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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1987
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAffiS
UNITED STATES (SENATE
ONE HUNDREDTH CONGRESS
FIRST SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1987
FEBRUARY 18 AND 19, 1987
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1987
For sale by the Superintendent of Documents, Congressional Sales Office
U.S, Government Printing Office, Washington, DC 20402
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
WILLIAM PROXM1RE, Wisconsin, Chairman
ALAN CRANSTON, California
JAKE GARN, Utah
DONALD W. RIEGLE, JR., Michigan
JOHN HEINZ, Pennsylvania
PAUL S. SARBANES, Maryland
WILLIAM L. ARMSTRONG, Colorado
CHRISTOPHER J, DODD, Connecticut
ALFONSE M. D'AMATO, New York
ALAN J- DIXON, Illinois
CHIC HECHT, Nevada
JIM SASSER, Tennessee
PHIL GRAMM. Texas
TERRY SANFORD, North Carolina
CHRISTOPHER S. BOND, Missouri
RICHARD SHELBY, Alabama
JOHN H. CHAFEE, Rhode Island
ROBERT GRAHAM, Florida
KENNETH A. MCLEAN, Staff Director
M. DANNY WALL, Republican Staff Director
ROBERT H. DUCGEK, Chief Economist
(11)
CONTENTS
WEDNESDAY, FEBRUARY 18, 1987
Opening statement of Chairman Proxmire
Opening statements of:
Senator Dixon
Senator D'Amato
Senator Heinz
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41
71
WITNESSES
Stephen Axilrod, vice chairman, the Nikko Securities Co. International, Inc....
Recent evolution of monetary policy
Recent economic data
Prepared statement
Budgetary1 deficits
Trade deficit and exchange rates
Momentum within the private economy
Economic policies and attitudes abroad
Conclusions for monetary policy
Lawrence Chimerine, chairman and chief economist, Chase Econometrics
Slow economic growth
World economy is fragile
Prepared statement
Summary
The recovery thus far
The current economic situation
Why has the economy been so sluggish?
The outlook for 1987
Monetary policy
Long-term outlook
Policy Implications
"Monetary Policy Analysts Foresee Recession in "88," article in the Monetary Policy Forum
Erich Heinemann, chief economist, Moseley Securities Corp
Growth in high-powered money
Velocity
Prepared statement
Chart 1: Federal Reserve actions—1960-86
Chart 2: The volitility of monetary expansion
Alan H. Meltzer, John M. Olin Professor of Political Economy and Public
Policy, GSIA—Carnegie Mellon University
Devaluation of the currency
Spending for consumption
Prepared statement
Trade and debt
The problem
Options
Conclusion
Paul Craig Roberts, William E. Simon, Chair, Political Economy, Center for
Strategic and International Studies, Georgetown University
Growth rate of nominal GNP
Acceleration of Ml
Prepared statement
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3
4
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15
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Page
Tables:
I: Comparison of original nominal GNP assumptions with actual
developments
II: Impact on budget deficit of unexpected collapse in nominal
GNP
III: Quarterly rates of growth
IV: Levels and percent of foreign holdings of gross Federal debt
and Federal debt held by the public
V: Federal Reserve Monetization as percent of Federal deficit
Chart I: Money growth rates and growth rates for the value of
the dollar over selected periods, 1977-86
Chart II: Ml velocity
Chart III: FRB monetization: percent of deficit
Chart IV: Growth of real GNP and money supply
"How the Defeat of Inflation Wrecked the U.S. Budget," from the Los
Angeles Times
"Beneath the 'Twin Towers of Debt'," from the Wall Street Journal
Panel discussion:
Projections on the M's
Effect of money growth on the stock markets
Stop lending to other countries
Consumer debt
Third World debt
Inflationary potential in monetary policy
Corporate debt
J-curve
Need to be patient
Rise on import prices
No. 1 debtor nation
,
Testing the outer bounds of structure
Broad-based consumption tax
Periodic recessions
Lower living standards in the future
Need to increase productivity
Domestic budget deficit
Foreign investment in American industry
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THURSDAY, FEBRUARY 19, 1987
Opening statement of Chairman Proxmire
Opening statements of:
Senator Garn
Senator Riegle
Senator Dixon
Senator Sarbanes
Senator Gramm
Senator D'Amato
Senator Heinz
Senator Shelby
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86
88
88
89
89
90
136
92
WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Fifth year of recovery and expansion
Complementary adjustments
Rapid growth of money aggregates
Rapid rate of debt
Inflation
Prepared statement
The economic setting
The broad policy approach
International consistency
The debt situation
Implications for U.S. policy
Rapid growth of money and liquidity
The approach to 1987
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93
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98
100
100
102
104
106
107
108
112
Page
Concluding comments
Witness discussion:
Reporting requirements for the Fed
Nonbank bank and securities issues
Gramm-Rudman
$1 trillion debt by 1990
Bank failures
Activity of the stock market
Debtor nation from 1620 to 1914
Surge of protectionism
Rise in debt erodes confidence
Protectionism
Japanese savings rate
Comparison to the Japanese and the Germans
Fed report to the Senate
Letter Senator Proxmire, Chairman, Senate Committee on Banking,
Housing, and Urban Affairs, from Paul Volcker, Chairman, Federal
Reserve
Humphrey-Hawkins Act reporting requirements
Debt to equity swaps
Dangerous and unwise policy
Foreign exchange rate of the dollar
Protectionism
FSLIC bailout
Responsible economic conduct
Upcoming G-5 meeting
Korean exports
Baker plan
Trading system unfairly structured against the United States
Response to written questions from Senator D'Amato
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165
167
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184
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1987
WEDNESDAY, FEBRUARY 18, 1987
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10 a.m., in room SD-538, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire, Riegle, Dixon, Sasser, Shelby,
Graham, Heinz, Hecht, and Bond.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. We begin this morning with the most important
oversight responsibility carried by any committee of Congress, that
of reviewing the monetary policy of the Federal Reserve Board of
Governors. Why is this responsibility so enormously important?
First, the monetary policy of the Federal Reserve and its implementation have profound and far reaching effects on the economic
wellbeing of our country. Second, our responsibility is dictated to
us by no less an authority than the Constitution itself in article I,
section 8, subparagraph 5. That provision states that only the Congress shall have the power, "To coin money and regulate the value
thereof."
During the nearly 30 years that this Senator has served on the
Senate Banking Committee, there has been little doubt about the
high quality of the Chairman of the Federal Reserve and their very
professional staff. And there is no doubt about the remarkable ability of the current Chairman or his staff. Indeed, Chairman Volcker
is viewed by this Senator as one of the most talented of those
giants who have so wisely guided the critical money and credit aspects of our economy.
Doubts arise not in regard to the Federal Reserve's leadership
but in regard to a monetary policy that seems increasingly out of
control. This Senator is concerned that the rapid growth of monetary reserves exceed prudence. This growth is unwise in view of the
inflation potential residing in dollar exchange rate declines, energy
price increases, and Federal spending imbalances. Realization of
this potential accompanied with continued rapid money growth can
have over time only one sure result—inflation—the result of too
much money chasing too few goods. In an economy as debt burdened as our own is, the further consequence of an up trend in in(1)
flation will be a skyrocketing of interest rates, followed by a sharp
economic slowdown, and rapidly increasing unemployment.
To weigh these and other risks, we have with us this morning a
panel of experts of international reputation. Mr. Axilrod, it is my
understanding that this may be the first time that you have appeared before a Congressional Committee to discusss monetary
policy. In light of your long professional role as the top staff official
at the Federal Reserve responsbile for monetary policy development and implementation, your appearance this morning is particularly significant. Two of our other witnesses, Mssrs. Erich
Heinemann and Allen Meltzer, on the other hand, have served for
many years on the Shadow Open Market Committee as critics of
the same policies Mr. Axilrod implemented.
To make this Australian Tag Team match even more exiciting,
Mr. Lawrence Chimerine of Chase Econometrics comes to us as a
widely respected critic of Reaganomics—the very policies Mr. Paul
Craig Roberts, our last witness, in part authored and now vigorously defends.
Together these witnesses represent a wide range of views on
monetary policy regarding both its domestic and international dimensions. We are very fortunate to have them here this morning
and look forward to the benefit of their testimony.
Senator Hecht, do you have a statement you would like to make?
Senator HECHT. No, thank you, Mr. Chairman.
The CHAIRMAN. Senator Dixon.
STATEMENT OF SENATOR ALAN DIXON
Senator DIXON. I thank you.
Mr. Chairman, I am pleased to be here this morning as the committee begins its oversight hearings on the Federal Reserve's First
Monetary Policy Report for 1987. This hearing comes at an uncertain time for the U.S. economy. Inflation has been low, but the
latest wholesale inflation figures are up. Economic growth is low
and we seem to be using only about 80 percent or less of our factory capacity, yet the stock market continues to move from one alltime high to the next almost daily. The dollar has declined precipitously, which should help our exports, yet imports continue to
grow, and our trade deficit has, at least so far, failed to show noticeable improvement.
There also seems to be some real uncertainty as to what the Federal Reserve's policy is, and what it should be. Some point to the
fact that Ml, the most basic measure of the money supply, has
been growing very rapidly in recent months, and argue that the
Federal Reserve should keep a tighter rein on the money supply.
Others, looking at the low growth in GNP, say that the Federal Reserve should conduct monetary policy in a way that will stimulate
higher rates of economic growth. They believe the fed can accomplish this objective without reigniting the fires of inflation.
The witnesses before the committee this morning are all distinguished economists. I look forward to hearing from them on the
issues I have mentioned, and on other issues related to the conduct
of monetary policy. I also look forward to hearing from the Chairman of the Federal Reserve, Paul Volcker, tomorrow.
The CHAIRMAN. Senator Shelby.
Senator SHELBY. I have no opening statement, Mr. Chairman.
The CHAIRMAN. Well, we'll start alphabetically with Mr. Axilrod
and go right across and end up with the cleanup hitter, Mr. Roberts.
Mr. Axilrod, go right ahead, sir.
STATEMENT OF STEPHEN AXILROD, VICE CHAIRMAN, THE
NIKKO SECURITIES COMPANY INTERNATIONAL, INC.
Mr. AXILROD. Well, thank you, Mr. Chairman. It's somewhat
daunting to be at this table after so many years of the comfort of
sitting right there behind and letting other people taking the
brunt.
This is not as you know a simple time for monetary policy by
any means. In 1979
The CHAIRMAN. May I just say—and this won't be taken out of
your time—that each witness will have 10 minutes and then the
red light will go on and then we'll have to terminate it. And if at
the end of our hearing you would like to state anything that you
would like that's been left out, you'll have 2 minutes to do that.
Mr. AXILROD. Thank you. 1979 was, in some sense, was simple for
monetary policy because it was clear that the objective was to control inflation and what needed to be done had to be done.
In 1982, it was very clear that inflation was to a reasonable
degree under control and recovery from recession had to be the
prime objective.
More recently, objectives have been much less clearcut and the
Fed has necessarily had to strike a much finer balance between the
need to encourage growth and the need to contain inflation. And
they have, in my view, been encouraging growth with relatively
rapid expansions in money and liquidity, but I don't believe at this
point excessive, and they have attempted to contain inflation by
maintaining a degree of pressure on short-term interest rates. In
real terms, after allowing for price increases, the level of shortterm interest rates is much higher than it was in the inflationary
period of the 1970's and about where it was in the less inflationary,
almost noninflationary period of the 1960's.
RECENT EVOLUTION OF MONETARY POLICY
More recently, the evolution of monetary policy has been quite
complicated by the twin deficits with which everyone is familiar—
the large rise in the trade deficit and the large rise in the budget
deficit.
The margin of error for monetary policy has become increasingly
narrowed as we move into a period when these deficits will necessarily be unwound.
The trade deficit is going to be unwound either deliberately
through acts of policy or through market developments because the
world simply is not going to accept a continuing outflow of dollars
of $150 billion or so a year. When a commodity gets in oversupply,
its price goes down and the price of the dollar has been dropping
sharply on exchange markets since early 1985.
At some point, this means our trade deficit will be reduced in
real terms, and I think that process is beginning right now. At
least the trade deficit has stopped rising, is leveling off, and I
would expect it to begin declining soon.
The drop in the exchange rate, then, provides an expansionary
impulse to the economy but it also provides an inflationary impulse
to the economy. So it's a double-edged sword,
I don't have to explain to this committee, Mr. Chairman, the
basic reasons for reducing the budget deficit and I will not. But I
should emphasize in the context of the trade deficit that it's very
important to reduce the budget deficit because that will release financial resources, it will release savings in this economy, and it
will release real resources that can be shifted into the international sectors.
As that happens, it will reduce the potential inflationary consequences of the reduction in the trade deficit. It will take pressure
off the balance of saving and investment and it will take pressure
off our labor, plant, and product markets by releasing real resources through restraint on Government spending.
So I regard the reduction in the budget deficit as a necessary
counterpart of the reductions in the trade deficit. If the deficits are
phased down together, there will be much less pressure on monetary policy. If the budget deficit is not reduced, for instance, there's
an even greater inflationary potential in the expansion of our
international sectors.
The behavior of the two deficits is not the only circumstance currently affecting our economy. A lot depends on whether the economy as a whole can be viewed as unusually strong or relatively
weak. In a relatively weak economy, for example, there is less pressure on the budget deficit as a needed offset to the reduction in the
trade deficit.
One way of assessing the structure of the economy is to look at
whether existing credit conditions in themselves are a propulsive
force in the economy. To do that, you can't quite look at the nominal level of interest rates; you have to look at the nominal level of
interest rates less price increases and less expected price increases
to see if in real terms interest rates are high or low.
The Federal Reserve can affect short-term interest rates. Longterm interest rates are somewhat influenced by their actions but
essentially depend on market attitudes.
The short-term interest rate in nominal terms has been fluctuating a bit recently, but it's somewhere in the 6 to 6.5 percent area.
Very recently, price increases looking over a 2- or 3-month period,
short term, are 3 percent or something like that. So you have a
level of real short-term rates at 3 or 3.5 percent. That, as I think I
mentioned earlier, is much higher than in the 1970's when we were
around zero all the time and it was an inflationary period, but it's
probably very close to where we were in the 1960's, which was for
most of the period a noninflationary period.
So I would say that there's nothing in the level of real rates at
this point to act as a strong propulsive force in the economy. In
practice, the question is whether they are about right or excessively restraining.
Unfortunately, at this point, Mr. Chairman, I have to revert to
my past as an economist and say it's not particularly clear whether
they are now about right or excessively restraining.
RECENT ECONOMIC DATA
The recent economic data that has been coming in are not really
too bad. The employment figures have been relatively strong and
the new orders figures on durables have been in some sense surprisingly strong, although there the tax situation has complicated
interpretation.
I personally would expect, looking about a year ahead, that consumption growth will slow because the personal saving rate will
probably begin rising back toward somewhat more normal levels.
Moreover, I don't see in the housing market very much lift and in
certain areas of nonresidential construction we are well overbuilt
for many years.
That simply means that basically we have to count on the international sector for most of this year's economic dynamic. There,
the drop in the exchange rate certainly helps. But in that respect
we also do need expanding markets abroad to receive the goods
which our manufacturing industry is increasingly being able to
produce on a competitive basis.
There is an inflationary potential, of course, in the drop in the
exchange rate. And we do have plenty of liquidity in this economy
to sustain that potential should it actually develop out of either the
drop in the exchange rate or other forces.
Inflation would reduce real interest rates and stimulate the economy in the short run. But it is a very unsatisfactory way of reducing real interest rates. It is very nonproductive for the long-run
health of the economy, and would require strong, quick countervailing monetary policy action. But we don't have evidence yet of
an upsurge in inflation.
There is also a potential for economic weakness in current circumstances, Mr. Chairman, if the turn to fiscal restraint here not
be accompanied by efforts of other countries to expand through
fiscal stimulation or if the basic spending forces here don't in any
event have sufficient dynamism. In that case, I would expect the
interest rates in the markets, the nominal interest rates, to begin
declining on their own. Indeed, there are circumstances under
which monetary policy itself might well take the risk this year of
shifting the balance between accommodation and restraint more
toward the easing side, becoming a little more willing to lead nominal rates down.
Stability for the dollar on exchange markets would be a sine qua
non since it would stabilize inflation expectations. In such a circumstance and especially in the context of a restrictive Federal
fiscal policy, a tilt toward market ease rather than restraint is less
likely to have the counterproductive effect of stimulating inflationary attitudes.
But any such tilt this year, when there are doubts about the
extent of inflationary potential, would also require clearer signs
that real economic growth is in fact in the process of faltering.
Moreover, such a tilt should be buttressed by a little more reliance
6
on the monetary aggregates, especially I would say M2 at this
point, though still viewing that aggregate in the context of the
whole group of money measures.
I have about 1 more minute, Mr. Chairman. Under current circumstances, the aggregates might in any event be given a little
more prominence in policy, most particularly if the economy does
not soon show indications of weakness. The essential reason is because of uncertainty that market forces, as embodied in labor,
goods and world commodity markets, will in and of themselves be
working to reduce inflation further and because of the nonnegligible risk that inflation could go higher.
In a period of sharply declining inflation and inflation expectations, the aggregates are not really an adequate guide to monetary
policy as we have seen in recent years because of related very large
and basically unpredictable changes in interest rates and attitudes
toward money. But when inflation stabilizes or threatens to rise,
the aggregates become a more useful guide simply in the sense that
they can then act like a governor on the fuel system.
I should hasten to add, however, that if we do succeed in bringing inflation below 3 percent on a sustained basis—and it's not
clear whether that can be done in an orderly fashion or whether it
will require a period of economic weakness to do so—a substantial
further decline in nominal rates, both short and long term, is at
some point ahead of us.
That decline would have to be accommodated, if not encouraged,
by monetary authorities, regardless of the behavior of the aggregates, if we are not to prolong the weakness unduly. Thank you.
[The complete prepared statement of Stephen H. Axilrod follows:]
Budgetary d e f i c i t
I lie
turned into an expansion.
The deficit has caused problenB because It has
than they had been.
begin improving.
flue it
OO
Is not gol
el al
in the U . S . ha
here. Bnd hou Iliey cope will a l s o I n f l u e n c e the U . S . e r o n o n y .
Suiac cf
Following the s h a r p drop In the dollar over I h e past tvi> y e a r s , the
expansion to keep t h e i r economies growing. T h e y , diiil J a p a n it Hit < ? x e n p l - i r .
w i l l need to shtf: resource!, away f r o m i n t e r n a t i o n a l i n i u s t r i e b toward
domestic uses—Mhereas thf U . S . w i l l be a t t e m p t i n g t h e r e u o r s e . J u s t at,
othir countries a more e x p a n s i v e f i s c a l p o l i c y is n e e d e d t n help j h ^ . i r b
out'—one t h a t , f o r ejfample, b r i n g s price Increases t h l e year beyond the 3
sgbdued.
That residual r e s t r a i n ! has been e v i d e n c e d by r e l a t i v e l y high
b o u n d s — a s s u m i n g the upper l l m i l s of the Feti t a r g e t s «ere not overly
11
should h a s t e
The CHAIRMAN. Thank you very much, Mr. Axilrod. As I said, for
the benefit of those who have come since then, this is the first time
that somebody in your position as the top man on monetary policy
for the Federal Reserve and implementing it as a staffer has appeared before a congressional committee and testified. I think it's
very helpful to have you appear today and this fine testimony.
Would like to extend our welcome to Senator Bond, formerly
Governor Bond, now promoted to the exalted position of U.S. Senator. We're delighted to have you with us. You have an excellent
background and it's going to be great to have you on the committee. We're very happy to have you.
Senator BOND. Thank you, Mr. Chairman. I'm certainly looking
forward to it.
The CHAIRMAN. The rules are that each of the witnesses will
have 10 minutes, then we'll have 5 minutes for each of the Senators to question, and we'll have whatever number of rounds necessary. This is the one panel we have today. We go back and forth
and after I question, Senator Hecht will then question and then
Senator Dixon and so forth, in the order in which they arrived.
Mr. Chimerine, go right ahead, sir.
STATEMENT OF LAWRENCE CHIMERINE, CHAIRMAN AND CHIEF
ECONOMIST, CHASE ECONOMETRICS
Dr. CHIMERINE. Thank you, Mr. Chairman. I get the feeling
you're trying to set an example for the Federal Reserve by limiting
our time this morning so I'm going to get right into the subject because I do have a lot to cover.
I would like to focus on two areas. No. 1, the current economic
situation; and, second, the implications for monetary policy.
SLOW ECONOMIC GROWTH
I think everyone in the room is well aware of the recent economic performance in this Jcountry. We have had extremely slow
growth now for the last 2 /2 years. As a result, the level of economic conditions, in my judgment, is far from satisfactory. Many parts
of the country are still experiencing recessionary conditions. People
on Wall Street probably think this is the greatest boom in history,
but you don't get quite the same feeling in Moline, IL or Sioux
City, IA, or lots of other places that I travel to.
12
It's a very mixed economic situation and, quite frankly, the
health of the economy, in my view, has been consistently overstated during the last several years.
There have been some stronger statistics recently which are leading to the view that the economy is finally starting to pick up, and
that the second leg of the economic boom is finally developing.
I would caution against such a conclusion. I think the recent
data are distorted by tax reform related activity, and by technical
problems with the data. Some industries clearly are picking up.
Others, if anything, are experiencing more weakness now than
they did several months ago.
It is a mixed bag primarily because the economy is in transition.
Some of the industries that are benefiting from the weaker dollar
are doing a little bit better but retailing, construction, and others
are slowing.
On balance, in my view, the current economic situation basically
is the same as it's been now for 2:/2 years—no evidence of recession, but no meaningful evidence of an acceleration in economic
growth. I think we're still stuck in this slow-growth mode that
we've been in since the early summer of 1984.
And, when you look at the underlying fundamentals, the approprate conclusion, at least in my judgment, is that this pattern of
slow growth is likely to continue for several more years at least. I
think the dominant factor in the outlook for the economy remains
the trade situation—not only what will happen to the trade deficit
itself, but the underlying causes of the trade deficit and what the
solutions will do to the rest of the economy.
In my judgment, the major reason we have large trade deficits in
this country is because the competitive advantages and productivity differentials that the United States had over the rest of the
world during the 1950's and 1960's when we dominated the world
economy have been narrowed dramatically. Other countries can
now do the same things we can do. They can produce the same
products, and in many cases of better or equal quality. They have
access to the same mass production capabilities and use the same
technology as we do.
But of course, in many of these countries, wages are a fraction of
what they are in the United States. When we dominated the world
economy we raised living standards in this country by increasing
wages and developing corporate structures which, quite frankly, we
could afford in those days based upon the productivity differentials
which existed, but they don't exist any more to the same extent.
They have been narrowed dramatically and, as a result, we have
become the high-cost producer in many industries and this situation is fundamentally what has produced the large U.S. trade deficits.
I think the trade deficit will eventually come down. As Steve Axilrod said, it has to. The world won't keep accepting all of these dollars. But the problem is that the solutions that are being implemented right now are not cost-free solutions. Cutting wages, laying
off high-wage workers, and pushing the dollar lower and lower,
which are the solutions that are now taking place, will all hold
back living standards and consumer spending in this country. They
are already beginning to squeeze consumer purchasing power and
13
we are now in the early stages of a sizable deceleration in consumer spending because of stagnating real incomes, high debt burdens, low savings, and the shift in the job mix away from highwage jobs to low-wage jobs. Second, most companies are still trimming back their investment budgets—real interest rates are high;
they have lots of excess capacity and they have lost the investment
tax credit.
Construction is coming down because of all the overbuilding.
Government spending is slowing.
So yes, I think we will get a modest improvement in the trade
deficit. Some industries are already experiencing it. But domestic
demand is slowing dramatically and, as a result, when we add it
together, it is unrealistic, in my judgment, to expect an acceleration in overall economic growth. The components are changing,
and will continue to change, but not overall grants.
WORLD ECONOMY IS FRAGILE
Next, I think the world economic situation is extremely fragile.
We have a world economy that is growing slowly at best. Conditions are weakening in Japan and Germany, and in many other
areas. Severe recessions are occurring in Mexico, some OPEC countries and Africa. Most of the world is pursuing restrictive fiscal
policies. Many countries are also pursuing restrictive monetary
policies. Overcapacity exists almost everywhere. Investment is
coming down and everybody seems to be engaged in competition
cost-cutting, which is designed to increase their share of a stagnant
pie, so to speak.
As a result, I think there is a greater risk of a worldwide downturn now than there has been in a number of years.
And third, while I understand the chairman's concern about inflation, I think the inflation risks are minimal at the moment. We
are moving into a higher inflation zone because we won't be seeing
the sharp decline in oil prices we had last year and because the
weaker dollar is pushing up import prices.
However, I don't see the conditions under which this is going to
lead to a typical kind of wage-price spiral. Quite the opposite—
wages are still being cut in most industries; we have massive excess
capacity, both here and abroad; and commodity prices, partly because of oversupply conditions and partly because of sluggish
demand, are coming down again.
So it seems to me the increase in inflation will be modest at best.
It will take place principally from external sources—namely, the
decline in the dollar and somewhat higher oil prices, and it's not
the kind of inflationary spiral that I think should cause any great
concern.
If this setting is correct, and when you take into account a
number of other factors—principally that I think the impact of
monetary policy on the economy in this environment is not symmetrical because of the high debt burdens we have and because of
all the over-building and excess capacity—modest declines in interest rates stimulate the economy only to a very limited extent, but I
think if we do the opposite—if the Fed were to tighten and push up
interest rates, it would slow the economy even further.
14
In fact, it has been my view in recent years, and still is, that we
need lower and lower interest rates just to keep the economy in the
same place, in part because real interest rates remain very high for
most borrowers. Many economists measure real interest rates by
adjusting interest rates for the Consumer Price Index, but as I like
to joke, all of the Consumer Price Index in recent years is in college tuitions. I pay those for my daughter on a regular basis.
For most borrowers in this country, especially commodity producers, and manufacturing companies, real interest rates remain extraordinarily high. They have had little or no price increases, so for
them, 8 or 9 percent interest rates represents a very high real interest and is prohibitive in many cases for investment decisions.
And, the LDC debt situation is still extremely serious. Higher interest rates would aggravate that.
In addition, we are embarked on a process of unwinding from
large Federal deficits, which is absolutely essential for the longterm health of the economy. This in the short term will be restrictive, however, and tighter money will compound the restrictiveness.
Next, I think the basic money supply measure enormously distorts the growth in the money supply. It's being affected by a
number of technical factors, such as deregulation and new financial innovation, and thus overstates the easing of monetary policy,
I think if you take all of these conditions into account, Mr.
Chairman, in my judgment, it is inappropriate for the Federal Reserve to change their relatively accommodative monetary policy
and, in fact, any change that would push up interest rates in the
short term is not only inappropriate but, in my judgment, is extremely risky in view of the fragile nature of the economic situation.
I could have added to my list of reasons the fragile nature of
many financial situations, especially in the view of the still serious
LDC debt problem.
Now having said that, Mr. Chairman, I share your concern about
the long term. The 8 or 9 percent growth in M2 and M3 of recent
years is both tolerable and necessary. But I would agree with you
that on a 5- or 10-year horizon that may be on the high side.
However, until we get Federal deficits down and reduce the pressure on credit markets from those deficits, and I think, as you
know, we will need some tax increases to accomplish that, I think
it will be very difficult to significantly reduce the growth in M2
and M3. But I do agree on a long-term horizon, that has to be
implemented.
My view, though, is that it is premature, and for the time being,
we have to tolerate a relatively accommodative monetary posture.
Thank you.
[The complete prepared statement of Lawrence Chimerine, Ph.D,
follows:]
By name is Lawrence Chimerine, and I am the Chairman and Chief
Economist of Chase Econometrics. I am delighted to have this
opportunity to testify before the Senate Committee an Banking,
Housing and Urban Affairs on monetary policy and the outlook for
the U.S. economy. In addition, I would like to address some key
economic concerns and their implications for longer-term economic
performance.
CHASE
In sum, my views are as follows:
Statement By
(1) Despite the fact that the current recovery is more than four
years old, the recovery process has not been completed. The economy
is far from being fully healthy and prosperous.
(2) Despite some uptick in several recent statistics, the long
period of slow and erratic growth that has been in place since
mid-19B4 appears to be continuing. Thus, at this point, there is
no conclusive evidence of either a major acceleration in the
economy, or of a slide into recession.
Lownnce Chlmarino, Ph.D
Chairman and Chiaf Economis
Chase Econometric*
Bala Cynwyd, Pennsylvania
Uilted State* Strata
i Banking, Homing end Urban Affairs
Washington, D.C.
February IS, 19B7
(31 Slow growth is continuing because the stimulative impact of
declines in oil prices, interest rates, and the U.S. dollar, and
the boom in the stock market, are providing only modest stimulus.
In addition, various negative factors are holding down economic
activity.
(4) The underlying fundamentals suggest that this pattern of slow
growth will continue during 1987 -- in particular, slower growth in
consumer spending, weakness in capital spending, cutbacks in
government expenditures, and very weak construction, will combine
to hold economic growth to the 2% to 2.5% range despite some
anticipated improvement in the trade deficit.
(5> The slow growth that is likely during 1987 implies that
unemployment is likely to remain close to the near 7% level that
has prevailed since early 1984. There will, however, be a modest
acceleration in inflation to the near 4* range ICPI], reflecting
rising import prices and higher oil prices — as a result, real
Income will rise little, if at all, for most workers. Finally, I
expect continued downward pressure on the U.S. dollar during the
remainder of this year as a result of still high U.S. trade
deficits, especially since economic growth in other parts of the
world is likely to be very modest, which will limit the rebound in
U.S. exports.
(6) The ability of the Federal Reserve to conduct monetary policy
has been severely hampered by a number of conflicting factors,
including still enormous budget deficits, the need to continue to
attract funds from overseas, the fragile financial system, the
potential for higher inflation, as well as still weak economic
growth. Under these circumstances, the Fed has done an admirable
Job. However, it should be noted that the ability of monetary
policy to produce faster economic growth is limited by the high
debt burdens which already exist, by widespread, excess capacity and
overbuilding, and by other factors -- thus, it is unlikely that
monetary policy can produce significantly faster economic growth in
the near term.
(7] The alow growth no« underway may in fact continue for maltf
years, in part reflecting the deterioration in L.S. competitiveness
in world markets, and the enormous debt buildup in recent years.
has been highly Uneven, with many sectors still mired in
recessionary conditions. This has created major industry and
geographic differences which are causing severe hardships in many
areas.
In sum, the performance of the economy in recent years, *t least
with respect to real economic growth, has been vastly overstated -the recovery in total has not been particularly strong and is far
from complete-, we have experienced only marginal additional
progress in completing the recovery process during the past two and
one-half years; and the economy is still operating at highly
unsatisfactory levels by historical standards.
THE CURRENT ECONOMIC SITUATION
Despite some uptick in recent statistics, the economy is still
growing at a relatively slow pace, in my Judgment. The uptick in
some of these recent data exaggerate strength in the economy:
The recovery which began near the end of 1962 is now more than four
years old — this makes this recovery period one of the longest on
record. However, the health of the economy has nonetheless been
overstated, as evidenced by the following;
(11 There have been two very distinctly different parts of the
recovery period. Th« first Bighteen months (or all of 19B3 ar.
vxperAenueu in IIIOBI utiiejr pu&*-l*ar iKUJvcry pvi^uua -- a<iu LUC
average growth o| slightly more than 2% since 1980 is far below
that experienced in previous postwar decades.
(2| This period of extremely slow growth has taken place even
though the level of economic conditions has not been satisfactory.
This reflects the fact that the 1981-82 recession followed closely
on the heels of a previous recession, so that economic conditions
were exttemely depressed when this recovery period r»egan.
Therefore, virtually all measures of economic performance are still
unsatisfactory. For example, the near 7% unemployment rate that
has prevailed during the last two years is obviously a significant
improvement over the near 11% rats of late 1982, but it is still
much higher tfcan st anytime in the postwar period prior to the
1980s with the exception of the 1974-75 recession.
131 The performance o£ tha economy during the past several years
1
1. unemployment has dropped slightly in recent months, in part
because of a relatively large increase in new jobs, especially in
January. However, it appears that this improvement has been
exaggerated somewhat by unreliable seasonal adjustment (actors,
particularly with respect to construction and retail trade Jobs. In
particular, the increase of nearly 450,000 payroll joBs in January
included a rise of HO, 000 in construction, with the remainder In
retail stores, fast food chains, health care, and othsr services.
However, new construction contracts have Been trending down for
more than a year, so thai: the increase in construction Jobs in
January will be reversed in the months ahead. Purthermota, a
relatively large share of the new Jobs in services in January were
part time, and were at wages well below the national average
-- thus, income growth was very ine-dest despite the large increase
in new jobs. And, many companies havs announced layoffs which Sjill
be effective at various points during 1987 -- most of these have
not yet shown up in the employment statistics. Finally, the still
sluggish level of help-wanted advertising also indicates that labor
2. The very strong 4.4% rise in retail Sales in December severely
distorts the underlying pattern of consumer spending: (a) The rise
uas heavily concentrated in purchases of new automobiles, prior to
the elimination of sales tax deducibility on January 1. Nonauto
spending rose a more modest 0.9%; and eon* pre- tax-reform
purchases of furniture, appliances and other consumer durables may
have artificially boosted sales of those goods, (bl Sales were
revised sharply downward for November -- thus, excluding the zigsag
pattern of auto sales, spending was almost flat for the two months
combined, and have grown, much mote slowly since mid-suitnier than
during 1985 and the first half of 1986. (c} Early indications
suggest a significant tailing oft of retail activity in January —
not only vere auto sales very soft because of the high level o£
"borrowed sales" in December, but many retail chains reported
sluggish activity as well, especially for tiousehold durables.
3. While industrial production will continue ta grow, after the
almost stagnant pattern of the past two and one-half years, the
rate of increase will decline significantly from the
November-December performance; (a) Auto production rose
significantly in December -- not only will such an increase not be
repeated, but significant cutbacks are likely in the months ahead.
lb) Defense and space output has risen at more than an 8% annual
rate since raid-summer -- recent cutbacks in appropriations for
military procurement will begin to slow the growth in military
output in the months ahead, (c) Utility output, while erratic on a
Monthly basis, has risen at a relatively strong but unsustainable
pace on average in recent months, (dl It is likely that production
of some business equipment and consumer durables were higher in the
last two months than would have been the case because of the pretax-reform related activity -- this should be reversed during "-.he
next several months.
4. The sharp rise in both housing starts and permits in December
has raised hopes that recent declines in mortgage rates are
beginning to spur a new surge in housing activity; however; fa] The
December rise comes from a relatively low (and downward revised)
level in November and earlier months, (b) More than half of the
rise was in multifamily structures, which is almost certain to be
reversed in coming months in view of the still enormously high (and
rising) vacancy rates in most areas, and the adverse effects of the
new tax structure. (c) The overall figures were heavily influenced
by a surge in activity in California as builders tried to avoid
higher building fees which became effective in January, (d) starts
were also bolstered by relatively mild weather in most of the
country in December -- January weather was less favorable.
5. While the trade deficit did drop sharply in December, it is
premature to conclude that a significant turn has developed. This
In part reflects the fact that imports surged in November prior to
the imposition of a new customs fee and prior to tar reform -- some
of this was probably borrowed from December. Thus, the average
level of Imports and the average trade deficit in the fourth
quarter was only slightly below the third quarter, imports from
some of the countries against which the dollar has not declined
were even down significantly in December -- this likely reflects
either erratic movements in the data, or the special factors cited
above, since it is unlikely that imports originating in those
countries are falling because of currency movements.
7. New Orders for Durable Ooods continues to see-saw — excluding
defense, they have trended only slightly upward in recent months.
Furthermore, much of the recent rise was probably tax reform
related -- in addition, orders for commercial aircraft have been
very strong, but because of the long production cycle, these will
contribute very little to near-term economic activity. And orders
for household durables have flattened out.
On balance, therefore, when erratic movements in the data,
revisions to earlier data, and the effects of tax reform are taken
into account, it is still premature to conclude that the overall
economy is accelerating -- this is confirmed by feedback from Chase
Econometrics clients, and from more recent economic data.
WHY HAS THE ECONOMY BEEN SO SLUGGISH?
The sluggishness has continued despite numerous forecasts that a
major acceleration would take place during 1936 because of declines
in interest rates, the dollar, and oil prices, and other apparently
favorable factors. However, the economy has not picked up, for the
following reasons;
II] The sharp decline in interest rates that has occurred since
late 1984 has had only a small stimulative effect on the economy
thus far, since real interest rates were extraordinarily high when
these declines began. Thus, in effect, rate declines were
necessary just to keep the economy in the same place, and in great
part have been caused by the weak economy. The only noticeable
effect of the decline in rates has been on the housing industry
-- real interest rates for industrial companies are still so high
that there has been virtually no impact of recent declines in
nominal rates on capital spending plans or on inventory policies.
The impact of declining interest rates ia also being limited by the
age of the recovery, the winding down of previously available
pent-up demands, low utilization rates, overbuilding, and already
high debt burdens, which have reduced the willingness of both
corporations and households to incur additional Qebt. Thus, the
Fed is in great part pushing on a string.
(2) The economy has not yet experienced any significant benefits
from the sharp decline in the value of the dollar, primarily
because the large trade deficit reflects major deterioration of the
United States competitive advantages that has occurred over many
years (this will be discussed further below) -- thus, modest
declines in the dollar will not solve the problem.
(3) The stimulative impact of lower oil prices on the economy has
been modest, at best. In great part, this reflects the fact that
the United States is a large producer of oil (we produce about 70%
o£ our own needs), so that the main benefit of declining oil prices
has come from a decline in the price of imported oil. However, oil
imports relative to GNP have fallen sharply since the early 1970s
[by more than 50%), reflecting that fact that we consume
Consume tar
tar lass
energy relative to the size of tha economy than we did then, that
all now constitutes a smaller fraction of our total energy
consumption than at that time, and that we produce a large
domestic oil prices. Furthermore, because of already large current
account deficits, most OPEC countries are reducing their imports of
military and manufactured goods from the United States and other
countries, Which is offsetting part of the favorable effects of the
J4) In my view, the stock market boom does not reflect either
current or expected economic strength — in fact, the rise in stock
prices is more accurately a sign of w^altneas, since it largely
reflects the sharp decline in interest rates, which in turn is a
direct result of the sluggish economy. In effect, the substantial
increase in liquidity that has been pumped into the economy by the
Federal Reserve has gone primarily into financial assets rather
than fixed assets, reflecting the lack of viable fixed Investment
opportunities due in part to overcapacity, overbuilding, etc. Thus,
many companies have found it more attractive to buy up thfcic own
stock, or someone else's, rather than malting investments in plant
and eguipment. Furthermore, the sharp increase in the value of
financial assets helo by consumers is also vastly overrated as an
economic stimulant, since; (a) ownership of financial assets is
concentrated among relatively high incotne fawllies with a
relatively low marginal propensity to consume, (b) most individuals
cannot gain access to these funds because they are tied up in
pension accounts, and tc) many oE those who have experienced
capital gains have rolled them aver rather than using them to
finance consumption. In addition, household debt has ris<sn
dramatically during this period, with a far more widespread
distribution across the population.
(61 Soms forecasters also predicted a surge in the economy as a
result of sharp increases in the basic money supply during the last
eighteen months. However, there is currently almost no
relationship between Ml and economic activity, reflecting1, (a*
continued increases in import penetration, which increases the
demand for credit and tBe money supply without increasing domestic
output; (b) declining interest rates, which have reduced the
opportunity costs of holding interest free or low interest
deposits; fc) concerns fegajaing the sajety at deposits at various
thrifts and other financial institutions, which has caused a shift
of savings into Ml types of deposits: and. Id) financial Innovation
and deregulation, which have created new instruments.
THE OUTLOOK FOR 19B7
I believe that the outlook is for continued subdued growth during
I9S7, vith a likely rise in real GUP of 2.5% at best. This
expectation is based not Only on my assessment of the recent data,
bat also on the underlying fundamentals.
(A/ As indicated earlier, consumer spending has already begun to
grow more slowly once the effects of auto incentive programs, tax
reform, etc. are smoothed out. This trend will continue through
19B7, and possibly beyond, for the following reasons; (a) There is
every Indication that real wfges will remain stagnant, reflecting
continued cautious wage policies and an acceleration in in£latiun.
while slow wage growth is still most pronounced in manufacturing
(fully one-third of all recent union contracts have actually
included wags roJlbscJis), it is now spreading to other sectors as
well (two-tiered wage systems and the increased use of lower wage
subcontractors are further holding down average uagest. The
acceleration in inflation is coming primarily from external sources
(ratfter Chan from internal income shifts), especially from the
recent increases in oil prices and sharp declines in the U.S.
dollar. Thus, even factoring in the personal tax outs which will
result from tax reform this year, real income per wocKer will grow
little, if at all. And, with slower growth in new jobs, and the
high concentration of those jobs in lower-than-average wage
occupations and industries, total real disposable income will grow
at only about 1.5* during 19S7. fb) It is increasingly clear that
consumers will be unable to continue to finance a relatively large
fraction of new spending by going deeper in debt. This in part
reflects the increased difficulty that many households are having
in servicing existing aet)t, tVie gradual tightening in lending
standards by many financial institutions, the already near-record
low saving rate, and the erosion in consumer confidence in recent
months, (c) Slow income growth, rising debt burdens, and lower
saving rates are coming at a time when available pent-up demand,
especially fci various consumer durables, has fallen — this will
compound their effect.
IB) The c»pit*l spending outlook remains poor. Low operating
rates, the neu (less favorable) tax structure, and already high
corpoiate debt ara all holding back new business investment -- the
only positive might be an improvement in profit margins for those
companies which will have more leeway to raise prices as prices of
competing imported goods rise in response to the weaker dollar.
However, capital spending will lag any improvements in profits, so
that any gains will not occur until very late in 1987 it the
OO
earliest. Inventory policies will also remain cautious.
(C) Despite lower interest rates, virtually all categories of
public and private construction are likely to be weaker this year
than last- Even new housing activity will be down by more than 5%
-- in fact, total housing starts rose only slightly last year,
income growth, depressed economic conditions in some regions, a
reduced number of first time buyers, overbuilding, etc. are already
beginning to hold down new housing construction,
ID) While the sharp drop in the dollar in recent weeks probably
reflect^ several factors, including Increasing concerns about the
health at the U-S, economy, the growing likelihood of U.S. trade
legislation, the rise in oil prices, the increasingly deadlocked
U.S. political situation, and the possible departure of Fed
Chairman Volcker, I believe the major factor is the increasing
recognition that the competitive problems which exist in tha United
States are more serious than earlier assumed (as will be discussed
will occur during 1987, for the following reasons: <aj The
Strengthening yen has already caused a significant decline in
Japanese exports -- signs of softening German exports are also
beginning to develop. Much of these exports would have flowed into
produced in those countries have begun to accelerate and spread
--considerably more are likely in the months ahead, fb) It appears
that Inventories o£ importeSt goods (especially automobiles) have
increased recently, which will reduce new orders in the months
ahead. (cJ The aoureciation of the y*n and the mark will enable
the United States to attain a higher share of worldwide exports to
the Far East NIC's and the lesser developed countries. Id) Oil
imports will grow more slowly in 1987, now that inventories of
crude and refined products have been built up.
It should be noted, however, that the effects of declines in the
dollar and the trade deficit an neat-term economic growth will be
modest:
1. The drop in the trade deficit will be fairly modest, because;
(aj The dollar bag not changed significantly against most
currencies other than the German Mark and the Japanese yen -- any
improvement in our bilateral trade deficit with these countries
will be offset at least in part by rising imparts from other
countries. [bj The impact of dollar declines "ill also be limited
by the tact that many imported goods have no domestically produced
counterparts, by the perception that some have higher guality than
comparable domestically produced products, and by the increased
familiarity of American citizens with foreign produced goods. (cj
Domestic demand remains soft in the industrialized world, and very
weak in Mexico, most OPEC countries, and Africa -- this will limit
any improvement ift U.S. exports. In essence, worldwide economic
growth is being limited by very restrictive fiscal policies in most
countries, by somewhat restrictive monetary policies in many
countries, by worldwide overcapacity, by weaksning investment
(particularly in those countries whose currencies have appreciated,
because of the squeeze on profits being caused by their stronger
limit any turnaround in trade in the neat term, but suggests that
significant additional declines in the U.S. dollar will be needed
to produce major improvements in the trade deficit in the years
ahead.
2. The increase in import prices, by adding to inflation and
squeezing purchasing power (especially since imports now account
for a much larger share of consumption than in the past), will
reduce spending for some domestically produced goods as well (the
income effect of the dollar decline).
3. The recent sharp drop in the dollar will probably delay any
additional cuts in tfie discount rate. Furthermore, it is unlikely
that long-term interest ratss will decline significantly from
current levels, barring a far weaker economy than now expected.
This reflects not only the added inflation resulting Iiom aollai
declines, but also that the apparent willingness of key U.S. policy
makers to see an even lower dollar may cause foreigners to cut
their purchases of Treasury and other securities until the currency
risk is reduced. Thus, the continued slow growth we envision win
not likely be accompanied by continued declines in long-term
constraint on growth, because even lower rates are needed to
bolster demand at this stage of the economic cycle.
These forces suggest that domestic demand will grow very
daring 1987 (1.5% - 2%), in contrast with the sharp tate
increase during tne past several yejrs. Thus, barring a
turn in trade, it is extremely unlikely that the economy
slowly
of
monumental
will break
improvement in trade will be counterbalanced by the significant
deceleration in final domestic demand already underway. And, while
industrial output may do somewhat better in 1987 than in 1986
because of the absence of additional sharp cutbacks in oil and gas
activity, as well as because of the smaller trade deficit (in real
terms), this Will be offset by slower growth in services as well as
by declines in construction. The recent boom in the stock market
will not significantly alter this pattern, primarily because the
incremental spending that is likely from the increase in household
net worth is very small in view of the heavy concentration of
ownership of common stocks among high-income individuals, and
because of the high debt/low saving environment which already
exists- Furthermore, as not£d earlier, the (narJset appears to be
being fueled mostly by the vast amount of liguidity that has been
pumped into the economy by the Federal Reserve, and the channeling
of a large amount of that liquidity into stocks rather thah capital
goods, commodities, real estate, etc. Finally, potentially higher
profit margins due to the -weaker dollar are also bolstering the
stock market.
I continue to believe that there are sizable downward risks in the
near-term outlook, so that a recession sometime during 1987 or
early 1988 cannot be ruled out. These include the following: (a)
Plant closings and production cutbacks in the auto industry may be
even greater than now expected -- moreover, the loss of income and
consumer confidence caused by these layoffs could cause weaker
consumer spending. Ib) It is possible that the turn in the trade
deficit could begin somewhat later, and/or could be somewhat
slower, than now expected. fc) The change in the tax structure on
expected.
With
measured by the CPI, is almost certain in 1937. This will
primarily reflect the modest increases in oil prices in recent
months (which contrasts sharply with the declines in energy prices
during much of 1986), and the fact that the weakness in the dollar
will cause more widespread and sharper increases in the prices of
imported goods. In addition, this will provide some leeway for
domestic manufacturers to raise prices, especially if they are more
shar
Consumer Price Index will rise by about 4% during the course of
1987, fallowing the 1.1* increase during 1986. It should be noted
that other measures of inflation, especially the GNP price deflator
and the Producer Price Index, will show considerably smaller
increases because they are not directly affected by import prices
as is the CPI.
The continuation of modest economic growth that I expect during
1987 will preclude any sizable declines in unemployment -- thus, it
is likely that the national unemployment rate will remain very
close to the current rate of slightly below 7». I do expect some
increase in manufacturing Jobs after declines in recent years -this will be counterbalanced by smaller increases in the service
sector and by declines in construction jobs.
MONETARY POLICY
The conduct of monetary policy has been complicated enormously by a
number of conflicting considerations:
1. The misguided fiscal policies of recent years, which have
produced enormous budget deficits, have put additional pressure on
the Federal Reserve to increase the supply of money, despite the
possible long-term inflationary conseijuences . Furthermore, the
Fed's policy decisions are now being complicated by the need to
the short term argues for even easier monetary policy, despite the
long-term risks.
2. In order to finance these large federal deficits and the growing
private demand for credit, it is necessary that we attract a large
inflow of capital from overseas. Thus, any changes in monetary
policy that could cause a free-fall in the dollar could be
counterproductive for the U.S. economy by discouraging foreign
investment in the United States, thus pushing up interest rates.
3. Long-term interest rates are still relatively high for most
borrowers, in part because of still widespread concerns about
future inflation in view of the large budget and trade deficits.
However, an excessively easy monetary policy could heighten these
concerns, and actually cause even higher long-term interest rates.
4. The Fed's policy decisions must take into account the fragile
nature of the economy, as well as of the financial system. Thus,
any tightening designed to maintain an inflow of credit and/or to
reduce inflationary expectations, could actually weaken the economy
in the short term and potentially lead to a significant downward
spiral. In effect, the impact of monetary policy changes in the
short run is now asymmetrical -- higher rates would weaken the
economy considerably, but lower rates will have only limited
stimulative effects.
federal spending in n
Under these conditions, I give the Federal Reserve high marks for
its conduct of monetary policy in recent years, particularly since
in the basic money supply. It is important that a relatively
accommodative monetary policy be continued for the following
reasons: (a) The relatively strong growth in HI in recent years
relationship between money growth and economic activity, which has
never been very precise, has been distorted even further by the
surge in import penetration in the United States. In effect, the
money and credit needed to purchase imported goods are essentially
the same as that needed to purchase domestic goods, so that the
growth in GNP will lag behind money growth when imports are rising
rapidly. Furthermore, financial market deregulation in recent
years has made Ml a less reliable measure of spendable cash. The
growth in other monetary aggregates have been much more moderate
— these are probably more meaningful guides to the availability of
money and credit in the current environment, (b) Despite the
decline in nominal rates, real rates still remain relatively high.
