The New Economy: No Fiscal Cure-All

Volume VII, Number 5 June 11, 2001

The current weakness in the economy should have leaders worrying about the durability of today's surplus projections. Most, however, accept the notion that America has entered an era of permanently higher growth in which fiscal plenty is virtually assured.

It is remarkable how quickly this "new economy" thesis has gained followers. A few years ago, most mainstream economists dismissed it. Today, it underlies the federal government's official fiscal projections. Since 1997, the CBO has raised its ten-year forecast for real GDP growth from 2.0 to 3.1 percent, a huge increase that explains nearly half of the cumulative budget surplus projected over the next ten years. Looking further into the future, Fed Chairman Alan Greenspan speculates that faster growth may largely solve Social Security's financial problems.

This official embrace notwithstanding, the new-economy thesis remains just that: a thesis. No one yet knows whether the surge in productivity that began in the mid-1990s will outlast the current business cycle. And in fact, there is reason to believe that much of the productivity improvement is illusory--and that what's real may not be sustainable. Even if the new-economy enthusiasts are right, moreover, faster growth alone won't do much to reduce the age wave's fiscal cost.

The latest data show that productivity fell sharply in the first quarter of 2001. The slowdown doesn't mean the enthusiasts are wrong. But it does suggest that it's time to step back and re-examine the evidence.

A Huge Departure

The central premise of the new economy thesis is that America's current prosperity is not just another upswing in the business cycle, but something bigger-an enduring upward shift in our nation's (and ultimately, the entire developed world's) rate of productivity and real wage growth. The shift, enthusiasts say, is the result of enormous new economic efficiencies made possible by information technology and globalization. It marks a return to the high growth of the 1950s and 1960s--and the end of the slowdown that began in the early 1970s.

Not all federal agencies accept the new-economy thesis. The Social Security Administration has so far declined to make any big changes in its long-term productivity assumption. Both the CBO and OMB, on the other hand, have embraced the thesis and incorporated much higher growth rates into their projections.

How much higher? Over the past quarter-century, economywide productivity has grown at the average annual rate of 1.5 percent per year. Since 1995, the rate has accelerated to 2.3 percent per year. In its January 2001 baseline, CBO assumes that potential productivity will grow at that same 2.3 percent rate over the next decade. In other words, it assumes that all of the recent productivity improvement will be permanent.

The extraordinary performance of the U.S. economy since the mid-1990s may justify ratcheting up growth expectations. But to assume a huge and permanent departure from the historical trend, based on five years of data, seems premature. As recently as January 2000, the CBO was warning that "it is not entirely obvious, despite productivity's healthy performance, that trend growth has changed." It is no more obvious today. No one really knows why productivity growth slowed in the early 1970s. And no one really knows whether the recent improvement will be more than temporary.

Good Reasons for Skepticism

There are good reasons for skepticism--starting with the possibility that much of the recent surge in productivity growth is a statistical illusion.

Roughly speaking, productivity growth can be thought of as the percentage growth in real output minus the percentage growth in worker hours. As it turns out, the official statistics may be understating the growth in worker hours, and hence overstating productivity. One reason is that it's difficult to count every worker. The 2000 Census found that the number of undocumented immigrants, many of whom work off the books, exceeds previous estimates by 50 percent or more. The data on average hours per worker may also be wrong. Amazingly, the official measure of average hours worked didn't increase at all in the 1990s. This flies in the face of abundant survey and anecdotal evidence that hours have grown rapidly in recent years, especially in white collar professional jobs where workers don't punch time clocks.

The official statistics may also be overstating real output itself. The recent surge in productivity has not been economywide--that is, it has not had much spillover beyond the information industry itself. In fact, some economists say that most of the gains have occurred in the companies that actually produce computers. This is a problem because of the way government economists calculate the real value of computers: hedonic pricing. In effect, hedonic pricing says that the Pentium you buy today is worth what that product (or that capability) cost many years ago when few people purchased it and when it was vastly more expensive. Over time, this method understates inflation and exaggerates the rise in living standards. Other developed countries do not use it, which is one reason they now lag the United States in measured productivity growth.

There is no doubt that some of the productivity surge is real. But just because something is real doesn't mean it's sustainable. Productivity soared starting in the mid-1990s in large part because capital spending soared. The CBO assumes that the growth in capital spending will continue unabated (indeed, accelerate) over the next decade. In other words, it assumes that companies will be investing as wildly in fiber optics and internet servers with the NASDAQ at 2000 as they did when it was at 5000. If capital spending growth reverts to its 1973-1995 trend, GDP growth would fall by roughly 0.5 percentage points. This alone would lower CBO's projection of GDP growth from 3.0 to 2.5 percent. Ominously, the latest data show that capital spending actually declined in each of the last two quarters.

The Long Run

It's worth recalling that information technology and globalization aren't the only forces shaping the economy. While they may be pushing productivity up, other forces are pushing in the opposite direction--and over the long run, the other forces may be more powerful.

There is the growth of low-productivity services. Economist William Baumol famously argued that services resistant to productivity gains (especially personal services such as teaching, medicine, counseling, law, and entertainment) tend to grow as a share of the economy as living standards rise. Many experts think this dynamic (known as "Baumol's disease") helps explain the productivity slowdown of the past quarter-century.

There is demographic sclerosis. As Boomers retire, workforce growth will slow to near zero. Without a demographic push, there may be less investment in capacity expansion. Many economists think that such expansion gives rise to the experimentation and "learning by doing" that underpins productivity breakthroughs.

Finally, there is the fiscal pressure of aging itself. According to the CBO, the major senior benefit programs are on track to grow by 10 percent of GDP from now to 2040. Absent fundamental reform, this growth points to a long-term future of resurgent federal deficits, rising real interest rates, falling national savings--and yes, stagnating productivity and real wage growth.

No Cure-All

Even if the enthusiasts are right about the new economy, higher growth is no long-term fiscal cure-all. It boosts tax revenue, and this improves the budget outlook. But on the outlay side, it also boosts spending, largely canceling out the gain. Most economists assume that, over the long run, discretionary spending will keep pace with the growth in the economy. Nor is there any necessary reason why, in the absence of programmatic reform, health-benefit spending won't grow at least as fast as real wages and real per capita income.

The most lock-step relationship of all is with Social Security outlays. It is true that faster near-term growth swells the Social Security trust funds--which is apparently what Chairman Greenspan has in mind. But the trust funds merely represent claims on future taxpayers. What matters fiscally is Social Security's long-term cash deficit, and here faster growth doesn't help much at all. Yes, when productivity goes up, average wages go up, and this adds to long-term tax revenues. But when average wages go up, average benefit awards also go up, and this adds to long-term outlays. The only way to get big savings from higher productivity is to sever the link between average wages and new benefit awards.

None of this is to say that faster growth--and the resulting rise in living standards--wouldn't bring vast benefits to society as a whole. It could even be argued that a more affluent society may be willing to allocate, through higher taxes, a much larger share of its income to old-age benefits. But this is a shaky case, and one that few new-economy enthusiasts are eager to make.

The Concord Coalition has a word of advice for America's leaders: Don't count on faster growth--not to buoy up the near-term budget outlook and certainly not to solve the long-term entitlement challenge. The new economy may or may not continue to pay the promised fiscal dividends. The bill for today's tax cuts and spending hikes will come due regardless.