Mr Greenspan discusses the US economy in a world context
Remarks by the Chairman of the US Federal Reserve System, Mr Alan Greenspan, at the 35th
Annual Conference on Bank Structure and Competition of the Federal Reserve Bank of
Chicago on 6 May 1999.
Any evaluation of the international financial crisis of the past two years would be incomplete
without an understanding of the extraordinary strength of the U.S. economy that has acted as a
buffer for much of the rest of the world.
There can be little doubt that the marked widening in our trade deficit on goods and services
has played an important, possibly a critical role in supporting world stability during these
trying years. Domestic demand growth in the United States has accounted for about one third
of the world total since 1996.
Now that there are tentative signs that we may be through the worst of the crisis abroad, an
issue to which I shall return shortly, it would be useful to address the benevolent, but
bedeviling, question of how the American economy, at least to date, has managed to remain
an oasis of prosperity, in sharp contrast to badly sagging economies in the developing world,
recession in Japan, and tepid growth in much of Europe. And, can we project how long our
economy will be able to provide support to the rest of the world?
Forecasts of inflation and of growth in real activity for the United States, including those of
the Federal Open Market Committee, have been generally off for several years. Inflation has
been chronically overpredicted and real GDP growth underpredicted. An increase in inflation
doggedly forecast to follow the ever lower unemployment rate - now the lowest in three
decades - has not occurred. In fact, even after accounting for the reduced bias in our price
statistics resulting from methodological improvements, some measures of inflation have even
continued to ease.
Subdued inflation, of course, has resulted, in part, from the sharp fall in oil prices from
mid1997 through early this year. Moreover, there has been a significant weakening in non-oil
import prices since 1995, owing largely to a combination of declining world commodity
prices and a strengthening dollar in our foreign exchange markets through last summer. The
decline in prices of oil and non-imports are clearly "one-off" events. Indeed, oil prices have
moved up sharply of late.
The remaining easing in the inflation rate owes to disinflation in domestic value added
excluding oil. The latter, in turn, is more than accounted for by a decline in the rate of increase
in unit costs of output, inasmuch as profit margins have increased significantly since 1993. A
pickup in the growth of labor productivity - beyond the effects of the business cycle -
appears to have been an essential factor behind the slowing in inflation. Growth in labor
productivity, which had averaged less than a 1 percent annual rate in the early 1990s, rose to
approximately 3 percent in the four quarters ending in the first quarter of 1999.
Increased labor productivity growth has directly lowered the growth of unit labor costs. And
that reduction in costs, in combination with declining import prices, has also apparently
engendered lower price inflation and inflation expectations that, in turn, have curbed both
nominal wage growth and unit interest costs. Consolidated unit nonlabor costs, excluding
interest, have played little role in the inflation accounting exercise in recent years. Apparently,
the effects of falling equipment prices have matched the upside influence of shorter service
lives on the average depreciation rate to keep unit capital consumption charges stable.
I say that accelerated labor productivity is arguably at the root of declining domestic
valuedadded price inflation because it can be misleading to identify a single variable as the
exogenous force in an essentially interactive process of cause and effect. But in this case, the
notion that labor productivity acceleration has been largely, though not wholly, exogenous,
appears persuasive. Its unexpected emergence also apparently explains much of the shortfall
in forecasting of overall economic growth in recent years.
I have hypothesized before this group on several occasions that the synergies that have
developed, especially among the microprocessor, the laser, fiber-optics, and satellite
technologies, have dramatically raised the potential rates of return, not only on new
telecommunications investments, but more broadly on many types of equipment that embody
or utilize the newer technologies.
The newest innovations, which we label information technologies, have begun to alter the
manner in which we do business and create value, often in ways not readily foreseeable even
five years ago.
I do not say we are in a new era, because I have experienced too many alleged new eras in my
lifetime that have come and gone. We are far more likely, instead, to be experiencing a
structural shift similar to those that have visited our economy from time to time in the past.
These shifts can have profound effects, often overriding conventional economic patterns for a
number of years, before those patterns begin to show through again over the longer term.
There was far greater justification to view the future with the unbridled optimism of a
presumed new era a century ago than today. Technological change was truly awesome around
the turn of the century. In a very short number of years the world witnessed an astounding list
of new creations: electric power and light, radios, phonographs, telephones, motion pictures,
x-rays, and motor vehicles, just to begin the list.
