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81–374 PDF 2002

S. HRG. 107–627

RISKS OF A GROWING BALANCE OF

PAYMENTS DEFICIT

HEARING

BEFORE THE

SUBCOMMITTEE ON ECONOMIC POLICY

OF THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

ON

THE BURGEONING BALANCE OF PAYMENTS DEFICIT WHICH NEARLY

DOUBLED IN THE LAST FEW YEARS, FROM $300 MILLION IN 1999 TO

AN EXPECTED $500 BILLION IN 2001

JULY 25, 2001

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

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

DANIEL K. AKAKA, Hawaii

PHIL GRAMM, Texas

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN ENSIGN, Nevada

STEVEN B. HARRIS, Staff Director and Chief Counsel

WAYNE A. ABERNATHY, Republican Staff Director

MARTIN J. GRUENBERG, Senior Counsel

AMY F. DUNATHAN, Republican Senior Professional Staff Member

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON ECONOMIC POLICY

CHARLES E. SCHUMER, New York, Chairman

JIM BUNNING, Kentucky, Ranking Member

ZELL MILLER, Georgia

JON S. CORZINE, New Jersey

DANIEL K. AKAKA, Hawaii

ROBERT F. BENNETT, Utah

JOHN ENSIGN, Nevada

KATE SCHEELER, Legislative Assistant

STEVE PATTERSON, Republican Legislative Assistant

(II)

CONTENTS

WEDNESDAY, JULY 25, 2001

Page

Opening statement of Senator Schumer ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Corzine ................................................................................................ 10

Senator Sarbanes .............................................................................................. 11

Senator Bennett ................................................................................................ 14

Senator Bunning ............................................................................................... 39

WITNESSES

Robert E. Rubin, Former Secretary, U.S. Department of the Treasury, Director and Chairman of the Executive Committee, Citigroup, Inc. ...................... 3

Prepared statement .......................................................................................... 39

Paul A. Volcker, Former Chairman of the Board of Governors, Federal

Reserve System .................................................................................................... 5

Prepared statement .......................................................................................... 41

William Dudley, Managing Director and Chief U.S. Economist, Goldman

Sachs ..................................................................................................................... 25

Prepared statement .......................................................................................... 42

Stephen S. Roach, Chief Economist and Director of Global Economics, Morgan

Stanley .................................................................................................................. 28

Prepared statement .......................................................................................... 45

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Graph of the U.S. Current Account Deficit As A Share of GDP submitted

by Senator Robert F. Bennett ............................................................................. 62

(III)

(1)

RISKS OF A GROWING BALANCE OF

PAYMENTS DEFICIT

WEDNESDAY, JULY 25, 2001

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

The Subcommittee met at 10:05 a.m., in room SD–538 of the

Dirksen Senate Office Building, Senator Charles E. Schumer

(Chairman of the Subcommittee) presiding.

OPENING STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. I would like to call the Subcommittee on Economic Policy to order.

This is our first hearing, at least with me sitting in this seat as

Chair, and I would like to thank my colleagues and particularly

Chairman Sarbanes and Ranking Member Gramm for the confidence they have shown in me and I will try to do the best job I

can. I would also like to thank our witnesses for coming today. It

is a very distinguished panel and I am honored that you are willing

to sacrifice your morning to be here. Your presence today indicates

the weightiness of the subject—the balance of payments deficit.

In my view, this is probably the least explored and least understood economic issue in Washington and the rest of the world. In

an increasingly globalized economy, no issue could be more important or ripe for study, particularly because even those who do

understand it, like our witnesses today, are not sure if there is any

right solution.

As we all know, the U.S. balance of payments deficit is burgeoning. Over the last 21⁄2 years, it has risen from $320 billion in 1999 to $500 billion this year.

A number of economists have already expressed concerns about

the sustainability of our dependence on foreign investment. With

the national savings rate dropping to around 4 percent in the last

few years and the personal savings rate in the red, the United

States was forced to fund its investment boom with foreign investment, which has generated the massive imbalance we have today.

But like the Egypt of 1875, which through its profligate spending

became so indebted it was forced to sell its ownership in the Suez

Canal to the British, we are living beyond our means and we cannot continue to do so, at least in the opinion of many.

What holds for individuals apparently holds true for the economy

at large. Living beyond one’s means is not sustainable in the long

run and the problem is not self-correcting.

2

Some economists thought that the problem would self-correct.

Over-borrowing would become a drag on the economy, as more of

the domestic GDP was allocated to foreign debt servicing. The

slower economy would weaken the dollar and, as a result, the

United States would become less attractive to foreign investors, but

that has not happened, at least in the last little while, the reverse

has. The dollar has never been stronger and now, more than ever,

foreign investment is descending upon the United States.

Recent gains in the Euro have been marginal and, arguably,

speculative. And as Mr. Roach notes, today foreign ownership of

U.S. Treasuries is 37 percent, U.S. corporate bonds is 46 percent,

and even in the vast equities market, 11 percent.

This is a dangerous paradox. Foreign investment should be slowing, but it is speeding up. The dollar should be getting weaker, but

it is getting stronger.

I would like to point out that our witnesses today disagree about

whether a weaker dollar is the right solution. This disagreement in

and of itself among the most studied economists in the United

States shows how complex this is. As I see it, this hearing is the

first foray into trying to elucidate this paradox, and in doing

so, maybe figuring out a way to overcome it. No four people could

be better called upon to meet this challenge. There are a number of questions that I am hopeful we will get some light shed

upon today.

First, what is the primary driver of this growing imbalance? Is

it simply the result of a mismatch in the supply of national savings

and the demand for investment?

Second, is the imbalance unsustainable? I am swayed by concerns that at some point, the imbalance will become unsustainable.

It almost seems as if a balance of payments-induced recession is

not a question of if, but when. If it is unsustainable, will it occur

gradually or is there a possibility of a coordinated, massive withdrawal of foreign capital that could straightjacket the economy?

Third, what are the risks to the economy? Should international

investors decide to retrench, would the United States be at significant risk for higher interest rates, more scarce investment sources,

and a bear market?

And finally, what policies, if any, should be considered to rectify

the imbalance or mitigate the resultant risks?

I look forward to exploring these issues today. As I mentioned,

we could not have assembled a more thoughtful or impressive

panel to do so. And I am hopeful that we can begin to come to some

conclusions about what policies we should be pursuing in order to

avoid this faultline that is running through our economy.

I want to thank our witnesses again, and I look forward to your

testimony and discussion.

Let me introduce our first two witnesses, who really need no introduction. These gentlemen have spent much of their lives trying

to help our country, particularly in the economic sphere.

Paul Volcker is the Former Chairman of the Board of Governors

of the Federal Reserve System. He has done an outstanding job in

that role and in subsequent and previous roles, in a long and distinguished career in Government. Robert Rubin, who is now the

Director and Chairman of the Executive Committee of Citigroup,

3

of course, has been one of the most successful Secretaries of the

Treasury that our Nation has known, following in the tradition

of great New York Secretaries of the Treasury that began with

Alexander Hamilton.

And let me call on Mr. Rubin first, and then Mr. Volcker for their

statements.

STATEMENT OF ROBERT E. RUBIN

FORMER SECRETARY, U.S. DEPARTMENT OF THE TREASURY

DIRECTOR AND CHAIRMAN OF THE EXECUTIVE COMMITTEE

CITIGROUP, INC.

Mr. RUBIN. Thank you, Mr. Chairman.

Secretary Hamilton was killed in a duel.

[Laughter.]

It struck me as you said that.

[Laughter.]

In any event, I thank you and I thank you for having us, and

it is an honor to be here with Chairman Volcker.

I think it is very useful and timely to develop further Congressional focus on our country’s current account deficit. And thus, I

think this hearing is a very good idea. I also think, Mr. Chairman,

that recent events in Genoa and elsewhere suggest that there is a

full range of issues with regard to globalization that would merit

further focus by this body.

The current account deficit, as you know, is basically the trade

deficit plus the deficit in payments, interest, dividends, and the

like. But public discussion of the current account deficit, it seems

to me at least, has become a symbol for concern about the whole

area of trade related matters. I will briefly express my views on

these matters, and related policy issues—hopefully, that will be responsive to the questions in your letter—as well as very summarily

sketching out an approach to the broader issues around

globalization.

To begin, the United States has had remarkably good economic

conditions over the past 8 years, with far stronger growth and far

greater productivity increases than Europe or Japan, and far lower

unemployment than Europe. At the same time, our markets have

been more open to imports than Europe or Japan, our currency has

been strong, our capital markets have been open, and our trade

and current account imbalances have grown substantially.

I have no doubt that our economy has benefited enormously from

both sides of trade, not only exports, but, even though it is not popular to say this, also very powerfully from imports. Imports lower

prices to consumers and producers, dampen inflation—and thereby

lower interest rates—provide a critical role in allocating our resources to the areas where our comparative advantage is greatest,

and, maybe most importantly, imports create competitive pressure

for productivity improvement. All this is contributing greatly to our

low levels of unemployment and to rising incomes at all levels that

we have had in recent years.

The imbalance between exports and imports, which is the core of

the current account deficit, has occurred because of vast net capital

inflows from around the world into the United States, motivated by

the relative attractiveness of the United States for investment and

4

as a repository for capital. That vast net inflow has allowed our

consumption plus our investment to exceed what we produce. The

consequence of that vast capital inflow has been a lower cost of

capital in our country and greater investment helping to increase

productivity.

Another consequence of net capital inflow has been a strong dollar, which has lowered cost to consumers and producers for what

we buy abroad, and created more favorable terms of exchange

between what we sell and buy abroad. The result is lower inflation, lower interest rates, higher standards of living, and greater

productivity. The strong dollar has also helped attract capital

from abroad.

The next question is, even with our open markets—and that was

a question that you put forth, Mr. Chairman—imports and a strong

dollar being beneficial, is the imbalance itself a problem.

While a current account deficit reduces aggregate demand, until

this year, we have had fully adequate demand and, where additional demand is desired, monetary and fiscal policy, such as the

current tax rebate, seems to be more preferable as a means of generating demand.

The claims against future output which worry some people from

the vast net capital inflows are like any other borrowing or raising

of equity capital—if the funds are well used for investment, then

the future contributions to growth should exceed the cost of repayment or other forms of return to foreign investors.

The remaining concern is that, in various ways, the current account deficit could contribute to future instability, as, for example,

by adversely affecting confidence with respect to the dollar or making us more vulnerable to a change in perception abroad about our

economic prospects or the soundness of our policy regime. And it

is that soundness of the policy regime which is another reason why,

at least in my judgment, maintaining fiscal discipline is so critically important for economic well-being. While we should be able

to sustain this deficit for an extended period because of the size

and strength of our economy, it would be desirable over time to

greatly reduce this imbalance.

There are some policy measures that could promote this purpose

and would be beneficial in other ways as well. And there are some

policy measures often more frequently advocated, which might help

reduce the current account deficit, but could have other severe adverse economic effects and, in my judgment, on balance, would be

most unwise.

Doing whatever we can to promote structural reform and trade

liberalization in Europe and Japan would contribute to greater

growth with more attractive investment opportunities in those

areas, thus increasing our exports to those areas and increasing investment flows to Europe and Japan. That is good for us in many

ways, including reduction of our current account deficit, and exemplifies why it is enormously in the interest of the United States to

be strongly engaged in providing leadership on international economic issues.

At home, increasing savings over the full business cycle would reduce imports and reduce the inflow of capital and, in my judgment,

would be the most constructive approach to reducing the current

5

account deficit. While our low personal savings rate seems to be a

cultural phenomenon and, in my view at least, there is a real question about how much net effect some savings tax credits have, I do

think carefully crafted tax credits for subsidizing saving is a useful

approach to explore if Congress at some point revisits the recently

enacted 10 year tax cut, which itself is a significant diminution of

future national savings and, in my view, was most unsound.

Two frequently mentioned correctives for the current account deficit that might have some impact, but on balance would be highly

detrimental to our economic well-being are increased trade barriers

and modifying our country’s strong dollar policy.

Increased trade barriers would increase prices, lessen the comparative advantage effects that we enjoy, and reduce competitive

pressure for productivity. Also, history suggests that if restrictive

trade measures are put in place here in the largest economy in the

world, that could readily lead to retaliatory trade measures in

other countries.

Modifying our strong dollar policy could adversely affect inflation, interest rates, and capital inflows and would lessen the

favorability of the terms of exchange that we have with the rest of

the world.

Having said all this, and this is my final point, as our Administration made clear over the past decade, trade liberalization,

though highly beneficial on balance for industrial and developing

countries, can create dislocations, just as technology does to a far

greater degree, and there are critically important matters, in our

country and around the globe, such as poverty and the environment, that will not be adequately addressed by the policy regime

that I have been discussing. The demonstrators this past week in

Genoa were sometimes strident, and we certainly must condemn

violence, but there are underlying concerns about globalization that

are serious and need to be addressed. Thus, in our country and

abroad, there should be a parallel agenda to promote productivity

and equip people to deal with change, including education, effective

retraining, programs to help the poor join the economic mainstream, environmental protection, and much else. And in my view,

the industrial nations, in their own self-interest, should greatly increase assistance to developing nations.

Mr. Chairman, let me conclude where I started. The current account deficit is a complex issue that immediately leads to the whole

range of trade-related issues. I believe this Committee performs a

great service by having this hearing and whatever other processes

it employs to provide serious public examination of these issues.

Thank you.

Senator SCHUMER. Thank you, Mr. Rubin.

I will now call on our Former Chairman, who has been such a

great leader for this country over many, many years, Paul Volcker.

STATEMENT OF PAUL A. VOLCKER

FORMER CHAIRMAN OF THE BOARD OF GOVERNORS

FEDERAL RESERVE SYSTEM

Mr. VOLCKER. Well, thank you, Mr. Chairman. I congratulate you

on assuming the Chairmanship of this Subcommittee.

6

I note of my personal knowledge that you have been working in

this area for, what, 20 years or something, and now in the Senate,

certainly going back into the 1980’s, when I was Chairman. And I

appreciate the background and leadership you bring. I agree with

my colleague here, Secretary Rubin. I want to congratulate you on

your initiative in having this hearing.

I could probably shorten it a bit by saying, after listening to your

statement and after listening to his statement, I will say, amen,

and go home.

[Laughter.]

Senator SCHUMER. We never do that in the Senate.

[Laughter.]

Mr. VOLCKER. Well, let me just take a few minutes to read what

I have written here about the broad nature of the challenge before

us in the face of these current account and trade deficits that have

reached historically large magnitudes.

And I would mention, too, as the Secretary just mentioned, what

has been going on, looking backward, where we have had a decade

characterized by a strong dollar and a large and growing net inflow

of capital, with its counterpart of a greatly enlarged trade and current account deficit. What has been little appreciated, I think, is

the extent to which those developments have supported the relatively strong and well-sustained performance of the U.S. economy.

For most of that time, the other main economic centers—specifically, Japan and the continent of Europe—were mired in some combination of slow growth, high unemployment, and excess capacity.

In sharp contrast, until recently, the U.S. economy was accelerating. There was good growth in investment and profits and a

sustained high level of consumption and by the end of the decade,

as a consequence of consumption, personal savings, as economists

measure those anyway, practically disappeared.

In those circumstances, labor markets tightened, tightened to an

extent that in the past had been associated with strong and accelerating inflationary pressures. Yet, prices, particularly of goods,

have moved relatively little at either the wholesale or retail level.

How could those contrasting developments be reconciled?

A key part of that explanation is that foreign capital—in effect,

the savings of other less affluent countries—has moved strongly toward the United States. They have been attracted by perceptions

of strong growth and productivity and the powerful attraction of

the booming stock market. Along with the rising Federal surplus,

it was that foreign capital that in the absence of personal savings,

in effect, financed much of our investment. The capital inflow has

also tended to strengthen the dollar despite the growing trade and

current account deficits. And that strong dollar, combined with the

ready availability of manufactured goods from countries functioning far below their economic potential, contributed importantly to

containing inflationary pressures. Now it seemed, for the time

being, a benign process: For the United States, a current account

deficit without tears; for other countries, the American market has

provided a sustaining source of demand in an otherwise economically sluggish environment.

What is in question is what you posed for us all, Mr. Chairman,

the sustainability. Our trade and current account deficits are now

7

trending toward $500 billion a year, close to 5 percent of our GNP.

Those are very large amounts by any past standard for the United

States. And given our weight in the world economy, we are absorbing a significant portion of other countries savings. With the low

level of our personal savings, and now the prospect of diminishing

Federal surpluses, this means we are dependent upon maintaining

a strong inflow of foreign funds. We have also become fully accustomed to a ready supply of cheap goods from abroad. Both factors

point to continuing large trade and current account deficits.

For the time being, growth in most of the rest of the world is so

slow that there is no near-term prospect that the world markets

will tighten, limiting the availability of imports at attractive prices.

Moreover, the latest indications are that the strong flow of foreign

funds into the United States is being maintained, even in the face

of our economic slowdown and stock market correction. But looking

further ahead, the risks are apparent.

We cannot assume that Japan and Europe will not at some point

resume stronger growth, and that they will then want to employ

more of their own savings at home. We would certainly like to see

stronger growth in the emerging world, which in turn would attract

more capital from the United States. Here at home we have become

less dependent on traditional ‘‘old economy’’ manufacturing industries, but there are surely limits as to how far we can or should

countenance further erosion in our manufacturing base.

All of this suggests that, over time, we must look toward a narrowing of the trade and current account deficit. That will require

a revival of personal savings and maintenance of a strong fiscal position. It may require, too, some strengthening of the Euro and the

yen relative to the dollar.

In concept, adjustments of that sort can be made over a period

of years consistent with continuing expansion in the United States

and stronger growth in the rest of the world. But as developments

in the ‘‘high-tech’’ world and stock market have again demonstrated, sentiment in financial markets can change abruptly and

bring in its wake strong pressures on economic activity. The timing

and degree of those changes simply cannot be predicted with any

confidence. It seems to me evident, however, that as our trade and

financial position becomes more extended, the risk of such abrupt

and potentially destabilizing pressures increases.

