Remarks by Martin N. Baily

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Remarks by Martin N. Baily, Chairman of the Economic Advisers, to the American Association
for the Advancement of Science - September 2, 1999

Statement by Martin N. Baily Chairman of the Economic Advisers, on GDP and National Product Accounts - December 7, 1999

Remarks by Martin N. Baily,
Chairman of the Economic Advisers, to the American Association
for the Advancement of Science

Thursday, September 2, 1999

I. Introductory Remarks

Thank you. It is a pleasure to join you here today. I would like to thank the American Association for the Advancement of Science for inviting me to address this distinguished audience of young leaders, who I am sure will make valuable contributions to both the worlds of science and public policy.

As Science and Engineering Fellows with the AAAS, you will have a unique opportunity this year to gain a deep understanding of how scientific research and public policy interact and influence one another.

The research you do in the laboratory may seem far removed from the economics and national economic policy that is the concern of the President’s Council of Economic Advisers. But, in fact, the two enterprises have significant long-term effects on one another: the products of your research lead to innovations and discoveries that spur competition and economic growth; in turn, the economic policies and funding priorities of the federal government can help seed and fuel further productive scientific inquiry. It is this relationship that I would like to discuss with you today – how science plays a role in economic growth and how policy makers can encourage science through various policy decisions.

The U.S. is currently enjoying a fabulous period of prosperity. We have had 100 months of economic growth – marking the longest peacetime expansion on record. Inflation has been subdued despite strong real wage growth and, for the last two years, the unemployment rate has been stunningly low – well below 5%.

A major factor in powering this unprecedented period of growth without inflation has been a recent resurgence in productivity growth. In the period after World War II through to the early 1970’s, labor productivity increased sharply, at a rate of nearly 3% annually.

But in the two decades that followed, productivity growth slowed sharply and living standards stagnated. However, in this expansion, productivity growth appears to be accelerating. Most notably in the past 3 years, it has increased at about a 2% annual rate (actually, 2.8% in the last 12 months). This productivity is fueling the growth in real wages and the increase in the economic well being of all Americans.

Unfortunately, there is a lot of uncertainty about why productivity growth slowed in the 70s and how rapidly it will grow in the next few years. What is clear, however, is that the ability of American businesses and workers to take the advances made in science and turn them into productive new investments and jobs has been a major contributing factor. And to insure continued growth, it is vital to encourage scientific progress and innovation.

The fruits of science and technology have played a central role in shaping this economic expansion. Technological advances are revolutionizing nearly all sectors of the economy and even creating whole new industries. Information technology now constitutes approximately 8.2% of GDP -- up from 4.9% in 1985. The IT sector accounted for one-third of real economic growth from 1995-97. Employment in the computer services has nearly doubled since 1994. And those jobs in the IT sector pay 80% above the average private wage. Supported by recent computer innovations, “just in time” inventories have revolutionized business practices, allowing the inventory-to-sales ratio to fall to historic lows. And, of course, the Internet is altering forever the way we do business and communicate with one another. Nearly 64 million American adults currently use the Internet up over 20% from only one year ago.

As we consider the role that scientific discovery has played in fueling our economy, it is important for us to consider how the policy decisions we make affects the scientific community’s ability to continue that process of discovery and advancement.

Certainly the private sector plays a dominant role for R&D: In 1997, approximately 63% of all R&D, or about 121 billion dollars, was spent by private companies on research and development efforts across a wide variety of industries. However, government policies designed to encourage innovation play a critical role in providing the right incentives to innovate.

In fact, many of the products and services we now consider indispensable – from communication satellites that bring us live television broadcasts to human insulin that saves and extends the lives of millions of diabetics – these have been facilitated by US policies to encourage private sector investments in science and technology.

For many types of research, the costs of creating the first innovation are much higher than the costs of duplicating that innovation. In the jargon of economics, the fixed cost is high, but the marginal cost is low. If duplication is relatively easy, there may be little or no economic incentive to innovate because the initial innovator cannot recover its investment in fixed costs. Therefore, one of the most fundamental roles of government is to provide rules that protect the intellectual property rights of inventors through patent and copyright law.

Government’s role in R&D, however, extends beyond simply establishing the rules for the protection of intellectual property. New technology and new innovations often depend on advances in understanding promoted by “basic” scientific research.

By its very nature, much of that research, (including, no doubt, some that has been conducted by members in the audience) is not the type of research that corporations find immediately interesting. In part, this reflects the fact that the primary output of basic research is knowledge, not patentable innovations. Moreover, even if the new knowledge developed through basic research suggests a specific, patentable concept, there may not be any obvious economic return in the near future.

In these circumstances, while the social returns to pursuing basic research may be very high in the long run, the private return available to a particular company may not justify further R&D.

In areas involving basic scientific research, therefore, there is an important role for government to play in funding projects designed to advance the frontiers of science even – or perhaps especially – when there is no obvious, immediate commercial application.

Indeed, when the precursor to the Internet was invented, it was not envisioned as a project designed for commercial purposes at all. Rather scientists working for the Defense Advanced Research Projects Agency (DARPA) were looking for a way to share data and programs across different computers located in different parts of the country. From that early scientific and academic communication network evolved what is now a major driving force in new business ventures and new ways of doing business.

It’s very important that we continue to support fundamental, curiosity-driven research in all science and engineering disciplines. Many areas of research that seem like they would have no practical application whatsoever turn out to be very important.

