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It has become increasingly
difficult to deny that something profoundly different from the
typical postwar business cycle has emerged in recent years. Not
only has the expansion reached record length, but it has done so
with far stronger-than-expected economic growth. Most remarkably,
inflation has remained subdued in the face of labor markets
tighter than any we have experienced in a generation.
While there are various
competing explanations for an economy that is in many respects
without precedent in our annals, the most compelling appears to be
the extraordinary surge in technological innovation that developed
through the latter decades of the last century. In the early
1990s, with little advance notice, those innovations began to
offer sharply higher prospective returns on investment than had
prevailed in earlier decades.
The first sign of the shift was
the sharp rise in capital investment orders, especially for
high-tech equipment, in 1993. This was unusual for a cyclical
expansion because it occurred a full two years after the trough of
the 1991 recession.
By 1995, the investment boom had
gathered momentum, suggesting that earlier expectations of
elevated profitability had not been disappointed. In that year,
with inflation falling, domestic operating profit margins started
to rise, indicating that increases in unit costs were slowing.
These developments signaled that productivity growth was probably
beginning to move higher, even though official data, hobbled by
statistical problems, failed to provide any confirmation. Now,
five years later, there can be little doubt that not only has
productivity growth picked up from its rather tepid pace during
the preceding quarter century but that the growth rate has
continued to rise, with scant evidence that it is about to crest.
The acceleration of productivity
stemming from the investment boom has held cost increases in
check. Despite the surge in demand, unit labor costs over the past
year have barely budged, and pricing power has remained well
contained. Apparently, firms hesitate to raise prices for fear
that their competitors will be able to wrest market share from
them by employing new investments to produce at lower costs.
Indeed, the increasing
availability of labor-saving equipment and software, at declining
relative prices and with improving delivery lead times, is
arguably at the root of the loss of business pricing power in
recent years. To be sure, marked increases in available global
capacity and the deregulation of key industries have removed
bottlenecks and increased the competitive supply response of many
economies, especially ours, and these developments have been
influential in suppressing price increases.
It would be an exaggeration to
imply that, whenever a potential cost increase emerges on the
horizon, a capital investment is available to quell it. Yet the
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, could hardly have occurred
without a large increase in the pool of profitable projects
available to business planners.
As our experience over the past
century and more attests, such surges in prospective investment
profitability carry with them consequences for interest rates,
which ultimately are part of the process that balances saving and
investment in a noninflationary economy. In these circumstances,
rising credit demand is almost always reflected in an increase in
corporate borrowing costs and that has, indeed, been our recent
experience, especially in longer-dated debt issues. Real interest
rates on corporate bonds have risen more than a percentage point
in the past couple of years. Home mortgage rates have risen
comparably. The Federal Reserve has responded in a similar manner,
by gradually raising the federal funds rate over the past year.
Certainly, to have done otherwise--to have held the federal funds
rate at last year's level even as credit demands and market
interest rates rose--would have required an inappropriately
inflationary expansion of liquidity. It is difficult to imagine
product price levels remaining tame over the longer haul had there
been such an expansion of liquidity. In the event, of course,
inflation has remained largely contained.
To be sure, the tripling of
crude oil prices has left its mark on "headline"
inflation rates and inflicted considerable pain on some sectors of
our economy. However, there is little evidence, at least to date,
to suggest that oil price increases have started to embed
themselves more broadly in the underlying cost structure of
American business--that is, beyond the direct effects of the
higher energy costs themselves. Nevertheless, despite the very
recent declines in the price of oil, there are risks here that
need to be monitored closely.
Given the persistent strength of
private credit demands, market interest rates would have risen
even more were it not for the emergence of a sizable unified
budget surplus following a long period of chronic deficits. More
recently, the Administration and the Congress have wisely chosen
to wall off the surplus in the social security trust fund and to
allow it to pay down Treasury debt held by the public. This action
will surely contribute to sustaining the rapid private capital
formation we have experienced in recent years.
I see no reason that
productivity growth cannot remain elevated, or even increase
further, to the undeniable benefit of American businesses and
workers.
