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28-071 PDF 2006

S. HRG. 109–484

THE ECONOMIC OUTLOOK

HEARING

BEFORE THE

JOINT ECONOMIC COMMITTEE

CONGRESS OF THE UNITED STATES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

NOVEMBER 3, 2005

Printed for the use of the Joint Economic Committee

(

(II)

JOINT ECONOMIC COMMITTEE

[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES

JIM SAXTON, New Jersey, Chairman

PAUL RYAN, Wisconsin

PHIL ENGLISH, Pennsylvania

RON PAUL, Texas

KEVIN BRADY, Texas

THADDEUS G. MCCOTTER, Michigan

CAROLYN B. MALONEY, New York

MAURICE D. HINCHEY, New York

LORETTA SANCHEZ, California

ELIJAH E. CUMMINGS, Maryland

SENATE

ROBERT F. BENNETT, Utah, Vice Chairman

SAM BROWNBACK, Kansas

JOHN E. SUNUNU, New Hampshire

JIM DEMINT, South Carolina

JEFF SESSIONS, Alabama

JOHN CORNYN, Texas

JACK REED, Rhode Island

EDWARD M. KENNEDY, Massachusetts

PAUL S. SARBANES, Maryland

JEFF BINGAMAN, New Mexico

CHRISTOPHER J. FRENZE, Executive Director

CHAD STONE, Minority Staff Director

(III)

C O N T E N T S

OPENING STATEMENT OF MEMBERS

Hon. Jim Saxton, Chairman, a U.S. Representative from the State of New

Jersey .................................................................................................................... 1

Hon. Carolyn B. Maloney, a U.S. Representative from the State of New

York ....................................................................................................................... 2

WITNESSES

Statement of Hon. Alan Greenspan, Chairman, Board of Governors of the

Federal Reserve System ...................................................................................... 3

SUBMISSIONS FOR THE RECORD

Prepared statement of Representative Jim Saxton, Chairman ........................... 27

To Hon. Alan Greenspan from Representative Saxton ................................. 28

To Representative Saxton from Hon. Alan Greenspan ................................. 31

Prepared statement of Senator Jack Reed, Ranking Minority ............................ 36

Prepared statement of Representative Carolyn B. Maloney ................................ 36

Prepared statement of Hon. Alan Greenspan, Chairman, Board of Governors

of the Federal Reserve System ............................................................................ 37

Letters:

To Hon. Alan Greenspan from Senator Bennett ............................................ 43

To Senator Bennett from Hon. Alan Greenspan ............................................ 44

To Representative Saxton from Senator Bennett .......................................... 46

Responses by Hon. Alan Greenspan to questions submitted by the Joint

Economic Committee ........................................................................................... 32

Core PCE Inflation Chart ....................................................................................... 41

Yield Spread Chart .................................................................................................. 42

(1)

THE ECONOMIC OUTLOOK

THURSDAY, NOVEMBER 3, 2005

CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITTEE, Washington, D.C.

The Committee met, pursuant to notice, at 10 a.m., in room

2175, Rayburn House Office Building, the Honorable Jim Saxton

(Chairman of the Committee) presiding.

Present: Representatives Saxton, English, Brady, Paul,

Maloney, Hinchey, Sanchez and Cummings.

Staff Present: Chris Frenze, Robert Keleher, Colleen Healy,

John Kachtik, Emily Gigena, Brian Higginbotham, Chad Stone,

Matt Salomon, and Nan Gibson.

OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN,

A U.S. REPRESENTATIVE FROM THE STATE OF NEW JERSEY

Representative Saxton. Good morning, I am pleased to welcome Chairman Greenspan before the Committee once again to testify on the economic outlook. We appreciate the many times that

you have testified before this Committee, Mr. Chairman, and recognize your outstanding stewardship of monetary policy during your

tenure as Fed Chairman.

You have guided monetary policy through stock market crashes,

wars, terrorist attacks and natural disasters with a steady hand.

Under your tenure, price stability has been the norm, with inflation low and stable. You have made a great contribution to the

prosperity of the United States, and the Nation is in your debt.

A broad array of standard economic data reflect the health of the

U.S. economy. Figures released last week indicate that the economy grew at a 3.8 percent rate last quarter despite the massive regional destruction wrought by the hurricanes.

So far during 2005, the economy has expanded at a 3.6 percent

rate, roughly in line with Federal Reserve expectations as well as

the Blue Chip indicators.

Equipment and software investment has bolstered the economy

since 2003 and continues at a healthy pace. This component of investment responded especially sharply to the incentives contained

in the 2003 tax package. Employment has also gained over the period with 4.2 million jobs added to the business payrolls since May

2003, and the unemployment rate is at 5.1 percent.

Consumer spending continues to grow. Home ownership has

reached record highs. Household net worth is also at a record level.

Productivity continues at a healthy pace, and although higher enVerDate 11-MAY-2000 12:45 Sep 12, 2006 Jkt 028071 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 C:\JEC\28071.TXT CarolB PsN: CarolB
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ergy prices have raised business costs and imposed hardships on

many consumers, these prices have not derailed the expansion.

As the Fed recently suggested, long-term inflation pressures are

contained. As a result, long-term interest rates, such as mortgage

rates, are still relatively low.

By its actions, the Fed has made clear its determination to keep

inflation in check.

In summary, the economy has displayed impressive flexibility

and resilience in absorbing many shocks. Monetary policy and tax

incentives for investment have made important contributions in accelerating the expansion in recent years.

The most recent release of Fed minutes indicates that the central

bank expects this economic growth to continue through 2006.

The Blue Chip Consensus of private economic forecasters also

suggests that the economy will grow in excess of 3 percent next

year.

Current economic conditions are positive, and the outlook for

2006 is favorable.

Mrs. Maloney, we are ready for your opening statement.

[The prepared statement of Representative Jim Saxton appears

in the Submissions for the Record on page 27.]

OPENING STATEMENT OF HON. CAROLYN B. MALONEY,

A U.S. REPRESENTATIVE FROM THE STATE OF NEW YORK

Representative Maloney. Well, thank you very much, Mr.

Chairman, and on that note I would like to place inside the record

Senator Reed’s opening statement and hope that everyone about

will get a chance to see it. It is over on the desk.

[The prepared statement of Senator Jack Reed, Ranking Minority

Member, appears in the Submissions for the Record on Page 36.]

Representative Maloney. First of all, I want to welcome Chairman Greenspan for his appearance before the Joint Economic Committee as Fed Chairman.

This will probably be your last appearance before us, and first

of all, I want to say that New York is so proud of you. And we take

tremendous pride in the fact that you are a born, tried and true

New Yorker. And many of my constituents have expressed their

gratitude for your service and their hope that in retirement you

will be able to spend more time back in New York City.

You have really done a great service for this Nation. You have

pulled us through some difficult times that were outlined by the

Chairman. I would like to add to that list, 9/11. That was a very

difficult economic time. And your leadership is greatly appreciated

by New York and the entire Nation.

Over the past 18 years, Chairman Greenspan has achieved a

really remarkable record of success as the country’s central banker.

He has steadfastly maintained the Fed’s credibility for keeping inflation under control while dealing flexibly with a variety of economic challenges. The 10-year economic expansion of the 1990’s

was the longest on record. One contributing factor was Chairman

Greenspan’s strong sense in the middle of that expansion that

there was room for monetary policy to accommodate further reductions in the unemployment rate, even though the conventional wisdom at the time said otherwise.

3

Of course, another contributing factor was the Clinton administration’s strong commitment to deficit reduction, which created a

fiscal policy environment conducive to strong, sustainable, noninflationary growth.

Unfortunately, that discipline is now a distant memory and

Chairman Greenspan’s successor will face a host of problems managing monetary policy in the face of historically large budget deficits, largest in history, a record current account deficit, a negative

household savings rate, rising inflation and a labor market recovery that remains very weak in many respects.

As always, I look very much forward to hearing Chairman

Greenspan’s testimony. I hope that, in addition to his views on the

economic outlook, he will share with us some reflections on what

has made his tenure at the Fed so successful and what are the key

lessons he would like to pass on to his successor. We thank you for

your many years of public service.

[The prepared statement of Representative Carolyn B. Maloney

appears in the Submissions for the Record on page 36.]

Chairman Greenspan. Thank you.

Representative Saxton. Mr. Chairman, let me just add my personal thanks for you being here today and just say that, in my office, there is a great picture of you with me, and as my constituents

come in and tell me whatever it is that is on their minds, on the

way out the door, I often point to that picture and say, ‘‘and there

we are planning for this great economy.’’ And so it has been a

pleasure working with you, sir, and Mr. Chairman, we are ready

for your statement.

STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN, BOARD

OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman Greenspan. First, let me thank you both for your

thoughtful and kind comments. I will be excerpting my prepared

remarks and request the full transcript be included in the record.

Representative Saxton. Without objection. Thank you.

Chairman Greenspan. Prior to the hurricanes that severely

damaged the Gulf Coast, the economy appeared to have considerable momentum. But pressures on inflation remained elevated.

Then Hurricane Katrina hit at the end of August, causing widespread disruptions to oil and natural gas production and driving

the price of light sweet crude oil above $70 per barrel. With the recovery from the first storm barely under way, Hurricane Rita hit,

causing additional destruction, especially to the energy production

and distribution systems in the Gulf.

These events are likely to exert a drag on employment and production in the near term and to add to the upward pressure on the

general price level. But the prices of crude oil and refined petroleum products have now fallen significantly from their peaks, and

repair and rebuilding activities are underway in many parts of the

affected region.

Outside the areas affected by the storms, economic fundamentals

remain firm, and the U.S. economy appears to have retained considerable forward momentum.

If allowance is taken for the effects of Katrina and Rita and for

the now-settled machinists strike at Boeing, industrial production

4

rose at an annual rate of 51⁄4 percent in the third quarter. That is

up from an annual rate of 11⁄4 percent in the second quarter when

a marked slowing of inventory accumulation was a restraining influence on growth.

The September employment report showed a loss of 35,000 jobs.

However, an upward revision to payroll gains over the summer indicated a stronger underlying pace of hiring than before the storms

that had been previously estimated.

The Bureau of Labor Statistics estimates that employment

growth in areas not affected by the storms was in line with the average pace over the 12 months ending in August.

Retail spending eased off in September, likely reflecting the effects of the hurricanes and higher gasoline prices.

