Ask Dr. Econ

August 1999

Do economists know more today about the economy than they did in the 19th and early 20th centuries?

Has this knowledge been the primary reason that business cycle downturns have been less severe in the post war years? Have the banking industry and the Federal Reserve played a role in promoting stability since 1950?

The economy and the study of economics have changed dramatically from the 19th and early 20th centuries. Technology and data also have changed substantially, just in the last half of this century. Some of the changes may affect both our knowledge of, and the strength of business cycles, which historically were often characterized by periods where financial panics were followed by bank failures, business bankruptcies, and economic downturns or recessions.

One important change that may affect the severity of business cycles today versus 50 or 100 years ago is the composition of the economy. In the 19th and early 20th centuries agriculture production workers made up the bulk of the labor force. Today they account for less than 2 percent of the labor force. Post war changes in the industrial structure, mainly the shift from a manufacturing-based to a service-based economy, also are dramatic and may affect business cycles as well. These shifts may be seen in Chart 1.

As economists Diebold and Rudebusch note in their 1999 book, Business Cycles: Durations, Dynamics, and Forecasting:

The possible postwar stabilization of the economy has been the subject of much controversy. After reviewing the evidence, our tentative conclusion is that the economy has undergone somewhat shorter and shallower recessions in the postwar period.

They analyzed several potential changes in the economy that may have an influence on the severity of postwar business cycles:

• Changes in the composition of production
• Changes in the composition of the labor force
• Changes in the technology of inventory management
• Changes in the importance and behavior of government

I will focus on the dramatic shift in the labor force and production away from manufacturing and into the service sector during the post war period. Remember that changes between the 19th and 20th century economies are even more dramatic.

In 1999 the national economy is much less dependent on jobs in industries like manufacturing, and transportation and public utilities, than it was in 1950, as can be seen in Chart 1. In 1950 manufacturing was the largest employment sector; it made up more than one-third of all the nonfarm payroll jobs in the nation. However, by year-end 1998 the manufacturing sector accounted for less than 15 percent of payroll jobs and it now includes a smaller share of jobs than either the service, trade, or government sectors.

At the same time the manufacturing sector was declining in relative size, the service sector was rapidly gaining in importance. The service sector grew from nearly 12 percent of all payroll jobs in 1950 to 31 percent in 1998 and it is now the largest industrial sector.

This shift in job composition also has implications for business cycle stability. The service sector tends to exhibit much smaller swings in job growth rates over the business cycle than does manufacturing employment. Manufacturing, especially durable goods manufacturing, including such key manufacturing industries as high technology and aerospace, exhibit large swings in employment growth rates over the course of the business cycle, as can be seen in Chart 2. In the post war era, the shift in job composition from manufacturing to services jobs and production alone would tend to damp volatility over the course of the business cycle.

In addition, better information technology and inventory control procedures in the computer era also may have served to reduce inventory cycles that often accompany business cycle swings.

Promoting stability in the economy also is an important central bank and governmental policy consideration. Since the creation of the Federal Reserve System in 1913 one of its primary responsibilities has been to promote economic stability through its conduct of monetary policy. The Federal Reserve Act specifies the goals of monetary policy as seeking, "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Finally, from the beginning of the post war period until 1999, the changes in the economy are extraordinary. For example, real (adjusted to exclude the effects of inflation) gross domestic product (GDP), the broadest measure of the output of the economy, is approaching $8 trillion on an annual basis, about four times the output in the late 1950s. Real per capita GDP had grown from about $12,500 in 1960 to nearly $28,000 in 1998. Nonfarm payroll employment has nearly tripled since 1950, increasing from 45.2 million to nearly 124 million in 1998 as labor force participation has climbed from under 60 percent to over 67 percent of the adult population. Likewise, financial markets and assets have recorded tremendous growth. Thus, the post war economy is much larger, more diverse, and has accumulated substantially more wealth than it had during the 19th and 20th centuries, changes that may make it more robust.

References

Diebold, Francis X., and Glenn D. Rudebusch. Business Cycles: Durations, Dynamics, and Forecasting. 1999. Princeton: Princeton University Press.

The Federal Reserve System Purposes and Functions. 1994. Board of Governors of the Federal Reserve System.