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Remarks by President William J. McDonough before the New York State Bankers Association Annual Financial Services Forum, New York, New York. It is a pleasure to appear before the New York State Bankers Association today. The opportunity to address you on the occasion of your annual meetings has been one of the great privileges of being President of the Federal Reserve Bank of New York. I regret that this will be the last time I will do so before my retirement. This morning, I would like to focus my comments on the issues of technology and structural change in the U.S. economy and the challenges I see ahead for our economy, our industry, and our region.
When I became President of the Federal Reserve Bank nearly ten years ago, the U.S. economy and the banking system were just beginning to heal from the severe problems that stemmed from the commercial real estate and leveraged buyout booms of the 1980s. In those days, we faced an economy that grew more slowly and produced fewer jobs than was typical of earlier postwar recoveries. We attributed that slow growth to the headwinds created by widespread financial distress.
Now, in March 2003, we are once again in the early stages of the recovery process. This time, the U.S. economy has been recovering from two major shocks: the bursting of the high-tech financial bubble and the devastating attacks of September 11, 2001.
The effects of the bursting of the stock market bubble have proven to be far more long term and pervasive than expected. Although many anticipated that the impact of a lower stock market would fall heavily on consumers, consumer spending and housing have remained remarkably buoyant. Rather, it is the business sector that has borne the brunt of the stock market declines. In contrast to the investment boom that accompanied the rising stock market, firms began sharply cutting back investment in plant, equipment, and software to reduce global excess capacity around the time that the stock market started falling. Major acquisitions and minority investments in high-tech firms were written down in value, sometimes with brutal results for corporate earnings. Those companies in weak or uncertain financial condition faced much higher financing costs, especially in the bond markets.
There have been some genuine surprises in the wake of the bursting of the stock market bubble. For one, the stock market boom proved to be fertile soil for serious corporate governance problems that began to come to light in the fall of 2001 and intensified thereafter. Second, state and local government deficits ballooned as revenues plummeted far more than expected, given the relatively mild recession. Third, nonprofit organizations saw their endowments and their incomes dwindle.
The tragedy of September 11 compounded some of the difficulties already facing the U.S. economy. The attacks not only temporarily depressed consumer and business spending, worsening the recession, but also ushered in a period of geopolitical uncertainty that continues to this day. Moreover, the need for stepped up defense and homeland security required a shift in resource allocation and led to at least some modest reduction in productivity growth. We estimate that the one-time decline in private- sector labor productivity due to homeland security costs will be no more than about 1 percent, but the size of the loss ultimately will depend on the nature and persistence of the security threat.
Notwithstanding the magnitude of these shocks -- the bursting of the stock market bubble and the accompanying corporate governance scandals, along with the attacks of September 11 -- the U.S. economy has held its own. The recession was mild. Real economic growth on a four-quarter basis slowed to near zero in 2001 and reached a respectable 2.9 percent in 2002.
But the recession and early recovery, as in 1991, no longer has the V-shape so familiar in early postwar business cycles. Currently, the U.S. economy is expanding below its potential growth rate -- that is, the rate at which it can grow without creating inflationary pressure. That speed limit for the U.S. economy, at least in the medium term, is set by the sum of labor force and productivity growth. We estimate potential sustainable growth to be between 3 and 3.25 percent. Moreover, net job growth since the apparent trough of the 2001 recession is weaker than it was in the same period of the early 1990s recovery.
These developments suggest that significant changes are taking place in the behavior of the U.S. economy over recent business cycles. One of the most notable changes has been the reduction in the volatility of GDP growth. More specifically, the volatility of U.S. quarterly GDP growth, as measured by its standard deviation, has halved in the twenty years since 1983 compared with the prior thirty years. Expansions are longer. Although the eight expansions between 1945 and 1980 lasted an average of fewer than 45 months, the two since 1980 have lasted 92 and 120 months. Recessions have been shorter and shallower.
A great deal of evidence points to technology as the major factor that helps account for changes in the U.S. business cycle. When I speak about technology, I am not referring simply to advances in the development of computers and other electronic devices. Rather, I mean the ways in which goods and services are produced and distributed within the economy. What is the evidence for technology's role? Two phenomena are of particular importance.
The first has to do with the striking changes in the behavior of inventories over the past two decades. Prior to the early 1980s, inventory investment typically exacerbated economic fluctuations. During sales slowdowns, businesses tended to find themselves with large excess inventory stocks that obliged them to make drastic cuts in production. During times of expanding sales, businesses had to scramble to replenish inventory stocks, leading to sharp, brief spikes in production.