Major chain stores report a gradual recovery over October in the

pace of spending, though light motor vehicle sales declined sharply

last month when some major incentives to purchase expired.

The longer-term prospects for the United States’ economy remain

favorable. Structural productivity continues to grow at a firm pace,

and rebuilding activity following the hurricanes should boost real

GDP growth for a while.

More uncertainty, however, surrounds the outlook for inflation.

The past decade of low inflation and solid economic growth in the

United States and in many other countries around the world has

been without precedent in recent decades.

Much of that favorable performance is attributable to the remarkable confluence of innovations that spawned new computer,

telecommunication and networking technologies, which especially

in the United States, have elevated the growth of productive capacity, suppressed unit labor costs and helped to contain inflationary

pressures. The result has been a virtuous cycle of low prices and

solid growth.

Contributing to the disinflationary pressures that had been evident in the global economy of the past decade or more has been the

integration of in excess of 100 million educated workers from the

former Soviet bloc into the world’s open trading system. More recently, and of even greater significance, has been the freeing from

central planning of large segments of China’s 750-million workforce. The gradual addition of these workers, plus workers from

India, a country which is currently undergoing a notable increase

in its participation in the world trading system, will approximately

double the overall supply of labor once all these workers become

fully engaged in competitive world markets.

Of course, at current rates of production, the half of the world’s

labor force that has been newly added to the world competitive

marketplace is producing no more than one quarter of world output. With increased education and increased absorption of significant cutting-edge technologies, that share will surely rise.

Over the past decade or more, the gradual assimilation of these

new entrants into the world’s free market trading system has restrained the rise of unit labor costs in much of the world and hence

has helped to contain inflation.

As this process has unfolded, inflation expectations have decreased, and accordingly, the inflation premiums embodied in longterm interest rates around the world have come down.

5

The effective augmentation of world supply and the accompanied

disinflationary pressures have made it easier for the Federal Reserve and other central banks to achieve price stability in an environment of genuinely solid economic growth. But this seminal shift

in the world’s workforce is producing, in effect, a level adjustment

in unit labor costs.

To be sure, economic systems evolve from centrally planned to

market-based only gradually and at times in fits and starts. Thus,

this level adjustment is being spread over an extended period. Nevertheless, the suppression of cost growth and world inflation at

some point will begin to abate and, with the completion of this

level adjustment, gradually end.

These global forces pressing inflation and interest rates lower

may well persist for some time. Nonetheless, it is the rate at which

countries are integrated into the global economic system, not the

extent of their integration, that governs the degree to which the

rise in world unit labor costs will continue to be subdued.

Where the global economy is currently in this dynamic process

remains open to question. But going forward, these trends will

need to be monitored carefully by the world’s central banks.

Mr. Chairman, I want to conclude with a few remarks about the

Federal budget situation which, at least until Hurricanes Katrina

and Rita struck the Gulf Coast, were showing signs of modest improvement. Indeed, tax receipts have exhibited considerable

strength of late, posting an increase of nearly 15 percent in fiscal

year 2005 as a result of sizable gains in individual and, even more,

corporate income taxes.

Thus, although spending continued to rise gradually last year, the deficit in the unified budget dropped to $319 billion, nearly

$100 billion less than the figure for fiscal year 2004 and a much

smaller figure than many had anticipated earlier in the year.

Lowering the deficit further in the near term, however, will be

difficult in light of the need to pay for post-hurricane reconstruction and relief.

But even apart from the hurricanes, our budget position is unlikely to improve substantially further until we restore constraints

similar to the Budget Enforcement Act of 1990, which were allowed

to lapse in 2002. Even so, the restoration of PAYGO and discretionary caps will not address the far more difficult choices that confront the Congress as the baby boom generation edges toward retirement.

As I have testified on numerous occasions, current entitlement

law may have already promised to this next generation of retirees

more in real resources than our economy, with its predictably slowing rate of labor force growth, will be able to supply.

So long as health care costs continue to grow faster than the

economy as a whole, as seems likely, Federal spending on health

and retirement programs would rise at a rate that risks placing the

budget on an unsustainable trajectory. Specifically, large deficits

will result in rising interest rates and an ever-growing ratio of debt

service to GDP. Unless the situation is reversed, at some point,

these budget trends will cause serious economic disruptions.

We owe it to those who will retire over the next couple of decades

to promise only what the government can deliver. The present polVerDate 11-MAY-2000 12:45 Sep 12, 2006 Jkt 028071 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 C:\JEC\28071.TXT CarolB PsN: CarolB
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icy path makes current promises, at least in real terms, highly conjectural. If fewer resources will be available per retiree than promised under current law, those in their later working years need sufficient time to adjust their work and retirement decisions. Crafting

a core strategy that meets the Nation’s longer-run needs will become ever more difficult and costly the more we delay.

The one certainty is that the resolution of the Nation’s demographic challenge will require hard choices and that the future performance of the economy will depend on those choices. No changes

will be easy, as they all will involve setting priorities and making

tradeoffs among valid alternatives.

The Congress must determine how best to address the competing

claims on our limited resources. In doing so, you will need to consider not only the distributional effects of policy changes, but also

the broader economic effects on labor supply, retirement behavior

and private savings. The benefits of taking sound, timely action

could extend many decades into the future.

Thank you very much.

I look forward to your questions, Mr. Chairman.

[The prepared statement of Hon. Alan Greenspan appears in the

Submissions for the Record on page 37.]

Representative Saxton. Thank you, very much, Mr. Chairman.

Mr. Chairman, let me refer first in a question to something that

you mentioned in your testimony, and that is, expectations related

to inflation. I would like to put up a chart, if I may, that shows

changes in core personal consumption expenditures, which is a

measure of inflation that the Fed likes to use. The Fed has successfully kept this measure of inflation between 1 and 2 percent, which

some refer to as the Fed’s comfort zone. By keeping inflation low

and in this narrow range, it seems to me that the Fed has reduced

and helped keep long-term interest rates lower than they would

otherwise be.

We know that we have had 12 short-term increases in interest

rates brought about by monetary policy. And at the same time,

long-term rates, which often in the past have tracked along with

short-term rates, have remained relatively low.

[The chart entitled ‘‘Core PCE Inflation’’ appears in the Submissions for the Record on page 41.]

By lowering uncertainty, by keeping inflation controlled and reducing the inflation premium embedded in interest rates, it seems

to me that price stability has helped promote long-term economic

growth and, in doing so, kept long-term interest rates relatively

low. Is this a policy result that was planned by the Fed, and, if so,

what is your perception of how well it has worked?

Chairman Greenspan. Well, I go back to the earlier years

when I first joined the Federal Reserve, and our general policy that

emerged from that particular period going forward was a recognition of our dual mandate to maintain maximum, sustainable

growth and price stability.

What we began to learn—which came as a conceptual shock to

most economists in the 1970s—is that you could get both rising unemployment and rising inflation concurrently. We began to recognize that, indeed, rising inflation causes unemployment or, the reverse, that a necessary condition for maximum sustainable growth

7

is price stability. So what has occurred over the years is a recognition that rather than having a dual set of goals which are independent of one another, which indeed was the general policy prescription in earlier decades, it is price stability which creates economic growth, employment and higher standards of living.

We have chosen the core PCE inflation measure as our standard

gauge largely because, as I have argued many times in the past,

there are structural problems in the consumer price index which

don’t capture the inflation rate per se.

We are also aware that even though this is a superior measure

to the CPI, it nonetheless does have upward measurement bias.

And it ranges, depending on how you look at some of the numbers,

from a half a percent, to as much as a percentage point.

Second, as you may recall, we ran into what looked to be the beginnings of at least possible disinflationary pressures in the summer of 2003, another surprise to economists who did not believe

that would be feasible in a world of fiat money, but Japan proved

otherwise.

We have gained from that experience a recognition that we don’t

want to get close to that particular area, either. So we have chosen

effectively to perceive price stability largely as the range which you

are seeing, after making adjustment for the statistical and economic adjustments which we learned over the last couple of decades.

I don’t want to communicate to you that somehow we had this

chart up there, and every time the inflation rate got close to the

top, we tightened it, and every time it got down to the bottom, we

eased. That is not the way policy is run because there are long

leads in various different things. But essentially, as I indicated,

fairly early on in this particular period, I thought that we had, in

fact, achieved price stability. While it has moved up and down

since then, it has broadly stayed in that range.

And judging from the data which you have cited, Mr. Chairman,

it appears to be a range which is really quite conducive to economic

growth and prosperity that are associated with that.

Representative Saxton. Thank you very much. Let me ask a

question that is related to inflation, as it also relates to energy. Oil

prices in particular have shot up, as every American consumer

knows, boosting increases in the major broad price indices. Arguably, however, the additional expense of oil might not be inflationary if it were offset by cutting back on other expenses.

In the absence of an accommodatative monetary policy, should oil

prices necessarily be expected to lead to increases in inflation?

Would you give us your response to that?

Chairman Greenspan. Yes, Mr. Chairman. I think there are

two aspects to this. One is a technical issue which relates to the

degree to which American businesses, confronted with increasing

energy costs, institute various different actions, either by capital

equipment or changing of the structure by which goods are produced. The extent to which they do that can increase the efficiency

of oil use. Indeed, we have been seeing that for several decades.

The ratio of British thermal units per constant dollar of GDP has

effectively been falling progressively decade after decade since the

1970s in this country, so that the intensity of energy use—and inVerDate 11-MAY-2000 12:45 Sep 12, 2006 Jkt 028071 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 C:\JEC\28071.TXT CarolB PsN: CarolB
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deed oil use as well—is about half of what it was relative to the

level of GDP, say, 30 years ago.

The increasing, if I may put it in these terms, productivity of energy, gains in productivity associated with more efficient use of energy, continues to this day. Indeed, as best we can judge, the very

sharp increases in prices, and therefore costs to the non-financial,

non-energy corporations of this country, actually induced a fairly

significant rise in efficiency, so it all didn’t pass through as cost increases. But more important is the perception that inflation overall

will be contained.

Indeed, as you point out, inflation expectation is a crucial variable in any market system, largely because it tends to be a key factor in wage rates and labor costs generally.

As long as the Federal Reserve is perceived to be holding inflation expectations in check, which means holding core inflation in

check, the pass-through of energy costs into the underlying inflation rate will be subdued.