As this century comes to an end, the defining characteristic of the current wave of technology
is the role of information. Prior to the advent of what has become a veritable avalanche of IT
innovations, most of twentieth century business decisionmaking had been hampered by
limited information. Owing to the paucity of timely knowledge of customers' needs and of the
location of inventories and materials flows throughout complex production systems,
businesses required substantial programmed redundancies to function effectively.
Doubling up on materials and people was essential as backup to the inevitable misjudgments
of the real-time state of play in a company. Judgments were made from information that was
hours, days, or even weeks old. Accordingly, production planning required adequate, but
costly, inventory safety stocks, and backup teams of people to maintain quality control and for
emergency response to the unanticipated and the misjudged.
Large remnants of information void, of course, still persist and forecasts of future events on
which all business decisions ultimately depend are still inevitably uncertain. But the recent
years' remarkable surge in the availability of real-time information has enabled business
management to remove large swaths of inventory safety stocks and worker redundancies, and
has armed workers with detailed data to fine tune product specifications to most individual
customer needs.
Moreover, information access in real-time resulting from processes such as, for example,
checkout counter bar code scanning and satellite location of trucks, fostered marked
reductions in delivery lead times on all sorts of goods, from books to capital equipment. This,
in turn, has reduced the relative size of the overall capital structure required to turn out our
goods and services, and, as a consequence, has apparently added to growth of multifactor
productivity, and thus to labor productivity acceleration.
Intermediate production and distribution processes, so essential when information and quality
control were poor, are being bypassed and eventually eliminated. The increasing
ubiquitousness of Internet web sites is promising to significantly alter the way large parts of
our distribution system are managed.
The process of innovation goes beyond the factory floor or distribution channels. Design times
have fallen dramatically as computer modeling has eliminated the need, for example, of the
large staff of architectural specification drafters previously required for building projects.
Medical diagnoses are more thorough, accurate, and far faster, with access to heretofore
unavailable information. Treatment is accordingly hastened, and hours of procedures
eliminated. In addition, the dramatic advances in biotechnology are significantly increasing a
broad range of productivity-expanding efforts in areas from agriculture to medicine.
The evident acceleration of the process of "creative destruction", which has accompanied
these expanding opportunities and which has been reflected in the shifting of capital from
failing technologies into those technologies at the cutting edge, has been remarkable. Owing
to advancing information capabilities and the resulting emergence of more accurate price
signals and less costly price discovery, market participants have been able to detect and to
respond to finely calibrated nuances in consumer demand. The process of capital reallocation
has been assisted through a significant unbundling of risks made possible by the development
of innovative financial products, not previously available.
The proliferation of products of all different designs and qualities has opened up the potential
for the satisfaction of consumer needs not evident even twenty years ago. The accompanying
expansion of wealth has been large, though regrettably the gains are not as widely spread
across households as I would like.
Thus, in summary, the technological innovation observed in recent years does not appear to be
a story of pure economic endogeniety. The aforementioned technologies appear largely sui
generis to the post World War II period, indeed to the last twenty years. They were
unanticipated, and evolved, for the most part, independent of the ebbs and flows of economic
activity. While the amount of capital investment that has carried these technologies into use
has been, of course, affected by the costs of capital and labor, and by consumer demand, the
rates of return offered by this new equipment have been largely rooted in the relative state of
technology.
It is the observation that there has been a perceptible quickening in the pace at which
technological innovations are applied that argues for the hypothesis that the recent
acceleration in labor productivity is not just a cyclical phenomenon or a statistical aberration,
but reflects - at least in part - more deep-seated, still developing, shift in our economic
landscape.
Indeed it remains a hypothesis, since in economics, unlike in the physical sciences, we can
never conduct fully controlled experiments for an overall economy. The evidence,
nonetheless, for a technology-driven rise in the prospective rate of return on new capital, and
an associated acceleration in labor productivity is compelling, if not conclusive.
Starting in 1993, capital investment, especially in high-tech equipment, rose sharply beyond
normal cyclical experience, presumably, as always, the result of expected increases in rates of
return. Had the profit expectations not been realized, one would have anticipated outlays to
have fallen back. Instead, their growth increased through the remainder of the decade.
More direct evidence supporting an improved underlying profitability has become
increasingly evident in company data. It seems likely that the synergies of advances in laser,
fiber optic, satellite, and computer technologies with themselves and with older technologies
have enlarged the pool of opportunities to achieve a rate of return above the cost of capital.
