September 17, 1999
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PANELISTS
PROCEEDINGS
MR. BERRY: I would like to welcome all of you to this International Monetary Fund forum this afternoon, in which we are going to discuss, with the help of four very able economists, what is going on in the U.S. economy. Whether they will be able to tell us very precisely, you can judge yourself at the end of this, as I am sure that they are going to fulfill the politician's nightmare of being economists with two hands. There is the old joke, you know, about the politician who wanted an economist with just one hand so he could get advice without having the man or woman go on to say, "And on the other hand, however."
The reality of the U.S. economy is that it is sort of two-handed. It is full of unknowns, unpredictabilities. One man who once was president of the Boston Federal Reserve Bank, Frank Morris, had a board of directors chairman named George Hetsopoulos, who was a physicist, thermodynamics specialist at MIT, but who was an entrepreneur and started his own company very successfully.
And he was always annoyed at the advice of economists because it was never very precise, and he once told Frank that economics was where thermodynamics was in the early 1850s, when somebody, I think at the University of Berlin, had made some revolutionary discovery about the flow of heat and he got it backwards. Frank's rejoinder to George Hetsopoulos was, "Yes, George, I understand that, but my electrons think."
And that is one of the problems, unpredictability. Well, economists I think can help us sort out some of this, help us find our way through the underbrush, but it is very pleasant underbrush in some ways right now. Something Bill Dudley, one of the speakers brought with him, starts off: "The current U.S. economic environment is the best ever--steady growth without inflation, and there is still no recession in sight."
Well, the recession in 1990-91 was actually pretty mild by most standards, so in a sense you have had a boom, not entirely a boom but you have had a long, long running expansion that in many ways stretches back to 1983. It is quite remarkable. The longest peacetime expansion in U.S. history was in the 1980s, until this one, and we are shortly, by the early part of next year, going to have the longest expansion in post-war history, and in fact that means in all of U.S. history. It is indeed a remarkable performance.
Some of the things that people on the panel will be talking about today are some of the changes in economic fundamentals that have made this possible; some of the changes, not changes so much as better policy, both on the fiscal and the monetary sides. But, you know, everywhere there is always something that is a little bit wrong.
The U.S. has enormous and growing external deficit which requires a very large inflow of capital to finance. Someday we are going to have to have some adjustments, some reductions in consumption or investment that--or at least slower growth in those--that will allow us to reduce this deficit. The question is whether that reduction will be smooth or whether that reduction could indeed perhaps precipitate a recession.
You are here to listen to the panelists, not me, so let me begin by introducing them. Our first speaker is Martin Bailey, who has just become chairman of the President's Council of Economic Advisors, who even though he has only been there a very short time, has already distinguished himself. He managed to get confirmed, which isn't easy in the hostile partisan atmosphere that prevails in the U.S. Senate these days.
Martin was a member of the CEA from October '94 to August 1996, working in what is regarded as the macro slot on the Council. Martin, are you unhappy with this introduction? He left the Council to join MacKenzie & Company's Global Institute here in Washington, and with the departure of Janet Yelin, who went back to teaching at Berkeley, he was appointed by President Clinton to the chairmanship. In fact, Martin is really an old Washington hand, and as someone who has been here for more than 30 years myself, I don't regard that as a pejorative. Martin holds a Ph.D. in economics from MIT and has taught economics there, and at Yale and at the University of Maryland. For many years, beginning in 1979, he was a senior fellow at the Brookings Institution.
One focus of his research has been in productivity and economic growth, which may give him a leg up in sorting out one of the U.S. economy's current puzzles: Why has productivity growth accelerated so much, and will that faster growth persist?
MR. BAILEY: Thank you, John. I didn't quite know what to make of that introduction, not so much of me, but I thought you were going to get into sort of economist jokes there, which seem to have become a habit. I agree we are not very precise, but in the interest of precision I am going to put up my first chart, which is our precise estimate of our forecast for the U.S. economy for the balance of 1999 and for 2000.
As you can see from this chart, the administration forecast of real GDP is 3.9 for '99, going down to 2.4 in 2000; the CPI, around 2.2 in '99 and going up to 2.4 percent in 2000; and unemployment rate just rising slightly from an average of 4.3 we expect in 1999 to 4.5 in 2000.
As you can see, we are very close to the Blue Chip on that. I think both we and the Blue Chip forecasters envisage a substantial moderation of growth between now and '99.
This was made, obviously, before we knew about the second quarter of '99, which was slower I think than expected, but the third and fourth quarters are looking a little stronger than expected, so again I think will in fact be something very close to our prediction for 1999. CPI, the last CPI gave us 1.9 percent, so that is going to be in good shape for inflation of around 2 percent.
In the material that I was sent in preparing for this talk, they asked were there substantial imbalances in the U.S. economy. I think the surprising thing or the wonderful thing is just how good this economy is. I would agree with Bill Dudley, who put it very well: This is perhaps the best economy ever.
In terms of making the transition to 2000, I think we are expecting some slowing of consumption, which has been running well ahead of GDP and has left the personal saving rate actually negative. In one way that is good news; it is reflecting the very strong performance of asset markets in the United States. We have seen those begin to flatten out this year, and given the baby boom generation and its desire to begin to accumulate for retirement, we would expect to see a return to more normal saving rates going forward, a slightly slower growth of consumption.
We also have increasing budget surpluses over time, so that rather than having a strong fiscal stimulus, we are moving to a more conservative fiscal policy which I think will also help us move to a sustainable growth rate for GDP.
The other imbalance, as John Berry mentioned, is that we do have a substantial current account deficit, and that is obviously a concern. I would make one contrast between the current account deficit we have now and the one that we had in the 1980s.
In the 1980s we had very large budget deficits, so that we were financing our budget deficit, our Federal budget deficit, by borrowing money from overseas. That is no longer the case, and what we have is foreigners that are anxious to purchase U.S. assets, both portfolio assets, direct foreign investment and so on, and so we have had a substantial capital inflow, and the assets that they are buying can be expected to generate the returns that will service that foreign debt, rather than having taxpayers responsible.
But, nevertheless, we would certainly expect to see some moderation in that current account deficit, and the way that ideally we would like to see it is through a growth of U.S. exports picking up the slack, perhaps, for some slowing on the private consumption, private demand side. I think we can expect to see some of that.
The projection for the 11 Euro countries is for 2.8 percent growth in 2000. Japan has started to look certainly not as weak and maybe a bit stronger than we had expected. Korea had 9.8 percent growth its second quarter, Taiwan 6.5 percent, so Asia is beginning to look definitely a bit better.
We would hope to correct that imbalance in our relationship with the world economy through a strengthening overseas. Again, it has been a weak growth overseas compared with very strong growth in the U.S. that has been largely responsible for the build-up of our deficit.
