In the last few years it has
become increasingly clear that this business cycle differs in a
very profound way from the many other cycles that have
characterized post-World War II America. Not only has the
expansion achieved record length, but it has done so with economic
growth far stronger than expected. Most remarkably, inflation has
remained largely subdued in the face of labor markets tighter than
any we have experienced in a generation.
A key factor behind this
extremely favorable performance has been the resurgence in
productivity growth. Since 1995, output per hour in the
nonfinancial corporate sector has increased at an average annual
rate of 3-1/2 percent, nearly double the average pace over the
preceding quarter-century. Indeed, the rate of growth appears to
have been rising throughout the period.
My remarks today will focus both
on what is evidently the source of this spectacular
performance--the revolution in information technology--and on its
implications for key government policies.
When historians look back at the
latter half of the 1990s a decade or two hence, I suspect that
they will conclude we are now living through a pivotal period in
American economic history. New technologies that evolved from the
cumulative innovations of the past half-century have now begun to
bring about dramatic changes in the way goods and services are
produced and in the way they are distributed to final users. Those
innovations, exemplified most recently by the multiplying uses of
the Internet, have brought on a flood of startup firms, many of
which claim to offer the chance to revolutionize and dominate
large shares of the nation's production and distribution system.
And participants in capital markets, not comfortable dealing with
discontinuous shifts in economic structure, are groping for the
appropriate valuations of these companies. The exceptional stock
price volatility of these newer firms and, in the view of some,
their outsized valuations indicate the difficulty of divining the
particular technologies and business models that will prevail in
the decades ahead.
How did we arrive at such a
fascinating and, to some, unsettling point in history? While the
process of innovation, of course, is never-ending, the development
of the transistor after World War II appears in retrospect to have
initiated a special wave of innovative synergies. It brought us
the microprocessor, the computer, satellites, and the joining of
laser and fiber-optic technologies. By the 1990s, these and a
number of lesser but critical innovations had, in turn, fostered
an enormous new capacity to capture, analyze, and disseminate
information. It is the growing use of information technology
throughout the economy that makes the current period unique.
However, until the mid-1990s,
the billions of dollars that businesses had poured into
information technology seemed to leave little imprint on the
overall economy. The investment in new technology arguably had not
yet cumulated to be a sizable part of the U.S. capital stock, and
computers were still being used largely on a stand-alone basis.
The full value of computing power could be realized only after
ways had been devised to link computers into large-scale networks.
As we all know, that day has arrived.
At a fundamental level, the
essential contribution of information technology is the expansion
of knowledge and its obverse, the reduction in uncertainty. Before
this quantum jump in information availability, most business
decisions were hampered by a fog of uncertainty. Businesses had
limited and lagging knowledge of customers' needs and of the
location of inventories and materials flowing through complex
production systems. In that environment, doubling up on materials
and people was essential as a backup to the inevitable
misjudgments of the real-time state of play in a company.
Decisions were made from information that was hours, days, or even
weeks old.
Of course, large voids of
information still persist, and forecasts of future events on which
all business decisions ultimately depend will always be prone to
error. But information has become vastly more available in real
time--resulting, for example, from developments such as electronic
data interface between the retail checkout counter and the factory
floor or the satellite location of trucks. This surge in the
availability of more timely information has enabled business
management to remove large swaths of inventory safety stocks and
worker redundancies. Stated differently, fewer goods and worker
hours are now involved in activities that, although perceived as
necessary insurance to sustain valued output, in the end produced
nothing of value.
Those intermediate production
and distribution activities, so essential when information and
quality control were poor, are being reduced in scale and, in some
cases, eliminated. These trends may well gather speed and force as
the Internet alters relationships of businesses to their suppliers
and their customers, a topic to which I shall return in a moment.
The process of information
innovation has gone far beyond the factory floor and distribution
channels. Computer modeling, for example, has dramatically reduced
the time and cost required to design items ranging from motor
vehicles to commercial airliners to skyscrapers. In a very
different part of the economy, medical diagnoses have become more
thorough, more accurate, and far faster. With access to heretofore
unavailable information, treatment has been hastened, and hours of
procedures have been eliminated. Moreover, the potential for
discovering more-effective treatments has been greatly enhanced by
the parallel revolution in biotechnology, including the ongoing
effort to map the entire human genome. That work would have been
unthinkable without the ability to store and process huge amounts
of data.
