[Economic Report of the President (2010)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 10

FOSTERING PRODUCTIVITY
GROWTH THROUGH INNOVATION
AND TRADE

Americans have always believed in building a better future. Each
generation has strived to pass on higher standards of living to their
children than they themselves experienced. And for most of American
history, this goal has been realized. Per capita income has risen
strongly for most of the past two centuries.
Such economic growth stems from a number of factors. Investment in
skills and education, or human capital, is a key determinant. The
United States has a long history of investing in people, and this has
enabled American workers to be among the most productive in the world.
Investment in physical capital is also important. The tremendous
accumulation of machines, buildings, and infrastructure has been a
source of America's prosperity, and times of particularly great
investment, such as the 1950s and 1960s, have been times of
particularly rapid advances in standards of living.
Because investing in people and capital is important to the
maintenance and growth of standards of living, the President has
fashioned an ambitious agenda of improvements in education, incentives
for investment, and financial regulatory reform to ensure that we
have the financial system needed to support such investment. These
initiatives have been described in detail in earlier chapters.
But as important as investments in labor and capital have been and
will continue to be, they are not the only sources of growth. A third,
more amorphous factor has also played a central role in American
economic growth: advances in the overall productivity of that labor
and capital. One need only think of a few of the technological changes
of the past century-- the airplane, antibiotics, computers, fiber-optic
cables, and the Internet--to see that technological discovery and
innovation are central to improved standards of living. Such
innovations not only make us richer as a country, they have the
potential to fundamentally alter the very way we live our lives and
interact with one another.
As discussed throughout this Report, in the past decade American
economic growth has slowed in important ways. American families saw
their median income actually fall from 2000 to 2006. An important part
of restoring growth and increases in standards of living is spurring
innovation and increases in productivity. American firms and
universities will naturally play the leading role in  this endeavor.
But that does not mean government has no role to play. Indeed,
overwhelming evidence shows that innovation creates positive
``externalities''--benefits for others beyond the  individuals or
firms who originally produce new ideas. Since  inventors do not reap
the full rewards, on its own the market will  produce less innovation
than is optimal. Public policy therefore has a powerful role to play
in fostering pursuit of the myriad possibilities for scientific,
technical, and analytical advances.
At its best, trade between regions of the country and across borders
can also be an engine of growth. Trade has the potential to allow the
U.S. economy to expand output in areas where it is more productive
and to enable higher-productivity firms to expand. Access to a world
market encourages American firms to invest in the research needed to
become technological leaders. Through these routes, a free and fair
trade regime can play an important part in lifting living standards
in the long run.
Based on an understanding that progress springs from achieving the
proper balance between generous rewards for the creation of new ideas
and encouraging the best of those ideas to spread widely, the
Administration has formulated a comprehensive ``innovation agenda'' that
reaches far beyond the traditional scope of science and technology
policy. This agenda touches everything from improvements in the Patent
and Trademark Office, to increased government investments in research
and development (R&D), to engaging the world economy in ways that
ensure that the United States achieves the maximum benefits from
trade's productivity-enhancing potential.
This chapter discusses the key components of the agenda in detail.
All advances in productivity, whether from scientific breakthroughs,
changes in the organization of firms, or increased international
trade, involve losers as well as winners. Because productivity growth
is the critical source of improved standards of living, the most
effective way to address the painful impacts for those harmed by
progress is not to stifle new ideas or trade. Rather, it is to build a
robust system of support that can help ease the transition from
employment in declining firms and industries to jobs in new, higher-
paying, higher-productivity areas. Even more important are broad-based
policies that ensure that the gains from rising productivity are
widely shared: progressive taxation, a health care system that
provides security and stability, a strong educational system, and a
secure social safety net.
For too many years, our Nation has ignored necessary reforms in these
broad-based policies and underinvested in areas such as health care
and education, which are essential to ensuring that middle-class
families will benefit from productivity advances. That is why the Obama
Administration has set as a central economic priority rebuilding our
economy on a firmer foundation. The Administration's innovation agenda
must go hand in hand with progress in those areas as well.

The Role of Productivity Growth in Driving Living Standards

In the long run, the critical determinant of living standards is
labor productivity--the amount of goods and services produced by an
average worker in a fixed period of time, such as an hour or a
40-hour week. Figure 10-1 provides striking visual confirmation of
this hypothesis. It shows that over U.S. history since the early
20th century, sustained increases in labor productivity have
translated nearly one-for-one into increases in income per person.



The importance of labor productivity to living standards may seem
obvious, or even tautological, but it is not. In principle, increases
in income per person could come not from more output per unit of labor
input, but from more labor input per person--that is, from increases in
the fraction of the population that is working or increases in each
worker's hours. But both the historical evidence from the United
States and the evidence from across a wide range of countries show
that differences in labor input per person account for at most a small
fraction of income differences.

Recent Trends in Productivity in the United States

Since labor productivity is the key driver of standards of living
in the long run, it is important to discern the underlying trends in
productivity. This task is complicated by the fact that in the short
run, productivity depends on more than those underlying trends. It is
powerfully influenced by the state of the business cycle,as well as
by other factors (including simple measurement error) that leave no
lasting mark on productivity.
Figure 10-2 shows the growth rate of labor productivity from four
quarters earlier over the last 62 years. One immediate message is that
although the overall pattern of productivity is strongly upward
(as shown clearly by Figure 10-1), there is enormous short-run
variation in productivity growth.




