Chapter 8: Not All Growth Is Good
By Myron Scholes
The United States has just experienced one of the largest asset bubbles in history. After peaking in 2006 and 2007 at prices that had more than doubled in some markets, in just a few years, home values crashed. The result was a financial panic that sunk storied Wall Street firms and erased the home equity of tens of millions of Americans. Those hit the hardest included Americans who suddenly owed more on their homes than those homes were worth.
It would seem that not all economic “growth” actually adds value to the national economy.
In truth, there are two kinds of growth. One kind is artificial and often driven by misguided policies that aim to increase GDP without regard to adding fundamental value to the economy. For example, monetary policy— through cheap credit— likely contributed to the housing bubble. For a time, this appeared to buoy the economy, even as it was setting the stage for millions of Americans to lose their life savings. Tax and fiscal policies can also create artificial growth. Building a road might create temporary jobs, but does it really create wealth if it doesn’t also shorten commute times or otherwise make society better off? Tax incentives might spur hiring in the short run, but how lasting are those gains if the jobs expire with the tax credits and they come at the expense of investing in the new technologies of the future?
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The other kind of growth actually increases our net wealth and is usually driven by progress in human or physical capital or advances in technology. This second kind of growth leads to long-term economic expansion by improving education, drawing in new high-skilled immigrants, freeing capital, or developing new technologies that make us more productive. Building that road could produce wealth, if it connects businesses in ways they were not connected before. Similarly, raising student achievement can make workers more productive, and changing tax and fiscal policies to allow entrepreneurs to invest in promising ventures can lead to innovation and to new jobs.
So how do we spur this second kind of growth?
In my view, the economy is facing a unique set of headwinds. The United States has sustained a housing crash of tremendous proportions. The policy response in Washington to this crash has not addressed fundamental underlying problems, even while it has created new problems of its own. And the United States has to survive in an increasingly competitive global marketplace where capital (both human and financial) can shift from one place to another. Any of these three issues would pose significant challenges by themselves. But add them together and you will see that over the past few years the United States has suffered a shock to its economic system that warrants a considered response.
First, let’s review a few missteps. Many of Washington’s policies over the past few years have created uncertainty among individuals and businesses. And uncertainty has an underappreciated negative effect on the economy. Why? Because people and businesses react to it in an understandable way— they hold on to their money rather than investing in ventures that might lead to innovations. The net result is that there is less money available for investing in technologies or other items that will lead to higher productivity down the road.
Policy makers have fed uncertainty by trying to steer the economy from Washington. The reason that this creates uncertainty is that Washington tends to support the first kind of economic growth—the kind that artificially inflates GDP, but which can actually reduce value to society. Inflating a housing bubble is one example of this. But there are others that range from wasting funds on unnecessary infrastructure projects to directing capital into endeavors that do little to
make the economy more efficient.
One way Washington directed capital to fruitless ends came in the form of a financial reform bill called Dodd- Frank, which became law in 2010. This new law was advertised as necessary to prevent the kind of financial collapse that happened in 2008. Instead it has provided little additional protection against a future crash, made financial markets less flexible, and imposed new costs on the system (something many consumers saw in 2011 with new debit card fees). Combined with new health-care requirements, employment regulations, immigration rules,
and constraints on innovation, it has led many of the country’s largest companies to sit on substantial financial reserves even while the economy sputters. Uncertain about the future, they are saving their capital for the rainy days that seem to await them.
The way I’ve often described the problem we face is this: Rather than having the “war generals” (private entrepreneurs) lead our economy, we’re being led by the “ordinance generals” in Washington. We need to replace the ordinance generals with war generals—those individuals
who can actually create innovations that add value to society.
One way to do that would be to pull back the policies briefly mentioned above that are adding to uncertainty. But that’s not enough. In a competitive global economy, we’ll need to make advances in computing, information, and telecommunications technologies as well as other
areas that will lead us to new ways of doing business. The goal is to increase our national output without increasing the resources we put into the economy. And to do that, we’ll have to also build flexibility into our thinking.
