The End of Affluence

1.

The last time Americans were strongly in favor of balancing the federal budget was during the Great Depression. Then, as now, the public generally thought that budget deficits were the cause rather than the result of their economic problems, and few politicians, including Franklin D. Roosevelt, disagreed or dared to contradict them. In his 1932 presidential campaign, Roosevelt criticized Herbert Hoover for not reducing federal deficits, and when the economy began to recover later in his first term, partly because of his own spending programs, he decided to deal firmly with the government’s growing deficit. By 1936, the deficit had risen to more than 5 percent of the gross national product, compared to less than 3 percent today. But FDR’s sharp cuts in government spending in 1937 did not have the effects he had hoped for; instead they contributed to a sudden, fierce recession later that year which reduced tax revenues and thwarted any attempts to balance the budget.

What FDR would learn during the next few years was that the opposite policy probably would have been preferable. Despite the Depression, the American economy retained so much capacity for growth that the stimulus of greater deficits, along with cooperative Federal Reserve policies to lower interest rates, would have expanded incomes and production rapidly—as deficit spending did during the war years—and probably raised tax revenues sufficiently to eventually eliminate the federal deficit. This of course is what happened after the war.¹

Today, we do not have this option. Since the early 1980s, the United States has run large budget deficits year after year, yet the economy has grown unusually slowly during this period. In view of the economy’s performance, there is certainly no good reason to believe that still larger deficits would have raised the rate of growth during these years or that the financial markets would have permitted such deficits, even if the government had pursued such a policy. With even larger deficits, fears of inflation would probably have driven interest rates so high that the effect of any added stimulus would have been offset by the higher cost of borrowing. As it is, most forecasters, including those at the Federal Reserve, believe that the economy will grow by only about 2.5 percent a year. At that rate of growth we now have little choice except to reduce projected government spending; otherwise federal deficits will rise further, continuing to strain the world’s financial markets and diverting more scarce funds away from investment.

To most Americans, therefore, it appears that we have no alternative than to do what FDR did in 1937, despite the risk of recession that rapid reductions in the deficit might entail. While the American economy is of course not as fragile as it was during the Great Depression, partly because of such “automatic stabilizers” as Social Security and unemployment insurance, both the Republican and the Clinton administration’s proposals to balance the budget are likely to slow the economy still further. Both plans are likely to lead to lower tax revenues than we would otherwise have. Contrary to the Republicans’ own forecast, a prominent econometric forecasting firm, The WEFA Group, calculates that even if Federal Reserve policies encourage growth by lowering interest rates, the Republican budget plan would (1) shave economic growth by about .3 percent a year on average, (2) consistently raise the unemployment rate above current levels to more than 7 percent, and perhaps to as high as 8.5 percent, and (3) fail to balance the budget as promised by 2002 because of the shortfall in tax revenues.² In my opinion, even this forecast may prove optimistic.

In view of such analyses, it is highly unlikely that cuts in government spending will by themselves solve our economic problems. A better approach would be to recognize that the fundamental problem is not the deficits themselves but slow growth, and to concentrate our attention largely on the problem of national productivity—the relatively low growth in the output of goods and services per hour of work that has characterized the economy for more than twenty years. If we recognize growth as the central issue facing the country today, we may be able to organize our scarce resources more effectively than the Republicans and Democrats have so far done with their broad budget proposals that do not address the specific failures of important parts of the economy. Ultimately, whatever we do, we may not be able to raise more than marginally the rate of productivity growth. But unless the rate rises from its historically low levels of the past twenty years, most other efforts we undertake to solve our economic problems will also probably fail.

