Mr Greenspan discusses the US economy in a world context  (Central Bank Articles and Speeches, 6 May 1999)
Central bank: fed | Type: speech | Date: 1999-05-06

## Mr Greenspan discusses the US economy in a world contextRemarks by the Chairman of the US Federal Reserve System, Mr Alan Greenspan, at the Annual

Conference on Bank Structure and Competition of the Federal Reserve Bank Chicago on 6 May 1999.Any evaluation of the international financial crisis of the past two years would be without an understanding of the extraordinary strength of the U.S. economy that has a buffer for much of the rest of the world.There can be little doubt that the marked widening in our trade deficit on goods an has played an important, possibly a critical role in supporting world stability d trying years.

Domestic demand growth in the United States has accounted for about on of the world total since 1996.Now that there are tentative signs that we may be through the worst of the crisis issue to which I shall return shortly, it would be useful to address the bene bedeviling, question of how the American economy, at least to date, has managed to an oasis of prosperity, in sharp contrast to badly sagging economies in the develop recession in Japan, and tepid growth in much of Europe.

And, can we project how lo economy will be able to provide support to the rest of the world?Forecasts of inflation and of growth in real activity for the United States, inclu the Federal Open Market Committee, have been generally off for several years.

Infla been chronically overpredicted and real GDP growth underpredicted.

An increase in in doggedly forecast to follow the ever lower unemployment rate - now the lowest in decades - has not occurred.

In fact, even after accounting for the reduced bias in statistics resulting from methodological improvements, some measures of inflation ha continued to ease.Subdued inflation, of course, has resulted, in part, from the sharp fall in oil pri 1997 through early this year.

Moreover, there has been a significant weakening in import prices since 1995, owing largely to a combination of declining world com prices and a strengthening dollar in our foreign exchange markets through last summ decline in prices of oil and non-imports are clearly 'one-off' events.

Indeed, oil moved up sharply of late.The remaining easing in the inflation rate owes to disinflation in domestic val excluding oil.

The latter, in turn, is more than accounted for by a decline in the ra in unit costs of output, inasmuch as profit margins have increased significantly sin pickup in the growth of labor productivity - beyond the effects of the business appears to have been an essential factor behind the slowing in inflation.

Growth productivity, which had averaged less than a 1 percent annual rate in the early 199 approximately 3 percent in the four quarters ending in the first quarter of 1999.Increased labor productivity growth has directly lowered the growth of unit labor c that reduction in costs, in combination with declining import prices, has also engendered lower price inflation and inflation expectations that, in turn, have c nominal wage growth and unit interest costs.

Consolidated unit nonlabor costs, e interest, have played little role in the inflation accounting exercise in recent yea the effects of falling equipment prices have matched the upside influence of short lives on the average depreciation rate to keep unit capital consumption charges stablI say that accelerated labor productivity is arguably at the root of declining domestic valuedadded price inflation because it can be misleading to identify a single variable a exogenous force in an essentially interactive process of cause and effect.

But in this c notion that labor productivity acceleration has been largely, though not wholly, exogen appears persuasive.

Its unexpected emergence also apparently explains much of the shortf in forecasting of overall economic growth in recent years.I have hypothesized before this group on several occasions that the synergies that developed, especially among the microprocessor, the laser, fiber-optics, and sate technologies, have dramatically raised the potential rates of return, not only on telecommunications investments, but more broadly on many types of equipment that embody or utilize the newer technologies.The newest innovations, which we label information technologies, have begun to alter t manner in which we do business and create value, often in ways not readily foreseeable e five years ago.I do not say we are in a new era, because I have experienced too many alleged new eras in lifetime that have come and gone.

We are far more likely, instead, to be experiencin structural shift similar to those that have visited our economy from time to time in th These shifts can have profound effects, often overriding conventional economic patterns f number of years, before those patterns begin to show through again over the longer term.There was far greater justification to view the future with the unbridled optimism presumed new era a century ago than today.

Technological change was truly awesome around the turn of the century.

In a very short number of years the world witnessed an astoundin of new creations: electric power and light, radios, phonographs, telephones, motion pict x-rays, and motor vehicles, just to begin the list.As this century comes to an end, the defining characteristic of the current wave of tech is the role of information.

