Remarks by Chairman Alan Greenspan Before the Economic Club of New York
December 19, 2002
Issues for Monetary Policy
Although the gold standard could hardly be portrayed as having produced aperiod of price tranquility, it was the case that the price level in 1929 was notmuch different, on net, from what it had been in 1800. But, in the two decadesfollowing the abandonment of the gold standard in 1933, the consumer priceindex in the United States nearly doubled. And, in the four decades after that,prices quintupled. Monetary policy, unleashed from the constraint of domesticgold convertibility, had allowed a persistent overissuance of money. Asrecently as a decade ago, central bankers, having witnessed more than ahalf-century of chronic inflation, appeared to confirm that a fiat currency wasinherently subject to excess.
But the adverse consequences of excessive money growth for financial stabilityand economic performance provoked a backlash. Central banks were finallypressed to rein in overissuance of money even at the cost of considerabletemporary economic disruption. By 1979, the need for drastic measures hadbecome painfully evident in the United States. The Federal Reserve, under theleadership of Paul Volcker and with the support of both the Carter and theReagan Administrations, dramatically slowed the growth of money. Initially, theeconomy fell into recession and inflation receded. However, most important,when activity staged a vigorous recovery, the progress made in reducinginflation was largely preserved. By the end of the 1980s, the inflation climatewas being altered dramatically.
The record of the past twenty years appears to underscore the observationthat, although pressures for excess issuance of fiat money are chronic, aprudent monetary policy maintained over a protracted period can contain theforces of inflation. With the story of most major economies in the postwarperiod being the emergence of, and then battle against inflation, concerns aboutdeflation, one of the banes of an earlier century, seldom surfaced. The recentexperience of Japan has certainly refocused attention on the possibility that anunanticipated fall in the general price level would convert the otherwiserelatively manageable level of nominal debt held by households and businessesinto a corrosive rising level of real debt and real debt service costs. It nowappears that we have learned that deflation, as well as inflation, are in the longrun monetary phenomena, to extend Milton Friedman's famous dictum.
To be sure, in the short to medium run, many forces are at play that complicatethe link between money and prices. The widening globalization of marketeconomies in recent years, for example, is integrating a growing share ofpreviously local capacity into an operationally meaningful world total. Thatprocess has, at least for a time, brought substantial new supplies of goods andservices to global markets. In addition, the more rapid rate of technologicalinnovation, so evident in the United States, has boosted the pace at which ourproductive potential is expanding. These shifts in aggregate supply--whetherforeign or domestic in origin--influence the relationship between money andprices. Moreover, the tie between money and prices can be altered bydysfunctional financial intermediation, as we have witnessed in Japan. Thus,recent experience understandably has stimulated policymakers worldwide torefocus on deflation and its consequences, decades after dismissing it as apossibility so remote that it no longer warranted serious attention.
The meaning of deflation and the characteristics that differentiate it from themore usual experience of inflation are subjects being actively studied inside andoutside of central banks. As I testified before the Congress last month, theUnited States is nowhere close to sliding into a pernicious deflation. Moreover,a major objective of the recent heightened level of scrutiny is to ensure that anylatent deflationary pressures are appropriately addressed well before theybecame a problem.
* * * * *
Central bankers have long believed that price stability is conducive to achievingmaximum sustainable growth. Historically, debilitating risk premiums havetended to rise with both expected inflation and deflation, and they have beenminimized during conditions of approximate price stability.
Although the U.S. economy has largely escaped any deflation since World WarII, there are some well-founded reasons to presume that deflation is more of athreat to economic growth than is inflation. For one, the lower bound onnominal interest rates at zero threatens ever-rising real rates if deflationintensifies. A related consequence is that even if debtors are able to refinanceloans at zero nominal interest rates, they may still face high and rising real ratesthat cause their balance sheets to deteriorate.