This second chart is in the direction of best economy ever. I am old enough to have been an economist in the 1970s when the Phillips Curve looked a little bit odd in the other direction. We kept having rising unemployment and rising inflation. Now we have experienced the happy situation of declining inflation with a rapidly declining unemployment rate, and this happy situation I think has been brought about by a number of factors.
On the unemployment side, and I refer you, and many of you probably know the work by Katz and Kreuger that point to some favorable demographics that have helped bring down the unemployment rate: increases in the efficiency of the labor market providing stopgap employment to people who lose their jobs, greater flexibility to employers, better job placement services.
One less pleasant reason for the decline in unemployment is that there has been a substantial growth in the prison population. But overall, I think, the labor market seems to be operating extraordinarily well, providing us with very low unemployment rates without putting inflationary pressure on the economy.
In terms of the CPI, a strong dollar has been very helpful, and the strong dollar I think has been a sign of the strong fundamentals in the U.S. economy, and we expect to continue to see a strong dollar, which is helpful on the inflation side.
Another reason we have had good news on the inflation side is that even though we have such low unemployment, we are not stretched on the capacity utilization side. You can see that actually capacity utilization at the moment is slightly below its historical norm, and that helps to keep pressure for price--to keep prices under control.
The last and perhaps in some ways most important reason we have had a good combination of inflation and unemployment is that we have had surprisingly strong productivity growth. We have had surprisingly strong productivity growth of over 2 percent for the last four years, 2.8 percent this last year. That is unusual at this point in expansion where one would expect, perhaps, productivity growth to be slowing down, as it usually does as you go on, extend an expansion, so that that is beginning to be a sign. I am going to talk a little bit more about this, but it is beginning to make a lot of people wonder about whether we have a new economy or not.
Okay, that is my last chart, so we can bring the lights back up.
Well, do we have a new economy? In some respects we obviously do: over 100 months of expansion, 4.2 percent unemployment, core inflation under 2, real wage gains, equipment investment growing at over 12 percent a year since '93, a budget surplus of over $100 billion and rising.
If somebody had predicted that 10 years ago or 8 years ago, I think they would have been dismissed as crazy. Probably somebody did, but they were well on the three standard deviation end of whatever was being predicted lately. This is really a remarkable situation that we now have.
The productivity--and let me then sort of make a caveat or warning about this productivity boom. It is only an infant. It is only really the last four years that we are beginning to see some evidence of an acceleration of productivity growth. We have had 1.3, 1.4 percent productivity growth since 1974, making a little adjustment for changes in the measurement that has taken place. And now we have gone to what appears to be about a 2 percent growth rate.
I think four years is enough to start to take seriously but it is not enough to say, however much of a productivity expert you claim to be, it is not enough to say that we know for sure that things are different. But I am optimistic. I don't take that optimism necessarily into our budget forecasts. Those have to be conservative. But in terms of what I am looking at and what I think I am seeing in the economy out there, I am more optimistic than our budget forecasts are.
As you know, we had a very strong productivity growth in the U.S. economy after World War II. The Great Depression and then World War II itself were a period where scientific and technological advance was still going along, was even perhaps stimulated by the war, but we didn't have the commercial development and diffusion of that innovation.
And so the period after World War II was really a sort of golden age of extremely rapid productivity growth. When that faded, as it did at the end of the '60s or in the early '70s, everyone expected that the next round of innovation would stimulate as fast or even faster growth, and that was the information technology revolution. It turned out that we didn't seem to get that rapid growth from information technology. Many of you, I know, are aware of the arguments. At least with hindsight we can look back and say perhaps we were looking for that too quickly; that when you have a new technology coming along, it takes some time before it is converted into ways of improving productivity.
It takes some time before those new ways of improving productivity are diffused around the economy. It takes complementary investment, complementary innovation, before some root change in technology can necessary translate into better performance. So is that what we are seeing now? Are we finally beginning to get the payoff to the information technology revolution?
Well, some observers say no, that even today the only thing we are really seeing is the effect of producing the computers themselves, and there is no question that is part of what we are seeing. The contribution of the manufacturing sector of the economy to total productivity is very substantial. I, however, don't find it reasonable to believe that that is the only thing that is going on. Before I joined the administration, I was involved with others in working on a number of industry studies, looking at both the U.S. and overseas industries.
I think we went beyond what you would think of as anecdotal evidence. We did fairly systematic quantitative evidence of a series of industries. We didn't specifically focus on following them over time, but we did these studies at enough different points in time that you could begin to see how these industries in fact devolved over time. And by comparing the U.S. with other industries overseas that were often at an earlier stage of development, you could see how the different operating procedures in the U.S. made the industry more productive than a comparable industry overseas. I will give a couple of examples, but there were a number of others that I don't have time to mention.
In retail distribution, for example, a modern mass merchandiser in the United States is about twice as productive as a traditional store. It achieves that in a number of ways, but one of the most important is that it uses information technology so that when someone buys something, that information is scanned in, feeds all the way back to orders to the manufacturer.
There is then an optimized transportation from the manufacturer to a wholesale distribution center. The item is put in the optimal place in the wholesale distribution center. The way in which the workers then pull that item off the shelf to load it is done in an optimized way. It is then taken to the loading dock, where the truck arrives at exactly the right moment that is destined for the store that needs that item. And so all the things that are destined for that store are collected up together. It optimizes the load on that truck. That truck is then taken and it is put in place in the retail store.
That is the kind of thing that makes that operation twice as productive as a traditional retail operation. It is obviously not just a matter of buying computers and thinking it is going to happen, but if it is combined with bricks and mortar, other equipment, a redesigned business system, training of the workers that are going to operate that system, it is much more productive.
Another example is in airlines, where the use of computers and information technology is used to manage the reservation system, to increase the load factors. It is quite striking, when you go on--and in some ways maybe we don't always like this--but we go on a U.S. airline, we find the load factor is typically much higher than when you travel on an overseas airline, because of the way they set the ticket prices and optimize the load factor.
They keep the planes in the air more hours, are able to utilize their fleets more effectively. U.S. airlines on average are about 50 percent more productive on a labor productivity basis than European airlines. We have looked at that over time. That lead has been pretty much maintained over time, even though the European airlines are improving their own productivity.
So that is just a couple of the examples, but those are the kinds of studies and the kinds of examples that I think make it very hard to believe that we are not getting some benefits in the use of this new technology.
Another study that I didn't participate in, but I was involved with the people that worked on it, was looking ahead. This study looked at the way workers in U.S. business spend their time. About 50 percent of the time is spent in what they called interactions, which could be data gathering, group problem solving, dealing with invoicing, things of those kinds.
Then the team did a number of experiments to find out how those interactions would be changed by what is coming down the pike and what is already there in terms of improvements in communication technology. They were able to make a rather convincing case that the information technology that is still coming down the line is going to make a very substantial increase in the productivity of those interactions. And I am not sure I gave the number, which is about--no, I did, I'm sorry--about 50 percent of the time is involved in those kind of interactions.
