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S. HRG. 109–164

THE ECONOMIC OUTLOOK

HEARING

BEFORE THE

JOINT ECONOMIC COMMITTEE

CONGRESS OF THE UNITED STATES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

JUNE 9, 2005

Printed for the use of the Joint Economic Committee

(

(II)

JOINT ECONOMIC COMMITTEE

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

HOUSE OF REPRESENTATIVES

JIM SAXTON, New Jersey, Chairman

PAUL RYAN, Wisconsin

PHIL ENGLISH, Pennsylvania

RON PAUL, Texas

KEVIN BRADY, Texas

THADDEUS G. MCCOTTER, Michigan

CAROLYN B. MALONEY, New York

MAURICE D. HINCHEY, New York

LORETTA SANCHEZ, California

ELIJAH E. CUMMINGS, Maryland

SENATE

ROBERT F. BENNETT, Utah, Vice Chairman

SAM BROWNBACK, Kansas

JOHN SUNUNU, New Hampshire

JIM DEMINT, South Carolina

JEFF SESSIONS, Alabama

JOHN CORNYN, Texas

JACK REED, Rhode Island

EDWARD M. KENNEDY, Massachusetts

PAUL S. SARBANES, Maryland

JEFF BINGAMAN, New Mexico

CHRISTOPHER J. FRENZE, Executive Director

CHAD STONE, Minority Staff Director

(III)

CONTENTS

OPENING STATEMENT OF MEMBERS

Representative Jim Saxton, Chairman, a U.S. Representative from New Jersey .......................................................................................................................... 1

Senator Jack Reed, Ranking Member, a U.S. Senator from Rhode Island ......... 2

Senator Robert F. Bennett, Vice Chairman, a U.S. Senator from Utah ............. 12

Representative Carolyn B. Maloney, a U.S. Representative from New York ..... 14

Senator Jim DeMint, a U.S. Senator from South Carolina .................................. 15

Representative Maurice D. Hinchey, a U.S. Representative from New York ..... 16

Representative Ron Paul, a U.S. Representative from Texas .............................. 17

Representative Loretta Sanchez, a U.S. Representative from California ........... 20

Representative Kevin Brady, a U.S. Representative from Texas ........................ 22

Representative Elijah E. Cummings, a U.S. Representative from Maryland ..... 24

Representative Thaddeus G. McCotter, a U.S. Representative from Michigan . 35

WITNESSES

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

Reserve System .................................................................................................... 4

SUBMISSIONS FOR THE RECORD

Prepared statement of Representative Jim Saxton, Chairman ........................... 40

Letter from Chairman Saxton to Chairman Greenspan ...................................... 41

Response of Chairman Greenspan to letter from Chairman Saxton ................... 44

Prepared statement of Senator Jack Reed ............................................................ 50

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

Federal Reserve System ...................................................................................... 52

(1)

THE ECONOMIC OUTLOOK

THURSDAY, JUNE 9, 2005

CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITTEE, Washington, DC.

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

HR–2118, Rayburn House Office Building, the Honorable Jim

Saxton, Chairman of the Committee, presiding.

Representatives Present: Representatives Saxton, English,

Paul, Brady, McCotter, Maloney, Hinchey, Sanchez, and

Cummings.

Senators Present: Senators Bennett, DeMint, and Reed.

Staff present: Chris Frenze; Colleen Healy; Bob Keleher; Brian

Higginbotham; John Kachtik; Natasha Moore; Jeff Wrase; Chad

Stone; Matt Solomon; and Nan Gibson.

OPENING STATEMENT OF HON. JIM SAXTON, CHAIRMAN,

A U.S. REPRESENTATIVE FROM NEW JERSEY

Representative Saxton. Good morning. The hearing will come

to order.

I am very pleased this morning to welcome Chairman Greenspan

before the Joint Economic Committee. Chairman Greenspan’s testimony will provide useful insights on the current economic expansion and the potential for further economic progress.

A broad array of standard economic data indicates that the economic expansion is on a solid footing. The U.S. economy grew 4

percent in 2004 and advanced at a 3.5 percent rate in the first

quarter of 2005.

A rebound in business investment has played an important role

in explaining the pickup of the economy since 2003. Equipment and

software investment has also been strong over this period.

The improvement in economic growth is reflected in other economic figures as well. For example, over the last 4 months, 3.5 million jobs have been added to the business payrolls. The unemployment rate stands at 5.1 percent, consumer spending continues to

grow, home ownership is at record highs and household net worth

is also at a high level.

Meanwhile, inflation pressures appear to be contained. Interest

rates remain at historically low levels with long-term interest

rates, including mortgage rates, actually declining recently. This

decline of long-term interest rates, even as the Fed is increasing

short-term interest rates, is very unusual, a topic I would like to

discuss later on.

2

In short, overall economic conditions remain positive. It is clear

that an accomodative monetary policy and tax incentives for investment have made important contributions to the improvement of the

economy in recent years. Recently released minutes from the Federal Reserve suggest that the central bank expects this economic

trend to continue. As always, there are some aspects of the economy that should be monitored quite closely. There appears to be

pressures in some local housing markets, but these are unlikely to

pose a significant threat to the national economic expansion.

Also, quite importantly, the increase in oil prices has had an impact on certain sectors of the economy, but has not severely undermined overall economic growth. A consensus of Blue Chip forecasters projects that the economic expansion will continue through

2005 and 2006. This is consistent with Federal Reserve forecasts

for economic growth through 2006.

In summary, the economic situation is solid and the outlook remains favorable. That is the good news.

At this point I would like to yield to the gentleman from Rhode

Island, Senator Reed.

[The prepared statement of Hon. Jim Saxton appears in the

Submissions for the Record on page 40.]

OPENING STATEMENT OF HON. JACK REED, RANKING

MEMBER, A U.S. SENATOR FROM RHODE ISLAND

Senator Reed. Thank you, Chairman Saxton, and welcome,

Chairman Greenspan, I want to thank you for coming here to testify today at a time when there are so many genuine puzzles about

the direction of the American economy. Chairman Greenspan, you

have been rather upbeat about the economic outlook and let me be

the first to say that I hope you’re right. However, I am concerned

about what continues to be a disappointing economic recovery for

the typical American worker. Economic insecurity for workers is

widespread as a healthy job recovery is yet to take hold, wages are

failing to keep pace with inflation, inequality is growing and private pensions are in jeopardy.

Job growth sputtered again last month when only 78,000 jobs

were added, calling into question the strength of the labor market

recovery. We still have not seen several consecutive months of solid

job gains, which is disappointing 42 months into a recovery.

At this point in the last recovery, the economy had created over

4 million more jobs than we have seen in this recovery and we regularly saw gains of 200,000 to 300,000 and sometimes even 400,000

jobs per month. Employers don’t seem to have enough confidence

in this recovery to pick up their pace of hiring.

Of course the real disappointment in this recovery is how workers have been left out of the economic growth we have seen so far.

Strong productivity growth has translated into higher profits for

businesses, not more take-home pay for workers. Since the start of

the economic recovery in late 2001, corporate profits from current

production have risen by 67 percent. By contrast, employee compensation rose by only 17 percent. Since the economy started generating jobs in June of 2003, the average hourly earnings of production workers in non-farm industries have fallen by 1.4 percent

after inflation.

3

The stagnation of earnings in the face of higher prices for food

and medical care is squeezing the take-home pay of workers. I hope

that the Federal Open Market Committee is paying close attention

to the labor market as they set the direction of monetary policy.

Workers have been short-changed so far in this recovery, and I believe that the economy should be able to accommodate some acceleration in wages to catch up to productivity growth without generating undue fears of inflation.

Any wage gains we have seen seem to be concentrated at the top

of the earnings distribution while the largest losses are at the bottom. As The New York Times noted this week, the distribution of

earnings has become so unequal that even the merely wealthy are

being left behind in the dust by the small slice of super-rich Americans.

I know, Chairman Greenspan, that you have expressed concern

about the widening inequality of income and earnings in the American economy. So this development cannot be encouraging to you.

Another troubling development is how unstable the private pension system is becoming. Data released this week by the Government’s Pension Benefit Guaranty Corporation show that the country’s 1,108 weakest pension plans had an aggregate shortfall of

$353.7 billion at the end of last year, 27 percent more than the previous year. Meanwhile, the PBGC itself is underfunded.

Social Security does face long-term challenges, but at the moment it looks like the strongest leg of our retirement system. Rising national savings is the key to our economic growth, a good way

to reduce our record trade deficit and, as your past testimony reflects, the best way to meet the fiscal challenges posed by the retirement of the baby boom generation. Unfortunately, the President’s large Federal budget deficits are undermining national saving and leaving us increasingly hampered in our ability to deal

with the host of challenges we face.

The President’s policy priority for large tax cuts for those who

are already well off and private retirement accounts that add to the

debt and worsen Social Security solvency would take us in exactly

the wrong direction for the future.

Finally, there are real questions about whether today’s workers

can look forward to a future of economic prosperity or one of continued risk and uncertainty about whether they will have good jobs

and the means to provide a comfortable standard of living for their

families. Indeed, it is a very real question in the mind of all the

people I represent whether they will enjoy the same standard of

living that their parents enjoyed before them or are enjoying at

this moment, and for the first time in my lifetime there is serious

concern that the quality of life—the standard of living in the

United States will slip rather than progress forward.

Chairman Greenspan, I look forward to your testimony about the

economic outlook and exploring some of these issues with you further in the questioning. Thank you, Mr. Chairman.

[The prepared statement of Hon. Jack Reed appears in the

Submissions for the Record on page 50.]

Representative Saxton. Mr. Chairman, thank you again for

being with us this morning, and we look forward to your testimony.

4

STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN,

BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM

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

and Members of the Committee. I am pleased once again to appear

before this Committee, as I have done for many a year.

Over the past year, the pace of economic activity in the United

States has alternately paused and quickened. The most recent data

support the view that the soft readings on the economy observed

in the early spring were not presaging a more serious slowdown in

the pace of activity. Consumer spending firmed again, and indicators of business investment became somewhat more upbeat. Nonetheless, policymakers confront many of the same imbalances and

uncertainties that were apparent a year ago.

Our household savings rate remains negligible. Moreover, only

modest, if any, progress is evident in addressing the challenges associated with the pending shift of the baby boom generation into

retirement that will begin in a very few years. And although prices

of imports have accelerated, we are at best in only the earliest

stages of a stabilization of our current account deficit, a deficit that

now exceeds 6 percent of U.S. Gross Domestic Product.

A major economic development over the past year has been the

surge in the price of oil. Sharply higher prices of oil imports have

diminished U.S. purchasing power. The value of petroleum imports

rose from 1.4 percent of nominal GDP in the first quarter of 2004

to 1.8 percent in the first quarter of this year. The alternating

bouts of rising and falling oil prices have doubtless been a significant contributor to the periods of deceleration and acceleration of

U.S. economic activity over the past year.

Despite the uneven character of the expansion over the past

year, the U.S. economy has done well, on net, by most measures.

Real GDP has grown by 3.7 percent over that period, the unemployment rate has fallen to 5.1 percent and core personal consumption expenditures prices have risen a historically modest 1.6 percent.

But the growth of productivity, though respectable at 2.5 percent

over the year ending in the first quarter, is far less than the extraordinary pace of 5.5 percent during 2003.

Excluding a large, but apparently transitory, surge in bonuses

and the proceeds of stock option exercises late last year, overall

hourly labor compensation has exhibited few signs of acceleration.

Thus, the rise in underlying unit labor costs has been mainly the

result of the slower growth of output per hour. At the same time,

evidence of increased pricing power can be gleaned from the profit

margins of non-financial businesses, which have continued to press

higher even outside the energy sector. Whether that rise in unit

costs will feed into the core price level or be absorbed by a fall in

profit margins remains an open question.

Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates in U.S. Treasury securities despite a 2 percentage point increase in the Federal funds rate.

This is clearly without recent precedent. The yield on 10-year

Treasury notes, currently at about 4 percent, is 80 basis points less

than its level a year ago. Moreover, even after the recent backup

in credit risk spreads, yields for both investment grade and lessVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00008 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
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than-investment grade corporate bonds have declined even more

than Treasuries over the same period.

The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and June of last year market

participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large

short positions in long-term debt instruments in anticipation of the

increase in bond yields that has been historically associated with

a rising Federal funds rate. But by summer, pressures emerged in

the marketplace that drove long-term rates back down. And in

March of this year, market participants once again bid up longterm rates, but as occurred last year, forces came into play to make

those increases short lived. There remains considerable conjecture

amongst analysts as to the nature of those market forces.

