Some observations on the Great Stagnation

An interesting article in The Atlantic by Derek Thompson where he highlights a deep productivity decline in the US economy.

He draws attention to the increasing deprivation of middle class Americans despite food, clothing, and entertainment getting cheaper and forming a smaller share of household budgets. He attributes this to the rising prices of health care, education, housing, and energy,

"You could say that everything is getting cheaper except for almost everything you need. We need places to live, energy to move, education to move up, and insurance to stay healthy. The productivity revolution isn't doing much to make those things more affordable. Even after decades of building up and building out, homes and apartments are still prohibitively expensive in our most productive cities. Adjusted for inflation, home energy costs doubled between 1967 and 2003, and continued to rise in the last ten years. The cost of medical insurance is growing faster than wages. Tuition and higher education fees are growing even faster."

The graphic below highlights how the rise in the prices of these items have far exceeded the general wage increases.



Thompson points to a graphic from a McKinsey report which shows that more than half of total productivity growth comes from computers and information technology and practically zero have come from health care, education, and housing. It is therefore no surprise that health and education have to keep hiring people to do the same job, even as elsewhere the same job is being done by far fewer people than earlier. The resultant pressure to keep prices up is therefore unexceptionable.



Health care and education are susceptible to Baumol's cost disease, where the wages of workers rise even in jobs that have experienced no increase of labor productivity since the wages of workers in other jobs which did experience such labor productivity growth have risen. He attributes the productivity weakness with health care and education to their inherent nature - both are local services that are labor intensive - and are therefore not amenable to any external competition.

I have three observations from this

1. Interestingly, this brings us to the issue of increasing productivity in both these services. How do we get the same teachers and doctors to cover more students and patients? How do we leverage technology to reduce the cost of service delivery in both these services?

All available evidence and experience of other sectors indicates that this can be achieved only through competition, direct or indirect. One, atleast some of these services should be outsourced or off-shored and technology leveraged to deliver the same or higher level of service, so that the cost of service delivery comes down. Or else, there should be direct supply-side competition in these markets. This can be brought about by direct participation of foreign teachers and doctors in the US labour markets.

Either way, there appears to be a strong possibility for convergence of interests between the developed and developing economies. As I had blogged earlier, immigration offers the greatest poverty eradication potential. The same immigrants also offer the best chance for America (and many other developed economies) to ward off the Great Stagnation's impact on their middle class. In the circumstances, labour mobility, atleast in knowledge-based fields like education and health care has the potential to be win-win trade for all sides.

2. The changing dynamics of deprivation from that caused by food, clothing and basic consumer durables, to one that is caused by the prohibitive cost of education, health, housing, and energy, has implications for many developing countries. In fact, in countries like India, as a generation of people emerge out of the traditional consumption poverty, they are set to face the poverty wall erected by these newer requirements.

As economies and jobs become more knowledge and skill-based, the college education premium (and more specifically those related to certain elite colleges) would rise, and if supply fails to keep up with demand, as is most certain to be the case if the prevailing trends continue, then access to education will be a major source of middle-class deprivation. In health care, since technology will improve and expand its scope but with a rising cost, affordability will emerge as a major problem.

Urban housing is already showing signs of reaching breakdown point, as affordable housing in most of our major cities is already beyond the reach of a large majority of the middle class. As economy becomes more energy intensive and people start using more of it, it will become untenable for utilities to supply energy at its current cheap and subsidized rates. This energy requirement will go beyond household electricity use to include fuel used for private vehicles and cooking gas. The share of income that gets spent on energy will only increase.

In view of all this, public policy has an important role in promoting the development of these sectors. Fortunately, countries like India have just about time to put in place these policies, before the real middle-class deprivation problem will materialize. Education will have to be carefully deregulated to attract greater private investments and government will have to dramatically increase its investments in secondary and higher education. Most importantly, policy will have to catalyze the development of a vibrant market for financing education.

The only way to sustainably and meaningfully address the problem of rising health care costs is to put in place a nation-wide health insurance system. This has to be complemented by substantial investments in public secondary and tertiary care facilities, which will provide the critical "public option" that is necessary to improve competitiveness and keep prices under control.

Housing will be a much more difficult challenge to surmount. In simple terms, urban immigration is simply much faster than anything that can be done to increase supply. The only way to address the supply-side is to deregulate urban planning regulations and permit massive vertical growth, while simultaneously providing the infrastructure to support that growth. Urban slums will have to go vertical. Government policy will have to catalyze the development of an adequate stock of affordable urban housing. Instead of the prevailing paradigm of urban home ownership, a more appropriate strategy would be for governments to themselves build and encourage private developers to construct these housing stocks which could then form the platform for a liquid and vibrant market for rental housing.

The requirements of energy is tied to purchasing power since both consumption of all energy sources will increase and their prices too will rise as subsidies get withdrawn. Consumers' pockets will face the impact of this twin effect. This cannot be easily mitigated with any one policy. Public transport facilities will have to improve dramatically, so as to minimize the reliance on private transport which will become increasingly expensive. Further, even if governments want to susidize people's energy consumption, subsidizing public transport may be one of the least distortionary and most effective means to do so. Piped gas will reduce many of the overheads and reduce the cost of cooking gas.

3. Derek Thompson argues that the middle class have been able to manage with relatively less problems though from 1970 to 2010 despite real earnings of middle class men falling 28% even as the real GDP doubled. This has been facilitated by people working harder (typical two-parent family worked 26 percent more hours in 2010 than in 1975) and the sharp increase in women entering the workforce and thereby nearly doubling family incomes. However, both these trends have now run their course leaving the middle class with nothing to fall back. In the circumstances, without higher wage growth, the deprivation will only increase.

This requires a more balanced distribution of the gains from economic growth. Inequality and the forces that have been responsible by accelerating its widening, need to be reined in. Or else, the middle class will face a hollowing out of their incomes, and income and social mobility will be increasingly constrained.