True and False Lessons Drawn from the Structural Slump

ANDREW ROSS SORKIN: Good afternoon, everybody. My name is Andrew Ross Sorkin with The New York Times and CNBC. I am pleased to introduce today Edmund Phelps -- Professor Edmund Phelps, I should say, director of the Center of Capitalism and Society at Columbia University and 2006 Nobel Laureate in economics.

I should remind everybody to turn off -- not just put on vibrate -- your cellphones, BlackBerrys and all other wireless devices to avoid interference with the very sensitive sound system. And I'd also like to recommend happily -- not recommend, rather, but remind everybody happily that this is on the record, for those journalists who are in the room, and finally to remind everybody that there is another meeting, a very exciting meeting tomorrow called the "Europe Update" tomorrow morning at 9:45 to 9:00 a.m. (sic). Hope you all can make that.

So with that very short introduction -- and then we're going to have a conversation in a little bit -- let me hand this over to the professor.

Professor.

EDMUND PHELPS: It's an enormous pleasure to be here. I'm all fired up over a number of issues, and I guess this'll be -- provide an opportunity to touch on some of them.

As you know and as I know, we have descended into a pretty deep slump, measured by unemployment and labor force participation rates. It is some consolation that we have been gaining some ground of late, private sector in particular. Public sector has been discharging people in the unemployment pool almost as fast as the private sector has been hiring them. But still I regard the situation as having moderately improved.

But my research suggests that we will not recover to the old normal, but to a new normal with, as a guess, an unemployment rate around 7 percent. We seek remedies for our ills, but the prescriptions we take will not have much value if they are not grounded in adequate economic theory, and that's where my -- where I come in today.

From the point of view of my theoretical and statistical work dating back to my 1994 book, "Structural Slumps," and my later research on structural blooms, not to mention my more recent work on economic dynamism, the present slump is widely misdiagnosed and the widely debated policy prescriptions ill founded, not grounded -- not well grounded.

Looking through my lenses, the present slump at this point appears to be structural. The previous structural slump, I would say, was Europe's slump in the 1980s. I'm inclined to think that the Great Depression was largely monetary, but more research could perhaps usefully be done.

I see three structural mechanisms at work behind today's structural slump. First, a depression has emerged in the values put on business assets such as commercial structures, such as important kinds of trained employees, those who handle information and those who used to be engaged in the innovation and growth departments. Price earnings ratios are around 12, where 10 years ago, if I'm not mistaken, the ratios were around, oh, 16. And I think I can recall 20 or more in frothier times.

The impact has been mainly -- the impact of these depression -- by this depression of business asset values per asset -- the impact has been mainly on business investment activity, and especially on innovative activity.

Employment in the financial sector has also taken a big hit. Second, a real exchange rate depreciation has come to the U.S., with the result that companies have been -- under the -- under the protection of the -- of the real exchange rate depreciation, they've been tempted to raise their markups, which they proceeded to do. Last -- third and last, the collapse of the artificial and highly speculative housing boom eliminated a huge number of construction jobs and jobs in some of the financial industries connected with construction.

I don't see the impairment of the banking industry by its -- by their -- by its poor balance sheets -- I don't see this impairment as a major cause of the slump, since the banks had ceased to be big lenders to business anyway. And I don't see the insolvency of households as a major source of the slump either. I don't think that consumer demand led the economy into the slump. Besides, production of consumer goods are far more capital-intensive than they are labor- intensive. And to put it crudely, investment activity is where the jobs are, including innovative activity -- development of -- development of projects that -- project development that is hoped to lead to innovation.

What are the main underlying structural causes of this depression?

The demographic prospect ahead of us is a large exodus of trained employees from the labor force, heavily over the 19 -- over the -- over the 2020s.

There has been a staggering rise of private wealth. In America, which I'm focusing on, much of this bloating is in the category of what I call social wealth. The present value -- and by the rise -- by private wealth here I mean the present -- I'm talking about the present value of assets, so to speak, present -- and the social wealth I'm talking about is the present value of unfunded social entitlements: $35 trillion for Medicaid, $23 trillion for Medicare and $8 trillion for Social Security, and that's not counting the public debt. In Greece and maybe France, I think we're seeing something similar.

In Europe, we see also a pathological excess of private saving, in part fueled by undertaxation, thus huge fiscal deficits and thus rising public debt. Now you might say, well, what's depressing about that? I thought capitalism was all about wealth accumulation, as one newspaper, I think is fond of saying. (Laughter.) Well, what's depressing about it is several things. It's not good for the labor force participation. If people are already as rich as Croesus, they may may not feel impelled to go out and get a job.

And another thing is it can cause big problems for companies when the personnel don't really need to take all that guff and don't need to put shoulder to wheel because they're doing fine, thank you, with their investments. And I could go on and on.

I could also argue the opposite side of this, but I won't do it. (Laughter.)

Another cause of the structural slump (trivially ?) is the overhang of housing, which leads to an enormous theoretical tangle of forces, which I won't dare go into today.

So that's my structural perspective. Oh, I wanted to say another thing. The -- perhaps the most -- single most important reason why we're in the doldrums is that we've been in a productivity slowdown since about 1973. And there were times when we forgot about it and thought it was over, because things were going so well; but then, after a while they weren't going so well any more. And it's now very clear, if you look at the data between 1973 or so and the present, that productivity growth is just a whole lot slower than it had been between, say, 1955 and 1973, or between 1921 and 1941. There's simply no comparison.

Now, the -- of course, there are all these rival theoretical perspectives. I had the pleasure at the Reuters Keynes-Hayek debate last week to attack the Keynesian premise that the slump is a result of deficiency of effective demand.

I'll just say here that there's no price deflation going on this slump, and there's not even any disinflation going on now. The Keynesian model simply has got -- not got to first base.

And it's appalling that so many people out there in the business world and elsewhere don't seem to realize that that's a totally outmoded -- oh, I won't say outmoded -- it's a totally inapplicable theory. The last time we had a hundred percent slump that was monetary in origin was the Great Slump in Britain in 1926, when Churchill put the pound back at the old price in terms of the dollar, requiring a humongous drop in money wages and money prices if they were ever to get back to full employment. And I could also oppose supply-side theories just as well.

But let me take the -- my remaining three minutes or so to say -- to articulate a couple of themes. People in this country have come to see the -- have been led to see the economy as a physical system that can be controlled by, so to speak, engineering the outcome you want to do, if necessary using rocket science. People -- and people have been led to that thinking because they're only provided with dumbed-down, highly mechanical, short-sighted, shallow theories like the rudimentary Keynesian theory and the rudimentary supply-side theory, which have no intertemporal depth to them whatsoever, because that would make them too hard.

Now, my keen interest in coming here today, I think, is really -- grows out of two particular irritations. One is the irritation -- my irritation with my friends on the -- shall we say Republican supply side, who think that a general tax increase would bring austerity, as if austerity were not already here and going to intensify anyway, whether or not we have a tax increase. I should try to say more about that later, but I can't say everything in my 15 minutes.

Also there's my irritation with the Democrat Keynesian group, who think that spending, and therefore employment, will be dashed by a cutback of 120 billion (dollars) in annual terms in government spending, as if the unfunded spending wasn't part of the problem, as if -- it's as if it's like recommending some guy with a terrible hangover that he go out and get another drink, the hair of the dog, you know? It just -- it boggles the mind.

This latter faction, the Democratic Keynesian faction, says -- and, I'm sorry, the supply-sider faction -- says that the only way out of the debt is not tax increases but to grow out of the problem, as if the function of the economy were to cover for the politicians who had blundered and overspent and as if there were push-buttons available for speeding up growth, which is one of the things we least understand.

I want to make just two crucial points in the last minute.

One, since 1990 or so, we've needed to build up fiscal surpluses in view of the looming overhang of entitlements that will start becoming due in the year 2012. I think -- I mentioned that we've got Medicaid entitlements of -- I've lost the number here, but -- these entitlements add up to 66 trillion (dollars).

I've asked myself, well, suppose we could get some insurance company in the Netherlands or something to annualize this for us so that the federal government would each year pay a constant flow. Well, how much would the insurance company require in constant flow to cover that 66 trillion (dollars)? And of course, it depends on what rate of return, so to speak, the insurance company requires. At 2 percent, the federal government would have to spend 1.52 trillion (dollars) per annum to the insurance company to take care of -- indefinitely, in perpetuity -- to take care of the problem. At 3 percent, it would 2.28 trillion (dollars). So we're just miles from getting into solvency the way we're going.

