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November 17, 1993 University of St. Thomas Remarks by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System The American economy is undergoing a major restructuring in the way we do business, that is, in the way we create wealth and augment standards of living. The advent of computer-based technologies has rendered obsolescent the heretofore productive activities of significant groups of our workers, most prominently those in middle management. Architectural drafting, for example, has been largely computerized and, more generally, major segments of clerical work have been stripped from business organizations. factory floor has not been immune. Clearly, the A generation ago, for example, steel rolling mills were run by seemingly vast numbers of operating personnel. Computer-based operations have eliminated many of their tasks and today, few hands-on people are visible. While the rate of change of new organizations and structures displacing older ones may be approaching its peak, the process almost surely will persist for some years to come. Announcements of companies downsizing their work forces are likely to continue at perhaps only a slightly lesser degree. While obviously painful to the workers whose jobs have been permanently excised, this restructuring process is surely elevating the long-term trend of American industry's productivity growth. Restructuring and increasing computerization of our economy is probably adding several tenths of a percent to our long-term annual growth rate. This would cumulate over the years as a significant addition to American standards of living. - 2 Associated with the massive restructuring, our economy is becoming increasingly dynamic. New firms, new products, new jobs, new industries, and new markets are continually being created, and they are unceremoniously displacing the old ones. The U.S. economy is a dynamic system, always renewing itself. It is extraordinary that the system overall is as stable as it is, considering the persistent process of change in its structure. Our habit of focusing on net changes in many of our economic statistics obscures the dynamics of the system. For example, the frequently cited figure of two million new jobs that have been created since the end of 1991, is a net change, which masks the many millions who found, lost, and changed jobs over the same period. Currently, people are being hired at a pace of approximately 400,000 per week, with job losses running modestly below that figure. Such vast churning in the nation's labor markets is a normal and ultimately a productive process. Central planning of the type that prevailed in postwar Eastern Europe and the Soviet Union represented one attempt to fashion an economic system that eliminated this competitive churning and its presumed wastefulness. But when that system eliminated the risk of failure, it also stifled the incentive to innovate and to prosper. Central planning fostered stasis: In many respects, the eastern-bloc economies marched in place for more than four decades. Indeed, we witnessed as close to a controlled experiment in alternative economic systems as is probably - 3 - possible in the decades following World War II. In the prewar period the economies of Eastern Europe had market economies similar to those in the West. In the postwar years the Iron Curtain limited interaction between East and West. When the Berlin Wall came down, the results of this inadvertent controlled experiment were unambiguous. Risk based capitalism has clearly proved to be a superior system to risk suppressed central planning. The most cogent way to understand why a centrally planned economic system, such as that which existed in the Soviet Union and its satellite economies, has great difficulty in creating wealth and rising standards of living is to examine how the production and distribution of goods and services takes place in such an economy. In theory, and to a large extent in practice, production and distribution are determined by specific instructions—often in the form of state orders—coming from the central planning agencies to the various different establishments, indicating from whom, and in what quantities, they should receive their goods and services, and to whom they should distribute their final outputs. The machinery factory is given a quota to produce a certain number of machines to be shipped at a certain time to industries x, y, and z. At the same time, it is given authority to procure from the relevant steel works so many tons of hot rolled sheet or cold finished bars, - 4 certain electronic components from the electrical works, etc. Its employment and wages are predetermined. But, although wages are paid in cash, the actual ability to employ cash for purchases is often constrained by the second element frequently found in a centrally planned economy, namely, rationing or its equivalent, standing in queues for limited quantities of goods. The consequences, as one might readily anticipate, are huge shortages of products that consumers desire, and are not produced in adequate supplies by the state orders, or huge surpluses of goods which, while produced, are not wanted by the populace. I do not suspect that shoe stores ended up with an excess of left-footed shoes, but I am not fully convinced. One might think that the planning authorities should be able to adjust to these distortions. They try. But centrally planned economies face fundamental handicaps in making such adjustments. They do not have access to the immediate signals of price changes that so effectively clear markets in capitalist countries. In addition, individual enterprises have no incentive to respond to shortages or oversupply since their only obligation is to fulfill their part of the "plan," while economic planners are generally insulated from the demands of consumers by totalitarian political systems. Finally, to adjust means to move resources, people, equipment, and factories from producing one good to producing another. This profoundly offends the - 5 underlying culture of a centrally planned economy, namely stability. The ideal state of affairs for such an economy is one in which there is continuous production of the same type of goods, of the same quality, of the same design, obediently purchased in repetitive quantities, with cash wages backed by rationing coupons. Innovation, new ideas, new products, and altered specifications cannot readily be accommodated in such an environment. Indeed, the extent to which such changes occurred in the centrally planned economies of Eastern Europe seemed invariably to result from the overseers of the state orders endeavoring to replicate changes in western market economies. One would presume, however, that had no such market-based economies existed side-by-side with the centrally planned ones, that few changes from the old ways of doing things would have been implemented. That these economies were highly inefficient is best illustrated by the fact that energy consumed per unit of output was as much as five to seven times higher in Eastern Europe and the former Soviet Union than in the West. Moreover the exceptionally large amount of resources devoted to capital investment, without contributing to the productive capacity of these economies, suggests that these resources were largely wasted. In addition, such gaps in efficiency actually understate the gap in performance because they fail to take into - 6 account the impact of industrial activity on the environment. The market economies of