Greenspan’s Judgement: Fed Back on the Beam

If economics were a boat, it would be a leaky tub. The pumps would be straining, and the captain would be trying to prevent it from capsizing. Which is to say: our ideas for explaining trends in output, employment and living standards – what we call “macroeconomics” – are in a state of disarray. If you’re confused, you’re in good company. Only recently Federal Reserve Chairman Alan Greenspan confessed again that he doesn’t understand why interest rates on long-term bonds and mortgages have dropped, just when the Fed is raising short-term rates. This is but one mystery.It’s not merely that we’re in the midst of changes (China’s and India’s entry into the global economy, the explosion of U.S. trade deficits) that are unfamiliar and, to some extent, unprecedented. What’s equally significant is that many assumptions that economists once casually accepted and taught are now suspect or discredited. Let me give you three examples.* We once thought we understood consumer spending, the economy’s mainstay. For decades, disposable income and consumption spending advanced in lockstep. Americans spent a bit more than 90% of their after-tax income and saved about 8% to 10%. In 1959, consumer outlays were 92% of disposable income. The figures for 1969, 1979, and 1989 were 92%, 91%, and 93%. Being so steady, consumer spending provided stability during recessions – in contrast to more sensitive investment spending for housing and business buildings and equipment. Since 1960, consumer spending has dropped in only two years; investment spending has dropped in 13.But since 1990, consumer spending has changed. It’s consistently outpaced income growth. In 2004, Americans spent 99% of their disposable income and saved only 1%. The main cause is the “wealth effect.” In the 1990s, higher stock prices caused Americans to spend more; now higher home values (up 55% since 2000 to $17.7 trillion) are doing the same. So consumer spending increasingly depends on “asset markets” – stocks and homes – and not just income. Query: suppose the next recession depresses both stock and real estate prices. Would consumer spending fall and deepen the slump?* We don’t know how much the world economy affects the United States – and vice versa.Economics textbooks once described the U.S. economy as mainly self-contained. Americans sold to each other; Americans’ savings were invested mostly in American investments (stocks, bonds, bank deposits). Trade was small. Globalization has shattered this model. More industries face foreign competition or depend on foreign markets. In 1960, exports and imports together totaled 9.5% of gross domestic product; in 2004, they were 25% of GDP. Savings and investment have also gone global. In 2003, Americans – mainly through pension funds, banks, and other big investors – owned $3.1 trillion of foreign stocks and bonds, while foreigners owned more than $4.1 trillion of U.S. securities, says the International Monetary Fund.All this alters the U.S. economy. One theory of low American interest rates is that foreign money flows have pushed rates down. Another development: stock and bond markets around the world may be more interconnected, because they increasingly have the same investors. Could a crash in one market cause a chain reaction? Globalization poses many unanswered questions like these.* We can’t determine “full employment.” Economists call full employment the “natural rate of unemployment” – the lowest rate consistent with stable inflation. Go lower, and tight labor markets trigger a wage-price spiral. Unfortunately, we don’t know what full employment is. The Congressional Budget Office now puts it at 5.2%.But past estimates have been too high and too low, because the “natural rate” – despite the label – isn’t natural and constantly changes. It’s influenced by population changes (younger workers have higher unemployment rates) and government policies, among other things. Our ignorance makes it hard to judge when to be satisfied.Although I could extend this list, the message would remain: change has outpaced comprehension. Should we be worried? Maybe. What confuses us may threaten us. But here’s an irony: the less we understand the economy, the better it does. In the 1960s and 1970s, many economists had confidence.They thought they understood spending patterns, could estimate “full employment” and propose policies to prevent recessions. What we got was high inflation and four recessions (1969-70, 1973-75, 1980, and 1981-82). Since then, we’ve had lower inflation, only two recessions (1990-91 and 2001), and faster productivity growth.Economists’ overconfidence – and the resulting policies – may have weakened the economy. But its improved performance could also have other explanations: lower inflation; the good judgment of two Fed chairmen – Paul Volcker and Greenspan; the economy’s self-regulating characteristics, and new technologies. It could be all of the above or dumb luck. We don’t know.

Greenspan’s Judgement: Fed Back on the Beam

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