Alan Greenspan: Productivity
Speech by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the US Department of Labor and American Enterprise Institute Conference, Washington,
D.C., 23 October 2002.
* * *
The increase in nonfarm business output per hour over the past year will almost surely be reported as
one of the largest advances, if not the largest, posted over the past thirty years. We at the Federal
Reserve, along with our colleagues in government and the private sector, are struggling to account for
so strong a surge. We would not be particularly puzzled if the increases in output per hour were
occurring during a period of very rapid economic growth, such as has often attended recoveries from
steep recessions. Historically, such recoveries have allowed overhead and maintenance employee
hours to be spread over a rapidly increasing level of production. But during the past year we averaged
only modest economic growth.
The reported estimates of output per hour do not appear to have resulted principally from faulty data or
measurement error. Whether output is measured from the expenditure side or from the independently
estimated income side of the national accounts, and whether hours of work are measured from the
survey of establishments or the survey of households, the same basic result is clearly evident: an
impressive gain in output per hour over the past year. This conclusion is buttressed by recent sizable
increases estimated for labor productivity for the manufacturing sector, derived from a data system
that, for the most part, is independent of the national accounts.
To be sure, because the productivity feast of recent quarters has been so difficult to explain, many
analysts expect a productivity famine in the period ahead. Others, however, are not so pessimistic.
Regardless of how events unfold, we will need to confront difficult questions posed by the recent
performance of productivity, if we are to properly evaluate economic developments going forward.
Indeed, if the recent surge in measured productivity is not a statistical mirage, or if it is not expunged
by data revisions, then we need to ask about its possible causes.
Clearly, over the past year corporate managers, confronted with tepid demand and a virtual
disappearance of pricing power, have struggled to maintain profit margins. With price increases largely
off the table and demand soft, lowered costs have become the central focus of achieving increased
profitability. 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 attention was focused primarily on the perceived profitability of expansion and less on
the increments to profitability that derive from cost savings.1 Managers, now refocused, are pressing
hard to identify and eliminate those redundant or non-essential activities that accumulated in the boom
years.
Now, with margins under pressure, businesses effectively have been reorganizing work processes and
re-allocating resources so as to use them more productively. Moreover, for capital with active
secondary markets, such as computers and networking equipment, 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 also may 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.
Perhaps the return to a low-inflation environment in recent years in itself explains the intensification of
competitive pressures, which has been a spur to the growth of productivity. Indeed, the data do
suggest a relationship between inflation and productivity growth over the long run. But that statistical
relationship is modest at best and inferring causality is complicated by a circularity that arises because
increased growth in output per hour depresses unit labor costs and, hence, prices.
Taken at face value, historical relationships suggest low inflation would explain very little of the most
recent surge in output per hour. To be sure, while lack of pricing power and associated competitive
pressures may have initiated much of the cost cutting and organizational changes that have occurred,
it will ultimately be the quantity of fat in the system and the opportunities for productive reorganization
that will determine the potential gains in productivity.
Only in retrospect, if then, will we be able to ascertain how much of the past year's elevated growth in
output per hour was transitory--that is, growth that resulted from cutting of fat, reorganizing operations,
and more fully exploiting technologies already embedded in the existing capital stock. Such
improvements, even though they are long-lasting, are, of course, a level adjustment with no necessary
implications for productivity growth going forward. Moreover, there is an upper limit to the amount of
output that can be produced from an existing facility, even in the short run, no matter how intensively it
is employed and how much fat is taken out of the system. Corporate management can not unendingly
reduce cost without at some point curtailing output or embodying new technologies through investment
to sustain it.
The recent upsurge in the growth of output per hour has understandably renewed interest in the
relationship between investment and so-called adjustment costs. Firms do not necessarily reap the full
benefits of their capital investments immediately because of the disruptions to activity that can be
initially created when new equipment is installed; these disruptions may include learning to use the
new equipment and software or getting the new machines to mesh with existing systems. Thus,
although capital investment ultimately boosts output per hour, these adjustment costs temper the initial
benefits to increased production obtained from new investment.
It is likely that as capital spending fell over the past couple of years, so did the disruptions that
accompanied its installation. Moreover, the dislocations associated with the substantial investment of
the late 1990s and 2000 also likely were waning. This lower level of disruption provides a boost to
growth in output per hour for a time. How much remains an open question. The quantitative evidence
on the magnitude of this effect spans the range from significant to small.2
The ability of businesses to boost productivity with what seems to be minimal new capital investment
over the past two years suggests that output per hour growth in the later years of the 1990s likely
trailed the growth in underlying productivity in those years. If this inference is accurate, part of that
