Alan Greenspan: Semi-annual monetary policy report to the US Congress
Testimony of Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, on the occasion of the Federal Reserve Board's semiannual monetary policy report to the
Congress, before the Committee on Financial Services, US House of Representatives, 17 July 2002.
* * *
I appreciate this opportunity to present the Federal Reserve's Monetary Policy Report to the Congress.
Over the four and one-half months since I last testified before this Committee on monetary policy, the
economy has continued to expand, largely along the broad contours we had anticipated at that time.
Although the uncertainties of earlier this year are as yet not fully resolved, the U.S. economy appears
to have withstood a set of blows--major declines in equity markets, a sharp retrenchment in investment
spending, and the tragic terrorist attacks of last September--that in previous business cycles almost
surely would have induced a severe contraction. The mildness and brevity of the downturn, as I
indicated earlier this year, are a testament to the notable improvement in the resilience and flexibility of
the U.S. economy.
But while the economy has held up remarkably well, not surprisingly the depressing effects of recent
events linger. Spending will continue to adjust for some time to the declines that have occurred in
equity prices. In recent weeks, those prices have fallen further on net, in part under the influence of
growing concerns about corporate governance and business transparency problems that evidently
accumulated during the earlier rapid runup in these markets. Considerable uncertainties--about the
progress of the adjustment of capital spending and the rebound in profitability, about the potential for
additional revelations of corporate malfeasance, and about possible risks from global political events
and terrorism--still confront us.
Nevertheless, the fundamentals are in place for a return to sustained healthy growth: Imbalances in
inventories and capital goods appear largely to have been worked off; inflation is quite low and is
expected to remain so; and productivity growth has been remarkably strong, implying considerable
underlying support to household and business spending as well as potential relief from cost and price
pressures. In considering policy actions this year, the Federal Open Market Committee has recognized
that the accommodative stance of policy adopted last year in response to the substantial forces
restraining the economy likely will not prove compatible over time with maximum sustainable growth
and price stability. But, with inflation currently contained and with few signs that upward pressures are
likely to develop any time soon, we have chosen to maintain that stance pending evidence that the
forces inhibiting economic growth are dissipating enough to allow the strong fundamentals to show
through more fully.
As has often been the case in the past, the behavior of inventories provided substantial impetus for
the initial strengthening of the economy. Manufacturers, wholesalers, and retailers took vigorous steps
throughout 2001 to eliminate an unwanted buildup of stocks that emerged when final demand slowed
late in 2000. By early this year, with inventory levels having apparently come into better alignment with
expected sales, the pace of inventory reduction began to ebb, and efforts to limit further drawdowns
provided a considerable boost to production. The available evidence suggests that, in some sectors,
liquidation may be giving way to a rebuilding of inventories. However, as inventories start to grow more
in line with sales in coming quarters, the contribution of inventory investment to real GDP growth
should lessen. As a result, the strength of final demand will play its usual central role in determining
the vigor of the expansion. While final demand has been increasing, the pace of forward momentum
remains uncertain.
Household spending held up quite well during the downturn and through recent months, and thus
served as an important stabilizing force for the overall economy. Real consumer outlays and spending
on residential construction each rose about 3 percent over the course of 2001, even as the growth of
real GDP fell off to only 1⁄2 percent. Household spending was boosted by ongoing increases in
incomes, which in turn were spurred by strong advances in productivity as well as by legislated tax
reductions and, in recent months, by extended unemployment insurance benefits.
Monetary policy also played a role by cutting short-term interest rates, which helped lower household
borrowing costs. Particularly important in buoying spending were the very low levels of mortgage
interest rates, which encouraged households to purchase homes, refinance debt and lower debt
service burdens, and extract equity from homes to finance expenditures. Fixed mortgage rates remain
at historically low levels and thus should continue to fuel reasonably strong housing demand and,
through equity extraction, to support consumer spending as well. Indeed, recent sizable increases in
home prices, which reflect the effects on demand of low mortgage rates, immigration, and shortages of
buildable land in some areas, have significantly increased the equity in houses that homeowners can
readily tap through home equity loans and mortgage refinancing.
