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24–852 PDF 2005

S. HRG. 109–204

FEDERAL RESERVE’S SECOND MONETARY POLICY

REPORT FOR 2005

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

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

JULY 21, 2005

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

(

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

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

PEGGY R. KUHN, Senior Financial Economist

MARTIN J. GRUENBERG, Democratic Senior Counsel

AARON D. KLEIN, Democratic Economist

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

THURSDAY, JULY 21, 2005

Page

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

Opening statements, comments, or prepared statements of:

Senator Schumer .............................................................................................. 2

Senator Allard ................................................................................................... 2

Senator Reed ..................................................................................................... 3

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

Senator Bennett ................................................................................................ 5

Senator Dole ...................................................................................................... 5

Senator Crapo ................................................................................................... 6

Senator Sarbanes .............................................................................................. 15

Senator Corzine ................................................................................................ 25

WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 6

Prepared statement .......................................................................................... 31

Response to written questions of:

Senator Reed .............................................................................................. 36

Senator Bennett ........................................................................................ 36

Senator Corzine ......................................................................................... 38

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Various charts submitted to the Committee ......................................................... 40

Letter to Senator Bennett from Alan Greenspan dated September 2, 2005 ....... 53

Monetary Policy Report to the Congress, July 21, 2005 ....................................... 59

(III)

(1)

FEDERAL RESERVE’S SECOND MONETARY

POLICY REPORT FOR 2005

THURSDAY, JULY 21, 2005

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

The Committee met at 10:07 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

We are very pleased this morning to welcome Chairman Greenspan once again before the Committee on Banking, Housing, and

Urban Affairs to testify on the Federal Reserve’s Semi-Annual

Monetary Policy Report to the Congress.

The June meeting of the Federal Open Market Committee

marked the 1 year anniversary of incremental increases in the Federal funds rate from a low of 1 percent. These measured changes

appear to have been accommodated pretty well by the economy.

GDP has sustained a strong rate of growth, increases in core inflation have been moderate, and we have seen a continued decline in

unemployment. The country is also fortunate to have enjoyed an

unexpected increase in tax revenues and subsequent reduction in

the Federal deficit for this fiscal year. But as your report highlights, Mr. Chairman, there are also some cautionary factors that

we need to be mindful of in the months ahead.

This morning we will have ample opportunity to discuss in greater detail the Federal Reserve’s performance in carrying out monetary policy and its views on the future direction of our Nation’s

economy. I look forward, as others will, to raise a number of issues

during our discussion.

Chairman Greenspan, I am told that today marks the 18th anniversary of your first appearance before the Congress for the nomination to be Federal Reserve Chairman. Since that time, you have

made 34 appearances before this Committee to discuss monetary

policy and conditions alone. While this morning may be your last

appearance—I hope it will not be, but it could be—as Federal Reserve Chairman testifying on the Federal Reserve’s Semi-Annual

Monetary Policy Report, the Committee would certainly extend a

warm welcome to you at any time should we end up hosting you

again in February of 2006.

But on behalf of the Committee, I want to thank you for your

many years of service and your respected counsel. I suspect that

2

this Committee may still be interested in hosting you as a witness

on other topics in the months ahead. Beyond your tenure, Mr.

Chairman, your voice will undoubtedly continue to be valued after

your departure from the Fed. We hope you will continue to accept

our invitation in the years ahead.

Senator Schumer.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. I just ask to make

a brief statement.

First, I want to join you, Mr. Chairman, in thanking Chairman

Greenspan for his amazing service to this country and his willingness. I only served under two Fed Chairmen, both of whom have

been very accessible, but your accessibility and interest in things

that we ask you about is just incredible, and we appreciate that.

And one of the things that we have worked together on, of course,

is the Chinese currency, and as you know, this morning the Chinese made their first step to revalue their currency. So, I just

wanted to read a brief statement on that.

And what I believe, Mr. Chairman, is that this is a good first

step, albeit a baby step. It is smaller than we had hoped. But to

paraphrase the Chinese philosophers, a trip of a thousand miles

can well begin with the first baby step.

The most significant thing about this move is that the Chinese,

in effect, have conceded that pegging their currency is bad for

China, for the world economy, and for the United States. And we

are glad they have come to this understanding. If there are not

larger steps in the future we will not have accomplished very

much. But after years of inaction, this step is welcome.

Again, I want to thank Chairman Greenspan. I want to thank

Senator Graham as well as Senator Bunning and Senator Dole on

this Committee, and Senator Bayh, Senator Reed, and some others

who were part of our effort, and we are beginning to bear some

fruit.

So, I thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

STATEMENT OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman, for holding this

hearing, and I would like to join my colleagues in welcoming Federal Reserve Board Chairman Greenspan to the Committee today

to discuss monetary policy and the state of the U.S. economy.

I also look forward to the opportunity to hear from Chairman

Greenspan. His expertise and insight is always helpful to the Committee.

Chairman Greenspan, I was pleased to hear in your testimony

before the House yesterday that the outlook for the U.S. economy

is positive and one of sustained growth. Under your leadership, the

Federal Reserve Board has done a good job monitoring the U.S.

economy and managing monetary policy, as appropriate. Since this

will be the last time you will be delivering the Fed’s monetary policy report in your current term—and I hope you continue to serve—

I want to take this opportunity to congratulate you on a job well

done. I also want to thank you on behalf of the American people

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for your years of public service. We have all been the beneficiaries

of your careful approach, and your service has set a high standard.

Thank you for taking the time out of your busy schedule to be

here, and I look forward to hearing your testimony.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman. And let me

commend you, Chairman Greenspan, for your extraordinary service

over 18 years, and I think you will continue to be invited back to

the Committee for many years to come.

We have a challenging economy before us. Last June, employment added about 146,000 jobs, which might be appropriate at the

end of an expansion, but we are coming out of a long, protracted

job slump. And this is far from the numbers we saw in the Clinton

Administration of 200,000 to 300,000 jobs a month. So we have essentially a jobless recovery, and the unemployment rate, although

it edged down to 5 percent, the Boston Fed points out there is still

considerable evidence of hidden unemployment that does not show

up. Labor force participation has not rebounded in this recovery. A

study finds that the labor force shortfall is between 1.6 million and

5.1 million people. Employers are not hiring as though they believe

the economy is strong, and potential workers are staying out of the

labor force.

We have discussed many times, Mr. Chairman, the fact that

there are disturbing trends in the distribution of earnings. Things

seem to be getting worse in this recover, with most of the gains

from productivity going into profits, not wages, and overall real

earnings remaining stagnant. And the only group that seems to be

doing exceptionally well are those at the top of the distribution of

earnings and wages. People in the middle and further down are

seeing their purchasing power fall because of rising costs of gasoline, food, medical care, housing, really eating into their ability to

maintain their families.

And then we have seen some news that the deficit—progress has

been made, but if you look behind the numbers, it looks like a onetime situation where certain tax advantages came to pass in this

particular period but are not sustainable over a longer time. The

deficit still is extraordinarily burdensome on our economy as we go

forward. Low national savings rates and the widening trade deficit

are problems that we have to deal with, an we are not dealing with

them effectively and permanently.

I hope at the hearing today, Mr. Chairman, that you will touch

on these issues, and once again let me commend you for your service and judgment in so many different ways. We have disagreed,

but it has been a productive exchange, and I thank you for that.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman, particularly for

holding this meeting today. I would especially like to thank Chairman Greenspan for delivering what will probably be your last monetary policy report to Congress.

4

According to the Congressional Research Service, this is the 35th

time that you have appeared before a Committee on which I sit. I

think I am finally starting to understand your statements and

answers——

[Laughter.]

Which probably means it is time for one of us to go.

[Laughter.]

Seriously, I will miss our sparring, and I thank you for your service. I am sure you would be disappointed if I gave you a speech full

of flowery tributes, and I would hate for you to be disappointed in

what could be your last appearance before this Committee. So, I

will point out my differences with the FMOC latest monetary policy

decision. As my good friend and fellow Hall of Famer Yogi Berra

once said, it is de ́ja` vu all over.

Once again, I believe the FMOC is taking us down the economic

path that is fraught with peril by unnecessarily raising interest

rates. Surveys show that Americans are much more worried about

filling their gas tanks than they are about fitting into their swimsuits this summer, which may be a first. But, nonetheless, despite

record high energy prices, the FMOC continues to raises rates. I

believe that you are fighting an inflationary bogeyman that does

not exist.

This reminds me of the summer of 2000 when all signs pointed

toward a recession, but the FMOC refused to cut interest rates.

When you finally did cut rates on January 3, 2001, in an emergency meeting after refusing to cut them at the FMOC’s regular

meeting on December 19, 2000, the damage was done and the recession then took place. That was greatly exacerbated by September 11, and it was already underway before that took place.

I am very concerned with the Federal Reserve’s continuing raising interest rates. The FMOC, it seems to me, continues to fix an

economy that just is not broken. It is almost as if the Fed is frightened by success. The FMOC is once again throwing a wet blanket

on the inflationary fire that does not exist.

As I have said before, I do not believe the Federal Reserve economic models are factoring in the impact of new technologies on

the economy. I also do not believe they take into account the psychological effect of higher energy prices and economic worries in

general. People in my State get nervous about our economy’s future

every time they fill up their gas tank. I also know that despite very

good economic numbers, many Americans are worried about the future. They are worried that if they lose their current job, they will

be unable to find another. I believe we are coming to a critical

point in our economy—a point where it cannot sustain higher and

higher interest rates. We almost have an inverted curve, as you

know. There are only 20 basis points between the 5-year note and

the 10-year note right now.

As our interest rates rise, our economy will suffer. Housing starts

will be down, and we will lose the economic momentum that we

have enjoyed. We just got good news about increased tax revenues

helping reduce our deficits. I know you are a deficit hawk, Mr.

Chairman. I hope you will do what you can to sustain our growth

and help reduce the deficit.

5

Once again, thank you, Mr. Chairman, for coming before this

Committee today and for your long and distinguished service to our

country.

Chairman SHELBY. Senator Bennett.

STATEMENT OF SENATOR ROBERT F. BENNETT

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

Chairman Greenspan, listening to all of the comments about

your service and your performance here reminds me of the story of

Henry Kissinger, who was in a group and the person presiding over

that particular event said, ‘‘We have with us today Henry Kissinger, who needs no introduction.’’ And Henry Kissinger said,

‘‘While it is true that I need no introduction, no one enjoys an introduction more than I do.’’ And you do not need the kind of praise

that is being heaped upon you, but I hope you enjoy it because it

is certainly deserved. And I want to join in it.

We appreciate your testimony here today. I have looked through

it, and I look forward to asking you some questions about it. But

I would hope that the tradition that when Greenspan speaks the

entire country listens will hold true for your testimony today, because the recovery that we are in could be labeled ‘‘the Rodney

Dangerfield recovery’’: It don’t get no respect. And your comments

about where we are and how robust the recovery is I think should

get a lot of respect and a lot of currency.

So, I appreciate your testimony and look forward to having the

opportunity to question you here today.

Chairman SHELBY. Senator Dole.

STATEMENT OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Chairman Shelby.

I want to join with Senator Schumer in recognizing the importance of China’s removal of their peg of their currency to the dollar.

This is significant and an important first step toward our long-term

goal of having the yuan freely float. Welcome, Chairman Greenspan, for what appears to be your final semi-annual report to the

Congress. Your service as Chairman of the Federal Reserve has

been truly admirable and deeply appreciated. While some may

worry if the overall economy will continue to improve without you

in the Chairman’s seat, I know that your efforts have put us on the

track to find long-term sustainable growth.

The times during which you have served, Mr. Chairman, have

been filled with extraordinary events and personalities. Over your

18 years as the Chairman of the Federal Reserve, the American

people’s understanding of the markets has dramatically improved,

as has our understanding of the role of the Federal Reserve Board.

I believe the relatively new measured pace that the Federal Reserve has adopted in its adjustments to the rates is part of this

progress, and this predictability has benefited our economy.

Three weeks ago, the Federal Open Market Committee again

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

by 25 basis points. This was the ninth straight increase in the

Federal funds rate. The release noted robust underlying growth in

productivity and a gradually improving labor market. These observations appear to indicate a positive track for economic expansion

6

in the coming years. While these trends certainly are encouraging,

I continue to be concerned about the slower pace of job creation.

