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Monday, July 21, 2003

Part II THE PROSPECTS OF THE US ECONOMY CONTINUED: WHY THE ODD JOBLESS RECOVERY SO FAR? Final Version

Originally published June 5, 2003, this is a revised, updated article on the prospects of the US economy. It replaces that earlier version, which is still missing and will continue to elude us until the buggy prof's web-manager is able to retrieve and then install the archives between April 19th and July 2nd.

Like its first six or seven predecessors, this article is an ongoing installment in a series on the economics profession and the US economy's prospects, this year and in the future, that began in May 2003. More to the point, consider the article as part II of a mini-series on those short-term prospects. Part I was published yesterday, July 20th . . . an updated version, essentially, of the original article and mini-series that started in early June. Part III will materialize tomorrow. All in all, there'll be about 5 or 6 parts here.

Remember, the short-term's our current preoccupation. Later on, in a new series of articles, we'll deal with the long-term future of the US economy --- say, the next two or three decades. Hard to foresee with any reliability any farther into the future. And when we finally get around to that new series in a couple of weeks or so, our perspective, it's worth stressing now, will be increasingly comparative. The primary aim? To tease out the ways in which economic growth and technological dynamism across countries, especially potential great powers that could rival the US --- China, maybe a unified EU, possibly a revived Japan --- will likely affect the global distribution of power.



THE MAIN PROBLEM: SLOW RECOVERY AND A DETERIORATING JOB MARKET

As the previous article noted, Part I of this two-part mini-series, the US economy's recovery from the recession of 2001 has been OK in terms of GDP growth --- which is why most analysts think the recession itself ended by the start of 2002 --- but has been disappointing in creating jobs, whether for laid-off workers or new entrants looking for work. The two growth rates, of course, are interconnected, with the causal influence running from faster rising GDP to eventually faster job growth.
More to the point, fairly slow GDP growth has been in line with what we would expect after a shallow, short-lived recession. Consider the evidence. Both recessions, the one in 1991 and the one we're still feeling the after-effects from in 2001 lasted about 9 months, and if anything, overall growth in 1991 was worse: -0.5% as opposed to a positive if mediocre 0.3% in 2001. In 1992, the economy started recovering and posted a GDP growth of 3.0%; in 2002, it was 2.4% and not much different . . . at most, a fifth less growth, hardly something to fret about. See the table at the Bureau of Economic Analysis

 

How Underperforming Is The Job Market?

How seriously the US economy is underperforming in job creation compared to earlier recoveries is another matter. Some observers, hardly Bush-haters, see it as horrific. In particular, The Wall Street Journal article that the buggy prof linked to yesterday claimed that it was the worst job market performance since the Great Depression. The main evidence for such a startling claim? The unpublished work of a Federal Reserve economist, Ms. Groschen, that showed an increase to 75% of firms restructuring and downsizing in the current recession and recovery as opposed to past ones (50% of such firms). Leave aside the figure about restructuring. No reason to question it. The claim itself -- which is the journalist's, not Dr. Groschen's --- seems exaggerated. In particular, the job market appears to be doing only slightly worse compared to the 1991 recovery. To see this, go to this Bureau of Labor link. Note too, since I'm clarifying sources, that the Groschen study hasn't made available to the public, not even as a working paper; that's clear from visiting her web site at the Federal Reserve of New York.

More generally, observe from the Bureau of Labor table two other key comparisons.

  [1] How much higher unemployment was throughout the 1980s compared to the 1960s and the first half of the 1970s, and again compared to the recent period since 1994.

That's because the dilemma of dealing with rising unemployment and rising inflation after the oil price rises of 1974 and again 1979 became acute, with the Federal Reserve finally deciding in 1979 to target inflation and bring it down, if need be with a recession --- there were two brief ones in 1980 and again 1982, the latter big in unemployment (9.7%), but fairly short-lived. Specifically, in 1979, unemployment was down to 5.8% (after five years of steady rise, peaking at 8.5% in 1975), and then from the high-point of 9.7% in the 1982 recession, it fell slowly the next few years. In 1987 it dipped below 7.0% for the first time; two years later, it reached the lowest point in the entire decade --- 5.3%. To repeat: 5.3% was the low point of the decade . . . a fairly lackluster job performance compared to the 1960s and early 1970s, to say nothing of the 1990s. Small wondr that as the 1990s started, the economics profession and the Fed alike agreed that the "natural rate" of unemployment --- the rate below which macroeconomic stimuli couldn't bring the level without setting off accelerating inflation --- was actually somewhere between 5.5 6.0%. Needless to say, they were wrong.

