Gary H. Stern
Federal Reserve Bank of Minneapolis
Association for Corporation Growth
January 20, 1998
Good afternoon. It is a pleasure to have this opportunity to discuss the economic outlook in broad terms and to address several public policy issues which bear on it. Of course, an appreciation of the economy's prospects requires an understanding of both recent performance and current conditions, so I will begin with a brief recap of our experience over the past several years. Next, I will peer into the future and hazard a view on the course of the economy through 1998. Finally, I want to raise three policy issues which may affect our performance and prosperity in both the near and longer term. These issues are the relation between wages and prices, the implications of developments in Asia for our domestic economy, and the origins of Asia's banking problems.
Let me begin with the economy. As is now well recognized, the U.S. economy has turned in a remarkably positive performance over the past seven years, following the end of the 1990-91 recession. Gains in employment and output have been substantial, productivity improvement has accelerated in recent years, inflation has diminished, and financial markets have been strong. Moreover, virtually all sectors of the economy and all regions of the country have participated in a meaningful way in the expansion. Our record over this period looks particularly favorable in comparison with that of many of the other major industrial economies and that, in itself, is noteworthy because it was not very long ago that many were predicting that Japan or Western Europe or whoever would soon surpass us economically.
In any event, we clearly have had an extended period of well-balanced, reasonably rapid growth, and one issue to confront in considering the outlook is whether this momentum and these favorable trends will continue. The general answer to this question, in my view, is yes, in that I think that the economy will continue to expand in 1998, although probably not at a pace comparable to last year. Let me review the analytics and the arithmetic underpinning this judgment.
On the supply side of the economyits capacity to produce goods and servicesgrowth is determined in the short run by expansion in employment and the productivity of employees. (I'll take up the demand side shortly.) In the current environment, with the economy operating at essentially full employment, employment growth will necessarily be limited eventually by the expansion of the labor force, which in turn depends largely on demographic factors; such factors suggest labor force growth of about one percent per year.
This arithmetic deserves some further explanation. When operating at high rates of employment, as our economy undeniably is, future increases in employment are necessarily limited largely by the expansion of the labor force, that is, the net increase in the number of people available to work. Absent a change in immigration policy, this number in turn is largely determined by demographic factorsthe difference between those who become old enough to enter the labor force and those who choose to leave it. To be sure, there is some short-term flexibility, in that people may choose to work longer hours, take second or third jobs, enter the labor force earlier or stay longer, but ultimately these options are exhausted and the demographics prevail.
Productivity, the second determinant of growth of aggregate supply, is more difficult to get a handle on. It is challenging to measure productivity accurately and, recently, it has not been conforming to previous cyclical patterns. But a reasonable expectation for 1998 would be productivity improvement of one to two percent for the year. While I am comfortable with this range, it is probably optimistic relative to the expectations of the majority of the forecasting community. In any event, taken togetherthat is, employment gains plus productivitysupply side considerations suggest overall economic expansion of two to three percent in real terms this year.
But, what of the demand side? If growth of demand surpasses that of supply, pressure on capacity could mount, resulting in inflationary pressures. Alternatively, if demand falls short, excess capacity could start to emerge. Within a reasonable range of tolerance, I suspect that growth of supply and demand are likely to be in balance this year, implying aggregate real expansion in the two to three percent range and little appreciable change in capacity pressures. As the economy is about to enter its eighth year of expansion, this performance, if realized, would seem fully satisfactory.
At this point, some might object that even if I am right about the general trends in economic activity, labor markets are already so tightboth regionally and nationallythat accumulating wage and price pressures are inevitable this year. I readily agree that wage increases, and compensation more generally, is likely to accelerate in response to labor market conditions, but such gains need not necessarily translate into inflation. There are more "degrees of freedom" in the wage-price relation than frequently appreciated, which may explain why the relation does not appear to be an especially robust one empirically. For example, the inflationary consequences of compensation increases can in theory be offset by productivity gains, reductions in nonlabor costs, narrowing profit margins, or some combination of these developments. The point is that one should not jump uncritically from a forecast of wages to a conclusion about prices.
Are there other factors which could derail this favorable outlook? Until fairly recently, concern seemed to focus on the possibility that growth in demand would outpace that of supply this year, raising the spectre of an acceleration of inflation. Many who anticipated this scenario expected the Federal Reserve to respond with a more restrictive monetary policy and attendant upward pressure on interest rates. Such a response, it was expected, would restrain the interest rate sensitive components of aggregate demand and, if calibrated appropriately, keep the dimensions of the expansion of demand commensurate with that of aggregate supply. Of course, it was never certain that the calibration would be precisely correct or that the economy would respond as anticipated, nor could the reaction in financial markets be foretold with complete confidence. Certainly, something could go wrong.
Developments in Asia appear to have changed this calculus, however. Now, it is anticipated that US exports and domestic industries facing significant competition from imports will be restrained by weakness in Asian economies and currencies, relieving, at least to some extent, concerns about demand pressures. In these circumstances, many believe it more likely that expansion of supply and demand will attain a rough balance, and therefore that it is less likely than formerly that monetary policy will become overtly more restrictive.
