Indeed, in our dynamic labor markets, the resources made redundant by
better information, as I indicated earlier, are being drawn to the newer
activities and newer products, many never before contemplated or
available. The personal computer, with ever-widening applications in
homes and businesses, is one. So are the fax and the cell phone. The
newer biotech innovations are most especially of this type, particularly
the remarkable breadth of medical and pharmacological product
development.
At the end of the day, however, the newer technologies obviously can
increase outputs or reduce inputs and, hence, increase productivity only
if they are embodied in capital investment. Capital investment here is
defined in the broadest sense as any outlay that enhances future
productive capabilities and, consequently, capital asset values.
But for capital investments to be made, the prospective rate of return
on their implementation must exceed the cost of capital. Gains in
productivity and capacity per real dollar invested clearly rose
materially in the 1990s, while the increase in equity values, reflecting
that higher earnings potential, reduced the cost of capital.
In particular, technological synergies appear to be engendering an
ever-widening array of prospective new capital investments that offer
profitable cost displacement. In a consolidated sense, reduced cost
generally means reduced labor cost or, in productivity terms, fewer
hours worked per unit of output. These increased real rates of return on
investment and consequent improved productivity are clearly most evident
among the relatively small segment of our economy that produces
high-tech equipment. But the newer technologies are spreading to firms
not conventionally thought of as high tech.1
It would be an exaggeration to imply that whenever a cost increase
emerges on the horizon, there is a capital investment that is available
to quell it. Yet the veritable explosion of high-tech equipment and
software spending that has raised the growth of the capital stock
dramatically over the past five years could hardly have occurred without
a large increase in the pool of profitable projects becoming available
to business planners. As rising productivity growth in the high-tech
sector since 1995 has resulted in an acceleration of price declines for
equipment embodying the newer technologies, investment in this equipment
by firms in a wide variety of industries has expanded sharply.
Had high prospective returns on these capital projects not materialized,
the current capital equipment investment boom--there is no better
word--would have petered out long ago. In the event, overall equipment
and capitalized software outlays as a percentage of GDP in nominal
dollars have reached their highest level in post-World War II history.
To be sure, there is also a virtuous capital investment cycle at play
here. A whole new set of profitable investments raises productivity,
which for a time raises profits--spurring further investment and
consumption. At the same time, faster productivity growth keeps a lid on
unit costs and prices. Firms hesitate to raise prices for fear that
their competitors will be able, with lower costs from new investments,
to wrest market share from them.
Indeed, the increasing availability of labor-displacing equipment and
software, at declining prices and improving delivery lead times, is
arguably at the root of the loss of business pricing power in recent
years. To be sure, other inflation-suppressing forces have been at work
as well. Marked increases in available global capacity were engendered
as a number of countries that were previously members of the autarchic
Soviet bloc opened to the West, and as many emerging-market economies
blossomed. Reductions in Cold War spending in the United States and
around the world also released resources to more productive private
purposes. In addition, deregulation that removed bottlenecks and hence
increased supply response in many economies, especially ours, has been a
formidable force suppressing price increases as well. Finally, the
global economic crisis of 1997 and 1998 reduced the prices of energy and
other key inputs into production and consumption, helping to hold down
inflation for several years.
Of course, Europe and Japan have participated in this recent wave of
invention and innovation and have full access to the newer technologies.
However, they arguably have been slower to apply them. The relatively
inflexible and, hence, more costly labor markets of these economies
appear to be an important factor. The high rates of return offered by
the newer technologies are largely the result of labor cost
displacement, and because it is more costly to dismiss workers in Europe
and Japan, the rate of return on the same equipment is correspondingly
less there than in the United States. Here, labor displacement is more
readily countenanced both by law and by culture, facilitating the
adoption of technology that raises standards of living over time.
There, of course, has been a substantial amount of labor-displacing
investment in Europe to obviate expensive increased employment as their
economies grow. But it is not clear to what extent such investment has
been directed at reducing existing levels of employment. It should
always be remembered that in economies where dismissing a worker is
expensive, hiring one will also be perceived to be expensive.
An ability to reorganize production and distribution processes is
essential to take advantage of newer technologies. Indeed, the
combination of a marked surge in mergers and acquisitions, and
especially the vast increase in strategic alliances, including across
borders, is dramatically altering business structures to conform to the
imperatives of the newer technologies.2
We are seeing the gradual breaking down of competition-inhibiting
institutions from the keiretsu and chaebol of East Asia, to the
dirigisme of some of continental Europe. The increasingly evident
advantages of applying the newer technologies is undermining much of the
old political wisdom of protected stability. The clash between
unfettered competitive technological advance and protectionism, both
domestic and international, will doubtless engage our attention for many
years into this new century. The turmoil in Seattle last month may be a
harbinger of an intensified debate.
