The Regional Economist • January 1998

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A Brave New[•̂ ^H*

ECONOMIC WORLD?by Kevin L. Kliesen

T o hear many economists and poli-cymakers tell it, U.S. economic per-formance is currently the best it has

been in a generation—maybe evenlonger. Indeed, relatively low inflation,low unemployment and strong econo-mic growth is a combination rarely seenover the past three decades or so. In fact,some analysts go so far as to insist thatthe U.S. economy has entered a new era.According to adherents of this view, busi-nesses are finally harvesting the fruitsfrom technological advancements relatedto the computer microchip, laser tech-nology and fiber optic communications.Among the gains to the economy are bet-ter inventory management practices andimproved productivity. Despite all thehoopla this economic performance hasgenerated—much of it deserved—thereare sound reasons to be concerned aboutfuture prospects for the U.S. economy. Itall goes back to fundamentals.

Miserable No More?My, how times have changed. A little

more than five years ago, many econo-mists were downright worried about thelong-term prospects for increases in U.S.living standards.1 Now, however, giventhe recent performance of several impor-tant economic indicators, many econo-mists are wondering whether highergrowth rates of real GDP and lower infla-tion rates are here to stay (see table). Infact, some believe that the current eco-nomic environment is reminiscent ofthe heady years (1950-70) in the after-math of World War II, when the livingstandards of U.S. workers (real GDP perperson) rose by almost 3.75 percent a

year. This is more than double the nearly1.5 percent a year gains seen from 1930to 1950.2

Few comparisons between today'seconomic environment and that seenbetween 1950 and 1970 are as apt as theabsence of debilitating rates of price infla-tion and high and rising unemploymentrates. These were the twin maladies thatplagued policymakers for much of thelate 1960s to the early 1980s, when livingstandards reverted to their prewar ratesof growth. After averaging 5.4 percent ayear from 1980 to 1991, inflation duringthe current business expansion has beenabout half of that.

Low and stable inflation has been aboon for the economy, providing busi-nesses with a solid foundation for under-taking investment initiatives, expandingproduction and boosting employment.In fact, in the fourth quarter of 1997,the civilian unemployment rate averaged4.7 percent, its lowest level in more than25 years. Moreover, real GDP has grownat an exceptionally strong 3.3 percentannual rate over the past two years,which is well above its 10-year averagegrowth rate of 2.5 percent. With infla-tion and unemployment low, and realGDP growth high, the misery index inthe third quarter of 1997 was at its low-est point in nearly 25 years.3

Does the recent macroeconomic per-formance of the economy signal thebeginning of a new economic era—onewhose operating paradigm is no longerrooted in the ebbs and flows of the tradi-tional business cycle? Moreover, what isthe role for monetary policymakers inthis new paradigm? Can they now showless vigilance against inflation? At firstglance, it would appear so, since the U.S.

economy has experienced only threequarters of negative real GDP growthin the past 15 years, and the flamesof inflation appear to have beenextinguished for good—or at leastsufficiently doused to be only mar-ginally worrisome. But is there moreto the story?

The conventional view—the oneheld by most forecasters—is that therecent surge in economic activity istypical of the increased productionthat normally accompanies thegreater demand for goods and ser-vices seen over the course of thebusiness cycle. Those who believethat something more fundamentalis taking place, however, ask the fol-lowing: With aggregate demand forgoods and services exceptionallystrong, why hasn't inflation acceler-ated as in previous expansions?Again, the conventional view holdsthat it eventually will once certaintemporary factors that have beenrestraining inflation fade from view.4

There is, however, an alternativeview, which has been looked uponfavorably by Federal Reserve Chair-man Alan Greenspan, amongothers.5 At its core, this view holdsthat the considerable capital stock

Tlxe Best of Times?How current economic statistics stack up against history

NOTE: Inflation and growth of the S&P 500 are four-quarter percent changes; measures of the unemployment rate,the misery index, new home sales and consumer confidence are quarterly averaaes of monthly rates.

will eventually accelerate, thus threat-ening the sustainability of the busi-ness expansion. The latter view, onthe other hand, implies that theeconomy has entered a new econo-mic era where inflation is perma-nently low and the capacity forgrowth is much higher than mostthought possible. Why is the newparadigm story gaining sway withsome very influential policymakers?