But those sources of strength probably will be tempered by other influences. As we noted in February,
because consumer and residential expenditures did not decline during the overall downturn, there is
little pent-up demand to be satisfied. Consequently, a surge in household spending early in this
recovery is unlikely. Moreover, the declines in household wealth that have occurred over the past
couple of years should continue to restrain spending in the period ahead. Still, despite concerns about
economic prospects, equity valuations, terrorism, and geopolitical conflicts, consumers do not appear
to have retrenched in retail markets. Indeed, consumers responded strongly to the new interest rate
incentives of motor vehicle manufacturers this month. Early reports indicate a significant improvement
in sales over June.
By contrast, business spending has been depressed. The recent economic downturn was driven, in
large measure, by the sharp falloff in the demand for capital goods that occurred when firms suddenly
realized that stocks of such goods--both those already in place as well as those in inventory--were
excessive. The resulting declines in the production of capital goods were particularly sizable in the
high-tech sector. Monthly shipments of computers and peripherals, for example, fell by about 40
percent from their peak in 1999 through their trough in 2001. Sales by communications equipment
producers slumped just as sharply. Outside the high-tech sector, production also declined. Assemblies
of commercial aircraft slowed abruptly. In addition, the construction of office and industrial buildings fell
off noticeably. The collapse of many Internet firms and the difficulties of the high-tech sector more
generally led to a significant drop in the demand for office space that was exacerbated as the
economic slowdown widened beyond the tech sector. Overall, the level of real business fixed
investment plunged about 11 percent between its quarterly peak in the final months of 2000 and the
first quarter of this year.
With the adjustment of the capital stock to desired levels now evidently well advanced, business fixed
investment may be set to improve. A recovery in this category of spending is likely to be gradual by
historical standards and uneven across sectors. For example, an upturn in production of
semiconductors and computers has been under way now for nearly a year, but with significant
overcapacity still prevailing in some segments of the telecom industry, investment in communications
equipment is likely to remain subdued for some time to come. Overall capital expenditures should
strengthen with time. In particular, firms should respond increasingly to the expected improvement in
the outlook for sales and profits, low debt financing costs, the heightened incentives resulting from the
partial expensing tax provisions legislated earlier this year, and especially the productivity
enhancements offered by continuing advances in technology.
Indeed, despite the recent depressed level of investment expenditures, the productivity of the U.S.
economy has continued to rise at a remarkably strong pace. In the nonfarm business sector, output
per hour is currently estimated to have soared at an average annual rate of about 7 percent over the
fourth quarter of 2001 and first quarter of 2002, and the available evidence points to continued gains
last quarter--though not at the frenetic pace of the preceding half year. In part, these increases in
productivity reflect the very cautious attitudes of managers toward hiring. But the magnitude of the
recent gains would not have been possible without ongoing benefits from the rapid pace of
technological advance and from the heavy investment over the latter half of the 1990s in capital
equipment incorporating such advances.
Despite these encouraging developments regarding the longer-term prospects for the economy,
financial markets have been notably skittish of late, and business managers remain decidedly
cautious. In part, these attitudes reflect the lingering effects of the shocks that our economy endured in
2000 and 2001. Particularly given the dimensions of those shocks, some persistent uncertainty and
concern are not surprising.
Also contributing to the dispirited attitudes among many corporate executives is the intensely
competitive business environment facing their firms. Increased competition, while producing manifold
benefits for consumers and for the economy as a whole, clearly makes individual firms' operations
more difficult. Past deregulation and, more recently, the enhanced speed and efficiency of information
flows resulting from technological advances are strengthening competition domestically. In addition,
globalization is intensifying competition in a broad range of markets and damping pricing power across
developed and developing nations alike.
Those businesses where heightened competition has engendered a loss of pricing power have sought
ways to raise profit margins by employing technology to lower costs and improve efficiency. In the
United States, as a consequence of the interaction of monetary policy, globalization, and
costreducing productivity advances, price inflation has fallen in recent years to its lowest level in four
decades, as has the recent growth rate of nominal GDP and consolidated corporate revenues.
