The New (and Improved) Economy
Minneapolis Fed directors hear arguments about what's new in the economy—and what isn't.
Ronald A. Wirtz
- Editor, fedgazette
Published June 1, 2000 | June 2000 issue
You've all heard it before. Name your productdog food, cars, detergent, light bulbssooner or later, advertisers are pushing it as "new and improved."
So it is, after a historic economic expansion in the United States with no end in nearby sight, that many want to slap that label on the good ol' U.S. economythe "new economy," they call it.
With higher productivity, low inflation, low unemployment and long-term growth, advocates argue, today's new economy is the updated and improved version of the old and average economy.
Well, is it?
That was the question posed during a special meeting of the board of directors of the Federal Reserve Bank of Minneapolis late last fall. Arthur Rolnick, senior vice president and director of research for the Minneapolis Fed, told board members at the start of the retreat, "We have evidence that maybe something is going on that's quite a bit different from the last decade or two."
Over the course of two days, board members listened to experts, looked at facts, heard a little history and added their own anecdotes about whether this was truly a new (and improved) economy.
Like any good discussion among a roomful of people, the answer was clear: yes and no. "Is this a new economy?" asked Gary Stern, Minneapolis Fed president, during his presentation to directors. "I don't think we have a definitive answer on that."
That's not to say there weren't strong opinions on both sides of the issue. New economy advocates point out that unemployment and inflation have been at low levels most experts previously believed were not coincidentally possible. Combined with high productivity growthand in a tight labor market, no lessthese three elements are the triumvirate for long-term growth and prosperity, new economy advocates argue.
But naysayers point out that, in fact, some of this has been seen before. While it might be a different economy, it is not a new economy.
"The facts support both sides," said Warren Weber, a senior research officer with the Minneapolis Fed, in his statistical overview of the issue.
The big picture
While unemployment and inflation trends still grab their share of headlines, productivity growth has been the showstopper. After languishing for better than two decades, productivity has posted strong gains since 1995, and is the real driver behind the new economy argument.
The key to recent productivity gains, to many at least, is the increased prevalence of knowledge in our society. To help the bank's directors put recent productivity growth into historical context, they were asked to take a couple of big steps backall the way to the Middle Ages. Gregory Clark, professor of economic history at the University of California-Davis, said that in the grand scheme of human history, living standards saw no marked improvement for hundreds of years until about 1820, and then "growth growth growth."
Productivity, for all practical purposes, was in the tank for centuries, Clark said. In fact, it took hundreds of years for the real living standard to exceed that of the 14th century. Before the 20th century, output was largely agricultural and driven by capital, land and labor, Clark said. Knowledge had little role in any country's economy. By its nature, the value of knowledge is hard to capture, and has what Clark called an "incentive problem." In the classical world, he said, there were "no institutions to provide the incentive that would allow people to reap rewards from knowledge." For example, the absence of property rights meant that one person's good idea soon became everyone's good idea. Because of this, in part, growth was rarely in evidence and, when so, fairly predictable.
The Industrial Revolution brought significant growth that was attributable to more traditional sourceseconomies of scale, increased efficiencies and so onbut by the 20th century growth became more difficult to categorize. It was "like manna from heaven," Clark said. Productivity increased through some unexplained source whereby the same inputs created more outputs, Clark said. Something had changed. Ultimately, increased productivity must come from one of two sources, Clark said: capital investment or increased efficiencies, or a synergy of the two. Clark theorized that growth in efficiency was driven by investments in people. IQ tests slowly drifted upward as the modern economy invested more in people's education and other knowledge enhancers.
Broader productivity gains came "as a result of the spillover effect of many of these private efficiencies and investments" in knowledge, Clark said, because only a small portion of the full spillover benefit is captured by those making the investment. Society harvests the rest.
Fast forward to today's economy, where knowledge has become king. John Rollwagen, a partner in St. Paul Venture Capital and former chief executive officer of Cray Research, told the board that today's economy values knowledge over everything else, and has changed the very nature of exchanges and transactions.
"I'll trade you what you know for what I know. That's happening around us all the time," Rollwagen said. He added that knowledge was a perishable good because its value decreased over time, and could only be shared (not exchanged) because the original holder retains ownership after the transaction. As such, the value of a knowledge exchange has even replaced that of a monetary exchange. In today's knowledge economy, Rollwagen said, "(Having) your knowledge and my knowledge wins out vs. my knowledge and your money."
