The Accidental Theorist (9 page)

Moreover, to the extent that you think some industries are more important than others—for example, because they yield technological spillovers—the jobs the United States gains by rolling back Japanese and European market shares in computers or semiconductors are surely more likely to produce those benefits than the jobs we give up by allowing in Chinese shirts and footwear.

The downside—which is significant—is that precisely because our more open markets lead us to gain high-wage jobs but lose low-wage employment, our disproportionate role as a market for Chinese exports may exacerbate the problem of growing income inequality.

The important thing to bear in mind is that the bilateral imbalance between the United States and China does not mean that the Chinese are taking advantage of our naiveté. (Which is not to say that they wouldn’t if they could.) It is mainly the result of the restrictions third parties place on China’s exports, not the restrictions China places on ours. And we are not being taken advantage of: In fact, the imbalance is actually a sign that America is taking advantage of opportunities that other advanced countries are passing up.

F
ew subjects in economics are as contentious as the business cycle—those fluctuations of output and unemployment around the long-run upward trend. A generation ago economists were all pretty much agreed on what caused business cycles. Then, partly as a result of “stagflation”—the unexpected and unpleasant combination of inflation and unemployment that emerged in the 1970s—but mainly as a result of differences in methodological tastes, economists studying the business cycle divided into rival factions. Some argued for an updated version of the old, mainly Keynesian approach; others wanted to reject it entirely. The great business cycle theory wars did huge damage to the prestige of economics as a profession; they also created a sense that nobody knew anything, which opened the door for various crank doctrines—most notably supply-side economics.

Don’t tell anybody, but those wars are basically over. (Princeton’s Alan Blinder calls this the “clean little secret of macroeconomics.”) While the factions still tend to use different language, their actual views have converged—to something not very different from the consensus view of a generation ago. But the damage has proved hard to repair: many people still think that economics has nothing useful to say about the business cycle, and crank doctrines continue to flourish.

The crank doctrine
du jour
is something widely known as the “New Paradigm” it amounts to the assertion that new forces such as globalization and technological change have cancelled all the old rules, that old speed limits on growth have been repealed, perhaps that the business cycle itself has been abolished. There are many things wrong with that story line, among them the question of whether globalization and technology are really proceeding as dramatically as its adherents claim. “We Are Not the World” already described my doubts about globalization; the first essay here describes some similar doubts about technology.

More important, however, the New Paradigm seems to involve confusion about the difference between the business cycle and long-term growth, coupled with a misunderstanding of the things that monetary policy can and cannot do. I try to explain those distinctions in the second essay, “Four Percent Follies.”

To be skeptical about the prospects for rapid growth is, it turns out, to run the risk of being identified with another, equally misguided camp: that which believes that controlling inflation is the only priority of policy, that nothing can be done to fight recession and unemployment. This belief, especially acute among central bankers, is arguably imposing huge, gratuitous economic pain in much of the world; the third piece here, “A Good Word for Inflation,” focuses mainly on Europe and makes the case against a single-minded emphasis on price stability, while the fourth essay argues that monetary passivity accounts for much (not all) of Japan’s economic malaise.

Finally, in “Seeking the Rule of the Waves,” I made use of a book review assignment to say some things I always wanted to say about economics, history, and the reasons why the business cycle is surely nowhere near dead.

Lately many business leaders and thinkers have become preoccupied with something called the Information Technology Paradox. It goes like this: We live in an age of unprecedented technological progress, which is making everyone far more efficient than before. Yet where is the payoff? The standard of living of ordinary Americans doesn’t seem to be soaring; if anything, many people are finding it harder, not easier, to make ends meet. If we’re so smart, why aren’t we richer?

A lot of ingenious things have been said about the reasons for the paradox, but there is one explanation that hardly anyone dares mention: Maybe the wonders of technology we keep hearing about aren’t really all that wondrous.

To get an idea of what I mean, think about
2001.
No, not the year—the movie
2001: A Space Odyssey,
which came out in 1968. Most readers must have seen it. The middle part of the movie offered what was supposed to be a realistic picture of life thirty-three years in the movie’s future, but barely four years from now. In that world there were regularly scheduled commercial flights to space stations with Sheraton-style lobbies, and computers smart enough to go on a postal worker–style rampage when they felt unappreciated. But airlines aren’t offering orbital vacations to their frequent flyers; Shannon Lucid could not call room service; and my computer’s idea of murderous revenge is to tell me “An error has occurred in your application. Terminate/Ignore?” If 2001 is actually going to look anything like
2001,
technology had better get a move on.

The point is that if you measure the progress of technology not by Mips and bytes but by how it affects people’s lives and their ability to get useful work done, you realize that the last thirty years have been a time not of unexpected achievement but of persistent disappointment.

