In 1974, Congress created the Congressional Budget Office (CBO). The CBO was given the responsibility of providing Congress with impartial economic analysis as it makes decisions about the federal government’s budget. One of the most widely discussed reports the CBO issues is the Budget and Economic Outlook. The report provides forecasts of future federal budget deficits and changes in the federal government’s debt that the budget deficits will cause. The CBO’s budget and debt forecasts rely on the agency’s forecasts of future economic conditions and assumes that Congress will make no changes to current laws regarding taxing and spending. (We discuss this assumption further below.)
On February 15, the CBO issued its latest forecasts. The forecasts showed a deterioration in the federal government’s financial situation compared with the forecasts the CBO had issued in May 2022. (You can find the full report here.) Last year, the CBO forecast that the federal government’s cumulative budget deficit from 2023 through 2032 would be $15.7 trillion. The CBO is now forecasting the cumulative deficit over the same period will be $18.8 trillion. The three main reason for the increase in the forecast deficits are:
1. Congress has increased spending—particularly on benefits for military veterans.
2) Cost-of-living adjustments for Social Security and other government programs have increased as a result of higher inflation.
3) Interest rates on Treasury debt have increased as a result of higher inflation.
The CBO forecasts that federal debt held by the public will increase from 98 percent of GDP in 2023 to 118 percent in 2033 and eventually to 198 percent in 2053. Note that economists prefer to measure the size of the debt relative to GDP rather than in as absolute dollar amounts for two main reasons: First, measuring debt relative to GDP makes it easier to see how debt has changed over time in relation to the growth of the economy. Second, the size of debt relative to GDP makes it easier to gauge the burden that the debt imposes on the economy. When debt grows more slowly than the economy, as measured by GDP, crowding effects are likely to be relatively small. We discuss crowding out in Macroeconomics, Chapter 10, Section 10.2 and Chapter 16, Section 16. 5 (Economics, Chapter 20, Section 20.2 and Chapter 26, Section 26.5). The two most important factors driving increases in the ratio of debt to GDP are increased spending on Social Security, Medicare, and Medicaid, and increased interest payments on the debt.
The following figure is reproduced from the CBO report. It shows the ratio of debt to GDP with actual values for the period 1900-2022 and projected values for the period 2023-2053. Note that the only other time the ratio of debt to GDP rose above 100 percent was in 1945 and 1946 as a result of the large increases in federal government spending required to fight World War II.
The increased deficits and debt over the next 10 years are being driven by government spending increasing as a percentage of GDP, while government revenues (which are mainly taxes) are roughly stable as a percentage of GDP. The following figure from the report shows actual federal outlays and revenues as a percentage of GDP for the period 1973-2022 and projected outlays and revenues for the period 2023-2033. Note that from 1973 to 2022, outlays averaged 21.0 percent of GDP and revenues averaged 17.4 percent of GDP, resulting in an average deficit of 3.6 percent of GDP. By 2033, outlays are forecast to rise to 24.9 percent of GDP–well above the 1973-2022 average–whereas revenues are forecast to be only 18.1 percent, for a forecast deficit of 6.8 percent of GDP.
The increase in outlays is driven primarily by increases in mandatory spending, mainly spending on Social Security, Medicare, Medicaid, and veterans’ benefits and increases in interest payments on the debt. The CBO’s forecast assumes that discretionary spending will gradually decline over the next 10 years as percentage of GDP. Discretionary spending includes federal spending on defense and all other government programs apart from those, like Social Security, where spending is mandated by law.
To avoid the persistent deficits, and increasing debt that results, Congress would need to do one (or a combination) of the following:
1. Reduce the currently scheduled increases in mandatory spending (in political discussions this alternative is referred to as entitlement reform because entitlements is another name for manadatory spending).
2. Decrease discretionary spending, the largest component of which is defense spending.
3. Increases taxes.
There doesn’t appear to be majority support in Congress for taking any of these steps.
The CBO’s latest forecast seems gloomy, but may actually understate the likely future increases in the federal budget deficit and federal debt. The CBO’s forecast assumes that future outlays and taxes will occur as indicated in current law. For example, the forecast assumes that many of the tax cuts Congress passed in 2017 will expire in 2025 as stated in current law. Many political observers doubt that Congress will allow the tax cuts to expire as scheduled because to do so would result in increases in individual income taxes for most people. (Here is a recent article in the Washington Post that discusses this point. A subscription may be required to access the full article.) The CBO also assumes that defense spending will not increase beyond what is indicated by current law. Many political observers believe that, in fact, Congress may feel compelled to substantially increase defense spending as a result of Russia’s invasion of Ukraine in February 2022 and the potential military threat posed by China.
