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[Senate Hearing 107-503]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 107-503

                FEDERAL RESERVE'S FIRST MONETARY POLICY
                            REPORT FOR 2002

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

                                   ON

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

                               __________

                             MARCH 7, 2002

                               __________

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

80-301              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2002
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov  Phone: toll free (866) 512-1800; (202) 512�091800  
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut     PHIL GRAMM, Texas
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia                 CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware           RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan            JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey           MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii              JOHN ENSIGN, Nevada

           Steven B. Harris, Staff Director and Chief Counsel

             Wayne A. Abernathy, Republican Staff Director

                  Martin J. Gruenberg, Senior Counsel

                  Tom Loo, Republican Senior Economist

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)

                            C O N T E N T S

                              ----------                              

                        THURSDAY, MARCH 7, 2002

                                                                   Page

Opening statement of Chairman Sarbanes...........................     1
    Prepared statement...........................................    39

Opening statements, comments, or prepared statements of:
    Senator Gramm................................................     2
    Senator Johnson..............................................     3
        Prepared statement.......................................    40
    Senator Bennett..............................................     3
    Senator Bayh.................................................     3
    Senator Hagel................................................     4
    Senator Carper...............................................     4
    Senator Bunning..............................................     5
    Senator Stabenow.............................................     6
    Senator Crapo................................................     6
    Senator Corzine..............................................     7
    Senator Allard...............................................     7
        Prepared statement.......................................    40
    Senator Dodd.................................................    11
        Prepared statement.......................................    41
    Senator Ensign...............................................    11
    Senator Akaka................................................    11
        Prepared statement.......................................    41
    Senator Miller...............................................    30
        Prepared statement.......................................    42

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     7
    Prepared statement...........................................    42

              Additional Material Supplied for the Record

Monetary Policy Report to the Congress, February 27, 2002........    49

                                 (iii)

 
         FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT OF 2002

                              ----------                              

                        THURSDAY, MARCH 7, 2002

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:10 a.m., in room SD-106 of the 
Dirksen Senate Office Building, Senator Paul S. Sarbanes 
(Chairman of the Committee) presiding.

         OPENING STATMENT OF CHAIRMAN PAUL S. SARBANES

    Chairman Sarbanes. The Committee will come to order.
    We are very pleased to welcome Chairman Greenspan back 
before the Committee on Banking, Housing and Urban Affairs this 
morning, to give testimony on the Federal Reserve's Semi-Annual 
Monetary Policy Report to the Congress.
    I just note, Mr. Chairman, that yesterday, as I understand, 
it was your birthday. We want to wish you a belated happy 
birthday, a day late, and many more of them to come.
    Chairman Greenspan. Thank you very much.
    Chairman Sarbanes. I am sure I speak for all the Members of 
the Committee when I say that. It is not like the board of 
directors voted, you know, the chief officer was ill and they 
voted 5 to 4 for a full recovery.
    [Laughter.]
    Chairman Greenspan. I am glad you did not take a vote, Mr. 
Chairman.
    Chairman Sarbanes. Actually, legislation that we enacted in 
the last Congress has set out a framework now for the Federal 
Reserve to submit a report to Congress twice a year on the 
conduct of monetary policy and for the Chairman of the Fed to 
testify before the Congress. Before that, it was a matter of 
custom. But Senator Gramm and I worked together with the 
Chairman, who was supportive of the idea that at regular 
intervals, it would serve an important public purpose for the 
Fed to come before the Congress and present testimony with 
respect to monetary policy in open session.
    Now, we alternate back and forth between the House and the 
Senate and the Fed testified last week before the House. So in 
a sense, much of the Chairman's initial readings of the economy 
have already been publicly given, although we have had some 
interesting reports since that testimony.
    Yesterday, the Fed issued the beige reports from the 
various regional banks around the country in terms of how they 
see economic conditions, and we have also gotten some 
additional statistics.
    Since you testified last Wednesday, the Commerce Department 
released a report which revised upward U.S. economic growth in 
the fourth quarter of last year. The Commerce Department 
report, as I understand it, revised it upward from \2/10\ of 1 
percent growth to 1.4 percent growth, for the fourth quarter of 
last year. Which leads me to ask the question, what kind of 
economic statistics do we have, if the margin of error is going 
to be of that magnitude?
    In other words, when trying to frame public policy, we look 
at an economic report and a statistic, it says, the growth in 
the fourth quarter was \2/10\ of 1 percent. So your thinking is 
geared to that. It is an important figure, that growth figure.
    Then they come in and they do the revision and now we are 
told it was 1.4 percent. Well, that could lead to a different 
judgment, so, I intend in the question period to explore with 
you this economic statistics issue. I also want to make a 
couple other observations.
    I think everyone now perceives the economy as recovering, 
but we expect unemployment to increase and that is, of course, 
the projection of the Fed. Over the last year, according to the 
Bureau of Labor Statistics, the number of people unemployed for 
more than 14 weeks has nearly doubled. Those unemployed for 
more than 26 weeks, the current cutoff for unemployment 
insurance, also nearly doubled. These figures, in my view, make 
a compelling case for the extension of unemployment benefits 
above the 26 weeks. We have consistently done that in every 
previous recession. We have not yet done it in this one. And I 
very much hope that the Congress will see its way clear to 
doing that in the very near future.
    I just want to underscore again that we are pleased that 
the Chairman is back with us. The New York Times has a story 
this morning about our economic situation. It says: ``The 
Recovery That Defied the Forecasts of Economists.'' And we look 
forward to exploring that with you.
    Senator Gramm.

                STATEMENT OF SENATOR PHIL GRAMM

    Senator Gramm. Mr. Chairman, thank you very much.
    Chairman Greenspan, thank you for coming before the 
Committee. I would just like to make a few points.
    First of all, I would like to thank you for the great job 
you have done. I think in the wake of someone's birthday, it is 
always a good opportunity to say something good about them.
    I have been somewhat dumbfounded by criticism, especially 
the one that you did not take action to combat the 
overspeculation in the high-tech area.
    You have to wonder where the hell these critics were when 
you appeared before this Committee and talked about irrational 
exuberance, and the whole world groaned and complained that you 
were talking down the stock market.
    I would just have to say that I have had the opportunity to 
work in this town and be involved in Government for 24 years. 
And in that 24 years, no person has done more to promote the 
economic well-being of this country and the people that work 
here than Alan Greenspan.
    I want to thank you for the great service you have 
rendered. As I have said on other occasions, millions of people 
who will never know your name have benefited from the service 
that you have provided.
    On behalf of the 21 million of those people that I 
represent, I want to thank you for the great job that you have 
done. Capitalism grows in fits and starts. It is the very 
nature of a dynamic system that is based on individual 
initiative and that is based on new ideas, new vision, and new 
leadership in the corporate sector, and good and bad leadership 
in Government.
    The duty of the Fed Chairman is to try to set a monetary 
policy that maximizes the economic growth that we can get and 
minimizes the variance about that mean.
    I just want to conclude by saying that in the 24 years that 
I have been involved in public policy, and in the years that 
you have been Chairman of the Federal Reserve Bank, I do not 
think anybody could have or ever has done a better job of 
achieving a combination of those two objectives--to set the 
framework in which productivity and the energies of a free 
people can promote economic growth, and to provide a monetary 
policy that tries to minimize the variance about the mean that 
is created by these basic forces in the most dynamic free 
society in history. So, I appreciate the great job you have 
done and it has been a privilege for me to work with you.
    Chairman Greenspan. Thank you very much, Senator.
    Chairman Sarbanes. Senator Johnson.

                COMMENTS OF SENATOR TIM JOHNSON

    Senator Johnson. Thank you, Mr. Chairman, for holding this 
hearing.
    Welcome to Chairman Greenspan.
    In order to expedite an opportunity to hear from Chairman 
Greenspan, I have an opening statement relative to some 
questions that I would like to present to Chairman Greenspan, 
as well as an observation relative to future hearings on the 
capitalization needs in Indian country, and I am going to 
submit that statement for the record.
    Chairman Sarbanes. Without objection, the full statement 
will be included in the record.
    Senator Bennett.

              COMMENT OF SENATOR ROBERT F. BENNETT

    Senator Bennett. I have no comment, Mr. Chairman. I will 
wait to hear the witness.
    Chairman Sarbanes. Senator Bayh.

                  COMMENT OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman. I am looking forward 
to hearing from Chairman Greenspan and I will save my comments 
for the questions.
    Chairman Sarbanes. Senator Hagel.

                 COMMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. I have no statement, Mr. Chairman. I look 
forward to the comments.
    Chairman Sarbanes. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Thank you, Mr. Chairman.
    Chairman Greenspan, I was listening to Senator Gramm and 
that was one of the nicest things I have ever heard him say 
about anybody.
    [Laughter.]
    I have known him for 20 years.
    [Laughter.]
    Yesterday might have been your birthday, but that is a 
pretty good present a day late. I think it reflects the views 
of a lot of us.
    For about the last 8 years I was the Governor of Delaware. 
Near the end of my tenure as Governor, and Evan Bayh can 
probably reflect on this in his time as Governor. But my the 
last year as Governor, somebody said to me, were you the 
Governor when we had the ice storm of the century?
    And I said, yes.
    Were you the Governor when we had the blizzard of the 
century?
    I said, yes.
    He said, were you the Governor when we had the flood of the 
century?
    I said, yes.
    He said, were you the Governor when we had the drought of 
the century?
    I said, yes.
    He said to me, do you know what I think? I said, no. He 
said, I think you are bad luck.
    [Laughter.]
    Compare my record to yours. You have been Chairman of the 
Federal Reserve when we have had the longest running economic 
expansion in the history of our country. And you have been the 
Chairman of the Federal Reserve during what appears to have 
been the shortest recession, at least as far as we can recall. 
That is a pretty good record.
    I am one who believes that we should go out on top. But I 
do not believe that you should go out any time soon. So, I 
would just suggest that to you.
    You testified before us, almost 5 or 6 months ago. We were 
just beginning at the time to debate what kind of economic 
recovery package or economic stimulus package that we should 
consider. And your advice to us at the time was something to 
the effect, it is better to be right than fast. I do not know 
if those were your exact words, but something to the effect, it 
is better to be right than fast.
    As it turns out, we were not fast. But in the end, I think 
we came out all right. And when you look back at how short the 
recession was and how we seem to be coming out of it fairly 
nicely, I am reminded of at least 3 factors that have been at 
play.
    The first of those is the most aggressive monetary policy 
that I have witnessed in my lifetime that you have led. The 
second is just some good luck. Energy prices have dropped 
precipitously across the country and around the world. And the 
third factor is, we are doing a fair amount of deficit 
spending, fighting the war in Afghanistan, the war against 
terrorism, helping New York State and the airline industries 
and others and pumping a fair amount of red ink into the 
economy to help bolster it. All of which I think factor in to 
shorten the recession that we have gone through.
    We have before us today, this week, probably next week, 
comprehensive energy legislation. It is before the Senate. A 
number of proposals that would help us to create more energy. A 
number of proposals that would help us to conserve more energy.
    When we get to the Q&A's, I would hope to have an 
opportunity, not just to talk about monetary policy, but to 
revisit with you the need for us to move on that front in order 
to better ensure a longer lasting economic recovery in the 
years ahead. Thank you very much. And thank you again for your 
stewardship.
    Chairman Sarbanes. Thank you very much, Senator Carper.
    Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    I would like to thank the Chairman of the Federal Reserve 
for testifying today. It is once again time for the biannual 
monetary policy report.
    Generally, I agree with Senator Gramm on about 99 percent 
of the things that he says. Today, I do not. Mr. Greenspan, 
once again today, I will probably be the only skunk at the 
garden party. Sometimes I feel like the lone voice crying out 
in the wilderness about our monetary policy. I just want to 
make sure you know, to quote ``The Godfather,'' it is business, 
not personal.
    It looks like we are coming out of this recession and I am 
guardedly optimistic, but I am not sure that we are not in the 
middle of a double-dip, where we start to come out and then go 
right back down again. I hope that is not the case.
    Mr. Chairman, one thing we have talked about before that I 
would like to highlight again today is my belief that we did 
not have to have a recession at all. I think that you 
unilaterally popped the bubble in the stock markets and that 
helped precipitate the economic downturn. And I do not think 
that is your job.
    I also do not think it is your job to jawbone market gains 
and to declare that gains were a product of irrational 
exuberance.
    No one individual should be able to influence the market so 
much and to be able to take trillions of dollars of market 
capital out of this economy.
    I know many of us have gotten lumps in our throats watching 
our 401(k) plans go down recently. We talked about it before, 
how the Fed's duty is to focus on monetary policy and should 
not overlap into equities.
    When I tried to talk to the people back home about these 
issues, their eyes sometimes glaze over. But these are real 
issues and the millions of workers who lost their job in the 
recession now have real problems. These folks are not just 
statistics.
    It may surprise you that I think you do a good job when you 
do what you are supposed to do. I think we all acknowledge the 
Fed has moved aggressively over the past year. Once the Fed got 
going, it did respond. I also think that the Fed did a very 
good job after September 11 to help shore up the confidence in 
our markets.
    You should be commended for that, and that might have 
helped limit the damage. But there was damage even before 
September 11, damage that I do not think we should have had. 
The Fed came to help, but it was too late in coming.
    Mr. Chairman, thank you again for coming before this 
Committee and I look forward to digging into these issues a 
little bit more during the question-and-answer period.
    Chairman Sarbanes. Thank you very much, Senator Bunning.
    Senator Stabenow.

              COMMENTS OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Well, thank you, Mr. Chairman.
    I would like to associate myself with Senator Gramm and 
reiterate the fact that you did come before our Committee and 
talk about irrational exuberance and did speak with caution 
about what was occurring in the economy. I appreciate the fact 
that the Fed has acted aggressively.
    I would only say that, as a Member of the Budget Committee, 
as we look to the long term, that while we are seeing some 
glimmers of hope, and I certainly want to hear from you this 
morning about your view the economy and where we are going, but 
we certainly know that we have many challenges left in the long 
term as we look at the budget and the economy.
    And I would have to say that while academics were debating 
last year whether or not we were technically in a recession, in 
my great State of Michigan, you only had to look to the iron 
ore mines in the upper peninsula or our cities in Detroit or 
Flint, or our farmers trying to get a good price for their 
products, to understand that this has been a challenging time 
for many families and many business people in our country. I 
appreciate your being here again and I look forward to your 
comments.
    Chairman Sarbanes. Thank you very much, Senator Stabenow.
    Senator Crapo.

                 COMMENTS OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman.
    I too want to thank you, Chairman Greenspan, for coming 
here for your annual report on monetary policy. And I look 
forward, as has been indicated by a number of the others here, 
to discussing a number of the issues relating to our monetary 
policy with you.
    Just to kind of get a heads-up for where I may be headed in 
my questioning, as I am sure you are already aware, there is a 
proposal now coming up before Congress dealing with derivatives 
and whether we are currently governing them in the right way, 
and basically whether the Commodities Futures Modernization Act 
that we passed a few years ago has approached the issue 
properly.
    I am very concerned that we may be addressing this issue in 
Congress without any hearings, without any analysis, and simply 
having an amendment coming up on the floor which has not had 
the kind of evaluation that is going to be necessary for us to 
make the right decision here. And I am going to be asking for 
your input on that issue.
    With that, Mr. Chairman, I thank you for holding this 
hearing.
    Chairman Sarbanes. Thank you very much.
    Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman.
    I would like to join with those who speak about 
appreciation for your thoughtful and balanced leadership with 
regard to economic issues in this country and your remarkable 
tenure. Thank you.
    Chairman Sarbanes. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I just want to join my 
colleagues to welcome Chairman Greenspan and look forward to 
his comments. I have some comments that I would just like to 
submit for the record.
    Chairman Sarbanes. Very good. Mr. Chairman, we would be 
happy to hear from you.