Know Your FundamentalsEconomists generally believe that

economic growth can be measured byhow fast living standards rise overtime, which is usually defined as year-to-year increases in GDP per person(or per worker). A country's per capitaGDP depends importantly on institu-tional factors that facilitate the pro-duction, distribution and sales ofgoods and services, otherwise knownas the economy's "infrastructure."6

Although many factors can come intoplay, a few crucial ones stand out—chief among them is the way a societyorganizes its form of government:Does the government encourage pri-vate ownership of the means of pro-

duction and respect forthe rule of law, includinga willingness to stampout corruption andenforce private contracts?Other crucial compo-nents of a healthy eco-nomic infrastructure are:an independent centralbank that is committedto achieving price stabil-ity, an adherence to theprinciples of free trade,legal protection of copy-rights and patents, and aregulatory system thateffectively balances thecosts and benefits of gov-ernment intervention inthe private sector. Eco-nomic infrastructure,

put into place by businesses overthe past two to three years—aug-mented with impressive technolo-gical advancements related to thecomputer microchip—has boostedthe economy's potential to growover time. Strong growth and lowinflation is simply the byproductof this development.

For monetary policymakers, thesetwo competing views offer an extra-ordinary challenge. The former viewsuggests that monetary policy, as intimes past, has been perhaps tooaccommodating of this upsurge indemand. If this is true, then inflation

then, appears to explainwhy per capita output

in the United States is roughly seventimes greater than that of Mexico,and nearly 10 times that of China.

If a country's economic infrastruc-ture goes a long way toward explain-ing why U.S. citizens are muchwealthier than those of Mexico orChina—or every other country forthat matter—it also directly influ-ences those factors that determinehow fast an economy grows overtime. Two basic factors—labor inten-sity and labor productivity—deter-mine this growth path over time,both of which can be affected by awide variety of influences.7 A coun-

The Regional Economist • January 1998

try's labor intensity is determined bythe number of people who are enter-ing the labor force, and thus avail-able to produce (and consume)goods and services. Labor intensityis mostly a function of populationgrowth—which generally changesslowly—although immigration canhave some effect.

It would be difficult to overstatethe importance of labor productiv-ity growth in determining futureincreases in living standards. Sim-ply put, when economic resources(whether human beings, machinesor land) are not very productive,the economy's potential to growover time is severely constrained.To use a sports analogy, a runningback who gains four yards percarry is much more productivethan one who gains only two. Notsurprisingly, the former is alsopaid much more than the latter.Thus, the more productive aneconomy's resources are, the moreincome they will produce, and thehigher the nation's standard of liv-ing will be.

Labor productivity can be influ-enced by many factors. In general,though, it depends on a country'scapital intensity, which comes intwo forms—tangible investmentand human knowledge, or, whateconomists call, respectively, phys-ical capital and human capital. Theaccumulation of physical capital (tan-gible investment) depends on suchfactors as a nation's saving rate, thereturn to investment and expecta-tions of future economic growth. Butcapital intensity is also influenced bythe accumulation of ideas, such asresearch and development (R&D)efforts that both build upon previousdiscoveries and lead to inventionsthat can be copyrighted or patented.The transfer of new ideas and techno-logical advances in a free and openinternational trading environment isalso crucial. The U.S. auto industry,for example, benefited immeasurablyfrom the competition offered byJapanese-produced cars and trucksin the early 1980s.

