WHATEVER HAPPENED TO THE BUSINESS CYCLE?

Is this remarkable state of affairs due to the policies of a Democratic president, or those of the Republican Congress? To the non-partisan Federal Reserve Board, or the private sector? Or to some combination of these institutions? The answer is far from trivial, because it goes to the heart of capitalism itself and why it is working so well.

Giving credit where he is certain credit is due, Bill Clinton assigns full responsibility for our prosperity to — -Bill Clinton. He says his pursuit of freer trade, his tax and budgetary policies, and his (actually, our) ” investment” in education have produced the permanent plateau of prosperity from which America now looks down on the troubles of France (unemployment 12. 5 percent and rising), Germany (unemployment 11.4 percent and rising), and Japan (a financial system on the brink of collapse).

Never mind that the burst of growth in the most recent quarter — an annual rate of 5.9 percent — merely took the growth rate above the 5 percent mark for the first time since the last quarter of the Reagan presidency. Nor that it was the rejection of Clinton’s economic stimulus package by the Republicans in Congress that has kept the economy from overheating. Nor that Republican rejection of his proposed massive tax increases prevented the economy from tipping in the other direction, into recession. Nor that the Republicans’ successful scuttling of his wife’s plan for a government takeover and bureaucratization of the health-care industry was followed by an end to double-digit inflation in health-care costs. Nor that the educational system that has received so much presidential attention is a shambles, with the only good news coming from the school-choice experiments that the president and the teachers’ unions so vehemently oppose.

Certainly, the president has reason to brag. In a deviation from form, he has shown constancy in pursuit of freer trade. This has opened overseas markets to American goods and services, driving exports (which now constitute over 11 percent of GDP, up from less than 8 percent 20 years ago) to record levels. It has also made everything from competitively priced T-shirts to well-built cars available to American consumers — a double boon, since the well-priced imports keep pressure on American manufacturers to seek higher profits from increased efficiency rather than higher prices. Lucky for the president, and for American manufacturers and consumers, that there have been enough Republicans in Congress to overcome the opposition of most of the president’s Democratic colleagues to such prosperity-producing measures as the North Atlantic Free Trade Agreement.

The Republicans are by no means immune to the temptation to emphasize their contribution to our well-being. No surprise there. After all, both parties have always claimed that they, and not the other guys, are the fount of economic wisdom and have the political courage to take hard decisions — such as the one to balance the budget by cutting federal programs after they have left office!

This quest for star billing for what are, if truth be known, minor actors in the economic play that is now unfolding cannot succeed in the end. The true co-stars, the ones responsible for the long-running hit show we are all enjoying, are not the politicians but the private sector and the economist in the chairman’s seat at the Fed.

The private sector made its contribution in spite of the opposition of the political establishment. When the financier Mike Milken burst upon the scene in the late 1970s, America’s corporations were overmanned and undermanaged. Corpocrats, beyond the reach of their widely scattered and therefore largely impotent shareholders, concentrated on acquiring corporate jets and other perks, rather than cutting costs and improving their products and services. Some corporate managers, of course, concentrated on increasing shareholder value by keeping costs down and profits up. But many did not, leaving their companies vulnerable to foreign competition and depriving consumers of access to the best technology had to offer.

Along came Milken. He noticed that over 95 percent of American companies with assets in excess of $ 25 million could not receive an investment-grade rating if they went to the bond market. Milken corrected this situation by developing high-yield bonds, derided by the establishment as “junk.” This liberated thousands of firms from reliance on their commercial banks for credit, and gave cash-short but idea-rich entrepreneurs the money they needed to mount hostile bids for inefficient companies. The money they would save from more efficient operation would pay the interest on the debt, and eventually permit the company to move to more conventional financing.

