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THE ECONOMY'S THERAPIST

One curiosity of this economic slowdown is that Federal Reserve chairman Alan Greenspan is trying to talk the country through it. The idea of Greenspan as a national therapist seems absurd, yet it's true. For 18 months he has engaged in the quiet exercise of confidence building. Even as the Fed has raised interest rates (in 1999 and 2000) to pre-empt inflation and cut them (this year) to prevent recession, he has consistently laced his speeches and congressional testimony with glowing appraisals of new technologies and the country's long-term prospects.

"With all our concerns about the next several quarters, there is still -- in my judgment -- ample evidence that we are experiencing only a pause in the investment in a broad set of innovations that has elevated the underlying growth rate in productivity," he said in May. Despite the convoluted syntax, the message was emphatic: keep the faith.

Productivity is the crux of the matter. From 1973 to 1994, nonfarm labor productivity (output per hour worked) rose at an average rate of 1.4 percent annually. From 1995 to 2000, the rate doubled to 2.8 percent. In 2000 the gain was an astounding 4.3 percent. These are huge improvements that get passed along in higher personal incomes (wages, salaries) or corporate profits. Consider how. With annual productivity gains of 1.5 percent, average incomes take 46 years to double. With 3 percent gains, the doubling occurs in 23 years.

As Greenspan knows, psychology matters -- and, to a large extent, today's attitudes about incomes and profits are the creatures of buoyant productivity. If people view the present economic slowdown as only temporary, they will stay optimistic. But suppose they decide that technology-driven productivity gains were flukes, mere artifacts of the economic boom. Then people would become more pessimistic. Stock prices (already down) might plunge further, because expectations of future profits would decline. Consumer spending might weaken. A slump could become self-fulfilling. Greenspan knows this, too.

There are essentially two ways to improve productivity. First, you can cut the cost of producing something by doing it quicker, cheaper or with less waste. Second, you can expand your market so your fixed costs -- product development, overhead -- are spread over a larger sales base. Computer and communications technologies arguably allowed companies to do both. With more information and quicker communications, companies reduce design cycles, control inventories more tightly and can sell to more customers.

Greenspan's message is that the process is real and ongoing. Ample opportunities remain for more improvements in productivity and profits. This implies that the present drop in computer and communications investment won't last.

All this sounds plausible -- but it might not be true. The best-known doubter is economist Robert Gordon of Northwestern University. Gordon has argued that computers and the Internet don't compare with many earlier new technologies (railroads, electricity, automobiles) in their impact on living standards. In addition, he contends that recent productivity growth has been skewed upward by the economic boom. This is possible.

During a boom, fixed costs are spread over more sales. Productivity benefits. Once the boom collapses, extra productivity gains vanish.

Ironically, computers and communications equipment may compound this effect. These sectors experienced huge productivity gains. Chips and networks got much faster. The improvements counted heavily in overall productivity statistics, because computers and software represented nearly 20 percent of economic growth from 1995 to 2000, says Commerce Department economist Barbara Fraumeni. (Now the computer slump reverses this effect. In the first quarter of 2001, productivity dropped at a 1.2 percent annual rate.)

Greenspan is right to try to put his spin -- an honest view reflecting his own analysis and experience -- on the present confusion.

Optimism deserves the benefit of the doubt, because if people act on their worst fears, the Fed's interest-rate cuts will have scant chance of averting a recession. But all therapies have limits. Although they can help us cope with exaggerated dangers, they cannot protect us from stubborn realities. If the boom left consumers and businesses over-extended, no amount of talk will prevent a painful reckoning.

Washington Post Writers Group

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