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For release on delivery
4 00 p m PDT (7 00 p m EDT)
September 4, 1998

Remarks by
Alan Greenspan
Chairman
Board of Governors of the Federal Reserve System
at the
Haas Annual Business Faculty Research Dialogue
University of California, Berkeley
September 4,1998

Question: Is There a New Economy?

The question posed for this lecture of whether there is a new economy reaches beyond the
obvious Our economy, of course, is changing everyday, and in that sense it is always "new "
The deeper question is whether there has been a profound and fundamental alteration in the way
our economy works that creates discontinuity from the past and promises a significantly higher
path of growth than we have experienced in recent decades
The question has arisen because the economic performance of the United States in the
past five years has in certain respects been unprecedented Contrary to conventional wisdom and
the detailed historic economic modeling on which it is based, it is most unusual for inflation to
be falling this far into a business expansion
Many of the imbalances observed during the few times in the past that a business
expansion has lasted more than seven years are largely absent today To be sure, labor markets
are unusually tight, and we should remain concerned that pressures in these markets could spill
over to costs and prices But, to date, they have not
Moreover, it is just not credible that the United States can remain an oasis of prosperity
unaffected by a world that is experiencing greatly increased stress Developments overseas have
contributed to holding down prices and aggregate demand in the United States in the face of
strong domestic spending As dislocations abroad mount, feeding back on our financial markets,
restraint is likely to intensify In the spring and early summer, the Federal Open Market
Committee was concerned that a rise in inflation was the primary threat to the continued
expansion of the economy By the time of the Committee's August meeting, the risks had

-2become balanced, and the Committee will need to consider carefully the potential ramifications
of ongoing developments since that meeting
Some of those who advocate a "new economy" attribute it generally to technological
innovations and breakthroughs in globalization that raise productivity and proffer new capacity
on demand and that have, accordingly, removed pricing power from the world's producers on a
more lasting basis
There is, clearly, an element of truth in this proposition In the United States, for
example, a technologically driven decline is evident in the average lead times on the purchase of
new capital equipment that has kept capacity utilization at moderate levels and virtually
eliminated most of the goods shortages and bottlenecks that were prevalent in earlier penods of
sustained strong economic growth
But, although there doubtless have been profound changes in the way we organize our
capital facilities, engage in just-in-time inventory regimes, and intertwine our newly
sophisticated risk-sensitive financial system into this process, there is one important caveat to the
notion that we live in a new economy, and that is human psychology
The same enthusiasms and fears that gripped our forebears, are, in every way, visible in
the generations now actively participating in the American economy Human actions are always
rooted in a forecast of the consequences of those actions When the future becomes sufficiently
clouded, people eschew actions and disengage from previous commitments To be sure, the
degree of risk aversion differs from person to person, but judging the way prices behave in
today's markets compared with those of a century or more ago, one is hard pressed to find
significant differences The way we evaluate assets, and the way changes in those values affect

-3our economy, do not appear to be coming out of a set of rules that is different from the one that
governed the actions of our forebears
Hence, as the first cut at the question "Is there a new economy?" the answer in a more
profound sense is no As in the past, our advanced economy is primarily driven by how human
psychology molds the value system that dnves a competitive market economy And that process
is inextricably linked to human nature, which appears essentially immutable and, thus, anchors
the future to the past
But having said that, important technological changes have been emerging in recent years
that are altering, in ways with few precedents, the manner in which we organize production, trade
across countries, and deliver value to consumers
To explore the significance of those changes and their relevance to the possibility of a
"new economy," we need to first detail some key features of our system
The American economy, like all advanced capitalist economies, is continually in the
process of what Joseph Schumpeter, a number of decades ago, called "creative destruction "
Capital equipment, production processes, financial and labor market infrastructure, and the whole
panoply of private institutions that make up a market economy are always in a state of flux—in
almost all cases evolving into more efficient regimes
The capital stock--the plant and equipment that facilitates our production of goods and
services—can be viewed, with only a little exaggeration, as continuously being torn down and
rebuilt
Our capital stock and the level of skills of our workforce are effectively being upgraded
as competition presses business managements to find increasingly innovative and efficient ways

