We are often depressed at our political economy--less about our economy today than about our politics, perhaps, but still depressed. My cure: Americans should travel abroad more. If we did, we would be a lot prouder of what we have accomplished. At the present time, the United States is almost the only country that can point with pride to its economic performance. We have thirty-year lows in both inflation and unemployment. We have a sustained economic expansion that has entered its seventh year.
As a former member of the Federal Reserve Board, I wish I could say that this desirable state is all due to me and my colleagues. I believe that the Federal Reserve, under Chairman Greenspan, deserves some credit. While government action does not necessarily solve problems, wrongheaded government action can certainly create a mess. It is fair say that the Federal Reserve has not made any major mistakes in recent years.
The Deregulation of America
The real reason, however, for our robust performance is not just a lack of mistakes by the Federal Reserve but rather some beneficial actions taken by government that do not get much attention. I refer to the series of steps over the past fifteen to twenty years to deregulate our economy and let markets work.
The series of deregulatory actions in America has been truly phenomenal, and I do not mean deregulation only in the narrow sense. Industries protected by regulators, by tariffs, by oligopoly, by conditions in their markets, or by other means, had considerable discretion in setting prices. The opening of these industries terminated that pricing power--including pricing power in labor markets--and that is the secret behind the American success story.
We started in our transportation industries--airlines, trucking, intercity bus, and rail. We ended oil price controls, and we deregulated natural gas. We removed or lowered our tariffs and ended so-called voluntary export restraints by other countries in such areas as steel, textiles, and autos. Later, we moved on to other industries. Telecommunications has been deregulated. The financial services industry has been deregulated. Banking has been largely deregulated, although more work remains.
The list goes on and on, but there is one clincher. When I go to Europe, I convey the extent of our accomplishment to those I meet by asking, "What is the last industry you would expect would lose its special status in any democracy?" The answer is always the same--agriculture. Last year we began phasing out farm price supports in the United States. When the farmers start taking their hits, we can be sure that all others have already lost their special status, and it is finally the farmers' turn. That shows how far our deregulation has gone.
There has been a parallel on the input side, in our labor markets. Today, only about one worker in ten in the private sector belongs to a union. America now has nearly as many public sector union members as private sector union members. Furthermore, those of us in white-collar jobs have had our own form of deunionization. The comfortable lifetime employment relationships that used to exist for many private sector bureaucrats are gone. Middle management has been squeezed, and we are as close to atomistic competition in the labor market as this country has ever been--certainly the closest since the 1920s.
As students of elementary economics are taught, the main advantage of markets is that they are efficient allocators: goods and services as well as capital and labor flow to their best uses least painfully when markets do the allocating. A macroeconomic corollary to that efficient allocation is less recognized: when labor and capital flow freely and efficiently, the average level of resource utilization in an economy can be higher than it otherwise would have been before bottlenecks or upward pressure on prices appears. We are able, in pure macroeconomic terms, to have a lower unemployment rate today because we have broken up the areas of pricing power that used to come into play when we had unemployment of, say, 6 percent or even 7 percent.
So with both product markets and input markets finally acting like markets, what is the result? Today, because there is less pricing power and markets can allow greater resource utilization, we can reach unemployment rates of 5.5 percent and even lower before we encounter inflationary pressure. That is good news. It has made the work of the Federal Reserve easier than it was twenty years ago. Thus, the microeconomic revolution in America, which freed our markets to work more effectively, has produced a kind of macroeconomic revolution and has allowed us to enjoy lower inflation and lower unemployment simultaneously.
Lessons for Other Countries
What can the rest of the world learn from us? The United States unquestionably leads its major competitors in deregulating industries and in letting markets work. These competitors, however, who are also America's major partners, are catching on to the secret of our success.
The most striking change that I have seen in the past two years has occurred in Japan, where a rather cozy bureaucratic relationship with industry is disappearing. Markets are taking hold there, although the transition is a painful one. It is occurring at least partly because the bureaucrats failed in a few areas, particularly in finance. Japan is now going through a meltdown from its "bubble" economy. A bureaucratic allocation model--which was much admired not long ago by some in the United States--is not appropriate to the challenges Japan will face in twenty years, and the political realization of that fact has now occurred.
In Europe the pace of change is slower. The need for change is recognized, but it is only just beginning. Unfortunately, the side show taking place there in the form of monetary union is gathering most of the attention. Monetary union may or may not be a good idea, but it is, at best, irrelevant to the fundamental problems that beset Europe, which are the same types of problems we had twenty years ago: dysfunctional labor markets, oligopolized industries on a continental scale, and tight relationships between regulators (and government in general) and big business.
Freer markets will come to Europe slowly. The crucial moment there will come when the public, which has been told to sacrifice to achieve monetary union, finally sees it arrive but also sees that the union has not solved their primary economic problems. When monetary union has taken hold and unemployment is still in double digits, the people of Europe will ask, What do we do now?
China is an interesting case as well. Some say it is growing so fast that its gross domestic product will surpass ours in ten or fifteen years. (The same thing used to be said several decades ago about the Soviet Union, incidentally.) Whenever a government has highly inefficient policies and gets rid of them, it tends to reap big initial gains. Then to make further gains, it has to do away with slightly less inefficient policies and the gains are not quite as big. The Chinese have eliminated their most ineffectual policies. They have some way to go, but unless they go much further in liberating their society from government control, they will begin to encounter the same limitations as others, and their growth too will slow. Because they have five times as many people as the United States, I do not claim that they will never overtake us in aggregate GDP, as they could have one-fifth the per capita GDP of the United States and still have a larger economy than ours. But I am skeptical about whether that will occur in the next ten to fifteen years.
