It's A Whole Different Economy

Last year, if you had said there could be 4% annual growth and a stable inflation rate of 2.7% in 1994, economic pundits and market practitioners would have said you were crazy. If you had said unemployment could drop to 5.6% with no wage inflation, the verdict would have been the same: crazy. And if you had predicted interest rates would soar 250 basis points while inflation remained just a specter on the horizon, again the pundits would have shouted the same thing: nuts!

Well, nuts to them. All three predictions have come true in 1994. This economic cycle is different from previous ones. Big gains in productivity, a monetary policy acting ahead of inflation, and a sharp reduction in the federal budget deficit are creating a new paradigm for the U.S. The economy has been growing faster without igniting inflation, and there is a chance that noninflationary growth can continue. Instead of a 2.5% "natural" rate of growth, the economy can cruise along at 3% plus. Instead of a 6.5% "natural" rate of unemployment, far more people can work without pushing up wages.

BUSINESS WEEK has previously said that a shift to higher productivity was radically altering the American economy. In Cover Stories "Why are we so afraid of growth?" (May 16) and "The real truth about the economy" (Nov. 7), we said a new era of high growth and low inflation might be at hand. The markets took many months to validate this view, but it is now quietly spreading to pundits and practitioners alike.

If current trends continue, the implications are profound: When economic growth broaches 3% without inflation, then investment spending soars, spurring even higher productivity and further investment. This is the virtuous cycle that was behind Germany's and Japan's successes in the 1980s. It may be close at hand in America, if Washington doesn't mess it up.

So far, the Fed has played a canny game. Chairman Alan Greenspan has been dead right in fighting the effects of high growth. By shifting to a policy of preemptive action, the Fed has proved to bond vigilantes that it will do whatever it takes to prevent inflation. For the future, the big question facing Greenspan is: What kind of monetary policy does the board run in such an economy? The answer should include targeting 3% growth while maintaining an anti-inflation vigilance.

Congress can still kill this high-growth, low-inflation economy. Critical deficit reduction is now threatened in Washington. Centrist conservatives want to shrink the government and lower the budget deficit by cutting spending. They are represented by the President's Bipartisan Commission on Entitlement & Tax Reform, led by Senators Bob Kerrey (D-Neb.) and John C. Danforth (R-Mo.). Within the Republican Party itself, Senators Robert Dole (Kan.) and Peter Domenici (N.M.) are strict conservatives. Among the Democrats, the Democratic Leadership Council (DLC) has a 10-point program to cut government spending.

The supply-side wing of the GOP, however, believes that cutting taxes will automatically generate enough revenues through higher growth, so that government spending won't have to be cut much. The danger is that $1 worth of tax cuts will not produce $1 worth of tax revenues. This risky strategy could backfire and produce huge deficits all over again.

For this economy to continue to prosper, all three innovations--high productivity, a preemptive Fed monetary policy, and serious deficit reduction by Congress--must continue. Washington policy should aim to bolster all three by fashioning tax and spending policies that work toward higher investment, smaller government, bigger savings, and freer trade. That translates into capital-gains tax cuts directed at future investments, not past ones, cuts in entitlement programs that match middle-class tax cuts, and a foreign economic policy that opens markets for U.S. exports. Something really good is happening to the American economy. Let's hope Washington doesn't screw it up.