The United States is already a very large net debtor internationally, and for some time ahead will remain dependent on foreign

capital if our economy is to resume growth. We should, and we do,

export capital as our businesses and our investors seek out prospects for the highest returns. To finance both our current account

deficit and our own export of capital, we must import close to $3

billion worth of capital every working day to balance our accounts.

That is simply too large an amount to count on maintaining year

after year, much less enlarging.

One way—an entirely unsatisfactory way—to approach the need

for adjustment would be to fall into extended recession or a prolonged period of slow growth. Given that the world economy as a

whole is operating well below par, the dangers of such a development would only be amplified.

8

Conversely, I do not think we can count on extending the experience of the 1990’s. That would imply further depleting our personal

savings, ever-larger external deficits, and adding even more rapidly

to our international indebtedness.

For the time being, confidence in the prospects of the U.S. economy, its financial markets, and its currency has remained strong,

little shaken, if at all, by the generally unexpected current slowing

of growth. Our leadership in innovation, the sense of increasing

productivity and efficient management, and the stability of our political institutions help underlie that confidence. Those are, indeed,

very precious assets. But, in my judgment, they are no cause for

complacency. The huge and growing external deficits are a real

cause for concern. They are symptoms of big imbalances in the national economy and the world economy that cannot be sustained.

Senator SCHUMER. Thank you, Mr. Chairman.

I appreciate both statements. I think they were excellent. I hope

all my colleagues will get hold of them and read them because they

are succinct and they lay out the problem and the dilemmas that

we face.

I am going to try to stick to my 5 minutes in the questioning and

go to my colleagues, and then, if we have other questions, we will

have a second round. Since this is my first hearing, is there someone who works the clock?

Yes, good. Okay.

The first question I have is, as you just mentioned, Chairman

Volcker, this cannot go on forever. Something has to give, and I

think Secretary Rubin also alluded to that fact.

Do you think there are warning signs of unsustainability that we

could look at? I mean, if things are beginning to break, would any

economic signs be available? Will this just happen? Is it such a new

area that we could not even guess that if X happens, that would

mean it is likely that Y and Z might occur and we ought to be at

least aware of it in terms of policy?

Mr. VOLCKER. Well, I am increasingly sensitive these days to my

increasing age, and I have observed these markets for some period

of time. The idea that you can project these changes and their timing or magnitude I think is excessive. You are not going to be able

to do that.

My experience suggests that there is a real danger that they

come about suddenly. Sometimes when they come about suddenly,

it creates more difficulty in dealing with them.

Specifically, I do not see many signs, as I say in my statement,

of unsustainability at the moment, in the short run. The capital

seems to be flowing in even more generously than in the past.

That is partly a function of a feeling that the rest of the world

is not doing very well and that we may have slowed down, have

an unforeseen slowdown—I might mention, I do not know anybody,

maybe some of your other panelists were so acute as to project the

slowdown a year ago, but there weren’t many——

Senator SCHUMER. I think one of them was.

Mr. VOLCKER. Well, he was a rare observer, but right now, given

the condition in the rest of the world, given that our stock markets

have had a large adjustment, at least in the high-tech area, we

seem to have achieved that without undermining basic confidence

9

in the outlook. Things look okay. But I do not think that can last.

And ironically, one of the things that could change it is much better prospects abroad. For better or worse, we do not see those at

the moment. I do not see them in the near future. But it is an ironic fact that one of our dangers would be good news abroad.

Senator SCHUMER. I find this area, there is almost a ying and

yang to everything. Something good might happen that would help

things out and at the same time, it creates something bad that you

wouldn’t want to happen for other reasons.

Mr. Secretary, do you have any thoughts on that?

Mr. RUBIN. I have no greater ability to predict than the Chairman did. If I did, I wouldn’t be here. I would be back taking advantage of it.

But in any event, no, I think markets are inherently unpredictable. I think the best thing you can do, Mr. Chairman, is to try to

have sound policy in your own country. And to me that means

sound fiscal policy and trying to work with countries abroad to encourage growth there so that they can gradually readjust.

Senator SCHUMER. The second question is for both of you.

Yesterday, when Chairman Greenspan was before our full Committee, I asked him if he thought, given this particular problem,

that the United States should reconsider its strong dollar policy,

which we have. And he, in a rare instance, demurred. He said that

the Administration had agreed that Secretary O’Neill would be the

spokesperson on that and did not want to say anything. In your

testimony, you seem to have somewhat different directions in this

regard. Would each of you want to comment on the idea that we—

and how you keep a strong dollar policy. This is one of the things

I was trying to learn last night and I called a number of people.

That too is a conundrum. Is it just verbiage? Are there other

things that you do other than just talk the dollar up, talk the dollar down?

Do either of you have an opinion on how the strong dollar policy

is working and whether we should continue it, modify it, change it?

Mr. VOLCKER. If you pressed me, I would have to confess that the

three words—a strong dollar policy—does not encompass the full

complexities of this situation.

Senator SCHUMER. Sure.

Mr. VOLCKER. I referred to my age earlier. I spent a long time

in the Treasury and in the Federal Reserve. And I spent most of

that time worrying about a weak dollar.

I think I am very clearly on the record of having a long period

of concern about a weak dollar. So, I do not want to be associated

with a weak dollar policy, whatever that means. I do think I want

a strong dollar in the sense of a strong and stable American economy and a unit of currency that people can count on.

Now if you ask me whether I think that the Euro is weak, too

weak to be sustainable over a period of time, and the yen is too

weak to be sustainable over a period of time, I think, yes, and that

will have to be corrected as part of a change in this balance of payments situation that we are talking about. I do not think that in

any way detracts from the benefits of a strong and a stable dollar,

but it changes exchange rates.

Senator SCHUMER. Mr. Secretary.

10

Mr. RUBIN. Mr. Chairman, as I said in my remarks, I think our

country has been very well served by a strong dollar policy and I

agree with Secretary O’Neill. I think that is exactly where we

ought to stay.

Senator SCHUMER. Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Senator Schumer, I congratulate you on your

Chairmanship of this Subcommittee and your first hearing. Great

topic to review.

I am impressed by your ability to get high-quality witnesses to

come and give us insight into very difficult issues. That was, of

course, the second panel as opposed to the first, Secretary Rubin.

[Laughter.]

The confidence that led to this tremendous inflow of investment

resources into the United States, at least in my mind, is in part

based upon the fiscal rationality that we implemented over the last

decade. Some of us are very concerned about the erosion of that.

I think I saw or heard that in Secretary Rubin’s comments.

The unfortunate personal savings rate that we have had has

been offset by these budget surpluses and we seemingly are reversing that.

Could that be one of those sparks when those abroad realize that

this is coming about, that this external borrowing of capital comes

home to roost? How do we make the public aware of such a risk

as it accumulates? That is my first question.

I cannot help but ask, given the basis of productivity being so

heavily emphasized and how our surpluses have been generated,

whether you have any concerns about the sharp deterioration that

now is only a quarter or so old, but is so prominent in the projections of budget surpluses and the 10 years ahead, underlying projections that led to tax cuts and change in fiscal policy.

I have given you enough room to roam in those questions and I

would ask for comments from either of you.

Mr. VOLCKER. If it is directed at me, on the fiscal policy question,

I very much agree with what Mr. Rubin said about the longer term

outlook.

You can support, obviously, tax relief in the short run, given the

performance of the economy. But if we move and are perceived to

be moving in a direction over a period of time of exhausting those

nice surpluses we built up, at a time when there are no personal

savings, and if we remain with no or very low personal savings, it

would be very dangerous, I think, to reduce the prospects of a

healthy Federal surplus.

And if perceptions of that gain ground, at a time when something

else may be changing, that is the kind of thing I think that can

trigger a reversal of sentiment toward the United States and a

sharper reversal of capital inflows than we would like to see. So,

I think that is very true.

You mentioned another conundrum, I think, for anybody concerned here as to how the public can be educated. Well, these hearings were called and we welcome them as a means of educating the

public. But you always run the risk of, I suppose, lighting the fire,

lighting the crisis that you do not want to see if you get too exVerDate 11-MAY-2000 10:03 Oct 15, 2002 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 81374.TXT SBANK4 PsN: SBANK4
11

treme in citing some of the dangers that are very real, but they are

not necessarily on the doorstep and they are not inevitable.

I do not know how you traipse your way through that kind of

minefield, to change the metaphor a bit, and get people educated

without trying to resort to extreme statements that might be

counterproductive.

Senator CORZINE. And the productivity question, Chairman

Volcker.

Mr. VOLCKER. I am no expert on productivity. I have a little difficulty getting my mind around the notion that the world has

changed completely. I think there is every reason to believe that

productivity will perform better than it did for about 20 years when

it was only 11⁄4 percent a year, which was abnormally low.

Whether the rather fantastic figures of the very late 1990’s can

be sustained, I am in a show-me posture, at least on that.

Senator CORZINE. Secretary Rubin.

Mr. RUBIN. I think I would add three comments, if I may. I agree

with everything that the Chairman said.

In 1993, when serious steps were taken to reestablish fiscal discipline, I think that had a symbolic significance that had very substantial impact on confidence and on our economy.

I think the 10 year tax cut cuts in exactly the opposite direction.

So, I do think it is a threat to creating deficits on the nonentitlement side of the budget that could even reach into the entitlement

side of the budget, and I think it is a significant adverse development with respect to confidence, or it has the potential of being

that, at least.

I do not have any wisdom on productivity, but I do think that

basing a 10 year tax cut on 10 year projections that nobody thinks

are anything other than highly unreliable, seems to me to be quite

unsound.

Senator CORZINE. Thank you.

Senator SCHUMER. Thank you.

We are honored to have our Chairman and leader here, Senator

Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Senator Schumer. I

want to make just a few opening comments.

First of all, let me say how pleased I am to join with you and

Senator Corzine and others in welcoming Former Treasury Secretary Rubin and the Former Federal Reserve Chairman Volcker

before the Subcommittee this morning.

I have had a long-standing interest in the subject of the risks of

a growing balance of payments deficit. In fact, two Congresses ago,

I cosponsored legislation with Senator Byrd and Senator Dorgan to

establish a trade deficit review commission. We felt there was a

need for an independent, bipartisan commission made up of distinguished individuals of varied backgrounds to study the nature,

causes, and consequences of the U.S. merchandise trade and current accounts deficit.

We thought that issue was poorly understood. In fact, there was

even a reluctance, I think, to discuss the trade deficit as a potential

12

problem for the U.S. economy. It was often ignored. Some even

denied it was an issue.

So the commission established by Congress had Murray

Weidenbaum, the Chairman of the Council of Economic Advisers

under President Reagan, and Dimitri Poppadimitrio, who is the

President of the Levi Economics Institute up at Bard College, as

the Cochairmen.

It had six Democrats, six Republicans. They did not reach consensus on many issues, but they did agree on one point and I quote

them: ‘‘Maintaining large and growing trade deficits is neither desirable, nor likely to be sustainable for the extended future. These

deficits reflect fundamental imbalances in the American economy.’’ And this is the report which they produced, entitled, ‘‘U.S. Trade

Deficit—Causes, Consequences, and Recommendations for Action.’’ I, frankly, think that we are ignoring this issue at our peril, the

continued growth in our trade and current account deficit and, as

a consequence, accumulation of large amounts of external debt.

I think we need a good, informed public discussion about the

causes and consequences and consideration of actions we might

take to minimize the risks. For that reason, I very strongly commend Senator Schumer for holding this hearing. We are deeply appreciative to this panel of witnesses and the panel that is to follow

for coming this morning and giving us their time and effort.

I am not going to go into a lot of the data, but let me just simply

note that we have gone from being the world’s largest creditor Nation to now being the world’s largest debtor Nation.

We have run these really extraordinary trade deficits year after

year, which has significantly built up our external debt. We were a $34 billion debtor in 1987, $200 billion in 1989, $767

billion in 1996, $1.2 trillion in 1997, and $1.5 trillion in 1998.

As a consequence, the balance of interest, dividends and profits

paid on foreign investments in the United States versus a return

on U.S. investments abroad has turned negative.

Throughout most of the post-war period, that was positive. We

hit a high of $33 billion in 1981. In 1998, it was minus $22.5 billion. We are the world’s largest debtor and servicing that debt has

increased the U.S. deficit on current account.

Obviously, in a sense, that puts us—I think that in a Tennessee

Williams’ movie with Vivian Leigh, there is a line—dependent on

the mercy of strangers, or in the hand of strangers, or some such

line like that as I recall.

Mr. RUBIN. ‘‘Streetcar Named Desire,’’ maybe.

Senator SARBANES. Yes.

Mr. RUBIN. Dependent on the generosity of strangers.

Senator SARBANES. Dependent on the generosity of strangers.

And I think that is where we are. The economic fortunes of the

United States are partially in the hands of foreign investors and

depends on whether they are willing to increase their investment

in U.S. assets enough to offset this deficit. So, I am extremely concerned about it.

I worked a year for Walter Heller when he was Chairman of the

Council of Economic Advisers. And in the economic report of the

President in 1962, which was Heller’s first report, he stated, and

I quote him: ‘‘The balance of payments objective for the United

13

States is to attain at high employment levels a balanced position

in its international accounts.’’ He then noted that this did not mean

doing that each year. It does not mean that balance must be maintained continuously. In some years, a surplus in international payments will be appropriate. In other years, a deficit. Do you think

that this ought to be an objective of U.S. economic policy?

Mr. RUBIN. I think, Senator, it is a desirable long-term situation.

But as we were discussing before, I think this is a very complex

issue. I think that the question, at least to me, is, what effects has

the current account imbalance had? And at least in the 1990’s, it

seems to me that what has really happened is we have had these

vast inflows of capital from abroad that have financed a lot of the

investment that has created productivity.

I do agree with you that the creation of the imbalances has the

risk of possible instability at some point in the future and it would

be desirable to get back into a balance over time.

However, I think it is a question of what policies one is thinking

of in terms of getting there. If we could increase our savings rate,

that would be good. On the other hand, we just enacted a 10 year

tax cut that is the antithesis of that.

If we can encourage growth in Europe and Japan, that would be

good. That is on the good side. On the bad side, Senator, I think

if we did anything in terms of increasing trade restrictions, that

would be enormously against our self-interest. And I at least believe that our strong dollar policy has served us well.

So the answer is, yes, there is a problem, but some of the cures

are I think a lot worse than the disease.

Mr. VOLCKER. Just as a kind of historical footnote, I suspect that

Walter Heller was talking about the overall balance of payments,

not the current account. And now the emphasis is on the current

account. With the floating exchange rate, we do not worry about

the overall so much because, in some sense, it always balances. But

to get to the point, I do not think we have to balance the current

account every year. We can probably sustain a small deficit. We

sustained a small surplus for many years. But it is a question of

proportions. And year after year, with not only a large deficit, but

a rising deficit, I think has to be unsustainable. After a while, we

can get all the international capital in the world and it is just not

going to happen.

And I might say, in your concern about being in the hands of the

generosity of foreigners, it is certainly true of foreign lenders. It is

also true that you are in the hands of American investors. They

also have feelings about confidence and prospects. And if they

begin putting money outside the United States in greater volume,

we also have a problem.

Those things tend to go together. The change in mood of the foreign investor will probably be matched by a change in mood of

American investors.

Senator SARBANES. Well, one of the things that concerns me is

that the debt has gotten so large, and the serving of it now exceeds

the flows into the United States, that we are in a self-perpetuating

cycle of the situation just worsening in and of itself, let alone any

further additions to it. Isn’t that a significant development, to sort

of cross that line?

14

Mr. RUBIN. I think it is, Senator. But on the other hand, I think

that one would find that, if one looked at least at the 1990’s, as

opposed to the 1980’s, that the return on investment that the

inflows have financed exceeds the cost of repayment or other sorts

of payments abroad.

So that, in effect, it is like any other borrowing or equity investment. I think we have actually benefited from these flows, although

we certainly have to either repay them or, in the case of equity investments, make payments of some sort or other.

But I think, on net, the benefits to growth have exceeded—I

guess that is one way of looking at it—that which we pay out. I

do fundamentally agree with you that there is a threat to stability

and I think the question is how do we get back?

I personally think that part of the danger in this that causes us

to do things—I was told in law school that bad facts make bad law.

And I think part of the problem here is that the problems could

lead us into directions that would be far worse than the thing we

are trying to deal with.

Senator SARBANES. Mr. Chairman, you have been very generous

with the time.

Senator SCHUMER. Please continue if you have another question.

Senator SARBANES. No, thank you very much.

Senator SCHUMER. Senator Bennett.

STATEMENT OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you, Mr. Chairman.

May I welcome you back, Mr. Secretary. I will still call you that

even though you are now earning an honest living.

[Laughter.]

Mr. RUBIN. I tried to be honest when I was in office, Senator.

[Laughter.]

Senator BENNETT. Yes, you were. I will stipulate to that.

Mr. RUBIN. Okay.

Senator BENNETT. I will stipulate that. But it is good to see you

back and it is good to have your counsel, and we appreciate that.

Mr. Volcker, I identify with anybody who is 6 foot 7, bald and

with white hair.

[Laughter.]

And wears glasses.

Senator SCHUMER. In a gray suit and a blue tie.

[Laughter.]

Senator BENNETT. Yes, gray suit and blue tie.

[Laughter.]

Mr. VOLCKER. I am so old, Senator, I identify with any Senator

named Bennett, including your father.

[Laughter.]

Senator BENNETT. Yes, indeed. Thank you. There are only a few

of us around who remember my father. He began what has now become the Utah seat on the Banking Committee, and I am delighted

to hold it now.

Mr. VOLCKER. I testified before him a number of times. So here

we are.

Senator BENNETT. Here we are.