Admittedly, the ramifications of the Asian situation are difficult to assess. It is not yet known how far the damage might spread or how severe it may be. Indeed, the extent of the difficulties in Japan is still coming to light, years after they first appeared. But even if we knew the extent and severity of the Asian problem, accurately estimating the implications for the US economy would be a formidable challenge. This may sound like a cop-out, but I think it is, rather, an honest admission of the limitations of our knowledge about such issues, for which there is, in fact, little historical precedent.
Some have gone further than considering Asia's impact on US economic performance and have begun to worry that Asia's troubles could precipitate worldwide deflation in the price of currently produced goods and services, particularly if the global spillover effects are greater than currently expected. To be sure, one can imagine demand or supply shocks of sufficient magnitude to produce a temporary decline in prices. But sustained deflationcontinuously falling prices of goods and servicesrequires the acquiescence or encouragement of monetary policy, for deflation, just like inflation, is ultimately a monetary phenomenon. That is to say, sustained deflation is unlikely unless monetary policy officials here and abroad permit it, and there is no reason to think that they are willing to do so.
My principal concern about Asia at this juncture takes another form. The current financial crisis in several Asian economies demonstrates once again the consequences of inadequate market discipline in financial affairs. I am referring, explicitly, to the moral hazard problem which results when bank creditors have insufficient incentive to price risk taking, thus permitting banks to take on excessive risks. Unfortunately, we have seen this before in Asia (and elsewhere), and this latest episode reminds us forcefully of the urgency of addressing the issue. I should add that insufficient market discipline is not, of course, the only factor contributing to financial difficulties in some Asian economies.
I am not today going to review proposals designed to correct moral hazard. Instead, I want to convince you that the issue is significant in its own right and that it may have serious implications for economic performance. To be sure, government deposit insurance has stabilized the banking system and, at least in the US, widespread banking panics are unknown since the 1930s. But stabilization comes with a cost, especially if it is perceived that there is a too-big-to-fail policy protecting all depositors and other creditors of large institutions. In these circumstances, depositors do not require an adequate risk premium and banks, therefore, have an incentive to invest in risky projects. Banks may also be insufficiently sensitive to exchange rate and interest rate risk in these circumstances. In short, deposit insurance encourages the misallocation of resources by contributing to excessive risk taking by financial institutions.
These are not just theoretical concerns; occasionally these chickens come home to roost. For example, the Presidential commission established to investigate the origins and causes of the savings and loan disaster in the US in the 1980s noted that the moral hazard of deposit insurance was "the 'necessary condition' for the debacle" and the "fundamental condition necessary for collapse." Examination of the banking crises of the 1980s and earlier in the 1990s in Asia and other parts of the world by the World Bank, the International Monetary Fund, and the Bank for International Settlements, among others, singled out the moral hazard of government depositor protection as a major culprit. And in 1991, in its recommendations for bank reform legislation, the US Treasury pointed to the "over expansion of deposit insurance" as a fundamental cause for the exposure of taxpayers to "unacceptable losses" as a consequence of bank failures.
Thus, respected international organizations, a Presidential commission, and the US Treasury all emphasize the costly consequences of depositor protection carried to excess. Clearly, moral hazard results in resource misallocation and, in some cases, substantial burdens on taxpayers. But the issue is even more important, for a recent study (Ross Levine, "Financial Development and Economic Growth: Views and Agenda," Journal of Economic Literature, 35 (2), 1997) persuasively makes the case that inadequate or incapacitated financial markets and institutions inhibit economic growth. Based on evidence from a large number of countries, the study states that "... the functioning of the financial system is vitally linked to economic growth. Specifically, countries with larger banks and more active stock markets grow faster over subsequent decades even after controlling for many other factors underlying economic growth. Industries and firms that rely heavily on external financing grow disproportionately faster in countries with well-developed banks and securities markets than in countries with poorly developed financial systems." Damage to a country's banks, and to its financial infrastructure more generally, may well damage its growth prospects. It is imperative, therefore, to introduce incentives to contain moral hazard and to deal with banking problems, once they arise, as expeditiously as possible.
This policy recommendation is as relevant to the US as elsewhere. Despite the reforms of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, I am concerned that the moral hazard problem as it pertains to large banks has not yet been effectively addressed in our country. Until it is, our banking system remains subject unnecessarily to this incentive problem.
In concluding, let me briefly summarize the points I have tried to emphasize. First, as recent data demonstrate, the domestic economy begins the new year in excellent condition, and it seems likely that many of the favorable trends of the past seven years will continue. Thus, overall I expect further real growth accompanied by modest inflation. There are, to be sure, risks to this outlook, risks that have their origins in unusually tight domestic labor markets on the one hand and in the disarray in Asian financial institutions, markets, and economies on the other. Because in some ways unprecedented, these risks are difficult to assess; but, in view of the sheer size and diversity of our economy, it may well weather these squalls with only minor turbulence.
It is important, though, that we understand both the nature and the consequences of the financial problem engulfing parts of Asia. As we have seen before, both here and abroad, moral hazard distorts incentives, resulting in excessive risk taking and, ultimately, in a significant if not severe financial correction. And history demonstrates that growth is adversely affected when the financial system is disrupted and contracts. While moral hazard is certainly not solely responsible for the current, or former, financial turmoil, it is an issue that can and should be addressed if we are serious about attaining over time maximum sustainable economic growth here and abroad.