July 18, 2002

The Wall Street Journal's David Wessel Writes About Macroeconomic Vulnerabilities

For once I have next to nothing to say... :-)


WSJ.com - Capital

How will this change the way the economy responds to the weaponry of macro managers? Mr. DeLong identifies three factors to watch. One is a big plus. Technology is quickening the pace of growth in productivity, the amount workers produce for each hour on the job. And that, Mr. DeLong points out, will grease the wheels of the labor market. Managing a low-productivity economy (Jimmy Carter's) is a lot harder than managing a high-productivity economy (Bill Clinton's). Faster productivity growth allows faster wage growth and lower unemployment rates without inflation. It makes shifting workers from yesterday's industries to tomorrow's much easier. It is a big reason the U.S. has performed so much better than Europe. Pray that Mr. Greenspan's undiminished productivity optimism proves to be his best forecast.

The other two items on the list are less comforting. Good times breed complacency even among policy makers who claim to be constant worriers. During a period of euphoria and boom, there's little attention to macroeconomic management because everything is going great. Government's capacity to make sound economic decisions degrades. Look at the long-run cost of the Bush tax cuts, says Mr. DeLong, a veteran of the Clinton Treasury. But former Treasury Secretary Lawrence Summers observes that after such a period, macroeconomic management becomes more important than ever. Look at Japan.

Governments often stick with the right policies for too long, as Argentina's experiment with a fixed exchange rate shows. And they often have excessive confidence in their ability to manage the economy. "Once in a while, we really think we understand everything," says Olivier Blanchard, a Massachusetts Institute of Technology economist. "We ought to be a little more humble." The last few months surely have accomplished that.

That leaves one big threat to economic stability: financial markets. The global reach of financial markets moves capital to places where it can be employed profitably -- both for investors and for society. The ready availability of credit means fewer good ideas languish for lack of cash. But the Great Depression and Japan's decade of stagnation show that a major role of government is to keep large-scale bankruptcies from disrupting the financial sector and choking the economy. To do that, policy makers need to understand and monitor how capital moves, even if they don't regulate it. But global financial markets are growing faster than underlying economies, and Wall Street wizards are devising complex financial instruments faster than regulators and private-sector bystanders can decipher them. The pattern isn't new. "Financial markets always contain some participants who are very good at figuring out previously unthought-of ways of gambling for resurrection with other people's money," says Mr. DeLong. But the dimensions are greater. Each frightening episode -- hedge-fund speculation in Asian currencies, Long Term Capital Management's implosion, Enron Corp.'s collapse -- brings calls for better disclosure and better surveillance. But the markets move faster than governments. And the hope that markets always will discipline themselves without collateral damage to the rest of us has yet to be realized...

CAPITAL
By DAVID WESSEL

With extraordinary speed, the U.S. has gone from a macroeconomic miracle to an economy enveloped by doubt about American-style government-supervised corporate capitalism.

Long ago, in the late 1990s, we fooled ourselves into thinking that we had mastered the art of managing the economy. Unemployment and inflation fell to the lowest levels in a generation. Federal deficits turned to surplus. Stocks did better than ever. Optimistic forecasts were routinely exceeded. Even the triple whammy of Long Term Capital Management's collapse, Asia's financial panic and Russia's default didn't overwhelm the mighty macro manager, Alan Greenspan.

Today the U.S. is "suffering a hangover" from the "binge" of the 1990s, says President Bush. Some businesses invested too much. Some stocks rose too high. Unemployment is up, and the victory over inflation has turned into fears of deflation. The federal surplus is gone. Too many of the corporate success stories of the 1990s are turning out to be fiction.

Does this tumult mean that the economy of the early 21st century will be a roller coaster, much tougher for Mr. Greenspan and his heirs to manage? Or is this a moment of exceptional volatility that will soon pass, so that we can return to the more placid business cycles that made the second half of the 20th century better than the first? It's too soon to know, but not too soon to speculate.

Rapid changes in technology can produce more booms and busts, says economic historian J. Bradford DeLong of the University of California at Berkeley. Technological change increases uncertainty about the future. And with more uncertainty come Nasdaq-like bubbles and busts. The promise of technology creates tidal waves of euphoria that are followed by tidal waves of despondency when profits prove disappointing.

