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- - Macroeconomics' Technology' and Economic Growth: An hn~oduction to Some Importar~t Issues MICHAEL J. BOSKIN It is incumbent on all of us to attempt to understand the relationship of macroeconomic policy, technical change, and economic growth much better than we do today and to make sure that this information, as it is generated, is used in the evaluation of economic policy. This chapter provides an introduction to some important issues in the interrelationships among macroeconomics, technology, and economic growth. Too often, technology is taken for granted and assumed to be exogenous in the analysis of economists. Similarly, those concerned with technology com- plain about the macroeconomic environment and macroeconomic policy, but have neither the time nor the resources to analyze how the macroeconomy affects technological advances and subsequent economic growth. And among economists? there is substantial division of labor; macroeconomists have little interaction with those economists generally working on issues of technology, and neither of these groups has much interaction with growth economists. My purpose in this chapter is to provide a heuristic, and impressionistic, introduction to various issues and events common to macroeconomics, tech- nology, and economic grown. The next section presents a taxonomy of the major economic issues in macroeconomics: fluctuations in output, employ- ment, and price levels; long-run trends in real economic grown; and issues in the composition of output. It suggests that while economic fluctuations may at times be induced by technological occurrences, and certainly the overall relative stability of the macroeconomy may influence investment in new technology and its dissemination, the major issues in economic fluc- 33

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34 MICHAEL J. BOSKIN tuations are probably less important for understanding the relationship be- tween technology and economic growth than is an understanding of the details of the underlying long-run growth potential of the economy. It also argues that the relationship of technology and economic growth may be substantially affected by what might be called "second-tier macroeconomic policy": the composition of government spending among R&D and investment, on the one hand, and consumption and transfer payments, on the other; the structure of the tax system used to raise given levels of revenue; and the influence of monetary and fiscal policies on the private economy's decision making. The discussion then turns to venous debates in macroeconomics concerning the structure of the economy and the efficacy of economic policy. It introduces some important but subtle issues to the concemed noneconomist. Included are brief discussions of the economic history of the 1970s; current debates among Keynesians, monetarists, "new classical" macroeconomists, and supply-side economists; and my own tentative conclusions concerning some basic issues of macroeconomic policy. The final section returns to the discussion of issues relating to technology and long-run economic growth and provides a partial research agenda on the subject of the macroeconomics of technology and economic growth, given the discussion in the preceding sections. It also points out that the micro- economics of technology and economic growth are likely to be at least as important as the macroeconomics thereof. ISSUES IN MACROECONOMICS RELATED TO TECHNOLOGY Macroeconomics- a study of the overall economy as opposed to that of a particular firm, market, or industry primarily deals win three interrelated issues. First, macroeconomics is concerned with fluctuations in the overall economy, Ocularly fluctuations in output, employment, and the price level. Thus, it is concerned win the causes and consequences of inflation and recession. Analyses of this first issue invariably focus on policies to dampen the amplitude or decrease the frequency of such fluctuations. The primary policies on which such analyses focus are monetary policies (which affect the supply of money and credit to the economy) and fiscal policies (changes in Me rate of government spending on goods and services or in Aces and debt). The primary controversies in macroeconomics concern He potential efficacy of monetary and fiscal policies (or a host of over policies) in controlling economic fluctuations. Based on alternative conceptual models, different evaluations of empirical (primarily econometric) analyses, and the study of historical experience, various schools of thought have developed concerning both He efficacy and the propriety of active use of monetary or fiscal policy in attempting to control economic fluctuations. Some of these different opinions are described below.

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MACROECONOMICS, TECHNOLOGY, AND ECONOMIC GROWTH 35 Second, macroeconomics is concerned with the long-run growth of He economy's potential and actual output. Just as bouts of inflation and persistent unemployment have motivated much of the study of economic fluctuations, so differentials in the growth of various measures of the standard of living motivate much of the analytic and empirical interest ~ economic growth. Across time in any county and across countries over any span of time, differences in growth rates, as in inflation and unemployment rates, can be substantial. This naturally spurs He scientific curiosity of growth economists. What factors are associated with differences in growth rates in the short or long run? And, as usual, not far behind the "positive" economist seeking to explain the observed economic phenomenon comes (often in the same person) the normative economist: How can we increase He growth rate? What is the optimal rate of economic growth? In my opinion, the study of economic growth is as important, if somewhat less suited to the short-run political time horizon, as Hat of economic fluctuations. Modest variations in growth rates compounded over, say, a generation or two, can drastically alter the nature of an economy and a society. One need only look at the performance of the United Kingdom relative to that of the United States, Germany, and France to realize how easy it is for a society to transform itself from the wealthiest on earn to a relatively poor member of the advanced economies. The studies of economic growth usually attempt to decompose the rate of grown of real GNPor some related measure into He contributions of venous factors thought to explain it. These include such factors as increased labor input, increased capital per worker, improved resource allocation, and a general category labeled "technical change." If we are examining the ability of the economy to improve standards of living per capita, for example, then He growth of real GNP per worker will depend heavily on the capital- labor ratio, the rate of technical change, the rate of improvement in the quality of the labor force, and other factors. The phrase "economic growth" is often misused in political and media discussions. Often, these discussions are concerned with growth over a few quarters, perhaps from the trough of a recession. An economist focusing on the long-te~ growth rate has a much longer time horizon and attempts to "net out" cyclical fluctuations. For example, it turns out that increases in real per capita income over the last century in He best-performing advanced economies have averaged a little less than 2 percent per year. While this number is substantially larger in less-developed counties during periods of rapid growth, let us take something like 1.5 to 2 percent as a range of reasonable long-run growth performance. Now, compound real per capita income over two generations in two hypothetical, initially identical economies at 1.5 percent and at 2 percent, respectively. The more rapidly crowing economy becomes one-third again as wealthy as the less rapidly growing