Regardless of the degree of their success, China's growth performance nicely demonstrates the benefits of getting rid of bad government policies.
Lessons for Ourselves
The foregoing is a brief account of what the rest of the world can learn from us. One of my greatest worries, though, is that Americans are becoming smug and complacent. After all, for quite a while now we have been the only growing, successful, low-inflation economy on the planet. And we--perhaps any humans would do the same--are beginning to think we have succeeded simply because we are Americans and not because we made some smart decisions during the late 1970s and the 1980s.
The truth is, anyone can imitate our success, and we are not simply destined to be the most efficient economy on earth. Let me cite a region that might, because of the country it is a part of, be regarded as inefficient: northern Italy. Although Italy as a whole gets bad press, northern Italy has an unemployment rate very similar to America's, the lowest in Europe. If it were a country, it would probably have the highest GDP per capita in Europe. And it is achieving this feat in the face of tax rates that go up to 65 percent, a bureaucracy that is horrifyingly stifling, and the need to carry the rest of Italy on its back--not to mention a public-debt-to-GDP ratio for Italy of about 120 percent, which is twice ours.
Now, suppose the northern Italians decided to rid themselves of the 65 percent tax rates and the other burdens they are carrying. Even under those burdens, they are performing as well as we are, and without these handicaps, they would be outperforming us.
The situation in northern Italy should inspire us to learn from our own successes and continue the process of deregulation. Even though we are doing very well, that process is not yet complete. True, if we go down the list of the private sector industries, there is not much left to deregulate; we have included even the farmers. But a big sector of our economy is still untouched by the winds of competition--the public sector. There, resources are badly misallocated, and there we could make considerable gains in efficiency.
My prime candidate for deregulation is the public school monopoly on education. We are squandering untold billions of dollars and getting a substandard product. Some people, including our president, have told us that to improve education we need to spend more money on it. We have tried that; during the 1980s, real per pupil expenditures in public education rose 39 percent. Incidentally, real per capita defense spending rose 30 percent. We know about the big defense buildup in the 1980s, but we had an even bigger public school education buildup. With the defense buildup, we won the cold war. What did we win with our increased expenditures on public schools?
We are now spending roughly $7,000 per child in the public school system. Anyone who wants to think like an entrepreneur should imagine a classroom of twenty-five with $175,000 of demand sitting there. Pay the teacher a very generous salary of $75,000, and there is still $100,000 to take care of everything else. At those prices schools would make a profit if education were a profit-driven industry.
We have a good comparison. The Catholic school system, which has about 5 percent of the nation's students, produces what most consider a better product at 40 percent of the cost of the public school system. These figures suggest that 60 percent of what we are spending in the public schools is what economists think of as dead-weight loss. This comes to $4,200 per pupil for the 60 million pupils in our country, and even in Washington $4,200 times 60 million adds up to a very big number. If we want to grow faster, that is certainly the primary area to address.
A second example is the public pension system. We have, as we all know by now, an unfunded social security liability of about $3 trillion. Our unfunded Medicare liability is a comparable amount. What does that mean? It means that the government has told us that we are to receive $5-6 trillion, in present value terms, in the form of social security and Medicare payments more than the government will tax from us. If, as a people, we think we will get that money, we think we are trillions of dollars wealthier than we really are.
Using an economists' rule-of-thumb that says there is a 3 percent marginal propensity to consume wealth, we can estimate that every year the American people save $150 billion less than they would if they really knew the truth of the matter. Considering that personal saving is only about $250 billion, an extra $150 billion would be a whopping increase. Again, let's bring competition and deregulation to the public sector.
A third area for improvement in the public sector is the decision-making process. The private sector weighs benefits against costs. We do not even try to do anything like this in the public sector. In fact, we make it illegal to do cost-benefit analyses in such cases as the Clean Air Act and the Food and Drug Administration.
Think of it in these terms: if we leave a dollar in the U.S. corporate sector today, society will be $1.09 wealthier a year from now. (The real return in the private sector is about 9 percent.) When the government taxes that dollar or borrows that dollar--it does not matter which, because either way the government is asking the private sector to give up a 9 percent return--and spends it on a project with a return of 15 percent, society is better off, and the economy grows faster. But if government fails to get a 9 percent return on that dollar, society and the economy are worse off than they would have been. By not even asking our government how much we will benefit as a society from its spending and by focusing instead on whether to pay for government's wasteful spending through taxes or borrowing, we miss the fundamental question.
What can we learn from our success? We have increased competition in the private sector. As a result, we now manage to use resources more wisely. The two-thirds of our resources currently allocated by the private sector is about as productive as it can be and is being tamed by market forces daily.
If we really want to grow faster as a society--and we will want to, because our friends overseas will be learning our lessons and catching up--we must turn our attention to the one-third of the resources not subject to competition and must demand that we, as consumers and as taxpayers, get the same kind of performance from public sector resources that we have expected of the private sector over the past twenty years.
Lawrence B. Lindsey holds the Arthur F. Burns Chair at the American Enterprise Institute.