Part II, Greenspan Berkeley Speech:
In addition, the longer the elevated level of stock prices was sustained, the more consumers likely viewed their capital gains as permanent increments to their net worth, and, hence, as spendable. The recent windfall financed not only higher personal consumption expenditures but home purchases as well. It is difficult to explain the recent record level of home sales without reference to earlier stock market gains.
The rise in stock prices also meant a fall in the equity cost of capital that doubtless raised the pace of new capital investment. Investment in new facilities had already been given a major boost by the acceleration in technological developments, which evidently increased the potential for profit in recent years. The sharp surge in capital outlays during the past five years apparently reflected the availability of higher rates of return on a broad spectrum of potential investments owing to an acceleration in technological advances, especially in computer and telecommunications applications.
This is the apparent root of the recent evident quickened pace of productivity advance. While the recent technological advances have patently added new and increasingly flexible capacity, the ability of these technologies to improve the efficiency of productive processes (an issue I will elaborate on shortly) has significantly reduced labor requirements per unit of output. This, no doubt, was one factor contributing to a dramatic increase in corporate downsizing and reported widespread layoffs in the early 1990s. The unemployment rate also began to fall as the pace of new hires to man the new facilities exceeded the pace of layoffs from the old.
Parenthetically, the perception of increased churning of our workforce in the 1990s has understandably increased the sense of accelerated job-skill obsolescence among a significant segment of our workforce, especially among those most closely wedded to older technologies. The pressures are reflected in a major increase in on-the-job training and a dramatic expansion of college enrollment, especially at community colleges. As a result, the average age of full-time college students has risen dramatically in recent years as large numbers of experienced workers return to school for skill upgrading. But the sense of increasing skill obsolescence has also led to an apparent willingness on the part of employees to forgo wage and benefit increases for increased job security. Thus, despite the incredible tightness of labor markets, increases in compensation per hour have continued to be relatively modest.
Coupled with the quickened pace of productivity growth, wage and benefit moderation has kept growth in unit labor costs subdued in the current expansion. This has both damped inflation and allowed profit margins to reach high levels.
That, in turn, apparently was the driving force beginning in early 1995 in security analysts' significant upward revision of their company-by-company long-term earnings projections. These upward revisions, coupled with falling interest rates, point to two key underlying forces that impelled investors to produce one of history's most notable bull stock markets.
But they are not the only forces. In addition, the sequence of greater capital investment, productivity growth, and falling inflation fostered an ever more benevolent sense of long-term stable growth. People were more confident about the future. The consequence was a dramatic shrinkage in the so-called equity premium over the past two years to near historic lows earlier this summer. The equity premium is the charge for the additional risks that markets require to hold stocks rather than riskless debt instruments. When perceived risks of the future are low, equity premiums are low and stock prices are even more elevated than would be indicated solely from higher expected long-term earnings growth and low riskless rates of interest.
Thus, one key to the question of whether there is a new economy is whether current expectations of future stability, which are distinctly more positive than say a decade ago, are justified by actual changes in the economy. For if expectations of greater stability are borne out, risk and equity premiums will remain low. In that case, the cost of capital will also remain low, leading, at least for a time, to higher investment and faster economic growth.
Two considerations are therefore critical to higher asset values and higher economic growth. The first is whether the apparent upward shift in technological advance will persist. The second is the extent of confidence in the stability of the future that consumers and investors will be able to sustain.
With regard to the first: How fast can technology advance, augmenting the pool of investment opportunities that have elevated rates of return, which engender still further increases in expected long-term earnings? Technological breakthroughs, as history so amply demonstrates, are frustratingly difficult to discern much in advance. The particular synergies between new and older technologies are generally too complex to anticipate.
An innovation's full potential may be realized only after extensive improvements or after complementary innovations in other fields of science. According to Charles Townes, a Nobel Prize winner for his work on the laser, the attorneys for Bell Labs initially, in the late 1960s, refused to patent the laser because they believed it had no applications in the field of telecommunications. Only in the 1980s, after extensive improvements in fiber-optics technology, did the laser's importance for telecommunications become apparent.
The future of technology advance may be difficult to predict, but for the period ahead there is the possibility that already proven technologies may not as yet have been fully exploited. Company after company reports that, when confronted with cost increases in a competitive environment that precludes price increases, they are able to offset those costs, seemingly at will, by installing the newer technologies.
Such stories seem odd. If cost improvements were available at will earlier, why weren't the investments made earlier? This implies suboptimal business behavior, contrary to what universities teach in Economics 101. But in the real world, companies rarely fully maximize profits. They concentrate on only those segments of their businesses that appear to offer the largest rewards and are rarely able to operate at the most efficient frontier on all fronts simultaneously. When costs rise, the attention of management presumably becomes focused more sharply on investments to limit the effects of rising costs.
But if cost-cutting at will is, in fact, currently available, it suggests that a backlog of unexploited capital projects has been built up in recent years, which, if true, implies the potential for continued gains in productivity close to the elevated rates of the last couple of years. Even if this is indeed the case, and only anecdotal evidence supports it, security analysts' recent projected per share earnings growth of more than 13 percent annually over the next three to five years is unlikely to materialize. It would imply an ever-increasing share of profit in the national income from a level that is already high by historic standards. Such conditions have led in the past to labor market pressures that thwarted further profit growth.
