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Making Sense of the Remarkable US Economy

Presented by Edward G. Boehne, President
Federal Reserve Bank of Philadelphia

At an Economic Forum Sponsored by Swedbank
Stockholm, Sweden
January 12, 2000

When I was here 10 years ago, the 1990s were widely expected to be the decade of Europe because of plans for economic integration and monetary union, while the United States was expected to do less well in terms of economic performance. For Europe, economic integration and monetary union proceeded on course and are providing major benefits to European economies. But the expectation that the U.S. economy would do less well in the decade of the 1990s turned out to be incorrect. This past decade proved to be one of the best for the U.S. economy in the nation's history. Today I want to speak about the factors behind the strong performance of the U.S. economy, the challenge this so-called 'new economy' has posed to monetary policymaking, and some thoughts about the role of entrepreneurship in the American economy's success story.

Recent U.S. Performance

U.S. real GDP has grown at an average rate of more than 3-1/2 percent per year since 1991 when our current expansion began. Growth has accelerated since the end of 1995, averaging about 4-1/4 percent per year. The strong pace of economic growth has been matched by the strong growth of employment. Since 1991, the U.S. has added about 2.5 million workers to payrolls each year, and the unemployment rate has fallen from above 7 percent to a 29-year low of just over 4 percent.

Consumer spending, in real terms, has grown at an annual rate of more than 4 percent since 1995, while business spending on equipment and software has skyrocketed at an annual rate of more than 13 percent. Such rapid growth of consumer and business spending generated rapid growth in aggregate demand for U.S. goods and services even as net exports fell. The latest data indicate that aggregate demand continues to grow strongly.

Twenty, or 15, or even 10 years ago, the combination of rapid growth of demand and tight labor markets would have led to a substantial acceleration of inflation. But that has not been the case in recent years. In fact, in 1998 the U.S. inflation rate fell even though growth of real GDP that year was above 4.5 percent. And in 1999, even though inflation rose compared with 1998, the increase largely reflected higher oil prices. Core inflation, which excludes volatile energy and food prices, did not rise in 1999, contrary to what most economists expected based on historical relationships between inflation and unemployment.

Why isn't strong growth of aggregate demand in the U.S. generating higher inflation? The answer to that question requires us to take into account what is going on with aggregate supply. And what appears to have happened in the U.S. in recent years is that the economy's capacity to produce goods and services has increased nearly as rapidly as demand. Some of the recent dynamics on the supply side are probably going to be temporary, but others seem to be more permanent.

In 1997 and 1998, the U.S. benefited to some extent from the fall in the prices of oil and other commodities that followed the slump in Asian economies. Falling prices of basic inputs acted as a positive supply shock to many U.S. firms, lowering production costs. At the same time, weaker currencies and excess capacity in Asia put tremendous pressure on U.S. manufacturing firms to cut costs and prices. The fall in import prices also helped to fuel the spending of U.S. consumers and, consequently, the surge in our trade deficit.

As Asian and other economies improved last year, oil and other commodity prices reversed course, but the U.S. economy continued to grow rapidly, with no increase in core inflation. That indicates the story on the supply side is not the result of temporary factors alone. What else has been happening? I believe the economy's favorable performance in recent years also reflects major advances in technology and better economic policies.

Technology and Productivity

Major changes in technology have spurred strong, and accelerating, growth in labor productivity, which in turn has contributed to strong U.S. economic growth. We have perhaps been experiencing the greatest advances in technology since the Industrial Revolution. Though all of the reasons for the recent improvements in productivity growth are not entirely clear, certainly rapid changes in computer, telecommunications, and medical technology have contributed to this development. In addition, surging investment spending has led to capital deepening — that is, more real capital for each worker.

For instance, improvements in transportation and communication, and more widespread use of computer networks to track and control inventories, have meant that inventory levels have shrunk for most firms. Many businesses now arrange to have raw materials or component parts arrive on the day they are needed on the assembly line, eliminating the need for storage facilities and for employees who used to move raw materials and components into and out of such facilities. Reducing inventories has also reduced the need to finance those inventories with short-term loans. These improvements in inventory management have lowered the costs of doing business, which in turn has helped to hold down prices to consumers.

