Just What Is Holding This Economy Up? The X Factor
By Justin Fox

(FORTUNE Magazine) – The U.S. economy is looking so strong, so steady, so perfect, it's enough to make a Federal Reserve chairman or a Treasury Secretary downright queasy. The GDP has been growing for more than seven years now. Unemployment, at 4.3% of the labor force, is the lowest it's been since 1970. Inflation is a measly 1.7%. Shouldn't something be going wrong by now? What mysterious force is holding everything together?

Fed Chairman Alan Greenspan has an answer, sort of: He calls it the "X factor"--an economic phenomenon that nobody can pin down now, but that should become clear to all after the fact. The term refers to Planet X, the name astronomer Percival Lowell gave back at the turn of the century to an unseen body that seemed to be exerting its gravitational pull on Neptune. The "X factor" name carries some fitting pop-culture overtones as well. ("Isn't that a movie?" says Alan Blinder, Greenspan's former No. 2 at the Fed.) As in The X-Files, the truth is out there.

The reason some sort of explanation is needed is this: Most economists agree there's a short-term tradeoff between unemployment and inflation. Push one down, and the other goes up. This tradeoff does change over time as the economy changes. (Remember "stagflation"?) Less than four years ago, however, the consensus was that the lowest the jobless rate could go in this economy without pushing inflation upward was about 6%. Since September 1994, however, unemployment has been below that mark--and inflation has just kept dropping.

One explanation for this curious confluence of decreasing inflation and decreasing unemployment is what Blinder, now an economics professor at Princeton, calls the "luck factor": a set of happy coincidences that have put downward pressure on prices. The measurement of inflation has changed, driving the rate down by about half a percentage point. There have also been sharp drops in health care, computer, and oil prices--and a steady rise in the dollar's value against foreign currencies. Beyond luck, there's also the fact that the economic policymakers of the developed world have stayed serious about fighting inflation since the early 1980s. That seriousness has convinced consumers and businesses that inflation will stay low, which in turn has reduced upward pressure on prices.

All this is uncontroversial and almost certainly true, and for Blinder and most other academic economists it's enough to explain the economy's recent behavior. This means the gravest danger facing the current expansion is that the luck factor will run out, inflation will rise, and the Fed won't be able to bring it back down without sending the economy into recession.

But the good luck has held out for an awfully long time now. What if there's something else at work? Possibly Greenspan's X factor, or for those less prone to caution than the Fed chairman, the "New Economy." The latter explanation, a favorite of Wall Street bulls and Silicon Valley futurists, holds that information technology and economic globalization have changed the rules of the economy and made inflation much less of a threat. Governments are shrinking, capitalism is rampant, and new inventions are making it possible to do more at less cost.

Mainstream academic economists are skeptical of this view, mostly because it doesn't show up in the data. But that doesn't mean the New Economy school is wrong. Mainstream economists are often the last ones to notice changes in the world around them. The problem is that economic data usually don't divulge trends until years after the fact. So economists have no choice but to look to the past and assume that historical patterns will be repeated. And American history of the past 50 years--the period for which economists have the best data--teaches us that economic expansions tend to die in a burst of inflation followed by a Fed crackdown.

If you look beyond postwar U.S. history, however, you can come up with very different patterns. Economist John Makin of the American Enterprise Institute sees the current expansion as an investment-led, inflation-free "golden age" similar to the U.S. scene in the 1920s and Japan's in the 1980s. Both those booms ended badly, of course--but they didn't end in bursts of inflation. James Paulsen, chief investment officer at Norwest Investment Management, looks back even further, to the U.S. in the second half of the 19th century. That was a period of no inflation, revolutionary technological advances, massive global capital flows, and rapid economic growth--and was also characterized by devastating spells of deflation.

This helps explain why the search for the X factor is so important--if there is some powerful new deflationary force out there, the Fed should be worrying more about falling prices than rising prices. It's just that it's not in the nature of such things to reveal themselves easily. Percival Lowell searched for Planet X until his death in 1916. Fourteen years later a young astronomer appeared to attain Lowell's goal by discovering Pluto. But it turned out Pluto wasn't nearly big enough to skew Neptune's orbit. So astronomers kept looking until they concluded a few years ago that maybe there really isn't anything that irregular about the way Neptune travels around the sun.

Alan Greenspan and Robert Rubin and everyone else trying to understand this economy may have just as much trouble nailing down the X factor. The truth is indeed out there, but that doesn't mean we can figure it out.