 

[2] Something no less important: how much higher the percentage was in the 1990s of Americans who worked --- the participation rate of the eligible population holding jobs, 16 years and older --- compared to the 1960s, 1970s, and the first part of the 1980s.

In the 1950s and 1960s, that participation rate was around 60%. At the start of the 1980s, it had climbed to 63.5% --- which meant that a fully employed economy now had to find jobs for about 4 million more Americans than just a decade earlier, on top of normal population growth. By the late 1980s and throughout the 1990s, the figure was even higher: about 67.0% on an average --- another 4 million roughly. By contrast, the EU countries --- faced with rigid labor markets, high labor costs and high social security taxes, plus other impediments to creating new businesses and jobs, especially in the service sectors --- found their participation rate was steadily dwindling from the 1970s right until the end of the 1990s, when it began to recover. At its low point, it was around 59.0% --- where it's headed again. (If you look at the percentage of the US and EU populations 18 years or older --- something that international comparisons use, for instance those of the OECD --- the gap is even greater. In 1975, the great divide in post WWII growth for all the industrial countries --- it more than halved, with only the US recovery its earlier post-war GDP growth rate --- both US and the current EU countries employed around 62% of their populations.

The US figure, remember, then climbed throughout the 1980s and 1990s, stabilizing in the latter decade at around 71%. The corresponding figure for the EU was 59-60%, briefly exceeded in the short-lived boom there of the late 1990s, only to fall back again. It's a clear sign of how hard it's been for the EU countries on the whole to create new jobs in line with population growth, and the numbers of young job-seekers who can't find gainful work.

Remember, the key point here is that the natural rate of unemployment in the US economy had improved markedly by the second half of the 1990s: the economy could now sustain growth over several years and reduce unemployment to somewhere between 4.0 - 4.5% of the US labor force without igniting an inflationary surge. In the 1980s and throughout the early 1990s, almost all economists and policymakers thought that the natural rate was much higher --- somewhere between 5.5 - 6.0%.

 

 

A Key Question Prompts Itself

What explains this great improvement in the US job market (which is the same thing, as we'll see, of asking what explained the great improvement in our long-term GDP growth trend)? The Answer: Supply Side Improvements . . . several of them:

 
  • First and foremost, higher productivity levels that would allow the economy to perform below the former "natural rate" without setting off inflation .. . exactly what happened in the 1990s, thanks to big breakthroughs in ICT and above all the ability of business firms and work forces to learn how to make better use of computer technologies for organizing and performing their tasks. That always takes time, sometimes decades. That was also the case with the other radically restructuring technologies of previous long-wave breakthrough innovations: electrification, for instance, didn't substantially alter the performance of the US economy for about 30 years. Fortunately, as the pioneer in the information-industries, US business and labor adapted the fastest, and hence the big productivity jumps of the last part of the 1990s --- still being sustained (a reason, as we'll see, for businesses --- faced with so-so sales --- getting along with fewer workers since 2001, and no big incentive to start hiring back laid-off workers or creating jobs for new entrants unless sales and profits increase. We are, it seems, faced with such increases starting the latter part of this year.)


  • The role of increased competition in the US economy --- owing to deregulation and far more exposure to imports (not least thanks to an accelerating dollar from 1995 on) --- reinforced the incentives of business managers to buy more and more Information and Communication technologies, including the ability to use the Internet now for purchasing component parts on a world-wide basis and to manage inventory far more efficiently. A clear sign of the accelerated incentives: ICT investments were about 2.0% of GDP at the start of the 1990s, then climbed to 7.0% in 2000 --- an extraordinary jump, with no parallel in US history of such fast-paced investments when new leading-edge technologies erupted into existence. (For a good overview of the productivity increase, including some good bibliography, go to DeLong is a perceptive economist, with an uncommon basis in historical economic studies, quantitative and comparative, who brings his historical perspectives to bear on current problems and prospects. When he deals with more political matters, alas, he's out of his depth and resorts, I fear, to ideological convictions in noticeable ways.
  •  