So, on balance, while recognizing the need to be cautious in making budget forecasts and so on, I am reasonably optimistic that we will see productivity growth somewhat better than the slowdown period ahead. Whether it goes back to the '50s and '60s, I am not sure, but I would hope to see us somewhere closer to the 2 percent.
What is the right policy environment to make that happen? Clearly we need to maintain competition. A highly competitive environment encourages both innovation and the adoption of innovation. It forces companies to change and be more productive.
The ways in which I think this administration and the President's policies are helping the cause of productivity going forward are first of all in making the right kind of investments, investments in science and technology, in the skills and education that will be needed, and perhaps most important, in the effort to make sure we have fiscal discipline.
Because in order to get the benefits of the productivity growth we have had--a lot of the productivity growth that we have had is certainly substantially attributable to the very high rates of investment that have been achieved in this expansion that I mentioned earlier, over 12 percent a year since '93. We need to keep that investment going, that high rate of investment going, if we are going to have a chance of keeping the productivity growth going.
Thank you, John.
MR. BERRY: Thank you, Martin.
[Applause.]
MR. BERRY: There was a little pitch there at the end for the President's program. That is the commercial that you get.
Our second speaker has quite a different perspective. He is not here in Washington. Well, he was here briefly at one point, on the staff of the CEA, but lots of economists survive that without damage.
Anyway, Greg Mankiw is professor of economics at Harvard, and I am proud to say that I knew him even before he got a $1.4 million advance for writing an economics textbook. Given the prices charged for textbooks these days, and the popularity of his book, I suspect he is now getting royalties beyond the advance, something most authors seem never to do.
Greg received tenure at Harvard in 1987, which, if I did my arithmetic right, he was 29. As you probably know, getting tenure at a place like Harvard at that age says a great deal about how one's academic credentials are regarded. His research and his very long list of publications while he has been at Harvard I think justify that decision.
Like Martin, he has a Ph.D. from MIT, where he taught briefly before moving to Harvard's high rent section of Cambridge. He was also a staff economist at the CEA. Someone who was explaining why he had chosen to read Greg's textbook--I suspect it was Bob Solow at MIT, though Greg doesn't actually know--described Greg as basically a macro economist interested in interest rates, and went on to praise the book for being shorter, the text more lively, and focused on students, not instructors, compared to competing textbooks.
And the person writing this went on to say, "Actually, I selected the book as our text because Mankiw likes to sail," as does Solow. That is one reason I think he wrote this. "And I have particular respect for sailors. They usually know when to tack."
MR. MANKIW: Thank you. It is a delight to be here. What I want to talk to you about is a question that a lot of U.S.-oriented macro economists like myself have been thinking about, which is, why is the U.S. economy so strong and why has it been so strong for the past decade or so?
And my message, to put it simply to you, is the following: I don't know. And I want to try to convince you that I don't know, and I want to convince you that you should be skeptical of anyone who claims they do know, because I think it is a truly deep puzzle.
First let me begin by admitting what I think is something that probably all of us will admit, that the economic performance has been very strong. There really is a puzzle to be explained. The U.S. economy is going great. To get some sense of how great it is doing, I went back to the forecast issued in the first Economic Report of the President. But I went back to the first Economic Report of the President issued by the Clinton administration and pulled out their economic projection of what they thought things would look like today back at the end of 1993, and I compared the actual today to what they predicted. And I am not picking on the Clinton administration because they were unusual, and indeed I think they were pretty much close to the consensus at the time. I just didn't have that handy.
The Clinton administration predicted growth between 1993 and 1999 at 2.7 percent, growth in GDP, and we have actually seen about 3.4 percent growth over that interval. So that means that output today is about 4 percent higher than it was expected to be in '93, the end of '93. Inflation, they expected inflation to be about 3.4 percent today, and it is actually running about 2 percent. They expected non-farm employment today to be about 122 million, and it is actually over 128 million, so employment is about 5 percent higher than was expected.
So we need to keep all those numbers in mind. We have about 4 percent more output, about 5 percent higher employment, and about a percentage point and a half lower inflation than was predicted. Those are all pieces of good news, and I am sure if I had a more complete projection and looked at other things, we would see a lot of other pieces of good news. So there is no question that things are very good in the economy.
The question is why, and how can we explain the success? And I have thought about that question from a variety of different perspectives, trying on different hats, that is, trying to imagine myself as a different kind of economist and trying to figure out which kind of economist could explain this most readily. And the answer I came up with is that sort of none of the sort of mainstream kinds of economists can easily explain this fact.
So let me go through what I think of as different denominations of this religion called economics and talk about how prophets of all of these denominations need to sort of question their deities. The church that I usually worship at is what I will call the Keynesian/monetarist church, the church that says that most fluctuations in the economy, most developments over the relatively short term, are due to fluctuations in aggregate demand. So the standard view that Keynesians and monetarists have is that changes in aggregate demand, changes in spending propensities of the general population drive the economy. And they have different views as to what might drive changes in aggregate demand. That is why I am lumping Keynesians and monetarists in the same group.
The Keynesians had this view that spontaneous changes in spending, animal spirits, irrational waves of optimism and pessimism, we might say irrational exuberance, was driving spending. So in that sense you might think of Alan Greenspan as sort of a very old-fashioned Keynesian.
Monetarists believed that it was changes in monetary policy--stop/go monetary policy, that drove fluctuations in aggregate demand. But whatever their view was, they shared the conviction that it was changes in aggregate demand that tended to drive the business cycle.
Well, that is obviously not what is going on here. If it were a change in aggregate demand driving the economy, what we should be seeing now is higher inflation accompanying this growth in employment and growth in output, not lower inflation. So whatever is driving this boom, it doesn't seem to be an aggregate demand story, which is--I mean, it is not a standard animal spirit monetary policy kind of story.
Something is going on on the supply side of the economy, good supply development, but supply side development that needs explanation. So what might that be? What might be going on on the supply side economy to drive these great developments we have been having? Well, maybe the supply-siders are right. Well, no, actually it is quite embarrassing to be a supply-sider now, because supply siders, if you remember, used to say that when you raised taxes that was an economic catastrophe.
In fact, one right-wing economist I know--I won't mention his name, I don't want to embarrass him in this forum--was so sure that Clinton raising taxes--remember, the first thing he did is, he raised taxes. He raised marginal taxes, especially on the rich, which was especially bad. The first thing my right-wing friend did was, he sold all his stocks because he was so sure it would be bad. Well, that was about 7,000 Dow points ago.
And I am a believer in lower taxes and smaller government, but this idea about higher taxes are going to cripple the economy, which was a view that you did hear from some supply siders when Clinton took office, clearly overstates the case. Okay, so that is--it does seem like it is an embarrassing time to be an extreme supply-sider.
