The Real Cause of American Growth

Richard Epstein*

Richard Epstein

Richard Epstein

Judging from all the hype, the economic book of 2016 is Robert Gordon’s The Rise and Fall of American Growth. Gordon’s book offers the definitive account of how the many technological innovations between 1870 and 1940 dramatically improved life in the United States. On the positive side, he accurately chronicles the major advances in electricity, public sanitation, pharmacology, and communications—and documents the rise of the internal combustion engine. But on the negative side, the book is utterly silent on why American society was capable of making such a radical transformation during that period.

Gordon’s book has attracted much attention because of his warning that America is not likely to again see such dramatic improvements in the standard of living. The question is why. The first part of the answer is simple enough. In the late nineteenth century, there was a lot of low-hanging fruit—that is, there were many ripe opportunities for innovation. This partially helps explain why American society grew in the years between the end of the Civil War and the start of the Second World War. The second part of the answer, which Gordon leaves unmentioned, is that these innovations coincided with a period of American history when laissez-faire capitalism was at its peak. Growth started to decline because of the massive expansion of the government occasioned by the New Deal, which put a strain on the free market.

Gordon paints a vivid portrait of the painful drudgery of life in 1870: heavy manual labor in darkness and silence, with only primitive drugs and medical procedures. Overall economic growth before 1870—and on this point 1850 may be a more accurate date—took place at a snail’s pace, with life expectancy stuck at 40 years for over three centuries. Gordon argues that things began to shift when Great Britain and the United States first developed decent sanitation systems. The natural experiment of the London cholera epidemic of 1854 persuaded Dr. John Snow that the pollution of the Thames River, and not some mysterious miasma, was the source of the disease. Thereafter, the construction of the London sewers dramatically reduced infectious diseases in England and, when imitated, produced the same result in the United States. Then, in 1881, Louis Pasteur developed the germ theory of disease, which led to the isolation of several major pathogens, and many human lives being saved. At the same time, technical progress surged forward with the invention of the telephone, the electric light, the radio, the automobile, the airplane, aspirin, and much more.

The reason for this advance, as Gordon points out, is that there was so much room for growth. A horse drawn carriage averages about five miles-per-hour. At that rate, a 1000-mile journey takes a painful 200 hours. A train moving at 50 miles-per-hour not only provides greater safety and comfort, but also allows that same journey take place in 20 hours. With the development of the airplane, 20 hours becomes two hours, saving 18 hours but at far greater cost.

This pattern repeats itself with other forms of innovation, too. Understanding vitamin deficiencies in the early part of the twentieth century eliminated many horrific diseases—niacin for pellagrathiamine for beriberi, and vitamin C for scurvy. Simple dietary supplements saved numerous lives. Similarly, the standard treatment for diabetes in 1920 was slow starvation, often ending in death. But the isolation and purification of insulin in 1922 saved many lives. (Consider the case of Elizabeth Hughes, daughter of Supreme Court Charles Evans Hughes. She contracted the disease at age 11 in 1919. When she was 15 years old in 1922, she weighed 45 pounds. But her life changed with her first shot of insulin. She rose, as if from the dead, married in 1930, and lived until 1981.) And the discovery of antibiotics had a similar transformation on the lives of individuals suffering from infectious diseases. The great Vannevar Bush, who headed the American science effort in World War II, noted in his neglected 1945 classic Science: The Endless Frontier, “The death rate for all diseases in the Army, including the overseas forces, has been reduced from 14.1 per thousand in the last war to 0.6 per thousand in this war.”

Gordon’s supports this thesis with an impressive amount of evidence. But his account overlooks why this transformation took place chiefly in the United States and Great Britain, and not elsewhere in Europe, the Americas, or Asia. The explanation cannot lie in the general state of scientific knowledge, which is always freely available across the globe. Rather it lies in the set of national institutions and norms that shape society. On this score, it is noteworthy that the words laissez-faire and capitalism do not appear in the index to American Growth, even though these institutions set the dominant political, economic, and legal frame of the age.