It appears that lower rates will be necessary to maintain current
economic growth rates, (c) The LDC debt crisis would be aggravated
by higher interest rates and slower economic growth — this could
Perhaps the biggest concern is that, while a highly accommodative
monetary posture is warranted now, it cannot t>e sustained on a
long-term basis. However, large and growing Federal budget
deficits, the net debtor status of the United States, and the
international debt situation, are pushing the Fed into a corner by
situation considerably healthier, even wit
LONG-TERM OUTLOOK
Trade Deficits and Long-Terra Growth
It is generally expected that the U.S. trade deficit will decline
during the years ahead, that these declines will add between 0.5%
and 1% per year to average economic growth (reversing the pattern
during the last several years!, and that this reversal will permit
overall growth to approach its near 3.51 long-term average. As
discussed earlier, I share the expectation that the trade deficit
will aoon begin to decline, and that this trend will continue over
the long-term — in fact, such an outcome is almost essential
because U.S. foreign debt would otherwise reach levels that would
be both unsustainable and potentially highly destabilizing.
However, a decline in the trade deficit does not necessarily imply
that economic growth will accelerate — it implies only that output
growth will exceed domestic spending.
I, in fact, believe that economic growth in the United States will
lag behind the postwar average for many years, despite a falling
trade deficit. One reason for this expectation is that a major
factor which produced the staggering U.S. trade deficits has been a
narrowing during recent years (or elimination in some cases) of the
competitive advantages that the United States enjoyed after World
War II. These advantages resulted from the development and
implementation of new technology, the use of more sophisticated
mass production techniques in manufacturing, the mechanization of
agriculture, etc. — they caused average productivity in the United
States to far exceed that of other countries (and the gap to widen)
for many years.
While efforts have been made to improve productivity and lower
costs in the United States in the last several years, it seems
clear they have not been enough to improve U.S. competitiveness
sufficiently to bring about a sharp decline in future trade
deficits. First, while productivity growth has accelerated in
manufacturing, aggregate productivity growth still remains
disappointingly low. And, much of the improvement in productivity
in industry reflects layoffs, rather than benefits from the
increased use of new technology or more efficiency in the
manufacturing process -- this process can't be repeated
indefinitely, especially since many of the employment reductions
have been among managerial and nonproduction workers. Many U.S.
industries thus are now experiencing the worst of both worlds
—falling employment and continued erosion in market share. Second,
while many companies have frozen or even cut wage rates Iln
addition to staff reductions), wage levels remain far above those
in many other countries (especially the Far East Nic's). Third,
efforts to improve efficiency and reduce costs are being
implemented in Japan and other countries, offsetting some of those
being made in the United States. Finally, the decline in the dollar
thus far has had only a modest affect on U.S. competitiveness
because it has been limited to the Japanese yen and the major
industrialized countries in Europe.
In view of these factors, and of the continuing sluggish conditions
in many other parts of the world (which will hold down U.S.
exports), I thus believe that a combination of additional dollar
declines (some are now happening) and slower growth in domestic
demand will be necessary to bring trade deficits down even modestly
(1) Underlying productivity trends suggest that the trade-weighted
average of the dollar in real terms may have to fall to, or below,
the early 1980s levels in order to produce the same degree of
relative competitiveness which existed at that time. This trend
implies a continued upcreep in inflation as dollar declines are
increasingly reflected in higher prices for imported goods, and as
prices of domestically-produced competing goods are raised in
response.
The "catching up" of the rest of the world during the last 15 years
appears to reflect a number of factors, including the spreading of
technology throughout the world, the rebuilding of war-ravaged
infrastructures in Japan and much of Europe, and investments in new
and modern facilities in many other countries. However, the earlier
U.S. productivity advantages were used to raise wages and Income
levels substantially throughout much of the economy -- these
Increases in wages have now produced an enormous disparity in labor
costs, which, when combined with differences in capital costs, can
no longer be Justified by productivity differentials. This
deterioration in relative U.S. competitiveness is evidenced by the
rise in the U.S. bilateral trade deficit with Japan and some other
countries during the late 1970s and early 1980s — several
temporary factors, including surges in bank-financed exports to
Latin America and oil-financed exports to the Middle East, as well
as an undervalued U.S. dollar (especially in relation to European
currencies), temporarily bolstered our aggregate trade performance
at that time despite the deteriorating fundamentals. When these
temporary factors were reversed, the U.S. trade balance began to
worsen rapidly — enormous budget deficits and the overvaluation of
(2) Barring even sharper declines in the dollar, a long period of
relatively slow growth in domestic demand will also be necessary to
bring the U.S. trade deficit down — each 1* decline in the growth
of domestic demand in the United states will reduce the growth in
real imports by approximately 2%, thereby cutting the trade deficit
by about $8 billion per year (on a cumulative basis). I especially
believe that growth in consumer spending will be sluggish for many
years, reflecting the effects of cutbacks in white and blue collar
employment and wages, and declines in the value of the dollar, on
household purchasing power (real wages already are stagnating, as
discussed earlier). This conclusion is reinforced by data
indicating that wages and salaries among the Job losers in recent
years have been above the average in most cases, and that wages for
12
13
a large fraction of the new Jobs that have been created have been
below the average. While the increase In prices caused by dollar
weakness will help bolster profits, I do not expect this to
translate into larger wage increases or employment gains for at
Economic Restructuring
It is commonly argued that the United States is now going through a
major restructuring, from a largely manufacturing to a
services-based economy, in the same way that it moved from
agriculture to an industrial economy earlier. Furthermore, many
many companies to rebuild profit margins*
Implications of the Debt Buildup
An normous and unprecedented buildup of debt has occurred in the
Uni ed States during the last five years — during this period,
tot 1 nonfinancial debt has increased at a rate more than twice as
f*i as nominal GNP, pushing the total debt-to-GNP ratio up sharply
aft r more than 30 years of stability. The rise in debt has
far outstripped the growth in domestic demand, so that the adverse
effect of the growing trade imbalance on real output explains only
a small portion of the rise in the debt/GNP ratio. Corporations,
households and the Federal Government have all significantly
increased their indebtedness during this period.
These high debt levels may well limit economic growth for many
years, for the following reasons: (a) Delinquency rates for
consumer loans, and corporate defaults and bankruptcies, have
increased sharply, indicating that at least a portion of the
economy has become overburdened. Furthermore, for the remainder of
the economy, the ability to continue financing a large fraction of
current expenditures by borrowing has diminished greatly because
debt servicing has increased significantly relative to cash flow
and household incomes, in fact, there is evidence that the buildup
of corporate debt in recent years is now causing cutbacks in
capital spending — this will not only prevent a stronger economy
in 1987, but could actually hinder growth in the longer term. It)
The large buildup of debt has been used primarily to finance budget
deficits, consumption, and financial transactions, rather than
investment -- thus, it will not yield improvements in productivity,
competitiveness, etc. that could increase potential growth, and
generate higher incomes to both service the debt and stimulate
•pending, (c) The massive accumulation of debt in recent years has
been financed in part by borrowing from overseas -- the increasing
cost of servicing this rapidly growing foreign debt will slow
long-term growth by transferring dividends and interest payments
out of the U.S. economy.
In addition, the difficulty in servicing the larger volume of debt
may make future recessions more steep, especially since any further
Increase in defaults and delinquencies will weaken the already
fragile financial system (bank failures continue to increase even
though the economy is still growingl. The corporate sector is
especially more vulnerable to an economic slowdown, or higher
interest rates, because it has not only been adding debt at record
levels, but it has also been redeeming equity since 1984, making it
more leveraged. The risks associated with the more highly
leveraged corporate sector is being exacerbated by the increased
portion of bank lending to more risky borrowers.
economy will begin to grow more rapidly. However, the industrial
revolution came about primarily because of rising productivity in
agriculture (which freed resources!, and resulted in a shifting in
resources to even higher productivity manufacturing. Thus, it
added to potential long-term economic growth.
The restructuring now taking place is in part being forced by
diminishing competitiveness in world markets, rather than because
Of rising productivity. Moreover, while some of this shift is now
into high value-added and productivity activities, involving the
use of new sophisticated technology, a large fraction of new jobs
are in relatively low-wage, low productivity occupations and
industries -- this is holding down overall productivity growth. The
current restructuring is also being accompanied by an enormous
buildup in corporate debt, which potentially will reduce
competitiveness even further las discussed earlier]. Thus, I
beli
taking place will produc significantly faster growth in the next
five or ten years.
W>ng-Term Growth Prospects
The combination of poor underlying competitiveness in world markets
and high debt levels, combined with relatively slow productivity
growth, the continuing loss of high-paying Jobs, and other factors,
gugge
that is now underway in tne United States may continue for many
years. In particular, since some of the factors that permitted the
rise in living standards during the 1950s and 1960s are no longer
as favorable, since the growth in two-income families and household
debt will slow, and since the recent low inflation rate caused by a
rising dollar and declining oil prices will not be repeated,
spending can no longer grow at anywhere near the rate of recent
deficit reduction, so that overall economic growth will not
accelerate significantly.
POLICY IMPLICATIONS
While many of our current problems cannot be easily addressed by
economic policy, I would nonetheless suggest the following:
(1) Budget deficit reductions remain essential. However: la) the
ceduction should be gradual so as not to further weaken the economj
in the short term (about 125 billion per year would be reasonable,
producing a targeted deficit of about tlOO billion in 1991 rather
than a balanced budget]. Thus, the current Gramm-Rudman-Hollings
targets should be abandoned or ignored. (b) Budget policy should
be formulated to address other priorities as well. Thus, some
additional funding for education, rebuilding the infrastructure,
15
Monetary Policy forum
by
by
1201 FilttEnlhSliwt.N W , WisMnslO", D C 20005 (202) 822-04B7
,
increases should be designed in such a vay
a
ey o no
ur
shift the tax burden avay from upper-income groups as in recent
rom external sources
.e., o
prces an
e ..
oar
exchange rate) will make future deficits larger than would hav
been the case.
(2) There is no way that our competitiveness in world markets can
be improved with one simple policy measure. It will require a
thorough evaluation of our educational system, our training
programs, our military expenditures, our trade laws, etc. It is
imperative that this process begin as soon as possible because of
the long lag before new actions begin to have a material effect.
Trade legislation should focus on improving U.S. competitiveness
and opening foreign markets rather than on protectionist devices.
(3) All economic and tax policy actions in the future should be
evaluated as to whether they Improve U.S. competitiveness and
growth prospects before enactment.
(4) As indicated earlier, I would strongly suggest that the Fed
maintain an accommodative monetary posture in the near term,
despite the rapid growth in the basic money supply — in fact, some
easing moves would be warranted if the economy becomes more
sluggish. It will be necessary to slow down the growth in money
and credit on a long-term basis, however.
FOB IMMEDIATE RELEASE
CONTACT: Larry Chimerine
6&7-600D
MOBETAR* POLICY ANALYSTS FORESEE RECESSION IK '88
Washington, February 18 —
Accommodative Federal Reserve
Board policies may be the only thing standing in the way of a 1988
recession, according to a recent supvey of the Monetary Policy
Forum (MPF).
Disappointed by considerably slower than expected economic
growth In recent months, forum members predicted a scant 3 percent
gain in the GNP this year and the continued unraveling of positive
factors in the nation's economy.
Increasingly pessimistic about prospects for the economy,
Forum members, on average, believe there Is a 65 percent ohanoe
for a recession in 19B8.
The key factor they cited was a maasive
accumulation of government, corporate and personal debt that will
goods.
"The news about the American economy has changed remarkably
little for some time," said Lawrence Chimerine, president of the
Monetary Policy Forum and chairman/chief economist for Chase
to
CO
Econometrics.
"Indebtedness at home, poor competitiveneas in
world markets, weak capital spending, and the need to reduce
inflationary concerns ought not to hamper the fed from supplying
sufficient credit to move the economy forward.
enorir.oua budget deficits will both hold down economic grouch and
limit our options.
Under these present conditions, any change in
federal reserve policy that would result in significantly higher
"Any tightening by the fed would affect housing and
investment related industries," said Michael Sumichraat, Senior
Economic Advisor, National Association of Home Builders. "Housing
interest rates could cause a sizable recession in the nest several
already shows a sharp 12 percent drop in permits in January
years," Chlmerine stated.
foretelling a future decline in this sector," said Sumichrast.
While HPF members said that the weakening dollar would have
Moat of the 'orum members who were aurveyed said that Paul
some beneficial effect on U.S, industry and force the nation's
Volcker uas their choice for the chairmanship of the fed.
1987 trade deficit down to about $138 billion, this trend was not
group would have difficulty finding a successor if he should step
expected to reverse the larger negative forces at work.
down.
"Probably one of the most important things we should be doing
is to Insist that the West Germans and Japan start to rev up their
economies with forceful fiscal stimulus," said MPF member George
Perry, Senior Fellow, of the Brookings Institution.
In the meantime, Forum members said, the fate of the economy
appears to he in the hands of the Federal Reserve Board.
Furthermore, they aaid mat
The HPF
the fed should he most concerned
about how to avert an economic downturn rather than about too much
growth of the monetary aggregates.
While they expect some
increase in the GNP price deflator this year, forum members said
that inflation would remain well under control and that
The
^
The Monetary Policy Forum is a group of 26 financial,
economic and business analysts,
25
The CHAIRMAN. Thank you very much, Mr. Chimerine.
Mr. Heinemann.
STATEMENT OF H. ERICH HEINEMANN, CHIEF ECONOMIST,
MOSELEY SECURITIES CORP.
Mr. HEINEMANN. Thank you, Mr. Chairman.
I take a somewhat different view of the current economy than
my friend, Mr. Chimerine. It seems to me that we have had a solid
expansion in domestic demand now throughout this business cycle
from 1982. From the end of 1982 up through the most recent quarter, growth in /eal domestic final sales was 4.8 percent, way above
the post-war average.
In the last 2Va years, which Mr. Chimerine made reference to,
the growth has been 3.9 percent—slower, but still above the average.
In the last 5 or 6 months, we have seen a sustained and quite
remarkable reacceleration in growth in payroll employment. Consumer attitudes, as measured by the Michigan survey, continue to
be quite good.
We have seen growth in the leading indicators accelerate close to
a 10-percent annual rate in the last 6 months or so—7 months—
compared to a growth rate of only 6 percent in the year ended
June 1986.
So I think we've got a lot of domestic momentum in the economy
at the present time. There is forward motion, and the trade deficit,
which has been the principal factor inhibiting expansion I think is
now clearly starting to turn around.
Now in this context of solid, if unspectacular, domestic expansion
and the probability of some significant improvement in our international sector, we have seen a very remarkable monetary acceleration which you made reference to, Mr. Chairman, in your opening statement.
GROWTH IN HIGH-POWERED MONEY
Over the past 2 years—actually over the past 4 years, we have
seen a systematic and progressive acceleration in the growth of
what I call high-powered money—the reserve aggregates most
closely related to the size of the Federal Reserve System balance
sheet. We have seen a progressive acceleration in the monetization
of the Federal debt.
Total bank reserves, according to Fed data released last Thursday night, averaged $56.7 billion in January. That was almost 25
percent higher than the same month a year earlier. This is not an
isolated phenomenon. This progressive acceleration has been going
on for a long time.
The average growth in bank reserves over the last quarter of a
century is somewhat less than 5 percent. So we are running close
to five times the characteristic behavior of reserve expansion over
the last quarter century.
It seems to me that over time ripple effects from this rapid expansion of liquidity will inevitably spread throughout the economy.
We already see debt rising much faster than GNP and I think that
process will continue.
26
Prices of imported products, other than oil, are rising at a rate of
about 8.5 percent at the present time. With the recent weakness in
the dollar I would expect that rate of increase to accelerate. Since
imported products represent about 28 or 29 percent of the goods
sector of the American economy, that increase in prices of imported products at the wholesale level will increasingly suffuse through
our domestic price structure, in my judgment.
I think the risk of general reflation is rising. I think our foreign
creditors, who are quite sensitive to this inflationary potential,
have become and will increasingly become reluctant to lend us the
roughly $3 billion per week that we must borrow in order to finance our imports.
They will in fact lend us what we need, but they will not lend us
those sums at prices we can afford to pay.
I think we will see, absent some tightening of monetary policy,
further declines in the dollar. I can see significant increases in interest rates and I can see the threat of a recession fairly close in
the future.
In my judgment, Mr. Chairman, monetary growth has already
reached such an extreme level that correcting the excess will inevitably involve a significant real economic cost. As usual, those least
able to bear it will have to carry much of the burden.
However, further delay in bringing monetary growth under control, in my judgment, would only increase those costs. I believe
very strongly the issue confronting Congress, the administration,
the Federal Reserve, and the financial markets is not whether interest rates will rise, but when and by how much.
No one wants a recession and we all recognize the structural
problems that Mr. Chimerine made reference to. However, notwithstanding the short-run costs, I think the Federal Reserve should
take four actions.
First, take immediate steps to reduce the rate of monetary
growth in the high-powered reserve aggregates most closely related
to the size of the Federal Reserve System balance sheet to levels
consistent with the Fed's own stated but generally ignored guidelines for non-inflationary monetary growth.
Second, I think we have to reverse the drift in Federal Reserve
policy back toward interest rate targeting. We gave it up in the
late 1970's on clear evidence from the Fed that using interest rates
for monetary policy targets had played an important role in contributing to the inflation of the 1970's. But we have drifted back
there.
Third, I think we should establish a single target for growth in
the monetary base. The base is in effect a proxy for the Federal
Reserve System balance sheet. It is similar to the target which the
Bundesbank, the German central bank, establishes for what they
call "central bank money." We should adhere to that target over
some reasonable period of time.
I think it is a mistake to publish multiple policy targets and then
decide ex post to focus on whichever one happens to be performing
in line with preconceived ideas about the level of interest rate. I
think it is wrong to establish targets and then regularly ignore
them. If targets are not going to be followed, they should not be
published.
27
Finally, the Fed should spell out clearly for the American public
what the implications of a policy of easy money and competitive devaluation really are. Any elementary economics textbook will tell
you that this policy is designed to produce a faster rate of domestic
inflation and a reduction in the relative real wage in the country
doing the devaluing, namely, the United States.
I think we have to make plain that if inflation does not speed up
and relative real wages do not decline, then we will not get the improvement in the trade balance which we all expect.
I think we have to be clear that if the external value of the
dollar declines, its internal value will drop as well. That is something that investors need to be very clear about.
VELOCITY
I do not see any empirical evidence of any permanent, long-run
change in the behavior of velocity. Velocity is always very volatile.
The ratio of GNP to money supply is most effectively described by
the term "white noise" in the very short run.
However, I see no systematic, sustained evidence that there has
been a permanent change in the long-run behavior of velocity. It
seems to me that the Federal Reserve in layman's terms is printing
money on the theory—or perhaps it's the hope or the prayer—that
no one will ever spend it. And I think that is a simplistic and dangerous assumption.
My colleague on the Shadow Open Market Committee, Robert
Rasche, has done extensive research on the behavior of velocity. I
would commend his work to you. I don't know whether it's actually
in final published form yet, but I would commend his work to you.
His conclusion: there has been no permanent change in velocity.
We have had repeated warnings in the foreign exchange markets
that declining real rates in the United States suggest a diminished
incentive for foreign investors to hold dollar balances at today's
price. We have seen a sharply declining dollar partially offset by
rising levels of central bank intervention to slow that drop.
The consensus forecast in Wall Street and here also in Washington suggests that the U.S. current account—a $150 billion deficit
which won't change very much in nominal terms this year—can be
financed readily and without disturbance if real interest rates
roughly decline by half this year.
The Congressional Budget Office, for example, suggests that real
interest rates, using the bill rate less the current inflation rate,
will be about 2.1 percent this year compared to 4,4 percent last
year.
I think we have clear evidence in the exchange markets that
that kind of an outlook will not be acceptable to foreign investors
from whom, as I noted earlier, we must borrow approximately $3
billion per week in order to finance our imports.
The record of monetary policy, Mr. Chairman, has been one of
great volatility in recent years. In my prepared statement I put together a little table reporting the year-on-year change in money
supply since 1979, picking the extremes in the curves, the tops and
bottoms. In the third quarter of 1979, money growth was about 8.3
percent; second quarter of 1980, 4.3 percent; second quarter of 1981,
28
9.9 percent; fourth quarter of 1981, 5 percent; third quarter 1983,
13 percent; fourth quarter of 1984, 5.4 percent; and, if current
trends continue, in the first quarter this year, the growth year-onyear will be about 17.3 percent.
It seems to me with this kind of a volatile record, it's very hard
to assess the impact of monetary policy on the economy. It's hard
to see that a strategy of monetary policy that relies on progressively larger oscillations in monetary growth will lead to stable macroeconomic performance.
I am particularly disturbed, Mr. Chairman, that since last September short-term interest rates have shown a modest upward bias
in the face of an average month-to-month change in total bank reserves something over 30 percent. Now something is wrong if interest rates go up in the face of that kind of an injection of liquidity
into the banking system.
This is not—and I repeat—not a short-term phenomenon. The
sustained decline in interest rates since 1984 has been systemmatically associated with accelerated rates of expansion in all of the
relevant monetary measures. When and at what level of growth in
high-powered money will this process come to an end? 50 percent?
500 percent? I don't know, and we don't have much guidance from
the Federal Reserve.
The Fed's rhetoric against inflation is vigorous. But its actions go
in the opposite direction.
[The complete prepared statement of H. Erich Heinemann follows:!
£
Statement by
H. ERICH HEINEHAHN
on Banking, Housing and Urban Affairs
United States Senate
February IB, 19S7
Second, eliminate short-term
interest rates as targets for nonetary
their principal means for implementing policy.
Third. establish a target for growth in the monetary base and adhere
to it over a reasonable period of tine, say, one year. The Federal Open
Market C o n m i t t e e should not publish nultiple policy targets, and then
decide to focus on whichever target appears consistent with the FOMC'9
preconceived ideas about interest rates- The Fed should not establish
to publish targets and subsequently disregard then.
Mr. Chairman, we are neeting at a crucial point in the history of the
Federal Reserve System. For more than two years, the Federal Reserve -
Fourth, play fair w i t h the American public. Let people know that the
current policy of easy money and competitive devaluation has been designed
to Federal Reserve data, total reserves in the American banking aysten
averaged S56. 7-bill iaci, 23.3 percent higher than the aave noDth Isst
r e l a t i v e real wages do not decline, then the U.S. trade balance will not
improve. Come clean that if the external value of the dollar declines.
reserves over the past 25 years was a l i t t l e less than 5 percent.
Keep in mnd
that the effective reserve requirement in the U.S.
almost $36 of a d d i t i o n a l deposits and/or loans and investmentsOver time, ripple effects from this rapid expansion of liquidity w i l l
apread through the economy. Total debt w i l l continue to increase nore
rapidly than GNP. Prices of imported products w i l l rise. The risk of
the *3-billion per week that we need to balance our books. They will lend
ua what we need, but not at a price we can afford to fay. The dollar w i l l
decline further. Interest rates w i l l rise. Another recession will loom
Mr. Chairman, monetary growth has already reached such an extreme
23.8
The background for these recommendations is straight forward: The
percent rate of gain in total bank reserves over the past year was
Anerica than the United States. Moreover, despite the Fed's efforts to
flood the markets w i t h noney, short-term interest rates have shown a
modest upward b i
have been at exceptionally low levels in recent months
so.
Will the pattern of the recent past continue? Many p e o p l e b e l i e v e
A widespread complacency about monetary policy has developed both
income velocity of money (the ratio of GNP to noney supply), has dropped.
Many think it w i l l keep on dropping. In popular terms, the Fed can p r i n t
all the money it likes, but no one w i l l spend it - at least, not to
The o b v i o u s short-run costs notwithstanding, I believe the Federal
unsupported by enpiricat analysis.
list.
cepts."
In layman's
As my colleague Robert H. Hasche nf
Once allowance is made for the break in the
language, if the Federal Deserve prints money withi
The U.S. dafic
been expanding within their anignad target range*.
One. the linge
ID •)• Judgment, the
aluation of the
CO
o
vaitors poured roughly *200-billion into mituel funds lait year.
Much of
(rom «
Pro.iu
r and how fast it will spread.
-5-
-6-
Mr. Chairman, one of government'a bedrock responsibilities - not On2 s~
honest money.
"Honest no^ey," by any realistic definition, ia money with
This ia not , 1 repeat, not, a ahort--teru phenomenon.
The auBtained
with accelerated rates of expansion in all of tbe relevant monetary
MONET SUPPLY BBOHTH BATES
Period Ended
change
Third Quarter 1979
Second auart*r 1930
Second QuartTr 1381
Fourth, Quarter 1331
Third Quarter 1383
Fourth Buarter 19B4
First Quarter 1987
8.28*
4.31
9.90
5.00
13.04
5.44
17.30 (E*t.)
"We have an Adminia tret ion, " Mr. Slocfciian added, "trbat is conducting
rnl Reserve constantly running from one aide of the
of monetary policy on the econooy.
The risk that we
currency. He have an Administration that articulated a supply-side notion
at how you get economic growth and wealth creation no* ainply resorting to
international demand stimulation."
I hope that Mr. stockman's peasimatic assessment is not correct.
But I fear thai it may be.
Several years ago, Herbert Stein, former chairmkn of the President's
Council of Eeononic Advisera, took the federal Reserve to task for its
the Fed ia committed to any lang-rua objective,"
should take a broader view.
On
Peter Sternlight. ia faced with a choice on a given day between maintaining a defined growth path for bank reserves and a defined level of inter-
than 30 percent. The Fed has hsd to flood the market with highred noney to keep interest rates fron rising even more sharply. To us
With due allowance for
Congress can maka a lasting contribution t
32
mnn ACTIONS -1960-1986
1
a*
5'/i'
Total Bank
Reserves
5>!
V
/
. ,
, . /MV ,-vA Vl
-
j
/
\
f\j A/
i
V
C.j
196B 1963 19&S 1969 1972 1975 1978 1981 1984
Motes: The chart shows rates of change in total bank reserves at
constant reserve ratios, The horizontal line shows the
average rate of change, 1960-1986, Vertical lines show
periods of recession.
Source: Heinewann EconoMic Research
THE VOLATILITY OF MONETfiR^ EVPANSION
I960 1963 1966 1969 1972 1975 1978 1981 1984 1987
Notes: The chart shows deviations frow trend (1947-1986) in yearQver-yea* changes in the namely-defined «oney supply (H-l),
In percentage points. Vertical lines show recessions.
Source; Heine«cinn Econonic Research
33
The CHAIRMAN. Thank you, Mr. Heinemann.
Dr. Meltzer.
STATEMENT OF ALLAN H. MELTZER, JOHN M. OLIN PROFESSOR
OF POLITICAL ECONOMY AND PUBLIC POLICY, GSIA-CARNEGIE MELLON UNIVERSITY
Dr. MELTZER. Mr. Chairman, in the 25 years I have appeared
before this committee and talked to you and your colleagues about
monetary policy and the economy, there are few periods in my
judgment which have been as critical as the current period.
I want to discuss two topics with you. First, is the monetary
policy which is the subject of these hearings; and, second, the problems of trade and debt, a critical national issue and one which will
make a great difference to the living standards of our population
for years to come. Let me begin with monetary policy.
In my opinion, we are back to the fast-break and slam- dunk
monetary policy of the past with a vengeance. Whatever statements may be made to the contrary, we are printing money at a
shameful rate.
This policy is counterproductive. It is going to cause more problems than it will solve.
DEVALUATION OF THE CURRENCY
Our problem is not solely with the Federal Reserve. The Treasury seems to know no solution except devaluation of the currency.
The administration has not had the judgment to offer policies other
than devaluation. It acquiesces in faster money growth in the hope
that it will relieve the current problems of trade and debt.
The Congress has not required disciplined monetary and fiscal
policies. It has not demanded that the Federal Reserve adhere to
its policy announcements. It has not insisted that the Federal Reserve choose a target that it can control and then carry out the
policies which it announces at these meetings.
Elsewhere in these halls, the Congress is investigating the
damage to the United States caused by our policy toward Iran that
occupies the headlines. The cost to the American people of the Iran
problem is small compared to the policies of inflation and devaluation and the effects that those policies will have on the living
standards of the American people.
I fully share your view, Mr. Chairman, that the hearings that
you are holding are critical hearings, and the policies that you are
discussing are critical, not for the short-term outlook for the economy, but for the longer term, for the living standards of the American public.
These policies—the policies of monetary expansion and devaluation—can only work to the extent that they reduce the living
standards of the American public and raise the cost of consumer
goods to the American public.
Whatever Mr. Volcker may say about his concerns about dollar
devaluation, the agency he heads has worked toward that goal and
is working toward the devaluation of the dollar by printing money
at an extremely rapid rate.
34
There is, in my opinion, no other way to explain the devaluation
of the dollar, in face of the sluggish performance of the rest of the
world economy compared to the U.S. economy, other than the fact
that the United States is contributing to the devaluation by an extraordinarily high rate of monetary growth.
Let me examine the policy from two aspects. First, can faster
monetary growth and monetary devaluation solve the trade problem? The answer is no. The problem is a real problem, not a monetary problem. It arises from spending, mainly for consumption, in
excess of production in both the private and the public sectors.
As a nation, we spend too much relative to what we produce. We
borrow to pay for the excess of consumption—mainly consumption—leaving debts to the future that will to have to be paid out of
incomes that we earn in the future. That's where the drop in the
living standard will come from, In the future, we will leave a large
debt and that debt will have to be paid by people working more
and consuming less. In order to service our debts we must in the
future produce more than we consume.
Inflation can contribute to the solution, but only for a time and
only by fooling people and reducing their living standards. Eventually, we will pay for the inflation with a painful period of disinflation that the public will demand. We will be poorer as a result of
that policy.
Mr. Chairman, on all sides we hear voices urging faster money
growth claiming that the economy is weak. This, in my opinion,
should be labeled as hokum. Faster money growth stimulates
demand. Our problem is not demand. Demand and spending has
grown rapidly, above the average rates of expansion for most postwar expansions, and demand continues to grow rapidly.
SPENDING FOR CONSUMPTION
Our problem is that we are not producing domestically the goods
to satisfy that demand. We are importing them from abroad. Consequently, we have a large trade balance. Our problem is that we
are spending most of the money that we are borrowing for consumption, not for investment. If we were spending more for investment, we would have the resources in the future to retire the debt
that we have put out and to service that debt. Because we spend
mainly for consumption, we live better now at the expense of the
future.
Because the Government budget is devoted mainly to consumption and not to investment, there, too, we are borrowing to spend
for consumption.
We must look behind the paper veils of the deficit and the monetary growth to ask about the use of resources in this country. Our
use of the resources is principally for consumption, which runs at a
near record rate, while net investment runs at one of the lowest
rates of the postwar period.
Our problem is, as I have said, that we consume too much relative to what we produce. We cannot solve that problem by faster
money growth.
Nor is it true that faster money growth can solve the problems of
the farmers, the real estate operators, the oil patch, the insolvency
35
of the thrifts or the international debt. Faster inflation will be a
temporary palliative, but it will bring us back the same kinds of
problems that we had in the 1970's.
Many of the problems to which I referred are the result of inflation. A high rate of inflation encouraged people to borrow and bid
up the prices of assets; then a severe and rapid disinflation brought
down those asset prices and left people who had invested based on
the expectation of a continuously high inflation—left them holding
assets which were of lower value than they had anticipated.
The problems of farming, real estate and so on are largely a consequence of the slam-dunk monetary policies of the past 10 or 15
years, policies which are now returning.
Senior policy makers brought the inflation down, in my opinion,
too quickly. Once inflation was brought to the 3 to 4 percent range,
they believed that the problem was largely over. That, of course,
was a mistake, a mistake that has been often repeated in monetary
history.
The rate of increase in output prices had adjusted downward, but
asset prices had not. The adjustment of farm prices, oil prices, land
prices and real estate prices to the lower expected rate of inflation
is the cause of many of our current problems. It is a mistake to
restart inflation and to bring back the problems of inflation and
drainflation 5 or 10 years from now.
Having paid a high price to make part of the adjustment, it is a
mistake to reverse direction, restart the inflation, and suffer another round of slam-dunk policies. Yet that, it appears to me, is
what we are doing.
Most of my written statement is concerned not with the problems of inflation but with the problems of trade and debt.
Mr. Chairman, we must recognize that these problems are interrelated. By the end of this decade, the United States will owe I
think on a conservative estimate somewhere between $600 and
$900 billion to foreigners. In 4 years, we have moved from being a
net creditor position of $150 billion to a net debtor position of $200
billion or more. In 4 more years, I estimate we will add another
half a trillion dollars to our foreign debt. We will be paying interest of $60 billion a year to service that debt.
We must earn that interest by producing more than we consume.
My calculations suggest that as a Nation we cannot turn the trade
balance and pay the interest to foreigners that we will owe without
reducing both our relative and possibly our absolute standards of
living. Most likely, both.
In my written comments I discuss four solutions. Each is painful.
In my opinion, the least painful is to adopt policies that increase
productivity. We must invest more and consume less, both publicly
and privately. In my opinion, we should institute policies of this
kind promptly. We should tax consumption and remove taxes from
investment to reduce private consumption and increase private investment.
We should cut Government spending for consumption and increase Government spending that encourages productivity by building infrastructure and helping the productivity that will promote
better jobs and higher productivity in our economy.
36
We should stabilize policies, provide greater certainty about the
future. We could look to Japan as an economy which has relatively
stable policies and much lower interest rates as a result of the lack
of the risk premiums. There is much greater certainty in Japan
about what the Government is going to do, and we might look at
the fact that Japan, a nation which is consuming far less than it
produces and exporting the balance, is shifting its tax rates in a
direction that I think we should be shifting ours—removing taxes
from investment and shifting them onto consumption. We should
be doing the same and more,
We should develop different and more useful approaches to the
Latin American debt. I discuss some of these in my paper. The
United States is a debtor country now. It cannot lend to Latin
America so that Latin America can solve its problems unless we
sell assets or borrow to make those loans.
As a net debtor and a borrower in international markets, when
we borrow to lend to Latin America that adds to the U.S. debt and
the interest we must pay in the future.
This is a critical period. I believe we are in danger of slipping
back into the chaos of the interwar period. For 40 years, the
United States used its wealth and power to provide a political, financial and trading order. Our relative wealth and power has diminished. We are embarked on a course likely to weaken our absolute position. We have given little thought to who, if anyone, will
provide stability in the world in which we now live.
Today, we are discussing monetary policy and economic policy.
But the more general subject is the world financial and trading
system and further removed the political stability of the world.
It is a serious mistake to sacrifice that stability, as we have,
without knowing what will take its place. But that is what we are
doing and we will come to regret it.
Thank you, Mr. Chairman.
[The complete prepared statement of Allan H. Meltzer follows:]
net foreign assets of nearly J150 billion, as at the end of 198S, we had net
foreign debts of more than $200 billion at the end of 1986.
will continue even or the most favorable assumption.
TRADE AND DEBT
Large borrowing
By the end of the decade
we will owe foreigners between S600 and $900 bilti'on,
By Allan H. Heltzer
These numbers seem large in an absolute Sense, and they are.
The U.S. is
a wealthy country, however, with assets of from $10 to $15 trillion and with
gross foreign assets of H trillion ar more.
Few subjects
have received is nucti cement 1n recent years as the
so-
called twin deficits in the Federal Budget and in net exports of goods and
services.
Many
eCdrtomltti
and
most
consequences of the budget deficit for
trade deficit for
politicians
po nt
out
the
dire
the future of the >conomy and of the
the Future of domestic manufacturing.
The deficits are
filanW for Sigh Interest rates, weakness In manufacturing output and sluggish
growth of employment at home.
Vet, despite the frequent discussion of these deficits for
the central problem has escaped attention.
paper transactions
four years,
Few have tried to look through the
to the reality that lies below.
Mad this been done, the
deficits «ould appear as symptoms—not causes—of the problems of
the
economy.
proposed
And. while
there
are no easy solutions, some of
the
J.S.
solutions—protection, currency devaluation, easier monetary polfcj-, general
tai Increases—would be seen to
be mistaken or less attractive-than some
available alternatives.
relative to "hat we produce.
is
that
The excess of spending over production shows up
the
Privately,
The government spends
the share of
spending for consumption
highest rate we have enperlenced, while net
remains at a very low rate.
Imports
Investment
To maintain spending In excess of production, we
sell assets and borrow abroad.
deficit--net
much
consumption—health, welfare, most of defense spending—and very
near
We accumulated the stock of foreign
In Just four years, we have wiped out the
net accumulation of several generations.
Should we he disheartened and ill at ease?
Are a foreign debt and trade
deficit of this sire good or bad for the economy?
mainly the size of
borrowing and net imports are used.
and
principal.
The answer depends not on
the deficit but on how the resources obtained through
productive Investment,
If
our borrowing financed a high rata of
the returns on the Investment would pay the interest
Our future
standard of
living would
be higher.
Since
borrowing is used nalnly to finance consumption, we live better now but leave
a debt to
be serviced and paid in the future.
At some time, we or our
children will be faced with two options.
believe likely.
as a nation we consume too
In the national accounts and a f f e c t s both deficits.
remains
Still, there fl a sense of unease.
assets over a period of 70 years.
Since our international borrowing 1s denominated in dollars, one option
The main econrmic problem
little on Investment.
by foreigners remain; far from reality.
is to reduce the reil value of the debt by inflating faster than people now
THE PROBLEM
mainly for
Visions of U.S. citizens living
in hones, or working in factories and office buildings all of which are owned
The counterpart of this borrowing fs the trade
from abroad.
For the
last year,
net
Imports
have
remained at about 2.5* of total output—about $150 billion 1n constant 1982
dollars.
In the past four years, we have borrowed so much that, instead of owning
on the debt.
Increased Inflation reduces the real cost of paying interest
Inflation Imposes a large cost on the foreigners who bought the
bonds and, as recent experience with inflation and disinflation shows, there
are large costs at home also.
The precise effect on International monetary
arrangements of anotner period of U.S. inflation cannot be predicted.
A new
monetary arrangement may emerge, or we may return to the chaos of the 1930s.
The
second
option
Is to
service the debt without
inflating.
This
requires producing more than we consume and selling the surplus abroad to pay
the Interest on the foreign debt.
the
U.S.
large enough
to
cover
This option requires a trade surplus
net
interest
payments attroad.
for
Using an
interest rate Of 8* and a net foreign debt of $600 Sillion to 1900 billion,
our trade surplus has to remain at $50 to $70 billion per year indefinitely,
a
larger
surplus
In
any year would reduce
the debt
and future
interest
CO
payments; a smaller surplus would add to the debt and raise future interest
payments.
The change from net Imports of 'ISO bill Ion to net exports of $50 to $70
ft mi on requires a major s h f f t
In world trade patterns and resource use.
Because the debt remains outstanding, the shift to a surplus must be
permanent. A shift of this size, though large by current or past standards Is
not large "in comparison to the dze of the U.S. economy.
A trade surplus of
160 billion by 1990 will be less than lyi >»f resl GUP In that year.
The problem cannot be solved 1> isolation, however. Me are not the only
ijabtor. Hany other countries haire lebts that must fie serviced also, so these
currently close to $1 trillion. This Units our options. For example, we
Cinr*t expect to solve-our problem by Increasing net exports to Latin American
Importers from the U.S. and other debtor countries If the debts are to be
serviced.
To Illustrate, Japanese and German trade surpluses equal to 1% of
ttwlr 1990 output would provide only 175 billion toward any deficits and
interest payments of the U.S. and other major debtors.
the amount of 1990 interest payments of these debtors.
This is about one-half
Many observers who discuss the twin deficits appear to reach conclusions
that are superficially similar.
They urge monetary enosnslon by Germany and
Japan to lower Interest rates and stimulate demand for our exports. Others
urge monetary expansion by the federal Reserve to depreciate the dollar or
monetary expansion In all three countries and oerttips eKe*here. These are
stop gaps, not solutions.
They work by putting the bandald of additional
demand on a problem that requires adjustment of costs and prices of exports
and imports. They offer short-term, not long-term, solutions.
debtors unless they increase their net exports, to Europe and ftsia. dor, can
The problens of trade ami debt are not mainly problems of weak demand.
we continue to be a net lender to Latin America to finance their trade and
Output growth In the U.S. has not been held back by weak domestic demand.
development. Every dollar we lend then has to be borrowed from the rest of
the world or earned by exporting more than we Import.
Consumer demand has been strong, but a large part of the demand has Been
There is no way to avoid the conclusion that. If the debts accumulated In
the seventies am) eighties are to be serviced, there must be a major change in
spurt (n world demand, an Increase in U.S. exports and a reduction In the
trade deficit.
But, faster coney growth abroad cinnot so We the long-term
trading patterns and, therefore. In ecooontc ind trading relations.
problem} of trad* and debt.
must becone a large net exporter to Europe and especially to Asia.
The U.S.
Europe and
tela mist becoro net Importers. The postwar strategy of export led growth to
finance Investment in the countries if Europe, t,s1a end parts of Latin America
satisfied by imports.
sets the stage for
Faster money growth abroad can produce a temporary
And, By increasing Inflation, faster money growth
another period of disinflation and another round of stop
and go that will make the problem harder to solve.
wa( highly successful. Standards of living rose. That strategy must change
to reflect the debtor position of the United States.
The magnitude of the required change Is Inpresslve. Currently, the U.S.
exports about S£00 billion and Imports more than 1350 billion. Closing the
To eliminate the trade deficit and service our debt, we must lower costs
of production relative to prices.
There are four options.
None offers an
9ip between exports and imports and paying the Interest on its debt is
equivalent to doubling the amount Of current exports (In constant dollars) by
easy, attractive solution.
1990, or reducing current Imports by more than one-half, or SOIK combination
These amounts are about 10* of total current world exports and,
We car Inflate, as many now urge. Inflation lowers the value of the debt
and devalues the dollar.
Ths decline in the value of tha debt transfers
perhaps more relevantly, more than three tines the average trade surpluses
wealth from the rest of the world but, sooner or later, Inflation raises all
(with all countries)
prices Including Interest rates and wages.
of the two.
nf
the two principal surplus countries--Germany and
Each dea's in a different ••aj *Uh the problems of
trade and debt.
The rise In wages and other costs
Japan.
Mucti of Germany's surplus is earned within the European Economic
Community, while much of Japan's surplus coraes from trade with the U.S.
it
of production offsets the effect of the devaluation on trade. To reduce tne
trade deficit permanently, we must reduce the cost of domestically produced
becomes clear that these countries must become, for the first time, large net
goods.
Inflation not only does
not solve
the trade
problem but,
by
00
encouraging consumption, it iwkes the problem worse.
We can protect against imports using quotas, surcharges and perhaps
t a r i f f s . This 1 iwers spending on imports but invites retaliation and shrinks
The problems of trade and debt require that we produce no's r e l a t i v e "
tne amount of world trade, ft lower level of trade makes more d i f f i c u l t tne
task of squeezing out S60 billion to pay interest on our foreign cebt.
In
the
debt.
The four options
take different
approaches
to
-.he :oc ?ti.
addition to all the other, well advertised disadvantages of trade
restrictions, we must add that they are in a real sense counterproductive when
Inflation does little to solve tne trade problem. D e v a i u a t l o r (in -ea' terms)
ami protection solve the uroDlem by lowering standards of > i < i n g at icme
we view the trade and debt problems as a whole.
reiat've to living standards abroad.
output and productivity.
Vie
years.
A real .evaluation, unlike inflation, raise; prices relative to costs
of production.
dearer.
This
The rise in prices makes our eiports cheaper, our imports
method of adjustment, like protectionist policy, reduces
would
raise
the
tax
None of these options work; to irc'aase
A general tai increase to reduce the bucget oe'icit
on
investment
to
maintain
government
spending on
Consumption.
This is the opposite of a policy to c l o s e the gaa between
Spending and production by increasing production.
It is oniy oy adopt ! ng
standards of Jiving relative tt> foreigners and perhaps in absolute terms. We
measures that increase productivity that we can hope to service our debt w h i ' e
cannot avoid devaluation, but we shou'd avoid policies aimed at manipulating
Shifting output from domestic use to exoorts without increasing frfTation and-
e*c"ange rates and "talking the dollar down."
without permanently reducing standards of living relative to foi-eigners and,
We can increase productivity.
Thsre are many ways to do this, none easy
to accomplish. At the national level, the four most important policy changes
In my Judgment, are: (1) without increasing taxes, shift taxation from capital
Herhaps, absolutely. Reductions in government spending on consumption, higher
taxes on private consumption and1 lower tdies on ini-estfflent and capital shifts
resources toward Investment and raises productivity.
to consumption so that tne share of consumption spending falls and the share
A few numbers bring the problem irito perspective.
Interest payments By
of capital spending rises to levels substantially above those achieved in the
last twenty years; (2) reduce government spending, particularly consumption
the end af the decade nil) be about 1>& of real output.
If real output grows
spending and.
If
possible,
shift government spending from consumption to
at an average rate of 2*ft to 11, per year, output per capita w i l l rise at no
more than 2% per yfcar.
The interest payments absorb all, or most, of the
productivity enhancing investments (n Infrastructure; (3} make a commitment to
increase.
maintain these policies--and a long-term pro-growth strategy— tc
2\%.
reduce
uncertainty about future after tax returns to Investment. Elements of t h i s
Strategy include more deregulation, Ifss costly mean; of reducing pollution,
In addition, we must eliminate the current net exports d e f i c i t o f
Tliese numbers imply that per capita incomes do not rise to the <^nc ;je t - e
(4) Shift from a policy of
decade, and may fall.
If such a fall is to be avoided, the soticns must
include more than inflation, protection and devaluation. A pro-competitive,
lending to foreign debtors to a policy of encouraging repatriation of foreign
pro-growth policy achieved through a permanent change in taxation must se part
capita' and dsbi r-eductlon hy foreign debtors.
of our policy.
enforcing product liability, safety and health.
It makes little sense for a
This policy does not avoid a reduction in current consumption,
American debtors. Instead, we should encourage Latin Americans to sell equity
but by increasing output
temporary, not permanent.
in their large state sectors or to adopt policies that attract some of the
capital held abroad by their citizens.
There is no easy way out.
Selling assets buys t'me, out something must
Oe done with the Mure that *e tuy. To avoid having all =f the problem solved
debtor country, the J.S., to borrow and sell assets to finance loans to Latin
per worker,
it
assures
that
tfie
reduction
is
by permanent'y reducing the real wages of American *orke--s 3rd -^he real
incomes of
American
consumers,
through inflation,
deva'uatisn and
protectionist policy, we must begin, now, on a sustained effort to increase
05
productivity. A Shift of taxes from capital to consumption is an important
first itep. If we could add just one-half percent to the average growth rate
for the next four years, we would have
1100 billion more awaHsole
for
consumption, exports and investment in 1990.
Much depends an our cfcclces. For the past forty years, the United States
haj Nad the relative wealth and power to maintain or impose a degree of
political, economic and trade stability on much of the world. We have not
always succeeded; we have made mistakes; but, we Have Molded tlie return to
the disorder that characterized the Interwar period, particularly the 1930s.
If iie solve our problems of trade and debt by reducing our relative
wealth, we move to a position of co-equal 1n a multi-centered world. Hew
arrangements must develop for sharing responsibility for defense, finance,
trade and the nraintenance of such ord«r li can be provided.
We have done
little to develop arrangements commensurate with the reduced role that our
relative wealth and power will bring.
If we fall to Increase productivity,
sued planning Is essential to avoid a return to the uncertainties of the
Intsnuar period.
41
The CHAIRMAN. Well, thank you very much, Dr. Meltzer.
Dr. Roberts.
If I could interrupt just for a minute, without objection, a statement by Senator D'Amato will be inserted in the record at this
point, and I apologize. Go right ahead, sir.
STATEMENT OF SENATOR ALFONSE M. D'AMATO
I commend the chairman for inviting the witnesses to appear
today, one day before Federal Reserve Board Chairman Paul
Volcker is scheduled to testify. This morning's testimony should
provide the committee with an appropriate context through which
we can evaluate the content of Chairman Volcker's remarks.
The testimony from today's witnesses reemphasizes several
points that have been made to the committee in the past regarding
the stability, or should I say the relative instability of our domestic
economy. Today's testimony substantiates the assertion that economic forecasting is hardly a precise science. However, certain
steps must be taken by the Congress, the President, and the Federal Reserve Board to ensure continued and stable economic growth.
If the economy continues to grow at a moderate rate and if we
are going to introduce more stability into the domestic and international economies, then Congress must address two problems that no
longer loom on the horizon—these problems are at the front door.
The first problem is that the Budget deficit must be reduced in a
rational and least painful manner as possible. The deficit issue has
become a political football with the Congress blaming the President
and the President blaming a profligate Congress. Such accusations
tend to exacerbate rather than resolve the problem. I am interested in the testimony of Paul Craig Roberts who introduces in his
testimony another culpable party in the deficit debacle—the conduct of monetary policy by the Fed. I hope he will elaborate on this
point during the hearing. I also hope each of our witnesses will
offer their recommendations on how the budget deficit may be cut
and whether they think Gramm-Rudman is effectively accomplishing its intended goals.