And then there's finally -- my second point is, I think in all the discussion of the poor condition of the economy, we're overlooking the tremendous slowdown since 1973. We had the -- and now there are signs that we're having technological displacement of a lot of workers as a result of the Internet revolution before that. So we're in really a terrible pickle, but I think at least we can be -- the way forward is -- it's got to begin with applicable thinking about the root causes of our situation.

Thank you. (Applause.)

SORKIN: Thank you, professor. So what we're hoping to do -- and that was just a framework to really get everybody thinking about where the professor's head is. And what I'm hoping we can do is make this as interactive as possible.

I have a couple of questions that your conversation's already raised for me, and then I'm hoping to throw it open to the audience, and I imagine you have much smarter questions than I do.

Given the news of the day, which is the failure of the supercommittee, it occurs to me that if I could make you the supercommittee of one, given the framework that you just laid out, in a politically palatable way -- if you think that's even possible -- you would do what?

PHELPS: (Sighs.) (Laughter.) Well, in that -- in the context of the supercommittee -- thanks for the question; it's nice. (Laughter.) Well, you sort of threw me with that last -- on the condition that it -- I not get assassinated the next morning by, or I wouldn't be --

SORKIN: Well, forget the politics. If you -- if you could do it your way --

PHELPS: -- chased by angry crowds burning torches?

SORKIN: No, if you could do it your way --

PHELPS: Yeah.

SORKIN: -- but recognizing the political climate that we're in --

PHELPS: But within the framework -- within the parameters of Western civilization, in other words, yeah. Yeah. (Laughter.)

SORKIN: Yeah, we'll take that.

PHELPS: (Laughs.) Right. I would go for a general tax increase, starting with the first bracket. I don't like the idea that the bottom 45 percent pay virtually no income taxes net of -- net of various sorts of entitlements. And I -- and I -- though I have no special sympathy for the rich, I do think that we'll get the -- we'll get the biggest bang in terms of employment, innovation and productivity growth if we go about raising our revenues more efficiently. And that means loading more of the burden on the early brackets -- on the first brackets, rather than focusing the heaviest burden on the higher brackets, which are marginal tax rates -- which are marginal tax rates for those people who are -- who are actually paying taxes.

If you wanted to raise the highest revenue you could, you wouldn't tax -- you wouldn't have a positive marginal tax rate on that last dollar. What would be the point?

SORKIN: Right. You -- but you would spend more attention on the taxes than you would on the cutting?

PHELPS: Secondly, I would also be happy to -- I'd actually -- the one-sentence answer that I should have started with, probably, is I would like to roll things back to about the year 2000, before the Bush free pills, before the Bush tax cuts, before the myriad spending motivated -- driven by both Democrats and Republicans. I would be very -- I would -- I would like to go back to there. And so yeah, I would -- I would certainly get rid of the free pills. And I don't -- and I don't like that -- I don't like the -- those across-the-board tax cuts that Bush initiated, no.

SORKIN: You mentioned the idea of 7 percent unemployment as a potentially realistic number that we could reach.

PHELPS: Yeah, right.

SORKIN: When could we reach that, and how?

PHELPS: I've been more confident about the number than about the speed. (Chuckles.) That's one derivative too much for me -- (laughter) -- for those mathematicians in the audience. The recovery has certainly gone much slower than I thought. I may have been hoping and expecting a very strong recovery such as occurred -- such as began in 1934 in the U.S. at the bottom of the Depression. But I guess there's just too much -- too much damage done to the system. It's just -- it was -- I think -- we're not going to have a --

SORKIN: But we can get to --

PHELPS: We're not going to have a fast recovery to 7 (percent). On the other hand --

SORKIN: But we can get to 7 percent by doing everything -- (inaudible) --

PHELPS: Belief that we're going to 7 (percent) doesn't mean that we're going to crawl there decade by decade. Look, I -- look, I -- the collapse started in 2007. I think a lot of macroeconomists would agree that by 2020 it would look like most of the damage had been cleared away and things were looking pretty normal again.

SORKIN: You made a comment about inflation versus deflation and suggested that we have not had any deflation. This was in the context of what would happen if we raised taxes. And I was going to suggest to you housing is a market that I think it would be hard to argue we haven't had deflation.

PHELPS: Well, that gets into how we want to talk about monetary magnitudes and how we want to talk about structural or nonmonetary magnitudes. For me, the interesting price of houses is the real prices of houses, the price that -- expressed in terms of consumer goods, the price deflated by the Consumer Price Index. So yeah, we've had a tremendous decline in the real price of houses, but we would have had that decline even if we somehow could figure out a way to operate the economy without money. We've still had -- we would have still had a speculative boom in the relative price of housing and still had -- and could still have had that and could still have had the collapse.

So -- there's a reason why the national income statisticians around the world fix on consumer goods when they talk about inflation. It's normal. Look, the decline in the real price of houses is on my side. It's a point in favor of the structural interpretation. You can't take that point away from me and say it's a point in favor of some monetary theory of the slump.

That doesn't make any sense to me.

SORKIN: OK. You know, in the conversation and debate between Hayek and Keynes, one of the comments you made that struck me was this idea that if we cut -- this was sort of the Keynes argument -- if we cut -- or the Democratic argument -- if we cut $120 billion -- I think was the number who had cited -- from the government, it wouldn't have an impact, or -- a lot of the Democrats would argue it would have a huge impact on the economy. You say it wouldn't.

PHELPS: It's what I said here.

SORKIN: That's what you just said.

PHELPS: Yeah.

SORKIN: Yes. (Laughter.)

PHELPS: (Laughs.) I thought you were saying that I said it in the Keynes debate.

SORKIN: No, I -- no, but I ask why, given that you're going to take that money directly out of the system tomorrow, maybe over a period of time, but the immediate has to be felt at some level, no?

PHELPS: Well, I was making a lot of -- I made -- I already hinted at some of the thinking I have in mind. A lot of consumer -- a lot of the -- much of the production -- the production of much of the consumer goods is highly capital-intensive, so -- ever seen "North by Northwest," that scene where Cary Grant is in the field and the crop duster pilot is trying to kill Cary Grant? And all you see is this vast openness, this vast field, producing this vast amount of farm output with not a single person in sight except for the Cary Grant character. (Laughter.) That's food, but it's really all over the place. Now, I guess how many jobs you lost on that account would depend upon the details.

The other thing is that -- a point behind my debunking or devaluing consumer demand, I mean, there are a number of things to say. I made one point -- just made one point against attaching so much importance to consumer demand; namely, the production is very capital intensive. Another point is, high consumer demand makes for a -- no, sorry, that's the wrong point. The other point is that if there's a -- you maybe think this is stretching things, but to the extent that the whole world thinks, oh, great, consumer demand, yes, let's offer more benefits to make people consumer more -- to the extent that that becomes a kind of endemic way of thinking in the Western world, that's going to drive up world real interest rates, and so you may lose more jobs indirectly by hitting investment activity on the head than you gain directly by the increased purchases of consumer goods.

Now, that's a complicated argument. If it's just the United States alone that increases consumer demand, you might say that, OK, the U.S. is big but it's not all that big, and the effect on the world real rate of interest -- and even the U.S. real rate of interest because it's to some extent linked to the world real rate of interest -- won't rise so much. But -- so, I mean, I got a whole portfolio of reasons for de-emphasizing consumer demand and emphasizing investment demand.

Finally, just if I can just add one more point, you can look at time series data for, let's say, the U.S. economy, and it's just extraordinary how output tends to be explained by one thing: namely, real investment expenditures. That just -- it just hits you. It strikes you that that is the -- it's naked on the face.

It's -- output is driven by investment expenditures, which in (turn ?) becomes somebody's income, which leads to consumption. But the driver -- it's statistically pretty evident that the driver is investment demand, it's not consumption demand.

SORKIN: You talked a lot about investment demand -- and this is my last question, then I will try to open it up. Virtually every CEO that I talk to suggests that one of the big problems that we're living in right now is this sense of remarkable uncertainty, that the regulatory environment, that -- which they suggest is impacting the economy unto itself, and that it is -- it is this general sense of uncertainty of what's coming next that is actually keeping people from making investments. Do you believe that?

PHELPS: I certainly believe that there's something in it, but then I also -- and what's in it is, of course, that business people don't yet know what the details -- what the description will be of the eventual response of the U.S. Congress to the towering fiscal deficits. So businesses may be afraid that the whole burden of adjustment's going to be loaded onto higher tax rates, including or not excluding higher corporate tax rates. So it's understandable that that's another reason for businesses to wait about investment projects.

