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21–981 PDF 2005

S. HRG. 109–54

FEDERAL RESERVE’S FIRST MONETARY POLICY

REPORT FOR 2005

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

FEBRUARY 16, 2005

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

PEGGY R. KUHN, Senior Financial Economist

MARTIN J. GRUENBERG, Democratic Senior Counsel

AARON D. KLEIN, Democratic Economist

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

WEDNESDAY, FEBRUARY 16, 2005

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 1

Senator Bunning ............................................................................................... 3

Senator Reed ..................................................................................................... 4

Senator Crapo ................................................................................................... 5

Senator Schumer .............................................................................................. 5

Senator Dole ...................................................................................................... 6

Senator Stabenow ............................................................................................. 7

Senator Bennett ................................................................................................ 8

Senator Bayh .................................................................................................... 8

Senator Martinez .............................................................................................. 8

Senator Dodd .................................................................................................... 9

Senator Corzine ................................................................................................ 9

Senator Carper ................................................................................................. 42

Senator Allard ................................................................................................... 48

WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 10

Prepared statement .......................................................................................... 48

Response to written questions of:

Senator Bennett ........................................................................................ 53

Senator Santorum ..................................................................................... 53

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, February 16, 2005 .............................. 56

(III)

(1)

FEDERAL RESERVE’S FIRST MONETARY

POLICY REPORT FOR 2005

WEDNESDAY, FEBRUARY 16, 2005

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:02 a.m., in room SD–G50, Dirksen

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order. We are very

pleased this morning to welcome Chairman Greenspan before the

Senate Banking Committee to testify on the Federal Reserve’s

Semi-Annual Monetary Policy Report to the Congress.

Chairman Greenspan, at its meeting earlier this month, the Federal Open Market Committee, FOMC, raised its target for the Federal funds rate by 25 basis points to 2.5 percent, the sixth increase

since June 2004, when the FOMC began raising the target rate

from a low of 1 percent. The FOMC has been consistent in noting

that its policy is one of accommodation and that changing the accommodative stance will be done in a ‘‘measured’’ fashion.

The U.S. economy, I believe, has responded well, in turn, with a

continuing expansion. Real GDP increased 3.1 percent in the fourth

quarter of 2004. We can now also point to a strong job growth with

payroll employment increasing at an average of 181,000 jobs per

month in 2004. On the unemployment front, the unemployment

rate decreased to 5.2 percent in January, falling half a percentage

point from the previous January.

This morning, we will have ample opportunity to discuss in

greater detail the Federal Reserve’s performance in carrying out

monetary policy and its views on the future direction of our Nation’s economy. I look forward to raising a number of issues during

our discussion.

Mr. Chairman, again, we are pleased to have you with us, and

we look forward to discussing with you the necessary actions we

must take to ensure that our economy grows and prospers in the

coming years.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Chairman Shelby. I

am pleased to join you in welcoming Chairman Greenspan before

the Committee on Banking, Housing, and Urban Affairs this mornVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
2

ing to testify on the Federal Reserve’s Semi-Annual Report to Congress on Monetary Policy.

Chairman Greenspan’s testimony on the Fed’s monetary policy

report is always widely anticipated by the Congress, the press, the

financial markets, and the public, as witness the large crowd in

this room this morning. In addition, I believe this is Chairman

Greenspan’s first testimony this year before any Committee of Congress. So, I suspect that that heightens the expectation.

The Federal Reserve Act requires the Board of Governors to submit a report to Congress by February 20 and July 20 of each year

on the conduct of monetary policy. It also requires the Chairman

of the Federal Reserve to testify before the Congress on both of

those reports.

Chairman Shelby, I would like, at the outset, to take note of a

decision announced by the Federal Open Market Committee, on

December 14, to expedite the release of the minutes of the FOMC

meetings. Beginning with the December 14 meeting, the minutes

of regularly scheduled meetings will be released 3 weeks after the

date of the policy decision, as I understand it. The previous policy

was to release minutes of the FOMC meeting after the next FOMC

meeting, usually a period of 6 weeks or more.

This move is consistent with previous actions by the Federal

Open Market Committee to announce its policy decisions immediately after its meetings to provide some explanation of the basis

for the decision in the announcement. In my view, greater transparency in the FOMC’s decisionmaking process is of great benefit

both to the operations of the market and to the public. This is an

effort which Chairman Greenspan has led during his tenure, and

I think it constitutes an important legacy at the Federal Reserve

and, Chairman Greenspan, I commend you and your colleagues for

this most recent step.

Chairman Shelby, I listened to your review of the economy, and

it all goes to show whether the glass is half-full or half-empty and

how you perceive it. Because I, actually, have concerns about——

Chairman SHELBY. We are trying to fill it up.

[Laughter.]

Senator SARBANES. Yes. —the outlook for the U.S. economy and,

therefore, about our current monetary policy, and I want to raise

those just briefly this morning.

As you noted, the Federal Open Market Committee raised the

Federal funds rate another quarter of a point at its last meeting.

This was the sixth consecutive quarter-point increase by the FOMC

in less than 8 months. It has now gone from 1 to 2.5 percent. It

seems to me that, while the Federal Open Market Committee apparently feels that this pace can be continued, I think there is some

cause for concern. The GDP growth in the fourth quarter actually

slowed to 3.1 percent, well below the rate most experts consider our

potential growth rate.

In my view, the labor market remains relatively weak. Employers added 146,000 payroll jobs in January, 157,000 in December,

137,000 in November, all of which are just about enough to keep

pace with population growth.

Now, while the Labor Department reported last week that the

unemployment rate dropped in January to 5.2 percent, from 5.4

3

percent in December, it was mostly because of a decline in the

number of people looking for work. In fact, most of the decline in

the unemployment rate over the last year occurred because of a decline in the share of people looking for work not because of a higher

share with jobs. Capacity utilization in our Nation’s factories remains at low levels. In fact, figures were released this morning

that capacity utilization fell to 79 percent. December’s level had

been reported as 79.2 percent, but had been revised downward by

a tenth of a point. Wages are rising more slowly than inflation. The

economy is still in the situation of three-quarters of a million fewer

private-sector jobs than existed when President Bush took office

over 4 years ago. Over 20 percent of those who are unemployed are

long-term unemployed; in other words, have been unemployed for

more than 26 weeks. This has been continuous now for the last 28

months, that more than 20 percent of the unemployed are longterm unemployed, which sets a record.

The Fed said, in its statement, ‘‘Inflation and longer-term inflation expectations remain well contained.’’ Given this, it seems to

me that the Fed should consider now taking a pause from its policy

of interest rate increases to see how the economy develops in the

first part of this year. Some expect that economic growth will slow

and, given that, it seems to me worth considering, and I commended to the Chairman the possibility of pausing to survey where

we are and assuring ourselves that the economy is, indeed,

strengthening and can withstand continuing to raise interest rates.

And I look forward to pursuing that with the Chairman in the

course of his appearance here this morning.

Thank you very much, Mr. Chairman.

Chairman SHELBY. Thank you, Senator Sarbanes.

Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman. I appreciate you

coming, Chairman Greenspan, for your second-to-last Federal Reserve Semi-Annual Monetary Report. Though some may not believe

this, I really do appreciate you coming up here. I am sure coming

up here is like going to the dentist for you, and I am probably the

dentist.

[Laughter.]

Your testimony is very important before this Committee, and we

have a lot of people waiting with bated breath to hear your

thoughts about the state of our economy. I hope I will be happy

and the people whose lives can be directly affected by your comments are happy when this hearing concludes.

I, like most of the people in this room, will be paying particularly

close attention to any insight you may give us about whether the

FOMC will continue its current tack of ‘‘measured accommodation’’

of monetary policy. Of course, that is the $64,000 question, and I

am sure you will do your best not to give us a hint of what the

FOMC will do at its next meeting.

Once again, I will be asking about the persistence and presence

of inflation in our economy, the same question I ask you every time

you come before us to give your report. If you do not see any evidence of inflation, I would hope you would take that into account,

4

in a big way, during the next FOMC meeting. You do not have to

raise rates just because many expect it. Low interest rates are not

necessarily a bad thing.

I will take this opportunity to bring up one other pet peeve of

mine, and I do it a lot. You will be asked a number of questions

over the next 2 days that have nothing to do with your job. I know

every time you come here, you are asked every question under the

sun. Just remember, you do not have to answer those questions.

You do not have to testify on subjects that are really not part of

the Fed’s jurisdiction. We will try to suck you in, but please do not

succumb.

Once again, thank you, Chairman Greenspan, for coming before

us today. I look forward to your response during the question and

answer period.

Thank you.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman, and welcome, Chairman Greenspan.

Four years ago, we found ourselves at a crossroads, and the Administration chose a path that led from record surpluses to record

deficits, both in our fiscal accounts and our current accounts, our

trade balance overseas, and much of that is being financed now by

foreign central banks. And we have the opportunity, I would suspect, the obligation to try to change that course.

The Congressional Budget Office has estimated that the Federal

budget deficit for fiscal year 2005 will be $368 billion. That does

not include an $80-billion supplemental for Iraq and more than

likely another $50-billion supplemental next year, given the troop

sizes we will have in Iraq. It does not include cost of Social Security privatization, whatever they may be, and it does not include

other operations. We have record deficits, stemming primarily from

the tax cuts and from the steadily increasing spending for needed

defense and homeland security measures.

Another aspect of the President’s budget for 2006 is the cutting

of numerous entitlement and domestic discretionary programs

without effectively reining in the deficit. And many of these programs go to the heart of building human capital, the education system, and other systems that will, I think, over time help increase

our productivity. And so we are dangerously underfunding those

programs. Once again, there are major issues left out—the war in

Iraq, alternative minimum tax reform, $1.6 trillion in extension of

expiring tax cuts, and associated debt service. So this is a rather

bleak picture of fiscal discipline.

You have reminded us already, Mr. Chairman, back in February

2002, that to the extent that we would be owing debt to other sovereign governments, in that respect there is a difficulty. We have

a serious difficulty at the moment. You, also, state in April 2002,

talking about current account deficits, countries that have gone

down this path have invariably run into trouble, and so would we.

Eventually, the current account deficit will have to be restrained,

and no one is anticipating any restraint at the moment.

5

Now, given this context for important decisions, we are facing

critical choices about extending on a permanent basis expiring tax

cuts for wealthy Americans. We are, also, according to the President’s Social Security, rather, contemplating borrowing trillions of

dollars to create private accounts.

I am deeply concerned about the direction the President is taking

in terms of our Nation’s commitment to providing retirement security to the elderly and income security to disabled widows and surviving families. Many people do not recognize that about 30 percent

of the recipients of Social Security are not the elderly, they are disabled or widows, or surviving families.

We all acknowledge that the long-term fiscal imbalance of the Social Security trust fund must be addressed. However, it is equally

critical to recognize that the concept of private accounts being advanced by the President does absolutely nothing to address this

imbalance. In fact, diverting payroll tax revenues exacerbates insolvency and accelerates the date of trust fund imbalance. Now, more

than ever, Social Security occupies a critical role in ensuring this

retirement is secure, especially at a time when the country is saving so little and fewer employers are offering the security of defined benefit pension plans. Defined benefit pension plans comprise

61 percent of all pension plans in 1980. By 2001, that number had

dropped to 25 percent, and this trend is only further exacerbated

by the solvency issues faced by the Pension Benefit Guarantee Corporation, which has been absorbing more failed employer-sponsored

defined benefit plans.

So, Mr. Chairman, we have a serious set of issues before us and,

as always, we look forward to your response to these issues.

Thank you very much, Mr. Chairman.

Chairman SHELBY. Senator Crapo.

COMMENTS OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman. Chairman

Greenspan, we welcome you here again. I am not going to give a

long opening statement. I am going to listen very closely to your

comments. We are very interested in your discussion with us about

the status and the prospects of the U.S. economy and whether it

is the issue of tax policy or derivatives, as you know, is a very critical issue to me or Social Security or entitlement spending. I think

that the issues that we are prepared to go into with you today are

those on which you can provide us some very significant insight,

and I look forward to it.

Thank you for coming.

Chairman SHELBY. Senator Schumer.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you very much, Mr. Chairman, and I,

too, want to welcome my friend and someone who has been just a

superlative Chairman of the Federal Reserve Board. He has a reputation—deserved—as a straight shooter and somebody who is

really brilliant on monetary policy and economic policy. And that

is why, when he comes here, we all want to ask him a whole lot

of questions because we respect his judgment so.

6

My view, Mr. Chairman, is that if we left things to you, and I

think the way you have handled monetary policy in the last few

years has been excellent. I think the steps where the market has

certainty and knows exactly what you are doing is a very good

idea, provided the economy continues to move along at this pace—

Senator Sarbanes mentioned that it may not—and then, of course,

it would have to be reexamined.

Down the road, on Pennsylvania Avenue, we tend to mess things

up. And I am truly worried about the debt, and particularly the

added debt that Social Security could create in terms of the privatization of accounts. I think they are ideologically driven, frankly.

I do not think they fall within the rubric of fixing Social Security,

of, as I would call it, ‘‘mend it not end it.’’ I think, rather, there

are a group of people who want to prove that every Government

program does not work and, therefore, they have come up with socalled ‘‘privatization.’’ That is what they want to do is privatize.

Now, they do not want to call it that because the public does not

like it, but I think the name has stuck. The junk bond dealers tried

to change the name of junk bonds for years, and they are still referred to as junk bonds 10 years later. I know they want them to

call them high-yield bonds, but these personal accounts, there is

privatization, and private accounts, and they are going to stick.

My view, you have been a strong voice for restraining our fiscal

policies. We have disagreed on some of the tax cuts, but you have

always talked about PAYGO, and you talked as early as 2001, I believe it was—it may have been 2000—of creating a glide path,

which reduces the debt to as close to zero as possible. We had that

under the Clinton years. We have lost it in the Bush years. My one

criticism of your nonmonetary aspects of your policy is that you

would speak out strongly, but I will be very interested in your

views of privatization and whether the so-called ‘‘gain of privatization,’’ having Joe and Jane Smith be able to manage a little bit of

their own money in some kind of account, is equal to the huge

amount of debt that it would throw on the shoulders of our already

burdened Government.

We are giving a birth tax to every child born in America now of

about $15,000. If we do all the things Senator Reed mentioned,

that birth tax will double to $30,000, and I do not think that is

good for the newborns. I do not think it is good for the economy,

and I am interested in your views and hope you will give us a

straightforward answer about the effects of privatization on debt.

Thank you, Mr. Chairman.

Senator Dole.

STATEMENT OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Mr. Chairman. Welcome, Chairman

Greenspan.

Two weeks ago, when the Federal Open Market Committee

raised its target for the Federal funds rate and the discount rate

by 25 basis points, the release noted robust underlying growth and

productivity, a gradually improving labor market and moderate

growth in output. All of these, coupled with low inflation, appear

to indicate a positive track for economic expansion in the coming

years.

7

While these trends certainly are pleasing, I continue to be concerned about the slower pace of job creation. As you well know, the

State of North Carolina has experienced dramatic losses in manufacturing employment. While the whole economy trends positively,

we continue to focus special attention on those who lost their jobs

due to the inability of their companies to compete with foreign

firms that operate with dramatically lower-cost structures.

We must equip our Nation’s poorest citizens with the necessary

tools to take advantage of new jobs created by the expanding economy. To this end, I continue to make strengthening our community

colleges a top priority.

I have spoken before about the work that Senators Enzi, Alexander, and I undertook last year. In addition to the President’s

$125-million proposal to establish a new community college access

grant program, our bill provides increased assistance to our community colleges and other institutions of higher learning for training and retraining of students in high-growth job markets. I look

forward to working again on this legislation with my colleagues in

this session of Congress.

I, also, remained concerned about high energy prices, the rise in

steel prices and the size of our trade deficit. In December, leaders

in the City of Charlotte, North Carolina, and I were shocked to discover that the contracts for the South Corridor Light Rail construction came in at $30 million over estimates due to the increases in

steel and concrete prices. It was explained that this dramatic rise

in price was caused by China’s growing demand for steel and concrete. Despite these concerns, though, I am confident that through

increased trade, hard work, global communications, and continuing

education of our workforce, we will achieve new levels of opportunity and global security for all Americans. I look forward to hearing from you on these and other matters, Chairman Greenspan.

Thank you for joining us today.

Chairman SHELBY. Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman, and welcome, Mr.

Chairman. It is wonderful to see you, again, and I want to join my

colleagues in thanking you for your leadership and service over the

last 16 years. We truly have appreciated and relied on your judgments and your thoughts, and I have appreciated, also, the opportunity to talk with you both privately in my office, as well as on

other occasions, about what we are facing in terms of out-of-control

deficits.

I know you have warned us, since I was in the House of Representatives, and, by the way, I was very proud of the fact, coming

into the U.S. House in 1997, that we balanced the budget for the

first time in 30 years. We, unfortunately, now have gone from the

largest surpluses in the history of the country projected in 2001 to

the largest deficits, and that is deeply, deeply disturbing, and I am

very interested in your current thinking as it relates to our economic environment with the deficit and the sustainability of that

and, in fact, the ethic and responsibility that we all have to address

that. I view that as a major moral issue.