That said, there can be little doubt that exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages,

have been a major factor in the recent surge of home building and

home turnover and especially in the steep climb in home prices. Although a bubbling in home prices for the Nation as a whole does

not appear likely, there do appear to be at a minimum signs of

froth in some local markets where home prices seem to have risen

to unsustainable levels.

The housing market in the United States is quite heterogeneous,

and it does not have the capacity to move excesses easily from one

area to another. Instead, we have a collection of only loosely connected local markets. Thus, while investors can arbitrage the price

of a commodity such as aluminum between Portland, Maine and

Portland, Oregon, they cannot do that with home prices because

they cannot move the houses. As a consequence, unlike the behavior of commodity prices, which varies little from place to place, the

behavior of home prices varies widely across the Nation.

Speculation in homes is largely local, especially for owner-occupied residences. For homeowners to realize accumulated capital

gains on a residence, a precondition of a speculative market, they

must move. Another formidable barrier to emergence of speculative

activity in housing markets is that home sales involve significant

commissions and closing costs, which average in the neighborhood

of 10 percent of the sales price. Where homeowner sales predominate, speculative turnover of homes is difficult.

But in recent years, the pace of turnover of existing homes has

quickened. It appears that a substantial part of the acceleration in

turnover reflects the purchase of second homes, either for investment or vacation purposes. Transactions in second homes of course

are not restrained by the same forces that restrict the purchases

or sales of primary residences. An individual can sell without having to move. This suggests that speculative activity may have had

a greater role in generating the recent price increases than it has

customarily had in the past.

The apparent froth in housing markets may have spilled over

into mortgage markets. The dramatic increase in the prevalence of

interest-only loans, as well as the introduction of other relatively

exotic forms of adjustable rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be emVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00009 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
6

ploying these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures

in the marketplace.

The U.S. economy has weathered such episodes before without

experiencing significant declines in the national average level of

home prices. In part, this is explained by an underlying uptrend in

home prices. Because of the degree of customization of homes, it is

difficult to achieve significant productivity gains in residential

building despite the ongoing technological advances in other areas

of our economy. As a result, productive gains in residential construction have lagged behind the average productivity increases in

the United States for many decades. This shortfall has been one of

the reasons that house prices have consistently outpaced the general price level for many decades.

Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur,

likely would not have substantial macro-economic implications. Nationwide banking and widespread securitization of mortgages make

it less likely that financial intermediation would be impaired than

was the case in prior episodes of regional house price corrections.

Moreover, a substantial rise in bankruptcies would require a quite

significant overall reduction in the national average housing price

level because the vast majority of homeowners have built up substantial equity in their homes despite large home equity withdrawals in recent years financed by the mortgage market.

In conclusion, Mr. Chairman, despite some of the risks that I

have highlighted, the U.S. economy seems to be on a reasonably

firm footing and underlying inflation remains contained. Accordingly, the Federal Open Market Committee in its May meeting reaffirmed that it ‘‘believes that policy accommodations can be removed at a pace that is likely to be measured. Nonetheless, the

Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.’’

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

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

Submissions for the Record on page 52.]

Representative Saxton. Mr. Chairman, thank you very much

for that very thorough statement. I would like to lead off with a

question that relates to something that you mentioned early in

your testimony, and that is the unusual set of circumstances that

we see in the relationship between short-term and long-term interest rates.

Over the last year or so, the Fed has increased short-term interest rates by a quarter point 8 times. And long-term rates, as you

pointed out in your testimony, have come down.

There is a chart displayed there that shows the increase in shortterm rates and that historically during a period of time such as

this, long-term rates would be expected to follow an upward path.

However, as the blue line shows, that has not happened. In this

case, and as a matter of fact I don’t know what the Fed policy is

going to be going forward, but if this trend continues those two

lines could actually meet at some point. So I have essentially three

questions.

7

In your opinion, what has caused this unusual set of circumstances in the relationship between short-term and long-term

rates? Second, what do you think might be the potential effects of

it on the economy going forward? Third, does this relationship suggest any negative impact on prices and in our ability to control inflation? Is there anything that from a policy point of view we

should begin to look at to correct the situation, if in fact it needs

to be corrected? And I would be interested in your thoughts on

those questions.

Mr. Greenspan. Well, Mr. Chairman, with respect to your first

question, as I have indicated previously in various commentaries,

this particular configuration is unprecedented in recent experience.

Indeed, it is even more exaggerated than it appears on the chart

for a very important reason; namely, that the 10-year note which

is I believe what you have plotted up there——

Representative Saxton. Is that correct?

Mr. Greenspan [continuing]. Is actually an average, both of

long-term rates, meaning, say, a combination of 1-year maturities,

9 and 10 years out, and comparable 1-year short-term rates. If you

average them out, you get the 10-year yield. But it means that

when the Federal Reserve is raising the Federal funds rate, the

short end of the market goes up, and the elements that go into the

construction of the 10-year average automatically go up solely because the short-term rates have gone up, which means that the

longer term rates—that is, say, from the 5-year maturities—the 1-

year maturities 5 years out and longer, have actually gone down

more. And if you actually plot those data it is the fastest decline

that we have seen in that longer term set of patterns in many decades.

So something unusual is clearly at play here. We have concluded

that it is not a U.S. phenomenon because all one needs to do is look

abroad and you get very much the same patterns that we see here

in the United States. So it is clearly of international origin. There

are numbers of hypotheses, frankly all of which are credible to one

degree or extent, which people have put forth to explain this. They

run anywhere from that the world economy is slowing down to the

fact that the degree of and pace of global integration is such as to

open up very significant areas of educated, low-cost employment

pools in China, India, and in the former Soviet Union. There are

vast numbers of people who are skilled, educated, and have a very

significant interest in working hard, and they have all come on the

market at the same time and have had the effect, as best we can

judge, in bringing the cost structure in the world down, which obviously would be reflected in inflation premiums in the low end of

the market, which clearly have gone down. I might say both inflation premiums and the real risk premiums as well.

All of these in one way or another probably are part of the explanation. We don’t know yet which are the really important ones and

probably will not know except in retrospect. But it is a profoundly

important phenomenon and really quite different from what one

would expect. Its effect on the United States is very clear in the

sense that, as I pointed out in my prepared remarks, mortgage

rates are lower than they would ordinarily be in a regular cyclical

pattern in the United States, and the consequence of that is we

8

have had a very strong housing market, as I am sure you are all

aware.

But certain elements of froth are clearly developing in local markets as a consequence. The low long-term interest rates have also

obviously affected other asset values, stock prices, and asset prices

elsewhere and has undoubtedly been a factor in the expansion of

the economy. How this will all turn out and how we integrate it

into the basic underlying monetary policy structure is something

we are spending a very considerable amount of time on, making

certain we understand this process that is going on as best we can.

Obviously, as you point out in your third question, what may be

quite critical here with these lower long-term rates than we ordinarily expect, is to be sure it isn’t potentially engendering inflationary forces, and that is something which, needless to say, we are

focusing on very extensively, endeavoring to get as much data as

we can.

At the moment we are finding little evidence of inflationary pressures on the product side, but it is certainly the case that underlying unit labor costs are rising. There is some evidence, as I indicated in my prepared remarks, that passing through of costs has

been easier, but in any event, the overall inflation rate does at this

stage remain modest. But we will remain vigilant.

Representative Saxton. Thank you. Let me just follow up, Mr.

Chairman. During this period of time when we have seen increased

short-term rates and falling long-term rates, the economy, as you

note in your statement, seems to be doing reasonably well. You

note that the economy has done well on net by most measures as

a matter of fact, and you cite standard data on GDP growth, unemployment, and inflation that reflect the ongoing economic expansion.

In addition, Fed projections of economic growth for 2005 and

2006 are generally consistent with the Blue Chip consensus, are

they not?

Mr. Greenspan. I believe they are, Mr. Chairman.

Representative Saxton. And your statement also suggests that

despite risks to the economic outlook, the economic expansion currently appears to be strong enough to absorb additional tightening

of monetary policy without serious damage. Is this a reasonable

reference to your remarks? Am I right in saying that?

Mr. Greenspan. I don’t wish to go beyond the statements that

the Federal Open Market Committee have agreed upon, and the

way we have formulated it is basically the way I communicated in

the very tail end of my prepared statement.

Representative Saxton. One final item and then we will turn

to Senator Reed. In this morning’s Wall Street Journal there is an

article which credits past Fed policy for curbing the effects of the

collapse of the stock market and the tech investment bubble in

2000. At the same time, the article suggests that an accommodative Fed policy has instead contributed to a housing bubble.

It seems to me that given the enormous shocks to the economy

from the collapse of the stock market and technology bubbles in

2000, that the Fed did the right thing in relaxing monetary policy

and in retrospect perhaps could have done that even sooner. The

thrust of Fed policy seems to have averted what could have been

9

a much more serious economic fallout from the popping of the bubbles in 2000.

Looking back, do you believe that the Fed relaxation of monetary

policy after the busting of the bubble in 2000 was the best course

given the risky conditions at the time?

Mr. Greenspan. I do, Mr. Chairman. We couldn’t draw that conclusion at the point we were implementing the policy, because we

knew that what we were doing—that is, addressing the consequence of a very severe deflation of a bubble—carried with it potential side effects.

As best we can judge, things have turned out reasonably as we

had expected, both positively and negatively. But in our judgment,

the positive effects of the policy far exceeded the negative ones.

And we decided at that time it was the appropriate policy to initiate, and while it is too soon to judge the final conclusions of how

all of this comes out, I think that given the same facts under the

same conditions we would have implemented the same policy.

Representative Saxton. I thank you very much, Mr. Chairman.

Senator Reed.

Senator Reed. Thank you very much, Chairman Saxton, and

thank you, Chairman Greenspan. Let me for a moment focus on

several aspects of your testimony, first your very useful comments

about the recent spike in employee compensation for the past two

quarters. As I understand your testimony, this was attributable

generally to a surge in bonuses and stock option exercises that are

transitory, is that correct?

Mr. Greenspan. As best we can judge. We don’t have actual official data. All we get are the data that are reported under the unemployment insurance system, which accounts for almost 100 percent coverage of wages and salaries. What we do not get is a breakdown in any form which tells us where it is. We have other data

which gives us the level of employment by supervised workers and

non-supervisory workers and payroll data for non-supervisory

workers, so we can infer certain things. And as you pointed out in

your earlier remarks, there really is a very substantial difference

in the labor market where the 80 percent of the non-supervisory

workers’ wage increases have been relatively modest, and indeed if

you deflate by the Consumer Price Index it is actually negative. I

don’t like the Consumer Price Index, but you do you get the numbers you are suggesting. What happens, however, is that the 20

percent, which is an issue of the supervisory, skilled and other

workers, is reflecting a problem which we have discussed in the

past; namely, we have a very significant divergence in our labor

market which has consequences we need to address soon rather

than later.

Senator Reed. As a follow-up point, Mr. Chairman, so wage

compensation is not a significant factor in driving inflation, as you

pointed out. If you use the Consumer Price Index deflator it is almost negative. Is that a fair statement?

Mr. Greenspan. That would not be true if you included 100 percent of workers. In other words, wages and salaries per hour overall, even excluding bonuses and stock option realizations, are rising

at a reasonably good clip, because the rate of increase in the superVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00013 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
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visory, skilled worker categories is far faster than the numbers you

were quoting.

Senator Reed. But essentially what we are seeing, I think unfortunately, is a divergence between highly-skilled, highly-compensated individuals and the rest of the work force. And we have

had this discussion before, and I know we all like to think about

the better education and better training, et cetera, but in the short

run, in the immediate run, what policy options should we pursue

to enhance the incomes of most of the workers of America?

Mr. Greenspan. Well, Senator, I don’t think there are shortterm policies other than the ones we typically use to assuage those

who fall into unemployment or policies in the tax area which we

endeavor to redistribute income.

The basic problem, as we have discussed previously, as best I can

judge, goes back to the education system. We do not seem to be

pushing through our schools our student body at a sufficiently

quick rate to create a sufficient supply of skilled workers to meet

the ever-rising demand for skilled workers, which means that wage

rates are accelerating. But the very people who have not been able

to move up into the education categories where they become skilled

overload the lesser skilled market and cause wages to be moving

up, well below average. The consequence, of course, is a divergence

and an increased concentration of income.