As you well know, the State of North Carolina continues to experience dramatic losses in employment, especially in textile and furniture manufacturing. While the national economy may be trending

positively, we continue to focus special attention on those who have

lost their jobs as their companies struggled to compete with foreign

firms that operate with dramatically lower cost structures. Congress continues to debate the positives and negatives of free trade,

and I continue to believe we must work on agreements that bring

new benefits to American workers and consumers while minimizing

the negative effects.

In this changing economic environment, there are fewer and

fewer opportunities for lower-skilled workers. The opportunity gap

is widening. We must do everything in our power to make sure

that these people do not fall through the cracks. We must educate

our less-skilled workers so they take advantage of new jobs created

by the expanding economy. To this end, I believe we should take

steps to improve trade adjustment assistance and continue to make

the goal of strenghtening our community colleges a top priority. In addition to the President’s $125 million proposal to establish

a new community college access grant program, which is included

in this year’s Labor-HHS-Education appropriations bill, Senator

Baucus and I have introduced legislation, S. 1068, which provides

better links between our higher education institutions and the

business community. This will help prepare a new generation of

skilled workers so our workforce will remain strong and competitive in years to come. The bill is currently in the Senate HELP

Committee, and I look forward to working with Chairman Enzi to

see that it becomes law.

And, of course, I also remain concerned about high energy prices,

the rise in steel prices, and the growing size of our trade deficit.

But in spite of these concerns, I am confident that through increased trade, hard work, global communications, and improved

education of our workforce, we will achieve new levels of opportunity for the people of North Carolina and for all Americans.

I look forward to hearing from you on these and other matters,

Chairman Greenspan. Thank you very much for joining us today.

Chairman SHELBY. Senator Crapo.

STATEMENT OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman. I came to

listen to Chairman Greenspan, so I will save everybody from having to listen to my opening statement.

Chairman SHELBY. Thank you.

Chairman Greenspan, your written statement will be made part

of the record today. You proceed as you wish. Welcome again to the

Committee.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN,

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. Thank you, Mr. Chairman. I have excerpted only part of that rather extended statement.

7

Mr. Chairman and Members of the Committee, I am pleased to

be here to present the Federal Reserve’s Monetary Policy Report to

the Congress.

In recent weeks, employment has remained on an upward trend,

retail spending has posted appreciable gains, inventory levels have

been modest, and business investment appears to have firmed. At

the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely

to place some upward pressure on consumer prices, at least over

the near term.

Should the prices of crude oil and natural gas flatten out after

their recent run-up—the forecast currently embedded in futures

markets, incidentally—the prospects for aggregate demand appear

favorable, and upward pressures on inflation would be reduced.

Thus, our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures. In our

view, realizing this outcome will require the Federal Reserve to

continue to remove monetary accommodation. This generally favorable outlook, however, is attended by some significant uncertainties

that warrant careful scrutiny.

With regard to the outlook for inflation, future price performance

will be influenced importantly by the trend in unit labor costs, or

its equivalent, the ratio of hourly labor compensation to output per

hour. Over most of the past several years, the behavior of unit

labor costs has been quite subdued. But those costs have turned up

of late, and whether the favorable trends of the past few years will

be maintained is unclear. Hourly labor compensation as measured

from the national income and product accounts increased sharply

near the end of 2004. However, that measure appears to have been

boosted significantly by temporary factors.

Over the past 2 years, growth in output per hour seems to have

moved off the peak that it reached in 2003. However, the cause, extent, and duration of that slowdown are not yet clear.

Energy prices represent a second major uncertainty in the economic outlook. A further rise could materially cut into private

spending and thus damp the rate of economic expansion.

More favorably, the current and prospective expansion of U.S. capability to import liquefied natural gas will help ease long-term

natural gas stringencies and perhaps bring natural gas prices in

the United States down to world levels.

The third major uncertainty in the economic outlook relates to

the behavior of long-term interest rates. The yield on 10-year

Treasury notes, currently near 41⁄4 percent, is about 50 basis points

below its level of late spring 2004.

Two distinct but overlapping developments appear to be at work:

A longer-term trend decline in bond yields and an acceleration of

that trend of late.

Some, but not all, of the decade-long trend decline in bond yield

can be ascribed to expectations of lower inflation, a reduced risk

premium resulting from less inflation volatility, and a smaller real

term premium that seems due to a moderation of the business cycle

over the past few decades.

8

In addition to these factors, the trend reduction worldwide in

long-term rates surely reflects an excess of intended saving over intended investment. What is unclear is whether the excess is due

to a glut of savings or a shortfall of investment. Because intended

capital investment is to some extent driven by forces independent

of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest rates that bring actual capital investment worldwide and its

means of financing, global savings, into equality. As best we can

judge, both high levels of intended saving and low levels of intended investment have combined to lower real long-term interest

rates over the past decade.

Since the mid-1990’s, a significant increase in the share of world

gross domestic product produced by economies with persistently

above average saving—predominantly the emerging economies of

Asia—has put upward pressure on world saving. These pressures

have been supplemented by shifts in income toward the oil-exporting countries, which more recently have built surpluses because of

steep increases in oil prices.

Softness in intended investment is also evidence. Although corporate capital investment in the major industrial countries rose in

recent years, it apparently failed to match increases in corporate

cashflow.

Whether the excess of global intended saving over intended investment has been caused by weak investment or excessive saving—that is, weak consumption—or, more likely, a combination of

both does not much affect the intermediate-term outlook for world

GDP or, for that matter, U.S. monetary policy. What have mattered

in recent years are the sign and the size of the gap of intentions

and the implications for interest rates, not whether the gap results

from a saving glut or an investment shortfall. That said, saving

and investment propensities do matter over the longer-run. Higher

levels of investment relative to consumption build up the capital

stock and thus add to the productive potential of an economy.

The economic forces driving the global saving-investment balance

have been unfolding over the course of the past decade, so the

steepness of the recent decline in long-term dollar yields and the

associated distant forward rates suggests that something more may

have been at work over the past year. Inflation premiums in forward rates 10 years ahead have apparently continued to decline,

but real yields have also fallen markedly over the past year.

Risk takers apparently have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines

in measures of expected volatility and equity in credit markets.

History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may

lead to financial excess and economic stress.

Such perceptions, many observers believe, are contributing to the

boom in home prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury

notes and hence on home mortgages have been a major factor in

the recent surge of homebuilding, home turnover, and particularly

in the steep climb in home prices. Whether home prices on average

9

for the Nation as a whole are overvalued relative to underlying determinants is difficult to ascertain, but 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. Among other indicators,

the significant rise in purchases of homes for investment since

2001 seems to have charged some regional markets with speculative fervor.

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

experiencing significant declines in the national average level of

home prices. Nevertheless, we certainly cannot rule out declines in

home prices, especially in some local markets. If declines were to

occur, they likely would be accompanied by some economic stress,

though the macroeconomic implications need not be substantial.

Historically, it has been rising real long-term interest rates that

have restrained the pace of residential building and have suppressed existing home sales.

The trend of mortgage rates, or long-term interest rates more

generally, is likely to be influenced importantly by the worldwide

evolution of intended saving and intended investment. We are the

Federal Reserve will be closely monitoring the path of this global

development few, if any, have previously experienced.

We collectively confront many risks beyond those I have just

mentioned. As was tragically evidenced again by the bombings in

London earlier this month—and, I might add, some questions

about what is going on in London today—terrorism and geopolitical

risk have become enduring features of the global landscape. Another prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which, if implemented, would significantly threaten the flexibility and resilience of many economies. This situation is especially troubling for

the United States, where openness and flexibility have allowed us

to absorb a succession of large shocks in recent years with only

minimal economic disruption. That flexibility is, in large measure,

a testament to the industry and resourcefulness of our workers and

businesses. But our success in this dimension has also been aided

importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the

openness of our market economy. Going forward, policymakers will

need to be vigilant to preserve this flexibility, which has contributed so constructively to our economic performance in recent years.

In conclusion, Mr. Chairman, despite the challenges I have highlighted and the many I have not, the U.S. economy has remained

on a firm footing, and inflation continues to be well contained.

Moreover, the prospects are favorable for a continuation of those

trends. Accordingly, the Federal Open Market Committee in its

June 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.’’

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

Chairman SHELBY. Thank you, Mr. Chairman.

Mr. Chairman, some Fed watchers speculate that the Federal

Open Market Committee may halt its incremental increases after

10

reaching a Federal funds rate of 4 percent in November, which assumes three additional quarter-point increases in upcoming FOMC

meetings. Mr. Chairman, to what extent does the Federal Open

Market Committee consider the long-term interest rate in pursuing

changes to the Federal funds rate? For example, would the Federal

Open Market Committee continue raising the Federal funds rate

even if the yield curve, which Senator Bunning alluded to, becomes

inverted in the months ahead?

Chairman GREENSPAN. First of all, I cannot comment for the

Federal Open Market Committee’s actions in the future because we

have not taken them, and we will obviously engage in ongoing deliberations to make judgments at each of our meetings. But I think

there is a misconception relevant not to what we may do but to the

importance of an inverted yield curve.

It is certainly the case that if you go back historically, an inverted yield curve has actually been a reasonably good measure of

potential recession in front of us. The quality of that signal has

been declining in the last decade, in fact, quite measurably, and

the reason basically is that it was a good measure in the early period when commercial banks were the major financial intermediaries, and when you had long-term interest rates rise. I should

say that when short-term interest rates—rise relative to long-term

interest rates, it usually implied a squeeze on the profitability of

commercial banks because they tend to hold somewhat longer maturities on the asset side of their balance sheet than on the liability

side. As a consequence, that squeeze was usually associated with

an economy running into some trouble.

But extraordinary new avenues of financial intermediation have

developed over the last decade and a half, and, therefore, there are

innumerable other ways in which savings can move into investment without going through the commercial banks. As a result, a

straightforward statistical analysis of the efficacy of the yield curve

inversion as a forecasting tool has diminished very dramatically because of economic events.

So, yes, we do look at the structure of long-term rates and the

inversion of yields as well as a whole panoply of everything else,

before we make judgments as to the Federal funds rate. Our basic

goal, as I have indicated many times here, is essentially to create

an environment which sustains maximum sustainable growth, and

we have always argued—because the data are so persuasive that

inflation stability is a necessary condition to achieve that goal. In

that context, we make our judgments meeting by meeting.

Chairman SHELBY. But is the possibility of an inverted yield

curve still relevant to your thinking along with other factors?

Chairman GREENSPAN. Yes, it is, and even though its forecasting

or anticipatory capability is greatly diminished, it is not zero.

Chairman SHELBY. I want to touch on something else that you

have spoken on many times here, and that is the GSE’s. You stress

the need for any GSE reform, Mr. Chairman, to provide clear guidance over the GSE’s portfolio. You have also indicated that you do

not believe that focusing GSE’s on their core mission and

securitization mission would not adversely impact liquidity in the

mortgage markets.

11

As this Committee moves forward hopefully toward a markup

next week, I would ask you to elaborate again for the record on the

issue of the GSE’s’ role of providing liquidity in the mortgage markets and how you see the GSE’s’ securitization and portfolio business affecting the GSE’s’ ability to carry out a liquidity role. In

other words, how important is the portfolio? And I know you have

spoken of the risk for the GSE’s being in a portfolio and so forth.

Chairman GREENSPAN. First of all, Mr. Chairman, let me stipulate that the secondary mortgage market functions of the GSE’s are

critical to our evolving economy. And indeed, I might say that is

one of the means of improved intermediation which I was referring

to previously. So let me just say that the actual actions taken by

the GSE’s to purchase mortgages, securitize them, and sell them

into the market has been an extraordinarily valuable addition to

American finance.

Chairman SHELBY. It brought liquidity to the housing market.

Chairman GREENSPAN. It brought very significant liquidity to the

housing market and indeed has offered the mortgage instrument in

a securitized form to a much broader segment of American investors, and that has been very helpful to them as well.

