Why We Grow
By Brendan Miniter
Economic growth is not an issue normally associated with the Pentagon. But on January 23, 2006, in a little-noticed ceremony, officials there handed the Defense Department’s Distinguished Public Service Award to then outgoing Federal Reserve chairman Alan Greenspan. The reason for the award: He helped unleash tremendous economic growth that had strengthened the country, led to new advances in science and technology, and demonstrated the power of a free and open economic system.
The importance of economic prosperity is hard to overstate. A growing economy produces jobs that allow workers to provide for their families, live comfortable and stable lives, and give back to their communities. A growing economy creates new opportunities for entrepreneurs. And it also creates the capital needed to support innovation and research in science and the arts. America’s economy has long produced the types of jobs that have enabled Americans to enjoy comfortable middle-class lives.
From the end of World War II until our recent “Great Recession,” the United States economy grew, on average, at a little more than 3% annually. At that rate the size of the economy doubles roughly every generation. There were, of course, recessions during that period. But nearly every economic downturn was followed by a period of significant growth. Over the past seventy years, the American economy has grown at 4% or greater about two-fifths of the time. The result has been a rapid transformation. Today most Americans have a substantially higher standard of living than previous generations. And they also carry with them an expectation for growth. Americans hold the optimistic view that it is natural for the economy to grow at a rapid pace year in and year out.
But survey the historical data stretching back long before World War II and you may be surprised to see that economic growth is a relatively new phenomenon. In an essay1 published before he won the Nobel Prize in Economics in 1995, Robert Lucas outlined the history of economic growth. His findings show that prior to the industrial revolution in the middle of the 18th century, per capita gross domestic product (GDP) growth had largely been flat around the world. Technological advancement had occurred, but the economic gains that were made were essentially offset by increases in population.
However, with the advent of the industrial revolution, economic growth managed to outrun population (industrialized economies grew, while birthrates declined) and the result was the rise of a middle class. Lucas calculates that the world economy grew at a fraction of 1% annually through the latter half of the 18th century, at about 1% annually on average through the 19th century, at about 2.4% for the first sixty years of the 20th century, and at about 4% annually after that.
Modern growth theory--the theory that looks at innovation and human ingenuity as engines for expanding the economy--is itself relatively new. Robert M. Solow, the economist often credited with advancing modern economic thought in this area, did much of his groundbreaking work in the 1950s and ’60s. Others, such as Lucas, have since developed alternative growth models, which have sparked research and debate among economists about the role of human capital, entrepreneurship, and other factors in economic growth. The short of it is that these are exciting times to be thinking about economics, growth, and the outer limits of human potential. There is a lot of cutting-edge work being done now. And it is reshaping what we know to be possible, while also forcing us to realize that much of what we have done in the past may have actually hamstrung the economy.
Consider the work of another economist who hasn’t won the Nobel Prize, but likely deserves such high honors: Gordon Tullock. Half a century ago, he worked closely with economist James Buchanan, who went on to win the Nobel for his work on something called public choice theory--a body of ideas that argues that rather than being driven by altruistic motives, government policies are often driven by hidden incentives. For example, government agencies have a strong incentive to spend all the money in their budgets, even if they have to spend it in wasteful ways, because not spending the money can lead lawmakers to cut those agencies’ budgets the following year.
The combined contributions of Tullock and Buchanan can be found in an often cited volume, The Calculus of Consent, which sorts through incentives that drive democratic systems and offers reasons why, for example, a legislature might back public policies that are not widely popular and may not even serve the greater public good. But perhaps Tullock’s most relevant work to discussions of economic growth has to do with what has been called “rent seekers”--those who seek special payment or privilege, usually from the government. His insight, accessible in a volume titled The Rent-Seeking Society, is simply that individuals or institutions often seek to profit by tilting the political landscape in their direction, rather than by creating real value.
This concept is critical to understand in today’s environment of large federal deficits and a stumbling economy. It’s often assumed that federal spending will stimulate the economy--after all, it pumps money into the system. But Tullock’s insight offers us an explanation into why government spending can actually be harmful to economic growth. Spending is funded by taxes, which pulls capital out of the productive economy. The destructive power of taxes is something that has been long discussed and seems to be well understood. Collecting taxes, however, is only part of the harm that public policies can cause. Rent seekers, as Tullock discovered, profit through the political process, not by producing a better or cheaper product. Their aim is to receive payment (or privilege) through government policy.
In some cases, rent seekers can look to gain privilege by lobbying for new regulations that, if imposed, would harm their competitors. In other cases, rent seekers can look to profit by receiving government payments or inflated prices thanks to government policies. Donald Boudreaux, an economics professor at George Mason University, brilliantly illustrated Tullock’s insight in the Christian Science Monitor in late 2008 by looking at Illinois governor Rod Blagojevich. At the time, Blagojevich was at the center of a corruption story involving naming someone to fill a vacant Senate seat.2 Boudreaux concluded that when the government can bestow a privilege or profit on someone there is a strong incentive for entrepreneurial people to spend their time figuring out how to profit off the government. “As Tullock first recognized (in a paper published in 1967),” Boudreaux wrote, “enormous amounts of resources--including human talent--are wasted in pursuit of government privileges.”
Not all payments or privileges provided by the government are problematic or even wasteful. But since the government uses a political process to decide whom it pays and how much, there is little incentive for rent seekers to push for greater efficiency or innovation. This is a problem in part because the public and the private sectors compete for the same financial and human capital. That is to say, they compete for the same pile of money and the same group of innovative entrepreneurs. So when the government spends a large volume of money, there is that much less money in the system for private entrepreneurs. And when the government has a wide variety of programs that businesses can profit from, without being efficient producers, it drains away talented entrepreneurs who would otherwise put their talents to work in the private economy. Think of it this way: When profits are relatively easy to make in government contract work, there are fewer innovators willing to spend their time and their capital developing the next new innovation that could revolutionize an entire industry.
If we place Tullock’s work next to the insights offered by Lucas, Solow, and Buchanan (among others), it is possible to imagine that the era of significant economic growth is only just beginning. If sustained economic growth is relatively new to human history, if many of the theories explaining growth are still being refined, and if Tullock is right that public policies can create incentives that hurt economic growth, then we may not yet know our full economic potential. We haven’t yet found out how fast the economy can run on a sustained basis if public policy is lined up with the right incentives to grow the economy.
There isn’t a clear consensus on the rate of growth that the country should shoot for. As this book came together, Lucas said to me in an email that he didn’t support the idea that sustained long-term 4% growth was possible for the United States. I understood his point to be that the world as a whole might grow at 4% or faster and some countries--including China--could far exceed that growth rate. But that was because many countries are racing to catch up to the United States. They are experiencing catch‑up growth, which is much easier to achieve because it involves adopting technologies and practices that others have already developed. It’s much harder to grow at an accelerated rate when you are leading the pack--when you are the one developing new technologies that everyone else will copy.
And he’s right to think so. The United States is much more likely to achieve the average growth rate it maintained from the end of World War II to the most recent economic downturn--a rate of about 3%--than it is to accelerate to a new long-term economic growth rate of 4%. That doesn’t mean that in the short run, the country won’t exceed that annual average--indeed it will have to grow at a rate that exceeds its long-term average rate of growth for a period of time just to return to the...