THE 20th CENTURY HAS BEEN CALLED THE "AMERICAN CENTURY." It was a century in which the standard of living of the average American increased six-fold. Economic booms lasted for decades--the 1920s, the 1950s and the 1960s all saw rapid economic growth and rising standard of living. But then our economy's engine began to sputter. From the early 1970s to the mid-1990s, the average growth rate of our economy slowed to about two-thirds of its average pace from the 1920s to 1970. Starting about 1995, however, the U.S. economy began to expand rapidly, and unemployment and inflation fell to low levels not seen since the 1960s. Although the pace of economic activity slowed during the second half of 2000, many economists remain convinced that the economy's growth potential remains high.
This year's annual report is concerned with economic growth. Over long periods, the principal determinant of how fast our economy can grow--that is, how fast our standard of living can increase--is the growth of labor productivity. Since the mid-1990s, the United States has witnessed a remarkable increase in the growth of labor productivity, exceeding that of all other G-7 countries. In this report, we look to history for information about how such surges in productivity come about, how long they can last, and whether economic policy can do anything to boost our economy's potential to grow.
Previous centuries' productivity booms were associated with fundamental technological breakthroughs and their widespread commercial application. Industrial revolutions of the 18th and 19th centuries were jump-started by the invention of new general-purpose technologies, such as the steam engine and the electric motor, which had wide application throughout the economy.
The breakthrough invention of modern times is the microchip. Because it too is a general-purpose technology, many observers believe that the broad application of information and communications technology throughout the economy will spur a sustained increase in productivity and economic growth. But the jury is still out on whether the recent surge in productivity will prove as durable as those of the past.
Our examination of the links between technological progress and economic growth reveals how clusters of technological breakthroughs lead to sustained increases in productivity growth and standard of living. Our study shows also how government policy can affect economic growth, principally by helping ensure an economic environment that encourages inventive activity and the efficient allocation of economic resources. As a central bank, we can play a role in this effort by ensuring that the market signals of the price system are free of distortions caused by uncertainty about the general level of prices. Price stability contributes significantly to an environment in which technological progress and productivity growth are encouraged and our economy can achieve its maximum sustainable rate of growth.
I invite you to read this year's annual report. By exploring the past, we can learn about the present and, perhaps, where our so-called new economy is headed.
William Poole, President and CEO
FROM THE TIME WE ARE YOUNG CHILDREN, WE MEASURE OUR ACHIEVEMENTS AGAINST THOSE OF OUR PREDECESSORS. In matters both trivial and weighty--height, athletic prowess, grades, ability to tie a shoe--we contrast and compare, gaining status from each piece of evidence that we are progressing faster or raising the bar higher. As we get older, such comparisons often focus on how well we are managing to improve our standard of living.
Every so often, an individual or an industry or a nation bursts through in some way that leaves its contemporaries and historical counterparts in the dust. Can anyone explain the remarkable achievements of golfer Tiger Woods? Using the same equipment as his competitors and playing the same courses, Woods rather suddenly began charging past opponents, setting tournament scoring records and, consequently, establishing a much higher standard of living for himself. In economic terms, you might say he has been more productive.
Although the inputs Tiger Woods uses to win golf tournaments are rather specialized, conceptually they are similar to the production of goods and services economy-wide. Woods employs both physical capital (golf clubs, tees, balls, etc.) and labor (physical exertion and skills, knowledge of the course, etc.) in some combination. In the economy, the production of some goods, like cars or corn, is inherently capital intensive--workers depend heavily on machines to get the job done. In the more dominant services sector of the economy, physical labor is the more abundant input.
What caused Woods' surge in productivity? We don't really know. It's likely to be some combination of experience, practice, coaching and other intangibles--what economists call human capital. Without some obvious technological breakthrough, however, other golfers may be at a loss as to how to duplicate Woods' efforts.