Prior to the advent of what has become a veritable avalanche innovations, most of twentieth century business decisionmaking had been hampered by limited information.

Owing to the paucity of timely knowledge of customers' needs and of location of inventories and materials flows throughout complex production systems businesses required substantial programmed redundancies to function effectively.Doubling up on materials and people was essential as backup to the inevitable misjudgmen of the real-time state of play in a company.

Judgments were made from information that w hours, days, or even weeks old.

Accordingly, production planning required adequate, b costly, inventory safety stocks, and backup teams of people to maintain quality control a emergency response to the unanticipated and the misjudged.Large remnants of information void, of course, still persist and forecasts of future ev which all business decisions ultimately depend are still inevitably uncertain.

But the years' remarkable surge in the availability of real-time information has enabled bus management to remove large swaths of inventory safety stocks and worker redundancies, an has armed workers with detailed data to fine tune product specifications to most indiv customer needs.Moreover, information access in real-time resulting from processes such as, for examp checkout counter bar code scanning and satellite location of trucks, fostered mar reductions in delivery lead times on all sorts of goods, from books to capital equipment.in turn, has reduced the relative size of the overall capital structure required t goods and services, and, as a consequence, has apparently added to growth of mul productivity, and thus to labor productivity acceleration.Intermediate production and distribution processes, so essential when information an control were poor, are being bypassed and eventually eliminated.

The incr ubiquitousness of Internet web sites is promising to significantly alter the way la our distribution system are managed.The process of innovation goes beyond the factory floor or distribution channels.

Des have fallen dramatically as computer modeling has eliminated the need, for example large staff of architectural specification drafters previously required for build Medical diagnoses are more thorough, accurate, and far faster, with access to h unavailable information.

Treatment is accordingly hastened, and hours of proc eliminated.

In addition, the dramatic advances in biotechnology are significantly in broad range of productivity-expanding efforts in areas from agriculture to medicine.The evident acceleration of the process of 'creative destruction', which has acc these expanding opportunities and which has been reflected in the shifting of cap failing technologies into those technologies at the cutting edge, has been remarkab to advancing information capabilities and the resulting emergence of more accurat signals and less costly price discovery, market participants have been able to det respond to finely calibrated nuances in consumer demand.

The process of capital rea has been assisted through a significant unbundling of risks made possible by the dev of innovative financial products, not previously available.The proliferation of products of all different designs and qualities has opened up t for the satisfaction of consumer needs not evident even twenty years ago.

The accom expansion of wealth has been large, though regrettably the gains are not as wide across households as I would like.Thus, in summary, the technological innovation observed in recent years does not appe a story of pure economic endogeniety.

The aforementioned technologies appear large sui generis to the post World War II period, indeed to the last twenty years.

The unanticipated, and evolved, for the most part, independent of the ebbs and flows of activity.

While the amount of capital investment that has carried these technologie has been, of course, affected by the costs of capital and labor, and by consumer de rates of return offered by this new equipment have been largely rooted in the relat technology.It is the observation that there has been a perceptible quickening in the pace technological innovations are applied that argues for the hypothesis that th acceleration in labor productivity is not just a cyclical phenomenon or a statistica but reflects - at least in part - more deep-seated, still developing, shift in ou landscape.Indeed it remains a hypothesis, since in economics, unlike in the physical science never conduct fully controlled experiments for an overall economy.

The evid nonetheless, for a technology-driven rise in the prospective rate of return on new an associated acceleration in labor productivity is compelling, if not conclusive.Starting in 1993, capital investment, especially in high-tech equipment, rose sharply b normal cyclical experience, presumably, as always, the result of expected increases in ra return.

Had the profit expectations not been realized, one would have anticipated outla have fallen back.

Instead, their growth increased through the remainder of the decade.More direct evidence supporting an improved underlying profitability has become increasingly evident in company data.

It seems likely that the synergies of advances in fiber optic, satellite, and computer technologies with themselves and with older technol have enlarged the pool of opportunities to achieve a rate of return above the cost of The bulge in the exploitation of these 'excess' potential rates of return has been stimul the accelerating decline in the prices of high-tech equipment starting in 1995.

