Believe Your Eyes; The New Economy Is Real
Wall Street Journal
Nov. 18, 1999

My favorite economists these days are Richard Pryor and Yogi Berra. Mr. Pryor once asked, "Who are you going to believe? Me or your own lying eyes?" Yogi is alleged to have said, "You can observe a lot just by watching."

In the past five years, our economy's paradigm has been shifting for the better, but the change is so gradual that many of us haven't noticed or have underestimated its significance. The defining feature of the new paradigm is faster productivity growth. From the early 1970s to the mid-1990s, productivity grew just over 1 percent a year. Since then, it has averaged more than 2 percent annually, meaning it has grown twice as fast as before.

This is a significant change. After two decades of 1 percent productivity growth, with a similar rise in employment, the economy's presumed noninflationary growth potential was just over 2 percent. Many policy makers came to regard a 2 percent to 2.5 percent supply-side growth potential as a "speed limit" and gave themselves over to the Keynesian focus on the demand side.

As faster productivity growth raised this speed limit, some policy forbearance was needed to find and test the new limits. The Fed's wait-and-see policy was a calculated risk, but it was ultimately rewarded with 4 percent real growth, 4.2 percent unemployment and core inflation below 2 percent—all better levels than most models had predicted. My dissent from the June and August Fed tightenings, as reflected in the published minutes, was based on my desire to test the growth limits of the new economy.

I believe that the way to minimize inflation risk is to focus directly on inflation indicators, regardless of the strength of real growth and employment. What the indicators show is no sign of inflation but plenty of welcome growth. Figures released last Friday indicate that the unemployment rate fell to 4.1 percent—its lowest level since 1970—while hourly wages rose the smallest amount since August. Squeaky tight labor markets have facilitated welfare reform and reduced poverty, crime and minority unemployment. In Texas, businessmen tell me they are now hiring and training the "unemployable." And most of our cities bordering Mexico have single-digit unemployment for the first time in years.

Globalization has been a key in reducing the inflation risk of faster growth. The churn of creative destruction and growth is accelerating. The collapse of communism, socialism and protectionism brought many new countries, their workers and consumers into the market economy. Deregulation, privatization and consolidation spread. World-wide, cheap labor and capital are coming together, bypassing national capacity constraints. Technology and trade are mutually reinforcing.

Many analysts believe such factors reduce the inflationary impact of rapid growth. But rapid growth itself is deflationary if it comes from the supply side. If the price level is total spending divided by output, then output growth resulting from new discoveries, inventions, innovations, deregulation, freer trade and tax cuts should be the opposite of inflationary. If I'm right about that, an unfortunate corollary is that a slowdown in growth from the supply side could worsen inflation.

Many new-paradigm skeptics argue that the economy's improved performance is based on temporary factors, including a strong dollar, the Asian crisis and falling energy prices. As such factors reverse, nonbelievers predict, the new economy will morph back into the old economy.

Perhaps. But the real key to our growth in productivity is information technology and the Internet revolution. Computer chips augment the brain power of our third-wave information economy, just as electricity and motors added brawn to the manufacturing economy. The new economy features low marginal costs and potentially increasing returns. In the industrial economy, additional cars are expensive even after the prototype is developed. But once software is developed, its duplication is cheap and using it doesn't use it up. As networks grow, their value multiplies.

The Internet changes everything. To my dad, business was buying wholesale and selling retail. Sorry, Willy Loman, but the Internet's disintermediation is squeezing it all down to wholetail.

Measuring productivity in a service economy is difficult. Even after its recent rise due to a calculation adjustment, the productivity gauge is no doubt still understated. Many of the fruits of high-tech, especially biotech, raise our living standards without showing up in the numbers. Preventing and curing disease and faster and better treatments may actually reduce measured GDP. The activities replaced or made easier by the Internet probably contributed more to GDP. Mass customization, which gives us made-to-order goods at mass-production prices, increases our satisfaction by replacing more stuff with the right stuff.

There is no good model to account for why we have been enjoying rapid, noninflationary growth. But I believe what I see with my own eyes, and I don't think things will change anytime soon.

About the Author McTeer is president and CEO of the Federal Reserve Bank of Dallas.