Achieving this outcome, however,
requires that imbalances not arise to drive the expansion off
course. Only a balanced prosperity can continue indefinitely; one
that is not will eventually falter. A change in market interest
rates is an important element of the balancing mechanism of a
market economy. Some misalignments have arisen over the course of
the expansion. Owing largely to the increased rate of return on
capital and a sizable wealth effect, overall demand for goods and
services for the past four years has been growing noticeably in
excess of the enhanced growth in potential supply, defined as the
sum of the growth in the working-age population and productivity.
An increasing share of the goods and services required to meet
this extra demand has been supplied by net imports, with the
remainder the result of an increase in domestic production
achieved by drawing down the pool of those we count as officially
unemployed and those otherwise available for work.
Short of a significant opening
up of our borders to more immigration, an increase in employment
beyond the growth of the working-age population is limited to what
remains of our shrinking pool of available workers. Although the
sum of the unemployed and those not in the labor force but who
nonetheless are available for work is still about ten million, the
level has been falling steadily. This year, the figure has been
lower as a percentage of the population than at any time in the
history of this series, which goes back to 1970. Should the pool
of available workers continue to shrink, there is a point at which
this safety valve for excess demand will effectively close, even
in the face of accelerating productivity. We do not know where
that point is, but presumably it would occur well before a full
depletion of the pool of potential workers. When we reach that
point, short of a repeal of the law of supply and demand, the
scarcity of labor will almost surely induce a rise in hourly
compensation gains that increasingly outpaces an even faster
productivity growth--a condition that would cause unit costs to
accelerate over time.
Moreover, we do not know how
long net imports and U.S. external debt can rise before foreign
investors become reluctant to continue to add to their portfolios
of claims against the United States. At that point, the safety
valve of net imports could narrow or close.
It is conceivable that these two
buffers can continue to absorb an excess growth of demand over
potential supply for quite a while longer. However, the
significant uncertainties surrounding these new economic forces
counsel prudence. We need to be careful to keep inflationary
pressures contained: The evidence that inflation inhibits economic
growth and job creation is too credible to ignore. Consequently,
maintaining an environment of low and stable inflation provides
the greatest opportunity for the dramatic increases in structural
productivity to show through fully into higher standards of
living. In that regard, readings from financial markets, despite
their recent upheavals, suggest that participants perceive the
most likely outcome to be a gradual adjustment to more balanced
noninflationary growth.
As I have argued previously, a
substantial part of the excess growth of demand over potential
supply owes to a wealth effect, induced by the rising asset prices
that have accompanied the run-up in potential rates of return on
new and existing capital. The rise in stock prices, as well as in
the capital gains on homes, has created a marked increase in
purchasing power without providing an equivalent and immediate
expansion in the supply of goods and services. That expansion in
supply will occur only over time.
The persuasive evidence that the
wealth effect is contributing to the risk of imbalances in our
economy, however, does not imply that the most straightforward way
to restore balance in financial and product markets is for
monetary policy to target asset price levels. Leaving aside the
deeper question of whether asset price targeting is an appropriate
governmental function, there is little, if any, evidence that
monetary policy aimed at achieving that goal would be successful.
The risks of investing in
equities come primarily from uncertainty about future earnings and
about the rates at which those future earnings should be
discounted, and much less from changes in overnight interest
rates, the principal tool of the central bank. Consequently, even
if we were to foster somewhat larger movements in short-term rates
to address changes in stock prices, I doubt that investors'
perceptions of equity risks would be much affected and thus that
equity prices would be meaningfully influenced. In short, monetary
policy should focus on the broader economy and on pending
inflationary or deflationary imbalances. Should changes in asset
prices foster economic imbalances, as they appear to have done in
recent years, it is the latter we need address, not asset prices.
* * *
In the economy overall, one
result of the more-rapid pace of information technology innovation
has been a visible acceleration of the process of "creative
destruction," a shifting of capital from failing technologies
into those technologies at the cutting edge. The process of
capital reallocation across the economy has been assisted by a
significant unbundling of risks in capital markets made possible
by the development of innovative financial products, many of which
themselves owe their viability to advances in information
technology.