For example, who would have predicted that studying the extinction of dinosaurs would cause us to focus on near-earth asteroids, which could wipe out human civilization? Or that an obscure branch of mathematics would provide us with the tools for secure electronic commerce.

Moreover, the research enterprise is interdependent. Biomedical research, for example, is heavily dependent on advances in the physical sciences and engineering – such as CAT scans, gene chips, and supercomputers for more rapid development of new drugs. We can not simply cut off some fields of research just because we don’t see its immediate relevance today.

IV. Administration Policies

It is clear that the partnership between the Federal Government and the scientific community has been a fruitful one. In recognition of the strategic, important role that scientific discovery plays in our long term economic welfare, President Clinton and Vice President Gore have pursued a comprehensive plan of investing in people, investing in technology and dramatically increasing our efforts in research and development, while continuing to be mindful of the fiscal discipline that has helped to make America’s economy strong and stable.

The Administration’s 2000 budget proposal reflects our continued support of science and technology, providing $78 billion for R&D investments. The centerpiece of the Administration’s budget proposal is the 21st Century Research Fund.

This fund is intended to insure continual stability and growth for the highest priority research funds by providing a proposed $38.1 billion be dedicated to R&D. $18 billion has been dedicated to basic research and $239 million to the Advance Technology Program – a program designed to encourage collaboration between industry and government in the research and commercial development of new technologies. The Administration has also proposed an Information Technology Initiative that will invest in long term fundamental research in computing and communications and will increase development and purchases of extremely fast supercomputers to support a broad range of civilian R&D.

Any discussion of science and technology would be incomplete with out mention of the most important input into the production of new ideas and technologies -- human capital. The government has taken and will continue to take an active role in supporting the education of scientists so that there will be in the future, as in the past, a cadre of highly trained American scientists engaged in the pursuit of new and exciting technologies.

That’s why the Administration is particularly concerned that the Congress has eliminated our proposed increase for the National Science Foundation – the only agency that has the mission of supporting all science and engineering disciplines.

As well as his commitments to Social Security and debt reduction, the President is committed to investments in the future, including investments in science and technology.
By contrast, the GOP budget actions threaten cuts in science and technology in key areas. And the proposed GOP tax cut could result in a 50% cut in R&D funds by 2009. I have argued today that strong support for funding of basic science and pre-commercial R&D is important not only for the scientific community, but for the whole economy.

It is a great pleasure to be here today and to say a few words about the meaning and importance of the GDP data and the National Income and Product Accounts. I would like to make some personal observations, based on the ways in which these data have been important to my work.

I started my career as an academic researcher with a strong interest in macroeconomics and it is hard to imagine how I or anyone else could have talked about the U.S. economy and the business cycle without timely and accurate information about GDP—or GNP as we used back then. One issue that I explored twenty years ago was the extent to which the economy has become more stable over time.

I carried out a series of econometric tests examining the response of consumption, investment and inventories to cyclical shocks. But it turned out the most compelling evidence came from simply plotting the growth rate of GNP over time. The resulting chart, subsequently reproduced in the New York Times, showed a dramatic decrease in the volatility of GNP in the postwar period.

I argued, as I still believe, that sound and cautiously active monetary and fiscal policy, together with automatic stabilizers, have been important to the increased stability of the macroeconomy. Others have disagreed as to whether policy is really stabilizing and even whether the economy has become more stable. But of course this debate would not have been possible without good historical GNP data.

More recently I, along with a team of researchers, have worked on a number of studies trying to understand the differences in productivity across countries. This work has been based on the scrutiny of very detailed, micro-level firm and industry data. But each study began with an aggregate analysis that featured GDP per capita as the best overall measure of economic performance across countries. We selected industries to study largely on the basis of whether they would add to our understanding of cross-country GDP per capita differences. By starting with a micro data base and building up to tell a macro GDP level story, I believe this work has added to understanding of the reasons for economic performance differences across countries. It would not have had the same impact or validity without good underlying GDP data.

A major task in my current position is to work with others in preparing the Administration’s forecast for budget purposes. GDP and its growth over time are the centerpiece of this exercise. We recognize the tremendous uncertainty in trying to predict GDP ten years into the future and the need to make policy decisions which recognize that uncertainty. But we rely on a solid starting point for our work - the GDP data prepared here at the Department of Commerce.

Working with our forecast, however, makes me realize the need for continued progress. Why was there a slowdown in productivity growth in 1973? Has the trend of productivity growth increased in the 1990s? How is the digital revolution affecting businesses and consumers? Does the rise in the stock market reflect an increase in intangible capital accumulation by companies? These are tough questions, central to any forecast, and finding the answers would be helped by better GDP data.

Major improvements have been made—the shift to chain indexes, the use of better price indexes both by BEA and the Bureau of Labor Statistics and the incorporation of software investment. But more needs to be done to capture a rapidly changing economy where services account for much of GDP, where the digital revolution is in full flight, and where quality changes may be as important as quantity changes. If our statistical agencies are to keep up with the demands of the economy they need to be adequately funded to support the wealth of commitment and expertise of the people that work there.

My experience as an academic, as an economist in the private profit-making sector and as a member of the Administration tells me that good GDP data are vital to high-quality research, a greater understanding of the U.S. economy, and, ultimately, to sound decision making.