And as I have often said, this is not the type of thing which a

democratic society, a capitalist democratic society can really accept

without addressing, and as far as I am concerned the cause is very

largely education. It is not the children, because at the 4th grade

they are above world average. Whatever it is we do between the

4th grade and the 12th grade is obviously not as good as what our

competitors abroad do because we, our children, fall below, well

below, the median in the world, which suggests we have to do

something to prevent that from happening. And I suspect were we

able to do that we will indeed move children through high school

and into college and beyond in adequate numbers, as indeed we did

in the early post-World War II period, such that we do not get the

divergence in income which is so pronounced in the data we currently look at.

Senator Reed. I have other questions, but this argument can be

looked at from a different perspective. Back in the 1950s and the

1960s, we had jobs that were producing incomes for families. We

had college education costs which were reasonable. We had in some

respects better access to health care at more affordable prices so

that families could, in fact, save and provide for their children in

a way that they can’t do today.

But let me move forward. This is a debate that will go forth, I

think, further.

You mentioned in response to Chairman Saxton’s question this

conundrum about interest rates, the yield curve, short-term and

long-term rates. But there are some that might see the lack of

movement in the long-term rates as a justification for deficits; i.e.,

deficits don’t make a difference, but I think, Mr. Chairman, you

have also insisted that deficits do make a difference ultimately for

interest rates. Is that true?

Mr. Greenspan. It is, Senator.

11

Senator Reed. And essentially we have choices before us with

respect to these budget deficits. They will, if we don’t respond to

them, continue to impair national savings and thus our ability to

invest in the economy. Is that correct also?

Mr. Greenspan. I believe so.

Senator Reed. And it seems to me at a time where we have to

deal with the interest rates to further compound our problems by

further reducing taxes, such as the estate tax, would be exactly the

wrong direction to pursue. What is your view, Mr. Chairman?

Mr. Greenspan. Well, all I can say is that I have argued before

the relevant committees that fiscal policy as it moves into the early

part of the next decade is going to run into very severe problems

unless we restore PAYGO and other means of restraint on the system. And so I don’t want to get involved in any particular policy

configurations, but I do think that we have to recognize that something very unusual is about to happen to this country in that we

are going to get a huge exodus from the labor force. And remember,

the baby boom generation was followed by the baby bust generation, which means that we have relatively fewer workers, on average, ever increasingly as we move into the next decade and beyond

to produce the goods and services required, not only for the workers and their families, but for the huge increase in retirees. So we

have a very important task out there of creating a level of savings

and investment which will make sure that the replacement rate in

real terms of retirees enables them to maintain a reasonably adequate standard of living without encroaching on the growth in

standard of living of the American work force.

Senator Reed. Just a final point, Mr. Chairman. It seems that

we have positioned ourselves adversely to deal with that challenge

as we have gone from a surplus to a significant deficit, and that

the proposal of the Administration is to further exacerbate the deficit by tax policies. Again that New York Times article to me was

extraordinarily revealing. It has been estimated that if the President’s tax cuts are made permanent, Americans making between

$100,000 and $200,000, the new middle class in America if you

will, will be paying 5 to 9 percent more in taxes than those making

over $1,000,000 a year. That doesn’t seem to me to be either good

economic policy or good social policy.

Mr. Greenspan. Well, Senator——

Senator Reed. We have to deal with these issues.

Mr. Greenspan. I don’t want to comment on individual policies.

I have stated before to you—and other committees, on occasion—

that I do think that there are parts of the existing recent tax

changes, especially with respect to eliminating part of the double

taxation of dividends, which I think enhance economic growth, enhance the tax base and increase tax revenues. And that is good economic policy. Having said that, I would argue that all tax and all

spending policy should be under PAYGO, which therefore makes

them, theoretically at least, hopefully deficit neutral.

Senator Reed. Thank you, Mr. Chairman.

Representative Saxton. I would like to thank Senator Reed for

asking the question about the educational component. I think that

is extremely important, and I am going to ask my staff to perhaps

get with your staff, Mr. Chairman, to explore the details of the

12

studies that you have referred to, and I thank you for your input

on that.

Now that the Ranking Member has completed his questions, we

are going to move to Senator Bennett and, as we do, we are going

to implement the 5-minute rule in the interest of making sure that

all Members have an opportunity to ask questions as well.

Senator Bennett.

Senator Bennett. Thank you, Mr. Chairman.

Chairman Greenspan, I agree with you that we don’t really know

what is behind the anomaly indicated by the chart that the Chairman put up and there are a number of theories.

I want to suggest another one to you, because I know you believe

in the power of markets, that markets send us messages, that

many times those of us who are policymakers want to ignore and

think we are smarter than the markets. The market is saying

something interesting here, and I have heard the various explanations. The one that I want you to consider and perhaps comment

on, maybe the markets are being very complimentary to you and

the Open Market Committee by saying: we like the way you are

handling the challenge of inflation and we like the measured pace,

to use your phrase, with which you have adopted the overnight

rate increases. And the reason the long-term rates are as low as

they are is because we have confidence that inflation is under control.

If that is indeed what the combined wisdom of the market is saying here, it might suggest that when you got to 3.5 in June you

stop. Or August, I guess, would be the time that the anticipation

is. I know you are far too cagey to respond to the number here because the television cameras are running, but would you comment

on the idea that there may be a different kind of message here

coming from the marketplace in terms of the way the interest rates

are reacting to what the Fed is doing and talking about where you

think the ideal overnight rate should be, whether 3 percent, 5 percent, 4 percent, something of that kind in an ideal set of economic

circumstances, the target that you could live with?

Mr. Greenspan. Well, Senator, I have commented that it is very

difficult to know where that so-called neutral rate is, but we probably will know it when we are there, because we will observe a certain degree of balance which we had not perceived before, which

would suggest to us that we are very close to where that rate is.

We don’t have the statistical ability to forecast where it is or to

judge it other than being in place at a certain time and looking at

what the specific events are, because that means we don’t have to

forecast what happens, we just can observe. But if you have to forecast and then observe, it makes it exceptionally difficult.

On the broader question of whether it is a Fed correction or, as

it is more generally stated, credibility of central banks throughout

the world, we obviously would like to believe it, but the problem

with it is, it doesn’t give us any information that is useful to us.

In other words, if we said that is true, it doesn’t tell us what to

do. And so, that is for others to judge. My own suspicion is there

is less there than meets the eye. But even if I am mistaken on it,

it does not help in knowing what to do next.

13

Senator Bennett. I accept that. My only comment would be that

this anomaly, this extraordinary circumstance, might suggest that

the golden mean, if I can use that term, is lower than we may have

thought in the previous analysis with respect to this.

I would like to focus on one other issue, and that is long-term

savings. The savings rate in this country, as you have told us and

as we recognized, is lower than it ought to be. That has entered

into the debate with respect to how we might deal with the Social

Security crisis that we are facing. I agree with you that we are

going to have an extraordinary, indeed unprecedented, historical

event in the next 20 years. The percentage of Americans of retirement age is going to double in a 20-year period. It has also gone

up in an incremental fashion, but it is going to go up in a very

sharp upward fashion that has never happened before.

What can we do to stimulate increased savings? Well, I have

some suggestions as to what we could do to stimulate increased

savings, and one of them is a form of payroll deduction separate

and apart from the payroll deduction that goes into Social Security,

called the Save For Tomorrow accounts. I think you may be familiar with those.

Have you any feel, or any opinion, as to what would happen if

there was a more formal kind of payroll deduction across the economy aimed at increased personal savings? And if that was successful, Save For Tomorrow has been successful in the firms that have

used it. If that was successful across the economy would that have

a beneficial effect if we saw the savings rate of everybody start to

go up?

Mr. Greenspan. Well, Senator, the only new evidence we have,

if I can put it that way, with respect to savings concerns the suggestion that if right now an employee has to opt in on a 401(k), for

example, there is some evidence to suggest that if the 401(k) is

automatic unless the employee opts out, that we may find that

there is a significantly larger amount of savings that is being created.

Senator Bennett. That is an aspect of the Save For Tomorrow

account.

Mr. Greenspan. Yes, I understand that, so there is some evidence to suggest that there is something valid in that general proposition. I am a little gun-shy on the issue of inducing savings in

this country because I have seen just too many vehicles promising

to do something important, and as you know we have ended up

with a very low savings rate.

So it is clearly the market that is generating the vast amount of

the savings flows, the expansion and contraction, and I am reasonably certain that if we get a significant increase in savings, in

household savings for example, it is more likely to be reflective of

a slowdown in the rate of mortgage increases rather than any of

the other variables that we are using. But I would say that anything which does promise to increase savings is a very worthwhile

endeavor because, as I said before, the slow growth that is implicit

in the labor force starting 2006, 2010, and thereafter, if it is going

to produce enough goods to meet all the retirees’ needs as well as

those of workers themselves, has got to have a significant pickup

in output per hour growth. And that historically has been associVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00017 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
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ated with increased capital investment, which in turn requires

mainly domestic savings to finance it since we cannot count indefinitely on foreign savings doing that.

Therefore, anything which increases domestic savings has a double effect in one respect on the longer term outlook, because it will

displace the potential loss of foreign savings and contribute to a

level of savings that will be required to maintain a viable society

with a very large number of retirees.

Representative Saxton. Senator Bennett, thank you for bringing up that extremely important subject of savings. It is something

that is on all of our mind, and thank you for bringing that up.

Mrs. Maloney.

Representative Maloney. Thank you, Mr. Chairman, Ranking

Member, and welcome, Mr. Greenspan. As you indicated in your

testimony, the American economy is resilient and I expect that we

will continue to experience a cyclical recovery in the economy. But

I did not hear much in your statement about the longer run imbalances associated with our failure to address the problem with the

large Federal deficits, the largest trade deficit in our history and

the largest debt ever in our history, over $7.6 trillion, and like Senator Bennett, I am concerned about our national savings. And, as

you both indicated, our national savings is quite low as a share of

our national income. And aren’t large Federal budget deficits one

of the main reasons why?

Mr. Greenspan. They are, Congresswoman.

Representative Maloney. We are financing an increasing share

of our net national investment with foreign borrowing rather than

our own saving, and as you indicate we can only depend on our

own domestic savings and not on more foreign borrowing, but

aren’t we financing an increasing share of our net national investment with foreign borrowing rather than our own saving?

Mr. Greenspan. Well, the significant increase in foreign borrowing or, to be more exact, the significant increase in the amount

of financing of our domestic consumption that is coming from

abroad, a very considerable amount of it is not debt, but when it

is not United States debt, when it is not the United States that is

borrowing, it is foreigners who want to invest here. So it is a mixed

issue, but however you look at it, it is not something on which we

can depend indefinitely.

Indeed, our net debt on foreign income is rising quite significantly year after year and the service cost, that is of course quite

substantial. So we can’t count on that going on indefinitely and if

we are going to cite the level of capital stock that is necessary to

meet the requirement of, say, 2020, 2030, we are going to have to

get a much higher level of savings than we have and in the process

we are going to have to create capital assets which induce a very

significant rise in productivity growth.

Representative Maloney. Doesn’t that mean, this increasing

share of net national investment with foreign money—doesn’t that

mean that most of the benefits from that investment will accrue to

our foreign creditors rather than increasing standards of living

here in the United States for our citizens?

Mr. Greenspan. Congresswoman, it will depend wholly on what,

of course, are net claims on U.S. residents, because obviously to the

15

extent that we borrow or even get equity capital from abroad, we

have got to pay the servicing costs of that. When you have a very

large net foreign debt, a significant amount of domestic production

is essentially owned by foreigners. Indeed the income from production goes abroad and is not available to domestic residents of the

United States, so that the issue is essentially what is the level of

net claims against U.S. residents as a share of GDP, that being the

best measure, as I can see, to measure the type of problem you are

raising.

Representative Maloney. Can you talk with the Committee

about what would happen to interest rates and investment if foreigners were no longer willing to accept our IOUs?

Mr. Greenspan. Well, I don’t think that is going to be an issue

anywhere of significance, because there is always a question, what

do they do with their other resources? But having said that, we at

the Federal Reserve have looked at a very special part of that problem, which is the large accumulation of U.S. Treasury issues in foreign accounts.

