The latest data, courtesy of the Census Bureau, which released its annual update on incomes and poverty yesterday, showed that median household income increased a whopping 5.2 percent in 2015 to an inflation-adjusted $56,516. As the New York Times, noted, it was “the largest single-year increase since record-keeping began in 1967.”

Some killjoys will note that median household income was $57,909 in 1999. That’s true, but the dot-com crash, housing bust and the credit crisis managed to cut that a lot. Median incomes fell 2.59 percent from 2000 to 2004, before almost rebounding to the pre-crisis peak. After 2007, the collapse was greater — a 4.94 percent drop that bottomed in 2013.

Positive Surprise

Ignore the naysayers; the most recent numbers were a huge positive surprise, showing that incomes for all Americans are rising in a meaningful way. Unlike in recent years, when much of the gains went to an increasingly narrow group at the top of the economic strata, last year’s improvements were broad.

Gains were spread across the income spectrum and by race, while women’s earnings inched closer to men’s.

This is yet more evidence of a job market that, as we previously noted, is not getting weaker but stronger — despite the occasional disappointing number.

Of particular surprise to many was that the strongest gains were found among the lowest earners. To what shall we attribute these gains? Two things deserve most of the credit:

More people working: The big year-over-year change in employment, with almost 2.5 million more Americans working now than a year earlier, contributed to a meaningful change in total household income.

Corporate pay increases: Some of the U.S.’s largest employers, such as McDonald’s and Wal-Mart, have played a significant role in raising incomes at the lower end of the income distribution. Wal-Mart in particular made substantial increases in wages for its lowest-paid employees. These increases stand in sharp contrast to the company’s pay policies of just a few years ago. Note that the increases are not just a public-relations effort, but due to the competitive labor environment; higher pay is needed to recruit and retain workers (and because workers demoralized by the low pay and unappealing employment conditions were hurting the shopping experience for Wal-Mart customers).

The latest data is unequivocally good for households; what investors need to do is consider what this might mean more broadly. Rising incomes have ramifications for inflation, Federal Reserve policy, interest rates, retail spending, auto sales and residential real estate.

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The U.S. is fairly close to full employment and seeing continued positive momentum. Supposed remedies such as making interest rates negative, with the goal of accelerating monetary circulation, seem better suited to 2010 than 2016.

Maybe it’s time to start paying more attention to other approaches, specifically those based on the supply side. Supply-side economics has been discredited since the Bush tax cuts failed to boost economic growth, but there is another way of thinking about the problem. It is not enough for funds to be left in the hands of the wealthy; rather they must be invested in risk-bearing equity capital, focused on innovation.

So argues Edward Conard in his new book, “The Upside of Inequality: How Good Intentions Undermine the Middle Class.” Think of it as a revamp of supply-side economics but with the concept of risk-bearing at the core, a fitting perspective for an author who was a founding partner of the private equity firm Bain Capital and a former business associate of Mitt Romney.

Secular Stagnation

In this view, traditional demand stimulus is at best defensive in nature. It may limit further collapse, but it won’t much revitalize risk-taking.

Weak demand is not a cause in and of itself. It is a symptom of a shortage of equity willing and able to bear risk.

You may recall that the iPhone made its debut in 2007, and it sold very well during the tough economic times that followed. Had there been more innovations of import, a simultaneous growth of production and market demand could have been self-validating and pulled the economy out of recession more quickly.

This framework makes Conard a revisionist on the U.S. trade deficit. The traditional story is that Americans buy goods from, say, East Asia, and the sellers respond by investing those dollars back in the U.S., a win-win situation. Conard believes that analysis would hold only if people who accumulate cash from foreign transactions invest their funds into risky, innovative enterprises.

So how can we stop savings from being deployed in too risk-averse a manner? To provide my own personal list, let’s target the bureaucratization of society, excess regulation, the high cost of moving talented labor into cities with building restrictions and thus expensive rents, overly cautious financial intermediaries (most capital isn’t venture capital), policy instability and a general fear of the future all may choke off entrepreneurship.

Keynesian economics

Keynesian economics focuses on sticky nominal wages as one obstacle to increasing production, but especially these days that seems like only one small part of a much bigger story. Some good news is that the Chinese are interested in further diversification into equity and away from government securities.

Maybe supply-side economics isn’t as wrong as its reputation indicates. Maybe the earlier supply siders just spent too much time focusing on one supply obstacle – high taxes – when other barriers were bigger problems.

Conard recognizes that there are many factors behind slow innovation, but for my taste he plays up tax cuts too much, believing that the wealthy are sufficiently willing to bear risk and dynamically invest. Consistent with this view, Conard argues that the American middle class has in recent times experienced bigger real income gains than the numbers indicate, once job benefits are counted properly.