The CBO forecast also assumes that the U.S. economy won’t experience a recession between 2023 and 2033, which is possible but unlikely. If the economy does experience a recession, federal outlays for unemployment insurance and other programs will increase and federal personal and corporate income tax revenues will fall. The CBO’s forecast also assumes that the interest rate on the 10-year Treasury note will be under 4 percent and that the federal funds rate will be under 3 percent (interest rates on short-term Treasury debt move closely with changes in the federal funds rate). If interest rates turn out to be higher than these forecasts, the federal government’s interest payments will increase, further increasing the deficit and the debt.
In short, the federal government is clearly facing the most difficult budgetary situation since World War II.
The Bureau of Labor Statistics is housed in the U.S. Department of Labor. (Photo from don.gov site.)
In a blog post at the end of August, we noted that real GDP declined during the first two quarters of 2022. On September 29, the Bureau of Economic Analysis (BEA) slightly revised the real GDP data, but after the revisions the BEA’s estimates still showed real GDP declining during those quarters.
A popular definition of a recession is two consecutive quarters of declining real GDP. But, as we noted in the earlier blog post, most economists do not follow this definition. Instead, for most purposes, economists rely on the National Bureau of Economic Research’s business cycle dating, which is based on a number of macroeconomic data series. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” The NBER discusses its approach to business cycle dating here.
The Federal Reserve Bank of St. Louis’s invaluable FRED economic data site has collected the data series that the NBER’s Business Cycle Dating Committee relies on when deciding when a recession began. The FRED page collecting these data can be found here.
Note that although the Business Cycle Dating Committee analyzes a variety of data series, “In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.” The following figures show movements in those two data series. These data series don’t give a strong indication that the economy was in recession during the first half of 2022. Real personal income minus transfer payments did decline by 0.4 percent between January and June 2022 (before increasing during July and August), but nonfarm payroll employment increased by 1.4 percent during the same period (and increased further in July and August).
As we noted in our earlier blog post, the message from most data series other than real GDP seems to be that the U.S. economy was not in a recession during the first half of 2022.
On September 16, 2022 an article in the Wall Street Journal had the headline: “Economic Worries, Weak FedEx Results Push Stocks Lower.” Another article in the Wall Street Journal noted that: “The company’s downbeat forecasts, announced Thursday, intensified investors’ macroeconomic worries.”
Why would the news that FedEx had lower revenues than expected during the preceding weeks cause a decline in stock market indexes like the Dow Jones Industrial Average and the S&P 500? As the article explained: “Delivery companies [such as FedEx and its rival UPS) are the proverbial canary in the coal mine for the economy.” In other words, investors were using FedEx’s decline in revenue as a leading indicator of the business cycle. A leading indicator is an economic data series—in this case FedEx’s revenue—that starts to decline before real GDP and employment in the months before a recession and starts to increase before real GDP and employment in the months before a recession reaches a trough and turns into an expansion.
So, investors were afraid that FedEx’s falling revenue was a signal that the U.S. economy would soon enter a recession. And, in fact, FedEx CEO Raj Subramaniam was quoted as believing that the global economy would fall into a recession. As firms’ profits decline during a recession so, typically, do the prices of the firms’ stock. (As we discuss in Macroeconomics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2, stock prices reflect investors’ expectations of the future profitability of the firms issuing the stock.)
Monitoring fluctuations in FedEx’s revenue for indications of the future course of the economy is nothing new. When Alan Greenspan was chair of the Federal Reserve from 1987 to 2006, he spoke regularly with Fred Smith, the founder of FedEx and at the time CEO of the firm. Greenspan believed that changes in the number of packages FedEx shipped gave a good indication of the overall state of the economy. FedEx plays such a large role in moving packages around the country that most economists agree that there is a close relationship between fluctuations in FedEx’s business and fluctuations in GDP. Some Wall Street analysts refer to this relationship as the “FedEx Indicator” of how the economy is doing.
In September 2022, the FedEx indicator was blinking red. But the U.S. economy is complex and fluctuations in any indicator can sometimes provide an inaccurate forecast of when a recession will begin or end. And, in fact, some investment analysts believed that problems at FedEx may have been due as much to mistakes the firms’ managers had made as to general problems in the economy. As one analyst put it: “We believe a meaningful portion of FedEx’s missteps here are company-specific.”
At this point, Fed Chair Jerome Powell and the other members of the Federal Open Market Committee are still hoping that they can bring the economy in for a soft landing—bringing inflation down closer to the Fed’s 2 percent target, without bringing on a recession—despite some signals, like those being given by the FedEx indicator, that the probability of the United States entering a recession was increasing.
