Speech

McDonough: A View of the U.S. and Regional Economies

June 13, 2000
William J. McDonough, President and Chief Executive Officer

Remarks by President William J. McDonough before the College of St. Rose Good afternoon, ladies and gentlemen. I am delighted to be able to join you at the Peter M. Tully Endowed Lecture on Financial Services and Economic Development here at the College of St. Rose. I would like to focus my remarks today on what has been happening in the U.S. economy over the past several years and share with you some of the implications of these developments for the State of New York.

The U.S. economy, as you know, has enjoyed a remarkable expansion since April 1991. It is the longest expansion in our history. In fact, annual real gross domestic product, GDP, has grown more rapidly in the past 4 ½ years than it has in decades--averaging 4 percent compared with roughly 3 percent in the 1970s and 1980s. Over this same period, core CPI inflation--that is, inflation excluding the volatile food and energy sectors--has fallen sharply, from average annual rates of over 6 percent to about 2 percent. Core inflation remains relatively low, although it is no longer slowing.

At the same time, the country's fiscal accounts are in surplus and labor markets have been the most favorable in a generation. Payroll employment has remained strong and unemployment has declined steadily, falling to a 30-year low of 4 percent early this year. Of particular note, the percentage of the population employed—nearly 65 percent--is the highest it has been in the postwar period.

An important implication of this economic strength for New York is the fact that job growth in the last several years has extended to those segments of the population in which unemployment has been most stubborn: the more disadvantaged parts of society, including the inner cities. The unemployment rate for 16-19 year-olds, for example, was about 20 percent in 1992. It is now under 13 percent. Similar trends hold for decreases in minority unemployment rates. Importantly, recent years have witnessed sharp gains in labor force participation rates for minorities.

Along with strong employment growth have come gains in personal income. Real disposable personal income in the United States, for example, has risen roughly 4 percent a year over the past two years.

In addition, there has been considerable vigor in household demand. In constant dollar terms, consumer spending, which posted a growth rate of more than 5 percent in 1999, its fastest rate since the mid-1980s, grew even faster in the first quarter, at about a 7 ½ percent annual rate. Housing has also been surprisingly strong, due to the best affordability conditions in a generation. Home ownership rates have risen strongly as well, reaching a record 67 percent in the second half of 1999.

What do these positive trends tell us about the trade-off between achieving price stability and employment gains? It certainly is true that the pace of wage gains has increased as the unemployment rate has come down. What is different in the current environment is that productivity growth has increased roughly in tandem with the rate of compensation growth. As a result, productivity growth has helped offset the inflationary impulses of the wage gains.

In a word, probably the most notable feature of the U.S. economy's remarkable performance over this past decade has been the rebound in the growth rate of productivity. Whereas productivity growth had languished at about 1 ½ percent a year for most of the 1970s and 1980s, it rose steadily over the 1990s, reaching a striking 3 ½ percent in 1999 and the first quarter of this year. It has been the impressive growth in productivity that has been the fundamental factor behind the sharp improvement in the output/inflation mix we have been observing these past several years.

Less often taken into account is the fact that the U.S. productivity surge of the 1990s took place against a background of very low inflation in the United States and rapidly decelerating inflation in almost every region of the world, where weak economic performance held down commodity price inflation and strengthened the dollar. Thus, it has been the strong productivity growth in the United States combined with the favorable world inflation environment that has helped keep U.S. core inflation as controlled as it has been in recent years.

While it might be tempting in this environment to sit back and declare victory, nothing would be more foolish. There is no question that the U.S. economy, especially in relation to the world economy, is beginning to exhibit signs of imbalance and strain.

Commodity prices, for example--and not just oil prices--have increased rapidly in recent months, as world growth has bounced back sharply. In the United States, rising costs for medical care and a number of other services make clear that we have to be especially alert now on the inflation front. Moreover, strong consumption growth in the United States has been fueled in part by sharp declines in the personal saving rate, although these declines may to some extent be due to technical measurement issues.