On the other hand, there's a fair amount of mistaken thinking on this score, I think, because if there's one thing that we can be sure of is that there's going to be a contraction of one kind of demand or another: either there's going -- either there going -- either there's going to be less government spending or there's going to be less -- which could -- which would further impact on consumer spending possibly -- or there's going to be higher taxes, which may impact on investment spending. But either way, there's going to be less money and the impact is going to be to either take away -- people are either going to -- the impact on their pocketbooks from day one is either going to be -- is going to be negative whether they've -- whether households have lost benefits or whether households have to pay more taxes. So there's a certainty about that.

SORKIN: Right, right.

PHELPS: It's only the incidence of whose ox is going to be gored that there's uncertainty over.

SORKIN: So the uncertainty is certain?

PHELPS: (Inaudible.)

SORKIN: On that note, why don't we open it for questions? I know many of you have one.

Dan, you have a good seat here in the front. So the microphone's coming around.

QUESTIONER: Hi, Dan Altman with North Yard Economics and NYU.

Professor, you said that we're heading for 7 percent unemployment. When I was first taking economics courses, they said that the natural rate of unemployment was 6.5 percent. (Chuckles.) That wasn't so long ago, maybe 20 years. And so my question for you is, instead of having a structural slump now that's heading us to a new normal, could it be that we had a monetary-fueled boom, which is now taking us back to the old normal? (Laughter.)

PHELPS: I'm not exactly sure when you were young and studying this -- (laughter) -- course. (Chuckles.) My benchmark has been the unemployment rate in the middle of the 1990s, which is 5.6 for two years in a row, with inflation neither rising nor falling, conditions pretty tranquil. It was just before the dawn of the age of the Internet.

And so -- so then how did I get to 7 (percent)? So I got to thinking, well, those times were a bit brighter than the times now. For one thing, the overhang of -- the overhang of entitlements had not gotten to nearly the same proportions that it has now.

Secondly, in 1995 and 1996, 2020 seemed remote. That's the time when the Baby Boomers will start leaving, en masse, the -- their jobs in the private sector. So for those two reasons alone, we would expect a higher natural unemployment rate now, in the sense of a steady-state, medium-term natural unemployment rate, than we had in the middle of the 1990s.

Finally, in addition, I have become gloomier about innovation and economic growth than I and, I think, most people were in 1995 and 1996. We've just been through 10 or 11 years with slower growth than we had between 1990 and 1995. I'm hard pressed to think of a single reason why the natural unemployment rate should be lower now than it was in 1995 and 1996, but --

SORKIN: Yes, sir.

QUESTIONER: I'm Kenneth Bialkin, Skadden Arps. I'm reminded, or I have to think about a statement made by President Roosevelt in the '30s, when he announced to the American public that the only thing we have to fear is fear itself. If we would translate that psychological observation to today, we'd define it in terms of optimism or pessimism, the willingness of businesses to invest and expand, the willingness of persons (and workers ?) to spend and look more optimistic about things.

And if our objective was to restore optimism to America about the future, if the objective was to restore optimism in the businesses who think about investing and expanding, what steps would be taken to try to encourage that optimism? And to what extent would that optimism depend, to some extent, on the prospects of political change or development? We're coming up to an election next year. Different people have different attitudes about what might be the economic policy of -- (inaudible) -- and I wonder if you could speculate or comment on the validity of this observation, that all economic activity is a derivative of the attitude that people have about the future.

PHELPS: Thanks a lot. I love that question. I think that the rebirth of optimism is going to depend upon the rebirth of something objective that you can hang your hat on, that you can hang your optimism on. In getting ready for -- in the preparations for this meeting, I had to write a few lines about what I wanted to talk about, and the lines in front of me I didn't get to at all. So let me, in answer to your question, say what I didn't -- what I said in my forecast of what I would say, which I didn't say here. I think -- I think what's required to get back to a genuine feeling of prosperity and flourishing is some long-needed surgery to shop the -- to stop the "short-termism," to restructure and innovate the financial sector, and to encourage the renewal of a culture of exploration and vision leading to economy-wide innovation -- and thus, a back seat for the money culture, which has been in the driver's seat for at least a decade.

And of course, we have to put down -- as I was saying, we have to put down -- we have to stop this push-button mechanics mentality that, oh, the economy, all you have to do is just get right the tuning of the various instruments and we'll be -- we'll be fine again. We have to stop that. That goes for the Keynesians as well as the suppliers -- supply-siders.

I would like to see the end of the "Know Nothings" in the free market camp. I'd like to see an end to the -- to the believers in scientism. That's the idea that all the fruits of Western civilization are owed to the scientists, and there's no creativity in the economy at all; nobody in the economy ever had a new idea in his or her life. And by the way, that goes back to Schumpeter and, before Schumpeter, Shpikov (sp). That's where Schumpeter got it.

In Schumpeter, the new ideas are from scientists and navigators outside the economic system. We have to stop that, and you people in business should really be pushing to make it clear to the general public that you are engaged -- in your good days, anyway -- you're engaged -- or in your better days -- (laughs, laughter) -- you're engaged, or you were engaged, in innovating and having new ideas, and mulling them over and talking about them and developing some of them, and then trying to market them and, with luck, getting them adopted.

And so that's -- I think that's -- we need to have a kind of reformation, a kind of restoration of the -- of the spirit of the country that I think prevailed between -- hard to say when it started, but prevailed -- it certainly was visible and present -- present and visible in the early 19th century, and was going full steam at least till the end of the 1940s.

SORKIN: I have a quick follow-up on that. And I should also tell you I am going to out you. The font on that that you were reading is impossible to read, even for myself, and I --

PHELPS: (Laughs.) Glasses.

SORKIN: It's the tiniest font you've ever seen, so -- You know, one of the things that strikes me as you were saying it, is I started to think a little bit about Occupy Wall Street, and the economic inequality story and argument that's been made for many years but is clearly now in focus. How important is it to bridge that divide for the long-term sustainability and success of our economy? Does it matter? PHELPS: Andrew, you ask such hard questions. That's a tough one.

SORKIN: I only ask because you talk about the confidence that the entire economy needs to keep growing, and I'm curious how the inequality story relates to that, if it does.

PHELPS: Well, let me say right away that I pride myself on having had an early interest in economic justice. And I was extraordinarily fortunate, and damn lucky, that for a year I sat in my office next to John Rawls, just across the wall, when he was writing his book, "A Theory of Economic (sic) Justice." But, you know, Rawls is not about inequality. He doesn't say you shouldn't have inequality. He says you're bound to have inequality; it's what you do with it that counts. And he wanted -- he was willing to harness inequality in the interests of people in the labor force who were disadvantaged and had the lowest wage rates.

His idea was that the tax system and other levers of government should be operated in such a way as to pull up wage rates at the bottom, and pull up employment opportunities as well, to the maximum possible extent, by calibration of the economic system in such a way that it would -- it would create incentives for everybody to work hard and invest and save and so forth, and then thereby pull up the bottom.

So I've been a little bit put off by the occupiers when they talk about inequality, but then I realize that's pedantic on my part.

They're not saying that they never saw an inequality they never liked -- that they didn't like -- that they liked; they're saying that it's the particular inequalities that they see that they are appalled by. And I suppose they haven't -- I did go down there one day and I did talk to them one day, and I acknowledged that in my humble opinion, I think there has to be some radical restructuring of parts of the financial sector. I think we need a banking industry that serves the needs of business for financing innovation, things like that.

Anyway, so -- but I think your question is really, is the economy, even in the most -- even in the more aggregative terms is the economy suffering from the inequality? And some crude Keynesians -- it's the only kind there are, but the -- (laughter) -- (laughs) -- the crude Keynesians, or for short, the Keynesians, suggest, of course, that, oh, the -- if there was -- if some income could be taken from the rich and be given to the poor, there would be higher consumer demand, and that would float the whole economy up and make everybody, maybe even the rich, better off, or make nearly everybody better off, in any case.

I think, you know, as you will see -- as you must have noticed from everything I said, I disagree vehemently with that idea that you can -- yeah, I can think of -- there's one argument you can make why higher consumption demand could be good for employment, but it's very short-termist. You could say that high consumer demand pushes up the currency, pulls up the currency and that cuts mark-ups of companies and that leads to higher employment. The trouble is that the -- the higher -- the appreciation of the currency, or the real exchange rate appreciation will drive away customers; eventually the stock of customers will have settled -- will have declined to the point where output is right back to where it was before. So that's a lousy argument. (Pause.)

SORKIN: Why don't we leave it there.

PHELPS: I mean, I just -- I just -- I have an old-fashioned position. I want to redistribute -- to pull up wages at the bottom. I really don't give a damn much about inequality as such.

SORKIN: OK.

PHELPS: I'm not interested in whether Rockefeller -- Rockefellers own half of Maine or Ted Turner owns some big chunk of Montana. It doesn't affect me in my daily life. I have my work, my gratifications. (Laughter.) I'm sorry, it just doesn't -- I don't see where people are coming from when they talk about that.