The bulge in the exploitation of these "excess" potential rates of return has been stimulated by
the accelerating decline in the prices of high-tech equipment starting in 1995. The amount of
capacity plowed into limited areas of technology led to extra heavy price discounting. The
rapid pace of innovation that has fostered shortened product life cycles also has contributed to
driving down prices of high-tech equipment.
Few business people report any significant perceived diminution of the backlog of these as yet
unexploited profitable synergies. In recent years, businesses often have indicated a capability
to dip into this backlog for capital investments that can quickly displace labor costs should
they be perceived as about to rise.
This view is reinforced by securities analysts who presumably are knowledgeable about the
companies they follow. This veritable army of technicians has been projecting increasingly
higher five-year earnings growth, on average, since early 1995, according to I/B/E/S, a Wall
Street research firm that compiles these estimates for the S&P 500. In January 1995, the
analysts projected five-year earnings to rise on average by about 11 percent annually. After
successive upward revisions, the March 1999 estimate was set at about 13.5 percent (profit
weighted), a peak for this expansion. While there are ample data to conclude that these
estimates are biased upward, there is scant evidence to suggest the bias has changed.
There appears little reason to doubt that analysts' continuous upward revisions reflect what
companies are reporting to them about improved cost control, which on a consolidated basis
for the economy overall, adds up to accelerating labor productivity. The alternative
explanations - more rapid growth in earnings from operations abroad, a rising rate of
increase in value-added prices received, or from an economy-wide prospective, ever faster
labor force growth - are not credible. Thus, companies are apparently conveying to analysts
that, to date, they see no diminution in expectations of productivity acceleration. This does not
mean that the analysts are correct, or for that matter the companies, only that what companies
are evidently telling the analysts about their productivity and profits are doubtless reflected in
the longer-term profit projections. The macroeconomic data to date certainly suggest little
evidence of a slowdown in productivity growth.
I said the evidence for technology-driven acceleration in productivity is compelling, but not
conclusive. Indeed, there are a large number of economists who doubt that the rise in
productivity growth is anything more than a cyclical phenomenon or some type of statistical
aberration. To be sure, they say, nonfarm productivity growth has risen in recent years, but
they note that there have been other periods in our postwar records that exhibited similar
patterns of acceleration only to fall back to subnormal growth. Many analysts offer as the
explanation of the recent acceleration the slow pace of labor productivity growth earlier this
decade. The current surge is judged a mere catch-up. The recent acceleration is admittedly not
sufficient proof of an irreversible trend for a variable as statistically volatile as labor
productivity.
But catch-up or not, the evidence appears to be mounting that, even if productivity does not
continue to accelerate, the pickup already observed does seem to explain much of the
extraordinary containment of inflation despite the ever-tightening labor markets of recent
years.
The newer technologies, as I indicated earlier, have facilitated a dramatic foreshortening of the
lead times on the delivery of capital equipment over the past decade, presumably allowing
businesses to react more expeditiously to an actual or expected rise in nominal compensation
costs than, say, they could have in the 1980s.
The newer technologies and foreshortened lead times apparently have made capital
investment distinctly more profitable, enabling firms to substitute capital for labor and other
inputs far more productively than they could have a decade or two ago. Capital, as economists
like to say, has deepened significantly since 1995.
The surge in investment not only has restrained costs, it has also increased industrial capacity
faster than the rise in factory output. The resulting slack in product markets has put greater
competitive pressure on businesses to hold down prices, despite taut labor markets.
Purchasing managers have been reporting virtually no material shortages for more than three
years.
Technology is also damping inflation through its effect on international trade, where
technological developments and a move to a less constrained world trading order have
progressively broken down barriers to cross-border trade. All else equal, the enhanced
competition in tradeable goods enables excess capacity previously bottled up in one country to
augment worldwide supply and exert restraint on prices in all countries' markets.
The resulting price discipline also has constrained nominal wage gains in internationally
tradeable goods industries. As workers have attempted to shift to other sectors, gains in
nominal wages and increases in prices in nontradeable goods industries may have been held
down as well.
The process of price containment has doubtless become, to some extent, self-reinforcing.
Lower inflation in recent years has altered expectations. Workers no longer believe that large
gains in nominal wages are needed to reap respectable increases in real wages. Moreover,
incongruously, at the same time that labor markets tightened, workers' fear of job skill
obsolescence rose, apparently, as a consequence of the rapid changes in technology that have
induced the accelerated churning in the nations' capital stock with which our workforce must
interact day by day. Job security has seemingly become more relevant than wage gains as a
result. The return of experienced workers for further schooling is remarkable and attests to the
surprising depth of worker job insecurity in the face of ever tightening labor markets.
