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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1986
HEARING
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN APFAffiS
UNITED STATES SENATE
NINETY-NINTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
JULY 23, 1986
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S.
GOVERNMENT PRINTING OFFICE
WASHINGTON : 1986
For sale by the Superintendent of Documents, Congressional Sales Office
US. Government Printing Office, Washington, DC 20402
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
JAKE GARN, Utah, Chairman
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
ALFONSE M. D'AMATO, New York
DONALD W. RIEGLE, JR., Michigan
SLADE GORTON, Washington
PAUL S. SARBANES, Maryland
MACK MATTINGLY, Georgia
CHRISTOPHER J. DODD, Connecticut
CHIC HECHT, Nevada
ALAN J. DIXON, Illinois
PHIL GRAMM, Texas
JIM SASSER, Tennessee
M. DANNY WALL, Staff Director
KENNETH A. McLEAN, Minority Staff Director
W. LAMAR SMITH, Economist
(ID
CONTENTS
WEDNESDAY, JULY 23, 1986
Page
Opening Statement of Chairman Garn
Opening statements of:
Senator Proxmire
Senator D'Amato
Prepared statement
Senator Riegle
Senator Mattingly
Senator Sasser
Senator Heinz
Senator Hecht
Senator Dixon
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WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Mixed performance
Fundamental adjustments must be made
Strains from unbalanced economy
Protectionist pressures are not the answer
Progress in countries south of our border
Benefits of oil price decline
Growth of Ml
Emphases on stronger trade balance
Legislative direction in the financial system
Prepared statement
Disequilibrium in the industrial world
The international debt problem
Monetary policy in 1986
Some lessons of recent experience
Witness discussion:
Possible loan loss reserve deductibility
Credits from tax reform
Cooperation of trading partners
Control of inflation
,
Increased debt in all sectors
Differences in two statements
Third World debt
Trade imbalances
Area of interest rates
Worsening trade balance
World economic interdependence
Room for separate judgments
Improvement in German economy
Withdrawal of international lenders
GNPrate
Possible lower interest rates
FOMC reports indicate a stronger second half.
Situation in Mexico
Relationship of bank and prime rates
Lower growth rate in many categories
Merrill Lynch forecast of economy
Budget deficit goals
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IV
Witness discussion—Continued
Effects of interest rate reductions
Restructuring debt of oil producing countries
Lack of adequate data from agencies
Complementary economic policies
Dealing with deteriorating framework
Employment figures
Closing nonbank bank loophole
Problems with the thrifts
Ownership of consumer banks by diversified corporations
Possible recession
Reduction of $76 billion in the deficit
Further loans to Mexico by banks
Response to written questions of:
Chairman Garn
Senator D'Amato
Senator Mattingly
Senator Proxmire
Senator Riegle
Senator Dixon
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FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1986
WEDNESDAY, JULY 23, 1986
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 9:30 a.m., in room SD-538, Dirksen Senate
Office Building, Senator Jake Garn (chairman of the committee)
presiding.
Present: Senators Garn, Heinz, D'Amato, Gorton, Mattingly,
Hecht, Proxmire, Riegle, Sarbanes, Dodd, Dixon, and Sasser.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. The Banking Committee will come to order.
This morning's hearing comes at a time when there is more than
the normal level of uncertainty about the economy and about monetary policy itself.
While yesterday's announcement by the Commerce Department
on real growth this year shows that the economic expansion that
began in 1982 is continuing, the rapid growth in the Ml monetary
aggregate that began late in 1984 has yet to produce the acceleration in real growth that many analysts have been predicting.
Similarly, the decline in the value of the dollar on foreign exchange markets since early last year has yet to produce the improvement in the U.S trade and current accounts that analysts have
been predicting.
The decline in the price of oil since late last year has yet to
produce the benefits for the economy in terms of real increases in
spending that have been forecast.
Declines in interest rates have not provided the hoped for stimulus in real economic growth.
The rate of growth in the Ml monetary aggregate has become
suspect as an indicator of the relative tightness or looseness of
monetary policy.
Questions have been raised as to whether declines in nominal interest rates have masked increases in real rates arising from even
faster declines in inflationary expectations.
Commodity prices, interest rates, and the foreign exchange value
of the dollar have been suggested more and more often as the focus
of monetary policy, either in place of or in addition to targeted increases in the monetary aggregates.
Unprecedented declines in velocity have raised questions as to
whether our current method for calculating velocity—which uses
(1)
nominal GNP as a proxy for spending in the economy—might not
be out of date.
I have long believed that uncertainty is not healthy for an economy, primarily because it impedes planning. That is why I have continued to support quicker release of the minutes of the Federal
Open Market Committee [FOMC] meetings.
Our task today, as I see it, is to try to reduce some of the unusual level of uncertainty surrounding the course of the economy and
of monetary policy.
While serious problems remain in agriculture, energy, and certain other sectors of our economy, we must also remember that we
do have an economy that is in the midst of one of the longest economic expansions in the postwar period. That economy is continuing to produce jobs at record rates.
We have made significant progress toward wringing inflation out
of the economy. Interest rates have been reduced markedly.
As is evidenced by Mexico's new accord with the IMF, progress is
being made on the problem of the heavily indebted LDC's. The dollar's value on the foreign exchange markets has come down to
more realistic levels that will help to correct our trade and current
account imbalances. Finally, we have a new agreement among the
G-7 nations to work together to resolve our common economic
problems.
Fortunately, as we work to reduce uncertainty and to resolve our
remaining problems, we at least seem to have a firm economic
foundation on which to stand.
Mr. Chairman, we look forward to your testimony this morning
on these matters, but before we turn to you I'd like to turn to my
colleagues to see if they have any remarks they wish to make.
Senator Proxmire.
OPENING STATEMENT OF SENATOR PROXMIRE
Senator PROXMIRE. Thank you very much, Mr. Chairman.
Mr. Chairman, I'm delighted to see the Chairman of the Federal
Reserve Board before us this morning. I think that in the many
years I've been in the Congress I can't remember a time when the
economic situation was so puzzling. It's always puzzling, but it
seems to me that it's a lot more puzzling now than it's ever been,
for many reasons.
I would just like to spend a minute dwelling on one subject that I
think tends to be forgotten. It is a rare day—in fact, I would say
it's a cold day in July in Washington when Members of the Congress ever criticize the Federal Reserve Board for pursuing too expansionary a monetary policy. That just doesn't happen. The reverse is almost always true, for obvious political reasons. We
always like to see low interest rates and we always figure that if
they 11 just loosen up on the money supply, interest rates will go
down. That habit is a hard one to die, but I think it's about time it
did die, in spite of the fact that we are now in a situation where we
have a slowed economy.
Memories are notoriously short in the political arena. Many of us
have conveniently forgotten the double digit inflation in the late
1970's and early 1980 s that almost wrecked our economy. Today
we hear more politicians calling for a growth-oriented monetary
policy reminiscent of the Keynesian liberals of the 1960's.
On the other hand, there are still many reasons for concluding
that there will be a resurgence of inflation in the next several
years. First, we have had the biggest peacetime budget deficits in
the history of this or any country year after year after year for 5
consecutive years—a highly inflationary policy on the basis of all
historical experience and on the basis of any kind of reasoning.
Second, we've had the extremely explosive growth in the money
supply in 1985 which will take 1 or 2 years to reflect itself in
prices. And I might say, apropos of that, Mr. Chairman, that your
original statement and report indicated that Ml will be given less
attention than the other monetary aggregates. Indeed, some observers have concluded that the Fed has decided to virtually ignore
Ml as a relevant monetary target.
For example, in the first week of July, Ml increased by a whopping $7.4 billion or more than 1 percent. That would produce an
annual growth rate of over 50 percent if continued.
I might also point out that we have had a sharp decline in the
value of the dollar which will raise the cost of imports and ultimately domestic goods. Finally we have the one-time bonanza realized from the sharp drop in oil prices and that's bound to be reversed.
For these and other reasons, I have real doubts that we have inflation permanently under control.
Finally, Mr. Chairman, I am concerned about the fact that if we
do suffer further stagnation, a growth recession, or an actual recession, it's very, very hard to know what policies we can pursue
under present circumstances. Do we deepen the deficit? I presume
we do. $200 billion isn't enough; we go to $300 billion, maybe $400
billion. We've deepened deficits in the past when we've moved into
recession. Do we have an even faster growth of the money supply?
As I pointed out, last week broke all records and the last year has
broken all records for Ml; M2, and M3, while they're within their
targets, the targets are far too generous in view of the level of inflation and nominal GNP growth.
At any rate, Mr. Chairman, I think that we are now in an extraordinarily difficult challenging time and it's going to be interesting to hear perhaps the wisest person who's presided over the Federal Reserve in the 30 years I've been here and that takes in a lot
of very, very able Chairmen.
The CHAIRMAN. Senator D'Amato.
Senator D'AMATO. Thank you, Mr. Chairman.
I'm going to ask that my statement be placed in the record as if
read in its entirety.
The CHAIRMAN. Without objection.
OPENING STATEMENT OF SENATOR D'AMATO
Senator D'AMATO. For several years we have watched and discussed with Chairman Volcker the expansion and contraction of
Ml and the effects of this expansion or contraction upon the economy. From the testimony this morning, it appears that Chairman
Volcker is admitting that during the last 2 or 3 years the Fed has
been paying too much attention and placing too much emphasis on
the effects of Ml on the economy. Now Chairman Volcker suggests
that we discount the impact of Ml.
I can't help but say that I think we've been too tightfisted. The
discount rate should have been cut sooner. I said it last time you
appeared. We play this game as if the Federal Reserve and the
Chairman is the only person who really can speak with any authority as to what the needs of the economy are. I disagree with
that. I'm not going to go back to the late 1970's when we saw the
same Chairman loosen up the money supply and drop the rates
that resulted in spiraling inflation.
I do not advocate the loosening of the money supply to ignite inflation. Rather, I am concerned that the Fed move too far in the
opposite direction and by doing so unnecessarily impede economic
growth. The inflation fears that I've heard expressed time and time
again have not come to pass. The last discount that we had was too
little and too late.
I'm sorry to see that some of my colleagues might say that privately but when we come publicly in front of the Chairman, his
great reputation and experience, et cetera, is such that they are reluctant to encourage you to lower the discount rate even further.
But I'm saying it. I said it last time, Mr. Chairman. I thought that
we should have had the cut earlier and I think that the cuts that
you finally made after a great deal of rancor behind the scenes
should have taken place much earlier. While we should be ever
mindful of the perils of inflation, we should also make every attempt to avoid the problems attendant to a recession.
I am not suggesting to you for one moment that the slowdown in
the economy is simply as a result of the failure to increase the
money supply and drop the discount rate, but certainly these are
contributing factors.
Further, many of the Nation's ills in the manufacturing sectors
of our economy have resulted from a lack of a trade policy. I think
this Nation has no trade policy and it's led to a lot of the job dislocation.
Having said that, I will ask that my remarks be entered into the
record again as if read in their entirety, Mr. Chairman.
The CHAIRMAN. Without objection.
[The complete prepared statement follows:]
STATEMENT OP SENATOR ALFONSE M. D'AMATO
I appreciate the time and efforts of Chairman Volcker who appears before the
committee once again to report on the conduct of monetary policy.
While I don't want to be an alarmist, I feel that we cannot overlook the depressed
conditions of the agricultural and energy sectors of our economy. The current
drought in the Midwest, Southeast, and Southwest and the continued depressed
prices of crude oil will only exacerbate the problems confronting farming communities and those communities depending upon oil production. Further, heavy industry
in this country remains in the midst of a prolonged slump. The financial difficulties
confronting primary industries such as steel have been most recently exemplified by
the bankruptcy of LTV Corp. last week and the recent closing of General Electric s
gas turbine plant in Schenectady, NY. Clearly, the concerted effort to drive down
the value of the dollar has not assisted these industries by encouraging the growth
of U.S. exports as anticipated. Therefore, more dramatic actions must be taken.
Although Chairman Volcker cites the creation of more jobs in the last year, I
wonder how many of these new jobs are in the relatively low wage fast food or computer programming sectors while the jobs lost to foreign competition or due to eco-
nomic downturns in rural America or the oil patch are relatively high paying jobs.
Could it be that although the number of Americans working has increased, the
quality of living for many Americans has actually fallen?
In citing these examples, I don't mean to lay all of the country's economic woes at
Chairman Volcker's feet. However, on a day to day basis, the decisions of Chairman
Volcker and his colleagues on the Federal Reserve Board have a dramatic and immediate impact on the health of the American economy and the economic welfare of
millions of Americans. Let's face it Chairman Volcker, you are a very important
man in determining the rate of this Nation's economic growth and well-being.
Behind the facts and figures you cite are individual Americans experiencing economic hardship. I think that a little dose of economic expansion is in order. The
GNP grew at the paltry rate of only 1.1 percent in the second quarter of 1986. If a
fundamental economic adjustment need be made in the near term, I would suggest
lowering the discount rate even further. I know the rate was recently cut, but was it
cut enough?
In your recent appearances before this committee, some of my colleagues and I
have consistently urged you to lower the discount rate and increase the money
supply to stimulate expansion. Each time we address these issues, you always respond by articulating your concerns with rekindling runaway inflation. Well let's
look at the facts. On March 7, 1986, the discount rate was reduced from 7Vi to 7
percent, on April 18, 1986, it was cut again to 6Va percent and on July 11, 1986 to 6
percent. Is there any evidence that these cuts have resulted in higher than anticipated inflation increases? Despite the many charts and graphs in the Board's monetary policy report, there are none that demonstrate a rise in the inflation rate that
corresponds to a lowering of the discount rate over the last 12-month period. Therefore, the answer to my question is: "No—inflation has not been rekindled." More
importantly, economic expansion in 1986 has not been rekindled either. I agree that
rates should not be artificially reduced, however, I have yet to comprehend how you
determined what constitutes a real versus an artificial reduction. Would anything
more than a one-half percentage point drop be artificial? Is there any real reason
why the rate wasn't recently lowered to 5¥z percent?
Perhaps concerns about inflation should not be your paramount concern and the
growth of the economy through the increased availability of credit and the growth
of the money supply should become the Board's major preoccupation. Monetary
policy can and must be designed to sustain the economic expansion that has continued longer than most. To achieve this goal, I think you should be serious about
being, as you said in your monetary policy report for last year, "Generally accommodative to emerging demands for money.' To this end, you should be serious about
lowering the discount rate and increasing the money supply. Recent experience has
demonstrated that functional decreases in the discount rate and increases in the
money supply have not resulted in a significant amount of inflation, let alone skyrocketing inflation. Therefore, logic dictates that the rate should drop further and
the money supply should be increased.
I look forward to your testimony and your responses to the issues raised by my
statement.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
OPENING STATEMENT OF SENATOR RIEGLE
To follow on a little bit here—and I'll make these remarks
brief—in today's Wall Street Journal, Al Wosenhower, the chief
economist of First Boston, is quoted as saying, that in tunes such as
we have at the moment, "Monetary policy is like an aspirin. It
helps, but it cannot play a fundamental saving role."
It seems to me that that is quite accurate. Monetary policy is a
very important component of overall economic strategy, but it is
not in any respect a cure-all. I think that it is quite limited at particular times what monetary policy can do to drive the economy or
fix other problems.
We might wish that it were otherwise, but that's a fact, and it is
not to diminish the importance of monetary policy. It is extremely
6
important, but I think there are a lot of other factors in the policy
mix here.
I want to say to you, Chairman Volcker, that I appreciate very
much the job that you have done over a long period of time. I think
whether people agree or disagree with different policy calls at different times along the way, your leadership has been critical
during this period of time and may be even more so in the period
ahead.
As I look at the economy, I see enormous difficulties out there. I
think if we take the right steps we can deal with them, but that's
by no means automatic. We see weak growth here and around the
world. We see the enormous trade deficits. We see the huge budget
deficits. We're going to probably exceed $220 billion this year and
there is a slippage on the revenue side which is beginning to widen
out those deficits. We've got the oil problems, and the banking
problems which I will be discussing with you a little later. There
are foreign debt problems, and the agricultural problems particularly here in the United States. It seems increasingly difficult to
achieve international coordination of our economic policies and you
stress that in your statement today—the importance of that kind of
coordination, especially among the major Western nations.
I gather, not happily, the last discount rate you took without
that coordination, you and the Board as a whole must have felt
enough of a sense of urgency to cut the discount rate by doing it
without being able to get a simultaneous response from the Japanese and the Germans particularly.
I am concerned about that and I hope that you will shed some
light on it later.
All of this is by way of getting to the point that I really want to
make here and that is, none of us know what's ahead. In 1983 you
said before this committee, that when you were confirmed you
were not going to commit yourself to necessarily serve out a full
term. You went on to elaborate under questioning that you thought
a President, after being elected, ought to have, perhaps after a year
or so, an opportunity to appoint a Fed Chairman of his own choice.
We're approaching that 1-year period. Your term, if you stay the
full term, ends at the end of 1987 or late in 1987, and I hope you'll
stay. I don't know what your plans are, but my great concern right
now is one of maintaining public confidence in this country. I think
the role that you have played, and I think can continue to play, is
a very important part of maintaining that public confidence
through a very turbulent and difficult period.
I don't know if you can enlighten us in that respect today, but as
one member of this committee, I hope that you will fill out the full
term. I think it's very important, particularly at this time.
The CHAIRMAN. Senator Mattingly.
OPENING STATEMENT OF SENATOR MATTINGLY
Senator MATTINGLY. Thank you, Mr. Chairman.
I'd just like to welcome Chairman Paul Volcker again to a full
hearing room, a standing-room-only crowd. I guess maybe we ought
to start moving to bigger quarters. Obviously, you draw a bigger
crowd than anybody else that comes before our committee here.
I would like to say one thing in reference to the remarks being
made and of course in the paper in reference to the GNP at 1.1percent growth. At least it's growth. At least it's heading in the
right direction.
I would like to also try to comment in reference to the Senator
from Michigan, my good friend Senator Riegle, when he referred to
the deficit that we have. I would like to say on the positive side
that what we see Congress doing in reference to the 1987 budget is
making certain that we keep the constraints on the deficit to $144
billion, and so far so good on that. We seem to be winning that
battle, and hopefully by the time we go into October 1, that we'll
have a budget deficit that has dropped tremendously and dramatically, and that's been brought on by a new process that even
though some of the Congress are a little skittish of, I'm glad
they're skittish of it because obviously it's working.
I d just like to reinforce what Senator D'Amato said, I'm glad to
see you here today and I hope that you make an announcement
today of how far the discount rate will drop. Because I don't know
what you have in your speech, I'm waiting to hear it. But, if it's
down there somewhere toward the end, if you would give that first
it would be better.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Sasser.
OPENING STATEMENT OF SENATOR SASSER
Senator SASSER. Thank you, Mr. Chairman.
I, too, want to welcome Chairman Volcker this morning before
the committee. I sometimes think when we're discussing this great
engine that we call the American economy we're very much like
the fable of the five blind men who examined an elephant and one
felt the elephant's leg and thought it was like a large tree. Another
felt his trunk and felt it was like a slithering serpent. All of us
look at the economy and come back with a different diagnosis for
the problem.
Some of my colleagues have their own diagnoses and I'm sure
the Chairman does also, but one that occurs to me and keeps recurring is that we're paying the price in this economy for the most
unorthodox fiscal policy that we have pursued in this Government,
probably the most unorthodox in this century. We're going from
one planned structural deficit after another, year after year after
year, and neither this administration, which in my judgment
should furnish the leadership for dealing with the deficit, nor the
Congress has been able to face up to this very, very serious problem.
Now I have been critical of the Federal Reserve Board and this
Chairman in times past for not lowering the discount rate enough
and in what I thought was a timely fashion. But let's face it, the
Fed and this Chairman are in a very precarious position. We are
borrowing at the present time about $100 billion in foreign funds to
finance an enormous Federal deficit. We are attracting these funds
with relatively high interest rates. If we get into the posture of
lowering this discount rate too rapidly, too precipitously, then we
could very easily and quickly see an exodus of foreign capital from
this country which I think could be a fiscal disaster and could also
be a disaster for what I perceive to be a relatively shakey financial
structure in this country.
The administration's growth estimates have been off the mark,
as they have been characteristically now for almost 6 years, and I
hope this morning that the Chairman can apply a little reality to
these growth estimates and numbers that we've been hearing.
So I welcome you, Mr. Chairman, and look forward to hearing
your statement this morning.
The CHAIRMAN. Senator Heinz.
OPENING STATEMENT OF SENATOR HEINZ
Senator HEINZ. Chairman Volcker, we welcome you back to this
committee. You're no stranger to this committee. What I suppose
many of us are really asking you—and we hope you do have a
chance to testify some time this morning—is why, with economic
conditions as they are, with the economy certainly at best soft,
with retail sales flat, with oil, gas, and the farm economy deeply
troubled, with basic industry very sick, the LTV bankruptcy of last
week reminding us of that, with auto sales from time to time going
soft, with the consumer price index for the first half of this year
having grown at a negative rate of zero or below, with the wholesale price index having been minus 12.4 percent in the first quarter, minus 0.1 percent in the second quarter, why, in view of the
deflationary trends in this economy, should the discount rate or interest rates be at 6 percent in the case of the Fed, 8.5 percent in
the case of the prime rate, especially since there seems to be little
or no demand for capital?
When I say there s little or no demand for capital, what I'm referring to is the indication that weekly loan and paper demand is
flattening out; business credit actually seems to be dropping; personal loans at banks have tapered off. About the only thing that
keeps going strongly, according to the statistics I have, are real
estate loans at banks. Scarcely a tremendous amount of demand.
It seems to me that those people—I number myself among
them—who call for a further drop in the discount rate are on solid
ground in indicating that there's certainly no reason to believe this
is going to bring about a wave of inflationary stimulation.
