Quarter 1, 1998
by Steven Sass

Capitalism has always been a game of leapfrog. In medieval Italy, Venice, Genoa, and Florence would surpass each other in a race for wealth and power. Then economic leadership leaped to Spain, Amsterdam, France, England, and finally to the United States. In each transformation an economic system, developed in a particular geographic setting, and grew to eclipse all previous productivity and income benchmarks. The American rise to economic leadership, between 1880 and 1914, derived primarily from the tremendously efficient new mass-production/mass-distribution enterprises that grew up, mainly, in the Mid-Atlantic and Midwestern regions. Based on their productive prowess, the past hundred years have been America's century.

In the 1980s, capitalism seemed poised for another turn of fortunes. Japan, which had achieved tremendous success in a string of mass-production industries, threatened to leapfrog U.S. productivity and income benchmarks in the twenty-first century.

Within the United States, clusters of "knowledge-based" industries, found mainly in the New England, Pacific, and Mid-Atlantic regions, seemed to define a new economic paradigm based on close geographic proximity to first-tier universities, research institutions, and support services needed for rapid innovation. As a revolution in information technology blessed these districts with a broad array of products to sell and tools to improve their own productivity, they also appeared set to eclipse the economic benchmarks set in the nation's industrial heartland.

The recessions of the late 1980s and early 1990s then hit the challengers hard. Japan remains mired in difficulty. But while the U.S. knowledge-based districts have recovered smartly, it is not obvious that knowledge-based industries will be the next font of economic progress, will cluster in just a few districts, and thereby shift economic leadership to new regions.

The very notion that regional incomes could diverge significantly runs against the grain of twentieth-century U.S. history. Income differentials have narrowed dramatically over the past hundred years, as poor regions played a successful game of catch-up. A divergence of incomes in the 1980s — and a shift at the top from the Midwest to the "bicoastal" regions — did lend support to the notion of a paradigm shift. But a return to convergence in the current decade, through 1995, suggests that this leadership transfer, if actual, could have limited significance.

To see a significant divergence develop, one must turn to the nineteenth century. Then the Industrial Revolution, centered in New England; destruction in the South from the Civil War; and the rise of giant enterprise in the Mid-Atlantic and Midwest regions generated an enormous gap between northern and southern incomes.

Understanding what drove incomes apart, and then what brought them back together, will help evaluate the possibility that the new knowledge-based industries will cluster in particular regions, which then could leapfrog past the classic U.S. industrial heartland.

The great divergence

The U.S. economy was a creation of the nineteenth century. In the Colonial era, the bulk of the population lived on the land. Most of what it consumed was produced locally. And trade with the outside world went to the Caribbean, Europe, and Africa as much as to other colonies along the Atlantic seaboard.

In the nineteenth century, that all changed. The expansion from the Atlantic to the Pacific, and the building of canal, railroad, telegraph, and telephone networks, greatly enlarged the benefits and slashed the cost of inland exchange.

The result was a great age of regional economic specialization. Responding to the new opportunities, regions specialized in activities in which they had a comparative advantage and produced surpluses to exchange for goods now cheaper to import from other parts of the nation. The South focused on cotton and tobacco; the West on cattle and mining; the Midwest on corn and wheat; and New England, the Mid-Atlantic, and later the Midwest, as well, on manufacturing.

This interregional trade was accompanied by a dramatic widening of income differentials. Ignoring the Mountain and Pacific regions, then in the process of settlement, the divide is a story of growth in the North and relative stasis in the South.

The sluggishness of the South is hardly novel. Over the great span of history, incomes had always grown slowly and were fragile in the face of conflicts as damaging as the American Civil War. Nor has any slave economy ever embarked on the process of modern economic growth, and slavery survived in the South two-thirds of the way through the nineteenth century.

What is unique, and bears explanation, is the performance of the North. Here a genie leaped out of the bottle to create an economy that set new world benchmarks of productivity and income.