                  STATEMENT OF ALAN GREENSPAN

              CHAIRMAN, BOARD OF GOVERNORS OF THE

                     FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Thank you very much, Mr. Chairman, and 
Members of the Committee.
    Since July, when I last reported to the Committee on the 
conduct of monetary policy, the U.S. economy has undergone a 
period of considerable strain, with economic output contracting 
for a time and unemployment rising.
    Chairman Sarbanes. Mr. Chairman, I think if you pulled the 
microphone a little closer, it would be helpful.
    Chairman Greenspan. We in the Federal Reserve System acted 
vigorously to adjust monetary policy in an endeavor both to 
limit the extent of the downturn and to hasten its completion. 
Despite the disruptions engendered by the terrorist attacks of 
September 11, the typical dynamics of the business cycle have 
reemerged and are prompting a firming in economic activity. The 
recent evidence increasingly suggests that an economic 
expansion is already well under way, although an array of 
influences unique to this business cycle seems likely to 
moderate its speed.
    One key consideration in the assessment that the economy is 
moving through a turning point is the behavior of inventories. 
Stocks in many industries have been drawn down to levels at 
which firms will soon need to taper off their rate of 
liquidation, if they have not already done so. Any slowing in 
the rate of inventory liquidation will induce a rise in 
industrial production if demand for those products is stable or 
is falling only moderately. That rise in production will, other 
things being equal, increase household income and spending.
    But that impetus to the growth of activity will be short-
lived unless sustained increases in final demand kick in before 
the positive effects of the swing from inventory liquidation 
dissipate. We have seen encouraging signs in recent days that 
underlying trends in final demand are strengthening, although 
the dimensions of the pickup remain uncertain.
    Through much of last year's slowdown, however, spending by 
the household sector held up well and proved to be a major 
stabilizing force. As a consequence, although household 
spending should continue to trend up, the potential for 
significant acceleration in activity in this sector is likely 
to be more limited than in past cycles.
    While consumer demand will have important consequences for 
the economic outlook in coming months, the broad contours of 
the present cycle have been, and will continue to be, driven by 
the evolution of corporate profits and capital investment.
    The retrenchment in capital spending over the past year and 
a half was central to the sharp slowing we experienced in 
overall activity. These cutbacks in capital spending interacted 
with, and were reinforced by, falling profits and equity 
prices. Indeed, a striking feature of the current cyclical 
episode relative to many earlier ones has been the virtual 
absence of pricing power across much of American business, as 
increasing globalization and deregulation have enhanced 
competition.
    Part of the reduction in pricing power observed in this 
cycle should be reversed as firming demand enables firms to 
take back large price discounts. Though such an adjustment 
would tend to elevate price levels, underlying inflationary 
cost pressures should remain contained.
    Improved profit margins and more assured prospects for 
rising final demand would likely be accompanied by a decline in 
risk premiums from their current elevated levels toward a more 
normal range. With real rates of return on high-tech equipment 
still attractive, that should provide an additional spur to new 
investment. However, the recovery and overall spending on 
business fixed investment is likely to be only gradual.
    Even a subdued recovery would constitute a truly remarkable 
performance for the American economy in the face of so severe a 
decline in equity asset values and an unprecedented blow from 
terrorists to the foundations of our market systems. For, if 
the tentative indications that the contraction phase of this 
business cycle has drawn to a close are ultimately confirmed, 
we will have experienced a significantly milder downturn than 
the long history of business cycles would have led us to 
expect.
    The imbalances that triggered the downturn and that could 
have prolonged this difficult period did not fester. The 
obvious questions are what has changed in our economy in recent 
decades to provide resilience and whether such changes will 
persist into the future.
    Doubtless, the substantial improvement in the access of 
business decisionmakers to real-time information has played a 
key role. The large quantities of data available virtually in 
real time allow businesses to address and resolve economic 
imbalances far more rapidly than in the past.
    The apparent increased flexibility of the American economy 
arguably also reflects the extent of deregulation over the past 
quarter century.
    Both deregulation and innovation in the financial sector 
have been especially important in enhancing overall economic 
resilience. New financial products, including derivatives, have 
enabled risk to be dispersed more effectively to those willing 
to, and presumably capable of, bearing it. Shocks to the 
overall economic system are accordingly less likely to create 
cascading credit failure. Despite the concerns that these 
complex instruments have induced--and that is an issue that I 
will address shortly--the record of their performance, 
especially over the past couple of stressful years, suggests 
that on balance they have contributed to the development of a 
far more flexible and efficient financial system--both 
domestically and internationally--than we had just 20 or 30 
years ago.
    As a consequence of increased access to real-time 
information and, more arguably, extensive deregulation in 
financial and product markets and the unbundling of risk, 
imbalances are more likely to be readily contained, and 
cyclical episodes overall should be less severe than would be 
the case otherwise.
    However, the very technologies that appear to be the main 
cause of our apparent increased flexibility and resiliency may 
also be imparting different forms of vulnerability that could 
intensify or be intensified by a business cycle.
    From one perspective, the ever-increasing proportion of our 
GDP that represents conceptual as distinct from physical value 
added, may actually have lessened cyclical volatility. In 
particular, the fact that concepts cannot be held as 
inventories means a great share of GDP is not subject to the 
type of dynamics that amplifies cyclical swings. But an economy 
in which concepts form an important share of valuation has its 
own vulnerabilities.
    As the recent events surrounding Enron have highlighted, a 
firm is inherently fragile if its value added emanates more 
from conceptual as distinct from physical assets. A physical 
asset, whether an office building or an automotive assembly 
plant, has the capability of producing goods or services even 
if the reputation of the managers of such facilities falls 
under a cloud. The rapidity of Enron's decline is an effective 
illustration of the vulnerability of a firm whose market value 
largely rests on capitalized reputation. The physical assets of 
such a firm comprise a small proportion of its asset base. 
Trust and reputation can vanish overnight, whereas, a factory 
cannot.
    The implications of such a loss of confidence for the 
macroeconomy depend importantly on how freely the conceptual 
capital of the fading firm can be replaced by a competitor or a 
new entrant into the industry. Even if entry is relatively 
free, macroeconomic risks can emerge if problems at one 
particular firm tend to make investors and counterparties 
uncertain about other firms that they see as potentially 
similarly situated. The difficulty of valuing firms that deal 
primarily with concepts and the growing size and importance of 
these firms may make our economy more susceptible to this type 
of contagion.
    Another, more conventional determinant of stability will be 
the economy's degree of leverage, the extent to which debt 
rather than equity is financing the level of capital. A 
sophisticated financial system, with its substantial array of 
instruments to unbundle risks, will tend toward a higher degree 
of leverage at any given level of underlying economic risk. 
But, the greater the degree of leverage in any economy, the 
greater its vulnerability to unexpected shortfalls in demand 
and mistakes.
    Although the fears of business leverage have been mostly 
confined to specific sectors in recent years, concerns over 
potential systemic problems resulting from the vast expansion 
of derivatives have emerged with the difficulties of Enron. To 
be sure, firms like Enron and Long-Term Capital Management 
before it, were major players in the derivatives markets. But 
their problems were readily traceable to an old-fashioned 
excess of debt, however acquired, as well as to opaque 
accounting of that leverage and lax counterparty scrutiny.
    Swaps and other derivatives throughout their short history, 
including over the past 18 months, have been remarkably free of 
default. Of course, there can be latent problems in any market 
that expands as rapidly as these markets have. Regulators and 
supervisors are particularly sensitive to this possibility.
    Derivatives have provided greater flexibility to our 
financial system. But their very complexity could leave 
counterparties vulnerable to significant risk that they do not 
currently recognize, and hence these instruments potentially 
expose the overall system if mistakes are large. In that 
regard, the market's reaction to the revelations about Enron 
provides encouragement that the force of market discipline can 
be counted on over time to foster much greater transparency and 
increased clarity and completeness in the accounting treatment 
of derivatives.
    How these countervailing forces for stability evolve will 
surely be a major determinant of the volatility that our 
economy will experience in the future. Monetary policy will 
have to be particularly sensitive to the possibility that the 
resiliency that our economy has 
exhibited during the past 2 years signals subtle changes in the 
way our system functions.
    Although there are ample reasons to be cautious about the 
economic outlook, the recuperative powers of the American 
economy, as I have tried to emphasize in my presentation, have 
been remarkable. When I presented our report on monetary policy 
to this Committee last summer, few if any of us could have 
anticipated events such as those to which our Nation has 
subsequently been subjected.
    The economic consequences of those events and their 
aftermath are an integral part of the many challenges that we 
now collectively face. The U.S. economy has experienced a 
substantial shock, and, no doubt, we continue to face risks in 
the period ahead. But the response thus far of our citizens to 
these new economic challenges provides reason for 
encouragement.
    Thank you very much, Mr. Chairman. I would appreciate if my 
full remarks were included for the record.
    Chairman Sarbanes. The full statement will be included in 
the record, without objection. And thank you for your 
testimony.
    Since the opening statements, we have been joined by 
Senators Dodd, Ensign, and Akaka. I will yield to them now for 
any opening statement they may have before we go to questions 
for Chairman Greenspan.
    Senator Dodd.

             COMMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Mr. Chairman, I just ask unanimous consent 
that my statement be included in the record and I look forward 
to the questions.
    Chairman Sarbanes. Very good.
    Senator Ensign.

                COMMENTS OF SENATOR JOHN ENSIGN

    Senator Ensign. No opening statement, Mr. Chairman.
    Chairman Sarbanes. Senator Akaka.

