Cato Online Forum

Forgetting How to Grow

By Tim Kane
November 2014

Trying to understand why the greatest nation in history is lurching from crisis to crisis leads many observers to the narrative of American decline in the face of a foreign rival. When confronted with such thinking, reflect on James Fallows who wrote books and articles in the early 1990s suggesting “the Asian system as a whole will almost certainly be the main source of worldwide economic energy for the next generation,” whereas Western economies would remain “slow” unless they learned from better forms of capitalism. In hindsight, such predictions are embarrassing, but they were common on the left and the right.

The thread that unites theories of decline across generations is the false idol of a rival power from the Soviets in the 1950s to the Chinese today. If we look at great power history, however, it categorically rejects the “great rival” premise, and instead shows that the true danger is self-inflicted stagnation.

In Balance: the Economics of Great Powers from Ancient Rome to Modern America, Glenn Hubbard and I examined how economies grow and stagnate. The good news is that American power is truly unrivaled, but unlike past powers, aware of the fundamentals of economics. Avoiding bad macro should be easy.

Contrary to the declinists, no economy is close to the U.S. Germany, France, England, Japan, and other near-peers operate 15-20 percent below the production possibilities frontier defined by U.S. per capita productivity. They have been hovering at that level for half a century. The existential threat facing America is not from China or Russia or, if it must be said, terrorists in the hinterlands. America is the only existential threat to America. The bad news is that the patterns of Great Power decline are the same, time after time, and we can see them playing out right now in the U.S.

In short, America is forgetting how to grow. This is quite an achievement in light of the relentless refinement of economists’ insights into the factors that drive growth. We know, in a technical sense of knowledge, how economic growth happens. Economists know more in 2014 than was known in 1994, by far, and knew far more in 1994 than the decades before. Unfortunately, we the people have become ever more confused and led astray by the politics of protectionism, redistribution, and what Mancur Olson called “the logic of collective action.”

“Nobody Knows Where Economic Growth Comes From,” said Matt Yglesias in a 2012 essay for SLATE. What? Saying that economists don’t understand growth is like saying doctors don’t understand cancer. There are always limits, but let’s not confuse humility with ignorance. Elhanan Helpman is a highly regarded Harvard professor of economics who titled his 2004 book, The Mystery of Economic Growth. William Easterly’s book, The Elusive Quest for Growth, is another case in point. Enough already. Growth is no mystery.

Hubbard and I advance a model of economic growth that is accessible and well-grounded in the current academic consensus. There are three different kinds of growth, the intangible drivers that explain GDP’s expansion. Innovative growth, which some call technology proper and others simply call “ideas,” is the easiest to understand. This is Schumpeterian growth, and it has boomed in the U.S. thanks to a unique style of entrepreneurial capitalism, which was presciently celebrated by Joseph Schumpeter. The second type, Solovian growth stems from investment. Think of Robert Solow’s workhorse model. The third type of growth comes from scale and the subsequent specialization of labor, known as Smithian growth, after Adam Smith.

The United States is in the process of slowly forgetting all three.

Entrepreneurship has been in a stunning decline since the 1970s. The percentage of companies that are startups has fallen during every presidency since Jimmy Carter. Back when disco was king, one in eight companies was a startup. Today, one in sixteen companies is. To be sure, the US has a head of innovative steam with a dynamic startup culture epitomized by Silicon Valley. The institutions of venture capitalism are world class. It’s the demographics that are the problem. The nature of risk-taking is simply less appealing, perhaps crowded out by a paternalistic state. We live in a country where it pays, literally, not to work, where occupational licensing has run amok, where patents are a thicket, and where trial lawyers have made a minefield out of the startup runway. Worst of all, medical insurance has been so highly regulated that it is foolish to leave a safe job at a big company with gilded coverage and even more foolish to hire more than 50 employees lest you take on paternalistic responsibility and a deeply uncertain regulatory burden.

Investment seems like a robust area for growth, especially with all-times highs on the stock market. This is probably not the best barometer, as equity markets are fickle. The emerging trend of corporate inversions-in which U.S. companies merge with a foreign firm-is the direct result of uncompetitive U.S. tax rates on profits. If investment is what puts capital in capitalism, it is alarming to see the decomposition of GDP data since the 1940s. Not only is the current ratio of investment to GDP at a post-war low during the current recovery, the previous decade’s expansion was fueled by artificially low credit that pushed up residential, not corporate, investment. A second alarming observation is the decline in the U.S. share of global foreign direct investment, once a third of the world share, is now down to a sixth.