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36 MICHAEL J. BOSKIN economy. Thus, we are evaluating differences of fractions of a percentage point in the long-term growth rate in attempting to assess our growth per- formance. Increasing He growth rate (at minimal opportunity costs) per- manently by a few tenths of a percentage point may not sound very exciting ,, but it is an enormous economic and social achievement. Policies designed to alter the rate of economic growth directly tend to focus on enhancing technological advances, the quality of the labor force, and the level or rate of growth of capital per worker. It is important to note that the only way to raise the long-n~n growth rate permanently is to increase the rate of technical change or to increase the rate at which the quality of the labor force is improved. Loosely, the rate of technical change is affected by R&D expenditures, and the rate of improvement of the quality of the labor force is affected by investment in human capital, such as education and training. A policy that can lead to higher levels of income and a tem- porarily higher growth rate is one that increases the capital-labor ratio (for example, by increasing the rate of investment and net capital formation). But such a policy will lead only temporarily to a higher growth rate, although it will lead permanently to a higher level of income. This is not just semantics. The situation is described in Figure 1, in which we see the economy's original growth path (labeled D, given its presumed (for the moment exogenous) constant rate of technical change. Real per capita income grows at the rate of technical change and labor-quality improvement, given the capital-labor ratio. Now along, comes a policy, perhaps tax policy, that increases the desired capital stock of firms (or perhaps more accurately, the desired wealth of the population, relative to levels of income). This leads to an investment boom for a span of years, which will cause a spurt in the short-run growth rate along the dotted path in Figure 1 until we get to the new long-mn growth path (labeled 21. Note that the level of per capita income is permanently higher along (2) than on growth path (1), but that once the transition to the new growth path is complete, the rate of economic growth (given by the slope of the output curve) returns to the original rate given by the underlying factors of the rate of technical change and improvement in labor-force quality. Anticipating somewhat the discussion below, one is immediately struck by the issue of what caused this rate of technical change. Clearly, it has not been constant; this is just a convenient abstraction. But is it really exogenous? Are there economic policies that can permanently affect it? Are those policies worth the cost of enacting them (for example, foregoing some current con- sumption in order to finance R&O expenditures)? ~ shall return to this issue below. But it is already clear that technology lies at the heart of the second great issue In macroeconomics. Another concern involves the relationship of these two issues of macro- economics. Is it the case that, in an economy subject to wider swings, to booms and busts, Can occur in a more stable economy, the rate of technical change is likely to be systematically different and that, therefore, controlling,

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MACROECONOMICS, TECHNOLOGY, AIRED ECONOMIC GROWTH Ct - Q Cal a' - Q - O Cal a) - - - - 1 - - - - / . 1 to t ~ , O . proinvestment policy leads to higher capital formation and transition to higher level of income. economy resu mes long-ru n growth rate or. throug h i nteractron of invest- ment and technical change. moves to more rapid growth path. FIGURE 1 Alternative growth paths: technical change and capital fonnation. 37 economic fluctuations, if it is possible, might increase or decrease the long- nan underlying rate of growth? And is it possible that in an economy with an environment which promotes long-te~m growth and rapid technological advance, more severe economic fluctuations are more likely? Or less likely? Does the promotion of technological change imply greater flexibility in adapt- ing our institutions to technical change? Or, does it imply greater short-tenn disruption in the economy? Finally, a host of policies designed to protect jobs or the capital in particular industries (e.g., tariffs, government loans, and other subsidies) may impede the adoption of new technology in favor of the short-term goal of mitigating the economic distress caused by economic fluctuations or industry- or region- . ~ . . . specific torelgn competition. While economic growth is good for the population as a whole, its benefits

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38 MICHAEL J. BOSKIN accrue unevenly. Much of our economic policy is designed to promote equity or spread the cost of economic disruption more evenly. Sometimes, unfor- tunately, these noble goals result in policies that impede growth. The third major issue in macroeconomics closely related to the two aboveconcerns the composition of the various components of aggregate output, such as consumption, investment, government expenditures, and net exports. Factors primarily affecting (in the first round) any of these major components of GNP obviously also potentially affect He level of aggregate demand and, therefore, the fluctuations in output, employment, and the price level. It is likely that the policies that most directly affect the generation of new technology, and therefore lon:,-term growth, occur here, one layer down from aggregate GNP, at the level of the components of spending in the economy. For example, while some people still focus on the level of real government spending in the control of economic fluctuations, the composition of that spending among research and development expenditures and physical and human investment, versus payments to individuals for income support, net interest, and purchases on noninvestment types of goods and services, obviously can affect the rate of technical change. Probably the most important of these is direct government support of research and development. Table 1 presents data on recent trends in federal ~,ovemment expenditures on R&D, physical investment, and other categories of government spending. As can be seen from the table, current real government spending on R&D and real government physical investment are both substantially lower as a percentage of GNP than in Me 1960s, although defense investment and defense R&D have made something of a comeback in the last few years. Tax policies make up a second set of policies that, by affecting the way in which the private sector utilizes its resources, can affect the generation of new technology. Again, the first major issue, economic fluctuations, tends to focus on the aggregate level of taxes and changes in total tax receipts. But the structure of the tax system can affect substantially He rate of in- vestment in the economy and the rate of R&D spending by changing the costs of such spending relative to other activities a firm might use to produce its current or prospective new product, and the methods by which it does so. Recent examples include a series of changes in depreciation schedules beginning in 1954, the investment tax credit introduced in 1962, the various swings in the differential treatment of long-term capital gains, and the R&D tax credit, to name but a few. Monetary policy also can affect the composition of output, as well as the level of aggregate demand in the economy. Monetary policy potentially affects the before-tax cost of capital, interest rates and their tea structure, and ~us, the real cost of embarking on R&D or investment projects. Finally, it is important to note some potential interactions among major categories of spending and the rate of technical change. Either of two

