Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's First Monetary Policy Report for 1988 : Hearings Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundredth Congress, Second Session

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FEDERAL RESERVE'S FIRST MONETARY POLICY
REPORT FOR 1988

HEARINGS
BEFORE THE

COMMITTEE ON
BANKING, HOUSING, AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDREDTH CONGRESS
SECOND SESSION
ON

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

FEBRUARY 24 AND 25, 1988

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

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1988
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 PROXMIRE, 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
CHIC HECHT, Nevada
ALAN J. DIXON, Illinois
JIM SASSER, Tennessee
PHIL GRAMM, Texas
CHRISTOPHER S. BOND, Missouri
TERRY SANFORD, North Carolina
JOHN H. CHAFEE, Rhode Island
RICHARD SHELBY, Alabama
DAVID K. KARNES, Nebraska
BOB GRAHAM, Florida
TIMOTHY E. WIRTH, Colorado
KENNETH A, MCLEAN, Staff Director
LAM AH SMITH, Republican Staff Director and Economist
PATRICK A. MULLOV, General Counsel
GILLIAN GARCIA, Director of an Economic Analysis Group, GAO

(II)

CONTENTS
WEDNESDAY, FEBRUARY 24, 1988
Page

Opening statement of Chairman Proxmire
Prepared statement
Opening statements of:
Senator D'Amato
Prepared statement
Senator Riegle
Senator Garn
Senator Bond
Senator Dixon
Senator Sasser
Senator Chafee

1
3
6
16
6
9
11
12
14
72

WITNESS
Alan Greenspan, Chairman, Board of Governors, Federal Reserve System
Prepared statement
1987 in perspective
Economic outlook and monetary policy for 1988
The challenges ahead
1988 monetary policy objectives
Response to written questions of:
Senator Proxmire
Senator Sasser
Senator Sanford
Witness discussion:
Challenges to Fed's independence
Household and business debt
Trade deficit
Fed's role as to recessionary economy
Lower value of the dollar
Housing starts
Money supply
Fiscal stimulus vs. money stimulus
Economic report by President criticizes the Fed
Foreign investment

18
19
20
22
26
27
80
109
122
42
43
45
55
57
67
69
74
76
78

THURSDAY, FEBRUARY 25, 1988
Opening statement of Chairman Proxmire
Opening statements of:
Senator Dixon
Senator D'Amato

129
131
133

WITNESSES
Robert J. Barbera, Chief Economist, Shearson Lehman Hutton, New York,
N.Y
Tightening of interest rates
Prepared statement
Richard N. Cooper, Professor of Economics, Harvard University
Opposes further weakening of dollar

(in)

134
134
137
146
146

Richard N. Cooper, Professor of Economics, Harvard University—Continued
Debt of Third World countries
Prepared statement
The current dilemmas for policy
The problem of medium-term adjustment
A long-run proposal
Jeffrey Sachs, Professor of Economics, Harvard University
Flexibility in monetary policy
Political business cycle and the economy
Prepared statement
Neal Soss, Chief Economist, The First Boston Corp., New York
Prepared statement
Transferring resources to foreign creditors
Fiscal policy
Inflation and financial stringency
Crashes and the economy
The monetary aggregates and monetary policy
Financial fragility
The Fed and the election
The Fed and foreign exchange
Summary
Panel discussion:
Fed is a political institution
Fed as part of the Treasury
Import quotas
Mortgaging our future
Recession would exacerbate our problems
Exchange rates and monetary policy
Inflation and lower unemployment
Possible recession in 1989
,
A democratic administration
Reducing deficit will spur economic growth
Floating exchange rates

Pa e

s
146
148
148
149
150
152
152
153
156
164
165
165
165
166
166
166
167
167
168
169
170
172
173
175
178
179
181
182
184
185
187

FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1988
WEDNESDAY, FEBRUARY 24, 1988
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, Garn,
D'Amato, Bond, and Chafee.
OPENING STATEMENT OF CHAIRMAN PROXMIRE

The CHAIRMAN. The Federal Reserve occupies a unique position
in economic policy making in this country at all times. The Fed determines the availability of credit. It has a profound, constant,
direct influence on the level of interest rates. As we all know, the
level of interest rates very largely drives this economy of ours.
The Federal Reserve Board's power is always a fact of life, but
this year more than in any of the 30 years I've served on this committee, this year the Fed's power is especially great.
The Federal Government has two primary tools in guiding the
economy. They are fiscal policy—the power to tax and spend—and
monetary policy, the determination of the availability of credit.
Fiscal policy that is expansive that holds down taxes and pushes
Federal spending can obviously stimulate the economy. Fiscal
policy that is restrictive, that reduces spending and increases taxes,
can certainly restrain the economy.
This year the President and the Congress are observing an agreement to follow a fiscal policy that was locked in late last year. The
President has told the country that he intends to live up to the
letter of that agreement. It's quite clear that the Congress will do
the same. So fiscal policy is a fixed, established, given factor.
This leaves monetary policy as the only show in town and the
Federal Reserve Board as the prime discretionary determinant of
our future for the next 12 months or so.
You tell us in your clear and incisive statement this morning
that you're going to follow a path that for the time being will
follow roughly the same policy the Fed has generally pursued in
recent months. That is, the Fed will increase the money supply at
a rate close to the present and predicted normal increase in the
GNP. But you also tell us that you may have to vary this policy.
You will slow the rate of monetary increase if wages, prices and
(l)

economic activity generally rise more sharply than expected. In
particular, you will act if the capacity utilization rates rise sharply
and unemployment continues to diminish.
This language is reassuring. What is not reassuring is that you
have widened the range that constitutes your goals for M2 and M3
and that you continue the policy established by your predecessor of
keeping the country and the Congress in the dark about your plans
for the basic monetary variable, Ml. You tell us that Ml is too erratic a variable to be useful because of recent changes in interestbearing checking accounts and various transaction vehicles.
The Fed and its policies are so important (and especially so this
year) that this committee some 15 years or so ago requested the
Fed to report to the Congress on its plans for Ml—not M2, not
M3—Arthur Burns brought those in later—but Ml. We specifically
requested that the report indicate not a range but a particular, specific figure, as they have for instance, in Germany, I understand,
for Ml. But today you give us nothing for Ml and the broadest
range ever for M2 and M3. For this reason, I get the feeling you're
not giving the Congress the information we should have if we are
to provide the necessary congressional oversight over the Federal
Reserve Board's policies.
Your explanations on pages 9 and following constitute the best,
concise discussion of the Ml, M2 and MS measures of monetary
policy that I've read. I think they are first class. They are very concise, direct, and excellent. But please give us more information and
a more specific goal, if you possibly can.
It would also be helpful to the committee to secure an analysis
from the Fed on what seems to this Senator to be an extremely serious overall debt problem that lies beyond even the mammoth
Federal Government debt. Household debt is nearly a half trillion
dollars higher than the Federal debt, yet household savings remain
much lower than in the past, although there's been a modest improvement in recent months.
Business debt is substantially larger than the Federal Government's debt also and is particularly burdensome in relationship to
earnings. The healthy $2.85 of debt for every dollar of earnings in
1955 for example, has swollen to a business debt of $9 of debt for
every dollar of earnings today. Of course, these figures are averages. Tens of thousands of our businesses are today struggling
under a debt that is 15 and 20 times their earnings.
It would seem that in the next recession the number of insolvencies and bankruptcies could be very large indeed.
Finally, a Fed policy that holds down interest rates tends to discourage savings and encourage borrowing. In the short run, this
policy stimulates the economy; but not in the long run. Only the
Fed among our Federal "policy making institutions has the kind of
institutional basis to consider the long run. The Congress and the
President are looking to the next election. Any Congress and any
President have to do that. So I hope you will include the overall
long-term debt problem in your monetary policy deliberations.
[The complete prepared statement of Chairman Proxmire follows:]

OPENING HT.URMI-^r
"ST MOM-.TAUV P'.'.LIC': RKT'CRT '-F
|'H \ i R>U\ 'v, I L..1 v'-1 Pku'.Mi -A\L
FEBKI'ARY 25,

T h i n morn i ng we i. ] 1 L h<*ar

19HH

from Alan Greenspan, Cha i rman of

the t edera1 Resprve, who is be fore the commit tee t.o discuss the
f i r s t , monetary po I icy

report

Chairman Greenspan,

t,r> rt)n«'i-«as

for-

1988.

I am troubled by the extent of the

political pressure being put on the Fed by the Reagan
Admin is t rat. i on in t.his presidential election year.

One of the virtues of granting the Federal Reset-', e a greaterdegree of independence from the political process than manv other
agencies is to insulate your institution from the pressures to
buy stimulus now and pay in inflation later.

I think it is both deplorable and counterproductive for the
Reagan administration to pressure you as much as they have in
recent months.

The evidence of p o l i t i c a l pressure on the Fed in recent
m n n l hs

i s oven* he lining .

Wf\ ] !. St reel
t l i ' - Trea:—ir\
1

r i si- .

Journal
had

reported on

the

front

page t h a t Serretar v

'^ua i'an t eeiJ. Lhat he w u n l i i nut, I ,; t, LII t c njs t. r a t . - s

I iio no I nccrl

F i r s t , on November 5 , 1 9 8 7 , t h e

t ,1 remind Mr , Baker tha I

the Fedi? :vi 1

1 ri Dec em her , w ides pi-fad r^por ts

in the press

1ft ft. no doub f.

tlmt Mr. Sprinkei a.L tin.- Count' i I u!' EuunomiQ Ad\ isors wan Led the
Fed to ease.

Th^n, in a l u t t e r dated January 21,

1933

Assistant

Secretary of the Treasury for Economic P o l i c y , Michael Darby sen t
a letLer to the Federal Reserve Governors and to the Presidents
of the Federal Reserve District Banks suggesting that real M2 was
growing

too s l o w l y .

The i m p l i c a t i o n : Ease up on the money.

F i n a l l y , The Economic Report of the President complains that
money growth was too slow in 1987 and criticizes the Federal
Reserve for contributing to the onset of the stock market crash
in October.

And the final report's substantial criticism was

apparently toned down
Secretary

from earlier versions at the request of

Baker.

Chairman Greenspan, the incumbent administration often has a
desire to ease money more than would be good for the economy just
before the preaidental election.

You and your fellow governors

arti entrusted uith resisting political pressure and implementing
good cconomi c po1iuv.

You and your fellow governors are

pnrt icu larl v vulm; ratals to th i s sort, of c r i t i c i s m because all
i; f th(j .:iir i-"tit

.401, i' rim v-; >;.*•'!•(' ^ipi>o i i;i <<\ hv t hi> Ri';i«ar:

Adrn in i rf t ra t i uri .

Your our f-j t-manre u L ! 1 be

cl JHC 1;

sum t ini-c-

hnv-r> eatiud ;nnnc v for ^DVini: tcs-hri i o:; 1 r •;,:;-; t> n ia , vou w i l l c:e r t ;i i n 1'.'
be

aeji-uscd of betid i a ij l.o poll t i.ja i. prcaiiur:;.

l;ui irsuat LOUS ,s!'

po 1 i. t i c;i 1 mani pu i a t i on harm hoi h vour repu t;ji t ion as

chairman iind

th>- r c p u t a t i u n of Lho Fed or ill Rh!si-r\'': .

The administration's haranguing unnecessarily raises the
cost to the Fed of making good policy.

h'ere it not for your

integrity, you might actually resist changing monetary pol 1C"-'
i.1 hen it is. .HIS. t. i T i SM! , Cor f par of under m ining tiie credibili t > u L"
the Federal Reserve.

Let us hope that in the future Mr. Baker, Mr. Darby, Mr.
Sprinkel and the rest of the Reagan Administration will begin to
trust the Chairman and the other five governors it has appointed
to make monetary policy for the country's best interest.

Let us

hope that they will develop greater respect for the Federal
Reserve's independence and refrain from asking you to make
monetary policy for the benefit of the Republican Party.
will make it easier for the Fed to implement good policy.

That
We

desperately need good economic policy. It's in such short suoply.

The CHAIRMAN. Senator D'Amato.
OPENING STATEMENT OF SENATE D'AMATO

Senator D'AMATO. Thank you, Mr. Chairman.
Mr. Chairman, it's good to welcome Chairman Greenspan to the
committee for his first effort to explain the Fed's monetary policy
report.
I note that yesterday, Chairman Greenspan delivered this report
to the House Banking Committee. It must have been fairly well received because the financial markets of the world which have been
relatively fragile lately, remained stable.
Chairman Greenspan and his colleagues at the Fed deserve considerable credit, Mr. Chairman, for their performance. The Fed responded swiftly and I believe correctly to avert the liquidity crisis
precipitated by the events of October 19 and 20. Alan, I want to
congratulate you for your handling of that very, very precarious
and difficult situation.
In his statement today, Chairman Greenspan underscores the
need to implement policies which will keep the economic expansion
moving in order to avoid a recession, and I couldn't help but agree
with him. In fact, this is the most forthright statement by any Fed
chairman regarding the Fed's intention in relation to the continued expansion of the money supply. Too often in the past, the Federal Reserve has been less than explicit with regards to its intention in this area and I commend you and your colleagues because I
think that's important, that there be some blueprint that is laid
out.
Further, I hope that we can get interest rates down a bit lower
because lower interest rates will prove to be a beneficial stimulus
to this economy. Chairman Greenspan also rates the precarious
balance between monetary growth and inflation. However, the experience of the early 1980 s I believe has taught us that some inflation, a little inflation, accompanying monetary growth and economic expansion is far better for the economy and the American people
than a recession.
Finally, as we've observed during our market crash hearings, the
United States and foreign economies are inextricably intertwined.
In his statement Chairman Greenspan discusses the prospects for
domestic economic growth. However, the statement is relatively
silent on the prospects for foreign economic growth and I hope, Mr.
Chairman, you might be able to give us some of your insight as it
relates to that area because as you know the balance of trade and
the deficit is largely dependent upon the ability of foreign governments to purchase U.S. goods and services.
So I look forward to your statement. Again, I want to congratulate you for your efforts and the Fed's efforts at being more
straightforward with us, particularly for your actions of October 19
and 20.
Mr. GREENSPAN. Thank you.
The CHAIRMAN. Senator Riegle.
OPENING STATEMENT OF SENATOR RIEGLE

Senator RIEGLE. Thank you, Mr. Chairman.

Let me welcome Alan Greenspan before us today. He's a person
we've all known for some time and with whom we all work closely.
There are three things that I would hope you comment on today
in the course of your remarks and I will ask you about them when
we have the opportunity.
In terms of the Federal deficit for this fiscal year that we are
now in, we have so far 3-months of data that have come in. We are
expecting the 4th month of data tomorrow. You may have some
sense for that, but it's not public today.
If you compare the deficit that we've accumulated in the first 3
months of this fiscal year to the previous fiscal year, already we
have logged a 3-month deficit of $80.4 billion. The previous year
through the first 3 months, the deficit was $64.6 billion. So through
the first quarter of the fiscal year we are up $15.8 billion, almost
$16 billion, above an actual booked deficit, and I find that a very
disturbing trend. I would like to know what you make of that and
where you think that's taking us.
The second thing is in the President's budget submission to us,
for the first time, the net interest costs in the budget which we
have to of course pay each year and comes off the top, will exceed
the estimated deficit itself, and we are getting into this compound
interest problem where past Federal deficits are now running up
the annual interest charges even at a somewhat lower level of interest rates to an annual operating amount that is exceeding $150
billion a year and therefore now running higher actually than the
deficits themselves because many of us think the deficit probably
will come in above $150 billion. So I'd like you to speak about that
kind of trend if you will as well.
Then finally, our debtor nation problem. And I brought a chart
here that I will hope to raise with you in the question period, but
as we continue to add international debt, principally driven by the
very substantial trade deficit still running in the range of $160 to
$170 billion a year, we are adding new international debt at the
rate of about $1 billion every 2Vz days or about every 60 hours, and
that figure is compounding. When I show it to you on a chart, it's a
real plunge into this debtor nation circumstance that we're on.
The Council of Economic Advisers the other day said:
Don't worry about this mounting international debt. Even if we're headed to a
trillion dollar international debt, we can take it in stride and not to be too concerned about it.

There's even a suggestion that maybe somehow it was good for
us, but at a minimum it wasn't something that we ought to lay
awake nights worrying about.
I find myself more and more concerned about that international
debt accumulation and in turn its implications for upward pressure
on interest rates and creating an ever more difficult situation for
the Fed down the line. There are other implications to that as well.
If you would, in the course of your comments or responses, I
would hope that you would find a way to touch on those three
issues.
Thank you, Mr. Chairman.

The CHAIRMAN. Senator Garn.
Senator GARN. Thank you, Mr. Chairman.

Chairman Greenspan, we are happy to welcome you here today
and I am absolutely certain that no one, and certainly my colleagues, did not come here to listen to me speak and therefore I
will simply ask unanimous consent that my statement be placed in
the record.
[The complete prepared statement of Senator Garn follows:]

AS WE BEGIN THESE HEARINGS ON MONETARY POLICY, WE CANNOT DENY THE FACT
THAT THE UNITED STAIRS FACES SOME FORMIDABLE ECONOMIC PROBLEMS.

HIGH ON

ANYONE'S LIST WOULD RE THE BUDGET DEFICIT, THE TRADE D E F I C I T AND CONTINUED
REGIONAL POCKETS OF RECESSIONARY CONDITIONS.

AT THE SAME TIME, WE SHOULD NOT OVERLOOK THE IMPRESSIVE ECONOMIC
ACCOMPLISHMENTS OF RECENT YEARS.
SIXTH YEAR OF EXPANSION.

THE U.S. ECONOMY IS NOW WELL INTO ITS

LAST YEAR ALMOST 3 MILLION NEW JOBS WERE CREATED;

AND THE UNEMPLOYMENT RATE HAS NOW FALLEN TO ABOUT 5 3/4 PERCENT.

LAST YEAR

CONSUMER PRICES ROSE SOMEWHAT OVER 4 PERCENT, A RATE OF INCREASE THAT IS
STILL TOO HIGH BUT FAR BETTER THAN THE DOUBLE-DIGIT RATES OF INCREASE AT THE
BEGINNING OF THIS DECADE.

1 SEE LITTLE TO CRITICIZE IN RECENT FEDERAL RESERVE POLICY.

THE FED

HAS PLAYED A MAJOR ROLE IN THE ECONOMIC ACCOMPLISHMENTS OF THIS DECADE.

THE

FED RESPONDED TO THE FINANCIAL- MARKET TURMOIL OF LAST FALL IN A WAY THAT
LIMITED DAMAGE TO THE ECONOMY AS A WHOLE.

I BELIEVE THAT THE FED'S OUTLOOK

AND POLICY PRESCRIPTIONS FOR !98H ARE REASONABLE.

OUR TASK IN CONGRESS

SHOULD HE TO SEEK WAYS OF HELPING THE FED TO CONFRONT OUR REMAINING ECONOMIC
PROBLEMS.

THK, PLACE TO REGIN [S CLEARLY TO WORK ON REDUCING OUR FEDERAL

DEFICIT.

10
WE MAY ALSO ASSIST THE FED BY E N C O U R A G I N G OUR T R A D I N G P A R T N E R S IN THE
INDUSTRIALIZED
EXPANSION.

WORLD TO 1)0 T H E I R

PART

I ti H E L P I N G S U S T A I N THE ECONOMIC

T H I S , OF C O U R S E , IS CRITIGA1, TO C O N T I N U I N G PROGRESS ON THE DEBT

PROBLEMS OF MANY I.OC'S.

FINALLY, I

B E L I E V E THAT C O N G R E S S H.4S A MAJOR R E S P O N S I B I L I T Y FOR

A S S U R I N G THE LONG-TERM
FINANCIAL

ISSTITL'TIONS.

STRENGTH AND C O M P E T I T I V E N E S S OF OUR N A T I O N ' S
I F WE DO NOT T A K E S T E P S TO UPDATE OUR LAWS ON.

F I N A N C I A L S T R U C T U R E , W E W I L L SADDLE O U R ECONOMY WITH S E V E R L Y W E A K E N E D
FINANCIAL

I N S T I T U T I O N S , AND THIS

I N T U R N W I L L W E A K E N THE ECONOMY AS A W H O L E .

11
The CHAIRMAN. Senator Bond.
OPENING STATEMENT OF SENATOR BOND

Senator BOND. Thank you, Mr. Chairman. That's a very difficult
act to follow, but I wanted to make a very brief comment saying
that as you know we all joked about the difficult job that Mr.
Greenspan was undertaking when he was before this committee
before, and few of us realized how difficult it would be. During the
course of the hearings that we've had on the stock market crash
and the activities of October 19 and 20, and afterward, there's been
a lot of finger pointing among the various agencies, groups and organizations before us. I think the only institution which has received praise from all quarters has been the Federal Reserve. The
Fed provided liquidity, and stability for the system, and I think everyone is in your debt for a job very well done.
In addition to your responsibilities for the financial system, you
also have the heavy responsibility of setting monetary policy
during a period of turmoil and far-reaching change in our economy.
The trade and budget deficits have already been mentioned and
have vastly complicated the conduct of our monetary policy, and
you're forced to maintain the balance of possibly higher inflation
due to the weakening of the dollar against the possible damage
that higher interest rates could do to the economy.
Certainly we in Congress, we in the elective branch of this Government, have limited your ability to maneuver and balance these
complex forces. I'm cheered by the cautious optimism of your statement and I hope that we here in Congress can benefit from your
guidance as to what we can do during this session to assure that
that progress continues.
The CHAIRMAN. Thank you, Senator Bond. Before we begin I
have statements for the record from Senators Dixon, Sasser, and
D'Amato.

MR. CHAIRMAN, I AM PLEASFD TO BE HERE THIS MORNING AS THE

O V E R S I G H T H E A R I N G S AS MANDATED BY THF, H U M P H R E Y - H A W K I N S ACT.

AT THE OUTSF:T, r WANT TO SAY THAT i SHARK CHAIRMAN
GREENSPAN'S VIEW THAT THE SETTING FOR MONETARY POLICY THIS YEAR
"IS MORE THAN NORMALLY COMPLEX".

IT SEEMS TO ME THAT THE OUTLOOK

FOR THE ECONOMY IS MORE THAN A LITTLE UNCERTAIN, AND I AM SUKE
THAT UNCERTAINTY MAKES THE FED'S JOB MUCH MORE DIFFICULT.

13
Page 2

STATEMENT OF SENATOR JIM SASSER

MR. C H A I R M A N , UlllAY WE P^WF IMF F 1 K S 1 ^ I A N N U A L R F P H R T n
M O N E T A R Y POLICY HY FEDERAL RESERVE C H A I R M A N GRF.FJiSPAM.
DOESN'T SEEM POSSIBLE THAT T H I S IS m. fiR^HSPMi'S FIRST REPORT
TO US ON T H I S I M P O R T A N T ISSUE.

HE HAS APPEARED B E F O R E THE

COMMITTEE A L R E A D Y ON A N U M B E R OF C R I T I C A L ISSUES.
AND DR- GREENSPAN HAS INDEED HAH (\ GREAT HEAL W EXPERIEHC^
IH THIS A R E A ALREADY.

HIS A C T I O N S !H E N S U R I N G THAT T^ER C WAS

ADEQUATE L I Q U I D I T Y IH THE SYSTEM FOLLOWIf'G THE OCTOBER STOCK
M A R K E T CRASH A R E U N I V E R S A L L Y CREDITED W I T H A V E R T I N G MICH MORE
SERIOUS ECONOMIC CONSEQUENCESTODAY WE W I L L HEAR A G A I N THAT THE LPJK BETWEEN G R O W T H OF THE
MONEY MEASURE Ml AND THE ECONOMY IS V E R Y U N C E R T A I N .

WE WILL H E A R

i F . h ' i A i U L Y , f uii; ECnuo-'Y is :j ,Fcnn;MG E'"J i r'nus,L^ COMPLEX AND
I N C R E A S I N G L Y I N T E G R A T E D WITH OTHERS W O R L D W I D E -

I N 1HESE V O L A T I L E

T I M E S IT HAKES MORE Sf-JJSF I R A N EVER TO CONSIDER THF N U M E R O U S
OTHER FACTORS THAT AFEECT THE ECONOMY, RATHER THAU A D H E R I N G
R I G I D L Y TO GROWTH IN THE HONEY A G G R E G A T E I AM I N T E R E S T E D IN H E A R I N G DR. GREENSPAN'S V I E W S ON OUR
E C O N O M I C PROSPECTS, AND W H A T E V E R S U G G E S T I O N S HE M I G H T HAVE FOR US
AS TO .HOW WE SHOULD ADDRESS THE BUDGET AM 1 T R A D E ISSUES THAT
O N T I N I I E TO PLAGUE US.

T H A M K YOU.

I WOULD L I K E TO WELCOME CHAIRMAN GREENSPAN TO THE COMMITTEE FOR HIS
F I R S T EFFORT TO E X P L A I N THE FEU'S MONETARY POLICY REPORT.

YESTERDAY,

CHAIRMAN GREENSPAN D E L I V E R E D THIS REPORT TO THE HOUSE B A N K I N G COMMITTEE AND
IT MUST HAVE BEEN FAIRLY WELL RECEIVED B E C A U S E THE FINANCIAL MARKETS OF THE
WORLD, W H I C H HAVE BEEN R E L A T I V E L Y FRAGILE LATELY,
TO DATE, CHAIRMAN GREENSPAN AND HIS
CONSIDERABLE CREDIT FOR T H E I R

R E M A I N E D STABLE.

COLLEAGUES AT THE FED DESERVE

PERFORMANCE.

THE FED RESPONDED SWIFTLY AND

CORRECTLY TO AVERT THE L I Q U I D I T Y C R I S I S P R E C I P I T A T E D BY THE EVENTS OF
OCTOBER

19TH AND 20TH.

IN HIS

STATEMENT TODAY, CHAIRMAN GREENSPAN

UNDERSCORES THE N E E D TO IMPLEMENT POLICIES W H I C H W I L L K E E P THE ECONOMIC
EXPANSION R O L L I N G ALONG TO AVOID A R E C E S S I O N .
FORTHRIGHT
RELATION

STATEMENT

IN FACT, T H I S IS THE MOST

BY ANY FED CHAIRMAN R E G A R D I N G THE FED'S INTENTIONS IN

TO THE C O N T I N U E D EXPANSION OF THE MONEY SUPPLY.

TOO OFTEN IN THE

PAST THE FED HAS BEEN LESS THAN E X P L I C I T WITH REGARDS TO ITS INTENTION

THIS AREA.

FURTHER,

I HOPE THAT WE CAN GET INTEREST RATES DOWN A BIT

LOWER BECAUSE

LOWER INTEREST RATES W I L L PROVE TO BE A REAL STIMULUS TO T H I S ECONOMY.
CHAIRMAN GREENSPAN ALSO CITES THE P R E C A R I O U S BALANCE BETWEEN MONETARY GROWTH
AND INFLATION.

H O W E V E R , THE EXPERIENCE

A LITTLE INFLATION
FAR BETTER

OF THE EARLY 80'S

HAS TAUGHT US THAT

ACCOMPANYING MONETARY GROWTH AND E C O N O M I C EXPANSION

FOR THE ECONOMY AND THE A M E R I C A N PEOPLE THAN A R E C E S S I O N .

F I N A L L Y , AS WE OBSERVED DURING OUR MARKET CRASH H E A R I N G S , THE U . S . AND
FOREIGN ECONOMIES ARE INEXTRICABLY INTERTWINED.

IN HIS STATEMENT, CHAIRMAN

GREENSPAN D I S C U S S E S THE PROSPECTS FOR DOMESTIC ECONOMIC GROWTH.
THE STATEMENT IS
GROWTH.

HOWEVER,

RELATIVELY SILENT ON THE PROSPECTS FOR FOREIGN ECONOMIC

I WOULD HOPE HE COULD OFFER SOME INSIGHT ON THIS TOPIC SINCE THE

BALANCING OF THE TRADE DEFICIT IS LARGELY DEPENDENT UPON THE ABILITY OF
FOREIGNERS TO PURCHASE U . S .

GOODS.

I LOOK FORWARD TO fOUS STATEMENT.

The CHAIRMAN. Mr. Chairman, can you enlighten the committee
on when the vacancy on the Federal Reserve Board is likely to be
filled, when the President will nominate a Member to take that position?
Mr. GREENSPAN. The only thing I can see, Mr. Chairman, is that
it is under active consideration by the White House and hopefully
a conclusion will be reached relatively shortly. I know that nothing, to my knowledge, is immediately pending, but I do know there
is active consideration going on.
The CHAIRMAN. Fine. I'm sorry to interrupt your opportunity to
read your statement. It's an excellent statement. Go right ahead.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM

Mr. GREENSPAN. Thank you very much, Mr. Chairman. I will excerpt from my written remarks and request that the full text be
incorporated in the record.
The CHAIRMAN. It will be printed in full in the record.
[The complete prepared statement of Alan Greenspan follows:]

1988
MONETARY
POLICY
OBJECTIVES
Testimony of Alan Greenspan, Chairman,
Board of Governors of the Federal Reserve System

February 23, 1988

Testimony of Alan Greenspan
Chairman, Federal Reserve Board
Mr. Chairman, members of the
Committee, I appreciate this opportunity to appear before you to discuss the conduct of monetary policy
and the economic and financial situation. You have received the more
formal report of the Board of
Governors detailing the economic
and financial situation and reviewing our policy actions in 1987,
and presenting our approach to
monetary policy this year.

the

Toward this end, the hederal Open Market
C o m m i t t e e (KOMC) two weeks ago sei somewhat
lower target ranges |<,i 1988, (.insistent with a moderate pace of monetary expansion t h i s year The
ranges for M2 and M!i art- 4 to 8 percent, lor debt,
we have sei a monitoring range of 7 to 11 percent. The annual ranges are wider than in die
past, rcio.gnizinjf that rhe linkage helweeji nii>nt-\
and credit growth and economic pcrluiindiue lias
become noticeably looser in i c t c n i veais
Betore discussing our monet.in p n l n v plan.- ior
1988 in derail, I would likp to review w'uh vou
the developments ol ihc pas: y e a r
1987 in Perspective
The \oai 19S7 was a time ol economic transition
and. like many periods of diangt, it had its dil'licull niiinienls. Nevertheless, cleai progress was
made in achieving a healthier, more balanced
eionomy. For the year as d whole, o u t p u t and
i-niploynn-nt e\panded stron^lv As measured bv
ihe gross national produei, prodm lion mireased
nearlv 1 penenl iioiii die fourth quarter of 1986
(o the luunh q u d i t c r 19ti7. according to the Coinineice Department's prelirnmarv escimates.
Alnmsi i million persons were added to pavrolh
ovt-t this period And [he ( i v i l i a n u n e m p l o v m e n i
rate dropped to about 'i1', percent —the lowest
level in Hn s d,-< ade
We achieved r h i < i-m«tli w i t h a belter i c l a i u m ship between domesiu spcndmi: and domestn
[iroduction (.rowih of private domeslk linal purchases has slowed progrcsstvelv Irom 7 ', peicent
in 198:i as the econnriu i-iru-rgc(t from lecession
to diioiit 1 perient lasi vear M e a n w h i l e , real
capons ol guilds and service;, rose more than 1 i
peuent o.ei die lour quar(ers of 1987. as our
international crjmpetiiiveness was enhanced b> the
surtoss of business and labui in nureasmg
p r o d u i t n i t v and restramint; cost pressures In
a d d i t i o n , ihe lower level ol the dollar on toieiim
exdidiige m a r k e t s , because i n u n h of it was noi
passed (hrough into wage and other costs domes.ilc a l K , also helped our linns price more compon-

21
lively in foreign markets and to compete with
imports in the Untied Slates. The trade sector
improvement accounted for more than a quarter
of the overall gain in GNP.
One aspect of the improved trade situation was
better balance of our economy internally, with
previously lagging sectors showing particular
strength. The manufacturing sector revived in
1987; industrial production in manufacturing
s'jtg'dd by 5'/i percent belvreen December 1986
and December 1987, and capacity utilization rose
to its highest level m seven years. For example,
output of sleel rose especially strongly, which was
the main fader in bringing capacity utilization in
this industry from about 65 percent ai the end of
19M6 to above 90 percent at the end of 1987. And
olher areas of our economy that had been notably
depressed earlier in the 1980s, such as farming,
mining, and oil extraction, showed some signs of
improvement.
The robust growth of the economy—in combination with the budgetary actions of the Congress
and the President, and a one-time boosi from tax
reform—brought about a major reduction in the
federal budget deficit last year To be sure, the
flow of federal red ink still was heavy, but last
December's agreement was at least a first step in
needed actions for the future.
On the negative side, inflation increased in
1987. This development was not altogether surprising, given the bounce-back in energy prices
early \n the ytai and she effects on import prices
of the decline in the dollar Although wage gains
have remained subdued, we clearly need sustained
effort to bring about a more stable price level.
As you may recall, the Federal Reserve set
ranges for monetary growth in 1987 that were
1/2 percentage point lower than in 19S6. We also
noted that we would be conducting monetary
policy with an eye toward a variety of economic
indicators, including the strength of the economy,
pressures on prices, and developments in international markets, as well as money growth relative
to the ranges.

Although the aggregates from very early in the
year tended to run low relative to the ranges, the
challenge as we perceived it through much of
1987 was less to buoy money growth than to prevent one-time price rises related to developments
in energy and foreign exchange markets from
becoming rooted in a renewed inflation process.
Concerns about potential inflationary pressures
were clearly manifested in financial markets as
we\l. During the spring and again in late summer, inflation worries pushed up commodities
prices and long-term interest rates, and heavy
downward pressures on the dollar developed in
light of growing pessimism about the prospects for
significant improvement in U.S. external balances;
concerns about the financing of our external deficit in turn apparently added to pressures on
interest rates during these episodes. In view of the
inflationary potential, the Federal Reserve
increased somewhat restraint on reserves in both
episodes, and in September raised the discount
rate from 51^ to 6 percent.
The balance of risks shifted following the stock
market collapse of October 19. The Federal
Reserve immediately modified its approach to
monetary policy in light of the turbulent financial
market conditions. During the crisis, the System
temporarily altered its focus somewhat from
reserve positions to more direct measures of
money market pressures, and took a number of
steps to ensure adequate liquidity in the financial
system. Moreover, we encouraged some decline in
short-term interest rates, as a precautionary step
in light of the possibility that the conlraction in
financial wealth and the deterioration in consumer
and business confidence might lead to a significant drop-off in spending.

22
These actions helped to restore a degree nl rnnEconomic Outlook and
fidence in financial markets As this occurred, the
Monetary Policy for 1988
Federal Reserve returned some way towald our
( n ( o r i ] l u i r t t i l l ( , ;, s m(.ini.tt,
•arlier locus on reserve positions in the da\-to-iiav
. j-Q\rf
" „... , ( L „
implementation of pohcv. But 1 think ,t » la,r to
^^ „[,,;,„, CV \-^"cf
sav that markets st, 1 are e x h i b i t i n g a certain edg,- (o ^ ^ u^utMam ^
ness, and we can t be sure vet that norm.il mar, ()||
,,.,,.,,,.,. , olv4U i r l i
ket functioning has been fully restored tullowms
the events of Oanber. In addition, the effects t>!
the stock market events on the economy may not
be tuIVy evident. Indeed, indications ol some
softening in the economy as the year began,
foreign exchans1" markets, led us to take a further
small casing ^ e P B f*1*1 ww ks a^«.
In the context of a monetary pohr.\ t h a t , tor
much of the ve.av needed to nmnwr infcrtiwwrv
, and in light of the very rapid money
growth in 1986 and marked vanatwns in velocitv
in rrrent years modes, expansion o( the mone.ary
amprgwes in 198, wa, v i e w e d as atcepiable and
appropnate. A, market interest rate, rose, interest
ra, PS on deposits b^ame less wmpetiliw l h , s
encouraged a shifting away from niom-tarv ,,ss<-t,,
and growth of all «,f the monetary ^gre^.es
slowed sharply In addit.on. some special la.tors
may also have damped money gro^h las, ve,,r.
such as the eff,-,-,, (,1 the new tax l a «, .hanjp-s m
bank fundmg sour,es, and evolvm^ busmen practices with respen to cash management anri r n m pensatmg balance,. M2 and MJ grew 4 and .->'-,
percent over the fo,,r quarters oi last vear. respe,tivdy, Icavmg them below and ju» a, the lower
en))s of .h«r annual rangft. Ml .nrrrwcd b

l>rj[Lirusni

tint unl

, ,s, '
[( .
^"^10!, .U.hough a, cur..-,
uu]rmilm an(| w i l h ri,,^ p r i ,

,mm

r[,t[,n, ()((llji ( I l . l ] l n e ( i

(j( rf n.v

nl, ((1

,0 b,,

L))nuiju|.

Mf^

of pOMC mem^. am] i > [ h _

p,,-,,,,,.,,,,' ,,,m;15,5 ls k,T ^
ar(((|rld ,, ,„ ._,,,,
m
from
^ , w _ ^ ^ li)ur(h
^
^
.
[hrfn
] W 7 < ])ul hk] ]v (
^.
^ ^ j
mfM f^ m d v „„, rf
m j Muld .^
lrl|j(](ed a( . roM [ n ( l u s l r j p s :ind
^
^
M , ](;h Q , ,h(, j m
^^^^ ^ ^ mc f r ( j
nf |K>[ e

p^^,. !j)(. ;)nl[ci, „,

a d j l l s l , n ,. n ,

Percen'
, ,
,
.
Debt R«*ih tJowd w ihc m«lp.»n, ot ,„

ante mternallv and externalh This
mvu|u , sj(?vt ^^ , n d n m f s t j { . d(,m

rnon.tormg range The progress m reducmg thf
federal Udget deticil h«rlp«l redvK* Imrro^mR
and debt issuance bv the private sector dropped
off as well. Deb. growth ,.,uld ^wcdy be charactenzed as slow; a, <)V, per< e n , , ,,jontmu.d th,
pattern of .n.rease, relative ,<> CNP

abu. e n e o l n p i l M i n R d a m p w l Ra]Ils i n

and ( mud ,
|njm [(]t
Rftenl

rerfurpd

n| jn ,,, n[l)rv

n(.a|, y e a r e||<]
ms (j|

t l d ,,, l n

mem , dn no, si.(.m [ ( ) l n d i c a u % r i v l m

^ ^^

A(. r,slr[lme(1 bfhav

,„ 0,

mid-1980s Although <apa. if, ,,,j|j/ a t i

23
in Our manufacturing sector, bottlenecks are not
as vet a problem, and are not expected to become
one if growth follows the subdued path of the
Committee's outlook for real GNP. Even so, we
cannot be complacent about the potential for
higher inflation; by the time an acceleration of
costs and price pressures were to become e v i d e n t .
the inflation process would already be- well
entrenched
With its objectives in mind, as I noted earlier,
the FOMC established ranges for M2 and M3 of
4 to 8 percent over the four quarters of 1988.
with the debt of domestic nonfmanciaJ sectors
expected to increase between 7 and 11 percent
The growth ranges for money represent a
decrease from those for 1987—bv one percentage
point in terms of the midpoints. This reduction is
viewed as another step in the longer-term process
of reducing targeted money growth to rates more
in line with reasonable price stability. Moreover,
the lower end of the ranges allows for the possibility of little pickup in money growth, especially
M2, from 1987 under certain circumstances. If.
for example, inflation expectations were to
strengthen, market interest rates would tend to
rise. and relatively .slow money growth could
again he an appropriate policy stance.
The FOMC does not anticipate that circumstances will call for such slow money growth. In
fact, it expects some acceleration of monetary
expansion in 1938, perhaps to around the middle
of the ranges. But changing circumstances could
easily require a considerably different outcome. In
recognition of the unusual degree ol uncertainty
in the economic outlook and the large movement!
of money relative to income in recent years, we
have widened the specifier! ranges for monetary
growth from the more traditional three percentage
points to f o u r points.

This change was advisable partly because the
linkage of money to spending and income appears
to have become looser in the 1980s. As you know.
most historical experience has suggested a fairly
close relationship between spending and the quantitv of money and. over a longer r u n . between
mone> and prices. These relationships established
die basis for adopting specific targets for growth
of money in order to attain the ultimate goals of
macrocconomic policy
Bu! these relationships appear to have changed
considerably in the 1980s, partly reflecting the
effects of deregulation, innovation, and changing
technology. The spectrum of stores of value is
extremely broad, extending from real capital, like
plant and equipment and houses on the one hand,
through stocks, bonds, and time deposits. :o perfectly liquid currency and checking accounts on
the other hand. Both households and businesses
are continually adjusting their balance sheets and
the allocation of their income flows between
accumulation of financial assets of different sons
and acquisitions of goods and services,
Transactions balances are on the edge of the
exchange of financial claims for goods and services. Regulation and established practices previously acted to enforce a marked separation
between transactions money balances and all other
balances, and supported a fairly close relationship
between spending and the quantity of transactions
money — as measured bv M l — w h i c h allowed it to
serve as a monetary policy guide Businesses and
households maintained transactions balances in
demand deposits in fairly close relation to their
spending requirements, and relied on other forms
o! deposits to serve aj longer-run stores of value.

