New investment and not merely capacity utilisation brings economic growth

There is an important debate now taking place among monetary policy analysts over the question of "capacity utilisation." Its resolution will tell us much about the future course of the U.S. economy, says Bruce Bartlett.

The theory is that if the economy has substantial unused capacity for production, then monetary policy can be expansive without the risk of inflation. Unused capacity in the economy would include unemployed workers and idled plant and equipment that could be used to produce goods and services if the demand was there.

The U.S. Federal Reserve is saying that it will continue pumping up the money supply and maintaining easy credit conditions for a "considerable period."

It’s view is that the economy is like a bucket that has been partially drained. Until the bucket is full again, there cannot be inflation.

Therefore, the Fed will continue stimulating demand indefinitely.

The problem with this theory, explains Bartlett, is that it is not borne out by experience. In the 1970s, there was high unemployment and low capacity utilisation, yet high inflation. A key reason is that labour, plant and equipment are not homogeneous. When demand is stimulated, it may require workers with different skills in different places to satisfy. Similarly, producers may not have the right equipment to make the things people want. Therefore, new investment must take place first before production can rise.

Bartlett believes that the message of markets, which is showing signs of inflation, is a more accurate indicator of future prices than the capacity utilisation index or the unemployment rate. If the Fed continues easing, it runs the risk letting the inflation genie out of the bottle. A little tightening now would be prudent, forestalling more severe tightening later.

Source: Bruce Bartlett, Capacity Utilisation, National Center for Policy Analysis, November 19, 2003.

For more on Federal Reserve Monetary Policy http://www.ncpa.org/iss/eco/

FMF Policy Bulletin\18 November 2003