               COMMENT OF SENATOR DANIEL K. AKAKA

    Senator Akaka. Mr. Chairman, I have a statement and I will 
submit it for the record.
    Chairman Sarbanes. It will be included in full in the 
record.
    Mr. Chairman, I would like to come back to this two-tenths 
of 1 percent growth figure that the Commerce Department gave us 
as the initial figure on fourth-quarter growth, revised to 1.4 
percent.
    Now, I take it that is a revision of sufficient magnitude 
and consequence that we ought to have some concern about the 
accuracy of our economic statistics.
    Chairman Greenspan. Well, the cause of that, Mr. Chairman 
is that the Commerce Department, the Bureau of Economic 
Analysis, chooses to make an early estimate of the gross 
domestic product for a quarter just passed before it has all of 
the important information. In this particular case and, indeed, 
in all of these advanced reports, two major items of exclusion 
which are never available at the point at which they make the 
earliest estimate, are, one, inventory change for the last 
month of a quarter and, two, the trade figures for the last 
month.
    Both of those numbers can be really quite difficult to 
judge. And what happens in the early data is that technicians 
at the Department of Commerce endeavor to make their best 
judgments as to what those numbers are likely to be.
    They publish their judgments, so it is not a black box 
which people who are trying to evaluate the numbers are unable 
to understand. And since those of us who endeavor to follow the 
GDP as it moves from one month to the next in its quarterly 
format are able to judge as the new monthly data comes in, 
whether in fact the numbers published--the last published set 
of numbers by the Department of Commerce--are going to be 
revised.
    Most people can reasonably judge what the nature of the 
revisions is going to be because they know what plugged numbers 
the Department of Commerce put in for data they did not have.
    Now, to be sure, that does create significant changes, as 
you just cited a particularly large one. The question would be, 
would we be better off if we did not have the advanced report? 
And I suggest the answer to that is no, it does help. But I do 
think it is important to point out that these numbers are 
subject to significant revision. Rarely do they give an 
impression of the economy which is false.
    Chairman Sarbanes. Presumably, they might have some impact 
on consumer outlooks and consumer confidence because I want to 
move now to consumers in this economic situation.
    Generally speaking, consumer demand has held up pretty 
well, as I understand it. It is in fact what has cushioned the 
downturn. The question then becomes whether it is been used up, 
in a sense.
    In previous sessions, when consumer demand slackens, it 
then picks up as we move into a recovery period and provides a 
boost for the economic recovery. That may not be there this 
time. What is your view on that question?
    Chairman Greenspan. Well, I think that is an important 
point to make, Mr. Chairman.
    In past periods of significant contraction, when inventory 
liquidation was a major factor pushing the economy down, 
consumer durable demand and homebuilding also tended to be much 
lower. And that was largely because interest rates at the top 
of the cycle were usually relatively high and that suppressed 
demand for housing and durables.
    When we got to the bottom of the cycle, as inventory 
liquidation started to slow and turn the economy around, there 
was an unmet demand for a number of motor vehicles and other 
consumer durable goods and new homes. And they tended to come 
back together and as a consequence of that, my recollection is 
that the average rate of increase in the first year after a 
recession ended has been something like 7 percent.
    This is almost certainly not going to be the case this 
time. And one of the reasons, as you point out, is we never 
went down and, consequently, the ability to go back up is 
limited because no matter how one looks at it, both motor 
vehicles have been doing really quite extraordinarily well, as 
well as homebuilding.
    So that there is very little upside potential to carry 
through. And that is the reason why I made my remarks in my 
formal text about the need for final demands to kick in prior 
to when the obvious significant increase in economic activity 
that is occurring now as a consequence of inventory liquidation 
slowing down finally dissipates.
    Chairman Sarbanes. Yes. Well, my time is expired.
    Senator Gramm.
    Senator Gramm. Thank you, Mr. Chairman.
    Alan, I have three short questions and then a longer 
question. Let me try and give them to you briefly, and if you 
could just give me a short statement on them.
    As you know, there is an effort afoot in both the House and 
the Senate to raise the level of deposit insurance. Could you 
tell me where you stand on that?
    Chairman Greenspan. We just recently had letters from both 
Chairman Bachus and Congressman LaFalce with respect to where 
the Federal Reserve Board is. What we have done is essentially 
indicated that for most of the bill which is being considered 
in the House, we find ourselves as a Board in agreement.
    We do not, however, subscribe to any change in the level of 
coverage of deposit insurance because all of our analysis has 
indicated the need for it is clearly not evident in the data 
that we have.
    And obviously, because there is some indication coming from 
the Federal Deposit Insurance Corporation that losses will be 
rising and, indeed, the so-called ratio of reserves to deposits 
that is relevant, as I recall came down to 1.27 at the end of 
the fourth quarter, and there is a statutory requirement to do 
things at 1.25.
    So it strikes me that if we move to any significant 
expansion of coverage, we are going to have to start boosting 
premiums. And I am not sure that that in total is a 
particularly useful activity.
    But most importantly, I think that we have to be very 
careful about the extent to which we create the levels of 
subsidy within our system to make certain that they are 
contained so that the probabilities of systemic risk which come 
as a consequence of them, are also contained.
    Senator Gramm. Okay. Let me go to the next two questions.
    We passed a security litigation reform bill, I believe in 
1995. We had a series of lawsuits where one big law firm had 
about 80 percent of the business and they literally had a 
boilerplate complaint. And if a company put out a prospectus on 
what it expected to do in the future, and they did better, it 
took that boilerplate thing and filed a lawsuit. If it did not 
do as well, it filed a lawsuit.
    What we tried to do is tighten up on the process, bring all 
those lawsuits to Federal court since the securities market is 
a national market.
    There is an effort underway to try to repeal that provision 
or substantially cut back on it. I would like to get you to 
comment on that. And also, the effort that might be underway to 
regulate energy derivatives and energy swaps.
    Chairman Greenspan. Senator, as I recall, when the original 
discussions of that legislation a number of years ago 
developed, we did not, I think, have a position on it as such, 
but I personally thought it struck me as a sensible idea 
because we have to be very careful in the functioning of our 
financial markets that we do not get swamped with lawsuits or 
challenges to the form of corporate governance and the whole 
structure of security issuances, beyond what is necessary to 
maintain the soundness and stability of the system.
    I have not been familiar with how successful, or lack 
thereof, that has been, so I cannot really comment on what has 
occurred. But certainly, the original principle strikes me as 
the correct one. And unless the evidence to date has indicated 
that that is wrong, I would presume that, at least from my own 
personal view, I would not change.
    With the issue of energy derivatives, as you may recall, in 
the Commodity Futures Modernization Act of 2000, we went over 
that issue in very considerable detail. The main issue involved 
was to recognize the extraordinary importance to improving our 
financial system of the whole derivatives market. And we were 
concerned about a numbers of things which included the 
uncertainties with respect to whether or not they were legally 
binding.
    And we came up with a bill which, I think in retrospect, 
was an exceptionally good bill. What it did with respect to 
energy derivatives--or I should be more exact--over-the-counter 
energy derivatives, was to recognize that public policy 
essentially focuses on three issues in this respect. First is 
consumer protection. The second is anti-manipulation. And the 
third is pricing systems which are not opaque so that we can 
understand what is going on.
    In the second two, the CFTC still has authorities to act 
against manipulation and act against systems in which it 
appears that pricing is not being appropriately indicated to 
the marketplace.
    The issue of consumer protection does not, or did not, in 
our view, apply--I am talking about the President's Working 
Group, as you may remember. The President's Working Group said 
it did not apply to transactions amongst professionals.
    Now, it was crucially important that we allow those types 
of markets to evolve amongst professionals who are most capable 
of protecting themselves far better than either we, the Fed, 
the CFTC, or the SEC could conceivably do.
    The important issue is that there is a significant downside 
if we regulate where we do not have to in this area because one 
of the major and, indeed, the primary, area for regulation and 
protection of the system is counterparty surveillance; that is, 
the individual private parties looking at the economic events, 
looking at the status of the people with whom they are doing 
business, with whom they have this derivative transaction. We 
have to allow that system to work because if we step in as 
Government regulators, we will remove a considerable amount of 
the caution that is necessary to allow those markets to evolve.
    And while it may appear to be sensible to go in and 
regulate, all of our experience is that there is a significant 
downside when you do not allow counterparty surveillance to 
function in an appropriate matter.
    Chairman Sarbanes. Senator Bayh.
    Senator Bayh. Thank you very much, Mr. Chairman, and 
Chairman Greenspan.
    I would like to begin by asking two questions regarding 
productivity growth, which, as you know, is so critically 
important to our economic and fiscal estimates.
    There was an excellent paper prepared by Dale Jorgensen of 
Harvard, Monhoe and Kevin Sterow--I hope I pronounced that 
correctly--regarding the methodology of productivity growth 
forecasts.
    Their conclusions, if I could just summarize them, were 
that the productivity revival of the 1995 to 2000 period 
remains largely intact, that information technology investments 
were critical to that revival, and that going forward over the 
next decade, they project only some slightening of that 
productivity growth.
    This is an important analysis. I was wondering if, and you 
and I have chatted about this, there has been some work at the 
Fed.
    Any update on their thesis that, to my understanding, the 
difference between state-of-the-art technology, the competitive 
advantage that it affords, and mean technology is expanding, 
giving added impetus for investing in technology, which will 
keep this productivity growth advancing.
    Chairman Greenspan. Senator, that is a crucial issue which 
a number of people are beginning to look at. There have been 
certain papers which suggest, indeed, that there has been an 
opening up of the difference between what you might say are the 
ultimate cutting-edge technologies and the average application 
that exists in the economy.
    It is too soon to conclude that. Indeed, if the conclusion 
is accurate, obviously, it says a great deal about the 
potential for the future. But I do not think we have gotten to 
the point at this stage where we can confirm that that is the 
case.
    The general notion, however, that something fundamentally 
important happened in the last 4 or 5 years is continuously 
being reaffirmed quarter by quarter and in the most recent 
period because, even as I indicated at the peak of the 
acceleration in economic activity and of productivity growth, 
we did not at that point have a real test of how the structure 
of productivity would respond when the economy weakened.
    Now, we have been through a period like that and the result 
is, if anything, somewhat suspiciously too strong, in the sense 
that, as you may know, this morning, the Department of Labor 
issued an estimate of productivity growth for the nonfarm 
business sector in the fourth quarter of last year and they 
revised the number up to 5.2 percent at an annual rate.
    Senator Bayh. Remarkably robust under the circumstances.
    Chairman Greenspan. Not only remarkably robust, but also 
very unlikely, if I may put it that way.
    Senator Bayh. That gets to your questions, Mr. Chairman.
    Chairman Greenspan. But what it does suggest is that, if 
you smooth through the noise in the data, we are getting 
increasing confirmation that something fundamentally important 
did happen in the latter part of the 1990's and it does give us 
some confidence projecting forward into the future.
    Senator Bayh. Certainly very good news going forward.
    Mr. Chairman, I would like to ask if you have an opinion on 
an accounting issue that may indirectly, have some impact on 
productivity in the longer term, specifically with regard to 
the treatment of stock options.
    We had some leaders in the high-tech community on Capitol 
Hill yesterday. This is a matter of great concern to them. 
Their argument is that the change in the treatment of stock 
options will limit their ability to attract and retain high-
quality people and that requiring these to be expensed will 
affect their income statements, their ability to attract 
capital, that even in the event that the options turn out to 
not be worth what they originally were calculated at being 
worth.
    So there is a great deal of concern. Innovation is so 
important to the new economy, growing productivity growth 
rates. Do you have an opinion about the treatment of these 
options?
    Chairman Greenspan. I can speak for myself, but I cannot 
speak for the Federal Reserve Board because I have not 
discussed it with them.
    The question basically is that stock options are a 
replacement for cash compensation. And if they are not that, 
what are they, as I think my good friend Warren Buffet once 
said.
    The truth of the matter is that if you do not expense the 
granting of stock options or their realization in the income 
statement, as indeed, we are required in our tax forms, then 
you will get a pre-tax income which is higher than one can 
argue you really had and the estimates by the Federal Reserve 
suggest that somewhere in excess of 2\1/2\ percent of the 
growth rate per year in earnings of major corporations is the 
result of this nonexpensing of stock options.
    I do not deny that earnings would be lower if you expensed 
them. I do not deny that there may be greater difficulty in 
attracting capital with presumed lower earnings than you would 
otherwise have. I do not disagree with the fact that if the 
company has lower earnings, that people may not be attracted to 
come to the firm. But there is no reason why you cannot issue 
stock options if you wish to attract people. It does not affect 
them. If the stock price goes up, they get the rewards.
    The only thing that is involved is the issue of, the 
question, is income being properly recorded? And I would submit 
to you that the answer is no. I do not understand why there is 
an issue here of great moment. The data does show that when you 
have a significant amount of stock options which are not 
expensed, and the higher the proportion that that affects pre-
tax income, the greater the volatility of the return from the 
stock.
    So the answer is yes. People argue that they are likely to 
get less capital, but that is only if the people who are 
lending to them just do not know how to count because these 
data are reported in footnotes. It does not require very much 
to figure out what part of the pre-tax income of any 
corporation which is issuing stock options is the result of 
stock options in lieu of compensation of employees.
    So the only issue here is, if you gain something, you are 
gaining something because people who are giving you something 
just did not quite understand what in fact they were reading.
    It is their fault. They should be doing the calculations. 
But nothing happens in the real world with respect to this 
question because for tax purposes, you have to expense it. If 
you issue options and the stock prices goes up, the effect of 
what the individual employee gets is there, wholly independent 
of what the company did with respect to the issue of earnings.
    Now if the stock market does not know what is going on and 
it overprices the stock because the earnings numbers are 
bigger, that is just because securities analysts are lazy.
    Senator Bayh. Thank you, Mr. Chairman.
    Chairman Sarbanes. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman.
    Chairman Greenspan, I assume, given all of the other things 
that you read, you have been familiar with the three columns 
now that have run in The Wall Street Journal by Robert Bartley, 
addressing the issue of whether or not spending stimulates the 
economy, deficits stimulate the economy, surpluses stimulate 
the economy, and for his final effort, marginal tax rates 
stimulate the economy.
    I find this series very interesting, not only because I 
know Mr. Bartley and have respected his opinion over the years, 
but also because these are the fundamental questions that we as 
policymakers have to face as we address fiscal policy.
    Should we encourage surpluses at the expense of everything 
else? Should we encourage deficits in the name of stimulating 
the economy? Should we say that as long as they are within 
various ranges, deficits and surpluses do not really matter?
    And the most important thing to focus on is the tax level.
    Right now, as a percentage of GDP, the tax burden is the 
highest it has been probably in history. And as you look ahead 
into the future, with your crystal ball, admittedly, clouded, 
but probably a little less clouded than ours, would you comment 
on this controversy about the impact of the size of a deficit, 
the impact of the size of a surplus, and the impact of the 
overall tax burden on the prospect for future economic growth?
    Chairman Greenspan. Well, first, Senator, let me just 
comment that the ratio of total Federal taxes over GDP is 
indeed at a record high, or at least it was up until very 
recently. We have to be a little careful because the GDP, the 
denominator of the ratio, does not include capital gains, as 
you know.
    Senator Bennett. Yes.
    Chairman Greenspan. Yet a significant part of the tax 
receipts in recent years has reflected either the capital gains 
tax, which has been quite substantial, or the issue I was just 
mentioning with Senator Bayh, namely, a very substantial amount 
of tax receipts that occur as a consequence of the exercise of 
stock options.
    And both of those items have been particularly large parts 
of the numerator of that ratio. I have forgotten what happens 
if you take them out, but it does look a good deal less 
burdensome.
    Nonetheless, the issue of taxes rising because, as real 
incomes rise, they gradually get up into ever-increasing tax 
brackets, so, indeed, one has to be very careful about that. 
And I must say I find myself in substantial agreement with Mr. 
Bartley on the question of marginal tax rates and I think it is 
important. If economic growth is a particular purpose, which it 
should be, of economic policy, then I think that is an 
obviously critical issue.