     

    Indicators of the Big Improvements:

    A clear sign of the big productivity jump: from 1973 to 1995, labor productivity increases in the US economy more than halved compared to the 1950s and 1960s: they grew about 1.4% annually for those 22 years. Then the big jump. After 1995, productivity began rising annually at 2.8% until the recession of 2001; then averaged 2.7% through the recession year of 2001, and then have risen rapidly again in 2002 and into the first quarter of this year. As a result, the economy's GDP real growth moved ahead yearly at 4.2% until the recession ---- with inflationary problems non-existent.

    The impact on the labor market was direct and immediate. At the start of 1995, as the Bureau of Labor stats show, unemployment was still over 6.0% ---- the level, remember, that most economists and probably most of the governors of the Federal Reserve regarded as the basement below which monetary policy couldn't bring it without stimulating inflationary expectations and hence a new accelerating price-rise trend. Thanks to the big improvements in US labor productivity, though --- thanks too to the courage of Alan Greenspan who was a bold optimist about these improvements and managed to convince the other governors to not raise interest rates (even to lower them after 1997) -- the economy performed with admirable whirring-and-clicking: GDP growth accelerated, the currency crisis of 1997 was navigated around and its dislocations avoided, and unemployment continued to fall steadily: by the end of 1995 it was down to 5.4%. then started to fall below 5.0% the following five years, reaching a trough of 4.0% in 2000. Even in the recession year of 2001, throughout most of it anyway, unemployment didn't start rising above 5.0% until the start of 2002.  

     




    Three major points in the analysis up to now are worth singling out and stressing. If you remember nothing else so far, try to keep these each in mind:

    [1] The recovery from the 2001 recession has been disappointing, both in GDP growth and in the job market --- especially the latter. Still, it's hardly the worst job market since the Great Depression as the Wall Street Journal article by Hilsenrath claimed: both the growth in GDP and the behavior of the labor market are more or less in line with what you'd expect, given the change in recessions: far less frequent and much shallower. For that matter, various regions are hit much more hard than others. California, especially the Bay Area, remains in a recessionary mode; the east coast has suffered more than the Mid-West and South.

     

    [2] All that granted, ponder a set of related pivotal changes since 1995 in the US economy's long-term growth trend --- its potential output --- and their policy implications:

  • Thanks to the big productivity surge after 1995, our long-term growth trend has risen noticeably from roughly 2.0 - 2.5% GDP annual growth between 1975 and 1995 to somewhere between 3.5 - 4.0% . . . much closer to what it was in the 1950s and 1960s.


  • In the upshot, the natural rate of unemployment --- more concretely, the NAIRU (non-accelerating inflation rate of unemployment) --- has improved considerably, and all to the good. That makes it possible for the US economy to perform near the point of full-employment as defined in the 1946 Unemployment Act, 4.0% of the labor force, as was the case between 1950 and 1975 and again between 1995 and the end of 2000 . . . with no sign of appreciating inflation.


  • Simultaneously, that higher potential output of the economy and hence its higher full-employment level will likely coincide with a strong growth of average and low-wage incomes.


      • Specifically, to clarify the latter point, the bottom 20% of American wage-earners barely saw any increase in their income between the 1975 watershed mar --- when the growth in the industrial world slowed down markedly everywhere, including in Japan and the EU --- and 1995: essentially, 0.2% rise annually. For that matter, the real growth of average income was much slower between 1975 and 1995 too: not much more than 1.0% on an average each year. Then suddenly, after 1995 --- as the economy was running near full employment and productivity gains were kicking in --- annual incomes were proceeding at about double that rate yearly, and believe it or not, the incomes of low-wage workers (who were very much in demand) now grew faster than those of high-wage workers, which means the professional and managerial classes.


     

    [3] As the economy's long-term performance soared after 1995, an improvement matched by economic growth each year --- meaning, in technical terms, annual GDP growth was essentially tracking potential output and sustaining full employment of around 4.0% with no inflation --- then, simultaneously, people's expectations have risen too. Consider the history briefly.

