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Wednesday, July 23, 2003

PART III THE SHORT-TERM PROSPECTS OF THE US ECONOMY: CONCRETE REASONS FOR OPTIMISM. Final Version

First published June 9th as part of a mini-series on the short-term prospects of the US economy --- that original, along with the missing buggy-prof archive, still drifting aimlessly in cyberspace like the unplugged psychopathic computer Hal in Kubrick's 2001: Space Odyssey --- the current article that unfolds here has been revised and thoroughly updated and now links more tightly to the first two parts in this series. Another three or four are destined to follow soon, the whole series of articles adding up to a coherent argument . . . at any rate in principle, subject as always to bugged-out quirks and aberrations.

Note the sub-title here: "Reasons for Optimism." In reality, to imitate Alan Greenspan's comments in early June, "cautious" optimism would be more appropriate . . . the Fed Chairman warning us that the US economy might be facing the danger of deflation, a persistent, self-reinforcing decline in the general price level. Is this danger at all probable? Hard to know. Coy as ever in his oracular way, Greenspan was hinting, it seems, that the Federal Reserve was ready to do what it had to in order to keep deflation at bay: if need be, presumably, by flooding the economy with dollars. A few days later, in another speech that he gave, the "cautious" qualifier was absent: what now struck the Fed chief was the remarkable resiliency of the US economy, considering how it had quickly absorbed several sequential shocks to GDP growth in the three year period from early 2000 to early 2003 . . . above all, the ballooning stock-market collapse, then the auditing scandals that have scared off investors ever since, then the jarring destruction of the 9/11 attacks, then the surge in oil prices, and more recently the Iraq war and the other geopolitical uncertainties that cut short, for several months, the stock market rally of last fall. Just two decades ago, these shocks would have been more than enough, the Fed chief noted, to send the US economy into a huge recessionary plunge, not the brief and shallow one of 2001. Under pressure of such dislocating turmoil, our economy's ability to bounce back and sustain effective growth, however disappointing on the job market --- 2.4% last year, with the EU growing a mediocre 0.7% that same year and lucky to grow half that this year, and Japan still stuck in its endless slump (with a few brighter spots now appearing) --- was and is impressive, a point that Greenspan made in that speech, and one we can agree with, no?
Nor was that all. The Fed chief was particularly optimistic about the economy's growth prospects for the next couple of years, buoyed along by the lowest interest rates in a generation and the recent Bush tax cuts, not to forget the expansionary effects --- short-term to be sure --- of a soaring federal deficit this year and next likely to be well over $900 billion total. Each year of deficit, as it happens, will amounto to about 4.0% of GDP --- much lower than the 1992 Bush-Sr. deficit of about 6.0%, but obviously something you don't want to sustain at anything like that level in the years that follow.

 

PAWKY GREENSPAN PROVISOS

Note that the Fed chief didn't say the job market would pick up immediately. He was right not to. In economic jargon, job-creation is a lagging indicator: it responds after increases in consumer spending, business profits, and business investment, with the heads of firms deciding that rising margins and profits warrant hiring more labor.

The Fed chief also didn't predict what growth would be: that's not his job, though the Federal Reserve has its own forecasting models --- which vary across Fed Reserve regions --- and it isn't my task here either. At best, forecasting is an inexact science . . . despite dozens of highly touted ones in universities, at private research institutes, in private banks and brokerage houses, and in the Federal Reserve and government, each with their own complex, computer-driven models of the economy and different weighted variables. It's not only inexact, it may be highly misleading --- and for years at a time. Consider the recent record. In the 1990s, Greenspan --- a robust optimist who fortunately didn't heed the advice of the alarmed worry-warts on the Fed's governing board and raise interest rates after 1996 when unemployment came down under 5.0% for the first time in nearly two decades and hence, according to the pessimist alarm-bells, was about to set off a new inflationary bout --- joked one day that the Federal Reserve had some of the best economists in the world; and if they had been wrong and underestimated the strong growth of the US economy without inflation "the last 15 times, it didn't follow that they wouldn't be right the 16th time."

