How the economy has changed. (1) The United States has become much more integrated into a highly competitive global economy. (2) There is greater competition at all levels, both in product and labor markets. (3) There have been revolutionary changes in manufacturing that have led to a transformation of how products are made, particularly on the factory floor and in the utilization of workers. (4) There has been a boom in capital investment, much of it in computers and information processing, that has contributed to a sharp rise in manufacturing productivity. (5) Workers are taking over control of production in an environment requiring increased skills and knowledge; this has been bolstered by incentive-based compensation systems. (6) All these changes have led to an increased capacity to grow with less inflation and a flatter business cycle.
Global integration. The main impetus for structural change originated with greater international competition, particularly pressure from imports penetrating the American market. During the early 1980s, foreign competition was seriously aggravated by the appreciation of the dollar. Even without this, however, the United States would still have had to contend with increased competition from the Third World, which had industrialized by the late 1970s. As a result, there is now a much greater emphasis on international markets by firms, both with respect to competing with imports and exporting to foreign markets in order to provide new opportunities for growth.
The combined effect of the low dollar and cost control at the firm level has made American industry highly competitive in world markets. For instance, the American share of world manufactured exports rose from a low of 11.6 in 1986, when the dollar was still highly overvalued, to 12.9 percent in the early 1990s.
Greater competition at all levels. There is much greater competition in product markets, due to global competition and deregulation. In essence, prices are no longer set just in the domestic economy, and firms possess limited market power. Rather, prices are set in the global economy, and firms are forced to compete by raising productive efficiency and lowering costs. Simultaneously, there is greater competition in labor markets.
Revolutionary change in manufacturing firms. In the face of greater competition, firms have aggressively reduced costs and restructured. There was a general flattening of the managerial system. Compensation was made more dependent on the profitability of the firm. After a long period in which firms had evolved into diversified conglomerates, they began to emphasize core businesses. they sold off subsidiaries and outsourced many activities, reducing overhead. The trend toward outsourcing became particularly marked during the early 1990s, when increased use was made of outside firms not only for inputs to production but also services and technical expertise. Greater emphasis was placed on product quality. The technique of continuous monitoring of products with automatic feedback to the production process has no become so common that it has acquired the generic term Total Quality Management (TQM).
Firms also undertook technological and process improvements. The most widely used is just-in-time (JIT) inventory control. A similar process improvement is material requirements planning. In statistical quality control (SQM), computers are used to monitor the quality of output and analyze defect rates. Other examples of process improvements are computer-aided manufacturing and networks. Finally, computer-aided design (CAD), in which graphics and visual software enable engineers to draft and manipulate designs on a terminal.
Capital investment and productivity. The current business cycle has witnessed a boom in business investment, which has been concentrated in computers and information processing equipment. In 1994, business fixed investment grew by 13.6 percent in real terms, while investment in equipment increased by 17.5 percent. Of the gains in equipment, fully 47 percent was accounted for by computers and information processing, and 26 percent was comprised by computers alone.
While productivity dropped throughout the economy during the mid-1970s, it rebounded in manufacturing starting in the early 1980s, and actually accelerated above its prior trend. The gains in productivity reflect several factors. We calculate that 30 percent was accounted for by reduced employment, 25 percent by rising capital intensity, and 45 percent by technological advance.
Higher productivity implies a faster growth rate of potential output -- the long-term rate of growth that is consistent with a stable rate of inflation. This can be roughly measured as the growth in the labor force plus the trend in productivity growth. We suspect that potential output in the late 1990s will be higher than the Federal Reserve's widely-cited estimate of 2.5 percent per year.
The new worker. The automation of the production process has meant that manufacturing jobs now require extensive technical knowledge, and as a result higher levels of education. The term "knowledge workers" -- employees with technical skills -- describes much of today's labor force, nowhere more than in manufacturing. The rise of skilled workers has to some extent been associated with the decline of pyramidal management. The higher salaries that go with these technical jobs are not dependent on advancing in a hierarchy, but rather reflect the value of the specialized skills in the market. As a result, organizations are more likely to be flat, and workers are likely to be organized into teams that combine particular sets of skills.
A further implication of knowledge-based work is that education will assume increasing importance. With the market paying salaries based on skill levels, workers who are most likely to be successful will be those who have had access to higher education, and who have obtained degrees in professions that are in demand.
The capacity to grow with less inflation. There are several reasons to expect inflation to remain low. One consequence of the more competitive environment was a drastic change in price expectations. Since the 1980s competition has kept prices lower, with the result that industry can only achieve higher margins by controlling costs. Simultaneously, workers have kept wage bids lower in an effort to preserve jobs. This new disinflationary mentality has gradually taken hold throughout the manufacturing sector, and has a deeper implication. With price expectations permanently lower, it has become possible to produce more output at lower inflation than in prior decades.
A final possible implication is that the business cycle as a whole may turn out to be flatter, with longer slower expansions and shallower, less frequent recessions. This reflects two factors. First, historically, a large share of the decline in output during recessions is accounted for by the selling off of inventories. Better control over inventories implies less severe recessions. Second, the primary cause of recessions has been a buildup in inflation, followed by a tightening of monetary policy. A general tendency toward lower inflation coupled with more stable monetary policies points to a less volatile path for the economy.
Further policy implications. The nation's overall focus in the new economy must be to do everything possible to improve our ability to compete. This in turn dictates that we move forward on two broad fronts. First, we must examine existing premises about what is acceptable policy, particularly with respect to government actions that are wasteful, impede private sector activity, and are simply too expensive in today's more demanding world. The transformations in manufacturing provide a guide for what the government should do. Second, we need to advance a positive agenda for manufacturing, for entrepreneurship, for growth and for jobs.
Regulatory Reform. The current regulatory system is extremely costly. We estimate hat in 1995 direct expenditures for compliance with environmental regulations were in the range of $128 billion, with up to $87 billion paid by business. There are also indirect costs in terms of lost production, which occur primarily because the capital stock becomes unproductive. The costs in terms of lost output came to 2.7 percent of real GDP, or approximately $149 billion in constant 1987 dollars. Congress should reform the regulatory system by repealing unnecessary and burdensome regulations. Environmental regulations should be made target- oriented, giving the private sector flexibility in meeting goals, in place of the current command and control system. All new regulations should be subject to a requirement of risk assessment and cost-benefit analysis.
Reducing the Federal Budget Deficit. The Federal deficit should be reduced. At its current levels, the Federal deficit is keeping real interest rates higher than they have to be, while at the same time Federal dissaving only creates an imbalance between saving and investment that worsens the trade deficit. A lower Federal deficit would lower real interest rates, while at the same time boosting savings and improving the trade balance.
Monetary Policy. Monetary policy should not be allowed to become so tight as to force the economy into a straightjacket of no more than 2.5 percent growth. Instead, policy should be sufficiently accommodative to allow growth rates in the 3 percent range. Both because of higher productivity and greater competition in labor markets, there is little risk of accelerating inflation.
A Positive Agenda for Growth. (1) In order to stimulate investment, repeal the Alternative Minimum Tax (AMT), and cut taxes on capital gains.
(2)In order to stimulate technological advance, the R&D tax credit should be made permanent, and possibly expanded. Patent protection should be strengthened.
(3)In order to promote exports, controls should be dismantled while export-promotion policies should be maintained.
(4)Education is sufficiently important that it will require greater action from all sectors. The Federal government should put emphasis on standards and educational programs. The states should reform existing guidelines for private sector training and vocational education.