The second problem confronting our domestic economy is the
trade deficit. Frankly, I am tired of hearing the same old arguments about how Americans can't compete; the unions have priced
American heavy industry out of the market; and America is losing
its technological advantage. I believe these arguments and those
advancing draconian protectionist legislation ring hollow when one
takes a real look at what's happening to American industry.
American Industry is at the forefront of innovation. U.S. companies spend billions on innovation each year and develop new technologies. However, before these new technologies can be put to
practical uses, we find that our foreign competitors are using the
same technologies, in practical uses, at lower costs. How can they
do this? Easy, many of our competitors are stealing us blind.
During our last hearing on the Federal Reserve's monetary policy
report, I stated that our so-called trading partners:
Steal our patents, intellectual property rights, systematically are adjudged guilty
in the courts, say we're sorry, pay back penalties, continue the same thing, infringe
on patents and then send the products here into the United States. Further, those
harmed have limited recourse under the current legal system. At present, even
42
though your copyright may have been infringed or your patent stolen you must
then demonstrate that there is substantial danger to the particular industry, before
damages can be awarded. Despite the failure of the laws and trade policies pursued
to date we hear, oh, yes, we're going to make changes. We've been waiting a long
time for negotiations or other bilateral approaches to work. We wait in vain. It
seems to me, absent any legislative action or some very real enforcement of present
trade practices, the policies of the Japanese and others will not change because they
lack any incentive to change.
I have not changed my point of view on the subject. I should also
note that Chairman Volcker supported my notion of the cause of
such competitive trade imbalances and urged us to act. I am sorry
to state that in the drive to make America more competitive, we
and the Administration have yet to consider the steps needed to
make technological piracy more punitive.
I look forward to the testimony of today's witnesses and would
hope they shed some light on the accuracy of the Administration's
predictions about GNP growth and the chances of increased inflation if the Fed continues its current monetary policies.
STATEMENT OF PAUL CRAIG ROBERTS, WILLIAM E. SIMON
CHAIR, POLITICAL ECONOMY, CENTER FOR STRATEGIC AND
INTERNATIONAL STUDIES, GEORGETOWN UNIVERSITY
Mr. ROBERTS. Thank you, Mr. Chairman.
Monetary targets fell into disrepute in the 1980's as Ml lost its
predictive quality. I think it would be mistake to conclude from
this that the targets don't matter or that money doesn't matter.
To the contrary, the main reason for the large budget and trade
deficits today is that the Fed followed an overly restrictive monetary policy in 1981 and that it had an inappropriate target in 1982,
one it was forced to abandon after mid-year in order to combat a
severe recession and a foreign debt crisis symbolized at the time by
Mexico's inability to pay its foreign creditors.
In discussing the economic outlook, many people often speak as if
everything depends upon fiscal policy. This has particularly been
the case in policy discussions about the U.S. budget and trade deficits. If belief in the primacy of fiscal policy gets out of hand, it
could downgrade the importance of monetary policy and the oversight responsibilities of this committee.
In my opening remarks I provide an empirical demonstration of
the power of monetary policy. Indeed, whether or not the fiscal actions of Government produce the desired results depends upon
whether or not the Fed conducts monetary policy in keeping with
the monetary policy assumptions in the budget.
GROWTH RATE OF NOMINAL GNP
The key to any budget forecast is the assumption made about the
growth rate of nominal GNP. If the Fed conducts monetary policy
in a way that causes the inflation rate and the real economic
growth rate to diverge from the assumptions or goals in the Government's budget, the Government will collect either more or less
revenues than it expected, and it will spend more or less in real
terms than it intended. In the 1980's inflation fell relative to expectations, causing the Treasury to collect less revenues than expected
43
and causing the Government to spend more in real terms than it
intended.
As tables I and II in my testimony show, the conduct of monetary policy is resposible for about 46 percent of the buildup in
public debt during the 1981-86 period.
Mr. Chairman, the collapse of inflation was a good thing, but it
was nevertheless hard on exporters, farmers, the energy industry,
and the deficit. The powerful disinflation cut more than $2.5 trillion from nominal gross national product over the 1981-86 period.
The budget effects of this are shown in table II. I will pass over
those in the interest of time.
The same unexpected disinflation that caused the budget deficit
also caused the dollar's rise in value and the U.S. trade deficit. It is
impossible for the inflation rate to unexpectedly drop from doubledigit rates back to the low single-digit rates of the 1960's without
the dollar rising in value. The Fed should have understood that it
cannot simultaneously make the dollar a more desirable currency
in which to hold assets and fail to meet the increased world
demand for dollars without the dollar rising in value. As chart I in
my testimony shows, the dollar has consistently risen with deceleration in the growth rate of money and fallen with acceleration in
the growth rate of money.
The same tight monetary policy that drove down inflation and
made the dollar more desirable also curtailed the supply of dollars.
The result was a steep rise in the dollar's price, or exchange value.
The Federal Reserve did not accommodate the higher world
demand for dollars, thereby keeping upward pressure on the dollar's value. In 1984, the Federal Reserve again tightened, simultaneously taking the bloom off a robust expansion in the real domestic economy and driving the dollar higher.
In the face of the abrupt change in U.S. monetary policy and inflation, nothing could have prevented the rise in the dollar. Indeed,
not even large budget deficits, which normally depress a currency's
value, could prevent the dollar from rising. Smaller deficits would
have added to the confidence factor and driven the dollar even
higher.
ACCELERATION OF Ml
Turning to the current situation, since the first quarter of 1985,
money growth, as measured by Ml and total reserves, has accelerated. I am not convinced that these growth rates are signs of an
inflationary policy, but many people have interpreted them that
way and rapid money growth can explain the decline of the dollar
without anything having been done about the budget deficit, which
was supposed to be the cause of the high dollar.
Another explanation for the dollar's decline is that a new liability has risen to take the place of double-digit inflation in depressing the value of the dollar. That new liability is the buildup in debt
owed to foreigners as a result of the trade deficit caused by the
sharp rise in the dollar's value in 1981 and in 1984. As our debtor
status deepened, the dollar turned around and began falling.
Mr. Chairman, to work our way out of our trade deficit requires
not just a weaker dollar but an expanding world economy.
44
We might not get one. Now that the dollar's decline is the focus
of attention, the Federal Reserve is feeling pressures to raise interest rates to save the dollar and forestall a renewal of inflation due
to rising import prices. I am not confident that the debt structure
at home and in the debtor countries that owe our banks so much
money is strong enough to accommodate a tightening of monetary
policy. I am not confident that the economy is robust enough at
this point to stand monetary tightening. There seems to be enough
evidence that we are still suffering the effects of severe deflation
from past monetary policy. Commodity prices have not broken out
on the upside, capacity utilization is not high, and the latest Fed
data show a continuing deterioration of the farm banks despite the
massive federal subsidies to farmers.
In general, I am somewhat skeptical the economy is strong
enough at this point to stand tightening.
Mr. Chairman, I have in my testimony comments about the
growth of Ml and total reserves. I am not certain that these are
reliable indicators for reasons that I indicate. I note the continuing
decline in velocity and note that that decline is somewhat ambiguous because it can fall for two reasons. It's not always clear which
one is the reason that is operative.
I look at some other monetary indicators and see less rapid acceleration in the growth of money than Ml indicates.
I am not a monetarist, but I do believe that money matters. If
monetary policy is going to be guided by money targets, they had
better be the right targets, and the Fed had better hit them. Otherwise, the Government's economic goals and deficit targets are not
going to be met. So far in the 1980's, the Federal Reserve has largely countermanded the Reagan administration's supply-side policy.
The benefit of the Fed calling the shots was a more rapid than intended deceleration of inflation. The costs are the large budget and
trade deficits and the severe debt crisis that stretches from the
American farm community to the Third World.
The breakdown in the monetarist relationships upon which the
monetary targets are based may only be temporary. However, in
view of the doubts about Ml and the actual conditions in the world
economy, the Fed had best watch, for a time at least, a broader
range of indicators than monetary aggregates provide. The behavior of commodity prices, the real growth rate of the economy, sectoral strengths and weaknesses, consumer behavior, business confidence and investment, the growth of the world economy, all bear
close watching. Without many signs of real strength, it could be a
disastrous mistake to tighten monetary policy on the basis of Ml
growth and speculation in the exchange markets that the Treasury
wants a lower dollar.
Mr. Chairman, That completes my opening remarks.
[The complete prepared statement of Paul Craig Roberts follows:]
Mr. Chairman, members of the Committee, monetary targets fell
into disrepute in the 1980s as Ml lost its predictive quality. I
t h i n k it w o u l d be a mistake to conclude from this that the
targets d o n ' t matter or that money doesn't matter.
To the
contrary, the main reason for the large budget and trade deficits
today is that the Fed followed an overly restrictive monetary
policy in 1981 and that it had an inappropriate target in 1982,
one that it uas forced to abandon a f t e r midyear in order to
combat a severe recession and a foreign debt crisis symbolized at
tha time by Mexico's inability to pay its foreign creditors.
TESTIMONY BEFORE THE SENATE BANKING COMMITTEE
FEBRUARY IS, 19B7
Paul Craig Roberts
William E. Simon Chair in Political Economy
Center for Strategic and International Studies
Georgetown University
1800 K Street, NW
Washington, D.C. 20006
In discussing the economic outlook, many people often speak
as if everything depends on fiscal policy. This has particularly
been the case in policy discussions about the U.S. budget and
trade deficits.
If belief in the primacy of fiscal policy gets
out of hand, it could downgrade the importance of monetary policy
and the oversight responsibilities of this Committee.
If people
believe that fiscal policy is the whole ball game, they are
unlikely to pay much attention to the Fed or to this Committee.
Therefore, in my opening remarks I would like to give you an
empirical demonstration of the power of monetary policy, indeed,
whether or not the fiscal actions of government produce the
desired results depends upon whether or not the Fed conducts
monetary policy in keeping with the monetary policy assumptions
in the budget.
the
mptic
The key to any budget foreca
the growth rate of nominal GNP. If the Fed conducts monetary
policy in a way that causes the i n f l a t i o n rate and the real
economic growth rate to diverge from the assumptions or goals in
the government's budget, the government will collect either more
or less revenues than it expected, and it will spend more or less
in real terms than it intended.
In the 1980e inflation fell
relative to expectations, causing the Treasury to collect less
revenues than expected and causing the government to spend more
in real terms than it intended.
We have all heard a great deal about the trillion dollars
that have been added to the public debt during the last six
years.
The R e a g a n Administration blames the Congress for
spending too much on domestic programs, and Congress blames the
President for cutting taxes too much and for spending too much on
defense.
These charges and counter-charges have turned the
budget into a political football.
Moreover, the charges are, for
the most part, wrong.
As Table I and Table II in my testimony demonstrate, the
conduct of monetary" policy *s responsible for the lion's share of
the buildup of public debt d u r i n g the 1981-86 period. The
unexpectedly and excessively tight monetary policy during 1981-82
expectations.
than occurs.
Normally, administrations forecast lower inflation
However, the Reagan Administration forecast higher
Cn
inflation
released
the next
collapse
including
than occurred.
Ironically, w&en the Administration
its forecast in 1981 showing declining inflation over
f i v e years, it was Jeered as a "rosy scenario." The
of i n f l a t i o n in 1982 was not predicted by anyone,
the Fed that caused it.
The collapse of i n f l a t i o n was a good thing.
But it was
nevertheless hard on exporters, farmers, the energy industry, and
the d e f i c i t .
The powerful d i s i n f l a t i o n cut more than 5 2 . 5
deficit also caused the dollar's rise in value and the U.S. trade
deficit. It is impossible for the inflation rate to unexpectedly
drop from double-digit rates back to the low single-digit rates
of the 1950S without the dollar rising in value. The Fed should
have understood that it cannot simultaneously make the dollar a
more desirable currency in which to hold assets and fail to meet
the increased world demand for dollars without the dollar rising
in value.
As chart I in my testimony shows, the dollar has
consistently risen with deceleration in the growth rate of money
and fallen with acceleration in the growth rate of money.
tax rsvenues by $556 billion.
I^ower than expected inflation also reduced spending relative
to the original forecast for those outlays that are indexed to
i n f l a t i o n or whose costs are d i r e c t l y related to i n f l a t i o n .
These costs include about two-thirds of the budget and reduced
outlays over the period By 5198 billion.
The impact on outlays of a higher unemployment rate due to
the unexpected and severe recession raised outlays by about 539
billion over the period. The debt service coats associated with
the larger than, expected deficits added $61 billion.
When these figures are added, unanticipated disinflation
caused by excessively tight monetary policy accounts for $459
b i l l i o n , or 46 percent, of the trillion dollar increase in the
public debt over ISBI-BG.
bion
forecast a cumulative deficit of 5122.5 billion for 1981-g3, we
have another 12 percent. And if we then add in David Stockman's
$40_ b i l l i o n in "unidentified spending cuts," it comes to 5120
billion for 1984-86, or another 12 percent.
Altogether that accounts for $700 billion, or 70 percent of
the trillion dollars.
in other words, only 30 percent, or $300
b i l l i o n over the six year period, is left to be blamed on tax
cuts, defense buildup, and domestic spending.
It seems to me,
Mr. Chairnar., that it is not very productive £or Congress and the
them they are only responsible for 30 percent of it.
I don't
think we should send the Fed a bill for the 46 percent for which
it is responsible, but I do think it is tins for all of us to
a d m i t that it is impossible to unexpectedly cure i n f l a t i o n
without paying a cost.
We have paid that cost, and to keep it
f r o m rising we need to make a level adjustment in the budget to
b r i n g it in l i n e w i t h the unexpected component in the
disinflation.
Probably a one-year spending freeze would do the
trick as long as it is a year during which we have a pretty good
economy.
The same unexpected d i s i n f l a t i o n that caused the budget
The same tight monetary policy that drove down inflation and
made the dollar more desirable also curtailed the supply of
dollars. The result was a steep rise in the dollar's price, or
exchange value.
The Federal Reserve did not accommodate the
higher world demand for dollars, thereby keeping upward pressure
on the dollar's value.
in 1984, the Federal Reserve again
tightened, simultaneously taking the bloom off a robust expansion
in the real domestic economy and driving the dollar higher.
In the face of the abrupt change in U.S. monetary policy and
in£lation, nothing coulfl have prevented the ris* in the dollar.
Indeed, not even large budget deficits, which normally depress a
currency's value, could prevent the dollar from rising. Smaller
deficits would have added to tne confidence factor and driven the
dollar even higher.
Since the first quarter of 1985, money growth, as measured
by Ml and total reserves, has accelerated.
1 am not convinced
that these growth rates are signs of an inflationary policy, but
many people have interpreted them that way, and rapid money
growth can explain the decline of the dollar without anything
having been done about the budget deficit, which was supposed to
be the cause of the high dollar.
Another explanation for the dollar's decline is that a new
liability has risen to take the place of double-digit inflation
in depressing the value of the dollar. That new liability is the
builSup in flebt o«eii to foreigners as a result of the trade
deficit caused by the sharp rise in the dollar's value in 1981
and in 1984.
As our debtor status deepened, the dollar turned
abound and began falling.
It got some ill-advised help along the way. At a meeting at
New Mark's Plaza Hotel in September 1985, Japan and West Germany
agreed to help reduce their trade surpluses vitfi the U.SThe
agreement itself was Tine, but the way it was implemented was
unfortunate.
They drove down the value of the dollar by
tightening their domestic monetary policies to drive up the value
of the yen and the mack, consequently, the Japanese econany went
into recession, and West German economic growth slowed. The
result was a weaker dollar but also weaker markets overseas for
*>•
Oi
our exports. To work our way out of our trade deficit requires
not just a weaker dollar but an expanding world economy.
We may not get one. How that the dollar's decline is the
focus of attention, the Federal Reserve is feeling pressures to
of inflation due to rising import prices.
I am not confident
that the debt structure at home, and in the debtor countries that
owe our banks so much money, is strong enough to accommodate a
tightening of monetary policy.
I am not confident that the
economy is robust enough at this point to stand monetary
tightening. There seems to be enough evidence that we are still
suffering the effects of severe deflation from past monetary
policy.
Commodity prices have not broken out on the upside,
capacity utilization is not high, and the latest Fed data show a
continuing deterioration of the farm banks despite the massive
federal subsidies to farmers. There was a 30 percent increase
last year in the number of farm banks with mote problem loans
than capital. The FDIC's problem-bank list now includes 615 farm
banks.
Land values are still drifting down in most of the
Midwest and the oil states. Massive federal farm payments, which
now exceed the value of farm output, have not yet stabilized the
situation. I wouldn't think monetary tightening would be helpful
to the situation.
I wouldn't think monetary tightening would help the Third
World debt crisis or the loan portfolios of their U.S. creditors.
Brazil, last autumn's big political success story, is again in
economic chaos, and Mexico, the big success story of two years
interest rates.
Those calling for monetary tightening had better
bigger subsidies, more bailouts, a weaker economy and a larger
budget deficit.
Concern about reflation has been caused by the increase in
HI and total reserves (Table III] . These numbers may be reliable
indicators. On the other hand, some people may be reading too
much into them. A lot of Ml growth can be explained by deposit
shifts.
Far example, when multi-year CDs in savings and loans
mature, people are more likely to shift them to a NOW-account in
a commercial banX than to roll them over. A shift in funds from
H3 to Ml increases total reserves, because reserve requirements
against HI deposits are higher than for M-3 deposits. If total
reserves rise because of deposit shifts, it is not an indication
of an expansionary monetary policy. The broader aggregate, M3,
does not show an increase in money growth. Indeed, the quarterly
quarterly growth rates during 1981, 1982, 1933, and 19B4, a span
that included periods of monetary tightening.
Moreover, rapid Ml growth is offset by a continuing decline
in velocity.
The decline in velocity is itself somewhat
ambiguous, because velocity can fall for two reasons: (1) It can
fall because inflation falls and people are more willing to hold
money, and (2) it can fall because a spurt in money growth causes
money to grow taster than nominal GHP.
If velocity Has fallen
because of the first reason, the double-digit Ml numbers of the
because of the second reason, sooner or later nominal GNP will
catch up with money growth. As Chart II in my testimony shows,
the fall in velocity dates from 1981 and includes periods of
monetary tightening and monetary ease (as measured by Ml).
numbers by looking at Ml-A (demand deposits plus currency).
This
accounts.
Ml-ft shows no inflationary acceleration in growth
until the second quarter of 1986, five quarters after HI turned
sharply up.
It is possible that some of the growth in Hl-A
simply reflects more lax management of cash balances by
individuals and companies as a result of the fall in interest
rates.
Table IV shows that contrary to conventional wisdom,
foreigners are not holding a rising percentage of federal debt.
Despite the large budget deficit* of the 1980s, foreigners are
holding a significantly smaller percentage of the Federal debt
than in the late 1970s.
Table V and Chart III show that during the 1980s, the
Federal Reserve has monetized a much smaller percent of the
federal deficit than during the 1970s. The claim that we have
had too much money creation is not obvious in view of declining
Fed monetization (as a percent) , declining foreign holdings (as a
percent), declining inflation, and declining interest rates. The
claim could nevertheless be true, but I would want to see more
signs of loose money before I tightened monetary policy.
Mr. Chairman,
members
if
the Committee, I am not
policy is going to be guided by money targets, they had better be
the right targets, and the Fed had better hit them. Otherwise,
the government's economic goals and deficit targets are not going
to be met. So far in the 1980s, the Federal Reserve has largely
countermanded the Heagan Administration's supply-side policy.
ration of inflation. The costs are the large
intended de
b u d g e t and t r a d e d e f i c i t s and the severe debt crisis that
stretches from the American farm community to the Third World.
The breakdown in the monetarist relationships upon which the
monetary targets are based may only be temporary (see Chart I V ) .
However, in view of the doubts about Ml and the actual conditions
ny, the
TftBIE II
Fed had best watch, for a time at
IMPACT CM EUCGET DEFICIT OF UNEXPECTED .COLtAPSE DJ MJCMM, 3)P fSBil.l
1331
monetary policy on the basis of Hi growth and speculation in the
exchange markets that the Treasury wants a lower dollar.
1282
Fiscal Year
138J
1SB4
12S5
12£6
Impact an receipts of lower than forecasted nominal QJP
"CiTunal OJP with
projected grcwth of
March 1981
Actual Ncminal Q1P
Difference
295B.4
29S6.4
28.0
Receipts effect*
3319.8 3742.4 4160.6 4574.5 5005.4
3139.1 3321.9 3686.3 3937.2 4163.3
-180.7 -420.S -473.8 -«37.3 -B42.1 -2526.4
6.2
-39.8
-92.5 -104.2 -140.2 -185-3
-555.8
'Marginal tax rate of 22 percent
Impact on outlays of louer than forecasted inflatio
TABLE I
C.-1IP deflator with
projected inflation
of ftirth 1981
Actual CWP deflator
Comparison of Original He
with Actual Devel ocnnents
13B1
1332
02S3 iJSJ 1585
(percent change)
Original flssunptions
nominal CMP
Real OIP
Off Deflator
11.1
1.1
9.9
12. s
4.2
8.3
12.4
5.0
7.0
10.8
4.5
6.0
9.8
4.2
5.4
9.3
4.2
4.9
Actual Cevelopnents
Noninal QJP
Real OIF
CMP Daflator
11.7
1.9
9.7
3.7
-2.5
6.4
7.6
3.6
10.5
6.4
6.2
2.7
3.3
5.3
2.5
2.7
3.9
a. a
19B6
Percent diffar<anoa
oitlays subject to
inflation adjustment
Outlay effect
92.1
22J,
10D.1 107.4
98.S _1S2J3
114.0
106.9
120.3
110.6
587.7
-39.1
640.6
-56.1
OO
.0
452.9
.0
531.9
-22.9
670.6
-73.4
Inpact on outlays of higher than forecasted unenjploymsnt rati
Total Unemployment Rate
Projected
7.8
Actual
7.3
Difference
-0.5
Outlay effect
-2.2
7.4
9.0
1.6
7.6
6.8
10.0
3.2
17.2
6.4
6.1
7.1
1.0
5.7
1.3
6.1
4.5
5.3
7.7
6.9
1.2
Debt slervice costs as*jcciated •with the above
3 -no. bill rate
(actual]
14.5
Debt service on direct
deficit effect
-0.6
Total Deficit Effect
-9.0
11.7
1.4
42.1
a. 4
9.5
6.4
14.7
93.2
85.9
7.9
IS. 5
107.1
6.4
21.6
138.8
NOTES OH TABLES I AND II
The national incooe and product accounts have been rebenchmatked since the time of the original Reagan Administration
economic path of March 1981,
The rebenchmarkeo' series
includes expanded imputations for tha underground economy.
Thus , it La not possible to compare levels of nominal GHP
forecasted in March 19S1 with the levels that actually
materialized. A nominal GNF series consistent with the 1981
forecast was constructed by moving forward the actual FY1980 n o m i n a l GNp now carried in the accounts by the
forecasted rated of increase. This secies was than compared
with tne actual series now being carried.
w h i c h c o v e r s a s p a n of the two years 1985 and 1 9 3 6 1 ,
Assuming Che overshoot for any one year enters Into the
spending base for the next y e a r , the figures can be
cumulated.
Calculation of Spending Overshoot Resulting From
Lower than Anticipated Inflation
Fiscal Ifear
1983
1984
tsoninf lation adjusted
outlays (Sbil.l
225.3
CEO inflation forecast
over two years (%)
(annual rate)
237.7
274.4
20.4
(9.6)
264.0
305.7
319.2
9.5
(4.6)
9.8
7.3
(4.8) (3.6)
8.3
(4.0)
7.5
6.5
(3.7) (3.2)
shortfall from the original path
The lower inflation than was originally forecasted implies
that outlays would have been substantially higher if the
original forecast had bean met.
A forecasted deflator
series was constructed by the same Bathod. «.« uaad in
constructing nominal GNP consistent with th* March 1981
scenario, and Che differentials in levels of the deflator
were applied to actual outlays to derive an eatinnte at the
amounts by which outlays would have been higher under the
original inflation assumptions.
The reduced outlay effect
of lover than foracaatad inflation was calenjlatad for those
outlays directly affectsd by inflation by law or default:
(1) indexed pragmas; (2) Health care oosts [Medicare,
Kedicaifl, VS health care); (3) employee compensation, which
typically moves with inflation, though with some lag; and
(4) interest; costs.
Altogether, these represent about twothirds of total outlays.
Actual inflation
over two years (%>
(annual rate)
19. T
(9.4)
(percentage points
-0.6
outlay impact (Sbil.)
(cumulative)
-1.3
1B.O
(8.6)
11. e
(5.7)
Calculations of the outlay effects of higher unemployment
rates than contained in the original forecast are tiasad on
OMB rules of thumb.
These calculations do not attempt to take into account the
lags between the time of differences in nominal GNP and the
impact Of those differences en revenues or between the time
of differences in price levels and their outlay impact. In
actuality, lags exist in both cases.
The calculations do not attempt to esCi.ma.te the additional
interest outlays due directly to the effect of the tight
monetary policy on tha real interest rate.
As a proxy for Congressional anticipations, we can use Che
CBo forecast of the GNP deflator made at the time o£ the
budget submission for the fiscal year in question ( e . g . , tor
FY-19S6, the CBO i n f l a t i o n forecast as of February 1985,
TABLE
4.a
-4.8
III
7.3
4,6
14. 5
4.a
1.4
4.2
15.0
- I
II
III
IV
- I
II
lit
IV
4.9
10.5
15.2
17.3
16.4
14.0
31. H
4-3.2
59.4
Sfi.B
16.6
14.5
15.0
17.3
10. ft
11.7
74.6
95.5
209.S
256.3
- I
II
III
4.4
11. 9
MONEY GROWTH HATES AND GROWTH RATES FOR THE VALUE
OF THE DOLLAR OVER SELECTED PERIODS, 1977-1986
= i d F ? n t . fhp bas Lc 50ucue Eor bjjth series is table FD-1 o E
ssury B u l l e t Jr.. 3oth, c o n c e p t s i n c l u d e Fe'lersl debt h e l d by
Foileral xessrJp. Foraiq". h c l d m q s :)f rh<> p u b l i c debt a r e
n t a b l e OFS-J D£ the Treasury Bjlletiji. f e d e r a l -isbt Tel'!
;lf.
r-rDss Pe-1er.il nebt ir.cljiies •Je'jt h e l l "ly r h e T r u s t Fu
Fwhral Bewrve Monetlwtion
of fMccal Deficit
[Annual Daca are Calendar
197 e
1971
1972
1973
1974
1975
1976
1977
1978
1979
1988
19B1
1982
1983
1984
1985
1986
86:1
:II
:III
:IV
FHERAL
DEFICIT
(=01 1)
511.4
24.3
17.4
7.9
19.9
75.4
56.6
51.0
44.1
28. 1
62.9
7B.4
13B.7
19*.4
183.5
215.6
239.9
fil.2
30. S
53.9
64.3
Qiangs in
FIB aoldinga o£
GOV'T DEBT*
bil.
{col 2)
$4.2 bil. "
7.5
1.9
a. 6
7.8
5.4
8.2
7.6
9.4
9.0
1.6
9.9
8.6
14.0
7.5
18.2
-3.9
7.9
6.0
8.2
Psccsnt
ars)
percent of
Deficit M=ra; tiled
[t(ool 2/col D ]
36.9*
38.3
19.9
169.8
64.3
7.2
14.5
14.9
21.3
32.9
2.5
12.6
6.6
7.4
4.1
S.7
-£.4
25.9
11.1
12.7
' U.S GoveEiraent eecuiiciea and Federal Agency obligations
Changes based on tuldinga for last month of each year
for annual calculations, and on holdings foe last nonth
quarter for quartsrly calculatlona.
Chart II
M. VELOCITY
52
C h a r t Til
FRB Monetization: Percent of Deficit
Calendar Years: 1970 - 1986
1970
1972
1974
1976
1978
1980
19B2
GROWTH OF REAL GNP AND MONEY SUPPLY (M,)
1984
1966
53
How the Defeat of Inflation
Wrecked the U.S. Budget
By PAUL CRAIG ROBERTS
Federal Reserve Chairman Paul A.
Volcker's unsung achievement is the destruction of the budget process in the
United Stales. Consider first the demise
of the process, and then Votcker's role in
bringing it about.
The budget for fiscal 1982 was the last
time that Congress carried out the responsibilities that it gave itself in the Congressional Budget Act of 1974. Since then the
budget process has collapsed so completely
that even Sen. Pete V. Domenici (R-N.M.).
the chairman of the Senate Budget Committee during 1981-86. has affirmed
the shambles: "Deadlines are regularly
missed," "Senate rules are ignored" and
"the year's legislation is compressed into
a few major bills, each of them hundreds
of pages in length, well beyond the individual member'* ability to comprehend or
influence."
The budget process of the United States
was broken apart by the large deficits of
the 1980s, and the abandonment of budget
procedure! in turn has reduced the U.S.
budget to the status of a political football.
Indeed, the situation today is lilUe better
than a shouting match between the Administration and Congress over who is
responsible. The White House claims that
the deficit is the result of Congress' refusal
to cut domestic spending. Congress claims
that the deficit is the result of the Administration's excessive tax reduction and
defense buildup. Neither claim is truly
correct
The "triple-digit" budget deficit of the
1980s has a single major cause: the unexpected collapse of inflation. Normally.
Administrations predict better performance in reducing inflation than is achieved.
The Reagan Administration, however,
forecast worse inflation than occurred.
This threw the budget off. in terms of both
revenues and spending.
Budgets are prepared in nominal terms.
So when inflation falls below the forecast,
it costs the Treasury revenues. It also
means that spending is higher in real terms
than was intended. For example, if the
government budgets for 10% inflation and
by the end of the year inflation has fallen
to 5%. the government ends up spending
far more than intended and collecting far
less revenues than expected. Every year
that inflation is overbudgeted adds to the
deficit. Indeed, according to former Budget
Director David A. Stockman, the morerapid-than-expected decline in inflation
cost the government a lax base equal to
half of last year's gross national productrough ly (2,15 trillion.
Although it was hard on the deficit.
farmers, exporters and the energy industry, the collapse of inflation was a good
thing overall. Nevertheless, it war. an
accident in the sense that il was not pre-
dicted by anyone, including the Federal
Reserve that brought it about. The Federal
Reserve vastly overestimated the inflationary effect of the 1981 lax cut and. as a
result, overcompensated with an excessively tight monetary policy. The cost of
curing inflation faster than the Administration had planned was triple-digit budget
deficits.
The appropriate response to the deficit is
a one-year budget freeze together with
Federal Reserve support for a higher rate
of real economic growth. The combination
of a spending freeze and faster economic
growth would quickly cut the deficit and
terminate the speculation about U.S. economic credibility.
Even more important, it would end a
budget impasse ihit is now five years oldloo long for a democracy to be immobilized
by such a critical operating feature as the
annual budget The festering budget stalemate between Congress and the White
House has produced an escalation of rhetoric that is undermining peoples' confidence in government and creating concerns abroad.
The budget will cease to be a political
football the day that the government
explains to the public the effect on the
deficit of the unexpectedly quick victory
over inflation. The easiest way to put the
issue behind us is to adjust the budget to the
unanticipated change in inflation with a
one-year spending freeze. This approach
would avoid the Tight over budget shares
that has stalemated the government, and
it would pose no threat lo the Federal
Reserve's disinflationary policy or to President Reagan's tax policy. Moreover, it
would encourage Volcker to allow faster
growth by sending a signal that he would
not raise interest rates if the economy
picked up steam.
This approach also has the advantage at
being one that the public can understand
and accept. The deficit is too large to be
handled by a rearrangemenl of budget
shares. People can more easily accept the
fairness of a freeze that would not alter the
relative shares of Ihe various constituencies. Getting the deficit under control is the
best way to assure a continuation of the
defense buildup, because there is no guarantee that defense can win a fight over
budget shares or lhat higher taxes would
be allocated lo defense.
Once the politicians adjust the budget for
the disinflation, they can resume the fighi
over budget shares. But the attempt to do
both at once has overwhelmed the process
A solulion is al hand if the politicians arc
interested in making government work.
Paul Craig Roberts served as asiiilanl
secretory ol Ihe Trra<un/ during the first
Reagan Administration
THU W A L L STREET J C J L K N A L TUESIJAY, OCTOBER 28, 1SSIJ
Beneath the Twin Towers of Debt'
B> p « t. CMK. RuwjmIt is tnfh fashion [o attribute the U.S.
budget .md trade deficits tothe issi liu-reducliuii ,ici This idea, bealen mm the pubhe's tDiisntnisness by constant repelition.
Is Incurred and dangerously misleading.
Vet 111 is misinformation survives a free
press rind freely available statistics.
1" lecenl editorials, the New York
Times, tlie Washington Posl, and Ne* liepublic saw -Hie twin lowers of debi" built
thus: Huge budget deficits from Ihe loss of
revenues brought high Interest rales.
Lured uy high interest rates, foreign
money (mured into Ihe U.S.. pushmi up (he
dollar ,md IMHSHUJ Ihe trade deficit. The
dp fin is l,i Ned ui cause Ihe Inflation lha!
the Times and the fusi had predicted "because ihey were financed by borrowing
frutn abroad."
Now comes economist David D. Hale
in Uw listing* FuunialiMi's laiesl Policy
Review to misinterpret the U.S budget
deficit as "a highly expansionary fiscal
policy since 1381" and ask whether Ihe
"first experiment In global Keyneslanism"
was leadme to world depression.
Capital Inflows Fell
Notice the chronology of tne eiplanalion: Tanuis ted to budget deficits, winch
led to high interest rates, winch led to an
v&wx of Surtign tapiial. *hifh &wc? up
Ihe dollar, which gave us the trade deficit.
No* I'omij.ire this chronology ttilli (he
facts in the L'.S. Capital account liee lablel.
Note th.ii between 1982 and 1933. when
the net identified capital inflow shifted
from negative lo positive, capital luflan-s
mto toe I'.S. artoanyfell 6y W Mian. The
change in the capital account resulted
from a 171 billion fall In U.S. capital out
fluws. not from [in Increase In capital Inflows And over Ihe I9W-B* perioU-Ihe
time when Hie story of massive foreign
monej pouring Into Ihe U.S. from abroad
was firmly fixed in the country's con
sciousness by Federal Reserve chairman
Paul A. Volcker, Council of Economic Advisers chairman Martin Feldstem, budget
director David A Stockman and then echoes on IVall Street and In Ihe media- there
was mi ugnificinl ctiange In inflows ol
capital min the U.S., but capital outflows
collapsed from 1121 billion ID J21 billion, a
u
decline ol Wv Inilows Indeed have risen
*»!«• >"" lh* outflow decline U clearly Ihe
"B<n °I the large Iradc aelicll. which by
definition is a mirror Image o( the capital
surplus.
m behavior is (lie primary reason U S. cap
Hal outflows dried up. In other words, the
U.S. has a trade deficit ami became a net
capilal Importer because U S. Inflation fell
for below anyone's forecast.
dollar's rise in \t\rn iifn-e.lcil the large
deficlls and the lux cuts The ilulhr
snapped tack nt I9S1 iiJu-n its Ir.ide
weighted >,iiue run- IT, t,l(,r ns iaso
willows? A case can be made that the
short-lived business lax cut In J9B1 and the
Reagan admlnlst ration's Inflation foiccasl
compares ivtlh whal actually materialised.
fit ruse onh r.i billnui n> f;n s bilium
from 1:3 .S billnui In IM).
ralu-1982 and mid-1983 raised the afier-lax
rate of return on real investment In the
U.S. relative to the rest of the world.
Therefore. Instead ol jolng abroad, the
money stayed home and Invested In equipment and structures. In this case. Ihe dollar nee from its historic lows ol 1973-60 because the tax cuts Improved the Invest-
forecast was released in ISKI, it w.is
harshly crlliciied as dishonest lor ureilictIng tailing Inflation In the f.ice of "inllutlonary tax cuts." No one expected that actual Inflation would come In far bebw the
adralnlstra lion's forecast- least of ail tne
readers o[ Ihe New York Tunes and Wash
ington Posl editorial pages. Yet the con-
term ratpi iituve kiiirti-mi i.iie-j. itar.it
Wtnttt Uve KUHOIII> ra Vffi. \afe» ami 1*81
US. Capital Account, 19* 0-85
"Us the siur>: lor
Ugl.ilorecastufll'i
ou
([nbill«uofdcillart)
dpfUIJnfkol.U.8.
Ltm capful outflow
frwlIJ).
EauhBHIdnnUltd
uptti] bltow
me mi IM im iiu it»
|tg (83 |M
5.4%
M
111 121
60
-Z3 -28 -27
as
24
10
26
21
36
11
27
CPf has continued to
«
s IKe )
23
Eqinb n«t uplul ,
Inflow
t
a. VS.
t -* * -6
vs. 4.0%. (The
32
PliuiutMkd
dlKnpwKT t Mhcr
(inlkwi)
i™ isa. B.I>, vs.
1 B H7 1107 HID
'
'
book, "The Triumph
ol Politics." DJVid
Stockman shows that
mis uneipeciea nisnr
Nation, together with
e
ere r
jj ,*"
n
«f™
Halt: C«iip«i«nli may not »dd due to rounding
S«T« Ciaiium Dlfail^H
source of the U.S.
budget deficit. Over
men! cllnuie In the U.S., and capital isports dried up. As a suppty-sider t am
sympathetic to this case. However, i
Ironeer force Uian tax cult was operallng
on U.S. capital oulHowi.
Thai Force was Ihe unexpected collapse
n the- U.S. Inllalton tale between 1900 and
962. This collapse caused a fundamental
hange In Ihe lending practices of U.S.
Danki. Money-center banks were heavy
enders to Ihe Third World, expecting rlsng commodity prkes. such as oil and copier, to service and reuay loans. When.
Baatlon uneipeciedly collapsed, 11* bit*s
realized that Ihey had overexposed their
apltal and stopped lending. This change
nominal gross national product mas' I!, 145
trillion below lorecast, Mince budgets are
prepared In nominal lenns. the unexpected
duUnIuttfcn not only COM il« Treasury «v
cnueB. It wiped nil spending cuts Mr.
Stockman thought tie had achieved, trans
lormlng Ihe nominal cuU Into Increases in
real government spending. Curiously. Mr.
Stockman's words do not make the same
argument af his facts. After showing the
quantitative Impact on the tai base of the
unexpected dklnflallon, he blames the
budget deficit on the 1981 tax cut.
The explanation that attributes the
Iwlns lower* ot debt la the 1981 UK cut
breaks down in Its other linkages at well.
For example, high Interesl rales and the
able sign lli.it higli uiirrrsl r.itcs were
causeil by stringent motu-lfiiy policv The
federal-funds rale. aiiuitrnigJit r-iir-sd t>v
Ihe Ked, wai high.'r tli.ni the inli'ii-st inkon lime term triple A < m l"T..ti- Ij-in.li fn.ni
Ociuiier la;s in il.n HIM) tmui ticinl«T
I3S1 1(ji> loU'l 11SI .lllil llnln HiiKh IBS?
toJiuif 1SB2 III April is™ I lit liiler.il dunls
i.lT percentage points jnd in December
19W by 3.63 percenlae.e pomls. In January
19S1, when Mr. Reagan *,,i lnaugur,ih>d.
Hie gap peaked al 6.2; peii-rnldge poini..
Overall, Interesl rates pejked in 18S1 wnh
till- budget deficj) iiiirlunieeil limn IJA pre
vious year's level The limljiri deficit ap
pears li> have peaked in hsii .it three limes
the size of the 1981 delnii. nun the fedei.i]
funds rate only one third ,is lugh ds n was
in 1961.
Depending on Luck
Far Irom being an ex pension a ly hsr.il
policy. Ihe U.S. budget di'dm u ;, S|B,, ,,1
unexpected duin flat ion The few po(,,i|e
who have tried to establish the facts haie
been misinterpreted and deiided .15 saying
that "deficits don'i m.iiiei." Tlidr aieu
mem Is different. Thei are sajing that
wllhoiil a pro-xniwth pilicy. debl cannol
be serviced or ri'iluctd. luimwin; ite
prospects for the mirhl economy In ,i
choice of deflation "r ri<ll.itiun
gel out of our difficiillii's. bin if ihi-y du inn
understand how we got nilo them, a stilu
lion will deiicnd entirely on lucd. Etononnc pulley making is hopeless if facts
cannot pen tl rate public discourse
Mr ftnfifijs. an rarlu Ri'tititut JVf«.s»Fii
af/lcial. lieHs fir Swian cliair in politu at
ecwmiiy nl aeon/rlma's Ceuli-r /oi sin
Irinc nail lulnantHmal Stmlin
55
PROJECTION ON THE M'S
The CHAIRMAN. Thank you very much, Dr. Roberts.
I'm going to ask each of you to be king for a day and just give me
a number in response to the first question and not any documentation of it or any additional comment on it.
Ml grew 16 percent last year. The question is this for each of you
in turn starting with Mr. Axilrod: if you were Chairman of the
Open Market Committee with six proxies in your pocket, what
would you have established as the monetary growth for Ml, M2,
M3 for 1986, and what would you be planning for 1987, just the
numbers?
Mr. AXILROD. Mr. Chairman, I would ignore Ml for 1986 and
1987.
The CHAIRMAN. All right. What about M2?
Mr. AXILROD. For M2, the 8.5 percent top of the range that they
projected for 1987 strikes me as a tad high and I would have that
at 8 percent.
The CHAIRMAN. M3?
Mr. AXILROD. Roughly the same, with margins of error.
The CHAIRMAN. All right. Dr. Chimerine.
Dr. CHIMERINE. Mr. Chairman, I would give exactly the same
answer. I think Ml is irrelevant and I would target M2 and M3 in
the current environment somewhere in the 8 to 9 percent range.
The CHAIRMAN. All right. Mr. Heinemann?
Mr. HEINEMANN. As I indicated in my statement, Mr. Chairman,
I would target the monetary base—the Federal Reserve System's
balance sheet. Growth in the base has accelerated approximately in
the 10 to 12 percent area. My own personal preference would be to
begin a systematic process of gradually reducing that growth. I
would set a target for 1987 of between 7 and 8 percent.
The CHAIRMAN. For the monetary base?
Mr. HEINEMANN. For the monetary base.
The CHAIRMAN. You have no comment on Ml, M2 or M3?
Mr. HEINEMANN. I would pass on Ml. I think, as I indicated in
my statement, that accelerations and decelerations in M2 and M3
are primarily a function of public portfolio decisions rather than
monetary policy actions.
The CHAIRMAN. So as far as the base is concerned, you said that
it was at what level in 1986?
Mr. HEINEMANN. As an order of magnitude, I think it's about 10
percent—a little higher than that,
The CHAIRMAN. And what would be your preferred level?
Mr. HEINEMANN. For 1986?
The CHAIRMAN. Yes, sir.
Mr. HEINEMANN. I wouldn't have allowed it to accelerate at all.
The CHAIRMAN. So there would be no increase in 1986, and 1987
would be what?
Mr. HEINEMANN. The question, as I understood it, sir, was what
would I do from the present starting point.
The CHAIRMAN. No, that wasn't quite it. I want to know what
you would have done in 1986 if you had been in charge, and then
what would you do for 1987?
56
Mr. HEINEMANN. I see. For 1986,1 would not have allowed an acceleration and for 1987 I would have aimed for a moderate reduction in that growth rate from the level that would have been
achieved in 1986.
The CHAIRMAN. Thank you. Dr. Meltzer.
Dr. MELTZER. Senator Proxmire, we long ago at the Shadow Open
Market Committee gave up on the aggregates for Ml because of
the various shifts that have occurred. We have shifted to the monetary base growth rate and so I will give my statement in terms of
the monetary base growth rate.
In 1985, it was 8 percent. In 1986, it was 8.5 percent, accelerating
at the end of the year to more than 12%. I would have not allowed
the acceleration in 1986 and I would reduce the growth rate to 7
percent in 1987 on a path to return the economy toward stable
prices and not be content with 3 to 5 percent inflation.
The CHAIRMAN. Thank you very much. Dr. Roberts.
Dr. ROBERTS. Mr. Chairman, I don't quite know what's going on
here, but I find myself agreeing with Mr. Axilrod and Mr. Chimerine.
Dr. CHIMERINE. Can I retract my answer and change it?
[Laughter.]
Dr. ROBERTS. I would add to that that I would watch other things
other than money, which I believe the Federal Reserve Board is
doing. They are forced off of the strict adherence to watching the
monetary aggregates, not just because of the behavior of Ml but
the monetary aggregates don't seem to—what you would expect
from those growth rates don't seem to be manifest in the economy.
So the Fed is watching a broad range of other factors which I believe they will have to continue to do.
The CHAIRMAN. Thank you, sir.
EFFECT OF MONEY GROWTH ON THE STOCK MARKETS
Mr. Heinemann, I would like to ask you about the connection, if
any, and the extent to which there is a connection between the
recent rapid money growth and the behavior of the financial markets, particularly the stock markets.
As we all know, there's been an enormous bull market going on
all of last year and it accelerated this year. Yesterday it went up
the biggest rise in history—not the biggest percentage rise by any
means, but a big rise, 54 points on the Dow Jones in one day.
The question is, is there a relation between recent money growth
and the financial market behavior? Particularly, is there a money
growth effect on the stock market that explains the recent record
increases?
Mr. HEINEMANN. In my judgment, Mr. Chairman, there is. In my
statement I suggest that the extreme rate of liquidity creation has
played a major role in fomenting the speculative atmosphere in the
stock market.
From my own work in the market from day to day, my regular
daily contact with institutional investors, it seems to me that the
liquidity effect on stock prices is very powerful. To me, the behavior of the stock market is one of the important signals that we are
now beginning to see a shift in price expectations in this country.
57
I find it difficult to believe that we will have an increase in unit
volume in the economy which would generate a rise in profitability
sufficient to justify the rise in stock prices.
I think what the market is telling us, in effect, that investors
expect—let's put it politely—some pricing flexibility. In other
words, wider profit margins in nominal terms. Inflation is on the
way and this will help justify the kind of aggressive bidding for equities which we have seen in the recent past.
The CHAIRMAN. Thank you very much. My time is up.
Senator Bond.
Senator BOND. Thank you very much, Mr. Chairman. I consider
it quite an honor to attend my first meeting with such a distinguished group of economists, particularly those who are using only
one hand instead of the "on the one hand and on the other hand"
solution, and it is very reassuring to hear such widespread agreement.
There are a couple things that I would like to address that are
slightly off the topic of your discussions today. Mr. Axilrod, for example, one of the concerns that's been expressed to some of us by
those who oppose loosening of the restrictions on activities for
banks is that if we allow banks to get into underwriting of government securities, et cetera, that it will limit the ability of the Federal Reserve to influence monetary policy directly.
To what degree should we be concerned about that?
Mr. AXILROD. Well, Senator, if you let banks get into the underwriting of state and local revenue bonds or corporate securities, I
don't see that that will have any basic effect on the ability of the
Fed to implement monetary policy, which goes through the reserve
base, goes through some short-term markets, and indirectly
through
The CHAIRMAN. Mr. Axilrod, would you pull the microphone a
little closer? It's a little hard to hear.
Mr. AXILROD. My response was I don't think permitting banks—
if you had decided to do that and I'm not addressing that issue—to
underwrite additional securities will have any effect on the Fed's
ability to implement monetary policy, which goes through a whole
other route.
The only conceivable adverse effect on monetary policy is if expanding the securities powers of banks leads to a weakening the
structure of the banking system and if that makes the Fed reluctant to undertake the degree of tightening, for example, that might
be needed under certain situations. But if you went the route of
permitting banks to underwrite more securities, I assume you
would do it in a way that would safeguard the core payments
mechanism of the banking system relative to those banking affiliates which might be engaged in such underwriting.
Senator BOND. Thank you, sir.
I might ask Dr. Roberts, in addition to your suggestions that a
looser monetary policy might assist with problems in the farm
economy and in the Third World debtor nations, are there other
remedies which you feel should be at least sought or implemented
by the Federal Government to deal with those problems?
58
Dr. ROBERTS. First, let me say that I'm not sure that I recommended a looser policy. I was just giving many cautions against interpreting the current policy as loose and tightening it.
As for your question, yes, there are many things you can do and
I think Professor Meltzer described them and I would agree with
him wholeheartedly—his entire litany of steps that we need to take
to focus on being a productive economy and it's very difficult to
make up with monetary policy for problems which have other
causes, and I think Professor Meltzer gave a thorough litany of
what those problems were and I associate myself with most of his
suggestions.
Senator BOND. Thank you, sir.
Professor Meltzer, you indicated that we cannot continue to lend
to Third World debtor nations without increasing our debt. So
what would you do for the debt problems in the Third World?
STOP LENDING TO OTHER COUNTRIES
Dr. MELTZER. I'm glad you asked that, Senator. I think for 4
years now I've advocated a policy which, if it had been implemented in 1982 or 1983, would have put the debt problem behind us to a
much greater extent.
There are three basic steps. First, the United States should stop
lending to other countries. It should request them to exchange debt
for equity. They have assets that they can sell. If we continue to
lend to them, we sell our assets to other people so that we can lend
money to them. That doesn't seem to me to be a sensible policy for
the United States. We are no longer a creditor nation. We are a
debtor nation now.
So the first step is we to encourage them to exchange debt for
equity.
Many of the governments are very concerned about of patrimony. As a second step, we should encourage them to adopt policies
that will repatriate their own capital so they will sell assets and
equity to their own citizens.
