The lure of the American way
Martin Wolf, Financial Times, November 1, 2000

Has the US economy become the only plausible model of how an advanced capitalist economy should be organised? Evidently it possesses a combination of economic strength with military power and cultural influence that no other country has previously enjoyed. But the issue here is different. It is how far other countries must imitate the US if they are to succeed.

The attributes of the US include: public spending at only 30 per cent of gross domestic product, against a European Union average of 45 per cent; weak trade unions and relatively unregulated labour markets; transparent regulation and a legalistic business culture; widespread direct and indirect share ownership; shareholder-controlled companies; a relative openness to immigration; and a diverse higher education system.

The salient features of US economic performance are also evident. Over at least a century, it has had the world's most consistently innovative economy and the highest real incomes per head (with the exception of resource-rich Australia in the early 20th century). More recently, as Richard Freeman of Harvard and the London School of Economics emphasises in a fascinating paper*, the US has generated higher employment and lower unemployment than in most advanced countries. The economy has also expanded strongly for almost a decade - and productivity growth has recovered from its 1973-95 slump to exceed rates in most other advanced economies. It is little wonder that euphoria in the US is matched by envy in the rest of the world.

Yet this employment, growth and productivity performance, remarkable though it has been, needs careful qualification.

While the US jobs record has been far better than that of the EU - though not of Japan - since the 1970s, this is largely explained by female employment.

In 1999, 81 per cent of US men of working age (15 to 64) were in employment, marginally down from the 83 per cent of 1973. For women, however, the employment rate was 68 per cent, up from 48 per cent in 1973.

In the EU, in contrast, male employment collapsed from 87 per cent in 1973 to 72 per cent in 1999, while female employment rose from 43 per cent to only 53 per cent.

Because the US did a better job of holding on to male employment and a far better job of generating new female employment, its overall jobs record was startlingly superior.

Until unemployment rates fell below 5 per cent and economic growth took off in the second half of the 1990s, employment growth seemed incapable of raising the earnings of the bulk of the labour force. Real earnings of production workers dropped by 14 per cent in the private sector from 1973 to 1995.

Median weekly earnings of all men fell, while those of women stagnated. Between 1995 and 1999, however, real hourly earnings of production workers rose by more than 5 per cent. Between 1996 and 1998 the earnings of workers in the bottom decile of the earnings distribution rose by 9 per cent, while numbers on welfare plummeted.

Thus, whether or not the US has become what Prof Freeman terms "a lodestar" must depend largely on the sustainability of the recent decline in unemployment and upsurge in productivity growth. Throughout the second half of the 20th century, productivity growth in the US was consistently lower than in almost all other advanced economies. Between 1973 and 1995 it was low even by its own historical standards.

In the second half of the 1990s this changed. Productivity, in terms of both output per worker and so-called "total factor productivity" (the rise in output per unit of inputs), rose faster than in any other big advanced economy. Christopher Gust and Jaime Marquez of the Federal Reserve Board argue that this is a genuine structural change, not purely cyclical.** A plausible explanation would be that the US is developing and adopting new technologies faster than anywhere else, just as it did in the early 20th century.

So does the superior US performance on employment, at least by comparison with Europe, and more recently on productivity and growth, allow one to declare the US model the winner? The answer is "no", for three reasons.

First, it remains unclear how far the exceptional recent US performance is the result of temporary and unsustainable stimuli, including an overvalued stock market and exceptionally strong investment. Even if it is not, the advantage may prove temporary. Others could well catch up again. It is all too easy to mistake temporary outperformance for durable superiority. Not long ago, Japan was hailed as the world-beater. Things look very different today.

Second, if the US model were unambiguously superior, those advanced economies most similar to it - such as the UK and Canada - would outperform the rest. They are not doing so. In particular, the productivity performance of Canada and the UK was strikingly poor in the second half of the 1990s.

Third, some of the most successful economies, in terms of high technology and low unemployment (though with a mixed record on productivity growth) have been the Nordic welfare states. Yet these are, in some respects, the polar opposites of the US, notably on taxation and public spending.

For all its success, it is unlikely that the US offers the only workable way to organise an advanced economy. It is also questionable how far other countries could replicate all aspects of its way of doing things, even if they wanted to. Its history makes the US exceptional.

*The US Economic Model at Y2K: Lodestar for Advanced Capitalism?, National Bureau of Economic Research Working Paper 7757, www.nber.org

**Productivity Developments Abroad, Federal Reserve Bulletin October 2000, www.bog.frb.fed.us

When luck runs out

Martin Wolf, FT, May 19, 1999, excerpts

Is the US in a "new era", enjoying a one-off productivity rise, or just plain lucky?

Can "tight labour markets . . . provide incentives for managerial innovation, skills acquisition and higher productivity, thereby leading to higher growth with little inflation", as Alice Rivlin, vice-chair of the US Federal Reserve, suggested on April 6?

Is the economy enjoying "a structural shift similar to those that have visited our economy from time to time in the past", as Alan Greenspan, the Fed chairman, argued in a speech on May 6? Or is it the beneficiary of a lucky streak?

This last is not implausible. For the US, the 1990s have been the happy reverse of the late 1960s and 1970s. Then it suffered a long series of demand and supply shocks.

These brought stagflation and an unexplained collapse in the trend rate of increase in labour productivity per hour in the business sector, from 2.9 per cent a year before 1973 to 1.1 per cent thereafter.

