by Bob Woodward
The I/B/E/S writers were confident that productivity was increasing. “What are corporations doing with their enormous cash flows?” Richard Pucci, an I/B/E/S analyst, had asked in a commentary several months earlier. “Certainly not paying dividends!” Corporations were investing in modern technology. “These immense investments in modern technology are another piece of the 1996 earnings puzzle. . . . Its ability to effect productivity improvements is being sorely underestimated by most social and economic observers.”
Greenspan realized that his arguments amounted to little more than back-of-the-envelope calculations to the Ph.D.’s on the FOMC and the staff. Only vast models and years of statistics would convince them—a kind of care he appreciated, on the one hand. On the other hand, he was pretty certain he was right.
How to convince the others?
The Republican Senate, which was increasingly hostile to Clinton, was giving Rivlin a hard time, dragging out both her confirmation and Greenspan’s as well. He stayed on as chairman in the absence of a successor, but Rivlin dangled. Greenspan ran into her at a social event.
“I hope they do it quickly, because I may really need you at the next meeting,” he confided.
The pressure from other FOMC members to raise rates was mounting substantially. The old economic models that most economists held sacred included the NAIRU, the non-accelerating inflation rate of unemployment. If unemployment dipped below the NAIRU, which was then commonly thought to be around 6 percent, economic theory held that inflation would start up. But unemployment was in the 51/2 percent range. Why was there no burst of inflation?
The old belief held that with such a low unemployment rate, workers would have the upper hand and demand higher wages. Yet the data showed that wages weren’t rising that much. It was one of the central economic mysteries of the time.
Greenspan hypothesized at one point to colleagues within the Fed about the “traumatized worker”—someone who felt job insecurity in the changing economy and so was accepting smaller wage increases. He had talked with business leaders who said their workers were not agitating and were fearful that their skills might not be marketable if they were forced to change jobs.
Janet Yellen was sympathetic to Greenspan’s hypothesis, and she was deeply bothered that the Fed staff seemed too set in their ways to engage alternative views of how the economy was functioning. Each staff forecast before the FOMC meetings insisted that inflation was about to take off unless interest rates increased substantially. Greenspan appeared to be going it alone.
Yellen went to work. She knew that a single year of anomalous data didn’t necessarily mean anything. The same held for a two-year period. The deviations of 1994 and 1995, when unemployment had dropped and inflation remained essentially stable, were not enough. But now, halfway through 1996, the deviation was continuing and becoming what she termed “increasingly deviant.”
Yellen thought Greenspan spoke a language different from what was taught in graduate school. Outsiders and non-economists thought his Fedspeak was the language of economics, but the chairman’s language was highly idiosyncratic, often not fully grounded in the data. He was prone to take leaps. At the FOMC, Yellen noticed that the Ph.D.’s on the committee, or some members of the staff, would be nearly rolling their eyes as the chairman voiced his views about how the economy might be changing. Nobody challenged him or dared say anything, but it weakened his hold on the committee.
Yellen told Greenspan that she might be able to find a theoretical underpinning for his job insecurity thesis. For most of her career, she had worked on labor markets. She had developed a standard model that went back about a decade, based on the theory of wages and efficiency. Working with data, graphs and some 14 complex equations, she drafted a 13-page memo that she sent Greenspan on June 10, 1996. It concluded that since workers had been paid more in the earlier years of the 1990s, the higher pay had induced them to feel greater attachment to their jobs and to be more productive—both in terms of quitting less and in terms of working harder to keep the jobs they had.
“Following our recent discussion concerning labor market issues,” Yellen’s cover letter began, “I thought I would try to codify my own thinking about the theoretical links among job insecurity, the pressure of wages, prices and profit margins, and the natural rate of unemployment. The attached note outlines the theory that I consider relevant. It shows why an increase in job insecurity due to changing technology or other factors could induce a permanent decline in the natural rate of unemployment. . . .”
Greenspan thanked Yellen. The memo was an economically conventional way of saying what he wanted to say. He had it circulated to the FOMC.
• • •
On June 20, the Senate confirmed Greenspan to another four-year term as chairman by a vote of 91 to 7. Republicans tried to defeat Rivlin, but she was confirmed 57 to 41. Laurence Meyer was confirmed without dissent, 98 to 0.
During the FOMC’s two-day meeting July 2–3, the members drifted into a long discussion of what price stability actually meant. Was the current 3 percent annual inflation sufficient price stability? Yellen felt that 3 percent was probably acceptable but was surprised to see that many, perhaps most, members felt that 3 percent was not price stability. They wanted to bring inflation down, say, to 2 percent. She knew that meant the FOMC would tolerate more unemployment. The standard rule of thumb was that to drop inflation by 1 percent, they would have to go through two years of 1 percent higher unemployment. Since unemployment was roughly in the 51/2 percent range, the discussion suggested that the committee might permit unemployment to go up to roughly 61/2 percent to drive inflation down further.