So as long as the revolution continues in information technology, in biotech and in finance, big swings in the stock market are likely. It's not just classic speculation that drives stock markets to dizzying heights; it's technological ferment.

That could compel policy makers charged with maintaining the system's stability to be more aggressive. "The central bank has to be prepared for larger-than-usual fluctuations in interest rates to counter these unusually large shifts in 'animal spirits,' " Mr. DeLong says, in an essay to be published by the journal International Finance. Mr. Greenspan had to decide whether to prick what, we know now, was a stock-market bubble. He decided not to -- the sort of call that comes once in a central banker's lifetime, and one that will be second-guessed for decades. But this could be a recurring dilemma for central bankers, at least until the pace of technological change subsides.

[Graph]

Technology may also provide a stabilizing counterweight, though. Much of the down and up of the economy in the recent past was caused when demand fell, and business inventories of unsold goods mounted. So companies cut production, laid off workers and depressed demand even more. "If information technologies really are information technologies, then inventories should behave better in the future," Mr. DeLong says, echoing an argument Mr. Greenspan often makes. Wal-Mart knows almost instantly what's selling and what's not, and adjusts orders accordingly.

Quicker business response to turns in the economy, much in evidence as the U.S. economy slowed abruptly late in 2000, may yield more-frequent bumps in the economy, but smaller ones. Discovering mistakes sooner is better.

Tension between these offsetting forces is apparent today. The "crisis of confidence" in corporate accounts and the stock market is a depressant. Yet businesses can monitor surprisingly strong consumer demand in real time, encouraging manufacturers to increase production and retailers to rebuild inventories despite the gloomy headlines.

How will this change the way the economy responds to the weaponry of macro managers? Mr. DeLong identifies three factors to watch.

One is a big plus. Technology is quickening the pace of growth in productivity, the amount workers produce for each hour on the job. And that, Mr. DeLong points out, will grease the wheels of the labor market. Managing a low-productivity economy (Jimmy Carter's) is a lot harder than managing a high-productivity economy (Bill Clinton's). Faster productivity growth allows faster wage growth and lower unemployment rates without inflation. It makes shifting workers from yesterday's industries to tomorrow's much easier. It is a big reason the U.S. has performed so much better than Europe. Pray that Mr. Greenspan's undiminished productivity optimism proves to be his best forecast.

The other two items on the list are less comforting.

Good times breed complacency even among policy makers who claim to be constant worriers. During a period of euphoria and boom, there's little attention to macroeconomic management because everything is going great. Government's capacity to make sound economic decisions degrades. Look at the long-run cost of the Bush tax cuts, says Mr. DeLong, a veteran of the Clinton Treasury. But former Treasury Secretary Lawrence Summers observes that after such a period, macroeconomic management becomes more important than ever. Look at Japan.

Governments often stick with the right policies for too long, as Argentina's experiment with a fixed exchange rate shows. And they often have excessive confidence in their ability to manage the economy. "Once in a while, we really think we understand everything," says Olivier Blanchard, a Massachusetts Institute of Technology economist. "We ought to be a little more humble." The last few months surely have accomplished that.

That leaves one big threat to economic stability: financial markets. The global reach of financial markets moves capital to places where it can be employed profitably -- both for investors and for society. The ready availability of credit means fewer good ideas languish for lack of cash.

But the Great Depression and Japan's decade of stagnation show that a major role of government is to keep large-scale bankruptcies from disrupting the financial sector and choking the economy.

To do that, policy makers need to understand and monitor how capital moves, even if they don't regulate it. But global financial markets are growing faster than underlying economies, and Wall Street wizards are devising complex financial instruments faster than regulators and private-sector bystanders can decipher them.

The pattern isn't new. "Financial markets always contain some participants who are very good at figuring out previously unthought-of ways of gambling for resurrection with other people's money," says Mr. DeLong. But the dimensions are greater. Each frightening episode -- hedge-fund speculation in Asian currencies, Long Term Capital Management's implosion, Enron Corp.'s collapse -- brings calls for better disclosure and better surveillance. But the markets move faster than governments. And the hope that markets always will discipline themselves without collateral damage to the rest of us has yet to be realized.

