I sent this to pen-l awhile back, but I think that if there are any folks on lbo-talk that aren't also on pen-l, they might be interested. Otherwise, erase now. I did revise it slightly, without changing my conclusions. -- Jim Devine
May 3, 1998, Sunday Section: Week in Review Desk
Ideas & Trends: Chaos Theory; Unlearning the Lessons of Econ 101
By SYLVIA NASAR
(Copyright 1998 The New York Times Company)
THERE it goes again. Just when economists were wisely preparing a fat and happy America to face the inevitable unpleasant fallout from last summer's Asian financial crisis, the Government reported last week that things are going better than ever. Inflation is more or less gone. Jobs keep going up and growth continues.
That's been the story of the current economic boom, one of the longest and healthiest in American history. It has confounded everybody, not least of all the folks who are supposed to know what's going to happen and when to expect it: professional economists. Economic tenets, taught half a generation ago as immutable laws, are turning out not to be true.
> by "professional economists," Nasar means mainstream economists. I'll ignore most of the other hyperbole, such as the assertion that the generalizations listed below were seen as "immutable laws," focusing instead on the generalizations themselves.<
Not all of them, of course. The vast bulk of mainstream economic theory has held up fine. Trade can make everybody better off. Free markets usually work best. High tax rates undermine incentives to work. The bedevilment is in the details.
> "usually" work best? for whom? for the poor and working people? for nature? And which_ taxes? the idea that the income tax discourages work is Laffer-Reagan supply-side nonsense. It is sad that this nostrum has gotten mixed up in vague statements about "high tax rates" _in general_ is a sign of the right-wing shift of the TIMES and of intellectual bankruptcy.<
Here are five economic principles, some called laws, others merely rules of thumb, that seem to have broken down:
Low unemployment = High inflation
Since 1960, the famous Phillips Curve posits that there can be low inflation or low unemployment, but not at the same time -- at least for long.
But so far in the 1990's, unemployment and inflation have not only been marching in the same direction -- south -- but they are now at their lowest levels in a generation. After seven years of economic expansion, unemployment dropped below 5 percent last fall for the first time since the early 70's.
Instead of accelerating, inflation has slowed even more. In the quarter that ended in March, the Government's broadest measure of inflation rose at an annual rate of less than 1 percent, the slowest rate since 1964.
What gives?
>Of course, we've benefited from a shift in the Phillips curve, just as a bad shift in the PC spawned stagflation in the 'seventies. So what else is new? Economists have been conscious of PC shifts for a long time. The argument is about why it shifts.<
Most economists agree with the Nobel Prize-winning economist Milton Friedman, who says the economy has a ''natural'' rate of unemployment, below which inflation accelerates, and above which inflation decelerates. Until recently, economists thought this natural rate was about 6.0 to 6.5 percent. It could be that the natural rate, which is affected by changes in demography, education and labor market institutions, has fallen sharply, perhaps to 5 percent, some economists say.
One intriguing explanation is offered by the Princeton economist Robert Shimer, who says, ''The U.S. employment rate is so much lower because the population is so much older.'' Teen-agers have an unemployment rate roughly five times that of adult workers, the thinking goes, and the declining number of teen-age workers is enough to pull down the overall unemployment rate to its current low level.
Robert Gordon, an economist at Northwestern University, points to possibly temporary factors -- including falling computer prices, the strong dollar, the shift to managed health care and more accurate [sic] measurements of consumer prices -- to account for the unexpectedly low inflation rate of the late 90's.
> All of these make sense, but these hardly form the whole story. We should remember that the US has also benefitted from falling oil and primary-products prices. The US has also benefitted from cheaper imports from East Asia, which is something more than a "strong dollar." We might also point to problems with the measurement of the unemployment rate, as did letters to the editor in May 8's New York TIMES. They pointed to the falling labor force participation rate among adult men, which means that some without jobs aren't counted as unemployed.
> In addition, the structure of the labor market (the locus of the wage-price spiral) has changed: just as unions and other institutions that allow workers to avoid real wage cuts have declined in power, companies have found it harder to raise prices (as competition has increased, partly due to globalization, partly due to deregulation and the like). (The companies are responding by merging, but so far haven't been able to get their monopoly pricing power back.) Both sides of the wage-price spiral have lost the ability to keep up with each other and with expected price increases. If the trend labor-productivity growth rate has been increasing (it's hard to tell), then this also weakens the wage-price spiral.