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Instead of clarity about the economic outlook, the Federal Reserve is delivering Kodak moments, highly staged events that seek to communicate control but which really suggest that form has replaced substance. If the Fed’s objective last week was to put its September meeting back into play as the potential venue for a rate increase, it can claim a partial success.

Prices in the futures market show traders now see about a 34 percent chance of a hike on Sept. 21, up from 22 percent two weeks ago. But you still have to go out to December before the likelihood rises above 50 percent.

There’s a very good reason for that market skepticism. Raising rates at a time when inflation is dormant and miles away from the central bank’s 2 percent target seems somewhat perverse.

The Jackson Hole Symposium (and let us note in passing what a great word symposium is, adding gravitas to what would otherwise be a mere conference) was an opportunity, as the event title said, to consider “Designing Resilient Monetary Policy Frameworks for the Future.” Instead, Fischer’s comment suggests it’s business as usual at the Federal Open Market Committee, with no room at present for such innovations as changing the inflation goal or targeting nominal gross domestic product.

Fiscal expansion

That’s a shame. There’s a consensus that monetary policy is becoming impotent, and that governments need to step in with fiscal stimulus. But until central banks admit that their firepower is waning, politicians can continue to evade responsibility. “You can’t expect us to do the whole job,” Christopher Sims, a Nobel Prize-winning economist from Princeton University, said last week. “Fiscal expansion can replace ineffective monetary policy at the zero lower bound. So long as the legislature has no clue of its role in these problems, nothing is going to get done. Of course, convincing them that they have a role and there is something they should be doing, especially in the U.S., may be a major task.”

Finance — particularly in an era of fractional reserve banking — is essentially a confidence trick. Depositors have to be confident their money will be there when they try to withdraw it. Businesses have to be confident that the economy is on a sound footing otherwise they won’t invest and hire. Central bankers aren’t just economists and policy makers; they’re also salespeople, selling a story.

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The key was the explosion of affordable information technology that made it easier to gather and analyze data. By the ’90s, there was such a huge stock of untested theories and such a wealth of new data that it made more sense for young, smart economists to turn their efforts in empirical directions. Unlike in physics, where theory and experiment call for very different skill sets, most economists found they could switch from theory to data relatively easily. Prizes like the prestigious Bates Clark Medal awarded to rising economics stars under age 40 started to flow to people whose work emphasized data.

But there’s a second shift in progress — a sort of Stage 2 of the data revolution in economics. The tools of economists are changing.

The core of economics theory, as it’s practiced today, is based on individual optimization. For example, economists often assume that businesses maximize profits or minimize costs. This is known as a structural model, because economists usually assume that this sort of optimization represents the deep, fundamental structure of the economy, just like everything in your body is made up of atoms and molecules. Comparing this kind of model to data is called structural estimation, and for a while it formed the core of empirical economics.

Structural models

But structural estimation has its limitations. Since structural models are usually very complicated, the answers they give to simple questions — for example, “How many people will lose their jobs if we raise the minimum wage?” — can be very sensitive to the assumptions of the model. Tweak one assumption, and the answer might come out completely wrong.

So in recent years, many economists have been turning to an alternative approach and chucking theory out the window entirely. Instead of a complicated model about optimization and utility functions and blah blah blah, just look for a case where some kind of random change in the economy — a so-called natural experiment — offers a window into some important question. For example, you could study a random influx of refugees to answer the question of how immigration affects local labor markets. You don’t need a complicated theory of how workers and companies behave — all you need is a simple linear model of how X affects Y.

The chief evangelists of this approach are economists Angrist and Jörn-Steffen Pischke. They have called the advent of natural experiments — also called quasi-experimental methods — the “credibility revolution.” And their book about the subject is titled “Mostly Harmless Econometrics.” The implication is that quasi-experimental studies, because they are more humble than structural models, are also less likely to give us the wrong answers to our most important questions.

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Most of the world’s wealthiest and best-governed countries got there without super-rapid bursts of growth. Denmark, which has a per capita income of about $52,000 and is frequently ranked as one of the happiest countries in the world, never experienced what anyone would call an economic miracle. If you Google that phrase, the main entry will be a research piece detailing how, in the 1990s, the country lowered its unemployment rate without having to dismantle its welfare state.

Economic Record

Denmark’s overall economic record is gloriously boring. From 1890 to 1916, per capita growth averaged about 1.9 percent per year, and if in 1916 you had forecast that this pace would continue for another 100 years, you would have been off by only about $200. Denmark had positive growth about 84 percent of the time and no deep recessions, according to a recent study by Lant Pritchett and Lawrence Summers.

