Why Is The Fed So Terrified Of Growth?

Despite rising productivity, real living standards have been falling for most Americans. Much of this reflects structural changes in the economy--the shift to deregulation, globalization, and the weakening of unions--all of which reduce job security and labor bargaining power. The result is that the well-off capture the lion's share of economic gains.

But in 1994, according to the Census Bureau, a funny thing happened. Median family income, after falling for four straight years, actually rose by $877, or 2.3%. In 1994, the economy did not become less global, or more regulated, or more unionized. So why did median incomes go up?

Easy. In 1994, the economy grew at a brisk 4.1%. This growth rate meant high job creation, which offset rising productivity and brought down the rate of unemployment. When the economy is growing rapidly and employers are adding new people, employees gain greater leverage to get their share of productivity gains--and the earnings of ordinary people go up.

But don't expect this trend to continue. The Federal Reserve thinks a 4.1% growth rate is dangerously high. This year, and for years to come, the Fed will target a real growth rate to around 2.5%. As long as this is the case, we can expect the broader structural trends to combine with sluggish growth to deny the average person increases in real living standards.

SALARY HIKE. This slow-growth consensus is beginning to erode, though the erosion is coming more from political forces than from the economics Establishment. Supply-siders, for example, have never bought what Robert L. Bartley once called the "root-canal" school of economics--the idea that economic virtue must be painful. Bartley's Wall Street Journal editorial page has continued to crusade for higher growth rates and has even given space to the Keynesian economist Robert Eisner, with whom Bartley agrees on little else.

In a recent essay, Professor Eisner pointed out that higher growth is associated with fuller employment and higher rates of productivity. When productivity rises, proportional wage increases are not inflationary. Hence high rates of growth and employment need not produce price increases and can actually counter inflationary pressures.

The prophets of slow growth ignore the recent structural changes noted above, which alter the historic association of tight labor markets with inflation. In a global economy, U.S. workers think twice before pressing for wage hikes in excess of productivity gains: They risk pricing themselves out of the market. For a decade, the norm has been for median wage growth to lag behind productivity growth, in boom years as well as recession years. Sellers are likewise restrained from extracting price increases by the proliferation of competitors. The more the economy becomes deregulated and globalized, the more it can sustain higher growth rates without courting inflation. Somebody should tell Alan Greenspan.

WALL STREET TALKS. Last month, the National Association of Manufacturers, not exactly a temple of Keynesian economics, issued a tough statement calling for a target growth range of 3% to 3.5%. (BUSINESS WEEK concurs; see its Oct. 9 editorial.) It is a bizarre moment in political economy when the NAM thinks the economy can prudently grow at 3.5% and a Democratic Administration (cowed by the Fed) gratefully settles for 2.5%.

This is an old story--Main Street vs. Wall Street. The real economy is capable of higher growth and fuller employment. This is vividly true in the 1990s, given the combination of computerization, higher productivity, global competition, and disciplined labor markets. But the financial economy, to which the Fed responds, is more concerned about the sanctity of the bond market and associates slower growth with financial soundness.

Economists debate the relative roles of macroeconomics as well as microeconomic interventions such as education, training, technology, and labor policy in raising living standards. Micro measures have their place but the growth rate is the cake and most else the frosting. When the economy grows at 4%, jobs are plentiful, labor has bargaining power, and wages can rise with productivity. In that context, it pays for companies to spend on training to upgrade skills and prevent worker shortages. But when growth is 2%, spending on human capital may not compensate corporations sufficiently and may yield an overeducated, underpaid, frustrated workforce. The preconditions are in place for a new era of rising growth and broadly distributed prosperity. The Fed should take its miserly foot off the brake.