Another example that better shows how technological breakthroughs can lead to a significant jump in productivity is laser eye surgery. For hundreds of years, eyeglasses were the only remedy for human sight impairment. In the 1940s, the development of contact lenses enabled many people to throw away their glasses. Contact lenses soon became the most rapidly growing means of vision correction.
Until recently, that is. In the 1970s, a breakthrough surgical procedure called radial keratotomy appeared in Russia. Combined with another breakthrough technology, the excimer laser, which was originally developed to etch computer chips, radial keratotomy revolutionized the field of eye surgery. Since FDA approval in 1998, such procedures are now so common that the advertising blitz for corrective laser eye surgery is quite impossible to avoid.
Still, such a specific technological change pales in comparison to an advance in what economists call a general-purpose technology. Clusters of new developments in these types of technologies characterized the major industrial revolutions, notably the British Industrial Revolution of the 18th and early 19th centuries and the so-called Second Industrial Revolution of the late 19th and early 20th centuries, in which the United States led the way. The British Industrial Revolution brought the introduction of the steam engine, mechanization of textile manufacturing, locomotive engines, chemical processes like bleaching, and numerous other important inventions with commercial applications. The late 19th century witnessed the introduction of the internal combustion engine, important advances in chemistry, medicine and engineering, and great strides in the generation, distribution and application of electric power.
Now at the dawn of the 21st century, many observers believe the U.S. economy has entered a new era, reflecting revolutionary technological advances associated with the microchip. These advances, some economists claim, permit the economy to grow faster and, hence, living standards to rise higher than they have in recent decades. Others are skeptical, contending that the recent productivity spurt will prove to be an aberration and that the sustainable pace of economic growth has not increased appreciably.
What is not up for debate is the economy's strength over the recent past. The United States entered its record-setting ninth consecutive year of economic expansion in 2000. Although the pace of economic activity slowed during the second half of 2000, productivity growth--the principal engine of long-term economic growth--remained strong. In fact, since the mid-1990s, the United States has enjoyed a remarkable increase in the growth of average labor productivity--an increase matched by few other countries.
Can the U.S. productivity surge be credited to the invention of the microchip and related technologies, as past eras benefited from their own major inventions? Are we in the midst of another industrial revolution that will generate years of rapid productivity increase and prosperity? Or are we riding a wave that will crest sooner than we think? On the following pages, we attempt to answer these questions by looking back at the past. First, we examine more closely the staggering productivity leap the United States has made over the past half decade.
Between 1980 and 1995, total output per worker in the United States grew at the slowest rate of any G-7 country. Since then, however, the growth of U.S. labor productivity* has exceeded that of all other G-7 countries (see chart), as has the growth of U.S. real Gross Domestic Product. Increased growth of labor productivity explains fully half of the increase in real economic growth in the United States since 1995. And, by expanding the economy's productive potential, faster productivity growth has resulted in rising real wages and declining unemployment without significantly higher inflation.
So why the dramatic reversal of fortune for the United States? Many attribute it to the microchip--more specifically, to investment by firms in computers and information processing equipment and software. Federal Reserve Chairman Alan Greenspan has noted that "technological innovation, and in particular the spread of information technology, has revolutionized the conduct of business over the past decade and resulted in rising productivity growth." Economists estimate that one-half to three-quarters of the increase in trend labor productivity growth in the United States since 1995 can be attributed to rapid rates of investment in information and computer technology (ICT) equipment.
The spread of information technology noted by Chairman Greenspan and others has been encouraged by rapid declines in the prices of ICT equipment and software. Investment in ICT capital has increased productivity by placing more capital at the disposal of each worker--a process that economists refer to as "capital deepening." For example, with a computer and simple software, a records-keeper in a medical office can maintain many more patient files than he or she can using a hand-filing system. Similarly, the use of computerized robots on assembly lines has increased the number of automobiles and other goods assembled per worker employed in manufacturing industries. Computers are also used for designing and testing new products, operating precision equipment, managing inventory and personnel, and even for designing new computers. In many firms, investment in ICT capital permits increased production without additional labor. Indeed, in some cases, such investment enables firms to adopt more efficient production technologies by aiding, for example, in the design of more efficient production lines. Through such efficiency gains, output increases without commensurate increases in labor or capital inputs.