U.S. businesses have been buying high tech equipment at a torrid pace in recent years. In fact, businesses have spent so much on equipment that has improved the productivity of existing physical facilities that industrial capacity (and hence aggregate supply) has risen at a faster pace than demand for industrial outputs. This is evident from the fact that the capacity utilization rate in U.S. industry has fallen since 1995, despite the rapid growth of aggregate demand in the U.S. economy.

Strong growth in investment spending has also contributed to rapid productivity growth in the U.S. Since late 1995, labor productivity (i.e., output per worker) has been growing at an average rate of 2.7 percent per year. That is almost twice as fast as its average growth rate during the previous 20 years. The faster pace of productivity growth in recent years has meant that businesses have been able to keep prices from rising while paying higher wages to workers. Moreover, productivity growth accelerated in 1998 and through the third quarter of 1999. This is extraordinary for an economy that has been expanding for nearly nine years.

Economic Policies

Technological changes and the consequent improvements in productivity are not the only factors that have helped alter the supply side of the U.S. economy. Changes in U.S. economic policies with regard to regulation and trade have also helped to increase competition and productive capacity — capacity that can be used to meet an increased demand for goods. U.S. trade policy, for instance, has generally focused on opening markets abroad rather than closing our markets. And that has given U.S. companies new opportunities to export while giving U.S. consumers the benefits of a variety of foreign goods. The greater globalization of all of our economies has increased the ability to use capacity abroad to meet domestic demand, and has thereby undercut businesses' power to raise prices.

Regulatory policy in the U.S. (or should I say de-regulatory policy) has fostered competition that has led to greater efficiency and innovation. In recent years the U.S. has continued the trend toward deregulation that occurred in the airline, trucking, banking, securities, and telephone industries in the 1980s. In the 1990s we saw further movement to deregulate telecommunications, banking and finance, and even the production and distribution of electricity. These further steps toward deregulation have likewise increased competition and reduced businesses' ability to raise prices. Equally important, these steps to deregulate have allowed firms to shift capital and labor into more productive uses.

On the demand side, the U.S. in the 1990s followed better economic policies in terms of fiscal and monetary policies. Fiscal policy constrained growth in federal spending during the past decade and produced the first budget surpluses in nearly 30 years. That has raised national saving, making more funds available to finance productive investment, thereby helping to finance U.S. businesses' rapid rate of investment in new equipment.

Monetary policy during the 1990s brought inflation down to levels we had not seen since the early 1960s, thereby providing a financial environment that has helped sustain the expansion. I believe the historical evidence shows that long-run economic growth is maximized by maintaining an environment in which there is so little inflation that expectations of future inflation have little or no influence on the decisions made by households and businesses. That pretty much describes the U.S. today. Low inflation is a friend, not an enemy, of maximum sustainable growth of the economy and jobs. And it is an important reason why I am basically optimistic about our economy's prospects.

In short, the U.S. has enjoyed a prolonged period of high economic growth, low unemployment, and quite low inflation because of developments on both the demand and supply sides of the economy. It has had a better mix of fiscal and monetary policies. And the supply side has been stimulated by more open and competitive markets, by deregulation, and by technological advances that have increased productivity.

Having strong growth and low unemployment is highly desirable — as long as it is sustainable. What we don't want is for strong growth to cross over into a boom, because we know that booms are followed by busts. How confident can we be that the U.S. has a 'new economy' or a 'new paradigm' in which inflation will remain low despite strong economic and job growth?

A 'New' Economy?

I believe that what is 'new' about the new economy is really rather old — it is the resurgence of the supply side. The major reason for the fortunate combination of strong economic growth, relatively low unemployment, and low inflation in the U.S. is that the economy has become increasingly more productive in its use of labor and capital. This is wonderful news for the average American, because higher productivity growth ultimately translates into higher wages and a higher standard of living. What's more, higher productivity growth means that faster growth of wages and salaries need not increase unit costs and put upward pressure on prices.

Why does a good thing such as faster productivity growth pose a challenge for monetary policy? Because monetary policy affects the economy with a lag. Policymakers therefore want to be as forward looking as possible when making decisions. Typically, being forward looking requires one to use forecasts. But our forecasts generally are based on historical relationships among economic variables such as the growth of real GDP, employment, consumer and business spending, inventories, net exports, inflation, and the average growth rate of productivity. If technological improvements have raised the underlying (or trend) growth rate of productivity, then the sustainable growth rate of aggregate demand and output will also be higher. But if we have greater difficulty forecasting productivity growth, our forecasts of inflation and output growth will also be more uncertain.

