The Revolution Has Just Begun.

The International Economy sat down with Dallas Fed President Bob McTeer, an early and outspoken apostle of the New Paradigm. He talks about the economic outlook, his critics, and possible troubles ahead for the New Economy.

TIE: You were among a group of central bankers who suggested there was a new dynamic at work in the economy. What are your views of the great productivity New Paradigm debate?

McTEER: I'm not sure there were any great revelations. I was making speeches using the term "new paradigm," and talking about technology and the "third wave" and all that, in '97. I know I gave a couple of graduation speeches in '98 entitled, "Graduating Into the New Paradigm Economy" So, I was impressed with that, but I wasn't necessarily thinking too much about monetary policy implications at that point. You have a meeting and you look around and you say, "Should you tighten or should you not tighten, or should you ease?" It was usually fairly clear that there's not much mason to tighten, but as unemployment kept getting lower and growth kept getting faster, they started reaching the limits of the old NAIRU [non-accelerating inflation rate of unemployment] and the old "speed limit." Everyone realized we were reaching levels here that normally are associated with inflation. I didn't have any alternative theory; I just looked around and didn't see any inflation.

Now, we tightened preemptively in '94. So what was different about '94? Well, before then, we had short-term rates down to 3 percent for a year and a half, with inflation at 3 percent, which meant the short-term rates were zero in real terms. And all during '94, commodity prices were going straight up, so you could see the inflation coming. Neither one of those things was true in '97, '98, and '99. By the time I dissented [when the Fed decided to tighten] in June 1999, we'd had about three years of commodity price deflation, and real short-term rates were about what they normally are, around 3 percent in real terms. So I didn't see the same need to be preemptive. One might argue that's because I wasn't a very good economist. But I was influenced by Richard Pryor's famous line, "Who are you going to believe, me or your own lying eyes?" And Yogi Berra, who said, "You can observe a lot just by watching." So, it became a choice between looking at the models of the economy and looking at the actual economy. We were piling up these 4 percent growth rates with no build-up of inflation, and economists were almost literally saying, "Well, it may be working in practice, but can it work in theory?"

TIE: How did you feel about critics, such as economist Paul Krugman, who sneered at the notion that the NAIRU was no longer valid? Does their scorn get to you?

McTEER: I spoke about the new paradigm economy in London a little over a year ago, and the guy on the panel with me virtually accused the United States of fudging the numbers, they were so good. Then he said something like, "Well, you put all your potentially unemployed people in prison, and you keep them out of the numbers." -- I joked, "We go farther than that in Texas."

There are only a few people who doubt anymore, and I joke that they're from elite universities that don't have good football teams. Yet, there's an element of truth to that. There's an element of elitism there. The established elite always has the most invested in the old paradigm. When the Republicans won the House in the '94 election, and started naming people to chairmanships, the Wall Street Journal had an article on what schools they were coming from, compared to the ones that the Clinton administration got their people from. Clinton was getting his from M.I.T. and Harvard, and here's [House Speaker] Newt Gingrich from Emory University and [Majority Leader] Dick Armey from Oklahoma State. I went to the University of Georgia and so did [Senator] Phil Gramm. So, I think there's some elitism. Plus, when someone says, "Things are different this time," that always sounds like unsophisticated famous last words. Sophistication is nothing new, and their sophistication was so strong that they found themselves saying that nothing's changed. They got it wrong.

TIE: What do you think the speed limit of the economy is?

McTEER: It's at least 4 percent, probably higher. We thought for twenty years that the annual increase in productivity was 1.1 percent a year. Then we revised those numbers last October, and they're calling it 1.4 [percent] now. But it's at least 3 percent, I think, because it's been there a couple of years. Add another 1 percent for labor force growth, and you get 4 percent. For the last four quarters, we've had over 5 percent productivity growth driving 6.1 percent GDP growth. That's probably not sustainable, but productivity is still accelerating -- it's showing no signs of slowing down.

TIE: How far are we through this period of surging productivity -- halfway, 20 percent?

McTEER: I think in terms of productivity based on new technology, we're very early in the game. I don't see why that's going to slow down. As for the stock market implications, I haven't a clue. But there's just too much going on. A term I use is that we have "invention-on-demand" now. People used to work in their garages and nobody knew they were doing it, and every now and then, one of them would produce something and it would be a big deal. Nowadays, if you think about it, we know what we're looking for. We've done all this; now, let's go back and do it wireless. We assign it to people. It's just a constant flow of innovations and new technology. So, technology is going to be huge. But which firms are going to be winners, and which are losers? I don't know how you do that.

TIE: Technology makes businesses and consumers more price-savvy. A competitor knows instantly if you change prices and can match or undercut you. Consumers use the Internet to find the best price. In that sense, is technology an anti-inflationary force?