Computer technology is not new. The first electronic digital computer was built before World War II, the transistor dates from the late 1940s, and the silicon microchip from about 1970. Personal computers became widely used in offices in the 1980s. Yet, aggregate U.S. labor productivity growth declined after about 1970 and remained low for another 25 years, even as other important computer technology breakthroughs occurred. Economists were puzzled. Why did it seem that the impact of computer and information technology was observed "everywhere but in the productivity statistics," as Nobel-laureate economist Robert Solow once quipped? In fact, there often is a delay between the invention of a general-purpose technology and its impact on productivity. The next section takes a closer look at this phenomenon.
* Labor Productivity is the output of either an industry or the aggregate economy divided by labor input. A change in labor productivity reflects any change in output that cannot be accounted for by a change in labor input; such changes may be due, for example, to changes in the amount of capital used per person employed or to changes in technology. |
History shows that new technologies do not move instantly from the inventor's laboratory to everyday usage. It can take a long time for them to increase productivity. The absence of immediate productivity improvement with the advent of new information processing technology was not unlike earlier experiences with general-purpose technologies. Similar delays in the impact of technological progress on aggregate productivity occurred during past industrial revolutions.
Part of the delay, according to Northwestern University economist Joel Mokyr, occurs because, important as they are, fundamental technological breakthroughs often require further inventions to make them broadly applicable: "Such gap-filling inventions are often the result of on-the-job learning or of a development by a firm's engineers realizing ad hoc opportunities to produce a good cheaper or better. Over time, a long sequence of such microinventions may lead to major gains in productivity, impressive advances in quality, fuel and material savings, durability and so on."
For example:
• Although Thomas Newcomen built the first successful steam engine in 1712, it was not until about 1765 that major improvements in the engine by James Watt made it suitable for factory use. Additional improvements, which included the addition of a governor and rotary movement, made the steam engine a huge economic success in the 19th century. Recent estimates suggest that at the height of the British Industrial Revolution (1760 to 1830) output per capita in the United Kingdom grew at less than 0.5 percent per year on average, about the same rate as during the period between 1700 and 1760. By comparison, per capita output increased at an average rate of nearly 2 percent per year from 1830 to 1870. Mokyr argues that despite slow growth during the era of high invention, rapid growth in Britain after 1830 could not have occurred without the technological breakthroughs of the previous 70 years.
• Although Michael Faraday invented the first electric motor in 1821 and the dynamo in 1831, it took nearly a century of additional, substantial breakthroughs to make electricity the dominant source of power in manufacturing. Despite major technological breakthroughs in electricity, chemicals, steel production and other major sectors, American manufacturing productivity slowed in the late 19th century. Whereas output per hour increased at 1.7 percent per year from 1869 to 1889, output per hour increased at just 1.4 percent per year from 1889 to 1909. U.S. manufacturing productivity growth remained modest until after World War I, but grew during the 1920s at an astounding rate of 5.6 percent per year. Productivity growth remained high for another 40 years.
• As with the steam engine and electric motor, the computer chip did not affect productivity in many industries until additional inventions came along to apply the new technology. In banking, for example, microinventions like the ATM, the debit card and credit-scoring software were required to generate the productivity gains promised by the computer.
Stanford University economist Paul David explores the dynamics of technological diffusion by comparing the electric dynamo, a key technological advance of the 19th century, with the modern computer. The dynamo, like the computer and steam engine, is a general-purpose technology, having profound effects on nearly all sectors of the economy. Decades elapsed, however, between the introduction of reliable electric motors and their widespread use in industry. Some of the delay was accounted for by lags in the development of efficient means of electric power generation and by competition between direct and alternating current. Electric power generation was reasonably efficient and commercially viable by 1880, however, and the superiority of alternating current for most applications was clear by 1893. Yet, as the chart to the left illustrates, electricity accounted for just 5 percent of mechanical power in U.S. manufacturing in 1900 and did not exceed 50 percent until 1920.