The government can also play apositive role in spurring labor pro-ductivity. For instance, some econo-mists favor permanent R&D taxcredits and/or lower capital gainstaxes to spur increased saving andinvestment. Government policy canplay a key role in boosting humancapital, too. Although it is very dif-ficult to measure, human capitaldepends crucially on educationalattainment, which is why manyeconomists favor universal subsidiesfor higher education, or policies thatwould promote competition among

private and public schools. Othersbelieve that human capital can beboosted by "technological spillovers,"which occur when workers are givenspecific knowledge and training thatenables them to operate equipmentand machinery which embodies thelatest technology, thereby leading toincreased real wages and higher liv-ing standards.

In the final analysis, an economygrows over time because of tangiblefactors—what economists call "realthings." These real things influencea country's productivity growth and,ultimately, its standard of living.

What's Wrong withThis Picture?

One way that a firm can offsetincreases in input costs is throughgreater labor productivity, namely byproducing more goods and services ata lower cost per unit. All other thingsequal, this would tend to increase thefirm's profits—thereby increasing thewealth of shareholders—and raiseworkers' real wages. If enough firmswere able to accomplish this to affectthe aggregate economy, the resultwould generally be rising output andfalling rates of inflation—in otherwords, a pattern that is broadly consis-tent with the above-average economicgrowth and falling inflation rates seenin the United States for the past cou-ple of years.

The peak of labor productivitygrowth and increases in living stan-dards during the postwar era occurredprior to 1973. Specifically, productiv-ity growth averaged nearly 3 percentduring the five business expansions

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from late 1949 to late 1973. At thisrate, U.S. living standards doubledabout every 24 years. Does the cur-rent economy measure up to thisimpressive performance? Hardly.Labor productivity during the cur-rent expansion has risen by a paltry1.3 percent average annual rate (seechart). In fact, this growth rate isvirtually identical to that seen in theprevious expansion. At this pace, itwould take about 55 years for livingstandards to double.

Glimmers of a potential increase inthe trend rate of labor productivitygrowth have recently emerged in theofficial statistics, however. For exam-ple, productivity grew at an impressive2.7 percent rate through the first threequarters of 1997. But is it credible toassume that this growth is part of adynamic that will return the U.S.economy to a time when labor pro-ductivity and living standards wereroughly doubling every two genera-tions? Economists do not yet have agood sense whether, as some have sug-gested, a fundamental shift has trulyoccurred, or, as others have claimed,that recent productivity gains are sim-ply temporary developments associated

ing productivity during this businesscycle has increased by a little morethan 3.25 percent a year, a gain that issurpassed only by that in the 1970-73expansion. At the same time, though,productivity for the entire nonfarmbusiness sector (manufacturing andnonmanufacturing) has grown byonly about 1.5 percent this expansion.This large difference implies that non-manufacturing productivity growthhas been well below 1.5 percent.

Common sense would suggest thatthe manufacturing sector has seen itsproductivity improve considerablydue to improved production processesbrought about by technological gains.But if the manufacturing sector hasbeen able to make better use of theseadvances, why hasn't the nonmanu-facturing (services) sector been able todo the same? After all, both sectorshave access to the same technology,and should therefore have equalopportunity to profit from these tech-nologies. One reason why producti-vity gains may be underestimated inthe nonmanufacturing sector is that itis very difficult to accurately measurethe output of many services, whichcomprise roughly three-quarters of

Ithough signs of faster productivity growth have Begun to

emerge in the official statistics, it is too early to determine

k whether these gains are permanent or temporary.

with a strong, cyclical upsurge inU.S. output growth. Either way, itseems unwise to attach a great dealof importance to three quarters of—admittedly—exceptionally strong pro-ductivity growth. And, as ChairmanGreenspan suggests, there may be twovery important reasons why analystsshould look beyond the productivitydata as currently measured.