Over the last two decades, this destabilizing inventory behavior has diminished significantly. Advances in information systems that track sales and inventories, reorder inventory automatically, and shorten production and delivery times have allowed businesses to be more timely in their responses to changes in demand, with the result that inventory investment no longer plays as prominent a role in economic fluctuations. Inventory-to-sales ratios have declined steadily over the past two decades, most notably in the durable goods sector.
Technology also is the major factor in the pickup in productivity growth that the United States has experienced since the mid-1990s. As has been well-documented, growth in labor productivity has been roughly 1 percentage point faster since 1996 than it was in the prior twenty-two years and close to the average of the strongest years of the early postwar period. This key driver of our economy allows us to grow faster without increasing the threat of inflation.
Thus, technology underpins a higher potential growth rate and more moderate business cycles. But another implication of technology is continuous change and what Joseph Schumpeter called "creative destruction," the rise of new firms, the renewal of old firms, and the failure of firms that do not innovate. This process of creative destruction is important in providing at least a partial explanation for the unusually slow and gradual recoveries and low job growth we have seen after the last two recessions.
An economy undergoing structural change is of necessity continuously creating and destroying jobs. During recessions, fewer jobs are created and more are destroyed. Until the early 1980s, these structural changes were small. The predominant employment dynamic was for cyclical industries to lay off workers temporarily in recessions and rehire them in the early recovery. Since 1980, however, we have seen that in each recession and early recovery, a falling share of job gains and losses was cyclical. Rather, the recession and early recovery have become especially intense periods of structural change. When we examine job gains and losses by industry in the last two cycles, we see that industries that added jobs did so both in recessions and in recoveries. Industries that lost jobs also did so in recessions and in recoveries. Job gains and losses thus provide a simple way to distinguish growing from shrinking industries.
A further explanation for the shallow recessions and slow recoveries of the recent past may have to do with the labor market. In recessions involving mainly temporary cyclical layoffs, firms require little time and cost to rehire workers and resume higher production levels. In recoveries involving substantial structural change, where workers are permanently laid off and need to seek employment in another sector, the time and resources required to complete the adjustment are greater and thus the recovery is slower.
These developments point to an important challenge our economy faces. Namely, how can we help to develop further flexibility in our markets and in our workforce to allow for the smoothest possible reallocation of resources across our economy as it continues the process of structural change? The question is especially difficult because of the considerable flexibility that already exists in the U.S. labor market.
Nonetheless, there are measures that can be taken. For example, I believe employers need to more fully understand and plan for the likelihood that employees will need to shift careers or locations one or more times over their working lives. We could do so by improving opportunities and offering incentives for education and training throughout a worker's career. To recognize the importance of worker mobility, we could look for further improvements in pension portability and benefits continuity. As employers, we need to communicate more often and more openly with employees and encourage them to be more proactive in augmenting their skills and seeking change over a career, whether in the same job or a new job, with the current employer or a new one.
One contribution to the increased flexibility of our economy in recent decades has been greater financial sector resilience, particularly in the banking industry. In the consumer sector, several decades of improvement in the availability of credit have enabled households to behave very much like the textbook model of consumption behavior: households smooth their consumption over time, taking into account the arc of their income over their lifetimes. For businesses, banks and financial markets have played a major role in supporting the economy through considerable structural change during this recession, a remarkable development when compared with the distress of financial institutions during the 1990-91 recession cycle.
In fact, credit markets have performed better in this recession and recovery than they did in the early 1990s, a period often characterized as a "credit crunch." Credit standards for bank lending began to tighten in 1999, well in advance of the economy's slowing. Although the credit risk appetite of the bond market has fluctuated since it first tightened in the fall of 2000, over the past two and a half years, the banking and bond markets have remained open to virtually all healthy firms and even many speculative-grade firms with stable financial prospects. Credit has flowed steadily to small businesses as well.
This ability to supply credit to strong or relatively stable borrowers reflects much greater discrimination by lenders and investors in the credit markets than was the case in the early 1990s. At their best, financial markets can and should be tough judges of creditworthiness. In an economy characterized by long expansions and by substantial, continuous structural adjustment, making such judgments is difficult but essential. Those judgments mainly involve credit decisions that are based on analyses of the long-run prospects of industries and of firms and their management. The amounts at risk include both the principal of loans, bonds, and other forms of credit and the value of income streams from a variety of fee services that have become a key component in financial services income.