As for the third area of growth, America’s economic strength stems from its vast internal scale. If all economics is ultimately based on free trade among individuals, the U.S. has enjoyed a tremendous advantage with a wealthy, educated population that is roughly the same size as Western Europe. Unlike Europe, our fifty state economies have enjoyed open borders to trade and migration for centuries. The European Union is making a belated effort to create the same internal scale benefits. The logic of scale is so uncontroversial that it is, sadly, easily forgotten. Despite the benefits of NAFTA and other trade agreements, free trade in principle is regarded with deep suspicion by the public. Even worse is the denigration of America’s traditional openness to immigration. Indeed, a major reason that Europe cannot reap the full advantage of its newly open internal trade scale is that population growth has been stagnant among its member states for decades. The U.S., thanks to immigration, adds one million legal permanent residents born abroad every year.

Sadly, the debate over comprehensive immigration reform in Washington, DC reveals how deeply confused American leaders have become. The push for comprehensive reform has been championed by a Republican president (George Bush) and a Democratic president (Barack Obama) with the same effect. Both led mixed Congress and unified Congresses (controlled by their party), yet somehow immigration remained stuck in the cloakroom. When legislation did emerge for a vote, it was inevitably “comprehensive,” which is code for including various special-interest provisions and poison pills. It looks now as if the endeavor was designed to fail, the kind of cynical ploy that lets politicians on both partisan extremes enjoy the fight (red meat for their respective donors and voters) while common sense, incremental reforms languish.

Steve Jobs famously challenged President Barack Obama at a private Silicon Valley dinner in February 2011 on why he wouldn’t support a simple bill to increase legal immigration of engineers, both with more green cards and more H-1B visas. Obama claimed that keeping all of the various pieces together in an all-or-nothing comprehensive bill was the only way. It’s not true. Even if it were, the result has been nothing. Meanwhile, what economist Bryan Caplan calls the “anti-foreign bias” continues to rise.

From the perspective of a proponent of greater immigration at all levels, a position I have long held, let’s shed some light on the latest incarnation of comprehensive reform, the Senate’s 2013 bill. This was a bad bill. Whenever the AFL-CIO-historically hostile to increased migration, especially of less-skilled labor-is a major proponent of legislation with a new work visa and an expansively empowered new bureau within the Labor Department, alarm bells should ring. The comprehensive bill tries to do too much, mixing illegal and legal immigration, low-skill farm hands with temporary visas and high-skill engineers with permanent residency. Hidden inside are three clauses that will chill the hiring of foreign guest workers: a non-displacement clause that bans firms from lay-offs of a single U.S. worker during a half-year window around the hiring of a single migrant, verification that no American was impacted by the hire, and a full spectrum set of wage controls.

In 2014, we at the Hoover Institution began a non-partisan survey of immigration experts from all over the US to evaluate incremental reforms to immigration in the hopes that a future Congress and President might finally try to find consensus rather than the high-stakes partisan fight over comprehensive legislation. If they limited their efforts to the singular issue of work visas - leaving alone the contentious issue of deportations, illegals, and the cable TV fodder - something amazing would happen.

The 35 experts were asked about the likely effects of an expanded and more efficient guest worker program. Net exports would rise according to 51 percent of them, versus 3 percent who said they would decline. GDP would increase according to 94 percent, versus zero who said it would decline. Some 80 percent said illegal border crossings would decrease, and 71 percent said the number of undocumented immigrants overall would decrease. What about the unemployment rate of U.S. workers? Zero impact.

Then we asked what elements should be included in a new temporary work visa. Giving migrants portability, meaning the freedom to change US employers and avoid exploitation (the bane of work visas in the past), was recommend by all but one expert on our panel. What about the non-displacement and employer certification clauses in Harry Reid’s Senate bill championed by President Obama? Those had 14 and 20 percent support, respectively. It was a bad bill, but Democratic partisans loved that it allows them to castigate do-nothing Republicans (while they do nothing to pass incremental bills themselves). And to be fair, Republican restrictionists loved it because it offered what looks an awful lot like amnesty. But isn’t this a false choice between deportation and amnesty?

A simple survey of scholars shows that designing incremental pieces of legislation that would enhance immigration, GDP, and trade is easy. Unfortunately, designing something that helps incumbent politicians get re-elected is easy too. The United States is a nation of immigrants that is building a wall against immigrants. This is how a great republic forgets.

References:

Organization for International Investment. “Foreign Direct Investment in the United States, 2013 Report.”


The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Tim Kane is a research fellow at Stanford University’s Hoover Institution and the coauthor with Glenn Hubbard of Balance: The Economics of Great Powers from Ancient Rome to Modern America (2013.)