The 'big trade-off' debunked: the efficiency of a fair economy.

The "Big Trade-Off' Debunked: The Efficiency of a Fair Economy

Americans are uncomfortable when it comes to talking about equity or economic fairness. They are willing to help those in need, but they don't like to think about economic justice in a larger context. Americans wish that the issues of economic equity would go away and hope that the market will turn up an acceptable distribution of income. Perhaps because of this strongly held desire, Americans of all income classes tend to believe that the distribution of income and wealth is more equal than it is.

As the income of the middle class has declined, the American distribution of income has become noticeably more unequal. Between 1969 and 1982 the income share going to the bettom 50 percent of all American families has fallen from 23 to 20 percent of the total; the income share going to the next 40 percent has fallen from 48 to 47 percent, while the income share of the top 10 percent of the population has risen from 29 to 33 percent of the total. As officially defined ($10,178 for a family of four in 1983), poverty is now rising rapidly, and about half of the people being added to the poverty rolls are children.

While slow productivity growth, recessions, demography, and trade deficits played a role in these adverse trends, the programs of the Reagan Administration have contributed to the changes. According to the Congressional Budget Office, Reagan programs added 557,000 people to the poverty rolls. The Urban Institute estimates that Reagan programs subtracted $281 from the average income of those in the poorest 20 percent of all families, while adding $598 to the average income of those in the richest 20 percent of all families.

If one looks at the distribution of wealth (net worth), inequalities are larger and growing more rapidly than those of income. While the top 10 percent of the population receives 33 percent of total income, they own 57 percent of total net worth. Almost 20 percent of all American families have zero or negative net worth.

The problem of economic justice is not going to go away as long as black males earn significantly less than white males (58 percent as much in 1983), as long as women earn significantly less than males (64 percent as much in 1983), and as long as the gaps between rich and poor are growing as they now are. Income distribution problems may for a while be superseded by other problems and lie dormant, but they will inevitably reappear. Democracies that profess to believe in political equality live only uneasily with rising economic inequalities.

Historically, it has been the role of the Democratic Party to work for economic justice. This is a role it cannot and should not attempt to jettison. Almost without notice, however, there has been a shift in the perceived strategy for dealing with economic injustice. Today the Democratic Party is tagged as the party in favor of welfare--income transfer payments. Such an identification is recent and in some ways not fair. Not so long ago welfare programs were seen by Democrats as a second-best temporary solution to a problem that required a first-best permanent solution.

A lesson from LBJ

In 1964, armed with a brand-new Ph.D. in economics and having just gone to work for the President's Council of Economic Advisers, I was given the task, at what I was told were the direct personal orders of President Johnson, of going through the Economic Report of the President and making sure that the words "welfare' and "income transfer payments' never appeared and never were associated with Johnson's Great Society programs. In Johnson's view, the Great Society programs (more education, more manpower training, less discrimination, more jobs) were to help people earn their own incomes. They were not income transfer payments designed to give anyone an income without work. At the time I remember thinking that I had been given a rather silly task. I no longer believe it was.

Looking back at Roosevelt and the New Deal, the same beliefs were firmly held. It was all right to provide relief for those who could not work (the elderly, the handicapped, the sick), and it was all right to give temporary relief to those who had previously been working and who had been thrown out of work (unemployment insurance), but permanent general welfare programs were never part of the New Deal ideology. Instead, jobs were provided. In 1938, 4.3 million people were employed in agencies such as the Works Projects Administration, the Civilian Conservation Corps, and the National Youth Administration. To employ the same fraction of the labor force today, more than 9 million jobs would have to be provided.

If one asks why the Democratic Party shifted from being a party with an emphasis on jobs and an opening up of opportunities for higher earnings to being seen as a party identified with higher welfare payments, there is an interesting story to be told. While one would think that there would be less political resistance to job programs than there would be to welfare programs (and that is true for the general amorphous public), precisely the reverse is true when it comes to special-interest groups. Most of these special-interest groups are producer groups, and they are much more willing to see general tax revenue go for expanded welfare programs than they are to see government actively working to create jobs or working to alter the distribution of earnings. Producer groups pay only part of the higher taxes necessary to finance more welfare payments, but any restructuring of the economy to produce more jobs or a more equal distribution of earnings directly threatens their current position.