15

Picking up on one of your comments, Mr. Volcker, going back to

Tennessee Williams for a minute, we are not, I think, dealing with

the generosity of strangers, but with the self-interest of foreign investors. They are not taking care of us out of a sense of generosity,

but because this is the best place for them to put their money, in

their own opinion.

And we are now faced with a borderless economy, so the same

is also true. American investors may be as friendly as possible, but

their self-interest will cause them to go elsewhere with the speed

of light on the Internet if they decide that their money is better

served some place else.

So in the borderless economy, and, frankly, I would prefer that

term to globalization, maybe because it has a slightly different

brand flavor to it and is less likely to get rocks thrown at it when

it was used in Genoa. But in the borderless economy in which we

operate now, money moves very, very freely and it goes wherever

the self-interest of the investor wants it to go.

If we get the effect that you talked about, Mr. Rubin, that having

it here produces an increase in the overall economy that is greater

than the amount we have to pay for it, it is a good thing for us,

regardless of what the current account deficit happens to be.

Now, I would like your comment on a chart. And unlike Chairman Sarbanes, I have not had the time to get it blown up big

enough so everybody can see it. So all you can see are the lines and

you cannot see the numbers. You will have to trust me on what the

numbers are.

Senator SARBANES. We are making progress just that you are

using the chart. We welcome that.

Senator BENNETT. Okay. Well, I usually use them on the floor

and not in Committee.

This is the U.S. current account deficit as a share of GDP. This

is not the total deficit that you are talking about, Mr. Chairman,

but it is the current account deficit. And it is by year and this

starts in 1980 and then goes to 2000. So that is 20 years.

Now, I am not an automatic believer in cause and effect. But you

lay that chart over American economic performance and the account deficit is positive or a surplus in 1980 and 1981. Again in

1991. And it is overwhelmingly in a deficit, soars up in 1984, 1985,

1986, 1987, then starts to come down.

Then when you became Secretary, Mr. Rubin, it starts going up

again. And the year of 2000, which some insisted was our very best

year, at least during the campaign season, it is at the highest point

it is in the chart. Is this sheer coincidence? I am perfectly willing

to believe that it is. Or is the best way to solve the current account

deficit to throw the U.S. economy into a recession?

Mr. VOLCKER. I must point out that those years in the 1980’s, I

was Chairman of the Federal Reserve Board.

[Laughter.]

Senator BENNETT. Okay.

Mr. VOLCKER. Well, as I mentioned in my statement, Senator

Bennett, you can solve this—solve is a strong word. It does not

really solve it in a fundamental way. But if the economy goes into

recession, the current account deficit will presumably improve, parVerDate 11-MAY-2000 10:03 Oct 15, 2002 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 81374.TXT SBANK4 PsN: SBANK4
16

ticularly if you can keep the rest of the world out of recession at

the same time. That is not the way you want to cure this.

The question is sustainability of the big deficits and what constructive ways short of recession you can find to achieve a more

sustainable outcome.

It was widely considered, and I think appropriately so, in those

years in the 1980’s that the deficit had gotten too large and certainly a feeling at that time that the dollar had gotten too strong.

It made me very nervous that that feeling was expressed in efforts

to deliberately weaken the dollar. But, nonetheless, it was corrected over a period of time.

I think we are not in the same situation as the 1980’s, but some

elements resemble it. This period of deficits has been longer, larger

now in relation to the GNP, as your chart points out, and it can

be sustained for some time given the present state of the world.

But I do not think it can be sustained indefinitely and the earlier

we recognize that and take the appropriate actions, the better off

we are going to be.

Senator BENNETT. Mr. Rubin, did you want to add something?

Mr. RUBIN. Senator, I would agree with both you and Senator

Sarbanes. I do think that the capital inflows have contributed,

probably substantially, to the economic growth of the 1990’s because the financed investment that our own low savings rate

wouldn’t have financed. On the other hand, it is not something that

can go on indefinitely, and as Senator Sarbanes said, it does create

at least the risk at some point of creating instability.

I do think it would be desirable to get back toward balance. So,

I both agree with you, and yet I do think that it is something that

we need to be concerned about.

What I would not do, though, is have that lead us into policy

areas like trade restrictions that I think would be highly adverse

to our self-interest.

Mr. VOLCKER. I agree with this point on trade restrictions. I just

want to say that, we do not want to get so concerned about this

that we do wrong policies.

But let me make one other point about the importance of foreign

investment.

It has not only been helpful during this period, it has also been

essential to the growth of the American economy when we haven’t

been saving anything. Or saving very little, anyway. If that situation remains, we are at the mercy, if that is the right word, of foreign investment. But we should not be in a position that we are

dependent upon foreign investment to a degree that I believe, anyway, cannot be sustained indefinitely. So, we therefore have to do

what is necessary at home to correct that imbalance.

Senator BENNETT. What is that?

Mr. VOLCKER. Well, to some degree, I hope it is self-correcting.

If you think the heart of the problem, or a large part of the problem is personal savings, when I look at the consumption patterns

of my own family, I am not sure it is entirely self-correcting.

[Laughter.]

But the fact is that it has been, I think, pushed in part by this

extraordinary boom in the stock market. And if the boom in the

17

stock market is dissipated or even levels off, I think, over time,

there will be some tendency to do more personal savings.

So far as direct Federal action is concerned, we both express caution about the outlook of the budget. So long as personal

savings is so low, it becomes extraordinarily important that the

Federal Government itself be the important part of the balancing

factor, instead of foreign investment in some sense, in maintaining

a surplus on its own account which contributes to the savings of

the country.

And that is why I think both of us express concern about the uncertainty in the current condition of the future outlook for the

budget because one of the reasons we did so well in the 1990’s, in

my opinion, was the combination of the foreign inflow of capital

from abroad, plus the rising Federal deficit——

Mr. RUBIN. Federal surplus.

Mr. VOLCKER. Federal surplus—which made up for the lack of

private savings.

Senator BENNETT. Thank you, Mr. Chairman.

Senator SARBANES. I think that is sort of the $64,000 question

that Senator Bennett asked.

You both have said that it is a potentially serious problem and

it introduces an element of risk and potential volatility. You then

have warned against certain measures that you think that people

will then seize upon this in order to do, primarily focusing on trade

restrictions.

And as I understood the question, it was, well, then, given that

you say there is a problem, you do not dismiss the problem. You

accept the proposition that there is a problem. What should be

done about it?

I would like to stay with that, Mr. Chairman, and see if we can

elicit something further from you on that question.

I guess there are potentially things that could be done in the

trade area that would not equal out to restrictions. If it is an open

door here but a closed door for us over there—for example, everyone keeps citing the trade with China. The figure they cite when

they do that is they say, well, we have $115 billion worth of trade

with China. This is a big item. Then they do not say that $100 billion of it is China sending things to us and $15 billion of it is us

sending things to China, for a net trade deficit of $85 billion.

In percentage terms, the largest that we have of any—actually,

even in dollar terms, it is now larger than Japan, just barely. But,

of course, the Japanese figure is off of a larger volume of trade.

Only 14 percent of the United States-China trade are our exports

to China. Japan, it is 30 percent. Europe, Canada, Mexico, it runs

about 45 to 50 percent, depending on the year. It fluctuates around

in there. Now those are very sharp differences. So let’s take the

Bennett question and stay with it for a minute. What can we do

about this?

Senator SCHUMER. Which is the $64,000 question that nobody in

all my reading has come up with a very good answer to? What do

we do?

Mr. RUBIN. I think it is a complex question and there are no easy

answers. I will give you my views, for what they may be worth.

18

First of all, I agree with the Chairman—increasing national savings is probably the most important thing we can do. But we just

go in the other direction in a very substantial way with this 10

year tax cut. I think that if Congress ever gets to the point where

it is willing to reconsider that, number one, I think it should be

made far more moderate. And number two, I think its content

should include incentives for savings that would work, not incentives that are simply going to shelter savings that more affluent

people are already making, but a structure that would actually

work for middle-income and lower-income people that would increase savings.

That is one thing, or two things, I suppose, I would do.

Senator SARBANES. What would that be? Like a matching contribution or something for lower and middle income people to induce them to save?

Mr. RUBIN. In some form or other, Senator, I think that would

have a realistic possibility of increasing savings, as opposed to tax

credits that mostly shelter more affluent people’s already existing

savings that are going to occur anyway.

But I wouldn’t add that to the existing tax cut. I think if the tax

cut could be revisited, although that may not be possible, and it

would be made far more moderate, and then, within that context,

do the sort of thing that you just mentioned, yes, I think that

would be a material contribution.

Senator SARBANES. I think that we are going to be compelled to

revisit the tax cut.

We have this situation now where they are going to work overtime to keep their elderly wealthy parents alive until the last year

of the stepdown in the estate tax. Then, you have a 1 year window

to get the estate without any taxes. And then the next year, it sunsets. So that is going to create a lot of interesting dynamics in families across the country.

Mr. RUBIN. It is an unusual structure, Senator.

[Laughter.]

Mr. VOLCKER. It suggests heavy investment in respirators.

[Laughter.]

Senator SCHUMER. 2010.

Mr. RUBIN. We should try to liberalize trade abroad. I agree, our

trade barriers are very low and they are higher abroad. Therefore,

trade liberalization is in our interest.

I personally think that we should have trade promotion authority

with appropriate terms of some sort or other. I think a new round

might make sense. I also think anything we can do to encourage

growth in Europe and Japan would make sense.

On the China situation that you mentioned, we benefit enormously from the imports, so I wouldn’t do something to restrict

those imports. But I sure as heck would try to increase access to

their markets.

Senator SCHUMER. Do you have anything to add to that?

Mr. VOLCKER. Well, you describe a pattern that one would love

to see and that ought to be encouraged by public policy by whatever means.

You certainly would want to see more rapid growth abroad,

which would greatly assist our export position. I would like to see

19

the opening of the markets, too. But after watching this for many,

many years, I would not count on that being a major influence,

although it could be helpful.

I think as we get out of this current slowdown, we certainly want

to grow again. But we want to avoid very high-powered growth, the

kind of boom and heavy pressure on our economy because that

makes us more dependent and less sustainable.

We certainly want fiscal restraint, and so far as this low personal

savings is concerned, to change that. To change the savings rate by

fiscal policy, I have become a bit of a skeptic over time, seeing all

of these experiments in personal savings accounts of various sorts.

If you really want to change it, I think you have to be pretty

drastic and go to a much more consumption-oriented tax system

than what we now have. And I doubt that there is any near-term

prospect of doing that.

Also as I alluded briefly to in my statement, as part of an orderly

adjustment over a period of time, I suspect you would see some

currencies that look rather depressed to me—the Euro, the yen, the

Canadian dollar—strengthen.

Some combination of these events, if they happened in a nice,

gradual kind of way, would maintain confidence during the interim

period, and over a period of time, produce a much more sustainable

position.

Senator SCHUMER. How do you do that in a period of floating

rates?

Mr. VOLCKER. Well, fiscal policy. Monetary policy is obviously important in gauging the right degree, more or less, of growth in the

United States. There are responsibilities in other countries that we

cannot directly affect of restoring their own growth patterns.

And as I say, I do not think the short-run outlook there is particularly favorable. But looking ahead, a year, 2 years, 3 years, obviously, that is an important part of the solution.

Senator SCHUMER. I know you gentlemen have tight schedules,

but Senator Corzine had another question.

Senator CORZINE. There is a changing nature of the inflow of assets. During most of the 1990’s, it was not entirely, but heavily

direct investment. A lot of merger and acquisitions, cross-border

activity, which has slowed dramatically.

In your judgment, is it safer or more risky for us as a Nation to

have flows that are security-denominated, if you would, as opposed

to the direct investment, which I think gets it sometimes the description that we are in debt, when we in fact have long-term direct

investments that may have a different nature than one where the

deficit is being funded by short-term flows of cash?

That is one question.

Then the other is another sort of technical one. What role and

how much of this benign reaction to our current account deficits,

comes because we are the reserve currency of the world, if we

are? And are there any risks that we are not fully appreciating and

taking into consideration? Are there changes ahead for us in

those areas?

Mr. VOLCKER. I will make a few remarks and then turn it over

to Mr. Rubin.

20

But I think, normally, you would think that direct investment is

more stable and more advantageous over time than portfolio investment, particularly short-term portfolio investment, which has a history of being very volatile, very short-term oriented. Direct investment can also be reasonably volatile, too, but probably not quite so

sensitive as portfolio investment.

Direct investment, we always argue when we are doing it abroad,

brings great management, productivity, technological improvement.

It is interesting that in this period of time, the foreigners have

been buying up our companies more than we have been buying up

other companies. But that is a reflection I think of the feeling that

the American economy has just been doing better and the prospects

are better.

Senator CORZINE. If I read the numbers right, though, that has

changed in the last 18 months.

Mr. VOLCKER. You are probably more familiar with the numbers

than I. And it tends to come in lumps, some very big investments

sometimes.

And the other part——

Senator CORZINE. Reserve currency.

Mr. VOLCKER. The reserve currency. Look, I think the feeling

that the United States is a big, strong, stable country with a relatively stable economy, a relatively stable, strong, big, internationally used currency, makes for a kind of feeling of safe haven when

the rest of the world has not been doing very well.

So it is both that the history of the dollar, not just the technicalities of the reserve currency, but the fact that it is such a widely

used international currency, not just by foreign central banks,

but—the statement I guess is true that there are more dollars circulating in Russia than there are rubles.

It may not be the only country where that relationship is true.

It just makes it a natural thing to do, so long as we are growing,

so long as our prices are reasonably stable. It is going to be a place

that benefits from difficulties in the rest of the world. And in recent years, there have been lots of difficulties in the rest of the

world. The other side of that coin is, if the economic prospects in

the rest of the world are perceived to improve, the capital wouldn’t

come in quite so easily.

Mr. RUBIN. I agree with all of that, Senator. I think the only

thing I—it is not really adding, it is just maybe repeating—is that

I believe it has been useful that the dollar has been the reserve

currency of the world. And I think it is just one more reason why

it is so important that we maintain sound policy in this country,

particularly fiscal policy, because I think that very much influences

how people around the world view keeping their assets in our dollar-denominated assets of one sort or another. Obviously, foreign

direct investment is more stable than portfolio capital and you are

correct about the change in flows.

Senator SARBANES. But isn’t this the problem? This is the real

dollar exchange rate in a basket of 26 currencies. There has been

a 30 percent appreciation in the dollar over the last 5 years.

Now, of course, the NAM, the Farm Bureau, the labor people are

all contacting us because of the impact of this. The manufacturing

21

sector is down 5 percent in this economic slowdown. It is a very serious problem.

We still go along with, ‘‘having a very strong dollar,’’ and I understand some of the benefits that flow from that. But there are

also disadvantages that flow from this. And this sort of marked

change over a relatively short period of time, this is 1989 back here

and we have moved along like this.

But look at what has happened over the last 4 years, I guess, in

the appreciation of the dollar. Of course, that worsens our trade

position. Now do we just accept that or should we be trying to do

something about it?

Mr. RUBIN. My view, whatever it may be worth, Senator, is that

the other side of the coin is that the result is that we have had

lower inflation, lower interest rates, it has given the Fed more

room to lower rates if it so desired.

Manufacturing actually increased by—I do not have the exact

number. It is roughly 35 percent, from 1993 to 2000. Not manufacturing employment because productivity increased so much.

Manufacturing increased substantially in this country, despite

our stronger currency. I actually think it is been a substantial

asset to it.

If we now have a shortfall, which we do have a shortfall of demand, what I think we ought to do, as I said in my remarks, is

look to a fiscal and monetary policy—that is to say, tax rebates and

monetary policy—to generate the demand. I do not think that we

should modify our strong dollar policy.

Senator SARBANES. Mr. Volcker.

Mr. VOLCKER. Well, I guess I would rather talk about modifying

the weak Euro policy or the weak yen policy or the weak Canadian

dollar policy because I do think that those currencies are abnormally restrained, let me put it that way, or unsustainably restrained, and that that, over time, I would look for some change,

which should make that chart look a little differently, not because

the dollar is weak. The dollar strength will be maintained if we

maintain the strength of our economy. But the exchange rate might

change.

The Chairman, in his opening remarks, I think said something

about this whole question gets into the question of globalization or

borderless world and what all the implications are.

I think the volatility in these exchange rates that are partly reflected in your chart is a very serious matter for the world economy

that deserves a lot more attention over a period of time, and it is

something that nobody has wanted to look at for a variety of reasons. But when you have the yen or the Euro, to take those two

cases, moving by 30, 40, 50 percent, over the course of a couple of

years, you get economic dislocations. And you get some of that economic dislocation in Argentina because they get caught in the slipstream. It is too complicated a subject to get into today, but I think

it is a very real problem.

Senator SCHUMER. Senator Bennett.

Senator BENNETT. Thank you, Mr. Chairman.

Let’s go back to my own experience in business. And I find that

the economy is much more like a business than a family.

22

We hear this rhetoric politically all the time—well, the Government is like a family sitting around the kitchen table trying to

make ends meet. If you cannot get a raise down at the factory, you

are going to have to cut back on the amount of meat you eat. And

so, we have to make the budget balance. And this is a very graphic

image that every voter can respond to and it is wholly wrong. The

economy is like a business that is constantly changing every day.

Pressures are changing every day.

I found as a businessman that the most important thing that I

could do is grow the business, that I could solve a whole lot of my

other problems if the business was constantly getting bigger in a

profitable way.

There are those of the dot-commers who think that they can

grow the top line and not pay any attention to the bottom line and

then suddenly discover that not having a bottom line is a bit of a

disadvantage.

I am biased to look at the economy through that lens and say

that as long as the economy is growing in a proper way, we can

handle the problem of account deficit. We can handle a whole series of other problems.

If the economy is not growing and we have difficulties, then

everything starts to come undone as well. And you talk about

the weak yen. The Japanese economy has been flat or deflating for

10 years. Why would you want to invest in a currency that is tied

to that?

Am I over-simplistic here when I am saying that——

Mr. VOLCKER. Just a little bit.