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40 MICHAEL J. BOSKIN appealing but difficult-to-document conjectures would imply that a society with a high investment rate would not only have a temporarily high growth rate in its transition to a higher growth paw (as in Figure 1) but actually could increase the long-run rate of growth. These are the so-called learning- by-doing and embodiment hypotheses. The former reflects the anecdotal notion that in the process of investment we learn new ways of doing things, such as new production processes, and new potential products become known. Thus, the rate of investment affects He rate of technical change in a positive manner. This process is displayed by growth path number (3) in Figure 1. At the microeconomic level, consider the options opening up in the course of a major project, e.g., of] exploration in the frozen tundra or the ocean depths. Just as new technologies arise sometimes to meet such chal- ienges, He rate of technical advance may depend on He level of investment. The embodiment hypothesis entails the notion that it is much too expensive to embody new technology in old capital by converting it and, therefore, that the rate at which new technology really does augment the productivity of labor and machinery will depend on the rate at which new capital is generated, i.e., our investment rate. ~ shall return to these issues below. Thus, three very important issues in macroeconomics, which concern the short- and long-run standard of living of our citizens, drive much of our economic policy. They are concerned with economic fluctuations, long-run grown, and a detailed examination of the composition of output. The three issues are interrelated in many ways, only some of which have been hinted at in this discussion. Underlying each issue is He current state of technology and the rate at which new technology enables us to produce more goods and services with the same labor input. Before turning to a more detailed dis- cussion of some of these grown issues and a partial research agenda, I want to develop a framework for analyzing, or at least a perspective on, some of the different schools of thought in macroeconomics Hat get so much press attention. CHANGING VIEWS ON A CHANGING ECONOMY: ALLEGED CRISIS IN ECONOMICS Macroeconomic analysis underwent significant changes in He 1970s as He prevailing Keynesian theories were found wanting in accounting for emerging economic events. Keypesian economics placed great fain in the government's ability to "fine-tune" He economy Trough aggregate demand managementwhich means constant adjustments in He level of taxes, gov- ernment spending, and He money supply. Keynesian analysis stressed He importance of the multiplier effect and the short-run ~ade-off between in- flaiion and unemployment, popularly known as the Phillips Curve. In He Keynesian perspective, policymakers could simply direct policy to achieve

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MACROECONOMICS, TECHNOLOGY, AIRED ECONOMIC GROWTH 41 the most desired combination of unemployment and inflation rates, e.g., they could maintain low unemployment by accepting some fixed, stable level of inflation. Unfortunately, events both worldwide and in the United States in the past 15 years have demonstrated the naivete of these Keynesian models and policy prescriptions. While there is no single model of the economy around which consensus can be reached, substantial strides have been made in improving our under- st;anding of the operation of the economy, which Is much more complex and subtle than had been presumed in earlier models. Since the economic events of the 1970s were so important to the decline in the acceptance of earlier models, there follows a whirlwind tour of the economic history of the 1970s. Economic Events of the 1970s The most important economic event from the late 1960s to the early part of this decade was the tremendous slowdown in economic growth. In the decade from 1973 to 1983, the standard of living for most working, taxpaying Americans improved hardly at all. This contrasts with the roughly 2 percent per year growth in real per capita income discussed above and the 2.5 percent per year growth in the period 1948 to 1973 in the United States. While the cause of the slowdown is disputed, its consequences are not: it was without a doubt, for example, a major cause of the tax revolt. Among explanations advanced for the slowdown are reduced sector-specific rates of technical change, a slowing rate of increase in the capital-labor ratio, energy price increases, changes in the legal environment, shifts in the economy toward services, and changes in the age and sex composition of the labor force. One major school of thought, to which I subscnbe, is that a major culprit in the slowdown was the decline in the incentives to produce income and wealth. Reasons for these declining incentives include rising marginal tax rates, especially on the return on saving and investment; high and rising inflation, which greatly increased uncertainty about the returns on investment and saving; and the growth of government regulation. Undoubtedly, many other causes of the slowdown in growth and, by implication, potential remedies to restore our long-term growth can be found and defended; an exact allocation of the slowdown by cause is still a subject of some dispute, and additional research on the subject continues to be a high pnonty. To place some of these issues in perspective, recall that the 1950s through mid-1960s were years of relatively low inflation, about 2 percent per year, on average. Substantial inflation occurred in the United States primarily with the removal of price controls at the end of wars. We have not experienced anything like the hyperinflation that ravaged Central Europe in the 1920s or the substantial inflation recently experienced in Latin America and Israel. Indeed, by intonational and historical standards, our inflation was quite