The advances in information
technology also have been an impetus to the ongoing wave of
strategic alliance and merger activity. Hardly a week passes
without the announcement of another blockbuster deal. Many of
these combinations arise directly from the opportunities created
by new technology--for example, those at the intersection of the
Internet, telecommunications, and the media. It is not possible to
know which of the many new technologies will ultimately find a
firm foothold in our rapidly changing economy. Accordingly, many
high-tech companies that wish to remain independent are hedging
their bets by entering into strategic alliances with firms
developing competing technologies.
In addition, the new technology
has fostered full mergers that allow firms to take greater
advantage of economies of scale and thus reduce costs. Without
highly sophisticated information technology, it would be nearly
impossible to manage firms on the scale of some that have been
proposed or actually created of late. Although it will be a while
before the ultimate success of these endeavors can be judged,
information technology has almost certainly pushed out the point
at which scale diseconomies begin to take hold for some
industries.
The impact of information
technology has been keenly felt in the financial sector of the
economy. Perhaps the most significant innovation has been the
development of financial instruments that enable risk to be
reallocated to the parties most willing and able to bear that
risk. Many of the new financial products that have been created,
with financial derivatives being the most notable, contribute
economic value by unbundling risks and shifting them in a highly
calibrated manner. Although these instruments cannot reduce the
risk inherent in real assets, they can redistribute it in a way
that induces more investment in real assets and, hence, engenders
higher productivity and standards of living. Information
technology has made possible the creation, valuation, and exchange
of these complex financial products on a global basis.
At the end of the day, the
benefits of new technologies can be realized only if they are
embodied in capital investment, defined to include any outlay that
increases the value of the firm. For these investments to be made,
the prospective rate of return must exceed the cost of capital.
Technological synergies have enlarged the set of productive
capital investments, while lofty equity values and declining
prices of high-tech equipment have reduced the cost of capital.
The result has been a veritable explosion of spending on high-tech
equipment and software, which has raised the growth of the capital
stock dramatically over the past five years. The fact that the
capital spending boom is still going strong indicates that
businesses continue to find a wide array of potential
high-rate-of-return, productivity-enhancing investments. And I see
nothing to suggest that these opportunities will peter out any
time soon.
Indeed, many argue that the pace
of innovation will continue to quicken in the next few years, as
companies exploit the still largely untapped potential for
e-commerce, especially in the business-to-business arena, where
most observers expect the fastest growth. An electronic market
that would automatically solicit bids from suppliers has the
potential for substantially reducing search and transaction costs
for individual firms and for the economy as a whole. This
reduction would mean less unproductive search and fewer workhours
more generally embodied in each unit of output, enhancing output
per hour. Already, major efforts have been announced in the auto
industry to move purchasing operations to the Internet. Similar
developments are planned or in operation in many other industries
as well. It appears to be only a matter of time before the
Internet becomes the prime venue for the trillions of dollars of
business-to-business commerce conducted every year.
There can be little doubt that,
on balance, the evolving surge in innovation is an unmitigated
good for the large majority of the American people. Yet, implicit
in the very forces of change that are bringing us a panoply of
goods and services considered unimaginable only a generation ago
are potential financial imbalances and worker insecurities that
need to be addressed if the full potential of our technological
largesse is to be achieved.
As I testified before the
Congress last month, accelerating productivity entails a matching
acceleration in the potential output of goods and services and a
corresponding rise in real incomes available to purchase the new
output. The pickup in productivity however tends to create even
greater increases in aggregate demand than in potential aggregate
supply. This occurs principally because a rise in structural
productivity growth, not surprisingly, fosters higher expectations
for long-term corporate earnings. These higher expectations, in
turn, not only spur business investment but also increase stock
prices and the market value of assets held by households, creating
additional purchasing power for which no additional goods or
services have yet been produced.
Historical evidence suggests
that perhaps three to four cents out of every additional dollar of
stock market wealth eventually is reflected in increased consumer
purchases. The sharp rise in the amount of consumer outlays
relative to disposable incomes in recent years, and the
corresponding fall in the saving rate, is a reflection of this
so-called wealth effect on household purchases. Moreover, higher
stock prices, by lowering the cost of equity capital, have helped
to support the boom in capital spending.