The amou capacity plowed into limited areas of technology led to extra heavy price discounting. rapid pace of innovation that has fostered shortened product life cycles also has contrib driving down prices of high-tech equipment.Few business people report any significant perceived diminution of the backlog of these a unexploited profitable synergies.

In recent years, businesses often have indicated a cap to dip into this backlog for capital investments that can quickly displace labor costs they be perceived as about to rise.This view is reinforced by securities analysts who presumably are knowledgeable about t companies they follow.

This veritable army of technicians has been projecting increasi higher five-year earnings growth, on average, since early 1995, according to I/B/E/S, a Street research firm that compiles these estimates for the S&P 500.

In January 1995, analysts projected five-year earnings to rise on average by about 11 percent annually. successive upward revisions, the March 1999 estimate was set at about 13.5 percent (pr weighted), a peak for this expansion.

While there are ample data to conclude that t estimates are biased upward, there is scant evidence to suggest the bias has changed.There appears little reason to doubt that analysts' continuous upward revisions reflect companies are reporting to them about improved cost control, which on a consolidated ba for the economy overall, adds up to accelerating labor productivity.

The alterna explanations - more rapid growth in earnings from operations abroad, a rising rate increase in value-added prices received, or from an economy-wide prospective, ever fas labor force growth - are not credible.

Thus, companies are apparently conveying to analy that, to date, they see no diminution in expectations of productivity acceleration.

This mean that the analysts are correct, or for that matter the companies, only that what com are evidently telling the analysts about their productivity and profits are doubtless ref the longer-term profit projections.

The macroeconomic data to date certainly suggest l evidence of a slowdown in productivity growth.I said the evidence for technology-driven acceleration in productivity is compelling, b conclusive.

Indeed, there are a large number of economists who doubt that the rise productivity growth is anything more than a cyclical phenomenon or some type of statisti aberration.

To be sure, they say, nonfarm productivity growth has risen in recent years they note that there have been other periods in our postwar records that exhibited si patterns of acceleration only to fall back to subnormal growth.

Many analysts offer a explanation of the recent acceleration the slow pace of labor productivity growth earli decade.

The current surge is judged a mere catch-up.

The recent acceleration is admittedl sufficient proof of an irreversible trend for a variable as statistically volatile productivity.But catch-up or not, the evidence appears to be mounting that, even if productivity continue to accelerate, the pickup already observed does seem to explain much extraordinary containment of inflation despite the ever-tightening labor markets years.The newer technologies, as I indicated earlier, have facilitated a dramatic foreshort lead times on the delivery of capital equipment over the past decade, presumably businesses to react more expeditiously to an actual or expected rise in nominal com costs than, say, they could have in the 1980s.The newer technologies and foreshortened lead times apparently have made ca investment distinctly more profitable, enabling firms to substitute capital for lab inputs far more productively than they could have a decade or two ago.

Capital, as e like to say, has deepened significantly since 1995.The surge in investment not only has restrained costs, it has also increased industr faster than the rise in factory output.

The resulting slack in product markets has competitive pressure on businesses to hold down prices, despite taut labor Purchasing managers have been reporting virtually no material shortages for more th years.Technology is also damping inflation through its effect on international trad technological developments and a move to a less constrained world trading order progressively broken down barriers to cross-border trade.

All else equal, the competition in tradeable goods enables excess capacity previously bottled up in one c augment worldwide supply and exert restraint on prices in all countries' markets.The resulting price discipline also has constrained nominal wage gains in intern tradeable goods industries.

As workers have attempted to shift to other sectors, nominal wages and increases in prices in nontradeable goods industries may have bee down as well.The process of price containment has doubtless become, to some extent, self-rein Lower inflation in recent years has altered expectations.

Workers no longer believe gains in nominal wages are needed to reap respectable increases in real wages.

Mo incongruously, at the same time that labor markets tightened, workers' fear of obsolescence rose, apparently, as a consequence of the rapid changes in technology induced the accelerated churning in the nations' capital stock with which our workfo interact day by day.

