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Special Issue




The Region

Federal Reserve Bank of Minneapolis
1996 Annual Report

Breaking Down the Barriers
to Technological Progress
How U.S. policy can promote higher economic growth

Special Issue

The Region

Volume 11 Number 1
March 1997
ISSN 1045-3369




Federal Reserve Bank of Minneapolis
1996 Annual Report

Breaking Down the Barriers
to Technological Progress
How US. policy can promote higher economic growth

By Preston J. Miller, Vice President and Monetary Advisor
and James A. Schmitz Jr., Research Officer

The views expressed herein are those o f the authors and n o t necessarily those
o f the Federal Reserve Bank o f M inneapolis o r the Federal Reserve System.




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President’s Message
A lthough frequently portrayed as “preoccupied” w ith price stability, for some tim e now
the Federal Reserve Bank o f M inneapolis has conducted and sponsored research aim ed
at understanding the determ inants o f econom ic grow th for, after all, it is grow th that
raises standards o f living. We are p roud that this research includes the w ork o f a leader
in the field, Ed Prescott, a University o f M innesota Regents Professor and consultant to
our bank. This year’s annual report essay, authored by Preston Miller and Jim Schmitz,
reflects Prescott’s leadership.
This year’s essay argues that openness to technological progress is the key to eco­
nom ic grow th in the U nited States. That is, the developm ent and im plem entation o f new
production and organizational technologies are prim arily responsible in the United
States for raising productivity and, thereby, econom ic growth. This view suggests th at by
reducing resistance to technological progress, governm ent policies can make a significant
contribution to econom ic growth.
Further, the scholarship sum m arized in this essay suggests th at the U nited States
is already doing m any o f the “right things.” This is because policies such as deregulation,
openness to foreign trade and prom otion o f vigorous com petition encourage the use and
adaptation o f new technologies. The U nited States has generally adhered to these p rinci­
ples, and one key in achieving sustained and, indeed, m ore rapid grow th going forw ard
is to rem ain com m itted to policies w ith a track record o f increasing productivity.
As always, a num ber o f staff contributed im portantly to the developm ent o f this
essay, bu t a special acknowledgm ent is due Dave Fettig, who perform ed yeom an service
in the preparation o f this piece.

Gary H. Stern
President

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Economic growth is about equal to the growth of labor productivity
plus the growth of labor intensity. Labor intensity—essentially, a
measure of how hard the population is working— is unlikely to
contribute much to economic growth in the coming years. For the
United States, then, labor productivity is the key.

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The Region

Federal Reserve Bank of Minneapolis
1996 Annual Report

Breaking down the barriers
to technological progress
How U.S. policy can promote higher economic growth
By Preston J. Miller, Vice President and Monetary Advisor
and James A. Schmitz Jr., Research Officer

In the past year, politicians from all bands of the political spectrum struck a common chord
in declaring that the outlook for U.S. economic growth is unsatisfactory. They pointed out
that economists both inside and outside the government predict growth in U.S. real gross
domestic product per capita of only about 1 percent to 1.5 percent per year. They declared
that the electorate should not be satisfied with this outlook for growth and argued that poli­
cy changes should be sought to improve it.
We agree. We should never be satisfied with modest real growth. And since policies
are never ideal, there is always scope to change them in ways to promote more growth. The
question, of course, is how to improve U.S. policy.
U.S. economic growth has depended primarily on growth in labor productivity, and
by labor productivity we mean output produced per hour worked. Unfortunately, it appears
that labor productivity growth has been very slow. It follows, then, that the less than opti­
mistic forecasts of economic growth are essentially extrapolations of expected slow labor
productivity growth.
Searching for higher economic growth, therefore, becomes a search for higher labor
productivity growth. Labor productivity depends, in part, on the capital—both physical and
hum an— employed per person in a country. Some argue that an increase in inputs, such as
more physical capital (by encouraging higher savings rates) or more hum an capital (by
encouraging higher education), is the answer. While these factors are im portant, for the
United States they are expected to have little impact in coming years.

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But labor productivity growth also depends on the available state of technology,
which refers to the efficiency with which a given set of inputs is employed— this is what econ­
omists term total factor productivity. It has long been known that improvement in the state
of technology, known as technological progress, is a key factor in growth in labor productiv­
ity. O ur search then leads us to focus on technological progress.
So far, so good: To improve economic growth we need greater technological progress.
As noted above, economists have understood this for some time. W hat has not been so clear,
however, is the answer to the question: How can government policy prom ote technological
progress?
O ur view is that the state of technology in a country depends, in part, on the pool of
world knowledge at a given time and, perhaps m ost importantly, on the country’s institutions
that promote or retard the use of this knowledge. Technological progress, therefore, depends
on the rate at which world knowledge grows and on how a country’s institutions evolve—
whether they provide greater (or fewer) incentives over time for employing the expanding
world knowledge. Government policy, then, can have its biggest impact by ensuring that it
provides institutions with incentives to use and adapt world knowledge.
This view is based on theories that suggest that some countries have such relatively
poor states of technology because groups in those countries erect barriers to the use of world
knowledge. These barriers, like tariffs and regulations, serve to protect groups that stand to
lose from the use of new world knowledge. Ultimately, such barriers serve to drag down the
country’s rate of economic growth. Recent evidence shows that the new theories have merit,
that is, that the state of a country’s technology is related to such policies as, for example,
deregulation and openness to trade.
But do these studies, many of which are based on cross-country data, have any
applicability to the United States? After all, the United States arguably has the “best” institu­
tions as regards providing incentives to use new knowledge; the United States is already rel­
atively open to new products and ideas. We argue that recent U.S. history strongly suggests
that these studies do have applicability here. Recent policy changes (like deregulation in many

