Alan Greenspan: The US economy
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Independent Community Bankers of America, Honolulu, Hawaii (via satellite)
13 March 2002.
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I am pleased to appear once again before the Independent Community Bankers of America. There
can be little doubt that the business environment in which you have operated over the past year has
been challenging.
Today I would like to review some of the principal forces likely to operate on the economy in coming
months. But I would also like to focus on the emerging longer-term challenges, particularly on the need
to augment our domestic saving rate to facilitate the financing of the investment that will almost surely
be required as the baby boomers retire. As bankers, you will play a central part in meeting that
challenge by channeling today's saving into the capital that will be essential in providing for tomorrow's
income.
As I have noted in recent testimony, in the past several months, we have seen increasing signs that
some of the forces restraining the economy over the past year are starting to diminish and that activity
is beginning to firm.
One key force in the economy is the movement of inventories. Stocks in many industries have been
drawn down to levels at which firms will soon need to taper off their rate of liquidation, if they have not
already done so. With production running well below sales, the lift to income and spending from the
inevitable cessation of inventory liquidation could be significant.
But that impetus to the growth of activity will be short-lived unless sustained increases in final demand
kick in before the positive effects of the swing from inventory liquidation dissipate. In recent days,
encouraging signs of strengthening underlying trends in final demand have emerged, although the
dimensions of the pickup remain uncertain.
Most recoveries in the post-World War II period received a boost from a rebound in demand for
consumer durables and housing from recession-depressed levels as well as an abatement of
inventory liquidation. Through much of last year's slowdown, however, spending by the household
sector held up well and proved to be a major stabilizing force. As a consequence, although household
spending should continue to trend up, the potential for significant acceleration in activity in this sector
is likely to be more limited than in past cycles.
Perhaps most central to the outlook for consumer spending will be developments in the labor market.
The pace of layoffs quickened last fall, especially after September 11 and the unemployment rate rose
sharply. However, layoffs diminished noticeably in January, and employment turned up last month.
Moreover, initial claims for unemployment insurance have decreased markedly, on balance, providing
further evidence of an improvement in labor market conditions.
The dynamics of inventory investment and the balance of factors influencing consumer demand will
have important consequences for the economic outlook in coming months. But the broad contours of
the present cycle have been, and will continue to be, driven by the evolution of corporate profits and
capital investment.
The retrenchment in capital spending over the past year and a half was central to the sharp slowing
we experienced in overall activity. On balance, the recovery in spending on business fixed investment
is likely to be only gradual; in particular, its growth will doubtless be less frenetic than in 1999 and
early 2000--a period during which outlays were boosted by the dislocations of Y2K and the
extraordinarily low cost of equity capital available to many firms. Nonetheless, if the recent
morefavorable economic developments gather momentum, uncertainties will diminish, risk premiums will
fall, and the pace of capital investment embodying new technologies will increase.
Even a subdued recovery would constitute a truly remarkable performance for the American economy
in the face of so severe a decline in equity asset values and an unprecedented blow from terrorists to
the foundations of our market systems. For if the tentative indications that the contraction phase of this
business cycle has drawn to a close are ultimately confirmed, we will have experienced a significantly
milder downturn than the long history of business cycles would have led us to expect.
Although there are ample reasons to be cautious about the economic outlook, the recuperative powers
of the U.S. economy in the recent past have been encouraging. One important ingredient in that
resilience has been the performance of productivity. Even discounting somewhat the phenomenal
strength of the growth of output per hour of late, one cannot help but be impressed with how well
productivity has held up in the face of the abrupt slowing of the economy in late 2000 and in 2001.
That performance has been encouraging because the nation's fortunes, to a very great degree, will
depend on the evolution of the growth of productivity. In particular, productivity will play a central role
in determining the nature of the economy's response to the aging of the population soon upon us.
