That Used to Be Us: How America Fell Behind in the World It Invented and How We Can

by Thomas L. Friedman

In the Terrible Twos we combined cutbacks in higher education with limits on admitting talented immigrants to our shores. The combination is eating away at our capacity to produce and attract creative risk takers at a time when other countries are better and better able to keep their own at home.

  If we don’t reverse this trend, over time “we could lose our most important competitive edge—the only edge from which sustainable advantage accrues—having the world’s biggest and most diverse pool” of high-IQ risk takers, said Mundie. “If we don’t have that competitive edge, our standard of living will eventually revert to the global mean.”

  Unfortunately, in the Terrible Twos the American political system failed to enact legislation to reform the nation’s immigration system. President George W. Bush made a mighty effort but was blocked largely by members of his own party, who were so outraged by illegal immigration that they could not think straight about the vital importance of legal immigration. “The H-1B visa program—that is the key to making us the innovators of energy and computers,” said Senator Lindsey Graham, the South Carolina Republican, who has been critical of his own party’s obstinacy on this issue. “It has been for most of our life. If you wanted to get really smart and have a degree that would allow you to be a leader in the world, you came to America. Well, it’s hard as hell to get to America now. And once you get here, it’s hard to stay.”

  Immigration reform that better secures the borders, establishes a legal pathway toward citizenship for the roughly twelve million illegal immigrants who are here, and enables, even recruits, high-skilled immigrants to become citizens is much more urgent than most of us realize. We need both the brainy risk takers and the brawny ones. Low-skilled immigrants may not be able to write software, but such people also contribute to the vibrancy of the American economy. As the Indian American entrepreneur Vivek Paul once remarked to Tom: “The very act of leaving behind your own society is an intense motivator. Whether you are a doctor or a gardener, you are intensely motivated to succeed.”

  Million? You Must Mean Billion? No. Million!

  In the fall of 2010, Tom had a visit from Kishore Mahbubani, a Singaporean academic and retired diplomat. In the course of their conversation, Tom told him of the Obama administration’s plan to set up eight innovation hubs to work on the world’s eight biggest energy problems. It was precisely the kind of project that could expand the boundaries of basic science across the entire energy field and launch new industries. Tom explained that the program had not yet been fully funded because Congress, concerned about every dime America spends these days, was reluctant to appropriate the full request of $25 million for each energy breakthrough project, let alone for all eight at once. Only three projects were therefore moving ahead, Tom told him, and none of the three would get the full $25 million. Mahbubani interrupted him in mid-sentence.

  “You mean billion,” he said.

  “No,” Tom replied, “we’re talking about $25 million.”

  “Billion,” Mahbubani repeated.

  “No. Million,” Tom insisted.

  Mahbubani was stunned. He could not believe that while his little city-state was investing more than $1 billion to make itself a biomedical science hub and attract the world’s best talent, America was debating about spending mere millions on game-changing energy research. That, alas, is us today: Think small and carry a big ego. This may seem to be a minor issue, but it is not.

  Nations usually thrive or languish not because of one bad big decision but because of thousands of bad small ones—decisions in which priorities get lost and resources misallocated so that the country does not achieve its full potential. That is what happened to America in the Terrible Twos. A graph from The Washington Post (April 30, 2011) makes the point: At a time when the pace of change in the global economy and the rising economic importance of knowledge make increasing investment in research and development an urgent priority, our spending in this vital area is actually declining.

  Source: From the Washington Post, © April 30, 2011 The Washington Post. All rights reserved. Used by permission and protected by the Copyright Laws of the United States. The printing, copying, redistribution, or retransmission of the Material without express written permission is prohibited.

  In 2005, both the Senate and the House encouraged the National Academies (of sciences, engineering, and medicine) and the National Research Council to conduct a study of America’s competitiveness in the global marketplace. They produced a report entitled Rising Above the Gathering Storm, which assessed America’s standing in each of the principal areas of innovation and competitiveness—knowledge capital, human capital, and the existence of a creative “ecosystem.” According to the National Academies website, “Numerous significant findings resulted … It was noted that federal government funding of R&D as a fraction of GDP has declined by 60 percent in 40 years. With regard to human capital, it was observed that over two-thirds of the engineers who receive PhD’s from United States universities are not United States citizens. And with regard to the Creative Ecosystem it was found that United States firms spend over twice as much on litigation as on research.”

  The Gathering Storm report eventually led to a bill called the America COMPETES Act, which authorized investments in a broad range of basic research. It did so on the grounds that

  a primary driver of the future economy and concomitant creation of jobs will be innovation, largely derived from advances in science and engineering … When scientists discovered how to decipher the human genome, it opened entire new opportunities in many fields including medicine. Similarly, when scientists and engineers discovered how to increase the capacity of integrated circuits by a factor of one million, as they have in the past forty years, it enabled entrepreneurs to replace tape recorders with iPods, maps with GPS, pay phones with cell phones, two-dimensional X-rays with three-dimensional CT scans, paperbacks with electronic books, slide rules with computers, and much, much more.

