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
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
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
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
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
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
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.