Outlays prompted by capital
gains in equities and homes in excess of increases in income, as
best we can judge, have added about 1 percentage point to annual
growth of gross domestic purchases, on average, over the past
half-decade. The additional growth in spending of recent years
that has accompanied these wealth gains, as well as other
supporting influences on the economy, appears to have been met in
equal measure by increased net imports and by goods and services
produced by the net increase in newly hired workers over and above
the normal growth of the workforce, including a substantial net
inflow of workers from abroad.
But these safety valves that
have been supplying goods and services to meet the recent
increments to purchasing power largely generated by capital gains
cannot be expected to absorb indefinitely an excess of demand over
supply. Growing net imports and a widening current account deficit
require ever-larger portfolio and direct foreign investments in
the United States, an outcome that cannot continue without limit.
Imbalances in the labor markets
perhaps may have even more serious implications for potential
inflation pressures. While the pool of officially unemployed and
those otherwise willing to work may continue to shrink, as it has
persistently over the past seven years, there is an effective
limit to new hiring, unless immigration is uncapped. At some point
in the continuous reduction in the number of available workers
willing to take jobs, short of the repeal of the law of supply and
demand, wage increases must rise above even impressive gains in
productivity. This would intensify inflationary pressures or
squeeze profit margins, with either outcome capable of bringing
our growing prosperity to an end. In short, unless we are able to
indefinitely increase the rate of capital flows into the United
States to finance rising net imports or continuously augment
immigration quotas, overall demand for goods and services cannot
chronically exceed the underlying growth rate of supply.
Our immediate goal at the
Federal Reserve should be to encourage the economic and financial
conditions that will best foster the technological innovation and
investment that spur structural productivity growth. It is
structural productivity growth--not the temporary rise and fall of
output per hour associated with various stages of the business
cycle--that determines how rapidly living standards rise over
time. Achievement of this goal requires a stable macroeconomic
environment of sustained growth and continued low inflation. That,
in turn, means that the expansion of demand must moderate into
alignment with the more rapid growth rate of potential supply.
The current gap between the
growth of supply and demand for goods and services, of necessity,
has been reflected in an excess in the demand for funds over new
savings from Americans, including those savings generated by
rising budget surpluses. As a consequence, real long-term
corporate borrowing costs have risen significantly over the past
two years. Presumably as a result, many analysts are now
projecting that the rate of increase in stock market wealth may
soon begin to slow. If so, the wealth effect adding to spending
growth would eventually be damped, and both the rate of increase
in net imports as a share of GDP, and the rate of decline in the
pool of unemployed workers willing to work should also slow.
However, so long as these two imbalances continue, reflecting the
excess of demand over supply, the level of potential workers will
continue to fall and the net debt to foreigners will continue to
rise by increasing amounts.
Until market forces, assisted by
a vigilant Federal Reserve, effect the necessary alignment of the
growth of aggregate demand with the growth of potential aggregate
supply, the full benefits of innovative productivity acceleration
are at risk of being undermined by financial and economic
instability.
The second consequence of rapid
economic and technological change that needs to be addressed is
growing worker insecurity, the result, I suspect, of fear of
potential job skill obsolescence. Despite the tightest labor
markets in a generation, more workers currently report they are
fearful of losing their jobs than similar surveys found in 1991 at
the bottom of the last recession. The marked move of capital from
failing technologies to those at the cutting edge has quickened
the pace at which job skills become obsolete. The completion of
high school used to equip the average worker with sufficient
skills to last a lifetime. That is no longer true, as evidenced by
community colleges being inundated with workers returning to
school to acquire new skills and on-the-job training being
expanded and upgraded by a large proportion of American business.
Not unexpectedly, greater worker
insecurities are creating political pressures to reduce the fierce
global competition that has emerged in the wake of our 1990s
technology boom. Protectionist measures, I have no doubt, could
temporarily reduce some worker anxieties by inhibiting these
competitive forces. However, over the longer run such actions
would slow innovation and impede the rise in living standards.
They could not alter the eventual shifts in production that owe to
enormous changes in relative prices across the economy.
Protectionism might enable a worker in a declining industry to
hold onto his job longer. But would it not be better for that
worker to seek a new career in a more viable industry at age 35
than hang on until age 50, when job opportunities would be far
scarcer and when the lifetime benefits of additional education and
training would be necessarily smaller? To be sure, assisting those
who are already close to retirement in failing industries is an
imperative. But that can be readily accomplished without
distorting necessary capital flows to newer technologies through
protectionist measures. More generally, we must ensure that our
whole population receives an education that will allow full
participation in this dynamic period of American economic history.