Why did northern incomes grow so fast?

1. Abundant capital.

A critical factor in the northern "takeoff" was its sharp jump in saving from about 10 to about 25 percent of income over the course of the century. If we add sums spent to augment human and intellectual capital — on education and invention — the North sharply increased its investment in the future. It also developed a profusion of new corporate and financial institutions to mobilize these resources effectively. The capital deepening that followed — more buildings, equipment, training, and productive techniques per worker — made the region far more productive.

The North's ability to generate and sustain this huge increase in saving and investment is astounding. A critical source of increased saving in the North were the profits reinvested by merchants, industrialists, and others in business. The prospect of healthy returns is also the critical inducement to invest. But since we invest in the most promising projects first, profits typically decline as investment rises. Profits did diminish over the course of the nineteenth century, and northern savings did flow to projects elsewhere in the nation, especially to the West. But given the magnitudes saved and invested, the fall in returns from about 7 to 11 percent was surprisingly mild. The process that sustained investment returns, generated savings, and induced investment thus was central to the long-term growth of the North.

2. Technical ingenuity.

Technical improvement — raising output per given capital or labor input — has long been viewed as the fundamental factor in modern economic growth. By creating new business opportunities, technical advances also sustained investment returns, and thereby generated more savings and induced more investment.

The North had a significant advantage in the matter of technical progress, for "Yankee ingenuity" was not just a figment of popular culture. New England was the patent king of the nation, economist Kenneth Sokoloff has shown, and the mills, machine shops, shipyards, railroads, blast furnaces, office buildings, and retail stores of the North were full of innovations.

Economist Jeffrey Williamson emphasizes the importance of improvements that halved the cost of industrial machinery, and increased its quality, in the middle decades of the century. In these advances, New England played a fundamental role: The "American system" of manufacturing, complete with new machines and production methods, originated in the Springfield Arsenal in the 1830s and was largely developed by machine makers in the region. Williamson argues that the profit-making opportunities opened up by such low-cost high-quality industrial equipment were the major factors not just in raising productivity, but also in boosting saving and investment rates in the nineteenth century.

While technical advances stimulated saving and investment in the North, the lines of causation also flowed the other way. Innovations are often embodied in new facilities, machines, or freshly trained workers. Saving and investment thus keep an economy flexible and able to absorb the latest techniques. Even investments that merely replace the worn-out stock of plant, equipment, and education, F.M. Scherer has found, are effective vehicles for introducing new technology.

3. Manufacturing.

Productivity and incomes also grew faster in the North because, in the great age of U.S. regional economic specialization, it specialized in manufacturing. It was here that Williamson's machines were used most intensively; "to manufacture," which means "to make by hand," would come to mean "to make by power machinery."

Nineteenth-century manufacturing also had characteristics that clustered productivity and income gains in particular regions, characteristics that made it the century's great engine of regional growth.

The North specialized in manufacturing, in part, because its greater population density allowed a finer division of labor. Divided labor increases productivity by encouraging the acquisition of specialized facilities, tools, and skills; and, as Adam Smith had pointed out in The Wealth of Nations, manufacturing offers far more opportunities for specialization than agriculture. Ppopulation density thus gave the Northa comparative advantage in yarn spinning, cloth weaving, garment stitching, leather tanning, shoe making, and a host of manufacturing industries that flourished by the mid-nineteenth century.

The clustering of manufacturers in Northern "industrial districts" allowed workers, machine makers, and industrial suppliers to specialize because they could serve various manufacturing establishments. This clustering also increased the spillover of technical ideas — like the mechanization of manufacturing — from one firm or person to another. This is one reason why economies based on human and intellectual capital, and on changing technologies, are typically organized into industrial districts: It pays to locate close to other firms in your industry to catch the spilled-over ideas and workers.