  Most of the original funding for the expanded research recommended by the Gathering Storm report got passed only due to the stimulus legislation enacted after the financial meltdown in 2008—and most of that was for only a limited duration. So in 2010, the same group gathered and issued an update, entitled Rising Above the Gathering Storm, Revisited: Rapidly Approaching Category 5.

  “So where does America stand relative to its position of five years ago when the Gathering Storm report was prepared?” the new report asked. “The unanimous view of the committee members participating in the preparation of this report is that our nation’s outlook has worsened. While progress has been made in certain areas … the latitude to fix the problems being confronted has been severely diminished by the growth of the national debt over this period from $8 trillion to $13 trillion.”

  To drive home the point, the updated report began with a series of statistics, which included the following:

  In 2009 United States consumers spent significantly more on potato chips than the government devoted to energy research and development—$7.1 billion versus $5.1 billion.

  China is now second in the world in its publication of biomedical research articles, having recently surpassed Japan, the United Kingdom, Germany, Italy, France, Canada, and Spain.

  In 2009, 51 percent of U.S. patents were awarded to non-U.S. companies. Only four of the top ten companies receiving U.S. patents last year were U.S. companies.

  Federal funding of research in the physical sciences as a fraction of GDP fell by 54 percent in the twenty-five years after 1970. The decline in engineering funding was 51 percent.

  Sixty-nine percent of U.S. public school students in the fifth through eighth grade are taught mathematics by a teacher without a degree or certificate in mathematics.

  Ninety-three percent of U.S. public school students in the fifth through eighth grade are taught the physical sciences by a teacher without a degree or certificate in the physical sciences.

  Thirty years ago, 10 percent of California’s general revenue fund wen
t to higher education and 3 percent to prisons. Today nearly 11 percent goes to prisons and 8 percent to higher education.

  The total annual federal investment in research in mathematics, the physical sciences, and engineering is now equal to the increase in U.S. health-care costs every nine weeks.

  China’s Tsinghua and Peking Universities are the two largest suppliers of students who receive Ph.D.’s—in the United States.

  And finally, our embarrassing favorite: 49 percent of U.S. adults do not know how long it takes for the Earth to revolve around the Sun.

  Rules

  An essential part of America’s traditional formula for prosperity is the appropriate regulation of American business. When conceived and administered properly, regulation has occupied a middle ground: neither so strong as to stifle innovation, entrepreneurship, and economic growth, nor too light to prevent the excesses and failures to which the free market is susceptible. In the Terrible Twos we managed the trick of going too far in both directions.

  The thicket of federal regulations under which the private sector must operate continued to grow during the last decade. In 2007, the Code of Federal Regulations, which includes the text of existing regulations, totaled 145,816 pages, and has since expanded. It is difficult to believe that every one of the listed regulations enhances the well-being of American citizens. Moreover, regulation can have unintended adverse consequences. In 2005 Congress, under pressure from the credit card and financial services industries, passed the Bankruptcy Abuse Prevention and Consumer Protection Act, a law making it much more onerous for a person or an estate to file for Chapter 7 bankruptcy and then start over with a clean slate. Under the new law, explained the website eFinanceDirectory.com, “you can no longer claim Chapter 7, and therefore dismiss all of your debts, unless you make less than your state’s median wage. Chapter 7 now stipulates that you must take a debt management class affiliated with the National Foundation for Consumer Credit at least 6 months BEFORE you’re eligible to apply for bankruptcy.” We are not in favor of encouraging recklessness, but we are in favor of encouraging risk-taking. And some experts speculate that one reason for the sharp drop-off in entrepreneurial start-ups during the Great Recession—a drop of 23 percent as opposed to the usual 5 percent in previous recessions, according to McKinsey’s research—is that fewer people are willing to take calculated risks and start new companies owing to this change in the bankruptcy laws. Ever since the dot-com boom, many small entrepreneurs have used their credit cards as their original source of venture capital. Now it is much riskier to do so.

  In the Terrible Twos, however, other areas of the financial and energy sectors in the United States suffered from too little regulation. The catastrophic financial meltdown of 2008 occurred in the wake of considerable deregulation of the nation’s financial system, which was spurred by, among other things, the belief that the financial industry could largely regulate itself, and that the separations between traditional commercial banking, on the one hand, and investment banking and proprietary trading on a bank’s own behalf, on the other—separations put in place to prevent a recurrence of the Great Depression—were no longer necessary. This belief turned out to be wrong, and devastatingly so.

  To be sure, the 2008 subprime meltdown was the product of many causes. A mountain of excess savings built up in Asia was looking for a higher return and flowed to subprime bonds—which paid significantly higher interest rates because they were made up of mortgages granted to people who were higher lending risks. The government directly relaxed mortgage standards to help more Americans buy homes. Banks and rating agencies relaxed their standards to get their share of the subprime housing bubble. Government failed to regulate exotic new financial instruments such as derivatives, under pressure from a financial industry that wanted free rein in this lucrative new area.

