New US paradigm is really just an old bugbear

Gavyn Davies on why inflation has stayed so low

Although it has not yet crossed the Atlantic, the financial markets in the United States are obsessed with a new economic "paradigm" which is held to explain why inflation has remained so low in recent years, and why equity and bond prices have been so buoyant. It would not be right to glorify the new paradigm with the title of a novel economic theory - rather it consists of a series of assertions, mixed in with a few empirical observations, and topped off with a healthy dose of optimism.

Nevertheless, anything which has influenced the thinking of Fed Chairman Alan Greenspan, which the new paradigm appears to have done this year, cannot be dismissed lightly, and some aspects of the optimists' case probably make some sense. For example, the focus on increasing returns to shareholders has clearly boosted the sustainable valuation of Wall Street.

But this week I want to examine the optimistic macro-economic aspects of the new paradigm. My conclusion is that the optimists' case looks very shaky, but that a quite different case for optimism is probably valid.

The macro-economics of the new paradigm rest on two unrelated assertions, which together explain why inflation has remained low during the economic upswing of the 1990s. The first is that underlying productivity growth has been greatly boosted by the revolution in information technology and other spin-offs from the microchip. This, it is claimed, has greatly boosted the potential output of the services sector, but the official GDP statistics have not correctly accounted for this change. Hence policymakers have not appreciated just how much productivity has actually risen. The second assertion is that wage inflation has been held down by the opening of a new global labour market, in which competition from the emerging economies has depressed the wages of unskilled workers in the west.

The combined effect of these two developments, according to aficionados of the new paradigm, is that output growth could be much higher than it actually has been, without any adverse effects on inflation. The villains of this story are the central bankers of the developed economies, especially the United States, who are accused of holding monetary policy too tight for too long. Far from needing to tighten policy today, the optimists demand that they should cut interest rates to allow the benefits of the new paradigm to shine through.

The popularity of the new paradigm has not so far been impeded by the fact that it is inherently implausible in several regards. For example, only a tiny fraction of the US economy is subject to competition from labour in emerging economies, which makes large systemic effects somewhat dubious. Furthermore, if productivity in the service sector is being systematically under-recorded, then so too is output. In other words, since real GDP is already growing much faster than the official statistics show, there is no case for central bankers to boost growth still further.

We can see from the employment figures in the US that output growth is higher than productivity growth, and that the labour market is tightening. That relativity is all that matters; the fact that output and productivity are both growing faster than the official figures show is not relevant for policy.

These rebuttals have become quite familiar in the debate in recent months, but have done little or nothing to stop the spread of the new paradigm. So today I would add two more facts that cast doubt on the hypothesis.

First, if the new paradigm were true, we would expect to see economic forecasting models breaking down, with a persistent tendency for price inflation to come in lower than expected for any given rate of output growth, and wage inflation to come in lower than forecast for any given level of unemployment. The inflation/output and wages/unemployment trade- offs should improve, relative to the past behaviour captured in macro models.

Furthermore, this should have happened on a global basis. Unfortunately, there is very little evidence that this has been the case. For simplicity, I have examined the track record of the IMF forecasts published each September since 1991 for the ensuing calendar year. (The IMF has been chosen because its forecasts are driven by a consistent global econometric model, though of course a great deal of judgement also intrudes into the process.) What do we find?

For the G7 as a whole, there has clearly been a tendency for the IMF to be too pessimistic about inflation prospects in the recent past - in the past five years, the actual inflation rate has been 0.3 per cent per annum lower than the IMF has forecast. This is encouraging for the new paradigm. However, the reason for this result is that the IMF has persistently been too optimistic about global GDP growth. Real GDP growth has on average been a remarkable 0.7 per cent per annum less than the IMF expected.

Consequently, there has been no improvement in the output/inflation relativity. All that has happened is that inflation has been lower than expected because output has remained much more depressed than the forecasts showed. Similar results hold for the wages/unemployment relationship. And the results also hold for the US economy taken in isolation.

The second argument against the new paradigm is this. Remember that, if the hypothesis were true, then the traditional relationships connecting spare capacity to inflation should break down. To test this, Francesca Massone of Goldman Sachs has just estimated equations linking the output gap to inflation in each of the major economies, and the graph shows the result for the developed economies as a whole. The equations were estimated on data running to the end of 1994, and the same estimates were then used to see whether anything has changed in the past three years. The basic answer is no - global inflation has indeed declined in the recent past, but it has done so exactly as would have been implied by previous relationships with the output gap.

The implication of these results is that the global inflation miracle has not been a miracle at all, but has been the result of the oldest bugbear of them all - sluggish rates of GDP growth. Since 1990, the major economies have grown at the funereal rate of only 1.7 per cent per annum, and even the wonder economy of the United States has grown by markedly less than 2 per cent per annum. Growth rates of this type are quite extraordinarily low in the years following a recession, and it is no surprise at all that they have been insufficient to place any pressure on global capacity or on global inflation.

Optimism about world inflation does not therefore need to be based on any new paradigm, but depends on an assessment of whether, for the first time this decade, growth in the three main geographical blocks of the US, Japan and Europe will enjoy a synchronised expansion. Given the sharp downward adjustments which have just been made to growth forecasts in Japan and the rest of Asia, this scarcely seems likely.

Believers in the new paradigm can dream on, but the real reason for low world inflation in recent years has been that GDP growth has been exceptionally low - and that unemployment has remained exceptionally high.