TABLE 1.1
Growth Rate of Real US GDP per Capita
Decade
1950s
1960s
1970s
1980s
1990s
2000s
2010–17
Average growth
2.4
3.1
2.1
2.1
2.0
0.8
0.6
Data source: FRED, real gross domestic product per capita, continuously compounded rate of change
If we are interested in happiness and standards of living, however, then per-capita growth is what matters. Per-capita growth is also usually the right way to analyze the consequences of economic policies and regulations. This will be our focus in this book.
The rate of per-capita economic growth in the US has declined over the past two decades. Table 1.1 shows the rate of growth of gross domestic product per capita for the US economy. GDP measures the value of all the goods and services produced within the borders of a country in a year. Dividing America’s GDP by its population highlights broad changes in the standards of living of US households.
US growth has been around 2 percent per year in the second half of the twentieth century. The 1960s stand out as a period of faster than average growth. Over the past eighteen years, however, growth has been substantially lower.
There is a lively debate among economists regarding the causes of the decline in the growth rate. Much of the debate has focused on three factors: employment, education, and technological innovation. On the question of employment, the US Bureau of Labor Statistics has been tracking the decline of the employment rate among prime-age workers (aged 25–54 years) (Krueger, 2017). After peaking in the late 1990s at nearly 85 percent, the rate fell to below 81 percent as recently as 2015. That may seem like a small change, but it represents the loss of millions of workers from the economy. Bottom line: when fewer people work, growth slows down.
Data collected by the Department of Education show that high school graduation and college completion rates rose rather slowly from the 1970s to the 1990s and have remained virtually flat since 2000 (Goldin and Katz, 2008). One in ten Americans under age 30 have no high school diploma, and nearly half have no post-secondary degree of any kind, which suggests that there is still room for improvement in education. Slower improvements in education have also contributed to the decline in overall growth since education makes workers more productive.
But the major contributor to long-term growth is technology—and that contribution is slowing down. When we say that technological progress has slowed, we are simply saying that, on average, businesses are not as good as they used to be at reducing the unit cost of production or at coming up with higher quality products. To assess the rate of technological progress, economists construct total factor productivity (TFP) growth, which measures the extent to which we can do more with less (or with the same). In other words, it measures how we can expand output for given levels of capital and labor inputs. Economic theory shows that this kind of technological progress is the only sustainable source of growth in the long run. The slowdown in TFP growth started in 2000 and is now widespread among rich countries. The Great Recession of 2008–2009 has probably reinforced this negative trend, but it has not created it (Cette, Fernald, and Mojon, 2016).
Robert Gordon, an economist at Northwestern University, argues that the remarkable growth in productivity from 1870 to 1970 is unlikely to repeat itself. The benefits of the Second Industrial Revolution, associated with electricity and the internal combustion engine, were deep and wide. In his view, computers and communication technologies are simply less important. Of course, it’s not as if people are standing idle instead of working hard. The pace of innovation is still rapid, but the impact of innovation on the broad economy is smaller. To be sure, there are techno-optimists who think that artificial intelligence is going to change our lives—and we will return to this debate later in the book—but it’s fair to say that we are still waiting to see real, tangible, and widespread gains.
Another important factor behind disappointing productivity growth is the lackluster rate of investment in the corporate sector. Technological innovations often need to be embodied in new equipment and new software. But US firms, despite high profits and low funding costs, have not upgraded their capital much in recent years. This is a puzzle that we will explore in Chapter 5.
Inequality
In addition to a slowdown in growth, inequality has risen over the past forty years. Broadly speaking, income inequality can grow between the middle class and the poor, or between the rich and the middle class. Or both, as it turns out, but not always at the same time. In the 1970s and 1980s, we observe mostly an increase in inequality between the middle class and the poor. This inequality goes hand in hand with the wage gap between college graduates and those without post-secondary degrees, a factor known as the college premium.
As we can see from Table 1.2, education wage premia rose rapidly in the 1980s and 1990s. In 1980, workers with a college degree earned 40 percent more than those with only a high school degree. In 2000 they earned almost 70 percent more. If we compare the more extreme cases (graduate degrees versus no degrees), the premium almost doubled, from 92 percent to 179 percent. Since 2000, however, education premia have been almost flat.
In the 1990s and 2000s, we also observe an increase between the rich (and super rich) and the middle class. Thomas Piketty and Emmanuel Saez (2006) estimate that the share of income earned by the top 1 percent has more than doubled, from less than 10 percent in the late 1970s to around 20 percent today. (The top 1 percent in the US includes well-paid professionals, like doctors or lawyers earning about $400,000 a year. The top 0.01 percent, the one percent of the one percent, includes the extremely wealthy, like LeBron James or Oprah Winfrey.)