Sources: Will Feuer, “FedEx Stock Tumbles More Than 20% After Warning on Economic Trends,” Wall Street Journal, September 16, 2022; Alex Frangos and Hannah Miao, “ FedExt Stock Hit by Profit Warning; Rivals Also Drop Amid Recession Fears,” Wall Street Journal, September 16, 2022; Richard Clough, “FedEx has Biggest Drop in Over 40 Years After Pulling Forecast,” bloomberg.com, September 16, 2022; and David Gaffen, “The FedEx Indicator,” Wall Street Journal, February 20, 2007.
The Bureau of Economic Analysis (BEA) publishes data on gross domestic product (GDP) each quarter. Economists and media reports typically focus on changes in real GDP as the best measure of the overall state of the U.S. economy. But, as we discuss in Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4), the BEA also publishes quarterly data on gross domestic income (GDI). As we discuss in Chapter 8, Section 8.1 when discussing the circular-flow diagram, the value of every final good and services produced in the economy (GDP) should equal the value of all the income in the economy resulting from that production (GDI). The BEA has designed the two measures to be identical by including in GDI some non-income items, such as sales taxes and depreciation. But as we discuss in the Apply the Concept, “Should We Pay More Attention to Gross Domestic Income?” GDP and GDI are compiled by the BEA from different data sources and can sometimes significantly diverge.
A large divergence between the two measures occurred in the first half of 2022. During this period real GDP declined—as shown by the blue line in the following figure—after which some stories in the media indicated that the U.S. economy was in a recession. But real GDI—as shown by the red line in the figure—increased during the same two quarters. So, was the U.S. economy still in the expansion that began in the third quarter of 2020, rather than in a recession? Or, as an article in the Wall Street Journal put it: “A Different Take on the U.S. Economy: Maybe It Isn’t Really Shrinking.”
In fact, most economists do not follow the popular definition of a recession as being two consecutive quarters of declining real GDP. Instead, as we discuss in Chapter 10, Section 10.3, economists typically follow the definition of a recession used by the National Bureau of Economic Research: “A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.”
During the first half of 2022, most measures of economic activity were expanding, rather than contracting. For example, the first of the following figures shows payroll employment increasing in each month in the first half of 2022. The second figure shows industrial production also increasing during most months in the first half of 2022, apart from a very slight decline from April to May after which it continued to increase.
Taken together, these data indicate that the U.S. economy was likely not in a recession during the first half of 2022. The BEA revises the data on real GDP and real GDI over time as various government agencies gather more information on the different production and income measures included in the series. Jeremy Nalewaik of the Federal Reserve Board of Governors has analyzed the BEA’s adjustments to its initial estimates of real GDP and real GDI. He has found that when there are significant differences between the two series, the BEA revisions usually result in the GDP values being revised to be closer to the GDI values. Put another way, the initial GDI estimates may be more accurate than the initial GDP estimates.
If that generalization holds true in 2022, then the BEA may eventually revise its estimates of GDP upward, which would show that the U.S. economy was not in a recession in the first of half of 2022 because economic activity was increasing rather than decreasing.
Sources: Jon Hilsenrath, “A Different Take on the U.S. Economy: Maybe It Isn’t Really Shrinking,” Wall Street Journal, August 28, 2022; Reade Pickert, “Key US Growth Measures Diverge, Complicating Recession Debate,” bloomberg.com, August 25, 2022; Jeremy L. Nalewaik, “The Income- and Expenditure-Side Estimates of U.S. Output Growth,” Brookings Papers on Economic Activity, Spring 2010, pp. 71-127; and Federal Reserve Bank of St. Louis.
In the textbook, we discuss several measures of inflation. In Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4) we discuss the GDP deflator as a measure of the price level and the percentage change in the GDP deflator as a measure of inflation. In Chapter 9, Section 9.4, we discuss the consumer price index (CPI) as a measure of the price level and the percentage change in the CPI as the most widely used measure of inflation.
In Chapter 15, Section 15.5 we examine the reasons that the Federal Reserve often looks at the core inflation rate—the inflation rate excluding the prices of food and energy—as a better measure of the underlying rate of inflation. Finally, in that section we note that the Fed uses the percentage change in the personal consumption expenditures (PCE) price index to assess of whether it’s achieving its goal of a 2 percent inflation rate.
In this blog post, we’ll discuss two other aspects of measuring inflation that we don’t cover in the textbook. First, the Bureau of Labor Statistics (BLS) publishes two versions of the CPI: (1) The familiar CPI for all urban consumers (or CPI–U), which includes prices of goods and services purchased by households in urban areas, and (2) the less familiar CPI for urban wage earners and clerical workers (or CPI–W), which includes the same prices included in the CPI–U. The two versions of the CPI give slightly different measures of the inflation rate—despite including the same prices—because each version applies different weights to the prices when constructing the index.