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U.S. labor productivity mostly depends on the available state of
technology, which refers to the efficiency with which a given set of
inputs is employed. Improvement in the state of technology, known
as technological progress, is a critical factor in labor productivity.
Our search then leads us to focus on technological progress.

industries), and continued com m itm ent to certain existing policies (like keeping the auto and
steel industries open to trade), have led to large gains in the use of world knowledge and gains
in labor productivity.
Moreover, we argue that there are other potential changes that can further improve
U.S. institutions, but in order for that to happen, U.S. policy m ust stay focused, generally
speaking, on technological progress. Also, in an era of the so-called global economy, U.S. pol­
icy m ust not be swayed by arguments calling for the protection of U.S. industries— such poli­
cies are bound to retard economic growth.

The key to economic growth is labor productivity growth,
which is driven by technological progress
Economic growth is about equal to the growth of labor productivity plus the growth of labor
intensity. Labor intensity— essentially, a measure of how hard the population is working— is
unlikely to contribute much to economic growth in the coming years, meaning that the frac­
tion of people working and the hours they are working are already relatively high, and any
further increases will add little to growth. For the United States, then, labor productivity has
been, and will continue to be, the key. As described earlier, the less than optimistic view of
future growth is based on expected slow labor productivity growth. [For more on labor inten­
sity and labor productivity, see story on page 6.]
To better understand the potential role of policies to stimulate labor productivity
growth, it helps to adopt a simple conceptual framework to identify the prim ary sources of
labor productivity. The framework, the aggregate production function, is widely used in eco­
nomics. It assumes that total output depends on inputs and the state of technology. Inputs
include labor, physical capital, such as machinery, and hum an capital, such as the education
levels of labor. The state of technology refers to the efficiency with which a given set of inputs
is employed. A comm on assumption is that if all inputs are increased by some percentage,
that output also increases by the same percentage (this property is known as constant returns
to scale). It follows from this assumption that the growth in labor productivity depends on

5

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Labor productivity is the key to economic growth
The wealth of a nation, as Adam Smith recognized two

cally equal to the growth in labor intensity plus the

centuries ago, lies not in the amount of gold or silver

growth in labor productivity because the growth identity

amassed within its borders, but in the goods and ser­

holds only for small changes.)

vices it can produce to meet the needs and wants of its

Labor intensity is a measure of how hard a popula­

people. For people to experience an increase in their

tion is working. It is determined by three factors. The

standard of living— for them to be able to meet more of

first is the labor force participation rate, which is the

their needs and wants— more goods and services must

percentage of people of working age who are in the

be produced.

labor force. The second is the employment rate, the

There are two ways such an increase in production

percent of all participants in the labor force who are

can come about. One way is to use existing resources

employed. The third is average hours worked, or the

more intensively, for example, to use more labor.

number of hours the average employed person works in

Another way is to use such resources more productively,

a week.

that is, to produce larger quantities of useful goods or

Since 1964, labor intensity has contributed little to
growth: In spite of the fact that a higher proportion of

services from each worker.
In real economies, increased output comes from

women work out of the home, the overall labor partici­

combinations of these two approaches. But the greatest

pation rate rose only at an annual rate of 0.4 percent

part of the increase in output comes from the fact that

for the period since 1964. This modest increase was par­

we use labor more productively, more efficiently, than

tially offset by a drop in average hours worked, which

at midcentury. In other words, economic growth, by

declined at an annual rate o f -0.4 percent. Finally, the

which we mean growth in per capita output, has been

employment rate did not change at all. In the future,

driven primarily by labor productivity growth. This is

these three components of tabor intensity, taken indi­

likely to be true in the future as well. The less than

vidually or collectively, are unlikely to contribute much

optimistic view about growth, then, is a view that labor

to economic growth.
Though increases in labor intensity did little to

productivity growth will be slow.
A simple equation, in words, can help us understand

increase output in the last three decades, and are not

the determinants of growth in per capita output. Per

likely to do so in the foreseeable future, labor produc­

capita output can be divided into two parts:

tivity growth is another story. It accounts for the bulk
of the growth in per capita output since 1964: Real per

_

Output
—

Population —

— Hours Worked —

"Per Capita Output "




capita output increased at a 1.9 percent annual rate,
Output

"Labor Productivity"

Hours Worked

•
—

Population —

"Labor Intensity"

while labor productivity increased at a 1.4 percent
annual rate. Given the muted outlook for labor intensi­
ty, it is likely that labor productivity growth will also
account for the bulk of future economic growth.