In part because nominal corporate revenues, although no longer declining, are growing only tepidly,
managers seem to remain skeptical of the evidence of an emerging upturn. Profit margins do appear
to be coming off their lows registered late last year, but, unsurprisingly, the recovery in economic
activity from a shallow decline appears less vigorous than in the past. The lowest sustained rates of
inflation in forty years imply that nominal growth in sales and profits looks particularly anemic. In
contrast, in the 1950s and early 1960s, the last period of stable prices, populations and employment
were growing considerably faster than the recent pace so that growth in nominal GDP, consolidated
corporate sales, and profits was seen as still quite respectable. Reflecting concerns about the strength
of the recovery, managers continue to limit capital spending to only the most pressing needs.
Given the key role of perceptions of subdued profitability in the current period, it is ironic that the
practice of not expensing stock-option grants, which contributed to the surge in earnings reported to
shareholders from 1997 to 2000, has imparted a deceptive weakness to the growth of earnings
reported to shareholders in recent quarters. As stock market gains turned to losses a couple of years
ago, the willingness of employees to accept stock options in lieu of cash or other forms of
compensation apparently diminished. According to estimates by Federal Reserve staff, the value of
stock option grants for the S&P 500 corporations fell about 15 percent from 2000 to 2001, and grant
values have likely declined still further this year. Moreover, options grants are presumably being
replaced over time by cash or other forms of compensation, which are expensed, contributing further
to less robust growth in earnings reported to shareholders from its trough last year.
In contrast, the measure of profits calculated by the Department of Commerce for the National Income
and Product Accounts is designed to gauge the economic profitability of current operations. It excludes
a number of one-time charges that appear in shareholder reports, and, importantly, records options as
an expense, albeit at the time of exercise. Although this treatment of the cost of options is not ideal, it
is arguably superior to their treatment in shareholder reports, where options are generally not
expensed at all. NIPA profits closely approximate those obtained from reports submitted for tax
purposes, and, for obvious reasons, corporations tend not to inflate taxable earnings. Consequently,
NIPA profits have been far less subject to the spin evident in reports to shareholders in recent years.
NIPA profits have increased sharply since the third quarter of last year, partly reflecting the dramatic
jump in productivity and decline in unit labor costs.
The difficulties of judging earnings trends have been intensified by revelations of misleading
accounting practices at some prominent businesses. The resulting investor skepticism about earnings
reports has not only depressed the valuation of equity shares, but it also has been reportedly a factor
in the rising risk spreads on corporate debt issued by the lower rung of investment-grade and
belowinvestment grade firms, further elevating the cost of capital for these borrowers. Businesses
concerned about the impact of possible adverse publicity regarding their accounting practices on their
access to finance could revert to a much heavier emphasis on cash generation and accumulation.
Such an emphasis could slow new capital investment initiatives.
The recent impressive advances in productivity suggest that to date any impairment of efficiency of U.
S. corporations overall has been small. Efficiency is of course a key measure of corporate
governance. Nonetheless, the danger that breakdowns in governance could at some point significantly
erode business efficiency remains worrisome. Well-functioning markets require accurate information to
allocate capital and other resources, and market participants must have confidence that our
predominately voluntary system of exchange is transparent and fair. Although business transactions
are governed by laws and contracts, if even a modest fraction of those transactions had to be
adjudicated, our courts would be swamped into immobility. Thus, our market system depends critically
on trust--trust in the word of our colleagues and trust in the word of those with whom we do business.
Falsification and fraud are highly destructive to free-market capitalism and, more broadly, to the
underpinnings of our society.
In recent years, shareholders and potential investors would have been protected from widespread
misinformation if any one of the many bulwarks safeguarding appropriate corporate evaluation had
held. In too many cases, none did. Lawyers, internal and external auditors, corporate boards, Wall
Street security analysts, rating agencies, and large institutional holders of stock all failed for one
reason or another to detect and blow the whistle on those who breached the level of trust essential to
well-functioning markets.
