Now, A Slower Economy Could Mean Higher Inflation
April 25, 2000

Now, A Slower Economy Could Mean Higher Inflation

If several million investors understood the process of technological change the way economist Michael Cox does, we might have a calmer stock market.

That thought occurred to me as I listened to Mr. Cox, Chief Economist at the Dallas Federal Reserve Bank, in the middle of the week in which the technology dominated NASDAQ index plunged 25.3 percent.

His audience, however, wasn't millions of investors. It was a group at the Camino Real Hotel in El Paso including twenty-eight people representing the boards of the Dallas Federal Reserve Bank and its branches in El Paso, Houston, and San Antonio.

Not much later, the board members met behind closed doors to vote on whether or not interest rates should be raised, once again to slow an overheating economy.

Sorry, I didn't get behind those doors, so I can't give any tips on future interest rates.

Ironically, the two--- Mr. Cox's speech and interest rates--- are closely related.

In his view, we are in a period of rising productivity. It will allow our economy to grow quickly for an extended period of time without inflation. Others aren't so sure.

Here is the nutshell version of our new economy and its relationship to history:

•           We've Had Changes Like This Before. While it is popular to think                that we are in a unique period, we've actually had a period very                much like this before. The invention of electricity was rapidly                followed by a series of powerful spillover inventions--- internal                combustion engines, the telephone, radio, airplanes,                refrigerators, and air conditioning. Each made massive economic                changes possible and resulted in entire new industries. Each                brought enormous increases in productivity.

               Mr. Cox likens the invention of the microprocessor to the                invention of electricity--- it is a prime mover creation,                one whose spillovers are still occurring. While electricity                enabled us to augment human muscle power, the microprocessor is                enabling us to augment human brainpower.

•           The Microprocessor Is Creating Three Levels of Cost Reduction.                The first level is direct costs, as evidenced by the incredible                decline in the cost of computing and moving information over the                last 20 years. One of the many examples he gives is the use of                smart sensors and other tools to reduce the electric consumption                of refrigerators by two-thirds since 1972. The second level is                electronic commerce, using the Internet to create altogether new                economies of time and place by simple e-shopping or more                sophisticated mechanisms like's group buying. The                third level is the broadest--- a long term shift in the costs of                production in which cost curves always decline because there is                more fixed cost and less marginal cost. Examples of this are                products like drugs and software--- both have high costs for the                first unit but very low costs for each additional unit.

•           The New "Rules" Mean Our Economy Can Grow Faster. In an economy                dominated by extractive industries (farming, mining) and                manufacturing, periods of high growth in demand usually brought                price inflation because producers used their least efficient land                and machines last. This led to rising costs and prices as the                economy approached full capacity. In the new economy, faster                growth actually lowers inflation because it reduces average long                run costs. While Mr. Cox doesn't mention it, one of the first                companies to grasp this idea was Texas Instruments when, nearly                two decades ago, they started pricing in anticipation of lower                long run costs. Another early advocate of the same idea was the                Boston Consulting Group.

               One very major implication: making policy decisions about                interest rates by the old rules could work to worsen inflation,                not slow it.

What does it all mean for you and me? First, what we are all experiencing is far broader and more solid that it feels from market day to market day. Second, just as there was a high fatality rate among early automobile, aircraft, and radio companies, we will see a high fatality rate among Internet companies. That's just the way it is.

Note to readers:   This entire report is 25 pages of core reading. You can read it directly on the web by visiting the Dallas Fed website at or, still better, you can download the report as a pdf file and get all the graphs and illustrations.

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