As we explain in Chapter 9, Section 9.4, the weights in the CPI–U (the only version of the CPI we discuss in the chapter) are determined by a survey of 36,000 households nationwide on their spending habits. The more the households surveyed spend on a good or service, the larger the weight the price of the good or service receives in the CPI–U. To calculate the weights in the CPI–W the BLS uses only expenditures by households in which at least half of the household’s income comes from a clerical or wage occupation and in which at least one member of the household has worked 37 or more weeks during the previous year. The BLS estimates that the sample of households used in calculating the CPI–U includes about 93 percent of the population of the United States, while the households included in the CPI–W include only about 29 percent of the population.
Because the percentage of the population covered by the CPI–U is so much larger than the percentage of the population covered by the CPI–W, it’s not surprising that most media coverage of inflation focuses on the CPI–U. As the following figure shows, the measures of inflation from the two versions of the CPI aren’t greatly different, although inflation as measured by the CPI–W—the red line—tends to be higher during economic expansions and lower during economic recessions than inflation measured by the CPI–U—the blue line.
One important use of the CPI–W is in calculating cost-of-living adjustments (COLAs) applied to Social Security payments retired and disabled people receive. Each year, the federal government’s Social Security Administration (SSA) calculates the average for the CPI–W during June, July, and August in the current year and in the previous year and then measures the inflation rate as the percentage increase between the two averages. The SSA then increases Social Security payments by that inflation rate. Because the increase in CPI–W is often—although not always—larger than the increase in CPI–U, using CPI–W to calculate Social Security COLAs increases the payments recipients of Social Security receive.
A second aspect of measuring inflation that we don’t mention in the textbook was the subject of discussion following the release of the July 2022 CPI data. In June 2022, the value for the CPI–U was 295.3. In July 2022, the value for the CPI–U was also 295.3. So, was there no inflation during July—an inflation rate of 0 percent? You can certainly make that argument, but typically, as we note in the textbook (for instance, see our display of the inflation rate in Chapter 10, Figure 10.7) we measure the inflation rate in a particular month as the percentage change in the CPI from the same month in the previous year. Using that approach to measuring inflation, the inflation rate in July 2022 was the percentage change in the CPI from its value in July 2021, or 8.5 percent. Note that you could calculate an annual inflation rate using the increase in the CPI from one month to the next by compounding that rate over 12 months. In this case, because the CPI was unchanged from June to July 2022, the inflation rate calculated as a compound annual rate would be 0 percent.
During periods of moderate inflation rates—which includes most of the decades prior to 2021—the difference between inflation calculated in these two ways was typically much smaller. Focusing on just the change in the CPI for one month has the advantage that you are using only the most recent data. But if the CPI in that month turns out to be untypical of what is happening to inflation over a longer period, then focusing on that month can be misleading. Note also that inflation rate calculated as the compound annual change in the CPI each month results in very large fluctuations in the inflation rate, as shown in the following figure.
Sources: Anne Tergesen, “Social Security Benefits Are Heading for the Biggest Increase in 40 Years,” Wall Street Journal, August 10, 2022; Neil Irwin, “Inflation Drops to Zero in July Due to Falling Gas Prices,” axios.com, August 10, 2022; “Consumer Price Index Frequently Asked Questions,” bls.gov, March 23, 2022; Stephen B. Reed and Kenneth J. Stewart, “Why Does BLS Provide Both the CPI–W and CPI–U?” U.S. Bureau of Labor Statistics, Beyond the Numbers, Vol. 3, No. 5, February 2014; “Latest Cost of Living Adjustment,” ssa.gov; and Federal Reserve Bank of St. Louis.
On Thursday morning, April 28, the Bureau of Economic Analysis (BEA) released its “advance” estimate for the change in real GDP during the first quarter of 2022. As shown in the first line of the following table, somewhat surprisingly, the estimate showed that real GDP had declined by 1.4 percent during the first quarter. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast had indicated that real GDP would increase by 0.4 percent in the first quarter. Earlier in April, the Wall Street Journal’s panel of academic, business, and financial economists had forecast an increase of 1.2 percent. (A subscription may be required to access the forecast data from the Wall Street Journal’s panel.)
Do the data on real GDP from the first quarter of 2022 mean that U.S. economy may already be in recession? Not necessarily, for several reasons:
First, as we note in the Apply the Concept, “Trying to Hit a Moving Target: Making Policy with ‘Real-Time’ Data,” in Macroeconomics, Chapter 15, Section 15.3 (Economics, Chapter 25, Section 25.3): “The GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different for what it at first appears to be.”
