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91–369 PDF 2004

S. HRG. 108–281

FEDERAL RESERVE’S SECOND MONETARY POLICY

REPORT FOR 2003

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

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

JULY 16, 2003

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

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

PEGGY R. KUHN, Senior Financial Economist

MARTIN J. GRUENBERG, Democratic Senior Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

WEDNESDAY, JULY 16, 2003

Page

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

Opening statements, comments, or prepared statements of:

Senator Johnson ............................................................................................... 2

Senator Allard ................................................................................................... 3

Senator Sarbanes .............................................................................................. 3

Senator Enzi ..................................................................................................... 5

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

Senator Reed ..................................................................................................... 7

Senator Bennett ................................................................................................ 7

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

Senator Hagel ................................................................................................... 8

Senator Chafee ................................................................................................. 8

Senator Corzine ................................................................................................ 22

Senator Carper ................................................................................................. 25

Senator Crapo ................................................................................................... 27

Senator Dodd .................................................................................................... 29

Senator Schumer .............................................................................................. 32

WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 8

Prepared statement .......................................................................................... 46

Response to written questions of:

Senator Shelby ........................................................................................... 50

Senator Sarbanes ...................................................................................... 53

Senator Bunning ....................................................................................... 56

Senator Miller ............................................................................................ 56

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, July 16, 2003 ....................................... 59

Letter to Senator Tim Johnson from Alan Greenspan, dated June 25, 2003 ..... 89

(III)

(1)

FEDERAL RESERVE’S SECOND MONETARY

POLICY REPORT TO CONGRESS FOR 2003

WEDNESDAY, JULY 16, 2003

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

The Committee met at 10:00 a.m. in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

I am very pleased this morning to welcome Chairman Greenspan

before the Committee on Banking, Housing, and Urban Affairs to

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

This morning, I will keep my remarks brief as we are all eager

to hear from the Chairman on his views on the U.S. economy and

other related issues. We also have the benefit, Mr. Chairman, of

having read about your remarks before the House yesterday.

At this time I would like to make two observations, both of which

you highlight in your statement or in your more extensive report.

First, the economy stands on the brink of, we hope, a strong recovery. The question is how strong will the rebound be and what

further steps can be taken should the recovery falter. There is little

question that we all would like to see the economy grow faster and

to have more jobs created for the American people. A number of

stimulative measures, including the tax cut enacted in May, have

already been taken. We know from your testimony that the Federal

Reserve also stands ready to take additional action should the

economy remain sluggish.

Second, the Congress, I believe, needs to remain focused on

achieving the appropriate fiscal policy. Yesterday, as we all know,

the OMB announced an update of its budget estimates, revising its

estimates of the 2003 deficit upward to $455 billion. The budget

forecast has been adversely affected by the relatively weak economy and by the necessary expenditures to fight the war on terrorism. Over the longer term, the Congress needs, I believe, to

renew its effort at reforming mandatory programs and controlling

Government spending. We would certainly welcome, Mr. Chairman,

your views of the importance of that goal.

We are happy to host you and we look forward to your remarks

and an enlightening discussion.

Senator Johnson.

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STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. Thank you, Chairman Shelby, for inviting

Chairman Greenspan before this Committee to present the Second

Monetary Report to Congress for 2003. I hope that we will find

some good news in the report given the recent demoralizing headlines about an exploding budget deficit, the tax cuts enacted earlier

this year, contrary to Chairman Greenspan’s recommendation that

any tax cuts be offset so as to minimize deficit.

Once again, the Office of Management and Budget has adjusted

its deficit estimates upward. We are now being told that this year’s

deficit will reach $455 billion, 50 percent higher than the Bush Administration forecast just 5 months ago. In fact, the deficit is $55

billion higher than many economists projected just last week. This

represents a fiscal reversal of more than $680 billion since 2000

when the Treasury reported a surplus—a surplus—of $236 billion.

At the same time, the unemployment rate has reached 6.4 percent. More than 9.4 million Americans are looking for work and

cannot find a job. Now, as much as the next person, I will take a

glass-half-full attitude any day, but at a certain point, one begins

to suspect that reports of an imminent economic recovery are assuming a bit more juice than we really have.

For example, just one year ago, Chairman Greenspan predicted

that our economy, our GDP, would grow between 3.5 and 4 percent

in 2003. Chairman Greenspan has now slashed those projections to

2.5 to 2.75 percent. A year ago, Chairman Greenspan predicted the

unemployment rate would be approximately 5.24 to 5.5 percent by

the end of 2003. We are now at 6.4 percent and rising steadily.

Now, I have enormous respect for Chairman Greenspan, and I

know that the depth of the economic malaise has taken us all by

surprise. But I am deeply skeptical of arguments by this Administration that all economic ills will be cured if we give massive tax

cuts, without offsetting them, to those at the top of the economic

ladder in the hope that the money will somehow trickle down to

working families.

At this point I would also like to make note of a topic on which

Chairman Greenspan and I do see eye to eye, and, Mr. Chairman,

I do have a 10-page letter from Chairman Greenspan that I would

ask unanimous consent that the letter be inserted into the record

in its entirety.

Chairman SHELBY. Without objection, it is so ordered.

Senator JOHNSON. This letter deals with the topic of the regulation of the industrial loan companies and the importance that these

banks come under consolidated supervision. As many of you know,

I have a longstanding concern about the mixing of banking and

commerce, and I am alarmed that recent attempts to expand the

ILC charter would undercut much of the progress we have made

over the past few years, including closing the so-called ‘‘unitary

thrift loophole’’ a few years ago. Of even greater concern, I believe,

is the ability of ILC’s, which may have commercial parent companies, to escape consolidated supervision by the Federal Reserve.

I would like to quote from Chairman Greenspan’s letter about

the critical importance of consolidated supervision:

Consolidated supervision provides the Board with both the ability to understand

the financial strength and risks of the overall banking organization and the authorVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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ity to address significant management, operational, capital, and other deficiencies

within the overall organization before these deficiencies pose a danger to subsidiary

insured banks and the Federal safety net. As the Treasury Department noted in its

1991 report and recommendations on modernizing the financial system, umbrella

oversight of a financial company that controls an insured bank, ‘‘is necessary to protect the insured depository [institution] from affiliate risk. Umbrella oversight is designed to identify problems in the holding company or affiliates that are likely to

cause difficulties for the insured bank, and to apply remedial action.’’

I would like to note my great respect for FDIC Chairman Powell,

and I do not mean in any way to impugn the supervisory capacity

of his agency. However, ILC’s which exist principally within large

affiliated structures should not be regulated separate and apart

from those affiliates. The Bank Holding Company Act provides a

unique set of supervisory powers which are vitally important where

banking and commerce are intertwined in a way that introduces

additional risk to the system.

Thank you, Mr. Chairman, for holding today’s hearing. I apologize in advance that I will be unable to stay for questions due to

competing and conflicting hearing obligations.

Chairman SHELBY. Senator Allard.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Mr. Chairman, I would also like to thank you

for holding this hearing and join my colleagues in welcoming Federal Reserve Board Chairman Greenspan to this hearing. I always

look forward to the opportunity to hear from Chairman Greenspan

concerning monetary policy and other economic issues.

I was pleased to hear Chairman Greenspan’s generally positive

comments yesterday. I share his belief that the economy is headed

in a positive direction. But the recovery is still preliminary, and we

need to ensure that we keep the country headed in the right direction. Now is the time to address the long-term solvency of Social

Security and Medicare and to put the Government on a plan to

eliminate the deficit and to pay down the national debt.

I would invite my colleagues to join me in voting to hold down

spending excesses on the floor of the Senate. So far, there have just

been a few that have been willing to join me in that effort. To balance the budget means that we need to hold down spending as we

go through the appropriations process, and that is what we are beginning to address now on the floor of the Senate.

By pursuing policies of low taxation, limited Federal regulation,

free trade, and sound monetary policy, the United States will prosper with wealth and opportunity.

Chairman Greenspan, again, thank you for appearing before the

Banking Committee today, and I look forward to your testimony.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I am

pleased to join with my colleagues in welcoming Chairman Greenspan to this morning’s hearing on the Federal Reserve’s SemiAnnual Report to Congress on Monetary Policy.

I went over Chairman Greenspan’s statement this morning. As

usual, it provided a thoughtful overview of the outlook for the economy and signaled the Fed’s willingness ‘‘to maintain a highly

4

accommodative stance of policy for as long as needed to promote

satisfactory economic performance.’’ However, I found very little

discussion in the statement of what I consider to be a significant

concern with respect to our economy today, and that is an exceptionally weak labor market.

Chairman Greenspan’s statement mentions that, ‘‘incoming data

on employment and aggregate output remain mixed.’’ In the context of a discussion of productivity, the statement also says that,

‘‘One consequence of these improvements in efficiency has been an

ability of many businesses to pare existing workforces and still

meet increases in demand. Indeed, with the growth of real output

below that of labor productivity for much of the period since 2000,

aggregate hours and employment have fallen, and the unemployment rate rose last month to 6.4 percent of the civilian labor force.’’

Now in my perusal of the statement, this is the extent of the discussion about jobs in our economy. Given what I believe is the disturbing prospect for employment, particularly at this stage of a socalled recovery, Mr. Chairman, I would like to take a moment or

two to review in a little more detail the employment situation.

Since January of this year, the unemployment rate has risen

from 5.7 percent to 6.4 percent, the highest unemployment rate in

over 9 years, since April of 1994; 9.4 million workers are unemployed, the most unemployed workers since December 1992, more

than 10 years ago. If individuals who have become too discouraged

to look for work were included in the unemployment rate figure, it

would be well over 7 percent.

The economy has lost 394,000 jobs since January, losing jobs

each of the past 5 months. Since February 2001, total jobs have

fallen 2.6 million, and private sector employment has fallen more

than 3.1 million. More than 3 million private sector jobs have been

lost since February 2001, a little over 2 years ago—2 and a half

years ago. Last week, the Labor Department reported that an additional 439,000 workers filed initial unemployment insurance

claims. More than 400,000 workers have been filing initial claims

now for 21 consecutive weeks. The last time we had such an extended streak was in September 1992—again, more than 10 years

ago.

Continuing claims for unemployment insurance are at a 20-year

high of 3.8 million. That is the highest level since February 1983—

more than 20 years ago. There are over 1.1 million Americans who

have already exhausted all of their unemployment insurance benefits still unable to find a job. The average unemployed worker has

been out of work 19.8 weeks. That is the highest duration average

for unemployed workers, 19.8 weeks, since 1948, except for a 7-

month period in 1983 and 1984 when unemployment ranged between 8 and 10 percent.

Since GDP reached a low in the third quarter of 2001, the economy has lost over 2 million jobs. At the same stage of the early

1990’s cycle—when the phrase ‘‘a jobless recovery’’ was coined—the

economy had already generated net job gains totaling 482,000, and

job growth had already turned positive on a sustained basis by the

summer of 1992, just a year after the recession officially ended. In

other words, it seems to me we are in a very difficult situation

5

here, and we really need to lay this out and then make some judgments about how to move on it.

Last week, The Washington Post reported that the National Bureau of Economic Research, the arbiter of when U.S. economic recessions begin and end, has been unable to declare an end to the

recession that began in March 2001, because payroll employment

has continued to decline long after the economy resumed growing.

The article noted that employment has never been down so much

this far into a post-recessionary phase. The article quotes a prominent Wall Street economist as saying, ‘‘The current situation makes

the early 1990’s jobless recovery look like a hiring spree.’’

On Monday, The New York Times reported that, ‘‘Teenagers are

facing the worst summer job market in years, with the percentage

of those holding summer jobs at its lowest in 55 years and the unemployment rate at its highest in a decade.’’

I take note of all of this because I think there is a serious prospect that the employment situation may not improve in the coming

months and unemployment may continue to rise. It is by no means

clear that a level of economic growth can be achieved that will

bring about a significant improvement in the unemployment rate.

Taken together, it seems to me more focused attention on our

employment situation is warranted. Unlike Chairman Greenspan’s

statement that he finds the situation mixed, I find it very negative

with respect to the employment situation.

Chairman Greenspan notes in his testimony the achievement of

‘‘effective price stability—a long-held goal assigned to the Federal

Reserve by the Congress.’’ And it is certainly part of the statutory

mandate of the Fed as determined by the Congress. But I would

note another goal assigned by the Congress not covered in the

Chairman’s statement and that is ‘‘maximum employment.’’ Mr.

Chairman, I think it is important that we focus on this. At a minimum, it seems to me critical that unemployment insurance should

be extended for those long-term unemployed who have exhausted

their benefits.

Thank you very much.

Chairman SHELBY. Senator Enzi.

STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Mr. Chairman.

Everyone always looks with anticipation toward this presentation. Of course, there is a little more anticipation when it is the

Senate’s turn for the first presentation, but we thank you for all

of the insight that you provide.

The U.S. economy is still the greatest economy in the world, but

there are certain issues that we need to address to ensure that we

retain that position. If I had to pick a single issue that has the

greatest impact on the financial affairs of Wyoming, and the rest

of the Nation, I would choose the state of the Nation’s energy development. Every sector of our economy relies on some form of

technology that in turn relies on electricity and/or fossil fuels to

function. And one of the secrets of the United States has always

been low-cost energy. Our economy is literally driven by our ability

to develop and maintain a steady, constant energy supply.

6

Wyoming’s role is much like the position held by the colonies

during America’s first years of European settlement. We provide

the raw materials or, in other words, the feedstock that makes the

rest of the Nation’s energy economy function. In my home county

of Campbell County, Wyoming, we would be the third largest coalproducing country in the world. One-third of our Nation’s coal is

produced in this county alone. We also produce more uranium annually than the rest of the Nation combined and have the greatest

potential for natural gas development in the entire continental

United States. In our county, we are in the process of building

some 50,000 wells for coal-bed methane, and they just made a discovery that there is another coal formation below the present one.

The top formation is 60 to 100 feet thick, and under about 60 to

100 feet of dirt. The other one is a little bit lower, but it is 200

feet thick and it has considerably more natural gas production than

the other. In short, we have what the rest of the Nation needs to

keep its technology fueled and running.

Unfortunately, most of that energy is stranded in Wyoming and

is inaccessible to other parts of the country that need it. Our natural gas development is being slowed down by the inability to get

the gas out of State. We are short of pipelines. We are talking

about some pipelines from Alaska. We need to talk about pipelines

to get the gas that has already been discovered in the lower 48 to

where it is needed. Our electricity runs into bottlenecks where the

power lines outside the State do not have enough capacity to carry

what we can generate, and our coal is being hit with the threat of

new regulations and bureaucratic limitations that could eventually

slow down exploration and development. All of these limitations

are having an effect on the rest of the economy.

I know that Chairman Greenspan has already visited the Hill on

a number of occasions and has testified on this issue. I look forward to any additional insights he might offer on how we can bolster the economy by increasing energy stability, and I hope he

could address what future role the energy-producing States can

play in meeting our energy demands.

I know that we have had a craze of trying to go with natural gas

for as many things as possible. The production of electricity can be

very efficiently done with coal, and I know they were making a decision in Rapid City one year on whether to use peaking power

from natural gas. They discovered that the peaking power would

require as much natural gas and be needed at the same time as

gas to heat Rapid City. It was an equivalent amount. It took as

much electricity as it would take to heat in winter in Rapid City.

So, we are talking about some large quantities of gas for things

that could be substituted by coal production. We do need to be able

to get the electricity around. And I have mentioned the need for

pipelines.

In addition to the importance of natural gas prices on our Nation’s economy, we must also ensure that we have a favorable business climate to encourage the creation and growth of our small

businesses. And small business has been the backbone for the

country; more than 97 percent of the businesses are small business.

I appreciate any of the concentration that people have done on imVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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proving small business, and I would ask that a copy of my full

statement be made part of the record.

Chairman SHELBY. Without objection, it is so ordered.

Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you, Mr. Chairman, and welcome, Chairman Greenspan. You are certainly a respected voice on these matters, not only here in Washington but also internationally.

We are in the midst of some of the worst economic news we have

had in a long time, particularly the unemployment numbers. And

the Administration seems to suggest more tax cuts and it will get

better. The Congress has passed more tax cuts, and it is getting

worse. I do not think that is the approach that we should take.

It is particularly worse when it comes to the increase in unemployment, and I think Senator Sarbanes’ comments are very precise and detailed about what is happening and the fact that it

seems in most cases to be a lag variable. So even when the GDP

starts improving, we are likely to see further increases in unemployment. We are reaching a critical juncture. These are the real

lives of our constituents.

And right over the horizon is Social Security and Medicare, and

rather than taking prudent steps today to strengthen those programs, or at least to reserve resources to do that, we have effectively funded the tax cuts with Social Security monies and other

monies. I know it is incumbent upon all of us to restrain spending,

but, frankly, in 2003, about 94 percent of the spending above the

baseline was devoted to defense, homeland security, and other

items as a response to September 11, plus Iraq and Afghanistan.

It is very difficult to hold down spending when we are spending $4

billion a month in Iraq and $1 billion a month in Afghanistan.

Today, we will consider and this week we will vote on a defense

bill that is a significant increase in spending, and, ironically, none

of those funds will include the cost of Iraq. That will come later,

probably in a supplemental. So, we have a policy that is difficult

to rationalize in terms of our fiscal policy here: Uncontrollable expenses, or at least very-difficult-to-predict expenses, resulting from

our operations in Iraq, Afghanistan, and homeland security, and

continued tax cuts which leave us, I think, not only with a poorly

performing economy but also in no position to deal with the issues

of Medicare and Social Security.

I look forward to your comments, Mr. Chairman.

Chairman SHELBY. Senator Bennett.

COMMENTS OF SENATOR ROBERT F. BENNETT

Senator BENNETT. Thank you, Mr. Chairman. I will resist the

temptation to engage in a debate and save that for speeches on the

floor.

I appreciate Chairman Greenspan’s being with us today and look

forward to his testimony.

Chairman SHELBY. Senator Bayh.

8

COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Welcome, Mr. Chairman. I look forward to your

testimony as well. I think my colleagues have covered most of the

relevant terrain.

