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Originally Processed With FOIA(s): FOIA Number: S S FOIA MARKER This is not a textual record. This is used as an administrative marker by the George Bush Presidential Library Staff. Record Group/Collection: George H.W. Bush Presidential Records Collection/Office of Origin: Speechwriting, White House Office of Series: Speech File Backup Files Subseries: Chron File, 1989-1993 OA/ID Number: 13745 Folder ID Number: 13745-012 Folder Title: Economic Club of New York 2/6/91 [OA 6855] [3] Stack: Row: Section: Shelf: Position: G 26 21 2 5 THE WHITE HOUSE WASHINGTON January 7, 1991 MEMORANDUM FOR CHRISS WINSTON FROM: MICHAEL P. JACKSON my I understand from scheduling that today we accepted an invitation for the President to address the Economic Club of New York on February 6. That speech will occur shortly after Treasury expects to have released its very important banking study, and Treasury would be grateful to suggest some speech ideas when you begin thinking about this event. I'd be happy to put your shop in touch with the right folks at Treasury. Thanks. CC: Ede Holiday Olin Wethington Ed McMally Carol: Call Michael with the and Feb.5. announcing big Treas/Banking study get right in following I touch at droft greasury. language Brady going w/poius on6th on R&D, 2 etc. of / prompromber Dn. Thanks on Ken -Ed January NYHilton 25,1991 Black tie dinner, 2400 attendees 6:25pmarrive Hilton go directly to head table reception (40-50people) in the Mercury Ballroom, mix & mingle 1/2 hr. 6:55 pm Potus holds 7:00pm- - POTUS goes into ballroom POTUS will eat dinner full honors 8:25 - program begins Chairman of the group will introduce POTUS POTUS speaks at 8:30 pm. following Speech is a Q$A w/ POTUS and 2 people chosen beforehand speech teleprompted 8-10 minimum, 1st trip since 1/16 1/2 hr. of questioning program its over around 9:45:sh 9:50pm departure January 28, 1990 MEMORANDUM FOR DAVID DEMAREST CHRISS WINSTON FROM: ED McNALLY SUBJECT: PRESIDENTIAL GUIDANCE ON SUBJECT MATTER FOR THE ECONOMIC CLUB OF NEW YORK SPEECH One week after the State of the Union -- on Wednesday, February 6th -- the President will address a black tie audience of 2,400 at the Economic Club of New York, his first out-of-town speech of the year. As has been discussed with Chriss, three different alternatives for the substance of the speech have been suggested by various White House staff. They are: (1) The Gulf War (2) The Economy (follow-up to the State of the Union) (3) Eastern Europe No doubt the President has a very clear idea of what he wants to say and how he wants to say it. This is to recommend that either formally (i.e., in an Oval Office meeting for that purpose) or informally, the President be asked for guidance on the subject matter (and length) of this address. * * As indicated in the research Memorandum prepared by Carol Blymire, Advance has advised that the format will be an 8-10 minute speech by the President -- after which he will take 45 minutes of Q & A from two "questioners" selected by the Club. Given the hour of the speech (an 8:30 p.m. speech, following a 7:00 dinner), given that it's out-of-town, and given the current situation -- you may want to consider recommending a more abbreviated format. CC: Christina Martin Carol Blymire 01/28/1991 16:36 ECONOMIC CLUB OF NEW YORK 2126896148 P.01 THE ECONOMIC CLUB OF NEW YORK Founded 1907 275 Madison Avenue, New York, N.Y. 10016 212-689-6148 FAX TRANSMITTAL SHEET Date: 1/28/91 To: CAROL BCYMIRE DIRHIR House Fax number: 202-456-6218 From: Am PAICE Number of pages: This cover sheet plus 6 others MESSAGE: Sender's FAX number: 212-557-1023 Sender's TELEPHONE number: 212-689-6148 01/28/1991 16:36 ECONOMIC CLUB OF NEW YORK 2126896148 P.02 THE ECONOMIC CLUB OF NEW YORK Founded 1907 275 Madison Avenue, New York, N.Y. 10016 212-689-6148 Raymond K. Price, Jr., President January 28, 1991 Memo for: Carol Blymire The White House From: Ray Price As promised, here's a copy of my original letter of invitation to the President. I've also copied out for you copies of those parts of the program from the Sununu dinner that I thought might be of use to you: a) the front and back covers (the back cover has a somewhat arbitrary list of some of the speakers over the years), b) the inside cover, with some brief material about the club, and its facing page; and c) a list of our trustees and officers with their affiliatons, and, facing 1t, the rather simple "program" itself of the speaking portion of the evening. If I can help either you or Ed McNally with anything else, please call. All best, Ray 01/28/1991 16:36 ECONOMIC CLUB OF NEW YORK 2126896148 P.03 THE ECONOMIC CLUB OF NEW YORK Founded 1907 275 Madison Avenue, New York, N.Y. 10016 212-689-6148 Raymond K. Price, Jr., President November 14, 1990 President George Bush The White House Washington, D.C. 20500 Dear Mr. President: It's nice to be able to use that salutation for you. And it's a special personal pleasure to invite you to be our guest of honor and speaker at an Economic Club dinner on either February 5 or February 6 in the Grand Ballroom of the New York Hilton. We hope very much that you'll be able to accept. Let me give you a little background on the Club, and on our dinners -- which have won a reputation as one of the most prestigious public policy forums in the United States. The Club was founded in 1907. It's non-profit and non- partisan. Its membership (individual, not corporate) of about 700 is drawn primarily from the top leadership ranks of the business and financial community in New York and the Northeast, though we have members from elsewhere in the U.S. and around the world. Nick Brady is a member, and was a Trustee of the club until he took over the Treasury. Alan Greenspan was our Vice Chairman when he took over the Fed. Larry Eagleburger is a member, as are John Whitehead, whom Larry replaced at State, and Georgette Mosbacher. The enclosed program from our most recent dinner, with John Sununu, lists the names and affiliations of our Trustees, and the dais list indicates what an Economic Club audience is like. We hold just four or five dinner meetings a year. These are large, black-tie affairs. Members are encouraged to bring guests. Most guests are senior business associates. Attendance is often a thousand or more. C-Span sometimes carries them nationally (it aired last month's Sununu dinner twice.) For the guest of honor, the evening begins with a 6:30 private reception for head table guests. We go in to dinner at 7:00. At about 8:25 we begin the speaking program. The entire evening is built around this; we conduct no extraneous business. The Club's chairman (now Richard A. Voell, CEO of the Rockefeller Group) very briefly introduces the guest of honor. The guest of honor speaks. We then go to a question period, which follows a format that works remarkably well. We don't take questions from the floor. Rather, we choose in advance two particularly well- qualfied members of the club to act as questioners and seat them on the dais, each with his own microphone. This ensures that the 01/28/1991 16:37 ECONOMIC CLUB OF NEW YORK 2126896148 P.04 2 cuestions are both knowledgable and courteous, and produces = lively, informal and good-natured exchange. When Brent Scowcroft spoke here last fall (together with John Major, then the British Foreign Secretary) I used the president of Columbia University as one of the questioners because Brent had taken his Ph.D. there. The question period usually runs a half hour or so; we always end before 10:00, usually by about 9:45. Other members of your administration who have spoken here, besides John Sununu and Brent Scowcroft, include Nick Brady (earlier, as head of the Brady Commission), Dick Thornburgh (whom we paired with Tom Kean), Jack Kemp (paired with Bill Bradley), and, last June, Dick Cheney. Besides John Major, recent foreign speakers have included Francois Mitterand, Jacques Chirac (as Prime Minister), Corazon Aquino, Yitzhak Shamir, Brian Mulroney, Francesco Cossiga and, last January, Karl Otto Poehl of the Deutsche Bundesbank (paired with Citicorp chairman John Reed). Though our normal pattern is to have two speakers, we of course always present a head of government as the sole speaker. President Nixon spoke here in 1984 and again in 1988, getting an immensely enthusiastic reception both times. At the Sununu dinner last month, I had your brother Jonathan there as my guest. He could tell you something about it, as of course could John Sununu, Nick Brady, Alan Greenspan or any of the others who have been here. Our principal scheduling constraint is the availablity of a suitable hotel ballroom, but we are holding both the 5th and the 6th of February at the Hilton. Since this would follow closely on the State of the Union, it seems to me (putting on my old White House hat) that it would be an especially good time for you to follow that up with a second punch. And we could certainly guarantee you a large, receptive and enthusiastic audience. It would, of course, be our lead-off dinner for 1991. I do hope you can do it. And it would be very good to see you again, and to tell you how much I've admired not only your handling of the crisis in the Gulf but also the exceptionally skillful way you calibrated the U.S. response to the events in Eastern Europe and the Soviet Union surely as sensitive and consequential a task as any President has faced in modern times. With very best wishes, as always, Raymond K. Price, Jr. THE HONOR ROLL OF SPEAKERS ECONOMIC CLUB Corazon C. Aquino Dr. Henry A. Kissinger Dean Acheson Edward I. Koch Menachem Begin Fiorello H. LaGuardia 16:37 Roger M. Blough Walter Lippmann Clare Boothe Henry R. Luce Louis D. Brandeis Cyrus H. McCormick William Jennings Bryan Anastas Mikoyan Dr. Zbigniew Brzezinski François Mitterrand Warren E. Burger Walter F. Mondale Dr. Nicholas Murray Butler Henry Morgenthau Andrew Carnegie Brian Mulroney Jimmy Carter B. K. Nebru Sir Winston Churchill Richard Nixon Gen. Mark Clark Sam Rayburn Gen. Lucius D. Clay Ronald Reagan Douglas Dillon Walter P. Reuther ECONOMIC CLUB OF NEW YORK John Foster Dulles Nelson Rockefeller Dwight D. Eisenhower Dean Rusk Dr. Ludwig Erhard Anwar Sadat Gerald R. Ford Alfred P. Sloan, Jr. Henry Ford, 11 Willam H. Taft PROGRAM Indira Gandhi U Thant Barry Goldwater Pierre Elliott Trudeau Dag Hammarskjold Juan T. Trippe W. Averell Harriman Paul A. Volcker William Randolph Hearst Dr. Paul Dudley White Charles Evans Hughes Wendell L. Wilkie John F. Kennedy Woodrow Wilson Nikita S. Khrushchev Dr. Stephen S. Wise 2126896148 OF P.05 THE ECONOMIC CLUB OF NEW YORK 275 Madison Avenue New York, NY 10016 212-689-6148 NEW YORK Founded 1907 The Economic Club of New York is a membership organization with members drawn from the top executive 83rd Year levels of business, industry and finance. Founded in 1907, the Club has served ever since as a major forum for discussion of a wide range of public issues of interest to 331st Meeting business people. Wednesday, October 17, 1990 The Club is nonpolitical, nonpartisan and nonprofit. It takes no sides on issues. Its individual members represent a Grand Ballroom wide diversity of opinion. Its speakers have complete freedom to express their views. All views expressed at Club functions are those of the speakers, not of the Club. New York Hilton Speakers are chosen for distinction and timeliness, and New York because of the Club's particular interest in hearing what they have to say. Over the years speakers have included 01/28/1991 16:38 ECONOMIC CLUB OF NEW YORK heads of government, cabinet ministers, legislators, economists, bankers, corporate executives, labor leaders, university presidents, governors, judges, generals and admirals, ambassadors and scientists. Each program includes a question period, in which questions are put by members of the Club specially selected in advance for that purpose and seated on the dais. Just as each speaker chooses what to say, each questioner chooses what to ask. Club dinners are open to members and their guests. They are also open to coverage by the press. 2126896148 P.06 "The foremost non-partisan forum ... in this country," Wendell L. Willkie Trustees Program RAND V. ARASKOG HENRY KAUFMAN Chairman President ITT Corporation Henry Kaufman & Company J. CARTER BACOT JONI LYSETT NELSON PRESIDING OFFICER Chairman Partner The Bank of New York Rogers & Wells RAND V. ARASKOG JOHN BRADEMAS JOHN J. PHELAN, JR. Chairman of the Club President Chairman New York University The New York Stock Exchange HAROLD BURSON PETER R. SCANLON Chairman Chairman GUEST OF HONOR Burson-Marsteller Coopers & Lybrand E. GERALD CORRIGAN WILLIAM A. SCHREYER JOHN H. SUNUNU President Chairman Federal Reserve Bank Merrill Lynch & Co. Chief of Staff of New York ROBERT G. SCHWARTZ The White House MARTIN S. DAVIS Chairman Chairman Metropolitan Life Insurance Paramount Communications Inc. Company QUESTIONERS RICHARD L. GELB RICHARD A. VOELL 01/28/1991 16:38 ECONOMIC CLUB OF YORK Chairman President Bristol-Myers Squibb Company The Rockefeller Group JOHN J. PHELAN, Jr. MAURICE R. GREENBERG DENNIS WEATHERSTONE Chairman and Chief Executive Officer Chairman Chairman The New York Stock Exchange American International Group J.P. Morgan & Co. Incorporated DAVID HARTMAN JOHN F. WELCH, JR. President Chairman RICHARD A. VOELL Rodman-Downs, Ltd. Inc. General Electric Company President and Chief Executive Officer The Rockefeller Group Officers The Question Period follows Chairman Treasurer immediately after the speech. RAND V. ARASKOG JOHN A. PANCETTI Chairman TOTAL P.07 President The Manhattan Savings Bank The meeting will close by 10:00 p.m. RAYMOND K. PRICE, JR. General Counsel 2126896148 P.07 Secretary DAVID R. BAKER LANDON HILLIARD Partner Partner Brown Brothers Harriman & Co. Jones, Day. Reavis & Pogue 02/04/91 09:03 202 786 8433 PA 001 COMMUNITY THE OF THE TREASURY OFFICE OF THE DEPUTY ASSISTANT SECRETARY PUBLIC LIAISON DEPARTMENT OF THE TREASURY Room 3452 - (202) 566-2278 1789. 1500 Pennsylvania Avenue, NW Washington, D.C. 20020 FACSIMILE COVER SHEET DATE: 2/4/91 NUMBER OF PAGES: 3 excluding cover TO: Michael Jackson Cabinet Affairs White House ADDRESSEE'S FAX NUMBER: 456-2223 ADDRESSEE'S PHONE NUMBER: FROM: Sarah Hildebrand FAX NUMBER: (202) 786-8433 COMMENTS/SPECIAL INSTRUCTIONS: Attached is the insert on Financial services you requested for the Economic Club of New York speech. Please deliver to Carol Blymire (456-7750), Thanks! 02/04/91 09:03 202 786 8433 PA 002 Suggested Speech Insert for the Economic Club of New York Financial Services Reform Our nation depends on a strong and progressive financial system that can meet the needs of every American citizen. American families look to banks, thrifts and credit unions to finance the purchase of homes and automobiles, save for their children's college education, and build up an economic cushion for retirement. American businesses look to these same institutions to provide financial support -- in good times and bad. The technological revolution has changed the way financial institutions do business. Americans have adapted to the signs of progress -- the laws, rules and regulations which govern the system have not. Around the world, other countries are changing the rules that govern how their financial institutions operate. In this country, our financial institutions are crippled by rules which date back to the 1930s. Our banking system cannot hope to be a world leader in the 21st century while operating under antiquated rules and regulations. If we don't update these rules, we risk falling behind our international rivals. Today only one U.S. bank is among the largest 30 banks around the world. 1 02/04/91 09:04 202 786 8433 PA 003 Outdated laws and outmoded structures can also put our financial institutions at risk. Institutions can be forced into making high-risk loans and investments as they struggle to compete. A lack of competitiveness could even undercut the safety and soundness of these institutions. We cannot and will not allow this to happen. Traditionally, a stable and competitive financial system has been there to help jump-start the economy during slower times. When the economy tightens, bank lending has historically acted as a "shock absorber" for consumers and businesses. Financial institutions that are well-capitalized can make loans and take reasonable risks to help out those families and businesses which are particularly affected by a slowdown. But financial institutions must be strong to be able to lend. Clearly, now is the time to buttress our economy and our financial system with new laws that will make our financial system stronger and ensure that it is safe, sound and able to lend. Under the direction of Secretary Nick Brady, the Treasury Department has recommended a comprehensive framework of changes to our financial system. These recommendations will be followed shortly by specific legislation aimed at modernizing and strengthening the structure and activities of financial service institutions. 2 02/04/91 09:04 202 786 8433 PA 004 Passage of these reforms must be a priority. A modern, safe and internationally competitive financial industry will protect depositors and taxpayers, serve consumers, benefit businesses, and strengthen our economy. Swift action by the Congress on these reforms will reaffirm the Federal Government's commitment to a safe and sound financial system that sustains the historical confidence Americans have always placed in their financial institutions. 3 EXECUTIVE OFFICE OF THE PRESIDENT OFFICE OF SCIENCE AND TECHNOLOGY POLICY WASHINGTON, D.C. 20506 February 1, 1991 MEMORANDUM FOR CAROL BLYMIRE FROM: STEVE OLSON SUBJECT: PARAGRAPHS ON R&D FOR PRESIDENTIAL SPEECH Here are a couple of paragraphs that you could use to describe the actions taken on R&D in the FY 1992 budget. 0 The budget sent to Capitol Hill two days ago includes record amounts for research and development, one of the most important investments we can make in the long-term economic and military strength of the nation. It especially focuses on basic research, the individual scientists working alone or in small groups to better understand human beings and the world around us. These explorers at the frontiers of human knowledge are the ones who uncover the new concepts and new discoveries that drive economic growth and improve the quality of life for us all. [The increase proposed in the budget for basic research is $1 billion, to a total of about $13 billion, or an increase of 8 percent.] 