As a result, an implicit compromise was worked out during the Nixon Administration. Programs would be expanded to help the poor, but they would be welfare programs and not programs that required any fundamental restructuring of the economy. After correcting for inflation, income transfer payments to persons rose 156 percent in the eight Nixon-Ford years--more than twice as much as they had risen in the eight years of the Kennedy-Johnson Administration. After correcting for inflation, income transfer payments actually fell 9 percent under Carter. Despite these statistical facts of life, the Democrats were tagged as the party in favor of putting people on welfare. Congressional Democrats had voted for the increases and Reagan, not being willing to extend the implicit compromise made by Nixon and Ford, made attacks upon a welfare mentality a central theme of his campaigns.

While welfare can be defended economically, it cannot be defended politically. To want to reform the welfare system to make it into a better, more humane system is politically seen, or can easily be made to be seen, as a policy advocated by those who want to put more people on welfare. Politicians placed in that position usually lose. Americans do not want to put people on welfare. Nor should they. The best that can be said for welfare (and it is a lot) is that it is better than having a society full of hungry people. But it is a second-best solution.

Democrats should focus their attention on first-best solutions--a restructuring of the economy to provide more jobs and a more egalitarian distribution of earnings. The time is ripe for such a shift, since the economy needs to be restructured anyway if productivity growth is to be enhanced and international competitiveness restored.

Fortunately, the changes that will be necessary to make the economy more efficient are congruent with what needs to be done to make the economy more equitable. All of our major international competitors have found this to be true. None have slower productivity growth; all (with the possible exception of France) have a much more equal distribution of income. While the ratio of average incomes between the top and bottom decile of incomes is 14 to 1 in the United States, it is only 6 to 1 in West Germany. What can be achieved in Germany can be achieved in the United States.

In an economy with rapidly growing productivity, it is possible to argue that equity questions can be pushed to the back burner. If everyone's income is going up, then equity is being enhanced--at least for those who believe that equity is best measured by looking at absolute incomes or the percentage of the population that cannot afford some minimum standard of living. It isn't possible to avoid equity questions, however, in an economy with low productivity growth, where the relevant question is not "How should the economy's growth division be allocated?' but "From whom should the resources be taken to provide the funds necessary to restore productivity growth?'

When the Reagan administration designed its 1981 tax and expenditure cut package, it claimed that the supply-side response to the tax cuts would be so rapid that no one's income would decline. As predicted by others, it did not work that way. Families with incomes below $40,000 had their incomes reduced; families with incomes above $40,000 had their incomes enhanced. Explicitly the Reagan Administration denied that it was making equity decisions, but in fact it made a very unfair equity decision to load the costs of rasing the American savings rate (the announced reason for the tax cut package) on low- and middle-income Americans. Since the American savings rate did not go up in the aftermath of the 1981 tax cut, the tax cut package was inefficient as well as inequitable, but that is a later story. Democrats need to replace such equity decisions with a better understanding of what economic justice is all about.

I believe that all those who argue that democracies cannot impose sacrifices on their citizens for the sake of the common good without the impetus of war are wrong. When I talk to different groups about the structural changes, such as the need for more savings and investment that America will need to make to restore productivity growth, I do not get a negative response. Instead the response goes something like this: "I don't like what I hear. I wish it weren't true. But I can understand that low productivity growth and big balance of payments deficits are not viable in the long run. I would be willing to make some of the sacrifices that will be needed to restore U.S. competitiveness if you could convince me that everyone else was fairly sacrificing and carrying his or her share of the load at the same time.'

No suckers

Sacrifices don't have to be identical, but they do have to be equivalent if they are to be voluntarily made; and in a democracy they must in some collective sense be voluntarily made. Americans are smart enough to understand that different groups will be asked to shoulder different burdens, but they want to be fairly treated when those sacrifices are assigned and assured that every other group will be carrying its proportionate share of the total burden. A sharing of burdens where the top 10 percent wins and the bottom 90 percent loses is not acceptable.