However one views the causes of our low inflation and strong growth,
there can be little argument that the American economy as it stands at
the beginning of a new century has never exhibited so remarkable a
prosperity for at least the majority of Americans.
Nonetheless, this seemingly beneficial state of affairs is not without
its own set of potential challenges. Productivity-driven supply growth
has, by raising long-term profit expectations, engendered a huge gain in
equity prices. Through the so-called "wealth effect," these gains have
tended to foster increases in aggregate demand beyond the increases in
supply. It is this imbalance between growth of supply and growth of
demand that contains the potential seeds of rising inflationary and
financial pressures that could undermine the current expansion.
Higher productivity growth must show up as increases in real incomes of
employees, as profit, or more generally as both. Unless the propensity
to spend out of real income falls, private consumption and investment
growth will rise, as indeed it must, since over time demand and supply
must balance. (I leave the effect of fiscal policy for later.) If this
was all that happened, accelerating productivity would be wholly benign
and beneficial.
But in recent years, largely as a result of the appreciating values of
ownership claims on the capital stock, themselves a consequence, at
least in part, of accelerating productivity, the net worth of households
has expanded dramatically, relative to income. This has spurred private
consumption to rise even faster than the incomes engendered by the
productivity-driven rise in output growth. Moreover, the fall in the
cost of equity capital corresponding to higher share prices, coupled
with enhanced potential rates of return, has spurred private capital
investment. There is a wide range of estimates of how much added growth
the rise in equity prices has engendered, but they center around 1
percentage point of the somewhat more than 4 percentage point annual
growth rate of GDP since late 1996.
Such overall extra domestic demand can be met only with increased
imports (net of exports) or with new domestic output produced by
employing additional workers. The latter can come only from drawing down
the pool of those seeking work or from increasing net immigration.
Thus, the impetus to spending from the wealth effect by its very nature
clearly cannot persist indefinitely. In part, it adds to the demand for
goods and services before the corresponding increase in output fully
materializes. It is, in effect, increased purchasing from future income,
financed currently by greater borrowing or reduced accumulation of
assets.
If capital gains had no evident effect on consumption or investment,
their existence would have no influence on output or employment either.
Increased equity claims would merely match the increased market value of
productive assets, affecting only balance sheets, not flows of goods and
services, not supply or demand, and not labor markets.
But this is patently not the case. Increasing perceptions of wealth have
clearly added to consumption and driven down the amount of saving out of
current income and spurred capital investment.
To meet this extra demand, our economy has drawn on all sources of added
supply. Our net imports and current account deficits have risen
appreciably in recent years. This has been financed by foreign
acquisition of dollar assets fostered by the same sharp increases in
real rates of return on American capital that set off the wealth effect
and domestic capital goods boom in the first place. Were it otherwise,
the dollar's foreign exchange value would have been under marked
downward pressure in recent years. We have also relied on net
immigration to augment domestic output. And finally, we have drawn down
the pool of available workers.
The bottom line, however, is that, while immigration and imports can
significantly cushion the consequences of the wealth effect and its
draining of the pool of unemployed workers for awhile, there are limits.
Immigration is constrained by law and its enforcement; imports, by the
willingness of global investors to accumulate dollar assets; and the
draw down of the pool of workers by the potential emergence of
inflationary imbalances in labor markets. Admittedly, we are groping to
infer where those limits may be. But that there are limits cannot be
open to question.
However one views the operational relevance of a Phillips curve or the
associated NAIRU (the nonaccelerating inflation rate of
unemployment)--and I am personally decidedly doubtful about it--there
has to be a limit to how far the pool of available labor can be drawn
down without pressing wage levels beyond productivity. The existence or
nonexistence of an empirically identifiable NAIRU has no bearing on the
existence of the venerable law of supply and demand.
To be sure, increases in wages in excess of productivity growth may not
be inflationary, and destructive of economic growth, if offset by
decreases in other costs or declining profit margins. A protracted
decline in margins, however, is a recipe for recession. Thus, if our
objective of maximum sustainable economic growth is to be achieved, the
pool of available workers cannot shrink indefinitely.
As my late friend and eminent economist Herb Stein often suggested: If a
trend cannot continue, it will stop. What will stop the wealth-induced
excess of demand over productivity-expanded supply is largely
developments in financial markets.
That process is already well advanced. For the equity wealth effect to
be contained, either expected future earnings must decline, or the
discount factor applied to those earnings must rise. There is little
evidence of the former. Indeed, security analysts, reflecting detailed
information on and from the companies they cover, have continued to
revise upward long-term earnings projections. However, real rates of
interest on long-term BBB corporate debt, a good proxy for the average
of all corporate debt, have already risen well over a full percentage
point since late 1997, suggesting increased pressure on discount
factors.3 This should not be a surprise because an excess of demand over
supply ultimately comes down to planned investment exceeding saving that
would be available at the economy's full potential. In the end, balance
is achieved through higher borrowing rates. Thus, the rise in real rates
should be viewed as a quite natural consequence of the pressures of
heavier demands for investment capital, driven by higher perceived
returns associated with technological breakthroughs and supported by a
central bank intent on defusing the imbalances that would undermine the
expansion.