Most economic forecasts are subject to significant uncertainty. At least by comparison, one judgment
looks to be a reasonably sure proposition: The ratio of retirees to those still working will rise
precipitously starting at the end of this decade and will continue to climb through the first third of this
century and remain high thereafter. In part, this projected development owes to the retirement of the
baby boomers. But the phenomenon is broader than that and reflects the aging of our society.
Importantly, according to the social security trustees, the demographic challenge will not go away with
the passing of the baby-boom generation.
This ever-larger retired population will have to be fed, clothed, housed, and serviced by a workforce
growing far less rapidly. The retirees may have accumulated a large stock of retirement savings, but
the goods and services needed to redeem those savings must be produced by an active workforce
assisted by a stock of plant and equipment sufficiently productive to meet the needs both of retirees
and of a workforce expecting an ever-increasing standard of living.
Though from an individual household's point of view, saving reflects financial claims adequate to meet
future needs, the focus for the economy as a whole, of necessity, must be on producing the real
resources needed to redeem the financial assets.
The role of finance is to channel saving into investment in the physical capital assets that assist in the
production of the gross domestic product, which, in turn, serves both retirees and active workers.
Clearly, an efficient system of finance can more effectively deploy a given stock of capital and thus
maximize its contribution to supporting the population.
Any analysis of the amount and type of saving required to finance the bulge in retirements that is just
over the horizon clearly needs to project (1) the number of retirees, (2) the size of our workforce, and
(3) the productivity of that workforce. Of the three, productivity is most directly affected by the level of
investment, which, of course, is financed by saving.
The size of the future workforce, excluding immigrants, and the size of the future retired population are
relatively simple to project from today's age distribution. The level of immigration, both legal and
illegal, will be dominated by public policy decisions and by economic forces, both in the United States
and in the countries from which our immigrants are drawn. This forecast is more problematic, and its
level matters: Over the past decade, for example, immigration accounted for approximately one-third
of the increase in our workforce. The larger our workforce in 2010 and beyond, the easier producing
goods and services for both retirees and active workers will be. Immigration policy will, therefore, be a
key component of baby-boom retirement policy.
The rate of saving--for retirement and other purposes--may not directly affect either the number of
retirees or the size of the workforce. But it surely affects capital investment, which it finances, and the
productivity that it engenders.
Besides the total amount of saving and investment, changes in the allocation of those funds among
different types of capital also appear to influence the growth of labor productivity. A dollar of new
saving flows through financial markets to firms that allocate it among different types of capital
investment. Clearly, firms' choices about the types of investments to make matter crucially for how
much labor productivity ultimately is boosted.
In the late 1990s, for example, businesses allocated much more of their investment dollars toward
high-tech, higher-return capital than they did in earlier years. Businesses made this shift and are
continuing to move further in that direction in response to the extremely rapid decline in the prices of
high-tech assets and the new opportunities that these assets have afforded. According to one set of
calculations, of the roughly 2-1/2 percent annual rate of increase in output per hour, or labor
productivity, between 1995 and 2001, perhaps a quarter of that growth could be attributed to on-going
shifts in the composition, as distinct from the dollar level, of capital.
Improvements in the quantity and quality of our workforce's education enhance workers' skills and
contribute importantly to the growth of labor productivity. But far more important over the past six years
have been the gains in output attributable to technological innovation, especially information
technology and improved managerial organization, and, as I noted in testimony last week, the greater
flexibility and resilience of our economy stemming from deregulation, primarily in finance.
Notwithstanding these more-intangible contributions, the level of saving remains a key ingredient of
economic growth. But we need also to know whether the source of that saving is sustainable and,
beyond that, whether the type of financial assets in which our saving overall is accumulated affects our
productivity.