earlier growth in underlying productivity is being reflected in today's gains in output per hour.
The difficulty in explaining the recent past is most evident when we decompose gains in output per
hour into the contribution from changes in worker quality, the amount of capital used by workers--that
is, capital deepening--and the contribution from all other factors, a notion that economists label
"multifactor productivity." By definition, multifactor productivity includes technical change,
organizational improvements, cyclical factors, and myriad other influences on output per hour, apart
from capital investment. With capital spending sluggish over the past year, and no evident acceleration
of worker quality, it is likely that growth of multifactor productivity accounts for an appreciable portion
of the rise in output per hour.
Based on historical experience, it seems improbable that all of the large rise in multifactor productivity
could be attributed to cyclical or transitory factors. Conversely, it seems very unlikely that all of the
increase in the growth of productivity could be attributed to structural influences. The truth,
presumably, lies between these two extremes, but where has yet to be determined. At minimum,
however, it seems reasonable to conclude 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, high growth of productivity over 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.
Our nation has had previous concentrated bursts of technological innovation. In those instances,
business practices slowly adapted to take advantage of the new technologies. The result was an
outsized increase in the level of productivity spread over a decade or two, with unusually rapid growth
rates observed during the transition to the higher level.
For example, as the benefits that attended the development of the electric dynamo and the internal
combustion engine more than a century ago became manifest in both the capital stock and the
organization of production, the growth of labor productivity surged. From an average annual rate of
13/4 percent in the late nineteenth and early twentieth century, it jumped to a 3-3/4 percent rate in the
decade following World War I. Subsequently, productivity growth returned to a 1-3/4 percent pace.
Then, for the quarter century following World War II, productivity growth rose to an average rate of
23/4 percent before subsiding to a pace of 1-1/2 percent annually from the mid-1970s to the
mid1990s.3
Arguably, the pickup in productivity growth since 1995 largely reflects 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.
Surveys of purchasing managers in recent quarters consistently indicate that an appreciable share
reports that their firms still have a considerable way to go in achieving the desired efficiency from the
application of technology to supply management. If the backlog of unexploited long-term profitable
technologies remains high, it should be assumed that once currently elevated risk premiums and the
heightened cost of equity capital (and some debt) recedes, or cash flows expand, new
productivityenhancing capital investment will pick up.
Further evidence that firms still have not fully adapted their operations to the latest state of technology
also is provided in a recent study4 that attempts to measure the "technological gap"--that is, the
difference between the productivity of leading-edge capital and the average productivity embodied in
the current capital stock. This gap is estimated to be quite wide currently, which suggests that there
are still significant opportunities for firms to upgrade the quality of their technology and with it the level
of productivity.
The paper presented by Stephen Oliner and Dan Sichel this morning also provides a basis for arguing
that a significant portion--and possibly all--of the productivity revival of the mid-1990s is sustainable.
Based on an analysis of a multisector growth model, their work suggests that a range for sustainable
growth in labor productivity over the next decade is 2 percent to 2-3/4 percent per year. Jorgenson,
Ho, and Stiroh use a similar methodology and find a range from a little less than 1-1/2 percent to about
3 percent with a central tendency of around 2-1/4 percent.5
These estimates are clearly plausible, but history does raise some warning flags concerning the length
of time that productivity growth continues elevated. Gains in productivity remained quite rapid for years
after the innovations that followed the surge of 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 this current
period of significant innovation.
* * *
In summary then: given the difficult adjustments that our economy has been undergoing, long-term
productivity optimism may currently seem a bit out of place. It may appear even more so in the months
ahead should output per hour soften following this period of outsized gains. Nevertheless, it is both
remarkable and encouraging that, despite all that has transpired over the past couple of years, a
significant step-up in the growth of productivity appears to have persisted.
William J McDonough: Promoting financial resilience
Remarks by Mr William J McDonough, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Cato Institute's 20th Annual Monetary Conference on "International Financial
Crises: What Role for Government?" cosponsored with The Economist, New York, 17 October 2002.
* * *
• Good morning. It is a pleasure to have the opportunity to join you on the occasion of this
timely conference, and to share with you my thoughts on promoting financial resilience.
• Despite the fact that periodic surges in volatility are a fact of life in financial markets, I think
there is general acknowledgment that recent years have been extraordinary in this regard.
This has been a period of historic change and remarkable volatility in markets, going well
beyond the emerging markets, and carrying with it important implications for political, social,
and institutional stability in significant segments of the globe.
• The experiences of recent years have reinforced old lessons and brought home new insights
about maintaining financial stability and sustained growth. In particular, a broad consensus
continues to develop on ways of strengthening the institutional framework at the national and
international level to create more robust, and thus more crisis-resistant, economies. There is
general agreement that in order for countries to enjoy sustained and stable growth, the
following are crucial:

a sound and stable macroeconomic environment, and

well-functioning and robust financial systems in both capital-exporting and
capitalimporting countries.
Moreover, both of these are most effective when supported by a dynamic and adaptive policy regime.
• The simple reality is that countries with robust financial systems, strong fiscal accounts, low
inflation, credible and coherent monetary and exchange rate policies, moderate external and
internal indebtedness, reasonable current accounts, and adequate domestic savings rates
are less likely to be buffeted by financial and economic turbulence. Moreover, when shocks
do occur, such countries tend to be far more resilient.
• There is also considerable agreement on many of the elements needed to achieve these
goals. This agreement has been reflected, in part, in the development and promulgation of
globally accepted standards and codes for best practices in areas ranging from transparency
in fiscal, monetary, and financial policies, to public debt management, and core principles for
bank supervision. Guiding themes across these various standards have included the
importance of consistent disclosure practices and of building stability up from the firm and
sector level. The latter is accomplished by encouraging sound risk management and
stronger balance sheets, and creating efficient systems of market, legal, and regulatory
discipline.
• But the learning process continues. For example, in this country, recent experiences have
brought to light the need to do more to strengthen corporate accounting and disclosure
standards, particularly with regard to guarantees and complex financial arrangements, such
as those funded offshore or through special-purpose entities.
• Our ongoing efforts to revise the Basel Capital Accord also reflect a learning process. We
embarked on this voyage in the late 1990s because we realized that the original 1988 Basel
Accord had been overtaken by advances in the financial sector - and in the broader
economy. While the 1988 Accord represented an important advance, new technology, the
globalization of financial markets, and innovative financial products and services have
changed the way that banks monitor and manage credit, market, and operational risks in a
manner that the 1988 Accord could not anticipate and does not address.
• To ensure that the New Accord remains flexible, forward-looking, and appropriate for the
risks and capital needs of internationally active banks of the twenty-first century, the Basel
Committee established several goals for its work, goals that the industry has embraced.

First, we intended to develop a framework that encompasses the "three pillars"
necessary to support an effective system of regulatory capital: the appropriate
measurement and minimum requirements, supervisory review, and market
discipline.

Second, we wanted to align the minimum requirements more closely with the
actual underlying economic risks to which banks are exposed, which should help
allocate capital resources effectively.

A third goal was to encourage banks to refine their measurement and management
of risk over time. By creating incentives in the New Accord for banks to re-evaluate
and enhance their tools constantly, we expect that banks themselves will adopt a
forward-looking perspective on risk.

I'm pleased to say that, through the Committee's efforts and the cooperation and
support of other supervisors and the industry, it appears that the proposed
framework will attain each goal. We can now count them among the milestones
we've achieved.
• However, though we have covered quite a bit of territory over the past three years, the last
miles of any marathon are the toughest to finish. I'd like to turn now to the status of the New
Accord and of the issues we are still resolving.
• Since the Second Consultative Document's release 21 months ago, the members of the
Basel Committee have worked collaboratively and publicly with supervisors, banks, and
others to revise the proposals so that they best serve the needs of modern banking. We've
published and discussed thousands of pages of proposals and studies with the industry and
the public. I'd like to share with you the latest news on how we are resolving the key
challenges and concerns that have surfaced in this process.
• One general issue raised is that the New Accord's increased sensitivity to risk will reinforce
procyclical behavior by banks, leading to increased cost of credit during cyclical downturns.
While we are working to address this concern, I would note that banks already are expected
to operate above minimum capital requirements, manage to their economic capital needs,
and evaluate how their risk profiles may change over time. Along those lines, the Committee
recently agreed that banks adopting the "internal ratings based" approach to credit risk will
be required to conduct appropriate credit risk stress testing, which should help to contain
procyclical behavior.
• Another concern raised about Basel II is its complexity. If the New Accord is to be more
risksensitive, however, it must involve an irreducible degree of complexity, which parallels the
changes in bank practices and market instruments. Indeed, some of this complexity stems
from the various options the New Accord provides to address the wide range of risk profiles,
strategies, and systems that banks maintain.
• The treatment of operational risk has been a more specific area of concern. While
operational risk cannot be quantified with the same degree of precision as credit or market
risk, the Committee believes that introducing a separate charge for operational risk will
bolster efforts to find better ways to address it. In this vein, we have seen encouraging
progress in operational risk measurement, although we recognize that the industry has not
settled on particular methodologies or principles. Accordingly, the New Accord will permit an
unprecedented amount of flexibility to accommodate a spectrum of approaches to
operational risk. Toward that end, under the "advanced measurement approach," the most
sophisticated institutions will be free to experiment with a great variety of methodologies.
• The Basel Committee expects that we will achieve our goal of not raising in aggregate the
capitalization required of the banking industry, though clearly and appropriately those banks
that engage in higher risk businesses may see their requirements rise, and vice versa.

