Mr. Greenspan considers whether there has been a profound and fundamental alteration in the way the economy works in the United States  (Central Bank Articles and Speeches, 4 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-04

Mr. Greenspan considers whether there has been a profound and fundamental alteration in the way the economy works in the United States Remarks by the Chairman of the Board of Governors of the US Federal Reserve System, Mr. Alan Greenspan the Haas Annual Business Faculty Research Dialogue, University of California, Ber California on 4/9/98.

## Question: Is There a New Economy?The question posed for this lecture of whether there is a new economy re beyond the obvious: Our economy, of course, is changing everyday, and in that sense it 'new'.

The deeper question is whether there has been a profound and fundamental altera the way our economy works that creates discontinuity from the past and promises a signi higher path of growth than we have experienced in recent decades.The question has arisen because the economic performance of the United Stat the past five years has in certain respects been unprecedented.

Contrary to convention and the detailed historic economic modelling on which it is based, it is most unusual f to be falling this far into a business expansion.Many of the imbalances observed during the few times in the past that a bu expansion has lasted more than seven years are largely absent today.

To be sure, labo are unusually tight, and we should remain concerned that pressures in these markets co over to costs and prices.

But, to date, they have not.Moreover, it is just not credible that the United States can remain an prosperity unaffected by a world that is experiencing greatly increased stress.

Dev overseas have contributed to holding down prices and aggregate demand in the United St the face of strong domestic spending.

As dislocations abroad mount, feeding back financial markets, restraint is likely to intensify.

In the spring and early summer, Open Market Committee was concerned that a rise in inflation was the primary threat continued expansion of the economy.

By the time of the Committee's August meeting, the had become balanced, and the Committee will need to consider carefully the pot ramifications of ongoing developments since that meeting.Some of those who advocate a 'new economy' attribute it generally technological innovations and breakthroughs in globalization that raise productivity a new capacity on demand and that have, accordingly, removed pricing power from the wo producers on a more lasting basis.There is, clearly, an element of truth in this proposition.

In the United example, a technologically driven decline is evident in the average lead times on the p new capital equipment that has kept capacity utilization at moderate levels and eliminated most of the goods shortages and bottlenecks that were prevalent in earlier sustained strong economic growth.But, although there doubtless have been profound changes in the way we orga our capital facilities, engage in just-in-time inventory regimes, and intertwine sophisticated risk-sensitive financial system into this process, there is one important notion that we live in a new economy, and that is human psychology.The same enthusiasms and fears that gripped our forebears, are, in every visible in the generations now actively participating in the American economy.

Human are always rooted in a forecast of the consequences of those actions.

When the future sufficiently clouded, people eschew actions and disengage from previous commitments. sure, the degree of risk aversion differs from person to person, but judging the way pr in today's markets compared with those of a century or more ago, one is hard pressed significant differences.

The way we evaluate assets, and the way changes in those valu our economy, do not appear to be coming out of a set of rules that is different from t governed the actions of our forebears.Hence, as the first cut at the question 'Is there a new economy?' the answ more profound sense is no. As in the past, our advanced economy is primarily driven human psychology moulds the value system that drives a competitive market economy.

And process is inextricably linked to human nature, which appears essentially immutable a anchors the future to the past.But having said that, important technological changes have been emerging recent years that are altering, in ways with few precedents, the manner in which we production, trade across countries, and deliver value to consumers.To explore the significance of those changes and their relevance to the pos of a 'new economy', we need to first detail some key features of our system.The American economy, like all advanced capitalist economies, is continual the process of what Joseph Schumpeter, a number of decades ago, called 'creative destr Capital equipment, production processes, financial and labor market infrastructure, whole panoply of private institutions that make up a market economy are always in a stat -- in almost all cases evolving into more efficient regimes.The capital stock -- the plant and equipment that facilitates our produ goods and services -- can be viewed, with only a little exaggeration, as continuously down and rebuilt.Our capital stock and the level of skills of our workforce are effective upgraded as competition presses business managements to find increasingly innovativ efficient ways to meet the ever-rising demands of consumers for quantity, quality, an Supply and demand have been interacting over the generations in a competitive environm propel standards of living higher.

