Summary of Greenspan’s Speech on the Health of the Economy Presented to the Bay Area Council Conference in San Francisco on January 11,2002.

(Click here for full text of speech)

By Russell P. Chuderewicz, Council of Economic Advisors (1/24/02)

This much anticipated speech by Alan Greenspan (Greenspan has been quiet as of late) was not particularly well received by the financial markets. Given his remarks, Greenspan’s outlook for the economy is that of caution and uncertainty rather than optimism that prevails among some analysts. Greenspan is primarily concerned about the demand side of the economy and in particular, worried about consumption and investment in capital equipment. I will first outline his concerns on the demand side of the economy and then outline his positive remarks regarding the supply side of the economy suggesting, perhaps, that the new economy is still alive but just napping at the moment.

Concerns about the demand side of the economy – Consumption and Investment

Consumption

Consumption is a concern to Greenspan on a variety of fronts. First, he is not sure if the deflation in equity prices has already had its influence on consumer behavior or if the full effects have yet to be felt. We are approaching the two year anniversary of the peak in the NASDAQ (March 2000) and Greenspan is concerned that people will start perceiving the decrease in their equity wealth as a permanent affair, and adjust their consumer behavior accordingly. In short, we really don’t understand for sure, the so-called wealth effect. He does stress, however, that this influence on consumption depends critically on the future path of equity prices, which in turn depends, naturally, on expected corporate profits.

The second concern is the rising unemployment rate. Greenspan, as well as many others, feels that the unemployment rate will continue to rise. Beyond the obvious influence due to the increase in unemployed workers (decrease in labor income), Greenspan is concerned about the influence on job insecurity: The more insecure the worker, the more tentative the worker is in terms of consuming, especially the big ticket items like autos, new appliances, housing, etc.

The third concern is rising mortgage rates and the corresponding influence on the amount of home refinancing and over all housing activity. Greenspan states:

The recent rise in home mortgage rates, however, is likely to damp housing activity and equity extraction. It is already having an effect on cash-outs from refinancing. Cash-outs rose from an estimated annual rate of about $20 billion in early 2000 to a rate of roughly $75 billion in the third quarter of last year. But the pace of cash-outs has likely dropped noticeably in response to the recent decline in refinancing activity that has followed the backup in mortgage rates since early November.

The graph below shows exactly what Greenspan is concerned about (source – Federal Reserve Board of Governors).

I think his big concern is whether or not rates will fall in the near future. There are at least three possible factors as to why longer-term rates have risen. First, if investors feel the economy is due to turn around sooner rather than later, then inflationary expectations rise which in turn, raises longer-term nominal interest rates. We can see this phenomenon (the Fisher effect) in the graph during the fall of 2000 (first line), where investors expected a weaker economy, and thus lower inflationary expectations, resulting in lower nominal interest rates. Note that the Fed did not change their federal funds rate target during this time, clearly showing the frequent disconnect between short-term and long-term rates. Thus, the recent rise in rates is due, in part, to more optimistic expectations about future economic conditions.

The second factor is the so-called risk premium that generally rises on longer-term rates when the future becomes more uncertain. Greenspan is extremely concerned about this risk premium on corporate borrowing rates, which raises the cost of investment in capital equipment, arguably the source the new economy (more on this below). Long-term Treasury rates have also remained high, which implies that the critical rate (according to economic theory), the long-term real interest rate, remains painfully high.

The third factor possibly raising long-term interest rates is the disappearance of US budget surpluses. The implication is that the US Government will need to finance the deficits by issuing more bonds and thus depresses the expected future price of these bonds. If you think the price of an asset is going to fall in the future, then don’t buy it today and if you are holding, sell. The fall in the price of longer term US securities is thus reflected in higher long term yields.

Given the complexities underlying the rise in longer term interest rates, Greenspan is clearly concerned about the near term influence on consumer behavior as well as the level of investment taking place in the current environment.

Investment

By almost all accounts, the initial stages of the recent economic slowdown corresponded with a sharp decline in capital investment during the second half of 2000 (recall the peak in the NASDAQ in March 2000). We can now probably (safely) say that firms overbuilt implying that the rate of capital investment during the latter part of the 1990s was unsustainable (see graph below – Source: Federal Reserve).