Therefore, the credit and income risks to financial firms today can be substantial -- one reason why financial firms have boosted their capital, diversified their risks, and advanced their risk management techniques over the last decade. Not surprisingly, during the recent downturn, banks and investors have experienced credit losses. But proactive risk management and the healthy capitalization of U.S. banks have allowed these losses to be recognized promptly and to be absorbed without the distress that characterized the early 1990s. Moreover, the market richly rewards this stabilizing behavior. The banking industry has earned record profits in the past two years.
One large shadow in this picture of more effective financial markets, especially in the investment-grade markets, involves corporate governance problems. When I speak about corporate governance, I am speaking about such issues as accounting and disclosure, the composition and independence of the board of directors, and executive compensation. The issues also involve concerns about conflicts of interest and the arrangement of tax-saving and balance-sheet-transforming financial transactions.
Some of you already know how strongly I feel about these issues and the damage they have done. Today, I would like to talk about the linkages between corporate governance and the performance of the economy.
One concern I have is that recovery in the business sector continues to be restrained not just by geopolitical uncertainty and the need for further restructuring in some key sectors, but by caution on the part of investors and lenders. They continue to doubt the quality of internal governance and external oversight, as well as the reliability of the information corporations provide -- in short, critical issues of investor and lender confidence.
Those of us who worked through the banking problems of the early 1990s also faced issues of confidence. At that time, two developments signaled a turnaround to investors and liability holders. The first was a recovery of bank balance sheets as banks worked down their stock of nonperforming loans and raised new capital. The second was an extensive wave of banking and supervisory reforms that continues to benefit us to this day, including key legislation such as the Federal Deposit Insurance Corporation Improvement Act, known as FDICIA.
I particularly want to emphasize the voluntary, self-directed efforts taken by both bankers and their regulators to ensure that such problems will not engulf them again. On the banking side, these efforts have led to important strides in internal risk management, such as developing more comprehensive and timely information systems, strengthening the loan review and audit functions, and providing a better, more organized flow of information to the bank's board of directors.
On the supervisory side, the training of examiners has been strengthened as have the analytical tools we use on the job. At the Federal Reserve Bank of New York, we have reorganized our examinations area in the last few years. We have developed more product and risk specialists, more opportunity for rotation, and more targeted reviews that enable us to stay on top of a rapidly changing industry. Finally, there is a generation of bankers and examiners who experienced the problems of the early 1990s firsthand and are now senior managers in financial institutions and supervisory agencies.
I submit that we have much the same situation today in the sense that we are making improvements in how our institutions are governed and in how the integrity of our markets is safeguarded. The public sector has acted. Congress has passed the Sarbanes-Oxley Act and the Securities and Exchange Commission has promulgated new rules. In the private sector, some leading corporations have taken steps to appoint a presiding director, to increase the number of independent directors on the board, and to introduce other corporate reforms.
We have seen some shareholder activism on the issue of executive compensation. Some have discovered that restricted stock options can be priced after all. And we now have a generation of corporate managers who have witnessed firsthand the enormous human and financial costs of personal improprieties, breakdowns in internal controls, and skewed incentives.
But we cannot really say that we have a wave of reform until we see governance reforms take hold broadly throughout the corporate sector. We need to see more progress on accounting reform, including efforts to strengthen training and governance within accounting firms to prevent the ethical lapses that so plainly occurred. We need to deal with the issue of executive compensation. It is clearly within our competence to address these problems without more legislation. These issues should be a top priority.
What other challenges lie ahead for the banking and financial industry? One immediate challenge for financial institutions, in my view, is to meet the changing product demands of customers and to do so with new, lower cost structures made possible by applying information and communications technology. At the high point of the tech bubble, the potential competitors with financial institutions appeared to be dot-coms offering stand-alone electronic services, with cost advantages that appeared overwhelming.
Many forms of electronic commerce survived the bursting of the dot-com bubble. Electronic bill payment and electronic banking have steadily increased over the last few years. For example, the proportion of banking customers who have used electronic banking has risen from around 8 to 24 percent over four years. Electronic trading platforms and electronic brokerage are essential elements in such core markets as foreign exchange, government securities, and equities. Loan and deposit information can be compared across institutions through the Internet. The streamlining of payment and settlement systems through the use of straight-through processing, central counterparties, and other innovations are continuing to change the architecture of some of the financial system's most essential functions.
Over the last two decades, we have seen dramatic growth in the financial sector, simultaneous with changes in the specific roles of individual banks and other financial firms and in the products and services they offer. Since deregulation began in earnest in the 1970s, financial institutions have shown an astounding ability to adapt or merge. And there certainly is more to come.