There is also another, a more liberal group which you might think of as the left-wing supply siders, that is, those who thought that government needed to take an active role in order to increase spending on infrastructure and worker training and so on, in order to increase the supply of business services. This is the view of the economy associated with Robert Reich and that sort of group of the Clinton administration.
And you might say, "Ah, ha, this is good evidence for them. Clinton came in. He promised a more activist government. That is why we are growing so rapidly." But actually really what happened is, we didn't actually get much of that spending on infrastructure and worker training and so on.
In fact, if you read Robert Reich's memoirs, he is pretty clear that he is very disappointed we didn't see that. His wing of the Clinton administration lost most of the fights to the more conservative fiscal--the fiscal conservatives, the deficit hawks, so we really didn't get all that extra government spending to boost growth, but the economy seems it was ready to grow anyway. The economy seems to grow without all that extra spending.
So is it the fiscal conservatives, is it the deficit hawks that get credit for this economic boom? I would really like to be able to say that, because being one of these people who always believed in increased national saving, I would love to explain the current boom with this morality play: We made a sacrifice, we taxed ourselves more, and now we are reaping the benefits. That really would be a terrific story to tell.
But if you really look at it very carefully, it is probably not right. It is probably not right because even the most optimistic calculations don't give you deficit reduction leading to this great of an economic boom. I went through that calculation in a couple of papers in which I asked the question: suppose we had completely eliminated the government debt? In fact, the story I envisioned was what I called the debt fairy, sort of related to the tooth fairy. Those of you who have small children, the tooth fairy, as you know, replaces teeth with quarters--or dollar bills, my 7-year-old tells me.
We imagined this debt fairy that went around and replaced every piece of government debt with a piece of capital of equal value, so immediate one-for-one crowding in of capital. So the debt fairy is going to go around and turn all our government debt into capital overnight. How much extra output would you get from that?
Well, debt is about half a year's GDP, so that is a point number about .5. The marginal product of capital is probably 8 percent per year. That is .08. You multiply those extra numbers together, you get about 4 percent extra output. So if I turned every piece of government debt into a piece of capital, that would only give me 4 percent extra output, and we didn't do anything near that. We just slowed down the rate of government increase, and debt-to-GNP fell a little bit.
In fact, if you do a calculation about 2 percentage points to growth from deficit reduction, and that number actually is from the first Clinton economic report. They said that deficit reduction would add about .2 to the growth rate, and I actually thought that was a very reasonable number. I think it is about the right number. So the extra growth we have gotten somewhat comes from deficit reduction, perhaps, but only a small amount from deficit reduction.
A more credible story probably goes the other way around, which is that we have had this tremendous rapid growth for some other reason. That has led to extra revenue. That has led to reduced spending on antipoverty programs, and that has helped balance the budget and led to the surplus. That is a much more plausible story numerically, I think, than saying the deficit reduction gets credit for the boom.
So this leads me to the internet. Perhaps the information revolution has spurred us on the new, unexpected heights, and Alan Greenspan has been touting this when he is not talking about irrational exuberance. Well, the best thing I think about this story is that it is hard to evaluate and therefore hard to reject. No, actually I hope it is true. When I think about it and I say, well, is this a really special technological revolution? Is this of a magnitude or even surpassing, say, electricity or the telephone or the internal combustion engine? Well, maybe, but it is hard for me to believe.
Economists who have studied the numbers--and I cite Robert Gordon here who has done a lot of this work--don't really see a lot happening to productivity growth outside of the sector of computer manufacturing. And if you go back to the numbers I started with, you can see it there. Remember, I mentioned to you that output today is about 4 percent higher than the Clinton administration forecast at the beginning of their term. Employment is about 5 percent higher. So that means that output per worker is about the same as what they expected it to be.
Now, as Martin mentioned, we have gotten a little bit of extra productivity growth the past few years, but in the mid-'90s we had sort of low productivity growth. So if you look at what the productivity level is today relative to what they thought it was going to be today in '93, the end of '93, it is about the same, so it doesn't look like there is a tremendous productivity revolution going on. Now, I hope I am wrong about this, because I would love to have this internet turn out to be a new economy, but I don't think the evidence is there for it.
Now, if you want to tell a story along these lines, it is going to involve several elements. One is, you have got to explain why one sector is driving all the productivity growth, because it really does seem like the computer manufacturing sector was where the productivity growth is happening.
So maybe you can tell a story about this spreading to other sectors via capital deepening. You know, basically we are getting really, really good at making computers, so computers are getting very cheap, everybody is buying computers, and therefore they are reaping the benefits not in terms of higher total factor productivity growth but in terms of higher labor productivity growth through this capital deepening term. That has some degree of plausibility if you look at the data. Let me note that producer durable equipment has grown very rapidly over this period of time. Since '93 it has grown about 9 percent per year. If you look at the composition of that, it is really fascinating. Computers as a percentage of producer durable equipment has risen from about 10 percent in the early '90s to about 50 percent today. That is just an astonishing change. So there is a change going on involving computers. Whether it is going to mean a new paradigm or not is still an open question.
Another effect that I think might be important to think about is changes in the composition of the work force. There seems to be some evidence lately that there has been a lot of entry of low-skilled workers into the labor force. Some of this probably has to do with welfare reform, probably not all of it.
But what this could mean is, that could mask underlying productivity growth. That is, if you have all these unskilled workers coming in, you might expect that to show up in terms of falling productivity growth. If productivity growth only remains steady, that means there is something else offsetting this.
So maybe if productivity growth corrected for the quality of the work force, say correcting for experience or skills, you might actually see more happening to overall, economy-wide productivity growth. But that is just a conjecture of a place we might look in the future.
Now I haven't said that much about the stock market, so let me close there. One question we had over lunch was, who is going to come to this, people who want to understand the economy or people who want to figure out what to do with their 401(k) plan? So let me sort of say something about what you should do with your 401(k) plan.
Is this a bubble? Well, I have a couple of reactions to this. Let me give my two reactions, on the one hand, and on the other. Is this a bubble? Well, if it ever was a bubble, what would it look like? It would look just like the economy looks now. We see P/E ratios very high, price/dividend ratios very high, price-to-book ratios very high. All those things are very high. Having said that, I haven't changed my personal portfolio a whit. And I do that because I am skeptical of economists' ability to recognize bubbles.
I know some very smart economists who have made these arguments that it is a bubble. Campbell and Shiller, for example, have written a well-cited paper on it that says that if historical relationships show up over the next few years, the stock market is going to go to something like half its current level. I know some very smart economists who have taken their money out of stock in response to these kind of arguments. They did this around 3,000 Dow points ago. Myself, I remain more agnostic, being very skeptical of our ability to know a bubble when we see it, and I basically buy and hold.