Knowledge as competitive advantage was not invented in the last five years, to be sure. However, knowledge today is increasingly well captured by advancements in computers and information technology, Rollwagen said. He passed a new digital camera among the directors, noting that the $1,200 camera had twice the computing power of the most powerful Cray computer he ever sold, which at the time was worth $30 million.
As the value of knowledge has increased, so too has the value of communications. At the same time, however, advancements in information technology have drastically decreased the transaction costs of communications, as computers, software and telecommunications are now "inexpensive commodities," Rollwagen said.
The impact of these technology advances has reached some industries faster than others. Philip Heasley, vice chairman of US Bancorp, told the board that banking is one of the few industries that is digital by naturephysical only in traditional currency of cash and checks, which are being replaced by credit and debit cards and e-banking.
Out with the old (economy), in with the new (economy)
Productivity comparisons of the last five years with the previous two decades show some striking differences. Labor productivity growth in the private sector was more than 2 percent from 1995 to 1999almost double the rate from 1972 to 1995, according to Weber.
Big productivity jumps have come in manufacturing. Although a modest part of gross domestic product (GDP), manufacturing productivity grew 4.4 percent annually from 1995 to 1999, and durables manufacturing saw impressive growth of 6.5 percent during this time, Weber said, most of it fueled by 40 percent annual productivity growth in the computer industry.
Weber acknowledged that the current productivity growth spurt spans only a short period. But he said that it occurred a few years into the economic expansion of the 1990s rather than early on (which is more common), and in the face of low unemployment.
Proponents of the new economy also point out that productivity is likely higher than the data suggest. Some have argued that current growth is riding on the back of the computer industry. But Weber said that economic growth has been very broad-based, and strong income and profit figures suggest that overall productivity might indeed be higher than current calculations indicate.
Plenty of anecdotes surfaced during the course of the retreat to support the idea that productivity growth was broad-based, though maybe triggered by computers and other technology-based advancements.
Jean Kinsey, professor of applied economics and head of the Food Retail Industry Center at the University of Minnesota, said productivity has increased significantly in food retailing through such innovations as the bar code and other technology investments that have made the industry more consumer-focused and efficient. These productivity gains have led to falling real food prices, lower distribution costs and a proliferation of new products and services.
David Koch, chairman of Graco Inc. and chairman of the Minneapolis Fed board at the time of the retreat, said his company's productivity has skyrocketed in recent years. From 1992 to 1998, company productivity improved 35 percent. Return on sales rose from less than 5 percent in 1980 to more than 13 percent in 1999, Koch said, and sales per person more than tripled from $66,000 in 1980 to $209,000 in 1999, with net earnings per employee seeing even greater growth, he said.
In years past, "the question every year was not if we were going to raise prices, but how much," Koch said. That's not so today, he added, because there is constant pressure on prices from global competitors and industry consolidation.
Director Kathryn Ogren said her Montana car dealership has seen significant labor improvement through the deployment of information technology. Director Rob Wheeler said his South Dakota jewelry business recently installed new technology in a manufacturing line, which cut the line's labor from nine to three people.
Been there, done that
Not everyone is ready to jump on the new economy bandwagon, however. Critics, for example, point out that average productivity growth from 1950 to 1972 was slightly higher than the growth achieved over just the last five years.
Much of the productivity growth is the result of gains in computer manufacturing, with annual productivity growth of better than 40 percent. "This has a dramatic effect even though it's only 1 percent of GDP," Weber said. After factoring out the effect of computer manufacturing, productivity growth in manufacturing was roughly 1.75 percent from 1995 to 1999.
"What I have an issue with is 'new' economy," said Dan Laufenberg, a senior economist with American Express. "Growth in productivity of 3 percent is not new." He said that there were several short periods in the 1970s and 1980s that saw productivity growth over 3 percent, despite the fact that the overall trend rate was much lower. He added that the current productivity push is merely "a catch-up" period to make up for slow growth earlier in the decade.
Laufenberg said the current expansion was "different, due specifically to capital deepening in computers," which in turn has been responsible for the productivity increases. "We're not seeing dramatic productivity gains in other areas right nowthe kind of 'general growth' that you would expect to see."
Capital deepeningusing capital to replace laborusually happens late in an economic expansion, Laufenberg said. The current expansion is no different, as capital deepening in computers has occurred in the last five years, much of it tied to large increases in the number of computer users and dealing with Y2K.