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42 MICHAEL J. BOSKIN modest. But recall that our current 4 percent inflation is down from double- digit rates in 1979-1980. To place this in perspective, President Nixon imposed wage and price controls when inflation was no higher than current levels. Certainly the energy price shocks in the 1970s caused a substantial dis- ruption in our economy- most importantly, a transfer of wealth from Amer- ican consumers of energy to producers outside the United States. Although these price shocks and our reaction to them probably contributed to the inflation, increases in energy prices caused no more than 3 percentage points of the double-digit inflation rate in 1979-1980. It was only a few years ago that both economists and politicians understated the cost of high and fluc- tuating inflation and oversold its benefits in permanently reducing unem- ployment. It was common to argue that we could learn to live with double- digit inflation merely by indexing venous features of our contracts, tax system, and the like. Numerous studies, however, such as those by Martin Feldstein, Stanley Fischer, and Franco Modigliani, illustrated how inflation distorts incentives and increases uncertainty about future returns. The 1970s destroyed the notion of a stable Phillips Curve relationship between inflation and unemployment. If there ever was a short-run trade- off, conditions for it have worsened considerably, and it is probably simply a statistical artifact. Government spending increased substantially in the United States in Me 1970s, but more significant was the change in its composition, both by level of government and by type of expenditure. By the late 1970s, exclusive of interest on the national debt, the federal ~,ovexnment was spending more on transfer payments to individuals than on purchases of goods and services (see Table 11. By dollar volume, the federal government's major role by 1980 was to redistribute income, not provide goods and services. While the result was a sharp reduction in poverty, the cost was staggering because the benefits were not targeted very effectively toward the poor. Accompanying the growth of spending, was the large increase in effective marginal tax rates the tax paid on incremental income. The fraction of American tax- payers subject to high marginal tax rates quadrupled between 1966 and 1980. No longer were high marginal tax rates exclusively the right of the rich. While somewhat controversial with respect to measurement problems, the rates of saving and investment in the United States, I believe, have declined substantially, and, in addition, there has been a bias toward shorter-lived assets. The share of GNP devoted to net nonresidential investment fell from the already dangerously low level of 7 percent in the 1950s and 1960s to only 2 percent in the late 1970s. It fell precisely at a time in which it should have been rising to equip the additional (primarily young and inexperienced) 20 million workers with the capital and technology to make them productive. While unemployment remains a problem, an amazing achievement of our

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MACROECONOMICS. TECHNOLOGY, AND ECONOMIC GROWTH 43 economy in the 1970s was that we absorbed 20 million additional workers into the labor force. This influx occurred primarily because of the maturing of the baby-boom generation and the substantial increase in the number of second earners in families, primarily working women. Other major structural changes occurred In the U.S. economy. Besides the demographic bulge described above, the changes included a shin in output away from manufacturing to services, the growth of world trade (sparked by venous rounds of tariff reductions), the move from fixed to flexible exchange rates, and the energy price shocks. Economic policy was also changing. The Kennedy-Johnson tax cut of 1964 was the first major attempt to manage aggregate demand when the economy was not even in a recession. The growth rate was too low, it was argued, and a tax cut could stimulate it. In the early 1960s, inflation in various sectors was dealt with by federal jawboning and threats, such as the proposal to dump excess supplies of government commodities onto the market if prices rose too rapidly. The Federal Reserve Board through 1979 continued activist attempts at managing demand through frequent changes in monetary policy. The 1970s were also marked by schemes to control wages and prices in an attempt to control modest inflation, such as the administrative bureaucracy spawned by various-guidelines under the Carter administration. The notion Tat you could hold down wages and prices and control inflation through moral suasion and presidential support for cooperation between businessmen and unions was at best naive. Thousands of price decisions are made daily and an attempt to keep ~ large subset of them under control would have led to a governmental nightmare so costly as to be beyond any possible gain. Since only about 20 percent of our labor force is unionized, it was strange to believe that hammering the wage demands of the larger unions could be the primary method of controlling inflation. The 1970s also saw the growth of government regulation of energy matters and new social regulations that attempted to correct perceived market failures in such areas as pollution, safety, and health. Fortunately, a general move to deregulation in traditionally regulated activities began in the late 1970s under President Carter. Where were we headed with these economic policies? It is useful to recall various proposals made only a few years ago. One example is the proposal for a national reconstruction bank to help revitalize American industry. An appointed group of business and labor leaders would decide where tens of billions of dollars of badly needed capital would be allocated. Fortunately, we were saved from such a policy, perhaps by the results of the election of 1980. One need only look at recent attempts in the United Kingdom, New Zealand, Mexico, and France, among others, to gain some perspective on direct government capital allocation schemes.

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46 MICHAEL J. BOSKIN ineffective as long as they are anticipated. The new classical macroeconomists conflict with Keynesian analysis in their judgment of the fluidity of market adjustments, the extent to which a full set of markets exists, whether markets clear quickly at competitive pnces, the length of infonnation and recognition lags, and how expectations are formed. Clearly, the failure of Keynesian theory to explain Me major economic problems of the 1970s was a compelling reason for the emergence an acceptance of at least some components of new classical macroeconomics. Many of the new analyses stress the importance of a longer time honzon, the role of expectations, and the role of incentives in the behavior of firms and households, and therefore, the overall economy. Focusing on expectations and time horizons has important implications for both monetary and fiscal policies. Consider what happens when an activist (Keynesian) demand-manager uses a particular short-run macroeconometuc model (call it Model A) to guide the choice of money growth over, for example, a decade. As Lucas (1981) notes: If we can see that Model A gives us an inaccurate view of the "long-run," then we have conceded that it leads us to bad short-run decisions because these decisions are sufficient to dictate our long-run situations as well. (This is not a hypothetical story of the 1980s, is it? It is a history of the 1970s.) A parallel critique of He efficacy of tax cuts to spur spending was elab- orated by Barro in the so-called Ricardian equivalence theorem. Briefly, the argument is that for a given level of government spending, a tax cut really does not increase the wealth of consumers, but merely postpones their taxes, because the present value of future taxes to pay the interest on the new debt will equal the size of the tax cut. Under some fairly strong assumptions about the types of taxes available to the economy, bequest behavior, and other things, Barro demonstrates that there will be no changes in spending and, therefore, no stimulative effect through fiscal policy. Note the impact of expected future taxes and the desire to undo a shift of liabilities to future generations by spending less oneself and increasing bequests. Thus, while only illustrative, the work of the new classical macroeconomists casts con- siderable doubt on the traditional fiscal and monetary remedies for fine- tuning the economy's fluctuations. While Keynesians, monetarists, and new classlca1 macroeconomists were; debating He efficacy of demand management in controlling economic fluc- tuations, a substantial amount of research has also addressed the effects of economic policies on incentives to work, save, and invest. The work of Feldstein, Jorgenson, Heckman, Hall, Hausman, and Boskin, among many others, has revealed that changes in real after-tax refilms to saving, invest- ment, and labor supply have had far greater incentive effect on those factors of production than had previously been ~ought. These studies and others

