April 14, 2004
Both the physicist and economist sometimes are solving
similar problems. The physicist
wants to know precisely how long the rocket must burn fuel to glide into a
sustainable orbit. The economist
wants to know how long to pursue a stimulative policy until a sustainable growth
path has been achieved by the economy.
Of course, the physicist has the easier problem.
The gravitational pool is precise, basically known, and the control over
policy (the burn of the rocket fuel) is virtually precise.
Indeed, the sustainable orbit is known with virtual certainty as well.
We economists must guess at the sustainable path, which
might have changed since the last time we sought it. Our policy controls (money growth, tax changes, and spending
programs) are buffeted by many factors that have little to do with optimum
Most importantly, the response to these policies depends
upon reactions by humans. As Nobel
Laureate Robert Lucas argued, all policy reactions are unique because this time
people not only know the policy and how they acted last time, but also how the
economy’s reaction differed from what they expected.
Thus, a tax cut this time gets a different response from
last time because we did not know what would happen from our response last time.
This time we do, and will behave differently because of that knowledge.
By the way, Lucas made a mistake by surmising that
uniqueness meant uncertainty. Perhaps
there is a range of results that we will never know precisely (how I envy those
physicists with their known physical properties). Yet, we should know enough to plead good policy.
Which brings me to the subject of this column.
When should the Federal Reserve slow the rocket burn to seek the
sustainable growth path.
Administration economists seem to think we can keep
interest rates below equilibrium until signs develop that we have overshot.
In other words, if no inflation surfaces, then we must not be there yet.
That is wrong. (Secretly,
they probably want interest rates unchanged until the people have spoken in
November, but I never knew that the correct policy was one that coincided with
the political calendar.)
Inflation’s response to policy works through many
channels, such as currency values, asset prices, material costs, labor
contracts, construction costs, etc. that do not surface in identifiable consumer
prices for many months. Just as you
know your house is in danger when you spot a termite, inflation already is
embedded by the time the popular inflation measures are accelerating.
Indeed, two of my measures of future inflation, the inverse
of the dollar’s value and the prices of crude materials other than food and
energy, have been soaring for many months.
The dollar has rallied recently (to show that precision is not possible
in these forecasting devices) but remains well below previous year values.
I might also argue that real estate prices are growing far
beyond what reasonable returns provided by those assets would predict.
Because job growth and its resulting increase in earnings
has been so hard to generate in this recovery, I have agreed with the Federal
Reserve’s patience in maintaining their low interest rate policy.
We need the wage growth to be assured that economic expansion will
persist once the tax injections cease.
(By the way, the President’s desire to make those tax
injections permanent is the equivalent of having the doctor continue to give you
medicine even after you are well. It
is bad policy and should be resisted, or are we so greedy for what comes to us
individually that we no longer care what is needed collectively?)
Would I object if the Federal Reserve remained patient
until they were assured that a job number that was surprisingly strong but was
not accompanied by surging earnings picked up those earnings in later months?
No I would not.
However, if another few months of above trend job growth developed with expanding hours and rising hourly earning, then I would know that politics, not economics, is piloting our policy. And we will surely miss that sustainable growth path. How does the inflationary recession of late 2006 sound?