If a sense of economic justice can be generated, it just might be possible to make the large number of changes that will be necessary to restore U.S. competitiveness, even though each of the individual changes, evaluated one at a time, would be called politically impossible. What is needed first is a sense of crisis--the U.S. faces a competitive fight for its economic life. Second, public education, in the best sense of that word, is needed to convince most Americans that the changes are necessary; and third, leadership is necessary to fashion a package of sacrifices where all end up feeling that they are carrying their fair share of the necessary burdens and that no one is escaping from his fair share.

In a democracy, fairness is doubly important. It helps create the common bonds that hold us together politically, but it is also necessary if markets are to be allowed to operate. Whatever the efficiency of free markets, in a democracy the majority or even substantial minorities can effectively vote to stop the market from working freely if they feel that the market is treating them "unfairly.'

Most often anyone who is a market loser, regardless of his previous religious attachment to the virtues of free markets, feels that he or she is being unfairly treated. Industries threatened by international competition, for example, invariably run to Washington for protection--right-wing Republican businessmen hand-in-hand with left-wing Democratic unions (see "Industrial Policy, Not Protectionism,' p. 49). Many groups have gotten such protection--dairy products, autos, steel, textiles, processed meat, motorcycles; many other groups want such protection--machine tools, semiconductor chip manufacturers. Demands for protection are not peculiar; they are the rule. Only market winners want to let the market work unfettered by government intervention.

Standards of fairness become central when an economy needs major restructuring if it is to remain successful. Any restructuring requires sacrifices on the part of someone, and in most cases such sacrifices cannot simply be ordered. Even in wartime, sacrifices cannot be commanded but have to be volunteered in a cooperative effort for victory.

To address major problems that require temporary sacrifices and changes in ways of life, Americans must feel (1) that they have something to lose if the problems confronting society are not solved, (2) that it is not possible to solve those problems unless everyone is willing to be mobilized, and (3) that such a mobilization can only occur if all Americans feel that they are being fairly treated in terms of the sacrifices asked.

In the case of low productivity growth and diminishing international competitiveness, America faces just such a wartime situation. Everyone, even the most favored group, has something significant to lose. Consider adult white males--the most favored group in the American labor market. The hammering that American industry is taking in world markets is being administered precisely to the industries where they have traditionally been employed. Males accounted for 65 percent of the more than 5 million people who had been working for more than three years but lost their jobs between January 1979 and January 1984. Three million of these job losses could be attributed to America's trade deficit. Not so long ago (1981), adult men had unemployment rates significantly below those of adult women. Today the reverse is true. Of the five million people who lost their jobs, 40 percent have not found new jobs. Of those who have found new full-time jobs, 45 percent are earning significantly less than before. Another 7 percent have suffered large income losses, since they have only been able to find part-time work.

If the only problem facing America were discrimination and low earnings for blacks, Hispanics, and women, white males could opt out. They cannot opt out from the problems of productivity and competitiveness, however, since they are losing their jobs at an even faster pace than the groups that have traditionally been at the bottom of the labor force. Successful foreign competition won't drive Americans from their bad jobs. Foreigners don't want those jobs. The competitive pressures will come precisely in those jobs Americans want to have.

Unconventional wisdom

If one examines what must be done to bring each of the major inputs going into the American economy up to world-class standards, it is clear that Americans are going to have to rediscover teamwork. No one, however, can build a successful economic team if the individual players on the team feel unfairly treated.

Conventionally, equity and efficiency are seen as mutually conflicting goals--the "big trade-off,' in the words of the late Arthur Okun. In economic theory, the free market in its search for 100 percent efficiency generates a particular precise distribution of income. Technically, every worker or unit of capital used in production is paid in accordance with individual (marginal) productivity. To interfere with the market distribution of income in any attempt to generate greater equity produces inefficiency. Any factor paid less than its productivity warrants works less or saves less than it otherwise would, so that total output to be divided falls. Efficiency suffers. The greater the interventions to promote equity, the less efficiently income is generated. As a result, there is only a limited amount of equity that any society can afford to buy--or so the argument goes. Conservatives argue that American economic problems spring from too much equity. More efficiency demands less equity.