> Put another way, the conflict theory of inflation explains inflation by refering to a unresolved battle over the production and distribution of the product. By knocking out one side of the conflict (the destruction of PATCO, the largely unionized manufacturing belt, etc.), the conflict has been resolved in capital's favor. This reduces the inflation rate, but it also produces another result: the widening gaps in the income distribution between the rich and the poor.
> Using the standard misery index (unemployment rate plus inflation rate) as a measure of stagflation, it sure looks as if the economy has returned to something like the "good old days" of 1965. But if we measure what I call the "workers' pain index (unemployment plus the fall in the real wage rate), 1997 was more similar to the stagflationary year of 1973. The fall in the real wage rate is used because it indicates the extent that inflation actually hurts US workers. By the way, it's quite a scandal that US workers aren't doing _better_ than they were in 1973, given all of the productivity growth that has occurred between then and now.<
Shrinking deficits = Slower growth
Ever since President Herbert Hoover made the Depression worse by trying to balance the budget as the economy was failing, deficit reduction has been widely held to be a drag on economic growth.
But growth has been stronger in the 1990's despite Washington's shift toward fiscal prudence. The Federal budget deficit, nearly $200 billion in 1992 and heading higher, is now effectively zero. Meanwhile, growth in the past eight quarters has averaged 3.8 percent.
The Government's most recent economic report drove the point home even more dramatically: In the first quarter, as Federal spending fell at an annual rate of $8 billion, the economy sprinted ahead at a 4.2 percent annual rate.
Today economists are more apt to claim, as the former Clinton economic adviser and Federal Reserve Vice Chairman Alan Blinder did last year, that deficit cutting can lift the economy by encouraging lower interest rates and more capital spending. Proof of the turnaround in thinking can be found in the 1998 edition of Paul Samuelson's classic introductory economics textbook, which asserts, ''a large public debt is likely to reduce long-term economic growth.''
> I guess macroeconomic education is on the decline, even among those at the top of the academic pecking order. No-one mentions the very simple fact that as the economy booms, the size of the deficit decreases automatically. The political establishment has been trying their mightiest to undermine the "automatic stabilizers" that lead to this result, but it still works. Adding to this is the fact that the economy has gotten down to very low unemployment rates (by recent standards, though not compared to the 1960s). This has allowed GDP to increase more than in previous upturns, reducing the deficit more. The structural change in the labor market discussed above has allowed these low unemployment rates to occur.
> The discussion above also forgets that the size of the (structural) government deficit is not the only source of aggregate demand. The US economy has benefited mightily from an investment boom and an export boom, both of which have pulled up consumer spending. The investment boom seems linked to a rising rate of profit, itself a result of the increased inequality of distribution. The high profit rate also helps pay for a boom in luxury spending, so that consumer spending can do well despite stagnant real wages. The export boom resulted from a low dollar exchange rate, a situation that is ending. The "real multilateral trade-weighted value of the U.S. dollar" fell from the 1980s to the 1990s, bottoming out in 1995 and then began to rise steeply. I think that rise will continue, due to the events in East Asia. This should make net exports even worse.
> In the meantime, the rising exchange rate gives us an illusion of prosperity, since the dollar can buy so many foreign goods. This illusion is paid for with rising debt to the rest of the world.
> The fact that Samuelson sees a "large public [sic] debt" as a barrier to long-term growth is pure ideology. It ignores the type of spending that led to the debt. Intelligent economists realize that government spending on education, research, and infrastructure _encourage_ economic growth.
> Further, it should be remembered that it's the _government's_ debt and this is mostly a debt _to_ the US public. After World War II, a large fraction of the population held government bonds. This helped stabilize the economy during the 1950s and maybe even during the 1960s. The economists want to gloss over the fact that currently the government debt is mostly owed to the rich.