Gordon seems determined to negate the importance of strong property rights and limited government. It is surely no accident that the dust cover of American Growth is the 1939 painting, “The Construction of a Dam,” by the artist William Gropper. The picture shows a group of muscular and determined men precariously perched in the dangerous work of putting up the iron bars needed to support the future dam. Gropper painted in the social-realist tradition, and was known for his “lifelong antipathy to capitalism.”

The picture is an absurd counterpoint to the underlying message of the book. The source of growth and innovation was not brawn. It was brains and innovation, both of which could only take place in a culture that cherished and protected both of these values. It is supremely ironic that the most dynamic period in the world is usually described by lawyers in ominous terms as the Lochner Era, during which the Supreme Court was denounced as a superlegislature for overriding the decisions of the political branches of government when, the story goes, they sought to ameliorate the hardships of the new industrial revolution. Pundits like Louis Brandeis and Felix Frankfurter chided the Supreme Court for failing to see that the rise of large industrial complex required not only a strong antitrust law, which came with the Sherman Act of 1890, but also an extensive range of other interferences in the market in order to promote health and safety.

It is impossible to reconcile the progressive attack on laissez-faire institutions with the huge rate of material and social progress that took place in large measure because the old Court consistently followed classical liberal principles. The majority in Lochner v. New York (1905) got it right when it recognized that the maximum hour legislation of the New York baker’s law was an anti-competitive effort to advance union labor at the expense of non-union, and often immigrant, workers.

The same theme runs through the Court’s stout response to organized labor. Thus the Court properly struck down mandatory collective bargaining statutes at both the federal level in Adair v. United States (1908), and at the state level in Coppage v. Kansas (1915) for the simple reason that labor cartels should never receive state support. The old Court was equally correct in Hitchman Coal v. Mitchell (1917) in enforcing yellow-dog contracts, under which employees agreed (often at their own request) not to become (or promise to become) union members so long as they remained on the job. Similarly, the Court rightly subjected unions in Loewe v. Lawlor (1908) to liability under the Sherman Act for their collective refusals to deal. The flexible labor markets that the Court protected resulted in higher productivity, higher wages, shorter workweeks, and a higher standard of living. The progressives never noticed.

The same pattern held with the new industries. It is not generally appreciated just how expert and precise the judicial response was to government regulation of large firms, common carriers, and public utilities. The Court understood that regulation was intended to curb monopoly profits, not to create endless cross-subsidies between interest groups.

Nor should anyone overlook the excellence of patent law during this period, which gave ample protection to inventors, without allowing any one to dominate an industry or new form of technology. The situation has gotten far worse now that the misnamed America Invents Act of 2011 has undone most of the good work done by the Patent Act of 1952. It is also worth noting that the FDA had no power to stifle the development of new drugs until the constitutional revolution of 1937 gave the United States virtually plenary power to regulate the economic sphere. The 1938 Food Drug and Cosmetic Act was the first modest foray into this space, but the 1962 Kefauver-Harris Act set back drug innovation in ways that continue to this day by requiring “efficacy” to be proven in addition to safety.

The list of course does not end here: just think of the impact of Dodd-Frank on financial regulation and the Affordable Care Act on healthcare. None of these major pieces of legislation receive more than passing mention in American Growth. In his TED talk on this issue, Gordon attributes the decline in innovation to matters of demographics, education, debt, and inequality, ruefully noting the negative growth in income over the last few years in the United States. But at no point does he mention that the source of all these negative trends is an expansion in the size of government that outpaces the rise in GDP.

