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The Growth Solution

From the July/August 2008 Issue

With America's new economic realities, an entrepreneurial agenda is in order.

Huge domestic challenges confront our next presidents (none of which is fully resolvable by a single president): ensuring greater access to and affordability of healthcare, addressing our looming entitlements crisis, making significant headway against poverty, and restraining man-made climate change.

By the policies they champion, our future presidents can have an important impact on how rapidly our economy grows. Continued growth in per capita incomes, generated through ongoing improvements in productivity, is what drives improvements in living standards. Faster growth also will give us more resources to address each of our major domestic and foreign policy challenges.

Of course, government does not generate growth. But the private sector’s success, and thus the pace at which the economy advances, depends heavily on the rules, incentives, and basic infrastructure that government sets and provides.

None of our long-run challenges or the opportunities afforded by faster growth will be achieved in the future without continued innovation—new products, services, technologies, and ways of doing things. Indeed, given the challenges ahead, we submit that in each case radical innovation is called for.

A quick look back through American history reveals that many of the most important radical innovations in the past—the telegraph, telephone, radio, television, automobiles, airplanes, computers and the software that operates them, and many of our current Internet-based successes (Google, Amazon, eBay)—have been introduced and commercialized first by entrepreneurs. What all of us, regardless of our political affiliation, should want in our next presidents and in our other governmental officials, therefore, is an understanding of the need to promote policies that will best foster the entrepreneurial spirit that drives radical innovation. 

The central task for policymakers is to ensure that our entrepreneurial revolution continues, and that we do not revert to anything like the Big Firm economy we once had.

We begin with the goal of rapid growth because it is so central to realizing all of the other objectives. It also has long had bipartisan support. For Republicans, of course, growth has been a central goal for some time. In 1980, President Reagan famously helped usher in the so-called “supply-side” revolution, which was all about increasing the economy’s long-term potential growth rate. What many Democrats today may forget is that two decades before, when John F. Kennedy ran for president in 1960, the Democratic platform also had its own, quite specific supply-side objective (although it was not labeled as such then). The 1960 platform urged policies that would enable the economy to grow at about 5 percent a year, more than a percentage point faster than the previous decade, and a growth rate not attained on a sustained basis any time since. 

Indeed, for two decades after the 1973–1974 oil shock, the economy grew at only 2.5 percent, or half the target set by the 1960 Democrats. From 1994 to 2000, annual growth jumped to 4 percent. Even after the 2000–2001 recession, and until the downturn this year, the economy still grew at roughly a 3 percent annual rate. What happened? 

The conventional wisdom is that, beginning in the mid-1990s, growth surged because of the information technology (IT) revolution. Productivity advanced rapidly in the manufacture of computer chips, the heart and soul not only of computers but also of an increasingly wide array of products (such as TVs, appliances, cars, and airplanes). In addition, the diffusion of computers, easy-to-use software, and the Internet goosed productivity at organizations throughout the economy.

The conventional wisdom is right, but also incomplete. Think for a moment about which firms made all this IT so easy to use. The answers that immediately come to mind are companies like Microsoft, Apple, Sun Microsystems, Intel, Oracle, and Google, firms that did not exist or were in their infancy as recently as 30 years ago. But the success of these entrepreneurial enterprises made it possible for the rest of us to change the way we live and for the firms we work for, or run, to churn out more products and services with ever fewer people.

It has not always been this way. Coming out of World War II and continuing through the late 1970s or early 1980s, the U.S. economy was very much driven by the success of large firms—Big Steel, the “Big Three” auto companies, and the old AT&T. Ours was a system of “Big Firm” or “managerial” capitalism, much like the capitalisms of Western Europe and Japan even today.

The Democrats’ 1960 platform urged policies that enabled growth of 5 percent a year, more than 1 percent faster than the previous decade, and a rate not sustained since.