Yellen’s husband, the economist George Akerlof, had just published a paper that argued that driving inflation too low might create higher permanent unemployment. The committee engaged in a lengthy but inconclusive discussion of the issue. Yellen was surprised that the committee almost never talked about its overall strategy or its ultimate goal for acceptable rates of inflation. How can you operate if you don’t know what your goal is?
Of course, the answer was that the flexibility and lack of clearly stated goals gave the FOMC, and Greenspan in particular, much more maneuvering room. It also demonstrated how inexact economics and interest rate policy were. Greenspan had come to believe that inflation numbers for the past were basically irrelevant. Their job was to deal with the future—with inflation expectations. They wanted stable prices in the next six months, not the past six months, so targeting an inflation number would be meaningless. He wanted inflation expectations to be benign, so consumers and businesses did not factor inflation into purchasing or investing decisions.
At the meeting, Greenspan was able to convince the FOMC not to raise rates. Only Gary Stern, the Minneapolis Fed bank president, dissented, because he thought a modest rate increase was called for. Even with only a single dissent, Greenspan could hear the hoofbeats. He was running into increasing resistance to the committee’s interest rate restraint. He couldn’t rely on his back-of-the-envelope calculations about prices and profits, even though he considered his computations about 95 percent accurate. He needed validation.
• • •
At the chairman’s weekly breakfasts with Rubin and his deputy Larry Summers, Greenspan had been floating his ideas about productivity growth.
“Yeah, but Alan,” Summers said once, “maybe there’s a constant error, and it should’ve been plus 1 percent for the last 40 years. How do you know it’s accelerated?”
Greenspan wasn’t sure, but he kept coming back, week after week, with more ideas. Summers tried them out on Treasury’s top economists, who thought the notions incoherent, if not idiotic. Greenspan’s theories simply did not fit into the rigorous, well-tested economic models and concepts that had been developed over decades.
• • •
During the coffee break of the FOMC’s next meeting, on Tuesday, August 20, Greenspan collared Larry Slifman, the associate director of the Fed’s Division o
f Research and Statistics. Slifman, a small-framed, intense Ph.D. economist of considerable caution, had been on staff going back to the Volcker era.
“Look at these numbers,” Greenspan said, pointing to a special monthly report of charts and tables that Slifman’s division had prepared for him. It was a crude attempt to refine the pricing and profit data by types of businesses. Greenspan pointed to data on prices, which were relatively stable, and then to profits, which were still going up, and then to productivity—the output per hour of a worker. The charts showed productivity going down.
“Does this make sense to you?” Greenspan asked him.
Slifman at first thought they might have made a mistake with the data. But Greenspan said once again and more pointedly that he thought there was something wrong with the incoming data from the Commerce and Labor Departments.
For years Greenspan had had Research and Statistics work on special studies that “disaggregated” data, broke it into finer pieces. Government statistics tended to come in overall total numbers that lumped together quite different segments of the economy—industrial and non-industrial production, for example—eradicating some important distinctions in the process. He had wanted them separated. He then had asked for more refinements, including a breakdown on the unit costs for the production of goods or supplying of services.
Greenspan wanted the numbers so he could get his hands around different kinds of businesses. There was not just one economy but many, and individual parts and types performed differently. How were the service businesses such as auto repair doing compared to retailers or manufacturers? National numbers with everything lumped together didn’t tell them enough.
In Slifman’s division, the economists sometimes called Greenspan’s requests the “embellishments and enhancements,” or they’d say that the chairman wanted more “slicing and dicing.” Greenspan had kept one research assistant busy much of that summer on special projects.
When Greenspan had come to the Fed nearly a decade earlier, Slifman had been dismissive of his research requests, certain they would be dry holes. But over the years, he had discovered that many yielded several barrels a day—and some occasionally produced a gusher of new, useful ways to look at information.
Greenspan had been questioning the official productivity numbers for almost three years. The numbers could not be right. The problem in part was that disputing them was almost like arguing with the reports of yesterday’s temperature range in the newspaper. Someone had assembled the data from all over the city. If your backyard thermometer registered something different, it was hardly convincing.
How to find the flaw? Where were the errors most likely to be?
Greenspan continued his own calculations. He wanted to start with some basic data that he knew were more accurate than the official government reports. First, the government provided another series of reports on the general price level of manufactured and other goods. These were very reliable because businesses knew what they were charging and customers knew what they were paying.
Second, the government reported domestic operating profit margins. Again, these were incredibly reliable because businesses had to know how much they were making. Various reporting requirements to stockholders and relatively rigid accounting practices also made these numbers accurate.
Next, it was a matter of basic economics. The price of producing something was algebraically equal to the unit labor costs plus the unit non-labor costs (depreciation, interest and taxes) plus unit profits.
It was generally accepted that about 70 percent of production costs were labor. The other costs—depreciation, interest and taxes—didn’t change much over the short run and could safely be assumed to be constant. Greenspan knew what average labor costs per hour were, within a reasonable range, from the reliable labor cost statistics. In the end, he had one of those tight, perfect formulas. The only variable was productivity, output per hour. With profits rising but prices staying the same, the laws of mathematics dictated that productivity had to be going up and unit labor costs had to be going down.