There is a reason to think that there is something fundamental going on here that is not a bubble, and there is this new book out that some of you may have heard of called "Dow 36,000," the kind of book that economists are usually embarrassed to read. Just the title of it tends to turn your stomach. But it is actually a serious argument that runs as follows: We academic economists, we economists of all sorts, have never really understood why the equity premium is so large. Historically the equity premium is, you know, 6 percent, 7 percent, something in that ball park, the extra return you get over T-bills. We have never understood why it is so large. The academic literature, when we try to calibrate the size, the equity premium gets much, much smaller than that, and there is this whole literature called the equity premium puzzle.
Well, maybe it has been a puzzle because people haven't understood that it is so large, and maybe it is a puzzle that is slowly going away. Maybe people said, "Ah, ha, stocks have historically been underpriced. Maybe the equity premium should really go away."
And if the equity premium should go away, that is saying that price/earnings ratios, for example, should be much higher than they have been historically. And maybe we should interpret the current stock market boom as simply being a reversion of the equity premium toward what is a more rational level, that is, going forward much smaller than it has been historically. This is a reason for believing that it is not just a bubble that has some credibility in my eyes.
Well, suppose it were a bubble, and suppose there were a crash. What damage would that do to the economy? Well, my guess is, not much. My guess is, we would see a repeat of '87. The Fed would ease a whole lot and we would live through it just fine. People would open up their 401(k) statements, feel sad for a few days, and life would go on.
On the other hand, maybe something more serious could happen. I don't know. I don't imagine that there is lots of Long-Term Capital Managements out there ready to crack as soon as the stock market fell. But then again, I didn't think Long-Term Capital Management would do that. Bob Burton seemed like a smart guy. I never saw that one coming.
So do I expect some sort of crash in the stock market? Do I expect some sort of massive capital outflow? Do I expect a financial crisis in the United States? Well, no. But here is one picture I am absolutely confident of, is that if there is ever one in the United States, it will catch all of us by surprise, even the economists of the IMF.
Thank you very much.
[Applause.]
MR. BERRY: Our next speaker is living in the middle of the bubble, if there is a bubble. Bill Dudley is on my short list of people I call when I want to know what is going on. I was going to call him yesterday. I was working on a story about the likelihood, or the lack thereof, of the Federal Reserve raising rates early next month. And I decided I really didn't want to call him and quote him, and then sit here as a moderator on the same day.
But there are so many analysts around whose work I have found over the years really doesn't hang together. When I find one whose views consistently make sense, I keep calling back. But, Bill, I have got a bone to pick with you. Your prepared biography notes that you are regularly quoted in The Economist, The New York Times, the Wall Street Journal, and the Financial Times.
MR. DUDLEY: I will amend that.
MR. BERRY: Thank you. Anyway, Bill holds a Ph.D. in economics from the University of California at Berkeley, so finally not everybody is from the East Coast. And he is director of the U.S. Economic Research Group at Goldman Sachs & Co. in New York. Essentially, he is the firm's chief economist. He is responsible for the economic and interest rate forecasts for the United States, and he also oversees the firm's Canadian economic research.
Prior to going to Goldman in 1986, he worked at J.P. Morgan, and once as a callow youth he worked in the Financial Studies Section of the Federal Reserve Board here in Washington.
MR. DUDLEY: Thanks, John. I will amend my bio. A lot of times in New York if you say Post, you know, that doesn't have quite the right connotation.
I am going to talk about some of the same things that Greg talked about, but probably in a little bit different way. I want to answer two questions: Why are things so good? And what are the prospects that they are going to stay that way? Unlike Greg, I work on Wall Street, so I have to pretend I have the answer, so I am going to pretend today.
The economy is performing very well, and I would argue that there are really three broad reasons why it is performing so well. And this paper is our shot we took about 18 months ago at why things were so wonderful, and they have stayed wonderful. It is not very often on Wall Street you can pull out a paper that is 18 months old and allow anyone to read it.
Three things that I think are causing the economy to perform well. First, I think there have been some fundamental changes in the economy structurally that have made the economy less cyclical. Second, I do think we have had very good policy. I think that is in part because the Democrats and Republicans are split, and so when the Democrats want to do something stupid, the Republicans won't let them, and vice versa. And, finally, I think we have had very good luck.
Now, turning to the structural changes that I think are really important, I am going to refer to a couple of charts in this paper. The first one that I think is very, very important is the fact that we have had a transition to just-in-time inventory management that was really taught to us by the Japanese. And I think that is very, very important in making the economy less cyclical, because what it means is that businesses get much better information about what is happening to demand for their goods and services. And so when there is a demand fluctuation, they find out sooner, and so they can make a production adjustment quicker. And because they can make the production adjustment quicker, it doesn't have to be as big.
About half of the decline in economic output in recessions historically has been due to inventory corrections, and I think what you are finding as we move along, that that is becoming less and less a factor. If you look at the paper on page 4, we have a little table that looks at how much inventories have contributed to downturns in the economy. And you can see, looking back, you know, to the 1960s and then the '70s and '80s and now the '90s, that the contribution of inventory to decline does seem to be declining over time.
And I would expect that it has actually accelerated in recent years, that effect, because you can see on the top of page 5, inventories to sales ratios have declined quite dramatically over the last 20 or 30 years. So inventories are very lean, and obviously if they are lean, that means people are getting a lot better information about--they have to be getting a lot better information about what is happening to demand.
The second thing on the structural side that I think is important is the fact that the economy is a lot more open than it has been in the past, and that is important because it means that when there is demand increases or declines in the U.S., U.S. production doesn't bear all of the burden. The trade sector, while we think of it as something that has hurt the U.S. economy over the last few years, it really is a shock absorber for fluctuations in domestic demand.
The third thing that is important I think on the structural side is something that Martin talked about, is the flexibility of the U.S. economy compared to how flexible it used to be. And certainly the labor market, we all know how flexible the labor market is because we all know we can lose our jobs at any moment.
Another part of the flexibility of the economy, though, that doesn't get as much attention is what is going on in terms of the capital equipment side. If you look at the chart on page 7, you will see that the number of months of unfilled orders of capital equipment has declined quite dramatically from the '70s to the '90s, and what that means is that people are basically able to put capital equipment into place much quicker.
Now, you are much more willing to invest in a paper plant if you know that plant can come on stream in 18 months than if it is going to come on stream in 4 years. And so the fact that the capital equipment cycle is quicker makes people more willing to invest, and it makes sense that if they are more willing to invest, the economy becomes less inflation-prone. And you can see how that generates a virtuous circle for the economy.
And then finally on the flexibility side, we have had a lot of deregulation. We have had financial market deregulation, deregulation of most transportation, oil and gas. Now we are moving on to telecommunications and electric utility generation. And I think all those things help keep those competitive pressures that Martin alluded to firmly in place, which also helps the economy perform better.
Second, as I mentioned earlier, good policy. I am going to go very quickly here. Trade liberalization, we got the Uruguay Round of GATT, we got NAFTA. Fiscal discipline, I think it is, you know, probably worth about the two-tenths of a percent a year that Greg implied, but it certainly helps. The pay-as-you-go provisions of the 1990 Budget Enforcement Act were important because they really capped the growth rate of government spending, and that freed up resources for the private sector of the economy.
