Alan Greenspan: The economic outlook
Testimony by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Joint Economic Committee, US Congress, Washington, 13 November 2002.
* * *
The past year has been both a difficult and a remarkable one for the United States economy. A year
ago, we were struggling to understand the potential economic consequences of the events of
September 11. At that time, it was unclear how households and businesses would react to this
unprecedented shock as well as to the declines in equity markets and cutbacks in investment
spending that had already been under way. Economic forecasts were lowered sharply, and analysts
feared that even these downward-revised projections might be undone by a significant retrenchment in
aggregate demand. The United States economy, however, proved to be remarkably resilient: In the
event, real GDP over the past four quarters grew 3 percent--a very respectable pace given the blows
that the economy endured.
Although economic growth was relatively well maintained over the past year, several forces have
continued to weigh on the economy: the lengthy adjustment of capital spending, the fallout from the
revelations of corporate malfeasance, the further decline in equity values, and heightened geopolitical
risks. Over the last few months, these forces have taken their toll on activity, and evidence has
accumulated that the economy has hit a soft patch. Households have become more cautious in their
purchases, while business spending has yet to show any substantial vigor. In financial markets, risk
spreads on both investment-grade and non-investment-grade securities have widened. It was in this
context that the Federal Open Market Committee further reduced our target federal funds rate last
week.
The consumer until recently has been the driving force of this expansion. Faced with falling equity
prices, uncertainty about future employment prospects, and the emergence of the terrorist threat,
consumer spending has slowed over the course of the past year but has not slumped as some had
earlier feared it might. Tax cuts and extended unemployment insurance provided a timely boost to
disposable income. And the deep discounts offered by many businesses on their products were most
supportive.
In particular, automotive manufacturers responded to the events of September 11 with cut-rate
financing and generous rebates. These incentives were an enormous success in supporting--indeed
increasing--the demand for new cars and trucks. Sales surged each time the incentive packages were
sweetened and, of course, fell back a bit when they expired. Some decline in sales was to be
expected in recent months after the extraordinary run-up recorded in the summer. However, it will bear
watching to see whether this most recent softening is a payback for borrowed earlier strength in sales
or whether it represents some weakening in the underlying pace of demand.
Stimulated by mortgage interest rates that are at lows not seen in decades, home sales and housing
starts have remained strong. Moreover, the underlying demand for new housing units has received
support from an expanding population, in part resulting from high levels of immigration.
Besides sustaining the demand for new construction, mortgage markets have also been a powerful
stabilizing force over the past two years of economic distress by facilitating the extraction of some of
the equity that homeowners had built up over the years. This effect occurs through three channels: the
turnover of the housing stock, home equity loans, and cash-outs associated with the refinancing of
existing mortgages. Sales of existing homes have been the major source of extraction of equity.
Because the buyer of an existing home almost invariably takes out a mortgage that exceeds the loan
canceled by the seller, the net debt on that home rises by the amount of the difference. And, not
surprisingly, the increase in net debt tends to approximate the sellers' realized capital gain on the sale.
That realized capital gain is financed essentially by the mortgage extension to the homebuyer, and the
proceeds, in turn, are used to finance some combination of a down payment on a newly purchased
home, a reduction of other household debt, or purchases of goods and services or other assets.
Home equity loans and funds from cash-outs are generally extractions of unrealized capital gains.
Cash-outs, as you know, reflect the additional debt incurred when refinancings in excess of the
remaining balance on the original loan are taken in cash.
According to survey data, roughly half of equity extractions are allocated to the combination of
personal consumption expenditures and outlays on home modernization. These data and some
preliminary econometric results suggest that a dollar of equity extracted from housing has a more
powerful effect on consumer spending than does a dollar change in the value of common stocks. Of
course, the net decline in the market value of stocks has greatly exceeded the additions to capital
gains on homes over the past two years. So despite the greater apparent sensitivity of consumption to
capital gains on homes, the net effect of all changes in household wealth on consumer spending since
early 2000 has been negative. Indeed, the recent softness in consumption suggests that this net
wealth erosion has continued to weigh on household spending. That said, it is important to recognize
that the extraction of equity from homes has been a significant support to consumption during a period
when other asset prices were declining sharply. Were it not for this phenomenon, economic activity
would have been notably weaker in the wake of the decline in the value of household financial assets.