8

The President would have us believe that Social Security, in 13

years, is going bankrupt even though we know that is not accurate.

We do know that there is a gap, 40 or 50 years down the road, and

I am confident that working with my colleagues that we will address that.

But what we are hearing from the President is that his sugges- tion as a way to fix it is to hoist an additional $5 trillion of national

debt on American families over the next 20 years, and he calls it

an ownership society. I would argue that what every man, woman

and child will own is an additional $17,000 in debt, on top of what

we already have as a birth tax right now of $15,000. Every time

a child is born, that is our gift to them, in terms of the current national debt. So, I am extremely concerned about where we are

going and the sustainability of that.

Right now, it will require decades for this debt to be fully offset,

and the projected savings being talked about in terms of the savings and the market growth, in terms of privatization of Social Security, ironically, is the same growth that would take care of the

Social Security gap if, in fact, it materialized. And so I would be

interested in your thoughts about that as well.

I am very interested in your discussion in terms of the national

debt, our chronic deficit and, also, what has been raised by my colleagues as troubling trade deficits, which are exploding, and particularly when we look at China and what is happening in terms

of our inability to enforce trade laws and to address the trade imbalances that we have that are causing great havoc in my home

State with manufacturers and others that are asking us for a level

playing field so that they can keep and create more jobs.

So, I thank you, Mr. Chairman.

Chairman SHELBY. Senator Bennett.

COMMENTS OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you, Mr. Chairman. I am going to resist the urge to continue the debate that probably should take place

on the floor and during morning business. But I think, perhaps, the

opening statements are not the place to do that. So, I will simply

pass and look forward to Chairman Greenspan’s testimony.

Senator Bayh.

COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Chairman Shelby. I was interested in

Senator Bunning’s dentist analogy. And not wanting to apply anesthetic to the patient, I will take a pass on my own remarks.

Mr. Chairman, I look forward to your comments about the critical issues that face us, and thank you for joining us today.

Chairman SHELBY. Senator Martinez.

COMMENTS OF SENATOR MEL MARTINEZ

Senator MARTINEZ. Mr. Chairman, thank you very much and,

Mr. Chairman, thank you for coming this morning. It is great to

see you, and I look forward to your remarks as well.

I do recall that we worked together on issues in my prior role,

and I look forward to any comments you might make that would

give encouragement to the housing market in America. I think that

9

in spite of what any might say of all Committees in this Senate,

this Committee should be particularly keen on ownership, private

investment and homeownership opportunities, all of which I think

are seeing tremendous record successes in recent days.

And so I would look forward to hearing your comments, particularly with an eye toward those issues that might have impact on

my home State of Florida, as well as something I care deeply

about, which is homeownership, mortgage rates, and things of that

nature.

So thank you, Mr. Chairman, for coming this morning.

Chairman SHELBY. Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you, Mr. Chairman, and I will join my colleagues in welcoming you, Mr. Chairman. It is a pleasure to have

you before this Committee again.

In the words of Morris Udall, ‘‘Everything has been said, but not

everyone has said it,’’ here this morning. So let me just associate

my remarks, briefly, with those of Senator Reed, Senator Schumer,

and Senator Stabenow. I know you are here to talk about monetary

policy, but, obviously, because of the high regard in which we hold

you and the tremendous respect we have for your knowledge about

broader economic issues, while the subject matter is of monetary

policy, obviously, these other issues are of keen interest to all of us

here. I can recall only 4 years ago talking about we have not had

hearings about the dangers of too steep a glide path on retiring the

national debt. It sounds difficult to believe that only 4 years ago

we had that hearing to talk about those issues.

Senator SARBANES. I remember it as though it was yesterday.

[Laughter.]

Senator DODD. But here we are in a very different situation, obviously. With estimates now, we have had to raise the debt ceiling

twice in the last 3 years in excess of $8 trillion. I am worried, as

well, about the amount of resources, the amount of this debt being

held off-shore. And I know you have talked about that in the past,

but the numbers seem to be going up. And the concern I see with

some of these countries purchasing assets, not dollar-denominated

assets, but looking more to the euro and whether or not we should

be worried about that as a country, and so I will be looking forward

to your comments on these matters that have been raised by others, and thank you again for your service.

Chairman SHELBY. Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman, and I will join my

colleagues in welcoming Chairman Greenspan. I truly want to congratulate and thank him for his service.

That said, we all have questions that most have already been

talked about—the twin deficits, and I am anxious to hear your remarks and how and whether you believe we can have a smooth adjustment to dealing with them, particularly the trade deficit, which

is shockingly large, at least from my perspective.

There are, also, some issues though that have not been mentioned, which I am personally quite concerned about. We have had

10

a stagnation of real wages in the country at least in the last 7

years, slow, absolute growth and what I believe will ultimately be

a real problem for the country, a growing concentration of wealth

and income disparity as revealed by statistics and share of population that is actually working is declining. There are a number of

issues that deal with the health of our labor force and, ultimately,

our broader economy that sometimes get pushed off of the discussion for good and proper reasons with regard to some of the major

issues that we debate every day—trade and fiscal deficits and, God

willing, some discussion on rational reform of Social Security.

So, I hope that we cannot forget that these underlying economic

conditions have real impact on people’s lives and the income disparity is growing in this country, and I am certainly anxious to

hear the Chairman’s views and suggestions on what maybe they

need to do to try to at least moderate some of those trends.

Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Greenspan, you proceed as you

wish. Welcome, again, to the Committee.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Thank you very much, Mr. Chairman and

Members of the Committee.

I am, as always, pleased to be here today to present——

Chairman SHELBY. Would you bring the mike just a little closer

to you. We have a huge audience here.

Chairman GREENSPAN. As usual, despite the fact that there is a

DDS sign in front of the Committee, I, nonetheless, feel that it is

a privilege to be here, as always, because I do find this an extraordinarily interesting discussion vehicle, and I trust that many of the

issues will get clarified or, if not that, at least, the level of discussion will get heated sufficiently to engage us in considerable discussion, which I have a suspicion it may well.

In the 7 months since I last testified before this Committee, the

U.S. economic expansion has firmed, overall inflation has subsided,

and core inflation has remained low.

Over the first half of 2004, the available information increasingly

suggested that the economic expansion was becoming less fragile

and that the risk of undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation that

had been in place since the middle of 2003 was no longer warranted and, in the announcement released at the conclusion of our

May meeting, signalled that a firming policy was likely. The Federal Open Market Committee began to raise the Federal funds rate

at its June meeting, and the announcement following that meeting

indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus.

Around the same time, incoming data suggested a lull in activity

as the economy absorbed the impact of higher energy prices. Much

as had been expected, this soft patch proved to be short-lived. Accordingly, the Federal Reserve has followed the June policy move

with similar actions at each meeting since then, including our most

recent meeting earlier this month. The cumulative removal of polVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
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icy accommodation to date has significantly raised measures of the

real Federal funds rate, but by most measures, it remains fairly

low.

The evidence broadly supports the view that economic fundamentals have steadied. Consumer spending has been well maintained

over recent months and buoyed by continued growth in disposable

personal income, gains in net worth, and the accommodative conditions in credit markets. Households have recorded a modest

improvement in their financial position over this period, to the betterment of many indicators of credit quality.

The sizable gains in consumer spending of recent years have

been accompanied by a drop in the personal savings rate to an average of only 1 percent over 2004, a very low figure relative to the

nearly 7-percent rate averaged over the previous 3 decades. Among

the factors contributing to the strength of spending and the decline

in saving have been the developments in housing markets and

home finance that have spurred rising household wealth and allowed greater access to that wealth. The rapid rise in home prices

over the past several years has provided households with considerable capital gains. Moreover, a significant increase in the rate of

single-family home turnover has meant that many consumers have

been able to realize gains from the sale of their homes. To be sure,

such capital gains, largely realized through an increase in mortgage debt on the home, do not increase the pool of national savings

available to finance new capital investment. But from the perspective of an individual household, cash realized from capital gains

has the same spending power as cash from any other source.

More broadly, rising home prices, along with higher equity

prices, have outpaced the rise in household, largely mortgage, debt

and have pushed up household net worth to about 5.5 times disposable income by the end of last year. Although the ratio of net worth

to income is well below the peak attained in 1999, it remains above

the long-term historical average. These gains in net worth help to

explain why households, in the aggregate, do not appear uncomfortable with their financial position even though their reported

personal savings rate is negligible.

For their part, business executives apparently have become

somewhat more optimistic in recent months. Capital spending and

corporate borrowing have firmed noticeably, but some of the latter

may have been directed to finance the recent backup in inventories.

Mergers and acquisitions, though, have clearly perked up.

Even in the current much-improved environment, however, some

caution among business executives remains. Although capital investment has been advancing at a reasonably good pace, it has

nonetheless lagged the exceptional rise in profits and internal

cashflow. This is most unusual. It took a deep recession to produce

the last such configuration in 1975. The lingering caution evident

in capital spending decisions has also been manifested in less-aggressive hiring by businesses. In contrast to the typical pattern

early in the previous business-cycle recoveries, firms have appeared

reluctant to take on new workers and have remained focused on

cost containment.

As opposed to lingering hesitancy among business executives,

participants in financial markets seem very confident about the fuVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
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ture and, judging by the exceptionally low level of risk spreads and

credit markets, quite willing to bear risk. This apparent disparity

in sentiment between business people and market participants

could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally

different assessment of macroeconomic risks.

Turning to the outlook for costs and prices, productivity developments will likely play a key role. The growth of output per hour

slowed over the past half-year, giving a boost to unit labor costs

after 2 years of declines. Going forward, the implications for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the

context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in unit labor costs.

Whether inflation actually rises in the wake of slowing productivity

growth, however, will depend on the rate of growth of labor compensation and the ability and willingness of firms to pass on higher

costs to their customers. That, in turn, will depend on the degree

of utilization of resources and how monetary policymakers respond.

To date, with profit margins already high, competitive pressures

have tended to limit the extent to which cost pressures have been

reflected in higher prices.

The inflation outlook will also be shaped by developments affecting the exchange rate of the dollar and oil prices. Although the dollar has been declining since early 2002, exporters to the United

States apparently have held dollar prices relatively steady to preserve their market share, effectively choosing to absorb the decline

in the dollar by accepting a reduction in their profit margins. However, the recent, somewhat quickened, pace of increase in U.S. import prices suggests that profit margins of exporters to the United

States have contracted to the point where the foreign shippers may

exhibit only limited tolerance for additional reductions in margins

should the dollar decline further.

The sharp rise in oil prices over the past year has no doubt

boosted firms’ costs and may have weighed on production, particularly, given the sizable permanent component of oil price increases

suggested by distant-horizon oil futures contracts. However, the

share of total business expenses attributable to energy costs has

declined appreciably over the past 30 years, which has helped to

buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still, although the aggregate

effect may be modest, we must recognize that some sectors of the

economy and regions of the country have been hit hard by the increase in energy costs, especially over the past year.

Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the

exchange rate for the dollar, core measures of consumer prices have

registered only modest increases. The core PCE and CPI measures,

for example, climbed about 1.25 to 2 percent, respectively, at an annual rate over the second half of last year.

All told, the economy seems to have entered 2005, expanding at

a reasonably good pace, with inflation and inflation expectations

well-anchored. On the whole, financial markets appear to share

this view. In particular, a broad array of financial indicators convey

13

a pervasive sense of confidence among investors and associated

greater willingness to bear risk than is yet evident among business

managers.

Over the past 2 decades, the industrial world has fended off two

severe stock market corrections, a major financial crisis in developing nations, corporate scandals, and, of course, the tragedy of

September 11, 2001. Yet overall economic activity experienced only

modest difficulties. In the United States, only five quarters in the

past 20 years exhibited declines in GDP, and those declines were

small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same

going forward.

Yet history cautions that people experiencing long periods of relative stability are prone to excess. We must, thus, remain vigilant

against complacency, especially since several important economic

challenges confront policymakers in the years ahead.

Prominent among these challenges in the United States is the

pressing need to maintain the flexibility of our economic and financial system. This will be essential if we are to address our current

account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run possibly to decrease the U.S. current account deficit and its attendant

financing requirements, some forces in the domestic U.S. economy

seem about to head in the same direction. Central to that adjustment must be an increase in net national savings. This serves to

underscore the imperative to restore fiscal discipline.

Beyond the near-term, benefits promised to a burgeoning retirement-age population, under mandatory entitlement programs, most

notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead. Real

progress on these issues will unavoidably entail many difficult

choices. But the demographics are inexorable, and call for action

before the leading edge of baby boomer retirement becomes evident

in 2008. This is especially the case because longer-term problems,

if not addressed, could begin to affect longer-dated debt issues, the

value of which is based partly on expectations of developments

many years in the future.

Another critical long-term economic challenge facing the United

States is the need to ensure that our workforce is equipped with

the requisite skills to compete effectively in an environment of

rapid technological progress and global competition. Technological

advances are continually altering the shape, nature, and complexity of our economic processes. But technology and, more recently, competition from abroad have grown to a point at which

demand for the least-skilled workers in the United States and

other developed countries is diminishing, placing downward pressure on their wages. These workers will need to acquire the skills

required to compete effectively for the new jobs our economy will

create.

Although the long-run challenges confronting the U.S. economy

are significant, I fully anticipate that they will ultimately be met

and resolved. In recent decades, our Nation has demonstrated remarkable resilience and flexibility when tested by events, and we

have every reason to be confident that it will weather future chalVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
14

lenges as well. For our part, the Federal Reserve will pursue its

statutory objectives of price stability and maximum sustainable

employment, the latter of which we have learned can best be

achieved in the long-run by maintaining price stability. This is the

surest contribution the Federal Reserve can make in fostering the

economic prosperity and well-being of our Nation and its people.

Mr. Chairman, I request that my full statement be included for

the record, and I look forward to your questions.

Chairman SHELBY. Without objection, your complete statement

will be made part of the record.

Thank you, Chairman Greenspan. Thank you for your wisdom

that you shared with us, some of it, at times.

Mr. Chairman, President Bush, I believe, has shown a lot of

courage and leadership in highlighting the need to deal with Social

Security. The President has proposed establishing, as you well

know, personal accounts with a portion of payroll taxes as a means

of reducing long-term Government liabilities. Some observers, however, have noted that up to $2 trillion—I do not know if that figure

is right—in new Federal borrowing would be needed to make such

a transition.

If that figure is a valid representation of transition costs, if so,

how do you believe financial markets would react to such borrowings and so forth?

Chairman GREENSPAN. Mr. Chairman, if I may, I would like to

just take a minute to put context around this whole problem.

Chairman SHELBY. Go ahead. Absolutely.

Chairman GREENSPAN. We have to really ask ourselves what the

problem we are trying to solve is. The problem essentially is that

we have an unprecedented potential increase in the number of people leaving the workforce and going into retirement over the next

25 years. Indeed, those age 65 and over will increase according to

the Bureau of Census by more than 30 million, and that is an inexorable move as we all age and retire.

The problem that creates is that unless productivity growth increases significantly, the per capita GDP must significantly slow.

That means either the retirees or active workers, say, in the year

2030, must experience a significant slow-down in their standard of

living. And my concern is that we are putting forward, in a number

of different programs, commitments to be fulfilled in the year 2030,

for which the real resources are not being made available.

And the way real resources are made available in such a context

is for savings to be put aside to be invested in capital assets, and

those capital assets, by increasing relative to the labor force, tend

to create increased output per hour. The correlation for that is very

close.

So that unless we develop the savings to invest or significantly

increase our borrowing from abroad, we are not going to be able to

create the capital assets, to create the amount of goods that are required. Our problem, with respect to retirement, has got nothing to

do with finance. It has to do with real assets, real physical resources, and goods and services that people consume.

What the test in this context of our individual financial systems

should be is do they or do they not create savings to create the capital assets or put it another way, are they fully funded or not? For

15

example, Social Security, as a pay-as-you-go system worked remarkably well for 50, 60, 70 years, largely because a pay-as-yougo system works if population is growing sufficiently quickly and

longevity is growing only modestly.

Now, we have had, in recent years, some slowing down in population growth, but a remarkable increase in life expectancy after

age 65. That has created a very major problem for a pay-as-yougo system. And the reason, essentially, is, by its nature, in the

purest form, pay-as-you-go creates no savings. It merely transfers

from taxpayers, in any particular period, to beneficiaries.

Now, to be sure, there are some savings involved in the OASI

fund in the sense of we have built up a trust fund, which is now

approximately $1.5 trillion, but a fully funded OASI would require

more than $10 trillion. So we are very far short, and we have very

great difficulty in fully funding the existing system, and that is the

reason why I think we have the problems that we are running into.

Not to take too much more time, let me just say very specifically,

in response to your question, there are basically two models that

we are confronting. One is the pay-as-you-go model which, if we

can fully fund it, will work, but it has shown very considerable difficulty in doing that.