Another concern about deflation resides in labor markets. Some studies havesuggested that nominal wages do not easily adjust downward. If lower priceinflation is accompanied by lower average wage inflation, then the prevalenceof nominal wages being constrained from falling could increase as priceinflation moves toward or below zero. In these circumstances, the effectiveclearing of labor markets would be inhibited, with the consequence beinghigher rates of unemployment.
Taken together, these considerations suggest that deflation could well be moredamaging than inflation to economic growth. While this asymmetry should notbe overlooked, several factors limit its significance. In particular, more rapidadvances in productivity can make this asymmetry less severe. Fast growth ofproductivity, by buoying expectations of future advances of wages andearnings and thus aggregate demand, enables real interest rates to be higherthan would otherwise be the case without restricting economic growth.Moreover, to the extent that more-rapid growth of productivity shows throughto faster gains in nominal wages, there will be fewer instances in which nominalwages will be pressured to fall.
One also should not overstate the difficulties posed for monetary policy by thezero bound on interest rates and nominal wage inflexibility even in the absenceof faster productivity growth. The expansion of the monetary base canproceed even if overnight rates are driven to their zero lower bound. TheFederal Reserve has authority to purchase Treasury securities of any maturityand indeed already purchases such securities as part of its procedures to keepthe overnight rate at its desired level. This authority could be used to lowerinterest rates at longer maturities. Such actions have precedent: Between 1942and 1951, the Federal Reserve put a ceiling on longer-term Treasury yields at2-1/2 percent. With respect to potential difficulties in labor markets, resultsfrom research remain ambiguous on the extent and persistence of downwardrigidity in nominal compensation.
Clearly, it would be desirable to avoid deflation. But if deflation were todevelop, options for an aggressive monetary policy response are available.
* * * * *
Fortunately, the ability of our economy to weather the many shocks inflicted onit since the spring of 2000 attests to our market system's remarkable resilience.That characteristic is far more evident today than two or three decades ago.There may be numerous causes of this increased resilience.1 Among them,ongoing efforts to liberalize global trade have added flexibility to many aspectsof our economy over time. Furthermore, a quarter-century of bipartisanderegulation has significantly reduced inflexibilities in our markets for energy,transportation, communication, and financial services. And, of course, thedramatic gains in information technology have markedly improved the ability ofbusinesses to address festering economic imbalances before they inflictsignificant damage. This improved ability has been further facilitated by theincreasing willingness of our workers to embrace innovation more generally.Irrespective of how deflationary forces might influence it, our economy has thebenefit of enhanced flexibility, which has, at least to date, allowed us towithstand the potentially destabilizing effects of some substantial negativeshocks.
* * * * *
Certainly, lurking in the background of any evaluation of deflation risks is theconcern that those forces could be unleashed by a bursting bubble in assetprices. This connection, real or speculative, raises some interesting questionsabout the most effective approach to the conduct of monetary policy. If thebursting of an asset bubble creates economic dislocation, then preventingbubbles might seem an attractive goal. But whether incipient bubbles can bedetected in real time and whether, once detected, they can be defused withoutinadvertently precipitating still greater adverse consequences for the economyremain in doubt.
It may be useful, as a first step, to consider both the economic circumstancesmost likely to impede the development of bubbles and the circumstances mostconducive to their formation. Destabilizing macroeconomic policies and pooreconomic performance are not likely to provide fertile ground for the optimismthat usually accompanies surging asset prices.
Ironically, low inflation, economic stability, and low risk premiums mayprovide tinder for asset price speculation that could be sparked shouldtechnological innovations open up new opportunities for profitable investment.Even in such circumstances, bubble pricing is likely to be inhibited for acompany with a history. To be sure, the stock prices of old-line companies dorise somewhat through arbitrage when the market as a whole is propelled higherby stock prices of cutting-edge technologies. But it is difficult to imagine stockprices of most well-established and seasoned old-line companies surging towholly unsustainable heights. With some prominent exceptions, theircapabilities for future profits have been largely tested and delimited.
