SYNOPSIS: Critical about New Economy claims, for many reasons. But holds out hope for higher Productivity

Twelve years ago the Brookings Institution commissioned a series of papers on Eurosclerosis - the syndrome of slowing growth and rising unemployment that had already become increasingly apparent in Western Europe. When a conference was held to discuss the papers, however, some European participants dismissed the whole enterprise as a case of fighting the last war. Europe, they insisted, was on the move again; energized by the move to a single market, it had embarked on a period of renewed growth and technological vigor. And indeed the late 1980s were a good time for Europe: as growth accelerated, unemployment fell, and dreams of European unity seemed to be taking on a new reality, a mood of almost giddy optimism - Europhoria - swept the continent. Even non-Europeans were caught up in the spirit - as late as 1992 Lester Thurow's best-seller Head to Head would proclaim that 'Future historians will record that the 21st century belonged to the House of Europe.'

In retrospect, European elation was, to say the least, premature. The structural problems that underlay Eurosclerosis had not been resolved, they had merely been masked by an upswing in the business cycle. When the next recession arrived - and there is, of course, always a next recession - it raised unemployment rates not merely to their previous peaks but, in most of Europe, to levels not seen since the 1930s. All in all, it was an object lesson in the difference between cycle and trend: one swallow does not make a spring, and a few good years of growth do not necessarily signal a turnaround in economic fundamentals.

While Europeans may have learned that lesson, however, Americans clearly have not. Although only a few years ago commentary about the U.S. economy was typified by the title of Bartlett and Steele's America: What Went Wrong?, and until quite recently economic journalism was dominated by scare headlines about downsizing, after a mere two years of good news America's mood has become startlingly triumphalist. In the view of many business and political leaders (though few academic economists) we have entered the era of the New Economy, an era in which traditional limits to economic expansion are no longer relevant. And because we have a New Economy and the rest of the world does not, we have also entered an era in which America is once more indisputably Number One - and the rest of the world must adopt our values, emulate our institutions, if it wants to compete.

To anyone with a sense of history, this is all deeply worrying. If pride goeth before a fall, the United States has one heck of a comeuppance in store. Yet the strengths of the U.S. economy are not merely a matter of boasting. The thing is to separate the realities from the myth. What has gone right with America - and what hasn't?



By any standard, 1997 was a very good year for the U.S. economy. GDP grew by almost 4 percent, well above the 2.4 percent average over the past 20 years. Unemployment fell to 4.6 percent, a 25-year low. Meanwhile inflation remained quiescent, at less than 2 percent.

How should we view this success? A year of fast growth, even a year of fast growth without inflation, is by itself not that unusual: in 1983 the economy grew by almost 7 percent, also without inflationary pressure. Yet 'morning in America' did not signal a long-term increase in the economy's growth rate: growth over the decade that followed averaged only 2.4 percent annually. How can we tell whether 1997 was a similar temporary surge or something to which we should become accustomed?

To answer this question it is essential to take on board a bit of economics that, though rudimentary, is often ignored in public discussion: the distinction between growth in the economy's productive capacity, and fluctuations in the utilization of that capacity - or, to use alternative jargon, the difference between trend and cycle.

Think of the economy as a machine that can be run at variable speed. It may sometimes be possible to increase output by running the machine faster; however, if it is run too fast, it will overheat. Thus while it is possible in the short run to get more output by using the economy's capacity more intensively - especially if the economy starts from a position where capacity is severely under-utilized - over the longer run the only way to achieve a sustained increase in output is to increase the machine's capacity, that is, to increase the output it can produce at a given speed

This may sound abstract, but in it is possible to make a fairly clear distinction between growth due to expanded capacity and growth due to fuller use of existing capacity. The unemployment rate turns out to be a pretty good indicator not only of the utilization of the labor force but of the utilization of economic capacity in general. In fact, there is a remarkably good (though not exact - this is economics, not physics) rule of thumb known as Okun's Law, which relates changes in the economy's utilization of capacity, as measured by the unemployment rate, to its growth rate. Here is how Okun's Law works: in a year in which the unemployment rate does not change, the economy typically grows about 2.4 percent; every percentage point decline in unemployment adds 2 percent to that growth rate (while every percentage point rise subtracts 2 percent). That 2.4 percent growth when the unemployment rate is constant is the growth in the economy's capacity; the extra growth when the unemployment rate declines (or growth shortfall when unemployment rises) represents a change in the utilization of that capacity.