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MACROECONOMICS, TECHNOLOGY. AND ECONOMIC GROWTH 47 gradually began to have some influence in macroeconomics, as relative pnces, as opposed to just short-run income flows, began to be included in the analyses. The change in emphasis away from short-te~ cash flows to relative prices and away from aggregate demand management to concern about the economy's potential to produce more output and the increasing concern over the slowdown in productivity growth brought with them the name "supply- side economics." The effects of taxes, inflation, and other government pol- icies on the factors of supply are complex. The studies in the 1970s and early l980s form the empirical base for supply-side economics and the counter to the Keynesian argument that the level and structure of tax rates, as well as other policy variables, were of only second-order importance relative to the size of the tax take. Supply-side economics was oversold by many in the recent political-economic history of the United States. There never was evidence that the response to a broad across-the-board tax cut, for example, would be large or immediate enough to be self-financin:,. Debates continue about how large these incentive effects are and how quickly they occur, i.e., what policies will get the biggest bang for the buck. Thus, the growth and productivity slowdown, and new theoretical and empirical research by econ- omists, shifted emphasis in economics toward renewed attention to what was, after all, its original question: the causes and consequences of long-term economic growth. Before turning to a partial research agenda concerning the ma~roeconomy, technology, and economic growth, let me just add that in addition to Me intramural disputes among Keynesians, monetansts, new classical macro- economists, and supply-side growth advocates, a very important set of de- velopments occurred that have influenced the thinking of economists about both short-run economic fluctuations and long-ran issues. This is the tre- mendous internationalization of both trade and capital flows. Until recently, the overwhelming majority of economic analyses, whether Keynesian or monetanst, with or without rational expectations, were done in the context of closed economies. The conclusions of many of the traditional analyses are subject to substantial alteration when one opens up the economy to trade and capital flows. For example, the stimulative impact of fiscal policy, guise aside from any Ricardian equivalence issues, is substantially dampened if there are rapid movements of capital in response to interest differentials and substantial trade responses to changes in relative prices of currencies. For example, consider an economy, such as that of the United States, in which taxes are cut to stimulate aggregate demand. The full impact of the demand stimulus will be offset substantially because the deficit will cause a small increase in interest rates, attract foreign capital, appreciate the dollar, and deteriorate net exports. Indeed, in the 1981-1982 recession, Filly 47 percent of the decline in U.S. real GNP was in net exports! Thus, the demand stimulus will be substantially offset.

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48 MICHAEL J. BOSKIN Also, the substantial flows of capital put a severe brake on the extent to which, at least in the short term, fiscal policies (such as deficit financing of government spending) will drive up interest rates, since as interest rates start to nse, foreign capital will be attracted and domestic capital will remain home, thereby offsetting some of the drag in capital markets caused by the deficit. Currently, for example, fully one-half of He huge federal government deficit is being offset by foreign capital flowing into the United States and less U.S. private capital flowing abroad. How long this will continue no one knows, but it is a stark reminder that, at least in the short run, analyses based on a closed economy can be substantially mistaken. RECENT ECONOMIC POLICY While the reduction in inflation and marginal tax rates, the increased investment and saving incentives in He 1981-1982 tax reforms, and reor- dered budget priorities are substantial achievements, much remains to be done to improve the prospects for long-run growth. Our budget dilemma may ultimately cause severe problems for capital formation, and there is a possibility that He pro-capital-formation tax changes may be repealed. Much controversy surrounds the likely impact of large current and prospective budget deficits on capital formation and growth. Table 2 shows the base-line budget projections of He Congressional Budget Office, assuming no changes in the laws governing taxes or entitlement spending and including the off-budget spending of $15 billion. (lust to give an idea of He problems in government budgeting, we now have an official category called off-budget spending, though it Is only a minute fraction of the total off-budget spending!) But the government does numerous other things Hat do not get included In He category of off-budget spending. Also shown in Table 2 is the debt held by the public as a percentage of GNP and TABf E 2 Base-line Budget Projections, Concessions Budget Office (fiscal year) 1983 1984 1985 Actual Actual Base 1986 1987 1988 1989 Total deficit,a $ billions 208 185 214 215 233 249 272 Deficit as % of GNP 6.4 5.2 5.6 5.2 5.2 5.1 5.2 Debt held by public, as % of GNP 35.4 36.7 39.6 41.8 44.0 46.0 41.9 NOTE: Assumes no change in laws governing taxes or entitlement spending. Includes off-budget deficit of $15 billion or 0.3 percent of GNP per year. SOURCE: Congressional Budget Office, The Economic and Budget Outlook, Fiscal Years 1985-1989 (Washington, D.C., Feb. 1984).