Indeed, this is the process that, in fits an characterized our and other market economies since the beginning of the Industrial Rev Earlier, standards of living barely changed from one generation to the next.This is the tautological sense in which every evolving market economy, our included, is always, in some sense, 'new', as we struggle to increase standards of liviIn the early part of the 19th century, the United States, as a developing borrowed much technology and savings from Europe to get a toehold on the growth ladder over the past century, America has moved to the cutting edge of technology.There is no question that events are continually altering the shape and n our economic processes, especially the extent to which technological breakthroughadvanced and perhaps, most recently, even accelerated the pace of conceptualization of domestic product.

We have dramatically reduced the size of our radios, for examp substituting transistors for vacuum tubes.

Thin fiber-optic cable has replaced huge t copper wire.

New architectural, engineering, and materials technologies have enabl construction of buildings enclosing the same space but with far less physical material required, say, 50 or 100 years ago.

Most recently, mobile phones have been markedly dow as they have been improved.

As a consequence, the physical weight of our GDP is growing very gradually.

The exploitation of new concepts accounts for virtually all inflation-adjusted growth in output.The cause of this dramatic shift toward product downsizing during the pas century can only be surmised.

Perhaps the physical limitations of accumulating goo moving them in an ever more crowded geographical environment resulted in cost pressur economize on size and space.

Similarly, perhaps it was the prospect of increasing processing ever larger quantities of physical resources that shifted producers toward alternatives.

Remember, it was less than three decades ago that the Club of Rome issue warnings about the prospects of running out of the physical resources that allege necessary to support our standards of living.

Finally, as we moved the technological forward and pressed for information processing to speed up, for example, the laws of required the relevant microchips to become ever more compact.But what was always true in the past, and will remain so in the future, is output of a free market economy and the notion of wealth creation will reflect t preferences of people.

Indeed, the very concept of wealth has no meaning other th reflection of human value preferences.

There is no intrinsic value in wheat, a mach software program.

It is only as these products satisfy human needs currently, or are p be able do so in the future, that they are valued.

And it is such value preferences, as themselves in the market's key signals -- product and asset prices -- that inform pr what is considered valuable and, together with the state of technology, what could be produced.To get back to basics, the value of any physical production facility depend perceived value of the goods and services that the facility is projected to produce.

Mo the current value of the facility can be viewed as the sum of the discounted value o outputs, net of costs.An identical physical facility with the same capacity to produce can have d values in the marketplace at different times, depending on the degree to which the public feels confident about the ability of the firm to perceive and respond to environments in which the plant will be turning out goods and services.

The value of a which has an unchanging ability to turn out sheet steel, for example, can vary wide marketplace depending on the level of interest rates, the overall rate of inflation, an other factors that have nothing to do with the engineering aspects of the productio What matters is how investors view the markets into which the steel from the mill is e be sold over the years ahead.

When that degree of confidence in judging the future discounted future values also are high -- and so are the prices of equities, which, o the claims on our productive assets.The forces that shape the degree of confidence are largely endogenous t economic process that is generally self-correcting as consumers and investors intera continually changing market reality.

I do not claim that all market behavior is a ratioto changes in the real world.

But most of it must be.

For, were it otherwise, the rela economic environments that have been evident among the major industrial countries ov generations would not be possible.Certainly, the degree of confidence that future outcomes are perceivabl projectable, and hence valued, depends in large part on the underlying political stab country with a market-oriented economy.

Unless market participants are assured that the commitments and contracts are protected by a rule of law, such commitments will not be productive efforts will be focused to address only the immediate short-term impera survival; and efforts to build an infrastructure to provide for future needs will be stA society that protects claims to long-lived productive assets thereby encourages their development.

That spurs levels of production to go beyond the needs moment, the needs of immediate consumption, because claims on future production values be discounted far less than in an environment of political instability and, for example of contracts.

At that point, the makings of a sophisticated economy based on lon commitments are in place.