0 At the same time, the budget recognizes that the government must help translate the results of basic research into the generic technologies that strengthen our industries and improve our lives. It proposes increases for applied research and development in such areas as high performance computing, energy conservation, manufacturing, aeronautics, and biotechnology. These technologies will intimately shape our lives in the 21st century, and we can be assured that if the United States does not lead in their development, other countries will. If you need any more input from me, give me a call at 2734. McNally/Blymire Jan. 31, 1991 Draft One (B:ECON-NYC) PRESIDENTIAL REMARKS: ECONOMIC CLUB OF NEW YORK NEW YORK HILTON, NEW YORK CITY WEDNESDAY, FEB. 6, 1991 I Thank you, . And thank you, each of you -- not for standing up to greet me -- but for standing up for all those fighting against aggression tonight in the Persian Gulf -- and spell out especially -- the fighting men and women of the U.S.A \\\ This year marks a defining hour : a moment of truth : for and toharsh this generation, for this country, flots the United Nations We were patient. We were cautious. We were slow to anger. not true But when the moment of truth came, America and the world did the right thing. We said the occupation of Kuwait would not stand. And three weeks ago tonight, at just about this time, we announced that the liberation of Kuwait had begun. \\\ Three weeks ago tonight, allied forces moved to end a conflict we did not seek and did not begin. But ladies and this is gentlemen -- it's one we and our allies do intend to finish. \\\ Tonight we are on course and on schedule. Mission by mission, hour by hour, Iraq's capacity to wage war is being systematically destroyed by American and Coalition forces. The road to real peace will be long and tough. But we will prevail. And when we do, we will have before us an a historic opportunity. From the confluence of the Tigris and Euphrates -- where civilization began -- civilization can begin anew. We can build a better world -- a new world order. III 2 Tonight, the world is united by shared commitments, shared interests, shared hopes. our efforts will determine the kind of legacy we bequeath our children, the kind of world they will live in. And so tonight, let us re-dedicate ourselves to the ideals in which our troops so resolutely believe. Because in the final analysis, America and her partners will be measured not by how we wage war -- but how we make peace. I said last week that "We are the Nation that can shape the future. " And shaping the future is a job that begins at home. Long-term growth is key to quality of life in America's families, quality of decency in America's communities, and to quality of leadership in America's special role as the world's leading diplomatic, cultural, and economic power. Despite present obstacles, we meet in an era of sustained and unprecedented growth. It began almost nine years ago -- the longest peacetime expansion in American history. Working together, we created millions of new jobs, and cut both interest rates and inflation in half -- a triumph driven by the energies of the most dynamic and diverse private economy on Earth. Against this background, the events of 1990 served to remind us that even a fundamentally healthy economy faces the risk of temporary disturbances and short-term setbacks. When Iraq invaded Kuwait in August 1990, it was a shock to the world's conscience. Business and consumer confidence fell. Oil prices rose. Taken together, this produced a very real blow to an economy that had already slowed. 3 But make no mistake: The downturn in the U.S. economy in the latter part of 1990 does not signal any decline in its fundamental, long-term health or basic vitality. America is home to the largest, most productive economy on Earth. America is a "can do" nation. And today, America is on the road back "back Awkward. on track?" My Administration's economic policies are designed to not only mitigate the current downturn -- but also strengthen the foundation for a solid recovery and the highest possible rate of sustained economic growth. I described the three pillars of that foundation in my State of the Union Address: Encouraging economic growth; investing in the future; and giving power and opportunity to the individual. Encouraging economic growth means reducing Federal borrowing by reducing Federal spending now. That's why we sent Congress a Budget that holds spending growth below the rate of inflation. And that's why the budget law was armed with real teeth -- "pay- as-you-go" provisions with enforceable spending caps -- aimed at cutting the growth of debt by nearly $500 billion. We must also fuel economic growth by providing incentives to promote private savings. That means tax-free family savings accounts penalty-free withdrawals for first-time home buyers, and yes a reduced tax for long-term capital gains. \\\ We must also renew our investments in America's future. That means investing in the education and safety of our kids. children Investing in the infrastructure of our financial and transpor- tation systems. Investing in high technology and in space -- to 4 the Moon and Mars and beyond. The Budget we sent to Capitol Hill includes record amounts for research and development, one of the most important investments we can make in the long-term economic and military strength of our Nation. Our Budget also recognizes that government must help translate the results of basic research into the generic technologies that strengthen our industries and improve our lives. III But our most important investment isn't in machines -- it's in the people they're designed to serve. Ankward Together with the Nation's Governors, my Administration has launched a comprehensive effort at reform and restructuring, aimed at producing an educational renaissance. Doesn't wecan't tech. H We've still got a long way to go. But don't sell our kids short. As one observer said of the troops manning Patriot missiles in the Gulf: "In one day, they wiped out the idea that young Americans are not smart enough for the 21st century." III Investing in the future also means a financial system that is both safe and profitable -- a world-class financial system for a world-class economy. The banking reform plan we unveiled yesterday puts greater reliance on the discipline of the marketplace. By allowing non-banks to invest in banking, it provides a fresh infusion of capital. By permitting nationwide banking, we can withstand regional downturns and provide economies of scale. And product diversification will provide greater competition, better service, and decreased risk. because of The challenges ahead are great. But thanks to all these 5 efforts, by any historical standard, the current downturn is expected to be mild and brief. And today in America, the bottom line is this: While our economy may be beset by difficulty -- it should not be beset by doubt. This sense of confidence is backed by the facts The good has news runs broad and deep: Inflation been kept under control. The trade deficit declined for the third year in a row. Inven- tories have been kept down, mitigating alleviating the need for production cuts to work off excess inventory. Because our major trading partners are seeing strong growth and strong currencies, the price of U.S. exports on world markets will remain low -- meaning the pace of U.S. exports will continue to set record highs. Productivity in manufacturing continues its impressive growth. Even oil prices have fallen substantially since their peaks Operation in October, especially since the start of Desert Storm. And in this way, the first-rate performance of American and Allied troops has already helped to preserve the global economic prosperity so crucial to achieving real peace. wecan't And don't forget another underlying strength: The flexi- bility of America's free market economy enables it to adapt to challenges and to make the most of new opportunities. Let me give you one example: When the "Revolution of '89" suddenly transformed a continent, American business stood ready. G.E.'s Jack Welch stepped in with a $150 million joint venture with Tungsraum in Hungary. Marriott launched a major joint venture with LOT, the Polish airline, for a hotel-office complex in THE WHITE HOUSE WASHINGTON 1/31 El m. - Call if you wat to discuss Stem Fane January 31, 1991 The President's Address to the New York Economic Club February 6, 1991 OUTLINE THEME: Economic Dynamism: The Source of U.S. Prosperity 1. Introduction 2. Persian Gulf 3. Enhancing Economic Growth Long-term growth is key to our standard of living, the quality of life, and to a stable, democratic society. Administration seeks to: -- Reduce uncertainty and maintain credibility of macroeconomic policies. Do not believe in fine tuning or quick fixes. : Encourage saving, investing, and innovating. Flexibility. The Federal spending must be controlled so that Federal borrowing can be reduced. A higher private savings level to fuel economic growth. FY 1992 budget holds spending growth below the inflation rate. "Pay-as-you-go" provisions of budget law will control spending. Tax changes designed to promote private savings: capital gains cut; family savings plan; IRAs. 4. Investing in the Future One of the most important strengths of the U.S. economy is its flexibility. Enhances the ability to -2- respond to change. Also enhances the rewards for innovation. To preserve this flexibility (which is a source of our economic dynamism, and thus of our prosperity), we need to make a series of investments that will pay off over the longer term. [If we are to achieve the productivity growth rates that are to provide for our aspirations as a nation, we must make reasoned investments in our future. This means raising our national savings rate and promoting innovation and investments in productive activity. We must restructure and revitalize our education system. And we have to embrace economic dynamism and a willingness to adapt, change, and innovate. This means eschewing measures that hold the false promise of protection from foreign competition. Instead, we must join with other nations to create a stronger and more open world trading system. ] Education -- the importance of a well-trained workforce. [According to the recent National assessment of Educational Progress, the U.S. ranks last in mathematics and in the bottom group in science in a comparison of American 13-year-olds with their counterparts in 11 nations and 4 Canadian provinces. Only 40 percent of U.S. students could perform a two- step math problem versus 78 percent of Korean students and 60 percent of students in most countries.] [The problem is not a willingness to commit resources -- the U.S. spends far more than most countries on educating its students. The difficulty appears to lie with: (1) an elementary and secondary school system that has little accountability, flexibility, or innovation; (2) an inadequate level of parental involvement; and (3) a need to shift the emphasis from resources to results. Together with the nation's Governors, my Administration has launched a comprehensive effort at reform and restructuring aimed at producing an educational renaissance.] Support for technology: 1992 budget provides additional funding for generic, precompetitive enabling technology. -3- - A record Federal budget commitment to science and expanding the frontiers of knowledge, including basic research and making government research more available to the private sector for speeedier commercialization. - Increased support for generic or enabling technologies at the pre-competitive stage of R&D in such areas as high-performance computing, new energy technologies, and advanced manufacturing and materials. - Making permanent the R&E tax credit. [Generic, pre-competitive technologies are those offering a wide breadth of potential application, forming an important technical basis for future product-specific applications and significant benefits to the economy by enhancing economic growth and raising productivity. This technology development will go to the stage where technical uncertainties are sufficiently reduced to permit assessment of commercial potential and prior to development of application-specific commercial prototypes.] Investment in infrastructure: transportation and information networks. Deregulation -- benefits hard to predict in advance. Chapter 4 of CEA Annual Report. Example: telecommunications deregulation. Seeking open world markets -- an important part of deregulation. Uruguay Round, U.S. -Mexico FTA, Enterprise for the Americas Initiative. [Dynamism also involves embracing open trade and investment policies. Businesses must continually improve and innovate to keep their products at the cutting edge internationally. ] 5. Financial Sector Reform A healthy economy requires a banking system that is both safe and profitable. A safer banking system means more effective restrains on excessive risk. Greater reliance on the discipline of the marketplace. -4- Increased supervision through more frequent on- site examinations. -- Strengthen the role for capital. -- Allow non-banks to invest in banking to provide an infusion of capital. -- Geographic diversification through nationwide banking to withstand regional downturns and provide economies of scale. -- Product diversification to provide greater competition, better service, and decreased risk. Streamlined regulation means a consolidated, simplified, and more efficient regulatory system. A well-capitalized insurance fund means an infusion of industry funds to minimize exposure of the taxpayer. Also, move toward risk-based insurance premiums. A world-class economy needs a world-class financial system. Increased consumer benefits of reform. Example: Automated teller machines. 6. Conclusion We are challenged as a nation to achieve the productivity growth rates that are needed to provide for our aspirations. To do so, we must make reasoned investments in our future. This means: - Raising our national savings rate; - Promoting innovation and investments in productive activity; - Restructuring and revitalizing our educational system; and - Embracing economic dynamism and a willingness to adapt, change and innovate. -5- Healthy competition is the key. It drives industries to produce better products at a lower cost. It gives consumers access to quality products at lower prices. Our own lives and those of our children depend on how we respond to this challenge. CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT CHAPTER 4 FLEXIBILITY AND CHANGE IN THE ECONOMY ONE OF THE MOST IMPORTANT strengths of the U.S. economy is its flexibility. Flexibility enhances the ability of a market economy to respond to change and, thereby, enhances the rewards to innovation. Strong demand for an innovative new product both rewards the innovator and is the signal that draws additional resources into production to meet the demand. An innovation that lowers cost drives down price, signaling greater availability to potential consumers and causing them to increase consumption. In this way, the flexible U.S. economy enhances the private and social benefits of desirable changes, such as technological improvements, and thereby encourages such changes. This dynamism has generated the high standard of living that the United States and other free-market economies enjoy and is one of the major reasons that people all over the globe are now moving to reform their economies to increase their reliance on free markets. Flexibility also reduces the cost of adverse changes, such as a sharp, unexpected increase in the world price of oil. As discussed in the previous chapter, such shocks may increase unemployment temporarily, but a flexible economy adjusts to new circumstances effectively and can return rapidly to full employment. THE PROCESS OF DYNAMIC CHANGE A clear picture of the dynamic nature of the U.S. economy can be produced by a simple visual inspection of a modern home, which may contain a microwave oven, a home computer, videocassette recorder (VCR), many pharmaceuticals, non-stick cookware, and numerous other products that did not exist a few decades or even a few years ago. The introduction and growth of all of these products required innovation, followed by the dedication of capital, labor, and other resources to new uses. This reallocation of resources occurs without government planning. The government took no action to guarantee that between 1985 and 1990, thousands of video rental stores would open so that the owners of VCRs would have movies to rent. Individual entrepreneurs made the decision to risk their capital and their labor to undertake these new ventures. A simple comparison of the prevalence of new products and new industries in market economies with their absence in nonmarket economies shows that the government is not nearly as good as the market at organizing the reallocation of resources that must accompany innovation. The ease with which resources can be shifted to the production of new goods and services raises the returns to innovation and thus encourages it. CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT The improvement in our lives provided by new products generally is not captured in statistics on real income growth. The increase from 1 year to the next in the number of cars, computers, video games, VCRs, or other products can be measured. But the qualitative leap in consumer welfare that occurs when a completely new product is introduced is extremely difficult to capture. Thus, conventional measures of economic progress, such as real income growth, will always tend to understate the benefits of the innovation and change that are the hallmarks of a free market economy. Such qualitative changes are very difficult to predict, and government interference in market forces can suppress them without anyone even being aware of the loss. Thus a benefit to the economy of the significant deregulatory initiatives of the last 15 years is the greater potential for innovation that enhanced flexibility provides. Indeed, the U.S. economy is arguably more flexible than other market economies, which tend to be encumbered by greater government involvement in direct production of goods and services and by restrictions on labor market practices. The long-run growth rate of the U.S. economy is dependent on continued efforts to eliminate government policies that inhibit flexibility and to resist pressures to reimpose unnecessary regulation on the economy. SOURCES OF ECONOMIC CHANGE The forces driving change come from several sources. On the supply side, changes in technology create entirely new products and eliminate the demand for others. For example, the invention of the transistor and its subsequent refinements made possible desktop computers, VCRs, facsimile machines, compact disk players, and a host of other products that never existed before, while virtually destroying the vacuum tube industry. Innovation also increases productivity and thus lowers the cost of existing goods and services. Population growth, immigration, and other demographic forces are also sources of supply-side change. Throughout its history the United States has absorbed wave after wave of new immigrants, integrating them into the economy and thereby increasing production. More recently, the economy has demonstrated its flexibility by accommodating a tremendous increase in the number of working women. Between 1970 and 1989 the labor force participation of women increased from 43 percent to 57 percent, and this huge influx of new workers was not accompanied by a fall in the relative wage of women workers. In fact, during the latter part of this period the gap between female and male wages narrowed. 