    The questions of when you have surpluses or deficits and 
the like, is a far more controversial issue because I suspect 
that it varies depending on the circumstances.
    I also come out pretty much where he does on most of those 
issues. But in certain places, I do not. On the issue of 
surpluses in the most recent period, I think they have created 
some value, especially in reducing long-term real interest 
rates, and I think that has been an effective factor in the 
last several years.
    But there is no question that it is important that in 
approaching various different forms of economic policy in 
Government, that we have answers to those questions.
    As you know, Senator, most economists would agree that, in 
evaluating the effects of various different fiscal policies, it 
would be far better to use what we call dynamic scoring, that 
is, the ability to get the interaction of the effect, as well 
as the initial impact.
    The only problem is that the interaction is a function of 
the particular model you are using, and no one can quite agree 
on what the appropriate model is. So that we have fallen back 
to a static analysis, which we can all somehow agree on as the 
first stage of the effect. But the questions that Bob Bartley 
is raising get into all of these questions. And while we do not 
choose to address them, that does not mean that we are not in 
fact making judgments about them.
    In certain instances, we are making very specific 
adjustments. In our budgetary analysis, we are saying that the 
secondary impacts of tax and spending programs are zero. Now, 
we know that to be false. But we are making those judgments 
because we have no alternative.
    So, I think it is an issue which is not going to get 
resolved easily, and probably requires continuous evaluation. 
But I think that Mr. Bartley is raising some of the crucial 
issues which essentially are closely involved with the type of 
decisionmaking which this body must make.
    Senator Bennett. Thank you.
    Chairman Sarbanes. Thank you, Senator Bennett.
    Senator Stabenow.
    Senator Stabenow. Thank you, Mr. Chairman.
    Again, Chairman Sarbanes, we appreciate your comments.
    I was particularly interested in your raising the issues of 
conceptual capital versus physical assets. I have had concern 
for some time particularly, again, coming from Michigan, where 
we turn those concepts into physical assets.
    We are seeing more and more relationship between Silicon 
Valley and Automation Alley, which is a high-tech manufacturing 
corridor in Michigan.
    I am concerned that we keep that balance. I appreciate what 
you have raised, not only the positives of concepts, but also 
the negatives that occur from that. I think that is an 
important issue for us long-term in the economy, as we move 
forward, and particularly, coming from a State that brings iron 
ore out of the ground and makes steel and all the implications 
that relate to having physical assets, which I think are a 
foundation for us in the economy. Many of those involved in 
those industries have raised a concern about credit standards 
that I wondered if you might speak to.
    I understand that lenders are tightening their terms and I 
am concerned about the negative impact, particularly for our 
smaller businesses, as we come out of the recession.
    I am wondering if you think that the higher credit 
standards are justified or if they are an overreaction or a 
misperception of the current economic risks.
    Chairman Greenspan. You are quite correct. Our surveys do 
pick up on that evidence of tightening. And it is clearly 
appropriate in many respects, if not most respects, because the 
balance sheets of borrowers have deteriorated over the last 18 
to 24 months. Profit margins are down quite significantly. So 
the actual creditworthiness of borrowers has come down.
    There has, however, been no evidence of anything remotely 
resembling the credit crunch that we had a decade ago, where 
you just could not get a loan out of a commercial bank no 
matter what your creditworthiness was, at least in some cases.
    The data that we have do not suggest that there is a credit 
crunch in small business, but undoubtedly numerous small 
businesses are having difficulty. One hopeful sign is that the 
economy appears to be turning and credit tends to come in with 
a lag. So that to the extent that numbers of firms, especially 
small firms, are finding difficulty in getting the credits they 
need at the prices they can afford to pay, that is likely to 
change to the better.
    Our commercial banking system has come through this period 
really quite effectively. It bodes well to the future of the 
system as a whole.
    Senator Stabenow. I wonder if you might also address 
another issue of concern to our U.S. manufacturing sector. 
Glenn Hubbard, the Chairman of the President's Council of 
Economic Advisers, noted in a speech that U.S. manufacturing 
jobs and our manufacturing exports have been badly hurt by a 
strong dollar.
    I know we are particularly concerned about the excessively 
weak yen. And I wonder if you would comment if you believe that 
that is in fact a serious issue and what you would comment 
about that.
    Chairman Greenspan. When your dollar strengthens, as ours 
has, clearly, it creates lesser competitive capability for 
exporting. And to the extent that that impacts on the job 
market it is a negative in that respect.
    But manufacturing jobs have been falling for quite a long 
period of time, not because manufacturing is disappearing, but 
because productivity, output per hour in manufacturing plants, 
has really accelerated and they are doing an exceptional job. 
So as a percent of the GDP, there has not been all that much 
change in manufacturing. As a percent of the total workforce, 
manufacturing jobs have been falling fairly appreciably for a 
while.
    One can hardly argue--I should say, argue against--gains in 
productivity. The vast majority of those people who have left 
manufacturing jobs obviously have gone into other parts of the 
economy 
because, as you know, up until fairly recently, the 
unemployment rate had gotten to 4 percent and less, which has 
been really quite a remarkable performance indicating a major 
improvement in labor market flexibility.
    Senator Stabenow. I wonder if I might just quickly ask one 
more question. That is, regarding the Treasury rule to allow 
banks into the real estate, brokerage, and managing business. I 
am wondering when you see a rule or what is happening in terms 
of the process of considering that regulation?
    Chairman Greenspan. Well, Senator, as I am sure you know 
better than anyone, we have had a flurry--I should say a 
deluge--of letters, comments and the like, on this issue of the 
question of real estate brokerage.
    We are in the process of processing the data, all of the 
information, as we are required to do, and at some point, 
hopefully sooner rather than later, we will be able to address 
the issue and in working with the Treasury--as you know, the 
statute requires a joint decision on this--we will be coming 
forth with some conclusion.
    Senator Stabenow. Thank you.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you very much, Senator Stabenow.
    Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Last year, Chairman Greenspan we were in a recession. I 
think that it started early in the fall of 2000. I let you know 
my thoughts then, that we should start loosening our monetary 
policy. I continued to argue that we should have loosened it 
all the way through the fall.
    The Fed finally did start seriously loosening it in 
January. But by then, the damage had been done. I have been 
highly critical of the Fed on the recession for two reasons.
    First, I think your attempts to pop the Nasdaq bubble 
greatly contributed to the recession. And I think the word you 
used about a year and a half ago was something about a wealth 
effect. I do not think it is the place of you or the Federal 
Reserve to pop these so-called bubbles.
    Second, I believe the Fed acted entirely too slowly in 
responding to the signs of an economic slowdown. I believe that 
this past recession could have been lessened, if not avoided, 
and a lot of people would not have lost their jobs.
    I also think that part of the problem is you need to have 
more independent voices at the Fed who will stand up and say 
when they think you are wrong on issues. Nobody needs the 
people around them to simply agree with everything they say.
    I think the last two nominees to the Board--Mark Olson and 
Susan Schmidt Bies--will be independent voices who will stand 
up and not be afraid to tell you when they think you are wrong. 
I can tell you this, I would not be as effective as I am as a 
Senator if I were surrounded by yes men and women.
    I am hopeful that the President nominates more independent 
voices for the two current vacancies on the Board. And I think 
that we should fill those vacancies as quickly as we can so 
that the Board has a full complement of members.
    I am not privy to the actual discussions of the meetings of 
the Board, so I might be wrong about the independence of the 
Board members. But I doubt it. Now to the question. Do you 
think the stock market gains this week and last Friday are 
products of irrational exuberance, or are they normal market 
fluctuations?
    Chairman Greenspan. Senator, I do not comment on stock 
market fluctuations in the short term. The issues that I raise 
really 
relate to long-term questions. If I may, can I comment on your 
various different points?
    Senator Bunning. Absolutely.
    Chairman Greenspan. Because I think I will endeavor to get 
to your conclusion as best I can.
    As I think I indicated to you previously, I do not think we 
did pop the bubble, as you may put it. We did raise interest 
rates in 1999, and the reason we did is real long-term rates 
were beginning to rise because the economy was beginning to 
accelerate. Had we not raised the Federal funds rate during 
that particular period, we could have held it in check only by 
expanding the money supply at an inordinately rapid rate. In 
other words, suppress the demand, or I should say, hold 
interest rates down by flooding the market. We did not have an 
alternative to do that.
    Senator Bunning. But you squeezed the money out of the 
market and therefore, you forced all those Nasdaq companies, 
because they could not go to the market, where they got their 
money, to look somewhere else.
    Chairman Greenspan. I do not think that is factually 
accurate, Senator.
    Senator Bunning. Well, we will disagree on that.
    Chairman Greenspan. The wealth effect is basically an 
analytical issue which refers to the fact that asset price 
changes do affect economic activity. Since it is the function 
of monetary policy to try to maintain long-term, sustainable, 
economic growth, by not evaluating factors as important as the 
so-called wealth effect on economic activity would be a 
dereliction of our duty, in my judgment.
    Senator Bunning. Is it your duty, then, to drive the wealth 
effect and make sure that there is no wealth effect?
    Chairman Greenspan. No, on the contrary. I have said 
innumerable times in years past that when I raised the question 
in 1996 as to whether monetary policy ought to address asset 
price changes, I subsequently concluded, and I think reported 
to this Committee, that it would be inappropriate for the 
central bank to be overriding the decisions of millions of 
investors in making their value judgments. I do not think, one, 
we ought to do that. I do not think that we did do that.
    Senator Bunning. But, sir, when you say something that is 
contrary or detrimental to the market in a public statement, 
the market immediately reacts. If you are positive in your 
statements about what is going to happen in the future, the 
market reacts. Should one person have that power?
    Chairman Greenspan. Well, Senator, the reason I did not 
answer the question as you put it is it probably could have an 
effect on the market in addressing the question about the 
recent stock price change.
    Senator Bunning. Are you telling me what you have said 
today is exactly--I read your statement twice that you gave the 
House. It is almost the exact same statement that you gave the 
House.
    Chairman Greenspan. Correct. What I am trying to say, 
basically, is that we should not be, and do not, as best I can 
judge, endeavor to address asset valuations and try to change 
them.
    What we do is take those changes into consideration as they 
impact on the economy and review monetary policy as essentially 
a vehicle to try to alter the liquidity of the system in a 
manner to maximize economic growth.
    And we do not address the issue of trying to change the 
wealth effect. We respond to the wealth effect. We do not try, 
nor do I think we would ever succeed, in changing the wealth 
effect, or I should say, asset prices, because human nature 
being what it is, people will valuate things one way or the 
other. And I do not think monetary policy in the long run 
actually could be effective even if we chose to do it.
    Senator Bunning. Well, we have a major disagreement on 
that.
    Chairman Greenspan. I agree. That I do agree with, Senator.
    [Laughter.]
    Chairman Sarbanes. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    I would like to turn a little bit to the current economic 
circumstance. If I read the papers right and hear from my 
colleagues, there is an additional stimulus bill making its way 
through the House tied to the extension of unemployment 
insurance benefits, $43 billion or so of additional tax cuts. 
Is the economy in need of additional stimulus, in your view?
    Then there is a second concern that I hear--actually, I 
think it is reflective of maybe a difference in what we hear 
from corporate executives out in the world about the state of 
the economy relative to the reported statistics, which is 
somewhat in dissonance.
    But it has to do with the issue of terrorist insurance and 
whether that is having significant impact in our real estate 
and construction markets, and whether it is having impact in 
our lending markets, and whether you think there is need for us 
to act in that area. I would love to hear your comments on 
that, and come back to counterparty surveillance issues, if we 
have time.
    Chairman Greenspan. On the issue of stimulus, as I have 
stated before the House and, indeed, before the Senate Budget 
Committee at an earlier time, as you may recall, if we are 
dealing with an outlook which seems to be reasonably positive, 
as the rate of inventory liquidation gradually goes to zero, 
then the key question is: will final demand kick in to keep the 
economy recovering after the inventory stimulus, so to speak, 
dissipates?
    If the conclusion is that it might not, then one can argue 
a stimulus program is a credible type of thing to try to do, 
largely because it rarely is anything useful in the short run 
because we can never implement it in time. But what we are 
talking about is 4 to 6 months from now, to be effective.
    As I indicated before the House, I doubt very much whether 
the economy, if it did not get a stimulus, would sag. And I 
think the crucial issue that the Congress has to make a 
judgment on is whether the cost to the budget and to the level 
of debt that is created as a consequence is a useful fiscal 
initiative.
    We do of course have the problem that the one fact we know 
with almost reasonable certainty is the huge demographic bulge 
of retirees that is going to occur at the end of this decade. 
And that is going to require that we have higher savings rates, 
higher capital investment, higher productivity, to make certain 
that the retirees can maintain a standard of living at the same 
time that the workers at that time continue to enjoy an 
increase in their standards of living.
    So as the years go on in this decade, we are going to 
become increasingly aware of the oncoming big bulge in retirees 
and the fiscal policies that that is going to require on the 
part of this country.
    Senator Corzine. Do I hear you saying that we are getting 
late in the game?
    Chairman Greenspan. The clock is ticking. And in any fiscal 
stimulus program that is started, you have to get that into the 
policy mix.
    With respect to the question of corporate executives being, 
as I think you put it, more subdued than the forecasters, I 
think they are just looking at a very low level of corporate 
profits, and that is creating a significantly less buoyant view 
of the outlook than that which most economists, even those who 
work for the corporate executives, have.
    On the issue of terrorist insurance, as I said at the House 
Committee last week, I do not think that it is possible to get 
any realistic view of what a probability distribution of the 
costs of a 
terrorist act will be.
    We know roughly what earthquakes can do. We know that it is 
extraordinarily unlikely that you get much above 8, 8\1/2\ on 
the Richter Scale and you can sort of figure out what the costs 
are. We do not have that ability on a terrorist act. And I am 
of the opinion that we probably ought to endeavor to reinsure 
such risks with some deductibles, that it may well be, as I 
said in the House last week, that if the Congress merely 
indicates that it perceives that terrorist acts will be 
essentially reinsured by the American taxpayer, how that is 
done can be left to after the fact because it is a very tricky 
issue.
    The question is, has it had an effect on real estate? Some. 
It is too soon to get a sense of any large numbers. Whatever 
the effect has been to date clearly is not yet showing up as a 
significant negative in the economy. But clearly, 
nonresidential building is being affected and certainly large 
projects are essentially going forward self-insured, which is a 
risky issue.
    It means that the insurance premium essentially, as you 
well know, ends up in the interest rate premium that these 
projects are required to pay to get funded.
    Senator Corzine. Have you seen that factor show up in rates 
and/or spreads in any of the marketplaces?
    Chairman Greenspan. I do not really think we see it as yet, 
and it would really have to be an analysis of individual 
projects because, obviously, the probability of a terrorist 
attack in the vast proportion of the area of the United States 
is very low. And one would presume that the premium in those 
areas would not show up significantly.
    Unless you took a look at the self-insurance of individual 
projects in areas where the risks of terrorist acts are much 
higher, I do not think you get a good sense of what the cost of 
self-insurance is.
    Chairman Sarbanes. Good. Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Mr. Greenspan, you have already answered my question in a 
general sense in response to Senator Gramm's inquiry about the 
derivatives issue.
    I take it from your answer that you do not believe that it 
was a mistake to exclude certain derivatives transactions from 
regulations under the Commodities Futures Modernization Act?
    Chairman Greenspan. I do not. I think that Act, in 
retrospect, was a very sound program passed by the Congress. I 
do not see any particular need to revisit many of the issues 
which were discussed at length at that time.
    Senator Crapo. Some have said, or at least have tried to 
establish some kind of a link between the failure to regulate 
these types of derivatives transactions and the Enron collapse.
    Do you have an opinion on whether the failure to regulate 
these specific types of derivatives transactions in energy is 
linked in some way to the Enron circumstance?
    Chairman Greenspan. Well, Senator, obviously, a lot of 
people are looking at this and it is quite conceivable that 
things will be unearthed at some subsequent date which will 
draw linkages.
    At the moment, I have not seen any. Clearly, what 
essentially undercut Enron were the special purpose vehicles 
which were off-balance sheet constructs which happened in 
certain respects to use derivatives as a means for trying to 