That particular function is unaffected, in our judgment, whether

purchases of mortgages by the GSE’s are securitized and sold off

in the market, held as mortgages on the balance sheet of the GSE,

or securitized and held on the balance sheet. So, in effect, the composition of the secondary market purchases—which is what their

charter is all about—as best we can judge, between portfolio accumulation and securitization, has very little effect on market liquidity, interest rates, or anything else except the profitability of the

GSE’s.

It is strikingly obvious to those of us who have looked at this in

some detail that the motive for accumulating portfolios is solely, essentially in all respects, profitmaking.

Now, I have no objection to that. Indeed, they are profitmaking

organizations. They are chartered as such. And indeed their shareholders could very well presumably sue if they did not pursue those

goals. But accumulating portfolios is not adding liquidity to the

housing market, nor in our judgment is it assisting the market

generally. In addition, because it is a highly leveraged operation,

and one which requires very sophisticated hedging of interest rate

risk, it is imparting a significant potential systemic risk to the

American financial system.

Chairman SHELBY. Thank you.

Senator Sarbanes.

Senator SARBANES. Senator Reed.

Chairman SHELBY. You want to defer to him? Go ahead, Senator

Reed.

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

Just to follow up with respect to the GSE’s, there are several

issues here. One is liquidity to the market, which you talked about.

Another is systemic risk. It strikes me, though, that many institutions that you regulate have very large portfolios, and they maintain them to increase their profits, which is not something bad.

Would you urge that we enact legislation to set limits on these

portfolios?

12

Chairman GREENSPAN. No, we do not, and the major reason is

that these are not leveraged in anywhere near the extent to which

the GSE’s are.

A critical aspect here of the problem is the fact that the GSE’s

have relatively small amounts of capital relative to the assets they

hold. Indeed, they hold 1 to 2 percent of assets. The commercial

banks, as you know, are several multiples above that. And indeed

interest rate risk originally was not even hedged at all by commercial banks and savings and loans in the very early years, largely

because their capital was adequate to self-insure.

The GSE’s cannot self-insure. Their capital segment in their balance sheet is too small. They cannot risk not fully hedging their position.

Senator REED. You raise, I think, an interesting point because

the typical way risk is managed in a regulatory process is to increase capital rather than to put limits on growth portfolios. That

is essentially what the Federal Reserve does. If you are concerned

about the ability to manage risk in an institution, your first response, your first authority is to increase capital, which to me,

frankly, is probably an appropriate response to some of the risk

that has been illustrated in GSE’s.

Let me change the subject slightly, and that is, I presume that

the current portfolio does not engender great risk since many of

your institutions hold a great deal of the paper of these GSE’s.

They must find that these investments are prudent.

Chairman GREENSPAN. They hold them wholly because there is

a perception they are guaranteed by the full faith and credit of the

U.S. Government, despite the fact that the debentures which they

buy literally say, as required by law, that this instrument is not

backed by the full faith and credit.

The problem basically is if you ask anybody on Wall Street, they

do not care about the status of the GSE’s, the financial state. It

goes up and it goes down. The stock prices of these companies

move all over the place, but the yield spread against U.S. Treasuries locks, and the reason is that they do not envisage their holdings of GSE’s to have anything to do with the GSE’s.

Senator REED. Are there some investors that buy the debt and

equity of companies you regulate because they feel that you could

never let them go out of business, the ‘‘too big to fail’’ phenomenon?

Chairman GREENSPAN. If, in fact, we found that the debentures

that they issued had very narrow spreads against U.S. Treasuries,

I would say yes. But they do not. There are very substantial

spreads. The only way you can tell whether they believe it is to

watch the spreads. The spreads of comparable debentures for large

commercial banks or even large mortgage holding commercial

banks is very substantially higher.

Senator REED. Let me change the subject. I mentioned in my

opening remarks the study by the Boston Federal Reserve with respect to labor participation, which suggests there is a significant

and growing lack of participation in the labor force which distorts

our ability to see how well we are doing with respect to recoveries.

In fact, one thing that I found interesting was the ratio of employment to population, 62.7 percent, is below the level at the start of

13

the economic recovery in November 2001. And this is the first time

the ratio has failed to surpass its trial level so far into a recovery.

The reality is—this is not just statistics—there could be millions

of people who have been discouraged by the workforce not working,

and we have to respond to that.

Can you comment?

Chairman GREENSPAN. Yes. We have looked at the Boston report,

and I must say Board staff does not come up with numbers anywhere near what they have. We have, as I think it is, less than half

a percentage point.

Senator REED. Could you share those numbers with us, Mr.

Chairman?

Chairman GREENSPAN. Certainly we can. But let me express to

you very succinctly why that is the case.

Labor force participation over the longer-run has been driven by

two factors here of importance. One is, as you know, a very marked

increase in the participation of adult women in the labor force,

which has been going up very dramatically for decades; it finally

reached a level which is about as high as apparently it is going to

go, and it has flattened out.

At the same time, the demographics are moving closer to retirement ages where the ordinary early retirement begins to occur. So

those two structural factors are very dominant forces as to why we

have not gotten that pickup that you were mentioning. And the result is that there is some evidence that the participation rate is

down partly because of economic forces, but our numbers are nowhere near the dimensions that the Boston Fed is showing.

Senator REED. Just if I may make a final point, if, in fact, there

is this type of employment slack in the economy, it would argue

against precipitously increasing the interest rates because you still

have some capacity, I would suspect.

Chairman GREENSPAN. Well, it would certainly be arguing

against concerns with respect to rising unit labor costs and the elements underlying the economic outlook, which we obviously appraise, of course.

Senator REED. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman Greenspan, I have been in some other hearings on the Pension Guaranty Corporation, and they face a deficit of over $20

billion presently. With a large number of pension plans appearing

to be teetering, we appear to be facing a very serious situation in

that Pension Benefit Guaranty Corporation.

What impact do you think would the dumping of a few more

large pension plans on the PBGC have on the economy, if any?

Chairman GREENSPAN. It is difficult to judge. It has similar effects of other types of deficits in the Federal system. It clearly is

negative, and I think it is a worrisome thing for American taxpayers, needless to say. But it is hard to see at this stage any spillover effects yet on economic forces. As large as the numbers are, relative to a $12 trillion economy

obviously they are not yet critical. My main concern is that it ultimately will require U.S. Treasury bonds to fill in the gap, which

14

is another way of saying increasing the deficit and increasing the

Federal debt.

Senator BUNNING. Do you have any comment on this morning’s

report that the Chinese are moving away from the dollar peg toward a currency basket?

Chairman GREENSPAN. I have not had a chance to look at the full

detail of what is going on, but I must say I associate myself with

Senator Schumer. This is certainly a good first step. It is the type

of step that you would want to take when you have a decade-long

fixed structure. And so they have been cautious, and I think admirably so. But I look at it as the first step in a number of further

adjustments as they invariably increase their participation in the

world trading markets. And so I believe it is a good start.

Senator BUNNING. Yesterday, in response to a question from Congressman Royce of California regarding moving the goalpost on this

legislation, you claimed that the Federal Reserve had no concerns

regarding the portfolios of Fannie Mae and Freddie Mac until recently. These companies have been around in one form or another

since 1938.

How is it that the portfolios of the two largest financial services

companies in the country, which you claim pose a systemic risk to

the Nation’s financial security, went unnoticed until the past year

by the Federal Reserve?

Chairman GREENSPAN. Well, that is a good question. First of all,

the portfolios did not exist in any substantial form prior to, say,

1990.

Yesterday, I was asked why I have not previously raised the

issue. Let me answer this very simply. It has taken me quite a

good deal of time to disentangle the very complex structure of these

institutions to really understand how they work, what motivates

them, and where the sensitive points are.

When I first looked at this situation, I knew what the stock of

the debt was and the types of risks that held. But I was not aware

of how sensitive their profitability was between securitizing and

selling mortgages that they purchased and the amount that they

accumulated in their portfolio.

It is only fairly recently that it finally became clear to me that

that was basically how the system works, and I must say that it

was a revelation in certain respects. The more I have looked at it

since, I am impressed at how quickly, once they realized in the

early 1990’s how important a vehicle this was to profitability, how

aggressively they pursued it.

Senator BUNNING. Last question. Do you believe energy prices

have stabilized, or do you believe consumers and businesses can expect lower or higher energy prices?

Chairman GREENSPAN. Senator, I cannot answer that question,

and I tried to express some of the reasons in the formal remarks

which I put in the record. The big problem is that demand has

picked up and has been going forward now, especially because of

increased pickup in oil demand in emerging Asia, and, incidentally,

also in the United States, the consequence of which has been, after

a very gradual rise over the years, the rate of increase has picked

up enough that it has eaten into the excess capacity of the system.

15

As I point out in my prepared remarks, the geographic location

of proved reserves is relatively concentrated in the Middle East,

and most of the oil-producing countries who perceive they had poor

results when private international oil companies were extracting

their oil have essentially restricted the entrance of either the majors who have significant financing capabilities. The result of this

is that they have found, because of their growing population needs,

they require a goodly chunk of the revenues from oil to finance

their domestic needs. Therefore, there has been, as best we can

judge, an inadequate amount of investment to convert the proved

reserves into actual productive oil capacity, that is, oil wells and

the infrastructure in which you can actually extract it. The markets, as far as long-term futures are concerned, have expressed real

concern about the balance of supply and demand.

But let me just say this to you: It is a very narrow balance, and

it can go either way. So we have had a very significant run-up, and

it is perfectly credible that it could go down for a while. But I do

think that we are in a position where forecasting the direction of

oil is a particularly tricky issue short term, but longer term, unless

we address the issue of getting adequate investment to convert the

proved reserves into productive oil capacity, we are going to have

trouble meeting long-term demands of the world a decade forward

or thereabouts.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

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

First of all, Mr. Chairman, I am pleased to welcome you back before the Committee. I think, if I am correct, this will be your last

opportunity to come before us to submit a report on the conduct of

monetary policy by the Fed pursuant to the changes that were

made to the Federal Reserve Act to require the semiannual report

to the Congress. I know we worked together on bringing about that

change. My recollection is you were supportive of it at the time.

Chairman GREENSPAN. I was.

Senator SARBANES. And I hope you feel that it has proven out.

I think it has been very beneficial to have these two set periods for

an open report by the Fed with respect to the development of monetary policy. And before, we were on a kind of ad hoc, hit-or-miss

basis. I do not think that was really very satisfactory, and my perception is that it has worked very well, and I hope you feel the

same.

Chairman GREENSPAN. I certainly agree with you, Senator.

Senator SARBANES. Thank you. Now, first, I have a few questions

I want to put to you. There is a vote on, so we will try to do the

best we can within its constraints.

I want to address minimum capital standards for the banks to

begin with in the context of the efforts to negotiate the Basel Capital Accords. Congress has expressed concern repeatedly that the

minimal capital requirements on federally insured banks should be

preserved in hearing after hearing. And we have been regularly assured by the bank regulators that that would happen.

16

Therefore, it was with some concern that we read the comments

by Federal Reserve Governor Bies back in March when she spoke

to the Institute of International Bankers Annual Washington Conference, and I will just quote the article reporting on that speech.

‘‘Ms. Bies made it clear the Fed still intends to jettison the straight

capital assets leverage ratio eventually. It is a position some other

regulators, particularly Mr. Powell at the FDIC, oppose. Executives

at the largest banks, however, have argued it makes no sense to

implement Basel II without also lifting the leverage minimums.

‘The leverage ratio down the road has got to disappear,’ Ms. Bies

said. ‘I would say to the industry, if you work with us and be patient, we understand the concerns about leverage ratios, and as we

get more confidence in the new risk-based approach, it will be easier for us to move away from the leverage ratio.’ ’’

And at a hearing before this Committee, you were asked about

the minimum capital issue, and you responded as follows, and this

was to Senator Bunning: ‘‘I think the issue that is raised with respect to the leverage ratio is that it duplicates numbers of other

types of measures of capital. As you move into the Basel II framework, which is a far more sophisticated capital ratio, the need to

get the old-fashioned leverage ratio, which has worked for many

generations—we basically employed as a sole measure of capital—

the need for that is significantly diminished.’’

So we had that indication of the attitude at the Fed on this issue.

Recently, at the end of May, Governor Bies gave another speech.