Further, the U.S. current account deficit has also widened markedly over the past several years, with corresponding large surpluses in Asia and Europe. The outlook is for continued worsening in the deficit that had already reached a record level last year, at about 4 percent of GDP. History tells us that such imbalances can persist for some time, but increase in risk as they widen. Eventually, persistent current account deficits require macroeconomic adjustment, which is smoother and more orderly when the policy response is earlier and more coordinated.

Of course, the issue of the day is whether one believes that the structure of the U.S. economy has changed so dramatically that what we see today in the United States is a "new economy." The bottom line is that there is no consensus on this issue. Nevertheless, there is no dispute that significant changes have taken place in the U.S. economy in recent years.

One important sign of underlying change has been a decline in the volatility of economic fluctuations since the mid-1980s, evidenced by the fact that there has been only one recession in this country in the past 17 years. Improved macroeconomic policy management and such positive trends as generally lower commodity prices have certainly been important contributing factors.

Also critical, however, has been the emergence of new technologies, among which has been the adoption of "just-in-time" inventory systems. Research at the New York Federal Reserve Bank has shown that these inventory systems have helped account for a significant reduction in the magnitude of inventory swings and hence less volatile growth of the U.S. economy. The spate of recent announcements of new resource management systems by auto companies, retailers, and others suggest that we have not yet exhausted the potential benefits from advanced inventory and production systems.

These inventory and production management techniques are one aspect of the improvement in productivity growth. How can we more fully account for this improved productivity, and is the productivity growth we have been observing temporary or permanent? These questions are really at the heart of the debate as to whether the United States is or is not a "new economy." No one disagrees that the surge in the production and availability of computers and software has been integral to the recent upswing in productivity. Where the differences in view enter is over the deeper sources of productivity growth and whether the productivity improvements are sustainable.

Those suggesting that there is no "new economy" argue that the recent improvement in U.S. productivity growth is easily explained: It is a combination of a normal cyclical reaction to a surge in demand and a pickup in the growth of the capital stock, most notably high-technology equipment and software. According to this view, once growth in demand settles down and investment in high technology slows, productivity growth will moderate. Even proponents of this view recognize, however, that the rapid increase in productivity and output growth in the computer industry will likely increase the growth rate of the economy over the longer term.

By contrast, those supporting the idea of a "new economy" tell us that what we are witnessing in the U.S. economy is the fruition of some longer term trends in information technology, deregulation, globalization, and labor markets. More specifically, proponents of a "new economy" contend that advances in computer power and software--combined with deregulation in the telecommunications, transportation, and financial industries--have produced many new profitable business opportunities. Using advances in technology and tapping into highly liquid world capital markets, many new and existing firms have been able to exploit these opportunities quickly.

Furthermore, the proponents of a "new economy" argue, information technology has produced numerous cost savings for business operations. The growing role of the Internet as the medium to exchange large volumes of information and conduct efficient transactions--among businesses as well as between businesses and consumers--will lead to a further acceleration of productivity growth. Thus, this view concludes, the increase in the output of the computer/software industry is both a cause and an effect of these deeper trends.

We cannot yet resolve the "new economy" debate. Nevertheless, I am persuaded that the longer productivity improvement continues, the harder it becomes to view this improvement as merely a cyclical phenomenon. Certainly, it seems to me that the accompanying low levels of inflation, together with relatively high rates of resource utilization, suggest that something more than normal cyclical forces is at work.

Let's keep in mind that it is not simply a question of productivity growth being driven by technological advances. It is also a question of how these technological advances are applied. At the end of the day, I believe that the United States has had such strong economic performance because of the high degree of flexibility and adaptability that has been built into the U.S. labor, product, and financial markets over the past two decades.

Large corporations, for example, have been increasingly willing to lay off workers and restructure their businesses during the expansion phase of the business cycle rather than waiting for a recession to do so. This process, to be sure, has not been accomplished without pain. There also has been a shift in the structure of compensation toward variable pay, including--but not limited to--stock options. This shift away from wages and traditional benefits has allowed for greater flexibility in labor costs and made it easier for new firms to add labor. In highly competitive goods and services markets, consumers' benefits show up in the form of lower prices, rather than entirely in higher pay.