create, which was what the program was, namely, to obscure some 
of the underlying debt and potential losses in the firm. They 
could have used anything else to do the same thing.
    Derivatives are a very effective financial instrument for 
good or ill. They in and of themselves are not anything that is 
potentially any more dangerous than the underlying assets which 
they are derived from.
    Remember that the derivatives were used in the Enron case 
as an end-user, not as a dealer, and that Enron Online, which 
is the derivatives dealer, has apparently not had any 
particular problems, except, obviously, that they have lost a 
lot of people. But, as you know, that particular part of Enron 
was sold and had value.
    So, you have to distinguish where the nature of the problem 
that created the collapse and what I call capitalized 
reputation in Enron came from.
    And at least to date, it does not appear to be--I will put 
it this way: derivatives do not appear to be a smoking gun. It 
is conceivable to me that we will find that the statement I 
just made is false on later evaluation of information we as yet 
do not have. But on the basis of what I have seen, I have seen 
none that suggests that that is a problem.
    Senator Crapo. And on sort of the flip side of that 
question, has the utilization of derivatives generally in the 
marketplace been a positive force in financial markets?
    Chairman Greenspan. Well, Senator, as I indicated in my 
prepared remarks, it is very difficult to make judgments as to 
what the effect of individual instruments are on the economy 
overall, but having observed this phenomenon now for a number 
of years, it does strike me as being a major contributor to the 
flexibility and resiliency of our financial system. Because 
remember what derivatives do. They shift risk from those who 
are undesirous or incapable of absorbing it, to those who are.
    Now that as an economic phenomenon is something which is 
always unequivocally positive. The issue is rarely, if ever, 
whether that instrument is a useful instrument. Obviously, if 
it were not you would not have the vast demand that has 
occurred for this type of hedging procedure, whose basic 
purpose is to lower risk, not increase it.
    And I think it has been a major factor in the resiliency of 
our economy and maybe a major player in why the contraction 
that we have just been through was so mild, why the financial 
system did not breach under the pressures of, one, the sharp 
decline in asset prices, and two, the events of September 11.
    I also indicated in my prepared remarks that, clearly, when 
you are dealing with very sophisticated instruments such as 
this, there are risks of things going wrong. But I cannot argue 
that you can therefore say it is the derivative that did it. It 
is the fact that they were misused or something about them did 
not work very well. But there is nothing inherently negative 
about them because, were that the case, the extraordinary small 
default record of these instruments, which is very low, would 
not be the case. And two, the demand for them year after year 
expanding at a dramatic rate, would not have occurred.
    Senator Crapo. Thank you very much for these good insights.
    Chairman Sarbanes. Thank you, Senator Crapo.
    To complete the first round, just so Members know where 
they are, I have on this side, Senator Dodd, Senator Akaka, and 
then Senator Miller. And Senator Allard, you are next on this 
side.
    Senator Allard. Yes, Mr. Chairman. Do you want me to go 
now?
    Chairman Sarbanes. No, because we just went from here.
    Senator Allard. Right.
    Chairman Sarbanes. Senator Dodd.
    Senator Dodd. Thank you, Mr. Chairman.
    Welcome, Chairman Greespan. It gets said often enough, but 
it deserves repeating--you have done a terrific job and we are 
all very grateful for your leadership.
    The fact that we are coming out of this recession, as brief 
as it is, I think you and your staff at the Federal Reserve can 
take a great deal of credit for what you have done over the 
last year or so, particularly the rate cuts.
    Let me, if I can, I will try to lump my questions together, 
too. It will give you more of a chance to respond than to 
listen to the question.
    I appreciate Senator Corzine raising the terrorism 
insurance issue. We did a lot of work on that a number of 
months ago. But I think your testimony helps this morning give 
us a better feel and flavor for that issue. It is one we need 
to watch and there will be an effort, I know, to try and 
probably revive that issue.
    Senator Stabenow raised the question of international. We 
have had either flat GDP rates, in Great Britain, zero, in 
Germany, I think, Japan, Argentina have problems.
    I would like to know if you could take the long-term rate 
issue, given the gap that exists between short- and long-term 
rates, and then tieing in the question of what is going on 
internationally economically, add to it, if you will, some of 
the projections that we are getting. The CBO's numbers indicate 
a budget deficit substantially different from what the 
President indicated only a few weeks ago. They are talking now 
about $121 billion versus $80. And a cumulative deficit over 
the next 10 years, excluding Social Security, of $1.8 trillion. 
I wonder if you might shed some light on to what extent that 
ought to be a concern in terms of those of us here as policy-
setters. That is number one.
    And then jumping to the issue--and I am not going to ask 
you to comment on specific bills because that is not a fair 
question for you. But pension reform, obviously in light of 
Enron, is going to be a major subject of debate. Another 
committee on which I serve may markup a bill as early as next 
week. Senator Corzine and Senator Boxer have offered ideas in 
this area.
    We are going to do some things in this area and I think you 
have raised the issue of unintended consequences of some 
actions. I wonder if you might comment here. I do not know if 
you are familiar with the bill that Senator Kennedy has 
proposed dealing with employer contributions, defined 
contribution, defined benefit plans, and so forth.
    But rather than getting it out in the details of a bill, I 
would like to hear you comment on pension issues, the numbers 
have come back down now, but they reached a high I think of 44 
percent of all stock was being held by employees in the firms 
in which they worked. That number seems to have dropped back to 
around 34 percent, the latest numbers.
    Give us some flavor and feel for that issue, if you will, 
because all of us want to do the right thing up here. We 
realize that this is a critically important issue. I, for one, 
have supported over the years the employee stock option plans 
not just because of its ability to generate wealth among those 
who work for companies, but also because of the productivity 
issues associated with these stocks, the kind of value.
    So, I want to be careful as I vote up here on these 
questions. I want to avoid the kind of Enron situation where 
people were absolutely taken to the cleaners by what happened.
    But simultaneously, I do not want to do something up here 
that has the unintended consequences of hurting people who 
legitimately are using these vehicles as a way of increasing 
their wealth and having other economic benefits. So those two 
questions.
    Chairman Greenspan. Senator, it is my impression that if 
the stock of Enron had not collapsed effectively to zero, this 
issue would not be on the table.
    Senator Dodd. I suspect it might not have been, certainly.
    Chairman Greenspan. Yes. If Dynergy, for example, had 
successfully merged with Enron, my impression is that the story 
of Enron would have been really quite different, not that there 
would not have been very significant losses, but the starkness 
of the evaporation would not have been evident in that respect.
    I agree with you. I think that the employee stock options 
plans have been a very positive force in this country in the 
sense of ownership and, indeed, because there is a positive 
equity premium in our economy, meaning that the rate of return 
on stocks is chronically in excess over a rolling 20 year 
period of say, bonds or debt instruments, that it is useful for 
pensions, which have at least 20 years to run, to make sure 
that they have adequate common stock coverage.
    I think the problem that may be an unintended consequence 
here is that corporations have been fairly generous in stock 
matching. And what I am concerned about is that you may reduce 
the share of the particular company stock within a 401(k), but 
it may be because that number went down and the rest did not go 
up. In other words, you can very readily create disincentives 
for corporate management in giving stock under ESOP plans 
because the incentive for them to do so has effectively been 
removed. It is not clear to me that that is offset by increased 
compensation and, hence, it is not clear to me that the 
employee necessarily benefits.
    So all I am really suggesting is that, whatever the bills 
of Senator Kennedy and Senator Corzine provide--and you had an 
earlier version and then you backed, as I recall, Senator 
Kennedy's position--I just merely request that you try to 
evaluate as closely as you can what the impact of ESOP issuance 
would be under these various different provisions that would 
appear in any bill that would reform the pension system.
    Senator Dodd. Can you comment on the long-term rate issue, 
the gap, and the questions of the intervention on domestic 
fiscal policy?
    Chairman Greenspan. There is always a tendency for the so-
called term structure of interest rates to be positive, meaning 
short-term rates are lower than long-term.
    Senator Dodd. Yes.
    Chairman Greenspan. Not all the time. Obviously, under 
inflationary speculative periods, you will often get short-term 
rates going higher than long-term rates.
    But, in general, I do not think there is something terribly 
significant here in the sense that a very dramatic decline in 
long-term interest rates occurred in the second half of the 
year 2000, and that a goodly part of the expected decline in 
rates that occurred then was in anticipation of an easing of 
monetary policy.
    And so, it is certainly the case, as many have argued, that 
short-term rates went down appreciably in the year 2001, but 
long-term rates did not. They went down some, but not a great 
deal.
    I think the problem in part is the timeframe in which we 
were looking at that process. If we extended it back into July 
of 2000, it looks a good deal different. You do get a 
measurable decline in long-term rates, as well as short-term 
rates.
    Senator Dodd. Thank you, Mr. Chairman. Thank you.
    Chairman Sarbanes. Senator Allard.
    Senator Allard. Chairman Greenspan, you noted in your 
testimony the economic importance of deregulation over the past 
25 years. You went on to further state as an example, where 
deregulation worked in a positive manner was in the area of 
energy, as well as financial markets. Are there other areas out 
there where you think deregulation had a positive impact on the 
economy?
    Chairman Greenspan. I do, Senator. As I indicated in my 
prepared remarks, I think that despite the fact that it is not 
terribly evident that deregulation has helped the profitability 
of airlines, there is no question that it has created a very 
much broader market and created the capability of American 
citizens to travel far more cheaply than they had in earlier 
periods. And the ability to create a very significant cargo 
freight system has I think facilitated the movement of goods of 
high economic value. Trucking, obviously, has been, in my 
judgment, a significantly improved system with the deregulation 
that has occurred there. There are all sorts of other smaller 
areas where it is questionable how much impact there has been.
    I would suspect that in certain areas of deregulation, you 
are going to find that it does not work, or it does not work as 
well. But, overall, the net effect of the last 20 years has 
been, as best I can see, a positive force.
    Senator Allard. Considering what our economy is doing right 
now, do you think it is an appropriate time now to consider 
reducing capital gains rates even further?
    Chairman Greenspan. Well, Senator, I always have been in 
favor of doing that, but on long-term structural grounds. I do 
not think the capital gains tax, as I have indicated many times 
before this Committee, is a particularly effective tool for 
capital accumulation and economic growth. It has other 
characteristics. I think, clearly, many people argue it has 
positive social impact and that is an argument which I think 
you have to put on the table because not everything is 
economics.
    But from an economic point of view, I would prefer that we 
displace the whole capital gains tax with some other form of 
revenue which has a less negative impact on capital 
accumulation, which I perceive to be a crucial issue in long-
term economic growth.
    Senator Allard. In my State of Colorado, with the 
international trade agreements, particularly NAFTA and GATT, we 
have experienced a greater growth in exports of any State in 
the country.
    So, we have a lot of people that watch the exports and the 
value of the dollar. Our value of the dollar in comparison to 
other economies, there are two variables there about what is 
happening. Two big variables--one is what is happening in the 
United States, and also, what is happening worldwide in other 
countries and how we are trading with them. Is there anything 
that could be done to change that value of the dollar that 
would encourage further exports.
    Chairman Greenspan. Senator, remember that the cause of the 
strength of the dollar is largely the presumed perception on 
the part of foreign investors that the rate of return in the 
United States is higher than in their home countries. And so, 
they are moving capital increasingly into the United States and 
that is pressing the exchange rate higher.
    I guess we could dissuade foreigners from investing here. I 
am not sure that that is to our advantage. We do have the 
obverse of this huge flow of funds into the economy, which is 
our current account deficit, which increasingly widens, and the 
trade deficit, which is the major part of that. And that 
implies that--which is, of course, the other side of the 
capital flowing in--that there are ever increasing claims on 
the American economy by foreign investors. And that cannot go 
on indefinitely without some difficulty, history tells us.
    So, I have argued many times in the past that the current 
account deficit, meaning the capital surplus, cannot continue 
to increase. But it is the capital surplus which is driving the 
exchange rate at this particular point. This process will end 
at some point, but I have been forecasting this for 5 years, 
and I guess I will be forecasting it for another five.
    [Laughter.]
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Sarbanes. Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    Chairman Sarbanes, on March 5, President Bush announced 
temporary tariffs on selected steel imports. I would like to 
know your comments on the economic consequences of this action.
    Chairman Greenspan. Well, Senator, as I have indicated 
before this Committee on numerous occasions, I am a very strong 
proponent of free trade because I believe a free international 
trading system has been a major contributor to the economic 
wealth created in this country.
    I believe we benefit more than anybody from an open trading 
system and we have, indeed, created a significant level of 
living in this country in large part because of our ability to 
expand and get the division of labor on a worldwide basis.
    I understand the obvious problems that are involved in the 
transition as you invariably move capital from less productive 
areas of an economy into the cutting-edge technologies. And it 
is difficult to maintain the process. There are lots of 
casualties, both in capital and in people, that are a 
consequence of these types of transitions, and that it is 
appropriate to try to meet them, to a certain extent.
    I understand the difficulties that any President has in 
trying to come to grips with our trade laws and conditions such 
as exist in our steel industry. I happen not to agree with the 
particular judgment, but I recognize that it is a very tough 
judgment that the President had to make, and I am glad that I 
was not in a position where I had to make that judgment.
    Senator Akaka. Chairman Greenspan, the confidence that 
investors have in the equity markets, I think there is no 
question, has been shaken because of the collapse of Enron and 
the accounting irregularities that have been found in the 
financial statements of other public companies.
    You mentioned about the earthquakes. And when I use the 
word shaken, I wondered at what part of the scale are we at.
    There is a concern about how badly confidence in our 
country has been shaken, to the point that there are proposals 
before this Committee addressing investor protection and also 
ways to improve accounting systems. So my question to you is, 
what actions do you recommend to restore investor confidence?
    Chairman Greenspan. Senator, I think one of the things 
about the Enron episode is that it is probably improved 
corporate governance to quite a significant degree.
    The one thing I think everybody became aware of immediately 
subsequent to the collapse of Enron is that investors started 
to put a price-earnings premium on those companies which they 
perceived to be free of spin in the sense of trying to game 
their earnings numbers to make it look as though they are doing 
better than they actually are. And what that has done is 
removed a very considerable amount of incentives to do that 
because if you are going to be penalized for doing it, you are 
going to do it less.
    And indeed, I think a considerable amount of changes that 
need to happen--and I do not deny that there are significant 
problems in corporate governance--have probably already 
happened.
    I do think that numbers of issues with respect to 
accounting and the structure of accounting and the issue of 
independent directors and a variety of issues that have come 
forth, they will be addressed and I think we are going to find 
out at the end of the day that, even though Enron was a great 
tragedy for a number of people, especially the employees who 
worked there, it probably has created a positive set of forces 
to improve corporate governance.
    I think at the end of the day, we are going to find that it 
was a net plus to our economy, with the obvious caveat that 
that is not the way those thousands of employees of Enron could 
conceivably visualize this very tragic incident.
    Senator Akaka. This next question is more parochial for me. 
The financial condition of Japan has significant influence on 
the economy of Hawaii. Some economists predict that the gross 
domestic product of Japan will decline during fiscal year 2002. 
And if you care to answer this, what is your economic forecast 
for Japan?
    Chairman Greenspan. Well, the Federal Reserve's forecast is 
not significantly different from what conventional forecasts 
are, either of the Ministry of Finance or the Bank of Japan or 
private forecasters. We are all struggling with the fact that 
Japan is in a deflationary environment, that prices continue to 
ease inexorably. And projecting what has been going on, it 
continues to be just a continuous erosion.
    I would suspect, however, that if we turn around, and I 
hope that the early data that we are seeing now are suggestive 
of that, it is quite likely to be helpful to Japan, and helpful 
to Southeast Asia, especially Japan. But we have never really 
had to confront something of the type of problem which Japan 
has been struggling with for the last 10 years. So that we are 
not quite confident about how to forecast that.
    Senator Akaka. Thank you.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Senator Miller.