"Part of the delay in the exploitation of the potential industrial productivity gains offered by the [electric] dynamo," according to David, "was due simply to the durability of old manufacturing plants embodying technology adapted to the regime of mechanical power derived from water and steam." A slow rate of decline in the cost of adopting electric power also contributed to the delay. Between 1907 and 1917, the price of electricity to industrial users dropped sharply, however, and the technology began to spread rapidly.
Once electricity accounted for some 50 percent of the power sources used in American manufacturing, U.S. productivity began to accelerate. Electrification enhanced productivity by affording greater flexibility and more efficient use of labor and capital in manufacturing. For example, electrification enabled more use of continuous-process techniques, such as the factory assembly line, which often reduced production times and waste. Efficiency was improved also by the wide adoption of "unit drive," that is, the use of dedicated electric motors to power individual machines and tools, rather than a system of shafts and belts powered by a single engine. Unit drive brought savings through reduced energy usage, less wear and tear, and more flexible and efficient factory design. Electrification also enhanced productivity by improving factory lighting and safety.
The histories of the steam engine and the electric dynamo show us that delays of years or even decades from the initial invention of a general-purpose technology and its impact on aggregate productivity and standard of living should not be surprising. Follow-up inventions and adaptations of existing workplaces and products to the new technology are required before large productivity gains arise. Is there any way to ensure that such microinventions do occur--that fundamental technological breakthroughs lead to growth in productivity and standard of living?
Many observers believe that a country's economic performance is related to its political and economic institutions. Countries with stable, democratic political systems, limited government involvement in economic decision-making, but strong protection of property rights, are thought to have institutions that are conducive for technological progress and economic growth. We turn next to how public policy might affect growth and what the histories of past industrial revolutions might teach us.
Thus far, we have focused on how technological progress can increase the growth of productivity and standard of living. But, how does technological progress come about and, specifically, can governments do anything to encourage it? During the industrial revolutions of the 18th and 19th centuries, invention and the application of new technologies were carried out by private individuals and firms, virtually without government subsidies or direction. Nonetheless, the histories of these industrial revolutions suggest that governments can have a powerful impact on growth.
Douglass North, a Nobel laureate economist at Washington University in St. Louis, argues that a nation's institutions, including its government, are fundamental determinants of economic growth. Focusing specifically on the role of government, North and his co-author Barry Weingast argue: "Successful economic performance ... must be accompanied by institutions that limit economic intervention and allow private rights and markets to prevail in large segments of the economy. ... The ability of a government to commit to private rights and exchange is thus an essential condition for growth." In his classic study of U.S. productivity growth, John Kendrick makes a similar point. Citing the importance of resources devoted to increasing scientific and technical knowledge, Kendrick contends that "the relative volume of resources devoted to research development and innovation depends on the basic values and motivations of a people and on the efficacy of the rewards and penalties provided by prevailing institutions for the success or failure in the efforts to improve productive efficiency."
In the view of North and Weingast, the "Glorious Revolution" of 1688 gave England political institutions, such as a representative parliament and independent judiciary, that produced a marked increase in the security of private rights. Secure property rights, in turn, provided the freedom and incentive to take economic risks, to invest in new technologies and to look for ways to use economic resources more efficiently. The United States inherited the English tradition of protecting property rights and, hence, the same fundamental mechanism for providing incentives for invention, investment and risk-taking that was in place in England by the early 18th century. Providing these incentives would seem to be a fundamental contribution that governments can make to encourage gains in productivity and standard of living.