For the first time, the nation’s corporate managers felt a twinge of the job insecurity usually reserved for workers on the line — coal miners, auto workers, and the like. As with all entrenched institutions, the business establishment’s first reaction was to turn to the government for help. And it got it. The Milken-led restructuring of American industry was opposed by Democratic congressman John Dingell, who mounted accusatory hearings; by headline-hunting Republican prosecutor Rudolph Giuliani, who persisted in publicly arresting people he later (much later) failed to indict; by state legislatures, which responded to corporate whining for relief from the predators’ pressure by passing anti-takeover laws.

The fact that these corporate raiders had names like Steinberg, Perelman, Jacobs, and Belzberg only heightened the establishment’s indignation at this upset to their clubby lives. As Connie Bruck pointed out in her Predators’ Ball, one deposed corpocrat called Milken a “pawnbroker”; others saw these takeover battles as “a class war between the corporate America and the Wall Street elite, and the . . . arrivistes” who had trampled on “two pillars of the establishment — the commercial banks and America’s corporations.”

The intensity of feelings is worth noting because it proves that the Milken- led assault was no minor matter. The safe, soft way of life of America’s corporations was threatened, and the managers of these companies knew it. Once a thrusting, hungry group of entrepreneurs was given access to the capital markets, the American economy changed as much as Britain’s when it was given access to Margaret Thatcher.

Economics trumped politics. The establishment failed to repel the raiders, and the nation’s corporations finally responded by cutting costs and becoming more competitive. The establishment may have succeeded in punishing Milken for the harm he did it, but the discomfort he caused nevertheless had its desired effect. Companies began to pay attention to efficiency, a new concern that helped produce the lean and mean corporate machines that can now compete with any in the world.

Again, no thanks to the politicians, who resisted downsizing with all of the (fortunately, limited) means at their disposal. Then-secretary of labor Robert Reich attacked layoffs from the left, contending that companies were dumping workers to increase profits and share prices, thereby breaking what he calls “the implicit social compact that once existed between companies and their employees.” Pat Buchanan attacked them from the right, Bob Dole attacked them from a place on the political spectrum that remains difficult to locate, and the president drew on his infinite supply of compassion to ask managers to consider their workers’ needs, as if slowing the productivity improvement that is the flip side of downsizing could somehow lead to a better life for Americans.

The private sector must share the stage with Alan Greenspan. To understand the magnitude of the Fed chairman’s contribution, one has to recognize the limits of the tools with which he has to work. On the analytical level, Greenspan has had to face the grim fact that economic theory has little to say about cause-and-effect relationships in our complicated $ 7.6 trillion economy. At one time he might have looked to John Maynard Keynes’s General Theory of Employment, Interest and Money for guidance, but Keynes’s notion that fine-tuning the economy through government spending and manipulating consumer demand can pull us out of a recession is no longer well regarded in informed circles, to put it mildly. After the Keynesians were routed by Milton Friedman and the monetarists, it seemed as if the Fed’s job had become simple: Control the money supply and you control the price level. Alas, when the more pragmatic members of the economics profession pointed out that the monetarists could not even define “money” (does it include only cash, or cash plus bank accounts, and if the latter, savings accounts as well as checking accounts?), much less control its supply, Fed chairmen were left to rely on their wits and their “feel,” informed by a reading of the imperfect economic data provided by the government and by private sources.

Greenspan is therefore on his own, left to apply his best judgment to often- revised economic data, much of them out of date by the time he receives them. Indeed, some of the revisions to government-gathered data are so substantial that it is often difficult to tell where we have been, much less where we are going.

When Greenspan does finally sort things out, the tools at his disposal are so few as to make one wonder why the world even cares what he thinks. He cannot control long-term interest rates, which are set in a highly competitive market in which borrowers bid for lenders’ capital. This so distressed the Clinton team that James Carville, his populist yearnings for a loose fiscal policy to finance more government spending doomed to go unsatisfied, groaned that he wished to be reincarnated as the bond market.