Why did corporate governance checks and balances that served us reasonably well in the past break
down? At root was the rapid enlargement of stock market capitalizations in the latter part of the 1990s
that arguably engendered an outsized increase in opportunities for avarice. An infectious greed
seemed to grip much of our business community. Our historical guardians of financial information were
overwhelmed. Too many corporate executives sought ways to "harvest" some of those stock market
gains. As a result, the highly desirable spread of shareholding and options among business managers
perversely created incentives to artificially inflate reported earnings in order to keep stock prices high
and rising. This outcome suggests that the options were poorly structured, and, consequently, they
failed to properly align the long-term interests of shareholders and managers, the paradigm so
essential for effective corporate governance. The incentives they created overcame the good
judgment of too many corporate managers. It is not that humans have become any more greedy than
in generations past. It is that the avenues to express greed had grown so enormously.
Perhaps the recent breakdown of protective barriers resulted from a once-in-a-generation frenzy of
speculation that is now over. With profitable opportunities for malfeasance markedly diminished, far
fewer questionable practices are likely to be initiated in the immediate future. To be sure, previously
undiscovered misdeeds will no doubt continue to surface in the weeks ahead as chastened CEOs
restate earnings. But even if the worst is over, history cautions us that memories fade. Thus, it is
incumbent upon us to apply the lessons of this recent period to inhibit any recurrence in the future.
A major focus of reform of corporate governance, of course, should be an improved functioning of our
economy. A related, but separate, issue is that shareholders must perceive that corporate governance
is properly structured so that financial gains are fairly negotiated between existing shareholders and
corporate officeholders. Shareholding is now predominately for investment, not corporate control. Our
vast and highly liquid financial markets enable large institutional shareholders to sell their shares when
they perceive inadequacies of corporate governance, rather than fix them. This has placed de facto
control in the hands of the chief executive officer. Shareholders routinely authorize slates of directors
recommended by the CEO. Generally, problems need to become quite large before CEOs are
dislodged by dissenting shareholders or hostile takeovers.
Manifestations of lax corporate governance, in my judgment, are largely a symptom of a failed CEO.
Having independent directors, whose votes are not controlled by the CEO, is essential, of course, for
any effective board of directors. However, we need to be careful that in the process, we do not create
a competing set of directors and conflicting sources of power that are likely to impair a corporation's
effectiveness. The functioning of any business requires a central point of authority.
In the end, a CEO must be afforded full authority to implement corporate strategies, but also must bear
the responsibility to accurately report the resulting condition of the corporation to shareholders and
potential investors. Unless such responsibilities are enforced with very stiff penalties for
noncompliance, as many now recommend, our accounting systems and other elements of corporate
governance will function in a less than optimum manner.
Already existing statutes, of course, prohibit corporate fraud and misrepresentation. But even a small
increase in the likelihood of large, possibly criminal penalties for egregious behavior of CEOs can have
profoundly important effects on all aspects of corporate governance because the fulcrum of
governance is the chief executive officer. If a CEO countenances managing reported earnings, that
attitude will drive the entire accounting regime of the firm. If he or she instead insists on an objective
representation of a company's business dealings, that standard will govern recordkeeping and due
diligence. It has been my experience on numerous corporate boards that CEOs who insist that their
auditors render objective accounts get them. And CEOs who discourage corner-cutting by
subordinates are rarely exposed to it.
I recognize that I am saying that the state of corporate governance to a very large extent reflects the
character of the CEO, and that this is a very difficult issue to address. Although we may not be able to
change the character of corporate officers, we can change behavior through incentives and penalties.
That, in my judgment, could dramatically improve the state of corporate governance.
Our most recent experiences clearly indicate, however, that adjustments to the existing structure of
regulation of corporate governance and accounting beyond addressing the role of the CEO are
needed. In designing changes to our regulatory framework, we should keep in mind that regulation
and supervision of our financial markets need to be flexible enough to adapt to an ever-changing and
evolving financial structure. Regulation cannot be static or it will soon distort the efficient flow of capital
from savers to those who invest in plant and equipment. There will be certain areas where Congress
will choose to provide a specific statutory direction that will be as applicable thirty years from now as
today. In other cases, agency rule-making flexibility under new or existing statutes is more appropriate.
Finally, there are some areas where private supervision would be most effective, such as that of the
New York Stock Exchange, which requires certain standards of governance for listing.