2 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT On the demand side, changes in the demographic composition of the economy and changes in people's tastes and preferences alter the demands for particular goods and services. The increasing fraction of the population that is elderly has greatly increased the demand for health care, for example, and the general movement toward suburban living and longer commutes has increased the demand for petroleum. The international economy is another source of change in both supply and demand conditions. The end of World War II, and the reduced industrial capacity that the war left in other countries, created an enormous opportunity for exports and overseas investment for U.S. firms. More recently, the growth in international travel has created an opportunity for domestic airframe manufacturers; the leading domestic manufacturers now export more than one-half of their civilian aircraft production. THE CHANGING STRUCTURE OF THE U.S. ECONOMY The broad dimensions of historical change in the U.S. economy are illustrated by Chart 4-1, which shows dramatic reallocations of resources within the U.S. economy over the last 150 years. The growth of manufacturing and service industries and the relative decline of agriculture have required an impressive reallocation of capital, labor, and other resources. Yet government did not have to decide that workers should be moved from farms or factories into banks or hospitals. These movements were brought about by market forces, driven in turn by changing demands, demographics, and the introduction of new technology. Growing Manufacturing Productivity and the Service Sector Recent decades have seen a continuing shift in employment from goods-producing to service-producing industries. The goods- producing sector accounted for 41 percent of nonfarm employment in 1946; 28 percent in 1980, and 23 percent in 1990. A similar shift of employment toward the service sector has taken place in other advanced economies. In 1966, for example, the goods-producing sector accounted for 37 percent of employment in the 24 nations of the Organization for Economic Cooperation and Development (OECD), which includes most of the industrialized market economies of the world. By 1988 this figure had fallen to 30 percent. Over the 1980s, the service-producing sector of the economy had a net increase of 20 million jobs, which exceeded the 19 million net job increase in the overall economy. The two industries adding the most jobs were business services, which includes 3 Chart 4-1 Labor Force Shares by Industry. U.S. workers have moved out of agriculture, first into manufacturing and later into services. Percent 100 90 80 70 60 50 40 30 20 10 0 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1989 1 Agriculture Manufacturing Transportation and Trade Other Services 1 Includes manufacturing, mining, and construction Sources: Department of Commerce and Department of Labor CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT advertising and computer and data processing services, and health services (discussed below). More than 5 million net new jobs, or 27 percent of the net employment gain in the 1980s, were in business or health services. This growth in service sector employment has absorbed labor resources freed by rising manufacturing productivity, just as the growth in manufacturing employment absorbed resources released by rising productivity in agriculture in earlier decades. Manufacturing productivity increased at an average annual rate of 3.7 percent from 1983 to 1990. This allowed manufacturing to maintain a roughly constant share of GNP even though only about half of the 3 million manufacturing jobs lost between 1980 and 1982 were regained by 1990. Less Aggregate Shifts Within these broad sectoral movements, many other changes have occurred. During the last 10 years, increased demand for convenience was a major force for change. The growth in retail grocery stores during the decade reflected this trend, as the concept of a "super" store with one-stop shopping for groceries, drugs, flowers, hardware, and other products took hold. Eating and drinking establishments enjoyed rapid growth, partially because the increase of two-worker families raised the value of people's time. On the supply side, advances in computer technology led to rapid expansion of such industries as computer and data-processing services, which alone added 499,000 jobs during the last 10 years. Changing lifestyles and family structure have also led to a rapid increase in industries providing care to the old and the young. Industries providing residential, nursing and personal care, largely for the elderly, and child day-care facilities added 825,000 new jobs from 1982 to 1990. Flexibility and Change in Labor Markets The constant reallocation of resources from shrinking industries to growing industries means that jobs are constantly being created and lost in the economy. This process of reallocation occurs without necessarily preventing the achievement of full employment. Indeed, the simultaneous creation and destruction of jobs continues whether the overall economy is in an expansionary period or a recession. During the two contractions between January 1980 and November 1982, for example, total employment fell by 2.1 million jobs. However, this net decrease consisted of a loss of 2.8 million manufacturing jobs, partially offset by increased employment outside of manufacturing. Even within 4 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT manufacturing, jobs were both created and lost. It is estimated that in an average quarter during this period, 6 percent of all manufacturing jobs disappeared, while 5 percent were newly created. Throughout the remainder of the decade, net employment increased by an average of 3 percent a year. Again, the net change conceals simultaneous gains and losses. Between it is estimated that each year 45 percent of all establishments experience net employment gains, with an average net gain of 30 percent; 47 percent experience net job losses, with an average net loss of 21 percent; and the remaining 8 percent maintain stable net employment levels. The dynamic nature of the labor market is also evident in unemployment statistics. In November 1988, for example, the unemployment rate was 5.3 percent, and 6.5 million workers were unemployed. The following month both of these statistics were essentially unchanged. On the surface, this lack of change might seem to indicate a static labor market. Yet, out of the 6.5 million unemployed in November, 3.1 million had left unemployment by December. About one-half of them had found jobs; the other half had withdrawn from the labor force. In the same month, roughly 1.5 million previously employed workers became unemployed and 1.6 million individuals entered or reentered the labor force and began looking for work. This continual reallocation of workers requires that labor markets be flexible and that workers be mobile. It is estimated that the average worker holds 10.5 jobs in a lifetime. Survey data also show that every year 10 percent of all workers change occupations. This number does not include the number of individuals who change jobs but remain in the same occupation. Only 1 out of 10 workers who change occupations do so because of layoffs. Most change occupations to earn higher pay or improve their working conditions. Geographic mobility is an important aspect of labor market flexibility. The movement of workers out of agriculture and into manufacturing and services was accompanied by a major migration from rural to urban areas. Over the last two decades, the percentage of the population residing in the Northeast and Midwest has declined from 51.9 percent to 44.1 percent, reflecting a movement to the relatively fast-growing South and West. The decline in the Northeast population share slowed during the 1980s, as strong growth in financial services, real estate, and other industries produced gains in per capita income in both New England and the mid-Atlantic States. Overall, about 6 percent of 5 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT the population moves to a different county each year, and about 3 percent moves to a different State. This mobility of people within and between regions is an important reflection of and contributor to the economy's flexibility. PRESERVING THE FLEXIBILITY OF THE ECONOMY The dynamic nature of the U.S. economy and the value of flexibility have important implications for economic policy. The incentives for firms to undertake innovation and investment are greatly affected by the overall macroeconomic environment, by the structure of taxation, and by legal rules governing the protection of intellectual property and product liability. To maintain a flexible and innovative economy, macroeconomic policy should seek to foster growth and predictability through sound and stable monetary and fiscal policy. The tax structure should not erect barriers to savings, investment, or innovation. Product liability rules should protect consumers from product-related harm in ways that do not unduly discourage the introduction of new products. (These issues are discussed in more detail in Chapter 4 of the 1990 Economic Report.) The Benefits of Economic Deregulation Reduction in market flexibility is an important and often overlooked effect of regulation. When the Federal Government regulated airline routes and fares, one effect was that fares were generally too high. But another effect, which was not visible until the regulations were removed, was that regulation prevented airlines from developing efficient route networks. After deregulation, the airlines evolved "hub-and-spoke" systems to channel passengers into hubs where they could be connected more efficiently to their ultimate destinations. As a result, airlines operate more efficiently, and most travelers today have a greater range of flight choices at lower real prices. Similarly, telecommunications regulation had, and continues to have, adverse effects on innovation by restricting which firms may enter particular segments of the industry. It is not coincidental or surprising that the adverse effects of regulation are often not perceived until after the regulation is removed. By its very nature, stifled change is very difficult to detect. If unexploited technology is observed "sitting on the shelf," then one can investigate whether regulation is preventing its adoption. But it is impossible to know to what extent regulation, by preventing change, stifles the incentive even to develop new ways of doing things. It is therefore also impossible to know the extent of the lost opportunities. 6 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT There are inherent institutional reasons why government regulation tends to inhibit change. Regulation is a legal institution, and legal processes rely heavily on precedent. This reliance creates an inherent bias in favor of the old and against the new. In addition, regulators face an extremely difficult problem: they are trying to make rules that constrain firms to act differently than they would otherwise choose. Regulators must do this knowing that the firms will always have better information about their costs, customers, and technology. Accomplishing the regulators' goals in a static world in which technology and institutions do not change would be hard, but it is even harder still in a world of constant change in which the regulators will always lag behind the firms in understanding what is going on. For this reason, regulators have an incentive to prevent regulated markets from changing too rapidly. These institutional biases against change inherent in government regulation do not mean that regulation is never desirable. Unregulated markets that generate serious pollution problems, have serious failures in the availability of information, or are inevitably served only by monopoly firms do not perform well. Regulation based on careful balancing of benefits and costs can sometimes improve their performance. Such regulation will, however, almost always impose some reduced flexibility. In balancing the costs and benefits of government regulation, these costs of reduced flexibility should not be forgotten, even though they are subtle and difficult to quantify. Government interference can also adversely affect the flexibility of labor markets. As discussed below, some States have responded to concerns about our education system by increasing certification requirements for teachers. Unnecessary certification requirements create an artificial barrier that prevents qualified teachers from moving from one State to another or moving into teaching from other professions. In the long run, this barrier will increase the cost and decrease the ffectiveness of education. Adapting to Changes in Technology and Institutions Failure to adapt longstanding government policies to a changing economy can be extremely costly. Regulation of railroads began in the 1890s, when they had a monopoly on the transportation of many goods. In the late 1970s, long after railroads had lost much of their business to trucks, regulation still treated them as monopolies, and partial regulation continues today. The decline of railroads when trucking developed was perhaps inevitable, but it was surely hastened by a regulatory regime that greatly limited the railroads' ability to compete. The banking and 7 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT financial services sector is another area in which regulation and other government policies have needed to adapt to changing technology and market conditions (see Chapter 5). Just as government regulation inherently inhibits change in the affected markets, regulation is itself inherently resistant to change. Once any regulatory regime is established, a constituency that benefits from it is created. No matter how out of date or counterproductive the regulatory regime becomes, that constituency is likely to resist efforts to change or end it. Therefore, it is to be expected that regulatory institutions will not adapt themselves well to changing circumstances, a tendency that should be considered when evaluating the long-run net benefits of deregulation. Lowering International Barriers to Trade and Investment In addition to being a driving force for change, free international trade can facilitate domestic adjustment to change. U.S. agricultural exports absorbed some of the increased output made possible by growth in agricultural productivity and thus cushioned the fall of agricultural employment. Further reductions in barriers to international agricultural trade would yield even greater benefits from high U.S. agricultural productivity. The United States currently has a relatively low rate of domestic savings. The free flow of foreign capital into the United States has maintained domestic nonresidential investment (and ultimately productivity growth) at a level above that which domestic savings would support. Thus international trade and investment flows provide an additional channel of flexibility to the economy. Administration efforts to further reduce international barriers are designed to maximize this flexibility (see Chapter 7). Cushioning the Effects of Change Despite its benefits, economic change can impose short-term costs. Workers and firms who face declining demand or have obsolete skills and technologies face declining incomes. It is good social and economic policy to cushion such blows and to facilitate the retraining or retooling necessary to move such resources into other uses. But the government should not try to prevent change itself in order to mitigate its consequences. Such efforts are ultimately futile; they only serve to squander a portion of the beneficial effects of change and, cumulatively, to reduce the economy's flexibility. 