Naked Economics (19 page)

Now consider scenario two: The guy who ambles into town has a Ph.D. in agronomy. He has designed a new kind of plow that improves corn yields. He trades his plow to farmers in exchange for a small share of their harvests. Everybody is better off. The agronomist can support himself; the farmers have more to eat, even after paying for their new plows (or else they wouldn’t buy the plows). And this community has just created one new job: plow salesman. Soon thereafter, a carpenter arrives at the train station. He offers to do all the odd jobs that limit the amount of time farmers can spend tending to their crops. Yields go up again because farmers are able to spend more time doing what they do best: farming. And another new job is created.

At this point, farmers are growing more than they can possibly eat themselves, so they “spend” their surplus to recruit a teacher to town. That’s another new job. She teaches the children in the town, making the next generation of farmers better educated and more productive than their parents. Over time, our contrived farming town, which had “no jobs” at the beginning of this exercise, has romance novelists, firefighters, professional baseball players, and even engineers who design iPhones and Margarita Space Paks. This is the one-page economic history of the United States. Rising levels of human capital enabled an agrarian nation to evolve into places as rich and complex as Manhattan and Silicon Valley.

Not all is rosy along the way, of course. Suppose one of our newly educated farmers designs a plow that produces even better yields, putting the first plow salesman out of business—creative destruction. True, this technological breakthrough eliminates one job in the short run. In the long run, though, the town is still better off. Remember, all the farmers are now richer (as measured by higher corn yields), enabling them to hire the unemployed agronomist to do something else, such as develop new hybrid seeds (which will make the town richer yet). Technology displaces workers in the short run but does not lead to mass unemployment in the long run. Rather, we become richer, which creates demand for new jobs elsewhere in the economy. Of course, educated workers fare much better than uneducated workers in this process. They are more versatile in a fast-changing economy, making them more likely to be left standing after a bout of creative destruction.

Human capital is about much more than earning more money. It makes us better parents, more informed voters, more appreciative of art and culture, more able to enjoy the fruits of life. It can make us healthier because we eat better and exercise more. (Meanwhile, good health is an important component of human capital.) Educated parents are more likely to put their children in car seats and teach them about colors and letters before they begin school. In the developing world, the impact of human capital can be even more profound. Economists have found that a year of additional schooling for a woman in a low-income country is associated with a 5 to 10 percent reduction in her child’s likelihood of dying in the first five years of life.
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Similarly, our total stock of human capital—everything we know as a people—defines how well off we are as a society. We benefit from the fact that we know how to prevent polio or make stainless steel—even if virtually no one reading this book would be able to do either of those things if left stranded on a deserted island. Economist Gary Becker, who was awarded the Nobel Prize for his work in the field of human capital, reckons that the stock of education, training, skills, and even the health of people constitutes about 75 percent of the wealth of a modern economy. Not diamonds, buildings, oil, or fancy purses—but things that we carry around in our heads. “We should really call our economy a ‘human capitalist economy,’ for that is what it mainly is,” Mr. Becker said in a speech. “While all forms of capital—physical capital, such as machinery and plants, financial capital, and human capital—are important, human capital is the most important. Indeed, in a modern economy, human capital is by far the most important form of capital in creating wealth and growth.”
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There is a striking correlation between a country’s level of human capital and its economic well-being. At the same time, there is a striking
lack
of correlation between natural resources and standard of living. Countries like Japan and Switzerland are among the richest in the world despite having relatively poor endowments of natural resources. Countries like Nigeria are just the opposite; enormous oil wealth has done relatively little for the nation’s standard of living. In some cases, the mineral wealth of Africa has financed bloody civil wars that would have otherwise died out. In the Middle East, Saudi Arabia has most of the oil while Israel, with no natural resources to speak of, has a higher per capita income.

High levels of human capital create a virtuous cycle; well-educated parents invest heavily in the human capital of their children. Low levels of human capital have just the opposite effect. Disadvantaged parents beget disadvantaged children, as any public school teacher will tell you. Mr. Becker points out, “Even small differences among children in the preparation provided by their families are frequently multiplied over time into large differences when they are teenagers. This is why the labor market cannot do much for school dropouts who can hardly read and never developed good work habits, and why it is so difficult to devise policies to help these groups.”
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Why does human capital matter so much? To begin with, human capital is inextricably linked to one of the most important ideas in economics: productivity. Productivity is the efficiency with which we convert inputs into outputs. In other words, how good are we at making things? Does it take 2,000 hours for a Detroit autoworker to make a car or 210 hours? Can an Iowa corn farmer grow thirty bushels of corn on an acre of land or 210 bushels? The more productive we are, the richer we are. The reason is simple: The day will always be twenty-four hours long; the more we produce in those twenty-four hours the more we consume, either directly or by trading it away for other stuff. Productivity is determined in part by natural resources—it is easier to grow wheat in Kansas than it is in Vermont—but in a modern economy, productivity is more affected by technology, specialization, and skills, all of which are a function of human capital.

America is rich because Americans are productive. We are better off today than at any other point in the history of civilization because we are better at producing goods and services than we have ever been, including things like health care and entertainment. The bottom line is that we work less and produce more. In 1870, the typical household required 1,800 hours of labor just to acquire its annual food supply; today, it takes about 260 hours of work. Over the course of the twentieth century, the average work year has fallen from 3,100 hours to about 1,730 hours. All the while, real gross domestic product (GDP) per capita—an inflation-adjusted measure of how much each of us produces, on average—has increased from $4,800 to more than $40,000. Even the poor are living extremely well by historical standards.
The poverty line is now at a level of real income that was attained only by those in the top 10 percent of the income distribution a century ago.
As John Maynard Keynes once noted, “In the long run, productivity is everything.”