To help ensure this, the Committee launched its third Quantitative Impact Study on
October 1, 2002, involving, to date, 265 banks from nearly 50 countries. The banks
will assess how the proposals will affect them and submit their findings by
December 20, 2002. These results will allow us to ascertain the need for
adjustments prior to the release of an updated proposal for public comment in the
second quarter of 2003, followed by finalization of the New Accord in the fourth
quarter of 2003, and implementation at year-end 2006.
• While much work clearly remains to be done over the next three years - including evaluating
banks' readiness, training supervisory staff, and working towards consistent implementation
across supervisors - in my view, both the journey and the ultimate destination of a New
Accord will contribute substantially to a more resilient international financial system.
• Unfortunately, while there is a deepening consensus on key elements about how to promote
resilience ex ante, there is no comparable degree of consensus on how best to handle
international financial crises once they do erupt, or the proper roles of public institutions and
the private sector in containing and resolving such crises. Notwithstanding considerable
efforts at the public and private level to search for a better way, no magic bullet or formula
has been found, although at times some have been asserted.
• Nor is one likely to be available. Experience and a reading of the historical record suggest
that the seductive allure of grand solutions must be resisted. Cases differ greatly with
respect to what is possible and desirable in terms of their implications for the interests of the
public and private sectors. Moreover, history tells us that new developments in markets and
practices quickly will render obsolete those measures that might seem well attuned to
today's circumstances.
• Allow me to explain how I think progress can be made by first focusing a bit on the problem
that confronts us. I would like to highlight some of the important changes that have taken
place over the past two decades in the patterns and instrumentation of capital flows to the
emerging world, and in the nature of crises that can arise associated with these flows.

First, it is important to keep in mind that the constellation of investors and the range
of instrumentation have broadened considerably over the past two decades. Equity
investors (both direct and portfolio) are now the principal source of net inflows for
emerging market countries, and most medium-term debt is held in tradable form by
a broad array of diversified, well-capitalized, fixed-income investors.

Second, there have been equally important changes in the destination of flows.
Reflecting the predominance of private-to-private flows since 1990, today
sovereign foreign debt often represents only a relatively small part of maturing debt
in crisis cases. Most maturing debt is owed by private borrowers and/or is locally
issued.

Third, the context has been fundamentally altered by broad institutional change.
Accounting, regulatory, technological, communications, and structural market
changes have fostered an environment characterized by mark-to-market
accounting and much more liquid and actively managed balance sheets. Investors
are focused on financial performance, and on their fiduciary responsibilities to their
largely private clients and shareholders, rather than on long-term strategic
relationships with sovereigns. Today this is as true for banks, which remain
important providers of credit, as it is for other providers of capital.

Last, the new environment entails new and complex linkages - - between domestic
and international markets, and within and across countries - - reflecting the
internationalization of local banking, equity, debt, and currency markets, and the
greater complexity of funding structures.

This new environment has important implications for policymakers and market
participants alike. Let me comment on just a few:

On the negative side, crises are more complex and unfold much more quickly and
with surprising dimensions. Variable and often highly interdependent cross-market
developments are often critical in the evolution of a given case and its implications
for others. Indeed, many of the more recent crises were triggered by problems in
domestic banking, currency, and debt markets that then spread to the capital
account. Also, in today's environment, the fear of an event often is the event itself,
because of the inherent tendency of markets to anticipate developments and
overreact.

But on the positive side, financial recoveries can proceed more rapidly in today's
environment, particularly with the right policy responses from borrowers. In part,
this reflects the fact that today's market participants generally have the capacity - -
and many have little choice, under mark-to-market accounting - - to digest losses
and move on. The broader sourcing of capital today also gives more scope to the
possibility that, while some investors may withdraw, others may take their place.
The caveat here is that the well not be poisoned through unnecessarily broad or
heavy-handed approaches, a point I will return to later.
• What is the right way to deal with this changed and changing environment? In my view, the
solution is neither a single piece of financial engineering nor a compact between the official
lenders and private creditors. Rather, it is a process incorporating a number of elements.
Essentially, I would suggest that our current case-by-case approach to crisis management
needs to evolve in ways that are market-based and adaptive, yet strategic, creative, and
principled.
• Being successful in today's environment requires adapting to the particularities of the case at
hand, as well as the global financial and economic context, and requires seeking, as far as
possible, to work with the grain of a given situation. The approach needs to be
marketbased, in part because that is what the game is all about. Today, the relevant considerations
for crisis management relate more to markets and the problem of restoring market
confidence, than to individual borrowers and creditors.