It follows, then, that economic growth is about

What is the likely future course of labor productivity

equal to the sum of the growth of its two parts; that is,

growth? In the accompanying chart we see that labor

the growth in per capita ouput is about equal to the

productivity growth averaged 2.8 percent over 1964 to

growth of labor productivity plus the growth of labor

1973; since then it has grown much more modestly— 1.1

intensity. (The growth in per capita output is not identi­

percent per year. The slowing in the trend growth of

The Region

Labor Productivity Growth
Index 1992 = 100




is correct that the Consumer Price Index is biased
upwards by more than 1 percent per year, then esti­
mates of Labor productivity are biased downward by
close to that amount. Actual increases may have been
greater than reported due to imperfect measurement of
price Levels.
b.
Two economists, Slifman and Corrado 1996, ana­
lyzed official U.S. data and found that these data imply
that productivity has declined in the service sector.
Such a decline is counterintuitive; it does not jibe with
readily apparent increases in service sector productivity.
Hence, there may be measurement problems in the pub­
lished data.
2. Acceleration may take time to occur.
a. Historically, it has taken time for major, earthlabor productivity during the 7 0 s remains, to a large

shaking innovations to have an impact on aggregate

extent, a puzzle. Since this is the case, a conservative

productivity. It takes time for firms and workers to

prediction is that labor productivity's recent perfor­

learn and adapt to such fundamental change. Some

mance will continue in the future. This, then, is how the

argue that the computer revolution fits into this story.

less than optimistic view of future labor productivity

(David 1990 has described the slow response to devel­

growth, and economic growth, are derived.

opment of electricity at the turn of the century.)
Consistent with this explanation that large productivity

Productivity growth may well have begun to pick up

gains from computers are on the horizon is the rise in

Some observers argue that the recent Labor productivity

stock market values. Market expectations of future pro­

figures are misleading. They argue that in recent years

ductivity gains may be what is driving up corporate

there has been a sizable opening of international trade,

earnings predictions and thus driving up equity values.

important industries have been deregulated, corpora­

We do not know with certainty why labor productivi­

tions have been restructured and there has been an

ty growth since 1973 has been so slow. A conservative

explosion of new technologies related to computers,

prediction is to assume its current growth trend will

telecommunications and medicine. All of these have

continue at a rate of a bit more than 1 percent a year.

strengthened the economy and made it more produc­

This implies that growth in real per capita income also

tive. These critics argue that reported U.S. statistics for

will be at a rate of slightly more than 1 percent a year.

labor productivity have not accelerated for a number of

However, if the arguments of the critics of official data

reasons:
1. There may be serious mismeasurement

are correct, future labor productivity growth could well

a.

Productivity measures are derived from measures

exceed the conservative prediction. In any case, given
labor productivity's poor recent performance, it is pru­

of the value of output, adjusted for changes in the gen­

dent to consider policy changes that might increase

eral price level. If the Boskin Commission's conclusion

labor productivity growth.




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So far, so good: To improve economic growth we need greater
technological progress. But how can government policy promote
technological progress?

the rate of technological progress and the rate of increase in capital intensity (capital per unit
of labor).
In 1957, Robert Solow published an im portant paper in which he concluded that in
the United States, for the period 1909-1949, “output per m an hour doubled over the interval,
with 87.5 percent of the increase attributable to technical change [technological progress]
and the remaining 12.5 percent to increased use of capital” (p. 320). In other words, growth
in labor productivity was driven primarily by technological progress and not by the expan­
sion of capital inputs available to workers.
In brief, using available data on hours, capital intensity and output, Solow was able
to derive a measure of the state of technology, and then to compute the contribution of both
increases in capital intensity and increases in the state of technology (that is, technological
progress) to economic growth. This accounting exercise for U.S. labor productivity growth
has been repeated many times in the last 40 years. For some exercises, hum an capital has been
added as an input. Refinements of Solow’s exercise have not changed the basic conclusion
that, in the United States, technological progress has played a major role in driving labor pro­
ductivity growth (see King and Levine 1994 for review).
So, given the importance of technological progress for labor productivity growth, we
tu rn naturally to seek its determinants. The next two sections will include a summ ary of some
of the economic literature on this subject.

Some theories about the determinants of the
state of technology and technological progress
Again, the state of technology gives us the level of efficiency with which a country employs a
given set of physical and hum an capital inputs. W hat does this depend on? It depends, in part,
on the state or pool of knowledge available in the world. But it also depends on the extent to
which a country’s institutions promote or retard its citizens from employing this knowledge.
It follows that technological progress depends on the rate at which world knowledge grows
and on how a country’s institutions evolve—whether they provide greater (or fewer) incen-

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tives over time for employing the expanding world knowledge (see Parente and Prescott
1994). In what follows, we will focus on what determines the extent to which a country uses
available world knowledge. We leave for others to discuss what determines the rate at which
world knowledge grows.
Now, there are many “natural” reasons why a country may not fully use all world
knowledge at a given time, even if a country’s institutions are very well designed. Natural
impediments can arise as new technologies are adapted to local conditions; for example, new
agricultural technologies m ust be adapted to local climatic conditions. Another natural
impedim ent is that the rate of diffusion may depend on the levels of other production inputs,
such as hum an capital. As an example, although hum an organ transplant surgery is general
knowledge, not all countries have the trained surgeons, professional staff and equipm ent to
perform it.
Griliches’ (1957) classic study of hybrid corn illustrates why the rate of diffusion of
new technologies can differ across locations due to natural impediments. The new m ethod of
production had to be adapted to local area conditions because of climate and soil differences;
hence, it hit some areas first and over time spread to others. Moreover, his study also dem on­
strated the complementarity discussed above: The rate the m ethod diffused within an area
was related to farmers’ education levels.
While the importance of these natural impediments cannot be denied, these reasons
are not sufficient, in our view, to explain why some countries employ so very little of the
world knowledge pool at a given time. The culprit here is very often the policies and institu­
tions that restrict citizens from employing world knowledge more fully. These restrictions on
the use of new knowledge are constructed (with the help of government) by groups that stand
to lose if the knowledge is employed.
Economic historians, in particular Mokyr (1990, pp. 209-272), assign a major role to
these restrictions on the use of world knowledge in their attempts to explain differences in
growth across nations. Mokyr (1990, p. 12) states:
In every society, there are stabilizing forces that protect the status quo. Some of these