Okun's Law works very well in accounting for the growth surge of 1983. As the economy recovered from the recession that had raised unemployment to a postwar high in the fourth quarter of 1982, the unemployment rate fell by 2.2 percentage points. The rule therefore says that the economy should have grown by 2.4 + 2 H 2.2 = 6.8 percent - very close to the actual growth. And the same rule works quite well for last year: since the unemployment rate fell from 5.3 percent in late 1996 to 4.7 percent in late 1997, we should have expected growth of 2.4 + 2H0.6 = 3.6 percent - close enough to the actual 3.9 percent to be well within the normal fuzziness of economic statistics.

The point of these exercises in arithmetic is that because the same rule that accounted for fluctuations of growth around its long-run average fifteen years ago continues to work today, we have no reason to believe that the rate of growth of the economy's capacity - and therefore its long-run growth rate - has accelerated.

What may have changed is the ability of the economy to make use of capacity without getting overheated. Until a few years ago, typical estimates suggested that any unemployment rate below about 6 percent would lead to a gradual but inexorable acceleration of inflation. But here we are with an unemployment rate of less than 5 percent, and with prices still stable. Does this represent a fundamental improvement in the economy's ability to deliver full employment?

The answer is definitely ambiguous. There is no evidence that the economy has become less inflation-prone for any given rate of increase in costs - where employee compensation is the most important such cost. However, for the last several years costs themselves have, for a variety of reasons, risen less than one might have expected given how hot the economy seems to be running. The most important restraint on inflation has been a squeeze on worker benefits, mainly due to the switch to managed health care. In the last two years the strength of the dollar and the economic woes of Asia have also pushed down import prices, helping keep inflation low. But for these special and necessarily temporary factors inflation would probably already have started to show clear signs of returning; wage increases have been accelerating steadily since 1995, and with the shift to HMOs more or less complete benefits have also started to rise again. Sooner or later the need to keep inflation in check will probably force the Federal Reserve to allow (or engineer) a rise in the unemployment rate.

Nonetheless, it is likely though not certain that the sustainable unemployment rate has fallen. Weaker unions, worker reluctance to demand wage increases in an era of downsizing, reluctance of employers to grant such increases in an era of greater competition, and a more flexible labor market due to the growth of temporary work may all imply that 5 percent unemployment isn't what it used to be. Taking recent experience into account, a middle-of-the-road estimate of the unemployment rate that is now consistent with stable inflation would be somewhere between 5 and 5.5 percent. The Administration uses 5.4 percent for its budget estimates; it is possible, though difficult, to make the case for 5 percent.

In sum, despite the rapid growth of 1997, there is nothing in recent experience to suggest that the U.S. economy is capable of more than about 2.5 percent growth in an average year. It is, however, likely that the sustainable unemployment rate has fallen, perhaps as much as a percentage point. Remembering Okun's Law, this means that the U.S. economy can produce at most about 2 percent more than we thought it could. This is good news - 2 percent of US GDP is more than $150 billion - but hardly a revolutionary improvement.

Of course, low unemployment has benefits that go beyond mere economics. A tight labor market disproportionately benefits marginal workers, those who tend to be last hired, first fired; for those attempting to take the first step out of the underclass the difference between 6 percent and 5 percent unemployment may be a large difference indeed. But in terms of the economic might of the United States, its ability to generate wealth (and perhaps to convert that wealth into power), the news in recent years has been relatively small change.

Or at least that is what the numbers say. But might the numbers be wrong?




The U.S. economy's productive capacity is, by definition, the number of employable workers multiplied by productivity - output per worker. The reason why the growth in that capacity seems to be rather slow is that productivity itself has, according to official estimates, risen at a modest pace - just over 1 percent annually during the 1990s to date, a rate similar to that during the previous two decades.

But many observers do not find these official estimates credible. After all, these are the days of re-engineering and total quality management, of Internet and intranets, an era in which many businesses boast of having achieved dramatic increases in productivity. Surely, the believers in a New Economy insist, so many tales of a productivity revolution cannot be mere hype - and surely the reality of much more rapid productivity growth than the numbers say is validated by the economy's unexpected ability to grow rapidly without inflation.

To parse these claims, it is essential to distinguish between two questions. One is whether official estimates are missing a lot of productivity improvement, to which the answer is yes, they are - but they always have. The other is whether the unmeasured productivity gains that are surely taking place can explain the economy's good measured performance, to which the answer is definitely no.