What we know is that we must innovate before we build infrastructure. And here I am using a definition of the term infrastructure that includes much more than bridges and roads. I’m using a definition that includes government regulatory structures as well as private systems that range from rules to habits of business that surround our industries and often determine how our markets function.
Innovation must lead infrastructure for a simple, but compelling, reason: Innovation produces new types of products and markets, and it is virtually impossible to know how to run those markets efficiently before they are created. We can all be thankful that there wasn’t a set of regulations in place that were so rigid that they would have made the iPhone impossible to create before Steve Jobs had rolled it out. If we seek to regulate future products and markets in advance, we’ll impose rules that will almost certainly end up crushing innovation. R&D, creating new products, or developing new types of capital investments requires building infrastructure only after making gains in innovation.
We can’t let infrastructure get too far behind innovation and creativity, of course. We need rules to run markets efficiently. But we can’t let old infrastructure stifle new innovation, either. So we have to think about how to repeal old rules that stifle new ideas. We have to think about the rigidities that are already in place. Most of these rigidities exist in places where we don’t allow individuals to use markets to compete or where we involve the government, which often won’t allow old infrastructure to be upended in favor of new innovations and new types of rules.
If all of that seems a little abstract, consider a real- world example in the form of China. The Chinese economy has grown for the past thirty years and, notwithstanding those who believe otherwise, I think it will continue to grow for the next thirty years. The reason it will grow is that it has made great strides by pulling more of its population into industries that are more productive than agriculture. At the same time, China has achieved significant growth in tangible capital—it has built roads, bridges, and other physical assets. But there has not been corresponding progress of the same magnitude in homegrown technology and innovation. This is similar to the growth experienced in years past in South Korea, Taiwan, and even Japan.
China’s growth has been hampered by overinvestment—by the habit of a centrally planned economy to invest not in things that make its economy as productive as it can be, but in hard assets that political leaders favor. These investments have been made with financial resources that come from a very high domestic savings rate. Essentially, China is funding its own overinvestment. So, in a sense, we can say that China both oversaves and overinvests. The net result is that its investments have produced some level of growth but have not made its economy nearly as efficient or as productive as it could be. In other words, its investments are paying off, but not nearly at the rate they should be.
One sign of that is this: About 30% of the labor force in China produces only 10% of the country’s GDP, and there is also a supply of surplus labor that is mostly unskilled. China has a lot of people who could be vastly more productive.
Over time, as labor continues to move from farms to factories, China will experience real growth. And as the society becomes wealthier (a 1.3 billion person society, mind you) there will be a great increase in the demand for housing, transportation, education, and health care, things that wealthier individuals want to consume. In the years ahead we can expect China not only to react to its growing middle class by allowing new homes and new industries to be built, but to invest in education and in R&D as well. And both education and R&D will almost certainly be areas of significant and lasting growth for China.
