Much of nation's recent growth may have been a mirage.

By Steven Pearlstein
Washington Post Staff Writer
Tuesday, February 1, 2011; 9:20 PM
Last weekend, I was invited to sit in on an unusual retreat attended by top political, business, labor and civic leaders in Massachusetts. Although that state is in better economic shape than most others, it is facing most of the the same problems - anemic job growth, looming budget crises for state and local governments, widening inequality of incomes and educational achievement. The purpose of the gathering was to create a sufficient sense of urgency about those problems to overcome the inertia, political squabbling and special-interest lobbying that inevitably stand in the way of doing something.

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After a few presentations, it didn't take participants long to conclude that one issue seemed to be at the root of all the others: a steep, relentless rise in health-care costs that has crowded out other public- and private-sector investments. Until medical costs are contained, they concluded, there would be no money for anything else.

You have to give them credit - while the rest of the country will spend the next year stuck in a Talmudic debate about the constitutionality of requiring all Americans to buy health insurance, Massachusetts has already achieved universal coverage and is moving on to controlling costs. And judging from the weekend discussion, I'd wager that by the time Massachusetts settles on a plan to reform its health-care delivery and payment systems, the rest of us will still be parsing the meaning of the "necessary and proper" clause and the Supreme Court's holding in Lochner v. New York.

The movers and shakers in Boston aren't the only ones who have focused on health-care costs as the central economic issue. Tyler Cowen, an engaging and peripatetic economist at George Mason University, has just published a short but important new e-book, "The Great Stagnation," that attempts to explain the slow growth and the rising inequality that characterize the U.S. economy over the past 35 years. (Full disclosure: I'll be joining Cowen on the GMU faculty starting next fall, although not in his department.)

Cowen's thesis is that the period of 3 percent annual growth in incomes that stretched back to the 19th century ended in the middle of the 1970s as the pace of innovation slowed. Before the slowdown, he argues, industrial economies realized rapid income and productivity gains by picking the "low-hanging fruit" offered by the industrial revolution's key innovations. While we like to think the Internet, the iPhone and microsurgery have dramatically altered the way we live, those changes pale in comparison to the impact on living standards from the introduction of electricity, motor cars and penicillin. Cowen's claim is that the industrial world has hit a growth plateau as innovation confronts one of the most enduring principles in economics: the iron law of diminishing returns.

As you might imagine, a spirited debate is underway on economics blogs about Cowen's view that the Internet may not really be the productivity bonanza that was once predicted. So far, he notes, the Internet has generated far less income and far fewer jobs than earlier innovations - think of the automobile - and the benefits it has yielded have been confined largely to the upper end of the income scale.

For me, however, the more intriguing argument in "The Great Stagnation" is that much of our recent growth may, in fact, have been a mirage. It is no coincidence, he writes, that during the recent decades of slow growth in incomes and productivity, three of the fastest-growing sectors of the economy have been education, financial services and health care. And while government statistics show productivity in those sectors growing at the same pace as the rest of the economy, other data suggest otherwise.

Although the United States spends at least twice as much on health care, per person, as other industrial countries do, Americans do not live any longer and often have measurably worse health.

Although spending on education has doubled in recent decades, average scores on standardized math and reading tests have remained about the same.

And what does the average American have to show for all that innovation and job growth in financial services over the past 20 years? A series of booms and busts that has left stock prices roughly where they began.

For Cowen, the central economic reality of the past three decades is that median household incomes have barely budged, even after adjusting for inflation and other factors. And his hypothesis is that too much money and talent and effort have gone into sectors where real productivity gains are hard to find. Once Americans became rich enough to satisfy ourselves with the basic necessities of life, it was only natural that we would decide to spend our additional income - our marginal dollars - on health care, education and financial services. We now discover, however, that each of those marginal dollars has generated less than a dollar of real value.

It is unlikely that the movers and shakers in Massachusetts last weekend were aware of Cowen's book or focused on long-term productivity trends. But they understood full well the roots of our current stagnation. When incomes were growing rapidly, it probably didn't matter if the fruits of that growth were sometimes unevenly distributed and unwisely invested. But now that innovation has slowed, and with it income growth, those realities can no longer be ignored.