We are now paying the price through inventory liquidation, the idea that firms are able to meet current demands through existing inventories, and thus, can afford to let workers go, consistent with the rising unemployment rate. Greenspan spends a significant amount of time discussing real time information, the idea that firms now recognize imbalances quickly and thus make the necessary adjustment(s) in a timely fashion. The good news is that inventories do not build up as much as before implying that the recovery will be quicker, as long as demand returns. The bad news is that we see the depressed economic activity sooner, as firms react quickly to the aforementioned imbalances. In short, Greenspan argues that given real time information, recessions should, on average, be shorter and milder relative to prior recessions.

That said, Greenspan is very concerned about the outlook for corporate profits. He argues that firms are now paying a significant risk premium in terms of acquiring funds given the uncertain profit outlook. He is hoping that profits (both realized and expected) will stabilize and hopefully increase relatively soon which would result in lower risk premiums and more investment in capital equipment, the engine of the new economy. In a best case scenario, the increase in capital investment, beyond the direct effects of more employment and thus spending, would result in higher rates of productivity growth resulting in higher profits, more employment, lower risk premiums, more consumption due to the wealth effect in equity prices, etc … the virtual circle that we enjoyed during the latter part of the 1990s.

The big question then is what is going to start the virtual circle since once it gets started, we should be able to climb out of this recession. Greenspan indicates that the key starting point is that the profit outlook needs to improve. But this is where the concern lies: What is going to get profits back on track? Given that consumption expenditures account for two thirds of the economy, we need consumers to consume. So we are back to the issues outlined above.

Broader Concerns

Upon reading Greenspan’s speech carefully, he mentions his concern after September 11 of a self-reinforcing cycle of contraction across world economies. Greenspan states:

The synchronous slowing in activity raised concerns that a self-reinforcing cycle of contraction, fed by perceptions of greater economic risk, could develop. Such an event, though rare, would not be unprecedented in business-cycle history.

This concern about a global depression (my interpretation) is consistent with the aggressive actions by the Federal Reserve. Somewhat ironically, this concern is based on some of the elements associated with the new economy: The global nature of many technology industries as well as the globalization of capital markets (e.g., intense competition).

Greenspan also does not rule out another terrorist attack and suggests that this recovery must:

…play out against the backdrop of a major uncertainty that we all must deal with these days - the specter of further terrorist incidents on American soil.

The Supply Side

Greenspan is quite positive about the supply side, or production side of the economy. So far, it appears that the rate of productivity growth has held up well during this slowdown, suggesting that firms will be able to increase production without raising prices. He does emphasize however, that the events of September 11 have resulted in a one-time downward shift in the level of productivity, since in the short-term, more resources will be needed to produce the same output, with the additional resources being devoted to (non-productivity enhancing) security concerns.

Recall that increases in productivity allow firms to pay higher wages (good for consumption) and increase profits (good for lowering the risk premium - more investment) and good for consumption (through the wealth effect)) without raising prices (allows the Fed to keep rates low). So productivity gains are the key and according to Greenspan, appear to be holding up well according to the available data at the time of his speech.

Conclusions

Greenspan feels that the key to the recovery and the return to prosperity lies in improved corporate profits. Once the profit picture brightens, the risk premium will fall inducing firms to invest more in productivity-enhancing technologies that result in higher profits, higher wages, higher employment, and thus, relatively high rates of economic growth without inflation that in a big sense, is self re-enforcing.

I personally feel that it was the market that got us into this mess and it’s going to take the market to get us out. Historically, the market rises 4 to 6 months before the official recovery begins, which goes a long way in explaining the recent optimistic projections by many analysts given that the market is quite a bit off the lows hit in the fall of 2001. That said, us economists enjoy a humorous statement about market gains and the associated recovery: The market has predicted 9 of the last 2 recoveries. Put differently, a bullish market is a necessary condition for a recovery henceforth, but certainly not a sufficient condition. Therefore, the market sometimes sends us false signals about the pending recovery. Unfortunately, I think we are especially vulnerable to these false signals since much of the world’s liquidity will return to US markets first since 1) there is essentially no place else to invest given weak world economic conditions and 2) the US has shown itself, at least in the latter part of the 1990s, to be the engine or locomotive of world economic growth and thus, it will be the US economy that recovers first. That’s good news.