It puts you in mind, as a recent Business Week article noted (getting the joke a little wrong), of what happened to Einstein after he died. Greeted with warm enthusiasm by St. Peter at the Pearly Gate, he's led by a working angel to a waiting room while all the papers are dotted and signed for his entrance into paradise. There, in the waiting room, all seated, are three other just-dead types. Einstein walks over to the first, introduces himself, holds out his hand, and is told in return, "Hello, Dr. Einstein, my name is Joe and I have an I.Q. of 190." "Splendid," he replies, "we can spend some time chatting about the prospects of general relativity and how to relate it to quantum theory." The next person introduces herself as Kathy: "and yes, Dr. Einstein, my IQ tests at 160." "Oh, that's just wonderful, Kathy: if we have time, we can chat about the latest developments in mathematical philosophy and aesthetics." When Einstein reaches the third person, a man, he notices that the fellow won't look him in the eye, and when the man speaks, he sounds very sheepish. "Dr. Einstein, my name is Sid, and . . . well, I have an I.Q. of 80." Einstein reflects a moment, then smiling again says, "Well, Sid, tell me: what do you think GDP and inflation rates will be next quarter?"

 

Granted all that, the buggy prof is happy to spell out the reasons for overall optimism about the economy and discuss the possible pitfalls that have to be navigated by policymakers before we can be sure that we're entering a good, sustained growth period for a few years into the future . . . in GDP and jobs and personal income. And remember, this is the 7th or 8th article installment in an ongoing series about the US economy, and its short- and long-term prospects . . . the latter always viewed in comparative perspective, including the implications of relative American economic and technological dynamism for the global distribution of power a couple of decades or more into the future.

 

BRIEF SUMMARY OF THE PREVIOUS TWO ARTICLES ON THE ECONOMY'S IMMEDIATE PROSPECTS

[1] What the analysis in Parts I and II showed --- or tried to anyway --- is that GDP growth since the end of 2001 has been OK, and isn't much different from what happened after a similar, fairly shallow and short-lived recession in the early 1990s. Both times, the GDP fell only slightly, then recovered at about the same rate --- around 3.0% --- the first year: for the current recovery, that meant 2002. And both times, the job market continued to worsen in the first year after recovery. That's unusual, compared to all the previous recessions in the US economy in the post-WWII era.

  • Specifically, as the Bureau of Labor site shows, unemployment was 5.6% at the end of 1990 on the eve of the 1991 recession: it then rose sharply to 6.8% the year of the recession, and continued to rise in the first year of recovery to a peak of 7.5% in 1992 even though GDP growth was a real 3.0%. The news then remained bad for at least a year or two: GDP growth was down to 2.7% in 1993 and unemployment fell only slightly to 6.9%, and it didn't return to the 5.6% jobless rate before the recession at the start of 1991 until 1995 . . . four years later. For that matter, it didn't return to the low-point of the 1980s decade, 5.3% in 1989, until 1996 ---- five years later.


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  • To repeat: the disappointing current recovery in GDP growth and in particular the job market isn't unique --- isn't the worst employment performance since the Great Depression as the Wall Street journal article we cited in a previous article claimed. Instead, current unemployment at 6.1% is, if anything, much better than the 7.5% unemployment rate that materialized in the first year of recovery after the 1991 recession. (Just as the recessionary rate of unemployment in 1991 was much lower than the 9.7% horrendous rate reached in the previous recession in 1982.)


  • What is different now is that the percentage leap in unemployment has been higher. The 1991 recession ended with a 6.8% rate of unemployment; it grew to 7.5% a year later --- a jump upwards of about 11% --- and only in 1993 did it start to come down again. Slowly. Very slowly. Currently, by contrast, the 2001 recession ended with a 4.8% unemployment rate; and the jump to the current 6.1% of May 2003, some 17 months later, has been on the order of 25%. This never happened in the pre-1990's period. Unemployment would always come down, however slowly, in the first year after a recovery. It suggests that something new marks the US economy, a deep structural change.
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    [2] So what gives? Why is the job market still languishing in this country despite a near 3.0% GDP growth last year?

  • The difference this time is reflected in the US economy's new Potential Output --- which means the sustainable, full-employment long-term growth trend in the US economy --- that emerged after the 1991 recession and during the 10 year boom, the longest in US history. In simple English, Potential Output has leapt upward from 2.2% annual GDP between 1975 and 1995 to around 3.5% and maybe even 4.0%. The new trend-improvement first showed up in the late 1990s. The result? Not only faster GDP without inflation, but also --- for the first time in 20 years --- the ability of the economy to bring unemployment down to around 4.0%. In more theoretical terms, that meant the "natural rate of unemployment" in the US --- the NAIRU (the non-accelerating rate of unemployment) --- was now down to somewhere around 4.0%. And of course, as our analysis showed, Potential Output not only is the same as sustainable long-term GDP growth in the US, it's also equal to the "natural rate of unemployment."