SORKIN: OK. Paul Steiger with a question, sir.

QUESTIONER: Paul Steiger from ProPublica and from your Economics 10 class 50 years ago. (Laughter.)

You talked about productivity and the attenuation of its growth. Could you talk a little more about that? What has caused it? Is it the reduction in manufacturing and its size in our economy? And how could that be turned around? And also, since increased productivity means, to some extent, fewer jobs, how do you reconcile those two objectives?

PHELPS: Thanks, Paul. He really was a student 50-some years ago. We were both young.

Well, funnily enough, the decline of productivity growth was rather abrupt. It was sudden. It was almost from one day to the next, (gone ?) by 1973. So it would be hard to say it was because of some long -- long, slow-moving, long-time shift in the structure of the economy.

So it's -- I think it's to some extent a puzzle. And I'm not -- I'm not sure that -- I'm not sure that there are any easy answers. I think we're a long way from an understanding of that puzzle.

I agree with you that it certainly hasn't helped that we've suffered a decline in the relative importance of manufacturing since 1973, maybe to some extent before that, too. So that since -- it seems to be easier to innovate in manufacturing than in some other sectors of the economy, that may be helping to account for slower productivity growth now than we had, let's say, in the 1950 and '60s. But manufacturing doesn't have any monopoly over productivity growth. There was phenomenal productivity growth in agriculture in the United States from the 1880s or so right through to 1930 or so. Let's leave the Dust Bowl out of it.

And I think we've had significant productivity gains in services, medical care; maybe some of medical care falls under manufacturing, I don't know. I think it's a cultural thing. I think we cannot have rapid productivity growth without -- without its being broad-based and without its -- without there being to some extent activity everywhere in the economy oriented to trying out a different -- conceiving, developing and trying out a different way of doing things, or conceiving, developing and marketing a different product.

I've read a little bit around about the 19th century. I'm finishing a book on the modern economy from 1815 or so to the present, so I've rummaged around quite a bit of literature, and I'm by no means a professional historian, but I got this sense that the 19th century was so exciting, because everybody in the little artisanal shops and everybody on the farms and everybody was tinkering. Everybody was exploring. Everybody was trying to look for a better way of doing things. There was a new culture. And I think -- I don't know -- I don't think we can just push buttons, enact some legislation and then sit back and watch the flowering begin. I think that we have to get back to the -- to the spirit of innovation.

SORKIN: Yes, sir.

QUESTIONER: I'm Gerald Pollack (sp). Professor Phelps, could you elaborate a little more your criticism of the Keynesian approach? Now, just assuming that we could have, you know, a longer-term solution to the budget problem, the debt problem, in the shorter term what's wrong with the government borrowing money now at currently low interest rates for the sake of spending money on behalf of infrastructure projects and to give to states so that they could maintain their employment rather than lay off as many people as they've been laying off? What's basically wrong with that?

PHELPS: Well, in general, it's not wrong. In general I think there are good instincts there. Hoover instinctively -- he was an engineer, as you know -- he instinctively thought in terms of engineering projects -- infrastructure projects. And Roosevelt, I think -- and some have said that the differences between Roosevelt's program and Hoover's program are not all -- are not great.

They don't bowl you over with their -- with their dissimilarity. And Keynes, of course -- and as you may know, in 1933 or so, he was -- or '32 -- he was always talking about infrastructure investments.

So it's always been part of the popular instinct to go for infrastructure developments, and it is -- it's not -- it's not the worst economics because investment goods tend to be labor intensive. So, as I was saying before, it does make a certain amount of sense to go for them.

The thing is, though, that we now have $66 trillion in -- of entitlements and $10 trillion of public debt, rising by $1 trillion every year, and we don't know what sort of a mess is going -- we're -- is going to be on our doorstep from Europe, and we don't even -- can't even be too sure about the health of the Chinese economy over the next two or three years. So I don't know.

We're in a very precarious situation, and I would be extremely concerned, just downright worried, if the Congress were to say, OK, let's do another half trillion (dollars) a year in infrastructure projects. I would be worried about what would happen to the stock market and the bond market and the dollar. I don't want to see a further weakening of the dollar. It'll push up markups. I don't want to see the stock market drop. It'll reduce IPOs, tend to reduce new firm startups.

SORKIN: And the market falls because?

PHELPS: Higher expectations of people gagging on all the increase in debt in the future and --

SORKIN: The stock market, though, you're saying falls?

PHELPS: Hmm?

SORKIN: You're saying the stock market falls? Some people would --

PHELPS: Sure.

SORKIN: -- argue the stock market would go up --

PHELPS: Some people would. SORKIN: -- with all that spending.

PHELPS: (Chuckles.) In economics, you can always take the other side. (Laughter.) I can -- I can do it too, you know. (Laughter.)

I have to -- at the end of the day, you have to use your intuition and judgment, and my intuition and judgment is this is not their -- we've gone as far as we can go. I think it's breathtaking that we were able to get this far and pay so little price for it. But I think now, the -- I think the day of reckoning is almost at hand, and we can't go in for the hair of the dog. We must not go -- it is not the time for more infrastructure projects.

SORKIN: OK, I'm going to try to get two more questions in.

You've had your hand up for a while, sir. Go ahead.

And then we'll try to get to you, and then we'll --

QUESTIONER: Nye Zwaboff (ph), Pace University. How do you reconcile your view of the world with the Reinhart-Rogoff view of the world?

PHELPS: I didn't know that there was a difference. I haven't read -- Carmen Reinhart's another student of mine in graduate school at Columbia. Ken Rogoff I know pretty well.

They say -- (inaudible) -- the difference would be that -- the difference would be -- look, there are two differences. First of all, they don't really come down on the side of one theory or another, so you never know exactly where you are in terms of a -- of a -- of a theoretical framework. They just -- but look, they grind a lot of data; they put a lot of data into the hopper, and they -- and they grind out some patterns, and they show you nice pictures, and there we have it. Still, you know, it's reasonable to pay attention to those -- to those observations.

And in one respect, they would -- they would support what I'm saying. They're saying look, you -- brace yourself for a long slump. When you get a deep slump, you don't come out of it right away. Usually, when you're having a deep slump, some pretty basic things are wrong, and it takes a while for them to get right. On the other hand, what I -- what -- I think that Reinhart and Rogoff are too narrow.

They're narrowly focused on financial crises. And I don't think that the -- I don't think that the slump we in -- that we're in is primarily financial. I think it's primarily those other things I talked about.

And I said -- made one point in my 15 minutes, namely that it's not as if the whole business sector was receiving massive loans from a kindly financial sector that was dutifully sifting good ideas from bad ideas and attentively hovering over the small-business men and helping them to innovate, and now -- and now that sector, which we love so much and on which we depended so much, has got sick. It's not as if that. They deserted us a long time ago. And they deserted the business sector a long time ago.

So I think Reinhart and Rogoff have gone too far in suggesting that our whole problem is the banking industry.

SORKIN: I promised I'd get one last question, so ask the question. We'll give you 60 seconds to answer it, since we are about -- we have about one minute left.

QUESTIONER: Jeff Laurenti with The -- Jeff Laurenti with The Century Foundation. To close on a foreign relations note, you know, what's striking in the current economic crisis is that U.S., Europe, Japan -- all stagnant. And the big developing country economies -- Brazil, India, China -- after an initial wobble seem to have resumed major growth rates. So the economically untrained person scratches his head and asks, I thought these were all supposed to be dependent on getting their imports -- or their exports into our markets, and what's going on here. So what's going on here? (Laughter.)

PHELPS: I go to China a lot, so -- in China, I think there's a lot of worry that things are not as rosy as you were suggesting they were. There's been a -- quite a correction in property prices, and this is -- politically, this is not a time when the government is prepared to take -- to conceive and to undertake some major new initiatives. It's the last year of the tenure of the present government. So I think it's an open question whether next year is going to be a good year for China.

But I -- but I think that generally, you're right that the idea of a rising tide lifts all boats -- that was never terrifically good theory, and I think -- (laughter) -- I think -- and I think we're now seeing that the boats are on separate oceans. Brazil is doing just fine, and some of the -- probably some of the countries in Asia, including India and maybe Vietnam and maybe Indonesia are also doing just fine, and even Africa has got a couple of stars. And to me, the world looks extremely variegated at the moment. And Europe and the United States are sick in part for the same reasons, but in part for different reasons.

SORKIN: Well, on that hopeful and somewhat depressing note at the same time -- (laughter) -- we would thank the professor. Thank you for being here. Appreciate it very, very much. (Applause.)

Thank you for your questions. Have a great afternoon, everybody. Thanks.

