Remarks by Vice Chairman Roger W. Ferguson, Jr.
At the U.S. Embassy, The Hague, the Netherlands (via videoconference)
June 14, 2001
The Productivity Experience of the United States:
Past, Present, and Future
Thank you for inviting me to address this group of distinguished business and government leaders from the Netherlands. As always, the views I will be expressing are my own and are not necessarily shared by other members of the Board of Governors or of the Federal Open Market Committee.
You have asked me to set the stage for our discussion with a brief review of the extraordinary performance of the U.S. economy during the second half of the 1990s. From 1995 to 1999, real gross domestic product grew, on average, about 4 percent per year. This pace was significantly above that in the previous five years, and you would have to go back to the 1960s to find even closely comparable periods of consistently robust economic expansion. In this environment, the unemployment rate fell to 4 percent, and the underlying rate of price inflation slowed, on net, despite very high rates of resource utilization. Even the most optimistic forecasters could not have anticipated such a favorable confluence of economic events.
Productivity Growth and Cost Reductions
Technological Change and Productivity Growth
Research by Federal Reserve Board economists Steve Oliner and Dan Sichel sheds some light on the sources of this faster productivity growth. The high (and rising) levels of business investment raised the amount of capital per worker and thereby boosted productivity. About 1/2 percentage point of the increase in productivity growth over the 1995-99 period can be attributed to this so-called "capital deepening," most of which reflected greater spending by businesses on computers, software, and communications equipment. The balance of the pickup reflected other factors, including technological innovations in the actual production of computer hardware and semiconductors as well as better management--perhaps assisted by these high-tech investments--of the nation's capital and labor resources. Oliner and Sichel estimate that the consolidated influences of information technology investments account for about two-thirds of the acceleration in productivity since 1995. This research supports the view that fundamental changes are under way in our economy.
What's So Special about this Capital?
Let me highlight three special characteristics of high-tech equipment. First, computers and communications equipment depreciate at a very rapid pace. The current best estimate is that computers probably depreciate about 30 percent annually, although that estimate might be low, while other equipment probably depreciates at a rate of less than 15 percent annually. Therefore, computers are retired, on average, after three years, and the useful life for other equipment is about seven years. Firms must invest in computers at a faster rate than they do in other forms of capital just to maintain a given level of the capital stock. The rapid replacement of high-tech capital means that technological progress becomes "embodied" in the capital stock at a faster rate than is the case for longer-lived assets.
The second feature of high-tech equipment that sets it apart from other classes of capital is the sensitivity of demand to fluctuations in the cost of capital. For decades, economists have debated the magnitude of cost-of-capital effects on traditional capital goods. A past consensus was that the cost-of-capital effect was small and difficult to identify empirically. But a somewhat different conclusion has arisen lately when the same basic models of investment are applied to spending on computers alone. The latest research suggests that the demand for computers is quite sensitive to movements in the cost of capital. The combination of an apparently high price elasticity and a rapid decline in relative computer prices--20 percent per year over the past decade--likely led to the boom in high-tech investment.
A third characteristic of some high-tech investment is the magnitude of external or spillover effects that it generates. Some high-tech equipment generates benefits not only to the owner of the machine but to other agents in the economy as well. I am thinking in particular about so-called network effects-the observation that four computers networked together are more than twice as valuable as two.
Supporting Structural Changes
Moreover, given intense competition and the resulting lack of pricing leverage, ongoing programs to reduce costs have become a key part of corporate strategies to maintain or improve profit margins. The focus on cost reduction has worked to head off the development of inflationary pressures in this expansion.
Productivity and the Current Macroeconomic Setting
Two fundamental factors lead me to be cautiously optimistic that the much of the improvement in productivity is likely to be sustained. Notable advances in microprocessors, or semiconductors, have been key to the enhanced productivity growth that we have experienced. Semiconductor industry experts indicate that the improvement in performance described by "Moore's Law," which predicts that the capacity of chips will double every 18 to 24 months, continues to hold true. My understanding from conversations with, and announcements by, leaders of the semiconductor industry is that later this year or early next year chip manufacturers plan to begin using larger wafers, allowing them to reduce costs by 30 percent. They also plan to adopt thinner circuit lines, which will allow the manufacturers to etch more transistors on a single chip.
A second reason to expect that much of the improvement in productivity growth is trend and not cyclical is that businesses indicate in their words and their deeds a commitment to improving productivity and maintaining costs by substituting capital, mainly IT capability, for labor. Overall growth of the economy has slowed to a pace between 1 percent and 2 percent at an annual rate for the most recent three quarters. However, investment in equipment and software has held at relatively high levels and is still sufficient to maintain relatively rapid growth of capital services. Moreover, end-use demand for communications services seems to remain strong. Since the early 1990s, the volume of data sent over networks in the United States has doubled each year, and there is no reason why that trend should abate.