8 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Probably the most important example of this mistake has been farm policy in the United States, and, to an even greater extent, in Europe and Japan. Rapidly rising agricultural productivity, combined with relatively slow growth in the demand for food and other agricultural products, required that resources move out of the agricultural sector. The market signal for this needed reallocation is that farm incomes do not rise as fast as incomes in other sectors. Many aspects of farm policy have, however, attempted to squelch this signal by maintaining some farm prices and farm incomes at artificially high levels. Though farm policy has not ultimately succeeded in preventing a dramatic movement of labor out of agriculture, it has significantly reduced the benefits of agricultural productivity growth. If government policies that interfere with efficient allocation of agricultural resources were eliminated both in the U.S. and abroad, all nations would benefit from a more efficient world-wide agricultural sector. Sometimes the economy must respond to changes that are inherently adverse. But if the initial shock is unavoidable, the government only makes things worse by preventing the economy from adapting to it. A good example of this policy mistake is the energy policy of the 1970s. When the Organization of Petroleum Exporting Countries (OPEC) raised the world price of oil in 1973, and when the Iranian revolution and Iran-Iraq war raised it again in 1979, the result was unquestionably damaging to the U.S. economy (see Chapter 3). The urge to try to cushion this blow by regulating the price of oil is understandable, but the result was the creation of artificial shortages and a delay in the adoption of energy-conserving technologies. Integration with the world economy also generates the need for adjustments in labor markets. Increasing imports can lead to reduced employment in domestic industries, generating demands for government protection from the forces of change. Such protection can come in many forms, but the two most widespread are subsidies and trade barriers. The U.S. textile, machine tool, auto, and other industries have received trade protection at various times. Many European nations give enormous subsidies to their steel and shipbuilding sectors. Subsidies and trade protection for declining industries are often a source of trade disputes among nations, but the strongest argument against them is that they prevent the efficient movement of resources among sectors, both within and across nations. The last decade has seen increasing awareness in many advanced economics that such policies are counterproductive. In Sweden, for example, subsidies to declining industries equaled 43 percent of manufacturing profits in 1977-78, but such subsidies have since been cut dramatically. 9 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT The economy as a whole benefits greatly if workers from industries subject to effective foreign competition are allowed to move to other sectors, but these moves are often painful for the workers involved. The decline of particular industries also creates problems for particular localities or regions that are heavily dependent on declining industries. Existing policies appropriately seek to mitigate these human costs and to facilitate retraining and reemployment, not to prevent labor market ad justments. The Unemployment Insurance System provides up to 26 weeks of income protection, and in some cases unemployed workers are eligible for extended benefits. A wide array of State and community-based programs for workers are provided through the Job Training Partnership Act. Such programs provide educational instruction, job training, counseling, and other support services. These programs can be designed to enhance flexibility. For example, the transferability of unemployment benefits across States allows displaced workers to move to another State where opportunities may be better, without immediately losing benefits. Some States have experimented with combinations of job search assistance, job training, and the provision of unemployment benefits in the form of a lump sum either at the time of reemployment, or in some cases, to finance the start-up of enterprises. Ultimately, the most important thing that the government can do for workers in declining industries is to facilitate the creation of new jobs elsewhere in the economy. Thus, these workers, too, are dependent upon government policy that fosters growth and maintains market flexibility. SUMMARY o The ability of the U.S. economy to change and evolve is one of its greatest strengths. o Flexibility encourages innovation, increases its benefits, and raises living standards. o Government policies can maximize the flexibility of the economy by forgoing unnecessary regulation, avoiding attempts to stymie the inevitable rise and fall of particular economic sectors, and removing barriers to innovation. EDUCATIONAL REFORM FOR AN ADAPTABLE WORK FORCE 10 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT A key determinant of the flexibility of the economy is the quality of its work force. Education raises skill levels that increase job performance and productivity. Well-educated workers have the basic skills necessary to adapt to the changing demands of a dynamic economy and are able to compete with their peers in other nations. Unfortunately, primary and secondary education in this country does an inadequate job producing such workers and is thus in need of sweeping reform. Parental involvement and student dedication--especially to homework--is essential to the successful reform of any school system. But greater parental and student effort alone cannot ensure success. At the core of the problem are insulated State and local educational bureaucracies that hinder rather than promote change, erect significant artificial barriers to entry into and mobility within the teaching profession, and severely limit parents' ability to select schools for their children. The educational system should, instead, encourage innovation and promote excellence among teachers and students. It should strive to earn the same high reputation as the U.S. post- secondary educational system, in which there is significant diversity and choice. It should provide the foundation that enables workers to adapt and respond to changing workplace technologies and economic conditions. And it should provide all high school graduates, whether they are college-bound or not, with the backgrounds necessary for advanced study or training. Many school districts have outstanding educational systems and achieve these goals. And in every school district in the Nation there are talented and dedicated teachers as well as concerned parents who work hard to improve the educational system. Success requires the commitment to excellence at each of these levels as well as by students themselves. However, despite some successes, too many State and local educational systems are notably inflexible and resistent to meaningful and effective change. Because they need not compete for students and are not held accountable for the quality of the education they provide, many State and local educational agencies in this country have become entrenched bureaucracies. As a result, U.S. students of ten receive unacceptably poor educations. Low-income parents have little power to ensure that their children receive a sound education, and many families send their children to private schools. The primary fiscal responsibility for public education lies with State and local governments, which determine the institutional framework for the operation of the educational system. Local school boards and State educational agencies determine who may teach, what schools students attend, and even 11 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT the general instructional methods that are adopted. The Federal Government has traditionally provided only a small fraction of total support for education at the elementary and secondary levels; in 1988 it provided only 6.3 percent of the funds spent on education for kindergarten through grade 12. As well-intentioned as school boards and educational agencies may be, a system that is not required to compete for its students and is not judged by their performance is hard pressed to avoid the mediocrity and resist the insularity that comes with being the only "free" game in town. As a result, although the United States spends more money per pupil than almost any other country in the world (in 1988 per pupil expenditures were $4,613), the return on this substantial investment is unacceptably low. THE CURRENT STATE OF EDUCATION The education provided by public primary and secondary schools in the United States is woefully inadequate. Evidence of this themselves. inadequacy can be found in the workplace and in the schools Evidence from the Workplace Today's high school graduate is often ill-prepared for the world of work. The National Assessment of Educational Progress, a nationwide Test of students conducted by the Department of Education, found that only 6 percent of 17-year old students demonstrate the capacity to solve multi-step problems and use basic algebra; only 8 percent have the ability to draw conclusions and infer relationships using scientific knowledge; and only 5 percent can synthesize and learn from specialized reading materials. Firms are finding it increasingly necessary to develop remedial training programs in reading and mathematical skills; they spend an estimated $20 billion annually on such programs. Even institutions of higher learning are adapting their course offerings to reflect the poor preparation of many freshmen; the fraction of colleges of fering remedial instruction has increaseD from 79 percent to over 90 percent since 1980. A second-rate educational system cannot support a first-rate. world-class economy. Workers unable to read and grasp complex concepts in mathematics and science cannot hope to adapt to changing technologies in the workplace. Poor training in mathematics and science at the elementary and secondary level also contributes to declining trends in college enrollment in these areas. This pattern threatens the creative foundation needed to discover and introduce advances in technology. 12 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Ineffective Reforms A key element weakening the quality and strength of the U.S. educational system is the failure of its institutions to adapt to the changing educational needs of its citizens. Even when they do respond, however, State and local educational systems have often been unable to adopt meaningful and effective reforms. In 1983 a Presidential Commission issued the report, A Nation at Risk, which painted a bleak portrait of the quality of education in elementary and secondary schools in the United States. The report struck a responsive chord. Reacting to its recommendations and challenges, State and local educational systems embarked on plans to introduce fundamental changes. It is nearly a decade later, and not much of consequence has changed. To be sure, a huge number of bills were introduced in State legislatures in response to the report, and many were passed. Forty-five States increased graduation requirements for core courses in subject areas such as mathematics, sciences, humanities, and social sciences. Many States also made teaching certification requirements much stricter and, in an effort to attract higher quality teachers, increased salary levels significantly. Teacher's salaries in public elementary and secondary schools increased by 18 percent in real terms between 1980 and 1990. Expenditures per pupil have also increased 28 percent in real terms since 1982. Despite these reforms. there has been no noticeable change in the per formance of the Nation's schools. Though students are taking more mathematics, science, and reading courses, test results show that no erformance improvements have been made in these subject areas since the appearance of A Nation at Risk. The percentage of students graduating from high school remains abysmally low, falling from 73 to 72 percent since the report's release. Finally, combined scores on the Scholastic Aptitude Test have barely risen since 1983, from 897 to 900. International Comparisons U.S. high school students consistently per form far below their foreign counter parts, especially in their knowled ge of mathematics and science. In an assessment of learning in six major developed countries in 1988, U.S. students ranked last in mathematics and second to last in science. Even the best U.S. students do not compare favorably with foreign students. The International Assessment of Educational Progress (IAEP) found that a very select group of college-bound American students scored far below a less select group of Canadian students on a standardized test, and no better than an even broader group of Hungarian students. 13 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Other indicators are also very telling. U.S. students spend an average of only 3 1/2 hours a week on homework. That compares poorly to the average 24 hours a week that high school seniors spend watching television. Studies show that European students spend far less time watching television and more time studying. Finally, American students spend much less time in school than their foreign counterparts. Even though the American system of education is highly decentralized, the 180-day school calendar is nearly national in scope. School calendars ranged from 226 to 240 days in pre-unification West Germany. In Japan schools are open 243 days on average. Some argue against lengthening the school year on the ground that it is the quality, not the quantity, of instruction that is at issue. Certainly, merely lengthening the school year is not the panacea for the ailing U.S. school system, but it is an issue deserving study and consideration. Evidence suggests that in countries with longer school years, more material is covered and at a much less hurried pace than in American classrooms. Thus even in U.S. school systems that attain high standards of excellence, the quantity of educational material provided to students is not competitive by world standards. TOWARD AN EFFECTIVE EDUCATION SYSTEM The Administration is fully committed to promoting excellence in the U.S. educational system and has undertaken significant initiatives to this end. In September 1989 President Bush convened a summit of cabinet officials and U.S. Governors to discuss the state of American education. Only the third such summit in American history, it was first ever on education. As a result of this historic meeting, the President and the Governors agreed upon six clearly defined goals for the American educational system to reach by the year 2000: o All children in America will start school ready to learn; o We will increase the percentage of students graduating from high school to at least 90 percent; 0 Students will leave grades 4,8, and 12 having demonstrated competency in challenging subject matter, including English, mathematics, science, history, and geography; and every school in America will ensure that all students learn to use their minds well, so they may be prepared for responsible 14 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT citizenship, further learning, and productive employment in our modern economy; o U.S. students will be first in the world in science and mathematics achievement; o Every adult American will be literate and possess the knowledge and skills necessary to compete in a global economy and exercise the rights and responsibilities of citizenship; and 0 Every school in America will be free of drugs and violence and offer a disciplined environment conducive to learning. President Bush outlined these goals in his 1990 State of the Union Address. In July 1990, the President and the Governors established a National Education Goals Panel that also includes participation of Congressional leadership. The Panel will recommend a measurement and assessment system that will provide the nation with information as to the progress being made in reaching these goals. Many of the reforms needed to achieve the national education goals would be substantially assisted by the Administration's Educational Excellence Act. This important legislation, introduced on April 5, 1989, was not enacted into law by the 101st Congress and will be reintroduced in the 102nd Congress. The Act embraces three principles that are central to the fundamental and effective reform of U.S. education: Schools must be encouraged to innovate and to provide students. parents, and teachers a greater voice in the education system; schools and teachers promoting excellence in education must be rewarded, and those that do not must be held accountable; and the artificial barriers to entry into the teaching profession must be lowered substantially. Programs of Choice The U.S. public educational system must be opened to the invigorating and challenging forces of market competition by empowering teachers, parents, and students to choose their schools. Over time, the schools that survive will be the most innovative and effective institutions, those capable of responding to the changing educational needs of society. Schools that must compete for students will work harder to deliver quality education. A school choice program can become the catalyst for greater diversity and help eliminate mediocrity in the educational system. An important step in this direction is the 15 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT magnet school concept in which schools specialize in particular subject areas or interests--such as science, mathematics, or the performing arts--and students and their parents choose which school to attend. The Administration has advocated adoption of choice programs in as many jurisdictions as possible across the country. There is no one "preferred" approach to educational choice. A State-wide choice plan exists in Minnesota, while a choice demonstration plan including both pubic and private schools has been launched in Milwaukee, Wisconsin. The Administration's new Center for Choice in Education has been established to provide information and assistance to anyone interested in learning about or implementing educational choice. A key to the success of a choice-based program is granting individual public schools the freedom to innovate. Schools must be freed from the grip of bureaucracies distant from the classroom. One popular version of this self-run school approach is to leave the governance of each school to a team composed of the principal, teachers, and parents. Such an arrangement creates a personal stake in the success of the school, rather than reliance on a central bureaucracy. It also provides parents and teachers an effective voice in determining how a school should change to attract students in an open-choice educational system. Accountability Unless teachers, school administrators, and elected or appointed officials are held accountable for the quality of the education they provide, the success of open-choice programs and self-run schools will be limited. Merely adopting new approaches does not ensure success. Schools and teachers must be held accountable for what their students learn. To this end, State and local educational agencies must work together to develop and publish ob jective measures of the output of the educational system. Meaningful performance measures are necessary for the success of school choice programs, allowing parents and students to leave choice programs that are failing. Such performance measures include basic competency tests for graduation from high school; tests