Few economists question the proposition that official measures tend to understate true growth in a technologically progressive economy. In essence, official measures of productivity are always backward-looking: they ask how much more of a given good a worker can produce this year than he could last year. But what if a worker produces something that simply was not on the menu last year? How do you compare the productivity of electricians with that of lamplighters, of auto workers with that of carriage-makers, of doctors prescribing antibiotics with those who had little to offer beyond aspirin and sympathy? Because such qualitative improvements are inherently difficult to put into an index number, productivity and economic growth in general have surely been understated throughout the past century and a half.

But are they more severely understated now than before? Certainly we talk more about technological progress than we used to; but that may have more to do with who does the talking than with the progress itself. Here is how Berkeley's Bradford DeLong put it in a commentary on one New Economy enthusiast:


Kevin Kelly [editor of Wired] has made an elementary mistake. He remembers the goods of the

industrial revolution- from automobiles to washing machines, railroads to container ships to airplanes to radios -- from his childhood. So he assumes that they must have always existed, and that the pace at which they changed must have always been glacial.

But revolutions in productivity in the economy's shifting set of leading sectors have been ongoing since 1760 or so, the beginning of the industrial revolution. In fact, that's why the age starting in 1760 or so is called the age of the industrial revolution.

Microelectronics as one of the leading sectors of technological change -- microelectronics as an industry -- is new to our generation, but productivity advances in leading sectors that are fast enough to be called industrial revolutions have not been news for two and a half centuries.

So what, then, is new about our post-industrial economy? What is new is that for the first time since the invention of printing, information processing and distribution has become one of the leading sectors. Previous leading sectors changed the conditions of the lives of weavers, spinners, transporters, framers, blacksmiths, and so on. Our leading sectors are changing the conditions of life of those who use information to direct enterprises -- managers -- and they are also changing the conditions of life of those who use information to decide what to buy -- consumers. Perhaps most of interest, however, society's information processors and distributors include its intellectuals.

So we intellectuals are, quite naturally, incredibly excited. And we are very, very articulate.


While a sense of history might lead one to be agnostic about claims of a productivity revolution in the United States, however, doesn't the experience of high growth without inflation show that something new and good is happening? Well, no. For one thing, the quiescence of inflation in the face of declining unemployment seems to be fully explainable in terms of other, less glamorous factors - mainly the sluggish growth in wages and benefits. Furthermore, there is a seemingly technical point that is nonetheless critically important here: official estimates of productivity are constructed using the same data that are used to construct estimates of GDP - indeed, official estimates of productivity are nothing more than GDP per worker. This means is that any understatement of one must imply an equal understatement of the other - and hence that unmeasured productivity growth cannot explain the good performance of measured GDP.

This seems to be a surprisingly difficult point to grasp. I have found it easiest to explain with the help of a parable.

Imagine, then, a New Economy advocate who discovers that he has a problem with his car. Whenever he drives too fast - whenever the needle on his speedometer goes above 40 - the car develops a dangerous shimmy. So he carefully drives the car to his mechanic, never letting the needle go past 39. Alas, the mechanic informs him not only that he cannot fix the shimmy, but that the car has another problem: something is wrong with the speedometer, which is consistently understating the car's speed. Indeed, when the needle is at 40 the car is actually going 55. To the mechanic''s surprise, the New Economy advocate is delighted with this news: 'What you're telling me is that the shimmy doesn't start until I'm actually going 55. That means I can drive home 15 miles an hour faster than I drove here!

Nobody would make this mistake in daily life, but many New Economy advocates make exactly the same mistake with regard to productivity and growth. Last year the U.S. economy grew by 3.9 percent, according to official numbers - which conventional economists reckon is about 1.5 percent more than its long-run sustainable rate. But New Economy enthusiasts argue that productivity growth is severely understated. And suppose, they say, that productivity is actually growing 1.5 percent faster than the numbers say; then the sustainable rate of growth of the U.S. economy is really 3.9 percent, not 2.4. And doesn't that mean that last year's growth didn't put any strain on capacity after all - which explains why it didn't cause inflation?

I hope the point is now obvious: since measured productivity growth is simply GDP per worker, if productivity has been understated, so has GDP, by exactly the same amount. So if productivity growth was really 1.5 percent higher than the numbers say, the economy really grew by 5.4 percent, not 3.9 percent - and the failure to show signs of inflation is as much (or as little) a puzzle as ever.

And what that means, in turn, is that the recent ability of the United States to drive the unemployment rate below 5 percent without inflation provides no evidence at all for the putative boom in U.S. productivity. You may choose to believe in such a boom if you like; but you cannot either use it to explain good macroeconomic performance or use good macroeconomic performance to justify your belief.

