Mr Greenspan testifies on the state of the US economy  (Central Bank Articles and Speeches, 20 Jan 99)
Central bank: fed | Type: speech | Date: 1999-01-20

## Mr Greenspan testifies on the state of the US economyTestimony

of the Chairman of the Board of Governors of the US Federal Reserve Syst Mr Alan Greenspan, before the Committee on Ways and Means of the US House of Representatives on 20/1/99.The American economy through year-end continued to perform in an outstanding manne Economic growth remained solid, and financial markets, after freezing up temporarily fo the Russian default, are again channeling an ample flow of capital to businesses and ho Labor markets have remained quite tight, but, to date, this has failed to ignite the pressures that many had feared.To be sure, there is decided softness in a number of manufacturing industries as wea many foreign economies has reduced demand for US exports and intensified competition imports.

Moreover, underutilized production capacity and pressure on domestic profit especially among manufacturers, are likely to rein in the rapid growth of new capital i With corporations already relying increasingly on borrowing to finance capital investm evidence of a marked slowing in corporate cash flow is likely to induce a relativel review of capital budgets.The situation in Brazil and its potential for spilling over to reduce demand in othe market economies also constitute a possible source of downside risk for demand in the States.

So far, markets seem to have reacted reasonably well to the decisions by the authorities to float their currency and redouble efforts at fiscal discipline.

But fol reducing budget imbalances and in containing the effects on inflation of the drop in v currency will be needed to bolster confidence and to limit the potential for contag financial markets and economies of Brazil's important trading partners, including th States.While there are risks going forward, to date domestic demand, and hence employment and in the United States, certainly has remained vigorous.

Though the pace of economic expa widely expected to moderate as 1999 unfolds, signs of an appreciable slowdown as yet scant.But to assess the economic outlook properly, we need to reach beyond the mere descrip America's sparkling economic performance of eight years of record peacetime expansion t a deeper understanding of the forces that have produced it.

I want to take a few mom morning to discuss one key element behind our current prosperity: the rise in the valu place on the capital assets of US businesses.

Lower inflation, greater competitivenes flexibility and adaptability of our businesses have enabled them to take advantage of a of technological change to make our capital stock more productive and profitable.

I w that the process of recognizing this greater value has produced capital gains in equ that have lowered the cost of investment in new plant and equipment and spurred consum But, while asset values are very important to the economy and so must be carefully mo and assessed by the Federal Reserve, they are not themselves a target of monetary po need to react to changes in financial markets, as we did this fall, but our obje maximum sustainable growth of the US economy, not particular levels of asset prices.As I have testified before the Congress many times, I believe, at root, the remarkable of capital gains of recent years has resulted from the dramatic fall in inflation expassociated risk premiums, and broad advances in a wide variety of technologies that p critical synergies in the 1990s.Capital investment, especially in high-tech equipment, has accelerated dramatically si presumably reflecting a perception on the part of businesses that the application emerging technological synergies would engender a significant increase in rates of retu investment.Indeed, some calculations support that perception.

They suggest that the rate of return facilities put in place during recent years has, in fact, moved up markedly.

In part th from improved capital productivity - that is, the efficiency of the capital stock.

In may be witnessing some payoffs from improved organizational and managerial efficienci US businesses and from the greater education - in school and on the job - that US work acquired to keep pace with the new technology.

All these factors have been reflect acceleration of labor productivity growth.Parenthetically, improved productivity probably explains why the American economy has so well despite our oft-cited subnormal national saving rate.

The profitability of inv has attracted saving from abroad, an attraction that has enabled us to finance a curr deficit while maintaining a strong dollar.

Clearly, we use both domestic saving and financial capital in a highly efficient manner, apparently more efficiently than many, other major industrial countries.While discussions of consumer spending often continue to emphasize current income from and capital as the prime sources of funds, during the 1990s, capital gains, which valuation of expected future incomes, have taken on a more prominent role in driv economy.The steep uptrend in asset values of recent years has had important effects on virtual of our economy, but perhaps most significantly on household behavior.

It can be see clearly in the measured personal saving rate, which has declined from almost 6% in effectively zero today.Arguably, the average household does not perceive that its saving has fallen off sinc fact, the net worth of the average household has increased by nearly 50% since the end well in excess of the gains of the previous six years.

Households have been accum resources for retirement or for a rainy day, despite very low measured saving rates.The resolution of this seeming dilemma illustrates the growing role of rising asset supporting personal consumption expenditures in recent years.

It also illustrates the when interpreting our official statistics of taking account of how they deal with chan values.With regard first to the statistical issues, capital gains themselves are not counted a some transactions resulting from capital gains reduce disposable household income measure it, while having no effect on consumption.

As a consequence, as capital gains a associated transactions mount, published saving rates are decreased.

For example, personal income is reduced when corporations cut back payments into defined-benefit p plans owing to higher equity prices; however, such reductions do not diminish ant retirement income and thus should not lower consumption.

And reported disposable inco decreased when households pay taxes on capital gains realizations that would not havelarge in less ebullient markets.

