The Sources of Productivity Growth
If productivity is the key to solving the aging crisis, what policies can increase productivity? Throughout history, productivity was enhanced by the creation of new machines: the cotton gin, the steam engine, railroads, automobiles, and telephones. Since these machines required capital to build, and this capital had to come from savings, many assumed that increases in saving would spur capital formation and hence productivity growth. This is why economists suggest that the United States increase savings to increase productivity and mitigate the impact of the age wave.
But this hypothesis, that extra savings will significantly boost productivity, was put to the test in the mid-1950s by the pathbreaking work of Professor Robert Solow of the Massachusetts Institute of Technology, for which he received the Nobel Prize in 1987.4 I studied under Professor Solow when I received my doctorate in economics at MIT, and I was fascinated with his finding that capital investment—all those machines, plants, and equipment that firms buy and utilize for production—is responsible for only a small part of the increase in productivity throughout history.
As noted above, most economists had previously thought that increases in the capital stock—the sum of all machines, factories, and other fixed assets—were the major source of productivity growth. But Solow’s research showed that productivity growth primarily came from other sources such as invention, discovery, innovative management philosophies, or just plain old learning by doing. Most of these sources did not require heavy capital expenditures or higher savings.
When capital was needed in our entrepreneurial economy, venture capitalists always were able to attract funds for promising new ideas, no matter what the savings rate. The development of the Internet and the fiber-optic revolution began in the United States when our personal savings rate was extremely low. Japan, which has one of the highest savings rates in the world, had very low productivity growth in the 1990s, while the United States, with a low savings rate, had strong productivity growth.
Japan also shows that it is possible for countries to save too much and actually reduce living standards. This was considered a theoretical curiosity when I was studying at MIT. But recent evidence has convinced me that the high savings rate in Japan has done little to boost its economy. In the 1990s the Japanese government, in a vain attempt to stimulate economic activity, sharply boosted public investment in bridges and roads, but these had very low returns. There is also evidence that much of the investment undertaken by the private sector in Japan also had a low, if not negative, rate of return.5
If savings were the answer to our demographic problem, then Japan, the country with the highest savings rate in the developed world, should have absolutely no worry about the aging of its population. But that is not the case. Paul Hewitt, an economist who has researched global aging, declares, “Most of Japan’s economic ills either arise directly out of, or are being exacerbated by its demography.”6 The Economist further states, “The bad news, however, is that even though the economy has sped up for a bit, Japan’s runaway demographic trends still threaten to leave it in the dust.”7
If increasing savings isn’t the answer, what is? Paul Romer, an economist from Stanford University and founder of “new-growth” theory, suggests that the most important source of productivity growth is the stock of ideas and inventions. My own research supports this view. Very few innovations are developed from scratch, where no previous knowledge or information is assumed. In fact, most inventions are simply extensions, combinations, and rearrangements of past inventions.
Romer believes that to spur invention and productivity growth, the government should either grant tax subsidies for research or direct more of its own funds toward this end. But government-directed research has its own pitfalls. Take the significant funds devoted to government-directed research in the U.S. space program. Putting a man on the moon was a wondrous technological achievement that gave Americans great pride in our country. But it is arguable whether the NASA space program has delivered significant private benefits, especially compared to a similar amount of funds funneled into private research. Academic research also suggests that indicative planning, a practice whereby the government sector tries picking “winning” industries and directs public funds to that end, has been unsuccessful.8
Historically, bursts of innovation, from the railroad to the automobile to the Internet, have come from the private sector, and investors willingly fund projects believed to be commercially profitable. Even though private capital markets go through euphoric and depressive episodes, they have proven to be the most efficient allocators of capital. Certainly productivity growth needs capital, but an increase in capital, by itself, produces little productivity growth.
Productivity Growth and the Age Wave
The bottom line is that increased saving has, at most, a modest effect on productivity. Moreover, productivity growth would have to increase dramatically to have a meaningful impact on the age wave.
The rate of productivity growth required to keep the retirement age at sixty-three in the United States is staggering, on the order of 7 percent per year.9 This is more than three times the historical rate of productivity growth, and a rate that has never been sustained beyond a short period of time. If we can raise the rate of domestic productivity growth to 3.5 percent—and this is the maximum the United States has achieved over any ten-year period since the end of the Second World War—the retirement age by 2050 would fall from only three years. Productivity growth within the United States (and most of the developed world) does not solve the problem because retirement benefits are linked to productivity through wages.
This pessimistic assessment of the impact of productivity growth on the age wave in the developed world has been echoed by Alan Greenspan and the Federal Reserve in its studies on productivity growth and the reform of the Social Security System.10 Certainly productivity growth determines the buying power of wages, but the rate at which the developed countries, already at the technological frontier, can increase their productivity is far short of what is needed to solve the aging crisis.
