What Greenspan Doesn't Know...

The dirty secret of today's economy is that no one truly understands it. Not Alan Greenspan. Not Larry Summers. Not Abby Joseph Cohen. We listen to these and other oracles, examining their every utterance for enlightenment. They're the experts. They know more than we do. But what they don't know may well be more important than what they do.

Ignorance can be a powerful force. It may help explain the erratic daily swings in stock prices. Stories about the economy's future alternatively elevate or depress the market with bewildering regularity. The stories may be contradictory. But if people don't know what to believe, any story can be believable--at least momentarily.

To say that Greenspan et al. don't truly understand the economy doesn't mean they know nothing. Economists pour out reports bulging with tables and charts. These often brilliantly illuminate some past economic trend. What they've consistently failed to do is anticipate the big economic upheavals of our time, including--most prominently--America's present low-inflation boom.

One reason is the gradual breakdown of the standard "model" (or theory) of how the economy operates. Simplified a bit, the model goes like this. At any moment, the economy has a given productive capacity, based on the number of workers and overall efficiency ("productivity"). People and corporations use up this capacity by spending, which is based on their wages, salaries, dividends and profits. Ideally, total spending ("demand") always matches the economy's productive capacity ("supply"). If spending grows too rapidly, inflation may result. The economy "overheats." This can cause a recession, because the Federal Reserve has to raise interest rates to suppress inflation.

By this model, the economy's stability depends on keeping demand and supply roughly balanced. The trouble now is that we're having a harder and harder time gauging either spending (demand) or productive capacity (supply). Consider the forces that obscure our vision:

Technology: Computers and communications technologies (it's said) have dramatically increased productivity growth. The economy can expand more rapidly without encountering inflationary scarcities. Great. Unfortunately, we don't know how much productivity growth has improved--or whether the gain is permanent. The old model recognized that productivity growth (based on technology, education and management) might shift from time to time; but the assumption was that, once a change occurred, it lasted for a while. But suppose that technology advances occur in irregular spasms. Sometimes we get torrents; sometimes we get trickles. What then?

Unemployment: The old model assumes that, below some unemployment rate, tight labor markets generate inflationary wage increases. As late as the mid-1990s, this threshold was widely thought to be between 5.5 and 6 percent. But the unemployment rate has been at or below 4.5 percent since early 1998 without--as yet--triggering a wage explosion. Where is the dangerous threshold, and is it stable? The answer obviously has immense social consequences. In today's economy, the difference between a 6 percent and 4 percent unemployment rate is almost 3 million jobs.

Globalization: Vast cross-border flows of goods, money, people and information defy easy analysis. (Hardly anyone predicted Asia's 1997-98 financial crisis.) In the old model, this didn't matter much. Exports and imports played a minor role in the economy. So did exchange rates and global money flows. This is no longer true. In 1960 exports and imports (combined) represented about 9 percent of gross domestic product (GDP), the economy's output; by 1999 they were 24 percent of the GDP. We are much more exposed--for better and worse--to foreign economic changes.

Financial Markets: The old model consigned them to footnotes. The stock market merely reflected the economy's performance and hardly affected it. Financial panics were historic relics. Here, too, the world has moved on. Since 1991 consumer spending has increased about 20 percent faster than after-tax income. People feel richer and spend more. Why do they feel richer? Well, it's mainly the "wealth effect" from the stock market. This emboldens people to save less, borrow more or spend some of their stock gains. As for financial panics, their occurrence in Asia and Russia makes them seem more possible anywhere.

This is a dizzying list. The unknowns have multiplied. We are increasingly at the mercy of surprises. The glory of the 1990s was that almost all the surprises were pleasant. Stronger consumer spending lowered unemployment. New technology aided productivity and dampened inflation. Higher imports did the same (between 1997 and 1999, the U.S. trade deficit rose 156 percent). Immigration may have restrained wages. Having quelled inflation--the chief source of instability in the 1970s and 1980s--we have embarked on endless growth. This is the refrain of the New Economy.

Perhaps. But that is only half the story. Vulnerabilities have multiplied along with opportunities. What we don't understand is, by definition, risky. Surprises may not always be pleasant. Technology might disappoint. Global developments could cause pain. There is an almost surreal quality to the present boom. What we get (in the stock market, most prominently) is a tug of war between wild optimism, based on the gains of the 1990s, and an instinctive caution, based on past experience that things don't always turn out right.

The struggle--the open questions--cannot be resolved by resort to economic authorities. The most experienced among them have yet to combine the new imperatives of technology, globalization and financial markets into a plausible model of the economy. They haven't made the essential connections, because the connections are so difficult to make. They (and we) don't know whether, in the long run, these forces make the economy more or less stable. But not one admits this. For now, it's a secret.