Alan Greenspan: Outlook for the United States economy
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the Securities Industry Association annual meeting, Boca Raton, Florida,
6 November 2003.
* * *
I am pleased to join you today to discuss the outlook for the United States economy.1
About a year ago, the uncertainties surrounding a possible war in Iraq began to have a perceptible
macroeconomic effect. Those uncertainties, coupled with the lingering concerns that had been created
by corporate governance scandals, were among the key factors causing the performance of the U.S.
economy late last year and early this year to be lackluster.
Risk spreads on corporate bonds peaked in the fall of 2002 at the highest levels observed in at least a
decade. Business fixed investment then stalled in the first quarter of this year, and many firms,
particularly outside the motor vehicle sector, were content to meet some of the increase in demand by
drawing down inventories. Fortunately, a vibrant housing market lifted construction activity and, by
facilitating home equity extraction, provided extra support to consumer spending.
When hostilities commenced in March, uncertainties related both to the potential for damage to Iraq's
oil fields and to the possibility of broader turmoil in the Middle East rapidly dissipated. Risk spreads fell
sharply as did the price of oil. Stock prices rose. Economic activity perked up in late spring and then
accelerated further this summer as tax cuts provided a substantial boost to the disposable incomes of
households.
For the third quarter as a whole, real GDP, our broadest measure of output, is reported to have
increased 7-1/4 percent at an annual rate, the fastest quarterly rate of growth in nearly twenty years
and obviously a pace not sustainable over the longer run. Even though consumer spending evidently
slowed somewhat this fall, new orders received by manufacturers of nondefense capital goods,
excluding aircraft, have been rising as have unfilled orders - developments that suggest some further
increase in equipment spending is likely in train.
There have been some signs in recent weeks that the labor market may be stabilizing. However,
viewed from the perspective of the past couple of years, the jobs picture has been weak. Indeed, since
November 2001 - the estimated trough of this cycle - total payroll employment is currently reported to
have declined by 1 million, and aggregate hours worked in the nonfarm business sector have come
down 1-1/2 percent.
The combination of growing output and falling hours worked was made possible by a startlingly large
rise in productivity. Indeed, since the fourth quarter of 2001, output per hour in the nonfarm business
sector has increased 5 percent at an annual rate. And during the second and third quarters of this
year, output per hour increased at the astonishing average annual pace of about 7-1/2 percent. This
outcome has been associated with a dramatic increase in profits despite little evidence of corporate
pricing power.
The explanations of the past two years' surge in productivity are wide-ranging.
One hypothesis is that some of the increase represents a temporary rise in the level of productivity
reflecting a view that an unusual amount of caution is leading businesses to press workers and
facilities to a greater degree than can be sustained over the longer haul. By this hypothesis, as that
caution dissipates, employment growth will pick up and the level of output per hour will drop back.
Another hypothesis is that the level of productivity has undergone a one-time permanent upward shift.
This hypothesis builds on the idea that the heavy emphasis on exploiting new and expanding markets
from 1995 to 2000 likely diverted some corporate management from the hard work of controlling costs.
The payoffs from cost control doubtless seemed small relative to those thought to attend big-picture
expansion. But with tepid sales growth, uncertainty about the strength of future demand, and a fierce
discipline exerted by financial markets, companies have been forced to search aggressively for ways
to use resources more efficiently, to cut costs, and restore operating profit margins. The extent to
which businesses have succeeded in boosting output with fewer labor hours and minimal capital
investment over the past two years points up the possibility that a considerable stock of inefficiencies
accumulated in the boom years and that this stock is still being worked off.
Finally, yet another hypothesis stresses a more-lasting increase in the growth of output per hour. This
notion focuses on the considerable lag between the introduction of new technologies and their full
integration into production processes and business practices. To reap the full benefits of technological
innovation takes learning time, especially if there are large synergies through network effects.
Of course, given the exceptionally high rate of growth in output per hour over the past two years, some
combination of short-term and longer-term productivity-enhancing forces seems likely to have been at
work. In any event, one consequence of these improvements in efficiency has been a temporary ability
of many businesses to meet increases in demand while paring existing workforces and continuing to
exercise restraint on capital spending.
* * *
If businesses are to spend and hire more vigorously, they will need to be convinced that economic
growth can be sustained beyond the short run. One prominent concern is that, if the labor market
remains weak, household confidence will suffer, with detrimental consequences for spending.
Although layoffs seem to be diminishing, surveys indicate that households continue to be worried
about the condition of labor markets.
While real after-tax personal income increased at more than a 7 percent annual rate in the third
quarter, most of that gain reflected the influence of this year's cut in taxes. Unless hiring picks up and
layoffs ease, assuaging the latent job security fears of many of those currently employed, the share of
income spent could decline, a development that would hamper the vigor of the expansion.
