America's Economic Malady: A Bad Case of 'Baumol's Disease'

America is suffering from a rough case of Baumol's Disease, and the symptoms are everywhere. But this isn't a new bacterial plague: It's an economic one.

Unlike an illness caused by microscopic invaders of your body, which might raise your temperature and cause you physical aches and pains, Baumol's Cost Disease, as economists call it, raises wages and causes some painful shifts in a nation's labor balance.

Why it matters is simple: Increases in national wealth result from increases in productivity.

The reason why the U.S. is wealthier now than it was in 1950 is that its workers and businesses -- some of them, in any case -- are much more productive today. Those increases in productivity are the payoff from capital investments in new technologies and skills. If productivity growth lags, so does wealth creation.

In this sense, the key to future prosperity rests largely on continued increases in productivity. If an hour of labor produces more goods or services than it did before, that's an increase in productivity -- some of which flows to the worker in the form of higher wages.

But what about those parts of the economy where productivity doesn't increase much -- because it can't?

The Bigger Productivity Pie

Baumol's Cost Disease is named after economist William J. Baumol, who, along with William G. Bowen, described a key difference between goods-producing and labor-intensive work.

The two men noted that if productivity and wages rose, for example, by 2.2% a year and costs rose by 2%, then over time, workers would be able to buy more of everything -- more goods and services directly, and more government services paid for with taxes. As the productivity "pie" expands, there's more wealth in the economy for every sector.

But they also observed a critical difference between the rates of productivity growth in goods-producing industries and labor-intensive arenas such as nursing and teaching.

No Productivity Growth, but Higher Wages

Goods-producing industries could achieve high productivity growth as labor-saving automation and supply-chain efficiencies scaled up. But jobs in nursing and teaching required the same number of person-hours with patients or students as they did in years past. In other words, labor-intensive services had far lower rates of productivity growth than did goods-producing industries. And yet salary increases in those service sectors -- education, health care, government, to name a few -- keep pace with those in industries where raises are justified by greater productivity.

This difference has a consequence that few had noticed before: As gross domestic product rises due to improvements in goods-creating productivity, the relative share of the economy occupied by low-productivity-growth services rises, too. As productivity gains boost overall wealth in the economy, the sum spent on goods decreases as a percentage of GDP, while the sum spent on services such as education and health care increases as a percentage of GDP.

This matches what we see today: The percentage of income spent on manufactured goods such as TVs and computers has dropped, while the percentage spent on health care and education has risen sharply.

Government's Growing Share of Economy Isn't Political

This has a direct bearing on government services' share of GDP. Since the labor-intensive productivity typical of government services isn't as responsive to capital investments as goods-producing industries, the public sector's share of the economy rises naturally. This helps explain why government's share of the GDP has expanded regardless of which political party is in power: It isn't politics; it's Baumol's Cost Disease.

Baumol also explained the dynamic behind higher salaries in low-growth-productivity fields. His example was performing arts: It takes the same time to learn and play a Mozart concerto now as it did in 1790, so productivity gains in the performing arts will be modest. Baumol proposed that the scarcity of people willing to do the low-productivity jobs would lead to high salaries for the few who pursued such careers.

For the first 30 years or so of the postwar boom, steady increases in productivity led to increases in wages across all income sectors, as the chart below illustrates. But the three decades since 1980 have seen a dramatic change in this distribution: The gains since 1980 have flowed mostly to the top 20% of wage earners.

Some observers attribute this to the greater productivity increases gained by "knowledge workers" in an increasingly global economy, and this is undoubtedly a significant factor. But other factors are at work as well.

In this chart tracking productivity, the cost of benefits (health care and pensions), and wages, we see that real wages have actually declined in the past decade, even as productivity has risen and the total cost of compensation (wages plus benefits) paid by employers has soared.

This means the gains in productivity are no longer boosting the wages of all workers. They're going to a few subsets: to the top slice of wage earners; to the health care industry, which has seen its share of the national economy burgeon to nearly 20% of GDP; and into corporate profits, which recently hit a record high of $1.66 trillion.

As my DailyFinance colleague Peter Cohen reported last month, U.S. corporations are on track to earn their highest annualized profits since records of such things began to be kept back in 1950. As we would expect, the gains in profits are due mostly to rising productivity.

Recently, those productivity gains have resulted from employees spending more hours working, and getting paid less for it. Specifically, between the third quarter of 2009 and the same period of 2010, productivity was up 2.5%, output rose 4.1%, hours worked increased 1.6%, and unit labor costs fell 1.9%.

As for skyrocketing health care costs, they can't all be attributed to Baumol's disease. The U.S. spends twice as much per capita as our competitors do. I explored some the reasons why in my article on the "fee for service" model of U.S. health care. (chart courtesy of the The Big Picture blog.)

Baumol foresaw that we as a society would have to make difficult choices about the consequences of "cost disease." The title of his 1993 paper sums the problem up: Health Care, Education and the Cost Disease: A Looming Crisis for Public Choice.

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Baumol concluded, reasonably enough, that we would have to pay more taxes in order to fund education and health care, and that rising productivity would give us the means to pay those higher taxes. But as we have seen, the gains from productivity haven't flowed to most workers, making tax hikes painful for the majority.

Rather than make politically unpopular trade-offs between benefits and taxes, the political class of the nation has filled the widening gap between government expenses and tax revenues with a lot of borrowed money -- more than $3 trillion in just the past few years.

Federal expenditures of $3.55 trillion this fiscal year are almost 25% of the $14.5 trillion GDP. Yet tax revenues are only about 17% of GDP. Roughly $1.2 trillion (8% of GDP and 37% of the budget) is borrowed. Unprecedented deficits in the past few years have driven the total federal debt to $14 trillion, roughly the same size as the nation's GDP. Despite their inability to agree on much else, Americans seem to understand that this level of borrowing is unsustainable.

Painful Options

As Baumol predicted, costs for low-growth-productivity fields such as health care, education and government services have grown to alarmingly large percentages of the GDP. Either we find ways to radically improve productivity in these sectors -- and that appears unlikely -- or we'll have to learn to accept either paying higher taxes for services, or limiting the services being offered.

Because as much as we might wish it otherwise, Baumol's Cost Disease doesn't have a miracle cure.