During the past six years, about 40 percent of the total increase in our capital stock in effect has been
financed, on net, by saving from abroad. This situation is reflected in our ongoing current account
deficit, which, by definition, is a measure of our net investment in domestic plant and equipment
financed with foreign funds, both debt and equity. But this deficit is also a measure of the increase in
the level of net claims, primarily debt claims, that foreigners have on our assets. As the stock of such
claims grows, an ever-larger flow of interest payments must be provided to the foreign suppliers of this
capital. Countries that have gone down this path invariably have run into trouble, and so would we.
Eventually, the current account deficit will have to be restrained. The nation's economic potential will
be brighter if that comes about through an increase in domestic saving rather than a reduction in
domestic investment.
A more contentious issue is whether the mix of domestic private and government saving affects the
rate of productivity growth. Another is whether the form of private saving--for example in stocks or debt
instruments including bank deposits--affects productivity growth.
Ultimately, the composition of real investment in our economy will reflect, among other influences, the
attitudes toward risk of those who own the financial claims against the capital stock. The nation's
savers, daily in the marketplace, exhibit an obvious sensitivity to the association between expected
return and risk. Few, if any, individuals would be willing to accept greater risk without the potential for
greater reward. Similarly, a nation as a whole would not be willing to invest in riskier assets without a
commensurately greater overall economic growth potential. That same tradeoff is reflected in the
willingness of many investors to forgo the higher rates of return on equity for the greater tranquility of
the lesser stress and risk associated with most debt instruments. Reflecting that differential in risk,
returns on common stocks over rolling twenty-year periods have almost always outpaced the returns
on less-risky securities.
Should relative preferences of savers in the aggregate shift toward debt instruments and away from
equity, interest rates will be driven lower and equity-price ratios higher. These shifts in asset valuation
will induce business enterprises to alter their choice of capital projects. Specifically, firms will find that
only projects with lower average rates of return will meet the requirement of providing the more
certain, more stable income stream desired by savers. The physical counterpart to this choice by
businesses of projects with lower expected financial returns is a slower growth of productivity, on
average, across the economy.
Conversely, if savers become more risk-tolerant, financial risk premiums will decline. In response to
these reduced penalties on risk, firms will be induced to adjust the mix of their endeavors toward
more-speculative projects--but, importantly, presumably ones that also offer higher prospective rates
of return on average, which more often than not, translate into higher long-term average economic
growth.
Thus, the answer to whether government or private saving does more to foster productivity growth
arguably comes down to the propensity of U.S. savers to take risks.
Government saving is reflected largely in a retirement of debt. Having chosen to hold at least a portion
of their savings in riskless securities, holders of government debt when confronted with debt retirement
presumably would chose less-risky private debt securities over common stocks to rebalance their
portfolios. Thus an increased share of saving from the government is a markedly more conservative
financial strategy than if the saving were undertaken in the private sector.
Obviously, the federal government could invest in higher-risk assets, such as equities. But for reasons
that I have expressed many times, I do not believe that, other than in defined-contribution plans, such
investment can be accomplished free of political pressures that would distort the efficient use of
capital.
Presumably, most of those who maintain that greater risk-taking would likely produce faster long-term
growth would acknowledge that increased competition and economic growth would also bring greater
volatility and social stress. Because of the near certainty of a major rise in the retiree-to-worker ratio in
the next few decades, we now face the pressing need to set policies for the enhanced productivity
growth that will be necessary if we are to successfully meet the pending demographic challenge.
How much personal stress--and, some argue, increased inequality, which may be a byproduct of a
highly competitive, high-octane economy--have we as a nation chosen? Is the amount compatible with
the level of domestic saving and possibly the risk-taking that is consonant with the elevated level of
productivity growth necessary to meet the needs of an aging population? A national consensus on
these questions is clearly missing. This is doubtless an area for useful debate.
Regardless of the outcome of that debate, there can be little disagreement that an efficient banking
system and sound financial markets will be critical in directing our scarce national saving into the
productive investments that will provide the wherewithal to meet our future needs. Each of you can
contribute to a process that will lift the standards of living enjoyed by our fellow citizens