The other is the forced savings model which, in the current context privatization, is not increasing savings because you are switching from Federal Government savings to a forced savings account.

But as a general model, it has in it the seeds of developing full

funding by its very nature, and therefore I have always supported

moves to full funding in the context of a private account, and I will

respond in more detail in response to a number of questions that

I am sure you and your colleagues have.

The issue with respect to the financing the transition is a difficult one to answer because there are things we do not know.

There are two things which we do not know which are important,

and if we knew them, we could answer it very explicitly.

First, we do not know the extent to which the financial markets

at this stage, specifically, those trading in long-term bonds, are discounting the $10-trillion contingent liability that we have. Actually,

it is more than $10 trillion now. It was $10 trillion a while back.

If, indeed, the financial markets do not discount that $10-trillionplus, and say it is just as much of a debt as the $4-odd-trillion that

is a debt to the public, then, one would say, well, if you wanted to

go to a private system, you could go fully to a private system without any response in interest rates because, obviously, you are not

changing the liabilities that are involved. You are just merely

switching assets to the private sector. But we do not know that.

And if we were to go forward in a large way, and we were wrong,

it would be creating more difficulties than I would imagine. So, if

you are going to move to private accounts, which I approve of, I

think you have to do it in a cautious, gradual way and recognize

that there is yet another problem involved, which is this: Unlike

almost all of the other programs with which we deal, moving to a

forced savings account technically does not materially affect net national savings. It merely moves savings from the Government account to a private account. One can argue at the margin as to

16

whether or not that induces some change in personal behavior, but

it is at the margin.

So the question really is if it does not affect national savings, it

should not affect the supply and demand for funds, but, again, we

do not know how the markets respond to that. It is one thing to

say it as an economist. It is another thing to say how the market

is responding.

All in all, I am glad that if we are going to move in that direction, we are going to move slowly and test the waters because I

think it is a good thing to do over the longer-run and, eventually,

because the pay-as-you-go system, in my judgment, is going to be

very difficult to manage, we are going to need an alternative.

Chairman SHELBY. Mr. Chairman, just to follow up, could we create the personal accounts without any substantial borrowing for

the transition? And, if so, how?

Chairman GREENSPAN. Obviously, if you raise taxes, you could.

Chairman SHELBY. What about cutting benefits?

Chairman GREENSPAN. You could certainly do it that way, too.

Chairman SHELBY. One of those two.

Chairman GREENSPAN. Yes.

Chairman SHELBY. If one of the goals of reform that you alluded

to is to increase real savings in this country, would it be desirable

to pursue personal accounts as an add-on rather than as a replacement?

Chairman GREENSPAN. Well, it depends on how you finance it.

We have add-ons. It is called a 401(k) at this stage.

Chairman SHELBY. That is right.

Chairman GREENSPAN. It is not clear to me what you want to do

other than perhaps expand the 401(k)s, which I think become a

very popular and very useful adjunct to our financial system.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman. I presume we are going to do multiple rounds here this morning.

Chairman Greenspan, the first thing I want to make clear or try

to get clear is you said the increase in net national savings is a

very important objective; is that correct?

Chairman GREENSPAN. Yes, sir.

Senator SARBANES. Is a reduction of the Federal deficit, does that

translate into an increase in net national savings?

Chairman GREENSPAN. It does, Senator.

Senator SARBANES. So that eliminating the deficit or even running a surplus constitutes a contribution toward raising net national savings; is that correct?

Chairman GREENSPAN. It may be the most significant vehicle we

have.

Senator SARBANES. I take it from that, that anything that markedly increases the deficit runs directly counter to the objective of

increasing the net national savings.

Chairman GREENSPAN. That is correct.

Senator SARBANES. Because I recall 4 years ago you came before

us—Senator Dodd alluded to that—and you told us, and I am

quoting you now—this was when we were projecting, over a 10-

year period, a $5.6-trillion surplus in the Federal budget, a $5.6-

trillion surplus projected over 10 years, and now we are projecting

17

a $3.7-trillion deficit. That is a rather staggering turnaround of

$9.3 trillion, almost $10 trillion. You told us, then, and that is why

I am really concerned here, ‘‘The time has come, in my judgment,

to consider a budgetary strategy that is consistent with a preemptive smoothing of the glide path to zero Federal debt or, more realistically, to the level of Federal debt that is an effective, irreducible

minimum.’’

Now, that was taken I think by all as a view on your part that

we were paying down the debt too quickly, and we had to alter the

glide path and the payment down of the debt.

I remember saying to you at the time you have just taken the

lid off the punch bowl because, at that time, of course, we were debating whether to do these extensive tax cuts. They were done.

They were done the following year. Even more were done the year

after, and now we have managed to transpose our economic outlook

from this projection of over $5 trillion in surplus to almost $4 trillion in deficits, which I would take it you would agree constitutes

a major setback to the goal of increasing net national savings.

Chairman GREENSPAN. I do, Senator.

Senator SARBANES. In view of that, would you say anything that

markedly increases the deficit is the wrong path to go down?

Chairman GREENSPAN. In general, but let us remember that the

basic issue is net national savings. Ordinarily, any increase in

spending or reduction in taxes which is funded by marketable securities clearly increases the deficit and lowers national savings. The

only reason I raise it at the moment is that we are discussing these

private accounts, and this is one of the very rare cases in which

you can increase the deficit, but not decrease the national savings.

Senator SARBANES. So you do not support through borrowing,

sustaining the existing benefit levels to cover monies diverted from

the trust fund into private accounts?

Chairman GREENSPAN. I think the issue is something which I am

still puzzling about in the sense I am trying to get a sense as to

whether the markets read this as no change in national savings,

and therefore it is not a problem.

I do say, as I said previously, that I would be very careful about

very large increases in debt, but I do believe that relatively small

increases are not something that would concern me.

Senator SARBANES. Do you regard increases of $1 trillion or $2 trillion or $3 trillion as large?

Chairman GREENSPAN. I would say over a trillion is large.

Senator SARBANES. Mr. Chairman, if I have time. I am sure we

will revisit this issue, but I want to come back to another issue.

You stated that inflation and inflation expectations are under control in your testimony here this morning.

Chairman GREENSPAN. I said they were contained, I believe.

Senator SARBANES. What factors warrant raising interest rates if

inflation and inflationary expectations are contained and if there

remains a jobs problem. In other words, the Federal has obviously

set out on this constant escalator now of taking up the interest

rates. Why would we continue to do that if we do not have an inflation problem that we have to confront? Why would we not, as I

suggested, pause and take a look at and see how the economy

strengthens and how we pick up on the job side? What is the factor

18

that drives raising these interest rates inexorably, meeting after

meeting after meeting, and where will it stop, or what factor would

determine when it stops?

Chairman GREENSPAN. Senator, I will not comment about the future because that is up to the Federal Open Market Committee in

its meetings, but I will address the issue as to why we have moved

from 1 percent——

Senator SARBANES. I am told you are primus inter pares in those

Federal Open Market Committee meetings.

Chairman GREENSPAN. I am sorry?

Senator SARBANES. Primus inter pares, that you speak for the

group.

Chairman GREENSPAN. I have one vote.

[Laughter.]

But let me address why it is that we have moved from 1 to 2.5.

We very purposefully moved the Federal funds rate down quite

sharply in the context of the set of financial deflationary pressures

which occurred as the stock market came down, and capital investment went down, and capital goods spending went down. And so

we very purposefully decided to drive the Federal funds rate well

below what we considered a long-term sustainable rate, and we got

down to 1 percent. We had no notion as to how far we would have

to go down, but we decided that we went down, when we got down

to 1 percent we could hold it there for a while.

When it became clear that the excessive accommodation which

we purposefully injected into the financial system was no longer

necessary, we then proceeded to withdraw it. We are withdrawing

purposefully injected excess accommodation into the system. Had

we left it there indefinitely, in our judgment, it would have engendered significant inflationary imbalances. So we embarked on, as

we discussed, what we called a measured pace of increase.

As you know, the response in the marketplace has not been one

of significantly rising long-term rates, difficulties in the housing

market, and other problems which we had run into in the past in

previous increases in rates. So that I would not look at this as a

pattern that we were involved in for purposes of addressing what

was then going on within the economy, but rather, as removing

something which we knew had to be temporary. And one tries to

remove it as rapidly as possible with the obvious caveat, that

should the economy show signs of weakening, clearly we would respond, and we have made that statement every time we have

issued one following a Federal Open Market Committee meeting.

We are not oblivious as to what is going on in the economy. Our

judgment, as I indicated in my prepared remarks, at the moment

is that the economy is moving forward at a reasonably good pace.

Senator SARBANES. Does this analysis assume that there is some

normal rate of interest, I mean a figure that you are trying to get

to that you say, well, this is what the normal rate of interest

should be? Is there a premise of that sort in this analysis?

Chairman GREENSPAN. There is, Senator. We do not know what

the actual number is, but it is that interest rate which creates a

degree of stability in the economy and removes any excess which

would create inflationary pressures.

19

Senator SARBANES. Is it possible that that rate would change as

circumstances develop? I thought it was commendable that you did

not buy the national accelerating rate of unemployment analysis,

which said at a certain unemployment figure, if we go below it, we

are going to drive inflation up, and therefore we start constraining

the economy, and that costs us jobs, and we do not get back to our

full potential, but we are prepared to go against that dogma at the

time and move on down the interest rates, give the economy a

boost and bring down the unemployment rate well below what had

previously been seen as normal.

I guess the question I am asking is whether we need to think in

those terms again with respect to this normal interest rate. I mean

what may be a normal interest rate in changing circumstances may

be lower than what previously was a normal interest rate. And of

course a lower interest rates stimulates the economy. Presumably

it makes carrying this debt less costly rather than more costly, and

has a lot I think of other benefits for the workings of our economic

system. So that is why I am suggesting that we need to reexamine.

Chairman GREENSPAN. We believe that so-called ‘‘normative

rate’’ or whatever you want to call it, is not stable. It does move

around, and that is the reason I say I do not know where it is. I

do know that we have the capacity to examine how the market is

behaving in all of its myriad manifestations so as to be able as a

committee, I hope and believe, to judge where we are at all times.

We may not be able to forecast it, but I do think we have enough

analytical technology to be able to make a judgment as to where

we are at any particular point in time. I am almost certain that

that rate does move around, and we are constantly trying to get

the appropriate fix because that is implicit, as you point out, in the

strategy that we started to pursue last year.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

I am not going to ask you the obvious question about inflation.

You already have answered it. In the past it is my recollection you

were not as concerned with the current account deficits as you

were with other economic figures. Back in November, when the

current account deficit reached record levels you did express concern. But in February, your concern eased as the current account

deficits decreased. Would you comment on the current account deficit and your concern or lack thereof?

Chairman GREENSPAN. Senator, it is an extraordinary part of a

phenomenon which has been going on for the last decade worldwide. Prior to 1995, there was a very major grossing up of exports

and imports around the world, leaving as a consequence on average

imports as a percent of GDP growing every year virtually. We

nonetheless did not find that there was any evident consistent increase in the dispersion of trade or current account surpluses and

deficits. In other words, there was what economists call a very considerable amount of home bias, meaning that countries tended to

use their domestic savings to very largely finance their domestic investment. But since 1995, there has been a very pronounced

change in which cross-border use of savings to invest in foreign

countries all over the world has increased dramatically, which has

20

meant that the dispersion of current account balances, both as surpluses on the one hand and deficits on the other, with the United

States as the largest deficit, has increased.

That phenomenon has given us the capacity to create a very

large deficit, and indeed it has been a major source of financing to

our domestic investment. But as I also said, and I think you pointed out, over the longer-run it is just not credible that it could go

on without change because you will get an undue concentration of

dollar claims on U.S. residents, which even though they are considered a highly valuable, and have high rates of return and the like,

they lack the diversification of a good portfolio, and foreign investors would therefore start to ease off. And if you cannot finance a

current account deficit, it will not exist. So that is surely the case.

But I have also said that the degree of flexibility, owing to deregulation, owing to technology, owing to lots of innovation, has created

a degree of flexibility and therefore resilience in this economy that

has in the past and is very likely in the future to defuse this large

current account balance without undue negative economic effects

on the American economy.

So what I said in the last several weeks is, one, this is a problem; we are approaching it and I think coming to grips with it in

the marketplace, and the evidence is that for the first time we are

beginning to see the impact of stable margins of foreign exporters

at very low levels now beginning to produce increases in import

prices in the United States, which is the first stage in the adjustment process.

Senator BUNNING. As you know, the SEC has proposed a new

Regulation B to Section 2 of the Gramm-Leach-Bliley Act. The Fed,

along with the FDIC and the OCC, wrote a very strong letter to

the SEC opposing their proposed regulation. Would you comment

on how this proposed regulation could affect the bankers?

Chairman GREENSPAN. I am sorry. I do not remember what the

specific nature of the regulation was.

Senator BUNNING. You do not remember what you wrote?

Chairman GREENSPAN. No, no, I do not remember the specific

SEC regulation to which you refer. I know I write a lot of things,

but I am just basically saying I do not—one of my staff will know

exactly what I wrote. They will tell me.

Senator BUNNING. So will my staff there.

Chairman GREENSPAN. Okay.

[Laughter.]

Senator BUNNING. How you would regulate new bank products?

Chairman GREENSPAN. I remember it now. I did not remember

the name, but I now remember the issue, which is a significant

issue.

Senator BUNNING. Our bankers think it is very significant.

Chairman GREENSPAN. It is. In fact, I think we are concerned

about that as well, and I think that the resolution of this question

is clearly going to have to be completed because the brokerage operations within the banks as such are integral parts of a process

which we perceive to be important to banks overall, and we will get

it resolved I hope sooner rather than later.

Senator BUNNING. Then you still oppose, along with the other

people who have written SEC?

21

Chairman GREENSPAN. Yes, sir.

Senator BUNNING. Thank you very much, Mr. Chairman.

Chairman SHELBY. Senator Reed.

Senator REED. Thank you very much, Mr. Chairman. Just for context, Chairman Greenspan, you referred to a $10 trillion shortfall in the Social Security trust fund. Over what time period is that?

Chairman SHELBY. This is the present value of the benefits

earned by those currently in the labor force over the years as of

right now, plus the benefits of those who are retired and receiving

benefits which they had earned previously. So it is the discounted

value of all of the benefits which are to be received by the total

labor force and retirees over essentially indefinite period in time.

Senator REED. Longer than the 75-year planning phase?

Chairman GREENSPAN. Oh, yes, yes. I think if you cut it off at

75, I think it is $3.7 trillion.

Senator REED. And that is generally the norm in terms of——

Chairman GREENSPAN. Yes, but I think that it is an artificial

norm, and most pension fund accounting thinks in the full context

of the actual liabilities one has, and a 75-year period is a convenience that relates largely to a pay-as-you-go system, but it is not

consistent with the general notion of how one runs a defined benefit program. Were pay-as-you-go a fully funded defined benefit, I

think many of the objections I raised earlier on would disappear.

Senator REED. Let me ask you another question, Mr. Chairman.

Various Administration spokespersons, somewhat reluctantly have

admitted that the private accounts plan that has been announced

will by itself alone do nothing to improve the long-term solvency of

the Social Security system. Do you agree with that?

Chairman GREENSPAN. I do, Senator.

Senator REED. Thank you. Would you also agree—and I think

this is a follow up really to your discussion with Senator Sarbanes—is that the private accounts will basically leave national

savings unchanged since the Government has borrowed money to

give to individual citizens to invest in the market. Do you agree

with that also?

Chairman GREENSPAN. Yes, I do.

Senator REED. Looking at the system, there are various means

to make it essentially a pay-as-you-go system. One would be to

take a portion of the proposed extension of the taxes the President

is talking about and putting that into the Social Security Trust

Fund. Just on a—that would establish a pay-as-you-go system; is

that correct?

Chairman GREENSPAN. It depends. If in the full context of accounting it increases national savings, then the answer is yes, but

the test has to be how it effects the private sector and the public

sector, and if net on balance is constructed in a manner to do that,

then yes.

Senator REED. Thank you. In 1983, Chairman Greenspan, you

were the Chairman of the Commission that rescued Social Security

from the brink. If this is a crisis, that was a catastrophe back in

1983. Your colleagues and yourself joined in saying that in the

words of the report, that Congress should not alter the fundamental structure of the Social Security programs or undermine its

22

fundamental principles. Part of the fundamental principle of Social

Security is it is an insurance program, not just an investment vehicle. One of the most obvious manifestations of that is that many

of the beneficiaries are not retirees at all, but they are disabled

Americans. They are children who do not have parents or they are

widows.

Proposals that are being assessed today could alter those principles fundamentally. I understand also in 1983 you did consider

the changes that would transform it from a defined contribution

plan into something else, at least you thought about those things.

But do you still believe that we should maintain the fundamental

principles of Social Security as you did in 1983?

Chairman GREENSPAN. I think we should maintain the principles

of Social Security, but I think the existing structure is not working,

and that until we can construct a system which creates the savings

that are required to build the real assets so that the retirees have

real goods and services, we do not have a system that is working.