[Laughter.]

Senator BENNETT. Okay. Help me out. Straighten me out. That

is why I come to these hearings, to be helped.

Mr. VOLCKER. Let me accept your metaphor about being in business. What occurs to me when you say that is certainly the importance of growth and all problems are easier to solve in a context

of growth.

Let me think about the headline of a certain business that I read

about in the paper coming down here this morning called Lucent

Technologies, a great growth business. People had enormous confidence in its growth and everybody wanted its stock and wanted

to invest. And the investment flowed into Lucent with great abandon a year or so ago and the stock price went to, I do not know

what, but some very high level.

Expectations about Lucent changed. The economy changed somewhat. Expectations about their business changed. And you had a

drastic, to use the analogy, outflow of interest in the stock of one,

Lucent Technology, in a way that is very hard now for it to reverse

in terms of market perceptions.

In that sense, I think the dollar has some—it is not so fragile as

any individual company, but it is important what perceptions are.

Senator BENNETT. Yes. Let me step in here with a clarifying

comment. I have run public companies and I have run private companies. And private is a whole lot more fun because you do not run

into that problem.

[Laughter.]

23

I am talking about the health of the company makes it easier for

you to solve problems.

Mr. VOLCKER. Obviously. There is no question about that.

Senator BENNETT. But I accept your correction here, that when

you are running a public company, the perception of where you are

going does kind of run away from you.

And I remember once when I was invested in a stock and my

stockbroker called me and said, I think you might consider selling

a little. I said why? It is doing really well. He said, yes, but today

it hit 100 times earnings, and that strikes me as just a little rich.

Mr. VOLCKER. Let me suggest to you the United States in that

sense is a public company.

Senator BENNETT. That is right. And that is why I accept your

comment. Now where is our price earnings ratio? Are we too rich

or too high?

Mr. VOLCKER. I guess in some sense, that is what we are talking

about.

Senator SCHUMER. I would just tack on one final point to Senator

Bennett and all of the questions before we let you gentlemen leave.

I guess the issue is, we have been talking before, is there another

way to deal with this problem other than recession?

That puts the cart before the horse. We are not going to create

a recession to deal with this problem. The question, and it relates

to Senator Bennett’s question, is, can we continue to grow without

dealing with this problem? Or will it in itself, with all its tentacles

and ramifications, cause a recession or a stoppage of the growth in

itself because of perception change? Because there just is not

enough money now in other places to continue to fuel the growth

and we have not dealt with the savings problem and we have

not dealt with—or we have dealt negatively, as Secretary Rubin

pointed out, with the governmental savings issue.

Sooner or later, I think what worries people is you hit a wall.

And everything seems peachy-keen and hunky-dory and because

we put ourselves in the hands of the generosity of strangers——

Senator SARBANES. Kindness.

Senator SCHUMER. Kindness. Sorry. Kindness of strangers.

Senator BENNETT. Self-interest.

Senator SCHUMER. It is self-interest that they are doing it. No

question. But then perception all of a sudden changes and, boom,

we find ourselves twirling downward and we have less control over

how to deal with that than we have had with other problems. Isn’t

that what we are worried about here?

Mr. VOLCKER. I think it is what we are worried about. In dealing

with the current account deficit, we deal with the imbalances that

give rise to the current account deficit.

The current account deficit is kind of a symptom——

Senator SCHUMER. Right. Of course.

Mr. VOLCKER. Of the underlying imbalance, not just in our economy, but also in the world economy. And that is what makes it so

difficult. The kind of thing you are talking about we saw in Thailand, we saw in Indonesia, we saw in a lot of places.

We are so much stronger, so much bigger, that that kind of crisis

is much harder to provoke, in a sense, in the United States. So, we

24

have, I think, still a margin of safety here, but we have to worry

about it.

Senator SCHUMER. It will not have the magnitude that it had

in Thailand, but it could still eat into the kind of growth that we

have seen.

Mr. VOLCKER. Right.

Senator SCHUMER. Certainly at the margins. Maybe not.

You look skeptical, Mr. Secretary.

Mr. RUBIN. No, it is not that I am skeptical, Mr. Chairman. I

guess I would just put it a touch differently.

It seems to me that what one would hope is that, for all the reasons that we have now discussed for quite sometime, that what you

get is a gradual adjustment of the underlying balances which then

results in a gradual adjustment of the current account deficit so

that you come back into something much closer to balance. The

risk is that you have instability.

Senator SCHUMER. Right.

Mr. RUBIN. And then it seems to me the question is what policies

do you have to maximize the probability of this more gradual adjustment? That is what we tried to respond to Senator Bennett on.

Senator SCHUMER. Macon, who was going to come here today and

could not and be on the second panel, his view is it will all just

correct itself in a nice, easy way and we do not have to worry about

it. Obviously, there is a different view among all of us here. There

is that other view out there, that it does not matter much.

Mr. VOLCKER. It could, but we do not count on it.

Mr. RUBIN. You maximize the probability of it by doing sensible

things.

Senator SCHUMER. Right. This has been a great discussion. I

think I speak on behalf of all of us that it was really wonderful of

both of you to donate your time, energy, experience, intelligence.

We have put ourselves in the hands of the generosity of you folks—

I am not going to get this right—kindness.

Mr. RUBIN. It is kindness of strangers, I think.

[Laughter.]

Senator SCHUMER. The kindness of you folks, and we really appreciate it.

Mr. VOLCKER. It is obvious that it must be in our self-interest.

[Laughter.]

Senator SCHUMER. As Senator Bennett pointed out.

Thank you very much.

Mr. RUBIN. Thank you very much, Mr. Chairman.

Mr. VOLCKER. Thank you.

Senator SCHUMER. Thank you.

Let me bring the second panel up.

[Pause.]

Let me call our second panel. And again, they have not had as

much Government service, but they are equally skilled in this area

and extremely distinguished.

I think these are two gentlemen who the entire economic world

listens to. And let me introduce them after I thank the Secretary.

I will do it in alphabetical order, as we did the previous panel.

Bill Dudley, William Dudley, whatever—I am just thinking of

something. You did not grow up in Brooklyn, did you?

25

Mr. DUDLEY. No, I did not. I have lived in Brooklyn, but I did

not grow up there.

Senator SCHUMER. Because there was a fellow who lived across

the street from me when I was a little boy named Billy Dudley on

East 27th Street.

Mr. DUDLEY. My grandfather was a minister in Brooklyn.

Senator SCHUMER. His name wasn’t Leopold?

Mr. DUDLEY. No, no.

Senator SCHUMER. Okay. Well, there you go.

Mr. DUDLEY. Small world.

Senator SCHUMER. Yes. Yes. Everyone else is, right.

Anyway, Bill Dudley is the Chief U.S. Economist, at Goldman

Sachs. He served at the Federal Reserve Board as an economist in

the 1980’s. He has a Ph.D, has his master’s from the University of

California and his Ph.D there from the University of California at

Berkeley.

Stephen Roach is the Chief Economist at Morgan Stanley and

has also served at the Fed in the 1970’s, has his BA from the University of Wisconsin, his Ph.D from NYU. So, we can say that both

were at the Fed, both worked at Morgan Guaranty, and then both

left and went on to other things.

With that, let me call on Mr. Dudley first. And I may have to

excuse myself—how are we going to do this? I have to run to the

Judiciary Committee for about 5 minutes. Senator Corzine will just

take over during that time, whenever it occurs.

Mr. DUDLEY. Okay. Thank you.

STATEMENT OF WILLIAM DUDLEY

MANAGING DIRECTOR AND CHIEF U.S. ECONOMIST

GOLDMAN SACHS

Mr. DUDLEY. Thank you, Mr. Chairman. It is my pleasure to

have the opportunity to testify today and follow two very, very distinguished members who I generally agreed with their remarks.

The United States has a large current account deficit, which has

grown sharply in recent years. To date, it has not proved problematic for the U.S. economy or for U.S. financial markets. But this

imbalance does create a risk. If foreign investors’ appetite for dollar-denominated assets were to diminish, the result could be a

sharp plunge in the value of the dollar and the potential for havoc

in the U.S. bond and equity markets. So how to minimize this risk?

I would suggest three approaches.

First, shift away from the so-called ‘‘strong dollar’’ policy. It is

better to make that shift now when the demand for dollar-denominated assets is still strong and policy is credible, rather than under

duress later. The goal here would not be to try to deliberately

weaken the dollar, but to deemphasize the dollar’s value as an explicit policy goal.

Second, I would implement measures that increase the pool of

national savings. This would reduce the dependence of the United

States on foreign capital inflows.

And third, pursue policies that ensure the United States remains

an attractive market in which to invest. This would help to keep

foreign capital flowing to the United States.

26

Before I discuss in detail what should be done in response to the

large U.S. current account deficit, let me start with my assessment

of the causes and likely sustainability of this imbalance.

In my opinion, the large current account deficit evident for this

country mainly reflects the disparity between the low supply of domestic savings and the high demand for investment, both for business and for housing.

Up to this point, the rise in the dependence of the United States

on foreign capital has not created any great difficulties. That is

mainly because foreign businesses have been eager to increase

their direct investment in the United States and foreign investors

to increase their portfolio holdings of dollar-denominated financial

assets. In fact, the desire by foreign investors to increase their

holdings of dollar-denominated assets has been so great that it has

caused the U.S. dollar to appreciate significantly since 1995. The

strength of the dollar, in turn, has helped to sustain the economic

expansion by helping to keep inflation in check.

In general, the desire by foreign investors to increase their investment in the United States should be viewed for what it has

been—a mark of the U.S. economy’s success. Capital is flowing here

readily because the U.S. economic system has been performing

well. Many factors including credible fiscal, monetary, and trade

policies, deregulation, a flexible financial system, and a transparent corporate governance and accounting framework have

helped to generate high productivity growth and a healthy return

on capital in the United States. These favors have helped to encourage the flow of foreign funds to the United States.

However, the dependence of the United States on foreign capital

inflows does create a vulnerability that needs to be acknowledged.

In particular, if the performance of the U.S. economy were to falter

on a sustained basis, the appetite for dollar-denominated assets

could decline sharply. The result would be a sharp decline in the

dollar and the risk of havoc for U.S. financial markets. The consequence could be a vicious circle in which dollar weakness contributed to poorer economic performance, which, in turn, reinforced the

dollar’s slide. There are three major reasons for concern.

First, as we have already heard, the U.S. current account deficit

is very large, both absolutely, and as a share of GDP.

Second, the upward trajectory of the U.S. current account deficit

evident in recent years must prove to be unsustainable at some

point. To see this, consider that a rising current account deficit

leads to greater net foreign indebtedness. Because the interest on

this debt must be paid, the increase in debt will lead, over time,

to a sharp deterioration in the net investment income balance.

Without trade improvement, that implies an even wider current

account deficit. The result is a vicious circle of climbing debt and

interest expense that ultimately is untenable.

Third, the risk that foreign investors lose their appetite for dollar-denominated assets has already increased because the performance of the U.S. economy has deteriorated sharply over the past

year. In particular, the growth rate of economic activity and productivity has faltered and corporate profits are contracting as the

investment boom in technology has gone bust. The budget surplus

is shrinking. Put simply, the notion of the new economy is being

27

called into question. If the economic rebound anticipated for 2002

disappoints, then the demand for U.S. assets is likely to lessen.

Up to now, prospects elsewhere have also diminished. However,

if the gap in economic performance between the United States and

the rest of the world narrows in the future, then it will become

more difficult for the United States to obtain the same huge sums

of foreign capital on favorable terms, for example, at low interest

rates and a high dollar exchange rate.

Danger signs for the dollar are already visible in the shift in the

composition of foreign capital inflows, a point raised by Senator

Corzine. The proportion of capital inflows consisting of direct investment, which is not easily reversed, has diminished sharply this

year. In contrast, portfolio inflows, especially into corporate and

agency bonds, have increased.

The composition of these capital inflows is important. In contrast

to direct investment, exit from publicly-traded securities is easy.

Liquidation can occur quickly, with potentially destabilizing consequences to the dollar and financial markets. So what should be

done to forestall such an outcome?

The goal should be to pursue policies that encourage a gradual

path of adjustment—a smaller current account deficit and an increase in the national saving rate. Three major policy adjustments

are appropriate, in my view.

First, the time has probably come to scrap the so-called strong

dollar policy. To fail to do so now, when the demand for dollars is

still strong, heightens the risk of a sharper adjustment later. It

would not be pleasant if U.S. policymakers were forced to jettison

the strong dollar policy under duress. The loss of credibility would

tend to drive up the risk premium on dollar-denominated assets,

necessitating a more painful economic adjustment.

A strong dollar policy made sense during the investment boom

when the main risk was that the U.S. economy might overheat.

After all, during the boom, a strong dollar helped to keep inflation

in check. Now that the boom is over, the rationale for a strong dollar has lessened, especially as the dollar’s strength is undermining

the effectiveness of U.S. monetary policy and undercutting U.S.

international trade competitiveness.

However, rather than a call for a weaker dollar, which might

provoke a sharp, destabilizing adjustment, I would shift the emphasis away from the dollar altogether toward the importance of

having a strong and healthy economy. If the U.S. economy performs well, then foreign capital will flow here readily and the dollar will take care of itself.

Second, policies should be pursued that would act gradually to

raise the pool of domestic saving. This can be accomplished in two

ways. Continued discipline in terms of fiscal policy is important.

The fact is that the dependence of the United States on foreign capital would be much greater currently if the U.S. budget balance

had not shifted sharply from deficit to surplus over the past decade. The improvement in the budget balance has enabled the

national saving rate to remain generally stable in recent years,

despite a sharp fall in the personal savings rate. Not only would

slippage here reduce the pool of domestic savings, but it also might

worry foreign investors that have invested large amounts of capital

28

in the United States, in part, because of the improvement in the

U.S. fiscal outlook.

Although the long-term fiscal outlook for the United States remains challenging given the impending retirement of the babyboom generation and the increase in life expectancy, it pales in

comparison to the challenges faced by Japan and Europe, which

have less favorable demographic trends and bigger unfunded pension obligations. It is important that the United States not squander its advantage in this area.

In addition, the tax code could be changed in ways that encouraged greater domestic private savings. This might include additional incentives to save or a more radical revamping of the tax

code to a consumption-based tax system.

Policies that raise the national savings rate would gradually reduce the dependence of the United States on foreign capital. Over

time, this would reduce the risks of a sharp reversal in the appetite

of foreign investors for U.S. assets.

Third, policies should be pursued that ensure the United States

remains an attractive market in which to invest. This includes lowering trade barriers, investing in education in order to raise the

quality of the U.S. labor force, and taking steps to make the U.S.

capital markets more transparent and efficient. By creating a good

environment for foreign investment—either direct or in financial

assets, this would help to ensure that the flow of capital from

abroad persists on favorable terms to the United States.

To sum up, the large U.S. trade imbalance is worrisome. A sharp

shift in perceptions among foreign investors could lead to a collapse

in the dollar that could conceivably destabilize the U.S. economy

and global financial markets.

The best way to deal with this risk is to keep the U.S. economy

healthy through the application of prudent economic policies. If the

U.S. economy remains more productive than its rivals and the U.S.

capital markets remain deeper and more liquid, then the flow of

foreign monies to the United States should continue relatively

smoothly and easily. The current account deficit probably would ultimately shrink, but in an orderly way that would not disrupt the

ability of the U.S. economy and the Nation to prosper.

Thank you.

Senator CORZINE. Thank you, Mr. Dudley.

It is very nice to see you, Steve. We are pleased you are here.

We would like to hear from you.

STATEMENT OF STEPHEN S. ROACH

CHIEF ECONOMIST AND DIRECTOR OF GLOBAL ECONOMICS

MORGAN STANLEY

Mr. ROACH. Thank you very much. It is a pleasure to be here,

Mr. Chairman.

I have a long statement that I would simply prefer to submit for

the record and just summarize some of the highlights.

I just want to echo the comments that were made by the first

panel, as well as by Mr. Dudley. I think the Subcommittee is to be

congratulated for having the courage to hold a hearing on a topic

that very few people understand, let alone talk about. I really beVerDate 11-MAY-2000 10:03 Oct 15, 2002 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 81374.TXT SBANK4 PsN: SBANK4
29

lieve that our external imbalance, no matter how you want to

measure it, is a topic for serious and deep concern in Washington.

The global economy, I think, suffice it to say, is in trouble right

now. By our estimates at Morgan Stanley, 2001 will go down

in history as a year of global recession. And it will be the second

global recession in 4 years. This recession-prone global economy of

ours, in my opinion, reflects some serious and worrisome imbalances in many major economies around the world. And one of those

economies is us in the United States.

I would argue that the U.S. economy at this point in time is far

more imbalanced than some of our fond recollections of the 1990’s,

especially the latter half of the decade, might otherwise lead us to

conclude. And I would just cite three imbalances, all of which have

already been discussed in this hearing this morning.

First, our negative personal savings rate. It is the first time we

have had this condition since 1933. That was not a particularly

good year in the long experience of our economy.

Second, we have a massive overhang of capital spending on new

capacity, especially in the technology area.

Third, very much a byproduct of the first two, is the topic of this

hearing—our current account deficit.

Mr. Chairman, I urge you not to treat this imbalance in our external condition merely as a benign symptom of America’s leadership role in the global economy, or as a necessary ingredient of

the great boom that we were able to achieve in the latter half

of the 1990’s. Instead, I believe that this imbalance should really

be taken as a sign of a Nation that has really gone to excess, a

U.S. economy that in many important respects has lived beyond

its means.

America, as both Chairman Volcker and Treasury Secretary

Rubin indicated, is a savings-short Nation that has a voracious appetite to spend or consume.

And yes, I think you in the Government are truly to be commended for taking our Government budget from deficit to surplus,

from transforming the role of the public sector from a spender into

a saver. But I think, unfortunately, we as a Nation have really

squandered this opportunity by pushing our private-sector savings

rate down to historic lows in the post-World War II period.