She said, ‘‘While the regulatory capital requirements ultimately

produced by Basel II would be, we believe, considerably more risksensitive than the current capital regime, this is not the only capital regulation under which U.S. institutions would operate.’’

More than a decade ago, the Congress, as part of the FDIC Improvement Acts, prompt corrective action to find a critically undercapitalized insured deposit institution by reference to a minimum

tangible equity to asset requirement, a leverage ratio. The agencies

have also used other leverage ratios because experience has suggested there is no substitute for an adequate equity to asset ratio.

Federal Deposit Insurance Corporation, which was responsible to

the Congress for the management of the critical deposit insurance

portion of the safety net, has underlined the importance of that

minimum leverage ratio. The Federal Reserve concurs with the

FDIC’s view.

Just to be clear, what is the Fed’s view on the minimum capital

issue, and does the Fed take the position that the leverage ratio

down the road has to disappear?

Chairman GREENSPAN. The general view that we are endeavoring to express is that when you have a Basel type capital accord

down the road, which is essentially fully sensitive to the various

different capital needs of an institution, that there is no further

need for other measures because, by definition, the system is fully

controlled.

We are not yet there with respect to Basel II. As I have often

said, there will be a Basel III and there will be a Basel IV because

the technologies are changing, commercial banking is evolving, and

supervision and regulation should not be fixed, it should actually

17

endeavor to adjust to the changing structure of a financial or commercial banking system.

So when we get to the point—and I do not think we are there

yet—that the various structures defining what capital should be

address everybody’s concerns about supervision and control, then

there is no longer a need for a minimum capital requirement. It

would be merely duplicative, and indeed, if the system is working

well, it is actually inoperative. We are not there yet, and I think

what Governor Bies is trying to say is that we recognize that that

not yet being there, there is still a role for minimum capital and

a leverage ratio.

But that does not change the fact that when we get a sufficiently

sophisticated structure of capital supervision, that issue will become moot. So it is really a question of, as you quoted earlier, the

word is ‘‘eventually,’’ and where that is, I do not yet know. But I

do know, as indicated by both Governor Bies and Chairman Powell,

that we are not there yet.

Senator SARBANES. One quick question and then I will——

Chairman SHELBY. Proceed.

Senator SARBANES. Every statistical study shows a marked growing inequality in the distribution of income and wealth in the country. The disparities are actually the largest of any of the advanced

industrial countries, and they also loom out at you when you look

at the United States in historical terms unless you go way back

into——

Chairman GREENSPAN. The ‘‘Gilded Age’’ as they like to say.

Senator SARBANES. —the Roaring 1920’s or the Roaring 1890’s or

something. What is your view of that development?

Chairman GREENSPAN. I think it is a very disturbing trend, Senator, and the reason I say that is twofold. One, it is a reflection,

as best I can judge, of a faulty educational system in the United

States. As you know, we receive relatively poor marks internationally, especially as our students move from the 4th grade to the

12th grade. That, as I think I have testified here before, creates a

inadequate movement of students through high school, into college,

and into skilled jobs, so that the total supply of skilled workers is

sufficiently large relative to the increasing demand for skills because of technology to keep the skilled wage level down.

We have been unable to do that, and indeed, we end up with too

many people who are lesser skilled, vying for jobs which are declining in number, so that the wage rates there are constricted, and

it is causing this rather major dispersion.

A free market democratic society is ill-served by an economy in

which the rewards of that economy distributed in a way which too

many of our population do not feel is appropriate. More importantly, they do not feel the advantages and benefits coming from

the system that a smaller but still significant group have experienced. So, I am concerned about this. I think it is a major issue

in this country.

Senator SARBANES. Thank you very much.

Thank you, Mr. Chairman.

Senator ALLARD. [Presiding.] Thank you, Senator Sarbanes. The

Chairman has stepped out. My turn is next, so I will go ahead and

resume questioning.

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As Chairman of the Housing Subcommittee, I would like to discuss a number of issues related to housing. Your testimony mentioned exotic loan products, and that caught my attention because

I believe that Colorado is probably one of the higher States as far

as foreclosures are concerned. Many in Congress I think have

shared your concerns about those certain loan products such as interest-only loans, and also what we call negative advertising loans.

My question is, do these loan products create new sustainable

homeownership? In other words, these new products, are they replacing the conventional loan, and are there some negative results

as a result of that?

Chairman GREENSPAN. Well, Senator, actually all of these loans,

properly used, are not bad instruments. In other words, they give

the consumers, the mortgagors, indeed the mortgagees as well, a

broader set of instruments which can be employed, so there is

greater consumer choice.

Our concern is that a number of these instruments are being

used to enable people to purchase homes who would otherwise not

have been able to do so. In other words, they are stretching to

make the payments, and that is not good lending practice for banks

or other purveyors of mortgages, and certainly it is not good practice on the part of pending homeowners.

It is a concern to us. Fortunately, it is not a large enough part

of the market to create serious systemic problems, but it is an

issue, and we at the Federal Reserve and other banking supervisors are looking at that. We are examining these issues, and we

are making decisions as to what, if any, guidance to the banking

system we would endeavor to convey.

Senator ALLARD. So just to follow up on that, you do not see any

need for any kind of legislative remedy or anything at this point

in time?

Chairman GREENSPAN. We do not need any legislative remedy. It

is wholly under the regulatory authorities of the banking agencies.

Senator ALLARD. Do you think the banks are utilizing proper underwriting standards for these type of products, and are we having

more of a problem in certain States than in other States?

Chairman GREENSPAN. I do not know that. That is factually capable of being ascertained, and I assume some of my colleagues do

know the answer to that question. It is not, in my judgment, at

least what I have heard, an issue that is critical or something that

requires immediate response. But it is enough of an issue that I

think we have to look at it, and that is what we are doing, we are

looking very closely.

Senator ALLARD. I appreciate your response on that.

Now, on various occasions you have downplayed the idea of a national housing bubble, and have instead pointed to a situation

which some regions of the country are exhibiting signs of, I quote,

‘‘froth’’ I guess. And I am pleased to hear comments that while

housing prices may well decline, such a decline would not necessarily derail the economy. Would you not agree though that while

this may be true for the Nation as a whole, a correction could have

a significant impact within a specific community or region? Could

you please elaborate what the future could hold for such a city or

19

region, and what can or should be done to mitigate the damage

such a correction could cause?

Chairman GREENSPAN. We have had such experiences in the

past, and quite correctly, there have been regional problems associated with unwinding of frothy local housing markets.

One thing that obviously is an issue with respect to the overall

economy of these metropolitan areas, is that unlike earlier history,

we have developed a mortgage instrument to a point, and the ability to extract equity from homes to such an extent, that now a surprisingly large proportion of consumer expenditures and home modernization outlays are financed by home equity extraction. That is

clearly a consequence of one, house turnover, largely because, of

course, the seller of the home extinguishes a mortgage which is less

than the mortgage of the buyer of the home, which is essentially

a reduction or extraction of equity from that home of that exact difference. Then of course there are cash-outs, which have increased

over the years, associated with refinancing, and then finally, a significant amount of extraction of unrealized capital gains essentially

from home equity loans.

These are large enough to be an issue in the overall consumption

expenditures of a local community, and in the event that you begin

to get a retrenchment in house turnover, which would presumably

be associated with unwinding of a frothy market, you would probably also have impacts on consumer expenditures in that particular

area.

There are obviously national implications of this as well. We

would expect as the housing boom eventually simmers down, as we

have long expected it would but find no evidence that it is about

to, that it would begin to have some impact on consumption expenditures, and if not for the fact that we perceive capital investment picking up the slack, it would give us some pause as to

economic consequences of the adjustment process.

Senator ALLARD. Mr. Chairman, you kind of moved into my second question where people were extracting this equity out of their

home. If the value of these homes should begin drop or something,

that could create some problems for our national economy, or would

it not?

Chairman GREENSPAN. Well, the run up in prices has been so

significant, and the accumulated equity has been so large, indeed,

it has been larger than the debt increase. So that the ratio of equity in homes to debt has been rising in the most recent period. So

there is a fairly significant buffer. But there is no question that,

if you confronted a situation of declining house turnover and even

declining house prices, home equity extraction would be expected

to decrease.

Senator ALLARD. Mr. Chairman, I have a few questions, if I may

proceed.

Chairman SHELBY. [Presiding.] You go ahead, you take your

time.

Senator ALLARD. This has to do with the terrorist attacks and

the security in our financial industry. Do you believe that the financial services industry is prepared to protect people, processes,

and infrastructure against potential disruptions from a terrorist attack, and do you see any further steps that need to be taken if not?

20

Chairman GREENSPAN. This is obviously under significant discussion now with the question of the expiration of TRIA. It gets to the

base of a very difficult question: How does a civilized society with

an economy based on the rule of law deal with the losses from violence?

What we have done over the years is very successfully construct

an insurance system which basically has picked up a lot of different losses from disruption from violence, from everything else,

and it is a very sophisticated system which has evolved over the

years and is still evolving.

We are now confronted with something different, and it is different because of the technological changes and the ways in which

things can be destroyed. There is a potential very large scope of

damage that can occur, which the existing insurance system would

have difficulty figuring out how to insure and basically cope with

the problem.

This is why I have argued that there should be a fall-back position for very large terrorist attacks, where as the Government socializes a good deal of potential violence—and that is what our

military budgets are, that is what our police forces are—there is a

role if this terrorism level continues to pose the potential for very

large disasters.

So, I would perceive that until and unless we get this issue of

terrorism to a dimension where the private sector can fully handle

it, there is a role here for Government.

Senator ALLARD. So you think that at this particular point, it

might be appropriate for the Congress to provide some subsidy to

the terrorist insurance, on the umbrella coverage?

Chairman GREENSPAN. Yes. But I think the Administration’s proposals of delimiting some of it and having very large copayments

are very sensible. The reason is that to the extent you socialize

risks, you cause the misallocation of capital in a market economy

and this reduce the standards of living, and so you have a tradeoff

here. The more socialization of risk that you create, which is what

we are talking about, the more potential distortion in the private

sector’s capital account allocation. So we have to be very careful

about what types of things we are trying to insure against, and it

should be very succinctly limited to very large events. Part of the

reason is that the technology has never been there for a small

number of people to create as much damage as they apparently can

with essentially various different forms of terrorism, which we

have not really experienced in this country, and hopefully will

never.

If we, however, can find ways of diminishing the risk, at some

point it is conceivable the private sector could handle the whole

thing.

Senator ALLARD. Thank you, Mr. Chairman. You have been very

tolerant.

And thank you, Chairman Greenspan.

Chairman SHELBY. Senator Bennett.

Senator BENNETT. Thank you very much.

Several items, Chairman Greenspan. In your prepared testimony,

in that portion which you read to us, you made reference to—let

me read it because I was struck by it as important to note—‘‘A

21

prominent concern is the growing evidence of antiglobalization sentiment and protectionist initiatives, which if implemented, would

significantly threaten the flexibility and resilience of many economies. The situation is especially troubling for the United States,

where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic

disruption.’’

I am fishing here for a comment on the importance of CAFTA.

I think economically CAFTA is a relatively small deal because the

economies of Central America are not that vital to our $12 trillion

economy, but symbolically I think CAFTA is a very big deal, and

I get the sense from your testimony that you would agree. But I

want to give you the opportunity to comment rather than just put

words in your mouth.

Chairman GREENSPAN. I do, Senator, and the reason is it is part

of the very critical issue of globalization. We in this country have

embraced globalization over the decades, very much to our benefit.

The world trading system has expanded dramatically. World standards of living have expanded dramatically, and it is we in the

United States who have benefited the most.

We recognize, however, that the very nature of globalization,

which creates ever higher standards of living, also is a process

which we call ‘‘creative destruction,’’ which essentially means that

the depreciation reserves of obsolescent capital get employed to finance cutting edge capital, and the differential productivity between the obsolescent capital and the newer capital creates the

increase in standards of living. That is the actual thing which engenders the result.

The problem with creative destruction is that it is destruction,

and there is a very considerable amount of turmoil that goes on in

the process. As I have mentioned here many times, we hire and essentially let go a million workers a week in this country. It is a

huge churning turnover. What we must focus on is that as we gain

the benefits of globalization, it is important that the problems of

those who are on the destruction side of the globalization problem

be addressed appropriately.