Now that isn't just a hope. We have experience with Chile and
now with Mexico. We have seen that that policy can work if the
local government wishes to make it work.
The third step that I have urged in the past and would urge now
is that exchanges of debt for equity be made at the market value of
the debt. This Committee could assist a great deal if it would tell
the banks that when they make those exchanges they don't have to
mark all the rest of their portfolio to market. That would encourage some steps in that direction.
But the committee could also work to encourage that policy by
leaning very hard on the regultors to see that that becomes the
policy of the United States Government.
Senator BOND. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Bond.
Senator Shelby.
Senator SHELBY. Thank you, Mr. Chairman.
In some of your testimony I think several of you touched on the
accommodative growth of the Fed as far as the monetary policy is
concerned, some of it being judged prudent to now. But how much
59
longer can we go on in an accommodative stance—that is, there's a
lot of money out there and the stock market some people think is
an example of it now—before inflation really turns the corner on
us?
Mr. CHIMERINE. Can I take a crack at that, Senator?
Senator SHELBY. Yes, sir.
Mr. CHIMERINE. I don't think anybody can give you a precise
answer. It's a matter of evaluating the relative risks and right now,
in my view, the risks of a higher interest rate led downturn in the
U.S. economy, perhaps spreading to the rest of the world, is so
large, and so far exceeds the risks of some more inflation, that I
think slowing money growth dramatically is premature at best.
I wish I could tell you the exact time when we will be able to do
that, but I can't. And, of course, the problem has been made more
difficult by large budget deficits because the Federal Reserve is
going to be under constant pressure to be accommodative in order
to finance these deficits until they are reduced—not only because
of the direct pressure on credit markets, but as you know, now that
interest expense has become such a large item in the Federal
budget, higher interest rates are just going to make future deficits
even worse if they come about.
So to answer your question, I can't give you an exact answer, but
I think we are not at that point yet.
Senator SHELBY. And does that also go because of the international debt situation?
CONSUMER DEBT
Mr. CHIMERINE. Yes. Not only the international debt situation,
but even the domestic debt situation. I'm not sure whether it was
touched upon before.
Senator SHELBY. Consumer debt?
Mr. CHIMERINE. Yes. We've had good growth in domestic demand
in this country in recent years, but a lot of it has been financed by
debt. However, demand is slowing dramatically. There is evidence
that the high-debt burden is causing that slowdown, on top of stagnant real income growth and so forth. And higher interest rates
would aggravate these problems and could dramatically slow the
economy further, in my judgment.
Senator SHELBY. Your look at things as you're discussing now, as
I read you, then the economy is not doing nearly as well as a lot of
people say it is, if you look at the underpinnings of it?
Mr. CHIMERINE. I agree completely. I think the underlying fundamentals are mixed at best and, in fact, there is more reason to be
concerned about the long-term health of the U.S. economy now
than there probably has been in a number of years. Quite frankly,
as I think most of us said here earlier, the conditions which existed
20 and 30 years ago which permitted us to significantly improve
living standards in this country no longer exist.
Second, we've borrowed from the future by going deeper and
deeper into debt and we can't keep doing that.
Third, these large budget deficits have now become counterproductive. All of their factors are going to limit economic growth in
the future and if monetary policy is tightened, and aggravates
60
those problems, we could have a very, very serious economic downturn.
Dr. MELTZER. Senator Shelby, may I respond to that also?
Senator SHELBY. Yes, sir.
Dr. MELTZER. I would like to give a different answer. First, The
long record of experience is that we cannot prevent a recession by
faster money growth. What we can do is postpone recessions, only
to create a bigger recessions later. That's what we did in the 197Q's.
"We printed money faster. We postponed the recession. We had a
really ripsnorting recession because we had a high rate of inflation
that the public wanted to end.
So the question is not, can you prevent recessions? The answer to
that is, no, you cannot prevent them. You may be able to postpone
one temporarily.
Second, I would like to ask: What are people betting on? The
whole policy of this administration and the Federal Reserve is to
devalue the dollar. That policy can only work by raising prices of
imported goods relative to wages. If it raises wages as fast as it
raises prices, then the policy will fail. All we will get is a nominal
devaluation. We will not get a permanent solution to our trade
problem.
Our policy can only work by raising prices. I believe that there
are better policies available, as I've said.
Mr. HEINEMANN. Senator, the inflation rate as currently reported is very low and many people believe that inflation will continue
to be very low. However, I think there are numerous signs of incipient price pressures, including most particularly the sharp increase
in prices of imported products other than oil.
I think quite apart from what expectations are in this country,
foreign investors who are the critical suppliers of funds to the U.S.
economy now, are concerned about the inflationary potential in
U.S. monetary policy. They are becoming increasingly reluctant to
lend us money at prices we can afford to pay.
We are holding down the short-term interest rate at the present
time, but only at the cost of a progressive acceleration in money
growth. We are putting more and more money in. We're like a
drug addict. We have to have a bigger fix every time in order to
satisfy ourselves.
Senator SHELBY. Dr. Roberts, did you want to comment?
Dr. ROBERTS. Yes, Senator- I want to address this question about
stock market behavior of foreigners.
I believe it's correct that foreign buying of U.S. equities or stocks
is now at an all-time high. It has been accelerating since the
second quarter of 1985. Prior to the weakening of the dollar, foreigners were net sellers of stocks. As the dollar has weakened,
their purchases of U.S. equities have reached an all-time high.
I think this is one of the reasons for the stock market's performance. Another I think is since about 1984, you have had over $200
billion of equities disappear off the market due to leveraged
buyouts, mergers and repurchases, and a third factor that's driving
the market I think is the tax reform.
As I testified at the time, one powerful impact of the tax reform
that I was concerned about was to give a windfall gain to all exist-
61
ing capital. When you cut the tax rates across the board, you give a
windfall gain to the existing capital stock.
What you see going on is the stock market repricing assets to reflect that windfall gain.
I think in view of these three factors it would be dangerous to
assume that the rise in the stock market is a reflection of the Fed
pumping out huge quantities of money.
I wouldn't want to deny that the Fed pumping out money could
cause the stock market to go up, but I think here we have three
very clearcut real factors that are causing the stock market to rise.
Senator SHELBY. My time is up. Mr. Chairman, thank you.
The CHAIRMAN. Mr. Axilrod didn't get a chance to respond to
your last question.
Senator SHELBY. I would like for him to respond. I appreciate the
chairman's indulgence.
Mr. AXILROD. Thank you, Mr. Chairman.
I think if you evaluate the monetary aggregates, you certainly
shouldn't evaluate them in isolation. In the 1970's, when the monetary aggregates were contributing to inflation, much of that inflation starting in a way from oil price increases, but the monetary
aggregates contributed and helped sustain it. You will also find
that at the time the level of real interest rates was close to zero.
That is, the nominal short-term interest rate and the rate of inflation were moving together. There were no real costs to stop people
from borrowing.
In the 1980's, we've had a very sharp growth in the monetary aggregates. I suspect in terms of Ml, much more than in the 1970's.
The reason that hasn't contributed to inflation—there are a lot of
reasons, but one very good reason—is that the level of real shortterm interest rates has been relatively high. Because of that, I
would not call Federal Reserve policy totally accommodative. It has
been accommodative, but I think there has been a residual degree
of restraint in that policy and that residual degree of restraint has
kept the rate of inflation from accelerating and has kept the unemployment rate in this country above what we like to think as
normal.
Still, there hasn't been enough restraint to get the inflation rate
down further.
Senator SHELBY. It's been balanced up to now, but will it stay
that way?
Mr. AXILROD. Well, no one can really foretell the future with
great certainty. The only obvious source of inflation at the moment
is the drop in the dollar, and that will become more obvious if
there's a very sharp drop in the dollar.
The budget deficit looks like it's coming under control. If the
people are disappointed in that, that would be another factor causing a change in inflation expectations.
Thus far, unit labor costs in our industry have been held down.
It was only a 2.25-percent increase last year, so it was very low. If
that is sustained, we have relatively little reason to fear a burst of
inflation except out of a sharp drop in the dollar, unless the oil
cartel has got a lot more power in it than I think.
Senator SHELBY. Thank you.
The CHAIRMAN. Senator Graham.
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THIRD WORLD DEBT
Senator GRAHAM. Dr. Meltzer, you were listing three steps that
you felt we should take in order to deal with the Third World debt.
The last of those related to pricing the trade of debt for equity at
market rates.
Could you elaborate on that and what specific policies you would
see as necessary in order to accomplish that?
Dr. MELTZER. Well, the debt is being traded. There is a secondary
market. It's not a very strong market, but from inquiries among
people who are making these transactions, in the banks and so on,
even quite sizable transactions are made not far from the quoted
prices.
To give an example, Mexican debt sells in the marketplace at
about 60 cents or 65 cents on the dollar, depending upon what the
prospects are. Brazilian debt was selling for somewhat higher until
very recently when it may have fallen. Argentina would sell somewhere like Mexico.
A person who wants to invest in Mexico—for example, suppose a
Mexican citizen who has sent his capital to the United States and
has it invested in the United States market or in some foreign
market, would like to repatriate part now. He goes to a bank and
buys back the debt at the market price of the debt, brings it into
Mexico and gets something close to the full face value in exchange.
He makes a very large gain which gives him a great incentive to
repatriate some of his capital.
What the transaction achieves is to reduce the debt from the
$100 billion range, in the case of Mexico or Brazil, and gradually
reduces the outstanding amount.
It's my estimate—a conservative estimate I believe— that if we
did something on the order of 2 to 3 percent of the debt in swaps
every year we could have that problem manageable at the end of 5
to 6 years, with a little bit of good fortune.
What needs to be done? One of the things—by no means the only
one—one of the things which inhibits those transactions is that
under the current regulations banks believe that they have to
mark to market all of the debt on their books and report the losses.
Since they sell the debt at 60 cents on the dollar, they might have
to report a loss of 40 percent of their debt on all of their holdings if
they in fact made that transaction.
So a lot of the transactions are being made not by using U.S.
banking-owned debt but buying debt from, say, Arab banks or
Third World banks and exchanging those debts for equity. I think
we would be well advised to consider the policy of trying to not
have mark to market all of those debts to encourage and facilitate
this exchange of debt for equity.
The other thing that we need to do is that we need to lean on the
U.S. Government to push a policy of exchanges as an alternative to
increases in World Bank quotas or increases in IMF quotas and
more lending. What we need to do is encourage our Government to
get out of the lending business, stop lending U.S. dollars to those
countries, to encourage them to solve that problem through the
marketplace in the way in which I have suggested.
63
Senator GRAHAM. Dr. Roberts, you referred to the importance of
the expanding world economy as one of the keys to dealing with
the concerns that you had outlined.
What would be your comments on Dr. Meltzer's proposal as it relates to a means of handling Third World debt and the impact of
that accommodation on general world economic expansion?
Dr. ROBERTS. I think, Senator, that it's clear that it would certainly help because it's very difficult for these countries to import
when they can't service their debt. So I think to sell it at its
market value is a good idea. It may put some hardship on the
banks, but I generally favor and have proposed the same type of
solution as Professor Meltzer.
I think it might also help if some of the G~5 trading partners
also look to the world growth rate and be sure they don't act in
ways that would curtail it. If our trading partners are too tight in
their exercise of policy, then we can't hardly make up the whole
difference.
Senator GRAHAM. No further questions.
The CHAIRMAN. Mr. Heinemann, I am concerned about the synergy here, the combination of expansive fiscal policy and expansive
monetary policy. We have been discussing so far primarily expansive monetary policy. It seems to me that they work together and,
together, they create a situation which in spite of the very thorough and able way that Mr. Chimerine described the deflationary
aspects in the economy or the antiinflationary aspects, that here is
something that over time and over a relatively short time is likely
to give us a tremendous inflation—worse than many people have
expected or talked about our having.
Plus the fact, there's one other element you may want to comment on, and that is the monetary policy contributes to the deficit
in quite a different way than I think Dr. Roberts and Mr. Chimerine described it in my view.
What monetary policy has done is to hold down interest rates
temporarily in the short run and, therefore, put less pressure on
the Congress and the administration to take the kind of action that
we should take to cut the deficit.
What's your reaction to those two observations?
INFLATIONARY POTENTIAL MONETARY POLICY
Mr. HEINEMANN. Senator, I have tried to emphasize in my statement and in my oral remarks the concern I have about the inflationary potential in current monetary policy.
I wonder if we will actually reach the point, though, of seeing a
runaway reacceleration of inflation in the near future. I do doubt
that. I think a substantially faster rate of change in prices is likely,
but a runaway inflation in the near future I think is improbable
for a whole host of reasons, many of them technical.
But most importantly, I suspect that the process of progressive
acceleration in money growth which is going on will bring the process to an end a lot sooner than we may now expect. Foreign investors have concerns about what we're doing in our monetary policy.
64
Bank reserve growth averaged 10.6 percent in 1984, 13.6 in 1985,
20.4 last year. It was much faster than that at the end of the year.
These are average month-to-month changes.
As I indicated, in the last few months, reserve growth has been
running over 30 percent in the context of slight increases in shortterm rates.
It strikes me this is a process which is starting to run out of control. I do strongly believe that rates are being held down through
progressive injections of liquidity. I am concerned that this boom in
money growth, which will come to an end like all booms—it's a
spike up and it will come down just the same way—when that happens, if it comes down from a very high level, we can have very
serious real shock effects on the economy.
I don't think we are going to get a major new inflation in the
immediate future, but the potential is there and financial markets
are already giving us fair warning that the time we have left to
correct policies is limited.
For an equally large number of reasons, I feel that we have
made a fundamental political mistake in being unwilling to impose
sufficient explicit taxes to pay for the Government services that we
want to consume. I think it's very hard for taxpayers to decide how
big they want the Government to be if they don't really understand
currently how much it's going to cost
I don't view the fiscal policy actions of last year as a net tax reduction. We shifted the incidence of explicit taxation from the individual to the corporation. I don't quite understand how that leads
to a revaluation of corporate assets. It does seem to me that the
total tax burden that the economy will have to bear over time has
gone up because Government is bigger today than it was at earlier
times.
Adjusted for the stage in the business cycle, Federal spending is
about 2 percentage points higher today than it was in the last business cycle at a comparable point. Government is much bigger today
than it used to be and, therefore, the total explicit and implicit real
tax burden is higher—not lower.
I think that it will be difficult to get a political consensus on reducing the size of Government, assuming that's what we want to
do, until we really understand what government costs.
The CHAIRMAN. Thank you very much, Mr. Heinemann.
I should have announced when I started, but since there are
three of us questioning now we will go to a 10-minute questioning
period and that leaves me with about 6 minutes.
Now, Mr. Axilrod, are you comfortable with a 23-percent increase in monetary reserves, the base reported by Mr. Heinemann;
and as one of the world's leading monetary policy experts, can you
tell us unambiguously that we should not be concerned about inflation?
Mr. AXILROD. I am not uncomfortable with that 23 percent. To
explain why, can I give you an example, if you'll bear with me for
just a second, through a simplified example.
Suppose there were two assets in the world. One was a long-term
bond and one was a deposit that bore interest and was subject to
reserve requirements. Suppose at the beginning that deposit had a
5-percent interest rate and the long-term bond had a 10-percent in-
terest rate. Then most people would be investing their money in
the bond.
But for one reason or another, suppose the yield on that bond
dropped to 6 percent and the yield on the deposit dropped only to
4.5 percent, so that the spread became much narrower. Then a lot
of people who don't like the risk of price fluctuations in the bond
would say:
Well, it's not worth my while to keep my money in that bond. I'll keep it in that
deposit where I can get 4.5 percent and I'm not subject to big price risks.
Now to support the money that is shifted to deposits, since they
are subject to reserve requirements, the Federal Reserve has got to
provide the reserves. You might very well get a 23-percent expansion in reserves at that point. The expansion is merely to accommodate the public's desire to hold that money there.
That would be, in a way, a passive role for the Federal Reserve.
The active role would be for the Federal Reserve, willy-nilly to
push that 23-percent increase out. Then, of course, it would be forcing money on the public that they didn't want; as a result, the
public would probably try to spend it, with inflationary potential.
So the answer to the question you raise depends on a judgment
about whether the public does or does not want to hold the deposits
supported by reserves as part of their longer run savings, and
whether the Fed is being passive or active in adding to bank reserves.
I feel relatively comfortable that we have a more passive attitude
on the part of the Federal Reserve in relation to Ml and currency,
which is the main component of the base, and that it's not an inflation-creating attitude. I think it's not inconceivable we will have an
inflation ahead, but I suspect if it comes it's going to come really
from a drop in the dollar far beyond what the fundamentals call
for and that is caused by loss of confidence.
The CHAIRMAN. You do that on the basis of the distinction between passive and willy-nilly?
Mr. AXILHOD. Well, I'm trying to put it in terms that are readily
understandable.
The CHAIRMAN. Dr. Meltzer.
Dr. MELTZER. I would say, Mr. Chairman, that one wants to be
cautious about that argument. The argument that the Federal Reserve should meet the demand for money because people want to
hold it is not very different—in fact, very similar—to the argument
that was made by the German central bank in the 1920's when
they bought additional printing presses because there was such a
large demand for currency.
I don't see signs of a large increase in the demand for money in
the United States.
I believe that the other interpretation, the more dangerous interpretation, is the more reasonable interpretation of current events.
And I say that because what we have seen is two things which
should warn us. One is that short-term interest rates, as Mr. Heinemann pointed out in his statement, have been rising despite massive money growth.
Second, we have seen a fairly substantial devaluation of the
dollar in a relatively weak world economy. That is, not a weak U.S.
66
economy, but a weak world economy. That's a sign that a good part
of that devaluation is very likely to be nominal, not real, and the
result of too much money being produced.
Dr. CHIMERINE. Mr. Chairman, can I answer that?
The CHAIRMAN. Go right ahead, sir. I have a question for you,
but go right ahead.
Dr. CHIMERINE. Why don't you ask your question and I'll try to
address both together.
The CHAIRMAN. All right. On page 14 of your testimony you say:
The corporate sector is especially more vulnerable to an economic slowdown, or
higher interest rates, because it has not only been adding debt at record levels, but
it has also been redeeming equity since 1984, making it more leveraged.
That's one reason you call on page 16 for a more accommodative
monetary posture in the near term.
My question is, is the hostile takeover phenomenon, in your
view, one of the reasons for the increasing corporate debt?
CORPORATE DEBT
Dr. CHIMERINE. Yes, without question, I think it has accounted
for a sizable part of the increase in corporate debt, but there are
other reasons corporate debt has risen as well.
The CHAIRMAN. Of course, there are, but is it substantial, and to
the extent that there are
Dr. CHIMERINE. It is a substantial part of the rise in corporate
debt, but the point is is this, Mr. Chairman, it still has to be financed and a significant number of our clients, for example, are
telling us that one of the reasons they are trimming their capital
spending budgets is because of the increased difficulty they are
having servicing that debt. So there are costs to it. It doesn't come
free, and my concern is that it is going to work at the expense of
near-term economic activity. And as I said earlier, I don't think the
Fed can stimulate the economy very much, but my concern is, if
they tighten on top of these factors, we have the chance of seeing a
sizable downturn.
If I might quickly make quick reference to a few of your other
comments. First of all, with respect to fiscal policy, well, I think
you are well aware of my concerns regarding the federal deficit for
many years. We are now paying a price for them. Nonetheless, as
we cut these deficits, we are implementing somewhat restrictive
fiscal policies in the near term.
So in the near term, it is a drag on the economy.
Second, as Steve Axilrod and I mentioned earlier, I haven't found
too many farmers or steel companies or energy producers who
think interest rates are low right now. For a large segment of the
borrowing population, particularly, the manufacturing sector and
the commodity producers, real interest rates are still very high. So,
from that perspective, monetary policy has not been extremely
loose and easy and inflationary, and when you have real interest
rates at the levels we have had in recent years.
Third, if we had managed the economy based on the rapid
growth in Ml in recent years, and tried to clamp down on Ml
growth, as many people argued, we would be in a severe recession
right now. You can't go back now and say, "Well, you're right, but
67
now let's focus on reserves, or on M2 or M3." I think some of the
monetarists are doing exactly what they accuse the Federal Reserve of doing in this respect.
The truth of the matter is that the money numbers and the reserve numbers are distorted by enormous shifts in deposits, and by
rising import penetration—the demand for credit is increased just
as much from imports as from domestic purchases but they don't
show up in domestic GNP and, therefore, the velocity declines. The
Ml numbers are just not useful.
Finally, the correlation between Ml and inflation has been enormously overstated, even before the technical factors began impacting Ml. The correlation is not anywhere near as close as some
people suggest. The relationship depends on underlying conditions—such as enormous overcapacity, wage restraints, high unemployement, weak commodity prices. Thus, even with the weaker
dollar, and while admittedly, we have to be concerned about the
potential down the road, I don't see how anyone can make now, a
valid argument for tightening significantly now, because we also
have to be concerned about slow growth, high unemployment, LDC
debt and all the other things we've talked about. And it is a matter
of balance.
Last point, about the dollar. The dollar is coming down, because
we have large and unsustainable trade deficits, and it is going to
come down regardless of whether we tighten money growth or
loosen money growth a little bit. The trade deficit is why the dollar
is coming down, and it will continue to come down. As for the
recent increase in interest rates, financial markets now play a
guessing game with the Fed, and for a while the markets expected
additional easing by the Fed. Recently, because of some recent
strange statistics and because the dollar is coming down, they are
questioning whether the Fed will ease, and as a result, interest
rates have backed up a little bit.
I don't think you can attribute the small increase in short-term
rates last week, to the fact that all of a sudden, the financial markets have gotten worried about the growth in Ml.
Dr. MELTZER. But it isn't last week. It's over the last 6 months.
Dr. CHIMERINE. Oh, it is not over the last 6 months.
The CHAIRMAN. Mr. Chimerine, I vigorously disagree with you,
but my time is up, and Senator Heinz now has 10 minutes.
Dr. CHIMERINE. Good. I'm glad. [Laughter.]
Senator HEINZ. I note from the almost, but not quite, unanimity
of the panel [laughter] the age-old adage that if you took all the
economists in the world and laid them end to end, they would not
come to a conclusion is still true.
Mr. ROBERTS. They will come to a whole bunch of different ones.
Dr. CHIMERINE. That seems to be true of Congress, as well, these
days.
Senator HEINZ. Different ones, yes.
I am particularly pleased to see that my two Pennsylvania constituents, Alan Meltzer and Lawrence Chimerine are still at opposite ends of the conclusion from time to time. You've got to make it
interesting for us, but it is good to see you, even if you give me conflicting advice.
J-CURVE
I want to ask a question about the J-curve, about trade, and
about the dollar. There are a lot of people, principally those in the
administration, who are saying the dollar has softened, a few other
currencies have strengthened, the mass of the currencies relative
to the dollar has strengthened and just wait, the solution to the
trade deficit problem is just around the corner. In their view, we
haven't quite yet hit the bottom of the J, but as soon as we do, it is
going to shoot right up into a big lovely capital letter like we want.
Is there any evidence that that is true? Who wants to take a
crack at that?
Dr. CHIMERINE. Well, I will, Senator. I think the best we can say
so far is that the trade deficit seems to have stabilized. It has been
very erratic on a monthly basis, but if you take the laset 3, 4, or 5
months on average, it looks like it has peaked out when you measure it in nominal terms. If you look at it on a real basis, it looks as
of the deficit has started to decline sharply.
We've got some anecdotal evidence in support of that. We have
seen an increase in export in a number of industries, particularly
chemicals, paper, some of the other industries that compete previously against Europe, where we have now become much more competitive, and where labor cost differentials aren't very important.
Senator HEINZ. You are something of a guarded optimist, that in
fact, first, the J curve exists and second, we are somewhere down
there.
Dr. CHIMERINE. Yes.
Senator HEINZ. But where you are guarded is that your not so
sure that the J isn't lying on its side. [Laughter.]
Dr. CHIMERINE. No, where I am most guarded, Senator, is that I
think the turnaround will be modest, partly of the J curve, partly
because for other reasons. And second, that doesn't mean the economy will grow more rapidly. I think the improvement in the trade
deficit will come at the expense of domestic demand.
Senator HEINZ. Does anybody either have a more pessimistic or
more optimistic view?
NEED TO BE PATIENT
Mr. AXILROD. I have a view. I am not sure how you would describe it as pessimistic or optimistic. I think we are moving in the
right direction. I think the worst thing that we could do is lose patience and seek a rapid solution to the trade problem, either
through protectionism, which has very obvious structural difficulties or other attitudes. Those other attitudes could get reflected, if
the world loses patience, or thinks we are losing patience, in a very
sharp drop in the dollar. It could be sharp enough to get the trade
deficit improving rapidly, but I think the other repercussions of
that, the inflationary repercussions of that, the fact that a rapid
improvement might come before our fiscal deficit is under control,
would mean the great risk of inflation followed by recession.
So I believe the best thing we can have is a degree of patience.
Thus far, the world is interested in putting its money in the United
States, and I can see no reason why it shouldn't, unless they sense
we are losing patience.
69
Dr. MELTZER. Senator, may I say one thing?
Senator HEINZ. Yes.
Dr. MELTZER. Incidentally, it is very good to see you again, sir.
I think we have to distinguish two things between real devaluation and nominal devaluation. Nominal devaluation may have
some advantage to us short term, but it is the real devaluation that
has to carry the ball to keep the trade problem under control for
the long term. I am optimistic that the trade deficit has turned. I
think we need to do considerably more to get us back to some kind
of reasonable position, where we are not pouring out debt. And I
believe what we need to do is much more to boost production in
this country by productivity-enhancing measures and to reduce
consumption.
Senator HEINZ. My question to you is this. How can the trade
deficit ever do anything much more than stabilize, as long as most
of the world's economies either are at or moving toward mercantilism? That is what we face in Latin American and the East Asian
economies. And we all know what a mercantilist economy is. It is a
one-way street.
Dr. CHIMERINE. Senator, I share your concern, and I think this is
one of the reasons the turnaround will be modest. We are beginning to see sharp declines in investment in a number of countries,
especially some of the large industrialized countries, because their
export industries are experiencing a profit squeeze. And historically, capital goods have been our stronger export sector along with
agricultural products. Furthermore, Mexico is still in terrible
shape. It is very hard to export anything into Mexico, and now
OPEC has been cutting back in their imports from the United
States as well. This gets back to the issue of evaluating monetary
policy in the insist of the underlying environment, because you are
absolutely right, our ability to improve our trade deficit through
faster export growth is being limited by weakness elsewhere.
That probably means that we are going to get more declines in
the dollar, and higher import prices, because a larger fraction of
the adjustment is going to have to come on the import side.
Dr. MELTZER. Senator, that leads us in the wrong direction.
Whatever may be going on in the world, we are moving in the
wrong direction, if we, in fact, joint them in a policy of mercantilism.
Senator HEINZ. Oh, I agree.
Dr. MELTZER. That is going to make the problem much harder for
us.
Senator HEINZ. I don't think there is a lot of support, I hope, for
mercantilism in the United States.
Dr. MELTZER. I hope that is right.
Senator HEINZ. I hope we are opposed to it, although it did wonders for us back in the 1890's. We were small, and, like other small
countries are now, we could get away with it. In addition, it also
built our steel industry.
Let me ask this, to bring this subject back to monetary policy
and the Federal Reserve's policies.
At some point, a dollar that continues to drop creates, as we all
know, inflationary pressures that become very powerful. How close
are we to hitting that kind of sound barrier? How close are we
70
coming to the drop of the dollar that will reignite inflation? It certainly did do that back in 1977-78.
Dr. MELTZER. Too close. Too close. That policy can only work,
Senator—the only way our policy can work is by raising prices relative to cost or production. That is what the policy of devaluation
is. So it not possible to have one without the other.
Senator HEINZ. Let me, for the sake of argument, assume Alan
Meltzer is right. We know he is right, but let's assume
Dr. MELTZER. Thank you.
Senator HEINZ [continuing]. On his evaluation, that we are getting close to the inflation reignition point.
Let me ask Mr. Heinemann, who's been smart. He's been very
quiet. Mr. Heinemann, if you were at the Federal Reserve, if you
were czar of the Reserve, and you saw inflation igniting or if you
saw us about to get there, what would you do? Would you tighten
monetary policy? Would you loosen it? What would you do regarding interest rates?
Mr. HEINEMANN. One of my colleagues on the Shadow Open
Market Committee and a former constituent of yours, Dr. Jerry
Jordan, has promulgated one of the basic laws of economics. And
Jordan's law is that the only way to prevent a hangover is not to
get drunk. I think that is the only effective way to deal with the
long-run inflation problem. We already see prices of imported products at the wholesale level, other than oil, rising more than 8 percent, the increase year
on year in the year ended September 1986
was actually about 101A percent.
RISE ON IMPORT PRICES
I would anticipate we will get some further acceleration in prices
of imported products. Imported products, as you know, constitute
almost a third of the goods sector of the American economy. I believe that the policy that we are following will produce its intended
result. As Dr. Meltzer said, this is a higher rate of domestic inflation in the United States. That is what the policy is designed to do.
As far as the J curve effects that you made reference to, I fully
share your concerns about mercantilism in this country or anywhere else. In the very short run, we've got to remember that the
dollar has been extraordinarily volatile. It went up sharply and has
come down sharply. So I suspect we are seeing in the marketplace
some echo effects of the past rise as well of the current decline.
My friend and colleague in New York, Larry Viet of Brown
Brothers, Harriman, has observed that we have an overlapping J
curve effect in the market today. The echo effects of the previous
overvaluation probably still influence the data. When you look at
the trade data in real terms and exclude oil—which, of course, is a
dollar-quoted commodity and would not be expected to respond in
the short run to changes in the external value of the dollar—the
trade deficit, the non-oil merchandise trade deficit in real terms
seems to have hit bottom in the second quarter of 1986. Both the
third and the fourth quarter were modestly better.
I fully recognize that many parts of the world are showing signs
of sluggish economic growth. But my sense is that the powerhouses
of American industry, the GE's, for example, are becoming quite
71
successful in taking market share away from their competitors in
Japan and in EEC.
GE has had a sensational performance in the recent past. I
happen to be a small stockholder. I am very pleased about that. Hitachi, a counterpart in Japan, is not doing well. They have cut executive salaries across-the-board not very many months ago.
I think this is a good metaphor for the kind of momentum which,
in the short run, is beginning to build up in the trade sector. So I
suppose I think we are going to get a good deal for more short-run
improvement in our trade numbers than Dr. Chimerine suggests.
Senator HEINZ. Mr. Chairman, my time has expired. I just ask
unanimous consent that my opening statement be put in the
record.
The CHAIRMAN. Without objection.
STATEMENT OF SENATOR JOHN HEINZ
Mr. Chairman, I would like to join you in welcoming our distinguished panel of witnesses today, in particular, Dr. Meltzer and Dr.
Chimerine, who are located in the State of Pennsylvania. I look forward to hearing their testimony today on the state of the economy
and monetary policy.
At first glance, January's economic statistics reveal surprising
strength despite the recent turnaround in oil prices, and reflect a
reduced likelihood of a sharp slowdown in U.S. Economic activity.
For example, both the producer price index and industrial production rate increased nearly one-half of 1 percent last month. January also experienced solid gains in aggregate employment of
448,000 net new jobs, with a concomitant rise in overall personal
income levels of 0.6 percent.
In addition, the U.S. trade deficit declined in December to $10.7
billion, down from November's deficit of $15.4 billion. This is the
smallest trade gap since the $8.1 billion deficit of March 1985. The
improvement was due in large part to the substantial decline of the
dollar and the associated changes in relative prices for internationally traded goods, resulting in nearly a 25-percent drop in imports.
These are positive economic signs. In fact, they may portend
better economic activity, as well as improved industrial competitiveness. This is especially true for the domestic manufacturing
sector who may be able to recapture two lost markets, the domestic
and foreign.
Despite these indicators, there are other factors which concern
me. For example, the healthy gains in production in the last 3
months, together with modest sales gains, have not led to surplus
inventories. Automobile sales and housing starts declined last
month. While the decline in these sectors may be attributable to
the tax reform legislation of last year, the drop-off may also reflect
other problems in these sectors. Finally, the consumer price index
has risen 0.5 percent in the last 2 months, revealing the risk of inflationary pressures.
Clearly, Mr. Chairman, we are at a crossroads in terms of the
country's economic and financial condition. Fed policy to cut dramatically the short-term interest rates last year as well as better
factory activity and production performance have diminished the
72
recession risk. A softer pace in spending and the decline of the
dollar have lessened the trade deficit. However, we still have a distance to go before the economy is in balance.
The dollar must decline substantially, even from its current
lower level, in order to bring U.S. imports and exports back into
balance and to reduce our dependence on the inflow of foreign capital. While recognizing that the lower dollar is depressing the Japanese and German economies, we must continue to encourage their
policymakers to provide the offsetting fiscal stimulus. This, in turn,
will reduce the need for foreign capital inflows into the United
States.
Finally, and not to be ignored in this education, Mr. Chairman, it
is incumbent upon us to establish policies to reduce the budget deficit. Any meaningful trade deficit reduction will be offset in the absence of a commensurate budget deficit reduction, no matter how
far the dollar falls.
The CHAIRMAN. Before I call on Senator Riegle, let me just say,
John, I appreciated your remark about how the way to never have
a hangover is not to get drunk, but that is only one way. There is
another way that I am afraid some of the panelists are moving in
the direction of, and that is, the way to never have a hangover is
never get sober. [Laughter.]
You know, the hair of the dog that bit ya. That is, unfortunately
a common attribute to many people in this field. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
I want to say to the panelists, that I am delighted that you are
here today, and I want to study carefully what you have had to say
to us. The Senate Finance Committee is also meeting this morning
on the revenue aspects of the budget request by the administration,
so as a member of that committee, I have been involved in that.
And I have just had the head of a major manufacturing company
in my State come by to talk about the urgency of the trade situation, a person well known to everybody in the room, who feels that
more is going to have to be done before we can have a very happy
or sanguine sense as to the future, notwithstanding your comments, Mr. Heinemann, about feeling a little bit better as a small
shareholder of GE these days.
NO. 1 DEBTOR NATION
Let me ask this question. We have become the No. 1 debtor
nation, and we have done it in a very short space of time. I have a
chart that I take around with me to illustrate on a scale graph
what it looks like, but the rate of descent from a creditor nation to
a debtor nation looks just like the Air Mexico plane looked after its
tail was sheared off and an amateur photographer took a picture of
it, as it was headed for the ground. That is what that curve looks
like, when you put it on a graph scale.
We are adding to the net international debt at the rate of about
$1 billion every 2 l/z days.
Now maybe we have got sort of a miracle turnaround coming in
the trade account, but I must tell you, I don't see it, not just from
the Michigan point of view, I just don't see it in the numbers. Now
maybe it will be there, but I can recall hearing that a year ago
73
from people who thought that it was coming, and then lo and
behold, even though the dollar fell versus the yen and the mark,
not much happened. In fact, what did happen was the wrong thing.
The trade deficit with Japan went up substantially, though the
dollar was down. Now maybe these reduced salaries at Hitachi and
other places or the firm that you mentioned will start to make a
difference, but we haven't seen that yet.
My question is this: The New York Federal Reserve Board has
now estimated that we are going to owe the rest of the world
roughly $1 trillion by 1990. That is their operational estimate, the
most recent one that I am familiar with.
Help me size that. What does that mean, in terms of future economic prospects? Can we tolerate a buildup over that period of
time of debtor nation status of $1 trillion? Can it go to $2 trillion?
If we went from $1 trillion to $2 trillion over a 3- or a 5-year
period, does it make any real difference? Can we continue to feel
that all the foreign money that is coming to us now that is paying
for all the debt that we are incurring; public, private, individual,
corporate, will continue to be available, or are we reaching some
kind of outer bound of these trend lines that ought to cause us to
say to ourselves that we've got a very serious international balance
sheet problem?
That is really my question. Do we or don't we? And if we don't
now, are these rates of change in these trend lines taking us to
that point where we'd better treat it as an urgent matter?
Let me start with you, Dr. Chimerine. You seem ready to respond.
Dr. CHIMERINE. Yes. I think the answer to that question, Senator—and by the way I just notice that I think we have scared away
all the newly elected Senators, Mr. Chairman. I hope that after sitting through this hearing, they haven't had second thoughts.
[Laughter.]
But anyway, I think the answer really has two parts to it. First,
how much are they willing to lend to us? At some point, they may
be unwilling to lend us increasing amounts of money as they have,
unless we push up our interest rates to make it more attractive for
them. So that is the first question.
Second, even if they are willing, even if we can continue to add
to our foreign debt at $100 billion or $150 billion a year, that
money is not coming free. If that $1 trillion estimate by the end of
the decade is right, we are going to be seeing something in the
range of $80 billion to $100 billion a year of interest and dividends
leaving the country, just getting sucked out of the income structure
in this country.
So one way or another, it is going to reduce future living standards. I think that is the real issue. It is not just the foreign debt
issue. It is "What does it mean for the economy in general," for
living standards, for domestic demand, for to the next generation,
and so forth. All of these things are moving us in the direction, in
my judgment, of holding down living standards in the years ahead.
74
TESTING THE OUTERBOUNDS OF STRUCTURE
Senator RIEGLE. But I still want a reflection from you and the
others, is the point where we are now, the rate of change, the rate
at which we are adding international debt, the $1 trillion estimate
by 1990, are these cause for sufficient alarm in your mind, in terms
of testing the outer bounds of structure, the international structure, people's willingness to lend, to cause us to say we are doing
some things now to get off those trend lines.
Mr. AXILROD. Yes. In this kind of a situation, and I think Alan
Meltzer earlier described it, the living standards will have to decline in the transition to a new period. In these circumstances, the
faster you act, in a way, the better. If you let the debt get higher
and higher and higher, then the tolerance of the foreigners for
holding it will get less and less and less. At that point you risk a
drop in the dollar that is extraordinarily sharp. It is impossible to
make the domestic adjustments to move resources from purely domestic sectors to foreign sectors very rapidly. So if the dollar drops
extremely fast, most of what you are going to get is the inflationary aspects of that because the real adjustments will not be coming
along in time. And if the trade deficit drops very fast before we
have our budget under control, then you could get the inflationary
aspects in spades.
So the sooner we begin making the trade adjustments the better,
and I think we have begun making them. The drop in the dollar
since February 1985 is certainly critical in that. But we are probably at the point we could well use a little breathing space—get the
budget deficit down, get the dollar stabilized, and begin making the
trade adjustments gradually. I don't think we should lose patience,
as long as we have the process under way.
Dr. MELTZER. May I join in that?
Senator RIEGLE. Yes, please.
Dr. MELTZER. I spent considerable time in my testimony on that
point, and I don't want to repeat all of it, but let me make two
prints. First, the debt is in dollars, so that we are not in the position of Mexico or Brazil It is important to understand that, because
we can try to inflate our way out of the debt. That is, we can
reduce the debt by inflation, and we are, in fact, moving to some
degree in that direction, I believe.
The longer term problem is, of course that we are going to have,
in my estimate, a minimum of 600 to 900 billion dollars' worth of
debt. We are going to be paying $60 billion in interest payments by
1990 under the most fortunate of circumstances. That is going to be
ll/2 percent of the GNP. Think about our problem. 4 percent of the
GNP, we have to turn, in order to get the trade balance in balance.
When we do that, we've got to do another 1 Vz percent, in order to
get the excess of production overspending, to pay the interest on
that debt.
Senator RIEGLE. Right.
Dr. MELTZER. Now it is almost impossible to see a increase in
living standards under those circumstances over that period. The
real question for the Congress is, what will happen after that. $80
or $60 billion in interest payments is more or less in the bag now.
That part of the problem is the result of what we've done up to
75
now. The question to be resolved is, where are we going to be in
1995, and what should we do? There is a lot that we can do now.
We can make our situation in 1995 much better or much worse.
The basic problem is that we are producing less than we consume,
both publicly and privately. And we have to reverse that. The way
to reverse it, in my opinion is, we have got to shift more funds into
investment, so that the money we borrow goes into productive investment, which creates productive jobs, which services some of the
debt when productive jobs come on stream. We should adopt a productivity-enhancing program, and that productivity-enhancing program, in my opinion, has to have a shift in taxes I know you are
not going to like to hear this, because you've just been through tax
legislation. We have to shift taxes from investment to consumption.
We have to shift spending, both private and public from
Senator RIEGLE. Don't you mean it the other way around? You
mean from consumption to investor?
Dr. MELTZER. No. We have to take the taxes off of investors and
put them on
Senator RIEGLE. I beg your pardon. I understand. Yes.
BROAD-BASED CONSUMPTION TAX
Dr. MELTZER [continuing]. Consumption. That is, we need to go to
a broad-based consumption tax. In my opinion, we should take all
taxes off of capital. And I remind you, that is what Japan is starting to do. And they need that kind of stimulus far less than we do.
Senator RIEGLE. You know, just as a followup to that, before the
other two respond, have you done an analysis to the degree to
which the tax bill actually takes effect, sort of works against us
and works against the argument that you have just raised?
Mr. MELTZER. Yes. It raises the cost of capital to American industry. All right. There are differences in the estimates of how much
it raises the cost of capital to American industry, but it is moving
in the wrong direction. We should be moving in the opposite direction. We should be reducing the cost of capital. We should encourage capital-intensive industry, which can produce high productivity, to produce exports for the world.
Senator RIEGLE. May I hear from the other two?
Mr. HEINEMANN. I totally support Professor Meltzer. That was a
key recommendation of the Shadow Open Market Committee at
our last meeting. I very strongly believe that—and I have said this
repeatedly in written material—the Tax Reform Act was upside
down. It is a good law for Japan, a bad law for the United States. I
strongly support Professor Meltzer's proposal that the corporate
taxes be repealed and be replaced with a broad-based consumption
tax.
Dr. ROBERTS. At the time of the debate I made those same points,
Senator.
Senator RIEGLE. May I ask, just as my time expires, on this question of the build up of the international debt, are either of you very
nervous about that, or do you think we can stay on these trend
lines here and ride on out to that $1 trillion debt in 1990 and
beyond and not suffer horrendous consequences, as a result of that?
76
Dr. ROBERTS. Well, I have the feeling that there is some self-correcting factors there, just because the build up of the debt is not
infinitely sustainable. So I sort of share the point of view of Mr.
Axilrod that probably something has got to happen to turn that
around. If you remember, it was only, you know, a year or two ago,
that everybody was worried about the crisis of the strong dollar,
and they were projecting out forever what the effects of this strong
dollar was going to be and everyone was testifying the dollar could
never come down until the budget deficit did.
And all of that hysteria turned out to be false. So it can be misleading to asume that unsustainable trends can be sustained and
taking how are you going to pay the cost, because probably they
won't be sustained. So you may never have to pay that cost. Now if,
for some reason, we manage to forever do the wrong thing and sustain an unsustainable trend, it is going to be bad, but I hope that
people learn from this in more general ways, because when the
lesser developed countries were building up massive foreign debts,
it was widely interpreted as a good thing for them. And if it was so
good for them, how is it so bad for us?
Senator RIEGLE. You know, it is interesting—my time is up—but
it seems to me a lot of what they were doing was, in a sense, investing in an infrastructure, an industrial base. They were importing consumer goods and other things, and we are hooked on just
the other side of it. We are buying the video recorders and everything else, and as a developed nation, carrying the free world's defense burden. It seems to me, we are totally out of synch with what
we ought to be doing at this stage of the game.
Dr. MELTZER. Right on.
Dr. ROBERTS. Well, I wouldn't push that too far, because apparently many of those investments were not successful
Senator RIEGLE. Well, I am not saying that their strategy worked
for them, but that doesn't mean that the strategy that we have, if
we are out of synch, is going to work for us any better.
Dr. ROBERTS. I don't think that it is a strategy we have. I think it
is a consequence of an unexpected, unanticipated collapse of inflation. The collapse of inflation that occurred was not predicted by
anyone, and it set in motion these events. So I wouldn't say it is a
strategy, and I think, my monetarist friends here read too much in
the decline of the dollar. They see it as some sort of Government
strategy to reflate. I just don't think there is a strategy like that. It
is not quite clear that government has a strategy as a government.
Senator RIEGLE. It sounds like it is time we had one. Thank you,
Mr. Chairman.
PERIODIC RECESSIONS
The CHAIRMAN. Mr. Heinemann—I just have two more quick
questions. First, Mr. Heinemann, what do we do in the event a recession comes? I get the impression that some of us feel we could
avoid a recession forever.
It seems to me, the price we pay for a free system is recessions
periodically. We have had them historically. I don't think we can
avoid them. So what do we do in the next recession? Can we follow
a policy of having a $300 or a $400 billion deficit? Now Henry
77
Kaufman said we can't afford a recession. Well, we are going to
have one, I think. Can we fight it by an even looser monetary
policy? A 23-percent increase in monetary base isn't enough? What
do we make it, 50, 100? Then what do we do? Take another drink?
Mr. HEINEMANN. Senator, the business cycle has not been repealed. I think you are correct in implying that policies designed to
prevent recessions characteristically create them. And so I think
you are on the right track, totally.
I think that mistakes have been made, and we have a real price
to pay. I think we can begin to minimize the cost of future recessions by insisting on a monetary policy which is less destabilizing.
The amplitude of fluctuations in money growth can be damped
down over time. We can have smaller fluctuations in money
growth rather than bigger ones. And over time, we can gradually
minimize the real cost to the system of the inevitable ebb and flow
of economic activity. I don't think we can repeal the business cycle,
but we can mitigate it.
As I said in my statement, I think policies that depend on progressively larger perturbations in monetary growth will give us an
unstable macroeconomic environment.
The CHAIRMAN. Thank you very much.
Now Mr. Axilrod, I would like to have you make history for us. If
you answer this question, you will make history as the first former
Federal Reserve official, with the kind of major monetary responsibilities that you had, to ever make an interest rate forecast.
[Laughter.]
You are in a position to do that now. You are unleashed. You are
in the private sector, so you are perfectly free to tell us, what are
the short- and long-term interest rates going to do over the next 6
months?
Mr. AXILROD. Mr. Chairman, I will tell you that, if I may have a
little preface to it, and the little preface I would like to have is sort
of implicit in many of the things that have been said here already.
I like to assume that we really are aiming for smaller price increases than the 3 to 4 percent that we have had over the last 3 or
4 years, though it was less than that last year.
So I am going to assume we are aiming for that. I think, in the
interim, before we get there, there is some little risk of a recession,
because you can't be sure that this drop in the dollar and the restraint in the budget are going to be so nicely phased that they will
be consonent with a sort of a balanced growth. We could have, for
example, a sharp drop in the dollar and not as much budget restraint as the Congress seems to be promising. Then we might well
have a little excess demand in the economy, with more upward
pressure on prices.
In my opinion, if that develops, it ought to be fought by the Fed
in the interest of getting to lower price increases over time; in that
case, interest rates will rise for a while. I don't think they will rise
for very long, because I agree with Dr. Chimerine that, basically,
there is not—aside from the international sectors, aside from the
exchange rate drop and what that might do—there is not much
real strong thrust in the economy, the reason being, real interest
rates are still relatively high. Certainly, they are not very, very
low. So any further rise in rates is probably going to, fairly imme-
78
diately, control the economy, cause it to drop off, control the inflation.
On the other hand, I don't think the economy is all that weak.
We have made substantial productivity improvements, so I think
that once inflation comes under firm control, the sort of the basic
strength we have built into the economy over the past several
years—for example, productivity improvements in manufacturing—will begin asserting itself. As a result, the economy will relatively promptly begin growing at near its potential. When that
happens, interest rates will be a lot lower than they are now, because the rate of inflation will be a lot lower than it is now.
So in my personal opinion, assuming I am right, that the Fed is
going to be going to aim at lowering rates of inflation over time,
interest rates will be lower over the next year or two. In the interim, however, I want to be somewhat agnostic about rates, because
no one can be absolutely certain that they won't have to go higher
before they go lower. That's my view on it.
The CHAIRMAN. Thank you very much. Senator Riegle has some
questions on that.
LOWER LIVING STANDARDS IN THE FUTURE
Senator RIEGLE. Thank you. Just one other thing, and that is,
several of you touched on this and maybe all of you did earlier,
about the prospect of lower living standards in the future, that the
crunch that we've got to work our way out of and pay off some of
the bills that we have accumulated, internationally and otherwise,
indicate that, as we look out, there is going to be a reduction of
living standard taking place here at some point. How we distribute
that is a very complex and sensitive question, or even if we can,
from a policy point of view. I would like your judgement as to what
kind of a downward adjustment in living standard are we apt to be
looking at here, and when it is likely to come. I mean, what are the
American people in store for here that may be unique in our contemporary economic history. Certainly, you know, post-World War
II history.
Mr. AXILROD. It is difficult to put numbers on it, Senator Riegle,
but it is coming right now. For the last 4 years or so—and I may be
off a bit1 in my numbers—our spending in this country has grown
about 1 A points on average per year, more than our output. Now
once we start shifting resources into the international sector—to
increase export, for example—then that spending has got to come
down. What we are going to be confronted with for several years
ahead is output growing by whatever our potential is—say 3, 3Vg
percent—and spending growing less. Depending on how fast an adjustment to country wants to make, spending can grow, say, a half
a point to one point less for several years or two or three points
less for a couple of years, or we could back ourselves into a sharp
recession and get the whole thing over with very promptly. But
that is what we are confronted with.
In Japan, for the previous 6 years, their spending grew much less
than their output. They have to make the symmetrical adjustment
to us, to keep the world economy growing. They've got to get their
spending growing more than their output to absorb the resources
79
that the rest of the world is going to be devoting to the international sector. If they don't do that, then that is something of a downward cast on the economy.