First, it is entirely possible that,despite their best efforts, governmentstatistical agencies cannot adequatelycapture the rapidly changing makeupof the U.S. economy. The content ofeconomic output, as Greenspan hasnoted, is becoming increasingly con-ceptual. That is, many firms—typical-ly, service-oriented nonmanufacturingfirms—create value by manipulatingideas or collecting and transmittinginformation. Measuring productivityimprovements in these types of indus-tries is difficult, to say the least. Thisproblem is less acute in the manufac-turing sector, though, where measur-ing physical quantities like cars andtons of steel is fairly straightforward.This is important because manufactur-

the U.S. economy. If output is mis-measured, then productivity is alsomismeasured because productivity issimply output divided by inputs.

Many economists believe that cur-rent productivity data understategrowth significantly because it is diffi-cult to disentangle quality improve-ments captured within price changes.The technological advancementsembedded within new automobiles orrevolutionary medical procedures aregood examples of this. This is impor-tant because a quality improvementshould boost output (GDP), and thusproductivity, while a price changeshould not. For example, if the CPIoverstates the inflation rate by 1 per-centage point a year, then, all otherthings equal, productivity growthwould be biased downward by about1 percentage point a year.8

Current productivity growth may beunderstated by that amount, or it maynot. In short, it is anybody's guess asto how much current labor productiv-ity growth is underestimated. Statisti-cally speaking, though, an increasingshare of output produced by the

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(hard-to-measure) nonmanufacturingsector may be biasing our estimates ofeconomic growth and, as a result, thepace at which U.S. living standardsare increasing. A recent FederalReserve study provides some supportfor this view, concluding that thestagnant productivity growth mea-sured in several service-orientedsectors is not consistent with themeasures of profitability, outputprices and wages in these sectors.9

The second reason why measuredproductivity gains may be elusive—despite the substantial amount ofcapital put in place by businesses inrecent years—relates to the transitionbetween technological eras. Stanfordprofessor Paul David maintains thatthe productivity gains associatedwith the widespread use of electricalpower that began in the late 1800swere very long in coming.10 Davidargues that significant productivitygains from the invention of the elec-tric dynamo did not begin to emergeuntil the 1920s since old technolo-gies, such as steam and water power,were not immediately discardedwhen electricity arrived on the scene.Moreover, new and innovative waysof using electricity in the manufac-turing and production of goods alsotook time to develop.

The economy may currently beexperiencing the same transitionwith the computer. As a share ofGDP, investment in high-technologyequipment is approaching 5 per-cent—a far cry from the approxi-mately 1.75 percent from a decadeearlier. It is just a matter of time,according to David and others,before firms learn how to fully adaptthese technological advances to theproduction of goods and services.

Some CaveatsMeasurement issues—which are

admittedly important—aside, it ispossible that the growth of workerproductivity has slowed consider-ably over the past 25 years or so formore fundamental reasons. Tobegin with, the accumulation ofphysical capital over time largelydepends on the saving behavior of acountry's citizens. Simply put, themore a country saves, the more itinvests. The more it invests, themore capital its workers have attheir disposal and, in general, themore productive they will become.The end result is a higher standardof living. Perhaps one reason whyrecent productivity trends have beensorely disappointing is that the U.S.saving rate averaged just over 2 per-cent between 1983 and 1996, which

pales in comparison to the morethan 6 percent saving rate seenbetween 1946 and 1982.

Because ideas are important inpromoting the technologicalprocess, R&D efforts can play a crit-ical role in determining long-termincreases in living standards.Another possible reason, then, whycurrent productivity growth doesnot measure up to previous periodsis that there has been a significantdrop in the amount of resourcesdevoted to R&D. Spending on R&Dfell from just under 3 percent ofGDP in the early 1960s to about 2percent in the late 1970s. Althoughit recovered strongly, rising to nearly2.75 percent by 1985, it has startedto wane once again, averaging about2.5 percent of GDP in 1996.