What, then, is left of the New Economy? We have had a favorable turn in the business cycle, abetted by some temporary factors that have helped keep inflation down, and probably also helped by shifts in the labor market that have reduced the bargaining power of workers and therefore allowed fuller employment without accelerating wage increases. The success is real, but it is also modest, and falls far short of justifying the triumphant rhetoric one now hears so often.




If the U.S. economy isn't really doing as well as advertised, why the sense of renewed American preeminence? One answer may be that other economies - in Europe and in Asia - have fallen short of expectations. In a world of stagnation and crisis, a country that actually continues to make even modest progress may be entitled to some self-satisfaction.

There is no question that much of the world has disappointed expectations that were widely held only a few years ago. The days when Thurow could confidently predict that 'Over the next five years Europe will move to full employment', or when James Fallows could declare that 'Like it or not, we live in the world that Asian success stories have shaped. We need to figure out how to compete in it' seem very distant right now.

But just as pronouncements of American triumph turn out, on close examination, to be overstated, so too do the dismissals of European and Asian prospects that one now hears. Let's take a quick tour of of the world to examine how matters actually stand.




Compared with the optimism that prevailed at the beginning of this decade, Europe's economic performance has indeed been a huge disappointment. Particularly distressing to those who place their faith in European unity has been the failure of measures aimed at reinforcing that unity - the creation of a single market, the drive toward a common currency - to provide a jump-start for the continent's economy. Indeed, a good case can be made that the efforts of European countries to meet the criteria for entry into EMU at the end of this year have actually aggravated the problems of slow growth and unemployment.

Will the achievement of EMU transform the situation? Almost surely not. There has been a massive and occasionally bitter debate over whether Europe really should have a single currency on economic grounds - whether it is an 'optimal currency area'.

Perhaps the best way to summarize the state of that debate is to say that EMU advocates have failed to make a convincing case for large gains, but that EMU opponents have not been able to make a conclusive case for large losses either. One thing that seems clear, however, is that establishing a single currency will have little if any impact on Eurosclerosis: the forces that keep unemployment high and job creation low will be as strong on January 2 of next year as they are today. My own amateur prediction is that this will lead to a period of great political disillusionment: having spent many years suffering under the disciplines of the Maastricht treaty, Europe will arrive at the Promised Land - and find that it looks an awful lot like the desert.

But that said, it is worth noticing that in some respects the European economy continues to show considerable resilience. Considering the general sense that the United States has once again seized the technological high ground, it is surprising to learn (from the numbers shown in Table 1) that the already small gap in productivity between the United States and advanced European countries has continued to narrow during this decade, and has indeed become so small as to be well within measurement error. And while slow growth in employment means that per capita income has not converged as rapidly as productivity, even there European countries are now close enough to the U.S. as makes no difference.

At a more impressionistic level, it is also far from clear that Europe really is lagging behind in technology. True, the United States dominates the high-profile sectors of the moment: microprocessors and operating systems. But the main economic payoff from these technologies lies not in their production but their application, and here the picture is mixed. The United States has taken more rapidly to the Internet and email than most European countries, largely because of low telephone charges - although the most 'wired' country in the world is, surprisingly, not the U.S. but Finland. Europeans, on the other hand, have technologically superior cellular phones. Which matters more for business? Never mind: the point is that Europe and the United States are operating at essentially the same technological level, with each side of the Atlantic having a small edge in some things.

Europe, in short, has a poorly functioning labor market, as it has for the past generation, and as a result has a dreary employment picture. But on other fronts the gap between Europe and the U.S. has narrowed (or vanished), not widened. The only sense in which Europe has fallen behind is its failure to live up to unrealistic Europhile expectations.




Japan, unlike Europe, has underperformed not merely relative to the expectations of its naive admirers but compared with almost anyone's forecast. An economy that had grown at an annual average rate of 4 percent during the 1980s has hardly grown at all since 1991. What went wrong?

The truthful answer is that nobody quite knows. The odd thing about Japan'>s economic stagnation is that many of the strengths that powered the economy's growth during the previous 40 years seem intact. High-quality manufacturing, innovative product design, even the famed skill at exporting seem still to be there: it was remarkable indeed that Japan managed to run trade surpluses during the mid-1990s, even though the yen was at a level that seemed to make its products radically uncompetitive.