World oil production is at a high since 1981 or 1982—remarkable—and the price is expected to stay quite soft. Our trade deficit,
of course, remains at a record. By the way, it's interesting to me
that it remains at or above record rates in spite of the fact that our
biggest import, oil, is selling at the lowest price that most of us can
remember.
You have indicated in your statement that you feel that a lot of
the problem is America's trading partners, particularly I assume
you're referring to the Germans and the Japanese who have refused to stimulate their economy, restimulate their economy, and
that that is a depressant on the world economy of which we're a
part. I don't quarrel with that. I think they should do a better job
of managing their economy.
Yet it doesn't answer the question of why there should be relative to inflation such high returns to capital when the wholesale
price index is going down, when the consumer price index is going
down or is for all intents and purposes flat, and when there is no
substantial demand. Demand seems to be falling relative to previous growth of demand for capital, for loans, for credit. It's significant to me that per capita income—not family income but per
capita income—has been almost flat since 1968. One way of putting
that is that the returns to capital have never been better; the returns to labor are not very good and at the present time seem to be
falling.
Something seems to be wrong and beyond just blaming our trading partners for it—and I think they do deserve some of the
blame—I hope you will address that issue.
The CHAIRMAN. Senator Hecht.
OPENING STATEMENT OF SENATOR HECHT
Senator HECHT. Thank you, Mr. Chairman.
Nice to welcome you, Chairman Volcker. I didn't get to this
august body until 1982 and as a businessman in the late 1970's I
struggled under 20 percent plus prime rate, 12 percent inflation, so
I say to you that you have made remarkable progress. We have
much work to do. I'm anxious to hear from you and I think we
should work together because certainly Congress shares a large
amount of responsibility for this huge deficit. Thank you.
The CHAIRMAN. Senator Dixon.
STATEMENT OF SENATOR ALAN DIXON
Senator DIXON. Mr. Chairman, we are here to consider the semiannual monetary policy report of the Federal Reserve Board. This
hearing comes at a time of great uncertainty in the economy.
Federal deficits for this year will likely be significantly greater
than last year's record level. Economic growth, however, is likely
to be lower than had been expected when the budget resolution for
this year was put together. While the money supply has increased
fairly rapidly in recent months, inflation is low, and interest rates
are down. Yet cheaper loans and low inflation have not resulted in
higher levels of production; the percentage of factory capacity in
use is falling.
The international scene is equally unsettling. The dollar has
fallen significantly over the past year, but the trade deficit does
not seem to be falling at all. The International Monetary Fund has
been able to put together a loan package for Mexico that is getting
generally favorable reviews, and which should avert a default in
that country, but today's papers indicate we could have an unprecedented default in Peru by August 15.
What is most disturbing is that neither the behavior of our domestic economy nor the world economy seems to be adequately explainable under the old rules. Conventional wisdom would suggest
that low inflation, a falling dollar, falling U.S. interest rates, a
very expansive fiscal policy as measured by the deficit, and a rapidly growing money supply should produce higher rates of economic
growth. But economic growth is falling. Our economy is becoming
more and more sluggish.
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I look forward to hearing from the distinguished Chairman of the
Federal Reserve, therefore, and to receiving the benefit of his analysis and recommendations on how best to come to grips with this
uncertain economic situation. Thank you.
The CHAIRMAN. Mr. Chairman, now that you have had the opportunity to hear all of our nonsolutions to the economy, I would also
advise you that you have other parliamentarians to listen to you
today. We have 11 committee chairmen from the Canadian House
of Commons visiting the committee this morning, so you have a
wide audience of politicians for your views. The Canadian Government is also listening this morning.
So we would be happy to hear from you at this time.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Thank you, Mr. Chairman, and I think you all
have emphasized one way or another the difficult and challenging
times in which we live and I agree that they are. I appreciate the
opportunity to report once again in this context on the conduct of
monetary policy. I would first like to place that matter in the
larger context of the performance of the United States and the
world economy.
MIXED PERFORMANCE
As you know, there have been marked contrasts in the economic
performance of different sectors and regions of this country. Consumption has been strongly maintained, and there have been large
increases in employment in the broad service sector. Housing is
being built at a high rate. But industrial activity and business investment, which had leveled off last year, have declined over the
last 6 months, and the agricultural and energy industries are
under strong pressure. As a consequence, activity in some areas of
the country has advanced rather strongly, while severe adjustments are taking place in the energy and agricultural belts.
The net result is that the overall economic growth rate in the
United States moderated to about 3 percent through 1985 and early
1986, and apparently slackened further in the second quarter of
this year. Moreover, growth in other major industrialized countries
remained slower than in the United States during 1985 and the
early part of this year.
Throughout this period, sizable increases in employment have
continued in this country, the unemployment rate has remained
generally at a little over 7 percent and, relative to the size of the
working age population, more people are employed than ever
before recorded. In Europe, unemployment has also remained relatively steady, but at much higher levels.
After more than 3 years of economic expansion, the process of
disinflation has continued, reinforced for the time being by sharply
lower prices of oil, by far the most important commodity. With industrial prices steady, the average level of wholesale prices has
been declining here, and even faster in key countries abroad whose
currencies have been sharply appreciating relative to the dollar.
Interest rates here and abroad have also declined appreciably, re-
11
fleeting both the sense of progress against inflation and the fact
that growth has been proceeding well within capacity restraints.
The large decline in U.S. interest rates and the sharply higher
stock market over the past year suggest the cost of capital has declined. The fall in oil prices has helped bolster the real income of
consumers. Meanwhile, the substantial depreciation of the dollar
has placed our industry in a decidedly better competitive position
vis-a-vis other industrial countries. As many have suggested, these
underlying forces should help sustain an economic expansion that
has already lasted longer than most.
FUNDAMENTAL ADJUSTMENTS MUST BE MADE
But I would be remiss in failing to emphasize much less satisfactory aspects of the United States and world economic situation.
There can be no evading the fact that some fundamental economic
adjustments must be made within our economy in the months and
years ahead.
The clear challenge is to find the ways and means to work
through those adjustments in a context of sustained growth while
also consolidating and retaining the progress toward price stability.
The conduct of U.S. monetary policy is obviously relevant to that
process. But that single policy instrument cannot itself provide the
answer. Complementary approaches in the fiscal, trade and other
policies of this country, and in the approaches of other countries,
will be required as well. The hard fact is that, while the need for
complementary actions to achieve the necessary adjustments in the
United States and world economy seems to be more widely recognized, progress in coordinating action toward those aims has been
limited.
Some obvious imbalances have developed in the economies of the
industrialized world. That is evident most of all in the enormous
deficit in our external trade and current accounts, and in the counterpart surpluses of a few other countries. Unless dealt with effectively and constructively, growing market and political pressures
will, sooner or later, inevitably have much more disturbing consequences.
The problem clearly emerged some time ago. The powerful thrust
of the strong U.S. economic expansion in 1983 and 1984 had spilled
out abroad in the form of sharply rising imports, aided and abetted
by the exceptional strength of the dollar internationally. There
were, for a while, benefits on all sides. At a time of slack demand
at home, exports to us helped Europe and Japan to restore and
maintain their growth. The United States also absorbed a disproportionate share of the necessary external adjustment efforts by
the heavily indebted countries of Latin America. Those countries
have sharply curtailed their imports since 1982, and they have
become more competitive in markets for manufactured goods.
At the same time, the United States began to be the recipient of
a growing flow of capital from abroad. That inflow, which pushed
the dollar so high in the exchange markets until early 1985, had
the practical effect of relieving potential pressures on our internal
financial markets even in the face of the massive and growing Federal deficit. Consequently, private investment and construction
12
could expand. At the same time, the competitive pressure from imports encouraged strong cost-cutting and productivity efforts in the
industrial sector. That has been one powerful factor accounting for
the near stability of prices of manufactured goods over the past
year or more.
We cannot, however, build a lasting foundation for sustained
growth and stability on massive international disequilibrium—
huge and rising trade deficits in the United States and counterpart
surpluses abroad. Nor can we count on satisfying indefinitely so
much of our own needs for capital by drawing so heavily on the
savings generated elsewhere in the world—savings that have been
so freely available in part only because internal growth in Europe
and Japan has been relatively slow.
STRAINS FROM IMBALANCED ECONOMY
Today the imbalances and strains are clearly showing. The forward momentum of our economy has been sustained almost entirely by consumer spending and housing construction, both of which
have been accompanied by unsustainably heavy borrowing. Savings
meanwhile have remained at a relatively low level, even by past
U.S. standards. For more than 1 year, industrial production in the
United States has not grown appreciably, and there has been some
decline in 1986. The pace of business investment has slackened.
Some of the relative weakness in industrial output and investment over the past 6 months can be attributed to temporary factors and to developments peculiar to the United States. For instance, some investment orders were speeded up late last year in
anticipation of tax reform, and the debate on the nature of that
reform has apparently led to some deferral of ordering this year.
The boom in spending for computers has subsided and commercial
construction, in response to large and growing vacancies of office
space, is predictably declining. Probably much more important in
recent months have been very sharp cutbacks in domestic oil exploration and investment, driving energy producing States into recession-like conditions and affecting production of steel and equipment
elsewhere as well.
But a large part of the difficulty stems from the continuing imbalances in the world economy. On the average, growth rates in
major European economies and Japan were about three-fourths
percent less than the reduced growth path of the United States
during 1985 and the first quarter of 1986. However, the more disturbing contrast lies in the source of that growth.
In the United States, the rate of growth in domestic demand,
while slowing
in the third year of expansion, continued to average
about 33/4 percent through that period. Domestic demand growth in
the industrialized countries of Europe and Japan was significantly
less—about 2Vfe percent. In the early part of this year, when their
exports slackened, those countries grew not at all.
The plain implication is that our overall GNP growth rate was
reduced by continuing deterioration in our trade and current account balances. With our current account deficit reaching a record
$135 billion annual rate in the first quarter of this year, industrial
production and investment were restrained. Meanwhile, foreign
13
surpluses continued to build through much of the period, and as
their exports have slowed, internal demand has not yet, in most of
those countries, picked up the slack.
Prospects for investment and for manufacturing activity in the
United States are heavily dependent on an improved trade outlook.
The sharp decline in the dollar since its peak in early 1985 should
help set the stage for such an improvement. There is evidence that
U.S. producers find themselves in a stronger competitive position.
However, the deterioration in actual trade in manufactured goods
has slowed little.
The decline in the dollar is both relatively recent and from a
very high level so the absence of a stronger response in trade so far
is not entirely surprising. What is of concern is that the domestic
markets of our major industrial competitors have remained so sluggish, raising a question as to the buoyancy of the markets for our
exports and of their own growth prospects.
PROTECTIONIST PRESSURES ARE NOT THE ANSWER
You are well aware that the present imbalance among industrial
countries is reflected in strong protectionist pressures in the
United States, Yet, as the President has so strongly emphasized, to
abandon our tradition of relatively open markets would surely be
to invite an unravelling of the international trading order. We
would then have less trade and more inflation. With that, prospects for sustained growth both here and abroad would clearly be
placed in jeopardy.
I know of the complaints about unfair trading practices of other
countries. We need to deal with them energetically. But I also
know the clear lesson of experience is that a protectionist retreat
by the United States, the world's leading economic power, would
invite recrimination and escalation. Certainly, the most effective
and promising avenue for dealing with the trade complaints on all
sides will be in the planned round of multilateral trade negotiations rather than in a tit-for-tat process of mutual retaliation.
Moreover, I believe it is demonstrable that, as a matter of relative importance, much more fundamental imbalances in the world
economy than unfair trading practices are responsible for the
present pattern of trade deficits and surpluses. Those underlying
imbalances can only be dealt with by complementary economic
policies, not protectionism.
Quite clearly it is in no one's interest—not the United States or
other countries—that we seek better balance in our external accounts by deliberately restraining further our own growth rate.
But it is also true that as things now stand, stronger domestically
generated growth in the United States will not reduce the international imbalances. Taken alone, it would aggravate our trade deficit further, posing an even more difficult adjustment problem later.
As I suggested, the recent exchange rate changes can help us to
escape that dilemma—they should work to improve our trade position and reduce the surpluses of others. In fact, faced with a combination of appreciating currencies and slower growth in overseas
markets, exporters in both Japan and some European countries are
experiencing reduced profits and more sluggish orders from, abroad.
14
However, in the absence of offsetting internal sources of expansion,
those same pressures could dampen their own prospects for growth.
That is one of several reasons we should not rely on exchange
rate changes alone to produce the needed international adjustments in the world economy. Over a number of years, we in the
United States will certainly need to shift more of our resources
into exports, and into recovering domestic markets where import
penetration has been so high. That, very broadly, implies relatively
more growth in manufacturing; relatively less growth in services,
in governmental spending, or in other sectors; and more savings
and less borrowing. For some of the rest of the world, the opposite
shift will need to be at work—less reliance on exports, and more on
domestic sources of growth.
Much still needs to be done to ease the way for those adjustments. For one thing, we in the United States are not prepared for
a really large improvement in our trade balance. Our financial
markets remain dependent on the large capital inflows from
abroad that are a necessary counterpart of our trade and current
account deficits. Moreover, taken by itself, depreciation of our currency in an effort to redress the trade deficit poses a risk of renewed inflation.
Only as our huge Federal deficit is cut can we comfortably contemplate less borrowing abroad and provide assurance against renewed inflation. Put another way, in a growing economy, reductions in the Federal deficit will be necessary to release the real and
financial resources necessary to improve our trading position in a
way consistent with rising investment.
In a few foreign countries, such as Germany, some signs of
stronger internal growth have appeared in recent months. But
such signs are far from uniform among key countries abroad, and
most projections of their growth for this year have been lowered,
not raised, as exports have slowed.
With rising currencies and falling oil prices, some of those countries after years of effort have now successfully achieved virtual
stability hi consumer prices. Moreover, their wholesale prices have
declined sharply and are appreciably lower than 1 year ago.
All of us—and certainly this central banker—can appreciate the
importance of maintaining a broad framework of stability and appropriate financial disciplines to sustain that progress. What is at
issue for some countries is their ability to achieve and maintain
vigorous internal growth at a time of high unemployment and
ample resources as external stimulus fades away, as it must if
international equilibrium is to be restored. The appreciation of
their currencies and the strong deflationary influences of low oil
and other commodity prices would appear to offer a prime opportunity for reconciling those goals of domestic growth and stability.
PROGRESS IN COUNTRIES SOUTH OF OUR BORDER
Four years after the international debt problem broke into our
collective consciousness in 1982, when Mexico abruptly lost access
to international credit markets, that threat to our mutual prosperity remains. The renewed difficulties of the oil producing countries
today should not, however, obscure the progress that has been
15
made. Collectively, the heavily indebted countries of Latin America
and elsewhere have made an enormous effort to adjust their external accounts; in fact in 1984 and 1985 they were in rough current
account balance, in contrast to an aggregate deficit of about $50
billion in 1982.
To be sure, that effort for a time was accompanied by sharply
lower imports, recession, and lower standards of living as they
brought their spending more in line with their internal resources.
But it is also true that many of those countries are again growing,
in some cases with vigor, as is the case with the largest single
debtor, Brazil. Helped by the reduction in world interest rates, external interest burdens have been reduced appreciably in some
countries relative to exports or other measures of capacity to pay.
A number of Latin American countries have also made striking
progress in dealing with ingrained inflation for the first time in
many years, in the process gaining political support. There has
been considerable, if uneven, progress toward liberalizing their economic structures in ways that should encourage more growth and
productivity over time.
In the midst of this progress, the sharp decline in oil prices over
the past 6 months has had an enormous adverse impact on the oilexporting heavily indebted countries—Venezuela, Nigeria, Ecuador, and Mexico. At current oil prices, for instance, Mexico would
lose about one-third of its 1985 exports, perhaps as much as 15 percent of its Government revenues, and the equivalent of some 5 percent of its GNP. Inevitably, that situation poses a new and severe
challenge for Mexico—a challenge that will require strong new efforts to make the necessary economic adjustments and to improve
the structure of their economy. There is no large cushion of external reserves to buffer the shock. Consequently, a large amount of
financial resources will have to be marshalled from abroad to help
ease the transition, to maintain continuity in debt service, and to
provide a solid base for renewed growth.
That combination of adjustment, structural change, and appropriate financing is, indeed, the essence of the approach announced
by the Mexican Government earlier this week. In cooperation with
the IMF and the World Bank, Mexico is undertaking a wide range
of efforts to deal with both its short and longer range economic
problems. To my mind, their efforts, in the midst of crisis to move
toward a more open, competitive economy, are particularly encouraging. They have joined GATT, import restrictions are being rationalized and liberalized, a good many state-owned enterprises are
being made available for sale—or, if too inefficient, shut down—
subsidies are being reduced and eliminated, and procedures for approving foreign investment eased. If carried through effectively,
those measures promise to work toward fundamental improvement
in the efficiency, competitiveness, and creditworthiness of the
Mexican economy, thereby enhancing prospects for longer term
growth.
Today, that country is in recession. But the program clearly contemplates economic recovery in 1987 and 1988. Certainly, sizable
amounts of financing from abroad will be required to support that
effort. About half of that can be committed by the IMF, the World
Bank, and the Inter-American Development Bank. But Mexico is
16
calling upon commercial banks, with so much already at stake, to
play a large role as well.
In assessing that situation, I would note that the Mexican exposure of commercial banks appears not to have increased for some
18 months. Indeed, there has been little net new lending to Latin
America as a whole over the past year.
Taking the entire period since mid-1982, the exposure of American banks to the heavily indebted countries of Latin America relative to their capital has declined appreciably. That ratio fell from
about 120 percent of the capital of lending banks to less than 75
percent at the end of last year, a decline of 38 percent. No doubt,
there has been a further reduction by now.
Those exposures, in relative terms, are actually considerably less
than in 1977 when the data were first collected. For some time, the
pace of lending has, in fact, been well below that contemplated by
Secretary Baker when he set out a framework for a growth-oriented approach toward the international debt problem at the IMF
meetings last autumn.
That initiative—essentially contemplating a combination of
strong adjustment efforts and structural reform by the indebted
countries with reasonably assured financing by international institutions and private banks—is now being tested. It is being tested in
difficult circumstances not foreseen at the time—the sharp break
in oil prices. But the basic community of interests among borrowers and lenders—and the world at large—in a coherent, cooperative
approach is as strong as ever.
The debtor countries themselves have an enormous stake in
maintaining their creditworthiness and in seeking solutions in the
framework of open, competitive markets. We all have a strong interest in international financial order—all the more when there
are other points of strain in the banking system. And, of course,
relationships beyond the purely economic are at stake, for the
United States most of all.
BENEFITS OP OIL PRICE DECLINE
The challenge is large, but with cooperation, also manageable.
Indeed, the same oil price decline that has undermined the budgetary and trading position of Mexico and other large oil exporters
has relieved the pressure on those importing oil. Interest rates
have declined. A number of borrowing countries will require significantly less, rather than more, financing than was contemplated
1 year ago. Given the enormous progress made in adjusting external positions, most of the borrowers can look toward more balanced
expansion in their imports and exports as they grow—among other
things, providing renewed opportunities for American exporters.
But I must also emphasize one essential ingredient for success
beyond the capacity of the indebted countries to manage. Only a
stable, growing world economy, with markets open to the developing world, can provide an environment conducive to economic expansion, more normal interest rates, and orderly debt service by
the borrowers. That ingredient is plainly the responsibility of the
industrialized world alone. It is one of the reasons why we must
collectively deal with the obvious imbalances among us.
17
These larger issues were the background against which the Federal Reserve has conducted monetary policy in 1986 and reviewed
its objectives for growth in money and credit this year and next.
The results of the review by the Federal Open Market Committee
[FOMC] of target ranges for money and credit for 1986 and tentative ranges for 1987 were discussed in the Humphrey-Hawkins
report published and sent to the committee at the end of last week.
That report also sets out projections for real activity and prices of
FOMC members and Reserve bank presidents.
As indicated in the report, the posture of monetary policy remained broadly accommodative over the past 6 months. The discount rate has been reduced in three steps this year by 1 Vz percent,
in part responding to and in part facilitating declines in short-term
interest rates of similar magnitude. Long-term interest rates also
moved lower, extending the sharper drops in the second half of last
year. The general structure of interest rates is now as low as at
any time since 1977.
The reductions in interest rates in 1985 and 1986 have clearly
helped support the more interest-sensitive sectors of the economy,
reflected in part in the highest level of housing starts since the late
1970's. The declines have also helped ease the debt servicing costs
of businesses, farmers, developing countries, and the U.S. Government itself.
On the other side of the ledger, as interest rates have declined,
the rate of growth in debt has remained at disturbingly high levels,
although there are at least faint signs of a slackening in the rate of
debt creation after a burst around the turn of the year. The declines in interest rates also clearly helped induce the general
public to increase its holdings of its most liquid assets, including
demand deposits and NOW accounts included in the narrow measure of the money supply, Ml. That reaction was undoubtedly amplified by the fact that interest is paid on NOW accounts, which
are now the favored form in which transaction balances are held
by individuals. With interest rate spreads currently quite narrow
between NOW accounts and other liquid assets, those accounts no
doubt have served increasingly as a repository for liquid savings as
well as for money held for transactions purposes.
Similarly, there are some indications of a greater willingness of
businesses to hold demand deposits at a time of lower interest
rates, partly because, with interest rates down, a larger balance is
necessary to compensate banks for a given amount of services. To
some extent, an environment of more stable prices may also be encouraging larger money holdings.
GROWTH OF Ml
None of that was predictable with any precision, and the rate of
growth in Ml, which ran at almost 13 percent over the first half of
the year, was far above the FOMC's target range. Action to restrain that growth within the target range—which would have required reducing the provision of reserves and a significant increase
in pressures on bank reserve positions—was not deemed desirable
in the light of other important considerations.
