Ev Ehrlich's Everyday Economics

The American Economy in the 1990’s: A Brave Same Old World

In the Jewish community of 17th century Holland there arose a self-designated, widely-followed, and, ultimately, false Messiah known today as Sabbatai Zevi. In his self-proclaimed Messianic Era, the very concept of “sin” became irrelevant. Freed by their savior's arrival from the moral burden associated with wrongdoing (today we would say liberated from the dictates of the superego), Zevi's followers embarked on a veritable jamboree of transgression, from rampant carnality to boiling meat in milk. Imagine their chagrin when, faced with a choice between apostasy and death, Zevi chose a life-extending conversion to Islam, thus ending his brief Reign on Earth.

Whoops!

Financial market participants should bear this story in mind as they consider whether we are in a proto-Messianic “New Economy” in which inflation and the business cycle are as outdated as sin seemed to be for the Dutch Jews of centuries ago. There is a very real danger that today's proponents of economic neo-Messianism will feel as chagrined as their Sabbatianist counterparts did when reality reasserts itself.

That's not to say that the American economy isn't functioning marvelously. Why shouldn't it? First, it's been blessed with a sensational policy mix. The 1993 budget package changed the course of fiscal policy for at least a decade, a change ratified by this year's package. Monetary policy has been guided by well-exercised, pragmatic judgment, rather than by the kind of unyielding ex ante rules and constructs that killed Billy Budd, not to mention some past economic expansions.

And, perhaps even more important, the economy is in the throes of technological change as profound as the rise of scale-driven mass production and process-based manufacturing. That technological progress has let loose a wave of restructuring in the economy that has improved its performance dramatically.

But does this all mean that we're living in a “New Economy” in which inflation is no longer a risk, or that the business cycle is obsolete? Hardly. The U.S. economy is better, and perhaps different, but not fundamentally changed. Keep those old rulebooks: They will come in handy before this expansion is over.

If a New Economy is not at hand, then why has macroeconomic performance been so impressive? Or, more to the point, where's inflation, and why haven't wages risen more rapidly?

A big piece of the puzzle is simply the high rates of capacity expansion we've seen in the past several years. Despite a brief respite at the end of 1996 and beginning of 1997, investment in durable equipment proceeds at double-digit rates. Thus, despite the economy's admirable growth record (admirable for its longevity rather than pace — this is a Cal Ripken expansion, not a Babe Ruth one), we're operating at lower levels of capacity utilization than we would otherwise have experienced.

But, more importantly, the economy has more capacity, and uses it more efficiently, than the official data suggest. First, of course, our measures of capacity are based on manufacturing and utilities. But the service sector is readily equal in importance and, relatively speaking, its capacity is plentiful and cheap to expand. Most service industries — telecommunications, finance, retailing, even transportation and health — are now creatures of the information age. Their capital stock is progressively made up of the computers and software applications that make telephone connections, price derivatives, reorder goods, process insurance claims, route airplanes and dispatch trucks, or pool and securitize receivables. The rise of these industries in the Information Age has made the entire economy more elastic on the margin.

And, in manufacturing, the level of capacity we report misses the fact that this capacity has been rearranged through corporate restructuring. Twenty years ago, capacity utilization of 90 percent in such industries as automobiles or computers meant that 90 percent of the capacity of vast, integrated value-chains was being deployed. But in the intevening two decades, those industries have been reorganized by networked production, outsourcing partnerships, and a far higher level of specialization. Chrysler is moving out of the business of making components, just as most PC makers don’t make their own chips.

Chips and auto components are now being made, therefore, and their capacity managed by, specialized firms, rather than integrated producers of the final product. The economy's manufacturing capacity has been rationalized by this type of restructuring — we're putting our capacity into the right hands. As a result, the economy is making better use of its capacity at any rate of capacity utilization. Taken together with cheap and easy service industry capacity, this allows the economy to show acceptable though unremarkable rates of growth and productivity (although slightly higher than trend once you account for biases in the data), yet truly remarkable price stability and sustained growth in profitability as well.

Then there are trade and global integration, which both play a major role in the Messianic New Economy story. There’s plenty of capacity in the world, the story goes: This output (or prospective output) forces the prices of U.S. production into submission. But the declining price of imports in this expansion probably has more to do with what's being traded than any notional higher level of competition. In fact, the price index for our durable good exports has fallen by more than its import counterpart. If trade helps inflation, it's most likely due to the fact that the products that it brings to us — computers, electronic components, telecommunications gear — are falling in price.

Moreover, the key to disciplining U.S. prices is not the level of integration but the price at which it’s experienced — the exchange rate. The good news for this expansion, now well into its middle age, is the strong dollar. So long as growth proceeds in the U.S., strong dollar “losers” will have a hard time pressing their case. But it remains to be seen whether the U.S. has the will to accept the tonic of a strong dollar should growth abate. If it can’t, then trade and global integration will seem more the conveyors of inflation than its cure.

The stickier issue is wages. The unemployment rate has fallen below most economists' guesses as to the “NAIRU.” When is the labor market going to start delivering higher real wages?

The fact is that it has, but not by enough to overwhelm the other influences on prices. Yet. Growth in hourly compensation in nonfinancial corporations bottomed out in mid-1993 at slightly less than 2 percent, stayed at that rate for about a year-and-a-half, and then doubled (to close to 4 percent) by the end of 1996. And this compensation escalation has occurred despite restructuring in the provision of health care that has allowed inflation in employer-provided benefits to fall. Wages are rising, and if profits have remained unaffected, it's because interest payments and other non-labor costs have provided some slack.

And wages are going to rise some more. Medical care inflation has declined for seven consecutive years: Will it decline for seven more? A record share of the population is at work after six years of expansion: Will the labor force continue to expand at this pace? Moreover, as the economy operates at this high level of employment, the likelihood that it will become skill-constrained increases, along with the premium that skills will demand. None of this augurs well for labor costs. Granted, some firms will have a harder time passing these costs forward than they would have in a previous expansion. But that doesn't mean that they're not going to rise, and put pressure on both prices and earnings.

Wonderful things are happening in the American economy today — a technological revolution, a sound economic policy, a wave of productivity-enhancing corporate restructuring (rather than “slash and burn cost cutting”), the vanquishing of inflationary psychology and the wage-price spiral. But that doesn't mean that we're in a Messianic New Economy in which the old rules no longer apply.

The tight U.S. labor market is going to lead to steadily rising wage gains. If the dollar falls, import-borne inflation will become a problem. And if profits growth slows, business may be tempted to use prices to catch up, no matter how much inflationary psychology has improved. The bond market is yet to build fully these prospects into its thinking.

That doesn't mean that the end of this expansion is nigh. But it does mean that we should think long and hard before buying into a New Economy Paradigm, let alone any strategy based on it. The proponents of this New Era, like the Sabbatianists, may very soon be forced into apostasy, but this time by equity and fixed income markets rather than the caliph.

An excerpt from this article was distributed by Reuters Financial as part of a series on “The New Economy” in October, 1997. The article is reproduced in its entirety for clients and friends of ESC Company.