24
But now deregulation and unproved mtorm,i
tion and communications (ethnologies h a v e
blurred distinctions between transactions balaiues
and other assets. Businesses can move unneeded
transactions bahimcs al each d a v ' s t 'use imo
I'.uvorlollars, repurchase agreenu nts. cotniiiiKi.il
paper, or CDs. at luile <ost. with the dion c
among these instruments often depending on \leld
iliiferrntials of onK a few basis points In aclclltion. firms now can maintain balances, in hvbrid
instruments like MMDAs and mone\ luiuls anil
retrieve them nearly as easily as the\ can tiom a
regular checking account Remaining business
demand deposits serve importantK as balances
that compensate banks lor sciviecs. and these
arrangemems. too. aie evolving over time ror
househoLdi. NO\V account—uueresi-eainin^.
fullv checkable deposits—are imponam savings as
well as l.ansauions vehides. and have contributed
grealK ic the decreasing usefulness of Ml as ,1
monetary target
This process of innovation and deregulation has
alfct_led tin' behavior of the monetatv aggicgatcs
m a number of ways, onlv some ol whith we liillv
understand '1 o some extent it seem- sirnplv to
have introduced more "noise" m the rnonev
spending relationship In addition, though, n
appe.-irs that one important consequent e has been
10 increase the sensitivity of the demand tor
monetary assets to changes m market interest
rates—at least over the shoil run While dereinjlation has allowed institutions to varv the rates on
deposits, in practice retuins on rnanv categories ot
deposits are adjusted sluggishlv in response ro
changes in maiket rates, giving rise to relativelv
large swings in iniemives to hold these
instruments

\O\Y anounl- rnav be the most prominent
e\Hinple ol this. Because ihesc .mounts are dose
snbsr.ir.utes lot oilier liquid instruments as a store
ti.r savmu.. holders ol NOW .mounts are highlv
svii-juvc to charges m interest rates on these
altci nativ e inv estrncni- 1 hcv place a larcet v o l utne ol kinds into NOW .mounts when rates mi
other deposits at hanks and thrills aie iclalivelv
l»« and deposit smaller amoimr-, .,t aitualK (haw
don n i h e c k m g account balances when investment
i<}>|>ortuniites are more a t l i a < t i v ( elsewhere
\\idespread (ompensating balance arr.mge
merits lor businesses impK a stiong interc-,1
responsiveness ol demand deposits, as w e l l ,
( hanges in maikei mleiesi rate- alter (he eainings value ot these deposits to banks. with jesulrins JiS|usuueiu-. ui (In UiUi-urs ri'()uiml ui <..\mpensate tin bank foi a given p.id-age ot -enni's.
M2 is a broader (ollei.ion ,,l the pubh.'s liquid
assets, and as a consequence inlcinali/cs some ol
the shifts that have plagued Ml But \U is still
soiuewhai limited m its j o v e t a g e of tinam lal
wealth held in liquid forms, and shift- between
Mi and othci financial assi'ts ma\ nor bv [hemselves irnplv (hanges in spending tcndcm ies Sudi
shilts h a v e been responsive ro movements in the
rail's on a l r e r n a i i v e inv esrments- relative to reuirnon M2 balaiues This s e n s i t i v n v . rhough nmsidcrablv less than loi Ml. also seems to have
increased siiue [lie laic IfTDs. perhaps as
improved information and comrnunicatkms, teihnnlogies have faulitaied transfer ol funds between
M2 asset- and those outside 1 this aggregate Over
the longer inn. OIK e rates on instruments in \1'2
ad|nsi to (hanges in market rates, this aggregate
tends 10 grow in line w i t h income, as u has on
average o v e r the postwar period

Inline- that hunks ,md t h n t t s use to supplement
their u-tail deposits in order to fund credit exp.liisum I'nlike Ml ,ind \12. it is highlv responsive

.111 aggtvg.itc (hat i, sensitive to movement', in
inteiest i.iies Sui.li L <imvth i ould ur.ge o v e r n
Link wide .pc. uuiii.' and Mill be <on.,i.teni wi>h

e-.|jand then IjaLiiue sheets ,md whnt p.'inuulai
. o u t x r , <,l funds lo ,eK on Small (liaises in
nueiesi rate relationships 1,1,1 have ven auljM.niddl nnpan.s on :he funding deiiaiinia fil iliese
nisi i! in ions and ( onsequtiuk mi M.i. without
ttiain; uupln .uioiis tor iiiioine and priies
Mi. ihen. is deteniiined laij;elv In th<- den-

< ir, unnl.m, es. tin: Commltlee dentied th.jt ,.
modesi widening «.i 'he range, lui \1'j and M't
would better riKompasa dppmpn.ite monetaiv
growth, while still pniMihinr ,i guide to polnv
I hH an.iksis aka underlies 0111 det i.ion ,m,tii:
not to est.ihlish a t,nget i.mtfe lot \11. UV h.i\ e
monitored llie hchii\ it.i ..1 Ml ,,iid u.ndutted

hlhtli-i and til «lul tNpe the\ wish to Mjpplv to
Ml\ cir-in. l)ell,un.. lelnains unexi^lained. we
the inaiki-is 1 he gn.innged li.ibihties in Mil ate
now behe\e th.it niosi ol its IIIHIMKL! niovenie;,t\rr\ iliiM 1 -iibstnines tor other mi>ne\ in.nkel
ieLni\e to inionir m icient \e,irs i-i iittnljin.ibliiiiknunieuts ui the jRiljlu's piintiilm \t 1 ,«id M'i. ID .1 tn-iu,!i!*-iii.-(i ASH! imv, ijiiiu- 1,11^' mlvvv^
bs umtrasi. ( ,in br' thought ol ,ts depending more , elaL-tluH
dire, Ik on ;he publn \ desin- to hold the asset-.
In Mew ol ihi- tiHi.n ior. our eahuhition-. sugnuklded in llie-e ayyienales. iris-en the tetuitls on
iiest th.it s,inielinni4 ''I11' •' -iev en-pen entaL;i--poiiil
various .ihern.itive ni\ t -stments ,is wi-11 as levels nt
lange would be needed tor Ml in ordei 10
wealth and innnne li.ink. and ilintts, ol uiiirse
eiuompasi the saint- range ot nni eit^inne- .is is
di> s.»rs die oltemis; r;nr"i on (heir M ^ - t ^ p e
( npturi'd b> our loin-pen cntaye-pomt i,ill!!e l"i
deposits in order to ,iile! i ihe quanutv ot these
M_> Sudl lt wide i.inge would bo ol little use in
10 lac !)],n-ke< i.ite.. .IIHI while die M2-li«.ldmy
pnblu i- sensitive to aitem.itive Melds, it is not
ne.nK .is s e n - l t l v e ,i- ihe mones maiket IlivestolInildi,m managed halniitie. In these UfLuinstan.r. the .onnenion between Ml and M'2 ami
llie e. ono,in ie-,1- inipoi MntK or, the e l t e t t ol
mieiest i.iics on ill. demand tor these aggn^atcs
1 in e\.iinple. ,i moii' e\pati-ive muiietaiv polii \,

1111; the M.in.e ot monel.-irv pohrv -o the publu
One should not < on. hide trorn this that I he
K-dei,il Reservr' is !;i\ni!.' up on rnrinel.u \ Miget
ing. We ,ire mil. The iiiikagrs between nu'llev (in
the one hand and pn.es and -pending on ihe
o! In i- ni,i\ h;i\e loosenerl. but ih.il i- mam> .1
problem ovei the ,lnni ILIU 'ihe diain -nil e x i s t s
\ \ e are eontinuim; lo -tuds ihese i i-latiotislups

i nun; iaii- boosis demand tur ihese agjjregaies ,is

(ould well become ughier .igani In ,iny eien>

eiononiK , u i m t \
( , i \ e n uiKeit,unties about how linam lal ni.irkpt
plcs,ii,fs in !d,.i ma-, need to v.u v in response tn
di.inginn umdition- in ihe euinomv n is difficult

quite po riu.ian e thai, ovei ;he loiiy ism. uione\.
in< onie. and prnes tend to m o v e loac'.her
The FOMl". e\pe. ts to athiL-ve us aiji!"'^'1"'
i,luges lor 1'IHH \ \ e will, how e v e , , need to ( o n tinue lo mlerpret the imolnmt; mloi m.i'ioli on
ihese measuies in ht;hi ol oiher d.ita on the pertonnrinic ot the cionoinv and pn,es. and othei
indi.arois nt the nnpait of moneMr\ poll,-.

26
The Challenges Ahead
We face formidable challenges over 1988 and
beyond in meeting national economic goals of sustaining growth and progress toward price stability. Some of these relate to the short-run outlook
for the economy, as the possible effects of the
slock market decline and (he build-up of inventories late last year work through in 1988.
But our more fundamental task remains
managing the process of restoring internal and
external balance that is now underway This is a
challenge that cannot be negotiated by the Federal
Reserve alone. It will require complementary and
consistent actions by our colleagues in the Congress and the administration, as weD as by our
major trading partners.
For the United States, the most direct and
beneficial approach would be to address the problem at its major source—the f(_.Xral budget deceit. Reducing the deficit further would give us the
opportunity to add to domestic saving and reduce
dependence on foreign capita], while still
encouraging much-needed investment spending.
Because the United States is now operating at
relatively high rates of resource utilization,
domestic demand must be restrained if our international sector is to expand without more inflation. In the absence of fiscal restraint, greater
pressures would be felt in financial markets, with
negative consequences for investment and other
private spending.
While recognizing the need to supply the
liquidity required to keep our economy expanding, monetary policy canno! lose sight of the need
to keep inflation pressures under control. We cannot permit the price level adjustments associated
with restoring external balance to feed through
into a renewed inflation process. Escalating prices
and costs would reverse the hard-won gam? in our

international competitive position, leading inevitably to more difficult and wrenching adjustments
down the road. Progress toward price stability is
the foundation on which the longest peacetime
expansion in our nation's history has been built,
and continued efforts along this line will be the
framework for future economic advances.
Our gains in international competitiveness have
reflected a number of factors. But we should not
underestimate the effects of the efforts of business
and labor over recent years to enhance productivity and restrain costs. And government has
made a contribution through deregulation and
through the absence of major initiatives that
would involve higher business costs
Our adjustment process by definition has a
counterpart for our trading partners. They must
promote expansion in their demands and reduce
trade barriers to assure active and receptive markets for exports from the United States and
elsewhere.
The build-up of imbalances occurred over a
period of years, and has involved major adjustments to the structure of economies here and
abroad. These will not be reversed easily—but
they must be addressed We must resist the lure
of "short-cuts", such as protectionist measures
which would only entrench inefficiencies and
reduce living standards at home as well as around
the world. We can make this difficult transition,
and monetary policy has a key role to play. But if
we are to have a chance of doing so without dislocations and detours in our national economic
advance, we will have to work together to utilize
all the tools at our command

1988
MONETARY
POLICY
OBJECTIVES
Summary Report to the Congress on Monetary
Policv pursuant to the Full Employment and
Balanced Growth Act of 1978. February 23,1988.

Contents

Section

Monetary Policy and the Economic Outlook for 1988
Monetary Policy Plans for 1988
Economic Projections

The Performance of the Economy during the Past Year
The External Sector

The Household Sector
The Business Sector
The Government Sector
Labor Markets
Price Developments

Monetary Policy and Financial Markets in 1987
Behavior of Money and Credit

Iinpl em en tat JOE of Monetary Policy

Page

Monetary Policy and the Economic
Outlook for 1988

i'-, p r i - t i ' i H i A e i (he k.ui qudi-R'is, ol ltlS7 t > u l s t r i p p e d most e x p e d a t i o r i s . and [lie u n r m p k n mi-til

past several w e e k s .
B u i w h i l e ihe Federal R e , c r \ e (us had In he

ic.is i l d . i i l r U n h Midi v x i o i , a. a i ; . H i i l u n e . nunm i > ,]|><l n i a n u l a u m m i ; beiiel'iuni; u n i - i d e r a b K t i i i n i

has noi lost sis;lit oi the p o t e n t i a l i n f l u e n t e of poll. \
. t t i n . n s on l o n y e r - t e r m l i r r u l . in tin eamorm I K.

e x p a n s i o n nl the e t o i i o n i i w a s benn balam ed t h a n
i n I ' W i - H f j Waije i r x r e a s e s . e n i a n i r d moderate and

j i i . t m e m in (he l > n l , i n . e < i l t - M . n o m u . u - i s i r v . a t i e t ,1
period of M - v e r a l war. in w h u h t;rt>wih ,.1 dome.d!

H n w e x e r . a r e b o u n d in m l p r u c x ( o u p l r d w i t h the
i - t l t - r d , (.1 ( h e d n l l . L i - ' s del l i n e o n t h e | > r i ( e s <>l
nnponcd i;.>o(K «eiu n i l k . pushed t h e 1,1(1 of pim.'
i n t l a t i o n h.it k u j i to ( h e 1 j x - i i f i n r.tin, r e l i v muM

tio.i O v e r i l i . i t -.pan. ( l i e -r.icie b;ilanu' t t n . M - M i n « i
tteep d f l i d l . a n d ( h e n , i t i < i | ) lie-in ( t . .iin.iss a l i u w
ncl (.'xteinal t t e l j t . !( is t i n p u n a n l TO alli>« ruutn t u t
a n ^ n i f n a n t iniprint.-iiit.-iil in our l i a t l u baiatRc.

Ai l i n n • l a s t \ e,n . '11,11 niL' t u t i i i i H i t i t i v pnst"sluiip d e i h n e . in the dollai. and bund pni i-s -14naletl die p o s s i b i l i t y ut ytvatei i n t l a l n n l a i i daniJeis
\ \ l l l l lllc e r ( . m > m \ i m n ' m g to-vai<i Inglit-r' lescU t,l
le-oime u l i h / . u i o n . '.he K-deial R C S C I M - had to be
tspcualK ak-n (o ihe.e and o t h e i indn .IIIOIIN ol
p i f s i u K - s l h a l miijlK h.nc letl t<. ,1 sisjmilt ant dep.n( u i f t i t H i i the l o n ^ f r - n m trend t o w a r d pni e st.ilnl
i t \ In ihese ( i n n m s t . i n i es. m n n e t a r v p n l n v was

.ttul io« n t u - r n p l m t u c i n . t-\ idem n\ m a i n • h t - n t t t c i i i s
nl n i d u s t i > MJSK1-1--1 [1"' rl"'(i '"' 'iddt-d ( a i e in
n i a i n t a n n n t ; progress t o w a r d p i n e M a b i l i K
'['hcsf i t m s i d c i M d o r i s u n d c r i r u tlif tlens.on. til the
Kederal Open M a r k e t C o m m i t t e e w h e n it met
e a r l i e r t h i s m o n t h to ( h.irt i t s m o i u t a r v p o l l . \
str,itfi,-v lor 14HH. SIK h t o n - i d e r a t i ( m < also m u s t be
kept in (he ttireirtnit ;is rift m t u i n u k p r s rkt-whrn- in
the guv r r n m m i •'"•( p o l K \ . In p a t i n ' i i l a i . i r i n i i n m i n ;

t h r o u g h List ( > t tobei 1 h i s i\as rellrrted in a m o i l e t ate n*f i n n i o n e v i n a i k t i n u t - i t - M ran--. w h i ( h in
l u r n d a m p e d g r o w t h o l ill. 1 m o n e l a i \ ay«rei;,Ltes
\ \ h l l f - Mi ^H-M ,11 a j i . u e equal 10 the Imic! b o u n d
nl the i ,11141' "'I 1"' l t « \ i , u in the [Y<l( ral Op, n
Markei Coiiiniide, i F O M f i . M2 tt-tl -ho,t ol il.
i . t i i H f M t e i i h e p l u n g e in ( h e s . , , t k m a i k e t in
( l u . i b e i i t i c S \ s l e i n t r u n s e d us e f f o r t s ]>i 1111,11 i l \ o n

resoim rs to U n a in e p r o d u u n iu - e n h a m i n k ' pi n an
im e s i n i r i n « l n l t - bi i n n i n g abom an impio'. ed ] > , i t d i n nl n u n n a t i o n a l tr,ms,ii t u r n s \ l o r e o \ ( ! . a i l i h
( n . n a l i - l l o r i - a! binmmi; u r o i t e i ( . . l n r . ' i m Hi poh. i t ' s , d o m , • m a l U ami nv, r n a t i o n a l X w i l l p i u n m t t
i.na«'i stabiliu in tinaiu >al maiket- and t;rc.ilfi
u i U ' i i i r i l a n d e v i e i n . i l baLnn e 10 - l i e e u i i m r r u

: n s m i m ; ,it , ( | n a t f 11,11 it i t \ in t le , ( onoitu . am
. n u e t h a t ' l i n e i n t c r r M ia!eb have rui-iM-tl a L'nod
pa,, ot th.' use l h . i l o . M i n . ' . l e . i r l i e r m ]<»»:
H o w < v f ' r . ( o n d m o n s in f i n a n . lat rn.it kt-ts h a v e v e i
t o i e : n i n t t i l k i t . " n o i i n a i . a n d i l n etlyme,. ,.l
p a i l K i p a n f K i n t i m i , ' . i t , In n lift t( d in M . l a t i h n
a n d i . m K . , / a b l e u.L p i e , : u a \ I < , n - , , % t r , : t i , ' , , ' h a v e
been sunn- sn;ns ol wra^n.-.. i n ihr e t o r n n m
| - . < i n t k I n pard, n l a i . d i e I o n n h ( | i i , i n e r o t !')H7
wa. m a i k e t l In a i h a r p r i s e in m v e n t o i i e s m .1 lew
set -iu-s, and th.'re w , re r n d u a n o n , ot a - l a , kenim? m
labo, demand eaiK iln. st'.ti X ^ a m M -In. b.nkdiop

Monetary Policy Plans for
1988
'
'
H ' " ' l ) » » . 'I" f o m n n u e , .r" r . t n ( r , ' s ol 4 „, }i ,,.-,' e n i I,,, i ; n m t h ..I \\2 . , n < ! M'l K.vp,.ns,,,n , , l
m o n e \ w i t h i n these i;m v res \,ht,se m i d p o i n t , a r e on.
p c n e n t a y e p. 11111 l o w e i t h a n ( h o s e ol the ram;es lot
i.tsl ^ ' . t r w o u l d b e ,-;}H-, [ , , < ' « . .nppci' ci "noisii.
i ; i o w i l i ,1- .1 ]i,ne d i a l i. , O I I S I M . - I I ' w n > , l o m m n c t l
e x t e r n a l a d u j . n n e i K a n d p r o g r e s s .m-t l i m e io.-.ard
}""• M . i l n l n \

30
Ranges of Growth for Monetary and
Debt Aggregates'
~~
•
'
'
Percent change, fourth quancr TO fmmh quancr
1988

~—"

1987

—_^_^-_—i^^^_^___^^^__

,,„

„

_—_
M3
•

,
4 ID 8

"—'

"
' '" ''

j,,
,,,,
__
_—_
5!^ tn a^
~
~~ '
emit

Decisions regarding the ranges for money and
credit growth in 1988 were shaped in pan by the
experience of 1987. Last February, the FOMC
established annual target ranges of 5 V? to 8 Yi percent for both M2 and M3. both aggregates had
increased mote than 9 percent in 1986, but slower
growth was expected to be continent with the Committee s goal of sustaining business expansion while
maintaining long-run progress toward price stability.
The deceleration proved sharper than anticipated.
and tn July, the Committee stated that growth for
the year around the lower ends of these ranges, or
even below them, might be acceptable in certain circumstances. Velocity had increased in the first half
of the year partly under the influence of rising
interest rates, and the Committee agreed that if
inflation farces, *ere to exhibit renewed strength and
interest rates were to increase further in the second
half of the year, continued slow money expansion
might be appropriate Rates did move upward again
in the late summer, including an increase of 1/2 percentage point in the discount rate to counter potennaJ i n f l a t i o n . M2 growth did in fact fall substantially
shon of the Committee's range, at 4 percent for the
year, while M3 growth, at 5 !/; percent, was at the
lower end of its range.

In light of the experience of recent years, which
have been marked by large swings in velocity, the
ranges for 1988 were widened somewhat. There is
continuing "noise" in the relationship of money
growth to economic activity, in addition, velocity of
.
.
,
'
money is sensitive (o changes in market rates of
interest. This sensitivity means that even small
changes in rates, caused by variations in spending or
prices, can have sizable effects on the quantity of
money the public wishes to hold Combined with an
uncertain outlook for the economy and inflation, this
implies that wider ranges are needed to encompass
possible outcomes for monetary growth consistent
with satisfactory economic performance in 1988.
Thus, while the Commute? at this time expects that
growth of M2 and M3 will be around the middle of
their ranges, the outcome could differ if significant
changes in interest rates are required to counter
unanticipated weakness in aggregate demand or an
intensification of inflation. In carrying out policy,
the Committee will continue to assess the behavior
of the aggregates in light of information about [he
pace of business expansion and the source and
strength of price pressures, with attention to the performance of the dollar on foreign exchange markets
and other indicators of i.he impact of monetary
policy.
The FOMC will continue to monitor the growth
of debt in 1988. The expansion of the debt of
domestic nonfinancial seciors is expected to slow
somewhat from the 9 V% percent pace of 1987, to
around the middle portion of a 7 to 11 percent
range Growth of debt however, appears likely to
outpace that of income, as it has for the past several
years. Although the debt of governmental units may
not grow as rapidly as i: did last year, continued
rapid expansion of private debt is probable, unless
the current tide of corporate restructurings ebbs
The Committee decided not \o establish a range
for M I in 1938 It is especially difficult to anticipate
the relationship between growth in this aggregate
and the performance of the economy. The character
of this aggregate had been affected more than the
broader monetary aggregates by deregulation,

31
Economic Projections
I h e uncertainties a t t e n d i n g the present etonorrnt situation are reflected in a (onsiderable range (it torecasts among Committee members and other Reserve
Bank presidents H o w e v c t . ihe central tendency
langes encompass the v a s t i n a b i l i t y of forecasts and
point to giowdl in real G \ P of 2 to 2 '•'; percent in
This paie of a d i M t v w o u l d be e x p c u t c d to generdic spprei iaWc iftiiii* u> i'U)f>lmnii'j)i m rr ihe
v e a r — a b o u t in line w i t h labor f o r c e g r o w t h — a n d
die civilian unemplovment rate is pro|cned to
( h a n g e l i t t l e on balamc between now and the end ot
l ( lfifl ['rues. a> measured b\ the i m p l i i 11 p i n e
d e f l a t o r tor CM', are expcucd u, rise ' i ' , to "', %
perrent. nor a p p r e n i a W i <!illffi-nt tr<tm chr [(,jcr Ijsj
vear; ( o n s i i r n c r p r i c e s l i k c l v w i l l niLreasc a l i t t l e
laster t h a n tipe deflator I h e < c n t r a l t e n d e n r v toreL a s t s e m o r n p a s s the A d n i i m s t i a l i o n s pro|ertions lor
real (A'P. but are a bit mon- o p i i m i i l i i on prospeds
loi p r u c intLinon
Higher real net e\j>orls of gooiiN anit s e r v j i e s are
e.\pei ted to provide a ma|oi impetus m 1.' ^ ecoiiomK a d i . i t . in 14HH As jetleded bv the j a p i d
growth ol ieal exports ol aood 1 - and services of more
dian l i peri cm las' \ e . i r . the i n t e r n a t i o n a l ( o i n j u - u -

rantlv By and large, U.S. mamif.K turcrs have lei
I he foreign < u r r e n c y prices of t h r u products derhnf
w i t h the depreciation of the dollar. a i h u ' M H C
cnhanrecl prntitahiliiv through greater \ o l u m e and
aytjrc'.sivf eliortq to in< rcasc e(fitiC!ic\ iin<i ( o n t r n l
( o s i s This enhanced rompt-tidveness is e x u e u c d to
u r o x i d e a f u r t h e r boost to export growth i h i ' year,
w h i l e [he jn< reasei in die r e l a t i v e j u i c e s ot f o r e i g n
i;oods apparentlv now in n a i n should < u r b n n p o i t
g r o w t h . As a result, some i m p i o v e m e n t in tinn a t i o n ' s t u r r e n t a i e o u n t baLinic i- a t i t i < ipau-d t h i s
I n c o n t r a s t , domestic demand is e.\pecled to
i c m a m relatively subdued in 19K8. as the e ( o n o m \
moves toward a bctier b a l a n c e b e t w e e n domesm
-pending and dorncsiu p r o d u c t i o n . C o n s u m e i
demand prohablv will b<- damped to a degree bv the
los.s (it household w e a l t h associated w i t h the dei l i n e
in stock prices last fall Some increase m personal
savins; iMiuld be benefit ial to the e t o n o m v , a' it
w o u l d aid i n v e s t m e n t and help r e d u i e oin depeiidem.e on lorcign (apital However, a sevenretrent h r n c n t by consumers t ould have a s i g m l l t d t u
dell.itionarv etleu. l o r t u n a t e l v . the mclnation-. t i o m
surveys ol household a t t i t u d e s arc t h a t the s h a i p
diop m umlidciKc t h a t o c r u r r e d immediatelv a f i c i
ihe October shot k has been substantial r e v e r s e d
Houitfji; , - K f J i i M 'thaultl pict >if> wmi'.- in I.IJIIIHH:

Etunomic Project ions for 1988

FOMC Mtmbtrs tnd other FRB

32
months as a result of the recent decline in mortgage
rates. In addition, business spending on plant and
equipment should be buttressed by the desire to
build upon the progress made in regaining internationa] competitiveness and by already high levels of
rapacity utilization in a number of major industries.
Although real G N P should rise moderately for the
year as a whole, ihe pattern of growth may be
uneven over time. An adjustment to the runup in
inventories that occurred in the fourth quarter of
1987 could produce relatively slow output growth
during the first pan of the year. Such an adjustment
appears in process in the auto sector, in light of
domestic automakers' current assembly schedules.
There may also be similar patterns in a few other
sectors, but at this time there are no signs that deep
cutbacks in production will be necessary
Although no significant change is anticipated in
the overall pace of inflation this year, the primary
source of the rise in prices is I' 1 ~'y to change.
Assuming relative stability in world oil prices,
domestic energy prices should increase only a bit
this year after their sharp rebound in 1987 However, prices of non-oil imports likely will continue to
rise substantially further in the wake of the decline
in the foreign exchange value of the dollar in 1987,
providing continuing impetus to domestic inflation.
This impulse to prices associated with the dollar's

depreciation is an unavoidable component of the
process of correcting external imbalance, as an
increase in the relative price of foreign goods
encourages exports and discourages imports. However, if we are to maintain and extend the progress
made in the 1980= toward price stability, it is crucial
that business and labor continue to exercise restraint
m p r i t e and wage behavior The forecasts of the
FOMC members and other Reserve Bank presidents
anticipate that such a pattern will persist through
this year. I t is important, too, that the Congress
remain mindful o( the effects of legislation on the
cost structure of American industrv
The forecasts of the Federal Reserve policymakers
also assume further progress in reducing the federal
budget deficit Continuing evidence of fiscal restraint
is viewed as crucial in maintaining financial conditions that are conducive to balanced growth and to
an improved pattern of international transactions. It
is critical that the package of deficit-reduction measures for 1938 and 1989 — agreed to in December—be
fully implemented

The Performance of the Economy
during the Past Year
1'he c.ononu umipleied a fifth < onsc< nm e vear ol
xpan-ion m 1'IH", w i t h renl yioss national prodm t

A mimbt i ot ,e< lor. lhal had been depressed in
icieiu years be^an to show sij>ns o( impiovpineni m

lereasins; aljout 'i % percent over the four quarters
I the vear • "1 he overall cjrowtb in output noi onK
as Beater than in I'tflfi, hul was bcttei linlanied
ross mduMiio and returns tit the umnttv In
Iduion, (he rise in a c t i v i t y supported a not yam o)

1%7 The turnaround was most pronotimed in
mamddiL tunni;. wlieie prodiution ,,nd emplowiieni.
evpe< i.ilk in i^pital ,>oods and industrial materials'
industries, puked up shaiplv. boih in lesponse 10
Mmnger oideis In mi abroad and lo lns-lioi levels ot

ore rhan three million |obs last vear, and the civiln imempUniiieiii rale siood at ~i ii pi'rcem in Jann
•\ of this \ear. nearU a penenlanc point below its
vei a -.ear-a^o
'

< ajmal spendiniJ b\ domcsm prodmei- Hi-Mevci.
nnpTo\enient also was apparent in the domestn
eneri;\ xeaor. wlieie, in response to the paili.il
icunery in oil pntes. oil dnlhni! ietra(ed a .m.ill
pan [)( us e.irlier pieupitons decline Hi^hei e v p o r t s
ami M.ntnmrd ledei,,] -tip}>on m .^nniltiiie booMed
lam-, miiime and helped filing about -ionic turinni;

Real GNP

I he nnpiXAemcni me.ononiH

( otidition.

la-,1 \e,ir

(oiild be t i a t e d to the cliem ot int reased . o n i p e t i -

tu-ase in the value, ot oil imports and iisini; p i n e s ol
non-tnl imports more than offset ;m improvemeni m
ie.il nel exports, and the no
i.ll trade deliul " K l ened to almost SI61) billion m I'm? In addition. „

!'.«•:

iQKi

,<m.t

:»!<=,

\"R>,

-m:

the pattern ot price movements ovei the past t w o
veais re-tier ted de^ploprnem- in oil markets, where
pines rehe-u dec! last vedi ..itei a sharp drop in
ptices also uise sharpK t(.r some
ner so»ds and. ai the producer level

ot/R>r servile rranvtf mini, puihtvJ t)w i-iifn-in ,UHHI»I
deiiut above JI60 bdlion.
Altliouu'h cionnmu <utiviu lose ai a brisk pai e

34
Foreign Exchange Value of the
U.S. Dollar*
i«d«. Mint, :°;i - i

The External Sector
The dollar depreciated by 14 percent in nominal terms
over the course of 198" relative lo a trade-weighted
average of the currencies of the other G-10 countries,
leaving the dollar by the end ol the year at a level
almost 4-5 percent below its February 19R5 peak and
close to its 1980 low. The decline in the exchange
value of the dollar was resisted b> substantial official
intervention purchases of dollars and an apparent
movement of differentials m long-term real interest
rates between the United States and major foreign
countries. Nonetheless, some depreciation in the dollar evidently was seen by participants in foreign
exchange markets as a necessary element in the
adjustment of the huge U S current account deficit.

The U.S. merchandise trade deficit widened for
1987 as a whole, but leveled off on balance in the
latter part of the year The volume of imports
increased, reflecting a moderate expansion in both
oil and non-oil imports. Moreover, non-oil import
prices moved up further in response to the continuing decline in the dollar through 1987, and, with oil
prices also up sharply, imports rose substantially in
value terms. Higher imports were matched, to a
arge extent, by merchandise exports, which also
grew briskly m 1987.
Economic expansion abroad strengthened slightly
in 1987 providing only limned support for the
improvement in the U S trade position. In the
other industrial countries, economic activity picked
up somewhat by the middle of the year after a slow
start, but on average real GNP grew less than 3 percent over the year
The Household Sector
Spending by households, which had been a major
contributor to growth m past yeari, slowed considerably in 1987. Real consumer spending rose less than
1 percent last year, after a 4 percent gain in 1986
Perr sonal Saving Rate

U.S. Real Merchandise Trade

In large pan, the cutback in spending reflected
smaller increases in real disposable income. Substantial employment growth and increases in farm and
interest income fueled continued gams in nominal
incomes. However, a pickup in consumer price
inflation eroded much of that rise and reduced real
income growth to about 2 percent last year, versus
3i/; percent in 1986.

, > i i d n , a b l < good-, w h i t
i n i i M i i e i . ! M , mc-c.i-,1 ,it ..bom
- U : ( l i i i i !b ( l ; i r , , b l < - , . ,iH [i l l h o n i ! 1 ' . m i l l i o n i i n i l -

, h«:•.%,
and < ,

Wi>, i . u r d iM'h l i i e i n . - ] , , , u n i o n - s p e n d i n g ;iai
1 . 1 us ,,t M . i i M i m n - ML l"H7 •„,,, ,i -.u.svm^ 1,1 II.^IM-

< ' " l i H"«" •"<>"« ."«! ' M ' 1 < ""'•
I n ' l - .nu.., i u e UL:..M.-U u u u li

d e c l u . M r d -,l,, l u ,K be, m.e ,,l Inyli ,iebi b i n d , - , , , ol

Changes in Real Business

•use bcsriiiniiii,' i n A p u l . KMihini? aho.u I I L, p e i i-ni tor t i x t - d - i . i u - loans bi nnd-Oetobct AlthoLis^h
nlrrc-l rate, on IIKH'UJ.IJJCS ti.ivf diopp.-d ^nbst.iniLilli s i m e t h e n t h e s i i r n u l . u i v i ' I I I U M I L o l llui
l u n n c (.11 housing' d(.'tiidi«i m.i\ h , t s c brrn o t h e r
lin- l.ii hi M ( « k i i w r k f i losses ,ind n - d n i c d uwiiKo w e a k e n e d < A C , die iia.t ,e.u
P r i v a t e Housin

Starts

as n.-ai l e . o n l ', „.'
»_
^LL;

l!!!.'!!l

V t n i-qinpnu-nt. trip yc.n bcijiin on [lie weak sule
w i t h l i i s l - ( [ U r t l t c i spi-nriinj; d o w n sli,,ipl\ jlter linn:
shiltrd cxpi'iidituri-s i n t o I n i c l ( 'Mi) t u take . i d v n t i r a u
ot the favofitblt ireatnicnt «f i n i i ' s t i i i t n t nndci [lie
i i i i ' f s i t n c i K in r t j i i i p m c n i rebounded shdrpli in the
set ond iind t h i r d q i i a r i f i s ot ]a-i\ i r a i
O u t l d v s lor n o n i o s i d e i n i a l s i f u c i n r e s jho mrm-d
u p tdsi \c<ir .liter a sharp drop in l«ib Much of, [ h
die ciHTjry SPC tor in ri-s[>oiiM.- [o lusher oil pines

36
Business inventory investment generally moved in
line with sales over most of 1987, but a sharp
accumulalion of stocks in the fourth quarter suggested the possibility of excess inventory levels at
some retailers. In manufacturing, inventories
changed little on balance over the first half of (he
year, but rose considerably in the second half as
activity picked up Stockbuilding was most evident
in capital goods industries, where orders and shipments strengthened substantially, as producers added
supplies in anticipation of higher production levels.
In the retail trade sector, inventories of goods other
than automobiles also rose over the year, pushing
the inventory-sales ratio to a relatively high level by
December. The accumulation was most pronounced
for home goods such as f u r n i t u r e and appliances and
for apparel. At auto dealers, stocks generally rose m
1987, and, at year-end, supplies appeared to be well
above desired levels despite the prevalence of spc-tial
incentive programs arid production cutbacks late in
tht year

The Government Sector
Lasl year, there was significant progres^ toward
reducing federal budget deficits. The FY 1987 deficit, at S150 billion, was about a third lower than the
record level of the previous year. The Administration and Congress reached agreement on deficit
reduction actions totaling more than $30 billion in
FY 19S8 and about S46 billion in FY 1989 However, a number of factors that raised receipts and
lowered outlays in FY 1987 are not likely to be
repealed, and—absent further legislative action —
deficits could expand again unless there are particularly favorable economic circumstances.
Labor Markets
Employment increased three million over the 12
months of 1987, as the p i c k u p in eionomit a c t i v i t y
led employers to add workers at a brisk pai e In
contrast to prior years when ihe labor market was
characterized by sharp disparities across Seirors. the
strengthening in hiring in 1987 was widespread by
i n d u s t n . In msinufat l u r i n g , employment edged up
over the first half of the vear and t h e n rose substan-

Civilian Unemploymcnl Rate

tially in the second half in response to the sharp gains
in industrial production. Moreover, the expansion of
jobs in the trade, service, and finance industries
remained sizable during most of 1987. Hiriiig in
trade and finance apparently slowed in the latter
part of the year in the wake of sluggish consumer
spending and the stock market crash.
The demand for labor considerably outpaced
increases m labor supply, and the civilian unemployment rate dropped nearly 1 percentage point over
the year to 5 3/, percent at year-end—[he lowest level
since 1979 The jobless rait for adult men moved
down to about 4'/; percent by the end of last year,
reflecting strong growth in the industrial sector. The
rate for adull women fell to around 4->i percent early
in the year, but changed lutle in the second half.
Nonfarm Payroll
Employment

Nc' '-liajigr. mjllirr.-

,r,t.>n»: uumi ran

CorsMimet- Prices'
i.n(e.f,<; "- l ' ' r t i , l l i f . . . c r i i > i i , > i L n-,iK,.i,'. i n I . , h o i
( l ) s t s p i i i i i . m k i , l i t , ! , ' , ; m,.Jei,itf t < i : i , p e i ; - , U i i M i

GNP

!lt>
[>(-[,,- .UK! pjodiu-fi p i n e indues sii(ii.,-sli-<l ,111 i-M-n
-li,ii] M -i- ,i(,clci.ilioii in (lines nvci l'ti!7. mvini; !o die

s i i i n r , pi id- index w a s u p 4 - , g,< i x . n l in ihr 12 m o n t h s
cmlc-,1 D f i n n l K ' i , dlu-i .1 : [ . f u t - i n r i s e in 1 "HO i l u - p i , , d n u - i p , , , f - , r i ( i ( - . \ . « [ i i d i , . n h nu hides pi i, ,-,,.( .(o.tiest u . i l K i H ' . n l t i i P i l ^ K K i j , n.sf 2 ' , i M - n e n l M s . ' i - f h , \ e , i r .
1
.ill.] dnipjnnt; '21, |iei<em in l''HI'
I
Pi lies I.,, m,inviii<hisiiialu.iiinio,hii(-,..isoiosr,(insnl. i, 1 } ) ]\ in 1 < W 7 . In ..ddiiinn n. rli, n i t i f . i s e ii-, ,rndf
oil [ i i i . i - s , iO(i|)er p i u r s nunv t i i . i n tl,,nl.led irist \t-.ir,
,uid \t ( el si (<tp priics were up ,)(> pelt fin To -.nine ex
_ , ii-nr, ihe sli.up nst' in t(imrriii(Jil\ pikes lellfi (Mile intlu

Monetary Policy and Financial
Markets in 1987
While the Federal Open Market Committee set targets for some of the monetary aggregates, it was
deemed necessary to maintain a flexible approach in
conducting its operations. The Committee looked at
a broad range of information in judging when or if
lo ad]usi its basic instruments—reserve availability
and the discount rate—in response to deviations in
monetary growth from expected rates. Such factors
as the pace of business expansion, the strength of
inflation and inflation expectations, as well as
developments in exchange market', played a major
role in governing the Svstem's actions In light of
the behavior of these other lactors. growth in the
targeted aggregates. M2 and M3. was permitted to
run at or below the established ranges
During episodes beginning in the spring and then
again in late summer, the dollar came under sustained downward pressure and inflationary expectations appeared to be on the rise, partially in
response to the dollar's wea« , rrformance With the
economy expanding at rates sufficient to produce rising rates of resource utilization, the FOMC sought
some firming of pressures on reserve positions and
increased the discount rate in September. When
stuck prices collapsed in mid-October, the resulting
turmoil required that the focus of policy be on
ensuring the liquidity of the f i n a n c i a l system. Over
the remainder of the year, emphasis in the conduct
of open market operations shifted toward maintenance of" steady and somewhat easier money market conditions to promote a return of stability lo
financial market; generally and to cushion the effects
of the stock market decline on [he economy
Behavior of Money and Credit
M2 increased onlv 4 percent in 1987. well below
both the lower bound of us 5 w to s '•/', percent
a n n u a l growth range and its more than 9 percent
rate of expansion over the preceding two years The
velocitv of this aggregate picked up substantially,
reversing a portion of (he shaip decline thai
occurred" in 1985-86. The rise m velocity mav have
reflected in pan a number of special factors affecting
the p u b l i c ' s demand for M2 balances in 1987.
i n c l u d i n g a much-reduced rate of saving out of
i n c o m e and a preference lor diawmt; upon liquid
asset 1 . — rather t h a n using consumer credit—to

finance purchases. The latter preference occurred in
the wake of tax reform measures which reduced the
deducibility of nonmortgage interest payment?
However, much of the pickup in velocity appears
attributable to increases in the competing returns on
other assets, which raised the o p p o r t u n i t y costs
associated with holding M2 iia^anies
M3 was stronger than M2 over the year, expanding 5H percent and ending the year at the bottom
of its 5'/2 to 8;-'i perient annual growth range. Its
faster growth reflected heavv reliance bv depository
institutions on large time deposits and on certain
other instruments included in M3 but not m M2.