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MACROECONOMICS, TECHNOLOGY, AND ECONOMIC GROWTH TABLE 3 Long-term Social Security and Medicare Deficits (Effect of 1983 Amendments on Actuanal Balance of OASDI and Medicare, Alternative Assumptions, 75-year Penod, percent of taxable payroll) 49 Indexing of Taxable 1983 Amendments. Amounts or Indexing and Pre-1983 Intennediate Dissipation of Dissipation of Amendments Assumptions Surplus Surplus Social Security -1.80 0.02 -0.60 -1 .20 Medicare - 5.21 - 5.21 - 5.21 - 5.21 Total -7.01 -5.19 - 5.81 - 6.41 SOURCE: Author's calculations arid 1983 Annual Report of the Trustees of the Social Secured Administration . how it is expected to rise under current law. Clearly these are very large deficits. The administration forecasts much lower deficits, partly because it is somewhat more optimistic about what it is going to be able to do on the spending side, and because it assumes that interest rates will fall substantially over the next few years (down to 5 percent). If you take the administration's forecast for the 1989 or 1990 budget and assume that interest rates are going to be what they are today, you would add about $70 billion to that fiscal year's deficit. Lest anyone think our current fiscal dilemma will be resolved in the course of this decade and that we can then breathe a deep sign of relief, we have impending a major conundrum with respect to the financing of our Social Security and Medicare systems (see Table 31. (Recall that we had a major, bipartisan Social Security reform in 1983.) Table 3 shows the Social Security and Medicare deficits before the 1983 amendments and the Social Security actuanes' intermediate assumptions, and other measures. The Social Security actuaries make assumptions about economic grown, inflation, unemploy- ment, life expectancy, fertility, how many workers there will be relative to the number of retirees, and other such things, and from those they calculate the likely future condition of the retirement fund, disability fund, and Me hospital-insurance fund that is part of Social Security (Medicare). Prior to 1983 Me Old Age and Survivor Disability Insurance (OASDI) Fllnd, com- monly called Social Security, was running an average 1.S percent deficit over Me 75-year projection period as a fraction of taxable payroll. On average, that 75-year projection includes a deficit in the 1980s, a huge surplus in retirement and disability funds starting in about 1990 that will run for about 25 years and then start to decline, and then an absolutely eno~ous deficit when the baby-boom generation retires early in the next century. So that 1.8 percent average masks deficits of 5 to ~ percent in the year 2030 and surpluses in the retirement and disability funds that are projected to build up to 5 to 7 times outlays by 2015. Prior to the 1983 amendments, it was not commonly

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so MICHAEL J. BOSKIN pointed out that the long-term deficit in Medicare was several times that in retirement and disability. That is primarily because the tax rate for Medicare was very low and not scheduled to rise as the tax rate was for retirement and also because of the presumed increase in the cost of medical care. The 1.8 percent deficit disappears under the intermediate assumptions (colt 2 in Table 31. But the 1983 amendments did two things that are going to be extremely difficult to live by politically. One is that we are now taxing Social Security benefits for well-off retirees. Half of a retiree's Social Secunty benefits are included in taxable income at an income of above 532,000 a year. But that number is not indexed. So eventually we are going to be taxing middle-class retirees, and it is unclear to me that we will be able to avoid indexing, the exempt amounts. If we index the exempt amount we will lose about a third of the financial solvency we gained in the OASDI system. Second, we should also remember that our Social Secunty system has never been able to run a surplus. As soon as we start running substantial surpluses we have either raised the benefits or, less commonly, lowered tax rates. The results will be very interesting if we keep the funds separate and do not allow the retirement fund to bail out Medicare when it starts running very large deficits in the next decade. If we do keep the funds separate, as was originally intended, we could use the surplus to try to dissipate the need for a huge Social Secunty tax increase early in the next century. If we do that, we are going to see, as I mentioned, a surplus in OASDI of 5 to 7 years of Social Security benefits. It will be such a large surplus that it may equal the national debt; indeed, the Social Secunty Administration may own all the government bonds. If we did still better and ran a higher suIplus or we brought some spending under control, we would have to ask ourselves whether we want the Social Security system to stab owning other assets, such as corporate shares. But have no fear. Medicare will bail us out of that dilemma. We face enormous long-term deficits in Medicare, deficits that will test not only our political acumen but Me moral fiber of our county in the next 20 years. What are We impacts of budgets and deficits on investment, technical changes, and growth? First, I think all economists would agree ~at, ulti- mately, at full employment, large deficits, net of the interest component (the so-called primary deficits, relative to the size of the economy that run for a very long period must be inflationary. There is no need for the current budget deficit to be inflationary for the next year or two. Bllt if we run primary deficits of several percent of GNP for a very long period, some strange things are going to happen. To analyze that, examine Table 4. This table indicates where the ratio of privately held federal government national debt (what is called debt held by the public or by Me private sector as opposed to the Federal Reserve and government agencies) to GNP is headed if we continue to non deficits as a share of GNP, net of the interest component, of several percent and run the real interest rates and growth rates that are being forecast.

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MACROECONOMICS, TECHNOLOGY, AND ECONOMIC GROWTH TABLE 4 Some U.S. Fiscal Episodes 51 1975 - 1979a 1984 - 1989 . Do 23.4% 37% - CBO Baseline Adminis~aiion d, average 3.7 1.8 1.4 g, average 3.5 3.8 4.0 i (net of monetization) 6.0 GNP deflator 7.2 r -1.2 3.6 2.4 g - r 4.7 0.2 1.6 Dc 79% 900% 88% cow: Bet D represent Me debt-G~ moo, d We deficit (net of mtemst)-G~ moo, r We m~ interest rate, and g the grown of real GNP. Then, by defluiiion, D' = at + artg:)dt; for a fiscal program with constant d and constant r and g, D will evolve toward an equilibrium Dc (if g > r) of D = d g - r add declined smadily from World War II to 1974. The ratio of the federal government debt to GNP evolves over iune de- pending on this primary deficit and Me relationship of the real rate of interest and the growth rate. For example, if we start out with a positive national debt, and We real interest paid on Me national debt exceeds Me grown rate, then the interest payments will grow more rapidly Man GNP, and if nothing else has changed, eventually the interest payments, in an explosive pattern, will gobble up aB of the budget, then ah of GNP, then all of national wealth. In the more usual case of the growth rate's exceeding the rate of interest, the debt-GNP ratio will evolve according to the equation D/GNP = d + (rgot. Thus, the equilibrium ratio of Me debt to GNP, given constant primary deficit (d), real interest rate (r), and growth rate (g), is simply given by d/(8r3. Table 4 presents some estimates of two recent major fiscal episodes in the United States. First, we see the substantial increase in the equilibrium debt- GNP ratio toward which we were headed if fiscal policy had not been changed In the 1975-1979 period, a period generally regarded as the begging of the increase of the ratio of debt to GNP after the substantial postwar decline in this ratio. Second, and more important for this discussion, we see where we are headed staging currently. We can see that under current projections the ratio of debt to GNP is heading toward an equilibrium that is many fumes, not only current GNP, but Me ratio of the entire value of the capital stock of He United States to GNP! This latter number is around three, so it is clear Cat either Me private sector will have to increase its wealth-income ratio by

