The Economy Really Is Fundamentally Strong
By Justin Fox
John McCain's claim that "the fundamentals of our economy are strong," uttered just before the financial crisis turned dire, may go down as one of the great blunders of presidential-campaign history. "Senator McCain, what economy are you talking about?" Barack Obama exclaimed hours after the words escaped his opponent's mouth. The mocking TV ads soon followed, and as the weeks wore on and financial jitters gave way to near collapse and certain recession, McCain's statement began to evoke unsettling memories of Herbert Hoover, who said similar things in the early 1930s.
Less likely to be remembered is running mate Sarah Palin's defense. "He means our workforce, he means the ingenuity of the American people," she said. "And of course that is strong, and that is the foundation of our economy."
Palin was actually on to something. Our workforce and the ingenuity of the American people are in fact among the most important of economic fundamentals. And it's not at all crazy to argue that these fundamentals are still strong.
When economists talk about such matters, they focus on the concept of productivity. "Productivity growth," wrote economist (and now Nobel laureate and New York Times columnist) Paul Krugman back in 1990, "is the single most important factor affecting our economic well-being." It was growth in productivity -- most commonly measured as economic output per hour worked -- during the Industrial Revolution that powered the rise of the West out of millenniums of stagnation. It was a productivity boom that ushered in America's postwar era of mass affluence.
And it was a lengthy productivity slump beginning in the early 1970s that created concern among economists such as Krugman. Low productivity growth explained much of what had gone wrong with the U.S. economy: stagnant wages, high inflation, ground lost to Japan. But what caused it? The most convincing explanation came from Northwestern University's Robert J. Gordon. In the early and mid-20th century, he argued, the U.S. benefited from a spectacular confluence of technological innovation involving electricity, the internal combustion engine, petrochemicals and communications. By the 1970s the economic impact of innovation in these fields had waned, and nothing came along to replace it.
Until the mid-'90s, that is, when productivity growth rebounded, from about 1.5% a year to more than 2.5%. The engine apparently was the rise of the computer and the Internet. And the boom continued even after the technology bust of 2001. In 2006-07, productivity growth slumped to pre-1995 levels, before rebounding somewhat in the first half of this year. But year-to-year numbers can be confusingly noisy; it's the trend that matters. Gordon, who doesn't buy that computers and the Internet are nearly as economically significant as cars, electricity and their ilk, thinks we're headed back toward the low pre-1995 productivity trend. The country's other most prominent productivity guru, Harvard's Dale Jorgenson, is more sanguine. He sees large swaths of the economy -- health care, education, government -- still waiting to be transformed by information technology and expects that to bring us another decade of high productivity growth. We'll have to wait and see who's right. In the meantime, if we average their latest projections, we get productivity growth of just over 2%, which isn't bad at all.
None of this means we won't see sharply rising unemployment and falling economic output in the coming months as we work off the financial excesses of recent years. Higher productivity makes higher economic growth possible; it doesn't guarantee it. What's more, a financial breakdown can trump long-term fundamentals for years. Gordon identifies the peak years of the 20th century's big wave of productivity growth as 1928 to 1950. A lot of good that did anybody in 1932.
But assuming such a breakdown is averted -- and recent government actions in the U.S. and Europe make that a plausible assumption -- economic fundamentals, and productivity growth in particular, are going to matter a lot. Strong productivity growth makes inflation less of a threat, giving the Federal Reserve more leeway in battling recession. And because it enables more economic growth down the road, it could make it far easier to pay off the giant debts the Federal Government is incurring to save the banking system and the economy.
And so, if he wins, Obama may partly owe the presidency to McCain's claim that our economic fundamentals are strong. But once in office, the winner's job will be made a lot easier if it turns out, as seems likely, that McCain was right.