Surely, for example, the startling thing about computers is not how fast and small they have become but how stupid they remain. Back in 1958 the pioneer computer scientist Herbert Simon confidently predicted that a computer would be the world’s chess champion by 1970; this makes the eventual victory of IBM’s Deep Blue over Gary Kasparov a bit of a letdown. And building a computer that plays high-level chess turns out to be an easy problem—nowhere near as hard as, say, designing a robot that can vacuum your living room, an achievement that is still probably many decades away.

Even where computers have become ubiquitous—such as in the modern office—it is very questionable how much they actually raise productivity. Recently many companies have begun to realize that when they equip their office workers with computers they also impose huge hidden costs on themselves—because a computer requires technical support, frequent purchases of new software, repeated retraining of employees, and so on. That $2,000 computer on your employee’s desk may well impose $8,000 a year in such hidden costs—and that’s even if the worker does not spend a significant part of the work day playing Tetris or surfing the Net.

And what about technologies that
don’t
involve manipulating digital information—for example, the technology of daily life? Think, for example, about how a typical middle-class family lives today compared with forty years ago—and compare those changes with the progress that took place over the previous forty years.

I happen to be an expert on some of those changes, because I live in a house with a late-fifties-vintage kitchen, never remodelled. The non-self-defrosting refrigerator and the gas range with its open pilot lights are pretty depressing (anyone know a good contractor?)—but when all is said and done it is still a pretty functional kitchen. The 1957 owners didn’t have a microwave, and we have gone from black and white broadcasts of Sid Caesar to off-color humor on The Comedy Channel, but basically they lived pretty much the way we do. Now turn the clock back another forty years, to 1917—and you are in a world in which a horse-drawn wagon delivered blocks of ice to your icebox, a world not only without TV but without mass media of any kind (regularly scheduled radio entertainment began only in 1920). And of course back in 1917 nearly half of Americans still lived on farms, most without electricity and many without running water. By any reasonable standard, the change in how America lived between 1917 and 1957 was immensely greater than the change between 1957 and the present.

In short, the idea that we are living in an age of dramatic technological progress is mainly hype; the reality is that we live in a time when the fundamental things are actually not changing very rapidly at all.

Now I am not saying that this is anyone’s fault. If Bill Gates turns out to be no Henry Ford, that is no reflection on his abilities. Really productive ideas, like internal combustion and the assembly line, are hard to find. It is no tragedy if we have to make do with second-rate inventions like the personal computer until the next Model T comes along. But the techno-hype that surrounds us has some real costs. It causes businesses to waste money; it causes politicians to seek high-tech fixes (give every child a laptop!) when they should be getting back to the basics (teach every child to read). The slightly depressing truth is that technology has been letting us down lately. Let’s face up to that truth, and get on with our lives.

Recently a lot of influential people have been berating Alan Greenspan and his colleagues at the Federal Reserve for not allowing the economy to grow faster. The most prominent of these critics has probably been Felix Rohatyn, who was proposed though never formally nominated to become the vice-chairman of the Fed. It’s important to note that Rohatyn is not arguing for a modest change in policy, a view that many economists share. What he is arguing for is a massive monetary expansion: instead of the 2 to 2.5 percent growth the Fed seems to be targeting, it should aim for no less than 3.5 or 4 percent over the next decade. In fact, let me refer to Rohatyn and allies for short as the “four-percenters.”

A talk given to the Economic Club of Washington, April 1996.

This debate over Fed policy is obviously a crucial issue in its own right; but I also find it a useful illustration of how and why smart people say foolish things about the economy.

I’m eventually going to get around to some specifics about what the four-percenters have to say, but let me start with some general conceptual issues. Here’s a question you probably don’t ask yourself very often, but should: What gives Alan Greenspan such power? I don’t mean why does he rule the Fed; I mean why do the decisions of the Fed’s Open Market Committee—a group of charisma-impaired economists and bankers sitting around a table every six weeks—matter so much?

To answer a question like that, you need some kind of
model
of the role of monetary policy. So let me spend a few minutes laying out such a model.

At this point you are thinking “Oh no! He’s going to start in with equations and economic jargon!” But don’t worry—it’s not that kind of model. In fact, I hope this will be fun. There will, however, be a quiz on this material—so listen carefully.

The model that I find most useful for understanding what the Fed can (and can’t) do is one that some of you may have seen described in my book
Peddling Prosperity.
It was originally described by Joan and Richard Sweeney in an article entitled “Monetary Theory and the Great Capitol Hill Baby-sitting Co-op Controversy.”

