Today’s Realities..Yesterday’s Models Today’s realities do not necessarily fit yesterday’s models. In a universe where shifting paradigms are the norm, scientists are in continued search to establish cause and effect relationships between events that can be modeled. We see behaviorists scurrying for specific reasons as to why two youths could commit such heinous acts in Colorado. Their existing models could not predict such atrocity. Meteorologists and environmentalists are developing an explanation for global warming. What new factors will explain the condition? Will updated models accurately predict future trends? Economists are not exempt from this process.
In today’s world, where markets are defying what was previously considered rational thought, economists are continually challenged to investigate, establish cause and effect relationships and develop new models to explain and predict our economic condition. A dramatic example of this process is the economist’s efforts to explain the relationship between unemployment, the failure of the economy to employ it’s labor force fully, and inflation, a sharp drop in the value of a nations currency that causes a rise in the general level of prices in the economy. In the past there were numerous theories that linked the two factors in a polar relationship. Simply put, when unemployment was low, inflation was high, and when unemployment was high, inflation was low. Today, however, traditional thought that linked unemployment and inflation is being challenged.
As Alan Greenspan, Chairman of the Federal Reserve, told Congress earlier this when discussing the relationship of inflation to unemployment, At some point, the general notion that a different type process is involved here is going to gain a majority view among economists.(Stevenson, April 11,1999). What did past theory tell us about the inflation – unemployment relationship? What is the current economic climate has changed to cause us to reevaluate these theories? What new theory suggests an explanation of the current condition that will enable us to model future events? There are two major historical views to the unemployment – inflation theory. From the 1930’s to the 1970’s, the Keynesian model was utilized to explain the relationship between full employment and stable prices. In it’s most basic form, Keynes’ theory states that the economy may realize either unemployment or inflation, but not both simultaneously.(McConnell and Bure, pg 338) The inverse relationship between unemployment and inflation was further supported by the British economist A.W. Phillips.
Phillips theorized that high demand drives higher inflation and the growth of real output and corresponding lower unemployment rates.(McConnell and Bure, pg. 339) The viability of these models was challenged with the events of the 1970’s and 1980’s. Specifically, we began to see the simultaneous co-existence of both rising unemployment and inflation that was not indicated in either Keynes or Phillips’ models. Stagflation was the word used to describe this new phenomenon in which the economy was impacted by high inflation rates and high unemployment. The reality of the current events do not fit this model.
The theories and terms used in the past modeled the times but none serve as a guide to describe today’s reality. Unemployment has been falling for the past several years, and last month dipped to 4.2 percent, its lowest level in nearly three decades and well below any mainstream estimate of the natural unemployment rate. Economic growth, while slowing somewhat, remains robust. Yet, the predicted inflation is nowhere to be found.(Stevenson, April 11,1999) We are in the longest peacetime expansion in American history. We continue to move into uncharted water(Thurow).
The growth rate for 1998 was 3.8 percent, the third consecutive year the economy has expanded at nearly 4 percent. Previous economic theory held that the economy could not grow in excess of 2.5 percent without igniting inflation.(Stevenson). Again, past theory does not reflect today’s realities of inflation rates of less than 1 percent with nearly a quarter of a million jobs added in each of the last twelve months. (Nason). Surely, the Federal Reserve monetary policy has been used wisely to positively impact these results.
Surely, advancements in new technology has created new markets for labor and reduced costs and increased outputs. The improved productivity levels have served to suffocate inflation. The best explanation for today’s condition, which began with the bull markets of the 1990’s, closing in excess of 11,000 on May 3 of this year, is the Perpetual Motion Economy Theory. Each part of the economy works in conjunction with the other. Each part keeps the other moving indefinitely and positively.
Mr. Richard T. Curtain, Director of the University of Michigan’s Consumer Surveys coined the flow as a virtuous cycle.(Uchitelle). In a Perpetual Motion Economy model, the rising stock market drives households wealth that encourages borrowing that pays for spending. This increase in spending creates more jobs that produce higher wages. This generates confidence that encourages people to invest in the stocks and causes the market to rise and so on and so forth.
As Stephen Roach, Chief Economist at Morgan Stanley Dean Witter, aptly observed, Many of us who have been doubters are starting to believe this can go forever. That is a complacency we may live to regret. But I cannot really substantiate doubt for a good analytic reason.(Uchilette) Buying into the Perpetual Motion Theory allows for a world in which low inflation and low unemployment can not only coexist, but also serve to feed a self-perpetuating process. Even the staunchest proponents of the Perpetual Motion Theory acknowledge that there is a trade off in the long term between inflation and unemployment. The question is not that these relationships exist, but rather are the relationships consistent enough to predict rates in a rapidly changing world.
L. Douglas Lee, Chief Economist at HSBC Securities, best sums up both current and past theory. These various road maps or rules that we use are valid at times but what you always have to remember is that the U. S. economy is a very dynamic creature and things don’t remain fixed. What works at one point in terms of understanding inflation may not work in another, but then may change and work again.
The trick for policy makers is to remain flexible and to recognize when their old assumptions are no longer working. Policy makers, and all of us , have to stay on top of things so we do not use the old map on a new road.(Stevenson, April 11,1999) Today’s realities do not necessarily fit yesterday’s models. Economics Essays.