Copyright 1997 The New Republic, Inc.
The New Republic

NOVEMBER 3, 1997

LENGTH: 1798 words


BYLINE: Paul Krugman

Why this is no time to gloat.


SYNOPSIS: The New Economy is great, but lies on quiescent workers and unrealistic assumptions on productivity growth.

At Bill Clinton's famous pre-inaugural economic summit in Little Rock in 1992, speaker after speaker invoked the end of the American Century. They darkly contrasted the United States not only with that economic paragon Japan, but even Europe. The president-elect quoted Lester Thurow's best-seller Head to Head, which declared that "Future historians will record that the twenty- first century belonged to the House of Europe!" But history, it turns out, is an ironist. In reality, 1992 was the year in which Japanese growth stalled, and in which Europhoria turned out to be just a brief remission in the grim progress of Eurosclerosis. The United States, meanwhile, has achieved the lowest unemployment rate in a generation--without even a hint of resurgent inflation.

Americans may be entitled to some malicious glee at the expense of those who used to lecture us on our failings--although trying to force Jacques Chirac and Helmut Kohl to wear cowboy costumes, as we did at the Denver economic summit last June, is surely going too far. But triumphalism presents its own troubles: though the "American model" has scored some important successes, it continues to fail in other respects, above all in generating an ever-increasing level of inequality. And we won't begin to address those failures if the national mood remains dominated by self-congratulation.

America's superiority complex rests on a fundamental misunderstanding of our success. The area in which America has been undeniably successful is job creation. In the past, efforts to expand employment have been limited by the threat of inflation: as workers become scarce, they use their increased bargaining power to ask for more money. The increase in labor costs, in turn, drives up prices, and job growth grinds to a halt. This scenario played itself out here and elsewhere as recently as the late 1980s, and it is why central bankers, hoping to contain inflation, generally raise interest rates during periods of low unemployment. But remarkably, in the U.S. inflation has remained low even as Federal Reserve Chairman Alan Greenspan has--to his credit--allowed the unemployment rate to fall below 5 percent.

What explains this good news? The prevailing belief, which we'll call the Business Week theory, is that U.S. companies have become more productive: their ability to produce ever more goods with a given amount of labor has kept costs down, thus allowing rapid growth without inflation. Just what this theory means for policymakers depends on which ones you ask. Many people-- mostly, but not only, in the Republican Party--regard America's good economic news as a vindication of the economic philosophy of Ronald Reagan. They claim that our prosperity is the result of reductions in tax rates, which have encouraged productivity-enhancing investment; and they have argued, to good political effect, that for the economy to grow further, America need only push those taxes even lower.

Liberals who subscribe to the Business Week theory agree that there is room for higher growth, although their explanation of how we got there is different--and thus, so is their prescription for the future. If productivity is up, they say, then workers deserve better pay. They recommend policies that strengthen unions or might otherwise encourage higher wages. Some also suggest protectionist trade policies to eliminate low-wage competition from abroad. Above all, the liberals suggest, the Fed should lower interest rates to keep the economy humming. (On this, some conservatives agree.)

The problem with both views is that the premise--the idea that the good news on inflation is the result of a revolution in productivity--doesn't make sense. There is, for starters, the awkward fact that America runs large trade deficits. Trade deficits aren't necessarily bad; they can be a sign of strength. But their persistence undermines the claim that American business has achieved great strides in productivity and product quality. In 1995, a Japanese employer had to pay hourly wages and benefits 38 percent higher than his American counterpart (although the cost of living was higher in Japan); the margin for German workers was 85 percent. But despite this cost advantage, America still ran a trade deficit of more than $100 billion. If U.S. companies have become so efficient, why can't their wares--produced by such relatively cheaper labor--do better on world markets?

Another reason to be skeptical about the productivity premise is that there's no evidence of it in the data. Official statistics say that from 1990 to 1996 productivity--output per hour worked--rose at an annual rate of less than 1 percent. That's about the same rate as the disappointing growth from 1973 to 1990; it is nothing like the nearly 3 percent growth of the 1950s and 1960s. And it is slower than the rate of productivity growth in Germany, France, or Japan. It's true that many business leaders insist that the data are wrong--that oldfashioned statistics cannot keep up with the new economy. But if so, then our estimate of inflation must, in turn, be too high. (This is because inflation and productivity are calculated from the same numbers.) And if our estimate of inflation is too high, then our real rate of inflation must be close to zero--which is a cheerful enough thought, but still doesn't help explain why even the measured rate of inflation has stayed so low.

