An Economist’s Viewpoint
Top of the Ninth
Gary H. Stern
- President, 1985-2009
Published September 1, 2004 | September 2004 issue
Editor's note: These remarks were delivered to the Kansas Council on Economic Education, April 29, 2004, in Topeka, Kan.
Economic education has always been a worthy cause, but I have become convinced in recent years that it is more—that economic and financial literacy may well be essential to the long-term success of the U.S. economy and to advances in our standard of living. Despite its value, and despite some progress in recent years, there is still a lot of ground to cover in order to achieve widespread economic literacy. And I am afraid that many of us in the profession, practitioners and educators alike, have not done enough to demonstrate in a truly compelling way the value an economic perspective contributes to understanding real-world policy issues. Partly as a result, we are confronted almost daily with reports containing major economic content which are misleading or, at best, incomplete. And the consequences of such depictions could be quite costly, were the public and its elected officials to take them seriously.
Thus, I want to take a few minutes to identify several policy issues which frequently are the focus of public commentary and attention, to discuss what economists have to say about them and to contrast conclusions economists might reach with the "conventional wisdom" on such topics. Some of these topics are contentious, and so in a sense I am urging that we keep an open mind about challenging policy issues and use both economic principles and historical evidence to narrow the range of debate. I will strive to be objective, but no doubt some of my biases will show through; in any event, rest assured that, as always, I am speaking only for myself and not for others in the Federal Reserve.
The debate over outsourcing
Let me start by introducing the first topic, namely, foreign trade and its frequent portrayal as negative for the American worker, and by implication, for the economy as well. Of course, concern about offshore outsourcing is all the rage today, to put it mildly. Greg Mankiw, chairman of the Council of Economic Advisers, found himself in hot water recently for endorsing the long-run benefits of outsourcing—in effect, for saying that "the earth is round," as Alan Murray of the Wall Street Journal so nicely put it.
Now, there are lots of things that can be said about outsourcing, but I will try to impose some self-discipline. First, as a quantitative matter, available evidence suggests that outsourcing accounts for a minor amount of the gross job losses that occur in the U.S. economy in a given year. More positively, outsourcing represents an improvement in the allocation of global labor resources and thus over time should contribute to higher living standards here and abroad. This is an important effect that should not be underestimated.
Attempts to limit or to prohibit outsourcing will, intentionally or not, make it more difficult for U.S. firms to compete internationally and may in time retard hiring domestically. Moreover, prices to U.S. consumers will be higher than they otherwise would be. These observations should sound familiar to economists, if not to the general public, because they are the same concerns raised about any form of trade restriction. And while it is certainly true that some of our trading partners have adopted policies to restrain imports or to subsidize exports, the cost of such initiatives is borne largely by the taxpayers and consumers in those countries.
In fact, if we look at the evidence, employment in the United States tends to increase over time with the population, and there is no extended episode of which I am aware where jobs overall have moved abroad. However, this is not to suggest that we should be indifferent to the workers, industries and communities adversely affected by foreign competition, technological obsolescence or other manifestations of that hallmark of capitalism called "creative destruction." But the appropriate response to such change is policies which emphasize education, retraining, programs to enhance labor mobility and similar initiatives.
Change is part and parcel of a market economy, as developments in the U.S. manufacturing sector over the past 50 years illustrate so well. While not often acknowledged, employment in manufacturing accounted for fully one-third of total nonagricultural employment in the mid-1950s, compared with about 11 percent today. In absolute terms, manufacturing employment peaked in 1979 at just under 19.5 million workers; today the comparable figure is about 14 million. Yet, because of rapid growth in productivity in the manufacturing sector, manufacturing output has expanded more rapidly than the economy as a whole over the past 50 years.
I would characterize this as an impressive record of success in manufacturing, recognizing that the overall economy also did well over the period. Moreover, there is no question but that many of the workers displaced from manufacturing, or from other sectors for that matter, found jobs. In the postwar period, unemployment in the United States has averaged less than 6 percent of the labor force, and real per capita income has approximately doubled since 1970.
Let me move now to a second topic where misunderstanding appears to reign. The topic is inflation, where relative price changes are sometimes confused with inflation or deflation. Just as declining prices for computers, for example, or for rents for office space do not indicate deflation, rising energy prices do not necessarily signal inflation. By inflation, economists mean a sustained increase in a broad measure of prices, such as the consumer price index or the price deflator for personal consumption expenditures. Various components of these indices are always moving up and down, sometimes by large magnitudes, in response to changing conditions in various markets for goods and services.
But perhaps a more serious error in understanding inflation results from the Phillips curve approach favored by some analysts and commentators. This approach, which emphasizes a relation between labor market conditions and inflation, is deceptively seductive. While the argument has taken several forms over the decades, it essentially maintains that the tighter the labor market—the lower the unemployment rate, say—the more rapid the inflation or, alternatively, the more rapidly inflation will accelerate. The argument seems plausible because it relies implicitly on the notion that labor costs are an important determinant of inflation.