18
One of those considerations was that growth in the broader
measures of money—M2 and M3—remained well within their respective target ranges of 6 to 9 percent, ending the second quarter
close to their midpoints. That and other evidence suggested that
much of the growth of Ml reflected a shifting of the composition of
liquid assets rather than excessive, and potentially highly inflationary, money creation. That judgment was, of course, reinforced by
the moderate rate of growth for the economy overall, the absence
of indications of a strong acceleration as the year progressed, evidence of greater stability in prices of manufactured goods, and declining commodity prices.
In looking ahead, the Committee decided to retain the existing
ranges of 6 to 9 percent for M2 and M3 this year. The range of 3 to
8 percent set for Ml early in the year was not recalibrated because
of the uncertainties as to the behavior of that aggregate at present.
Certainly the inflationary potential of excessive money growth remains a matter of concern. But in current circumstances, the Committee decided that the significance of changes in Ml could only be
judged in the context of movements in the broader aggregates, and
against the background of movements in interest rates and the
economy generally. Taking account of those factors, growth in
excess of the target established at the start of the year will be acceptable.
In circumstances of greater economic, price, and interest rate
stability, more predictable relationships between Ml and the economy may reemerge over time, although the trend of Ml velocity—
the ratio between GNP and Ml— will likely be different than earlier in the postwar period. However, a firm conclusion concerning
the nature and stability of future velocity characteristics may take
years of experience in the new institutional and economic setting.
For the time being, in looking to next year, the Committee set out
a highly tentative range of Ml growth of 3 to 8 percent on the assumption that velocity changes will be within the range of most
postwar experience. However, that judgment—and indeed the
weight to be given any Ml range for 1987—will be carefully reviewed at the start of next year.
The tentative 1987 ranges for M2 and M3 were lowered by onehalf percentage point to 5Va to 8Vz percent. That modest reduction,
consistent with the long-term objective of achieving a rate of monetary growth compatible with price stability, is judged to be entirely
compatible with a somewhat greater rate of economic growth next
year, provided that growth is not accompanied by a marked increase in inflationary pressures.
The actual price statistics for some months have, of course, reflected the precipitous drop in the price of oil, and consumer prices
have dropped slightly this year. But equally clearly, the price of oil
will not continue falling so fast, and at some point could well rise
again. More predictably, the large depreciation of the dollar will
bring in its wake an increase in import prices of manufactured
goods. That impact has been moderated so far by the narrowing of
the earlier wide profit margins of many of those exporting to us
and by the availability of imports from developing countries, few of
which have had any appreciable appreciation of their currencies
vis-a-vis the dollar.
19
The rate of increase in costs of housing and of many services,
which account for a large proportion of the economy, has decelerated little if at all in recent years. With demand strong, measured
productivity gains limited, and compensation
increases in service
occupations continuing to average 4l/2 percent or more, those areas
continue to lend a chronic inflationary bias to the general price
level.
Those underlying forces are reflected in the projection of FOMC
members and Reserve bank presidents that the overall inflation
rate is likely to be somewhat higher next year. That prospect underscores the need for vigilance in the conduct of monetary policy.
We want to assure maintenance of the remarkable progress toward
stability as the economy grows more strongly and as a large
amount of resources are shifted back to manufacturing industries
as our trade balance improves. Without such assurance, there
would be no firm basis for expecting the level of interest rates to
remain for long at lower levels or to decline further.
EMPHASIS ON STRONGER TRADE BALANCE
In looking toward growth in the 3 to 3Vz percent range next
year, considerable emphasis was placed by committee members on
the potential contribution to that growth of a stronger trade balance. As I emphasized earlier, that shift, if it is to take place in the
context of sustained and stronger world growth, will require appropriately complementary policies here and abroad. Significant
progress toward dealing with our own budget deficit seems to me a
key ingredient in that overall policy mix.
The timing of another important domestic policy instrument—
discount rate cuts—has been influenced by international financial
and exchange rate considerations. A substantial realinement of the
excessively strong dollar exchange rate has been a necessary and
constructive part of achieving the necessary adjustment in external
trade. But there are clear dangers in placing excessive weight on
that approach.
History demonstrates all too clearly that a kind of self-reinforcing cascading depreciation of a nation s currency, undermining confidence and carrying values below equilibrium levels, is not in that
nation's interest or that of its trading partners. Among other
things, such a movement of the dollar now could transmit strong
inflationary pressures to the United States and inhibit the free
flow of capital from abroad at reasonable interest rates. Moreover,
other countries would find it more difficult to sustain their forward
momentum.
In the light of all these considerations, the discount rate reductions in March and April were timed to coincide with similar
changes by one or more other key countries, minimizing any
impact on the exchange markets and consistent with the desirability of some reduction in interest rates in the industrialized world
generally.
Experience over the first half of 1986 underscored the difficulty—I would say the impossibility—of conducting monetary policy
in current circumstances according to one or two simple, preset criteria. For instance, the rapid growth of debt and Ml clearly bear
20
watching because of the potential for aggravating the vulnerability
of the financial structure to adversity and because of the inflationary potential. However, the weight of the evidence strongly suggests that Ml alone during this period of economic and institutional transition is not today a reliable measure of future price pressures—or indeed a good short-term leading indicator of business activity. The more restrained performance of the broader aggregates,
as well as the performance of the economy and prices themselves,
point in a different direction.
At the same time, pressures on the oil industry, agriculture, and
parts of manufacturing and the more general disinflationary process are reflected in strains on some depository institutions. Those
strains emphasize the importance of dealing with factors more directly under the control of lenders themselves: excessive leveraging
of borrowers and loose credit standards. A broad array of approaches by the supervisory and regulatory authorities has been necessary to deal with the particular points of pressure in a manner consistent with the stability of the entire fabric of financial institutions and markets.
LEGISLATIVE DIRECTION IN THE FINANCIAL SYSTEM
The present situation certainly makes all the more pointed the
need to provide a stronger sense of legislative direction about the
evolution of the financial system over time. There are also urgent
specific pieces of legislation before you to permit the FDIC and the
Federal Reserve to facilitate interstate acquisitions of failed or failing banks and to supplement the resources of the FSLIC.
The difficulties of some financial institutions are one specific example of economic problems that cannot be effectively dealt with
by monetary policy alone. It is indeed a strength of monetary
policy that it can respond flexibly to changing circumstances. But
it is equally true that that single, broad-brush policy instrument
cannot, at one and the same time, be called upon to stimulate the
economy, protect the dollar, restrain excessive debt creation, and
shift resources away from consumption and back into investment,
manufacturing and exports—as desirable and important as all
those goals may be.
Events of recent years have also heavily underscored how cumbersome fiscal policy can be, and the difficulties of achieving political consensus on such matters as tax reform and the appropriate
legislative framework for financial institutions. On an international scale, achieving consensus on appropriate action can be still
more difficult.
We have nonetheless come a long way toward restoring growth
and stability in this decade. But my sense is that all that progress
is in growing jeopardy unless we act—we in the United States, we
in the industrialized world, and we in the world as a whole—in mutually supportive ways.
The main directions of that effort seem to me clear enough. The
Gramm-Rudman-Hollings legislation is an expression of the sense
of urgency surrounding our budgetary effort in the United States.
The rest of the industrial world needs to achieve and maintain a
momentum of home-grown expansion. With strong national and
21
international leadership—and with the cooperation of private and
public lenders—a constructive resolution of the economic crisis in
Mexico can point the way to a wider resolution of the debt problem
in a context of growth.
Hard as it may be to carry through on those efforts, that is what
needs to be done if the imbalances in the economy are to be effectively addressed. Then we will have a really solid base for sustaining the momentum of growth and the progress toward stability in
the years ahead. Certainly, the Federal Reserve will play its part
in that effort.
[The complete prepared statement follows:]
Ur.
As you know, there have been marked contrasts in the
S t a t e m e n t by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve Syste
economic performance of difCerent sectors and regions of thi.=
country.
Consumption has been strongly maintained, and thers
have been large increases in employment in the broad service
CSS
to
before the
Committee on B a n k i n g , Housing and Urban A f f a i r s
activity and business investment, which had leveled of£ last
United States Senate
and energy industries are under strong pressure.
July 23,
As a consequ
1986
ongly.
-2quarter of this year.
-3-
Moreover, growth in other major
reflecting both the sense of progress against inflation and
the fact that growth has been proceeding well within capacity
during 19B5 and the early part of this year.
restraints.
Throughout this period, sizable increases in employment
have continued in this country; the unemployment rate has
employed than ever before recorded.
In Europe,
The large decline in U.S. interest rates and the
sharply higher stock market over the past year suggest the
unemployment
has also remained relatively steady, Dut at much higher levels.
After more than three years of economic expansion.
unde
that has already lasted longer than most.
most important commodity,
with industrial prices steady,
the average level of wholesale prices has been declining
But I would be remiss in falling to emphasize much
ry aspe
adir
ental economic adjustments niust be made within our economy
n the months and yeats ahead.
-5-
growing market and political pressures will, sooner or later,
inevitably have much more disturbing consequences.
The problem first clearly emerged some time ago.
The
powerful thrust of the strong U.S. economic expansion In 1983
anci 1984 had spilled out abroad in the fotm o£ sharply rising
dollar internationally.
There were, for awhile, benefits on all
sides, fit a time of slack demand at home, exports to us helped
The hard fact is that, while the need for complementary actions
world economy seems to be more widely recognized, progress in
necessary external adjustment efforts by the heavily indebted
coordinating action toward those aims has Been limited.
countries of Latin America.
Those countries have sharply
curtailed their imports since 19S2, and they have become
Some obvious imbalances have developed in the economies
of the industrialized world.
That is evident most of all
mote competitive in markets for manufactured goods.
At the same time, the United States began to be the
in the enormous deficit in our external trade and current
accounts, and in the counterpart surpluses o£ a few other
countries.
Unless dealt with effectively and constructively,
inElow, which pushed the dollar so high in the exchange markets
-7-
entirely by consumer spending and housing construction, both
the fa
of the massive and growing federal deficit.
Consequently ,
private investment and construction could expand.
of which have been accompanied by unsustainably heavy borrowing.
Savings meanwhile have remained at a relatively low level, even by
At the same
time, the competitive pressure from imports encouraged strong
in the united States has not grown appreciably, and there has bean
some decline in 1986.
The pace of business investment has slackens
Some of the relative weakness in Industrial output
of prices of manufactured goods over the past year oc more.
We cannot, however, build a lasting foundation for
and investment over the past six months can be attributed to
temporary factors and to developments peculiar to the United
sustained growth and stability on massive international die-"
on the nature of that reform ha* apparently led to some deferral
indefinitely so much of our own needs for capital by drawing so
heavily on the savings generated elsewhere in the world -- savings
subsided and commercial construction, in response to large and
growth in Europe and Japan has been relatively Blow.
Probably much more important in recent months have been very
Today the imbalances and strains are clearly showing.
sharp cutbacks in domestic oil exploration and investment,
-9-
driving energy producing states into recession-lilte conditions
and affecting production of steel and equipment elsewhere as cell.
first quarter of this year, industrial production and investment
weie restrained.
continuing imbalances in the world economy.
On the average,
Heariwhile, foreign surpluses continued to
build through much of the period, and as their exports have
growth rates in major European economies and Japan were about
slowed, internal demand has not yet, in most of those countries,
3/4 percent less than the reduced growth path o( the United States
picked up the slack.
during 1985 and the first quarter of 19B6.
However, the more
Prospects for investment and for manufacturing activity
in
demand, w h i l e slowing in the t h i r d year of expansion, continued
1985 should help set the stage for such an improvement.
to average about 3-3/4 percent through that period.
Domestic
is evidence that U.S. producers find themselves in a stronger
Japan was s i g n i f i c a n t l y less — about 2-1/2 percent.
In the
c o u n t r i e s grew not at
in manufactured goods has slowed little.
from a very high level so the absence of a stronger response in
all.
The p l a i n i m p l i c a t i o n is that our overall GNP growth
trade so far is not entirely surprising,
what is of concern is
that the domestic markets of our major industrial competitors
rate was re
and current account balances.
There
With our current account
have remained so sluggish, raising a question as to the buoyancy
-11iou are well aware that the present imbalance among
ist
pressures in the United States.
let, as the President has
Moreover, I bel
it is demonstrable that, as a matte
of relative importance,
more fundamental imbalances in the
world ecor.omy than unfair trading practices ace responsible fa
the present pattern of trade deficits and surpluses.
open n.sckata vould suialv be tc invite an unravelling o£ the
international trading order.
Those
underlying imbalances can only be dealt with by complementary
We would then have less trade and
interest —
not the
here and abroad would clearly be placed in jeopardy.
I Know of the complaints about "unfair" trading practice
But I also know the clear lesson of experience is that a
stand, stronger domestically generated growth in the Unite
an even more difficult adjustment problem later.
As I suggested, the recent exchange rate changes can
sn in a tit-
help us to escape that dilemma —
they should work to improve
fact? faced with a combination of appreciating currencies and
slower growth in overseas markets, exporters
in botn Japan and
-12soroe European countries are experiencing reduced profits and
more sluggish orders Eroro abroad.
However, in the absence of
Our financial markets remain dependent on the large capital
could dampen their own prospects for growth.
That is one of several reasons «e should not rely on
exchange rate changes alone to produce the needed international
adjustments in the world economy.
Over a number of years, we
in the United States will certainly need to shiEt more of our
Only as our huge federal deficit ia cut Can we comfortably
iterr
renewed inflation. Put another way, in a growing economy,
oo
where import penetration has been so high.
That, very broadly,
position in a way consistent with rising investment.
and more savings and less borrowing.
For some of the rest of the
In a few foreign countries, such as Germany, some si
of stronger internal growth have appeared in recent months.
on exports, and more on domestic sources of growth.
Much still needs to be done to ease the way for those
such signs are far from uniform among key countries abroad,
most projections of their growth for this year have been low
not raised, as exports have slowed.
With rising currencies ana lulling oil prices, some o
those countries after years of effort have now successfully
-15-
mutual prosperity remains.
The renewed difficulties of the
oil producing countries today should not, however, obscure
in 1984 and 19B5 they were in rough current account balance,
in contrast to an aggregate deficit of about 550 billion in 19B2.
To be sure, that effort for a time was accompanied by sharp
lower imports, recession, and lower standards of living as they
in some cases with vigor, as is the case with the largest single
debtor, Brazi 1.
Helped by the reduction in world interest rates,
external interest burdens have been reduced appreciably in some
The International Debt Problem
Four years after the international debt problem broke
Into our collective consciousness in 19B2, when Mexico abruptly
countries relative to e«ports or other measures of capacity to
pay..
A number of Latin American countries havt also made striking
progress in dealing with ingrained inflation for the first time
in many years, in ths process gaining political support.
There
h35 been considerablef jf uneven, progress towarri i i h^" i * 'H •*"
-16-
-17-
their economic structures in ways that should encourage more
taking a wide range of efforts to deal with both its short In the midst of this progress, the sharp decline in oil
and longer-range economic problems.
To my mind, their efforts,
prices over the past six months has had an enormous adverse impact
economy, are particularly encouraging.
They have joined GATT,
Hie
Mexico would lose a&out a third o£ its 1985 exports, perhaps as
good many state-owned
much as 15 percent of its government revenues, and the equivalent
sale {or, if too inefficient, sbut down), subsidies are being
ne« and severe challenge for Me
— a challenge that Bill
investment eased.
enterprises are being made available for
If carried through effectively, those measures
promise to work toward fundamental improvement in tne efficiency,
ents and to improve the structure of their economy.
There is
a large amount of financial resources will have to be marshalled
competitiveness, and. eredltwarthine.ee at the ««Klcan economy,
Today, that country is in recession.
clearly contemplates economic recovery
That combination of adjustment, structural change, and
announced by the Mexican Government earlier this week.
In
But the program
in 1987 and 19BB.
committed
by the IMF, the World Bank, and the Inter-American
with so much already at stake, to play a large role as well.
Mexican exposure of commercial banks appears not to have increased
for some IS months.
Indeed, ttiere has been little net new lending
to Latin America as a whole over the past year.
Taking the entire period since mid-1982, the exposure of
being tested in difficult circumstances not foreseen at the
time -- the sharp break in oil prices.
But the basic community
of interests among borrowers and lenders —
fell from about 120 percent of the capital of lending banks to
less than 75 percent at the end of last year, a decline of 38
considerably less than in 1977 when the data were first
collected.
For Borne time, the pace of lending has, In fact,
and the world at
The debtor countries themselves have an enornous stake
CO
-20The challenge is large, but with cooperation, also
manageable.
Indeed, the same oil price decline that has under-
mined the budgetary and trading position of Mexico and other large
oil exporters has relieved the pressure on those importing oil.
Monetary Policy in 1986
These larger issues wece the background against which
Inte
the Federal Reserve has conducted monetary policy in 1986 and
to
and nest.
The results of the review by the Federal Open HarKet
tentative ranges for 1987 were discussed in the Humphrey-Hawkins
oppc
But I must also emphasize one e s s e n t i a l i n g r e d i e n t for
success beyond the capacity of the indebted c o u n t r i e s to manage
week.
That report also sets out projections for real activity
and prices of F°MC members and Reserve Ban* presidents.
Only a stable, growing world economy, w i t h m a r k e t s open to the
developing w o r l d , can provide an environment conducive to
economic e x p a n s i o n , mote normal i n t e r e s t rates, and orderly
debt service by the borrowers-
That i n g r e d i e n t is p l a i n l y the
policy remained broadly accommodative over the past six months.
decli
Long-term interest rates also moved lower, extending the sharper
drops in the second half o£ last year.
The general structure
of interest rates is now as low as at any time since 1917.
The reductions in interest rates in 1985 and 1986 have
other liquid assets, those accounts no doubt have served
clearly helped support the mors interest-sensitive sectors of
increasingly as a repository for liquid savings as well as for
the economy, reflected in part in the highest level of housing
money held for transactions purposes.
starts since the late 1970s.
The declines have also helped
ease the debt servicing costs of businesses, farmers, developing
Similarly, there are some indications of a greater
willingness of businesses to hold demand deposits at a time
countries and the tl.S. Government itself.
On the other side of the 1-edger, as interest rates have
down, a larger balance is necessary to compensate banks for a
declined, the rate of growth in debt has remained at disturbingly
given amount of services.
To some extent, an environment of
high levels, although there are at least faint signs of a slackening
more stable prices may also be encouraging
larger money holdings
None of that was predictable with any precision, and the
year.
The declines in interest rates also clearly helped induce
the general public to increase its holdings of its most liguid
assets, including demand deposits and NOW accounts included in
the narrow measure of the money supply, Ml.
That reaction
CO
CO
-24rfould have required reducing the provision of reserves and a
measures of money —
M2 and «3 —
remained well within their
ignificance of changes in Ml could only be judged in the context
f movements in the broader aggregates, and against the background
close to their mid-points.
That and other evidence suggested
CO
that much of the growth of HI reflected a shifting of the
composition cf liquid assets rather than excessive, and potentially
at the start of the year will be acceptable.
reinforced by the moderate rate of growth for the economy overall,
the absence of indications of a strong acceleration as the
Ml and the economy may reemerge over time, although the trend
year progi
of Ml velocity —
the ratio between GNP and Ml —
be different than earlier in the postwar period.
will likely
However,
-26-
looking to next year, the Committee set out a highly tentative
predictably, the
range of Ml growth of 3-8 percent on the assumption that velocity
in its wake an in.
goods.
However, that judgment -- and indeed the weight to be given any
That Impact has been moderated so far by the narrowing
of the earlier wide profit margins of many of those exporting
few of which have had any appreciable appreciation of their
currencies vis-a-vis the dollar.
by one-half percentage point to 5-1/2 - 8-1/2 percent.
That
The rate of increase in costs of housing and of many
services, which account for a large proportion of the economy.
CO
cn
achieving a rate o£ monetary growth compatible with price stability,
is judged to be entirely compatible with a somewhat greater
4-1/2
rate of economic growth next year, provided that growth is not
; inflationary
accompanied by a marked increase in inflationary pressures.
The actual price statistics for some months have, of
bias to the general price level.
course, reflected the precipitous drop in the price of oil,
and consumer prices have dropped slightly this year.
But
of FOMC members and Reserve Bank presidents that the overall
inflation rate is likely to be somewhat higher next year.
That
remarkable progress toward s t a b i l i t y as the economy grows
A substanti
strong d o l l a r
igly and as a large amount of resources are s h i f t e d
achieving the necessary adjustment in external trade.
But
there are clear dangers in placing excessive weight on that
approach.
nd of
In looking toward growth in the 3-3 1/2 percent range
3l£-r
CO
next y e a r , considerable emphasis was placed by Committee members
balance.
As I e m p h a s i z e d earlier, that s h i f t ,
if it is to take
partners.
Among other things, such a movement of the dollar
place in the context of sustained and stronger world growth,
w i l l r e q u i r e appropriately complementary policies here and
abroad.
S i g n i f i c a n t progress toward dealing w i t h our own
budget d e f i c i t seems to me a key ingredient in that overall
more difficult to susta
policy " m i x . "
In the light of all the
snsiderations, the discount
The t i m i n g of another important domestic policy
changes by one or more other X.ey count*
-31-
any impact on the exchange markets and consistent with the
At the same time pressures on the oil industry,
desirability of some reduction in interest rates In the
agriculture,
industrialized world generally.
disinflationary process are reflected
depository
and parts oE manufacturing and the more general
institutions.
in strains on some
Those strains emphasize the
the
Experience over the first half of 1986 underscored the
the weight of the evidence strongly suggests that HI alone during
a reliable measure of future price pressures (or indeed a good
more restrained performance of the broader aggregates t as
well as the performance of the economy and prices themselves,
point in a different direction.
The present situation certainly makes all the
He have nonetheless come a long way toward restoring
The d i f f i c u l t i e s of some f i n a n c i a l i n s t i t u t i o n s are
one specific example of economic problems that cannot be
all that progress is in growing jeopardy unless we act
—
sffe
indeed a strength of monetary policy that it can respond
flexibly to changing circumstances.
and we in the world as a whole —
in mutually supportive ways.
CO
00
But it is equally true
that that single, broafl-brush policy instrument cannot, at
enough.