We have one that basically moves cash around, and we can guarantee cash benefits as far out and at whatever size you like, but

we cannot guarantee their purchasing power. This is why the issue

ultimately has to be resolved in terms of do we have the material

goods and services that people will need to consume, not whether

or not we pass some hurdle with respect to how financing occurs,

because the financing is a secondary issue, and it is the means to

create the real wealth, not an end in itself.

Senator REED. That goes back to your fundamental point that

unless you increase national savings, you will not have these resources.

Chairman GREENSPAN. Yes, sir.

Senator REED. And just to follow up on your point before, as the

Administration has admitted, and as you concur today, that the

present proposed private accounts will not add to those national

savings?

Chairman GREENSPAN. It does not add, but it does not subtract

either, that is correct.

Senator REED. So it is a zero?

Chairman GREENSPAN. Let me just say that in any move which

we endeavor to create full funding, there is a huge transition cost

because we have not built the stock of assets required, and that is

the shortfall of the difference between the $1.5 trillion and the $10

trillion plus in funding assets. Actually, if you go further and you

put Medicare in here, we are talking another $60 trillion. So the

problem that we have is there is a huge transition cost to get us

to a point where we are building the savings adequate to produce

the assets. We are not doing that, and any scheme cannot get

around the fact that there is a huge hole in the system, and we

have no choice but to find a way to fill it.

Senator REED. I am recalling reading the book, Secretary

O’Neill’s book, in which if you believe it is accurate, and I do, is

that you have discussions with him about solving some of these

issues with the surplus, which at that time we could fund transition costs, but at this point, running a deficit, we have squandered

the opportunity to make a serious transition in terms of both Social

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Security, Medicare, Medicaid, and other programs, and that to me

is one of the casualties of the Administration’s policies.

And I thank you, Mr. Chairman.

Chairman SHELBY. Senator Crapo.

Senator CRAPO. Thank you very much, Mr. Chairman.

Chairman Greenspan, I want to continue on this same line of

questioning. We are hearing a tremendous amount of discussion in

the public today, both among the political leadership here in the

U.S. Congress and in the Administration as well as out in the public about these transition costs that are related to the proposal to

move to personal accounts with a portion of the taxes paid in payroll.

And as you have discussed today, I believe I understand your testimony to be that with regard to national savings—and I assume

that means governmental savings.

Chairman GREENSPAN. National savings is another word for domestic savings to differentiate it from the fact that we do not include the current account deficit or foreign savings that we borrow

in that total.

Senator CRAPO. All of this is a discussion of the Government’s

posture and the Government’s savings, is that not correct?

Chairman GREENSPAN. Government savings, both State and local

and Federal, is part of national savings. Maybe that is a bad term.

Probably domestic savings should be used.

Senator CRAPO. Does it include the personal savings of the individuals across the country?

Chairman GREENSPAN. Yes. The way to think about this is that

the aggregate of domestic savings includes the savings of households, businesses, and governments, and that is the part which we

call domestic savings.

Senator CRAPO. If we move then to a system of personal accounts, where individuals were able to save a portion of their payroll taxes, can I correctly assume that the reason you say that does

not increase national savings is because it is putting money in individual accounts that would otherwise be in a different savings account?

Chairman GREENSPAN. No. Let me see if I can come back at this.

If in its original form we did not have anything other than a requirement that we had 12.4 percent tax which was put into a private account, in other words, that particular fund coming off the

person’s income and the employer’s income would go into a forced

savings account. In a sense private savings would increase by that

amount, and the part that the corporation contributed which would

have reduced its undistributed earnings, which would have been

savings, would be a negative. But net it would, except under a certain number of distant conditions, it would be a net increase.

Senator CRAPO. So the employer’s savings would be reduced but

the employee’s savings would have gone up, and there would be a

net zero balance?

Chairman GREENSPAN. Yes. In order to get savings, remember

you have to get consumption declining relative to income.

Senator CRAPO. I appreciate that because I think that there is

a lot of misunderstanding about that fact, as we discuss this issue.

And when we discuss the cost, there is a lot of discussion about the

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transition cost being—I have heard the number of $2 trillion. The

Administration says the number in terms of its proposal is more

in the neighborhood of the $7 to $8 hundred billion over 10 years.

Is the same not true about that transition cost in the sense that

those costs are actually related to debt in out-years or obligations

in out-years of the Social Security system that are being borrowed

to take care of in earlier years?

Chairman GREENSPAN. Well, the President has not made a formal proposal.

Senator CRAPO. I understand.

Chairman GREENSPAN. But I gather what he has in mind is in

a sense that the amounts that go into the private account are offset

after discount with benefits that would have been paid with those

monies in the Social Security system.

Senator CRAPO. And making that assumption, is it not correct to

say then that the transition costs, although they would be incurred

now, and would require some borrowing to pay for them now, are

actually relieving an obligation of the Social Security system in

out-years?

Chairman GREENSPAN. The problem is that you cannot commit

future Congresses to stay with that.

Senator CRAPO. Unfortunately, I understand that.

Chairman GREENSPAN. And as a result, the markets will not discount as though that were the case, even though it is the intention

and that is what the law would say, and if you could put it in the

Constitution I suspect you may be right.

But I think the relevant issue here is that how the markets interpret it is really in a sense the important issue because if the

markets correctly or incorrectly make a judgment as to what they

think the potential outcome is, we can get interest rates going up

or going down, and we would have significant effects that we would

prefer probably did not occur. So my caution here is based on not

knowing and not knowing how to know in advance how markets

will respond.

I do know that asking people in the marketplace is of no value

at all, because they do not know. They will tell you they know, but

I have not found that a very useful forecast.

Senator CRAPO. I appreciate your encouragement that we move

cautiously in terms of this proposal, but I also appreciate that you

have said that you believe that we should look at a personal account.

Chairman GREENSPAN. Oh, indeed I do.

Senator CRAPO. Could you give us just quickly your reasons for

that?

Chairman GREENSPAN. Well, basically it has to do with the issue

of personal accounts have far greater probability, indeed, almost it

is built into their nature, of being fully funded. And the simple

form of pay-as-you-go by construction saves nothing. And unless

you save, merely basically creating dollar commitments in the future without the corresponding real resources to accommodate the

claim, you will get more claims on a fixed amount of goods than

is good for the inflationary balance of the system. So it is strictly

a question of where can we create a system which we get full funding. It did not matter 20, 30, 40 years ago because the ratio of

25

workers to retirees was quite high and that therefore the implicit

tax per worker for each retiree was very small. But now we have

3.3 workers for every retiree, and that number is falling quickly.

So the current system is ill-suited to the demographics that we

are expecting to evolve in the future. And while a pay-as-you-go

system worked very well, I thought, surprisingly well, through decades, that was because of the special case of the demographics of

the society at that point. It is not a general system in the sense

of a defined benefit or defined contributions system, which very explicitly indicates what type of replacement rate to expect meaning

the amount of income you expect in retirement to get relative to

the amount of income you are making in the last years of work.

Senator CRAPO. Thank you very much.

Chairman SHELBY. Senator Schumer.

Senator SCHUMER. Well, once again, Mr. Chairman, thank you

for your erudition on this, which leaves us all better educated and

maybe more confused, too.

I would like to go back to these accounts and Senator Sarbanes’s

questions. You said you cannot really tell if net savings will increase or decrease with a private account system that draws money

from the existing Social Security system because you do not know

how much the markets have discounted, if at all, the future obligations that we have.

Chairman GREENSPAN. If I may, whether it actually increases

savings or not is a fact independent of what people’s opinions are.

Senator SCHUMER. I agree.

Chairman GREENSPAN. So it is not the market. I think the problem here is that we have a system in which, starting from scratch,

forced savings will be pay-as-you-go all the time.

Senator SCHUMER. Right. But a transfer, which is proposed now,

is a different issue, and we do not know how the markets will regard that transfer.

Chairman GREENSPAN. Exactly. Yes.

Senator SCHUMER. Okay. Now I want to take two cases. One,

they have discounted for it; the other, they have not. If they have

not, and we go forward with this system that we hear about, where

you transfer some money from the existing Social Security system

to private accounts, that would create a real problem, particularly,

as you have mentioned to Senator Sarbanes, if the amount is $1

trillion or $2 trillion or whatever. That is indisputable, I presume.

Chairman GREENSPAN. It is a trillion dollars over 10 years we

are talking about.

Senator SCHUMER. Yes. Yes.

Chairman GREENSPAN. Two trillion is indisputable. A trillion dollars, I think, is right at the margin. I should not say I know that.

That is my assumption.

Senator SCHUMER. Yes. Understood. And we are all guessing

here.

Chairman GREENSPAN. Yes.

Senator SCHUMER. But that could be bad. Let us make no mistake about that.

Chairman GREENSPAN. It could be bad and it could be very good.

I mean, my judgment is we have a problem in that the existing

pay-as-you-go system is not working and we have to change it.

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Senator SCHUMER. Well, nobody disputes that.

Chairman GREENSPAN. We have to change it. The question is

how.

Senator SCHUMER. Yes. Well, nobody disputes that we need some

change. But it seems to me if the markets have discounted all of

this, then it does not do any harm, but it does not do any good,

because net savings is not increasing, as you said before. If the

market has not discounted a rather large amount of debt being

added to the existing debt—obviously, 15 or 20 years ago this

would not have been a problem—then we have real trouble.

Chairman GREENSPAN. Well, but if you move——

Senator SCHUMER. So it is not win versus lose, it is either lose

or stay static.

Chairman GREENSPAN. No, because if you begin to move significant parts of the existing social insurance system into accounts

which begin to create full funding, whereas left where they were,

they won’t, then you do increase national savings over time.

Senator SCHUMER. But that is a huge ‘‘if.’’

Chairman GREENSPAN. Well, no, it——

Senator SCHUMER. Because it will only increase full funding if

you dramatically cut a benefit. You have to do other changes than

simply move one to the other. What we are trying to get at here

is not the overall change that is needed, and I do not think anyone

disputes what you say, but whether setting up a private account—

under current conditions, not starting from scratch—does anything

to alleviate the problem.

Chairman GREENSPAN. In and of itself it surely does not alleviate

the current problem. Actions have to be taken.

Senator SCHUMER. Exactly.

Chairman GREENSPAN. I am merely saying that if you move to

private accounts and——

Senator SCHUMER. And.

Chairman GREENSPAN. —the financial markets have at least partially discounted the contingent liabilities, then you are a net plus,

because then you have——

Senator SCHUMER. Right. Understood. Okay. But if they haven’t,

you are not.

Chairman GREENSPAN. That is correct.

Senator SCHUMER. Okay. So it seems to me that what you really

are advocating here without saying it, which would truly increase

net savings, is what is called around here Social Security Plus. Fix

Social Security on its own and if you want to do private accounts

and increase net savings over the present system, you do those in

addition, whether it is for savings or greater incentives, which

401(k)’s or whatever mention; in other words, fix the present system and then do the private accounts, not in replacement but in

addition—do more for net savings?

Chairman GREENSPAN. It depends on how you finance them. In

other words, the question here is if you are going to expand

401(k)’s, I think that is a desirable thing, too.

Senator SCHUMER. Exactly.

Chairman GREENSPAN. If you are going to set up another program which is an entitlement, which——

27

Senator SCHUMER. No, no, no. I am just saying a 401(k) the first.

I am saying the first. That will do more to increase net savings

than simply shifting some money from the present system to a socalled ‘‘private account.’’ I think that is indisputable.

Chairman GREENSPAN. Well, 401(k)’s are private accounts, so——

Senator SCHUMER. I understand. But in addition, as opposed to

replacement. Because you will have more net savings.

Chairman GREENSPAN. Yeah. No, no, I am not disagreeing with

you. I say that that is correct. I just want to make sure that you

are not talking about a new entitlement.

Senator SCHUMER. No, I am not. And furthermore, we would

have an easier time fixing Social Security if our debt went down.

It would have been easier to fix it 6 years ago or in 1983 than it

is today because one of the great problems is all the debt we have

right now. Is that not fair to say, too?

Chairman GREENSPAN. I think that is fair to say.

Senator SCHUMER. Okay. Let me tell you just—I know my time

is up—it seems to me that what you are saying here is that moving

to the system that is outlined, that the President may propose, is

risky. It is risky because we do not know what the markets will

do if they see it, and at the same time it does not increase overall

net savings in and of itself. And I know you do not want to say

that, but it seems to me it is inevitable and inexorable from what

you have outlined here in terms of those two parts. Where am I

wrong there?

Chairman GREENSPAN. Senator, it is risky. Doing nothing is

risky. Doing any other solution to this is risky. We have this huge

hole in our long-term funding problem, and I know of no way to

resolve it without some risk. It is a question of which risks are

more likely to be——

Senator SCHUMER. Right. It seems to me what you are saying is,

just on the way the privatization accounts are proposed, the risks

far outweigh the benefits unless we do something else with it.

Chairman GREENSPAN. That is the reason why I think that starting slowly and finding out how it works is a very good idea. Because if it turns out to be something which creates problems, or if

people do not like the thing—remember, it is a voluntary issue and

they may just choose not to take it. My own judgment is when you

have assets which you own, which you can bequeath to your children, and which have your name on them that is a highly desirable

thing because you give wealth basically to people in the lower- and

middle-income groups who have not had it before. Because remember, these private accounts, even though they are forced savings,

are indeed owned by the people and they have wealth which they

probably would not have had before. So that I can conceive of these

being extraordinarily popular accounts. And if they are, I think it

is a very important addition to our society, because as you know,

I have been concerned about the concentration of income and

wealth in this Nation, as indeed your colleague has been as well,

and this in my judgment is one way in which you can address this

particular question.

Chairman SHELBY. Senator Dole.

Senator DOLE. I would like to ask you to discuss the issue of rising health care costs and the impact on businesses. I have heard

28

from a number of North Carolina businesses that rising costs are

directly affecting their hiring decisions. Could you give us your

views on this area and whether or not you believe it is having a

negative effect on wage rates and employment?

Chairman GREENSPAN. Senator, I think it is a very difficult

issue. And I think that to the extent we see that benefits are going

up and wages have flattened out, relatively speaking, a goodly part

of this is the fact that individuals are willing to take health benefits in lieu of wages and salaries, but only in part. So overall, there

is no question that the net effect on cost to businesses is rising.

My own judgment is that the Medicare problem is, of course, several multiples more difficult than is Social Security. But I am also

of the belief that we probably ought not to address the medical

issue quite yet, until we get much further down the road in the advance in information technology in the medical area, which a number of individuals are looking into, and indeed there are Members

of this body on both sides of the aisle who are focused on this issue,

and I think, to the extent that we can begin to get major advances

in information technology at an encrypted individual level, I think

that best clinical practice is going to change. And it is going to

change because we are going to see things that we already suspect,

on the basis of certain different types of surveys, namely, that

there are all different types of practices for specific diseases across

this country with very varying outcomes, and it is largely the unavailability of all of the information which has made the improvement in clinical practice difficult. And in my judgment, we have to

get to the point where the medical profession, following from the

information technology, creates a best clinical practice, at which

point I think that an endeavor to address the problems that you

are concerned with and, in the broader sense, the medical profession generally is concerned with, would be appropiate. If we were

to do it now or even next year, I am fearful we would be restructuring an obsolete model and have to come back and undo it.

So, I agree with people who are saying we should do Medicare

first before Social Security because it is a much bigger problem. I

agree it is a hugely much more difficult problem. But I am not sure

I would agree with the issue of the sequence, wholly because of

what is now occurring in medicine.

Senator DOLE. And let me ask you about manufacturing. As I

mentioned in my opening statement, and we all know, North Carolina and a number of other States have been hit hard by the loss

of manufacturing jobs since 1998. According to the Bureau of Labor

Statistics, manufacturing employment has remained level in the

last year. Do you see growth in manufacturing in this next year?

Chairman GREENSPAN. Senator, it is hard to tell. And the reason

is that it is very difficult to judge how fast productivity is going to

advance. As you know, productivity in manufacturing has really

been very impressive. The downside, obviously, is it has created

fewer job opportunities. And we can reasonably assume that the

economy is going forward at a fairly good clip and that therefore

the demand for manufactured goods will continue reasonably significant. But it depends on productivity growth, or I should say the

extent to which manufacturing jobs change one way or the other

depends on whether productivity growth goes up or slows down. It

29

is very tough to judge. So, I could not give you an answer, because

I have tried to forecast manufacturing employment and, I must tell

you, my record is not altogether terrific.

Senator DOLE. Thank you, Mr. Chairman. My time has expired.

Chairman SHELBY. Senator Stabenow.

Senator STABENOW. Thank you, Mr. Chairman. And welcome

again, thank you for your service and for your being with us today.

I want to follow up on Senator Dole’s questions on manufacturing. I share her concerns. Michigan has had the same type of,

certainly, challenges as it relates to manufacturing.