Trade also lets producers capture economies of scale. By the end of the nineteenth century, such economies in manufacturing were often enormous. A bigger plant was generally cheaper to build and operate per yard of cloth, gross of clocks, barrel of whiskey, or ton of iron. In order to capture these scale economies, and to minimize the cost of transportation to markets and to supplies of labor and raw materials, large manufacturers typically set up in the Mid-Atlantic and Midwestern heartland. As they did, productivity gains again concentrated in the North.

In turning productivity gains into income gains, the North also benefited from the greater elasticity of demand for manufactures relative to agricultural products. As incomes advanced, consumers asked for only a bit more food, but a lot more clocks and shoes. Since capital and labor did not shift effortlessly from agricultural to industrial regions, incomes in the North rose disproportionately.

4. Urbanization.

The North's specialization in manufacturing encouraged the concentration of labor in the region's cities and towns. So did the railroad, the century's dominant form of transportation. So did the tendency of commercial and financial firms to locate near manufacturers, not agricultural producers. By allowing specialization and scale economies in industries that serve the local market, this concentration further expanded incomes in the North.

Larger markets encouraged specialization and industrial-district efficiencies in everything from eating establishments to medical care. A dense, urban population also justified larger-scale trains, banks, public works, distribution channels, and educational and cultural enterprises that cut costs on basic items or offered a wider array of products. This rising scale culminated in the classic mass-production/ mass-distribution enterprise that defined the American economic achievement at the turn of the twentieth century.

How the South caught up

The key factor in the dramatic narrowing of regional income differentials in the twentieth century is the end of slavery and the attenuation of its legacy of de jure segregation and de facto discrimination.

Slavery and its aftermath impeded all three of economist Simon Kuznets's prerequisites for modern economic growth: broad-based schooling, a shift in the work force to employee status, and urbanization. It thereby restricted the accumulation of capital (especially human capital), technical progress, and the rise of modern industry. Only after slavery had ended, and segregation's harshest restrictions were attenuated, could the South begin the process of modern economic growth.

For a handful of countries and regions, capitalism has been a game of leapfrog. But for the South, and for most countries and regions, capitalism has always been a game of catch-up.

Beginning this century at relatively low productivity and income levels, the South copied technology developed in the North. Manufacturing industries such as textiles moved south. As they did, income rose and the region raised its investment in plant, equipment, and education.

Capital and labor flows, as Jeffrey Williamson has shown, can also narrow dramatically regional income differentials. From the 1920s, northern capital flowed south to build utilities and textile mills. From the mid 1930s, northern taxes paid for the Tennessee Valley Authority, new defense installations, and interstate highways. More important, perhaps, were the labor flows. After the effective halt of foreign immigration in the 1920s, large numbers of Southern workers, both white and black, began to move north.

These factors jelled in the 1940s, as the economy emerged from depression and mobilized for war. The gap in regional incomes narrowed more in that decade than at any other time in the century.

Also drawing incomes closer was the sharp decline in regional specialization by broad industrial sectors. Manufacturing, mining, and agriculture, which had tended to concentrate in particular regions, are now much less important than services — health care, banking, retailing, education, and the like — which tend to locate close to their customers. Manufacturing, the great engine of northern advance in the nineteenth century, has spread far more evenly across the nation. The continuing fall in transport and communication costs has allowed manufacturers to move away from customers and suppliers, to regions with lower wage rates.

Whither New England?

Today, essentially all parts of the nation are "modern." Differences in the availability of capital, including human capital, are much smaller than they were in the nineteenth century. So all regions should be able to absorb new technologies, import capital, and export labor in ways that reduce productivity and income differentials. No region should expect to race very far ahead or fall very far behind.

Nevertheless, knowledge-based industries have characteristics, like nineteenth-century manufacturing, that concentrate productivity and income gains in specific geographic locations. In particular, they cluster near the top-tier universities and research institutions, which are a critical component of their knowledge base.

These districts then become leading sources of technical progress. The Massachusetts Technology Collaborative's Index of the Massachusetts Innovation Economy reports that the Commonwealth leads the nation in patents per capita, and is exceptionally strong in technology licensing agreements and in corporate intellectual capital levels (measured by the difference between book and market value of publicly traded companies).

