Don't be Blinded by the Headlights The problem with the conventional wisdom is that it is blind to the most important thing about economic change: the headlights. These are the forces of innovation and invention that drive the economy and are the foundation of prosperity. Those forces do not grow on trees—they have to be created. Like the power plant, the roads, or the computer, they are inanimate objects with "inputs" (resources, labor, capital) and "outputs" (goods and services), which interact in complex ways to produce the goods and services of a growing economy. These inputs and outputs both represent real wealth that can be quantified, unlike the headlights, which can be valued only in subjective terms, one person's vision of "bright" versus another person's vision of "dim." Some think-tanks try to deal with this by using a standard of the "average American" when they discuss the state of the economy. While this may have been an appropriate way to gauge the physical and social health of a nation's economy in an era when it was hard to move and the world was small, it no longer applies. Even if there was a "gold standard" of prosperity for society as a whole, we would still see massive variation in the level of prosperity in different regions of the United States today. What looks good for some parts of the country may seem bad for others. That is not a bug, it's a feature—a key dynamic of a changing economy. In fact, the idea that there is a single standard of "economic health" or a single "level" that all parts of the country have to aim for can even be destructive. It creates a zero-sum game. If all parts of the country did well, then we would be in a race to the bottom, where the benefits of progress in one region would only be at the expense of other regions. If we want prosperity to be spread around, then a standard where everyone has to be poor to be "on target" is the wrong way to go. For that reason, it is always a mistake to evaluate a country's overall economy solely in terms of a national number. Rather, the idea is to see what's happening in the economy at each geographic area. If there are parts of the country that have been on a tear for several years now, then it may well be that other regions will be doing better soon, which could lead to some interesting dynamics over time as the country continues to evolve. If people in California are working, enjoying their homes, and getting paid overtime because more and more of them are working in the new and improved, high-tech, high-wage economy, then the state's economy is going to keep growing, as will California's population. This is important because it's not California that is growing—it's California that's growing California. Not many Californians live in Detroit, and those who do represent a fairly small fraction of the state's total. Thus, the population growth in Detroit is more of a problem for the rest of the United States than it is for California. So, it's not so bad if Detroit does poorly. But if that means that California's economy also does poorly, then it's a different story. Californians would have less of everything—more pollution, less manufacturing—and this will mean fewer jobs and less prosperity overall for the country. The more closely you examine an economy, the better it works, because you are dealing with not one, but many economies all jammed into one pot. The bigger the country, the more complicated the mix and more difficult it becomes to make generalizations about how things work on a national basis. What does this mean for the Fed? First, it means that economic prosperity is a messy, complex, many-pronged phenomenon. Many things need to be considered to truly understand its direction. These include: population and employment growth, the mix of industries in an economy, investment, and productivity. It's important to think about these trends because the Fed is likely to find itself more and more involved in trying to coordinate the ups and downs of these areas of the economy. What counts as prosperity and how we define prosperity may vary by region and could be changing for good reasons—in terms of productivity, technology, and innovation—or bad ones—because of the global recession. While we might think of the Fed as a single institution with a mandate to promote prosperity, the truth is that prosperity is a complex and dynamic thing that requires constant monitoring and analysis to see how it is evolving. * * * When it comes to dealing with economic headlights, it pays to keep an eye on both the front (investment) and the back (productivity) of the car. Each plays a role, and by itself, each is too important to ignore. It would be nice to know what the car is driving toward, but a whole lot better to know what it is driving at. THE DOWNTURN Despite the recession and financial crisis, it's not all doom and gloom for the US economy. Unemployment is dropping, consumers are spending more, and some industries are benefiting from trade. The economy is also growing and this represents a good start for President Obama. After the financial crisis, there was some talk that a recession was really on the way. What happened to a growth-focused economy, however, is that there was actually a drop in GDP during the first quarter of 2009, just as a financial crisis broke out. From a growth standpoint, we are all in the dark. This doesn't have to be the case, though. While the economy hasn't grown for nine months, employment has continued to grow. By and large, the US economy has been adding jobs. In the first quarter of 2013, employment rose at an annual rate of 217,000. Of the 1.85 million net new jobs created since the recession ended in 2009, two-thirds have been added in the private sector. That is pretty good going. There is a real sense of optimism at the moment, as if things are on the mend and a rebirth of growth is just around the corner. This view has its appeal, but it seems to be ignoring some pretty significant headlights that have been lit up over the past couple of years. The employment rate is still declining, the housing sector is in recovery, and the rate of inflation is trending up toward where it used to be. While this means that the economy is growing, the increase in growth could take a while to manifest, given the challenges facing the economy. Here's a story of what happened. When the economy takes a turn for the worse, like many things in the natural world, it's always important to figure out why things are going in one direction or another and then make sure that the change does not continue, or go backward, for a long time. This is because there are natural and structural forces that are difficult to overcome in the long run. If we are going to change our behavior, we should be able to see the change coming. While economists have been slow to understand this (it is hard for many people to foresee a recession), we should learn the lesson now that things are looking up, and we should figure out how to move forward to protect our economic prosperity. The Fed can help in this regard. The Economy Is Growing Again, But Slowly The main reason that we are seeing a change in the fortunes of the economy is that it's doing better than it did during the recession. This means the economy is "growing again." The growth is very low, though. It isn't clear how long the good news will last, because the economic picture remains pretty poor. Overall economic growth (as measured by GDP) has been growing since the start of 2009, but it is only growing at a rate of 1.3 percent. While this figure doesn't capture much in the way of dynamism or change, it is the rate that the economy has been growing for the last three years, or the annual growth rate. The main reason the economy is growing is because consumer spending is growing. From the end of 2009 to the end of 2012, consumer spending increased by 4.3 percent, which amounts to an annual rate of 2.6 percent. While there has been a drop since the start of 2013, which will likely be associated with the weather, consumer spending was still increasing at the end of 2012. It is not just housing or consumer spending driving this. The investment side of GDP is also moving along nicely. Business investment grew by 6.2 percent in 2012. Some of this is likely to be related to the fiscal cliff deal in early 2013, which was a big hit to the level of investment we see this year. However, business spending grew by 6.1 percent during the fourth quarter of 2012. While some of this was the result of large-scale investment (housing and commercial real estate), the majority of it was due to investment in nonresidential structures (data shows that this trend will likely continue). From a long-term economic perspective, this is a good thing. The challenge in the financial market is not that companies are not investing, it is that they are doing so less than they have historically. There are several reasons for this, but some of the main ones are the uncertainties that have come to the forefront in the wake of the financial crisis. The two main questions are whether there is going to be another financial crisis and whether there is going to be a slowdown in Europe that will depress trade with other countries. Both these issues are related to the headlights of the economy. The "slowdown in Europe"