at the beginning and end of the school year to determine progress; changes in high school drop- out rates; and high school transcripts that provide meaningful information on course content and student skills to parents, employers, and colleges. At the Federal level, the Department of Education is charged by law to "collect, collate, and from time to time, report 16 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT full and complete statistics on the condition of Education in the United States." The National Center for Educational Statistics (NCES) has developed a series of national measures of the output of the educational system. The NCES publishes an annual digest of education statistics and also periodically publishes the National Assessment of Educational Progress. And beginning in 1988, the NCES began publishing a selection of indicators on the condition of education in the U.S. The 1990 report confirms the dismal state of public education in this country. Each of these reports provide an ongoing basis for parents to test the success of educational reform. and are important tools for increasing accountability. Alternative Teaching Certification Programs Each State sets up standards that determine who can teach in elementary or secondary school systems. Differences in certification requirements across States produce substantial limitations on teachers' job market options. Although many States have formal reciprocity agreements, teachers still encounter significant barriers when they try to cross a State line. For example, until recently an individual qualified to teach in Massachusetts was required to get a masters' degree in order to teach permanently in a school system in neighboring Connecticut. This particular limitation has been abolished, since each of the six New England States recently agreed to accept the teaching credentials of applicants from any other New England State. Although this New England program is a step in the right direction, remaining artificial barriers to entry into the teaching profession within each State are at least as important. Most States currently require that an individual either graduate from a 4-year college as an education major or take a certain number of education courses before being allowed to teach. Talented individuals who decide to switch careers and become teachers find they have to complete either a traditional teacher preparation program or, under fairly recent reforms in some States, complete a graduate degree program in education. While these requirements discourage many talented professionals seeking a career change from entering the teaching profession, they do not ensure that the school system is getting high-quality teachers. In fact, the poor academic performance of teachers in the subject areas they teach led many States to impose minimum grade requirements for education majors. The solution to the problem of attracting talented teachers. however, is not to regulate the industry further but to open it up to the competitive process and to reduce eligibility requirements in ways that do not threaten but instead encourage excellence in teaching. 17 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Currently, 29 States have implemented some form of alternative teaching certification program. Mainly small, pilot programs, these are based on the general principle that an individual with a bachelor's degree in a specific field of study can be a successful teacher with a certain minimum training in education. In the Texas program, for example, the teaching candidate begins with three to nine hours of education course work. (see Box 4-1). The minimum varies across States, but all programs reflect the belief that the minimum needed to guarantee quality is far less than that currently required by traditional certification routes. Box 4-1.--Texas Alternative Certification Program Starting with one school district in 1985, the Texas State school system has taken a national lead in introducing alternative teaching certification programs. The program is currently operating in nearly 20 percent of the State's school systems, and the number of teachers certified by the alternative route has grown from 276 in the first year to 1,241 in 1990. In a typical program, a candidate with a bachelor's degree takes 3 to 9 hours of education coursework, learning basic classroom management, along with disciplinary and evaluation skills. The candidate/intern is then assigned to his or her own classroom for the year, receiving a first-year teacher's salary and a year of experience on the career ladder. Throughout the internship year, the candidate works closely with a mentor, often meeting on a daily basis for support and problem-solving. In addition, interns take other education coursework throughout the year. The alternative programs have been very successful in attracting highly qualified, diverse interns. In 1990, 30 percent of the interns were men and 52 percent were minorities, compared with traditional education programs, where 23 percent of the enrollees are men and 12 percent are minorities. Interns are older than the traditional education major: 90 percent are over 25, and 50 percent are over 30 years of age. Evaluations of the program thus far suggest it is working very well. Interns do as well as or better than their traditional- route counterparts on the certification exams required by the State. Studies show that teachers qualified by the alternative route are comparable in quality to teachers qualified through the traditional route. It is important to recognize that removing artificial barriers to teaching does not threaten the stature of the profession. First, 18 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT one already well-defined qualification for entry into the teaching profession, the acquisition of a 4-year college degree, will not change. Second, what helps promote respect for the teaching profession is effective teaching, not arbitrary certification requirements. The experience in Texas and in numerous other programs suggests that lowering the barriers to entering the teaching profession can improve the quality of primary and secondary education. SUMMARY o Public schools in the United States are failing to prepare students for either the world of work or higher education. This failure threatens the ability of the United States to maintain its leadership in the world economy. o Competition and accountability are essential if schools are to innovate and improve the quality of education. o Alternative certification programs can enhance educational quality by removing artificial barriers to entry into the teaching profession. AGRICULTURE: TECHNOLOGICAL SUCCESS AND MORE FLEXIBLE POLICY The agricultural sector illustrates dramatically both the tremendous dynamism of the U.S. economy and the costs of government policy that tries to inhibit change. Technological progress and the increased integration of world markets have transformed the U.S. farm sector, leading to growing production of wheat, corn, meats, and other products using a fraction of the labor force previously devoted to agriculture. At the same time, a complex structure of Federal farm policies has evolved that often inhibits the efficient use of agricultural resources. These programs impose significant costs on taxpayers, consumers, and the economy as a whole, thereby mitigating potential benefits of agricultural progress. TECHNOLOGICAL CHANGE AND PRODUCTIVITY GROWTH Technological innovation has been a driving force behind dramatic changes in both agricultural production and agriculture's role in the economy. Many important technological changes in agriculture occurred in response to market signals. The initial great surges in farm mechanization, for example, came in response to the farm labor shortages associated with the Civil War. The 19 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT widespread adoption of mechanization allowed fewer workers to cultivate more land and facilitated agriculture's westward expansion. The advent of tractors around the close of World War I not only increased each worker's productivity but freed land from the production of food for draft animals. The demands on farm output associated with World War II, coupled with increasingly limited opportunities to bring more land into production, provided the impetus for a new wave of technological innovations that increased the productivity of each unit of land and livestock. Following World War II, farmers increased crop yields greatly through the adoption of chemical fertilizers and pesticides, irrigation, and improved seed varieties such as hybrid corn. Corn yields per acre, for example, more than tripled from 1945 to 1990. Improved livestock breeds, artificial insemination, and greater feeding efficiency enhanced the productivity of the livestock sector as well. The average dairy cow produced almost three times as much milk in 1989 as in 1945. In response to changing technology, the agricultural work force in 1980 was one-fifth of what it had been a half century before, while the use of chemical inputs increased twenty-fold. Agricultural productivity per unit of all production inputs increased more than two and one-half times between the 1930s and 1980s. Government has had a long and important role in supporting and disseminating agricultural research, but innovations also come to the farm sector because private sector entrepreneurs are able to profit from them. What are the major implications of these dramatic changes in productivity? First, employment in farming fell rapidly as fewer and fewer farm workers were required to meet the food demands of the nonfarm sector. While this decrease means that farming has become much less representative of the American lifestyle--2 percent of the American labor force is employed on the farm today, compared with 22 percent in 1930--it also means that labor was freed from agriculture to contribute to the growth of other industries and sectors. Industries that emerged to support a more modern agriculture, such as financial institutions, farm equipment and fertilizer manufacturing and distribution, and food processing, were important new sources of employment. Second, agricultural supply expanded faster than agricultural demand. Accordingly, real farm prices have trended downward in the United States since the Civil War. The decline in agricultural prices contributed to the fact that American consumers now spend only about 16 percent of their disposable income on food-- near the lowest in the world--and are among the best-nourished people in the world. 20 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT CONSUMER DEMAND AND INTERNATIONAL TRADE In addition to technology, other factors have been important sources of agricultural change. Changing consumer tastes and preferences have changed the relative profitability of alternative crops and products and reshaped the composition of agricultural production. The health-motivated interest in lower fat foods, for example, has contributed to the rapid growth in the production of poultry meat since 1980, while the output of other livestock products has been roughly constant. Product Changes Within Agriculture Consumer demand sometimes shifts in response to exposure to new agricultural products through international trade. Kiwi fruit, for example, entered the U.S. market just a few years ago from New Zealand. Rapid consumer acceptance created the incentives for the development of a domestic industry, and U.S. kiwi production grew from a estimated 5,000 tons in 1980 to 40,000 tons in 1989. Another demand-side factor with potentially large effects on the agricultural sector is the growing consumer concern with food safety and the environmental effects of chemical-intensive farm production techniques. Some trends in frontier research in biotechnology could help farmers respond to these consumer concerns. Bioengineered crop varieties that are resistant to diseases and pests are now emerging as proven technologies. Their adoption could ultimately reduce the intensity with which chemical inputs are used and again change the nature of agricultural production and the surrounding infrastructure. Interaction with World Markets One of the great benefits of productivity growth in U.S. agriculture has been the expansion of the supply of food and other agricultural products to countries all over the globe. Expanded trade, along with the direct transfer of agricultural technology to producers in other countries, has improved diets and living standards around the world. And, as U.S. agriculture has become more important to the world, trade has become more important to the economic performance of U.S. agriculture. Agricultural exports increased sharply in the 1970s; during that decade the value of exports increased from somewhat less than 15 percent to more than 25 percent of farm cash receipts. In the 1980s exports as a percent of production were even higher for selected commodities. Depending on the year, anywhere from 40 21 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT percent to 80 percent of U.S. wheat production, for example, and 30 percent to 50 percent of soybeans were consumed in other countries. The importance of exports to U.S. farm income--combined with adverse world market conditions and rising international tensions over agricultural trade barriers in the mid-1980s-- encouraged the United States to put agriculture at the top of its list of priorities for the Uruguay Round of General Agreement on Tariffs and Trade (GATT) negotiations (see in Chapter 7). A successful conclusion to these trade talks, aimed at lowering barriers to agricultural trade worldwide, would help open foreign markets further to U.S. farm products. In return, U.S. barriers to imports would come down as well, bringing the benefits of increased competition in agricultural products to the U.S. marketplace. TOWARD A MARKET-ORIENTED AGRICULTURAL POLICY The long-term decline in U.S. farm prices has been one of the great benefits of increasing productivity in agriculture. Farmers, though, fearing that lower prices would mean lower incomes, have sought and secured a significant degree of government assistance in keeping the prices they face from falling. Government agricultural policy, which partly insulates farmèrs from market forces. operates at the expense of consumers and taxpayers. The sharp escalation of farm program costs in the mid-1980s, together with some of the adverse effects of inflexible farm programs, highlighted the need for policy reforms. The Costs of Failing to Accommodate Market Forces Government farm programs consist principally of two types of subsidies: direct payments, financed by taxpayers; and programs that hold farm prices above free-market levels, paid for by consumers at the grocery store. At their peak in 1986, Federal subsidies of both types to U.S. producers of wheat, rice, feedgrains, sugar, milk, and beef were valued at almost $27 billion--that is an average of $12,000 for each U.S. farm, although many farms receive no subsidies. One recent study estimated that economy-wide income would have been roughly $9 billion higher in 1987 in the absence of these subsidies. In other words, the benefits to consumers and taxpayers of allowing the market to allocate agricultural resources would have outweighed the loss of farm subsidies to producers by $9 billion. 22 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT It is also instructive to examine some of the problems caused by specific policy measures designed to counteract market signals. A key component of U.S. agricultural policy is the provision of price floors for major commodities. Prices of wheat, feedgrains, rice, and cotton are held above the floor by allowing farmers, or sometimes other farm product suppliers, to pledge their crops as collateral to the government in exchange for a loan. Pledged crops are valued at the legislated support price. By putting their crop "on loan" when the market price is below the support price, suppliers remove some portion of the current crop from the market, which helps pull the market price back up toward the support price. Should the market price rise above the support price, crops on loan may be redeemed from the government and of fered to the market. If not redeemed by loan repayment, the crop is said to have been "forfeited." The prices of sugar, milk, and several other commodities are also maintained above legislated price floors. A combination of government purchases of dairy products--including cheese, butter, and non-fat dry milk--and restrictions on the quantities of these products that can be imported is used to support milk prices to dairy farmers, for instance. (The sugar support system is discussed in Chapter 7.) Under each of these programs, farmers are guaranteed at least the support price--regardless of supply and demand conditions. A system of Federal regulations called "marketing orders" sets minimum prices for about 80 percent of fluid milk sales; forty-six other "marketing orders" place restrictions on the quality or the quantity sold of various fruits, vegetables, nuts, and specialty crops. Studies have shown that milk orders raise retail prices above the level that the price support system alone would produce. Orders that merely enforce minimum grade, size, and maturity standards also interfere with competition, and affect consumer choices and prices by removing some product from the market. Kiwi fruit orders, for example, which began in 19xx, after U.S. kiwi production had begun to expand, put size and grade requirements on domestically produced and imported kiwis. These requirements reduce the quantity marketed and raise prices. Over time, policymakers have learned that when support prices for export crops are set too high, U.S. commodities accumulate in government warehouses, while other countries benefit from the absence of U.S. competition. Foreign farmers expand production and their share of the export market at the expense of the United States. The high wheat support prices set in the 1981 farm legislation have often been cited as one reason for the sharp drop in U.S. wheat exports and the large buildup in government-held stocks during the early- to mid-1980s. Support 23 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT prices for wheat and other exported commodities were lowered in 1985 legislation, but policymakers have not had this same incentive to