On the Record

The Challenges of Affluence

Alice M. Rivlin

I feel extremely fortunate today for two reasons. First, thanks to the invitation of Diane Swonk and the leadership of NABE, I have the privilege of addressing this lively, knowledgeable group of business economists. Second, NABE’s leadership chose to build this conference around an issue, “The Challenges of Affluence,” that I feel strongly must be addressed by all of us in our roles as economists, public and private policy makers, and citizens.

“The Challenges of Affluence” has an oxymoron flavor to it. What’s so hard about being well off? However, because national growth and affluence offer more choices, the policy challenges they posed are at least as tough-intellectually, morally and politically-as the challenges posed by national economic adversity.

The first challenge of affluence is to ensure more of it-to perpetuate the rapid productivity growth that creates personal and national wealth. The second challenge is to use that income and wealth wisely to build a strong and just society that does not dissolve in decadence and disunity. I will try to address both questions today.

Keeping the Good Economy Going

To keep something going, it is useful to know why it is happening. Unfortunately, this simple proposition poses a serious problem for economists right now. We can’t honestly say we know why the U.S. economy has done so well since the mid-1990s. Most of us did not expect this combination of high growth, low unemployment, and quiescent inflation to occur in our professional lifetimes or, if it did, to last for so long. Some of us wrote articles explaining why it couldn’t happen. Our most sophisticated models, those that fit the data best, persistently under-predicted growth and over-predicted inflation. The past five years have seen continuous revision of forecasts and recalibration of models in the optimistic direction. That’s a lot more fun than the alternative, but it does undermine the credibility of economists, especially macro forecasters, when we are asked to prescribe how to perpetuate this combination of favorable factors we didn’t think could occur.

We do know that the key to the economy’s great performance is the thing we didn’t predict – the acceleration of productivity growth in the second half of the 1990s. We don’t know why this occurred when it did or how long it will last. We can only identify the favorable factors, exogenous to the usual macro models, that might, in gloriously fortuitous combination, have accounted for this excellent turn of events.

When models require recalibration the standard explanation of economists is “technological change,” and this time the textbook answer is a huge part of the story. The explosive development of computers and telecommunications, especially in combination, provided the impetus for a sustained surge in investment, or “capital deepening,” as we like to call it. The mystery is why the avalanche of investment in information technology took so long to manifest itself in productivity statistics (outside of the rapid increase in productivity of manufacturing the information technology goods themselves).

It may simply have taken a long time, as Paul David has shown it did in other technology revolutions, for users to learn how to reorganize their activities to use the new machines productively (David,1990). It may also be that the capabilities of American firms improved dramatically in the 1990’s in response to fierce global competition and the high value of the dollar. The increased nimbleness of American business is clearly part of the current success story, but the timing raises the same question raised by the impact of technology. Growing competitiveness, creativity, and willingness to change has been evident in U.S. business for at least two decades, since the agonizing rust belt restructuring of the 1980s. Why did improved management capabilities take so long to show up in productivity statistics?

One can only speculate that an increasingly competitive, change-oriented mindset in the business community, combined with a rapidly expanding technological frontier and unusually favorable macroeconomic conditions in the mid-1990’s made the American economy capable of extraordinary performance. The favorable macro conditions, of course, involved the coexistence of sustained low inflation with extremely tight labor markets. Low inflation, and the expectation of its continuance, improved the climate for investment by lowering long term rates and providing more certainty for planning. The tight labor markets of the second half of the 1990’s provided an increased incentive to substitute capital for labor at just the opportune point in the technology cycle. In the face of an acute shortage of labor and scads of adaptable technology, substituting computers for people was suddenly the obvious thing to do.

We economists used to regard tight labor markets as bad for productivity, because they brought less skilled workers into jobs. At least in this cycle, however, scarcity of labor may have strengthened the impetus, not only for implementing new technology, but also for enhancing the capabilities of workers and firms through training and process reengineering.