There are few, if any,
indications in the marketplace that the reallocation process,
pushed forward by financial markets, is slowing.
While growth in companies'
projected earnings has been revised up almost continuously across
many sectors of the economy in recent years, the gap in expected
profit growth between technology firms and others has persistently
widened. As a result, security analysts' projected five-year
growth of earnings for technology companies now stands nearly
double that for the remaining S&P 500 firms.
To the extent that there is an
element of prescience in these expectations, it would reinforce
the notion that technology synergies are still expanding and that
expectations of productivity growth are still rising. There are
many who argue, of course, that it is not prescience but wishful
thinking. History will judge.
* * *
Before this revolution in
information availability, most twentieth-century business
decisionmaking had been hampered by pervasive uncertainty. Owing
to the paucity of timely knowledge of customers' needs and of the
location of inventories and materials flowing 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. Decisions were made from
information that was hours, days, or even weeks old. Accordingly,
production planning required costly inventory safety stocks and
backup teams of people to respond to the unanticipated and the
misjudged.
Clearly, the remarkable surge in
the availability of more timely information in recent years has
enabled business management to remove large swaths of inventory
safety stocks and worker redundancies. That means fewer goods and
worker hours are absorbed by activities that, while perceived as
necessary insurance to sustain valued output, in the end produce
nothing of value.
These developments emphasize the
essence of information technology--the expansion of knowledge and
its obverse, the reduction of uncertainty. As a consequence, risk
premiums that were associated with many forms of business
activities have declined.
In short, information technology
raises output per hour in the total economy principally by
reducing hours worked on activities needed to guard productive
processes against the unknown and the unanticipated. Narrowing the
uncertainties reduces the number of hours required to maintain any
given level of production readiness. Because knowledge is
essentially irreversible, much, if not most, of the recent gains
in productivity appear permanent.
Expanding e-commerce is expected
to significantly augment this trend. Already major efforts have
been announced in the auto industry to move purchasing operations
to the Internet. Similar developments are planned or are in
operation in many other industries as well. It appears to be only
a matter of time before the Internet becomes a prime venue for the
trillions of dollars of business-to-business commerce conducted
every year.
Not all technologies,
information or otherwise, however, increase productivity--that is,
output per hour--by reducing the inputs necessary to produce
existing or related products. Some new technologies bring about
new goods and services with above-average value added per workhour.
The dramatic advances in biotechnology, for example, are
significantly increasing a broad range of productivity-expanding
efforts in areas from agriculture to medicine.
Indeed, in our dynamic labor
markets, the resources made redundant by better information are
being drawn to the newer activities and newer products, many never
before contemplated. The recent biotech innovations are most
especially of this type, particularly the remarkable breadth of
medical and pharmacological product development.
One less welcome byproduct of
rapid economic and technological change that needs to be addressed
is the insecurity felt by many workers. This stems, I suspect,
from fear of job skill obsolescence. Despite the tightest labor
markets in a generation, for example, more workers currently
report in a prominent survey that they are fearful of losing their
jobs than was reported in 1991, at the bottom of the last
recession. The marked movement 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 knowledge and
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 by on-the-job training being
expanded and upgraded by a large proportion of American business.
It is not enough to create a job
market that has enabled those with few skills to finally be able
to grasp the first rung of the ladder to achievement. More
generally, we must ensure that our whole population receives an
education that will allow full and continuing participation in
this dynamic period of American economic history.
* * *
In summary, we appear to be in
the midst of a period of rapid innovation that is bringing with it
substantial and lasting benefits to our economy.
But policymakers must be alert
to the full range of possible outcomes. In the end, I do not
believe we can go far wrong if we maintain a consistent, vigilant,
noninflationary monetary policy focused on achieving maximum
sustainable economic growth, a fiscal policy that produces
substantial saving to accommodate investment in productive
capital, a trade policy that fosters international competition
through broadened market access, and an education policy that
ensures that all Americans can acquire the skills needed to
participate in what may well be the most productive economy ever.
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