  • Remember, Potential Output = Sustainable Non-inflationary Long-term Growth = Full Employment GDP. And the latter is the inverse in employment terms of the Natural Rate of Unemployment, the NAIRU. If the Natural Rate is now 4.0 - 4.5% --- which means the US economy can grow steadily into the future on its new long-term growth trend without stimulating new inflationary bursts --- then the full employment rate is 96% of the population actively wanting work. In the US, that's about 71% of the adult population between 18 and 65, a good eighteen per cent higher than the EU's equivalent rate.


  • Why has Potential Output and hence the long-term growth prospects in the US economy been improved, with its big boost to our living standards in the future? Essentially, as the previous article showed, for three related reasons.


      • Big progress in productivity, thanks mainly to firms finally learning how to make good use of the radically new information-and-communication technologies that the US largely pioneered from the early 1970s on.


      • New competitive pressures in the economy --- thanks to deregulation, globalization, and mergers, takeovers, and acquisitions --- that had emerged in the 1980s and induced the heads of firms to invest more and more in ICT and encourage their work-forces to learn how to tap the new machines and software more effectively.


      • Enrepreneurial dynamism, unique to the US economy, that created thousands of new firms --- from Microsoft and Intel to Yahoo, Amazon, and Wal-mart --- and that in turn helped transform the economy much more rapidly than in other countries . . . with 75% of the Fortune 500 companies in 1996 not in existence two decades earlier. The equivalent index of big companies in Japan and Germany, by contrast, have hardly altered since 1975.


     

    [3] What follows? Our key point. Bluntly put, the long-term improvement of American economic prospects has created a short-term problem: an output gap between actual GDP and potential full-employment GDP --- which reflects the underlying improvement. Specifically:

  • Whereas actual GDP growth has been OK and would have stopped the unemployment hemorrhage caused by a recession in the 1980s or earlier --- and prevented the jobless level from rising 22% in the initial year or year-and-a-half afterward --- it now has to be raised above the underlying productivity trend of 3.5 - 4.0% annually in order for jobs to be created. Remember, 3.5 - 4.0% annual GDP growth is what will bring the economy to its full-employment level as well. In contrast to the period from 1975 to 1995 when that full employment rate was about 94% of the work force, it's now risen to somewhere around 95.5% to 96.0% --- or roughly an unemployment rate of around 4.0 - 4.5%.


  • The only way to raise current GDP is by finding the means to stimulate AD --- Aggregate Demand (private consumption, business investment, government expenditures - taxes, and exports - imports) --- more than has been the case so far. (To clarify briefly this last component of AD: the US has, of course, been running a huge trade deficit --- imports > exports --- for several years now, and so a reduction in the trade deficit would further stimulate actual GDP growth . . . and a surplus even more. Technically, it's worth adding, the deficit isn't just in the traded good sector, but also the service sector . . . the two sectors adding up to what's called "current account" in the Balance of Payments. A deficit on current account is automatically offset by a surplus on capital account, both short-term and long-term capital flows. Double-entry book-keeping ensures that: it's really an accounting identity on the bottom line, where credit entries must equal debit entries. None of this is controversial. What remains a theoretical controversy is how to interpret the causal relations between the two main parts the Balance of Payments: the capital account and the current account for goods and services. We'll deal with the controversy later on here when we talk about the likely benefits of a cheaper dollar compared to just 18 months ago.)
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    [4] Add up the first three points, and what have we got?

    What we've got is a new challenging economy to fiscal and monetary policymakers . . . the latter in particular focusing for several decades until recently on the problems of inflation. Now the Fed is focused much more on upping the rate of GDP annual growth, to close the gap between Potential and Actual Output and bring economic growth closer in line to the full-employment level. And fiscal policy --- very permissive in the Reagan and Bush eras of the 1980s and early 1990s, only to tighten and in fact generate surpluses in the late 1990s under Clinton --- has to become permissive again, at any rate for a while.

    Hence the key challenges facing our policymakers, those in the Bush administration and Congress and those in the Federal Reserve . . . all of which prompts a question: do the policies they've initiated, together with certain recent changes in the private economy that we'll be explaining in a moment, look liking closing the output gap? The answer is yes, or so it appears . . . enough to justify the "cautious optimism" mentioned earlier.

     

     



    CONCRETE REASONS FOR OPTIMISM

    Essentially, despite the ups and downs in monthly trends --- consumer spending and confidence, employment, business investment (manufacturing, services), price indexes, energy prices, residential starts and purchases, and the like: all of which have to be plumbed for some trend-line amid the monthly reports --- it appears that certain key indicators are encouraging. (Be sure to click the link here.) Specifically:

     

  • The stock market seems to be back on a clear upward path (though that was also the case for a while in 2001 and last fall, only to fizzle out). Since late March, we appear to be in a bull market again.


