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For Release On Delivery
6:00 p.m. CDT (7:00 p.m. EDT)
October 15, 1992

"Our Remarkably Resilient Economy"
by
Edward W. Kelley, Jr.
Member
Board of Governors of the Federal Reserve System
Before
Government Bond Club of Houston

Houston, Texas
October 15, 1992

All observers can quickly agree that the United States’
economy is not as strong as we wish it were and is not behaving as
we would like to see it. This has been going on for some time.
The Gross Domestic Product has been in either a slow or negative
growth mode since 1988, when we had 3.3% growth. Consumption
expenditures are up only .8% in total from the peak second quarter
of 1990 through the second quarter of 1992. Employment peaked
in the second quarter of 1990 and has not regained that level.
Depending on when one starts counting, there have been thousands
of failures of financial institutions. By any standard, this has not
been a good era and has not been what we want.
But wait a minute. How bad is it, really? Have we had our
day and we are facing sunset in America? Some say we are in a
state of irreversible decline and that we have become a flabby
people who either cannot or will not work. Are we doomed to
become the listless and uncompetitive wards of more productive
states?

I think not. Given the events of the past five years or so, I
believe that in many respects our economy had turned in a
remarkable performance. It has demonstrated great resilience and
an underlying vitality that is enormously impressive and holds out
every possibility for an excellent future.
Let me hasten to say this is not a political statement. I am not
here to either blame or praise this donkey or that elephant. A look
at recent economic history offers an opportunity for some applause
and abundant blame to be assigned to everybody. Certainly, many
of the negative factors impacting the economy should not and need
not have occurred; and, there is ample evidence of poor policy and
overly partisan politics. But much that has happened occurred in
other lands, beyond our control, and much of what holds us back
today will have a positive impact in the future. These remarks are
intended to focus on the economy itself and not on policy or
politics.

Let’s go through a quick review of what our economy has
been through in the past half decade or so. Both internationally and
domestically this has been an historically turbulent time.
Easily the most significant event has been the demise of the
USSR. Without attempting to assess the full scope of this event,
here is a quick list of the major economic impacts to date. First,
the defense industry is a major part of our economy, and it has been
undergoing a radical downsizing and a shift in composition that is
a major economic drag. The end of the cold war opened the way
for the major disruption in the Middle East and our brief war with
Iraq. Overnight our economy was required to first buildup and then
standdown a very significant war machine. Also, this episode
caused a huge, if brief, oil shock that many economists feel was
more economically significant than the war itself. Lastly,
massive forces have been set in motion in Europe with the
emergence of the former Iron Curtain countries which, while full of
long term promise, have provided abundant short term problems.
These disruptions, especially in Germany, have been major factors

in the slowdown of the European economy which has adversely
impacted our volume of exports, a major source of economic
strength in recent years.
Domestically we have had an equally excruciating period. In
my view the most important single development has been the
deleveraging of America. Two years or so ago, our household and
corporate sectors decided they had accumulated too much debt and
reversed course. We stopped rapidly creating new debt, which had
been stimulating economic growth through the 1980’s, and began
deleveraging by reducing our debt level, which has had the opposite
effect of slowing economic activity. This process continues to have
an enormous impact. Concurrently, and also of vital importance,
we have been engaged in the process of corporate cost cutting and
restructuring. The causes of this effort have been many and the
long term effects will be very beneficial. However, in the short
term there have been massive job loses, which has had a direct
effect on employment and income and an equally important indirect
effect on confidence.

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Then there is the powerful real estate contraction. Con­
struction is a large industry and a key cyclical swing factor. The
current situation is the mother of all real estate downswings. Part
of this contraction’s impact has been it’s effect on the value of
homes, which are a crucial wealth component of the American
family. Home values went up consistently for years and that
process has now largely ceased, a fact which has become a major
contributor to consumer reluctance to spend.
The collapse of the commercial real estate market was a major
cause of the trauma in the banking system, which has undergone a
terrific implosion as thousands of institutions and hundreds of
billions of dollars of assets have been blown away. The many
causes of this have been endlessly discussed and need not be
repeated here. However, a healthy banking system is a key
foundation block for any economy and (by historic standards) our’s
was crippled. This event, had it occurred in an earlier age,
would have been sufficient by itself to cause a substantial economic
crash.