The situation is likely different in the case of a new company that employs aninnovative technology. Under these circumstances, the dispersion of rationallyimagined possible future outcomes could be wide. If forecasts are unfetteredby a need for consistency with the past, investors might take off onunwarranted flights of optimism. Moreover, skeptics find it too expensive ortoo risky to short sell the shares of such a company, especially when its stockprice is rising rapidly.
The conditions of extended low inflation and low risk were combined withbreakthrough technologies to produce the bubble of recent years. But do suchconditions always produce a bubble? It seems improbable that a surge ininnovation in the near future would generate a new bubble of substantialproportions. Investors are likely to be sensitive to the need for asset prices tobe backed ultimately by an ongoing stream of earnings. Hence, a furthernecessary condition for the emergence of a bubble is the passage of sufficienttime to erode the traumatic memories of earlier post-bubble experiences.
* * * * *
Most standard macroeconomic models fitted to the experience of recentdecades imply that a distortion in valuation ratios induced by a bubble can beoffset by adopting a sufficiently restrictive monetary policy. According to suchmodels, a tighter monetary policy, on average, credibly constrains demand andlowers asset prices, all else being equal. These models can also be interpretedto suggest that incremental monetary tightening can gradually deflate stockprices. But that conclusion is a consequence of the model's construction. It isnot based on evidence drawn from history. In fact, history indicates thatbubbles tend to deflate not gradually and linearly but suddenly, unpredictably,and often violently. In addition, the degree of monetary tightening that would berequired to contain or offset a bubble of any substantial dimension appears tobe so great as to risk an unacceptable amount of collateral damage to the widereconomy.
The evidence of recent years, as well as the events of the late 1920s, castsdoubt on the proposition that bubbles can be defused gradually. As I relatedthis summer at the annual Jackson Hole symposium sponsored by the KansasCity Federal Reserve Bank, "...our experience over the past fifteen yearssuggests that monetary tightening that deflates stock prices without depressingeconomic activity has often been associated with subsequent increases in thelevel of stock prices....Such data suggest that nothing short of a sharp increasein short-term rates that engenders a significant economic retrenchment issufficient to check a nascent bubble. The notion that a well-timed incrementaltightening could have been calibrated to prevent the late 1990s bubble is almostsurely illusion."2
In short, unless a model can be specified to capture the apparent markettendency toward bidding stock prices higher in response to monetary policiesaimed at maintaining macroeconomic stability, the accompanying forecasts willbelie recent experience. Faced with this uncertainty, the Federal Reserve hasfocused on policies that would, as I testified before the Congress in 1999,"...mitigate the fallout [of an asset bubble] when it occurs and, hopefully, easethe transition to the next expansion."3 The Federal Open Market Committeechose, as you know, to embark on an aggressive course of monetary easingtwo years ago once it became apparent that a variety of forces, includingimportantly the slump in household wealth that resulted from the decline instock prices, were restraining inflation pressures and economic activity.
It is too soon to judge the final outcome of the strategy that we adopted. Thecontractionary impulse from the decline in equity prices appeared to bediminishing around the middle of this year. But then the fallout for stock pricesfrom corporate governance malfeasance, argued by some as having beenspawned by the bubble, became more intense. This, in turn, damped capitalinvestment and trimmed inventory plans. More recently, of course, geopoliticalrisk has risen markedly, further weighing on demand. Though unrelated to thebubble burst of 2000, it has muddied the evaluation of the post-bubbleeconomy.
If the postmortem of recent monetary policy shows that the results ofaddressing the bubble only after it bursts are unsatisfactory, we would be leftwith less-appealing choices for the future. In that case, finding ways to identifybubbles and to contain their progress would be desirable, though historycautions that prospects for success appear slim.