And so, the math is pretty straightforward here. The national

savings rate is still subpar and a savings-short U.S. economy has

had little choice other than to turn to foreign investors to finance

our investment spending.

We have had to, of course, run this record current account deficit

to attract the foreign capital that has kept the economy on this

track. And that, of course, has left us in this very precarious place

that was so vividly described—I won’t use the line again by Tennessee Williams, but it has taken to keep the magic of our virtuous

circle alive.

But the cost here is that, right now, foreign ownership of a lot

of assets in the United States is at record levels. Thirty-seven percent of U.S. Treasuries are owned by foreign investors. Twenty percent of all corporate bonds are owned by foreign investors. And I

have to correct. There was an incorrect figure and estimate in my

testimony that Senator Schumer cited. The number is 20 percent,

30

not 46. And 11 percent of all U.S. equities are owned by foreign investors. All of these ratios are virtually double where they were in

the mid-1990’s.

Now yesterday, in front of the full Senate Banking Committee,

Federal Reserve Chairman Alan Greenspan admitted in a response

to a question from Senator Schumer that America’s massive foreign

imbalances are not a sustainable state of affairs for the United

States. He went on further to say that, some day, something has

to give.

Now as economists, our models leave us with the same conclusion. In all of recorded history, no nation has been able to sustain

a prosperity built on a shaky foundation of subpar domestic saving

and increased dependence on foreign capital. Yet, that is exactly

the condition that we now find ourselves in. It is an unsustainable

and very worrisome state of affairs for the United States.

What can be done? That is the—I guess Senator Schumer called it the $64,000 question.

First of all, I do not have anything brilliant to add other than

that which has been stated. But I want to caution you in two areas.

Number one, there is no quick-fix to this problem. I think we

must resist the temptation to find an easy way out of the structural problems that beset both the United States and the global

economy.

I worry, for example, that if we go down the road we went down

in late 1998, by reflating through overly aggressive monetary policy

and create another boom in the United States, that would give us

exactly the same set of conditions that put us in the place we are

in today—another liquidity-induced boom in the stock market, another binge of unnecessary capital spending, a further plunge in

the personal savings rate.

And it would also temper the urgent need for reforms around the

world and structural change that could really create better balance

in the global economy. We did that in 1998. It was not that long

ago. And here we are again, back in global recession, for the second

time in 4 years.

Number two, I would suggest that this is not a time to deal with

trade tensions on a bilateral basis. I wish Senator Sarbanes was

still here. But I am really very nervous about viewing this as a

Japan problem or a China problem, or even a NAFTA problem. The

problem is really in the mirror. We are a saving-short economy and

if we do not import from somewhere, we will import from somewhere else. That is what is required to attract the foreign capital.

I think the options that have been laid out by the gentlemen that preceded me are fairly straightforward and I would agree

with them.

I would simply underscore the following sort of three premises

that reflect my own philosophy in dealing with this problem.

First, just recognize that we are, in fact, a Nation that has been

living beyond its means. And when that occurs, the prudent course

of events is to learn to live better within our means. And that may

mean that we cannot return to the booming period of economic

growth that we had in the latter half of the 1990’s for a long time.

Second, and related to that is the belief that I think that Chairman Volcker and Mr. Dudley expressed, and that is that market

31

forces will take care of the value of the dollar. I happen to think

that the dollar is over-valued. I certainly concur that that view is

arguable. But I believe strongly that the yen and the Euro are

under-valued and market forces will take those currencies up. Currencies are relative prices. So when one goes up, the other falls and

that means the dollar, more likely than not, will fall, and when the

dollar falls, financial markets will be, I think, taken by significant

surprise.

The third principle, and it is not a sexy one, but one that is just

absolutely critical to the whole equation, is that this is a global

problem. Our current account imbalance is a symptom not just of

our own problems, but the world itself, which has been overly dependent on the United States as a source of growth.

So key for us is to continue to push for reform and restructuring

amongst our trading partners so that they too can unlock their efficiencies, grow more rapidly without hooking themselves to the coattails of the United States.

So in closing, Mr. Chairman, I really commend you for having

the courage to hold this hearing. It is a tough and critical issue.

I want to stress that America, in its long history, is the leader

of the global economy since the end of the World War II, has never

had a more worrisome external imbalance than it has today. And

I really urge you in the Congress—this is a wake-up call that something needs to be done to an imbalanced U.S. economy.

Thank you very much.

Senator SCHUMER. Well, thank you both.

Let me apologize to Mr. Dudley for not being here, but I am

familiar with his testimony and have read it.

Let me ask a couple of questions here.

I take it, just drawing it out, neither of you think that this can

be sustained forever. Is that fair to say?

Mr. DUDLEY. That is fair to say.

Senator SCHUMER. Okay. There are a few who do, and Secretary

Rubin was not 100 percent sure that it could not be sustained, at

least for a long time. Let me ask you the question that I asked each

of the other gentlemen. Might there be some warning signs of

unsustainability and are they upon us?

Mr. DUDLEY. I agree with Chairman Volcker who answered the

question. It is very, very hard to anticipate developments in financial markets, especially in currency markets where you can go from

a virtuous cycle to a vicious cycle, very rapidly.

There is one symptom already that has become visible that may

be the leading edge of a warning, and that is the shift in the composition of foreign capital inflows into the United States away from

foreign direct investment, which is not readily reversed, into U.S.

corporate bonds and agency bonds and equities, publicly-traded

securities, which is very easily reversed.

So to the extent that the capital is now flowing into assets that

are more liquid, there is more risk that those inflows could reverse

more quickly. I think that that is the only thing that I could really

point to.

The second thing is that if growth in the rest of the world picks

up, that is also going to be, ironically, a little bit problematic for

the dollar in the short run because one of the reasons why the capVerDate 11-MAY-2000 10:03 Oct 15, 2002 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 81374.TXT SBANK4 PsN: SBANK4
32

ital has come here so readily is because the U.S. economy has performed so well relative to its major trading partners. And so, if we

get the recovery in the rest of the world that we actually want, one

of the consequences of that probably would be a weaker dollar.

Senator SCHUMER. Mr. Roach.

Mr. ROACH. I think that there is no real clear set of early warning indicators that we are going to move from a period where the

current account has been benign to where it really turns into a destabilizing force on the U.S. economy.

What will probably occur here is that there could be a set of conditions that could lead to a weaker dollar that could certainly come

about from improvement overseas or a loss of confidence, for one

reason or another, in foreign investors in dollar-denominated assets. And then, when the dollar goes, it will not be an orderly correction. The gentlemen that preceded me were hopeful that if the

dollar were to correct, that it would be a gradual and well-managed

process. Having spent an inordinate amount of my time in the markets, if there is one thing that I have been taught, and painfully,

is that there is no such thing as an orderly decline in extended

markets.

Markets tend to overshoot. And as the dollar has overshot to the

upside, the distinct possibility is that the dollar overshoots to the

downside. Why does it do that? Because foreign investors all of a

sudden wake up and they say, the dollar is weak and you have this

horrible current account problem.

They are paying no attention to the current account right now

because it is a capital flow story. Everyone wants a piece of America because we have cornered the market on the so-called productivity new economy miracle.

Well, if that miracle gets drawn into question and the dollar

goes, the current account then becomes the excuse to take it down

a lot further.

So it is a set-up. And I urge you to take it in that regard. The

markets always figure out ways to humble and humiliate you in

ways that you have not been humiliated in the past. There is no

clear set of early warning indicators that we can focus on, but that

does not mean that we should not be more attentive than ever to

this possibility.

Mr. DUDLEY. If I could just add one more thing, Mr. Chairman.

Senator SCHUMER. Please.

Mr. DUDLEY. I think this whole question of how much the new

economy is real and how much of the new economy turns out to be

a mirage is critical in the outlook in terms of whether the adjustment is gradual or precipitous.

And in that regard, things that suggest that the new economy is

real, like sustained high-productivity growth, would makes you feel

a little bit more comfortable about the outlook that the adjustment

might take place more slowly, and things such as low productivity

growth numbers, for example, what we received in the first quarter, shrinking budget surpluses, things of that nature, that suggest

that some of the miracle was a mirage, those would be early warning signs that would make you a bit nervous about the outlook for

the currency.

33

Senator SCHUMER. Let me ask you, Mr. Dudley, because you

were quite explicit in saying that we should not be focused on the

value of the dollar, but, rather, on other things in the economy and

let the dollar—because this is a question that I am just learning

this issue, really.

What do we do now? How much does just talking about, well, we

want a strong dollar, cause the dollar to be strong? And what are

the other policy things that we do now that explicitly bolster the

dollar that we might not do? How much of this is talking it up in

psychology and how much of it is real?

When I first came to Washington from New York, when I was

a Congressman, I would say, oh, boy, here’s Washington. It is a lot

of fluff and it is a lot of hype and a lot of psychology.

But up there in the markets, they are immutable. You cannot

fool them. And the more I am around, the more I see that the markets also are influenced by puff and hype and psychology, at least

in the short run. Can you give us some enlightenment about this?

Mr. DUDLEY. I cannot give you very much enlightenment, I am

afraid.

I think, generally, for the foreign exchange markets in particular,

psychology is very important. And the reason why it is very important is that, when currencies appreciate or depreciate, the feedback

effect on that appreciation or depreciation in terms of real trade

flows takes place very, very slowly. There is always a very good

question when you look at any currency, where does it really belong? Where should it truly be?

People do not really know. And so, changes in psychology can be

very, very important in changing those beliefs of where the currency belongs in the medium- to long-run because the feedback

from changes in the currency to the real economy happen so gradually and so slowly.

I think this is one of the problems right now with the strong dollar policy. I think the Administration feels that they are a little bit

in a box, that if they change the strong dollar policy in any way,

the dollar will fall precipitously. They are afraid that if that happens, they will be blamed for that. They do not want that to happen. And so, they are sort of sticking with the strong dollar policy.

I understand that fear. However, I think that if you do that and

keep the dollar supported on the thin air of just your belief that

you want it to be strong, the risk is that you could have a bigger

adjustment later.

So my view is, let’s move away from the dollar as the focus of

policy. Let’s make the focus of policy the health of the economy. If

we make the focus the health of the economy, the dollar should

over time take care of itself. So, I would argue against propping it

up on psychological factors. I do not think that is going to gain you

much in the long term.

Senator SCHUMER. Thank you.

I know Senator Corzine has to leave.

Senator CORZINE. Thank you.

Senator SCHUMER. I will come back. I have a few more questions.

Mr. ROACH. I would just say, as a card-carrying economist, I continue to this day to be truly staggered by the fact that we, in a

huge market, the world’s largest and deepest market, which is the

34

foreign exchange markets, really condone the setting of an asset

price based on the rhetorical elements of human beings.

Supply and demand is a very powerful force and I truly believe

that the currency will be determined by those forces rather than

by the ability of a person, whoever that person is, to say those

magic words—a strong dollar policy.

The Europeans certainly are saying the same thing about their

currency. Ultimately, the Japanese will as well. It is a zero-sum

game, so they cannot all be strong at once.

Senator SCHUMER. Senator Corzine.

Senator CORZINE. Thank you.

I would like to follow up a little bit on that comment and the recommendation that we should be shifting from a strong dollar policy. I am not sure I fully understand how that gets accomplished,

what kind of methodology brings that about, because, ultimately,

supply and demand for dollars makes that case by whatever the

market price is at a given point in time.

So, I would love to hear some comments on how you go about

shifting it. I mean, you can shut up, but the fact is that it really

has been driven in part by, if not in the long run, by the supply

and demand conditions. I think we have talked today that this is

a potential for instability in financial markets and ultimately,

translation into the economy.

I am always curious about what are the shocks that we think are

the elements that bring about the change in the current status of

the market. When do people no longer want to hold on or demand

those dollars that change the context of its value?

I continue personally to believe that our foreign holders of dollars

believe we have a quality fiscal policy in place and are expecting

significant budget surpluses.

I would love your own anecdotal information on your conversations with foreign investors about whether that is true. And if that

perception changes quickly, do we have a potential for a shock in

currency markets and a reversal of some of the problems here.

Then, finally, I think both of you have talked about steps that

we need to take ultimately to have a strong and healthy economy.

It does not appear that we have a strong economy now. Some

might argue that it is more healthy than otherwise.

I would love to hear your current quick views on where we are,

and what do we need to do to restore a healthy economy?

Mr. DUDLEY. Well, Senator Corzine, how do you shift from a

strong dollar—I want to make very clear, I am not advocating a

weak dollar. I am advocating a shift in emphasis away from the

idea that our goal or policy is a given value of the currency.

I think our goal or policy should be a healthy economy and not

be so worried about where the dollar ends up. Let supply and demand take care of it. Change the game. Let the markets determine

where the dollar should be and not have our rhetoric enter in as

an important factor.

Right now, I think rhetoric is important in the markets because

certainly people hang on Treasury Secretary O’Neill’s every word

in terms of the dollar. So, obviously, the markets view is that it is

pretty important.

35

On the issue of the fiscal side, I agree with you 100 percent. The

improvement in the U.S. fiscal position was important both for generating more savings to finance the investment boom that we had,

but also, it was one factor that clearly supported the demand of foreign investors for dollar-denominated assets. Any backsliding on

the fiscal side I think would be negative in that regard.

One thing you can already see evident this year is, as the budget

surplus projections are starting to come down, we have had a

steepening of the Treasury yield curve, suggesting that people are

more nervous about the fiscal outlook now than they were a few

months ago before the passage of the Bush Administration tax cut

plan. I think staying on course on the budget, staying the course

in terms of being fiscally prudent on the budget is very important.

One area where we have a tremendous advantage relative to

most of our major trading partners is that while we have a Social

Security problem, our Social Security problem is very, very minor

compared to the problem that you have in other countries. And we

should act to keep it that way because that is I think something

that makes the long-term fiscal outlook in the United States quite

a bit better than in, say, Europe and Japan, which have a much

greater unfunded pension liability and much less favorable demographic trends.

Mr. ROACH. I would just briefly, in response to these questions,

say three things.

In terms of shifting the policy, my strong recommendation is simply to take the rhetoric out of the asset price. Do not personalize

the relative price of one of the most important assets in the world.

This morning, Treasury Secretary O’Neill has an extensive interview in the Financial Times as Treasury Secretary and dollar

spokesman articulating and personalizing his own stylized interpretation as to why the dollar should be at a certain level. With

all due respect to the Treasury Secretary, it is a personal view and

the markets will make that judgment. I think there is just far too

much emphasis placed in rhetoric in setting asset prices.

In terms of shocks that could cause a problem here, there is a

lot of them that you could always sort of conjure up in your darkest

moments. I have been accused of spending too much time worrying

about dark moments. So, I will not belabor those. But I think the

one that we need to think about most seriously is really the final

question, Senator Corzine, you raise, and that is the state of the

U.S. economy.

Federal Reserve Chairman Alan Greenspan reiterated yesterday

in front of the Full Committee that he is hopeful that the U.S.

economy may be forming a bottom.

What if it is not? What if this is a false bottom? What if there

is another leg down to come? And there is a good case to, I think,

worry about precisely that possibility.

The state of the global economy, as I indicated in my own statement, poor and deteriorating as we speak. The feedback from that

will come back to crimp exports. That is another potential source

of downward adjustment in the United States that has not even

come close to fully playing out. And then, finally, there is, I would

say, the $64,000 question, Chairman Schumer, and that is the

state of the American consumer.

36

American consumers just hung in there. Slowed a little bit, but

basically, continues to spend, remains pretty much in denial that

anything adverse could ever happen to the Good Ship America.

What if that changes? And my guess is that there is risk to come

to the American consumer who had depleted his or her savings balance, is overly indebted, and has also run out of spending from the

now-infamous wealth effect.

So if the consumer who is as precarious as I have ever seen him

or her, since, probably the early 1970’s, throws in the towel, that

could be a shock that certainly could reverberate into our foreign

exchange markets and then all of a sudden, the current account

will matter.

Senator CORZINE. Thank you.

Senator SCHUMER. Thank you, Senator Corzine.

I thank both of you. Let me ask you this question. I do not know

if you saw, but yesterday, I asked Chairman Greenspan about this

conundrum of interest rates, long-term, anyway, not responding to

the constant drop, I think 275 basis points, that the Federal Reserve has done in the funds rate.

He basically said, we are not seeing anything happen because

Treasuries are being eaten up at a greater amount, which led me

to question the wisdom of the tax cut.

He actually demurred. I do not know if you saw this. He said,

please, I would ask your indulgence that I not have to answer that

question. Since I respect him, I did not push the issue, uncharacteristically of me. But could it be that this is related to the flood

of foreign investment? Could it be that we do have some form of

inflation going on a little bit more here than people think, but it

is covered up because of all this foreign money coming in, and that

if it left, things would bounce up more quickly?

Is there a relationship there? That just hit me as we were going

through this hearing. Maybe not.

Mr. ROACH. I would say it is quite possible. But we are not able

to isolate and identify that with precision.

But the theory, Chairman Schumer, is that when we ask foreign

investors to fund our domestic savings shortfall, we have to make

that funding attractive to them.

Senator SCHUMER. Right.

Mr. ROACH. Nasdaq 5,000 was all the attraction they needed. So,

they did not demand a premium on dollar-denominated assets.

Nasdaq has again—I do not know where it is today, but yesterday, it closed back below 2,000 again. And so, suddenly, what

seemed like a sure thing to foreign investors, whether they were

buying our assets or buying our companies, is not quite the sure

thing that it was a year or a year and a half ago.

It is perfectly appropriate under those conditions for foreign investors to begin demanding a premium on dollar-denominated assets, and that could well be one factor that is keeping longer-term

interest rates higher than might otherwise be the case in a regime

of Federal Reserve monetary easing.

Mr. DUDLEY. Mr. Chairman, my assessment is that long-term

rates are probably being held up by mainly two things.

37

One, the deterioration in the outlook for the Federal budget. And

two, a very strong belief that 275 basis points of easing is going

to generate a pretty healthy rebound in the economy next year.

