* part of year
FIGURE 4.4 Lots of Excess Capacity in America
Source: Federal Reserve
In the midst of the 1990sÔÇ™ stock market bubble, one of the common justi-
fications for ridiculous stock prices was the entry of China into the world
economic system. CiscoÔÇ™s high stock price, it was widely said, made
sense because Cisco would sell a lot of product to China. More broadly,
the hope was that U.S. companies could export products to many foreign
markets and thus not depend on the U.S. consumer.
While this export-based argument was wrong with regard to stock
prices (Cisco shares have lost 75% of their value), a significant and grow-
ing proportion of U.S. output is indeed sold to foreign consumers. With
U.S. consumers possibly looking to save, and U.S. factories sitting idle,
perhaps the foreign consumer will provide growth.
Unfortunately, important foreign economies are not in great shape.
Japan and GermanyÔÇ”the worldÔÇ™s second and third largest economiesÔÇ”
continue to struggle to recover from economic slumps. The German
economy is barely growing at all, and the German unemployment rate is
The Japanese economy is not in much better shape. Since the late 1980s,
76 The Old Art of Macroeconomics
the Japanese stock market average has declined from 40,000 to just over
11,000 (July 2004). This decline far exceeds both the length and depth of
the U.S. stock market troubles. The Japanese stock market decline pro-
vides a measure of Japanese economic weakness. It also reduces the
wealth of Japanese people and puts further downward pressure on the
Even the effect of Chinese economic liberalization has been negative
for U.S. producers. Chinese workers make products more cheaply than
U.S. workers. The export of those Chinese products has negative effects
on the U.S. economy.
Conclusion: Exports are a potential source for economic growth, but
given their relatively small role in the U.S. economy, the effect may not
The final significant piece of economic consumption is local, state, and
federal governments. With overburdened U.S. consumers, idle factories,
and less than robust foreign economies, can government spending fuel
Most of the discussion about government spending revolves around
U.S. federal spending. It is important to note that state and local gov-
ernment spending is almost as important as that of the federal govern-
In his campaign for California governor, Arnold Schwarzenegger
famously remarked, ÔÇťThe public doesnÔÇ™t care about figures.ÔÇŁ5 That may
be an accurate assessment of voter sentiment, but governors themselves
must care about numbers. Most state and local governments are legally
required to run balanced budgets so when times are tough, their spending
must be reduced.
All around the country, state and local governments are cutting ser-
vices and raising taxes. In order to close its budget gap, New York City
raised property taxes. California Governor Gray Davis earned the hatred
U.S. Economic Snapshot 77
of many by tripling the tax on car registration. A similar story is unfold-
ing across the country. The conclusion is that state and local governments
will be a drag on economic recovery, not a stimulant.
What about the federal government? As we discussed earlier in the
chapter, the federal government has been the major supporter of economic
growth by heavy deficit spending. Can the federal government increase the
deficit even more and provide more economic growth? Yes. A $500 billion
deficit is large by any measure. When compared to the size of the economy,
however, the current deficit is much smaller than historical extremes.6
Thus, if needed, the federal government can increase purchases.
There are, however, risks to increased federal deficits. The most obvious
is the possibility of rising interest rates. If large, additional government bor-
rowing forces up interest rates, the increase in mortgage rates will depress
the housing sector. The U.S. market for homes has remained strong
because it has been fueled by low mortgage rates. The housing market will
be hurt if mortgage rates rise in response to additional federal spending.
Conclusion: The U.S. government has the potential to increase deficit
spending and provide a boost to the economy. However, additional deficit
spending may cause an increase in mortgage rates and damage the hous-
The United States is struggling with a financial hangover. The effects of
the 1990sÔÇ™ excesses will reduce economic growth.
Bull #1: Economic Eyeglasses
for the Short-Sighted
The first optimistic defense of the economy simply looks at the longer
trend instead of the recent past. If we cast our eyes back to the immediate
post-bubble past, the picture painted above is quite grim. We are told that
things are often darkest before the dawn. It is easy to repeat such phrases,
78 The Old Art of Macroeconomics
but harder to feel optimistic during tough times. This lesson was demon-
strated by one of General George CusterÔÇ™s men at the Battle of the Little
There is a story that has been passed around about the battle. As is well
known, General CusterÔÇ™s men were wiped out and none of his troops sur-
vived. According to this storyÔÇ”which would have come from Sioux
warriorsÔÇ”one of the cavalrymen had an opportunity to escape. He was
riding away and had enough of a lead over his pursuers that his odds were
good. At precisely the moment when he looked likely to escape, however,
he pulled out his pistol and committed suicide.