Job security has seemingly become more relevant than wage gai result.

The return of experienced workers for further schooling is remarkable and at surprising depth of worker job insecurity in the face of ever tightening labor marketBecause neither business firms nor their competitors can currently count any long general inflationary tendency to validate decisions to raise their own prices, eac feels compelled to concentrate on efforts to hold down costs.

The availability technology to each company and its rivals affords both the opportunity and the com necessity of taking steps to boost productivity.

This contrasts with our experiences 1970s and 1980s, when firms apparently found it easier and more profitable to see from rising nominal labor costs through price increases than through cost-reducin investments.It is difficult to judge how much of our benign overall price behavior during the pas decade is attributable to these significant shifts in the environment in which firms fu Undoubtedly, other factors have been at work as well, including those temporary oil import price declines that I mentioned earlier and some more lasting influences that I ha discussed, such as worldwide deregulation and privatization, and the freeing up of reso previously employed to produce military products that was brought about by the end of cold war.

There also may be other contributory forces lurking unseen in the wings that only become clear in time.Over the longer run, of course, the actions of the central bank determine the degree of liquidity and, hence, the rate of inflation.

It is, thus, up to us at the Federal Reserv the favorable inflation developments of recent years and remain alert to the emergenc forces that could dissipate them.

For, at root, it has been the remarkably quiescent i that has provided the favorable financial conditions and stable economic environment which businesses have been able to function most efficiently.

Were that not the case, innovations of the last decade could not have been implemented and the 1990s would sure have looked far less impressive.In the event, the performance of the American economy over the past seven years has be truly phenomenal.

The breadth of technological advance and its application has engendere major upward revaluation of business assets, both real and intangible.

That revaluatio induced a spectacular rise in equity prices that to many has reached well beyond justifiable.Of most concern is how long this remarkable period of prosperity can be extended.

As I h said on previous occasions, there are imbalances in our expansion that, unless redressed bring this long run of strong growth and low inflation to a close.Although productivity has accelerated in recent years, the impressive strength of dome demand, in part driven by sharply rising equity prices, has meant that the substitut capital for labor has been inadequate to prevent us from steadily depleting the poo available workers.This worker depletion constitutes a critical upside risk to the inflation outlook bec presumably cannot continue without eventually putting increasing pressure on labor marke and on costs.The number of people willing to work can be usefully defined as the unemployed component of the labor force plus those not actively seeking work, and thus not counted in the force, but who nonetheless say they would like a job if they could get one.

This poo potential workers aged sixteen to sixty-four currently numbers about 10 million, or 5¾ percent of the corresponding population.

This is the lowest such percentage on record which begins in 1970 - and is 2½ percentage points below its average over that period.The rapid increase in aggregate demand has generated growth of employment in excess of th growth in population, causing the number of potential workers to fall since the mid-1990s rate of a bit under one million annually.

We cannot judge with precision how far this lev decline without sparking upward pressures on wages and prices.

Accelerating productivi may have appeared to break the link between labor market conditions and wage gains i recent years, but it cannot have changed the law of supply and demand.At some point, labor market conditions can become so tight that the rise in nomin will start increasingly outpacing the gains in labor productivity, and prices inevit eventually begin to accelerate.Under those circumstances, inflation premiums embodied in long-term interest rates doubtless rise.

The attendant increased risk premiums would boost real interest rat as investors become less certain about future price prospects.

Thus, while rates o new capital equipment might remain elevated, the real cost of capital could rise suppress capital expenditures and, perhaps of greater relevance to the outlook, market.Our negative personal saving rate indicates that the wealth effect is alive and wel has unquestionably been a key factor in the rise in domestic demand, which d productivity improvements has exerted increasing pressure on labor markets.

Thus, equity markets retrench, consumer and business investment demands would, doubtl weaken considerably.A more distant concern, but one that cannot be readily dismissed, is the very cond has enabled the surge in American household and business demands to help sustain stability: our rising trade and current account deficits.

There is a limit to how lon deficits can be sustained, since current account deficits add to net foreign claims o States.It is very difficult to judge at what point debt service costs become unduly burde can no longer be sustained.