It will be an economy that saves and invests -- that is, com future -- and, hence, one that will grow.But every competitive market economy, even one solidly based on a rule of la always in a state of flux, and its perceived productiveness is always subject to uncertainty that are inevitably associated with endeavors to anticipate future outcomes.Thus, while the general state of confidence and consumers' and invest willingness to commit to long-term investment is buttressed by the perceptions of the s the society and economy, history demonstrates that that degree of confidence is subjec variations.

Most of those variations are the result of the sheer difficulty in makin and, therefore, commitments about, and to, the future.

On occasion, this very difficul less-disciplined evaluations, which foster price volatility and, in some cases, wha market bubbles -- that is, asset values inflated more on the expectation that others wi prices than on a knowledgeable judgment of true value.The behavior of market economies across the globe in recent years, especia Asia and the United States, has underscored how large a role expectations have come to real economic development.

Economists use the term 'time preference' to identify the tradeoff that individuals are willing to make, even without concern for risk, betwe consumption and claims to future consumption.

Measurable discount factors are inten capture in addition the various types of uncertainties that inevitably cloud the future.Dramatic changes in the latter underscore how human evaluation, interacting the more palpable changes in real output, can have profound effects on an economy, experiences in Asia have so amply demonstrated during the past year.Vicious cycles have arisen across South-East Asia with virtually no notice. point, an economy would appear to be struggling, but no more than had been the case many in the past.

The next moment, market prices and the economy appeared in free fall.Our experiences with these vicious cycles in Asia emphasize the key role market economy of a critical human attribute: confidence or trust in the functioning o system.

Implicitly, we engage in a division of labor because we trust that others will be willing to trade the goods and services we do not produce ourselves.We take for granted that contracts will be fulfilled in the normal co business, relying on the rule of law, especially the law of contracts.

But if trust e every contract had to be adjudicated, the division of labor would collapse.

A key char perhaps the fundamental cause of a vicious cycle, is the loss of trust.We did not foresee such a breakdown in Asia.

I suspect that the very nature process may make it virtually impossible to anticipate.

It is like water pressing aga Everything appears normal until a crack brings a deluge.The immediate cause of the breakdown was an evident pulling back from fut commitments, arguably, the result of the emergence among international lenders of wi doubt that the dramatic growth evident among the Asian 'tigers' could be sustaine emergence of excess worldwide capacity in semiconductors, a valued export for the tige have been among the precipitating events.

In any case, the initial rise in market uncer a sharp rise in discounts on future claims to income and, accordingly, falling prices o and equities.

The process became self-feeding as disengagement from future commitments still greater disruption and uncertainty, rising risk premiums and discount factors, an in production.While the reverse phenomenon, a virtuous cycle, is not fully symmetrical, part is.

Indeed, much of the current American economic expansion is best understood context of favorable expectations, interacting with production and finance to expand r implode economic processes.The American economic stability of the past five years has helped enge increasing confidence of future stability.

This, in turn, has dramatically upgraded market's valuation of our economy's existing productive infrastructure, adding about $ of capital gains to household net worth from early 1995 through the second quarter of thWhile the vast majority of these gains augmented retirement and other sa programs, enough spilled over into consumer spending to significantly lower the propo household income that consumers, especially upper income consumers, believed it necess save.In addition, the longer the elevated level of stock prices was sustained, consumers likely viewed their capital gains as permanent increments to their net wo hence, as spendable.

The recent windfall financed not only higher personal consu expenditures but home purchases as well.

It is difficult to explain the recent record l sales without reference to earlier stock market gains.The rise in stock prices also meant a fall in the equity cost of capital th raised the pace of new capital investment.

Investment in new facilities had already be major boost by the acceleration in technological developments, which evidently increa potential for profit in recent years.

The sharp surge in capital outlays during the p apparently reflected the availability of higher rates of return on a broad spectrum investments owing to an acceleration in technological advances, especially in compu telecommunications applications.This is the apparent root of the recent evident quickened pace of produ advance.

While the recent technological advances have patently added new and increa flexible capacity, the ability of these technologies to improve the efficiency of processes (an issue I will elaborate on shortly) has significantly reduced labor requi unit of output.

This, no doubt, was one factor contributing to a dramatic increase i downsizing and reported widespread layoffs in the early 1990s.

