Tuesday, November 7, 2006

The Two Banana Economy: Economic Growth, Inflation and Productivity




At every Fed meeting, whether Bernanke raises interest rate or not depends on whether he thinks there is Inflation. Understanding Bernanke means understanding clearly the concepts of Inflation, Economic Growth and Productivity. And so What’s Hot for this week features a short lesson on Inflation, Economic Growth and Productivity.
Inflation happens in an Economy when Price growth outstrips Output growth, resulting in spiraling prices [including spiraling wages, the price of Labor], and loss of incentive to work and save as costs living became unmanageable. Extreme cases of inflation [such as sometimes happens in third world countries like Zimbabwe or Indonesia] will mean you have to carry a wheelbarrow full of notes to Wal-Mart. And you would not want to keep money in the bank or under the bed when you know $1 will be worth less than $1 tomorrow. One way Inflation can happen is when the rate of Productivity growth is less than the rate of Economic Growth. Simplified Example: There is a Country that has $2 of Money in circulation. The whole Economic output is 2 Bananas per year consumed locally with no Exports. Velocity of circulation of the $2.00 is assumed to be constant. Assume zero profit margin so Price = Cost. Thus the price/cost of a Banana is 2 Bananas divided by $2 = $1.00. If Demand for Banana increases, but Economy can still produce only 2 Bananas. Price of Banana will rise. To >$2.00. That's Inflation!
Many things can happen to increase the total output of Bananas. More workers join the labor force, more land is used, more capital is injected. But these last three will not increase Productivity-which is the total amount of Input that is required to produce one Output of Banana. Putting 5 men to produce 2 Bananas when previously there were 3 is a loss in productivity. Using 5 acres to produce 2 Bananas instead of 3 acres is also a loss in productivity. Some of the things that will increase Productivity and require less Input for one Output are for example:
1.Use of fertilizers to increase output such that maybe the Banana tree can now have 4 Bananas instead of 2.
2.Use of machines so that less Labor is required or the same can be done in less time
3.More skilled workers who perhaps can harvest the Banana in a shorter time
4. Packaging the Bananas in a nice box, calling them Natural Potassium Boosters, and selling them for a higher price. [the Bananas can now be sold for $3.00, Price does not equal Cost now, productivity increases]
Although the Two Banana economy is an oversimplification, the general principles are still valid when we apply it to the U.S. Economy. The question of what is an acceptable rate of Inflation rests on what is the rate at which the U.S. Economy can grow without being subject to Inflation. And that depends a lot on it’s Productivity. When we see media reports about China’s economy growing at 10 % a year or so for the last decade, we know that it would be an impossible rate of growth for the U.S. The reason lesser-developed countries can grow at such break-neck speed without hyperinflation is because, starting from a low, inefficient base they have a lot of unused resources, spare capacity and productivity growth to catch up on. And being second-in-line they can benefit from the advances in technology that were the results of R & D in the developed countries, without having to reinvent the wheel. Every country has what The Economist magazine calls the Speed Limit of Growth. This Speed Limit depends on both the amount of spare capacity in the Economy, as well as it’s Productivity. Spare capacity can allow an Economy to increase it’s Speed Limit. For example, more retired baby boomers or bored house-wives coming out to work will increase the total output of an Economy without causing inflation.
In the U.S., the last great surge of Productivity was brought about by the advent of the Internet, high-powered computers and software. If you ever wondered what it would be like without email, e-commerce, bank ATMS, online share trading, and all the thousands of things that the IT revolution has allowed businesses to do in less time, with less manpower and at less cost, then you would have grasped the enormity of the impact it had on increasing Productivity.
Historically, great surges in Productivity like those following the building of the Railroads, or the extensive use of Machinery in Agriculture allowed the U.S. to increase it’ Speed Limit of Growth. In the early 80’s the Speed Limit of U.S. growth was 2-3 %. After which worries of inflation would surface. For the last 5 years, economists and Alan Greenspan knew that this speed limit could be increased to 4-5 % because of increases in Productivity brought about by Information Technology as well as the stiff cost-cutting measures imposed by Companies after the irrational exuberances of the early 2000's.
But academics and pundits believe that we have just about used up all the productivity growth we can expect, and for the near future, any growth above 3 % and we may see signs of inflation. There is no vast reservoir of untapped labor as in China. Immigration is at a stand-still because of political concerns. U.S. factories are stretched, competing demand from China and India push up raw material prices; so economist expect the sustainable rate of growth for the U.S. Economy to fall back to 2.5 %. In that case, Bernanke may have to increase interest rates sooner than Alan Greenspan did.

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