During the seventies the Sweeneys were members of a baby-sitting co-op—a group of young couples, mostly working on Capitol Hill, who agreed to baby-sit for each others’ children on a rotating basis. Any such group, once it goes beyond a few members, requires some sort of system to make sure that each couple does its fair share. This particular co-op settled on a scrip system: Members were issued coupons worth one hour of baby-sitting time. When a couple went out for an evening, the baby-sittees would give the appropriate number of coupons to the baby-sitters, who would then be able to “spend” them on some other occasion. The system, as you can see, was self-policing: Over time each couple would necessarily give as many hours of baby-sitting as it got.

Now if you think about it, a system like this requires that there be a fair bit of scrip in circulation. A couple might want to go out several times in close succession, and might find itself unable to take the time (or find the opportunity) to baby-sit and earn more coupons in between. Furthermore, a couple might be uncertain about its schedule, proving a further incentive to keep a reserve of scrip on hand. So on average, for the baby-sitting co-op to work properly, there needed to be quite a few coupons in circulation per couple.

I don’t want to get into the fairly complicated details of how scrip was issued. Suffice it to say that after a while the co-op got into a situation in which there weren’t enough coupons out there. This had some peculiar effects. Couples became reluctant to go out for the evening—because the typical couple did not have much of a reserve of baby-sitting coupons, and was anxious to keep that reserve for an important occasion. In order to build up their reserves, couples tried to do extra baby-sitting—but one couple’s decision to go out was another’s opportunity to baby-sit, so chances to earn coupons by baby-sitting became hard to find; and so couples became even more reluctant to spend their reserves of coupons by going out. Eventually the co-op consisted largely of couples sitting glumly at home, unwilling to go out until they had more coupons, unable to earn more coupons because nobody else was going out either.

In short, the baby-sitting co-op had managed to get itself into a recession.

Most of the members of the co-op were lawyers, so it was hard for the economists in the group to convince them that the problem was essentially monetary. Instead, the initial reaction of the co-op’s officers was to treat the problem as something to be solved by regulation: For example, they tried to enforce a rule that
required
each couple to go out at least twice a month. Eventually, however, the economists prevailed, and more coupons were distributed.

The results were astonishing: With larger reserves of scrip, couples became more willing to go out, which made it easier to get opportunities to baby-sit, which made people still more willing to go out, and so on. The GBP—the gross baby-sitting-co-op product, measured in units of babies sat—soared. Of course the co-op then went on to overdo it, issuing too
many
coupons. That led to new problems, and incipient signs of inflation…

I warned you that there would be a quiz. So here it is—just one question: How did you feel about my telling you that story?

If your answer was “Well, that was a cute story, but I don’t see what it can have to do with the U.S. economy,” you get a D. You have failed to understand the usefulness of simplified models in cutting through the complexity of the real world.

If your answer was “What’s all this about? I want to talk about globalization and the new information economy, and he’s telling me about baby-sitting,” you get an F. Not only don’t you understand the uses of models, but you have fallen into the naive error of supposing that the way to be sophisticated about economics is to use big words and talk about big things.

For the fact is that by studying our model—the baby-sitting co-op, which is like a miniature version of the real U.S. economy, in which Alan Greenspan controls the supply of coupons—we can gain some very important insights that many people who believe that they are knowledgeable about these things never do seem to grasp. Let me emphasize two insights in particular.

First, we learn that there is a fundamental difference between the kind of growth associated with an increase in the money supply and the sources of longer-term growth in the economy. When GBP surged after the issuance of new coupons, it wasn’t because the couples in the co-op had installed new high-tech baby-sitting equipment, or because they had been retrained to be effective in the new global baby-sitting economy, or because they had been freed from the burden of government regulations and taxes that frustrated private sector baby-sitting initiative. All that happened was that a failure of coordination due to inadequate liquidity was cured by increasing the money supply—end of story.

Second, as soon as we think about the baby-sitting story we realize that there are limits to monetary policy. Too little money is a bad thing; but while GBP could be expanded up to a point by printing more coupons, this process could only go so far. Indeed, issuing too many coupons actually hurt the co-op: an excessively expansionary monetary policy is counterproductive.

Now surely these two insights apply to the full-scale, adult economy as well. Business-cycle recoveries like 1982–1989 or 1992–1994, in which the Fed pumps money into a depressed economy and brings idle capacity back into use, tell us very little about the kind of growth that the economy can achieve on a sustained basis. Anyone who says that the Reagan-era recovery is an indicator of the kind of long-term growth that our economy could achieve if only we would institute a flat tax has simply failed to learn one lesson of the baby-sitting co-op. Anyone who thinks that the Fed can arbitrarily choose a rate of growth as a target, and achieve it indefinitely, has failed to learn the other lesson.

Can we be more specific? Indeed we can. In the U.S. economy, it is quite easy to separate cyclical fluctuations in output from the long-term growth in the economy’s potential. For the past twenty years it has been quite reliably true that whenever the economy grows faster than 2.5 percent, the unemployment rate falls (about half a point for every extra point of growth), while whenever the economy grows more slowly than 2.5 percent, the unemployment rate rises. This is a pretty solid indication that the economy’s potential output is growing at about 2.5 percent per year. And there is no sign whatsoever in recent data that this underlying rate of growth has accelerated—if anything, it has slipped a bit due to slower labor force growth.