To be sure, the optimal government is not so small that Grover Norquist could “drag it into the bathroom and drown it in the bathtub,” whatever that means. It should be large enough to deal with the protection of individuals and their property, the creation of infrastructure, and the regulation of monopoly. But over the last 50 years, most government growth has been unrelated to these ends and concentrates on a dangerous combination of redistributive policies, which do not help the poor, and excessive economic regulations that harm everyone. Is there any wonder that the rate of economic growth has slowed, and that median income has gone down as the size of government has gone up? Gordon misses how the decline in our political institutions and social ethos have kept our anemic growth rate below 3 percent per annum since 2005. Gordon, it seems, wants to be understood as yet another champion in the war against economic inequality, just like the flawed Thomas Piketty. Pity he is fighting on the wrong side of the battle. 

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.

Our Fickle Fed

Richard Epstein*

Richard Epstein

Richard Epstein

Two related topics have defined our news cycle of late. The first is the deep populist discontent in the face of prolonged tepid economic growth rates and anemic labor markets. The second is that the Federal Reserve is once again uncertain about whether to raise the interest rate above the near-zero level where its lingered since December 2008. As recently as September 24, 2015, Fed Chairwoman Janet Yellen warned the financial markets that the low rates would not be kept forever, and that firms should adjust by gradually increasing wages. But less than one month later, her plan seems to have been derailed by the disappointing performance in wages, job creation, and consumer spending. The new thinking is that the Fed wants to wait until prices and wages firm up before it begins raising rates. It may wait until 2016 or later. Some experts, like former Fed advisor Andrew Levin, recommend interest rate increases be postponed until the labor markets are nursed back to health.

That analysis is necessarily complicated at the outset because it is difficult to estimate the level of slack in the labor markets. Right now the current unemployment rate stands at about 5.1 percent, which could be read as relatively full employment. That in turn means that wage levels should start to rise as employers compete for new workers. But the low rate of employment growth in the past several years points to serious economic underemployment, well caught in the consistently low levels of labor market participation. The 5.1 percent official unemployment rate does not include those people who have quit looking for work because their job prospects are grim. Nor does it include the many workers with only part-time employment who would be only too happy to take full time jobs if they were available.

From this baseline of conventional wisdom, Levin urges that we delay any increase in interest rates until the slack is absorbed so that employers will be willing to assume the costs of higher interest rates. But just when will this take place? Yellen takes the conventional line and assumes that the recent round of bad news is best attributable to temporary factors including weak energy prices and low import prices. But this is wishful thinking. The low energy prices are in part a function of improved fracking technologies that are only going improve with time. And they could still go lower if at long last the U.S. allows the export of crude oil, and OPEC members maintain their current high production levels. Yellen also believes that the flood of imports attributable to the relative weakness of the Euro is another factor that explains our weak economy. But this, too, is not likely to change any time soon.

Even if both of my predictions are proven wrong, temporary economic impediments are never in short supply. A cold spell, or hurricane, or political disruption could count as a short-term factor. None of these temporary factors precluded the far higher rates of growth that the United States enjoyed during much of the post-World War II period. But now, these factors always seem to count.

It’s likely that the slack in labor markets has become the new normal, which means that interest rates will never be allowed to rise. We have now tried to boost the economy and labor markets with a zero-interest rate strategy for close to seven years, with nothing to show for it. The belief that low interest rates will make the economy stronger is the triumph of hope over experience. In my view, our sorry state of affairs is no surprise. There is no theoretical reason to believe that any interest rate manipulation could repair fractured labor markets.

Let’s start with the simple observation that if low interest rates work in hard times, why don’t they work in good times? The answer is that artificially low interest rates are bad at all times. The stated rationale is that these interest rates are needed to stimulate borrowing and investment. Of course, low rates induce people to borrow. But from whom? It can only be from the people who will be less willing to lend at low interest rates. The affected classes include the large number of retired individuals whose ability to maintain their standard of living is reduced by the low rates of interest that they are likely to receive. They may now have to cut their consumption in the short run in order to make ends meet, just as their lower savings translate into reduced pools of investment capital. The entire strategy is just an ill-disguised subsidy to borrowers from lenders, which at best is a zero-sum transaction with little or no net economic effect.