As Senator Dole said earlier today, we have to get focused on

training, on the issue of various different means to retrain

workforces which are being altered, or doing what is required to

recognize the nature of the problems of those people who are associated—it is a minority of the people, but it is a large enough minority that we have to address the fact that they are in serious

trouble on occasion.

Senator BENNETT. When you are a member of the minority, it is

not a small problem.

Chairman GREENSPAN. It is 100 percent of the problem.

Senator BENNETT. Let me turn again to the GSE’s and the issue.

One of the facts of life that I have learned here is that you can tell

how a piece of legislation is going to affect the marketplace by seeing who is lined up on which side of the issue. And as people have

come to see me, pleading that heavy restrictions be put on the portfolio size of the GSE’s, and then others have come to see me pleading that nothing be done with respect to the portfolios of the GSE’s,

aside from the GSE’s themselves—you know, you kind of set aside

22

their statements because their position is fairly clear. A pattern

has seemed to emerge. The small banks, the mortgage brokers, the

homebuilders, realtors, are all saying do not mess with the portfolios of the GSE’s. The big banks, Citibank, Wells Fargo, saying

yeah, absolutely do this to the GSE’s.

This may be an oversimplification, but as I sort through the advocates on either side of this fight, I find it is kind of rural on one

side and big city on another. It is kind of small bank brokerage operations that deal with small institutions on one side, big banks on

the other. The implication being that the independent banks, the

community banks are benefitted by the present situation and the

big banks are competing with the present situation; therefore, the

one would like to see it stay and the other would like to see it

change.

Fannie Mae and Freddie Mac do not require anybody to sell

them a mortgage. The market works. People bring it to them. And

the only reason that somebody would bring a mortgage to Fannie

Mae would be if the price were better or if the service were better.

And as I have talked to people on the anti side, if you will, they

have indicated that they believe if Fannie Mae and Freddie Mac

are constrained in their portfolios, that the price will go up and

they will be forced to deal with other institutions where they think

the service—if the price goes up, they still would rather deal with

Fannie Mae because they think it is more convenient, they move

more rapidly, they are much more flexible.

What would you say to these groups, legitimate groups, who are

not shareholders of Fannie Mae or Freddie Mac? How would you

reassure them that if we did what you wanted to do, they were

going to be just fine?

Chairman GREENSPAN. It is a question of fact. See, here is what

the problem is, to directly relate to your issue. I am a community

bank and I have been very appreciative of the secondary mortgage

market to take the mortgages I have and sell to them. They are

confronted with an issue of uncertainty as to what would happen

in the event if the portfolio of the GSE’s went down. The GSE’s and

a lot of other people say it is going to cause interest rates to go

up. Nobody says, including the Federal Reserve, that will cause interest rates to go down.

So, they are confronted with an uncertainty of the fact that they

seem to be better off with the status quo. The truth of the matter

is they are not. That is, there is no evidence that the amount of

purchases made by Fannie, Freddie, and indeed a very large and

increasing private sector, would be bidding significantly different

prices for their home mortgages. And the decision whether those

accumulated mortgages by, say, Fannie and Freddie, end up in

their portfolio or end up securitized and sold into the marketplace

is essentially made after they are purchased from, let us say, a

community bank.

So there is an understandable concern if you are not fully familiar with how the markets work and there is no potential on the

other side. In other words, if I am confronted with very little

knowledge but I know the chances are only that a certain thing can

go in the wrong direction for me, I will argue for the status quo.

Now, that is a perfectly understandable and reasonable case, and

23

that is true, incidentally, I think, of the homebuilders as well. I

think they are mistaken. Indeed, I know they are mistaken. But I

fully understand where they are coming from.

So the concern that I have is that over the longer-run they are

actually at risk here, as we will all be at risk if indeed there is a

systemic problem. Then there will be very serious problems for the

housing market and they will find that they are at significant risk.

They do not perceive that now because they do not perceive what

could conceivably be occurring in the future, which is what is motivating Federal Reserve. So it is a difficult issue of who knows what

about what is going on. I do not find any difficulty in understanding where these various positions are coming from. And I

would make the same argument, incidentally, in reverse, for the

big banks.

Senator BENNETT. If I may, Mr. Chairman, go forward with that.

Chairman SHELBY. Go ahead.

Senator BENNETT. You would make the same argument in reverse?

Chairman GREENSPAN. Yes, in other words——

Senator BENNETT. The big banks presumably will increase their

market share——

Chairman GREENSPAN. Yes, what I am basically saying is I think

that the amount of market share that they think that will occur

as a consequence of this is not obvious to me in any particular way.

Senator BENNETT. Okay, so you are saying that the big banks

who are beating on me, you have to do this, this is a terrible competitive they are going to be disappointed.

Chairman GREENSPAN. Well, unless they are using the arguments that I am using. We have to distinguish between the mortgage market and the securitized market. In the securitized market,

yes, the commercial banks will probably pick up some advantages

because indeed that will be one of the purposes of changing the

system. I think, however, that the nature of the argument misses

the really fundamental point, which is that we are creating a potential very serious systemic risk. And to have arguments that are

going on about whose market share or whose potential profits will

change in somewhat different ways, I think, is missing the much

larger point.

Let me respond in writing to you about how I think the specific

changes might occur in these markets. There are changes. I do not

want to deny that there will be changes. But I think people extraordinarily exaggerate what the implications are. And for the

self-interest of all parties, in my judgment, making certain that we

do not have a systemic problem occurring because there is a very

large accumulation created by incentives to hold ever-increasing

portfolios to get ever-increasing incomes, in the long-run will redound to nobody’s benefit, because we will all lose.

Chairman SHELBY. Mr. Chairman, I would also request a copy of

that letter, if you would, please.

Senator BENNETT. Yes, that would be very helpful. And my time

is gone, but I look forward to having additional conversations with

you about this.

Thank you very much.

24

Chairman SHELBY. Chairman Greenspan, since we are talking about GSE’s, how many companies with $12 billion accounting errors—which would be representing a significant portion of the capital of that company—see no increase in debt cost in the market

after that? I am referring to Fannie Mae.

Chairman GREENSPAN. It is very simple. Because it has nothing

to——

Chairman SHELBY. Oh, it is the implicit guaranty.

Chairman GREENSPAN. Yes. It has nothing to do with the status

of Fannie Mae or Freddie Mac.

Chairman SHELBY. Thank you.

This Committee has previously raised questions with you, Mr.

Chairman, and Treasury Secretary Snow regarding the large Chinese and Japanese official holdings of U.S. Treasuries. Your report

today indicates that data from Treasury indicates that demand for

these securities from foreign official investors has ebbed during the

first 5 months of this year. Obviously, the Chinese Government announcement to switch to a currency basket in setting its peg could

also affect that demand.

Mr. Chairman, do you anticipate that long-term rates may be affected by the changes in foreign official demand, or do you expect

such changes to unfold slowly over time and thus be absorbed into

the market?

Chairman GREENSPAN. Well, two things happened. We have estimated, I think I have testified before, that the accumulation on foreign account has probably subtracted something under 50 basis

from long-term interest rates in the United States. Should that unwind, that is about the order of magnitude we are talking about.

But markets anticipate what is likely to occur. As a consequence

of that, you could very well get changes that are up front in anticipation of things that will go on longer term.

Chairman SHELBY. Factored it in, in a sense?

Chairman GREENSPAN. Yes. In other words, the markets do not

wait—they anticipate. So we could get some impact sooner rather

than later.

Chairman SHELBY. Mr. Chairman, the Chinese Government

today, as we have been talking about, announced a 2 percent reevaluation of its currency and the move to a currency peg linked

to a basket of currencies rather than just linked to the U.S. dollar.

Other Asian countries, like Japan and Korea, who have extensive

trade relationships with China, have grown accustomed to China’s

fixed exchange rate policies. How will China’s other Asian trading

partners manage this transition by the Chinese, and won’t these

countries have to allow more flexibility in their currencies in order

to see a more level playing field for the United States?

Chairman GREENSPAN. I think we are already seeing that. I

mean, Malaysia this morning also moved, as I recall.

Chairman SHELBY. So the market again anticipated this move

and has reacted to it?

Chairman GREENSPAN. Yes. If you look, for example, the dollar

weakened significantly against the yen this morning, as a consequence of this move.

Chairman SHELBY. Mr. Chairman, your testimony also discussed

at length what others have referred to as the savings glut. One facVerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00028 Fmt 6633 Sfmt 6633 24852.TXT SBANK4 PsN: SBANK4
25

tor you note is corporate behavior and the softness in capital investment. This is particularly puzzling in light of strong profits in

the corporate sector and lower interest rates. Could you touch further on the potential causes of this behavior and whether our Nation’s economy has ever experienced similar circumstances? Should

the situation persist, how would this affect the Federal Reserve’s

growth projections?

Chairman GREENSPAN. Well, as I indicated in my prepared remarks, capital investment in the United States is expanding, and

indeed we are expecting it to expand a good deal further.

Chairman SHELBY. Do you think it is adequate?

Chairman GREENSPAN. It is less than one would have expected,

given the levels of cashflow and, indeed, other measures that usually were associated with capital investment. I attribute this in my

remarks to the aftermath of the stock market liquidation and the

corporate scandals, which had a fairly profound effect on corporate

governance and on the risk aversion of corporate managers. I think

we are still seeing the aftermath of that, although there is some

evidence that it is beginning to dissipate, and that is one of the

reasons we perceive that the outlook for capital investment in the

United States is quite favorable.

Chairman SHELBY. Thank you.

Oh, excuse me, Senator Corzine. My eyes aren’t as good as yours.

Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Your eyes are pretty good, particularly when

we are looking at legislation, Mr. Chairman.

I appreciate the Chairman being here. Let me ask, have you commented today, with respect to the House bill, with regard to GSE’s?

Chairman GREENSPAN. I have not, Senator.

Senator CORZINE. Do you have views with regard to the House

bill?

Chairman GREENSPAN. You are talking about what the House Financial Services Committee voted on?

Senator CORZINE. Yes.

Chairman GREENSPAN. That question was asked me yesterday at

that Committee, and I said it did not address the problems that I

thought were extant with respect to the GSE’s, and indeed, went

further and said that we would probably be better off with no bill

than a bill of that nature.

Senator CORZINE. And your major problems?

Chairman GREENSPAN. Largely the issue of portfolio to what we

have been discussing with——

Senator CORZINE. And I know you have spoken often about this,

but have you narrowed or become more precise on how you believe

those portfolios restrictions should——

Chairman GREENSPAN. I thought that the particular formulation

by the Secretary of the Treasury with respect to what he thought

would be an appropriate bill struck us as pretty much where we

thought it should be. That is essentially, as you may recall, stipulating that the level of portfolio should reflect, aside from obvious

liquidity needs and the turnover of very vast amounts of mortgages, the charter requirements of the GSE’s, but that strictly for

26

the purpose of creating increased earnings would not be a justification for building up portfolios.

Senator CORZINE. But are you suggesting, and is the Treasury

Secretary suggesting, in your view, that would be based on riskbased modeling with respect to what was an appropriate——

Chairman GREENSPAN. You mean for the GSE’s?

Senator CORZINE. Yes.

Chairman GREENSPAN. No. We are not raising the question with

respect to the portfolios as a risk to the GSE’s; on the contrary. It

is expanding their profitability and everything else that goes with

it. Our concern is the systemic risk, not safety and soundness risk.

The House bill specifically puts the capability of a regulator to adjust portfolios on the basis of safety and soundness, which I read

refers to the safety and soundness of the GSE’s, not the systemic

questions that we raise.

Senator CORZINE. Is that consistent with bank regulation?

Chairman GREENSPAN. No, it is a different standard.

Senator CORZINE. It is a different standard for GSE’s?

Chairman GREENSPAN. Yes, indeed. At least in my judgment.

Senator CORZINE. And could you explain to me why that systemic

risk is so much different in an institution of a trillion dollars in one

format versus a trillion dollars in another format?

