New Orleans Times-Picayune Money Watch Live 2001 Conference
New Orleans, Louisiana
March 10, 2001
Thanks for that introduction. I’m honored and impressed that so many of you would sacrifice a perfectly good New Orleans Saturday afternoon to come hear me and others share our views on the broad subject of investing.
Over the course of my career, I held three different assignments in New Orleans and lived here for a total of about 12 years. I take every opportunity I can to come back. I love this city. There’s no place like it on earth. But you knew that already.
Something you might take for granted, though, since you hear them all the time, are New Orleans’ great idioms. One that everybody knows is “Let the good times roll.” In economic terms, that expression might have described the thinking of lots of folks after nearly ten years of economic expansion. Many consumers, businesses and investors became pretty complacent, assuming that economic adjustments and downturns were a thing of the past. But the last six months have felt less like good times and more like an old-fashioned, pass-the-aspirin morning after.
There’s another local idiom that I love, one that gets me some strange looks back in Atlanta - “plenty enough.” It’s one of those wonderfully ambiguous expressions that can mean anything — from “just fine” to “way too much.” That second definition, way too much, was what I thought when I heard that our Times-Picayune hosts wanted me to talk for 50 minutes. (Don’t worry, I won’t go on that long.) But then I thought of the other definition — just fine, in good shape — and I decided that that was a good way to describe my view of the underlying fundamentals of the U.S. economy.
Without question, painful adjustments are taking place in some sectors of our economy, and I’ll come back to those from time-to-time in my remarks. But today I want to emphasize the very positive fundamentals that remain in place and that bode well for the longer-term economic outlook and for investors. Those fundamentals determine the performance of the U.S. economy, and, ultimately, the prospects for earnings, cash flow, fund returns and everything else you’re learning about today, too. Your investment decisions ought to be informed by a broad consideration of the national economy, and that’s where I think I can make the greatest contribution to your program.
In that spirit, what I’d like to do today is assess the prospects for the U.S. economy from three fundamental perspectives:
Let’s begin by thinking through the fundamental composition of GDP — the way we measure the value of all goods and services produced in the United States.
C plus I plus G plus net X (Exports - Imports). Remember that? (I bet some of you are still trying to forget it). That formula is shorthand for consumer spending, plus business investment, plus government purchases, plus net exports. Everything that’s produced in the United States is classified within one of those four accounting categories. As we think through what’s been going on within each of those categories of spending, we can get a better sense about what’s behind the most recent economic developments and the prospects for the longer term.
Of the four categories, consumer spending is by far the largest. Preliminary estimates are that last year the United States produced nearly $10 trillion worth of goods and services. Of that amount, about $6.8 trillion — around 2/3 of all goods and services — were purchased by consumers. So, while it’s a cliché, it’s also the truth: “As the consumer goes, so usually goes the U.S. economy.”
This long period of economic expansion has been characterized by plentiful jobs, strong income gains, and, especially, robust consumer spending. In fact, there have been many months when consumers spent all — and sometimes more than all — of their current incomes. And they spent it not just for essentials, but on cars, houses, vacations and other “big ticket” items, too. Not suprisingly, consumer debt also increased, although it’s not yet at alarming levels. So in the last half of 2000, with debt on the rise, higher energy prices cutting into discretionary budgets, and the so-called “wealth effect” of stock portfolios clearly less positive, consumers became considerably more cautious. We shouldn’t be surprised at the moderation in spending we’ve seen.
Going forward, I think that employment — jobs and basic income — will be the most important factor in consumer spending. And while we’re likely to see some uptick in unemployment rates as the economy continues its temporary adjustments, unemployment should remain low by historical standards. Consequently, the longer-term prospects for income gains, and therefore consumer spending, remain positive.
The second largest category of spending is business investment. While it accounts for only around 18 percent of GDP — less than one-third of consumer spending — business investment is absolutely critical to the economy because of the future productivity gains it helps generate. I’ll have more to say about productivity in a moment.
Throughout this expansion, business investment spending has grown much faster than we’ve seen in previous expansions. But then late last year it nearly came to a halt. As sales slowed, as inventories in some sectors began to climb, and as earnings came under pressure, businesses did what you might expect — they canceled or postponed capital expenditures. I’ll get back to this in a minute, but for now I’ll say it’s very likely that businesses will resume capital expenditures reasonably soon, especially for technology. For that reason, I think the longer-term outlook for business investment spending is also positive.
The third component of GDP, government spending, covers purchases of goods and services only: submarines, space shuttles, asphalt, prisons, salaries and so on. Because most government expenditures are not purchases but transfer payments — social security benefits, Medicare, interest on the public debt, et cetera — government actually accounts for a relatively small percentage of GDP, about 17 percent. However, because it can have such a powerful effect on financial markets, the way government funds its expenditures is actually more important than the total level of its purchases. I’ll get back to that in a moment, too.