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forces protect entrenched vested interests that might incur losses if innovations were
introduced, others are simply don’t-rock-the-boat kinds of forces. Technological cre­
ativity needs to overcome these forces.
Mokyr (1990, p. 16) also notes that technologically progressive societies are the
exception. Usually, the forces opposing technological progress are stronger than the forces
striving for change.
To give an idea of the type of restrictions that are imposed, a clear example is the dif­
fusion of new innovations in construction. One innovation in the industry occurred when
engineers came to understand that wider spacing of wall studs would not influence the struc­
tural integrity of homes. W ith wider spacing there would be need for fewer materials and, of
course, less labor. While this particular innovation was costless to introduce, it diffused very
slowly. Oster and Quigley (1977) argued that it was likely construction workers, applying
pressure on building code administrators, that blocked the adoption of this and other laborsaving technologies. They also showed that the procedures (that is, institutions) for choos­
ing administrators influenced whether construction workers were able to restrict the new
methods.
Groups use many other means, in addition to regulations imposed by government,
to restrict the use of world knowledge. Tariffs or, more generally, restrictive trade practices
are a key m ethod. W ith trade barriers, groups are able to continue producing with outdated
methods by erecting barriers to imports produced with new additions to world knowledge.
Regarding theory, Olson (1982, especially chapter 5) has discussed how trade and
factor mobility may limit the effectiveness of special interest groups.
Holmes and Schmitz (1995) have recently formalized these ideas about trade and
resistance. They study a simple model where a special interest group can spend resources to
block a new technology that threatens its privileged position. If there is no trade, the group
may very well find it worthwhile to spend these resources. If, however, there is trade, so that
the good can be produced elsewhere with new technology and shipped to the country, the
special interest is likely to abandon its resistance (see also Parente and Prescott 1996 for
recent models).

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Our view is that technological progress depends on the rate at which
world knowledge grows and on how a country’s institutions evolve—
whether they provide greater (or fewer) incentives over time for employ­
ing the expanding world knowledge.

Recent evidence suggests these restrictions on use of knowledge, laid out in regula­
tions (like those in the building industry) and supported by tariffs, have a large impact on the
state of technology in a country. We now turn to this evidence.

Recent evidence supports the new views
There are large differences in the state of technology across countries, suggesting different
countries access the world knowledge pool to varying degrees. While this has been known for
some time (for example, Denison 1967 found this in his comparison of the United States and
Europe; see King and Levine 1994 for a review of this literature), recent studies using many
more countries find the same result. Three such studies are King and Levine (1994), Klenow
and Rodriguez-Clare (1996) and Hall and Jones (1996).
Recent studies also find that the state of technology in a country is related to gov­
ernm ent policies. As mentioned, Hall and Jones calculate the state of technology for a large
num ber of countries (for the year 1988). They show that variation in the state of technology
is related to measures of policies and institutions. For example, their list of policies included
measures of government support of production (including the extent to which government
enforced private contracts), the type of economic organization employed (capitalist vs. sta­
tist) and openness to international trade. Hall and Jones find that differences in policy explain
a large fraction of differences in the state of technology. In particular, openness to interna­
tional trade is found to lead to much higher levels of the state of technology.
Hall and Jones’ work supports the above view that differences in the state of tech­
nology are caused by differences across countries in restrictions on the use of world knowl­
edge. By showing that openness to trade influences the state of technology, it lends support
to the views above. The evidence is indirect, though. Openness to trade could be increasing
the level of the state of technology through other mechanisms than the one we suggest, that
is, by reducing restrictions on use of world knowledge.
Other research attempts to show through more direct means that restrictions on the
use of world knowledge cause big differences in the state of technology. One example is

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Recent evidence suggests that restrictions on use of knowledge, laid
out in regulations and supported by tariffs, have a large impact on
technological progress in a country.




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Schmitz (1997), who studies a particular restriction on technology: the requirem ent that gov­
ernment, rather than the private sector, produce investment goods in a country. A num ber of
countries have imposed this restriction, including Egypt, India and Turkey. He estimates that
this restriction has had large impacts on the state of technology and labor productivity in
those countries.
Other direct evidence is provided by McKinsey and Co., who have compared the
labor productivity of various industries across the United States, Europe and Japan (these are
summarized in Baily 1993, and Baily and Gersbach 1995). They find that productivity is often
higher in the United States, and one of the reasons they give is that there are typically fewer
regulations and restrictions on business practices in this country. For example, consider the
retail sector. McKinsey argues that retail productivity is m uch higher in the United States than
Japan. One of the reasons is that there are limits on the size of store that can be opened in
Japan. These limits on store size effectively restrict some of the new retailing technologies, like
better inventory management, since a larger store is better able to exploit this technology.
These restrictions on size are maintained by lobbying and political pressure of small stores in
Japan (such stores have had a rough time against such large retailers as Wal-Mart in this
country).
Before turning to whether this has anything to do with the United States, we should
m ention that there are economists who, in trying to explain growth, do not place as much
emphasis on how a country’s institutions influence the incentives to use and adapt world
knowledge. In particular, these economists have argued that the state of technology plays a
m inor role, if any, in explaining differences in output per worker across countries, and claim
that varying levels of capital—both physical and hum an— explain differences in output. We
are not persuaded by these arguments, based on two sets of studies: One set directly criticizes
the research and the other takes its conclusion as an assumption— that is, that all countries
have the same state of technology— and finds that differences in physical and hum an capital
cannot account for unequal cross-country productivity levels. [For a further examination of
this debate, see page 14.]