You can't put an exact number on it, but we are in the process of
reducing domestic spending now. That will occur until we are in
whatever reasonable trade balance, whether it is a little surplus or
little deficit that all the world and we are satisfied with. When you
reach that point, then spending and output can all begin growing
together, because the shift has occurred.
Senator RIEGLE. Let me go right down the table.
Dr. CHIMERINE. I agree, Senator, and again, it is hard to give a
number but one way of measuring this phenomenon it is with real
incomes or real wages. And, in my judgment, they have begun to
stagnate already. We had a temporary increase in real wages last
year, because of the decline in oil prices, but now that that is over,
real wages are stagnating, and when you add to that the increased
debt servicing for most consumers, you can make a case that the
average American family will experience either stagnant or modestly declining living standards on average for the next 5 years or
longer. It doesn't sound so bad if you already have high living
standards, but the problem is, it is not equally distributed. We are
seeing a number of people losing relatively high-wage jobs. Most of
the new jobs we are creating are at much lower wages. I think that
the boom in the stock market, you know, is making a small fraction of the population wealthier. Most others are not benefiting
from it.
So we are probably widening the income disparity or income distribution disparity, but if you look at the average, I would agree
that about the only thing we all agree on this morning is, at a minimum, living standards will stagnate and probably edge lower on
an average basis for the next 5 years. It is hard to measure exactly
how much.
Mr. HEINEMANN. I would like pass to Dr. Meltzer for the moment
and then come back to something else.
Senator RIEGLE. OK.
Dr. MELTZER. Let me give you a ballpark estimate. Like all estimates by economists, it has large variation around it. We are good
at some things, but forecasting isn't one of them. But let me give
you a ballpark estimate and tell you how I got it, so it may help
you a little bit.
The economy for 100 years has grown at a rate of 3 percent a
year. Population is growing at a rate of a one-half to l 1 percent a
year. So that gives us a base of 2 percent a year, 2 to 2 /z percent a
year in growth of per capita income.
Against that, we have a trade deficit of 4 percent of GNP, which
we have to turn around, plus 1 Vs. percent of GNP that we are going
to be paying in interest rates on my estimates, which are lower
than the ones that you used. So against our 2 percent minus in per
capita income, we have IVb percent for debt service plus a 4 percent one-time reduction in income to turn the trade balance. You
only have to turn the trade balance once. But part of it is permanent. The debt that we have out there, we pay interest on forever.
So that gives you some limits, so some idea of the ballpark estimate. It says we may suffer a drop or a slow increase if we close
80
the trade deficit over the period to 1990, and after that, we are
going to have relatively slow growth in living standards.
NEED TO INCREASE PRODUCTIVITY
I agree with Dr. Chimerine that it is not going to be across-theboard. I disagree with Dr. Chimerine when he says that we are creating jobs which are low-paying jobs. We always create low-paying
jobs, because we create them for entry level people. We are not
doing it at any greater extent in the past 5 years than we have
over any other reasonable period of the time. Our problem is not to
argue over the past. It is to ask how are we going to turn the problem around, and the answer is, the only way that we have is, to
increase productivity, so that output grows a little bit faster.
Senator RIEGLE. I think the part that is different with respect to
your last point is, it may well be that we have created lower wage
jobs when there has been a job creation spurt. I don't know that we
have seen the disappearance of the higher paying jobs at the same
time. In other words, the windfall reduction or loss of high valueadded, high-income manufacturing wage jobs is really, I think, an
extraordinary phenomenon that is going on at the same time.
Dr. MELTZER. You've seen that in the auto industry and in Pittsburgh
Senator RIEGLE. We are seeing it all over the country.
Dr. MELTZER. But we are also creating- high-paying jobs. We are
turning out a fair number of college graduates who are going into
technical jobs. You know, all these kids who go to Wall Street, and
there are large numbers of MBA graduates. There are doctors.
They are going into high-paying jobs in service industries. So it is
not true statistically. In fact, Bob Samuelson has a column in the
Washington Post this morning that says exactly the same thing.
Senator RIEGLE. I understand that, but frankly, it doesn't square
with what I am seeing, not just from a Michigan point of view.
Last week, we had a group in the Defense Department say that we
now ought to consider direct financial subsidies to the computer
and semiconductor industry in this country, because it is in trouble. And last year, we imported more high-technology items that
we exported.
I mean, we are upside down on that account, apart from cars and
trucks, apart from agriculture. And it goes right on across the
board. I mean, the problem that I see is exactly the Samuelson
column, and if we can't get past understanding what is, in fact,
happening outside, you know, textbooks that are 20 years old, I
don't think we are going to deal with that problem.
Dr. MELTZER. Whether you are right or I am right, the answer is
going to be the same. The answer has to be the increase in productivity, investment that increases productivity.
Whatever we have been doing in the past, it is clear that the
only way we are going to solve the problem in the future is to increase productivity.
Senator RIEGLE. I do want to hear from Dr. Roberts and Mr.
Heinemann.
Dr. ROBERTS. On this topic, if Congress is to compensate for what
it sees as changes in income distribution it's likely to work against
81
the measures it needs to enhance the productivity. So if Congress
does its old ways, it's not likely to help the situation with regard to
increasing the productivity.
I agree with what's been said about the implications for our
living standards of building up large foreign debt if you're not
building it by building productive capacity to pay for it. So we want
to be sure we build some more to do that.
But population growth is about as unpredictable as anything
else. It could actually decline, in which case it's not clear you
would find a surplus of too many people chasing low-paying jobs.
So the wild card in all that is the behavior of the population
growth and I don't think any of us here can predict it. Not even
people who are supposed to be able to predict it can predict it.
Mr. Chairman, are you still giving us 2 minutes at the end?
The CHAIRMAN. At the end, yes, sir. If you want those 2 minutes
you can sure have it.
Dr. ROBERTS. Can I take them now or should I wait?
The CHAIRMAN. Take them now.
DOMESTIC BUDGET DEFICIT
Dr. ROBERTS. I want to caution against seeing in the domestic
budget deficit an expansionary fiscal policy. I don't think it is an
expansionary fiscal policy because it wasn't created in order to be
that. It was the effect of the collapse of inflation below expectations, below forecasts.
So, if the domestic budget deficit is in large part a reflection of
an unexpected disinflation, it would be a mistake to see it as an
expansionary force in the economy.
And if it is not an expansionary force and it's seen as one, it
could lead to tighter monetary policy than we could really afford.
Since the collapse in inflation was not anticipated, it affected the
budget dramatically, I think it would have been useful if several
years ago the Congress and the administration had adjusted the
budget to the unexpected component in the decline of inflation. It
could have done that by having a 1-year spending freeze instead of
fighting over budget shares, a spending freeze would have gone a
long ways toward adjusting the budget to this collapse in inflation.
Because when inflation collapses unexpectedly, it doesn't bring the
spending down hand-in-hand with revenues. And so the failure to
make this adjustment to the unexpected disinflation has caused a
lot of problems, a lot of misinterpretations, a lot of wrong solutions
that are advocated that just confuse everyone and give a continued
divided house and prevent any decisive action.
And what I think we all agree on is that we have reached the
point where we need to have some decisive action which improves
the situation and, therefore, we have to fully assess the costs as
well as the benefits of whatever action that we take.
The CHAIRMAN. I take it, Mr. Heinemann, you passed and you
wanted to come back. So you make your statement and anybody
else who has a closing thought or two, preferably one, let us have
it.
Mr. HEINEMANN. I waive my 2 minutes. I just want to respond to
Senator Riegle.
82
Senator, it seems to me that in thinking about the implications
of the buildup of the net U.S. foreign debt there are a couple of
points that we really haven't talked about here this morning. They
are obvious but I think they need to be made,
FOREIGN INVESTMENT IN AMERICAN INDUSTRY
One, the foreign assets in the United States are not going to stay
invested in Treasury bills and Treasury bonds. They are going to
move into the real economy. That's already started. And I think we
need to think in political terms very thoroughly about the implications of very broad-scale, widespread foreign ownership of American industry.
We need to think about the mix of production: What kind of production will be in the U.S. vis-a-vis the home country? Will it all be
low end, low-value-added assembly operations or will the highvalue-added manufacturing processes also occur here if the company is foreign-owned?
In the auto industry, which I presume you have some concern
about occasionally, my sense is that most of the foreign-owned U.S.
operations are at the low end of the scheme—the assembly operation.
That is one broad set of concerns. I have to assume, if these numbers are anywhere near correct, that we haven't even begun to see
the beginning of the change.
Now by the same token, it's fascinating to contemplate what
kind of a convergence may occur between the interest of our principal creditors in our export performance and our own interest in
our export performance. Longer term it seems to me our creditors
are interested in seeing us not try to inflate our way out of our foreign debt. They are going to be interested in seeing our export performance improve just as we're interested in seeing the Brazilian
export performance improve.
I would not be surprised to see, for example, just taking a name
out of the air, the Honda plant in Marysville, OH producing for
export within a very short period of time. Chrysler now seems to be
making the same point in starting to sell U.S. North American produced products in Europe. They're not going to sell very many
units there but Mr. lacocca is making a very important political
point in doing this. That is another set of problems.
I also am concerned that there may be some security issues involved here too that don't get much discussion. We saw during the
Vietnam War that De Gaulle was able to put an enormous amount
of pressure on Lyndon Johnson by withdrawing gold at the wrong
time and in the wrong way.
Our creditors, if they become anywhere near as big as we think
they're going to become, are going to have an important voice in
our political affairs—indirectly, but they are going to be there, just
as we have a voice in Mexican or Brazilian or Argentinian affairs
today. I think we need to think through very carefully what our
longer-run role may be as a superpower if in fact we are going
around the world with a tin cup asking for money all the time.
The CHAIRMAN. Anybody else?
Dr. CHIMERINE. Can I have part of my 2 minutes?
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The CHAIRMAN. Go right ahead.
Dr. CHIMERINE. First, I'd like to register a strong disagreement
with the last comment by Dr. Roberts on the cause of the budget
deficit. The slowdown in inflation was a minor factor in these large
budget deficits.
The truth of the matter is they were caused principally by the
combination of a large military buildup and large tax cuts unmatched by sufficient budget cuts elsewhere. You can blame them
on somebody for not making other cuts or you can blame it on the
tax cuts or whatever, but the slowdown in inflation was not the
major cause.
Second, I agree strongly with your comment, Senator Riegle. I
didn't read the article this morning in the Post, but based on the
work we've done, a relatively large fraction of the jobs that have
been lost in the last several years have been high-paying jobs and a
relatively large fraction of the jobs that have been created have
been low-paying jobs.
You can point to a few "whiz" kids on Wall Street, but there are
a lot more people getting jobs in fast food restaurants or whatever
at the minimum wage, and many of them part-time, than there are
new jobs on Wall Street.
Third, Senator Heinz asked a question before that I didn't get a
chance to respond to about the implications of the decline in the
dollar on inflation.
Clearly, the decline in the dollar is going to add to inflation. We
can't get the trade deficit down without it.
The key question, though, is whether or not it's going to trigger
the kind of wage-price spiral we had in the 1970's, after oil prices
rose and ultimately led to the 10 or 12 percent inflation we had.
Underlying conditions strongly suggest no that it won't. We can't
avoid some dollar-related inflation, but as long as it doesn't feed
into the wage structure, and commodity prices don't start rising,
and as long as we have this cushion of a lot of excess capacity, inflation may rise to 3 or 4 percent, but it's unlikely to approach the
7, 8 or 10 percent range.
The last comment I'd like to get equal time for the Monetary
Policy Forum, Mr. Chairman. You may not know this, but we have
strongly advocated a position of ignoring the growth in Ml in
recent years, and that if the Fed had tightened during the last several years because of the strong growth in Ml I think we probably
would be in a severe recession right now. I'd like to submit for the
record the latest statement of the Monetary Policy Forum on its
views on monetary policy.
The CHAIRMAN. Thank you very much. Anybody else want to
make a comment?
Dr. MELTZER. I'll take 1 minute. I think the issue before us, Senator, is, as it always is, how do we maintain high productivity and
low inflation or price stability in the economy.
I think you're on the right track. We cannot forecast. In studying
the records of forecasters—all forecasters, including my own forecasts, Dr. Chimerine's forecasts, the Federal Reserve forecasts—the
simple fact is that we cannot tell, on average, whether we're in a
recession or a boom in the very quarter in which we're making the
forecast. That's the record of forecasting over time.
84
To guide the economy by that kind of forecasting is to produce
the kinds of mistakes we have made repeatedly. The Japanese
don't do it. The Germans don't do it. They have much more stable
policies and they have higher productivity, not entirely but partly
as a result of that. We would do well if we would emulate them in
that respect.
I think you're on the right track and I hope you will continue
with it.
The CHAIRMAN. Thank you very much, Dr. Meltzer. I want to
thank all of you, gentlemen. This has been one of the best panels
I've heard in 30 years. It's really been very good, stimulating, different opinions and so forth, and it provides an excellent groundwork for Chairman Volcker, who will appear tomorrow and respond to some of the very excellent points you have raised. Thank
you.
The committee stands recessed until tomorrow morning at 10
o'clock.
[Whereupon, at 12:30 p.m., the hearing was recessed, to be reconvened Thursday, February 19, 1987, at 10 a.m.]
FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1987
THURSDAY, FEBRUARY 19, 1987
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10 a.m., in room SD-538, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire, Riegle, Sarbanes, Dixon, Sasser,
Shelby, Graham, Garn, Heinz, Armstrong, D'Amato, Hecht,
Gramm, and Bond.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
We continue this morning with the most important of congressional oversight responsibilities. As I said yesterday, this is probably the most important oversight hearing that any committee of
Congress has inasmuch as we have a clear constitutional responsibility. And that is, of course, overseeing the development and implementation of Federal Reserve monetary policy.
We have a clear and exclusive constitutional authority over the
money supply. We have delegated the implementation of that authority to the Federal Reserve Board. We cannot and should not
delegate our fundamental responsibility, however, for overseeing
the implementation and direction of the Fed's action.
As you know, Chairman Volcker, this Senator and, I think, the
committee as a whole takes that responsibility very seriously and
feels that our duties under the Constitution compel us to challenge
the monetary policy which, at least this Senator believes, is inappropriate and perhaps dangerous. Simply said, Chairman Volcker,
the present rapid pace of money growth exceeds prudence.
As you know, in 1985, the target range was 4 to 7 percent and
you came in with a 12 percent for Ml. In 1986, last year, the target
range was 3 to 8 percent. I thought it was far too large a range. We
came in with 17 percent. As you know, since October, the increase
has been 21 percent. On page 26 of your statement for the coming
year, you tell us that we're not going to have a target, in effect, for
Ml. You will monitor it; you will watch it; you will keep close to it.
But as the author of the law that mandated the targeting of the
aggregates, it seems to this Senator that your failure to provide a
target range for Ml violates the spirit—I presume not the letter,
but the spirit of the law calling for targets for the various aggre-
(85)
86
gates and especially Ml which is certainly fundamental, not alone
and perhaps no longer the most important, but one which is significant.
Current monetary growth rates are unwise in view of the inflationary potential inherent in the falling dollar and continued deficit spending. To make matters worse, we are far more vulnerable
to a resurgence of inflation than we were a few years ago given our
own massive consumer debt and corporate debt and our position as
the world's largest debtor Nation.
If foreign investors lose confidence in our price stability and
withdraw their funds, interest rates will go through the roof. In the
words of one former Treasury Secretary, "We will then have a recession that will curl your hair." "Knock the ashes off your cigar"
may be more appropriate. [Laughter.]
We are sensitive to the enormously complex nature of monetary
policy developments. We heard a panel of five internationally
known economists yesterday, including your former staff director
for monetary policy, Stephen Axilrod, a man whom I know you
greatly respect and admire, and who worked for you for years. The
analyses and conclusions of these outstanding economists were
thorough but conflicting.
Certain principles of monetary economics, however, are not subject to doubt. Among the most important of these is that money
growth greater than nominal GNP will result in accelerated inflation. We are aware of the uncertainties associated with the demand
for money that have caused the Fed to disregard the rapid growth
of the monetary base and Ml. Nevertheless, the rough interest rate
and inflation rate stability of the past several months should have
also stabilized the money demand function, making the aggregates
the most appropriate of the available measures of monetary ease.
A look at the growth rates of any of the aggregates reveal monetary growth to be greater than that of nominal GNP and much
greater.
With debt, both domestic and international, and exchange rates
in as precarious a balance as they are, the Federal Reserve has
little room to maneuver. This situation is not likely to change
making the best policy, in the judgment of this Senator, one in
which money growth should be moderated now rather than risking
the need for a drastic and destabilizing reduction later.
We can joke about when to take away the punch bowl, but at
risk is something far more serious than just a hangover. That risk
is economic collapse, widespread personal and corporate bankruptcies, and rampant unemployment. At risk is the economic future of
this Nation and of the world.
Chairman Volcker, we appreciate your being here this morning
and look forward to receiving the benefit of your testimony.
Senator Garn.
OPENING STATEMENT OF SENATOR GARN
Senator GARN. Thank you, Mr. Chairman.
As we meet here this moring to continue the first round of monetary policy oversight hearings for 1987, I believe that it is most im-
87
portant for us to maintain a balanced view of the current state of
the U.S. economy.
Certainly there are problems demanding our attention. The Federal budget deficits and the trade deficits are creating debt burdens
that will weigh heavily on future generations. Severe sectoral problems are creating economic hardship for the energy industry, for
agriculture, for the real estate industry in certain parts of the
country, and for many financial institutions.
At the same time, we are in the midst of an historically longterm economic expansion that began more than 4 years ago. In
each year of this expansion, more jobs have been created in the
United States than in the combined economies of the next six largest industrial democracies.
Most importantly, the conditions of rising inflation and rising interest rates that have aborted previous postwar expansions are not
evident in the U.S. economy today.
Thus, we have a good chance of sustaining this expansion as we
work on the budget deficit, the trade deficit and the remaining sectoral problems.
The hearings that began yesterday are of critical importance because of widespread concern that monetary policy may be inadvertantly laying the groundwork for the very conditions—rising inflation and rising interest rates—that could put an end to the expansion.
Growth of the Ml aggregate during 1986 at a rate of over 15 percent—almost double the maximum rate forseen by the Fed's own
target growth range—is raising the most concern. A related issue
is: How can Congress meet its monetary-policy oversight responsibilities if the Fed misses its announced target by such a great
margin.
At the same time there is also concern over a premature tightening of monetary policy. Such an action also could put an end to the
economic expansion.
A healthy economy over the long-term requires healthy financial
institutions. Today financial institutions in this country are laboring under some heavy burdens.
Problems in certain economic sectors are creating sever difficulties for many banks and thrifts. These problems are compounded
by Congress failure to update the outdated, decades-old financialstructure laws that do no take into account recent changes in financial markets.
An end to the economic expansion brought on by misguided macroeconomic policies would compound the problems already facing
our Nation's financial institutions.
Fortunately for our financial institutions, prospects are good for
sustaining economic growth with moderate inflation. The time is
long overdue, however, to also overhaul our financial-structure
laws in light of the ongoing changes in financial markets. This
would enable our Nation's banks, thrifts and other financial institutions to play their proper role as pillars of strength for our economy.
The CHAIRMAN. Senator Riegle.
OPENING STATEMENT OF SENATOR RIEGLE
Senator RIEGLE. Thank you, Mr. Chairman.
I want to add just a point that may be somewhat different in
tone than the statement that you've just made. That is that I am
very uneasy about the prospect of higher interest rates right now
and it seems to me that the whole question of how the monetary
aggregates are managed leads very quickly to the question of
whether or not we should in effect raise interest rates.
I see two major dangers if that were to happen right now. One is
that growth would slow down in the economy. The revenue coming
into the Government would tend to be less and our budget deficit
would widen out, and we've got a terribly serious problem with the
Federal budget deficit anyway. I don't want to see it getting bigger
because the economy in effect begins to slow down.
The other side of it is, if the cost of capital, which is already very
high in this country relative to our major trading partners, is
driven even higher by higher interest rates, the trade deficit, which
was $170 billion last year, will rise even higher.
I don't want to see American business burdened with a higher
capital cost today than it presently is, certainly relative to our
major trading partners, and I worry about that effect of higher interest rates. So it's one thing I think to have a concern about how
our monetary aggregates are managed and how they look in total,
but I think we're walking on a tightrope here and there isn't much
room for maneuvering.
It seems to me, on the one hand, while we don't want to reignite
inflation, in a sense, our two very dramatic problems right in front
of us, the fiscal deficit and the trade deficit, are things that have to
be improved and they have to be reduced, and lower interest
rates—certainly not higher interest rates—is really the way, I
think, to try to give us some measure of improvement in both those
areas.
So I would hope that comments today might reflect on these
tradeoffs because they are certainly at the heart of these policy decisions.
I thank the Chairman.
The CHAIRMAN. Thank you, Senator Riegle.
Next in line—we do this on the basis of who appeared in the
committee first—is Senator Hecht.
Senator HECHT. Thank you, Mr. Chairman. No statement. I'm
just waiting to hear our distinguished witness.
The CHAIRMAN. Thank you.
Senator Dixon.
OPENING STATEMENT OF SENATOR DIXON
Senator DIXON. Thank you, Mr. Chairman.
Mr. Chairman, I am pleased to be here this morning to hear the
Chairman of the Federal Reserve Board, Paul Volcker, testify on
the Federal Reserve's plans for the conduct of monetary policy and
the Board's economic forecasts and assumptions. This is an important and sensitive? time for the ucunOniy. THe Federal Reserve has
to chart a course through perilous waters.^ la void tipping the economy into recesskKB^S<Amf5imifeiltH^Mrrat!onary pressures. I know
89
the Chairman's testimony will be of great value to the committee,
and I look forward to hearing from him.
I want to take this opportunity, however, before Chairman
Volcker begins, to suggest to the administration that he should be
renominated as Chairman of the Federal Reserve Board when his
term expires. Paul Volcker has been an outstanding public servant.
He enjoys a reputation in the financial community that is unequaled. I do not think we can afford to lose his services to the
Nation in these difficult economic times.
I have had the opportunity to come to know the Chairman since
I came to Washington. I have been deeply impressed by his dedication to public service, and by the leadership he has provided over
the course of his Government career.
I know the Chairman is making a real financial sacrifice by staying in Government rather than moving to the private sector, and I
know it may be unfair to him to ask him to stay on. However, I
hope the administration will do the right thing and ask Paul
Volcker to remain as Chairman of the Federal Reserve, and I hope
Paul will find it possible to accept that offer. The old Army recruiting posters used to say "Uncle Sam wants you"; I would paraphrase that to say "Paul, Uncle Sam still wants you."
The CHAIRMAN. I certainly echo that view absolutely.
Next is Senator Bond.
Senator BOND. Thank you, Mr. Chairman. I am here to learn and
I look forward to hearing Chairman Volcker's testimony.
The CHAIRMAN. Senator Sarbanes.
OPENING STATEMENT OF SENATOR SARBANES
Senator SARBANES. Thank you very much, Mr. Chairman.
I am pleased to welcome Chairman Volcker and I may not be
able to stay for the hearing but I hope at some point he will address the difficulty we always confront that, on the one hand, he
says that we need to do things about our fiscal policy—and I agree
with that—on the other hand, if monetary policy moves in what
may be the wrong direction, it compounds the fiscal problem. In
other words, an upsurge in interest rates may lead to a downturn
in the economy and a downturn in the economy will simply compound the fiscal problems. So we're caught once again in trying to
balance those two and we obviously need the Fed to be sensitive to
that as we try to work out of this situation.
The CHAIRMAN. Senator Gramm.
OPENING STATEMENT OF SENATOR GRAMM
Senator GRAMM. Well, Mr. Chairman, let me join everybody else
in welcoming you here. I think as we look back on your period of
service, whenever it's over, whether it's over soon or over a long
time from now, I think it's clear you will have served in a very difficult period where fiscal policy was often moving in the wrong direction and monetary policy had to take up the slack. I have never
been one who has been a Fed basher in terms of blaming the Federal Reserve for all our problems.
I would have to say in looking at the growth of the monetary
base that I share some of the concerns of our Chairman. If it
90
weren't for the situation we face in terms of the inflation rate, if it
weren't for the relative flatness of the economy, and regional weaknesses within the economy, I would be quite concerned about the
growth of Ml.
On the other hand, taking those weaknesses in the economy into
account and looking at the fact that M2 is not growing, I have not
changed my belief that the money supply and monetary base are
important. I guess my problem is trying to decide what is money.
So I'm not ready to go back and throw out the money and banking
textbook that the money supply is an important factor in the economy. I just don't know whether it needs to be rewritten in terms of
what is money.
But in any case, I know you are following the monetary aggregates. At the current time I am not willing to say that I am
alarmed. On the other hand, I think the money supply is growing
very rapidly. We have worked very hard, at great sacrifice to the
economy, to get the inflation genie back in the bottle, and I think
it's very important that we continue to monitor what's happening.
I think at the current time I am not concerned about the growth in
the money supply, but I think it's something we've got to follow
very closely, because if the situation should change in the economy
dramatically—with the decline in the value of the dollar, obviously
the price of imports is going to rise, and we're going to see an increase in the demand for American goods. Our trade deficit is not
the result of unfair trade practices by our trading partners, which
have not changed dramatically in 20 years. It's, instead, the result
of the fact that the highest interest rates in the world in the last 6
years have driven up the value of the dollar and those capital inflows have been offset by a trade deficit. As that process reverses—
and it will reverse and is reversing now—at least we're beginning
to see the beginnings of it—I think we are going to have to go back
and look at our inflation problem, and at that point I think we're
going to have to look at these monetary aggregates very closely.
With that, Mr. Chairman, I appreciate your giving me time.
The CHAIRMAN. Senator Armstrong.
Senator ARMSTRONG. Mr. Chairman, I didn't intend to make a
statement but I'm tempted to respond to Senator Gramm's observations about Fed bashing. I'll just tell you, Senator, don't knock it
until you've tried it. [Laughter.]
I have nothing else, Mr. Chairman.
The CHAIRMAN. Senators D'Amato and Heinz have requested
that their statements be inserted in the record.
STATEMENT OF SENATOR ALFONSE M. D'AMATO
Senator D'AMATO. I would like to welcome Federal Reserve
Board Chairman Volcker to the committee this morning. Due to
the rumors swirling about Washington and Wall Street about the
Fed's course, his appearance before us this morning is most timely.
I am concerned about recent indications that the Federal Reserve may be tightening monetary policy. For example, the increase in interest rates in the last week was caused by fears resulting from the Fed's failure to inject reserves into the banking
system when the Federal funds rate was well above 6 percent. The
91
Fed's inaction made many market participants nervous and this
was reflected in the wild, albeit short, gyrations in the short-term
Treasury markets. Hopefully, Chairman Vplcker will inform us
whether or not the Fed is shifting toward a tighter monetary policy
or whether it is continuing to pursue the same course as Chairman
Volcker indicated during his discussion of these issues before this
committee on July 26, 1986.
A shift to a more tightened monetary policy could have drastic
results for the economy. Although monetary policy alone is not a
cure all to the problems confronting our domestic economy, a tightening or slowing down of the growth of the monetary supply could
trigger a recession. The drastic results and the budgetary impact of
such a policy were articulated by Paul Craig Roberts in yesterday's
hearing. While the potential inflationary impact of an increase in
the monetary supply poses a threat that must be considered, the
certain recession that can be triggered by drastic reductions of the
monetary supply presents a peril that must be avoided.
Chairman Volcker's testimony also emphasizes several points
that have been made to the committee in the past regarding the
stability, or should I say the relative instability of our domestic
economy. Today's testimony again substantiates the assertion that
economic forecasting is hardly a precise science. However, certain
steps must be taken by the Congress, the President, and the Federal Reserve Board to ensure continued and stable economic growth.
If the economy continues to grow at a moderate rate and if we
are going to introduce more stability into the domestic and international economies, then Congress must address two problems that no
longer loom on the horizon—these problems are at the front door.
The first problem is that the budget deficit must be reduced in as
rational and least painful manner as possible. The deficit issue has
become a political football with the Congress blaming the President
and the President blaming a profligate Congress. Such accusations
tend to exacerbate rather than resolve the problem. I am interested in the testimony of Paul Craig Roberts who introduces in his
testimony another culpable party in the deficit debacle—the conduct of monetary policy by the Fed. I hope he will elaborate on this
point during the hearing. I also hope each of our witnesses will
offer their recommendations on how the budget deficit may be cut
and whether they think Gramm-Rudman is effectively accomplishing its intended goals.
The second problem confronting our domestic economy is the
trade deficit. Frankly, I am tired of hearing the same old arguments about how Americans can't compete; the unions have priced
American heavy industry out of the market; and America is losing
its technological advantage. I believe these arguments and those
advancing draconian protectionist legislation ring hollow when one
takes a real look at what's happening to American industry.
American industry is at the forefront of innovation. U.S. companies spend billions on innovation each year and develop new technologies. However, before these new technologies can be put to
practical uses, we find that our foreign competitors are using the
same technologies, in practical uses, at lower costs. How can they
do this? Easy, many of our competitors are stealing us blind.
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During our last hearing on the Federal Reserve's monetary policy
report, I stated that our so-called trading partners:
Steal our patents, intellectual property rights, systematically are adjudged guilty
in the courts, say we're sorry, pay back penalties, continue the same thing, infringe
on patents and then send the products here into the United States. Further, those
harmed have limited recourse under the current legal system. At present, even
though your copyright may have been infringed or your patent stolen you must
then demonstrate that there is substantial danger to the particular industry, before
damages can be awarded. Despite the failure of the laws and trade policies pursued
to date we hear, oh, yes, we're going to make to make changes. We've been waiting
a long time for negotiations or other bilateral approaches to work. We wait in vain.
It seems to me, absent any legislative action or some very real enforcement of
present trade practices, the policies of the Japanese and others will not change because they lack any incentive to change.
I have not changed my point of view on this subject. I should also
note that Chairman Volcker supported my notion of the cause of
such competitive trade imbalances and urged us to act. I am sorry
to state that in the drive to make America more competitive, we
and the administration have yet to consider the steps needed to
make technological piracy more punitive. Thank you, Mr. Chairman.
STATEMENT OF SENATOR JOHN HEINZ
Thank you, Mr. Chairman. It is always a pleasure to welcome
Chairman Volcker, who may be setting records by making his
second appearance in less than one month before the committee.
Mr. Chairman, there are concerns regarding the dramatic
growth in the money supply during the past year, particularly in
the Ml category. Several of the witnesses yesterday expressed
alarm at the fact that Ml grew 17 percent, well exceeding the
Fed's target boundaries of 3 to 8 percent. They also noted that 1987
has opened with a further dramatic increase in Ml growth, again
considerably ahead of Federal Reserve targets and, in fact, ahead
of rates in the 1970's when inflation was at its peak.
These witnesses believe the Fed is ignoring the lessons of history
and planting the seeds of disaster because in the long run, the traditional relationship between the supply of money and inflation
will prevail. In their view, the Fed's tolerance of excess growth in
Ml will trigger a sharp growth of economic activity and an early
renewal of inflation.
Other witnesses, while not dismissing monetarism altogether, at
least questioned its import. In their view, other factors must be
taken into consideration. First, they noted problems with how to
define "money" for monetary policy 1purposes. According to them,
the traditional definitions of "money have changed—especially in
the Ml category—and that it might not be an appropriate basis for
setting monetary policy.
Second, and perhaps more importantly, they noted that the relationship between Ml and economic growth has changed. In essence,
the gross national product is simply not following Ml the way it
used to. In fact, GNP has been showing only a moderate growth in
recent quarters compared to the rapid growth.
These witnesses pointed out that the same thing has been happening in other Western countries. I think the obvious answer is
the sharp decline in interest rates in recent years. Depositors are
93
now willing to carry more funds in Ml form because it costs less to
do so.
Despite these varying views, all the witnesses suggested that the
Fed's tolerance on credit could be temporary due to new developments.
One is the recent increase in the price of oil. While this may be a
factor, it may take on lesser importance. Today's Wall Street Journal reports that world oil prices have skidded to their lowest level
this year. Of course, this could be temporary.
Another important factor is the sharp decline in the value of the
dollar relative to other currencies. This has already resulted in
rising prices of imports and has the potential of leading to higher
prices generally down the road.
Mr. Chairman, I am not sure which of these schools of thought
should prevail in the setting of monetary policy. However, I am
sure that the debate about whether money should grow on a formula basis or whether judgment should be used in allowing money
growth will continue today with Chairman Volcker's testimony.
The CHAIRMAN. Mr. Chairman, I understand that you were asked
to confine your remarks to 10 minutes. You've got about 38 pages.
That is awful rapid reading.
Mr. VOLCKER. I hadn't gotten that message, Mr. Chairman.
The CHAIRMAN. Well, if you can do it in 11 or 12 minutes, we can
extend it from 10, but seriously
Mr. VOLCKER. Well, I wont read this whole statement, but I
think you have raised some questions which I attempt to answer in
the statement and I think I ought to take advantage of this opportunity.
The CHAIRMAN. Well, we won't run the light on you. We'll get in
trouble with other people by not doing it, but we won't. Whatever
time you take, I hope you can do it as rapidly as possible.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Let me say first of all, thank you, Mr. Chairman
and Senators. You have our full monetary policy report to the Congress. That includes a lot of details, including projections of the
committee and our target ranges and so forth. I would like to take
a few minutes before getting to those money supply questions by at
least alluding to the broader economic setting.
FIFTH YEAR OF RECOVERY AND EXPANSION
You know that we are now entering into the fifth year of recovery and expansion and I think this is an unusual expansion in
more respects in that it's been relatively long already. Among
other things, at the end of this 4-year period, we find both the inflation rate and the interest rate lower than when expansion started, which is unusual in itself.
And I think basically the traditional indicators of cyclical problems that we have had in the past are largely absent.
But I do have to emphasize that the economy is struggling with
structural distortions and imbalances that for this country have
little precedent. You know the facts and outline. The economic ac-
94
tivity over the past 2 years has been supported very largely by consumption. That's been at the expense of reduced personal savings
rates that by world standards were already chronically low. At the
same time, the huge Federal deficit is absorbing a disproportionate
amount of what savings we have in this country. We have largely
escaped the adverse impacts of that for financial markets by drawing on capital from abroad.
In 1986, the capital that we have enjoyed from abroad has actually exceeded all the savings by U.S. households. The other side of
that coin, however, is a massive trade and current account deficit,
restraining growth in manufacturing generally and incentives for
the industrial investment that we will need in the years ahead.
The simple facts are that we are spending more than we produce
and that we are unable to finance at home both our investment
needs and the Federal deficit. Those are not conditions that are
sustainable for long—not particularly when, as at present, the
influx of capital from abroad cannot be traced to a surge in productive investment.
Sooner or later that process will stop and the only question is,
how? I go over in my statement some possible approaches that I
reject and say basically the only reasonable alternative is adopting
a variety of measures. It's a complicated process, but it is the only
promising prospect to me as opposed to protectionism or permitting
inflation to rise or not dealing with the deficit.
We have to draw upon a combination of policy instruments. The
results are going to take time, but they will come with greater certainty, and they should be consistent with maintaining growth
here and abroad.
They have to be consistent with price stability and with open
markets and I think very broadly that is the course upon which we
are embarked. And the success of that course is going to require an
unusual combination of discipline, patience and international cooperation. But the stakes are such that I don't think we have any
choice, not just for the United States but for the world.
I review the progress that has been made. The dollar is at much
more competitive levels than it's been. We are making progress at
least this year on the deficit question. I think that's going to be
harder for you next year. Some of the things contributing to the
reduction from a record deficit are temporary and we've got to
keep that deficit coming down on an orderly course.
COMPLEMENTARY ADJUSTMENTS
I do spend some time in the statement pointing out the implications for the world economy. We loom very large in that economy.
If we move to improve our trade deficit here, it obviously has impacts on others. We would like to see complementary adjustments.
I think the world must see complementary adjustments in the
major countries with exceptionally large surpluses and that, of
course, notably means Japan and Germany, both of which now are
experiencing some decline in their net exports but alongside of that
I think there's some evidence that their economic activity is faltering. They essentially have the opposite problem that we do, sustaining internal demand while reducing the trade surplus. We're
95
going to have to diminish internal demand while seeing more
demand from abroad.
Certainly they don't find these changes much easier than we do.
The design, nature of the measures, are going to have to be their
decision, the precise timing—they are all strongly debated, but
what really matters is that they do, it seems to me, have a clear
responsibility for maintaining a strong momentum of growth in
their economies as they absorb more imports from the rest of the
world.
I could make similar comments about a few of the newly industrialized countries.
I should at least allude to the fact which is discussed in my statement that the international debt situation remains highly relevant
to growth and financial stability around the world. I think there's
been progress in that area over the past 4 years, but I think there
are clear problems as well. And the fact that world growth has not
been as well-maintained as we hoped makes it more difficult for
them but, more precisely, right now in recent months, the process
of reaching agreement on adequately supportive and timely financing programs for those countries, whether by restructuring existing
debts or by arranging what new loans are necessary, has conspicuously slowed, for a variety of reasons. I think that logjam has to be
broken.
Now the implications for broad U.S. policy I think are pretty
clear. We have an inescapable responsibility to deal with our
budget deficit. We have got to restore internal balance if we're
going to restore external balance. And I don't think that responsibility is important just because of our own situation where we are
so dangerously dependent on foreign savings, but because of a
broader consideration.
Progress abroad, as a practical matter, is likely to be stymied
without constructive leadership from the largest and strongest
nation. And if we, instead, resort to closing our markets, if we are
indifferent to depreciation of our own currency, if we permit inflationary forces to regain the upper hand, there isn't going to be any
basis for confidence in the United States, and prospects for complementary action abroad or for growth in the world economy would
then be dim indeed.
Second, I think we have to recognize the adjustments do require
a shift in financial and real resources into internationally competitive industry and away from consumption and Federal deficits.
Without a sharp rise in overall productivity from the 1 percent
or so rate characteristic of the past decade or more, I see no reason
to suggest that trend will change abruptly—the recent rate of consumption is simply unsustainable for long. More of our growth
needs to be reflected in exports and in business investment and less
savings will be available to finance the Government.
Now fortunately, in the manufacturing area, which is the key
area of international competition, growth in productivity and restraint on costs have been relatively strong, and that is very helpful, but the challenge is to maintain that performance in the face
of a depreciating currency.
96
Now a lot of policy instruments are involved here, but let me
turn to monetary policy which obviously has a critical role to play
and it has a great advantage of flexibility.
RAPID GROWTH OF MONEY AGGREGATES
I review in the statement what you have already alluded to—you
and others, Mr. Chairman—the rapid growth of the various monetary aggregates, particularly Ml last year. We also reduced the discount rate several times last year. Essentially, I think we have had
a generous provision of reserves, a large expansion in money.
I must emphasize that that took place in and appeared justified
by an environment of restrained economic growth and declining inflationary pressures. The latter, to be sure, was dramatically and
importantly reinforced by a temporary factor—the sudden collapse
of the world's most important commodity—oil.
But potentially more lasting indicators of inflationary pressure—
the rate of increase in workers compensation and the prices of
some services that respond slowly to changes in economic environment, were also trending downward. For much of the year, most
commodity prices other than oil measured in dollars were falling
despite the depreciation of the dollar in the exchange markets.
Moreover, sizable declines in long-term interest rates seem to reflect some easing of fears of a resurgence of inflationary pressures
in the future.
Nonetheless, the possibility of renewed inflation remains of concern both in the markets and certainly within the Federal Reserve,
and I would note that one potential channel for renewed inflationary pressures would be an excessive fall of the dollar in the exchange markets and at times during the past year such exchange
rate considerations did prompt particular caution in the conduct of
policy.
Now I review in several pages here, Mr. Chairman, the analytic
work that's been done quite intensively through the year to try to
get a handle on this growth in the monetary aggregates. I won't
take the time to review that here. It is obviously related in substantial part to the declines of interest rates we've had that affects
the demand for money. I hope that it reflects some greater confidence in money. It may, to some degree, reflect the exceptional
amount of financial activity we've had in markets, but the changes
in these relationships, partly growing out of institutional changes,
certainly does pose new questions in setting monetary targets to
help guide the conduct of monetary policy. In the broadest terms, a
leveling, and even some decline, in velocity could be welcomed as
an appropriate sign of growing confidence in the value of holding
money during a period of disinflation. But explanations revolving
around declining interest rates and greater confidence in price stability beg the larger issue.
Not all the increases in money can be adequately explained by
interest rate relationships, nor can we be certain about what interest rate is appropriate. We know that confidence is hard to win and
easy to lose. We need to be conscious of the fact that the effects of
excessive money creation on inflation may only be evident with
lags and they may be quite long.
97
As a consequence, we cannot avoid relying upon a large element
of judgment in deciding what, considering all the prevailing circumstances, money growth is appropriate.
Obviously, so far as 1986 is concerned, the Open Market Committee made the judgment that relatively strong growth in the aggregates, and particularly Ml, could be accommodated consistent with
the more basic objectives of orderly growth and price stability. Neither the rate of economic growth, nor the margins of available resources, nor underlying cost trends, nor the movement of sensitive
commodity prices suggested money growth was setting in train renewed inflationary forces.
RAPID RATE OF DEBT
I must say the continuing rapid rate of debt throughout the economy has raised one warning flag. In one sense, the enormous
volume of purely financial activity, especially at year end but also
at times earlier, reinforced other factors increasing the demand for
money. But from another point of view, the ready availability of reserves and money was also a factor facilitating that same increase
in purely financial activity.
The implicit dangers in that process should be clear. More leveraging of corporations, aggressive lending to consumers already laboring under heavy debt burdens, and less equity in homes all increase the vulnerability of the economy to economic risk. The fact
that after 4 years of expansion many measures of credit quality are
tending to deteriorate rather than improve, and that too many depository institutions are strained, should be warning enough.
Restraining more speculative uses of credit by more restrictive
monetary policy is, of course, possible. But that blunt approach inevitably has implications for all credit and for the real economy as
well as financial activity. It cannot substitute for prudent appreciation of the risks in highly aggressive lending by those engaged in
financial markets, reinforced and encouraged by regulatory and supervisory approaches sensitive to the potential problems.
Now in looking at 1987, the Open Market Committee remains
highly conscious of the long historical patterns that relate high
rates of monetary growth over time to inflation. Consequently, in
approaching 1987, it starts with the strong presumption that such
growth should be moderated. Reflecting that intent, the tentative
target ranges for M2 and M3 set out last July were reaffirmed.
While those ranges are only slightly below those set 1 year ago, the
Committee expects that the actual outcome should be much closer
to the middle of the range and near to the anticipated growth in
nominal GNP, assuming interest rates prove to be more stable
than in recent years.
While anticipating much slower growth than in 1986, the Committee did not set out a specific target range for Ml. Given the developments of recent years, uncertainty obviously remains about
the long-term relationship between Ml and nominal GNP in
today's institutional setting. That uncertainty about the trend
might be encompassed by a relatively wide target range. However,
the shorter term sensitivity of Ml currently to interest rates and
other economic and financial variables realistically would require
98
so wide a range, or tolerance for movements outside its bounds, as
to provide little guidance for the Committee's operational decisions
or reliable information for the Congress or for market participants.
Instead, the Committee will monitor Ml closely in the light of
other information, including whether or not changes in that aggregate tend to reinforce or negate concerns arising from movements
in M2 and M3. More broadly, the appropriateness of changes in Ml
will depend upon evaluation of the growth of the economy and its
sustainability and the nature of any emerging price pressures.
Among important factors influencing such judgments may be the
performance of the dollar in the exchange markets.
I recognize the success of that approach rests on good judgment
and a degree of prescience. It is justified only by the fact that setting out a precise Ml target—and weighing it heavily in policy implementation, whatever the circumstances—would run greater
risks for the economy.
I must also point out that the sensitivity of Ml to interest rates
and other developments will not always work in the direction of
relatively high growth. To the contrary, action to reduce the rate of
Ml growth, promptly and substantially, would be called for in a
context of strongly rising economic activity and signs of emerging
and potential price pressures, perhaps related to significant weakness of the dollar externally. In that connection, the Committee explicitly reserves the possibility, in making shorter run oeprational
decisions from meeting to meeting, to use Ml along with M2 and
M3 as a benchmark. Conversely, lower interest rates in a context
of weak growth and further progress toward reducing inflation
pressures would suggest an accommodative approach toward Ml
growth.
In fact, as you know, the statistical and other signals provided
about economic activity and prices seldom are unambiguous or
have the same directional implications for policy. In evaluating the
evidence as it does appear, the Committee will naturally be sensitive to the desirability of maintaining the forward momentum of
the economy, as well as encouraging greater price stability. Quite
obviously, our task in that respect will be eased to the extent fiscal
policy is consistent with the needed internal and external adjustments.
INFLATION
Finally, so far as inflation is concerned, what is critical is that
the anticipated bulge in prices this year related to identifiable temporary external developments—oil and import prices—not be translated into a broad-based cumulative upward movement. As you
well know, just such a cumulative upward inflationary process
started in the 1960's and then extended well over a decade into the
1980's. It was eventually brought to an end, but only with great
effort and at considerable cost. The scars of that experience
remain.
Against that background, participants both in financial markets
and in business have persistently been skeptical of prospects for
lasting price stability in making investment and pricing decisions.
They are bound to be alert and responsive to any sense of adverse
99
change in the underlying inflation trend, with implications for interest rates, exchange rates, and pricing policies. The consequences
for the economy would clearly be undesirable.
In effect, neither the internal nor external setting permits thinking of trading off more inflation for more growth. Nor would inflation ease the problem of international adjustment. Quite to the
contrary, it would both undercut some of our competitive gains and
threaten the orderly inflow of funds from abroad. The implications
for caution in the conduct of monetary policy are evident.
Thank you, Mr. Chairman.
[The complete prepared statement of Paul Volcker follows:]
I appreciate this opportunity to review once again
with this Committee the conduct of monetary policy against the
background o£ economic and financial developments here and
abroad.
As usual, a mare detailed review of last year, of the
by the federal Open Market Committee, and of the Committee's
TMtiraony by
Paul A. Volcker
Chairman, Board of Governor* of the Federal Reserve Systc
before the
Comlttee on Banking, Bousing, and Urban Affaire
United States Senate
projections for economic activity and Inflation are set out in
the Hoard's formal Humphrey-Hawkins Report delivered to you
earlier.
This morning, I want to concentrate on more general
considerations underlying the policy approaches of the Federal
Reserve.
1 will emphasize particularly how those approaches
must fit into a broader pattern of complementary action both in
the United States and in other countries if the common objective
February 19, 1987
reached.
The Economic Setting
The current economic expansion —
now extending into
the absence of certain signs of cyclical excesses that often
rates, after four years of expansion, ars substantially lower
develop after yearK of expansion.
than when the recovery started.
For instance, inventories
Homebuilding is being well
have t?een held well within past relationships to sales, and
maintained, and both capital a^ labor appear available to
spending by manufacturers for plane and equipment has, if
support further growth for some time without undue strain on
anything, been resti-'^ined relative to prospective needs*
resources.
While the overall rate of economic yrowth ^as been
Certainly, conditions in financial markets, with
stock prices exuberant and interest rates generally as low as
rather moderate since mid-1934, averaging about 2-1/2 percent
at any time since the mid-1970s, appear supportive of new
a ye a i*, that growth hae been -ia inta L ned despite gtriincj pressures
i nvr:a ti"e nt.
on sizable sectors of the economy.
Oil exploration and develop"
But it the traditional indicators of cyclical problems
ment activity and agricultural prices have both been heavily
are largely absent, it is also evident that the economy is
many areas is suffering from earlier over~building.
for us, have little precedent.
o£ the country
Regions
in «hich those impacts have been particularly
large have thus regained relatively depressed.
Difficult as
Economic activity over the past
two years has been supported very largely by consumption-
That hi
been at the expense of reduced personal saving rates that, by
those regional conditions have been, however, many of the necessary
world standards, were already chronically
adjustments are well advanced and other areas of the economy
the huge federal deficit is absorbing a disproportionate amount
have been moving strongly ahead.
of our limited savings.
low.
At the same time,
-4-
-5It IB not supportable politically, as the pressures
For a time, we ha.«e largely «acapad the adverts
consequences for financial markets of that insidious combination
on our Industrial base are transmuted into demands for protection.
Ultimately it will not be supportable from an international
of low saving rates and high federal deficits by drawing on
capital from abroad —
the flow of which in 1986 actually
exceeded all the savings by U.S. households.
The other side of
perspective either, as the confidence that underlies the flow of
foreign savings will be eroded.
Sooner or later, the process will stop.
that coin, however, is a jaaasive trade and current account
deficit, restraining growth in nanufactoring generally and
question Is how.
Incentives Cor trie Industrial tnveitnent that we will need
The Broad Policy Approach
The only
In concept, MB could shut Olf th* Clou ol import* by
tn the y«r« ahead.
O
to
The simple facts are that we are/ spending more than we
aggressive, broadbrush protectionist measures.
But the result
produce and that we are unable to finance at home both our investment
would be to drive up the rate of inflation and interest rates
needs and the federal deficit.
here, to damage growth abroad, and to invite retaliation.
Those are not conditions that are
Instead of sustained and orderly growth, we would invite
(com abroad cannot be traced to a surge in productive investment.
world-wide recession.
