The Economy Needs a Bit of Ingenuity

By EDMUND S. PHELPS

THE steps being taken by government officials to help the economy are based on a faulty premise. The diagnosis is that the economy is “constrained” by a deficiency of aggregate demand, the total demand for American goods and services. The officials’ prescription is to stimulate that demand, for as long as it takes, to facilitate the recovery of an otherwise undamaged economy — as if the task were to help an uninjured skater get up after a bad fall.

The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address — our skater has broken some bones and needs real attention.

The good news is that some of the damage done in the past decade will heal. The pessimism that broke out in 2009 is dissipating. The oversupply of houses and office space, which is depressing construction, will wear off. Banks and households are saving quickly enough to retire most of their excessive debt within a decade.

But other problems are not self-healing. In established businesses, short-termism has become rampant. Executives avoid farsighted projects, no matter how promising, out of a concern that lower short-term profits will cause share prices to drop. Mutual fund managers threaten to dump shares of companies that miss quarterly earnings targets. Timid and complacent, our big companies are showing the same tendencies that turned traditional utilities into dinosaurs.

Meanwhile, many of the factors that have long driven American innovation have dried up. Droves of investors, disappointed by their returns, have abandoned the venture capital firms of Silicon Valley. At pharmaceutical companies, computer-driven research is making fewer discoveries than intuitive chemists once did. We cannot simply assume that, when the recession ends, American dynamism will snap back in place.

Many pin their hopes for reviving the economy on gains in worker productivity. But such workplace advances often destroy more jobs than they create. That happened in the Great Depression, when increased worker productivity allowed companies and the economy to expand without creating new jobs.

The decline in American dynamism is not the only problem. It has been accompanied by a decline of what I call inclusion. Not only were low-wage workers largely cut out of the economic gains of the 1990s and 2000s — much of the middle class was, too. In part, this is because the emerging economies around the globe have ended our competitive advantage in manufacturing, and jobs have fled. We can’t compete in those industries any more, and our business sector has not yet found new advantages.

The worst effect of focusing on supposedly deficient demand is that it lulls us into failing to “think structural” in dealing with long-term problems. To achieve a full recovery, we have to understand the framework on which our broad prosperity has always been based.

First, high employment depends on a high level of investment activity — business expenditures on tangibles like offices and equipment, and also training for new or existing employees, and development of new products.

Sustained business investment, in turn, rests on innovation. Business cannot wait for discoveries in science or the rare successes in state-run labs. Without cutting-edge products and business methods, rates of return on a great many investments will sag. Furthermore, innovation creates jobs across the economy, for entrepreneurs, marketers and buyers. State-led technology projects do not.

High business investment also depends on companies having confidence in the future. A company might be afraid to invest in research or product lines if it fears the rest of the economy is not doing the same — or if it fears the government might become hostile to its goals. During the Depression, John Maynard Keynes warned President Franklin D. Roosevelt not to damage business confidence with anti-profit rhetoric — to treat titans of business “not as wolves or tigers, but as domestic animals by nature.”

What, then, is to be done? One reform would be to create a First National Bank of Innovation — a state-sponsored network of merchant banks that invest in and lend to innovative projects. Another would be to improve corporate governance by tying executives’ compensation to long-term performance rather than one-year profits, and by linking fund managers’ pay to skill in picking stocks, not in marketing their funds. Exempting start-ups from corporate income tax for a time would also help.

We also need a program of tax credits for companies for employing low-wage workers. That may seem counterintuitive at a time when the Obama administration is pressing education and high-paying jobs, but we need to create jobs at all levels. Early last year, Singapore began giving such credits — worth several billion dollars — and staved off a recession. Unemployment there is around 3 percent.

A revamp of the economy for greater dynamism and inclusion is essential for prosperity and growth. Rather than continuing to argue over solutions to a problem we do not have — low demand — the country needs to focus on fixing the structural problems that, unresolved, will stymie the economy over the long haul.

LABOUR is cheap in India: signage is painted by hand; bricks are piled nine-high on the crowns of construction workers; shops are more crowded with attendants than customers. As China’s workforce becomes older, costlier and stroppier, some firms will look to exit the dragon. Only India has the numbers to match it.

According to the International Labour Organisation, the number of Indians in the workforce will increase by almost 80m over the next decade. But that is an understatement, argues a new paper* by Tushar Poddar of Goldman Sachs and Pragyan Deb, now at the London School of Economics (LSE). Only a third of Indian women currently seek paid work, they point out (other estimates are even lower). If that figure rises to 38% by 2020, then the Indian workforce will swell by 110m, they reckon. Three out of every ten extra workers in the world will be Indian.

India’s renowned services sector will employ about 45m of them, the authors forecast. But 40m will have to find work in industry. Overshadowed by India’s digital dynamos, India’s widget-makers are no slouches. Manufacturing grew at a perky 8% annual rate over the past decade and in the last fiscal year contributed a greater share (16.1%) of India’s GDP than agriculture for the first time in the country’s history. But its contribution to employment is less impressive: just 12%.

Unfortunately, India’s manufacturers economise on labour, despite its abundance, favouring capital or technology instead. … in industries such as clothing, jewellery and toymaking, the ratio of labour to capital halved over the 1990s…The regiments of assembly-line workers characteristic of China’s industrial revolution are harder to find in India. Several scholars have identified a “missing middle” in Indian manufacturing: workers cluster either in minuscule factories or large and sophisticated ones (see right-hand chart).

What is deterring Indian manufacturers from hiring more people? Messrs Poddar and Deb name India’s “archaic labour laws” as the “biggest challenge” among many to industrial growth. According to India’s employers’ association, the central government imposes over 55 labour laws and the states another 150 or more. The most notorious is the Industrial Disputes Act, which requires any establishment employing 100 or more workers to ask the state’s permission before firing anyone.