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Another view about economic growth
As we mention in the accompanying essay, there are

across countries than does MRW's. Hence, human capi­

some economists who do not place such emphasis on

tal is less likely to have a big role in explaining differ­

how institutions influence the incentives to use and

ences in labor productivity. And this is what KRC find.

adapt world knowledge. For example, in a recent arti­

That is, when KRC use the expanded measure of human

cle, N. Gregory Mankiw argues that the state of tech­

capital, they find that differences in technology once

nology plays a minor role, if any, in explaining differ­

again play a big role in cross-country productivity dif­

ences in labor productivity across countries. He states,

ferences.

"Put simply, most international differences in living

KRC have other problems with MRW's treatment of

standards [author's note: labor productivity] can be

human capital. In particular, they object to the nature

explained by differences in accumulation of both

of the accumulation technology for human capital.

human and physical capital" (1995, p. 295). (See also

Fixing this accumulation technology adds still more to

Chari, Kehoe and McGrattan 1996.)

the role of the state of technology, and less to capital,

What evidence does Mankiw have for his claim? His
evidence is from his work with Romer and Weil (Mankiw,

in explaining labor productivity differences across coun­
tries. After these changes in the treatment of human

Romer and Weil (MRW) 1992). MRW perform an

capital, KRC are essentially back to the old view about

accounting exercise, like that by Denison (1967)

the key role of the state of technology.

decades earlier, but find that nearly all differences in
labor productivity are due to differences in capital,
both physical and human.
We are not persuaded by the MRW evidence due to

A second consideration for why we don't accept
MRW's findings is based on recent work of Prescott
(1996). He supposes that atl countries use the same
state of technology and asks whether differences in

two types of considerations. One is a critique of the

inputs of physical and human capital can, in plausibly

MRW study itself. The other is a demonstration that

calibrated growth models, account for differences in

counterfactual implications follow from the assumption

cross-country labor productivity levels. He finds that

that all countries have the same technologies.

they cannot. Furthermore, he argues that such models

First, as Klenow and Rodriguez-Clare (KRC) show, the
MRW result is fairly fragile. For example, KRC take

have two other counterfactual implications:
1. They imply capital-output ratios should be relatively

exceptions to the measure of human capital employed

higher in rich countries than in poor ones. Prescott

by MRW. One objection is that MRW use secondary

argues that evidence, such as Kuznets (1967), suggests,

school enrollment rates to construct their measure of a

if anything, the opposite is true.

human capital stock for each country. A more compre­

2. They imply that the real rate of return on capital in

hensive measure would use, for example, primary and

rich countries should be lower than that in poorer

post-secondary school enrollment rates to construct

countries because richer countries have relatively more

stocks. Primary enrollment rates, not surprisingly, vary

capital. Prescott argues that there appear to be only

much less than secondary, so a more comprehensive

small differences in real rates of return between rich

measure of human capital turns out to vary much Less

and poor countries.




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One study reveals that variation in the state of technology among countries
is related to measures of policies and institutions. For example, such policies
included measures of government support of production (enforcement of
private contracts), the type of economic organization employed (capitalist vs.
statist) and openness to international trade.

What, if anything, does the new evidence
have to teach the United States?
In some im portant ways the U.S. economy is unlike many economies in the cross-country
studies that provide much of the new evidence. First, it already has relatively good policies
and institutions. Most observers would probably rate the United States as having the best
institutions in regards to prom oting competition among businesses. Second, the United
States economy contributes m uch to the world knowledge pool. It is a major spender on
research and development, which is one key to growth in that pool. Though both these facts
suggest the United States has little to gain from policy changes, and little to learn from the
recent studies, we argue that recent U.S. history strongly suggests otherwise. U.S. policy
changes have indeed led to large gains in access to world knowledge. And there is more to do.

Openness to technological progress has led
to substantial labor productivity gains...
Recent U.S. history suggests that policy changes, and continued com m itm ent to existing poli­
cies, have led to large gains in the use of world knowledge and gains in productivity. One
im portant area of change has been the large num ber of industries that have been deregulat­
ed over the past two decades. These include airlines, trucking, railroad, the securities indus­
try and long-distance phones. As a result of deregulation and increased competition, these
industries have experienced rapid drops in prices and strong gains in productivity (see, for
example, W inston 1993).
A study by Olley and Pakes (1996) of the U.S. telecommunications industry suggests
that labor productivity growth spurted after the industry was deregulated and that the growth
was fueled by the introduction of new technology. It suggests that the state of technology had
been stifled by regulation.
There have been other changes, for example, in the area of trade policy. (See Miller
1993 on the relationship between trade policy and economic growth— including the refer­
ences therein.) A high-profile case has been the lowering of trade barriers associated with the

15




The Region

At first glance, the policy prescription advocated in this essay—open trade,
deregulation and increased competition—seems merely like a reiteration of
well-accepted economic principles. However, these principles are more often
preached than practiced, and many policy-makers are not necessarily con­
vinced of their wisdom.

