Remarks of Martin Feldstein
The performance of the U.S. economy now is simply astonishingly good. All of you know that, but I suspect that its actually better than you think and so I'll take a few minutes today to talk about some aspects of that economic performance. I think the key to the very good recent economic performance has been the increase in productivity--the increase in output per worker hour--and so I will talk about some of the reasons for that increase in productivity. But the most frequently asked question and the one that the organizers of this session have highlighted in the program is the question, Is there now a "new economy" in the United States? I think we can always define that question so the answer is either yes or no, but I think the right way to define it and an interesting way to define it is to ask, Have the relationships that govern economic processes in the United States--the relationships between growth, unemployment, inflation, and budgets--changed in a fundamental way? And my answer to that question is no. The astonishingly good performance represents a change in productivity, but not a fundamental change in the relationships among the major macroeconomic variables. So Im going to talk about these points in detail and then comment very briefly on their implications for the rest of the world.
Outstanding Economic Performance
Let me start with economic performance, where I would say the current situation and the situation over the last several years has been outstanding, both in an absolute sense and also relative to our own past. Let me comment on five things in particular.
1. Strong real growth. For the past three years real GDP has been increasing at a rate of more than 4 percent. In the final quarter of last year real GDP rose at a rate of more than 7 percent. And looking ahead to whats likely to happen in the year 2000, most forecasters are now expecting to see more than 4 percent real growth.
2. Low unemployment. The unemployment rate is now 4.1 percent. When the Trilateral Commission last met in Tokyo three years ago it was 4.9 percent, and at the time of the previous Tokyo meeting three years before that it was 6.1 percent. So we have seen a one-third reduction in our unemployment rate. And as we look ahead for 2000, I think we can expect to see the unemployment rate continue to fall, so that the first number in measuring our unemployment rate, the number to the left of the decimal point, will be a 3.
3. Continued low inflation. Despite the strong growth, despite the low unemployment, we have a continued low inflation rate. Indeed, if we focus on the core CPI-the consumer price index exclusive of the volatile components of food and energy-the rate of change is lower now than it was three years ago and six years ago. Indeed, while inflation may pick up in the year 2000 it is going to remain relatively low.
4. Improved fiscal situation. I have worried over the decades about our large budget deficits, and now our fiscal situation has improved remarkably. This is a result primarily of strong economic growth leading to additional tax revenue, but it also reflects the fact that for the last eight years we have had one party in the White House and a different party in control of the Congress. The Republican Congress has not been eager to endorse new programs that President Clinton sent to them and President Clinton has not been eager to endorse any initiatives that the Republicans in Congress have proposed. So spending has been kept under control at the same time that tax revenue has increased substantially.
The result of all of these factors in terms of our budget situation is really striking. In 1994, the United states had a budget deficit of $200 billion. In 1997, we were essentially in balance, although we had a small deficit. Now, this year, we look forward to a surplus of nearly $200 billion. Looking ahead, the Congressional Budget Office in the United States forecasts that if there are no changes in tax rules and if discretionary spending on the full range of programs continues to increase at the rate of inflation, by the year 2009 the entire U.S. national debt will be paid off. Now thats not very likely to happen because Congress is not very likely to look at those large budget surpluses and pass up the opportunity for some tax cuts or some new spending increases. But even if Congress simply leaves alone the surpluses in our Social Security and Medicare programs--something that both parties have committed themselves to do--and spends all of the other surplus either on new programs or on tax cuts, by the year 2010 the national debt will be down to about 10 percent of GDP. So were looking at a fundamentally improved fiscal situation.
5. Increase in national savings. Reductions in budget deficits have caused a sharp increase in national savings. If we combine households, businesses, and government, the gross savings rate is now about 19 percent of GDP in the United States. Our net savings rate is now about 8 percent of GDP--about twice what it was at the beginning of the 1990s. So although household saving has gone down sharply, improvements in business profitability and in government budget surpluses are giving us a very strong national savings rate.
Strong Improvement in Productivity Is Key
So I think its fair to say that what were seeing is an astonishingly good performance of the U.S. economy. Now why are we experiencing such good performance? Again, I think the key has been the strong improvement in productivity. In the first half of the 1990s, productivity rose at an annual rate of 1.5 percent. From 1995 to 1999, it rose at a rate of almost 3 percent--2.8 percent. Last year it was rising slightly above 3 percent and, if one is to believe the statistics, in the second half of last year it actually rose at a rate of more than 5 percent. That kind of fast productivity growth translates directly into faster GDP growth. It holds down the inflation rate and it allows the Federal Reserve to take an easier approach to monetary policy, therefore permitting the unemployment rate to be lower than it would otherwise be. In turn, faster economic growth and low unemployment contribute to the rise in tax revenue and therefore the improved budget situation and the improved national savings situation.
Why has productivity increased so much? I think there are three different reasons for it. First, total real non-residential fixed investment in the U.S. has been rising very rapidly over the last seven years, at 10 percent a year. Investments in equipment and software have been rising even faster. Second, I think the internet plays an important role in all of this, but its not the only kind of technical changes that have contributed to increased productivity. And a third factor is better management driven by increased incentives to managers to cut costs and to increase output. This third factor is often lost sight of when looking for what I would call "engineering explanations," such as more capital and new technology.
Observed Relationships among Growth, Unemployment, and Inflation Are Not New
So that brings me then to the question of whether there is a "new economy" in the United States. As I have emphasized, there are important improvements in productivity, there is exciting new technology, and the labor force behavior of young people today is different from what it was in the past. I believe all of this can continue for years into the future and continue to give us faster productivity growth. But is there a new economy in the sense that old relationships are no longer true? One reads in the newspaper every day that one has to throw away the old road maps, the old guidance, the old textbooks. Nevertheless, I dont think there is a new economy. Now let me be clear. I am talking about the economy and not about the stock market. I dont understand some of the share price movements of the last few years any better than many of my friends. But I think its worth remembering even in the area of the stock market that, while in the last year the Nasdaq has risen about 100 percent in the United States, the broad Standard and Poors Index has only increased about 10 percent. So there is clearly a group of technology stocks that are being given extremely high valuations by the market.