Above all, we must bear in mind that the critical issue should be how to strengthen the legal base of
free market capitalism: the property rights of shareholders and other owners of capital. Fraud and
deception are thefts of property. In my judgment, more generally, unless the laws governing how
markets and corporations function are perceived as fair, our economic system cannot achieve its full
potential.
* * *
A considerable volume of market commentary in recent weeks has suggested that concerns about
earnings prospects and the proliferating revelations of serious governance and accounting issues
have contributed not only to lower equity prices but also to a decline in the foreign exchange value of
the dollar. And some of that commentary has extrapolated the trend of dollar weakness. As you know,
the Secretary of the Treasury speaks for our government on exchange rate policy. But, given the
recent intense interest in the future course of the dollar, I would like to raise a technical issue and a
flag of caution regarding those forecasts--or, for that matter, any forecast of exchange rates. There
may be more forecasting of exchange rates, with less success, than almost any other economic
variable.
The reason that it is so difficult is that an exchange rate is a very complex price that balances, on the
one hand, the demand for, for example, dollars stemming from the demand for dollar investments and
for U.S. exports against, on the other hand, the demand for foreign currencies by U.S. investors
desiring to acquire foreign assets and by U.S. importers of foreign goods and services. Hence,
exchange-rate movements depend on shifting perceptions of the relative returns from investing in
different countries and on the myriad influences on relative tendencies to import and export. The net
effect of these factors over any future time period is extraordinarily difficult to assess in advance.
Although measures such as real interest rate differentials, differential rates of productivity gains, and
chronic external deficits are often employed to explain exchange rate behavior, none has been found
to be consistently useful in forecasting exchange rates even over substantial periods of one or two
years.
Our ability to attract foreign capital in coming years will help facilitate the increases in investment that
will promote continued gains in productivity and standards of living. But policymakers should also
recognize the important role that prudent fiscal policy can play in promoting national saving and
maintaining conditions conducive to investment and continued strong growth of productivity. Beginning
in the late 1980s, impressive progress was made in reining in federal expenditures and restoring a
better balance between spending and revenues. The lower federal deficits and, for a time, the
realization of surpluses contributed significantly to improved national saving and thereby put
downward pressure on real interest rates. This, in turn, enhanced the incentives of businesses to
invest in productive plant and equipment.
Recently, however, some of those gains have been given up. To a degree, the return to budget
deficits has been a result of temporary factors, especially the falloff in revenues and the increase in
outlays associated with the economic downturn. Those influences should tend to reverse over the next
year or two, other things equal, although the decline in revenues reflecting the drop in capital gains
realizations, including those on options, is unlikely to be fully reversed. And the necessary rise in
expenditures related to the war on terrorism and enhanced homeland security has also played a role,
as have the tax reductions legislated last year. Unfortunately, there are also signs that the underlying
disciplinary mechanisms that formed the framework for federal budget decisions over most of the past
fifteen years have eroded. The Administration and the Congress can make a valuable contribution to
the prospects for the growth of the economy by taking measures to restore this discipline and return
the federal budget over time to a posture that is supportive of long-term economic growth.
To sum up, the U.S. economy has confronted very significant challenges over the past year or so.
Those problems, however, led to only a relatively brief and mild downturn in economic activity,
reflecting the underlying strength and increased resiliency that the economy has achieved in recent
years. The effects of the recent difficulties will linger for a bit longer but, as they wear off, and absent
significant further adverse shocks, the U.S. economy is poised to resume a pattern of sustainable
growth. Indeed, the central tendency of Federal Reserve policymakers' forecasts is for expansion of
real GDP over the four quarters of 2002 of 3-1/2 to 3-3/4 percent, somewhat above the rates
anticipated in our February report. Economic growth is projected to be solid again next year, with real
output rising 3-1/2 to 4 percent. Monetary policymakers anticipate that these gains should be sufficient
to bring the unemployment rate down to 5-1/4 to 5-1/2 percent by the end of next year. Inflation is
expected to be subdued throughout, with prices for personal consumption expenditures increasing at
only a 1-1/2 to 1-3/4 percent rate. Our prospects for extending this performance over time can be
enhanced through implementation of sound monetary, financial, fiscal, and trade policies.