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52 MICHAEL J. BOSKIN TABLE 5 Effective Tax Rates for All Assets, 1965-1982, Selected Years Auerbacha Hulten-Robertsonb 1965 35.7 26.3 1970 49.7 52.3 1975 37.0 32 1 1980 31.9 33.1 1981 17.7 4.7 1982 24.6 15.8 aAlan Auerbach, Corporate taxation In the United States, Brookings Papers on Economic Activity, Vol. 2 (Washington, D.C.: The Broolcings Institution, 1983). Auerbach assumes a 4 percent real after-tax rate of rental and forecasts inflation based on past values. bC. Hulten and J. Robertson, Corporate Tax Policy and Economic Growth, Unload Institute Discussion Paper (Washington, D.C.: The Urban Insatiate, December 1982). These estimates assume a 4 percent real aher-tax rate of return and, for 1981 and 1982, a 6 percent rate of inflation. an enormous increase in saving, or Me rest of the world will have to buy up We T-bills that we float, or if neither of these alternatives is available and we persist in our current fiscal policies for the indefinite future, the Federal Reserve will have to buy up Me bonds as the lender of last resort, Hereby re-igniting ~nflanon. Can we reasonably expect foreigners to continue to finance our deficits ad infinitum? ~ believe it would be imprudent of us to operate on the assumption Mat this is possible, let alone desirable. Eventually, foreign Sirens and individuals will have a progressively higher fraction of their wealth in dollar-denominated assets, which will mean that furler in- creases in dollar-denom~nated assets will be even more nsky. Thus, we can expect the flow of foreign capital into Me United States, ceteris Paribas, to slow. Nor do ~ foresee such a huge increase in our saving rate as to increase the capital output ratio by such a large amount. In shoe, the current fiscal policy, if continued, is either inflationary or unsustainable. This does not mean Cat we have no time whatsoever to deal with the problem, but the longer we delay in cutting spending or adopting a last-resort tax increase, the worse the problem will become as the interest burden rises still furler. Thus, my conclusion is that while we had an investment boomlet in the United States in 1984, largely as a result of the proinvestment tax policies enacted in the 1981 tax laws, eventually our large deficits will crowd out our own investment. Currently, they are probably playing some role in crowd- ing out our net exports. Table 5 indicates the decline in effective tax rates on marginal investment due to He Economic Recovery Tax Act (ERTA) of 1981 and He Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. This decrease was sub- stantial and must be part of He explanation for the resurgence, once out of He recession, of investment. Ano~er reason for He resurgence is that He extended invesunent tax credit and the accelerated cost recovery system

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MACROECONOMICS, TECHNOLOGY, AND ECONOMIC GROWTH TABLE 6 Role of Federal Deficit in National Saving and Investment (as percentage of GNP) 53 Capital Net State-Local Federal Net Outflow (-) Net Private Surplus/ Su~plusl National or Foreign Domestic Saving Deficit Deficits Saving Inflow (+) Investment (1) (2) (3) (4) (5) (4 + 5) 1950- 1959 7.2 - 0.2 0.0 7.0 - 0.2 7.0 1960- 1969 7.9 0.0 - 0.3 7.6 - 0.5 7.1 1970-1979 7.1 1.0 - 1.8 6.3 0.0 6.4 1982 5.3 1.0 -4.8 1.5 +0.3 1.8 1983 5.9 1.3 -5.4 1.8 ~ 1.0 2.8 1984 7.4 1.4 -4.8 4.0 1 2.6 6.5 aLianonal Income and Product Accounts (NIPA) basis. SOURCE: U.S. Department of Commerce, NationalIncome and Product Accounts of the United States (Washington, D.C.: U.S. Government Prinung Office, venous years). (ACRS) are available only on domestic investment. This, in turn, has prob- ably also been a cause of We decrease in U.S. capital exports, which again has been part of the reason for relieving some of Me potential pressure of deficits on interest rates. Current net saving and investment figures for Me private economy are shown in Table 6. Clearly, while we have had an investment boomlet, our net national saving and net national investment are still quite modest relative to our history and to Nose of our major trading partners. Finally, Table 7 reports alternative ways of reviewing Me share of society's resources devoted to the present as opposed to Me future. It becomes clear that, for a variety of reasons, the U.S. economy has been consuming a huge TABLE 7 Alternative Measures of National Saving Behavior, Selected Years National Household Income Consumption Accounts Rate Basis, Net Household GoverTunent out of NNP- National Consumption Consumption Government Saving Rate Rate (2) ~ (3) Consumption Penod (1) (2) (3) (4) (5) 1951-1960 13.4% 64.3% 22.3% 86.6% 82.7% 1961-1970 13.8 63.7 22.5 86.2 82.2 1971-1980 12.3 65.3 22.4 87.7 84.1 1981-1984 8.6 68.2 23.4 91.6 88.9 NONE: NIPA data adjusted to treat durable purchases (household and government) as saving and imputed rental flow on household durables, plus govem~nent tangible assets on consumption. Net national product (NNP) adjusted to include imputed rent and exclude depreciation on household durables and government tangible assets.