The final component of GDP is net exports, which is shorthand for exports minus imports. With the U.S. economy booming over these last nine years and growing considerably faster (until recently) than the economies of our major trading partners, imports have exceeded exports, creating a net trade deficit. However, the trade deficit has been accompanied by an enormous level of foreign investment in the United States.
Here’s why: In a flexible exchange-rate system, it’s a basic fact of balance-of-payments accounting that a trade deficit must be “financed” by foreign investment; in other words, the net outflow of funds must be matched by an identical inflow. In the case of the U.S. trade deficit, what this means is that our purchase of foreign-made goods is matched by foreigners’ investments in the United States.
Now, why do you think foreigners invest here? Probably for the same reasons that you do. The United States is the world’s largest and most innovative economy. Of course the world wants to invest here. But I think there’s another reason. I think the world wants to invest here because we’re willing to compete with anyone, because we’re willing to risk failure. I’ll have more to say about this in just a minute, too.
So, consumer spending, business investment, government purchases and net exports are one way of thinking about the fundamental composition of GDP. And while growth has slowed and some painful adjustments are taking place, I think the fundamentals in each category are still quite positive, and I expect at least moderate growth to resume later this year.
And that brings me to the second fundamental I’d like to discuss today — the fundamental developments that have been powering the economy. I think there are three: The first is productivity growth; the second is business investment; and the third is a general renewal of the entrepreneurial spirit in the United States.
I’ll start with the most widely cited development, which is, of course, productivity growth. While productivity growth is an economist’s term, most people understand intuitively what it means. It means growth in output per worker per hour — or getting more accomplished in the same amount of time. And that’s exactly what businesses have done over the last six years. Between 1995 and 2000, productivity growth in the non-farm business sector rose at an annual rate of nearly 3 percent, which is slightly more than double the average rate between 1973 and 1995. This upturn in productivity growth helps explain a lot about the current expansion.
At the national level, it explains why GDP growth accelerated to over 4 percent from 1997 through 2000, the sixth, seventh, eighth and ninth years of the current expansion. At the firm level, it explains how companies have been able to grow profits without substantially increasing prices (because labor productivity growth has outpaced the increase in labor costs per unit of output). And it explains how wages have been able to grow without increasing unit costs (because wage gains have been largely matched by productivity gains).
Productivity usually grows for two reasons. The first is that the amount of capital relative to labor increases, such as when a farmer trades up to a bigger, faster combine. Economists call this “capital deepening.” The second way productivity grows is through technological innovation, such as when that same farmer adopts a new variety of higher-yielding corn.
Technological innovation is, of course, a direct result of investments in research and development. But in my view, it’s also a product of the general embrace of technology in the United States. True, technological proliferation is not without its drawbacks (and I thank you for setting your cell phone on “vibrate”), but I think it does make the United States more conducive to technology-generated productivity growth than other economies. And while it’s probably impossible to prove that theory, it just makes sense that a country with complete access to, and a fully developed respect for, technology will incorporate technological innovations more quickly than competitors that do not. I’m convinced that this quality accounts for some of the productivity growth we’ve witnessed since 1995.
Without question, though, so has capital deepening. And that brings me to the next fundamental development powering the economy, capital investment. From 1960 to 1990, investment in durable equipment grew at an average annual rate of around 6 percent. During most of that time, productivity growth was also stuck, at about 1 ½ percent a year. Beginning around 1992, however, durable equipment investment doubled to more than 12 percent. Around 1995, productivity growth doubled, too. As I said, I’m confident that technological innovation has been an important part of the productivity explosion. But I’m equally certain that it wouldn’t have happened without an increase in capital investment.
And this takes me back to the flip side of the net X trade-deficit issue I mentioned earlier. Remember that the amount we’re paying for imports in excess of exports has to be matched by an equivalent flow of capital back into the United States from overseas. The investment boom of the 1990s would not have happened without foreign capital, and we Americans probably ought to be grateful, because we don’t come close to saving enough to finance our investments internally.
Clearly, though, the foreigners who invest here must be grateful as well — or at least very confident — simply because they keep investing, too. And they keep investing not just because the U.S. is the world’s biggest economy, not just because it’s the most innovative, not just because productivity has doubled over the last four years. I think they keep investing because the United States is also the world’s most entrepreneurial economy.
That entrepreneurial spirit is the third fundamental development powering the U.S. economy. Now, I will concede that America’s entrepreneurial spirit was a lot more apparent at this time last year, when everybody knew someone who chucked his or her career to go work for a start-up and the NASDAQ soared to over 5000. That was just as overdone as the pessimism we’re witnessing now. Still, while it’s true that many — maybe even most — start-ups won’t amount to much, it’s also true that the ones that do succeed will redeem the failures thousands of times over. This entrepreneurial spirit — the willingness to risk short-term failure in order to ensure long-term success — is almost unique in the world. No wonder it wants to invest here!