Crediting the unusual economic conditions with a catalytic role in the economy’s recent success prompts the question, debated vigorously by candidates for national office: was the economy’s great performance caused – or at least helped – by policy actions? And, if so, whose policies? I believe policy helped quite a lot, although it is impossible to say exactly how much, or what would have happened under a different set of policies. Since I spent much of the last decade in the fiscal and monetary policy establishment, however, my views on the importance of these activities are a more than a little suspect.

On the fiscal policy front, the big achievement was the successful battle – and, believe me, it was a battle – to move the federal budget from massive deficit to substantial surplus. Both parties deserve some credit here: President Bush and the Democratic Congress in 1990; President Clinton and the Democrats in Congress (no Republicans voted for that one) in 1993; President Clinton and the Republican Congress in 1997. The efforts were painful at the time, but thanks to the extraordinary performance of the economy, they were more successful than any of the participants dared hope. As recently as mid-1996, when I left OMB for the Fed, we were agonizing over the severity of the caps on discretionary spending that we thought necessary to bring the budget (the whole budget, including social security) into balance by FY2002. As the planning starts for FY 2002, the surplus for that year is estimated to exceed $200 billion by a considerable margin, and even the non-social security part of the budget is in balance.

Turning a profligately dissaving government into a responsible saving one took a decade of restraint on both discretionary and entitlement spending, some tax increases, a lot of ugly political battles and difficult compromises, plus the impact of the roaring economy and the booming stock market on the revenues produced by a moderately progressive tax structure. The policy process wasn’t pretty, but it produced results-and apparently at just the right moment.

Credit for good policy also goes to the Federal Reserve, which for more than a decade has moved the monetary levers in the right direction at the right moment, but has not overdone it. The tightening in 1994 kept the economy from overheating and prolonged the expansion long enough for the productivity surge to kick in. The Fed’s more significant contribution, however, was doing nothing, or almost nothing, in 1996 and 1997. At that time econometric models were predicting that inflation would soon start up again, labor markets were getting tighter than most economists thought sustainable, and the productivity surge could still plausibly be regarded as a temporary blip associated with stronger cyclical growth.

If the model projections had been right, the Fed would now be deemed to have acted recklessly in 1996-97. If doing nothing hadn’t worked, and the productivity surge had not proved so durable, there would be a whole lot of people saying, “I told you so!” in 2000 – some of whom actually did – and conceivably a new chairman at the Fed.

Since raising interest rates is generally unpopular, central bankers get credit for political courage when they raise interest rates to head off inflation and limit the economy’s growth to a sustainable rate, as the Fed did in 1994 and again in 1999. Indeed, that’s why we have an independent central bank. But especially when central bankers are professional economists, they also show courage by not raising rates when they suspect the economy is changing faster than the conventional wisdom of the profession is ready for. The gut instinct of Alan Greenspan and his colleagues to trust observation and anecdote over model-generated projections looks brilliant with hindsight, but, if things had turned out differently, it could easily have looked foolhardy or even irresponsible.

It is tempting to say that the moral of this episode is that “optimists are not always wrong.” However, it should be remembered that they often are, and that politicians tend to be optimists, in part because optimism reduces the hard choices they have to make. Reliance on the optimistic forecasts that went with President Reagan’s budget proposals in the early eighties cost Rosy Scenario her good name and led to the agonizing battle to get the resulting deficits under control. Maybe there is no moral.

While fiscal and monetary policies are the most visible aspects of economic policy, they are not necessarily the most important. The list of policy credits for the movie entitled “The American Economy’s Great Run” has to include the scenery that enabled the actors to play their parts. The scene was set by the cumulative effect of many policy actions, over several decades, that lowered trade barriers, deregulated whole industries, and improved the functioning of markets. These actions, as Alan Blinder pointed out in his Adam Smith lecture last year, brought not only the U.S., but much of the world’s economy closer to the textbook model of a competitive market economy than it had been in decades, maybe ever (Blinder 1999).