That is something that both Mr. Roach and I would disagree

with. We think that monetary policy is not particularly powerful in

the current environment, partly because financial markets have

not cooperated with the Fed. The stock market is down. The dollar

has appreciated. And the long-term rates have not changed very

much. But I think the markets—a lot of investors have the belief

that the economy is going to come back very, very quickly.

Now coming back to this question of the dollar, has the dollar’s

strength supressed some inflation that could come back if the dollar were to depreciate?

Absolutely, that is a risk. However, in the current environment,

that is probably not a very big risk because the U.S. economy has

been weak enough for long enough, that you are actually freeing

up quite a bit of slack in terms of the labor market and industrial

capacity.

So that, yes—if the dollar were to go down, you would probably

get higher import prices and a little bit more flexibility for U.S.

producers to raise prices. But that would be offset by the fact that

the slowdown has freed up a lot of capacity in the United States.

Senator SCHUMER. This is the subject of a different hearing,

which maybe we ought to have. But it seems to me what you are

saying is that this globalization, internationalization of the world

capital markets, in general, makes monetary policy less effective

than it used to be.

Mr. ROACH. Absolutely. I think globalization reflects an extraordinary new conductivity in the world through trade flows, through

capital flows. It is characterized by global supply chains, by rapid

expansion of multinational corporations. And so, a lot of the rules

that we have embraced and understanding asset price movements,

to say nothing of reverberations from, say, the United States to

non-Japan Asia, those rules are changing before our very eyes.

So talk about a new economy, I would far prefer to have the

globalization be discussed in the context of a new economy than the

sort of Nasdaq-type bubble that has since popped.

And I think you are entirely right to draw attention to really

probing what we know about globalization, what we do not know

about globalization, and what we need to know about globalization

going forward.

Senator SCHUMER. Is this a consensus among practical economists like yourselves that monetary policy is less effective than it

used to be because of globalization?

Mr. DUDLEY. I think there are certainly a number of people that

would agree with that statement. Both of us would agree with that

statement. I do not think it is yet a consensus view.

Senator SCHUMER. Gotcha. The easiest way out of this whole conundrum we are in, of course, is to have Americans save more.

Now particularly Chairman Volcker, but even Bob Rubin, had

doubts that there was much from a policy point of view we could

do to induce savings, that most of the experiments that we have

done in terms of tax incentives and other types of things to increase savings have not been terribly effective.

38

Do either of you disagree with that? Is there anything that we

could do? And what about this new idea, which I think Al Gore had

proposed, which is that, since we need to increase savings in lowerincome people, that a Federal match might do it. Of course, you are

having a dollar outflow there, too. So tell me in general.

Mr. ROACH. I would just agree with Chairman Volcker that using

fiscal policy to incent private saving is something that history has

really not spoken very kindly of. I think we have been frustrated

over the years in being able to raise the level of savings. The best

that these measures do is alter the composition of savings, shifting

it from one asset to another.

And I would actually urge you to think about our savings shortfall in a similar context. It is not that Americans are not saving

at all. It is that American individuals have mistakenly transferred

an awful lot of their incremental savings into the stock market.

They believe that the stock market has become a permanent new

source of saving. And if that view is correct, why should you save

out of your paycheck?

The stock market is in the process of painfully pointing out to

many Americans that that premise may be flawed. And so, I think

that our system is adaptable enough to enable individuals to rethinking their savings motives away from their mutual funds,

which are now at greater risk than they had thought before, and

back into more traditional savings vehicles.

Mr. DUDLEY. I think the challenge in designing tax changes that

encourage savings is to design changes that do not allow people

just to move already-existing financial assets they have into the

new tax-favored class to take advantage of that tax break, and not

actually increase their saving. And that is really the challenge.

I think probably what we need to think about a little bit more

is whether a shift to a consumption-based tax system is appropriate. But, unfortunately, I think that is not very likely politically,

especially given the fact that we have now spent most of the nonSocial Security surplus.

One of the great unhappinesses to me of what has happened in

recent months is that we had this big surplus that we could

have used to do a major revamping of the U.S. Tax Code in ways

that could have accomplished some of these goals, and we did not

even try to take advantage of that opportunity. And I think that

is unfortunate.

Senator SCHUMER. Okay. Well, I want to thank both of you for

excellent testimony, great answers.

Unlike many hearings, there has not been much heat and there

has been some light.

Thank you.

Mr. ROACH. Thank you.

Mr. DUDLEY. Thank you.

Senator SCHUMER. The hearing is now adjourned.

[Whereupon, at 12:15 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

39

PREPARED STATEMENT OF SENATOR JIM BUNNING

Mr. Chairman, I would like to thank you for holding this very important hearing

and I would like to thank all of our witnesses for agreeing to testify today. This is

a very important topic you have chosen today.

I am not sure if the average American realizes how much foreign investment we

have coming in right now. Our economy is becoming increasingly dependent on foreign investment. Without it, we would not be experiencing even the anemic growth

we have now.

Of course, we must think about the consequences of that investment. Specifically,

I am worried that the foreign money valve may get shut off. I have heard many

economists say that will not happen in the near future, and I hope they are right.

However, my fear is that we have a rapid market change and it becomes more attractive to invest foreign capital elsewhere.

With increased globalization, worldwide economic factors change faster and worldwide economic changes are recognized faster. It was only a year ago that the

Nasdaq was hovering at 4,029, this morning it opened at 1,959. If suddenly, American investment became unfashionable and foreign capital was pulled, it would have

a devastating effect on our economy.

Of course, that leads to the question, what do we do? Well, that is why our witnesses are here today. I eagerly await your testimony to find out, what if anything

we should do to ensure our economy does not experience damage from the ever increasing balance of payments deficit. I believe our economy is weak enough right

now, it doesn’t have to go down any further.

Thank you, Mr. Chairman.

—————

PREPARED STATEMENT OF ROBERT E. RUBIN

FORMER SECRETARY, U.S. DEPARTMENT OF THE TREASURY

DIRECTOR AND CHAIRMAN OF THE

EXECUTIVE COMMITTEE, CITIGROUP, INC.

JULY 25, 2001

Mr. Chairman and Members of the Subcommittee, I think it is both useful and

timely to develop further Congressional focus on our country’s current account deficit. Thus, I think this hearing is a very good idea. Moreover, recent events in Genoa

and elsewhere suggest that the full range of issues around globalization merit great

focus by this body.

The current account deficit is basically the trade deficit plus the deficit in net payments, including interest, dividends, and the like, but public discussion of our deficit

has, I think, become a symbol for concern about the whole area of trade related matters. I will try to very briefly express my views on these matters, and related policy

issues, and hopefully that will be responsive to the four questions in the Chairman’s

letter outlining this hearing, as well as very summarily suggesting an approach to

the broader issues around globalization.

To begin, the U.S. has had remarkably good economic conditions over the past

8 years, with far stronger growth and far greater productivity increases than Europe

or Japan, and far lower unemployment than Europe. At the same time, our markets

have been more open to imports than Europe or Japan, our currency has been

strong, our capital markets have been open, and our trade and current account imbalances have grown substantially.

I have no doubt that our economy has benefited enormously from both sides of

trade, not only exports, but, even though it is not popular to say this, also very powerfully from imports. Imports lower prices to consumers and producers, dampen inflation—and thereby lower interest rates—provide a critical role in allocating our resources to the areas where our competitive advantage is greatest, and, maybe most

importantly, create competitive pressure for productivity improvement. All this has

contributed greatly to the very low unemployment and rising incomes at all levels.

The imbalance between exports and imports has occurred because of vast net capital inflows from around the world into the United States, motivated by the relative

attractiveness of the United States for investment and as a repository for capital.

That vast net inflow has allowed our consumption plus our investment to exceed

what we produce. The consequence has been a lower cost of capital in our country

and greater investment, which helped increase the rate of productivity growth.

Another consequence of the net capital inflows has been a strong dollar, which

has lowered costs to consumers and producers for what we buy abroad, and more

40

favorable terms of exchange between what we sell and buy abroad. The result is

lower inflation, lower interest rates, higher standards of living, and greater productivity. The strong dollar has also helped attract capital from abroad.

The next question is, even if our open markets, imports and a strong dollar are

beneficial, is the imbalance itself a problem.

While a current account deficit reduces aggregate demand, in recent years we

have had fully adequate demand, and, in any case, monetary and fiscal policy—such

as the current tax rebate—are a far preferable means of generating demand, if this

is desired.

The claims against future output from the vast net capital inflows is like any

other borrowing or raising of equity capital: if the funds are well used for investment, then the future contributions to growth will exceed the cost of repayment or

other forms of return to foreign investors.

The remaining concern is that, in various ways, the current account deficit could

contribute to future instability, as, for example, by adversely affecting confidence in

the dollar or making us more vulnerable to a change in perception abroad about our

economic prospects or the soundness of our policy regime—which, parenthetically,

is another reason why maintaining fiscal discipline is so critically important for our

economic well-being. While we should be able to sustain this deficit for an extended

period because of the relative size and strength of our economy, it would be desirable over time to greatly reduce this imbalance.

There are some policy measures that could promote this purpose and would be

beneficial in other ways as well, and there are some policy measures that are more

frequently advocated, which might help reduce the current account deficit but could

have other severe adverse economic effects and on balance would be most unwise.

Doing whatever we can to promote structural reform and trade liberalization in

Europe and Japan would contribute to greater growth with more attractive investment opportunities in those areas, thus increasing our exports and increasing investment flows to Europe and Japan. This is good for us in many ways, including

reduction of our current account deficit, and exemplifies why strongly engaging in

international economic issues is greatly in our interest.

At home, increasing savings over the full business cycle would reduce imports and

reduce the inflow of capital and would be the most constructive approach to reducing the current account deficit. While our low personal savings rate seems to be a

cultural phenomenon—and there is a real question about how much net effect some

savings tax credits have—I do think carefully crafted tax credits for subsidizing saving is a useful approach to explore if Congress at some point revisits the recently

enacted 10 year tax, which is itself a significant diminution of future national savings and, in my view was most unwise.

Two frequently mentioned correctives for the current account deficit that might

have some impact but on balance would be highly detrimental to our economic wellbeing are increased trade barriers and modifying our country’s strong dollar policy.

Increased trade barriers would increase prices, lessen the comparative advantage

effects, and reduce competitive pressures for productivity. Also, history suggests

that protectionist measures here could lead to retaliatory trade measures in other

countries.

Modifying our strong dollar policy could adversely affect inflation, interest rates,

and capital inflows and would lessen the favorability of our terms of exchange with

the rest of the world.

Having said all this, as our Administration made clear over the past decade, trade

liberalization, though highly beneficial on balance for industrial and developing

countries, can create dislocations—just as technology does to a far greater degree—

and there are critically important matters, in our country and around the globe,

such as poverty and the environment, that won’t be adequately addressed by the

policy regime that I have been discussing. The demonstrators this past week were

sometimes strident—and we must condemn violence—but there are underlying concerns about globalization that are serious and need to be addressed. Thus, in our

country and abroad, there should be a parallel agenda to promote productivity and

equip people to deal with change, including education, effective retraining, programs

to equip the poor to join the economic mainstream, environmental protection, and

much else. And the industrial nations, in their own self-interest, should greatly increase assistance to developing nations.

Mr. Chairman, let me conclude where I started. The current account deficit is a

complex issue that immediately leads to the whole range of trade-related issues, and

I think that this Committee performs a great public service by holding this hearing

and whatever other processes it employs to provide serious public examination of

these issues.

41

PREPARED STATEMENT OF PAUL A. VOLCKER

FORMER CHAIRMAN OF THE BOARD OF GOVERNORS

FEDERAL RESERVE SYSTEM

JULY 25, 2001

Mr. Chairman and Members of the Subcommittee, I welcome your timely initiative in arranging this hearing focusing on the U.S. Balance of Payments.

Others are better equipped than I to discuss the specifics of current developments

and their significance for particular sectors of the economy. In this short statement,

I want to emphasize the broad nature of the challenge before us as our current account deficit reaches magnitudes with little historic precedent.

The past decade has been characterized by a strong dollar and a large and growing net inflow of capital. The counterpart has been a greatly enlarged trade and current account deficit. What has been little appreciated is the extent to which those

developments have supported the relatively strong and well-sustained performance

of the U.S. economy.

For most of that time, the other main economic centers—Japan and the continent

of Europe—were mired in some combination of slow growth, high unemployment,

and excess capacity. In sharp contrast, the U.S. economy was, until recently, accelerating. There was good growth in investment and profits and a sustained high level

of consumption. In fact, by the end of the decade, personal savings, as the staticians

measure those savings, had practically disappeared.

In those circumstances, labor markets tightened, tightened to an extent that in

the past had been associated with strong and accelerating inflationary pressures.

Yet, prices, particularly of goods, have moved relatively little at either the wholesale

or retail level. How could those contrasting developments be reconciled?

An important part of that explanation is that foreign capital—in effect, the savings of other less affluent countries—moved strongly toward the United States, attracted by perceptions of strong growth and productivity and the powerful attraction

of the booming stock market. Along with the rising Federal surplus, it was that foreign capital that in the absence of personal savings, in effect, financed much of our

investment. The capital inflow also tended to strengthen the dollar despite the growing trade and current account deficits. That strong dollar, combined with the ready

availability of manufactured goods from countries functioning far below their economic potential, contributed importantly to containing inflationary pressures. It has

seemed, for the time being, a benign process: for the United States, a current account deficit without tears; for other countries, the American market has provided

a sustaining source of demand in an otherwise economically sluggish environment.

What is in question is sustainability. Our trade and current account deficits are

now trending toward $500 billion a year, or close to 5 percent of our GDP. Those

are very large amounts by any past standard for the United States. Given our

weight in the world economy, we are absorbing a significant portion of other countries savings. With the low level of our personal savings, and now the prospect of

diminishing Federal surpluses, this means we are dependent upon maintaining a

strong inflow of foreign funds. We have also become accustomed to a ready supply

of cheap goods from abroad. Both factors point to continuing large trade and current

account deficits.

For the time being, growth in most of the rest of the world is so slow that there

is no near-term prospect that world markets will tighten, limiting the availability

of imports at attractive prices. Moreover, the latest indications are that the strong

flow of foreign funds into the United States is being maintained, even in the face

of our economic slowdown and stock market correction. But looking further ahead,

the risks are apparent.

We cannot assume that Japan and Europe will not at some point resume stronger

growth, and that they will then want to employ more of their savings at home. We

would certainly like to see stronger growth in the emerging world, which in turn

would attract more capital from the United States. Here at home we have become

less dependent on traditional ‘‘old economy’’ manufacturing industry, but there are

limits to how far we can or should countenance further erosion in our manufacturing base.

All this suggests that, over time, we must look toward a narrowing of the trade

and current account deficit. That will require a revival of personal savings and

maintenance of a strong fiscal position. It may require, too, some strengthening of

the Euro and the yen relative to the dollar.

In concept, adjustments of that sort can be made over a period of years consistent

with continuing expansion in the United States and stronger growth in the rest of

the world. But as developments in the ‘‘high-tech’’ world and in the stock market

42

have again demonstrated, sentiment in financial markets can change abruptly and

bring in its wake strong pressures on economic activity. The timing and degree of

those changes simply cannot be predicted with any confidence. It seems to be evident, however, that as our trade and financial position becomes more extended, the

risk of such abrupt and potentially destabilizing pressures increases.

The United States is already a large net debtor internationally, and for some time

ahead will remain dependent on foreign capital if our economy is to resume growth.

We should and we do export capital as our businesses and our investors seek out

prospects for the highest returns. To finance both our current account deficit and

our own export of capital, we must import close to $3 billion of capital every working

day to balance our accounts. That is simply too large an amount to count on maintaining year after year, much less enlarging.

One way—an entirely unsatisfactory way—to approach the need for adjustment

would be to fall into extended recession or a prolonged period of slow growth. Given

that the world economy as a whole is operating well below par, the dangers of such

a development would only be amplified.

Conversely, I do not think we should count on extending the experience of the

1990’s. That would imply further depleting our personal savings, ever-larger external deficits, and adding even more rapidly to our international indebtedness.

For the time being, confidence in the prospects of the U.S. economy, its financial

markets, and its currency has remained strong, little shaken if at all by the generally unexpected current slowing of growth. Our leadership in innovation, the sense

of increasing productivity and efficient management, and the stability of our political institutions help underlie that confidence. Those are precious assets. But, in my

judgment, they are no cause for complacency. The huge and growing external deficits are a real cause for concern. They are symptoms of imbalances in the national

economy and the world economy that cannot be sustained.

—————

PREPARED STATEMENT OF WILLIAM DUDLEY

MANAGING DIRECTOR AND CHIEF U.S. ECONOMIST

GOLDMAN SACHS

JULY 25, 2001

My name is William Dudley. I am the Chief U.S. Economist for Goldman Sachs

& Co. It is my pleasure to have the opportunity to testify before the Subcommittee

on Economic Policy of the Senate Banking Committee. The views expressed in my

statement are my own and do not necessarily reflect the positions or views of Goldman Sachs.

The United States has a large current account deficit, which has grown sharply

in recent years. To date, it has not proved problematic for the U.S. economy or the

U.S. financial markets. But this imbalance does create a risk. If foreign investors’

appetite for dollar-denominated assets were to diminish, the result could be a sharp

plunge in the value of the dollar and the potential for havoc in the U.S. bond and

equity markets.

So how to minimize this risk? I would suggest three approaches:

1. Shift away from the so-called ‘‘strong dollar’’ policy. It is better to make

that shift now when the demand for dollar-denominated assets is still strong

and policy is credible, rather than under duress later.

2. Implement measures that increase the pool of national savings. This would

reduce the dependence of the United States on foreign capital inflows.

3. Pursue policies that ensure the United States remains an attractive market

in which to invest. This would help to keep foreign capital flowing to the United

States.