For the first quarter century after the war, managerial capitalism worked: the economy advanced, with ups and downs to be sure, at a relatively rapid annual rate of 3.5 percent. But then the economy began to run out of gas—figuratively, if not literally—once the oil shock hit. The strength of large firms, their efficiencies in mass production and enviable records in continued innovation, became their weaknesses. In a new economic environment of higher energy costs and increasing globalization, large firm bureaucracies had difficulty adapting. The Big Firms here lost ground to their overseas competitors.

We were told by some that unless we copied the industrial policies that favored large firm growth in Western Europe and Japan, we would soon lose our economic preeminence.

The pessimists were wrong. They completely missed the rise of entrepreneurial capitalism, which renewed America’s strength by ushering in the innovations that have transformed our economy. Meanwhile, the economies we were told to copy struggled.

Looking ahead, rapid growth could not be more important. Thirty years hence, per capita income will be roughly 35 percent higher if we can grow at the 4 percent annual rate we achieved in the last half of the 1990s, rather than the 3 percent annual rate that many now optimistically project for the future. Over a century, the difference between the two annual growth rates would be even larger: the economy would be three times larger if it grew by 4 percent annually instead of 3 percent.

But what can be done to maximize our chances of growing at the more rapid clip? The clear lesson from our recent past is that once the U.S. economy recovers from the current downturn, the central task for policymakers is to ensure that our entrepreneurial revolution continues, and that we do not slip back into anything like the Big Firm economy we once had. To accomplish this, at the very least, will require attention to the following matters.

Build a skilled workforce: Entrepreneurs tell us that finding skilled workers, especially those with math, science, and engineering skills, is one of the most difficult challenges they face. In its continuing efforts to leave no child behind by focusing on students’ performance on standardized tests, the federal government must also allow and encourage schools (at all levels) to experiment with ways of stimulating students’ interest and creativity in math and science, as well as their interest in pursuing entrepreneurial careers. This may be accomplished by adding other benchmarks to the existing federal requirements or awarding incentive monies to schools in low-income areas that show significant increases in the number of students taking advanced subjects in these areas.

Welcome high-skilled legal immigrants: With so much attention focused on illegal immigration policies, lost in the shuffle are the nation’s highly skilled legal immigrants, many of whom are here on short-term H-1B visas and may eventually have to leave the country. In light of recent research indicating that immigrants are founding or co-founding fully one-quarter of high-tech companies, this outcome could not be more unfortunate. Rather than continuing the “small ball” debate over how many temporary H-1B workers to admit, it’s time to act much more boldly: increase the number of student visas and give a permanent green card automatically to foreign students who earn degrees in science, math, or engineering at U.S. universities.

Create a more balanced intellectual property rights system: One of our strongest incentives for commercially useful innovation is the patent, copyright, and trademark protection we give to inventors. But in recent years, the patent system in particular has come close to the breaking point. The U.S. Patent and Trademark Office (PTO) is overwhelmed with patent applications and has a growing backlog, while patents granted for “obvious” innovations are cluttering the economy, making it more difficult for entrepreneurs to enter markets without paying what amounts to ransom to some patent holders.

Recent Supreme Court decisions may help restore some balance to the intellectual property system by establishing stiffer tests for patent applicants to prove their inventions really are novel. The legislation that Congress is currently considering to create means of resolving patent disputes outside of the formal court system also could help.

But the best hope for lasting reform may lie outside the law. Currently, the PTO is experimenting on a limited basis with an “open source” system that allows people from outside the agency to assess whether applications are novel. In effect, this technique draws on the “wisdom of the crowd” for its intelligence and experience rather than continuing to rely on a few agency experts to make this assessment. Assuming this experiment proves to be as promising as it sounds, the next president should urge the PTO to adopt and Congress to accept this new way of assessing patents much more broadly.