McTEER: The New Economy is wonderful for consumers. Consumers get to participate in it -- businesses have to. And it's not all that wonderful for businesses because it moves them more toward the perfect competition model in the textbooks, and they don't have any real slope in their demand curve. They don't have much monopoly power, and any economic profits that they start making will be gobbled up by the hyenas real fast. So, they don't have any choice but to become part of it. To succeed, they're going to have to keep innovating and innovating so they can keep getting the newest thing, because after a while, somebody in the world is going to move in and do their old thing for less money. And the consumers are going to be the huge beneficiary of that.

The distinction you see, on CNBC and these financial shows, between new economy firms and old economy firms, is a false distinction. Old economy firms are adopting new technology, too, and they're doing things in new ways. They may not be doing all new things, but they've got a churn going on within them. The greatest productivity gains are coming in manufacturing.

TIE: There's a lot of B2B going on in the automobile industry.

McTEER: B2B promises to be much more significant than B2C. I've got a term I've been trying to get adopted on B2C: "whole-tail." You used to have "wholesale," and then "retail." Now you're taking out the middleman and it's becoming "whole-tail."

TIE: Do you see higher off prices as an inflationary force or a contractionary force on the economy?

McTEER: People got used to thinking of oil price hikes coming from cutbacks on the supply side. That's what we learned in the 70's. I was slow to notice, but this one is coming more from the demand side. Output of oil and gas are growing. It's just that once Asia started recovering, worldwide demand started growing more rapidly. They're producing more and the prices are still going up. So what are the implications of that? If oil prices are being pulled up, it's going to be less disruptive to the economy than if the economy is weak and they're being pushed up by reduced supply. The bad thing, though, is that it's not likely to be as temporary as it would be if it were just a cartel. If the cartel were trying to raise prices for fear of a weak demand, they'd start cheap and break down. But if they're doing it during strong demand, it may last awhile.

TIE: Former Federal Reserve Governor Larry Lindsey says that the New Economy is a real energy consumer. He says 8 percent of all U.S. energy consumption is due to Internet usage. Could it be that the New Economy is an energy hog?

McTEER: I'm kind of surprised to hear that the Internet is energy consuming. I understand he's correct; I'd just never thought of it. If prices are rising because demand is growing, it's not going to curb demand very much. If prices are rising because supply is shrinking, that's worse. Right now, refineries are producing at their capacity limits, but if product demand remains strong, capacity will expand and will sow the seeds of its own correction.

TIE: If your prediction that the U.S. economy can grow 4 or 5 percent is correct, what does this say about the value of the dollar, which is growing so much faster than money in Europe and Japan?

McTEER: Well the way we studied our economics, it would have negative implications because it would stimulate our imports more than our exports. But it almost seems now that our trade deficit is financing our capital inflow rather than the other way around. We've got this strengthening dollar while we're recording these record current account deficits. So obviously, even though we have double-entry bookkeeping and the balance of payments is always in balance, the way it's working seems to be that there's more pressure coming from the inflow of capital than there is from the deficit in trade. Capital is driving trade and the United States is still the best place for the world's capital.

TIE: Are you worried that a change in domestic conditions might cause investors -- foreign or otherwise -- to lose confidence?

McTEER: I don't worry too much about the current trade or current account deficit. But every year that we have a large deficit like that does put more dollar claims in foreign hands, and it does make their confidence in the continued strength of the dollar very important. So, if something were to come along and disturb that confidence, it could cause a lot of pressure on the dollar in pretty short order. [A Washington policy analyst] gave a talk at the bank several months ago, and his prediction was that sometime this year, financial flows were going to reverse, and they would go from the United States to Europe, and the United States to Japan. Not because things were so wonderful there, but because things are so bad there -- there's so much room for improvement. Once Europe gets its act together on the supply-side and loosens up its labor markets, it might become a very attractive place to invest. That may happen, but I don't think it will happen suddenly.

TIE: After the collapse of the Berlin Wall, global markets assumed that the American model of capitalism was going to take over the world. It happened in Europe; it happened in Asia. But then you had the Asian crisis and Russian default in 1997-98. Suddenly, global markets were saying, "Well, maybe the world isn't moving toward the American model." Europe will never quite restructure, Japan will never quite get its act together. There are reports that the Korean banks are in worse shape than before the Asian crisis. The markets are very uncertain now. Where is this all going?

McTEER: Well, it seems to me that the Asian crisis was like draining a pond: You didn't know what was under there until the water level went down, and you saw a lot of bad things under there. They put a label of "crony capitalism" on it: state-directed capitalism -- the capitalism of a lot of planning, and it was a Japanese model that apparently was being copied by the other Asian countries. So, the Asian crisis showed the flaws of that. In Europe, their unemployment rate was high because all the things they've done to protect their workers have worked against their workers. Somebody called it "nanny-state" capitalism. It seems to me that both Europe and Asia have seen that our version of capitalism is better, and they are trying to move more toward ours. Of course, the ultimate would be "Cowboy Capitalism."

TIE: The rising markets reflected perceptions that Europe and Asia will become more like us. But they haven't. Is that why the global markets have gone sideways?