                STATEMENT OF SENATOR ZELL MILLER

    Senator Miller. Thank you, Mr. Chairman. I have an opening 
statement that I would like to request be made part of the 
record.
    Chairman Sarbanes. It will be included in full in the 
record.
    Senator Miller. Mr. Chairman, thank you so much for being 
with us. You are always very patient in answering our 
questions. I will be brief. I have a couple of questions.
    First, I would like to associate myself with Senators Gramm 
and Crapo on the derivatives question. I know you have already 
spoken at length about it, but one thing I would be interested 
in is if you had any thoughts on the impact of derivatives on 
energy prices during the California energy crisis.
    My other question, if I may go ahead and just ask you both, 
has to do with something that could affect my home State of 
Georgia in a dramatic way. As you well know, agri-business is 
the backbone of the Georgia economy. It is a $60 billion 
business. One out of six jobs come from agri-business. Our 
farmers right now are facing a very uncertain future. They have 
skyrocketing production costs. They have low commodity prices. 
And as they get ready to get into their spring planting, many 
banks, I am told, are balking at issuing loans to these farmers 
until we have a new farm bill. It is causing a lot of 
instability, I am told.
    My question is this. All my information is just anecdotal. 
I am wondering if you, Mr. Chairman, have seen any reticence 
out there from banks about making agricultural loans.
    Chairman Greenspan. The evidence that we have is that loans 
coming from so-called agricultural banks, which are those with 
a significant part of agricultural loans in their assets, have 
not been basically holding back until, as you point out, 
possibly recently because of the seeming stalemate between the 
House and the Senate on the farm bill.
    But we do not see any material or significant 
unavailability of credit, either through the commercial banks 
or the farm credit system. And one of the reasons obviously is 
that, not speaking about Georgia but generally speaking, 
Government payments have been at significantly higher levels 
and have basically supported levels of net farm income, and the 
real estate values, farm values, the land values, have been 
doing reasonably well.
    The underlying income and collateral of the farm community 
has been such as to, as best I can judge, maintain the flow of 
credit.
    I am not aware of banks balking, but I can understand why 
it could create some hesitancy on the part of some lenders. But 
we do not see that.
    Senator Miller. Thank you.
    Chairman Greenspan. With respect to the California electric 
energy issue, you do not need to advert to derivatives to get a 
judgment as to why prices did what they did.
    My recollection is that, 10 years ago or so, the sort of 
capacity buffer that the California electric power system had 
was the typical 15 percent for summer peak loads, which is what 
generally a regulated industry had because you effectively 
guaranteed a rate of return on capacity which was not being 
used. But that 15 percent kept prices down.
    As the years went on and demand went up in California, 
especially from Silicon Valley, where electric power demands 
are very high, but no new capacity, no new plants, as you know, 
came on stream, that 15 percent gradually dissolved because 
there is no way to have inventories of electricity. Our battery 
systems are just inadequate for that. So, you get into a 
situation where the demand load, if it is running up against a 
limited capacity--and the demand tends to be price inelastic, 
as economists like to say, can produce some huge price spikes 
because there is no way to store electric power. And indeed, 
that is exactly what happened.
    Then the authorities in California raised the retail prices 
of power and demand came off, as you might expect, fairly 
abruptly. And then, the actual load factors fell further in 
California, in part, remembering that one of the reasons was 
that the weather was favorable toward less electric power use 
through the summer of 2001.
    But prices have come all the way down. Excess capacity 
exists. There has been, in fact, some delays in some of the 
capital expansion projects that were there.
    You do not need derivatives to explain what happened to 
prices. It is conceivable that there may have been price 
manipulation. There may have been a number of things. But I do 
not think that you need to advert to that, as I said earlier, 
to explain what happened. It is a question of fact. The 
authorities, to inhibit price manipulation, are following the 
statutes that we currently have and I do not see any particular 
need, as I indicated to Senator Crapo, of any major change in 
the underlying Commodity Exchange Act.
    Senator Miller. Thank you.
    Chairman Sarbanes. Good. Mr. Chairman, I have one subject 
that I want to cover very quickly, and we may do another round. 
I see Senator Corzine is still with us. I want to discuss the 
unemployment insurance benefits for a moment.
    In every recession over the past 30 years, we have extended 
unemployment insurance benefits. That has not yet been done in 
this economic downturn, and it is in part because and I do not 
want to draw you into this issue--but there is a very sharp 
conflict in the Congress.
    Our colleagues particularly on the other side of the aisle, 
on the House side, are insistent that they will not extend 
unemployment insurance benefits unless there is a large tax cut 
again for what many of us regard as being for people who do not 
need a tax cut.
    It looks like they may now be relenting on that, or we 
certainly hope so. But in any event, I have regarded it as 
something of an outrage that extending the unemployment 
insurance benefits would be linked to a tax cut, rather than to 
get that to help the needy.
    But leaving that to one side, I think you have testified 
previously, you are supportive of extending unemployment 
insurance benefits. Is that correct?
    Chairman Greenspan. That is correct, Mr. Chairman. I think 
that our unemployment insurance system is actually a reasonably 
well constructed one in recent years. The 26 week length of 
total insurance, which is pretty much general throughout the 50 
States, is not a bad limit because you do not want, as other 
countries have, to use the unemployment system to induce people 
to leave the workforce.
    But the premise of that is that, after 26 weeks, you should 
be able to get a job. When we are in a recession, that may not 
actually be the case. And therefore, the logic of having 26 
weeks as a discipline issue in a market system is lost.
    So, I argued at the House hearing that extension, temporary 
extension of unemployment insurance during periods of 
significant decline in labor demand, seems to be a most 
reasonable approach to the pattern. And I think the way we have 
done it is a fairly sensible approach to the whole concept of 
unemployment insurance.
    Chairman Sarbanes. I might note that in the downturn in the 
early 1990's, actually when the previous President Bush was in 
office, that in the end, we extended it for an additional 33 
weeks. We really ran it up to 59 weeks because we had 
difficulty coming out of that downturn. But as you point out, 
it then reverted back to 26 weeks as we moved into a more 
stable and growth economy.
    I want to ask two questions on what you said on the 
construct of it because I am beginning to think that maybe we 
need to examine that a little bit.
    One is that, on average, only 46 percent of the unemployed 
qualify for unemployment insurance. So, we have a significant 
part of the workers who lose jobs who do not qualify for 
unemployment insurance because we require them to have worked a 
certain length of time and so forth. This gets complicated when 
you get more and more people working part-time. That is a 
significant component. And part-time often means 30 to 35 hours 
a week. They are relatively shy of full-time.
    Also, you get workers coming into the workforce, like 
Welfare To Work, where we are trying to move people into work, 
and then they lose the job. And where does that leave us? Is it 
worth examining the coverage of the unemployment insurance 
program? I do not have an answer in mind. I am just beginning 
to think that we probably need to look at that. Let me ask the 
other dimension of that question.
    Unemployment insurance benefits now average about $230 a 
week. In Northern Virginia, for example, the maximum 
unemployment insurance benefit is $1,160 per month. The rent 
for a typical two-bedroom apartment is $907 per month.
    So, again, that raises the question whether we need to 
examine the level of the payments in terms of accomplishing our 
purposes.
    Now, I know both of these raise questions because you do 
not want to turn it into some kind of semi-permanent way of 
life. But are those two issues worth taking a look at?
    Chairman Greenspan. It is very difficult for me to answer. 
And the reason I say that is, it gets down to what the economic 
effects in the labor market would be were you to introduce 
them.
    I do not know the answer to that. All I can say is that it 
has been my experience that the system has worked remarkably 
well. But implicit in it is that unemployment insurance is not 
freely available, and that it induces a flexibility in the 
workforce which has us down to an unemployment rate of under 4 
percent. And I think that is a highly desirable issue.
    It is always easy to find selected people within the pool 
of unemployed who are not getting benefits and find reasons why 
they should be. If you do that, I think you end up with a much 
higher level than you would like for purposes of macroeconomic 
stability and that is a judgment which I think the Congress has 
to make. I do not think economists can help materially in that.
    Chairman Sarbanes. I would just observe, the trend lines 
show that the percent of unemployed having access to 
unemployment insurance has been trending down from where it 
used to be.
    Chairman Greenspan. I think that is correct, yes.
    Chairman Sarbanes. I also think the amount of income 
replaced by the unemployment insurance has also been trending 
down. So, at an earlier time, the system was in effect more 
comprehensive.
    Chairman Greenspan. I think that is correct, Mr. Chairman. 
The system was significantly more comprehensive. But, in my 
judgment, less effective in its purpose to maintain as a safety 
valve which does not undercut the basic viability of the labor 
market.
    Chairman Sarbanes. Senator Corzine, did you want to wind 
this up here?
    Senator Corzine. Yes. Thank you, Mr. Chairman. I will be a 
quick second.
    Mr. Chairman, in no way does the question I am going to ask 
change the view that I concurred with Senator Gramm and others 
at the start on the job that you have done in the leadership of 
the Federal Reserve. But I am really mystified a little bit 
about the response to the question with regard to the CFTC Act 
and the exemption of over-the-counter derivative activities and 
derivative entities outside regulatory oversight, if not 
regulatory regimes. It seems inconsistent to me relative to the 
needs of consumer protection or antimanipulation or price 
transparency in a market that has secondary implications, if 
not direct implications, on consumers.
    There is a serious issue about whether price manipulation 
actually ends up backing into causes of consumer losses in 
California. I think that is the question that Senator Miller 
was referencing.
    It is for certain that it has had implications on 
investors, at least the overall Enron issue, yet to be 
determined, as I think you outlined. Whether the derivatives 
were a driver or not certainly has not been revealed by the 
information we have today. But that does not necessarily mean 
that it is not a part of it.
    I think back into relatively recent history on nonregulated 
entities having impact into financial markets that then have 
secondary implications, whether it is long-term capital, go 
into some of the commodity trading problems that came with 
Sumotomo Corp.
    I go back into history, Lombard Wahl and Drysdale and a 
whole series of things where no oversight ended up having 
significant impacts into other areas.
    And I think I recall another time and another place that 
the Federal Reserve--I do not know your own position on this--
thought that the Government securities market might need some 
oversight so that it does not have to be ham-handed regulation. 
And certainly believe in counterparty surveillance, so that 
people would have a sense of responsibility about how they are 
operating. I think we do that with banks and securities firms.
    And this idea that there is no oversight of a potentially 
significant market does not seem to gibe with the kinds of 
initiatives that I have seen out of the Federal Reserve Board 
or yourself in some instances. I would love for you to comment 
on that because it is inconsistent, at least in my eyesight.
    Chairman Greenspan. No. Fair question. First of all, the 
CFTC clearly has supervision over regulated markets in energy 
and elsewhere. They also have authority under existing statute 
to act against price manipulation in the over-the-counter 
markets. And indeed, had Enron been involved in price 
manipulation, there is authority as of today for the CFTC to be 
looking at that.
    Senator Corzine. If there is not an ongoing oversight, 
though, then it is only a response to an event.
    Chairman Greenspan. No. What I am trying to say is that the 
CFTC has legal authority. In other words, the question is, do 
you need additional legislation?
    Senator Corzine. Right.
    Chairman Greenspan. And the answer is, they already have 
it. It is there.
    What the only issue here really gets down to is the 
question of consumer protection, per se, in which, as I recall, 
when we addressed this issue in the President's Working Group, 
which led to the Commodity Futures Modernization Act of 2000, 
that when we discussed that issue at considerable length, the 
notion was essentially when you are dealing with small 
investors, do you want protection? The answer was yes. And that 
is what the statute does.
    The question, however, of over-the-counter derivatives 
being overseen by regulation runs into two problems, at least 
from the discussions that we had at the Working Group. One, 
that the whole derivatives area was and still is in the process 
of evolving. And as you well know, when you stick a regulatory 
structure on top of an evolving market, you freeze it. Two, the 
effective advantages that one can get are particularly 
questionable.
    The only issue that is involved here reflects the question 
as to whether there is oversight on the nature of the contract 
itself.
    I remember when I was on the J.P. Morgan board and you were 
at Goldman Sachs, there was a huge amount of credit that moved 
between J.P. Morgan and Goldman and there was not any 
Government official overlooking whether the creditworthiness of 
the institutions was there or not. I would venture to say, 
looking at it from the point of view of what bank regulators 
can do, we do not have the capacity to look at counterparties 
at the level that it is possible for individual institutions 
such as Morgan or Goldman. And that, in our judgment, it was 
not, as we said at the time, the most effective means of 
regulation that you can have in those markets.
    Senator Corzine. You would not suggest that the 
relationship between Morgan and Goldman and credit extension 
between the two is not supervised either by the Federal Reserve 
System and/or by the SEC? There are limits.
    Chairman Greenspan. What I am saying is that there is no 
way that the Federal Reserve, which, as you know, supervises 
Morgan, has better judgments on a loan to Goldman than the 
people at the bank would have.
    Senator Corzine. I am certainly not suggesting that. But 
there are supervisory oversights--
    Chairman Greenspan. There are. And indeed, you have to ask 
whether they are positive or negative to the system.
    I have no doubt that we could put every sort of regulation 
on derivatives and over-the-counter derivatives and force them 
into specific molds. I will tell you, as you would agree 
probably more so than I, that you will dry up that market. And 
if, indeed, we had seen significant problems in the over-the-
counter market, I think that that is where we would be at this 
stage.
    But what is really quite remarkable about the evolution of 
that market is that when problems of risk emerged, you know, we 
went to collateralization of derivatives, and the default rates 
are unimaginably low. There is this large legal issue as to 
whether certain transactions with Enron were a debt or a 
derivative--so the surety bonds are under dispute--but if you 
eliminate that, it is very hard to find defaults. And it was 
our view that in the over-the-counter energy area, it was 
desirable to allow that market to evolve.
    We think it has. The collapse of Enron did not demonstrably 
impact on the prices of natural gas or electric power or any of 
the elements that they were significantly involved as the major 
player in.
    Senator Corzine. Well, though, it is not just the impacts 
that occur in the market, the immediate market. It has other 
implications for other activities when there is a financial 
dislocation with a particular market entity, Long-Term Capital 
or any other.
    Chairman Greenspan. Let me just say this. Long-Term 
Capital, as you may recall, was not taking hedging positions. 
They took principled positions. They happened to use 
derivatives as the vehicle to make some of those bets. They 
turned out to be dubious, to say the least. But I would 
scarcely argue that derivatives were a factor. They could just 
as readily have done it by plain vanilla stocks, bonds, 
leverage, any other thing they could have done.
    It is the case that derivatives are a very powerful tool. 
And if misused, they can create problems. LTCM was a problem. 
But I think we have to distinguish between the instruments and 
the actions. What I think was involved in LTCM and in Enron 
was, as I put in my prepared remarks, just plain, old-fashioned 
excess of debt. The derivatives were a vehicle in enabling that 
debt to be accumulated. But they could have done it in 20 other 
different ways. They would not have done it as efficiently or 
as quickly. I will grant you that.
    And if it does turn out, Senator, that these types of over-
the-counter derivative activities which are not now regulated, 
do impinge on consumers, I think that would be appropriately 
revisited.
    What we said was that it was inappropriate at that time, 
meaning the year 2000, to effectively be locking in regulation 
until we saw a particular need for it. And at least those of us 
who were involved in it, did not see it then. I must say that I 
have not yet seen evidence to suggest that that is the case 
now.
    But I grant you, it may turn out that way. If it does, I 
think it would be most appropriate to take legislative action 
to address that subject. However, at the moment, I have not 
seen anything that suggests the need for it.
    Chairman Sarbanes. Senator Carper.
    Senator Carper. Thank you, Mr. Chairman.
    Chairman Greenspan, shortly after you completed your 
statement and the questioning began, I had to slip out to 
preside in the Senate where we are debating today, again, the 
comprehensive energy bill that is before the Senate.
    I telegraphed you earlier in my opening statement that I 
would like to visit with you just briefly before we conclude, 
some energy-related issues. If you could do that with me, I 
would be grateful.
    As we debate the energy legislation before the Senate, we 
do so at a time when our oil imports are approaching 60 percent 
of that which we consume, where our trade deficit, I believe 
for last year, reached $300 billion. And we know that not all 
of that is oil, but a significant piece of that trade deficit 
is.
    I learned this week that apparently, there is some talk of 
a cartel being formed similar to OPEC that might deal with 
another commodity, and that is natural gas. There was some talk 
of that occurring around the world.
    Against that backdrop, and the debate on energy, I wanted 
to ask, if you could, just to share a word or two with the 
implications for our economy going forward, on our failure to 
adopt a comprehensive energy policy that does two things. One, 
produces more energy; and two, conserves more energy.
    Chairman Greenspan. Senator, it is fairly apparent from all 
of the data that we have seen over the decades that there is a 
fairly close relationship between energy consumption and GDP. 
Indeed, we must be certain that even though the ratio of energy 
per constant dollar GDP has been falling over the years as we 
have gone to increasing efficiencies of various different 
forms, the longer-term outlook for energy is a crucial element 
in any view of where this economy is going over the next 10, 
15, 20 years.
    The problems that I see we have crucial difficulties with 
are more natural gas than oil because oil we can import. And 
one must presume that we have been able to do that to date and 
hopefully, we will be able to do it in the future.
    Natural gas is a much more difficult issue in the sense 
that we have chosen natural gas as the preferred fuel for 
emissions reasons and there is, as you know, on the drawing 
board, a very significant number of gas-fired electric power 
plants to effectively meet the problems that we saw, not only 
in California, but also in many other areas of the country.
    The difficulty is that natural gas is essentially a 
domestic and Canadian source of supply. That is, my 
recollection is we import about a sixth of our gas from Canada 
and we produce the rest of it essentially here by drilling.
    And what we have found is that as the technology improves, 
increasingly the reservoirs that we get from drilling dissipate 
far more rapidly than they have in the past, which means that, 
if, for example, which is relative to the case, that we lose 50 
percent of a new reservoir a year, then, clearly, you need 
gross additions to gas production to just maintain a net 
growth.
    We expended a huge amount of effort in drilling in the last 
couple of years and only increased net marketed gas by a very 
small percent. And if you project out into the future, and if 
you take a look at the potential demands for natural gas, it is 
going to create a problem because we cannot drill fast enough 
to do it, which leads to the conclusion that we either get it 
from Canada, which is already beginning to run into capacity 
problems itself, or liquefied natural gas imports.
    It is very likely that that is where an increasing 
proportion of our gas is going to come from. But we have been 
hesitant to put in the terminals that are required to import 
gas from Indonesia or from Qatar. And the reason is that there 
are environmental concerns about the issue of liquefied natural 
gas, which is a very tricky commodity to handle at cryogenic 
temperatures. So, we are going to have to build a number of 
areas which can bring the gas in and we have not really 
addressed that issue, and I think that is where a long-term 
program is required.
    Second, we obviously are going to need to take a real close 
look at our electric grids, which are really deteriorating. And 
indeed, I noticed the Supreme Court, was it yesterday or the 
day before, unanimously voted to grant authority to FERC to 
require that individual utilities open up their electric power 
to feed into the grid, at least as I read it. That is helpful, 
but you need a grid that is not deteriorating to handle those 
particular qualities.
    So, I think that if you start to look at all the various 
different things, including coal, there is still a very big 
problem that we are importing an ever-increasing proportion of 
our oil, which creates some national security problems as well.
    It is going to be important, as far as I can judge, that we 
indeed take a very close look at the long-term outlook and the 
supply of energy and then take a close look at what our 
alternate sources of conservation are.
    Fuel cells have a huge potential, but they are considerably 
far out in the future. They are not something that is going to 
be a major factor. And as somebody said the other day, every 
time we seem to be getting a fusion breakthrough, it is 
commercially available 50 years out.
    It reminds me of shale oil. As you may recall back in the 
1970's, the cost of shale oil was always something like $6 a 
barrel more than crude oil, no matter what the price of crude 
oil was, which made no sense whatever. It just sort of 
indicated to you that we tend to look at these newer forms of 
energy supply and they seem to be less available than we would 
like.
    I think the issue of conservation, the issue of sources of 
production, our import strategy, our environmental strategy, 
are all part of an integrated strategy which the Congress has 
to address in total.
    Senator Carper. Thank you. Thank you, Mr. Chairman.
    Chairman Sarbanes. Mr. Chairman, thank you very much for 
appearing before the Committee. As always, we very much 
appreciate your testimony. And again, we wish you a happy 
birthday.
    Chairman Greenspan. Thank you very much, Mr. Chairman.
    Chairman Sarbanes. The hearing stands adjourned.
    [Whereupon, at 12:35 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

             PREPARED STATEMENT OF SENATOR PAUL S. SARBANES

    I am pleased to welcome Chairman Greenspan before the Committee on 
Banking, Housing, and Urban Affairs this morning to testify on the 
Federal Reserve's Semi-Annual Monetary Policy Report to Congress.
    Legislation enacted in the last Congress requires the Federal 
Reserve not only to submit a report to Congress twice a year on the 
conduct of monetary policy, but also requires the Chairman of the 
Federal Reserve to testify before the Congress on the report. Prior to 
the enactment of that legislation, the Fed Chairman testified before 
Congress on the report as a matter of custom, but was not actually 
required to do so by statute. Senator Phil Gramm and I worked together 
with the Fed on that legislation, which provides that the Fed Chairman 
testifies first before the House in February in even numbered years and 
first before the Senate in odd numbered years. The House thus had the 
benefit of Chairman Greenspan's testimony last week. The Senate has the 
benefit of a week to review the testimony presented before the House.
    Chairman Greenspan's testimony last week and this morning presents 
a positive, but cautious outlook for the U.S. economy. He speaks about 
a ``subdued recovery,'' which he views as remarkable in light of the 
severe shock experienced by the economy as a result of the terrorist 
attack on September 11.
    According to his testimony, the central tendency of the forecasts 
of the Federal Open Market Committee prepared for the Monetary Policy 
Report to Congress was for real GDP to rise 2\1/2\ to 3 percent during 
2002. Unemployment was expected to rise to 6 to 6\1/4\ percent, and 
inflation as measured by the price index for personal consumption 
expenditures was expected to increase only 1\1/2\ percent. Chairman 
Greenspan pointed out that despite the forecast of a resumption of 
economic growth, the FOMC at its meeting on January 30 saw the risks as 
continuing to be weighted toward conditions that may generate economic 
weakness in the foreseeable future.
    Since Chairman Greenspan testified last Wednesday, the Commerce 
Department released a report which revised upward U.S. economic growth 
in the fourth quarter of last year from 0.2 percent to 1.4 percent. In 
addition, the Institute for Supply Management (ISM), formerly known as 
the National Association of Purchasing Management, released its index 
of manufacturing activity which showed a larger than expected rise and 
gave the first sign of growth in manufacturing in 18 months. The 
Federal Government also reported that consumer spending and income 
growth increased in January, and that construction activity expanded. 
These reports have led to increased optimism that a recovery is taking 
hold. Chairman Greenspan slightly modified his testimony from last week 
to reflect those reports. The Banking Committee will be very interested 
to hear Chairman Greenspan's views on them this morning.
    I would like to make just a few of observations. First, I believe 
the Federal Reserve's caution about the outlook for U.S. economic 
recovery is well placed. Sustained consumer demand has been the 
foundation of the improved outlook for of the economy. However, both 
the University of Michigan's Consumer Sentiment Index and the 
Conference Board's Index of Consumer Confidence declined last month. 
Consumers reported that they are increasingly worried about 
unemployment and future income prospects. Those worries are grounded in 
the current weakness of labor markets, and they will only be 
exacerbated by the projected increases in unemployment.
    In addition, most observers agree that the key to the strength of a 
recovery will be significant growth in capital spending, and there is 
great uncertainty as to whether that will occur. According to the 
Commerce Department, business fixed investment in the fourth quarter of 
last year declined at an 11 percent annual rate, even as the overall 
economy grew at a 1.4 percent rate.
    Finally, even as the economy recovers, unemployment is expected to 
continue to rise, as the FOMC forecasts. Over the last year, according 
to the Bureau of Labor Statistics, the number of people unemployed for 
more than 14 weeks has nearly doubled (from 1,357,000 to 2,547,000). 
Those unemployed for more than 26 weeks, the cutoff for unemployment 
insurance, has also nearly doubled (from 648,000 to 1,127,000). This 
affects consumer sentiment. In my view it also makes a compelling case 
for the temporary 13 week extension of unemployment benefits, as passed 
by the Senate, for those who are looking for work but cannot find it. 
The extension should not be tied to the enactment of the extreme tax 
cut proposal put forward in the House.
    The Federal Reserve is prudent to emphasize the uncertainties still 
present in the economic outlook. With inflation contained the Fed can 
afford to adopt a wait and see attitude, and certainly not move 
precipitously to raise interest rates. I look forward to hearing 
Chairman Greenspan's testimony this morning.