Or consider the U.S., where per capita income surpassed Latin America in the 19th century –thanks mainly to the latter’s stagnation. U.S. growth rates at the time were typically below 2 percent, and even lower up through 1860, hardly impressive by the standards of today’s China or India — or for that matter today’s U.S. The big advantage of the U.S. is that it avoided major catastrophe for long periods of time, apart from the Civil War, and pushed ahead with fairly steady progress.

The 19th-century Latin American stagnation, aside from wasting valuable time, left much of the region with weaker infrastructure, poor educational systems and a more dysfunctional politics.

Slow growth doesn’t mean that the U.S. or Denmark were failures in the 19th century. It’s hard for economies at or near the technological frontier to rapidly improve living standards, because invention is usually slower than playing catch-up by borrowing technologies from wealthier nations. Such borrowing of know-how, along with exports and rapid investments in education and infrastructure, is what later allowed the Asian tigers of Japan, South Korea, Taiwan, Hong Kong, Singapore and China to achieve growth rates of 8 percent to 10 percent a year.

Slow and steady

If you’re an investor, the experience of Denmark and other “no drama” growth stories provides some clues to the future of developing economies. The East Asian growth model, for all its wonders, belongs to history. Slow and steady may be the only option left. For whatever reasons, few countries have been able to scale up their educational successes as rapidly as the East Asian tigers. Trade growth, which exceeded overall output growth in the late 20th century, now seems stagnant. Many export industries are automated and hence don’t create as many middle-class jobs as they used to.

In other words, today’s world may resemble the 19th century more than the last few decades. That could mean fairly low measured growth rates, a premium on stability, few if any “break out of the box” alternatives and a time to invest in institutional quality. American democracy arguably was working better by the early 20th century than it was during the presidency of Andrew Jackson, and that helped America cope with later crises.

What’s also striking about the 19th century is that some countries, such as China and India, didn’t keep up. Indeed, their economies actually shrank for sustained periods of time. They had some bad luck, pursued bad policies and suffered under colonial and imperial oppression. Foreign rulers often were more interested in control than in producing public goods for the citizenry.

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I have my own suspicions that monetary stimulus works well enough to thaw frozen credit markets, as it did amid the 2008 financial crisis. But if we want to stimulate the economy, then a fiscal, rather than monetary policy, is the way to go (nevermind that lots of pundits also claim that the federal government’s 2009 economic stimulus package didn’t work either).

But proving the efficacy of monetary or fiscal policy can’t easily be accomplished. This is one of the biggest challenges for economics, and why critics sometimes say that economists suffer from physics envy (I’m ignoring the Freudian implications here, but would note that the phenomenon has its own Wikipedia entry).

Testing the thesis

The problem with any line of economic policy argument is that there often isn’t much of a way to test any one thesis in order to prove or disprove the underlying claim. There is, for example, no laboratory where we can test side-by-side how QE performed for the U.S. economy versus an alternative scenario without QE. If we had that ability, we could get a better idea of whether QE, zero interest rates, fiscal stimulus or other programs work. Alternatively, we could run experiments about what would happen if there was no central bank or federal government economic intervention, letting the system cleanse itself of excesses.

If only. Instead, many pundits fall back on partial arguments without recognizing what the lack of a counterfactual means to their analysis. As we noted two years ago:

This flawed analytical paradigm has many manifestations, and not just in the investing world. They all rely on the same equation: If you do X, and there is no measurable change, X is therefore ineffective.

The problem with this non-result result is what would have occurred otherwise. Might “no change” be an improvement from what otherwise would have happened? This, or course, has consequences not just for economic-policy choices, but also for corporate decision-makers, investors and — not least of all — voters in the U.S. presidential election.

Policy experiments

There is some good news on this issue: the states, those so-called laboratories of democracy, have been engaging in a variety of different policy experiments. These are obviously not perfect scientifically rigorous experiments; it’s impossible in complex social and economic systems to create two identical test groups, with the variable to be verified versus a control group. However, the various states can give us some ideas about how successful one form of public policy may be versus its peers and the national averages.

We may never have a laboratory for national economic experiments such as QE, but at least we have an approximation at the state level. It’s something worth watching.

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But in the age of digital-account management, this cost is nonexistent. The same is true of so-called menu costs, a name for the hassle of companies changing their posted prices. In the modern world, these things just don’t matter that much. A more sophisticated argument against inflation is that when companies want to change their prices but for some reason can’t, inflation distorts prices from what they should be, which decreases economic efficiency.