We could try to drive the dollar much lower —
It'e not sustainable from an economic perspective to
or
pile up foreign debts while failing to make the Investment that
complacently sit back while the market forces produce that
we need both to generate growth and to earn the money to service
result.
the debts.
against inflation, and would risk dissipating the flow of
But that too would undermine the hard-won gains
be consistent with maintaining growth here and abroad, with
financial markets would be jeopardized, and export prospects
markets.
That is, in fact, tne course on which we are embarked.
might reasonably embark upon strong austerity programs —
indeed
sooner or later would be forced to undertake such programs.
To be sure, its success will require an unusual combination
Large
doses of fiscal and monetary restraint would be taken, risking
I djn't think there is any real choice.
respond vigorously, imports would decline, and their economies
Important steps have already been taken in the needed
o
CO
would soon resume growth on a much sounder footing.
But, in the
context of a sluggish growth of the world economy, for the United
and the results would be problematical at best.
complicated, but at the same time much more promising.
He can draw upon a combination of policy instruments to
encourage the needed adjustments.
Results may take time.
epreciatic
But
we have been fortunate that the initial impact on the overall pr
level was more than offset by falling oil and other conmodity
Success in my mind will not be measured so much by
whether we meet some pre-ordained arbitrary target but by
wages relative to productivity, has continued to fall.
whether in fact a reasonably steady downward pace in the
deficit is maintained as the economy grows —
and maintained
aoye
abroad, has been well
nalr
that, it's hard to see how a sustained decline in the trade
deficit, 1C possible at all in the face of huge budget deficits,
In reducing our current account deficit, the net capital inflow
will bring net benefit to the economy.
will decline as well.
would be congested capital markets, higher interest rates,
That enphasizes the critical importance
The clear implication
of moving ahead with further reductions in the federal budget
deficit which absorbs so much of our own savings.
The progress being made in that direction this year
Is heartening.
But that can only be a start.
The projected
Inevitably, because we loom so large in the world
economy, marked improvement in our trade balance will be
reduction of S40 to SSO billion this year is fron a record high
matched by noticeable deterioration elsewhere.
deficit of more than $220 billion in fiscal 1966 —
that should take place largely in the major countries with
5 percent of the GNP —
temporary factors.
more than
Appropriately,
and it is being assisted by some
Progress next year will be harder.
al net
effectively
-10-
unless those c o u n t r i e s and others are able to m a i n t a i n a strong
For years, those countries have been dependent Cor
growth m a i n l y on high and r i s i n g export surpluses.
In both
instances, some s h i f t toward domestic demand was apparent in
IB being -- strongly debated within those countries.
What is
the measures or their enact timing, but that, at the end of the
day, they are successful in maintaining a strong momentum of growth
even as they absorb more imports from the rest of the world.
One rianger is that, in the absence of stronger domestic
That p o i n t s in the needed d i r e c t i o n .
declined.
But there are also signs
At the same time, r e l a t i v e l y high levels of
unemployment
growth, pressures will intensify for more appreciation of their
Given the size of the exchange rate adjustments already made,
o
en
and unused
of inflationary pressures that they, understandably, want to
Quite obviously, the needed reorientation c-f economic
policies —
essentially the complement of our own —
is no
Some newly industrialized countries also have clea
-13In the interests of their own citizens as consumers, as well
jl action te
increase imports, whether by reducing tariffs, by lifting othe
thwart prospects for expansion, and with it the encouraging
progress that has been made toward both more open, competitive
economies and political democracy.
Success in these efforts, I must emphasize, will not
necessarily oc primarily be measured by changes in our own
bilateral trade vis-a-vis particular countries.
What la needed instead is
greater access by those countries to growing markets in Europe
and Japan as well as here.
The recent changes in exchange rates
An open
competitive trading order ia by its nature multilateral, and u
and others should judge equilibrium in a world-wide content.
In that connection, most of the developing world,
Japan.
At the same time, imports by the developing world from
already carrying heavy debt burdens, is in no position to
a year or two ago.
revalue currencies or to absorb much higher imports (from the
The Debt Situation
United States or from others) without more or less parallel
I cannot neglect emphasizing one further continuing
countries.
Management of the debt problems of Latin America and
some other developing countries is again at a critical stage.
exports
reason Is not that progress is absent.
at all.
the heavily indebted countries have been growing —
o
Oi
the United States have become much more price competitive than
The
To the contrary, most of
it for the most
move lower r e l a t i v e to exports or other measures at capacity to
pay,
and new f i n a n c i n g needs have been reduced.
Perhaps most
the unfortunate effect of dulling a sense of urgency and cooperation
progress toward liberalizing trade, opening markets, and reducing
by some.
i n t e r n a l economic d i s t o r t i o n s , w i t h the World Rank p l a y i n g a
through on past efforts now would plainly jeopardize much of that
p a r t i c u l a r l y h e l p f u l role.
success and threaten new strains on the financial system.
I do not want to deny the progress.
But to fail to carry
Implications for U.S. Policy
col
Several key implications of all this for the United
Impair prospects for the developing countries to find the markets
ttiey need.
More tinned, lately, in recent months, the process of
reaching agreement on adequately supportive and timely financing
what new loans are necessary, has conspicuously slowed.
complexity of the individual financing programs themselves,
most of which require the agreement of hundreds of banks around
tne world.
States should he clear.
In some instances, policy set-backs in the borrowing
fit
-16-
forces to regain the upper hand, then there would be no basis
£ar confidence. Ln the United States.
Prospects ior etteEtive
that performance in the face of a depreciated currency, higher
import prices, and more sizable needs for new investment to
Second, we have to recognize that the needed adjustments
Finally, achieving these goals in the context of
into internationally competitive Industry and away from consumpt ion
the capacity of any single policy instrument.
and federal deficits.
monetary policy will have a critical role to play.
Without a sharp rise in overall productivity
Quite obviously,
In doing so,
o
00
is simply unsustainable for long.
Instead, more of our growth
will need to be reflected in net exports and business investment,
and leas savings will be available to finance government.
conflicting criteria.
Rapid Growth of Money and Liquidity
Throughout 1986, monetary policy accommodated a
growth and restraint on costs in the key manufacturing sectors
the narrowly measured money supply —
has been relatively strong during the period of economic
particularly rapid pace.
Ml -- grew at a
The discount rate was reduced
four
-IB-
-19-
pressures, measured by average adjustment borrowings o£ depository
the future.
institutions from the Federal Reserve, was relatively low throughout
1986, and has remained BO since.
Nonetheless, the possibility of renewed inflation
remains of concern both in the markets and within the federal
This generous provision of reserves and expansion in
Reserve.
One potential channel for renewed inflationary pressures
noney took place in, and appeared justified by, an environment
would be an encessive fall of the dollar in the exchange markets,
of restrained economic growth and declining inflationary
At times during the past year, such exchange rate considerations
pressures.
prompted particular caution in the conduct of policy.
The latter, to be sure, was dramatically and
The timing
collapse in the price of the world's most important comtnodtty,
the provision of reserves was affected; on occasion close
pressure —
particularly important.
the rate of increase in workers' compensation
and in prices of some services that respond slowly to changes
in the economic environment —
More generally, intensive analytic work during the
were also trending downward.
year suggested that much of the relatively rapid growth in the
For much of the year, most commodity prices other than oil,
various monetary aggregates was closely related (with lags] to
measured in dollars, vere falling despite the depreciation of
the rather sharp declines in market interest rates late in
the dollar in the exchange markets.
1985 and the aarly months of 1986.
Moreover, the sizable
declines in long-term interest rates seemed to reflect Borne
The responsiveness of
money demand to changes in interest rates is a well established
ause ol its composition, Ml was p a r t i c u l a r l y
influenced
widely used by i n d i v i d u a l s are close to rates paid on competing
accounts have riot declined n e a r l y as much as m a r k e t rates or
those on longer—term deposit accounts.
C o n s e q u e n t l y , there
Both H2 and >43 ended the year w i t h i n -- hut
w i t h i n — t h e i r target r a n g e s .
just
Even so, the increases of
has been a strong incentive to t r a n s f e r f u n d s to NOW ( a n d to
almost 9 percent were about as large as most e a r l i e r years,
some e x t e n t s a v i n g s ) accounts and away from other, leas l i q u i d
when i n f l a t i o n and the cat* af economic growth wete higher.
instruments.
Demand deposits, which are largely held by businesses
r a p i d increases in monetary growth m e a n t that all
measures of
v e l o c i t y ( i . e . , the r a t i o of n o m i n a l GUP to money) d e c l i n e d .
in earlier years.
In p a r t , that was also a r e f l e c t i o n of
That was p a r t i c u l a r l y e v i d e n t in the case of M l ; the v e l o c i t y
decline of 9 percent was greater t h a n in any year since
World War II.
Hh
attractive.
jrt
-22since intsreat rates peaKed In 1981 and 1982.
The earlier post-
and easy to lose.
We need to be conscious
the effects of excessive money creation on inflation ma/ only
trend established during a period of generally rising inflation
and interest rates —
be evident with lags —
possibly quite long.
clearly does not provide a reasonable base
for judging appropriate HI growth today.
Historically, there
level is historically a bit low relative to other periods of
low or declining interest rates.
element o£ judgment in deciding what, considering all the
Obviously. 50 far as 1986 is concerned, the FOMC made
the judgment that relatively strong growth in the aggregates,
All of this posea new questions in setting monetary
and particularly Ml, could be accommodated consistent with the
more basic objectives of orderly growth and price stability.
broadest terras, a levelling, and even some decline, in velocity
Neither the rate of economic growth, nor the margins of available
could be welcomed as an appropriate sign of growing confidence
resources, nor underlying cost trends, nor the movement of
In the value of holding money during a period of disinflation.
sensitive commodity prices suggested money growth was setting
in train renewed
greater confidence
in price stability beg the larger issue.
Not all the increases in money can be adequately explained
inflationary forces.
The continuing rapid rate of debt throughout the economy
running far above the rate of economic growth since 1982 —
has
by interest rate relationships, nor can we be certain about
raised one warning flag.
what interest rate is appropriate.
purely financial activity, especially at year end but also at
Confidence is hard to win
In one sense, the enormous volume of
-25reinforced and encouraged by regulatory and supervisory
for money.
approaches sensitive to the potential problems.
But
The_flpproach to 1987
increase in f i n a n c i a l a c t i v i t y .
corporations, aggressive lending to consumers already l a b o r i n g u n d e
high rates of monetary growth over time to inflation.
ties
in approaching 1987, it starts with the strong presumption that
such growth should be moderated.
four years of expansion, many measures of credit quality are
Consequently,
Reflecting that intent, the
5-1/2 to 8-1/2 percent uere reaffirmed.
while those ranges
are only slightly below those set a year ago, the Committee
depository institutions are strained, should be warning enough.
expects that the actual outcome should be much closer to the
ipated gt
restrictive monetary policy is, of course, possible.
blunt approach inevitably has implications for all credit and fc
stable
But that
than in recent years.
While anticipating much slower growth than in 1986,
Given the developments of recent years, uncertainty obviously
-27-
-26remains about the long-term relationship between Ml and nominal
GNp.
That u n c e r t a i n t y about the trend might be encompassed by a
good judgment and a degree of prescience.
It is j u s t i f i e d only
by the f a c t that s e t t i n g out a precise M l target — and w e i g h i n g
it h e a v i l y in policy i m p l e m e n t a t i o n , whatever the c i r c u m s t a n c e s —
would run greater r i s k s for the economy.
tolerance for movements outside its bounds) as to provide l i t t l e
rates and o t h e r d e v e l o p m e n t s w i l l not always work in the d i r e c t i o n
of r e l a t i v e l y h i g h growth.
information
To the c o n t r a r y , action to reduce the
r a t e of Ml growth, promptly and s u b s t a n t i a l l y , would be called for
i n a context of s t r o n g l y r i s i n g economic a c t i v i t y and s i g n s of
emerging and p o t e n t i a l price pressures, perhaps related to
tram movements in M2 and M3.
More broadly, the appropriateness
economy and ita austaInability and the nature of any emerging
peice pressures. flmong the important factors influencing such
along w i t h H2 and H3 as a benchmark.
judgments nay be the performance of the dollar in the exchange
rates in a context of weak growth and f u r t h e r progress toward
market a.
approach toward Ml growth.
Conversely, lower interest
That would be about
about economic activity and prices seldom are unambiguous or
have the same directional implications for policy.
In
So Ear as infl
temporary external developments not be translated into a broadforward momentum of the economy, as well as encouraging greater
band cumulative upward movement.
price stability.
c u m u l a t i v e inflationary process started in the 1960s and then
Quito obviously, our task in that respect
will be eased to the extent fiscal policy Is consistent with the
As you well know, just such a
extended well over a decade into the 1930s.
It wag eventually
Most members believe that GNP growth of 2-1/2 to 3 percent
is now likely, although a few individual members have higher or
lower projections.
such growth should be consistent uitti continuing
Against that background, participants both in financial
markets ar,fl in business have persistently been skeptical ot
sizable gains in employment and a slight downward tilt in the
prospects for lasting price stability in making investment and
unemployment rate.
pricing decisions.
Membera also agree that the rate of price
They are bound to Be alert and responsive
increase is very likely to be greater than last year( essentially
to any sense of adverse change in the underlying inflation
because oil prices are expected to average higher and because
trend, with implications for interest rates, exchange rates,
and pricing policies.
forecasts bunch in the 3 to 3-1/2 percent area for the GNP deflator.
The consequences for the economy would
clearly b* undesirable.
permits t h i n k i n g of trading off more i n f l a t i o n foe more growth.
involved, and all of them have tough p o l i t i c a l decisions to
c o m p e t i t i v e g a i n s and threaten the orderly i n f l o w of funds team
make.
Nor are th« key decisions entirely in the hands of
governmental authorities.
it.
A m e r i c a n industry, in p a r t i c u l a r ,
has the challenge to build upon the efforts of recsnt years
and imbala
p r e s s i n g debt problems of their borrowers at home and abroad.
from one point of view, it may seem liXe a lot to a s k .
J i l l be amplified by tne effects on other countries.
Moreov
We already have a c h i e v e d a long economic expansion.
We have managed to combine that w i t h progress toward price
-32-
rates.
Financial markets more generally
reflect renewed confidence
And the broad outline o£ policies that can preserve and extend
those gains are by now well known.
resistance.
Hut. those are also precisely the ways by which we
would turn out hack to the bright promise before us.
It 1* only a concerted effort here and abroad that will
estend and reinforce the economic expansion, consolidate the
environment in which all countries c<
117
REPORTING REQUIREMENTS FOR THE FED
The CHAIRMAN. Thank you very much, Chairman Volcker.
Chairman Volcker, let me first ask about that question that I
raised with respect to your dropping Ml as far as a specific target
is concerned.
I want to read from the law of 1978. It says:
In furtherance of the purposes of the Full Employment and Balanced Growth Act
of 1978, the Board of Governors of the Federal Reserve System shall transmit to the
Congress not later than February 20 and July 20 of each year
and so forth,
The objectives and plans of the Board of Governors and the Federal Open Market
Committee with respect to the ranges of growth or diminution of the monetary and
credit aggregates for the calendar year during which the report is transmitted.
Now technically, the law does not spell out a definition of the
monetary aggregates, although at the time it was written Congress
clearly had Ml in mind. It was only at the request of Chairman
Burns that the phrase "monetary aggregates" was used to allow
the Fed to report on additional measures of the money supply such
as M2 and M3.
The fact that Congress gave the Fed leeway to include additional
measures does not mean you have the authority to drop Ml from
your reporting requirements. Clearly, Ml is a monetary aggregate,
although economists have some dispute about its velocity. In any
event, I believe the law does not give you leeway to ignore reporting at least a range on Ml.
So my question is, have you obtained an opinion from your general counsel as to whether the Fed has the authority to drop Ml
from its Humphrey-Hawkins report and, if not, why didn't you
seek such an opinion?
Mr. VOLCKER. I think it's fair to say that our general counsel was
present when many of these discussions took place and he raised
no objection. I think the clear, plain language of the law as you
read it does not necessarily require an Ml target range.
The substance of the matter, as I tried to describe in my statement, is that I don't think it would be of benefit to you or to us or
to the public at large to set forth either a target range so extremely wide it's of no operational significance, or set out a target range
and say in a variety of circumstances we would expect to be above
or below it.
The CHAIRMAN. Let me interrupt at that point and suggest that
under those circumstances, why not ask us to change the law?
Mr. VOLCKER. Well, we have not interpreted the law as requiring
that in any sense, Mr. Chairman. We have set out several monetary and credit aggregates, as the law calls for, and we have set out
the ones that in the present situation seem to us most meaningful.
The CHAIRMAN. Would you dispute the notion that in 1978 when
we set this forth we had Ml specifically in mind as the aggregate
and then we only yielded to Chairman Burns
Mr. VOLCKER. Well, I wasn't here during that discussion, but
Chairman Burns, I would say, showed a little foresight in taking
you away from too single-minded a devotion to Ml.
The CHAIRMAN. He didn't take us as far away as you have, however.
118
Mr. VOLCKER. I compliment the Congress for recognizing his concerns.
The CHAIRMAN. Well, he did several things to us. No. 1, he took
us away from just Ml; and No. 2, he took us into a range. And the
ranges, in my view, have become almost meaningless sometimes.
You go from 3 to 8 percent. And then you go to 17 percent in reality. But when you have that big a range, of course, it doesn't mean
very much. The ranges mean very little.
Mr. VOLCKER. Well, I think it doesn't mean very much when we
have a range of 3 to 8 percent and end up at 15 on the basis of the
ranges expressed, to be precise, which is precisely why I don't
think it's a contribution to your discussions and to our discussions
to set out a range in which neither we have any confidence nor
would propose to you to have any confidence in.
The CHAIRMAN. But the value of a benchmark, whether it's 3 to 8
or whether it's 5 or 6 or whatever it is, is that when you do vary
from it we have some basis for asking why, challenging it. We have
a discussion of it.
Mr. VOLCKER. Right.
The CHAIRMAN. When we have something as vague as saying
you're going to monitor it, watch it carefully, and so forth, we don't
have any basis for judging whether it's high, low or in-between or
what it is.
Mr. VOLCKER. Well, one can argue what is the best way of facilitating a discussion, but I would hope we have this basis. We do
have some target ranges and I have tried to set out in the statement some criteria which I think are appropriate for judging movements in Ml. That is precisely the point. If we had a cumulating
expansion and evident signs and maybe even some signs that
aren't conclusive of growing price pressures, a declining dollar,
given the sensitivity of Ml now to these variables, a quite low rate
of expansion of Ml might be appropriate. And that is what I am
suggesting.
It might be below any range that we would set out now and you
ought to have that in mind. Conversely, if we had a situation like
last year—oil prices plunging, the underlying inflation rate declining, the economy rather sluggish—a rather accommodative approach would be desirable.
It all depends I think, given the current institutional setting, on
the economic context in which you are working.
The CHAIRMAN. I want to come back to that. I do want to ask one
other question before my time is up.
This is a hearing on monetary policy and I apologize for asking
one question off the subject but it's so important and timely I must
ask it. My question is on the banking bill this committee will be
considering next week. It has been suggested that the FSLIC recapitalization bill is so important that we should deal only with
that item and take up other issues such as the nonbank bank loophole and security powers for banks at a later date.
119
NONBANK BANK AND SECURITIES ISSUES
What is your view on how urgent it is to act on the nonbank
bank and security powers issues, and should we postpone action as
some have suggested?
Mr. VOLCKER. Well, my view is clearly that those issues are ripe
for action, that they should be acted upon. Indeed, failure of the
Committee and the Congress to act on those issues would be an abdication of your responsibilities to try to direct change in the financial system in a constructive way,
The CHAIRMAN. Thank you very much, Mr. Chairman.
Senator Garn stepped out, so we will go to Senator Hecht.
GRAMM-RUDMAN
Senator HECHT. Thank you, Mr. Chairman.
Mr. Volcker, you more than anyone else have been given credit
for bringing down interest rates and inflation, but I think Congress
in the last couple years had a part in it and my illustrious colleague from Texas I think in Gramm-Rudman in bringing the deficit down in deficit reduction.
If we do not adhere to the Gramm-Rudman reductions in the deficit this year, the targets, and go on a spending spree, what is this
going to do to interest rates and inflation?
Mr. VOLCKER. If you go on a spending spree, to take that part of
the question, and the deficit doesn't decline and increases, I think
it will undercut confidence in our economic prospects. I think it
would be damaging from the viewpoint of the dollar. I certainly
think it would increase inflationary expectations and inflation in
fact, and the consequences from the money market standpoint and
interest rates and economic prospects would be extremely adverse.
Now whether or not you meet the exact targets that the distinguished Senator from Texas set out, I think it's important to have
those targets, I suppose, in the context of the discussion I just had
with the Chairman about monetary targets, but I suppose I must
make a comment similar to Ml. I think what is important is that
you maintain that clear downward momentum, if I can say we
have that—I'm not sure we do—but maintain the pattern at least
this year of a declining deficit in a significant way, not just in 1988
but in the years beyond—are you on a trend that is what the Senator from Texas had in mind that clearly deals with this problem?
Whether or not you reach exactly a $108 billion deficit I don't
think is in that sense the issue. Are you on a clear and sustainable
downward process on the deficit?
Senator HECHT. Well, the 100th Congress has only been in session roughly a month and several times on key votes—are we going
to waive the Gramm-Rudman and spend more than budgeted—and
I think there's a clear indication that this Congress might not
adhere to these limits.
Mr. VOLCKER. Well, when you say $108, that's a limit, that's a
rather arbitrary number. What I would urge with all the force at
my command is that you maintain the deficit reduction, assuming
growth in the economy and forecasts based upon reasonable estimates of growth in the economy—that you maintain a strong
downward momentum in the deficit.
120
Senator HECHT. What I want to do is bring this to the business
people back home that I've been associated with all my life, the
people that have created all these new jobs. If we do not—let me
just be specific. If we do not continue this downward holding the
budget and tightening our belt, this will produce higher interest
rates.
Mr. VOLCKER. I think that is on a course toward fewer jobs and
more inflation.
Senator HECHT. Thank you. Let me just talk about a statement
that Secretary Hodel made yesterday. It is possible by the year
1990 we're going to see oil lines again. We all know about the decline in oil production in America and the volatile Middle East.
What will this do to our economy and interest rates if we are
forced to pay higher prices for oil?
Mr. VOLCKER. Well,, of course, it depends upon how much. We
would like a situation in the oil market that I think is not—I
would anyway—one that doesn't go up and down so much because
that's disturbing in itself. What level of prices is the best level in
some sense for a balance in supply and demand around the world
that could be sustained—and I think it is a worldwide problem—is
the question at issue.
Clearly there is a matter of judgment here insofar as the United
States is concerned as to what price maintains reasonably our own
oil production, which is probably declining anyway. I think in a
sense the more significant question is, because oil is a worldwide
commodity, how we best keep the worldwide situation in some kind
of reasonable equilibrium for the next 5 or 10 years.
Senator HECHT. Of course, this is a military situation because the
Middle East is militarily unstable right now.
Mr. VOLCKER. True.
Senator HECHT. And we have such a huge amount of proportion
of oil in that that we have no guarantee.
Mr. VOLCKER. The world's and our reliance on Middle Eastern oil
has been going up some recently, but there's a lot of oil in the
Western Hemisphere too, and there are a lot of other questions of
oil policy from a security standpoint that arise here as well as to
what the relative different sources of supply are and to what
degree we should be relying upon different sources.
I think it's clear we are import-dependent in any event and we
seem to be getting more import-dependent. It's a question of how
fast and then many other questions of policy as to how you best
assure the supply that we are inevitably going to have to import.
Senator HECHT. When you get in Washington, we call it the beltway area, and for some reason there's always a certain amount of
gloom attached to it, but then when you look at what's happening
in the world markets, the stock markets particularly, there's nothing but expectation and what's been going on.
Getting back to Congress again, if we do not hold these spending
cuts down and interest rates go up, what will this do to the economic situation around the world?
Mr. VOLCKER. I don't know what it will do in the short run to
some of those financial markets, but it will be a decided disservice
to the economic situation around the world.
121
As I indicate in my statement, I think there are very heavy responsibilities on the part of other leading economies to take appropriate action. But I think all the lessons of history suggest that if
the United States, as the world's strongest and leading economy
and power, does not take actions on its own that point in the right
direction so far as our own situation is concerned, we are not going
to have many people following us in terms of constructive consistent international policies either.
So you're not only talking about a failure of American policy. I
think under those circumstances you're not going to get much
chance for the right policies abroad and that compounds the risks
for the world economy.
Senator HECHT. Thank you. My time is up.
The CHAIRMAN. Thank you, Senator Hecht.
Senator Riegle.
Senator RIEGLE. Chairman Volcker, I am very much concerned
about the fact that we have become a debtor nation in the United
States within the last 2 years and we are adding new international
debt at the rate of about $1 billion every 2Vfe days. I have made a
chart that I just want to show you here. I'll just hold it up because
I think it relates very importantly to future monetary policy.
It indicates that going back to 1914 we were a creditor nation
without interruption and then when we crossed this line, as I say,
within the last 2 years, we have gone into this debtor nation status.
This chart is to scale, as you can see, both by year and in terms
of billions of dollars. I'm concerned about several things, but I'm
certainly concerned about the velocity of this curve in the
sense
Mr. VOLCKER. You should be.
Senator RIEGLE. Pardon?
Mr. VOLCKER. You should be.
$1 TRILLION DEBT BY 1990
Senator RIEGLE. Well, I think we all should be. The New York
Federal Reserve Board has estimated that by 1990 this trend is
going to continue and their best estimate is that we will owe the
rest of the world roughly $1 trillion based on their current projections.
Now my question is this. Having come into this debtor nation
status, having passed Mexico, Brazil, Poland, and all the other
debtor nations, when we discussed this yesterday with a panel of
economists that were here and others that I've spoken to, they say
there is only really two ways to get out of that kind of a debtor's
hole, which of course, is getting deeper and deeper every day, and
they are: to inflate our currency, and that that's been the historic
way in the past for nations to dig out of an international debt situation if they're in a position to do so; and to recognize that there's
going to be a very substantial reduction in the United States standard of living in the future. Now how that gets spread across the
society is a separate question, but all five economists who were
here yesterday covering a broad range of opinion were unanimous
in their view that the only way to reconcile that kind of interna-
122
tional debt is to accept the fact that we're going to have a lower
standard of living in the future.
Now I'd like your reaction to that. Do you see this as an urgent
problem? Does it lead to those kinds of consequences, in your view?
And if it does, doesn't this—whether you're running the Fed or
somebody else is—doesn't this set us up for an inflationary spiral
at some point in the future simply to try to reconcile that kind of a
debtor nation status? I'd like your reaction to that.
Mr. VOLCKER. Well, I obviously think it's a very serious problem.
I think it's a total illusion to think you're going to escape it by inflating. You may try to fool some of the people some of the time
but you're not going to fool them all all of the time—that old
lesson—too recently we've had inflation, and that is no orderly way
out of that hole. So I think you just reject that.
Although there are pressures that arise out of this situation that
increase the inflationary dangers, there's no doubt about it. If that
capital does not continue to flow at present and the dollar is sharply affected, you have a major source of inflationary impetus.
Senator RIEGLE. Are we seeing some of that now with the dollar
having declined?
Mr. VOLCKER. Well, you are inevitably seeing an increase in
import prices. There's no way you can have this degree of depreciation without import prices going up. They have not gone up nearly
in proportion to the depreciation of the dollar because there was a
lot of slack there, among other factors. The appreciation of the
dollar was relatively recent. Profit margins were very wide. In
some of the countries that export to us from which we import in
the nonindustrialized world, there obviously haven't been much exchange rate change, and until trade patterns change that's provided some relief.
So we have had an increase. We are having an increase in
import prices. We have been somewhat shielded from the effect so
far but we would expect those to be more pronounced this year.
Last year they were offset by the decline in oil prices.
So if you look at the total net effect, it was minus, from oil and
from import prices. Assuming the oil price doesn't go down again,
that won't be the case in 1987.
So you do have an inflationary impact from that source and
what we've got to do is absorb that without it setting off a cumulative inflationary movement. That I think we can do and that is our
job collectively, and it's got particular implications for monetary
policy.
So far as reducing the standard of living is concerned, certainly
it has implications for the standard of living. There is no escape
from that. The increase in consumption has been practically as
large as the GNP. That can't happen continuously. That has only
been possible because we are importing so much.
Senator RIEGLE. And paying for it with borrowed money.
Mr. VOLCKER. And paying for it with borrowed money. If you're
going to stop that process and deal with the debt problem, relatively we're going to have to export more. That will mean consumption
cannot rise so fast. I don't think you have to say the standard of
living is going to decline. The standard of living will not be rising
as fast as it would otherwise rise. There is not doubt about that.
123
Senator RIEGLE. Well, but if you have to pay off that foreign
debt, how do you pay that off without reducing your standard of
living to pay it off?
Mr. VOLCKER. It depends on how long you took to pay it off and
in what circumstances. If you had to pay off all that debt as fast as
it was put on, yes, the standard of living might have to decline. But
if we stabilize it I would be happy for a while and in time I'd like
to see it paid off. The richest country in the world should be exporting capital, not importing capital. But doing that over a period
of time, yes, means our domestic consumption cannot rise as fast as
it has been rising unless we have some miraculous increase in productivity, which I don't think you should count on.
Now how does that come about in an orderly way? It will come
about in an orderly way by reducing the Federal deficit.
Senator RIEGLE. My time is up. I hope to come back to that subject.
The CHAIRMAN. Senator Bond.
Senator BOND. Thank you, Mr. Chairman.
BANK FAILURES
Chairman Volcker, in testimony before this committee we have
heard a great deal about the persistent weakness in agriculture
and energy. Certainly in my State, a heavy agricultural State, and
In States in the oil patch we've seen this reflected in increasing
number of bank failures. In testimony before this committee, FDIC
Chairman Seidman has indicated that there will be a significantly
higher number of bank failures this year than the 145 last year.
What implications, if any, does this have for monetary policy?
What, if any, actions would you propose that Congress might take
to alleviate this problem either through stretching out losses over a
number of years, providing some sort of partial guarantees for loan
write-downs?
Mr. VOLCKER. So far as the implication on monetary policy is
concerned, I would read them more as longer term implications.
Part of this process reflects the difficulties of adjusting to disinflation. Part of it reflects—not so much in your area, but in some
other areas—overexuberance in lending.
I think the greatest contribution we could make to preventing
those problems from arising is dealing with the inflation problem
over time so that we don't have to reverse the process and get into
all these squeezes.
Now obviously, in the agricultural situation, there's just a worldwide problem at the moment that isn't susceptible I think to monetary policy or any other policy except the Government is providing
$30 billion a year for the support of agriculture which indirectly
obviously helps the lenders as well as the farmers themselves. So
there is really rather massive Federal support being given.
I do not see that the situation requires special guarantees or
whatever for those banks or for their lenders, against the background that the Government is providing a great deal of support to
the farmers themselves.
Senator BOND. You have mentioned in your testimony the great
concern over the growing corporate debt load in this country. Are
124
there steps which you might recommend to Congress that we take
in terms either of requiring full financing be available before a
takeover or applying margin requirements to takeovers that might
responsibly inhibit the growth of that debt?
Mr. VOLCKER. I don't have any recommendations of that sort
now, Senator. In the area of margin requirements where we have
experience, that is a question we have looked at in the past and
made a rather marginal ruling that attracted a great deal of attention at the time. But I don't think those margin requirements are
designed to deal with this kind of takeover problem and I'm not
sure that that's a tool that can be adequately used.
I think we do have responsibilities, insofar as we supervise the
banking system anyway, to encourage prudence in that area. And
that is a very important ingredient I think in an overall approach
toward the financial problems that I see not just in the corporate
area but elsewhere. We have a rapid expansion in consumer credit,
mortgage credit and other types of credit. So there are clear implications there.
I think the market itself has to look at some of its practices.
Senator BOND. The Farm Credit System, as you well know, has
been running up increasing losses and I understand that Federal
Reserve banks are allowed to purchase Farm Credit System securities. What, if any, steps would the Federal Reserve take if there
were a funding crisis for the Farm Credit System?
Mr. VOLCKER. Well, I think if there were that kind of liquidity
crisis that you suggest, we do have some authorities to lend the
money. We also have authority to buy their securities, as you say,
but that is an open market authority, if I can make a distinction.
Those operations should be conducted entirely with a view toward
the monetary and credit base of the country.
If you have a liquidity problem of that sort, the tool would be
through the discount window and there is some quite limited direct
authority in the Federal Reserve Act for lending to certain elements of the Farm Credit System. It is quite limited. We have
broader emergency powers as well.
But I think fundamentally the answer to that question should
not be sought simply in Federal Reserve lending—but we do have
some authority.
Senator BOND. There has been some speculation that the rising
stock market has reflected primarily the increase in the money
supply and the falling value of the dollar.
Do you feel that this market rally is driven by liquidity or by
basic economic facts?
Mr. VOLCKER. Well, I hate to speculate upon particularly shorter
term market movements and I'm not sure my understanding is any
greater than the commentary you can read in the paper every day.
I don't trace it to any particular recent increase in the money
supply, but as I say in my statement, I think it could be argued
that the rather liberal growth of the money supply this year certainly was not inconsistent with more money flowing into the stock
market or other areas of the financial markets.
And to the extent that would be determined to be overexuberant
or too much credit being created for nonproductive purposes, one
125
could say, well, is that one criteria for an excessive growth in the
money supply? And I think that is a reasonable question.
On the other hand, growth in the money supply or the general
tools of monetary policy cannot single out one sector of the economy for restraint and if you're dealing with an overall situation
that didn't seem to require more restraint you have a dilemma.
That's why you have to rely upon other tools, including supervisory
tools.
Senator BOND. Thank you, sir. My time has expired.
The CHAIRMAN. Thank you, Senator Bond.
Senator Dixon.
Senator DIXON. Chairman Volcker, as you know, last year the
Congress thought it met the Gramm-Rudman-Hollings threshold
requirements which were $144 billion or as much as $154 billion.
Now, of course, it appears that the deficit will actually be over $170
billion. Instead of a $36 billion reduction this year to meet the targets without raising taxes, therefore we would have to make a $60
billion cut.
My question to you is, What would be the impact on the economy
of that kind of a cut? In other words, is there a risk to the economy
if we try to reduce the deficit too fast?
Mr. VOLCKER. Yes, in theory I think you could do it too fast. I
think that's more theoretical than real. I have often responded in
answer to a similar question, Senator, that I really don't stay
awake nights worrying about you reducing the deficit too fast, as a
practical matter. [Laughter.]
ACTIVITY OF THE STOCK MARKETS
Senator DIXON. I'm certainly not an expert on the stock market,
but I continue to be amazed at how it flourishes while we have
what appears to be a recession in agricultural America, a kind of
sluggish economy generally. Is what the stock market is doing a
sign that things are going to get better and better, or can it be an
omen that things are like they were in the 1920's?
Mr. VOLCKER. Well, I'm not going to comment on the stock
market specifically. But let me say that in parts of my statement I
did not read, I think that we are in a both very difficult and very
promising economic situation.
The difficulties are obvious: the chart on debt, the big deficit, regional problems. Those problems can only be dealt with by both a
forceful and rather complicated combination of policies. When
you've got two or three things to do at the same time, I suppose
that's complicated. It's not just a national problem but an international problem. That's the difficulty.
But I think in fact it is also true to say that we have promise
that's unparalleled at least for two or three decades. We already
have 4 years of expansion. We have inflation coming down, not
going up. And that will presumably be interrupted next year to
some extent by the rising import prices and the higher oil prices,
but the underlying trend of inflation is down.
Interest rates have been moving lower after 4 years of expansion—or did much of last year anyway. We have the ability—we
don't have big, traditional type imbalances. We've got that enor-
126
mous trade imbalance which is more serious in some ways. But we
have a chance of having a prolonged business expansion here consistent with greater and greater stability. We haven't had that
chance for a long time and I think we have it now. We are perfectly capable of blowing it, but if we don't blow it but we operate correctly and do these difficult things, then I think a lot of confidence
is justified. But that is what's at issue.
Senator DIXON. You mentioned interest rates. I've seen predictions that they are going to go up and predictions that they are
going to go down. What's your prediction about interest rates?
Mr. VOLCKER. That's a normal market situation and I am delighted to be in the midst of a normal market situation.
Senator DIXON. Mr. Chairman, a recent story in the Washington
Times stated:
Mr. Volcker hinted last week that the Fed would welcome subpar economic
growth this year in order to slow business and consumer spending and thus get
some control on rising public and private debt.
Is that story accurate and would the Fed welcome subpar economic growth?
Mr. VOLCKER. Well, I didn't read that story, but it may have
grown out of some testimony before the Joint Economic Committee
a few weeks ago. What I said precisely was in judging progress this
year, I think it is less important to worry about precisely what the
growth rate is within some limits than worry about whether
progress is being made on the structural adjustments that we must
make. And I would repeat that statement. I think this is a year
where what's critical is that we begin dealing with that trade deficit, that we make progress on the budget deficit, that we keep the
inflation rate under good control. If those things are happening, I
frankly think it's a somewhat secondary issue whether we're at the
top or the bottom of these ranges that we have projected or other
people have projected for economic growth.
It is far more important that we are doing the things that will
sustain growth into the future than that we buy another quarter's
growth or even another year's growth with the implication that
that's the end of the road and we have created conditions that will
create a recession. That doesn't make any sense.
Senator DIXON. Thank you, Mr. Chairman. My time has expired.
The CHAIRMAN. Thank you, Senator Dixon.
Senator Gramm.
Senator GRAMM. Well, Mr. Chairman, let me say I'm sorry our
distinguished colleague from Michigan has left because I can't
leave one point he made unrevisited and that's the point about
debt.
DEBTOR NATION FROM 1620 TO 1914
Imagine that I have a great big blue and red chart that begins in
1620, and beginning in 1620 we have an unbroken train of debt as
we engage in the horrors of a debtor nation from 1620 to 1914, By
the logic of our distinguished colleague from Michigan, our Nation
would have been filled with misery, penury and woe. And yet, from
1620 to 1914, we became the world's greatest trading nation. We
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became an economic and world power and our standard of living
grew faster than any nation in the history of mankind.
The idea that somehow being a debtor nation is a catastrophe is
absolute nonsense.
What matters—and what I want to go back to is your point—
what matters is what you do with the money. A lot of people have
become wealthy—nations have flourished by borrowing money if
they invest it productively. If, on the other hand, you go out and
borrow money and blow it in on a hot weekend, you become poor
quickly.
I want to go back and give you a chance to basically say yes or
no. Your concern about the debt is primarily what we're doing with
the money, that it is funding consumption; much of that consumption is part of the Federal debt. Is that correct?
Mr. VOLCKER. Yes. I was looking for the exact words in my statement to make your point. I say we are spending more than we
produce. We are unable to finance at home both our investment
needs and the Federal deficit. These are not conditions that are
sustainable for long, not when, as at present, the influx of capital
from abroad cannot be traced to a surge in productive investment.
It's not sustainable from an economic perspective to pile up foreign
debts while failing to make the investment that we need to generate growth.
Your comments remind me of a story, a true story, that I can't
refrain from saying.
Senator GRAMM. Make it short because the chairman is going to
get me and I've got one more question.
Mr. VOLCKER. It's a good story but I'll deprive you of it.
The CHAIRMAN. Go ahead and tell the story and we'll give you a
little more time.
Mr. VOLCKER. Well, I once heard a distinguished Finance Minister of a foreign country giving a litany of his current problems
about balance of payments, deficits and that and all the rest. The
first question he got was like yours, he said:
Well, back in the 19th century your country was in debt all the time and piling
up great balance of payments problems and the country was doing all right. Why
didn't we ever hear about the problems?
And he said, "No statistics." [Laughter.]
Senator GRAMM. Also politicians who understood our problems.
I'd like to go to my second question. I'd like to begin it by basically defining the political problem and then ask your response to
it.
Every day we hear this assertion that the United States is exporting jobs. I could give you a thousand examples of where people
say, "For every $1 billion of trade deficit we're losing 25,000 jobs.
We export not goods but jobs." But yet, nowhere do I ever see anybody demonstrate that.
In fact, we have since 1982 created 11.2 million new jobs, more
jobs than Europe and Japan put together. Our unemployment, in
the midst of this ballooning trade deficit, has gone down. And the
nations that have the big trade surpluses have had unemployment
go up.
128
Now when you begin to respond in that way, invariably people
say, "Yes, but we're creating jobs making hamburgers, that we're
deindustrializing the economy." Yet, the fact is, from 1972-82, we
lost manufacturing jobs and from 1982 to today we have gained
406,000 jobs in manufacturing. Real wages, which declined from
1972 to 1982, are rising today, so we are creating more manufacturing jobs. In fact, Japan and Germany are both losing manufacturing jobs. We are gaining manufacturing jobs. Real wages are rising,
not declining.
The importance of all this is that the protectionists cloak their
argument in a new cloak and that cloak is sort of a lame appeal to
nationalism and this assertion that we are losing jobs.
SURGE OF PROTECTIONISM
And I'd like as my final question—and whatever time you've got
left please use it—do you see any evidence that a surge in protectionism, the imposition of quotas and tariffs, the limitation on
trade—do you see any evidence that those proposals, if implemented, would create more jobs in the United States, raise real wages,
raise the living standards of our people, or enhance the well-being
of the working men and women of America?
Mr. VOLCKER. No. If I may make—obviously, not only that, I see
a threat to our prosperity and the world's prosperity.
Senator GRAMM. So you would say a movement toward reducing
trade through the imposition of protectionism would lower jobs,
lower standards of living, and compound our economic problems?
Mr. VOLCKER. Yes. I don't want that to be interpreted obviously,
nor your earlier comments which I think are accurate, to mean
that we don't have a very serious imbalance in our trade position
that must be dealt with decisively or that, too, will bring real problems. But not on the arguments that you recite and I think quite
correctly refute.
Senator GRAMM. Would you agree, as a final point, that the
major cause of our trade deficit is the huge capital inflow that has
been produced by our high interest rates?
Mr. VOLCKER. There's a certain amount of chicken and egg here,
but certainly the surge in capital inflow beginning some years ago
is certainly related to our trade deficit, yes. And the other side of
that coin is we needed the capital inflow to finance the budget deficit and you can't have one without the other.
Senator GRAMM. And without it, all of our problems would have
been worse?
Mr. VOLCKER. I think given the budget deficit, the problem probably would have been worse, certainly in the short run. I don't
know about the long run, but in the short run it would have been
worse. And you can't deal with that problem—you're either going
to run much lower levels of investment, which obviously will
reduce the standard of living, or you've got to run lower budget
deficits.
The CHAIRMAN. Thank you, Senator Gramm.
Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
129
Chairman Volcker, some years ago we were talking here in this
committee about the problem of the Federal budget deficit and we
took the position—and I think witnesses did and perhaps you did
also—that we needed to get a handle on the Federal debt and get
our deficit under control. Otherwise, as the Federal Government
got out and started borrowing money in the private capital market,
what we would witness was a crowding out, which would drive up
interest rates here in the United States. And where we all seemed
to miscalculate was forgetting the free flow of capital across frontiers. As the debt mounted we did not see the attendant increase in
interest rates; what we saw, as you have described this morning, is
the financing of a large portion of this indebtedness with capital
coming in from abroad—as much as 50 percent of the indebtedness
financed with capital from abroad, as I recall, in fiscal year 1986;
25 percent of it being financed with capital flowing in from Japan,
if memory serves me correctly.
Now in your statement, Mr. Chairman, you say that this international flow will continue to be available until the confidence that
underlies the flow of foreign savings will be eroded.
My question to you, Mr. Chairman, is: When do we get to the
saturation point? When is the confidence of foreign investors
eroded to the point that they won't invest here in our deficit, and
what are the signals that this is coming?
Mr. VOLCKER. Well, my answer to you has to be I do not know
but I don't want to find out. I think the whole essence of the problem here is that we should be conducting ourselves so that we do
not face that event because when it happens it's too late.
And I think the problem is so evident and so clear that there is
no justification for waiting until the worst happens. Even this year
we are relying, mainly because the deficit is bigger, on an increasing flow of official capital rather than private capital. Private capital isn't closing the whole current account deficit. That's not a terribly happy sign in and of itself. It's not because most types of capital flow have been particularly reduced—some have gone up—but
as the deficit got bigger, they didn't go up by enough to provide the
capital we need. And that is one maybe very early warning signal.
RISE IN DEBT ERODES CONFIDENCE
The rise in the debt itself obviously at some point erodes confidence. The decline in the dollar at some point could erode confidence. Now we've avoided most of that, happily. We have avoided
it partly because the inflation performance, among other things,
has been good. That helps undergird confidence.
It would be a clear and present danger, in my judgment, with respect to foreign capital flows if people thought our inflation was beginning to get out of control again. That would be very alarming in
these terms.
Senator SASSER. Mr. Chairman, it's occurred to me with regard to
foreign investors that they might be in the same position vis-a-vis
the American economy that the FDIC and the Fed were vis-a-vis
Continental Illinois. They simply can't afford to let us get into serious economic trouble. They simply couldn't afford to see the Ameri-
130
can economy go down as a result of a rapid runup in interest rates
here because of unavailability of foreign capital.
Would you want to comment on that?
Mr. VOLCKER. Well, there doesn't seem to me to be a credible
comment. The Federal Reserve and the FDIC are public institutions with certain responsibilities to deal with situations of that
kind. When you're talking about foreign capital, you're talking
about thousands and hundreds of thousands and millions of individuals.
Senator SASSER. If I could interrupt just a moment, one of the
reasons given for coming in with a massive infusion of capital to
keep Continental Illinois going was the detrimental ripple effect
throughout the whole economy if we allowed it to go under. I'm not
questioning the judgment on that.
Mr, VOLCKER. I understand that, but that's precisely the point.
You have institutions here that are charged with taking that into
account. When you're dealing with a great variety of foreign investors, they are not responsible for upholding the American economy.
They may worry about it, but if they are worried about it what
they are going to do is cut and run and not organize a rescue
effort. And that's precisely the problem.
Senator SASSER. And you think the Japanese would cut and run
on us?
Mr. VOLCKER. Well, individuals, yes. It's not the Japanese Government. You may get some shift.
Senator SASSER. They have a way of seeming to act in unison to
me.
Mr. VOLCKER. Well, they have more of a way of acting in unison
than other people, but I think it would be a mistake to say they
can act against the perceived economic incentives of all the individuals.
Now the governments may indeed—you may get an official capital inflow instead of a public capital inflow. And to some degree
you probably would, but that would be a very defensive operation
and not a very happy one, and how long that would last is questionable, too.
There will be a capital inflow, looking at it from another perspective, because we're going to have to borrow the money to cover the
deficit. The question is, what are the terms and conditions? What
will be charged for the capital inflow, not that it's going to disappear. Individuals can take their money out. The collectivity cannot.
But if they're not willing to put it in freely, then that has severe
repercussions on the exchange rate and on the interest rate.
The CHAIRMAN. Thank you, Senator Sasser.
Senator Heinz.
PROTECTIONISM
Senator HEINZ. Mr. Chairman, I welcome Chairman Volcker
once again to these hearings. I apologize for not being here at the
outset. We had Secretary Baker down in the Finance Committee
testifying on the administration's trade bill and I couldn't help but
think about that subject in your response, Chairman Volcker, to a
question asked by Senator Gramm.
131
Senator Gramm asked if protectionism would have an effect on
economic growth and standards of living and, undoubtedly, it
would have an effect.
But the thought that crossed my mind was this. Fifteen years
ago, the Japanese had a standard of living about half of ours.
Today, it's about the equal. For the last 15 years, maybe longer, the
Japanese have been following a policy of unmitigated protectionism. It has worked for them beyond anybody's expectations, perhaps even—although I don't want to underestimate them—perhaps
even theirs.
Why has it worked for them and why would it not work for us?
Mr. VOLCKER. Japan has had a tremendous record of economic
growth and productivity increases. I think my question would revolve around how much of that was a reflection of protectionism.
There are some other things going on in Japan, like a 20-percent
savings rate, a very high rate of investment, big increases in productivity, and a very aggressive, disciplined, active, intelligent
work force.
I would look there for the explanations of the phenomena that
you describe.
Senator HEINZ. I think those are good explanations for a good
part of their economic performance, but is that to say then that
their protectionist policy has slowed them down?
Mr. VOLCKER. Well, I don't know. I think at some times it may,
but even to the extent that this image of a coordinated Japan rationally maximizing the benefits of protectionism in their particular instance by giving a chance for high productivity industries to
get started and expand and all the rest—even if you give some
weight to that—and I don't think that's the mainspring of their
growth—Japan is still not the United States. They could get by
with it. I don't think we can, in terms of retaliation and so forth.
But I don't think it's the main spring of their growth.
Senator HEINZ. I assume that earlier in your testimony you
made the point—I hope you did if you didn't—that the United
States should be doing all those other things that Japan is doing
other than protectionism.
Mr. VOLCKER. Many of them anyway.
Senator HEINZ. Of that list, what are the two or three most important ones for the United States?
JAPANESE SAVING RATE
Mr. VOLCKER. Japan, for instance, has had a very high savings
rate. We've got a very low one. They're at the top of the international league; we're at the bottom of the international league, and
there's quite a difference between the top and the bottom.
I think it would be nice to have a higher savings rate. I did not
have a lot of oratory about a higher savings rate because I think as
a practical matter we're not going to get it. We've got a long—I'm
not saying we can't go above the very low level it is today and I
presume that it will, but to make a major change in the savings
rate, a large structural change in our rate of savings, I frankly am
not very hopeful about. We haven't saved much for 30 years in
good times, bad times, under different kinds of policies, different
132
kinds of legislation, and I think I would be deluding you if I suggested to you there was some answer that you could adopt some
law and that's going to have some dramatic change in the savings
rate.