N orth American Free Trade Agreement (NAFTA). Other negotiations to lower trade barriers
with South America are under way.
While these changes are im portant, so, too, have been the battles fought to continue
existing policies that foster growth. Regarding trade policy, in many markets, like steel and
autos, the United States maintained its com m itm ent to open markets. There was great pres­
sure to limit trade in these markets and there were some programs that did slow imports. On
balance, however, the markets were kept open. As a result, the United States more quickly
adopted new m ethods than, for example, its European counterparts (as the above ideas sug­
gest). U.S. car producers adopted Japanese “lean” production well before its more closed
European rivals (see Holmes and Schmitz 1995).
In the steel industry and, in particular, the iron-ore industry, the United States also
kept its markets open in the face of increasing international competition. As a result, as the
international price of taconite fell in the early 1980s, the Minnesota industry was able to dou­
ble its labor productivity in a fairly short period. This was accomplished not with new
machines and the like, but in part by changes in work practices.

... but there’s more to do

While much has been accomplished, there is still more to do. For example, deregulation has
begun in telecommunications, but m uch remains to be done; reform of the electricity indus­
try has just started; and there is also the recent drive to end “corporate welfare,” including
subsidies to producers. Im portant areas under study are: tort reform, liability reform and
increasing competition in prim ary and secondary education.
This is not to say that reform is not difficult. Even if a policy change would lead to
large productivity gains, it still, most likely, would harm some groups. These groups may well
seek access to the political market to block reform. Recognizing this, the current adm inistra­
tion has developed some programs to help defray the costs borne by groups so affected. Their
policies of retraining workers who lose jobs due to NAFTA is one such program .1




The Region

Technological progress is a key element of economic growth, and to encourage
technological progress, the United States must constantly refocus its efforts on
policies that reduce resistance to technology and increase the use of world
knowledge.

Breaking down the barriers
At first glance, the policy prescription advocated in this essay— open trade, deregulation and
increased competition— seems merely like a reiteration of well-accepted economic principles.
However, these principles are more often preached than practiced, and many policy-makers
are not necessarily convinced of their wisdom. Governments are often tem pted to engage in
policies that, for example, protect certain industries from foreign competition or, in the case
of internal markets, make it difficult for innovative companies to compete in established
industries.
Recent U.S. history strongly suggests that the lessons being learned from cross-country comparisons of labor productivity and growth apply to the United States. In brief:
Technological progress is a key element of economic growth, and to encourage technological
progress, the United States m ust constantly refocus its efforts on policies that reduce resis­
tance to technology and increase the use of world knowledge.

Endnote
1M ost of the reforms we have discussed involve less gov­
ernment. We do not want to tip the balance too m uch here.
Government m ust play an im portant role in ensuring a produc­
tive economy. For example, antitrust is an im portant role for gov­
ernment. Just as trade ensures open markets across borders,
antitrust can ensure that monopolization doesn’t reduce compe­
tition at home.

17




The Region

Bibliography

Baily, M artin. 1993. Com petition, regulation, and efficiency in
service industries. Brookings Papers on Economic Activity,
M icroeconomics, pp. 71-130.
Baily, M artin, and Gersbach, Hans. 1995. Efficiency in m an u ­
facturing and the need for global competition. Brookings
Papers on Economic Activity, Microeconomics, pp. 307-47.
Boskin, Michael, J. Chairman, Advisory Commission to Study
the Consum er Price Index. 1996. Toward a more accurate
measure o f the cost o f living. Final report to the Senate
Finance Committee.
Chari, V.V.; Kehoe, Patrick; and M cGrattan, Ellen. 1996. The
poverty of nations: A quantitative exploration. Staff Report
204. Federal Reserve Bank o f Minneapolis.
David, Paul. 1990. The dynam o and the computer: An histori­
cal perspective on the m odern productivity paradox.
American Economic Review 80 (May): 355-61.
Denison, Edward. 1967. W hy growth rates differ: Post war expe­
riences in nine western countries. W ashington, D.C.: The
Brookings Institution.
Griliches, Zvi. 1957. H ybrid corn: An exploration in the eco­
nomics of technological change. Econometrics 25 (October):
501-22.
Hall, Robert, and Jones, Charles. 1996. The productivity of
nations. W orking Paper 5812. N ational Bureau of Economic
Research.

Mankiw, N. Gregory. 1995. The growth o f nations. Brookings
Papers on Economic Activity, pp. 275-310.
Mankiw, N. Gregory; Romer, David; and Weil, David. 1992. A
contribution to the empirics of economic growth. Quarterly
Journal o f Economics 107 (2): 407-37.
Miller, Preston J. 1993. The high cost of being fair. Annual
Report. Federal Reserve Bank of Minneapolis.
Mokyr, Joel. 1990. The lever o f riches: Technological creativity
and economic progress. New York: Oxford University Press.
Olley, G. Steven, and Pakes, Ariel. 1996. The dynamics of p ro ­
ductivity in the telecommunications equipm ent industry.
Econometrica 64 (6): 1263-98.
Olson, M ancur. 1982. The rise and decline o f nations: Economic
growth, stagflation and social rigidities. New Haven: Yale
University Press.
Oster, Sharon, and Quigley, John. 1977. Regulatory barriers to
the diffusion of innovation: Some evidence from building
codes. Bell Journal o f Economics 8 (Autumn): 361-77.
Parente, Stephen L., and Prescott, Edward C. 1994. Barriers to
technology adoption and development. Journal o f Political
Economy (April): 298-321.
----------------------- . 1996. M onopoly rights: A barrier to riches.
W orking Paper. Federal Reserve Bank of Minneapolis.
Prescott, Edward. C. 1996. Notes on barriers to riches. W orking
Paper. Federal Reserve Bank of Minneapolis.

