January 2000
Federal Reserve Bank of Dallas

Drivers of Economic Prosperity

Today we face the end of a decade in which we have seen many significant changes in the economy. The world has witnessed the collapse of communism and the end of the cold war. There has been European monetary union, an expansion of trade and the birth of the commercial Internet. Capital and labor flow between countries as never before in the postwar era and technological innovation continues. Meanwhile, in the United States, we are currently experiencing an economic boom of unprecedented endurance. How are these phenomena related? The 1990s U.S. economy has gone from recession to boom and a look back is warranted. What have been some of the key economic drivers of the 1990s and what do they hold in store for us in the near future?

The changes that have shaped the U.S. and district economies over the last decade can be summarized in a popular format: a top-ten list of what's "in" and what's "out." Much of what is in today, like budget surpluses, did not exist ten years ago. Of those that existed, such as the Internet, drastic transformation over the decade has rendered them barely recognizable.

To a certain extent, the 1990s have witnessed a reduced role of government. We are experiencing budget surpluses—unheard of 10 years ago. Utilities such as electricity are being deregulated and comprehensive banking reform, years in the making, has finally become a reality. Action on fiscal policy changes has been consistent, whether intentionally or not, and the absence of drastic tax code changes has reduced uncertainty for individuals and businesses.

The past decade has also experienced accelerating globalization. Liberalized trade through NAFTA and the World Trade Organization (formerly GATT) Uruguay Round has led to an increased role of trade in the U.S. economy. International flows of capital and labor (international migration) have grown and monetary union in Europe has led to growth in European capital markets (specifically in euro-denominated bond markets).

The role of the stock market has been transformed and amplified. A 1990s theme has been the democratization of capital markets, which has come about through, among other things, the popularity of 401(k) plans. The surge in investor wealth has been dramatic and should lead to some early retirements. The increase in wealth has translated to strong consumption, which in turn has been an important source of growth in this expansion. More than ever the stock market can be considered a source of low-cost capital for firms, the recent flurry of initial public offerings is a case in point. Also, enhanced corporate governance has raised accountability of firm management to shareholders.

Advancements in technology are also in and have led to accelerating productivity. The spreading Information Revolution includes the commercial use of the Internet. Almost every firm now already has a web site or is in the process of constructing one. Telecommunications, cell phones for example, has also changed the pace and efficiency with which we communicate and transmit information.

Some important concepts are also out now as compared with those a decade ago. The economic expansion has held inflation at bay so far, but is inflation really out for good? Implications of the new economy are promising in this respect, but traditional drags such as labor shortages may still be around. Sick banks and the Resolution Trust Corporation (RTC), remnants of the 1980s, are definitely out however—as is Communism. The fall of the Berlin Wall marked the end of the cold war. It also marked the end of the prominence of Japanese and German economic models of which government interventionism was a cornerstone and capitalism a bad word.

Although these topics are listed here as if they were separate and unrelated phenomena, this is not the case. Without the fall of the Berlin Wall and the resulting collapse of communism, European monetary union might not have taken place. There would likely not be government surpluses either. Another example of the synergies in the economy is the rise of the stock market and how the access to low-cost capital has been instrumental in fueling investment. This investment has in turn resulted in technological advancement and increases in productivity growth.

Overview of the Economy
Before studying the drivers of prosperity more closely, the many facets of this expansion need to be reviewed. This section provides an overview of the U.S. and district economies over the last decade.

Currently the economy is on the road to the longest expansion ever. Of the three significant economic expansions in the postwar era: the 1960s witnessed a 105-month expansion, the 1980s a 99-month expansion, and in the 1990s the expansion is now 105 months old and counting.

The expansion has translated to strong growth regionally, with the Dallas Fed District employment growth ahead since 1992. The dominance of Texas is in part due to the remarkably strong employment growth in Austin which has been ongoing since 1992 and is obvious in Figure 4.