Indeed a fuller evaluation is more pessimistic. Individuals and firms must borrow and invest over the long term. They cannot introduce major capital improvements in a day, a month, or even a year. Every time the Fed flips in one direction and then another, the added uncertainty negatively impacts borrowers, lenders, savers, and consumers alike. That added uncertainty reduces participation on both sides of any market, consistent with the low long-term levels of growth.

The unbroken record of disappointment should give rise to a fresh start. The first place to look is the Fed’s own mission statement, which lists as its first duty “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.” The difficulty here is that the Fed cannot be all things to all people. There is no question that only the Fed can make adjustments in interest rates that will stabilize the money supply and eliminate one measure of uncertainty in lending, labor, and sales markets—thus increasing the ease of voluntary business transactions.

Nonetheless, the successful execution of this part of its mandate is inconsistent with the Fed’s efforts to create maximumemployment. There is no way that the Fed can pick a single interest number that discharges both functions if stable money requires a market rate of interest and maximum employment requires a low rate of interest. There is no reason why the Fed should even try to serve two inconsistent objectives. It is striking that virtually none of the discussions of the Fed’s role on the labor market asks this simple question: What other factors influence efficiency in labor markets?

Why that reticence? The simplest explanation is that the Fed thinks that the interest rate is the close to an all-powerful determinant of labor market health. But this view reflects a total lack of awareness of the massive impact that multiple forms of labor market regulation can have on job creation and wages. Instead of relying on complex macroeconomic calculations, let’s take a hard look at some of our microeconomic realities. It is no secret that President Obama thinks that we need a wealth of government interventions in the economy to improve the position of the middle class. As he said at the White House Worker Voice Summit: “Labor unions were often the driving force of progress,” and “the middle class itself was built on a union label.” It is also no secret that the current populist agenda favors a push of the minimum wage to $15, mandatory paid-leave policies, the repeal of right-to-work laws, treating franchisors like McDonald’s as employers subject to the National Labor Relations Act, and expanded overtime coverage under the Fair Labor Standards Act.

The President’s pro-union policies are deeply regressive. They hearken back to a clunky and rigid legal regime from an older economy defined by large assembly lines. That regime cannot keep pace with the dynamic technological innovations that define today’s economy. The President’s harsh rhetoric may play well to a gallery of like-minded enthusiasts. But it strikes terror in the hearts of those individuals who are on the fence about opening a new business or expanding an old one. This entire class of potential employers includes, of course, many people who regard themselves as part of the shrinking and beleaguered middle class. To them any restriction on their freedom to set the terms and conditions of their employment is a good reason not to start a business in the first pace. Yet it is just policies of this sort that receive legislative enactment, such as the misnamed California Fair Pay Act. These policies pose a serious threat to the vitality of their respective labor markets.

There is, unfortunately, a close relationship between the Fed’s effort to make labor markets whole and the unending array of government initiatives targeted at the labor market. It is easier to the supposed reformers of labor markets to think that their job is to ensure equity so long as it is tacitly understood that the push toward full employment can be handled best by the Fed. The role of the Fed thus makes it possible to debate labor reform measures in terms of their distributional aspirations, given that the institution is supposedly there to set interest rate policies that will return labor markets to the full employment of the post-World War II era.

This sorry combination gets both sides of the equation wrong. There is almost nothing that monetary policy can do to get the cobwebs out of the labor markets. The Fed should stop acting as though its interest rate decisions can do any good. At the same time, everyone must understand that the current stagnation in labor markets is driven by policies to tighten government control. No amount of political rhetoric can conceal the central point about the sound operation of labor markets. The key government role is to reduce the barriers to voluntary contracts in order to maximize economic activity. Tighter regulation pushes in exactly the wrong direction. It’s like feeding sugar to a diabetic. There is little support for deregulating labor markets so we should expect the stagnation to continue for some time, regardless of what the Fed chooses to do. 

*Considered one of the most influential thinkers in legal academia, Richard Epstein is known for his research and writings on a broad range of constitutional, economic, historical, and philosophical subjects.