The Microchip Flexes Its Muscle Can It Complete With

The Regional Economist • July 2001

The Microchip Flexes Its

Can It Compete with History's Best?

By Kevin L. Kliesen and David C. Wheelock

he U.S. economy has experienced more than 18 years of uninterrupted growth since the end of the 1981-82 recession. The lone blemish during this so-called Long Boom was a recession lasting just nine months, from July 1990 to March 1991. But what T has so enthralled many economists is not the length of the boom but the accelera- tion in the economy's rate of productivity growth during the last half of the 1990s. Most economists who have attempted to explain the cause of this productivity boom point to the spate of innovations and technological advances associated with the microchip, which has spurred heavy investment in high-tech information and communica- tions technology equipment and software. Many questions about the pro- 'We are witnessing nothing ductivity boom remain, however: less than the rise of a digi- tal economy and a new Why did it take so long to begin? global medium that will be How long will it last? the single most important Can public policy do anything to encourage productivity booms and driver of business, eco- lasting increases in economic growth? nomic and social change in the coming century."1 Our current boom period appears similar to past eras of rapid techno- logical progress and economic growth. In the late 19th and early 20th — Louis Gerstnerjr., centuries, advances in the distribution and usage of electric power, new chairman of IBM processes for making steel, development and application of the internal combustion engine, and expansion of the chemical industry and numer- ous other important sectors delivered impressive gains in manufacturing productivity and the standard of living. Like our current experience, however, a consider- able delay occurred between the introduction of new technologies and measurable increases in aggregate productivity growth. Once productivity and economic growth began to accelerate, however, they remained high for several decades. What can we learn from history that might be relevant for understanding our current productivity boom and for understanding whether public policy can play a constructive role in fostering sustained growth in living standards?

The Importance of Productivity Growth Economists and policy-makers pay so much attention to productivity growth for a simple reason: The more productive the nation's workforce becomes, the higher will be its citizens'

[5] standard of living. In the United States, which was centered in the United States per capita real gross domestic product at the end of the 19th century. Faster rose by 2.2 percent per year on average TFP growth explains more than 70 per- from 1929 to 1994. At this rate, the aver- cent of the acceleration in British per age American's living standard doubles capita income during the First Industrial about every 33 years. But if per capita Revolution, according to Northwestern GDP increases at a 3.4 percent annual University Professor Joel Mokyr. An rate—its growth from 1995 to 2000—then examination of the Second Industrial only 21 years would be needed for living Revolution also shows that aggregate standards to double. (See chart Page 7.) output growth accelerated once the What causes productivity growth new technologies had become widely rates to speed up or slow down? Clearly, adopted in U.S. manufacturing and improvements in the quality of labor had precipitated a marked acceleration Productivity Boom input, such as a more educated work- in TFP growth. force, do. An increase in the quantity of Economists now debate whether the By the Numbers capital per worker—known as capital computer revolution measures up to the deepening—also increases average labor great industrial revolutions of the past. Real gross domestic prod- productivity over time. In recent years, If so, we may see a sustained accelera- uct—the broadest measure of the economy's production this phenomenon has been especially tion in TFP growth as in past industrial of final goods and services— important, as sharp declines in the prices revolutions. That the U.S. economy has grew by about 4.5 percent a of computers, software and other infor- stretched the bounds of growth previ- year during the last half of the mation and communications technology ously thought unattainable a generation 1990s. Roughly a percentage equipment have caused businesses to ago suggests that the microchip revolu- point faster than its long-run dramatically ramp up their spending on tion has engendered some economy- average, this growth was strong enough to push the such things. wide benefits. Nonetheless, some civilian unemployment rate Besides changes in measured labor reputable economists believe that previ- down to about 4 percent by and capital inputs, productivity can ous episodes of innovation were much the end of 2000, a rate not increase for other reasons. To capture more significant and that the strong pro- seen since 1970. these reasons, economists use the con- ductivity growth of recent years is but a Conventional economic cept of total, or multi, factor productivity temporary phenomenon. The jury is still theory holds that an economy's (TFP). In general, labor productivity out. But since maintaining this prosperi- capacity for growth largely depends on the productivity growth—and, hence, growth of living ty for future generations is the overarch- of its work force. This is not standards—is a function of capital deep- ing goal of public policy, policy-makers to say that other factors cannot ening and TFP growth. would like to have some insight into also influence economic growth. Broadly, TFP growth is a measure of those forces driving the recent accelera- For example, this heartening the economy's rate of innovation, or tion in labor productivity. Maybe some- performance of the late 1990s technical progress, over time. Though thing can be learned from the past. occurred against the backdrop of low and stable inflation, perhaps a nebulous concept to non- economists, technical progress can be suggesting that sound mone- Productivity Puzzles, tary policy may have helped. thought of as the myriad improvements Past: and Present: In the end, however, it to standard of living arising from inno- appears that the key develop- vations that allow firms to produce new Citing technological advances stem- ment of the last five years goods and services or to reduce the cost ming from the microchip, some observers has been an enhanced rate of existing goods and services. Some of recent economic developments have of labor productivity growth. concluded that the U.S. economy has The most commonly used examples are: measure of productivity is aver- entered a new era. Federal Reserve age labor productivity (output • Medical advances that improve Chairman Alan Greenspan, for example, per hour). Since the beginning health care; said, "When historians look back at the of 1996, nonfarm business • More-powerful computers and latter half of the 1990s a decade or two sector productivity has grown improved software; hence, I suspect that they will conclude at an annual rate of about • Increased efficiencies associated we are now living through a pivotal 3 percent, far above the roughly 2 1.25 percent average annual with the Internet, such as e-com- period in American economic history." rate of increase from 1973 merce; Nonetheless, the rapid growth of U.S. to 1983. Productivity growth • Satellite- and land-based communi- productivity since 1995 has easily pro- during the past five years has cations technologies that lower the duced more questions than answers: even exceeded the exceptional cost of acquiring and disseminating gains of 1950 to 1973, when • Why did the productivity surge output per hour grew by almost information; 2.75 percent per year. • Cars and airplanes that use less fuel; come about? and • If information technology is the story, • More-efficient means of growing why did productivity not accelerate and producing food. sooner, when fundamental techno- logical breakthroughs began to occur? Historically, TFP growth has been an • Can the increase in productivity be important cause of economic growth. To sustained, or does the surge reflect see this, consider the First Industrial temporary factors that will soon ebb? Revolution, which occurred in Britain • Can public policy play a role in pro- during the 18th and early 19th centuries, moting or sustaining high rates of and the Second Industrial Revolution, productivity growth?