Chairman SHELBY. Senator Hagel.

COMMENTS OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you.

I, too, welcome Chairman Greenspan. With all of this good news

floating around today, I look forward to your comments.

Thank you.

Chairman SHELBY. Senator Chafee.

COMMENTS OF SENATOR LINCOLN D. CHAFEE

Senator CHAFEE. Likewise, welcome, Mr. Chairman, and you

have the back-to-back—the House yesterday, the Senate today. I

look forward to your testimony.

Chairman SHELBY. Chairman Greenspan, your written testimony

will be made part of the record in its entirety. You proceed as you

wish. Welcome to the Committee again.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

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

Members of the Committee.

When in late April I last reviewed the economic outlook before

the Congress, full-scale military operations in Iraq had concluded,

and there were signs that some of the impediments to brisker

growth in economic activity in the months leading up to the conflict

were beginning to lift. Many, though by no means all, of the economic uncertainties stemming from the situation in Iraq had been

resolved, and that reduction in uncertainty had left an imprint on

a broad range of indicators.

Stock prices had risen, risk spreads on corporate bonds had narrowed, oil prices had dropped sharply, and measures of consumer

sentiment appeared to be on the mend. But, as I noted in April,

hard data indicating that these favorable developments were quickening the pace of spending and production were not yet in evidence, and it was likely that the extent of the underlying vigor of

the economy would become apparent only gradually.

In the months since, some of the residual war-related uncertainties have abated further and financial conditions have turned

decidedly more accommodative, supported, in part, by the Federal

Reserve’s commitment to foster sustainable growth and to guard

against a substantial further disinflation. Yields across a number

of maturities and risk classes have posted declines, which together

with improved profits boosted stock prices and household wealth.

If the past is any guide, these domestic financial developments,

apart from the heavy dose of fiscal stimulus now in train, should

bolster economic activity over coming quarters.

To be sure, industrial production does appear to have stabilized

in recent weeks after months of declines. Consumer spending has

held up reasonably well, and activity in housing markets continues

strong. But incoming data on employment and aggregate output reVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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main mixed. A pervasive sense of caution reflecting, in part, the

aftermath of corporate governance scandals appears to have left

businesses focused on strengthening their balance sheets and, to

date, reluctant to ramp up significantly their hiring and spending.

Continued global uncertainties and economic weakness abroad,

particularly among some of our major trading partners, also have

extended the ongoing softness in the demand for U.S. goods and

services.

When the Federal Open Market Committee met last month, with

the economy not yet showing convincing signs of a sustained pickup in growth, and against the backdrop of our concerns about the

implications of a possible substantial decline in inflation, we elected to ease policy another quarter-point. The Federal Open Market

Committee stands prepared to maintain a highly accommodative

stance of policy for as long as needed to promote satisfactory economic performance. In the judgment of the Committee, policy accommodation aimed at raising the growth of output, boosting the

utilization of resources, and warding off unwelcome disinflation can

be maintained for a considerable period without ultimately stoking

inflationary pressures.

The prospects for a resumption of strong economic growth have

been enhanced by steps taken in the private sector over the past

couple of years to restructure and strengthen balance sheets. These

changes, assisted by improved prices in asset markets, have left

households and businesses better positioned than they were earlier

to boost outlays as their wariness about the economic environment

abates.

Nowhere has this process of balance sheet adjustment been more

evident than in the household sector. On the asset side of the balance sheet, the decline of longer-term interest rates and diminished

perceptions of credit risk in recent months have provided a substantial lift to the market value of nearly all major categories of

household assets. Most notably, historically low mortgage interest

rates have helped to propel a solid advance in the value of the

owner-occupied housing stock. And the lowered rate at which investors discount future business earnings has contributed to the substantial appreciation in broad equity price indexes this year,

reversing a portion of their previous declines.

On the liability side of the balance sheet, despite the significant

increase in debt encouraged by higher asset values, lower interest

rates have facilitated a restructuring of existing debt. Households

have taken advantage of new lows in mortgage interest rates to

refinance debt on more favorable terms, to lengthen debt maturity,

and, in many cases, to extract equity from their homes to pay down

other higher-cost debt. Debt service burdens, accordingly, have

declined.

We expect both equity extraction and lower debt service to continue to provide support for household spending in the period

ahead, though the strength of this support is likely to diminish

over time.

In addition to balance sheet improvements, the recently passed

tax legislation will provide a considerable lift to disposable incomes

of households in the second half of the year, even after accounting

for some State and local offsets. Most mainstream economic models

10

predict that such tax-induced increases in disposable income should

produce a prompt and appreciable pickup in consumer spending.

The evolution of spending over the next few months may provide

an important test of the extent to which this traditional view of

expansionary fiscal policy holds in the current environment.

Much like households, businesses have taken advantage of lowinterest rates to shore up their balance sheets. Most notably, firms

have issued long-term debt and employed the proceeds to pay down

commercial paper, bank loans, and maturing high-cost debt. The

net effect of these trends to date has been a decline in the ratio

of business interest payments to net cash flow, a significant increase in the average maturity of liabilities, and a rise in the ratio

of current assets to current liabilities.

With business balance sheets having been strengthened and

with investors notably more receptive to risk, the overall climate

in credit markets has become more hospitable in recent months.

Specifically, improvements in forward-looking measures of default

risk, a decline in actual defaults, and a moderation in the pace of

debt-rating downgrades have prompted a marked narrowing of

credit spreads and credit default swap premiums.

In the past, such reductions in private yields and in the cost of

capital faced by firms have been associated with rising capital

spending. But as yet there is little evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment. Corporate

executives and boards of directors are seemingly unclear, in the

wake of the recent intense focus on corporate behavior, about how

an increase in risk-taking on their part would be viewed by shareholders and regulators.

As a result, business leaders have been quite circumspect about

embarking on major new investment projects. Moreover, still-ample

capacity in some sectors and lingering uncertainty about the

strength of prospective final sales have added to the reluctance to

expand capital outlays. But should firms begin to perceive that the

pickup in demand is durable, they doubtless would be more inclined to increase hiring and production, replenish depleted inventories, and bring new capital online. These actions in turn would

tend to further boost incomes and output.

The favorable productivity trend of recent years have continued,

which certainly bode well for the future. Output per hour in the

nonfarm business sector increased 2.5 percent over the year ending

in the first quarter. It has been unusual that firms have been able

to achieve consistently strong gains in productivity when the overall performance of the economy has been so lackluster. To some extent, companies under pressure to cut costs in an environment of

still-tepid sales growth and an uncertain economic outlook might be

expected to search aggressively for ways to employ resources more

efficiently.

However, one consequence of these improvements in efficiency

has been an ability of many businesses to pare existing workforces

and still meet increases in demand. Indeed, with the growth of real

output below that of labor productivity for much of the period since

2000, aggregate hours and employment have fallen, and the unemVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
11

ployment rate rose last month to 6.4 percent of the civilian labor

force.

Inflation developments have been important in shaping the economic outlook and the stance of policy over the first half of the

year. With the economy operating below its potential for much of

the past 2 years and productivity growth proceeding apace, measures of core consumer prices have decelerated noticeably. Allowing

for known measurement biases, these inflation indexes have been

in a neighborhood that corresponds to effective price stability—a

long-held goal assigned to the Federal Reserve by the Congress.

But we can pause at this achievement only for a moment, mindful

that we face new challenges in maintaining price stability, specifically to prevent inflation from falling too low.

This is one reason the Federal Open Market Committee has

adopted a quite accommodative stance of policy. A very low inflation rate increases the risk that an adverse shock to the economy

would be more difficult to counter effectively. Indeed, there is an

especially pernicious, albeit remote, scenario in which inflation

turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral.

It is incumbent on a central bank to anticipate such contingencies, however remote, and the Federal Reserve has been studying how to provide policy stimulus should our primary tool of

adjusting the target Federal funds rate no longer be available.

Indeed, the Federal Open Market Committee devoted considerable

attention to this subject at its June meeting, examining potentially

feasible policy alternatives. However, given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions

are most unlikely to arise. Furthermore, with the target funds rate

at 1 percent, substantial further conventional easings could be

implemented if the Federal Open Market Committee judged such

policy actions warranted. Doubtless, some financial firms would

experience difficulties in such an environment, but these intermediaries have exhibited considerable flexibility in the past to

changing circumstances. More broadly, as I indicated earlier, the

Federal Open Market Committee stands ready to maintain a highly

accommodative stance of policy for as long as it takes to achieve

a return to satisfactory economic performance.

Thank you very much. I look forward to your questions.

Chairman SHELBY. Thank you, Mr. Chairman.

Mr. Chairman, in response to your remarks yesterday, bond markets moved the yield on the benchmark 10-year Treasury up to

3.93 percent. Was the market reaction, in your judgment, in line

with what you anticipated would be the case? And if not, would you

take an opportunity to redirect your thoughts or just tell us what

your thoughts are?

Chairman GREENSPAN. Well, as I indicated yesterday, remember

that just prior to our last meeting, the financial markets had been

split on the evaluation of whether we would move 25- or 50-basispoints. In the event, of course, we moved 25-basis-points and we

concluded as a consequence that when we announced that, interest

rates would rise, as indeed they did.

12

It is difficult to judge what causes market rates to move. There

are a great number of opinions out there, and I hesitate to give an

opinion because that is basically endeavoring to try to answer the

question why did a large number of market participants do certain

things?

You can draw certain inferences. For example, Treasury rate

yields went up significantly, as, in effect, did high-grade corporates.

But speculative-grade bond yields actually went down and the exchange rate firmed up. So a number of commentators have concluded, looking at those data, that the general view of the economy

which we expressed—meaning the Federal Reserve—was somewhat

stronger than they had expected we would have indicated.

There was also a general judgment that, in a sense, we took off

the table, as I read one commentator stipulating, the notion that

we might use so-called nontraditional means. I was not aware I

took anything off the table at any time, but apparently that was

the view that was taken at the time.

Remember that the Federal Open Market Committee can make

a judgment about policy probably with a 15-minute lead. And our

job is to be prepared to be able to move if we have to in any particular case. But that requires a good deal of backup analysis, and

that is what we have been doing, and we have been trying to convey what we are learning along the way to the American public

and the markets.

Chairman SHELBY. Mr. Chairman, what is your view on the

spread between short- and long-term rates at the moment?

Chairman GREENSPAN. The market is obviously responding to

our general view—which has been our policy and will continue to

be our policy, as best I can judge—that we will hold rates until the

economy achieves satisfactory performance, which means that we

tend to anchor the short-term rate structure because what we are

targeting, as you know, is the overnight rates.

Chairman SHELBY. Sure.

Chairman GREENSPAN. And the longer-term rates reflect three

things: They basically reflect inflationary expectations, the expectations of real economic growth, and the supply of securities. And in

all of those cases, those markets will move essentially independently in many respects of what Federal Reserve policy is.

Chairman SHELBY. Mr. Chairman, this morning’s data released

on industrial production showed an output gain for manufacturing.

Does this signal a potential rebound for this sector of the economy

which has been lagging?

Chairman GREENSPAN. It certainly indicates—at least, as I say

in my prepared remarks—that industrial production has stabilized.

But it is stabilized, as best I can judge on the data we are looking

at, with inventories being liquidated, which effectively is saying

that the consumption of industrial production, is somewhat higher

than the production level, implying that at some point it will rise

further. But short of that, I would just as soon not give you any

projection because we do not have one immediately that is useful.

Chairman SHELBY. We respect that.

Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

13

In this July report, the Fed has downgraded its projection for

GDP growth for 2003 for the second time. Last July, the Fed forecast GDP growth for 2003, the year we are in, between 3.5 and 4

percent. In February, it lowered that forecast slightly to between

3.25 and 3.5 percent. And now it estimates growth between 2.5 and

2.75 percent for 2003.

Regrettably, this pattern is similar to forecasts for the previous

several years. In February 2001, the Fed projected economic

growth of between 2 and 2.5 percent. In July, we were already in

the midst of a recession, and the Fed significantly lowered its projections to between 1 and 2 percent growth. Growth in 2001 was

barely even positive at 0.3 of a percent.

In February 2002, the Fed projected growth of between 2.5 and

3 percent for 2002, only to revise that projection upward in July

to between 3.5 and 3.75 percent. Growth came in below projections

at 2.4 percent. Those are the three most recent years.

So far economic growth in the first quarter of this year was a

meager 1.4 percent. The consensus estimate is that the second

quarter will hardly be any better. But now we are hearing that

next year the growth will pick right back up to between 3.75 and

4.75 percent, according to this report.

It leads me, Mr. Chairman, to ask: Are the models that you are

using at the Fed overly optimistic? Or have we all fallen into the

trap of believing that there is a mythical recovery which is just

around the corner? I mean, in all three of these years now, the Fed

has really been off the mark on its projections, overly optimistic

consistently?

Chairman GREENSPAN. That is true, and I would suggest to you

that it is not the result of a single model because what you are

quoting is, I would put it this way, the consensus of the individual

forecasts of the members of the Federal Open Market Committee.

That is not the staff forecast as such, which we produce separately.

But it is certainly the case that we and others—in fact, the general consensus—have been projecting a recovery sooner than it has

obviously been occurring.

Senator SARBANES. Well, that would lend some weight to the

view that we have a more serious economic situation on our hands

than is being generally acknowledged or admitted to.

Chairman GREENSPAN. Oh, there is no question that that is the

case, and indeed, remember that we did have the emergence of

Afghanistan and especially the Iraqi war, the big surge in oil

prices, and a number of events which we did not forecast.

Senator SARBANES. Let me ask about the labor market, just to

follow along with this line of thought. The June 25, Federal Open

Market Committee statement said, ‘‘Recent signs point to labor and

product markets that are stabilizing.’’ Now this was a shift from

the FOMC meeting on May 6 in which the FOMC found, ‘‘Initial

claims for unemployment insurance remained at an elevated level,

suggesting further labor market weakness in May.’’ Indeed, the

labor market was quite weak in May, with the revised data reporting that 70,000 jobs were lost. Initial claims for unemployment

remained above the 400,000 level throughout May and June.

Since your June report, initial claims have risen to 439,000 for

the most recent week. They have been above the 400,000 level for

14

21 consecutive weeks. The unemployment rate jumped to 6.4 percent, a 9-year high, and the economy continued to lose jobs in June

for the fifth consecutive month. As I said earlier, the number of

workers who were unemployed for more than one week has reached

a 20-year high of 3.8 million.

Would it not be more accurate now in describing the labor market to go back to the May formulation, an elevated level suggesting

further labor market weakness rather than the June formulation,

the labor markets are stabilizing?

Chairman GREENSPAN. Well, Senator, my recollection—and I

would have to look at the data—is that the reason the statement

of stabilization was put in there is that the employment data historically were revised to, as I would put it, a more stable pattern.

They then were revised again down in the most recent report. So

what we were reflecting were the BLS payroll data, which, as I recall, had shown signs of stability, which then was erased in the

next month’s report.

Senator SARBANES. Yes, I understand that, and the point I was

trying to get at is, given the additional data that is now available

to us, as you come this morning, wouldn’t the May formulation of

a further labor market weakness be more apt to our current circumstance than the June formulation of a stabilizing labor market?

Chairman GREENSPAN. Senator, we will not know until we get

beyond the July initial claims figures, and let me explain to you

what that is.

We have very considerable difficulty during the month of July,

especially in the first 2 weeks of July, in seasonally adjusting the

normal retooling that goes on in the motor vehicle industry and

seasonal shutdowns in a number of different industries, and they

vary. And we have found that the variants of the seasonals are

very large, and so until we get into August, we will not get a good

reading on initial claims or insured unemployment.

It is conceivable that the formulation you just suggested may, in

fact, turn out to be the correct one. I would like to wait a couple

of weeks before I respond to that in any definitive manner.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

Senator ALLARD. Chairman Greenspan, we just enacted a tax

cut. Would you say that that tax cut increases the likelihood that

our economy will recover more quickly?

Chairman GREENSPAN. I have argued in the past that I did not

view fiscal measures as being appropriate for purposes of shortterm fiscal stimulus. I have said that over the years. I have indicated that in many testimonies here.

The truth of the matter is that more, I suspect, for fortuitous

reasons, the last two tax cuts have turned out to be timed in a

manner which would affect the economy. And I do believe that the

current one, as I indicated in my prepared remarks, by shifting a

very substantial amount of monies to reduce taxes and increase

disposable personal income in the third quarter has the makings

of a fairly prompt impact on sales.

It is too soon to judge whether that impact is going to be, as I

put it in my prepared remarks, what standardized conventional

models ordinarily suggest would occur. But there is no question

15

that the quality of the data on sales have been improving. The retail sales released for the month of May, which is obviously prior

to these data, was obviously above expectations. And, indeed, chain

store sales in recent weeks have been running above expectations.

Motor vehicle sales seem to be a shade better, but it is too soon

to tell. And the best thing is we will probably find out the answer

to your question of whether the tax cuts really made a difference

I would say probably toward the end of this quarter.

Senator ALLARD. Thank you for your response.

As you know, you and I have had a discussion about the capital

gains tax. In some of those hearings where you appeared before

either this Committee or the Budget Committee, you have strongly

argued for its elimination or reduction. Whenever we get a fiscal

note on a capital gains proposal, or tax reduction proposal, it has

a positive fiscal note; in other words, it shows increasing revenue

to the Federal Government.

So, I was struck by your comment yesterday when you acknowledged that the tax cuts have a stimulatory effect, although you

noted that you doubted the tax cut paid for itself. Would you modify that comment, specifically with regards to capital gains?

Chairman GREENSPAN. No, not really, Senator. It is certainly the

case that if you cut the capital gains tax, you are likely to get fairly

significant revenue initially. You probably will get an initial response in revenue raising as the turnover occurs.

Senator ALLARD. Right.

Chairman GREENSPAN. But over the long run, I do not think the

data show that. In other words, you get an initial surge in revenues followed by a significant decline from the capital gains tax,

and taken over the long run, you would lose revenue, as best I can

judge.