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THIS IS A RUSH TRANSCRIPT.

ANDREW ROSS SORKIN: Good afternoon, everybody. My name is Andrew Ross Sorkin with The New York Times and CNBC. I am pleased to introduce today Edmund Phelps -- Professor Edmund Phelps, I should say, director of the Center of Capitalism and Society at Columbia University and 2006 Nobel Laureate in economics.

I should remind everybody to turn off -- not just put on vibrate -- your cellphones, BlackBerrys and all other wireless devices to avoid interference with the very sensitive sound system. And I'd also like to recommend happily -- not recommend, rather, but remind everybody happily that this is on the record, for those journalists who are in the room, and finally to remind everybody that there is another meeting, a very exciting meeting tomorrow called the "Europe Update" tomorrow morning at 9:45 to 9:00 a.m. (sic). Hope you all can make that.

So with that very short introduction -- and then we're going to have a conversation in a little bit -- let me hand this over to the professor.

Professor.

EDMUND PHELPS: It's an enormous pleasure to be here. I'm all fired up over a number of issues, and I guess this'll be -- provide an opportunity to touch on some of them.

As you know and as I know, we have descended into a pretty deep slump, measured by unemployment and labor force participation rates. It is some consolation that we have been gaining some ground of late, private sector in particular. Public sector has been discharging people in the unemployment pool almost as fast as the private sector has been hiring them. But still I regard the situation as having moderately improved.

But my research suggests that we will not recover to the old normal, but to a new normal with, as a guess, an unemployment rate around 7 percent. We seek remedies for our ills, but the prescriptions we take will not have much value if they are not grounded in adequate economic theory, and that's where my -- where I come in today.

From the point of view of my theoretical and statistical work dating back to my 1994 book, "Structural Slumps," and my later research on structural blooms, not to mention my more recent work on economic dynamism, the present slump is widely misdiagnosed and the widely debated policy prescriptions ill founded, not grounded -- not well grounded.

Looking through my lenses, the present slump at this point appears to be structural. The previous structural slump, I would say, was Europe's slump in the 1980s. I'm inclined to think that the Great Depression was largely monetary, but more research could perhaps usefully be done.

I see three structural mechanisms at work behind today's structural slump. First, a depression has emerged in the values put on business assets such as commercial structures, such as important kinds of trained employees, those who handle information and those who used to be engaged in the innovation and growth departments. Price earnings ratios are around 12, where 10 years ago, if I'm not mistaken, the ratios were around, oh, 16. And I think I can recall 20 or more in frothier times.

The impact has been mainly -- the impact of these depression -- by this depression of business asset values per asset -- the impact has been mainly on business investment activity, and especially on innovative activity.

Employment in the financial sector has also taken a big hit. Second, a real exchange rate depreciation has come to the U.S., with the result that companies have been -- under the -- under the protection of the -- of the real exchange rate depreciation, they've been tempted to raise their markups, which they proceeded to do. Last -- third and last, the collapse of the artificial and highly speculative housing boom eliminated a huge number of construction jobs and jobs in some of the financial industries connected with construction.

I don't see the impairment of the banking industry by its -- by their -- by its poor balance sheets -- I don't see this impairment as a major cause of the slump, since the banks had ceased to be big lenders to business anyway. And I don't see the insolvency of households as a major source of the slump either. I don't think that consumer demand led the economy into the slump. Besides, production of consumer goods are far more capital-intensive than they are labor- intensive. And to put it crudely, investment activity is where the jobs are, including innovative activity -- development of -- development of projects that -- project development that is hoped to lead to innovation.

What are the main underlying structural causes of this depression?

The demographic prospect ahead of us is a large exodus of trained employees from the labor force, heavily over the 19 -- over the -- over the 2020s.

There has been a staggering rise of private wealth. In America, which I'm focusing on, much of this bloating is in the category of what I call social wealth. The present value -- and by the rise -- by private wealth here I mean the present -- I'm talking about the present value of assets, so to speak, present -- and the social wealth I'm talking about is the present value of unfunded social entitlements: $35 trillion for Medicaid, $23 trillion for Medicare and $8 trillion for Social Security, and that's not counting the public debt. In Greece and maybe France, I think we're seeing something similar.

In Europe, we see also a pathological excess of private saving, in part fueled by undertaxation, thus huge fiscal deficits and thus rising public debt. Now you might say, well, what's depressing about that? I thought capitalism was all about wealth accumulation, as one newspaper, I think is fond of saying. (Laughter.) Well, what's depressing about it is several things. It's not good for the labor force participation. If people are already as rich as Croesus, they may may not feel impelled to go out and get a job.

And another thing is it can cause big problems for companies when the personnel don't really need to take all that guff and don't need to put shoulder to wheel because they're doing fine, thank you, with their investments. And I could go on and on.

I could also argue the opposite side of this, but I won't do it. (Laughter.)

Another cause of the structural slump (trivially ?) is the overhang of housing, which leads to an enormous theoretical tangle of forces, which I won't dare go into today.

So that's my structural perspective. Oh, I wanted to say another thing. The -- perhaps the most -- single most important reason why we're in the doldrums is that we've been in a productivity slowdown since about 1973. And there were times when we forgot about it and thought it was over, because things were going so well; but then, after a while they weren't going so well any more. And it's now very clear, if you look at the data between 1973 or so and the present, that productivity growth is just a whole lot slower than it had been between, say, 1955 and 1973, or between 1921 and 1941. There's simply no comparison.

Now, the -- of course, there are all these rival theoretical perspectives. I had the pleasure at the Reuters Keynes-Hayek debate last week to attack the Keynesian premise that the slump is a result of deficiency of effective demand.

I'll just say here that there's no price deflation going on this slump, and there's not even any disinflation going on now. The Keynesian model simply has got -- not got to first base.

And it's appalling that so many people out there in the business world and elsewhere don't seem to realize that that's a totally outmoded -- oh, I won't say outmoded -- it's a totally inapplicable theory. The last time we had a hundred percent slump that was monetary in origin was the Great Slump in Britain in 1926, when Churchill put the pound back at the old price in terms of the dollar, requiring a humongous drop in money wages and money prices if they were ever to get back to full employment. And I could also oppose supply-side theories just as well.

But let me take the -- my remaining three minutes or so to say -- to articulate a couple of themes. People in this country have come to see the -- have been led to see the economy as a physical system that can be controlled by, so to speak, engineering the outcome you want to do, if necessary using rocket science. People -- and people have been led to that thinking because they're only provided with dumbed-down, highly mechanical, short-sighted, shallow theories like the rudimentary Keynesian theory and the rudimentary supply-side theory, which have no intertemporal depth to them whatsoever, because that would make them too hard.

Now, my keen interest in coming here today, I think, is really -- grows out of two particular irritations. One is the irritation -- my irritation with my friends on the -- shall we say Republican supply side, who think that a general tax increase would bring austerity, as if austerity were not already here and going to intensify anyway, whether or not we have a tax increase. I should try to say more about that later, but I can't say everything in my 15 minutes.

Also there's my irritation with the Democrat Keynesian group, who think that spending, and therefore employment, will be dashed by a cutback of 120 billion (dollars) in annual terms in government spending, as if the unfunded spending wasn't part of the problem, as if -- it's as if it's like recommending some guy with a terrible hangover that he go out and get another drink, the hair of the dog, you know? It just -- it boggles the mind.

This latter faction, the Democratic Keynesian faction, says -- and, I'm sorry, the supply-sider faction -- says that the only way out of the debt is not tax increases but to grow out of the problem, as if the function of the economy were to cover for the politicians who had blundered and overspent and as if there were push-buttons available for speeding up growth, which is one of the things we least understand.

I want to make just two crucial points in the last minute.

One, since 1990 or so, we've needed to build up fiscal surpluses in view of the looming overhang of entitlements that will start becoming due in the year 2012. I think -- I mentioned that we've got Medicaid entitlements of -- I've lost the number here, but -- these entitlements add up to 66 trillion (dollars).

I've asked myself, well, suppose we could get some insurance company in the Netherlands or something to annualize this for us so that the federal government would each year pay a constant flow. Well, how much would the insurance company require in constant flow to cover that 66 trillion (dollars)? And of course, it depends on what rate of return, so to speak, the insurance company requires. At 2 percent, the federal government would have to spend 1.52 trillion (dollars) per annum to the insurance company to take care of -- indefinitely, in perpetuity -- to take care of the problem. At 3 percent, it would 2.28 trillion (dollars). So we're just miles from getting into solvency the way we're going.

