Why Economic Growth Is Getting Harder -- And What To Do About It

04/25/2011 12:57 pm ET | Updated Jun 25, 2011

The worst of the Great Recession is apparently over. The economy is growing again, and the unemployment rate is down to 8.8 percent from its peak of 10.1 percent.

Yet even if the acute crisis is abating, the grim fact is that the U.S. economy still faces chronic health problems. Even before the recession hit, back in 2007, real income for the median American household was lower than it had been in 2000. So too was total employment as a percentage of the population.

Here's the fundamental problem. Economic growth is harder than it used to be. This is the argument made by the economist Tyler Cowen in his provocative new e-book The Great Stagnation. Even if you don't buy all his analysis (and I don't), he's right that the American economy will have to contend with some pretty stiff headwinds over the next couple of decades.

Let me mention here one of the main challenges that confronts us: increasingly unfavorable demographics. If you want to increase GDP per person -- the main yardstick for economic growth -- one of the best ways is getting an ever-higher percentage of the population into the business of producing GDP.

And that's exactly what happened over the course of the 20th century with the rise of women in the work force. In 1900, only 20 percent of women sought work outside the home; in 2000, the female labor force participation rate hit an all-time high of 60 percent. As a result, the overall employment-to-population ratio climbed steady, and this progressive mobilization of Americans into the money economy helped to propel growth and prosperity.

But now demographics are pushing in the opposite direction. Female participation in the labor force started falling after 2000, well before the Great Recession. Meanwhile, the percentage of adult men in the workforce has been slowly declining for decades, thanks to later entry due to more schooling and more years in retirement. And looking ahead, the aging of the population will put further downward pressure on labor force participation.

The switch from a rising to a falling employment-to-population ratio matters a great deal. A recent report by the McKinsey Global Institute estimates that growth in the workforce (due to increasing population) will add only 0.5 percentage points to the average annual growth rate between 2010 and 2020. By contrast, the expanding workforce added 2.0 percentage points to growth back in the 1970s. If we're going to avoid a historically unprecedented slowdown in the long-term growth rate, something has to make up the difference.

That something is productivity. Economic growth can be seen as having two basic sources: (1) increases in working hours per person, and (2) increases in output per working hour. Since the first has tailed off, the second -- otherwise known as productivity growth -- needs to pick up the slack for growth to stay on course. According to McKinsey, we will need to boost productivity growth by roughly 25 percent above present levels to keep economic growth from falling below the long-term historical trend line.

Welcome to the era of "frontier economics." That's the term I used to describe our situation in a recently released study for the Kauffman Foundation. In that study I argue that growth comes in two basic forms: imitation, or expansion based on the application of existing knowledge; and innovation, or the development of new ideas at the technological frontier. Because of shifting demographics and other factors as well, the sources of imitative growth are being exhausted. As a result, we are now increasingly reliant on innovation to keep prosperity alive. The only alternative to Cowen's "great stagnation" is to push back the frontier of our knowledge and know-how.

Once the challenge that confronts us is understood, the implications for economic policy become clear. If we are to pull out of the current slump and launch a 21st-century boom that rivals the growth record of decades past, it will be through unleashing the power of competitive markets to spur innovation.

I'm not talking about laissez-faire here, or the absolute minimum of regulations and taxes. Competitive markets don't exist in a vacuum: They are the product of a highly developed and sophisticated regulatory structure. And the example of the Nordic countries shows that robust competition is possible even with much bigger government than I would personally prefer.

Rather, I'm talking about an economic environment in which new businesses are free to enter the market, struggling businesses are free to exit, prices move freely in response to supply and demand and product offerings change freely in response to consumer preferences.

Both empirical researchers and theorists of economic growth agree: Competitive intensity is the key to spurring progress at the technological frontier. Existing firms pressed by their rivals have sharper incentives to innovate. Meanwhile, a competitive business environment open to entrepreneurial upstarts creates opportunities for those new firms with new ideas that are so frequently the agents of disruptive, discontinuous innovation.

That's the big picture, but what are the specific steps we need to take to make America a more competitive, innovative economy? To answer that question, the Kauffman Foundation launched the Law, Innovation, and Growth initiative to explore how to reform the country's laws and regulations to promote long-term growth. The early fruits of this project were published this year in a new book by the Kauffman Foundation titled Rules for Growth, which contains specific policy recommendations from some of the nation's top legal experts.

We still have much work to do. But here in the era of frontier economics, the choice is clear: innovation or stagnation. To keep the American dream of widely shared prosperity alive, we need to choose entrepreneurship and competition over the vested interests of the status quo.