    Few Americans now remember the dismal days of the 1930s Great Depression. The prosperous 1950s and 1960s were then followed by the big structural problems of the 1970s: huge oil price hikes, a big upsurge in the inflation rate, and the sudden dilemma of rising inflation and rising unemployment at one and the same time . . . a double-whammy that contradicted the dominant Keynesian guide to the economy in those days, the Phillips curve. The need to choke out inflationary expectations culminated then in the brief but scary recession of 1981, with unemployment spiraling rapidly to double-digit figures, only to come down rapidly in the years following. The 1980s reflected an improved economy, but subject to two big qualifications: unemployment never got below 6.0%, with the natural rate assumed by most economists to be that, and average incomes hardly rose at all, while the bottom 20% of wage-earners saw a steady decline of around 1.0% a year in their incomes. Only two income-earners in a family kept average household income from falling.

    The early 1990s weren't different.

    The natural rate of unemployment seemed to be around 6.0%, something that couldn't be reduced by expansionary monetary or fiscal policies without sparking off new inflationary surges. GDP growth was also in the 2.0-2.5% range, and there was even a recurring scare of downsizing as US firms --- facing new competition in global markets and at home --- continued the struggle of the previous 15 years to restructure and become more competitive even as the new ICT technologies were still not fulfilling their promise of higher productivity performance, either on the level of business firms or nationally. All that changed after 1995. Employment soared; productivity soared --- not least because managers and employees were beginnign to get the hang of how to work smarter thanks to the new technologies and ideas of running business firms more successfully; GDP growth leapt ahead around or over 4.0% for the next six years; and above all average incomes rose rapidly for the first time in two decades --- and, to everyone's surprise as labor markets tightened --- low-wage income earners actually saw their wages rise faster than those at the top of the wage-pyramid. (Not to worry about the very affluent and rich: they were reaping huge gains on the stock-market, a bounty sustained by few of them after the stock market balloon burst in 2000).

    The outcome of all this overlapping progress? People's expectations have changed. Even the 1970s and the stagnant income growth of average workers in the 1980s seem to have been forgotten, as distant in American memories now as the 1930s. We rightly expect that the economy should be creating lots of jobs, good ones to boot, with the productivity gains of the post-1995 period not just sustained but spilling over into rising incomes for average and low-wage Americans.  

      GROWTH PROBLEMS REMAIN ALL THE SAME

    For Jobs To Be Created: A Higher Potential Output of the US Economy --- Its Long-Term Growth Trend --- Requires Higher Short-Term GDP Growth

    None of the above reasoning doesn't mean there aren't problems with the pace of the economy's growth and job-creation. And paradoxically, they seem connected with the big long-term structural improvements in the US economy and people's justified expectations.

    Specifically, this has driven a wedge between the economy's long-term potential output and real short-term GDP. In particular, if the potential output of the economy --- defined for the moment as the long-term growth rate over the next decade or two (or more) that can be sustained without inflationary problems --- has improved the last few years, say from a disappointing 2.3-2.5% annual rate between 1973 and 1995 to about 3.5% since that year, then Aggregate Demand in the US economy has to rise to that level and produce actual GDP growth each year for new jobs to be created overall on a sustained basis.

    Ponder this line of reasoning carefully, particularly the long last sentence. If anything, its pivotal point about the US economy's prospects --- abstractly stated to be sure --- is probably understated. Why?

    Well, given that the economy has lost about 2.1 million jobs since the recession started in March 2001, annual GDP would have to exceed the potential GDP output of 3.5% for a while --- say, a couple of years depending on the pace of job recovery. [(Brief clarification of the components of Aggregate Demand: C (private household consumption), I (business investment, including new inventory orders), G-T (government spending minus taxes, at all levels of the US federal system), and X-M (exports-imports).

     

    The conclusion? It's worth putting in bold too.

    In plain language, until Aggregate Demand picks up noticeably, then business firms --- facing fairly lackluster sales to domestic customers (consumers and other firms) and foreign customers by way of exports --- will continue to do what they've done for the last year or so in the recovery: their managers will find that it's safer to get by with fewer workers than before, something they can do because of the higher productivity of their workforce.

