Interesting Times

First of four parts

by Gordon Ringoen, March 02, 2010

The question of the day is how we get out of our economic morass? Is it through financial bailouts, stimulus packages, foreclosure forbearance, tax cuts, or cash for clunkers and caulkers?

Second, who can we blame, greedy Wall Street, incompetent government or the over consuming, foolish public?

The presumption is that if we can just restore our economy to our recent prosperity and punish the miscreants, all will be well.

However, it might be prudent to step back and look at how our economy actually works and create a vision as to what we want it to look like in the future.  If we don't, we might find that the cure for our immediate ills causes more economic chaos in the future.  Our current financial debacle resulted from extrapolation of past trends with little thought about the fundamentals.  The CBS documentary, "2100," gave us a grim view of our future with a business as usual approach.

To view our economy in the broadest perspective is not to answer the question why it is so bad, but rather to ask why it has been so good.  We have a GDP of approximately $12 trillion out of a total world GDP of $52 trillion.  How is it that we produce approximately 24% of the world's GDP with less than 5% of the world's population?

In my experience, few people seem to know.  I recently asked the question to a college Business class. Some students were able to explain our economic strength through the principles they had learned in their Macro-Economic classes.

Let's look at what is being taught by our most esteemed Economic professors. N. Gregory Mankiw, Harvard economics professor and previous chairman of the Economic Advisors for President George W. Bush, in his textbook, "Macroeconomics'' Sixth edition, had this to say about the determinates of GDP:

"Factors of production are the inputs used to produce goods and services.  The two most important are capital and labor.  Capital is the set of tools that workers use:  the construction worker's crane, the accountant's calculator, and the author's personal computer.  Labor is the time people spend working."  p. 46

"The available production technology determines how much output is produced from given amounts of capital and labor."  p. 47

"These theories hold that high wages make workers more productive."  p. 170

Per the Solow model, "If the savings rate is high, the economy will have a large capital stock and a high level of output in the steady state.  If the saving rate is low, the economy will have a small capital stock and a low level of output in the steady state."  p. 195

"In the long run GDP depends on the factors of production – capital and labor – and on the technology for turning capital and labor into output."  p. 548

"The economy's natural level of output depends on the amount of capital, the amount of labor, and the level of technology.  Any policy designed to raise output in the long run must aim to increase the amount of capital, improve the use of labor, or enhance available technology."  p. 550

Some argue that policymakers should not encourage generations to make sacrifice, because technological progress will ensure that future generations are better off than current generations.  (One waggish economist asked, ‘What has posterity ever done for me?)"  p. 550

Ben Bernanke, the Federal Reserve chairman, previous chairman of the Economic Advisors to the President and Princeton economics professor, had this to say in his textbook, "Macroeconomics'' Fourth edition:

"What determines the quantity of goods and services that an economy can produce?  A key factor is the quantity of inputs – such as capital goods, labor raw materials, land and energy – that producers in the economy use."  p. 61

"Of the various factors of production, the two most important are capital (factories and machines) and labor (workers)."  p. 61

"Much of any country's economic well-being flows from natural, rather than human-made assets – land, rivers, and oceans, natural resources(such as oil and timber),and indeed the air that everyone breathes.  Ideally, for the purpose of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measured in the national income accounts.  Unfortunately they are not."  p. 31   

In summary, it is quite clear that according to established economic theory, our GDP is determined by capital and labor with an overlying umbrella of technology and a few incidentals.

If this sounds familiar, it should.  More than 200 economic professors in the leading universities in the country, including their home bases of Harvard and Princeton, use Bernanke and Mankiw texts.  Most importantly, their theories are bedrock principles for our economic policies.

The veracity of any theory is that it stands up to real world tests.  If these theories are valid, we should be able explain why our GDP is three times greater than our nearest competitor, Japan, by analyzing our capital, labor, and technology.

Capital

As we know, the most important source of capital is our domestic savings.  In 1990, our net savings was $255 billion.  In 2008, our net savings was negative $249 billion.  That is right, we consumed more that we produced.  The only net investment came from investments and loans from abroad.

Over the last 20 years the U.S. has the lowest rate of savings and investment among Organization for Economic Cooperation and Development (OECD) nations.  It has averaged approximately 62% of the average OECD rate.

In the period 2001-2008, the U.S. had the smallest growth in capital stock since the troubled economic times of 1970-1973.