Austin is a microcosm of the new economy in the sense that it has the highest concentration of high-tech firms in the state. With a somewhat broader industrial base, the Dallas metropolitan area surged ahead in the mid-'90s, sporting higher employment growth than the other Texas cities (except Austin) in the last five years. Houston, despite further contraction in the oil and gas industry, has also fared well[1] One exception is El Paso, where employment growth has taken a turn for the worse, and the implication may be that there has been some structural adjustment there following the passage of NAFTA.

Behind the success of Texas metropolitan areas is the transformation of a state economy from an energy-dominated economy to a more diversified economic portfolio with particular strengths in electronics and business machinery ("information technology"), wholesale and retail trade ("distribution"), communications and banking.[2 3 4] (Figure 5)

The increased proportion of Texas output attributed to the information technology (IT) sector has been accompanied by large and sustained price declines in computers, microprocessors and memory chips (Figure 6). For example, average annual price declines over the last five years are 28 percent for PCs and 35 percent for microprocessors. Of course, when improvements in the quality of these products are accounted for, the actual price declines are much steeper.

Drivers of Prosperity
On the what's-in list, the drivers of prosperity were denoted as smaller government, globalization, the stock market, productivity increases, and the Information Revolution. The above section demonstrated some of the results of the strength and longevity of the 1990s expansion. In this section the sources of this growth will be discussed.

One source of growth is a reduced role of government in the economy. Is government finally getting out of the way? There has been a budget surplus since 1997 (federal, state and local) and a federal government surplus in 1999 (Figure 7). The last government surplus (federal, state and local) was in 1969 and the last back-to-back surplus was in 1956–57!

One key determinant of government surpluses has been the large decline in military spending—a consequence of Soviet disunion and the collapse of communism (Figure 8). Scaled down military spending has freed up both physical and human capital to be used in the private sector.

An additional source of capital has been foreign investment. Globalization is in and as economic growth has accelerated in the United States, capital has flowed in from the rest of the world, stimulating more investment and hence continued growth. Figure 9 illustrates how capital inflows are the mirror image of the trade deficit.

With accelerating globalization, trade in general has become more important to the U.S. economy over the last decade. In this sense, the United States continues to be an engine of growth for the rest of the world. From a trade perspective, the increased participation of the United States in the global economy is apparent in Figure 10. GDP has grown, but U.S. trade with the world has grown even faster. Free trade agreements, such as NAFTA, and lowered tariffs as provided by the GATT (now WTO) Uruguay Round, have been driving forces behind this trend. NAFTA has been particularly important to our regional economy.

Globalization and a closer integration of markets have meant more trade in physical and financial capital but also more trade in human capital. Why is immigration in? Today's expansion is witness to the lowest unemployment rate in thirty years (Figure 11). And although there have been increases in labor force participation among women and entry into the labor force of thousands of former welfare recipients, reports of labor scarcity abound. Employers have dealt with labor scarcity in a variety of ways including increased perks and nonsalary compensation and where possible, by outsourcing (virtual immigration). However, actual immigration has been more important than previously thought.

Normally the widely discussed labor shortages this far into an economic expansion would have touched off wage and price inflation. Has immigration been an escape valve or does the trade-off between inflation and unemployment not hold true for the economic boom years of the 1990s? The relationship is flat for the 1990s expansion and several factors have been instrumental in keeping this relationship flat over this time. These factors include the role of technology (increases in productivity) and the globalization of markets (heightened competition through increased trade). However, an expanded labor supply through the immigration of workers from around the world has been not only essential, but also underestimated.

So far this decade, legal immigration has brought in more than nine million people. Some interesting institutional changes are obvious in Figure 13. The peak years of 1989-1991 correspond to the 1986 amnesty law known as the Immigration Reform and Control Act (IRCA). Between 1989 and 1991, over three million illegal immigrants residing in the United States had their status legalized as a result of the Reagan amnesty.