Because neither business firms nor their competitors can currently count any longer on a
general inflationary tendency to validate decisions to raise their own prices, each company
feels compelled to concentrate on efforts to hold down costs. The availability of new
technology to each company and its rivals affords both the opportunity and the competitive
necessity of taking steps to boost productivity. This contrasts with our experiences through the
1970s and 1980s, when firms apparently found it easier and more profitable to seek relief
from rising nominal labor costs through price increases than through cost-reducing capital
investments.
It is difficult to judge how much of our benign overall price behavior during the past half
decade is attributable to these significant shifts in the environment in which firms function.
Undoubtedly, other factors have been at work as well, including those temporary oil and
import price declines that I mentioned earlier and some more lasting influences that I have not
discussed, such as worldwide deregulation and privatization, and the freeing up of resources
previously employed to produce military products that was brought about by the end of the
cold war. There also may be other contributory forces lurking unseen in the wings that will
only become clear in time.
Over the longer run, of course, the actions of the central bank determine the degree of overall
liquidity and, hence, the rate of inflation. It is, thus, up to us at the Federal Reserve to secure
the favorable inflation developments of recent years and remain alert to the emergence of
forces that could dissipate them. For, at root, it has been the remarkably quiescent inflation
that has provided the favorable financial conditions and stable economic environment in
which businesses have been able to function most efficiently. Were that not the case, the
innovations of the last decade could not have been implemented and the 1990s would surely
have looked far less impressive.
In the event, the performance of the American economy over the past seven years has been
truly phenomenal. The breadth of technological advance and its application has engendered a
major upward revaluation of business assets, both real and intangible. That revaluation has
induced a spectacular rise in equity prices that to many has reached well beyond the
justifiable.
Of most concern is how long this remarkable period of prosperity can be extended. As I have
said on previous occasions, there are imbalances in our expansion that, unless redressed, will
bring this long run of strong growth and low inflation to a close.
Although productivity has accelerated in recent years, the impressive strength of domestic
demand, in part driven by sharply rising equity prices, has meant that the substitution of
capital for labor has been inadequate to prevent us from steadily depleting the pool of
available workers.
This worker depletion constitutes a critical upside risk to the inflation outlook because it
presumably cannot continue without eventually putting increasing pressure on labor markets
and on costs.
The number of people willing to work can be usefully defined as the unemployed component
of the labor force plus those not actively seeking work, and thus not counted in the labor
force, but who nonetheless say they would like a job if they could get one. This pool of
potential workers aged sixteen to sixty-four currently numbers about 10 million, or just
53⁄4 percent of the corresponding population. This is the lowest such percentage on record -
which begins in 1970 - and is 21⁄2 percentage points below its average over that period.
The rapid increase in aggregate demand has generated growth of employment in excess of the
growth in population, causing the number of potential workers to fall since the mid-1990s at a
rate of a bit under one million annually. We cannot judge with precision how far this level can
decline without sparking upward pressures on wages and prices. Accelerating productivity
may have appeared to break the link between labor market conditions and wage gains in
recent years, but it cannot have changed the law of supply and demand.
At some point, labor market conditions can become so tight that the rise in nominal wages
will start increasingly outpacing the gains in labor productivity, and prices inevitably will then
eventually begin to accelerate.
Under those circumstances, inflation premiums embodied in long-term interest rates would
doubtless rise. The attendant increased risk premiums would boost real interest rates as well,
as investors become less certain about future price prospects. Thus, while rates of return on
new capital equipment might remain elevated, the real cost of capital could rise enough to
suppress capital expenditures and, perhaps of greater relevance to the outlook, the stock
market.
Our negative personal saving rate indicates that the wealth effect is alive and well. The latter
has unquestionably been a key factor in the rise in domestic demand, which despite
productivity improvements has exerted increasing pressure on labor markets. Thus, should
equity markets retrench, consumer and business investment demands would, doubtless,
weaken considerably.
A more distant concern, but one that cannot be readily dismissed, is the very condition that
has enabled the surge in American household and business demands to help sustain global
stability: our rising trade and current account deficits. There is a limit to how long and how far
deficits can be sustained, since current account deficits add to net foreign claims on the United
States.