A more subtle message is that the average or trend rate of
productivity growth is not constant but changes substantially over
extended periods. It is conventional to divide the era from the
beginning of the sample until about 1995 into two periods: the
"immediate postwar" period from 1947 through 1972, and the
"productivity growth slowdown" period from 1973 through 1995.
In the immediate postwar period, the average rate of productivity
growth was 2.8 percent per year. During the productivity growths
low down, it was only 1.4 percent.
This division into different periods lets one see the cumulative
importance of even seemingly modest changes in productivity growth.
For example, if the high productivity growth of the immediate postwar
period had continued through 1995 instead of slowing, the level of
productivity in 1995--and hence standards of living--would have
been more than one-third higher than they actually were.
The pattern of productivity growth since 1995 is somewhat
complicated. From 1996:Q1 to the last available observation (2009:Q3),
it averaged 2.7 percent per year, almost equal to its rate over the
immediate postwar period. But that rapid growth was concentrated
in the first part of the period. In the first eight years (1996:Q1
to 2003:Q4), productivity growth averaged 3.3 percent; in the four
years before the business cycle peak (2004:Q1 to 2007:Q4), it averaged
only 1.7 percent. A four-year period is too short to confidently
determine underlying trends. But productivity growth in the years
leading up to the recession was not strong enough to generate robust
increases in standards of living.
A final pattern revealed by Figure 10-2 is a relationship between
productivity growth and the business cycle. Productivity growth tends
to fall during recessions and surge near their ends (marked by the
vertical lines in Figure 10-2). This pattern has been operating
strongly in the current recession. Productivity growth averaged less
than 1 percent at an annual rate over the first five quarters of the
recession, but then surged in 2009:Q2 and 2009:Q3, and appears to
have remained high in 2009:Q4.
This recent experience highlights the importance of distinguishing
between cyclical movements in productivity and longer-term movements:
the pattern in productivity growth in 2009 largely reflects the fact
that employment moves more slowly than production over the business
cycle. The sluggishness of employment growth has meant that even as
output reached its low point and began to recover, employment
continued to decline. This cyclical improvement in productivity is
obviously of a different character than the secular improvements that
are the source of long-run increases in standards of living. Over
the course of 2009, standards of living clearly did not follow
productivity closely. But once the cyclical dynamics play themselves
out, the usual long-term role of productivity growth in driving
income growth is bound to reassert itself. An important goal of
policy is to make the long-term path of productivity as favorable
as possible.

Sources of Productivity Growth

Productivity growth is the overwhelming determinant of the progress
of economic well-being over extended periods. It is therefore
imperative to understand what determines productivity growth. Three
sources have been identified as key.
The first source is the accumulation of physical capital--the
machines, tools, computers, factories, infrastructure, and so on that
workers use to produce output. Each year, some of our Nation's
economic output takes the form of these capital goods. When workers
have more or better capital to work with, they are more productive.
The second source is the accumulation of human capital--workers'
education, skills, and training. The accumulation of human capital is
just as much an investment as the accumulation of physical capital is.
When some of the economy's out put takes the form of physical capital
goods rather than consumption, we are forgoing some consumption
today in exchange for the ability to produce more in the future.
Likewise, when students and teachers are in a classroom, or when an experienced worker is taking time to train a new hire, resources that
could be used to produce goods for current consumption are being
used instead for activities that increase future productive capacity.
And just as a worker with better equipment is more productive, so
too is a worker with more skills.
The third source of productivity growth is increases in the amount
that can be produced from given amounts of physical and human capital.
This factor goes by various names, such as "total factor productivity
growth" or "the Solow residual." It encompasses all the forces that
cause changes in how much an economy produces from its stocks of
physical and human capital. Most obviously, it encompasses advances in
knowledge and technology. These advances in knowledge and technology
allow factory workers to build better automobiles and electronics from
the same raw materials; they allow doctors to provide more accurate
diagnoses and prescribe better treatments in the same office visit;
and much more.
But total factor productivity growth includes more than advances in
knowledge and technology. For example, if an economy faces an increase
in crime, individuals may devote more of their skills and physical
capital to protecting the goods they have rather than producing more
goods, and so total factor productivity growth may be low or even
negative. If a country switches from central planning to a
market-based economy, then workers and capital are likely to be
allocated more effectively, and so output given the economy's stocks
of physical and human capital may increase greatly. Changes in these
types of "organizational capital" (or "institutional" or "social"
capita) are potentially critical determinants of total factor
productivity growth.
Research has not just identified changes in these three factors
(physical capital, human capital, and total factor productivity) as
critical determinants of productivity growth; it has also come to a
fairly clear view about their relative importance. Perhaps
surprisingly, the ranking of the three factors appears to be the same
whether one is trying to understand the enormous growth in productivity
over extended periods in the United States (for example, Jones 2002), or
the vast differences in the level of productivity across countries
(for example, Hall and Jones 1999).\1\
---------------------------------------
\1\ See also Klenow and Rodriguez-Clare 1997; Hendricks 2002; Caselli
2005; and Hsieh and Klenow 2007.


The factor that is most obvious and easiest to quantify--physical
capital accumulation--turns out to be only moderately important.
Differences in the fraction of output devoted to physical capital
investment account for some portion of both long-run productivity
growth and cross-country productivity differences, and increases in
investment can have a significant impact on productivity growth, and
hence on standards of living. At the same time, the evidence suggests
that the other factors are even more important.\2\
------------------------------------
\2\There is a subtlety here. When total factor
productivity or human capital improves, the result is higher output,
which then leads to more physical capital investment if the fraction
of the economy's output that is invested does not change. The
decompositions that find a moderate role for physical capital assign
these indirect effects of total factor productivity and human capital
investment to those factors, and not to physical capital. If those
effects are instead assigned to physical capital, its importance
increases greatly.