But I first want to thank you for some insights in your statement

that you expand upon in your written statement more than you are

able to do as you spoke today, as it relates to education. Because

I think this is critically important, and I appreciate your wisdom

of your comments here and I think they are comments that we

should take very, very seriously. You talk about, ‘‘The failure of society to enhance the skills of a significant segment of our workforce

has left a disproportionate share with less skills. The effect is a

widening wage gap between the skilled and the less-skilled.’’ And

then you go on to talk about ‘‘In a democratic society, such a stark

bifurcation of wealth and income trends among large segments of

the population can fuel resentment and political polarization,’’

which I believe is happening today. And I share your concern about

the concentration of wealth and, really, what I view as splitting of

the middle class in this country due to a host of issues.

But I think it is important to emphasize that you said that

strengthening elementary and secondary schooling in the United

States, especially in the core disciplines of math, science, and written and verbal communications, is one crucial element in avoiding

such outcomes. I would not expect you to comment on this, but I

would just say for my colleagues, putting my budget hat on, this

is of deep concern to me when I see that one-third of what has been

proposed in the President’s budget in terms of cuts are in education. And I think that goes right to the heart of what you speak

about here. I would not necessarily expect you to comment on the

President’s budget, but I think we should be listening to you because we have huge wage and skill gaps that will affect us for decades to come and we need to be investing in skills and education.

Turning to a different subject, in terms of our debt, and this actually goes back to my concerns on manufacturing, but it relates

indirectly to manufacturing when we look at our dependency on inflows of foreign capital to finance economic activity. And then I

would argue on the other hand our difficulty in enforcing trade

agreements against those who own so much of our foreign debt. I

think this is going to be making it more and more difficult for us.

I would welcome your thoughts on that.

But when we look at the fact that—and I just have a small chart,

but in the last 4 years, foreign holdings of U.S. Treasury debt has

gone from basically a trillion to $1.85 trillion, and about half of

that is owned by China and Japan. People would be shocked to

know who else owns our foreign debt, as we are talking about financing private accounts through Social Security or other privatization efforts or anything else that we are doing for that matter—

the war or anything else. That South Korea, Taiwan, Germany,

30

Hong Kong, OPEC, Switzerland—we have a lot of foreign entities

that hold portions of our debt right now. And I am wondering at

what point, particularly when we are looking at $2 trillion, or we

are hearing now that 20 years down the road, two decades, potentially $5 trillion in new debt added if in fact privatization in some

part goes into effect, of Social Security, at what point do you believe that we should be concerned that our foreign financing of our

national debt is becoming too great?

Chairman GREENSPAN. Senator, we have the difficult problem

that people find U.S. Treasury securities the safest in the world.

And it is not as though we are forcing them to go buy our securities, nor do I believe we have any legal mechanism to prevent them

from buying them in the open market, which is what they do. So,

I am not sure how to address this issue because I am not sure what

we can do about it. The notion, however, which came out, I think,

a couple of weeks ago, that there was a significant move toward

selling off U.S. dollar instruments by foreign central banks, that

actually was not accurate. The extent of holdings remains very

heavy for dollars as a share of their aggregate holdings. And part

of the decline, very small, is the very fact that if you take a portfolio with dollars and, say, euros, and a dollar’s price falls relative

to the euro, then the value of euros in dollar equivalents rises and

that therefore it looks as though the dollar has gone down as a

share of total outstanding portfolios, when indeed it has not. That

is basically what the case is.

But on the broader issue you are raising, I am not sure how to

handle that because I am not sure what the longer-term implications are. You are quite correct at the moment, excluding the U.S.

Treasury debt held by the Federal Reserve, half of our debt is

owned abroad. And I would assume at some point it has consequences, but I cannot tell you what they are.

Senator STABENOW. Mr. Chairman, is it not reasonable to assume, though, that every time we are adding national debt, we are

adding opportunities for foreign investors to purchase those bonds,

so that one way to stop the foreign holdings increasing would be

to stop the national debt from increasing?

Chairman GREENSPAN. Well, we had believed we were going to

run the debt down to zero not that many years ago. That would

have solved the problem.

Senator STABENOW. I remember your being here with us in 2001,

when we were talking about the wonderful problem of having too

large of a surplus and the question of what we do about that.

I wonder if I might ask one further question. I know my time has

expired.

Chairman SHELBY. Go ahead.

Senator STABENOW. Thank you, Mr. Chairman. One further question. It is similar in terms of what is happening abroad for us.

Would it be your position that free-floating currency is an essential

element of efficient capital markets? And to that end, would you be

supportive of mechanisms whose goals are to ensure that nations

allow for floating currencies?

Chairman GREENSPAN. Well, in general I would say flexibility,

which is an extraordinarily valuable asset to the world financial

system, is clearly advanced by having essentially a free-floating

31

rate system—which is largely what we have. The difficulty is that

numbers of nations find dealing with fluctuating or variable currencies difficult to handle for lots of different reasons, and they

choose on their own to lock in against the euro or the dollar or a

basket of something, and accumulate or decumulate their foreign

assets to sustain it. So it is largely actions taken by foreigners, not

something which can be mandated by anybody. In other words, I

am not sure of the mechanism that, for example, the IMF would

be involved in to induce somebody to go from a fixed to a flexible

rate. They could suggest to them that it is in their interest. And

indeed, we do on numerous occasions. But there is no legal mechanism to require it because they always have the capacity of purchasing or selling dollar, yen, or euro, or Sterling assets in the

marketplace and thereby create a nonfloating currency.

Senator STABENOW. One mechanism—and I will close, Mr. Chairman; thank you for your patience—but we do have in the Banking

Committee, I am sure we will be hearing from Secretary Snow in

his yearly report that he is required to give about countries that

may be pegging their currency. And certainly many of us on both

sides of the aisle have expressed concern, particularly about China

and what the impact of pegging their currency has done in terms

of the costs of goods and services in our country as well as selling

into their country. And so there is a mechanism. If in fact the

Treasury Secretary would just simply certify that it is happening,

at least internationally, we would have the opportunity to make

our case. And I am hopeful the Secretary will do that before the

Committee later this spring.

Chairman SHELBY. Thank you, Senator.

Senator Bennett.

Senator BENNETT. Thank you, Mr. Chairman.

It has been a most illuminating morning, Mr. Greenspan, and

you have helped focus a lot of issues on this debate. The debate,

of course, has been primarily on Social Security. I had some questions on the band of interest rates similar to Senator Sarbanes, but

I think you exhausted those with Senator Sarbanes with your stating that the band of normal keeps changing, and normal keeps

changing. I would just hope in the Federal Open Market Committee you might think that around a 3-percent band has become

normal in the present economy and not feel the need to go to higher levels, which may have greater historic patterns to them. And

I am encouraged by your comment on that.

But the Social Security debate has dominated the morning, so I

will get into it as well and make the general statement that I always make. There is no such thing as repetition in the Senate, I

have discovered, so you just keep saying it. Any economic forecast

that goes out more than 6 months is wrong. I do not know whether

it is wrong on the high side or the low side. I just know that the

way the economy works and all of the changes that go in, if you

get beyond 6 months you are getting into difficult territory. I believed that about the $5 trillion surplus. I knew that number

was wrong. I believed that about the projections of a $4 trillion deficit. I think now that number is wrong. It will be different.

The one thing that is not wrong, that is much more inexorable

than an economic forecast is the demographic forecast. The demoVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
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graphics are destiny, and they change very slowly and over long periods of time. So, I am delighted to have you in your presentation

here and in your written statement say that the demographic pressure on Social Security is going to begin in 2008, not 2018, not

2042, not 2052 or whatever, because that is the date when the demographics kick in and say that we are going to have a 30-year period of dramatic increase in the percentage of Americans who are

over 65.

I am delighted to hear Senator Schumer, as you talk about the

fact that the present system is not working, say nobody disputes

that. I can quote some statements on the floor during morning

business where there are a lot of people who dispute that and say

this present system is working beautifully and we do not need to

do anything about it. And I am also delighted to have Senator

Schumer say in your dialogue that we should have started on doing

something about Social Security 10 years ago, and it would be easier if we had started then instead of waiting this long.

With that, let me get, however, to the point once again that you

were debating with Senator Schumer as to whether or not a personal account would increase national savings. Your point here is

a block of tax money, 12.4 percent of payroll, and you are saying

if that portion which is currently coming out of the employer’s side

goes to a personal account, it produces no net increase in savings

because the employer would save that if he did not have to pay it

and presumably would invest it in capital stock, whatever, that

would increase the productivity and, therefore, the reason you want

national savings. So you could increase the national savings by saying to the employer do not pay that anymore, invest it.

But that portion that comes out of the individual’s side gets invested in capital assets, which is different than how it is being invested now. So doesn’t that shift in the investment strategy to capital assets as opposed to an accounting number somewhere in the

unified budget mean that you will, in fact, get some increase in

capital investment and, therefore, make a contribution toward increasing the productivity of the economy?

Chairman GREENSPAN. Yes, Senator, I agree with that. Let me

just reiterate that what obscures the discussion is how to handle

the transition costs, which are the equivalent in one form of a huge

unfunded liability. But if you set that aside as a consequence of the

past and you merely ask which type of vehicle has the greater

probability of adding to national savings in the example that you

gave, clearly one which is forced savings and, therefore, reduced

consumption will add to household or personal savings and, therefore, to national savings.

If, however, you put it into the existing system and for the moment leave aside the question of changes in the trust fund, it is essentially a pay-as-you-go system, which does not create national

savings. And, therefore, the two models are fundamentally different, and the complexity is how you go from here to a differing

system, and to a very large extent, one’s capacity to do that does

rest with that issue of to what extent of the financial markets taking the $10 trillion-plus contingent liability and assumed its a cost

or debt of the Government and have set long-term U.S. Treasury

interest rates in the context that that is their target of what the

33

supply of debt is and, hence, that which moves the price and not

the $4 trillion, which is the debt to the public, which is what

changes with the unified budget balance.

Senator BENNETT. Well, I run a business, and you focus on

cashflow. And I remember very clearly the speech by the President

of the United States who said we are going to include surpluses in

the Social Security account as part of the overall cashflow. His

name was Lyndon Johnson, and it was during the time he was discussing the Great Society. And Republicans were claiming that he

was running a budget deficit, and he said, No, we are not running

a budget deficit because we have this extra money coming into Social Security. I remember that speech very clearly because I was

in town and involved in that at the time. And ever since we went

to a unified budget, on a cashflow basis the surpluses in Social Security have reduced the cash needs of the Government to meet its

obligations.

Starting in 2008, that will begin to stop as the Social Security

surplus will begin to fall in the face of the demographic arrival of

the baby-boomers.

Chairman GREENSPAN. I think that what happens, however, is

that the rate of increase falls and, indeed, at 2018 is the issue of

when—

Senator BENNETT. That is right.

Chairman GREENSPAN. —taxes fall below benefits. But you are

quite right. When you get into 2008, you begin to see the leading

edges effect, but because we still have—I think it is $150 billion

per year additions to the OASI surplus, that first has to go to zero.

Senator BENNETT. Yes, sure. That is right. But in terms of the

unified budget, the amount that we can get—‘‘we’’ being the Government as a whole—from Social Security to deal with the unified

budget deficit begins to decrease in 2008.

Chairman GREENSPAN. That is correct.

Senator BENNETT. And it becomes—when it gets to 2018 or

2020—again, economic forecasts are never exactly accurate. When

it gets to that point, we will already on a unified budget point of

view have had to raise our external borrowing, whether it be Senator Stabenow’s concern of China or whatever, to make up the

amount that we were not getting from the Social Security. It will

begin to produce a cashflow problem.

When it crosses the line, we will have to borrow that much more

because at that point the Social Security trust fund will come to

the Government and say redeem this bond, and the Government

will have to redeem the bond. It is a legitimate claim on the Government. And then the Government says, in order to redeem that

bond, we will sell a bond to the Japanese or the Europeans, or whoever, so that we can have the money to redeem that bond. At that

point the interest on the bond to the Japanese or the Europeans

will hit the unified budget pressure, cashflow pressure, differently

than the interest on the Social Security bond. Isn’t that true?

Chairman GREENSPAN. It depends on how the accounting goes.

Remember, what is going to happen in 2008, I believe, is you begin

to get the extent of the Social Security surplus, which is part of the

unified surplus. That begins to decline.

Senator BENNETT. Right.

34

Chairman GREENSPAN. And you are quite correct, it means that

less and less is being added to the fund which reduces the amount

of borrowing that would be required. At 2018, if you believe the

numbers, what happens is that the Social Security nonmarketable

issues have to be converted to marketable, and they are sold.

The issue of interest payment, remember, refers to interest outside the intragovernmental transfers, and I do not think that you

get a significant interest rate effect there, but you do get the issue

that you are pointing out.

Senator BENNETT. You do not get a significant rate difference,

but you get a significant cashflow difference, because the

intragovernment transfers—the interest obligation is an

intragovernment transfer, and you do not have to come up with the

cash for it. But once you have sold a bond on the public market

to replace the bond that is an intragovernment transfer, that interest payment has to be met in cash rather than the

intragovernment transfer.

Chairman GREENSPAN. That is part of the whole issue of the Social Security system going from accumulating surpluses to then

creating deficits.

Senator BENNETT. Sure.

Chairman GREENSPAN. But the point that I think is a more important and critical issue is that even those accumulations of surpluses are far short of anything that requires the full funding and

that while you can be concerned about the mechanics, I think quite

properly, of what is happening, let us not lose sight of the fact that

the real problem is not that we are going from a $150 billion annual OASI surplus. The problem is that the number is not hugely

larger and building up the——

Senator BENNETT. My time is up, Mr. Chairman. The only point

I want to leave us with is that if we do nothing, as some are suggesting, we have still got to find several trillion dollars of additional cash. So when we say, gee, if we do the private accounts, we

are going to have to find some cash, that is a transition cost. The

point is if we do not do anything, we have to find some cash.

Chairman GREENSPAN. It is the same cash.

Senator BENNETT. Yes. Thank you.

Chairman SHELBY. Senator Bayh.

Senator BAYH. Chairman Greenspan, thank you for your patience

today and your testimony. I apologize for shuttling in and out. We

are having a simultaneous hearing in the Intelligence Committee

on global threats to the Nation’s national security. So we are trying

to deal with both our physical security as well as our economic

prosperity and security today. And I appreciate your contributions

to the latter. And I might ask at the end of my questioning about

the intersection between these two things.

My first question deals with the deficit, and some comments that

you made recently, I think at a foreign forum of some kind, about

the voices of fiscal responsibility stirring here in our Nation’s capital. When I read those comments, I was inclined to think it might

be the triumph of hope over experience, but I was interested to see

you say it, nonetheless.

So my question involves this: There are, as you know, skeptics

who have not heard those voices yet. One, in fact, referred to the

35

budget proposal as a Swiss cheese, more interesting for its holes

than anything else. And so I would like to ask you, when we look

back on this year and we can quantify the size of the deficit for this

year, what number would tell you that it was something more than

a siren song, that, in fact, it is true fiscal harmony stirring? I think

the budget deficit this last year was $412 billion. When we look

back, you know, a year or so from now, what figure would you look

at and you would conclude those voices were more than just rhetoric but, in fact, had been put into effect?

Chairman GREENSPAN. There are two aspects to this. One is the

short term, going out to, say, 2008 and then there is the post-2008

issue. The most important thing would be to look at——

Senator BAYH. I am just looking for accountability to hold all of

us, the executive branch, the legislative branch, to some benchmark of performance.

Chairman GREENSPAN. I have been traumatized by Senator Bennett saying forecasts do not work out for 6 months, so I am trying

to avoid making a forecast out beyond 6 months.

I think that, first of all, if the deficit as a percent of GDP does

not go down, I think we are going into the 2008 are forward period

poorly positioned.

Senator BAYH. Do you have a figure in terms of percentage of

GDP you would look at to——

Chairman GREENSPAN. I would just as soon not put a number because it depends on so many different things, and that number in

and of itself is——

Senator BAYH. Unlike the rest of us, Mr. Chairman, you will

have the luxury of reentering the private sector by that time. So

you perhaps have some more liberty to try and quantify these

things.

Chairman GREENSPAN. I would say that whatever it is we do in

the short-run, unless we start getting serious about the longer-run

problems, I think we are going to run into them and be poorly positioned to effectively handle them without very significant problems.

Senator BAYH. At some point when you feel comfortable, in some

forum, it really would help us to try and have some benchmarks

of performance against which we can judge all of ourselves, both

sides of the aisle, all branches of Government. As you know, it is

easy to talk about these things. It is a lot more difficult to implement them and then hold ourselves to some kind of standard.

Chairman GREENSPAN. Well, let me tell you one of the reasons

I hesitate: It is that the unified budget is not the be-all and endall of a measure of what Government is doing because it is ultimately supposed to give us a judgment of the allocation of real resources essentially preempted by the Federal Government or, in

fact, added if there is a surplus. And the trouble is there are other

ways in which Government can preempt resources, either by regulation, by guarantees, which are not fully accounted for in the

budget, by any of a number of different legal forms of preemption

of property and the like. So you cannot take only that as a measure

of what the overall issue is or its impact on interest rates.