To the extent that systemic concerns pertain, they more often relate to the risks of
market disruption and over-adjustment than to potential domino effects caused by
the failure or impairment of key institutions. Also, in today's environment, a
marketbased approach is much more feasible, because financial recoveries can proceed
more rapidly than in the past.

To be more specific, in my view, although much has been made of the difficulties in
achieving debtor workouts, the truly thorny issues associated with emerging market
financial crises usually relate to the following:
 containing the fallout to domestic financial systems and to local consumer
and investor confidence,
 minimizing contagion and spillovers to other cases and markets,
 maintaining or restoring market access, particularly for private sector
borrowers, and,
 most importantly, encouraging policy reform so that a given crisis falls as
closely as possible to the liquidity, rather than the solvency, end of the
spectrum.

Working with the grain means recognizing the realities and limitations inherent in
the current market structure and its functioning, and tailoring approaches to the
specifics of individual cases. This involves acknowledging that attempts to impose
solutions from outside are unrealistic and potentially counterproductive. Instead it
involves identifying ways to induce and encourage desired behaviors. I would also
suggest that it means avoiding departures from normal market functioning
whenever possible. Interventions should seek not to override or suspend market
functioning, but rather to guide market processes.
 This is not to say that payment suspensions always can and should be
avoided, or that ever-larger bailouts are desirable or feasible. I would
note that we at the New York Fed in numerous instances, spanning
several decades, have worked to help borrowers and creditors find
mutually beneficial solutions that involved some degree of concerted or
coordinated financing.
 But in such instances, when payment interruptions or resort to concerted
financing truly are unavoidable, experience has shown that minimalist
approaches - - where only certain payments are suspended or delayed,
and only when absolutely necessary - - generally offer the best
prospects for minimizing spillover effects and for restoring market
access rapidly.

The linchpin of a market-based, minimalist approach has to be a strong policy
response on the part of the country in crisis. Markets may not always be
reasonable, but they usually have reasons for reacting adversely. Those reasons
most often relate to policy or institutional shortcomings. Across all of the episodes
of market distress in the emerging world over the past two decades, an essential
element of heading off or minimizing damage from a crisis has been policymakers
showing that they "get the message" about the need for reform, and are prepared
to take appropriate measures.
 In this regard, the comparative advantage of the international public
sector is in guiding economic and financial policy, and fostering the
conditions that will facilitate the restoration or maintenance of voluntary
credit and investment flows. IMF support should provide an unambiguous
signal of the international community's confidence in the capacity of
crisis-affected countries to take the measures necessary to restore
economic health.

This role is particularly important in unfolding crisis situations, because
borrowing country authorities too often are slow to recognize the full
dimensions of the policy challenges confronting them, and the private
sector is ill-equipped to deal with this.
• A case-by-case approach by definition is supremely tactical, but it also needs to be strategic
in orientation if it is to be successful in the longer run. I would like to highlight several ways in
which the case-by-case approach needs to be strategic.

First off, strategy needs to be informed by a long-run view about the case at hand.
The emphasis should not be merely on "working out" the problems at hand, but on
"working through" them. The latter orientation focuses attention beyond the current
circumstances to the restoration of growth, access to capital, and normal market
functioning, recognizing that workouts are but one of several means to that end,
not an end in themselves.

We should not forget that a crisis is not over when capital outflows have
been halted and prices stop falling. Emerging market economies depend
on sustained and predictable access to international capital market and
bank credit, and economic recovery and restoration of growth depend on
confidence being reestablished, so that the necessary financing, beyond
emergency lending, can be obtained.

Secondly, we in the public sector would be well served to maximize the
complementarity between efforts to prevent crises and efforts to contain and
resolve crises when they do arise.
 The consensus on sound preventative policies includes precepts that public
sectors should limit the scale of their involvement in the domestic economy,
and that borrowers, public and private, should be encouraged to follow best
practices in the management of their liquidity, foreign exchange, and credit
risk. Indeed, as I discussed earlier, this is the essence of what we are trying
to do under the revised Capital Accord. Moreover, countries are being
encouraged to strengthen their legal and regulatory regimes for insolvency
resolution to deal more e