And indeed, the data indicate that while, prior to the early

1980’s, a goodly part of energy costs were indeed passed through

into the general price level, subsequent to then, there is very little

indication that has been the case, and we associate it with the significant decline in inflation expectations. One of the reasons why

we are very firm in the notion that this country should not visit

the 1970s again, in the way of inflation, is that we have managed

to keep expectations contained. As difficult as energy problems

are—there is no doubt there has been a very significant amount of

hardship, and I think people are going to be quite surprised at

their heating bills this winter—we have not had the pass-throughs

into other products in a manner which existed in the 1970s.

Representative Saxton. Let me ask you just one final question.

According to a FOMC statement of last Tuesday, ‘‘core inflation has

been relatively low in recent months and longer-term inflation expectations remain contained.’’

Given the need for the Fed to preempt inflation, to what extent

is the Fed now addressing inflationary expectations or fears that

may not be fully evident in the current available data?

Chairman Greenspan. Inflationary expectations are reasonably

well measured concurrently and in real time in the sense that we

pick them up from a variety of different sources, but mostly from

the structure of interest rates: very specifically, the differences between interest rates, which are defined in real terms, such as

Treasury TIPS, and what we call additional compensation required

for inflation. That pretty much picks up what we are looking at.

Although we measure the same phenomena in a number of different ways—in other words, we have a whole series of measures

which relate to inflation expectation, essentially picking up the

same general attitude that is embodied in the marketplace—they

all very much show the same sort of pattern, which is that inflation

expectations are contained.

Representative Saxton. Thank you, Mr. Chairman.

We are going to move now to Mrs. Maloney for her questions.

Representative Maloney. Thank you, Chairman Greenspan.

The question that my constituents ask me, I am going to ask you:

If the economy is so good and inflation is so well behaved and there

9

is price stability, then why does everything cost so much more

when you go to buy something? They are feeling pressured in their

lives.

The question that I hear from my neighbors and friends and constituents is, when we have so many economic indicators that are

unhealthy, how are we having a healthy economy? We have a costly war, the largest deficit in history, the largest trade deficit in history, high energy costs, a weak dollar, huge investment from foreign countries. All of these patterns are very troubling to people,

yet the economy appears, according to your testimony, strong and

moving forward.

They question, how can it be strong when there are so many concrete problems out there that are unhealthy for the economy? And

I would like to frame the question in terms of your career at the

Fed. When you first came in the 1970s, your first job was with

President Ford as the head of his Council of Economic Advisors.

And when you took that job, the country was going through a great

deal of what we are going through now, possibly less shocked than

we are now, you had the high energy price shock, but not the huge

deficits in history, and you didn’t have a war. But inflation in 1974

shot up to double-digit territory, and by 1975, the economy was in

a serious recession with the unemployment rate rising from under

6 percent in 1974 to 8.5 percent in 1975.

Now we are experiencing yet another energy price shock. But

your testimony is very optimistic. And you are saying that we will

not see any inflation, that we will not see any recession. You are

very optimistic.

I want to know how are you confident that we will not—that we

will be able to avoid the same type of economic outcomes now that

we had in the 1970s? Has the economy fundamentally changed?

Are we more competitive? Is it the world economy? Is it Fed policy?

What has changed so that the economy has not experienced the

really dramatic problems that we had in the 1970s?

I guess a part of it is, what are the key changes over the past

30 years in our economy and in the way that we are conducting

monetary policy that have put us in a better position to withstand

energy supply shocks or price shocks?

Chairman Greenspan. Well, Congresswoman, that is a very

important question, because it is the experience that we had in the

1970’s that gave us a far better understanding of how the postWorld War II American economy functions.

First, let me say that we have a very complex, huge economy

which is churning. There are winners, and there are losers, and

there are pockets in the economy where things are exceptionally

weak, areas where they are strong.

The best way of summarizing why I say things are doing well is

that I would suspect that, on average, I worry about 20 different

problems which seem insurmountable out there. Today, there are

only 12 or thereabouts. So, they are still out there. And you know,

I have mentioned on innumerable occasions, despite the fact that

the economy overall is growing, there is a definite bimodal labor

market in the sense that for the 80 percent of the labor force which

are production workers, wages are growing far less quickly than

the skilled workers. This is, as I have mentioned before you on nuVerDate 11-MAY-2000 12:45 Sep 12, 2006 Jkt 028071 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 C:\JEC\28071.TXT CarolB PsN: CarolB
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merous occasions, essentially an educational problem which we

need to adjust because it is creating a skewing of economic distribution in this country, which I think is a very unsettling trend

for a democracy.

That, to me, is where I think the major problems are.

But what I should also point out the reason people are seeing

prices rising is that they are. They are seeing them, however, for

a lot of petroleum-related products. The one statistic that I think

almost everybody is able to audit clearly every day, every week, is

the price of gasoline. It is a homogeneous product, and it is listed

on the signs in the service stations all the time, and needless to

say, the price has been fluctuating all over the place.

But the Bureau of Labor Statistics does an excellent job in trying

to truly get what is the structure of price change in this country.

Those data, which essentially come from the BLS and in detail, are

the best we can do. So I think that it is mainly a selective view,

when you look at the total, which people often see in a period like

this. But when you look at all the data, it doesn’t show the concern

of acceleration that I often hear, as you do.

What has changed since the 1970s with respect to oil is, as I

mentioned before, we are using only half as much as we used to

relative to the GDP in the 1970s. As a consequence of that—and

also because of the fact that the underlying inflation rate is now

much lower—we are able to absorb a remarkable amount of that

increase because we have an extraordinarily more flexible economy

than we had in the mid-70s.

Indeed, that very flexibility itself is one of the reasons we have

gotten through a whole series of shocks that the Chairman mentioned early on. It is the development of that flexibility, coupled

with the fact that the use of energy is much less than it was, that

has enabled us to absorb the energy shock with nowhere near the

consequences that we confronted in the earlier period.

Representative Maloney. Thank you.

In your testimony today, Chairman Greenspan, you stress the

long-term core pressures that we face with the retiring baby

boomers. And we have very little flexibility in our core. Most of it

is entitlements. We have very little discretionary spending now in

our Federal core. So this is a huge challenge. But weren’t those

pressures also there in 2001? And wouldn’t it have been better if

we had focused on that challenge in 2001, instead of enacting tax

cuts that lost revenue and reduced our national savings? And I

want to read the following quote from a story that was in the New

York Times on Monday:

‘‘Mr. Greenspan is widely perceived as having given an agreement to President Bush’s plans for a big tax cut in 2001 and thus to have helped set the

stage for the huge deficits that followed.’’

And do you have any regrets about the way you expressed yourself in 2001? And were you surprised that your testimony was interpreted as having given a green light of support for these policies

that have added to this extremely large core deficit?

Chairman Greenspan. Let me review what was going on then

and what I actually testified to with respect to the budget at that

particular point.

11

We, as you know, then had very large surpluses, which all of the

technical experts projected further, and indeed, the Congressional

Budget Office projected them further. The Office of Management

and Budget projected them further. The staff at the Federal Reserve projected them further. We were all trying to get as full detailed an analysis as we could on something which we found very

surprising, namely, chronic surpluses, which we never believed we

would ever see, and we could not find any technical reasons to say

that those data were incorrect.

Indeed, the Federal Reserve embarked upon a study of what we

would do when the actual supplies of U.S. Treasury issues would

become inadequate for purposes of open market operations, meaning that the level of debt outstanding would approach de minimis

levels.

The problem, if you get to that point and still have surpluses, is

that you have to accumulate technically private assets plus State

and local assets.

I have always argued that that is potentially very destabilizing

where large claims on American businesses would be held by the

U.S. Government.

As a consequence, I argued at that time that we ought to cut

taxes before the debt would get to such levels that we couldn’t reduce it any more and would therefore have to accumulate assets.

Were I confronted with the same data today as I was then, I would

have given exactly the same testimony.

I must tell you, however, that in that whole evaluation I did recognize, in the testimony, that even though we couldn’t find anything wrong with the forecasts of surpluses should they, in fact,

dissipate, we ought to have procedures which would follow up any

changes in budgetary policies, whether for tax cuts or expenditure

increases, and essentially have triggers or other means of review

that would reverse the actions that would be taken at that particular point in time.

So, I have gone back and I have reviewed that testimony. And

I must tell you that, aside from the fact that the probability that

we all perceived of the deficit reemerging was small and that was

clearly a forecast gone wrong—not that the probability was small,

but that we would maintain the surpluses. Aside from that, I must

say, I would reproduce the testimony word for word.

Representative Maloney. Well, former Treasury Secretary

O’Neill reports that when he expressed concern about the possible

impact of the proposed tax cuts on the deficit and he said that Vice

President Cheney said, ‘‘Reagan proved that deficits don’t matter.’’

And did you have any idea when you gave that testimony in 2001

that the Administration was not serious about containing deficits,

was not serious about enforcement rules to help turn record deficits

into surpluses and to control the core?

Chairman Greenspan. I think the ‘‘deficits don’t matter’’ was

a reference that they don’t have an impact on interest rates. And

I disagree with that. I disagreed with it then; I disagree with it

now. And I disagree with it because the facts prove otherwise.

Representative Maloney. My time is up, and as always, it is

a great pleasure to listen and learn from you. Thank you.

Chairman Greenspan. Thank you.

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Representative Saxton. Thank you, Mrs. Maloney.

Mr. Paul.

Representative Paul. Thank you, Mr. Chairman.

And welcome, Mr. Greenspan.

Looking at your last three paragraphs, I certainly would agree

with your concern about the concerns for the future, the future financing of the medical care system as well as the retirement programs, as well as financing the debt. And to me, I read that as a

rather dire warning of what we should be dealing with in the Congress. And you make a suggestion that the entitlement laws should

be looked at because we cannot much sustain this.

And yet I think that is only part of the problem, because the entitlement system is certainly one reason why we spend a lot of

money. I don’t think we can do this without addressing the subject

of what we do with our foreign policy as we spend hundreds of billions of dollars overseas destroying countries and then rebuilding

countries.

I cannot see how we can adjust our ways here unless we talk

about that as well. But I also think that we should tie in this deficit spending and this commitment to the future to overall monetary policy because I think the system of money that we have had

helped create the problems that we have. And we can’t separate

the two because it certainly makes it a lot easier for Congress to

spend if there is some way of creating new money to accommodate

these deficits.