The difficulties that policymakers and private agents face become especiallyacute as an economic expansion lengthens. The decline in risk premiums underthese circumstances presumably results, in part, from rational appraisals. In aneconomy in which the business cycle has averaged four years in length over aprotracted period, households and businesses would doubtless become morecautious in the fourth year of a new cycle. But how do they behave when, asfor the past two decades, expansions have been long and cyclical downturnshave been exceptionally rare? After five or six years of uninterruptedexpansion, is it irrational or even unreasonable to assume that expansion wouldcontinue for the subsequent six months? Thus, it was disturbing to observerisk seemingly being priced so cheaply in late 1997 when BBB corporatespreads over ten-year Treasuries sunk to only 70 basis points. That spread isnow about 250 basis points, although it has narrowed significantly in recentweeks.
* * * * *
Weaving a monetary policy path through the thickets of bubbles and deflationsand their possible aftermath is not something with which modern centralbankers have had much experience.
As I noted earlier, it seems ironic that a monetary policy that is successful ininducing stability may inadvertently be sowing the seeds of instabilityassociated with asset bubbles. I trust that the use by the central bank ofdeliberately inflationary policy as protection against bubbles can be readilydismissed. While the current episode has not yet concluded, it appears that,responding vigorously in a relatively flexible economy to the aftermath ofbubbles, as traumatic as that may be, is less inhibiting to long-term growth thanchronic high-inflation monetary policy. Moderate inflation might possiblyinhibit bubbles, though at some cost of reduced economic efficiency.However, I doubt that such policies could be sustained or well-controlled bycentral banks. Among our realistically limited alternatives, dealing aggressivelywith the aftermath of a bubble appears the most likely to avert long-termdamage to the economy.4
Regardless of history's verdict on a policy that addresses only the aftermath ofbubbles, we still need to improve our understanding of the dynamics ofbubbles and deflation to contain the latter, if not the former.
* * * * *
Before closing this evening, I would like to take a few minutes to addressrecent economic developments.
As I pointed out earlier, the U.S. economy exhibited considerable resilience toa series of post-boom shocks. The list is rather impressive: First, a halving ofstock prices and household equity wealth; second, a dramatic decline in capitalexpenditures; third, the tragic events of September 11; fourth, the disturbingevidence of corporate malfeasance; and fifth, the recent escalation ofgeopolitical risks. I would scarcely state that our economy was not shaken bythese series of shocks, one on top of the other. But after we experienced a mildrecession, real GDP grew in excess of 3 percent over the year ending in thethird quarter.
The recovery, however, ran into resistance in the summer, apparently as aconsequence of a renewed weakening in equity prices, further revelations ofcorporate malfeasance, and then the heightened geopolitical risks. Concern onour part led the Federal Open Market Committee to reduce its targeted federalfunds rate 50 basis points at our early November meeting as some insuranceagainst the possibility that the weakening would gain some footing. Althoughour most probable forecast already was that growth would pick up, we judgedthe cost of the insurance provided by additional easing as exceptionally modestbecause we viewed the risk of an imminent rise in inflation as remote.
The limited evidence since the November easing has supported our view thatthe U.S. economy has been working its way through a soft patch. And thepatch has certainly been soft. The labor market has remained subdued, asbusinesses apparently have been reluctant to add to payrolls. Themanufacturing sector remains especially damped, and nonresidentialconstruction has trended lower. By all reports, state and local governmentscontinue to struggle with deterioration in their fiscal conditions. Oil prices haverecently risen and, not least, the economies of most of our major tradingpartners have shown little vigor.
Still, low interest rates and rapid advances in productivity have been providingconsiderable support to economic activity. Those influences have been mostevident on consumer spending and new home sales, which have beenremarkably firm this year. Motor vehicle sales have been supported by lowfinancing costs, by high levels of customer incentives, and by high rates ofvehicle scrappage and multiple car ownership. More broadly, strong growth oflabor productivity, supplemented by reduced tax payments, has provided aboost both to incomes and to spending. Meanwhile, new home sales have beenbuoyed by low mortgage interest rates as well as favorable demographics.