Higher Social Security Taxes Are Not the Answer
Many believe that the age wave crisis can be relieved by boosting payroll taxes today, thereby increasing revenues to the Social Security trust fund. The argument goes that if the Social Security trust fund held more government bonds, this would decrease the amount of government debt held by private investors, allowing these investors to use their savings to fund more productive projects in the private sector.
This solution suffers from two problems. We have already shown that it is unlikely that an increase in the personal savings rate can increase productivity sufficiently to offset the age wave, so an increase in government savings, which is what increased funding of the trust fund accomplishes, is also unlikely to work.
But increasing payroll taxes has another, more pernicious impact on the economy’s ability to cope with the growing number of retirees. Taxes that lower take-home pay discourage workers from working, and taxes that raise employment costs discourage firms from hiring. Just when we need more workers, we would be getting less.
There has been much written in economics on the effect of income and payroll taxes on the incentive to work. Recent evidence strongly supports the proposition that payroll taxes can have a significantly negative impact on the incentive to work. Edward Prescott, a recent Nobel Laureate in economics, wrote a paper entitled “Why Do Americans Work so Much More than Europeans?”11 In it he reported that Americans not only work 50 percent more hours than the Germans, the Italians, and the French, but Americans also take about ten days of vacation a year, while Europeans take six to seven weeks. There is a popular perception that the contrasting work ethics stem from differing cultures; it is widely believed that Europeans have different priorities and simply enjoy their leisure time more than Americans do. As Jeremy Rifkin, author of The European Dream, wrote, “The American Dream pays homage to work ethic. The Eu
ropean Dream is more attuned to leisure and play.”12 But Prescott finds otherwise. Currently European tax rates on wages and salaries are much higher than rates in the United States. But in the early 1970s, when European and U.S. tax rates were comparable, European and U.S. workweeks were roughly equal. Prescott finds the reduced workweek directly related to the rise in payroll taxes.
Confirming this work, Steven Davis at the University of Chicago and Magnus Henrekson of the Stockholm School of Economics, conducted an econometric study of rich countries in the mid-1990s. They also found that higher tax rates are negatively correlated with the number of people working as well as with the number of hours each employee works.13
Perhaps if workers saw these payroll taxes directing flowing into their pension benefits, then the negative impact of higher Social Security taxes on employment would be reduced. But surveys overwhelmingly indicate that workers see the deductions taken from their paycheck as taxes, not as “contributions.”
And from a legal standpoint, they are perfectly right. Two Supreme Court cases have confirmed that the Social Security (and Medicare) taxes carry no implied right to a future benefit. In 1937 the Supreme Court wrote, “The proceeds of both [employee and employer] taxes are to be paid into the Treasury like any other internal-revenue taxes generally, and are not earmarked in any way.” In 1960 the Court further affirmed, “To engraft upon the Social Security system a concept of ‘accrued property rights’ would deprive it of the flexibility and boldness in adjustment to ever-changing conditions which it demands.”14
The perception of Social Security being a tax instead of a contribution to a personal retirement account carries much significance. If the current 12.4 percent tax on the first $87,900 of wages (2004 levels) were allowed to accrue directly to a worker’s savings account that could be used for retirement or even major purchases such as a home, the positive incentive effects on work effort, not to say savings, could be significant.
Although I do not believe that an increase in the savings rate will solve the problem caused by the age wave, personal accounts are a far more attractive option than trying to increase government savings through higher taxes.
Immigration
Because the decrease in the number of workers causes the scarcity of output, immigration might be seen as the answer to the problem. If workers are added at a young enough age, they could provide labor services for many years before collecting pension benefits.
The number of immigrants needed to keep the retirement age of Americans at sixty-three depends on assumptions such as the average age of the immigrant, the average number of dependents per worker, and the workers’ skill level. Assuming that the average immigrant upon arriving in the United States earns one-half of the average per capita income of Americans, the number of immigrants needed over the next forty-five years to keep the retirement age constant is over 400 million, far in excess of the current U.S. population. The reason the number is so high is that immigrants also have dependents, use government services, and receive pension benefits upon retirement, putting more strain on the system.
There is much debate over the right immigration policy, and I personally favor liberalizing the laws governing immigration. However, it is unreasonable to expect that immigration can by itself solve the aging problem of the developed world.
What to Do?
The traditionally offered solutions to the aging crisis are seriously flawed. Although increased savings is a worthy goal, it will have limited impact on reducing the retirement age. Productivity growth, the commonly cited answer to the problem, has limited impact because benefits are themselves largely tied to productivity, offsetting its ability to solve the crisis. Higher taxes and increased immigration are also not the answers. Like Thomas Edison, quoted at the head of this chapter, I believe we have found many results that won’t work.