Senator ALLARD. Chairman Greenspan, this Congress is right

now wrestling with the reauthorization of transportation bills,

highway transportation and mass transit in particular. Members of

Congress are struggling with how they are going to pay for all

these transportation projects. Some have called for an increase of

2 cents per gallon, while others are calling for an increase in excess

of 12 cents per gallon.

First, I wonder if you might comment on how you think this tax

increase could have an impact on our economy when it is dedicated

to improving the infrastructure of this country. The second part of

the question: In Colorado, we have a unique situation. We have

some of the highest gas taxes in the country. And, our neighbor,

Wyoming, has some of the lowest gas taxes in the country. Could

you talk a little about how those two extremes may be impacted

since they are right next to each other? I would appreciate it.

Chairman GREENSPAN. Well, it should be apparent that if you increase the gasoline tax, consumption of gasoline will go down. That

has two effects. Since a significant part of the crude oil and, indeed, even gasoline stocks that we consume are imported, it probably has the effect of reducing consumption of gasoline, reducing,

I should say, aggregate consumption, which is partially offset from

imports. The net effect is probably to weaken the economy slightly.

But I would be doubtful that that is a big issue, and I think there

are far more important other issues that are involved in gasoline

16

tax, which obviously gets to questions of conservation, gets to questions of security of supply, and I would be hesitant to draw the economic impact as being a crucial issue in the context of the small

changes that we tend to talk about.

I have really nothing to say about the disparity among States.

That has to do with your legislatures, and if you want to have a

meeting at the border to marginalize them, that is a question for

the States.

Senator ALLARD. Let me rephrase that question. Is there likely

to be a greater economic impact on States that have high gas taxes

as opposed to those who have lower gas taxes?

Chairman GREENSPAN. Yes.

Senator ALLARD. I see my time has expired. Thank you.

Chairman SHELBY. Senator Reed.

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

Thank you, Chairman Greenspan.

In this Monetary Report to the Congress, page 12, and I quote,

‘‘With little change, on balance, in non-Federal domestic saving

over this period, the downswing in Federal saving’’—which I think

roughly is the surplus—‘‘showed through into net national saving,

which was equal to less than 1 percent of GDP in the first quarter,

compared with the recent high of 6.5 percent of GDP in 1998. If

not reversed over the longer haul, such low levels of national saving could eventually impinge on the formation of private capital

that contributed to the improved productivity performance of the

past half-decade.’’

Today’s headlines from The Washington Post,—White House

Foresees 5-Year Debt Increase Of $1.9 Trillion.—‘‘The Federal Government will pile up $1.9 trillion in new debt over the next 5 years

and will still be running an annual deficit of $225 billion by 2008,

long after White House economists assume current war costs will

have subsided and the economy will have recovered. . . .’’ Those

are pretty rosy predictions but, nevertheless, even the White House

assumes we will be running deficits and not surpluses by 2008.

The question is: Where is the long haul? Is it 2005, 2006, 2007,

2008, 2009? When are we going to start seeing this adverse impact

requiring us to do something more than just talk about it?

Chairman GREENSPAN. Remember that the statement in that

report is a statement of accounting and arithmetic; that is, the accounts of savings and investment must balance. Obviously, if you

get an absorption of savings from the private sector by increased

Federal deficits, that will reduce the private savings available to finance investment.

But as I said yesterday in response to a related question, that

leaves open the question of financing domestic capital investment

by essentially borrowing savings from abroad, as one possibility,

which we have done, obviously, quite extensively. And then there

is a quite important question which gets to the issue that only

roughly half of our productivity increases are directly attributable

to the amount of capital investment that is employed in the economy. The rest are technological changes, organizational changes,

things which economists call ‘‘multi-factor productivity.’’

There is no question that if you run substantial and excessive

deficits over time, you are draining savings from the private sector,

17

and other things equal, you do clearly undercut the growth rate of

the economy. That is one of the reasons I have argued for years

about getting the deficit down. So, I have no question that if we

do not come to grips with these deficit issues, it will make it more

difficult for us to maintain the type of growth rates which, to respond to Senator Sarbanes’ concerns, will bring total employment

up and bring the unemployment rate down.

Senator REED. As I understand the numbers out of the White

House, though, they are assuming a full-employment economy by

2008 and still deficits. Is that accurate?

Chairman GREENSPAN. That is certainly economically consistent.

It depends on the nature of the individual assumptions that are

made with respect to a lot of different variables.

Senator REED. I still have not heard the long haul, where I am

looking over the horizon. Where should I put my stake down for

the long haul? Certainly that is something that you must think

about. It is one thing, because your models and your presumptions

all have a time base as well as other parameters.

Chairman GREENSPAN. That is exactly right, Senator. Even

though, as I indicated earlier, we can move on 15 minutes notice,

nonetheless, unless we have a broad overview of the forces that are

driving the economy, not only in the short run but also in the long

run, it is difficult to make judgments as to what the appropriate

posture of monetary policy is unless you have the full context of

both the short term and the long term.

Senator SARBANES. Jack, would you yield for a second?

Senator REED. I would yield to the gentleman.

Senator SARBANES. Would you run large deficits at full employment levels? If the economy is at full employment levels, what is

your view with respect to running large deficits in the Federal

budget?

Chairman GREENSPAN. I would be against it.

Senator REED. May I ask one more question? That is, the consumer has been one of the stalwarts in the economy. Getting back

to the taxes, there are at least two issues with the taxes. One is

the size and the other issue is who are the beneficiaries? It seems

to me, and the one phrase I remember from college economics is

that the marginal propensity to consume is the inverse of proportional income. So that if we target these tax cuts—I have exhausted all my economic knowledge, I will admit it.

[Laughter.]

Senator REED. If we target these tax cuts to the wealthiest,

which seems to be the case, we will not get the proportional benefit

from consumption that we would if we had targeted these tax cuts

to lower-income Americans.

Chairman GREENSPAN. Senator, I was exposed to the same economic education that you were as an undergraduate.

Senator REED. I think it took in your case.

[Laughter.]

Chairman GREENSPAN. I would merely qualify the conclusion.

What we have found recently is that while indeed the marginal

propensity to consume does fall as incomes rise, that the extent of

the decline is much less than has been our previous expectation,

and what I also would presume to be conventional wisdom. So, yes,

18

it is true that marginal propensities to spend fall, but it is not

enough to really make a very substantial difference when you

apply it to various different income distributions.

Senator REED. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bennett.

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

Chairman Greenspan, this is anecdotal from my own observation,

but I want to share it with you and get your response. One of the

areas where I have found that the recent recession and soft recovery has hit very, very hard is in the area of venture capital. VC’s,

as I have discussions with them about new ideas and new opportunities, say very flatly, ‘‘We have no money. There is no VC money.’’

What little VC money that has been available has gone not to fund

new ventures but to follow the pattern that you outlined in your

statement, to shore up the balance sheets of the ventures that they

funded during the bubble of the 1990’s, so that when we had the

froth and the excitement of the late 1990’s, and you could get venture capital for almost any idea, no matter how hare-brained it

might have been in retrospect, the system washed out all of the

bad investments and the venture capitalists took what money they

did have and went back to the investments that were just hanging

on, but surviving nonetheless, and put money that would have gone

into new ventures and thus created new jobs into strengthening

the balance sheets of the companies that they had.

The VC’s were saying to me, ‘‘We have a liquidity crisis. We cannot get any money out of the banks. The banks are getting very,

very anxious about making sure that they are not taking undue

risks, much the way they did after the savings and loan crisis

when banks got very, very conservative in their lending process.

We cannot raise very much money from individuals. They are

burned. They are being very, very cautious, and consequently there

is a liquidity crisis in the venture capital world.’’

I think that may have some impact on the unemployment situation that Senator Sarbanes is so concerned about because much of

our job creation comes from new business creation. Fortunately, we

are not like Europe, and we are not like Japan where they do not

have the VC tradition. So until we get venture capitalists funding

new entrepreneurial activities, we are probably not going to make

as big a dent on the unemployment number as we would like. The

Fortune 500 cannot solve the unemployment problem. The Fortune

500 has always been lagging in job creation as opposed to the entrepreneurial side of the house.

Do you have any data, or if no data, any intuition about what

might be happening in the venture capital world and what we

might be able to look forward to in this uniquely American phenomenon of a lot of private capital funding brave new entries into

the world?

Chairman GREENSPAN. Senator, the data that we have show, as

you correctly point out, a moderate to small industry prior to the

mid-1990’s, and then with the surge of the stock market there is

this huge increase in venture capital as a spike, and indeed it has

come all the way back down to where it had been. It is not below,

but clearly it was all the way up and all the way down. My impresVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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sion is that it depends to a very large extent not just on the availability of capital without the ideas, but you need to start to get

market values up first, so that there are presumed opportunities.

Remember, that so far as financing is concerned, as important as

venture capital is for these highly speculative and very imaginative

projects, and as you pointed out, some of them perhaps a little exotic, too exotically imaginative in the past, far more important is

the fact that there has been a very significant decline in what we

call junk bond yields. Those are high-yielding bonds which are a

large source of financing for capital investment in a number of

lower-grade corporations whose fluctuation in capital expenditure

is quite large. So, yes, I do think if we were to get increased venture capital going it would be helpful, but I think if the economy

gets going, venture capital will follow along.

I do not believe that it is a leading indicator at all, and it is one

which really requires opportunities to arise and individuals looking

for various different types of investments because they presume

that other market prices have gone up too high.

Senator BENNETT. Thank you.

Chairman SHELBY. Senator Bayh.

Senator BAYH. Thank you, Mr. Chairman. Time permitting, I

have three questions, two of a short-term nature, one of a longerterm nature.

My first question would be: When do you anticipate a pickup in

capital investment, and how robust would you expect that to be?

Particularly, Mr. Chairman, you mentioned three factors in your

testimony. First, the increased risk aversion by corporate decisionmakers because of the recent scandals. I will assume that they will

eventually become acclimated to the new rules and that will abate.

Second, you mentioned overcapacity in some parts of the economy.

You did not mention telecom, but some of those areas I assume we

will just have to work their way through that. In particular, if you

could, I would like for you to address the third point you mentioned, which is when do you think the pickup in demand will be

perceived as being durable, thereby incenting corporate decisionmakers to increase their capital investments?

Chairman GREENSPAN. Senator, if we knew the answer to just

any two of those three questions, I think we would have the elements of an economic forecast, because that is really where the

major uncertainties are.

The problem in the corporate governance area is one in which

there has been a shock to the corporate sector because the types

of things that occurred were not presumed contemplatable in an

earlier period, and it is going to take a while for that to wear off.

I do not know how long it will take, but one way of getting some

judgments, I would be looking to see whether mergers and acquisitions begin to pickup. That would give you a sense that there is

lessened concern.

Senator BAYH. There are some tentative signs of that, more MA

activity.

Chairman GREENSPAN. Well, I have heard the same, but it is still

quite preliminary and not really evident.

Senator BAYH. Could I ask, Chairman—forgive me for interrupting, but our time is unfortunately limited—if you might focus

20

on the third factor, when the pickup in demand will be perceived

as being more durable?

Chairman GREENSPAN. It will depend on two things. One, on the

issue which I was discussing with Senator Reed, what the propensity to consume out of these very substantial tax cuts concentrated

in a short period of time is, and, two, whether the increase in demand is perceived by the business community as not a blip but as

something which is more ongoing. I cannot answer that question

with any degree of certainty, but at the moment most private forecasters have forecast for the third quarter which I will tell you are

higher than ours.

Senator BAYH. Well, that is encouraging.

Chairman GREENSPAN. I do not know whether that makes it

right. I am just saying it.

[Laughter.]

Senator BAYH. It is always nice to be encouraged, right or not.

It seems to me though that that really lies at the crux of the issue,

that the risk aversion because of the corporate scandals will eventually subside as decisionmakers acclimate themselves to the new

rules that we have attempted to put in place and that some of the

overcapacity, we will eventually work our way through that, but

really the key here is the perception of the durability of demand

going forward on a sustainable basis, to the increase in CapEx

which has been a significant missing component of this tentative

recovery to date.

My second question I do not think I am going to get to my third,

which is unfortunate because I wanted to ask you about the longterm fiscal challenges that we face when the baby boomer begins

to retire. Perhaps that will await another time.

We all care about the deficit here. I know when I go home people

occasionally ask about it, but my perception is that the public only

begins to focus on the deficit when it begins to bite in real rather

than theoretical terms, and public policymakers tend to only make

the difficult decisions that have to be made once the public has

begun to focus because of real world consequences.

So my question would be, and you mentioned in response to one

of my colleagues’ questions, or rather one of my colleagues may

have mentioned the activity in the credit markets yesterday, and

then you mentioned that the more high-yielding securities actually

responded well, I assume because of perception of a reduced default

risk. But the treasuries and high-grade corporates went the other

direction. My question would be: When do you perceive that the adverse consequences of the deficit will actually begin to manifest

themselves in real terms? It seems to me that the markets yesterday were at least sending a near-term signal that the answer may

be now. In terms of the crowding out, they are anticipating both

higher private demand, which was the reason for my first question,

simultaneously with high ongoing deficits, and that we may see

crowding out sooner rather than later.

Chairman GREENSPAN. I think it is difficult to separate the issue

of increased supply in the short term, and general notions of broad

economic recovery. They are interrelated and very difficult to separate. We have found that the impact of deficits on current longterm interest rates are related to changes in long-term deficit exVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
21

pectations, not generally short-term issues of deficits and Treasury

borrowing. So it is not clear to me to what extent changes in yields

are impacted, although there is no question that if you put new

securities in the market, prices will tend to adjust. But the real impact on long-term interest rates which matter are really driven by

long-term expectations of the deficit to the extent that interest

rates are affected by deficits, which as you know, I am a firm believer they are.

Senator BAYH. My time has expired, Mr. Chairman, which is too

bad, because that led directly to my third question which was the

long term—

Chairman SHELBY. Senator, we will have another round.

Senator BAYH. Thank you, Mr. Chairman.

And thank you, Chairman Greenspan.

Chairman SHELBY. Senator Hagel.

Senator HAGEL. Mr. Chairman, thank you.

Chairman Greenspan, thank you again for appearing before the

Committee. Actually, I would like to pick up where the Senator

from Indiana left off, staying within the universe of deficits, and

I think where the Senator from Indiana was going with this is in

the unfunded entitlement liabilities direction, or at least that is

where I want to go with the question.

First, it has been noted here, and you have responded to some

questions about OMB’s numbers that they released yesterday

which appeared in the papers today about a $1.9 trillion deficit

over the next 5 years, and I think we are all familiar with the

numbers that they have projected for this fiscal year as well, as

higher numbers for next year. Staying in that universe for a moment, there was a piece in the Financial Times yesterday, and I

do not know if you saw it. The headline was ‘‘The Fiscal Overstretch That Will Undermine An Empire.’’ As a matter of fact, one

of the authors of this, according to the story, is a senior economist

at the Federal Reserve in Cleveland. It talks about the unfunded

entitlement liabilities that are out there for this country. And you

know the numbers very well on this, Mr. Chairman. In 8 years, 77

million baby boomers start collecting Social Security benefits.

What they did in this study is they tried to, as best they could,

develop a model that would tell them what kind of revenues we

could expect within that time frame versus the commitments that

the Government had. What they found was a $44 trillion shortfall

in revenues, and a great amount of that was due to the MedicareSocial Security liabilities that are unfunded.

Now, in light of that, as you have been following, and you and

I have had some discussions about this previously, both the House

and the Senate have passed a Medicare reform bill, and the centerpiece of that, as you know, is a prescription drug plan. I would be

interested in your thoughts about the entirety of this issue because

of the kind of obligations that we are saddling future generations

with a prescription drug plan in a Medicare reform bill, and any

other comments you would like to make in this regard, because I

think you just said that large deficits, in your words, undercut the

growth rate of an economy.

So with all of that, have at it. Thank you.

22

Chairman GREENSPAN. Without discussing any particular programs, I do think that it is possible to get a general projection of

what under the best conditions the revenue flows in this country

would be to the U.S. Treasury. Wholly independent, the Congress

passes legislation with commitments for the future which do not relate to the available revenues. It is a very difficult evaluation, and

I will grant you that others will come to different conclusions. In

recent years it has been my impression that the statutes that we

have now currently in place, granted the demographics that will

emerge in the years ahead, will create a level of spending in excess

of our capability to finance it. It is not an issue of raising taxes

because there comes a point, as everybody agrees, when you raise

taxes, you will lose revenue eventually, so it is not an open-ended

situation.

As a consequence of that I do think that it is crucially important

for us to look at the whole fiscal situation in the context of whether

our laws are internally consistent, whether, in fact, the structure

of obligations we have presented for the future are indeed capable

of being financed in real terms, because remember, we are talking

real resources. Money is merely an intermediary here. From the

types of numbers that I have been looking at, when we get into the

period beyond 2010, 2011, and 2012, we are running into potentially serious troubles in which the claims on the aggregate GDP,

in order to finance what is required by law for retirees, would require a significant reduction in the real earnings of the working

people over and above what otherwise would be the case. In other

words, a disproportionate amount of the GDP would have to be diverted, and it is not clear under those conditions whether we create

a very major problem between generations in that regard. I think

it is readily forecastable now because we may, as Senator Sarbanes

says, have some trouble with our GDP forecasting. We do not have

trouble in forecasting the age structure of the American population

and what the demographics are going to impose on us as we move

toward the movement of this very large baby boom generation from

productive work into retirement.

Senator HAGEL. Thank you.

Chairman SHELBY. Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman.

I welcome Chairman Greenspan. Let me just follow on there just

for a brief second. I think your arguments today with regard to

structural deficits which we apparently have now in place due to

the set of policies and the need to prepare for the demographic reality that you suggest, tells us that our imprudence at the current

moment is only going to aggravate the problems that one could anticipate coming down the pike with how we deal with these obligations. We certainly put ourselves on a course where we may be in

a position where we have no choices to deal with that, and we are

taking those choices off the table as we go, and it is very troubling

to me.

We have a statement you made to this Committee in February.

We have to be very careful in talking about structural deficits because there is no self-equilibrating mechanism when structural

23

deficits are occurring because the rise in indebtedness increases the

amount of interest payments which, in turn, increases the debt still

further, and there is an acceleration, a pattern, till you reach a certain point of no return. You put that against the demographic situation, and we are taking off the table our ability, many of the

options to deal with just the issue we are talking about suggests.