And then finally on the policy front we have had--apparently we have had quite a bit better monetary policy regime. I say "apparently" because obviously until it all plays out, we won't know for sure, but it seems that policy has done a better job in anticipating movements in the economy.
Certainly 1994-95 was a really good performance by the central bank, tightening monetary policy by 300 basis points without much inflation pressure. There aren't many examples of that in U.S. economic history, and that really prevented the inflation from getting entrenched and helped sustain this expansion.
And then, finally, good luck. The two things on the luck side that I would really point to is, first, the end of the Cold War. Maybe that wasn't completely luck, but the timing of when we won the Cold War was luck, and that allowed a defense dividend which obviously, again, freed up resources for the private sector of the economy.
And the second thing that really has been good luck is, all the shocks from abroad to the U.S. economy over the last few years have been--have had terrific timing, when they occurred. Terrific direction, they helped the economy in the direction that it needed helping. In other words, when you had the Mexican peso crisis and the Asian crisis, you needed things to slow the economy down and you got shocks from abroad that slowed the economy down. And they were the right magnitude. They were big enough to slow the economy down but not big enough to push the economy into recession.
So I think what has happened is, we have gotten a less cyclical economy because of some combination of these three factors, and that less cyclical economy has generated a kind of virtuous circle. It has led to more investment. Greater investment spending has led to greater productivity. The increases in productivity have helped restrain inflation. It has also generated more revenue to the government, and so on.
Now in terms of this question: is it a new era? We hear that bandied around a lot and I always feel very uneasy when people ask me that question because I don't want to sign up to be part of a new era, because everyone who signed up to new eras in the past always ends up as sort of in the proverbial dust bin of history. But if you think about it, it sure seems like we are, because we have had two very long-lived economy expansions in a row, '82 to '90 and then '91 to today. We have had 8 months of recession in the last 17 years. That is about 4 percent of the time. Prior to 1983, the U.S. economy was in recession about 25 percent of the time.
We did a little statistical test at Goldman this summer. We asked ourselves a very simple question: If we assume that these two economy cycles were generated by the same distribution that generated all the other business cycles in the post-World War II period, what would be the probability of that happening just by luck? We calculated the probability of that happening just by luck was less than 1 percent.
We did the same analysis extending back to 1854, which is about as far back and our data goes, and I don't think the data is probably very good. And it turns out there, because the economy was even more cyclical, the chances of that happening was less than one-tenth of 1 percent just by luck. So I think luck has had something to do with it, but that is not the only explanation.
Well, the next question is, will the good times continue? Well, who knows, as Greg put it. It depends not only on whether these structural changes persist, but also on policy and luck.
Not knowing what will actually happen, I will though, nevertheless, be brave and make three general observations. First, I think the good policy that we have had is not just an accident. I think the fact that the capital markets have become much more important in this country relative to the banking system means that it is harder to conduct bad policy and get away with it.
If you start following a policy that the financial markets deem as a bad policy--and we are sort of deeming that the financial markets know what a good policy is when they see it, but I work on Wall Street, so you have to give me a little bit of rope on this. If the capital markets see a bad policy, they automatically exert a penalty against the administration or Congress that is trying to implement that policy, which dramatically increases the cost to the administration or Congress of actually implementing the policy. So a lot of bad policies are probably going to get junked before they see the light of day, in part because the capital markets exert a substantial discipline on the policy-making apparatus, much more so I think than 20 or 30 years ago.
Second, the economy's sterling performance has created some significant imbalances which John alluded to earlier. The shift from the very bad economy of the early 1980s to the very good economy of the early 1990s has resulted in a dramatic revaluation of the equity market, which I would agree with Greg seems generally appropriate. A substantial shrinkage of the equity risk premium seems appropriate, given that the economy today is much better than it was 20 or 30 years ago.
But this surge in the equity market has created two significant imbalances. What you have seen happen is just a spectacular increase in household net worth, especially since the end of 1994. That has generated a dramatic decline in the household savings rate.
That decline in the household savings rate is not sustainable indefinitely, because the wealth gains that we have seen, 15, 20 percent a year in terms of stock price appreciation, is not sustainable. The equity risk premium can shrink for a time, but the equity risk premium probably cannot shrink indefinitely, so at some point wealth has to grow more in line with the growth rate of nominal GDP rather than growing many, many multiples of that speed.
The second imbalance created by this revaluation of the equity market has been that there has been a big surge in consumption investment, and that surge in consumption investment has not been completely satisfied by domestic production, and so we have gotten a very big trade deficit and current account deficit. As Martin pointed out, so far at this point it has not created any problems. Foreign investors want to hold more U.S. financial assets, and so foreign investors are happy to fund the U.S. savings shortfall.
But this smooth matching of the savings rate plunging and the current account deficit widening, happening in a nice smooth way that doesn't cause any problems for the economy, I think that is a very, very big risk going forward. The chances are that foreign investor appetite for U.S. assets will not evolve exactly at the same rate of speed as the household savings behavior.
And so at some point we are probably going to have an imbalance in terms of aggregate demand, either too much aggregate demand if the savings rate does not rise and the current account deficit shrinks, or a shortfall of demand if it happens the other way around.
My own view is, I worry mostly about the foreign investors reacting first because the current account deficit has doubled just the past two years. So not only are we asking foreign investors to continue to have a good appetite for U.S. financial assets, but we are asking them to increase their appetite over time. And we have seen around the world the last couple years, with countries like Thailand and Korea and others, current account deficits that are increasing rapidly are not sustainable over time.
The final observation that I would make in terms of what all this means for the economy is, if it really is a new era, then that implies higher real U.S. interest rates, inflation-adjusted U.S. interest rates. This is the dark secret that new agers don't want to tell you about, because the reality is, if it really is a new era, the return on capital to new projects has gone up. And to allocate the supply of savings, which is actually shrinking because of the wealth effect, which is driving down the household savings rate, guess what? How are we going to allocate that smaller pool of savings among a wider, greater array of investment projects? Well, the only way we are going to do it is either we are going to keep monetary policy too loose and print too much money, or we are going to have to have interest rates go up.
Now, the second paper I handed out that I am not going to go into in any great degree is our take on sort of why monetary policy is probably going to have to be made tighter over the next couple of years. And that is the fact that we think that financial conditions in the U.S. are quite accommodative. If you look at the first page of this paper, there is just a little chart showing our Goldman Sachs Financial Conditions Index. It has four variables: short-term rates, long-term rates, trade-weighted dollar, and the secret ingredient, which is the stock market, the market cap to GDP ratio.
And what that shows you is that despite the Fed tightening that we have seen over the last couple of months, financial conditions in the U.S. are still very accomodative. The strength of the stock market is really making the financial conditions accommodative, and the Fed really hasn't done enough to offset that.