At the end of the day, the standard of how well we are doing

really gets to the question of how have we financed this and what

are we doing. The financial markets will tell you very quickly

36

whether there is something wrong with the budget processes, and

rather than, say, get somebody to forecast and say this is the

standard, I will assure you the far more useful standard is watching what is happening to long-term U.S. Treasury rates. If longterm U.S. Treasury rates are behaving well, it is saying you do not

have a significant problem over the maturity of Treasury instruments, most of the maturity. If they start to behave poorly, the

markets are sending a signal which I think it is very crucial that

the Congress be aware of.

Senator BAYH. I agree. This is a longer discussion. I am afraid

that if we wait—many observers, including myself, have been surprised the markets have not reacted more than they have to date.

And I am afraid, as you know, market psychology being what it is,

if we reach that tipping point, it may require more difficult steps

to turn around than would be necessitated if we act sooner rather

than later.

But let me get to a second question, Mr. Chairman. I think you

know what I am driving at here. I am looking for some benchmarks

of performance against which to try and hold the Government accountable when it comes to the deficit, understanding that regulatory policy and other things also contribute to economic performance.

Chairman GREENSPAN. One standard is if the unified budget deficit is 2 percent of GDP or less, it stabilizes the ratio of debt to

GDP. So if you are looking at a straightforward numerical type,

that is not a bad one. But, again, I want to caution you that it is

a little simplistic, and I would not want to press it too far.

Senator BAYH. We should be so fortunate as to get to 2 percent

of GDP, and we could argue about the other factors that might

come into play. But thank you.

My second question, Chairman, perhaps you can help me—and

I again apologize I missed some of the discussion because I had to

attend the other hearing, and I am going to have to return to the

other hearing—with some cognitive dissonance I am having over

some of the debate here in Washington where, as many of my colleagues and I think you alluded to, quite rightly, we have this tremendous demographic challenge that is going to affect our fiscal

position coming along. We have the underlying—the current budget

problem, both of which are going to—the latter of which necessitates borrowing in the short-run, the latter of which is going to

necessitate perhaps, if nothing is done, large and ongoing borrowing in the long-run. So we have that message that we have, you

know, serious fiscal challenges that we have to face that may necessitate large amounts of borrowing.

At the same time, in the President’s budget proposal we have additional tax cuts included. So apparently we are in such good fiscal

condition that we can afford additional tax cuts, and as you have

convinced me in the past, there is no such thing as a self-financing

tax cut. We can argue about the percentage of growth that is occasioned by that, but, you know, there is a loss of revenue.

How do we reconcile these two positions? On the one hand, we

are facing large and perhaps ongoing needs to borrow, but, on the

other hand, we are flush enough with cash we can continue with

additional tax cuts at the same time.

37

Chairman GREENSPAN. The way I would do it is there are certain

of the tax cuts which I view as enhancing economic growth and,

therefore, enhancing the revenue base. I have been arguing, since

the PAYGO has been dropped in September 2002, that we should

restore it as quickly as possible. The way I would reconcile my own

position is that I think maintaining the reduction in taxes on dividends, which essentially partially integrates the individual and corporate taxes, eliminating part of the double taxation on dividends,

I think is a good thing. But because I hold to the position that we

should be adhering to PAYGO, I think it is necessary to offset it

by other means as required by the law were PAYGO still in effect.

But I do not think you can essentially eliminate all tax cuts or

increased spending because you are endeavoring to get the budget

deficit down. You would probably argue, as I would, that there are

a number of things which should be done even if we have this type

of problem, but that does not mean that we should not be focusing

on the goal of getting the deficit down, especially as quickly as we

can before we begin to run into the really serious problems maybe

in 2012, 2014. We do not have a great deal of time to do it.

Senator BAYH. Mr. Chairman, do I have time for just one more?

Chairman SHELBY. Hurry.

Senator BAYH. Very quickly. I want to ask you about our comparative advantage looking forward, Mr. Chairman. You have been

a long-time observer of our economy. Here shortly you are going to

be liberated from the burdens of public responsibility and might

have a chance to reflect at greater length. But I was struck in December when my wife and I were in India, in Bangalore, and visited General Electric, who employs 6,000 people in our State. One

of their worldwide innovation centers was located in Bangalore.

There is a biotech company there that heretofore has been only engaged in generic production but is now getting into proprietary discover.

Our economy—and my State is a good example. A hundred years

ago, most people were employed in agriculture. We transitioned

into manufacturing, which peaked in the 1950’s. We then

transitioned into a service sector economy.

As succinctly as you can, how would you define, looking forward,

our comparative advantage in a world in which our competitors—

India, China, and the others—are rapidly moving up the innovation

curve?

Chairman GREENSPAN. I think, Senator, the question you are

asking is what creates the wealth of nations. And as best I can

judge, our comparative advantage has been a combination of our

Constitution and the skills of our workforce. It is not raw materials. It is not anything other than what is in people’s heads and

the laws of the land, the rule of law, the protection of property

rights, and a general view on the part of the rest of the world that

this is a wonderful place in which to invest because property rights

are sacrosanct to as extent that they are not elsewhere.

Remember, there is an awful lot of investment that has come

into the United States. We have moved a lot of our investment

abroad, but a lot of investment has been moving here as well. But

the bottom line is that the only thing that we have which maintains our standard of living, that which creates essentially our abilVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
38

ity to have a level of income which is a claim against the rest of

the world, the reason we are able to do that is we create things,

the ideas that we have. And we have an economic system which

capitalizes on the way those ideas function, which most of the rest

of the world, indeed perhaps all of it, cannot match.

That is the reason why I have argued that our education problems are serious because it is right at the root of where our, as you

put it, comparative advantage is.

Senator BAYH. So our comparative advantage lies in the rule of

law that we have and in the quality of our people.

I would just conclude by thanking you again, Mr. Chairman, and

observe, Chairman Shelby, I well recall Chairman Greenspan in

my previous incarnation, and I think, Corzine, this gets to your

point, and perhaps Tom Carper was there. I well recall your addressing a meeting of the National Governors Association many

years ago on the issue of productivity growth and mentioning that

one of the most important things we could do to increase productivity was to enhance the skill level of our people, and that would

help us close the increasing gap between the haves and have-nots

in our society and, indeed, improve the comparative advantage of

our society as a whole.

Thank you for your words, and the indulgence of my colleagues.

Chairman SHELBY. Thank you, Senator Bayh.

Senator Corzine, thank you for being so patient.

Senator CORZINE. Thank you, Mr. Chairman.

I want to get to the integration of this issue of wealth disparities

or income disparities and the Social Security question. First of all,

I have a couple of just housekeeping things.

Do you recall what the 1983 Commission used as far as a time

horizon to figure out its suggestions on solving the then Social Security crisis? Was it an indefinite one, or was it an actuarial——

Chairman GREENSPAN. No, it was 75 years, through 2058.

Senator CORZINE. As I recall, and so you are now suggesting that

that was the wrong——

Chairman GREENSPAN. No, I am saying that it was wrong back

then, but the real problems which would be confronted as a consequence of that were still 25 years off.

Senator CORZINE. There is a huge difference between 3.7 and 10

whatever and——

Chairman GREENSPAN. The 3.7, let us put it this way, any defined benefit program goes to perpetuity of necessity, so that the

75-year is an artifice. I am not sure what it means. We knew that

back in 1983, but that was the historical conventional——

Senator CORZINE. Well, it does allow for thinking about financing

mechanisms that are within the mind-set of most of the people who

are in that workforce today, and a whole bunch of them that are

not even born yet. And so it strikes me that one could reasonably—

and I think actuarials often do—think in some finite timeframe so

that you are not actually trying to solve some problem that is——

Chairman GREENSPAN. But Senator, I think it works fine for the

cash pay-as-you-go system, but it does nothing to create the savings which creates the capital investment which creates the goods

and services that——

39

Senator CORZINE. I could not agree more. I just wanted to know

whether in 1983 we were using 75.

Senator SARBANES. Will you yield for a question?

Senator CORZINE. Sure.

Senator SARBANES. In 1983, did you say that in a few months’

time, the money being paid into the Social Security trust fund

would not be sufficient to pay the benefits?

Chairman GREENSPAN. Correct. What happened would be that

the trust fund was essentially running down to zero, which statutorily required that we pay benefits only to the extent that revenues came in.

Senator SARBANES. So that is a situation comparable to what is

now forecast to happen in 2050, correct?

Chairman GREENSPAN. Well, 2042 or 2052, yes.

Senator SARBANES. Okay.

Senator CORZINE. I just want to reiterate, and this won’t take a

second, but one is not arguing that the financing structure that is

being suggested by the President with private accounts is dealing

with that solvency issue, whether you use 75 years or you use infinity?

Chairman GREENSPAN. No. You mean the private accounts by

themselves, the personal accounts?

Senator CORZINE. When we were dealing with this problem in

1983—and I think Senator Reed quoted, ‘‘should not alter the fundamental structure of the Social Security program or undermine its

fundamental principles,’’ the fundamental principles being guaranteed benefits for the disabled, child and survivor benefits, and retirement.

I want to get at this because the fundamental principle is a social insurance program, not an investment program, not a defined

benefit or a defined contribution program.

Chairman GREENSPAN. No. The question that you have to answer

is whether or not you want to commit to that, irrespective of the

source of revenue. Indeed, you know, we have actually done that.

I cannot believe, and did not believe in 1983, that somehow or

some way we would cut benefits. That was not something which,

in my judgment, seemed credible at all. Nor do I believe that if the

world were to emerge—and I think that Senator Bennett is right.

The one thing we are sure of is it won’t happen the way we are

saying.

Senator CORZINE. I think all of us accept that.

Chairman GREENSPAN. But if it did, the chances of cutting benefits in 2042, for example, because we run out—I put that probability close to zero, if I could not find a lower number.

Senator CORZINE. It all depends on how you define that. I mean,

I think in 1983 you talked about changing the timeframe in which

people—we go on to extending the timeframe before benefits would

be received. One person would look at that and say it is a benefit

cut.

What I would like to get to is that the fundamental financing

structure still has variables that you could adjust to deal with even

the $10 trillion gap.

Chairman GREENSPAN. Oh, absolutely.

40

Senator CORZINE. So there are solutions and they are easier to

implement if we do them sooner rather than later, which is what

was done in 1983, which was to build up these surpluses. Unfortunately, we turned around and spent them for current expenses on

the cashflow basis that Senator Bennett talked about, but there

was a desire to prefund liabilities that was embedded in the recommendations.

We have prefunded them, but because of the reality of the unified budget, we have taken payroll taxes to pay for tax cuts or wars

or whatever the expenditure or reduction of revenues has been. If

I am not mistaken, just on an accounting basis, payroll taxes come

in, they go out for some other purpose with a bunch of borrowing

going on.

My real question is, because I think the fundamental principles

are still sound, that there is need for social insurance on disability,

child and survivor benefits, and for seniors. My own view is we

may have to deal with the financing structure, and you have had

great ideas in the past.

This is going to be hard for you to see, but actually the only

thing that really counts—and I worry about this very deeply—is

that because of a lot of the reasons you have talked about, skill

sets and others, real earnings for the bottom decile in our country

have actually declined in the last 4 years. They are flat for the

25th percentile. They are up a measly two-tenths of 1 percent for

the median percentile, and they are a little bit better for the 75th

percentile and the 90th percentile. I wonder what they are for the

1 percent. We did not have it on this chart. I suspect real earnings

have gone up pretty well for the most skilled in our society.

But aren’t we setting up a situation, if we take away guaranteed

benefits, that the vast majority of people in this society are going

to end up with less savings? Maybe we can have broad changes in

our educational skill levels development in our society, but otherwise we are going to end up with a society that has less ability to

save and we are talking about the guaranteed benefit.

Chairman GREENSPAN. Well, the guaranteed benefits are, I

think, unrelated to this question which you raise with which I

would agree, namely obviously the lower the level of income, the

less capability——

Senator CORZINE. If the individuals do not have the capacity to

save, then we get back to a situation that we have had in other

periods in history where those most vulnerable in society do not

have the ability to maintain an above-poverty standard of living,

which is where we came from before Social Security was implemented both for children and the disabled.

Chairman GREENSPAN. But Social Security—it depends on

whether you are discussing the Social Security for retirees. In other

words, that is different. What I am trying to get at is the issue that

you are raising with respect to the shortfall of incomes of those

below the median or just above the median is——

Senator CORZINE. Fifty percent of the workforce.

Chairman GREENSPAN. Yes, it is the active workforce. To the extent that real wages fall in that area, one would presume that their

savings rates fall as well because that is what people do when their

incomes go down. I think the question of Social Security and the

41

guarantees and the like is a somewhat different issue. But I think

there is also a very interesting question here.

Senator CORZINE. Well, that was the fundamental principle of

Social Security, though, was to provide guaranteed benefits for all.

That was the contract.

Chairman GREENSPAN. Well, it was mainly for retirees. We now,

because we have DI, disability, which is a different program, we

have a lot of people under OASI who are below the so-called retirement age. But the basic purpose is a retirement program.

Senator SARBANES. And survivorship, too.

Senator CORZINE. And survivorship.

Chairman GREENSPAN. That is the basic purpose of it. The problem here is I think we have to make some decisions on whether we

want to make programs as social insurance or means-test programs

and make them essentially for people who are in really serious difficulty.

Senator CORZINE. That is getting at a financial structural solution which you could put into any suggestion that would be independent of whether you had personal accounts.

Chairman GREENSPAN. I agree with that.

Senator CORZINE. Finally, I know my time is up, but you have,

and I think appropriately so, said forced savings as you have described the private accounts.

Chairman GREENSPAN. It is forced in the sense that they should

not be available for other than retirement purposes.

Senator CORZINE. Forced savings is not unlike forced savings at

a national level with regard to taxes, I suppose. I mean, they are

roughly the same equivalent with regard to getting to whether we

have increased savings. If we run deficits and the Government is

spending more than it is taking in, you end up with this declining

savings rate or hole in our savings function.

But you do have choices and we have avoided those choices pretty clearly as we have built up these deficits in the last 4 years. And

it strikes me that along the lines of what Senator Bayh was talking

about you may not know what the right number is, but if you look

at 2009 and beyond—and this is the point that I want to make—

I hear this described as a $743 billion hole in the first 10 years in

this transition to private accounts.

The fact is that allows for the fact that we are not doing anything between 2005 and 2009, and then we will get to 2009 and

find out it is $1.4 trillion, like we found out on Medicare. We need

to have some truth or precision in what it is we are comparing and

contrasting when we are comparing these numbers. I am afraid

that we are using multiple sets of books under the rubric of a unified budget.

I guess that is more of a statement than it is a question, but the

fact is that somebody is going to say $735 billion doesn’t meet the

Greenspanian test of serious borrowing when, in fact, we are just

avoiding the first 4 years and then we are going to start it in 2009.

I just want to make sure we get that clear.

Chairman GREENSPAN. I think the issue essentially is that savings, as you know as well as I, doesn’t create investment. Implicit

in all of this is that the incentives for investment are there and

that when you think in terms of taxation and how one creates the

42

savings, it is conceivable that you can create the savings, but regrettably at the same time so diffuse the incentives to invest that

we will not get the capital assets we need to essentially produce

the goods and services.

So proper balance here, I think, is quite important, and I think

that it is an extraordinarily complex and difficult issue. We have

known about the demographics for quite a long time, but we have

never really addressed them. And it is only now that we are beginning to see the significance of how big the size of the hole is.

Senator CORZINE. Mr. Chairman, I——

Chairman SHELBY. Go ahead.

Senator CORZINE. That is true, but we have a Medicare problem,

a Medicaid problem, a pension benefit guarantee problem. These

figures, when you use the 75-year horizon, which I tend to do, I

think an estimate we heard in the Budget Committee of something

like $43 trillion. Even using a 75-year horizon, Social Security is

3.7 of that.

Chairman GREENSPAN. In fact, actually, I believe I have that

number.

Senator CORZINE. We need to really make sure that we are looking at where the problem really is if we are going to be intellectually honest about getting at these issues.

Senator SARBANES. In fact, Chairman Greenspan, you said before

this Committee in February, 2 years ago, ‘‘The really major fiscal

problem is not Social Security. It is Medicare.’’

Chairman GREENSPAN. I agree with that.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thank you, Mr. Chairman.

Chairman Greenspan, welcome. Sometimes, when I speak to a

group back in Delaware and I am the last speaker before they have

a meal, I will say to them I am all that stands between you and

your meal.

Chairman SHELBY. Maybe not. You have the two of us left here

again.

Senator CARPER. Is that right?

When I have a witness who has been sitting for hours and hours

testifying without a break and I am the last person to ask a question, I will say I am all that stands between you and a chance to

visit the nearest restroom. I won’t say that today, but I might say

it on another occasion.

We have talked a lot about Social Security today, and I want to

beat a dead horse—well, actually, a live horse. I want to ask you

to go back in time with me about 23 or 24 years. I sit on another

Committee called Governmental Affairs and Homeland Security.