But R&D could also be an area of significant growth for the United States. The United States has a huge advantage in R&D. China issues about 1,000 patents a year. South Korea and Taiwan issue about 8,000. And Japan issues maybe 10,000. The United States, on the other hand,
issues something closer to 100,000. So R&D is one area that offers significant growth for the United States. All of these new patents offer the United States the chance to harness new innovation and new creativity and to take advantage of all of the cumulative know-how built up over the years and represented in all those previous patents. That knowledge is a tremendous edge in a global information economy. Now, we’ve heard from some quarters that China has an edge of its own—that its economy is centrally directed and can therefore quickly marshal resources to productive ends. The argument is that China can be more nimble or more adept at directing investments in areas that will produce real economic growth than the United States. To the extent that this is true, it is because China is trailing the United States in innovation. Think of it this way: When you are at the cutting edge of development, the only way to find new efficiencies is to conduct research. But when you are trailing behind someone who is conducting cutting-edge research, you can easily copy any critical breakthroughs that are made without doing much research on your own. You don’t have to be too smart to figure out how to improve when others have already done the thinking for you. And in China’s case, it can use the large trading firms of Japan and Hong Kong to import the ideas of financiers, intermediaries, managers of logistics, and so on to reduce innovation costs dramatically. If you reduce such costs, then obviously the deadweight costs of thinking and trying to address uncertainty are also reduced. So we can expect China to close the gap with the United States relatively quickly, much the way Japan once closed the gap with the industrialized world. We’ve seen lots of growth in China in the coastal areas, and that growth will likely now extend into the center of the country. I think China will be self-sufficient and diversified but use a lot of imports and knowledge from the rest of the world. Some of those imports will come from the United States, which will work to access the sizable Chinese market for its goods and services. Once China makes the relatively easy strides in its progress by borrowing our technology, the question will arise of whether it will be able to lead the pack with innovations of its own. If it can, it might be able to supplant the United States and claim to have the most productive workers in the world. But to do that, China will have to overcome the uncertainties and other challenges that the United States faces today. It will also have to compete head-on with the United States, something that will be a lot harder to do if we take the opportunity now to reduce uncertainty and rev up the engines of innovation in the United States. So uncertainty really has a large effect on growth and innovation. The United States has been in the forefront of R&D and accumulative knowledge and can remain there and even grow dramatically if it concentrates on increasing the efficiency of its human and financial capital. There are several ways to do that, and they start with developing new technologies and finding new ways to use existing technologies. The oil and gas industry is giving us one example of how we can profit by using existing technologies in new ways. Over the past several years it has started to adapt techniques first developed to extract gas from shale deposits to now extract oil. Similarly, we need to find new ways to apply technology in health care, retail, and education. And we need to rethink infrastructure and delivery systems to make them more efficient. Regulations can be streamlined, necessary roads can be built, advances in logistics can continue to allow retailers to free up capital previously committed to inventory, and better schools can help our students become more productive. And we need to rethink our approach to success. We have to encourage success (and allow for failure), because that is how we grow. We also need to better understand what success actually requires. We tend to think that success is based on luck and not skill, and we tend to penalize success through excessive regulation and taxation. This approach has to end. We need to encourage long- term investing that leads to more R&D and a greater accumulation of valuable knowledge. At the same time, we need to think about our human capital. The United States has been experiencing unusually high unemployment, so it has surplus labor. We need to get unemployed workers back to work in ways that actually increase value to society. Make-work infrastructure projects won’t lead to long-term prosperity. But innovations that provide workers with jobs in new industries will. To do all of these things, we need to remain flexible. I think in our global economy, uncertainty is ever increasing. So to accommodate for that, we need to build a dynamic economy and dynamic rules that can adapt to changing circumstances. In the coming decades, we’re likely to see several surprising shifts as financial capital chases new opportunities and as human capital moves from one country to another or one region to another. The world’s population is expected to increase to nine billion people in the foreseeable future, with more than half living on less than two dollars a day. Aging of populations, movement of people from rural areas to cities, from south to north, and from country to country will create new challenges. We’re going to have to worry about how vast movements of people affect scarce resources. And we are going to have to see all of these things as opportunities. If we position ourselves well, we’ll benefit from shifts that await the world. Likewise, advances in education and technologies will offer new opportunities to grow our economy. There are already innovations in the works that will make great strides in information technology, biology, nanotechnology, and neuroscience. We can nurture these innovations, in part, by allowing innovation to lead infrastructure. Too much infrastructure and entrenched infrastructure tend to stifle innovation. And stifling innovation on a grand scale can stifle the national economy. Rather than stifling our own success, we can unleash the creativity pent up in our economy. If we respond to our current situation by unleashing our war generals—our innovators—we’ll put ourselves at the cusp of a new economic boom that will lead to benefits that will surprise even us. Shocks create change. We had a shock recently. Let’s not let a good shock go to waste.
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