Greenspan can, however, set short-term rates, a fact that is significant in itself and because it gives him a method of signaling to the waiting world just where he thinks the economy is heading. By raising rates, he flags a concern that inflation may be rearing its unlovely head; by standing pat, he tells investors and others that all is about as well as it can be in this almost best of all possible worlds. Because he is held in high regard by many of the nation’s money managers, because he is seen as independent of political pressure (an independence he paradoxically maintains by remaining aware of the political realities), because his demeanor commands respect bordering on awe (this, despite a taste for the celebrity cocktail circuit), Greenspan has made himself a force to be reckoned with. And he has used that power to help keep the economy moving steadily forward.

No thanks to critics on both the left and the right. Liberals such as Northwestern University’s Robert Eisner think that Greenspan’s tightfistedness dooms the economy to “lower employment and slower growth than their potential.” That is a view shared by one of Wall Street’s leading Democrats, Felix Rohatyn, as well as several Democratic congressmen, who fret that Greenspan is likely to tighten just when the fruits of prosperity are starting to become available to lower-paid workers. Indeed, the whole notion that monetary policy should be aimed at keeping inflation in check is unacceptable to most Democrats. In his novel-cum-memoir, Robert Reich disapprovingly reports that “Wall Street bankers and Federal Reserve members . . . want more than anything in the world to eliminate inflation. This is what the rich (who lend their money and bear the risk of inflation) have always wanted.”

The Right, most notably Steve Forbes and gold-standard-bearer Jack Kemp, also goes in for Greenspan-bashing. They complain that the Fed is keeping the economy from growing at an annual rate of more than the 2.5 percent Greenspan allegedly considers to be the maximum non-inflationary rate. Forbes and Kemp have the support of the Wall Street Journal editorial page, which delights in excoriating what it calls “the fear-of-growth crowd,” and Republican congressmen who fear inflation less than they do facing constituents who may find the value of their shares reduced by some Washington central banker whom they think their elected representatives should be able to control.

Greenspan has withstood these challenges and done what he can to keep the economy on a non-inflationary growth path. But a central banker’s role can only be that of a moderator of underlying economic forces: Were he capable of creating prosperity, rather than merely prolonging it for some limited time, we would never have another recession.

Never have another recession. Suddenly, an amazing idea is in the air — the idea that the business cycle has at last been interred by a newly flexible economy. Fortune magazine put it this way: “The U.S. economy is stronger than it’s ever been before . . . [reflecting] fundamental improvements . . . that . . . ensure that future fluctuations will be less extreme and less harmful than those of the past.” Business-Week headlined a recent cover story “How Long Can This Last? Strong growth with little unemployment and low inflation doesn’t have to peter out.” U.S. News asks: “Are Recessions Necessary?” It answers: “The restructured economy may be less vulnerable to the business cycle.”

Although no one is quite willing to say we will never have another recession, the mainstream media are clearly saying that it definitely won’t happen soon, hinting that it may never happen again, and adding that if it does, it will be mild by historical standards. And all this just a few short years after the New York Times examined post-downsizing America and announced “that people were bitter, anxious, disenfranchised”! That remark appeared in the Times just a few years after Paul Kennedy, in his much- heralded Rise and Fall of the Great Powers, warned of “the erosion of . . . U.S. manufacturing supremacy,” “the uncompetitiveness of U.S. industrial products abroad,” and “the massive long-term decline in blue-collar . . . employment.” Kennedy called for policymakers to manage our affairs so that the relative erosion of our position could take “place slowly and smoothly.” Now it seems that instead of declinists telling us we are heading for steady impoverishment, we have triumphalists asserting with equal fervor that we have reached recession-free nirvana.

That optimistic scenario rests on three related changes in the economy: globalization, deregulation, and technology- and investment-driven increases in productivity. Because of these changes, the Clinton team and others boast of “a new economic paradigm,” to borrow a phrase from the documents distributed at the G-7 summit.