So if productivity isn't the explanation, what is? The proximate answer is simple: prices aren't going up much because wages, the main component of costs, aren't going up much either. Despite an abundance of jobs and actual labor shortages in some places, workers have been astonishingly cautious about demanding better pay. Some economists see subtle signs of a wage acceleration just beginning; but few would have thought that the signs would be so subtle in such a favorable job market.

The main reason for worker restraint is probably fear: apparently the recession and initially jobless recovery left a deep mark on the national psyche. Downsizing has shaken confidence, and there's always the specter-- real or imagined--that a worker in a Third World country can do your job for a fraction of your salary. Unions here are too weak to bargain for higher wages; and if a U.S. worker loses his job, he had better take another one soon on whatever terms he can get. In most other advanced countries, it is possible in practice for the unemployed to collect some income support indefinitely. In America, after twenty-six weeks, you're on your own. With such a nervous and timid workforce, the economy can gallop along for a while without setting in motion a wage-price spiral. And so we are left with a paradox: we have more or less full employment only because individual workers do not feel secure in their jobs. Indeed, we are able to be prosperous as a nation precisely because as individuals we do not trust in that prosperity. The secret of our success is not productivity, but anxiety.

There is something to be said for such an economy; things could be worse, and in most countries they are. But rather than congratulate ourselves, we should be asking whether our system really has to be as harsh and brutal as it is. Conservatives insist that growth will solve all problems, and that the way to achieve that growth is still lower marginal tax rates (and hence lower tax rates on the rich). But while America has greatly reduced marginal tax rates from their mid-'70s levels, and while we have substantially lower overall taxes than European countries, none of the good things that were supposed to happen as a result of lower tax rates have actually happened. In particular, investment is not up. Indeed, as a share of Gross Domestic Product, investment is a bit lower than it was twenty years ago, and substantially lower than it is in those high-tax European countries.

Unfortunately the usual liberal solution isn't credible, either. As the sad state of Europe shows, countries that are too solicitous about the wages and job security of employees tend to find themselves stuck with high unemployment. While it's true that the recent increase in our own minimum wage has had no visible adverse effect on employment, that was probably because America's minimum wage is still so low that it hardly matters.

But if we reject both the claims of conservatives that tax cuts for the rich will create prosperity for all, and the claims of liberals that the market can be ordered to produce fairer outcomes without nasty side effects on employment, what is left? The answer is to let markets work--but to redistribute some of the wealth to those who would otherwise not share in prosperity. We already have a program that shows the way. The Earned Income Tax Credit raises incomes for many of the working poor by as much as 40 percent, at a taxpayer cost of about 0.4 percent of GDP--and most studies indicate that it not only raises incomes but encourages more people to work. The program isn't perfect--there is some waste and abuse--but the perfect is the enemy of the good, and the eitc is overwhelmingly a good thing. Let's do more of the same.

Another sensible way to increase living standards without meddling with the economy's ability to create jobs would be to provide better social services. True, this may sound like the kind of thing that European countries--who are now disparaged as mindlessly as they used to be praised--tend to do. But Europe isn't sclerotic because its citizens have national health insurance; and such insurance wouldn't bring Eurosclerosis to America. On the contrary, it is our current system that discourages poor people from trying to better themselves; the prospect of losing Medicaid if they do too well amounts to a tax on gainful employment. Like the eitc, an expansion of health insurance would help make our society less brutal while actually promoting employment.

Where is the money for this to come from? From taxes. Remember that there is no evidence that the tax cuts of the '80s did anything positive for the economy--and no reason to expect any positive effects from the tax cuts embodied in the latest budget deal, many of which provide no incentive to work harder, invest more, or take bigger risks. If we really wanted to spend an extra 2, 3, or even 4 percent of GDP helping our less fortunate citizens, we could do it with few, if any, adverse side effects. The truth is that nothing in the experience of the last few years contradicts the idea that we could have a kinder, gentler economy that preserves the main virtue of the American system--high employment. All it would take is compassion. And a little less gloating.

Paul Krugman is professor of economics at MIT.