There are two problems with the Phillips curve approach to inflation, but they can be summarized by saying that the hypothesis does not fit the facts particularly well. Specifically, there is a large body of empirical evidence, which holds both across countries and over long time periods, indicating that inflation is a monetary phenomenon. That is, in the long run, inflation results from excessive growth in the money supply, irrespective of conditions in the labor market. Moreover, and this is the second criticism of the Phillips curve approach, empirical evidence since the mid-1980s shows no significant relation between unemployment and changes in inflation for the U.S. economy. Whatever relation previously existed seems to have disappeared, perhaps because inflation has been relatively modest and stable for much of the past 20 years.
If in the long run inflation is a monetary phenomenon, then central banks, including of course the Federal Reserve, have the ability and the responsibility to restrain it. It is essential that we do so, for inflation can be destructive to economic performance, as we saw in the late 1970s and early 1980s. In contrast, a stable, low inflation environment can accompany, and I believe contribute to, sustained economic expansion and rising living standards, as we have seen for most of the past 20 years.
Foreign exchange interventions
While on the topic of monetary policy, there are two other misconceptions I want to address. The first is one that claims that manipulation of foreign exchange rates represents a monetary policy tool independent of domestic policy. We frequently see, for example, comments to the effect that "country x" should reduce the international value of its currency, presumably by selling it in exchange for foreign currencies, so as to, say, stimulate its exports and reduce its trade deficit. Such advice ignores the crucial distinction between "sterilized" and "unsterilized" intervention in currency markets (I apologize for the jargon but it is unavoidable here).
Sterilized intervention—that is, foreign exchange market intervention which is offset in domestic financial markets so that neither growth in the money supply nor interest rate levels change—will at most have a short-lived effect on exchange rates; to be direct, sterilized intervention will be ineffective. In contrast, unsterilized intervention by definition means that interest rates and money growth will be affected; in the example here, interest rates should decline (at least initially) and money growth accelerate. But, note, what I just described as unsterilized intervention is the conventional depiction of expansionary monetary policy, so, as I asserted a moment ago, the exchange rate does not represent an additional policy tool.
A resilient economy
At this point, before turning to your comments and questions, I want to introduce my final topic, which also pertains to monetary policy but which really has to do with the fundamental nature of the U.S. economy. Our economy is described, all too often from my perspective, as poised on a "knife's edge," ready to fall off into the abyss of recession on the one hand or spiral off into rapid inflation on the other unless Federal Reserve policymakers, and perhaps others as well, adjust policy with astute precision. This vision is evident in the outsized attention paid to speeches and other commentary from Federal Reserve officials and in the scrutiny devoted to weekly and monthly economic statistics, although of course it is not the only factor contributing to devotion to these matters.
But I would maintain that the U.S. economy is rarely if ever poised on a knife's edge, dependent on policymakers getting things just right. To the contrary, the history of the past 20-plus years reveals that we have an exceedingly resilient, self-correcting economy that performs reasonably well irrespective of the adverse shocks that hit it.
Recall that the U.S. economy has expanded almost uninterruptedly since 1982, save for two short, mild recessions. Over this period, something like 40 million net jobs have been created, inflation has declined persistently, and living standards have improved materially. And yet, during the period since 1982, we had the stock market collapse of October 1987 and the prolonged bear market in equities earlier this decade, major economic and financial dislocations among some of our largest trading partners including Mexico and Japan, the virtual demise of the savings and loan industry, as well as serious problems in commercial banking in this country in the late 1980s and early 1990s, significant downsizing of our defense industry followed by rebuilding, and the terrible events of 9/11.
To be sure, appropriate policy responses helped to cushion the reaction to some of these shocks, but I think it a gross overstatement to attribute the economic success of the past 20 years principally to monetary policy, wise though it may have been. A better interpretation, in my view, is that the U.S. economy is fundamentally sound and resilient. And one principal reason for this resilience is that we have most of the "big things" right in the economy: The rule of law prevails and property rights are honored, prices allocate most resources, labor markets are permitted to adjust, and government generally plays a constructive role.
The benefits of building literacy
In concluding, let me summarize the ground I have covered and the points I have tried to make.
- Foreign trade, including outsourcing, is good for the U.S. economy, consumers and many businesses. Too often, trade is portrayed negatively and, in those instances where it adversely affects workers and communities, remedies emphasizing training, education and mobility should be pursued.
- Inflation, or deflation for that matter, is at heart a monetary phenomenon, and therefore price stability is the responsibility of central bankers. Inflation is not the consequence of changing commodity or computer prices, just to pick two examples, except for perhaps in the most transitory of circumstances, nor does it appear to have much to do with contemporary labor market conditions.
- Intervention in foreign exchange markets does not represent a monetary policy tool separate and distinct from domestic policy, despite media coverage which implies that it does.
- The U.S. economy is highly resilient and is not dependent on the Federal Reserve or others getting policy precisely correct, which is too high a standard in any event. Instead, policymakers need to avoid large errors and assure that policy is approximately correct.
I noted at the opening of these remarks that economics can make a valuable contribution to understanding policy issues, and I have tried to illustrate that point with these specific examples. In closing, I would urge that we continue and, indeed, redouble our efforts to build economic and financial literacy; we will all benefit from the success of such efforts in terms of improved economic performance.