[6] The Regional Economist • July 2001

Historically, productivity booms have For example, at the height of the British followed technological breakthroughs Industrial Revolution (1760-1830) output that had widespread commercial appli- per capita in the United Kingdom grew cations. The industrial revolutions of the at less than 0.5 percent per year on aver- 18th and 19th centuries were associated age, about the same rate as during 1700- with the introduction of new general pur- 60, according to recent estimates. By pose technologies, such as the steam engine comparison, per capita output increased and electric power, which had numerous at an average rate of nearly 2 percent applications throughout the economy. per year from 1830-70.4 The computer also appears to be a gen- According to Mokyr, technological eral purpose technology and an impor- breakthroughs often require further Changes in U.S. Living tant source of the recent increase in developments—or mzcroinventions productivity and economic growth. to use Mokyr's term— Standards Over Time Still, the computer is not a new tech- to make them broadly nology. The first electronic digital com- applicable. For exam- puter was built before World War II, and ple, while Thomas the first microchips appeared in 1970. Newcomen built the The fact that U.S. productivity growth first successful steam did not begin to accelerate until about engine in 1712, it was 1995 long puzzled economists. This not until about 1765 puzzle led economist Robert Solow, a that major improve- Nobel laureate, to quip that the impact ments in the engine by of computer and information technology James Watt made it was observed "everywhere but in the suitable for factory use. productivity statistics." Still-later improve- NOTE: 10-Year annualized growth rote of per capita real GOP. Slowly but surely, the productivity ments, which included puzzle is apparently being solved. A the addition of a governor and rotary The growth of U.S. living standards recent summary of economic research movement, made the steam engine a during the past five years has been published by the International Monetary huge economic success in the 1800s. unusually brisk—a percentage point Fund suggests that approximately 1 per- A technological innovation from faster than the long-run average. centage point of the increase in U.S. the American Industrial Revolution was labor productivity growth during the the electric dynamo, or generator.5 past five years is due to structural— The dynamo, like the steam engine, that is, permanent—forces, mainly the was a general purpose technology. diffusion of information and communi- As with the steam engine, decades cations technology equipment.3 More elapsed between the introduction of important, the evidence suggests that a reliable electric motors and their wide- significant portion of the faster rates of spread use in industry. Some of the Electrification Boosts labor productivity growth stems from delay was accounted an acceleration in TFP growth. for by lags in the development of effi- The Steam Engine, the Dynamo... cient means of In many ways, the absence of imme- electric power genera- diate productivity improvement with the tion and by competi- advent of information processing tech- tion between direct nology was not unlike earlier experiences and alternating cur- with general purpose technologies. As rent. High prices for the pattern of growth during past indus- electrical equipment trial revolutions shows, technological and the fragmented diffusion must reach a critical level before structure of the elec- widespread gains in manufacturing tricity industry also Swim:, >• productivity occur. contributed to the delay. This chart shows the relationship The British Industrial Revolution By the 1920s, electricity was the between the share of electrical power brought the introduction of the steam dominant source of power in U.S. used in U.S. industry and average annu- engine, mechanization of textile manu- manufacturing. Electrification enhanced al TFP (Total Factor Productivity) growth. facturing, bleaching and other chemical productivity by affording greater flexibili- By the 1920s, electricity provided more processes, the first locomotive engines ty and more efficient use of labor and than 50 percent of the mechanical power and numerous other important inven- capital in manufacturing. For example, in American industry. The switch to elec- tricity from water and steam power tions with broad commercial applications. electrification enabled more use of con- helped bring about a sharp increase in The American Industrial Revolution tinuous process techniques, such as the TFP growth, which was interrupted only brought important advances in the gen- assembly line, which often reduced briefly by the Great Depression of the eration, distribution and application of assembly time and waste. Efficiency 1930s. electric power, the introduction of the was improved also by the wide adoption internal combustion engine and major of "unit drive,"i.e., the use of dedicated SOURCE: David (1991) advances in chemistry, medicine and electric motors to power individual engineering. But in neither case did machines and tools, rather than a system aggregate productivity growth respond of shafts and belts powered by a single immediately to technological progress. engine. Unit drive brought savings