It is very difficult to judge at what point debt service costs become unduly burdensome and
can no longer be sustained. There is no evidence at this point that markets are disinclined to
readily finance our foreign net imbalance. But the arithmetic of foreign debt accumulation and
compounding interest costs does indicate somewhere in the future that, unless reversed, our
growing international imbalances are apt to create significant problems for our economy.
Finally, while it is reasonable to conclude that some of the gains in output per hour have been
driven by fundamental forces, and are not only a cyclical phenomenon or a statistical
aberration, it remains a wholly separate question of whether they can be extended. The rate of
growth of productivity cannot increase indefinitely. While there appears to be considerable
expectation in the business community, and possibly Wall Street, that the productivity
acceleration has not yet peaked, history advises caution.
As I have noted previously, history is strewn with projections of technology that have fallen
wide of the mark. With the innumerable potential permutations and combinations of various
synergies, forecasting technology has been a daunting exercise.
There is little reason to believe that we are going to be any better at this in the future than in
the past. Hence, despite the remarkable progress witnessed to date, we have to be quite
modest about our ability to project the future of technology and its implications for
productivity growth and for the broader economy.
For, if productivity growth should level out or actually falter because additional technology
synergies fail to materialize, or because output per hour has been less tied to technology in the
first place, inflationary pressures could re-emerge, possibly faster than some currently
perceive feasible.
For, obviously if productivity growth slows, unit labor costs would rise, first pressuring profit
margins, and then prices. Indeed, we cannot rule out such a process if labor productivity
growth simply levels out. Our ability to forecast, when a diminishing pool of potential
workers begins to raise costs or when productivity trends change, is limited. We do know,
however, that if, and when, either materializes, inflation pressures are likely to again surface.
To return to my opening question: can we project how long the economy of the United States
can act as a buffer to weakness elsewhere?
The answer: not easily. History counsels us that sharp changes in direction are rarely, if ever,
anticipated. Indeed, were these changes readily apparent, presumably, businesses would adjust
to that anticipation and, hence, significantly damp the cyclical tendencies in the economy.
The outlook for the American economy is particularly relevant to the realization of a full
recovery of East Asia. To be sure, there are definite signs of activity bottoming out in
Indonesia and Hong Kong and evidence of some gains in Thailand and Malaysia, with the
most progress reported in Korea. Japan, whose economy is considerably larger than the rest of
East Asia combined, excluding China, is still bedeviled by its inability to restore a vibrant
banking system, though they seem to be making some progress.
But the emergence of East Asia out of its severe crisis, though real, remains fragile. The very
improvements now under way could be threatening the resolve of a number of countries to
adhere to the disciplined plans that have been instrumental in their recovery to date.
Brazil has managed to stem a prospective implosion that followed in the wake of its currency
crisis. But there, as well as some other parts of Latin America that seem to have dodged the
bullet of a Brazilian-induced contagion, the potential for a letdown in their policy discipline
that has served them well, also is a concern.
But, in general, discipline is likely to hold, because the lessons of 1997 and 1998 are too
recent and vivid to be soon forgotten. Hence, with a little backing and filling, the emerging
nation crises of the last two years are likely to gradually dissipate and these countries should
move onto a significant recovery path. The overhang of debt and difficult unresolved
structural problems, however, are likely to keep a vigorous recovery at bay. But, in the end,
their outlook will be influenced importantly by developments in Japan, Europe, and especially
the United States.
In Europe, gains in real GDP have remained modest, though inflation appears nonexistent.
Arguably, the rapidity of the introduction of cutting-edge technologies has not seemed to be as
evident in Europe as in the United States. Though somewhat puzzling, this is surely
temporary, unless the thrust of innovation in the United States comes to an unexpected halt, or
existing rigidities in European markets unexpectedly persist in the face of growing
international competition. Europe, as a consequence, is likely to remain a positive contributor
to world economic stability in the years ahead.
Let me conclude with an observation I have made before: We policymakers have been
engaged in a lot of on-the-job training in recent years. The remarkable American economy,
whose roots are still not conclusively known, and the Asian crises that caught us by surprise,
among other humbling experiences, have made policymakers particularly sensitive to how fast
the world can shift beneath our feet. We need to be alert to the dramatic changes that are
continuously confronting us, but recognize that neither the fundamental laws of economics,
nor human nature, on which they are based, has changed, or is likely to change. This will be
an especially important notion to keep in mind as we continue to grapple with the rapidly
changing global economic environment and its regulatory structure, which this symposium
has been convened to address.