One of those more important factors is human capital accumulation.
Increases in the education and skills of the workforce play a
substantial role in the long-term growth of labor productivity, and
cross-country differences in human capital per worker are important to
cross-country differences in labor productivity. Thus, increases in
human capital investment through a stronger educational system and
greater educational attainment at all levels, together with lifetime
learning, provide another powerful route to raising productivity
growth and standards of living.
The most important determinant is not physical or human capital
accumulation, but changes in how much can be produced with them--that
is, total factor productivity growth. Again, this finding applies to
both long-term growth and cross-country differences. At an intuitive
level, this result is not surprising. It seems very plausible that the
most important reason we are so much more productive than our
forebears is that, for reasons ranging from advances in basic
scientific knowledge to improved ways of organizing the workplace,
we have found vastly better ways of producing output from a given
set of inputs. Likewise, it is likely that a key reason the United
States outperformed the Soviet Union economically in the postwar
period was not that the United States was better at channeling its
productive capacity into producing capital goods and its children
into education (both of which the Soviet Union did on a very l
arge scale), but that the United States' free-market
institutions led it to produce more from its inputs, and led to myriad
innovations that widened the productivity gap over time.
This discussion implies that in order to foster improvements in
standards of living, policy should foster investment in physical
capital, investment in human capital, and crucially, improvements in
total factor productivity. Physical and human capital investment are
discussed in earlier chapters-most notably Chapter 4 (as well as
Chapters 5 and 6) in the case of physical capital investment, and
Chapter 8 in the case of human capital. The remainder of this chapter
turns to measures to improve total factor productivity. Such
improvements in total factor productivity can be described broadly as
"innovations."

Fostering Productivity Growth
Through Innovation

Because total factor productivity reflects all determinants of labor
productivity other than physical and human capital, it has a wide
range of elements. As a result, there are many avenues along which
well-designed policies can work to improve total factor productivity.
It is for this reason that the Administration has proposed a
comprehensive innovation agenda (Box 10-1).
--------------------------------------------------------------------
Box 10-1: Overview of the Administration's Innovation Agenda

On a September 21 visit to New York's Hudson Valley Community
College, President Obama presented the first comprehensive description
of the Administration's Innovation Agenda, the conceptual framework
underpinning the wide range of initiatives that the Administration has
undertaken that share a common aim of fostering innovation.
The Agenda has three elements. The first is a commitment to invest
in the building blocks of innovation, including basic scientific
research and infrastructure, as articulated in detail in the body of
this chapter. The second is a recognition of the vital role that
competitive markets and a healthy environment for entrepreneurial
risk-taking play in spurring innovation; reform of the Patent Office,
improving the accessibility and usefulness of government statistics,
and increasing the predictability and transparency of government
policy are all parts of this effort. The final part of the agenda is
a particular focus on innovation targeted toward specific national
priorities, including the development of alternative energy sources,
reducing costs and improving medical care through the use of health
information technology, the creation of a "smart grid" that will
allow more efficient use of existing energy generation capacity, and
initiatives aimed at inventing cleaner and more fuel-efficient
transportation technologies.
The Agenda builds on over $100 billion of funds appropriated in the
American Recovery and Reinvestment Act of 2009 for the support of
innovation, education, and technological and scientific
infrastructure. It also encompasses directives to regulatory and
executive branch agencies designed to help them refocus their missions
to support the Agenda in whatever ways are most appropriate to their
usual activities. A final key tool is the commitment to science-based,
data-driven policymaking that brings to bear all the intellectual,
statistical, informational, and analytical resources necessary to make
sure that government policies achieve their stated aims as efficiently
and effectively as possible.
----------------------------------------------------------------------

The Importance of Basic Research

One uncontroversial conclusion of work on the determinants of
productivity growth is that the payoff to investment in basic
scientific and technological research has been vast, at least in some
fields and over the long run. Breakthroughs on fundamental questions
of physics, chemistry, biology, and other sciences have powered the
transformations of economic production that underlie much of the
productivity growth measured (however imperfectly) in economic
statistics (Nordhaus 1997; Nelson and Romer 1996).
The Administration has taken that lesson to heart in its support for
basic research in science and technology, especially in two areas
where the need for progress is pressing: energy and biomedical
research. The Department of Energy has created a new Advanced Research
Projects Agency-Energy (ARPA-E), with the objective of pursuing
breakthroughs that could fundamentally change the way we use and
produce energy. In the medical and biological sciences, the
Administration has ended restrictions on Federal funding for embryonic
stem cell research, and in September 2009 it announced $5 billion in
grants under the American Recovery and Reinvestment Act to fund
cutting-edge medical research.
Across all areas, the Recovery Act included $18.3 billion for
research funding. Because the Administration's commitment to
evidence-based policymaking will require substantial improvements in
the ability to reliably measure economic outcomes, the Act committed
$1 billion to the 2010 Census as a first step in a longer-term
effort to revamp the Nation's statistical infrastructure--process
that will not only improve policymaking but will also help private
businesses make better decisions (for example, about where to
locate new production or sales facilities).
In addition, the fiscal year 2011 budget enhances research funding
in numerous ways. First, it continues to work to fulfill the
President's pledge to double the budgets of three key science
agencies (the National Science Foundation, the Department of
Energy's Office of Science, and the Department of Commerce's National Institute of Standards and Technology). Second, it boosts funding for
biomedical research at the National Institutes of Health by $1
billion to $32.1 billion. Third, it reinvigorates climate change
research through increased investments in earth observations and
climate science in agencies such as the U.S. Geological Survey and
the National Oceanic and Atmospheric Administration. Fourth, it
funds potentially groundbreaking discoveries with a boost to
Department of Defense basic research and $300 million for the
Department of Energy's ARPA-E program. Finally, it supports
world-class agricultural research for national needs such as food
safety and bioenergy with $429 million for the competitive research
grants program in the Department of Agriculture's new National
Institute of Food and Agriculture.
As part of the innovation agenda, and to ensure that the increased
research funds are spent well, the Administration has also instructed
agencies to work on constructing a set of systematic tools to track
the long-term results of federally sponsored research, such as journal
articles published and cited, patents obtained, medical advances
achieved, or other measurable consequences (particularly in areas of
national importance such as health or energy). Although the fruits of
this effort will not be available for a number of years, the project
is one of the most promising in the Administration's efforts at
turning the evaluation of scientific research into a "science of
science."