We cannot predict with any assurance how long a growing wealth
effect--more formally, a rise in the ratio of household net worth to
income--will persist, nor do we suspect can anyone else. A diminution of
the wealth effect, I should add, does not mean that prices of assets
cannot keep rising, only that they rise no more than income.
A critical factor in how the rising wealth effect and its ultimate
limitation will play out in the market place and the economy is the
state of government, especially federal, finances.
The sharp rise in revenues (at a nearly 8 percent annual rate since
1995) has been significantly driven by increased receipts owing to
realized capital gains and increases in compensation directly and
indirectly related to the huge rise in stock prices. Both the
Administration and the Congress have chosen wisely to allow unified
budget surpluses to build and have usefully focused on eliminating the
historically chronic borrowing from social security trust funds to
finance current outlays.
The growing unified budget surpluses have absorbed a good part of the
excess of potential private demand over potential supply. A continued
expansion of the surplus would surely aid in sustaining the productive
investment that has been key to leveraging the opportunities provided by
new technology, while holding down a further reliance on imports and
absorption of the pool of available workers.
I trust that the recent flurry of increased federal government outlays,
seemingly made easier by the emerging surpluses, is an aberration. In
today's environment of rapid innovation, growing unified budget
surpluses can obviate at least part of the rebalancing pressures evident
in marked increases in real long-term interest rates.
As I noted at the beginning of my remarks, it may be many years before
we fully understand the nature of the rapid changes currently
confronting our economy. We are unlikely to fully comprehend the process
and its interactions with asset prices until we have been through a
complete business cycle.
Regrettably, we at the Federal Reserve do not have the luxury of
awaiting a better set of insights into this process. Indeed, our goal,
in responding to the complexity of current economic forces, is to extend
the expansion by containing its imbalances and avoiding the very
recession that would complete a business cycle.
If we knew for sure that economic growth would soon be driven wholly by
gains in productivity and growth of the working age population,
including immigration, we would not need to be as concerned about the
potential for inflationary distortions. Clearly, we cannot know for
sure, because we are dealing with world economic forces which are new
and untested.
While we endeavor to find the proper configuration of monetary and
fiscal policies to sustain the remarkable performance of our economy,
there should be no ambiguity on the policies required to support
enterprise and competition.
I believe that we as a people are very fortunate: When confronted with
the choice between rapid growth with its inevitable insecurities and a
stable, but stagnant economy, given time, Americans have chosen growth.
But as we seek to manage what is now this increasingly palpable historic
change in the way businesses and workers create value, our nation needs
to address the associated dislocations that emerge, especially among
workers who see the security of their jobs and their lives threatened.
Societies cannot thrive when significant segments perceive its
functioning as unjust.
It is the degree of unbridled fierce competition within and among our
economies today--not free trade or globalization as such--that is the
source of the unease that has manifested itself, and was on display in
Seattle a month ago. Trade and globalization are merely the vehicles
that foster competition, whose application and benefits currently are
nowhere more evident than here, today, in the United States.
Confronted face-on, no one likes competition; certainly, I did not when
I was a private consultant vying with other consulting firms. But the
competitive challenge galvanized me and my colleagues to improve our
performance so that at the end of the day we and, indeed, our
competitors, and especially our clients, were more productive.
There are many ways to address the all too real human problems that are
the inevitable consequences of accelerating change. Restraining
competition, domestic or international, to suppress competitive turmoil
is not one of them. That would be profoundly counterproductive to rising
standards of living.
We are in a period of dramatic gains in innovation and technical change
that challenge all of us, as owners of capital, as suppliers of labor,
as voters and policymakers. How well policy can be fashioned to allow
the private sector to maximize the benefits of innovations that we
currently enjoy, and to contain the imbalances they create, will shape
the economic configuration of the first part of the new century.
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Footnotes
1 Since the early 1990s, the annual growth rate in output per hour of
nonfinancial corporate businesses outside high tech has risen by a full
percentage point.
2 For example, the emergence of many alternate technologies in areas
where only one or two will set the standard and survive has created
high-risk, high-reward outcomes for their creators. The desire to spread
risk (and the willingness to forgo the winner-take-all return) has
fostered a substantial number of technology-sharing alliances.
3 The inflation expectations employed in this calculation are those
implicit in the gap between the interest rates on ten-year Treasury
inflation-indexed notes and those on a nominal security derived from
Treasury STRIPS constructed to have comparable duration. The latter are
used because they have the same relatively limited liquidity as
inflation-indexed notes.
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