The Independent Market Observer

2/13/13 – Where Does Growth Come From?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Feb 13, 2013 5:09:16 AM

and tagged Politics and the Economy

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The story today is the President’s State of the Union address last night. He made many points, but all centered around the role of government in the economy. Implicit in his program was the presumption that government can engineer outcomes superior to what the market would create. Also implicit was the notion that government can be key to kick-starting growth. Are those presumptions right, and can the President’s proposals really start to create a better outcome?

Let’s step back a moment and consider what “growth” means. If we are looking at a pie, any way we slice it, for someone to get more, someone else has to get less. This is how much of the debate on spending and taxes has been framed so far—either we cut spending or raise taxes, because the pie is only so big.

What would make at least some of the problem go away is a bigger pie. That way, everyone could get more at the same time. To get a bigger pie, of course, we need growth. The question is, how do we get it?

Growth in the past couple of economic recoveries has been well below what used to be considered normal. Had growth been at more normal levels in the most recent recovery, for example, GDP would be hundreds of billions of dollars higher, possibly trillions, with all that means for tax revenues and employment. If growth took off, our current problems would largely solve themselves. Current tax rates on a larger economy, for example, would raise more revenue without a tax increase, and spending would go down as countercyclical programs like unemployment insurance payments would decrease.

Historically, growth has sprung from two roots: population growth and growth in productivity. Population growth is largely set in stone in the short to medium term, and the potential for the government to materially change this seems limited. That said, declines in population growth, or actual population declines, are a major cause of slowing growth in developed economies like ours. Given declining fertility rates and an aging population that consumes less and is less in the labor force, growth over time has dropped below historically normal levels. We’ll defer this discussion to another time, but note that this will be a headwind going forward.

The other component of growth, productivity, can be subdivided into technological progress—the Internet or computers, for example, and before that the fax machine and the telephone—and capital investment. If a business invests in a new machine that lets it produce more in the same time, that is productivity enhancement. If a business can redesign its processes so it can produce more, that is productivity enhancement. Technological change, like population, can be effected by government over the longer term, but it is difficult to effect in the short term . . . which leaves us with capital investment.

The question, then, is whether and how government can support growth. In some areas, there’s no question that it can. For example, direct governmental capital investment in infrastructure, if wisely done, can generate not only immediate jobs and economic activity but also provide the foundation for future productivity increases that more than pay for the initial cost. The interstate highway system, which more than pays for itself over time, is the poster child for this type of spending.

Other areas are more questionable. The increase in the minimum wage, for example, will indeed raise the incomes of minimum-wage earners, as long as they keep their jobs. The work of many of those making the minimum wage is worth that amount—otherwise they would get higher-paying jobs—so if you raise the minimum, many people currently employed at the lower rate won’t be worth the new, higher rate and will lose their jobs. The net gain in income after all is said and done might or might not be positive and, in any event, will price many out of the job market, especially younger workers who haven’t yet developed marketable skills.

Growth, when it happens, will come from business investment in equipment, personal investment in increasing skills through education, and investment in infrastructure, whether public or private. To the extent proposed government action supports any of these, it will be growth-positive. If not, such programs will be growth-neutral at best. There’s certainly a case for growth-neutral spending if otherwise justified, but it won’t solve our problems as a country.

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