Edmund S Phelps: This is how to reverse the productivity slowdown

It has become impossible to deny the so-called secular stagnation gripping the world’s most developed economies: Wealth is piling up, but real wages are barely rising and labor force participation has been on a downward trend. Worse yet, policymakers have no plausible idea about what can be done about it.

Behind this stagnation is the slowdown in productivity growth since 1970. The wellspring of such productivity gains – indigenous innovation – has been badly clogged since the late 1960s (mostly in established industries) and was even more so by 2005.

Ronald Reagan and Margaret Thatcher viewed the stagnation that was gripping economies by the 1970s from the supply side. They pushed through tax cuts on profits and wages to boost investment and growth, with debatable results.

But today, with tax rates much lower, cuts of that size would result in huge increases in fiscal deficits. And with debt levels already high and large deficits ahead, such supply-side measures would be reckless.

So now the best and brightest view things from the demand side, using the theory built by John Maynard Keynes in 1936. When “aggregate demand” – the level of real expenditure on final domestic goods that households, businesses, the government, and overseas buyers are willing to make – falls short of output at full employment, output is limited to the demand. And innovation won’t happen.

But the demand-siders’ conception of the economy is strange. For them, private investment demand is autonomous, governed by forces that Keynes dubbed “animal spirits.” Consumer demand is essentially autonomous, too, because the so-called induced part is yoked to autonomous investment through the “propensity to consume.” Thus, government measures are the sole way to boost employment and growth when autonomous demand falls short and jobs are lost.

This conception grasps neither growth nor recovery. In healthy economies, a contractionary demand shock sets off two types of responses fueling recovery.

Adaptations to emerging opportunities are one such response. When firms hit by reduced demand contract operations, the space they give up becomes available for use by entrepreneurs with better ways of running the business – or with better businesses. Some of the employees they let go will start firms (and hire employees) of their own. With every recession, many shops on Main Street disappear; and, over time, new shops – generally more successful – appear.

The other response is indigenous innovation – new ideas springing from the brows of various businesspeople. When firms hit by reduced demand stop hiring for a time, some people who would have joined established firms use their situation to dream up new products or methods and organize startups to develop them.

The growing number of aspiring innovators toiling in home garages may self-produce some of their capital goods. More important, the accumulation of new startups will gradually generate rising investment demand – induced demand! – and growth, too.

Some may doubt this. Can new products and methods fare well in the market if demand is deficient? As an innovator said to me amid the financial crisis, his objective was to take over a market – it mattered little that the targeted market was only 90% of its former size.

Can capital be raised where incomes are depressed? Small firms and startups must always struggle for credit, and the Great Recession that followed the 2008 financial crisis made it harder for them. Yet the recession did not prevent droves of such firms from finding financing in Silicon Valley, London, and Berlin. No wonder Germany, the United States, and the United Kingdom are more or less recovered. In the US, total factor productivity growth set records in the 1930s, when the economy fell into and then grew out of the Great Depression.

Recovery has fallen woefully short in two kinds of economies. France and Italy are lacking young people who want to be new entrepreneurs or innovators, and those few who do are impeded by entrenched corporations and other vested interests. Greece has no lack of would-be entrepreneurs and innovators, but it lacks a system of angel and venture capital. Some Greeks have formed startups, though not in Greece.

The demand-siders say that innovation only makes recovery harder, because it enables firms to meet existing demand with fewer employees. Thus, they call for annual public-sector investment up to the level needed for full employment. But such infrastructure investment would go far beyond what would ever have been undertaken had the economy been left to regain high employment through the workings of adaptive or innovative activity. Indeed, such investment is costly beyond the expense because it preempts the adaptation and innovation that would have brought higher employment and faster growth.

Moreover, as long as Western innovation remains narrowly confined, a demand-side commitment to a large, sustained flow of infrastructure investment – and, likewise, a supply-side commitment to a similar flow of private investment – must bring ever-diminishing returns, until, ineluctably, the economy reaches its near-stationary state.

Supplying more of the same old goods never “creates its own demand,” as Keynes thought. But supplying new goods can. It is the impediments to adaptation and innovation – not fiscal austerity – causing our stagnation. And only renewed dynamism – not more fiscal irresponsibility – offers any hope of a durable way out.