Finally, I’d like to talk about the fundamental economic policies that have been in place over the last decade. I would emphasize three: trade policy, fiscal policy and monetary policy.
To me, trade policy is another manifestation of the national entrepreneurial spirit I just mentioned, that willingness to fail. The United States has some of the lowest — but not the lowest — trade barriers in the world. The competition this creates guarantees that consumers have the greatest range of choices and that manufacturers have the greatest incentive to remain efficient. And for the foreigners who provide the critical financing for U.S. investments, free trade policies guarantee that imported goods will be just as welcome as imported capital. Again, you can’t have one without the other. I’m concerned, however, that the difficulty several recent minor trade initiatives faced in Congress is evidence that too many Americans take for granted — or have forgotten altogether — the benefits of free trade. I hope this is not the case.
Better fiscal policy has also been an essential part of the economy’s performance over the last few years. Indeed, it has even been more important than the total level of government purchases I mentioned during my discussion of GDP composition. As you know, the federal government has been running a budgetary surplus since fiscal year 1998. Through the previous two decades, though, fiscal policy was characterized by no-end-in-sight deficits.
These deficits had a very real and very substantial (if not always a very well understood) effect on economic growth. Government borrowing left fewer financial resources available for business investment. Also, because the government could always issue more debt in order to pay a higher price for those resources — and because there was no easy way to bring the borrowing to an end — interest rates were bid up. Now, though, with government consuming a smaller percentage of funds in capital markets, interest rates are relatively lower and much closer to the inflation rate. Fiscal and monetary policies are pulling in the same, low-inflationary direction.
And that brings me to the third fundamental public policy I’d like to discuss, monetary policy. Now, it may surprise you to learn that the central objective of monetary policy is not to give the financial media something to talk about on a slow news day. It only seems that way. Actually, there are three broad goals of monetary policy: stable economic growth, full employment and low and steady inflation. (You can look them up.) Until just a few years ago, though, the idea that the economy would achieve all three at the same time seemed about as probable as New Orleans college students skipping Mardi Gras. A nice little fantasy, but it was never going to happen in real life.
But then, beginning in the mid-1990s, it did. What happened, of course, was that monetary policy — with a big assist from the aforementioned fiscal policy — finally delivered relatively low and stable inflation, significantly lower than we had in the 1970s and 1980s. And when it arrived, strong growth and low unemployment soon followed. But low inflation had to be present first.
Remember, when inflation isn’t low or stable, there is an additional element of uncertainty about an investment’s “real” return, and that means risk is higher, too. And if businesses believe their investments won’t generate sufficient returns relative to the level of risk, they’ll be less likely to invest. But in a low-inflation environment, real economic signals are clearer, inflation risks are lower, and investments are much more likely to be profitable.
Also, in a low inflation environment, the real cost of capital is lower. Partly, this is a function of the risk element I just mentioned: Capital providers (investors) will simply charge a higher interest rate when they perceive a higher risk. But it’s also a function of supply. When inflation is low, investors are more willing to make long-term investments, increasing the supply of funds and bringing down interest rates.
I want to emphasize one thing, though: While good monetary policy is absolutely essential for sustaining low inflation and continuing the expansion, it is not sufficient. This has not been the Fed’s boom. Yes, we have done our part, but the long boom we have enjoyed belongs to the millions of businesses, investors and consumers who seized the opportunities presented in a low-inflation environment.
Let me try to tie together everything I’ve said. I’ve argued that your investment decisions can be informed by thinking about the economy in terms of three fundamentals: the fundamental composition of GDP; the fundamental developments shaping it; and the fundamental economic policies currently in place. But it may have occurred to you that not everything I mentioned belongs strictly in one of those categories.
And that’s the way it should be. When an economy is functioning as it should be — when it’s thriving — it’s a self-energizing dynamo that draws on all its strengths and meets its own potential, even as it creates more of both in the process. Low inflation facilitates investment, which generates advances in technology, which lead to more productivity growth, which creates more value in the economy. And so on. Does that sound familiar?
It ought to. The U.S. economy is the most competitive in the world, and demand for its products remains solid. Productivity growth, investment and the entrepreneurial spirit continue to thrive. And the trade, fiscal and monetary policies that facilitated the expansion remain in place. Yes, we are currently working our way through some temporary imbalances that are painful to some industries, companies, employees and investors. But the fundamentals of the U.S. economy remain in very good shape. They’re plenty enough.
And now, I suspect, you’ve had plenty enough of me. Thank you again for allowing me to share these thoughts.