the West have expended resources to minimize the adverse impact of industrial activity on the environment and thereby lowered their net output. No such resource allocation was made in the Soviet bloc, and the cumulative effect of this neglect is appalling. Risk-taking is crucial to the process that leads to a vital and progressive economy. Indeed, it is a necessary condition for wealth creation. Every potential innovative advance carries the possibility of failure. In a market economy, competition and innovation interact; those firms that are slow to innovate or to anticipate the demands of the consumer are soon left behind. The pace of churning differs by industry, but it is present in all. At one extreme, firms in the most high-tech areas must remain constantly on the cutting edge, as products and knowledge become rapidly obsolete. Many products that were at technology's leading edge, say five years ago, are virtually unsalable in today's markets. can shift rapidly. In high-tech fields, leadership In some markets where American firms were losing share just a few years ago, we have regained considerable dominance. In one case, U.S. firms have seized a commanding lead in just two years in the new laptop computer market, and now account for more than 60 percent of U.S. sales last year, triple the figure for Japanese firms. More generally, it appears that the pace of dynamism has been accelerating. As one indication, the average economic - 7 life expectancy of new capital equipment has been falling. The average life of equipment purchased in 1982, for example, was 161/2 years. By 1992 that figure had declined to 14-1/2 years, a drop more than twice as large as that over the preceding decade. In addition, telecommunications technology is obviously quickening the decision-making process in both financial and product markets. We do not have the option of slowing this process down short of putting barriers around the United States and freezing the innovation that is engendering the world's highest standard of living. Change is unsettling to human beings, and the stress of the accelerating restructuring is clearly taking its toll. In endeavoring to assuage this distress, as we must, we need to be careful not to undermine the very dynamics that will spread prosperity to all of our citizens in the years ahead. While organization restructuring is, doubtless, impeding short-term growth as it improves longer-term economic potential, so is the balance-sheet restructuring, which has been so dominant a force in the pattern of economic activity during the last several years. For the first time in well over a half century, the American economy was confronted with a dramatic decline in the market value of commercial real estate several years ago. Moreover, the expected inflationary increases in the market value of homes has now largely dissipated. Much of the rise in real estate market values through a good part of the - 8 1980s was heavily leveraged with debt and, when market prices slowed or declined, balance sheets of both households and businesses became unduly strained. In an endeavor to restore a better balance in their accounts, both households and businesses began to divert significant amounts of their normal cash flow into the repayment of perceived excess debt burden. This inevitably slowed the pace of economic activity, a phenomenon that I dubbed several years ago, an economy endeavoring to advance against a fifty mile an hour head wind. There has been much progress in balance-sheet restructuring during these last several years and debt burdens have clearly eased. The heavy refinancing of home mortgage debt as interest rates declined has dramatically lowered mortgage interest payments as a percent of cash disposable income, although a shortening of the average maturity of new mortgages has kept principal amortization at a high level. New equity financing and increasing retained earnings coupled with slow net debt growth in the corporate sector has raised book net worth to liability ratios quite significantly in recent years. Moreover, the very heavy flotations of new bond and note issues has largely been for refinancings of high interest cost debt, and to fund short-term, especially bank, liabilities. The latter, incidently, is one of the major reasons why net loan demand has been so tepid. - 9 But while substantial progress has been made in reversing the balance-sheet strain of the late 1980s, there is obviously much more to come. First, the usual balance-sheet and debt burden ratios, which measure the extent of strain, have reversed only part of the increases that took place in the latter part of the 1980s. Moreover, owing to the financial trauma that followed in the wake of asset price adjustments, desired net worth to debt ratios are likely higher today than they were, say, five or ten years ago. More conservative financing is also apparent in the household sector and, therefore, balance-sheet repair may well carry further than is necessary merely to regain the relationships of the latter part of the 1980s. While balance-sheet repair is likely to continue for several years into the future, this does not mean that its grip on economic growth will not continue to ease. As I have indicated elsewhere, the fifty mile an hour head winds, which hobbled the rate of growth several years ago, have now come down to perhaps twenty or twenty-five miles an hour, to continue the metaphor. That is, less cash flow is being diverted for debt repayment, releasing resources for a quickened pace of growth over the past year or two. Nonetheless, we are likely to find the inhibiting elements of both financial and company restructuring with us for a significant period ahead. The obverse of balance-sheet strain on the part of households and businesses has been the, so-called, credit crunch in the banking sector, indeed among most, if not all, of our - 10 financial intermediaries. While the construction of commercial buildings is a relatively small part of gross domestic product, because such assets are long lived, they amount to a significant part of the collateral supporting loans in the banking system. This is especially the case for small and medium sized businesses whose major asset is their building. The fall in commercial real estate values several years ago, created a large increase in nonperforming loans and a significant strain to the lending capacity of commercial banks. In short, the banks were reluctant to lend as freely as in the past, but borrowers were not that anxious to borrow considering their debt burdens, with the consequence that loan growth and, indeed, net private debt growth has been the lowest in recent memory. More generally, the phenomenon of declining real asset prices and balance-sheet strain has become a global problem, with much the same forces effecting the economies of Japan, Australia, Scandinavia, Great Britain, and to a lesser extent, Canada. There was even some evidence that weakened asset values were beginning to effect continental Europe until the process was diverted by the financial consequences of unification of East and West Germany. In general, I would suspect that we in the United States are somewhat more advanced in the balance-sheet adjustment process than those of our trading partners. The trends of recent years exhibit a rather distinctly different business cycle recovery from those that we have experienced in the past. - 11 Nonetheless, we are clearly making headway and I trust we will continue to do so.
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