However, capital gains tax payments also are highly unl associated with lower spending because the cash realized from the sale of the asset e tax, and in most cases the typical household presumably does not perceive this trans reducing available income or financial resources.

Together these two effects probably ac an appreciable portion of the reduction in the reported saving rate.But beyond these statistical issues, there is little doubt that capital gains ha consumption relative to income from current production over recent years.

Economists ha recognized a 'wealth effect' - a tendency for consumption to rise by a fraction of t gains on existing assets owned by households - though the magnitude of this effect difficult to estimate accurately.

We have some evidence from recent years that all or decline in the saving rate is accounted for by the upper income quintile where the ca have disproportionately accrued, which suggests that the wealth effect has been r significant.

Thus, all else equal, a flattening of stock prices would likely slow t spending, and a decline in equity values, especially a severe one, could lead to a c weakening of consumer demand.Some moderation in economic growth, however, might be required to sustain the expan Through the end of 1998, the economy continued to grow more rapidly than can be curr accommodated on an ongoing basis, even with higher, technology-driven productivity gr Growth has continued to shrink the pool of workers willing to work but without jobs higher productivity has helped to keep labor cost increases in check, it cannot be exp so indefinitely in ever tighter labor markets.Despite brisk demand and improved productivity growth, corporate profits have sagged recent quarters.

This is attributable in part to some acceleration in labor compensati factors have also been pressing, especially intensified competition and lower prices exporters and those industries competing with imports.

In these circumstances, busine feel under considerable pressure to preserve profit margins should labor costs acceler or should the falling prices of commodity inputs, like oil, turn around.

But, to date evident pricing power has been scant.

Either that would change and inflation could mount or, if costs could not be recouped, capital outlays might well be cut back.The recent behavior of profits also underlines the unusual nature of the rebound in eq and the possibility that the recent performance of the equity markets will have difficu sustained.

The level of equity prices would appear to envision substantially greater profits than has been experienced of late.Moreover, the impressive capital gains of recent years would seem also to rest on a per relatively low risk in corporate ownership.

Risk aversion and uncertainty rose sharpl late summer and fall of 1998 following the Russian default in mid-August, as eviden widening spreads among yields on debt of differing credit qualities and liquidity.

T uncertainty increased the discounting of claims on future incomes, and that reduced sto prices even as the long-term earnings growth expectations of security analysts continu As risk aversion subsided after mid-October, stock prices returned to record levels.Markets have doubtless stabilized significantly after the turbulence of last fall but fragile, as the repercussions of the recent Brazilian devaluation attest.

Moreover, current account deficit has widened significantly, in part reflecting the strength demand that has accompanied the further accumulation of capital gains.

The continued i in our net external debt and its growing servicing costs clearly are not sustainable indIn light of the importance of financial markets in the economy, and of the volat vulnerability in financial asset prices more generally, policymakers must continue particular attention to these markets.

The Federal Reserve's easing last fall respo abrupt stringency in financial markets and the effects that the consequent increased ri was likely to have on economic activity going forward.

We were particularly concerned higher costs and disrupted financing in debt markets, where much of consumption investment is funded.

We were not attempting to prop up equity prices, nor did we continue to ease rates until equity prices recovered, as some have erroneously inferred.This has not been, and is not now, our policy or intent.

As I have discussed earlier, m equity prices can play an important role in the economy, which the central bank must account.

And we may question from time to time whether asset prices may not embody a optimistic outlook than seems reasonable, or what the consequences might be of a furthe those prices followed by a steep decline.

But many other forces also drive our economy, the performance of the entire economy that forms our objectives and shapes our actions.Nonetheless, in the current state of financial markets, policymakers are going to h particularly wary of actions that unnecessarily sow uncertainties, undermine confide interfere with the efficient allocation of capital on which our economic prosperity values rest.

It is important not to undermine the highly sensitive ongoing process of of capital from less to more productive uses.

For productivity and standards of livin not only must capital raised in markets be allocated efficiently, but internal cash fl the depreciation charges from the existing capital stock, must be continuously direct most profitable uses.

It is this continuous churning, this so-called creative destruc become so essential to the effective deployment of advanced technologies by this coun recent decades.

In this regard, drift toward protectionist trade policies, which ar difficult to reverse, is a much greater threat than is generally understood.It is well known that erecting barriers to the free flow of goods and services acro borders undermines the division of labor and standards of living by impeding the adjus the capital stock to its most productive uses.

Not so well understood, in my judgme impact that fear of growing protectionism would have on profit expectations, and henc current values of capital assets.

Protectionism was a threat to standards of living asset values were low relative to income.

It becomes particularly pernicious in an env such as today's, when that is no longer the case.In sum, it has been the ability of our flexible and innovative businesses and workfor enabled the United States to take full advantage of emerging technologies to produce growth and higher asset values.

Policy has facilitated this process by containing infl promoting competitiveness through deregulation and an open global trading system.

Ou going forward - at the Federal Reserve as well as in the Congress and Administration sustain and strengthen these policies, which in turn have sustained and strengthened record peacetime economic expansion.