And then there's finally -- my second point is, I think in all the discussion of the poor condition of the economy, we're overlooking the tremendous slowdown since 1973. We had the -- and now there are signs that we're having technological displacement of a lot of workers as a result of the Internet revolution before that. So we're in really a terrible pickle, but I think at least we can be -- the way forward is -- it's got to begin with applicable thinking about the root causes of our situation.

Thank you. (Applause.)

SORKIN: Thank you, professor. So what we're hoping to do -- and that was just a framework to really get everybody thinking about where the professor's head is. And what I'm hoping we can do is make this as interactive as possible.

I have a couple of questions that your conversation's already raised for me, and then I'm hoping to throw it open to the audience, and I imagine you have much smarter questions than I do.

Given the news of the day, which is the failure of the supercommittee, it occurs to me that if I could make you the supercommittee of one, given the framework that you just laid out, in a politically palatable way -- if you think that's even possible -- you would do what?

PHELPS: (Sighs.) (Laughter.) Well, in that -- in the context of the supercommittee -- thanks for the question; it's nice. (Laughter.) Well, you sort of threw me with that last -- on the condition that it -- I not get assassinated the next morning by, or I wouldn't be --

SORKIN: Well, forget the politics. If you -- if you could do it your way --

PHELPS: -- chased by angry crowds burning torches?

SORKIN: No, if you could do it your way --

PHELPS: Yeah.

SORKIN: -- but recognizing the political climate that we're in --

PHELPS: But within the framework -- within the parameters of Western civilization, in other words, yeah. Yeah. (Laughter.)

SORKIN: Yeah, we'll take that.

PHELPS: (Laughs.) Right. I would go for a general tax increase, starting with the first bracket. I don't like the idea that the bottom 45 percent pay virtually no income taxes net of -- net of various sorts of entitlements. And I -- and I -- though I have no special sympathy for the rich, I do think that we'll get the -- we'll get the biggest bang in terms of employment, innovation and productivity growth if we go about raising our revenues more efficiently. And that means loading more of the burden on the early brackets -- on the first brackets, rather than focusing the heaviest burden on the higher brackets, which are marginal tax rates -- which are marginal tax rates for those people who are -- who are actually paying taxes.

If you wanted to raise the highest revenue you could, you wouldn't tax -- you wouldn't have a positive marginal tax rate on that last dollar. What would be the point?

SORKIN: Right. You -- but you would spend more attention on the taxes than you would on the cutting?

PHELPS: Secondly, I would also be happy to -- I'd actually -- the one-sentence answer that I should have started with, probably, is I would like to roll things back to about the year 2000, before the Bush free pills, before the Bush tax cuts, before the myriad spending motivated -- driven by both Democrats and Republicans. I would be very -- I would -- I would like to go back to there. And so yeah, I would -- I would certainly get rid of the free pills. And I don't -- and I don't like that -- I don't like the -- those across-the-board tax cuts that Bush initiated, no.

SORKIN: You mentioned the idea of 7 percent unemployment as a potentially realistic number that we could reach.

PHELPS: Yeah, right.

SORKIN: When could we reach that, and how?

PHELPS: I've been more confident about the number than about the speed. (Chuckles.) That's one derivative too much for me -- (laughter) -- for those mathematicians in the audience. The recovery has certainly gone much slower than I thought. I may have been hoping and expecting a very strong recovery such as occurred -- such as began in 1934 in the U.S. at the bottom of the Depression. But I guess there's just too much -- too much damage done to the system. It's just -- it was -- I think -- we're not going to have a --

SORKIN: But we can get to --

PHELPS: We're not going to have a fast recovery to 7 (percent). On the other hand --

SORKIN: But we can get to 7 percent by doing everything -- (inaudible) --

PHELPS: Belief that we're going to 7 (percent) doesn't mean that we're going to crawl there decade by decade. Look, I -- look, I -- the collapse started in 2007. I think a lot of macroeconomists would agree that by 2020 it would look like most of the damage had been cleared away and things were looking pretty normal again.

SORKIN: You made a comment about inflation versus deflation and suggested that we have not had any deflation. This was in the context of what would happen if we raised taxes. And I was going to suggest to you housing is a market that I think it would be hard to argue we haven't had deflation.

PHELPS: Well, that gets into how we want to talk about monetary magnitudes and how we want to talk about structural or nonmonetary magnitudes. For me, the interesting price of houses is the real prices of houses, the price that -- expressed in terms of consumer goods, the price deflated by the Consumer Price Index. So yeah, we've had a tremendous decline in the real price of houses, but we would have had that decline even if we somehow could figure out a way to operate the economy without money. We've still had -- we would have still had a speculative boom in the relative price of housing and still had -- and could still have had that and could still have had the collapse.

So -- there's a reason why the national income statisticians around the world fix on consumer goods when they talk about inflation. It's normal. Look, the decline in the real price of houses is on my side. It's a point in favor of the structural interpretation. You can't take that point away from me and say it's a point in favor of some monetary theory of the slump.

That doesn't make any sense to me.

SORKIN: OK. You know, in the conversation and debate between Hayek and Keynes, one of the comments you made that struck me was this idea that if we cut -- this was sort of the Keynes argument -- if we cut -- or the Democratic argument -- if we cut $120 billion -- I think was the number who had cited -- from the government, it wouldn't have an impact, or -- a lot of the Democrats would argue it would have a huge impact on the economy. You say it wouldn't.

PHELPS: It's what I said here.

SORKIN: That's what you just said.

PHELPS: Yeah.

SORKIN: Yes. (Laughter.)

PHELPS: (Laughs.) I thought you were saying that I said it in the Keynes debate.

SORKIN: No, I -- no, but I ask why, given that you're going to take that money directly out of the system tomorrow, maybe over a period of time, but the immediate has to be felt at some level, no?

PHELPS: Well, I was making a lot of -- I made -- I already hinted at some of the thinking I have in mind. A lot of consumer -- a lot of the -- much of the production -- the production of much of the consumer goods is highly capital-intensive, so -- ever seen "North by Northwest," that scene where Cary Grant is in the field and the crop duster pilot is trying to kill Cary Grant? And all you see is this vast openness, this vast field, producing this vast amount of farm output with not a single person in sight except for the Cary Grant character. (Laughter.) That's food, but it's really all over the place. Now, I guess how many jobs you lost on that account would depend upon the details.

The other thing is that -- a point behind my debunking or devaluing consumer demand, I mean, there are a number of things to say. I made one point -- just made one point against attaching so much importance to consumer demand; namely, the production is very capital intensive. Another point is, high consumer demand makes for a -- no, sorry, that's the wrong point. The other point is that if there's a -- you maybe think this is stretching things, but to the extent that the whole world thinks, oh, great, consumer demand, yes, let's offer more benefits to make people consumer more -- to the extent that that becomes a kind of endemic way of thinking in the Western world, that's going to drive up world real interest rates, and so you may lose more jobs indirectly by hitting investment activity on the head than you gain directly by the increased purchases of consumer goods.

Now, that's a complicated argument. If it's just the United States alone that increases consumer demand, you might say that, OK, the U.S. is big but it's not all that big, and the effect on the world real rate of interest -- and even the U.S. real rate of interest because it's to some extent linked to the world real rate of interest -- won't rise so much. But -- so, I mean, I got a whole portfolio of reasons for de-emphasizing consumer demand and emphasizing investment demand.

Finally, just if I can just add one more point, you can look at time series data for, let's say, the U.S. economy, and it's just extraordinary how output tends to be explained by one thing: namely, real investment expenditures. That just -- it just hits you. It strikes you that that is the -- it's naked on the face.

It's -- output is driven by investment expenditures, which in (turn ?) becomes somebody's income, which leads to consumption. But the driver -- it's statistically pretty evident that the driver is investment demand, it's not consumption demand.

SORKIN: You talked a lot about investment demand -- and this is my last question, then I will try to open it up. Virtually every CEO that I talk to suggests that one of the big problems that we're living in right now is this sense of remarkable uncertainty, that the regulatory environment, that -- which they suggest is impacting the economy unto itself, and that it is -- it is this general sense of uncertainty of what's coming next that is actually keeping people from making investments. Do you believe that?

PHELPS: I certainly believe that there's something in it, but then I also -- and what's in it is, of course, that business people don't yet know what the details -- what the description will be of the eventual response of the U.S. Congress to the towering fiscal deficits. So businesses may be afraid that the whole burden of adjustment's going to be loaded onto higher tax rates, including or not excluding higher corporate tax rates. So it's understandable that that's another reason for businesses to wait about investment projects.