The limits to expansion are harder to pin down. But we know there must be a limit
somewhere
—the baby-sitting co-op tells us so. After thirty years of intense debate, and hundreds of statistical studies, most economists have come to agree that inflation will spiral upward if the Fed tries to push unemployment too low. How low is too low? Past experience suggests that the red line—the infamous NAIRU (non-accelerating-inflation rate of unemployment)—is an unemployment rate in the 5.5 to 6 percent range; but as I’ll explain in a second, the precise number is not crucial for the debate with the four-percenters.

Now, armed with our model, let’s talk about what the Fed’s critics have been saying. In particular, what do we make of it when someone advocates a growth target of 4 percent per year for the next five years?

Well, bear in mind that the rate of growth of potential output is reliably estimated to be less than 2.5 percent per year, and that every extra point of growth reduces the unemployment rate by half a percentage point. It immediately follows, then, that 4 percent growth for five years would mean targeting an eventual unemployment rate of something like 1.5 percent.

Now I don’t know anyone who thinks that is a plausible goal. Maybe you think the NAIRU is 5 percent, not 5.5; maybe you even think that it’s 4.5, though that seems grossly inconsistent with the statistical evidence. But
1.5
percent? So how can smart people think that a 4 percent growth target is feasible? Well, I’ve had discussions with pro-growth types myself, and have had reports from other economists who have tried to have such discussions, so here is an outline of how the discussion goes.

The first thing they say is that the old rules no longer apply, because we have had a “productivity revolution.” The economy’s productive potential, we are told, is now growing much faster than in the past.

What’s wrong with this claim? Well, for what it’s worth the numbers produced by the Bureau of Economic Analysis, which estimates productivity, do not show anything that looks like a productivity revolution. To be sure, many businessmen claim that the numbers are wrong (although there are some independent reasons to suspect that productivity growth remains fairly pedestrian). But in any case such claims don’t help the pro-growth argument. The reason is that the
same
numbers are used to estimate productivity growth and GDP growth. If you think that productivity is really growing at 3 percent, not the 1 percent the BEA reports, then you must also believe that GDP is really growing at 4 percent, not 2—in other words, the Fed is
already
giving us 4 percent growth, so what’s your problem? (By the way, I am told on unreliable hearsay that economists at the Fed have tried to explain this point to prominent four-percenters, and met a blank wall of incomprehension).

The second argument that growth advocates usually produce is the claim that globalization—the new openness of the U.S. economy to imports—now prevents any resurgence of inflation. This can sound plausible—but only if you don’t know recent economic history, and don’t think too hard about it. How can anyone think that being an economy open to trade ensures against inflation, when they have the example of Britain to contemplate? In the late 1980s Britain—a nation with a share of imports in GDP almost three times that of the United States—allowed its monetary policy to be guided by wishful thinking about how much the economy could be expanded. The result was right out of the textbook: an explosion of inflation, which was brought under control only by a return to double-digit unemployment rates.

Moreover, how can you discuss globalization without noticing that the
U.S.
has a floating exchange rate? If the Fed were to pursue a radically more expansionary monetary policy, one sure consequence would be a lower value of the dollar. If you really think that U.S. prices are basically limited by foreign competition, then you have to believe that a fall in the dollar will translate almost directly into higher inflation. In fact, traditional analyses of inflation in trading economies conclude that expansionary monetary policy has
more,
not less, effect on inflation in a country with a large import share and a floating exchange rate than it does in a relatively self-sufficient economy.

So neither productivity growth nor globalization make sense as arguments for looser monetary policy. Maybe there are other arguments—but people like Felix Rohatyn have not produced them. In short, this is not a serious debate: Although the four-percenters command a lot of political and business support, intellectually they have failed to make even the ghost of a case for their views.

Now you may think that what I am saying is that these guys are dumb—that as Bob Dole might put it, Paul Krugman thinks that he is smarter than Felix Rohatyn. But of course I’m not—after all, if I’m so smart, how come I’m not rich? No, the puzzle is why smart people say foolish things. Why haven’t the four-percenters managed to make a better case? What’s their model?

The answer, of course, is that they have no model. What’s wrong with the kind of economics that Felix Rohatyn and many others practice is that they have failed to understand the principle. They think that you do economics the way a lawyer prepares a brief for a client—first you decide on your opinion, then you marshall as many plausible arguments as you can in support. And they imagine that the orthodoxies of economics—like the belief that the U.S. economy’s potential growth rate is only 2.5 percent, or that free trade is a good thing—were arrived at in the same way.