-4to meet the ever-nsing demands of consumers for quantity, quality, and vanety Supply and
demand have been interacting over the generations in a competitive environment to propel
standards of living higher Indeed, this is the process that, in fits and starts, has characterized our
and other market economies since the beginning of the Industrial Revolution Earlier, standards
of living barely changed from one generation to the next
This is the tautological sense in which every evolving market economy, our own
included, is always, in some sense, "new," as we struggle to increase standards of living.
In the early part of the 19th century, the United States, as a developing country, borrowed
much technology and savings from Europe to get a toehold on the growth ladder But over the
past century, America has moved to the cutting edge of technology.
There is no question that events are continually altering the shape and nature of our
economic processes, especially the extent to which technological breakthroughs have advanced
and perhaps, most recently, even accelerated the pace of conceptualization of our gross domestic
product We have dramatically reduced the size of our radios, for example, by substituting
transistors for vacuum tubes Thin fiber-optic cable has replaced huge tonnages of copper wire
New architectural, engineering, and materials technologies have enabled the construction of
buildings enclosing the same space but with far less physical material than was required, say, 50
or 100 years ago Most recently, mobile phones have been markedly downsized as they have
been improved As a consequence, the physical weight of our GDP is growing only very
gradually The exploitation of new concepts accounts for virtually all of the inflation-adjusted
growth in output

-5The cause of this dramatic shift toward product downsizing during the past half century
can only be surmised Perhaps the physical limitations of accumulating goods and moving them
in an ever more crowded geographical environment resulted in cost pressures to economize on
size and space Similarly, perhaps it was the prospect of increasing costs of processing ever
larger quantities of physical resources that shifted producers toward downsized alternatives
Remember, it was less than three decades ago that the Club of Rome issued its dire warnings
about the prospects of running out of the physical resources that allegedly were necessary to
support our standards of living Finally, as we moved the technological frontier forward and
pressed for information processing to speed up, for example, the laws of physics required the
relevant microchips to become ever more compact
But what was always true in the past, and will remain so in the future, is that the output of
a free market economy and the notion of wealth creation will reflect the value preferences of
people Indeed, the very concept of wealth has no meaning other than as a reflection of human
value preferences There is no intrinsic value in wheat, a machine, or a software program It is
only as these products satisfy human needs currently, or are perceived to be able do so in the
future, that they are valued And it is such value preferences, as they express themselves in the
market's key signals—product and asset prices—that inform producers of what is considered
valuable and, together with the state of technology, what could be profitably produced
To get back to basics, the value of any physical production facility depends on the
perceived value of the goods and services that the facility is projected to produce More
formally, the current value of the facility can be viewed as the sum of the discounted value of all
future outputs, net of costs

-6An identical physical facility with the same capacity to produce can have different values
in the marketplace at different times, depending on the degree to which the investing public feels
confident about the ability of the firm to perceive and respond to the future environments in
which the plant will be turning out goods and services The value of a steel mill, which has an
unchanging ability to turn out sheet steel, for example, can vary widely in the marketplace
depending on the level of interest rates, the overall rate of inflation, and a number of other factors
that have nothing to do with the engineering aspects of the production of steel What matters is
how investors view the markets into which the steel from the mill is expected to be sold over the
years ahead When that degree of confidence in judging the future is high, discounted future
values also are high~and so are the pnces of equities, which, of course, are the claims on our
productive assets
The forces that shape the degree of confidence are largely endogenous to an economic
process that is generally self-correcting as consumers and investors interact with a continually
changing market reality I do not claim that all market behavior is a rational response to changes
in the real world But most of it must be For, were it otherwise, the relatively stable economic
environments that have been evident among the major industnal countries over the generations
would not be possible
Certainly, the degree of confidence that future outcomes are perceivable and projectable,
and hence valued, depends in large part on the underlying political stability of any country with a
market-oriented economy Unless market participants are assured that their future commitments
and contracts are protected by a rule of law, such commitments will not be made, productive