Before I discuss in greater detail what should be done in response to the large

U.S. current account deficit, let me just start with my assessment of the causes and

likely sustainability of this imbalance.

In my opinion, the large current account deficit evident for the United States

mainly reflects the disparity between the low supply of domestic saving and high

demand for investment both in business plant and equipment and in housing. This

imbalance has developed primarily for four reasons.

First, household saving has been depressed as a consequence of the long bull market in U.S. equities. The rise in the U.S. equity market generated a huge increase

in household net worth. This caused households to save less out of their current inVerDate 11-MAY-2000 10:03 Oct 15, 2002 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6621 81374.TXT SBANK4 PsN: SBANK4
43

come. The result has been a sharp fall in the personal saving rate to the lowest level

since the Great Depression.

Second, investment spending on plant and equipment surged as a consequence of

technological change, which lifted productivity growth, and the buoyant equity market, which reduced the cost of capital. Investment spending also probably got a boost

from a bit of irrational exuberance as investors mistook profits generated from the

boom for profits that were sustainable on a long-term basis.

Third, the buoyant economy stimulated household formation and the demand for

housing, which also increased the demand for capital.

Fourth, the willingness of foreign investors to supply capital to the U.S. also exacerbated this imbalance. The appetite of foreign investors for U.S. assets kept the

dollar strong and inflation low. This helped to foster a more robust stock market

and encouraged greater investment.

Up to this point, the rise in the dependence of the United States on foreign capital

has not created any great difficulties. That is mainly because foreign businesses

have been eager to increase their direct investment in the United States and foreign

investors to increase their portfolio holdings of dollar-denominated financial assets.

In fact, the desire by foreign investors to increase their holdings of dollar-denominated assets has been so great that it has caused the U.S. dollar to appreciate significantly since 1995. The strength of the dollar, in turn, has helped to sustain the

economic expansion by helping to keep inflation in check.

In general, the desire by foreign investors to increase their investment in the

United States should be viewed for what it has been: A mark of the U.S. economy’s success. Capital is flowing here readily because the U.S. economic system has been

performing well. Many factors including credible fiscal, monetary, and trade policies,

deregulation, a flexible financial system, and a transparent corporate governance

and accounting framework have helped to generate high productivity growth and a

healthy return on capital in the United States. These factors have helped to encourage the flow of foreign funds to the United States.

However, the dependence of the United States on foreign capital inflows does create a vulnerability that needs to be acknowledged. In particular, if the performance

of the U.S. economy were to falter on a sustained basis, the appetite for dollardenominated assets could decline sharply. The result would be a sharp decline in

the dollar and the risk of havoc for U.S. financial markets. The consequence could

be a vicious circle in which dollar weakness contributed to poorer economic performance, which, in turn, reinforced the dollar’s slide.

There are three major reasons for concern. First, the U.S. current account deficit is already very large, expected to reach nearly $450 billion in 2001. This is big

relative to both GDP—about 4 percent—and relative to the dollar value of U.S. exports—about 11 percent of GDP.

Second, the upward trajectory of the U.S. current account deficit evident in recent

years must prove to be unsustainable at some point. To see this, consider that a

rising current account deficit leads to greater net foreign indebtedness. Because the

interest on this debt must be paid, the increase in debt will lead, over time, to a

sharp deterioration in the net investment income balance. Without trade improvement, that implies an even wider current account deficit. The result is a vicious circle of climbing debt and interest expense that ultimately is untenable.

Third, the risk that foreign investors lose their appetite for dollar-denominated

assets has already increased because the performance of the U.S. economy has

deteriorated sharply over the past year. In particular, the growth rate of economic

activity and productivity has faltered and corporate profits are contracting as the

investment boom in technology has gone bust. The budget surplus is shrinking. Put

simply, the notion of a ‘‘New Economy’’ is being called into question. If the economic

rebound anticipated for 2002 disappoints, then the demand for U.S. assets is likely

to lessen.

Up to now, prospects elsewhere have also diminished. However, if the gap in economic performance between the United States and the rest of the world narrows in

the future, then it will become more difficult for the United States to obtain the

same huge sums of foreign capital on favorable terms, for example, at low interest

rates and a high dollar exchange rate.

Danger signs for the dollar are already visible in the shift in the composition of

foreign capital inflows. The proportion of capital inflows consisting of direct investment, which is not easily reversed, has diminished sharply this year. In contrast,

portfolio inflows, especially into corporate and agency bonds, have increased.

For example, in the first quarter of 2001, the rate of foreign direct investment into

the United States fell to $41.6 billion, less than half the pace of the prior three

quarters. Conversely, investment in private-sector equities and bonds increased to

$147 billion, an all-time record.

44

The composition of these capital inflows is important. In contrast to direct investment, exit from publicly-traded securities is easy. Liquidation can occur quickly,

with potentially destabilizing consequences to the dollar and financial markets. So

what should be done to forestall such an outcome?

The goal should be to pursue policies that encourage a gradual path of adjustment—a smaller current account deficit and an increase in the national saving rate.

Three major policy adjustments are appropriate.

First, the time has probably come to scrap the so-called ‘‘strong dollar’’ policy. To

fail to do so now, when the demand for dollars is still strong, heightens the risk

of a sharper adjustment later. It would not be pleasant if U.S. policymakers were

forced to jettison the ‘‘strong dollar’’ policy under duress. The loss of credibility

would tend to drive up the risk premium on dollar-denominated assets, necessitating a more painful economic adjustment.

A ‘‘strong dollar’’ policy made sense during the investment boom when the main

risk was that the U.S. economy might overheat. After all, during the boom, a strong

dollar helped to keep inflation in check. Now that the boom is over, the rationale

for a ‘‘strong dollar’’ has lessened, especially as the dollar’s strength is undermining

the effectiveness of U.S. monetary policy and undercutting U.S. international trade

competitiveness.

However, rather than call for a weaker dollar, which might provoke a sharp, destabilizing adjustment, I would shift the emphasis away from the dollar altogether

toward the importance of having a strong and healthy economy. If the U.S. economy

performs well, then foreign capital will flow here readily and the dollar will take

care of itself

Second, policies should be pursued that would act gradually to raise the pool of

domestic saving. This can be accomplished in two ways. Continued discipline in

terms of fiscal policy is important. The fact is that the dependence of the United

States on foreign capital would be much greater currently if the U.S. budget balance

had not shifted sharply from deficit to surplus over the past decade. The improvement in the budget balance has enabled the national saving rate to remain generally stable in recent years, despite a sharp fall in the personal saving rate. Not

only would slippage here reduce the pool of domestic saving, but it also might worry

foreign investors that have invested large amounts of capital in the United States,

in part, because of the improvement in the U.S. fiscal outlook.

Although the long-term fiscal outlook for the United States remains challenging given the impending retirement of the baby-boom generation and the increase

in life expectancy, it pales in comparison to the challenges faced by Japan and

Europe, which have less favorable demographic trends and bigger unfunded pension

obligations. It is important that the United States not squander its advantage in

this area.

In addition, the tax code could be changed in ways that encouraged greater domestic private saving. This might include additional incentives to save or a more

radical revamping of the tax code to a consumption-based tax system.

Policies that raise the national saving rate would gradually reduce the dependence of the United States on foreign capital. Over time, this would reduce the risks

of a sharp reversal in the appetite of foreign investors for U.S. assets.

Third, policies should be pursued that ensure the United States remains an attractive market in which to invest. This includes lowering trade barriers, investing

in education in order to raise the quality of the U.S. labor force, and taking steps

to make the U.S. capital markets more transparent and efficient. By creating a good

environment for foreign investment—either direct or in financial assets, this would

help to ensure that the flow of capital from abroad persists on favorable terms to

the United States.

To sum up, the large U.S. trade imbalance is worrisome. A sharp shift in perceptions among foreign investors could lead to a collapse in the dollar that could conceivably destabilize the U.S. economy and global financial markets. The best way

to deal with this risk is to keep the U.S. economy healthy through the application

of prudent economic policies. If the U.S. economy remains more productive than its

rivals and the U.S. capital markets remain deeper and more liquid, then the flow

of foreign monies to the United States should continue relatively smoothly and easily. The current account deficit probably would ultimately shrink, but in an orderly

way that would not disrupt the ability of the U.S. economy to grow and the Nation

to prosper.

45

PREPARED STATEMENT OF STEPHEN S. ROACH

CHIEF ECONOMIST AND DIRECTOR OF GLOBAL ECONOMICS

MORGAN STANLEY

JULY 25, 2001

Mr. Chairman, I commend you in the Congress for looking at the U.S. economy’s

problems through a global lens. America’s gaping balance-of-payments deficit is but

one symptom of the stresses and strains of globalization. The angst of Genoa is another. Yes, there are unmistakable benefits of an increasingly integrated world economy, especially the opportunity to bring less-advantaged developing countries into

the tent of global prosperity. But we can do a better job in managing our collective

journey. The United States is hardly an innocent bystander in the momentous

transformation that is now reshaping the global economy. We must take a leadership role in facing the challenges of globalization head-on. These hearings are an

important step in that direction.

The world is in the midst of what could well go down in history as the first recession of this modern era of globalization. It is a recession whose seeds were sown

in the depth of the financial crisis of 1997–1998. Under the leadership of Treasury

Secretary Rubin, the United States played a key role in staving off what he called

the world’s worst financial crisis since the 1930’s. It is an honor to share this platform with him this morning. But just as America moved aggressively to save the

world nearly 3 years ago, it has paid a steep price for those noble efforts. That rescue mission fostered a climate that took the U.S. economy to excess—resulting in

a destabilizing asset bubble, an overhang of excess capacity, and an extraordinary

shortfall of consumer saving. It also left the United States with its largest balanceof-payments deficit in modern history. As you probe the implications of America’s

unprecedented external imbalance, I urge you to do so in this broader context.

A World In Recession

It has been a long march on the road to global recession. As recently as October

2000, the global economics team that I head up at Morgan Stanley was still calling

for a 4.2 percent increase in world GDP growth in 2001. But then a series of shocks

begin to take an unrelenting toll on our once-optimistic prognosis. First, came last

fall’s spike in energy prices. Then came the most devastating blow of all—an

unwinding of the U.S. boom in information technology (IT) spending. Another

downleg in world equity markets added insult to injury, especially in wealthdependent economies such as the United States. And the rest is now history—an

inventory correction, the earnings carnage, intensified corporate cost-cutting, and

global reverberations of these largely American-made shocks. It was only a matter

of time before the world economy crossed into recession territory.

According to IMF convention, the global economy is technically in recession when

world GDP growth pierces the 2.5 percent threshold. And that is exactly the outcome we now anticipate. Over the past 9 months, we have slashed our once optimistic 2001 growth estimates repeatedly for the United States, Europe, non-Japan

Asia, and Latin America. And we have pared further our long-cautious prognosis for

Japan. As a result, we are now estimating a 2.4 percent increase in world GDP in

2001—0.4 percentage point slower than the crisis-induced outcome of 1998. Like it

or not, 2001 is likely to go down in history as another year of global recession.

This is the fifth global recession since 1970. All of these recessions have one thing

in common: They were triggered by a shock. The global recession of 1975 was a byproduct of the first oil shock. The downturn of 1982 was driven by the shock therapy

of the U.S. Federal Reserve’s anti-inflationary assault. The global recession of 1991

came about in the aftermath of another oil shock—this time the brief spike that

led to the Gulf War. The downturn of 1998—the mildest of the lot—came about

when a global currency crisis pushed most of East Asia into depression-like contractions. And the global recession of 2001 certainly stems, in large part, from America’s

IT shock.

The world economy is currently about midway through a three-stage downturn in

the global business cycle. The first stage was dominated by the abrupt about-face

in the U.S. economy in the final 6 months of 2000; as recently as the middle of last

year, the economy was still surging at a 6.1 percent annual rate, whereas by yearend it had slowed to about 1 percent. Wrenching adjustments in America’s IT and

corporate earnings dynamics were at the crux of this transformation from boom to

bust. While the forecasting community was quick to lower its sights on the U.S. economic outlook in early 2001, it was not as swift to diagnose the second stage of this

cycle—surprisingly serious collateral damage to the broader global economy.

46

In retrospect, we should have seen that one coming. Courtesy of the new

connectivity of globalization—expanded trade flows, globalized supply chains, and

explosive growth of multinational corporations—the loss of U.S. economic leadership

reverberated quickly around the world. The global trade dynamic has been especially important in transmitting this new contagion. By our estimates, the volume

of world trade currently amounts to almost 25 percent of world GDP, essentially

double the share prevailing in the 1970’s. That reflects over 30 years of 6 percent

annualized expansion in global trade volumes, fully 60 percent faster than the 3.7

percent average growth in world GDP over this same period.

Moreover, the world’s dependence on cross-border trade became even more pronounced in the 1990’s. Over the 1989 to 1997 interval, growth in global trade averaged 2.3 times the growth in world GDP. By contrast, over the preceding 17 years,

the growth in global trade was only 1.4 times the growth in world GDP. With global

trade accounting for a much larger portion of world GDP today than it did in the

not-so-distant past, it exerts far greater leverage over the global business cycle. Out

of that leverage has come a new strain of global contagion—linking the world economy more closely than ever before.

But now global trade, the glue of globalization, is screeching to a standstill. Our

latest estimates point to just a 4.3 percent increase in world trade volumes in 2001,

a deceleration of 8.5 percentage points from the record 12.8 percent increase in

2000. This outcome represents the steepest year-to-year decline in global trade

growth on record, setting in motion a ‘‘negative accelerator’’ effect that is wreaking

havoc on industrial activity around the world. If anything, our latest estimates may

be understating the downside to global trade in 2001. Outright declines in the first

half of this year—especially in the United States—suggest it will be a real stretch

to hit our projected 4.3 percent increase for the year as a whole. That, in turn, underscores the downside risks to our global recession forecast.

The sharp deceleration in global trade is symptomatic of a world that had become

overly dependent on the United States as the engine of global growth. Our estimates

suggest that America accounted for close to 40 percent of the cumulative increase

in world GDP in the 5 years ending in mid-2000. The United States-led slowdown

in global trade also unmasks the world as being without an alternative growth

engine. Once the U.S. economy slowed to a crawl, it quickly became apparent that

there was no other candidate to fill to the void. The rest of the world has tumbled

like dominoes—first non-Japan Asia, then Japan, America’s NAFTA partners, and

now Europe and Latin America. The result is a rare synchronous recession in the

global economy.

Alas, there is a third phase to this global downturn, one that has yet to really

play out. It will be defined by the feedback effects that could well take an additional

toll on the U.S. economy. Two such impacts loom most prominent—the first being

a likely downturn in U.S. exports brought about by the confluence of a weakening

external climate and a strong dollar. Inasmuch as the U.S. export growth dynamic

has only just begun its descent, there is plenty of scope on the downside; in global

recessions of the past, America’s real exports have declined by anywhere from 6 percent to 20 percent.

The other shoe about to fall in the third phase of the global downturn could well

be the American consumer. This judgement is not without controversy. But as I see

it, the case against the U.S. consumer is more compelling than at any point since

the early 1970’s. Saving short, overly indebted, and wealth depleted, consumers

are about to get hit by the twin forces of layoffs and reduced flexible compensation—

the year-end payouts granted in the form of stock options, profit sharing, and performance bonuses. Tax rebates notwithstanding, I believe that this confluence of

forces will finally crack the denial that has kept the American consumer afloat. In

my travels around the world, the wherewithal of the American consumer is at the

top of everyone’s worry list. A U.S.-dependent global economy needs the American

consumer more than ever. I fear that the world is about to be in for a huge disappointment.

The Legacy of 1998

Alas, there is a more sinister interpretation of the events now unfolding: I do not

believe that the current global recession should be viewed as merely the latest in

a long string of isolated and unexpected shocks. Instead, I see it as more of a byproduct of the previous crisis-induced downturn in 1998. If that view is correct, it

would be appropriate to treat these two downturns as more a continuum of a drawnout global business cycle—one that could well go down in history as the world’s first

recession of this modern-day era of globalization. Moreover, I would go further to

argue that if the world does not get its act together, this type of downturn could

47

well be indicative of what lies ahead—a more unstable and recession-prone global

economy.

It all started in the fall of 1998. The global currency crisis that began in Thailand

had cascaded around the world, eventually leading to Russian debt default and the

related failure of Long-Term Capital Management. The result was what Federal

Reserve Chairman Alan Greenspan dubbed an ‘‘unprecedented seizing up of world

financial markets.’’ United States President Bill Clinton and Treasury Secretary

Robert Rubin went even further, both calling it the world’s worst financial crisis

since the Great Depression.

The Fed swung into action to save the world, leading the way with an ‘‘emer- gency’’ monetary easing of 75 bp in late 1998. Other G–7 central banks more or less

joined in, albeit on the their own terms and with something of a lag. This led the

Bank of Japan, which had just about run out of basis points, to adopt its now infamous ZIRP—zero-interest-rate policy. Europe also jumped in—belatedly, of course:

First, there was a pre-ECB coordinated rate cut in December 1998 and then there

was another 50 bp easing once the new central bank opened its doors in early 1999.

Collectively, the authorities did what they do best—cutting official overnight lending

rates in a classic reflationary ploy.

The world economy sprang back with a vengeance that few anticipated. The outof-consensus ‘‘global healing’’ scenario that we embraced in late 1998 placed us very

much at odds with financial markets that were positioned for global deflation and

another year of ever-deepening crisis and recession. But we felt that the world had

been given the functional equivalent of a massive global tax cut. It wasn’t just the

monetary easing, but it was also an IMF-led liquidity-injection of $181 billion in

bailouts in Thailand, Indonesia, Korea, Russia, and Brazil, collectively worth about

0.5 percent of world GDP. The boost to industrial-world purchasing power brought

about by cheaper Asian-made imports was icing on the cake. A seemingly resilient

global economy accelerated sharply in the second half of 1999, and world GDP

growth spiked by 4.8 percent in 2000—the fastest such gain since 1976. The

footprints of global healing were unmistakable. So were the perils of its unintended

consequences.