Holmes, Thomas J., and Schmitz, James A. Jr. 1995. Resistance
to new technology and trade between areas. Federal Reserve
Bank o f Minneapolis Quarterly Review 19 (Winter): 2-17.

Schmitz, James A. Jr. 1997. Governm ent production of invest­
m ent goods and aggregate labor-productivity. W orking
Paper. Federal Reserve Bank of Minneapolis.

King, Robert G., and Levine, Ross. 1994. Capital fundam ental­
ism, econom ic developm ent, and econom ic growth.
Carnegie-Rochester Conference Series on Public Policy 40
(June): 259-92.

Slifman, L., and Corrado, C. 1996. Decomposition of produc­
tivity and unit costs. Occasional Staff Study. Board of
Governors of the Federal Reserve System.

Klenow, Peter, and Rodriguez-Clare, Andres. 1996. The neo­
classical revival in growth economics: Has it gone too far?
Discussion Paper. Federal Reserve Bank of Minneapolis.
Kuznets, Simon. 1966. Modern economic growth: Rate, structure
and spread. New Haven: Yale University Press.

Solow, Robert. 1957. Technical change and the aggregate p ro ­
duction function. Review o f Economics and Statistics 39
(August): 312-20.
W inston, Clifford. 1993. Economic deregulation: Days of reck­
oning for microeconomists. Journal o f Economic Literature
31 (September): 1263-89.

The Region

Statement of Condition




(in millions)

December 31,
1996

December 31,
1995

$ 168
144
19
639
7
5,946
480
54
0
119
19

$ 203
180
20
450
4
6,894
563
70
3
62
18

$7,595

$8,467

$5,503

$5,990

721
5
653
6
453
32
11

741
6
411
0
1,082
29
10

$7,384

$8,269

ipital:
Capital paid-in
Surplus

107
104

99
99

Total capital

211

198

$7,595

$8,467

Assets
Gold Certificates
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Prepaid interest on Federal Reserve notes
Bank premises and equipment, net
Other assets
Total assets

Liabilities and Capital
Liabilities:
Federal Reserve notes outstanding, net
Deposits:
Depository institutions
Other deposits
Deferred credit items
Statutory surplus transfer due U.S. Treasury
Interdistrict settlement account
Accrued benefit cost
Other liabilities
Total liabilities

Total liabilities and capital

19




The Region

Statement of Income

(in millions)

D ecem ber 31,

$454
21
4

389

Total interest income

1995

$375
11
3

Interest income:
Interest on U.S. government securities
Interest on foreign currencies
Interest on loans to depository institutions

D ecem ber 31,

1996

479

Other operating income:
Income from services
Reimbursable services to government agencies
Foreign currency (losses) gains, net
Government securities gains, net
Other income

44
16
(42)
1
1

42
14
27
0
1

Total other operating income

20

84

Operating expenses:
Salaries and other benefits
Occupancy expense
Equipment expense
Cost of unreim bursed Treasury services
Assessments by Board of Governors
Other expenses

61
6
7
4
10
29

60
4
7
3
11
28

117

113

Income before cumulative effect of accounting change

292

450

Cumulative effect of changes in accounting principles

0

Total operating expenses

(20)

$292

Net income prior to distribution

Distribution of net income:
Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on
Federal Reserve notes
Payments to U.S. Treasury as required by statute

$430

$

$

6
8
216

6
1
423
0

$292

0

62

$430

The Region

Statement of Changes in Capital

(in millions)

For the years ended D ecem ber 31, 1996, an d D ecem ber 31, 1995

Capital
Paid-In
Balance at January 1, 1995 (1.97 million shares)
Net income transferred to surplus
Net change in capital stock issued (.01 million shares)

$ 98

Balance at December 31, 1995 (1.98 million shares)

$ 99

$196
1
_____ 1

$ 99

$198

8

8

(3)

Statutory surplus transfer to the U.S. Treasury

Balance at December 31, 1996 (2.1 million shares)

$ 98
1

1

Net income transferred to surplus

Net change in capital stock issued (.15 million shares)

Surplus

(3)

8
$107

8
$104

These statements are prepared by Bank management. Copies of full financial statements complete with footnotes
are available by contacting Public Affairs at (612) 340-2446.




Total
Capital

$211




The Region

1996 Minneapolis Board of Directors

1996 Helena Branch Board of Directors

Jean D. Kinsey
Chair

Lane W. Basso
Chair

David A. Koch
Deputy Chair

M atthew J. Q uinn
Vice Chair

Class A Elected by M em ber Banks

Appointed by the Board o f Governors

Dale J. Emmel
President
First National Bank of Sauk Centre
Sauk Centre, M innesota

Lane W. Basso
President
Deaconess Research Institute
Billings, M ontana

Jerry B. Melby
President
First N ational Bank
Bowbells, N orth Dakota

M atthew J. Q uinn
President
Carroll College
Helena, M ontana

William S. Pickerign
President
The Northwestern Bank
Chippewa Falls, Wisconsin
Class B Elected by M em ber Banks

Dennis W. Johnson
President
TMI Systems Design Corp.
Dickinson, N orth Dakota
Clarence D. M ortenson
President
M /C Professional Associates Inc.
Pierre, South Dakota