This conventional view is incorrect. All of our major industrial competitors, with the possible exception of France, distribute income both before and after tax more equally than the United States. The world is full of empirical evidence that efficiency does not require less equity. Quite the contrary, to obtain the efficiency the United States needs, it is going to have to promote equity.

Equity is often incorrectly used as a synonym for equality. Equity does not arise when everyone is treated equally regardless of circumstances or contribution, but when everyone is treated "fairly.' What any population is willing to regard as fair depends upon history, institutions, and values. It also changes over time.

With the onset of World War II, for example, social standards of fairness changed. Because many Americans were risking their lives in combat, those at home were convinced that civilian earnings were unfair relative to the sacrifices on the front lines. As a result, wage and price controls were deliberately used during World War II to narrow the distribution of earnings. The sacrifices of those directly fighting the war required more fairness in the domestic economy, and those indirectly fighting the war willingly gave up their unfair wage differentials.

According to conventional economic wisdom such efforts to promote fairness should have led to less efficient military production. But they didn't. The American economy enjoyed enormous gains in both output and productivity-- up 22 percent from 1940 to 1945. The perception of fairness created a feeling of teamwork and esprit de corps that contributed to efficiency and output rather than subtracting from it. Any major initiatives to restore American competitiveness will require the same feelings.

Present peacetime economic problems are not all that different from those experienced in World War II. Americans must mobilize to increase the quantity and quality of the products they produce, and this requires a widely shared perception of fairness. Just as an army can move only as fast as its slowest unit, so the economy can only be as good as its poorest motivated, least cooperative component. As with an army, the economic problem is teamwork--obtaining sacrifices from everyone, getting everyone to march faster and work together better.

Similarly, real efficiency does not result from the simple enforcement of rules and regulations on a sullen work force. Everyone is familiar with instances where workers do not strike but withdraw their voluntary cooperation and "work to rule.' In the Boston subway system, for example, the rules say that a train cannot leave the train yards without its window wipers in working order. Normally, the rule is ignored on sunny days, but when working to rule, it is not. Within a few weeks of working to rule a few years ago, the whole subway system essentially ground to a halt for a lack of operational equipment. A society or a firm that depends solely upon the enforcement of rules and regulations is an inefficient society or firm. All societies need voluntary cooperation to be efficient.

Hi-ho, Silver!

Americans like to view themselves as economic descendants of the Lone Ranger. It was "rugged individualism' that made the American economy great. Or was it?

Social myths are important. True of false, they are part of what we are. They color how we see ourselves. More important, they create a set of blinders so we see only part of our history and only part of the vista before us. As a result, we are apt to act without a complete view of who we are and where we are going. Not surprisingly, those who act in partial blindness are apt to make blind mistakes.

Consider Fortune magazine's Business Hall of Fame. What rugged individuals hang on the walls? Henry Ford. What did he invent? The assembly line--a form of social organization where production workers worked together in more efficient ways than they had before. Alfred Sloan. What did he invent? The committee system--a form of social organization where managers and white-collar workers learned to work together more efficiently in planning company operations.

Ford and Sloan were bright individuals but their genius was not found in Line Ranger solo activities. Their genius was found in their ability to get other individuals to work together in more productive ways.

Since economies are almost by definition social organizations, it is not surprising that economic genius almost always involves the ability to organize society better; but any society that insists on describing its own history as if it were a product of rugged individuals and nothing else is apt to underestimate the importance of social organization and focus too little of its attention on improving social organization. And if there has ever been a society that has fallen into this trap, it is America.

The Reagan Administration and much of the economics profession believe that social institutions and structural arrangements either don't matter or take care of themselves. "Get the government out of the economy and off the backs of the people.' Underlying this political battle cry is the belief that competition forces the best possible institutional arrangements to the fore. "If it wasn't efficient it wouldn't exist. If it does exist, it must be efficient. If there was a better way to do it, that better way would automatically drive the inferior way now in use out of existence.' Therefore, as the syllogism goes, societies don't have to make deliberate social changes in their institutions and the ways in which they organize themselves. Instead of trying to improve the ways that society is organized so that it works better, as President Roosevelt did when the American economy failed to recover from the Great Depression by itself, Americans have merely to stand aside and "let free enterprise do its thing.'

