Recession Fears Are Top Of Mind, But We Should Be More Worried About America’s Weak Economic Growth

New data show that inflation remains high—up 9.1% over the last 12 months—and economic growth is slowing, so naturally talk of recession is filling the air. The ups and downs of the business cycle have real consequences, so concerns about a looming recession are understandable. But over decades, economic growth, not the business cycle, determines living standards. Unfortunately, economic growth is slowing in America, but our federalist system can help us grow again if we do not destroy it.

Economic growth makes countries richer and richer countries are better able to cope with the fluctuations of the business cycle. Sadly, U.S. economic growth is waning. From 1960 to 1999, U.S. per capita GDP growth was 2.4% per year, meaning living standards doubled roughly each generation. Since 2000, per capita growth has averaged 1.3% per year. Projections from the Congressional Budget Office predict more slow growth, with real GDP growth rates below 2% for the next 10 years.

Reversing this trend and increasing economic growth should be the priority of every U.S. policymaker. Fortunately, America’s federalist system gives us a built-in advantage for generating sustained growth.

Federalism Fosters the Technological Progress That Drives Growth

Economists often divide economic growth into two categories: Smithian growth and Schumpeterian growth. Smithian growth, named after economist Adam Smith, is the result of increased worker specialization and market expansion.

Schumpeterian growth, named after economist Joseph Schumpeter, is the result of innovations that transform industries or create entirely new ones. Schumpeterian growth is what most people think of when they think of technological progress—new products and services that fundamentally change how people live.

Henry Ford’s assembly line generated Smithian growth: It made cars cheaper and more reliable without fundamentally changing them. The invention of the steam engine and later the internal combustion engine that enabled the seismic shift from horse-powered transportation to trains and then cars is an example of Schumpeterian growth.

Both types of growth are important, but Schumpeterian growth is responsible for the largest increases in living standards. Without big, life-altering innovations, smaller improvements would eventually wane.

Schumpeterian growth is also the hardest to maintain. In his book The Lever of Riches, economic historian Joel Mokyr writes that “if there is one lesson to be drawn from this search for the causes of technological progress, it is that [technological progress] should not be taken for granted.”

Mokyr goes on to say that the biggest enemy of progress is not a lack of useful new ideas, but the variety of specials interests and social forces that act to inhibit new innovations despite their usefulness. These include unions that oppose new labor-saving technology, politicians that protect favored industries, and established firms that lobby government to secure their market share. Each of these groups regularly oppose new technologies that disrupt the present order.

One way to overcome the forces hostile to progress is interjurisdictional competition. Technological progress in the West leading up to and during the Industrial Revolution was in part fostered by the many kingdoms and empires seeking to outdo one another. If a beneficial innovation was rejected by one society, it was usually able to find a home nearby where it flourished.

America’s federalist system, in which each state is free to enact most of its own regulations and laws, is thus a key reason for America’s technological progress. If one state is antagonistic towards new technology, another can welcome it with open arms.

Take drone technology. A study from the Mercatus Center at George Mason University ranks the 50 states according to how friendly they are to the commercial use of drones. North Dakota, Arkansas, and Oklahoma are the three states most friendly to drones, while Iowa, Mississippi, and Kentucky are the most antagonistic. Entrepreneurs who want to experiment with drones or use them in their businesses can set up shop in drone-friendly states.

Without federalism, there would be only one legal regime—and one choke point—for drone technology in the United States. With federalism, America can still be a leader in drone technology even though some states are not on board.

The Hubs of America’s Growth and Innovation are Shifting

Federalism also means that the impact a state has on America’s economic growth can change over time. For several decades, two states have been especially important drivers of America’s growth: New York, home of America’s financial industry, and California, the center of the tech world. Now, the hubs of growth and innovation are shifting.

Eleven years ago, Texas overtook New York as the country’s second largest economy. California remains the largest, but unlike California, Texas is still growing: Over 300,000 people moved there from 2020 to 2021 and it is closing in on 30 million people. Dozens of companies have also relocated to Texas, including Caterpillar and tech giants OracleORCL
and Hewlett Packard. Texas’s modest taxes, low level of regulation, and relatively affordable housing are turning the Lonestar state into the driver of America’s economic growth.