Chairman GREENSPAN. Let me be very explicit. It has to do with

the extent of leverage. In commercial banks, for example, I should

say capital is several multiples, many multiples higher than what

the GSE’s are holding. As a consequence, banks do not, in our judgment, raise the level of systemic risk that the GSE’s raise. It is a

different order of magnitude largely because of, one, the size of the

leverage and two, the extent to which the financial markets grant

the GSE’s effective U.S. Treasury status with respect to their bond

issuance, when they do not do for commercial banks.

Senator CORZINE. Okay, so if it were capital, then risk capital associated with the underlying assets should put them on an equal

playing field, I would think. If their regulator chose risk capital

measures——

Chairman GREENSPAN. There would be two issues here. Unquestionably, if their risk-based capital were raised to the level of

where the commercial banks are, that would assuage a good deal

of the problem. It would still leave the issue, however, of the ability

of the part of these institutions to raise any amount of capital at

very low interest rates, irrespective of the status of the institution.

Indeed as the Chairman pointed out, how is it possible I do not

know whether that was just before you came in or not——

Senator CORZINE. I apologize. I had other things——

Chairman GREENSPAN. —how is it possible to have these huge

accounting losses and serious questions about what the earnings of

these institutions are and have virtually no effect on the rates at

which they can sell debentures. The reason, essentially, is that the

financial state of Fannie and Freddie has almost nothing to do with

what the interest rate is on their debentures or their ability to actually sell them.

Senator CORZINE. Supply and demand, at some point, has impact

on rates.

27

Chairman GREENSPAN. It does, and it will eventually occur with

U.S. Treasury issues, and I presume at that time it will affect the

GSE’s.

Senator CORZINE. May I ask one other question?

Chairman SHELBY. Go ahead.

Senator CORZINE. Have you been asked about TRIA?

Chairman GREENSPAN. Yes, I have.

Senator CORZINE. I will check the record, then, unless you want

to repeat.

Chairman GREENSPAN. I will be glad to respond in writing to you

if there are other things that you would like.

Senator CORZINE. Please. Thank you.

Chairman SHELBY. I will get Senator Bennett first. I think he

has a question.

Senator BENNETT. Yes, one quick additional issue that I would

like to raise with you again just to get this on the record.

As we grapple with the Social Security problem, and I am trying

to craft a solution that deals with the solvency challenge, I think

the political situation says that the personal accounts will be a

fight we will have at some future point. I think there are good

enough idea that they will stay around and I think eventually the

Congress will adopt them. But in this Congress, there does not

seem to be an appetite to do that and the solvency issue is still

very much with us. So, I have tried to craft a bill to deal with that,

as my colleagues know.

But in this process, I come back to an issue that you have commented on in the past and I would like to get a fresh response from

you so that I am not guilty of using outdated information. This has

to do with the professional consensus among economists which says

that the CPI overstates changes in the cost of living, and the Bureau of Labor Statistics in 2002, perhaps in response to that consensus, began publishing a new index called the Chain CPI. I had

a little trouble understanding what that meant. But it takes into

account the fact that consumers will make substitutions in their

purchases. If the price of X goes so high, they will switch to Y, and

so their standard of living presumably has not changed that much,

but the cost of living is better measured by the chain CPI.

My staff on the Joint Economic Committee has come up with information that the implications of using the chain CPI as opposed

to the CPI are huge. Over 10 years, the Boskin Commission says,

quoting CBO, that if CPI overstated the cost of living by 1.1 percent per year, the standard programs that we have in place would

increase the national debt by a trillion dollars over a 10-year period. And Congress may want, as a matter of policy, to say let’s increase the national debt by a trillion dollars in order to increase

these programs by more than the cost of living, but at least the

stated position of Congress in the current law is that we simply

want to have the actual cost of living taken care of.

Another side of it is that CPI is tied to the taxation bracket,

which means that people get a massive tax cut over time with respect to the issue of bracket creep. Bracket creep is dampened by

using the CPI. So you get less revenues and more expenditures by

doing this, which means that the trillion-dollar number may be exacerbated by the impact on the tax side. I do not think they took

28

the tax side into consideration when they looked at the expenditure

side.

Could you comment on all of this and where you think we as policymakers should go on this issue?

Chairman GREENSPAN. We at the Federal Reserve Board have

been looking at this for a number of years. I think our most recent

estimate is that the Consumer Price Index itself is biased upward

by a little under 1 percent at this stage.

Senator BENNETT. That is a little less than the Boskin thing, so

it would not be quite a trillion dollars.

Chairman GREENSPAN. Yes. The reason for that is, remember

that the Bureau of Labor Statistics has made a number of changes

addressing the problems of the Boskin Commission, which in retrospect probably underestimated the extent of what the issue of the

bias was. Because if you take our current evaluation and add back

the BLS adjustments, I think we go higher than the Boskin Commission data would suggest.

What we also find is that the CPI chain index takes off roughly

half of that bias. It does not take the whole bias out, and indeed,

if the Congress literally wanted to have an index which was the optimum estimate of what the cost-of-living change really was, you

would need to find a mechanism that actually made the adjustment

for the full bias. And that, you know, is close to the 1.1 percent

number to which you were referring.

I think that is very difficult to do unless you get, as I suggested

many years ago, a commission which would sit there each year, reevaluate what the nature of the bias was, and set what the adjustment for all Federal programs would be. Short of that, switching

to the chain index, which is just a reweighting in a fully mechanical, understandable way by the BLS, would give us a far superior,

less biased measure of what the cost of living is. It will not go all

the way, but it will take a good deal out of both, obviously, the tax

side and the spending side.

Senator BENNETT. Thank you very much.

Chairman SHELBY. Mr. Chairman, just for the record again, I

would like to know what size portfolio, in your judgment, roughly,

should the GSE’s maintain?

Chairman GREENSPAN. I do not have a specific number. It is significantly below where it is now. They still have very significant

needs for liquidity, but incidentally, that liquidity should be in

Treasury bills. But they do not want to hold Treasury bills, because

to sell debentures and invest in Treasury bills does not make any

money; in fact, you would probably lose something. It is the selling

of debentures to invest in mortgage-backed securities which gives

you a nice big fat yield.

So the presumption that is often stated—that they need this

whole stock of mortgage-backed securities for liquidity purposes—

raises a very interesting point: How in the world does holding

mortgage-backed securities in your portfolio give you the capability

of buying other mortgage-backed securities? In other words, the

only thing that will do that——

Chairman SHELBY. That is a bogus argument, really.

Chairman GREENSPAN. Yes. The only thing that will do that is

if they built up either cash balances or Treasury bills or something

29

which they could liquidate quickly and employ. The presumption

that you have a large portfolio of mortgage-backed securities for

the purposes of liquidity presupposes that you sell a mortgagebacked security to get the cash to support another mortgage-backed

security. That obviously is a zero-sum game.

So the amount of liquidity that is involved and required, strikes

me as something that the regulator has to make a judgment on.

But I do think that what should be specified is what that portfolio

could be held for. There are liquidity purposes; there are a significant number of mortgages which cannot be securitized, a lot of

them basically under affordable housing programs, and we would

say they should be held in the portfolio; and a number of other

things. But essentially restrict it to the purposes of the charter.

Chairman SHELBY. The mission, huh?

Chairman GREENSPAN. Yes.

Chairman SHELBY. Thank you.

Senator Schumer.

Senator SCHUMER. Well, thank you, Mr. Chairman. I apologize

for being away for a long, busy day in many ways.

I know you have talked a little bit about the Chinese currency,

so I will not have you repeat that. You were asked about terrorism

insurance, so I will not have you repeat that. And I could not agree

with you more, the private market cannot handle this alone.

I have one topic I would like to ask about, and I thank the Chairman.

As you know, Mr. Chairman, there are ongoing discussions as to

whether we should fully repeal the estate tax—this is a tax that

affects about one American in 100—or whether there can be some

reasonable or permanent compromise that can garner the necessary 60 votes, because it breaks the Budget Act, as you know.

The Federal deficit this year, excluding Social Security, will be

huge, more than half a trillion this year alone. You also know, of

course, that full repeal would cost $300 billion in the next 10 years

and $750 billion if you go between 2011 and 2020—you know, the

years that the present law is not in effect. And that would be if

the costs are not offset.

So my question is, given these deficits and the cost of repeal, if

there are no offsets, can we afford to repeal the estate tax and increase the deficit by another $750 billion, if there are no offsets?

Chairman GREENSPAN. I think that is the critical question because, as I have testified on numerous occasions, I am strongly in

favor of reducing taxes on capital, but under PAYGO. As a consequence, I would say if there are no offsets, obviously PAYGO is

operative in that respect and the issue is moot.

Senator SCHUMER. The issue is not moot.

Chairman GREENSPAN. Well, the issue—in other words, if you—

the issue——

Senator SCHUMER. Not everyone has your view.

Chairman GREENSPAN. Okay. Well, that is a——

Senator SCHUMER. But I just—if we could just translate——

Chairman GREENSPAN. I will rephrase.

Senator SCHUMER. If we could just translate that into a

straight—you know, into——

Chairman GREENSPAN. I am trying not to translate.

30

Senator SCHUMER. Oh, c’mon. This is your last time here. We

have a big, big deficit.

Chairman GREENSPAN. You mean I am going to become perfectly

clear the last time I come here?

Senator SCHUMER. Yeah, exactly.

[Laughter.]

But is it unfair to say you would advise not to repeal the estate

tax if there are not offsets, if there is no PAYGO?

Chairman GREENSPAN. That is correct. I think that PAYGO is an

essential ingredient going forward and that all programs, both the

spending and revenue programs, come under that.

Senator SCHUMER. I take it there is a proposal for a compromise,

which would cost about 80 to 90 percent of the full cost. In other

words, some have proposed going to a capital gains rate rather

than the 55 percent—that would be 15—and raising the floor to

about $7.5 million. It is now, I do not know, it was originally 1. I

think it is 1.5 now. It is one and a half now; it goes up and then

it goes back down.

I take it that would cost, instead of $750 billion over the next 10

full years, v2011 to 2020, that would cost $600, $625, $630 billion.

I take it, again, without PAYGO, without an offset, you would

think we should not do that at this point.

Chairman GREENSPAN. That is correct.

Senator SCHUMER. Thank you, Mr. Chairman.

Chairman SHELBY. Chairman Greenspan, thank you for your appearance today and all the other appearances and your service to

the country.

The hearing is adjourned.

[Whereupon, at 12:10 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

31

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

JULY 21, 2005

Mr. Chairman and Members of the Committee, I am pleased to be here to present

the Federal Reserve’s Monetary Policy Report to the Congress.

In mid-February, when I presented our last report to the Congress, the economy,

supported by strong underlying fundamentals, appeared to be on a solid growth

path, and those circumstances prevailed through March. Accordingly, the Federal

Open Market Committee (FOMC) continued the process of a measured removal of

monetary accommodation, which it had begun in June 2004, by raising the Federal

funds rate 1/4 percentage point at both the February and the March meetings.

The upbeat picture became cloudier this spring, when data on economic activity

proved to be weaker than most market participants had anticipated and inflation

moved up in response to the jump in world oil prices. By the time of the May FOMC

meeting, some evidence suggested that the economy might have been entering a soft

patch reminiscent of the middle of last year, perhaps as a result of higher energy

costs worldwide. In particular, employment gains had slowed from the strong pace

of the end of 2004, consumer sentiment had weakened, and the momentum in

household and business spending appeared to have dissipated somewhat.

At the May meeting, the Committee had to weigh the extent to which this weakness was likely to be temporary—perhaps simply the product of the normal ebb and

flow of a business expansion—and the extent to which it reflected some influence

that might prove more persistent, such as the further run-up in crude oil prices.

While the incoming data highlighted some downside risks to the outlook for economic growth, the FOMC judged the balance of information as suggesting that the

economy had not weakened fundamentally.

Moreover, core inflation had moved higher again through the first quarter. The

rising prices of energy and other commodities continued to place upward pressures

on costs, and reports of greater pricing power of firms indicated that they might be

more able to pass those higher costs on to their customers. Given these considerations, the Committee continued the process of gradually removing monetary accommodation in May.

The data released over the past 2 months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in

the pace of activity. Employment has remained on an upward trend, retail spending

has posted appreciable gains, inventory levels are modest, and business investment

appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer

price inflation have eased of late, the prices of oil and natural gas have moved up

again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near-term. Slack in labor and product markets has

continued to decline. In light of these developments, the FOMC raised the Federal

funds rate at its June meeting to further reduce monetary policy accommodation.

