Today’s conventional policy recommendations are leading the nation astray. They rest on two questionable assumptions, neither as well-supported by theory or history as their advocates claim. The first is that the long-run growth potential of an economy is wholly determined and indeed fixed by its productive capacity (physical and human capital and technological know-how). The second is that this productive capacity will be fully utilized by the economy as long as markets are encumbered as little as possible by government regulation. In other words, savings will generally be fully invested, labor fully utilized, and potential innovation fully exploited as long as government keeps out.

But such a prescription, though it contains elements of truth, is a recipe for stunting economic growth, not maximizing it. And it is endangering, not protecting, the nation’s future.

The current view has two central problems. The first is that an economy’s productive capacity is not fixed. Rapid economic growth expands the capacity to produce, innovate, and invent in key ways. It makes possible the development of economies of scale (falling per unit costs as production rises) and increases opportunities to learn-by-doing, a key source of rising productivity and innovation. Growth itself breeds more investment in research and more ideas beget still more ideas. Higher wages can contribute to faster growth and rising potential productivity by supporting this process. Rather than thinking that an increase in wages will raise unit labor costs because productivity is fixed, rising wages may raise rates of productivity growth, thus reducing unit labor costs. Indeed, despite the conventional wisdom, economic history supports the relationship between high wages, capital investment, and productivity growth.

The second problem with the conventional view is that the private sector alone cannot be counted on to make the investments in public goods that maximize economic and social returns. In other words, the growth of the stock of human capital and technical know-how will flag without government support. Early childhood education is just one example of extraordinary social returns that are tragically neglected in the current policy environment. Economists acknowledge that private markets often fail to create adequate incentives to support public investments with high social returns. Thus, government must be a participant in building an economy’s productive capacity. Yet many minimize this obligation, especially in a time when budget deficits receive so much attention.

This problem description is adapted from the article Breaking the Stranglehold on Growth, originally published June 22, 2007 by the Economic Policy Institute. It is used here with permission.
© 2007 Economic Policy Institute