Now, having said that financial conditions must become less accommodative over time, we really don't know. There is lots of ways that can come about. The stock market can decline, the dollar can appreciate, or interest rates can go up.
So we are not sure which way it is going to go, but I would point out that spontaneous stock market declines are rare. Usually they are preceded by an unfriendly central bank. And, two, given the current account imbalance, it seems to me a lot more likely that the dollar depreciates than appreciates.
So if you accept the notion that financial conditions right now are very accommodative and probably are going to need to become tighter over time, the bottom line is pretty self-evident. Interest rates are probably going to have to move up.
The bottom line, sitting at Goldman Sachs, maybe contrasting our views a little bit with Martin's, is the economy is likely to remain a bit stronger than expected because financial conditions still are more accommodative than people realize. And the consequence of this is that pressures on the Fed to do more, probably not very quickly but to do more eventually, are going to continue to grow over time.
Thank you.
[Applause.]
MR. BERRY: I think he may have just pricked the bubble. Anyway, Greg is going to have to slip out of here soon, perhaps before our next speaker finishes. If so, don't take it as a comment on the speaker or what he is saying.
Anyway, Steve Dunaway has what you might call home court advantage today. He is batting last, and he is on the IMF staff.. Steve is currently Assistant Director in the Western Hemisphere Department and in charge of the division dealing with the United States and Canada. Previously he was in the IMF's Asian Department and in the Policy Development and Review Department, where he worked on issues related to private capital flows to developing countries. He is probably glad to be in a different section these days. At one point he was also a senior economist at the Commerce Department's Bureau of Economic Analysis. Those are the folks who are responsible for estimating U.S. Gross Domestic Product, among other things.
Like all the other members of the IMF, the United States is subjected to what is known as Article IV consultation with IMF economists and other officials. The result is an analysis of what is going well in the economy, what is not, and what U.S. Government officials should do about the latter.
The latest consultation, which was concluded at the end of July, which Steve helped direct, is pretty clear evidence he knows the nitty-gritty, the uncertainties of the American economy. I would be very interested sort of to have an international organization's perspective on all this. Steve?
MR. DUNAWAY: Thank you. Well, in answering your first question in terms of how we got here, I can't dispute most of what has been said. I just would change the emphasis a little bit. In particular, coming from the perspective of being here at the IMF, if you don't believe that economic policies don't have a key role in determining economic outcomes, then you are probably in the wrong institution.
So I see a lot of what we have seen in the development of the economy, in the kind of structural changes in particular that Bill Dudley was talking about, as the roots lying in the incentives created by the policy changes that have taken place over the last two decades. And it has been a period in general where there has been a lot of good policy decisions made, beginning at the outset of the 1980s when the Federal Reserve and Paul Volcker decided enough was enough and they were going to put a stop to the rising trend in inflation and bring inflation down.
That was followed in turn by the ongoing deregulation of the economy which Bill alluded to, which created a lot of the incentives for changing the way that businesses conducted their operations, and to me sone of the most important actions were in transportation. With deregulation of transportation, you immediately cut costs dramatically and you opened the door for making it feasible to engage in new management practices, like just-in-time inventory management. You also broadened the scope for competition, because a firm could widen the sources that it could use for the imputs that it needed. You also opened up new business opportunities. For example, in the retail sector, the direct sales business picked up dramatically, and a lot of that was tied to declining transportation costs. In fact, I would argue that the development of e-commerce, particularly in goods, in the end is dependent upon transportation. If you cannot deliver a package cheaply to your door, then there is no advantage in ordering it over the internet, as opposed to walking down to the neighborhood mall.
So deregulation had a big part in terms of changing, as I said, business incentives and changing the structures and the ways in which business operated, and it has been extended into other areas. Also critically important was increased competition coming from trade liberalization, first with the U.S. free trade agreement with Canada and then followed by the extension of that agreement to Mexico with NAFTA, and the Uruguay Round of the World Trade talks.
But there is, ironically, I think, one piece of bad policy that ended up having some very favorable effects, and that bad policy was the relatively disastrous expansionary fiscal policy in the early 1980s. Now, what it succeeded in doing was to push the value of the dollar up to extremely high levels, and by the mid-1980s there were a lot of stories floating around that manufacturing was basically going to disappear in the United States.
As a result of the incentives created by having their backs pushed to the wall, businesses in the U.S. got leaner, they got meaner. They became much more cost-conscious. They moved to restructure their lines of business, shedding businesses, becoming more specialized. They downsized, and in general took steps to improve their cost competitiveness. And these things have carried over. Those bitter lessons from the '80s have not been forgotten, as reflected in the statements that you hear from members of the business community now and in their actions. In a period where corporate profits have been rising very substantially, you still see firms pushing to reduce costs and continuing rounds of downsizing.
The last piece of policy which underlies the very solid foundation of the U.S. economy was put in place in 1993 with the tax increase that was alluded to, and the other measures included in the Omnibus Budget Reconciliation Act. This act set the foundation for the fiscal surpluses that we have seen today. Some analysis that we have done indicates that since 1992 the majority of the improvement in the fiscal balance--we had a swing from a deficit of roughly 4.7 percent of GDP to a surplus this year probably greater than 1 percent of GDP-- is attributable to tax increases and spending cuts, particularly discretionary spending reductions. So we find ourselves now at a point where I think, we have got a pretty good policy foundation. The question is, where does the U.S. economy go from here?
And again starting from my basic bias, that policies in the end determine what is going to happen, I think that as long as the U.S. continues to follow sound macroeconomic policies, there is no reason to expect that the economy can't continue to cruise along, although I think it is going to have to cruise at a somewhat reduced speed than in the past couple of years. But, looking around, people have pointed to a number of potential risks and potential imbalances--things that have been mentioned here--stemming from potential overvaluation of the stock market, the decline in household savings, and of course the current account deficit.
Household savings in the United States have been declining since the 1980s, and the trend decline in the savings rate can be well explained, I think, in terms of, one, the decline in inflation which has reduced nominal savings, because in order to maintain your real savings, you need to save less in a lower inflation environment. It is also attributable in part to increases in per capita transfers from Social Security and Medicare, so that removes another incentive for saving in terms of providing for retirement and medical care in old age. Also during this period we have seen a substantial expansion in the availability of credit to the household sector, and that too has been a factor, I think, that has worked to reduce the savings rate. Now, added to that is the effects of the improvement in the fiscal position, so called Ricardian equivalence effect, that at least in part this improvement in the fiscal position is perceived by households as reducing future tax burdens and in turn has contributed to lowering their savings rate.
Also in recent years, of course, one key factor in reducing the savings rate and the one that has received a lot of attention is the rise in equity wealth. But if you look at the other factors that explain this trend decline, most of these are relatively permanent and you wouldn't expect that they would be subject to a very rapid turnaround. So if there were to be a rapid turnaround in savings behavior, it is likely going to be tied to a sharp correction in the stock market.