One other. Government policies allowed our fiscal deficit and
the national debt to explode through the boom years of the 1980’s.
The result has been that when a downturn came, deficit spending
was not available to help out when needed. That policy option has
been taken off the table, at least so far.
Have these not been tremendous shocks to our economy?
What should one expect to be the result? Can you imagine these
things having occurred without creating any serious slowdown?
There was no chance of that. This has not been your typical garden
variety cyclical recession. Far more than that has been going on.
So where, in fact, is the economy today?
Shortly, we will have the data on third quarter Real Gross
Domestic Product which almost certainly crossed over into new high
ground in the period. If so, we are no longer in "recovery" but
now must technically call this an "expansion". Employment is
down only 1.5% from its peak in the second quarter of 1990. On
a purchasing power parity basis our per capita Gross Domestic
Product is the highest in the world. And our banking system, while

battered, is in place serving our society and earning record profits.
All of this is certainly not great economic performance, and a great
deal of pain has been inflicted upon many people, but it is far from
doomsday.
Nevertheless, you may argue that the situation is largely
unnecessary, totally unsatisfactory, and intolerable. Granted. I
agree. My point is that these things happened. They are historical
fact and in the face of them our economy, in my view, is displaying
an amazing resiliency, flexibility and underlying strength. I doubt
that there has been another society in history, or is existent in
today’s world, that could have been through what we have been
through and be performing as well as our economy is today.
How has monetary policy fit into this episode? Policy is
formulated from a mix of many factors, but two concepts are at its
heart. The first is our long term national economic goal, which is
to create maximum sustainable economic growth over time. As
an element of the national policy machinery, the Federal Reserve
strives to support this goal. Second is the concept of what

monetary policy can and cannot do. Most economists, probably not
all, agree that monetary policy can affect real activity in the short
run but cannot directly do so in the long run. In the long run,
monetary policy affects the price level which does, of course, have
a very important indirect effect on real economic activity.
These are the key components of policy development. Price
level stability is a necessary precondition to sustainable long-term
growth and the Fed is in a unique position, and has a unique
responsibility, to foster stable prices. This is the main contribution
it can make to the national economic goal and the members of the
FOMC are determined to meet that responsibility. If the Fed fails
in this, there is no other institutional way to hold inflation in check
and thereby meet this precondition for long-term sustainable
economic growth.
But policymakers also cannot be indifferent to the short-run
consequences of their actions. Since June 1989, when it became
apparent to the FOMC that the economy was weakening, the Fed
has eased well over twenty times. Fed funds have fallen from just

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under 10% to around 3%, a drop of 70%. This has been in
response to a weakening economy and an effort to keep policy
supportive of economic activity.
Given, first, the set of economic conditions just described;
second, the Fed’s important but limited capabilities; and, third, the
Fed’s assigned mission in our structure of government, should a
different monetary policy path have been followed? Those who
have been focused on short-term employment growth say "yes" —
easing has been too little and too late. The financial markets, by
creating an historically steep yield curve, suggest we have gone
too far, too fast. It is impossible to reach a definitive resolution of
what constitutes perfect policy and I would not claim that it has
necessarily been perfect. I will say, however, that I am comfortable
that the Fed has performed well and responsibly.
Consider a few quick points. Long-term interest rates are
critically important and are set by the market, not by the Fed.
They have been very sticky, in large part due to bond market
skepticism as to the Fed’s determination to hold the line on
inflation. It could be counterproductive to ease short rates if that

were to trigger market nervousness which forced long rates to rise.
Second, monetary policy change impacts the economy with a lag,
and then over a rather extended period of time. The frequent small
easings have kept an important stimulus consistently in the economic
pipeline, somewhat like an "IV" does for a patient following
surgery. Third, many have remarked that the monetary aggregates
M2 and M3 have grown very slowly. It is clear that the function
of money in our economy has been changing, that this phenomenon
is not fully understood, and its longer-term effect is an open
question. However, it is also clear from other measures of money
that there is plenty of liquidity available to support the economy
now and, indeed, this degree of liquidity has been itself a source of
concern for some. Last but not least, inflation is now falling
steadily but its reemergence two or three years down the road must
be prevented.
What does all this imply for the future? Certainly we have
pressing national problems that must be addressed. The deficit. A
decaying infrastructure. Health care. The education system. Job

creation. However, consider the emerging strengths. Capitalism
has triumphed over Communism and the cold war is over. Incal­
culable positive results will flow from this momentous event.
Domestically our economy is adding muscle materially day-by-day.
Our balance sheets are strengthening, our productivity and
competitiveness are improving, our financial system is regaining it’s
health and, inflation is coming under control.
Are all things exactly as we would like them to be? No. Are
we in a long-term decline? No, and it is not necessary that we fall
into one. Are we in depression? No, far from it. Are we
displaying some basic strengths? Yes, remarkable strengths. Is
there good reason to feel positive about the future? You bet!