The persistent decline in economic growth since 1973 has done far more damage than is generally realized. According to a former economist of the Organization of Economic Cooperation and Development, Angus Maddison, who has comprehensively compiled the long-term growth rates of the world’s nations, the American economy had been growing at an annual rate of 3.4 percent after inflation between 1870 and 1972. From a much smaller base in 1820, the annual rate of growth until 1972 had been 3.7 percent. But between 1973 and 1993, our economy grew at an average of only 2.3 percent a year after inflation (rising to 2.4 percent a year if we include the latest data for 1994). In no other twenty-year period since the 1870s has the American economy grown as slowly as it has since 1973, excepting the period that ended with the collapse in production early in the Great Depression. Though the US economy suffered many brief downturns over the past century and a half, it invariably recovered so robustly thereafter that it made up for these drops in production relatively quickly. Even the two sharp economic contractions before and after World War I did not reduce the average twenty-year growth rate as much as it has declined since 1973, a period moreover in which the labor force expanded rapidly as baby boomers and many more women went to work.³

It may at first seem unlikely that a mere 1 percent drop in the annual rate of economic growth can have large consequences. But the damage done by slow growth accumulates the way interest does in savings accounts. It does so slowly and almost imperceptibly at first, and then surprisingly rapidly over the years until we have fallen much further behind than we realize. During these twenty years, the loss of goods and services produced by the economy as a result of the 1 percent a year reduction in the growth rate has amounted to roughly $12 trillion (in 1987 dollars). By a conservative estimate, the typical family would have earned an additional $50,000 over these two decades as the demand for labor forced wages up had the economy continued to grow at its historic rate. That would have been enough for many Americans to put a down payment on the first house they have so far been unable to buy, or to buy the health insurance they couldn’t afford, or to send a child to college.

As for the federal budget deficit, not only would it have disappeared entirely had the country grown at its historic rate, but by the early 1990s the US would have run a substantial budget surplus. This would have happened because, with no change in tax rates, tax revenues would have been about $2.5 trillion higher over these years as personal incomes rose, and we could have avoided over half of the more than $4 trillion in federal debt we currently have. Interest expenses would thus have fallen sharply. The resulting budget surplus would have paid for health insurance for the 37 million people who have none, with some money left over to provide free day care for more children whose working mothers can’t afford it.

It would alternatively have been more than enough to provide as much in welfare for the poor as we now do for the aged in the form of Social Security. In addition, state and local governments would have collected nearly $1 trillion more in tax revenues for education and infrastructure. If the US had grown at its historic rate, we would also have had additional capital available for investment from higher individual savings and corporate profits of roughly $700 billion over twenty years. About 14 percent of everything Americans now spend goes to health care; but had the US economy grown at its historic rate, health care would have come to a more manageable 11 or 12 percent.⁴

No one fully understands how the damage done by slow growth is distributed among us, but workers have been hit especially hard. Average wages for most categories of workers have fallen; the poverty rate even for those who work full-time has climbed sharply; and, on average, incomes even for the best-educated among us have not risen nearly so fast as they did in the 1950s and 1960s. Differences in incomes are greater now than at any other time since the 1930s, giving the US the most unequal distribution of income in the advanced world. ⁵

Meantime, the costs of housing, education, and automobiles have been rising faster than American incomes. A lower proportion of Americans own homes than did so twenty years ago, especially those in the youthful home-buying years. The average number of cars per worker bought each year is down sharply from its level in 1973. And primary, high-school, and college educations are relatively more expensive than before, so that even well-to-do communities are cutting back on public-school spending. College students are taking increasingly longer to get degrees, as well as borrowing more from their parents and government to stay in school.⁶

These are the consequences of slow growth. Partly because few have understood what has been happening to us and we are consistently told by journalists and politicians that growth will soon resume, Americans have saved less and borrowed more in order to support the standard of living many have taken to be their natural right. Both public and private spending for health care has soared. The federal government raised spending on defense dramatically in the 1980s. There should be no mystery why the nation’s savings rate is so low or why federal deficits are so high.

In the past, when incomes were growing rapidly and seemed likely to do so forever, Americans were willing to subsidize welfare as well as new roads, public universities, space programs, and the construction of nuclear colliders. When growth was relatively rapid, Americans tended to be more open to ideas about including everyone in the American dream. They voted for politicians who advocated affirmative action, a war on poverty, Medicare and Medicaid, and generous student loans. But today, as slow growth makes it difficult for many of us to buy what we once did and impedes the steady financial progress that most of us once took for granted, these same programs are denounced as the work of a conspiracy of soft-headed liberals. The once popular idea that government should actively encourage equality of opportunity is now increasingly scorned. Many experts forget how much our democratic traditions contributed to our growth. Those traditions did so by favoring widespread ownership of property and a broad distribution of income, which created a powerful consumer market-place, as well as an openly competitive business environment, and a free public education system for all. Instead of addressing the slowdown in economic growth directly, politicians now address its symptoms, as if everything, from welfare to broken families to angry urban ghetto songs, is the cause and not, in considerable part, the consequence of poverty. If the American economy continues to grow at the same slow rate, we will lose approximately another $25 trillion in production over the next twenty years compared to what we would have earned had we grown since 1973 at what had been our historic rate. That loss would come to more than $75,000 a person, excluding the effects of inflation. Numbers like these change history.

