The uncertain prospects for the economy of the U.S.

Press, 8 March 1989, Page 20

The uncertain prospects for the economy of the U.S.

The “Economist” on the rift between President Bush and the Fed

THE BIGGEST single factor in Mr George Bush’s election victory last November was the American economy. Discounting the one-off effect of last summer’s drought, underlying growth in 1988 was a robust 3!4 per cent — far more than most forecasters had expected after the October 1987 stockmarket crash. Unemployment hit a 14-year low. Consumer-price inflation remained steady at just over 4 per cent. The external trade deficit improved somewhat in the year preceding election day.

Having elected Mr Bush, the economy may now be presenting him with its bill for services rendered. The latest batch of economic indicators included a horrific 1 per cent jump in producer prices in January; confirmation that industry is using its capacity more fully than at any time since 1979; and further steady growth in retail sales. January’s consumer-price index recorded another upward blip of 0.6 per cent, taking the year-on-year rate up to 4.7 per cent (three years ago it was below 2 per cent). And the December trade figures suggested that last year’s improvement might not endure into 1989. The financial markets have had a jittery couple of weeks. In his quarterly testimony to Congress, the Federal Reserve chairman, Mr Alan Greenspan, said emphatically that the greatest threat to America’s economic prosperity is now inflation, not recession. He promised to err on the side of restraint rather than stimulus. And he declared that the current rate of inflation is itself unacceptable.

Spotting rifts between the president and the Fed chairman is one of Washington’s favourite spectator sports. Because of their different jobs and constituencies, the Fed is always likely to give

first priority to price stability, while the Administration wants to sustain economic growth. Mr Bush and Mr Greenspan have duly gratified the spectators: the President by saying he sees no need for “substantially” higher interest rates, the chairman by disputing administration forecasts for 1989 and stressing his anti-inflation credentials.

In fact the argument over the immediate future is trifling. Mr Bush seems happy with further small rises in interest rates. Both sides agree on the urgent need to cut the Budget deficit, preferably on the spending not the revenue side.

The real divide between central bank and Government will take longer to emerge. It will stem from what looks like a fundamental rift in thinking about the prospects for the American economy. In particular there are differences over the effect of capacity constraints and the outlook for productivity. Mr Greenspan believes that

America is “in the vicinity” of the point at which increased demand forces prices up because the economy is producing at close to its current capacity. There is some anecdotal evidence to support his worry. In New England, for instance, low unemployment is driving up wages. Once an economy is close to capacity limits, it cannot grow faster than productivity rises. The attempt to do so produces inflation, not real growth. And, at least by implication, the Fed thinks it would be unwise to count on a jump in America’s dismal productivity growth. The Administration is more optimistic. Officials are not impressed by any analysis that seems to accept the oldfashioned “Phillips curve” tradeoff between unemployment and wage inflation. They point out that capacity utilisation around the world is much higher than it was a decade ago, yet inflation is

generally lower. They stress that foreign competition now exerts more pressure on American companies to hold down prices and costs. And they point to an increasingly fragmented and insecure labour force as a further reason not to expect strong wage pressures.

Nor does the Administration subscribe to the doomsters’ view of productivity. It argues that gross investment in real terms is strong. Women and immigrants are moving from low- to highproductivity jobs. Recent productivity growth of less than 1 per cent a year is an aberration from a higher trend growth-rate of at least 2 per cent. In short, administration economists believe that the Reagan economic expansion can continue without a serious risk of inflation. And the last thing they envisage is the need for a restrictive monetary policy. Optimism is an admirable quality, but sometimes a dangerous one. Mr Greenspan is right to

stress the evidence that inflationary pressure is already rising. No-one expects early action to cut the Budget deficit. It would be splendid if capacity utilisation and low productivity ceased to be constraints on economic growth. But firms are already responding to the labour shortage by holding on to people they might otherwise lay off: not a promising portent for productivity. There are two other reasons not to bank on favourable economic developments. One is the fragility of market confidence. With little sign of a big fall in the trade deficit, America will continue to need foreign capital. But foreign investors might easily be scared by a revival in American inflation — especially an inflationary surge to which the Administration seems indifferent. If that fear pushes the dollar down, this would itself add to inflation.

The second argument is more subtle. Because of America’s fiscal and external imbalances, and because the present boom has lasted so long, there is a danger of recession whatever policies are followed in Washington. Coping with such a recession would be far easier if inflation (and the Federal budget deficit) started out firmly under control. To put it another way, the optimists might be right; but if they prove not to be, the result of following their counsel will be especially unpleasant. Mr Greenspan’s term as Fed chairman expires in 1991. Mr Bush will decide next year whether to reappoint him. Market confidence and the dollar’s prospects could turn on that decision.

Copyright — The Economist