In terms of our capital stock, in 1990 we had gross savings of $940 billion and consumption of fixed capital (depreciation and wear and tear) of $608 billion, which resulted in an increase of our capital stock of $332 billion.  In 2008, we had gross savings of $1,650 billion while we had consumption of fixed capital of $1,900 billion, which means that our capital stock actually declined by $350 billion.  We are not even maintaining our capital base.  The U.S. Civil Engineers estimate that we need to invest $2.5 trillion to get our infrastructure back to "good."

Finally, to our humiliation, in 2008, our gross investment as a percent of GDP placed us in 135th place of 145 nations in the world!  Our rate was 1/3 of that of the leaders!

It is unreasonable to think that our capital investment is the reason for our outsized GDP.

Labor

Well, if the accepted economic theory is correct, and it is not capital that makes us rich, it must be labor.  Let's look.

As we know, our current unemployment rate is around 10% and the underemployed and part-time raises the rate to approximately 18%.  The average work week has declined to 33 hours per week.  A full 56% of layoffs are claimed to be permanent, an historic high.  Yet, the story of this sorry state of employment is still to be written.   Since the decline in employment has largely been felt in the last 2 years, it has not much yet affected reported GDP.

So, we will look at our labor from the recent past, when we were more prosperous.

Approximately 51% of our population is gainfully employed, which places us 57th in the world.  We have, until recently, worked longer than most at 1,792 hours worked per year, which ranked us 3rd.

It might be argued that our work force is better educated and therefore more competitive.  The numbers don't seem to bear this out.  Our education spending as a percentage of GDP is 5.7%, ranking us 37th in the world. 

Our reading literacy places us 15th, near the bottom for developed nations.
 
The educational areas where we seem to excel are most regrettable.  We rank 5th among developed nations in students who dislike school, and 2nd among nations with students who find school boring.

It is hard to argue that we produce more because we are healthier.  The World Health Organization rates us 37th in health care systems, ranking us just ahead of Slovenia but behind Costa Rica.  Or life expectancy from birth places us at 46th.  Unbelievably, our maternal mortality places us 121st!  We are 37th in hospital beds per thousand and 31st in physicians per 1,000.

However, we are 1st in plastic surgeries.  Also, we lead the world in obesity, teenage pregnancy, and teenage births per capita.

And, of course we lead the nearest competitor by nearly double in the amount of money spent on health care per capita.

Socially, we lead the world in incarcerations per 100,000 and beat 2nd place Russia by 20%.  We rate 19th in safety and security, governance at 16th, and corruption at 19th.

We are ranked 1st in entrepreneurship and innovation, and 2nd in Democratic institutions.

Technology

Although capital and labor do not seem to explain our outsized GDP maybe it is the third leg of our economic theory stool which is technology. 

In the world's global economy, technology tends to be available to everyone, whether it is GPS, prescription drugs, Internet, cell phones, or the latest hybrid automobile technology.

Yet, there is certainly an advantage to those who lead in R&D, science education, and patents.

In the 1960-70s, we spent 3% of our GDP on R&D.  Today we spend about 2.6%.

In big physics R&D, funded by the federal government, our investment has dropped by three-quarters from 2% of GDP to 0.5%.

The U.S. ranks 16th in broadband access per person.

Japan has now passed us in patent applications.

Measuring greater than 12th grade advanced students in science, we place last among the developed economies.  Currently, India has three times, and China four times, the engineering graduates per year. 

Although we clearly lead in innovation, China has far outdistanced us in the production cycle, getting from prototypes to full production. 

So, when you combine capital, labor, and technology you find that only 13% of our GDP actually goes to producing value added manufacturing, which places us 75th in the world and far behind Estonia, El Salvador, Bangladesh, and even Afghanistan.

On the other hand, the finance industry accounts for 40% of corporate profits and 30% of the market value of stocks while providing the relatively minor economic value-added function of moving money from A to B. 

Yet, with all of this, how do we explain that we have three times GDP of Japan, which is in 2nd place?  If the leading economists and government policymakers have other ideas than capital, labor and technology, they are not sharing them with us. But, assuming they are giving us their best shot, it is safe to say that their economic theories don't stand up to the simplest real world examination.  In short, their theory must be flat wrong. 

Tomorrow: A theory that does make sense