The second consideration with respect to how high asset values can rise is: How far can risk and equity premiums fall? A key factor is that price inflation has receded to quite low levels. The rising level of confidence in recent years concerning future outcomes has doubtless been related to the fall in the rate of inflation that has, of course, also been a critical factor in the fall in interest rates and, importantly, the fall in equity premiums as well. Presumably, the onset of deflation, should it occur, would increase uncertainty as much as a reemergence of inflation concerns. Thus, arguably, at near price stability, perceived risk from business-cycle developments would be at its lowest, and one must presume that would be the case for equity premiums as well. In any event, there is a limit on how far investors can rationally favorably discount the future and therefore how low equity premiums can go. Current claims on a source of income available 20 or 30 years in the future still have current value. But should claims on the hereafter?
An implication of high equity market values, relative to income and production, is an increased potential for instability. As I argued earlier, part of capital gains increases consumption and incomes. Since equity values are demonstrably more variable than incomes, when equity market values become large relative to incomes and GDP, their fluctuations can be expected to effect GDP more than when equity market values are low.
Clearly, the history of large swings in investor confidence and equity premiums for rational and other reasons counsels caution in the current context. We have relearned in recent weeks that just as a bull stock market feels unending and secure as an economy and stock market move forward, so it can feel when markets contract that recovery is inconceivable. Both, of course, are wrong. But because of the difficulty imagining a turnabout when such emotions take hold, periods of euphoria or distress tend to feed on themselves. Indeed, if this were not the case, the types of psychologically driven ebbs and flows of economic activity we have observed would be unlikely to exist.
Perhaps, as some argue, history will be less of a guide than it has been in the past. Some of the future is always without historical precedent. New records are always being made. Having said all that, however, my experience of observing the American economy day by day over the past half century suggests that most, perhaps substantially most, of the future can be expected to rest on a continuum from the past. Human nature, as I indicated earlier, appears immutable over the generations and inextricably ties our future to our past.
Nonetheless, as I indicated earlier, I would not deny that there doubtless has been in recent years an underlying improvement in the functioning of America's markets and in the pace of development of cutting edge technologies beyond previous expectations.
Most impressive is the marked increase in the effectiveness in the 1990s of our capital stock, that is, our productive facilities, the issue to which I alluded earlier. While gross investment has been high, it has been, in recent years, composed to a significant extent of short-lived assets that depreciate rapidly. Thus, the growth of the net capital stock, despite its recent acceleration, remains well below the peak rates posted during the past half century.
Despite the broadening in recent decades of international capital flows, empirical evidence suggests that domestic investment still depends to a critical extent on domestic saving, especially at the margin. Many have argued persuasively, myself included, that we save too little. The relatively low propensity to save on the part of the American public has put a large premium on the effective use of scarce capital, and on the winnowing out of the potentially least productive and, hence, the least profitable of investment opportunities.
That is one of the reasons that our financial system, whose job it is to ensure the productive use of physical capital, has been such a crucial part of our overall economy, especially over the past two decades. It is the signals reflected in financial asset prices, interest rates, and risk spreads that have altered the structure of our output in recent decades towards a different view of what consumers judge as value. This has imparted a significant derived value to a financial system that can do that effectively and, despite recent retrenchments, to the stock market value of those individual institutions that make up that system.
Clearly, our high financial returns on investment are a symptom that our physical capital is being allocated to produce products and services that consumers particularly value. A machining facility that turns out an inferior product or a toll road that leads to nowhere will not find favor with the public, will earn subnormal or negative profits, and in most instances will exhibit an inability over the life of the asset to recover the cash plus cost of capital invested in it.
Thus, while adequate national saving is a necessary condition for capital investment and rising productivity and standards of living, it is by no means a sufficient condition.
The former Soviet Union, for example, had too much investment, and without the discipline of market prices, they grossly misplaced it. The preferences of central planners wasted valuable resources by mandating investment in sectors of the economy where the output wasn't wanted by consumers--particularly in heavy manufacturing industries. It is thus no surprise that the Soviet Union's capital/output ratios were higher than those of contemporaneous free market economies of the West.
This phenomenon of overinvestment is observable even among more sophisticated free market economies. In Japan, the saving rate and gross investment have been far higher than ours, but their per capita growth potential appears to be falling relative to ours. It is arguable that their hobbled financial system is, at least in part, a contributor to their economy's subnormal performance.
We should not become complacent, however. To be sure, the sharp increases in the stock market have boosted household net worth. But while capital gains increase the value of existing assets, they do not directly create the resources needed for investment in new physical facilities. Only saving out of income can do that.
In summary, whether over the past five to seven years, what has been, without question, one of the best economic performances in our history is a harbinger of a new economy or just a hyped-up version of the old, will be answered only with the inexorable passage of time. And I suspect our grandchildren, and theirs, will be periodically debating whether they are in a new economy.
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