Appointed by the Board o f Directors
Federal Reserve Bank o f Minneapolis

Donald E. Olsson Jr.
President
Ronan State Bank
Ronan, M ontana
Ronald D. Scott
President and CEO
First State Bank
Malta, M ontana
Sandra M. Stash
M ontana Facilities M anager
ARCO
Anaconda, M ontana

Kathryn L. Ogren
Owner
Bitterroot Motors, Inc.
Missoula, M ontana
Class C Appointed by the Board o f Governors

Federal Advisory Council M ember

James J. Howard
Chairman, President and CEO
N orthern States Power Com pany
Minneapolis, M innesota

Richard M. Kovacevich
Chairm an and CEO
Norwest Corporation
Minneapolis, M innesota

Jean D. Kinsey
Professor of C onsum ption & Consum er Economics
University of M innesota
St. Paul, M innesota
David A. Koch
Chairman
Graco Inc.
Golden Valley, M innesota

The Region

Minneapolis Board of Directors
Seated (from left): Dennis W. Johnson, Jean D. Kinsey, James J. Howard,
Dale J. Emmel; standing (from left): William S. Pickerign, Jerry B. Melby,
David A. Koch, Clarence D. Mortenson, Kathryn L. Ogren

Federal Advisory Council Member
Richard M. Kovacevich




Helena Branch Directors
Seated (from left): Ronald D. Scott, Donald E. Olsson Jr.;
standing (from left): Matthew J. Quinn, Sandra M. Stash,
Lane W. Basso
23

The Region

Advisory Council on Small Business, Agriculture and Labor

Eric D. Anderson
Business Agent
United U nion of Roofers,
W aterproofers and Allied W orkers
Eau Claire, Wisconsin

Clarence R. Fisher
Chairm an and President
U pper Peninsula Energy Corp.
Upper Peninsula Power Co.
H oughton, Michigan

James D. Boomsma
Farmer
Wolsey, South Dakota

Thomas Gates
President and CEO
Hilex Corporation
Eagan, M innesota

Gary L. Brown
President
Best W estern Town ’N C ountry Inn
Rapid City, South Dakota
Jeanne Davison
Owner
Butterfield Farms
Hokah, M innesota

William N. Goldaris
Vice President
Globe Inc.
Minneapolis, M innesota
Howard H edstrom
Partner
H edstrom Lumber Co.
Grand Marais, M innesota

Dennis W. Johnson, Chairm an
President
TMI Systems Design Corp.
Dickinson, N orth Dakota
Dean A. Nelson (Resigned September 1996)
Former President
American Bank
Whitefish, M ontana
Virginia Tranel
Rancher
Billings, M ontana
Harry W ood
President
H.A. & J.L. W ood Inc.
Pembina, N orth Dakota

I

Advisory Council on Small Business, Agriculture and Labor
Seated (from left): Dean A. Nelson, Thomas Gates, Virginia Tranel, James D. Boomsma, Clarence R. Fisher;
standing (from left): Harry Wood, Jeanne Davison, Gary L. Brown, Dennis W. Johnson, Eric D. Anderson,
William N. Goldaris




The Region

Officers

Federal Reserve Bank of Minneapolis

December 31, 1996

Gary H. Stern
President
Colleen K. Strand
First Vice President

Melvin L. Burstein
Executive Vice President,
Senior Advisor and General Counsel
and E.E.O. Officer
Sheldon L. Azine
Senior Vice President
James M. Lyon
Senior Vice President
A rthur J. Rolnick
Senior Vice President and Director of Research
Theodore E. Umhoefer, Jr.
Senior Vice President

Scott H. Dake
Vice President
Kathleen J. Erickson
Vice President
Creighton R. Fricek
Vice President and Corporate Secretary
Karen L. G randstrand
Vice President
Edward J. Green
Senior Research Officer
Caryl W. Hayward
Vice President
William B. Holm
Vice President
Ronald O. Hostad
Vice President
Bruce H. Johnson
Vice President
Thomas E. Kleinschmit
Vice President
Richard L. Kuxhausen
Vice President




David Levy
Vice President and D irector of Public Affairs

Kinney G. Misterek
Assistant Vice President

Susan J. Manchester
Vice President

H. Fay Peters
Assistant General Counsel

Preston J. Miller
Vice President and M onetary Advisor

Richard W. Puttin
Assistant Vice President

Susan K. Rossbach
Vice President and Deputy General Counsel

Paul D. Rimmereid
Assistant Vice President

Charles L. Shromoff
General Auditor

David E. Runkle
Research Officer

Thomas M. Supel
Vice President

James A. Schmitz Jr.
Research Officer

Claudia S. Swendseid
Vice President

Kenneth C. Theisen
Assistant Vice President

Warren E. Weber
Senior Research Officer

Richard M. Todd
Assistant Vice President

Robert C. Brandt
Assistant Vice President
Jacquelyn K. Brunmeier
Assistant Vice President
James T. D eusterhoff
Assistant Vice President
Debra A. Ganske
Assistant General Auditor

Thomas H. Turner
Assistant Vice President
Niel D. Willardson
Assistant Vice President

M arvin L. Knoff
Supervision Officer
Robert E. Teetshorn
Supervision Officer

Michael Garrett
Assistant Vice President
Jean C. Garrick
Assistant Vice President
Peter J. Gavin
Assistant Vice President
Linda M. Gilligan
Assistant Vice President
JoAnne F. Lewellen
Assistant Vice President

Helena Branch
John D. Johnson
Vice President and Branch Manager
Samuel H. Gane
Assistant Vice President
and Assistant Branch Manager


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102