Last August, among our witnesses were Governor Kean and former

Congressmen Lee Hamilton, and they had come to us that day to

present the recommendations of a bipartisan commission, 10 members, five appointed by the President and five appointed by the

Democratic leadership of the Congress.

They recommended to us unanimously that we take 44 different

steps as a follow-up to the attacks of September 11. I remember

saying to Governor Kean and Congressman Hamilton, how did you

43

do this? In a politically charged time and arena, with a diverse

group of people on your commission, how did you fashion a bipartisan consensus on all these issues? There were literally 10 to zero

votes on all of them.

They said in response what happened is that the two of them,

the Chair and the Vice Chair, one appointed by the President, the

other appointed by Senator Daschle and Congresswoman Pelosi—

they said we spent a lot of time together over the last 2 years and

we got to know each other and developed a sense of trust for each,

and friendship. And out of that bond came an environment for the

rest of the commission to band together and to join together, setting aside their partisan differences, just to work to try to do what

was right for the country.

I was elected to the House in 1982 and joined a young Mr. Shelby down there. I like to say I knew him when he was a Democrat.

We were both on the House Banking Committee. We used to work

out in the House gym together. Now, we work out in the Senate

gym together.

When I joined him, I found out on January 3, 1983, which was

the day I was sworn into the House, that we had a crisis with respect to Social Security and that we needed to do something about

it. I had always heard talk about it. I talked a little bit about it

when I ran in 1982 for the House, but I found that in 1983 this

was real and there was a real crisis and we faced the possibility

of running out of money.

Fortunately, you and a number of other people had been, I think,

appointed by President Reagan and I think by Tip O’Neill, and

maybe by Robert Byrd. Whoever was the Democratic Leader of the

Senate, I think, made appointments to another bipartisan commission that worked, I believe, throughout 1982 and came to us in

1983 with a host of recommendations.

The way I like to describe it is we joined hands, the House and

Senate Democrats and Republicans, and we either jumped off the

bridge or we drank the Kool-Aid together, and end up adopting

lock, stock, and barrel all your recommendations. We passed them

and set Social Security on a more sound footing for several more

decades.

What I want to ask you is really the same question I asked Lee

Hamilton and to Kean. I think you were the Chair or the Vice

Chair or the Co-Chair of the commission, as I recall. How were you

able to create at that time a unanimity across party lines on a politically charged, difficult issue to be able to present to us a consensus perspective and recommendations that we adopted?

Chairman GREENSPAN. Well, I would hope so. It was done actually in two ways. The first was that one of the senior commissioners was an expert and appointee of Tip O’Neill, Bob Ball, who

is still around.

Senator CARPER. Yes.

Chairman GREENSPAN. He and I merged in the sense that he

would represent the Speaker and report back to him about what

the various choices were, and I would report back to Jim Baker and

President Reagan. And so we kept a line going between the decisionmakers in the White House and the Congress as the commission moved forward from position to position, and in a sense

44

worked concurrently both within the commission and in the Congress and in the White House so that we did not find that at the

end of the day the commission came out one place and there was

no support back with the Speaker or the President.

So that occurred, and then at the end we came up with a report,

and Bob Ball and I went up to the Ways and Means Committee to

testify on the report and we indicated that it is an up-or-down vote.

I said to Ball, when the Republicans ask you a question, I will answer it and I hope you will answer the questions that the Democrats ask me.

It worked remarkably well, and the reason it did is, similar to

the Kean-Hamilton relationship. Remember, we had Pat Moynihan

and Claude Pepper and Bob Dole, and I do not know whether Jack

Heinz was on that.

Senator CARPER. He was.

Chairman GREENSPAN. It was a pretty formidable group of people and what we eventually decided was that the commission report was a compromise, and that it was up or down. In other

words, we argued that this should not be subject to amendment because if it were, it would unwind the whole compromise. And with

very minor exceptions, the Senate and the House both agreed with

that, and what came out was essentially the commission report

preagreed to by the Speaker of the House—and I think Jake Pickle

was at Ways and Means at that time—and President Reagan. So,

essentially, the agreement did not occur as a commission report

and then it went to the Congress. I suspect that rarely, if ever,

works.

Senator CARPER. Would you just refresh my memory. My recollection is that President Reagan appointed some of the members,

that Tip O’Neill appointed some of the members, and that perhaps

the Democratic Leader of the Senate appointed some of the members. Do you recall?

Chairman GREENSPAN. I think that is correct. It was a national

commission which would be presented in the form that you suggest,

Senator.

Senator CARPER. And my recollection is the commission was created maybe in the second half of 1981, and that you worked

through 1982 and presented your recommendations to us in 1983.

Chairman GREENSPAN. I think that is probably correct. I do not

remember the actual date it began.

Senator CARPER. Do you think that the way that the commission

members were selected—that is, some by the President and the Republicans, and some by some of the Congressional leaders who in

that case were Democrats—do you think that had maybe some

bearing on the fact that you were able to bring a consensus proposal to us?

Chairman GREENSPAN. You know as well as I, there was a far

greater degree of comity back then, and I think that what we need

is a good deal more of that. But primarily what you need is a bipartisan group of people getting together who have the capacity not

only to reach a compromise agreement, which means that there are

parts of that agreement with which everyone in the room disagrees

and present it as an up-or-down type of issue. You need a mechaVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 21981.TXT SBANK4 PsN: SBANK4
45

nism in which that occurs because you cannot have a particular

commission report subject to continuous revision.

I remember on another commission that I was on, one of the

members said I would like to agree with you at this particular

stage, but since this is not the final negotiation, I do not want to

state my position at this particular point. And it was a perfectly

sensible operation, and indeed we did not get very far basically because of that problem.

So you have to figure a way in which the final decisions are

made concurrently with the commission and the Congress, because

if you leave those types of results, especially things which are compromises, they get amended to death and it unwinds the whole

agreement.

Senator CARPER. Mr. Chairman, thanks very, very much.

Chairman SHELBY. Thank you for bringing that up. Chairman

Greenspan, we need to find another Chairman Greenspan in the

making out there somewhere to put this type of thing together.

I have a couple of questions and I will try to be quick.

One of the Social Security reform options—and there are many

out there and there will probably be many more—that has been

mentioned is changing the way that benefits are adjusted over

time, or indexing. Today, it is my understanding that the indexing

is based on wages, mainly, as opposed to an inflation-based index.

What impact would such a change to an inflation-based index

have on the financial soundness of the Social Security program in

the years to come?

Chairman GREENSPAN. Well, Senator, currently we index the initial benefit.

Chairman SHELBY. Explain how that works.

Chairman GREENSPAN. Well, what they do is they effectively take

an average of wages over a long period of time and they construct

effectively a specific benefit that is the initial benefit.

Chairman SHELBY. For an individual.

Chairman GREENSPAN. For the individual.

Chairman SHELBY. Okay.

Chairman GREENSPAN. The intial benifit is thereafter indexed by

inflation, so that the real benefit doesn’t change after retirement,

whether it is at 62 or 65. And trying to get the average wage as

the index creates a much higher initial benefit than were you to

use prices retrospectively and the reason is that wages will reflect

productivity increases, whereas prices will not.

If you, however, now substitute prices for wages in creating the

initial benefit, you will have essentially a benefit which, whereas

now its ratio to your previous income has been stable, will begin

to fall through time. And if you make a full adjustment going from

a so-called wage-adjusted initial benefit to a price-adjusted initial

benefit——

Chairman SHELBY. Initial benefit is what you are talking about?

Chairman GREENSPAN. I am sorry?

Chairman SHELBY. You are talking about initial benefit.

Chairman GREENSPAN. Initial benefit. You effectively wipe out

all of that $10 trillion that I have been mentioning.

Chairman SHELBY. Over many years?

46

Chairman GREENSPAN. Yes, but as a number of people have mentioned, the replacement ratio, which is not around 40 percent, as

I recall, starts to go down materially. One of the issues that is involved here is that with the demographics that we are looking at,

in most of the scenarios the replacement rate would go down in any

event.

Chairman SHELBY. Any event.

Chairman GREENSPAN. And the only issue is to what extent. So

it is not a question of being capable of holding that 40 percent indefinitely without causing problems in the standards of living of

the active working population at that time.

Chairman SHELBY. Chairman Greenspan, what about if you are

55 years of age and you have just retired? If they were to go to the

inflation-based index for the future, what would that do to the retirees? Or let’s say you are drawing Social Security now and you

are 70 years of age. Let’s say you are drawing Social Security now.

What would that do to the future?

Chairman GREENSPAN. It would have no effect.

Chairman SHELBY. No effect on the people that are retired?

Chairman GREENSPAN. It is the initial benefit.

Chairman SHELBY. Initial when you retired, isn’t it?

Chairman GREENSPAN. I am sorry?

Chairman SHELBY. When you initially start computing it?

Chairman GREENSPAN. Yes. Once you are retired and you are

getting a benefit, that is indexed by the Consumer Price Index and

that is not involved in this change, as I understand it.

Chairman SHELBY. But it is something that as things are put on

the table we all should maybe consider anyway. Is that correct?

Chairman GREENSPAN. I think that it is one of the most effective

ways to come to grips at closing the actual gap between expected

revenues and expected benefits. There are a lot of other things you

can do, but the impact is fairly substantial from that change.

Chairman SHELBY. I want to touch on one last thing. Your written testimony Mr. Chairman, notes that the low national savings

rate could eventually slow the rise in living standards either by increasing the burden of servicing U.S. foreign debt or by impinging

on domestic capital formation.

To what extent will the anticipated further increases in interest

rates affect this possibility?

Chairman GREENSPAN. Well, it has two effects, in a sense. One,

if real interest rates rise, one would presume that the incentives

to invest would fall. It will concurrently presumably attract funds

into the United States because of the rates of return. I do not think

you could make a judgment as to what the overall impact is, but

it is one of the issues.

Far more important, for example, is the differential growth rates

between the trading partners. Clearly, the exchange rate has an

impact. Interest rates have a number of different effects, but they

are rarely critical in the issue of determination of the current account balance.

Chairman SHELBY. Mr. Chairman, last week Atlanta Federal Reserve President Jack Gwynn, in an interview with The Wall Street

Journal, said, as I understand it, that the central bank could soon

47

remove the word ‘‘measured’’ and the word ‘‘accommodation’’ from

the official statement.

What is your view as to whether such a change in the FOMC’s

message is likely, and what would such an action tell us about the

likely course of action in the future as far as interest rate increases

or movement?

Chairman GREENSPAN. Well, I think what President Gwynn was

saying was obvious. We are not going to have the same statement

in perpetuity. At some point, it is going to change. I cannot really

comment on when and under what conditions because that is a decision that the Federal Open Market Committee has to make.

Chairman SHELBY. Mr. Chairman, thank you for your appearance here today and we will see you a lot probably before the year

is over. Thank you very much.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 1:01 p.m., the hearing was adjourned.]

[Prepared statement, response to written questions, and additional material supplied for the record follow:]

48

PREPARED STATEMENT OF SENATOR WAYNE ALLARD

Thank you, Chairman Greenspan for coming to the Senate today to share the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress. This Committee and the Congress greatly benefit from your reports and visits, and the expertise that you offer to us and the Country.

The economy is healthy and expanding, with GDP having increased in both the

third and fourth quarters of 2004. Productivity and output both increased as well

during the last months of 2004. We have even seen recent increases in exports and

a decrease in the U.S. current account deficit.

The Federal Reserve Board has done a good job at monitoring monetary policy

and economic indicators in order to see that policy remains accommodative to the

ebbs and flows of the U.S. economy. Their steadfastness in recognizing the immediate monetary needs and adjusting policy accordingly is to be commended. Dr.

Greenspan, I appreciate your commitment to this Committee, the Congress, and this

country. I look forward to hearing your evaluation and insights on monetary policy,

the condition of the economy, and your forecast for the next several months. Thank

you, Chairman Greenspan for coming to the Senate today to share the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress. This Committee and

the Congress greatly benefit from your reports and visits, and the expertise that you

offer to us and the Country. The economy is healthy and expanding, with GDP having increased in both the third and fourth quarters of 2004. Productivity and output

both increased! as well during the last months of 2004. We have even seen recent

increases in exports and a decrease in the U.S. current account deficit. The Federal

Reserve Board has done a good job at monitoring monetary policy and economic indicators in order to see that policy remains accommodative to the ebbs and flows

of the U.S. economy. Their steadfastness in recognizing the immediate monetary

needs and adjusting policy accordingly is to be commended.

Dr. Greenspan, I appreciate your commitment to this Committee, the Congress,

and this country. I look forward to hearing your evaluation and insights on monetary policy, the condition of the economy, and your forecast for the next several

months.

—————

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

FEBRUARY 16, 2005

Mr. Chairman and Members of the Committee, I am pleased to be here today to

present the Federal Reserve’s Monetary Policy Report to the Congress. In the 7

months since I last testified before this Committee, the U.S. economic expansion has

firmed, overall inflation has subsided, and core inflation has remained low.

Over the first half of 2004, the available information increasingly suggested that

the economic expansion was becoming less fragile and that the risk of an undesirable decline in inflation had greatly diminished. Toward mid-year, the Federal Reserve came to the judgment that the extraordinary degree of policy accommodation

that had been in place since the middle of 2003 was no longer warranted and, in

the announcement released at the conclusion of our May meeting, signaled that a

firming of policy was likely. The Federal Open Market Committee began to raise

the Federal funds rate at its June meeting, and the announcement following that

meeting indicated the need for further, albeit gradual, withdrawal of monetary policy stimulus.

Around the same time, incoming data suggested a lull in activity as the economy

absorbed the impact of higher energy prices. Much as had been expected, this soft

patch proved to be short-lived. Accordingly, the Federal Reserve has followed the

June policy move with similar actions at each meeting since then, including our

most recent meeting earlier this month. The cumulative removal of policy accommodation to date has significantly raised measures of the real Federal funds rate, but

by most measures, it remains fairly low.

The evidence broadly supports the view that economic fundamentals have

steadied. Consumer spending has been well-maintained over recent months, buoyed

by continued growth in disposable personal income, gains in net worth, and accommodative conditions in credit markets. Households have recorded a modest improvement in their financial position over this period, to the betterment of many indicators of credit quality. Low interest rates and rising incomes have contributed to a

decline in the aggregate household financial obligation ratio, and delinquency and

charge-off rates on various categories of consumer loans have stayed at low levels.

49

The sizable gains in consumer spending of recent years have been accompanied

by a drop in the personal saving rate to an average of only 1 percent over 2004—

a very low figure relative to the nearly 7 percent rate averaged over the previous

three decades. Among the factors contributing to the strength of spending and the

decline in saving have been developments in housing markets and home finance

that have spurred rising household wealth and allowed greater access to that

wealth. The rapid rise in home prices over the past several years has provided

households with considerable capital gains. Moreover, a significant increase in the

rate of single-family home turnover has meant that many consumers have been able

to realize gains from the sale of their homes. To be sure, such capital gains, largely

realized through an increase in mortgage debt on the home, do not increase the pool

of national savings available to finance new capital investment. But from the perspective of a! n individual household, cash realized from capital gains has the same

spending power as cash from any other source.

More broadly, rising home prices along with higher equity prices have outpaced

the rise in household, largely mortgage, debt and have pushed up household net

worth to about 51⁄2 times disposable income by the end of last year. Although the

ratio of net worth to income is well below the peak attained in 1999, it remains

above the long-term historical average. These gains in net worth help to explain

why households in the aggregate do not appear uncomfortable with their financial

position even though their reported personal saving rate is negligible.

Of course, household net worth may not continue to rise relative to income, and

some reversal in that ratio is not out of the question. If that were to occur, households would probably perceive the need to save more out of current income; the personal saving rate would accordingly rise, and consumer spending would slow.

But while household spending may well play a smaller role in the expansion going

forward, business executives apparently have become somewhat more optimistic in

recent months. Capital spending and corporate borrowing have firmed noticeably,

but some of the latter may have been directed to finance the recent backup in inventories. Mergers and acquisitions, though, have clearly perked up.

Even in the current much-improved environment, however, some caution among

business executives remains. Although capital investment has been advancing at a

reasonably good pace, it has nonetheless lagged the exceptional rise in profits and

internal cashflow. This is most unusual; it took a deep recession to produce the last

such configuration in 1975. The lingering caution evident in capital spending decisions has also been manifest in less-aggressive hiring by businesses. In contrast to

the typical pattern early in previous business-cycle recoveries, firms have appeared

reluctant to take on new workers and have remained focused on cost containment.

As opposed to the lingering hesitancy among business executives, participants in

financial markets seem very confident about the future and, judging by the exceptionally low level of risk spreads in credit markets, quite willing to bear risk. This

apparent disparity in sentiment between business people and market participants

could reflect the heightened additional concerns of business executives about potential legal liabilities rather than a fundamentally different assessment of macroeconomic risks.