Cash borrowed in the process of mortgage refinancing, an important supportfor consumer outlays this past year, is bound to contract at some point, asaverage interest rates on households' total mortgage portfolio converges tointerest rates on new mortgages. However, applications for refinancing, whileoff their peaks, remain high. Moreover, simply processing the backlog ofearlier applications will take some time, and this factor alone suggestscontinued significant refinancing originations and cash-outs into the earlymonths of 2003.
Corporate risk-taking underwent pronounced retrenchment following thetraumatic disclosures of corporate malfeasance this summer. Capitalappropriations slowed noticeably across a broad spectrum of Americanindustries. Aggressive accounting practices seemingly disappeared virtuallyovernight. I would not be surprised if further disclosures of questionablepractices were to surface in the months ahead, but I would be quite surprised ifsuch practices were introduced after mid-2002.
Since early October, conditions in financial markets have turned less adverse.Stock prices have, on net, moved up, and corporate yield spreads, especiallyfor below-investment-grade debt instruments, have narrowed significantly.Those spreads, nevertheless, remain quite elevated relative to their readings ofearly 2000. Credit derivative default swaps have improved recently in line withyield spreads. The overall cost of business capital has clearly declined,inducing in recent weeks increased issuance of bonds of all grades and haltingthe runoff of commercial paper and business bank loans.
The recent increase in the expansion of business credit may hint at somestirring in capital investment, but it is simply too early to tell. There is evidencethat some corporate managers are beginning to tentatively venture out on therisk scale. New orders for capital goods equipment and software, after fallingsharply over the preceding two years, have stabilized and in some cases turnedup in nominal terms this year--an improvement, to be sure, but not necessarilythe beginnings of a vigorous recovery.
In the end, capital investment will be most dependent on the outlook for profitsand the resolution of the uncertainties surrounding the business outlook and thegeopolitical situation. These considerations at present impose a ratherformidable barrier to new investment. Profit margins have been running a littlehigher this year than last, aided importantly by strong growth in laborproductivity. But a lack of pricing power remains evident for mostcorporations. A more vigorous and broad-based pickup in capital spendingwill almost surely require further gains in corporate profits and cash flows.
A full enumeration of the caveats surrounding the economic outlook would, asusual, be lengthy. But often-cited concerns about the levels of debt anddebt-servicing costs of households and firms appear a bit stretched. Thecombination of household mortgage and consumer debt as a share ofdisposable income has moved up to a historically high level. But the upwardtrend in the series reflects, in part, financial innovations that have increasedaccess to credit markets for many households. These innovations include thedevelopment of a deep secondary market for home mortgages, along with theadvent of credit scoring and automated underwriting models that haveenhanced the ability of loan officers and credit card companies to identifygood credit risks. These innovations lower the risk level of any given amountof debt.
To be sure, the mortgage debt of homeowners relative to their income is highby historical norms. But, as a consequence of low interest rates, the servicingrequirement for that debt relative to homeowners' income is roughly in line withthe historical average. Moreover, owing to continued large gains in residentialreal estate values, equity in homes has continued to rise despite very largedebt-financed extractions. Adding in the fixed costs associated with otherfinancial obligations, such as rental payments of tenants, consumer installmentcredit, and auto leases, the total servicing costs faced by households relative totheir income appears somewhat elevated compared with longer-run averages.But arguably they are not a significant cause for concern.
Some strain from corporate debt burdens became evident as rates of return oncapital projects financed with debt fell short of expectations over the pastseveral years. While overall debt has not been paid down, corporations havesignificantly increased holdings of cash and have reduced their near-term debtobligations by issuing bonds to pay down commercial paper and bank loans.