The unemployment rate began to fall as the pace of new hires to man the new facilities exceeded the pace of l the old.Parenthetically, the perception of increased churning of our workforce 1990s has understandably increased the sense of accelerated job-skill obsolescence significant segment of our workforce, especially among those most closely wedded to technologies.

The pressures are reflected in a major increase in on-the-job train dramatic expansion of college enrolment, especially at community colleges.

As a res average age of full-time college students has risen dramatically in recent years as la of experienced workers return to school for skill upgrading.

But the sense of incre obsolescence has also led to an apparent willingness on the part of employees to forgo benefit increases for increased job security.

Thus, despite the incredible tightne markets, increases in compensation per hour have continued to be relatively modest.Coupled with the quickened pace of productivity growth, wage and bene moderation has kept growth in unit labor costs subdued in the current expansion.

This damped inflation and allowed profit margins to reach high levels.That, in turn, apparently was the driving force beginning in early 1995 in analysts' significant upward revision of their company-by-company long-term ear projections.

These upward revisions, coupled with falling interest rates, point t underlying forces that impelled investors to produce one of history's most notable b markets.But they are not the only forces.

In addition, the sequence of greater investment, productivity growth, and falling inflation fostered an ever more benevolen long-term stable growth.

People were more confident about the future.

The consequence dramatic shrinkage in the so-called equity premium over the past two years to near his earlier this summer.

The equity premium is the charge for the additional risks tha require to hold stocks rather than riskless debt instruments.

When perceived risks of are low, equity premiums are low and stock prices are even more elevated than wou indicated solely from higher expected long-term earnings growth and low riskless r interest.Thus, one key to the question of whether there is a new economy is whe current expectations of future stability, which are distinctly more positive than say a are justified by actual changes in the economy.

For if expectations of greater stabili out, risk and equity premiums will remain low.

In that case, the cost of capital will low, leading, at least for a time, to higher investment and faster economic growth.Two considerations are therefore critical to higher asset values and economic growth.

The first is whether the apparent upward shift in technological adva persist.

The second is the extent of confidence in the stability of the future that c investors will be able to sustain.With regard to the first: How fast can technology advance, augmenting the p investment opportunities that have elevated rates of return, which engender still furth in expected long-term earnings?

Technological breakthroughs, as history so amply demons are frustratingly difficult to discern much in advance.

The particular synergies betwe older technologies are generally too complex to anticipate.An innovation's full potential may be realized only after extensive improve or after complementary innovations in other fields of science.

According to Charles T Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, 1960s, refused to patent the laser because they believed it had no applications in telecommunications.

Only in the 1980s, after extensive improvements in fiber-optics tec did the laser's importance for telecommunications become apparent.The future of technology advance may be difficult to predict, but for the ahead there is the possibility that already proven technologies may not as yet have exploited.

Company after company reports that, when confronted with cost increases competitive environment that precludes price increases, they are able to offset th seemingly at will, by installing the newer technologies.Such stories seem odd.

If cost improvements were available at will earlie weren't the investments made earlier?

This implies suboptimal business behavior, con what universities teach in Economics 101.

But in the real world, companies rarel maximize profits.

They concentrate on only those segments of their businesses that a offer the largest rewards and are rarely able to operate at the most efficient frontie simultaneously.

When costs rise, the attention of management presumably becomes foc more sharply on investments to limit the effects of rising costs.But if cost-cutting at will is, in fact, currently available, it suggests t of unexploited capital projects has been built up in recent years, which, if true, potential for continued gains in productivity close to the elevated rates of the last c Even if this is indeed the case, and only anecdotal evidence supports it, security ana projected per share earnings growth of more than 13 percent annually over the next thr years is unlikely to materialize.

It would imply an ever-increasing share of profit in income from a level that is already high by historic standards.

Such conditions have past to labor market pressures that thwarted further profit growth.The second consideration with respect to how high asset values can rise is far can risk and equity premiums fall?

A key factor is that price inflation has receded levels.

The rising level of confidence in recent years concerning future outcomes has been related to the fall in the rate of inflation that has, of course, also been a crit fall in interest rates and, importantly, the fall in equity premiums as well.