On the current account, a lot of the concern stems from the fact that the deficit is large, and the concern is whether it will contract very sharply. But how did the deficit get the way that it is? Well, it got there, one, because the U.S. has grown substantially faster than most of its major trading partners, so this relative cyclical difference has been a major contributor. It has gotten there, as well, because at least whether it is proven or not, and Bill casts some doubts, there is at least a perception that real returns on investment in the United States have risen relative to the rest of the world, and that has encouraged capital inflows. And, in addition, there has also been the inflow of flight capital, and all of this has worked to appreciate the dollar and led to this deterioration in the current account.
So the question is now, how is this going to unwind? Well, we expect that the current account will correct itself as activity in the rest of the world picks up, as conditions in the rest of the world stabilize and some of the flight capital returns to its origins. So ithas been anticipated that over the medium term the dollar would probably depreciate and the current account would adjust.
Now, the question is, is this going to be a relatively smooth process or is this going to be a very jerky one? And I think you are hard-pressed to say with a high degree of certainty that it is going to necessarily be an abrupt process. I think a lot hinges on policies, and as long as you have sound fiscal and monetary policy in the United States, you are going to maintain confidence in the U.S. economy and you are probably going to be less susceptible to runs on the dollar. Now, that is not saying you might not encounter periods where there might be relatively sharp movements in the nominal value of the dollar, but it is not altogether clear that such sharp movements in the nominal dollar will be translated into sharp swings in the real economy.
To give you a good example, if you look back at 1995, in the early part of the year the dollar depreciated substantially against the yen, and the current account over the following two quarters adjusted very sharply, but there was not a dramatic impact in terms of overall growth in the United States. So it is not clear how much of a threat the external position poses, because in the end it is just a reflection of a number of factors which you would anticipate are going to reverse themselves. So I am not as concerned, or as worried as Bill in terms of how smoothly these adjustments are going to take place and how the path of the current account may follow.
The last question, then, comes down to the stock market. The stock market seems to be the culprit for a lot of concerns. And like Bill and Greg, I am puzzled and I don't know if the stock market is overvalued, and if it is overvalued, I don't know by how much. Chairman Greenspan, has pointed out on occasion, said he thinks the market is 20 percent overvalued. But then he turns around and tells you in the next breath that he thought the same way 2 years ago, so no one is sure exactly.
But there are good reasons to believe that some of the run-up in stock prices may be permanent, reflecting changes in the composition of household balance sheets. The baby boomers in particular, having perhaps over-consumed in their younger years, may face retirement with prospects of not having as much income as they would like. There are two ways to boost your future retirement income. You can either raise your savings or you can raise the return on your existing stock of wealth, and it is the latter that may have been a factor that motivated households to diversify their portfolios.
And helping in the process is the innovations in the financial market, which through mutual funds has made it very easy to hold a very diversified portfolio, and the costs of the transactions have been lowered dramatically. So some of this run-up in stock prices is likely to stay. Now, we may come back to this question of whether returns on investment have gone up, and this would be another justification for higher prices in the stock market.
In any event, the stock market doesn't look like it is tottering on a precipice and ready of its own weight to fall off the cliff, and I agree with Bill that it looks like it is going to take something to push it, to see a dramatic decline.
But if it does decline, what kind of an effect is that going to have on the economy? Well, if it falls by 25 percent, it takes the value of stocks back to their level in mid-'98. Generally, in the estimates in the consumption function, you have a 2-year lag on changes in wealth in terms of effects on consumption. So a good portion of the increase in the stock prices we have seen over the last couple of years have not been reflected in consumption decisions yet anyway, so that if the market declined, we may not see as much of a direct impact on consumption. We are likely to see much more of an impact coming from confidence effects, and we saw that last year, when the market declined in the fall of last year, how consumer confidence very rapidly turned around and spending began to look like it was going to slow down appreciably.
But in the end, the impact of a sharp stock market correction on the economy depends upon the reaction of policy, and there is every reason to believe that the Fed is not going to just stand back and watch the economy fall into an abyss because of a decline in the stock market without moving. So in the end we come back to policies once again as being the keys as to how the economy moves from here.
So, what's going to kill the goose that lays the golden egg? Business cycles in the U.S., at least in the modern era, tend to be caused by policy mistakes, with monetary policy usually being the culprit. The Fed has established a relatively good track record over this expansion, and they have managed policy extremely well, so there is reason to have some faith in their ability to continue to do so.
I think that a bigger problem probably rests on the fiscal side; an expansionary fiscal policy at this point would be absolutely disastrous. So in my Fund career I find myself in a very unique position that, given the current stand-off between the Congress and the administration in the United States, this is probably one of the few times I have ever seen where a stalemate with respect to fiscal policy may be a good thing if it prevents a bad policy decision from being enacted.
MR. BERRY: We have got just a few minutes for some questions from the audience. If anybody has one there, keep it short, and we will keep the answer short, too. Sir?
QUESTION: Could anyone on the panel try to comment on the possible international dimension on the U.S. economy going into 2000?
MR. BERRY: The international dimension? What do you have in mind?
QUESTION: I mean we are part of the world economy, and although we are leading the world economy, we cannot neglect or ignore what is happening in the world, so there is always an international dimension that is part of the U.S. economy, negatively or positively. So far it seems to be turning more on the positive side.
MR. BAILEY: Yes, I mentioned in my remarks that I think it does look as if Europe and Asia are somewhat stronger, and the prognosis is somewhat better. I think that is good news for the United States. It will be good news for our exports and in helping reduce this imbalance of the large current account deficit.
Certainly there is a question that the U.S. has been the sort of locomotive of the world economy, and to the extent that the U.S. growth is going to moderate going forward, to the extent that we are going to reduce our absorption of foreign goods, I think it becomes an important ingredient in policy decisions around the world, that they do take the appropriate policy actions to make sure that they continue the strength that we are now seeing.
MR. BERRY: Other questions? Sir?
QUESTION: When we look at the price indices in August, one did notice that the producer price index is higher than consumer price index. If it is--it is the same with the core ones. On the other hand, the margin amount of interest rates on 1-year Treasury bills and 3 to 5 year interest rates is getting larger. The third thing is, I think capital inflows tends to be capital outflows to European markets and Japanese markets. Will these be very initial signals of the economic slowdown?
MR. BERRY: Bill?
MR. DUDLEY: I would say that, you know, if the U.S. does slow and foreign economies do pick up, I mean, one consequence of that will probably be some softening in the dollar strength that we have seen over the last few years, because the return on capital abroad will tend to increase, the return on capital in the U.S. will maybe, you know, stabilize or even decline a little bit. So I would guess that, you know, it would be a little bit harder at the margin for the U.S. to track foreign capital as we get this foreign economy recovery.
MR. BERRY: Okay. Anybody else?
MR. BERRY: All right. Let me thank you for coming, and thank the panelists for being here.