Human capital is a key compo-nent of the production process—especially in a knowledge-basedeconomy. Therefore, a final reasonwhy worker productivity growth hasslowed could be the performance ofour education system, particularly atthe elementary and secondary lev-els. According to a recent survey,U.S. students registered the lowestaverage test score from the ThirdInternational Mathematics andScience Study.11

And the Verdict Is . . .As nearly all economists recognize,

measuring productivity accurately isa difficult task. Still, a cursory look ateconomic fundamentals suggests thereare reasons to believe that things arenot as rosy as many insist. At thesame time, there are also solid reasonsto believe that technological improve-ments related to the computer micro-chip have changed the U.S. economyin fundamentally important ways—improved labor productivity growthand slowing rates of inflation, amongthem. Although signs of faster pro-ductivity growth have begun toemerge in the official statistics, it istoo early to determine whether thesegains are permanent, or, as others haveclaimed, simply temporary. Thus,while greater gains in labor productiv-ity would be a welcome developmentfor monetary policymakers, it remainstrue that inflation is ultimately deter-mined by how fast the central bankcreates money. By itself, therefore,faster productivity growth—if that iswhat is occurring—is not enough tokeep inflation low and stable.

Kevin L. Kliesen is an economist at the FederalReserve Bank of St. Louis. Daniel R. Steinerprovided research assistance.

The Regional Economist • January 1998

ENDNOTES1 See Federal Reserve Bank of

Kansas City (1992).2 See Mankiw (1997).3 The misery index is the sum of: the

unemployment rate, the inflationrate, and the quarterly change in thelong-term Treasury interest rate, lessthe deviation of quarterly real GDPgrowth from its 10-year average.

4 The most commonly cited factor inthis regard is the recent effort ofbusinesses to rein in benefit costs(and in particular, health care costs).

5 See Greenspan (1997).6 See Hall and Jones (1997). The

term infrastructure, as used here,does not refer to a nation's roads,bridges, highways, tunnels orother structures.

7 Broadly speaking, growth of percapita GDP (living standards) is thesum of output per hour (labor pro-ductivity) and the number of hoursworked per capita (labor intensity).By this formula, the U.S. economy'spotential growth rate appears to bebetween 2 percent and 2.5 percent,with labor intensity contributingabout 1 percent of this growth andlabor productivity contributingroughly 1 percent to 1.5 percent. Agood discussion of this topic can befound in the Minneapolis Fed's1996 Annual Report.

8 See Kliesen (1996).9 See Slifman and Corrado (1996).

10 See David (1990).11 U.S. students were compared with

those from the other Group ofSeven (G-7) countries: Canada,France, Germany, Italy, Japan andthe United Kingdom.

REFERENCESDavid, Paul A. "The Dynamo and

the Computer: An HistoricalPerspective on the ModernProductivity Paradox," TheAmerican Economic Review (May1990), pp. 355-61.

Greenspan, Alan. "Remarks at theUniversity of Connecticut," Storrs,Conn., October 14, 1997.

Federal Reserve Bank of Kansas City.Policies For Long-Run EconomicGrowth, A Symposium Sponsoredby the Federal Reserve Bank ofKansas City (1992).

Federal Reserve Bank of Minneapolis.Breaking Down the Barriers toTechnological Progress: How U.S.Policy Can Promote Higher Growth,1996 Annual Report.

Hall, Robert E. and Charles I. Jones."Levels of Economic ActivityAcross Countries," The AmericanEconomic Review (May 1997),pp. 173-77.

Kliesen, Kevin L. "Critiquing theConsumer Price Index," TheRegional Economist, Federal ReserveBank of St. Louis (July 1997),pp. 10-11.

Mankiw, N. Gregory. Principles ofEconomics (Fort Worth, Tex.: TheDryden Press, 1997).

Slifman, Larry and Carol Corrado."Decomposition of Productivityand Unit Costs," Mimeo, Board ofGovernors of the Federal ReserveSystem (November 18, 1996).

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