TCS Daily

The Internet Killed Inflation

By Kevin Hassett - June 12, 2000 12:00 AM

Several weeks ago, I was debating Bob Shiller, the author of the bearish book Irrational Exuberance, for Time magazine online. Nasdaq had just been pummeled, down about 2,000 points from its peak. Bob got to trashing the Nasdaq market, and, believer as I am in the hypothesis that the economic rules are changing, I challenged Bob to a bet. If Nasdaq reaches its 2000 peak again (5132) over the next three years, then Bob has to buy me dinner at my favorite restaurant in New York City. If it doesn't, I am buying at his favorite. Confident that the new-economy bubble had finally burst, Bob jumped at the bet.

Over the past two weeks a series of data releases have caused the market to boom, with Nasdaq up about 20 percent since our bet, finishing last week at 3874. The key news was a modest increase in unemployment, followed by a number of favorable reads on inflation. Last Friday we learned that producer prices for finished goods---the so-called PPI---did not increase at all in the month of May, and Nasdaq took off in response, jumping more than a percentage point in one day. The reports of the demise of the new economy appear to have been premature.

Why is the market flying around so sharply in response to each little piece of news? I believe there is a simple answer. For several years now our economy has experienced an unprecedented growth surge without generating inflation. If this growth continues, then we will all become very, very wealthy. If it turns out to have been a happy accident and old relationships are a useful guide to the future then inflation will soon take off, forcing the Federal Reserve to slam us into a recession; economic misery may be lurking around the next bend. The market, like the rest of us, is trying to decide which view is correct, and it is a tough job.

In a March 6th address at Boston College, Alan Greenspan explained how the digital economy has produced growth without inflation: "Since 1995, output per hour in the nonfinancial corporate sector has increased at an average annual rate of 3-1/2 percent, nearly double the average pace over the preceding quarter-century." In other words, computers and other digital tools make us more productive. They allow us to do more in the same hour of work.

This has nothing to do with business cycles or the money supply and this phenomenon is not going away. As long as Silicon Valley can continue stuffing more transistors on to a sliver of silicon and sending more light pulses along more optical-fiber networks, American workers will continue to get more productive. So when analysts see that wages are starting to rise in a given sector, that doesn't mean inflation is under way. Yes, companies may be paying higher wages, but they're getting more work out of their people.

Despite his Boston College remarks, the Fed Chairman still may not fully appreciate the inflation-fighting power of the New Economy. Recent interest-rate increases suggest that the Fed governors, along with many other economists, still question if the New Economy is really all that new. So Jim Glassman asked me to delve more deeply into the underlying data to provide policymakers and investors with new information and new ways of looking at this New Economy.

After some very stimulating conversations, Jim and I agreed that what those curious about the economy really needed was a New Economy version of the document that Federal Reserve economists prepare for each Fed meeting, the Greenbook. The Greenbook is the professional staff's summary of what has been going on in the economy since the last Fed meeting. A "Digital Greenbook" would be open-minded about the notion that something unique is happening in the economy right now. It would sort out the various ways of looking at things, dispose of the pure baloney, and confront new and old theories with the movements of the data in real time. Readers would be able to judge for themselves who is winning the debate, and watch as the participants change their arguments in response to new observations. Tech Central Station is the natural place to launch such a thing, and Jim talked me into giving it a go.

Why me? Almost eight years ago I took a leave from my job as a professor of economics and finance at Columbia to go work at the Federal Reserve in Washington, DC. At the time, I was thrilled about the opportunity. I would be joining the crack staff of economists that put together the "Greenbook"---the document that Chairman Greenspan and the other Fed Governors have on their laps while they vote on interest rates---and be a fly on the wall at some of the most important economic policy meetings in the world. And working on the Greenbook itself would be a tremendous opportunity. For each meeting the staff gathers and processes information on all sectors of the economy, updating predictions of economic models with responses to breaking news. The data and analytic resources available were second to none.

A colleague at Columbia who was upset that I was taking time away from my academic research to participate in policy making suggested that my trip to the Fed would be about as productive for my academic career as going to Borneo. I responded that I was going to Borneo for the right reasons: I would be doing field work, observing the vast and changing tapestry of economic data full time. What better way was there for a scientist to proceed?

As it turned out, I arrived at the Fed at just the right time. The economy was about to enter a historic period of growth without inflation. Time and again, the data repudiated the predictions of the models that had worked so well for so many years, and a frantic, exhilarating search for new ways of looking at things began. Each new piece of news heightened the puzzle. Conflicts between economic Newtonians, who believe that what goes up must come down, and new-economy apprentices, who believed that the information technology revolution would allow this time to be different, but were unsure of exactly what the channels might be, were heated and urgent.

I rapidly acquired an acute appreciation for the benefit of such "field work." Economists, it seems, are brilliant at looking at events in the distant past and rationalizing them, but somehow, their creations always seem to fail us going forward. I have never been too satisfied with the traditional methodology because it is far too easy to use ex post reasoning to delude yourself into believing that an economic model explains everything. Kind of like the guys who believe they can predict the stock market based on the conference affiliation of the Super Bowl winner.

While the data were not kind to the old models, the dust has not even begun to settle. So far, our visions of the "new" economy have been analogous to the occasional limbs glimpsed in the tornado surrounding Bugs Bunny's nemesis the Tasmanian Devil. We know there is a beast in there, but we are not sure what type of beast it is.

But the questions have emerged. Have computers and other high tech breakthroughs changed the way the economy works in a way that is significantly different from past technological revolutions? After all, the wheel and the steam engine were pretty big in their time. And second, have the old reliable relationships broken down, or have they simply been hibernating?

Working on these questions, economists have developed two schools of thought. Old economy adherents believe that the old relationships still hold, but that a sequence of happy accidents that can not be expected to continue have kept us on this golden path temporarily. The new economy view is that there are logical and verifiable connections between the rapid technological advances we have seen and the breakdown of the old economy relationships.

To these I add a third possibility. The "no economy" view. According to this view there are no relationships in the economy that are so time invariant and trustworthy that they can be relied upon to predict the future path of society. Sure, the old economy relationships have broken down, but that doesn't mean that they were ever that trustworthy to begin with, nor does it mean that some reliable new-economy model that solves the problem of the economy once and for all will ever emerge. Economists are just wasting their time.

Each of these views has something to say about our future, and each little piece of data adds another piece to the puzzle. If the old-economy high priests are correct, then we are about to see a surge in inflation, followed by Fed rate increases and a big increase in unemployment. If the new economy gurus are correct, then economic growth will not tail off, inflation will not get out of hand, and we will all stay blissfully employed. If the no economy view is correct, something weird will happen that can not be explained by either of the other views.

And as we saw again last week, the battle's front line is the inflation war. Inflation has always taken off in past booms. Is this time different? The only way to find out for sure is to watch the data. That's why last Friday's PPI could move the market so much. Another month of flat prices added a little bit of evidence supporting the new economy view. Analysts were expecting prices to increase sharply, after being relatively tame over the previous two months. With no inflation in sight, the Federal Reserve may not need to force a slowdown to reign in price increases, at least for another month.

Which view will win? If the Digital Greenbook is successful, its readers will be the first to know. In coming weeks and months we will add nuance to the opposing views, and confront their predictions with the cold hard facts as they are released.

Kevin Hassett is the co-author, with James K. Glassman, of Dow 36,000.

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