March 10, 2006
JS-4113
Speech to Augusta, Georgia Business Leaders
Assistant Secretary Mark J. Warshawsky
It is a pleasure to be in your lovely city today and to have the opportunity to discuss with you the current state of the U.S. economy. In addition to a general overview, I'd like to devote a few extra moments to looking at two special aspects of economic activity. Given that this is the day of the monthly Department of Labor release on the employment situation, a review of recent labor market developments seems to be in order. Secondly, I'd like to touch on the role of foreign direct investment in the U.S. economy, a topic which is currently receiving considerable public attention.
In recent years, the economy's resilience in the face of a range of unprecedented shocks has been perhaps its most outstanding characteristic. That resilience was evident once again last year in the face of the energy price shock and curtailment of business activity generated by the Gulf of Mexico hurricanes. Despite, at times, record high oil prices, the expansion has continued with solid growth of real GDP, steady job creation, and low core inflation, and remains well-positioned to continue this growth going forward.
The year 2005 marked the fourth straight year of expansion and, in our view, economic performance was right on target. Real GDP grew 3.5 percent on an annual average basis. Personal consumption expenditures rose by 3.6 percent during 2005 while business investment in equipment and software increased at a double-digit pace for the second straight year. Residential building was a source of strength again in 2005: housing starts hit a 33-year high, and single family homes sales posted a fresh record. The economy generated 2 million jobs over the course of the year, and the unemployment rate fell by one-half percentage point to 4.9 percent by year's end.
This performance was particularly remarkable given the continued hike in energy prices. The energy component of the consumer price index rose by 17 percent during 2005 for the second straight year, as hurricanes battered oil- and gas-producing facilities in the Gulf of Mexico. While headline consumer price inflation was 3.4 percent last year, core price inflation (excluding food and energy) remained low at 2.2 percent, the same as in 2004. Part of the explanation for benign core inflation lies in the continued strong growth of productivity, or output per hour. Productivity in the nonfarm business sector grew by a solid 2.5 percent during 2005, virtually the same pace as during 2004. Growth of unit labor costs – the biggest single cost for most businesses – was held to just 1.3 percent last year, helping to restrain inflation. The ability of the economy to grow strongly in the face of the energy price increases without these costs being passed into other prices is a tribute to the flexibility and ingenuity of American business. The economy recovered quickly from the hurricanes and the related spike in energy prices and is now on firm footing.
The economy's trend performance has been good but, as usual, shorter-term movements have been more varied. For example, real gross domestic product rose by a fairly modest 1.6 percent annual rate in the fourth quarter, a deeper look at the GDP numbers shows that growth was restrained by a number of special factors. Real consumer spending slowed to only a 1.2 percent pace after employee pricing incentives in the auto industry pulled motor vehicle sales into the third quarter; oil imports surged to replace domestic oil production disrupted by the hurricanes; and defense spending plunged temporarily because of budget and accounting issues. All of these developments are expected to be transitory.
In fact, we are now far enough along in the first quarter to have a reasonably clear view on how real GDP in this quarter is shaping up and solid growth appears to be underway. Real consumer spending in January was well above its fourth-quarter level and is on track for a significant gain in the first quarter. The manufacturing sector is performing well, with manufacturing output up by 0.7 percent in January, a fourth straight strong monthly gain. Shipments of nondefense capital goods excluding aircraft, a guide to the likely growth of business capital spending, also appears to be poised for a solid gain in the first quarter. Indexes on activity in manufacturing and non-manufacturing from the Institute for Supply Management both point to an improved pace of growth in February.
January foreign trade figures showed strength in both imports and exports. Imports rose in January, led by increases in imports for petroleum products, consumer goods, and auto-related goods. Imports of crude oil were actually down in January. Exports also strengthened in January, rising by 2.5 percent to a record $114.4 billion. As was the case with imports, the export gain was spread widely across major categories. Overall, goods and services exports are running 12 percent ahead of year-earlier levels.
The news on inflation at the start of 2006 shows the split between energy prices and prices in the rest of the economy is continuing. The total consumer price index rose by 0.7 percent in January, boosted by a 5.0 percent jump in energy prices following two large monthly declines. The total CPI for the month was 4.0 percent above the year earlier level. While the overall CPI measure is important, many monitor underlying inflation trends by the core index – consumer prices excluding food and energy. Here the news reasonably good: core prices rose 0.2 percent in January and were up only 2.1 percent over the past year. That's about what core prices have been rising at since the end of 2003.
Strong, steady job growth is the hallmark of a sustainable expansion and labor market developments over the past two and a half years have been quite favorable. Through the first eight months of 2005, nonfarm payroll job growth averaged 175,000 a month, or equivalent to a little more than 2 million annually – the same as during all of 2004. Progress was temporarily delayed last fall by the hurricanes and the attendant hike in oil prices, however. In September and October, only 41,000 jobs were added each month on average as the hurricanes devastated the Gulf Coast area and oil and gas production was shut in. But the economy shook off the effect of the hurricanes quickly. In November, job growth rebounded and has continued to rise strongly in the subsequent months. In February, 243,000 jobs were created and job gains have averaged 228,000 in the four months since October.
Measured from the low point in payroll employment in August 2003 through February of this year, the economy has generated about 5 million new jobs and since June 2003, the unemployment rate has fallen from 6.3 percent to 4.8 percent. This is quite a strong performance, bringing the unemployment rate within a range that many economists consider to represent full employment. Other indicators also suggest that the labor market has hit its stride. Initial claims for state unemployment insurance benefits have recently been at levels last experienced in early 2000 – and those earlier levels were lows for the previous economic expansion. Continued unemployment claims are at five-year lows and the Conference Board consumer confidence survey indicates that consumer perceptions of job availability are at a four-and-a-half year high.