Senator HEINZ. What you're saying, at least to me, is quite distressing, even though I suspect you're right. What you're saying is,
even if Congress made the tough choices to reduce the budget deficit, even if we found some ways to give more incentives for saving
and investment, we would still be so consumer-oriented that we
would never generate the savings to improve the productivity that
would improve our competitiveness ever again. Now that's a very
pessimistic assessment.
Mr. VOLCKER. Well, let me make a distinction, a semantic distinction—what we mean by savings. My comment was about private
savings.
What you obviously can do, that is fully within your control, to
make a big difference in our overall savings is reduce the Government's dissavings. That you can do. That has been the biggest
change in recent years, from a relatively balanced Government position to big dissavings—in the jargon. If you want to increase the
savings rate, which we must, that is where to work on it.
Senator HEINZ. One last question. Let's assume we could reduce
the Government's dissavings by reducing the budget deficit somehow, magically, to zero. Where would that money go? There's an
assumption built into your prescription that it is going to go to corporate savings as opposed to individual bank accounts and then to
something. I would like to believe that it would go into savings of
either individuals or corporations but I don't see that happening.
Mr. VOLCKER. I'd like to see it go to two places where I think it
would go. One is to reduce our dissavings from abroad. We are now
borrowing more abroad than all the individuals in the United
States are saving. Now that's a pretty sad statistic. We are borrowing more from foreigners than the collective savings of all the individuals in the United States.
So what I would like to do is reduce the dissavings from abroad,
which is the same as our trade deficit or technically the current
account deficit.
The other place I'd like to see some go is into investment to support productivity and to support the exports that are part of the
process of reducing the borrowing from abroad.
Senator HEINZ. Chairman Volcker, I like those goals.
Mr. VOLCKER. I don't think those goals are at all impossible.
Senator HEINZ. My time has expired. Maybe we can come back.
Mr. VOLCKER. Well, I just—after all, the cynical comment I made
about increasing the private savings rate by fiddling around with
some tax incentives or something, I don't want to be at all pessimistic about the possibility of reducing the government's dissavings. It's within your grasp and that's what will happen.
The CHAIRMAN. Senator Shelby.
Senator SHELBY. Mr. Chairman, I have a written statement I'd
like to have included in the record.
The CHAIRMAN. Without objection, it will be included in the
record.
133
COMPARISON TO THE JAPANESE AND GERMANS
Senator SHELBY. Dr. Volcker, following up on the savings subject
here, as far as private savings are concerned in the United States,
prior to the 15 or 20 years ago—let's say 20 years ago, was the
American savings rate near the Japanese or the West German savings rate?
Mr. VOLCKER. No, not in my memory.
Senator SHELBY. When was it? Back in the 1950s or the 1940's?
Mr. VOLCKER. Back before we had the statistics, I guess. I don't
know. Not in my working lifetime. That's as near as I can remember.
Senator SHELBY. In other words, the psychology out there is not
in the American to save?
Mr. VOLCKER. That's right. For whatever reason, they historically have had very high savings rates. My staff has given me a table
going back to 1965 anyway. These are gross savings rates.
Senator SHELBY, This is private savings, is it not?
Mr. VOLCKER. Well, this probably includes the governments. But
in any event, their savings rate was 12 percent higher than ours in
1966.
Senator SHELBY. This is the Japanese you're talking about?
Mr. VOLCKER. The Japanese was 12 percent higher than ours. In
1985, it was 15 percent higher than ours. Subtract out the Government deficit—I don't know what it was in 1966—you would get basically no change or relatively no change.
Senator SHELBY, Is the German savings rate similar to that?
Mr. VOLCKER. Well, the German savings rate is currently halfway in between, but I just haven't got the private figures in front
of me, but their deficit isn't all that big.
Senator SHELBY. Would you furnish that to me and the committee if you would, private versus Government savings rate?
Mr. VOLCKER. Sure. I'm looking down the list here to find somebody—this is the gross, total, public and private—the only country
I can find as low as us is Iceland, offhand—and Greece, I guess.
134
Chairman Volcker subsequently furnished the following information for inclusion in the record of the hearing:
Japanese, German, and U . S . Savings Rates
Selected Years, percent of GDP
Japan
1970
1965
Gross savings
private
public
31.5
25.6
5.9
40.2
33.1
7.1
31.4
27.2
4.2
Less depreciation:
Net savings
private
public
18.1
12.7
5.4
26.9
20.2
6.7
17.7
14.2
3.5
1965
1970
1985
Gross savings
private
public
27.2
21.9
5.3
28.1
21.8
6.3
22.2
19.4
2.8
Less depreciation:
Net savings
private
public
17.8
12.9
4.9
18.0
12.2
5.8
9.6
7.6
2.0
United States
1965
1970
1985
Gross savings
private
public
21.0
18..6
2..4
18.1
17.4
0.7
16.5
18.4
-1.9
Less depreciation:
Net savings
private
public
11.2
10,.1
1.1
7.5
8.2
-0.7
3.7
7.1
. -3.4
Data are taken from OECD National Accounts. The OECD distinguishes
between government current expenditure and government Investment. It
thus reports greater government saving (or smaller deficit) than would
be the case If government saving were measured as revenue less total
government expenditure. There are additional small differences between
the procedures followed in the OECD national accounts and those used in
the U.S. National Income and Product Accounts.
135
Senator SHELBY. Do you think that some type of legislation
would help change that psychology of American consumers' consumption?
Mr. VOLCKER. Well, I'm expressing some skepticism about that,
given what it's practical to do.
Senator SHELBY. In other words, an incentive to save?
Mr. VOLCKER. You could pass a tax law and give a bonus for savings and tax consumption very heavily, but I don't think you're
going to do that. It would be interesting to see what results that
had. I presume it would have some impact, but you have to talk I
think in such extreme fashion that it is not within
Senator SHELBY. A lot of money was pumped through the IRA's
into the banks and thrifts.
Mr. VOLCKER. A lot of money was pumped through IRA's, no
doubt about it, and that I think is an illustration of what I'm talking about. During most of that period when a lot of money was
pumped into IRA's, the overall savings rate declined. What a lot of
people were doing was shifting savings they otherwise had into
IRA's because they got a tax break.
Senator SHELBY. Dr. Volcker, you said earlier that we being the
richest country in the world, we should be exporting capital, not
importing it. To export it, we're going to have to create it. We're
going to have to save it, are we not?
Mr. VOLCKER. Yes.
Senator SHELBY. It just begs the question.
Mr. VOLCKER. Yes.
Senator SHELBY. If we keep importing capital and keep consuming it, as Senator Gramm was alluding to, and not using it wisely
for the future in developing this country—in other words, if we
keep paying our national debt and our credit with it and we keep
consuming in other ways, what's going to be the answer in 3 or 4
years or 10 years? Isn't the international debt situation versus ours
going to be like a Third World nation?
Mr. VOLCKER. Well, I think it just leads you to a dead end, and if
you just continue with it, eventually
Senator SHELBY. A literal dead end?
Mr. VOLCKER. Well, literally in the sense—to get back to Senator
Riegle—if you let it go on long enough, the actual standard of
living will decline—I don't think we're in that situation yet, but if
you don't repair the imbalance you eventually get in that position.
Senator SHELBY. Senator Gramm was also talking about the year
1620 to 1914. During those years when we were importing capital,
we were also a developing nation here and used a lot of that capital as such rather than to use it for our basic consumer tastes, is
that correct?
Mr. VOLCKER. Yes. Again, we haven't got any statistics for that
period.
Senator SHELBY. And we didn't have those big Federal deficits
year after year then, for the most part?
Mr. VOLCKER. No, I'm sure—not only for the most part, I think
we didn't have them at all during that period. We didn't have the
mechanism for running federal deficits. We didn't have a Federal
Government then either during part of that period.
136
Senator SHELBY. We didn't know how, did we? We didn't have
the Federal Reserve then, did we?
Mr. VOLCKER. We didn't have the Federal Reserve to print the
money, but if you go back to 1620 we didn't have a Federal Government.
Senator SHELBY. Well, that does go back quite a ways.
Dropping over to one other thing, my home State of Alabama
and other rural States have not shared in the coast-to-coast or bicoast prosperity that we've had. A lot of it has been on the west
coast, a lot of it on the east coast. There are distortions and structural imbalances there.
What is the answer for us dealing here in the Senate with some
of this in the Midwest, the South, and the Northwest?
Mr. VOLCKER. Well, I think that gets you into quite different
policy issues than we can deal with by monetary policy. Those big
depressed areas of the country are largely a reflection of either oil
or agriculture and, of course, if you've got both you've got a double
whammy. Both of those are similar in a way in that they are both
a response I think not to specifically a U.S. problem but a worldwide relative glut of oil or agricultural products. And as you know,
that raises a whole lot of issues of agricultural policy and energy
policy.
Take the agricultural one, which I presume is more important in
Alabama
Senator SHELBY. But all of this feeds into our monetary policy,
doesn't it?
Mr. VOLCKER. Well, it affects the environment in which monetary policy operates as does the relative boom let's say in New England, and you have to look at both of them.
Senator SHELBY. My time has expired. Thank you, Mr. Chairman.
[The complete prepared statement of Senator Shelby follows:]
STATEMENT OF SENATOR RICHARD SHELBY
Senator SHELBY. Mr. Chairman, these hearings come at a time
when the economy has us all perplexed.
First, I want to commend Chairman Volcker for his leadership
and guidance in bringing interest rates down to their lowest level
in 9 years and in bringing inflation under control.
Although our economy is in its fifth year of expansion, I detect
warning signs on the horizon, both here and abroad, that indicate
trouble ahead.
Domestically, I see warning signs from an economy in transition—in transition to a service economy with substantially lower
wages. In this respect, I am concerned about the mounting consumer debt and its impact on the economy should we experience a
downturn.
I also see warning signs from an expansion that has been geographically uneven. Recent reports indicate that we now have a bicoastal economy and that the expansion has by-passed the citizens
of middle America.
Similarly, as a Senator representing a largely rural State, I am
concerned about a two-tier economy. Rural areas and communities
137
are not experiencing economic growth. Agriculture and industries
such as textiles, steel and rubber, which were once the very life
blood of these communities, have fallen upon difficult times.
Of course, the most serious warning sign is from the twin deficits
in our Federal budget and trade with foreign countries.
Internationally, I see warning signs from the Third World debt
situation. Witnesses before the committee yesterday stated that our
economy is controlled by external forces. While the falling dollar
may give us the month-to-moiith satisfaction of a declining trade
deficit, I worry that the dollar's decline threatens our standard of
living. Global cost-cutting and the inherent slow-down in expansions abroad may thwart our hopes of economic growth fueled by
exports.
Again, I welcome Chairman Volcker and thank him for sharing
with us his insights about the economy.
The CHAIRMAN. Senator Sarbanes.
Senator SARBANES. Chairman Volcker, I'm concerned by the exchange that you had with Senator Proxmire right at the outset of
the questioning period.
Mr. VOLCKER. On Ml?
Senator SARBANES. On the fact that you had not submitted any
Ml figures. It's my understanding that this is the first time that
the Fed has not done that, is that correct?
Mr. VOLCKER. I believe so, yes.
Senator SARBANES. So the Fed has understood the law heretofore
at least to require an Ml target range?
Mr. VOLCKER. No.
Senator SARBANES. Well, then, why has the Fed always submitted the figures heretofore?
Mr. VOLCKER. Because we thought it was useful and provided information disciplined to ourselves, information to the public and to
the Congress that was relevant.
Senator SARBANES. Well, do you read the law as enabling the Fed
to determine what is useful and to submit that, or that you have
to, in effect, interpret the law and submit what the law requires?
Mr. VOLCKER. I think the law requires us to submit some target
ranges of credit and monetary aggregates.
FED REPORT TO THE SENATE
Senator SARBANES. No, no, I want to get an answer to my question, whether it's your view that the Fed can determine what to
submit or that the Fed is supposed to determine what the law requires it to submit?
Mr. VOLCKER. I think I'm trying to answer that question. I think
we are bound to submit some monetary and credit aggregate numbers that are presumably relevant to judging policy and relevant to
the conduct of policy. Precisely what those measures are and how
they are defined, as I understand it, is up to us.
Senator SARBANES. Let me repeat my question again. Do you
think that you are to submit what the law requires or to
submit
Mr. VOLCKEH. I'm trying to describe what I think the law requires.
138
Senator SARBANES. OK. Very good. But your view is that you are
to submit what the law requires?
Mr. VOLCKER. Of course.
Senator SARBANES. Now it's a question of what does the law require, is that correct?
Now heretofore, you have perceived the law to require that you
submit Ml figures, is that correct?
Mr. VOLCKER. No, not the law by the language of the law. I perceived that Ml was a useful, relevant aggregate to submit consistent with the law. When I perceive it no longer to be relevant in
that respect, I don't think the law directs us to submit Ml.
Senator SARBANES, Well, now, it doesn't say that. I mean, it says
the objectives and plans of the Board of Governors and the Federal
Open Market Committee with respect to the ranges of growth or
diminution of the monetary and credit aggregates for the calendar
years during which the report is transmitted and it doesn't say "as
it may be deemed relevant or not by the Fed."
Let me ask you this question. In preparing this report, the Monetary Policy Report to the Congress, pursuant to the 1978 Act, was
discussion held with respect to the fact that an Ml figure was not
going to be submitted?
Mr. VOLCKER. Of course. It was discussed and debated on substantive grounds, but I don't think we had any legal argument
about it. I don't think there was any difference of opinion that it
was not required by law.
Senator SARBANES. That issue did not come up in the discussion
at the Fed?
Mr. VOLCKER. That issue did not come up.
Senator SARBANES. No one raised a concern that the failure to
submit this particular monetary and credit aggregate might raise—
particularly in view of the fact that it had always been submitted
in the past, raise a question about complying with the law?
Mr. VOLCKER. As best I can recall it, as a legal matter—there
was a lot of debate as a substantive matter—as a legal matter, I do
not recall that question being raised.
Senator SARBANES. What was the nature of the substantive
debate?
Mr. VOLCKER. Whether it was useful or not, whether it was
useful to the committee first of all in its own operations to have it,
and second of all, whether it was useful—given the answer to that
question, whether it was useful to have a published Ml target.
Senator SARBANES. Is it your view that the Fed could make the
judgment that it would not be useful to submit any monetary or
credit aggregates and then proceed not to do so?
Mr. VOLCKER. No. I think with the language of the law we would
be hard-pressed not to submit any, so we would look for whatever
we thought was most relevant. We have changed them in the past.
We have redefined Ml. We have redefined M2. We have redefined
M3. We have changed the credit aggregate that we submit to you.
Senator SARBANES. That's right.
Mr. VOLCKER. The credit aggregate has never had the same
weight as the other aggregates, although it doesn't say that in the
law.
139
Senator SARBANES. But having done that, you do then submit
them?
Mr. VOLCKER, Oh, yes, as we did this year.
Senator SARBANES. Well, except you left out a major component
which has always been submitted in the past.
Mr. VOLCKER. We dropped out at one point bank credit, which
had always been submitted in the past, and we dropped it once and
we have never readopted it.
Senator SARBANES. In having the substantive discussion, was the
issue raised that the line of questioning which both the chairman
and I have now directed to you might in fact come up?
Mr. VOLCKER. No.
Senator SARBANES. It was your assumption you could simply
leave it out and no one would sort of say how come this happened?
Mr. VOLCKER, I certainly expected people to say why did you
leave this out as a matter of substance, and I have 10 pages before
you to explain that.
The CHAIRMAN. Would the Senator from Maryland yield, not on
his time?
Senator SARBANES. Sure.
The CHAIRMAN. I want to commend the Senator from Maryland.
I think it's very, very important that Congress insist that the law
be obeyed to the full and I want to make a formal request, Mr.
Chairman, that you have your counsel give us a strictly legal opinion. The committee is going to seek independent outside legal opinion on this. I have the greatest admiration and respect for you, as
you know. I know that you want to comply with the law, but I
think this is a duty that we have as the Congress to make sure
that when a law is enacted that it's complied with in full by our
agencies,
Mr. VOLCKER. I agree with your philosophy, I would be glad to
have our counsel submit such an opinion. I tell you that there was
no question in my mind at any time in this procedure that we were
not fully and fairly complying with the specific language and the
spirit of the law.
The CHAIRMAN. Thank you.
Senator SARBANES. I have no further questions. I think the
Chairman has been responsive to Chairman Proxmire's question
and we look forward to that material.
[The information referred to follows:]
140
Chairman Volcker subsequently furnished the following Information for
inclusion in the record of the hearing:
8QARQ OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, Q. C. SOSSI
April
6,
1987
OAUL A. V Q L C K E B
CHAIRMAN
The Honorable William Proxmire
Chairman
Committee *>n Banking, Housing
and Urban Affairs
United States Senate
Washington, D.C.
20510
Dear Chairman Proxmire:
During the course of my testimony on February 19, 1987,
you raised a question about whether the Board is required by
Section 2A of the Federal Reserve Act to submit a target range
for Ml as part of its Semi-Annual Monetary Policy Report to the
Congress. It was your view that the decision by the Federal
Open Market Committee not to establish a specific target range
for Ml, although ranges were provided for M2, M3, and for debt,
was not consistent with the requirements of this section. You
requested an opinion of the Board's General Counsel on this
matter.
That opinion has now been prepared and I am enclosing a
copy for your review. The General Counsel has concluded that,
as a matter of textual interpretation, Section 2A requires a
report on the Federal Reserve's "objectives and plans" with
respect to the monetary aggregates and if the Federal Reserve
has not formulated "objectives and plans" with respect to one
particular aggregate, it is not required to report on it. This
reading of the text is supported by other provisions of Section
2A, by administrative practice and most importantly by the
legislative history.
1 have paid particular attention to the legislative
history because of your direct involvement in it and because I
am concerned that the Federal Reserve maintain the close consultative relationship with the Congress that we have had in the
past. I hope that you will agree with us, after going back over
the history, that this relationship would not be served by our
providing you with a target range for an aggregate that the
Committee itself does not feel can provide a reliable quantitative standard for the conduct of policy at a particular point in
time.
141
The Honorable William Proxmire
Page Two
Our concerns, I suppose, are similar to those raised
with you by Chairman Burns in 1975. Those concerns were
reflected in the compromise language you developed at the time
speaking of both "objectives and plans" and substituting the
phrase "monetary and credit aggregates" for Che "money supply".
I would be glad to discuss this opinion with you
further should you have ariy questions.
Enclosure
142
BOARD OF GOVERNORS
or THE
FEDERAL RESERVE SYSTEM
WASHINGTON, O, C. 10551
April 2, 1987
MEMORANDUM
Subject;
Humphrey-Hawkins Act Reporting Requirements
During the course of Chairman Volcker's testimony on
February 19, 1987, before the Senate Banking Committee on the
Board's semiannual
Section 2A
of
the
report
to
Federal
Congress
Reserve
provided
Act,
for
by
Chairman
William Proxjnire requested the opinion of the General counsel
of the Board on whether the Board is required by Section 2A of
the Federal Reserve Act (12 U.S.C. 225a) to submit a target
range for Hi as a part of this report.
This question arises
because, as- noted in the Board's February 19, 1987 report under
Section 2A, the Federal Open Market Committee ("FOMC") elected
not to establish a specific
target range for Ml because of
uncertainty about its underlying relationship to the behavior
of the economy and its increased sensitivity to interest rate
changes due to the deregulation of interest rates and other
factors.
The Board, in its Report, stated
that the FOMC had
established a range of 5-1/2 to 8-1/2 percent for M2 and M3 and
143
-2-
8 to 11 percent for debt as the "Ranges of Growth for the
Monetary and Debt Aggregates" for the period from the fourth
quarter of 1986 to the fourth quarter of 1987.
In addition,
the Report noted that while no range had been included by the
FOMC foe 1987, the POHC would continue to monitor Ml behavior
carefully, assessing the growth of the aggregate in the context
of other financial and economic developments.
Board
Finally, the
reported that in the future the POMC might set more
specific objectives for Ml.
Section 2A of the Federal Reserve Act, as amended by
the Full Employment and Balanced Growth Act of 1978
{92 stat.
1897) ("Humphrey-Hawkins"), provides in relevant part that
. . . the Board of Governors of the Federal
Reserve system shall transmit to the
Congress, not later than February 20 and
July 20 of each year, independent written
reports setting forth (1) a review and
analysis of recent developments affecting
economic trends in the Nation; (2) the
gbjectives and plans of the Board of
Governora^ and the Federal Open Market
Cpjnmi'ttee^ wi th^ respect to the ranges "of
growth or diminution of the jggnetary and
credit aggregatesFor the calendar year
duringwitchthe
report
is
transmitted. . . . Nothing in this Act
shall be interpreted to require that the
objectives and plans with respect to the
ranges of growth or diminution of the
monetary and credit aggregates disclosed in
the reports submitted under this section be
achieved if the Board of Governors and the
Federal Open Market Committee determine that
they cannot or should not be achieved
because of changing conditions. . . .
(Emphasis added).
144
-3-
I.
ANALYSIS OF THE TEXT
As a preliminary mattec, the first question that
should
be addressed
is whether
reporting of numerical ranges
aggregates.
Section
2A requires the
for the monetary
and credit
On its face, the language of the statute is not
entirely clear on whether numerical ranges are required.
statute
provides that the
Board
report
"objectives
The
.and
plans . . . with respect to the ranges of growth or diminution
of the monetary and credit aggregates. . . ."
Id.
It might be
argued that the only obligation of the Board is to formulate
and
disclose
establishing
"objectives
and
and plans" without
publishing
monetary aggregates.
quantitative
necessarily
ranges
for
the
There is nothing in the language of the
quoted sentence that would prevent the Federal Reserve from
formulating its objectives and plans
in qualitative terms
rather than assigning quantitative values.
However, the last
sentence of the section quoted above refers to "objectives and
plans with respect to the ranges of growth oc diminution of the
monetary
and
credit aggregates
disclosed
in
the reports
submitted under this section. . . .", Id. thus expressing a
clear expectation for the disclosure
of quantitative ranges of
growth or diminution of the monetary and credit aggregates.
Moreover, the legislative history and administrative
practice support the view that
Congress
obligation on the Federal Reserve:
imposed
a dual
to establish and publish
ranges of growth or diminution of the monetary and credit
145
-4aggregatei. and to report its objectives and plans with respect
to these ranges.
This conclusion is borne out by statements in the
record of Congressional action on this subject.
For example,
the Senate cepoct on the Humphrey-Hawkins Act states that the
"Federal Reserve would report its numerical monetary targets
tor a fixed calendar year rather than a constantly rolling 12
month period."
(S. Rep. No. 1177,
(Sept. 6. 1976). p.98.)
95th Cong.. 2nd Sees.
Similarly, the 'Senate
Report on
Resolution 133 of 1975 notes that "Discussion and disclosure of
planned 'ranges of growth or diminution of the monetary and
credit aggregates
in the upcoming twelve months' will not
eliminate all uncertainty about the future growth of the money
supply and other aggregates, but it will provide reasonably
reliable information about this crucial element in the economic
decision making process."
Seas. (Mar. 17, 1975}
{S. Rep No. 38, 44th Cong.. 1st
p. 7.)
Moreover, the hearing record on
the predecessor legislation to Section 2A. which is discussed
In detail below, makes It cleat that Congress Intended that the
Federal Reserve report quantitative tacget ranges foe the
aggregates to provide a specific focus Cor consultations with
the Federal Reserve on monetary policy.
With respect to the adninlstratlve practice, following
passage of Humphrey-Hawkins
in October of 1973, reports wee*
filed In February and July of 1979 and In February of 1980 with
the House and Senate Banking Committees, and hearings were held
146
-5by each Coautittee on the reportB.
These reports contained
numerical monetary aggregate target ranges.
However, while the
report filed with the House and Senate Banking Committees in
July of 1980 retained the ranges contained in the February 198O
report for the remainder of 1980,
the report did not contain
precise numerical ranges for 1981 since
. . . most members [of the FOMC] believe it would
be premature-at this time to set forth precise
ranges for each monetary aggregate for [19611.
given the uncertainty of the economic outlook and
institutional changes affecting the relationships
among the aggregates.
(Annual Report of the
Board of Governors of the Federal Reserve System,
1980, p. 52.)
The
absence
of
numerical
ranges
for
criticized in both Senate and House Hearings.
1981
was
(Hearings Before
the Senate Banking Committee on the Federal Reserve's Second
Monetary Policy
July 21-22, 1980:
Report for
1980,
on the Conduct of Monetary Policy,
July 23, 1980.)
96th
Cong.
2nd
Sees.,
Hearings Before the House Banking committee
96th Cong. 2nd sees.,
Shortly after the hearings were completed, and
before the Senate Report was prepared, the Federal Reserve did
submit numerical monetary aggregate ranges of growth for 1981
to Congress.
(Letter dated July 29, 1980, printed in Federal
Reserve Bulletin. Vol. 66, August 1980.
p. 649.)
Each such
report filed since then has included such ranges, although as
noted above the report for February 1987 did not contain a
target for Ml.
147
-6-
However, this conclusion on the dual obligation to
establish and publish quantitative ranges foe the monetary and
credit aggregates and report on objectives and plans with
respect to those aggregates still leaves the question raised by
Chairman Ptoxmire unanswered.
It gives no guidance on whether
the obligation to report "objectives and plans with respect to
the ranges and growth or dininution of the monetary and credit
aggregates"
requires
that
the Federal
Reserve
-quantitative ranges foe all of the monetary
establish
aggregates and
formulate objectives and plans for all of these ranges, or
whether it gives the Federal Reserve broader discretion to be
selective about both the ranges and its plans and objectives
with respect to those ranges.
Three
textual elements
of Section 2A give
some
guidance on the question raised by Chairman Proxmire on the
meaning of the statute:
the literal emphasis on the Federal
Reserve's objectives and plans, the absence of any definition
of Monetary and credit aggregates, and the discretion to change
objectives and plans in the light of changing
A.
circumstances.
POM th« Language on Section 2A Require an
Ml Target Literal construction
First, read literally, it the Federal Reserve does not
have
"objectives and plans" with
respect to a particular
measure of money or credit. Section 2A does not require the
inclusion ol a range
report.
for that measure in the semiannual
When Interpreting a statute, analysis must begin with
148
-7the language of the statute itself.
Tguehe Ross & Co. v.
Redington, 442 U.S. 560, 568 (1979).
The language of Section 2A only calls for the Federal
Reserve to report its objectives and plans with respect to the
aggregates for which it has formulated objectives and plans.
If it has no such objectives or plans with respect to a
particular aggregate, the statute does not require the Board to
report to congress on that aggregate.
B. Federal Reserve Defines the Aggregates
Second, the flexibility
establishing
intended
by Congress
the formulation of goals with respect
in
to the
ranges of growth or diminution of the monetary and credit
aggregates is also reflected in the fact that Section 2A does
not provide definitions of the monetary and credit aggregates.
Instead, the definition of the aggregates was
left to the
Federal Reserve, which defines the aggregates, collects data on
them and publishes the data in periodic statistical releases as
well as in the Federal Reserve Bulletin.
Ben. Guar. Corp., 744 F.2d 133 (D.C.
See Rettig v. Pension
Cic. 1984).
In this connection it is also important to point out
that the Federal Reserve definitions of the monetary aggregates
have changed from time to tine in response to changes in an
evolving financial system.
At the time Humphrey-Hawkins was
enacted
the Federal Reserve had already
in October of 1978
begun to change Ml.
Immediately prior to that date Ml equalled
currency plus demand deposits at commercial banks with certain
149
-8-
adjustmenta.
In October the Federal Open Market Committee
began to set a target range foe M1+ which included ML and
savings deposits at commercial banks, NOW accounts at all
depository Institutions, credit union share draft accounts and
demand deposits at mutual savings banks.
In I960 all of the
monetary aggregates were revised and for a period two versions
of Ml. Ml-A and Ml-B, were used
in order
to provide a
transition for the introduction of nationwide NOW accounts
under the Monetary Control Act.
In this new formulation. Ml-A was basically the old
Ml. not Ml*, except that demand deposits held
by foreign
commercial
including
governmental
banks
and
official
entities, were
Institutions,
removed.
Ml-B
was
a
more
comprehensive measure of transaction accounts which included,
along with Ml-A, the interest bearing checkable deposits held
at
all depository
Institutions -- NOW accounts, automatic
transfer accounts, and credit union share draft accounts.
In
January of 1982, Ml-A was dropped and Ml-B was redefined as Ml.
Because of the changing character of the aggregates in
a dynamic economy It Is absolutely necessary to have flexibility
to adjust the aggregates to changing circumstances.
For
example, if the definition of Ml was fixed at the time that
Humphrey-Hawkins was enacted, today it would not include NOW
accounts which have become a substitute for consumer checking
accounts and would
not provide a meaningful
supply of transactions money.
measure of the
150
-9Federal Reserve
definition
of
the aggregates
is
entirely consistent with the intention of congress to leave
formulation of goals with respect to the monetary and credit'
aggregates to the Federal Reserve, and for the Congress to
review them to determine their consistency with other national
economic
policy objectives.
Where a particular measure of
money or credit has become obsolete or unreliable, it would be
entirely consistent 'with the" wording and intent of the statute
for this measure to be removed from the definitions of the
monetary and credit aggregates.
It makes equally good sense,
where this has occurred, to interpret the provisions of section
2A to allow the Federal Reserve to omit formulating goals with
respect to the range of increase or diminution of such
an
aggregate even if this aggregate continued to be calculated and
reported.
C. Discretion to Change Objectives and Plans
Third,
the
last
sentence
of
Section
2A
also
demonstrates that Congress did not intend that the Federal
Reserve should be bound by the objectives and plans stated in
its report and that the Federal Reserve has discretion to
depart
from
these
objectives
and
plans, with
limitation that the departure be reported
the
only
to the Banking
Committees at the next scheduled semi-annual consultation with
the Committees, together with an explanation of the reasons for
the changes
provision,
in the System's objectives and plans.
clarifying
the Federal
This
Reserve's discretion in
151
-10carrying out monetary policy, suggests that if the System has
the discretion to diverge from its objectives and plans, it
also has the discretion to inform the Committees that the
formulation of objectives and plans for a particular measure of
money or credit would not be reasonable in the circumstances.
In this situation"the provision of objectives and plans for
that measure of money or credit in its report to the Congress
would be materially misleading, and Congress cannot be held to
have intended such a result.
II.
THE INTENT IOJLJ3F CONGRESS
This reading of the text of Section 2A is supported by
the legislative history of this provision.
Reference
to the
legislative history is particularly important in construing a
statute that regulates the relationship between Congress and an
administrative agency in carrying out authority delegated by
the Congress,
see, PPG industries. Inc. v. Harrison, 660 F.2d.
628 (5th Cir. 1981).
Broadly stated, the legislative history of Section 2A
demonstrates that Congress intended
that the Federal Reserve
inform the Congress of its "objectives and plans with respect
to the ranges of growth or dininution of the monetary and
credit aggregates" and
left to the
Federal Reserve
the
discretion to formulate these objectives and plans, to select
the monetary aggregates that were meaningful in implementing
these objective and plans, and to define the monetary and
credit aggregates which were to be used in implementing these
152
-iiobjectives
and plans.
This
interpretation
of
Section
2A
emerges from the hearings on S.con.Res. 18, the predecessor to
Section 2A, where the language on formulation of plans and
objectives
with respect to the monetary aggregates was worked
out.
These
hearings can be best characterized as having
resulted in a compromise between the desire of Chairman Burns
to consult with the Congress in a general and unspecific manner
without quantifying the POHC's policy objectives, and Chairman
Proxmire's goal of putting a quantitative focus on Federal
Reserve monetary policy for the near term future as a basis for
consultations between the Federal Reserve and the congress on
this policy.
This
Proxmire
dissatisfied
was
Congressional
history makes it clear
with
consultations with
the
the
that
Chairman
general
nature
of
Federal
Reserve
on
monetary policy and wanted more than a general description of
past actions
and future intentions.
On
the other
hand.
Chairman Burns and the Board were deeply concerned about the
impact of the Resolution on the implementation of monetary
policy through Congressional
limitations on Federal Reserve
discretion in carrying out monetary
history
reveals that
these
policy.
conflicting
The legislative
objectives
were
reconciled by the adoption of the broad and flexible concept of
the Federal Reserve reporting its own goals with respect to the
monetary aggregates as opposed to any specific measure of the
aggregates to avoid any implication of placing a "straitjacket"
153
-12-
ott the
Implementation of monetary
Reserve.
policy
by
the Federal
(Hearings before the Senate committee oa Banking,
Housing and Urban Affalcs. 94th Cong. 1st Sees.. February 25
and 26. 197S. p. 46.)
A.
The. Derivation 9t F«4«r«l ft»«»rr» Raoortino:
Requirements
The
key
language ~ of
the
Humphrey- Hawkins Act
oa -
reporting objectives and plans cones from H. Con. Res. 133
adopted by congress on Match 24. 1975.
This Resolution was
initially proposed by Congressman Reuss and provided for a
direction to the Federal Reserve to conduct monetary policy in
the first six months of 1975 BO as to reduce interest rates.
In the Senate the proposal took the form of S. Con. Res. 18,
introduced
by Chairman proxmlre on February 12. 1975.
This
Resolution directed the Federal Reserve to take
appropriate action in the first half of 1975 to
increase the money supply at a rate substantially
higher than in recent experience and appropriate to
actively promote economic c*covecy.
It also required the Federal Reserve to consult with Congress
at semiannual hearings before the committees on banking "about
its money
supply
growth targets and other monetary
policy
actions required in the upcoming six months."
Chairman
February 25. 1975.
Burns
on
this Resolution on
and at this hearing
considerations underlying
testified
the basic
policy
the Resolution, and the Federal
154
-13Reserve1s concerns
about
It, were articulated.
(Heatings
before the Senate Committee on Banking, Housing and Urban
Affairs, 94th Con?., 1st Sees., February 25 and 26. 1975.
p. 37, et. seg..)
In his opening statement Chairman Burns
criticized the proposed Resolution because it would result in a
more detailed involvement of the Congress in the implementation
of monetary policy.
He summed up the Board's position in the
two concluding paragraphs of his opening statement:
In conclusion. Resolution 18 raises in the Board's
judgment momentous issues with respect to the role of
the Federal Reserve in the economic life of our
Nation, whether the Federal Reserve's traditional
insulation from political pressures will continue,
whether resistance to Inflation may not further
diminish, and whether the dollar will remain a
respected currency around the world.
If the Congress should seek through Resolution IB to
become deeply Involved in the implementation of
monetary policy, it would enter an Intricate, highly
sensitive, and rapidly changing field —
with
consequences that could pcove very damaging to our
Nation's economy.
We therefore hope that this
committee will consider
very carefully the
consequences for our national welfare that could
result from adoption of this resolution. Id. at 43-44.
In reply. Chairman Proxmire stressed the Importance of
the Resolution as a means of providing information on which the
Congress could make Intelligent judgments about the course of
monetary policy without the Congress becoming involved in the
details of implementation of that policy.
He
said that
Congress as an institution "should have a voice in shaping the
broad outline oC monetary policy -- not the day to day details,
but the broad direction monetary policy Is taking."
Id. at
155
-14-
44.
In answer to Chairman Burns' criticism that the directions
contained in S.Con.Res. 18 would mean that "Congress would, in
fact be malting monetary policy, and I do not think that would
be wise." Id. at 45, Chairman Proxnlre noted that he wanted to
90 beyond mere consultations to provide a quantitative basis to
measure Federal Reserve Intentions, but tlfat this quantitative
basis would
be set as the Federal Reserve's goals for the
future conduct of monetary policy.
Thus, Chairman Proxraire
emphasized the Importance of providing additional Information
on which Congress could base its analysis of Federal Reserve
policy, and rejected mere consultations on the ground that he
felt "very strongly that if It is going to have any
significance and meaning, we ought to have some focus."
real
Id. at
45.
However, he Indicated that in providing that focus the
Federal Reserve should have broad discretion.
To ensure this
unfettered discretion, Proxmlre proposed that the quantitative
COCUB he wanted should be based on the Federal Reserve's own
goals.
He said.
. . . and that focus is what you intend to
do. You can explain the past action of the
Federal Reserve, and that is history. It is
not very significant. It Is not likely to
demand the attention or the understanding of
the Congress.
On the other hand, if you tell us what
yout goals are going to be. then we have the
bails on which we can focus discussion and
understanding. Id,- at 46.
156
-15-
JU
another
point.
Chairman Proxmlre answered the
criticism that Congress would become too much involved in the
details of monetary policy by emphasizing.
You set the goals, we don't. You set the
goals, we hear them, discuss the goals with
you. debate them, cry to understand them,
and on that basis, reach some understanding
on the pact of the committee, and on the _
part of the congress as to whether or not to
proceed in some other way. Id. at 46.
At still another point. Chairman Burns criticized the
proposal on the grounds that it would put the Federal Reserve
". . . in a s tea it jacket and we could damage our country,
because we had been put in a strait jacket."
Id. at 46.
Again,
Chairman Proxmlre replied by emphasizing that the Congress was
asking for the goals to be established by the Federal Reserve
which could change 1C Federal Reserve goals changed:
I want to make it clear we are not asking
Cor a strait jacket.
Those goals are
certainly goals. They are not anything that
puts you la concrete.
You would be
perCectly able to vary from the goals, if
conditions change, which they often do. Id.
at 46.
Finally,
as
the
discussion
proceeded.
Chairman
Projcmite again stressed that the proposal was focused on goals
set by the Federal Reserve.
He said:
Furthermore, we say goals. He don 1 t eay
this has to be the limit either way. on the
way the Fed proceeds. He say that it is Che
goal. Id. at 46.
157
-16-
During
the remaining discussions between
ChaLcman
Proxmire and Chairman Bucns the dialogue turned to the issue of
the narrow focus of the Resolution on a growth target with
tespect to the "Money supply."
Chairman Burns criticized this
emphasis on reporting on the 'money supply' and noted the
limited ability of the Board to achieve specific "money supply"
targets.
It is clear that in the context of the hearing that
both Chairman Proxmire and Chair nan Burns, believed
term "money supply" referred to Ml.!'
that the
tn response to these
celticisms. Chairman Proxmire said
Hell, supposing we modify the Resolution to
say. "monetary aggregates."
Mould that
help?"
Chairman Burns replied
I think that would be an improvement. I
would like it still better if it read "money
and credit aggregates."
I am sure you are
Interested in the credit supply. Id,, at 47.
It was obviously the intention of Chalcman Proxmire in
proposing this change in language to make S.con.Res. 18 more
acceptable by allowing the Federal Reserve greater flexibility
!
' In introducing this Resolution In the Senate. Senator
PcoKalte described the money supply as publicly held currency
and demand deposits. 121 Cong. Rec. s.3018 (1975). At that
time, this definition of the money supply generally
corresponded to the Federal Reserve's definition of Ml.
158
-17in setting its goals by expanding the scope of the elements
that
the
Federal
Reserve
establishing its goals.
could
take
into
account
in
Moreover, there is no suggestion that
the Federal Reserve would be bound by any mechanistic formula
in setting its goals with respect to the monetary aggregates.
On the contrary, the varying importance of different aggregates
in
different circumstances was
clearly
recognized.
For
example, as the discussion continued concerning the rate of
growth in the "money supply," chairman Burns emphasized that
the Hi definition of the money supply, "... made sense 50
years ago, 30 years ago, maybe 20 yeacs ago, but not today, as
I have testified time and time again."
and chairman
appropriate
Proxmire
measures
^d. at 48.
agreed, that there were
of money
to take
He argued,
numerous
into account
in
formulating monetary policy.
B.
s. Con^ Res. 18 Modified gnd Incorporate^
Into Section 2A
As a result of this discussion, S. Con. Res. 18 was
modified in the senate to require semiannual consultations with
both the Senate and House banking committees about the Board's
and FOMC's "objectives and plans with respect to the ranges of
growth or diminution of monetary and credit aggregates in the
upcoming 12 months."
(1975))
(H. Con. Res. 133/ 94th Cong., 1st Sess.
The Resolution also provided that "nothing in this
Resolution shall be interpreted
to reguire that such ranges of
growth or diminution be achieved if the Board of Governors and
159
-18the Federal Open Market Committee determine that they cannot or
should not be achieved because of changing conditions."
(Id.)
The senate language was ultimately adopted by both the
House and Senate in H. Con. Res. 133.
This Resolution was then
carried on essentially unchanged into the Federal Reserve Act
through the Federal Reserve Reform Act of 1977
(P.L. 95-188,
approved November 16, 1977, 91 Stat. 1387), with the addition
of specific reporting requirements with respect
economic factors.
to certain
This addition to the Federal Reserve Act was
adopted because H.Con.Res. 133 had expired at the end of
1976,
and, although Chairman Burns continued to appear before the
Banking Committees as provided by the Resolution, the Congress
wished to assure that "these appearances should be regularized
and made businesslike by statute."
(Hearings before the House
Banking Committee on H.ft. 8094, The Federal Reserve Reform Act
of 1977, July 18, 1977, remarks of chairman Reuss at p.2.)
C.
conclusions Drawn from th^j.egislatiye^ History
The
points.
legislative
history
clarifies
two
important
First, it emphasizes that Congress was looking to the
Federal Reserve to formulate "goals" with respect to the ranges
of growth and diminution of the monetary and credit aggregates
because it did not wish to circumscribe the Federal Reserve's
discretion in formulating and implementing monetary
policy.
The fundamental purpose was to allow Congress to better inform
itself about the Federal Reserve's intentions with respect to
the future course of monetary policy.
To do this, congress did
160
-19-
not establish arbitrary and objective reporting formula, but
sought to continue to rely on the expertise and policy judgment
of the Federal Reserve, subject to a requirement that Congress
be informed about that policy in a sufficiently precise manner
so as to permit a full analysis
consequences.
This framework
of the ^policy and
its
Is fully consistent with not
reporting on ranges for a particular aggregate Where the
Federal Reserve judges that such ranges would not be useful in
the formulation and implementation of policy.
Second, the legislative history clarifies that the
term "monetary and credit aggregates" was inserted
In the
statute in place of the term "money supply" because Congress
recognized that the importance of the various aggregates varies
and
the
aggregates
themselves
change
in composition as
different kinds of monetary instruments fall into di:;uBH oc new
instruments rise in Importance.
This
emphasis
on
maintaining
Federal
Reserve
discretion through the use of the Federal Reserve's own goals
with respect to monetary and credit
Congress recognized
aggregates
that the
were flexible and changing provides the
answer to the question
calsed
by Chairman Ptoxnlre.
The
legislative history Indicates that it a particular monetary
aggregate is no longer reliable or useful as a guide
monetary
policy and the Federal
for
Reserve determines not to
foraulate a goal with respect to that measure, the Congress did
161
-20not require the Federal Reserve to make a report to Congress
with respect to that element of the monetary aggregates.
This analysis of the legislative
history
is also
supported by the fact that the Federal Reserve has never
formulated targets wtth respect to all of the monetary or
credit aggregates,
III.
see, Jtettig, supra.
FEDERAL RESERVE TARGETS DO HOT APPLE TO APE OF
THE AGGREGATES
If Section
2A were
interpreted
to
require
the
formulation of objectives and plans with respect to each of the
monetary and credit aggregates, then the Federal Reserve would
have been required since 1975 to formulate goals and report
them to Congress with respect to each of the monetary
and
credit aggregates for which the Federal Reserve maintains
data.
This in fact has not been the case.
Although the Federal Reserve may monitor or measure a
variety
of monetary
or
credit
aggregates,
it
has
not
historically established target ranges for all aggregates and
included them in its reports to Congress.2/
For example, the
monetary aggregate "L," total liquid assets in the hands of the
public («3 plus the nonbank holdings of U.S. savings bonds,
short-term Treasury securities, commercial paper and bankers
2/ Money Stock, Liquid Assets, and Debt Measures, Table 1.21,
Federal Reserve Bulletin, March 1987 lists the current monetary
stock and debt measures.
162
-21acceptances, net of money market mutual fund holdings of these
assets), is regularly reported in the Federal Reserve Bulletin
but no target range for this aggregate has been included in
reports to Congress under Humphrey-Hawkins
requested targets for this aggregate.
not has Congress
Similarly, the Federal
Reserve does not target the debt of domestic nonfinancial
sectors even though the aggregate is monitored by the Federal
Reserve
relative to a range expected
ranges for money growth.
to be consistent with
In the past, the Federal Reserve has
monitored ocher monetary aggregates without including them in
the Humphrey-Hawkins report.J/
IV.
CONCLUSION
The language of Section 2A does not require reports on
a particular monetary or credit aggregate if the Federal
Reserve has not formulated objectives and plans with respect to
such an aggregate.
supported
by
the
This literal reading of Section 2ft is
last
sentence
of
the
section
which
contemplates that the Federal Reserve may change its plans and
objectives, subject to reporting the changes to Congress.
A
requirement that the Board report to Congress on objectives and
plans on a changing aggregate that might be abandoned within a
short
time
would
not
—
See, e.g^. Table 1.21, Honey Stock Measures and Components,
FederaT Reserve Bulletin, January 1979 listing money stock
measures H-l, M-l-f, M-2, H-3, M-4 and M-5. The February 20,
1979 Humphrey-Hawkins report projected tatgets for M-l, M-2 and
M-3 but not M-4 or M-5. (Federal Reserve Bulletin, March 1979,
p. 196.)
163
-22secve
che
intention
of
Conge ess
to use
the
reporting
requirements to provide a focus foe its review of monetary
policy.
Moreover, this conclusion is strengthened by the fact
that Congress
has
not defined
the monetary
and
credit
aggregates but has left this task to the Federal Reserve.
It
is also supported by the fact that the Federal Reserve has
never reported plans and objectives on all of the monetary and
credit aggregates and such reports have not been requested by
the Congress.
Finally, the discretion inherent
in the statutory
language is borne out by the expressed intention of Congress in
enacting Section 2A.
It was the intention of Congress to
Cuethec the monetacy policy making process by cequicing the
Federal Reserve to inform the Congress of the its goals with
respect to monetacy policy over the coning year in a concrete
and quantitative way without limiting the discretion of the
Federal
Reserve
in the formulation
and
implementation
of
monetary policy.
This
objective
would
not
be
interpretation of Section 2A which would
served
by
an
require the Federal
Reserve to formulate a goal with respect to a range of increase
oc diminution of a pacticulac monetary or ocedit aggregate
when, in the judgment of the Federal Reserve, such a cange
would not provide a reliable guide in the formulation and
execution of monetary policy.
Such a requirement would distort
164
-23rather than improve the consultation
process between
the
Federal Reserve and the Congress.
The Federal Reserve has concluded in its February 1987
report
that
at
this
time the
uncertainties about
the
relationship between Ml and economic performance are sufficient
so as to preclude setting such ranges.
not be consistent
Accordingly, it would
with the -text or the stated
purpose of
Section 2A to require the Federal Reserve to formulate and
report goals with respect to Ml in connection with its monetary
policy report for February 1987 because the Federal Reserve has
not formulated
objectives and plans with respect to this
aggregate for the period of the report.
165
The CHAIRMAN. Senator Graham.
Senator GRAHAM. Thank you, Mr. Chairman.
Mr. Chairman, yesterday Mr. Meltzer of Carnegie Mellon made
three suggestions for dealing with Third World debt problems, with
particular attention to Latin America.
One was to stop U.S. lending to foreign countries and emphasize
trades for debt for equity. The second was to encourage Latin
American countries to repatriate their own money. And third, to
swap debt for equity at market value.
What would be your response to these suggestions?
DEBT TO EQUITY SWAPS
Mr. VOLCKER. Well, the more equity that could be sent to those
countries, the better. And debt to equity swaps are one vehicle and
the effectiveness depends upon the particular circumstances and
times.
The part that I would question is stop all lending. You're not
contributing to the process I think of growth in those countries and
our own interest in stable political and economic developments in
those countries by simply saying stop lending.
Senator GRAHAM. Implicit in his proposal is that those who hold
Third World debt would agree to the writedown between its nominal value and its marketplace value and in subsequent questioning
Mr. Meltzer indicated that he felt that it would require actions by
regulatory agencies in order to move private financial institutions
towards such a proposal and would require some change in the
method of asset accounting for the balance of their debt.
I assume that you would be a key figure in implementing those
regulatory changes. What would be your response to those suggestions?
Mr. VOLCKER. Well, I think the description of the changes it
would require suggest the difficulties—we'll arbitrarily change a
few accounting procedures, we'll have to command them to write
down the debts—I don't know how you do that—to market value. I
assure you once you do that they will have a new market value
that's less than the written down value. You don't sustain the
value of the debts by writing them down and I have not thought
that that's a very effective approach.
Among other things, by writing them down, I suppose you mean
relieving the countries of paying the debt ultimately. Depending on
how much you did it, there s a question of how much they would
benefit in the short run.
What they need is an environment of growth, enough new money
to maintain liquidity, and to pay interest, among other things.
Sometimes, theoretically, you could, by not receiving the interest,
provide the money. Are you creating an environment in which they
can grow, return to the markets in the future, maintain open
economies—these I think are the points at issue and they are very
much at issue.
Senator GRAHAM. What's your assessment of the current policy—
I would call the Baker policy—relative to Third World debt and its
effectiveness in creating an environment of growth, particularly in
the context of what is happening now in Brazil?