Just in the time that you have been at the Fed, we have had a

lot of monetary inflation. We have had a lot of new money pumped

into the system. As a matter of fact—over $600 trillion as measured by M3—it is all new money. It is three times as much money

as we had in 1987. But interestingly enough, the total debt, government debt, corporate debt and personal debt, has done the same

thing. It has tripled. It was approximately $8 trillion in 1987, and

now it is like $25 trillion. So a lot of new money was created. And

we have a lot of new debt in the system. But we also suffered a

consequence, our dollar now is worth 55 cents. So that to me seems

unfair because if I had saved money in 1987, I am only going to

get 55 cents back on my dollar.

I think there is a moral element to this, too, as well as an economic argument. Why save? And we don’t save. And if we need

more money to take care of our entitlements or fight a war or accommodate the debt, we just literally are able to go and depend on

the Federal Reserve to make sure interest rates don’t go up.

And then I think another problem we have is we look at the

wrong things when we are looking at our problems. It has been

said that the government tells us there is really no inflation. But

you know we could use what we strike out. We could look at medical care costs. We could look at food. We could look at energy. We

could look at the cost of government, taxes. And who knows, the

inflation rate might be 12 percent or 14 percent. So sometimes I

think we deceive ourselves with the system of money that we have

today by looking at the wrong things.

Because of globalization and productivity, prices have in some respect been held in check. But I cannot see how we can continuously

reassure ourselves that that is good, because it doesn’t deal with

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the problem of the malinvestment, the overinvestment, the bubbles

that develop, as well as the debt that builds up.

And this could not be done other than with someone being able

to create credit out of thin air.

I think it should be held in check.

So, in order to get this into a question, isn’t there—isn’t there

something unfair about the system? How can we justify stealing

value from people who save, cheat the people who are on retirement and then they get so little on their interest earned as well?

Is this a wise thing to do economically? Because you have expressed the concerns that I have. But I cannot see how you can

separate that from the overall monetary system that we have been

dealing with a lot longer than you have been in charge of the Fed.

Chairman Greenspan. Well, Congressman, the first thing that

we have to recognize is that the inflation rate, properly measured,

at this particular stage has been very close to zero for a very long

period of time.

In other words, as I said earlier, those numbers are biased upwards because of the way we calculate it. So while that is true

about a number of the statistics you quote, those statistics go back

well before the inflation rate stabilized and are reflecting very substantial inflation pressures which existed, especially during the

1970s when the inflation rate was double-digit.

But the level of nominal GDP has gone up basically roughly the

same after certain types of adjustments, with what the real underlying GDP properly measured would have done. That tells me that

we are not unduly inflating the system.

Representative Paul. Well, I don’t think that reconciles the

facts that I can get from the Federal Reserve that show that our

dollar is worth 55 cents compared to 1987. If that is not the reverse

of what you see in rising price and inflation, my dollar just doesn’t

buy as much any more. And the trend is continuous since 1914. It

is worth 5 cents. So I don’t see how you can say there is no inflation.

Chairman Greenspan. Well, you and I have discussed this

issue at length many times over the years. And I agree with you

in part, and I disagree with you on the other part.

Representative Paul. Can you say anything favorable about

gold today?

Representative Saxton. The gentleman’s time has expired. We

are going to go now to Mr. Hinchey.

Representative Hinchey. Thank you very much, Mr. Chairman.

Mr. Greenspan, I just want to say that we are going to miss you,

really miss you.

I think that you have probably been one of the most effective

chairmen of the board in the history of the Federal Reserve.

Chairman Greenspan. Thank you.

Representative Hinchey. And also I think one of the most interesting and instructive. And I think that that instruction has

come on a variety of levels, so you have done one heck of a job. I

won’t say, Brownie, but you have done one heck of a job. And I

think we are going to miss you a great deal, and I want to thank

you, take this opportunity to thank you very much for your service

14

and to share the things that were said by my friend and colleague,

Mrs. Maloney, a few moments ago. As a New Yorker, I am very

proud of you, too.

The economic circumstances that we are experiencing today,

growth in the economy, is a result of a variety of things, not the

least of which, the most of which, frankly, I think is the conflux

of some extraordinary circumstances of economic stimulation. We

have had record low interest rates, extraordinary amount of Federal spending and record tax cuts, all coming at the same time.

And if you don’t have economic stimulation and a growing, creating-new-money economy when you are pouring all that money in,

both in terms of monetary and fiscal policy, then you are in deep,

deep trouble.

So I am frankly very concerned about what is going to happen

when the conflux of circumstances wears out. And it certainly will

in the not-too-distant future.

So that would be my first question to you. What is going to happen when all of this stimulation starts to decline?

Chairman Greenspan. Congressman, it depends on what is

going on in the world generally, because you can remove all of that

stimulation, but if the underlying incentives in the private system

are increasing—and I think they are, at the moment, especially

coming out of the hurricanes—you can more than offset the stimulation, if you want to put it that way, from the private sector.

Representative Hinchey. That is true. And if that happens,

that may be the case——

Chairman Greenspan. Well, the history of stimulating a market economy is mixed. There are innumerable occasions in the past

when we have engaged in very significant stimulation—in other

words, large deficits, large expansions of the monetary base—and

we found that real GDP barely grew, and often fell into recession

because of the inflation which was engendered by the excess stimulant. I think we have to be careful about defining what type of

stimulus, what part of the economy it is imposed on or injected into

and what is going on mainly in the private sector, because that is

where most of the job generation occurs.

Representative Hinchey. Well, the job generation in the private sector——

Chairman Greenspan. Let me just follow up. I recognize that

and agree with you. I think that there is going to be significant

pulling back in the overall degree of stimulus. At least I hope there

is, because if we engage in fiscal policy that I was concerned about,

that was in the latter part of my testimony, then we are going to

get exceptionally large amounts of fiscal stimulus which we are not

going to want.

Representative Hinchey. Well, Mr. Chairman, I know that is

a very vague and ambiguous answer. And it is probably the best

you can do in the context. But the fact of the matter is that I think

we are going to be facing some very serious problems when we

begin to pull back. And we will have to pull back. In terms of the

job production in the private sector, this economy has lost substantially more than a million manufacturing jobs in the last 5 years.

And those are the best paying jobs.

15

One of the scholars at the American Enterprise Institute very recently made the observation that the benefits in the economy—and

these are his words—the benefits of the economy are not filtering

down, that the creating-new-money benefits are going to capital

and not to workers.

And we see that very, very clearly. The median pre-tax income is now $44,389. That is the lowest it has been since 1997.

We have a situation here in our country where the average, the

median income of the average American family has been flat for 5

years. The biggest problem that we are going to face, in addition

to maintaining the growth of the economy, assuming that we can

do that, even as we have to withdraw all of this stimulation that

we have been pouring into it because growing core deficits and a

national debt now that exceeds $8 trillion—the biggest problem

that we are going to face, is how to engage in some more equitable

distribution of the benefits of the creating-new-money growth in

the context of a democratic society.

How are we going to do that?

Chairman Greenspan. Well, first of all, let me just say that

there is a question about what the real median income level has

been, and it gets to different types of price deflation and which

types of data are employed.

Representative Hinchey. That number takes into consideration inflation.

Chairman Greenspan. I don’t disagree with the conclusion that

you raised as a consequence of that.

The issue is most vividly reflected in the fact that, in the last period, 20 percent of the workforce, which is largely supervisory by

definition, has had hourly wage increases approaching 10 percent,

whereas the increase for those in the 80 percent, who are perceived

to be production workers, is under 4 percent.

That is essentially creating a type of bimodal distribution.

The argument that seems most convincing to me as to the cause

of this problem, indeed it is almost necessary, is that we have

clearly observed a major increase in the need for skilled workers

to basically staff our ever-increasingly complex technological capital

stock.

On the other hand, we have seen a relative decrease in those

who are required to do less skilled work. Our educational system,

however, has, as best we can judge, been falling short in pushing

our students, from fourth grade to high school and from high school

into the universities relative to the rest of the world. As a consequence, we are left with a shortage of skilled workers who go

through this whole educational process, and with a lot of more lesser-skilled people than are needed to staff our capital structure. The

result is that wages are rising rapidly among the skilled and at a

very subdued level for the lesser skilled, creating a very marked

change in the distribution of income. And it is showing up in the

capital as well.

Representative Saxton. Thank you very much, Mr. Hinchey.

Representative Hinchey. Wish we had more opportunity to follow up, Mr. Chairman.

Chairman Greenspan. I agree with you. I think this is a very

important question for the United States.

16

Representative Saxton. Thank you, Mr. Chairman, and Mr.

Hinchey.

We are going to go to the gentleman from northwestern Pennsylvania, a Member of the Ways and Means Committee, Mr. English.

Representative English. Thank you, Mr. Chairman.

Chairman Greenspan, let me first say I would also like to thank

you for your long years of testimony before this and other committees up here on the Hill and your willingness to speak truth to

power and present some powerful economic realities to us whether

they are politically comfortable at the moment or not.

I am particularly grateful in this testimony that you have focused on the nuances of the problems that you see in our fiscal policy, and particularly the fact that we have an ongoing challenge in

dealing with the deficit. I was particularly grateful for how your

testimony also focused on the fact that prior to Katrina, we had,

in effect, seen a lowering of the deficit by a little under $100 billion

for the previous year, the result at least in large part of economic

growth interacting with the Tax Code to produce additional revenues. To me, that points the way for at least partially digging out

from under this problem even though we now have huge additional

obligations, as some of the other Members have noted.

To me, through all of this you have made the case for strong policies to continue to encourage economic growth, and I am concerned

that we have, in effect, in the Tax Code scheduled under current

law a tax increase in a couple of the provisions that directly impact

on our growth rate, and here I am noting for the record that in

2008 under current law, the capital gains tax rate will go back up,

and the reforms in dividends will be phased out. And I wonder if

you would comment on whether you think that that is sound policy,

or whether Congress should move now while we have the opportunity to make the current rates permanent before the market begins to anticipate that we might allow those tax increases to go

into law. Do you share my concern, Mr. Chairman?

Chairman Greenspan. I think there are two issues here, Congressman, and I thank you, incidentally, for your kind remarks.

The first is, I have testified previously that the partial elimination

of the double taxation of dividends has been a major contribution

to the structure of our tax system, and I should very much like to

see it continued.

Secondly, however, I would like to see it continued in the context

of PAYGO, in the sense that we should not be cutting taxes by borrowing, we should be cutting taxes by reducing the level of spending, and that is an issue which I think is critical.