Private Research and Experimentation

Scientific breakthroughs are only the first step in producing
improvements in total factor productivity and hence living standards.
Benjamin Franklin's discovery that lightning was a form of electricity
did not produce an immediate reduction in damage from electrical
storms; much further research and development was necessary to turn
that discovery into the lightning rod (though by late in his life
Franklin was able to observe a flourishing industry that had been
built upon his insight).
Measuring the returns to the economy as a whole from private
research and experimentation is almost as formidable a challenge as
measuring the returns to basic research. But most studies find that
aggregate returns to such spending are much higher than the returns
to ordinary investments in physical capital. Some work estimates
the aggregate returns at 50 percent or higher (Hall, Mairesse, and
Mohnen 2009).
These returns are mostly not received by the firms or individuals
who pay for the work, because the ideas ultimately benefit others
in many ways whose value is not captured through markets. Economic
theory provides a clear prescription for policy toward activities
that have measurable positive externalities: the activities should be
subsidized.
This is the logic behind the research and experimentation (R&E) tax
credit that has been an off-and-on part of the tax code for many
years. But the credit's effectiveness has been hampered by chronic
uncertainty about how long it will remain in force. Partly for
budgetary accounting reasons, the R&E tax credit has been treated for
many years as a temporary provision that was scheduled to expire at
some point in the near future. Yet each year (except for 1995),
Congress and the President have agreed (sometimes at the last minute)
to extend the credit. The effect has been to substantially increase
the uncertainty that firms face about the costs that they will end up
paying for their research and experimentation projects; this
uncertainty can have a serious negative effect on research, which is
already a highly uncertain investment. The problem is particularly
acute for the kinds of projects that might be expected to have the
highest returns: long-term projects that require continuing
expenditures over many years. For such projects,
uncertainty about whether the R&E tax credit will be in place through
the duration of the project can make the difference between pursuing or abandoning the research. The Administration therefore supports efforts
in Congress to make the R&E tax credit permanent, so that the
highest-return long-run projects can be confidently started without
uncertainty about whether the credit will be there for the duration.

The importance of both public and private R&D spending for
innovation and improvements in standards of living forms the basis
for a key Administration goal. In a speech in May 2009 to the
National Academy of Sciences, the President articulated the ambition
of boosting total national investment in research and development to
3 percent of gross domestic product. As can be seen from
Figure 10-3, this is a rate that would exceed even the peak rates
reached in the 1960s. As described earlier, the American Recovery and
Reinvestment Act began the Federal contribution with a historic
increase in direct funding for scientific and technological
research, as well as major investments in technological and
scientific infrastructure detailed below. But reaching the
President's goal will require not just an increase in the
Federal Government's role; equally important is the need for a
resurgence of entrepreneurial and corporate investment in research.
The Administration's consequent focus on creating the best possible
environment for private sector innovation is one of the many novel
aspects of its innovation agenda.





Protection of Intellectual Property Rights

A subsidy like the R&E credit is one way to address underinvestment
caused by the fact that the inventor of a new technology does not reap
all the benefits of that invention. An older approach is embodied in
the American system of patents and copyrights that had it origins in the Constitution (and before that, in the English legal system).
One leading scholar (Jones 2001) has argued that the invention of
ways to protect intellectual property may have been a trigger for the
industrial revolution that led to the modern era of economic growth.
In this interpretation of history, the creation of a legal system that
could protect intellectual property may have been one of the most
important "technological" developments in human history. Though this
interpretation can be debated, the practical implication is surely
correct: achieving the proper balance between the private and the
societal rewards from innovation is a critical element in creating and
sustaining long-run economic growth.
The existing U.S. patent system developed over many years in
response to the needs of an industrial economy. That system has
been under considerable strain in the past couple of decades as the
United States and the world have moved increasingly toward a
"knowledge-based" economy. The Patent and Trademark Office (PTO)
has been required to answer many questions that could not have been
imagined in 1952 when the current patent statute was written, such
as how and whether to grant patents for human genes or for Internet
advertising tools. Further, the sheer volume of information
necessary to evaluate a patent application, which might now arrive
from any country in the world and might rely on ideas that even an
expert might be unfamiliar with, has made the PTO's job increasingly
daunting. As a result of these challenges, the agency currently
faces a backlog of over 700,000 unexamined applications. Waiting
times on a patent application can extend to four years or more.
The costs that such waiting times impose on firms are substantial;
and delays impose a particularly large burden on start up firms that
rely on patents to attract venture capital funding precisely--the
kind of firms that the Administration's innovation agenda is
particularly designed to help.
While the PTO has made progress in responding to these problems,
most notably by developing a "peer review" system modeled on academic
publishing, observers agree that the patent system is in need of an
overhaul. The Administration has endorsed the aims of bills pending
in Congress that would address many of these problems, particularly
by giving the PTO authority to set fees that cover the cost of
application processing, and also by barring diversion of fees to
projects unrelated to PTO activities. The PTO is also in the process
of creating an Office of the Chief Economist, which will provide a
mechanism for better integration into patent policy of economic
research on how to properly reward innovation without stifling the
widespread use of good ideas.
In recognition of the role of innovation and intellectual property
in advancing continued U.S. leadership in the global economy, in 2008
Congress created the Office of the United States Intellectual
Property Enforcement Coordinator. This office is charged with
creating and implementing a strategy to coordinate and enhance
enforcement of intellectual property rights in the United States and
overseas. By ensuring that the Administration has a coordinated
strategy, this office will work to ensure that the effort of
American workers and businesses to produce creative and innovative
products and services is valued fairly around the world.