That action brought the cumulative increase in the funds rate over the past year

to 21⁄4 percentage points.

Should the prices of crude oil and natural gas flatten out after their recent runup—the forecast currently embedded in futures markets—the prospects for aggregate demand appear favorable. Household spending—buoyed by past gains in

wealth, ongoing increases in employment and income, and relatively low interest

rates—is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions

in financial markets and the ongoing need to replace or upgrade aging high-tech and

other equipment. Moreover, some recovery in nonresidential construction appears in

the offing, spurred partly by lower vacancy rates and rising prices for commercial

properties. However, given the comparatively less buoyant growth of many foreign

economies and the recent increase in the foreign exchange value of the dollar, our

external sector does not yet seem poised to contribute steadily to U.S. growth.

A flattening out of the prices of crude oil and natural gas, were it to materialize,

would also lessen upward pressures on inflation. Overall inflation would probably

drop back noticeably from the rates experienced in 2004 and early 2005, and core

inflation could hold steady or edge lower. Prices of crude materials and intermediate

goods have softened of late, and the slower rise in import prices that should result

from the recent strength in the foreign exchange value of the dollar could also relieve some pressure on inflation.

Thus, our baseline outlook for the U.S. economy is one of sustained economic

growth and contained inflation pressures. In our view, realizing this outcome will

32

1 Under current law, those longer-run pressures on the Federal budget threaten to place the

economy on an unsustainable path. Large deficits could result in rising interest rates and evergrowing interest payments on the accumulating stock of debt, which in turn would further augment deficits in future years. That process could result in deficits as a percentage of gross

domestic product rising without limit. Unless such a development were headed off, these deficits

could cause the economy to stagnate or worse at some point over the next couple of decades.

require the Federal Reserve to continue to remove monetary accommodation. This

generally favorable outlook, however, is attended by some significant uncertainties

that warrant careful scrutiny.

With regard to the outlook for inflation, future price performance will be influenced importantly by the trend in unit labor costs, or its equivalent, the ratio of

hourly labor compensation to output per hour. Over most of the past several years,

the behavior of unit labor costs has been quite subdued. But those costs have turned

up of late, and whether the favorable trends of the past few years will be maintained is unclear. Hourly labor compensation as measured from the national income

and product accounts increased sharply near the end of 2004. However, that measure appears to have been boosted significantly by temporary factors. Other broad

measures suggest hourly labor compensation continues to rise at a moderate rate.

The evolution of unit labor costs will also reflect the growth of output per hour.

Over the past decade, the U.S. economy has benefited from a remarkable acceleration of productivity: Strong gains in efficiency have buoyed real incomes and restrained inflation. But experience suggests that such rapid advances are unlikely to

be maintained in an economy that has reached the cutting edge of technology. Over

the past 2 years, growth in output per hour seems to have moved off the peak that

it reached in 2003. However, the cause, extent, and duration of that slowdown are

not yet clear. The traditional measure of the growth in output per hour, which is

based on output as measured from the product side of the national accounts, has

slowed sharply in recent quarters. But a conceptually equivalent measure that uses

output measured from the income side has slowed far less. Given the divergence between these two readings, a reasonably accurate determination of the extent of the

recent slowing in productivity growth and its parsing into cyclical and secular influences will require the accumulation of more evidence.

Energy prices represent a second major uncertainty in the economic outlook. A

further rise could cut materially into private spending and thus damp the rate of

economic expansion. In recent weeks, spot prices for crude oil and natural gas have

been both high and volatile. Prices for far-future delivery of oil and gas have risen

even more markedly than spot prices over the past year. Apparently, market participants now see little prospect of appreciable relief from elevated energy prices for

years to come. Global demand for energy apparently is expected to remain strong,

and market participants are evidencing increased concerns about the potential for

supply disruptions in various oil-producing regions.

To be sure, the capacity to tap and utilize the world’s supply of oil continues to

expand. Major advances in recovery rates from existing reservoirs have enhanced

proved reserves despite ever fewer discoveries of major oil fields. But, going forward,

because of the geographic location of proved reserves, the great majority of the investment required to convert reserves into new crude oil productive capacity will

need to be made in countries where foreign investment is currently prohibited or

restricted or faces considerable political risk. Moreover, the preponderance of oil and

gas revenues of the dominant national oil companies is perceived as necessary to

meet the domestic needs of growing populations. These factors have the potential

to constrain the ability of producers to expand capacity to keep up with the projected growth of world demand, which has been propelled to an unexpected extent

by burgeoning demand in emerging Asia.

More favorably, the current and prospective expansion of U.S. capability to import

liquefied natural gas will help ease longer-term natural gas stringencies and perhaps bring natural gas prices in the United States down to world levels.

The third major uncertainty in the economic outlook relates to the behavior of

long-term interest rates. The yield on 10-year Treasury notes, currently near 41⁄4

percent, is about 50 basis points below its level of late spring 2004. Moreover, even

after the recent widening of credit risk spreads, yields for both investment-grade

and less-than-investment-grade corporate bonds have declined even more than those

on Treasury notes over the same period.

This decline in long-term rates has occurred against the backdrop of generally

firm U.S. economic growth, a continued boost to inflation from higher energy prices,

and fiscal pressures associated with the fast approaching retirement of the babyboom generation.1 The drop in long-term rates is especially surprising given the inVerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00036 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4
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2Dollar interest rate swaps 5 years forward and maturing in 10 years declined 19 basis points

per year on average over the same period. Comparable euro (pre-1999, Deutschemark) swaps

declined 27 basis points, sterling swaps 35 basis points, and yen swaps 23 basis points. 3Term premiums measure the extent to which current prices of bonds discount future uncertainties. 4 Nominal GDP figures by country are estimated in dollars by the International Monetary

Fund using purchasing power parities (PPP) of currencies. These GDP figures are used to calculate weights applied to national saving and investment rates to form global measures. When

the GDP figures are instead measured at market exchange rates, the results are similar. The

PPP estimates emphasize the economic factors generating investment and the use of saving. Exchange rates emphasize the financial forces governing the financing of investment across borders. Both approaches are useful.

crease in the Federal funds rate over the same period. Such a pattern is clearly

without precedent in our recent experience.

The unusual behavior of long-term interest rates first became apparent last year.

In May and June 2004, with a tightening of monetary policy by the Federal Reserve

widely expected, market participants built large short positions in long-term debt

instruments in anticipation of the increase in bond yields that has been historically

associated with an initial rise in the Federal funds rate. Accordingly, yields on 10-

year Treasury notes rose during the spring of last year about 1 percentage point.

But by summer, pressures emerged in the marketplace that drove long-term rates

back down. In March of this year, long-term rates once again began to rise, but like

last year, market forces came into play to make those increases short lived.

Considerable debate remains among analysts as to the nature of those market

forces. Whatever those forces are, they are surely global, because the decline in

long-term interest rates in the past year is even more pronounced in major foreign

financial markets than in the United States.

Two distinct but overlapping developments appear to be at work: A longer-term

trend decline in bond yields and an acceleration of that trend of late. Both developments are particularly evident in the interest rate applying to the 1 year period ending 10 years from today that can be inferred from the U.S. Treasury yield curve.

In 1994, that so-called forward rate exceeded 8 percent. By mid-2004, it had declined to about 61⁄2 percent—an easing of about 15 basis points per year on average.2 Over the past year, that drop steepened, and the forward rate fell 130 basis

points to less than 5 percent.

Some, but not all, of the decade-long trend decline in that forward yield can be

ascribed to expectations of lower inflation, a reduced risk premium resulting from

less inflation volatility, and a smaller real term premium that seems due to a moderation of the business cycle over the past few decades.3 This decline in inflation

expectations and risk premiums is a signal development. As I noted in my testimony

before this Committee in February, the effective productive capacity of the global

economy has substantially increased, in part because of the breakup of the Soviet

Union and the integration of China and India into the global marketplace. And this

increase in capacity, in turn, has doubtless contributed to expectations of lower inflation and lower inflation-risk premiums.

In addition to these factors, the trend reduction worldwide in long-term yields

surely reflects an excess of intended saving over intended investment. This configuration is equivalent to an excess of the supply of funds relative to the demand for

investment. What is unclear is whether the excess is due to a glut of saving or a

shortfall of investment. Because intended capital investment is to some extent driven by forces independent of those governing intended saving, the gap between intended saving and investment can be quite wide and variable. It is real interest

rates that bring actual capital investment worldwide and its means of financing,

global saving, into equality. We can directly observe only the actual flows, not the

saving and investment tendencies. Nonetheless, as best we can judge, both high levels of intended saving and low levels of intended investment have combined to lower

real long-term interest rates over the past decade.

Since the mid-1990’s, a significant increase in the share of world gross domestic

product (GDP) produced by economies with persistently above-average saving—

prominently the emerging economies of Asia—has put upward pressure on world

saving. These pressures have been supplemented by shifts in income toward the oilexporting countries, which more recently have built surpluses because of steep increases in oil prices. The changes in shares of world GDP, however, have had little

effect on actual world capital investment as a percentage of GDP. The fact that investment as a percentage of GDP apparently changed little when real interest rates

were falling, even adjusting for the shift in the shares of world GDP, suggests that,

on average, countries’ investment propensities had been declining.4

34

5 A significant part of the surge in cashflow of U.S. corporations was accrued by those financial intermediaries that invest only a small part in capital assets. It appears that the value

added of intermediation has increased materially over the past decade because of major advances in financial product innovation. 6The decline of euro, sterling, and yen forward swap rates also steepened.

Softness in intended investment is also evident in corporate behavior. Although

corporate capital investment in the major industrial countries rose in recent years,

it apparently failed to match increases in corporate cashflow.5 In the United States,

for example, capital expenditures were below the very substantial level of corporate

cashflow in 2003, the first shortfall since the severe recession of 1975. That development was likely a result of the business caution that was apparent in the wake of

the stock market decline and the corporate scandals early this decade. (Capital investment in the United States has only recently shown signs of shedding at least

some of that caution.) Japanese investment exhibited prolonged restraint following

the bursting of their speculative bubble in the early 1990’s. And investment in

emerging Asia excluding China fell appreciably after the Asian financial crisis in the

late 1990’s. Moreover, only a modest part of the large revenue surpluses of oil-producing nations has been reinvested in physical assets. In fact, capital investment

in the Middle East in 2004, at 25 percent of the region’s GDP, was the same as

in 1998. National saving, however, rose from 21 percent to 32 percent of GDP. The

unused saving of this region was invested in world markets.

Whether the excess of global intended saving over intended investment has been

caused by weak investment or excessive saving—that is, by weak consumption—or,

more likely, a combination of both does not much affect the intermediate-term outlook for world GDP or, for that matter, U.S. monetary policy. What have mattered

in recent years are the sign and the size of the gap of intentions and the implications for interest rates, not whether the gap results from a saving glut or an investment shortfall. That said, saving and investment propensities do matter over the

longer-run. Higher levels of investment relative to consumption build up the capital

stock and thus add to the productive potential of an economy.

The economic forces driving the global saving-investment balance have been unfolding over the course of the past decade, so the steepness of the recent decline in

long-term dollar yields and the associated distant forward rates suggests that something more may have been at work over the past year.6 Inflation premiums in forward rates 10 years ahead have apparently continued to decline, but real yields

have also fallen markedly over the past year. It is possible that the factors that

have tended to depress real yields over the past decade have accelerated recently,

though that notion seems implausible.

According to estimates prepared by the Federal Reserve Board staff, a significant

portion of the sharp decline in the 10-year forward 1 year rate over the past year

appears to have resulted from a fall in term premiums. Such estimates are subject

to considerable uncertainty. Nevertheless, they suggest that risk takers have been

encouraged by a perceived increase in economic stability to reach out to more distant time horizons. These actions have been accompanied by significant declines in

measures of expected volatility in equity and credit markets inferred from prices of

stock and bond options and narrow credit risk premiums. History cautions that long

periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress.

