Sputnik moment

Last Tuesday January 25th, president Obama addressed the nation with the State of the Union's speech. This was one of the most profound speech I heard so far in my life. And yet, judging by the comments the next day, and the reactions on the markets, the speech were mostly unnoticed.

What is it that he said that is so profound? He said that US faces "...Sputnik moment." That will define whether America leads of follow on the global stage. He went ahead stating that the country "...lags behind..." other countries in academic achievement and Obama said that "...US lead has slipped..." And then he also said "...we are poised for progress..."

Why are those words so important and what does he really mean?

Lets do some basic economics. Look at figure 1 below.

Figure 1

This is a classical output function. The output function goes like this: Y=Af(L,K,H) where Y represent the national output of products and services. L represent labor, K represents capital and H represent training and formation. So output is a function of labor, capital and training.

As you can see the slope of the production function is increasing but less and less. This is what is called the decreasing marginal return. Lets take a simple example to explain this phenomenon. Lets say we want to paint rooms. Now to do so we need at least paint and a paint brush. Thus we need to invest capital (K) in order to get the work done. By investing capital we will get the good tools to do the work. But tools without painters gets us nowhere. We will have to hire people to get the rooms painted. Therefore we add labor (L). Now we're in business. We have a painter with some paint and a paintbrush. The job gets done. What do you think will happen if we add another painter and invest a little more capital? Why yes that's it! We'll get more rooms painted. Now what would happen if the first painter shows his skills to the newbie? He will learn faster and the job will get done faster too. So it doesn't hurt to inject some training (H) into our little exercise. And our output (Y) will increase again.

But what happens if we add more paint brushs than painters? Or if we add more and more painters? There will come a time where all those people will step on each other's foot and then the production will decrease. Even training has its limitation. That is why the output slope is increasing fast at first and then, decreases. But now what? Are we doomed to get to a certain level of production and then stagnate there for eternity?

Lets get back to reality a little. USA's output has increased to a pace of about 2% per year for the last decade or so. Same thing for most of the OECD countries. Why can't America change gear and get more produced? Because America is at point USA1 (see Figure 1). And with all the effort it can pull, it would may be able to advance to point USA2 if it's lucky. Ok so why is it that for the same period China output increased at a pace of something like 6% to 7% per year? Are they better than America? They have better planners or its the population?

None of it. China is able to get from point China1 to point China2 (again see figure 1) in a short period of time because China was behind and is now playing catchup. In other words they had less qualified painters and less paintbrushes and now they are investing more capital and more training to get the job done. But don't worry, when they'll get to USA's level, they will also loose pace and their growth will be much more like USA.

Ok so we are all doomed at one point to anemic growth? And what does this have to do with Obama's speech?

Look at the output function again. What do you see? Yes. You see that A is multiplying all the other factors. But what is A? Well A my friend is technological innovation. Look at Figure 2 now.

Figure 2.

As you can see with technological innovation USA can move from point USA1 to point USA2. So with no more investment in capital, labor and training, USA is able to increase its output by innovation. This is the equivalent in our example of inventing the paint gun. Therefore our painters will be able to paint more rooms in less time. The painted rooms output would increase.

Do you begin to see where Obama's speech is leading? He wants to educate the Americans in order to produce a pool of brains that will, hopefully innovate in their respective fields and ensure that America will keep and edge and its leadership in the world.

Now that you understand Figure 1 and Figure 2, you are able to appreciate what Obama really means when he says "we are poised for progress."

This is why I say that Obama's speech is clever, profound and visionary.

This is a pure move of national strategy. And to me, he took the right turn.

Oh! And by the way. If you don't believe that America is getting behind in education. I suggest you put your hand on the documentary Waiting for Superman. It's very enlightening.