On the other hand, there's a fair amount of mistaken thinking on this score, I think, because if there's one thing that we can be sure of is that there's going to be a contraction of one kind of demand or another: either there's going -- either there going -- either there's going to be less government spending or there's going to be less -- which could -- which would further impact on consumer spending possibly -- or there's going to be higher taxes, which may impact on investment spending. But either way, there's going to be less money and the impact is going to be to either take away -- people are either going to -- the impact on their pocketbooks from day one is either going to be -- is going to be negative whether they've -- whether households have lost benefits or whether households have to pay more taxes. So there's a certainty about that.

SORKIN: Right, right.

PHELPS: It's only the incidence of whose ox is going to be gored that there's uncertainty over.

SORKIN: So the uncertainty is certain?

PHELPS: (Inaudible.)

SORKIN: On that note, why don't we open it for questions? I know many of you have one.

Dan, you have a good seat here in the front. So the microphone's coming around.

QUESTIONER: Hi, Dan Altman with North Yard Economics and NYU.

Professor, you said that we're heading for 7 percent unemployment. When I was first taking economics courses, they said that the natural rate of unemployment was 6.5 percent. (Chuckles.) That wasn't so long ago, maybe 20 years. And so my question for you is, instead of having a structural slump now that's heading us to a new normal, could it be that we had a monetary-fueled boom, which is now taking us back to the old normal? (Laughter.)

PHELPS: I'm not exactly sure when you were young and studying this -- (laughter) -- course. (Chuckles.) My benchmark has been the unemployment rate in the middle of the 1990s, which is 5.6 for two years in a row, with inflation neither rising nor falling, conditions pretty tranquil. It was just before the dawn of the age of the Internet.

And so -- so then how did I get to 7 (percent)? So I got to thinking, well, those times were a bit brighter than the times now. For one thing, the overhang of -- the overhang of entitlements had not gotten to nearly the same proportions that it has now.

Secondly, in 1995 and 1996, 2020 seemed remote. That's the time when the Baby Boomers will start leaving, en masse, the -- their jobs in the private sector. So for those two reasons alone, we would expect a higher natural unemployment rate now, in the sense of a steady-state, medium-term natural unemployment rate, than we had in the middle of the 1990s.

Finally, in addition, I have become gloomier about innovation and economic growth than I and, I think, most people were in 1995 and 1996. We've just been through 10 or 11 years with slower growth than we had between 1990 and 1995. I'm hard pressed to think of a single reason why the natural unemployment rate should be lower now than it was in 1995 and 1996, but --

SORKIN: Yes, sir.

QUESTIONER: I'm Kenneth Bialkin, Skadden Arps. I'm reminded, or I have to think about a statement made by President Roosevelt in the '30s, when he announced to the American public that the only thing we have to fear is fear itself. If we would translate that psychological observation to today, we'd define it in terms of optimism or pessimism, the willingness of businesses to invest and expand, the willingness of persons (and workers ?) to spend and look more optimistic about things.

And if our objective was to restore optimism to America about the future, if the objective was to restore optimism in the businesses who think about investing and expanding, what steps would be taken to try to encourage that optimism? And to what extent would that optimism depend, to some extent, on the prospects of political change or development? We're coming up to an election next year. Different people have different attitudes about what might be the economic policy of -- (inaudible) -- and I wonder if you could speculate or comment on the validity of this observation, that all economic activity is a derivative of the attitude that people have about the future.

PHELPS: Thanks a lot. I love that question. I think that the rebirth of optimism is going to depend upon the rebirth of something objective that you can hang your hat on, that you can hang your optimism on. In getting ready for -- in the preparations for this meeting, I had to write a few lines about what I wanted to talk about, and the lines in front of me I didn't get to at all. So let me, in answer to your question, say what I didn't -- what I said in my forecast of what I would say, which I didn't say here. I think -- I think what's required to get back to a genuine feeling of prosperity and flourishing is some long-needed surgery to shop the -- to stop the "short-termism," to restructure and innovate the financial sector, and to encourage the renewal of a culture of exploration and vision leading to economy-wide innovation -- and thus, a back seat for the money culture, which has been in the driver's seat for at least a decade.

And of course, we have to put down -- as I was saying, we have to put down -- we have to stop this push-button mechanics mentality that, oh, the economy, all you have to do is just get right the tuning of the various instruments and we'll be -- we'll be fine again. We have to stop that. That goes for the Keynesians as well as the suppliers -- supply-siders.

I would like to see the end of the "Know Nothings" in the free market camp. I'd like to see an end to the -- to the believers in scientism. That's the idea that all the fruits of Western civilization are owed to the scientists, and there's no creativity in the economy at all; nobody in the economy ever had a new idea in his or her life. And by the way, that goes back to Schumpeter and, before Schumpeter, Shpikov (sp). That's where Schumpeter got it.

In Schumpeter, the new ideas are from scientists and navigators outside the economic system. We have to stop that, and you people in business should really be pushing to make it clear to the general public that you are engaged -- in your good days, anyway -- you're engaged -- or in your better days -- (laughs, laughter) -- you're engaged, or you were engaged, in innovating and having new ideas, and mulling them over and talking about them and developing some of them, and then trying to market them and, with luck, getting them adopted.

And so that's -- I think that's -- we need to have a kind of reformation, a kind of restoration of the -- of the spirit of the country that I think prevailed between -- hard to say when it started, but prevailed -- it certainly was visible and present -- present and visible in the early 19th century, and was going full steam at least till the end of the 1940s.

SORKIN: I have a quick follow-up on that. And I should also tell you I am going to out you. The font on that that you were reading is impossible to read, even for myself, and I --

PHELPS: (Laughs.) Glasses.

SORKIN: It's the tiniest font you've ever seen, so -- You know, one of the things that strikes me as you were saying it, is I started to think a little bit about Occupy Wall Street, and the economic inequality story and argument that's been made for many years but is clearly now in focus. How important is it to bridge that divide for the long-term sustainability and success of our economy? Does it matter? PHELPS: Andrew, you ask such hard questions. That's a tough one.

SORKIN: I only ask because you talk about the confidence that the entire economy needs to keep growing, and I'm curious how the inequality story relates to that, if it does.

PHELPS: Well, let me say right away that I pride myself on having had an early interest in economic justice. And I was extraordinarily fortunate, and damn lucky, that for a year I sat in my office next to John Rawls, just across the wall, when he was writing his book, "A Theory of Economic (sic) Justice." But, you know, Rawls is not about inequality. He doesn't say you shouldn't have inequality. He says you're bound to have inequality; it's what you do with it that counts. And he wanted -- he was willing to harness inequality in the interests of people in the labor force who were disadvantaged and had the lowest wage rates.

His idea was that the tax system and other levers of government should be operated in such a way as to pull up wage rates at the bottom, and pull up employment opportunities as well, to the maximum possible extent, by calibration of the economic system in such a way that it would -- it would create incentives for everybody to work hard and invest and save and so forth, and then thereby pull up the bottom.

So I've been a little bit put off by the occupiers when they talk about inequality, but then I realize that's pedantic on my part.

They're not saying that they never saw an inequality they never liked -- that they didn't like -- that they liked; they're saying that it's the particular inequalities that they see that they are appalled by. And I suppose they haven't -- I did go down there one day and I did talk to them one day, and I acknowledged that in my humble opinion, I think there has to be some radical restructuring of parts of the financial sector. I think we need a banking industry that serves the needs of business for financing innovation, things like that.

Anyway, so -- but I think your question is really, is the economy, even in the most -- even in the more aggregative terms is the economy suffering from the inequality? And some crude Keynesians -- it's the only kind there are, but the -- (laughter) -- (laughs) -- the crude Keynesians, or for short, the Keynesians, suggest, of course, that, oh, the -- if there was -- if some income could be taken from the rich and be given to the poor, there would be higher consumer demand, and that would float the whole economy up and make everybody, maybe even the rich, better off, or make nearly everybody better off, in any case.

I think, you know, as you will see -- as you must have noticed from everything I said, I disagree vehemently with that idea that you can -- yeah, I can think of -- there's one argument you can make why higher consumption demand could be good for employment, but it's very short-termist. You could say that high consumer demand pushes up the currency, pulls up the currency and that cuts mark-ups of companies and that leads to higher employment. The trouble is that the -- the higher -- the appreciation of the currency, or the real exchange rate appreciation will drive away customers; eventually the stock of customers will have settled -- will have declined to the point where output is right back to where it was before. So that's a lousy argument. (Pause.)

SORKIN: Why don't we leave it there.

PHELPS: I mean, I just -- I just -- I have an old-fashioned position. I want to redistribute -- to pull up wages at the bottom. I really don't give a damn much about inequality as such.

SORKIN: OK.

PHELPS: I'm not interested in whether Rockefeller -- Rockefellers own half of Maine or Ted Turner owns some big chunk of Montana. It doesn't affect me in my daily life. I have my work, my gratifications. (Laughter.) I'm sorry, it just doesn't -- I don't see where people are coming from when they talk about that.