In addition to enforcing contracts and limiting arbitrary confiscation of property, governments often extend special protections to inventors in the form of patents and copyrights. Such protections seem particularly important in the case of intellectual property or knowledge-based products, such as computer software. The initial development of a piece of software might be extremely costly, but the costs of producing and disseminating copies of the software are trivial. Without strong protection of intellectual property rights, such as a software developer's copyright, there will be little incentive to produce knowledge-based products. In other words, secure property rights encourage the technological breakthroughs that accelerate productivity growth and living standards. British patent law dates from 1624, whereas France and other continental European countries did not have patent laws until at least 1791. (The first U.S. patent law was enacted in 1790.) Scholars debate the extent to which patent protection contributed to the high rate of invention during the Industrial Revolution, in part because of inconsistent enforcement of patent laws by British courts. Enforcement of property rights granted by patents and copyrights is, of course, crucial to their success as stimulants to invention. Patents and copyrights can also inhibit innovation if firms are permitted to extend them indefinitely.
Well-designed patent and copyright laws, along with a legal system that protects property rights, are examples of how governments can promote economic development. Other contributions that governments can make include sound macroeconomic policies and, in the view of many economists, a strong education system. Paul Romer, a leading growth economist at Stanford University, for example, argues that "the real success of American economic policy has been to have moderately strong property rights with lots of subsidies for inputs--like research and education--that are used in the innovation process."
The United States has long supported both public and private education. In the 19th century, federal assistance to education was largely in the form of land grants used to finance the establishment of public schools and colleges. The Morrill Act of 1862, for example, provided land grants for the establishment of colleges teaching "agricultural and mechanical arts," including engineering and other technical subjects. Economists widely believe that basic and technical education enhanced the productivity of American labor and contributed to the accelerated pace of productivity growth that began in the 1920s. High school graduation rates were at high levels in the 1920s, and, as in recent decades, income growth rates were higher for more-educated workers.
Defense of property rights, sound macroeconomic policies, a strong educational system, and patents and copyrights are institutional supports that governments can use to strengthen economic growth in a market system. Such supports promote the allocation of economic resources to their most productive uses and encourage technological progress by ensuring that inventors are rewarded for developing successful technologies. Many countries, however, have pursued technological progress and economic growth by limiting, even eliminating, market forces. Although growth rates can be high for short periods under government ownership and control of economic resources, history suggests that market-based economies have faster growth rates over the long term.
Today, few observers contend that highly controlled economies will grow faster for long periods than market economies. Nevertheless, many believe that governments can do more to promote technological progress and economic development than simply providing a conducive climate for markets to work their magic. Some countries have adopted formal "industrial policies" aimed at guiding technological change by subsidizing or otherwise promoting specific technologies, industries or firms over others. Economists do not agree whether such policies can enhance economic growth, and some argue that the policies are more likely to retard growth by interfering with the efficient allocation of economic resources.
To some extent, all countries, including the United States, have used subsidies, protective trade barriers, and other direct means to foster technological development. A feature of the 18th and 19th century industrial revolutions, however, was the limited extent that governments sought to dictate or interfere with the form and extent of technological progress. The great economist Joseph Schumpeter coined the term "creative destruction" to describe how economic growth arises from the continual reallocation of economic resources as new, more productive firms and technologies replace old and inefficient firms and technologies. Paul Romer argues that America's great success comes from allowing this process to occur: "The United States has maintained a regulatory and financial system that makes it easy to create new companies, raise capital and start new businesses. We also tolerate failure." By contrast, other countries have "focused on what they call 'national champions,' which they identify as a few big firms whose monopoly positions they try to protect. That really goes in all the wrong directions."
The fundamental technological inventions of the past 50 years have given us an astonishing variety of new products and services, from cellular telephones to digital video to e-commerce. At the same time, ICT has also enabled firms to produce many old-economy goods and services, such as automobiles, steel and financial services, more efficiently. Since the mid-1990s, the U.S. economy has witnessed an astounding increase in productivity growth that has brought higher standards of living, employment and real incomes to most Americans. How long can it last?
Although GDP growth slowed toward the end of 2000, there is no sign that the forces causing the rise in productivity growth have diminished. This suggests that the recent slowdown will prove to be a temporary, cyclical phenomenon and not the beginning of a return to a slower long-run growth path.