What we have concluded is that because of the extraordinary

depth of the U.S. Treasury market, even as large as the holdings

are of those abroad, their impact on the Treasury interest rate

level is still rather modest. The reason why is that U.S. Treasuries

complete with a huge block of other debt instruments throughout

the world—both dollar dominated instruments, and of course a

very large block of foreign currency denominated issues.

As a consequence, even were the net accretion of U.S. Treasuries

on foreign accounts to cease, its impact, I think, would be evident,

but not serious.

Representative Saxton. I thank the gentlelady for the questions.

We will move now to Senator DeMint.

Senator DeMint. Thank you, Mr. Chairman.

Thank you, Mr. Chairman for being here today. I appreciate very

much the confidence that your steady hand has given to our economy over many years.

Today you have described a short-term economic situation as

steady, as sound. But reading between the lines, and I think about

what you have said about a long-term scenario, I think if we contemplated that for a few moments, it seems very alarming.

You have described a situation in which over the next 10 or 20

years, we will have the largest decrease in workforce and increase

in retirement that we have ever faced as a Nation. You have also

said at the same time that the workforce that we are leaving behind is well below an ability to compete in the international market as we are training them today.

As I look at where we are headed, it seems very close to Europe;

a little older society, moving toward heavy social benefits, raising

taxes to pay for it; a real burden on the economy. I mean, is it fair

to say that there should be a greater sense of urgency on this panel

and in Congress in dealing with our education situation, our entitlements?

With this massive change in front of us, it seems to me there

should be a greater sense of urgency on how to deal with this and

avoid the situation that many European nations are in. I know that

16

is a very broad question to answer, but if you could give us any

direction there, I would appreciate it.

Mr. Greenspan. As I have testified previously, before a number

of committees in the House and the Senate, as best I can judge,

especially with respect to Medicare, because of the huge prospective

increase in the number of beneficiaries, which will invariably occur

and our inability to have any real particular judgment of what the

trend in healthcare per beneficiary is going to be in the years out

into the future, there is a not insignificant probability that we have

already committed under existing law and presumed demographics

far more in real resources than we can actually deliver without significantly undermining the very base of the economic system.

I think that unless we start to address this issue sooner rather

than later, the markets will force it on us, and that is usually an

unhappy circumstance. So I think that the extent of entitlements

that have been created in the system have not been properly evaluated with respect to whether, in fact, the implicit real resources,

which those commitments require, fit into a reasonable expectation

of what the structure of the American economy is able to produce,

especially as you put it in the context of a labor force, which may

not have the skills that are required to create a level of goods and

services output that will be necessary to maintain reasonable

standards of living, not only of the working population, but of this

huge increase in retirees.

Senator DeMint. Thank you.

Representative Saxton. Thank you.

Mr. Hinchey.

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

Good morning, Chairman Greenspan, it is a pleasure to see you

and thank you for being here. I just wanted to make an observation

about the baby boom generation and the retirement of that baby

boom generation and the maintenance of those programs. It seems

to me that there are more children in secondary schools in America

today than ever before in history.

Our job is to create and maintain fiscal and monetary policies

that are going to insure that when they get out into the workforce,

they will have an abundance of good-paying jobs in order for programs like Social Security and Medicare to be sustained. That is

really what our job is, isn’t it, Mr. Chairman?

Mr. Greenspan. I would say that if we all are successful in

doing that, it is a job well done.

Representative Hinchey. You pointed out in your testimony

and in your response to questions that we are at a moment of conflicting economic circumstances, kind of a convergence of those conflicting circumstances. Since June, the Central Bank has reduced

short-term interest rates by 2 points.

Mr. Greenspan. Increased.

Representative Hinchey. Increased, rather, right. Thank you.

Increased short-term interest rates by 2 points, but at the same

time, the 10-year Federal Reserve bond has gone down by roughly

about 80 basis points, now, under 4 percent.

So the economic and financial world, as you pointed out, I think

very, very correctly, is indeed changing. My question is, does the

unusual behavior of the global bond market signal economic weakVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00020 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
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ness, because that is what we are hearing from other predictors,

from Wall Street, particularly?

Mr. Greenspan. Well, it is one of the possible hypotheses. There

is no question that growth is slowing in a goodly part of the world.

But this has been a characteristic of the world economy ever since

we started to seriously proceed toward advanced globalization,

which is what I would say occurs when you begin to get not only

trade imports and exports, expanding relative to the GDP which

has been occurring for the last 50 years, but, more importantly, in

addition, get savers willing to reach beyond their natural borders

to invest abroad, which is a phenomenon which has arisen in a material way only in the past decade.

What that has done is to alter the way the world’s economy functions. In so doing, I think we are getting a goodly part of backing

and filling and adjustments of all sorts in which you find that instead of the economy going very smoothly forward, it goes in little

cycles.

Hence it is often misread as though we are about to tilt into a

recession. I think in that respect, it is important to try to cut

through some of this. If that is the case, then the hypothesis that

it is a weak world economy, which has been driving down longterm interest rates, is probably not correct. Indeed, it can’t explain

the fact that rates were going down in 2004 when we had the fastest growth worldwide in a very long period of time.

The idea of weakness—there is a certain credible ring to it. But

when you begin to look at the details of the argument, it becomes

less persuasive.

Representative Saxton. Mr. Hinchey, thank you very much for

the questions.

We are going to move now to Mr. Paul.

Representative Paul. Thank you, Mr. Chairman.

Mr. Greenspan, I have a short question, hopefully, and then a

follow-up. You talked frequently about the conundrum that was

mentioned already today about the interest rates not being as low

as one would anticipate. I am wondering why this is such a conundrum in the sense that this could well represent just the flattening

of a yield curve, which is well-known and established and generally

presages a recession, and the fact that you have mentioned that

this is different in that it is worldwide. Could this not be a bad

omen, that it is just a flattening of a yield curve and presages a

coming recession?

Mr. Greenspan. Well, the flattening of the yield curves which

get engendered as a consequence of ever-tightening monetary policy

are usually in the context of rising short-term rates and rising

long-term rates.

Most importantly, in the context of where they are perceived to

be precursors of economic decline, it essentially commercial banks,

which are the main forces of intermediation in the economy. Because obviously, if short-term rates are rising and long-term rates

are holding steady or falling, and because the maturity of annual

bank assets is somewhat longer than the maturity of their liabilities, if you raise short-term interest rates and lower long-term interest rates, you get a squeeze in the commercial banking system

18

and a pulling back of loans, which has usually been in the past a

precursor of a significant decline in economic activity.

Representative Paul. Thank you. My second question has to do

with debt. You have frequently talked about us having too much

debt and too many deficits here in the Congress. But I am really

concerned about it when you look at the unfunded liabilities of

Medicare, the problems we face with Social Security, and now we

have evidence that our private pension funds backed up by the U.S.

Government probably have the characteristics of a Ponzi scheme

similar to Social Security and that their reporting requirements

have not required that they report their true assets, but just their

cash-flow.

But we have a current deficit which you talk about frequently,

and also a foreign debt that is into the trillions of dollars. I just

wonder if we might not be fooling ourselves about our prosperity.

Because if I could borrow a lot of money, if I could borrow $1 million every year, I would have pretty good prosperity and eventually

it would come to an end.

So a Nation probably has an end point as well. I think this has

been magnified by the fact that the efficiency of the central banker,

which you have explained that you have gotten fiat money to act

as if it is gold, and in some ways, I think that is true, that people

do accept our money, and that this encourages us to have more deficit, it encourages us to buy more than we pay for, buy more than

we save, and contribute to the current account deficit.

So it is the combination of the monetary system and the acceptance of our money that has contributed this huge debt. But most

people say, most economists recognize that there is a limit to how

far we can go on the accumulation of this debt.

It is almost a Catch 22. The more efficient we are in convincing

the world to take our money, the worse the problem gets, and the

bigger the bubble. Instead of borrowing that money to build our

manufacturing base, which we are not, everybody knows that is

dwindling, we are using it for consumption. So why is it that we

should be reassured that our prosperity is sound and we don’t have

to worry about paying this debt back?

Mr. Greenspan. Well, I think we have learned very early-on in

economic history that debt in modest quantities does enhance the

rate of growth of an economy and does create higher standards of

living, but in excess, creates very serious problems.

First of all, I would think that one way to address the question

you are raising with respect to unfunded liabilities is that we need

to do a good deal more of accrual accounting in the Federal Government, which will automatically pick that up and get a realistic size

of what we are dealing with. But there is no question that the

amount of debt that is out there has to be serviced, and so that

debt per se can not grow indefinitely.

But if we can grow indefinitely and sustainably, if we assure a

means of servicing that debt, which is essentially what we try to

do, but we may not be doing it as well as we should and have in

the past, we have not always done it well.

Let me just make one final remark, because I didn’t want to

leave the implication with respect to the yield curve as though I

19

am concerned that the potential tilting of the yield curve is

precursing a significant economic weakness.

What is different, in the past when commercial banking was our

key form of financial intermediation, is we have created many more

means of intermediation, so that even if the commercial banks pull

away, as they did indeed in the very early 1990s, like 1990–1991,

we have alternate means of financing. Indeed, with the increase of

technologies and the broader globalization, I would hesitate to read

into an actual downward tilt of the yield curve as meaning necessarily what it invariably meant 30, 40 years ago.

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

We are going to return to Mr. Hinchey. I think I may have shorted him on his time. Mr. Hinchey. You are recognized for 2 additional minutes.

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

Chairman.

Mr. Greenspan, I think you are absolutely correct, a modest

amount or reasonable amount of debt carefully applied and intelligently invested does lead to strong growth.

But the question is, how can it be carefully applied and intelligently invested? I think that part of the Federal debt that we

hold, which is approaching $8 trillion, is neither of those things.

You said a few moments ago that you continue to support the

President’s tax cuts. But the President’s tax cuts have not only contributed to the huge debt and the annual budget deficits that we

are experiencing, but they are also making it very difficult for us

to meet other obligations.

In your testimony and in response to questions, you emphasized

the importance of education and we all, I am sure, agree with you

on that. If we are going to be competitive in the future, we have

to have the best educational system training the best people in the

world.

But because of this debt and because of these huge budget deficits, the Federal Government is defunding education, all across the

board, and that is particularly true of higher education, making it

much more expensive and much more difficult for people to go to

college. The cutbacks in Medicare and Medicaid are causing problems for local and State governments, thereby causing them to

raise the price of education. In my State, for example, the Governor

has increased the cost of public education at the New York State

University system by enormous amounts over the course of the last

several years.

Aren’t we in some kind of a conflict here that we need to resolve?

Do you still support the tax cuts and do you believe that those tax

cuts should be made permanent?

Mr. Greenspan. Mr. Hinchey, I have said on numerous occasions that I support the tax cuts in the context of PAYGO. I support a lot of programs directly and indirectly, but only if they don’t

affect the deficit. The only way that is true is if they are passed

under PAYGO.

Now the problem is that I—and I suspect all—the Members of

Congress who have a vote, which I don’t have, have a lot of priorities. There is a physical amount of resources which is available to

make them real. We have to choose between a whole series of

20

things we all perceive to be of value. Indeed, numbers of bills that

have come up in the Congress would not have come up if a large

number of the House or the Senate didn’t believe it was a worthy

cause. But if you put them all together, it is very obvious that you

have a large number of worthy causes, but not enough resources

to meet them.

Representative Hinchey. But we have cut our resources, we

have cut our resources dramatically, and this Government has

abandoned PAYGO. Since the Government has abandoned PAYGO,

should we make the tax cuts permanent?

Mr. Greenspan. All I will say is I will repeat what I have said.

I have always approved of and have always made fiscal policy

choices and recommendations only in the context of PAYGO.

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

We are now going to move to Ms. Sanchez.

Representative Sanchez. Thank you very much, Mr. Chairman, thank you very much for being here today. I am a Blue Dog

Democrat. As you know, one of our policies is to try to institute

PAYGO as much as possible here in the Congress. You know, I live

my life under PAYGO, I have only one outstanding loan and that

would be a mortgage.

I don’t owe anybody any money—and I think that is a good way.

I think the biggest problem that the United States has is a large

debt and a large deficit situation going on, a structural problem

that is going to be very difficult to get ourselves out of. So I have

a question with respect to PAYGO, because you keep coming back

to it. I think we should switch to PAYGO.

I mean, if you were in Congress, what sort of—how would you

get to PAYGO? We have entitlements. We had a Medicare part D

plan that was passed that was supposed to be $400 billion over 10

years. It is $1 trillion and growing, who knows how that is going?

