. Given the dismal jobs situation, that’s the highest priority. Currently the percentage of the working-age population (age 16 and over) that is actually working is very low at 58.4 percent. In the year 2000 it reached 64.7 percent, so that is at least a feasible number. Raising the employment-to-population ratio to 64.7 means an employment increase of 10.8 percent (64.7-58.4/58.4 = .108) or about 1 percent per year over 10 years, even without any growth of the population. Adding in about 1 percent for population growth (from Census projections), gives employment growth of 2 percent per year.

Now consider productivity growth. Since the productivity resurgence began around 1996, productivity growth in the United States has averaged 2.7 percent according to the Bureau of Labor Statistics. So numbers in that range are not pie in the sky. As Harvard economist Dale Jorgenson and his colleagues have shown, the IT revolution is part of the explanation for the productivity growth, and, if not stifled, is likely to continue, as is pretty clear to me as I sit a few hundred yards from Facebook and other high-tech firms.

Now if we add the 2.7 percent productivity growth to the 2 percent employment growth, we get 4.7 percent economic growth, which is within reaching distance of—or simply rounds up to—the 5 percent target set by Governor Pawlenty. Thus, five percent growth is a good goal to aspire to, whereas 3 or 4 percent would be too little and 6 or 7 percent too much. Of course, one can fine-tune these calculations–for example, by estimating changes in hours per worker or the difference between nonfarm business (which BLS productivity numbers refer to) and total GDP–or raise questions about demographic effects on the employment-to-population ratio. And one could use different examples, perhaps lower employment growth and higher productivity growth, but the basic point about the goal would be the same.

You can see how the types of pro-growth policies in the Pawlenty plan would work toward the goal by reducing spending growth enough to balance the budget without tax increases and thereby remove threats of a debt crisis; by lowering marginal tax rates to spur hiring and job growth; by scaling back unnecessary new regulations which impede private investment and higher productivity, and by restoring sound monetary policy to remove uncertainty about inflation or another financial crisis.