Second, even though business writers often define a recession as being at least two consecutive quarters of declining real GDP, the National Bureau of Economic Research has a broader definition: “A recession is a significant decline in activity across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” Particularly given the volatile movements in real GDP during and after the pandemic, it’s possible that even if real GDP declines during the second quarter of 2022, the NBER might not decide to label the period as being a recession.
Third, and most importantly, there are indications in the underlying data that the U.S. economy performed better during the first quarter of 2022 than the estimate of declining real GDP would indicate. In a blog post in January discussing the BEA’s advance estimate of real GDP during the fourth quarter of 2021, we noted that the majority of the 6.9 percent increase in real GDP that quarter was attributable to inventory accumulation. The earlier table indicates that the same was true during the first quarter of 2022: 60 percent of the decline in real GDP during the quarter was the result of a 0.84 decline in inventory investment.
We don’t know whether the decline in inventories indicates that firms had trouble meeting demand for goods from current inventories or whether they decided to reverse some of the increases in inventories from the previous quarter. With supply chain disruptions continuing as China grapples with another wave of Covid-19, firms may be having difficulty gauging how easily they can replace goods sold from their current inventories. Note the corresponding point that the decline in sales of domestic product (line 2 in the table) was smaller than the decline in real GDP.
The table below shows changes in the components of real GDP. Note the very large decline exports and in purchases of goods and services by the federal government. (Recall from Macroeconomics, Chapter 16, Section 16.1, the distinction between government purchases of goods and services and total government expenditures, which include transfer payments.) The decline in federal defense spending was particularly large. It seems likely from media reports that the escalation of Russia’s invasion of Ukraine will lead Congress and President Biden to increase defense spending.
Notice also that increases in the non-government components of aggregate demand remained fairly strong: personal consumption expenditures increased 2.7 percent, gross private domestic investment increased 2.3 percent, and imports surged by 17.7 percent. These data indicate that private demand in the U.S. economy remains strong.
So, should we conclude that the economy will shrug off the decline in real GDP during the first quarter and expand during the remainder of the year? Unfortunately, there are still clouds on the horizon. First, there are the difficult to predict effects of continuing supply chain problems and of the war in Ukraine. Second, the Federal Reserve has begun tightening monetary policy. Whether Fed Chair Jerome Powell will be able to bring about a soft landing, slowing inflation significantly while not causing a large jump in unemployment, remains the great unknown of economic policy. Finally, if high inflation rates persist, households and firms may respond in ways that are difficult to predict and, may, in particular decide to reduce their spending from the current strong levels.
Adam Smith bronze statue on Royal Mile Market square in front of Saint Gilles Cathedral in Edinburgh, Scotland.
Growth matters. A lot. A slightly higher rate of economic growth, sustained over time, can make the difference between a big increase in living standards and relative stagnation. Whether we can still generate strong and steady growth is a “$64,000 question” for the economy — the question. Nobel Prize–winning economist Robert Lucas famously observed that once economists think of long-term growth, it is hard to think of anything else. A pro-growth policy agenda is a good idea because growth is a good idea.
But a deeper question remains: Is public support for growth guaranteed? Oren Cass of American Compass refers to growth and economists’ fealty to economic participation for all as “economic piety.” This critique resonates for a simple reason: Forces that propel growth invariably leave a wake of economic disruption for people in many places and political disruption for the nation. A serious discussion of pro-growth policy must account for that disruption.
A conventional pro-growth policy agenda can be enhanced by support for openness to markets, ideas, and new ways of doing things, and for the ability of firms to adapt to change. Such an enhanced agenda would center on infrastructure broadly defined, development and dissemination of better management practices, and reduced barriers to competition.
Yet the political process, and even many a conservative, is openly skeptical of such an agenda. This skepticism is rooted not in disagreement over the future of scientific advances or of organizational adaptation — but in a concern that growth’s benefits be shared broadly. Addressing this skepticism head-on is essential for rebuilding social support for growth and for countering well-meaning but potentially harmful policies.
The system that needs defending is a mature and successful one. Adam Smith, the great proponent of the “invisible hand” (not the visible hand of a state-directed economy), saw openness and competition as worth the candle. His 1776 publication of The Wealth of Nations came before what we would recognize today as industrial capitalism, though technological change and globalization were features of economic debates in the aftermath of Smith’s ideas.
Smith’s radical insight is central to economic policy today: National prosperity (the “wealth of a nation”) is represented by consumption of goods and services by its people — i.e., their living standards. The goal of the economy in Smith’s telling was to make the economic pie as large as possible. His advocacy of free markets and competition rested on their ability to boost consumption possibilities.