[7] through reduced energy usage, less applications have spawned a burgeoning wear and tear, and more flexible and e-commerce industry. Today, goods and efficient factory design. Electrification services ranging from airline tickets to also enhanced productivity by improv- CDs, from automobiles to clothes, can ing factory lighting and safety. be purchased via online transactions. According to the U.S. Department of ...the Computer and the Laser Commerce, the value of these e-sales Some economists, such as North- increased 24 percent in 2000, from western University Professor Robert $20.8 billion in 1999 to $25.8 billion. 'Old Economy' Firms Gordon, argue that the effects on society (Traditional retail sales totaled $3.2 tril- and the nation's standard of living from lion in 2000.) Online transactions Tackle Productivity today's computer technolo- between firms are also increasing dra- gies pale in comparison to matically and comprise about 90 percent the impact of past innova- of all e-commerce. For example, using tions. While Gordon may business-to-business (B2B) e-commerce be proved correct, evidence applications, Toyota can order up to is accumulating that infor- 11 different automobile frames from the mation and communica- Dana Corp., which can then ship them tions technologies are being to Toyota within nine hours. According used throughout the econ- to the Census Bureau, combined e-com- omy. Not only are New merce trade by manufacturers and Economy startups using wholesalers in 1999 totaled almost $625 them to create products billion, representing, respectively, 12 per- and services few conceived cent and 5 percent, of total shipments.8 of a decade ago, but Old These types of innovations, and Economy industries are future ones that might flow from them, using these technologies to hold considerable promise. Whether trim costs and boost profit today's semiconductor-led innovations margins. For example, will result in a sustained increase in pro- Boeing now uses high- ductivity comparable to the industrial speed, computer-assisted application of electricity in the early machine tools to manufac- 20th century remains to be seen. But ture landing gear bulkheads in exploring the causes of past booms, for the C-17 military trans- we may shed light on what public policy The hot former, such as this one port plane. Under the old can do to promote maximum long-term headed for a Goodyear plant in technology, the bulkhead was made up economic growth. Lawton, Okla., is expected to revolu- of 72 parts and required 1,720 fasteners. tionize tire manufacturing. The hot Using the new technology, the bulkhead former is, in effect, a miniplant for is comprised of just two parts and Old Lessons for New Economy Policy-Makers making tires. Eventually, these laser- requires only 35 fasteners. The bulk- guided machines are expected to be head can now be assembled 15 times During the industrial revolutions of installed next to auto assembly plants. 6 Transportation and inventory carrying faster than before. the 18th and 19th centuries, the inven- costs will practically be eliminated. The commercial application of lasers tion and application of new technologies Goodyear's Rick Vannan shows off is also revolutionizing manufacturing, as were carried out by private individuals his company's former. well as distribution. The use of laser and firms without government subsidies scanning machines in retailing to link the or direction. Technologies that failed the supply chain management process market test were not saved by govern- between the retail, wholesale and man- ment bailouts or contracts. Nonetheless, ufacturing levels, as pioneered by Wal- the histories of the British Industrial Mart, is the best-known example. Such Revolution and the American Industrial developments may have permanently Revolution suggest that governments lowered the level of inventory buffer can have a powerful effect on a nation's stocks in the U.S. economy. In the economic growth. manufacturing process, one innovation that promises to revolutionize tire man- Institutions Matter ufacturing is the hot former. Using a Douglass North, a Nobel laureate laser-guided machine, Goodyear's hot economist at Washington University Boeing workers in Long Beach, Calif., in St. Louis, and his co-author, Barry build the C-17 military transport plane. former will enable a dramatic reduction Thanks, in part, to computer-assisted in the space needed to manufacture Weingast, argue that a nation's institu- machine tools, the landing gear bulk- tires. Putting tire miniplants next to tions, including its government, are cru- head of the plane can be assembled existing automotive manufacturing cial determinants of economic growth. 15 times faster than before. 4 facilities will not only reduce the cost of Among the most important institutions manufacturing tires, but will cut trans- is the rule of law, along with a commit- portation and inventory carrying costs.7 ment to enforce existing property rights. In addition to improving manufac- Secure property rights provide the free- turing and inventory control processes, dom and incentive to take economic synergies between the Internet and risks, to invest in new technologies high-tech equipment and software and to look for ways to use economic