We had tax cuts, which the President’s own comptroller said that

the tax cuts are responsible for 70 percent of the deficit that is

going on. What that means is there is less revenue coming in.

Some had thought if we did tax cuts somehow we would get more

revenue, because people would invest more—and it doesn’t seem

like that really happened. We have defense spending going up, $1.5

billion a week in Iraq alone. You know, we don’t know how long

we are going to be there.

Then we have discretionary spending, education, transportation,

research, healthcare. You know I like to spend on investment. I

took out loans to go to college, as did the rest of my family members. I think that is a good place, if you are going to be spending.

You are concerned about the haves and have-not problem and

the gap growing wider. You are concerned about education, as you

told us. Yet the President’s policies have been to cut Head Start,

to shortchange No Child Left Behind by $9 billion, to cut funds at

the community college level, to cut student loans.

Where would you go to PAYGO? What would you do? What tax

cuts would you keep—I know you don’t like to get into individual

policies. But, you know, when you say you have got to get back to

PAYGO Congress, what do you mean by that?

Mr. Greenspan. Well, let me try to be as explicit as I dare.

21

We have passed a large number of bills on the outlay side, and

we have instituted a tax structure on the receipt side. They don’t

balance. But it is very clear that a majority of both Houses and the

President of the United States, whoever it was at the particular

time, thought that all of these items on both sides of the ledger

were things that were of value to the American people, but that

some of them are not possible, which means that choices must be

made between very goods and only lesser goods.

In other words, what is missing in the process is choosing between things that people think are of value. I have seen very little

in the way of interest in curtailing anything. There is a constituency out there for tax cuts. There is a constituency out there for

expenditure increases, and very little constituency for balancing

the budget—although I must say the Blue Dogs come as close as

any part of the Congress to being in that particular area.

But as I recall, when I first came to Washington in the 1970s,

there was at least an awareness that balancing the budget was a

critical issue. Indeed, we have carried out of the 1974 Act, from

which PAYGO—actually, PAYGO comes out of the combination of

the 1974 and the 1990 Acts. But we constructed a system which

essentially seemed to work. We have abandoned it, and I think

that we have got to find a way to construct a system which enforces the issue of choosing between A and B.

Right now, everybody wants A and B. Unless you repeal the laws

of arithmetic, it won’t work.

Representative Sanchez. Let me ask you another question.

This is with respect to housing, because I represent Orange County, California, probably the hottest housing market right now,

where the mean value of a resale 1,500-square-foot 40-year-old

home is running about $600,000.

You say in your testimony that you do not think—you say these

declines, were they to occur, would not likely have substantial

macro-economic implications. You are talking about maybe a decline in housing in certain markets.

You know, when I look at what is going on in Orange County,

I see interest-rate only loans, lots of them. I see ARMs that people

are just beginning to understand are going to choke them in the

next year or two. I see a lot of people who took equity out of homes

that grew with the housing boom, but which they are not—if housing stops—they are not going to be able to recover out of that.

How can you say, when the brightest spot in the economy has

been housing and refinance, how can you say that you don’t believe

that if there is a slowdown, even in some of these markets, that

it will have substantial macro—it will not have substantial macroeconomic implications?

Mr. Greenspan. It really gets to the question of what I mean

by ‘‘substantial.’’ Clearly, if you get a flattening out of prices, not

even a decline, and you gradually reduce the realized capital gains

and the unrealized capital gains on homes, equity extraction, which

is a very significant contributor to personal consumption expenditures, will go down. I have no doubt that as this boom begins to

basically diffuse, we will see the rate of increase in mortgage debt

largely driven by equity extraction, slow down.

22

Since a significant part of personal consumption expenditures—

and I might say home modernization—are financed by equity extraction, one would presume one will also be observing a slowing

in consumption expenditures. Higher savings, but slower economic

growth, at least as far as the consumer is concerned.

The reason I don’t suspect that there will be substantial macroeconomic effects is that I envisage, as it is occurring, capital investment will begin to take up the slack and growth will continue to

a greater or lesser extent.

So I am really not saying that it has no local effect. I mean, remember what happened to Silicon Valley, which is just up the

State from you. It had a really severe local effect. But it was not

a national macro-economic effect.

What I was referring to was basically not that it would have no

effect, but I don’t perceive it on net to be a major macro-economic

effect.

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

We will go now to Mr. Brady.

Representative Brady. Thank you, Mr. Chairman, I thank

Chairman Greenspan. I would like to ask two questions related to

the deficit, one trade and one our Federal financial deficit. You

have spoken frequently about the growing role of international

trade in the U.S. economy, about the savings to consumers, the opportunity to raise the standards of living, and a repeated note of

caution about the trade deficit.

We have a relatively open economy, yet we find when our companies try to compete around the world, we often run into strong tariff barriers and non-tariff barriers around the world. How important is it that we pursue a trade agenda and trade agreements, like

with Central America, that lower those trade barriers for U.S. producers of goods and services?

Mr. Greenspan. Congressman, I think it is exceptionally important. The major reason is that a very substantial amount of American prosperity is the consequence of an opening up of the world

trading system over the last 50 years. Everybody has benefited

from the increasing globalization, net—and I mean net. I do not

deny that as you get globalization and the churn of the economy,

there are winners and losers. But the number of winners are far

in excess of the number of losers. The resources that are created

in the process can help take care of those who are on the wrong

side of the tradeoff.

However, a very major part of our current standard of living

rests on our position in the global markets. If we start to retreat

from that, I think we will find that we are very significantly impaired with respect to living standards. Competition is not something anybody likes.

I didn’t like it when I was in the business community. I thought

my competitors were always unfair, and I wished they would go

elsewhere. But at the end of the day, I realized that they made me

work harder, do better and be more successful. It is a tough thing

to think in terms of, but that is what our problem is.

The facts are, the more we liberalize trade, the more we expand

it, the higher are our standards of living. While we might prefer

23

to be quiescent and not engage in so much competition, we can do

that. But there is a cost. That cost could be very significant.

Representative Brady. Thank you, Chairman. I will just thank

you. That was very revealing.

On our Federal deficit, I am convinced after 9 years in Congress,

if Congress were a manufacturing plant, we would manufacture

spending, that is what we are good at doing. If we want to manufacture savings and efficiency, we have to retool the plant, change

the process that we go about reaching our budget each year and

controlling spending.

In the past you have supported a sunset process where at the

Federal level we require agencies and programs to justify their existence or face consolidation, streamlining or, in some cases, elimination—the goal being to eliminate the duplication of services, to

eliminate obsolete agencies, to find a more thoughtful way really

of getting the bang for the buck up here.

Do you still support a sunset mechanism of some type, as a tool,

one tool, to help reach that efficiency?

Mr. Greenspan. I certainly do, Congressman. One of the reasons is, as you point out, it is exceptionally effective mechanism to

force a review of an ongoing program, whether it is an entitlement

or any other form of program. I think we would find, that even

though there is a general, conventional wisdom, that this country

is extraordinarily split 50/50, we would find that the vast majority

of programs that are now on the books would very readily be renewed without any question.

But enough of them would not be, and that could create fairly

considerable avenues of budget savings which we don’t seem to be

able to create these days. As you say, it is only one tool. I mean,

there are triggers, there are sunsets, there are a variety of other

things, along with PAYGO, which, as far as budget process is concerned, I think would give us a far more sensible structure. But I

have always envisaged sunset as being the crucial issue because

every agency, every program should be reviewed.

Another Member of your Committee, Senator Sarbanes, many

years ago, asked me when I was raising this issue, does that include the Federal Reserve? I said absolutely, Senator. If we cannot

convince the Congress that we should still be here, we shouldn’t be.

Representative Brady. Thank you, Chairman, very much.

Thank you, Chairman Saxton.

Representative Saxton. Thank you. We will move now to my

friend, Mr. Cummings.

Representative Cummings. Thank you, Mr. Chairman.

Chairman Greenspan, you know they say that when you speak,

to paraphrase the investment commercial, everybody listens. I am

hoping that they listen to some of the most powerful words I have

heard from you. Those were your comments on education and how

important education is and how we need to bring our children and

our young people up so that they can take on these jobs that you

talked about.

I am just wondering, if we have a situation where in many parts

of our country where 50 percent, sometimes as much as 60 percent,

of young people are dropping out of school, then you have a number

of students who will get a diploma, but can barely read the diploma

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itself. Even though we may—let us assume that the things that we

are doing now to try to help these young people become all that

God meant for them to be, taking into account all that you said

about the people retiring and the problems that we have with our

public education system, looking into your crystal ball—what do

you see for our future?

In other words, you are talking about something that is going to

take a little while to reverse, I mean, to get back on track. So those

kids who may be in the—we saw in the State of Maryland some

good great developments with our recent test scores. But we are

talking about kids in elementary school.

So I am just wondering what do you see?

Mr. Greenspan. Well, I wish my crystal ball were as clear as

I would like it to be. But let me just put a little perspective on this

issue. I have been dealing on a day-by-day basis with the American

economy and the American institution since 1948.

Every decade or so we look forward and it looks awful. There is

no way that the United States is going to continue to survive in

the state that we have been in. We, somehow by some means, seem

to recreate ourselves. I think it is one of the extraordinary aspects

of our country that the Constitution and the culture that derived

from it is creating a dynamism that we seem to have which one

way or the other we seem, when confronted with problems, to get

them resolved.

With all of that experience of that happening all of these years,

my inclination is just to assume. I don’t know how it is going to

happen, but we will do it. The trouble I have is that we only seem

to do it when we are forced into a crisis.

I trust that we have the capability of being able to see something

in the future, which is reasonably certain to happen, namely the

demographic shifts in retirement and the problems that are now

emerging in our schools. We know what will happen if we don’t address both of those questions.

I should hope that instead of waiting till we are at the edge

where we have to really get to work to resolve them, we can do

them in advance where less effort and less resources and less angst

would be required. I trust we will be able to address what we see

as real problems in the next decade, in this decade, rather than

waiting for them to come right up to our door.

Representative Cummings. Just, very quickly, on the pension

situation, Chairman Greenspan, with companies turning to the

Pension Benefits Guarantee Corporation, and it seems like many

anticipate there will be a stream of companies coming, not having

sufficient funds to pay off these pensions. How do you suggest that

problem be addressed?

Mr. Greenspan. It is. Let me just start off with what an economist or an accountant would say about how you can fund, with no

risk, a pension fund at relatively little risk.

Since you can project the liabilities, really the amounts of payout

that your workforce when they retire will require, you know that

cash-flow needs on a yearly basis, going out 30, 40, sometimes 50

years.

If you invested on the asset side of your balance sheet in U.S.

Treasuries, which matured in the periods when you knew you

25

would have your cash-flow, you would have a riskless system. But

that is very expensive in the sense that you don’t get the interest

rates or the dividends that most private pension funds get.

So what we are dealing with here is that to the extent that pension funds are invested in other than risk-free instruments, risks

are being taken. It is perfectly sensible to do that, when you realize, for example, stocks over the very long term yield more than

U.S. Treasuries with a reasonable degree of accuracy. There is a

tendency to have not all U.S. Treasuries in your portfolio.

However, it is important to recognize that all of that is risk, and

the question is somebody has to bear that risk in the event of failure. It is either the employees, corporate shareholders, or now with

the Pension Benefit Guarantee Corporation, the American taxpayer. I think we have to recognize what it is we are doing when

we are setting up a pension fund.

If there are risks involved, they should be identified, and the

question is in the event of a problem, who bears the cost? Historically, it was always either the shareholders of the corporation or

the beneficiaries. Now that we have got a very big slug of possibilities that the American taxpayer is going to have to pay for it. The

Congress will have to judge how far you want to carry this.

Representative Cummings. Thank you.

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

Mr. McCotter, would you have a question at this point?

Representative McCotter. No, thank you.

Representative Saxton. Thank you. Let me just say where we

are in terms of time. We have been informed we will have a vote

on the House floor sometime between 11:40 and 12:00 or a little bit

after. So if it is all right with you, Mr. Chairman, we will begin

a second round and try to do it quickly. When the time comes for

us to go to vote, we will go to vote, and we will adjourn the hearing

at that point.

Mr. Chairman, you have pointed out some good news. Real GDP

growth is paced over 3 percent, and that is expected to continue

into 2006. Housing and real estate remains strong—and as a matter of fact, at near record levels. Payroll employment is up 3.5 million jobs over the last 24 months. The unemployment rate is at 5.1

percent, which is a historic low, particularly when compared to the

averages of the 1970s, 1980s and 1990s and inflationary pressures

appear to be contained.