Spurring Progress in National Priority Areas

Much of the Administration's innovation agenda is aimed at
creating a general economic environment that encourages innovation
across the board. But the Administration has also focused special
attention on certain areas where particular national needs are
urgent. These include investments in building a "smart grid" to
enhance the reliability, flexibility, and efficiency of the
electricity transmission grid; research on renewable energy
technologies like wind, solar, and biofuels; and support for
research into advanced vehicle technologies. These investments
are motivated not only by the perception that technological
breakthroughs are possible and would be highly valuable, but
also by the enormous potential benefits that such
breakthroughs could have in terms of enhancing national security,
mitigating pollution, and stemming climate change. These are also
investments that have a direct impact on creating high-paying, durable
jobs--something that is particularly valuable at a time of high
unemployment. Thus, as noted in Chapter 9, investments in the clean
energy transformation involve two layers of externalities: innovators
fail to receive the full economic benefits of their breakthroughs as
measured by market valuation, and the market valuation itself
understates the true social benefits of the breakthroughs.
Another priority, given the looming threat that health care
spending poses to the Federal budget, is developing technologies
for measuring and monitoring health more efficiently. Through the
Recovery Act, the Administration has allocated substantial funds to
development of a 21st-century system of medical recordkeeping that
should jump-start work in this area.

Increasing Openness and Transparency

To noneconomists, the idea that the legal system or the Patent
Office is a form of technology seems a bit of a stretch. Even more
challenging is the idea that a society's overall degree of openness
and transparency may be a key determinant of economic progress. Yet a
substantial body of economic research has found that measures of
openness and transparency in governmental policymaking processes have
a strong association with growth outcomes.
There are several reasons why this may be so. One fairly simple
one is that openness and transparency make it more difficult for
special interests to achieve their aims at the expense of the
public. Another view, which is not in conflict with the first, is
that the process of requiring policies to be explained and encouraging
wide discussion about them yields new ideas and improvements of
existing ideas that might not otherwise have occurred even to the
cleverest and most well-motivated public servant.
A more speculative proposition is that a commitment to openness and
transparency on the part of the government is a form of investment in
the kind of "organizational capital" described earlier. Economic
research has found a strong correlation between measures of
governmental transparency or openness and private sector
productivity. Interpretations of this relationship are a matter of
debate; some scholars argue that higher levels of productivity and
income cause citizens to demand better government; others argue that
both governmental openness and private productivity are a reflection
of deeper unmeasured forces; and some advocate the straight-forward
view that open and transparent government has a direct effect in
producing greater private sector efficiency.
The Administration's commitment in this area has been on full
display in the unprecedented openness and transparency surrounding
implementation of the Recovery Act. The most obvious manifestation of
this transparency is the creation of the independent Recovery
Accountability and Transparency Board charged with monitoring and
reporting on the government spending under the Act. Likewise, the
requirement that recipients report on jobcreationand retention
each quarter provides a new source of information on the employment
impact of the Act. The knowledge generated by the data collection
and measurement under the Recovery Act will be valuable in assessing
economic policymaking for years to come.
The principles of openness, accountability, and public input are
far broader than just the Recovery Act, however. The Administration's
"open government" initiative aims to harness the power of the Internet
to bring the same commitment to transparency and accountability to
every part of the Federal Government. New tools for this purpose are
being developed not only by government agencies but by the private
sector, by open source software programmers, and by citizens around the
country. It seems plausible that eventually the new kinds of openness
and transparency made possible by new forms of technology will have
the same kinds of positive effects on growth that openness and
transparency seem to have had across countries in the past.

Trade as an Engine of Productivity Growth
and Higher Living Standards

Specialization has long been understood to be an important source of
productivity growth. In his Wealth of Nations, Adam Smith (1776)
extolled the virtues of specialization in the pin factory where many
different specialized laborers were involved in producing a simple
pin. Perhaps the most important form of specialization is a transition
from a subsistence society, where people produce all their consumption
goods themselves, to a market economy, where people focus on
particular skills and occupations and depend on purchases for their
daily needs. Another significant transition, though, is one from a
country that must produce everything its inhabitants
want to consume toward one that specializes in particular goods and
services and sells them on global markets for other goods and
services.
Increases in trade and increases in GDP tend to go hand in hand,
but untangling whether economic growth is generating more trade or
whether trade is lifting growth is a difficult task. Creative
research, however, has been able to demonstrate the causal role
trade plays in increasing the amount a society can produce. One study
demonstrated that countries that were geographically better suited
for trade (because of their proximity to trading partners, access
to ports, and the like) have higher levels of GDP
(Frankel and Romer 1999). Another demonstrated that the same
relationship can be seen across time (Feyrer 2009).\3\
------------------------------------
\3\The transition from sea to air traffic for much of the world's
trade has meant more of a collapsing of distance for some nations
than others. Because some sea-based trading routes are inconvenient, a
shift to air transport has increased trade more for some nations than
others. Controlling for other features, countries whose trade has
increased due to this transition have grown faster than other
countries.

Initially, trade was about introducing products (such as spices)
from one market to another, providing consumers with choices they
previously did not have. Still today, trade can offer consumers
different goods and different varieties of products already available
to them and bring new technology from other countries. By allowing
countries to specialize based on skills or endowments, trade can also
allow countries to improve their standards of living. Trade can also
help a country increase its overall output by allowing firms or
industries to take advantage of economies of scale or by encouraging
the growth of more productive firms. Thus, trade has the potential to
increase the overall quantity of goods and services that a given
economy can produce with its resources--and hence increase the overall
standard of living--making global commerce a cooperative, not a
competitive venture. A clear rules-based system with enforcement of
those rules can help ensure that trade is mutually beneficial.
While the act of specializing should lift living standards over
time, it requires shifting resources from one sector to another, and
so can generate short-run dislocations. As a result, it is essential
to strengthen both targeted and more general policies that seek to
ensure all can benefit from increases in trade. For this reason,
after this section describes the productivity-enhancing benefits
trade can generate for the U.S. economy, the following section
discusses how progressive taxation and a strong social safety net
are crucial counterparts to productivity change of all types.