lower the price floors for commodities subject to competition from imports, such as dairy products and sugar. "Deficiency" payments are another major component of farm programs. They are paid to qualifying wheat, feedgrain, rice, and cotton producers and are based on a "target" price, which is set higher than the support price for these crops. Each qualifying farmer receives a check from the government in an amount equal to the difference between the legislated target price and the market price or support price, whichever is higher, multiplied by qualifying production. These deficiency payments are made in proportion to a farmer's crop acreage. As a result, the distribution of deficiency payments is dramatically skewed toward large, often wealthy farmers. In 1988, for example, more than 40 percent of direct subsidy payments, which include deficiency payments and a smaller amount of some other payment types, went to the wealthiest 60,000 farms. These wealthiest farms averaged almost $62,000 in payments, almost $100,000 in net cash farm incomes, and more than $800,000 in net farm worth. Further, the incentive to overproduce provided by a target price set well above the market price requires offsetting measures to control program costs, such as requiring farmers to take land out of production. Farmers thus have been required over the years to cede some of their production decisions to the government. The 1990 Farm Bill In recent decades, farm legislation has been written often, but each law has retained the general structure of the original 1930s legislation. The 1985 legislation introduced important market-oriented reforms, such as more flexible approaches to determining support prices for exported commodities. Support prices for most program commodities began to be based on a 5- year moving average of market prices, rather than being set independently of price trends. U.S. farm exports performed considerably better after this change. The most significant change of the 1990 farm legislation. the Food, Agriculture, and Trade Act of 1990, in conjunction with the Budget Reconciliation Act. is the "triple-base" provision, which extends increased planting flexibility to farm program participants while reducing the acreage qualifying for deficiency payments. This planting flexibility provision (explained in Box 4-2) makes market prices more important to production decisions. It will thus help reverse the longstanding tendency of farmers to overproduce crops 24 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT whose target prices are set above market prices of substitute crops that do not qualify for the deficiency payments. Two particularly important outcomes are likely. First, the production of existing and potentially profitable alternatives, such as soybeans and other oilseeds, can now expand. Second, environmentally sound crop- rotation practices might be encouraged in some agricultural regions where substitute crops are available or are likely to be introduced. Box 4-2.--How the "Triple Base" Provision Works Every year the government assigns farmers an "acreage base" and a "payment yield" for each program crop, such as corn, historically planted on the farm. Under the 1985 farm bill, a farmer could receive deficiency payments for producing corn only if some portion of the corn acreage base was put into a conserving use and not planted to corn. Deficiency payments were not made on this idled, or conserved, acreage, and the farmer could incur penalties for planting certain crops, such as soybeans, on it. The 1990 farm bill divided the acreage base into three parts: the two parts described above, and a third part that may be planted to any crop except fruit and vegetables but that does not qualify for deficiency payments. The bill set this third category-- the flexible acres--at 15 percent of the base acreage. By disallowing deficiency payments on this 15 percent, the flexibility provision reduces government outlays. Farmers can, however, offset some of the lost subsidy by planting crops with the greatest market returns on the triple-base acreage. Therefore, the provision makes market signals more important to farm production decisions. The following example shows how the 15-percent flexible acres reduce payment acres and deficiency payments for a farm with a 100-acre corn base, assuming the required idled acreage is 7.5 percent, the target price for corn is $2.75 a bushel, and the market price is $2.25. The deficiency payment is thus $.50 a bushel. Item 1985 Act 1990 Act Calculation a. Base acres 100 100 Assumed b. 7.5 percent unplanted acres 7.5 7.5 Assumed 25 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT C. 15 percent triple base acres 0 15 Set by law d. Payment acres 92.5 77.5 a minus b minus c e. Payment yield, bu./ac. 110 110 Assumed f. Payment production, bu. 10,120 8,525 d times e g. Payment rate $/bu. .50 .50 Assumed h. Deficiency payments, $ 5,060 4,263 f times g The flexibility provisions of the 1990 legislation also create considerable taxpayer savings, as farm subsidies are eliminated on 15 percent of the farm program acreage base. This change alone saves about $7 billion over 5 years and makes an important contribution to the overall Federal deficit reduction package. However, while reducing deficiency payments and increasing the importance of market prices in farm production decisions, the new farm bill retains high and rigid price supports for dairy products and sugar and continues extensive government management of some markets, such as peanuts. While the Administration applauds the move toward increased flexibility that the 1990 farm bill represents, continued forts to reduce distortions created by farm policy are desirable. SUMMARY 0 A series of technological revolutions dramatically increased the productivity of agriculture during the last century, freeing labor from agriculture, lowering the cost of farm products, and enhancing the prosperity of the economy. 0 Productivity growth also facilitated a tremendous increase in agricultural exports, linking the future of U.S. agriculture to the openness and growth of world agricultural markets. o U.S. Agricultural policy, as evidenced by the 1990 farm bill, is gradually being changed so that agriculture is more able to respond to market signals, but further reforms are necessary to reduce the distortions created by farm policy and to reduce the burden of farm support on consumers and taxpayers. HEALTH CARE: DYNAMIC TECHNOLOGY AND CHANGING DEMOGRAPHICS 26 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Health care has been one of the fastest growing and most innovative sectors of the U.S. economy during the last three decades. Although many factors have contributed to the rapid pace of change, the fundamental driving forces have been technological advances and shifts in the demographic makeup of the population. These forces, along with the lack of market incentives for cost-conscious behavior, have resulted in escalating costs and much concern about lack of access to health care for many Americans--particularly the 33 million people who lack health insurance coverage. While government programs finance care for the poor and elderly, increasing government involvement in the health care delivery system has also aggravated the problems of cost and access. RECENT TRENDS The most dramatic illustration of the growing importance of the health sector is its rising share of GNP. In 1960, health care accounted for 5.3 percent of GNP; its share rose to 11.6 percent in 1989. To put those numbers in perspective, total health care spending in 1989 was twice as large as Federal spending on defense, and more than six times greater than the value of U.S. farm output. The growing share of health care in the U.S. GNP can be traced to developments on both the supply and demand sides of the health care market. On the supply side, technological advances have made possible a vast array of medical treatments that were unheard of even a decade ago. Developments in diagnostic equipment and pharmaceuticals, for example, have promoted earlier and more successful treatment of many diseases. Much of this technology, however, is costly. Therefore, while technological advance has undoubtedly improved the quality of treatment received, it has simultaneously made that treatment more expensive. On the demand side, economic growth favors health care expenditures. As incomes rise, people tend to attach more importance to trying to live longer and healthier lives. Most advanced economies have experienced increases in the share of resources devoted to health over time. In addition to technological advances and economic growth, health costs have increased because of the aging of the population. Older individuals incur more health expenditures, on average, than the young or middle-aged. The percentage of Americans aged 65 and older rose from 9.2 percent in 1960 to a projected 12.6 percent in 1990, representing an increase of 14.9 million older Americans. During this period, life expectancy rose by more than 5 years and 27 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT infant mortality rates declined by 63 percent. These statistics indicate that increases in the amount of resources devoted to health are not necessarily bad, since to a large extent they represent an investment in health, the changing preferences of a wealthier society, and the extra cost of a longer lived population. Table 4-1 Aging of the U.S. Population (In Millions) Age 65 and Age 65 Over as % Total and of Total Year Population Over Population 1960 180.7 16.7 9.2 1980 227.8 25.7 11.3 2000 268.3 34.9 13.0 2020 294.4 52.1 17.7 2040 301.8 68.1 22.6 Source: Department of Commerce Table 4-1 shows that the aging of the population will continue to exert a large influence on the health care system for several decades. Even without above-average increases in medical prices, the rise in the elderly population means that the United States will pay much more for health care in the coming decades unless dramatic developments occur that reduce costs. PERCEIVED PROBLEMS OF THE EXISTING SYSTEM Despite the beneficial effects of much spending on health care, there is a general perception that the U.S. health care system should perform better than it does. Costs are seen to be out of control, and millions of households are not receiving adequate health care. 28 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Rising Government Health Care Costs Health care costs paid by Federal, State, and local governments have exploded. The combined total spent by all levels of government on health care rose from $28.1 billion in 1960 (in 1989 dollars) to $253.3 billion in 1989 and is expected to continue rising. These escalating costs place great stress on the ability of governments to fund current and future liabilities in health care. Medicare, the principal program for providing medical care to the elderly and disabled, illustrates the changes in government spending on health. Medicare expenditures were $17.6 billion (in 1989 dollars) in 1967, the first full year of the program, and 19.5 million people were enrolled. By 1989 the Federal Government was spending $100 billion on medicare, and 33.6 million elderly and disabled Americans were enrolled. The enormous increase in outlays for medicare can be traced to the increase in the number of people covered by the program, general increases in medical care expenses, and the increased share of program costs borne by the Federal Government. For example, the Federal Government originally shared equally with enrollees the cost of physician services, but in recent years beneficiaries have paid only 25 percent of the cost. Even when all benefits and patient payments are included, the Federal Government pays out $3 for every dollar spent by medicare patients. Medicaid, the program that funds health care for the poor, illustrates the effect of changing demographics on both the type of care received and increasing government costs. Started in 1965, medicaid was initially designed as a joint Federal/State program to provide health care for those too poor to afford care on their own. Total medicaid expenditures in 1967 were only $7.6 billion (1989 $). In 1989, the Federal Government financed 57 percent of a total medicaid bill of $59.3 billion. The most significant trend in recent years has been the increase in medicaid spending on nursing home care for the elderly. Long-term care spending on the elderly accounted for about 25 percent of all medicaid spending in 1989. As the number of elderly citizens continues to rise, the costs of long-term care will also increase. Excessive Medical Care Inflation Medical care inflation rates that far exceed price increases for other goods have contributed to the overall rise in the cost of health care. From 1980 to 1989, price indexes for medical care rose by 99 percent, twice as fast as the average for all goods and services, 29 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT though difficulties in measuring the inflation rate in technologically dynamic sectors suggest that the real difference in inflation rates was probably somewhat less. Those rapid price increases combined with growth in the volume of services demanded to raise total health care expenses. The health care sector has responded to cost escalation in several innovative ways. One of the most significant changes is the growth in Health Maintenance Organizations (HMOs) and Preferred Provider Organizations (PPOs). HMOs provide medical services for a fixed annual fee, rather than by being paid for every service provided. In a PPO, a group of providers negotiates prices and patient volume with a large health care purchaser, such as an insurance company or employer. Through their greater potential for supplying cost-effective care, HMOs and PPOs provide. competitive alternatives to traditional fee-for-service insurance policies. The rapid growth of HMOs and PPOs illustrates both the important role of competition and the ability of the health care sector to respond innovatively to the challenge of cost escalation. The Medically Uninsured One of the most critical deficiencies of the U.S. health care delivery system is the large number of people who lack health insurance or access to health care. Although estimates vary, recent calculations place the number of uninsured Americans at around 33 million. Because the very poor are usually covered by government programs such as medicaid, many of the uninsured are employed workers or children and spouses of workers. Many lack insurance coverage because their employers cannot afford to offer it, they cannot afford to purchase it on their own, and they do not qualify for government-subsidized programs. Many young, healthy workers also prefer not to purchase insurance when given a choice, since the cost of a policy outweighs its benefits. To a great extent, the lack of access to health care or affordable insurance is due to the increase in health care costs during the last few decades. WHY HEALTH CARE MARKETS PERFORM POORLY Why is the health care sector able to perform so well in meeting certain demands yet unable to control costs or provide adequate services to all who need them? The institutional structure of the U.S. health care delivery system and the poor incentives for cost control it provides are at least partially to blame. Health Insurance and "Third-Party Payments" 30 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT The most important institutional feature of the existing system is the prevalence of Federal or private insurance policies. People purchase insurance because they want to be protected from the costs of accidents, fire, or, in the case of health insurance, disease and sickness. But one consequence of insurance coverage is that those who are protected from harm by an insurance policy have less reason to take actions to reduce the probability that any harm will occur. When harm does occur, consumers covered by insurance face diminished incentives to minimize the cost of care, since someone else pays the bills. The effect of insurance generally to diminish the incentive to minimize cost is called moral hazard (see Box 4-3). In the context of health care, insurance provides an incentive to increase the quantity of services consumed, since the patient does not pay the full cost of additional services. INSURANCE Box 4-3.--INCENTIVES IN THE MARKET FOR HEALTH One of the most important issues that arise in examining the mounting cost of health care in the United States is the extent to which the widespread use of insurance distorts incentives to make cost-effective choices. In health care and other markets, insurance coverage reduces the incentive to balance costs and benefits at the margin because the consumer does not pay the full cost of the treatment. This phenomenon, called moral hazard, is common to all insurance markets. Using health care as an example, consider the situation confronting an insured consumer who visits a physician. If the insurance policy pays 80 percent of the cost of treatment, the price to the consumer of care costing $100 is only $20. Therefore, the consumer would purchase the treatment even though he may value it less than $100. Alternatively, if the consumer could prevent the need for treatment by spending $40, he would not do so because his cost would exceed his savings of $20, even though the true savings is $100. Thus, insurance coverage creates a gap between the price paid by the consumer and the cost of providing care, so that the choice made is inefficient. The health sector has responded to the moral hazard problem in several ways. The most direct response is to place restrictions on the care that is reimbursed by increasing the deductible. Larger deductibles force the consumer to pay the full price of treatment for relatively low-cost care, at least until the deductible is reached. That is an effective way to encourage the consumer to make cost-conscious choices and thus reduces the overall cost of health care for the average consumer. 