Put it more simply. Take some item with a market price of $10—say, roughly $6 in labor costs, $2 in other costs and $2 in profit. Suppose the price stays at $10 in a low-inflation environment, other costs remain at $2, and profits go up to $3. That would mean labor costs had to be lower, at about $5. Since wages had not gone down, the only way for this to be possible was for the output per hour to have gone up. Productivity had to be rising.
Greenspan wondered how he could prove it to the satisfaction of the economists.
“Do you have a few minutes?” Greenspan said on the phone to Larry Slifman right after Labor Day. The chairman suggested Slifman bring with him someone expert in national income.
Slifman and Carol Corrado, another Ph.D. in economics and the chief of the industrial output section, went to Greenspan’s office. He had the formula written out:
Price = labor costs + non-labor costs + profits
They agreed.
Greenspan sketched out a massive research project. He wanted them to take all of the aggregate data on productivity and break them into their component parts by business sector—the legal forms of business organization. Find some way to separate out the farms and corporations, the manufacturers and the financial firms, he told them. He suggested a way it could be done. They would have to make their own calculations and a few careful assumptions.
Corrado could see that the chairman almost saw the forensics as he laid out a detailed research agenda.
After about 45 minutes, Slifman and Corrado left, feeling they had been assigned the economist’s equivalent of a Manhattan Project.
The chairman was also developing a parallel track. He delved deeper into the ranks of the Research and Statistics Division. “I would like for someone to produce numbers for me on output per hour—productivity—by industry,” he requested. There were dozens of different industries—farming, mining, public utilities, finance, health service, education and even motion pictures. He wanted productivity calculations for each.
Slifman and Corrado merged the legal breakdown with the breakdown by industry. On Thursday, September 19, Corrado wrote a computer program that looked back to 1960, producing 155 categories.
When they looked at the results, the stunner was that the service businesses, from the gas stations to the sole proprietorships and partnerships—roughly one-third of the businesses in the country—showed a 1/2 percent decline in productivity over the last two decades.
Slifman’s wife was a lawyer in that service category. He knew it was totally impossible that productivity had declined in that profession over the 1980s and 1990s. Something was wrong with these numbers. But more important, those numbers were dragging down the overall productivity statistics for the corporations that were the other two-thirds of the businesses.
It was a double discovery of immense significance. The service productivity numbers, which were negative, had to be wrong. These wrong numbers were dragging down the aggregate productivity numbers for the economy as a whole. Therefore, productivity was higher across the board.
Greenspan was delighted. It was, at this preliminary point, a hypothesis that could readily dissolve. But it was a possible explanation. He had the economists up to his office before the next week’s FOMC meeting to express his appreciation.
• • •
In the weeks before the next FOMC meeting, the pressure to raise rates had ratcheted up another notch. A story had leaked to Reuters news service that 8 of the 12 Federal Reserve Banks had requested at least a 1/4 percent increase in the discount rate; 3 of these 8 wanted a 1/2 percent increase.
BusinessWeek magazine was reporting discord. “A Tug-of-War Inside the Fed,” read one of their stories that month. Another was headlined “Political Hardball Inside the Fed: Using the Press, Regional Banks May Force Greenspan’s Hand.”
As the FOMC gathered in their cavernous meeting room on Tuesday, September 24, tension was unusually high
.
Greenspan finally had some hard evidence. For three years almost to the day, he had been insisting that something was seriously wrong with their data. He quoted from the Slifman and Corrado study and dwelled on their double discovery. Using the tables they had compiled, he showed that disaggregating demonstrated that productivity in the service businesses had declined for years. This was just flat-out implausible.
Greenspan related this with the deepest conviction. Those numbers were dragging down the productivity growth numbers for the corporations and manufacturers, raising the obvious point that those numbers were too low for productivity growth. Productivity growth numbers were the hardest to capture—it had taken economists up until the late 1970s to determine that productivity growth had begun to decrease in the late 1960s. On top of this, Greenspan noted that the consumer price index was overstating inflation by approximately 1 percent, because the CPI didn’t accurately measure new products, rent and other consumer goods. Nonetheless, the core inflation rate as reported by the government was only 2.6 percent over the last 12 months—the smallest increase in three decades.
He put it bluntly. There was a real world out there, and they were not measuring it properly. The dominant feature of the outlook was uncertainty. Since higher inflation was not a foregone conclusion, it would be best to do nothing. Because several of the committee members wanted to raise rates now, Greenspan proposed that they maintain the directive that would give him the power to raise rates between meetings if any alarming new data arrived. The prudent course would be to hold steady, no increase.
Bill McDonough, the 62-year-old New York Fed president and FOMC vice chairman, was ready to speak next. In the time since he had succeeded Gerry Corrigan three years earlier, he had forged a close relationship with Greenspan. He realized that being the Fed’s man in the New York financial markets was one of the best jobs imaginable with that relationship. He suspected the job would be a goddamn nightmare without it.