39
U n t i l l u r i i n i . K i , i l b.mks .mi! l i i u l i M L t n u l i n n M,' M w,l M]) tnt-u iv-u.im*- ol \%hi.ti-' i ;i > , l - man.ujctl hab i h i i t - . i , . m i x ! 1 1 u i r c .I-TI i;i-o«rli l l i . n i < i ml J bf
. H M H i n n , n l . i l o l In u r i ' . u K irdm i-ii m l ] , . u s , > l o r e
. i q H . s i t x I ' ^ ' - i i s , , M't t;n'«:h «.i. M i b d u , , ! J i ' L t t i M
'.. [)i Mr \ r - , i j - , , [ ] , - « - i n s ; i n S ).i: t i . ' d n < , - d , , % . • ! , i l l
i n • ( r j s |,n- t t m i U .1. ,i.-, t .•-,!>.ni-i,i!i .it l i . i n k - . J i u l
r l l t l t o . s l i m i ' d 111 , i d i l i l l . , n l i . l i l k ' r r l i i ' d h, ,IM!\ nil
iii,in,is,'ffi li.itjihdfs . i l i t , t i n , d l u n n nniiAH sonnr.
r-limalK h i i u K b ' l i i n w n l l i , , i n liicn u . i f i i j n
',,.,nihi-.
( n n u i h <»l M I •,!,.«,-.1 in !.• , ) » • ] ( . ' l i t t n
lie
s r n t a p u l I ' M . p o m m i . K n - d - c po-.nl i h r p i . - M u u .
v r . i t . OVMDI,' n. ,i . i n . i l l ( l . ' i l u u - in il.'m.nid d . ' | ) « ' M i .
.nul a xh.npk U.V.M-I *-v t l ,,ll-l(>li ol (Xh.'l ,lH'A.)Wtd.'I),..,!. I l l , - , , - i , , , i f , n l M l 111,1.'.,.r,l . I t n l l l K . . l l t r t

G r o w t h of Moiiev and

Debl ' I V i , , ' i n , i G . i h a n < < -

.1 r < ' < , , , , ! JK.MVVO d c ( l m < ' ;i \.-,ii r a t l i n I hi .h..|-|>
.luumi; , i l u r m M l i ami t h e a b t n p l nn iiabnul in h\ i ' l ( n n \ ,i:c i n i l n ,,m c nl i h r in, ic.ivM . M i - i m i K to
mm.-ini-nl" in m . i r k i ' l i n l t rest r.ncv t h . i t h,n rnu-it;iIcr M l I n u x r i i t \,-.,i- A^ Mum.",rrd li\ i ' < M.I,,\IM Jtu.'K ;.nu,i'i drx. U'l.un-n 111 1 ( HIT M l i«.^
. i i > | n \ u ^ it' h , i \ f .1 an-,m i -.•n.itix i t \ i» , h.nmr- m
l l l M . ' M r . i t l ' s lh.111 t h e I m i . l d r t ,l^"--^«* ll >
MH dcln ( i r d u m i ' - i i i n i n i l i n . i i u i j l scm.i-. t;rc«
' ' ' . pen cut l.i-r v c . u . f i n l i i i K (hr vc.ir ,it 'he n u d d l ,
"I thf C n t n i i i n T f i - X i i K i n i i i H i i i i . i.met' i > f K m M pri
n - n i 11,-lit . ' v i i a t i M u n i n u d r r a t c d ( i n i . M d , - i , ) b K I n . i n
' I n 1'i h j),.r,- , , t ih,' t u n [jn'Moi^ v,-.ir< I x i ! M i l l
i , > - < I.IM.-I ih.m I I I « H M < '

40
target range for Ml, given the unpredictability of
Implementation of Monetary Policy
the behavior of this aggregate relative to economic
During the first hall of 1987, monetary policy was
activity.
carried out in an atmosphere of increasing concerns
For a short time after the July meeting, the dollar
about the course of inflation, arising in part from
rose further, but with ihe release of trade data in
heavy downward pressure on the dollar. Growth of
the economy was bringing about noticeable increases mid-August that disappointed market participants,
the dollar again came under substantial downward
in resource utilization. Inflation was picking up,
pressure. Long-term bond vields moved up sharply
reflecting the effect of a weaker dollar on import
as the dollar's weakness against a backdrop of
prices as well as a rebound of oil prices from low
strength in the economy spurred concerns about
1986 levels When the dollar came under heavy
inflation and possible firming of monetary policy.
pressure in late March, previously tranquil credit
I Interest rates in short-term markets also increased,
markets began to exhibit concern about the effect
i but by lesser amounts. In light of the potential for
that declines of the dollar w'Ould have on prices.
greater inflationary pressures, in part related to
Long-term interest rates, in particular, moved up
weakness m the dollar, the Federal Reserve sought
strongly. In conjunction with some easing moves
to reduce marginally the availability of reserves
abroad, the Federal Reserve sought somewhat
through open market operations, it also raised its
greater restraint in the provision of reserves to the
discount rare hy 1/2 percentage point in early Scpbanking system. Initially, this action produced
lembcr to 6 percent. After the discount-rate action,
further increases in interest rates, but subsequently,
, interest rates rose further, especially in short-term
financial pressures eased somewhat. In response to
markets.
reductions in interest rates abroad, to some flattenStock prices, which had reached very high levels
ing in commodity prices, and to belter news on the
relatiir to earnings and had been failing since midU.S. trade deficit, the dollar firmed and there was a
August,
plunged on October 19 in chaotic trading
broad decline in interest rates, with long-term rates
The stock market drop prompted a marked decline
falling soroewhai more rhan short-term rales.
in interest rates as investors sought refuge in the
When the FOMC met in July to review its
perceived safety of fixed-income assets, especially
growth ranges for money and credit, all of the
Treasury securities. Although most stock indexes
monetary aggregates had decelerated considerably.
recovered somewhat in the wake of the crash, finanThe weakness in monetary 1 growth did not reflect
cial markets remained turbulent, with bond and
any evident weakness in the economy Rather, the
equity
prices fluctuating widely.
slower money growth, and accompanying strengthIn a financial environment of extraordinary turening in velocity, appeared largely attributable to
moil and apparent fragility, the Federal Reserve
the rise in market rates of interest fostered in pan
shifted the emphasis in the conduct of open market
by the Federal Reserve';, response to adverse
transactions to providing reserves generously to
developments with respect to the dollar and inflaensure that adequate liquidity would be available to
tion. The Committee decided to reaffirm its 1987
1
growth ranges for M2 and M3 in doing so, it antic- meet any unusual needs This action helped to calm
the financial markets, although conditions remained
ipated some pickup in the growth of W2 over the
somewhat unsettled over the rest of the vear.
remainder of the year. It indicated that growth for
Earlv in 19S8, as incoming data suggested that
all of 1997, near or even below the bottom of the
economic expansion over the firsi p<sr! of the year
target ranges, might he acceptable for both aggremightj;?
weak, bond rates dropped substantially and
gates, depending on the behavior of their velocities
Ihe Federal Reserve sought some slight additional
and other financial and economic developments,
easing in desired pressures On reserve positions Betnotably the evolving strength of inflationary prester tr.ide news bolstered confidence in the dollar.
sures The Committee also decided noi to set a
and the monetary aggregates showed signs of
renewed strength

Footnotes
1 Ml i- (Uii.n. \ h.-ld In i In- pubhi. plus Iras dels'
. h,.k. plus drriwnd drp-.s.ts. plus nthi's (he<kjble
d,T.i-n- Imiliiduiij m x <>ti.ib]f urdei ol «irhdi,iv.,il iNO
rfiid Super \(.)\\ i jtiounrs .lunniL.ni, ir.irisli-i- " UK ••
i.VISl ,(iuninis. ,ind cretin union sluir ,li,jh .i,«nniK|
M2 i> Ml plti, MMna= and snull dt-nuriniurion mm
dcposirs. plus Mnne\ Maikfi IVpu^n Ammii!-.. pin-iharts in ni»tn-\ cnaikn nnitual funds urthn i)i,,n ilmsi'
< ) I , L V .i^wmi-m. ,ind , I ' r - r f i n r.vdmijlii t - u m i l i i l J . t r
M3 is MJ plui krs-c time dc-posirs. p i n - l.n^r di-miii
market ITIUEII.,] iuniti rcstnt tdt t<- insiinin-.rirfl IIUCSKTS
,uid tcnain (fini Kuiodolldr rlfptmis
2 Ml M2. and \Vi i n n . i p d r . n c .-lien- <>l hnuliin.n-li
and MMsdiidl ad|iiitini-nl revisions m,idr in hclji-u.ii-v
I")S8 Cenain i ^ h n u a ] r v d c n n i n o n - alln tins? t.nl\ Ml
were rn.uk- ,« the sinit- t u n e

The CHAIRMAN. Thank you very much, Mr. Chairman.
CHALLENGE TO FED'S INDEPENDENCE

Chairman Greenspan, there have been a series of challenges to
the Federal Reserve's independence in recent months. As you
know, we have an election coming up in 8Va months, a Presidential
election and a congressional election. Every member of the Federal
Reserve Board now has been appointed by the same administration, by the same President. This is the first time I think since
Franklin Roosevelt who served for 12 years—and I'm not even sure
if Roosevelt had ever done that, because Board service is, a 14-year
term. So it's an extraordinary situation, making the Board particularly susceptible to the appearance of this kind of pressure.
The challenges I refer to were first from repeated criticisms of
Federal Reserve policy by the Chairman of the Council of Economic
Advisers, Mr. Sprinkel, including the latest economic report of the
President, which criticized monetary policy openly. Second, Assistant Secretary of Treasury, Michael Darby, sent a letter with analytic work on real M2 to the Federal Reserve Governors and the
Presidents of the Reserve Banks just prior to the last meeting of
the Federal Open Market Committee [FOMC].
I don't know of any occasion in which this direct effort to influence the policy of the Open Market Committee has been so clear
and so overt and the message was obvious that they wanted the
Fed to ease.
Chairman Greenspan, you and the members of your Board who
were all appointed by the Reagan administration, demonstrated
your abilities in October 1987 to the great benefit of our country
when the crash occurred.
Why is the Reagan administration so concerned? Do you really
need so much help from the administration to figure out what policies to follow?
Mr. GREENSPAN. Well, all I can say, Mr. Chairman, is that when
I heard about Dr. Darby's letter, I objected quite strongly. As best I
can judge, he was not aware of the implications of what he was
doing just prior to an FOMC meeting.
I am reasonably certain that such actions will not occur in the
future.
It's difficult to know what to make of anybody's criticism, advice
and the like that we get, and we get it from all sources. And I
think it's important that we listen because the worst thing that
could happen is that we would shut ourselves off from all advice,
criticism from any source.
I, myself, am not particularly concerned that we be unduly influenced by the administration. I'm not certain that they really are
intent upon pressuring us. I think what's happened is they think
they have really strong reasons. I must say to you that I happen to
disagree with both Dr. Sprinkel and Dr. Darby on their interpretation of the monetary aggregates in the last year and currently, although in very recent weeks Dr. Sprinkel has indicated that he is
satisfied with Federal Reserve policy. But I do fully expect at some
point in the future that we will have differences with people in this

and other administrations. I think we will have differences with
economists on the outside.
The only thing I hope does not happen is that the concern of our
responding to political pressures gets so extraordinary that we will
feel a necessity to do precisely the opposite and we could very well
be taking actions which would be counter to our best judgment.
That is the type of problem which concerns me more than my concern that the current administration will pressure us into doing
things that we don't think are appropriate for monetary policy for
this country.
The CHAIRMAN. That's a good, solid, sensitive answer. However, I
can't recall a situation in which pressure from the administration
or the Congress resulted in an overreaction against the pressure
that leaned so strongly against the pressure that it was against the
public interest. That outstanding Chairman of the Federal Reserve
Board, Arthur Burns, that may or may not have been influenced
by pressure, but he followed a policy in 1972 that served the interests of the administration.
HOUSEHOLD AND BUSINESS DEBT

Let me ask you about the point I made in my opening statement
on household and business debt. Because this debt is much bigger
than the Federal debt, it has very serious implications for the vulnerability of our economy in the event of the recession which we
must expect at some time.
How serious is a household debt that has grown rapidly to over
$2.8 trillion, and that occurs at a time when savings have diminished sharply?
Mr. GREENSPAN. Well, I am concerned about the issue of debt, although there are certain technical factors in the data which I
think are creating something of an exaggeration. We have, as you
know, over recent years moved currency to credit card purchases
in a number of instances, and that is debt but it's very short-term
debt and it's a very marginal change in patterns of purchasing. As
a consequence, it is not something I worry about as much as I
worry about other types of debt categories.
And similarly, the decline in the published permanent savings
figures reflects in part fairly substantial realized capital gains on
the sales of existing homes which do not appear as savings in our
regular statistics.
The CHAIRMAN. How big a factor is that?
Mr. GREENSPAN. I think it's a percentage point or so. It's not a
small number and it's been a factor which I think accounts for part
of the decline—I've forgotten exactly how much—but not a insignificant part of the decline in the savings rate over the last year or
two.
Having said all that, however, I think that the fundamental
point you make, Mr. Chairman, is one which worries me a great
deal in the sense that I believe that our economy is overleveraged,
that we have built up debt in the business, household and financial
sectors. This is a problem that we have periodically, It's not something that I would consider to be of grave immediate concern, but
it is certainly the case that when you have excessive debt and very

heavy fixed costs in the system that you have less downside flexibility if the economy wants to make minor adjustments.
It s not something which is a short-term concern, but it is something which should concern us when we look at the longer term
and the process by which this economy will evolve over the next 5
or 10 years.
The CHAIRMAN. Thank you very much. My time is up.
Senator Bond.
Senator BOND. Mr. Chairman, I was very interested in that line
of questioning and I wondered if there were any further implications that Mr. Greenspan might want to expand upon on the issue
of the corporate debt as opposed just to personal household debt.
Have we built up a corporate structure where there is so much
debt and so little equity that we are likely to be losing them in
undue number if there is a recession? What's the remedy?
Mr. GREENSPAN. I don't want to state that we are in a severely
difficult position. Remember, the debt that has been built up in
most cases is voluntary. It's decided upon by corporate managements. They have reasonably good judgments in virtually every
case that I'm aware of as to what they can afford over the longer
term, and with the exception of the merger-acquisitions which I'll
get to in a minute, I don't perceive that the debt is crucially overhanging the system.
It is, nonetheless, creating a level of fixed costs within the corporate business sector which is much higher than it's been and, I
think, does create some difficulties.
I am particularly concerned, as I've mentioned to this Committee
on previous occasions, with this extraordinary amount of shift from
equity to debt in our corporate balance sheets which result from a
combination of very heavy purchases of company stock by the company—that is buying back one's own stock—mergers, acquisitions
and leveraged buyouts. It has created a fairly pronounced addition
to the overall debt and at the moment I don't see any immediate
falloff in that propensity. But I suspect that we will within some
short period see an end to that type of pattern at least in the order
of magnitudes that we've been looking at.
Senator BOND. Following up on your point about mergers, I
gather when the Fed reviews a contested or uncontested bank
merger the Board scrutinizes financial and managerial capabilities
of both institutions and looks at the public interest and competitiveness.
Does the Federal Reserve look at any additional factors when it
is a hostile takeover? Do you feel that hostile takeovers of banks
could cause any public policy concerns and any other type of hostile takeover or any other type of financial institution merger?
Mr. GREENSPAN. Well, I think hostile takeovers create some analytical problems which can be overcome. It's a little more difficult
to get information sometimes, but that's a technical problem and I
don't think it's a particularly major issue.
Let's remember when we talk about hostile takeovers, the hostility is between the managements of the two organizations, not between the shareholders of either. In fact, the problem that exists is
that too often, in my judgment, the managements try to protect
themselves from, in effect, their own shareholders, who are essen

tially their bosses; and I don't think that it is appropriate for us to
try in any way to differentiate between so-called hostile and nonhostile takeovers.
I do think, however, that we should apply in all applications the
same scrutiny with respect to not only the issues you raised but
also capital and a number of other implications that could arise in
such mergers. But I would not, myself, draw any really significant
distinction between the particular merger of a financial institution
as hostile or otherwise.
Senator BOND. What do you see happening to the trade deficit
which we have all mentioned is too high, and are there any constructive steps that we might take to improve the situation?
Mr. GREENSPAN. I think that the trade deficit, as I have said in
my formal remarks, is expected to decline moderately, but because
of the nature of the data, the changes are likely to be erratic from
month to month. But I think we've turned the corner and the
trend is definitely down from everything we've seen. And I would
suspect that if we can increase the stability of the American economy, reduce the Federal deficit, and essentially create the type of
economic environment in which capital investment can take place
which can be used for export demand, I think that we will find ourselves in a position where the difficulties that we've had in our
trade accounts will pretty much be behind us.
Senator BOND. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Riegle.
TRADE DEFICIT

Senator RIEGLE. Mr. Chairman, I want to follow right on in that
vein if I may because when you make the comment to Senator
Bond that the trade deficit seems to be getting better this is official
Department of Commerce data and what it shows is our trade deficit through the end of 1986 is posted at a figure of about $160 billion, and as the monthly figures have come in through now all of
1987 expressed on an annualized basis, we actually had a larger
trade deficit, as I'm sure you know, in 1987 than we had in 1986.
Now one can argue, as perhaps the implication of your comment
was, that the last 2 months of data, the last of those which we just
got about 2 weeks ago, means that we've finally turned the corner.
I hope that's right, although I think if you look at the pattern of
the data over the year and the fact that the October data was the
worst in our history—$17.6 billion in 1 month—I really don't know
what you hang your hat on when you say we've turned the corner
on the trade situation.

U.S. MERCHANDISE TRADE DEFICIT
$ in Hillions

Annuallzed Rate
1987

7/ie trade deficit in 1986 was
greater than the total of all
the trade surpluses accumulated
since World War II.

1970

1972

197-1

1976

O f f i c e of Senator Donald W Riegle, Jr

1978 1980 1982 1984 1986

M A M

Source: Department of Commerce

U.S. MERCHANDISE TRADE BALANCE IS DETERIORATING
AT AN HISTORIC RATE

100

Tile trade deficit in 1987 was greater than the
total of all the trade surpluses accumulated
since World ttar II.

'.80

^969

1971

1973

of Senator Donald W. Kiegle. Jr.

1975

1977

1979

19B1

1983
Source:

1985

1987

Department of Commerce

I think the trade problem is a very serious one and I want to
pose a couple of questions about this, but I also want to go to the
balance sheet, and that is the accumulation of international debt
and the degree to which foreigners are going to continue to lend us
money to finance that trade deficit.
If you look at the balance sheet, again using Department of Commerce data, what I see here is a trend line that is without precedent and I really don't think it's being addressed and I want to get
into it not just in this round but hopefully in the second round.
What this chart shows [indicating] is that we became a debtor
nation in roughly 1984 for the first time since 1914. What is disturbing to me as I look at the trend line coming down through the
end of 1986 and now we've got the four quarterly figures posted for
1987, is that we are riding this debtor nation curve at the rate—as
I say, we're adding new international debt at the rate of roughly 1
billion dollars every 2V2 days.

FOR THE FIRST TIME SINCE 1914 THE U.S. IS A DEBTOR XATIOX
S in Billions

1987

<£>

Office of Senator Donald W. Riegle, Jr.

Ql Q2 Q3 Q4-

Source; Deportment of Commerce

TOTAL FEDERAL DEBT
Dollars in Trillions

0.5-4

1.5-

2.5J
1977

1978

1979

Office of Senator Donald W. Riegle, Jr.

I960

1981

1982

1983

198-i

1985

3986

1987

1988

Source:

Economic Report of the President

FEDERAL BUDGET DEFICIT
Dollars in Billions

156

200-

221
-250
1977

1978

1979

Office of Senator Donald W. Riegle, Jr.

I960

1081

1982

1983

1981

1985

1986

1987

19B8

Source:

Economic Report of the President

Now my question really is, can this go on indefinitely? Will foreigners continue to lend us the money to finance that huge trade
deficit? Will foreign banks and foreign nations in effect continue to
supply the credit that they are doing?
It seems to me that at some point we run a real risk that if they
should decide to draw back that we will see upward pressure on
interest rates and I'm very concerned about that because the unemployment rate in Michigan now for the last month has just gone
over 10 percent. We are at 10.2 percent. So this manufacturing recovery that you speak about is very uneven. If you look at Ford
Motor Co., right now they are doing very well. They've paid a large
profit sharing payment to their workers. General Motors are not
doing so well and paid nothing to their workers.
So I find the picture to be very mixed on the manufacturing side
in contrast to the rather upbeat things that you said.
My question really has two parts to it here for openers. No. 1,
how do we really anticipate that the rest of the world is going to be
able to suddenly take this huge new volume of U.S. exports, assuming that we are now somehow more competitive, and do we even
have the capacity to pump out huge additional amounts, but even
if we do, are they prepared to buy it in very large amounts, $50 to
$75 billion a year, if we're going to put much of a dent in that deficit?
No. 2, how much longer are foreigners willing to let us live on
their credit card? Is this a problem? Is it something that we just
take in stride, this change in national condition; or are we headed
in a direction that has some real dangers to it?
Mr. GREENSPAN. Senator, let me just first take a minute to go
back and say that our expectations about improving the trade deficit are not based on merely looking at the nominal data, but what
we are impressed with is what's happening to the physical volume
constituents of both imports and exports. When you look at that in
the context of domestic and export prices it gives us a fairly encouraging picture—erratic, but not one which I would find discouraging.
As I said on another occasion, I thought that that extraordinary
October figure was an aberration and not anything specific to a
trend; and as a consequence, I think that we have, hopefully, a
little more than just merely tracing the nominal trade figures to
give us some confidence that we have turned the corner.
The issue of how much in the way of increased exports we can
generate is an issue which clearly is a forecasting question. One of
the problems that we have in this country is that the level of our
exports is relatively low, especially relative to our imports, and
that we therefore have a considerable way to go on the upside. In
other words, we are not taking that much of a share of other countries imports and that is something which at this stage strikes me
as a real potential restraint.
The markets in countries to whom we export are likely to be
moderately better. The world economy is moving up moderately.
It's sluggish but still persists in moving ahead and we think that is
enough. We hope that there will be a significant turn in the ratio
of imports to domestic consumption. And there is another major

factor which I think, would contribute to the improvement in our
overall trade balance.
I would expand the issue you raised with respect to the question
of will foreigners continue to hold dollars. I would expand it not
only in terms of will they hold the increased claims from U.S. citizens, which is the financing number you're looking at, but also
would they be willing to continue to hold their huge block of dollardenominated securities in both the Euro and Asian currency markets, because in a sense it's one large block of funds.
What we have seen in the past is that the willingness on the part
of foreigners to hold dollars is very closely related to their sense of
soundness of our economic policies. And as best I can judge we
have the capacity to absorb—or rather to, in a sense, have foreigners absorb—still fairly substantial blocks of dollars provided their
presumption is that this is a good place to invest directly and indirectly.
I don't perceive there to be a significant problem out there provided we have, as I say, a stable economic environment. The difficulty arises should there be a perception that we are going in the
wrong direction. And should that happen, then I think there will
be an endeavor to shift out of dollars. That could cause the types of
problems which you suggest, Senator, which is all the more reason
why I think it is so important that we address the budget deficit
question and I think we are making progress with it. We should
not forget that with all the struggles that have occurred, progress
has been made, but a lot more is required to resolve the type of
question which I think you are raising.
Senator RIEGLE. I hope to follow up later, Mr. Chairman.
The CHAIRMAN. Thank you. And congratulations on the superb
charts.
Senator RIEGLE. Thank you.
The CHAIRMAN. Senator Shelby.
Senator SHELBY. Thank you, Mr. Chairman. I hope Senator
Riegle will pass that chart around because it is graphic and we will
all use it at some time.
The CHAIRMAN. It's very good.
Senator SHELBY. Chairman Greenspan, I want to follow up on
some of the areas that both Senator Bond and Senator Riegle were
getting into.
I think it's important, (1) as you point out, to do something about
our deficits that we are creating here in the Congress each year.
That's No. 1. But if we're going to have those deficits, which is not
desirable—if we're going to have those deficits, we should borrow
that money from our own people that's generated from savings in
this country rather than the Germans and the Japanese and other
blocks in the world because, as his chart points out, we are a big
debtor nation now and I worry about the problem down the road of
making policy; that sooner or later people in other countries will
have a hold of some kind in this country and will make some type
of policy. I'm not talking about monetary policy. I'm talking about
political policy and economic policy. Maybe they're already doing
this a little bit.

Does that bother you, the fact that we are in hock, so to speak, a
country with a gross national product like we have and one of the
most dismal savings rates in the world?
Mr. GREENSPAN. Well, it certainly does, Senator, and I think the
concern that I would have is what tends to occur in an economy
with fairly large external liabilities when we run into some difficulties, which we periodically do, as all economies do. It is certainly
the case that the behavior of the holders of our dollar denominated
assets will have a significant impact on what we do here and how
we evolve our own policies and what happens to us.
Senator SHELBY. Mr. Chairman, does that put us at risk some
when our debt is external?
Mr- GREENSPAN. Yes, it does. However, let me just comment that
it's our aggregate debt—the aggregate holdings of dollar-denominated securities, whether or not they are U.S. Treasury securities
and whether or not we finance our Federal deficit wholly internally or partly externally. The crucial issue is to what extent do we
have large external dollar liabilities?
We needn't go back very far in history to see the types of problems we can get. Remember Britain had a very serious problem at
the end of World War II with very large external sterling liabilities
which it gradually unwound. But during the process it was very obvious that those international obligations had a very significant
effect on domestic economics and politics of Britain.
Senator SHELBY. Mr. Chairman, do you think it's time we took
some legislative initiatives to encourage people in this country to
save more money? Have you looked at that?
Mr. GREENSPAN. Senator, I've been looking at that for many
years and I must say to you that I am somewhat discouraged. We
have had innumerable legislative initiatives. We have had many
changes in our tax code, the base for which was to try to increase
savings in this country.
While there is some dispute on the statistics, the way I read the
numbers suggests to me that we've had very little progress, that
while some IRA's and other types of tax saving gimmicks have exhibited very large increases, as best we can judge, they were
merely taken from some other pot of savings and the aggregate did
not increase substantially.
Senator SHELBY. The aggregate didn't change.
Mr. GREENSPAN. I think it's terribly important that we try to
find ways of doing this, but I must say to you, Senator, that it's
something which has been rather discouraging to economists who
over the years have been trying to find ways in which to do this.
What we do know, however, is that in order to increase savings
we've got to reduce consumption and that is difficult to do.
Senator SHELBY. My time is up.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
Dr. Greenspan, we are living in a time of enormous Federal
budget deficits. We are all aware of that. And there is apprehension I think on the part of economists across the board that the
economy could be moving into a slowdown if not this year certainly
next year. Indeed, that the economy could fall off into a recession
that could be fairly severe.

Now I think the great legacy of this administration is going to be
that it's deprived the Congress and the American people of the tool
we've used to deal with recessions and depressions since 1932, and
that is the tool of economic stimulus. In other words, if we fall off
into a recession in January or February of next year, we're simply
not going to have the ability with these enormous deficits to
engage in the economic stimulus that we have engaged in at other
times when we've gotten into a recession situation.
Given that scenario, it appears to me that the Federal Reserve is
going to be our last resort and that last resort is going to be in the
form I suppose of increasing money supply and lowering interest
rates.
FED'S ROLE AS TO RECESSIONARY ECONOMY

What do you view as the Fed's role here in an environment in
which the Congress and executive branch are deprived of our economic stimulus tool when we get into a recessionary economy?
What do you view the role of the Fed being in that situation and
do you agree with my assessment that we are deprived of that tool?
Mr. GREENSPAN. Well, Senator, I think this may come as somewhat of a surprise answer, but there's something different about
the current environment and I would be inclined to say at this
moment that stimulus coming from the budget side over the next
several years could very well be in the context, of reducing the deficit rather than expanding it.
The reason I say that is that however one reads the numbers, the
real rate of interest is higher in this country than it should be and
I would contend that the budget deficit is the primary cause of that
problem.
If we could reduce the real rate of interest—which the Federal
Reserve has very little capability of doing but can be done from the
fiscal side—I think we open up a whole layer of potential effective
demand in this country. So what I would suggest here is not that
we try to think in terms of reducing the deficit as a fine-tuning operation—I don't seriously believe you can do it in that context—but
I do believe that if we get the budget deficit down to a point where
real interest rates fall, then actions by the Federal Reserve can
become quite effective in endeavoring to forestall economic declines.
If we are forced to try to act in a market where real interest
rates are high because deficits are extraordinary, I think the ability of monetary policy to function in its historic role will be curtailed. And as a consequence of that, I urge the Congress to address
this question largely because the deficit itself limits what monetary
policy can do when it is required to do something important in restraining declines in economic activity.
I don't know whether this responds to your question effectively,
Senator.
Senator SASSER. Well, I think it is a good response, Dr. Greenspan, but I'm not quite sure that I fully understand it. I'd like to go
a little further.
Did I understand you to say on the front end that in seeking to
reduce interest rates or to bring real interest rates down that we

might want to engage in stimulus spending; that is, move more in
the Keynesian direction or the supply side direction?
Mr. GREENSPAN. I'm sorry, I thought I said reduce the deficit. In
other words, let me explain what I think is involved here.
At the moment, the budget deficit as best I can judge is causing
an increase in the real rate of interest which is preventing capital
investment from being at levels which I think it would otherwise
be and probably is acting as a depressant in housing as well—two
very major areas of our economy. In other words, overall effective
demand in this economy is significantly lower than it could be at
lower real interest rates.
So what I'm saying, Senator, is that if we can find a way over
the next several years to bring the budget deficit down in a permanent way, I think that that will, by reducing real interest rates,
create an environment of potentially greater effective demand. If
we do get a recession in that period—in two years or so or whatever then monetary policy could be particularly effective in fending
it off.
Senator SASSER, I agree with that. Dr. Greenspan, but the thrust
of my original question is how do you get from here to there. In
other words, you're talking about reducing the deficit down to the
point that real interest rates will follow it down, and I'm not prepared to disagree with you on that point; that if we did significantly reduce the deficit as a percentage of GNP, if we started financing this deficit hopefully more internally and less externally, we
would see real rates come down.
But the question is, if and when we fall off into a recession, the
deficit historically—and correct me if I'm wrong—almost always
comes close to doubling, how can we then react to the recession by
trying to come up with additional stimulation to the economy at
the Federal level?
Now if we fall off into a recession and the deficit get even worse,
we will be deprived of a stimulus tool because of the very large
deficits we have now. In fact, if we start playing the stimulus game
it appears to me we are going to be driving interest rates further
up because of the deficit.
Mr. GREENSPAN. I agree with that, I was agreeing with what
you're saying. What will be the Fed's role? I was just going to the
next step. I don't disagree that there's very severe limitations, and
I think it would be really counterproductive at almost any point to
try to consciously expand the deficit as a countercyclical policy.
Senator SASSER. My time has expired. I'd like to pursue this with
you further.
The CHAIRMAN. I want to pursue the deficit issue too. Mr. Chairman, your analysis is revealing and exciting if it is correct. Few
people in Congress believe that if you raise taxes and cut spending
you stimulate the economy through a drop in real interest rates. If
that were true, that would be marvelous. To sell that to the Congress and the country, would be a great achievement. Maybe we
can do it, but I don't think many people believe that now. It turns
Maynard Keynes on his head, doesn't it?
Mr. GREENSPAN. No, I don't think it does.

The CHAIRMAN. Ignoring the real interest rate, Keynes view was
that in recessions and depressions you have to do your best to stimulate the economy by running a deficit deliberately.
Mr. GREENSPAN. Well, Mr. Chairman, I don't think that this is
particularly a bizarre point of view. I think there are a large
number of economists who hold this view.
The CHAIRMAN. I didn't say it would be bizarre. It's exciting. It's
great.
Mr. GREENSPAN. Let me put it this way. It is certainly the case
that the evolution from Maynard Keynes' original notions in the
mid-1930's as it evolved in the post World War II period did have
much greater emphasis on expectations, especially inflationary expectations, and they become critical factors in the elements of how
the system works. I don't think the issue of real rates as they come
into the system were fully understood, largely because we never
had rates anywhere near as high as we have had in the last decade
or so.
The CHAIRMAN. This analysis has great appeal to me. I hope we
can implement it.
Turning to the Glass-Steagall reform bill for a moment, I understand that the Securities and Exchange Commission and the banking agencies recently agreed on a compromise proposal regarding
which securities activities may be conducted directly in a bank and
which activities should be conducted in an SEC registered subsidiary or affiliate.
Does the Federal Reserve Board fully support that proposal?
Mr. GREENSPAN. I have been over it and I personally support it.
We have not yet formally put it by the Board, but I have no reason
to believe that, having spoken with them individually, that there is
any dissent on that agreement.
The CHAIRMAN. That's very, very reassuring. It looks as if we
have on board the banking agencies, the SEC, as well as the administration, and that's extraordinarily helpful.
LOWER VALUE OF THE DOLLAR

We have been discussing what effect of the drop in the dollar
will have on our economy. I'm very concerned with what effect this
may have on the European economy, given great interdependence
of economies generally today. You have a situation now where I'm
told that the rate of unemployment in Western Europe is 11 percent. It's as high as 20 percent in Spain, 19 percent in Ireland, 9.5
percent in the strongest economy in Europe—the German economy. If we proceed with a policy which is very attractive to us of
letting the dollar go down so that we can export more, aren't we
running into a situation where we're going to be adversely affected
by a recession that could begin in Europe?
Mr. GREENSPAN. Well, first of all, I am not an advocate myself of
driving down the dollar to export more. I think it's a futile activity.
In the end it doesn't work because you drive up internal U.S. costs
and we will end up being noncompetitive because of rising internal
costs.
Japan clearly has had a remarkable capability of adjusting and
has shown very little evidence of any internal weakness as a conse

quence of the strength of the yen vis-a-vis other currencies, especially the dollar.
The CHAIRMAN. My time is up. Senator Riegle.
Senator RIEGLE. To follow along that line, if you look at the bilateral deficit with Japan for 1987 versus 1986, we've had basically no
improvement, despite the big shift in the value of the dollar versus
the yen and the notion that economists say that this will give us
the improvement, J curve effects and other things where suddenly
we will see a balance coming about. It didn't happen and it's not
going to happen.

U.S. TRADE WITH JAPAN, TAIWAN, AND KOREA ACCOUNTED FOR NEARLY
FIFTY PERCENT OF U.S. TRADE DEFICIT IN 1987
(Dollars in Billions)

100

120

140

160

180

1980

1981

1982
Japan
1983

Taiwan
Korea

1984

Others

1985

1986

1987

Office of Senator Donald W. Riegle, Jr.

Source: Department of Commerce

en
<£>

The thing that bothers me about the testimony today—and I'm a
great admirer of yours, as you know—is that it is very casual, very
relaxed, very business as usual, and I don't detect any sense of urgency, despite the trend lines, despite a lot of things that have been
said here today. When you talk about pumping out much higher
dollar amounts of U.S. exports and being able to sell them overseas, you've got to sell them somewhere. Somebody has to take
those goods. Central and South America can't take them because
they don't have any credit anymore, so they can't buy what they
would like to and therefore we can't sell it. With the unemployment rates in Western Europe that the chairman talks about,
they're not about to put more of their people out of work to take a
huge influx of American production. And out in the Pacific rim,
the Japanese are the masters on the globe at practicing that kind
of mercantile trade and they're not going to let the deficit come
down. They're taking $5 billion a month out of this economy.
That's what that $60 billion trade deficit does.
I want to show you one other chart that we just made overnight
so that we could have it here today for you to see. I was showing
you the trade deficit before. This is again all official Government
data. But this looks, Mr. Chairman, as well, that the buildup in our
Federal national debt just in the last few years—look at 1981, for
example. We were roughly at $1 trillion in national debt. By the
end of this year, we're going to be at $2.5 trillion. Now these are
big numbers. A trillion is a thousand billion. So we've left from
millions to billions to trillions.
But if you take that debt buildup and riding that debt accumulation line—and frankly this year's deficit which you didn't respond
to is worse than last year's deficit through the first 3 months—but
if you take that debt trend line and you imagine that one with this
one [indicating] because these two are really the foundation on
which the economy is performing—and so when you talk in a sense
as if we can just sort of work our way through this, I have really
not heard anything about how we deal with the magnitude of those
trend line shifts.

TOTAL FEDERAL DEBT
Dollars in Trillions

0.5-

1.5-

-2.5J
1977

1978

1979

Office of Senator Donald W. Hiegle. Jr.

1980

1981

1982

1983

198t

1985

1986

1987

Source; Economic Report of the President

To come back just to the international part of it, the notion of
going from this position internationally in 1982 as a creditor nation
[indicating] through the end of the fourth quarter—and this data
just came out and this data is our latest information—to go from
here to here in roughly a 5-year period of time is a breathtaking
change in national circumstance. And I think anything that suggests that we can keep riding this curve or somehow this curve is
changing magically—where is it changing? I mean, where is the
data that shows that it's changing either on this debt accumulattion chart or on the Federal budget deficit accumulation chart?

FEDERAL BUDGET DEFICIT
Dollars :n Billions

100-1

150-

156

200-

-250J
1977

1978

1979

Office of Senator Donald W. Rieglc, Jr.

1980

1981

1982

1983

1984

1985

1986

1987

1988

Source: Economic Heport of the President

I don't see it and what I see instead is the situation—and there's
a piece in this morning's Washington Post—I don't know if you
know this man, John Paulus, who is the managing director and
chief economist at Morgan Stanley—but he addresses this issue. He
says we're in for a very major shock coming here in terms of a scaling down—he describes it—that American citizens are going to
suffer an enormous loss of wealth because of the decline of the
dollar that accompanies the effective downgrading of American
means that prices of imported goods are going to go up and we're
going to have a hard time selling abroad. In any event, I'll put that
in the record. I don't know if you've had a chance to see it or not.

l-'rom the
Washington Post---Feb.

JotmD.Pbutus

24,

J988

America the Irresponsible
Recently, there has been much loose utk
abool America's borrowing abroad being a
reflection of the United SUM' attractiveness as an investment tot foreigners. Nothing could be lurthtT (ram the truth, given
the U.S. dollar's fall of more than 10
percent agalnat the lading currencies during the past three Bwolht and ill decline of
a far larger amouot in the put two yeara.
This depreciation in the U.S. currency,
especially when viewed againal the background of ihuply dimMuihed capital inflows
from private investors, coupled with increasing inflows from foreitji central banks
attempting to prop Dp the ffltthii dollar,
ptnpfe* that the United Staua a seen n a
riiky natm in which lo place funds.
TheaadfactiithetoverthepiMlS yam
America, in proving to be an unrelHbk master
of the global financial syiWm, ran squandered
a (realresource—mrndy.its frindwe w the
, premierfinancialponer in the world, toe best
HOB in Ihe market, so to spot, However,
thia Batten's fraicaj hegemony in promoting
a strong dolar had eaabted America to purchase forew) gooda cheaply and to attnct
capital from abroad at bargain rates.
IVve achieved the diibiOMdiatinction of
' 'Amending our name and, therefore, of
•wnpenlfeg our financial might, by punubf
UtattMary noottary pofcfea ta be IBTOa
and by implementiag In the 1980* a atimuhdv* bed policy, while other Mutrial
powen tightened (heir fiacal policies
(trough tax ioercaae* and nductnM in
tAKRiinenl attending. Indeed, the ttinmhttve U^. fiacal pokey hw been ao far out of
pn ... ..Mac* 1982 Hut it hiu
T IB MptMba of domeatk ipeDdI haa been M penoit greater than
.si Ottn MwtrU a«kn over the
ppt •« yttra. A* a CMMequence of these
Mtfe *id ^guided polkSafor the put
18 *att, QMOgW RM Ukn raore than 50
r*neot tfaM ON JapaneM yen ud nore

"America now must borrow roughly $150 billion per
year from foreigners to finance its bulge in household
spending."
than 30 percent apinat mod other major
currenciea during tils period.
The hteM eomple of U^. Bretpcnaibili17 ia Anerica'a severe omrconaumption
probtoffl, atemming from the diaparity in
fiacal policiea in the 1980*. A* * rbwlt of
ovenoMumptta, Anerka now m*t borrow roughly *1SO bjUon per year from
fonignera to finance ita bag* in houaehoM
apending which, acconling to my ealcukttion*. ii running about $150 billion above
its lonf-term trend. In other words, we u a
nation are borrowing from foreigners to
maintain a high level of consumption Hnce,
as it tintta out, the ahare of groaa national
product devoted to household apending
HKe 19W has been it. or clcoe to, a
pwt-World War II retort Ugh.
laodentatty, there b no truth to the
aaaerbon advanced by proponenta of the
view that foreign borrowing reflecU food
Ifcngc and tkat "•* capital fadowa have
baeo and to ma»i the V£. conuaHaaept
to capful apenaW On Uw contnry, the
ihue of CNP devoted to bualneaa find
•HttniHOt. at 11.8 percent in 1987, is
practictBy the nme aa H m in 1980. U
there wr woader that foreitn ceatral banla
have had to play an incraaamgly dominant
role in financing the United State*, supplynf M Mimited 75 percent of fordgn
capUal needed to stem be sbortfnJl in
•lonlfn trade In 1987, M private tamatora
around the worid throb their ooaee at us?
The baa of America's {rwchke aa the
worifi ftuncW leader h» throe maioi impicatena. Fto, the Uaked State* MM «urren-

deramBaaure of pofcy autonomy. Because of
the aiirfeaatniiofirreipnB»l)le economic pohdea ower the paat 16 yean, Bnancbl markeM
have taken a hanker view of certain American economic poidaa, which they regard as
aef-ontend. A* a mult, our sbflity to
Mndartaie aai independeDt courae without
pnUm coata hM dJowohcd.
Saooad. AMcican citijens wi auffer «n
•Bomaw km o( wafch. Thededkie in the
dabr HM aceompaniM the efltoive downvadnf of America meana that pricea of
imported foods, which now account for »
Htki man than 10 percent of domestic
apendng, vril have to raw. In fact, from
cvmt tavda every 10 peroant drop la the
datar «« add *bout ISO bHon to Annka's
a«cat bal not >at for oae JPMT hot fcr every
mr la tha fabn. Moreover, tm vmatt Wat
M eroded hecwae America wl have to payj
•no lo bpnov abruaa n ordor to ooriMien
•ate kntera bt lote*r*« h * Mea MgeL
It i»M &4tcM to tay Out tie ttmU M
Ik* MotS good name In fimMUcMn
cokld neaa c&tt Ameiican* wK haiw to f«y
•pward cftlOO hMon eSraper *BK to
knport and nreJgB buiuvuf coata, a
aumeven In Waahingion.