SORKIN: OK. Paul Steiger with a question, sir.

QUESTIONER: Paul Steiger from ProPublica and from your Economics 10 class 50 years ago. (Laughter.)

You talked about productivity and the attenuation of its growth. Could you talk a little more about that? What has caused it? Is it the reduction in manufacturing and its size in our economy? And how could that be turned around? And also, since increased productivity means, to some extent, fewer jobs, how do you reconcile those two objectives?

PHELPS: Thanks, Paul. He really was a student 50-some years ago. We were both young.

Well, funnily enough, the decline of productivity growth was rather abrupt. It was sudden. It was almost from one day to the next, (gone ?) by 1973. So it would be hard to say it was because of some long -- long, slow-moving, long-time shift in the structure of the economy.

So it's -- I think it's to some extent a puzzle. And I'm not -- I'm not sure that -- I'm not sure that there are any easy answers. I think we're a long way from an understanding of that puzzle.

I agree with you that it certainly hasn't helped that we've suffered a decline in the relative importance of manufacturing since 1973, maybe to some extent before that, too. So that since -- it seems to be easier to innovate in manufacturing than in some other sectors of the economy, that may be helping to account for slower productivity growth now than we had, let's say, in the 1950 and '60s. But manufacturing doesn't have any monopoly over productivity growth. There was phenomenal productivity growth in agriculture in the United States from the 1880s or so right through to 1930 or so. Let's leave the Dust Bowl out of it.

And I think we've had significant productivity gains in services, medical care; maybe some of medical care falls under manufacturing, I don't know. I think it's a cultural thing. I think we cannot have rapid productivity growth without -- without its being broad-based and without its -- without there being to some extent activity everywhere in the economy oriented to trying out a different -- conceiving, developing and trying out a different way of doing things, or conceiving, developing and marketing a different product.

I've read a little bit around about the 19th century. I'm finishing a book on the modern economy from 1815 or so to the present, so I've rummaged around quite a bit of literature, and I'm by no means a professional historian, but I got this sense that the 19th century was so exciting, because everybody in the little artisanal shops and everybody on the farms and everybody was tinkering. Everybody was exploring. Everybody was trying to look for a better way of doing things. There was a new culture. And I think -- I don't know -- I don't think we can just push buttons, enact some legislation and then sit back and watch the flowering begin. I think that we have to get back to the -- to the spirit of innovation.

SORKIN: Yes, sir.

QUESTIONER: I'm Gerald Pollack (sp). Professor Phelps, could you elaborate a little more your criticism of the Keynesian approach? Now, just assuming that we could have, you know, a longer-term solution to the budget problem, the debt problem, in the shorter term what's wrong with the government borrowing money now at currently low interest rates for the sake of spending money on behalf of infrastructure projects and to give to states so that they could maintain their employment rather than lay off as many people as they've been laying off? What's basically wrong with that?

PHELPS: Well, in general, it's not wrong. In general I think there are good instincts there. Hoover instinctively -- he was an engineer, as you know -- he instinctively thought in terms of engineering projects -- infrastructure projects. And Roosevelt, I think -- and some have said that the differences between Roosevelt's program and Hoover's program are not all -- are not great.

They don't bowl you over with their -- with their dissimilarity. And Keynes, of course -- and as you may know, in 1933 or so, he was -- or '32 -- he was always talking about infrastructure investments.

So it's always been part of the popular instinct to go for infrastructure developments, and it is -- it's not -- it's not the worst economics because investment goods tend to be labor intensive. So, as I was saying before, it does make a certain amount of sense to go for them.

The thing is, though, that we now have $66 trillion in -- of entitlements and $10 trillion of public debt, rising by $1 trillion every year, and we don't know what sort of a mess is going -- we're -- is going to be on our doorstep from Europe, and we don't even -- can't even be too sure about the health of the Chinese economy over the next two or three years. So I don't know.

We're in a very precarious situation, and I would be extremely concerned, just downright worried, if the Congress were to say, OK, let's do another half trillion (dollars) a year in infrastructure projects. I would be worried about what would happen to the stock market and the bond market and the dollar. I don't want to see a further weakening of the dollar. It'll push up markups. I don't want to see the stock market drop. It'll reduce IPOs, tend to reduce new firm startups.

SORKIN: And the market falls because?

PHELPS: Higher expectations of people gagging on all the increase in debt in the future and --

SORKIN: The stock market, though, you're saying falls?

PHELPS: Hmm?

SORKIN: You're saying the stock market falls? Some people would --

PHELPS: Sure.

SORKIN: -- argue the stock market would go up --

PHELPS: Some people would. SORKIN: -- with all that spending.

PHELPS: (Chuckles.) In economics, you can always take the other side. (Laughter.) I can -- I can do it too, you know. (Laughter.)

I have to -- at the end of the day, you have to use your intuition and judgment, and my intuition and judgment is this is not their -- we've gone as far as we can go. I think it's breathtaking that we were able to get this far and pay so little price for it. But I think now, the -- I think the day of reckoning is almost at hand, and we can't go in for the hair of the dog. We must not go -- it is not the time for more infrastructure projects.

SORKIN: OK, I'm going to try to get two more questions in.

You've had your hand up for a while, sir. Go ahead.

And then we'll try to get to you, and then we'll --

QUESTIONER: Nye Zwaboff (ph), Pace University. How do you reconcile your view of the world with the Reinhart-Rogoff view of the world?

PHELPS: I didn't know that there was a difference. I haven't read -- Carmen Reinhart's another student of mine in graduate school at Columbia. Ken Rogoff I know pretty well.

They say -- (inaudible) -- the difference would be that -- the difference would be -- look, there are two differences. First of all, they don't really come down on the side of one theory or another, so you never know exactly where you are in terms of a -- of a -- of a theoretical framework. They just -- but look, they grind a lot of data; they put a lot of data into the hopper, and they -- and they grind out some patterns, and they show you nice pictures, and there we have it. Still, you know, it's reasonable to pay attention to those -- to those observations.

And in one respect, they would -- they would support what I'm saying. They're saying look, you -- brace yourself for a long slump. When you get a deep slump, you don't come out of it right away. Usually, when you're having a deep slump, some pretty basic things are wrong, and it takes a while for them to get right. On the other hand, what I -- what -- I think that Reinhart and Rogoff are too narrow.

They're narrowly focused on financial crises. And I don't think that the -- I don't think that the slump we in -- that we're in is primarily financial. I think it's primarily those other things I talked about.

And I said -- made one point in my 15 minutes, namely that it's not as if the whole business sector was receiving massive loans from a kindly financial sector that was dutifully sifting good ideas from bad ideas and attentively hovering over the small-business men and helping them to innovate, and now -- and now that sector, which we love so much and on which we depended so much, has got sick. It's not as if that. They deserted us a long time ago. And they deserted the business sector a long time ago.

So I think Reinhart and Rogoff have gone too far in suggesting that our whole problem is the banking industry.

SORKIN: I promised I'd get one last question, so ask the question. We'll give you 60 seconds to answer it, since we are about -- we have about one minute left.

QUESTIONER: Jeff Laurenti with The -- Jeff Laurenti with The Century Foundation. To close on a foreign relations note, you know, what's striking in the current economic crisis is that U.S., Europe, Japan -- all stagnant. And the big developing country economies -- Brazil, India, China -- after an initial wobble seem to have resumed major growth rates. So the economically untrained person scratches his head and asks, I thought these were all supposed to be dependent on getting their imports -- or their exports into our markets, and what's going on here. So what's going on here? (Laughter.)

PHELPS: I go to China a lot, so -- in China, I think there's a lot of worry that things are not as rosy as you were suggesting they were. There's been a -- quite a correction in property prices, and this is -- politically, this is not a time when the government is prepared to take -- to conceive and to undertake some major new initiatives. It's the last year of the tenure of the present government. So I think it's an open question whether next year is going to be a good year for China.

But I -- but I think that generally, you're right that the idea of a rising tide lifts all boats -- that was never terrifically good theory, and I think -- (laughter) -- I think -- and I think we're now seeing that the boats are on separate oceans. Brazil is doing just fine, and some of the -- probably some of the countries in Asia, including India and maybe Vietnam and maybe Indonesia are also doing just fine, and even Africa has got a couple of stars. And to me, the world looks extremely variegated at the moment. And Europe and the United States are sick in part for the same reasons, but in part for different reasons.

SORKIN: Well, on that hopeful and somewhat depressing note at the same time -- (laughter) -- we would thank the professor. Thank you for being here. Appreciate it very, very much. (Applause.)

Thank you for your questions. Have a great afternoon, everybody. Thanks.

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