But let me focus on the economy. Do we have a new economy in which old relationships among growth, unemployment, and inflation have changed and therefore we have to change the way monetary and fiscal policies are conducted? The answer, as I have already indicated, is no. First, the relationship between the strong growth and the low inflation that we have been observing is not a puzzle. There is no reason to expect that a high rate of growth per se is inflationary. It depends on the nature of that growth. There never has been a reason to believe that faster growth per se will lead to increased inflation. To the extent that the faster growth that we have been observing reflects faster productivity increases, it is not inflationary. This is simply the standard old-fashioned relationship and there is nothing new about it.
But what about the reduction in unemployment? The rapid growth of GDP that we have experienced has been brought about in part by this continuing fall in unemployment. The unemployment rate is now 4.1 percent. A few years ago most economists, including myself, would have said that an unemployment rate below 5 percent or 5.5 percent would lead to a tight labor market which would push up the rate of growth of wages and that, in turn, would lead to rising costs of production, and those rising costs of production would have to show up in increased price inflation. Well then, why havent we observed price inflation? Why is the consumer price index inflation rate rising at a slower pace today than it did a half dozen years ago? Isnt that a new economy? I still think the answer is no and let me explain why.
First of all, the basic fact is that the falling unemployment rate has been associated with increasingly rapidly rising wages. So we are seeing wage inflation, we are just not seeing price inflation. In 1994--95 when we had a 5.5 percent unemployment rate, wages were increasing at just 2 percent. Two years later the unemployment rate had dropped to 5 percent and wages were increasing at 3.5 percent. And over the most recent two years, the unemployment rate has fallen to 4.3 percent and wages have been increasing at 5.1 percent. So the old verity about a relationship between tight labor markets and increasingly rapid wage inflation has proven true. Wages went from a 2 percent rate of increase to 3.5 to more than 5 percent. But this didnt translate into higher product prices because it didnt translate into higher unit labor costs. Why not? Because of the productivity gains. In 1994--95, productivity was rising at 1 percent and unit labor costs were increasing at 1 percent. By 1996--97, although wages were rising rapidly, productivity was increasing at 2.5 percent. And so there was no increase at all. In fact, there was a slight decrease in the rate at which costs of production were increasing. Only in the last two years, despite the fact that productivity gains have increased to 3 percent, have wages risen so rapidly that unit labor costs have begun to increase more rapidly as well, at about 2 percent a year. But even this increase in unit labor costs has not translated into an overall rise in the consumer price index. And why is that? Primarily because of import prices.
Import prices have fallen sharply in the last few years in the United States. Over the last three years they are actually down by about 9 percent. This has reduced the costs of production for firms that use inputs imported from the rest of the world. And it has brought competitive pressures to bear on American firms that havent been able to increase their prices because their import competition is offering lower prices. So the net result is no great surprise. We are observing low inflation despite tightening labor markets because we are also experiencing improving productivity at a more and more rapid rate, coupled in the last few years with lower import prices.
Implications for the World Economy
Let me comment briefly now on the implications of all of this for the rest of the world. The strong growth of the U.S. economy and the increases in the stock market prices are leading households to spend more and to save less because households have more wealth (share ownership in the United States is so broad now that many people are sharing in these increases in the value of the stock market), but also because even those who are not directly benefitting from share ownership are benefitting from the growth of real wages and productivity. They are looking at the low unemployment and are optimistic about the future. So households are spending more and saving less. The household saving rate has actually declined to virtually zero. Businesses are also responding to this favorable environment by investing more in new plant and equipment. This combination of increased spending by households and businesses has led to faster growth of demand than of output so that, although our output has been rising rapidly because of productivity gains, our spending has been rising even more rapidly. And there is only one way you can do that as a country, and that is to increase your imports from the rest of the world.
So our trade deficit has ballooned in the last few years. We have gone from a trade deficit of $200 billion in 1997 to a trade deficit this year thats likely to be about $400 billion. From the point of view of the rest of the world thats $200 billion more of demand that the United States has injected into the world economy, helping keep the Japanese economy up and contributing to the recovery in Europe. But looking forward this is not likely to be sustainable. Private financial markets around the world may tire of supporting loans to private institutions and investments in private securities in the United States. And if that happens, if we can no longer continue to finance trade deficits of $400 billion and current account deficits that are larger and rising, then our net imports will have to decline and therefore our contribution to aggregate demand in the rest of the world will have to come down as well.
In addition, if foreign lending to the United States is reduced, the dollar will decline and interest rates in the United States will rise. That weaker dollar will contribute to inflation, just as the strong dollar has reduced our import costs and allowed us to have very low unemployment with very low inflation. When the dollar starts coming down, there will be increased inflationary pressure in the United States causing the Federal Reserve to tighten further. This would slow the U.S. economy even more and reduce our imports from the rest of the world even further. Indeed, to reduce the risk of future increases in inflation, the Fed is likely to increase interest rates to slow the growth of demand in the United States. In short, Europe and Japan cannot expect the U.S. to continue adding to demand in Japan and in Europe, but from the American point of view, I think we can continue to look forward to strong growth of productivity and rising real GDP.
Martin Feldstein is President of the National Bureau of Economic Research, George F. Baker Professor of Economics at Harvard University, and former Chairman of the Presidents Council of Economic Advisors.