A more fundamental question, however, is whether the U.S. economy can sustain a high pace of trend economic growth over many years, even decades. Many economists think so, but there are skeptics. One skeptic is Robert Gordon, a professor of economics at Northwestern University. Gordon argues that much of the recent acceleration in U.S. productivity is due to cyclical forces, suggesting that productivity growth will fall as economic activity slows to a more modest pace. Moreover, he contends that the computer, the Internet and other high-tech products of the late 20th century pale in comparison with the great inventions of the late 19th century in terms of their impact on productivity and long-run standard of living. Electricity, the internal combustion engine, and significant advances in chemicals, medicine and communication were much more important for sustained economic development, Gordon contends, than the transistor, the microchip or the Internet.
Thus far, the short period since 1996 favors those who believe we have a "new economy." Average labor productivity growth in the United States has increased at an average rate of 2.8 percent since 1996. Productivity is now growing at about the same rate as it did during the halcyon productivity boom of 1919 to 1973, which scholars attribute to the industrial revolution of the late 19th century. Although interrupted by a major economic depression and a world war, the great boom of the mid-20th century produced a quadrupling in U.S. standard of living. By contrast, productivity grew only half as fast between 1974 and 1995, at 1.4 percent per year. Were that rate to persist for 50 years, standard of living would only double. Obviously we hope that productivity will continue to grow at the pace of 1996-2000, but to be on par with the great booms of the past, our current rate of productivity growth will have to continue for decades more. It's simply too soon to tell whether the productivity surge of the last five years will prove to be a boom or a boomlet.
In the past, long booms in productivity growth and standard of living proceeded from clusters of major technological breakthroughs, made commercially successful by subsequent inventions and gap-filling innovations. The histories of the great industrial revolutions of the 18th and 19th centuries teach us that technological progress and economic development are encouraged by a market system that rewards individuals and firms whose advances increase productivity and economic growth the most. A high standard of living and sustainable economic growth are surely a testament to our free market economic system and the opportunities for wealth creation that spring from it. Strong support of property rights, stable macroeconomic policies and a sound educational system underpin our market system and encourage technological progress and economic growth. Macroeconomic growth is, in the end, the product of countless microeconomic decisions made everyday in response to market signals. As a society, we can best ensure a high, sustainable rate of economic growth over the long term through a market system that encourages the search for new technologies and more efficient methods of production.
Barro, Robert J., and Xavier Sala-i-Martin. Economic Growth. New York: McGraw-Hill, 1995.
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David, Paul A., and Gavin Wright. "Early Twentieth Century Productivity Growth Dynamics: An Inquiry into the Economic History of 'Our Ignorance.'" University of Oxford Discussion Papers in Economic and Social History no. 33, October 1999.
Gordon, Robert J. "Does the 'New Economy' Measure up to the Great Inventions of the Past?" Journal of Economic Perspectives, Fall 2000, pp. 49-74.
International Monetary Fund. "Current Issues in the World Economy: Productivity and IT Growth in the Advanced Economies," World Economic Outlook, October 2000, Chapter 2.
Jorgenson, Dale W., and Kevin J. Stiroh. "Raising the Speed Limit: U.S. Economic Growth in the Information Age," Brookings Papers on Economic Activity 1, pp. 125-211.
Kendrick, John W. Productivity Trends in the United States. Princeton: National Bureau of Economic Research, 1961.
Mokyr, Joel. "Editor's Introduction: The New Economic History and the Industrial Revolution," in Joel Mokyr, ed. The British Industrial Revolution: An Economic Perspective. Second edition. Boulder: Westview Press, 1999, pp. 1-127.
Mokyr, Joel. "The Second Industrial Revolution, 1870-1914." Northwestern University Department of Economics working paper, August 1998.
North, Douglass C., and Barry R. Weingast. "Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England," Journal of Economic History, December 1989, pp. 804-32.
Oliner, Stephen D., and Daniel E. Sichel. "The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?" Journal of Economic Perspectives, Fall 2000, pp. 3-22.
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