The United States and International Trade

Because of its massive size, the United States can engage in a
considerable amount of specialization and trade within its own
economy. Historically, foreign trade as a share of GDP has been
smaller in the United States than in most other countries. In 1970,
exports as a share of GDP for the average member of the Organisation
for Economic Co-operation and Development (OECD) was 25 percent, while
in the United States, the share was just 6 percent. By 2008, exports
had increased to 13 percent of the U.S. economy (see Figure 10-4).
Although that share is still relatively small, the increase in trade
over the past four decades has meant that even in a large country like
the United States, global commerce is an important part of the economy
and--as discussed below--can be an important source of productivity
growth.





Millions of American workers contribute to the production of goods
and services that are exported to foreign markets, and their jobs,
on average, pay higher wages than a typical job. The Commerce
Department estimates that in 2008 U.S. exports represented the work
of roughly 10 million American workers. The majority of these
export-supported jobs were related to the export of goods; millions
more were related to services exports and nearly a million were
related to agricultural exports. The manufacturing sector is
particularly connected to exports; 20 to 30 percent of manufacturing
employment in the United States in 2008 was supported by exports.
These estimates represent the number of job-equivalents based on
total hours needed to produce the volume of exports. Because few
workers produce exclusively exports or inputs for exports, the
number of workers who are involved with exports is likely
much larger than 10 million.
Currently, the U.S. economy is far from full employment, and any
increased production could generate an increase in jobs. Chapter 4
discusses how an increase in exports may be an important part of
GDP growth in the medium term. In the long run, though, the principal
contribution of an increase in the trade share will be the increase
in productivity and living standards it can generate. Thus, the rise
in the export share of the economy from 6 percent in 1970 to 13
percent today represents specialization, as some workers who
produced goods for domestic use have moved into export sectors.
The following sections describe the ways in which trade can increase
productivity.

Sources of Productivity Growth from International Trade

Productivity growth can come from a number of channels. Trade can
allow increased specialization; it can allow increased scale of
production; and it can allow more productive firms to grow rapidly,
increasing their share of the economy.
Specialization. Inthe United States, a primary source of
trade-related productivity growth is specialization. The concept of
Ricardian comparative advantage--that nations specialize in producing
the goods that they can produce cheaply relative to other goods--can
be seen in a number of aspects of U.S. trade. America makes far more
aircraft, grain, plastics, and equipment (optical, photographic,
and medical) than it consumes. In these product areas, the United
States has a substantial trade surplus, totaling over $100 billion
in 2008. Conversely, the United States produces less electrical
equipment, clothing, furniture, and toys than it consumes, and
therefore imports more of these goods than it exports. If America
cut its production of aircraft, where it has a comparative advantage,
by the $50 billion it currently exports on net and instead tried to
produce more of the goods we currently import, productivity would
likely be lower.
Specialization also takes place within industries. For example,
within the broad category of "electrical machinery and equipment,"
America imports telephones (including cell phones) and computer
monitors, but exports electronic integrated circuits. Specialization
can even take place within more narrow product classifications
(for example, computer memory). Advanced countries with higher wages
tend to produce and export more high-quality products even as they
import lower-cost, lower-quality products from abroad in the same
product type. Economists refer to this within-product differentiation
as the "quality ladder," and extensive research in recent years has
noted this pattern of specialization within products (Schott 2004).
Over time, high-skill countries climb the quality ladder, making
higher-quality products and increasingly importing low-skill products.
For example, consider the category "electrically erasable
programmable read-only memory." The United States both imports and
exports billions of dollars worth of products in this category every
year, but the average unit price of the exports is roughly three times
the average unit price of the imports. The U.S. products may have
bigger memories with more complex production processes or be of higher
quality than the cheaper imports. In any event, the imports and
exports do not appear to be overlapping. Again, such a division of
labor allows for higher standards of living across the world.
Intra-Industry Trade. Beyond specialization, trade can generate
productivity advances in a number of ways. One important channel is
that trade can allow companies to achieve a scale of production that
they could not attain by selling just to the local market, thus
increasing their productivity. Within any given economy, there is a
limit to the quantity of a specific good that the domestic market
will want to consume. The ability to manufacture more of a product
than domestic consumption supports and exchange it for other
products--even ones that are extremely similar to the
exported good--can be quite beneficial. It results in economies of
scale that can be internal to a firm, where one company grows quite
large and productive at making one good, or to a region, where a
particular good tends to be made in a given physical location as a
substantial amount of expertise builds up there.
Trade in which different quality or simply different brand products
are traded in both directions, known as intra-industry trade,
represents between 40 and 50 percent of trade in the world economy.
For the manufacturing industry of the United States, that figure is
even higher. As Figure 10-5 shows, intra-industry foreign trade moved
from roughly 65 percent of U.S. manufacturing trade in the 1980s to
roughly 75 percent in 2001. Frequently, this means two very similar
countries engaging in trade with each other. Five of the seven largest
U.S. trading partners are advanced economies; in fact, despite some
observers' focus on low-wage country imports, roughly 50 percent
of U.S. imports come from other advanced economies. These countries
often have similar endowments of labor and are generally able to use
the same technology, but narrow specialization within product
classes, different brands, or differences in resource allocations
allows for productive exchange.