In the 1990s, however, US expansion has benefited from persistently weak growth in Japan and continental Europe and, more recently, from the Asian financial crisis. These delivered a powerful dollar, global excess capacity and weak commodity prices, above all of oil.

As the latest Economic Outlook from the Organisation for Economic Co-operation and Development notes: "In early 1999 non-oil commodity prices in real terms had fallen back to the lowest levels reached in the postwar period."

With the dollar so strong and world prices so weak, the US has imported disinflation.

The question is how much of its economic performance this explains.

That performance is impressive: economic growth averaging 3.7 per cent over the past three years; the unemployment rate down to 4.3 per cent; and core consumer price inflation in April at a year-on-year rate of 2.2 per cent.

The simplest way to analyse the links among monetary policy, inflation and growth is in terms of nominal domestic demand. This has been growing steadily in recent years, by 5.4 per cent in 1996, 5.8 per cent in 1997 and 5.6 per cent last year.

Over the same period, price pressures have been easing: the increase in the deflator for gross domestic product (the broadest measure of inflation) fell from 1.9 per cent in 1996 and 1997 to 1 per cent last year. The decline in inflation has allowed an acceleration in the growth of real demand, from 3.6 per cent in 1996 and 3.8 per cent in 1997, to an astounding 5.2 per cent last year.

There are two cogent reasons for believing this rate of growth of real demand is unsustainable.

First, it is generating a growing trade deficit: the real deterioration in the balance of trade on goods and services was 0.4 per cent of GDP in 1997, 1.4 per cent last year and is forecast by the OECD to be another 0.9 per cent of GDP this year, raising the current account deficit from 1.8 per cent of GDP in 1996 to a forecast of 3.4 per cent this year.

Second, unemployment is falling, from 5.4 per cent of the labour force in 1996 to 4.5 per cent last year and 4.3 per cent today.

Thus real domestic demand must be expanding faster than the economy's output, which must in turn be expanding faster than its potential. These points stand whether or not the underlying rate of productivity growth has accelerated, since higher productivity growth only increases potential output.

How does unsustainable demand growth come to an end? In higher inflation is the standard answer, either directly or via an exchange rate collapse.

Whether this is likely to happen to the US, and - if so - when, are the questions the Fed must confront.

It has to judge how far the recent happy combination of fast growth with very low unemployment and falling inflation is permanent or reflects the exceptional events of the 1990s.

A general answer is provided in a paper published by the Federal Reserve Bank of Boston. In this, Roger Brinner of the Parthenon Group argues that the good old-fashioned Nairu (the rate of unemployment consistent with stable inflation) is not dead, but merely sleeping.

(Is Inflation Dead?, Roger Brinner, January/February 1999. Federal Reserve Bank of Boston)

According to Mr Brinner, the Nairu remains 5½ per cent. But these have been exceptionally favourable times. While the very low rate of unemployment would tend to raise inflation, weak import prices, particularly the collapse in energy prices, more than offset its effects after 1996.

Another paper - by Alan Carruth of the University of Kent, Mark Hooker of the Federal Reserve and Andrew Oswald of Warwick University - indicates just how important those low energy prices may be.

(Input Prices and Unemployment Equilibria: Theory and Evidence from the United States, Alan Carruth, Mark Hooker and Andrew Oswald, Review of Economics and Statistics, vol. 80 (November 1998)

There has been a close relationship between unemployment and the real price of crude oil since the mid-1950s.

The underlying theory is straightforward: an increase in the price of oil, relative to output, erodes profit margins.

If real returns on capital do not decline, the real price of labour has to adjust. Higher unemployment brings this adjustment about.

The policy mechanism would be tighter monetary policy aimed at preventing higher nominal oil prices from turning into a general rise in prices and wages.

The effect of energy prices on corporate profits is quite visible. The recovery in corporate profits as a share of GDP, after their post-oil-shock collapse, began in 1986, when the oil price started to tumble.

This simple model turns out to have surprising explanatory power. Its contemporary relevance is also evident.

Between the third quarter of 1997 and 1998 the real price of oil fell 40 per cent, to the lowest level since the 1950s. But since then nominal oil prices have risen substantially: the price of Brent crude is up almost 60 per cent since last October.

Thus the most important windfall gain to inflation (and unemployment) is in the past. It is not surprising, therefore, to find inflation performance in the US beginning to disappoint, as it did last Friday.

The conclusions of this analysis are four.

First, the combination of very low unemployment with fast growth and declining inflation is partly explained by good luck.

Second, the Federal Reserve has not allowed excessively fast growth in nominal demand. But the increase it has permitted has split between an exceptionally rapid rise in real demand and extraordinarily low inflation.

Third, as the good luck of recent years passes into history, the Fed will need to act, to keep curbs on the growth in nominal demand.

Finally, the Fed will be able to avoid taking such action only if very recent year-on-year rates of growth in labour productivity per hour, of 4 per cent, prove durable.

Anything is possible; this is highly unlikely.

The Federal Reserve's job of containing increases in inflation and nominal demand will be tricky.

It may prove very difficult, for example, to curb demand without causing a stock market collapse and an unmanageable decline in demand, as household savings rise and corporate investment is cut.

With continued weakness of economies elsewhere, the Fed may be able to risk delaying the tightening for a while. But that time is likely to come.

It is one thing to enjoy the blessings of luck; another to rely on its lasting forever.

Interesting times ahead for all
Rolf Englund, Letters to the Editor, Financial Times, November 6, 2000

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