Third, there U a risk that the American
government Witt be forced by the electorate
to adopt economic poboe* favoring even
more conamption in a vain attempt to re*ore the tat wealth and 10 boost the lagging
Mtndard of |vk«. Sock (Aorta, of courae,
wadd hi bMMte they would dtacnnae the
prinuryaowte of Health inaaUnert, aired
capkaL In the process, however, theaetAteti
could came further havoc in the struggle to
ehmiHte the trade deficit.
The world will surriv* without the United State*1 serving alone aa the linchpin of
the global financial system, a role thit most
likely will have to be shared by a reluctant
Japan, a hesitant Germany and a chastened
United States. Moreover, it is powiMe that
global economic growth could actually accelerate during the next decade if the
movement toward reduced government inwlvement in economic affairs continues
and if tbe revolution in high technology
cornea to fruition. Nevertheless, rt will be a
leu hoapttiUe ptec* for America.
Sanity * Co.

Senator RIEGLE. But you really haven't said much today that
deals with those trend lines. So the only thing I'm left to conclude
is you're really not very concerned about them, at least not to the
point of saying that there has to be some heightened sense of urgency to do some set of policy adjustments and steps to do something about them because right now we're on automatic pilot. The
administration is on its way out the door. They have no intention
to change the policy mix. The fix is in on the budget. All those stories have been written to sort of take it on through the next year.
And these are the curves we're riding and I think you ought to
be speaking out about it, quite frankly.
Mr. GREENSPAN. Well, let me come to grips with a few of the
problems. First of all, as I said before, I'm very much concerned
about the issue of the Federal budget deficit.
I would just want to point out there is a technical problem on
the 3 month over 3 month Federal deficit comparison. My recollection is that a Social Security payment that's usually paid in the beginning of January was paid in December, so it snowed up in the
first 3 months of the fiscal year and when we see the 4 months
through January we don't see that big jump.
Nonetheless, I do think it is correct to presume that there will be
some modest increase under existing forecasts of the Federal deficit
for fiscal 1988 over fiscal 1987 and I think that is unacceptable
myself.
On the issue of the debt question that you're raising, Senator, I
think we have to get the current account deficit down because it's
basically the accumulation of the current account deficit which is
engendering that net debtor position that you're showing on your
chart.
There are very few ways in which that can be done. Fundamentally, we have to reduce our demand for imports and that almost
invariably means domestic consumption has got to slow and,
indeed, it is slowing. We have made progress in that respect.
Second, exports have to rise and, indeed, they have been rising
very significantly. I realize that it is difficult to see how in the
world we can get 15 percent increases in physical volume for exports or even any double digit number for a while and have it absorbed in the world economy. But it is true that the aggregate ratio
of exports in the world to GNP is still rising. In other words, the
market for goods over national boundaries is moving faster than
domestic increases in demand.
As a consequence of that, when we put a rising forecast in any of
our models, we are required to ask where is it going and from
whom is it being taken, and we are not at a point where the capacity of American exporters to ship abroad on an increasing trend is
as yet running into any trouble of the type that you're mentioning.
So all I can say, Senator, is that it is absolutely essential that we
continue on the path of trying to make our external adjustments as
quickly as possible to forestall the types of problems that you raise.
If I seem to you to be unconcerned, it's only because we have
looked at it in great detail. We know what the dangers are. We
know what the nature of the problem is. I think it is an issue of
concern, but I think it's far more important for us to focus on how
we solve these problems. And I think at the moment we are on the

road to solving them. I would like to see it done much more quickly. I sincerely trust that we don't try to do it through some quickfix type of program which is very easy for the Congress to react to
in frustration. I think that could be very counterproductive and in
fact not create the solution to the problem. I have a great deal of
sympathy with your concern because I am concerned as well.
Senator RIEGLE. But we haven't suffered, I might say, Mr. Chairman, from any quick fixes, as these charts show. I think we've suffered from sort of a no-fix problem and I have heard an awful lot of
esteemed economists—and you are certainly among the highest in
that rank—keep saying it's all working out, the J curve is taking
effect and this thing is going to level itself out and so forth.
I think you have an obligation to bring some data in here that
shows that and if you can't demonstrate it, I think we're at a point
where we need some far more rapid action. And that means we
need a far blunter assessment of where we are and adjustments in
policy rather than just stay on automatic pilot for another 12 to 18
months here and somehow hope that everything is going to correct
itself.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
HOUSING STARTS

Dr. Greenspan, housing starts for January were at an annual
level of 1.4 million units, which, as I'm sure you know, is the
lowest level in 5 years.
This follows a very low level for December as well, and additionally, building permits for January declined by 6.9 percent and
building permits are considered to be the most reliable indicator of
future housing starts.
Now my question is, what are your expectations for housing
starts in the year ahead? And I ask that question in this context.
The housing industry has traditionally been on the leading edge of
the business cycle either up or down and I'd like to know whether
you think it's leading us up or leading us down.
Mr. GREENSPAN. Well, Senator, I think the December and January figures were a bit of an aberration. We always have trouble
with those months—and February as well—because the seasonal
adjustment factors which we use are very low, largely because of
the usual poor weather in the north which makes construction difficult. And while it's very difficult to prove, the implication is that
the numbers in December and especially in January were statistically low, meaning that that's not the way the market really was.
Moreover, there is some evidence from homebuilders during the
month of February of some quickening in the pace of sales of existing homes and some renewed interest in home buying as a result of
the decline in mortgage interest rates. To be sure, we don't have
the data yet and the month is scarcely over, but there seems to be
a somewhat better tone to the market and we would expect that
starts will be climbing in the spring and into the summer months.
Senator SASSER. So you don't see that as an ominous sign, that
these housing starts are at the lowest level in 5 years?

Mr. GREENSPAN. No. I must say I was surprised at both the December and January figures. I did not expect them to go that low.
But having evaluated the data, I'm not particularly concerned that
it was a trend that should worry us.
Senator SASSER. Dr. Greenspan, I serve on the Senate Budget
Committee and am aware of this conflict between the Congressional Budget Office and OMB as to basic economic assumptions. Traditionally—at least in recent years—the OMB assumptions have
been overly rosy—when compared with the average of economic
predictions. I have more confidence in CBO's numbers, but it's been
suggested that the Federal Reserve ought to be the final arbiter between CBO and OMB as to what should be the genuine economic
assumptions to be used in formulating the budget.
What say you to that, Dr. Greenspan?
Mr. GREENSPAN. We thank you for your confidence. However, we
would have a technical problem which rests on the difficulty that
we would have in forecasting interest rates, because there is no
useful budget forecast—whether by CBO or OMB—which does not
embody in it their view of where they think interest rates are
going. Largely because they do not have an influence on where interest rates are going, that is not a particular problem. But because
the Federal Reserve by its nature is involved and has considerable
influence on interest rates, it is very difficult for us to make forecasts without creating market instabilities. So that if we were out
there to arbitrate between CBO and OMB, we would have to make
judgments about their interest rate forecasts.
Senator SASSER. But the beauty of that is you could make your
assumptions come true.
Mr. GREENSPAN. No, I'm afraid it wouldn't because the irony of
this exercise is that, if we were to forecast interest rates, the
chances are the markets would create an environment which
would probably make our forecast wrong. It's a very difficult situation to be in, but it does preclude our capability of adjudicating between OMB and CBO in an effective way.
Senator SASSER. Well, I see my time has expired again. Thank
you.
The CHAIRMAN. Mr. Chairman, many people feel that anybody
who runs for President these days is crazy because in the beginning of 1989 we're bound to have terrible economic problems and
probably a very deep recession and maybe the first depression since
the 1930's. If that happens, you could well be right in the middle of
it. Some people argue that there's not much Congress or the President can do once we move into a very deep recession or depression.
What can the Federal Reserve do? They say we should have
learned lessons from what the Federal Reserve did wrong in the
early 1930's when it decreased the money supply and followed very
conservative policies. Is there much that the Federal Reserve
Board could do in the next crisis or would you be just pushing on a
string, as former Chairman Martin used to say?
Mr. GREENSPAN. The problem that I have in answering the question, Mr. Chairman, is that there are so many different types of
severe economic contractions, all of which have differing characteristics with respect to inflation, with respect to financial stress, with
respect to bankruptcies and the like, that you can't really general

69
ize in advance on what type of policy the Fed would pursue under
those adverse conditions.
My impression is that, should that hypothetical event ever occur,
I think it would be terribly important for us to be very clear on
trying to understand precisely why it occurred and what the particular internal structure of the economy was doing because unless
we addressed—as far as our policies were concerned—the specific
form of problem that confronted us at that time, we probably could
very readily provide the wrong remedy, as indeed was done, in my
judgment, in the late 1920's and the early 1930's.
So without actually being there and seeing in detail what that
structure looks like, I don't think I can effectively answer that
question.
The CHAIRMAN. Do you have confidence that the Federal Reserve
could substantially ameliorate and improve the situation if we
went into a recession?
MONEY SUPPLY

Mr. GREENSPAN. I would certainly hope so.
The CHAIRMAN. To get back to the issue that I raised in my opening statement, last year the Fed unilaterally dropped the target
range for Ml. Now you come before the committee and widen the
range for M2 and M3 and don't have any target range for Ml.
This Senator very much disapproves of the range that we have.
When Chairman Burns came before the committee, I argued with
him at great length and pleaded for a single figure not a range.
You not only give us a range but you widen the range. The range is
now so wide that if you follow the low money growth policy and
come in with a 4-percent increase, given the rate of inflation, it's
quite conservative; and if you go to the 8 percent, it's very stimulative. So the range you give does not tell us anything about what
your objective really is.
Do you agree?
Mr. GREENSPAN. Well, Mr. Chairman, let's take a step back to
what these ranges are for and why we want to adhere to them.
Our basic goal in monetary policy, as I see it, is to maximize
long-term sustainable economic growth and employment in this
economy. And as a necessary condition of that, we perceive the
need to maintain a non-inflationary environment.
What history has told us is that money and prices in the very
long run are tied together. They may not be in the short run, but
over the very long run they are.
What we have observed in history is that if we can maintain
some relatively stable set of relationships between money and
income we can maintain a stable economy and stable growth and
achieve long-term monetary policy objectives.
It is important, however, to recognize that the objective is longterm sustainable economic growth and not the proxy, which is the
monetary aggregate which we are endeavoring to use as a means—
as an instrument to obtain our goal of much broader long-term economic growth.
In the 1980's we began to see that the tie between money as we
measured it—the specific proxies, the Mi's, the M2's, the M3's—

and real economic growth began to loosen. What we felt necessary
to do was to loosen the tie to money because we might follow the
proxy, the instrument to achieve our goal, and succeed, but fail in
our goal.
The best example occurred in recent years. In recent years, economic growth has been relatively stable. It has not been as high as
I think we would like to have seen it obviously, but not bad. The
money supply, however, has fluctuated all over the place. Had we
endeavored in 1986 and 1987 and even in 1985, for example, to stabilize money, we would have probably temporarily distabilized our
economy.
I think that this condition is temporary. I think it's a function of
the whole period of changing markets, deregulation, the tremendous extraordinary changes in telecommunications, and the whole
structure of the financial system. But I think we're adjusting.
Since I firmly believe that money matters, we will at some point
find that the monetary aggregates are again tracking very closely
with income. At that point it would be wholly appropriate and I
think mandatory for us to narrow the target ranges very considerably. We would argue that that is inappropriate at present because
we think there are special factors such that strict adherence to
money—the instrument of policy—would create difficulties in attaining our goal, which is stable, long-term economic growth.
The CHAIRMAN. Then I take it you would object strongly if we
were to change the law and require you to report a range of no
more than 3 percent. In other words, instead of 4 to 8, it would be
narrower—5 to 8 or 4 to 7, for example. You would prefer to wait
until you get the kind of resolution you're talking about, is that
right?
Mr. GREENSPAN. I would certainly think so, Mr. Chairman. I
think that it would not be appropriate for the Congress to do that.
The CHAIRMAN. Since you ve discarded Ml, suppose we were to
ask you then to give us a target rate for the monetary base?
Mr. GREENSPAN, Well, strangely enough, we have been discussing
the issue of the monetary base as a target amongst ourselves.
The problem is that it has many of the characteristics of Ml and
the reason it does is that the monetary base very crudely reflects
currency in circulation plus commercial bank reserves. And since
Ml essentially reflects currency in circulation and demand deposits
and other transaction deposits, the only difference between the
monetary base and Ml is reserve requirements on the transaction
balances which are roughly 12 percent and the fact that there are
excess reserves in our total reserve base.
So what I'm saying is that the actual arithmetic shows that the
monetary base, especially in the current environment, and Ml are
very closely related with respect to their targeting characteristics.
And my impression is that when Ml comes back into usable targeting range, so will the monetary base, but I doubt that the monetary base itself will be effectively usable until Ml is also usable.

The CHAIRMAN. I want to follow up on that but my time is up.
Senator Chafee.
Senator CHAFEE. I don't have any questions. Like everybody else,
I've got these terrible conflicts, Mr. Chairman, so I am not able to
stay. I apologize for just dropping by but I wanted to look at Mr.
Greenspan's statement. Thank you very much for coming up, Mr.
Greenspan.
[The complete prepared statement of Senator Chafee follows:]

72
SPFFCH RY
SFHATflR JOHH H. CHAFFE

in
SFHATF RAMKIHfi CnMMITTF.F
FEDERAL RF.SFRVF MONETARY POLICY REPORT
(FEBRUARY ?H
MR. C H A I R M A N . 1 A*I PLEASED TO W F L C O M E C H A I R M A N G R E E N S P A N
BEFORE THE COMMITTEE THIS MORNING.
THE ROLE OF THE F E D E R A L R E S E R V F HAS BECOME I N C R E A S I N G L Y
IMPORTANT Iti THE L a S T DECAFF AND W I L L BF C R U C I A L IN THE YEARS TO
COME. T H I S IS TRUE FOR TWO R E A S O N S F I R S T , THE SCALE AND SCOPE OF M O N E T A R Y POLICY HAVE RROADFNF.n
G R E A T L Y , DI1_E TO THE R I I R G E O N I N f i I N T E R N A T I O N A L SECTOR, E S P E C I A L L Y
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THE FEDERAL R E S E R V E CAN NO LONGER M E R E L Y C O N C E N T R A T E ON H E L P I N G TO
C R E A T E A LOW

INFLATIONARY

PATH TO R F A L E C O N O M I C GROWTH - IT MOW M U S T

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73
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AMERICA'S ECONOMIC

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HELP AMERICA ACHIEVE GREATER I N T E R N A T I O N A L C O M P E T I T I V E N E S S .
I W I S H YOU WELL IN THFSE E N D E A V O R S .

The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Mr. Chairman, I just want to touch on something that you developed earlier that we kind of went by in a
hurry but I think ought to be touched on just for a moment and
then I want to go into a different area myself.
FISCAL STIMULUS VERSUS MONETARY STIMULUS

When you engaged in that colliquy on the question of fiscal stimulus versus monetary stimulus and real interest rates and so forth,
in effect, what I understood you to say was your interpretation of
what Dr. Greenspan is saying is that if you could somehow get consumption down, maybe have higher taxes that led to lower real interest rates, that you could actually get an expansion of the economy and that you might in fact be able to make supply side economics work with lower interest rates and, in a sense, monetary stimulus rather than this reliance we've seen over such a long period of
time on just fiscal stimulus.
If in fact anybody wants to advance that theory, I think that becomes a very interesting concept to look at, and that is that if
you're stuck with very high real interest rates that may be the
thing that's limiting your growth at this point, a real spurt in
growth, more than anything else.
I heard Dr. Greenspan in effect say some of that today and I
would be very interested myself in finding a way through this set
of problems to lower real interest rates. I think that really is the
key to the kind of surge that we have to make, not just by itself
because we've got to jack up savings rates and we've got to get the
investment going into things that improve productivity and capital
formation—but lower real interest rates, it seems to me, would give
us the biggest single economic surge that we could get out of the
sort of monetary-fiscal policy mix, and that has not been discussed,
has not been focused, but I think your observation hit on that
today and I think it does open up a different way to look at this
problem.
I want to raise one other thing with you related to that and test
it a little bit. What would happen right now, Dr. Greenspan, if the
Fed acted to try to bring interest rates down? Let's say the Fed
were to meet and decide that it should try under the current situation to bring interest rates down, say, a full percentage point by
means of using all of the internal mechanisms that the Fed has
available to it with money supply and so forth?
I assume that you would feel that you can't just arbitrarily push
interest rates down, say, a full percentage point because you decide
you want to do it or a percentage point and a half, but I'd like you
to address that.
If real interest rates are high, what really limits the Fed right
now from embarking on a strategy that would force those interest
rates down more abruptly, and if you tried to do that, what would
be the problems that we might encounter?
Mr. GREENSPAN. Well, let me first emphasize we're discussing a
hypothetical case.
Senator RIEGLE. I understand.

Mr. GREENSPAN. You have problems if monetary policy endeavors to move in a manner which the markets are working against—
and this would be true whether or not you try to lower rates or
raise them. Take the case in which, let's say, we forced the funds
rate down by 1 or 2 percentage points, which we could do. What
would happen if the market were not prepared for that and in fact
felt that was an inappropriate rate? Money supply would rise very
sharply, inflation expectations would jump immediately, long-term
interest rates—rather than following the short-term Federal funds
rates down—would go up, and we would find ourselves in a situation in which inflation would likely be taking hold and we would
get a tremendously disruptive economy.
This similar exercise would be occurring on the opposite side if
interest rates were raised 1 or 2 percentage points against trends
that were developing in the markets.
This is the reason why we say it is so important to coordinate
policies and in effect to set interrelationships to get the type of
result we desire.
Senator RIEGLE. May I pursue this just for 1 minute?
The CHAIRMAN. Yes.
Senator RIEGLE. A lot of people go back and they look at the
market break on October 19 and 20, and they point to a lot of
things that seem to have built up to create the change in psychology and the very sharp plunge in the market, the greatest crash in
percentage terms that we'd ever had before. I find very persuasive
the argument that says that the interest rate spike on long interest
rates that occurred as the market was approaching on October 19,
that that sudden rise in long-term rates and the very high priceearnings ratios that we had in the stock market and the widening
out of the gap between the interest rate spread versus in a sense
the multiples that the market was supplying created a tremendous
amount of stress. If that were right, that would in a sense support
the kind of an argument that you're making and that is that if interest rates suddenly shoot up because of inflationary expectations
or because there's the perception that the Fed is flooding money in
to the system unwisely and interest rates go up, you can start to
see a lot of shuddering and shaking in the capital structure. I think
we've just seen an example of it. We might see it again.
The reason 1 pose the question—and it relates to what the chairman has been saying and others of us have been saying today—and
that is, I get the sense that the Fed doesn't have an awful lot of
maneuvering room right now and, despite your adeptness in terms
of managing our way through the market crash and assuming that
job as you have over the last several months, that the operating
range of the Fed to go very far one way or the other isn't very
great and the Fed is quite hemmed in and the Fed is really quite
hemmed in because of these charts that I was describing earlier.
We've had a buildup of circumstance over a long period of time
that I think is taking your maneuvering room down to a dangerously small margin, in my view. Those are my words. I don't try to
put those words into your mouth. But I am very uncomfortable
that the maneuvering room on monetary policy has been reduced
to such a small level and it worries me because it goes back to the
earlier discussion—we've played the fiscal policy strategy—I think

the Government has gone wild in that area, and now we're to the
point where we've got to balance that back the other way, move in
the direction of finding how we push real interest rates down so we
can get an authentic surge into our basic economy, but it seems to
me we're very much out of position. You and I may have a difference of opinion there because I have not heard a very persuasive
case made today that says that all we really have to do is just
enjoy this nice smooth transition that we're in the process of
making. I don't see that happening and I think we need an active
set of policy adjustments and that we need somebody like yourself
speaking to that problem if that's so, and that if we talk ourselves
into the notion that we can go on automatic pilot for the next 12 to
18 months because we've got an administration leaving after 8
years and a new administration coming in in the early part of
1989, that that would be a very serious miscalculation, although I
think that's what's happening.
I think that the view is now let's not rock the boat. Let's just
ride it on through and hope for the best, although privately in the
cloakroom, as the chairman will say, everybody says whoever the
next President is going to be, he's going to have a very tough job at
that time because a lot of these problems are just being postponed.
I don't know if we can find a way to make some policy adjustments during this year but we should try and I want to try and I
will work with you and anybody else that's willing to work to try
to find a different mix to give us more maneuvering room and get
us out of this I think box canyon that we've gotten into.
Thank you, Mr. Chairman.
ECONOMIC REPORT BY PRESIDENT CRITICIZES THE FED

The CHAIRMAN. Mr. Chairman, the economic report the President published a couple of weeks ago holds the Fed policy in the
months before the stock market crash partly responsible for the
market's precipitous decline.
Do you agree or disagree?
Mr. GREENSPAN. I disagree, Mr. Chairman.
The CHAIRMAN. Why?
Mr. GREENSPAN. I think that what we were looking at at the
time—and I would say I subscribe to Senator Riegle's view about
the effective interest rates at that time—we were confronted then
by a worldwide rise in interest rates, which struck me as essentially reflecting a flight from currencies generally. It was an extraordinary period.
What essentially was driving the yield-spread differentials was
the 30-year Treasury bond yield, which I must say we had great
difficulty understanding on a day-by- day basis at that time. I made
a very extensive analysis and had many discussions with my colleagues at various central banks around the world and a number of
economist friends of mine, and I must say to you I never really
fully understood—at least to my satisfaction—precisely what the
driving forces for that worldwide rise in interest rates were.
In my judgment, the Fed could have done very little to prevent
that from happening at that time.

The CHAIRMAN. Certainly on any kind of a basis, any kind of experience, the market was selling at 23 times earnings—this is extraordinarily high, regardless of the level of interest rates or the
pattern of interest rates.
Mr. GREENSPAN. Yes, I would agree with that, Mr. Chairman.
What I'm saying is that even if that last surge in long-term rates
did not occur, I think the market would have topped out and come
down anyway because it had reached levels which in historic terms
usually signaled some form of top.
So I find it difficult to perceive how actions by the Federal Reserve were a material factor in the market when, as best I can
judge, there were so many other issues which would have driven
the market down in any event. In other words, no matter what we
did, in my judgment, the market probably would have come down
at some point and probably in much the same way it did. And if
one can say that, then it's very difficult to say that we had a material effect on it.
The CHAIRMAN. Let me ask one final question. You said that Ml
and the monetary base are closely related. Furthermore, you say
that Ml was unstable in the 1980's and should not be a target. You
implied that the monetary base should not be a target.
Wasn't the instability in Ml related to the interest-sensitivity to
deposits such as NOW accounts which are not included in the monetary base and to the fact that reserves and/or currency become
very unstable in the 1980's?
Mr. GREENSPAN. Well, in effect, Mr. Chairman, the interest sensitivity that affects demand deposits affects total required reserves
obviously, because to the extent that we have required reserves for
demand deposits they are in the total reserve number and, therefore, in the total monetary base.
So while it is true that it is somewhat less sensitive than Ml, it
nonetheless captures most of the problem, largely because the volatility in transaction deposits as a consequence of interest sensitivity
causes a virtually fixed relationship between required reserves for
transaction deposits. What we find is that we mirror that instability in Ml in the required reserves part of the monetary base.
The CHAIRMAN. But you can control required reserves. You can
control the monetary base.
Mr. GREENSPAN. Sure, we can. I'm saying that. Nonetheless, it
would create the same degree of problem that would occur were we
to try to control Ml. I don't deny that if we were absolutely forced
to that we could get Ml to stay within a specific narrow range. My
concern, however, is that there are occasions when trying to do
that would destabilize the economy.
The CHAIRMAN. That's exactly right. I think that perhaps there's
a misunderstanding at least between you and me on what these
target ranges mean. I don't think a target range means you have to
meet it. I don't think that your success or failure depends upon
whether you meet the range. I don't think that should ever be the
case. You certainly should have flexibility. You have to have it.
What we want to know is, at the beginning of a period, what you
feel should be the policy and then, of course, as conditions change,
if you have to modify it then you can explain why.

So I would hope that you would consider that monetary base suggestion as a possibility. Thank you.
Senator RIEGLE. Could I ask just one more question, Mr. Chairman?
The CHAIRMAN. Certainly.
FOREIGN INVESTMENT

Senator RIEGLE. I don't know if you saw Malcolm Forbes' editorial in an issue a few weeks ago to the effect of him expressing a
great concern about foreign investment in the United States, about
these recycled dollars, money that used to be ours now belongs to
somebody else, coming back in and picking off strategic assets of
various kinds, as apart from coming in and building a manufacturing plant and so forth.
Mr. GREENSPAN. Was he saying strategic in a national security
sense?
Senator RIEGLE. Well, that would have been part of it, the question of whether they were coming in and picking off a high technology company or an electronics company or somebody who's defense
sensitive, but also financial services. The point he was making was
broader than just that and it addressed real estate and other
things.
Do you have any concern at all about this money coming back in
in terms of this increasing foreign investment of that kind in the
United States?
Mr. GREENSPAN. No, with the sole exception of national security
secrets, which is a different category. What's happening is that
we're shifting ownership from American to foreign. The corporation remains American, it remains under our laws. It is subject to
the same taxes. It is subject to all the other considerations that an
American-owned organization would have. So in that sense, I'm not
concerned about the form of the ownership.
I think, strangely enough, there is a difference as far as these
policies are concerned between whether the ownership is in real
terms—that is owning real estate or a company—and owned in
liquid-asset terms. The liquid-asset holding that is the external liability of financial claims raises a number of the issues that you
raise with respect to our policies and our financial instability. But
once those monies are committed to real assets, they are no longer
that liquid and capable of being shifted around. And provided that
the owners adhere to the laws of this land, these are creators of
jobs and these are creators of prosperity.
Remember that the United States was a major investor in Western Europe after World War II and, in my judgment, those vast investments were a major factor engendering the extraordinary recovery in Europe. We created jobs. We created technology. We created standards of living there, and I don't think we should look
askance at others investing here. I mean free trade, in my judgment, the movement of goods and services, enhances everybody's
standard of living and the free movement of capital does the same
for much the same reasons.

Senator RIEGLE. Well, Malcolm Forbes, who I would think probably describes himself as a raving capitalist and is a real believer
Mr. GREENSPAN. He's a good friend of mine.
Senator RIEGLE. I know he is and when somebody like that, as
opposed to a Felix Rohatyn or Robert Rice, speaks out because they
are concerned about it, I think it's a significant piece of data and
I've heard this from a lot of other people who would share Malcolm
Forbes' general vantage point who are now concerned about this
from the point of view where they see other implications to it; that
if you've got mercantilist nations that are very predatory in their
trading practices and you can document that, who are loaded with
dollars and they come in and pick off choice assets, not just the
people who design the black boxes for the Defense Department but
other strategic industries—high technology, computer chip type industries and so forth—that gives them a degree of operational control in this country that's quite different than we have perhaps
seen before and sometimes they can shut down certain things. If
you're looking at a worldwide marketing scheme and a worldwide
business scheme, the degree to which you do or don't produce part
of that output in the United States is part of a much larger corporate multinational strategy and very often a nationalistic strategy—what's good for the people who are domiciled in another country.
I think this is now an issue that we need to look at very carefully. I think Malcolm Forbes is not just seeing shadows on the wall
here. I think this issue is now one we'd better take a look at because of the charts I was describing earlier. We've put so much of
our wealth, if you will, in other hands. We've gone from being a
creditor to a debtor. We've exchanged equity capital for consumer
goods and now the other person has taken title to the equity and
they're lending it back to us in a debt form, and we're in an entirely different posture than we were before.
And I don't think it is the same old story that we've seen in the
Marshall Plan days. I wish it were. But I would like to urge the
Fed to take a look at that and see if the view that some major
people in the private sector are beginning to express apprehension
about this has something more to it that we'd better understand
while we still have some chance to do something about it.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you very, very much, Chairman Greenspan, for a superlative performance. We're in your debt.
Mr. GREENSPAN. Thank you very much.
The CHAIRMAN. The committee stands adjourned.
[Whereupon, at 12:05 p.m., the hearing was adjourned.]
[Response to written questions of Senators Proxmire, Sasser, and
Sanford follow:]

80
Chairman Greenspan's Responses to Written Questions from
Chairman Proxmire in Connection with the Bearing Held on
February 24, 1988
Question 1.

In your written testimony, on page 6, you

state:
"Indeed, indications of some softening in the economy
as the year began, against a backdrop of a more stable
dollar in foreign exchange markets, led us to take a
further small easing step a few weeks ago."
Some will insinuate that the Fed's ease was
acquiescence to pressure from the Reagan Administration rather
than good policy. To clear the record would you please give us
a precise description of the economic factors that were the most
prominent influence in your decision to pase? What indications
of softening in the economy did you see?
Answer:

As you know, the decline in the stock market

and buildup in business inventories last fall were key causes
for some, concern about weakness in the economy in the first part
of 1988.

In addition, monetary growth was weak in the latter

part of 1987.
During January, the incoming news gave some indications
that, indeed, we might be moving toward a narked slowdown in
production growth.

Among the indicators were a substantial jump

in initial claims for unemployment compensation and weak figures
for housing activity.

Fears of possible recession were re-

flected in a good many private forecasts, and this kind of
thinking obviously carried risks of a self-fulfilling prophecy
if business decisionmafcer.1? became too gloomy.
Meanwhile, inflationary pressures seemed to be in
check, with favorable near-term prospects for energy prices in
particular.

In addition, the dollar was exhibiting greater

stability on exchange markets; the weakness in the dollar in the
latter part of 1987 had militated against a greater adjustment
in System policy to compensate for the risks to the economy
associated with financial fragility in the aftermath of the
stock market break. Under the circumstances prevailing in early
1988, we felt it appropriate to move to reduce modestly further
the pressures on the reserve positions of depository
institutions.

Question 2. Many including myself are concerned by the
growth of debt in our economy. Debt to GNP ratios for all
classes of borrowers have risen to very dangerous levels.
Doesn't this limit the ability of the Federal Reserve to contract credit without causing widespread default on credit
obligations? In the 1980's the ex-post real interest rate has
exceeded the real GNP growth rate on average. Doesn't this
imply that the debt to GNP ratio must rise?
Answer;

We do need to be concerned, in general, that

the highly levered positions of many businesses and households
might make them more vulnerable to adverse economic or financial
developments.

So, I share your concern about this pattern of

developments over the course of the 7980s.

There were some

hopeful signs in the deceleration of debt growth last year, and
I would hope to see that trend continue.
Your observations about the arithmetic of interest
rates and GNP growth is correct up to a point, but it abstracts
from all considerations other than interest payments on the
debt.

Consider, for example, the case of the federal government

alone:

If the interest rate were above the GNP growth rate and

the current primary deficit (that is, the total deficit, less
interest payments net of the taxes paid on that interest) were
zero or positive, your formula would tell us correctly that the
government debt to the GNP ratio would rise; however, if there
were a sufficiently large primary surplus, the ratio could be
stable or declining.

Question 3. There appear to be two schools of thought
on exchange rate policy. The first group says let the dollar
fall and fall a lot in a hurry. Then investors will clamor to
buy dollars and U.S. interest rates will actually decline. This
school claims that if we let the currency decline a great deal
the expectation will be that it can only rise. They point to
the experience of devaluations during the fixed exchange rate
period when the rule of thumb was if you are going to do it
don't undershoot.
The second school believes that a gradual managed
decline of the dollar is necessary because in a floating exchange rate world expectations are unstable and a rapid fall in
the dollar would create the expectation continue depreciation
leading to high interest rates and an exchange rate collapse.
It appears to me that a key question in exchange rate
management is how actions today affect expectations of exchange
rate changes in the future. Do you agree? Which of these
schools of thought has the story right? Why is the right one
right and the wrong one wrong?
Answer;

The comparison between a devaluation under a

fixed exchange rate regime and a depreciation under a floating
rate regime is not a simple one.

In a fixed exchange rate

regime, the monetary authorities of a country declare a discrete
change in the currency's parity (and intervention limits).
Under the Bretton Woods regime, where parity changes were very
infrequent, it can fairly be stated that the rule of thumb was
to make sure that the change was large enough to avoid a widespread expectation that a further change would be needed soon.
Even so, parity changes by major industrial countries rarely
were as large as 15 percent.

Within the European Monetary

System (EMS), where parity changes are more frequent, the
changes have been smaller, generally 5 percent or less.

And the

operative rule of EMS devaluations in the 1980s has been to
"underdo it" so as to maintain an anti-inflation pressure on
economic policy in the higher inflation countries.

Under both

Bretton Woods and the EMS, parity changes required the agreement
or acquiescence of the other members of the regime.

Under

neither system could monetary and fiscal policy among the partners move drastically out of line so as to build up enormous
external balances; macroeconoraic policy was constrained by the
agreement to maintain fixed exchange rates.
Under the floating rate regime enormous imbalances were
allowed to build up in the 1980s since there was no prior agreement to focus economic policy mainly on the exchange rate.

1985 an international consensus had been reached that the dollar's exchange value was too high, but there was no agreement on
how much too high.

Nor is there any consensus now on the

dollar's long-run equilibrium value.

The purpose of the

February 1987 Louvre Accord and the reaffirritation in December
1987 was to give the U.S. and foreign economies time to adjust
to the cumulative substantial depreciation of the dollar that
had already occurred, while recognizing the uncertainties of
where the dollar's long-run equilibrium value may lie.
The Federal Reserve's concern over a precipitous dollar
decline has not been that the dollar would fall to zero under
the influence of extrapolative expectations, but that a huge

decline over a very short period could disrupt financial markets
generally and would certainly subject the economy to severe
inflationary pressures in an environment in which still large
budget deficits are making substantial net claims on our
resources.
The economic function of the dollar's depreciation has
been to induce expenditure switching from foreign to U.S. output
so as to adjust an unsustainable current account deficit.

But

in the context of an economy near full employment, this means
that domestic absorption has to be restrained by macroeconomic
policy to make room for the increase in export demand if we are
not to incur an acceleration of inflation.
In a context of slow reductions of the budget deficit
to slow domestic spending, the faster the current account adjustment iSjthe greater the burden on monetary policy to curtail
private domestic spending.

Indeed, a precipitous fall in the

dollar and a very rapid adjustment of our current account
deficit would require a draconian monetary tightening to reduce
private spending if we were to contain total demands on the
economy's resources.

Question 4. Real interest rates have been unusually
high in the U.S.in recent years. Arc real interest rates in
the U.S. higher than in those countries with which it competes
internationally? What are the causes of high real interest
rates in the U.S.? Do you foresee real interest rates declining
in the near future? What changes in public policy would help to
lower real rates of interest?
Answer;

Real interest rates are defined as the

difference between nominal interest rates and expected inflation.

Because expected inflation cannot be measured directly,

neither can real interest rates.

T_f real rates are calculated

assuming that expected inflation can be adequately represented
by actual inflation over the immediate past, rates in the United
States now are well within the range of values for major industrialized countries.

These rates are considerably higher than

in the late 1970s, when their very low level contributed to
rising inflation.

But they are lower than earlier in the 1980s,

when restrictive monetary policy was needed to bring down inflation and fiscal policy was unusually expansionary.
Lowering real rates further probably would require that
the United States generate additional savings internally to meet
our investment needs, rather than depending on foreign capital
inflows.

The most direct and dependable approach to this would

be to lower the federal budget deficit.

Although some reduction

in the budget deficit has been achieved, the deficit remains
quite large considering the prolonged expansion of the economy.

Further reductions in the deficit, by increasing national savings, would provide downward pressures on real rates and encourage rrmch-needed capital formation.

Question 5. In 1987 the Federal Reserve Board appeared
to tighten monetary policy several times to arrest the decline
in the exchange value of the dollar. The Fed's monetary base
growth decelerated in February, May-June, and in AugustSeptember before the stock market collapse. In each of those
time periods the dollar was skittish. Why not just let the
dollar decline and pursue a steadier course with monetary
growth? Wouldn't letting the dollar fall further cause a fall
in our huge trade deficit by reducing U.S. imports, and promoting our exports?
Answer;

In the spring and the late summer of 1987, it

was widely perceived--by the Federal Reserve and the market-that inflationary expectations were increasing, partially in
response to the dollar's weak performance.

With the economy

expanding at rates sufficient to produce rising rates of resource utilization, the FOMC sought some firming of pressures on
reserve positions and the discount rate was raised in September.
It is critical that the risk of inflation be controlled
and that resources be available in our economy to accommodate a
shift In demand toward net exports.

Otherwise, a further de-

cline in the dollar's value would be counterproductive.

would not help significantly to reduce our external imbalance,
but it would tend to weaken foreign growth and to exacerbate
inflationary pressures in the United States.

88
-10-

Question 6. Privately many people are suggesting that
the U.S. economy is going to be put into a severe recession by
policymakers in 1989 just after the Presidential election. Some
suggest that this is the only way to reduce the trade deficit.
Does the Federal Reserve intend to contribute to putting the
economy into a recession in 1989 by tightening money after the
election? Are there not some very adverse consequences associated with a prolonged recession given the condition of Latin
American debtors, farmers, banks, S&Ls and businesses with such
high levels of debt? Does not that limit the extent of a recession that policymakers could tolerate before easing up to alleviate these maladies? Is not further exchange rate depreciation
the alternative to reducing absorption by inducing a recession?
Why not encourage continued growth and let the dollar fall
rather than force the economy into recession?
Answer:

The Federal Reserve does not view a recession

as being necessary to reduce the trade deficit or as being
desirable in any way.

Indeed, the real trade deficit has been

shrinking steadily since the third quarter of 1986, albeit from
an extraordinary

size, over a period when the U.S. economy has

been expanding at a quite satisfactory pace.

The turnaround in

trade was one of the princip.il contributors to U.S. economic
grovth in 1987.
We are optimistic that the balance of trade will
continue to improve in 1988 and beyond.

The effects of the drop

in the dollar's value that began in 1985 do not appear, as yet,
to be fully reflected in the terms of trade or, consequently, in
imports and exports, but these effects should continue to unfold
in coning months.
The process of international adjustment is a
challenging one.

Achieving a better external balance without

increasing inflationary pressures will require a restrained pace
of expansion of domestic demands.

Surh restraint could best be

obtained by limiting federal spending and the budget deficit,
which would increase our savings and put downward pressures on
interest rates, helping to sustain capital formation.

This

would be entirely consistent with continued expansion in our
economv.

90
-12-

Question 7. Over the last decade economists' estimates
of the so-called non-accelerating inflation rate of unemployment
(NAIRU) have varied considerably. Large changes in demographic
factors and sectorial dislocation may have provided good reason
for these varying estimates over time. In recent months the
estimates have been declining. What is your estimate of NAIRU
for today and for the near future? Do you believe that the
current declines in the unemployment rate imply that inflation
will accelerate? Could not the presence of foreign competition
increase the discipline of wage demands in light of the possibility of losing business to competitors offshore? Have not
real wages in the United States been falling in recent years?
Ts this the result of the influence of foreign competition?
Answer:

It should be kept in mind that the concept of

the NAIRU is open to question; it is typically identified with a
particular formulation of wage determination (the
"expectations-augmented Phillips curve"), which may not capture
all significant aspects of behavior.

Even within that general

analytical framework, empirical estimates of the NAIRU vary
considerably among researchers.

It is fair to say that most

analysts believe that the NAIRU has teen declining in recent
years.
It is my assessment that we probably have not yet
reached the level of unemployment--of general labor market
tightness — that will spell a significant increase in real wage
inflation.

One factor in this is, as you suggest, the awareness

on the parts of labor and business that the competitive realities of the domestic and international marketplace will not
permit cost increases to be passed through readily to prices.
In effect, last year's decline in real wages is consistent with
the painful fact that the reversal of the earlier runup in the

foreign exchange value of the dollar implies a deterioration in
terms of trade, which must be inevitably reflected in our
purchasing power.

Question 8. Governor Johnson, in a speech at the Cato
Institute in February, suggested that the Federal Reserve is now
watching three new indicators in setting monetary policy: 1)
the term structure of interest rates; 2) the exchange value of
the dollar; 3} the price of commodities.
Please discuss what variations in each of these
individual indicators would imply about economic developments
and how monetary policy would be used to respond to the signals
sent by the indicators.
Answer;

Exchange rates, commodity prices, and the

spread between long- and short-term interest rates are just
three of the many financial and nonfinancial indicators used by
the Federal Reserve to assess where the economy is headed and
the effects of monetary policy.

They have been among the im-

portant types of information the Federal Reserve has been
looking at for some time, but as confidence in the relationship
of the money supply to the economy has eroded in recent years,
many policymakers have been paying greater attention to other
indicators — including the three cited.

Interpreted together and

with information provided by other variables, the three indicators help in the assessment of whether an adjustment of policy
is needed to achieve ultimate objectives for employment and
prices.
Changes in these variables can reflect shifts in
supply/demand balances in our economy and market expectations
about prices and activity — important information for monetary
policy formulation.

For example, a widening of the yield

93
-15-/6"

spread, a fall in exchange rates, and rising commodity prices
could signal the potential for a stronger economy and
potentially a pickup in inflation.

A narrowing in the yield

spread, a stronger dollar, and weakness in commodity prices
could indicate the potential for a slowing in economic activity
and possibly disinflation or deflation.