The Gramm-Rudman-Hollings legislation is an expressic
one and the same time, be called upon to stimulate the
of the sense o£ urgency surrounding our budgetary effort in
the United States.
and shift resources away from consumption and back into
The rest of the industrial world needs
to achieve and maintain a momentum of "home-grown" expansion.
Mi
important as all those goals may be.
the cooperation of private and public lenders —
how cumbersome fiscal policy can be, and the difficulties of
to a wider resolution of the debt problem in a context of
growth.
a constructiv
-34-
Hard as it may be to carry through on those efforts,
that is what needs to be done if the imbalances in the
economy are to be effectively addressed.
Then we will
growth and the progress toward stability in the years ahead.
Certainly, the Federal Reserve will play Its part in that
effort.
CO
to
40
POSSIBLE LOAN LOSS RESERVE DEDUCTIBILITY
The CHAIRMAN. Thank you, Mr. Chairman.
Mr. Chairman, as I'm sure you are well aware, the House version
of the tax bill would repeal the deduction of contributions to loan
loss reserves by banks. Previously this year you have been opposed
to that provision. I am opposed to it. It makes no sense to me at all,
whatever else we're doing with tax reform, not at a time when we
are constantly talking about safety and soundness and the domestic
as well as international problems of many financial institutions in
this country and talking about encouraging them to increase capital and loan loss reserves.
Do you still feel that it would not make a great deal of sense to
take away that incentive to increase loan loss reserves for safety
and soundness at this time?
Mr. VOLCKER. Yes, I do, Mr. Chairman. I have expressed my
opinion on that earlier to the Senate committee. I think on that
point, and on the somewhat related point of the foreign tax credit
provisions where a long transition is provided for loans to the heavily indebted countries, I think the Senate bill dealt with those
areas in a responsible way, particularly given existing problems to
which you refer.
The CHAIRMAN. I'm sure before we get through with all the questions you will be asked every facet of your opinions on monetary
policy and the discount rate in particular, so I will not go into that.
I am interested, however, in your feelings on what the uncertainties of our current tax legislation are doing in contributing to the
problems of the economy.
I am not asking for your opinions on various parts of the tax
reform bill, but it seems to me that, since I have been in the
Senate, it has been very difficult for people to make business decisions because we have changed the tax laws so often and it is so
difficult to forecast what Congress is going to do. We have gone
through nearly a year now of hearings in both the House and the
Senate and, at least in my opinion, it has caused a lot of disruption
in the market, not because of what we ultimately may do but because of the lack of understanding of what we may do and, of
course, the conference will probably continue for several weeks.
Do you feel that getting away from the M's and the discount
rates and all of that, that merely the uncertainty that Congress is
projecting on tax legislation has a part in the difficulties in the
economy right now?
Mr. VOLCKER. Well, you asked a question that is obviously impossible to identify statistically or quantitatively, but I share the feeling that you expressed. In talking with businessmen and others,
you do see evidence that the uncertainty itself has led to some deferral of ordering, simply on the basis that we might as well see
what the shape of the bill is when it comes out in the end before
ordering things that don't necessarily have to be ordered and put
in place immediately.
So I think it has had an effect. Whether there is also an effect, or
the extent to which there is an additional effect, from the standpoint of both bills to different degrees removing some investment
incentives is also impossible to identify. But I agree with you that
41
the uncertainty alone appears to have led to some deferral and has
probably been an identifiable influence on the rather weak ordering figures that we had for investment over the past 4, 5, or 6
months.
The CHAIRMAN. It's interesting in the time I've been in the
Senate I've never seen such a steamroller or train brushing every
obstacle aside without regard to some of the merits or demerits of
the bill itself.
One thing that I think has been overlooked that I've heard several people comment on is the fact that doing away with so-called
loopholes or preferences potentially occurs on January 1, 1987, but
the lower rates don't occur until July, and that has not been widely
discussed. In fact, a lot of people may not understand that that is
the case, precipitating considerably higher taxes for a lot of people
and businesses next year.
Do you also feel that that possibly has an impact on the economy
and the perceptions of what is taking place?
Mr. VOLCKER. Perhaps less so, because I take the view that a reduction in the deficit is important in achieving a better-balanced
economy. Those transitional revenue increases, I suppose, would
call for
The CHAIRMAN. Well, but we're not using them. Senator Dole
suggested that at the beginning and was immediately jumped on by
everybody arguing that we don't play that game, don't take that
$22 billion and use it as a credit.
CREDITS FROM TAX REFORM
Mr. VOLCKER. Well, I understand the argument about using it as
a credit or not using it as a credit against Gramm-Rudman, but if
it passes that way it's there and will have the effect presumably of
reducing the deficit somewhat in the short run, not in the long
run. It's a very temporary effect, but I think it does push in the
direction of moving the deficit lower.
Now if you've got sufficient progress on the deficit without counting that, then obviously that could be changed without taking into
account the deficit implications. But that's a big if, I guess.
The CHAIRMAN. Well, you and I know, as we've discussed many
times in this committee the importance of perceptions. We play
scoring games with OMB and what we're going to find out is that
neither OMB nor CBO, none of them, the Congress, the President,
are going to be right on their estimates.
Mr. VOLCKER, I think that's a fair assumption.
The CHAIRMAN. That's a very fair assessment. But nevertheless,
it does have an impact if we do not score it. If we don't show it as a
reduction, I frankly would be more pragmatic and say, look, we
play 1-year games at a time anyway, so why not take credit for the
$22 billion and help solve our problem because this ridiculousness
of 5-year projections in this body is so absurd that we play the 1year game at a time anyway, so why not be honest about it and
take credit for it and worry about the 1988 budget when it comes.
I think we should take a longer look but we never have in the 12
years that I've been here.
42
Mr. VOLCKER. Well, I think I would get very worried if you took
credit for it and didn't take the longer look. That, of course, is a
question of presentation. But as I understand it, the implication of
that bill in raising revenues in the first year is that it loses revenues thereafter. That would have to be taken account of too. You
can't play it one way.
The CHAIRMAN. But at least it is there and it is real compared to
the mirrors and smoke that we are playing with the current budget
resolution and you wait and see, that thing is not going to be $144
billion; that is going to be $10 or $15 billion more than that. We
are playing with a sham in that budget resolution.
Mr. VOLCKER. Whether it's there or not, of course, depends on
how it comes out of the conference committee, too.
The CHAIRMAN. A great deal of interest has focused on the fact
that the Fed pointed to the low level of commodity prices in explaining the July 10 reduction in the discount rate. Doesn't focusing on the level of commodity prices risk confusing relative prices
with the overall price level?
Mr. VOLCKER. Well, I'm glad you raised that question. I saw some
attention directed toward the fact that commodity prices were
mentioned in that announcement, so I went back and looked at a
little history.
And commodity prices, I think, have been mentioned in the last
four out of five announcements of the discount rate change and
were mentioned back in 1979 in one of the first discount rate
changes after I took office. So it's not exactly a new departure to
take account of commodity prices in those announcements.
But I would answer your question yes and no. Commodity
prices—as the frequency with which we mentioned them suggests—
is one sensitive indicator of the condition of the economy, and the
world economy, and to some degree price trends more generally.
But certainly commodity prices fluctuate much more than the
basic trend of consumer or wholesale prices and I think you could
be misled by assuming that commodity prices give you the whole
picture in terms of inflationary or deflationary forces in the economy.
COOPERATION OF TRADING PARTNERS
The CHAIRMAN. You have emphasized not only today but in previous weeks and when the second discount rate cut of the year occurred the need for cooperation by some of our friends and allies,
particularly West Germany and Japan. They appear to be again resisting any reductions.
Can you give us any reasons why they are not willing to attempt
to solve some of the problems in their own economies?
Mr. VOLCKER. Well, I suppose they would see it somewhat differently than failing to solve the problems in their own economies and
there may be different perspectives. But I think in both of those
countries, in a general way, they have worked hard to achieve stability in the inflationary sector. In varying degrees, they have had
some optimism about the strength of their economies. In both
cases, monetary aggregates have been rising somewhat faster than
43
they had announced or intended early in the year, although the deviation is not very large.
And when they look at their internal situations, they reach the
judgment that they reached. It is also true that the economic
growth rate in Europe generally, and in Germany and Japan in the
early part of the year, was not up to expectations. In fact, it was
negative in those two countries. As I indicate in my statement,
there is some early indications anyway of a considerable rebound
in Germany during the current quarter.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Mr. Chairman, you have appeared before this
committee testifying on this particular subject 14 times in the last
7 years, is that about right?
Mr. VOLCKER. I don't know; 7 years, twice a year, that must
make 14 times.
CONTROL OF INFLATION
Senator PROXMIRE. Well, that's the way I count. At any rate, it
seems to me that there's been somewhat less emphasis by you than
usual on inflation. And as I tried to point out in my opening remarks, we have deficits now that have gone on for 5 years at an
enormous rate. In spite of Senator Mattingly's statement, the fact
is the 1986 deficit is going to be the biggest ever. The first year
Gramm-Rudman is in effect, obviously that's not doing much about
it. In my judgment, we'll have another $200 billion deficit in 1987
in all likelihood.
Furthermore, the money supply is increasing more rapidly than I
can ever remember it increasing. The decline in the value of the
dollar and the likely end of the oil price drop, which you cite as a
matter of fact in your statement, will have an inflationary effect.
Have you really stopped worrying about inflation?
Mr. VOLCKER. I never stop worrying about inflation. I think
when you stop worrying about inflation is when you get it. It had
better be a constant worry.
Senator PROXMIRE. Well, I'm glad to hear you say that, but when
I look at your monetary policies it seems to me that there's less
concern and, of course, in the short run the situation looks terrific.
Here we have a situation where we have an excess of labor still.
We have high unemployment, as you said, a big increase in jobs.
We have 8.4 million people out of work. We have a surfeit of oil, a
surfeit of food. We have all kinds of reasons to argue that inflation
is under control.
On the other hand, we have that monetary component—and as
you know better than anybody in the world, the fact is that inflation is too much money chasing too few goods, there's no question
about it, and we may be moving in that direction.
Mr. VOLCKER. Well, I think it's legitimate to raise concern about
that and we look at it all the time. I expressed some concern in my
statement, but you have to take it in the context of what else is
going on in the economy at the moment. I suppose I want to look
at that increase in the money supply pretty closely from that point
of view and make whatever judgment seems appropriate. But
looked at in a kind of medium-term perspective, it is that continu-
44
ing pressure of the budget deficit. When we get through this period
where we are immensely favored in inflationary terms by the oil
price decline, when we look to the adjustment that we have to
make in our external position, when we look to the consequences of
a depreciating dollar down the road, there obviously are reasons to
be concerned that the inflationary rate could speed up once again.
And I think the best single piece of protection that we can have
against that, in a kind of structural way, is to work to reduce the
budgetary deficit and the demands that that places upon financial
markets and the economy, as the trade situation gets better.
In fact, I would argue more fundamentally that the chances of
the trade deficit getting better—and the chances of us dealing in
that context with financial market problems—are not very good
unless the budgetary deficit is reduced more or less in line with the
reduction in the trade deficit.
INCREASED DEBT IN ALL SECTORS
Senator PROXMIRE. Now you properly are concerned and express
your concern very strongly about too little savings and too much
debt and the debt is particularly conspicuous. We have the highest
personal debt ever. We have the highest corporate debt ever. We
have the highest Federal debt, heaven knows, ever. As a matter of
fact, corporate debt is even bigger than the Federal debt. Our savings are at an all-time low in relationship to income.
And yet the policy now of lower interest rates which all of us
would like for many reasons tend to go in exactly the wrong direction as far as this is concerned.
Mr. VOLCKER. I agree with that.
Senator PROXMIRE. They discourage savings. They encourage
debt. The one element that's keeping growth in the economy now is
increased housing—increased government too, but increased housing.
Mr. VOLCKER. Increased consumption, too.
Senator PROXMIRE. Well, increased consumption expressed in
housing starts primarily.
Mr. VOLCKER. Not just in housing starts. Consumption is pretty
strong across the board.
Senator PROXMIRE. And that's because interest rates are low. So
that we're following policies it seems to me that are going to continue to aggravate the situation, increase corporate, Federal, and
personal debt, and discourage savings.
Mr. VOLCKER. It is one of those dilemmas that we face right now
and it is a perfect illustration how monetary policy can't solve everything at the same time.
If you simply look at the factors that you were looking at, then I
think the implication would be one thing. If you look at it in the
context of total economic performance and other problems in the
United States and around the world, you reach a different conclusion. And we have to balance those off.
Senator PROXMIRE. Now let me look at it from a different standpoint right away and meet myself coming the other way, but I
think it's an immediate question for all of us.
45
Suppose the economy continues to slow further and we stagger
along at a 1-percent or close to 1-percent level of growth or maybe
even less, and we follow your prescription of reducing the deficit
and somehow Gramm-Rudman comes out right and we do in fact
cut spending.
Won't that have a direct predictable adverse effect on economic
growth? Won't that tend to push us into a recession? It seems to
me that we're in a position that's extraordinarily difficult now for
that reason.
Mr. VOLCKER. I think the answer to that question—and what I
try to say maybe too opaquely in my statement—is that the implications of that kind of a situation depend very much on what kind
of a world economy we're living in. If we're living in an economy
where we have a good economic expansion going in the rest of the
world, I think that kind of a situation will be reflected in a rather
pronounced and important change in our trade balance, which
would be the best thing that could happen for us in terms of restoring a basic equilibrium in the world economy.
Senator PROXMIBE. That's a nice dream but we're not living in
that kind of world and we probably won't be.
Mr. VOLCKER. Well, I'm not so sure about that. We can't solve all
these problems by ourselves and there are very mixed indications
abroad. But the indications are mixed and obviously there's always
the opportunity for policy actions abroad.
But given a starting point of a $135 billion deficit in our current
account and the importance of that in terms of progress in our
manufacturing industry and in our investment, I simply do not
think you can deal with, and project with any reasonability, the
performance of our economy and the various risks that are involved without considering what kind of world environment we're
living in. And that is the world we're living in.
DIFFERENCES IN TWO STATEMENTS
Senator PROXMIRE. Now you gave us two statements. One statement we got 24 hours in advance. The other statement we got just
before we came in. And you made some interesting changes in
them, particularly on page 31. On page 31 you made a statement in
your original text that you deleted. You said:
There is no escape from the fact that strains on depository institutions are not
simply a possible threat for the future but a present reality.
And you deleted that.
And further down you made one other deletion. You said:
Developments under control of the lenders themselves, even abused by some federally insured and protected depository institutions of their responsibility to employ
their funds prudently free of conflicts of interest.
Was that deletion made at the request of the Treasury?
Mr. VOLCKER. No. I read it last night and I wanted to make sure
that I had it in the proper perspective. The phrase that I took out
was about "even abuse of the responsibility to lend funds prudently
by federally insured depository institutions." We certainly see that,
but I think it's relatively few institutions. I was afraid that statement was a little out of context. It was entirely at my own initiative in rereading the statement last night.
46
Senator PROXMIRE. Well, what did you have in mind by that?
Mr. VOLCKER. I'll give you two prime examples of what I had in
mind—what went on in the States of Ohio and Maryland, and I
think we are not entirely free of those same kinds of symptoms,
particularly in some areas in the savings and loan industry.
Senator PROXMIRE. Now over the last 12 months the money
supply as measured by Ml has grown by 12.8 percent, well in
excess of the Fed's targets. That explosion in money growth is
sometimes blamed on financial deregulation and lower interest
rates. That is, as interest rates come down people shift their money
from short-term liquid investments into NOW accounts. However,
the demand deposit component of Ml has grown by nearly 10 percent over the last year. Of course, demand deposits pay zero interest.
As a result, why wouldn't it be just as accurate to conclude that
the explosion in money growth is due to the Fed's decision to
supply more money rather than an increase in the public demand
for money?
Mr. VOLCKER. Well, it's always a chicken and an egg. You have
supply and demand, and we certainly satisfied the demand. That is
the sense in which our policy was accommodative. We satisfied
that increase in demand that took place as interest rates declined
based on the considerations I discussed in my statement. And you
can say that the money supply would not have increased so much
if we had been more restrictive in the provision of reserves. I agree
with that. But we chose to be less restrictive in the overall context
in which we were operating.
THIRD WORLD DEBT
Senator PROXMIRE. Now Senator Bradley has proposed a farreaching alternative to the Baker plan for Third World debt relief,
as I'm sure you know. Senator Bradley calls for a substantial writedown and rate reductions in the Third World debt on the part of
U.S. banks. He argues that's the only way these debt-ridden countries are going to get back on their feet and resume normal economic growth.
What's your reaction to the Bradley proposal?
Mr. VOLCKER. Well, I'm obviously concerned about the same set
of circumstances, broadly, that Senator Bradley is concerned with,
and his approach in some of its elements is directly on point with
the approach we have been taking. In the element of interest rate
subsidies and writedowns, it obviously differs.
I do believe that that approach would be counterproductive, looking over a period of time in terms of restoring these countries to
creditworthiness into the marketplace.
I would also point out that if you take the case of Mexico, for
instance, and look at the relief that they would get in actual cash
terms for their external position, from his plan it wouldn't be
enough. Reducing the interest rates by 3 percent on bank debt hi
the case of Mexico would produce something under $2 billion a
year. That's significantly less money than the banks are being
asked to provide hi the program that the Mexicans announced this
week. Moreover, under a Bradley-type plan, it would be unreason-
47
able to expect banks to lend additional money and he didn't call for
that. So in that sense, I don't think it would work.
I think his kind of approach would necessarily lead to a quick
generalization. However much he might want to shape it case by
case, the politics simply wouldn't permit that.
Senator PROXMJRE. My time is up, Mr. Chairman.
The CHAIRMAN. Senator D'Amato.
TRADE IMBALANCES
Senator D'AMATO. Thank you, Mr. Chairman.
Chairman Volcker, in your remarks that you prepared for the
committee today, the second set of remarks received only this
morning, you allude to the problems we are experiencing due to
pur trade imbalances. My question is, looking at the history, looking at our efforts to reduce the value of the dollar, and the limited
success, if any success, in bringing that balance of payments down,
how realistic do you believe it is that our trading partners will
change their policies without any legislative action or other executive action?
Mr. VOLCKER. Well, you're talking about trade policies, a trading
practices question rather than the size of an imbalance. They're
not unrelated. But I think the best chance of addressing those problems does lie in multilateral trade negotiations. I know that's a difficult, anguishing process, but we shouldn't forget they have complaints about us, too.
Senator D'AMATO. The Japanese should complain about us?
Mr. VOLCKER. I think
Senator D'AMATO. They steal our patents, intellectual property
rights, systematically are adjudged guilty in the courts, say we're
sorry, pay back penalties, continue the same thing, infringe on patents and then send the products here into the United States. Further, those harmed have limited recourse under the current legal
system. At present, ever though your copyright may have been infringed or your patent stolen you must then demonstrate that
there is substantial danger to the particular industry, before damages can be awarded. Despite the failure of the laws and trade policies pursued to date we hear, oh, yes, we're going to make changes.
We've been waiting a long time for negotiations or other bilateral
approaches to work. We wait in vain. It seems to me, absent any
legislative action or some very real enforcement of present trade
practices, the policies of the Japanese and others will not change
because they lack any incentive to change.
And then you say, well, our best hope is bilateral
Mr. VOLCKER. I was not suggesting the situation with respect to
Japan either in policy or results was in balance. It obviously isn't.
Senator D'AMATO. It isn't in balance?
Mr. VOLCKER. It's not in balance.
Senator D'AMATO. OK. We agree.
Mr. VOLCKER. It clearly is widely out of balance, however you
look at it. The question is how you best approach this problem in
some of the very areas that you re talking about in copyrights and
patents and so forth. It may be—and I don't want to get too deeply
into an area that's outside my expertise—the kind of area that the
48
best prospect for getting results is when you can bring a world consensus to bear on the problem.
Senator D'AMATO. Let me suggest that, absent possibly some
strong legislation or other actions requiring reciprocity, the trade
imbalance will continue unabated.
Mr. VOLCKER. Well, we do have laws and they ought to be enforced. I don't disagree with that. But you asked me where the emphasis should be at this point. I don't think we have exhausted all
the other routes and as a matter of emphasis I think that's where
it should be.
But let me not leave this question without reiterating something
I said in the statement, that if one looks at our trade balance—I
mean the actual quantitative results rather than the kinds of
things that you're talking about that are important in their own
right—I don't think there's any doubt that our total trade imbalance is more a matter of inconsistencies, lack of complementarity,
imbalances in other policies. The contribution that trading practices themselves can make are not insignificant, but they don't account for a $135 billion trade deficit or anything like it.
AREA OF INTEREST RATES
Senator D'AMATO. Let me shift if I might, Chairman Volcker, to
one other area, and that is the area of the interest rates and how
you determine real and artificial rate cuts.
A hindsight question. The last cut it was a reduction of one-half
of 1 percent. Now let me ask you, if you were to have perceived
that the economic growth would have come in at the 1.2-percent
level, might you have opted to make that cut in the discount rate
an additional one-half percent?
Mr. VOLCKER. Well, we always debate those things. That figure
was not terribly surprising and I don't want to overly emphasize
one quarter's figure. While announcing 1.1 percent in the second
quarter, the Commerce Department revised the first quarter
upward by almost 1 percent. That second quarter figure was heavily influenced by two always volatile factors—inventories and the
trade situation. These components are purely estimates, almost
guesses at this point, because the Department doesn't have the
data for the whole quarter. And what data they have is subject to
revision.
WORSENING TRADE BALANCE
The reduction was in those two volatile items, where final demands were pretty well maintained during the quarter. One of
those areas where the number was so adverse—the trade area—is
an illustration of the underlying problem. That is an area that's
been getting worse quarter after quarter by and large. It is an area
that explains in very large degree the sluggishness of manufacturing business, the sluggishness of business investment.