The U.S. economy has taken some severe blows in recent years. Yet
we may be on the cusp of recovery and ought not despair at what might
be our darkest hour. If we take even a slightly longer-term perspective,
most economic statistics look quite good. The U.S. stock market as mea-
sured by the S&P 500 index is down about one-third from its all-time
high (as of July 2004). It has, however, gained almost 1,000% since the
stock market bottom in the early 1980s.
A similar pattern emerges across almost all the seemingly dire eco-
nomic landscape. Interest rates have risen from their lows (including one
amazing 50% rise in little over a month), yet rates remain near 50-year
lows. Inflation has become so low that the Federal Reserve has spent con-
siderable effort wondering how to stop prices from falling.
Rising unemployment is perhaps the worst aspect of current economic
troubles. The unemployment rate has risen by almost 50% and literally
millions of people have lost their jobs. Even in this area, the longer-term
news is good. As recently as 10 years ago, the current unemployment rate
of about 6% would have been considered good news.7
What about the enormous federal government deficit? Surely the rapid
swing from large government surplus to gaping deficit cannot be over-
looked. Surprisingly, even in this area, the longer-term perspective is
very positive. If we measure the amount of U.S. government debt as a
percentage of the total economy, the debt is significantly smaller than it
U.S. Economic Snapshot 79
was in 1993. Measured this way, the current federal debt is only about
one-half as big now as it was at the end of WWII.8
Conclusion: While the last few years have been painful, there is no proof
that the longer-term economic miracle has ended.
Bull #2: Vince Lombardi Meets the Computer
ÔÇťWinning isnÔÇ™t everything, it is the only thing.ÔÇŁ
This quote is misattributed to legendary Green Bay PackersÔÇ™ Coach
Vince Lombardi who actually said, ÔÇťWinning is not everythingÔÇ”but
making effort to win is.ÔÇŁ It is an odd quirk of history that Lombardi is
most remembered for something he didnÔÇ™t say. What he did say on a vari-
ety of topics is great, and much of it is relevant to investing. Among my
favorites is, ÔÇťWinning is a habit. Unfortunately, so is losing.ÔÇŁ
When it comes to economic growth, productivity isnÔÇ™t everything, it is
the only thing. Even though Coach Lombardi probably never said this
either, it is a mathematical fact.
There are two roads to wealth: One is to work harder, and the second
is to work smarter. Obviously working smarter is the preferred route;
productivity measures the economyÔÇ™s ability to work smart. Thus pro-
ductivity becomes the key to long-term economic growth.
Optimists can make a good argument based on U.S. productivity as
shown in Figure 4.5.
This young decade has had higher U.S. productivity growth than any
other in the post-WWII era.
Is productivity really higher now than in the past and can the good
news continue? It seems possible. Some economic historians make an
analogy between the Industrial Revolution and the information technol-
ogy revolution. It took many decades to learn how to harness machines
effectively. Thus the benefits from the Industrial Revolution were not
80 The Old Art of Macroeconomics
Average annual productivity rise
1950s 1960s 1970s 1980s 1990s 2000+*
* through mid 2004
FIGURE 4.5 U.S. Productivity Growth Is Very Rapid
Source: U.S. Bureau of Labor Statistics (non-farm business output per hour)
We may just be getting to the time when information technology is
being understood well enough to make us richer. If so, it is possible that
the recent high productivity will not only continue, but could even
Is the recent rise in productivity really a big deal? Yes, because of the
magic of compound interest. My favorite example of compound interest
comes from Charles Darwin. In Chapter 3 of the Origin of Species, he
The elephant is reckoned to be the slowest breeder of all known ani-
mals, and I have taken some pains to estimate its probable mini-
mum rate of natural increase: it will be under the mark to assume
that it breeds when thirty years old, and goes on breeding till ninety
years old, bringing forth three pairs of young in this interval; if this
be so, at the end of the fifth century there would be alive fifteen mil-
lion elephants, descended from the first pair.
U.S. Economic Snapshot 81
Darwin was calculating compound interest. If something grows at just
over 2.3% a year, it doubles in 30 years. The magic of compound interest
means that even with slow rates of growth, given enough time, the over-
all growth is stunning. The inability of the world to support so many ele-
phants was an important step on DarwinÔÇ™s intellectual road.
To appreciate what different productivity rates mean, letÔÇ™s take Keynes
at his word. What are the economic possibilities of our grandchildren? In
particular, letÔÇ™s contrast the wealth of our grandchildren under two possi-
ble scenarios. In the high-growth scenario, productivity grows at the
3.62% average of this decade. In the lower-growth scenario, productivity
grows at the 1.72% average of the period 1970 to 1999.
Does it matter much for your grandchildren which of these two pro-
ductivity rates exists for the next 40 years? LetÔÇ™s test your intuition. How
many hours per week will your grandchild work to have the same
lifestyle as could be earned by working 40 hours now? Here are four pos-
(1) 29.3 hours per week.