Originally published in THE BOSTON GLOBE
Tuesday, March 28, 2000
Fed is right to try to dampen consumers overexuberance
Spending tomorrow's income
By Martin and Kathleen Feldstein
"We can spend more than we produce only by borrowing from abroad."
Alan Greenspan is famous for cryptic expression. But recent remarks by the Federal Reserve chairman left many people more puzzled than usual.
Greenspan has expressed concern that the recent surge in productivity might actually contribute to inflation. We agree that this does seem counterintuitive. After all, higher productivity means more output per hour of labor. If consumer demand remains unchanged, the additional output should help to relieve excess demand pressures, rather than the other way around.
Greenspan has a particular scenario in mind when he links higher productivity with increased inflation. Most likely, he is concerned that the productivity increases may fan expectations of higher incomes in the future. That might, in turn, lead to a surge in consumer spending today.
If, for whatever reason, consumer spending runs ahead of actual increases in income, the result could be a combination of increasing inflationary pressures and a rise in imports, which would worsen our already large current-account deficit.
The Fed chairman, seeing a danger that the good news on productivity will spark an unsupported increase in spending, is using his bully pulpit to put a damper on consumer exuberance. And he is likely to back up his words with more interest rate increases.
The economic behavior that Greenspan worries about is clearer if we look first at an individual and then generalize to the larger economy. So imagine a friend who has just found himself on the fast track: There is the promotion, with a substantial pay increase. And the boss who says the future looks bright, that the employee can expect more promotions and bigger pay increases over the next several years.
With such high expectations, this friend might well decide to improve his lifestyle now, by making purchases based on future income, rather than on todays income. To do so, he might cut back on savings. But even if he borrows to finance his new spending, he is confident he will be able to pay off his debts and still save more in the future. So he might buy a bigger house than he can afford on current income, get a new car or even buy a sailboat.
Our friends enthusiasm might be even greater if part of his extra compensation comes in the form of stock or stock options. He can expect his wealth to grow along with the positive results from his company.
In the last few years, strong productivity growth and rising share prices have created lots of situations like this. Many Americans are seeing their real wages rise rapidly and have the prospect that continued rising productivity growth will deliver even faster wage growth. Expectations like this are also pushing up share prices.
For the nation as a whole, though, attempting to spend more than current income will eventually lead to increased inflation.
An individual can spend more than he earns as long as he can get credit, but for the total economy, more spending requires increased production.
While faster productivity growth provides some of that extra production, additional employment is also needed. The process of hiring more workers has reduced the unemployment rate to about 4 percent nationwide while causing wages to increase more rapidly year after year. That has not yet translated into increased inflation. But increasingly fast wage growth will eventually lead to accelerating costs and higher inflation.
Which explains Greenspans puzzling words of caution.
The Federal Reserve also worries that if the expected increases in income do not materialize, and if share prices come down from their dizzying heights, many individuals will have difficulty paying off debts. Then, it is not hard to see the danger to the economy.
The link between rising productivity and overspending creates a further problem: As a nation, we can spend more than we produce only by borrowing from abroad. That is, indeed, what the United States is doing. In 1999, the country borrowed more than $300 billion from the rest of the world, or about 3 percent of the nations output. Thats up significantly from $220 billion the year before, and it will probably grow significantly larger this year.
At some point, foreign lenders and investors may conclude they have too much exposure to the American economy and to the dollar. If that happens, the dollar will fall, interest rates will rise, and share prices will decline. If that happens quickly, it could push the US economy into recession.
The Fed is doing the right thing by trying to prevent optimism about the future from turning into excessive demand today. A little caution today will help to keep that future bright.
Martin Feldstein, former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.