Firm Productivity. Trade can also allow productive firms to grow
relative to less productive firms as they increase their scale. A new
literature on "heterogeneous firms" has focused less on differences in
endowments or comparative advantage across countries and more on how
firms within an economy respond to trade. A crucial insight in this
literature is that most firms do not engage in trade, but those that
do are on average more productive and pay higher wages. This
literature shows that when a country opens to trade, more productive
firms grow relative to less productive firms, thus shifting labor and
other resources to the better organized firms and increasing overall
productivity. Even if workers do not switch industries, they move from
firms that are either poorly managed or that use less advanced
technology and production processes toward the more productive firms.
Thus, firm-level evidence demonstrates that trade allows not only
economy-wide advances through resource allocation, but also allows
within-industry productivity advances through reallocation of
resources across firms. This shift has clear welfare-enhancing
impacts; see Bernard et al. (2007) for a general overview of this
literature.
Vertical Specialization. Thus far, the discussion regarding
sources of productivity growth in international trade has assumed
that finished goods are being bought and sold across borders. The
world of trade, though, has changed substantially. Today,
multinational corporations (U.S. or foreign-based) are involved in
64 percent of U.S. goods trade (imports and exports), and fully 19
percent of U.S. goods exports are sales from a U.S. multinational firm
to its affiliates abroad. An increase in international vertical specialization, where firms have production in multiple countries
and break up the production of a particular good into stages across
different countries, has contributed significantly to growth in
world trade. The process can be within a large firm or intermediate
inputs can be bought and sold on the market. Decreased trade costs
have made it easier to break up the value chain of production as
various parts of production can be done in different places and an
in-process good can be shipped many times before final assembly.
One study estimates that roughly one-third of the growth in world
trade from 1970 to 1990 was attributable to the growth in
vertical-specialization exports (Hummels, Ishii, and Yi 2001).
Calculations about the extent of vertical specialization vary
from estimates that 30 percent of OECD exports contain imported inputs
to estimates that intermediate inputs account for up to 60 percent of
world trade.\4\
-------------------------------
\4\The 30 percent figure refers specifically to the share of exports
that is made from imported inputs--sometimes called the vertical
specialization of exports. The larger figure includes the volume of
trade that is imports of intermediate goods used in the production of
goods for either exports or the home market.

A trade system in which the same firms are both importers and
exporters complicates considerations of the impacts of trade on
different groups, as comparative advantage may not matter as much for
a particular good as for a particular task or piece of the production
process. Specialization by process should allow the United States to
focus on jobs oriented toward the processes that match the human
capital, physical capital, and technology in the United States, again
increasing productivity. But it has also raised fears that the process
of adjustment could be disruptive, as a broader range of jobs could be
exposed to international competition. The crucial policy goal is to
harness the benefits of trade and ensure that its benefits are shared
broadly by all Americans.

Encouraging Trade and Enforcing Trade Agreements

All of these aspects of trade highlight its potential to contribute
to the long-run expansion of productivity in the United States.
Many of the advantages of increased trade come from opening foreign
markets to the products of U.S. workers. The best way to guarantee
reliable access is through negotiated trade agreements and consistent
enforcement of existing trade rules. As noted in Chapter 3, one
positive development in the recent crisis is that, for the most part,
countries did not resort to protectionism; that is, they did not close
their markets to imports. Had they done so, the dislocation in U.S.
employment would likely have been much worse. As it was, U.S. imports
of goods and services fell 34 percent and exports dropped 26 percent
from July 2008 to April 2009. From their peak in the third quarter of
2008 until the trough in the second quarter of 2009, the nominal value
of exports of goods and services fell more than $400 billion at an
annual rate, a drop of almost 3 percent of GDP. Imports also dropped
substantially. In the long run, such a decline in world trade would be
harmful for the U.S. economy. If trade had stayed at that depressed
level, with lower trade surpluses in the United States' main export
goods and smaller trade deficits in our import goods, the long-run
dislocations from the crisis would have been worse than now expected.
But U.S. exports are rebounding, opening the possibility that many
workers who lost jobs in the crisis may find employment in the same
productive industries where they were before the crisis.
Several explanations have been offered for this avoidance of
protectionism during the crisis. One is the availability of
macroeconomic policy tools such as fiscal and monetary policy
(Eichengreen and Irwin 2009); another is the public commitments made
by leaders at the Group of Twenty summits to avoid protectionist
strategies. But the clear and concrete rules-based trade system was
helpful as well. That rules-based system, embodied by the World Trade
Organization (WTO) and by other trade commitments, allows the United
States to take steps to ensure that other countries will abide by
their obligations. It is also designed to give U.S. workers and
firms confidence about the economic environment they will be facing
and confidence that commitments made when trade agreements
are negotiated will be kept. In addition, creating predictable and
enforceable markets for innovative and creative works grounded in
intellectual property rights is essential to spurring and protecting
U.S. investments in technology and innovation.
The Administration recognizes that simply negotiating trade
frameworks is not enough; robust enforcement of trade rules is an
important part of our engagement in the world economy. The
Administration has taken many trade enforcement actions recently.
For example, the Administration has continued pressing a WTO case
that challenged China's treatment of U.S. auto parts exports. The
ruling in this case resulted in China having to change its policies
and increase its openness to U.S. exports. The United States
(joined by Mexico and the European Union) has also initiated an
action challenging China's use of subsidies and taxes to keep input
costs low for firms in China, which lowers the cost of final goods
from China relative to the world. Further, the Administration takes
very seriously the "Special 301" process under which it monitors
the protection and enforcement of intellectual property rights.
In 2009, it added Canada to the priority watch list because Canada
has not implemented key proposals to improve enforcement and
protection of intellectual property rights. Actions
like these represent the Administration's intent (made explicit, for
example, in United States Trade Representative Ronald Kirk's
speeches\5\) to enforce trade rules and aggressively pursue actions to
open markets to U.S. exports.
---------------------------------
\5\See for example his speech at Mon Valley Works-Edgar
Thomson Plant on July 16, 2009.