* * * * *
In early 2000, as financial imbalances and increased risk brought the surge incapital investment to an end, significant profitable opportunities remained to beexploited. One must presume that they still exist and may well have beenenlarged by subsequent technological advances. Indeed, one of the mostremarkable features of the performance of the U.S. economy over the past yearhad been the extraordinary gains in productivity. The increase in output perhour over the year ending in the third-quarter--5-1/2 percent--was the largestincrease in several decades. That pace will not likely be sustained, but itsuggests that the underlying supports to productivity growth have not yet fullyplayed out. Against that background, any significant fall in the currentgeopolitical and other risks should noticeably improve capital outlays, theindispensable spur to a path of increased economic growth.
* * * * *
In summary, as we focus on the dangers of bubbles, deflation, and excesscapacity, the marked improvement in the degree of flexibility and resilienceexhibited by our economy in recent years should afford us considerablecomfort for now. Still, economic policymakers are having to grapple with whatseems to be a much larger portfolio of problems than that which ourpredecessors appeared to face a half-century ago. The ever-growingcomplexity of our global economic and financial system surely plays a role.Moreover, the very technologies that have helped us reap enormousefficiencies have also presented us with new challenges by increasing ourinterconnectedness.
I venture that future invitees to the Economic Club of New York dinners willnot lack interesting problems to address.
Footnotes
A considerable economics literature in recent years has documented adecline in the volatility of real GDP over the past two decades. Someresearchers have argued that the decline in volatility is the result of smallerdisturbances to the macroeconomy. Others have argued that improvedmonetary policy should be credited for the reduction. Another line of workpoints to structural changes that have increased the flexibility of the economyto respond to shocks. In that vein, I have argued that advances in informationtechnology and the cumulative effects of a quarter century of deregulation havelikely played a major role in promoting the increased flexibility of our economy.Of course, these explanations are not mutually exclusive and could, indeed, beinterconnected.
2. But to the extent that this resilience reflects increased flexibility of the
economy, we should be searching for policies that will further enhanceeconomic flexibility and dismantling policies that contribute to unnecessaryrigidity. The more flexible an economy is, the greater is its ability to self-correctto inevitable disturbances, reducing the size and consequences of cyclicalimbalances. An implication is that, at any given point in time, the economy ismore likely to be producing close to its productive potential. So often,discussion of policies intended to improve macroeconomic performance havefocused solely on traditional monetary and fiscal policies. But structuralpolicies intended to promote flexibility may be an important complement tostandard macro policies, and they may be important enough to influence boththe cyclical performance and long-run growth potential of the economy. Thisissue surely deserves examination and debate. Return to text
3.Alan Greenspan, "Economic Volatility," August 30, 2002, at a symposiumsponsored by the Federal Reserve Bank of Kansas City in Jackson Hole,Wyoming. Return to text
4. Committee on Banking and Financial Services, U.S. House ofRepresentatives, July 22, 1999. Return to text
5. Some argue that bubbles can be prevented or defused by financial regulatoryinitiatives. It is observed that asset bubbles have often been associated withrapid credit expansion, and hence it is claimed that restraining credit growthcould quash nascent bubbles. A bubble could conceivably be defused byrestrictive credit regulations that stifle economic growth. It is by no meansclear, however, that such a regime would be more conducive to wealth creationover time than our current regulatory system. Also of relevance, in a vibrantfinancial system, such as exists in the United States, there will always be manyavenues available to investors for financing a bubble. Furthermore, manyanalysts maintain that stocks are priced at the margin by institutions with littleor no financing needs.
FAIR USE NOTICE. Many of the stories on this site contain copyrighted material whose use has not been specifically authorized by the copyright owner. We are making this material available in its efforts to advance the understanding of environmental issues and sustainability, human rights, economic and political democracy, and issues of social justice. We believe this constitutes a 'fair use' of the copyrighted material as provided for in Section 107 of the US Copyright Law. If you wish to use such copyrighted material for purposes of your own that go beyond 'fair use'...you must obtain permission from the copyright owner. In accordance with Title 17 U.S.C. Section 107, the material on this site is distributed without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. For more information go to: http://www.law.cornell.edu/uscode/17/107.shtml