In some ways Japan seems to resemble nothing so much as the United States during the 1930s: a highly productive industrial society that managed to stumble into a financial crisis (the stock market crash of 1929, the bursting of the 'bubble economy' in the early 1990s) and has not been able to get itself restarted despite near-zero interest rates and intermittent efforts to pump-prime the economy with deficit spending. Part of Japan's problem is rooted in a banking system that cannot function effectively because it has never come to terms with its bad loans; part of the problem also lies in a service sector that, because it is overregulated and lacks competition, cannot supply the investment demand the economy needs to get moving again. Japan's once-fabled Ministry of Finance also shares much of the blame: it has consistently raised taxes whenever the country showed signs of recovery, seemingly determined to keep the economy depressed. Whatever the nature of the malady, there is no question that Japan's stagnation makes the United States look good by comparison.

But we should bear in mind the comparison with the United States in the 30s: the strengths of our economy then were real, and once a recovery began in earnest it was the Depression, not the Roaring Twenties, that began to look like an aberration. Japan may well be back.


Emerging Asia


Rarely in the course of economic events has a region's economic reputation suffered as severe a reversal as that of Asia's emerging economies since last summer. I argued rather notoriously more than three years ago that reports of an Asian miracle were exaggerated (The myth of Asia's miracle, Foreign Affairs, November/December 1994). What are we now to make of Asia's collapse?

Events are now moving too quickly to be sure how far and deep the crisis will reach, although it has already exceeded anyone's worst expectations. The best available diagnosis of the crisis is that it was made possible by runaway financial institutions that in effect gambled with other people's money, but that the inevitable failure of many financial intermediaries was hastened and reinforced by a circular process in which collapsing asset values undermined banks, and an imploding banking system not only further depressed asset values but disrupted the normal functioning of business. Meanwhile, foreign investors, whose excessive optimism had helped create the bubble, panicked and headed for the exits. At the time of writing the success of IMF-sponsored stabilization plans was still very much in the balance.

While the scene has been astonishingly grim, however, Asia's present failures need to be viewed with as much perspective as her past successes. An economy may suffer a severe financial crisis, then recover and grow as rapidly as ever. In fact, the susceptibility of an economy to financial crises and its ability to deliver sustained growth in general have very little to do with each other. The United States economy between the Civil War and World War I was notoriously crisis-prone. Nor were catastrophes like the Panic of 1873 pure accidents: they were made much more likely by a business and political culture in which petty things like scrupulous accounting were disdained, wholesale corruption was a matter of course, and many business empires were built on the strength not so much of productive efficiency as of political connections. Yet despite a steady stream of scandals and the occasional devastating panic, the United States rose over those years to the position of economic preeminence that it now, rather prematurely, claims to have recaptured.

In short: emerging Asia will be back.




Suppose that you had made a realistic assessment of the economic prospects of the world's major economies circa late 1992 - say, at the time of President-elect Clinton's famous economic summit. You would have noted that the one-time dominance of the United States - that postwar peak of influence when America produced as much as all other market economies together, when American technology was superior in almost every industry - had long since passed. Instead, we were in a world in which Europe, Japan, and the United States were all more or less on the same technological level; and in which the economy of Europe as a whole was more or less the same size as that of the United States. But the U.S. economy not only was still larger than that of any other country, but seemed likely to remain so for at least several decades. Europe was growing no faster than America; Japan was growing faster (4 percent versus 2.5), but since its economy was less than half our size even a persistence of that growth differential would take more than half a century to close the gap. The only way that the United States might be displaced as the world's leading economic power would have been for Europe to form a true federal union, something that looked almost as unlikely in 1992 as it does now.

How much has that assessment changed in the five years since? Hardly at all. Certainly there has been no revolutionary improvement in the performance of the United States itself. True, the U.S. economy is doing better than most economists expected, but as we have seen the good news, while real, is fairly modest. Europhiles do have grounds for dismay - but mainly because their expectations 5 or 6 years ago were unrealistically high. Only in Asia has there been a true reversal of fortune; yet it is too soon to count emerging Asia out, and even Japan may yet stage a recovery.

None of this is meant to suggest that the United States is in any sense on the verge of crisis; our economy does seem fundamentally sound (but then don' t they all?). However, our current sense that we are on top of the world is based on a huge exaggeration of the implications of a few good years here, a few bad years elsewhere. Let there be even a mild recession in the U.S., a moderate recovery in Europe and Japan, and a bounceback in emerging Asia, and all this talk of the return of American dominance will start to sound very silly indeed.

Future historians will not record that the 21st century belonged to the United States.




a. Real GDP per capita, US = 100


Japan France Germany

1989 82.6 77.7 80.9

1995 79.7 78.0 83.4


B. Real GDP per employed person, US = 100


Japan France Germany

1989 80.9 95.2 87.7

1995 81.7 97.7 93.2