But this does not mean that we should be resigned to the consequences of the age wave. There is a source of productivity growth that offers much hope. Not only do China, India, and other developing countries stand on the brink of rapid economic expansion, but their huge populations have an age profile that is sharply different from that of the developed world. Bringing more people into the production process can solve the age wave crisis. Immigration was needed in the 19th and early 20th century to bring workers to the most advanced technology. Now state-of-the-art capital is being brought to the workers anywhere in the world.
Can the growth in the developing world, which today produces only a fraction of the world’s output, truly offset the pernicious impact of the age wave? That is the topic of the next chapter.
CHAPTER FIFTEEN
The Global Solution:
THE TRUE NEW ECONOMY
Some men see things as they are and say, “Why?” I dream of things that never were and say, “Why not?”
—George Bernard Shaw, 1949
Has demography—the future that cannot be changed—doomed the developed world to a much shorter and less affluent retirement and investors to falling asset prices? After analyzing our aging economy, a good case could be made for this dismal scenario. But this grim conclusion is based on a far too narrow view of the world.
Historically, the young have earned enough to provide both for themselves and the elderly. Some of this income is transferred through government pension programs, such as Social Security. But in the rich countries, the elderly largely finance their retirement by selling their assets and using the proceeds to fund their needs. This symbiotic exchange of the young’s earnings for the older generation’s assets is how the young generation accumulates its wealth and the retirees support their lifestyles.
Markets for financial assets allow this exchange to work over wide geographic areas. For example, no one fears that the state of Florida will fall into an economic slump because there are not enough workers in the state to provide for its huge retirement population. We know that the consumption of Florida’s elderly can be supported by importing goods and services from the younger population in the remaining forty-nine states. Furthermore, Florida retirees have no problem selling their assets to younger investors in the rest of the country.
But very soon, the elderly will reside in all fifty states and in Canada, Europe, and Japan. Who will buy their assets when they retire?
Expand your horizons and think of the world as one economy instead of separate nations, each one attempting to provide goods for its own citizens. Although the developed world is aging rapidly, the rest of the world is very young. Take a look at Figure 15 1. This shows the age profile of India, China, and the rest of the developing world. The young of the world can produce the goods for, and buy the assets from, the retirees of the developed world. For more than 80 percent of the world’s population, there is no age wave.
Can the aging populations in the richer countries in fact be supported by the young workers in the developing world? Right now the answer is no. The developing countries, despite having more than 80 percent of the world’s population, produce less than one-quarter of the world output measured in dollars.
But something extraordinary is happening in these young, developing countries. For the first time, China and now India have launched into a sustained period of rapid growth. Their growth, if it can continue at the levels achieved over the past decade, will have an extremely significant effect not only on their countries but on the rest of the world as well.
FIGURE 15.1: DEVELOPING WORLD POPULATION PROFILE 2005 AND 2050
Figure 15.2 shows how higher productivity growth rates in these developing countries can impact the retirement age in the rich countries. And the impact is dramatic.
If the developing world can increase productivity at 6 percent per year over the next several decades—and this rate has long been surpassed in China and has now been achieved in India—then the retirement age of the boomer population need rise only modestly. On the other hand, if the developing world stops growing, the retirement age in the United States would have to rise
from sixty-two to seventy-seven. As can be seen in Figure 15.2, each 1 percent increase in developing-world growth rates equates to about two extra years of retirement for the developed world.
Growth in the developing world will be fueled by the explosive growth of exports to the aging world. These young countries must find an outlet for the dollars, yen, and euros they receive from their exports. Despite the rapid growth in their own economies, they will find U.S., European, and Japanese assets attractive for their brand names and their managerial, marketing, and technical know-how. The Indian-based Tata Tea’s acquisition of the global giant Tetley and the Chinese Lenovo’s acquisition of IBM’s personal computers are just the tip of the iceberg. The next half century will see a massive exchange of goods for assets that will not only shift the center of the world economy eastward but also negate the destructive impact of the age wave on asset prices and retirement opportunities.
FIGURE 15.2: PROJECTED RETIREMENT AGE FOR DIFFERENT GROWTH RATES OF DEVELOPING COUNTRIES
I call this the global solution.
I admit that the global solution is not the conventional wisdom. It depends on sustained rapid growth in the developing countries. Doubters can point to flashes of growth in many parts of the globe that subsequently died out. At the turn of the twentieth century, Argentina was one of the ten richest countries in the world before going into a long decline. More recently the “Asian tigers”—Thailand, Taiwan, the Philippines, and South Korea—stumbled during the currency crises of the late 1990s. Communism, socialism, and other anti-market policies have squelched much development throughout history.
But something very different is happening today. I believe the world is ripe for a dramatic change. The communications revolution, which caused so much pain to investors in the telecom industries, ultimately planted the seeds for the global solution.
The Future for Investors Page 21
