ECON102: Principles of Macroeconomics (2021.A.01)

Today, Federal Reserve economists use a number of measures to determine whether monetary policy should be tighter or looser. One approach is to compare the actual and potential growth rates of the economy. Potential growth is presumed to equal the sum of the growth in the labor force plus any gains in productivity, or output per worker. In the late 1990s, the labor force was projected to grow about 1 percent a year, and productivity was thought to be rising somewhere between 1 percent and 1.5 percent. Therefore, the potential growth rate was assumed to be somewhere between 2 percent and 2.5 percent. By this measure, actual growth in excess of the long-term potential growth was seen as raising a danger of inflation, thereby requiring tighter money.

The second gauge is called NAIRU, or the non-accelerating inflation rate of unemployment. Over time, economists have noted that inflation tends to accelerate when joblessness drops below a certain level. In the decade that ended in the early 1990s, economists generally believed NAIRU was around 6 percent. But later in the decade, it appeared to have dropped to about 5.5 percent.

Perhaps even more importantly, a range of new technologies – the microprocessor, the laser, fiber-optics, and satellite – appeared in the late 1990s to be making the American economy significantly more productive than economists had thought possible. "The newest innovations, which we label information technologies, have begun to alter the manner in which we do business and create value, often in ways not readily foreseeable even five years ago," Federal Reserve Chairman Alan Greenspan said in mid-1999.

Previously, lack of timely information about customers' needs and the location of raw materials forced businesses to operate with larger inventories and more workers than they otherwise would need, according to Greenspan. But as the quality of information improved, businesses could operate more efficiently. Information technologies also allowed for quicker delivery times, and they accelerated and streamlined the process of innovation. For instance, design times dropped sharply as computer modeling reduced the need for staff in architectural firms, Greenspan noted, and medical diagnoses became faster, more thorough, and more accurate.

Such technological innovations apparently accounted for an unexpected surge in productivity in the late 1990s. After rising at less than a 1 percent annual rate in the early part of the decade, productivity was growing at about a 3 percent rate toward the end of the 1990s – well ahead of what economists had expected. Higher productivity meant that businesses could grow faster without igniting inflation. Unexpectedly modest demands from workers for wage increases – a result, possibly, of the fact that workers felt less secure about keeping their jobs in the rapidly changing economy – also helped subdue inflationary pressures.

Some economists scoffed at the notion American suddenly had developed a "new economy," one that was able to grow much faster without inflation. While there undeniably was increased global competition, they noted, many American industries remained untouched by it. And while computers clearly were changing the way Americans did business, they also were adding new layers of complexity to business operations.

But as economists increasingly came to agree with Greenspan that the economy was in the midst of a significant "structural shift," the debate increasingly came to focus less on whether the economy was changing and more on how long the surprisingly strong performance could continue. The answer appeared to depend, in part, on the oldest of economic ingredients – labor. With the economy growing strongly, workers displaced by technology easily found jobs in newly emerging industries. As a result, employment was rising in the late 1990s faster than the overall population. That trend could not continue indefinitely. By mid-1999, the number of "potential workers" aged 16 to 64 – those who were unemployed but willing to work if they could find jobs – totaled about 10 million, or about 5.7 percent of the population. That was the lowest percentage since the government began collecting such figures (in 1970). Eventually, economists warned, the United States would face labor shortages, which, in turn, could be expected to drive up wages, trigger inflation, and prompt the Federal Reserve to engineer an economic slowdown.

Still, many things could happen to postpone that seemingly inevitable development. Immigration might increase, thereby enlarging the pool of available workers. That seemed unlikely, however, because the political climate in the United States during the 1990s did not favor increased immigration. More likely, a growing number of analysts believed that a growing number of Americans would work past the traditional retirement age of 65. That also could increase the supply of potential workers. Indeed, in 1999, the Committee on Economic Development (CED), a prestigious business research organization, called on employers to clear away barriers that previously discouraged older workers from staying in the labor force. Current trends suggested that by 2030, there would be fewer than three workers for every person over the age of 65, compared to seven in 1950 – an unprecedented demographic transformation that the CED predicted would leave businesses scrambling to find workers".

Businesses have heretofore demonstrated a preference for early retirement to make way for younger workers," the group observed. "But this preference is a relic from an era of labor surpluses; it will not be sustainable when labor becomes scarce". While enjoying remarkable successes, in short, the United States found itself moving into uncharted economic territory as it ended the 1990s. While many saw a new economic era stretching indefinitely into the future, others were less certain. Weighing the uncertainties, many assumed a stance of cautious optimism. "Regrettably, history is strewn with visions of such `new eras' that, in the end, have proven to be a mirage," Greenspan noted in 1997. "In short, history counsels caution".