So in that sense, f think that quarter's figure was very symptomatic of the underlying problem of the economy.
Senator D'AMATO. Do you see anything on the horizon that
would give you reason for hope that the future will be any differ-
49
ent than that which we have experienced in the past 6 months
with regard to trade inbalances?
Mr. VOLCKER. We do have a big change in exchange rates vis-avis our industrial competitors and you would certainly expect that
to have an effect but that takes time. That effect works all the
more slowly if you don't have a buoyant world economy. So again
to deal with your question, I think it is a question of what is the
buoyancy of the rest of the world economy. If that's going to be
very sluggish, it's going to be a tough process to see our trade balance improve, and particularly to see it improve in the context of
world growth and prosperity. We don't want to see the trade balance improve in the midst of a recession here and abroad. We want
to see it improve in the context of growth. And that depends on the
strength of economic activity elsewhere in the world. That is our
market.
Senator D'AMATO. Mr. Chairman, I am particularly pleased with
the candor in which you address the questions on trade and trade
policy because I couldn't agree with you more as it relates to the
total problem in terms of economic growth, or more precisely, the
recent lack of growth.
Having said that, I believe it is incumbent on this Congress to
demonstrate more than its concern, but also put forth for debate
and possible legislative enactment proposals that will deal with the
kinds of practices that are totally unfair, that are predatory, that
in some cases involve actual larceny. Recent judicial rulings that
fail to redress the wrongs suffered by American manufacturers
from the actions of our "trading partners" must be addressed by
this Congress. Thieves must not escape with impugnity. The actual
taking of people's property rights that they've invested millions
and millions of dollars in, is not an offense that will not be deterred by paying, in many cases, only a relatively small fine. And
that's what's been taking place and many Americans have been
losing their jobs as a result.
I think it's time to say, because I see a lack of determination of
this administration to deal with some of these difficult problems
and say to so-called friends, "We're going to insist that there be
fair trade, free trade has got to work both ways," and I don't believe that the American people have been dealt with fairly by
many of our trading partners.
I would like to conclude with one other observation and that
would be, Chairman Volcker, that I do believe, given the sluggishness of the economy at the very least, and given the trade problems
that you have touched on, that I do think that a further discount
rate reduction is needed to stimulate the economy. And I know
that more than just this Senator will be anxiously watching the actions of the Fed and I hope they act sooner rather than later. I
don't want to see the situation deteriorate more, nor do I suggest
that a further interest reduction in and of itself is going to cure the
problem. I think it might ease the situation for some and stimulate
some economic growth.
I thank the Chairman for sharing his thoughts with us in as
candid a manner as I've ever heard you express them. Thank you.
The CHAIRMAN. Senator Riegle.
50
Senator RIEGLE. Chairman Volcker, in your statement on page 6
and in fact in all your remarks, you speak of massive international
disequilibrium and your concern about it. A little further down you
talk about imbalances and clearly showing strains.
WORLD ECONOMIC INTERDEPENDENCE
It seems to me, as I listened carefully to what you said, and the
emphasis you gave it orally, as well as reading it beforehand, that
it is your view that world economic interdependence has really
grown dramatically in say the last 10 years for a lot of reasons. Is
that a fair judgment?
Mr. VOLCKER. Well, I think it's been growing for a long time and
it's certainly reached a high level and never before has the trade
balance and changes in the trade balance loomed so large in terms
of our own domestic performance.
Senator RIEGLE. Well, as a measure of that, the latest estimates
of the trade balance that I've seen indicate that it may be up in the
range of $165 billion. I'm just talking about the merchandise trade
deficit. The current account deficit might be in the range of $135
billion. The $135 billion figure is what's taken us up to the No. 1
debtor nation in the world, and in a way it means that we go
deeper in debt to the rest of the world about $1 billion every 2V4
days. I don't think the public is yet accustomed to thinking in
those terms because it's a dramatic change in circumstance.
Mr. VOLCKER. I think your arithmetic is correct, unfortunately.
Senator RIEGLE. I find to be a worrisome reality the meaning of
that fact, having gone from a creditor nation consistently every
year from 1914 until about \Vz year ago, to now having gone to the
top of the debtor nation list and adding to it to the tune of $1 billion every 2 Vs days.
Now I got the clear sense from what you're saying now that the
nature and the mix of these problems is such that we can't solve
them by ourselves even if we take the right policy steps. In other
words, we've got to coordinate those right policy steps particularly
our Western allies. Is that right?
Mr. VOLCKER. Coordinate in the sense of broadly complementary
policies, yes.
Senator RIEGLE. Now I know you feel strongly about that. You've
said so and that's been your pattern of action. We've had two discount rate cuts this year that were coordinated but the most recent
one was not, and that really sticks out to me. I want to understand
why the Fed, given the need for that kind of international coordination would have gone ahead with the last discount rate cut without our allies coming along with us.
Mr. VOLCKER. Let me make a general point first of all. I think
the kind of broad coordination or complementary action that I'm
talking about doesn't require close coordination or precise timing of
every discount rate or monetary policy change. I think the issue is
broader than that.
But we obviously arrived at the judgment, with this last discount
rate change, that, given conditions in the economy and indeed
given conditions in the exchange markets, a cut of one-half percent
was appropriate and not likely to be unduly disturbing internation-
51
ally in the context of events at that particular time. That was a
judgment reached on the basis, in part, that while the dollar has
been generally declining this year, it's been declining at a slower
rate of speed, and in the last few months by and large has not been
declining in the same one-way direction that it was earlier.
Senator RIEGLE. Did we ask the Germans and the Japanese to
come along with us?
Mr. VOLCKER. Well, they were aware of our intentions anyway.
Senator RIEGLE. Well, I'm sure they might have been, but I'm
asking a more direct question than that. I want to understand
whether we're running into a difference of opinion internationally.
In other words, did we urge them to match that cut or to move
at the same time or not?
ROOM FOR SEPARATE JUDGMENTS
Mr. VOLCKER. Well, I don't think I want to go into great detail.
There are different judgments on these things. As I say, I don't
think we should expect that they will move precisely the same day
or the next day every time we move, or vice versa. But they
reached a judgment clearly that whether or not we moved they
didn't want to move this time.
Senator RIEGLE. Well, let me ask then this question. Does that
mean that we still have the flexibility to maybe move again without them? Could we take another discount rate step if they are not
willing to do so?
Mr. VOLCKER. Sure. I think that's implicit in everything I've said.
We did it this time. It depends upon the setting. I don't think we're
frozen into making every move precisely when others are ready nor
are they frozen into making moves precisely when we think it s appropriate.
Senator RIEGLE. Well, if we can continue to make discount rate
cuts now and not coordinate them—and I'm reading between the
lines that we had given them signals that we hoped that they
might come along with us—that leaves the impression that we in
effect can move on an uncoordinated basis, that we can go ahead
and lower the discount rate once, twice, maybe other times, without them, and the whole rest of your testimony argues against
that.
Mr. VOLCKER. Well, I think I would make a distinction. Certainly
much of my testimony argues and emphasizes that policy and developments need to be broadly complementary. There's no doubt
about that.
But what's important, for instance, is that we get a fair amount
of growth abroad in their own interest and the interest of the rest
of the world. That may or may not require easier monetary policies. They have the question of fiscal policy. Growth may develop
without further policy actions.
What's important is that the growth be there, and that is a question different from a much more technical and limited question as
to how or whether or in what circumstances it's important, in a
very narrow sense, to coordinate a particular discount rate or other
changes. Sometimes that's very important in my mind. Other times
it may not be.
52
Senator RIEGLE. Well, I want to get to the growth issue because I
agree with you that that's critical and I think we need to discuss
that at some additional length. What I'm concerned about now is
that if we are so dependent on foreign capital to finance these huge
budget deficits and trade deficits that we have, if we continue to
make unilateral drops in the discount rate and bring down our own
interest rates, and the other countries don't follow, what guarantee
is there that we can continue to attract all this foreign capital that
we're hooked on?
Mr. VOLCKER. Clearly, that is one of the risks that one has to
take into account. The risk of excessive reaction in the exchange
markets. The risk of—which is the same thing—losing the willingness to invest as eagerly in the United States. And that is why
some coordination of these moves at some times is very important.
Senator RIEGLE. Well, I gather, though, that that's not a great
concern of yours at the moment, that we may be reaching the point
where
Mr. VOLCKER. It is a continuing concern. The degree of concern
waxes and wanes depending upon other circumstances.
Senator RIEGLE. Well, I guess that's what I'm getting at. I'd like
to get a sense for the level of your concern in that area and I just
have to tell you that my own concern is high and it relates precisely to the growth issue. Most of the economists today feel that the
Western growth rate has to be about 3 percent if we're going to
maintain stability and not have the Third World countries slip into
a deeper adverse situation. I gather you agree with that.
Mr. VOLCKER. As a broad judgment, yes.
Senator RIEGLE. If we look at the picture currently, you mentioned that there is some pickup in Germany in the second quarter.
You did not say anything about Japan. I assume that we're not
seeing the same thing in Japan.
IMPROVEMENT IN GERMAN ECONOMY
Mr. VOLCKER. I do not see it to the same degree certainly. I'm
not right on top of it, but I think the signs are rather clear in Germany. I don't see them so clearly elsewhere.
Senator RIEGLE. So the German pickup in the second quarter is
something of an improvement, but do you see it on a broader base
in the Western economies or not?
Mr. VOLCKER. I would point out, too, in looking at that improvement in Germany in the second quarter, that they had a decline.
We're talking about a 1.1-percent increase at an annual rate in the
gross national product in the United States, according to a preliminary estimate right now. Germany had a decline of 6.5 percent in
gross national product in the first quarter, following a decline in
the fourth quarter of last year.
Senator RIEGLE. That's right. But I'm saying
Mr. VOLCKER. So they are getting a rebound from that decline
quite clearly.
Senator RIEGLE. I guess what I'm concerned about here, is that
we're in a very ticklish situation in the sense that we don't have a
lot of maneuvering room left unilaterally. It seems to me if we're
going to lower the discount rate much more, we're going to have to
53
have a coordinated response from that. Now do you disagree with
that?
Mr. VOLCKER. We haven't got a lot of maneuvering room, in a
broader sense and sometimes in the narrower sense, on the discount rate. But that depends upon particular circumstances at the
time.
Senator RIEGLE. I want to draw attention also to one other
change in your testimony that was submitted yesterday versus the
version today. In your text yesterday on page 4 on this very subject, you start with a sentence that says, "A major faultline runs
through the economies of the industrialized world" and then you
go on to discuss this problem in terms of how we work out these
imbalances.
I noticed that you chose not to go with that language today and
it seems to be softened. It seems to me we do have a major faultline running through here in terms of some structural disequilibrium we're going to have to manage our way out of. Isn't that really
what you're saying?
Mr. VOLCKER. That is what I am trying to say. We have a structural disequilibrium and we have to work our way out of it. I decided that word was overly cute when I looked at it and might be
taken out of context. It did not really convey what I wanted to
convey, that this is something that we can repair. It didn't pass the
wife test.
WITHDRAWAL OF INTERNATIONAL LENDERS
Senator RIEGLE. Can international lenders withdraw their money
as a practical matter? Some people say that even if the foreigners
who are loaning all this capital wanted to get out they really have
no place to go. I don't tend to buy that thinking.
Mr. VOLCKER. Well, there is a logic to that thinking in the sense
that for the United States as a whole, we are going to import capital because we must depend upon the current account deficit.
You've got to pay for it.
Senator RIEGLE. Right.
Mr. VOLCKER. And the only way we can avoid importing capital
is to reduce the current account deficit.
Senator RIEGLE. Right.
Mr. VOLCKER. But the terms and conditions upon which you
borrow that money can change. If people are trying to get out—
let's say at current interest rates and exchange rates—what would
happen is that interest rates would go up and the exchange rate
would go down. And that may not be what the doctor ordered in
terms of a healthy U.S. economy. It is, in that sense, that we are in
jeopardy.
Senator RIEGLE. Yes, but I'm saying from their vantage point,
are they able to withdraw and put their money elsewhere? If foreigners want to
Mr. VOLCKER. Only individuals are. Individual investors are
always free to do that. On balance, if they do it—if somebody does
it—we've got to replace that with somebody else's money and that
is where the issue arises of what do you have to pay to do it.
54
Senator RIEGLE. Exactly. And that's what could produce higher
interest rates.
Mr. VOLCKER. That is what could produce higher interest rates.
And, on balance, they can't get out. Parts of that whole sum can
get out, but then it would have to be replaced by other parts and
the question is at what interest rate and what exchange rate would
that happen?
Senator RIEGLE. My time is up.
The CHAIRMAN. Senator Heinz.
Senator HEINZ. Mr. Chairman, thank you very much.
Chairman Volcker, first I noted that you did something that I, in
my recollection, hadn't seen you do for quite a while and that is
you delivered your entire 34-page statement. Obviously, you attach
a lot of weight to what you have told us today and I do, too. I think
it's a very comprehensive statement, probably as good as or maybe
even better than any you've ever given and you maintain a very
high standard.
GNP RATE
On page 26 of your testimony you make the following statement
in part,
We want to ensure maintenance of the remarkable progress toward stability as
the economy grows more strongly and as a large amount of resources are shifted
back to manufacturing industries as our trade imbalance improves.
So in your estimation, you're saying things should get better.
Then you go on to say,
In looking toward growth in the 3- to 3.5-percent range next year, considerable
emphasis was placed by Committee members on the potential contribution to that
growth of a stronger trade balance.
Senator D'Amato explored with you to a certain extent what
might or might not happen there; however, I've got a different
question for you.
Would you consider growth, if it didn't come in at 3 to 3.5 percent, but averaged approximately 2.5 percent—which is, in fact,
what it has averaged for the first half of this year—would you consider that strong growth?
Mr. VOLCKER. I would not consider 2.5 percent strong growth, no.
Senator HEINZ. Mr. Chairman, I would agree with you.
Now you have expressed concern several times in recent months
about the possible negative effect on the value of the dollar if there
was unilateral U.S. action taken by the United States. I assume
you're referring to unilateral cuts in the discount rate. You have
also said this may trigger a free fall that if we cut the discount
rate and interest rates too precipitously and that that would limit
the U.S. ability to attract the capital necessary to finance our current account deficit.
Now obviously if a rapid devaluation of the dollar did, in fact,
limit our ability to do that, that could be a problem. But in cutting
the discount rate as you did a few weeks ago, the dollar has only
marginally fallen. The price of gold has remained relatively stable.
It went up a little bit in dollar denominated terms.
55
POSSIBLE LOWER INTEREST RATES
My question to you is: Doesn't the absence of panic or the absence of any instability in currency markets in the wake of your
action—which was unilateral—indicate that those markets are capable of coping with U.S. policy changes, additional ones of that
kind, and that further steps to lower high real interest rates can be
undertaken if appropriate conditions exist in the U.S. economy?
Mr. VOLCKER. It all depends upon what the surrounding circumstances are. When that change was made, I didn't anticipate it
would have a major effect upon the variables you mentioned. Although the dollar has gone down since then, it's gone down partly
because of the weaker economic news itself, which is one consideration and an important consideration that affects exchange market
behavior. So other factors are at work here. It all depends upon the
surrounding circumstances.
Senator HEINZ. Well, my followup question is, don't you think
that if you did cut the discount rate another half a point or a point
and that was followed as it usually is by other cuts in interest rates
in this country, that that would be a sign to the world that the
United States is serious about addressing the weakness of 2.5-percent growth, that it would signal that we anticipated taking the
necessary steps to have a stronger economy, and that view of the
U.S. determination to have a stronger economy in fact, would cause
our currency to strengthen or remain stable rather than to
weaken? Isn't that a reasonable point of view?
Mr. VOLCKER. I think in some circumstances that could happen.
Senator HEINZ. In 1979 or 1980, the Fed quite properly applied
the brakes to an inflationary situation and I don't criticize the Fed
for doing what they did then. But I think the Fed does deserve
some criticism for not fully appreciating the economic circumstances that we were in by the time we got to 1982. We were into a
recession and the Fed maintained the discount rate, as I recollect,
certainly above 10 percent until July 22, 1982. There were no cuts
for the first 6 months and even halfway through the seventh
month of 1982. The economy was really in very difficult shape. I
think there is no doubt that the Fed misjudged the economic problems we had and, although obviously this wasn't your intent, as a
result, we ended up with a recession that was longer and deeper
than we should have had, needed to have, and which still has been
exacting some costs on us.
Now my question to you is this: Isn't it possible that just as in
1982 the Fed didn't wake up to the problems early enough that we
are repeating history; and that the Fed is taking too benign and
optimistic a view, is seeing the possibility through rose-colored
glasses when indeed there's very little assurance that those possibilities are going to be as rosy and optimistic as you think?
Mr. VOLCKER. I'm inclined to say anything is possible, Senator.
Senator HEINZ. Well, you can do better than that, Mr. Chairman.
Mr. VOLCKER. But I don't want to associate myself with your
Monday morning quarterbacking of 1982.
Senator HEINZ. It's Wednesday.
Mr. VOLCKER. I'm not sure. Anytime the economy deviates from
what you would like to see, it's always easy to say that if you had
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only done something differently at the time maybe it would have
been better.
I don't know whether if we had eased policy all that much sooner
in 1982 whether we would have had anything like the progress we
have had toward dealing with inflation, anything like the strength
of the recovery we had, anything like the base we now have for
future growth.
Senator HEINZ. Chairman Volcker, I understand that. No one
has a perfect model and can predict with certainty what's what.
I'm trying to determine in my own mind and for the record whether there is a bias that the Fed has had for the last 5 or 6 years that
might have a major impact upon us as we once again seem to have
entered into a period of economic weakness.
FOMC REPORTS INDICATE A STRONGER SECOND HALF
Now let me come down to what I've really been leading up to
with these questions. There have been some recent reports indicating that at the May 20 Federal Open Market Committee meeting
the Fed actually leaned toward tightening rather than expanding
credit. The reports say that part of its inclination to maintaining
pressure on credit seemed to have stemmed from a staff forecast
that a stronger economic expansion could be expected for the
second half of this year without further prodding from the Fed and
any cut in the discount rate. Now is that correct?
Mr. VOLCKER. I would have to modify your description of that
meeting a little bit. We did not lean toward tightening. What we
said is we might lean toward tightening depending upon developments during that period. That is an accurate statement. It wasn't
much of a leaning, but it said we might. We never did.
Senator HEINZ. Did not the staff forecast a fairly healthy economy in the second half?
Mr. VOLCKER. As that report probably indicated the staff was
projecting increased activity in the second half of the year, along
with about 90 percent of the other economists.
Senator HEINZ. Chairman Volcker, that's what I'd like to focus
on, not the press release, but the staff report, because you rely, as
do many of us, on analytical work done by very competent staff.
But if they are wrong, if they misjudge something, at least—and
you're quite right, you can accuse me of Monday morning quarterbacking, but I'm not a member of the Federal Reserve Board and
maybe I would and maybe I wouldn't have been guilty of what I
have intimated the Fed may have been guilty of in 1982. But in
any event, not to put too fine a point on that, the question is: Why
did the staff think that we were going to have a healthy economy
in the second half of 1986?
Mr. VOLCKER. Well, let me distinguish between rate of growth
and a healthy economy in terms of the imbalances in the economy.
I think the staff forecast was outlined in that report, as it often is,
in very general terms. I don't think, in terms of direction, it differed much from the garden variety forecast prevalent at the
time—that the trade balance was going to improve; that you were
going to get sustained consumption in the light of the decline in oil
prices, among other things; that interest rates were down, the stock
57
market was up. Those factors entered into a judgment that the
economy was more likely to grow more rapidly rather than more
slowly in the second half of the year.
I might say, too, that the responsibility for those judgments lies
with the committee, not with the staff, which presents one point of
view.
Senator HEINZ. I understand that but I would hate to think that
you would simply ignore the analytical work and the data presented by the staff. It clearly has a great influence on your decisionmaking process. I don't think you would deny that.
SITUATION IN MEXICO
Let me just ask you this concluding question. You spent several
pages in your statement singling out and discussing the situation
in Mexico and appropriately so. They are a massive debtor. Their
economy is in desperate straits. And you said that with the restructuring that Mexico has agreed to, Mexico expects to grow in 1987
and 1988 and to permit or complement that growth, it's going to
need new bank loans over and above what it already has.
Mr. VOLCKER. Correct.
Senator HEINZ. Now if the United States economy should weaken
or, God forbid, go into a recession, what will happen to Mexico's
ability to grow and, for that matter, to service their already backbreaking debt?
Mr. VOLCKER. It would be impaired. Certainly their ability to
grow would be impaired. Extension of lower interest rates would
cause something of an offset to the financing problem, but I have
no doubt that the American economy in a recession would make
life still more difficult for the Mexicans and for others.
Senator HEINZ. More difficult even than now?
Mr. VOLCKER. More difficult than now, assuming the price of oil
remains at current levels. Of course, if the price of oil went up, the
Mexican current position would look quite different.
Senator HEINZ. Well, Chairman Volcker, you've given very good
answers to my questions and the purpose of this line of inquiry has
been to illustrate, I hope, that first, there's room for fallibility in
economic forecasts, that the consequences of fallibility as we
learned in 1982 and as might be the case as you've just suggested
in the case of Mexico could be, in concrete terms, unusually severe
and world-shaking. I think perhaps among other things, it also underscores what you've called for today, which is for other countries
to cooperate with us.
But I've got to tell you that if they don't cooperate with us, I
regret to say I don't think you're going to have many options left. I
think you're going to have to cut and I think you will cut the discount rate—and you don't have to agree or disagree with that.
Knowing you, you're so cautious and you're so prudent, and whatever it is you say you'll fuzz it up. [Laughter]. But nonetheless, I
think you re going to be forced to do that, with or without help
from our trading partners. I also think that the concerns that have
been expressed about the dollar going into a free fall are rather pro
forma. Speaking for myself, I don't really think that that would
happen, but you're an imminent economist or practitioner of eco-
58
nomics and I'm not going to get into an argument with you about
that, but I thank you for your testimony.