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54 MICHAEL }. BOSTON fraction of its net national product in recent years and that our national saving rate has plummeted. What do I conclude from all of these figures? My tentative conclusion is that we still have an investment problem in the United States, that we will probably have to finance investment by our own domestic saving,, and that we have an equally severe savings problem. Economic policies designed to encourage consumption at the expense of saving and investment have marked U.S. fiscal history far too long. It is time we consolidated those policies begun in 1954 (and continued in 1962, 1978, and 1981) to move our tax policy toward neutral consumption taxation and our overall fiscal policy toward achieving appropriately measured budget balance over periods longer than cycles in economic fluctuations. Such policies would renew the prospect of a hi ,h-savin~ and high-investment economy, which in turn could lead to a higher rate of technological change and economic growth. Let me note that many of the links in this chain of argument are based on less-than-firm footing. Much more research needs to be done, for example, on the determinants of saving and investment in the United States, on the potential links between investment and technical change, and so on. It is my opinion that we badly need to rededicate our economic policies to promoting our lon~-term growth and international competitiveness and that these, in turn, will ultimately require much higher rates of national saving and in- vestment In plant and equipment as well as research and development ire the United States. CONCLUSION AND PARTIAL RESEARCH AGENDA While short-tenn fluctuations in the economy can be quite costly, active demand management may be extremely difficult and counterproductive, and at the very least, f~ne-tuning is unlikely to be productive. Inflation and high and rising tax rates have eroded incentives to produce income and wealth and are probably part of the explanation for productivity declines. More importantly, however, the sources of long-term growth in the economy have less to do win short-te~ macroeconomics than with "second-tier macro- economics." This is certainly only my casual judgment, but the composition of government spending, the structure of taxes, and the effects of monetary and fiscal policies on the composition of output are likely to be more important to the determinants of our long-term grown rate, generation of new tech- nology, and rising standards of living than minor changes in the policies designed to mitigate economic fluctuations. Further, while there probably are links among the overall macroeconomic climate and innovation, technical change, and economic growth, it will not be easy to establish more than anecdotal evidence of a relation. Therefore, it is my conclusion that a much greater emphasis should be placed on the effects of these second-tier policies

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MACROECONOMICS, TECHNOLOGY, AND ECONOMIC GROWTH 55 on physical and human capital formation, research and development expen- ditures, and therefore, innovation, technical change, and economic growth. In addition to various and very important microeconomic issues relating to technology and economic growth, a short macroeconomic research agenda would include the following: Analyses of the effects of the composition of government spending, at He federal, state, and local levels; 2. Further analysis of the effects of alternative tax structures on invest- ment, human capital investment, and R&D spending; 3. The relationship of investment and technical change through learning arid embodiment, and the diffusion of technology in general; 4. Renewed studies of the sectoral details of technical change and its relationship to aggregate economic growth; 5. Analyses of broad macroeconomic policies to promote innovation and the generation and adoption of new technologies, e.g., comparative inter- national and historical studies; 6. Analyses of the impact of foreign trade and capital flows on investment and technical change both in the United States and abroad and at both the aggregate and industry level. In conclusion, ~ hope this discussion proves useful to readers who are not economists. It was designed to introduce a variety of controversies and issues and to provoke discussion and comment. ~ have deliberately avoided any attempt to be encyclopedic and have stressed my own judgments and impres- sions, which should be taken for what they are, one economist's opinion. Let me stress, however, the enormous stake that our economy and society have in issues of technology and economic grown. I do not believe that we can continue to go along merrily assuming that the technology will be gen- erated and disseminated, and that our own long-term growth will be assured via some mysterious exogenous process. It is likely that economic policies do affect the generation and dissemination of new technology and our rate of investment in improving the quality of our labor force, both of which have the capacity to affect our long-term growth rate. A difference of even half a percentage point in the long-term growth rate can dramatically ~ans- form a society over a generation or two. It is incumbent upon all of us to attempt to understand the relationship of macroeconomic policy, technical chance, and economic growth much better than we do today and to make sure that this information, as it is generated, is used in the evaluation of . , . economic pOllCy.

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56 MICHAEL J. BOSKIN REFERENCES AND BIBLIOGRAPHY Barro, R. J. 1974. Are government bonds net wealth? Journal of Political Economy (November- December): 1095-1117. Barro. R. J., and C. Sahasakul. 1983. Measuring the average marginal tax rates from the individual income tax, Journal of Business (October). Boskin. M. 1976. Notes on the tax treatment of human capital, U.S. Treasury, Conference on Tax Research. Boskin, M. 1978. Taxation. saving and the rate of interest. Journal of Political Economy 86:S3- S27. Feldstein, M., and L. Summers. 1979. Inflation and the taxation of capital income in the corporate sector, National Tax Journal (December). Fischer. S., and F. Modigliani. 1977. Aspects of the Costs of Inflation. MIT Working Paper (unpublished). Friedman, M. 1968. The role of monetary policy, American Economic Review 58(March):1-17. Hall, R., and D. Jorgenson. 1967. Tax policy and investment behavior. American Economic Review. Hausman, J. 1981. Labor supply, in H. Aaron and J. Pechman, eds., How Tares Affect Economic Behavior. Washington, D.C.: Brookings Institution. Heckman, J. 1974. Shadow prices. market wages and labor supply of married women, Econometrical Lucas, R. 1981 Tobin and monetarism: A review article, Journal of Economic Literature 19(June):558- 567. Phelps, E. 1968. Money-wage dynamics and labor market equilibnum. Journal of Political Economy 76(July-August):678-71 1. Sargent, T. 1979. Macroeconomics. New York: Academic Press. Sheshinski. E. 1967. Optimal accumulation with learning by doing, in K. Shell. ea.. Essays on tile Theory of Optimal Economic Growth. Cambridge, Mass.: MIT Press.