Thursday 30 October 2003

Pic of the day: Growth pines. (Photo from the past summer.)

New growth in the USA?

Even optimists were taken by surprise by the explosive growth in the third quarter, corresponding to 7.2% for a whole year. This is the fastest growth since 1984, so it doesn't exactly smell of recession. Does this mean the threat of economic disaster is definitely over and the party can begin again? (Especially the Republican Party, which has a presidential election to win in the not so far future...)

I don't think so. And - more importantly - neither does Alan Greenspan, chairman or the Federal Reserve, the US Central Bank. Through the budding recovery, Greenspan has kept interest rates as close to zero as possible without giving up all room for maneuver. In his job, Greenspan is informed of economic news at least as early as the rest of us, and earlier for all official statistics. He has had time to react if he thought we were heading toward a runaway growth that could herald new inflation.

***

Let us take a look at the relationship between inflation and economic growth, and why central banks are staring at just inflation with such fascination.

Basically inflation can be in three different states. Negative inflation, called deflation, is seen as falling prices. This may sound like a good thing, but it is not. Since wages are much harder to slide down in a controlled manner, falling prices mean falling profits, and eventually bankruptcy and closed doors. Even if you miraculously could get workers to accept lower wages, there is still the problem that loans would become unbearably expensive. Even without paying interest, you would still have to pay back more than you borrowed, because the same amount of money would now require a much higher profit margin to earn. As an economic indicator, deflation is a sign that the capacity of the economy is not being used. Capital, labor and tools lay fallow. This is generally seen as the worst possible outcome.

The opposite is hyperinflation, where prices just explode. This makes it hard to save money, it makes it hard to guess what is the correct price for goods and services, and people stop trusting the currency. Inflation is a sign that there are bottlenecks in society, which people throw money at in a desperate attempt to get through. True hyperinflation is a sign that the country lacks a reliable government, as the people in power just print money in an attempt to get something for nothing.

A moderate inflation is currently the ideal. If inflation is zero, it is very easy to compare prices and wages over time as well as calculate the true costs of loans. The problem with zero inflation is once again the wages and salaries. It is very hard to get people to accept less pay, even if there are good reason for it (their work is no longer as important as it was, for instance handling snail mail after e-mail has become common). The alternative is to keep wages up but kick people out. This also tends to cause social unrest. If you have a low inflation, you can simply keep wages constant and gradually people will realize that they could earn more elsewhere. So for society to function smoothly, it is considered best to have a low but steady inflation. Most central banks aim for something around 2% these days.

(Another reason to aim for a positive inflation is that conventional statistics tend to exaggerate inflation. For instance a computer this year is much better than a computer ten years ago. You get much more for the money, but this deflation is not shown in statistics. The same goes for cars and other things that improve in quality or features.)

***

If economic growth really takes off, inflation will come. The reason is that some resources are limited, at least for a while. Most common is a shortage of skilled labor. As employers compete for the labor, they offer more and more money and fringe benefits. In other places there could be a shortage of suitable buildings for factories or offices. Whatever the bottleneck, the automatic reaction is to throw money at it.

Therefore, if the economy grows faster than our society can support it, inflation is sure to rear its ugly head. The central bank can cool the growth by raising interest rates. This discourages people from borrowing and encourages saving. Both citizens and companies are more likely to wait and see when interest rates are high, and "just do it!" when rates are low.

In newly industrialized countries economic growth can often be around 8% per year, as they have cheap labor and space and can import technical know-how that already exists in developed countries. In rich countries where the labor force is already specialized and technical improvement requires substantial research & development, around 4% per year is considered reasonable. Much more than that, and there will be inflation.

A growth of more than 7%, as indicated by the latest numbers from the USA, would without doubt lead to shortages and inflation. But the central bank keeps its cool. Why? Because it knows this cannot last. And it cannot. Much of the consumption is financed by large tax breaks, of a dimension that would ruin the nation if they were kept up. Heavy investment in the military is also financed with budget deficit. The growth is simply not sustainable.

If the growth keeps up, the central bank will need to raise interest rates. This will hurt all those who have gotten used to cheap credit, and even a small rise in interest rates would slow down consumption drastically. At the same time, the price of homes would fall, leaving people unable to borrow against their homes anymore. Much of the private capital for spending has come from borrowing against private property. This trend would be reversed if interest rates were raised even a little. So the Fed will keep cool and wait to see. They will not raise interest rates more than marginally until they are convinced that there is stable growth. And I doubt that will happen under the current US government.