Start with globalization. There is little question that rapid reductions in transport and communications costs, freer trade, the partial prying open of Japan’s markets, and the increased internationalization of even medium-sized American businesses have reduced the danger of inflation. No longer is it the case that domestic producers can raise prices or reduce quality with impunity when they have reached the limits of productive capacity. To do so is to invite a flood of imports, as the Big 3 auto companies found to their dismay. The world is truly the American consumer’s oyster. And the American manufacturer’s as well. No longer need our managers respond immediately to worker demands for higher wages when the unemployment rate reaches rock bottom. Instead, they can call on Indonesian and Central American workers to manufacture sneakers, and the Asian and Mexican labor pools for apparel. Or rely on immigrants (legal and illegal) to supplement the supply of domestic labor.

In short, it is nonsense, say these new paradigmists, to continue to believe that inflation threatens when the no-longer insular American economy reaches the limits of its productive capacity. It is therefore unnecessary to take demand-dampening, economy-cooling measures merely because American industry is producing at 85 percent of capacity (thought by traditionalists to be the upper limit of which it is capable), or because there are no longer the “few hungry men at the gates” whom Henry Ford is alleged to have found so useful when dealing with the wage demands of his workers.

The second ingredient of this new paradigm is deregulation. Lawrence Lindsey, a former governor of the Federal Reserve who now makes his home at the American Enterprise Institute, says “the real reason for our robust performance” is the ongoing deregulation movement, using that term in its broadest sense, initiated by President Carter and carried forward by Ronald Reagan, George Bush, and Bill Clinton (the last two by lowering trade barriers). “Industries protected by regulators, by tariffs, by oligopoly, by conditions in their markets, or by other means, had considerable discretion in setting prices,” Lindsey writes. “The opening of these industries terminated that pricing power — including pricing power in labor markets — and that is the secret behind the American success story.” The oil, gas, transportation, telecoms, and (soon) electric industries now must compete for business. The steel, textile, and auto industries are no longer fully protected by tariffs and “voluntary” quotas. Banking is being deregulated by a process of administrative fiat. And, notes Lindsey, “it is finally the [politically powerful] farmers’ turn. That shows how far our deregulation has gone.”

This means that firms are now free to innovate and price as they see fit and that capital and labor flow to their highest and best uses. One example: The deregulated transport industries in 1990 claimed 7.6 percent of our gross domestic product to move goods around the country, according to a study by Primark Decision Economics, a consulting firm headed by Allen Sinai. By 1996 the figure had fallen to 6 percent. That annual saving of 1.6 percentage points comes to $ 12 billion. Add in lower telephone costs, fuel prices that have declined precipitously since they were deregulated, and cheaper products available from abroad in our freer trading environment, and you get an economy capable of operating at far lower cost, one that is less likely to hit bottlenecks early in an expansion. Indeed, if the process of replacing regulation and monopoly with competition continues, not only in the electric industry but in the provision of government services such as education and postal services, the savings will help fuel further inflation-free growth.

Which brings us to the final ingredient of this new paradigm: rising productivity produced by technological advance and capital investment. Even if wages begin to rise noticeably in response to the pressure of increased demand for workers, inflation need not follow. Massive investment in new plant and equipment in recent years has raised the productivity of our work force; even the investment in computers, which for a long time seemed not to have paid off in America’s offices, is now bearing fruit. We have learned from the Japanese the art of just-in-time inventory management, reducing the economy’s vulnerability to involuntary inventory accumulation and subsequent sharp reductions in orders. We have learned how to improve our information systems so that manufacturers can adjust supplies and prices more quickly to market conditions, thereby avoiding more massive, delayed adjustments.