At the same time, the banking system has been far stronger in the 1990s than it was in the previous two decades, and capital markets have deepened significantly. Expanded equity markets have served as important sources of finance for new businesses, while venture capital markets have provided increased access to risk capital. Also important has been the increased liquidity of financial assets. Today, asset portfolios of loans and credit cards are easily transferable through securitization or outright sale.

As a result, the corporate sector, too, has changed significantly with the formation of many new businesses over the past decade and the transformation of many old ones. Just consider how many of the household names we take for granted today were formed sometime in the last 25 years. To remain competitive, firms have had to shed some business lines that no longer fit their overall strategies and invest in new lines. They also have had to pay more attention to evaluating business opportunities by using more sophisticated risk/return analysis, a strategy financial firms have been particularly aggressive in pursuing.

As technology and competition force businesses to pursue more competitive strategies, the regions in which the firms are located are also affected. It is the cities, of course, that provide the critical infrastructure that is integral to the ability of businesses located there to compete effectively--be it the tax environment, the education facilities, the transit system, or the cost of electricity.

Businesses and workers in New York State have benefited from the strong expansion of the U.S. economy over the past decade, although not all parts of the state have seen benefits accrue at the same pace or to the same degree. Consistent with national trends, employment in the state has been expanding over the past seven years. In fact, job gains in New York--even upstate and in the western counties, where employment gains often have been most sluggish--were so robust in 1999 that the state’s rate of growth accelerated even as the nation’s growth rate declined. In 1999, over 200,000 new jobs were created in the state, equivalent to a 2.6 percent increase. Private-sector employment growth in the state--at 2.9 percent in 1999--led overall employment growth and continued to play the major role in the recovery.

In New York City, private-sector employment growth of 2.8 percent exceeded the corresponding rates for New Jersey and the nation as a whole.

One striking feature of the recovery in our state has been the broadening in the base of private-sector employment. With the exception of manufacturing, all major sectors in the state added jobs. Especially noteworthy was the fact that a diverse group of service industries accounted for about 60 percent of the new jobs.

Among the main contributors to new jobs were engineers and management consultants, lawyers, computer and new media specialists, brokers, and temporary and contract workers. Consumer services, including the restaurant and entertainment industries, health services, and social services, also were important in contributing new jobs to the state. The trade and construction sectors and segments of the transportation, communications, and public utilities industries made smaller contributions to job growth. On a less positive note, manufacturing jobs fell more rapidly last year than in 1998, and thus extended the long-term contraction in that sector. In the past few months, though, manufacturing employment has shown signs of stabilizing.

In New York City, Wall Street retained a key role, not so much for its contribution to new jobs as for the fact that it continues to generate a disproportionately large share of earnings in the state. These earnings—wages and salaries and bonuses--accounted for roughly 30 percent of the earnings growth in the entire New York City economy in 1998 and likely exceeded that share in 1999.

The outlook for 2000 is for continued job growth in New York State--on the order of about 2.0 percent, which is equivalent to about 165,000 new jobs. Continued job gains will be sustained by the ongoing expansion of the services sector, though a slowdown in the national economy this year could dampen the state's job growth rate.

Similarly, significant job gains in New York City in sectors not directly tied to Wall Street are likely to help stabilize the city’s employment in the event of a financial market downturn. The city's expanding health and social services industries, for example, are largely insulated from the immediate impact of developments in financial markets. Similarly, growing demand in such industries as motion pictures and computer services are likely to continue. There also may be room for further gains in business and consumer service employment in New York City in the coming years. These sectors, in effect, have created at least a partial buffer against job losses due to future financial sector shocks.

As job growth has expanded in our state, unemployment has declined. In 1999, the unemployment rate in New York State was 5.2 percent, versus about 4 percent nationally. Unemployment was closer to 7 percent in New York City, but still down sharply from recession highs.