Mr. VOLCKER. Let me comment just briefly on your rather summary statement. I don't want you to have the impression that
there is some answer to all these problems by reducing the discount rate or easing policy or tightening it, without that move
being part of a particular environment in the world economy.
Our domestic demand, which is what presumably you affect most
directly by monetary policy and discount rate changes, has been
quite strong. That is not the weak area of the economy. Consumption has been doing quite well. Housing is having one of its best
years on record. You could presumably pump up that part of the
economy for a little while longer and a little more strongly.
But that does not deal with the underlying imbalance that
sooner or later we will have to deal with. It could aggravate it. So
it's just not a simple either/or question, that if this other thing
doesn't work we've got another policy instrument. You've got an
inadequate policy instrument.
Senator HEINZ. Well, I could agree with you except for one thing.
And that is, that if the United States does further lower its interest rates, other countries will have to do the same and that will
bring about the stimulation of their economies, whether it be
Japan or West Germany.
So I really can't quite agree with the conclusion you've come to.
It's good as far as it goes, but it doesn't go far enough.
Mr. VOLCKER. Well, that's certainly right. There is nothing inconsistent about reducing the discount rate and other actions being
taken that help the other problems.
Senator HEINZ. It's a little bit like who goes first, Gaston or Wakanobe. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
RELATIONSHIP OF BANK AND PRIME RATES
Mr. Chairman, since the beginning of March, the Fed has lowered the discount rate three times from 7.5 percent on March 7 to
its current 6-percent level. Now without regard to the advisability
of dropping interest rates much lower—and we won't get into the
merits of that—is there technically a point at which the discount
rate cut is not going to cause banks to respond by lowering their
interest rates? Are we getting close to that point?
Mr. VOLCKER. Well, the bank prime rate tends to bear a rough
relationship with short-term market rates. The discount rate also
bears a relationship typically to short-term market rates although
the relationship can vary. So normally you would expect some relationship between the two.
I think a lot of bank lending these days is done at unpublished
rates more closely related to market rates and if the market rates
go down, those rates go down. That is the pattern you see on business lending.
Now when you're talking about mortgages, they tend to move in
roughly the same direction but that's a longer term instrument
and has other influences.
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When you're talking about consumer rates, they are very sticky,
particularly some types of consumer credit like credit card rates
which haven't moved very much at all.
Senator SASSER. They haven't varied much in the last 5 to 8
years.
Mr. VOLCKER. That is correct.
Senator SASSER. They're still operating as if we had 20-percent
interest rates.
Mr. VOLCKER. Well, on credit cards, they tend to be close to 20
percent.
Senator SASSER. Well, at what point, Mr. Chairman, do you think
a further cut in the discount rate would reach a point of diminishing return as far as forcing further cuts in interest rates charged
by banks?
Mr. VOLCKER. Charges by banks would tend to follow short-term
rates in the market which tend to get pretty well integrated with
the discount rate.
If you're talking about longer term rates—corporate bond rates,
mortgage rates, that kind of thing—there is no necessary correlation and the limiting point in that area would be the minute the
market began thinking that the cuts were clearly inflationary.
Then, you might get a counterproductive action in the long-term
markets with rates going up instead of down.
Senator SASSER. Do you think we might be reaching a point of
diminishing return with regard to cutting the discount rate? Some
economists are saying that you won't get much of a kick from a
further cut.
Mr. VOLCKER. Well, I think that's sometimes said, not just because of the technical reaction of bank rates. Some might say that
even if bank rates went down you wouldn't get much stimulus to
the economy. I'm repeating myself, but I think so much of the malaise—if I may use that word—in the industrial side of the economy
is related to the trade position. And I don't think you're going to
see a dramatic change in the economy without some prospects of
improvement on the trade side.
Another big element in the recent picture has been the decline
in oil prices and investment in that area. Production of investment
goods in that area have been cut to shreds—very sharp cutbacks in
the number of rigs at work, the pipes that they take, and the work
that goes into the exploration and development side of the oil industry.
Now maybe a decline in interest rates to some degree moderates
that, but compared to the force of the oil price dropping from $25
to $10, it obviously has a minor impact on that particular industry
which has been quite an important factor in this sluggishness in
business investment.
So you get those kinds of distortions in some areas of the economy which are not going to be very responsive to a decline in interest rates.
Senator SASSER. They're just not going to respond sometimes, I
think, because of the underlying structural problems that we have
in this economy that have not been dealt with.
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LOWER GROWTH RATE IN MANY CATEGORIES
With regard to this much balleyhoo'd—this "remarkable"—I put
"remarkable" in quotation marks—recovery that we've experienced over the past few years. But when you compare this recovery
to recoveries from recessions over the past 25 years, what we find
in this recovery is the lowest growth rate of real GNP of all four
recoveries in that period, the lowest growth rate of industrial production, the lowest growth rate of real after-tax income, the lowest
growth rate of productivity, and the second lowest growth rate of
employment.
Now superimposed on that, Mr. Chairman, we've been hearing
some very disturbing reports about the state of this so-called economic recovery. People are beginning to wonder if this recovery is
more public relations in some areas than it is reality.
In the first 6 months of this year, for example, the industrial production index dropped by 2.1 percent. That wiped out more than 80
percent of the production gains of 1985. And as of June of this
year, we had more than 22 percent of our industrial capacity standing idle, more than at any time in the last 2% years, as I'm sure
you know.
Now we are seeing at the same time banks failing at a rate
faster than last year when we set a record of 120 banks failing,
capped by the failure a couple weeks ago of the First National
Bank and Trust of Oklahoma City—which I understand was the
second largest bank failure in the history of the country.
Now, Mr. Chairman, I realize that the Fed can't do everything,
and perhaps I'm coming reluctantly to the conclusion we expect too
much out of the Fed. But are we in the middle of a sustained economic stagnation as opposed to a much balleyhoo'd recovery?
Which is it?
Mr. VOLCKER. First of all, let me just reserve the right to go back
and look at some of those figures on that list that you reeled off
because I am surprised at some of them. I am not surprised about
industrial production. As we have emphasized collectively again
and again this morning, industrial production has not been doing
well over the past 2 years or so.
I might also mention that one of those figures explains the real
income question that you touched upon and that Senator Heinz
touched upon earlier. Productivity has not been doing brilliantly,
to say the least. Overall productivity has been rather restrained for
almost 10 years and that is the key to rising real income. You're
not going to get average real income rising very fast if you don't
have rising productivity.
Senator SASSER. Let me interrupt you there and just ask you
this, Mr. Chairman. Did the recession of 1982, which was the deepest recession we've had since the Great Depression years of the
1930's, did that shake out any of our problems of productivity or
are those productivity problems as pronounced as they were prior
to the recession?
Mr. VOLCKER. Well, Senator, there's a certain mystery here to
me—and I think to many other people—because you do get continuing reports that manufacturing productivity—if you talk to
businessmen—is improving rapidly. They've done a lot of things to
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improve productivity and actually you see some evidence of that in
the manufacturing sector of the economy.
It is really the rest of the economy—that broad and growing
service area—where the productivity is so poor.
Now having said that, you have real statistical problems in measuring it when you get out in the service area. In these last revisions of GNP Figures, the growth rate was raised largely because
more services, so to speak, and output were found, and that, I presume, is going to make the productivity figures look a little better.
But in manufacturing you see some signs, and you would see
more signs if you hadn't had this leveling that we both have been
talking about. In the rest of the economy, no.
MERRILL LYNCH FORECAST OF ECONOMY
Senator SASSER. Well, last week, Merrill Lynch's chief economist,
from Don Regan's old firm, predicted that there would be little or
no growth in the second half of this year, much less any acceleration from the slow pace of the first 6 months of this year. This
economist said business spending on new plant and equipment is
likely to be weak over next year and the hoped-for lift to U.S. manufacturing from the dollar s decline in foreign markets remains
way off.
I would ask you, Mr. Chairman, if you disagree with this economic forecaster and others who predict that there's not going to be
any growth for the rest of this year and, if you do disagree, principally why?
Mr. VOLCKER. That does not seem to me a likely outlook for the
various reasons that have been touched upon already. I was looking at my briefing book last night and I saw a Merrill Lynch forecast that must be a little out of date. It was 2 weeks old. It didn't
show that. The papers said they've made a big revision in their
forecast, which is perhaps a commentary on the volatility of these
forecasts and one's inability to put too much weight on any forecast, including our own staffs forecast.
Senator SASSER. Mr. Chairman, I had an old law school professor
who said one time the reason the dinosaur is extinct is that it
couldn't turn around fast enough. That's not going to happen to
Merrill Lynch's economist, apparently.
Mr. VOLCKER. That may be so. But this all comes back, I think,
to the basic point I'm trying to make this morning—that these
questions about the outlook are really inextricably tied up in this
question of the trade picture. And once you begin looking at trade,
it's tied up with what s happening in the rest of the world. So you
really not only have to forecast the United States as best you can,
but also you have to have some sense of what the prospects are in
the rest of the world. And that's a new kind of world for us to be
living in.
Senator SASSER. My time is up but I will just end with this statement. One of my principal concerns is that our economy may be
coming noncompetitive in a world economy, and if we're depending
on world trade to pull us out, it may be a long wait.
Mr. VOLCKER. Well, let me just respond to that comment, too. I
think certainly with the change in the exchange rates that we've
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had we're a lot more competitive against our major industrial
country competitors, but you also see some longer term trends that
bear out your concerns. I don't think you can always repair that by
changes in the exchange rate.
Senator SASSER. No.
Mr. VOLCKER. I think we have had some problems in the area of
productivity. But I think that can change and it must change.
When you look ahead in this economy for the next 5, 6, 7 years, it
seems to me you must arrive at the unambiguous conclusion that
our manufacturing industries are going to have to do a lot better
relative to what they have been doing because that's the only way
we can get the trade balance in to better shape. The only other assumption you can make is that it's not going to get in better shape
and I just simply do not think that is possible over that kind of
timeframe. What's at issue is how it gets in to better shape. Does it
get into better shape in the context of a growing economy or do you
have a much more difficult time of unsatisfactory adjustment
effort? But it's going to have to get better sometime. It's got to
start moving in that direction and that means we have to have a
much more competitive—one way or another—manufacturing industry.
Senator SASSER. Thank you.
The CHAIRMAN. Senator Gorton.
BUDGET DEFICIT GOALS
Senator GORTON. Mr. Volcker, how important is it to both the
short- and long-range future of our economy that Congress meet
the Gramm-Rudman budget deficit goals for 1987 either at the $144
billion figure or within $10 billion of that figure?
Mr. VOLCKER. Well, I think it has been and remains crucially important that you make very substantial progress in that direction. I
don't think that depends upon reaching any particular figure. I
would emphasize substantial progress. You have a political target
to be met and you have to have a certain amount of discipline, but
I'm not good enough to answer your question within $10 billion. I
do think substantial progress over time is going to be necessary as
part of correcting this trade situation we have.
Senator GORTON. What would be the likely consequences of an
abject failure to meet those goals or to make strong progress
toward them?
Mr. VOLCKER. Well, I think the good news would be—and nobody
can project this—that you go on for another year or so more or less
the way we have been going on, with a trade balance not getting
better, maybe getting worse, but the rest of the economy doing
pretty well. The bad news would be when you run out of steam on
that approach and part of the threat is not just a protectionist reaction to the trade imbalance, but economically there's a loss of
confidence in the prospects in the United States. The capital
doesn't flow in from abroad so easily, and you've still got to finance
that same budget deficit. You have a mess.
Senator GORTON. Let's assume that we meet or come very close
to meeting those deficit reduction goals. We will then have in place
a fiscal policy aimed at reducing the deficit decisively. And let's
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assume for the time being no additional substantial stimulus from
monetary policy.
Under those two sets of circumstances, what factors will cause
growth in 1987 to be any larger than it is so far in 1986?
Mr. VOLCKER. Without improvement in the trade balance?
Senator GORTON. Pardon?
Mr. VOLCKER. You're assuming no improvement in the trade balance?
Senator GORTON. No, I'm not making any such assumption. I'm
allowing you to state if we have a deficit reduction fiscal policy and
no additional stimulus from monetary policy, why and under what
circumstances will the economy go?
Mr. VOLCKER. Under those circumstances, I would think you've
got a big force in there moving toward lower interest rates. But
your major improvement—again, an improvement that is consistent with the direction we have to go over time—would be on the
trade side which would feed back into business investment. But I
think the important stimulating factor would be on the trade side
feeding back into business investment and therefore into manufacturing activity generally.
Senator GORTON. Is it your view that at this point we have not
yet seen much, if any, of the impact from previous discount rate
reductions and the rather dramatic drop in the value of the dollar
as respects our international trade deficit?
EFFECTS OF INTEREST RATE REDUCTIONS
Mr. VOLCKER. Well, I think you have seen the effects of the substantial reductions in interest rates that we've had for about a year
now, whether or not they are directly tied to changes in the discount rate. I think housing is doing well and parts of consumption
are doing well. So I think you see those effects rather directly. I
don't think you've necessarily seen all those effects.
On the trade side, you have not seen it in a pronounced turnaround in trade flows or even an absolute leveling off so far. I think
you can see evidence of an improved competitive position and at
least maybe scattered evidence of the order situation changing a
bit. There are fewer orders for exporters apparently in Japan and
Germany. There are other factors at work but that's one factor.
There are reports of more orders by some of our industries that are
heavy in the international area, but it's still in the beginning turn
around stage in orders and expectations than in actual trade flows.
You do not see it in actual trade flows.
Senator GORTON. Is it your view that the decline in the dollar as
against the yen and the mark has—I can't say it's run its course—
but a further substantial decline of the value of the dollar against
the yen or the mark would be likely to have more adverse than
positive consequences?
Mr. VOLCKER. Again, it depends. Given the circumstances that
exist, I think the most important and constructive way that we can
get an improvement in our trade balance—given the substantial
depreciation we've already had—is through expanding markets
abroad.
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Relying entirely upon exchange rate changes certainly does help
our competitive position and in concept will improve the trade balance and our economy. If nothing else is done, however, it may
weaken the foreign economies. So again, you don't have the markets for your goods. It depends upon whether they have other
things going on that help to push their economies forward and
that's what's been in some question.
In some European countries and in Japan, as they've faced a
tougher competitive position internationally, there has not been a
thrust of internal growth to replace it. They either have a very
sluggish situation or no growth at all. If we're going to improve our
trade balance and they reduce theirs, they've got to have more internal growth. It's just almost arithmetic. And if that's not there,
there will be a sluggish picture, one that's not very good for our
exports.
Senator GORTON. On another but related subject, a great deal of
your written and oral testimony relates to the international debt
situation. I think it's appropriate to describe your views on some
nonoil producing countries as relatively positive. Declines in interest rates and growth in productivity and the like has been very
helpful to Brazil.
Mr. VOLCKER. Precisely. I think there's more progress in that
area than is generally realized.
Senator GORTON. But, of course, that's not true with respect to
oil-producing countries, especially the Latin American oil-producing countries.
RESTRUCTURING DEBT OF OIL-PRODUCING COUNTRIES
Mr. VOLCKER. Even some of the oil-producing countries—take a
small one like Ecuador—a great deal Has been done to restructure
the economy and to open it up and improve its competitivenss.
They were in the midst of doing that in a rather aggressive way
and then were hit by the oil situation proportionately as much as
Mexico. The numbers, of course are smaller for Ecuador.
Senator GORTON. Focusing on Mexico, is it your view that without a real increase in oil prices over the period of the next 2 or 3
years that its debt is in any way manageable or sustainable without a cut in interest rates or some kind of forgiveness of principal.
Mr. YOLCKER. Well, I think it could be manageable even under
those circumstances, but it obviously would be a lot easier should
the oil price go up some. I wouldn't particularly forecast this, but if
the oil price in real terms stayed down, the Mexican economy is
going to have to reorient itself more quickly and more heavily
around nonoil business, and that requires a lot of structural change
consistent with the directions they ve announced in the last few
days. They want to go in that direction anyway. But certainly
there is an additional burden upon them. Every time the oil price
goes down by $1, it's another $500 million to Mexico on the minus
side. When it goes up, it's on the plus side.
Senator GORTON. If you were a private banker—I'll give you two
examples—either without much investment in Mexico or with a
large amount of investment in Mexico, would you be willing to
follow up with more now as a result of this IMF agreement?
65
Mr. VOLCKER. I think that obviously has to depend upon what
you think the prospects are, and that gets back into some evaluation of their program. But if I had a large exposure to Mexico,
knew that they were very hard hit by the oil situation and trying
to cope with it, and I had a large stake in preserving the stability
of what I've got, I would look at what is necessary to help Mexico
do what will retain and improve its creditworthiness over time.
And that is the issue.
Senator GORTON. Thank you, Chairman Volcker.
The CHAIRMAN. Senator Sarbanes.
Senator SARBANES. Mr. Chairman, I join with my colleagues in
welcoming you.
I want to diverge for just a moment. I've been chairing some
hearings in the Joint Economic Committee on our statistical base,
our information base, and in the course of those hearings as
they've progressed I think there's a growing concern that lack of
accurate information may in fact be becoming an increasing impediment to our economic growth and to important policymaking,
both public and private.
LACK OF ADEQUATE DATA FROM AGENCIES
I'm prompted to ask the question by your reference on the GNP
growth figure and the point you made that while the second quarter figures were anemic the first quarter figures have been revised
upward. That reflected that the trade figures in particular are inadequate and, of course, that's quite true. What we have is actually
the Customs Bureau still doing it by hand. They don't even have it
computerized and the Commerce Department now in effect appends a consumer warning on each monthly package of trade numbers that it issues by talking about the carryover rate. In effect,
they say we can't really vouch for anything that's in here.
You also have this problem on accounting accurately for the
service sector of the economy. We've not updated those statistics.
How much of a concern do you have about the deterioration of
our ability to collect accurate statistics for the purpose of economic
decisionmaking?
Mr. VOLCKER. Well, I have no great expertise in statistical collection, but I share the view that you infer that the amount of money
and effort spent on dealing with these statistics is not up to the job
currently, given the attention that we give to these figures.
But I also have the feeling—take that service side of the economy—that there's just inherently very difficult conceptual problems
that suggest that nobody is going to have perfect figures. Take the
housing price figures where the method of collection changed. Both
the old method and the new method had their own kind of purely
statistical imperfections of some size. Depending on the method
used you get a widely different result over the past 3 or 4 years. I
think if the old method were still being used, the consumer price
index would have shown a decline in housing costs over this period.
Using the current method, housing is one of the fastest rising elements in the Consumer Price Index.
I would conclude from that that some of these problems are
pretty insoluble. We are all tempted to put too much weight on
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these figures. They all should be taken pretty much, in varying degrees, with that warning that you noted for the Customs figures—
too much reliance on these figures may be dangerous to your
health.
I also think that some figures are inherently more reliable than
others and among the more reliable are some of the employment
figures. It's interesting that they have shown a consistently stronger economic picture over the last couple of years than the GNP figures, and now the GNP figures have been revised upwards. Revisions for last year and the first quarter of this year put the GNP a
little more in line with its historical relationship with the employment figures.
So we have those problems which I don't think we can solve completely. You can deal with them to a degree with more money and
more effort, but I think there are some problems that just lead to a
certain caution in using any of these figures.
The trade figures are a classic case in point. They jump way up
and down month by month and then you find out that the figures
may not even refer to the month that they are reported for.
Senator SARBANES. Recognizing that you have to be careful in
your use of them, at least I would submit that the quality of our
statistical data—the quality of it—is the vital factor in making
sound judgments possible. Good statistics will not guarantee good
policies but they are part of a framework of decisionmaking which
makes good policies more likely.
Mr. VOLCKER. I could hardly disagree with that and I think my
gut feeling is there may have been some slippage. The effort put
into this has not kept up with the increasing complexity of the
economy.
Senator SARBANES. I might note that the Japanese today have a
national statistics law and they have a month-long national celebration in honor of statistics and the theme of that month-long
celebration last year was "Statistics are the Beacon for a Happy
Life."
Mr. VOLCKER. Well, we could have a national statistics day.
COMPLEMENTARY ECONOMIC POLICIES
Senator SARBANES. Let me turn to your statement. First of all, I
want to address this point on the coordination of economic policy
among the industrial countries. On page 11 you say, "Those underlying imbalances can only be dealt with by complementary economic policies."
What are the factors, in your judgment, that have prevented or
precluded the development of complementary economic policies?
Why aren't the countries able to get together?
Mr. VOLCKER. Well, one of those areas where I think we need
complementary policies deals with our own budget deficit, and you
are one of the world's leading experts on the difficulty of dealing
with our internal budgetary deficit.
I think clearly other countries have similar difficulties. We used
to think that fiscal policy could be conducted with some flexibility.
I think any hopes on that have been reduced over the years. When
one looks at this in an international context, one of the things you
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run into is that there are very firm and fixed long-run fiscal objectives—budgetary objectives I suppose I should call them rather
than fiscal objectives—in some of these countries. They don't want
to deviate from those very fixed objectives in terms of reducing—or
eliminating—what were once very high budget deficits.
So that's a clear problem nationally and internationally.
Senator SARBANES. Do you think the effort on the part of the
major industrial countries to coordinate their policies has diminished? There used to be a time when the meetings of the OECD
were regarded as extremely important.
Major efforts were made to develop a coordinated economic approach. Now my perception is that Secretary Baker has tried to
revive that, at least to some extent. Would you agree with that?
Mr. VOLCKER. Well, I've been watching this process for many
years now and it's never been easy. It's always fallen far short of
what one considers the ideal. I don't really think it is all that much
different in recent years than it was earlier. Certainly Secretary
Baker has made some particular procedural proposals which' are
aimed at creating an environment and a kind of discipline that
would produce more substantive results. The first stage is a procedural one and that's difficult enough, but he's certainly working on
that problem.
