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Why the Economy Is a Lot Stronger Than You Think
By Michael Mandel, with Steve Hamm in New York and Christopher J. Farrell in St. Paul, Minn.
BusinessWeek Online
2006

In a knowledge-based world, the traditional measures don't tell the story. Intangibles like R&D are tracked poorly, if at all. Factor them in and everything changes

You've heard, over and over, about the underlying problems with the U.S. economy -- the paltry investment rate, the yawning current account deficit, the pathetic amount Americans salt away. And you know what the experts are saying: that the U.S. faces a perilous economic future unless we cut back on spending and change our profligate ways.

But what if we told you that the doomsayers, while not definitively wrong, aren't seeing the whole picture? What if we told you that businesses are investing about $1 trillion a year more than the official numbers show? Or that the savings rate, far from being negative, is actually positive? Or, for that matter, that our deficit with the rest of the world is much smaller than advertised, and that gross domestic product may be growing faster than the latest gloomy numbers show? You'd be pretty surprised, wouldn't you?

Well, don't be. Because the economy you thought you knew -- the one all those government statistics purport to measure and make rational and understandable -- actually may be on a stronger footing than you think. Then again, it could be much more volatile than before, with bigger booms and deeper busts. If true, that has major implications for policymakers -- not least Ben Bernanke, who on Feb. 1 succeeded Alan Greenspan as chairman of the Federal Reserve.

Everyone knows the U.S. is well down the road to becoming a knowledge economy, one driven by ideas and innovation. What you may not realize is that the government's decades-old system of number collection and crunching captures investments in equipment, buildings, and software, but for the most part misses the growing portion of GDP that is generating the cool, game-changing ideas. "As we've become a more knowledge-based economy," says University of Maryland economist Charles R. Hulten, "our statistics have not shifted to capture the effects."

The statistical wizards at the Bureau of Economic Analysis in Washington can whip up a spreadsheet showing how much the railroads spend on furniture ($39 million in 2004, to be exact). But they have no way of tracking the billions of dollars companies spend each year on innovation and product design, brand-building, employee training, or any of the other intangible investments required to compete in today's global economy. That means that the resources put into creating such world-beating innovations as the anticancer drug Avastin, inhaled insulin, Starbuck's, exchange-traded funds, and yes, even the iPod, don't show up in the official numbers.

Now, a generation of economists who came of professional age watching the dot-com boom and bust are trying to get a grip on this shadow economy: People like Carol A. Corrado and Daniel E. Sichel of the Federal Reserve Board, who, along with Hulten, figured out that businesses are spending much more on future-oriented investments than widely believed. In a way, these economists are disciples of Greenspan, who understood earlier than most that the conventional numbers don't capture the emerging knowledge economy.

Greenspan was continually digging into arcane factoids he hoped would give him a better insight into what was going on under the hood of the U.S. economy. And Bernanke seems to understand the importance of doing the same. In a speech last year, he said that intangible investments "appear to be quantitatively important." As a result, Bernanke noted, "aggregate saving and investment may be significantly understated in the U.S. official statistics."

BEYOND WIDGETS

As Greenspan would be the first to tell you, it's a lot easier counting how many widgets the nation produces in a year than quantifying the creation and marketing of knowledge. After all, we're talking about intangibles: brand equity, the development of talent, the export of best practices.

This stuff is hard to measure, but to ignore it is to miss what the economy is telling us. And to miss that is to increase the likelihood of committing policy blunders. Including these intangible investments could provide a better picture of the economy, one that offers more advance warning of recessions, slippage in our ability to innovate, and other nasty surprises.

To understand why the government measures the economy the way it does, it helps to go back in time to the 1930s. The Great Depression had the nation in a death grip, and government planners and politicians lacked the tools to answer the big question of the day: Was the economy getting better or worse? To find out, the Commerce Dept. brought in economist Simon Kuznets , then at the National Bureau of Economic Research, to calculate for the first time the nation's income and output -- the purchasing power and production of the U.S. economy. Setting such a benchmark would allow the government to figure out if the economy was growing or shrinking.

A BREAK WITH THE PAST

Kuznets' work set the tone for the rest of the century, not to mention helping win him the Nobel prize in Economics in 1971. Machines and buildings were counted as future-oriented investment, but spending on education, training, and R&D was not. No attempt was made to judge the social utility of expenditures. For example, the $6 million cost of building the Flamingo Hotel, the Las Vegas casino opened by Bugsy Siegel in 1946, was tallied as an investment. But AT&T's funding of Bell Labs, where the transistor was invented around the same time, wasn't even included in GDP. Kuznets himself acknowledged the limitations of his system, yet it stayed basically the same for most of the postwar period.

By the early '90s, Greenspan was becoming increasingly frustrated by the official numbers' inability to explain a rapidly evolving economy. In 1996 and 1997 he refused to accept conventional data telling him that productivity growth was falling in much of the service sector, noting -- correctly, as it turns out -- that "this pattern is highly unlikely." He also pointed out that the official numbers for consumer inflation were too high.

Most of the workers who immigrate to the U.S. each year have at least a high school diploma, while about a third have a college education or better. Since it costs, on average, roughly $100,000 to provide 12 years of elementary and secondary education, and another $100,000 to pay for a college degree, immigrants are providing a subsidy of at least $50 billion annually to the U.S. economy in free human capital. Alternatively, valuing their contribution to the economy by the total wages they expect to earn during their lifetime would put the value of the human capital of new immigrants closer to $200 billion per year. Either the low or high estimate would make the current account deficit look smaller.