How policy might react

to these signals would depend on whether the trends were confirmed by other information and whether they were considered
unfavorable to the economy.

For example, indication of greater

strength expected in the economy would be viewed quite differently in a recession then if the economy were near full
employment and in.-'lation a more immediate threat.
The need for looking at a number of indicators together
arises from the possibility that any one of them may be subject
tn a variety of influences that could result in inappropriate
policy signals.

Commodity prices, for example, can reflect

developments in particular markets and represent only a small
component of overall business costs; the exchange rate is influenced by developments overseas as well as in the United
States; and the yield curve is influenced by expectations about
Federal Reserve policy and shifting valuations of liquidity, as
well as the outlook for the economy and prices.

Even so, all

three of these, when used with care, can convey to the policymaker important information about market expectations and supply
and demand conditions not only in the narrow markets in which
they are determined but in the overall economy as well.

Question 9. In your testimony you suggested that the
monetary base had been considered as a target for monetary
policy in light of the decision to drop Ml targets in the report
to Congress. You also suggested that it was not desirable to
target the monetary base.
(a) Please provide the Committee with a history of the
velocity of the monetary base from 1960 to January
of 1988. How does the variability of base velocity
compare with the variability of the velocity of Ml?
(b) Please provide the Committee with data on the
variability of the components of the monetary base
from 1975 to the present. How does the variability
of these components compare with the variability of
components of Ml that are not included in the
monetary base?
(c) Why do you oppose establishing the monetary base as
a target in lieu of the Ml target that was discarded last year?
Answer:

(a) As you know, the monetary base consists of

the monetary liabilities of the Federal Reserve and the
Treasury.

There are two publicly available measures of rhe

monetary base, one constructed by the Board and the other by the
Federal Reserve Bank of St. Louis, with differences between the
two measures reflecting mainly alternative treatments of vault
cash.

The discussions below focus on the base measure con-

structed by the Board, after adjustments for changes in reserve
requirements and seasonality.

As measured by the Board, the

base is the sum of total reserves (adjusted for changes in
reserve requirements), the currency component of the money
stock, and a small residual item equal to the surplus vault cash
of depository institutions — that is, vault cash in excess of
reserve requirements.

Table 1 presents quarterly velocity data for the
monetary base and Ml for the period 1960:Q1 through 1987:Q4,
both in levels and in growth rates.

Since velocity is calcu-

lated as the ratio of GNP to money, velocity data are available
only on a quarterly basis — the frequency at which GNP is
measured.
Statistics summarizing the variability of base and Kl
velocity (measured as the standard deviation of velocity growth
rates) are shown in Table 2 for the period 1960:Q1
1987:Q4, and for subperiods of this interval.

through

The table indi-

cates that over the 1960s and 1970s the variability of base
velocity and variability of Ml velocity were about the same, but
that over the 1980s the variability of Ml velocity nearly
doubled while that of base velocity rose by considerably less,
leading to a substantial increase in the variability of Ml
velocity relative to that of the base.
The greater variability of Ml velocity compared with
base velocity over the 1980s reflects two factors:

(1) that the

currency component of Ml accounts for a much greater share of
the base (roughly three-quarters) than of Ml (about onequarter), and (2) that most of the increased variability in Ml
velocity in the 1980s, relative to the 1960s and 1970s, can be
traced to components of Ml other than currency.

As shown in

Table 3, the variability of the velocity of transaction deposits

96
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in 111 (the sum of demand deposits and other checkable deposits),
which account for about three-quarters of Ml, increased sharply
in the 1980s.

In large part, this heightened volatility re-

flected greater fluctuations in interest rates as well as the
nationwide authorization of NOW accounts and other financial
deregulation that increased the sensitivity of this component to
movements in interest rates and to shifts in the portfolio
preferences of the public.

In contrast, the variability of

currency velocity was little changed in the 1980s compared to
earlier periods.

The increased variability in transactions

deposits is reflected in greater variability of the reserve
components of the base.

But the greater share of currency and

smaller share related to deposits in the base has tended to damp
the increase in the variability of base velocity relative to
that of Ml.
(b) Table 4 summarizes the variability of base and Ml
growth rates, and the variability of components of these aggregates, for the period 1975rQl through 1987:Q4 and for subperiods
of this interval.

The table indicates that quarterly growth

rates of the base tend to be appreciably less variable than
those of Ml.

This relationship reflects mainly the large share

of the base accounted for by currency, which tends to grow more
smoothly than transaction deposits.

97
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(c) The Federal Reserve does not necessarily oppose
establishing growth targets for the monetary base.
is currently being considered within the System.

This issue

We are at-

tempting to evaluate whether the establishment of such targets
would enhance the Federal Reserve's ability to achieve its
policy goals or our ability to convey our policy intentions to
the public.

This involves questions about the value of the base

as a forerunner of economic developments and whether its movements add to the information already in the broad aggregates.
In large part, the base is closely related to Ml, with different
weights on the various components.

The heavy weight given to

currency in the base significantly affects its characteristics
as a policy target.

For one, as noted above, its velocity is

considerably less variable than that of Ml.

A second charac-

teristic, however, arises from the policy of the Federal
Reserve, since its founding, to accommodate the public's demand
for currency.

Targeting the base together with accommodating

currency demand would imply that, if demands for currency were
weak or strong, offsetting increases or decreases in reserves
might be needed, leading to multiple expansion or contraction of
deposits; this could have important effects on interest rates.
In any event, regardless of whether it is deemed advisable at
some future date to establish monetary base growth targets, it
seems likely that monetary policy would need to remain flexible

and that movements in all the monetary aggregates would still
need to be evaluated within the broader context of other information about developments in the economy and in financial
markets.

99
Table 1
Selected Velocity Measures

Monetary Base

Period

Velocity

Growth Rate
of Velocity
(annual! zed
percentaae)

1960:Q1
1960:Q2
1960:Q3
1960:Q4

3.689
3.685
3.674
3.642

1961:Q1
1961:Q2
1961:Q3
1961:Q4

3.655
3.702
3.754

1962:Q1
1962:Q2
1962:Q3
1962:Q4

3.875
3.902
3.954
3.956

6.8

1963:Q1
1963:Q2
1963:Q3
1963:Q4

3.979
3.996
4.040
4.060

2.3
1.8

1964:Q1
1964:Q2
1964:Q3
1964:Q4

4.130
4.157
4.156
4.132

6.9
2.7

1965:Q1
1965:Q2
1965:Q3
1965:Q4

4.238
4.289
4.336
4.386

10.3

1966:Q1
1966:Q2
1966:Q3
1966:Q4

4.446
4.455
4.546

5.5
0.6
8.2

4.609

5.6

1967:Q1
1967:Q2
1967:Q3
1967:Q4

4.615

0.5

4.587
4.583
4.5B7

-2.4
-0.4
0.4

3.810

12.1
-0.4
-1.2
-3.5

1.5,.
5.1
5.7
6.0

2.8
5.4

0.2

4.4
2.0

-0.1
-2.3
4.8
4.3
4.6

Velocity

Growth Rate
of Velocity
(annual! zed
percentage)

11.966
11.931
11.964
11.834

11.8
-1.2
1.1
-4.4

11.940
12.192
12.354
12.491

3.6
8.4
5.3
4.4

12.711
12.778
12.867
12.850

7.0
2.1
2.8
-0.5

12.918
12.960
13.070
13.114

2.1
1.3
3.4
1.3

13.273
13.297
13.301
13.222

4.9
0.7
0.1
-2.4

13.535
13.642
13.767
13.960

9.5
3.2
3.7
5.6

14.187
14.195
14.300
14.469

6.5
0.2
3.0
4.7

14.418
14.354
14.433
14.443

-1.4
-l.fl
2.2
0.3

100
Table 1 (continued)
Selected Velocity Measures

Monetary Baae
Growth Rate

Ml
Growth Rate
of Velocity
(annual!zed
percentage)

of Velocity
Period

Velocity

(annual! zed
percentage)

1968:Q1
1968:Q2
1968:Q3
1968:Q4

4 .666
4 .715

1969:Q1
1969:Q2
1969:Q3
1969:Q4

.720
.754
.831
4 .832

1970:Q1
1970:Q2
1970:Q3
1970:Q4

4 .831
4 .669
4 .695
4 .624

-0.1

1971:Q1
1971:Q2
1971:Q3
1971:Q4

4 .945
4 .931
4 .935
4 .947

10.1
-1.2

1972:Q1
1972:Q2
1972:Q3
1972:Q4

6.9
4.2
-0.2
-2.5

6.3

14.672
14.855
14.858
14.816

5.0
0.1
-1.1

14.996
15.073
15.244
15.114

4.8
2.0
4.6
-3.4

15.115
15.106
15.144
14.928

0.0
-0.2
1.0
-5.7

0.3
1.0

15.276
15.258
15.219
15.252

9.3
-0.5
-1.0
0.9

5 .020
5 .071
5 .079
5 .117

5.8
4.1
0.6
3.0

15.504
15.614
15.716
15.817

6.6
2.6
2.6
2.6

1973:Q1
1973:Q2
1973:Q3
1973:Q4

5 .207
5 .270
5 .312
5 .414

7.1
4.8
3.2
7.7

16.022
16.122
16.131
16.292

5.2
2.5
0.2
4.0

1974:Q1
1974:Q2
1974:Q3
1974:Q4

5 .373
5 .448
5 .510
5 .545

-3.0

16.102
16.068
16.078
16.154

-4.7
-0.8
0.2
1.9

1975:Q1
1975:Q2
1975:Q3
1975:Q4

5 .540
5 .599
5 .719
5 .850

-0.4

16.035
16.181
16.546
16.S03

-2.9
3.6
9.0
6.2

.712
.683

3.2r.
2.9
6.5
0.1
3.1
2.2

-5.8

5.6
4.5
2.5
4.3
8.6
9.?

101
Table 1 (continued)
Selected Velocity Measures

Period

Monetary Base
Growth Rate
of Velocity
(annualized
percentage)
Velocity

Growth Rate
of Velocity
(annualized
percentage)

5.6

1976:Q1
1976:Q2
1976:Q3
1976:Q4

5.953
5.964

e.on

7.1
0.7
3.1

6.058

3.2

17.040
16.979
17.038
17.174

1977:Q1
1977:Q2
1977:Q3
1977:Q4

6.097
6.211
6.301
6.261

2.6,.
7.5
5.8
-2.5

17.362
17.658
17.822
17.727

3.7
-2.1

1978:Q1
1978:Q2
1978:Q3
1978:Q4

6.288
6.498
6.537
6.643

1.7
13.3
2.4

17.698
18.307
18.390
18.643

-0.7
13.8
1.8
5.5

1979:Q1
1979:Q2
1979:Q3
1979:Q4

6.711
6.738
6.702
6.748

4.1

18.754
18.867
18.942
18.811

2.4
2.4

1.6
-2.8

1980:Q1
1980:Q2
19BO:Q3
1980:Q4

6.886
6.990
0.819
6.902

19.000
18.658
18.739
19.090

4.0
-7.2
1.7
7.5

1981:Q1
1981:Q2
1981:Q3
1981:Q4

7.179

19.752
19.689
19.963
19.876

13.9
-1.3
5.6

1982:Q1
1982:Q2
1982:Q3
1982:Q4

7.039
7.109
7.005
6.608

19.497
19.478
19.254
19.049

-7.6
-0.4
-4.6
-4.3

1983:Q1
1983:Q2
1983:Q3
1983:Q4

6.756
6.770
6.727
6.818

18.917
19.012
19.063
19.251

-2.8
2.0
1.1
3.9

7.149
7.224
7.171

6.4

1.6
-2.1
2.7
8.2

6.0
-9.8
4.9

16.0
-1.6
4.2
-2.9

-7.4
4.0

-5.9
-11.3
-3.1
0.9
-2.5
5.4

-1.4
1.4

3.2
4.4

6.8

-1.8

102
Table 1 (continued)
Selected Velocity Measures

Monetary

Base

Growth Rate
of Velocity
(annualized
percentage)

Growth Rate

of Velocity
Period

Velocity

(annualized
percentage?

1984:Q1
1984:Q2
1984:Q3
1984:Q4

6.961
7.000
7.020
7.035

B.4
2.3
1.1
0.9

19.447
19.503
19.444
19.412

1.2
-1.2
-0.7

1985 :Q1
1985:Q2
1985 :Q3
1985:Q4

6.980
6.898
6.774
6.694

-3.1
-4.7'
-7.2

19.368
19.262
19.132
19.007

-0.9
-2.2
-2.7
-2.6

1966:Q1
1986:Q2
1986:Q3
1986:Q4

6.658
6.465
6.277
6.049

16.971
18.716
18.488
18.094

-0.8
-5.4
-4.9
-8.5

19B7:Q1
1987 :Q2
1987:Q3
1987:Q4

5.976
5.971
6.065
6.112

17.974
17.942
18.030
18.001

-2.7
-0.7
2.0
-0.6

-4.7
-2.1
-11.6
-11.6
-14.6
-4.7
-0.5

6.3
3.1

4.1

1. Board of Governors concept. This measure is seasonally adjusted and
adjusted for regulatory changes in reserve requirements.

Table 2

Variability in Quarterly Growth Rates of Selected Velocity Measures
(percent, annual rates)

Standard Deviation of Growth Rates
Period
1960:Q1-1987:Q4

Monetary Base
Velocity

4.2

1960:Q1-1969:Q4

HI
Velocity
5.2
3.6

1970:Q1-1979:Q4

3.9

3.8

1980:Q1-1987:Q4

4.6

7.0

Table 3

Variability in Quarterly Growth Rates of Selected Velocity Measures
(percent, annual rates)

Standard Deviation of Growth Rates
Monetary
Base

Currency Component
of Ml

1960:Q1-1987:Q4

4 .2

4 .0

1960:Q1-1969:Q4

3,.5

1970:Q1-1979:Q4
1980:Q1-1987:Q4

Period

Memo:
Transaction Deposits
in Ml

Residual
Item

Memo:
Ml

6,.9

30.2

5..2

6..1

3,.3

6,.1

29.7

3..6

3..9

4..1

5,.2

26.4

3..8

4. 1

4,,6

4..1

7, 7

33.5

6. 9

8. 6

Total
Reserves

1. The residual item is surplus vault cash of depository institutions less that part of the vault cash holdings of
thrift institutions that is already included in the currency component of Ml. Although growth rates of the
residual and its velocity are quite volatile, the absolute level of the residual is relatively small, about $3
billion currently compared with about $260 billion for the entire monetary base.
2. Sum of demand deposits and other checkable deposits.

o
CO

Table 4

Variability in Quarterly Growth Rates of Selected Monetary and Reserves Aggregates
(percent, annual rates)

Standard Deviation of Growth Rates
Monetary
Base

Currency Component
of Ml

1975:Q1-1987:Q4

1.7

1.5

1975:Q1-1979:Q4

1.4

1980:Q1-198T:Q4

1.9

Interval

Total
Reserves

Memo:
Transaction_Deposits
in Ml

Residual
Item

Memo:
Ml

6.3

27.6

4.7

6.3

0.9

3.9

15.7

2.5

3.3

1.6

6.5

31.9

5.5

7.5

1. The residual item is surplus vault cash of depository institutions less that part of the vault cash holdings of
thrift institutions that is already included in the currency component of* Ml. Although growth rates of the
residual and its velocity are quite volatile, the absolute level of the residual is relatively small, about $3
billion currently compared with about $260 billion for the entire monetary base.
2. Sum of demand deposits and other checkable deposits.

105

Question 10. A recent Federal Reserve press release
(for the FOMC meeting of December 15-16, 1987, page 10) referred
to "fiscal, monetary, and trade policies by the United States
and its major trading partners" that are appropriate to the
realignment of the U.S. economy called for by the "unsustainable
size of the current trade deficit and the rapid growth in the
nation's external indebtedness." GNP data show that real exports have grown recently more quickly than consumption.
What further changes in the U.S. economy do you believe
necessary to deal with the problem of the trade deficit? What
fiscal and monetary policies do you consider desirable to promote the realignment? What actions would we like the U.S.'
trading partners to take to further the necessary adjustments in
the U.S. and the world economies?
Answer:

We have a long way to go in restoring our

external position to a sustainable posture.

It will require

continued effort to enhance the efficiency of our productive
processes and the quality of our goods, and continued restraint
on prices.

Monetary and fiscal policies in the United States

must be aimed at noninflationary growth of aggregate activity,
which likely will entail a considerably slower increase of consumer spending than we saw earlier in the present economic
expansion—so that resources will be available to support gains
in net exports.

Our trading partners, in contrast, must work to

ensure adequate, growth of domestic demand in their economies.

106
-23-24--

Question H. In the Wall Street Journal for Tuesday,
February 23", Edouard Balladur, the finance minister of France,
referred to the "anarchy of floating exchange rates" during the
past 15 years. Several well-known analysts now recommend that
the international financial system needs reform. Others disagree .
In the Fed's estimation, how urgent is reform of the
international financial system?
Answer:

Calls for reforming the international monetary

system stem primarily from dissatisfaction with the wide swings
in exchange rates that have occurred in recent years.

However,

the complexities of negotiating a new international monetary
system would be immense.

The issue of reforming the interna-

tional monetary system has been studied repeatedly over the past
20 years in various international fora, and no political, conceptual, and operational consensus has emerged about the need
and manner of restructuring the international monetary system.
In practice, modifications in selected aspects of the
international monetary system are likely to evolve through
pragmatic adjustments in current arrangements.

In recent years,

policymakers in the major economies have concluded that there is
no substitute for sound, compatible, non-inflationary policies
by all major countries on a sustained basis as the most promising way to achieve and maintain greater exchange rate stability.
Ongoing efforts to strengthen the process of international
policy coordination, as evidenced by the Louvre statement of
February 1987 and the G-7 statement of last December, are
directed at reinforcing this pragmatic approach to achieving
greater exchange rate stability.

107

Question 12. Many financial firms, particularly those
in Texas and other energy producing and agricultural states, are
currently undergoing trauma. Their survival is threatened.
Do you consider that the resources of the FDIC and
FSLIC funds are adequate to deal with the problems of these
institutions? What do you believe is the correct public policy
to deal with this situation?
Answer:

Many thrift institutions and commercial banks

have run into serious difficulty over the current decade, resulting in substantial losses to the federal deposit insurance
funds.

The problems of the thrifts have been particularly acute

relative to t.he resources of the Federal Savings and Loan
Insurance Corporation (FSLIC).
The large number of troubled thrift institutions,
principally in Texas and California, has put a particularly
severe strain on the resources of the FSLIC.

Given the added

resources to be obtained from the recent recapitalization of the
insurance fund and the continued inflow of insurance premiums
from insured institutions, the FSLIC now appears to have sufficient funds to permit it to begin to address many of the more
serious problems in the industry.

The FSLIC will undoubtedly

require a further injection of capital to complete the process
of resolving the problems in the thrift industry.
As for the Federal Deposit Insurance Corporation
(FDIC), it, too, has incurred substantial costs in resolving the

108

-7.6-

problems of troubled commercial banks—most recently, in particular, in the State of Texas.
ever, it managed

In the case of the FDIC, how-

to build up its insurance fund over the early

part of the decade and thus, given the current level of the fund
and prospects for a continued inflow of insurance premiums from
commercial banks, it appears that it remains strong and will
have sufficient resources to resolve existing and new problems
that may arise in the industry.

FDIC Chairman William Seidman

has stated recently that the insurance fund remains healthy and
is more than adequate to address the problems he foresees this
year.
The FDIC and the FSI.IC were established by the Congress
for the express purpose of dealing with insolvent commercial
banks and thrifts.

As a matter of public policy, it would seem

appropriate to continue to address problems in the thrift and
commercial banking industry through the auspices of their
offices .

109
Chairman Greenspan's Responses to Written Questions from
Senator Sasser in Connection with the Hearing Held on
February 24, 1988
Question 1. We have seen an extraordinary decline in
the value ofthe dollar over the past year. In previous times,
such declines in our currency value have been accompanied by
rises in prices, in inflation generally. Imported goods become
nore expensive and at the same time it gives a window to
domestic producers to increase prices also.
Why haven't we seen dramatic increases in import prices
and resulting inflation? Are foreign suppliers being cautious
about increasing prices — trying to preserve their market shares?
Answer:

There are basically two phenomena working to

Unit the rise in import prices following the sharp declines in
the dollar.

First, production costs for foreign exporters have

tended to decline, in terms of their own currencies, as prices
of imported raw materials and intermediate goods have declined
and as domestic prices and wages have been quite stable.
Second, as you suggest, foreign exporters have been reluctant to
allow their prices in the United States to rise by the full
amount of the dollar's decline.

In an attempt to preserve their

market position as much as possible, they have preferred to see
an erosion of their profit margins, which had been built up
substantially over the period of the dollar's rise from 1980 to

1985.

110

Question 2. As you know, the central bankers of the
major western countries have developed a plan to raise the capital of banks dealing in international markets. By 1992, banks
would have to have minimum capital of 8 percent of assets, of
which 4 percent would have to be common equity and disclosed
reserves. This is obviously a very good idea—capital is the
best cushion against loss and the best protector of the safety
and soundness of the banking system that there is.
Well 1992 is only five years away and there are a great
many of our banks that are pretty far away from meeting this
standard. Will they make it?
The recent GAO study on the repeal of the
Glass-Pteagall Act says that bank holding companies that are
undercapitalized have incentives to take risks that could
threaten the insured bank. "Our work has shown that solvent
thrifts with capital below 3% of assets tend to undertake more
risky activities than do their well-capitalized peers." Indeed,
the GAO is worried that the shakiest banks might be the first to
take advantage of the repeal of Glass-Steagall.
Do you agree that capital is the best firewall? I
understand that under the Chairman's bill, S. 1886, a bank
holding company has to have excess capital to have a securities
affiliate. Wouldn't it nake sense to set the capital level even
higher if banks get into the securities business, would it nake
sense to speed up the implementation of this international capital agreement? If we tied securities powers to bank capital it
would be an incentive for banks to get their capital up, don't
you think?
Answer:

Most regional and community institutions

already meet or exceed the proposed capital standards by a comfortable margin—both the interim ratios specified for 1990 and
the somewhat higher ratios targeted for 1992 and beyond--and so
do more than half of the large multinationals.

Some of the

organizations that will have to increase their capital ratios to
meet the standards may find that difficult to do but we believe
that, by concerted effort, most, if not all, will be able to
accomplish that end over the specified phape-in period.

Ill

With regard to undercapitalized banks being the first
to take advantage of the repeal of Glass-Steagall, that is not a
reasonable concern,

S. 1886 specifies that bank holding com-

panies will be permitted to engage in securities activities, not
previously authorized for banks, in a newly established nonbank
subsidiary only after obtaining the approval of the Federal
Reserve Board.

And, the Act prohibits the Board from granting

such approval to banking organizations that do not have sufficient resources to adequately capitalize the securities
affiliate and, at the same time, meet the capital standards set
down for banking organizations.

The bill also provides that a

member or nonmember bank, whether it is owned by a bank holding
company or independently operated, may not be affiliated with a
company that engages in securities underwriting activities except as provided under the new securities affiliate provisions
of S. 1886 or to the extent permitted by statute for national
banks.
As for the appropriate capitalization of banking
organizations that wish to own a securities affiliate, it is
important to keep in mind, in addressing that question, key
provisions of S. 1886.

Certain provisions, referred to above,

require that a banking organization wishing to own a securities
affiliate must be able to capitalize it in accordance with

112

standards set down for securities firms and also meet the capital standards for banking organizations, without counting the
capital invested in the affiliate.

Other provisions (that

establish a so-called firewall) prohibit insured depositories in
a holding company from lending to or investing in the securities
affiliate and place other restrictions on transactions and
arrangements between the securities affiliate and other elements
of the holding company.

The purpose of all these provisions is

to protect insured depositories of holding companies from losses
occurring at their securities affiliate and to gain assurance
that a bank holding company will be able to serve as a source of
strength for its banks and other insured depositories.
Because of the requirements for separate accounting for
capital in the securities affiliate and the firewall specified
in S. 1886, it appears appropriate that capital standards for
banking organizations be set, as contemplated by S. 1886, without regard to whether an organization has a securities affiliate.

Moreover, there would appear to be no reason to alter the

timetable for implementing the risk-based capital standards for
banking organizations simply because they are given the authority to establish securities affiliates.

In this regard,

S. 1886 provides that a bank holding company may not engage in
underwriting certain corporate securities unless all of its
subsidiary banks are in compliance with any applicable riskbased capital standards.

113

Question 3. Would you please address the recent Louvre
Accord on exchange rates. How do you think it is working? Does
this indicate that there is a much greater level of international macroeconoraic cooperation taking place today than there
was in the past. Does this give you hope that we will begin to
make greater progress on the trade and budget deficits?
Answer:

Following the Louvre Accord of February 1987

and again following the G-7 statement this past December, the
exchange value of the dollar experienced a period of relative
stability.

Such stability is welcome.

It reflected mutually

supportive economic policy actions in the United States and in
other major countries, especially last spring, and more recently
the recognition of progress toward reducing the U.S. trade and
budget deficits.
The increased degree of international cooperation in
recent years and the role that has played in achieving exchange
rate objectives are noteworthy.

However, the ongoing process of

cooperation should not obscure the underlying need for individual countries to pursue appropriate policies.

In the case of

the United States, a key element is that we make further progress in reducing our federal budget deficit.

114

Question 4. Commentators on the current fiscal deficit
point out that a sizable portion of those deficits were incurred
to finance corporate cash flow in the form of investment incentives provided in the 1981 tax bill (primarily accelerated
depreciation). They also point out that subsequently investment
in new plants and equipment declined while mergers, acquisitions, leveraged buyouts and buybacks skyrocketed.
These
investment incentives were cut back in the 1986 bill but we'll
be paying for them for years to come.
Some people argue that these transactions that we are
financing with the deficit benefit very few people. Moreover,
the deficit itself, or rather the debt, is owned by very few
people. According to the Treasury, 71% of the "debt is held by
2% of U.S. households. And U.S. taxpayers are paying the owners
of the debt billions o£ dollars annually in interest.
Is there any way to increase the number of people that
participate in this process—make ownership more widespread. I
happen to think that our capital raising process would be
stronger if more participated. What about ESQFS?
Answer;

Broad ownership of business clearly is a

concept that is consonant with our economic system; it can, as
you suggest, contribute to a strong capital raising process and
sounder financing for our firms.

I think we must be careful

about utilizing tax gimmicks to encourage particular forms of
investment, for they can easily cost a good deal of revenue for
modest net effects.

Perhaps the most important focus for policy

would be to do more to remove the incentives firms now have to
rely heavily on debt as opposed to equity finance.

115

Question 5. Last Friday, Senators Proxmire, Sanford
and I wrote, to you and expressed our concern about a trend that
could be developing—hostile takeovers of banke. I think the
najnr question in this is how it would affect the capital positions of banks that are not in the best of shape anyway. In the
corporate sector we have seen in the last few years an enormous
number of highly leveraged hostile takeovers. If these takeovers spread to banking where many institutions are already
highly leveraged against inadequate capital, it could compound
existing problems,
When the Federal Reserve reviews an application from a
bank holding company to acquire another bank or bank holding
company, capital adequacy is probably your number one concern.
Correct?
Do you think that the combined effect of a trend of
hostile bank takeovers, and repeal of Glass-Steagall, could lead
to fewer and larger financial services organizations?
(I recognize that there are some merger limits in the Proxmire bill.)
What about the combined effect of a trend toward
hostile bank takeovers and the dropping of the states' restrictions against interstate banking? What effect will that have on
comnunity-oriented banks?
Answer:

The Board has indicated that it will apply the

same financial standards in evaluating applications contested by
management as it applies to negotiated mergers and acquisitions.
The Board's basic policy is that banking organizations contemplating expansion proposals maintain strong capital positions
and that there should be no significant diminution of financial
strength below these levels to effect major expansion proposals.
Thus, as a condition of approval, the Board may require the
newly combined organization to increase its capitalization above
pre-acquisition levels within a reasonable period.

116

Contested acquisitions and other negotiated mergers, in
part fostered by the lifting of restrictions on interstate
banking, will no doubt lead to fewer and larger financial
organizations.

Indeed, there is already a well-established

trend in this direction.
To date, however, there does not seen to be an undue
level of concentration in major banking markets.

In fact, the

number of competitors in the banking industry is still large
relative to the number of competitors in most other industries.
Moreover, the very changes that have accelerated the trend
toward bank mergers and acquisitions also appear to have increased the level of intra-industry competition.

For example,

the removal of legislative barriers to intrastate and interstate
banking which paved the way for consolidation also induced
highly competitive organizations to expand into markets by opening new branches, establishing ATM networks, and acquiring and
revitalizing marginally competitive institutions.

In many

cases, the new entrants brought added capacity, better service,
and more attractive pricing in an effort to gain market share.
As a result, competition intensified and the consumer benefited.
The provision of financial services by nonbank firms
also mitigates the need for concern about impact of consolidation within the banking industry on competition.

Over the past

decade, the industry's competitive position has been challenged

117

on many fronts.

Thrift institutions have been competing more

aggressively with banks, and competition from foreign

banking

institutions, credit unions, money market mutual funds, and
other nonbank firms has intensified.
In short, consolidation has reduced the number of
competing commercial banking organizations and increased the
concentration of commercial banking assets at larger organizations.

But it is far from clear that these changes have re-

sulted in any lessening of competition! in fact, the intensity
of competition appears to have increased.
Finally, it is important to note that many communityoriented organizations have been able to meet this competitivechallenge and maintain their market positions as well as
reasonably acceptable profit margins.

Given their performance

to date, there would appear to be no reason why community banking organizations cannot continue to survive and, indeed, thrive
in the years ahead.

118
-10-

Questlon 6. On pp. 6-7 you outline generally the steps
the Fed took following October 19. I think the role of the Fed
and its effect is a little understated. You say "the System
temporarily altered its focus somewhat." It's been the impression of at least some of us that the intervention was more
dramatic. You say "we encouraged some decline in short-term
interest rates . . . " Well, the federal funds rate dropped from
7-1/2 percent to 6 percent in a day or two.
I was wondering if you could review the situation again
with the Committee from a monetary policy standpoint. How much
liquidity was supplied to the system by the Fed following
October 19? How did the Fed's response compare to normal
operating procedure--how much more money was supplied? Over how
long a period did the intervention last? What have been the
effects in the rest of the economy? On the dollar? On
inflation?
Answer;

The Federal Reserve provided liquidity

temporarily following the stock market collapse to meet extra
demands for reserves arising from two sources.

One was an en-

hanced demand for excess reserves by depository institutions;
the other was an increased demand for required reserves to back
higher levels of demand deposits and NOW accounts.

In addition,

the Federal Reserve undertook a measured easing of overall reserve pressures as the balance of risks in the economy
in the aftermath of the crash.

shifted

This easing was not as great as

might have been inferred from the levels of federal funds trading on particular days, which might be subject to a variety of
influences.

On a statement week average basis, the federal

funds rate fell from 7.6 percent during the week of October 14
to 7.0 percent in the October 28 week and to 6.4 percent during
the following week.

119

Reserve needs were met through open market operations
in the form of daily repurchase transactions in the market from
October 20 through November 2.

These operations were undertaken

more frequently than usual, in order to quell market fears.

The

maturity of the repurchase agreements (RPs) ranged from overnight to four days, and on several days the Federal Reserve
entered the market earlier than normal to reassure markets of
our intentions.

The unusual demands for liquidity reversed in

November as the market atmosphere calmed somewhat, and the
Federal Reserve open market operations accommodated the reduced
demand for reserves.

Trading in the federal funds market

settled down in the f-3/4 percent area in the latter part of the
year.
There are several measures that can be used to gauge
the extent of the Federal Reserve's reserve provision after the
stock market decline of October 19 and its subsequent reversal.
One is nonborrowed reserves—these are the reserves that are
available to depository institutions without going into the
discount window and are the most direct reflection of our open
market operations.

These reserves rose by $800 million to $58.3

billion in the two-week reserve maintenance ending November 4,
the first period following the crash.

They fell by around S600

million to $57.4 billion over the subsequent two maintenance
periods in the latter part of the year.

120
-12-

Another view of our operations can be had from looking
at "net free reserves", which is the excess of reserves we supply in nonborrowed form over that depository institutions need
to back deposits, in the November 4 statement period, these
rose to SI, 275 million from $440 million the previous two weeks,
also indicating a more generous stance of reserve provision.
Net free reserves dropped off to average $630 million in the
next two maintenance periods.
The. response of the Federal Reserve seems to have
helped prevent the shock from the stock market crash from
spreading throughout the financial system.

Extreme fears and

the accompanying demands for liquidity quickly abated.

Concerns

about a recession have now eased, and economic growth has
continued.
The decline in short-term interest rates after
October 19 did place limited downward pressure on the value of
the dollar, by making short-term investments In the U.S.
slightly less attractive.

However, the decline in the dollar

was halted early this year, and in any case it did not seem to
adversely affect inflationary expectations, given concerns about
the economy.

In fact, inflationary expectations appeared to

diminish following the stock market collapse owing to the possibility of a period of economic weakness or even recession
caused by the drop in wealth and confidence.

As the economic

121

expansion has been seen to be continuing at a good pace, these
expectations are no longer declining, but the moderate easing by
the Federal Reserve since October 21 is not expected to add to
inflation pressures in our economy.

122
Chairman Greenspan's Responses to Written Questions from
Senator Sanford in Connection with the Hearing Held on
February 24, 1988
Question 1. The U.S. Treasury is supporting a
case-by-case, market-driven, menu-approach to the internationaldebt crisis as part of the Baker Plan. An important feature of
the Plan is economic restructuring by the debtor countries involved, with the privatization of government enterprises a high
priority.
One means of privatizing while at the same time
reducing the debt is through debt-to-equity swaps. A
Presidential Task Force on Project Economic Justice recommends
that LDC debt be restructured to encourage swaps which include
employees through part-ownership of the privatized companies
through stock ownership plans (ESOPs). As a regulator of the
banking system, do you see any means by which we can encourage
ESOPs in debt-to-equity swaps?
Answer:

ESOPs are useful vehicles to encourage

employee participation in the success of their employer company.
It would appear that ESOPs would be readily accepted only where
there is broad public acceptance of the concept of private
ownership of stock.

The menu of options developed by the

Administration includes encouraging lesser developed countries
to adopt policies that will promote development of marketoriented practices in those countries.

As these policies are

implemented, there may be greater acceptance of private ownership of corporate stock and a concomitant growth in the
establishment of ESOPs.
With respect to establishment of ESOPs by foreign
companies in which banking organizations invest through debtfor-equity swaps, the Board does not direct or dictate the
business practices of these companies.

It is the Board's policy

that, consistent with any measures necessary to protect the

123

banking organization's safety and soundness, the foreign companies in which a banking organization invests should be able to
compete with other companies on an equal basis.

Such companies

should not be required to offer benefits that may disadvantage
them vis-a-vis their competitors.

If it becomes useful to pro-

vide for employee participation in management or ownership in
order to attract and retain employees, companies owned by U.S.
banking organizations would no doubt establish ESOPs and would
not be restricted from dnine so.

124

Question 2. As you well know, a great de.al of
attention is being paid to the growing level of foreign investment in the U.S. along with our growing foreign indebtedness.
Rome believe that foreign investment is beneficial in that it
provides much needed capital for economic restructuring and
industrial revitalization. Others believe that it surrenders
control over our industrial base and drains our financial resources. What is your view of the role of foreign investment?
Is there a maximum desirable level? If so, have we reached it?
Given our propensity to deficit spend, coupled with the
attractiveness of the U.S. to foreign capital for both economic
and political stability reasons, is it indeed possible to reduce
our deficit and our dependence on foreign capital? In other
words, if we were to eliminate our budget deficits, wouldn't
that make the U.S. an even more attractive site for foreign
investment?
Answer:

When a nation runs a trade and current account

deficit as we are, there must be a capital inflow of some sort
to "finance" it.

As you note, this inflow has taken the form

not only of net borrowing from abroad, but also of equity investments by foreigners in U.S. business.

At this juncture, I

think we should fake a generally positive view of such investment; we are far from the point of foreign domination of
American industry, and in many instances the foreign participation offers the potential for the transfer of valuable technological and organizational expertise that will aid our economy.
You are correct in suggesting that success in
eliminating our budget deficits would bolster the confidence of
foreigners in our ability to manage our economic affairs, and
this might--all other things equal--encourage investment in the
United States.

But other variables would change as well, and I

125

think the evidence suggests that, in the end. the restoration of
better fiscal balance would be compatible — indeed, would
foster — greater external balance.

126

Question 3. Many economists believe there is a strong
possibility of a recession beginning in 1989. If the LDC debt
problem continues to be addressed as "business-as-usual", what
will be the impact of a U.S. recession on debtor nations? What
are the implications to U.S. banks holding large third world
debt portfolios and the U.S. banking system?
Another troublesome aspect of the third world debt
problem has been capital flight, much of it winding up in the
U.S. What can we do to encourage the return of capital for
productive investment in the debtor nations from which it
originated?
Answer;

The Federal Reserve does not now foresee a

recession in the United States in 1988 or 1989, though we would
be foolish to pretend we have perfect insight into events two
year from now.

However, in the event of a U.S. recession, or

more importantly for debtor countries, a recession in industrial
countries generally, the heavily indebted countries would be
affected in several ways.

On the one hand, a recession in

industrial countries is likely to result in reduced demand for
exports from developing countries and in a decline in commodity
prices.

This would adversely affect the balance of payments and

growth prospects of developing countries.

However, in a reces-

sionary environment, world interest rates would likely fall and,
as a result, interest payments on the external debt of developing countries would fall.

This would strengthen the balance of

payments of developing countries with large amounts of floating
rate debt.

On balance, the net result would depend on the indi-

vidual borrowing country's circumstances.

127

The U.S. banking system would be adversely affected by
a recessionary environment because the quality o£ its loan
portfolio — including domestic and international loans—would
tend to deteriorate.

However, given the strengthened capital

position of the U.S. banking system in recent years, it is now
in a better position to withstand shocks that are either domestic or foreign in origin.
Better policies in developing countries are the key to
encouraging

the return of flight capital.

In particular, appro-

priate exchange rate and interest rate policies, by providing a
stable, investment climate, will help encourage residents of
developing countries to repatriate capital that they have placed
abroad.

FEDERAL RESERVE'S FIRST MONETARY
POLICY REPORT FOR 1988
THURSDAY, FEBRUARY 25, 1988

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, Dixon, Garn, Heinz, and Hecht.
OPENING STATEMENT OF CHAIRMAN PROXMIRE

The CHAIRMAN. The committee will come to order.
I want to thank you for your excellent statement. We look forward to your views of the Fed's policies. They are most helpful to
us as we conduct our oversight responsibilities.
International considerations have been of vital importance to
this country's monetary policy in recent months. There are currently great divisions of opinion concerning the appropriate level of
the foreign exchange value of the dollar. With large trade surpluses in Japan, West Germany, and Taiwan and an enormous current
account deficit in this country it is hard to resist the temptation to
let the dollar fall to address the problem.
On the other hand, many believe that the dollar has fallen
enough already, or at least it has fallen as much as it can in a
short period of time without causing a recession in the countries
whose currencies rise against the dollar. Many of those countries
are already suffering from very high levels of unemployment and
further exchange rate pressure could put them into a recession
that feeds back on this country as well.
A related problem is the impact on the domestic economy when
monetary policy is used to defend the dollar. Some, including the
Council of Economic Advisers, have suggested that monetary policy
was too tight in 1987 because of efforts to defend the dollar and
that tight monetary policy significantly contributed to the stock
market crash in October.
A third concern derives from the large accumulations of debt
owed to foreigners as a result of our persistent large current account deficits. Owing large amounts of debt to foreigners, who are
quite sensitive to exchange rate fluctuations, appears to significantly alter the tradeoffs that our central bank faces when setting monetary policy. A look at the data for 1987 suggests that the Fed
slowed the growth of the monetary base whenever downward pres-

(129)

130

sure on the dollar developed. Perhaps there is more truth than I
would like to admit in economist Albert Bressand's witty remark
that "the United States now has two central banks, the Federal Reserve and the Japanese life insurance companies." Our ability to
devote monetary policy to purely domestic economic consideration
is compromised by the importance of foreign creditors.
Finally, the effect of our monetary policy on the Latin American
debtor nations is a source of concern. A rise in interest rates increases the cost of debt service, slows our economy and reduces our
ability to import from those debtor nations. When we need to tighten monetary policy to arrest inflationary pressures the ability of
debtor nations to pay debt service to our banks is reduced. That in
turn may have significant domestic repercussions.
These international challenges posed for our monetary authorities are here to stay. I look forward to hearing our witnesses' views
in this vital area of national interest.
Before we start, I have statements for the record from Senators
Dixon and D'Amato.

131
FEBRUARY 25, 1988

STATEMENT OF SENATOR ALAN DIXON

SENATE BANKING COMMITTEE OVERSIGHT HEARING
ON
THE CONDUCT OF MONETARY POLICY

MR. CHAIRMAN, I AM PLEASED TO BE HERE THIS MORNING AS THE
BANKING COMMITTEE CONTINUES ITS SEMI-ANNUAL MONETARY POLICY
OVERSIGHT HEARINGS AS MANDATED BY THE HUMPHREY-HAWKINS ACT.
HAVE A DISTINGUISHED

GROUP OF WITNESSES BEFORE THE COMMITTEE

TODAY, AND I LOOK FORWARD TO THEIR TESTIMONY.
AT THE OUTSET, I WANT TO SAY THAT I WAS DEEPLY CONCERNED BY
CHAIRMAN GREENSPAN'S TESTIMONY YESTERDAY ON THE EXTENT OF THE
POLITICAL PRESSURE THE FEDERAL RESERVE IS GETTING FROM THE
ADMINISTRATION ON ITS CONDUCT OF MONETARY POLICY.