31 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT A second approach to reducing moral hazard is to encourage the physician, rather than the consumer, to make efficient choices. That is one goal of health maintenance organizations (HMOs) and other capitated systems in which care providers are paid a fixed amount per policy, regardless of the amount of care provided. The physician, therefore, has an incentive to provide only care that is cost-effective. One possible drawback to this approach is that it gives the physician an incentive to gain by providing less than the needed amount of care. This problem can generally be avoided by paying the physician a salary instead of a per-patient fee. Under a capitated system it is the doctor, not the consumer, who has a greater incentive to balance the costs and benefits of treatments. Federal and private insurance distorts consumer incentives to a large and increasing extent. In 1970 patients paid 41 percent of the costs of their care out-of-pocket. By 1989 that percentage had fallen to 24 percent. Increasingly, health care expenses are paid by third-party payers, primarily the government and insurance companies. Although ultimately the cost of care must be paid by recipients (in the case of private insurers), or taxpayers (in the case of Federal insurance), consumers of medical treatment who have insurance do not generally need to be concerned at the margin about either the cost of the services they receive or even whether those services are necessary or cost-effective. Consequently, unlike most markets for goods and services, medical care does not have a built-in balance between cost and value. Health insurance differs from fire or auto insurance in the extent to which its structure creates incentive problems. Until recently, health insurance has tended to cover more and more of the care received by patients. For example, many policies have small deductibles, so that patients do not have to pay for even routine care, such as a physical exam or treatment for a sore throat. This type of "first-dollar coverage," as it is called, is analogous to homeowners' insurance that would pay not only for the damage caused by a house fire, but also for a burnt pan caused by leaving the stove on too long. The analogy in auto insurance would be a policy that paid not only for damages resulting from moving accidents but also for paint chipped when the car is scraped in a parking lot by another car's opening door. The cost of such policies would be much higher than existing home or auto policies. Government Regulation Government regulations, especially those that require insurers to provide specific benefits, have a large effect on the 32 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT cost of health insurance. Health insurance policies are regulated by the States, and every State requires that insurance companies doing business in their State include certain benefits. That means that it is illegal for an insurance company to offer a bare-bones, low- cost insurance policy to consumers who only want to insure against catastrophic accidents or illnesses. The States instead require that virtually all consumers purchase coverage for a package of treatments that varies from State to State. The required benefits can include maternity care, alcoholism and drug abuse treatment, mental health care, chiropractors, and assorted other treatments, regardless of the consumer's willingness to pay for such coverage. These requirements raise the cost of health insurance and make it too expensive for many individuals and firms. As a result, many individuals who would willingly purchase low-cost insurance against catastrophic illness are not allowed to do so. A recent study estimated that as many as one-fourth of the uninsured, or more than nine million people, lack health insurance because of the high cost of policies due to State regulations. Another effect of government involvement in financing health costs occurs through the means-testing of the medicaid program. To target benefits at the poor, income limitations are set to restrict eligibility. If earnings exceed the maximum allowed, all benefits are taken away. (Medicaid availability is also af fected by participation in other means-tested programs, particularly Aid to Families with Dependent Children.) For low-income families, this loss of medicaid eligibility can create a large penalty for employment, since medical benefits potentially worth thousands of dollars, as well as peace of mind, can be lost if replacement health insurance is unavailable. Employer-Based Insurance and Tax-Free Health Benefits One fundamental characteristic of the U.S. private health insurance system is that it is predominantly employer-based; that is, most Americans with health insurance obtain it through their employer. Providing insurance through employment is a natural mechanism for achieving the risk-sharing benefits of insurance. Economies in administrative, sales, and purchase costs also enhance the desirability of employer-based group insurance. By covering everyone in a large group, insurers avoid the problem of "adverse selection," which occurs because those most likely to need expensive care, such as the chronically ill, are also the most likely to seek insurance. However, these advantages pertain primarily to large employers. Small firms are less likely to offer insurance if some employees are likely to need care, and the economies in administrative expenses are much reduced for small 33 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT groups. Firms with fewer than 50 workers incur administrative costs of about 25 to 40 percent of total claims, versus only 5.5 percent for the largest employers. Typically, health insurance is not only organized in the workplace, it is largely paid for by employers. On average, employers pay about 90 percent of the premium for single workers and 75 percent of the cost of family coverage. This practice makes sense for firms and workers because the cost of employer- provided health insurance is tax-deductible for firms, but the benefit is not taxed for workers. The tax treatment of employer-provided insurance means that taxpayers subsidize the provision of health insurance to workers. As a result, individuals' incentives are not only distorted by the existence of insurance, but they are also induced to carry more insurance than they would if they faced its true cost. Thus employees tend to demand both more health insurance and more health care than they would if they had to pay the full price. The increased demand for health care drives up the average price, if there is no of fsetting rise in the supply of care made available. The overall structure of financing and regulation of the health care sector combine to reduce significantly the flexibility of health care markets. Fundamentally, consumers do not have adequate incentives to avoid services that are too expensive, and providers who are not cost-efficient are not disciplined by the market. Without these incentives, markets cannot function well. Health care reform, designed to control the rate of cost increase and improve health care access, must confront the problem of creating appropriate incentives for health care consumers and providers. SUMMARY 0 The health care sector grew rapidly during the last three decades due to advances in technology, the aging of the U.S. population, and increased government financing of health care expenses. These trends are expected to continue. o Many of the inefficiencies in health care are attributable to the dilution of market incentives and the reduction in market flexibility created by third- party payments and government-mandated benefits. 0 Health care policy reform will not be successful unless it restores the incentives for health care consumers and providers to balance costs and benefits. 34 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT TELECOMMUNICATIONS TECHNOLOGICAL AND REGULATORY INNOVATION The telecommunications industry, like the health care industry, has been undergoing particularly rapid change. As few as a dozen years ago, it consisted almost entirely of regulated service providers with and dominant equipment providers substantial market power; today, much of the regulation has been removed and competition is vigorous in many of its component markets. Deregulation is a natural experiment that demonstrates the benefits of increased flexibility and the hidden costs of regulation. Because the crucial local telephone exchange segment of the industry will remain regulated for the foreseeable future, careful-thinking is required to design its regulation to minimize those hidden costs. LESSONS FROM DEREGULATION Deregulation of telecommunications began with Federal Communications Commission (FCC) and judicial decisions of the 1950s, 1960s and 1970s. It continued with the breakup of AT&T in the early 1980s, the passage of the Cable Franchise Policy and Communications Act of 1984 (the 1984 Cable Act), and further deregulatory decisions in the 1980s. These policy changes helped transform the telecommunications industry from a structure dominated by regulated monopolies into one in which several deregulated competitive sectors coexist with a remaining regulated monopoly component. Both the difficulty of bringing about this transition and the benefits that it has generated provide lessons about government regulation and market flexibility. Adapting to Changing Circumstances The early history of the telecommunications sector was characterized by extensive competition. In the period following the expiration of Alexander Graham Bell's original patents in 1893 and 1894, many new firms entered the telephone business, eroding the monopoly held by American Telephone and Telegraph (AT&T), which had evolved from Bell's original company. By 1907, 49 percent of installed telephones were controlled by non-Bell companies, and most Bell operating subsidiaries faced some direct competition. AT&T then adopted an explicit strategy of reducing competition through mergers and acquisitions, willingly accepting regulation, both to exclude competitors legally and also to blunt public criticism of monopoly. By 1932 Bell's market share had returned to 79 percent, and direct competition had been virtually 35 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT eliminated. With the passage of the Communications Act of 1934, the regulated monopoly structure of the telephone system was completed. In 1970 AT&T controlled 95 percent of local and long- distance telephone revenues, and its Western Electric manufacturing subsidiary provided almost all of Bell's equipment needs. Changing technology eventually made this monopoly regime unsustainable. As early as the 1950s other companies sought permission to sell types of telephone equipment that AT&T did not produce. The development of economical microwave transmission technology made competition for long-distance telephone service feasible, and the FCC permitted a competitor to enter this market in a limited way in 1969. The completely regulated monopoly structure of the telecommunications industry might have made sense in 1930, but by the 1970s it clearly was incompatible with the new state of technology. Competition, not regulated monopoly, emerged as the appropriate policy for the equipment and long- distance components of the telephone industry. The history of the cable television segment of the industry of fers the same lesson. In the 1960s, cable TV provided television to remote areas that could not receive standard broadcast signals. Cable TV operators clearly had a monopoly over an important segment of the entertainment market in these areas, and the widespread practice by State and local governments of regulating cable TV rates developed in this eΓa. Over time, cable evolved in many areas into an alternative to "over-the-air" TV, and it also faced increasing competition in the broader entertainment market from direct satellite broadcasts and widely available videocassette rentals. Regulation of cable TV rates persisted, however, until the 1984 Cable Act deregulated rates except in areas with limited broadcast competition. Again, policy had to change to recognize the change in the underlying industry conditions. Thus, in telephone equipment, cable TV and long-distance telephone service. a regulatory regime appropriate to a technology at one stage gave way, slowly and reluctantly, to new policy appropriate to new technological realities. Of course, the evolution of telecommunications regulation is not over. Today, local telephone service remains largely a regulated monopoly, because it doesn't make economic sense for more than one company in an area to build a complete system of copper wires, fiber optic cables, and switches connecting all customers. That too could change if, for example, radio technology developed that was competitive with the wired system for nonmobile communications. More likely, technological developments that cannot yet be anticipated will change the nature of the industry in ways that will make the current regulatory structure obsolete. 36 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Unanticipated Benefits of Deregulation Deregulation and the ensuing competition in the markets for telecommunications equipment and long-distance service facilitated development of products and services that did not exist before. The development of the facsimile (fax) machine in different versions offered by many different companies could not have occurred if telephone equipment had remained regulated. In addition to the fax, an enormous variety of portable telephones, answering machines, and computers with built-in communication abilities have all emerged in the deregulated equipment market. New services have also been introduced, based both on new technologies and new arrangements that were either not permitted or not conceived of under regulation. Today, cellular technology has taken mobile telephones from the realm of spy-movies and given them to 4.4 million subscribers. Long-distance competition has reduced the cost and expanded the range of "800" and "900" number services available to businesses, thereby increasing the flexibility with which they reach their customers and suppliers. Combined with deregulation of the surface freight industry, the fax machine, electronic data interchange and other new communications technologies are changing the way firms organize the distribution networks that connect their factories, stores, and customers. Some of these changes were anticipated when deregulation was contemplated, but most were not. MAINTAINING A DYNAMIC TELECOMMUNICATIONS INDUSTRY The policy framework that will ultimately replace the old framework of near-total regulation is still emerging. Ahead are a number of policy choices that of fer opportunities to increase the benefits of deregulation. The principle of designing government policy to foster flexibility is crucial in order to ensure that the United States has the most effective telecommunications infrastructure possible. Maximizing the Scope for Competition In several markets in the telecommunications sector current policy inhibits competition. Cable TV operators are subject to competition from other media, but in most areas State or local governments grant a franchise to a single cable operator in a given area, preventing operators from competing with each other for customers. Local telephone companies are also prohibited by law from acting as cable operators. These restrictions reduce the power of competition to discipline cable prices and services and give 37 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT cable operators inadequate incentives to adopt the latest technology. The FCC and many States also continue to regulate AT&T's long-distance rates, despite the presence of competition in these markets. This is a vestige of an earlier era that now serves to inhibit competition. Another area in which government policy could further recognize the potential for competition is in the management of the electromagnetic spectrum. The spectrum consists of the range of frequencies in which radio-based technologies such as broadcast television and radio, cellular telephone, and microwave transmissions operate. The range of frequencies with desirable technical properties is limited and therefore is a scarce resource that must be allocated efficiently. The Federal Communications Commission allocates particular "bands" of frequency to specific uses and then assigns the right to operate in these bands to specific private parties. Assignment and allocation of spectrum bands require administrative hearings that can be very cumbersome and time- consuming. As a result, competition among technologies and among different firms seeking to operate a given technology is greatly reduced. Without the force of competition, spectrum bands are not necessarily used in ways that generate the greatest social value. The invention of new technologies is stifled because their investors may be unable to get access to the spectrum, and there is an inadequate incentive to refine existing technologies to conserve the amount of spectrum that they use. If instead of assigning spectrum rights administratively, the Federal Government auctioned them to the highest bidder and permitted their sale and reassignment, the flexibility of the telecommunications sector would be greatly increased. In particular. when portions of the spectrum previously reserved for government use are made available to the private sector, they should be auctioned off without restrictions on resale. The resulting competition would likely lower prices and increase the diversity of available service ferings for over-the-air communications and broadcast media generally. The government also limits competition by restricting the entry of the regulated local telephone companies into unregulated businesses. Under the terms of the consent decree governing the breakup of AT&T, local operating companies are not allowed to manufacture telephone equipment, offer various information services, or provide most long-distance service. 