Overall, economic activity appears to be on a steady, sustainable upward path. Most private forecasts for the first quarter point to real GDP growth in the 4 to 5 percent annual rate range, figures that are plausible given the available data. For the entire year, the Administration projects real GPD growth of 3.4 percent and payroll job growth averaging 178,000 a month – results also compatible with most private-sector forecasts.
One of the key reasons for the recent success of the U.S. economy is that it is open to foreign trade and investment. The U.S. is the world's top single market for many goods and services. Producers from around the world compete on a daily basis to bring their goods and services to the vast U.S. market. U.S. consumers benefit because foreign producers are competing in the U.S. marketplace, driving prices down and quality up.
In addition to being an attractive destination for foreign goods and services, the U.S. economy is an attractive place to build and grow businesses. U.S. workers are highly productive, well-trained, and – more than most countries – highly adaptable. We have deep capital markets and comparatively few of the bureaucratic restraints that prevent businesses from starting or growing in other countries. All of these characteristics make the U.S. the destination of choice for capital seeking good returns. In many respects, the pace of the flow of foreign capital into a country is a referendum on the success of the economy. Judging by foreign investment, the U.S. economy is a resounding success.
Foreign investment can flow into a country primarily in two forms: as portfolio capital, (through the purchases of U.S. securities) and as foreign direct investment (the direct purchase of a business). In 2004, about one-fifth of the $12.5 trillion in foreign-owned assets in the United States were in the form of foreign direct investment (FDI). FDI in the United States has grown rapidly over the past decade. In the first three quarters of 2005, net financial inflows for FDI in the U.S. averaged $118 billion at an annual rate – double the average flow of FDI recorded in the mid 1990s.
Canada is the single largest source of FDI in the United States, accounting for 33 percent of all FDI inflows in 2004. The United Kingdom accounted for 20 percent of 2004 FDI flows, and Japan accounted for an additional 17 percent.
U.S. manufacturing is a large recipient of FDI, accounting for 20 percent of all FDI inflows in 2004. Within manufacturing, the biggest recipient industries were chemicals (8 percent of total FDI) and transportation equipment (5 percent of total FDI).
FDI is an important source of high-skilled, high-wage jobs. While the FDI-related data on jobs is collected less frequently than the financial flow data, in 2003, FDI supported a little over 5.2 million jobs in the nonbank sector (i.e. excluding depository institutions) in the United States, or about 5 percent of private nonbank employment. And about 40 percent of all FDI-supported jobs are in manufacturing, a relatively high-paying sector.
Several academic studies have confirmed that FDI-supported jobs pay higher wages on average than jobs at domestically-owned firms. One study suggests the foreign-firm wage premium is as high as 30 percent.
Beyond the direct wage effect of FDI, there is also evidence that in the U.S. a high level of foreign ownership in a given location has a "spillover" effect, causing domestic establishments in the same area to pay higher wages – even domestic firms in other industries. Positive spillovers are not limited to wages. Foreign-owned firms also tend to be more productive than their domestic counterparts, and some of this superior productivity spills over to domestic firms.
It appears that not only do foreign affiliates employ U.S. citizens at higher-than-average wages and generate higher productivity, but that foreign affiliates help spur technological innovation. Research and development expenditures by foreign affiliates in the U.S. are substantial – totaling $29.5 billion in 2003 (latest available) and accounting for about 14 percent of U.S. R&D performed by all U.S. businesses.
About three-quarters of total R&D spending by U.S.-based foreign affiliates is done by manufacturing firms. Among manufacturing industries the biggest spender is chemicals (43 percent of all R&D spending in manufacturing), followed by computers and electronic products (23 percent spending in manufacturing). U.S.-based affiliates of European firms perform the most R&D in the U.S., accounting for 75 percent of total R&D spending by foreign affiliates. U.S.-based affiliates of firms headquartered in Asia and the Pacific region account for about 12-1/2 percent of total foreign R&D spending in the United States. Roughly 90 percent of Asia/Pacific R&D spending here is performed by Japanese companies.
Overall, it appears that one reason the U.S. economy is so vibrant and resilient, and on the cutting edge of economic innovation, is that we are open to foreign products, foreign ideas, and foreign capital. A recent careful study suggests that FDI has helped to raise both overall U.S. economic growth and total factor productivity growth. Now among economists, raising total factor productivity – the part of productivity that is not the result of more machines or a better-educated workforce -- is the key to a sustained increase in the standard of living. But economists have had a hard time figuring out exactly what to do to increase total factor productivity. Research suggests that at least a partial recommendation is to encourage FDI.
Looked at this way, foreign investment is an important component of future U.S. economic growth. But our investment in business abroad is also a key element in maintaining strong growth and high levels of innovation. At the end of 2004, the U.S. held about $3.3 trillion in directly invested assets abroad. From 1982 through 2004, our return on these foreign assets has averaged about 7.6 percent. That return was considerably above the 2.2 percent average rate earned by foreigners in the U.S. As a result U.S. investment income from investments abroad is larger than the outflow to foreigners. The income we receive on these foreign holdings gets spent in the U.S., supporting overall income and job growth. If these foreign opportunities were not available to U.S. investors, the overall rate of return on U.S. capital would be lower and U.S. GDP and employment would be smaller.