2.

The immediate cause of slowing economic growth since 1973 has been the steep drop in the growth rate of productivity. Since a few years after the Civil War, the average output of goods and services per hour of work by American workers had grown at an average rate of about 2 percent each year. Beginning in the 1890s, the rate of productivity growth rose to 2.3 percent or so a year. In the years just after World War II, productivity grew at 2.5 to 3 percent a year. Coupled with the country’s rapidly expanding population, these rates produced an economy that grew faster over a longer period of time than that of any other major nation in the world, providing the unprecedented prosperity that we still take for granted.

Since 1973, however, the average annual growth of productivity has fallen to about 1 percent a year, the worst twenty-year showing since the Civil War. The expansion of the economy during the Reagan administration did little to reverse the trend, and during the 1990s, productivity has shown at best only a marginal improvement in its rate of growth over equivalent periods in the business cycles of the 1970s and 1980s. What improvement there is comes largely from record layoffs—i.e., a smaller number of workers turning out more work—and from slower growth in the number of new jobs than has accompanied other economic expansions. Once appropriate statistical revisions are made to the way we measure prices, as the Commerce Department is about to do, it could even turn out that productivity has been growing somewhat more slowly in this decade than it did in the past two decades.⁷

No one can be sure that fast productivity growth will not suddenly return, of course. The causes of the twenty-year lag are continually debated among economists, but no consensus has emerged. For example, many economists blamed the slowdown in productivity growth on the sharp hike in oil prices in 1973. But within a half dozen years these prices had fallen to levels, that, when discounted for inflation, were not much higher than they were before 1973. They continue to be relatively low. Those economists who blame the slowdown in America mostly on federal deficits must account for the fact that deficits began to grow to dangerous levels long after slow economic growth was under way. Similarly, the rate of productivity growth had begun to slacken well before America’s savings rate fell or its education system began to falter seriously.⁸

We can begin to understand better what we have lost—perhaps permanently—by getting a firmer grasp on what it was that we once had.⁹ Most of us assume that plentiful land and natural resources originally accounted for America’s economic advantages, along with the entrepreneurial spirit of our people and the free markets they created. Americans were economically privileged almost from the very beginning. They were healthier and, on average, earned higher incomes than Europeans even before Independence. But the availability of land and the abundance of resources do not explain the progress Americans continued to make once industrialization got under way. Nor were Americans uniquely entrepreneurial. Britain invested successfully around the globe. Germany had a robust industrial revolution in the latter half of the nineteenth century.

What America did have, however, was an enormous domestic market-place that enabled it to invest in efficient forms of mass production and exploit cheap, abundant natural resources to a degree no other nation could match. Central to rapid growth in productivity were economies of scale, both in manufacturing and in services such as transportation and retailing. The more you sold, and the more quickly you sold it, the lower the costs of production. By World War I, America’s continent-wide market-place, unified by cheap, efficient rail transportation, was three to four times larger than that of any European nation. For that domestic market, US companies mass-produced everything from steel to oil to cigarettes and soap at astonishingly low cost, and distributed these goods through giant wholesalers and highly efficient new department stores and retail chains. The advantages of mass production and mass distribution built on each other, benefiting from unique American expertise in production technology, in marketing and advertising, and in management. The whole was greater than the sum of its parts, and though the country’s population exploded over these years, its economy grew significantly faster than either Europe’s or Japan’s, even on a per capita basis, and average wages remained significantly higher as well.