All of this has happened and continues to be a good picture, in

spite of the fact that we today see oil prices well over $50 a barrel.

If someone had told me in 2003, when oil prices were at $30 a barrel, that the economy would have continued to expand with oil

prices at $50 a barrel, I would have had great doubts. In spite of

this, we have continued to see good growth.

I would just ask you, in spite of the fact that oil prices are in

nominal dollars, far in excess of what they were in the late 1970s

and early 1980s, adjusted for inflation, today oil prices are significantly below what they were in the late 1970s and 1980s. Can you

expand on this and help us understand what is happening here in

the economy, in spite of the fact that we have historically high oil

prices in today’s dollars, measured in nominal terms?

26

Mr. Greenspan. I think one of the important issues to focus on

is the fact that when oil prices go up or, more exactly, when gasoline and oil prices, for example, in the United States go up, we

don’t curtail consumption in any measurable way. However, as

time goes on, you get a change in the motor vehicle stocks, use of

gasoline, so that while people don’t curtail the amount of miles

they travel, over the longer run, as prices stay high they start to

buy increasingly fuel-efficient cars.

So while the consumption levels don’t get impacted right away

with a rise in oil prices, whether it is gasoline or in the case of

home heating oil whether insulation is put in the home—over the

longer run it does. What we find is that there is a fairly significant

response in consumption, both in the United States and worldwide,

over the longer run when oil prices go up.

So that the effect has been over the years, as we have moved

from, for example, the late 1960s, early 1970s, when oil prices really began to move, we have seen a very dramatic decline over the

long run in the ratio of oil consumption to real GDP, indicating

that the structure of the American economy, its capital assets that

consume energy and specifically petroleum-based products, that

capital structure becomes ever more energy efficient, because it

turns over toward more energy efficient-type capital, whether it be

passenger cars or capital equipment.

We are now confronted with an issue where presumptions have

changed. The earlier presumption was that the longer-term price

will go back to what used to be termed normal, which was $20 a

barrel. We no longer perceive that that is going to occur, even

though the evidence of a long-term decline in the ratio of oil to

GDP continues and the evidence of increasing fuel efficiency in cars

is occurring.

I think that the significant increase in the long-term futures

prices for crude oil 6, 7 years out, in recent years, is suggestive of

the fact that the markets do not believe that after we go through

a price bulge, which then ultimately gets reversed because consumption settles down, that is not going to happen now.

Future prices have gone up for the year, to the year 2011, for example, they are up quite significantly from what they were. The

reason why that has happened, as best I can judge, is more political than economic. The reserves of crude oil, as you know, are

largely concentrated in OPEC countries where to a very substantial

extent, national oil companies have evolved and have become monopolies in their countries and are having considerable difficulty in

choosing whether the cash revenues go for domestic uses and the

budgets in those countries, or are plowed back into drilling, not

just to increase the oil reserves, but the capacity to produce oil

from those reserves.

We are having significant shortages in the growth of long-term

crude oil capacity availability, which seems to be falling short of

what our projections of oil use over the longer run will be, and that

has created an increase in expectations of shortages in the long

run, and it is the reason why prices are up. We also have significant problems, I might add, with capital expenditures and capital

availability for world refining as well.

27

So the international oil system is changing. We are able to function and be able to grow economically, especially in the United

States, because we find ever more sophisticated ways to remove petroleum and energy as a cost in our production structures.

As a consequence, we have managed to find ways around these

ever higher increases in prices. I think we will continue to do so.

But there is no question that if the real price of oil were what it

was back in the early 1970s, our rate of growth and our current

standard of living in the United States would clearly be lower

today than it currently is.

Representative Saxton. Thank you, Mr. Chairman.

Senator Reed.

Senator Reed. Thank you, Mr. Chairman.

Chairman Greenspan, you have identified two contemporary

challenges to our economy, principally the housing bubble and also

the trade deficit, which has to be financed. With respect to the

housing bubble, you suggest that it is really a froth.

By the way, I have this image of thousands of Ph.D. students in

economics running to a thesis advisor and changing the topic from

exuberance, irrational exuberance, to housing froth. So that is happening as we speak.

But the housing bubble may be something because of the nature

of housing and the localized implications. That is not serious. But

financing our deficits, and dependence upon foreign central banks,

could be the most significant challenge we face, given the fact that

if there is a moment’s lack of confidence in our economy or our decisionmaking, if they feel that our deficit projections would continue to be unremitting and without any type of break, there would

be a tendency, obviously, to move out of dollars.

In fact, there was a stutter in the market several weeks or

months ago when the South Koreans seemed to be moving. Is that

to you a most significant challenge, and how long do we maintain

this co-dependency?

I mean, we are hooked on their central bank money. They are

seeing it as a way to continue to give us money to buy their products. How long can we maintain this, in my view, unstable co-dependency?

Mr. Greenspan. The expanding dispersion of current account

balances which, as you know, are a big chunk of the deficit side,

is a function of the degree of globalization.

The increasing tendency of domestic savers to invest outside of

their country necessarily implies that the dispersion of current account balances will increase. The dispersion of current account balances is not necessarily a problem, provided that you do not, as a

consequence, build up very significant levels of debt is a consequence of chronic deficits.

If you move between a surplus and a deficit, it is no real problem. But what our concern has got to be, especially in the United

States, is if we continue to build up net claims against U.S. residents, which must be serviced.

That, I suspect, will get resolved, because the markets will not

allow that to happen. The prices will change, terms of trade will

change, interest rates will change. At the end of the day, exchange

28

rates will change one way or the other, which will effectively create

changes in these balances.

But the thing which should concern us is more that which the

markets cannot adjust, which is the Federal budget deficit. There

is a policy question. I would focus on that as being the major issue

which I think we have to worry about, because I believe that if we

maintain the degree of flexibility in our economy that we have

achieved in recent years, and which enabled us to absorb 9/11’s economic impact, the bubble of the markets in 2000, the corporate

scandals and their aftermath, it is the flexibility of the American

economy, which has enabled us to do that.

I do think that so long as we continue that, and avoid protectionism, which would undermine it, I am not worried about how

the international system will restructure itself. But we cannot

count on the international system or the markets as such to solve

our budget deficit problem. That is an issue of choice and an issue

which is quite difficult, and I think must be addressed.

Senator Reed. Well, I agree with you, Mr. Chairman, we made

those choices in the early 1990s, we raised taxes and we cut expenditures. Do you think there is any other way we can deal with

this deficit other than by pursuit of those two courses?

Mr. Greenspan. Not that I am aware of.

Senator Reed. Thank you very much.

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

Senator Bennett.

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

As I look around the world, I become more discouraged than I

am about the United States. Japan seems to be unable to come out

of their now decade-long recession. I spend time with Europeans

now to a greater degree than I used to, and any country in Europe

would kill to have our numbers, our productivity numbers, our

GDP growth numbers, our unemployment numbers; they are behind us in every category. And their demographic challenge is

greater than ours.

We, at least, have immigration to help us deal with the challenge. The retirement end. They don’t, to the extent that we have,

they are below replacement level. Their population is shrinking.

One statistic that struck me: in the Second World War, Germany

had 70 million population, today they have 80 million, whereas we

had what—140 million in the Second World War, and we are now

closing in on 290 million. The European Union in the next 30 years

will become smaller than the United States populationwise. We

will grow, they will not.

Basically, we are carrying the rest of the world on our shoulders

in this situation.

We can talk about our deficit problem, we can talk about the foreign money we depend on, but as you indicated in an answer to a

previous question, a large part of the reason the foreign money is

coming here is because it feels safer here than any other place. You

can you address this whole question of what we have to do in the

overall context of dealing with globalization, it is a reality. It cannot be repealed. I agree were you absolutely, that we must pass

CAFTA, and we must pass other free trade agreements in an effort

29

to get the greatest efficiency and benefit out of globalization that

we can.

Protectionism would be a disaster. But other than that, comment

on the overall international situation that we face in the next 10

to 15 years.

Mr. Greenspan. Well, Senator, a while back, I had to deliver a

memorial lecture on Adam Smith and was required as a consequence to read The Wealth of Nations again, which I must say,

I hadn’t read for 50 years. And it was obviously different. Somebody came in and rewrote it one way or another because it seemed

so modern in so many of its insights. The major insight is, I think,

the serious question of what does create the wealth of nations?

What is it about the United States that which gives us a special

status? And, I think the way I would put it is first, it is not our

real resources as such, although we, over the generations, have had

a considerable amount of oil, copper, ore, iron ore and the like.

But it is fundamentally our Constitution, because the Constitution is structured in a manner which protects property rights better than anywhere else in the world. And one of the reasons why

businesses have flocked here, why they have invested here, is that

they know that in the event of adjudication they get a fair trial.

And that our Constitution protects them.

The second major issue that has always been relevant to the

United States is the nature of the people and their education and

what they have in their heads. And we have managed, up until

very recently, to maintain a very high level of skills. It became obviously most manifest in World War II when the kids who came out

of the war were able to put together an automotive engine in 20

minutes where the rest of the world had not yet even gotten close.

And we maintained that all the way through the 1960s, the 1970s.

We are running into problems now. They are not overwhelming yet.

But I am concerned about the quality of our workforce that we

have got to make certain can have the skills that will be required

of us in the next generation. As I said to your Congressman colleague from Maryland, I have been around long enough to have

considerable expectation that we will figure it out at some point.

Over the years, I have been through too many hanging-over-theedge-of-cliffs scenarios about whether we would do it or not, but we

managed to. I think it would be very useful to anticipate sometime

in the future what we are going to have to do and do it sooner rather than later.

Representative Saxton. Thank you very much.

Mrs. Maloney.

Representative Maloney. Thank you, Chairman Greenspan,

for your truly insightful testimony today. You mentioned you just

read Adam Smith. Well, have you read The World Is Flat by Thomas Friedman? And do you have any comments.

Mr. Greenspan. Well, the picture on the cover of his book is so

revealing. I don’t know if you remember what it is. It is the galleons going off the cliff and falling off the region of the earth. I

found it sufficiently riveting to go find out what is in the book. And

I think it is an interesting book and I think I haven’t read it in

full detail, but I have read parts of it.

30

There are big issues out here, which I think we are all trying to

come to grips with. This is a different world. I mean, it is a world

in which we all are economically related. When I first started in

business and had to forecast the American economy, I did not have

to avert to what was going on in the rest of the world because it

didn’t matter that much to what the GDP—or then the GNP—

would be for the United States. But now, unless you start with

what is going on in the rest of the world, you don’t have a clue with

what is going to happen here. And I think books like Tom Friedman’s and others trying to delve into this have got good things and

bad things in them, but I think we are all learning a great deal

about how the world works. And I think it is helpful.

Representative Maloney. You commented to Senator Reed’s

focus on the deficits that it is a tremendous problem, and I would

like to ask, wouldn’t we see a sharp increase in interest rates and

a decline in investment if we continued to run large Federal budget

deficits?

Mr. Greenspan. Well, Congresswoman, the real problem that I

have is that if you take what I perceive is likely increases in outlays, as you move into the next decade and beyond, you begin to

create potentially unstable deficit situations in which deficits increase, the debt increases, the interest on that debt increases, both

because interest rates go up and because the debt itself goes up,

and that increases the deficit still more, and a number of the econometric scenarios that we run in that context do not reach equilibrium very easily so that we have a major task in front of us.

Representative Maloney. Thank you. You also mentioned

today several times and advocated as for a pay-as-you-go policy for

all of our Federal budget decisions. And that would also include

budget decisions concerning tax cuts becoming permanent, would it

not?

Mr. Greenspan. It would.

Representative Maloney. It would. OK. And currently that is

not the policy of the Administration, and have you talked to members of the Administration and tried to persuade them of the need

for pay-as-you-go rules for all of our budget decisions?

Mr. Greenspan. I have tried to persuade lots of people in this

town, sometimes with success, more often than not, lesser success.

Representative Maloney. But we always listen to you, Mr.

Chairman, we may not agree, but we always listen to you with

great attention. And I really need more evidence to be convinced

that we have a robust economic recovery, particularly for the typical American worker. And how would you characterize the behavior of payroll employment over the most recent cycle? Wouldn’t you

say that it took an unusually long time just to erase the jobs deficit

created by the 2001 recession and that we are still well behind the

pace of job creation typically seen in past economic recoveries? And,

related to that, how would you characterize the unemployment? I

know that it has edged down to 5.1 percent in May. But aren’t we

still waiting for labor force partnership participation to bounce

back from the effect of the recession?