We do not have the capability of having both productive tax cuts

and large expenditure increases and presume that the deficit

doesn’t matter, because it will create very serious backlashes in the

system. So I would like to see the extension of that provision in the

tax law, but I would insist that it be done in the context of a

PAYGO, which is not currently on the books. As I indicated in my

testimony, one of the very first things that we ought to recognize

is that if we are going to come to grips with the long, very difficult

budget problems that exist as the baby boomers start to retire, we

have to put in place a structure which will enable the Congress to

make rational choices. I don’t believe this is realistically possible

17

unless something like the Budget Enforcement Act of 1990 is on

the books, and if that is the case, then I would say let’s confront

the question of the tradeoffs, of what the advantages are of keeping

or even increasing the reduction of the double taxation on dividends with the context of what other priorities there are.

There are no easy choices. The easy choices are long gone. These

choices are between things which a majority of the Congress has

previously said are good and another one which the majority of

Congress has said are good, but both can’t exist at the same time.

Representative English. Thank you, Mr. Chairman, and thank

you, Mr. Chairman.

Representative Saxton. Thank you, Mr. English.

Ms. Sanchez.

Representative Sanchez. Thank you, Mr. Chairman, and

thank you, Chairman Greenspan, for your service to our country.

I think most of my colleagues have already spoken about your service, and I would associate myself with their words.

I have a couple of questions. One has to do with the capital markets and our budget situation here in Washington, D.C., and the

other has to do with something in your testimony on page 5 with

respect to the result of 100 million educated workers from the

former Soviet bloc entering into the world’s trading system, China’s

750 million people workforce, and India are also engaging in it.

Let me go first with this one, because basically what you have

said in here is the economy, the world’s economy, has been able to

absorb much of this workforce. You have also said in there, or you

alluded to the fact, that they are educated workers, and my biggest

fear for this country’s future, competitively speaking, is that we are

doing such a poor job in education. When I go to the universities,

the teachers in the graduate departments of science and math tend

to be foreigners, and probably three-quarters of the classes are.

So I guess my question to you is with this disparity that we continue to see growing between no growth or actually a decrease in

the real income of unskilled workers in the United States versus

the high-skilled workers, what do you think we do as a Nation to

address that?

Chairman Greenspan. Let me address the issue, because I

think this is a critical question that we will be confronted with as

the years go on. The global world is changing in a way which is

that an ever-higher proportion of value added in the world, goods

and services produced—meaning value which the world consumers

view as value—is becoming increasingly conceptual and less physical, more services and less physical goods.

We have recently done an analysis of 136 countries in the world

which indicates that there is a very high correlation between the

proportion of services to GDP and the relative real per capita income in that country, reflecting that those countries with an aboveaverage amount of services relative to goods being produced tend

to have the higher standard of living.

What we in the United States are going through is a very difficult transition. Our standard of living continues to increase, our

per capita real GDP continues to be increasing amongst the major

countries; we are obviously well ahead even considering the problem I was discussing with Congressman Hinchey previously. On

18

the average we are well ahead, which essentially says that we are

going through a period which is extremely stressful for those people

who are producing goods. Indeed we have had an extraordinary decline—not in industrial production, which has held up—but in employment involved in industrial production. The job loss has been

horrendous, and in certain areas of the country it has really been

a very serious and stressful problem.

It does say to us, however, that our standard of living is dependent on our ability to create services, conceptual services, ever more

as an increasing ratio to goods, and this is where our educational

system is going to be critical. While we will find that both China

and India have a huge number of educated people, they still are

missing one thing which we have, which in addition to our fairly

wide but, as I said previously, less than numerous skilled workers,

we have a really very imaginative workforce and a very productive

workforce.

We also have what the others don’t have, namely the Constitution of the United States. What that has done, in my judgment, is

to create a rule of law which enables individuals both in this country and those investing from abroad—in other words, those who invest in the United States—to know and trust the course of this

country to protect their rights. That is true both of citizens of the

United States and foreigners, and I believe that has been a very

major factor in why we do as well as we do, and indeed a lot of

the so-called development research which endeavors to determine

why certain economies prosper and others don’t would subscribe to

that.

But unless we get our educational system in check, even our

Constitution is not likely to protect us over the very long run. But

we do have an awful lot going for us, and if we can resolve our educational problems, we will maintain the very extraordinary position

the United States holds in the world at large.

Representative Sanchez. I see my time has expired, Mr.

Chairman.

Representative Saxton. Thank you very much, Ms. Sanchez.

Mr. Brady.

Representative Brady. Thank you, Mr. Chairman, for this

hearing and, Mr. Chairman, like others, I want to thank you for

your service. It has been famously said you make a living by what

you get; you make a life by what you give. You have given back

so much through your guidance of our economy and the Fed to the

prosperity of this Nation. I just want to join others in thanking you

for your leadership.

I want to ask two questions, one related to foreign holdings of

U.S. debt and the other to the account deficit the United States is

running. In your view, what do you see as the real world risk to

the large amount of foreign holdings of our U.S. debt? In the account deficit, while we mostly look at that as a function of what

we purchase and what we export, there is a savings component in

that trade deficit that I think is often ignored. Can you give your

views to us on what impact we can have, what role that plays long

term for us?

Chairman Greenspan. I think it is part of the globalization

process which has been accelerating over recent years, especially

19

since 1995. In other words, the last decade has been a remarkable

period of expanding trade, movement of capital, and all the various

measures which we use to say that globalization has increased. You

can compare, for example, the U.S. economy 150 years ago—where

we had a lot of interstate movement of goods and services and

trade deficits between the States, but very little outside of our borders—as we expanded into a national market, all of that activity

that is going on between peoples in different geographical areas—

which creates deficits and creates debts and all the variety of other

elements—spills over our sovereign borders, and now we look at it

in somewhat a different way, but it really is not.

I grant you that there is exchange-rate risk and legal risk with

respect to whose jurisdiction you are in, but a lot of what we are

observing is economic process, which is adjusted. The markets are

gradually adjusting.

The big puzzle to everybody is how is it possible for the United

States to have a current account deficit of more than 6 percent of

the GDP. It is one of the major puzzles, and the reason why I believe it exists is that it is a market phenomenon which is reflecting

globalization. It can’t go on indefinitely, as I indicated previously,

but a lot of these variables—that is, the big increase in debt holdings or U.S. Treasury holdings by foreign central banks or the even

larger holdings of American debt by foreign citizens—all of this is

a buildup which is characteristic of the global markets.

At some point globalization will slow down, but we are in a period where it has been undergoing extraordinary expansion and

has had effects we have yet to fully understand. Indeed, one of the

problems that we have run into, which was a great surprise to us,

is how apparently globalization forces have affected the long-term

interest rates when we started tightening our monetary policy in

June 2004. Long-term interest rates did not rise because of these

extraordinary forces, which we are just now beginning to understand.

So, yes, we ought to be looking at these various different increases. A very significant part of our Federal debt is held outside

of this country. It is close to half, depending on what the denominator is. But that is part and parcel of the globalization process,

and I think the presumption that when it stops, the whole world

is going to collapse is not correct, unless we fall back on a degree

of protectionism which has not existed in the world in the postWorld War II period.

Representative Brady. Thank you.

Would your advice to Congress be to not overreact to those elements until we see further how it is working out? And what the

impact is in this?

Chairman Greenspan. Yes. Most certainly, Congressman, and

indeed I have argued in other recent testimony that the best way

we can address this type of problem is to make certain that our

economy overall is sufficiently flexible so that adverse events—the

unforecastable events that occur as a part of this globalization—

will not have a significant negative impact on production or employment in this country. As far as policy is concerned, that is a

policy issue, and I think we ought to move as best we can to create

as much flexibility as we can in our system.

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Representative Brady. Thank you, Mr. Chairman.

Representative Saxton. Mr. Chairman, let me just ask a quick

question here. We have talked about various stimuli that have occurred in recent years, and one of the by-products of the easing of

monetary policy which began in 2001 was to give homeowners

whose properties had increased in value the opportunity to refinance at lower rates of interest. And as people did that, we found

them not only refinancing to the balance of their higher rate mortgage, but also taking out more of their equity, which supported

consumer spending.

I am just curious to know whether the Fed anticipated that this

would happen and your thoughts on—just generally on this matter.

Chairman Greenspan. Well, in the early stages we didn’t,

largely because the proportion of cash-outs that were associated

with refinancing were relatively small. But as refinancing became

ever easier, as the costs of refinancing declined, and as the home

equity loans became a major instrument for household debt accumulation—or, more exactly, an ability to extract equity from

homes, plus the automatic extraction of equity that occurs when

homes are sold and the realized capital gains for all practical purposes come out as cash—these have turned out to be extraordinarily large amounts relative to disposable income. Ten years ago

we would not have been able to forecast them because we would

not have been able to foresee the extraordinary changes that would

emerge in the mortgage markets, in the secondary mortgage market, in the whole structure of asset-based securities generally, and

the willingness on the part of households and their ability to extract very substantial amounts of equity as the capital gains built

up.

We have been observing that phenomenon very closely. Indeed,

my colleagues at the Fed and I have put together a fairly detailed

series trying to trace the issue of cash-outs and the effects of equity

extraction from home turnover and home equity loans, and trying

to determine to what extent that has been a factor in the decline

in the savings rate in this country. We are still examining it. There

are conflicts in the data, and it is very clear a good part of the decline in the savings rate is directly attributable to the extraction

of equity.

Representative Saxton. Mr. Chairman, one of my great staffers and I have had ongoing conversations about the so-called flattening of the yield curve, which essentially means that short-term

rates have gone up, while long-term rates have stabilized, creating

a very small gap between short-term and long-term rates. What, in

your opinion, is the effect of this on the economy in the future?

Chairman Greenspan. Mr. Chairman, that used to be one of

the most accurate measures we had to indicate when a recession

was about to occur and when a recovery was about to occur. It has

lost its capability of doing so in recent years. The markets have become far more complex, and the simple relationships that that

yield curve slope indicated no longer work. For example, remember

we used to have Reg Q a number of years ago, which essentially

limited the extent to which you could increase interest rates, shortterm deposit rates, and that created all sorts of imbalances in the

system and was an indicator which induced the change in the

21

structure of the yield curves, which did anticipate fairly accurately

what was going to happen to financial markets and to the economy.

The effectiveness of that relationship to where the economy is

going has virtually disappeared, and while it has significant financial impacts, it’s no longer useful as a leading indicator to the extent that it was.

Representative Saxton. I thank you for that.