The large impact of IRCA proves that a sizable share of immigration to the United States is illegal. This implies that conventional measures of changes in the labor force and the unemployment rate might be far off the mark. As shown in Figure 13, Border Patrol activity suggests illegal immigration may even be on a similar scale as legal immigration. Clearly some of the variation on this chart is due to changes in enforcement manpower and technology; nonetheless, the data are suggestive of annual illegal labor inflows numbering in the hundreds of thousands. This growing clandestine workforce has been an escape valve and helps explain how the economy has come to sustain low inflation rates throughout the recent high growth years.

What has this meant for Texas and the regional economy? The message is just as clear on a local level. International labor flows have been instrumental to growth in the region as well. In fact, one of the main reasons the Dallas District tops the other Fed districts in employment growth is the flow of labor into the state. As Figure 14 shows, since 1995, more than one-half of these flows have been of international origin.

So labor inflows have helped keep inflation down, and most of the expansion has in fact been accompanied by disinflation, as shown by the GDP deflator and the core CPI, which is the CPI less food and energy, in Figure 15. As recently as a year ago, all the inflation indices told this tale of disinflation, but this may no longer be the case.

In fact, recent changes in the overall CPI, the PPI and PCE are suggestive of a resumption of an upward trend in prices. The PCE implicit price index is a broader measure of consumption than the CPI. According to these measures, the outlook for inflation could be changing.

Price stability in recent years has created a favorable climate for the stock market. For now, the stock market is in. Does that mean inflation can end the boom? Well, looking back to the inflationary 1970s (Figure 17) we see that the overall stock market was not a good inflation-adjusted investment. More favorable inflation climates, such as that of the 1980s and 1990s, are correlated with bull markets. By one estimate, the current bull market and strong economy have contributed to an increase in the net worth of the American consumer of more than $12 trillion (in 1996 dollars) since 1990.[5] This tremendous increase in wealth has spurred consumer spending, which in turn has been an important driving force behind much of the current economic expansion.

The increasing importance of the stock market to the economy extends beyond the simple generation of investor wealth and the role of consumption in economic growth. By providing low-cost capital to more firms than ever and by enhancing corporate governance, the stock market has provided both the incentive and the means for firms to invest at unprecedented rates.[6] This investment has triggered technological innovation and increasing labor productivity. As shown in Figure 18, productivity growth is in. It is the highest it has been since the 1960s.

Normally we would expect productivity gains to peter out this far into the business cycle upswing, but no such decline is evident as the expansion approaches its ninth birthday (Figure 19).

The low inflation climate has also spearheaded the recovery of the U.S. banking system. "Sick" banks are most definitely out. Rates of return on assets for U.S. banks have been on a comfortable upward trend since 1989 (Figure 20). Texas banks, after suffering terrible losses in the 1980s, have also recovered. Bank capital ratios tell the same story and now lie between 8 and 9 percent for Texas and U.S. banks as a whole. Since 1994, troubled assets represent less than 1 percent of bank assets (as compared with over 8 percent for Texas banks in 1988 and over 3 percent for U.S. banks in 1990 at the respective highs of the banking crises). Healthy banks are aggressive lenders; hence they have contributed importantly to the current economic boom.

The banking crises resulted in hundreds of failed banks, the majority of which were in Texas (Figure 21). While peaking in 1988–89, bank failures have since declined substantially. Today's economy has fewer and healthier banks, as a result. Of course, Texas was also the hotbed for S&L failures, another sector that has recovered and looks healthy. The RTC once managed hundreds of billions of dollars in troubled assets. Although the RTC has been out since 1995, the lessons for financial system managers around the world remain. In this case, timely resolution of financial system failure minimized the impact of the crisis by preventing it from spreading through the economy. The return to profitability in the sector then provided a healthy banking system with which to foster economic growth. In this regard, it is noteworthy that Japan's economy and financial markets languished for a decade while the sorry condition of its banking system was not addressed.