Two centuries later, Nobel laureates Kenneth Arrow and Gérard Debreu added the jargon and mathematics of contemporary economics to formalize Smith’s intuition. While individuals and firms act independently, competitive markets lead to an efficient allocation of resources and a maximized economic pie. Friedrich Hayek, another Nobel laureate, hailed the virtue of a decentralized competitive price system in maximizing economic activity.
Smith’s radicalism draws from his attack on mercantilism—the economic orthodoxy of the day—which stressed a zero-sum view of trade and state intervention to promote and protect certain firms and industries. (Sound familiar?) His second radical insight was that the “nation” did not mean the sovereign and the well-connected. In Smith’s view, individuals as consumers—all people—were kings. Finally, channeling the sympathetic concern espoused in his earlier classic, The Theory of Moral Sentiments, Smith championed mass participation in the productive economy as a precondition for human flourishing.
It is fair to say that Smith lacked a theory of per capita growth in the economy over time; indeed, he wrote before the massive increase in living standards attendant upon the Industrial Revolution. After 1800, per capita income in the United Kingdom — and the United States — witnessed a 30-fold increase. There have also been major improvements in the quality of goods and services that such a statistic doesn’t quite capture. And, of course, many of today’s offerings — from smartphones to computers to air-conditioning — were not available even in 1900, let alone 1800.
That lacuna in Smith’s theory partly reflects technical difficulties in modeling growth. Higher output can come from growth in inputs such as labor and capital, but what determines their growth? Today’s economists highlight population growth and society’s willingness to work, save, and invest. Still more important is growth in productivity, or the efficiency with which inputs are used to produce goods and services.
Smith’s pin-factory example — in which output rose with the specialization of tasks — links how things are done with the level of productivity. But what factors determine productivity growth over time? Today’s economic analysis focuses on technology and the process of generating ideas. Since economic growth is still crucial for people seemingly marginalized by capitalism, it’s worth asking whether the economic foundations expressed in The Wealth of Nations are still relevant today. Where does growth come from now? And do those sources still require openness and competition?
The short answer is that they do, but to see why, we need to focus on the ideas of two prominent economists after 1800: Edmund Phelps and Deirdre Nansen McCloskey.
Phelps, a Nobel laureate, has done much to connect growth to Smith’s foundational ideas. He starts with Smith’s emphasis on a great many individuals (not the state or privileged firms) searching for new and better ways of doing things. This relentless search produces innovative ideas, processes, and goods that drive growth — but only if the political economy allows openness. Smith’s messy, “bottom up” version of the market therefore puts mass innovation at the heart of economic growth. Phelps’s argument reflects how Smithian societies committed to openness are best able to prosper and promote growth.
This argument has two important applications. The first is to debunk the sometimes fashionable view of secular productivity decline — that we have run short of new things to discover and exploit. The second is to give an answer to economies struggling with growth in a period of structural changes from technology and globalization. Slowdowns in innovation are likely not due to scientific barrenness but to walls against openness and change — that is, fears of disruption.
Phelps’s concern with economic dynamism draws him to Smith’s arguments against mercantilist tinkering in the economy. Like Smith, he worries about the hidden costs of tinkering with competition by blocking change from the outside and by enabling rent-seeking on the inside. These “corporatist” policies — fashionable among some conservatives at present — inevitably embolden vested interests and cronyism, slowing change and growth. Even seemingly small interventions can subtly diminish innovation, a point to which I’ll return.
Yet such a critique must acknowledge the political consequences of disruption. Dynamism is messy. It creates growth in the aggregate, but with many individual losers as well as individual gainers.
McCloskey, an economic historian, has similarly identified the continuous, large-scale, voluntary, and unfocused search for betterment as the source of new ideas that can produce economic growth. She sees this “innovism” as primarily a cultural force, preferring the term to the more familiar “capitalism,” and connects innovism to economic liberalism. Echoing Smith, she emphasizes how an open economy allows individuals—from the moderately to the spectacularly talented—to “have a go.” This economic liberalism allows competition to enshrine liberty and mass flourishing.
In McCloskey’s telling, growth depends on a liberal tolerance and openness to change, which encourage many people to be alert to opportunity. Sustaining that tolerance as structural shifts bring economic misfortune to many individuals, however, requires more than devotion to Smith.
Therein lies the current economic-policy rub. Economists’ theories of growth bring to mind a coin: Sunny descriptions of growth and dynamism are “heads,” and hand-wringing over disruption is “tails.” As I observed earlier, growth is messy. It can push some individuals, firms, and even industries off well-worn and comfortable paths.
But Smith offers more in defense of growth than paeans to laissez-faire. Though he is sometimes caricatured as being anti-government in all cases, Smith was principally opposed to mercantilist privileges for specific businesses and industries and to the governmentalization of social affairs. He wanted government to provide what economists today call “public goods,” such as national defense, the criminal-justice system, and enforcement of property rights and contracts the institutional underpinnings of commerce and trade. He also favored support for infrastructure to keep commerce flowing freely.