I just want to refer to the chart that we put up. The red line,

of course, refers to short-term rates, which have gone up 12 times.

The darker gray line indicates the level of long-term rates. My

question is: If banks are forced to pay interest at relatively high

rates on short-term loans, what is the encouragement to loan with

long-term rates when there is such a small difference in the

spread?

[The chart entitled ‘‘Yield Spread’’ appears in the Submissions

for the Record on page 42.]

Chairman Greenspan. Well, what is happening is that, for example, in the mortgage market where we used to find that rates

were low, say, back closer to June 2004, adjustable-rate mortgages

became an extraordinarily important instrument. They are obviously undergoing significant contraction now, as rates go up, even

though a very substantial number of those loans are so-called hybrids, they are half short-term, half long-term mortgages. But consumers are changing their behavior, and we would have clearly expected that to happen, and we don’t think that’s bad. We think

that is good.

Representative Saxton. Thank you.

Mrs. Maloney.

Representative Maloney. Thank you, Mr. Greenspan.

When you say that inflation causes recession, are you saying that

the private economy on its own collapses, or are you saying that

inflation leads to a monetary policy response of higher interest

rates that slows the economic activity?

Chairman Greenspan. I think the problem is that it is the inflation process itself that creates the difficulty, and to the extent

that monetary policy is inappropriate, the central bank can contribute to that, or it can actually reduce the probability. But there

are broader inflationary processes in the private economy as well,

so it is a combination of a number of forces.

Representative Maloney. What caused the 1981 recession?

Chairman Greenspan. Essentially a recognition on the part of

government generally that the acceleration of inflation that was

building for the latter part of the 1970s was creating such huge

distortions that unless and until we confronted it, this country

could get into very serious trouble. As a consequence, my predecessor in October 1979 withdrew a huge amount of liquidity from

the system in order to bring down the inflation rate. That process,

while it ultimately was clearly successful and importantly successful to the economy longer term, had short-term consequences,

which was a very severe recession.

I would in a sense debit the recession to the earlier policies that

created the inflationary pressures which necessitated the reaction

that we had rather than to the Federal Reserve’s action in 1979.

We had no choice, and indeed had that action not been done, had

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that action not been implemented, I fear for the stability of our system, therefore, going forward.

Representative Maloney. You have spoken very eloquently

today about the growing—and expressed concern about the growing

gap between the haves and the have-nots, the inequality that is

growing in our country, which is a very bad trend, and the solutions that you have talked about are all long term.

I want to pick up on one of the points that you made about the

effects of integrating China and India into the world economy, and

you described that as helping to keep labor costs contained and

helpful in restraining inflation, but doesn’t it also contribute to inequality by putting a downward pressure on the wages of U.S.

workers and the competition that they feel internationally?

Chairman Greenspan. It hasn’t put downward pressure overall. What it has done is tended to put downward pressure mainly

in the goods area of the American economy, because that is where

their capabilities at this particular stage of the development are

most evident, and the impact has been fairly pronounced in a number of areas of this country, especially in the manufacturing area.

Representative Maloney. I would like to bring up a point that

Dr. Alan Blinder brought up at a Democratic forum we had on the

economy, and he argued that continuing advances in telecommunications technology are going to make global outsourcing of jobs a

much larger problem in the future. He says we have a challenge

now, but in the future it is going to be absolutely huge, and that

in the coming years the highly-skilled educated workers could be

just as vulnerable as the less-skilled workers. And doesn’t that

imply that education and training are at the least a very incomplete answer to the challenge that we confront with the outsourcing

of jobs and the growing middle-class job insecurity that I hear

every day in my office?

Chairman Greenspan. As globalization proceeds and very

clearly creates an average higher level of standard of living in this

country, it also, because it rests upon what we call creative destruction, induces a greater degree of insecurity in the system. This

is manifested by the fact that today half a million people lose their

jobs every week, and another half a million quit, and we hire a million people, plus or minus, every week. The churning is extraordinary. It basically means that the old view of job security which

we tended to have, or the way we viewed what it was in earlier

generations, is disappearing.

We are now finding that education is not wholly constrained to

our earlier years; it is basically becoming a lifelong proposition.

Community colleges, for example, are becoming a major part of our

education system, and the average age of the people in community

colleges is quite high. So people are recognizing that they are going

to have more than one job—indeed, they may have more than one

profession—in their lifetime.

This is the choice that we must make. In other words, if we want

the benefits of the huge amount of interaction, division of labor and

specialization that is implicit in an ever-growing world economy,

that implies a huge amount of both insourcing and outsourcing of

all goods. We at the moment, of course, are the recipient of more

insourcing than we send out. We have a net surplus of services.

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I don’t know whether that will continue to exist or not, but I do

agree that the amount of exchange of services across national borders is almost surely going to increase, and as a consequence,

standards of living will increase. But in the process there are winners and losers, and if you have creative destruction—which essentially means you move the obsolescent capital, less productive capital, to cutting-edge technologies—it necessarily means that the

workforce which is involved in the growingly obsolescent technology

has to move to another part of the economy.

That is happening. It is happening in the vast, vast majority of

cases. But there is a small and very pronounced segment of the

world economy which is creating problems which are difficult to reverse.

Representative Maloney. My time is up. Thank you very

much.

Representative Saxton. Mr. Paul.

Representative Paul. Thank you, Mr. Chairman.

You mentioned earlier that we have been debating the monetary

issue for a long time, and I guess that will go on. I am quite confident that what I say here or whatever we say together probably

won’t determine whether paper wins over gold or vice versa, because I think the market will determine that.

I think the only thing that I have on my side is history, because

paper currencies don’t have a very good history. They usually end

up in the waste can, and gold survives the many thousands of

years it has been used. So time will tell.

But a question I have relating to gold is currently, especially

since the early 1980s, 25 years, the last time there was ever any

serious talk about gold, today it is inappropriate to talk about it,

but since that time, of course, the dollar has lost a lot of value. But

during that time essentially paper has won out, intellectually

speaking. Nobody speaks of gold, but the question I have is why

does our Government—why does policy still mean that we should

hold the gold?

And I don’t have any problems with this. I would think that if

we trust paper, we ought to just get rid of the gold and spend the

money. We are in big deficits; we could get a lot of money for it.

So if gold is so out of place, and we will never have to use it again,

why couldn’t we make the case for just getting rid of it, as well as

the IMF?

Representative Saxton. Mr. Chairman, before you answer, if I

may just ask my colleagues, Mr. Hinchey and, I think, Ms. Sanchez

also have a question. We are in the beginning of a series of votes,

so if we could get through this question rather expeditiously and

go to Mr. Hinchey and then Ms. Sanchez, and then we will vote,

and we won’t have to ask you to wait for us to come back from this

series.

Go ahead and respond to this question, if you would.

Chairman Greenspan. The question is what do we do with the

gold supply?

Representative Paul. If we don’t believe in gold, why don’t we

just get rid of it?

Chairman Greenspan. It is a very interesting question and a

question debated at length on rare occasions within government.

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The bottom line is that in periods of extreme chaos, it has turned

out that gold has been the ultimate means by which transactions

have been consummated. It occurred, for example, during World

War II when you could only negotiate transactions with gold.

I must say, however, there was a vigorous debate in the Ford administration as to whether it made any sense to hold gold stock at

all, and the debate ended up with leaving it as it is. I would suspect the same psychology exists around the world, and that is the

reason why the IMF basically holds the gold that it does and is also

the reason that other central banks are holding the gold that they

do. You might be aware, for example, that the Europeans have sold

off significant amounts of their gold, but they still hold quite a good

deal.

Representative Paul. Thank you.

Representative Saxton. Thank you, Mr. Paul.

Mr. Hinchey.

Representative Hinchey. Thank you, Mr. Chairman.

Mr. Chairman, in response to one of the questions that I was

asking earlier with regard to this growing inequality in income, you

were drawing attention to the inequality between supervisory personnel and nonsupervisory personnel. I understand that, and that

is fine, but that isn’t the real issue. The real issue is the huge

growing inequality between people at the top of the income ladder

and those down at the middle.

As I pointed out, even a very conservative scholar at the very

conservative American Enterprise Institute pointed out the benefits

of the tax cuts are going to capital and not to workers. That is a

problem that we face.

Now, you, of course, looking at these growing surpluses back in

the beginning of this decade, were very supportive of the ideological

tax cuts that came out of this Administration which were designed

to benefit people at the upper income of the ladder.

Now, at the same time, this country for several decades now has

been facing some very serious infrastructure deterioration, everything from energy to transportation, to environmental protection,

health care, general quality of life. All of that has been declining

for decades in the public sector. Wouldn’t it have been wiser to take

some of that money in those surpluses, rather than just give almost

all of it to the wealthiest people in the country, to use some of it

to build up the basic infrastructure of the country rather than continuing to witness this serious deterioration?

The final aspect of my question is we have another tax cut coming up next year, 2006. That tax cut comes about at a time when

the median income is just over $44,000, meaning half of the people

in the country make less than that. This tax cut is going to benefit

people making over $182,000 and couples making more than

$326,000. Aren’t we on the wrong track here, Mr. Chairman?

Chairman Greenspan. Congressman, I think that a large number of economists, perhaps most, view the issue of tax policy in two

ways: one, how does it impact on the growth of the economy and

the increase in the tax base that is associated with the growth. My

argument in favor of a number of the tax cuts which have been offered in recent years, especially the one which I thought was the

most structurally desirable—namely the elimination of the double

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taxation of dividends for lots of reasons—is essentially because I

believed they would enhance economic growth. Similarly, I was a

strong supporter of the 1986 Tax Reform Act, which, as you know,

eliminated many of the loopholes, expanded the tax base and improved the system materially.

As I said there are two schools with respect to taxation. One is

what does it do to the economy and to the tax base; and two, what

does it do to the distribution of income. In considering the issue

you have to look at both, and I think that there is a tendency for

one side of this aisle to look one way, the other side to look at the

other. Perhaps we ought to be aware that there is double-entry

bookkeeping involved here, as in many other things.

Representative Saxton. Thank you, Mr. Chairman.

Representative Hinchey. That is not an answer, Mr. Chairman, but I thank you very much for it, and I wish you the very

best in the future.

Chairman Greenspan. Thank you very much, Congressman.

Representative Sanchez. Thank you, Mr. Chairman.