This unrivaled advantage in mass production, based on a unique market-place, declined and ended for the US after World War II when trade barriers came down along with transportation costs. Now the products of the rest of the world had access to our markets. The major nations of Europe, in turn, created their own Common Market. Japan and Europe, which had always made some mass-produced goods, now installed processes of mass production similar to America’s. As everyone well knows, their products invaded our shores and undercut our export markets as well; soon the level of productivity and the standard of living in these nations began to converge with ours. Later, low-wage competitors from Korea to China, Indonesia, India, and Mexico carried out their own mass-production revolutions.

But foreign competition alone cannot explain the decline in America’s rate of growth. New methods of manufacture based on electronics and computerization as well as aggressive new management techniques made both world competition and domestic competition much more intense. For example, in 1955 there were only 30 basic car models on the world market. By the late 1980s, there were 140 basic models. While Japanese companies were the main innovators in producing autos and consumer electronics, the fragmenting of markets and the dramatic expansion of consumer choice spread well beyond autos and consumer electronics to almost all markets, including specialized steel, chemicals, cable TV, home appliances, and clothing, to name only a few. American companies were deeply involved in almost all these markets. An IBM executive points out that his company had about 2,500 competitors in the 1960s, compared to some 50,000, many of them American, in its various markets today. While some 1,000 new food products were marketed in 1970, 13,000 were introduced in 1993, most of them by US companies. New methods of production that were more flexible than the old assembly line, and also more flexible distribution techniques, enabled companies to sell specialized products profitably to fewer consumers. The new methods not only permitted an increasing number of companies around the world to compete but made competition at home much more intense as well.¹⁰

During the past few decades, economies of scale have been less and less able to guarantee rising profits as domestic and foreign businesses compete with one another to introduce both new products and more efficient methods of management as well as make important technological and scientific discoveries. Such break-throughs, however, no longer assure even a semi-permanent lead to an enterprising company, since companies quickly imitate one another and often improve on the original discovery. Capital investment becomes inherently riskier; doing business in general more uncertain, and rates of return decline. To the extent we can measure such things, even the rate of return on investment in research and development has fallen.¹¹

Such optimistic writers as George Gilder, Alvin Toffler, and Newt Gingrich nevertheless welcome more flexible processes of production, distribution, and communications, and more fragmented markets, arguing implicitly that they will prove as powerful a stimulus to productivity as traditional mass production had been. But so far such optimism has not been justified. Markets are likely to remain fragmented, competition intense, and profits tight. Uncertainty and lower rates of return will continue to restrain capital investment. Companies that once seemed stable giants of mass production have given way increasingly to smaller companies that may be more innovative but typically can’t afford large permanent work forces and are often reluctant to invest their profits aggressively. The management. consulting firm McKinsey and Co. raised the question whether “the fundamental research done by IBM in the 1950s and 1960s would have been economically possible in the more competitive environment [that began in] the 1970s.”¹² Productivity will continue to grow, but in these circumstances it is unlikely to resume the high rates of growth that accompanied the rise of traditional mass production. We should keep in mind that over the past twenty years the growth of productivity has slowed in virtually all the advanced nations even as business evolved toward more flexible production and distribution.

3.

To a nation whose optimism has long been based on its exceptional economic history, the possibility of permanently diminished fortunes cannot be accepted easily. Typically, the first reaction of many citizens has been denial. Scholars, politicians, journalists, and radio talk-show hosts tell us we are as strong as ever. Some say that new products will improve our lives more radically than products have ever done before; they underestimate the ways everything from cheap kerosene lamps to sewing machines to the automobile and electricity dramatically transformed American lives in the past. We can doubt whether interactive communications will affect our economic prospects as dramatically as mass-production changes once did.

The “Contract with America” promises that the US can afford to cut taxes, raise military spending, leave Social Security untouched, and balance the budget at the same time. Clinton’s budget-balancing scheme makes much the same promise, and similarly implies that a less active and less expensive government will automatically create the kind of prosperity we once had. Such rhetoric is suffused with nostalgia for the days of rapid productivity growth, but no amount of budget cutting can restore them. A smaller government will not bring back the age when American resources were uniquely abundant and when we alone had a marketplace that sustained for over a century a mass production economy unequaled anywhere in the world. Our disappointing experience in the 1980s, when Reagan cut taxes sharply and preached that American optimism would restore high growth, should have taught us that.

