The US economy in the ‘90s was never what it seemed under Greenspan

Gerard Jackson
BrookesNews.Com
Monday 22 August 2005

It was good news all the way for the US economy in early 1999. Buoyant employment figures, the lowest inflation rate in more than 12 years, rising consumer spending, low interest rates and a growing GDP. What could possibly be wrong? Plenty — and Greenspan clearly sensed it, despite the Pollyanna-like optimism of a great number of commentators who had foolishly proclaimed a “New Era” for the American economy, just as so many did in the 1920s.

That the Federal Reserve had no time for this fantasy was made clear by Michael Prell, its chief forecaster, when he rejected the naive view promoted in certain quarters that the Fed had successfully banished the ‘trade cycle’.

However, the Fed’s view that a structural change had transformed the American economy and this transformation largely accounted for the economy’s current behaviour was, in its own way, just a more subtle version of the New-Era thesis that helped bring about the Great Depression.

What was getting at the Fed was the fact that manufacturing was definitely weakening while consumption spending still surged ahead. This is the sort of economic paradox that the Keynesian and monetarist schools are unable to deal with. All Prell could do was to weakly declare that ‘we need to be careful about letting the trials of the manufacturing industries colour our sense of the overall picture excessive”.

In short, “I don't know what the hell’s happening”. The present condition of manufacturing left Federal Reserve governor Roger Fergus arguing that traditional indicators like capacity utilisation are now becoming less useful as measures of resource scarcity. Meaning he didn’t know either.

Prell followed the usual line that large increases in household wealth generated by the booming stock market had fuelled consumer spending and the demand for housing. Some call this the “asset price-driven wealth effect”. Assets rise in value which makes households wealthier which then fuels their consumption spending. (The word for this line of ‘economic’ reasoning is incredible, and that’s being polite). This was followed by the suggestion that there had been a shift toward investment in less durable equipment with the result that it now needs larger amounts of gross investment to get the same addition to the capital stock.

To begin with, the ‘asset price-driven wealth effect’ is a complete furphy. As I explained at the time, there is no way this so-called ‘wealth effect’ could in itself boost consumption. A household can only use an increase in asset values to increase its consumption by either selling assets or borrowing against them. (I have ignored dissavings for reasons of simplicity). Either way, it is patently obvious that for the alleged wealth effect to operate on a national level there would have to be a monetary expansion.

This leads me to my previous conclusion that surging consumer demand and the rise in asset values were being generated by credit expansion. Yet Fed operatives, Wall Street economists, media commentators, etc., were, and still are, totally blind to this possibility. It is as if they truly think “money does not matter”, that it really is neutral and only has a passive role to play in the economy, simply changing with the needs of the economy. Money is not neutral and it does matter.

Prell’s opinion on capital spending involved capital theory and certainly cannot be satisfactorily dealt with in a short article, let alone a couple of paragraphs. Several points do, however, need to be stressed. Capital goods are noted for their durability, though this obviously varies according to the type of good, the extent to which it is worked, maintained, etc.

Now the less durable, less labour-saving and more easily replaced capital goods tend to be employed closer to the point of consumption. This suggests that a shift in investment to Prell’s shift “toward shorter lived equipment” was really a shift away from capital intensive activities to labour intensive activities. In other words, a move to invest that does little to raise labour productivity.

The Austrian school of economics stresses that capital always forms a heterogeneous structure consisting of complex stages of production. As an economy progresses it lengthens the structure by adding more and more complex stages to it. This process increases labour productivity which is what raises living standards. It follows that if the process is reversed, i.e., stages are abandoned and the structure shortened productivity will slow and real wages will eventually fall.

Nevertheless, this process could be concealed for a time by even small increases in productivity in the remaining stages of production. Three things could cause this investment shift: (a) falling savings, (b) falling rates of return in the higher stages of production caused by continual Keynesian pump priming and (c) a combination of (a) and (b).

I think it is becoming increasingly plain that the Fed’s failure to understand what happened to the American economy in the 1990s drove it to make ad hoc statements. This failure is why it could not explain the impending bust even though it knew one was on the way. Hence it is repeating the same mistakes.

Note: A view that became the received wisdom of some that America was building “a new form of capital based on information technologies” was very superficial and third rate. Capital is the material means of production.

It is this that raises real wages and living standards. If information technologies are the same as nineteenth century and twentieth century transport technologies or power generating technologies in the sense that they lengthen the capital structure then they will raise living standards. But it must also be remembered that only savings can fuel investment. Without savings, an economy is doomed to decline.

Gerard Jackson is Brookes’ economics editor