Alas, although all of this is true, it does not mean that the economy is now traveling a one-way street to permanent prosperity. For three reasons. First, a major policy error can derail the train to perpetual prosperity. Suppose that an obliging Congress had enacted Clinton’s stimulus package, at a time when the economy was growing rapidly, which it turned out it was? Surely the Fed would have reacted to this fiscal madness with a major rise in interest rates and a sharp tightening of the money supply. Since it is difficult to determine precisely how much monetary tightening is needed to offset a given loosening of fiscal policy, the Fed might well have erred in the direction of caution and produced at least a non-trivial recession.

Second, there is the small matter of human weakness. Lindsey noted in a recent talk, “At the present time, the United States is almost the only country that can point with pride to its economic performance.” But, he quickly and sensibly adds, “It is the height of hubris to believe that we have found the magic solution to economic problems. There is simply not enough history to allow us to decide that we won’t have another recession.”

Lindsey worries that the longer the expansion lasts, the dimmer the memory of recession becomes. Investors begin to bid share prices up to levels that don’t reflect the risk of their equity investments, and foreign bond prices to levels that fail to include proper acknowledgement of the risk involved. A more-than-modest downturn inevitably follows, with adverse effects on consumer confidence and spending, and eventually on economic growth.

This is more than a theoretical concern. The current level of stock prices depends on investors’ expectations that corporate profits will continue to grow, perhaps even at a rate that continues to exceed the growth rate of the overall economy. But profits have increased so rapidly in the past five years partly because wages have not. Indeed, profits now claim a share of national income three percentage points larger than they did in 1992.

Lindsey reasons that wages can’t be squeezed much more, especially with unemployment a mere 4.8 percent. So it will be difficult for the growth in profits to continue to exceed the rate at which the overall economy is growing.

If investors have bid up share prices in the expectation that profits can continue to grow at anything like the rate of recent years, they are in for a shock — a drop in share prices of as much as 20 percent, which comes to almost 1,500 points on the Dow. Call it a downturn or call it a correction; whichever term you use, it would result in consumers who feel poorer and businessmen who pay more to borrow money and raise equity capital.

The third reason that this, or any other, prosperity might come to an end relates to forces beyond the control of the masters of our monetary and fiscal policies, beyond the control of consumers, and beyond the control of the private sector. Asked to identify the biggest challenge governments face, then-British prime minister Harold Macmillan fatuously responded, “Events, dear boy, events.”

We already have experience with one such event — an oil-supply interruption and subsequent price run-up. When the Arabs chose to unsheath their oil weapon in the 1970s, they ushered in a period of stagflation from which it took the Western economies years to extricate themselves. And we already face the risk of another such happening — a trade war or, more likely, creeping protectionism.

Clinton is right to claim that our current prosperity is due in part to increasingly freer trade. But free trade is now at risk from a coalition of trade unions that fear competition with lower-paid overseas workers, and those who want to use the withholding of most-favored-nation status to discipline regimes that violate human rights or countries that don’t meet certain environmental and labor standards.

A strong effort by the president, whose one constancy has been his support for free trade, last week beat off the efforts of just such a coalition to deny continued MFN status to China (to the consternation of this publication’s editors). But with America’s trade deficits with both China and Japan soaring, an election year coming, and the unions prepared to spend millions to support politicians who vote with them, the protectionists’ voice may again be heard in the land.

That’s the bad news. And it comes as no surprise to Americans that the triumphalists have got it wrong, In response to a recent Wall Street Journal poll, three out of four people said they still expect there to be periods of recession. They may remember that a 1969 conference titled “Is the Business Cycle Obsolete?” was followed shortly by a recession.

The good news is that although we are not recession-proof, remaining subject to policy errors, hubris, and Macmillan’s “events,” we have achieved a major improvement in the trade-off between inflation and economic growth. For all the reasons cited above, it now seems that the economy can grow more rapidly, and sustain lower rates of unemployment, without triggering inflation, than was possible before Milken, downsizing, globalization, and deregulation. No small achievement.

Irwin M. Stelzer is director of regulatory policy studies at the American Enterprise Institute.