    Only when sales pick up and profits along with them --- and, moreover, they look like staying there to the owners and managers of firms --- will individual firms start increasing their inventory orders, buy new machines or even expand their plants, and hire back laid-off workers and create jobs for new job-seekers. And at some point, thanks to the dynamism of the US economy, we can expect the economy to continue to do effectively what it has for generations: create new products, improve existing ones, and hence create new firms that succeed in the marketplace and create entirely new jobs that didn't exist before. That's hardly speculative. One out of 12 Americans have been found in recent studies to create a new business each year --- most of them small of course, including mama-papa stores and one or two-man gardening services, but some with giant promise such as Wal-mart or Microsoft or Intel or CNN or Amazon or Oracle or Yahoo that didn't exist a generation ago. By comparison, 1 out of 33 Italians and Britons create new businesses on a yearly average, and the figure falls to about 1/50 for the Japanese and Germans.

    The revealing chart that the WSJ article by Jon Hilsenrath has puts all this in good graphic form. Go to the link and find the chart on the left side. What it shows is that in every economic recession since WWII save for the brief recession in 1991 and the current one, real GDP growth outpaced productivity growth in the recession, and hence when recovery began --- something not shown alas (though you can make some inferences about the 1982 recession and recovery from the BEA link) --- firms were more willing to call back laid-off workers.

    To put it differently, recall further from the Hilsenrath WSJ article and his references to the work by Ms. Groshen, that only 50% of US firms before the 1991 recession were restructuring and downsizing in the recovery-phase after those recessions. Since then, it's now 75%. Only faster growth in Aggregate Demand --- and hence in real GDP, enough to outpace the growth of productivity's new long-term trend --- will apparently offset the continued concerns of firms to produce goods and services at existing levels of sales and profits with fewer workers than would have been the case in the past. For the long-term health and economic growth prospects of our economy, it's good news. It isn't for the short-term and new job creation, unless (as we'll see) Aggregate Demand picks up much more than it has so far. A higher performance-standard is now needed to create more jobs again.

    Note: should the WSJ link to Jon Hilsenrath's article not show up on your computer, here's the chart in question. Remember, it belongs to the Wall Street Journal and Hilsenrath, and all citations should carefully note this.

    USjobs (11k image)  

     

    MORE CLARIFICATION

    The above points, purposefully stated in fairly abstract terms --- we'll get to some actual real-world trends in the economy at the end of this article (or more likely in its successor) --- need to be fleshed out and explained briefly.  

    First, recall the triad of causes that have improved the long-term growth potential of the US economy since 1995.

  • The higher level of labor productivity and its pace of growth --- sustained and even, remarkably for the economy, increased during and after the recessionary period of 2001 --- thanks largely, it appears, to a remarkable investment in ICT technologies and the eventual mastery, a long-term process of years or decades, by managers and their workforces within firms (and bureaucratic agencies) of how to make good use of these new information and communication technologies.


  • The ever greater competitive nature of our economy, a result of de-regulation in product markets and far more exposure to international competition in the US home market: mergers and take-overs have accelerated the pace of restructuring and downsizing to make firms more competitive.


  • The big progress in reducing the natural rate of unemployment, from around 6.0% at the end of the 1980s to apparently 4.0 - 4.5% at the start of 2001.


  •  

      Second, Potential Output needs to be clarified.

    It's the maximum GDP growth rate that can be sustained without creating inflation, particularly of an accelerating sort. If actual GDP as it rises or falls year to year fails to reach potential output or come close to it, then short-term unemployment will be higher than the natural rate . . . which is probably around 4.5% these days, though it's worth remembering here that in the years between 1996 and the end of 2000 it fell to 4.0% or so and stayed that way.

    Be sure to grasp that potential output is determined by overwhelmingly supply-side matters, which together explain long-term economic growth: the input-contributions to long-term growth of a

    [1] growing capital stock (machines, plants, infra-structure); [2] the growth of the labor force and hours worked; modified by

    [3] improvements in the quality and skill-levels of the work force --- formal education plus, something very important, on-the-job training and experience; and

    [4] technological progress, broadly defined to mean improved knowledge, whether embedded in new or better machines, better marketing, better managerial organization of the labor force, and so on.