  • Essentially, despite some ups and downs, falling energy prices in the US have been occurring if slowly.


  • A robust housing market continues to thrive. In June, housing construction was at its highest level since January of 2003. True, some of this thriving might reflect speculative money, but it's unlikely --- as some fear --- to balloon to heights and then burst like the stock market (houses and office buildings aren't liquid assets and can't be quickly sold way stocks and bonds can) . . . so an encouraging sign. Mortgage rates at a generational level now helping to fuel the housing market.


  • Despite a dip in May, consumer confidence has since returned to more optimism, and consumer spending itself is rising continually --- with households increasing their debt to sustain their consumption. As for the Jeremiads about unsustainable debt, keep in mind that these were first sound with even more alarm than now in the mid-1980s.


  • The falling dollar --- on a trade-weighted basis about 9% now compared to 18 months ago (though since May 27th it has risen about 6% against the euro ) --- will start having an effect at some point. Record high trade and current account deficits (trade in goods plus services and what are called unilateral transfers like foreign aid or immigrants sending dollars back to Mexico) will likely come down, adding to domestic growth through more exports sold abroad and fewer imports bought here. So far, though, none of this bounty has materialized.


  • There are a couple of caveats here, which we'll examine in a few moments: [1] The dollar hasn't fallen against the Asian currencies, Japan's central bank buying dollars galore with Yen to keep the Yen from appreciating, and it has even risen against some currencies like Mexico's. China, with which we have the largest trade imbalance ($103 billion deficit las year) --- and also the fastest growing --- also artificially keeps the Yen low at 8.3 Yuan to the dolllar, resulting in increasing complaints about its neo-mercantilist policies in Congress . On the conflicting motives of the Bush administration in dealing with these growing trade frictions with China, above all security concerns vs. domestic political repercussions of the huge trade imbalance, The International Herald Tribune. And [2], most of the key countries in the world besides the US depend on export-led growth, and have a long record --- Japan, China, the smaller Asian dynamos, Southeast Asian countries, Germany and other parts of the EU --- of waiting for rapid US growth to materialize after a world-wide slowdown or recession and begin to suck in their exports as a way to kick-start their own slumping economies. The result is a big imbalance in the global economy. In the Chinese case, the best solution --- now being voiced by Secretary of the Treasury John Snow --- would be to put pressure on the Chinese to float the Yuan.

  • A slight expansion in the service sector, and in June, the best news for five months of growing sales in the manufacturing sector. In June too, the US Commerce Department reported that capital goods spending --- a sign of revived manufacturing investment --- was up a strong 3.6% . . . not least thanks to defense spending, though even private-sector manufacturing purchases are up too.


  • Even the rise in unemployment in May was misleading. Almost all the net loss of jobs in May --- which raised unemployment to 6.2% ---- were in the government sector. For that matter, a clear rise in temporary jobs --- almost always a sign of improving business confidence, a prelude to more permanent job creation --- has emerged. What's more, at the end of July, the lowest level of newly registered unemployed was recorded since the end of January 2003


  • Then too--- something hardly to be sneared at, given two years of living with it since 9/11's terrorist attacks --- an end to geopolitical uncertainty, which increased in the four or five month run-up to the Iraqi war, only to subside since.


  • Finally, after two quarters of mediocre GDP growth of around 1.4% --- last fall, then this winter --- the economy jumped at almost double the rate in the spring, ending up with a preliminary 2.4% annual growth rate. Defense spending was a big driving influence, but so too was new business investment.

    In short, almost all the news about the US economy's short-term prospects for the remainder of this year and probably through the next is encouraging and a sign of a strong revival in the making.

     

      Anything else? Yes, Two other encouraging signs: big monetary and fiscal stimuli to the economy:

  • The Federal Reserve's interest rate cuts, 13 in a row for the last two and a half years now --- with a 13th likely soon --- the key targeted rate, overnight bank lending to one another, already at a 41 year low. Interestingly, harder to make sense of --- probably a result of uncertainty and lack of confidence still among investors after the stock market crash in 2001 and the subsequent revelations about large-scale accounting scandals --- the short-term rate on Treasury securities keeps falling too: usually, when the stock market looks like regaining momentum out of a falling or stagnant bear market, investors switch from short- and long-term securities (bonds) and start buying stock.


  • a $400 - 450 billion federal deficit this year, the upshot of of rising defense spending and the Bush tax cuts, which should also help prod GDP growth. (Whether the tax cuts are equitable is a political judgment, moderate Democrats like myself particularly concerned that $8 billion or so intended to help working families who don't pay on balance taxes because of low income was cut out of the Congressional compromise, and still languishing in the Republican-controlled House despite Bush's appeals to reinstate it.)