There is no evidence at this point that markets are di readily finance our foreign net imbalance.

But the arithmetic of foreign debt accumu compounding interest costs does indicate somewhere in the future that, unless reve growing international imbalances are apt to create significant problems for our econoFinally, while it is reasonable to conclude that some of the gains in output per hou driven by fundamental forces, and are not only a cyclical phenomenon or a sta aberration, it remains a wholly separate question of whether they can be extended.

T growth of productivity cannot increase indefinitely.

While there appears to be con expectation in the business community, and possibly Wall Street, that the prod acceleration has not yet peaked, history advises caution.As I have noted previously, history is strewn with projections of technology that h wide of the mark.

With the innumerable potential permutations and combinations of v synergies, forecasting technology has been a daunting exercise.There is little reason to believe that we are going to be any better at this in the the past.

Hence, despite the remarkable progress witnessed to date, we have to modest about our ability to project the future of technology and its implica productivity growth and for the broader economy.For, if productivity growth should level out or actually falter because additional synergies fail to materialize, or because output per hour has been less tied to tech first place, inflationary pressures could re-emerge, possibly faster than some perceive feasible.For, obviously if productivity growth slows, unit labor costs would rise, first pres margins, and then prices.

Indeed, we cannot rule out such a process if labor pr growth simply levels out.

Our ability to forecast, when a diminishing pool ofworkers begins to raise costs or when productivity trends change, is limited.

We do kn however, that if, and when, either materializes, inflation pressures are likely to againTo return to my opening question: can we project how long the economy of the United Stat can act as a buffer to weakness elsewhere?The answer: not easily.

History counsels us that sharp changes in direction are rarely, anticipated.

Indeed, were these changes readily apparent, presumably, businesses would ad to that anticipation and, hence, significantly damp the cyclical tendencies in the economThe outlook for the American economy is particularly relevant to the realization of a recovery of East Asia.

To be sure, there are definite signs of activity bottoming o Indonesia and Hong Kong and evidence of some gains in Thailand and Malaysia, with the most progress reported in Korea.

Japan, whose economy is considerably larger than the res East Asia combined, excluding China, is still bedeviled by its inability to restore a banking system, though they seem to be making some progress.But the emergence of East Asia out of its severe crisis, though real, remains fragile.

T improvements now under way could be threatening the resolve of a number of countries t adhere to the disciplined plans that have been instrumental in their recovery to date.Brazil has managed to stem a prospective implosion that followed in the wake of its curr crisis.

But there, as well as some other parts of Latin America that seem to have dodge bullet of a Brazilian-induced contagion, the potential for a letdown in their policy di that has served them well, also is a concern.But, in general, discipline is likely to hold, because the lessons of 1997 and 1998 a recent and vivid to be soon forgotten.

Hence, with a little backing and filling, the e nation crises of the last two years are likely to gradually dissipate and these countrie move onto a significant recovery path.

The overhang of debt and difficult unresolv structural problems, however, are likely to keep a vigorous recovery at bay.

But, in th their outlook will be influenced importantly by developments in Japan, Europe, and especi the United States.In Europe, gains in real GDP have remained modest, though inflation appears nonexisten Arguably, the rapidity of the introduction of cutting-edge technologies has not seemed to evident in Europe as in the United States.

Though somewhat puzzling, this is sur temporary, unless the thrust of innovation in the United States comes to an unexpected ha existing rigidities in European markets unexpectedly persist in the face of grow international competition.

Europe, as a consequence, is likely to remain a positive contr to world economic stability in the years ahead.Let me conclude with an observation I have made before:

We policymakers have been engaged in a lot of on-the-job training in recent years.

The remarkable American econo whose roots are still not conclusively known, and the Asian crises that caught us by sur among other humbling experiences, have made policymakers particularly sensitive to how fa the world can shift beneath our feet.

We need to be alert to the dramatic changes tha continuously confronting us, but recognize that neither the fundamental laws of economi nor human nature, on which they are based, has changed, or is likely to change.

This wi an especially important notion to keep in mind as we continue to grapple with the rap changing global economic environment and its regulatory structure, which this symposiu has been convened to address.