I THINK IT IS

VITALLY IMPORTANT TO HAVE A SOUND, COORDINATED MONETARY AND
FISCAL POLICY.

THIS ADMINISTRATION, HOWEVER, HAS GIVEN US BIGGER

FEDERAL DEFICITS THAN ALL OF ITS PREDECESSORS COMBINED, AND THAT

132
Page 2
FACT CLEARLY HAS TO ADD TO THE DIFFICULTIES THE FED FACES IN
TRYING TO ACHIEVE THE KIND OF MONETARY POLICY THAT MAINTAINS THE
CONDITIONS FOR SOUND ECONOMIC GROWTH WHILE NOT REKINDLING THE
INFLATIONARY FIRES THAT WERE DAMPENED AT SUCH GREAT COST.
IF THE CRITICISM OF THE FED IS AN ATTEMPT BY SOME IN THE
ADMINISTRATION TO DIVERT ATTENTION FROM THEIR OWN STEWARDSHIP OF
THE FEDERAL BUDGET, I CAN TELL THEM NOW THAT IT WILL NOT WORK.
THEY WOULD BE MUCH BETTER ADVISED TO BEND THEIR EFFORTS TO SEE
THAT THE EXECUTIVE BRANCH IS POING EVERYTHING IT CAN TO REDUCE
THE TERRIBLE TWIN TRADE AND BUDGET DEFICITS THAT SO JEOPARDIZE
OUR ECONOMIC FUTURE.

133
STATEMENT OF SENATOR ALFONSK M. D'AMATO
FEBRUARY 25, 1988

EACH OF THF, EXPERT WITNESSES BEFORE THE COMMITTEE THIS MORNING
ARTICULATES THE DILEMMAS FACING BOTH THE FED, THE TREASURY AND THE CONGRESS
REGARDING THE HEALTH OF THE U.S. ECONOMY.

AT A TIME WHEN WE ARE

EXPERIENCING THE AFTER SHOCKS OF A HUGE MARKET CORRECTION, A VOLATILITY IN
THE VALUE OF THE DOLLAR, A TRADE BILL WHICH CAN HAVE MANY DETRIMENTAL
EFFECTS ON THE U.S. AND WORLD ECONOMY.

I BELIEVE THAT THE CONGRESS SHOULD

PUT ASIDE PARTISAN DIFFERENCES AND WE SHOULD WORK WITH OUR ALLIES TO PROMOTE
U.S. ECONOMIC GROWTH, WHICH TO A LARGE PART IS DEPENDENT UPON GLOBAL
ECONOMIC GROWTH.
TODAY'S WITNESSES RECITE THE LITANY OF DILEMMAS FACING THE NATION.
ALTHOUGH THESE DILEMMAS HAVE CREATED A CLIMATE OF EXCEPTIONAL UNCERTAINTY, I
BELIEVE THAT THE AMERICAN PEOPLE, AND PERHAPS THE REST OF THE WORLD IS
LOOKING TO THE CONGRESS OF THE UNITED STATES FOK SOLUTIONS.

THE SOLUTIONS

TO THE ECONOMIC PROBLEMS CONFRONTING THE U.S. AND GLOBAL ECONOMIES ARE NOT
EASILY IMPLEMENTED, NOR ARE THEY SHORT TERM IN NATURE.

UNDERSTANDING THIS

WE SHOULD BEGIN TO LOOK AT SOME LONG-TERM PROPOSALS SO THAT WE WON'T BE
CONFRONTED WITH SIMILAR ECONOMIC DILEMMAS 10 YEARS FROM NOW.

EACH OF OUR

WITNESSES HAS PROVIDED SOME GUIDANCE WITH REGARD TO BOTH LONG-RUN AND SHORTTERM SOLUTIONS.

IN THE SHORT-TERM, THE FED IS IN A BETTER POSITION TO DEAL

WITH ECONOMIC GROWTH THROUGH ITS CONDUCT OF MONETARY POLICY.

HOWEVER, THE

LONG-TERM SOLUTIONS CAN ONLY BE DEVISED AND IMPLEMENTED BV THE CONGRESS THIS IS A RESPONSIBILITY WHICH WE CANNOT LIGHTLY TAKE.

134

The CHAIRMAN. I'm going to ask each of you gentlemen if you
would to confine your oral remarks to 10 minutes or less. We have
had a chance to see your statements in advance so, we will proceed
alphabetically. That's about as democratic—I like that word—an
approach as we can have. So we will start with Dr. Barbera, who is
the chief economist Shearson Lehman Hutton in New York. My
eldest son works as a broker for Shearson Lehman. I'm very proud
of the way he's done and the way the organization has done. So go
right ahead.
STATEMENT OF ROBERT J. BARBERA, CHIEF ECONOMIST,
SHEARSON LEHMAN HUTTON, NEW YORK, NY

Mr. BARBERA. Thank you, Mr. Chairman. As you said, I am
Robert J. Barbera and I am the chief economist of Shearson
Lehman Hutton. I would like to add that I did sit over there as a
legislative assistant for economics for Paul Tsongas for several
years while you were chairman. It is very interesting to sit on this
side of the dais.
I would like to frame my testimony in terms of answering four
questions.
First, were Fed officials compelled to tighten in the spring and
fall of 1987?
Can the Fed be held largely accountable for the October stock
market crash?
Was the Fed's dramatic swing toward ease immediately after the
October crash appropriate?
Is current Fed policy, with a slight tilt toward ease, in keeping
with the Fed's disinflation bent or is the November election preventing the U.S. central bank from returning to its precrash bias
toward tightening?
TIGHTENING OF INTEREST RATES

To briefly summarize my answers to these questions, I believe
that consistently faster than expected U.S. economic growth in
1987, alongside bouts of rising commodity prices, dollar weakness
and the flight of foreign capital from the United States, impelled
the Fed to raise short-term interest rates and validate the tightening of interest rates that market forces generated during these periods. Had U.S. spending been reined in by budget cuts in 1987, Fed
action may have been less severe, but fiscal policy moves to tighten
have been most modest, leaving the job of slowing U.S. spending
largely to the Fed.
The second leg up for short rates in November on the heels of
decidedly disappointing U.S. trade data announcements made in
the summer and was to an important degree an attempt by the Fed
to counteract dollar weakness. The October crash reflected not just
the new higher rate structure, but, importantly, the announcement
of an extraordinarily disappointing trade number in mid-October. I
think the Fed then really is much less accountable for that crash
than was the continued deterioration on the trade side.
Once stocks crashed in the United States and quickly moving
abroad, the Fed had no options. The safety and soundness of the
U.S. financial system was ensured by the prompt and dramatic pro

135

vision of liquidity by the U.S. central bank. That infusion of liquidity and the consequent sharp fall in the Fed funds was essential.
Currently however, with risks to the financial system diminished, the Fed appears to be tilting toward an easier policy again.
Some see this as a case of election engineering. I see it as a response to a world different in two important ways from 1987. First,
significant leading indicators of the U.S. economy have begun to
falter. Second, the world and the Fed have been blessed by two decidedly better than expected trade announcements, which generated a U.S. dollar bounce. Were the Fed to continue to tighten in the
fact of weakening leading indicators, recession would be the clear
risk. And given growing evidence that the U.S. advance right now
is export-driven and therefore likely consistent with an end to the
one-way—down—dollar market, recession seerns absolutely inappropriate, election in November or not.
The two tightening moves in 1987 were, in part, explicable
simply based upon real economy variables: faster price increases
for commodities; sharp gains for U.S. industrial activity; and rapid
growth in employment.
This committee, however, should also understand that bouts of
dollar weakness which we saw in 1987 unquestionably also helped
force the Fed to be firm.
Why? Because U.S. financial markets—the markets that finance
U.S. economic activity—now depend upon foreign capital.
To keep that capital inflow voluntary and therefore preserve
well functioning capital markets, foreigners need evidence that
these inflows are temporary, or at least receding. Fed tightening,
by slowing U.S. spending, promises slower import flows, better
trade numbers, and, therefore, less foreign capital need in the
future.
The last page of my printed testimony includes some sober arithmetic. If you grant me excellent trade improvement—that is trade
improvement well above what econometric models would look for—
a $125 billion trade deficit this year falling to $30 billion in 1992,
and the accumulated net capital need from abroad totals to $500
billion, ownership of $Va trillion of U.S. assets will be handed over
to foreigners.
I think that's a staggering figure, but if trade were to fail to improve rapidly—that is, if we had more conventional development
on trade numbers—the number could approach $1 trillion by 1992.
I think therein lies the world financial markets' morbid fascination with U.S. trade numbers. Better than expected trade numbers
allow investors around the globe to scale down their fears about
future U.S. capital needs from abroad.
Conversely, when those numbers disappoint they are immediately translated to a worldwide announcement that U.S. addiction to
foreign capital is worsening, and hence our extraordinary focus
with the trade numbers and the Fed's focus with those numbers.
As I see it, it was just such disappointment in the form of a
much worse than expected nominal trade deficit on October 14,
1987 that burst the bubble of investors looking for receding U.S.
capital needs and catalyzed the October crash.
Foreign investors, all agreed, would not countenance another leg
up for U.S. capital inflow needs and the investors leaped to the

136

conclusion that a U.S. recession was the only way to curb the U.S.
appetite for spending, foreign financed.
U.S. stocks collapsed, foreign stocks followed. The Fed's second
tightening, then, played only a small role in the stock market fall.
Foreign anxiety about our trade deficit was central.
Again, once stocks crashed, safety and soundness forced the Fed
to leave its focus on world imbalances and confront the financial
system crisis. Safety and soundness of the U.S. banking system demanded the Fed ease and it was forthcoming.
Now for the present, clearly our capital needs from abroad
remain with us, but the last two trade numbers were well below
expectations and they have given the dollar some bounce. Moreover, we appear to be in the midst of a much needed stall for U.S.
consumer spending. And taken alongside the extreme inventory
overhang that U.S. retail stores are burdened with, I think it is
likely that U.S. trade numbers, for some months, will show good
improvement.
That, as I see it, gives the Fed some breathing room. They are
not consigned to lean against U.S. spending at present, as it is already sagging; and it promises to deliver dividends in the form of
better trade numbers.
At the same time some U.S. leading indicators are flashing warning signs. As is typical when Fed policy moves toward restriction,
as it did in 1987, financial indicators showed the first signs of
rising rates. Real money growth traditionally stalls and stock
prices tumble. They certainly both did in 1987. Weakness in these
leading indicators in the financial system is then typically followed
by weakness in leading indicators tied more directly to the economy. We are now seeing that. Initial unemployment claims, though
moderating from their sharp rise in January, are well above the
October levels; industrial commodity prices are well off their highs;
and building permits have fallen sharply for two consecutive
months.
The Federal Reserve Board, therefore, now confronts an economy
that is not unambiguously robust. Some caution flags are waving
and, again, trade improvement has lifted the dollar. Accordingly,
monetary policy needs to be sufficiently accommodative to prevent
the ongoing consumer pullback from devolving into recession. In
that light, the modest tilt toward ease in place at present appears
appropriate irrespective of political considerations. It is instructive
to note that, I think, that reflecting upon the weakening U.S. leading indicators, the two better than expected trade numbers, we did
have a substantial decline in long-term interest rates from 9 percent to 8.3 percent before any move to ease by the Fed occurred.
At the same time, I must point out that the Fed cannot be so
stimulative as to generate a strong rebound in U.S. consumer
spending. In effect, the U.S. consumer is balanced atop a knife's
edge, and the U.S. Fed must work to keep the consumer in place.
Thank you.

[The complete prepared statement of Robert J. Barbera follows:]

137
Testimony Before The Senate Banking Committee, February 25, 1988
Good morning, Mr. Chairman and members of the committee. My
name is Robert J. Barbera and I am the chief economist of
Shearson Lehman Hutton.
I would 1 ike to thank you for the
opportunity to testify at these hearings.
In order to frame my
testimony, I have chosen to answer four questions:
Here Fed officials compelled to tighten in the spring
and fall of 1987?
Can the Fed be held largely accountable for the October
stock market crash?
Was the Fed's dramatic swing toward ease immediately
after the October crash appropriate?
Is current Fed policy, with a slight tilt toward ease,
in keeping with the Fed' s disinflation bent or is the
November election preventing the U.S. central bank from
returning to its precrash bias toward tightening?
To briefly summarize my answers to these questions:
I believe that consistently faster than expected U.S.
economic growth in 1987, alongside bouts of rising commodity
prices, dollar weakness and the flight of foreign capital from
the U.S., impelled the Fed to raise short-term interest rates and
validate the tightening of interest rates that market forces
generated during these periods. Had U.S. spending been reined in
by budget cuts in 1987, Fed action may have been less severe, but
fiscal policy moves to tighten have been most modest, leaving the
job of slowing U.S. spending largely to the Fed.
The second leg up for short rates, which developed in
September, followed on the heels of decidedly disappointing U.S.
trade data announcements made in the summer and was to an
important degree an attempt by the Fed to counteract dollar
weakness.
The October crash reflected not just the new higher
rate structure, but, importantly, the announcement of another
wildly disappointing monthly U.S. trade performance.
Investor
opinion in mid-October swung radically toward the notion that
U.S. trade would not improve without deep U.S. recession. Fed
tightening therefore played a role in the stock market's fal1,
but it was a secondary one.
Once stocks crashed, beginning in the U.S. and quickly
movinq abroad, the Fed had no options. The safety and soundness
of the U.S. financial system was ensured by the prompt and
dramatic provision of liquidity by the U.S. central bank. Thus
that infusion of liquidity and the consequent sharp fall in U.S.
Fed funds was essential.

138
Currently, however, with risks to the financial system
diminished, the Fed appears to be tilting toward an easier policy
again. Some see this as a case of election engineering. I see
it as a response to a world different in two important ways from
1987.
First, significant leading indicators of the U.S. economy
have begun to falter. Second, the world and the Fed have been
blessed by two decidedly better than expected trade
announcements, which generated a U.S. dollar bounce.
Were the
Fed to continue to tighten in the face of weakening leading
indicators,
recession would be the clear risk. Given growing
evidence that the U. S. advance is export-driven, and therefore
likely consistent with an end to the one-way—down—dollar
market, recession seems absolutely inappropriate, election in
November or not.
In the spring and fall of 1987, the Fed tightened.
periods the economic backdrop was one of:

In both

rapidly rising prices for industrial commodities;
strong growth for U.S. employment and industrial output;
excellent gains for U.S. exporters;
still hefty gains for U.S. import volumes, with rising
prices;
disappointing nominal trade deficits;
bouts of dollar weakness;
periods of foreign selling of U.S. assets;
large foreign central bank intervention to absorb unwanted
dollars.
Clearly, then, better economic performance and rising
commodity prices, in and of themselves, gave some justification
for a tighter Fed.
The change in the pace of U.S. economic
growth was important to Fed policy. But the changing financial
situation of the U.S. in the world was equally significant. The
U.S. had become highly dependent on foreign capital by 1987, and
once U.S. interest rates ended their incredible decline, foreign
investors began to balk at supplying that capital.
During 1987, the U.S. broke its two-year pattern of
weak industrial production and sharp declines in
industrial commodity prices, which had permitted sharp
declines in U.S. long-term interest rates alongside a
falling dollar.
Thus, in early 1987, foreign investors faced, for the
first time in two years, the prospects of an end to the
explosive gains in U.S. bond prices.
stronger GNP
growth was raising inflation concerns and capping the
bond rally. And overseas investors still faced likely
hefty declines in the dollar. The prospects for large
decreases in the local currency-denominated returns of
U.S. assets caused a run from U.S. assets.

139
The Fed, then, faced the task of both moderating the U.S.
output advance and tempering foreign investors' flight from U.S.
assets.
By tightening in 1987, the Fed was, I believe,
attempting to do its part to help trade and the dollar and
thereby restore foreign investor inflows.
How can tighter Fed policy help improve the U.S. trade
deficit?
Simple.
Higher rates slow U.S. spending, and when
spending slows, spending on imports shares in the slowdown.
The Fed' s second move to tighten was followed soon
thereafter by the crash of 1987.
Again, however, rather than
holding the Fed accountable for the sharp stock market swoon, I
would point the finger at the second wave of disappointing U.S.
trade reports that confronted world financial markets.
That
second round of reports was the fundamental driver in the stock
market slide.
Throughout the late spring and early summer, U.S.
companies across a wide array of sectors were reporting
extraordinary gains in the sales of exports.
In stark
contrast, U.S. retailers were reporting significant
sales weaknesses—a precursor, one would imagine, to a
fall off in imports.
Many equity investors, seeing
this as bottom-up evidence of a much improved U.S.
trade picture, discounted several very disappointing
trade reports.
The wildly disappointing trade
statistics on October 14 caused investors to capitulate
to the view that trade was not turning and recession
was likely the only way to right U.S. trade sector
woes.
Perhaps the easiest assessment of appropriate Fed policy can
be tied to the immediate aftermath of the U.S. and worldwide
stock market crash.
Once that slide occurred, financial market
frailty could easily have spilled into the economy, and the U.S.
and the world ran the risk of sharp economic contraction.
Dramatic Fed ease was appropriate and it was forthcoming.
Currently the Fed, as we see it, must ponder the following
economic backdrop: U.S. exporters are enjoying explosive demand
for their products.
Consumer spending, however, in part
reflecting last year's move to a more restrictive Fed policy,
remains stagnant. These data suggest, in turn, that U.S. output
advance will indeed slow in the quarters before us. Importantly,
however, slack demand for consumer products promises both slower
U.S. economic advance and a falloff in U.S. import inflows.
Better than expected trade numbers and slower but still positive
economic advance should be the rule in the months ahead.
A
string of better than expected trade statistics should also
catalyze a healthy dollar bounce. More voluntary capital inflows
can be expected in the coming months.

140
the multiquarter poor performance for U.S. consumers
has begun to temper demand for goods, both here and abroad, which
should help improve U.S. trade statistics. With the U.S. export
sector still minute in comparison to the U.S. consumer sector,
however, consumer quiescence cannot be permitted to deteriorate
into consumer contraction.
U.S. leading indicators are in fact flashing such warning
signs.
As is typical when Fed policy moves toward restriction,
leading financial indicators showed the first signs of the
effects of rising rates. In 1987, real money growth stalled, and
of course stock prices tumbled. Weakness in these early leading
indicators is now being met by declines for leading indicators
tied more directly to economic performance. Initial unemployment
claims, though moderating from their sharp rise in January, are
well above the October levels; industrial commodity prices are
well off their highs; and building permits have fallen sharply
for two consecutive months.
The U.S. Federal Reserve Board, therefore, confronts an
economy that is not unambiguously robust. Some caution flags are
waving.
And again, trade improvement has lifted the dollar.
Accordingly, a monetary policy needs to be sufficiently
accommodative to prevent the ongoing consumer pullback from
devolving into recession. In that light, the modest tilt toward
ease in place at present appears appropriate irrespective of
political considerations.
It is instructive to note that,
reflecting upon weakening U.S. leading indicators and the
dollar's bounce, U.S. long rates fell 3/4 of a percentage point
from 9.1% to around 8.3% before any Fed easing took place. The
Fed, then, has followed the markets toward an easier policy.
At the same time, I must point out that the Fed cannot be so
stimulative as to generate a strong rebound in U.S. consumer
spending.
In effect, the U.S. consumer is balanced atop a
knife's edge, and the U.S. Fed must work to keep the consumer in
place.
To be sure, the task the Fed faces at present is daunting.
The U.S. central bank is at once attempting both to help prevent
a worldwide economic downturn and to assist in effecting a turn
in U.S. trade.
Again, this amounts to a policy of engineering
stagnant but not sliding U.S. spending.
Growth in the U.S.
economy depends in turn on healthy export gains, and trade sector
improvement will reflect both export advances and import
declines. Export strength, however, hinges in part upon foreign
central bank stimulus and consequent spending patterns abroad.
Other nations must ensure sufficient demand growth abroad to
absorb the slackening in demand for their products that an
extended period of stagnant U.S. spending assures.
In that
sense, we remain hostage to foreign savers. That's a handcuff it
will be difficult to slip through in the coming years.

141
a n d F a l l of 1987. U . S . d o l l a r d e c l i n e , c o i n c i d e n t
»t« ^d sl.*pem n g for U . S . y i e l d curve co^ell

I n h n t h the s
r IS
the Fed to t i g h t e n .

Laje Ian.

Steepening Yield*"*
Curve

EarijMug

-3.a%

U.S. dol lar'

Rise for U.S."
Long rates

Midway

7.4%

Mid-Oct.

9.
220

9.0%

215

10.1%
276

- Federal Reserve Board trade weighted d o l l a r index, percent change.
** 30 year U S. Treasury bond y i e l d .
.
• • * 30 year U . S . Treasury bond y i e l d less i n t e r e s t r a l e on Fed Funds ( i n basis
points).

THE FED'S TIGHTENING IN 1987 OCCURRED
WHILE THE ECONOMY WAS EXPERIENCING
QUITE ACCEPTABLE OVERALL GROWTH.

10-1

v W
Indurtrial Production
(6-Month « Chute, AnnualiKd)

-C

Bern! GHP
(Quarter/Quarter * Chwif*, AmraiUnd)

J--4

142

DURING THE FUST FBI WEEKS Of 1900.
LONG RATES DECLINED WFTH STEADY FD
POLICY. RECENT FED EASING FOLLOWED
THE JANUARY BOND MARKET RALLY.

LIKEWISE. THE FEDERAL RESERVE BOARDS

SLIGHTLY EASIER STANCE HAS BEEN TAKEN
WITH THE DOLLAR OFF ITS LOIS.

BOTH LONG-TERM INTEREST RATE DECLINES AND
THE DOLLAR'S RECENT BOUNCE DIRECTLY REFLECT
TWO MONTHS OF BETTER-THAN-EXPECTED
MERCHANDISE TRADE DEFICITS.

143
CURRENT FED POLICY, WITH A SLIGHT TILT TO EASE.
ALSO REFLECTS, NO DOUBT, THE DECLINE FOR U.S.
LEADING INDICATORS.

Financial Indicators Fell First.

i •• i i ~i • [ r i r
A 9 0 H 0 J P H
ItM

J-160

144
ANOTHER MONTHLY FALL IM THE U.S. INDEX OF LEADING INDICATORS?

These Economy Related Leading Indicators Pulled the Indei Down in January.

Oct .
I n i t i a l Unemployment C l a i m s
Bui[ding Permi ts
Vendor Performance
Sensitive M a t e r i a l Prices

Forecast
Contribuli an

Jan.

284
116.7
70

312
108.5

1 .67

fl.84

Financial Leading Indicators, However, Bounced Back and f i l l Lift Ihe Index.
2427, 4
280.2

M-2 (S2S)
SSP 500

2419.1
243.4

2420.1

2443.8
250.4

241 .0

0.43
0 33

The Swing Factor for the Monthly Move is Factory Orders.
Should They F a l l , As We Expect, The Index H i l l Decline in January.

87.8
42.0

Consumer Goods Orders
Capilal Goods Orders

87.0
-12.4

190.2
-0.2

193.3
-0.1

Index of Leading Indicators
Percent Change)

-.14
0.01

'The i n i t i a l 0,2% decline of the December index of Leading Indicators w i l l 1 ikely
he revised up to 0.3% w i t h the next release.

1-5 -t
- 1.0

J.lllll

0.0

Index or Leidinf Indie*tors
{Month/Month > Change)

-1.0-

- -1.0

r~~i—i

1—i

r~-\

1—i

J
F
IBM

J
F
1M7

1—i—
M

145

THE EXPLOSION OF THE US. MERCHANDISE TRADE DEFICIT
IN THE EARLY 1980s WILL RECEDE IN THE LATE 1960s
AND BARLY 1990s.
MOREOVER, EVEN WITH AN
OPTIMISTIC VIEW ABOUT TRADE IMPROVEMENT

. . THE VS. CURRENT ACCOUNT DEFICIT WILL FALL
MORE SLOWLY AS INTEREST AND DIVIDEND PAYMENTS
ON FOREIGN-HELD ASSETS MOUNT AND .

. . AS A CONSEQUENCE, NET FOREIGN INVESTMENT—
THE EXCESS OF THE VALUE OF FOREIGN-OWNED
VS.
ASSETS COMPARED TO THE VALUE Of U.S.-OWNED
FOREIGN ASSETS—WILL LIKELY EXCEED 1750 BILLION
IN 1992, THIS IN TURN IMPLIES AN ADDITIONAL
$500 BILLION IN NET FOREIGN PURCHASES OF
US. ASSETS OVER THE 1988-1992 PERIOD.

IMPORTANTLY. FOREIGN PURCHASES OF VS. ASSETS
WILL EXCEED "NET FOREIGN PURCHASES" BY A
•IDE MARGIN. NET FOREIGN INVESTMENT FOCUSES
ON THE NEED FOR FOREIGN ASSET OWNERSHIP ABOVE
THE LEVEL OF US. ASSET PURCHASES ABROAD.
FROM 1980-IW2. WE ENVISION FOREIGN PURCHASES
OF AN ADDITIONAL tSOO BILLION IN VS. ASSETS.

146

The CHAIRMAN. Thank you, Dr. Barbera.
Dr. Cooper is professor of economics at Harvard University and
he's served with distinction as Assistant Secretary for Economic
Policy in the State Department. Go right ahead, Dr. Cooper.
STATEMENT OF RICHARD N. COOPER, PROFESSOR OF
ECONOMICS, HARVARD UNIVERSITY

Mr. COOPER. Mr. Chairman, I appreciate very much the opportunity to testify in these important hearings. I have provided a statement and, with your permission, I'd just like to emphasize several
points and in the process address some of the questions that you've
posed.
OPPOSES FURTHER WEAKENING OF DOLLAR

First, I do not share what I take to be the strong consensus
among American economists that the dollar must weaken further,
that the Fed or other central banks should do nothing to stop it,
and if anything, they should push the dollar further down.
For reasons given in my statement, I believe that a further sharp
drop in the dollar may perversely enlarge rather than narrow the
U.S. trade deficit over the next 12 to 18 months by creating a recession in Europe and even possibly in Japan, both of which areas are
economically fragile at the present time and are feeling the impact
of a decline in real exports.
Recession abroad would affect the United States adversely because our near-term economic growth depends heavily on an improvement in net exports and on the investment which will be in
large part associated with that improvement in net exports.
Now I don't want my position to be interpreted as favoring a
tightening of U.S. monetary policy in order to keep the dollar from
dropping. I do not. And in fact I support the course of policy that
the Fed has recently been on. But the U.S. should not try to dissuade other countries from intervening in exchange markets to
prevent sharp appreciations of their currencies against the dollar
which intervention incidentally involves monetary expansion in
other major countries which I believe is desirable in its own right.
DEBT OF THIRD WORLD COUNTRIES

Second, I believe that the heavy debt of many Latin American
and African countries is a continuing problem, both for the debtors
and for the creditors. While it is not perhaps a threat to the world
financial system, it continues to nag at the world economy acting
as a costly drag on economic growth. There is no easy way out, but
certainly if the world economy goes into recession or if short-term
interest rates rise markedly, we will see even more debtors declining to service their debts. Politically, most of them will not have
the option of squeezing their economies further in order to pay interest on debts that were incurred 5 to 15 years ago.
Third, I do not believe that the rapid growth of net U.S. foreign
indebtedness per se will affect the ability of the Federal Reserve to
set U.S. monetary policy.
I dp believe, however, that the increasing integration of world financial markets, the increased gross indebtedness of the United

147

States to foreigners, and the increased ease with which Americans
can invest overseas in many forms, will result in a gradual reorientation of U.S. monetary policy to the external environment and
with greater attention being paid to "confidence" in the world financial community.
The world financial community includes U.S. American participants. I do not believe that foreigners are more fickle in their holdings of dollars than Americans are.
These developments will occur via exchange rate as well as interest rate impact on the U.S. economy. Indeed, I see a growing tension between the relative importance of the U.S. dollar in the
world economy, which I suspect will continue, and the relative—
and I emphasize relative—decline of U.S. output as a share of gross
world product; not because the U.S. economy is doing badly but because over the next 10 to 20 years other economies will grow more
rapidly.
For this reason, as well as because it will be desirable to reduce
the influence of turbulence arising in financial markets on real
business decisions, I put forward at the end of my statement what
many will consider a quixotic suggestion that we should begin now
to think about steps necessary to create and manage a single currency for the industrialized democracies.
The management arrangements could be modeled on our own
Federal Reserve System, but those who would sit on the equivalent
of the Transatlantic Open Market Committee would involve Western Europe, Canada, as well as the United States, and Japan.
That sounds very radical at the present time, but in fact it represents a clean solution to a number of problems which we already
face and which are likely to get more acute as the years go by. I
believe that a single currency for the industrialized democracies is
now technically feasible, by which I mean the markets exist that
could support it in a reasonably smooth way, but of course it would
require a major change in our political thinking, but it's not too
early to start.
Thank you, Mr. Chairman.
[The complete prepared statement of Richard N. Cooper follows:]

iranndmte rflw-tjons a f f p r t i n g only 125-30 billion. The only ways to make
thob» rnn.srd commitments in the American system is either through tax
adjus ing the formulae that nffer^t social entitlements, such that Ihe^i'
hee

nt values of tn
f vm:! 1 ] l
t h r > do] ];i

-stimulu

H r'fpct I .S. e\i»)rl-i neEatiM'ly, -,i*-h t h a t the shfrt-run affect of d n i l i r
traiji' Ijat.uice. i t is noteworthy, in this connection, that U . S . forecast'
pcoiion-ic et:»,i'i ri,ji-inB ISf'S Biaoc hesw veiEh: on sii improvHiicrii in net
:-ts (.-,i, oti.. forer-ast of 2.3 ucn-pnt, growth, nearly KO tcr.-ent 15
utv.iic, ,I,i|wii, nrnt .'lsni.1iot-p, I h i i l . S , evport
ill

col:

Broi.lh

rtoes not materialize.

b haris over the uot Id s-'ninmv s.: tf iir<«[In- hed^ral Ecsci-.f Sitlem in t h f i n u r d
> conditions ir. order in preier.t tri- dr.lia
b i t i n f l a t i a i i in t h e i n i t e d S t a t e f ,

allo

• dr.lla

Depression,
Uebt-riflJeii .ie\-lanins countries trajlri be further devastated by
protect ioni=t jn^tntrb, nnd could not cont.riJMJte to vvorld gn^,-th. Some
ri.nBressmeri '-ill be (jimpted to threaten to withhold \otcs for the L.S.-Caji
lU-uwsLoris in the UiitiilBjs Tnute B i l l that he IKB,- threatens to % e t o .

lea

S[.in->i!r fnr :-r-l'j, L r « (he biidBc^r in the- l.iiited Sta'ps - ' h p
s, an],. s, nnJ Thr- [ I '.B]-.IL. o f hfth nartlft 111 lioth house' 'if
r i f : , i n t n rti f fr-t .'i.' k i n.i of rt.] Praia. Financial markets .Ti'i I h i ' i r
i -.r, rh. 1 .1. la^K't r t e f i n t .

EStit too •srrarn and tin ran'! a

, ii f.!, •. ot i I... '. i onilrfssmrTi rai,1 tct Pi s.^] dent ni" t u j J ;

!l >-r>

just wliF'n [.'.fi. evoorts or** lining irell, and a IKIJ«I turnaround in the I'.S,
ad,
OtiM

h« 1 H

uld

publii 1 del,', which to domestic residents of both countries is alreadv
unt;, m! ,)i-t ably high. tin fact, West Gcirouir has at 4] percent the loues
ra^io i], TA.f- Vnil^i ^1«ti^ i>i 50 -percent, and in Japan it has reached I".
percent . ] Japan ^-aiits tf, avoid increasing debt by offsetting any sf iimi
action through increasing new 1ji\es, notably a tax on consular speiKiin'?
unhelpful!? mav actual]? 1 further increase household savings in Japnn. ,
prnpriwi 1C offset n-ts m inconn ta.\f>s by cutting subsidies, a mm <• til
surcli mi-ritnriou^ in thr mp-iuim (o lone run, hut tlin-h ™ulti rffiuce nr
plirEiii>/it,- the il,-i.UL,i •-tiniiliii ansina from the proposer! ta.\ reduct 1011=.
Tl.,

al tieh;
nu Uw necessarv f Lev.! hill'_>
". The alternative w i l l I*, r
ion of the dollar, whirh IHBV
>\pli

the debt. Avr,ida!i

to nv<>id the hsrd
( the- nevl f i i e ?,"3r-,
s universally desired,
nt IMSI r i i e l o r i c s l l j . Vumljcrs are t«Jious, bit thf> are osss-r.l ial toi 1
untiorsl nfirf i ng Ihe majonturfr and Ili'-rcfare the nature of the nroblex. At 1
p-'n^si'i '. h" C ' n i l e H ?tste= iiin^ J n^rrhanHise trado deficit of routhly Slj '
b i l l i o i , i . i ' h services and reiriittijic^*i approximately in helyno?- Durina the
I«st f i i l > yr-ars- thp I n i t e d States -las aiwumilated over (5TO billion in list
obi igat nais to foreigners, anrl it i-t llkel! to apcumu]att> rwnrly that much
agEiin during th,. i»>! ind 1HHS-1992. Thus, there w i l l be itn-reased debt
Fli

year in L.S. nnt evpt-rts.
grinultEirp is lik-c!y to prm ide l i t t l e of the ner-egsary improve
r irar^rter of fa™ prortwts,
has noi.- become the second ]j.rBe=t
-ho (r-.ited f<.-.<>•*.. Jani"1 nesMly prot->ct? rice and othnr aerie
ts,, r.i-n^tn,- .id ion HS« [winfijl ly started in Furipc, In it i'

Who w i l l be or. the other sidr of this large 3.,-ing of 1200 billion in
i-orid trade in manufactured goods" Developing oountriea would like to
•ore.

imp=tinent^ that tuined out successfully but produced goods that compel." i . i t
prndLicts fi-om industrialized counti-ips. There is soine merit to these

Wills the currant debt situation may ease some-Jhat, net capita] inflo

discussed. That lea\es Europe and Japan to do most of the adjusting, plus a
feu other countries such as Taiwan and Korea.
nt deficit*. 1
large surplus*^ ar** eonrontratFd in the Federal Republic of Germany, thn
Netherlands p and Switzerland. But those countries that rould be on U,^ old*• ide nf a major U.S. correction, especially Japan and Wpst Germany, have kf^.
their i-cGdCHnies over thp post decade or longer to e^-port-led firowth- The J-P

JatAn spcmft To Y,a\c started the process of adjustment , arrf the Japanp^f
diArtJss publicly thp imjor structural changes that may hnvc to lAk? iilaoi" ir

the same high standard: for exgjnplp, comnercial office apace in I . E . citif,
vns substantially overbuilt f i t h the help of atrona ta>. incentives during (>i
earl) 19fiOs.; ant] Rurope hus made numeroua public inveatments, sm;h as in sti m e s l n n n t . Furl-hf.j-im.re, nvcr the decades 1960-1980 developing countries g.
at extraordinary rates, and it is hard tc belief that inflm-'s of capita] If

Ui fulure defauirs.

but sopie combination of pubiic loans and guarantees

LjH'^jiisjdn of thf; niH^d iV.i structural change along Ihpfif lines is ini^h k-Efi
a l t u i n a t j M ' , if world recession IB to be avoided, f i l l bf continued len(*
the liuted SL.T.CS,. Tliat is not de?iruble t rom the American pprsDPCti\p
e, interest rates, and so on, Japan and Vtest Germany
r
inss far in evncss of tne uiilineriess of donestie
ftrid invest in plant and equipment. Tlie sovemnei]!^ alisor-l:
- throiish T h e i r budget d n ' f i c i T s . But larse Amnunte of
alinu.i, csT»^iHUy in DIP United States. Developing
to iminm.. fi.ture qtandanh of living. Since the debt crisis of 1962 nel
lending to capital minorting de\e]o n ins (t)nntries hus stagnated, falling frnm
(103 b i 1 1 ion in 19S1 to mi estimated 314 b i l l i o n in 198", and the rain brunt
of t h i ^ decline Ins f a l l e n on imestjnent. Private inveatora are lear? abniil

Ki tJm

efu]

the

publi

i n v e s t m e n t ) , they Ki 1 1 tie d i s s i

evjipttdiluie or reductions in Saves that encourage private spending, that IB,
In highei budget defit-its. Thig recoranendation does not f i t comfortably nth
thF,l i f eier<:>ne - Iniiiselinlrts and businesses na tell as gm-emments - ia

ill

tha

Ainr-j-i. .in laiKis ftiivi-, In an extent that t i l l not tx-t-ui in nut them liu!-"H' nn
Japun. Tliv V t i i t i i l S t a l e s I -au use inws,tinenl r>"idi»'l ivclv for e^uipiunt ..nd
hiHisiiit h giouirig l.iliru fiii,-*-, whoic.1!, in r i o i l h e m Furope rich invfitiwt.t
op,..Mm i l i e s k i l l L- l i r a i l e i j t u th,is B t-renleti by te-.-hnologn-^l :-k*nfr : and
eien Ihoss- n i l lie di s<'om-.,g«l hy SI rong r-urreniriee. Tt is therefore l l k c l ;
S l n l e s . For I h i s rea-i,,n , it mny he H ralsUke to think of hm ing to e] imiliii'
e n t i r e l y I he I'.S. current afcnun! d e f i i - l l v i l h i n the ne-,1 f i v e ypBT-i. To r h
e\1.etiL lhat the rniterf .-itntes runs a d e f i c i t in the mid-1990s, the nioblem o
atljustlris the utirlri st rut-t lire of trade H i l l lie eased.

.-ing cai
rid

of si in-- fi-ni-th i n the Jalor torn- and an aging population. The LniteH state
is al-'i f-.i»>rieni-;ni a declinr- in the natural groi.-th of the labor f'ci-irr- fnr

red

th- i « , s s i h i ! i 1 > oi continual overshooting of exchange rsil-^, nth
OVBI-I i l i u t inn folltn.'ed. by undervaluation, and vice vprsa. This, ryissi hi 111
o \ c i s l v i . i l i n g , iifrtmiw for prolonged periods, introduces a disturbing soun-

i n l r o i u t - i - Uijit from thr •.iei.-point of the busine^iman nr farmer is a u h n l l y
»rin!r-nri B'nji^i' of ura-crta int j into his protiuction miii investment

ill

anc-hor fnr thf •ii-.lem. Ratht-t-, the Federal Reserve w i l l find itself ra-.-f
frenuenllv ha. in/ to r»s,,<iii<] to intcrnationai finnnc-ial pressures, whethr-r
the' n<-f radorvil 111 t h e Inrgr-i scheme of thinss or rait, und thess may
rnr the ucalth-producing
i currency for the industrial ited OtttnncriK-ifs s
ing nations, arid irrdeed it invnlvp-, a mejnr lf<ir>
i t c i F i g r i : } w i l l seem to be the niajnr obateclf-; liu
i* i-apiiil> ,-roding the a b i l i t y of netiong to
ooll&:ti>p i - r i n t n i l . >k, mn - 1- , it 51 could be acconiDli5h«J, it umild gipat
a i m p l j f i the iirdlilsan of coord mat ins economic policy among nations, "tour L
policv could I*' aig.icJ cut in the Btard, arri fiscal polic? could proceed
independent I j , -cixiEdirwtp.]" thioi^h Ihc pn ssure of the nErketplaoe . T l
represent
a wcilhy anhil ion I:,, the fulurp evolution of the industrial i ^i-

152

The CHAIRMAN. Thank you, Dr. Cooper. That's a very interesting
suggestion.
Dr. Sachs, professor of economics, at Harvard University. This is
Harvard day. As a Yale man, I don't know whether that's a good
idea or not. You were a consultant, as I understand, with respect to
Bolivia and you suggested some innovative approaches to their
problems. We're delighted to have you. Go right ahead, sir.
STATEMENT OF JEFFREY SACHS, PROFESSOR OF ECONOMICS,
HARVARD UNIVERSITY

Mr. SACHS. Thank you very much, Mr. Chairman, for the opportunity to testify. I hope that despite my scholarly connection you
will find some interest in the testimony.
I must say I'm quite relieved, after hearing my colleague's testimony, I agree with most of it so we won't have to have arguments
on the airplane back home, although I would have some pause
about the final suggestions of one world currency which maybe we
can speculate on later on.
FLEXIBILITY IN MONETARY POLICY

I think that both speakers already this morning have explained
why this is a period of unusual complexity in monetary policy.
There are a number of cross-cutting aims of monetary policy which
are extremely difficult to satisfy right now. I, like the first two
speakers, support the current settings of monetary policy by the
Fed, but would stress and do stress throughout my testimony that
there is a considerable need for continued flexibility in monetary
policy. This would be a terrible time, in my view, to enter into any
kind of international arrangements to peg exchange rates or to
rebase the currency on the basis of a commodity standard or other
such innovations, particularly because given the kinds of real economic transitions that we're aiming for in the next few years we
don't really have the capacity to say very clearly what the appropriate exchange rate will be. We just don't know enough to know
what kinds of responses will occur in export and import demand
and other variables which will determine the appropriate level of
the exchange rate.
We are in a fundamental transition I hope from domestic-led
growth to export-led growth in this country, and that involves a
number of tradeoffs and risks. Exports are rising right now and on
the one side there is a risk that if domestic demand does not slow
sufficiently the rise in exports coming from the decline of the
dollar will lead to overheating of the economy.
On the other hand, there are very legitimate concerns that the
rise of exports will not be sufficient to match what is now projected
to be a slowdown of domestic aggregate demand.
So there is an unusually wide range of forecasts right now ranging from overheating to recession this year, which comes from the
fact that we are undergoing a rather major structural change in
this economy whose outcome is very hard to see on a quantitative
basis, though relatively straight-forward to understand on a qualitative basis.

