SYNOPSIS: Liberal and Conservative cranks alike want the Fed to drive unemployment below the NAIRU
Delightful fairy tale has taken olf in some economic policy circles. After decades of inflation, slow growth and stagnant wages, the story goes, a restructured United States economy is poised for a glorious burst of sustained, 60's-style growth without inflation. It's a tale told by a spectrum of influential figures -- conservatives like Steve Forbes, the neo-Reaganite candidate, and Robert Bartley, editor of The Wall Street Journal, and liberal luminaries like the economist Lester Thurow and the financier-pundit Felix Rohatyn, who has recently been mentioned as a candidate for vice chairman of the Federal Reserve Board. Like most good fairy tales, this one features a horrible monster who is blocking the path to eternal happiness. That would be Alan Greenspan, the chairman of the Fed, which controls the nation's money supply. The evil Greenspan and his colleagues, blinded by their obsession with inflation, cannot see that the economic terrain has shifted, that the economy can now grow much faster than previously without risking more inflation. Thus, to slay the inflation dragon, the Fed is keeping interest rates unnecessarily high, in a pointless war against a phantom enemy.
Editorials demanding that the Fed promote faster growth have appeared in major magazines like Business Week and U.S. News & World Report. Business groups like the National Association of Manufacturers have joined the chorus. The time has come, they all agree, for Greenspan and the Fed to get off the back of business, cut interest rates and go for growth. It is indeed a delightful tale. If only it were true. In fact, the so-called revolutions in management, information technology and globalization are vastly overrated by their acolytes. While the economy is relatively healthy today, there is no evidence of a transformation so vast that we need to rewrite the basic rules of economics.
Where do these demands for growth come from? People like Bartley and Forbes are motivated by their faith in supply-side economics. After all, the economy grew at an average rate of 3.6 percent between 1982 and 1989. Doesn't that prove that the only thing needed to bring back the boom years is to return to Ronald Reagan's policies?
But the supply-siders have been promising rapid growth all along. The reason some centrists and liberals now join them is that they have been listening too closely to business leaders. It has become a cliche in the business world that in the last few years tighter management and sophisticated technology have led to a "productivity revolution." And since productivity is the main factor determining long-run economic growth, this productivity must surely imply that the economy is now capable of much faster growth.
For those who believe that the economy is capable of rapid growth, it is understandably frustrating that its actual performance has been so sluggish. Admittedly, America has bounced back from the recession of the early 90's, but gross domestic product -- after jogging along for a couple of years -- has again slowed to a walk. Median family income is actually lower now than in 1990. In short, the revolutionary progress that business believes it is making is not reflected in overall measures of growth or family incomes -- or in a general public sense of prosperity.
If America's private sector is so dynamic, why isn't it growing faster? The obvious answer is that something is standing in the way. And that is where the Fed comes in.
Could a handful of misguided technocrats really be frustrating the dynamism of an economy with more than 120 million workers? Well, the Fed does have enormous power, at least in the short run. It is fully capable of plunging the economy into a punishing recession -- as Paul Volcker, Greenspan's predecessor as Fed chairman, did in 1979 -- or of converting such a recession into an exuberant boom, as Volcker did in 1982. And the Fed deliberately reined in economic growth in 1994 to head off any risk of renewed inflation. So it is not surprising that many observers support the idea that the economy could grow faster if only the Fed would let it.
But when economists declare that the economy's "speed limit" is about 2.5 percent -- not the 3.5 percent that the growth lobby believes -- they are not pulling a number out of thin air. For the last 20 years it has been reliably true that when the economy grows faster than 2.5 percent, the unemployment rate sinks. Indeed, for every point of growth beyond 2.5 percent, the unemployment rate falls by half a point. There is not the slightest hint in recent experience that this historical relationship (known as Okun's Law, for the late Arthur Okun) has changed. For example, from the middle of 1993 to the middle of 1995, the economy grew 7.5 percent. That's 2.5 percentage points of extra growth, which according to Okun's Law should have reduced unemployment by 1.3 points. Sure enough, unemployment fell from 6.9 to 5.6 percent.