McTEER: My sense is that you're worded too much about the stock market implications of it. Maybe the stock market just got way ahead of itself, and all we're doing is letting the economy catch up to it.

TIE: We thought Fed Chairman Alan Greenspan was the one worried about the stock market implications on the real economy, such as how the "wealth effect" drives consumption.

McTEER: I think the Chairman was misunderstood on that point. He wasn't saying we need to curb stock prices to curb the wealth effect. He was just citing stock prices -- along with rising home equity -- as the main source of the wealth effect. I guess the stock market took care of the wealth effect on its own.

TIE: Is there still a debate at the Fed between the New Paradigm crowd and the defenders of NAIRU and the Phillips Curve who still say, "My God, the economy's grown over 5 percent! Inflation's breaking out!" Is this a fight that has to be argued out at every meeting?

McTEER: No, it's not discussed like that. My theory is that it's the model-builders -- and this sounds like sour grapes because I got into economics before I had a math background, so I never did learn the mathematical part of it -- but those who started building models got little relationships in there. You've got people like Governor [Larry] Meyers, who sounds like he's defending the Phillips Curve and worrying that unemployment might get too low. But it may just be that he has found the Phillips Curve relationship to be useful in his forecasting model, which has served him well over the years. As for unemployment being "too low," he probably means too low to be sustainable. The rhetoric just gets tricky.

TIE: One of the traditionalists was Mike Prell, who recently retired as the Fed's chief economic forecaster. He predicted the next move by the Fed will be a hike in rates.

McTEER: I made a speech recently where I made a joke -- but I really had Mike in mind. I said, "Do you want to know my forecasting methodology? What I've been doing lately is taking the model's results and subtracting a half a point from the inflation number and adding it to real growth." That's not as farfetched as it sounds.

TIE: Some historians compare this period to the start of the Nineteenth Century, when you had tremendous technological changes and a long period of prosperity. Of course, things ended very badly: You had couple of world wars, the Great Depression. Do you see parallels?

McTEER: There's a public television program about everything happening around the year 1900, and the huge changes in technology within a few years of 1900. We may be in another such period. But I don't think there's anything inherent in prosperity that makes it turn on you. I think it's random events. I don't know what causes a Hitler to come along. Maybe the [World War I] reparations were the mistake that was fatal there.

TIE: Despite the prosperous times, there are still problems. There is a growing wealth gap, and the personal savings rate has been in negative territory.

McTEER: I think the economy is obviously lifting some a lot, and others not much. That's mainly a problem for the education system. But I don't see that as something that's going to bring an end to the rising tide. On the personal savings rate, it would be nice if it were higher. A lot of things would be better. But it's fairly easy to understand if everybody's got a 401(k) that's going through the roof for several years, they feel kind of flush and don't mind spending all their income. It [personal savings rate] went down to around zero about the same time as the federal budget went from a negative [deficit] to a surplus. So, it was an offset. National savings didn't go down, although some people worry about the vulnerability of the dollar with the continuing current account deficit. The things that worry me more than that are oil and gas prices.

TIE: A lot of people say it's a short-term problem. You don't agree?

McTEER: Unfortunately, I've been quoted several times lately as saying that we'll be over that hump soon. I don't know if that's true or not. The futures market has prices moving down. One of our energy economists told me the other day that he thought that we'd all gotten into this paradigm in the 70's, of thinking of rising oil prices as always a supply phenomenon engineered by OPEC, and we've just lazily not changed our thinking this time. And, it's suddenly dawning on him and others that hey, oil output has been growing, and it's demand that has been pulling up the price. It may make OPEC happy, but they didn't really do it.

TIE: They still have some capacity, don't they?

McTEER: A little bit, not a lot.

TIE: It also may be true that there's a lot of capped technology from the 70's out there. If some of that price keeps going up, it might pop back in there.

McTEER: The technology in the oil business is doing wonderful things. For every hole you dig, you hit a lot more oil now than you used to. You don't have to dig as many dry holes--3-D seismic technology; I think it's called. They can aim better, and so they can be profitable at lower prices. Actually, the increase in natural gas prices is more than in oil prices. It's much more significant, and one problem with it is there are an awful lot of environmentalists who prevent substituting oil for gas and coal for gas. People are sort of locked into gas, and when its price goes up, they can't substitute anything for it. About 80 percent of our rigs right now are drilling for gas rather than oil.

TIE: Are there a shortage of refineries and pipelines because the federal government won't give permits?

McTEER: I think there are some, and there are places where they won't let us drill where we could probably find some oil.

TIE: Any thoughts on the structure of the Fed? McTEER: As for structure, if it ain't broke, don't fix it. TIE: What are your impressions of Greenspan?

McTEER: When we have our go-around, he always is the most creative and original person at the table. I just look forward to what he's going to focus on because it will be something that most people haven't thought of yet.

Robert D. McTeer, Jr. is President and CEO of the Federal Reserve Bank of Dallas.