Indeed, most economic forecasts have been off the mark during the past several years. They have predicted a rise in inflation that has not occurred, primarily because productivity growth has accelerated substantially.

The strong increase in productivity growth has also shown up in strong growth of corporate profits — consistently stronger than most economic models had predicted. This, in turn, has led to a rise in stock prices that has both pleased and perplexed most investors and stock market analysts. But how, if at all, should monetary policymakers respond to such a rise in stock prices?

Although in my view policymakers should not target asset prices, they still have to take into account the effect that a rise in the stock market has on the overall performance of the economy. Since a rise in stock prices increases consumers' wealth, and an increase in households' wealth tends to increase personal consumption and reduce personal saving, monetary policy decisions have to be made in the context of whether the increase in consumption contributes to a growth rate of aggregate demand that is not sustainable and that could lead to a build-up of inflationary pressures.

Whether corporate profits will continue to pleasantly surprise investors depends on whether productivity growth will continue to help businesses contain increases in unit costs. The outlook for productivity growth is positive but remains uncertain. Will it continue to accelerate, or level off, or slow down? This uncertainty challenges monetary policymakers to look for clues to the behavior of productivity growth and inflation in whatever data we can find. We can't rely solely on our traditional models of the economy — at least not with the sense of confidence we once had in them.

My own sense is that the recent improvements in productivity growth likely will continue for some time, so that we should continue to enjoy relatively high economic growth, low unemployment, and relatively low inflation for the coming year at least, and probably longer. Nevertheless, since we cannot be completely confident about how long the sources of this recent favorable economic mix will persist, the Fed must remain alert to significant increases in inflationary pressures, while at the same time fostering maximum sustainable growth in the remarkable U.S. economy.

So, I am persuaded that faster productivity growth has raised the sustainable growth rate in the U.S. — at least for now. But will increases in productivity growth continue forever? — Not likely. Whenever the growth rate of productivity levels off or declines — and no one knows when that will occur — the risk of rising inflation will increase and monetary policymakers will have to act in a timely fashion to prevent inflationary pressures from undermining this extraordinary economic expansion.

Entrepreneurial Infrastructure

The growth of productivity in the United States is closely tied to the rapid development and deployment of new computer and telecommunications technologies. These new technologies are being implemented in old-line companies as well as in new ones. Witness Kodak's line of digital cameras and digital versions of processed pictures. Or consider how businesses are using the Internet to place orders for materials and supplies, thereby allowing many companies to reduce the use of paper forms and administrative costs in their purchasing departments.

But most of the impetus for the introduction of new technologies has come from newly formed companies that have introduced new products into the market or that provide traditional products or services using new technologies. For example, global positioning systems have allowed companies to trace the delivery of goods and accurately determine their delivery time. The same technology, by the way, has allowed us to quickly find stolen cars. These are examples of things we could not do before. Other companies, however, are simply providing traditional services in a new format. The purchase of books or even clothes over the Internet is just a new and, in many cases, more efficient way of doing what we did before in person, by mail, or by telephone. Whether new venture firms in the U.S. deliver traditional products and services in a new way or provide new products or services, they are increasing our productivity, helping us hold down costs, and raising our living standards.

There have always been new inventions and new ways of doing things. What is different in the U.S. economy today is the fact that we have developed an extensive infrastructure to help entrepreneurs bring new products, services, and processes to the market. This infrastructure consists of several elements. Let me mention just a few. First, we have developed mechanisms for financing new ventures. Second, we have developed institutions for technical and managerial support of new ventures. And third, we have created the role of the professional entrepreneur in the U.S. economy. Let me make a few comments about each of these elements of the entrepreneurial infrastructure.