I had a couple of micro issues. Since we are now seemingly going

to be financing the U.S. Treasury for very significant amounts of

dollars for a very long period in time, regardless of how you calculate it, including what the Budget Office let us know yesterday,

is it not time that the Treasury reconsider the issuing of 30-year

notes? At the time they ended the 30-year bond, they argued that

we were headed into surplus. I think that was 2 years ago or 21⁄2

years ago. And a long bond was no longer necessary to meet Government financing needs. They also added at the time that the return to deficit might necessitate a reintroduction.

I would also ask that, given the debate that we are now having

about discount rates for pension policies, which are so important

for the private sector and others, there is also a need for clarity

with regard to what the yield curve looks like, using indices that

may be an accurate reflection of longer dated markets for discount

rates. It just seems there are a number of reasons to spread out

over a longer period of time. I remember these arguments being

made by the most eloquent economists in the late 1970’s and early

1980’s of why we needed a full-year curve. Is it not time to reconsider that point of view? I would love to hear how you feel about

it yourself.

And then finally, another micro issue. We see the SEC talking

about easing voting for outside directors and other issues. Do you

have any comments on how that might impact capital formation?

Is that a positive? Is that a negative? And how would you respond?

Chairman GREENSPAN. On the 30-year bond I am going to be interested in hearing the various debates and arguments on both

sides of the issue, which I think will eventually materialize for exactly the reasons that you raise, Senator. There are pros and cons

to the issue, as you are aware, and I do not want to anticipate how

Treasury will come out, but I would presume we will be involved,

as we have been over the years, in discussions on this issue as it

affects our monetary structure. While to be sure the ultimate decision has to be with the Secretary of the Treasury, we do have input

and we will endeavor to review the pros and cons and try to come

to a conclusion ourselves on that issue.

Senator CORZINE. Did you have a view about whether it was constructive or not in the period of time? We had almost 20 years of

experience.

Chairman GREENSPAN. Yes. I thought that if you took the projections of the surpluses seriously, and remember, we all were skeptical, but those were nonetheless the best judgments that people

could make at that time, then the issue of taking the 30-year off

the table clearly was a very reasonable one. Times have changed,

Senator. Presumably these issues will be revisited as part of a

broader set of questions of how Treasury needs to fund itself, or

more exactly, how Treasury needs to fund the debt requirements

of the Government.

24

Senator CORZINE. Shareholder issues?

Chairman GREENSPAN. Actually, I am aware that the SEC was

discussing that yesterday and I have not caught up to what they

have been mentioning on the issue. I am aware that it is in the

papers this morning, but I have not as yet had a chance to see, and

hence to comment on anything that they have said on that regard.

Senator CORZINE. Thank you.

Chairman SHELBY. Senator Chafee.

Senator CHAFEE. Thank you, Mr. Chairman.

Again, welcome, Chairman Greenspan. In your written testimony

you say there is an especially pernicious, albeit remote scenario, in

which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral. Can you

describe what might be a worst case scenario of this corrosive deflationary spiral?

Chairman GREENSPAN. Sounds by itself as a worst case scenario.

[Laughter.]

It is an issue which economists never even thought about largely

because, as I indicated in my prepared remarks, it was considered

a curiosity, because with fiat money it just seemed noncredible that

you could get too little inflation and that the capacity of central

banks essentially to print money at will could not overcome any

such tendency. That changed with the evident difficulties that

Japan has been having. Even though there are good arguments, as

I point out in my prepared remarks, to presume that the Japanese

case of modest deflation is idiosyncratic, especially related to their

institutions and specific difficulties that they have. But it still

raises questions as to whether we are prepared as a central bank

in the event that that happens.

It was not an issue that concerned us when the inflation rate

was 5 percent, 3 percent, or even 2 percent, but in the last 6 to

9 months the rate of inflation has fallen quite dramatically in this

country. It has triggered a fairly extensive evaluation on our part

as to what we would do if we perceived that that issue was becoming an important one. And as I indicated, we have spent a good

deal of time on examining types of alternative monetary policies

which we believe could successfully address that problem and fend

it off. It is quite remote, in our view, because we do not see the

elements of that occurring, but if it occurs, it is a very major event.

Even though its probability is very small, the size of the problem,

should it occur, is sufficiently large to have engaged our attention,

and it will continue to engage our attention until it is very clear

that it can be fully taken off the table.

Senator CHAFEE. And as you war game for this scenario, do you

worry about, as you said, stoking inflationary pressures on the

other end?

Chairman GREENSPAN. We certainly do, and obviously a central

bank needs to be acutely aware of that, but as I indicated in my

prepared remarks, the impact of a number of forces from the collapse of the bubble in stock prices and its downward pressure on

asset values for a while, and the issue of globalization, are all

working at this stage to contain inflationary impulses. But it is obvious that our goal is price stability, and it is price stability on both

sides. We are engaged in trying to fend off both deflation and inflaVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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tion, and hopefully we can maintain the degree of price stability

that we have finally achieved and hopefully do so for a very considerable period of time.

Senator CHAFEE. I do not think you mentioned in your testimony

exactly what you would do if we went down that pernicious path

of disinflation?

Chairman GREENSPAN. Senator, we have discussed what we call

nontraditional means, meaning the focus of central bank policy in

this country has, for a very long period of time, been restricted to

endeavoring to change the overnight rate of interest without any

advertence to how we might impact longer-term interest rates.

The reason that issue comes up is that with the Federal funds

rate at 1 percent, there is obviously a downside limit to how far

we could engage in further monetary expansion which is the obvious remedy that a central bank would create to confront this type

of difficult deflationary process. Obviously, with only 100 basis

points left, we have to first conceive what we would do in the

event, which I have indicated we consider is remote, of needing to

go well beyond that, and we have engaged in a number of different

issues, all of which are involved in expanding the balance sheet of

the central bank, which essentially means that we buy different

types of assets and we do different types of things including moving

out on the yield curve well beyond the issue of overnight funding.

That is an issue which we have been concerned about for a number of months. We have accordingly, not having focused on it before

because we, as I said, thought it was an academic curiosity, but I

think we have pretty much caught up to speed, so to speak, and

we trust we never have to engage in such policies, but I think we

are in a position to know what to do and how to do it should that

necessity arise.

Senator CHAFEE. Thank you.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman.

Welcome, Chairman Greenspan. Good to see you.

Senator Chafee and I have offered legislation, along with Senators Judd Gregg of New Hampshire and also Lamar Alexander of

Tennessee, that attempts to address the need to clean our air further with respect to emissions of sulfur dioxide, nitrogen oxide,

mercury, and also CO2. We have sought to find a middle position,

if you will, between Clear Skies over here, the President’s proposal,

the competing proposal over here by Senator Jeffords, and we

sought to put something right here in the middle which puts in

place caps on emissions including carbon, but relies on market systems, such as cut cap and trade. For example, if you are a utility

and I am a farmer, and you have to reduce your emissions, you can

use technology, you can change up your mix of fuels. You can say

to this farmer: I would like for you to put more money in and expand the number of trees on your land, reforestation, change the

planting patterns on the land, change what I do on our animal

feedlots, that kind of thing, so different ways to achieve the goal.

It has been estimated over the next I guess 17 years, by 2020,

if there is no change in the law at all, just business as usual, the

26

cost of generating electricity for the producers is about $95 billion.

The cost under the President’s Clear Skies Initiative is about $101

billion. The cost under our proposal is about $102 billion. So, we

are trying to decide whether or not at a time when we want utilities to be able to create the electricity, we want them to reduce

their sulfur dioxide, nitrogen oxide, and mercury, if this is also a

time to come in and say, all right, somewhere along the line you

are going to have to face reducing carbon dioxide, and rather than

wondering when that is going to happen, let us just provide some

certainty and to try to do it now. There are some, as I suggested,

marginal costs that are involved in that, about a billion dollars it

looks like by 2020.

I wanted to talk with you a little bit this morning. You and I

have talked about energy costs before, but I want to talk a little

bit this morning about the cost of trying to regulate carbon dioxide,

and the effect that that might have on our economy, and just your

counsel on how we might go about it. I have a concern. I am a native of West Virginia and I have a lot of concerns about coal still

in my native State. I am not interested in seeing a lot of change

in the fuel mix. I want us to use coal, but use clean coal. Interestingly enough, under the President’s proposal and in the proposal

that we have made, by 2020 it is estimated about 45 percent of

electricity generation will still come out of coal, in either proposal.

And what has been suggested to us by some analysis done by people more objective than we are, is we can have some good outcomes

with respect to better health outcomes, less premature deaths with

our approach. Health care savings of about $50 billion under our

approach. And to do so without putting huge burdens on utilities

and on the consumer.

That is kind of laying it out there. I do not know if there is a

question in there or not, but I hope there might be.

[Laughter.]

The thought is, in regulating CO2 how might we go about it?

Does any of that make any sense? I will not be offended by what

you might say. Senator Chafee might be.

[Laughter.]

Chairman GREENSPAN. Senator, I think the type of analysis that

you are discussing is probably the most complex type of statistical

analysis which you can bring to bear on Government policy. First

of all, we have a number of different problems all emerging simultaneously. We have an issue of the new technologies enabling the

wielding of power over very significant areas, and hence the whole

question of the nature of regulation of the electric power industry

by itself is a very difficult issue, which is all the more difficult because, as you know, there is no way, with the exception of a minor

situation with hydroelectric facilities, of effectively storing electric

power. And if you do not have inventories in a product, the tendency for markets to spike in all different directions with respect to

price is very high, as we observed in California a couple of years

ago. I do not think yet we have come to grips with the question of

exactly how to manage our power industries in a manner in which

the efficiencies which are evident in the newer technologies are

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puts in the CO2 emissions, and then of course, there is the Kyoto

Protocol out there which is also overhanging this whole question.

The trouble I see is that, because these issues are extremely complex, we develop very complex models and the conclusions of a

number of these studies may be model specific as distinct from

what economists would say robust, meaning the same results

would come up no matter what models you tend to use.

So, I am not someone who has been involved in this specific problem but I have spent a good deal of my life involved in this type

of process. I would essentially suggest, if I may, that the resolutions of all the related issues be done simultaneously because you

cannot, as far as I can see, make the judgments with respect to

natural gas or coal, or various different emissions requirements,

without having an understanding simultaneously of what the underlying technology force is, specifically the new technologies which

enable a very large regional bridge to be created. You have to address them at the same time, and I think that is going to be very

difficult, and all I suggest to you is that when you get a number

from a specific model which has three digits in it, you may suggest

that only two of them may be accurate, and indeed it is quite possible that only one is. So it is a very difficult issue, and I understand where you are coming from and I wish you well.

Senator CARPER. I will take those good wishes and run with

them. Thank you.

Chairman SHELBY. Senator Crapo.

COMMENTS OF SENATOR MIKE CRAPO

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

Chairman Greenspan, thank you for coming here and presenting

your information about our monetary policy in the country.

I want to go back to an issue you and I have discussed several

times over the last 2 years, and that is derivatives. As you well

know, we have for the last 2 years faced, on two or three occasions,

efforts to change the manner in which we regulate derivatives.

Under the Commodities Futures Modernization Act of 2000, the

President’s Working Group and others recommended a structure by

which we approach the management of commodities in a number

of contexts, and derivatives were handled in a particular way

under that approach.

By the way, let me interject. I want to thank you, the Secretary

of the Treasury, the Chairman of the Securities and Exchange

Commission, and the Chairman of the Commodities Futures Trading Commission for being so prompt in responding to our letter inquiring about this yet once again this year when the amendment

came forward on the energy bill once again to try to make this

change in the way that we regulate derivatives.

The purpose of my bringing it up with you again is that there

are again rumors that we will see another effort to try to in some

way similar to the previous amendments change the Commodities

Futures Modernization Act so that we create a new regulatory regime for derivatives, and in my opinion, create some confusion with

regard to the regulator in terms of the introduction of regulation

from FERC as well.

28

The question I have is, has anything changed? Is there a reason

that we should change our approach to the regulation of derivatives

or does the Commodities Futures Modernization Act still represent

a very solid approach to managing this issue?

Chairman GREENSPAN. I am of the opinion that it was an excellent Act when it was passed in 2000 as I recall.

Senator CRAPO. In 2000, that is right.

Chairman GREENSPAN. And as far as I can judge, I see nothing

which would alter my view and my appraisal of it.

Senator CRAPO. I know you have done this before, but could you

give us your understanding of why derivatives are helpful in our

markets?

Chairman GREENSPAN. We have a very complex financial system

in which we endeavor to regulate in a manner to enable the system

to be stable and function in a way which contributes to economic

growth, not only in our country but also for the world at large.

What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer

risk from those who should not be taking it to those who are willing to take it and are capable of doing so.

Prior to the advent of derivatives on a large scale we did not

have that capability, and we often had, for example, financial institutions like banks taking on undue risk and running into real serious problems. From 1998 to 2001, we had a trillion dollar increase

in debt in telecommunications worldwide. A significant part of that

debt went into bankruptcy, and yet no financial institution of any

significance was caught in that, and the reason was that, in this

case, credit derivatives were employed to transfer the risk from

these highly leveraged financial institutions to other institutions

and pension funds, insurance companies, pension funds largely,

which had much more equity and could absorb the costs of default

which they did, but they did not like it. But they are still around

and they are still viable.

The vast increase in the size of the over-the-counter derivatives

markets is the result of the market finding them a very useful vehicle. And the question is, should these be regulated, well, indeed

for the United States they are obviously regulated to the extent

that banks, being the crucial creators of these derivatives, are regulated by the banking agencies, but not beyond that.

The reason why we think it would be a mistake to go beyond

that degree of regulation is that these derivative transactions are

transactions amongst professionals, and the institutions which are

involved have very considerable what we call counterparty surveillance, where, for example, one major bank will know far more

about its customer, whether it is a bank or something else, than

we could conceivably know as regulators. In a sense this counterparty surveillance has become the crucial element which has created stability in that particular system.

My concern and others’ concerns about going in the direction of

an increasing degree of Government regulation is that we will undercut counterparty surveillance and that the net effect will not be

to enhance the stability of that overall structure, but undermine it,

and it has become such a valuable tool, in my judgment, in the

international financial system that anything that we can do to enVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00032 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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hance its capability of internal stabilization, which is currently the

case, we ought to do, and I do not believe that many of the measures that have been offered to introduce increased regulation are

indeed positive in the sense that they would have a positive outcome. My fear is that their effect would be counterproductive and

that is the reason I wrote the letter, the response to you on that

occasion, and why the President’s Working Group came out the

way that it did on that issue.

Senator CRAPO. Well, thank you very much for that extended explanation. Each time we face this issue we pick up a little support

and our strength grows, and I think it is because we are better able

to explain to the Members of the Senate the issues as you have just

done. So thank you very much.

Chairman SHELBY. Thank you, Senator Crapo.

Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

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

Mr. Chairman, thank you once again for being here. I apologize,

I was not here for your opening comments. We had a briefing by

Secretary Powell, so a lot of us, about half the Members of the Senate were up there for about an hour or so.

Let me preface, I gather others have raised a number of questions about the deficits and your thoughts about them. I thank you

again.

Your comments earlier this year about the tax cuts and their

being revenue neutral I think were tremendously helpful to many

of us. Unfortunately, they were not heeded by many, nonetheless

I think your cautionary note about the importance of the revenue

neutrality of those proposals was worthwhile to be heard. Clearly,

and obviously, I join with those who are deeply worried about the

overall condition of the economy. I know you struck a more optimistic note, and I appreciate that, but as I look at these numbers,

with more than 3 million private sector jobs having been lost over

the last couple of years and business investment is down by 12 percent. Consumer confidence is down by 28 percent. This is the only

Administration in 70 years that has seen a decline in private sector

jobs. I find that deeply, deeply troubling. When you add the fact

that the Administration’s solution to the Nation’s economic woes

has been more tax cuts, and if you add them up over the next few

years, you get in excess of $3 trillion, not to mention of course the

cost of the war in Iraq and elsewhere.

In fact, the Administration’s own estimate is that more than half

of the changes in the Federal deficit, changes which total over $4

trillion, according to them between the years 2004 and 2008, are

a result of the President’s domestic policies, which include three

tax cuts and international policies including the war with Iraq. So

there is a real concern here.

I would like to focus on the trade deficit and the loss in manufacturing jobs. I spent some time over the last several weeks, as all

my colleagues have, in my State, I attended meetings in my business community and labor community separately. If I had been

taken into both of them blindfolded and not told which group was

which, I could not have distinguished them in terms of their conVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
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cerns about job loss and what is happening to the manufacturing

sector in our society and the growing trade deficits.

I was stunned, like many were, to read where Japan bought up more than $42 billion in May, a record number. If you take Japan,

Taiwan, Korea, and China, there is a trillion dollars that countries

have accumulated in reserves. Now many would argue that this

amounts to manipulation, that this was not just coincidental. I

agree with you that these values ought to be determined by the

international marketplace, but nonetheless there are provisions in

the International Monetary Fund and other organizations that require that when you have manipulation of currencies, particularly

when it affects jobs to the extent that it appears to be doing in our

own country, than others have to step up.

I was disappointed. I know, Mr. Chairman, you have asked the

Secretary of the Treasury to be here before the Committee. He was

due to be here tomorrow, I think, or the next day, and he turned

us down. Of course under the Trade Act of 1988, the Secretary of

the Treasury is required to report to this Committee and to submit

a report twice a year. So, I am hopeful that before this year is out

he will be here to respond to these questions about the trade deficit

that now is going to, based on a quarterly report, exceed $540 billion this year.

I know it is not the Fed’s job to get into this specifically, but this

is such a growing concern to me about what is happening here,

when you look at the job loss, the businesses that are going out of

business. I see it in my own State to an alarming degree. Someone

has to respond to this. We need some ideas on how to respond to

this. If, in fact, we are seeing currency manipulation going on by

some of our partners, particularly in the Pacific Rim, then I think

it is critically important that we answer this in some way, and I

would be very curious what your thoughts might be as to how we

might respond to this. First of all, is it a matter of concern to you?

