If economics were a boat, it would be a leaky tub. The pumps would be straining and the captain would be trying to prevent it from capsizing. Which is to say: Our ideas for explaining trends in output, employment and living standards -- what we call "macroeconomics" -- are in a state of disarray. If you're confused, you're in good company. Only recently Federal Reserve Chairman Alan Greenspan confessed again that he doesn't understand why interest rates on long-term bonds and mortgages have dropped, just when the Fed is raising short-term rates. This is but one mystery.
It's not merely that we're in the midst of changes (China and India's entry into the global economy, the explosion of U.S. trade deficits) that are unfamiliar and, to some extent, unprecedented. What's equally significant is that many assumptions that economists once casually accepted and taught are now suspect or discredited. Let me give you three examples.
* We once thought we understood consumer spending, the economy's mainstay. For decades, disposable income and consumption spending advanced in lock step. Americans spent a bit more than 90 percent of their after-tax income and saved about 8 to 10 percent. In 1959 consumer outlays were 92 percent of disposable income. The figures for 1969, 1979 and 1989 were 92 percent, 91 percent and 93 percent. Being so steady, consumer spending provided stability during recessions -- in contrast to more sensitive investment spending for housing and business buildings and equipment. Since 1960 consumer spending has dropped in only two years; investment spending has dropped in 13.
But since 1990, consumer spending has changed. It has consistently outpaced income growth. In 2004 Americans spent 99 percent of their disposable income and saved only 1 percent. The main cause is the "wealth effect." In the 1990s higher stock prices caused Americans to spend more; now higher home values (up 55 percent since 2000, to $17.7 trillion) are doing the same. So consumer spending increasingly depends on "asset markets" -- stocks and homes -- and not just income. Query: Suppose the next recession depressed both stock and real estate prices. Would consumer spending fall and deepen the slump?
* We don't know how much the world economy affects the United States -- and vice versa. Economics textbooks once described the U.S. economy as mainly self-contained. Americans sold to each other; Americans' savings were invested mostly in American investments (stocks, bonds, bank deposits). Trade was small. Globalization has shattered this model. More industries face foreign competition or depend on foreign markets. In 1960 exports and imports together totaled 9.5 percent of gross domestic product; in 2004 they were 25 percent of GDP. Savings and investment have also gone global. In 2003 Americans -- mainly through pension funds, banks and other big investors -- owned $3.1 trillion of foreign stocks and bonds, while foreigners owned more than $4.1 trillion of U.S. securities, says the International Monetary Fund. (Note: The $4.1 trillion excluded China.) All this alters the U.S. economy. One theory of low American interest rates is that foreign money flows have pushed rates down. Another development: Stock and bond markets around the world may be more interconnected, because they increasingly have the same investors. Are investors better protected (because they're more diversified) or could a crash in one market cause a chain reaction? Globalization poses many unanswered questions like these.
* We can't determine "full employment.'' Economists call full employment the "natural rate of unemployment" -- the lowest rate consistent with stable inflation. Go lower and tight labor markets trigger a wage-price spiral. Unfortunately, we don't know what full employment is. The Congressional Budget Office now puts it at 5.2 percent. But past estimates have been too high and too low, because the "natural rate" -- despite the label -- isn't natural and constantly changes. It's influenced by population changes (younger workers have higher unemployment rates) and government policies, among other things. Our ignorance makes it hard to judge when to be satisfied.
Although I could extend this list, the message would remain: Change has outpaced comprehension. Should we be worried? Maybe. What confuses us may threaten us. But here's an intriguing irony: The less we understand the economy, the better it does. In the 1960s and 1970s, many economists had confidence. They thought they understood spending patterns, could estimate "full employment" and propose policies to prevent recessions. What we got was high inflation and four recessions (1969-70, 1973-75, 1980 and 1981-82). Since then we've had lower inflation, only two mild recessions (1990-91 and 2001) and faster productivity growth.
Economists' overconfidence -- and the resulting policies -- may have weakened the economy. But its improved performance could also have other explanations: lower inflation; the good judgment of two Fed chairmen -- Paul Volcker and Greenspan; the economy's self-regulating characteristics, and new technologies. It could be all of the above or just dumb luck. We don't know.