The Downside of ‘‘Global Healing’’

In retrospect, global healing sowed the seeds of its own demise. It led to a false

sense of complacency on two critical fronts: First, it created the climate that culminated in the Nasdaq bubble. The Federal Reserve was, in effect, easing aggressively at a time when the U.S. economy was already booming. In the midst of the

Fed’s emergency easing campaign, America’s real GDP surged at a 5.6 percent annual rate in the fourth quarter of 1998. Far from faltering, the U.S. economy was

on a tear. I cannot remember when such an aggressive monetary easing had occurred in the context of such an outsized gain in economic growth. Although our

central bank began to take back its extraordinary monetary accommodation by mid1999, by then it was too late—the damage had been done. Moreover, it was compounded by the Fed’s now infamous Y2K liquidity injection of late 1999. America

was on the brink of a runaway boom. A Fed-induced, Nasdaq-led liquidity bubble

gave rise to the great IT overhang that has since wreaked such havoc on the United

States and the broader global economy. Such was the legacy of global healing.

Global healing dealt another critical blow to the world economy. The tonic of vigorous growth dampened enthusiasm for reform. Asia rode the coattails of the same

powerful IT-led U.S. growth dynamic. Indeed, we estimate that United States IT exports accounted for as much as 40 percent of non-Japan Asia’s overall GDP growth

in 2000. With growth like that, who needs reform? Everything that was wrong had

seemingly been fixed—and quite quickly at that. At least, that was the implicit logic

throughout Asia, as banking reform was put on hold, corporate restructuring

stalled, and the old ways of crony-capitalism endured. Global healing was a powerful antidote for the region’s devastating crisis—the cover that impeded long-overdue

reforms.

The same was the case for any repair that was about to be made to the world

financial architecture. Out of the depths of the crisis of 1997–1998 came renewed

commitment by the major industrial nations to make the world a safer place for

globalization. The great powers of the world insisted they had learned a most painful lesson. Commissions were formed—I had the pleasure of serving on one of them,

sponsored by the Council on Foreign Relations. Recommendations on architectural

reforms were put forth, only now to gather dust on bookshelves around the world.

Sadly, the power of global healing tempered the urgency of these reforms, as well.

All this speaks of a world that has yet to come to grips with the full ramifications

of globalization. The crisis of 1997–1998 was, in retrospect, a warning of what was

to come. In increasingly connected world financial markets, systemic risks in the

48

emerging world loom all the more potent—especially if the industrial world has been

lagging on its own reform agenda. The current events unfolding in Argentina, along

with the potential for a new round of contagion in Brazil and elsewhere in Latin

America, are the latest painful reminders of just such a possibility. The quick fix

of reflationary interest rate cuts is not the panacea for a Brave New World in need

of fundamental reform. It is high time to face up to the heavy lifting that is needed

to make globalization work. Until that occurs, I suspect the global economy will remain more recession-prone than ever.

A Fragile Global Recovery

As day follows night, recovery will, of course, come. It always does. But the real

issue is the character, or quality, of the coming global upturn. Hope springs eternal

on that score. Financial markets are lined up on the optimistic side of the 2002 outcome—yield curves have steepened, equity cyclicals have rallied, and next year’s

earnings expectations are brimming with optimism. The risk, in my view, is that

the outcome for the United States and the broader world economy will not conform

to these optimistic expectations—that the world will remain on a decidedly subpar

growth trajectory.

Such are the realities of what has been dubbed a U-shaped world. By definition,

a U-shaped upturn is a protracted period of subpar growth. Morgan Stanley’s current baseline prognosis calls for 3 percent average growth in world GDP in 2001–

2002—an outcome fitting that description to a tee. It depicts a world economy that

falls short of its long-term growth trend by about 0.7 percentage point per annum

over this 2 year interval. Moreover, I fear that risks could tip to the downside of

the scenario, suggesting that the world’s potentially chronic growth deficiency will

become even more pronounced. In such a subpar growth climate, the risk of a recessionary relapse is high. The world economy will be lacking in both the leadership

and the cyclical resilience that typically cushion unexpected blows. Little wonder

the world has tipped so quickly back into recession in the aftermath of the crisis

of 1998.

But there is a deeper and more profound meaning to this U-shaped world. On the

one hand, it reflects a worrisome imbalance in the broader global economy—the

world has simply become too dependent on the United States. Lacking in structural

reforms, the world has been unable to unlock the efficiencies that would create new

and autonomous sources of domestic demand. Instead, on the heels of a U.S.-led

boom in global trade, the rest of the world took the easy way out—hitching itself

to surging external demand. Only through structural reform can the global economy

wean itself from excessive dependence on the American consumer and the U.S.

IT cycle.

A U-shaped world also poses a major challenge to the United States: America

must now begin the heavy lifting that is needed to come to grips with the painful

legacy of a popped financial bubble. Rationalizing the great IT capacity overhang

is at the top of that agenda, followed by a long overdue need to rebuild personal

saving. The bubble took America to excess, and those excesses must now be purged.

As I put the pieces of global economic recovery together, I worry most about the

quality of the coming upturn. The quality factor hinges critically on the combination

of reforms and structural change. Unfortunately, based on recent experience, there

is little ground for encouragement.

This global recession is different. It is both the first recession of the Information

Age, as well as the first recession in the modern era of globalization. As such, it

should be viewed as a critical wake-up call. One can only hope it will trigger structural reforms that will rejuvenate domestic demand in the broader global economy.

With any luck, it should also force America to come to grips with many of its own

post-bubble excesses. If progress is made on those counts, a high-quality upturn in

the global economy will ensue. If, however, the world sidesteps the challenge and

squanders the opportunity for meaningful reform, a low-quality rebound will occur.

That, unfortunately, would be a setup for an even more painful day of reckoning.

The stakes are enormous for a world now back in recession.

America’s External Imbalance

The United States has shouldered a heavy burden as the engine of global growth.

Excesses have built in the structure of the domestic economy. That is the message

from the Nasdaq bubble, a negative personal saving rate, and an outsize capacity

overhang. At the same time, America’s economic and financial relationship with the

rest of the world has been stretched as never before. That is the message from a

massive balance-of-payments deficit. All this poses risks on the dark side of the

great American boom.

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While there can be no mistaking the extraordinary performance of the U.S.

economy in recent years, unfortunately, it has been built on a shaky foundation

of increased foreign indebtedness. History demonstrates that such external imbalances cannot persist indefinitely. Something usually gives in response—the currency, other asset prices, or the economy. Steeped in denial, few worry of such

consequences. Therein lies a key risk for the global economy and world financial

markets.

America’s current-account deficit hit 4.4 percent of GDP in 2000, and, by our estimates, is likely to hold near that share through 2002. That qualifies as the widest

external gap of the post-World War II era—a full percentage point larger than the

previous record of 3.4 percent in 1986–1987. We should avoid the slippery slope of

looking to our trading partners as scapegoats. Our balance-of-payments deficit

should not be viewed as an indication of a competitive assault on American markets.

It is not a Japan problem, or a China problem, any more than it is a NAFTA problem involving Canada and Mexico.

If there is a scapegoat, it can be found in the mirror. America’s external imbalance is, instead, more a reflection of serious flaws in the macro structure of the U.S.

economy—namely, a chronic domestic saving deficiency. From an accounting point

of view, national investment must always equal saving. Consequently, when there

is a lack of saving, one of two things has to happen: Either investment must be reduced or an alternative source of saving must be uncovered. America has opted for

the latter of these options. A shortfall in domestically generated saving has been

augmented by an inflow of saving from abroad—inflows that can only be attained

by running a massive external deficit.

The imbalance between domestic saving and national investment has not come

out of thin air. It is very much a hallmark of America’s bubble economy. Five years

of excess returns in the U.S. stock market—with the broad Wilshire 5,000 surging

by an average 25 percent per annum. over the 1995–1999 interval—led to serious

distortions of both consumer and business sector behavior. Consumers became convinced that an ever-rising stock market had become a permanent new source of saving. As a result, they drew down their income-based saving—with the conventionally

measured personal saving rate—national income accounts basis—falling from a prebubble 6.6 percent in late 1994 to a negative 1.2 percent in early 2001. Why should

American workers save out of their paychecks if the stock market was automatically

performing this function? Similarly, Corporate America became convinced that IT

investment was a surefire recipe for enhanced returns in the stock market. The ITled investment cycle soared in response, with business capital spending hitting a

record 13.9 percent of nominal GDP in late 2000.

This juxtaposition between negative personal saving and record investment spending was a classic recipe for an ever-deepening current account deficit. Ironically, it

occurred at precisely the moment when the Federal Government was getting its fiscal house in order—moving from being a dis-saver to a saver by transforming seemingly open-ended budgetary deficits into surpluses. Indeed, Government net saving—Federal, State, and local, combined—moved from a pre-bubble deficit of 2.8

percent of nominal GDP in the fourth quarter of 1994 to a post-bubble surplus of

3.1 percent of GDP in early 2001. Unfortunately, this 5.9 percentage point positive

swing in greater public sector saving was more than offset by the 7.8 percentage

point decline in the personal saving rate. As a result, the net national saving rate—

a broad aggregate that includes personal, business, and public saving—stood at only

4.8 percent in the first quarter of 2001; that is little changed from the pre-bubble

reading of late 1994 and less than half the 10 percent average of the 1960’s and

1970’s. Such a saving-short U.S. economy had little choice other than to turn to foreign investors to finance its investment boom.

In retrospect, it is not surprising that an asset bubble produced this unstable

state of affairs. Just as American consumers and businesses came to believe that

ever-ebullient equity markets had become a new source of saving and excess return,

so did foreign investors. They became more than willing to invest in dollardenominated assets. Portfolio inflows surged from abroad, as did foreign direct investment, especially through a surge of European-led cross-border merger and

acquisition activity. Largely as a result, foreign investors currently own 37 percent

of U.S. Treasuries, 46 percent of corporate bonds, and 11 percent of equities. It was

the ultimate in virtuous circles. America’s New Economy prowess won over converts

at home and abroad. The rest of the world was dying to buy a piece of the action,

and so there was little reason for foreign investors to exact a premium on dollardenominated assets. That is exactly what should happen in a financial bubble—that

is, until it pops.

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A Venting Of Excesses

Yet, this is not a sustainable course for any nation. It depicts a U.S. economy that

is now living well beyond its means, as those means are defined by the domestic

capacity to fund its investment needs. That, in my opinion is the painful legacy of

a financial asset bubble that took our real economy to excess. Consumers have overspent. Businesses have over-invested. And the United States funded these excesses

by borrowing from abroad. There is no telling when the music will stop. The longer

this state of affairs persists, the greater will be the temptation to ignore its consequences. But the math is straightforward: If left unchecked, an ever-widening

current-account deficit raises the debt-servicing burden of international indebtedness to onerous levels. And an increasingly larger share of domestically generated

income will have to be exported to offshore creditors, who, in turn, establish an everlarger claim on the ownership of dollar-denominated assets. An ever-widening current-account deficit implies that foreign investors will ultimately end up ‘‘owning’’ America—unless, of course, something gives. And it usually does.

What should give, in my view, will be the high-flying U.S. dollar. In the interest

of full disclosure, I have been wrong on the dollar for close to a year. I felt the dollar

would finally fall as the United States veered toward recession. I also felt the current-account deficit would exacerbate the correction, once it got going. Over the past

several years, however, the dollar call has not been driven by the current account— instead it has been all about capital flows. The rest of the world wanted a claim

on America’s New Economy prowess and has been willing to pay up to get it. And

despite the ever-widening current-account deficit, the dollar has soared. A broad

index of the real trade-weighted value of the dollar is up 31 percent since late 1994

to a level that now stands just 12 percent short of its all-time high in March 1985.

Like any currency, the dollar, of course, is a relative price. If you are negative

on the dollar, you have to give careful consideration to the alternatives. This has

not exactly been a year to fall in love with yen- or euro-denominated assets. But

I suspect their day is coming. First of all, I continue to believe that the U.S. economy will surprise on the downside. While the case for outright recession is admittedly arguable—although one that I continue to embrace—I remain convinced that

any recovery is likely to be muted. That would most assuredly dampen the likelihood of an earnings resurgence that would validate the New Economy play still

priced into the strong dollar.

At the same time, I believe that global investors could well begin to flirt with

reform stories in both Japan and Europe. Indeed, the micro evidence of corporate

reform is building in Japan. At the same time, structural change in Europe looks

increasingly impressive—underscored by tax and cost harmonization, improved

labor-market flexibility, enhanced shareholder value cultures brought about through

cross-border merger and acquisition activity, and ongoing deregulation. Politics remain the major impediments in both cases, in my view. If Prime Minister Koizumi,

the reformer, carries the day in the upcoming Japanese Upper House elections,

Japan’s political risk premium could start to narrow. And if European politicians

start pulling together—seemingly a stretch right now—the euro might rise as well.

The dollar could then finally be in trouble, with its downside exacerbated by an outsized U.S. current-account deficit.

History shows that massive current-account deficits eventually trigger currency

depreciation. The key word in this statement, of course, is ‘‘eventually.’’ Economics

often does a good job of revealing the endgame. Timing is a different matter altogether. But the lessons of the second half of the 1980’s should not be forgotten:

A then-record current-account deficit set the stage for sharp depreciation of the

U.S. dollar. I see no reason to believe that the endgame will be any different this

time around.

But not only could the dollar give—so, too, could America’s current-account deficit.

Usually, it takes a recession to force a major current-account adjustment. That is

what is required to reduce domestic demand—and the import content of such spending. That was the case in the early 1990’s when the United States last dipped into

a mild recession. The current account went from a deficit of 3.4 percent of GDP in

1987 to virtual balance in 1991—an outcome assisted by the inflow of foreign payments that helped finance America’s military efforts in the Gulf War. If I am right

and the U.S. economy slips into a mild recession, an import-led current-account

adjustment could well be in the cards over the next year, as well.

Courtesy of the bubble-induced excesses of the 1990’s, America is still living well

beyond its means. Foreign investors have been more than willing to subsidize a

profligate U.S. economy. The combination of an overvalued dollar and a massive

current-account deficit underscores the tensions that have arisen from this state of

affairs. These distortions are not sustainable for any economy. As the U.S. economy

now begins to vent its post-bubble tensions, dollar and current-account adjustments

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seem more likely than not. And, by the way, that is the last thing most investors

currently expect.

Backlash Against Globalization?

Where might this all take us? The most worrisome possibility is that trade liberalization might give way to some form of protectionism. To the extent that slow

growth prompts mounting layoffs, the political winds could well shift. The outcome

might lead to the erection of new competitive barriers that would supposedly shield

workers from the harsh winds of globalization. While the body politic has steadfastly resisted this temptation, there may be a change of heart as the world now

slips into recession.

Public opinion polls reveal that U.S. workers oppose several aspects of globalization—especially trade liberalization, immigration, and foreign direct investment.

(See Kenneth F. Schreve and Matthew J. Slaughter, Globalization and the Perceptions of American Workers, published by the Institute for International Economics,

February 2001.) Even during goods times, according to these polls, the benefits of

globalization are thought to be largely outweighed by the costs. In tougher economic

times, that resistance can only intensify.

Moreover, there is a gathering sense of anti-American sentiment around the

world. In my travels, I have heard firsthand more than one distinguished European

leader sarcastically describe globalization as ‘‘economic integration according to

American rules.’’ The Asian crisis took this resentment to a new level. Crisis-torn

countries in the region deeply resent IMF-led bailouts that sent their economies into

depression-like contractions from which many have never really recovered. With the

United States the IMF’s largest shareholder and the major architect behind the

stringent bailout packages of 1997–1998, America is blamed for much of which still

ails Asia. The recent escalation of sino-U.S. tensions underscores a different strain

of this same animosity.

In my visits to Japan I detect a similar sentiment; the logic goes something like

this: ‘‘We followed your policy recommendations, and look where they got us.’’ Ongoing trade skirmishes between the United States and Europe—to say nothing of the

recent dispute over the GE-Honeywell merger—are part of this same script. Fair or

not, the legitimacy of such claims is not the issue. Anti-American sentiment is a

growing problem around the world. The widening of income disparities between rich

and poor nations over the past century adds insult to injury. Globalization is not

perceived as the rising tide that lifts all boats. Instead, it is increasingly thought

of as the wedge of disenfranchisement. In theory, globalization is all about a shared

prosperity—bringing the less-advantaged developing world into the tent of the far

wealthier industrial world. But, in reality, when there is less prosperity to share,

these benefits start to ring hollow. As the world economy now tips into recession,

the assault on globalization can only intensify. That is the tough message from the

streets of Genoa.

Mr. Chairman, if this hearing accomplishes one thing, it should underscore America’s commitment to globalization and the principles of free trade on which it rests.

Protectionism is antithetical to everything that globalization stands for. However,

if a backlash arises, protectionism could be the gravest risk of all. While the voices

of dissent are few, they are growing louder. Yet this is not a time to turn back the

clock and single out scapegoats for a world in recession. America’s gaping currentaccount deficit should not be viewed as a lightning rod for pointing fingers at our

trading partners. It is a by-product of the profound imbalances that lie at the core

of the global economy—a world that has become overly dependent on a saving-short

United States as the engine of global prosperity. Yet it is also a by-product of an

American appetite for excess—and our willingness to rely on foreign capital to sustain that excess. It is time to face these excesses head-on.

There is no guidebook to globalization. We are learning along the way. It is inevitable that we will stumble from time to time. Fortunately, our system is

strong enough to give us valuable feedback at critical junctures. This is one of those

wake-up calls. The world economy is back in recession for the second time in

4 years. That, more than anything else, is an unmistakable sign of stresses and

strains in the very fabric of globalization. Don’t be tempted by the quick fix as you

frame policies aimed at enhancing United States and global prosperity. The heavy

lifting of reform and structural change is really the only way to make globalization

work. We must not squander this opportunity.

Thank you very much.

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