The world economy will almost certainly remain intensely competitive. Americans will have to raise the proportion of their income invested in plants and sophisticated equipment in order to meet that competition. Tax incentives can benefit that effort, especially if they are aimed at businesses that are willing to invest for longer rather than shorter payoffs.

We can increase productivity growth by improving the skills of a broader range of workers, concentrating more resources in education, especially early education for the poor and technical education for those most able to benefit from it. The government can contribute more to civilian scientific research and development, which has become increasingly risky for individual corporations to undertake. It may be able to do more to develop practical job-training programs, with which the US business community has little experience. To increase the productivity of the work force, government can also support high-quality day care to help working parents. Studies show that worker participation, including management–worker teams, quality and job-safety committees, and employee ownership, often enhances productivity, and government policies could be used to encourage these practices as well.¹³ Productivity could also be enhanced by privatizing some government services, streamlining regulations, and cutting down on bureaucracy—not for ideological but for pragmatic reasons.

These are only some examples of what might be done to stimulate the economy. But I do not want to minimize the political and other difficulties that will stand in the way of such programs, much less the health and retirement costs of an aging population, the growing environmental penalties of industrialization, and the cost of decaying inner cities. All of these will continue to retard productivity growth.

In this situation, what would be a useful approach to the central political question of the day, the attempt to limit budget deficits? It should be clear that it is risky to cut deficits quickly, however appealing that may be politically, because such cuts will reduce demand for goods and services and therefore may reduce growth and deplete funds available for investment. Even a reduction of .3 percent per year in growth by the year 2002 would, after inflation, result in a loss of GDP of nearly half a trillion dollars. That the Federal Reserve, as so many experts confidently claim, can compensate for a rapid reduction in government spending by lowering interest rates or expanding the money supply simply doesn’t square with the historical record. There is considerable doubt that expansive monetary policy is as effective at igniting a sluggish economy as a retractive policy is at dampening an overheated one. That issue aside, the Federal Reserve has almost always been hesitant to reduce rates, preferring, as it does today, to err on the side of too much restraint rather than risk renewed inflation. The international mobility of capital has also reduced the Federal Reserve’s maneuverability, as have the inflation-sensitive financial markets. Relying on the Federal Reserve as the sole government engine of growth will probably assure us a performance below our already diminished potential.

In reducing the deficit, as we must, we should keep in mind that our first concern, other than to prevent unjust suffering, should be to enhance productivity. On that principle, cuts in some government programs, including defense and Social Security, make sense no matter how unattractive they will be politically, especially when maintaining these programs comes at the expense of spending for education and research as the Republicans propose. However often we have failed at it, reforming the health-care system to make it more productive is the best way to contain the soaring expenditures for Medicare and Medicaid instead of merely cutting benefits. It is also hard to see how tax cuts for better-off Americans will enhance our overall productivity more than, say, childhood nutrition programs for the poor or providing day-care systems that private industry is incapable of setting up on its own. While President Clinton’s budget includes some programs that would raise productivity, he, too, insists on tax cuts, and his proposed increases in spending for job training and for research that would enhance productivity are so modest as to be inconsequential.

To confront America’s flagging productivity honestly and vigorously will, in my view, be an unprecedented challenge to the American public. Until we acknowledge the damage done by slow economic growth, and the distinct possibility that our prospects may have permanently changed, we will continue to make incorrect choices. Instead, our politicians seek scapegoats and promote illusions about our own past when we were allegedly a better people. Yet it is unpersuasive, to say the least, to blame our current problems on a wrong ideological or moral turn. What we lack more than anything else is the prospect of constant material betterment that characterized most of our history. No matter what we do, we may not be able to improve our rate of growth by much, and so we may have to learn how to live within our reduced circumstances and apportion the costs of slower growth in a way that will maintain social stability. This will not be agreeable, but it need not be a disaster, either. Meanwhile, many people live in fear that they will never achieve the presumed comforts of an imagined past. They fail to see that without the growing affluence to which we have long been accustomed we may no longer know who we are.