    [5] the institutional and policy framework of the economy:

     

    Third: The Key Importance of An Economy's Institutional and Policy Framework

    The latter, the institutional and policy framework of the economy --- sometimes called its social capability --- can't be exaggerated in importance. It refers to a complex of matters that economists have generally shied away from until recently, mainly because of the problems that quantifying them for statistical modeling cause. They're critical all the same and interact with all the first four factors. What institutions and policies do we mean? Here's a list of key ones:
  • the quality of financial institutions (banks and stock and bond markets, brokerage firms, insurance firms, venture capital) that bring savers and investors together and allocate capital for productive uses;


  • legal institutions that protect private property and innovations through patents and copyrights, and also prohibit and punish corruption by officials and political leaders while ensuring good accounting methods in the financial and business sectors;


  • the quality of the R&D base of the economy, including its educational institutions --- especially universities and technical schools and their links to the business world;


  • the ease or not of social interaction that facilitates innovation and start-ups in complexes like Silicon Valley or around Route 128 in Boston. Related to this would be the degree of trust in any one national society, which facilitates spontaneous cooperation across family, class, regional, or ethnic-racial lines in the society.


  • the dynamism of economic actors, including risk-taking entrepreneurs and investors, without punishing failure excessively. Optimism about the future --- or oppositely pessimism and hence an entrenched resistance to changing the economic and social status-quo of a country --- also figures prominently here, just as it varies across countries considerably as do all of these institutional and policy matters.


  • If there is comparatively good performance on these institutional matters, then the long-term growth prospects of the economy --- its sustainable, non-inflationary potential --- will be impressive on an international basis and show that the economy is capable of good flexibility and adaptability, even when big dislocations occur as they did in the big oil price rises of the 1970s or earlier during WWII and right after or in the resilient ability more recently of the US economy, as Alan Greenspan noted in early June, to absorb a big stock market crash in 2000-2001, then the financial scandals that were uncovered at the same time, then the 9/11 terrorist attacks, and more recently the war with Iraq . . . for that matter, add high oil prices the last three years. In the past, say before the end of the 1980s, Greenspan noted, we wouldn't have suffered only a short-lived recession, we would probably have seen a far deeper, more serious economic downswing. We haven't. Our economy has become far more productive and adaptive.

     



    Fourth, our list hasn't mentioned yet one other key institutional arena --- government and its policies for the economy.

    In particular, long-term growth potential in the US or any economy --- including its levels of capital investment, the growth and quality of its labor force, its technological progress, and its innovative and risk-taking propensities as well as its overall flexibility --- will hinge in no small part on: the quality of political leadership and administrative agencies, in particular their ability to correct market failures without overregulating the economy, overtaxing private savers and workers and hence undermining economic incentives, and closing it off from domestic and international competition through too many subsidies, tariffs, quotas, and ineffectual nationalizations. For the US, deregulating product markets has been a big plus in reinforcing new competition. By contrast, under-regulating financial institutions --- stock markets, brokerage firms, accounting firms, accounting procedures used by all businesses --- has backfired and reinforced the problems of a stock-market recovery since 2001's financial scandals hit the headlines. And of course a sound money that doesn't lose its value quickly owing to government overspending or over-permissive monetary policy --- the bane of Latin American economies for decades after 1929 until recently --- is crucial too.

     

     

    FURTHER CLARIFICATION: THE OUTPUT GAP IN THE US ECONOMY

    Against this background, we can now deal more directly with the underlying problems of slow GDP growth and job-creation in the US economy the last year and a half or so, ever since the economy ended its shallow recession. (Remember, that's nation-wide. Some regions, like Northern California, have been badly dislocated and can still be regarded as in recession.) Consider the following points carefully:  

    [1] The Long-Term Growth Trend of the Economy Changes Slowly. Potential output --- the long-term growth trend of an economy --- doesn't change monthly or yearly except in two sets of circumstances: 1) when clustered waves of revolutionary technologies occur and shift upwards the growth trend (think of electrification and the internal combustion machine after the 1890s or ICT since the 1970s); or --- oppositely --- 2) big disruptive shocks throw the economy off its growth track and policymaking doesn't effectively cope with the downturn. Think here of the policy failures after the 1929 stock market crisis and deflation, which kept the US economy from recovering in the 1930s and maintained an unemployment rate near or above 20% throughout most of the decade (with some ups and downs). Needless to say, the impact and response abroad were severely dislocating too, except that Nazi Germany, when Hitler came to power in 1933, found a sustained fiscal stimulus that brought down unemployment there quickly: huge steady rearmament, the key preparation for its subsequent effort to conquer Europe and the world. Again, think of the decade-long plunge in post-Communist Russia in GDP growth --- as policymakers struggled, only half successfully so far (GDP growth has been around 6.0% for three years or so, but limited to a handful of sectors, especially petroleum) --- to create the institutional base of a market economy