38 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT It might appear that keeping these particular firms out of these businesses would not have serious costs, so long as other firms are free to enter. The government, however, has no way to determine who the most qualified or most advanced potential competitor might be. Further, there are reasons to believe that the local telephone companies might have much to offer these other markets. Experience developed in the construction or operation of the hardware and software for the telephone system itself could be very valuable in developing information services for sale to customers. These and other potential "economies of scope" between the local exchange and other markets are limited or lost when the telephone companies are barred from related businesses. The lesson from easing previous restrictions is that increased competition produces additional benefits that cannot be foreseen today. These restrictions reflect a concern that local telephone companies would have unfair advantages in competing against others in markets that are somehow connected to the local exchange. For example, they might try to hide some of the costs of their competitive activities within the regulated local exchange sector, thereby transferring the costs to the local ratepayers. They might also exploit their knowledge of the technical details of the local network, or even design the configuration of the network in ways that favor their product of ferings in the related competitive businesses. These are real concerns that must be addressed. If the local telephone companies are permitted to compete, regulators will need to scrutinize their activities to prevent ratepayers from subsidizing the competitive businesses and to ensure that the regulated firms do not unfairly exploit their monopoly position. Monitoring of regulated firms competing in unregulated markets will be imperfect, and it will not be a costless process. But regulators have developed better monitoring tools than they previously had, and the alternative is the extreme option of banning firms from participating in related businesses without even attempting to make competition work. Regulatory Approaches that Encourage Innovation Traditionally, monopolies are regulated by what is called "cost of service" regulation. Regulators determine the total costs incurred by the monopolist in providing the regulated services and then set prices designed to recover those costs, including a competitive rate of return on the capital invested in the regulated company. This method is intended to ensure that the company will not lose money, but also that it will not be able to charge prices in excess of its costs. 39 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT The fundamental problem with this approach is that a firm subject to "cost of service" regulation has limited incentives to reduce its costs or improve its services. A reduction in costs will eventually be translated into a reduction in allowed revenues, leaving the firm no better off. If improved products lead to a rise in profits, prices will eventually be reduced by regulation to bring revenues and costs back into line. Again, the benefit to the firm has been reduced. A firm presented with these incentives will not seek change and innovation as aggressively as one that is able to retain the profit from doing so. Recently, economists and regulators have become interested in developing forms of regulation that would prevent abuses of monopoly power while preserving incentives for innovation. These approaches are often referred to loosely as "incentive regulation." All forms of incentive regulation are designed to preserve the overall or long-run relationship between prices and costs but to sever or limit that relationship in the short run or for specific investments. In other words, if a firm undertakes to reduce its costs or improve its products, it would be permitted to keep some of the profit that the innovation generates. The key to maintaining the incentive to innovate is to tie the regulated firm's price level to some overall or general indicator of costs, rather than to actual costs incurred. For example, prices could be allowed to rise each year by the rate of inflation, minus a fixed percentage reflecting expected productivity improvements. Alternatively, the firm's prices could be tied to a general index of costs in the industry. In these ways, regulators could achieve a better balance between the desire to prevent monopoly profits from being earned and the goal of maintaining incentives for efficiency and innovation. SUMMARY o Telecommunications is a dynamic sector in which regulation must continually evolve to reflect changing conditions. 0 Deregulation has permitted innovation that could not have occurred under the previous regulatory regime. o To promote the continued dynamism of the industry, regulation should seek to maximize the scope of competition and avoid preventing particular firms from competing in particular sectors. 40 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT o "Incentive regulation" is an attractive policy innovation that has the potential to reduce the adverse effects of continued regulation on innovation. DEFENSE INDUSTRIES: ADJUSTING TO THE END OF THE COLD WAR With the end of the cold war, U.S. defense expenditures are scheduled to be reduced by substantial amounts in the next decade. Although the current situation in the Persian Gulf creates some uncertainty about the immediate future, the scheduled reductions would continue the recent trend that saw defense spending fall in real terms starting in 1987. One obvious impact of these spending decreases will be a substantial reduction in the size of the defense sector, creating a challenge and opportunity for markets to adapt. HISTORICAL EXPERIENCE The historical experience with fluctuations in defense expenditures shows that the U.S. economy has little difficulty responding to shifts in defense spending. As shown in Chart 4-2, government expenditures on defense have varied considerably since the late 1930s. Industry responded quickly when defense needs increased, most notably during wartime but also in more recent years. Defense purchases of durable goods, for example, increased more than 50 percent from 1980 to 1984. Declines in spending also provided opportunities for demonstrating the economy's flexibility. Even during the period of greatest reduction, when defense spending fell from 41 percent of GNP in 1944 to 4.3 percent in 1947, the economy adjusted quickly. Although total output fell in 1946 and 1947 because of the dramatic decline in government spending, consumption and private fixed investment rose as the United States made the transition to a peacetime economy. A similar temporary decrease in real GNP occurred at the end of the Korean war. As defense spending dropped from 13.2 percent of GNP in 1953 to only 11.2 percent in 1954, the economy fell into a recession that lasted 10 months. In 1955 output grew 5.6 percent even though defense spending continued falling to 9.6 percent of GNP. As shown in Chart 4-2, defense spending as a percentage of GNP was lower during the Vietnam war than during previous conflicts. Given this smaller role, it is not surprising that the declines in defense spending in the early 1970s had virtually no impact on growth. 41 Chart 4-2 Defense Purchases as a Percent of GNP, 1939-93. Projected declines in defense purchases are small by historical standards. Percent of GNP 45 40 35 30 25 20 15 10 5 0 1939 1945 1951 1957 1963 1969 1975 1981 1987 1993 Calendar Year Sources: Department of Commerce and Budget Projections CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT This historical experience suggests that future defense cuts will not adversely affect the economy as a whole, since t h e relative importance of defense in the U.S. economy has been declining since the early 1950s, and even the increases of the early 1980s made only a small, temporary bump in the downward trend. The relatively small role played by the defense sector in the U.S. economy helps to ensure that the transition to lower spending levels will be manageable and that resources will be able to move to alternative uses with little impediment. By historical standards, the magnitude of expected defense cuts during the next few years is very small. Under current budget plans, defense spending in 1993 will be lower by only 1 percentage point of GNP than in 1990. Since the economy successfully adapted to much greater disruptions following World War II and the Korean war, there is little reason to think that the present changes will be troublesome. The precise magnitudes of the spending cuts are uncertain, and some of the decreases could be delayed, or even reversed, by changes in the world situation or an extended deployment in the Persian Gulf. THE PROBLEM AND POTENTIAL OF DEFENSE CONVERSION The key problem with the transition of the defense sector to lower spending levels is that the impact is not broad-based but tends to affect drastically firms in only a few industries. The resources of these firms, both the physical capital and the skilled labor, are somewhat specialized for military production and so are reduced in value when defense cuts occur. The communities in which these firms are located will also be adversely affected as employment is reduced. Although these disruptions may require some difficult adjustments, defense cuts are an opportunity to allow market forces to redirect resources toward other productive uses. Government policy should seek to ensure that the transition occurs as smoothly as possible. In that way, the harm to communities will be minimized, and unemployment effects will be shortened or reduced. One possible additional concern with cuts in defense spending is their potential effect on the defense industrial base and U.S. technological superiority. In managing the proposed spending cuts, the ability of the United States to continue to produce the equipment needed to fight future conflicts should be maintained. Furthermore, the advantage the United States has in defense technology should be protected through continued investment in research, although some of the priorities may be shifted. The defense technology base can also be protected further by relaxing procurement regulations, particularly those that restrict the transfer of defense technology to civilian uses. 42 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT Facilitating the Redeployment of Resources The Federal Government has programs in place that address the problems facing workers and communities affected by defense reductions. It is important to recall that even in times of expanding budgets, some firms and workers lose contracts, as purchases shift to different products or services. Therefore, the problems caused by expected defense cutbacks can be viewed as a somewhat larger version of the typical shifts in demand that occur in a dynamic economic environment. The true "peace dividend" is not the amount of money saved in the Federal defense budget. but rather the real resources that are made available as defense spending declines. The economy will benefit from the end of the cold war only if these resources are allowed to shift to new, high-value uses. Sectoral shifts take place continuously in the U.S. economy, so it is useful to ask whether anything about the defense industry merits special treatment. Because defense spending is exclusively a government endeavor, some have argued that the government has a special obligation to protect those who are affected by declines in Federal defense spending. This argument suggests that government contracts are an entitlement and that any reduction in spending should be offset by compensation. Similar arguments have been made to support policies targeted toward assisting workers adversely affected by other changes in Federal policy. It would be unwise to accord special treatment to workers or firms directly affected by changes in Federal spending. In addition to the practical difficulties of determining fairly who is actually affected, such an approach effectively divides the work force into two groups, one that receives both Federal support and funding and special privileges when that support is reduced, and all other workers. To the extent that such a policy gave defense workers special benefits, it would be extremely unfair to workers in other sectors. This approach would also make it difficult and costly for the Federal Government to change spending patterns in response to changes in society's needs and priorities. The existing rigidity in government spending patterns, which already makes eliminating programs and policies that have outlived their usefulness difficult enough, would only increase. For several reasons, defense firms sometimes cannot easily transfer their engineering and production capacity to civilian uses. Although many products have both military and civilian uses, many others have characteristics unique to the military. For those firms producing products limited to military uses, the transition to civilian production means dealing with an entirely different set of 43 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT products. The emphasis in military procurement on producing a limited number of high-performance items with the latest technological advancements, such as fighter aircraft, does not typically encourage the development of organizational skills needed to produce high-quality but not necessarily state-of-the- art products for civilian buyers at lower cost. Perhaps more important, conversion to civilian production means responding to different customers, with goals and constraints often much ifferent from those of the government. Selling to civilian markets differs markedly from competing with only a few other firms for government contracts in a highly politicized environment. Although the effects of defense spending cuts are likely to be felt in most sectors of the economy, a few industries will be most affected. Producers of aircraft, ordnance, missiles and space vehicles, and ships are expected to incur some of the largest employment losses. Job changes will probably be more evenly distributed among States because of the wide geographic dispersion of defense production. Many of these forecasts are tentative, however, because of uncertainty about the eventual magnitude of the cuts and which individual spending programs will be reduced or eliminated. The most appropriate policy for dealing with the problems of defense cutbacks is to cushion the effect of change by providing the same assistance to affected defense workers and firms that is available to all workers displaced by economic changes. Many such programs are available to workers who lose their jobs because of spending cuts. The Job Training Partnership Act provides training opportunities for those workers whose skills are no longer in demand, and the Employment and Training Administration of the Department of Labor also has numerous programs for addressing the needs of displaced workers. In addition, the President's Economic Adjustment Committee, chaired by the Secretary of Defense and composed of 18 Federal departments and agencies, is explicitly charged with providing financial assistance and other support to communities affected by defense spending reductions. These existing programs should be sufficient to ease the transition for workers displaced by defense spending cuts of the size now likely to occur. The Effect of Reduced Manpower Needs on Civilian Labor Markets Changes in the Nation's defense budget are also likely to reduce the military's need for manpower. During the 1980s, the four military services recruited and trained nearly 3.1 million young men and women, or about 300,000 people each year. This number is expected to decline substantially in the decade ahead. Although the size of the reduction is difficult to forecast with 44 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT certainty, the services could reduce their annual recruiting by about 100,000 inductees below the average of the 1980s. This number can certainly be absorbed easily in an economy that produced a net employment increase of 19 million jobs during the 1980s, and will reduce the impact of the lower rates of labor force growth that are expected during the next decade. It is not widely known that the military services are one of the largest single providers of vocational training in the U.S. Each year, trained veterans return to civilian life with skills that are highly valued by civilian employers. In the short term, the economy will benefit from the release from military service of a large number of well-trained veterans. Over the long term, the military services will continue to provide training and employment for hundreds of thousands of young people. SUMMARY O Proposed cuts in defense spending over the next few years are small by historical standards. o The economy will adjust smoothly to reductions in defense spending, but some workers and firms will need to adapt to new circumstances. 0 Programs are in place to help workers and communities adjust to reductions in defense employment. CONCLUDING COMMENTS The ability of the U.S. economy both to generate and to accommodate change is remarkable; the economy's flexibility is one of its major assets. The high U.S. standard of living is due in large part to a flexible economy that encourages innovators to invest in finding new ways to do things and allows entrepreneurs to marshal the resources necessary to bring new products and processes to market. The government affects the flexibility of the economy in many ways. Flexibility is enhanced by creating an environment conducive to investment and innovation, by minimizing regulatory interference in markets, by lowering barriers to international trade and investment, and by providing a competitive and accountable education system. The evolution of the agriculture, health care, and telecommunications sectors illustrates the potential for innovation but also demonstrates the harm of government policies that reduce flexibility. Reduced military spending will provide 45 CHAPTER 4 (01/15/91, 10:19am) FOR OFFICIAL USE ONLY SECOND STAFF DRAFT another opportunity to benefit from the economy's ability to redirect resources to new uses. Change generally creates both winners and losers, and the U.S. political system always allows the losers to argue for protection from the impersonal forces of the market. The true long-run costs of accommodating such demands for interference with market forces is almost always underestimated because the value of the opportunities lost when the economy's ability to change and adapt is reduced can never be fully known. If it is decided that victims of change must be helped, the assistance should not inhibit the economy's natural evolution. Doing so else would reduce the economy's flexibility and thus throw away a significant portion of the possible benefits of change. 46

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Economic Club of New York 2/6/91 [OA 6855] [3]

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