153
POLITICAL BUSINESS CYCLE AND THE ECONOMY

One issue that you raised in the invitation was the question
about how the political business cycle might interject itself with
this delicate decision about the risk of overheating versus the risk
of contraction, and I think it's a very interesting question. I do
spend a couple of pages in my testimony describing that and if you
could look at one of the tables in the testimony after page 3, I
think that the history gives an interesting lesson actually about
the political business cycle that's worth pondering.
In recent research that I've been doing and others have also
found the same thing, there does not seem to be any overwhelming
case of a political business cycle in the sense of election year
changes in monetary policy for the purpose of affecting the election.
If you look in this table, for instance, you notice that the average
growth rates in the fourth year of Presidential terms is approximately the overall average growth rate of the economy and when
one scrutinizes fairly closely the monetary policies of the various
administrations in the fourth year of office or of the Fed during the
fourth year of office of the various administrations you don't really
see too much manipulation of monetary policy for political ends
except during the term of that most political of our Presidents,
President Nixon, in 1972, where we have the single case of fairly
clear evidence of excessive monetary growth for the sake of the
1972 election.
But more generally in our history that has not been a pattern
which has played an important role.
However, there is a very strong political business cycle of a different sort which I wanted to draw your attention to, and that is
that the Fed does respond to politics but not in the fourth year of
Presidential terms but in the beginning of Presidential terms. And
there is clearly a partisan business cycle in our country with Republican administrations almost invariably leading off with recessions. Indeed, every Republican Presidential term, save the most
recent one, started out with a recession that began in the first or
the 2d year of office.
No Democratic term has ever started out with a recession. And
when one traces the monetary policy, you do indeed find the Democratic terms start out with quite expansionary monetary policy
from the Fed and Republican terms start out with quite contractionary monetary policies from the Fed, in my view indicating the
relative priorities given to growth versus anti-inflation policies of
the different political parties, and indicating that the Fed is certainly not a purely autonomous institution that is not subject to political change. Indeed, it does move quite strongly with the political
winds, but in the beginning of presidential terms, not at the end of
presidential terms.
So aside from particular historical anamolies, it has not been a
general pattern—the concern that you raised.
Now let me say a few words about the present situation, the difficulties of managing a transition from domestic-demand led
growth to export-led growth.

154

One point I think should be understood at the beginning. A big
part of that transition, of course, involves a continuing reduction of
the Federal budget deficit as a share of GNP, but strikingly, all the
evidence suggests that even if we were to get the budget down to
that magic number that we're aiming for of zero in 1993, that in
and of itself would not even be sufficient to restore trade balance
in this country, if we don't, in addition, have a rise in private savings in this country because the private savings, private investment balance in this country is sufficiently adverse, private savings
are sufficiently low that we would be relying on foreign capital inflows even if there weren't a Federal budget deficit right now.
Our true long-term policy crisis in this country involves the private savings rate just every bit as much as it does the public savings rate.
Now in the short term, however, we do have the pressing public
policy concern of reducing the budget deficit and managing monetary policy during the transition.
The major problems for monetary policy, of course, are that
there are great uncertainties in this transition. First, we don't
really know what the strength of private demand will be, particularly after the collapse of the stock market last year. Export
demand equations which predict how the exports should respond to
movements of the exchange rate are also not performing very well
now. So there are great uncertainties about the continuing
strength of export demand.
And finally, the inflationary risks of continuing using monetary
policy are present, but once again, the traditional equations that
we rely on are not performing very well. Inflation has not responded as significantly as one would have expected to the falling dollar.
So the guideposts for moving between these difficult positions of
overheating and recession remain a matter of very good luck and
considerable risk because most of the traditional quantitative
guidelines that would be used simply are not up to the task at
hand.
I think the main implication for policy, therefore, is that monetary policy has to remain flexible and we should continue to avoid
any adherence to firm rules either on the exchange rate or to monetary aggregates right now. If it does turn out that private demand
falls more than is currently being forecasted, we do want to have
the option of easing monetary policy and causing the dollar to go
down further and we want to be able to do that without tremendous concern of international agreements pegging the dollar.
So I think that the main policy implication right now is that the
Fed is probably on the right policy course and that it should
remain flexible to stay on that course if either the economy starts
to overheat to be able to tighten, or if the economy actually starts
to fall into recession to be able to ease monetary policy significantly in order to keep the economy growing, one implication of which
would be a more sharp fall to the dollar than has already occurred.
But that seems to me to be a risk that would be appropriate in the
circumstances of a sharp slowdown in the economy and one that
we want to have available to us later on.
A word on the developing country debt. There is a real sense in
which our monetary policy is hostage to the debt crisis right now

155

because a sharp rise of interest rates would do considerable
damage to the prospects of the debtor countries. But as I stress in
the testimony, this is an unfortunate situation because our overall
debt management policy is so poor right now and so unrealistic
that to hold monetary policy hostage to a very poor debt management policy is itself adding a disaster on top of a disaster. It's time
to move toward a more realistic reduction of the debt burden for
these countries and if we did so, then the extent to which our monetary policy had to reflect the concerns of the debtor countries
would be substantially reduced.
So the element of constraint on monetary policy vis-a-vis the
Latin countries follows very closely from the fact that we are already living in a very unreal debt management situation where
countries are being called upon to service debts that are far beyond
their steady state capacity to service. I'll stop there.
[The complete prepared statement of Jeffrey Sachs follows:]

complicating element is the fact that the recent declines of the
dollar might provoke a rise in inflation via higher import prices
Testimony to the Senate Banking Committee
Professor Jeffrey Sachs
Harvard University

even if the overall econony is relatively slack.
Because of the central importance of balancing a slowdown of
donestic denand with an acceleration of exports, the most

February 25, 19BS

inportant questions now confronting monetary policy involve the
appropriate management of the exchange rate. If moietary policy
Mr. chairman, thank you very much for this opportunity to
testify on the current management of U.S. ncnetary policy, as part
of this Conmittee's serai-annual review of the Humphrey-Hawkins
testimony of Chairman Greenspan. It is widely appreciated that
the uncertainties now surrounding ncnetary polity are mxre
profound than usual, in view of the large external deficits of the
U.S. economy and the financial market instabilities in the past
half year.

Under the best of circumstances, the U.S. economy is

in the process of a delicate transition from consumption-led

is eased, the dollar will depreciate further, and export demand
will be further stimulated. Tne risks of recession will thereby
be reduced, but at the possible costs of higher inflation
(directly through higher inport prices, and indirectly, through
tighter labor market conditions) . If tanetary policy is instead
tied to a target for the exchange rate (either by unilateral Fed
policy, or in an agreement with our trading partners) , the risks
of renewed inflation nay be reduced, but at the cost of a possible
slowdown in export growth, and a slowdown in the ecorcrry overall.

growth in recent years to export-led growth in the future. Die
monetary authorities therefore have the central task of managing
monetary policy

(and exchange rate policy) so that escort growth

is fast enough to compensate for a decline in domestic demand, but
not so fast as to result in an overheated economy and renewed
inflation.
The dilemmas facing the Federal Reserve Board are perhaps
most simply illustrated by the fact that pundits and forecasters
can't decide whether the economy is at risk of overheating, with
renewed inflation, or is instead on the brink of recession. Cue

Tne Effects of the Election Cycle cm Monetary Bslicy
Before analysing the more technical aspects of the choices
facing the Fed, it is worthwhile to turn to one of the particular
concerns of the Committee: whether the choices made by the Fed
this year are likely to be influenced in an important way by the
elections. Tne historical record is, I believe, both interesting
and a bit surprising on this score.
It is widely believed that the Federal Reserve Board tends to
choose policy actions in an election year in order to improve the

electoral prospects of the Administration in power (either the

Rate of I3routh

of GNP

reelection of the president, or the election of the President's
party). There are usually tuo links to the acganant: that W\ite
Democratic Administrations

House pressure can nave an important effect on monetary policy,
and that these pressures are clear and overwhelming during

Year

election years. The enpirical evidence does supf&ri. one lit* of
this argument: the ability of the White House to influence the
Federal Reserve Beard actions, despite the smiceed institutional
independence of the Fed from outside pressures (see the recent
paper by Havrilesky, 19BB, for a review of the evidence).
Cn the other hand, the historical record does not suggest any

First

Second

Third

Fourth

Truman
Kennedy
Johnson
Carter

0.5,
2.6
6.0
5.5

B.7
5.8
6.0
5.0

8.3
*.0
2.7
2.8

3-T
5.3
H.6
-0.3

Average

3.T

6.11

H.5

3.3

Average
First/Second Halves

5.0

3.9

flagrant manirulatics] of Fed policies during election years for
the sake of the incuitoent Administration,

indeed, the "political

business cycle theory", uhich predicts such manipulation, was bom

Republican Administrations

in the wake of the 1972 election, an election fchich raw eeems to
Tear

be the <slv fairly clear case of monetary mnipulation for
First

Second

Third

Fourth

CamegieH*!llQn University, 198B) there is no discernible pattern

Elsenhower I
Elsenhower II
HlHon I
Nixon II
Reagan

3.8
1.8
2.8
5.8
2.5

-1.2
-0.1
-0.2
-0.6
-2.1

6.7
6.0
3.1.
-1.2
3-T

2-1
2.2
5.1
5.1
6.8

of especially rapid OJP growth during election years (th* fourth

Average

3-3

-0.9

J.7

1.«

year of each Administration), as a naive theory of tte political

Average
First/Second Halves

electoral purposes.
As shown in the attached table (taken from a stuSy that I
have recently published with Professor Alberto ftlesina, of

business cycle would suggest.

1.2

There is, however, a remarkable

effect of political parties on the economy in the two years
following a Presidential electicn. To the extent that political

Oil shocks
Suurce; Alesina and Sachs

1988

tt.O

variables are important in the economy, they seed to operate at
the beginning of Presidential tens, not at the ena.
Almost invariably, Denocratic Aiministraticns begin with

Die fundamental macroeconanic policy goal that will face the
country in the next few years, no matter which party is in office,
is the reduction of the external deficit, a«J the ccnscwaitant

boons (especially in the second year of office), nhile Republican

reduction in the U.S. dependence on foreign capital inflows.

Administrations alacet invariably begin with recessions. These

order to achieve a shift in the external deficit, it is required

differences average out by the third and fourth years of office.

that total domestic spending in the U.S. should decline relative

It is remarkable to contemplate that every Republican

t» OJP, in order to free up the resources that nust be devoted to

Administration except the second Iteagan term began with a

an increase in exports. Since the economy is already (pirating

recession during the first tH3 years of office, while no

near full employment, the only way to increase exports

Democratic administration ewer began with a recession- In the

significantly is reduce donestic demands for donestic goods, and

vi«j of Alesina ana nyself, the differences betwen the Democratic

thereby to free up writers and other resources to devote to export

and Republican Presidencies reflect the differing (eights that the
two parties put en the objectives of economic growth versus

The nost reliable way to reduce domestic spending relative to

inflation control, teraocratic Administrations have tended to

QfP is to reduce the government budget deficit, either by

favor growth (and employment) at the risk of higher inflation, and

expenditure reductions or by tax increases, or nest likely, by a

the Republican Administrations have tended to favor inflation-

combination of the two. It should be noted, hcwver, tt^t even 4f

fighting even at the risk of a slowdown in growth, or even a

the budrfM- Deficit is virtually qjjminated . it ia likely that an

recession.

U .s._ gyterriaf deficit will renaii^ unless nrivatn rrr+r

It seems, moreover, that the differences in economic
performance between Administrations of the two parties can be

also increase
Put another way, the U.S. external deficit is equal to the

traced to differences in economic policies, particularly monetary

excess of donestic investments over national savings.

policies. Huts, the Fed does seem to be susceptible to important

government dissavings is reduced, thereby raising overall national

partisan influence, but in ways that are more subtle than simply

savings, the excess of investment over national savings will tena

pjnpijig up the economy on electim eve.

to fall, and the external deficit will be reduced. However, even

Managing the Transition to Export-lad Growth

likely to be an excessive of private sector investment over

if government dissavings are virtually eliminated, there is still

private sector savings. Tills is because our domestic savings is

the fall of the dollar since 1985. Also, inport prices were mutii

now extremely low, both by historical and international standards.

lower than would have been predicted according to historical

•OBJE, a fall talarcirg oi the external accounts will likely

relation^iips, so that the effects at the weak dollar on tkmestic

require a rise in private savings {or, less attractively, a fall

inflation had been much less than feared.

in investment) in addition to the elimination cf goverment
dissavings.
The great trick for monetary policy these days is to get

What remains to be seen, however, is blether these breaks
with historical experience are simply ten^porary aberratiais in the
data {i.e. time lags in exports and import prices that are

exports growing fast enough to mate up for the demand shortfall

difficult to explain), or whether there are nore fundamental

that might arise from the reduction in the government deficit, as

structural shifts underway in the U.S. econoay. Some have argued,

well as any accompanying increase in private savings that might be

for example, that the dollar has to go raKSi lower than it is today

achieved. The precision with which monetary policy can be

because the U.S. has lost fundamental ocnipetitiveneES with the

deployed in this task is limited by several factors:

Asian eccranies, so that the previous basis for judging the

(1) it is extremely difficult to predict accurately now the
state of private demand and private savings, especially
following the events of Black Monday;

appropriate level of the D.S. exchange rate no longer apply.

(2) it is difficult to predict the linkages of easier
monetary policy to faster export growth, since both the
linkage of money to the excharge rate, and of the exchange
rate to exports, are difficult to gjage with precision.
Statistical relationships of esqwrts to exchange rate
changes, based on past history, have not fared well in the
past year;

that we stidt with the historical experience as long as possible

(3) it is very hard today to guage the inflationary risks
that arise from a further decline in the dollar. Those risks
are of W) sorts: a general overheating as well as the effect
of a weaker exchange rate on higher import prices. The
historical linkages between exchange rate changes and import
prices have tended to break down in the past year.
Thus, to appreciate the Fed's current guandry, note that the

As a general strategy in such uncertain periods, I imia urge
(i.e. that we continue to rely on the earlier statistical
relationships) as our guide to policy, rather than believing that
we are always living with a new "^iecial case", requiring new
"special attention".

Ihe normal disciplines on policyiraking tend

to fall apart if policymakers are prone to abandon earlier
guideposts every time that six months to on* year of data come a
cropper. Moreover, it is almost surely the case that ws are
better at estimating the long-run effects of policies than their

historical bases for designing exchange rate policies have been

short-run effects.

unreliable guides in the past year. Until very recently, export

wrmg the dynamic responses of exports and imports to the exchange

growth was less bouvant than would have been predicted in light of

Technical econonists ar* alicst bound to get

rate, even if they can acre reliably estiirate the long-run effects

"equilibrium" value of the dollar. How strong will export growth

of such policy changes.

be?

In this view, we stould expect two things from the fall of
the dollar that has already taken place.

First, export growth

How inflationary will dollar depreciation be? How ouch will

U.S. domestic demand slow in the coming year, and EO how fast must
export growth be in order to compensate for the slowdown of

should remain strong for a while even if there is no further

domestic denand? H™ much progress will be made in the next

significant depreciation of the dollar. This is because there is

eighteen months of budget deficit reduction? All of these

evidently sane remaining lagged response of export growth to the

questions bear directly on the appropriate value of the dollar.

exchange rate depreciations to date. Second, import prices should

Since we won't know the answers to these questions except in the

be expected to rise more rapidly in the coming year, since the

course of tine, ue should maintain the flexibility to respond to

response of ijiport prices to the dollar depreciation has so far

develt^ments with changes in monetary stimulus, and charges in the

been notably less than would have been anticipated from historical

value of the currency.

relationships.

To take one case, suppose that domestic demand in 1988 turns
out to be ouch Bore sluggish than currently forecasted.

To conclude this testimony, I would like to offer my

The

appropriate response for the Fed will be to ease monetary policy,

observations en the specific issues raised by Qiainnan i/i his

with a resulting further depreciation of the dollar.

invitation to me to testify today, specifically: (1) the costs anl

the straightforward reason that more donestic resources will

benefits of a policy of defending the dollar on foreign exchange

become available for export, without a further depreciation, the

markets; (2) the constraints on monetary policy resulting from the

unexpected demand slowdown would tend to result in a rise in

fragility of the debtor nations; and (3) the inpact of increasing

uneEployment. With depreciation, however, the incipient rise in

net indebtedness of the U.S. on the conduct of monetary policy.

unenployment can be absorbed into export expansion.

C«i the Costs and Benefits of Cefending the Collar

the Yen in an international arrangement, however, we would not

This is for

In the event that the dollar were to be tied to the l» and

IMs is a very poor time indeed for the U.S. to enter Into

have the unlimited discretion to ease monetary policy. Nor could

international agreements to support any particular value of the

we enjoy the stintilative benefits of a further fall in the dollar.

dollar. The whole thrust of my testiiraiy has been to suggest the

We would likely enter into a rather acrimonious dispute with

profound uncertainties that now revolve around the appropriate

Germany and Japan ever the appropriate canton response of the

three countries to the growth slowdown. Germany and Japan would

claims should usefully be converted from variable-interest-rate to

tend to fear the inflationary consequences of further easing of

fbted-interest-rate securities, so that the vagaries of U.S.

ittietary policies, and put pressure on the U.S. to ride out the

ncoetary policy would not have the effect of wiping out the debtor

demand slowdown with somewhat Indited overall economic growth.

Countries.

The Links of hfcretary policy and ICC Debt

dencnstratad (see Sachs , 1987 , for some details) , as can the

The financial feasibility of such an approach, can be
I have very recently testified (February 4, 1988) at length
to the House Banking Committee on the state of tha debt crisis,

economic rationale for proaeedirg in that direction. With latin
flzerica in its k»rst financial turmoil in decades (average

and I would kindly refer this Ctmoittee to that testimony for a

inflation now exceeds 200 percent per year in the region! } , it is

detailed discussion of ray views. Here, it should suffice to make

time to face up to the shortcomings of the current ways of

two sonevfliat contradictory remarks. Cn the one side, tighter

managing the crisis.

monetary policy clearly exacerbates the crisis, by raising
interest servicing coets of the dsbtor countries and by depressing
the prices of omrtidity exports of the debtor countries, on the
other side, however, the whole defct crisis is being so poorly

Die Inpact of Increased U.S. Net Indebtedness on Jfcnetary Policy
in a woria of high private capital ncbility, as now exists,
each country's monetary policies are inherently constrained by

managed by the U.S. Treasury mat it makes little sense over the

international factors, whether the country is a net debtor or a

longer run to hold U.S. monetary policies hostage to the current

net creditor country. In either case, a reductioi in domestic

debt management strategy.
The time has long since arrived to reduce the debt burden of

interest rates is bound to set in motion a (rapid) process of
portfolio adjustment leading to a depreciation of the domestic

the major debtor countries through some mechanism of debt

currency. A drop in the real long-term interest rate of 1

conversions, in whicii the commercial banks admit substantial

percentage point tends to depreciate the real exchange rate by

losses in return for having some or all of their IDC claims taken

approxijiately 6 or 7 percent. TtjB big swings of the dollar in

over (at a deep discount) by an intematicnal agency, such as the

recent years can indeed be well explained by shifts in the U.S.

Vtorld Bank. The agency, in turn, would hold the claims CHI the

interest rate differential vis-a-vis our trading partners, as is

debtor countries, and would reduce the debt servicing burden in

shown in the attached figure, taken from Keeper and Harm, 1987.

line with the ability to pay. In the debt conversim, the ICC

FiBUre i.

th, Dollar ind R»il lnt.r»»t FUt*t
(Outrun* eitt) v
•>««!. Mirth If 73 •tog

For this t«aBC*if the Knetajy 4ut±uritlflB mist «lwayB grapple
with the fact that "tWnestic" nmetary policy changea uill row
inAvitobly heive direct and nearly ivtantanaoua reftuxUBHioiH 01
thfi «9EttwigH rat«f the iiinrt pritv level, and •iqxeT
ccnpatJltLlvenaas. A BJVB to Danaged exctiange mtaa wjulcl nat tad
to chaiEe this fact: 1C would nerely tend to llait the rnngp of
diacreticfi now enj^ed by the Knetory autlKritias. (Afcdttedly,
if the U.S. vere at the center of a iBnacpad ayaten, 0ur direct
itlClixnce over foreign nonetaiy poltclas could td onbamed. I 013
not vieu B U.S.-centered systen as a raalietic prospect, however).
The fact that the U.S. la a net debtor, and OB Ixportantly, a
net borrower currently, also Bane that U.S. intoroBt: rates and
nonetary policy could also ba oubjast to the audits In portfolio
pmtaaee of foreign iiwastors — bWh private and official.

Ritl Leng Ten* kiten»t fttU* «/

the Japanese imrastore ufclenly decide on average that thiy
reopire a risk pragiiw of a feu percentage point* on U.S.denomlnated aasets, the result ncula certainly b> a sharp rise in
U.S. Interest rates and a significant alniltaneaus Cell of the
dollar. Such a shift in the tsjiimd ride praaiiu in the central
BBChanisn behind stejimn Harris' uell-knaun forecasts of a "hardlanding" in the warld eomv In the next tw to three yours.
for feint It ia teeth (aol here history Ky be B ratnor
unrellBble guide), thors la little evldance of a rising risk
prendiOB on U.S. assets in the past tea years, despite the rapid
huildup of U.S. dBmglnated assets In the portfolios of Japanese

»»

-ar>

Sfcurce: Hooper Bud Mann (19B7), Chart 13, p. 51i. The rcil cichgnge rite 1i • CCI
tdjuitid fichangf rite fur the non-U.S. G1D countrtei plus Sultierlind. Uelghtlng 1i
ictordtrg to th* ihire of the country 1ri world trtde durlnj 1978-81. The long-teni
Intcrctt rite 1i > government long-tin bond rite >fnus i 16-Minth, centered. Inflation
rite. The 1ong>tem Interest ntt 1ndei utei the stnt weights a the real etching*
rite tndei.

wealttitulderB. Die fears of a sudden uithdrouel of creditB from

the U.S. haveremainedjust that . . . fears.

Foreign private

investors have continued to accunulate U.S. denaninated claims at

List of References

a rapid rate. Jtovorents in U.S. interest rates have apparently
been the result iroetly of shifts in U.S. ncnetary and fiscal
policies, and not of swings in foreign portfolio preferences.

Alesina, A. and J. Sadis, "Rjlitical Parties and the Business
Cycle in the United States, 1948-1984", Joumal^f Ifcnev. Credit,
and Banking. February 1988
HavrilesXy, T., "Monetary Itolicy Signalling fnm the
Administration to the Federal Reserve", Jg^qnal pi Mnney. Credit,
anri flanking February 1988
Sachs, J., "Ihe U.S. COnrercial BanXs and the Cevelcping-Country
Debt Crisis", Brookinas Papers en ECcnouic Activity, 1987:2

Sadis, J. Testincr^ to the Hcuse Banking Connittee on the
Developing Country Debt Crisis, February 4, 1988

164

The CHAIRMAN. Thank you very much, Dr. Sachs.
Our last witness is Dr. Neal Soss, Chief Economist, First Boston
Corporation in New York. We're delighted to have you. You're
also, I understand, a former top assistant to Chairman Volcker of
the Federal Reserve Board.
Mr. Soss. And from Princeton.
The CHAIRMAN. Well, nobody's perfect. [Laughter.]
Nice to have you. Go ahead.
STATEMENT OF NEAL SOSS, CHIEF ECONOMIST, THE FIRST
BOSTON CORP., NEW YORK

Mr. Soss. Thank you, Mr. Chairman. I appreciate the opportunity to be here as well.
[The complete prepared statement of Mr. Soss follows:]

Mr. Chairman. 1 appreciate [his opportunity to testify before the Senate Banking
Committee as part of the Congressional oversight of [he Federal Reserve's conduct of
monetary policy.
Transferring Resources to Foreign Creditors
Two transitions—delicate and intertwined—challenge the American economy in the year
ahead. The first is to stow output growth to a more sustainable pace after 1987's -urge
The second is to base growth more heavily oil foreign demand and relatively less on
domestic demand, The.se transitions are fraught with risks, and financial markets have
been resonating to those risks since [he bond market collapse last spring.
Testimony by
Neal M. Soss
Chief Economist, The Frist Boston Corporation
before die
Committee on Banking, Housing & Urban Affairs
United Stales Senate
February 25, 1988

in i y s / pusneci me u..v economy lowaro its resource utilization
limits too fast to permit continued low-inflation expansion The question is what
derate the pace of growth and relieve the potential inflationary pr
mec
sures

The devaluation policy of recent years renewed American industry's access ro
markets around the world, [n real terms, manufactured exports ate growing at (ioubledigit rates while imports of manufactured items are stagnating. The world wants
America's output because the dollar 15 cheap. And Americans are inclined to lay claim
to the same output because of the jobs, wages, and profit opportunities created by the
trade boom. The confrontation between an economy moving toward full resource utilization and rising demands, both foreign and domestic, is a recipe for inflationary excesses and mounting financial stringency. The prescription over time is for policies restrictive enough to moderate domestic demand (arid so relieve the import side (if ;he
trade imbalance) but stimulative enough to perpetuate the resurgence of U.S. esport
competitiveness.
Frijm the outset, the devaluation policy required thai resources would someday
have to be shifted away from domestic use and toward the foreign sector. Somedav
began to arrive in 1987, and will be with us for several years. What mechanisms can
accomplish the resource transfer 1 *
fiscal Policy
Fiscal policy can play a constructive rale in this process A tighter budget— whether
from higher taxes or lower expenditures— would act directly on domestic demand ,ind
allow foreigners to exercise ihe first claim on America's oulput that the cheap dollar
has given them. The symptoms of [he economy and the verdict of the markets sueeest
that still more fiscal restraint is in order A cheap dollar and nearly full employment
mean that for the first time in several years [he U S economy needs a shrinking
budget deficit to sustain [he business e\pansion and stabilize financial conditions

Inflation and Financial Stringency
As we learned in the 197Js, inflation itself is a resource transfer mechanism. Escalating prices ahead of wages (and inieresi rales) [axes away from (he domestic economy
some of the fruits of its labor. That margin is freed for export. In a broad sense, inflation was a ceniral mechanism of the resource transfer to the oil-producing nations that
occurred in [he Seventies.
By contrast, i n f l a t i o n has remained under control so far in the 1980s despite a
record-long peacetime business expansion, accompanied on average by quite high rates
of money growth, and lately a sharply devalued currency. Financial market vigilantes
have launched pre-emptive strikes at every inflection point in this business cycle when
conditions threatened to overheat. While cost pressures are now trending up with
iiehier labor marker and capacity utilization conditions, the demand side of inflation
has had a hard time gaining momentum because of the prompt and severe bouts of
financial instability the economy periodically experiences. Regulating the pace of business through unfettered financial markets is dangerous and messy, however, since the
markets have (o make loud crashing noises to he heard by the real economy
Crashes and ihe Economy
The message to the economy in each instance has been to slow from an over-rapid
pace. In particular, recession is not now required to deal with the problems of the
economy or the financial system Indeed, recession now would make the problems
worse. But there is no clear calibration between the degree of setback suffered in financial markets and the cooling of demands on the economy lhat is induced. Moreover, repeated shocks have taxed the resilience of financial institutions and mechanisms
Crashes heighten forecasting uncertainties. Domestic demand softened in the
fourth quarter of last year, while production momentum continued. The result was a
build-up of inventory. Will production now decelerate to bring inventories into better
alignment with sales, or will sales pick up?
The most recent statistical readings point to a remarkable (implausible?) rebound in consumer sentiment and spending only 3-4 months afler October's Black
Monday While each of us may express assessments of how sustainable these developments may be, the Federal Reserve requires a higher standard of proof, for its actions
not only reflect its assessment but also have an important bearing on the outcome.
The Monetary Aggregates and Monetary Policy

reflect a heightened preference for liquidity rather than for the other goods and services the economy could produce'
Monetary aggregates are not goals in their own right. They are important insofar
as they shed light on current and prospective developments affecting the true goals of
economic performance—sustained growth at high levels of employment and reasonably
stable prices. The link between money and economic activity is velocity (nominal GNP
divided by the money supply). During the 1960s and 1970s Ml velocity displayed a
fairly stable trend growth of about 3% per year. Ml was used for making transactions,
arid transactions are the stuff of GNP. Thus, for a given growth rate of Ml you could
be fairly confident that nominal GNP would grow about 3 percentage points faster. The
Fed made use of this relationship when it set growth targets for Ml.
The historic pattern of velocity was a fundamental rationale of the Fed's monetarist experiment in October 1979. The Fed would provide reserves sufficient to support only a targeted amount of Ml growth, which in turn would support only so much
nominal GNP growth. Over time, it was hoped, the economy would allocate more of
that nominal GNP to the real component and less to the inflation component.
Then the link changed. The earlier stable relationship of money growth to GNP
growth dissolved into an erratic trend decline in velocity. By late 1982 the Fed was g i v ing less weight to Ml in its policy deliberations—actual Ml growth vastly overshot its
targets m 1982, '83. '85, and '86—and the Fed didn't set an Ml target for 1987
In part, the change in its velocity reflects regulatory initiatives that have altered
the composition and character of Ml. Today over one-third of the monetary assets included in Ml earn interest. In 1980 less than one-twentieth did, and ihe interest rale
on even that small component was subject to strict limits. Since 1983 interest rate restrictions on checkable deposits held by individuals have been removed. Now the aggregate that we call Ml has both a transactions component and a large savings component.
The lifting of interest rate restrictions has also had an effect on the relationship
of GNP and the broader monetary aggregates, M2 and M3. In general, both M2 and
M3 velocity have become more volatile in recent years This volatility makes M2 and
M3 less reliable monetary policy targets.
The component of "money" that has been least affected by regulatory innovations is currency—folding money and coins. Yet, even currency has misbehaved; its
pre-1980s trend increase in velocity has given way to erratic declines in the last few
years, mimicking other forms of "money." It seems likely that the harsh early-'&Gs recession and the long disinflationary business expansion that followed have shifted the
public's desire for and use of "money" in ways that go beyond the effects of regula-

Money is probably still sending a message about economic performance, just as
before. -The difference is that in Ihe "good old days" the monetarist message was decipherable by the 3% velocity trend. The code has changed in [he last few years, and we
haven't yet broken the new one. This fact does not make anyone's job any easier—not
the Fed's in framing policy, not the Congress's in oversee me policy, not the market
participants' in making business decisions in anticipation of economic and iinancial developments
As the relationships have become less stable, the Fed has given less and less
weight to all Ihe monetary aggregates. Currently, the monetary aggregates rank last in
the Ms! of factors that the Fed considers before adjusting short-term policy They fall
behind strength of the business expansion, inflationary pressures, and developments in
foreign exchange markets
Velocity is not likely to be any more predictable in 1988 than in other recent
year:; The Fed will continue to set longer-range targets for monsy growth, but it is unlikely to react to growth that is above or below target unless business conditions and
inflation pressures are confirming the signals.

.Significant risk remains of a sudden and perhaps exaggerated shift in liquidity
preferences that would require the Fed to exercise us responsibilities as lender ol last
resort. The Fed cannot pre-empt that risk by adopting a monetary posture ihat is
chronically too easy. But a judgmentally-bascd Fed approach, by making for more stable money market conditions, w i l l lessen the risk of a renewed outbreak of financial
instability on a grand scale
The Fed and the Election

The Federal Reserve System is designed to provide insulation from the b i e n n i a l
and quadrennial partisan pressures [hat are the lot of Congresses and Administrations
Fed Governorships last 14 years, and appointments are staggered to reduce the potenliai influence of one President or political party. The four-year term of the Chairman
has not been formally synchronized with the President's. The leadership and governance of the twelve Federal Reserve District Banks, including rotating voting roles on
the Federal Open Market Committee, add further insulation from political pressures
that might al times draw their primary inspiration from electoral objectives

Financial Fragility

Successive shocks in recent years have undermined confidence in the f i n a n c i a l
system, affecting the level and distribution of economic performance. The more comfortably an activity can be financed, the more of it will be undertaken—a id vice versa
Credit quality problems have hindered financing for Latin America, the oil patch and
other commodities industries, with contractionary implications for [hose sectors For a
time, this diverted credil to support booming securities markets and regional economies
jlong America's coasts

The nation's largest commercial banks have seen [heir credit ratings slip on a v erage below the ratings of their largest corporate customers. Regulators of all major
countries propose stricter bank capital adequacy that should induce tighter credit standards More prudent lending is the Iinancial synonym for more cautious spending

It has often been observed that presidential elections tend not to coincide w i t h
economic recessions. There have been eight presidential elections since the emergence
of a Federal Reserve unfettered by wartime and demobilization responsibilities al the
end of the Korean War Only once since then, in 1960, did the election occur d u r i n g
what is officially designated as a recession, while a somewhat broader standard would
recognize November 1980 as a time of severe economic turbulence, even if not technically recession.
Thus, at least six (strictly speaking, seven] of the last eight elections occurred m
months of business expansion. For perspective, however, recall that expansion is the
normal condition of (he economy; recession is the rarity. From 1956 through 1984, [he
economy grew about four-fifths of the time and suffered recession only about one
month in five. Given the relative infrequency of presidential Novembers, their overlap
with recession seems about what you'd expect from the "luck of the draw "
If policies have been put in place with the intent of influencing election vear
economic performance, they have shown no systematic tendency to work. Real (ISP
growth, for example, averaged ~$Vt,% in the last eight election years, well within the
measurement error of the economy's long-run 3% growth trend- Moreover, the record
does not reveal a 'vstematic tendency for the growth rate to accelerate in election

years or to decelerate thereafter. In 1968, 1972. and 1976 real GNP grew faster than it
had the year before; in the other five election years growth slowed. Pillowing the elections of 1956. 1968, 1972, and 1984 growth decelerated, but growth sped up in the
years after the other four.

The absence of a systematic tendency for the economy to perform differently in
election years does not prove that the Fed (or other policy-makers) do not try to make
it otherwise.
The monetary aggregates have been a prominent indicator of the Fed's posture
only in the period encompassing the last four presidential election years. Their record
is clouded. Ml growth accelerated by one and three-quarters percentage points in election year 1972 and about one point in 1976; Ml growth decelerated by one-half percentage point in 1980 and four and three-quarters points in 1984. These "facts" do not
tell us about Fed motives— judgments about the best interest of the economy long-term
or about the candidates short-term. More fundamental ambiguity lies in our inability to
separate out of short-run changes in money stock the Fed's influence in supplying
money and that of millions of households and businesses in demanding Ml balances.
The federal funds rate is not ambiguous. Except for quite short periods, fed
funds trade at rates the Federal Reserve sets or condones. Fed funds behavior around
elections suggests the Fed is more apt to avoid involvement at politically sensitive
times than to be active.
There is no systematic tendency for the federal funds rate to go down or up in
election years. Fed funds were higher in election season than a year earlier in five of
the last eight presidential years and lower in three. (Of these, the incumbent party was
ousted twice— 1960 and 1976— and returned once— 1984.) Recognition that it takes time
for interest rates to influence the economy, and hence perhaps the election, leads to
review of the fed funds pattern before election years. Here again there seems to be no
suspicious pattern. The federal funds rale rose in five of the eight pre-election years
and fell in three (Of these, the incumbent party was ousted in 1968 and 1976 and returned in 1972.)
The magnitude of Fed policy change; in election periods presents a more revealing picture than their direction.

From 1955 to 1985, the fed funds rate changed on average about 160 basis
points—sometimes up, sometimes down—from year to year. The average absolute
change in the funds rate in both the eight pre-election and eight post-election years has
been about 175 basis points—substantially like all other years Except presidential
years. In the last eight of those, the funds rate has changed on average only 94 basis
points, less than two-thirds the norm.
This behavior is not puzzling. The Fed is constituted to set it apart from the
government. But the central bank is also a part of the government. On both counts, its
incentives are to keep out of the public eye when the limelight is properly focused on
the candidates. On the basis of past patterns, the fact that 1988 is a presidential year
means the Federal Reserve will do what it otherwise would, only less so and as unobtrusively as possible.
The Fed and Foreign Exchange
The foreign exchange value of the dollar is one policy matter on which the Fed's independence is deliberately circumscribed. The dollar is an instrument of foreign relations
and foreign trade policies, and as such falls within the purview of the Executive. The
Treasury Secretary has a particularly influential role in determining how much weight
the Federal Reserve may give the dollar in monetary policy This has been evident
throughout the G-5 (G-7) process since mid-1985
The United States is today a gargantuan debtor to the rest of the world. In the
best of circumstances, even as the trade deficit shrinks in the next few years, foreigners will have to absorb several hundred billion more dollars . To induce foreigners to
hold rising amounts of U.S. dollar claims—perhaps beyond the level of their demand
for dollars—requires making American assets more attractive to them. That can happen
by making the dollars cheaper or by making the assets (stocks, bonds, real estate and
businesses) cheaper. The latter is a high-risk route that could end in premature domestic recession or deflation.
Defending the dollar means forcing up short-term interest rates—in the extreme,
demonstrating a willingness to push rales high enough to provoke recession. A rising
fe<i funds rate is no comfort to domestic financial markets, as we saw in the violently
adverse reaction to the Federal Reserve's dollar-targeting posture last April. After seeing the sour outcome of defending the dollar from April to October, the relevant policymakers downplayed that policy in the wake of the Crash, li is unlikely that the
Treasury Secretary will countenance a rerun in 1988 When the domestic economy and
inflation require higher interest rates later in 1988. the Fed will tighten policy accordingly, but it is unlikely to raise interest rates for the express purpose of supporting the
dollar's value against the judgment of the foreign exchange market.