Mr. Chairman, before I came to the Congress, I was involved in

the capital markets, and so I have a question for you, just an overall question that has been bothering me for a while. And I asked

my friends on Wall Street, and most of the time they just shrug

their shoulders and don’t have a good answer for this. Maybe I

thought as a parting—since this will be the last time you are before

our Committee, maybe you could give me some advice on this. I am worried that we have an $8 trillion debt, and from my calculation, even though you brought up today that you thought the

unified budget was at a deficit of $319 billion right now, I sometimes, when I look at it, truly look at it, I look at us spending between $400 and $800 billion more every year, at least in the last

5 years of this Congress, because I think—and I believe there is a

lot of things that don’t get taken into account; supplementals that

we do here, supplemental appropriation bills, the two Louisiana

Senators asking for $250 billion just for Louisiana; a Medicare Part

D package that was supposed to be $400 billion spending over 10

years, now it is calculated at at least $1.3 trillion, probably will get

to $2 trillion by the time we finish with that. We spend $1.55 billion a week in Iraq, with no end in sight in that place, and that

doesn’t include the reinvestment we are going to need to do in our

vehicles and everything that is wasting away in that desert right

now. I have in Congress a lot of colleagues who want to increase

our Army by 100,000 new troops and don’t really know what the

cost is to that or the capacity that we currently have and how that

is going to affect our troops. So we have all these big spending

plans out there.

My question is why haven’t the capital markets told Congress

and Washington, D.C., to get their act together? Why are they ignoring what is happening here?

Chairman Greenspan. That is an excellent question, Congresswoman, and let me explain to you what I think the answer is, but

I don’t know for certain. As part of this globalization trend, not

only have we had the major disinflationary forces that are occurring because of the educated workers of the former Soviet Union,

China and India coming in, but we also have had the issue of, as

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I think I testified before the House Banking Committee, an excess

of saving over investment and a general set of forces suppressing

long-term interest rates.

So the question really is why is it that with what has to be rising

expectations of very heavy borrowing as we move out, say, into the

early part of the next decade, why isn’t that beginning to reflect

itself in, say, 10-year notes, because it has to be out there for 10

years.

I think the answer—I don’t really fully feel comfortable with it,

it is one of the issues that I think is on the table and has to be

understood—is that the disinflationary pressures, the excess savings pressures, have more than offset the expectational concerns

that rising supplies of U.S. Treasury debt have out there. I think

that is going to change. I think, as I tried to indicate in my prepared remarks, that is a gradually changing process, but I find it

utterly inconceivable, frankly, that we can have the type of potential fiscal outlook which now confronts us over the next 15, 20

years without having a significant impact on long-term interest

rates.

So I guess the answer to your question is there are other forces

involved offsetting it, or, to put it another way, that the impact has

been delayed.

Representative Saxton. Mr. Chairman, just let me add to the

chorus of appreciation for the many appearances that you have

made here before the Joint Economic Committee over the years.

We have benefited greatly from your wisdom, and we thank you.

And in conclusion I would just like to offer my wishes for the best

of everything in the future. Thanks for being with us.

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

and I thank the Committee. I have always enjoyed being here, and

I must say I get questions at this Committee which I don’t hear

elsewhere, and they are most interesting. Thank you.

Representative Saxton. Thank you, sir.

[Whereupon, at 11:48 a.m., the Committee was adjourned.]

(27)

Submissions for the Record

PREPARED STATEMENT OF REPRESENTATIVE JIM SAXTON, CHAIRMAN

I am pleased to welcome Chairman Greenspan before the Committee once again

to testify on the economic outlook. We appreciate the many times you have testified

before this Committee, and recognize your outstanding stewardship of monetary policy during your tenure as Fed chairman.

You have guided monetary policy through stock market crashes, wars, terrorist

attacks and natural disasters with a steady hand. Under your tenure price stability

has been the norm, with inflation low and stable. You have made a great contribution to the prosperity of the U.S., and the Nation is in your debt.

A broad array of standard economic data reflects the health of the U.S. economy.

Figures released last week indicate that the economy grew at a 3.8 percent rate last

quarter, despite the massive regional destruction wrought by the hurricanes. So far

during 2005, the economy has expanded at a 3.6 percent rate, roughly in line with

Federal Reserve expectations as well as the Blue Chip Consensus.

Equipment and software investment, which has bolstered the economy since 2003,

continues at a healthy pace. This component of investment responded especially

sharply to the incentives contained in the 2003 tax legislation. Employment has also

gained over this period, with 4.2 million jobs added to business payrolls since May

of 2003. The unemployment rate is 5.1 percent.

Consumer spending continues to grow. Homeownership has reached record highs.

Household net worth is also at a record level. Productivity growth continues at a

healthy pace.

Although higher energy prices have raised business costs and imposed hardship

on many consumers, these prices have not derailed the expansion.

As the Fed recently suggested, long-term inflation pressures are contained. As a

result, long-term interest rates, such as mortgage rates, are still relatively low. By

its actions the Fed has made clear its determination to keep inflation in check.

In summary, the economy has displayed impressive flexibility and resilience in

absorbing many shocks. Monetary policy and tax incentives for investment have

made important contributions in accelerating the expansion in recent years. The

most recent release of Fed minutes indicates that the central bank expects this economic growth to continue through 2006. The Blue Chip Consensus of private economic forecasters also suggests that the economy will grow in excess of 3 percent

next year.

Current economic conditions are positive, and the outlook for 2006 is favorable.

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PREPARED STATEMENT OF SENATOR JACK REED, RANKING MINORITY

Thank you, Chairman Saxton. I want to welcome Chairman Greenspan for his

last appearance before the Joint Economic Committee as Fed Chairman. As always,

I look forward to his perspectives on the economic outlook, but I’m also interested

in any reflections he may have on his tenure as Fed chairman.

Some have called Chairman Greenspan the most successful central banker in history. On his watch, inflation was kept under tight control and we enjoyed the longest economic expansion on record from March 1991 to March 2001.

While the Chairman’s track record managing monetary policy is very impressive,

his role in justifying the 2001 tax cuts is more problematic. I know that Chairman

Greenspan will point to his caveats about the need for triggers and other cautions,

but in the real world of politics, he was seen as giving the green light to President

Bush’s tax cuts, and now we are living with the consequences.

President Bush’s tax cuts were poorly designed to stimulate broadly shared prosperity and have produced a legacy of large budget deficits that leave us increasingly

hampered in our ability to deal with the host of challenges we face. Large and persistent budget deficits are undermining national saving, and they have contributed

to an ever-widening trade deficit. Our vast borrowing from abroad puts us at risk

of a major financial collapse if foreign lenders suddenly stop accepting our IOU’s.

Raising national saving is the key to our economic growth, a good way to reduce

our record trade deficit, and, as the Chairman’s past testimony reflects, the best

way to meet the fiscal challenges posed by the retirement of the baby boom generation. But what has the President offered us? A plan to replace part of Social Security with private accounts that would increase the deficit without raising national

saving and a proposal to make his tax cuts permanent that is simply incompatible

with reducing the deficit.

Sound policies for the long run are clearly very important, but I am also deeply

concerned about what continues to be a disappointing economic recovery for the typical American worker. Strong productivity gains have shown up in the bottom lines

of shareholders but not in the paychecks of workers. The typical worker’s earnings

are not keeping up with their rising living expenses, including soaring energy

prices. And both earnings and income inequality are increasing.

Chairman Greenspan has regularly expressed concern about the widening inequality of income and earnings in the American economy, but his solutions are always focused on the long term. While I too acknowledge the importance of education

and training, we face an immediate problem.

The flooding of New Orleans forced America to confront the existence of poverty.

A new report shows that hunger in America has risen dramatically over the last

5 years, with more than 38 million people living in households that suffer directly

from hunger and food insecurity, including nearly 14 million children. The minimum

wage has been losing purchasing power steadily, and low- and moderate-income

households face crushing energy bills this winter.

Of course, many of these problems in the American economy lie outside the purview of the Federal Reserve, where Chairman Greenspan has carried out his official

monetary policy responsibilities well. He has shown flexibility rather than a rigid

adherence to any predetermined policy rule in responding to changing economic circumstances, in order to pursue the multiple policy goals of price stability, high employment, and sustainable growth.

I hope the next Fed chairman observes that precedent when he takes up his duties in the face of historically large budget deficits, a record current account deficit,

a negative household saving rate, rising inflation, and a labor market recovery that

remains tepid in many respects.

Chairman Greenspan will be a hard act to follow. The impending ‘‘Greenspan deficit’’ is but the latest addition to our concerns about the economic outlook. Chairman

Greenspan, I want to thank you for your public service and I look forward to your

testimony today.

PREPARED STATEMENT OF REPRESENTATIVE CAROLYN B. MALONEY

Thank you, Chairman Saxton. Senator Reed will not be able to be here because

of votes in the Senate, so I request that his opening statement be entered into the

record, and I would like to make a few brief remarks.

I want to welcome Chairman Greenspan for his last appearance before the Joint

Economic Committee as Fed Chairman. Over the past 18 years, Chairman Greenspan has achieved a remarkable record of success as the country’s central banker.

He has steadfastly maintained the Fed’s credibility for keeping inflation under control while dealing flexibly with a variety of economic challenges.

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The 10-year economic expansion of the 1990s was the longest on record. One contributing factor was Chairman Greenspan’s strong sense in the middle of that expansion that there was room for monetary policy to accommodate further reductions

in the unemployment rate, even though the conventional wisdom at the time said

otherwise. Of course, another contributing factor was the Clinton administration’s

strong commitment to deficit reduction, which created a fiscal policy environment

conducive to strong, sustainable, non-inflationary growth.

Unfortunately, that fiscal discipline is now a distant memory, and Chairman

Greenspan’s successor will face a host of problems managing monetary policy in the

face of historically large budget deficits, a record current account deficit, a negative

household saving rate, rising inflation, and a labor market recovery that remains

tepid in many respects.

I look forward to Chairman Greenspan’s testimony. I hope that, in addition to his

views on the economic outlook, he will share with us some reflections on what made

his tenure at the Fed so successful and what are the key lessons he would want

to pass on to his successor.

PREPARED STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN,

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Mr. Chairman, when I last appeared before the Joint Economic Committee in

early June, economic activity appeared to be reaccelerating after a slowdown in the

spring. The economy had weathered a further run-up in energy prices over the winter, and aggregate demand was again strengthening. Real gross domestic product

(GDP) growth averaged 31⁄2 percent at an annual rate over the first half of the year,

and subsequent readings on activity over the summer were positive. By early August, the economy appeared to have considerable momentum, despite a further

ratcheting up of crude oil prices; pressures on inflation remained elevated.

