Academic journal article Economic Review (Kansas City, MO)

Alan Greenspan: Chairman, Board of Governors of the Federal Reserve System

Academic journal article Economic Review (Kansas City, MO)

Alan Greenspan: Chairman, Board of Governors of the Federal Reserve System

Article excerpt

Over the past two decades we have witnessed a remarkable turn-around in the U.S. economy. The aftermath of the Vietnam War and a series of oil shocks had left the United States with high inflation, lackluster productivity growth, and a declining competitive position in international markets.

But rather than accept the role of a once-great, but diminishing economic force, for reasons that will doubtless be debated for years to come, we resurrected the dynamism of previous generations of Americans. A wave of innovation across a broad range of technologies, combined with considerable deregulation and a further lowering of barriers to trade, fostered a pronounced expansion of competition and creative destruction.

The result through the 1990s of all this seeming-heightened instability for individual businesses, somewhat surprisingly, was an apparent reduction in the volatility of output and in the frequency and amplitude of business cycles for the macroeconomy. While the empirical evidence on the importance of changes in the magnitude of the shocks impacting on our economy remains ambiguous, it does appear that shocks are more readily absorbed than in decades past. The massive drop in equity wealth over the past two years, the sharp decline in capital investment, and the tragic events of September 11 might reasonably have been expected to produce an immediate severe contraction in the U.S. economy. But this did not occur. Economic imbalances in recent years apparently have been addressed more expeditiously and effectively than in the past, aided importantly by the more widespread availability and more intensive use of real-time information.

But faster adjustments imply a greater volatility in expected corporate earnings. Although direct estimates of investors' expectations for earnings are not readily available, indirect evidence does seem to support an increased volatility in those expectations. Securities analysts' expectations for long-term earnings growth, an assumed proxy for investors' expectations, were revised up significantly over the second half of the 1990s and into 2000. (1) Over that same period, risk spreads on corporate bonds rose markedly on net, implying a rising probability of default. Default, of course, is generally associated with negative earnings. Hence, higher average expected earnings growth coupled with a rising probability of default implies a greater variance of earnings expectations, a consequence of a lengthened negative tail. Consistent with a greater variability of earnings expectations, volatility of stock prices has been elevated in recent years.

The increased volatility of stock prices and the associated quickening of the adjustment process would also have been expected to be accompanied by less volatility in real economic variables. And that does appear to have been the case. That is, after all, the purpose of a prompter response by businesses: to prevent severe imbalances from developing at their firms, which in the aggregate can turn into deep contractions if unchecked.

As might be expected, accumulating signs of greater economic stability over the decade of the 1990s fostered an increased willingness on the part of business managers and investors to take risks with both positive and negative consequences. Stock prices rose in response to the greater propensity for risk-taking and to improved prospects for earnings growth that reflected emerging evidence of an increased pace of innovation. The associated decline in the cost of equity capital spurred a pronounced rise in capital investment and productivity growth that broadened impressively in the latter years of the 1990s. Stock prices rose further, responding to the growing optimism about greater stability, strengthening investment, and faster productivity growth.

But, as we indicated in congressional testimony in July 1999, (2) "... productivity acceleration does not ensure that equity prices are not overextended. …

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