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More on the Fed and Long-Term Growth

Posted by: Michael Mandel on October 28

First, let me say that I just reviewed Ben Friedman’s new book, The Moral Consequences of Economic Growth. People should take a look.

Now onto Bernanke and what the Fed can do about growth:

In a comment to my previous post, pgl of Angry Bear writes:

Dr. Lingle is saying what Mark Thoma is saying - that the Federal Reserve can only influence real GDP in the short-run but cannot change either long-run output or output on average. In fact, most economists - Keynesian or classical - believe as such.
Right. Conventional macroeconomic theories have no role for macroeconomic policy affecting the underlying rate of technological change. In fact, the rate of technological change…which is what determines long term growth of per capita GDP…is completely outside the conventional model.

However, there are plenty of theories of so-called “endogenous” growth in which macro policy, or the capabilities of the financial system, can affect the rate of technological change.

Here’s one. Suppose that companies set their level of R&D spending as a percentage of sales (which in fact seems to be a typical rule of thumb). Also suppose that R&D spending permanently improves productivity.

It might make sense, then, to run the economy as hot as long as you can stand it, boosting sales and R&D spending, and getting productivity as high as you can. Then absorb a short nasty downturn to get the excesses out of the system, and then do it again.

Over the long run, that kind of stop and start behavior will give you faster growth than a smooth path—and it is something that the Fed can affect. That is, a central bank which tries to smooth out growth may end up discouraging welfare-enhancing R&D investments.

Three important notes here:

1.You know those old commercials, “I’m not a doctor but I play one on TV.” In my case, I am an economist by training (PhD, Harvard, same entering class as Glenn Hubbard). But I don’t do regressions and I don’t write down equations and mathematical models. These days, I work with words and concepts that anyone can understand.

2.However, plenty of professional economists have written down models where booms and busts can be welfare-improving. For example, see the paper, “Speculative Growth: Hints from the US Economy” by Ricardo Caballero, Emmanuel Farhi and Mohamad L. Hammour

3.I’m frankly tired of economists quoting conventional macro models at me, when it’s clear that all the action in recent years has been on the technology side. Get with the 21st century, guys.

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Reader Comments


October 28, 2005 01:49 PM

It would seem such a theory would be dependent on the period such R&D can deliver results. If it were longer than the cycle, it might end up wasted. It does seem reasonable, though, that without the necessity for improvement of running the economy hot, such innovation may not be undertaken. There is still the question of whether this would be more, or less effective and efficient than direct funding. One could maket the case we are already stretched in the area of energy and any more would be of limited value at this point.

Mike Mandel

October 28, 2005 03:33 PM

You raise the right issues, and I can't claim that I have all the answers. But for heaven's sake, it's better to talk about what macro policies will foster innovation and risk-taking, rather than just obsessing about savings.


October 29, 2005 03:52 AM

A few thoughts on R&D:

When was the last time something important was invented? 1945? 1960?

I think a lot of the recent productivity gains from technology aren't really gains. They are just means for company's to pass costs on to consumers and society as a whole.

Look at IVRs. Sure, you can lay off some people because you installed an automated phone system, but your customers have to punch their way through endless options just to get to a real person.

My garbage company recently replaced their two-man trucks with enormous new garabge trucks that have just one operator. It has cracked the asphalt on our street(and some water pipes beneath it), knocked down countless power lines, phone lines, cable TV lines, etc. And worse, the automated can grabber spews trash everywhere.

My local grocery store has installed some self-checkout lanes and laid off half their human checkers. The store may be saving money, but I drive a few miles down the road now to do my shopping, and I get home sooner.

I think we will soon see a resurgence in human-supplied service.

David Foster

October 29, 2005 01:27 PM

I have a sense that a lot of the crucial innovations over the next 10 years are going to be more real-asset intensive than those of the last 10...for example, there was recently a story somewhere about a guy who has built an advanced plastics recycling plant. Our current capital-allocation system is pretty good at funding ventures in fields like software that don't involve a lot of investment in hard assets, and also at funding asset expansion for existing large companies..but I don't think it's as good at funding new businesses that are asset-intensive.

Mike Mandel

October 29, 2005 10:15 PM


Boy, are you asking the right questions. Our financial system was great for funding the rapid development of software, which is human capital intensive and not physically intensive. It seems to be sputtering a bit in the biotech field, and it's been pretty much a flop so far in energy, which as you say is capital-intensive.

What kind of capital structure would be needed to fund a massive energy startup? Or do we just need a way to funnel the money from private equity funds?

David Foster

October 30, 2005 12:21 PM


I think the closest we have is now is the "business development" companies like ALD,ACAS,and AINV (disclosure: I'm an investor in all of these) which do a lot of debt and equity investment in hard-asset companies. But I don't think they're well-suited to very large projects like, say, investing $5B to build a large-scale solar plant) And I don't think an IPO would be very likely to fly, given that profitabiity probably wouldn't be achievable (or even within view) prior to large-scale operations.

Which leads me to think that such projects will probably be funded by very large existing companies with an entrepreneurial spirit (I'm thinking specifically GE)

Mike Reardon

October 31, 2005 04:38 PM

Massive unlimited innovative expansion is possible, but it cannibalizes past recent
innovative expansion. That is why they turned off the unending internet expansion in 2001, it was so deflating to passed innovative investment, that every new project will always eat the lunch of past innovation and investment. You can't make money off old investments, new ones will replace your effort and investment. It works but it can't be done and return any sustainable profit.

There is danger in hot over heated economies, but even more dangerous are over heated expanding innovative economies. The reason for the Fed's turning off the 2001 internet expansion, was only my take on that time.

But still look for more investment in technology that deflate hard assets values. It is the finance of deflating innovative systems, that keep the economy still expanding. Only the finance is really expanding the economy.


November 1, 2005 05:47 AM

Clearly, long boom periods followed by short bust periods can generate higher average growth. But you still have to explain who is paying for these policy induced booms. The excessive money growth necessary to fuel your low interest environment, is a tax on wealth. Why is this tax more efficient (i.e. less disturbing for the economy) than, say, an income tax that is used to finance R&D subsidies?
My Ph. D. is not from Harvard, but I suppose that in Boston they do not serve free lunches, either. So who is paying for this meal?

Thank you for your interest. This blog is no longer active.



Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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