> The current anti-Keynesian attitude toward the government deficit and debt is part of the general shift toward the "Alan Greenspan knows best" view, a symptom of the rise of financial capital. <
Rapid money growth = Higher inflation
Mr. Friedman's famous dictum that ''Inflation is always and everywhere a monetary phenomenon,'' -- meaning that inflation is caused by the Government's decision to print too much money -- is in no danger of becoming obsolete. Nonetheless, the historical link between the nation's money supply and inflation has all but collapsed. The money supply jumped sharply in the mid-1990's, yet no acceleration of inflation followed.
In the early 80's, the German, American and Canadian central banks adopted targets for money growth. But that experiment had barely begun when new financial innovations -- everything from money market accounts to electronic money transfers -- produced gyrations that all but rendered the money supply useless as a target for controlling inflation.
Alan Greenspan, the chairman of the Federal Reserve, made it official in 1993, announcing that he was no longer paying attention to the money supply -- even though the Fed is still required by law to publish monetary growth targets.
> I agree with Nasar on this one. But it should be remembered that one can be very conservative, like Alan Greenspan, without being a Friedmaniac conservative. He's a follower of Ayn Rand.<
World growth = Higher oil prices
Since energy stokes the machinery that drives the global economy, it seems perfectly reasonable to expect oil prices to rise during periods of economic growth.
Much of the global economy is growing now. But the price of a barrel of oil, if one takes inflation and changes in the value of the dollar into account, is about the same as it was on the eve of the Arab oil embargo of 1973 (around $3 in 1973 dollars). ''It's definitely a surprise,'' says Geoffrey Heal, an economist at the Columbia Business School: ''The conventional wisdom is that growth pushes up commodity prices.''
What happened to the forecasts of $20 a barrel oil? Three things. Despite the proliferation of four-wheel-drive vehicles and outsized family homes, average energy efficiency is way up. Second, the spreading recession in Asia, a heavy user of oil, has cut into demand. But the main reason for low prices is a flood of new oil supplies. Not only is Iraq back in business, but hardly a day goes by without an announcement from another former Soviet republic of a pipeline project.
> This seems basically correct. The downside of falling real oil prices should be noted, however. It encourages more use of a global-warming-promoting fuel. <
Stock prices = Earnings expectations
The value of stocks has quadrupled in the past six years, adding a staggering $1 trillion to household balance sheets in the last three months alone. Share prices are so high, in fact, that almost all measures of valuation are at record levels (and these records go back in some case to 1871). The rule of thumb is that when prices step out of the bounds of historical norms, investors had better watch out.
Some experts argue that the old rules no longer apply. Stock prices reflect the riskiness as well as the expected future returns of the investment. Jeremy Siegel, a professor of finance at the Wharton School, argues that stocks aren't as risky in the long run as everybody always thought they were, compared to low-risk investments like bonds. Since 1871, stocks have risen more than twice as fast as bonds -- 7.0 percent a year versus 2.8 when adjusted for inflation.
Thus, Mr. Siegel says, people are smart to pay a lot for the fast-growing stocks of the present bull market. There is some evidence, from surveys as well as the investment choices of participants in large retirement funds, that investor attitudes have indeed changed.
If Mr. Siegel is correct, the fact that today's share prices are historically high in comparison to companies' earnings doesn't necessarily mean stocks are overvalued.
But the Yale economist Robert Shiller cautions that the same ''new era'' claims were being made during another huge run-up in the stock market. He quotes a fellow Yale economist, Irving Fisher, who said in 1929 that, ''It was only as the public came to realize . . . that stocks were to be preferred to bonds . . . that the bull market began in good earnest to cause a proper valuation of common shares.''
> I think that there's a rational core to the stock market exuberance: the high profit rate means that companies can buy back their own stock, while the rightward shift in the income distribution gives more income to those who are most likely to speculate on the capital-M Market. The run-up of asset values encourages the rich to accumulate debt, while the poor are being pushed deeper in debt. We should pay more attention to net worth rather than simply assets.
> Given this, we should examine how stable the high profit rate and the rightward shift are. Is the economy going to continue to make the rich richer, with their incomes coming from increased private investment, luxury spending, and exports? Or will it follow a scenario similar to that of the late 1920s, as described in my 1994 article in RESEARCH IN POLITICAL ECONOMY? (note: self-serving plug) <
>By the way, I quoted Nasar's entire article, leaving not a word out.<