Mr. Greenspan. Well, remember, one way of looking at the fact

that employment significantly lagged the recovery in the economy

earlier in this decade is we had an extraordinary rise in producVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00034 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
31

tivity growth. Indeed, looking back at the figures, even though the

economy was relatively weak very early-on in the decade, productivity started to pick up, which was very unusual and as we moved

through 2002 and 2003, as I pointed out in my prepared remarks,

productivity growth continued to expand, and hence raised the

overall standard of living of the American economy. And that therefore, is the source of the delayed recovery in employment.

But employment, obviously, is coming back. The unemployment

rate is down to quite low levels historically. It is certainly the case

that the participation rate of the labor force has been moving down,

although it’s flattened out very recently. A goodly part of that is

merely the demographics that as you move through cohorts which

generally have lower labor force participation, the average comes

down and that is one of the things that we are looking at.

But even making adjustment for the demographic shifts, there is

a tendency for people to desire to work less than they did historically. A lot of them are going to school. And it is not only the kids.

I mean, there is a very significant increase in enrolment at community colleges which have average ages of enrollments, 30, 35 and

more.

Representative Maloney. My time is up, thank you very much.

Representative Saxton. I thank the Gentlelady. I just would

remind the Gentlelady that today’s unemployment rate is 5.1 percent, which is, as the Chairman has just pointed out, is historically

low. To be more specific, during the 1970s, the average unemployment rate was 6.2 percent. During the 1980s, it was averaged at

7.3 percent. During the 1990s, it averaged 5.8 percent. And so 5.1

percent doesn’t appear to me to be too bad. And I think we need

to look at this in that context, and hopefully, it will be reduced

even more. But in terms of the last three decades, we are doing

pretty well.

Representative Maloney. Well, I thank the Chairman for

pointing that out to me and would like to comment that it was

lower in 2000. Thank you so much.

Representative Saxton. Again during the 1990s, the unemployment rate averaged 5.8 percent. Historical facts will bear that out.

Mr. Paul.

Representative Paul. Thank you, Mr. Chairman, I would like

to follow up on Chairman Saxton’s question about the oil prices.

You said that the discounting of future high oil prices is probably

more political than economic, and I would like to suggest that possibly there are some economic factors. You know in the 1970s, we

faced a somewhat similar problem. We had a lot of inflation, and

yet we had political turmoil which helped push oil prices up. But

we were also living after the decade of the 1960s where we were

financing the Vietnam War as well as the Great Society programs

and that led to a whole decade of stagflation and significant inflation.

And most individuals now recognize that general price inflation

simply is a reflex of money policy and it is not a result of political

turmoil, although, the political turmoil can contribute to higher

prices. And today certainly we have political turmoil in the Middle

East. We see oil pipelines being burned almost on a daily basis,

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and that, I would agree, certainly contributes to this anticipation

that there will be future price increases in oil.

But, it also, we talk a lot of about increase and demand and I

would recognize that that has something to do with the demand

coming from China and other far eastern countries that would put

pressure on the oil prices. But that the one factor that we essentially never talk about nor recognize is the monetary factor that

maybe we still have some old fashioned inflation around. We have

some house pricing inflation. We have medical care cost inflation.

And we have educational cost inflation. And we also know that one

true characteristic of monetary inflation when it translates into

price inflation, it is never uniform. Some prices go down. Some

prices go up, but you still can have inflation; you can have prices

of houses going up with computer prices and TV pricing going

down.

So I am suggesting that quite possibly the markets are saying to

us in the Congress that we are discounting Congress’s inability to

handle the deficit, and therefore putting more pressure on the monetary authorities to do what they do. And that is, accommodate

deficits and eventually inflate just as we do to accommodate the

deficits of the 1960s, and contributed to the 1970s. Why couldn’t a

case be made that there is a monetary factor in here or would you

still stick to the argument that you will say no, there is no economic factor, it is all political factor that anticipates higher prices

of oil in the next decade or so?

Mr. Greenspan. Well, with regard to the political factors I was

referring to, I am not sure I made myself clear. It was not so much

the violence and terrorism that is involved, but the fact that very

few of these nationalized oil companies will allow foreign oil companies to come in and drill and increase their productive capacity. In

Mexico, for example, its constitution prohibits foreign involvement

in its underlying crude oil reserves.

The issue of monetary policy is potentially a significant inflationary force as we have discussed before on numerous occasions.

The history of fiat monies, which is what we have, tends to be

chronically inflationary. At the current time, money supply growth

is really quite modest. And I think it is modest around the world,

and I think the reason is that a large number of us recognize that

the inflation is a very deleterious force in a market economy, and

that if we feed inflationary forces, we ultimately undermine the

economy. The argument that we at the Fed make is that our statutory requirement is to maintain maximum sustainable growth, but

we perceive the necessary condition of that to be a non-inflationary

monetary policy.

Representative Paul. Thank you.

Representative Saxton. Thank you very much.

Mr. Hinchey.

Representative Hinchey. Thank you very much, Mr. Chairman, Chairman Greenspan it is always more than a pleasure and

also always instructive to listen to you. I very much appreciate the

opportunity to be here with you today.

Mr. Greenspan. Thank you.

Representative Hinchey. As you point out, whenever you put

into place a program or a policy, it is always prudent to periodically

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review that policy or program to see that it still makes sense and

that it is performing as you anticipated it might.

We have an economic policy in place today which has been in

place now for about 41⁄2 years, and we have an opportunity to

evaluate the outcomes and to see what it is doing for us. We talk

about growth in the economy and that seems pretty significant.

Unquestionably, that growth seems strong and solid. But it doesn’t

seem to be affecting everyone. For example, in the last 41⁄2 years,

there are now 4 million more Americans without health insurance.

That number is up to 45 million now, and there are tens of millions

more who have inadequate health insurance. There are about 1.3

million more Americans living in poverty than there were 41⁄2 years

ago. And the median annual income of middle class families is

down by $1,400 over the course of that period.

In the private sector, we still have not produced the number of

private sector jobs that would bring us back to the number of private sector jobs that we had 41⁄2 years ago. The benefits of our

economy are increasingly flowing to a smaller number of people. In

fact, a recent analysis by The New York Times, for example, indicates that about less than 1⁄10th of 1 percent of the population are

getting not just the lion’s share of the benefits, but most of the entire pride’s share of the benefits.

If we are going to maintain a kind of social equality, or the social

opportunities at least that we have had throughout our history,

don’t you think that we need to re-examine this policy and begin

to do something different so that more people can begin to benefit

from the enormous opportunities that exist in this country? Instead

of having just a tiny fraction of people get all the benefits,

shouldn’t we be trying to share them more equitably? Aren’t there

things we need to be doing better?

Mr. Greenspan. I didn’t read The New York Times article in detail, but it is a fact that the concentration of income has increased

for reasons I discussed before. I do think it is important to recognize that to the extent that that occurs, it is not helpful for a democratic society, especially one of the breadth and heterogeneity of

this type of society.

I have looked at the various different things that can be done.

And I have concluded that with education reforms necessary, whatever that means, because I don’t know enough about how to teach

children in a way that would prevent them from falling to the bottom of the barrel by the time they go from 4th grade to 12th grade.

But I do know that that is both the necessary and sufficient condition to solving the problem that you are most concerned about.

I am not sure what a whole series of other programs would succeed

in doing. I am reasonably certain if we don’t solve the education

problem, whatever else we do isn’t going to help very much.

Representative Hinchey. I am really talking now about the

monetary and fiscal policies that we are pursuing. For example the

huge tax cuts.

Mr. Greenspan. The problem I am concerned about is on a

pretax level. You will get the same numbers.

Representative Hinchey. The ones I am concerned about are

at a post-tax level.

Mr. Greenspan. I understand that. What I am trying to say——

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Representative Hinchey. Because if you have these huge tax

cuts, which take enormous amounts of money out of the Treasury,

put them into the hands of just a tiny fraction of the American people, and just let them do with it what they want, they will not invest that money into society. If you had a tax cut, for example, that

was more equitable, that was distributed more equitably among

the middle class, then you would see more investment going back

into the society. You talk about education. Because of the fact that

we are running these huge budget deficits now as a result of the

tax cuts and other actions—the war in Iraq, for example—we can’t

afford to invest more in education. Now the Administration is arguing that we can’t afford Social Security. We can’t afford Medicare,

we can’t afford education. They are cutting back on Pell Grants.

They are cutting back on other means of funding education.

So if we are not putting enough money into education then you

have classrooms that are overcrowded. You have educational conditions that are actually depriving young people of the education that

they should have. We are not using our resources equitably, intelligently, we are using them in ways that are reckless and radical

and putting them into the hands of a tiny fraction of the American

people rather than having those resources spread in a more, not

just egalitarian, but at least more democratic way.

Mr. Greenspan. Well, it is a factual issue here that leaving

aside the question of equity, those monies come back into investment. In other words, unless you consume your income, it is going

back into financing investment.

Representative Hinchey. But Mr. Chairman, the investments

are going to buy an island in the South Pacific or buy a factory in

China or buy some kind of information distribution system in

India. That is where they’re going. They are not coming back into

our economy.

Mr. Greenspan. I think you would find if you actually had the

full detail, those would be extraordinarily small proportions of

what actually gets invested. Look, the truth of the matter is, I don’t

want to argue the other side of the question of equity, because I

don’t necessarily disagree with that. But there is no question that

this standard of living is unmatched. And it is unmatched for everybody. Everybody has got a car. And the cars that people have

today are so superior to what they were 50 years ago it is unimaginable.

So, you can look at the system and say it has got a lot of problems. And sure it does. It always has. But, you can’t get around the

fact that this is the most extraordinarily successful economy in history. And while we may not distribute the resources in the way

that you or maybe I would think is necessarily appropriate, the fact

is it is still a very successful economic system. And what we are

going to find is that over the years, if we resolve the education

problems, I think we will find that everybody is getting very significant advances.

If we were in such poor shape why do so many people want to

come to this country?

Coming to this country, taking the lowest paying jobs which are

several multiples of what they can make at home. We have got to

be doing something which is not bad.

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

Mr. McCotter has joined us and we are going to move to him for

a question.

Representative McCotter. Thank you, Mr. Chairman. You had

spoken about having to dust off your Adam Smith. I guess I have

to dust off my civics book when I get home, because it was always

my understanding that taxation occurred with the consent of the

governed. The tax cuts are not taken from the Treasury and placed

in the hands of the few unless at first they are taken from the

hands of the people who earned them and then stuffed into the

Federal Treasury. And it can only be done with their consent. So

maybe we have a difference of opinion. I will go check and see

whether I am right or not.

Speaking of the consent of the governed, in economic models as

you rightly pointed out, in the past we only had to focus on the

United States of America, what is good for GM is good for the country, and so forth.

At this point in time, given the globalization of much of the economic sectors, do any economic models take into account the different natures of the governments involved in global trade?

Mr. Greenspan. Different what?

Representative McCotter. The different type of government.

For example, let’s use two examples. The United States of America

is a free republic. It has an entrepreneurial system and, say, somebody like the People’s Republic of China, which is a communist

government, it is a totalitarian state.

Do economic models anywhere account for the different natures

of the governments? For example, we can discuss where we would

rightly or wrongly invest, in education or elsewhere, but we have

to do it through the consent of the governed and through consensus

in the Congress and then express incentivize. We cannot command

and control an economic sector or our economic decisions. We have

a free market. We can help. We can hurt. We cannot command and

control.

How does a free republic with the entrepreneurial free market

system engage with a communist country which is a totalitarian

state which has a command and control structure which we cannot

follow? Do economic models take these into account? My concern is

that over time, as we look at this, is that economists tend to look

at market forces. Not the aberrations in market forces that can be

caused by a totalitarian government, whereby an economic policy

will not be determined by an aggregation of individual decisions

made throughout a free market, but at the behest and the command of a dictatorial government.

Do any economic models take this into account or do we simply

assume that perhaps these totalitarian states can be treated as a

dichotomy between their government and perhaps a system that

they are employing economically at a given time?

