A little while ago, Federal Reserve Chairman Alan Greenspan appeared before the House Committee on Financial Services for his semiannual update on the health of the U.S. economy.

Greenspan gets a lot of grief, much of it deserved, for his reporting style, better known as "Greenspeak," to some an often indecipherable way of putting things. But if you read his statements, they actually represent a good lesson on the economy and the markets. His opinions and forecasts are not always right (whose are), but since this link, in particular, is designed to educate, I thought I would take some of his thoughts from his 7/18/01 and 2/27/02 appearances.

There are a few overriding themes in the following; a focus on demand, inventories, consumer spending, innovation / productivity, the overall strength of the economy, and, of more import in his latter take, a renewed focus on debt and risk. Keep these ideas in mind as you read his statements.

Finally, while he refuses to admit it, Greenspan was far too optimistic on productivity in his 7/01 speech and he continues to wrestle with the idea that there must be a better way to forecast future demand in the economy. Well, there isn't. There are simply too many variables, 9/11 just being one example. And I would also urge you to read his 2/02 conclusions on what to me is a huge issue going forward, derivatives. He is as blunt as he has ever been on this topic.

What follows are the chairman's exact words. Again, these are excerpts.

July 18, 2001

By aggressively easing the stance of monetary policy, the Federal Reserve has moved to support demand and, we trust, help lay the groundwork for the economy to achieve maximum sustainable growth. Our accelerated action reflected the pronounced downshift in economic activity, which was accentuated by the especially prompt and synchronous adjustment of production by businesses utilizing the faster flow of information coming from the adoption of new technologies. A rapid and sizable easing was made possible by reasonably well- anchored inflation expectations, which helped to keep underlying inflation at a modest rate, and by the prospect that inflation would remain contained as resource utilization eased and energy prices backed down.

In addition to the more accomodative stance of monetary policy, demand should be assisted going forward by the effects of the tax cut, by falling energy costs, by the spur to production once businesses work down their inventories to more comfortable levels, and, most important, by the inducement to resume increases in capital spending. That inducement should be provided by the continuation of cost-saving opportunities associated with rapid technological innovation. Such innovation has been the driving force raising the growth of structural productivity over the last half-dozen years. To be sure, measured productivity has softened in recent quarters, but by no more than one would anticipate from cyclical influences layered on top of a faster long-term trend.

But the uncertainties surrounding the current economic situation are considerable, and, until we see more concrete evidence that the adjustments of inventories and capital spending are well along, the risks would seem to remain mostly tilted toward weakness in the economy.

...Because the extent of the slowdown was not anticipated by businesses, some backup in inventories occurred, especially in the United States. Innovations, such as more advanced supply-chain management, and flexible manufacturing technologies, have enabled firms to adjust production levels more rapidly to changes in sales. But these improvements apparently have not solved the thornier problem of correctly anticipating demand.

...At some point, inventory liquidation will come to an end, and its termination will spur production and incomes. Of course, the timing and force with which that process of recovery plays out will depend on the behavior of final demand. In that regard, the demand for capital equipment, particularly in the near term, could pose a continuing problem. Despite evidence that expected long-term rates of return on the newer technologies remain high, growth of investment in equipment and software has turned decidedly negative. Sharp increases in uncertainties about the short-term outlook have significantly foreshortened the time frame over which business are requiring new capital projects to pay off. The consequent heavier discounts applied to those long-term expectations have induced a major scaling back of new capital spending initiatives, though one that presumably is not long-lasting given the continuing inducements to embody improving technologies in new capital equipment.

...But there are also downside risks to consumer spending over the next few quarters. Importantly, the same pressure on profits and the heightened sense of risk that have held down investment have also lowered equity prices and reduced household wealth despite the rise in home equity. We can expect the decline in stock market wealth that has occurred over the past year to restrain the growth of household spending relative to income, just as the previous increase gave an extra spur to household demand. Furthermore, while most survey measures suggest consumer sentiment has stabilized recently, softer job markets could induce a further deterioration in confidence and spending intentions.

While this litany of risks should not be downplayed, it is notable how well the U.S. economy has withstood the many negative forces weighing on it. Economic activity has held up remarkably in the face of a difficult adjustment toward a more sustainable pattern of expansion.

...The period of sub-par economic performance, however, is not yet over, and we are not free of the risk that economic weakness will be greater than currently anticipated, and require further policy response. That weakness could arise from softer demand abroad as well as from domestic developments. But we need also to be aware that our front-loaded policy actions this year coupled with the tax cuts under way should be increasingly affecting economic activity as the year progresses.

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February 27, 2002

Since July, when I last reported to you on the conduct of monetary policy, the U.S. economy has gone through a period of considerable strain, with output contracting for a time and unemployment rising. We in the Federal Reserve System acted vigorously to adjust monetary policy in an endeavor both to limit the extent of the downturn and to hasten its completion. Despite the disruptions engendered by the terrorist attacks of September 11, the typical dynamics of the business cycle have re-emerged and are prompting a firming in economic activity. An array of influences unique to this business cycle, however, seems likely to moderate the speed of the anticipated recovery.

...If ever a situation existed in which the fabric of business and consumer confidence, both here and abroad, was vulnerable to being torn, the shock of September 11 was surely it. In addition to the horrific loss of life, enormous uncertainties accompanied the unfolding events and their implications for the economy. Indeed, for a period of weeks, U.S. economic activity did drop dramatically in response to that shock.

...As the fourth quarter progressed, business and consumer confidence recovered, no doubt buoyed by successes in the war on terrorism. The improved sentiment seemed to buffer the decline in economic activity.