First, the financial element. Start-up firms in untested markets are not good candidates for direct financing from commercial banks. This is especially true for service firms that often have few or no tangible assets. So start-up firms normally get their financing from wealthy individuals, appropriately called angels, or from venture capital funds whose major sources of money are pension funds, insurance companies, and university endowments. Venture funds and angels look for startups that have a very high expected rate of return because they know that some will inevitably fail. The funds expect to cash in on their investment in new companies in about five years, either by selling the company to a larger firm or through an initial public offering. The relative success of these initial public offerings gives investors some idea of the quality of the venture capital fund. The more than $6 billion in new funds committed annually to venture capital funds in the U.S. in recent years is small compared with the total amount spent on research and development. But the amount of venture capital was less than $1 billion annually before 1979, and it has doubled since the 1980s. Moreover, the venture fund industry has had a disproportionate effect on innovation in the U.S. economy.

A second element in the entrepreneurial infrastructure in the U.S. is the institutions that provide technical and managerial support. The two major institutions that provide this kind of support are small business development centers and business incubators. At the prompting of the Small Business Administration, 10 business schools at universities on the East Coast of the United States started small business development centers in 1980. These centers are designed to give technical, managerial, and financial advice to small business owners, and they draw on the expertise of various members of the university. From the original 10 small business development centers in 1980, their number has grown to more than 900.

Business incubators offer some of the same resources as small business development centers. In addition, start-up companies are often housed in a business incubator and share some services such as secretarial help, copy centers, and conference facilities. These incubators are most often sponsored by state and local government and nonprofit organizations. The University City Science Center in Philadelphia, founded in the 1960s, was one of the earliest business incubators. It is owned by a group of 30 academic and scientific institutions. The center has launched more than 215 successful start-up organizations. Nationally, the number of business incubators has grown from 12 in 1980 to about 600 today.

A third element in the development of an infrastructure for entrepreneurship in the U.S. has been the emergence of the professional entrepreneur. Thirty or 40 years ago when someone had a new idea or new invention, he or she might have founded a company, seen it grow to maturity, and remained CEO for the rest of his or her career before leaving the company to the children. Today we are seeing more and more people who start one company, sell it after a number of years, and then start another company and perhaps several more. They are, in effect, professional entrepreneurs. These individuals are willing to take a substantial amount of risk to start up a new enterprise because of the potential rewards — not only in terms of their annual salaries but also in various types of incentive pay, such as bonuses and stock options.

American entrepreneurs can also get encouragement and support in a number of other ways. There are a number of journals and magazines devoted to entrepreneurship, and several hundred colleges and universities in the U.S. offer courses on entrepreneurship. Around the U.S., a variety of organizations have been formed at the local level to provide entrepreneurs with opportunities to obtain advice. At the Federal Reserve Bank of Philadelphia, we host the monthly meetings of an entrepreneurs' forum that brings together entrepreneurs and service providers to discuss common issues.

Let me caution that the development of this entrepreneurial infrastructure in the U.S. economy has not eliminated the risk of new ventures; it has simply made it easier for more people to take that risk. A few numbers illustrate this point. In 1997 there were more than 160,000 business startups in the U. S., but there were also more than 80,000 business failures. Every year INC. magazine publishes a list of the 500 fastest growing, privately owned companies in the U.S. Of the 500 companies on the list in 1985, almost 20 percent had disappeared or failed by 1995. The competitive marketplace continues to perform its role of testing new ideas and products. The new infrastructure for entrepreneurship doesn't eliminate that test; it simply allows more new companies to take the test.


In conclusion, the U.S. has been enjoying a remarkable period of economic growth. Next month our current economic expansion will become the longest in U.S. history, with an average inflation rate that is as low as the average inflation rate in the decade of the 1960s, and with rising real wages generated by strong productivity growth.

The job of monetary policy is to foster an environment friendly to growth — to let the economy reach its potential without contributing to excesses. As I said earlier, low inflation is a friend, not an enemy, of maximum sustainable growth. Even so, the current environment — while welcome — is more challenging for monetary policymakers because the traditional uncertainties on the demand side are made more complicated by 'new' uncertainties on the supply side.

Monetary policy is basically a demand management tool. Whether we have a 'new' economy or not, going forward, the Fed will need to stay alert to the dynamics on the supply side as well as the dynamics on the demand side to achieve maximum sustainable growth with little or no inflation.

To the extent that high tech start-up firms are contributing to the acceleration of productivity improvements in the U.S. economy, finding ways to foster the development and financing of such firms should provide significant benefits in terms of raising future standards of living. The entrepreneurial infrastructure in the U.S. that helps to foster such firms should also help to provide a fertile environment for future gains in productivity in the 21st century.