Productivity is the concept that takes the suck out of Ross Perot’s “giant sucking sound.” When Ross Perot ran for president in 1992 as an independent, one of his defining positions was opposition to the North American Free Tree Agreement (NAFTA). Perot reasoned that if we opened our borders to free trade with Mexico, then millions of jobs would flee south of the border. Why wouldn’t a firm relocate to Mexico when the average Mexican factory worker earns a fraction of the wages paid to American workers? The answer is productivity. Can American workers compete against foreign workers who earn half as much or less?
Yes, most of us can.
We produce more than Mexican workers—much more in many cases—because we are better-educated, because we are healthier, because we have better access to capital and technology, and because we have more efficient government institutions and better public infrastructure. Can a Vietnamese peasant with two years of education do your job? Probably not.

Of course, there are industries in which American workers are not productive enough to justify their relatively high wages, such as manufacturing textiles and shoes. These are industries that require relatively unskilled labor, which is more expensive in this country than in the developing world. Can a Vietnamese peasant sew basketball shoes together? Yes—and for a lot less than the American minimum wage. American firms will look to “outsource” jobs to other countries only if the wages in those countries are cheap relative to what those workers can produce. A worker who costs a tenth as much and produces a tenth as much is no great bargain. A worker who costs a tenth as much and produces half as much probably is.

While Ross Perot was warning that most of the U.S. economy would migrate to Guadalajara, mainstream economists predicted that NAFTA would have a modest but positive effect on American employment. Some jobs would be lost to Mexican competition; more jobs would be created as exports to Mexico increased. We are now more than a decade into NAFTA, and that is exactly what happened. Economists reckon that the effect on overall employment was positive, albeit very small relative to the size of the U.S. economy.

Will our children be better off than we are? Yes, if they are more productive than we are, which has been the pattern throughout American history. Productivity
growth
is what improves our standard of living. If productivity grows at 2 percent a year, then we will become 2 percent richer every year. Why? Because we can take the same inputs and make 2 percent more stuff. (Or we could make the same amount of stuff with 2 percent fewer inputs.) One of the most interesting debates in economics is whether or not the American economy has undergone a sharp increase in the rate of productivity growth. Some economists, including Alan Greenspan during his tenure as Fed chairman, have argued that investments in information technology have led to permanently higher rates of productivity growth. Others, such as Robert Gordon at Northwestern University, believe that productivity growth has not changed significantly when one interprets the data properly.

The answer to that debate matters enormously. From 1947 to 1975, productivity grew at an annual rate of 2.7 percent a year. From 1975 until the mid-1990s, for reasons that are still not fully understood, productivity growth slowed to 1.4 percent a year. Then it got better again; from 2000 to 2008, productivity growth returned to a much healthier 2.5 percent annually. That may seem like a trivial difference; in fact, it has a profound effect on our standard of living. One handy trick in finance and economics is the rule of 72; divide 72 by a rate of growth (or a rate of interest) and the answer will tell you roughly how long it will take for a growing quantity to double (e.g., the principal in a bank account paying 4 percent interest will double in roughly 18 years). When productivity grows at 2.7 percent a year, our standard of living doubles every twenty-seven years. At 1.4 percent, it doubles every fifty-one years.

Productivity growth makes us richer, regardless of what is going on in the rest of the world. If productivity grows at 4 percent in Japan and 2 percent in the United States,
then both countries are getting richer.
To understand why, go back to our simple farm economy. If one farmer is raising 2 percent more corn and hogs every year and his neighbor is raising 4 percent more, then they are eating more every year (or trading more away). If this disparity goes on for a long time, one of them will become significantly richer than the other, which may become a source of envy or political friction, but they are both growing steadily better off. The important point is that productivity growth, like so much else in economics, is not a zero-sum game.

What would be the effect on America if 500 million people in India became more productive and gradually moved from poverty to the middle class? We would become richer, too. Poor villagers currently subsisting on $1 a day cannot afford to buy our software, our cars, our music, our books, our agricultural exports. If they were wealthier, they could. Meanwhile, some of those 500 million people, whose potential is currently wasted for lack of education, would produce goods and services that are superior to what we have now, making us better off. One of those newly educated peasants might be the person who discovers an AIDS vaccine or a process for reversing global warming. To paraphrase the United Negro College Fund, 500 million minds are a terrible thing to waste.

Productivity growth depends on investment—in physical capital, in human capital, in research and development, and even in things like more effective government institutions. These investments require that we give up consumption in the present in order to be able to consume more in the future. If you skip buying a BMW and invest in a college education instead, your future income will be higher. Similarly, a software company may forgo paying its shareholders a dividend and plow its profits back into the development of a new, better product. The government may collect taxes (depriving us of some current consumption) to fund research in genetics that improves our health in the future. In each case, we spend resources now so that we will become more productive later. When we turn to the macroeconomy—our study of the economy as a whole—one important concern will be whether or not we are investing enough as a nation to continue growing our standard of living.

Our legal, regulatory, and tax structures also affect productivity growth. High taxes, bad government, poorly defined property rights, or excessive regulation can diminish or eliminate the incentive to make productive investments. Collective farms, for example, are a very bad way to organize agriculture. Social factors, such as discrimination, can profoundly affect productivity. A society that does not educate its women or that denies opportunities to members of a particular race or caste or tribe is leaving a vast resource fallow. Productivity growth also depends a great deal on innovation and technological progress, neither of which is understood perfectly. Why did the Internet explode onto the scene in the mid-1990s rather than the late 1970s? How is it that we have cracked the human genome yet we still do not have a cheap source of clean energy? In short, fostering productivity growth is like raising children: We know what kinds of things are important even if there is no blueprint for raising an Olympic athlete or a Harvard scholar.