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January 02, 2006

US Economy and Productivity: Some Truths and Fallacies
by Gerard Jackson

Economics is a highly theoretical discipline with particular characteristics of its own, the main one being that economic problems tend to require long chains of complex reasoning. It is this inherent difficulty that gives rise to an abundance of fallacies and explains why people, seeing only the immediate effects of a particular policy or investment decision, tend to fall into the fallacy of composition and assume the same must hold for the economy as a whole. That the layman should fall prey to them is to be expected; that some economists should do likewise is a disgrace. This brings me to American investment and productivity.

Two dangerous myths - one a crude derivation of the other - appear to be re-emerging as an explanation of the Bush boom. One is that an economy based on hi-tech information is emerging in which "gain sharing" replaces rent, wages and profits. With information as a new and vital factor of production productivity and living standards will continue to rise even if manufacturing shrinks in absolute terms. This is akin saying we don't need farming and fishing because we've got supermarkets.

The other and more advanced fallacy states that improved technology results in the employment of less capital and labour per unit of output. In other words, not only is capital a substitute for labour but capital saving machinery has reduced the need for additional investment, which has even created more advanced products. Because of this the US economy will be able to grow with very little savings. Like all economic fallacies, there is nothing new in this one. The idea of capital saving investments is an old one.

Böhm-Bawerk developed production structure analysis which shows that production takes place in stages and that as an economy progresses these stages multiply and become more complex and productive. Naturally, increasing savings is what makes an expanding capital structure possible. Curiously enough, the capital economising argument was used as a criticism of Böhm-Bawerk's approach. Now this is not a piece of esoteric economic thought. It is, in my opinion, very important in contributing to our understanding of what is currently happening.

Horace White produced the example of oil extracted from bores as a capital saving innovation. Before this development oil was produced by whalers which involved a very lengthy and complex production process. (One only had to think of what was involved in just designing and building whaling ships). It was obvious to White that simply boring a hole in the ground to extract vastly more quantities of oil at ludicrously low prices was a huge capital saving innovation that greatly shortened the production process. Or did it?

Drilling for oil resulted in huge new investments being made not to mention developments in engineering and refining. Oil rigs became more complex as did refineries and huge oil tankers, ship yards and docks that had to be built. All of these tasks required production processes that dwarfed anything that had gone into whaling, while all the time dramatically driving down the price of kerosene.

In other words, White's 'capital saving' innovation was only able to yield its greater total output through investing in longer production processes. The very opposite of what he claimed. But Böhm-Bawerk pointed out that White's criticism rested on the implicit assumption that the capital saving invention was progressively capital-saving.

White failed to see the flaw in his argument because he could not take it beyond one stage. Because he could see that drilling for oil was a shorter though more productive process he failed to see that incorporating the process into lengthier production processes would yield even great output. And this brings us to the present. What may have happened in some cases is that inventions have rendered some shorter processes more productive than the older but lengthier processes. But this has concealed from some that had these inventions been used in lengthier processes the yield would have been even greater*.

In addition, those who deal with only one stage of a product tend not to see how complex the complete chain of production is. Hence those who argue, putting it rather crudely, that all America needs is the Net have never thought about what it really takes just to supply it with cables and electricity let alone those little things called chips. In short, it takes a lot of investment in manufacturing. This should help make it clear why more advanced products always require lengthier production processes and not shorter ones.

The fundamental point is that the ultimate source of rising productivity is investment. That US investment is more productive than Japanese and European investment is due entirely it having freer markets. This is the basic reason it produces more for less. This dynamism (denied by some) has, I believe, caused more productive techniques to be developed. Nevertheless, they are not capital saving and they are not substitutes for labour.

No country can continue to prosper in the absence of savings. While entrepreneurship drives an economy only savings can fuel it. This is why the President's 2003 tax cuts are so important. By cutting capital gains taxes he increased savings and capital mobility while spurring entrepreneurship.

It is to deeply regretted that so many in the media, the Democratic Party and academia remain stubbornly -- or should I say wilfully? -- blind to the success of the President's tax policy.

*See Böhm-Bawerk's The Positive Theory of Capital and Its Critics, Part III.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2008 Gerard Jackson

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