The Good Bad News

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The consensus view of the board was that "soft" meant a growth rate of 3% to 3.5% over the next year or so. That, says Blinder, might cause unemployment "to creep up ever so slightly." But it would be another Panglossian development; it would reassure the Fed, says Blinder, that the economy had slowed enough to keep inflation in check with no need for additional interest-rate hikes.

Wyss figures the economy is slowing enough to reduce the "core rate" of inflation--the underlying trend, minus usually volatile food and energy prices--to about 2.5% a year. That is believed to be just about Fed Chairman Alan Greenspan's target. Result: after about a year of "below-trend" growth, output could be able to speed up again. Wyss figures the economy has the potential to grow almost 4% annually over the next 10 years.

At first glance that might seem--well, Panglossian. But whatever the actual numbers, board members agreed that the economy's potential for sustained rapid growth with only mild inflation is "a whole lot higher than we thought seven years ago, five years ago," in the words of Robert Reischauer, president of the Urban Institute and a former director of the Congressional Budget Office.

The big reason: productivity. For more than two decades, through the mid-1990s, the output of goods and services per worker hour rose at a sluggish pace. But it is now riding what Feldstein calls a "rising wave." Productivity increased 5% last year, and is still accelerating through the slowdown; in the second quarter of this year it shot up at an annual rate of 5.7%. One result: though "tight labor markets are pushing up wages at a faster and faster clip," says Feldstein, unit labor costs--what employers pay out in wages and benefits for each pound of plastics produced or hamburger served by their workers--are lower than a year ago. And unit labor costs, he notes, are the "key driver of inflation."

Moreover, Feldstein expects productivity to continue to grow rapidly over the next several years. One reason is that companies are putting much more invested capital behind each worker these days. Also, "managers are managing differently." They are concentrating on cutting costs much more than in the past. Partly that is because they have been "scared by international competition." And stock options and other incentives push them to pare expenses as the best way to increase profits at a time when price increases run into stiff resistance.

The biggest reason for increasing productivity, Feldstein says, is, of course, the computer and particularly the Internet. Wyss cites a little-noticed benefit: with computers, managers "can get a high school graduate to do the work a college graduate used to do." One example: a mortgage-loan applicant was once interviewed by "a trained loan officer with a college degree" who probably referred the application to a loan committee, which might have given an answer in two weeks. Today "you'd be sitting across the desk from somebody who was probably a teller two weeks ago, and she's reading the questions off a PC screen and typing the answers you give her. In five minutes you know whether you got the mortgage or not."

One result is that unemployment has recently dropped most sharply among less educated people. And, says Wyss, "by creating jobs for lower-skilled people, you have changed the basic way income is distributed." From 1973 to 1993, he notes, only the top-earning 20% of the population received any gain at all in real income, but "in the past five years the bottom 20% had the highest income gains" of any group.

At the same time, Cohen points out, corporations and investors are also doing well. She expects corporate profits to increase at about a 10% rate this winter. That would be only half the "very robust 20%-plus" rise last winter but still "quite comfortable." And though stock markets suffered a severe shake-out last spring, Cohen thinks their future also looks good. Says she: "The stock market performs well when investors have confidence in the durability and longevity of economic expansion, and we think that's what the situation is likely to be."

So does Dr. Pangloss rule unchallenged? Not quite. Lindsey sights two potential clouds on the long-range horizon. The more hazy threat, in an expansion still heavily dependent on business investment, is a decline in the yield on marginal investments--the last and most speculative dollars sunk into a venture. Lindsey's scenario: "The marginal investment yields a rate of return which is below the rate demanded by the markets. All of a sudden these investments don't look so good. A few bond issues fail. The economy can be going along just fine, and all of a sudden this hits, and you get a possible recession."

The bigger potential danger, though, is a weakening of the almighty U.S. dollar. In view of the monstrous U.S. trade deficit--a hemorrhage of greenbacks spent on foreign goods that is currently heading toward $400 billion a year--it is a bit surprising that that hasn't happened already. The reason, says Blinder, is that "the representative centimillionaire in a neutral country like Switzerland or Singapore, sitting down to figure out where to put his last $10 million, is saying, 'The U.S. looks pretty good.'" So the dollars spilled abroad by the trade deficit come right back in the form of investment, and the buck stays strong.