[8] The Regional Economist • July 2001

resources more efficiently. They also Advanced Technology Program, that reduce the cost of market transactions subsidizes high-tech research by private ENDNOTES 1 See http://www.house.gov/ and limit uncertainties associated with companies. The histories of the British jec_democrats/documents/106th/ arbitrary confiscation of property or and American governments during the hearings/gerstner61499.htm. incomplete enforcement of contracts. First and Second industrial revolutions 2 Greenspan (2000). By 1700, the United Kingdom had a show, however, that direct government 3 See IMF (2000X78516 2.1. representative parliament, an independ- sponsorship of new technologies is not 4 N. F. R. Crafts. British Economic required for technological progress and Growth During the Industrial ent judiciary and a system of patents Revolution. NewYork: Oxford to protect the rights of inventors. Other economic growth to occur. Modern University Press, 1985. countries were far behind. For example, examples of industrial policies in Europe, 5 See David (1991). no other European country enacted a Asia and especially in post-war commu- 6 See Duesterberg (2000). patent law until 1791. The U.S. inherit- nist countries also offer scant evidence 7 See Aeppel (2001). ed English legal traditions and respect that government direction can produce 8 See Mesenbourg (2001). for property rights and, thereby, had higher sustainable growth of living stan- 9 See Barro and Sala-i-Martin (1995). similar mechanisms for promoting the dards than can free enterprise. 10 See Romer (1997). invention and application of new tech- What sets the United States apart? nologies that are crucial for productivity Paul Romer, a leading growth economist REFERENCES growth and rising living standards. at Stanford University, notes that "the Aeppel, Timothy. "Mounting Pressure: Under Glare of Recall, Tire Makers are United States has maintained a regula- Giving New Technology a Spin," The Education May Matter tory and financial system that makes Wall Street Journal, March 23, 2001. Educational achievement, particularly it easy to create new companies, raise Barro, Robert J. and Xavier Sala-i- Martin. Economic Growth. NewYork: in math and science, often is cited as capital and start new businesses. We McGraw-Hill, 1995. crucial for economic development. also tolerate failure." By contrast, the David, Paul A. "Computer and the Although the United Kingdom did not European approach "has focused on Dynamo: The Modern Productivity have a superior educational system on what they call 'national champions,' Paradox in a Not-too-Distant Mirror," in Technology and Productivity: The the eve of its industrial revolution, econ- which they identify as a few big firms Challenge for Economic Policy. Paris: omists who have looked at this issue whose monopoly positions they try to Organization for Economic across countries in modern times have protect. That really goes in all the Cooperation and Development, 1991. Duesterberg, Thomas J. "Manufacturing found a positive statistical relationship wrong directions. What the Europeans in the Era of the New Economy: between educational attainment and really should be doing is thinking about Evidence for Sustainable Productivity per capita income growth.9 the process that brings new entrants Gains,"Speaking Out on Critical Issues, 10 Manufacturers Alliance, December The United States has a long history into the market." 21, 2000. of supporting both public and private Greenspan, Alan. "The Revolution in education. 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Even the Communications Industry Association United States has a small program, the (October 2000).

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