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    HYPOTHETICAL DANGERS, MAINLY OF AN ACADEMIC SORT

    As for the dangers that might interfere with a recovery --- including fiscal and monetary stimuli --- the following stand out and will be discussed in the next article or two. Here we just list them:

     
  • Deflationary dangers (a persistent, self-reinforcing fall in general prices);


  • A liquidity trap (a problem first encountered, it's said, in the 1930s when monetary policy becomes ineffectual in stimulating Aggregate Demand and hence actual GDP growth: nominal interest rates are at or near zero and the economy still isn't responding to the stimuli, yet the rates, it's said further, can't be brought down below zero).


  • The ineffectuality of fiscal stimuli, owing to what's called the Ricardian effect: an expanding governmental deficit doesn't generate increased Aggregate Demand and actual GDP growth because households and businesses --- anticipating that the growth of governmental debt (national debt) will necessitate higher interest payments on the debt in the future --- immediately take offsetting action in the form of increased savings in order to be able to pay the future higher tax burdens that higher interest payments will require. Worse, it's said, even if the deficit is accompanied by tax cuts rather than by increased government expenditures (say, on defense or road-building), the public will anticipate that the deficit will still incur higher burdens of interest-payments by the government; and because that means higher taxes again, it will pocket most of the money from the current reduced taxes in the form of savings and offset any fiscal stimuli to the economy. (In Keynesian terms, the initial fiscal stimuli is largely offset, and the multiplier tapers off drastically.)


  • On the new classical Ricardian view, only permanent tax cuts will stimulate current increased consumption and business investment, and even then only if there are credible cuts being made in government spending.

     
  • Lingering Problems in the world economy, which might offset the advantages of a "cheap" dollar: above all because, it's said, the rest of the world --- especially the rich EU, the rich Japanese and East Asians, and rapidly growing China --- depends on export-led growth, and the declining dollar will therefore impede their GDP growth and hence lessen their ability to buy US exports despite the cheaper dollar for some of them.


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    A Foreshadowing

    In the next article, we'll show that though these problems can't be brushed off, they aren't intractable and beyond being resolved or overcome by proper policies. In particular, as we'll see:

  • Deflation seems, at first and last glance, to be an overblown danger . . . at any rate for the US. Yes, it afflicts Japan, but so does a lot else afflict that country's economy, swamped by decades of market inefficiencies. Some say Germany is threatened by deflation too. Is that possible, what with Germany sharing a currency and central bank policies with 12 other EU countries . . . any more possible, say, than Texas suffering deflation with New York or California suffering it? (If prices, for some reason, started to fall faster in Texas than in New York or California by a noticeable margin, why wouldn't the firms and residents of the latter two states start buying their cars and televisions and computers there with US dollars.)


  • As for a liquidity trap, it's not clear it ever has existed even in the 1930s Great Depression, though Japan seems, on the face of it, to be suffering from it. Note though: on the face of it . Japan, to repeat, suffers from so many problems it's hard to separate them out. What is fairly clear is that its problems aren't likely to be those that the US has to confront.


  • And a lack of fiscal stimulus from huge federal deficits this or next year (at a minimum)? That seems implausible. True, the Barro-Ricardian view can't be ignored, and there's some evidence for it --- but also, as is almost always the case when controversies flare in economic theorizing, plenty of evidence that it exaggerates its predictive effects.


  • Finally, when it comes to the dollar and the global economy, there is clearly an imbalance in the latter. In plain English, huge wealthy economies like the EU's or Japan's --- or giant populated countries with a rising GDP like China's --- should be able to generate far more domestic-led growth than they've done so far. That said, some improvement in the US trade and current accounts (trade in goods, plus services and unilateral transfers like foreign aid or Mexican workers sending money home, say, to Mexico) can be expected.


  • Note something on this latter score. In the early Reagan era, the growing deficit-led recovery of the US economy after the big menacing recession of 1981 also sparked the rebirth of growth in the EU and Japan --- to the tune, it was later estimated, by as much as 40-50% of the subsequent return to better GDP performance in both Japan and Germany. The same can be expected, if to a lesser degree --- lesser, because of the untackled structural problems in Germany and Japan (and to an extent in much of the EU) --- in the Bush-Jr. era next year. Their recovery, in turn, should help the rest of Asia and Latin America and East Europe, and by a ricochet process, as they recover, lead to far greater export sales of US goods and services abroad . . . albeit, as US economic vigor outpaces their's, with a rapidly rising dollar again offsetting some of these potential sales.