Ease Americans’ anxieties about trade but maintain and further open global markets: Many Americans feel threatened by global trade. But the evidence is overwhelming that trade expands our welfare by giving us access to cheaper goods and granting wider opportunities to market our goods and services abroad. Indeed, every one of the entrepreneurial companies that helped usher in the IT revolution has benefited handsomely by being able to sell abroad, while using talent from all over the world to continue innovating.

Welcome high-skilled legal immigrants: give a permanent green card automatically to foreign students once they earn degrees in science, math, or engineering at U.S. universities.

Keeping markets open at home and abroad will be critical to birthing the next wave of radical innovation. Consider, for example, the huge incentives that await the future innovators of carbon dioxide–reducing technologies by reaching a global customer base. The “pull” of the global marketplace will only grow stronger as other economies grow richer, an outcome that will depend, in part, on keeping the U.S. market open to the goods and services of others. Conversely, because our commitment to open markets has encouraged other countries to relax their restrictions—to our products, and to those from other countries—a shift in direction on trade on our part risks ending liberalization abroad and possibly sparking a tit-for-tat process of retaliation that will harm everyone, everywhere.

Since health insurance is tied to employment, improving access to affordable healthcare and insurance would go a long way toward easing workers’ anxieties. So would a program of wage or income insurance that would reimburse, for a limited time, a portion of any income loss displaced workers may face when accepting new jobs that pay less than their old ones.

Entrepreneurial solutions are essential not only for sustaining rapid growth, but also to help meet our various domestic challenges. Consider first our “entitlements challenge.” Even if many citizens are not yet aware of the problem, every elected federal official and presidential candidate should know what the Congressional Budget Office (CBO) and Government Accountability Office have been saying for years: that, on the current course, spending for the three major entitlement programs—Social Security, Medicare, and Medicaid—eventually will lead to growing and economically unsustainable federal budget deficits. Further, of these three, the cost projections for the two medical programs are by far the most worrisome.

The current structure of health insurance is the key impediment to the development and diffusion of new methods of more cost-effective healthcare delivery.

The CBO has highlighted that projected healthcare inflation is the dominant reason for the rapid escalation in costs. This raises a potential “outside the Beltway” entrepreneurial solution that could ease the pain of the conventional political solutions: Why can’t there be healthcare discounters, much like the big-box retailers or discount airlines, that bring greater efficiency to healthcare delivery and slow the rate of cost escalation? Put differently, what might induce such entrepreneurs to come forward to make an impact?

For answers, just look at the way that health insurance currently operates. In a “market” in which few insured consumers pay directly out of pocket more than a small co-pay, why would any of them have an incentive to look for less expensive healthcare? Knowing this, it is little mystery why no chains of general purpose or specialty healthcare providers have developed: they have no market to appeal to under current insurance conventions. For the same reason, hardly any physicians or doctors display or even advertise their prices; for consumer-patients, price simply does not matter.

In short, the current structure of health insurance—both inside the two medical entitlement programs and in the rest of economy—is the key impediment to the development and diffusion of new methods of more cost-effective healthcare delivery, to more competition in the healthcare delivery market, and even to the development of new technologies that might save money rather than continue to contribute to price and cost escalation. To have a chance at achieving any one or all of these favorable outcomes requires health insurance policies to have much higher deductibles, if not across the board, then at least on a means-tested basis. In this way, consumers will have reason to view medical care like they do any other product and service in our economy: as a valuable and indeed essential service, but also one whose price actually does matter. There may be many ways to do this, but one might be to provide tax incentives to employers that require all employees to have means-tested Health Savings Accounts (which currently are voluntary at the employee level, and thus may tend to attract only those who believe they are healthy, leaving less healthy individuals in the low-deductible plans).

We realize, of course, that in suggesting that health insurance and Medicare move in the direction of covering catastrophic healthcare outcomes rather than everyday office appointments and routine treatments, we are running against the grain of current healthcare proposals to extend the current low-deductible coverage to many of the currently uninsured, or even perhaps to everyone. But before policymakers go too far down that path, we suggest they pause and think of the long-run implications of such efforts on the growth of future healthcare costs. By tweaking the current ideas for health insurance reform to give far greater incentives for entrepreneurial and market-based solutions to the cost escalation problem, policymakers also would give voters and themselves a far better chance of cutting the future fiscal problem down to size.