Measuring these costs

Economists have tried to measure these costs, and found that they’re just as small as we might expect. In 1981, and again in 2000, University of Chicago economics professor Robert Lucas — sometimes cited as the father of modern macroeconomics — investigated the costs of inflation. Lucas’s chosen model told him that inflation doesn’t put much of a dent in human welfare — according to his 2000 paper, 10 percentage points of inflation is only about as harmful as a 1 percent reduction in gross domestic product. In other words, according to Lucas, even a mild recession is worse for people than the inflation of the 1970s.

Lucas’s model didn’t take into account the menu costs mentioned above. But economists Ariel Burnstein and Christian Hellwig looked at those in 2008, using data on how often companies change their prices.

They find that, as one might expect, inflation has almost no perceptible impact on productivity — and hence, on well-being.

So the typical arguments for why inflation is bad don’t stand up. A better argument is that when prices rise fast, they also tend to be more volatile — high inflation equals uncertain inflation. If inflation is predictable, lenders and borrowers can build it into their financing deals; nominal interest rates simply rise to take into account the shrinking value of money.

Workers can ask for cost-of-living increases in their paychecks, effectively indexing wages to inflation. And businesses can build inflation into their investment plans. But when inflation bounces around from month to month, it’s harder to plan for the future. That makes financing, investing, hiring and any decision that involves forward-looking planning much more of a gamble. Naturally, that will tend to hurt growth.

Historical correlation

Although the historical correlation between inflation and inflation uncertainty is well-documented, that doesn’t mean the one causes the other. If the Federal Reserve had a 4 percent inflation target, and managed to hit that target every year — thus eliminating uncertainty — we wouldn’t really be any worse off than if it hit its current 2 percent target.

So what does this imply about Fed policy? A lot, actually. The Fed’s so-called dual mandate, as laid out by Congress, is “to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” But that says nothing about the relative weights that the Fed should put on maximum employment versus stable prices. The central bank is perfectly free to worry about this.

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When Mitt Romney recently attacked Donald Trump for threatening a trade war that would plunge the U.S. back into recession, Paul Krugman, a leading authority on the economics of trade, assaulted Romney for his misunderstanding:

Now suppose we have a trade war. This will cut exports, which other things equal depresses the economy. But it will also cut imports, which other things equal is expansionary.

Set aside the idea that a trade war, “other things equal,” would have no effect on world demand — a questionable claim (even if it comes from a Nobel laureate who assures his readers, “I really, truly know what I’m talking about”). What’s striking is that Krugman thought it more useful to attack Romney for his flawed thinking on trade than Trump for his. On the Trans-Pacific Partnership, Krugman has described himself as a “lukewarm opponent,” and has said that the case for more trade agreements is “very, very weak,” adding:

And if a progressive makes it to the White House, she should devote no political capital whatsoever to such things. So much for Adam Smith.

Free Trade Feud

The lack of expert enthusiasm for trade liberalization isn’t confined to Krugman. Contributing to it most recently is a new strand of the trade literature that looks carefully at the costs of adjusting to foreign competition. This work, notably papers by David Autor of MIT and collaborators, has attracted attention.

The Economist, which has campaigned for free trade since it was founded in 1843, discussed the findings in an article ominously titled “Trade in the balance.” It said the results “provide convincing evidence that workers in the rich world suffered more from the rise of China than economists thought possible.”

Well, Autor and his co-authors find that some workers have suffered more from Chinese competition than most economists would have thought likely. That’s still an important thing to know, and policy prescriptions follow from it. But those prescriptions aren’t new, and they sure don’t include raising trade barriers. This research doesn’t come close to refuting the traditional case for liberal trade — and its authors are careful never to suggest otherwise.

Adjusting to competition is difficult

Autor’s work draws on masses of data to show that for workers in affected industries and localities, adjusting to foreign competition is a surprisingly hard, slow business. One of the papers finds that competition from China caused net job losses in the U.S. of between 2 and 2.4 million from 1999 to 2011.

Uncertainty still attaches to the estimates of Autor and his colleagues. Their reckonings require many supporting assumptions. The authors have made them conservatively — that is, in a way that’s likely to understate rather than overstate the costs. On the other hand, the studies can’t easily measure some of the gains. Trade with China didn’t just destroy jobs; it also created jobs. Identifying and measuring the new ones is harder to do.

Despite such uncertainties, the new research is the best and most exhaustive available. The question is, what’s new here?

The traditional case never said that free trade makes everybody better off, let alone that it makes everybody better off immediately. The consensus view always acknowledged that there would be winners and losers. (Why would the demand for trade barriers arise if competition from imports didn’t hurt somebody?) The argument has only ever been that free trade raises real incomes in the aggregate — that the gains exceed the losses. The new work leaves this claim intact.

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