Turning to the outlook for costs and prices, productivity developments will likely

play a key role. The growth of output per hour slowed over the past half year, giving

a boost to unit labor costs after 2 years of declines. Going forward, the implications

for inflation will be influenced by the extent and persistence of any slowdown in productivity. A lower rate of productivity growth in the context of relatively stable increases in average hourly compensation has led to slightly more rapid growth in

unit labor costs. Whether inflation actually rises in the wake of slowing productivity

growth, however, will depend on the rate of growth of labor compensation and the

ability and willingness of firms to pass on higher costs to their customers. That, in

turn, will depend on the degree of utilization of resources and how monetary policymakers respond. To date, with profit margins already high, competitive pressures

have tended to limit the extent to which cost pressures have ! been reflected in higher prices.

Productivity is notoriously difficult to predict. Neither the large surge in output

per hour from the first quarter of 2003 to the second quarter of 2004, nor the more

recent moderation was easy to anticipate. It seems likely that these swings reflected

delayed efficiency gains from the capital goods boom of the 1990’s. Throughout the

first half of last year, businesses were able to meet increasing orders with management efficiencies rather than new hires. But conceivably the backlog of untapped

total efficiencies has run low, requiring new hires. Indeed, new hires as a percent

of employment rose in the fourth quarter of last year to the highest level since the

second quarter of 2001.

50

There is little question that the potential remains for large advances in productivity from further applications of existing knowledge, and insights into applications

not even now contemplated doubtless will emerge in the years ahead. However, we

have scant ability to infer the pace at which such gains will play out and, therefore,

their implications for the growth of productivity over the longer-run. It is, of course,

the rate of change of productivity over time, and not its level, that influences the

persistent changes in unit labor costs and hence the rate of inflation.

The inflation outlook will also be shaped by developments affecting the exchange

value of the dollar and oil prices. Although the dollar has been declining since early

2002, exporters to the United States apparently have held dollar prices relatively

steady to preserve their market share, effectively choosing to absorb the decline in

the dollar by accepting a reduction in their profit margins. However, the recent

somewhat quickened pace of increases in U.S. import prices suggests that profit

margins of exporters to the United States have contracted to the point where the

foreign shippers may exhibit only limited tolerance for additional reductions in margins should the dollar decline further.

The sharp rise in oil prices over the past year has no doubt boosted firms’ costs

and may have weighed on production, particularly given the sizable permanent component of oil price increases suggested by distant-horizon oil futures contracts. However, the share of total business expenses attributable to energy costs has declined

appreciably over the past 30 years, which has helped to buffer profits and the economy more generally from the adverse effect of high oil and natural gas prices. Still,

although the aggregate effect may be modest, we must recognize that some sectors

of the economy and regions of the country have been hit hard by the increase in

energy costs, especially over the past year.

Despite the combination of somewhat slower growth of productivity in recent

quarters, higher energy prices, and a decline in the exchange rate for the dollar,

core measures of consumer prices have registered only modest increases. The core

PCE and CPI measures, for example, climbed about 11⁄4 and 2 percent, respectively,

at an annual rate over the second half of last year.

All told, the economy seems to have entered 2005 expanding at a reasonably good

pace, with inflation and inflation expectations well anchored. On the whole, financial markets appear to share this view. In particular, a broad array of financial indicators convey a pervasive sense of confidence among investors and an associated

greater willingness to bear risk than is yet evident among business managers.

Both realized and option-implied measures of uncertainty in equity and fixed-income markets have declined markedly over recent months to quite low levels. Credit

spreads, read from corporate bond yields and credit default swap premiums, have

continued to narrow amid widespread signs of an improvement in corporate credit

quality, including notable drops in corporate bond defaults and debt ratings downgrades. Moreover, recent surveys suggest that bank lending officers have further

eased standards and terms on business loans, and anecdotal reports suggest that

securities dealers and other market-makers appear quite willing to commit capital

in providing market liquidity.

In this environment, long-term interest rates have trended lower in recent months

even as the Federal Reserve has raised the level of the target Federal funds rate

by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the

yield curve governs the relationship between short- and long-term interest rates.

Ten-year yields, for example, can be thought of as an average of 10 consecutive 1

year forward rates. A rise in the first-year forward rate, which correlates closely

with the Federal funds rate, would increase the yield on 10-year U.S. Treasury

notes even if the more-distant forward rates remain unchanged. Historically,

though, even these distant forward rates have tended to rise in association with

monetary policy tightening.

In the current episode, however, the more-distant forward rates declined at the

same time that short-term rates were rising. Indeed, the tenth-year tranche, which

yielded 61⁄2 percent last June, is now at about 51⁄4 percent. During the same period,

comparable real forward rates derived from quotes on Treasury inflation-indexed

debt fell significantly as well, suggesting that only a portion of the decline in nominal forward rates in distant tranches is attributable to a drop in long-term inflation

expectations.

Some analysts have worried that the dip in forward real interest rates since last

June may indicate that market participants have marked down their view of economic growth going forward, perhaps because of the rise in oil prices. But this interpretation does not mesh seamlessly with the rise in stock prices and the narrowing

of credit spreads observed over the same interval. Others have emphasized the subVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6621 21981.TXT SBANK4 PsN: SBANK4
51

dued overall business demand for credit in the United States and the apparent eagerness of lenders, including foreign investors, to provide financing. In particular,

heavy purchases of longer-term Treasury securities by foreign central banks have

often been cited as a factor boosting bond prices and pulling down longer-term

yields. Thirty-year, fixed-rate mortgage rates have dropped to a level only a little

higher than the record lows touched in 2003 and, as a consequence, the estimated

average duration of outstanding mortgage-backed securities has shortened appreciably ! over recent months. Attempts by mortgage investors to offset this decline

in duration by purchasing longer-term securities may be yet another contributor to

the recent downward pressure on longer-term yields.

But we should be careful in endeavoring to account for the decline in long-term

interest rates by adverting to technical factors in the United States alone because

yields and risk spreads have narrowed globally. The German 10-year Bund rate, for

example, has declined from 41⁄4 percent last June to current levels of 31⁄2 percent.

And spreads of yields on bonds issued by emerging-market nations over U.S. Treasury yields have declined to very low levels.

There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world’s productive capacity is being tapped to satisfy global demands for goods and services.

Concurrently, greater integration of financial markets has meant that a larger share

of the world’s pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services, and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation

risk premiums. But none of this is new and hence it is difficult to attribute the longterm interest rate declines of the last 9 months to glacially increasing globalization.

For the moment, the broadly unanticipated behavior of world bond markets remains

a conundrum. Bond price movements may be a short-term aberration, but ! it will

be some time before we are able to better judge the forces underlying recent experience.

This is but one of many uncertainties that will confront world policymakers. Over

the past two decades, the industrial world has fended off two severe stock market

corrections, a major financial crisis in developing nations, corporate scandals, and,

of course, the tragedy of September 11, 2001. Yet overall economic activity experienced only modest difficulties. In the United States, only five quarters in the past

20 years exhibited declines in GDP, and those declines were small. Thus, it is not

altogether unexpected or irrational that participants in the world marketplace

would project more of the same going forward.

Yet history cautions that people experiencing long periods of relative stability are

prone to excess. We must thus remain vigilant against complacency, especially since

several important economic challenges confront policymakers in the years ahead.

Prominent among these challenges in the United States is the pressing need to

maintain the flexibility of our economic and financial system. This will be essential

if we are to address our current account deficit without significant disruption. Besides market pressures, which appear poised to stabilize and over the longer-run

possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the

same direction. Central to that adjustment must be an increase in net national saving. This serves to underscore the imperative to restore fiscal discipline.

Beyond the near-term, benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and

Medicare, threaten to strain the resources of the working-age population in the

years ahead. Real progress on these issues will unavoidably entail many difficult

choices. But the demographics are inexorable, and call for action before the leading

edge of baby boomer retirement becomes evident in 2008. This is especially the case

because longer-term problems, if not addressed, could begin to affect longer-dated

debt issues, the value of which is based partly on expectations of developments

many years in the future.

Another critical long-run economic challenge facing the United States is the need

to ensure that our workforce is equipped with the requisite skills to compete effectively in an environment of rapid technological progress and global competition.

Technological advance is continually altering the shape, nature, and complexity of

our economic processes. But technology and, more recently, competition from abroad

have grown to a point at which demand for the least-skilled workers in the United

States and other developed countries is diminishing, placing downward pressure on

their wages. These workers will need to acquire the skills required to compete effectively for the new jobs that our economy will create.

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At the risk of some oversimplification, if the skill composition of our workforce

meshed fully with the needs of our increasingly complex capital stock, wage-skill differentials would be stable, and percentage changes in wage rates would be the same

for all job grades. But for the past 20 years, the supply of skilled, particularly highly

skilled, workers has failed to keep up with a persistent rise in the demand for such

skills. Conversely, the demand for lesser-skilled workers has declined, especially in

response to growing international competition. The failure of our society to enhance

the skills of a significant segment of our workforce has left a disproportionate share

with lesser skills. The effect, of course, is to widen the wage gap between the skilled

and the lesser skilled.

In a democratic society, such a stark bifurcation of wealth and income trends

among large segments of the population can fuel resentment and political polarization. These social developments can lead to political clashes and misguided economic

policies that work to the detriment of the economy and society as a whole. As I have

noted on previous occasions, strengthening elementary and secondary schooling in

the United States—especially in the core disciplines of math, science, and written

and verbal communications—is one crucial element in avoiding such outcomes. We

need to reduce the relative excess of lesser-skilled workers and enhance the number

of skilled workers by expediting the acquisition of skills by all students, both

through formal education and on-the-job training.

Although the long-run challenges confronting the U.S. economy are significant, I

fully anticipate that they will ultimately be met and resolved. In recent decades our

Nation has demonstrated remarkable resilience and flexibility when tested by

events, and we have every reason to be confident that it will weather future challenges as well. For our part, the Federal Reserve will pursue its statutory objectives

of price stability and maximum sustainable employment—the latter of which we

have learned can best be achieved in the long-run by maintaining price stability.

This is the surest contribution that the Federal Reserve can make in fostering the

economic prosperity and well-being of our Nation and its people.

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RESPONSE TO A WRITTEN QUESTION OF SENATOR BENNETT

FROM ALAN GREENSPAN

Q.1. In 2002, the Home Mortgage Disclosure Act (HMDA) regulations were revised to allow for additional data collection from the

lending industry. On March 1, 2005, banks and other covered lenders will be required to submit data to the Federal Reserve that will

include more loan-pricing data and new ethnicity data. Concerns

have been raised that this new HMDA data, if taken out of context,

might allow for misinterpretation. Can you explain what the intent

of the new HMDA data is, the context of the data, and what some

of the key limitations of that data are, that is, what the data might

show and might not show?

A.1. The new public disclosure of price information under HMDA

is intended to ensure that the HMDA data set continues to be a

useful tool to improve market efficiency and legal compliance with

the fair lending laws. Since HMDA was last amended by the Congress, technological advances have made it possible for lenders to

more accurately gauge credit risk. Lenders will lend to higher-risk

individuals whom they previously would have denied credit, albeit

at higher prices commensurate with the higher risk. Broader access

to credit has been a largely positive development, expanding opportunities for homeownership and allowing previously credit-constrained individuals to tap the equity in their homes. However,

expansion of the higher-priced lending market also has been associated with concerns about the fairness of pricing in the market.

The price data newly required to be disclosed under HMDA can

be used as a screen that identifies aspects of the higher-priced end

of the mortgage market that warrant a closer look. Conclusive

judgments about the fairness of pricing, however, must consider all

of the legitimate factors that underlie pricing decisions, including

risk-related factors. Risk-related factors include measures such as

the borrower’s credit history and debt-to-income ratio, and the

loan-to-value ratio of the specific transaction. The expanded HMDA

data do not include these factors, or many others that are potentially relevant to a pricing decision. Absent information about all

relevant pricing factors, one cannot draw definitive conclusions

about whether particular lenders discriminate unlawfully or take

unfair advantage of consumers. Thus, any price disparities by race

or ethnicity revealed in the HMDA data will not, by themselves,

prove unlawful discrimination. Such disparities will, however, need

closer scrutiny. In the case of depository institutions, for example,

that scrutiny will be supplied by bank examiners, who will have access to information about all of the relevant variables.

RESPONSE TO A WRITTEN QUESTION OF SENATOR SANTORUM

FROM ALAN GREENSPAN

Q.1. The final version of Basel II was, as I understand, agreed to

last summer. How final is the Accord? Are there issues that still

need to be addressed? How will U.S. regulators work to mitigate

possible negative competitive impacts of the Accord on U.S. banks?

Particularly regarding the operational risk sector: (1) Could Pillar

1 treatment actually increase risk as more money goes to meet regulatory capital demands and less is therefore potentially available

to apply to risk avoidance, and (2) Could there be increasing comVerDate 11-MAY-2000 17:38 Jun 29, 2005 Jkt 000000 PO 00000 Frm 00057 Fmt 6633 Sfmt 6601 21981.TXT SBANK4 PsN: SBANK4
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petitive concerns for U.S. banks, particularly in business lines for

which we are world leaders, such as credit cards and asset management? What is being done to ensure that we continue to maintain

our leadership and are not competitively disadvantaged?

A.1. The participating countries in the Basel Committee on Banking Supervision reached an ‘‘Agreement in Principle’’ in mid-2004

and each country is now following its national procedures for review. As you know, in the United States, that procedure requires,

among other things, a Notice of Proposed Rulemaking (NPR), followed by a comment period, the adoption of a final rule, and a delayed effective date. The U.S. banking agencies have made it clear

to the Basel Committee that there is no final agreement until we

once again have reviewed and evaluated public comments on our

NPR. We published in 2003 an Advance Notice of Proposed Rulemaking (ANPR), reviewed comments on the ANPR, and we are now

in the process of preparing an NPR that reflects those comments.

The mid-2004 Basel II text issued by the Basel Committee followed

several years of industry consultation in the late 1990’s and early

in the current decade, resulting in modifications to the proposal.

The U.S. ban! king agencies expect to issue a final rule implementing Basel II in the United States in mid-2006 but every provision is still subject to public comment and review by the agencies.

The Basel Committee is still working on some important issues,

at the request of the U.S. agencies, and under their leadership.

These are (1) the capital rules for certain guaranteed obligations,

where both the borrower and the guarantor would have to default

(double default) before the lender faces losses, (2) issues involving

capital charges for certain trading account assets, and (3) the development of measures of Loss Given Default under conditions of

stress.

In the ANPR, the U.S. banking agencies proposed a bifurcated

application of Basel II in the United States; that is, we proposed

that certain large banks would be required to be under Basel II,

any bank that meets the infrastructure requirements and wished

to do so could opt in to Basel II, and all other banks would remain

under the current Basel I-based capital rules. Federal Reserve staff

has conducted and published several studies on the competitive implications of the proposed bifurcated application of Basel II in the

United States. These studies were of mergers and acquisitions,

loans to small- and medium-sized businesses, and operational risk.

Early in April, Federal Reserve staff plans to release a residential

mortgage study and before mid-year a consumer credit card study.

The studies published so far suggest that the proposed U.S. implementation of Basel II would have at most modest competitive

impacts, although the studies do indicate that there may be some

po! tential effects on regional banks in the market for loans to

small- and medium-sized firms. The U.S. banking agencies also

have recently conducted their fourth Basel II quantitative impact

study (QIS 4), and the results of this study (which should be available in the coming months) should shed additional light on the potential competitive impact of Basel II on the U.S. banking system.

The U.S. banking agencies have announced their intention to

propose changes in either the application of Basel II in this country

or in the current U.S. capital rules that would continue to apply

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to non-Basel II banks in order to address potential competitive distortions, as well as to make the current capital regime more risksensitive. Proposed changes to the current capital rules would be

included in an ANPR to be published shortly after the Basel II

NPR.

Many banks that have been preparing for Pillar 1 treatment of

operational risk, using the Advanced Measurement Approach

(AMA), which allows banks great flexibility, continue to tell us that

they perceive that the process has spawned risk management benefits for their organization that go beyond regulatory compliance. In

addition, we as supervisors—and increasingly rating agencies and

counterparties—believe that such mechanisms are necessary in

well-managed organizations that seek to play a role in global financial markets, in extending credit, trading in large volume, and

managing and processing financial assets for a significant share of

the global financial system. In effect, the market—independently of

Basel II—is requiring that banks establish and maintain an operational risk management infrastructure that is similar in nature

and cost to the infrastructure that would be required under Basel

II. Moreover, we do not expect that Basel II will impede banks’ efforts to m! itigate their operational risk; in fact, Basel II allows

banks to reduce substantially their capital requirements for operational risk to the extent the bank has taken action to control or

hedge its operational risk.

U.S. banks would be stronger, safer, and less vulnerable to

shock—and thus the preferred entities for global counterparties—

because of having the strong risk measurement and management

systems that Basel II requires. This proposition holds true in credit

cards, asset management, and across the full range of bank activities. A bank is not competitively disadvantaged if it has strong risk

and capital management systems vis-a`-vis its rivals here and

abroad. In any event, foreign rivals will be subject to the Basel II

rules, and securities firms in this country will be subject to similar

rules.

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