  The University of California Berkeley economist Barry Eichengreen argues that the subprime crisis was partly a case of regulation and regulators not having kept up with the consolidation and internationalization of the commercial banking, investment banking, and brokerage industries. In other words, we did not update our formula in this area. Over the previous two decades, some of the key firewalls erected after the 1929 crash came down, along with regulations stipulating the amount of reserves banks had to keep on hand. The merging of the different financial industries was actually “sensible and well-motivated,” argues Eichengreen. It lowered the costs of stock trading for consumers, reduced borrowing costs, and created new financial products that, in theory, could promote growth in different markets. The problem was that this kind of global financial integration was a total misfit with the fragmented, outdated American financial regulatory system, so it was very hard for regulators to get the full picture of the level of risk and leverage different players in the market were taking on. “At the most basic level,” Eichengreen argued in an October 2008 paper entitled Origins and Responses to the Crisis, “the subprime crisis resulted from the tendency for financial normalization and innovation to run ahead of financial regulation.” It ran so far ahead that not only did the regulators not fully understand the level of risks being piled up by different financial houses, but even the CEOs of these firms did not understand what the rocket scientists turned bankers were concocting under them.

  One of those new financial instruments—a derivative known as the credit-default swap, a form of private insurance that paid off if a subprime package of loans defaulted—was specifically kept out of the jurisdiction of government regulators through aggressive lobbying by the financial industry. We wound up with a trillion-dollar market in these swaps without either meaningful government oversight or transparency. Its implosion helped to create the worst financial crash since 1929.

  That lack of oversight was a bipartisan effort. In 1999, Republicans passed legislation specifically exempting credit-default swaps from regulation—and President Bill Clinton signed it. There is a fine line between a regulatory environment that promotes the risk-taking that is necessary in a market economy and an environment that fosters destructive recklessness. In the Terrible Twos, we crossed that line, in part because some important people, chief among them Federal Reserve chairman Alan Greenspan, came to believe that the markets could be “selfregulating”—and that big financial institutions would police themselves because it would be in their self-interest to do so—and in part because the financial industry used its ever greater clout on Capitol Hill to ensure lax regulation in the new markets it had pioneered and to “capture” regulators. It did so in order to maximize risk-taking so as to create astronomical sums of personal wealth for its executives.

  Better regulation and regulators might not have prevented the economic crisis in the last part of the Terrible Twos, but it surely would have made the crisis less severe. In the wake of the crisis, Congress passed and the president signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which imposed new regulations on the financial industry with the goal of making its operations safer. The banking industry, however, did everything it could to weaken that legislation, and the ultimate impact of the reforms remains to be seen.

  The result, as the Columbia University economist Jagdish Bhagwati observed, was that a financial industry built to finance “creative destruction” (the formation of new companies and industries to replace old ones) ended up promoting “destructive creation” (the buying and selling of financial instruments with little intrinsic value), the collective implosion of which threatened the whole economy.

  The fact that virtually none of the main culprits in bringing about this huge destruction of wealth has suffered any legal penalties suggests that our regulations need some updating. At the very least, we should heed what Warren Buffett told the Berkshire Hathaway annual shareholders meeting (April 30, 2010): “Any institution that requires society to come in and bail it out for society’s sake should have a system in place that leaves its CEO and his spouse dead broke.”

  Striking the proper bal
ance between the under- and overregulation of financial markets will be difficult. There is no magic formula for this, and we surely do not wish to stifle all innovation in this area. But finding that balance is crucial because, as we saw in 2008 and thereafter, a major failure in this sector of the economy can inflict massive and long-lasting damage on the economy as a whole.

  Income Inequality

  A critical reason that America has failed to update its formula by reinvesting in education, infrastructure, and research and development, and hasn’t adjusted our immigration policy to promote economic growth or implemented appropriate economic regulations, is that all these require collective action—America as a whole has to act—and lately we have lost our capacity for collective action. One reason for this damaging form of paralysis is the growth of inequality in America, itself the product, among other things, of the further flattening of the world. That flattening has created a global market for the goods and services of people skilled enough to take advantage of it. The earnings in this huge global market can be staggering for the “winners.” Consider what a basketball player such as LeBron James can earn in this era when the National Basketball Association sells its branded products from Stockholm to Shanghai—we are talking tens of millions of dollars—compared to the biggest star of the early 1950s, George Mikan of the then Minneapolis Lakers, whose earnings were limited to the United States and were measured in the tens of thousands of dollars.

  It is harder to generate collective action when people are living in different worlds within the same country, argues the Nobel Prize–winning economist and Columbia University professor Joseph E. Stiglitz. Historically, Americans have tended to be less troubled by inequality than citizens of other countries. Both the myth and the reality of individual opportunity and upward mobility in America have been so powerful and so deeply ingrained that the socialist narrative of government-sponsored redistribution has never taken root. But the income gaps during the Terrible Twos grew so large, and could well grow larger still, that inequality now threatens to fracture the body politic in ways that could undermine our ability to do big hard things together.