Add it all up, and what do you get? A reminder that the lessons learned in mastering the economic rapids of the past few decades didn't teach us all we need to know to steer through the whitewater up ahead.

Write to David Wessel at capital@wsj.com6

Posted by DeLong at July 18, 2002 09:49 AM | TrackBack

Comments

i am puzzled and concerned about what i take to be a significant negative wealth effect of the bear market - surely women and men of 50 and on have seen their equity holdings decline by at least 40% on average these past 28 months - the length of time of the fall and the depth of the fall which is not cushioned be ample dividends should be a meaningful problem for many - though mr. greenspan speaks of the cushion of rising home prices, i do not hold that a true offset - the 1973 - 1974 bear market did not seem to have a significant negative wealth effect - with defined contribution retirement plans now dominent and an aging population and an absence of ample dividends i am concerned

randall

Posted by: randall on July 18, 2002 10:59 AM

I forgot to bookmark it, but somebody was saying that, in a survey, 1/3 of people aged 50-64 stated that they are postponing retirement (or moving the planned date back) due to recent portfolio losses.

And the survey was supposed to be from last Frebruary. If true, this number should have increased since then.

Barry

Posted by: Barry on July 18, 2002 02:04 PM

Would it be possible that the high-tech buble would be judged much less irrational if 9.11 had not happened and if different budget policy decisions were being taken by the federal government?

Where would the Dow Jones and the NASDAQ be at this point had the NSA/CIA/FBI been able to avoid the attacks? Similarly, where would these indices be if taxes hadn't been cut and military expenditure et al. had not been jacked up towards cold war levels?

If it can be argued that excessive cash can fund too risky ventures, couldn't a cash drought (combined with geopolitical uncertainty) deter investment, and hence producers' forecast of future productivity and profits, hence prompting lay-offs... ?

Posted by: Jean-Philippe Stijns on July 18, 2002 03:16 PM

Re the apparent modest impact of the "reverse wealth effect" on consumer spending, remember that the market rose as quickly as it fell. The S&P 500 was about where it is now at the end of 1998, so it's just 3 1/2 years for both up and down.

I.e., the top from which all the huge losses are measured was there only for about a year, which may not have been long enough for most people to factor those short-lived big paper gains into their real wealth.

Also, if you go from recession trough to trough, '92 to today, the S&P over the period has returned just about the same real 7% annually as is has on average for the last 150 years.

If in 1992 when the S&P 500 was at 400 a genie told you that in 2002 it would be at 900 your reaction probably would have been "well, people are going to be doing fine with that".

Plus the typical family has three times as much invested in housing than equities, and housing's been doing very well. Now if the housing market turns out to be the next bubble to burst...

Posted by: Jim Glass on July 18, 2002 03:19 PM

It is interesting to notice the generalized belief is sun-spot / multiple macro equilibria:

"If consumer confidence holds steady, everything will go well for the stock market and the economy, but if it falters then we're probably in for a double-dip global recession."

So basically, our consumer is currently deciding on the future of the American and, hence, global economy. Fine. But then, I think wealth uncertainty, rather than just wealth levels, should be enough to cool our rational consumer (as seems to be the trend recently.)

Or... our consumer is not so rational, and (s)he is the sun-spot we need to watch for. Scary. These are times I don't want to believe in sun-spot theories.

Out of risk aversion, and not knowing exactly how much credit to give to these theories, I would support a motion for free distribution of xanax and prozac across the country. Might even consider dropping off boxes of those medecines on foreign investors.

"I don't know what I don't know," has Greenspan just reminded us when asked if he had any idea about whether recent falls in the stock market were an aberration or a natural correction. "That is what distingishes you from members of the United States Congress," said Congressman Jim Leach, R-Iowa.

Posted by: Jean-Philippe Stijns on July 18, 2002 05:07 PM

I think that Jim Glass's hope that the current crash will do little damage because the previous runup was so large and so quick may well be right. At least I hope so...

Brad DeLong

Posted by: Brad DeLong on July 18, 2002 08:24 PM
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