               PREPARED STATEMENT OF SENATOR TIM JOHNSON

    Chairman Greenspan, thank you for coming to today's hearing to 
discuss the Federal Reserve's monetary policy and the state of the U.S. 
economy. I would also like to recognize your staff for preparing such a 
comprehensive written report on these issues.
    I sense a cautious optimism in your written testimony that reflects 
well on the resilience of the U.S. economy, especially in the wake of 
September 11. Further, I want to thank you, Chairman Greenspan, for the 
Federal Reserve's diligent management of U.S. monetary policy in 
helping to make the recent economic downturn, I hope, relatively 
shallow and brief.
    While most Americans can look forward to continued prosperity 
during 2002, I would like to draw your attention to a segment of the 
population that will not share in this prosperity: the approximately 
2.7 million Native American and Native Hawaiian people living in the 
United States.
    Consider the following statistics. According to U.S. Department of 
Commerce's census data, unemployment rates on Indian Lands in the 
continental United States ranging up to 80 percent compared to 5.6 
percent for the United States as a whole. Census data also show that 
the poverty rate for Native Americans during the late 1990's was 26 
percent, compared to the national average of 12 percent. In fact, 
overall, Native American household income is only three-quarters of the 
national average.
    This disparity is particularly evident in my home State of South 
Dakota where Native Americans represent over 8 percent of the State's 
population. While the overall State economy is relatively strong with a 
low 3.1 percent unemployment rate, the Native American population 
continues to suffer. South Dakota counties with Indian Reservations are 
ranked by the U.S. Census Bureau as among the most impoverished in the 
United States.
    This past Tuesday's Wall Street Journal carried an article by 
Jonathan Eig that focuses, in part, on the toll of poverty for the 
Oglala Sioux living on the Pine Ridge Indian Reservation. The article 
notes that:

        Nearly half the tribe's population is destitute. The 
        unemployment rate is about 75 percent. There is no bank, no 
        motel, no movie theater. Restaurants open and close down before 
        anyone notices. . .. The community has the shortest life 
        expectancy of anywhere in the Western Hemisphere outside Haiti: 
        48 years old for men and 52 for women.

    In light of this unacceptable economic disparity, it is important 
to address this issue in a comprehensive manner. Therefore, as I 
announced at the National Congress of American Indians 2 weeks ago, I 
am moving forward with a Financial Institutions Subcommittee hearing on 
developing capital resources for Native Americans. At the hearing, we 
will consider issues such as:

  mechanisms for providing small business capital;
  means for fostering the growth of Native American-owned 
            financial intermediaries;
  incentives for financial institutions to provide services on 
            Indian Lands;
  ways to encourage personal savings; and
  vehicles for improving financial literacy.

    The goal of these discussions will be to assess the state of 
affairs of Native American capital formation and to develop strategies 
for addressing the barriers that keep the first Americans out of the 
financial mainstream.
    I thank you, Chairman Greenspan, for your extensive and thoughtful 
written testimony, and for the Federal Reserve's efforts to keep the 
U.S. economy on track. However, in closing, I would encourage you to 
consider the economic problems facing Native Americans. I believe we 
all, including the Federal Reserve Board and Federal Reserve Banks, 
have a responsibility to address these issues, and I look forward to 
working with you on this matter.

                               ----------

               PREPARED STATEMENT OF SENATOR WAYNE ALLARD

    Mr. Chairman, I would like to thank you for holding this hearing 
today and I want to welcome Federal Reserve Board Chairman Greenspan. I 
always look forward to the opportunity to hear from you, Chairman 
Greenspan, regarding monetary policy and other economic issues.
    The Federal Reserve's quick and aggressive efforts to counteract 
the effects of our Nation's weakened economy during 2001 should be 
applauded. The resiliency of our economy through the September 11 
attacks was remarkable and it seems that the economy today is slowly 
gaining strength, which we can attribute to prudent monetary and fiscal 
policy.
    Consumer spending remained high in recent months, particularly in 
the Housing and Automotive Sectors. This strong consumption, along with 
other factors, helped bring about a more stable economy. Chairman 
Greenspan, I look forward to hearing from you what else can be done to 
continue strengthening our economy.
    Thank you, again, Mr. Chairman, for holding this hearing and 
Chairman Greenspan, I look forward to your report.

                               ----------

           PREPARED STATEMENT OF SENATOR CHRISTOPHER J. DODD

    It is always a pleasure to see you, Chairman Greenspan. I 
appreciate your coming before the Committee today to deliver the 
Monetary Policy Report to Congress.
    The last time Chairman Greenspan reported on the Nation's monetary 
policy before this Committee was last summer. During that time we were 
wondering if our economy was heading toward a significant downturn. 
Soon after, the events of September 11 occurred, and it was announced 
that we were officially in a recession, and actually have been since 
March 2001. Never would we have predicted that so much would have 
occurred in the last 5 months. I would like to commend you for doing a 
great job in taking aggressive action to counter the effects of the 
shock suffered by the economy after September 11.
    It has been a difficult year for our Nation. We have seen the 
unemployment rate climb to rates higher than we have seen in almost a 
decade. In 2001, the real GDP grew only 1.2 percent, inflation as 
measured by the Consumer Price Index rose 1.6 percent in 2001. 
Interesting enough, while unemployment rates climbed in 2001, consumer 
spending remained steady throughout. During the last 2 months, we have 
seen somewhat of a small rebound. The unemployment rate has decreased 
during the last 2 months, and hopefully, we will continue to see a 
decline.
    Just yesterday, the Fed's Beige Book reported that a majority of 
Federal Reserve districts reported some signs of improvement in 
economic conditions in January and early February. The Beige Book also 
reported that the increase in retail sales during the last 2 months is 
an indication that the U.S. economy is recovering from the recession, 
but that the recovery will be a slow and weaker one than the average 
post-recession recovery. While a recovery is good news, there are many 
challenges that loom ahead. Challenges that must be confronted if we 
are going to build a strong economy that will afford every hard working 
American an opportunity to build a sound and secure future.
    I look forward to hearing from the Chairman and my colleagues this 
morning. I especially look forward to hearing the Chairman's thoughts 
on the diminished surplus, the duration of the recession, and his 
predictions on future unemployment rates.
    Again, thank you Mr. Chairman for your time before this Committee.

                               ----------

             PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA

    Thank you, Mr. Chairman. As we all know, in November 2001, the 
National Bureau of Economic Research declared that the U.S. economy has 
been in recession since March 2001, ending the longest expansion in 
U.S. history and beginning the first downturn in a decade.
    Chairman Greenspan and the Federal Reserve Board of Governors have 
been confronted with a recession very different than those in the past. 
Previous recessions were a result of a decline in consumer spending 
which led to a reduction in production and capital investment. The 
current recession has resulted from a decline in production and capital 
investment while consumer spending has remained strong. The Federal 
Reserve sharply reduced the Federal funds rate in 2001 to encourage 
economic growth.
    There have been some encouraging economic indicators that show the 
early signs of a recovery. Examples of these include the growth of the 
gross domestic product in the fourth quarter by 1.4 percent and the 
significant increases in the consumer confidence index since November. 
In addition, durable goods orders rose in January by 2.6 percent.
    However, not all economic data has been positive. Unemployment 
remains much higher than it was a year ago. Corporate profits remain 
weak and new home sales reached an 18 month low in January.
    Chairman Greenspan, I thank you for appearing today. I look forward 
to hearing your thoughts on the state of the economy.

                               ----------

               PREPARED STATEMENT OF SENATOR ZELL MILLER

    Mr. Chairman, it is a pleasure to have you before the Committee 
today. My State of Georgia has been through some troubled economic 
times over the past few months, just as the rest of the United States 
has as well. In Georgia, manufacturing activity has been weak and we 
have seen job cuts in several industries.
    Tourism has been especially hard hit after September 11. Hotel 
occupancy is still below normal and we are seeing continued price 
discounting for hotel rooms and rental cars. Our Georgia travel 
industry is vigorously promoting travel and tourism in our State both 
domestically and internationally.
    Additionally, agriculture has been a big concern in Georgia. Our 
farmers are hurting and they are facing an uncertain future. They are 
struggling with skyrocketing production costs and low-commodity prices. 
They are desperately seeking the stability a farm bill will offer them. 
However, because it is taking longer to get a farm bill than 
anticipated, many bankers are balking at issuing loans to farmers. The 
bankers want a guarantee that there will be a new farm bill this 
season, or at the very least a disaster relief package. Our farmers 
cannot operate without loans. Their livelihood depends on getting that 
bank loan each season, so we have left them in limbo, anxiously 
awaiting our next move.
    And finally, many of my small businesses are reporting fairly steep 
increases in their property and liability and workman's compensation 
insurance premiums. Ed Northup with Burger King in Albany, Georgia, 
reports that his workman's comp premiums increased 50 percent from 
$28,400 in 2001 to $43,366 in 2002, and his property and liability 
premiums increased 26 percent from $26,264 in 2001 to $33,213 in 2002. 
These increases may reflect post September 11 needs for a terrorism re-
insurance bill.
    When my time comes for questions. I look forward to asking you 
about many of these concerns.
                               ----------

                  PREPARED STATEMENT OF ALAN GREENSPAN
       Chairman, Board of Governors of the Federal Reserve System
                             March 7, 2002