    Otherwise, except in these two sets of cirumstances, the trend line of long-term growth in countries like the US and West Europe and, more recently, East Asia (save for Japan), is steadily upward over the decades. For instance, the US economy's potential growth trend has been remarkably stable since the very early 19th century: about a steady increase in annual per capita income of about 2.0% a year, with the late decades of the 19th century showing a steeper upward angle (hence a growth rate that rose by about 50%), then stabilizing again until the 1930s, and then rising upward again at a steeper angle from the start of WWII for the next three decades until 1973. Between 1973 and 1995, remember, the long-term growth trend for the US economy (and all other industrial economies even more) markedly slowed. It was reflected in the much lower productivity rate here (and abroad). For the US, labor productivity had grown nearly 3.0% a year over those previous three decades. Afterwards, until 1995, it fell and stayed stuck at around half that rate of increase; and it was only after 1995 that the work force of firms and agencies began to make good use of the ICT breakthroughs of the previous two decades . . . the pace of change accelerated, recall, by the sharply increased nature of competition, domestic and foreign, in the US economy.

    The upshot?

    Thanks to that big leap forward in productivity and efficiency, the economy could grow faster again --- at a real 4.20% a year for six years. Simultaneously, unemployment could be brought down to the 4.0% level once more that had prevailed throughout the 1950s and 1960s; and --- something often overlooked --- and average and low-wage incomes could bound ahead too compared to the past. In short, the US economy had and apparently still have --- given the surprising big spurt of productivity growth last year (around 4.0%) --- a much higher potential output than before. It appears to be somewhere around 3.5 - 4.0%.  

     

    [2] Enter Real GDP Growth, Which Fluctuates Over the Years

    So we now have, to repeat, a much improved long-term growth trend in the US (potential output has sharply risen.)

    By contrast, if the potential output of an economy changes little except when these 40-60 year waves of radical, leading-edge technologies erupt onto the scene --- or huge shocks like wars or OPEC energy price rises materialize --- actual GDP growth fluctuates considerably year to year (or anyway every few years): hence what we call the business cycle with its ups and downs over a 4 - 5 year period in the US economy between 1945 and 1982, and more or less every 10 years since then.

    Such business-cycle swings can be sharp: hence the plunge in the 1930s in economic growth, and the big slowdown after 1975. They can also be modulated, as has been the case since 1982 when recessions --- which marked the US economy every 4 to 5 years after 1945 until then --- became infrequent and shallow: one lasting 9 months in 1991, with output for the year a - 0.5% (compared to 1.8% and 3.5% for each of the two preceding years; and the only other, 2001, also lasting 9 months and the year finishing with a 0.3% growth after being preceded by 3.8% in 2000 and 4.1% in 1999.  

     

    [3] What Causes These Fluctuations in Real GDP, Sometimes Sharp in Nature?

    The answer creates big controversies among macroeconomists. It separates New Keynesians from monetarists and rational-expectations theorists. Most, however --- save for what's called real business cycle theorists --- think the fluctuations in real GDP over the years that create the business cycle's ups and downs have to do with Demand Side variables such as changes in consumption and investment patterns in the private economy, changes in government spending (including deficits or surpluses), and above all changes in monetary policy as conducted by the Central Bank --- the non-governmental Federal Reserve in our case. And especially as all of these are reflected in the changing expectations about the health of the economy, now and in the future, on the part of key economic actors, and their resulting behavior:

    -- [1] households as consumers and savers,

    -- [2] business firms as investors and job-offerers,

    -- [3] workers as wage-earners and what they expect,

    -- [4] and the influence on all of them of government policies as well as those of the Federal Reserve.

    (Note that Real Business Cycle theory, developed since the 1980s, holds that the fluctuations in GDP are caused by "real" changes in the economy, above all changes in technology, as opposed to the influence of "nominal" or Demand-side variables such as changes in the money supply and interest rates or in government spending. Its arguments are fairly technical and won't be dealt with here..)