From banks to the Internet, the high-tech sector has clearly been a driving force in the current expansion and continues to have tremendous potential (Figure 22). It is far from satiated, as less than 40 percent of U.S. households are utilizing Internet services and less than 1 percent of gross retail sales are currently conducted over the Internet. Business-to-business Internet transactions are also promising to be a strong area of growth. Forrester projects that intercompany trade of hard goods over the Internet will hit $43 billion in 1998 and surge to $1.3 trillion by 2003, implying an annual growth rate of 99 percent.

This concludes the discussion of changes responsible for our current period of low-inflation, high-rate economic growth. The next question is, Will the sun ever set? What is necessary to sustain the boom?

Sustainability
Given the right policy choices, the prospects for continued growth are good. If government stays out of the way, the trend to smaller government and the stability of fiscal policy will provide the backdrop for continued growth and hence good prospects for balanced budgets. Therefore, expect more budget surpluses and continued deregulation. Surpluses help keep the national debt in control, further stimulating growth through lower interest rates. The collapse of communism and the reaffirmation of free market principles around the world also suggest there is less of a chance of a resumption in government interventionism and overregulation. Look for immigration to continue. Many forecasters are predicting further decline in the nation's unemployment rate (to 3.9 or 3.8 percent).[7] In times of labor market tightness, the government would do well to consider passing current proposals in Congress that would increase U.S. firms' access to international workers.[8]

The influence of the stock market on growth will not diminish. Democratization of capital markets should continue to facilitate investment by a large range of people and businesses. Just over two years ago, about 20 percent of U.S. households owned equity—now that number is more than 50 percent.

With regard to increased productivity, there is still room for more growth here. Current rates of productivity growth are not unprecedented. The post–World War II era (through the 1960s) experienced even higher rates of productivity growth.

The banking sector is finally being liberated of restrictive regulation through the Gramm–Leach–Bliley Act. The recent legislative reform will pave the way for further expansion in the banking and finance sectors and, hopefully, a more healthy and diversified banking sector.

Investors have clearly forecast further spread of the Information Revolution. For example, Internet company stocks are currently trading at many times conventional measures of their valuations, indicating expectations of high rates of growth in the future. Currently more than half of all venture capital investment goes to Internet-related companies. Growth here is likely to accelerate. Expansion of Internet utilization will further the globalization of markets and hence competition, foster growth through declining transaction costs, and contribute to disinflation. In conclusion, prudent policy decisions mean that the drivers of prosperity will continue to keep the economy on the road to low-inflation growth.

—Harvey Rosenblum, Pia M. Orrenius and Mark G. Guzman

Notes Between January 1995 and November 1999, employment in Dallas grew 21.6 percent, and in Houston, over the same time period, employment grew 16.8 percent.   These industry categories are mostly at the 2-digit level. Information technology includes 35, 36 and 38. Distribution also includes trucking and warehousing.   These shares are real. Nominal shares of Gross State Product are quite different for some categories. Because prices of IT goods have fallen so dramatically and since the price deflator corrects for this, we see much larger change in the contribution of the IT sector as compared with what one sees using nominal shares.   Note that the service sector is growing very quickly over the decade but is not depicted here.   Goldman Sachs U.S. Economic Research.   This refers to the contribution of fixed investment to GDP (almost at 12 percent in the 1990s), the highest of any post–World War II expansion.   These include the Conference Board, Société Générale, JP Morgan, Goldman Sachs, Moody's Investor Services, National Association of Realtors.   As you well know, our own Bank president has been instrumental in bringing these issues to the forefront. Partly as a consequence of President McTeer's opinion editorial in the Wall Street Journal in May 1999, Senator Gramm introduced the New Workers for Economic Growth Act (S. 1440) to the U.S. Senate in July 1999. A companion bill was later introduced to the House of Representatives by David Dreier (H.R. 2698 in August 1999). About In Depth This article is based on a presentation by Harvey Rosenblum, senior vice president, Pia M. Orrenius, economist and Mark G. Guzman, economist, Research Department, Federal Reserve Bank of Dallas. The views expressed are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of Dallas or the Federal Reserve System.