When people argue that the economy can grow at 3.5 percent for years to come, they must either be unaware of this relationship or have a wildly unrealistic view about how low the Fed can push the unemployment rate. For example, when supply-siders call for a return to the growth rates of the "seven fat years" from 1982 to 1989, when the unemployment rate fell from 10.7 to 5.2 percent, one wonders what they are thinking. Since the current rate is only 5.6 percent, a similar growth spurt would produce a negative unemployment rate by 2003. Even Reagan never promised that.
How large a reduction in the unemployment rate is it realistic to hope for? Perhaps none at all. Most economists believe that inflation begins to accelerate when unemployment falls below what is gracelessly known as the Nairu (for "nonaccelerating inflation rate of unemployment"). The theory of the Nairu has been highly successful in tracking inflation over the last 20 years. Alan Blinder, the departing vice chairman of the Fed, has described this as the "clean little secret of macroeconomics."
The Nairu is usually put at 5.5 to 6 percent -- the current unemployment rate, more or less. To question whether this is too pessimistic misses the point. If the Nairu is 5 percent rather than 5.5, the economy can grow at 3.5 percent -- but for only one year. If the Nairu were 4.5 percent -- which would be utterly inconsistent with historical experience -- you would get two years of 3.5 percent growth. It's still hardly the kind of explosive growth the Fed's critics say we should aim for.
How do the advocates of faster growth respond to such calculations? They don't. As one frustrated official remarked: "The problem with these guys is not that they don't know enough economics. It's that they don't understand what it means to have a logically consistent argument."
There is a lesson in all this -- namely, that some of our most influential economic commentators are not in the habit of doing much homework before issuing their pronouncements. But there is still a puzzle: why hasn't the productivity revolution made any difference to the economy's ability to grow? The most likely answer is that this storied revolution never happened. During the postwar decades, when the economy really was a productivity powerhouse, technological advances affected every aspect of life. In 1945, cross-country travel meant a two- or three-day train ride and consumers bought groceries in mom-and-pop stores. By 1970, people crossed the country in five hours and groceries came from large, efficient supermarkets. In these and a thousand other ways, life was transformed.
Has recent experience offered any comparable transformation? We have made some spectacular advances. But these have taken place on a very narrow front, tied directly or indirectly to the magic of silicon, which allows us to manipulate and transmit vast amounts of information at blinding speed. How much difference does this really make to people's lives? Information is a means, not an end: people can't eat information, wear it, live in it. Even the fanciest information technology may have only a marginal impact on the material world in which we all still live. Computerized ticketing is a great thing, but a cross-country flight still takes five hours; bar codes and laser scanners are nifty, but there's still time to read about celebrities and space aliens in the checkout line.
The statisticians agree with this skeptical assessment. Recently the Bureau of Economic Analysis, which is responsible for tracking gross domestic product, decided that it has been overstating growth. Loosely speaking, the agency is trying to correct for the fact that while the computer on my desk today may be 50 times as powerful as the one I had in 1985, it is nowhere near 50 times as useful. So much of the recent growth in our economy has been concentrated in computers that this technical adjustment leads to a substantial reduction in our measured performance. In the postwar years we were getting gradually better at many things; these days we are getting rapidly better at just a few things, and it's not clear how much good that really does us.
In short, there is no good reason to believe that the speed limit on the economy has been raised. The influential voices who claim otherwise have confused hype and wishful thinking with analysis and have ignored or simply failed to understand the strong evidence against their claims.
Does it matter? The experience of Britain in the late Thatcher years offers a clear example of economic policy based on unrealistic beliefs about potential growth: a brief boom was followed by surging inflation and a disastrous recession. There is little immediate danger of a similar cycle here, since the current leaders of the Fed are determined to follow responsible policies. But that can all change with the next Presidential election. If the last 15 or 20 years teach us one overwhelming lesson in political economy, it is this: just because an economic doctrine is patently false, that does not mean it can safely be ignored, especially when that doctrine tells people what they want to hear.
Originally published in The New York Times, 2.4.96