But the truth is that societies that win economically are the ones that pay attention to improving their social organization. If America wants to be a market winner, it must organize itself to win.

Team USA 

In international trade, precisely the opposite is happening. The rest of the world is organizing itself to make America a loser. Our bilateral balance of trade deficit with Japan is so large as to be embarrassing. Polite people simply don't talk about the actual numbers in public. Whatever one thinks about the causes of Japanese success, it cannot be attributed to rugged individualism. If there was ever a culture that deemphasized rugged individualism and emphasized social organization, it is the Japanese.

Industrial societies need brilliant individuals, but they succeed or fail depending upon the average quality of each of the components going into the economy, and a high average almost always requires social organization. A society where everyone can read and write beats a society where most are illiterates but a few are geniuses. This is why our forefathers invented mass public education and required that everyone be educated. They understood that they could not be successful unless all of their neighbors' children were well educated and capable of being productive members of the work force.

In the late nineteenth century and the early twentieth century, when the United States was overtaking Europe, America had mass education on its side while Europe had elite education on its side. Economically, mass education beat elite education. Today the reverse is true. Americans win more than their fair share of Nobel prizes, but the average Swedish high school graduate knows twice as much math as the average American high school graduate. Based on America's own history, it should come as no surprise that America is simultaneously dominating in elite education while falling behind in mass technology. In the past it happened to Europe; today it is happening to America. To improve American education, and it will have to be improved if we are to succeed economically, will take a lot of social organization and very little rugged individualism.

The interesting thing about America's love affair with the Lone Ranger myth is not that the Lone Ranger did not in fact exist. It is that he could not have existed. The American West was not settled by Lone Rangers. Precisely the opposite, it was settled by wagon trains and community barn-raisings--social organization. Individuals alone on the high plains of Montana in 1840 or 1870 weren't successful--they were dead. What was in fact a social triumph is mythologically described as if it were an individual triumph.

Evidence for the importance of teamwork is all around us. Each of us knows that her own individual wages will be higher if she plays on a successful economic team (IBM) than if she plays on an unsuccessful team (Braniff Airways).

Firms that can inculcate a feeling of teamwork do better than those that cannot. Such individual experiences are confirmed statistically in the learning or experience curves used in operations research. Typically, in the first two or three years after a new plant opens, productivity rises 200 to 300 percent as workers learn how to work together as a team. Yet Americans often deny the obvious when describing what they do.

The poor American productivity performances come not so much from less "hard' productivity (inferior technology) but from less "soft' productivity (poorer motivation, less cooperation, adversarial relations rather than teamwork). Soft productivity is an untapped productivity vein of gold. America must tap this vein to create a winning economic team--but this means doing the things that are necessary to generate motivation, cooperation, and teamwork.

Consider for a moment the fact that Japanese businessmen would regard as the most devastating fact they had ever heard about the American economy: America's labor force turns over at the rate of 4 percent per month. Within any one year the average American company loses about half its total labor force--about half of those quit and half are fired. If one ignores the importance of teamwork, high turnover represents high efficiency. From the perspective of conventional economic theory, unneeded labor is laid off and reallocated to more efficient uses while workers with better income opportunities are quitting to engage in more productive activities. In this reallocation process labor will be used more efficiently, so that the total output increases. High turnover simply reflects an efficient labor market allocating workers to the jobs where they are most needed.

But what worker or manager will sacrifice to make a company successful ten years from now if he or she knows that there is a high probability that they will not be around in ten years? Research and development, investment in production facilities, and marketing often take ten years or more for a major new product, but no one is going to work to ensure success ten years from now if he doesn't expect to be around to harvest the fruit. Yet no one has fruit unless someone plants fruit trees.

Business firms are the social and institutional embodiment of economic teams. They are not simply statistical units where the more efficient automatically drive the less efficient out of business. Efficient firms are not a collection of elements but an organic whole. Individual members agree to make short-run personal sacrifices for the long-run common good. To do this, individuals need to know that they will be on the team in the long run and that the team is being fairly run. Without both of these elements, a willingness to make sacrifices for the future simply isn't there--on the playing fields, in the firm, or in the society. Fair treatment is central to a well-motivated, cooperative, highquality economic team. Equity is the essence of efficiency.