And if so, what can the Fed do or what can we do to begin to try

and stem this tide?

Chairman GREENSPAN. Well, I think, Senator, it is important to

understand the causes of the problem before we try to address

them. On the import side, as I think I have indicated to this Committee on many occasions, we observe in our international accounts

a fairly significant difference between the propensity to import

goods and services relative to our incomes in the United States

compared with our trading partners, which is another way of saying, if everybody’s GDP were increasing at the same pace, we

would have a trade deficit which is ever increasing, and indeed

there would be a counterpart increase of surpluses elsewhere. So,

we do have this imbalance in the system which at some point is

going to adjust, and there is some evidence that it is in the process

of adjusting, but clearly, the proportion of the consumption of goods

in this country that is imported has been rising for quite a long

period of time.

In addition, the productivity in manufacturing has been exceptionally impressive, more so than for the economy as a whole, and

obviously if you have a very rapid rate of increase in productivity,

any particular increase in industrial output will have a lower requirement for workers than one when productivity were growing

31

less. So it is the combination of these two factors which has been

decreasing the level of employment in the manufacturing area, coupled with the fact that there has been a gradual reduction in manufacturing relative to the economy as a whole over and above these

other factors.

The question you raise with respect to currency manipulation is

a tricky issue because it would be desirable and has evidently been

desirable for emerging countries to have reasonably high reserves

because what has happened is that in crisis conditions when their

reserves are high there has been less in the way of underlying

world instability, say, as we had in 1998. Now, having said that,

there is no question that the motives of some of the accumulation

of reserves has been to stabilize exchange rate against the dollar

on the part of a number of countries, and that process obviously

means that you will accumulate dollar denominated assets as indeed a large number of them have, and the figures you cite are related to this particular question.

This is not, however, an activity which a central bank can engage

in indefinitely because as you buy dollars, as indeed you used to

buy gold under the gold standard, the asset side of the balance

sheet of the central bank expands unless, as we say, it has been

sterilized, and it is increasingly more difficult to sell off other nonU.S. dollar assets to effectively neutralize the effect of accumulating these dollars.

The consequence of the big rise in the asset side of the central

bank is to create a major increase in money supply growth, and

that cannot continue indefinitely. So this is not a process which

central banks can engage in indefinitely. Something has to give.

But there is no question that the motive here in many respects at

least as I judge it, is to suppress the value of their currency. They

cannot do it indefinitely, and I think a number of my colleagues,

the Secretary of the Treasury, for example, have indicated that

they would like to see less of that going on.

Senator DODD. I appreciate that, and I would hope that, Mr.

Chairman, he would be here. I do not know what his motivations

were for not coming tomorrow, but obviously there is a growing

concern.

Chairman SHELBY. I understand he is going to be with the President tomorrow, but Secretary Snow has indicated on many occasions, that he will appear before the Banking Committee.

Senator DODD. I hope so. Again, I appreciate the Chairman of

the Fed’s response, and obviously, I am fully aware that the Central Bank’s responsibility in this regard is very different, but as I

hear from my own constituencies and others—and a lot of it is unemployment, but going out of business too. I mean their productivities are rising but they are finding it more and more difficult

to compete in the marketplace. I have been supportive in the past

on free trade agreements and so forth for all the obvious reasons,

but that free trade is always conditioned on fair trade as well, and

when you have what you and I suspect is currency manipulation

going on simultaneously, then it makes it very, very difficult for us.

As I sat in a room the other day, one fellow got up and he said:

‘‘I am the CEO of a company. I am the only one in this room that

32

still makes anything.’’ There is a growing concern in the United

States about the fact that we are making fewer and fewer things.

Chairman GREENSPAN. Just remember that the nature of the

economy is becoming increasingly conceptual as distinct from physical, in the sense that ideas are becoming increasingly the predominant means by which we create wealth. The consequence of that

is that there is less physical stuff around. I think that is good, not

bad for the economy as a whole, but if you are a maker of stuff,

it is not.

Senator DODD. If your job depends upon being a maker of stuff,

it is more than just a conceptual kind of problem you have. It is

a real problem.

As I saw the other day in Wal-Mart, they had a sale on and they sold $1 billion in one day of television sets made in China. One

day, $1 billion. Not a single one of them made in the United States.

Now there is something fundamentally wrong if we cannot do a

better job of at least creating an atmosphere where there is an opportunity for U.S. manufacturers to have the same kind of opportunity. I worry about that, and I know you do as well.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Schumer.

COMMENTS OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. I want to thank

you again for the job you do.

I have a few questions. One is a little bit related to Chris Dodd’s

but somewhat different. One of the reasons we lose manufacturing

jobs is trade with China, and there are the classic free trade arguments about why businesses would go to China. But there is something else that has been happening, and I would like your comment

on that, and that is that the Chinese have tightly pegged their currency—it is a fixed rate. The yuan has been, since 1994, at 8.3

yuan per dollar.

Now if you let that currency float, almost every economist says

it would be valued higher. Goldman Sachs says 15 percent; some

say 25 to 40 percent. And the natural reason that we all went to

floating currencies among the major currencies is, it is a self-correcting mechanism that you and Chris Dodd were talking about.

Why wouldn’t it be a good idea for our President to jawbone the

Chinese, or our Treasury Secretary, to let their currency float? You

know, the Chinese seem in a lot of ways to want to be part of the

family of nations when it benefits them, you know, the bigger, more

productive nations, but not when it doesn’t. Why wouldn’t it help

everybody to let the yuan float? And why wouldn’t it be a good idea

for our Government to urge the Chinese to make it happen?

Chairman GREENSPAN. Well, the Secretary of the Treasury has

indicated that.

Senator SCHUMER. I have not heard any public pronouncements

about that.

Chairman GREENSPAN. No, indeed, there has been a public statement.

Senator SCHUMER. Why do the Chinese resist? Well, we know

why but——

Chairman GREENSPAN. Let me just say this——

33

Senator SCHUMER. If you could comment in general on that.

Chairman GREENSPAN. Yes. There is an issue here, but remember that it is very much to the advantage of the United States to

have China involved in world trade interrelated to all the various

institutions with which we are involved. They had and indeed still

have the centrally planned economy, which has considerable rigidities in it, and they have been endeavoring, and with some success,

to open it up, creating property rights, creating markets, which

seems to be contradictory to their political system. But, so far, it

is working and they are increasingly engaging on trade throughout

the world. I happen to think that is very good. Most economists

would say that is good.

In the process of doing that, because of the structure of the

rigidities of their system, they tended for purposes of stability to

fix the yuan to the dollar. And to date——

Senator SCHUMER. They have not changed it——

Chairman GREENSPAN. No, they have not, exactly. And that obviously from their point of view has created a degree of stability, but

it has required them, in order to hold that rate, to be very heavy

purchasers of U.S. dollar-denominated assets. And they have accumulated a very large store of assets, as has been indicated in various different fora.

At some point they will no longer be able to do that because it

will create an inability of their monetary system to function well.

How one approaches the issue of getting the exchange rates better

balanced is partially an economic issue, partially a political issue.

Senator SCHUMER. You are good at both.

Chairman GREENSPAN. My tools are limited.

Senator SCHUMER. But would it be, all things being equal, better

to have either a revaluation of the yuan or at least to let it float?

Aren’t they a big enough economy now? It is not 1994. Do you

think they should be letting it float?

Chairman GREENSPAN. I think that from an economic point of

view it is going to become increasingly evident that that is what

is going to have to happen if the existing cost structures around

the world remain as they are. And I think the Chinese economists

are sufficiently sophisticated to understand that.

Senator SCHUMER. When you hear—and we are all hearing what

Senator Dodd talked about—that manufacturing is just shrinking

and shrinking, and you are right, you said once before, something

I have repeated often, high value is added more by thinking things

than by making things these days. That is correct. But you still

have a large manufacturing base. I do not know if the same is happening in agriculture as in manufacturing; in other words, there is

more production with fewer workers, or is it less production?

Chairman GREENSPAN. Oh, no, in fact, if anything, it may be

more impressive.

Senator SCHUMER. More than agriculture.

Chairman GREENSPAN. Remember, crop yields are incredible.

Senator SCHUMER. Okay, so I understand that. Let me ask you

one other question, if I might, Mr. Chairman. We are in this period

now where the economy moves along at not a terribly rapid pace,

but a decent pace, 1 percent, 2 percent, maybe 3 percent growth.

Because productivity outstrips that growth, the number of jobs deVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
34

clines, and I am sure my colleagues have talked about that. This

is the first Administration since Herbert Hoover’s where the absolute number of jobs has declined, even though growth has occurred.

How long can this continue? Now, I understand that incomes are

going up. But if incomes continue to go up and jobs continue to

decline, it means that wealth, almost by definition, is being more

concentrated.

Is this bad for the economy? Can we just continue to go along

at this pace? And doesn’t the job loss—if it does matter—help drag

the economy and instead of creating an upward cycle, which we

had in the 1990’s where productivity and job growth went hand-inhand, really provide a drag on the economy where productivity goes

up and jobs go down?

Chairman GREENSPAN. It has certainly been our experience, Senator, that you cannot have the situation with productivity growth

growing faster than the economy as a whole; in other words, essentially rising output, falling employment. The reason basically is

that one must presume that the consequence of that is an opening

up of profit margins as one characteristic and historically increased

capital investment.

Over time, that situation is unstable and eventually adjusts to a

higher level of economic growth and, hence, increasing employment, or productivity growth slowing down. Obviously, if you continue GDP growing and employment declining, at the end of the

day everything is being produced by nobody.

Senator SCHUMER. Right. Or another country. See, that is what

may change this, the interrelatedness of the world economy.

Chairman GREENSPAN. But then the question is: Where do we

get the purchasing power, meaning the goods and services we

produce, to be able to buy it from others? So it is an internally

long-term inconsistent framework, and our expectation is that what

will occur as a consequence is that the GDP growth will move

above the productivity rate and employment will start to turn up

accordingly.

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Greenspan, could you just briefly

highlight for the Committee the nature of your concerns regarding

the industrial loan corporations and the extent to which your concerns are based on safety and soundness consideration?

Second, could you provide commentary as to the deficiencies in

the current regulation, if any, of industrial loan corporations that

lead you to these concerns, if you have them?

Chairman GREENSPAN. Mr. Chairman, my major concern is the

fact that under Gramm-Leach-Bliley, we significantly increased the

powers of our financial system, and in very important ways, in my

judgment. But with the advent of these increased powers and the

new technologies and products—for example, derivatives, as I mentioned before—we have a whole new array of types of regulatory

issues which confront us.

I believe, as I have stated previously, that in the future it is

going to be impossible to distinguish between commerce and banking, and ultimately we are going to be in a position where we are

not going to try to make that distinction.

35

But, it is important, in my judgment, to move in that direction

in a calibrated way and to understand first what the consequences

from a regulatory point of view have been as a consequence of the

significant changes that have occurred in regulation in the last decade. It is not only Gramm-Leach-Bliley. It is a whole series of other

regulatory changes.

If we eventually get to the point where we fully understand and

are comfortable with the issue that we have imposed a new set of

regulations on the system, then I think we can start to think about

the issue of moving further. However, I do not believe we are there

at this point.

My concern is that the vehicle of the industrial loan company, as

it is being currently constituted and expanded under existing proposals, will, for all practical purposes, create an institution which

will be very attractive for commercial enterprises, irrespective of

their size, and will have a functioning commercial bank with Federal deposit insurance, and that will effectively create a melding of

commerce and banking inadvertently—if I may put it that way, because that is not the purpose, obviously, of this——

Chairman SHELBY. But we are not there yet, are we?

Chairman GREENSPAN. We are not there yet, but I would suggest

that it is very important, before we move to effectively convert

industrial loan corporations into commercial banks without overriding supervision, that the issue of whether we wish to move more

broadly in this direction come before this Committee and your

counterparts in House Financial Services, because there is a very

major policy question here which, in my judgment, is not being addressed. And I think prior to moving forward and changing the

structure, as indeed it will change under certain proposed legislation, it is important that the Congress come to a policy conclusion

of a much broader dimension.

Chairman SHELBY. Mr. Chairman, tomorrow this Committee will

hold a hearing focused on the oversight of Government-sponsored

enterprises with an eye toward the accounting issues that have

recently surfaced at Freddie Mac. Some people have criticized

OFHEO, the regulator, noting that it lacks many of the powers

that the bank regulatory agencies possess.

Without getting into this morning who the GSE regulator should

be or where the regulator should be situated, what additional authorities, if any, in your judgment, should the GSE regulator have?

Chairman GREENSPAN. It is difficult to say because I think the

broader issue, as I have indicated in public testimony previously,

is the question of the subsidy which the financial markets grant to

the GSE’s on the presumption that they will be bailed out in the

event of difficulty by the Federal Government.

Their debentures, as they point out quite correctly, are not guaranteed by the full faith and credit of the United States, and there

is no statute under which there is effectively a Government guarantee or subsidy issue.

Chairman SHELBY. It is all perception, isn’t it?

Chairman GREENSPAN. There is a strong perception, and I do

think that, in considering the issue of where the focal point of supervision and regulation is, it be in the context of understanding

36

how that particular subsidy impacts on the financial structure of

those institutions and the various markets they are involved in.

As I have said previously, these are very well-run companies,

leaving aside the most recent problems with regard to accounting,

and it is not an issue of them having, for example, techniques in

derivative employment that are not the very finest in risk management. They do very well in that regard.

The problem has to do with a much broader question, and I think

what you need is a regulatory supervisor which has the capability

of viewing the GSE’s in total, not only Fannie and Freddie, but also

I will include the Federal Home Loan Banks in this as well. You

need to construct a regulator which has the reach to fully grasp the

very major questions which were involved in these now very important institutions in our financial system.

Chairman SHELBY. They would need the reach and the depth,

wouldn’t they, to get into real regulation?

Chairman GREENSPAN. It is going to be an interesting transition,

I believe.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman. I will be very

quick. I have just a few points on this second round.

First of all, Chairman Greenspan, I have to say I think we are

being much too sanguine about this trade deficit and foreign indebtedness. As recently as 1982, just over 20 years ago, we had a

net asset position worth 7 percent of our GDP. Our liabilities to

foreigners now exceed our assets abroad by $2.6 trillion, equal to

25 percent of the GDP. We ran a current account deficit in the first

quarter of $544 billion, a record 5.1 percent of GDP. That deficit

that is financed by more foreign borrowing will raise our indebtedness another 3 to 4 percent, depending on the growth of GDP.

Japan bought more than $40 billion in dollar assets in the month

of May alone. And the governments of China, Korea, and Taiwan

have been actively intervening to keep their currencies low relative

to a market-determined price for their currencies.

We are becoming increasingly dependent on the kindness of

strangers and, in particular, on foreign government lenders. In

fact, the Fed pointed out in its report, ‘‘The U.S. current account

deficit continued to be financed in large part by private flows into

U.S. bonds and by foreign official inflows. Private foreign purchases

of U.S. securities, which slowed in the latter part of 2002, stepped

down a bit more in the first quarter of 2003. In contrast, inflows

into the United States from official sources, which surged in 2002,

picked up further in the first half of 2003.’’

I mean, we are obviously, it seems to me, being taken advantage

of in the international marketplace because others are not playing

by the rules of international trade, and it is working very much to

their advantage, and we continue to get deeper and deeper into the

hole. And it seems to me we need to move this up on the priority

list of our concerns, and certainly that is one of the matters we will

focus on when Secretary Snow comes.

I do not really have a question. I just want to put that to you

and hope you will take it under advisement in terms of the need

to really start thinking seriously about this issue. Otherwise, one

37

of these days things may just snap, and we will find ourselves in

a difficult situation.

Let me ask you, just as kind of an aside: Do you think that the

responsibilities of the presidents of the Federal Reserve branch

banks are equal to or perhaps greater than the responsibilities of

the presidents of Federal Home Loan Banks?

Chairman GREENSPAN. I would certainly think so. At least it is

my judgment. I am sure that they have a different view. I mean

the Federal Home Loan Bank presidents.

Senator SARBANES. I am not putting a question—I mean, that is

the question I want to ask. Mr. Chairman, Chairman Shelby, I just

want to note for the record this is not the hearing to explore that,

but these salaries and compensation of the presidents of the Federal Home Loan Banks are going through the roof. In most instances, they have doubled or tripled over the last 3 years. They

far exceed, again, by a factor of 2 to 3 times, what Federal Reserve

branch bank presidents are making. They are now up counting

their other benefits in excess of $1 million in some of these Federal

Home Loan Banks. It is a bonanza.

Now, you know, we need to address that when we have the Federal Home Loan Bank people here.

Chairman SHELBY. Proper hearing, absolutely.

Senator SARBANES. But I have been looking at some of these

figures, and they just leap off the page at you in terms of what is

taking place.

Now, Chairman Greenspan, you said in your statement, ‘‘The

Federal Reserve has been studying how to provide policy stimulus

should our primary tool of adjusting the target Federal funds rate

no longer be available. Indeed, the FOMC devoted considerable attention to this subject at its June meeting.’’

I think the Fed has done a good job in increasing transparency

in recent years, and I think that is a very important contribution

to enabling people to know where the Fed is going with respect to

its policy.

If you have to shift off the Federal funds rate, what will you go

to in terms of assuring transparency out there for the public? How

will you signal policy for longer-term rates? Would you choose a

specific maturity, or set some sort of time frame? You know, your

policy has been widely acclaimed on transparency, but if you shift

the focus, how will you do that?

Chairman GREENSPAN. There are a large number of variations,

any one of which could be usable. Remember, the major issue that

we are confronted with is expanding the balance sheet of the Federal Reserve in total.

Now what that means is we, as I indicated previously, could

move out on the maturity schedule and buy longer-term bonds.

There has been a big discussion of whether you try to peg the rates

or not peg the rates.