Accompanying the decline in unemployment has been marked gains in income, aided by healthy corporate profits and booming stock markets during most of the past several years. Housing markets throughout the state also are strong, and we are not seeing the speculative construction of office space that typified the expansion in the 1980s. In New York City, for example, the arrival of new firms and the expansion of older ones have led to a steady decline in vacancy rates.

Moreover, the state and local governments are recording operating surpluses in their budgets. These developments are taking place even as governments in the state are working hard to lower taxes and business costs in a broad effort to improve New York’s competitive environment. Certainly, some of the statistics on job and income gains in our state testify to the success of many of these efforts.

I am particularly struck by the number of changes I have witnessed since coming to New York at the depth of the state’s recession and joining the Federal Reserve Bank in 1992. For example, the effort to improve the long-run competitiveness of the state has included a reduction in the gross receipts tax on utilities from 3 ½ percent to 2 ½ percent, and additional reductions are planned for future years. To the best of my knowledge, no other state imposes a comparable tax and its reduction will surely help to ease utility cost burdens on businesses and households throughout the state. In addition, New York’s top personal income tax rate has been reduced over a full percentage point in recent years and the state’s corporate income tax rate has been cut five-tenths of a point.

Another significant change since 1992 has been the reform of workmen’s compensation. Tax rates have been reduced and restrictions on third-party lawsuits have been tightened. In New York City, an important development has been the marked cut in the tax rate on hotel rooms, which fell from 21 ¼ percent to 15 ¼ percent. This tax had discouraged many convention planners from choosing New York City as a meeting site. Still further state and city tax cuts have been applied in recent years in New York City on the retail sale of clothing costing less than $110. Some other areas of the state have chosen to retain the local portion of the tax.

The bottom line is that these developments have helped make it less costly to live and work in New York State. The regulatory and tax changes we have experienced undoubtedly are part of the story behind the resurgence in jobs and income in communities throughout the state.

While these developments are certainly encouraging, much work is still to be done on a number of issues. Let me highlight a key concern I have about an area of potential vulnerability: My concern is that some of the sectors providing new jobs in our state are also sectors other states are seeking to attract or develop. Here, I am thinking about new media, bio-technology, computers, and financial services. Despite the rapid job growth I have already noted in these sectors, particularly in the greater-New York City metropolitan area, New York State’s share of total U.S. employment in these sectors--with the exception of motion picture production--is not expanding. The implications are clear:

First, if our state is to retain its leadership in these sectors, we must continue to sharpen our competitiveness. This means that New York will be challenged to make certain that its educational facilities are up to the demands of preparing highly skilled workers.

Second, the state also needs workers with a variety of skill levels to meet the growing demands of employers in the services sector. In a survey of regional business conditions completed by my Bank toward the end of 1999, the business community reported that the availability of executive and highly skilled labor in our state was excellent compared to that of other states, but the availability of low-skilled workers was more limited here than elsewhere. Thus, it is critical to provide the training and language skills that will enable the less-skilled and new immigrant populations to join the workforce quickly in a productive capacity. Such training raises their earnings and standard of living, and provides the state’s businesses the workforce they need.

Third, the large dependence of New York City on financial services industries exposes its economy disproportionately to the vagaries of a cyclical sector. State and city taxes, corporate and personal taxes, and job growth in related sectors are all dependent on the fortunes of this sector. Thus, the need remains for policymakers and business leaders to focus even more attention on broadening the state’s business base.

The very positive long-term developments in our national and state economies cannot lull us into a sense of complacency. Many people have benefited greatly from the strong gains in economic growth over this past decade--whether directly in financial terms from their businesses and investments or indirectly from increased job security and employment opportunities.

Nevertheless, many of those gains have failed to touch large segments of our population and to address other less visible needs of our state. What is most important as we look ahead is to focus our energies on how we may best work together to seek solutions to the many outstanding issues that challenge all of us. With the economy strong, I believe that there is no better time than now to carry out this work.

Thank you.