Meanwhile, California’s and New York’s regulatory environments are notoriously unfriendly to businesses of all sizes. People and companies are fleeing both states to escape their high taxes, onerous regulations, expensive housing, and deteriorating public services. California’s population declined by 182,000 people from 2020 to 2021, while New York’s declined by 319,000. Since 2018, over 260 companies have relocated from California to more business-friendly states.

New York and California powered much of America’s growth in the past, but today neither are friendly to markets or innovation. Captured by unions and other special interests, their politicians erect barriers to entrepreneurship at every opportunity.

The growing gig economy is a great example. For years, California Democrats tried to make it harder for gig-economy companies such as UberUBER
to operate in the state by changing the classification rules for independent contractors. They finally succeeded with the passage of AB5, though Uber and a few other companies were able to get voters to exempt them. Other independent contractors, however, are now prohibited from setting the terms of their own employment and are essentially forced to become employees.

U.S. Federalism Is Under Attack

California is also trying to undermine federalism by imposing its tax policy on residents who leave the state. A proposed tax would impact wealthy individuals who move out of California for up to 10 years after they leave. If states are allowed to tax people who leave, often because of high taxes, it will be more difficult for pro-growth states to differentiate themselves from anti-growth states such as California.

Federalism is also under attack by both Democrats and Republicans at the federal level. Many on the left have long opposed states being free to set policies inconsistent with their progressive worldview. The PRO Act—passed by the House of Representatives on a near party-line vote in 2021—would ban state right-to-work laws that benefit workers and employers alike. It would also impose restrictive independent contracting rules like California’s AB5 on all 50 states.

Another bill, Senator Elizabeth Warren’s Accountable Capitalism Act, would undermine state corporate charters and force large businesses to get a federal corporate charter before they could operate. It would also give the federal government the power to revoke corporate charters.

If enacted, companies would be forced to adopt one-size-fits-all federal rules for corporate governance or cease operations. The creation of a single chokepoint for incorporation is the type of top-down regulation that reduces the experimentation that makes technological progress more likely.

On the right, Republican lawmakers such as Senator Josh Hawley want to use the federal administrative state to break up businesses they do not like, most notably “Big Tech”. Attacking businesses for being big is more likely to slow economic growth than promote it.

Other Republican senators want the federal government to play a larger role in the economy through industrial policy that would tilt the economic playing field in favor of “key” industries such as semiconductors, steel, medical supplies, and rare earths. Channeling taxpayer resources toward “key” industries may seem like a good way to promote growth and innovation, but it is likely to fail for two reasons.

First, governments are notoriously bad at predicting which industries will matter in the future. Semiconductors seem essential for economic success now, but rapidly rising production costs signal that the industry is reaching its limit as a driver of technological progress. As tech scholar Milton Mueller recently put it “If people think dumping big government subsidies into the chip industry is an innovation policy that will win the future, they are going to be deeply disappointed.”

Second, governments often turn against technological progress. If they are the primary promoters of innovation when they do, progress may stop altogether, or at least slow dramatically. In his analysis of why technological progress slowed in China around 1400, Mokyr writes:

“technological change that is generated in large part by public officials and the central government has the nasty weakness of depending on the government’s approval. As long as the regime supports progress, progress can proceed. But the government can flip the switch off…Because most entrenched bureaucracies tend to develop a strong aversion to changing the status quo, state-run technological progress is not likely to be sustained over long periods.”

The long-term result of U.S. industrial policy will be economic sclerosis, not economic progress. Instead of making America stronger, it will make America weaker. A robust private sector that enables entrepreneurs to bring new ideas to market is the real driver of innovation.

America Must Lead

Technological progress is the most important cause of economic growth. Without it, living standards in developed countries would stagnate and billions of people in developing countries would never attain the living standards enjoyed by Americans today.

Maintaining technological progress is not easy, but America’s federalist system gives us an advantage that we must not squander. As Mokyr notes “multiplying the number of societies in which the experiment is carried out and allowing some measure of competition between them improves the chances for continued progress. As long as some societies remain creative, others will eventually be dragged along.” For America to retain its position as leader of the free world, some states must remain creative. Otherwise, instead of doing the dragging, we will be dragged.