    Since July, when I last reported to the Committee on the conduct of 
monetary policy, the U.S. economy has gone through a period of 
considerable strain, with output contracting for a time and 
unemployment rising. We in the Federal Reserve System acted vigorously 
to adjust monetary policy in an endeavor both to limit the extent of 
the downturn and to hasten its completion. Despite the disruptions 
engendered by the terrorist attacks of September 11, the typical 
dynamics of the business cycle have reemerged and are prompting a 
firming in economic activity. The recent evidence increasingly suggests 
that an economic expansion is already well under way, although an array 
of influences unique to this business cycle seems likely to moderate 
its speed.
    At the time of our last report, the economy was weakening. Many 
firms were responding to the realization that significant overcapacity 
had developed. The demand for capital goods had dropped sharply, and 
inventories were uncomfortably high in many industries. In response, 
businesses slashed production, and the resulting declines in incomes 
amplified the cyclical downturn. Real gross domestic product did not 
grow in the second quarter and contracted in the third.
    A coincident deceleration in activity among the world economies was 
evident over the past year, owing, at least in part, to the 
retrenchment in the high-technology sector and the global reach of the 
capital markets in which the firms in that sector are valued and 
funded. However, before the terrorist attacks, it was far from obvious 
that this concurrent weakness was becoming self-reinforcing. Indeed, 
immediately prior to September 11, some sectors exhibited tentative 
signs of stabilization, contributing to a hope that the worst of the 
previous cumulative weakness in world economic activity was nearing an 
end.
    That hope was decisively dashed by the tragic events of early 
September. Adding to the intense forces weighing on asset prices and 
economic activity before September 11 were new sources of uncertainty 
that began to press down on global demand for goods and services. 
Economies almost everywhere weakened further, a cause for increasing 
uneasiness. The simultaneous further slowing in activity raised 
concerns that a self-reinforcing cycle of contraction, fed by 
perceptions of greater economic risk, could develop. Such an event, 
though rare, would not be unprecedented in business-cycle history.
    If ever a situation existed in which the fabric of business and 
consumer confidence, both here and abroad, was vulnerable to being 
torn, the shock of September 11 was surely it. In addition to the 
horrific loss of life, enormous uncertainties had accompanied the 
unfolding events and their implications for the economy. Indeed, for a 
period of weeks, U.S. economic activity did drop dramatically in 
response to that shock.
    In the immediate aftermath of the strikes, the Federal Reserve 
engaged in aggressive action to counter the effects of the shock on 
payment systems and financial markets. We provided a huge volume of 
reserves through open market operations, the discount window, and other 
means to facilitate the functioning of the financial system. We worked 
closely with many market participants, industry groups, and other 
Government officials on a broad range of financial infrastructure 
problems that needed to be resolved quickly and in the common interest.
    Still, market functioning was impaired for a time. The substantial 
damage to trading, settlement, and communications facilities forced 
many market participants to their backup sites. Owing in part to 
careful and thorough contingency planning, many firms, markets, and 
exchanges were able to resume business within a few hours or days of 
the attacks. Nonetheless, the episode did reveal threats to, and 
vulnerabilities of, the operations of financial institutions that had 
not been previously considered and illustrated the significant 
interdependence of the modern financial infrastructure. Institutions 
will need to continue to work diligently toward ensuring that their 
backup capabilities are adequate. We at the Federal Reserve have been 
reexamining intensively our own contingency capabilities to ensure that 
our central banking functions can be performed in the most pressing of 
emergency circumstances.
    In the weeks following the attacks, along with the drops in 
activity and confidence, equity prices fell markedly, and lenders 
became more cautious, boosting risk premiums, especially on credits 
already considered to be weak. In response, the Federal Reserve reduced 
short-term interest rates considerably further. Longer-term yields, 
including mortgage rates, fell to extraordinarily low levels. The 
monetary stimulus that we provided was visible not only in interest 
rates but also in a rapid growth of liquidity over the final months of 
the year, as gauged by the broad monetary aggregates. As the fourth 
quarter progressed, business and consumer confidence recovered, no 
doubt buoyed by successes in the war on terrorism. The 
improved sentiment seemed to buffer the decline in economic activity.
    Indeed, in the past several months, increasing signs have emerged 
that some of the forces that have been restraining the economy over the 
past year are starting to diminish and that activity is beginning to 
firm. The appearance of these signs, in circumstances in which the 
level of the real Federal funds rate was at a very low level, led the 
Federal Open Market Committee to keep policy unchanged at its meeting 
in late January, although it retained its assessment that risks were 
tilted toward economic weakness.
    One key consideration in the assessment that the economy is moving 
through a turning point is the behavior of inventories. Stocks in many 
industries have been drawn down to levels at which firms will soon need 
to taper off their rate of liquidation, if they have not already done 
so. Any slowing in the rate of inventory liquidation will induce a rise 
in industrial production if demand for those products is stable or is 
falling only moderately. That rise in production will, other things 
being equal, increase household income and spending. The runoff of 
inventories, even apart from the large reduction in motor vehicle 
stocks, remained sizable in the fourth quarter. Hence, with production 
running well below sales, the lift to income and spending from the 
inevitable cessation of inventory liquidation could be significant.
    But that impetus to the growth of activity will be short-lived 
unless sustained 
increases in final demand kick in before the positive effects of the 
swing from inventory liquidation dissipate. We have seen encouraging 
signs in recent days that underlying trends in final demand are 
strengthening, although the dimensions of the pickup remain uncertain.
    Most recoveries in the post-World War II period received a boost 
from a rebound in demand for consumer durables and housing from 
recession-depressed levels in addition to an abatement of inventory 
liquidation. Through much of last year's slowdown, however, spending by 
the household sector held up well and proved to be a major stabilizing 
force. As a consequence, although household spending should continue to 
trend up, the potential for significant acceleration in activity in 
this sector is likely to be more limited than in past cycles.
    In fact, there are a number of cross currents in the outlook for 
household spending. In recent months, low mortgage interest rates and 
favorable weather have provided considerable support to homebuilding. 
Moreover, attractive mortgage rates have bolstered the sales of 
existing homes and the extraction of capital gains embedded in home 
equity that those sales engender. Low rates have also encouraged 
households to take on larger mortgages when refinancing their homes. 
Drawing on home equity in this manner is a significant source of 
funding for consumption and home modernization. The pace of such 
extractions likely dropped along with the decline in refinancing 
activity that followed the backup in mortgage rates that began in early 
November. But mortgage rates remain at low levels and should continue 
to underpin activity in this sector.
    Consumer spending received a considerable lift from the sales of 
new motor vehicles, which were remarkably strong in October and 
November owing to major 
financing incentives. Sales have receded somewhat, but they have 
remained surprisingly resilient. Other consumer spending appears to 
have advanced at a solid pace in recent months.
    The substantial declines in the prices of natural gas, fuel oil, 
and gasoline have clearly provided some support to real disposable 
income and spending. To have a more persistent effect on the ongoing 
growth of total personal consumption expenditures, energy prices would 
need to decline further. Futures prices do not suggest that such an 
outcome is in the offing, though the forecast record of these markets 
is less than impressive.
    Changes in household financial positions in recent years are 
probably damping consumer spending, at least to a degree. Overall 
household wealth relative to income has dropped from a peak multiple of 
about 6.3 at the end of 1999 to around 5.3 currently. Moreover, the 
aggregate household debt service burden, defined as the ratio of 
households' required debt payments to their disposable personal income, 
rose considerably in recent years, returning last year to its previous 
cyclical peak of the mid-1980's.
    However, neither wealth nor the burden of debt is distributed 
evenly across households. Hence, the spending effects of changes in 
these influences also will not be evenly distributed. For example, 
increased debt burdens appear disproportionately attributable to 
higher-income households. Calculations by staff at the Federal Reserve 
suggest that the ratio of household liabilities to annual income for 
the top fifth of all households ranked by income, who accounted for 44 
percent of total after-tax household income last year, rose from about 
1.10 at the end of 1998 to 1.20 at the end of the third quarter of 
2001. The increase for the lower four-fifths was only about half as 
large. Although high-income households should not experience much 
strain in meeting their obligations, others might. Indeed, repayment 
difficulties have already increased, particularly in the subprime 
markets for consumer loans and mortgages. Delinquency rates may well 
worsen as a delayed result of the strains on household finances over 
the past 2 years. Large erosions, however, do not seem likely, and the 
overall levels of debt and repayment delinquencies do not, as of now, 
appear to pose a major impediment to a moderate expansion of 
consumption spending going forward.
    Although the macroeconomic effects of debt burdens may be limited, 
we have already seen significant spending restraint among the top fifth 
of income earners, presumably owing to the drop in equity prices. The 
effect of the stock market on other households' spending has been less 
evident. Moderate-income households have a much larger proportion of 
their assets in homes, and the continuing rise in the value of houses 
has provided greater support for their net worth. Reflecting these 
differences in portfolio composition, the net worth of the top fifth of 
income earners has dropped far more than it did for the bottom 80 
percent.
    As a consequence, excluding capital gains and losses from the 
calculation, as is the convention in our national income accounts, 
personal saving for the upper fifth, which had been negative during 
1999 and 2000, turned positive in 2001. By contrast, the average saving 
rate for the lower four-fifths of households, by income, was generally 
positive during the second half of the 1990's and has fluctuated in a 
narrow range in the past 2 years. Accordingly, most of the change in 
consumption expenditures that resulted from the bull stock market, and 
its demise, reflected shifts in spending by upper-income households. 
The restraining effects from the net decline in wealth during the past 
2 years presumably have not, as yet, fully played out and could exert 
some further damping effect on the overall growth of household spending 
relative to that of income.
    Perhaps most central to the outlook for consumer spending will be 
developments in the labor market. The pace of layoffs quickened last 
fall, especially after September 11, and the unemployment rate rose 
sharply. However, layoffs diminished noticeably in January, and the 
reported unemployment rate declined--though adjusting for seasonal 
influences was difficult last month. Moreover, initial claims for 
unemployment insurance have decreased markedly, on balance, providing 
further evidence of an improvement in labor market conditions. Even if 
the economy is on the road to recovery, the unemployment rate, in 
typical cyclical fashion, may resume its increase for a time, and a 
soft labor market could put something of a damper on consumer spending.
    However, the extent of such restraint will depend on how much of 
any rise in unemployment is the result of weakened demand for goods and 
services and how much reflects strengthened productivity. In the latter 
case, average real incomes of workers could rise, at least partially 
offsetting losses of purchasing power that stem from diminished levels 
of employment. Indeed, preliminary data suggest that productivity has 
held up very well of late, and history suggests that any depressing 
effect of rapid productivity growth on employment is only temporary.
    The dynamics of inventory investment and the balance of factors 
influencing consumer demand will have important consequences for the 
economic outlook in coming months. But the broad contours of the 
present cycle have been, and will continue to be, driven by the 
evolution of corporate profits and capital investment.
    The retrenchment in capital spending over the past year and a half 
was central to the sharp slowing we experienced in overall activity. 
The steep rise in high-tech spending that occurred in the early post-
Y2K months was clearly not sustainable. The demand for many of the 
newer technologies was growing rapidly, but capacity was expanding even 
faster, and that imbalance exerted significant downward pressure on 
prices and the profits of producers of high-tech goods and services. 
New orders for equipment and software hesitated in the middle of 2000 
and then fell abruptly as firms reevaluated their capital investment 
programs. Uncertainty about economic prospects boosted risk premiums 
significantly, and this rise, in turn, propelled required, or hurdle, 
rates of return to markedly elevated levels. In most cases, businesses 
required that new investments pay off much more rapidly than they had 
previously. For much of last year, the resulting decline in investment 
outlays was fierce and unrelenting. Although the weakness was most 
pronounced in the technology area, reductions in capital outlays were 
broad-based.
    These cutbacks in capital spending interacted with, and were 
reinforced by, falling profits and equity prices. Indeed, a striking 
feature of the current cyclical episode relative to many earlier ones 
has been the virtual absence of pricing power across much of American 
business, as increasing globalization and deregulation have enhanced 
competition. In this low-inflation environment, firms have perceived 
very little ability to pass cost increases on to customers. To be sure, 
growth in hourly labor compensation has moderated in response to slowed 
inflation and deteriorating economic conditions. A significant falloff 
in stock-option realizations and in other forms of compensation related 
to company performance has likely been a factor. But over most of the 
past year, even those smaller hourly compensation increases outstripped 
gains in output per hour, precipitating a marked decline in profit 
margins.
    Business managers, with little opportunity to raise prices, have 
moved aggressively to stabilize cashflows by trimming workforces. These 
efforts have limited any rise in unit costs, attenuated the pressure on 
profit margins, and ultimately helped to preserve the vast majority of 
private-sector jobs. To the extent that businesses are successful in 
stabilizing and eventually boosting profits and cashflow, capital 
spending should begin to recover more noticeably.
    Part of the reduction in pricing power observed in this cycle 
should be reversed as firming demand enables firms to take back large 
price discounts. Though such an adjustment would tend to elevate price 
levels, underlying inflationary cost pressures should remain contained. 
Output per hour is not likely to accelerate this year as much as in a 
typical recovery because businesses have not delayed, as they have in 
past recessions, shedding workers at the first indications of weakened 
demand. But slack in labor markets and further increases in 
productivity should hold labor costs in check and result in rising 
profit margins even with inflation remaining low.
    Improved profit margins and more assured prospects for rising final 
demand would likely be accompanied by a decline in risk premiums from 
their current elevated levels toward a more normal range. With real 
rates of return on high-tech equipment still attractive, that should 
provide an additional spur to new investment. Reports from businesses 
around the country suggest that the exploitation of available 
networking and other information technologies was only partially 
completed when the cyclical retrenchment of the past year began. Many 
business managers are still of the view, according to a recent survey 
of purchasing managers, that less than half of currently available new, 
and presumably profitable, supply chain technologies have been put into 
use.
    Recent evidence suggests that a recovery in at least some forms of 
high-tech investment could already be under way. Production of 
semiconductors, which in the past has been a leading indicator of 
computer production, turned up last fall. Expenditures on computers 
rose at a double-digit annual rate in real terms last quarter. But 
investment expenditures in the communications sector, where the amount 
of overcapacity was substantial, as yet show few signs of turning up, 
and business investment in some other sectors, such as aircraft, hit by 
the drop in air travel, will presumably remain weak this year.
    On balance, the recovery in overall spending on business fixed 
investment is likely to be only gradual; in particular, its growth will 
doubtless be less frenetic than in 1999 and early 2000--a period during 
which outlays were boosted by the dislocations of Y2K and the 
extraordinarily low cost of equity capital available to many firms. 
Nonetheless, if the recent more favorable economic developments gather 
momentum, uncertainties will diminish, risk premiums will fall, and the 
pace of capital investment embodying new technologies will increase.
    Even a subdued recovery would constitute a truly remarkable 
performance for the American economy in the face of so severe a decline 
in equity asset values and an unprecedented blow from terrorists to the 
foundations of our market systems. For, if the tentative indications 
that the contraction phase of this business cycle has drawn to a close 
are ultimately confirmed, we will have experienced a significantly 
milder downturn than the long history of business cycles would have led 
us to expect. Crucially, the imbalances that triggered the downturn and 
that could have prolonged this difficult period did not fester. The 
obvious questions are what has changed in our economy in recent decades 
to provide such resilience and whether such changes will persist into 
the future.
    Doubtless, the substantial improvement in the access of business 
decisionmakers to real-time information has played a key role. Thirty 
years ago, the timeliness of available information varied across 
companies and industries, often resulting in 
differences in the speed and magnitude of their responses to changing 
business conditions. In contrast to the situation that prevails today, 
businesses did not have real-time data systems that enabled 
decisionmakers in different enterprises to work from essentially the 
same set of information. In those earlier years, imbalances were 
inadvertently allowed to build to such an extent that their inevitable 
correction engendered significant economic stress. That process of 
correction and the accompanying economic and financial disruptions led 
to deep and prolonged recessions. Today, businesses have large 
quantities of data available virtually in real time. As a consequence, 
they address and resolve economic imbalances far more rapidly than in 
the past.
    The apparent increased flexibility of the American economy arguably 
also reflects the extent of deregulation over the past quarter century. 
Certainly, if the energy sector were still in the tight regulatory 
fetters of the 1970's, our flexibility today would be markedly less. 
That the collapse of Enron barely registered in the relatively recently 
developed markets for natural gas and electric power was encouraging. 
Although the terrorist attacks hit air travel especially hard over the 
past few months, deregulation of that industry has demonstrably 
increased the quantity and flexibility, if not the profitability, of 
air travel over the past 20 years. Trucking and rail deregulation has 
added flexibility to the movement of goods across our Nation.
    Both deregulation and innovation in the financial sector have been 
especially important in enhancing overall economic resilience. New 
financial products--including derivatives, assetbacked securities, 
collateralized loan obligations, and collateralized mortgage 
obligations, among others--have enabled risk to be dispersed more 
effectively to those willing to, and presumably capable of, bearing it. 
Shocks to the overall economic system are accordingly less likely to 
create cascading credit failure. Lenders have the opportunity to be 
considerably more diversified, and borrowers are far less dependent on 
specific institutions for funds. Financial derivatives, particularly, 
have grown at a phenomenal pace over the past 15 years, evidently 
fulfilling a need to hedge risks that were not readily deflected in 
earlier decades. 
Despite the concerns that these complex instruments have induced (an 
issue I will address shortly), the record of their performance, 
especially over the past couple of stressful years, suggests that on 
balance they have contributed to the development of a far more flexible 
and efficient financial system--both domestically and internationally--
than we had just 20 or 30 years ago.
    As a consequence of increased access to real-time information and, 
more arguably, extensive deregulation in financial and product markets 
and the unbundling of risk, imbalances are more likely to be readily 
contained, and cyclical episodes overall should be less severe than 
would be the case otherwise. If this is indeed the case--and it must be 
considered speculative until more evidence is gathered--the implied 
reduction in volatility, other things equal, would lower risk and 
equity premiums.
    Other things, however, may not be wholly equal. The very 
technologies that appear to be the main cause of our apparent increased 
flexibility and resiliency may also be imparting different forms of 
vulnerability that could intensify or be intensified by a business 
cycle.
    From one perspective, the ever-increasing proportion of our GDP 
that represents conceptual as distinct from physical value added may 
actually have lessened cyclical volatility. In particular, the fact 
that concepts cannot be held as inventories means a greater share of 
GDP is not subject to a type of dynamics that amplifies cyclical 
swings. But an economy in which concepts form an important share of 
valuation has its own vulnerabilities.
    As the recent events surrounding Enron have highlighted, a firm is 
inherently fragile if its value added emanates more from conceptual as 
distinct from physical assets. A physical asset, whether an office 
building or an automotive assembly plant, has the capability of 
producing goods even if the reputation of the managers of such 
facilities falls under a cloud. The rapidity of Enron's decline is an 
effective illustration of the vulnerability of a firm whose market 
value largely rests on capitalized reputation. The physical assets of 
such a firm comprise a small proportion of its asset base. Trust and 
reputation can vanish overnight. A factory cannot.
    The implications of such a loss of confidence for the macroeconomy 
depend importantly on how freely the conceptual capital of the fading 
firm can be replaced by a competitor or a new entrant into the 
industry. Even if entry is relatively free, macroeconomic risks can 
emerge if problems at one particular firm tend to make investors and 
counterparties uncertain about other firms that they see as potentially 
similarly situated. The difficulty of valuing firms that deal primarily 
with concepts and the growing size and importance of these firms may 
make our economy more susceptible to this type of contagion.
    Another, more conventional determinant of stability will be the 
economy's degree of leverage--the extent to which debt rather than 
equity is financing the level of capital. The proper degree of leverage 
in a firm, or in an economy as a whole, is an inherently elusive figure 
that almost certainly changes from time to time. Clearly, firms find 
some leverage advantageous in enhancing returns on equity, and thus 
moderate leverage undoubtedly boosts the capital stock and the level of 
output. A sophisticated financial system, with its substantial array of 
instruments to unbundle risks, will tend toward a higher degree of 
leverage at any given level of underlying economic risk. But, the 
greater the degree of leverage in any economy, the greater its 
vulnerability to unexpected shortfalls in demand and mistakes.
    Indeed, on a historical cost basis, the ratio of debt to net worth 
for the nonfinancial corporate business sector did rise, from 71 
percent at the end of 1997 to about 81 percent at the end of the third 
quarter of last year, though it is still well below its level at the 
beginning of the recession in 1990. The ratio of interest payments to 
cashflow, one indicator of the consequence of leverage, has slowly 
crept up in recent years, reflecting growth in debt. Owing to lower 
interest rates, it remains far below its levels of the early 1990's.
    Although the fears of business leverage have been mostly confined 
to specific sectors in recent years, concerns over potential systemic 
problems resulting from the vast expansion of derivatives have 
reemerged with the difficulties of Enron. To be sure, firms like Enron, 
and Long-Term Capital Management before it, were major players in the 
derivatives markets. But their problems were readily traceable to an 
old fashioned excess of debt, however acquired, as well as to opaque 
accounting of that leverage and lax counterparty scrutiny. Swaps and 
other derivatives throughout their short history, including over the 
past 18 months, have been remarkably free of default. Of course, there 
can be latent problems in any market that expands as rapidly as these 
markets have. Regulators and supervisors are particularly sensitive to 
this possibility. Derivatives have provided greater flexibility to our 
financial system. But their very complexity could leave counterparties 
vulnerable to significant risk that they do not currently recognize, 
and hence these instruments potentially expose the overall system if 
mistakes are large. In that regard, the market's reaction to the 
revelations about Enron provides encouragement that the force of market 
discipline can be counted on over time to foster much greater 
transparency and increased clarity and completeness in the accounting 
treatment of derivatives.
    How these countervailing forces for stability evolve will surely be 
a major determinant of the volatility that our economy will experience 
in the years ahead. Monetary policy will have to be particularly 
sensitive to the possibility that the resiliency our economy has 
exhibited during the past 2 years signals subtle changes in the way our 
system functions.
    Our most recent experiences underscore this possibility, along with 
the persistence of a long list of older, well-tested, economic 
verities. Inventories, especially among producers and purchasers of 
high-tech products, did run to excess over the past year, as sales 
forecasts went badly astray; alas, technology has not allowed us to see 
into the future any more clearly than we could previously. But 
technology did facilitate the quick recognition of the weakening in 
sales and backup of inventories. This enabled producers to respond, as 
evidenced by output adjustments that resulted in the extraordinary rate 
of inventory liquidation that we experienced late last year.
    For the period just ahead, the central tendency of the forecasts of 
the members of the Federal Open Market Committee prepared earlier for 
our monetary policy report to the Congress was for real GDP to rise 
2\1/2\ to 3 percent during 2002. Such a pace for the growth of real 
output would be somewhat below the rates of growth typically seen early 
in previous expansions. Certain factors, such as the lack of pent-up 
demand in the consumer sector, significant levels of excess capacity in 
a number of industries, weakness and financial fragility in some key 
international trading partners, and persistent caution in financial 
markets at home, seem likely to restrain the near-term performance of 
the economy.
    In line with past experience during the early stages of expansion, 
labor market performance was expected initially to lag as firms rely 
primarily on overtime and shifts from part-time to full-time work. The 
unemployment rate was anticipated to rise somewhat further over 2002, 
to the area of 6 to 6\1/4\ percent. FOMC members evidently anticipated 
that slack in resource utilization, the lagged effects of past declines 
in energy prices, and productivity growth will keep inflation low this 
year, with the price index for personal consumption expenditure 
increasing 1\1/2\ percent.
    Despite its forecast that economic growth is likely to resume at a 
moderate pace, as I already noted, the Federal Open Market Committee at 
its meeting on January 30 saw the risks nonetheless as continuing to be 
weighted mainly toward conditions that may generate economic weakness 
in the foreseeable future. In effect, the FOMC indicated that until the 
dynamics of sustained expansion are more firmly in place, it remained 
concerned about the possibility of weak growth for a time, despite the 
very low level of the Federal funds rate.
    Although there are ample reasons to be cautious about the economic 
outlook, the recuperative powers of the U.S. economy, as I have tried 
to emphasize in my presentation, have been remarkable. When I presented 
our report on monetary policy to this Committee last summer, few if any 
of us could have anticipated events such as those to which our Nation 
has subsequently been subjected. The economic consequences of those 
events and their aftermath are an integral part of the challenges that 
we now collectively face. The U.S. economy has experienced a 
substantial shock, and, no doubt, we continue to face risks in the 
period ahead. But the response thus far of our citizens to these new 
economic challenges provides reason for encouragement.

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