Senator SARBANES. Would you say the Treasury under his leadership is showing a greater sensitivity and concern for this coordination than has previously been the case before he took over?
Mr. VOLCKER. Well, I'm not going to make comparisons but he is
certainly concerned with this problem and I think he's demonstrated that in the initiatives he's taken.
Senator SARBANES. Now on the Baker plan for the international
debt situation which you discuss at some length in your statement,
do you think that reasonably assured financing by international institutions has been given sufficient weight in the Baker approach?
Mr. VOLCKER. I think it's been given sufficient weight in the approach. Whether it's been given sufficient weight in practice is another question.
Essentially, since he made that speech in Seoul last year—which
was kind of a codification of what had developed case by case, with
some further emphasis on growth—we have not had a big test case,
so to speak. So this is really the first that we have had. There has
been progress in some directions on a more piecemeal basis or with
much smaller countries, but the amounts involved are so much
smaller it hasn't been a real test. So we are going to see whether
we have adequate progress in that direction in the Mexican case.
Senator SARBANES. Wouldn't it be a positive path to follow to try
to shift some of the Third World debt or the ratios at least of the
Third World debt from the private sector, the private banks, to the
international institutions?
Mr. VOLCKER. Actually shift the debt, the outstanding debt or
new debt?
Senator SARBANES. Well, shift the ratio which of course could be
done by shifting the new debt.
Mr. VOLCKER. Well, as part of this process, I think yes.
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Senator SARBANES. Because you make the point that the private
exposure is diminishing in a number of these countries and if that
happens where are the countries going to find the growth?
Mr. VOLCKER. As a matter of emphasis, I think that is shifting
and should shift through relative amounts of new debt. I'm not
sure the banks should just walk away from this problem. I think
they should be involved. But as a matter of emphasis, yes, I agree
with that.
DEALING WITH DETERIORATING FRAMEWORK
Senator SARBANES. And my final question is—and it follows
along the line of questioning of Senator Sasser—earlier this week
the former Chairman of the Council of Economic Advisers, Alan
Greenspan, was quoted in the Washington Post as saying,
We have had all the elements which now should be affecting the American economy in a positive way. The fact that they are not raises some very serious questions
about whether we are looking at the fundamental forces that are driving the economy. It's too early to say we're on the edge of a recession but there is no question
that the underlying framework is deteriorating.
I'd appreciate your comments on that Greenspan quote.
Mr. VOLCKER. All I can do is repeat, I suppose the theme of much
of what I am saying this morning—that international imbalances
are large and they have been growing. And in that sense the
framework has been deteriorating. It should be of first priority in
terms of our own development of policies here and abroad to deal
with that, in his words, "deteriorating framework."
Senator SARBANES. Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Chairman, there are some additional questions that some of the members of the committee wish to ask you
in writing. Senator Proxmire and possibly Senator Riegle have additional questions. I do have another meeting that I have to go to,
so I leave you to the tender mercies of Senator Proxmire.
Senator PROXMIRE. Thank you very much, Mr. Chairman.
Chairman Volcker, I have just a few questions. First, I'd like to
say I couldn't agree with you more on your concern about our statistical figures that you and Senator Sarbanes brought out so well.
EMPLOYMENT FIGURES
You referred to our employment figures as being among the
more reliable. We're very proud of our employment figures and
people say they're the best in the world and the most exhaustive.
On the other hand, just last week there was a detailed article in
the New York Times going into considerable lengths in documenting the weaknesses of our employment figures.
Mr. VOLCKER. Of the employment figures?
Senator PROXMIRE. Yes, indeed, especially the household survey.
The establishment survey is much more reliable.
Mr. VOLCKER. I was thinking particularly of the establishment
survey. They've got some deficiencies also. I'm no expert in these
figures, but my comment was really directed toward the establishment figures.
Senator PROXMIRE. Of course, one of the problems is that we
count anybody employed who has worked at least an hour in the
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preceding week so that people who are working part time for economic reasons are considered employed.
Mr. VOLCKER. But you also have hours Figures, and some of that
shows up in the hours figures.
Senator PROXMIRE. Well, to some extent they do. And then we
don't count discouraged workers. If somebody has looked for a job
and looked for a job and can't find one and stops looking, they're
not considered to be unemployed. In fact, it was estimated by the
experts they interviewed that if our unemployment figures were
accurately kept, they would be about twice as high as shown, as
much as 14 percent instead of 7 percent.
Mr. VOLCKER. On the other hand, unemployment in those terms
is a state of mind. We do have more people employed relative to
the working age population than ever before.
Senator PROXMIRE. No question about it, and that's an important
figure. It's something over 60 percent now. It's higher than it's ever
been.
I'd like to ask you about the banking bill introduced by the
chairman of this committee, Senator Garn, S. 2592. As you know, it
makes a number of major changes in our banking laws. Although
the nonbank bank loophole would be closed, S. 2592 also makes it
far easier for diversified firms to buy and operate savings and loan
associations as a unitary thrift holding company.
Now I'm concerned that the character of the thrift industry
could be profoundly changed over the years if we allowed that to
happen.
Moreover, it will become increasingly more difficult to supervise
thrifts when they come under diversified corporate ownership.
Is that the direction you think we should be going or not?
Mr. VOLCKER. You're commenting on the draft bill that I understand is in the process of revision. But I do not think the approach
that earlier bill took toward the thrift industry—or the possibility
of banks buying thrifts and through that avenue acquiring what
powers might be provided by the Home Loan Bank Board—was satisfactory. With the liberalization of the powers of thrifts to provide
demand deposits and all the rest, it purports to close the nonbank
bank loophole but opens up another loophole that could be larger
and produce a real mixture of commerce and banking.
Senator PROXMIRE. Well, I share that view and I'm very grateful
to you for stating it so clearly and explicitly.
Now because of the lateness of the session, it's been suggested
the only way to get a banking bill through the Congress is to drop
all controversial items and deal only with essential matters. Some
contend that only two items are really essential—the FSLIC recapitalization and the regulators' bill on the interstate sale of failing
banks.
CLOSING NONBANK BANK LOOPHOLE
To that list, I'd add a third—the closing of the nonbank bank
loophole along the lines of the bill passed by the Senate in 1984.
What are your views on this? How essential is it that Congress
close the nonbank bank loophole this year?
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Mr. VOLCKER. Well, I think it's quite essential that the Congress
really resolve this issue. With each year that it doesn't resolve the
issue, the market obviously does move and the difficulties of pressing a congressional view on the direction the banking system
should take gets worse. I think that's illustrated by the fact that
Senator Garn has made very firm statements in the past about
grandfather dates and that kind of thing but they seem to be up in
the air again.
So I think it's important that we act in this area. I don't see any
inconsistency between acting and going at least a bit beyond what
you describe. This issue of so-called powers has been thrashed out
again and again and I think it's time to act.
Senator PROXMIRE. Well, do you agree that that kind of a
stripped-down bill may be the most practical in view of the fact
that we have only a few days left in this Congress?
Mr. VOLCKER. Well, that's a matter of legislative judgment. I
think those items are essential items. Whether it's best to strip
them down or not is a matter of legislative judgment but I think
they are very important.
PROBLEMS WITH THE THRIFTS
Senator PROXMIRE. Now my next question is, how sick is the
thrift industry? We're getting conflicting opinions on the condition
of thrifts and FSLIC. The Reagan administration has recommended
that FSLIC borrow $10 to $15 billion to liquidate insolvent thrifts.
However, a recent article in the Wall Street Journal argued the administration's plan was woefully inadequate and that at least twice
as much money would be needed. At the same time, the U.S.
league has contended that the problem can be solved without any
borrowing.
What are your views on the problem of the FSLIC and the adequacy of the administration program?
Mr. VOLCKER. I have not looked at that in great detail. The thrift
industry is currently made up of a great many extremes. A large
number of thrifts that have stuck to their knitting and put good
loans on the books are doing quite well now. With interest rates
down, their margins have improved, even dramatically, and they
are in quite healthy condition. Some of them had gravely weakened capital positions earlier, but in many cases those capital positions are being recovered.
On the other hand, there are a sizable number of thrifts that
have increasing asset problems arising from less conventional
areas of lending and activity. I think that has become an increasing problem and that's what puts the burden on FSLIC. The
quicker some of those problems can be taken care of, the smaller
the problems will be over a period of time.
It also highlights the supervisory problems that have existed in
that industry. I think Mr. Gray, through enormous difficulties, has
moved quite forceably in this direction, given the problems he has
to cope with. But there has obviously been a lot of room needed for
improvements. So I think that side is relevant as well.
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But some enhancement of the resources of the FSLIC would
enable them to take care of some of these problems more expeditiously.
Senator PROXMIBE. Is there any reason to believe that the administration's plan on thrifts is inadequate, the $10 to $15 billion?
Mr. VOLCKER, I have no analysis that would suggest that. Obviously it is an area of estimates here, but it does provide a large
supplement and certainly provides what would appear to be a reasonable sum at present.
OWNERSHIP OF CONSUMER BANKS BY DIVERSIFIED CORPORATIONS
Senator PROXMIRE. I have one other question. Those who favor
nonbank bank or a consumer bank concept argue there's nothing
wrong with a bank being owned and operated by a diversified corporation as long as the bank is a separately organized subsidiary
that is examined and supervised by the bank regulatory authorities.
Do you see any potential problem if we open up the opportunities
for owning limited-service banks that only make consumer loans?
Mr. VOLCKER. Well, if they only make consumer loans it would
be less of a problem. There's enormous possibilities for a tie-in even
in consumer loans. You see it in the automobile companies where
they choose to provide a competitive edge apparently through subsidized credit rather than through other pricing opportunities. And
somebody who is able to do that—which is an effective marketing
tool—has an advantage over other competitors. So there are problems in that area.
More generally, as you say, the concept was put forward that if
these institutions were regulated and supervised like other banks—
if they are insulated from their corporate parent it's OK. Maybe so.
But I think the corporate parent would have limited interest in
running these nonbank banks if they were really insulated from
the rest of their business. Why are they interested in getting them
in the first place?
Senator PROXMIRE. What about the ability of the regulators to effectively supervise the thrift if they can't regulate the corporation
that owns it.
Mr. VOLCKER. Well, there are two ways of doing it. One is to supervise the parent, which is neither possible nor feasible. Nobody
wants to extend banking supervision into that area. Or you could
draw a very, very tight line around the banking subsidiary. And as
I said, if you drew that tight a line, I don't think anybody would be
much interested in buying them. They would then have to buy
them as a bank, not because they fed into their commercial operations. You have examples of that historically in the thrift industry and I don't think there's anything particularly the matter with
it, if you maintain that distinction. But if you maintain that distinction, as a practical matter it also involves the supervisors of the
bank to make sure that tandem relationships don't develop between the bank and its parent.
Senator PROXMIRE. Senator Riegle.
Senator RIEGLE. Mr. Chairman, just as a follow-on to what Senator Proxmire was asking, the three items that you thought, along
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with Senator Proxmire, are key items in my view as well. They include getting a banking bill through this year that takes care of
the emergency acquisition authorities which you and other regulators need, taking care of the FSLIC recapitalization, and doing
something on the nonbank bank issue. Are there any other key
items that have not been mentioned that you think have a sufficient degree of urgency that you would put them into the same category as those three?
Mr. VOLCKER. You have this whole contested area of what I will
call powers. When you say nonbank bank, if you take the very restricted view of a nonbank bank I would say you have to take care
of nonthrift thrifts, too. It's a parallel problem.
I think those cover a large part of the areas that require early
attention. There are a lot of questions dealing with the insurance
system that I think are very relevant but may be less ripe for decision. In fact, in my view, many of those are not ripe for decision.
Senator RIEGLE. You mean the Federal Deposit Insurance
System?
Mr. VOLCKER. The Federal Deposit Insurance System, although I
think there are very important questions that ought to be looked
at. Changes are necessary there, but it's only a question of timing,
not of relevance to the subject.
Senator RIEGLE. Economists are now divided on the economic
outlook. Several members have mentioned forecasts by certain
economists that are quite pessimistic.
Mr. VOLCKER. If I might go back to your earlier question in the
area of more emergency areas, I know the FDIC has a strong interest and I think it makes good sense—this transitional bank idea in
handling a failed or failing institution. So that might be another
element.
POSSIBLE RECESSION
Senator RIEGLE. All right. I appreciate that elaboration.
As we've been discussing here this morning, economists generally are quite divided on the economic outlook. You can find people
that are very pessimistic and some that are more optimistic and so
forth.
Against that backdrop, we do have all these serious structural
problems which I think you've laid out chapter and verse in your
statement and I think they are very sobering and very worrisome.
And my question is this. As we try to formulate these policies
and try to get the international cooperation and coordination and
so forth, and as we go along here over the next few months, if despite our best efforts, for whatever the reasons—the oil price goes
too low for economic reasons and stays there or other events—we
begin to slide into a recession in this country and presumably more
broadly, how serious from the point of view of timing, if we were to
find ourselves moving into a recession over the next 6 or 12
months, does that come at a particularly worrisome time in terms
of all these structural problems? Is it something we think we could
pretty much just take a deep breath and deal with, or should we
view that prospect if it were to start to loom as one that would
cause us to say we'd better figure out how to avoid it?
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Mr. VOLCKER. Well, it's obviously desirable to avoid it in any
event and it would complicate our problems under any circumstances. But I would have to emphasize again that the seriousness
of that situation would depend a great deal upon whether the rest
of the world, at the same time, was moving ahead with some buoyancy, or whether there was also a threat of recession in the rest of
the world. That would greatly aggravate the circumstances and the
difficulties of dealing with it.
That is the thing you don't want. You don't want that coordination—you don't want a coordinated recession. That's for sure.
Senator RIEGLE. Well, that gets right to my point. If we started
to see ourselves working our way into a recession that was worldwide and the other Western countries were involved in it as well as
ourselves, what I'm really asking is if this backdrop of structural
problems which have been piling up over a long period of time are
now of such a magnitude and difficulty that this would pose some
exceptional dangers for us.
Mr. VOLCKER.Yes, because that problem is aggravated by these
underlying structural problems which is why I emphasize them
and the need to deal with them. That is precisely the point.
Senator RIEGLE. Well, I conclude from that in listening to everything you've said today, every word, that we really need to coordinate these policies, take the tough medicine that we must take as a
nation, and in conjunction with our allies work out a common plan
and carry it out. If we don't—if we were to fail in that effort, either
in taking our own steps or working with them to take the steps
that they need to take, and we would go into a worldwide recession
at this point, a particularly dangerous situation. It's something
that ought to be avoided, I gather, pretty much at all costs.
Mr. VOLCKER. I think the premium on nonconstructive action is
very high and I would just put a footnote on that. It doesn't necessarily mean a need for new action in all cases. In some countries
abroad, we may be building up the momentum that's necessary,
but that's a rather critical judgment to make.
Senator RIEGLE. The evidence by and large isn't there yet to tell
us that.
Mr. VOLCKER. The evidence is mixed, I think, to put it neutrally.
Senator RIEGLE. Well, that may be more generous. Maybe it is
mixed. When I look for the bright spots, I
Mr. VOLCKER. It is mixed in a technical sense. Canada has a
record quite similar to our own. Their domestic demand has been
expanding quite rapidly but their trade surplus is very high. Their
current account has been deteriorating. They haven't got the big
deficit we have, but it's been deteriorating and they've had a pretty
good rate of growth.
Italy currently, for instance, has had quite vigorous growth and a
lot of domestic demand over the past year or so. Other countries,
obviously there are a good many, where you can't make that statement.
Senator RIEGLE. Right. No one quite knows then, just to carry
through this macroeconomic analysis, where we may be headed
here, because of this divided opinion and these high risks that are
there because of all the structural problems. If we actually carry
out the Gramm-Rudman cuts which are more than just a political
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requirement—they are now the law of the land in terms of trying
to hit this $144 billion deficit next year—we're going to come in
this year somewhere over $220 billion in the deficit. That's the
latest estimate from OMB, as you know. I think it could be maybe
$225. Who knows? But it's going to be in that range.
REDUCTION OF $76 BILLION IN THE DEFICIT
If we manage to go from $220 this year down to $144 next year,
it seems to me that is a very dramatic reduction in the deficit. To
go down $76 billion at one time, which is what the law now mandates us to do, may be precisely what we've been struggling to do
for a long period of time, but it may happen at a time where for
some kind of cyclical reasons we may want a good part of that deficit reduction or we may not want that much simply because it may
be too much contrary to the softness in the economy. Does that
give you any particular concern?
Mr. VOLCKER. I think it's obvious—with the current estimated
deficit going up and with growth of the economy somewhat slower
even through the first quarter—that you would have a much
bigger cut than was anticipated. This raises a question from a
purely economic standpoint whether that bigger cut is feasible.
As I said earlier, I'm at least not good enough to tell you down to
the last $10 billion where success in this effort rests. I would
simply say, as I've said so many times before, that a very significant move in the direction of getting the deficit on a declining
path is what's called for.
Senator RIEOLE. Is it likely to imagine, if we were to do that in
what is a relatively short timeframe. You've got to go from a
spending pattern that's giving you a $220 billion annual deficit
within literally 1 month's time as you click into the new fiscal
year. On the average you've got to a spending pattern that takes
you down to $144 billion if you're going to get this reduction in deficit that Gramm-Rudman requires—if you take that much stimulus
out of the economy. If you argue that Government overspending, if
you will, nevertheless stimulates the economy, if you take that
amount of stimulation out that abruptly, is it likely that anything
else in equal amount could materialize to come in and fill that gap
that you would see?
Mr. VOLCKER. I do think we have to take that stimulus—it's got
pluses and minuses—out of the economy over a period of tim« if
the trade balance is going to improve, but we can't be unrealistic
about how fast that can take place. What's really important i* a
clear sense of direction on both of those fronts which are related
and not just a sense of direction for some trivial amount, but a
sense of direction that reflects some real quantities.
Senator RIEGLE. A significant change in direction.
Mr. VOLCKER. I don't know whether that's a good word or not. A
substantial change.
Senator RIEGLE. Substantial or whatever. I mean, it's got to fundamentally change the trend line. You've got to sharply decline
deficits rather than incline deficits.
Just a couple of other areas. In an article in today's Washington
Post about the latest tentative agreement here between Mexico and
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the IMF on the new loan program, it says that commercial banks
might be called upon to put up $5 or $6 billion in new money over
the next 2 years. It went on to say that the banks are under pressure from Secretary Baker and from yourself to get involved in this
in terms of coming up with the money, and that many were reluctant to do so because they felt that even they would reduce some of
their exposure and they may still feel overexposed and not have
much appetite for that additional lending.
FURTHER LOANS TO MEXICO BY BANKS
My question really is along these lines: Are we intending to put
pressure on the major or even the smaller banks to put money into
Mexico? Are they absolutely free not to do it if they wish? And
also, I'm wondering if we're doing this as a matter of national
policy? Clearly we are. Your whole statement about interdependence today I think really underscores that.
If we really need as a matter of national policy to extend additional credit to these countries, why shouldn't the Government, our
Government, do it, directly rather than force the banks either
grudgingly—some maybe willingly and some by gunpoint—to have
to come up with the money when they don't want to? Why run the
risk of impairing the balance sheets of the banks when we've got so
many in trouble anyway? If this is a matter of enormous national
self-interest, why don't we just face that and do it directly?
Mr. VOLCKER. Well, we do do some.
Senator RIEGLE. I'm talking about the increment here, though,
that apparently they're going to do.
Mr. VOLCKER. This whole program assumes—and this is not a
change in policy—some significant lending by the CCC for the purchase of our agricultural crops to Mexico, perhaps the Paris Club
agreement, and other lending by the U.S. Export-Import Bank as
well as other countries' export financing agencies to provide some
very significant assistance to Mexico in financing their exports. So
there is some direct assistance by the U.S. Government and by
other governments.
I think it's fair to say that those countries with great big surpluses now and a lot of capital to export, might want to look particularly carefully at that area.
Beyond that, all of us officially in the developed world, of course,
ultimately provide the support for the World Bank and for the
IMF. This larger role that the World Bank in particular is assuming is supported by the collectivity of governments in the industrialized world.
Finally, I don't think it's inappropriate that banks be asked by
Mexico to participate as part of this program. They have the loans.
They have a large stake. If the program is an effective one and
they think it's adequate, they ought to take some risks and participate in the program, given the amount of risk they already have
and their involvement in those countries and their eager lending in
the past. There is a common responsibility there. I don't interpret
that as putting pressure on those banks.
Senator RIEGLE. Are they free not to do it if they want to? I
mean, they're not going to hear from you or from Baker?
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Mr. VOLCKER. In the end, it's their decision. I think what tends
to put the pressure on, to use that word, is that if banks are going
to respond there is a strong sense of pressure or discipline to respond jointly, because there's obviously a problem if some banks
are asked to lend disproportionately more in relation to their exposure than another bank. So there's a certain discipline that works
through the system which is not unique. What's unique here is the
scale. But it's not unique with the situation they face with troubled
borrowers in an ordinary situation with a variety of creditors. You
don't solve those problems unless the creditors hang together and
take proportionate shares in whatever risks are involved. So you
have that problem here in spades, with hundreds of banks involved
all over the world, not just in the United States. That is the real
pressure on this situation.
Senator RIEGLE. Just one final thing. I raised this at the outset.
Your term runs for another 12 months. It ends in July of next
year. Is it your intention to remain through the end of the term?
Mr. VOLCKER. Well, I left myself some flexibility on that score
and I think I'll just leave it.
Senator RIEGLE. Well, everybody pays attention to what you say
especially in this setting, and I think the world economic people
are very much interested in that question and you may have to
leave it that way for your own reasons. I just want to say again
that I hope you will finish the term. In fact, I would hope the administration would think about asking you to stay beyond that,
which you might or might not be willing to do. I think the continuity and the stability and the sense of confidence that we need to
maintain here is a very high and critically important level, and I
think is rising because of all the problems that we've been discussing this morning, I think to get through this problem it's going to
take extraordinary skill, management, good judgment, and leadership—and that's in short supply.