Candidates for national office have to convince the voters that what happens to the economy is determined in Washington, but people in this room know that the course of the economy is mostly determined by the interaction of millions of decisions made by businesses, workers, consumers, and lower levels of government. Whether the current dynamism continues – and how long – depends more on the technology cycle and intangible factors affecting confidence and – Keynes had it right – “animal spirits” than it does on policy.

Nevertheless, policy does matter. In the longer run, it’s the scene-setting policies that matter most – making markets work more efficiently, reducing barriers to entry, improving skills of workers, supporting research and development, increasing public and private saving. In the shorter run, inappropriate and/or poorly timed fiscal and monetary policy can mess things up pretty badly. Hence, the most important rule for economic policymakers is the same as for the medical profession: first, do no harm.

The past decade has been blessedly free of fiscal and monetary policy mistakes. The next few years, however, may pose harder challenges for both the fiscal and monetary policy authorities.

No one has really discussed fiscal policy since the early 1980’s. The big deficits of that decade were such a whopper of a policy mistake that they closed down fiscal policy debate until the mistake was corrected. For the long-run health of the economy, the deficits had to come down to get the federal debt service under control and reduce the drain on national saving of the government’s large borrowings. Some of us were regarded as impossible dreamers when we even suggested that it would be desirable to get the federal budget into surplus and making a positive rather than negative contribution to national savings.

Deficit reduction was less obviously the right short-run fiscal policy in the early 1990s. Indeed, opponents of President Clinton’s 1993 deficit reduction package argued that it would slow the economy too much. As the economic growth accelerated and labor markets tightened, however, deficit reduction became indisputably the right short-run, as well as long-run fiscal policy. Had the government’s growing surplus not dampened the surging growth of the economy in the last several years, the Fed would surely have felt compelled to raise interest rates sooner and more aggressively than it did.

Reducing the government’s deficit had a nice moral ring to it, which made it an easier political sell. Eliminating the deficit restores fiscal policy to the roster of usable macroeconomic tools, which is good, but also brings back the risk of making a mistake.

In my view, a massive tax cut right now would be a stupid mistake – bad fiscal policy for both the short and the long run. If a major tax cut were enacted while the economy is still growing strongly it would only force the Fed into tighter monetary policy, hardly a desirable trade-off from an investment perspective. If the economy slows enough make recession a serious threat, the short run arguments for a tax cut would be stronger, although it is hardly sensible for a country facing mounting claims on its future GDP from a growing proportion of older people, to make permanent cuts in its government’s saving rate, and tilt the mix of policies toward looser fiscal policy and higher interest rates.

At the moment, monetary policy looks like a winner. The Fed’s successive rate hikes appear to have slowed the economy significantly, while inflation, despite rising oil prices, is still not worrisome, and productivity growth still roars ahead fast enough for unit labor costs to fall.

Some Fed watchers are already declaring the proverbial “soft landing” achieved. Unfortunately, the soft-landing metaphor is pernicious. Economies don’t “land,” they keep going. Monetary pilots never get to bring the plane down safely, turn off the key, and go home to dinner. They always have to expect turbulence ahead.

The record of the last several years suggests that productivity growth may have moved to a high enough trend to allow the economy to grow at 4% a year or more without accelerating inflation and that unemployment rates in the low four percents are not only sustainable, but may actually provide incentives for greater productivity growth. What we do not know is what would happen if some or all of the special factors holding down inflation in recent years were to reverse simultaneously.

The Fed could be faced with a situation in which oil prices keep rising and begin to show up in other price increases; the backlash against managed care touches off a new round of medical price inflation; shortages of workers push wages up faster, and the dollar falls as growth and confidence pick up in Europe and Asia. The question then would be whether productivity increases and continued national and international competitive forces were still strong enough to keep inflation from accelerating. If the Fed feared not, this set of circumstances would likely prompt renewed rate hikes to slow the economy down. Aggressive tightening, given all the uncertainties about how quickly monetary policy achieves results, could lead to significant unemployment, which might, in turn, slow productivity growth.