In the business sector, there have been few signs of any appreciable vigor. Uncertainty about the
economic outlook and heightened geopolitical risks have made companies reluctant to expand their
operations, hire workers, or buy new equipment. Executives consistently report that in today's
intensely competitive global marketplace it is no longer feasible to raise prices in order to improve
profitability.
There are many alternatives for most products, and with technology driving down the cost of acquiring
information, buyers today can (and do) easily shift to the low-price seller. In such a setting, firms must
focus on the cost side of their operations if they are to generate greater returns for their shareholders.
Negotiations with their suppliers are aimed at reducing the costs of materials and services. Some
companies have also eschewed the traditional annual pay increment in favor of compensation
packages for their rank-and-file workers that are linked to individual performance goals. And, most
important, businesses have revamped their operations to achieve substantial reductions in costs.
On a consolidated basis for the corporate sector as a whole, lowered costs are generally associated
with increased output per hour. Much of the recent reported improvements in cost control doubtless
have reflected the paring of so-called "fat" in corporate operations--fat that accumulated during the
long expansion of the 1990s, when management focused attention primarily on the perceived
profitability of expansion and less on the increments to profitability that derive from cost savings.
Managers, now refocused, are pressing hard to identify and eliminate those redundant or nonessential
activities that accumulated in the boom years.
With margins under pressure, businesses have also been reallocating their capital so as to use it more
productively. Moreover, for equipment with active secondary markets, such as computers and
networking gear, productivity may also have been boosted by a reallocation to firms that could use the
equipment more efficiently. For example, healthy firms reportedly have been buying equipment from
failed dot-coms.
Businesses may also have managed to eke out increases in output per hour by employing their
existing workforce more intensively. Unlike cutting fat, which permanently elevates the levels of
productivity, these gains in output per hour are often temporary, as more demanding workloads
eventually begin to tax workers and impede efficiency.
But the impressive performance of productivity also appears to support the view that the step-up in the
pace of structural productivity growth that occurred in the latter part of the 1990s has not, as yet,
faltered. Indeed, the high growth of productivity during the past year merely extends recent
experience. Over the past seven years, output per hour has been growing at an annual rate of more
than 2-1/2 percent, on average, compared with a rate of roughly 1-1/2 percent during the preceding
two decades. Although we cannot know with certainty until the books are closed, the growth of
productivity since 1995 appears to be among the largest in decades.
Arguably, the pickup in productivity growth since 1995 reflects largely the ongoing incorporation of
innovations in computing and communications technologies into the capital stock and business
practices. Indeed, the transition to the higher permanent level of productivity associated with these
innovations is likely not yet completed. Once the current level of risk recedes, businesses will no doubt
move to exploit the profitable investment opportunities made possible by the ongoing advances in
technology.
However, history does raise some warning flags concerning the length of time that productivity growth
remains elevated. Gains in productivity remained quite rapid for years after the innovations that
followed the surge in inventions a century ago. But in other episodes, the period of elevated growth of
productivity was shorter. Regrettably, examples are too few to generalize. Hence, policymakers have
no substitute for continued close surveillance of the evolution of productivity during this current period
of significant innovation.
In summary, as we noted last week, "The [Federal Open Market] Committee continues to believe that
an accommodative stance of monetary policy, coupled with still-robust underlying growth in
productivity, is providing important ongoing support to economic activity. However, incoming economic
data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical
risks, is currently inhibiting spending, production, and employment. Inflation and inflation expectations
remain well contained." In these circumstances, the Committee believed that the actions taken last
week to ease monetary policy should prove helpful as the economy works its way through this current
soft spot.