Regulators must not stand in the way of these important structural changes. Financial firms must be able to respond constructively to changing conditions, employ new technologies, and take on new risks. The regulatory process needs to be oriented positively to change; it should be timely in delivering decisions -- all the more so given today's short product cycles and the rapidly changing competitive environment.
For their part, financial firms need to bring the necessary capital, management skill, and risk discipline to their activities. Well-managed institutions in strong financial condition should have great freedom. And regulators should pursue with vigor financial institutions that permit incompetence or impropriety.
What do all of these developments mean for our region and our city? The issue of restructuring in the financial industry is especially important for New York City and New York State. Although the national economy has suffered two major shocks, New York City has suffered three: the national recession, the terrorist attacks of September 11, and the restructuring of the financial industry.
New York City is particularly dependent on the financial industry. The financial sector accounts for 15 percent of all jobs in New York City, but roughly 35 percent of the income earned. Jobs in the business services sector, many related to the financial industry, also pay above-average wages. Together, these two sectors account for roughly two-thirds of all income in the city. And when we look at tax revenues, the major swings in New York City revenues reflect the fortunes of the securities industry.
Economists at the Federal Reserve Bank of New York have developed a set of coincident indicators to help forecast the economic outlook for the New York City and New York State economies. These indicators show that the downturn in both the city and the state began early in 2001. In particular, a fairly sharp dropoff in employment in both the city and the state began in early 2001.
The employment count shows that the city's economy sustained a further heavy blow with the destruction of the World Trade Center. We estimate that the city lost around 80,000 jobs in the immediate aftermath of the attack. But once that short and sharp blow was absorbed, developments in employment in the city have broadly mirrored those that have been taking place in the national economy -- namely, a jobless recovery that since the beginning of the year seems to have weakened further.
One reason that the city and state economies have shown some resilience in the recent period is because they were growing strongly before the 2001 recession took hold. For New York City, economic performance in the 1990s was remarkable, as the financial industry boomed and various sectors -- such as the entertainment industry, new media, and health care -- expanded. Moreover, the crime rate came down -- in recent years, it fell below the national average -- and immigration picked up. Similarly, the New York State economy enjoyed robust growth in the 1990s. For the past four years, job growth in the state has roughly matched or exceeded that of the nation. More recently, job losses in most of New York City's suburbs have been fairly mild, while upstate losses have been on a par with the nation.
In the city, optimism continues, as reflected by the continuing willingness of people to make a home here. Housing prices have outpaced the nation since the mid-1990s and continue to do so, a sign of the fundamental strength in the local economy that should help us work our way through the difficult days ahead. Nevertheless, in New York, as in other states and municipalities, the long-term effects of the high-tech bubble have left a more permanent problem.
For example, I discern a general consensus that although the city's economy is still sound, despite its trouble, the structural problems in the budget will not disappear with the resumption of economic growth. During the boom, the long-run trend of revenues was hard to separate from the cyclical and special factors, such as taxes on capital gains and realized stock options that boosted the city coffers. Long-run revenue trends were overestimated; long-run spending trends were accordingly adjusted upward. Today, the city and state governments have begun the difficult task of bringing spending and revenues into better alignment.
Here in the region, therefore, we too are coping with structural change. Technology advances have created benefits for the private sector that could also improve the long-term fiscal outcome of state and local governments. Cities and states could usefully re-examine regulations and governmental practices that limit flexibility for businesses to be established and to grow. Also, cities and states could more aggressively explore new ways of working to enhance their services while reducing costs.
In my remarks this morning, I have focused on the theme of technology and the constancy of change in our economy and our financial system. Technology has helped to account for the increased resilience of the U.S. economy. It has also generated substantial structural change in our economy -- change, as we have seen, that may have its most powerful effects in recessions and early recovery periods.
In turn, flexibility in our labor and financial markets has facilitated the deployment of technology. I believe we can continue to enhance the flexibility of our economy -- particularly in the labor market, the delivery of government services, and the setting of local regulations. And we must move aggressively to resolve the problems of corporate governance.
Clearly, the financial industry has benefited greatly over the last two decades from technology and structural change. At the same time, I believe we may well be in an important period of further structural change in the financial industry -- a period potentially as transforming as the explosion of the capital markets in the 1980s. If so, we as regulators should not impede that transformation, even as we remain committed to maintaining the soundness and stability of the financial system.
If I am correct and we are in a period of rapid structural change in the financial industry, this change will have a major impact on New York City and New York State. In view of the proven ability of the financial industry and our region to adapt to change thus far, as well as, the resilience demonstrated by our city over the last eighteen months, I am confident in our joint capacity to master whatever challenges subsequent change brings to our doorstep.