Remember, we did peg the rates from 1942 to 1951. That was a

wholly different world, of course, and markets were different. But

we have examined a number of different issues and, needless to

say, discarded a large number of them as impractical or inappropriate. But all I can say to you is that, for what we would have

to do in the remote event that those conditions arose, it is not that

38

we have inadequate choices. We have more than we need. And we

would then have to choose amongst them. Because we can create

what we need to create in any of a number of different ways——

Senator SARBANES. Yes, but the thrust of my question is not

whether you have these tools, but whether you will depart from, I

think, the welcome trend toward greater transparency in the Fed’s

decisionmaking and go to a more opaque approach so that people

perceive——

Chairman GREENSPAN. No, no. Remember, Senator, we publish

our balance sheets every week, and it is in sufficient detail to be

able to very quickly understand exactly what it is the 12 operating

central banks are doing.

Chairman SHELBY. Senator Bennett——

Chairman GREENSPAN. I will say to you that if we do things

which are somewhat different, we will alter our reporting in a manner to make clear what it is we are doing.

Senator SARBANES. Will your policy statement make this clear?

Or will we have to get a whole new breed of Fed watchers or——

Chairman GREENSPAN. No, if we go in this direction—I just want

to emphasize this is a remote contingency. It will be clear what we

are doing, and there will be no purpose in being obscure or unclear.

It will not serve the purposes of monetary policy to do that.

Senator SARBANES. Thank you.

Chairman SHELBY. Senator Bennett.

Senator BENNETT. Thank you, Mr. Chairman.

Chairman Greenspan, listening to this whole conversation this

morning, first, I share your sense of optimism about the economy

near term. I think we are rebounding. We are coming back. And

as we come back, Federal revenues as a percent of GDP will go up,

and we will see, as we always see, revisions in the projections as

to what the deficit or the surplus will be. I have said before and

repeat here, the only thing I know about the figures we are seeing

for the future is that they are wrong. I do not know whether they

are too high or too low, but I know that they are wrong.

Chairman GREENSPAN. I think that is a sound judgment, Senator

Bennett.

Senator BENNETT. Okay. Now, I would like to go where some of

the conversation here has gone, which is beyond the near term, beyond this recovery and how long will it take and how good will it

be, on into those dreaded years of 2012 and beyond. And I think

we have a model—imperfect, of course, but a model of what might

very well happen to us as we look at contemporary Germany.

In Germany, if they had an unemployment rate of 6.4 percent

right now, they would rejoice and think that was absolutely wonderful. If they had a deficit at our percentage of GDP, they would

rejoice. If they had a national debt at our percent of GDP, they

would rejoice.

They have over the years built into their entire culture a welfare

state mentality of the things that they will take care of and the

things that they will fund, and now they are hitting the demographic wall that we are facing, much more rapidly than we. And

because they do not have the level of immigration that we do, it

is going to be far worse. That is, the overall population is shrinking; ours will continue to grow. Even in the face of the retiring

39

baby boomers, we will still continue to have new workers coming

into the country by virtue of immigration, and our population will

grow. Their people are stagnant, if not, in fact, scheduled to shrink.

And they are faced with the systematic dismantling of many of the

social services that they have built into their culture over the previous decades.

We have held hearings in the Joint Economic Committee about

medical costs, and there is a perverse and counterintuitive circumstance going on in that the more technology we bring into

health care, the more it costs. This is exactly different from the

way things work in other parts of the economy. The more technology you apply, the lower the cost becomes. And as we have tried

to pursue why we have the opposite trend in health care, it is because you keep people alive longer. If you were aimed at cost control only, you would let them die and thereby save the cost of their

medical care in their later years. But we get technology coming

along that solves some of the health care problems, keeps them

alive longer, but in terms of the impact on Medicare, raises the

overall cost. So the more technological innovation we have and the

more breakthroughs we have, from an economic point of view the

more expensive Medicare is going to get.

Can we look at Germany and some of the other countries that

are seeing this demographic impact more rapidly than we see it,

that is, it is coming 10 years or 15 years before it will hit us, and

learn anything, or do we just look at them and say: Gee, there is

where we will be and we have no choice but to start to lower benefits and dismantle services later on if we are going to afford it?

Chairman GREENSPAN. Senator, I certainly hope that we can

learn. Indeed, I think the Germans are learning from us in the

sense that they are aware that their labor market, which has become exceptionally rigid, has been a major factor in the sluggish

growth in their country, and they are endeavoring to change it, and

the model they are moving toward, not fully but at least in the direction, is the one that we have, which does work in a remarkably

flexible way, at least certainly considering all others.

I think we learn from each other and I do agree that it is an unusual phenomenon of watching an economy essentially decline as

population declines, even though standards of living per capita can

be rising, the aggregate economy can be declining. That will change

the structure of how production is organized, and it has a very

major impact obviously on the relationship of retirees to workers,

especially, as you point out, if the medical technology increases life

expectancy.

We are all going to be learning from each other, but you are

quite correct in saying that Germany, Italy, Japan, specifically, and

maybe Europe in general, are clearly well ahead of us in that regard, and so we will be observing what can happen to an economy

in which population is stable or declining, and while that is not on

the horizon directly for the United States, remember, our fertility

rates are higher than theirs. I notice we had a surprisingly low

birth rate the last year, but our fertility rates generally have been

up at least to replacement levels, and immigration has increased

the population. So, we are not confronting the same problems they

do, but the underlying pressures are there and it is important that

40

we recognize the implications of what it means to have an increasing retirement-to-working age population even if your population in

itself is not slowing.

Senator BENNETT. That is my point. Their situation is worse

than ours, but the underlying pressures are basically the same.

Chairman GREENSPAN. Indeed they are.

Senator BENNETT. Thank you.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

I appreciate this wide-ranging discussion and find it highly informative, and I am going to say all the positive things and then

come back to an overview.

Chairman GREENSPAN. Mr. Chairman, may I have a 5-minute

break at this moment?

Chairman SHELBY. You can. The Committee will stand in recess.

[Recess.]

Chairman SHELBY. The Committee will come to order.

Senator Corzine.

Senator CORZINE. Thank you. I knew my questions were going to

scare him to death.

Chairman SHELBY. I do not believe that now.

Senator CORZINE. I do not either.

[Laughter.]

As I was beginning, Mr. Chairman, I want to preface what I say

by saying I have great respect for you and all you have done, and

the Federal Reserve as an institution, which I think is terrific. I

have listened both to recaps of yesterday’s hearing and today’s

hearing, and frankly, one individual. I do not come away as sanguine as I think the tone of the discussion has been.

My colleagues have talked about the straight deficit and its

translation into the loss of manufacturing jobs, which there was a

response yesterday that did not seem as serious to me as it is in

the lives of the people that I see in New Jersey. Federal budget

deficits, a $4 trillion negative cash swing in 21⁄2 years by projections, is by anybody’s standards an incredible change in fiscal circumstances. The demographic problem that we know we face. Our

State and local governments, we see $100 billion, give or take a little bit, at the State level in the fiscal time frame. It is much larger

at the State level. Property taxes are going up to offset in many

places all of the Federal tax cuts we have had. There is 8 out of

9 quarters we have under this Administration, we have seen a decline in business investment by the GDP numbers, not a long-run

formulation for a long-term increase in productivity, even though

I understand we are in a conceptual economy as opposed to a physical economy, accept that. But it is not a statement of confidence

if nothing else. And the job deficit is real. We have used the headline, used the 21 weeks of initial claims, and set aside the seasonal

adjustment issues. These are real problems. The unemployment

rate for African-Americans has gone up 31⁄2 percent while for white

Americans it is 1.7. We are up at something like 11.5 percent. Minorities are suffering a disproportionate burden, and as I think

Senator Sarbanes indicated in his first question, that there have

been projection errors, not only by the Federal Reserve but also by

41

private sector and a broad set of economists. We have not really

changed the policy mix.

I am going to read a quote from Mr. Rosenberg from a firm that

I know well, but did not work at one that I worked with. ‘‘This is

the third round of Bush tax cuts, the thirteenth round of Fed rate

relief and about the sixth mortgage refinancing wave so far this

cycle,’’ Mr. Rosenberg from Merrill Lynch said in a report commenting on the latest rate cut. ‘‘And what do we have to show for

it except an economy struggling at a 1 or 2 percent rate.’’

Now maybe that is changing, but I do not understand what is

different in the policy mix we have today versus what we had 21⁄2

years ago, a year and a half ago, and now, that gives us so great

a confidence that this is all going to work as well as everybody

projects it is, and I could not agree more, that the one thing that

is for certain, projections are likely not to be met. We do not know

whether they are going to be under or over, but we seem sanguine

about a state of occurrence in our economy where there is real job

loss, it is making a real difference, the income distribution is more

than likely widening, given the kinds of nature of where tax cuts

and job cuts and manufacturing are going in this country. I am

troubled more than what the tone of the discussion is about.

Chairman GREENSPAN. I think the best way to confront the issue

is that there is a good deal more to how an economy evolves than

what policy is. Policy is at the margins of what an economy is

doing. I think that we have to go back to how the economy evolved

subsequent to the big stock market break, the sharp decline in

capital investment, and indeed the shocks to our economy that

occurred subsequent to that.

I have testified on numerous occasions that in spite of those, we

have hung in there. The economy has not grown particularly, but

it has not receded. This is a very unusual cycle, and as you well

know, the recession has been very shallow, and as a consequence

of that, you cannot have a kickback from a nonsignificant recession. There is no bounce in the structure of the economy.

What strikes me about the degree of flexibility which is broad,

is it has been able to absorb a very surprisingly large number of

the types of shocks that in my historical experience would have created real serious problems to this economy, and they did not. What

it did do, however, is it took all of the buoyancy out of the economy.

That is, rather than have significant negative GDP numbers, what

we have had is absorbing a whole series of negative forces and essentially stand still, so to speak, or grow very gradually. That is

far superior in my judgment.

Senator CORZINE. I would say though we have had 13 rate cuts

and something that is approaching, depending on how you count

the numbers, $1.8 to $3 trillion in tax cuts. I mean these are not

light stimulants to an economy.

Chairman GREENSPAN. No. And I would go further. I would say

that it has required all of this to essentially be able to come off a

very substantial collapse of a bubble and yet have an economy

which is at least gradually growing, which it has been. And one has

to presume that if that is the correct analysis of what it is we are

observing, at some point we absorb the full negative shocks and the

underlying flexibility shows through.

42

Now, I am fully aware of the fact that out there everybody’s forecasts, including those of your old firm and all of its competitors,

have fairly significant acceleration in the current quarter and in

the fourth quarter, and the reason is they all have the standard

basic models which we all employed to forecast the economy, and

the general presumption is, if even a modest part of the big tax cut

is spent in retail, the GDP will go up. That is what is causing these

forecasts to be what they are.

I try to indicate within the context of my prepared remarks that

there is a distinction between what is occurring and what the forecasts are. Now the data that had been coming in are not inconsistent with this economy picking up. I do not know whether they

can meet the particular forecasts of some of the forecasters, but we

are seeing gradual changes, all which are consistent with that process happening. Are we far along in that process? We are not. We

first had to stop eroding, because remember, in April and May this

economy was weakened, or I should say more exactly in March and

April. May stabilized, and as best we can judge, June has come

back a bit. The crucial issue is going to be whether, in fact, capital

investment comes back because that is the key link to this system,

and right at the moment it is a forecast, and we will be watching

it very closely. If it fails to materialize we will continue to be going

up and going down, but not carrying through in a way which one

would call a vibrant economy. I happen to be optimistic about how

this process is going, but I must tell you I do recognize the difference between economic reality and a forecast, and all I will say

to you is that we are not quite up to where we are getting clear

indications that the forecast is coming up, but we are moving in

that direction. Statistic by statistic tends to be coming in somewhat

better than we expect, and that is usually a sign that things are

changing.

Senator CORZINE. Thank you.

Chairman SHELBY. Senator Schumer.

Senator SCHUMER. Thank you.

I want to thank you for staying and answering these questions.

It is a great discussion. I just want to go back to the yuan for a

minute. My staff, who is usually right, although not infallible, says

that while Secretary Snow has talked in general about floating

rates, he has never specifically and publicly talked about devaluing

the yuan, and it just seems to me that China should be stepping

up to the plate here, and we should not wait until they can no

longer buy any United States Treasuries and then let it unravel at

that point in time.

Chairman GREENSPAN. Senator, unless I am mistaken, the Secretary did raise the issue enough so that the Chinese officially said

it was false. Now if they did not, my memory may be faulty in this

regard, but I suggest that——

Senator SCHUMER. Do you not think a little more of this would

be helpful? I mean, here is something that is not against free trade

principles. In fact, the fixed income rate probably is. We have a

huge problem with China. That is going to be a problem because

of discombobulations of the economy, no matter what the yuan is

pegged at, but it is artificially low, and it is being kept that way

by the Chinese for their own advantage.

43

Chairman GREENSPAN. You know, a number of trading partners

with China have raised this issue. I think the question is whether

or not public discussion moves the ball further down the road than

private discussion.

Senator SCHUMER. Right. You have now answered my question.

I appreciate it. Next question I have is, just related to your last

interchange with Senator Corzine. It is a very interesting perspective. I think it helps us understand things, and that is that with

all this stimulus and which is very significant. I cannot remember

interest rates being low and taxes being cut as much in my lifetime

as now. You needed this to shield the economy or at least temper,

cushion the economy from the bubble bursting and all the effects

there, not only stock market but also I guess over investment in

certain sectors as well. It would seem to me that if you are right

and we have overcome these bumps, then something we have not

worried about in a long time, which is the dangers of inflation,

might rear its head back. It just strikes me as, you know, your assurance yesterday that interest rates are going to stay low for a

long period of time, do not quite fit into the puzzle of dramatic

stimulus of the economy, shocks that obviously should be receding

as we move on in time from them, we are 2 years and 3 years away

rather than 1 year. Could you comment on that?

Chairman GREENSPAN. Certainly. It is our judgment that the extent of the downward pressures on the price level that are coming

not only from the aftermath of the bubble, but also increasing

globalization are significantly greater than the inflationary forces

that are emerging in various different areas of the world economy.

Remember, it is not only the United States who has had a significant reduction in the inflation rate, but also it is pretty much

around the world, including a number of emerging countries whose

problems were chronic inflation of a most destabilizing form. This

is a world phenomenon, and in that sense it is larger than the

United States as such. It has been the conclusion of the Federal

Reserve that while we obviously over the years have been extraordinarily sensitive to the issue of inflation, and indeed our policies

were fundamentally to get to price stability, we have recognized

that the world has changed in a way which requires us to alter our

policy mix, but I do not deny that some time down the road, that

the situation will turn again, and I trust we will have a very long

lead time to anticipate that.

Senator SCHUMER. One final question, Mr. Chairman. There has

been a recent discussion between two of my fellow New Yorkers,

your colleague and a man I supported for the SEC, Mr. Donaldson,

our New York Attorney General in the last while, about—and I

have not made up my mind on this one, so I would like your guidance—basically on whether legislation in Congress or some attempt

to say that State regulators, they can prosecute wrongdoers under

their local security laws but not sort of set agreements, change the

basic tableau, that that ought to stay national. And obviously, the

Donaldson argument is this is a national function, we have national markets and to have 50 regulators go willy-nilly creates a

nearly impossible situation. Spitzer’s counter argument is we had

that, and when you have one regulator, the chance of that reguVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6633 91369.TXT SBANK4 PsN: SBANK4
44

lator being asleep at the switch is greater than if you had 50, and

he did a good job stepping into this.

Would you comment, if not on the specific legislation that is approaching, if you want to do that, great, but on the general conflict

between those two ideas?

Chairman GREENSPAN. I think the argument that you have national markets and you should have a single regulator is the correct position. If you are worried about a single regulator having

problems, that is a legitimate concern. It does not follow that that

is solved by having 50 additional regulators, but it does suggest

that there needs to be oversight of all regulatory agencies. I think

that it is important that the Federal Reserve has Congressional

oversight. The oversight of the SEC is this Committee. And indeed,

it is important that they have the authority to do what they need

to do, but there is always the danger that monopoly regulators can

begin to become very inefficient and very disturbing.

I, for example, have argued in the past that we should not have

a single regulator for American banking because I am worried

about monopoly regulation. But the answer is not an indefinite proliferation of alternate regulators.

Senator SCHUMER. So, you would be sympathetic to the legislation the House just passed?

Chairman GREENSPAN. I am.

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Mr. Chairman, we appreciate your staying

with us all morning and into the early afternoon. We appreciate always your appearance here and your insightful views. Thank you.

Chairman GREENSPAN. Thank you, Mr. Chairman.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 12:55 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

45

PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI

The U.S. economy is still the greatest economy in the world. However, there are

certain issues that we need to address to ensure that we retain that position. If I

had to pick the one single issue that has the greatest impact on the financial affairs

of Wyoming, and the rest of our Nation for that matter, I would have choose the

state of our Nation’s energy development. Every sector of our economy relies on

some form of technology that, in turn, relies on electricity and/or fossil fuels to function. Our economy is literally driven, therefore, by our ability to develop and maintain a steady, constant energy supply.

Wyoming’s role in this situation is much like the position held by the colonies during America’s first years of European settlement. We provide the raw materials, or

in other words the feedstock, that makes the rest of our Nation’s energy economy

function. If my home county, Campbell County, Wyoming, were its own country we

would be the third largest coal producing Nation in the world. One-third of our

Nation’s coal is produced in this one county alone. We also produce more uranium

annually than the rest of the Nation combined and have the greatest potential for

natural gas development in the entire continental United States. In short, we have

what the rest of the Nation needs to keep its technology fueled and running.

Unfortunately, however, most of that energy is now stranded in Wyoming and is

inaccessible to the parts of the country that need it. Our natural gas development

is being slowed down by the inability to get the gas out of the State. Our electricity

runs into bottlenecks where the power lines outside the State do not have enough

capacity to carry what we can generate and our coal is being hit with the threat

of new regulations and bureaucratic limitations that could eventually slow down exploration and development. All of these limitations are having an effect on the rest

of the economy.

I understand Chairman Greenspan has already visited the Hill on a number of

occasions and has testified on this issue. I look forward to any additional insights

he might offer on how we can bolster our economy by increasing energy stability,

and I hope he could address what future role Wyoming can play in meeting our

energy demands.