Such perceptions, many observers believe, are contributing to the boom in home

prices and creating some associated risks. And, certainly, the exceptionally low interest rates on 10-year Treasury notes, and hence on home mortgages, have been

a major factor in the recent surge of homebuilding, home turnover, and particularly

in the steep climb in home prices. Whether home prices on average for the Nation

as a whole are overvalued relative to underlying determinants is difficult to ascertain, but 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. Among other indicators, the significant rise in purchases of homes for investment since 2001 seems to

have charged some regional markets with speculative fervor.

The apparent froth in housing markets appears to have interacted with evolving

practices in mortgage markets. The increase in the prevalence of interest-only loans

and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But some households may be employing these instruments to purchase

homes that would otherwise be unaffordable, and consequently their use could be

adding to pressures in the housing market. Moreover, these contracts may leave

some mortgagors vulnerable to adverse events. It is important that lenders fully apVerDate 11-MAY-2000 17:10 Dec 08, 2005 Jkt 000000 PO 00000 Frm 00038 Fmt 6621 Sfmt 6621 24852.TXT SBANK4 PsN: SBANK4
35

preciate the risk that some households may have trouble meeting monthly payments

as interest rates and the macroeconomic climate change.

The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. Nevertheless, we certainly cannot rule out declines in home prices, especially in some local markets. If

declines were to occur, they likely would be accompanied by some economic stress,

though the macroeconomic implications need not be substantial. Nationwide banking and widespread securitization of mortgages make financial intermediation less

likely to be impaired than it was in some previous episodes of regional house-price

correction. Moreover, a decline in the national housing price level would need to be

substantial to trigger a significant rise in foreclosures, because the vast majority of

homeowners have built up substantial equity in their homes despite large mortgagemarket-financed withdrawals of home equity in recent years.

Historically, it has been rising real long-term interest rates that have restrained

the pace of residential building and have suppressed existing home sales, high levels

of which have been the major contributor to the home equity extraction that arguably has financed a noticeable share of personal consumption expenditures and

home modernization outlays.

The trend of mortgage rates, or long-term interest rates more generally, is likely

to be influenced importantly by the worldwide evolution of intended saving and intended investment. We at the Federal Reserve will be closely monitoring the path

of this global development few, if any, have previously experienced. As I indicated

earlier, the capital investment climate in the United States appears to be improving

following significant headwinds since late 2000, as is that in Japan. Capital investment in Europe, however, remains tepid. A broad worldwide expansion of capital investment not offset by a rising worldwide propensity to save would presumably

move real long-term interest rates higher. Moreover, with term premiums at historical lows, further downward pressure on long-term rates from this source is unlikely.

We collectively confront many risks beyond those that I have just mentioned. As

was tragically evidenced again by the bombings in London earlier this month, terrorism and geopolitical risk have become enduring features of the global landscape.

Another prominent concern is the growing evidence of antiglobalization sentiment

and protectionist initiatives, which, if implemented, would significantly threaten the

flexibility and resilience of many economies. This situation is especially troubling for

the United States, where openness and flexibility have allowed us to absorb a succession of large shocks in recent years with only minimal economic disruption. That

flexibility is, in large measure, a testament to the industry and resourcefulness of

our workers and businesses. But our success in this dimension has also been aided

importantly by more than two and a half decades of bipartisan effort aimed at reducing unnecessary regulation and promoting the openness of our market economy.

Going forward, policymakers will need to be vigilant to preserve this flexibility,

which has contributed so constructively to our economic performance in recent

years.

In conclusion, Mr. Chairman, despite the challenges that I have highlighted and

the many I have not, the U.S. economy has remained on a firm footing, and inflation

continues to be well contained. Moreover, the prospects are favorable for a continuation of those trends. Accordingly, the Federal Open Market Committee in its June

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.’’

36

RESPONSE TO A WRITTEN QUESTION OF SENATOR REED

FROM ALAN GREENSPAN

Q.1. I mentioned in my opening remarks the study by the Boston

Federal Reserve with respect to labor participation, which suggests

there is a significant and growing lack of participation in the labor

force which distorts our ability to see how well we are doing with

respect to recoveries. In fact, one thing that I found interesting was

the ratio of employment to population, 62.7 percent, is below the

level at the start of the economic recovery in November 2001. And

this is the first time the ratio has failed to surpass its trial level

so far into a recovery. Can you comment?

A.1. At my July 21 testimony before the Senate Banking Committee, you asked if I could provide additional detail concerning the

Board staff’s assessment of recent developments in labor force participation and their implications for the interpretation of the unemployment rate as a measure of slack in the labor market. As I

noted in my response at the hearing, while cyclical factors likely

have contributed to the weak recovery in labor force participation,

our staff estimates that part of that weak performance in recent

years can also be traced to a downtrend in the underlying rate of

participation. The change in the overall trend has occurred both because the trend in the participation of adult women appears to

have flattened out and because the large baby boom cohorts are

moving into the age range in which their labor force participation

will likely drop off sharply as many workers in these cohorts retire.

More specifically, we estimate that the underlying trend in the participation rate has fallen from a little more than 661⁄2 percent of

the civilian working-age population in 2001 to about 661⁄4 percent

this year. Because the participation rate in recent months has

averaged just over 66 percent, we estimate that the implied cyclical

shortfall in participation equates to a few tenths of a percentage

point on the unemployment rate.

Our estimates are broadly similar to those of the Congressional

Budget Office. Differences between our estimates and those reported in the Boston Fed study that we discussed at my hearing

primarily reflect different views about the evolution of trends in

participation for various demographic groups and different ways to

measure the size of the current participation shortfall. In particular, the Boston Fed study examines a range of alternative trajectories for participation rates for women and older workers and

calibrates the size of the estimated current shortfall as a percentage of the labor force. Of course, all such estimates are subject to

considerable uncertainty, and our understanding of the relationship

between labor force participation and labor market slack will undoubtedly benefit from additional research on this topic.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BENNETT

FROM ALAN GREENSPAN

Q.1. What guidance could you offer for selection of an index to use

for maintaining purchasing power over time in Federal programs

with cost-of-living adjustments?

A.1. As you know, I have long advocated improvements in the price

indexes published by the Bureau of Labor Statistics (BLS). As you

37

have indicated, this issue is important for several reasons. In addition to the need for accurate measures of inflation, price indexes

are used for the automatic inflation adjustments of many Federal

tax and spending programs, and inaccurate price measures can

lead to adjustments that are inconsistent with true changes in the

cost of living.

In recent years, the BLS has taken important steps to improve

the quality of the price indexes. However, reviews of the academic

literature on price measurement suggest that frequently cited consumer price indexes published by the BLS still tend to overstate

increases in the cost of living. This evidence indicates that, if Congress intends the inflation adjustments to compensate for changes

in the cost of living, adjustments based on the CPI-U or CPI-W will

be too large, perhaps by a significant amount.

Q.2. Do you believe that replacing the CPI-U with the C-CPI-U in

indexing Federal programs would be truer to the original intent of

Congress in making cost-of-living adjustments?

A.2. As indicated, research suggests that the CPI-U and CPI-W

overstate increases in the cost of living. A portion of this measurement error owes to substitution bias, and, to address this problem,

the BLS recently developed the Chained CPI-U (C-CPI-U).

Although the C-CPI-U is still subject to other sources of bias—

especially those related to changes in the quality of existing products and introduction of new goods and services—basing inflation

indexation of Federal programs on the C-CPI-U would, in my view,

give us a less biased measure of changes in the cost of living.

Q.3. Because construction of the C-CPI-U requires data on the

changing expenditure patterns of consumers as relative prices shift,

the index is subject to revision as better data on expenditures become available. However, this presents a problem because retroactive adjustments may become necessary as revisions are made if

the C-CPI-U were to be used for indexation purposes in Federal

programs.

One possible way to overcome such a problem would be to use

‘‘true up’’ factors as revisions are made. For example, if last year’s

C-CPI-U growth was revised down by 0.2 percent and this year’s

C-CPI-U growth was 1.4 percent, then we could actually increase

whatever is being indexed by only 1.2 percent (this year’s 1.4 percent less a ‘‘true up’’ factor of 0.2 percent to reflect the revision).

Assuming that errors are unbiased (essentially, that revisions have

mean zero), such a procedure should average out correctly over

time. However, in the short-run, revision issues could be significant.

If you believe that the C-CPI-U represents a truer measure of

the cost of living than the CPI-U, how would you address the problem of data revisions?

A.3. As you noted, the indexation of Federal programs to a price

index that is subject to revision, such as the C-CPI-U, does lead to

certain complications. If the index is subsequently revised, then

programs tied to that index will have been set at levels learned, ex

post, to have been inappropriate. (Of course, use of a price index

that is not subject to revision also may generate inappropriate adjustments to Federal programs, and the absence of revision may

38

mean that any such errors are never corrected.) The complications

introduced by such revisions are readily surmountable, however.

Indexation formulas may be structured in ways that take such revisions into account and ensure that, in the period following the revision, the programs are set back at appropriate levels. The use of

‘‘true up’’ factors, as you suggest, is one way to achieve this goal.

Q.4. If you were to change the price measure used in indexing Federal programs, how would you respond to a criticism that such a

change is merely a sneaky way of cutting benefits and increasing

taxes?

A.4. As indicated above, I believe that it would be desirable, insofar

as possible, to index Federal programs in a way that captures actual changes in the cost of living.

Q.5. In remarks on price measurement at the Center for Financial

Studies in Frankfurt, Germany on November 7, 1997, you advocated establishment of an objective, nonpartisan, and independent

national commission to set annual cost-of-living adjustment factors

for Federal programs. Do you still feel that it would be beneficial

to establish such a commission? How would you constitute such a

commission? Would you be willing to coordinate research efforts of

Federal Reserve staff with those of my staff on the Joint Economic

Committee to help explore the possibility of formalizing such a

commission?

A.5. Further improvements in our price indexes would be a welcome development. In the meantime, it is important to consider

how best to index Government programs, given price measures still

appear to suffer from significant biases. Many approaches to this

latter problem have the potential to yield progress, including the

establishment of an independent commission.

RESPONSE TO A WRITTEN QUESTION OF SENATOR CORZINE

FROM ALAN GREENSPAN

Q.1. This morning, the Senate Agriculture Committee is marking

up legislation reauthorizing the Commodities Futures Trading

Commission. The proposed legislation would modify the Commodity

Futures Modernization Act (CFMA) of 2000, which, as you know,

this Committee and Agriculture jointly worked on to develop. That

effort was based on recommendations from the President’s Working

Group (the Federal Reserve, Treasury, SEC, and CFTC) on Financial Markets.

Yesterday, you expressed concerns to Agriculture Committee

Chairman Chambliss about the legislation in response to a letter

from Senator Crapo. Those concerns seem to revolve around the

fact that the President’s Working Group has not had the opportunity to review or deliberate key proposals contained in the draft

reauthorization legislation. SEC Acting Chairman Glassman has

expressed a similar concern, and Chairman Shelby and Ranking

Member Sarbanes have done so as well.

As you know, of major concern with the draft legislation are the

provisions that would modify portions of the CFMA that were

painstakingly crafted to balance the differing interests of all Federal financial regulators. I wonder if you could discuss more in

depth the nature of the concerns you expressed in your letter and

39

what specific harm could come from Congressional action that,

done in haste, could disrupt the balance and legal certainty the

CFMA struck which has aided the development of important financial markets and reaped significant benefits for the broader economy?

A.1. The Federal Reserve Board believes the CFMA has unquestionably been a successful piece of legislation. It enacted provisions

that excluded transactions between institutions and other eligible

counterparties in over-the-counter financial derivatives and foreign

currency from regulation under the Commodity Exchange Act

(CEA). This exclusion resolved long-standing concerns that a court

might find that the CEA applied to these transactions, thereby

making them legally unenforceable.

Another important part of the CFMA addressed problems associated with ‘‘bucket shops’’ that were marketing foreign currency futures to retail customers (that is, an individual or business that

does not meet the definition of eligible counterparty). The legislation marked up by the Senate Agriculture Committee in July 2005

would apply the CEA as a whole to certain retail foreign currency

contracts, regardless of whether they are futures contracts. We seriously question whether it is necessary to apply all the provisions

of the CEA to these transactions in order to enable the CFTC to

address fraud, and believe that a broad application of the Act could

have unintended consequences.

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