TABLE 1.2
Labor Earnings, Education, and Inequality
1980
1990
1992
2000
2010
2015
Evolution of real hourly wage by education (2015 $)
No degree
14.19
12.84
12.47
13.03
13.22
13.56
High school
16.33
15.99
15.87
17.2
17.77
17.98
Some college
18.8
19.29
19.16
20.84
21.47
21.59
Four-year college
22.85
25.32
25.18
28.98
30.49
30.93
Graduate degree
27.27
31.43
31.66
36.4
39.7
39.48
Education premia
College / high school
40%
58%
59%
68%
72%
72%
Graduate / no degree
92%
145%
154%
179%
200%
191%
Data source: Valletta (2016)
Inequality and growth are best discussed together, for various reasons. First, and most obviously, we want to know if everyone benefits from growth. When growth is slow and inequality rising, it is possible for the standard of living of the lower middle class to stagnate or even decline in real terms. This has happened in the US in recent years. Table 1.2 shows that the real income of workers without much education has barely improved over the past forty years. For some, it has decreased.
But the most important reason to analyze growth and inequality together is that they are not independent and unrelated phenomena. They interact, sometimes feeding on each other, sometimes canceling each other out. G
rowth can reduce inequality, inequality can be necessary for growth, or inequality can hinder it.
The debate on growth versus inequality hinges on the idea of incentives. When economists talk about incentives, they mean a motivation for material (monetary) gains. People work hard because they expect that their efforts (their investment) will increase their income. For the economic system to work, there needs to be a connection between (ex-ante) effort and (ex-post) income. Does that mean that some degree of inequality is necessary? Does that mean that more inequality always creates better incentives? The answers are probably yes and no, but the link between incentives and inequality can be subtle.
The children’s story of Goldilocks can figure in the theory of incentives. Money needs to be hard to get, but not too hard. If money is too easy to get, people become lazy. If you earn a lot without working hard, you may not bother to try harder. But if money is too hard to get, people become discouraged.
If we apply this idea to workers within a firm, we see that it justifies performance-based compensation. And as long as performance varies across workers, this will lead to inequality. But it does not necessarily justify high degrees of inequality. Even if we take for granted that people work for money, this does not mean that more money always means more effort. What matters is the correct balance of incentives.
But how do we know that a given degree of inequality is justified? How do we know that it is not excessive? The answer, of course, is that we can never know for sure. Understanding incentives in a modern economic system is quite complicated. There is, however, one critical factor that can give us some confidence, and that factor is competition.
Competition and Growth
Economists like competition for several reasons. The first reason is that competition pushes prices down, since the most direct way for a company to increase its market share is to offer a lower price than its competitors. When a firm lowers the price of the good that it sells, this has two beneficial consequences. The first and most obvious one is that consumers save money, which they can use to buy more of the same good, or more of some other goods. In practice, they tend to do both. If health insurance becomes cheaper, you might purchase a plan with better coverage, and also buy an extra toy for your kids. The second, indirect, effect is that increased demand encourages businesses to produce, invest, and hire. In general, if we compare two economies, the one with more competition will have lower prices, higher production, higher employment, and higher investment. Competition therefore increases our standards of living.
Prices are not the only thing people care about. The quality of services matters a great deal too. If we look at the American Customer Satisfaction Survey, we see some striking patterns. Internet service providers seem to be the most disliked companies in the US. We have already noted that this industry is highly concentrated and charges higher prices than in most other developed countries. This is certainly not by accident.
In a competitive market, firms seek to attract customers not only by reducing prices, but also by offering a wide menu of quality goods and services. Competition leads to more choices for consumers as businesses cater to different segments of the population and as they try to differentiate their products from those of their competitors.a
One of my favorite examples of the positive impact of competition comes from taxis in Paris. First, about the prices: I grew up in the suburbs, and my friends and I would always go into the city by train or metro on Friday or Saturday nights. On the way home, however, we sometimes missed the last metro, typically at 1 or 2 AM. And yet we never took a taxi. If we missed the subway, we would walk—for miles. Taxis were hard to find and expensive: we were priced out.
Second, about innovation in the service industry: when incumbent taxi companies were forced to compete with new platforms, they suddenly discovered that clients appreciated bottles of water and the ability to charge a cell phone, and that basic politeness did not cost that much. These were not high-tech innovations, but they certainly improved the experiences of clients. Uber and its ilk may have many downsides (noncompliance with labor laws, an increase in traffic congestion), but they also illustrate the basic virtues of competition: nothing improves customer service quite like the threat of a new competitor.