But Smith went further: To prepare workers and enrich their lives, he called for government to provide universal education, and he drew a connection between education and liberty as well as work in a free society. But boosting participation in today’s economy—participation that provides support for growth—will require a bit more.
Not surprisingly, political reaction to economic disruption brings about — pardon the econ-speak—a “demand” for and “supply” of policy actions. Job losses, firm failures, and diminished industry fortunes bring about a demand for help, for adaptation. The political process responds with a supply of ideas in one of two forms: walls or bridges. Walls are protections against disruption or change. Bridges, ways to get somewhere or back, prepare individuals for the changed economy and help those whose economic participation has been disrupted reenter the workforce.
Proposals for walls are familiar. They can be physical, of course, but they needn’t be. Conservative populists advocate limits on trade and technology, in order to advance industrial policy. Some progressives advocate universal basic income. All these policies would diminish the prospects for economic advances.
The most prominent sort of wall today is what I call “modern corporatism.” It assumes that Smith was wrong: The “wealth of a nation” lies not in consumption or living standards (and so ultimately in growth) but in jobs, good jobs, even particular good jobs, with good manufacturing jobs the very paradigm. The sort of tinkering with the market that drew Smith’s ire may actually be a necessary way of recentering economic policy on jobs, so the theory goes. Opportunities for work, and for the dignity it can bring, are surely important.
A gentle industrial policy devised by social scientists who are worried about jobs is not the answer. It results in state tinkering for special interests, precisely the kind of thing that prompted Smith’s criticism of mercantilism. Moreover, as University of Chicago economist Luigi Zingales argues in A Capitalism for the People, it risks a vicious cycle: A little bit of tinkering becomes a lot of tinkering—and anyone who cannot justify special privileges is left out, calling into question social support for growth. Nevertheless, industrial policy has caught the attention of elected officials on the right, from Donald Trump to Josh Hawley to Marco Rubio. While national security and the border can be exceptions as concerns, advice from Milton Friedman to the party of Ronald Reagan this is not.
That said, economists’ invocation of Smith as a proponent of let-’er-rip laissez-faire is neither faithful to Smith nor particularly helpful to individuals and communities buffeted by disruption. With today’s rapid and long-lasting technological change and globalization, “having a go” requires support for acquiring new skills when they are needed.
That is why we need more bridges. Bridges take us somewhere and bring us back. The journey to somewhere is about preparation for new opportunities. The journey back is about reconnecting to the productive economy when economic forces beyond our control have knocked us away.
Economic bridges have three features. The first is that they help people overcome a specific challenge on their way to economic flourishing — they don’t provide that outcome directly. The second is that wider society builds the bridge, through private organizations, governments, or public–private partnerships, as globalization and technological change have introduced significant risks that individuals by themselves cannot avoid. The third feature is that they avoid restraints on openness to changes in markets and ideas.
We once did better, much better. During the Civil War, President Abraham Lincoln worked with Congress to pass the Morrill Act, directing resources to the development of land-grant colleges around the country, extending higher education to citizens of modest means, and enabling workers to develop skills for new industries, particularly in manufacturing. As World War II drew to a close, President Franklin D. Roosevelt and Congress came together to enact the G.I. Bill, helping to educate returning troops for a changing economy.
Supporting economic growth and undergirding broad participation in the economy require similarly bold ideas. To begin, community colleges are the logical workhorses of skill development and retraining, and their presence in regional economies makes them attractive partners for employers. Yet community colleges have seen their state-level public support wither. The Biden administration calls for free tuition, which would boost demand but provide no support for community college to offer a practical education and an emphasis on completion. Amy Ganz, Austan Goolsbee, Melissa Kearney, and I proposed an alternative approach based on the land-grant-college model. We proposed a supply-side program of federal grants to strengthen community colleges — contingent on improved degree-completion rates and labor-market outcomes. To further encourage training, the federal government could offer a tax credit to compensate firms for the risk of losing trained workers. It could also increase the earned-income tax credit for workers with or without children.
New ideas are also needed to promote workers’ reentry into the workforce. Personal reemployment accounts, for example, would support dislocated workers and offer them a reemployment bonus if they found a new job within a certain period of time. The “personal” refers to individuals’ choosing from a range of training and support services. Another idea is to beef up support for place-based assistance to areas with stubbornly high rates of long-term nonemployment. Such support could be integrated with an increase in the earned-income tax credit and the supply-side investment in community colleges. Building on the decentralized approach in the land-grant colleges and grants to community colleges, expanded place-based aid would be delivered via flexible block grants encouraging business and employment.