Entrepreneurship and radical innovation have long been hallmarks of the American experience and keys to our success.

Reducing poverty: After falling precipitously after World War II due largely to rapid income growth in the economy, the official poverty rate has remained stuck in the 11 percent to 15 percent range for over 40 years. Looking ahead, it is almost surely the case that something more than growth will be required to get the poverty rate down significantly. Simply handing out money won’t cure the problem, since this would not give the skills to the poor that would make a permanent difference in their lifetime earnings. Also, enlarged handouts would only aggravate what appears to be a deeply rooted cultural problem by perpetuating dependence on government.

Any part of an effective solution requires a radical change in education that will dramatically reduce the appalling dropout rates that doom far too many of our children to low-income or poverty-level adult lives or to lives of crime, and which contribute to teen pregnancies that help transmit poverty from one generation to another.

As economists, we believe that incentives matter. Since high school graduation and even college attendance are critical for breaking the cycle of poverty, why not design new incentive structures for those on the educational front lines—teachers and principals—that reward these results? For example, the federal government could fund a new performance-based bonus for teachers and principals in schools with high proportions of students from low-income families, with the bonus tied specifically to the high school and even college graduation rates of their students.

In effect, such a system would give teachers and principals in schools with the worst dropout rates incentives not just to raise students’ one-year test scores, but to instill in students the desire and knowledge that it takes to finish high school and go on to college. Teachers that have these goals in mind would teach, from the day students start school to the day they graduate, very differently than many do now. And principals would have new incentives to encourage their teachers to approach their jobs in a wholly different way, and also to offer to students who won’t go on to college courses that will qualify them for high-paying technical jobs and thus give them an economic reason to finish high school. Who knows what other new approaches principals and teachers throughout the public school system would adopt?

Addressing climate change: For all the political posturing about what to do about man-made climate change, one thing is certain: any meaningful progress to address global warming will require the commercialization of new technologies that reduce or sequester carbon dioxide emissions. How can government maximize the chances that entrepreneurial solutions will emerge here?

Government support of more basic research will help, but it is not the only answer. Government must also ensure that the “price of carbon is right”—that the cost of all products and services that lead to emission of carbon reflect the social cost that carbon imposes through the “greenhouse effect” or possibly through other means. Only when this occurs will entrepreneurs have appropriate incentives to commercialize new technologies, and consumers will have the same incentives to conserve or use products or technologies that are less carbon-intensive.

Why can’t there be healthcare discounters, much like the big-box retailers, that bring greater efficiency to healthcare delivery and slow the rate of cost escalation?

The “cap-and-trade” plans for CO2 backed by the current presidential candidates are positive steps forward, since each would have the government create a market in—and thus put a price on—CO2 emissions. It’s true that most economists would prefer a direct tax on carbon emissions instead of a cap-and-trade system. But both approaches place a price on CO2, which is the first step in getting incentives aligned to address the problem adequately.

But policymakers must resist having the government, rather than the market, choose technologies. Here we refer to the subsidies or tax incentives for a range of biofuels. It is now becoming clear that such incentives will do more damage than good by encouraging de-vegetation that reduces the planet’s ability to absorb CO2 and increasing world food prices, which then fosters further social unrest. Entrepreneurship and radical innovation have long been hallmarks of the American experience and keys to our success. Let us hope that our future presidents and policymakers recognize that as they lead us in taking on the next great challenges of our times.

Carl Schramm is president and CEO of the Kauffman Foundation and Robert E. Litan is vice president for research and policy at the foundation. This article highlights themes from their next book, “Better Capitalism” (to be published by Yale University Press).

Illustration by Brucie Rosch.

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