Competition encourages investment and pushes businesses to innovate, either to improve the quality of goods and services they sell or to find ways to reduce the cost of providing these goods and services. From an economic perspective, higher quality and lower cost are two sides of the same coin, and both count as technological progress. In advanced economies, however, the link between competition and innovation is complex and depends on property rights, patents, and market structure. This is why we need to build good theories and to study the data carefully, as we will do in the next chapters.
Competition and Inequality
Competition encourages growth and probably equality too. It encourages growth because it leads to higher output and employment.b It also reduces inequality because competition increases wages and decreases profit margins. Hence, in a competitive economy, payouts (dividends, shares buybacks) are small relative to labor income. Since financial capital (ownership of financial claims, mostly stocks and bonds) tends to be more unequally distributed than human capital (your labor and your education), it follows that a more competitive economy is also likely to be less unequal.
Before discussing the more complicated connections between competition and inequality, it makes sense to pause for a moment to define the term rent as it applies to economics. A rent is a payment received by the owner of an asset (human or physical, material or immaterial) in excess of the cost of reproducing or re-creating that asset. For instance, if a good that can be produced for $10 is sold for $15 because it is protected by a patent, then the rent to the patent holder is $5.
Some rents are protected by artificial restrictions. For example, draconian occupational licensing laws that restrict entry into certain professions protect those who already hold licenses from competition, allowing them to charge higher prices. When economists talk about “rent-seeking,” they refer to the attempt by individuals or by groups to tilt public policy in a way that establishes or increases those artificial advantages in their favor. This term does not necessarily have a moral connotation. It is rational for people to protect their rents. That does not make them bad people. But it often leads to bad policies.
The interplay between rents and inequality means that competition does not always reduce inequality. Competition can make some income-sharing agreements more difficult to sustain. For instance, a business might agree to share some of its rents with its workers. Competition can lower these rents and indirectly hurt some workers. Similarly, competition for talent can push the earnings of some groups to very high levels.
Overall, however, it is difficult to come up with convincing examples of domestic competition that hurts the poor and the middle class, and it is easy to come up with many examples (low-cost retail and airlines, competition in telecoms, among others) where competition is clearly beneficial. Broadly speaking, this is because domestic competition creates efficiencies, and these efficiencies are redistributed among the citizens of the country. It is true that domestic competition leads to reallocations of rents, to gains for some and losses for others. Competition destroys and creates jobs at the same time, but in different places or different communities. My key point, however, is that within a country there are mechanisms to spread both the gains and the losses. This does not guarantee that domestic competition improves the welfare of everyone, but it makes it more likely to be true, at least after some time.
Foreign competition is an altogether different issue. Foreign competition benefits domestic consumers, but it can hurt domestic producers and their employees. Standard economic theory shows that the gains from trade outweigh the losses, so in principle, there should be a way to make everyone better off. In practice, it does not always work so well. Foreign competition might benefit domestic
consumers more than it disrupts local businesses and employees, but there is no natural way to redistribute these gains and losses. Countries have experimented with all kinds of trade adjustment programs, but most have been rather ineffective. In addition, competition across countries to attract talent and capital can lead to more regressive tax systems. This is exactly the opposite of what we would need in order to accommodate the impact of trade shocks.
Two of my colleagues at New York University, Spencer G. Lyon and Michael E. Waugh, have provided some fascinating new insights on this issue in a 2018 paper. We know that exposure to trade creates winners and losers. Lyon and Waugh study how society can mitigate the losses while preserving the gains from trade. They find that a progressive tax system is very helpful and that the optimal level of progressivity increases with the exposure to trade. What is the mechanism? As we have explained, trade benefits consumers through lower prices and increased variety of available goods. The picture is more complicated for workers. Most of them are not affected by trade, but those who compete directly with foreign workers are strongly affected. This unequal exposure is at the core of the public debate surrounding international trade. Lyon and Waugh show that an effective way to compensate workers for reduced earnings and lost employment opportunities is through a progressive tax policy.
Why Free Markets Are Fragile
We started this chapter by explaining that economics is concerned with the allocation of limited resources. At some abstract but intuitive level, we can see the deep connection between the fact that economic resources are limited and the value of competition. Since resources are limited, it would be damaging to waste them. So how can we make sure that resources are used effectively? One answer is to let people and organizations compete for these resources, ensuring that the resources end up in the hands of those who value them the most. The price system at the core of modern economies is one way to organize this competition. Conversely, when competition weakens, capitalism loses much of its appeal.
The Great Reversal Page 3