In addition to the importance of natural gas prices on our Nation’s economy, we

also must ensure that we have a favorable business climate to encourage the creation and growth of our small businesses. For many industries, small businesses

represent more than 97 percent of the number of businesses in the industries and

the vast majority of them are critically reliant upon access to credit from our financial institutions.

Recently, the Office of Advocacy of the Small Business Administration released an

independently conducted study that showed that small businesses are disproportionately affected by a tight Federal monetary policy. Specifically, the study showed that

the vital link between small businesses and small community banks can be worsened when community banks have difficulty adjusting to tighter monetary policies

and to adverse banking developments and lending conditions. The study also found

that community bank capital was capable of stimulating employment about three

times compared to large bank capital. While the study cited the importance of SBA

loan programs to stabilize lending to small business in tight monetary policy times,

I believe that it is more important to keep in mind the effects on small business

as the Federal monetary policy is being developed.

Another critical issue for small businesses and our economy is the state of our

initial public offering (IPO) market. Recently, news articles cited statistics that

China has gained the crown for the IPO market and that Singapore has the fastest

growing IPO market. In the first 6 months of this year, each of those countries had

more IPO’s than the U.S. markets. Last year, Congress took great pains to pass the

Sarbanes-Oxley Act to help restore investor confidence in our financial markets,

however, it is clear that the IPO market has failed to materialize. I am very concerned that our overall business climate may not be sufficient to encourage the

creation and growth of our small businesses.

In addition, recent news articles cite that many of our high-technology jobs may

be heading overseas. The combination of the loss of high-technology jobs and of the

rise in the overseas IPO markets, is troublesome at best. I would like to hear Chairman Greenspan’s perspective on how we can remedy this situation.

Mr. Chairman, thank you again for holding this hearing. I look forward to hearing

from Chairman Greenspan.

46

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JULY 16, 2003

Mr. Chairman and Members of the Committee, I am pleased to present the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress. When in late

April I last reviewed the economic outlook before this Committee, full-scale military

operations in Iraq had concluded, and there were signs that some of the impediments to brisker growth in economic activity in the months leading up to the

conflict were beginning to lift. Many, though by no means all, of the economic uncertainties stemming from the situation in Iraq had been resolved, and that reduction

in uncertainty had left an imprint on a broad range of indicators.

Stock prices had risen, risk spreads on corporate bonds had narrowed, oil prices

had dropped sharply, and measures of consumer sentiment appeared to be on the

mend. But, as I noted in April, hard data indicating that these favorable developments were quickening the pace of spending and production were not yet in evidence, and it was likely that the extent of the underlying vigor of the economy

would become apparent only gradually.

In the months since, some of the residual war-related uncertainties have abated

further and financial conditions have turned decidedly more accommodative, supported, in part, by the Federal Reserve’s commitment to foster sustainable growth

and to guard against a substantial further disinflation. Yields across maturities and

risk classes have posted marked declines, which together with improved profits

boosted stock prices and household wealth. If the past is any guide, these domestic

financial developments, apart from the heavy dose of fiscal stimulus now in train,

should bolster economic activity over coming quarters.

To be sure, industrial production does appear to have stabilized in recent weeks

after months of declines. Consumer spending has held up reasonably well, and activity in housing markets continues strong. But incoming data on employment and aggregate output remain mixed. A pervasive sense of caution reflecting, in part, the

aftermath of corporate governance scandals appears to have left businesses focused

on strengthening their balance sheets and, to date, reluctant to ramp up significantly their hiring and spending. Continued global uncertainties and economic

weakness abroad, particularly among some of our major trading partners, also have

extended the ongoing softness in the demand for U.S. goods and services.

When the Federal Open Market Committee (FOMC) met last month, with the

economy not yet showing convincing signs of a sustained pickup in growth, and

against the backdrop of our concerns about the implications of a possible substantial

decline in inflation, we elected to ease policy another quarter-point. The FOMC

stands prepared to maintain a highly accommodative stance of policy for as long as

needed to promote satisfactory economic performance. In the judgment of the Committee, policy accommodation aimed at raising the growth of output, boosting the

utilization of resources, and warding off unwelcome disinflation can be maintained

for a considerable period without ultimately stoking inflationary pressures.

***

The prospects for a resumption of strong economic growth have been enhanced by

steps taken in the private sector over the past couple of years to restructure and

strengthen balance sheets. These changes, assisted by improved prices in asset markets, have left households and businesses better positioned than they were earlier

to boost outlays as their wariness about the economic environment abates.

Nowhere has this process of balance sheet adjustment been more evident than in

the household sector. On the asset side of the balance sheet, the decline in longerterm interest rates and diminished perceptions of credit risk in recent months have

provided a substantial lift to the market value of nearly all major categories of

household assets. Most notably, historically low mortgage interest rates have helped

to propel a solid advance in the value of the owner-occupied housing stock. And the

lowered rate at which investors discount future business earnings has contributed

to the substantial appreciation in broad equity price indexes this year, reversing a

portion of their previous declines.

In addition, reflecting growing confidence, households have been shifting the composition of their portfolios in favor of riskier assets. In recent months, equity mutual

funds attracted sizable inflows following the redemptions recorded over much of the

last year. Moreover, strong inflows to corporate bond funds, particularly those

specializing in speculative-grade securities, have provided further evidence of a

renewed appetite for risk-taking among retail investors.

47

On the liability side of the balance sheet, despite the significant increase in debt

encouraged by higher asset values, lower interest rates have facilitated a restructuring of existing debt. Households have taken advantage of new lows in mortgage

interest rates to refinance debt on more favorable terms, to lengthen debt maturity,

and, in many cases, to extract equity from their homes to pay down other highercost debt. Debt service burdens, accordingly, have declined.

Overall, during the first half of 2003, the net worth of households is estimated

to have risen 41⁄2 percent—somewhat faster than the rise in nominal disposable personal income. Only 15 percent of that increase in wealth represented the accumulated personal saving of households. Additions to net worth have largely reflected

capital gains both from financial investments and from home price appreciation. Net

additions to home equity, despite very large extractions, remained positive in the

first half.

Significant balance-sheet restructuring in an environment of low interest rates

has gone far beyond that experienced in the past. In large measure, this reflects

changes in technology and mortgage markets that have dramatically transformed

accumulated home equity from a very illiquid asset into one that is now an integral

part of households’ ongoing balance-sheet management and spending decisions. This

enhanced capacity doubtless added significant support to consumer markets during

the past 3 years as numerous shocks—a stock price fall, September 11, and the Iraq

war—pummeled consumer sentiment.

Households have been able to extract home equity by drawing on home equity

loan lines, by realizing capital gains through the sale of existing homes, and by

extracting cash as part of the refinancing of existing mortgages, so-called cash-outs.

Although all three of these vehicles have been employed extensively by homeowners

in recent years, home turnover has accounted for most equity extraction.

Since originations to purchase existing homes tend to be roughly twice as large

as repayments of the remaining balances on outstanding mortgages of home sellers,

the very high levels of existing home turnover have resulted in substantial equity

extraction, largely realized capital gains. Indeed, of the estimated net increase of

$1.1 trillion in home mortgage debt during the past year and a half, approximately

half resulted from existing home turnover.

The huge wave of refinancings this year and last has been impressive. Owing

chiefly to the decline in mortgage rates to their lowest levels in more than three

decades, estimated mortgage refinancings net of cash-outs last year rose to a record

high of more than $1.6 trillion. With mortgage rates declining further in recent

months, the pace of refinancing surged even higher over the first half of this year.

Cash-outs also increased, but at a slowed pace. Net of duplicate refinancings, approximately half of the dollar value of outstanding regular mortgages has been refinanced during the past year and a half. Moreover, applications to refinance existing

mortgages jumped to record levels last month. Given that refinance applications

lead originations by about 5 weeks and that current mortgage rates remain significantly below those on existing mortgages, refinance originations likely will remain

at an elevated level well into the current quarter.

We expect both equity extraction and lower debt service to continue to provide

support for household spending in the period ahead, though the strength of this support is likely to diminish over time. In recent quarters, low mortgage rates have carried new home sales and construction to elevated levels. Sales of new single-family

homes through the first 5 months of this year are well ahead of last year’s record

pace. And declines in financing rates on new auto loans to the lowest levels in many

years have spurred purchases of new motor vehicles.

***

In addition to balance sheet improvements, the recently passed tax legislation will

provide a considerable lift to disposable incomes of households in the second half

of the year, even after accounting for some State and local offsets. At this point,

most firms have likely implemented the lower withholding schedules that have been

released by the Treasury, and advance rebates of child tax credits are being mailed

beginning later this month. The Joint Committee on Taxation estimates that these

and other tax changes should increase households’ cashflow in the third quarter by

$35 billion. Most mainstream economic models predict that such tax-induced increases in disposable income should produce a prompt and appreciable pickup in

consumer spending. Moreover, most models would also project positive follow-on

effects on capital spending. The evolution of spending over the next few months may

provide an important test of the extent to which this traditional view of expansionary fiscal policy holds in the current environment.

48

***

Much like households, businesses have taken advantage of low interest rates to

shore up their balance sheets. Most notably, firms have issued long-term debt and

employed the proceeds to pay down commercial paper, bank loans, and other shortterm debt. Although rates on commercial paper and bank loans are well below

yields on new long-term bonds, firms have evidently judged that now is an opportune time to lock in long-term funding and avoid the liquidity risks that can be associated with heavy reliance on short-term funding. At the same time, the average

coupon on outstanding corporate bonds remains considerably above rates on new

debt issues, suggesting that firms are well positioned to cut their debt service burdens still further as outstanding bonds mature or are called. The net effect of these

trends to date has been a decline in the ratio of business interest payments to net

cashflow, a significant increase in the average maturity of liabilities, and a rise in

the ratio of current assets to current liabilities.

With business balance sheets having been strengthened and with investors notably more receptive to risk, the overall climate in credit markets has become more

hospitable in recent months. Specifically, improvements in forward-looking measures of default risk, a decline in actual defaults, and a moderation in the pace of

debt-rating downgrades have prompted a marked narrowing of credit spreads and

credit default swap premiums. That change in sentiment has extended even to the

speculative-grade bond market, where issuance has revived considerably, even by

lower-tier issuers that would have been hard-pressed to tap the capital markets over

much of the last few years. Banks, for their part, remain well-capitalized and willing lenders.

In the past, such reductions in private yields and in the cost of capital faced by

firms have been associated with rising capital spending. But, as yet there is little

evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment. Corporate

executives and boards of directors are seemingly unclear, in the wake of the recent

intense focus on corporate behavior, about how an increase in risk-taking on their

part would be viewed by shareholders and regulators.

As a result, business leaders have been quite circumspect about embarking on

major new investment projects. Moreover, still-ample capacity in some sectors and

lingering uncertainty about the strength of prospective final sales have added to the

reluctance to expand capital outlays. But should firms begin to perceive that the

pickup in demand is durable, they doubtless would be more inclined to increase

hiring and production, replenish depleted inventories, and bring new capital online.

These actions in turn would tend to further boost incomes and output.

Tentative signs suggest that this favorable dynamic may be beginning to take

hold. Industrial production, as I indicated earlier, seems to have stabilized, and various regional and national business surveys point to a recent firming in new orders.

Indeed, the backlog of unfilled orders for nondefense capital goods, excluding aircraft, increased, on net, over the first 5 months of this year. Investment in structures, however, continues to weaken.

The outlook for business profits is, of course, a key factor that will help determine

whether the stirrings we currently observe in new orders presage a sustained pickup in production and new capital spending. Investors’ outlook for near-term earnings has seemed a little brighter of late.

The favorable productivity trend of recent years, if continued, would certainly

bode well for future profitability. Output per hour in the nonfarm business sector

increased 21⁄2 percent over the year ending in the first quarter. It has been unusual

that firms have been able to achieve consistently strong gains in productivity when

the overall performance of the economy has been so lackluster. To some extent, companies under pressure to cut costs in an environment of still-tepid sales growth and

an uncertain economic outlook might be expected to search aggressively for ways to

employ resources more efficiently. That they have succeeded, in general, over a

number of quarters suggests that a prior accumulation of inefficiencies was available to be eliminated. One potential source is that from 1995 to 2000 heavy emphasis on new and expanding markets likely diverted corporate management from tight

cost controls whose payoffs doubtless seemed small relative to big-picture expansion.

However, one consequence of these improvements in efficiency has been an ability

of many businesses to pare existing workforces and still meet increases in demand.

Indeed, with the growth of real output below that of labor productivity for much of

the period since 2000, aggregate hours and employment have fallen, and the unemployment rate rose last month to 6.4 percent of the civilian labor force.

49

***

Although forward-looking indicators are mostly positive, downside risks to the

business outlook are also apparent, including the partial rebound in energy costs

and some recent signs that aggregate demand may be flagging among some of our

important trading partners. Oil prices, after dropping sharply in March on news

that the Iraqi oil fields had been secured, have climbed back above $30 per barrel

as market expectations for a quick return of Iraqi production appear to have been

overly optimistic given the current security situation.

Also worrisome is the rise in natural gas prices. Natural gas accounts for a

substantial portion of total unit energy costs of production among nonfinancial, nonenergy-producing firms. And as I noted in testimony last week, futures markets anticipate that the current shortage in natural gas will persist well into the future.

Although they project a near-term modest decline from highly elevated levels,

contracts written for delivery in 2009 in excess of $4.50 per million Btu are still at

double the levels that had been contemplated when much of our existing gas-using

capital stock was put in place.

The timing and extent of the pickup in economic activity in the United States will

also depend on global developments. Lethargic growth among many of our important global trading partners is posing some downside risk to the U.S. economic outlook. As has been true for some time, Japan’s economy remains in difficult straits,

burdened by a weak banking sector and an ongoing deflation, although recent data

have seemed somewhat less negative. Economic activity in many European countries—especially Germany—has been soft of late and has been accompanied by a

decline in inflation to quite low levels. While Japan and Europe should benefit from

global economic recovery, the near-term weakness remains a concern.

***

Inflation developments have been important in shaping the economic outlook and

the stance of policy over the first half of the year. With the economy operating below

its potential for much of the past 2 years and productivity growth proceeding apace,

measures of core consumer prices have decelerated noticeably. Allowing for known

measurement biases, these inflation indexes have been in a neighborhood that corresponds to effective price stability—a long-held goal assigned to the Federal Reserve by the Congress. But we can pause at this achievement only for a moment,

mindful that we face new challenges in maintaining price stability, specifically to

prevent inflation from falling too low.

This is one reason the FOMC has adopted a quite accommodative stance of policy.

A very low inflation rate increases the risk that an adverse shock to the economy

would be more difficult to counter effectively. Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop

of weak aggregate demand, engendering a corrosive deflationary spiral.

Until recently, this topic was often regarded as an academic curiosity. Indeed, a

decade ago, most economists would have dismissed the possibility that a government issuing a fiat currency would ever produce too little inflation. However, the

recent record in Japan has reopened serious discussion of this issue. To be sure,

there are credible arguments that the Japanese experience is idiosyncratic. But

there are important lessons to be learned, and it is incumbent on a central bank

to anticipate any contingency, however remote, if significant economic costs could

be associated with that contingency.

The Federal Reserve has been studying how to provide policy stimulus should our

primary tool of adjusting the target Federal funds rate no longer be available. Indeed, the FOMC devoted considerable attention to this subject at its June meeting,

examining potentially feasible policy alternatives. However, given the now highly

stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the Committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise. Furthermore, with

the target funds rate at 1 percent, substantial further conventional easings could

be implemented if the FOMC judged such policy actions warranted. Doubtless, some

financial firms would experience difficulties in such an environment, but these

intermediaries have exhibited considerable flexibility in the past to changing circumstances. More broadly, as I indicated earlier, the FOMC stands ready to maintain a highly accommodative stance of policy for as long as it takes to achieve a

return to satisfactory economic performance.

50

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY

FROM ALAN GREENSPAN

Accuracy of Credit Reports

Q.1. The Banking Committee is currently considering whether to

reauthorize the preemption provisions of the Fair Credit Reporting

Act. An issue that has emerged from our hearings is the fundamental importance of the accuracy of the information contained in

credit reports.

A.1. The information gathered by credit reporting companies on the

borrowing and payment experiences of consumers is a cornerstone

of the consumer credit system in this country. Experience indicates

that the information assembled and provided by these companies

enables our consumer credit and mortgage markets to function

much more efficiently than would otherwise be possible. Moreover,

automated credit evaluation systems based on that information

have improved the overall quality and reduced the cost of credit decisions while expanding the availability of credit. These benefits of

the credit reporting system are evident both from comparison with

other countries that have less developed information sharing structures, and from statistical analyses demonstrating the usefulness

of credit history information for predicting an individual’s future

performance with new credit.

Q.1.a. Would you agree that accurate reports are essential for the

efficient operation of our economy considering the prevalence of

their usage and the manner in which risk-based pricing calibrates

credit risk to credit price?

A.1.a. Clearly, some minimum degree of accuracy of credit reports

is required for such benefits to be realized. Moreover, the more accurate the information assembled by credit reporting companies,

the greater the potential to enhance efficiency in the credit granting process, reducing costs to the advantage of both the consumers

and creditors.

Although inaccuracy can limit the potential efficiency benefits

from a well-developed credit reporting system as well as disadvantage individual consumers who have errors in their credit reports,

there are limits to the degree of accuracy that can be obtained

without undue costs. Some inadvertent errors inevitably will arise

in a system comprising millions of account records and billions of

transactions yearly. The fact of some degree of inaccuracy does not

necessarily argue that the system is not functioning well, or for

strong measures to make changes in the system. Ultimately, the

question is the frequency with which errors in credit files actually

lead to improper credit-granting decisions.

At present it appears that the system is functioning reasonably

well and it is not obvious there are easy ways to improve accuracy

substantially without also raising costs. It is always useful to keep

in mind the importance of maintaining a system that serves its

intended purposes without onerous requirements that inflate costs

with only limited benefit.