What is new, Laufenberg said, is the net effect of changes to price measurement. A reformulated consumer price index, for example, added 0.35 percentage points to productivity in 1998. "But we don't go back and revise history" with regards to past productivity growth, Laufenberg pointed out to board members.
The reclassification of GDP means that the United States is looking at 3 percent to 4 percent growth going forward, Laufenberg said, but much of that "new" growth is merely through recalculating the measuring sticksimilar to changing the number of feet in a yard, or creating a 14-inch foot. People wouldn't suddenly become shorter or taller just because the measuring standard had changed.
"It doesn't change reality," Laufenberg said.
Laufenberg also is skeptical that the application of technology is generating the productivity gains. "There is no statistically significant evidence that the overall economy is showing productivity gains from technology," Laufenberg said, because virtually all of it is captured or realized by the individual.
Laufenberg said his colleagues considered him a "raving lunatic" for being too optimistic in 1990, when he predicted productivity growth of 1.8 percent for that year (which ended up 1.7 percent). In a similar vein, "you have to be careful to not be too exuberant" about recent productivity gains, he said. "We won't know what the answer to this is for some time."
That uncertainty was shared by others at the retreat.
"It's clear economists don't know what's driving this," said Tom Melzer, former president of the Federal Reserve Bank of St. Louis, who is now an investment banker.
What effect on Fed monetary policy?
Regardless of any agreement over whether this is truly a "new" economy, the Federal Reserve is faced with the responsibility of making some sense of the current economic order, and determining a proper direction for monetary policy in the, er, not-yet-officially-agreed-upon-economy.
Uncertainty over some fundamentals in the U.S. economy can make this a tricky task. Forecasting models can give policymakers a good idea of what to expect economically, but it "doesn't give us the story of why it happened," said Minneapolis Fed President Stern. "We don't know as much as we would like about productivity and why it accelerates," nor does the Fed "have a good explanation for why the slowdown happened" from 1972 to 1995, he added.
Given that uncertainty, Melzer said it is important for monetary policy to remain focused, and that is precisely the Fed's goal. Essentially, forecasting future growth expectations is a simple formula with three basic pieces: labor pool growth, labor productivity growth and inflation, according to Melzer. Of these pieces, labor pool growth is very predictable, and the Fed typically targets an inflation rate, which means that "productivity is the only moving part," Melzer said. In the last few years, monetary policymakers have had the good fortune to see higher-than-expected productivity gains and lower inflation.
"I'd much rather be surprised on the positive side than the negative side [regarding demand growth projections]," Melzer said. This ultimately leads to conservative productivity estimates. If demand projections are overestimated, higher inflation is likely to occur, "which takes a lot of political and economic capital to rein in," Melzer said.
For this reason, Melzer said, monetary policy "shouldn't get enthusiastically on board on the high end" of growth projections. He reminded the directors that price stabilitynot general economic growthwas the Fed's main objective. Monetary policy has little or no direct effect on the size of the labor force or productivity growth, which meant that inflation was the only piece of the economic growth equation that the Fed could control, Melzer said.
"Many people believe that the FOMC (Federal Open Market Committee) is targeting real growth," Melzer said. To the contrary, the Fed does not and should not set expectations for real growth"the economy will determine that," Melzer said.
In keeping its sights on inflation and price stability, Melzer said the Fed should establish clearer objectives. "We should tell people that's what we're trying to do," he said, such as publicize a targeted range for the annual inflation rate.
But there is no agreement on what the inflation target should be, both within the Fed and among private sector forecasters, Melzer said. Although there is loose agreement on a 2 percent inflation rate, an opportunity is missed to create more certainty with regard to growth expectations.
"We're compounding uncertainty about productivity with lack of agreement on what we want to achieve with regard to inflation," Melzer said. "We need more consensus on what that inflation number should be."
Stern said the FOMC has been grappling with inflation targets "for some time," but ultimately the uncertainty and lack of agreement on inflation targets require the Fed to move very slowly and cautiously. Maybe a new approach by the FOMC was necessary, one that was less anticipatorya common FOMC dispositionbecause no one knows exactly what's happening, much less why. Or maybe the FOMC "should react more quickly to indicators of inflation rather than indicators of a slowing economy," Stern said, to keep the focus on inflation rather than on influencing the economy directly.
"You have to be cautious given the uncertainty about what's going on," Stern said, adding that societies often do not recognize or understand major economic shifts when they occur. As a result, Stern said, "as you change policy, do it incrementally and infrequently, because we just don't know enough about the animal with which we're dealing."