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Created 10/22/1997
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The Current Boom

KQED Talking Points: 10/23/97

Contents

 Dynamic Forecasts of Inflation as of 1992
 Inflation, Unemployment, and the Federal Reserve
 Potential Output
 The Productivity Slowdown
 Warranted Stock Market Values
 Stock Market Forecasts

Dynamic Forecasts of Inflation as of 1992
There has been a shift--a significant shift--in this decade with respect to how the economy's inflation and unemployment rates interact. Given the unemployment rates we have seen recently, the inflation rate should   today be hitting five percent--if the economy were still behaving the same way that it behaved between the mid-1970s and the early 1990s. The red line in the figure above shows what we would have expected. Why the difference? The true answer is that no one really knows, but there are a number of theories, all of which seem plausible, and all of which may be contributing. Workers have been so terrorized by the memory of the recession of 1982--and the near-collapse of the private-sector union movement in the 1980s as the Reagan-era NLRB switched from being the friend to the foe of the unions--that they are extremely, extremely slow to ask for wage increases, and hence inflation stays low even in a boom (likely to have had a large effect). A better match between the skills of the labor force and the requirements of employers: a given unemployment rate today is associated with a much smaller vacancy rate than in the past, hence unemployment can go low without triggering inflation (likely to have had a large effect). The Federal Reserve has done a good job of restoring confidence. No one fears rising inflation, so no one demands preemptive wage or price increases--and so the Federal Reserve no longer has to keep demand artificially low (as it had to do throughout the 1980s) in order to neutralize these preemptive increases. The Federal Reserve has done a good job of lulling managers. Just as a lobster doesn't notice if you raise the temperature in its pot gradually, so businesses haven't noticed as demand pressure has been increased gradually--and so they have not recognized how much room there is for large-scale price increases (likely to have had a small effect). Increased productivity growth and stable health-care costs have raised the real wage increases that firms can afford to give without requiring price increases (likely to have had only a small effect).

Potential Output

• The rate of growth of output per worker--net national product--has been gratifying since 1991: some 1.5 percent per year.
• There is an economic rule of thumb--Okun's Law--that allows us to assign some part of output per worker growth to growth in the economy's productive potential, and some part of it to shifts in unemployment and employment related not to changes in productive potential but to the state of the business cycle and the degree to which we are using the productive resources we have.
• When applied to the post-1991 period, all of the acceleration in economic growth since 1991 is due to increased cyclical utilization, and none is due to increased growth in potential output relative to the average since 1973.

The Productivity Slowdown

• Since 1973 output per worker growth has been much, much slower than the pre-1973 trend: only some 0.7% per year, compared to 2.3% per year in the generation that ended in 1973.
• Had economic growth since 1973 maintained its pre-1973 post-World War II pace, we would today be some 50% better off as a country than we are--we would have a net national product per worker of some $70,000 1992-value dollars a year, rather than $47,000.
• Measured growth of 0.7% per year is a lot better than nothing, and "true" growth is perhaps 1% per year higher--so our true material standard of living is still doubling every 45 years or so. But our true material standard of living used to double every 25 years.
• Thus there is a sense in which the productivity slowdown is the biggest macroeconomic event of our century--so far three times the size of the Great Depression.
• In addition, the productivity slowdown will cause a political crisis: we still have a social insurance system--taxes, social security, medicare--tuned to an economy with measured output per worker growth of 2.0% per year or more. Our explicit and implicit promises for the future cannot be met unless growth accelerates. And if growth doesn't accelerate we as a nation have to decide which sets of explicit and implicit promises we will keep, and which we will break.

(By contrast, actual dividend growth has averaged 1.6% per year above inflation over the past century and a quarter.) Current stock prices are predicting not only a boom, they are implicitly predicting a doubling of the rate of economic growth--not something that there is any sign of anywhere outside the stock market. Conclusion? The stock market today is as overvalued as the Japanese market was in

Warranted Stock Market Values
Another possibility is that the risk premium--the premium expected return over bonds that investors demand for holding risky assets like stocks--has greatly shrunk, or disappeared. Once again, however, the current level of the stock market is just too high for such a story to make sense. I could believe that the risk premium had shrunk, but that would justify a Dow of 5500 or so--not 8000.

Stock Market Forecasts

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Created 10/22/1997
Go to Brad DeLong's Home Page