As noted in Chapter 4, the Administration is currently pursuing these
and other options to expand American exports, recognizing that
increasing exports will be a key part of the U.S. growth model.
Increases in our exports in the short run can help to return the
economy to full employment. Over the longer run, increases in trade
provide avenues for the United States to increase productivity through
specialization, scale, and firm effects, and in turn, increase
standards of living for American families.
Currently, a number of other trade expansion opportunities exist for
the United States. The Administration supports a strong market-opening
agreement for both goods and services in the WTO Doha Round
negotiations and is continuing to work with U.S. trade partners on
potential free trade agreements. Because the United States is a
relatively open economy, negotiated trade deals often involve
substantial improvements in access for U.S. exports to other countries relative to the market opening made by the United States.
It is also important that these trade frameworks protect
productivity-enhancing innovation through adequate provisions for
intellectual property rights and that they reflect our values
regarding workers and the environment. An example of the
Administration's actions to improve the world's trading regime is
seen in the way the Administration is working to engage our trading
partners across the Pacific region in a new regional agreement
(the Trans-Pacific Partnership). It will be a high-standards
agreement that expands trade in a way that is beneficial to the economy, workers, small businesses, and farmers, and is consistent
with the values of the United States.
In addition to benefits to the United States, trade benefits our
trade partners. This is of direct benefit to Americans in the sense
that as these economies grow, they can grow as a destination for
U.S. exports. Trade can also have large benefits for the poorest
countries. In particular, multilateral agreements that open trade
flows between developing countries can have substantial impacts on
poorer countries, and trade relations with the United States can be
a crucial part of the path to development for the poorest countries.
For example, the African Growth and Opportunity Act seeks to increase
two-way trade with poor nations in sub-Saharan Africa, help
integrate these countries into the global economy, and do so in a
way that improves their institutions and reduces poverty. As
development in the poorest nations of the world is in our national
interest strategically, economically, and morally, trade presents
win-win opportunities to advance development.

Ensuring the Gains from Productivity
Growth Are Widely Shared

Any productivity advance--be it from technological change, trade,
or other factors--will have different impacts across the economy. As
discussed earlier, productivity advances are crucial to an increase in
living standards. Still, those firms that do not make a specific
advance will likely contract or fail, and some workers in the affected
industry may face losses. Likewise, international trade can have
disparate effects across industries, firms, and workers. In both
cases, society on average will be better off because the economy is
able to generate a higher standard of living. But the recent
stagnation in median real wages despite positive productivity growth
(discussed in Chapter 8) highlights the challenge of ensuring that the
gains from productivity growth are widely spread.
The potential for productivity advances to generate disparities in
outcomes suggests the need for strong social policy to support those
who do not immediately benefit and to ensure that gains from trade and
productivity advances are shared by all. Because identifying directly
impacted individuals is difficult, the logical response to
productivity advances is a strong social safety net that ensures that
all benefit from the rise in living standards.
Trade theory suggests that trade liberalization can generate gains
that are large enough that they can be shared in a way that every
member of society is made better off. In the past, however, the
gains from our trade policies have not been shared sufficiently, and
technological change and globalization have left many behind.
Trade adjustment assistance, worker retraining, and temporary relief
programs are ways the Federal Government can and does support those
who do not benefit from these advances. The Administration has
supported trade adjustment assistance, which provides additional
unemployment funds, retraining, and health coverage assistance, and has
made trade adjustment assistance available to a wider set of employees
through the Trade and Globalization Adjustment Assistance Act of 2009.
These specific institutions, though, are not enough. More broad-based
policy must ensure that as the economy grows in the long run, it
enhances living standards for all citizens. Progressive
taxation--which can be justified in many ways--is supported by the
uneven outcomes from productivity advances and globalization. Those
whose incomes rise can pay a larger share of total taxes and still
be better off than before the gains. By doing so, they support lower
taxes for others whose incomes may have declined. This process makes
everyone better off and thus supports innovation and open borders
by minimizing the number of people who feel threatened by
productivity advances and therefore oppose them.
For example, the ability to sell books across borders certainly
enhanced the income J.K. Rowling was able to collect from writing the
famous Harry Potter books. Had she been able to sell her books only in
the United Kingdom, her audience and income would have been much
smaller. In addition, millions of American readers benefited from the
increased consumer choice and the ability to purchase her books.
Similarly, more Americans can work as well-paid aircraft engineers or
manufacturing employees for Boeing or as technology specialists for
Apple because those firms are able to sell on a world market. At the
same time, it is distinctly possible that some American authors who
would have captured a larger share of the "magic-oriented book" market
had there been no trade in literature were crowded out by Rowling's
success, or that some handheld music device
engineer in the United Kingdom has had to find another career because
of Apple's success.
A progressive tax rate combined with trade allows those who realize
substantial income gains from globalization to still prosper a great
deal relative to the state where there is no trade and incomes are
taxed at a flat rate. And it does so while making sure that those who
face lower incomes from globalization also obtain benefits--not just
through the lower prices and expanded choices associated with trade,
but also through lower taxation.
Beyond a progressive tax rate, a strong social safety net can
cushion the disruption generated by a dynamic economy. Unemployment
insurance can provide temporary income. A robust health care system
can ensure that temporary dislocations do not generate drastic
consequences. And a vibrant education system can prepare workers for
changing economic needs.

Conclusion

Advances in productivity are crucial to increasing the living
standards of all Americans--to building a better future. Innovation
initiatives, such as increased research and development, targeted
investments, stronger intellectual property rights, and harnessing
trade's productivity-enhancing potential, are all essential parts of
lifting living standards in the long run. But to ensure living
standards are rising for all, a dynamic open economy depends on a
robust social infrastructure. Education improvements described in
Chapter 8 are crucial to creating a well-trained labor force able to
thrive in a flexible economy where innovation and trade may reshape
industries over time. A sound health care system is needed to provide
the certainty that changing jobs will not mean a loss of health
services. And a productive, well-regulated financial system is
essential to allocate capital to growing sectors. Thus, the
initiatives being taken today as part of the Administration's
rescue-and-rebuild programs are not meant only to correct the
problems of today, but to set the stage for strong growth over
decades to come.