The Role of Government Policy
The economy of the United States has also benefited from past actions by the government to deregulate industries. The more intense focus on the removal of unnecessary government regulation started more than twenty years ago, during the Administration of President Ford, and gathered momentum during the Carter years. Deregulation has altered the business landscape by allowing--indeed forcing--businesses to focus more clearly on a more competitive marketplace with fewer constraints and increased flexibility. Again, as with macroeconomic policy, a policy of deregulating industry cannot create greater potential growth, but it can create the conditions under which such growth might occur.
A third way in which the government and the private sector together have assisted the process of technology adoption is by fostering a highly flexible system of education and training that focuses on both theoretical and practical skills. In part because of the rapid changes in technology, today's students and workers no longer expect to keep a job for life, and they are keenly aware that, throughout their careers, new skills will be required for advancement. Employers, too, recognize the value added by developing human capital to complement their fixed capital. Thus, the United States has experienced a demand for educational services catering to participants at various stages in life.
The demand for skill development and upgrading has been met in a number of ways--through on-the-job training, at so-called corporate universities, and in a range of public and private institutions of higher learning. Surveys conducted by the U.S. Department of Education show that participation in adult education programs expanded over the past decade, with 46 percent of all adults reportedly having been engaged in an adult education program in 1998-99. In part because much of the training is work-related, the rates of participation are positively related to formal educational attainment. The trend toward lifetime learning also shows through in the enrollment statistics for higher education. Today, more than 20 percent of the students in U.S. institutions of higher education are age 35 or older, up from less than 15 percent in 1985. In part, this increase has been fueled by the rising number of part-time students and of enrollees at two-year colleges. The latter group of schools, in particular, has lowered the cost of education for working students with night and weekend courses and with the development of contracts with employers to provide skill training. Another way to meet the needs for skill training in coming years will involve distance learning. In 1995, one-third of U.S. institutions of higher education reported some use of distance education--two-way or one-way videos, on-line connections, and the like. Another one-fourth planned to offer courses in the subsequent three years, with an eye to targeting workers seeking re-certification or skill updating.
In addition, the U.S. government influenced the increase in productivity growth by supporting the early development of what later became known as the Internet. In the mid- to late 1960s the Department of Defense's Advanced Research Projects Agency (ARPA) created a small network, ARPANET, which was intended to promote the sharing of computers among researchers in the United States. In 1969, ARPANET connected the first four university participants, and researchers on those campuses created the first hosts of the ARPANET. Over time, this process of linking computers evolved into the Internet. Importantly, much of the work of creating the standards that drove the early creation of the Internet was led by the private sector, both commercial and academic.
Finally, the federal government is reported to be an active user of the Internet to sell its products, including financial products. A recent study indicates that the government of the United States made $3.6 billion of transactions over the web in 2000, which was significantly larger than the revenue of any web-based retailer.
The Macroeconomic Implications of Faster Productivity Growth
A second important reason for being interested in the growth rate of productivity is that in the near term it affects both the supply of and demand for goods and services. On the supply side, the effect is fairly clear and immediate: An increase in trend productivity growth implies a more rapid pace of growth of the economy's productive capacity. In short, the economy can produce more, overall, without running up against production bottlenecks. Of course, this effect tends to cumulate over time, with progressively larger increases in supply coming as time goes by. Separately, businesses may respond to the increase in trend productivity growth by stepping up the pace of their investment in plant and equipment, further boosting the growth in the supply potential of the economy.
How does the increase in trend productivity growth play out on the demand side of the economy? One immediate effect is the step-up in capital expenditures that I just noted, as businesses perceive and react to new profit opportunities. In addition, stock market investors will react to the pickup in productivity growth by looking ahead, recognizing the improved prospects for future earnings, and bidding up equity prices today. The run-up in equity prices implies a reduction in the cost of capital for businesses, which could support a further increase in investment demand, especially on the part of firms that rely on this market for at least part of their funding.
The increase in stock market wealth will also operate through the household sector. As you know, economists often speak of the "wealth effect." Econometric modeling indicates that consumers eventually tend to raise the level of their spending by approximately 3 to 5 cents for every incremental dollar of wealth. Given changes in stock market wealth as large as the ones we have seen recently, this wealth effect can have a noticeable effect on consumption and macroeconomic performance. To take the most prominent example, the wealth effect is the most important reason why the personal saving rate in the United States has fallen from roughly 8 percent in 1990 to -1 percent in the first quarter of this year. And to put a rough number on the impact on aggregate activity more recently, simulations by the Board staff using our econometric model of the economy suggest that wealth generated in the equity markets over the past four years added about 1 percentage point to the growth rate of real GDP.
Overall, the stock market, working through the spending decisions of both households and businesses, will act to bring forward the demand effects of the improved outlook for supply, potentially even pushing demand up ahead of the increase in supply.
It is important to emphasize that higher productivity growth translates into higher real income growth for employees. This added income is seen most clearly in the higher wages paid to that growing number of workers whose cash compensation is tied to company performance, either directly or through stock options. But real incomes should increase even for workers whose compensation is not directly linked to company performance, as profitable business opportunities bolster the demand for scarce labor.