166
Mr. VOLCKER. There has been, viewed against history, some significant progress in Latin America in what I think are constructive
directions of opening up their economies, reducing trade barriers,
reducing distortions within their economies and, of course, that has
accompanied a political opening as well. And I think it is quite
promising.
And during this period, by and large, their external debt burdens
have been reduced. But we clearly have a half-full glass and if you
asked it from the other direction, are there lots of problems, there
are clearly lots of problems. If you ask me whether the process
right now has bogged down in inability to complete some financing
programs for countries, I would have to say, yes, that is true in
quite a number of countries, and that is threatening to the whole
process I'm very much supportive of.
Now Brazil has a special kind of problem. What I am referring to
in bogging down of some of these financial programs relates to
countries basically that have an economic policy and have been
proceeding broadly in the right direction. There are financing programs that have been negotiated. Brazil is in a grave economic
crisis right now. They took some constructive steps earlier in the
year. They had very rapid growth for a while. They were extremely
competitive, which is, I think, good overall internationally, but in
recent months inflation has resumed, confidence has been lost to a
considerable extent, and their trade position has deteriorated.
That all obviously affects their financial position and their ability to raise money and the Brazilian situation is in a very difficult
stage right now after a brilliant performance for a couple of years.
Senator GRAHAM. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Graham.
Mr. Chairman, I want to return to the debt problem and the debt
problem for the consumers, for the corporations, and for the Federal Government. I think on every front your monetary policy has
been driving us into further debt. Let me tell you exactly why.
As interest rates drop—and I realize it is unpopular for interest
rates to do anything but drop, but as interest rates drop, what do
they do? They provide a diminished incentive for saving. If you
save, you get a lower return.
As interest rates drop, you also have an increased incentive to
borrow because you can borrow at a lower cost.
Now while that's not the only element, it seems to me it's a
clear, decisive, objective measurable element. And therefore, I
think that when you criticize—and you properly do criticize the
Federal Government for running such an extraordinary deficit, one
reason is because we have a lesser incentive because interest rates
are low and we can borrow cheaply.
If interest rates were higher, the cost of the debt would be an
even more spectacular and a discouraging element in our letting
the deficit go up.
So I think we can't escape from that effect of monetary policy on
debt. We've had a spectacular drop in interest rates over the past
few years. Lots of other elements and all the urging you get from
the administration, from 99 percent or 95 percent of Members of
Congress is keep it up, keep those interest rates down; when you do
167
anything else you get denounced. The American people feel the
same way.
But I think we have to recognize that that's the price you pay.
You're going to have a lesser incentive to save. You're going to
have a higher incentive to borrow for the Federal Government and
for consumers and corporations.
Mr. VOLCKER. I don't think the evidence is that it very much affects the savings rate, but leave that aside—you can argue it moves
in that direction, but I accept your general point that declining interest rates or more money facilitates growth of debt among other
things. Whether that's appropriate or not depends upon all the surrounding economic circumstances. And I have tried to describe our
dilemma in that respect.
I note in my statement that that is a potential problem, but we
have to reach a judgment with some view toward that but with
some view with what's going on in the real economy, what's going
on in inflation, what's going on in other dimensions.
We reached particular judgments last year. They may be right or
wrong. We thought they were right and I continue to feel that
they're right. But the consideration you mention is one factor in
the equation.
The CHAIRMAN. Well, I appreciate that and I only mention it because I think it's been ignored. I think all these other factors have
been discussed and almost nobody discusses the effect of lower interest rates in encouraging borrowing.
Mr. VOLCKER. Well, I don't know about on the Treasury borrowing.
The CHAIRMAN. No, no, but it's encouraging consumer borrowing
and corporate borrowing.
Mr. VOLCKER. There's no question about that and I explicitly say
so in the statement.
The CHAIRMAN. And, of course, consumer borrowing and corporate borrowing is far bigger than Federal Government borrowing.
DANGEROUS AND UNWISE POLICY
Let me ask you this. Essentially your excuse for letting Ml grow
so rapidly is that the public wants to hold more money balances
and the Fed decided to accommodate that demand. It seems to me
that this is an extremely dangerous and unwise policy and here's
why.
First of all, no one can predict very accurately what the actual
demand is for money. But even assuming your estimates are correct, your actions over the last two years have built up a tremendous amount of liquid balances in the economy. Eventually, when
the money demand function shifts, those balances are going to be
spent.
Isn't it true that the exceedingly liberal supply of new money allowed by the Fed in 1985 and 1986 constitute an enormous inflationary threat to the economy. What happens when the public decides to spend all the money you've created? Will the Fed then actually contract the money supply by 15 or 17 percent or whatever
it was that you expanded it by?
168
Mr. VOLCKER. Well, I think that would be rather extreme. I can't
imagine the situation where that would happen, although it's theoretically possible. But I went at some length in my statement to
make precisely I think the general point that you are making; that
in other economic circumstances—and I attempted to describe
them—a very sharply lower growth in the money supply would be
appropriate, precisely because of all the reasons you suggest.
The CHAIRMAN. Well, I read your statement carefully. I didn't
get that emphasis, but I'm glad you're giving it to us now.
Mr. VOLCKER. Well, I refer you to page 27.
The CHAIRMAN. I'm sure it's there. I don't doubt your word.
Mr. VOLCKER. I don't think, it's a part I skipped over under your
urgings, but I
The CHAIRMAN. Let me pursue this in a different way then.
Mr. VOLCKER. I just want to point out page 27 and commend it to
your attention.
The CHAIRMAN. What page?
Mr. VOLCKER. Page 27.
The CHAIRMAN. All right.
Mr. VOLCKER [reading].
To the contrary, action to reduce the rate of growth of Ml promptly and substantially would be called for in a context of strongly rising economic activity and signs
of emerging and potential price pressures, perhaps related to significant weakness
of the dollar externally.
The CHAIRMAN. Of course, that raises another question. It's
never the time, you know. We had somebody yesterday say the way
you avoid this kind of a situation we're getting into is never get
drunk. And another way to do it, the way we're doing now, is to
never be sober. If you're never sober, you never have a hangover.
It's a hair of the dog that bit you, get another drink in the morning
and you're good for the day.
Mr. VOLCKER. That's not my vision.
The CHAIRMAN. Well, I'm glad you don't follow that policy. Neither do I. But it's sometimes a tempting policy.
At any rate, let me ask you this. Over the last 12 months the
money supply as measured by Ml has grown by 15 or 17 percent,
depending on how you measure it, well in excess of the Fed's targets. That explosion in money growth is sometimes blamed on financial deregulation and lower interest rates. That is, as interest
rates come down, people shift their money from short-term liquid
investment into NOW accounts.
However, the demand deposit component of Ml has grown by
nearly 13 percent over the last year. Of course, demand deposits
pay zero interest.
As a result, why wouldn't it be accurate to conclude that the explosion in money growth is due to the Fed's decision to supply
more money rather than an increase in the public demand for
money?
Mr. VOLCKER. Well, it takes both sides of the supply and demand
equation to produce the result, and we supplied the reserves. But
demand deposits are also affected by declines in interest rates, by
at least two avenues. I'll add a third avenue. It's true they pay no
interest, but most demand deposits these days are held by businesses, many of them in compensation for services provided by the
169
bank. When the interest rate goes down, the bank says to get the
same income I need a larger deposit because their return on that
money has gone down.
These explanations are not alternatives. They go on at the same
time. The fellow who is managing his demand deposit account isn't
going to manage it so carefully when the reward of taking the
money out of the demand deposit and putting it in something else
is reduced. And this shows up in equations over a period of time.
So the direction of the movement is not at all unusual. The size
of the movement is unquestionably unusual. The size of the interest rate decline was pretty unusual, too.
In part, you may have here a phenomena of whereas more
demand deposits are held by businesses—that is, a bigger proportion of demand deposits are held by businesses—and banks are all
sharper on their costing, so you may get more responsiveness to
this compensating balance phenomena that I referred to than you
got earlier when a lot of individuals held demand deposits and
banks and their customers may not have been so precise in their
calculations. That's speculation on my part. But the direction of
the tendency is clear.
The third factor which is somewhat different, you have already
mentioned—the obverse of that anyway. There are so many financial transactions going on which in the immediate sense may require some demand deposits to lubricate, that tends to pull up deposits, too. There is one type of financial transaction which has
been very active, the settlement of mortgage-backed bonds, that requires explicit putting of demand deposits in escrow for a while,
and that activity is so big it probably has some impact.
You saw this very clearly at the end of the year. This was—I
don't know whether disturbing or comforting, depending on the
way you look at it. There was an explosion in credit demands at
the end of the year for a variety of reasons, including tax law
changes, and there was a very large increase in demand deposits
and the money supply generally at the same time. You had as
much increase in the money supply around the turn of the year as
we ordinarily get in a year and it was clearly related to an explosion in financial activity. Most of that has washed out. The increase in the money supply in February is going to be very small it
looks like, and you ve had a relapse from that explosion around the
year end.
But that more persistent pressure from financial transactions is
in there someplace. I don't think it's the major cause of the rise,
but it is a third factor to put together with the others.
FOREIGN EXCHANGE VALUE OF THE DOLLAR
The CHAIRMAN. I'd like to ask you a question about the trade deficit. On page 18 of the monetary policy report that accompanies
your testimony the Fed says that the foreign exchange value of the
dollar has declined about 40 percent against a weighted average of
the currencies of the other G-10 countries since February of 1985.
But on page 18 of that same report, it's noted that since early
1985 the dollar has appreciated in real terms relative to the currencies of Canada and some developing countries which account for
170
almost half of the U.S. nonpetroleum imports. In other words, we
are not benefiting from the dollar decline in relation to those countries with whom we do almost half of our trade.
Mr. VOLCKER. Did it say that?
The CHAIRMAN. I notice that the Dallas Federal Reserve
Bank
Mr. VOLCKER. I hope our report didn't say that last sentence.
You said that we didn t
The CHAIRMAN. No, no. I said that we are not benefiting from
the dollar decline with those countries with whom we do almost
half of our trade. That was my conclusion. Your quotation is "Since
early 1985 the dollar has depreciated."
Mr. VOLCKER. Your conclusion I think is wrong, and I just want
to note that.
The CHAIRMAN. Well, all right. What puzzles me is that the
Dallas Federal Reserve, a branch of your operation, said that if you
have a comprehensive weight, including Canada and the developing countries and so forth, that the dollar has depreciated 5 percent, and that seems to be a far different situation than the 40-percent decline with respect to Japan and Germany and the 30 percent with respect to Great Britain, for example.
Mr. VOLCKER. Yes, that would be quite a different situation. I am
aware of the Dallas Federal Reserve's calculations. I have told
them I think that they are unrealistic and misleading in terms of
the economic situation. They are well aware of my view on this
subject. I do not think it's a good index and I'll tell you why.
It's the same observation you made. It's just nonsense to look at
an exchange rate for Latin America or most of these countries
before allowing for changes in prices. In the exchange rate itself,
we have appreciated enormously against most of those currencies
because they're having great big inflations.
Even if you put it in real terms, the implication that we do not
benefit in trade terms with those countries from the change in the
exchange rates among the industrialized countries is simply wrong.
If you have no change in the exchange rate vis-a-vis the Korean
won, but our exchange rate has changed 50 percent against the
Japanese yen, obviously the Koreans now have an enormous incentive to export to Japan instead of to us and to import from us
rather than from Japan. And that's the market that is supposed to
work.
It doesn't make any sense for a country—take Canada—that
Canada does not have a current account surplus. They have not
been in a position—I'm just speaking very generally—for a major
appreciation of their currency, but they certainly now have more
incentive to export to Europe and Japan and less incentive to
export to us and our market as a market from which to import is
certainly more attractive now than it was two years ago relative to
Japan and Europe. That's what these exchange rate changes are
all about.
Now the difficulty is that the effects may be greatly slowed down
or thwarted if Japan in fact refuses to import from Korea or the
Europeans don't open their markets and then these financial incentives don't work. But that's not an exchange rate problem.
That's a trade problem.
171
The CHAIRMAN. My time is up. Senator Heinz.
Senator HEINZ. Chairman Volcker, I wasn't going to talk about
trade, but since you left Senator Proxmire on that note I will just
ask you one quick question on trade.
PROTECTIONISM
This goes back to the subject of how we avoid protectionism in
this country and maybe some semantics on the subject.
Many of us are persuaded that the only way that we can get
countries to open their markets to us is to threaten or perhaps go
as far as to deny, until such time as other markets are opened to
us, access to this market. It is no coincidence that this country accounts for roughly 22 or 23 percent of the free world's aggregate
gross national product and we accept 50 to 60 percent of the free
world's merchandise trade as imports.
My question to you is, is it protectionist for the United States to
have a law that in effect says we will deny a particular country or
particular sectors of a particular country market access until that
country removes the trade barriers that are denying us access—
probably as a practical matter in different sectors—is that protectionism or not?
Mr. VOLCKER. I think you're asking me a semantic question that
I find difficult to deal with.
Senator HEINZ. I don't know whether it's semantical or not.
Mr. VOLCKER. I think there's a real issue here, don't mistake me,
but I think you would say if you put up a trade barrier that's protectionism, whether it's for a good purpose and for the purpose of
trying to get somebody else to reduce their trade barriers so that
the total in the end will not be protectionist
Senator HEINZ. Let me help you a little bit with semantics. I
would argue I think as a scholastic matter that protectionism, as
defined, is to protect an industry and that if you're going to protect
an industry in this day and age you had better have very broad
comprehensive trade barriers affecting every country.
Now the President has a steel import restraint program in effect
on steel. It isn't working too well because there are just three countries out of about two dozen—Canada happens to be one of them,
Sweden and Taiwan until recently—that simply weren't participating and, as a result, it hasn't had the effect the President wants it
to have.
So my argument would be, if you're picking on a particular country with your retaliation that it is probably not protectionistic because there are so many sources in this day and age of substitute
products and, therefore, I really don't see your semantical problem.
Do you still see it after that explanation? Have I given you cause
for hope and light?
Mr. VOLCKER. I don't think the real problem is what is semantics. The problem is whether, in the interest of a greater good, as
you describe it, in breaking down the trade barriers of others this
is an effective, efficient, understandable technique. And in some
particular instances it may be. I certainly understand the frustrations that underly that approach.
172
I would think also if it's clear enough, you could get multilateral
support for that effort and that might be a test.
Senator HEINZ. Let me return to a subject I wanted to pursue
with you originally and that has to do with the overleveraging of
the economy. Many of us today have heard you and others talk
about high burden of consumer debt, the national debt, the debt we
owe other countries, corporate debt, and the jury seems to be in
that we are overleveraged and that entails a number of risks to our
economy. Is that right?
Mr. VOLCKER. Well, I, unfortunately, don't think you can say the
jury is in. A lot of Wall Street doesn't seem to think so. I understand it's a badge of honor these days not to have
Senator HEINZ. Well, as a jury of one sitting down there, what do
you think?
Mr. VOLCKER. I think we are in danger obviously of moving too
rapidly in that direction, I have no doubt about that.
Senator HEINZ. To what extent do you believe the Federal Government's policy of insuring financial institutions against risk is a
contributing—not maybe the determining factor but a significant
contributing factor? Is it or is it not accurate that by providing deposit insurance—and I'm not necessarily arguing against it, but
just to understand the effect—that by providing deposit insurance,
we guarantee that institutions, some of which will take bigger risks
than others, will have access to funds and, therefore, by having
that kind of policy, we perpetuate risk-taking through a government policy? Is that a fair statement? Is that accurate or have I
missed something?
Mr. VOLCKER. I'm afraid I would get maybe semantical and say
we're not insuring the institution, and many institutions are failing, as you know. But we are protecting depositors through the
FDIC and through other events, and 1 don't think there is any
doubt that in some circumstances that protection which enables institutions to raise more money more freely than would otherwise
be the case may contribute to risk-taking, excessive risk-taking.
Senator HEINZ. Among banks or among S&L's, don't we insure
deposits for the same cost, irrespective of the policy of lending of
the particular institution?
Mr. VOLCKER. Of the individual one, yes. Of course, as you the
know, the S&L's now pay a premium.
Senator HEINZ. And so we have the Continental Illinois Bank. I
seem to recollect that we did a little rescue operation there.
Mr. VOLCKER. I think you've got your hands on a real problem. I
have not thought that the way to handle this ideally is by riskbased premiums, if that's what you're getting at. But I have no
doubt in my mind you've got a problem.
Senator HEINZ. I'm getting at—since I think we both understand
there can be difficulties with risk-based premiums, I'm looking for
a way to address the problem. Because if it's true that we are overleveraging ourselves and putting ourselves unnecessarily into a
dangerously risky position—we may not be there yet, but we can
see the tunnel at the end of the light. We ought to be doing something about it rather than just talking about it.
Mr. VOLCKER. Well, I obviously can't disagree with that. Now
this insurance only goes to depository institutions—commercial
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banks, and savings and loans, leaving out credit unions for the
moment, which are not a source of the problem. That is an area of
the financial community that we otherwise regulate and that is
part of the balance. They do get the benefits of insurance, but
we're supposed to be supervising them, collectively and not just the
Federal Reserve. And the supervision is supposed to obviously be
alert to precisely the kind of developments that you're talking
about.
A lot of the leveraging in the economy is going on outside these
institutions—not entirely, but in good part outside the areas that
are technically covered by deposit insurance.
Nonetheless, I think you have your mind on a problem that
needs to be dealt with.
I would say the other side of that is we've got to proceed very
cautiously in this area, given the existing strains that are evident
on many financial institutions.
Senator HEINZ. Chairman Volcker, your admonition as to caution
is well taken. I don't quarrel with that. I can't help but reflect,
however, that our solution to the problem you and I have been discussing is that next week we're going to hold a markup in this
Committee to approve a $12 to $15 billion bailout of the Federal
Savings and Loan Insurance Corporation. What we are doing is, in
effect, just keeping a system afloat
Mr. VOLCKER. I agree.
Senator HEINZ [continuing]. That has all kinds of—is leaking desperately and badly. And there's no institutional reform. All we're
doing is we're putting more of the taxpayers' dollars beyond the
premiums that that particular industry has contributed, and we
have a great, wonderful and fundamentally phony way of doing it
so that it doesn't show up on budget, but make no mistake, there
are going to be $12 to $15 billion more allocated to the FSLIC and,
correspondingly, less will be available elsewhere.
So this is not an academic question.
Mr. VOLCKER. I agree with that fully and I have urged before and
I will again that I think this whole problem that you're raising
now should be addressed by the Congress. I think it has to be addressed with great care and deliberation, but I certainly hope that
will be on your agenda for more comprehensive legislation when
you get this immediate question out of the way.
Senator HEINZ. That is a critical point.
Mr. VOLCKER. What's a critical point?
Senator HEINZ. Do you say to a fellow who is drowning, "I'm
going to give you a life preserver and drop you off back out in the
middle of the ocean and see how long that keeps you afloat," or do
you tow him into shore and show him what dry land looks like and
teach him to walk again?
FSLIC BAILOUT
The problem I have with simply passing an FSLIC bailout bill is
all we do is tow these people back out in the middle of the ocean
and see how long it is they can stay afloat out there without
making any provisions either to lower the water level or to teach
these people to swim or walk.
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Mr. VOLCKER. Well, what people are you talking about, the
FSLIC?
Senator HEINZ. The FSLIC.
Mr. VOLCKER. Well, I think you are certainly throwing them a
life preserver if you're talking about the FSLIC. I think that that is
essential under current circumstances. This plan, as you know, is
basically
Senator HEINZ. But what you're saying is don't do anything
about the basic problem, wait until later. How long do we have to
wait?
Mr. VOLCKER. I don't know, but I think a lot of difficult problems
arise here that have to be carefully considered and you sure have
got to wait more than a month or two, and I think the time plan
you have for this program should be in the framework of a month
or two, but I am not discouraging you from getting to work on the
other problem.
I am urging caution and care because I think it is a very difficult, complicated problem. I think you ought to get to work on it. I
have occasionally had some thoughts on the subject myself. I don't
think you have to delay at all, and I don't think there has been
any delay. I think there has been very considerable effort in the
Home Loan Bank Board and the FSLIC to tighten up their regulatory and supervisory approaches, and I think that ought to be recognized. It's not quite that you're just throwing them this money
and nothing has been done. Quite a lot has been done over the last
few years.
Senator HEINZ. Mr. Chairman, my time has expired. If I could
have one additional minute, there's one followup question I would
like to ask on this.
The CHAIRMAN. Go ahead.
Senator HEINZ. Virtually every economist and financial expert
I've talked to has agreed with the proposition that nonbank banks,
consumer banks, the creation of those, is a direct threat to the
S&Ls. They syphon off deposits. Now I don't think it is actually
fair to say that tying a closure of the nonbank bank loophole to
FSLIC is actually plowing brand new turf.
We passed legislation to do that about 3 years ago in the Senate.
Now are you saying that we shouldn't, at the minimum, do that?
Mr. VOLCKER. Quite the contrary. This issue arose before and I
really think, as I said before, the failure to act in that area is an
abdication. I think it has the effect that you're talking about, but I
think it's a much broader issue.
I was interested in noting in some newspaper column this morning people upset with the grandfathering and tandem restrictions
that Senator Proxmire put in the bill. They said, "My goodness,
that's what it is all about. We want to cross-market all these services with our commercial firm." And, of course, that is just the
issue. What kind of a banking system do you want? Do you want a
banking system that's primarily devoted to cross-marketing the
services of Sears Roebuck, Ford, Chrysler, and all the rest with all
the problems that arise, or do you want an independent banking
system?
Senator HEINZ. So it is your strong view, as I understand it, that
we should address those issues as part of a FSLIC recapitalization.
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Mr. VOLCKER. On that issue, it is my very strong view you should
address along with it that issue of those particular securities
powers that the Chairman has put in the bill. I think it would be a
dereliction if you don't deal with those issues at this time.
Senator HEINZ. Mr. Chairman, thank you.
Senator Sarbanes, I thank you. You were kind enough to delay
your time.
The CHAIRMAN. Let me just say that I'm going to have to leave
and, Senator Riegle, if you'll take over as Chairman in my absence.
Senator SARBANES. Chairman Volcker, I wanted to follow along a
line of questioning that Senator Heinz put to you and I thought put
very well on this protectionism, and I think the one agreement I
got out of all of it is that it really is a matter of semantics. I mean,
various proposals for looking at this thing are brushed away by a
lot of people by trying to stick that label on it, and then you can't
in a sense come to grips with it.
Mr. VOLCKER. If I may just interject, I think you could call that a
matter of semantics. He put a very limited question, a specific restriction, with the clear and single objective of getting the other
country to remove a restriction.
Senator SARBANES. Well, that's right. And I want to turn to
pages 11 and 12 of your testimony where you talk about Taiwan
and Korea, where you've been, in effect, so bold as to actually pick
out a couple of countries.
What approach is there other than the one Senator Heinz suggested to move these countries to deal with what you have termed
a strong wall of protectionist barriers? As long as they can go along
as they are, it's very much to their advantage.
Mr. VOLCKER. Well, it's not entirely to their advantage and one
would like to think that reason prevails at times, although I recognize that they're very—it's not to the advantage of particular industries that are being protected in those countries.
Just how that is dealt with—and you're really going to get outside an area where I think I can be very helpful. I'm not an
expert—maybe I shouldn't have mentioned Taiwan and Korea, but
that involves a lot of negotiating considerations and a lot of facts
that I may not be familiar with.
I can understand that what Senator Heinz was talking about is
one possible approach in particular selected instances.
RESPONSIBLE ECONOMIC CONDUCT
Senator SARBANES. Don't you think it's reasonable to assume
that it's unlikely they are going to take forceful action to increase
imports, whether by reducing tariffs, lifting other trade restrictions, or by exchange rate changes, all of which of course suggest
that you think their performance in those three areas fall short of
responsible economic conduct—on tariffs, trade restrictions, and exchange rates.
Mr. VOLCKER. My sense is that they will and are doing something
and I don't know what word I use there—I have great doubts that
it's going to be sufficiently forceful. I think they are taking action.
Senator SARBANES. If they perceive that their access for markets
for their exports were going to be affected, it might move them
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rather quickly to address these three items to which you make reference.
Mr. VOLCKER. That is one possibility, but those kinds of actions
and threats have dangers of their own which you have to take into
consideration.
Senator SARBANES. That's right, but none of the other possibilities seem to have worked.
Mr. VOLCKER. Well, I am not ready to make that sweeping judgment, but I understand.
Senator SARBANES. Which leads me to my next question. You
preface that paragraph by saying, "Some newly industrialized
countries also have clear responsibilities for contributing to a
better world balance."
My question is somewhat broader than that. Is it your view,
given the strengths of various national economies, that there are a
number of countries that are not assuming their international responsibilities in terms of contributing to a better world balance
that's commensurate with the strength of their national economy?
Mr. VOLCKER. Well, clearly, when you're talking about the imbalance related to trade or current accounts, you look around. We've
got a big deficit. We are one of them on the deficit side. Germany,
Japan, Taiwan, and Korea—Taiwan stands out more frankly than
Korea. It's a little country with an enormous trade surplus and
enormous reserves already accumulated. But then I think you have
to look further and say, are they contributing or not depends upon
their internal economic situation. Are they growing? Are there
areas where they are reasonably falling short or not?
Now I would say in the case of Taiwan and Korea, as I stated,
that you look at those countries and their strength externally has
been growing. They have room to move much more aggressively on
their trade barriers now than they would have had 5 years ago.
Senator SARBANES. Let me ask about Japan and West Germany,
two major industrial countries who are running very large surpluses.
Do you think that a new and broader perception needs to be developed on their part in terms of their responsibilities with respect
to the international economy?
Mr. VOLCKER. Well, I think the whole effort of the administration and others has been to move clearly in that direction and I
think there is a better appreciation now than perhaps a few years
ago. Indeed, you see—for that reason or otherwise, you see some results. Both of those countries, at least in relative terms, have had a
better expansion and internal demand and some decline in their
real net exports last year. That is a direction in which things I
think must move and that is the direction in which things did
move last year to some degree.
Now one can sit here and say, as I would, that given the overall
growth rates in those countries, given the amount of resources they
have that are unemployed, the availability of capital and so forth—
is the rate of movement optimal?
Senator SARBANES. What about their responsibilities, given their
surpluses, to move capital into the Third World and contribute to
the possibility of the Third World being able to go on to a growth
pattern? That's traditionally a responsibility the United States has
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tended to assume in the post-war period. We're not in a posture to
do that and, in fact, our trade deficit, if you look at it, where it has
worsened most noticeably in many instances it's with respect to
trade in the Third World, which before was always an offset
against the deficits we were running with these very industrial
countries.
Now given their surpluses and their strength, why shouldn't
they have a responsibility to circulate some of that to contribute
towards Third World growth?
Mr. VOLCKER. Well, in some kind of broad concept, that would be
very helpful to see much more capital flowing from those countries
to Third World countries, let's say, and we earn it back in trade
instead of borrowing it ourselves. This is what it would amount to
and that would be a nice outcome.
In practice, I don't think you can say those countries officially—
and I haven't looked at it recently in detail—are probably doing
any worse, they are probably doing better than we are relatively in
terms of sheer official aid.
And when you talk about a kind of grand conception that you
have of much bigger flows of capital out of those countries, you run
against a problem that those capital outflows they have are essentially in private hands, and how do you redirect a private flow of
capital? That basically depends upon perceptions of market incentive.
For the government to redirect it in the kind of billions and billions of dollars that you're talking about, the taxpayers in those
countries and the budgets in those countries would be taking on
the burden. And on the scale that you're talking about—I'm not
talking about the direction, but the scale that you're talking
about—I think it's simply unrealistic to think that Japan with a
surplus of whatever it is—$60 or $70 billion—is going to appropriate $30 billion for aid to Latin America rather than some proportionately small amount.
I just give you a practical judgment. However desirable that may
be, it ain't going to happen.
Senator SARBANES. What about trying to get them to work multilaterally to accumulate resources from a number of places and,
second, so that they don't tie the aid. I mean, Japan moves forward
now and says, "We're going to meet our responsibility." Then they
have a bilateral flow and then they tie it, which simply worsens
the trade problems.
Mr. VOLCKER. Those comments are very relevant. There are both
some progress and some work going on, and I think it's a very relevant comment.
Senator SARBANES. Thank you.
Senator RIEGLE. Thank you, Senator Sarbanes.
Mr. Chairman, three topics. You've been here quite a while and I
don't want to keep you too great a length.
UPCOMING G-5 MEETING
Regarding the upcoming G-5 meeting, for our goals to be
achieved, many of which you've talked about today, it seems to me
the economies of those other nations have to grow and I'm wonder-
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ing what kind of growth rates you and Secretary Baker might have
in mind.
For example, West Germany, would we be thinking of maybe a
growth rate of 3 or 4 percent, something in that range; and with
respect to Japan, are we thinking about something like 4 or 5 percent? Where are we in terms of what it takes to make the system
balance here?
Mr. VOLCKER. Well, those growth rates would be very nice, but I
don't want to set out a particular target. I think obviously I have
some concern at least—and Secretary Baker is perfectly capable of
speaking for himself—that those growth rates, particularly the
growth in domestic demand, while in relative terms it has been improving, I would feel a lot more comfortable about the world situation—I would feel a lot more comfortable about the speed of these
international adjustments, if it were growing more rapidly.
The latest evidence in those countries tends to be on the side of
flattening growth rather than speedy growth.
Senator RIEGLE. When you say the latest data, you mean within
the last say quarter?
Mr. VOLCKER. Yes.
Senator RIEGLE. So growth may be slowing down in Japan and in
Germany?
Mr. VOLCKER. Well, in Germany in particular, the figures definitely show a slowdown. Now you can get into all the arguments
about seasonal, whether it's been a bad winter and all the rest. In
Japan, I don't think they've slowed down particularly in the last
few months, but it's not a very vigorous growth rate—2.5 percent
or something, as I remember, which is way below Japanese standards.
So what I'm saying is that in these recent months I think within
those countries more questions have been raised about the adequacy of their growth rate than earlier. I share that concern.
Senator RIEGLE. Well, that's really the point of my question. In
terms of balancing the international trading and financial system,
you have testified here before that we are now interconnected in
ways that we might not have been in years past and that's it's very
important that we get corresponding adjustments that fit together.
So I guess you're saying that you feel that the whole system would
be better off if we could get higher rates of growth in both those
countries than we are presently seeing?
Mr. VOLCKER. There is no doubt about that. Now in saying that,
they are going to say, "Well, don't forget, we want to safeguard our
internal stability, our prices," which I have great sympathy with. I
think that could be managed. They also say, "Yes, but this is a twosided process and where is your adjustment? And you don't give us
very encouraging signals about your budget deficit and we think
this process ought to start with reducing your budget deficit."
Well, I don't know where it should start and where it should end.
They both have to be done, but I do think, as I said in my statement, that without them having some feeling of confidence that
the United States is moving forcefully in the right direction it saps
their will to take what they see is equally politically tough decisions to move in the other direction.
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And we both ought to be moving, in a sense, in opposite directions. That's what would make for the international consistency I
think in dealing with these adjustment problems.
Senator RIEGLE. Well, you properly I think point out the role of
our federal fiscal deficit. Last year it was the highest in our history, $221 billion, and maybe it's going to be substantially below that
for this fiscal year that we're now in. We hope that it will be, but
we won't know until all those numbers are in.
I agree with your emphasis on that, but so much of the time you
seem to leave out the trade deficit and the trade deficit is running
at $170 billion at the same time. It seems to me that we have to
move on both those problems and they're connected to one another
and we've got to make progress I think very rapidly on both. Isn't
that correct?
Mr. VOLCKER. Yes, that is correct, and I don't think you're going
to make progress on the one without making progress on the other.
Senator RIEGLE. Well, that comes back to Japan. With respect to
Japan, if you look at our trade deficit last year, $170 billion, the
Japanese figure in terms of their surplus with us was, according to
the Commerce Department, about $59 billion, by far and away the
largest single part of that $170 billion deficit. And without repeating all of the litany of factors, you know that the Japanese are
very skillful at keeping our products and other nations' products
out of their markets and so the trading system is not open both
ways.
Isn't it also necessary that if they're going to expand their internal economies that something has got to be done about these incredible bilateral deficits with countries like Japan? You mentioned Korea and Taiwan and I think properly so because those are
now persistent problems that are in the multibillion dollar range—
about $16 billion last year with Taiwan alone. But isn't Japan
going to have to find a way in their bilateral trading relationship
with us either to buy more or send less so that we get this deficit
down from an area of roughly $60 billion a year?
Mr. VOLCKER. Well, obviously, their surplus with us is enormous
and it's very hard for us to see us dealing with our general problem
without a reduction in that deficit. But I think that's the wrong
focus to look at it in. I think the world trading system—maybe less
so—but nonetheless is still a multilateral system and where the individual bilateral deficits fall out I don't think is so significant.
What matters is their overall surplus. That's what I would emphasize, their $70 billion overall surplus, and our overall deficit,
rather than the bilateral one.
As I indicated before, it would be greatly in our interest, as Senator Sarbanes was illustrating on the capital side—but just on the
trade side, if they absorbed a lot more imports from Latin America,
that would give Latin America the capacity to import a lot more
from us and might not affect our trade balance directly with Japan
at all but it would be a remarkably constructive contribution to
their overall surplus and our overall deficit.
Senator SARBANES. Would the Senator yield?
Senator RIEGLE. Yes, I yield. By the way, I think that's an important point.
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Senator SARBANES. Provided that Japan didn't tie taking more
imports from Latin America to Latin America taking Japanese exports, which of course they tend to do.
KOREAN EXPORTS
Mr. VOLCKER. I agree, which would be inconsistent with our exports rising. You just mentioned Korea. Korea, of course, is right
next to Japan and I read in the newspapers anyway that Korean
steel is now pretty competitive in Japan and it's pretty competitive
in the United States too, I guess. But it must be, given these exchange rate changes, a very considerable incentive—just to pick
out one product—cars—to sell them to Japan. But if Japan isn't
going to take them, that process is thwarted. It's not a trade barrier against us. It's against them.
Senator RIEGLE. Well, it's not only thwarted. What happens is, is
that steel then basically comes to the last big market that's left,
and that's here. And just with respect to cars—and cars, of course,
contain a lot of steel—if you take the Hyundai, which is a very
popular new Korean import, they are planning to ship about
200,000 of those in here this year but their goal 3 years down the
line and their production plans in Korea are to produce and ship in
here roughly 1 million cars. And it's an enormous fact of life, not
just for that sector of the economy, but that is a pattern we're
seeing way beyond steel and cars.
Mr. VOLCKER. Well, I understand that and I suspect that those
plans were made and developed over a period of time and against
competitive positions that existed in part some time ago.
The logic of the exchange rate changes we've had is that they
should be thinking of exporting more of that planned million or
whatever it is to Japan or to Europe or elsewhere and less here.
Now whether that works, of course, is related to your comment—
if we're the only open market, that process doesn't work.
Senator RIEGLE. Well, I want to tie down two other things on this
because it's important and your testimony is important.
As I understand it, even though the dollar has come down substantially against the yen over the last year, we really have not
had any major change in currency value between our currency and
the Korean currency. Is that right?
Mr. VOLCKER. That's correct. I think there's been some appreciation but not much.
Senator RIEGLE. I think less than 1 percent.
Mr. VOLCKER. Well, I'm not sure about that, but it's small
anyway. I will accept your statement. It's negligible.
Senator RIEGLE. Here's the point. Some will argue that what's
going to happen here with the 40-percent decline of the dollar
versus the yen, is that over a period of time after a lag, you'll start
to see some adjustments in the trade situation unless there are just
naked barriers that prevent that from happening.
But with respect to Korea, if changes in currency value are not
reflected in any differential way between the two countries, it
seems to me we're not going to get that kind of effect in six months
or sixty months.
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Mr. VOLCKER. Well, I think that's just plain bad economics. Abstracting from the trade barriers, which are very real, but just
looking at the currency values, the change in relative currency
rates between the United States, Europe and Japan gives Korea
more incentive to export to those countries and to import from the
United States without the dollar-won exchange rate changing by 1
won, or whatever the rate.
Senator RIEGLE. Well, that's if they can get in those markets.
Mr. VOLCKER. If they can get in them, that's right.
Senator RIEGLE. But if they can't get into the markets, then they
come back.
Mr. VOLCKER. If they can't get into those markets, that process
does not work and then you've got another set of problems.
Senator RIEGLE. Two other things quickly. Citicorp seems not to
want to make further loans to the LDC's at this point. At least
they seem to be the one bank that is the least enthusiastic about
doing so. That's what the stories say.
Mr. VOLCKER. Well, the stories don't say that—just to be clear—I
don't want to comment about an individual bank, but I think the
stories focus on questions about what the interest rate should be,
not whether they are willing to lend or not.
Senator RIEGLE. I'll accept that correction. I think that's a very
important point. It sounds to me as if they don't have much enthusiasm for wanting to lend at the rates that maybe they're being encouraged to lend at. Is that a fair summary?
Mr. VOLCKER. Well, I don't know what's being encouraged or discouraged. It's a question of negotiations between the countries and
the lenders.
Senator RIEGLE. Well, let me ask a very direct question. Will the
Fed pressure any of the banks to extend or increase their loans to
the LDC's?
BAKER PLAN
Mr. VOLCKER. We have made our feelings in this general area
amply clear—I do practically every time I testify—about the overall interest that we see in this process moving forward under the
broad rubric of the so-called Baker plan. It's always been understood that the banking community as a whole had certain responsibilities in that area if the plan was going to work.
I don't consider that pressuring the banks. That's making a point
of view known and we do it pretty clearly when we're talking to
banks in groups or when I'm talking in public I say the same thing.
Now that process has slowed down. It's bogged down recently
and I think the atmosphere, for a variety of reasons, has undermined the atmosphere surrounding the whole initiative and many
of these programs don't require new money. Some of them are just
refunding, which are usually very simple—very simple is not the
right description—but considerably simpler to implement than
when you're asking for sizable amounts of new money.
But we've got a lot of—seven or eight countries that have been
negotiating financing plans for months and none of them have
been absolutely completed. Some of them are on the edge, but none
of them have been conclusively completed.
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This is a long and frustrating process and, obviously, I would feel
more comfortable if that was moving more expeditiously.
Senator RIEGLE. One of the questions in my mind—and it isn't to
take the argument or position of any private banking institution,
but it seems to me that these loans are very much—they have a
national interest component to them and it makes me wonder at
what point, if banks are being pressured by events or pressured by
our Government to either continue loans or extend loans or to give
favorable interest rates, that if there's a public policy component to
that, that maybe the Government itself ought to be extending
those loans rather than go through the fiction that they are private
sector loans and recognize that they are really perhaps public
sector loans.
Mr. VOLCKER. Well, I don't accept that the loans that the banks
made were public sector loans. They were pretty eager to get into
that business at one point.
Senator RIEGLE. I'm talking about from here forward.
Mr. VOLCKER. From here forward, I think the United States and
other governments, acting either bilaterally through export credits
or otherwise, and certainly acting multilaterally through the
World Bank and the IMF, have a clear responsibility to support
this process and, in some cases, put up new money, which, of
course, is what the World Bank in particular is doing now.
If you look at the Mexican program, which isn't quite tied up—
it's one of those that's been caught—a very large program and a
very difficult one because they were so hard-hit by the oil situation
exclusively in terms of the size of the program, roughly half of the
new money involved in that program comes from official sources—I
think a little more than half.
Senator RIEGLE. Just one other thing and this is—I don't mean
for this to be an overly provocative question to you. I'm trying to
get a sense as to the margins we have right now in terms of managing our financial problems and we've got a whole laundry list—
the Federal budget deficit, the trade deficit, the working out of
multilateral arrangements, Third World lending and a host of
other things—monetary policy, where that fits in. The question I
have in my own mind in terms of how much margin we have and
the parameters we're working within—if we were to see a recession
of any consequence, say, over the next 12 months, would that come
at a time that would be particularly worrisome in your mind in
terms of navigating our way through all of these difficult problems?
Is it very important for us to stay out of a recession now? We
never want one, but I'm asking the question, does it pose extraordinary dangers?
Mr. VOLCKER. I think the risks of that are inevitably greater to
the extent the rest of the world is not growing on its own momentum with some strength, and I think the risks are inevitably greater to the extent that the international debt problem is still there,
as it obviously is. I would think the risks grow over time.
I would take a somewhat different perspective if the financial
system gets too highly leveraged. But the more questions there are
in the world economic and financial system outside the United
States, the bigger the problem potentially you have.
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Senator RIEGLE. I would just finish by saying, when I try to think
of what would happen if we started to slip into a recession, with
the Federal budget deficits rising because revenues would fall and
transfer payments would
Mr. VOLCKER. If I may just interrupt, that's not the part of the
budget deficit 1 would worry about. I mean, really when I'm talking about the budget deficit, I'm talking about reducing the budget
deficit in the context of growth. Obviously, if you were in a recession, the budget deficit would be affected.
But what you've got to aim at is get that structural deficit under
control.
Senator RIEGLE. Well, you make the point I was coming to and
you were ahead of me, so I'll let your point stand.
Senator Sarbanes, you wanted to make an observation.
Senator SARBANES. I just wanted to get one final sort of reaction
from the Chairman.
TRADING SYSTEM UNFAIRLY STRUCTURED AGAINST THE UNITED STATES
First of all, let me say I'm not trying to lead toward any conclusion or any way you go about redressing the situation I'm about to
set. But there's a perception I think in the Congress and in the
country that the international trading system is currently structured—is unfairly structured against the United States. In other
words, we are being taken advantage of, that our market is much
more open than other markets are to us. We had the whole problem of the currency valuation which put our producers out of business because of that problem.
We carry a heavy strategic responsibility, a defense strategic responsibility, so we have 6 percent of our GNP going into defense
and other countries have much lesser percentage so we're carrying
those broad responsibilities.
And that, in a sense, perhaps the United States is still operating
on the premise that prevailed in the years after World War II
when we were clearly the dominant economic power and, in many
respects, I think made concessions to help the rest of the world
grow, that that time has passed, that we're in a very different situation.
Now how you address it is a complicated matter and one of controversy. But what I'd like to get from you is whether you think
the perception that the system is not now fairly structured, that
the rules are not fair and need adjusting—and you can adjust them
in lots of ways obviously—but whether that perception you think
has some accuracy to it?
Mr. VOLCKER. I would not say the rules themselves I think. I sit
here and think there is some truth to the perception that in fact,
at least among the major countries, we are the most open market.
We obviously have the biggest defense spending and I think those
perceptions are accurate.
I'm not sure that they have changed dramatically. You say this
was kind of built into the postwar system to some extent and if you
take a long sweep—go back 30 years to the 1950's when we consciously almost unbalanced the system, I suspect it may be less unbalanced.
184
But nonetheless, I share the perception that, by and large, we
have more open markets. We are more welcoming of imports,
whether by governmental policy or culture or whatever, and that
we do carry certain burdens that other countries do not carry. I
agree with that, but I'm not so sure it's changed so much in
recent—I don't think that's the explanation of why our trade balance is $150 billion worse than it was 4 years ago.
Senator SARBANES. When Secretary Baker went to the Treasury
in February 1985, he moved pretty quickly to address—at least in
my judgment pretty quickly—to address the currency overvaluation question because it was by that fall that he had the Plaza
agreement.
I take it it's your view that, one, he needed to do that; and, two,
that we had failed for too long to come to grips with that problem?
Mr. VOLCKER. Well, I certainly think that the dollar had gotten
to extremely high levels and was overvalued. It had been declining
for nine months before the Plaza agreement but that gave it further impetus. But I think it's very hard to see a more balanced
trade pattern emerging without a substantial realignment of the
major currencies. I agree with that.
Senator SARBANES. Thank you.
Senator RIEGLE. Thank you, Senator Sarbanes.
Thank you, Mr. Chairman.
The committee is adjourned.
[Whereupon, at 12:45 p.m., the hearing was adjourned.]
[Response to written questions of Senator D'Amato from Paul A.
Volcker follows:]
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Chairman Volcker subsequently submitted the following in
response to written questions from Senator D'Amato in connection
with the hearing held February 19, 1987:
Question 1: Mr. Paul Craig Roberts contended during
the hearings that unanticipated disinflation caused by an
excessively tight monetary policy accounts for $459 billion, or
46 percent, of the one trillion dollar increase in the public
debt over 1981-1986. If Mr. Roberts is correct and the Federal
Reserve's monetary policy contributed to the budget deficit, do
you have any suggestions on how the Federal Reserve may use
monetary policy to assist in deficit reduction?
Answer:
Characterizations of "unanticipated disinfla-
tion" and "excessively tight" money are, of course, uniquely
those of Mr. Roberts and have no independent analytic value.
In
general, however, there can be no clear answer to a question of
what the deficit would have been in more inflationary conditions.
While one might assert that the spending and revenue
programs actually in place over the 1981-1986 period would have
produced a smaller cumulative deficit if inflation had been
greater (and all other things, including real growth), that begs
a lot of obviously important questions about how Congress would
have behaved in a different economic environment and whether
greater inflation would have been consistent with achievement of
t'ne favorable trends in real output, employment, and interest
rates we experienced during the five year span.
I strongly
suspect that there is less than meets the eye to Mr. Roberts'
claim.
Whether or not Mr. Roberts is correct in his claim, I
believe that the way the Federal Reserve can best contribute to
deficit reduction over the long haul is the same way that it can
contribute raore generally to healthy economic performance', by
pursuing a monetary policy consistent with sustainable, noninflationary economic growth.
186
Question 2: Despite claims to the contrary, the
Secretary of the Treasury seems to have determined upon a level
to which he intends to drive down the value of the dollar. Do
you feel that there is a yen/dollar exchange rate that is too
low? What are the risks for our domestic economy if the value
of the dollar is driven down too far?
Answer:
Secretary Baker and I have agreed with finance
ministers and central bank governors of other major countries
that around current levels exchange rates are within ranges
broadly consistent with economic fundamentals and basic policy
intentions.
Moreover, both Secretary Baker and I have said that
a further decline in the dollar in the present circumstances
could be counterproductive.
It would tend to weaken economic
activity abroad, by reducing demand for their exports and consequently by discouraging investment in new productive capacity.
In this country, it could pose substantial risks of renewed
inflation momentum and undermine confidence in future financial
stability—developments that could jeopardize prospects for a
sustained economic expansion.
Instead, we should recognize that the favorable impact
on our external position of the considerable decline in the
dollar we have already seen will be fully realized only with a
lag.
We should, in the meantime, act to reduce further our
federal budget deficit—while other countries provide stimulus
to their economies--in order to create the domestic conditions
that will accommodate the adjustment in our external position
without the pressures on prices and interest rates that might
otherwise occur.
187
Question 3: One of the witnesses suggested during the
hearings thatTthe dollar's decline has resulted in the Federal
Reserve feeling pressured to raise interest rates "to save the
dollar" and forestall a renewal of inflation due to rising
import prices- Is this a correct assessment of the Federal
Reserve's feelings? If the Federal Reserve were to succumb to
these pressures and raise interest rates, could not this have a
recessionary impact on the economy?
Answer:
Developments in exchange markets have been for
some time among the factors considered by the Federal Open
Market Committee in its monetary policy deliberations.
That is
because exchange rates do have implications for the U.S.
economy.
We have already expetienced a substantial decline in
the dollar's value, and I believe in current circumstances a
further sizable depreciation of the dollar could well be counterproductive.
Officials in other countries share that view,
and large-scale intervention has been undertaken to support the
dollar.
But in the end, confidence in the current exchange rate
levels will depend upon perceptions that more fundamental policies will in fact be brought to bear.
I have emphasized the
need for complementary changes in fiscal policies in the United
States, Germany, and Japan.
The conduct of monetary policy,
here and abroad, will be relevant as well, and the performance
of the dollar in the exchange market might become a factor
bearing on our provision of reserves.
There could be circum-
stances in which the Federal Reserve could act to restrain the
supply of reserves to resist the dollar's decline.
Those
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circumstances are more likely to be associated with excessive
pressures on resources and a greater risk of inflation than with
a recessionary situation.
189
Question 4: During the hearings, one of Che witnesses
suggested that the current Gramm-Rudman deficit reduction targets should be abandoned or Ignored. Do you think that the
Gramm-Rudraan targets should be abandoned? What would the consequences be of our failure to realize these reductions on
interest rates and GNP growth?
Answer:
Enactment of the Gramm-Rudman-Hollings Act had
a positive effect in financial maikets as it bolstered confidence in the ability of the government to bring order to its
finances and led to expectations of reduced pressures in credit
markets from Treasury borrowing.
Simply abandoning Gramin-
Rudman-Hollings thus would appear to entail some risk of
damaging sentiment.
At the same time, though, I believe
analysts recognize that hitting the statutory targets exactly is
not what is required to solve our fiscal problem.
For example,
a failure to hit the prescribed number in some year might not be
especially dismaying if significant action had been taken and
the miss resulted from deviations of the economy from reasonable
assumptions used in the budget projections; on the other hand,
success in hitting the target in a particular year would not be
impressive if it were achieved largely by accounting legerdemain
or resort to transactions that provided one-shot improvements at
the cost of longer-term problems.
The important objective is
meaningful and lasting reductions in the structural deficit.
As
long as the fiscal authorities adhere to this principle—be it
through retention of Gramm-Rudman-Hollings or through some other
mechanism--! believe that the financial markets will be reassured, interest rates likely will be lower than otherwise, and
the prospects of achieving sustained, noninflationary economic
growth will be enhanced.
@FedFRASER