Indeed, in the past several months, increasing signs have emerged that some of the forces that have been restraining the economy over the past year are starting to diminish and that activity is beginning to firm. The appearance of these signs, in circumstances in which the level of the real federal funds rate was at a very low level, led the Federal Open Market Committee to keep policy unchanged at its meeting in late January, although it retained its assessment that the risks were tilted toward economic weakness.

One key consideration in the assessment that the economy is close to a turning point is the behavior of inventories. Stocks in many industries have been drawn down to levels at which firms will soon need to taper off their rate of liquidation, if they have not already done so. Any slowing in the rate of inventory liquidation will induce a rise in industrial production if demand for those products is stable or is falling only moderately. That rise in production will, other things being equal, increase household income and spending. The runoff of inventories, even apart from the large reduction in motor vehicle stocks, remained sizable in the fourth quarter. Hence, with production running well below sales, the lift to income and spending from the inevitable cessation of inventory liquidation could be significant.

But that impetus to the growth of activity will be short-lived unless sustained increases in final demand kick in before the positive effects of the swing from inventory liquidation dissipate. Most recoveries in the post-World War II period received a boost from a rebound in demand for consumer durables and housing from recession-depressed levels in addition to an abatement of inventory liquidation. Through much of last year's slowdown, however, spending by the household sector held up well and proved to be a major stabilizing force. As a consequence, although household spending should continue to trend up, the potential for significant acceleration in activity in this sector is likely to be more limited than in past cycles.

In fact, there are a number of cross currents in the outlook for household spending. In recent months, low mortgage interest rates and favorable weather have provided considerable support to homebuilding. Moreover, attractive mortgage rates have bolstered the sales of existing homes and the extraction of capital gains embedded in home equity that those sales engender. Low rates have also encouraged households to take on larger mortgages when refinancing their homes. Drawing on home
equity in this manner is a significant source of funding for consumption and home modernization. The pace of such extractions likely dropped along with the decline in refinancing activity that followed the backup in mortgage rates that began in early November. But mortgage rates remain at low levels and should continue to underpin activity in this sector.

...Changes in household financial positions in recent years are probably damping consumer spending, at least to a degree. Overall household wealth relative to income has dropped from a peak multiple of about 6.3 at the end of 1999 to around 5.3 currently. Moreover, the aggregate household debt service burden, defined as the ratio of households' required debt payments to their disposable personal income, rose considerably in recent years, returning last year to its previous cyclical peak of the mid-1980s.

...Although the macroeconomic effects of debt burdens may be limited, we have already seen significant spending restraint among the top fifth of income earners, presumably owing to the drop in equity prices. The effect of the stock market on other households' spending has been less evident. Moderate-income households have a much larger proportion of their assets in homes, and the continuing rise in the value of houses has provided greater support for their net worth. Reflecting these differences in portfolio composition, the net worth of the top fifth of income earners has dropped far more than it did for the bottom 80 percent.

...Perhaps most central to the outlook for consumer spending will be developments in the labor market. The pace of layoffs quickened last fall, especially after September 11, and the unemployment rate rose
sharply.... Even if the economy is on the road to recovery, the unemployment rate, in typical fashion, may resume its increase for a time, and a soft labor market could put something of a damper on consumer spending.

...The retrenchment in capital spending over the past year and a half was central to the sharp slowing we experienced in overall activity. The steep rise in high-tech spending that occurred in the early post-Y2K months was clearly not sustainable. The demand for many of the newer technologies was growing rapidly, but capacity was expanding even faster, and that imbalance exerted significant downward pressure on prices and the profits of producers of high-tech goods and services.

...Recent evidence suggests that a recovery in at least some forms of high-tech investment could already be under way. Production of semiconductors, which in the past has been a leading indicator of computer production, turned up last fall. Expenditures on computers rose at a double-digit annual rate in real terms last quarter. But the contraction of investment expenditures in the communications sector, where the amount of overcapacity was substantial, as yet shows few signs of abating, and business investment in some other sectors, such as aircraft, hit by the drop in air travel, will presumably remain weak this year.

On balance, the recovery in overall spending on business fixed investment is likely to be only gradual; in particular, its growth will doubtless be less frenetic than in 1999 and early 2000 - a period during which outlays were boosted by the dislocations of Y2K and the extraordinarily low cost of equity capital available to many firms.

[Following is an extremely important statement on financial derivatives, at least in my opinion.]

Although the fears of business leverage have been mostly confined to specific sectors in recent years, concerns over potential systemic problems resulting from the vast expansion of derivatives have reemerged with the difficulties of Enron. To be sure, firms like Enron, and Long-Term Capital Management before it, were major players in the derivatives markets. But their problems were readily traceable to an old fashioned excess of debt, however acquired, as well as to opaque accounting of that leverage and lax counterparty scrutiny. Swaps and other derivatives throughout their short history, including over the past eighteen months, have been remarkably free of default. Of course, there can be latent problems in any market that expands as rapidly as these markets have. Regulators and supervisors are particularly sensitive to this possibility. Derivatives have provided greater flexibility to our financial system. But their very complexity could leave counterparties vulnerable to significant risk that they do not currently recognize, and hence these instruments potentially expose the overall system if mistakes are large.

...(Concluding)...The U.S. economy has experienced a substantial shock, and, no doubt, we continue to face risks in the period ahead. But the response thus far of our citizens to these new economic challenges provides reason for encouragement.

Source: The Federal Reserve Board

Next week: the 1830s.

Brian Trumbore