Presumab of deflation, should it occur, would increase uncertainty as much as a re-emergence of concerns.

Thus, arguably, at near price stability, perceived risk from busin developments would be at its lowest, and one must presume that would be the case for premiums as well.

In any event, there is a limit on how far investors can rationally discount the future and therefore how low equity premiums can go.

Current claims on a s income available 20 or 30 years in the future still have current value.

But should cl hereafter?An implication of high equity market values, relative to income and product an increased potential for instability.

As I argued earlier, part of capital ga consumption and incomes.

Since equity values are demonstrably more variable than inc when equity market values become large relative to incomes and GDP, their fluctuations expected to effect GDP more than when equity market values are low.Clearly, the history of large swings in investor confidence and equity pr for rational and other reasons counsels caution in the current context.

We have rel recent weeks that just as a bull stock market feels unending and secure as an economy market move forward, so it can feel when markets contract that recovery is inconceivab of course, are wrong.

But because of the difficulty imagining a turnabout when such e take hold, periods of euphoria or distress tend to feed on themselves.

Indeed, if this case, the types of psychologically driven ebbs and flows of economic activity we have would be unlikely to exist.Perhaps, as some argue, history will be less of a guide than it has been in Some of the future is always without historical precedent.

New records are always bein Having said all that, however, my experience of observing the American economy day by over the past half century suggests that most, perhaps substantially most, of the fu expected to rest on a continuum from the past.

Human nature, as I indicated earlier immutable over the generations and inextricably ties our future to our past.Nonetheless, as I indicated earlier, I would not deny that there doubtless in recent years an underlying improvement in the functioning of America's markets and pace of development of cutting edge technologies beyond previous expectations.Most impressive is the marked increase in the effectiveness in the 1990s capital stock, that is, our productive facilities, the issue to which I alluded earli investment has been high, it has been, in recent years, composed to a significant short-lived assets that depreciate rapidly.

Thus, the growth of the net capital stoc recent acceleration, remains well below the peak rates posted during the past half centDespite the broadening in recent decades of international capital flows, e evidence suggests that domestic investment still depends to a critical extent on domes especially at the margin.

Many have argued persuasively, myself included, that we save The relatively low propensity to save on the part of the American public has put a larg on the effective use of scarce capital, and on the winnowing out of the potenti productive and, hence, the least profitable of investment opportunities.That is one of the reasons that our financial system, whose job it is to e productive use of physical capital, has been such a crucial part of our overall economy over the past two decades.

It is the signals reflected in financial asset prices, int risk spreads that have altered the structure of our output in recent decades towards view of what consumers judge as value.

This has imparted a significant derived val financial system that can do that effectively and, despite recent retrenchments, to market value of those individual institutions that make up that system.Clearly, our high financial returns on investment are a symptom that our p capital is being allocated to produce products and services that consumers particularl machining facility that turns out an inferior product or a toll road that leads to nowfind favor with the public, will earn subnormal or negative profits, and in most ins exhibit an inability over the life of the asset to recover the cash plus cost of capitaThus, while adequate national saving is a necessary condition for c investment and rising productivity and standards of living, it is by no means a condition.The former Soviet Union, for example, had too much investment, and without discipline of market prices, they grossly misplaced it.

The preferences of central plan valuable resources by mandating investment in sectors of the economy where the output wanted by consumers -- particularly in heavy manufacturing industries.

It is thus no su the Soviet Union's capital/output ratios were higher than those of contemporaneous fre economies of the West.This phenomenon of overinvestment is observable even among more sophisticate free market economies.

In Japan, the saving rate and gross investment have been far hi ours, but their per capita growth potential appears to be falling relative to ours.

It their hobbled financial system is, at least in part, a contributor to their economy' performance.We should not become complacent, however.

To be sure, the sharp increases the stock market have boosted household net worth.

But while capital gains increase the existing assets, they do not directly create the resources needed for investment in n facilities.

Only saving out of income can do that.In summary, whether over the past five to seven years, what has been, wi question, one of the best economic performances in our history is a harbinger of a new or just a hyped-up version of the old, will be answered only with the inexorable passag And I suspect our grandchildren, and theirs, will be periodically debating whether the new economy.