The odds, however, do increasingly favor a revival in job creation. The surge in final demand in recent
months has been met in part by drawing down inventories. In many industries, available data suggest
that inventories have become low relative to sales, and purchasing managers' perceptions of their
customers' inventories corroborate that view. Any swing from inventory liquidation to accumulation
would add significantly to the level of GDP. Efforts to rebuild inventories and a dwindling pool of
possible efficiencies seem a combination that could generate a notable pickup in hiring should growth
in final sales remain firm.
* * *
A critical factor distinguishing the current economic environment from much of the previous experience
of the past half century is the inflation backdrop. In previous recessions since the 1960s, the
underlying rate of inflation at economic troughs remained clearly above any level that could be
associated with effective price stability. As a consequence, with some risk to economic activity,
monetary policy typically had to move aggressively in the uncertain early stages of past economic
recoveries to ensure that inflation would be contained.
By contrast, in the current episode, core consumer price inflation as measured in the national income
and product accounts has been running only a little more than 1 percent over the last year, and firms
exhibit scant evidence that they are gaining appreciable pricing power despite the pickup in the pace
of economic growth. Indeed, the Federal Open Market Committee has judged that the probability,
though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low
level. In these circumstances, monetary policy is able to be more patient. That said, no central bank
can ever afford to be less than vigilant about the prospects for inflation.
* * *
The foregoing relatively optimistic short-term outlook for the U.S. economy is playing out against a
backdrop of growing longer-term concern in financial markets about our federal budget.
As you know, the Congressional Budget Office is projecting that, if current policies remain in place, the
unified budget will post deficits throughout the remainder of this decade - a sharp turnaround from the
large and growing surpluses projected just a few years ago.
Given the events of the past three years - the economic downturn, the retrenchment in equity markets,
the increased need for spending on homeland security, and the wars in Afghanistan and Iraq - some
deterioration in the federal budget balance was probably unavoidable, particularly in the short term.
One source of deterioration - the buildup of a larger military force structure - will not persist indefinitely.
Merely maintaining a given force structure rather than increasing it will remove an important factor
driving the deficit higher.
Of course, the deterioration in the fiscal balance has already increased the level of debt relative to
GDP, and thus has elevated the starting point from which policymakers will soon have to address the
budget implications of the impending retirement of the baby-boom generation.
Recent budget deliberations are not encouraging. The current debate appears to be about how much
to cut taxes or how much to increase spending. No significant constituency seems to support taking
the actions that will be necessary to move toward, and one hopes achieve, budget balance. In
retrospect, the emergence of budget surpluses in the late 1990s eroded the discipline that emerged as
a consequence of the earlier fear of ever rising and, hence, potentially destructive deficits.
Indeed, many of the rules that helped to discipline budgetary decisionmaking in the 1990s - in
particular, the statutory limits on discretionary spending and the so-called PAYGO rules - were allowed
to expire. Many analysts properly continue to be concerned that, without these enforcement
mechanisms and the fundamental political will they signal, the built-in bias in favor of red ink will once
again become entrenched. Policymakers have become all too aware that government spending
programs and tax preferences can be easy to initiate but extraordinarily difficult to shut down once
constituencies develop that have a stake in maintaining the status quo.
The now-expired major provisions of the Budget Enforcement Act of 1990, and the act's later
modifications and extensions, provided a set of rules that helped translate a general commitment to
fiscal discipline into the actions necessary to achieve it.
Remember that in just five years the first cohort of the baby-boom generation will reach 62, the earliest
age at which social security retirement benefits may be claimed and the age at which about half of the
prospective beneficiaries choose to retire. In about 2008, the proportion of the working-age population
that will retire is projected to begin escalating. Almost surely, the social security and Medicare benefits
that are promised under current law to future retirees cannot be financed with existing tax rates.
Budget simulations by a broad range of analysts (including those at the Office of Management and
Budget and the Congressional Budget Office) suggest that the rapid increase in the unified budget
deficits that would occur under current law as the baby-boom generation retires could set in motion an
unsustainable dynamic in which large deficits result in growing interest payments that augment deficits
in future years. Such a development could have notable, destabilizing effects on the economy.
Increased productivity growth, while helpful, does not alter that conclusion, because when productivity
growth increases, so do social security obligations and, indirectly, Medicare benefits as well.
Productivity would have to grow at a rate far in excess of the historical average to fully resolve the
long-term financing problems of social security and Medicare.
Tax rate increases of sufficient dimension to deal with our looming fiscal problems arguably pose
significant risks to economic growth and the revenue base. The exact magnitude of such risks are very
difficult to estimate, but they are of enough concern, in my judgment, to warrant aiming to close the
fiscal gap primarily, if not wholly, from outlay restraint. At the same time, the dimension of the
challenge, especially in later years, cannot be underestimated. The one certainty is that the resolution
of this situation will require difficult choices, and the future performance of the economy will depend on
those choices.
History has shown that, when faced with large challenges, elected officials have risen to the occasion.
In particular, looking back over the past twenty years or so, it has been evident that the prospect of
large deficits generally has led to actions to narrow them. I trust that the recent deterioration in the
budget outlook and the fast-approaching retirement of the baby-boom generation will be met with
similar determination and effectiveness.