As you know, the economy suffered significant shocks in late summer and early

autumn. Crude oil prices moved sharply higher in August, bid up by growth in

world demand that continued to outpace the growth of supply. Then Hurricane

Katrina hit the Gulf Coast at the end of August, causing widespread disruptions to

oil and natural gas production and driving the price of West Texas Intermediate

crude oil above $70 per barrel. Because of a lack of ready access to foreign supplies,

natural gas prices rose even more sharply. At the end of September, with the recovery from the first storm barely under way, Hurricane Rita hit, causing additional

damage and destruction—especially to the energy production and distribution systems in the Gulf. Most recently, Hurricane Wilma caused widespread power outages

and property damage across the State of Florida. These events are likely to exert

a drag on employment and production in the near term and to add to the upward

pressures on the general price level. But the economic fundamentals remain firm,

and the U.S. economy appears to retain important forward momentum.

Of course, the higher energy prices caused by the hurricanes are being felt well

beyond the Gulf Coast region. Those higher prices resulted from the substantial

damage that occurred to our nation’s energy production and distribution systems.

Of the more than 3,000 oil and gas production platforms in the paths of Katrina

and Rita, more than 100 were destroyed, and an additional 50 suffered extensive

damage. Of the 134 manned drilling rigs operating in the Gulf, 8 were lost, and an

additional 38 were either set adrift by the storms or were badly damaged. At

present, both oil and natural gas production in the Gulf are operating at less than

50 percent of pre-Katrina levels. Since the first evacuations of oil and gas facilities

were ordered before Katrina, cumulative shortfalls represented almost 4 percent of

the nation’s annual production of crude oil and 2 percent of our output of natural

gas.

The combination of flooding, wind damage, and a lack of electric power also forced

many crude oil refineries and natural gas processing plants to shut down. The restoration of production at the affected natural gas processing facilities has proceeded

particularly slowly, in part because of the lack of natural gas feedstocks and infrastructure problems. Most refineries, however, will be back on line within the next

month or so, though a few may take longer.

In the interim, a greater output of refined petroleum products in other areas of

the country and much higher imports, especially of gasoline, are making up for the

production shortfalls in Gulf refining. The temporary lifting of some environmental

regulations and the suspension of the Jones Act facilitated those adjustments. In addition, refiners have shifted the mix of production toward more gasoline and less

heating oil and jet fuel. That shift has had benefits in the short run, though the

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longer it continues, the greater the possibility of upward pressure on distillate fuel

oil prices during the winter heating season.

Releases from the nation’s Strategic Petroleum Reserve relieved much of the upward pressure on crude oil prices, and imports of refined products responded rapidly

to ease the price pressures stemming from the loss of refinery production in the

Gulf. As a consequence, the nationwide retail price of gasoline for all grades has declined 60 cents per gallon from its peak of $3.12 per gallon in the week of September

5. Motorists appear to have economized on their driving, and gasoline demand appears to be off a bit. However, it will take time and an appreciable increase in the

fuel economy of our stock of motor vehicles to fundamentally change the amount of

motor fuel used on our nation’s highways.

The far more severe reaction of natural gas prices to the production setbacks that

have occurred in the Gulf highlights again the need to expand our nation’s ability

to import natural gas. In contrast to the fall in crude oil prices and the sharp narrowing of refinery margins during the past 2 months, natural gas prices have remained high. Moreover, judging from elevated distant futures prices, traders expect

natural gas prices to edge lower but to stay high for the foreseeable future. This

expectation largely reflects a natural gas industry in North America that is already

operating at close to capacity and our inability to import large quantities of far

cheaper, liquefied natural gas (LNG) from other parts of the world. At present, natural gas supplies appear to be sufficient to meet the near-term demands—even with

some ongoing shortfall in Gulf production. However, a colder-than-average winter

would stress this market, and prices will likely remain vulnerable to spikes until

the spring.

U.S. imports of LNG have been constrained by inadequate global capacity for liquefaction, as well as by environmental and safety concerns that have restricted the

construction of new LNG import terminals in the United States. In 2002, such imports accounted for only 1 percent of U.S. gas consumption. Despite the major effort

to expand imports, the Department of Energy forecasts LNG imports this year at

only 3 percent of gas consumption. Canada, which has recently supplied one-sixth

of our consumption, cannot expand its pipeline exports significantly in the near

term, in part because of the role that Canadian natural gas plays in supporting increasing oil production from tar sands.

The disruptions to energy production have noticeably affected economic activity.

We estimate that the storms held down the increase in industrial production 0.4

percentage point in August and an additional 1.7 percentage point in September.

Except for the hurricane effects, readings on the economy indicate a continued

solid expansion of aggregate demand and production. If allowance is taken for the

effects of Katrina and Rita and for the now-settled machinist strike at Boeing, industrial production rose at an annual rate of 51⁄4 percent in the third quarter. That’s

up from an annual pace of 11⁄4 percent in the second quarter, when a marked slowing of inventory accumulation was a restraining influence on growth.

The September employment report showed a loss of 35,000 jobs. However, an upward revision to payroll gains over the summer indicated a stronger underlying pace

of hiring before the storms than had been previously estimated. The Bureau of

Labor Statistics estimates that employment growth in areas not affected by the

storms was in line with the average pace over the twelbe months ending in August.

Retail spending eased off in September, likely reflecting the effects of the hurricanes and higher gasoline prices. Major chain stores report a gradual recovery over

October in the pace of spending, though light motor vehicle sales declined sharply

last month, when some major incentives to purchase expired.

The longer-term prospects for the U.S. economy remain favorable. Structural productivity continues to grow at a firm pace, and rebuilding activity following the hurricanes should boost real GDP growth for a while. More uncertainty, however, surrounds the outlook for inflation.

The past decade of low inflation and solid economic growth in the United States

and in many other countries around the world has been without precedent in recent

decades. Much of that favorable performance is attributable to the remarkable confluence of innovations that spawned new computer, telecommunication, and networking technologies, which, especially in the United States, have elevated the

growth of productivity, suppressed unit labor costs, and helped to contain inflationary pressures. The result has been a virtuous cycle of low prices and solid

growth.

Contributing to the disinflationary pressures that have been evident in the global

economy over the past decade or more has been the integration of in excess of 100

million educated workers from the former Soviet bloc into the world’s open trading

system. More recently, and of even greater significance, has been the freeing from

central planning of large segments of China’s 750 million workforce. The gradual

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addition of these workers plus workers from India—a country which is also currently undergoing a notable increase in its participation in the world trading system—would approximately double the overall supply of labor once all these workers

become fully engaged in competitive world markets. Of course, at current rates of

productivity, the half of the world’s labor force that has been newly added to the

world competitive marketplace is producing no more than one quarter of world output. With increased education and increased absorption of significant cutting-edge

technologies, that share will surely rise.

Over the past decade or more, the gradual assimilation of these new entrants into

the world’s free-market trading system has restrained the rise of unit labor costs

in much of the world and hence has helped to contain inflation.

As this process has unfolded, inflation expectations have decreased, and accordingly, the inflation premiums embodied in long-term interest rates around the world

have come down. The effective augmentation of world supply and the accompanying

disinflationary pressures have made it easier for the Federal Reserve and other central banks to achieve price stability in an environment of generally solid economic

growth.

But this seminal shift in the world’s workforce is producing, in effect, a level adjustment in unit labor costs. To be sure, economic systems evolve from centrally

planned to market-based only gradually and, at times, in fits and starts. Thus, this

level adjustment is being spread over an extended period. Nevertheless, the suppression of cost growth and world inflation, at some point, will begin to abate and,

with the completion of this level adjustment, gradually end.

These global forces pressing inflation and interest rates lower may well persist

for some time. Nonetheless, it is the rate at which countries are integrated into the

global economic system, not the extent of their integration, that governs the degree

to which the rise in world unit labor costs will continue to be subdued. Where the

global economy is currently in this dynamic process remains open to question. But

going forward, these trends will need to be monitored carefully by the world’s central banks.

I want to conclude with a few remarks about the Federal budget situation,

which—at least until Hurricanes Katrina and Rita struck the Gulf Coast—was

showing signs of modest improvement. Indeed, tax receipts have exhibited considerable strength of late, posting an increase of nearly 15 percent in fiscal 2005 as a

result of sizable gains in individual and, even more, corporate income taxes. Thus,

although spending continued to rise rapidly last year, the deficit in the unified

budget dropped to $319 billion, nearly $100 billion less than the figure for fiscal

year 2004 and a much smaller figure than many had anticipated earlier in the year.

Lowering the deficit further in the near term, however, will be difficult in light of

the need to pay for post-hurricane reconstruction and relief.

But even apart from the hurricanes, our budget position is unlikely to improve

substantially further until we restore constraints similar to the Budget Enforcement

Act of 1990, which were allowed to lapse in 2002. Even so, the restoration of

PAYGO and discretionary caps will not address the far more difficult choices that

confront the Congress as the baby-boom generation edges toward retirement. As I

have testified on numerous occasions, current entitlement law may have already

promised to this next generation of retirees more in real resources than our economy, with its predictably slowing rate of labor force growth, will be able to supply.

So long as health-care costs continue to grow faster than the economy as a whole,

as seems likely, Federal spending on health and retirement programs would rise at

a rate that risks placing the budget on an unsustainable trajectory. Specifically,

large deficits will result in rising interest rates and an ever-growing ratio of debt

service to GDP. Unless the situation is reversed, at some point these budget trends

will cause serious economic disruptions.

We owe it to those who will retire over the next couple of decades to promise only

what the government can deliver. The present policy path makes current promises,

at least in real terms, highly conjectural. If fewer resources will be available per

retiree than promised under current law, those in their later working years need

sufficient time to adjust their work and retirement decisions.

Crafting a budget strategy that meets the nation’s longer-run needs will become

ever more difficult and costly the more we delay. The one certainty is that the resolution of the nation’s demographic challenge will require hard choices and that the

future performance of the economy will depend on those choices. No changes will

be easy, as they all will involve setting priorities and making tradeoffs among valued alternatives. The Congress must determine how best to address the competing

claims on our limited resources. In doing so, you will need to consider not only the

distributional effects of policy changes but also the broader economic effects on labor

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supply, retirement behavior, and private saving. The benefits of taking sound, timely action could extend many decades into the future.

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