Nowhere has technology progressed more quickly than in information processing, and these advances parallel the nineteenth-century improvements in industrial machinery emphasized by Williamson. New technologies cut prices, improve performance, and create a wide array of commercial opportunities, often in other knowledge-based industries, which are heavy information processors.

Because knowledge spillovers and a plentiful supply of skilled specialists and experts are so valuable in knowledge-based industries, they cluster geographically. The MTC Index identifies clusters in software and communications — the latest phase in the information technology revolution — and in financial services, a critical user. A Price Waterhouse survey shows that New England and California capture over 40 percent of U.S. venture capital investment. And economist Andrew Sum finds that professionals not only make up a disproportionate share of the New England work force, but that the differential has been rising in recent years.

The knowledge-based sector, however, differs in critical ways from the experience of nineteenth-century manufacturing.

First, consumers as well as producers enjoy the fruits of productivity gains as prices on new goods and services fall. In the nineteenth century, consumers had to live within the northern rail net to capture those gains for transporting goods, even agricultural goods, outside the region grew costly. Most knowledge-based products, however, are easily transported and the consumers' gain, which is often huge, is captured largely outside of the knowledge-based districts. In information technology, the main beneficiaries indeed have often been the mass-production/mass-distribution enterprises located in the nation's industrial heartland.

Second, knowledge-based districts are metropolitan, not regional in geography. And metropolitan areas suffer significant decreasing returns in the production of real estate that offset the increasing returns that come from spillovers and specialization economies. As the metropolitan work force expands, developers must put homes and buildings on lots farther from town or on lots with fewer amenities. Public roads and facilities also grow congested. These decreasing returns — reflected mainly in higher real estate prices — help explain why New England, despite its higher wage rates, has seen such little in-migration. Given current housing tastes, especially, the economies generated in its knowledge-based industrial districts have not been large enough to offset the diseconomies in its real estate market.

One result has been competition from other parts of the nation. Other regions can and have played catch-up. They have made major investments in their universities, waited twenty years, and now see knowledge-based clusters sprouting up. Even if productivity, incomes, and growth prospects are less than in New England or Silicon Valley, these upcoming districts can be competitive, and their workers have little incentive to migrate, if a lower cost of living makes up the difference. Interestingly, some of the more successful competitors, such as Austin, Texas, and the "research triangle" around Raleigh, North Carolina, are in the South.

This rise of competitive knowledge-based districts around the United States, and around the globe, may not seem like the best of all possible news for New England. But if such districts do set the next productivity and income benchmarks, then the rise of competitive districts in other regions could be far more attractive than the alternative. We are clearly better off with a geography that looks like the United States today — with all regions relatively prosperous — than the alternative, which would look more like the United States in the nineteenth century.

The growth of the knowledge-based districts in the United States does demonstrate the advantage of past economic success. The knowledge-based industries flourished first, and still flourish most vigorously, in metropolitan areas endowed by the past with great universities and professional institutions. While competitors have emerged, the leaders have kept their edge. In the millennium-long game of leap-frog, the front-runners sometimes hold on for a very long time.

We can neither predict nor choose whether the twenty-first century will be dominated by a new game of leapfrog — with regions sheltering knowledge-based industries, or another advanced productive complex, rising above the rest. Catch-up, with the United States remaining ahead, might again be the dominant game.

All we can do is play our best.

CAPITAL GAIN
Technical ideas are a peculiar form of capital. They do not decay the way buildings, machines, or skilled workers do. So maintaining an economy's stock of ideas is a far less costly affair. Ideas are also "non-rival" goods: Many people can simultaneously use an idea (say, use trigonometry to calculate the height of a tree) whereas most forms of capital (say, a shovel) can't be used by two people at once. The durability and non-rival character of practical ideas significantly enhances their ability to keep productivity rising.