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80–301 PDF 2002

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 PURSUANT 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

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

DANIEL K. AKAKA, Hawaii

PHIL GRAMM, Texas

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

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)

CONTENTS

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)

(1)

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.

2

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.

3

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.

4

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 AfghanVerDate 11-MAY-2000 12:24 Jul 09, 2002 Jkt 000000 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 80301.TXT SBANK2 PsN: SBANK2
5

istan, 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.

6

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.

7

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

8

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

9

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

10

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.

11

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?

12

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

13

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

14

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.

15

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 21⁄2 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

16

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.

17

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.

18

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.

19

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.

20

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.

21

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?

22

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, 81⁄2 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.

23

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 offbalance 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.

24

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

25

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 legitiVerDate 11-MAY-2000 12:24 Jul 09, 2002 Jkt 000000 PO 00000 Frm 00029 Fmt 6633 Sfmt 6633 80301.TXT SBANK2 PsN: SBANK2
26

mately 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 socalled 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 shortterm rates went down appreciably in the year 2001, but long-term

rates did not. They went down some, but not a great deal.

27

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.

28

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.

29

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.

30

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.

31

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.

32

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

33

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

34

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.

35

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 overthe-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-thecounter 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

36

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 energyrelated 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 alVerDate 11-MAY-2000 12:24 Jul 09, 2002 Jkt 000000 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 80301.TXT SBANK2 PsN: SBANK2
37

ready 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:]

38

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 SemiAnnual 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 21⁄2 to 3 percent during 2002. Unemployment was expected to

rise to 6 to 61⁄4 percent, and inflation as measured by the price index for personal

consumption expenditures was expected to increase only 11⁄2 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.

39

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

40

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.

41

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

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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.

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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 aftertax 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 adVerDate 11-MAY-2000 12:24 Jul 09, 2002 Jkt 000000 PO 00000 Frm 00047 Fmt 6633 Sfmt 6621 80301.TXT SBANK2 PsN: SBANK2
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justing 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

45

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

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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

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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 21⁄2 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 pentup 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 61⁄4 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 11⁄2 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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