More important, the FCRA itself has long contained a mechanism whereby consumers are able to review their credit reports

without cost in the case of an adverse action based upon a credit

51

* Held in the Senate Banking Committee files or available at http://www.federalreserve.gov/

pubs/bulletin/2003/0203lead.pdf.

report. More recently, many consumers have availed themselves of

opportunities provided by credit reporting companies to review

their own reports as frequently as they desire at nominal cost.

Over time, both mechanisms should continue to lead to improvements in the quality of information held by the credit reporting

companies.

Q.1.b. Does the Federal reserve have any definitive statistics regarding the current level accuracy of credit reports?

A.1.b. The information the Federal Reserve has concerning the accuracy of credit reports was reported in the Federal Reserve Bulletin earlier this year. This information was based on a nationwide

sample of credit records drawn as of June 1999, and as such may

not be representative of the information currently in credit reporting files. These data supported an assessment of the degree to

which credit files contain missing and ‘‘stale’’ (nonupdated) information, but did not permit an assessment of the degree to which

wrong information is present in credit files. The Federal Reserve

does not have any definitive statistics concerning the current level

of accuracy of credit reports. A copy of the article in the Federal

Reserve Bulletin is attached. *

Q.1.c. In light of the significance of this matter, do you believe

there should be an effort to obtain information regarding the level

of accuracy?

A.1.c. There has been little direct analysis of the degree of accuracy of credit reports; to the extent that studies have been done,

they are limited in scope or lacking in statistical rigor. On the

other hand, the credit reporting system is operating quite well at

present, despite some degree of inaccuracy in credit reporting. It is

not clear that the usefulness of an effort to obtain fuller information regarding the level of accuracy would justify the substantial

costs such an effort would require.

Potential Weaknesses in the Housing Market

Q.2. The housing market continues to prosper with low interest

rates spurring home purchases and refinancings. However, a recent

report from the Harvard University Joint Center for Housing Studies cited two concerns. First, the growing number of loans to

borrowers with weak credit histories. Second, the number of homeowners who have spent more than 50 percent of their incomes on

housing has increased significantly. To the extent these borrowers

are concentrated in particular markets or neighborhoods, any economic downturn could lead to an increasing number of late payments, and even foreclosures. Do you share these concerns and how

significant are they?

A.2. Recent developments in mortgage markets have provided

broader access to mortgage financing for borrowers with lower incomes and less-established credentials for borrowing. As you noted

from the report from the Joint Center for Housing Studies, expanding the availability of mortgage credit entails some risks. However,

the overall impact of this additional risk on the mortgage market

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and the economy as a whole is likely to be rather small. Data from

the Federal Housing Finance Board indicate that the average loanto-value ratio for mortgages excluding refinancings has decreased

from a touch below 80 percent in the mid-1990’s to an average of

73 percent so far this year. In addition, mortgages with loan-tovalue ratios of 90 percent or more have declined from 27 percent

of total mortgages in 1995 to less than 20 percent so far this year.

Moreover, house prices generally have risen fairly rapidly in recent

years, providing an equity cushion for many mortgagors.

Bank Capital and Credit Extension

Q.3. You mentioned in your testimony that the banks remain well

capitalized. How does this compare to previous recessions? Did

banks largely manage to avoid overextending credit during the

1990’s expansion?

A.3. Bank capital ratios by virtually all measures (including equity

relative to problem assets) are significantly higher now than in the

prior economic cycle, that is, in the early 1990’s. Moreover, 98.4

percent of all insured commercial banks meet the regulatory criteria to be considered ‘‘well capitalized,’’ which is the highest percentage in more than a decade of calculating the statistic. As stated

in my testimony, this depth and breadth of capitalization leaves

banks well-positioned to support economic growth through sound

lending.

It appears that banks have largely avoided the temptation to

overextend credit in the more recent period. Increases in problem

assets and credit losses over the past few years, while significant,

have been modest relative to those seen in the last recession. Nonperforming assets represent only about 5 percent of the capital and

reserves in place to absorb them compared with more than 27 percent at the end of 1991. Indeed, despite somewhat elevated levels

of nonaccrual loans, capital ratios have risen significantly during

the recent cycle, reflecting both record industry earnings and continuing supervisory attention to capital adequacy. Early indications

suggest that credit quality problems may have reached their peak

in the fall of last year and have receded gradually since then.

Basel II Capital Accord

Q.4. On July 11, 2003, the banking regulators released proposed

rules and guidance relating to the Basel II Capital Accord. It appeared from these releases that the bank regulators are not in total

agreement about these standards. What is the process for resolving

any disagreements between the regulators regarding the application of these standards?

A.4. Because the Basel II Capital Accord revisions encompass a

number of significant and complex issues, interagency differences

of opinion are to be expected. In our experience, these differences

and the interagency process in place that allows, as a matter of

course, for them to be fully aired and discussed, almost invariably

result in a better outcome from both a supervisory and industry

perspective than would be the case if a single agency was the sole

decisionmaker. Each agency has unique insights and experiences it

brings to particular issues and it is the agencies’ collective belief

that it is crucial to the success and the effectiveness of the final

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outcome that these be thoroughly considered and debated before a

final consensus is achieved.

The agencies have well-established interagency mechanisms for

communication and decisionmaking at all levels within the agencies. In particular, for the Basel revision process several chains of

communication are in place to develop U.S. views and communicate

them consistently to the Basel Supervisors Committee, the industry as a whole, and to other interested parties. For example, interagency staff meetings and conference calls are held almost daily on

one or more of the substantive issues raised by the proposed new

framework. Senior staff regularly schedules interagency meetings

prior to significant Basel meetings (most notably the Basel Supervisors Committee or the Capital Task Force). The agency principal

representatives also have scheduled meetings prior to significant

international meetings. Through these discussions, the U.S. views

on particular issues are formulated. In addition, as is always the

case, bilateral discussions on individual issues on an as-needed

basis are conducted so that concerns and objectives are appropriately addressed and achieved.

At the current stage of development of the revised Basel Capital

Accord, we expect that the agencies will have different views on a

number of issues. We are confident that, as we work through these

differences, the end result will be the best product for U.S. banking

organizations.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES

FROM ALAN GREENSPAN

Q.1. There are many questions as to how the Federal Reserve

would conduct monetary policy if it should decide that further easing was appropriate but that further reductions in the Fed funds

rate was not appropriate. In testimony before the Joint Economic

Committee in May, you stated that the Fed: ‘‘do[es] have the capability, should that be necessary, of clearly moving out on the yield

curve, essentially moving longer-term rates down and in the process expanding the monetary base and the degree of monetary stimulus.’’

In your written testimony at this hearing you also raised that

point: ‘‘The Federal Reserve has been studying how to provide policy stimulus should our primary tool of adjusting the target Federal

funds rate no longer be available. Indeed, the FOMC devoted considerable attention to this subject at its June meeting, examining

potentially feasible policy alternatives.’’

Chairman Greenspan could you describe in some detail what conclusions have been drawn from your research and conversation

during the June meeting? In addition, could you also answer the

following specific questions regarding the use of nonprimary tools

to provide economic stimulus:

Will the Fed set a target rate at a single point or range along

the yield curve as it currently does with the Fed funds rate?

If so:

What point or range along the yield curve will the

FOMC target? Will the FOMC announce the target point

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or range along the yield curve? Will the FOMC announce

the target interest rate for that point or range?

If not:

Will the FOMC specify some other policy variable related to longer term interest rates? If so, what would that

policy variable be?

Will the FOMC communicate its decisions in a manner similar

to its announcements regarding the Federal funds target rate or

will another method of communication be used? If you are contemplating additional or alternative methods of communication, could

you please describe how you envision they would operate?

A.1. The Federal Open Market Committee recently released the

minutes of its June 24–25, 2003, meeting, at which the issue of unconventional monetary policy tools was discussed. I have attached

the relevant section of those minutes for your convenient reference.

As that section makes clear, the FOMC believed that the probability that unconventional tools would be needed was quite low.

Consequently, the Committee’s discussion of unconventional policies was very general. Apart from agreeing that it would not be appropriate to establish an artificial floor below which the Federal

funds rate could not be lowered, the FOMC reached no decisions

on specific approaches to unconventional policies. As stated in

those minutes, ‘‘[t]he members did not see the need at this time to

reach a consensus on the desirability of any specific nontraditional

approach to the implementation of monetary policy, particularly

given the low probability of its near-term use. As experience had

shown, at times of economic and financial market stress the specific policy tools used would depend on circumstances. For now,

however, they believed that arriving at an understanding of the

various options that might be employed prepared them to respond

more flexibly and effectively to unanticipated developments.’’ Consequently, it is not possible to answer your specific questions at

present. However, as I indicated at the July hearing, the Federal

Reserve will communicate the relevant information to the public in

a timely fashion in the event that the adoption of unconventional

policies ever proves necessary.

Q.2. The President’s Fiscal Year 2004 Budget includes an increase

for the Bureau of Economic Analysis to launch several initiatives:

(1) purchase of more real-time data now collected by the private

sector, particularly scanner data; (2) collection of missing information on derivatives; (3) meeting international commitments for the

collection and presentation of information on international transactions and asset positions; and (4) acceleration of the processing

and release of balance of payments data. The BEA also continued

to purse its plan to accelerate the production of input-output tables

based on the 2002 economic census. What is your evaluation of

these initiatives?

A.2. The Fiscal Year 2003–2007 Strategic Plan prepared by the

BEA lays out a well-designed plan for improving the national economic accounts as well as the international accounts. The plan

reflects the input of many facets of the BEA’s user community, including the Federal Reserve. The initiatives presented in the PresiVerDate 11-MAY-2000 07:14 Jan 29, 2004 Jkt 000000 PO 00000 Frm 00058 Fmt 6633 Sfmt 6601 91369.TXT SBANK4 PsN: SBANK4
55

dent’s Fiscal Year 2004 Budget reflect the BEA’s requirements for

carrying out its strategic plan. The specific initiatives you mention

in your question will help BEA achieve two laudable objectives: (1)

improve the reliability and timeliness of GDP and related measures, and (2) meet the commitments of the United States to the

International Monetary Fund to increase the transparency, timeliness, and accuracy of data on our international investment position. Achieving these objectives will provide important benefits to

the formulation and the implementation of monetary and financial

policy at the Federal Reserve.

Excerpt from Minutes of the Federal Open Market Committee

June 24–25, 2003

The Committee discussed at length alternative means of providing monetary stimulus should the target Federal funds rate be

reduced to a point where there was little or no latitude for additional easing through this conventional policy instrument. The

members agreed that current economic conditions and the prevailing stances of monetary and fiscal policy made the need to use

unusual monetary policy tools a quite remote possibility. Even so,

they believed it was useful to discuss that possibility because of the

implications for financial markets and institutions and for the conduct of monetary policy of reducing short-term interest rates to

very low levels. An environment involving such interest rates could

have adverse repercussions on the functioning of some sectors of

the money market, but the members agreed that the potential

extent of such disruptions would not be sufficient to prevent the

Committee from taking advantage of the full scope of conventional

easing of the Federal funds rate, should that become necessary. Beyond that, a variety of nonconventional measures for further easing

was available. In this regard, the members discussed the advantages and disadvantages of various approaches that, possibly employed in some combination, would alter the size and composition

of the System’s balance sheet. They also considered aspects of the

Committee’s communications as a means of underscoring to the

public its willingness to follow a sufficiently accommodative path of

monetary policy for as long as necessary to foster improved economic performance. The members did not see the need at this time

to reach a consensus on the desirability of any specific nontraditional approach to the implementation of monetary policy, particularly given the low probability of its near-term use. As experience

had shown, at times of economic and financial market stress the

specific policy tools used would depend on circumstances. For now,

however, they believed that arriving at an understanding of the

various options that might be employed prepared them to respond

more flexibly and effectively to unanticipated developments. While

considerable uncertainty surrounded each individual policy option,

the members agreed that the effectiveness of these alternative

tools, along with the 125 basis points of conventional easing still

available, would allow monetary policy to combat economic weakness and forestall any unexpected tendency for a pernicious deflation to develop.

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING

FROM ALAN GREENSPAN

Q.1. The last time the FOMC met, you cut the Fed funds rate by

25-basis-points. The markets did not react well because they were

expecting a 50-basis-point cut. Yesterday, you indicated that more

cuts will be made in the near future. Why didn’t you just cut the

rate by 50-basis-points last time the FOMC met?

A.1. The Federal Open Market Committee judged at the time of the

June FOMC meeting that a 25-basis-point reduction in the Federal

funds rate, in the context of a substantial previous easing of monetary policy, a stimulative fiscal policy, and strong growth in productivity, would be sufficient to foster satisfactory growth in economic

activity. The economic data that have since come in hand have

tended to confirm that judgment.

I did not indicate that more rate cuts will be made in the future.

Rather, my point was that they could be made if circumstances

warrant.

Q.2. I want to get back to your testimony of last week on Natural

Gas Prices. Do you feel the high prices that we have had and expect in the future are largely because of past Federal Government

policies? Specifically, do you agree that in the past we have encouraged demand for natural gas by giving incentives to use it for electricity generation and for other uses without increasing supply by

allowing for new drilling?

A.2. We cannot on the one hand encourage the use of environmentally desirable natural gas in this country while being conflicted on larger imports of liquefied natural gas (LNG) and new

wells. Such contradictions are resolved only by debilitating spikes

in price.

Q.3. Would opening up the Artic National Wildlife Refuge (ANWR)

help the demand side?

A.3. Unquestionably, the more oil and gas that we get down into

the lower 48 the better for meeting our energy needs. I realize that

there is a very difficult tradeoff between maintaining the pristine

nature of the wilderness in the ANWR and the economic value of

producing the oil and natural gas that is located there. The tradeoff

is a value judgment that is up to Congress to make on behalf of

the American people.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR MILLER

FROM ALAN GREENSPAN

Manufacturing

Q.1. Many small manufacturing companies in my State feel that

they are under assault (principally from China) and if the trend

continues there will be few, if any, manufacturing (mostly textile

manufacturing) jobs left in America. On the other hand, large manufacturing companies like the fact that they can do more business

in China. How do we balance out the needs of both the large and

small manufacturing concerns? What should I tell my constituent

companies?

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A.1. Economists generally believe that the extent of a country’s

openness to trade and its integration with the rest of the world

exert positive influences on its economic growth and standard of

living. Among other things, international trade allows the United

States to purchase goods abroad at lower cost than we could

produce them at home. This raises our standard of living both directly, by reducing costs, and indirectly, by allowing us to specialize

in products in which we are most competitive. In some cases, the

opportunity to buy raw materials and intermediate inputs at lowest

global cost is the key to success for both large and small U.S. manufacturing concerns. Moreover, less competitive operations shrink

while capital investment contributes to the expansion of competitive enterprises that embody cutting-edge technologies; this process

of ‘‘creative destruction’’ leads to higher productivity and higher incomes. International trade, it should be added, is not a one-way

street: Not only does an open global trading system allow us to import more and at lower cost, but it also allows us to access foreign

markets and sell more of our product abroad.

It is certainly the case that as the adjustment engendered by

international trade proceeds, some industries that were once thriving but are now less competitive will experience distress. This may

lead to factories being shut down and workers being laid off. However, the proper response to the distress of particular sectors is not

to inhibit international competition, thereby limiting the growth

potential of the economy as a whole. Rather, we should focus our

response on enhancing job skills and retraining workers. If necessary, selective income maintenance programs could also be employed for those workers for whom retraining is problematic. More

generally, establishing the conditions for sustained economic

growth—macroeconomic stability, a strong financial system, and institutions that support market-driven private investment—should

allow the U.S. economy to fully exploit the benefits of international

trade while easing any associated transitional difficulties.

Q.2. I understand that in an answer yesterday to Representative

Mark Green, you said you had visited textile factories in the 1970’s

and also recently. Based upon this recent visit, you said you had

noticed how technology had become an integral part of manufacturing. I think you also said that as long as we have technology we

could be self-sufficient, and that ‘‘one pound of technology versus

one ton of raw materials,’’ means we have shifted resources to our

most effective parts. Am I quoting you correctly and what is your

overall view of what is happening to the manufacturing sector?

A.2. Modern technology has become an integral part of U.S. manufacturing in two ways. First, all products that we manufacture are

now produced with far more technology and appropriately different

infrastructure than used to be the case. Second, the composition of

U.S. manufacturing has been shifting toward goods that make

greater use of high technology in their manufacture. However, I

would not argue that technology makes the United States self-sufficient. Self-sufficiency is not, in itself, a valuable goal. Rather, the

specialization that goes with globalization has been extremely valuable to our economy and living standards. Where national security

is a concern, producing particular goods here rather than importing

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them from abroad may be essential. In other cases, the key objective is to raise the productivity of American workers in whatever

they are producing.

Effects of State Budget Deficits

Q.3. Just yesterday, in The Washington Post a lead story entitled

‘‘Budget Woes Trickle Down’’ discussed a lady who said ‘‘her taxes

are going up so much that, at 70, she may have to sell her house

to pay them.’’ The article goes on to say that State and local governments, to meet their Federal responsibilities in education,

health care, and homeland security obligations, are either having

to make cuts or raise taxes. In February, the National Conference

of State Legislatures said States’ current budget gaps have grown

to a total of nearly $26 billion [for this year]. What is more, the

shortfall projected for fiscal 2004, the budget year that States are

now planning for, is forecast to be at least $68.5 billion—and probably will rise significantly since 11 States had no projections.’’

Chairman Greenspan, what impact will the State and local governments decisions to either cut programs or raise taxes have on an

economic recovery?

A.3. In the short-run, State and local government decisions to cut

spending or raise taxes would tend to reduce aggregate demand

and slow (other things held constant) the growth of output a bit.

However, in comparison to other factors that recently have had a

positive effect on aggregate demand and the economy (such as the

recent Federal tax cut and added spending for the Iraq war and

homeland security), the adjustments that States and localities will

need to make to restore budget balance are small. Indeed, the effects of an improving economy on State and local tax receipts likely

will produce a significant portion of the required adjustment.

Moreover, in the longer run, improved State and local budget

balances also have a positive effect on national saving and the

economy. In particular, the increased saving will set the stage for

future productivity gains by keeping long-term interest rates low

and encouraging investment.

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