Broad public support required for growth and dynamism requires both bridge-building and a political language that frames it. Growth, opportunity, and participation are good, and we do not need a new economics. But phrases like “transition cost” and “inevitable economic forces” must give way to bridges of preparation and reconnection.
‘Why did nobody see it coming?” a quizzical Queen of England questioned a quorum of economists at the London School of Economics about the global financial crisis as it emerged in late 2008. How could major disruptive forces build up over time and yet escape the attention of experts and leaders?
Of the disruptive structural changes accompanying economic dynamism, one might ask a similar question. Growth matters. But that growth is one side of a coin whose flip side is disruption is known, certainly to economists. Why has our political discourse not emphasized this basic point?
Why did we not see fatigue with change coming among the people who most had to bear its ill effects?
However foolishly, we did not. Some so-called conservatives today have responded by saying that we should limit change. Surely a better response is that we should seek ever more growth by allowing unfettered change, but also facilitate the establishing of ever more connections in a growing economy. That classical-liberal answer has the better place in American conservatism — and in American economic life.
— This essay is sponsored by National Review Institute.Originally published here.
Supports: Macroeconomics, Chapter 10, Section 10.5, Economics Chapter 20, Section 20.5, and Essentials of Economics, Chapter 14, Section 14.2.
On March 2, 2022, as the conflict between Russia and Ukraine intensified, an article in the Wall Street Journal had the headline “Investors Pile Into Treasurys as Growth Concerns Flare.” The article noted that: “The 10-year Treasury yield just recorded its largest two-day decline since March 2020, while two-year Treasury yields plunged the most since 2008.”
a. What does it mean for investors to “pile into” Treasury bonds?
b. Why would investors piling into Treasury bonds cause their yields to fall?
c. What are “growth concerns”? What kind of growth are investors concerned about?
d. Why might growth concerns cause investors to buy Treasury bonds?
Solving the Problem
Step 1: Review the chapter material. This problem is about the effects of slowing economic growth on interest rates, so you may want to review Chapter 10, Section 10.5, “Saving, Investment and the Financial System.” You may also want to review Chapter 6, Appendix A (in Economics, Chapter 8, Appendix A), which explains the inverse relationship between bond prices and interest rates.
Step 2: Answer part a. by explaining what the article meant by the phrase “pile into” Treasury bonds. The article is using a slang phrase that means that investors are buying a lot of Treasury bonds.
Step 3: Answer part b. by explaining why investors piling into Treasury bonds will cause the yields on the bonds to fall. As the Appendix to Chapter 6 explains, the price of a bond represents the present value of the payments that an investor will receive over the life of the bond. Lower interest rates result in a higher present value of the payments received and, therefore, higher bond prices or—which is restating the same point—higher bond prices result in lower interest rates. If investors are increasing their demand for Treasury bonds, the increased demand will cause the prices of the bonds to increase and cause the yields—or the interest rates—on the bonds to fall.
Step 4: Answer part c. by explaining the phrase “growth concerns.” In this context, the growth being discussed is economic growth—changes in real GDP. The headline indicates that investors were concerned that the Russian invasion of Ukraine might lead to slower economic growth in the United States.
Step 5: Answer part d. by explaining why investors might purchase Treasury bonds if they were concerned about economic growth slowing. Using the model of the loanable funds markets discussed in Chapter 10, Section 10.5, we know that if economic growth slows, firms are likely to engage in fewer new investment projects, which would shift the demand curve for loanable funds to the left and result in a lower equilibrium interest rate. Investors who have purchased Treasury bonds will gain from a lower interest rate because the price of the Treasury bonds they own will increase. In addition, stock prices depend on investors’ expectations of the future profitability of firms issuing the stock. Typically, if investors believe that economic growth is likely to be slower in the future than they had previously expected, stock prices will fall, which would make Treasury bonds a more attractive investment. Finally, investors believe there is no chance that the U.S. Treasury will default on its bonds by not making the interest payments on the bonds. During an economic slowdown, investors may come to believe that the default risk on corporate bonds has increased because some corporations may run into financial problems. An increase in the default risk on corporate bonds increases the relative attractiveness of Treasury bonds as an investment.
Source: Gunjan Banerji, “Investors Pile Into Treasurys as Growth Concerns Flare,” Wall Street Journal, March 2, 2022.
Authors Glenn Hubbard and Tony O’Brien as they talk about the leading economic issue of early 2022 – inflation! They discuss the resurgence of inflation to levels not seen in 40 years due to a combination of miscalculations in monetary and fiscal policy. The role of Quantitative Easing (QE) – and its future – is discussed in depth. Listen today to gain insights into the economic landscape.
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