In sum, the general policy prescriptions for keeping the good economy going would seem to be three:

  • Keep the market-oriented scene-setters in place-no retreats into protectionism or reregulation.
  • Keep and enhance the federal budget’s contribution to national saving-no massive tax cuts or unpaid-for spending surges, either.
  • Try to continue a monetary policy that contains inflation without significantly loosening labor markets.

If we can do all this-if we are neither egregiously dumb nor spectacularly unlucky– the prospects for continuing the economy’s good run are bright. Technology is still on a roll, confidence is high and capital is available. The promises of biotech are just beginning to unfold, and the impact of the internet on productivity and competitiveness is still mostly in the realm of speculation. Increasing use of the internet and interconnectivity generally has the potential for accelerating productivity growth in major sectors of the economy through better inventory and supply chain management, more efficient exchange of information, scheduling and resource deployment among business partners, and more competitive pricing. Before the dust settles, if it does, the internet may profoundly alter the structure of significant industries and markets. It may also provide consumers widespread opportunities to obtain customized products quickly and easily-a benefit that will be hard to capture in the macro statistics.

Using the Affluence Well

If we can keep the good economy going, we have an unprecedented chance to build a society in which:

    (1) Individuals have increasing opportunities to grow, develop their skills, earn rising incomes, own homes and other assets, and participate fully in the life of their communities;
    (2) Communities-urban, suburban and rural–are increasingly attractive, safe and healthy places to live and work, with good schools and public services, thriving social and cultural institutions, and a strong sense of pride and hope.

Despite all the good economic statistics, we are not there now. Although more people have jobs than even before, and wages and average family incomes are creeping up, millions of Americans feel left out of the good times and injured or threatened by the changes that are bringing them about. Many communities, especially inner city neighborhoods, older suburbs and areas of rural poverty, are being left behind and feel increasingly isolated from places of rising affluence.

I think it is especially hard for those of us who work with macroeconomic statistics that never looked this good before, and interact all day with people at the top of successful businesses and organizations, to understand that there are a great many people and places that do not share-and even resent-our enthusiasm for the performance of the U.S. economy. The protests against global trade and market capitalism that erupted at the WTO summit and the IMF and World Bank meetings-and are likely to be a continuing feature of such gatherings-seemed to most of us quite bizarre. It was tempting to dismiss the demonstrators as a ragtag collection of belligerent misfits-and some of them were. It was hard to understand why international organizations were the targets of such animosity. Earnest international delegates working together to establish trading rules, avert financial crises or help poor nations develop their economies, while they undoubtedly make mistakes, hardly seem to us to be villains in a tragic drama of global competition.

However, I believe the demonstrations should be seen as a metaphor for the challenges of affluence. They remind us that the benefits of technological change and an increasingly competitive national and international economy–of the economy resembling the model, as Blinder puts it-are huge, but people and places are left behind, and negative externalities are created, especially for the environment.

Most of those left behind were not left there by “globalization,” the bugaboo of the protestors, but they have been left behind, nevertheless. In the United States income and wealth are distributed much more unequally than they were thirty years ago, and the benefits of growth and change have been highly concentrated at the top of the distribution. These widening disparities in income and wealth are principally associated with the rising demand for education, skill and entrepreneurial talent-hardly surprising in dynamic economy whose leading edge is information technology-and outsourcing of unskilled jobs to lower wage workers overseas.

The gap between income groups widened, not in the last few years, but in the 1970’s and 1980’s when productivity growth was slow, average wages were stagnating, workers with low skill and education found their incomes falling in real terms, and only the top of the income distribution was doing better. In the 1990’s, productivity growth and tight labor markets combined to increase wages across the board. Even unskilled workers were in short supply, and their wages moved up along with those of the more skilled. That’s another benefit of low unemployment rates, but it is not much comfort to those at the bottom to know that their relative situation has finally stopped getting worse.