-7efforts will be focused to address only the immediate short-term imperatives of survival, and
efforts to build an infrastructure to provide for future needs will be stunted
A society that protects claims to long-lived productive assets thereby surely encourages
their development That spurs levels of production to go beyond the needs of the moment, the
needs of immediate consumption, because claims on future production values will be discounted
far less than in an environment of political instability and, for example, a weak law of contracts
At that point, the makings of a sophisticated economy based on longer-term commitments are in
place It will be an economy that saves and invests-that is, commits to the future-and, hence,
one that will grow
But every competitive market economy, even one solidly based on a rule of law, is
always in a state of flux, and its perceived productiveness is always subject to degrees of
uncertainty that are inevitably associated with endeavors to anticipate future outcomes
Thus, while the general state of confidence and consumers' and investors' willingness to
commit to long-term investment is buttressed by the perceptions of the stability of the society
and economy, history demonstrates that that degree of confidence is subject to wide vanations
Most of those vanations are the result of the sheer difficulty in making judgments and, therefore,
commitments about, and to, the future On occasion, this very difficulty leads to less-disciplined
evaluations, which foster pnce volatility and, in some cases, what we term market bubbles~that
is, asset values inflated more on the expectation that others will pay higher pnces than on a
knowledgeable judgment of true value
The behavior of market economies across the globe in recent years, especially in Asia and
the United States, has underscored how large a role expectations have come to play in real

-8economic development Economists use the term "time preference" to identify the broader
tradeoff that individuals are willing to make, even without concern for risk, between current
consumption and claims to future consumption Measurable discount factors are intended to
capture in addition the various types of uncertainties that inevitably cloud the future
Dramatic changes in the latter underscore how human evaluation, interacting with the
more palpable changes in real output, can have profound effects on an economy, as the
experiences in Asia have so amply demonstrated during the past year
Vicious cycles have arisen across Southeast Asia with virtually no notice. At one point,
an economy would appear to be struggling, but no more than had been the case many times in the
past The next moment, market prices and the economy appeared in free fall
Our experiences with these vicious cycles in Asia emphasize the key role in a market
economy of a critical human attribute confidence or trust in the functioning of a market system
Implicitly, we engage in a division of labor because we trust that others will produce and be
willing to trade the goods and services we do not produce ourselves
We Lake for granted that contracts will be fulfilled in the normal course of business,
relying on the rule of law, especially the law of contracts But if trust evaporated and every
contract had to be adjudicated, the division of labor would collapse A key characteristic,
perhaps the fundamental cause of a vicious cycle, is the loss of trust
We did not foresee such a breakdown in Asia I suspect that the very nature of the
process may make it virtually impossible to anticipate. It is like water pressing against a dam
Everything appears normal until a crack brings a deluge

-9The immediate cause of the breakdown was an evident pulling back from future
commitments, arguably, the result of the emergence among international lenders of widening
doubt that the dramatic growth evident among the Asian "tigers" could be sustained The
emergence of excess worldwide capacity in semiconductors, a valued export for the tigers, may
have been among the precipitating events. In any case, the initial rise in market uncertainty jed
to a sharp rise in discounts on future claims to income and, accordingly, falling pnces of real
estate and equities. The process became self-feeding as disengagement from future commitments
led to still greater disruption and uncertainty, nsing risk premiums and discount factors, and a
sharp fall in production.
While the reverse phenomenon, a virtuous cycle, is not fully symmetrical, some part is
Indeed, much of the current American economic expansion is best understood in the context of
favorable expectations, interacting with production and finance to expand rather than implode
economic processes
The American economic stability of the past five years has helped engender increasing
confidence of future stability This, in turn, has dramatically upgraded the stock market's
valuation of our economy's existing productive infrastructure, adding about $6 trillion of capital
gains to household net worth from early 1995 through the second quarter of this year
While the vast majority of these gains augmented retirement and other savings programs,
enough spilled over into consumer spending to significantly lower the proportion of household
income that consumers, especially upper income consumers, believed it necessary to save
In addition, the longer the elevated level of stock pnces was sustained, the more
consumers likely viewed their capital gains as permanent increments to their net worth, and,

-10hence, 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 dunng 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

-11college 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

-12Thus, 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

-13Company after company reports that, when confronted with cost increases in a competitive
environment that precludes pnce increases, they are able to offset those costs, seemingly at will,
by installing the newer technologies
Such stones 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 nsing 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, secunty 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 nse is How far can
risk and equity premiums fall? A key factor is that pnce 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

-14fall 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

-15Perhaps, 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 shortlived 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

-16over 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 consumeis particularly value A
machining facility that turns out an infenor 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

-17hobbled 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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