    It's the shifts in those expectations about the future and related behavior at present --- matters of the Aggregate Demand curve of the economy shifting up and down over an upward slanting and fairly stable, slowing rising Aggregate Supply Curve --- that explains the ups and downs of annual GDP growth: in particular, because of swings in stock and bond markets; the savings level of the economy (and the flip side, the consumption level); taxes and fiscal deficits of the government; the vigor or lack of it behind business investment and job-creation depending on sales and business expectations for the future; orthe demands of workers for certain wages and the willingness of managers or entrepreneurs to meet those demands or not, as well as creating new jobs.

       

    [4]What follows theoretically?

    Essentially, despite the ongoing macroeconomic flare-ups --- which again reflect largely views about the stability and efficiency of the market economy (viewed as an aggregate) compared with views about the ability of governments to improve the workings of the private economy, but with the debates carried out in technical modeling form --- everyone now agrees since the early 1970s that all macroeconomic policymaking, whether fiscal or monetary, plus all regulatory behavior, has to be traced through carefully onto the expectations of individual economic actors in the private economy. It's for his path-breaking work here in the 1970s and 1980s that Robert Lucas of Chicago, a younger colleague of Milton Friedman, eventually won a Nobel Prize, though Robert Barro of Harvard probably deserved one too.

    All this, as we'll see, has led to a major hot-wire debate in the economic profession and among policymakers and pundits about the likely impact of the current expansionary policies to raise the short-term growth rate of the US economy and bring it closer to its new and higher long-term rate . . . somewhere in the neighborhood of 3.5 - 4.0%, which would coincide with the newer, more sustainable level of unemployment of around 4.0 - 4.5%. This output gap between current GDP growth of around 2.- -2.5% annually and the higher potential output of the economy --- which is the same as its long-term growth rate, to which the lower natural rate of unemployment coincides --- has been, remember, one of the culprits in forcing unemployment to continue to slide the last 27 months or so since the recession officially ended in the fall quarter of 2001.

    The expansionary policies --- very low interest rates, accelerating federal deficits (on the order of $450 this year, and probably $400 billion next year --- about 4.0% of GDP each year) --- may or may not work, given this debate.

  • It pits, essentially, New Keynesians like Gregory Mankiw of Harvard, Bush's new chairman of the Council of Economic Advisers, with the support of supply-side economists against three different strands of new classical economic theories --- supply-siders themselves otherwise part of the reaction against original Keynesianism as a guide to understanding the national and global economies and their interaction as well to helping policymakers:


  • Monetarists, who believe that deficit spending won't work to stimulate short-term economic growth because of crowding-out, explained in the next article. Essentially, what happens is that to finance new or expanding federal deficits, the US Treasury sells new Treasury bills and bonds to the public. In the process, these sales compete with private investors for national savings. The result? Interest rates will rise to choke off private investment and borrowing by households that want to buy residences or autos or other durable goods with credit.


  • New Ricardians, especially Robert Barro of Harvard, the pioneer of this revived insight of the great 19th century English economist David Ricardo, who argue that deficit spending won't stimulate short-term economic growth because any tax-cuts the government undertakes that lead to new deficits --- or greater deficits now and in the future --- will be fully offset by the public saving all the money. Why this? Because the public expects that tax cuts not matched by reduced government spending will have to be financed in the future by future tax raises of an equivalent or larger amount.


  • Real Business-Cycle Theorists, who contend that the business-cycle's ups and downs reflect wholly supply-side phenomena --- especially the disruptive impact of new technologies --- and who therefore argue that there is nothing policymakers can do to reduce the depth or length of a recession as firms struggle to absorb the new technologies and competition in private markets prunes out ineffective and uncompetitive and outdated firms. Not only that, policymakers can't therefore accelerate the pace of the upturn in the business cycle either --- as the Bush administration on one side, and the Federal Reserve on the other with its low interest-rate policies, think they can. Oppositely, they can make things worse . . . both in the short- and long-term for the economy's health.


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    ALL TO BE AMPLIFIED AND EXPLAINED IN PART III OF THIS MINI-SERIES ON THE ECONOMY, AND ON INTO PART IV, STARTING TOMORROW (July 23, 2003)