Mr. Greenspan. Econometric models don’t. In fact, they presuppose a market economy and are not sufficiently sophisticated in

their mathematical constructions to say they differentiate between

differing types of market capitalism. There are huge differences in

economic development, depending on whether or not you have a

rule of law, whether you have property rights, what type of governVerDate 03-FEB-2003 15:58 Nov 09, 2005 Jkt 023584 PO 00000 Frm 00039 Fmt 6601 Sfmt 6601 D:\JEC\23584.TXT SSC2 PsN: SSC2
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ment you have, is it representative, is it republic, is it democratic

in its nature? That is a part of economics which I wouldn’t call

modeling, but it is called development economics, and what they

try to figure out is, as did Adam Smith, what causes the wealth

of nations? And there the conclusions come out fairly clearly.

Namely that when you have, if you want to call it a model, you actually had an experiment in central planning versus market forces

for 40 years with East Germany and West Germany in which they

came out of the same culture, language, everything similarly. The

only thing that was fundamentally different was their political

structure. And when the end of the 40 years, the experiment came

to an end and we looked. East Germany’s standard of living was

a third of West Germany’s.

So you can, in a sense, get a model, if you want to call it that,

to produce those results. But, it is very rare that that occurs. And

the only time I know they would use models in central planning

was the Gosplan in the Soviet Union which was very sophisticated

and didn’t work.

Representative McCotter. And bring this up to my concern

over time whether or not there is a lot of faith in the permanent

normalization in trade relations with the People’s Republic of

China has been that you will get democracy following economic opportunity if we continue to trade with China on this basis, if we

drop human rights as a criteria, if we allow them access to our

markets and we go back and forth is that somehow they will magically realize that the vanguard of the proletariat is no longer needed to run the lives of their people.

My concern is not that we have soon a past model, such as the

Soviet Union or East Germany. My concern is that we may be seeing a different hybrid of a totalitarian government. We may be seeing a totalitarian government that will allow a limited amount of

economic opportunity without any political freedom whatsoever,

without any real democracy whatsoever. And as a resident of the

United States, I asked the question because my concern is that we

tend to think that what we have here in the free republic through

democracy and through an entrepreneurial economy is somehow

entitled to us rather than simply an experiment in democracy

which, as some of us know, did not work out too well in the ancient

Athenian city-state very long. And that as Russia goes backwards

with their economic models and China continues down the path, we

are basically, as an article of faith, hoping that China does the

right thing and becomes more like us in the next 20 years, rather

than even bother to entertain the notion if we continue to trade

with them in the manner that we are trading with them and dealing with them, that somehow in the next 20 years, we might start

looking a lot more like them. So that is why I asked the question,

but as always, I enjoy engaging with you, Mr. Chairman.

Mr. Greenspan. Thank you.

Representative Saxton. Thank you very much.

Ms. Sanchez.

Representative Sanchez. Thank you, Mr. Chairman.

Mr. Chairman, what I want to go back to, what I see over time,

your concern of this, I hate to call it as the haves and have-nots,

but the widening and disparity of what is going on, and to a large

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extent, you talked today at length about how education may be one

of those big issues that makes the widening, or the gap that is occurring.

I ask because I come from the fifth wealthiest county in the Nation, Orange County, California. And yet, the Rockefeller Foundation about 5 months ago issued a report that said that the city that

was the worst place to be poor is Santa Ana, California. That is the

county seat of Orange County. And then when I look at the percent

of giving rates, charitable giving, county-by-county in the Nation,

Orange County is pretty low on the list as a percent. And when we

see where it gives, a lot of the giving that we are seeing in my area

goes to the arts.

So I am looking at the policy or what is it that is creating this

disparity and one of the issues that comes up is this whole issue

of the estate tax. And to tell the truth, that has come up in different forms, I have voted one way or the other depending on

whether or not I think this will work.

As a Blue Dog, we tried to put in a proposal that would basically

have no tax all the way up to 97 percent of all households in the

United States. But that didn’t go through. The House recently

passed an estate tax that said there will be no estate tax. I want

to ask you because one of the arguments that people used in trying

to sway some of us to vote one way or the other was this other

whole issue of if you don’t tax with an estate tax, then people will

not put their monies into charitable types of institutions. They

won’t make the Carnegie Foundation. They won’t make these foundations that in turn come back and do education on a more broad

base, or invest in research on a more broad base.

What do you think about eliminating completely the estate tax

versus something of, you know, trying to eliminate it from most,

but not the very top 2 percent of estate tax estates? What is your

opinion on that?

Mr. Greenspan. I don’t have a view on that particularly. I think

that there is a great deal of literature as to whether or not Americans contribute to charities because of the graduated income tax or

not at all. I mean, obviously, through very significant charitable

contributions and bequeathing of very large trusts for charitable

distributions, before the income tax, we obviously had Carnegie

and Rockefeller, and a variety of other major contributors. But it

is an analytical question as to the impact of the estate tax or indeed the income taxes on charitable giving, and I am not sufficiently familiar with the conclusions of that. I don’t really have a

position on it.

Representative Sanchez. Aside from this education gap, what

do you think might be other policies that we, the Federal Government, have instituted that are creating this widening of the gap between those who have the low paying service jobs and those who

have the creative, technological-type jobs?

Mr. Greenspan. Congresswoman, I don’t think we need to do

anything else. If we succeed in solving the education issue, I think

we have got it solved. Remember, we came out of World War II

with the GI Bill of Rights, and a lot of technological capability,

what the technologies were back at the end of World War II. And

we had, for several decades, a very rapidly growing economy and,

38

no increasing concentration of income. In other words, all wage levels moved the same. You are not going to eliminate the differential

wage levels because those are skill-based.

But what we need to eliminate is the ever gradual spreading of

those wages which we now see and there are lots of ways you can

come out at it, but all I can say is that if you can solve the education problem you don’t have to do anything else. And if you don’t

solve it, nothing else is going to matter all that much.

Representative Sanchez. Thank you Mr. Chairman. Thank

you.

Representative Saxton. Thank you, Ms. Sanchez.

Mr. Chairman, we have got to go vote, and we want to thank you

for being here with us this morning. We are pleased with the news

that you bring us today. And, I want to thank you also for emphasizing the concern that you have with regard to the educational

issues in our society. I think that is extremely important. I sit here

in this room, actually on the Armed Services Committee, and one

of the things that we are reminded about from time to time is the

shortage of engineers that work in various capacities that provide

for expertise in the area of defense, national security. These are

important issues and I agree with you that we need to recognize

them and work on them. Thank you again for being here with us

this morning and we look forward to seeing you again in the future.

Mr. Greenspan. Thank you, Mr. Chairman.

[Whereupon, at 12:30 p.m., the hearing was adjourned.]

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Submissions for the Record

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PREPARED STATEMENT OF HON. ALAN GREENSPAN, CHAIRMAN,

BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM

Chairman Saxton, Vice Chairman Bennett, and Members of the Committee, I am

pleased to appear once again before the Joint Economic Committee.

Over the past year, the pace of economic activity in the United States has alternately paused and quickened. The most recent data support the view that the soft

readings on the economy observed in the early spring were not presaging a moreserious slowdown in the pace of activity. Consumer spending firmed again, and indicators of business investment became somewhat more upbeat. Nonetheless, policymakers confront many of the same imbalances and uncertainties that were apparent

a year ago.

Our household saving rate remains negligible. Moreover, modest, if any, progress

is evident in addressing the challenges associated with the pending shift of the

baby-boom generation into retirement that will begin in a very few years. And although prices of imports have accelerated, we are, at best, in only the earliest stages

of a stabilization of our current account deficit—a deficit that now exceeds 6 percent

of U.S. Gross Domestic Product (GDP).

A major economic development over the past year has been the surge in the price

of oil. Sharply higher prices of oil imports have diminished U.S. purchasing power.

The value of petroleum imports rose from 1.4 percent of nominal GDP in the first

quarter of 2004 to 1.8 percent in the first quarter of this year. The alternating bouts

of rising and falling oil prices have doubtless been a significant contributor to the

periods of deceleration and acceleration of U.S. economic activity over the past year.

Despite the uneven character of the expansion over the past year, the U.S. economy has done well, on net, by most measures. Real GDP has grown by 3.7 percent

over that period, the unemployment rate has fallen to 5.1 percent, and core personal

consumption expenditure prices have risen a historically modest 1.6 percent. But

the growth of productivity, though respectable at 21⁄2 percent over the year ending

in the first quarter, is far less than the extraordinary pace of 51⁄2 percent during

2003. Excluding a large but apparently transitory surge in bonuses and the proceeds

of stock option exercises late last year, overall hourly labor compensation has exhibited few signs of acceleration. Thus, the rise in underlying unit labor costs has been

mainly the result of the slower growth of output per hour. At the same time, evidence of increased pricing power can be gleaned from the profit margins of nonfinancial businesses, which have continued to press higher even outside the energy

sector. Whether that rise in unit costs will feed into the core price level or will be

absorbed by a fall in profit margins remains an open question.

Among the biggest surprises of the past year has been the pronounced decline in

long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the Federal funds rate. This is clearly without recent precedent. The yield

on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than

its level of a year ago. Moreover, even after the recent backup in credit risk spreads,

yields for both investment-grade and less-than-investment-grade corporate bonds

have declined even more than Treasuries over the same period.

The unusual behavior of long-term interest rates first became apparent almost a

year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected,

they built large short positions in long-term debt instruments in anticipation of the

increase in bond yields that has been historically associated with a rising Federal

funds rate. But by summer, pressures emerged in the marketplace that drove longterm rates back down. In March of this year, market participants once again bid

up long-term rates, but as occurred last year, forces came into play to make those

increases short lived. There remains considerable conjecture among analysts as to

the nature of those market forces.

That said, there can be little doubt that exceptionally low interest rates on tenyear Treasury notes, and hence on home mortgages, have been a major factor in the

recent surge of homebuilding and home turnover, and especially in the steep climb

in home prices. Although a ‘‘bubble’’ in home prices for the Nation as a whole does

not appear likely, there do appear to be, at a minimum, signs of froth in some local

markets where home prices seem to have risen to unsustainable levels.

The housing market in the United States is quite heterogeneous, and it does not

have the capacity to move excesses easily from one area to another. Instead, we

have a collection of only loosely connected local markets. Thus, while investors can

arbitrage the price of a commodity such as aluminum between Portland, Maine, and

Portland, Oregon, they cannot do that with home prices because they cannot move

the houses. As a consequence, unlike the behavior of commodity prices, which varies

53

little from place to place, the behavior of home prices varies widely across the Nation.

Speculation in homes is largely local, especially for owner-occupied residences. For

homeowners to realize accumulated capital gains on a residence—a precondition of

a speculative market—they must move. Another formidable barrier to the emergence of speculative activity in housing markets is that home sales involve significant commissions and closing costs, which average in the neighborhood of 10 percent

of the sales price. Where homeowner sales predominate, speculative turnover of

homes is difficult.

But in recent years, the pace of turnover of existing homes has quickened. It appears that a substantial part of the acceleration in turnover reflects the purchase

of second homes—either for investment or vacation purposes. Transactions in second

homes, of course, are not restrained by the same forces that restrict the purchases

or sales of primary residences—an individual can sell without having to move. This

suggests that speculative activity may have had a greater role in generating the recent price increases than it has customarily had in the past.

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the

introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.

The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. In part, this is explained by an underlying uptrend in home prices. Because of the degree of

customization of homes, it is difficult to achieve significant productivity gains in residential building despite the ongoing technological advances in other areas of our

economy. As a result, productivity gains in residential construction have lagged behind the average productivity increases in the United States for many decades. This

shortfall has been one of the reasons that house prices have consistently outpaced

the general price level for many decades.

Although we certainly cannot rule out home price declines, especially in some

local markets, these declines, were they to occur, likely would not have substantial

macro-economic implications. Nationwide banking and widespread securitization of

mortgages make it less likely that financial intermediation would be impaired than

was the case in prior episodes of regional house price corrections. Moreover, a substantial rise in bankruptcies would require a quite-significant overall reduction in

the national housing price level because the vast majority of homeowners have built

up substantial equity in their homes despite large home equity withdrawals in recent years financed by the mortgage market.

In conclusion, Mr. Chairman, despite some of the risks that I have highlighted,

the U.S. economy seems to be on a reasonably firm footing, and underlying inflation

remains contained. Accordingly, the Federal Open Market Committee in its May

meeting reaffirmed that it ‘‘. . . believes that policy accommodation can be removed

at a pace that is likely to be measured. Nonetheless, the Committee will respond

to changes in economic prospects as needed to fulfill its obligation to maintain price

stability.’’

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