The income and wealth disparities themselves might not cause such resentment if the opportunities to get into the game were perceived as more equal. But vast neighborhoods of major cities, many towns and substantial rural areas as well are cut off from the prosperous “new economy.” Where surroundings are dismal, streets unsafe, schools dilapidated and ill-equipped, and jobs that pay good wages are three bus rides away in a place with an unfamiliar culture, technology and even language, its hard to feel that the economic future is a bright welcoming place for you and your children.

The biggest challenge of affluence, is to make the economy more inclusive, to open up the opportunities, substantially and visibly, to those that are not now able to participate, and to do that in ways that will enhance, not destroy, the productivity growth that makes the affluence possible.

This will take a double agenda-a people agenda and a place agenda. The people agenda should focus on making work more rewarding for those struggling to make ends meet on low wages without undermining either their incentive to work or employers’ ability to hire them. That’s a tall order, but we certainly know some tools that will help.

The earned income tax credit is effective and should be expanded. We need to find a way to provide health insurance, not just for children of low wage earners, but for their parents as well. It never made sense for working families to have less affordable health care coverage than people on welfare. Now that we have gotten serious about welfare reform and, with the help of a strong economy, succeeded in reducing the welfare rolls substantially, we have to get serious about affordable health care – and child care – for workers who don’t have it.

Another obvious key to widening opportunity, as well as keeping productivity growth rising, is access to training and skill development at all levels. An explosion of training is already occurring. Tight labor markets provide enormous incentives for improving skills, and millions of workers are finding ways to do this, frequently with company resources and support. But those in low-wage jobs are often left out. They do not have the resources, the self-confidence, or even the basic literacy skills to take advantage of training . The “digital divide” is a fancy name for an old problem, but its one an affluent nation with a shortage of technically skilled workers ought to make an aggressive effort to solve.

The place agenda is far more challenging because it involves trying to build thriving communities in places that have been left behind, but it is even more crucial to our national future than the people agenda. The place agenda is so critical because the people agenda can’t succeed without it. Skill training and retraining are important, but effective schools are even more so, and no one knows how to “fix” schools without fixing neighborhoods. As long as children are growing up in unsafe, dismal, dysfunctional neighborhoods, they will have a hard time succeeding and contributing to their community or the economy. Similarly, health insurance is important, but will not overcome the effects of drug abuse, poor nutrition, and early pregnancy.

My personal vantage point on the place agenda is the city of Washington DC, which, like many core cities has lost population, especially its middle income population, both white and African American, and lost the tax base needed to support good public services. Meanwhile its suburbs have burgeoned, sprawling out from the center, and creating traffic congestion, air pollution and pressure on the ever-receding countryside. But the Washington area, like other metropolitan areas, is beginning to see the downside of having its core city be the hole in the donut of suburban prosperity-and also beginning to realize the upside of revitalizing the city.

It will take enormous skill, and community effort, built around genuine working partnerships between the public and private sectors, to revive our central cities and turn them into attractive, safe places to live, work and raise children. It can only be done neighborhood by neighborhood, with the full participation of current residents and sensitivity to the fears and stresses that any change creates. But if we could do it, we would have accomplished something truly great with our affluence, and built a more cohesive society in the process.

 

The place agenda is emphatically not just a central city agenda. Community-building and opening opportunities for everyone are the big challenges of affluence all across the country. Meeting these challenges is not just a use of affluence, it is essential to keeping the high performance economy going. And the agenda is not just for government, despite election-year rhetoric. Meeting the challenges of affluence is a job for business, workers and citizens everywhere.

References
Blinder, Alan S. “How the economy came to resemble the model,” Business Economics; Vol. 35, Issue 1, January 2000, pp. 16-25.

David, Paul A. “The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox,” The American Economic Review; Vol. 80, Issue 2, May 1990, pp. 355-361.

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