Ihe dollar, insofar as exchange rales influence domestic
business conditions or prices,
the monetary aggregates, to the degree thai other indicators
permit interpretation of the information hidden in the
money supply;

Once again, Mr. Chairman, I v,ant to express my appreciation ro (he Committee
for the privilege of appearing hefore you today

170

The CHAIRMAN. Thank you, Dr. Soss.
I'd like to start off with Dr. Sachs and Dr. Soss on one particular
line. I'm concerned about the independence of the Federal Reserve
Board and you seem to feel that, on the basis of the record, they
can resist.
Well, it's an entirely different situation than it's ever been now.
We have for the first time in 50 years, maybe the first time ever—
I'm not sure about the Roosevelt administration—I haven't been
able to get it clear—but this is the first time an administration has
appointed every single member of the board unanimously, all six of
them. Of course, there's a seventh being appointed at any time.
Also, this is an administration that has leaned very hard on the
Board. I had a letter just yesterday from the Assistant Secretary of
the Treasury which was, I thought, very specifically directed at the
Open Market Committee. Right on the verge of their meeting, it
was delivered to each member of the Open Market Committee, telling him what the Treasury thought they ought to do.
So I'm very much concerned about that. And I might say that
Chairman Greenspan yesterday expressed some resentment of the
recent efforts by the administration to influence monetary policy.
I understand that former Chairman Paul Volcker is said to have
written in his thesis at Princeton that the Fed should be made a
part of the Treasury to promote coordination of monetary and
fiscal financial policies. I think he undoubtedly changed his view as
he matured.
William Greider, in his recent book, "Secrets of the Temple,"
also suggests that the Fed should be made part of the Treasury to
increase political accountability.
First, Dr. Sachs, as an old Fed man, what's your view?
FED IS A POLITICAL INSTITUTION

Mr. SACHS. Well, I actually did not mean to leave the impression
that I think that the Fed can generally resist pressures. Indeed, I
think what the evidence shows is that the Fed is a political institution which swings with the politics of administrations and there's a
clear pattern of partisan shifts in the party that holds the White
House leading to shifts in monetary policy.
Historically, however, the shifts in policy have come at the beginning of presidential terms. There isn't that much evidence that
election years per se have been manipulated by the Fed. What
there is evidence, however, for is the proposition I believe that if a
Democrat
The CHAIRMAN. Let me just interrupt to ask—I understand that
some people argue that there's a lag between the action by the Fed
and the Open Market Committee and the effect on the economy, a
lag of perhaps a year or so.
Mr. SACHS. Right.
The CHAIRMAN. So if you say "in the election year" you don't
see much of a shift, shouldn't we take a look at the year before the
election?
Mr. SACHS. In the election year, neither do we see a shift in
policy nor in effect, and in the year before we also don't see—apparently, we don't see enough of a shift in year 3 in order to lead

171

to different outcomes in year 4. In other words, the policy outcomes
in year 4 are not significantly different from the outcomes in an
average year in the economy.
The CHAIRMAN. Well, how important actually is the independence of the Federal Reserve Board?
Mr. SACHS. I think that there are conflicting interests at stake. A
purely independent Fed I think would be—a totally independent
Fed I think would be quite problematic because there should be
some democratic constraint on the institution.
The CHAIRMAN. Why?
Mr. SACHS. Why?
The CHAIRMAN. With a democratic constraint on the institution
it seems to me there would be an inflationary policy constantly.
Everybody wants to have low interest rates. Everybody wants to
avoid a recession. We inevitably have them but nobody ever wants
them—not on his watch. It seems to me that if you're going to have
a democratic effect—we have elections every 2 years—you're going
to have a policy that will be less sound, less responsible, and it
would seem to me there's a good argument for insulating the Fed
from that democratic effect.
Mr. SACHS. I think that there is an argument on the other side
that having it in the Treasury would be quite problematic, but I
must say that there's responsibility on both sides.
The Bundesbank is probably the most independent central bank
in the world and I'm not sure that that is really delivering good
public policy for the German people right now. It does deliver
stable prices and it's delivered significantly high unemployment
rates for much of the last 15 years. And I think that there's a real
problem there.
We have a balance where we have some political input and we
also have institutional independence.
The CHAIRMAN. Right now it's a balance of living beyond our
means. It's a balance which is failing to accommodate a fiscal
policy which is grossly irresponsible.
Mr. SACHS. Right. Living beyond our means is the one clear thing
that can't be put at the doorstep of the Fed. That's a problem of
Congress and the administration and not a problem of monetary
policy per se.
The CHAIRMAN. Well, it's a problem that monetary policy tries
to compensate for.
Mr. SACHS. The problem of monetary policy is that given that
quite problematic fiscal policy it's extremely hard to operate between the competing demands of accommodation and trying to restrain an overheating of the economy. And I think on the whole
the Fed has done a good job of walking that narrow line. I think
most of the testimony this morning illustrated just how difficult it
is to do that and, given how many conflicting demands there are on
monetary policy, how difficult it is to find a middle ground right
now.
The CHAIRMAN. Dr. Soss.
Mr. Soss. Well, I want to echo the sentiment about the role, if
you will, of analysts or scientific kinds of approaches to assess patterns and to the degree that any particular instance or episode
might tend to deviate from a pattern perhaps the sunlight that

172

you've directed to the issue of a more politically oriented Fed will
help to sanitize the situation.
There is no question in my mind, however, that if financial markets came to believe that the Federal Reserve's behavior this year
or any other year was motivated by the kind of partisan political
concerns that—that the markets would not take that well.
FED AS PART OF THE TREASURY

The CHAIRMAN. Do you specifically think the Fed should be part
of the Treasury?
Mr. Soss. I don't think the Federal Reserve should be part of the
Treasury, no. I think we're probably better off with the kind of balance that exists wherein the Federal Reserve is apart from the
Government but also right here in Washington being a part of it as
well. Paul Volcker's view on the question matured with age as
well.
Mr. COOPER. May I comment on this question?
The CHAIRMAN. Dr. Cooper, I wish you would.
Mr. COOPER. I think that the formalities of the relationship are
less important than the established conventions and expectations.
Jeff Sachs has pointed out that from a formal point of view the
most independent central bank is really the Bundesbank in Germany, and in two other European countries, Britain and Italy, from a
formal point of view, the central bank is under control of the
Treasury.
The CHAIRMAN. Let me interrupt. Isn't it true that West Germany has had an economic miracle? Isn't it true that that's the
strongest economy in Europe?
Mr. COOPER. Absolutely.
The CHAIRMAN. Isn't it true on the basis of that independence
that by and large over the years they've been able to avoid inflation? While it's true they have high unemployment now, it's lower
than it is in other European countries and by and large it's been
quite a success.
Mr. COOPER. Mr. Chairman, with deference, this would take us in
another direction. I think the U.S. economy today is in much better
shape than the German economy is— much better. It's true that
we have a problem with our fiscal policy at the present time.
The CHAIRMAN. I'd be in better shape, too, if I took a credit card
and lived on that credit card and ran up huge bills and lived way
beyond my means. I'd be in great shape for a while.
Mr. COOPER. But in terms of its flexibility, its innovativeness, its
capacity for change, its capacity to roll with the punches, we just
have much less rigidity than the German economy does. That gets
us well outside the role specifically of the central bank. I don't
think the German central bank can be credited with the German
miracle or faulted with the rigidities of the German economy. It's
just one among many features. But I would not trade places with
them for a moment in terms of the fundamental soundness of the
economy.
I know that sounds a little odd because everyone attaches enormous importance to the trade position and the United States is
now running a trade deficit and the Germans are running a large

173

trade surplus, but that is not the be all and end all of economic
performance.
Anyway, the point I wanted to make was that in both Britain
and Italy formally the central bank is under the control of the
Treasury, in the sense that at the end of the day the government
can order the central what to do. But in both countries the tradition has been established that the central bank will operate with a
high degree of independence except perhaps in a real crunch, and
people of sufficient stature have typically been appointed as governors of those institutions that if they were to make a row about an
order given to them by the Minister of Finance that would create a
large political stink in both countries. And I think that is much
more important than the formal arrangments between the institutions.
Having said that, let me point out that there is a serious anamoly in the present U.S. arrangements and that is that the Federal
Reserve is formally in charge of domestic monetary policy but the
Treasury is formally in charge of exchange rate policy. That was
an arrangement that worked perfectly well under the Bretton
Woods system in which the U.S. was the passive player and we
didn't intervene actively in exchange markets. That is an anomolous arrangement in a world of flexible exchange rates and it is
one of the sources of the tensions that exist between the Treasury
and the Fed today.
The CHAIRMAN. Senator Hecht,
Senator HECHT. No questions.
The CHAIRMAN. Senator Garn.
Senator GARN. Mr. Chairman, I have no questions at this time.
Gentlemen, I apologize. I intended to be here earlier, but as you all
know, we are having a very big markup next Tuesday on a major
banking bill that Senator Proxmire and I have been working on for
a long time and we had a Republican caucus going on to discuss
the provisions of that bill and, as you know, caucuses sometimes
last a long time. We were supposed to finish at 10 and just did.
I want you to know I'm sorry for not being here, but we were not
malingering. We were doing important business on the Republican
side and we appreciate your testimony.
The CHAIRMAN. Senator Heinz.
Senator HEINZ. Mr. Chairman, I will have to make Senator
Garn's speech. I, too, was at the caucus. I apologize to our witnesses, but I thank them for their testimony. Perhaps I'll be able to
submit some questions in writing.
The CHAIRMAN. Well, this is a very fine panel we have this
morning.
IMPORT QUOTAS

I want to ask Dr. Barbera, the Wall Street Journal earlier this
week reported shortages of semi-finished steel. The article blamed
import quotas for contributing to the shortages and encouraging
price-gouging by U.S. manufacturers.
Have you observed any capacity constraints operating in the
manufacturing sector?

174

Mr. BARBERA. I think that certainly on the bottom end of the
economy we've got such capacity
The CHAIRMAN. I might say, if I could interrupt, Senator Heinz
was elated by that news.
Senator HEINZ. I said I would be elated by it if it were true.
[Laughter.]
Mr. BARBERA. There's ample evidence of booming demand for
steel from the. United States abroad, particularly in the Far East,
that we are not meeting now because of capacity constraints,
I would point out, however, that there are those who are quick to
jump at shortages of copper or steel and talk about running up
against capacity for the entirety of the economy and then you
could leap and say we're really dangerously close to a period where
we should move toward recession but because of a Presidential
election we're avoiding it.
I really think that's a gross mischaracterization of where we are.
We have shortages at the bottom end of the economy, but once you
move from steel and copper and get on to higher value-added products, in fact what we find is a great many nations producing products looking for consumers to purchase it. Big retail inventory excesses on the apparel, consumer electronic side, obviously we have
a big chronic oversupply on the auto side. The Japanese are putting two million production capacity in the United States. They
will be able to produce two million cars in the United States in
1989. It doesn't appear they are filling up the productive capacity
they have in Japan with cement. So I would say that, except for
the bottom end of the economy, we still have ample capacity and
we're not dangerously close
The CHAIRMAN. Well, I'm a little puzzled by that because they
tell us that we're operating at a high level of capacity compared to
our operations in the past—85 percent of capacity or something
like that
Mr. BARBERA. 82 percent.
The CHAIRMAN. They tell us that in paper and chemicals, for instance, we're operating at an even higher level, 95 percent of capacity. Do you think that production bottlenecks will be encountered in the near future?
Mr. BARBERA. I think on the bottom end of the economy, yes. I
think, as I said, as you move up the value-added chain, no. I don't
see it in cars. I don't see it in capital goods. I don't see it in farm
machinery when I look at capacity on a worldwide basis and unemployment on a worldwide basis.
The CHAIRMAN. Again, what industries do you consider most vulnerable to capacity shortages?
Mr. BARBERA. As I said, the very basic industries where we've
had sharp deflation. In other words, primary metal industries. As
you said, paper and forest products, chemicals. We're at high levels
of capacity because with the big decline of the dollar for a homogeneous commodity like that, we became wildly competitive very
soon with the dollar decline and our exports have been very strong
there. But once you move beyond that, I don't see those extraordinary capacities.
The CHAIRMAN. Dr. Cooper.

175

Mr. COOPER. Can I make a general observation? In today's world,
we should address the question not of U.S. capacity or indeed capacity in any other single country, but worldwide capacity. There, I
would say there is worldwide excess capacity, not deficient capacity, in almost every industry that you can think of.
The CHAIRMAN. But if you look at it that way, doesn't that mean
that at least in the short run we will tend to have an even worse
balance of trade?
Mr. COOPER. That's what I was going to say. If we run into bottlenecks and provided we do not have import controls, we simply
import the goods, and the bottleneck is broken. The bottlenecks
need not be a source of inflation or constraint to production up the
line, but—and here's the important qualification—we want additional investment and the way you get additional investment is to
have some degree of pressure on the market. If imports are coming
in at higher prices, we get the supply of goods but we also get the
stimulus to investment in this country. Indeed, we have seen a
pickup in the last three quarters in manufacturing investment and
that's what we're looking for. That's to be welcomed.
The real problem is the one you put your finger to, where a bottleneck develops in this country and we have effective import controls, so that we can't relieve the pressure by drawing on the
excess capacity elsewhere.
The CHAIRMAN. Dr. Cooper, let me ask you about a statement by
your colleague at Harvard, Robert Reich. He has an article in the
most recent edition of Foreign Affairs in which he claims that our
massive trade deficits of recent years have led us to become the
world's largest debtor country.
MORTGAGING OUR FUTURE

He states in that article, "Without a surge in productivity, the
present debt cannot be repaid unless we dramatically reduce our
standard of living." And he further claims that so far our country
has avoided being compelled to reduce the standard of living only
by the steady sale to foreigners of shares in our companies and
prime real estate. He claims we are, in essence, selling the house to
pay the future rent.
Do you share Professor Reich's views that we are in effect now
selling off our assets to finance our still massive trade deficits? If
so, would you state that getting our budget deficits under control is
the remedy for such concern?
Mr. COOPER. Well, let me say iirst that Harvard is a large and
diverse institution and I don't take either credit or responsibility
for everything that anyone associated with Harvard says.
The CHAIRMAN. In other words, you disagree with your colleague?
Mr. COOPER. Particularly with Bob Reich. Having said that, I
guess I would say, stripped of the hyperbole in the quote that you
read, I agree with the basic point, that we are now selling assets in
order to finance an excess of consumption over output and we have
been doing so since 1982. There is a risk that unless we do something about getting our overall macroeconomic situation into better

176

balance that we will sell our assets even more cheaply than we
have been up to now.
The sale of assets we've made so far have not been such a bad
deal for the United States actually, but it's getting worse because
we're selling them more cheaply as the dollar goes down.
There's one red herring in the quote you read from Reich, and
that is that we don't ever have to repay this debt. We may choose
to repay it but we don't ever have to repay it as long as we're a
productive economy. But I agree with the fundamental proposition
that we are selling assets in order to finance an excess of spending
over output and that is not desirable unless we were investing the
difference at very high rates of return on investment,
The CHAIRMAN. I can't resist disagreeing a little bit with the argument that we will never have to repay it. You say that if we
have a growing economy we will never have to repay a $2.5 trillion
debt. But, as it grows (and it's growing even by the rosy estimates
of OMB), it's shortly going to be $3 trillion and then $4 trillion. Is
there no limit? Won't we some day have to repay that?
Mr. COOPER. Let me counter by giving the example of Canada,
which is a country which, with the exception of a few years mostly
associated with World War I and World War II, has borrowed from
the rest of the world in every year of its entire existence.
We don't talk about a Canadian external debt problem. We don't
even think about it. The reason is that Canada has invested its borrowings profitably. It services its debt punctually and in fact the
debt-to-GNP ratio, which is the key thing to look at, has gone down
over the last 50 or 60 years, since the 1920's when it reached its
peak. But the absolute amount of debt has gone up year after year.
The CHAIRMAN. That's not quite true in our country, though, is
it?
Mr. COOPER. Well, we have gone through a period of being a net
creditor, which Canada never did. After World War I we did build
up assets in excess of our liabilities to the rest of the world, until
1982.
The CHAIRMAN. Our ratio of debt to GNP (and of business debt to
GNP and of household debt to GNP and especially of household
debt to savings and of business debt to earnings) has risen. In 1955
we had what I thought was a lovely ratio of $2.85 in debt for every
dollar of earnings. Today it's $9. That's a terrific difference.
Mr. COOPER. I'm sorry. I was addressing your quote from Reich
which had to do with external debt, not the internal debt. I was
talking about the debt to the rest of the world.
The CHAIRMAN. Dr. Sachs.
Mr. SACHS. This is a good opportunity to disagree with both of
my Harvard colleagues.
The CHAIRMAN. Great.
Mr. SACHS. I think first there's a semantical problem. If you say
you don't have to repay the debt, it's true that you don't have to
reduce the principal back down to zero, but you do have to repay
the debt in the sense of servicing it. People will not lend you the
money to service those accumulated debts forever and then the
debt would grow at an explosive rate and eventually the lending
will stop. Canada, for instance, does pay its debts in the sense of a
trade balance surplus every year. It sends abroad more resources

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than it imports and that's the way you pay the debt. You pay it in
the annual debt servicing, which is a heavy burden.
Mr. COOPER. But he said "repay."
Mr. SACHS. OK. Well, that s the semantical point. You service
your debts. You don't have to repay the principal, but it conies out
to a real burden in any event.
I think where Reich goes wrong, however, is in the magnitudes.
It's a quotation without any sense of quantitative—I think the
quantitative importance of these things. Our accumulated foreign
debt right now is somewhere on the order of perhaps $400 billion,
which is a very large amount, but we have a $4 trillion economy.
That makes a debt to GNP ratio of perhaps 10 percent and a real
interest servicing bill each year if we were to stabilize at that ratio
of something on the order between Vz of 1 percent and 1 percent of
GNP. To say that we can't afford that is a silly proposition. To say
that it will be politically painful to turn from a trade balance deficit to a trade balance surplus is undoubtedly correct.
The CHAIRMAN. That's a very, very healthy and proper correction, but looking toward the future, if we continue this, it's a problem. Then, there's another problem involved here. When the debt
to GNP ratio increases, doesn't it limit the ability of the Federal
Reserve to contract credit, diminish credit, without causing widespread defaults on credit obligations, driving interest rates up?
Mr. BARBERA. I do think the markets have told us something in
1987 and that is that we've reached a point where we are no longer
going to have the voluntary financing of that spending without
clear evidence that that spending is slowing. I mean we did have
two big bouts of dollar weakness in 1987 which was combined with
big selling of bonds, as you said, by Japanese insurance companies.
In both those instances, they were precipitated by disappointing
evidence on trade which indicates a growing need rather than a declining need for U.S. foreign capital. I think we're already at the
point where we are going to, one way or the other, see trade improve over the next 3 or 4 years and reduce our capital needs because foreigners simply aren't going to voluntarily provide that
capital.
It seems to me that where you go to then is, if we're going to
have economic growth over the next 3 years that stays within the
disinflationary mode, let's say 2.5 percent on average the next 3
years, and if you talk about getting on a real balanced basis of
something close to zero, you really don't have much in the way of
room for growth on the consumer side.
I would posit that that suggests that goods spending—take services out—goods spending 1988 through 1990 is going to average
something like zero or 1 percent in terms of growth compared to 5
percent from 1983 through 1986.
Now there's an easy way to do that. We talk about that at Shearson in terms of voluntary quiescence. We seem to be serendipitously right now in the midst of that, but if the consumer were to come
back and spend strongly, I would argue, world financial markets
would work to knock them down in America.
The CHAIRMAN. Dr. Soss.
Mr. Soss. I want to add two points on the financing of all of this.
It is certainly the case that organizations as complex as a whole

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economy rarely pay down the principal of debt, but there are two
developments going on now that reflect how difficult it is to raise
this new indebtedness.
The first is that not only is the private foreign capital inflow becoming more tenuous from time to time, but as you may have noticed in the Treasury's financing's of late, increasingly what we're
doing is financing this budget deficit by having foreign central
banks and foreign finance ministries directly buying Treasury obligations through the so-called foreign add-ons, which I think we can
characterize as a reflection of how inadequate private foreign demands are for those bonds.
So we are requiring a more routinized, regularized, dare I say it,
IMF style financing of this budget deficit.
The second thing that's going on is that we are, ourselves, experiencing the debt for equity swaps that we have so often recommended for Latin America and other debtor countries.
The foreign financial inflow is not as much coming in the form of
bonds or even for that matter hundred shares at a time in the
stock market; it's coming in the form of 100 percent. Foreigners
want control of productive assets rather than subjecting themselves
to financial claims directly.
RECESSION WOULD EXACERBATE OUR PROBLEMS

The CHAIRMAN. Dr. Soss, your testimony suggests that the calibration between the degree of setbacks suffered in the financial
system—the crash—and the cooling off of the real economy is missing. Furthermore, you say that a recession would just make the
problems worse.
Is this lack of correspondence between the real and financial
economies in the short run new? Didn't stocks crash in 1962 without precipitating a recession?
Mr. Soss. That is correct, Mr. Chairman. This calibration problem is not novel. It is to my mind a bit interesting to point out that
we had, a relatively weak Christmas season at retail and if you attribute that to the crash, then I think you have to say that the
crash is now behind us because January retail sales and February
auto sales picture and all the rest suggests that the consumers
have
The CHAIRMAN. How about the Fed's vigorous lender-of-lastresort activity and their coming on hard and fast with more liquidi-

ty?

Mr. Soss. There are Hobson's choices that are faced from time to
time and I think in that respect one can say that the Federal Reserve had no choice but to rescue the financial system on October
20 and that doing so as effectively as they did may be why consumer demand in fact is rebounding so promptly.
Mr. BARBERA. May I take a little bit of issue?
The CHAIRMAN. Please.
Mr. BARBERA. If we look at consumer demand, we are slaves to
weekly and monthly numbers because both Dr. Soss and I forecast
interest rate changes daily. If you look at the numbers that we've
seen for January, you did have an upward revision for December

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retail sales and a decent January number, so things were not quite
as bad as they appeared.
However, take November, December, and January retail sales
and compare them with May, June, and July—in other words, 6
months percent change annualized—and we're falling
The CHAIRMAN. And correct it for seasonal factors?
Mr. BAEBEBA. Seasonal factors and inflation. We're falling at a 3
percent rate. So we are still below where we were in the middle of
last year and I certainly wouldn't characterize consumer spending
right now as robust.
We also, dare I say, poll the stores on a weekly basis and February looks fairly weak.
We did have a 35-percent decline in the stock markets around
the globe. The precedent for that is 1929. I think it's absolutely unconscionable to consider that the Fed should have stuck to a tight
monetary policy based on a fear about a little more inflation when
you're faced with that kind of financial market fissure.
Obviously it was very difficult on the brokerage industry. Some
brokerage companies are no longer there that were there in October. I worked for one. It was a difficult environment. I think the
Fed had to ease money.
The CHAIRMAN. Dr. Soss, does the cumulative decline in the resiliance of our financial system limit the ability of the Fed to arrest
inflation in the real economy because the cost of credit stringency
has grown?
Mr. Soss. I think what it does is give you periodic crashes where
the financial markets themselves insist on performing the function
that monetary and fiscal policies from time to time are reluctant to
perform.
The CHAIRMAN. Very interesting.
Mr. Soss. People who were cheated out of their coupons in the
1970's have long memories. We have a financial system which from
time to time gives you events like October 19 and requires the Fed
to ease, and I certainly share the judgment that there was no alternative in that episode but to do so.
EXCHANGE RATES AND MONETARY POLICY

The CHAIRMAN. Dr. Cooper, let me ask you a somewhat lengthy
question on exchange rates and monetary policy.
There appears to be two schools on exchange rate policy. The
first group says let the dollar fall and fall a lot in a hurry. That
school claims that if the currency declines a great deal the expectation will be that it can then only rise. During the fixed exchange
rate period, the rule of thumb was that if you were going to do it,
don't undershoot.
The second school believes that a gradual, managed decline of
the dollar is necessary because, in a floating exchange rate world,
an unstable and rapid fall in the dollar would create the expectation of continued depreciation leading to high interest rates and exchange rate collapse.
It appears to me that a key question in exchange rate management is how actions today affect expectations of exchange rate
changes in the future. Is that right?

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Mr. COOPER. Mr. Chairman, I belong to both of those schools of
thought, depending on the circumstances. In 1985,1 was very much
of the first school. I argued that the proper task was to get the
dollar down and get it down very quickly and for that reason I welcomed the Plaza Accord. I had already urged that course well
before September 1985.
Starting from where we start now, however, I worry very much
about a sharp drop in the dollar for the reasons that I gave. I think
in the short run, by which I mean 6 to 24 months, a further sharp
drop of the dollar on the world economy and hence on us, the
United States, would be negative, not positive, because of the heavy
dependence of many other economies, especially Germany, on exports. That dependence will have to change, but it will not change
quickly, and it's not in our interest to shock Europeans into recession. So, my judgment at the current time is to try to avoid a further drop in the dollar.
Mr. COOPER. Now the market may have a different view and
then somebody would have to decide my guess it would be the foreigners in the first instance—how they want to play that.
My view at the present time is conditioned by two other judgments that are worth making explicit. One is that I am not as certain as many of my academic colleagues that the dollar actually
needs to go down further. It may be so. I'm not saying it's not the
case, but I'm not certain in my own mind that it does.
Therefore, at the present time, I would not want to see a deliberate depreciation of the dollar. That judgment, in turn, is conditioned by a view which again differs from many American academics that have spoken out on this question, that I do not think it is
either necessary or possible—I actually do think it's desirable but I
don't think it's necessary or possible to achieve a balanced U.S.
current account by the early 1990's. I look at the adjustments that
the world economy would have to make in order for us to achieve a
$200 billion swing in net exports of manufactures and I cannot see
that taking place politically or psychologically.
For that reason, the improvement in the U.S. trade position that
I target is rather less than that that other people are either implicitly or explicitly targeting. Some of my colleagues want a current
account surplus by the early 1990's, to start to repay the debt, I
don't think it's in the cards and trying to force it would not serve
either the United States or the rest of the world well.
I do believe that the U.S. should work to get the budget deficit
down at a regular steady pace, but I don't think—and in this respect I agree with Dr. Sachs—I don't think that by itself that will
generate a current account balance in the United States, much less
a surplus, in this timeframe.
So for all of those reasons, I am not enthusiastic at the present
time either about a sharp drop in the dollar or a further gradual
drop in the dollar, although that's not to deny that one or the
other might not take place as a result of market forces.
The CHAIRMAN. Dr. Barbera, the Federal Reserve has been
widely praised for its action—in fact, I think it's more widely
praised for this than anything that's happened since Dr. Greenspan
has been Chairman of the Fed—for its action in the aftermath of
the stock collapse on October 19. They came right in like gangbus

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ters on Terrible Tuesday with a tremendous amount of liquidity—
prompt and dramatic action, as you say.
Now while they did act skillfully and decisively and they really
had no choice but to act, we now have kind of a moral hazard problem where the financial sector will take even greater risks knowing that the Fed will come to the rescue when danger comes and
liquidity is near at hand.
Mr. BARBERA. I don't think so. I think that what you had was the
Fed coming in providing liquidity obviously during a period where
many of the marketplaces really were, if functioning at all, functioning very poorly. We did have during that period some combination of events that exacerbated the stock market swoon with the
combination of program trading and portfolio insurance. My firm,
for one, has stepped back from program trading.
I don't think that simply because the Fed prevented that fissure
and the extraordinary losses of the world's financial system and in
the industry—they prevented that fissure from becoming a worldwide recession, that that certainly doesn't make it easy once again
to increase speculation.
INFLATION AND LOWER UNEMPLOYMENT

The CHAIRMAN. Dr. Sachs, one of the problems that always concerns us very deeply is the tradeoff between unemployment and inflation and the fact that as unemployment diminishes inflation is
likely to come on. We now have a situation where unemployment
is lower than it's been in 7 or 8 years. It's down to about 5.8 or 5.7
percent, depending on how you measure it. It's down at a low level.
I understand that economists estimate a so-called nonaccelerating inflation rate of unemployment. Some say it kicks in when unemployment gets below 6.2 percent. Then inflation comes on.
Others say it's lower. Others say it changes. The estimate varies
considerably. Large changes in demographic factors and sectoral
dislocation may provide a good reason for these varying estimates
over time.
In recent months the estimates have been declining because the
unemployment rate has been declining and inflation hasn't risen
very sharply.
What's your estimate of the so-called nonaccelerating inflation
rate of unemployment today and for the near future?
Mr. SACHS. Well, like many things, we don't really know, but I
think that there has been relatively good success statistically with
using demographically weighted unemployment rates over the past
years adjusting for the composition of the labor force to include
new entrants, for instance.
The CHAIRMAN. Let me just interrupt. One of the problems here
that you see is that up in the area where you are, up in Massachusetts, there's a very low level of unemployment. In Texas there's a
very high level of unemployment. Louisiana there's a high level of
unemployment. It would seem to me that those regional factors
would make a great difference. You should have a difference in the
level of inflation in New England where unemployment is very low
than in the South where it's higher.

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Mr. SACHS. And we do. Of course, if you look at housing prices in
Boston compared to Texas you can see what happens with non-tradable goods in the economy. Prices have skyrocketed in Boston and
have collapsed in the Southwest. So indeed for those goods that
can't be transported easily across State boundaries you see exactly
the kind of phenomena you're talking about.
Overall, there is probably a small effect on the aggregate NAIUR
that comes from regional mismatch and in fact some economists
have tried to estimate that and I can provide for the record some of
the estimates on that.
I would say that there's a mainstream view among people that
are in this business now that the NAIUR may have come down
from somewhere around 6 percent to something like 5.5 percent,
but that we're very close to the range at which a significant downward push on unemployment would start causing wages to rise rapidly. Indeed, the slowdown in nominal wage growth which had
been occurring every year since 1981 stopped slowing down last
year and we had a slight uptake in hourly compensation in 1987
relative to 1986. So we are seeing a firming of the labor markets
and I think we're around the range at which we have to be careful
and we shouldn't expect another freebie of 1 percent of unemployment that can be reduced without having significant inflationary
consequences down the road.
The CHAIRMAN. But we also have in 1988, 40 percent of organized
labor contracts expiring, I understand, covering 40 percent of the
workers. So it could be a year for big increases, especially in view
of the fact that in many industries the real wage has not increased.
Mr. SACHS. That's right. Real wages on average have declined
during the Reagan term from 1981 and that's partly because there
was an enormous overhang of real wages. They were too high by
the time the administration came to office, given all the adverse
productivity.
The CHAIRMAN. How about the presence of foreign competition?
Could that increase the discipline of wage demands in light of the
possibility of losing business to competitors overseas?
Mr. SACHS. I think that the main way that that works through
the system is not directly so much as affecting the overall state of
the labor market. I don't think that there's been a significant
structural shift in our economy which has made the wage equation
all the sudden react for a given unemployment rate differently
from what it would because of the presence of foreign competition.
I think the evidence is that there s a fairly stable relationship of
wage inflation to lack of price change and to the demographically
adjusted unemployment rate and that's a fairly good relationship
that doesn't give us a lot of surprises year after year, and that suggests that we are in a range now where we have to be careful.
POSSIBLE RECESSION IN 1989

The CHAIRMAN. Dr. Soss, privately many people are suggesting
that the U.S. economy is going to be put into a severe recession by
policy makers in 1989 just after the presidential election. I think
that's baloney. I've never known a policy maker who had any
notion of getting into a recession. By a policy maker, I mean an

183

elected official. Obviously, the elections come frequently and so
that's not likely to happen, but some suggest that this is the only
way to reduce the trade deficit. Do you agree with that?
Mr. Soss. I've had over 10 years experience in public service,
Senator, not quite as long as your own and not nearly as distinguished, but I would share very strongly your sentiment that I've
never known a policy maker deliberately to choose a recession if he
had to face the voters.
On the question of do we have to have recession in order to deal
with the trade problem, I think to get back to Dr. Cooper's observation that you have to be careful what you wish for. There is a limit
to how fast the world economy can tolerate a shrinkage in the U.S.
trade deficit because of course the counterpart to that is the
shrinkage in everybody else's trade surpluses. And I don't think
that we require literally a balance all that quickly and I don't
think that we require literally a recession to improve conditions.
Running the economy, so you don't ever need a recession, should be
the real good.
The CHAIRMAN. And there's some very adverse consequences associated with a long recession given the condition of Latin American debtors, farmers, banks, S&L's, and businesses with such high
levels of debt. Doesn't that limit the extent of a recession that
policy makers could tolerate to alleviate these matters?
Mr. Soss. My own judgment, Senator, is that the financial structure in that regard is not that significant to the macroeconomic
problem. If the goal of policy makers is to keep the physical and
other resources of the economy fully employed, there are plenty of
ways to do that and I doti't think it's really a function per se of
whether the capital in the real economy is reflected in claims
called debt or claims called equity.
The Japanese, for example, have a very much more leveraged
structure in many ways than we and yet no one seems to think of
their economy as at risk thereby. There are lots of other economies
around the world that have less leverage than we and don't do
nearly so well.
So it seems to me that that is much more a matter for financial
stability and for the risk that financial blowoffs can from time to
time impose on the real economy than for whether the policy
makers can keep the economy productive independent of the financial structure.
The CHAIRMAN. Now that I'm about to retire—this is my last
year—I have, I think, a more objective attitude toward recession
than I did when I was running for reelection. If I were running for
reelection I'd be up in November and undoubtedly a recession
wouldn't help any incumbent's reelection chances. But it seems to
me that one of the prices you pay for a free economy are regular
recessions. You don't have recessions the same way in socialist
economies. We have them in a free system and that's one of the
things we have to do. Recession does have the salutary effect of
providing a very tough discipline in the society. It means that
people have to be more prudent, more careful. They have to exercise more judgment. It penalizes people who don't have that prudence. And not only from that general standpoint but also from the

184

standpoint of recognizing that you can't live beyond your means
forever,
Mr. Soss. That's another argument in the direction of the independence of the central bank.
Mr. BARBERA. If I could just add one thing, I do think in terms of
notion that perhaps we're due for a recession in the United States
to pay for past sins. We have had an exclusive focus here on the
excess of spending in the United States vis-a-vis production and the
fact that we've financed that by foreign capital.
I do think, though, if you turn it on its head, notwithstanding
the admonition of most foreigners, we did do the world a favor. We
allowed Latin America to essentially avoid default and Europe
grew at about 2.5 percent, even though spending was rising at
about 1.5 percent. Japan got to grow at 4 percent though spending
was at 3.
The CHAIRMAN. What period are you talking about?
Mr. BARBERA. 1983 through 1986. And the Pacific Basin and
Japan exploded, largely on the backs of our growth. I think we're
done. I think it's absolutely impossible for us to perform in 1988
through 1992 as we did 1983 through 1986, but I think the risk is
that there are no new volunteers in terms of the rest of the world
to provide that kind of spending and that absorption of product. It
seems to me that rather than the need for a U.S. recession we need
a U.S. spending recession and some much better spending performances abroad.
The CHAIRMAN. Dr. Sachs, how enthusiastically do you endorse
the views of Dr. Barbera?
Mr. SACHS. I have a growing inventory of small complaints on
comments in the last 5 minutes.
First, I'd like to return to the Wall Street Journal statement
about a recession being likely. I think it is important to point out
that five of the last six Republican terms of presidencies started
with a recession. No Democratic terms did, but five of the six Republican terms did.
The CHAIRMAN. That means if we elect a Republican this year
we'll have a recession in 1990?
A DEMOCRATIC ADMINISTRATION

Mr. SACHS. Much more likely because what will happen this
year, with all likelihood, in my view, is inflation will start to rise.
A Democratic President won't care so much about that and will be
more interested in job creation and getting the exports growing. A
Republican administration will try to clean that up in the first
year and could have a conscious policy of tightening monetary
policy to stabilize the dollar. That may be how it's put next year.
There will be a difference in preference that will involve a real
tradeoff of policy and judgment and values and people who will get
hurt and who won't. Democratic administration is much more
likely to lean toward job creation and continue growth of exports
and I think a new Republican administration will be much more
likely to say if inflation hits 6 percent we've gone far enough with
the weak dollar, it's time to tighten up. So that's the way that it
might be seen next year.

185

Recessions are created as a matter of policy in this country,
mainly as anti-inflation policies, and I think that we may be heading for that cycle right now, given the 40 to 45 percent drop in the
dollar.
Another point I wanted to make is that I think that the debt
structure is a danger. We don't have a lot of the institutions which
allow us to have the kind of leveraging the Japanese firms do
where you have a close special relationship between banks and
firms which allow for enormously high leveraging ratios. We do
have some financial instability here, particularly in the banking
system, that could mean that high interest rate policy once again
could have very serious real consequences, in my view.
Finally, and this may be a quibble because it's past history, although I think it's more than a quibble, I don't think the U.S. did
the world much of a favor at all in the last 7 or 8 years because
while we did give them more export growth, we created enormously high world interest rates. That meant that while we gave in the
sense of higher exports, we took away in the sense of reduced investment in those countries and, in my view, Europe was hurt
much more by the reduced investments over the last few years as
they sent capital here rather than investing in their own country
rather than being helped on that by increased exports to the
United States. Job creation in Europe was very much hurt by
Reaganomics it seems to me and we contributed to the high unemployment in the European economies.
REDUCING DEFICIT WILL SPUR ECONOMIC GROWTH

The CHAIRMAN. What do you think of the point that Dr. Greenspan made for us the other day that if we cut the deficit we'll spur
economic growth because the real interest rate would drop and
that would compensate?
Mr. SACHS. I saw in the press reports that you expressed some
surprise at that view.
The CHAIRMAN. I sure did. It's a refreshing notion that you can
do that. I'm willing to pay the price.
Mr. SACHS. I actually share Dr. Greenspan's view of it, provided
that he goes along and importantly accommodates our fiscal contraction with easier monetary policy. In other words, if the policy
mix in this country changes toward
The CHAIRMAN. But I can't get away from the view expressed by
Martin so beautifully that you can't push a string. No matter how
you flood the economy with credit, if you're in a recession people
are just gloomy and pessimistic about it, they won't borrow. They
won't care if they pay 5 percent interest rate instead of 10 percent.
Mr. SACHS. Well, I think the evidence is that if you're hanging at
the end of the string because real interest rates have been so high
for the last 10 years, that letting up on the string could give you
some breathing space and let you start to grow again.
So in my view, a shift in the policy mix toward tight fiscal and
easy money will not have contractionary effects abroad but indeed
could have expansionary effects abroad and would likely in my
view because I think it would give an investment stimulus to

186

Europe which is going to provide jobs there much more than the
export stimulus has.
What I would agree with my colleague, Professor Cooper, point,
an economy has to be ready for the transition to investment led
growth from export led growth. Japan is in the midst of that transition now and it's very consciously in the midst of that transition.
The European economies might not be consciously ready of shifting
out of export industries and into domestic investment, but they will
have the potential and we should give them the chance to do it by
having a sharp cut in fiscal policy in this country balanced by easy
money. I think the world will be much better off. The developing
world, the debtors of this world, the financial structure, and the
Europeans will be much better off in a low interest rate regime in
the world economy.
Mr. BARBERA. Your point is that a lower budget deficit would be
stimulative if compensated, but not in the U.S.
Mr. SACHS. Well, both. Yes, we need lower worldwide interest
rates. By our interest rates coming down we will give the opportunity in Europe to have lower interest rates.
Mr. BARBERA. I agree, but the point I'm making is based on our
trade deficit, it's wrong to think that there's any combination of
events that can make it easier for us to spend more.
Mr. SACHS. I'm not calling for us to spend more. I'm calling for
us to spend less.
Mr. BARBERA. There's a opportunity to make it easier for them to
spend more.
Mr. SACHS. Exactly.
Mr. BARBERA. I don't think that's quite what Greenspan said.
The CHAIRMAN. Do you want to comment, Dr. Cooper?
Mr. COOPER. I think the way to reconcile this dispute, if I can put
it that way, between you and Greenspan, is to introduce the time
dimension quite explicitly. At least that's the way I reconcile it in
my own mind. Greenspan presented and Sachs has just agreed with
what I would call the classical economic view, which is the longterm interest rate makes things all come out right in the end.
But econometricians have tried for 40 years to discover the short
run impact of that effect and they can't find it. And that's why I
come down with you and Martin in the short run. You cannot push
on a string. Lowering interest rates at the same time that you're
contracting demand simply will not increase investment in the
same short timeframe. There's no empirical evidence for it. During
the last several years I have sat on several committees that make
decisions about investments and the interest rate just doesn't
figure in the calculations whether to undertake them.
In the long run, there will be an impact. Where there could even
be a short-run impact these days is in the liquidity constrained less
developed countries. They would get immediate relief from a reduction in dollar interest rates and are willing to spend more. So there
you would get a relatively short-run effect. But I simply do not believe that fiscal contraction accompanied by a decline in interest
rates will in the same time period be offset by increased investment at home or abroad. If demand goes down because of fiscal
contraction, businessmen will wait before they make their investment decisions, even though interest rates are lower, until they see

187

reasonable prospects for setting the increased production. The most
promising prospect today is higher exports, but that depends on
continued demand abroad.
FLOATING EXCHANGE RATES

The CHAIRMAN. Let me ask you one final question. In Tuesday's
Wall Street Journal, Edward Balladur, the Finance Minister of
France, referred to the "anarchy of floating exchange rates during
the past 15 years." In your statement you referred to this system
as not wholly satisfactory, although probably superior to alternatives available during this turbulent period.
Your statement suggests that you do not join in Mr. Balladur's
extreme condemnation of the system of floating exchange rates.
The question is, how urgent is reform of the international financial system in your estimation?
Mr. COOPER. Urgent suggests an immediacy, a crisis without it,
and in that sense I do not think it's urgent. However, I do think
that it's highly desirable. I think we have monetary arrangements
now which are not sustainable over the long run and they are
going to come and zap us in one way or another if we don't get
ahead of the game. So I think that it's desirable to start in a systematic way to think about where we would really like the system
to be 15 years from now. Fifteen years seem like a long time, but it
isn't too soon to begin thinking about fundamental changes.
The CHAIRMAN. You talked about a world currency. That's a
marvelous thought. What reality is there here? Is it a real possibility, do you think? What would be the consequences when we have
an adverse balance of trade and we can't fool around with our currency and compensate in that way?
Mr. COOPER. Well, in the first place, just to be clear, I have not
spoken of a world currency. I don t think a world currency is either
desirable or necessary. What I have spoken of is a single currency
in the core of the world system.
The CHAIRMAN. I should have said that.
Mr. COOPER. Europe, United States, and Japan. What other countries do is up to them—many of them would find it convenient to
peg their currencies to this currency but they would not be participate directly in this system. An analogy to the United States is
worth noting. We have, as you know, 12 currencies in the United
States Act. Each Federal Reserve Bank issues currency. If you look
in your wallet you can discover several currencies. Most people are
not aware of it because these currencies trade at par and are freely
interchangeable throughout the country.
That system has served this country well. I do not think it's desirable to break New England off, even though it's booming now,
and break Texas and Oklahoma off and introduce floating exchange rates between their respective currencies.
The CHAIRMAN. How about starting with a Northern Hemisphere
currency?
Mr. COOPER. That's up to Canada. It seems to me that that's less
important for the world than to engage the major trading areas —
Canada is one-tenth the size of the United States. Europe taken as
a whole is equal in size to the United States, and Japan is about

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half the size, so those are more important for the world monetary
systems than Canada.
My view stems from the fact that I think the financial side of a
system with flexible rates will increasingly be a source of disturbance to the real side of the economy. It already has been. Since
we're really interested in the real side of the economy—that's what
provides people with the goods and services that determine welfare.
The financial side of the economy should serve the real side of the
economy. We should worry about disturbances coming from the financial side. While it has some problems, moving to a single currency over the next 15 or 20 years, will have the offsetting advantages of eliminating a major source of uncertainty for and disturbances to the real economy.
One reason investment has been as weak as it has been in the
last 5 years is exchange rate uncertainty. Until 1986, Europeans
had been doing smashingly in terms of export orders but they were
not willing to invest on it because they thought that 3 marks to the
dollar or even 2 marks to the dollar was a temporary and couldn't
last. They turned out to be right. Now you find American firms
hesitating to invest because even though their export orders are
way up, there's a question of how long this can last. They're not
confident. They don't accept the economists' argument that the
dollar is bound to go down rather than up. Exchange rate uncertainty is a general dampener to more investment.
The CHAIRMAN. Gentlemen, I want to thank you very, very
much. This has been an excellent panel and you've certainly given
me an education.
The committee will stand in recess.
[Whereupon, at 11:40 a.m., the hearing was adjourned.]

Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's First Monetary Policy Report for 1988 : Hearings Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundredth Congress, Second Session

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