President Bush's selection of Hank Paulson to be the next Treasury secretary is cause for cheer. His nomination also offers a pause for reflection on the economy's performance and its productivity muse--and on concerns about the economic outlook.

Visiting Scholar R. Glenn Hubbard

First-quarter GDP revealed growth at a nearly 5% annual rate. And many forecasters estimate that GDP growth over the full year will be in line with the economy's potential GDP growth (between 3% and 3.5%). Outside the U.S., much improved growth prospects for Japan and nascent growth in Europe are good news for global activity.

Yet the public's anxiety over the economy does not align with those headlines. One possibility is that the economy's performance simply is not as good as the data suggest. In this view, Americans used housing equity gains to finance consumption, expanding the already large current account deficit. As housing price appreciation starts to vanish, the engine for spending growth stalls, and foreign investors may lose faith in the U.S. economy's spendthrift ways.

While such a story offers drama, economic practice is likely to be more subtle. Flattening house price growth--embedded in forecasts of reasonably good GDP growth--will lead consumers gradually to raise saving.

And the recovery's strength has already rotated to business capital spending. Gradually rising U.S. saving and a pickup in domestic demand growth in key emerging economies should facilitate gradual adjustment of U.S. external imbalances.

Proponents of the "imbalances in the recovery" view often suggest that public policy played an unwelcome role. The Fed pursued an accommodative monetary policy in the aftermath of balance-sheet deterioration, business uncertainty, terrorism and geopolitical risk--and that policy stimulated the housing market, consumer spending and the current account deficit. Inflation risks are a legitimate concern. But can one seriously believe that a much tighter monetary policy over that period would have proven better for incomes and employment?

And tax policy? Investment incentives, lower marginal tax rates and cuts in dividend and capital gains taxes promoted investment at a time when investment decisions faced many headwinds, and such tax changes are consistent with fundamental tax reform.

Are we to believe that higher marginal tax rates would have led to better outcomes for output and employment over the past five years? Should we think that raising taxes on capital income would be an encouraging sign for foreign investors about the U.S. investment climate?

While pundits' hand-wringing about the economy misses the mark, there is a void in talking about the big story--the extraordinary performance of productivity growth in the U.S. economy over the past decade. Productivity growth has accelerated a full percentage point, with enormous implications for growth in living standards. And this growth reflects the power of openness, innovation and entrepreneurship in the economy. The productivity performance in the rest of the industrial world has been less impressive.

It is tempting to credit "technology" with our central success story. But while technology may be at the heart of the success of our greatest companies, these companies did not become more productive simply by buying faster computers. They became more productive by having managers and entrepreneurs who faced global competition and knew how to integrate these investments with new business models to raise productivity.

This entrepreneurial response is linked to public concern: The growth boom in the Unites States carries with it change--business starts, successes and failures. And steady aggregate growth can mask shifts in the returns to different skills and industry occupations. To maintain growth, we must resist the strong political pressure to protect existing "jobs" and "firms." Rather, well functioning labor and capital markets--cushioned by public support for training and education--offer a better route to success.

Many question whether workers are sharing in the surplus created by faster productivity growth. In a competitive economy, workers should see the benefits of higher productivity. And looking at postwar data for the U.S., productivity and real compensation grow together.

But at the same time, the co-movement is not instantaneous. In the mid-1990s, for example, higher productivity was not immediately reflected in compensation. GDP growth at roughly potential in 1994 was drowned out by worries over job cuts and downsizing until compensation shared more fully in productivity growth's dividends later in the decade.

What about "wage stagnation"? Health-care costs rising more rapidly than inflation strip out potential wage growth (while allowing greater compensation growth, including employer-paid health-care costs). Allowing productivity growth to pass more completely into wages would be easier if market forces were used to help restrain health costs.

But there is real danger. A legitimate fear is likely weighing on the public's mind--a large tax increase that could leach the innovative capacity of our vibrant and entrepreneurial business sector and eliminate the growth dividend of the past decade.

The lurking challenge lies in our entitlement programs. A recent front-page story in USA Today assigned Americans a bill for the present value of all federal obligations not currently funded of about $500,000 per household. For those wagging their finger at current federal budget deficits, about 8% of the bill was for conventional federal debt, while 80% was for Medicare and Social Security benefits.

Secretary Snow has rightly celebrated the economy's success, and Mr. Paulson will no doubt do so as well. But explaining the fount of that success and confronting real fears about change and entitlement spending would be a welcome addition.

R. Glenn Hubbard is a visiting scholar at AEI.