So that's my thought on it.
Mr. VOLCKER. Well, I appreciate that confidence, Senator, and
I'm still here.
Senator RIEGLE. Good.
Senator PROXMIRE. Well, I want to add to that. I think you
should by all means accept another term and a term after that if
at all possible. If Don Riegle is President of the United States,
maybe you'll get that, but I think the prospects are not great, but
anything is possible.
Mr. VOLCKER. Well, I have no greater ambitions.
Senator PROXMIRE. Regardless of that, I want to say that I've listened to a lot of witnesses in 30 years, that you're frank, you're
direct, you don't duck, you don't dodge, you don't double-talk; you
answer frankly, and yet you don't get in trouble. That I can't understand. I have yet to hear any Diamond Don remarks from you
at all.
What I can't figure out, however, is how you can sit there smoking a cigar which undoubtedly is carcinogenic. You don't get
cancer. You don't have heart disease and you seem to go on and on
and thrive on it.
Mr. VOLCKER. I hope all those comments are justified.
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Senator PROXMIRE. Maybe we should find out what brand you
smoke.
Mr. VOLCKER, I just have faith that all those comments are justified. Sometimes I wonder, but I find these sessions useful in trying
to clarify my own thinking and understanding what's on your mind
and I appreciate your attention.
Senator PROXMIRE. Well, you certainly clarify our thinking.
Thank you very, very much.
The committee will stand in recess.
[Whereupon, at 12:40 p.m., the hearing was adjourned.]
[Response to written questions of Chairman Garn, Senators
D'Amato, Mattingly, Proxmire, Riegle, and Dixon follow:]
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RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN GARN FROM
PAUL A. VOLCKER
Question:
last fall.
Nominal interest rates have declined since
For real interest rates to fall, however, nominal
interest rates must fall faster than inflationary expectations.
While it is impossible to measure inflationary expectations directly, the sharp decline in commodity prices since last
year together with low measured rates of inflation this year
suggest that inflationary expectations may have declined even
faster than interest rates since last year.
In spite of the decline in nominal interest rates since
last fall, do you believe it possible that real interest rates
may have actually risen and, if so, given the relatively weak
economy thus far this year, shouldn't the Fed be pushing harder
to lower interest rates?
Answer:
Given the difficulties you note with respect
to the measurement of inflation expectations, one cannot state
with certainty what has happened to real interest rates.
There
is survey evidence, however, that indicates that expected rates
of inflation have fallen less than nominal interest rates over
the past year; moreover, the behavior of exchange rates, of
stock prices, and such interest-sensitive areas of spending as
housing is consistent with falling real rates.
Be that as it may, the question remains whether the
Federal Reserve should be "pushing harder to lower interest
rates."
As I indicated to your Committee, we are endeavoring to
pursue a policy that is conducive to noninflationary growth of
the economy.
But it is important to remember that monetary
policy is far from the only determinant of the course of economic developments, and there arc limits to what we can do to
encourage growth without sowing the seeds of future difficulties.
Our economy is suffering from serious imbalances that
cannot be overcome through monetary expansion; sound U.S. fiscal
policy and adequate growth of demand abroad clearly are two
critical ingredients to rectifying those imbalances.
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GARN—VOLCKER
Question: In recent years, Ml has been growing much
faster than nominal GNP and, as a result, Ml velocity has been
falling.
The Federal Reserve has sought to explain these
developments in terms of factors, such as the availability of
NOW accounts and lower interest rates, that have caused people
to want to hold larger money balances relative to their
spending.
An alternative explanation is that transactions (such
as the purchase and sale of financial instruments) which are not
included in GHP have grown faster than GNP. Transactions balances must be held against these non-GNP transactions, and when
velocity is measured as the quotient of GNP divided by Ml,
velocity appears to have fallen.
If this alternative explanation is correct, monetary
policy has not been as expansionary as would be suggested by the
rapid growth in Ml relative to GNP.
What is your view of this alternative explanation of
the decline in Ml velocity and its implications for monetary
policy?
Answer:
In principle, an increase In financial trans-
actions relative to GNP should add to the public's need for Ml
balances relative to GNP, thereby tending to reduce velocity.
The evidence suggests that in practice, however, a strong rise
in financial transactions probably has played only a minor role
in the recent strength of Ml.
A major reason may be that the
vast bulk of these transactions are undertaken by dealers,
institutional investors, and other agents that are quite efficient in their use of Ml balances.
One type of financial
transaction that likely had some impact — in part because it
involves the retail market—is mortgage financings.
The surge
in activity in this market probably boosted Ml growth to some
extent this year.
However, the decline in Ml velocity appears
largely to reflect other factors — especially th-.> decline in
interest rates, which has reduced the income sacrificed ir
nolding such highly liquid assets.
The Federal Reserve has
considered all of these influences on Ml in evaluating its
behavior.
80
RESPONSE TO BRITTEN QUESTIONS OF SENATOR D'AMATO FROM
PAUL A. VOLCKER
Question: Do you anticipate interest rate reductions
in Germany or "Japan?
Answer:
Interest rates have declined in Germany and
Japan over the past year, although not as much as in the United
States.
The decline in interest rates in Germany and Japan, and
to some extent elsewhere, have occurred in an environment of
greater price stability and relatively weak economic growth in
these countries, particularly growth arising domestically.
While I and others have indicated that it is in these countries'
interests, as well as the interest of the global economy, to
pursue economic policies that would generate adequate and sustained "home grown" economic growth, it remains the responsibility of the national authorities to decide how to achieve it.
Whether or not interest rates will decline further in the
near-term in Germany and Japan depends upon developments in
these economies more generally as well as upon policy choices
open to the authorities.
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2
D'AMATO—VOLCKER
Question: If Japan and Germany won't agree to follow
the U.S. lead and reduce their interest rates, how will the
coordination of economic policies as outlined in the Tokyo
Summit communique be achieved?
Answer:
The question of coordination of economic
policies among industrial countries extends beyond whether other
countries follow the lead of the United States.
Such policy
coordination in the end depends on an ongoing dialogue among
officials of the major industrial countries concerning their
assessments of economic performance and prospects in their
respective countries and a policy environment conducive to
achieving sustainable, non-inflationary growth in industrial
countries and narrowing imbalances among them.
Institutions and
fora for such coordination have existed and have been reasonably
effective for decades; with the political impetus derived from
the Tokyo Summit, efforts are being made to render them more
effective.
Given the increasing interdependence of the major
industrial countries, the effects of the actions or inactions by
one country on others are becoming increasingly important.
Authorities of the major industrial countries roust take into
account the effects on their own economies of economic conditions in their major trading partners and must similarly
recognize that their economic performance affects others.
Mutual awareness of this increasing interdependence over time
could lead to a better coordination of economic policies among
the industrial countries.
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3
D'AMATO—VOLCKER
Question: If interest rate reductions, combined with
the drop in the dollar, don't stimulate growth in the U.S., what
policy changes would you recommend?
Answer:
tion.
This is a very difficult, hypothetical ques-
It seems to me doubtful that declining interest rates and
the lower dollar would not have some stimulative effect, all
other things being equal.
At the same tine, I have repeatedly
emphasized the limitations on "easy money" and exchange rate
changes as a solvent for our economic difficulties.
We already
have clearly excessive debt creation in the United States and we
remain highly dependent on capital inflows from abroad.
Your
question does underscore the limitations of domestic demand
stimulus in addressing satisfactorily the major problems ve
face.
For example, a healthy solution to the problem of the
uneven pattern of economic activity associated with our trade
imbalance will require, in my judgment, healthy "home grown"
growth in other major Industrialized countries.
At the same
time, it is essential that we move forward with actions to reduce outsized federal deficits that have been intertwined with
our foreign imbalances. Clearly, there are other problems of a
structural nature, such as the Third World debt difficulties,
that require continued efforts on many fronts to assure their
satisfactory resolution.
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D'AMATO—VOLCKER
Question: The U.S., its allies, and the multilateral
development~banks just agreed to an emergency loan for Mexico.
Given the size of this commitment:
A.
Do you anticipate similar agreements for other oil-exporting
debtor nations?
B.
Are there enough funds to assist the other oil-exporters
such as Venezuela, Ecuador, Nigeria, Indonesia, gt: aj-?
C.
Do you see the oil price drop as temporary? Shouldn't these
debtor nations be forced to adjust (as the oil-producing
states in the U.S. are being forced to do) instead of
increasing already heavy debt burdens?
D.
Won't increased commitments to these large debtors restrict
the flow of funds (particularly concessional funds) to the
least-developed debtor nations?
Answer:
The bulk of the funds of the financial package
for Mexico is to come from international financial institutions
(the International Monetary Fund and the World Bank) and commercial banks.
The international institutions are currently suffi-
ciently liquid to provide the new lending for Mexico, while at
the same time remain able to meet calls on them by other potential borrowers, including other oil-exporting countries.
flow of nonconcessional
The
funds to the least-developed debtor
nations is relatively small and will not be restricted because
of new lending to Mexico.
The concessional lending for these
countries is provided by other international institutions and by
bilateral donors.
All oil-exporting countries are being adversely
affected by the decline in world oil prices.
However, the
impact on Mexico was particularly acute because of Mexico's
heavy reliance on oil revenue and its limited international
reserves.
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D' AMATO—VOLCKEH
The objective of the new financial arrangements for
Mexico is to support Mexican efforts to adjust to the reality of
lower oil prices.
In particular, the Mexican Government has
agreed to restructure its economy and, thereby, develop its
non-oil export sector and become less dependent on oil, and at
the same time, to continue to pursue complementary macroeconomic
policies, including reducing the budget deficit and curbing the
growth of consumption.
The increased borrowing on a moderate
scale is intended to limit somewhat the size of the immediate
adjustment for the Mexican economy without reducing its longerrun magnitude.
The outlook for oil prices is, of course, highly
conjectural.
85
RESPONSE TO WRITTEN QUESTIONS OP SENATOR MATTINGLY FROM
PAUL A. VOLCKER
Question! Assuming there is not sufficient time
remaining in the current session to pass comprehensive banking
legislation, would the Fed prefer a moratorium on the approval
of new "nonbank bank" charters as opposed to not addressing the
issue in any fashion before adjournment?
Answer:
The Board on numerous occasions has urged
Congress to adopt comprehensive legislation to deal with the
serious and urgent problems facing the depository institutions
industry, including the provision of new products and services
and the closing of loopholes that undermine the fundamental
structure and basic safety and soundness of the banking system.
The Board believes that these issues have been the subject of
extensive public hearings, testimony, and debate, and that a
sufficient record exists for Congressional action this year.
However, with the understanding that a short moratorium on new
nonbank banks (and with some limitations on the activities of
existing nonbank banks) cannot be an effective substitute for
more comprehensive action, such a moratorium would be clearly
useful as a prelude to the needed larger effort.
I would hope,
of course, chat a more comprehensive bill will be enacted at the
earliest possible time.
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2
MATTINGLY--VOLCKE R
Question: At a time when many financial institutions
are in severe financial straits, would the safety and soundness
of the country's financial system be threatened or adversely
affected by Congressional elimination or restriction of the
deduction for loan loss reserves?
Answer:
The taxation of loan loss reserves could have
a negative effect on the safety and soundness of the country's
banking system.
Banks might be discouraged from maintaining
loan loss reserves as large as they otherwise might have done
under current tax law.
The elimination or restriction of the
deduction of loan loss reserve provisions could increase the
costs banks incur in establishing and maintaining such reserves.
In particular, the ability of banks to retain and attract capital would be affected adversely by the five-year recapture
provision, which would subject 1985 reserve balances to
taxation.
I have stated to the Senate Banking Committee that, as
a regulator, I am in favor of measures that will encourage banks
to build up and maintain adequate loan loss reserves because I
believe this will promote their safety and soundness.
The in-
creased taxation of loan loss reserves is inconsistent with this
objective,
ha you know, however, the conference report does
change existing provisions in this respect.
87
3
MATTINGL Y--VOLCKER
?
uestIon: Some financial publications have speculated
ederal Reserve has tentatively agreed to approve the
controversial Citicorp application interpreting the phrase
"principally engaged" in the Glass-Steagall Act. Moreover, they
allege the Fed will delay a formal decision until Congress adjourns to avoid incurring the wrath of the legislative branch.
What is the status of the Citicorp application? Will you provide the Committee with the minutes of any discussions on the
issue? How many other bank holding companies have submitted
similar applications?
Answer:
The Board has discussed Citicorp's current
application to underwrite and deal in certain securities on the
basis that it would not be "engaged principally" in that
activity under Section 20 of the Glass-Steagall Act on three
occasions:
May 13 and December A, 1985, and March 28, 1986.
The Board has not, however, reached a decision on the
application.
While the application has not yet been rescheduled
for Board consideration, the Board has also made no decision to
delay reaching a determination until after Congress
adjourns.
In addition to Citicorp's application, J.P. Morgan &
Co., Incorporated, and Bankers Trust New York Corporation have
filed applications to underwrite and deal in certain securities
on the basis that they would not be "engaged principally" in
that activity within the meaning of Section 20 of the GlassSteagall Act.
With regard to the minutes of those meetings, the
Board's practice has been not to release minutes prior to final
Board action on an application, because such release could
prejudice the Board's decisionmaking process on the application.
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MATTINGLY—VOLCKER
Question: Last November I introduced legislation,
along with Sen". Bill Bradley, to establish U.S. policy on exchange rates and. developing country debt. This legislation was
also incorporated into the bipartisan Trade Enhancement Act, S.
1860.
Sen. Bradley, in the meantime, has criticized the ineffectiveness of the so-called "Baker Plan" on Third World debt
and has proposed a plan to cut interest rates as well as forgiveness of a certain percentage of the debt. Mr. Volcker, you
have in the past rejected proposals that call for cancellation
of Third World debt; would you please, for the record, comment
on Sen. Bradley's proposal?
Answer:
The "Bradley Plan" entails no new bank
lending, although it does provide substantial amounts (some $3
billion per year) in increased multilateral development bank
lending.
Senator Bradley is opposed to solutions that involve
new bank debts.
Instead, his plan calls for interest rate
relief (3 percentage points for three years) and principal forgiveness (3 percent of outstandings for three years) from both
commercial bank and official creditors.
These figures, however,
are targets to be negotiated each year and are to be conditional
on the debtors making certain structural adjustments.
The "Baker Plan" involves a significant amount of new
bank lending and in that respect appears to be the opposite of
what Senator Bradley wants.
However, it should be pointed out
that both the Baker Plan and the Bradley Plan have much in common, including the objectives o£ structural adjustment and
growth in the debtor countries and more support from the
multilateral development banks.
Taking the recently announced Mexican program as an
example of the Baker Plan approach, banks are expected to provide some $6 billion in net new lending to the public sector
over a two-year period.
In contrast, the interest rate relief
granted to Mexico under the Bradley Plan, that is, external
89
5
MATTINGLY—VOLCKER
interest payments that would not have to be made, would amount
only to $2 billion per year, assuming all Mexican public sector
and publicly guaranteed bank debts were affected.
From the
point of view of balance-of-payraents financing, the forgiveness
of principal involved in the Bradley Plan is irrelevant—other
than the extra boost to interest relief that it contributes,
which is included in the above figure—since no amortization of
bank debts is included in the Mexican program.
Quite aside from the amount of external finance
provided by the two approaches, there is the fundamental question of how Senator Bradley 1 s proposal could be implemented.
How would consensus be reached at the "summit" among the representatives of the banks, the official creditors, and the World
Bank?
What mechanism could be used to induce or force the banks
to provide the concessions?
What would be the implications for
the debtors' future access to credit markets?
How would the
summit effectively discriminate among the deserving and less
deserving borrowers?
In my opinion, Senator Bradley's plan does not appear
to be a practical or even desirable approach.
It provides less
immediate help on balance-of-payments financing than does the
approach outlined in the Baker Plan.
Moreover, the help that
the Bradley Plan does provide--assuming that somehow the parties
involved could agree on how to implement it for specific
countries—would come in a way that affects adversely banks'
financial health and probably would hamper the debtor countries'
90
6
MATT INGLY—VOLCKER
access to commercial bank credits in the future.
Restricted
access to bank finance—including trade credits and interbank
lines—would be a high price for the middle-income developing
countries covered by the Baker Plan to pay for the amount of
debt relief envisioned by Senator Bradley.
Finally, I believe
it would be very difficult, in the framework proposed, to in
fact discriminate among borrowing countries as to the amount and
nature of interest rate relief, raising a question about the
efficacy of the approach in achieving its reform objectives.
Question: We are seeing some signals that perhaps the
U.S. economic recovery is not as robust or sustainable as we had
predicted. What steps is the Fed prepared to take or endorse to
encourage, for instance, business growth? How real a threat is
inflation if adjustment "policies" are adopted?
Answer: The economic expansion has been somewhat weaker
this year than many had hoped or expected.
It is against this
backdrop, including favorable price performance, that the
Federal Reserve has pursued an accommodative monetary policy.
Although we believe that many ingredients ot stronger
business expansion are in place, there are obvious strains and
uncertainties in the economy today, and we shall have to continue monitoring developments closely to judge what further
steps, if any, are needed.
I believe that your question
correctly calls attention to the fact that, while price pressures seem on the whole well-contained at present, we must be
careful to avoid reinvigorating inflation down the road through
monetary excesses.
This underscores the importance of bringing
a comprehensive approach to the achievement of our economic
goals, including sound U.S. fiscal policy and policies abroad
that promote satisfactory growth in the other industrialized
economies.
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MATTINGLY—VOLCKER
Question: Yesterday's agreement between Mexico and the
InternationaTTEonetary Fund is being hailed as the first successful application of the "Baker Initiative", You were, I
believe, instrumental in crafting the loan package. There are
estimates that Mexico will now need as much as $6 billion in new
commercial bank loans over the next two years for the package to
succeed. Commercial banking interests have been, and I believe
rightly so, reluctant to expand in any way their exposure among
the developing debtors. With regard to Mexico specifically,
commercial banks are owed over $75 billion. Can the banks
reasonably expect to recover the majority of this debt and, if
not, what incentive is there for them to follow the lead of the
IMF and the Treasury Department and make new loans? Wouldn't it
make better sense for commercial banks to resign themselves to
writing off a certain portion of this debt? It seems like we
are left to make the decision which is the lesser of two evils.
Answer:
There are circumstances under which some
additional new lending can preserve the value of existing loans.
This seems particularly to be the case for the new money that
Mexico's commercial bank creditors are expected to lend to
Mexico in the next two years as part of the recently announced
package.
The new loans will be used to support a comprehensive
program of policy measures aimed at achieving macroeconomic
stability, structural adjustment, and sustainable economic
growth in Mexico.
Assuming they are successful, these measures
will protect the value (and ultimate collectibility) of Mexico's
existing bank debts.
Thus, it seems to me reasonable that a
bank reach the judgment that it is in its own self-interest to
support Mexico's economic and financial program by some new
lending.
The key is, of course, the prospects for the Mexican
economy, given the reform measures undertaken.
92
RESPONSE TO WRITTEN QUESTIONS OF SENATOR PROXMIRE FROM
PAUL A. VOLCKER
Question: In July of 1984 when you testified before
this Committee you said that high interest rates in the United
States, which were partly the result of the big federal budget
deficit, had raised the value of the U.S. dollar, thereby
hurting out exporters and boosting foreign imports to this
country. I agree with you.
In the last year the dollar has fallen dramatically
against the yen, Deutschmark, franc and pound. Yet the U.S.
still has massive budget deficits. Were we wrong in 1984 in
attributing the over-valued dollar to our irresponsible budget
deficits? Are such budget deficits still a major cause of our
still growing trade deficit and if so how?
Answer:
I do not think we were wrong to attribute much
of the rise in the exchange value of the dollar to our massive
federal budget deficits.
These deficits contributed signifi-
cantly to the strong growth of demand In this country and to a
level of domestic interest rates higher than they would otherwise have been.
Essentially, these interest rates attracted
savings from abroad that helped to finance our budget deficits,
but in the process the exchange rate for the dollar was bid up.
The high value of the dollar and the strong growth of domestic
demand resulted in the high trade and current account deficits
we have been experiencing.
While our budget deficit persists at a high level, the
economic environment has changed.
Inflation rates have come
down markedly from rates earlier in the 1980s, real economic
growth has slowed, and interest rates have declined substantially.
The exchange rate for the dollar, too, has declined, by
about 30 percent from its peak in early 1985 (as measured on a
multilateral-trade weighted basis).
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2
PROXMIRE—VOLCKER
The decline in the dollar's value will tend to reduce
our trade deficit, but the lags in that process are considerable
and somewhat uncertain.
The trade deficit will come down faster
and further if growth of domestic demand in other major countries were to strengthen.
I might note, however, that as long
as our budget deficits persist, the inflow of capital from
abroad that is the counterpart to our current account deficits
is to some extent welcome.
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3
PROXMIRE--VOLCKER
uestioni On pages 14 and 15 of your prepared state§
iscuss the international debt problem. On June 25 our
Committee had a hearing on that problem and it became clear that
there are major differences of opinion between the more exposed
and the less exposed banks about how each should deal with their
exposure in various LDC countries. A witness from one large
bank noted, for example, that the less exposed banks might well
prefer to write the debt off while those with more exposure
could not afford to do that. A witness for a smaller bank noted
that "many smaller banks might prefer to drastically lower interest rates rather than contribute new funds." Is there such a
split between the larger and smaller banks on how to deal with
the debt problem?
Answer:
I believe there is an underlying community of
views on the kinds of responses to international lending problems that are in the long-term interests of lending banks and
major international borrowers.
The lending institutions as well
as borrowing countries have a large stake in returning to an
environment in which the creditworthiness of borrowers can be
maintained.
Given the large number of banks holding claims on major
international borrowers facing debt-servicing problems, however,
it is not surprising that there exist specific differences of
views among creditors on how to deal with debt problems.
These
differences of views cut across the size of banks and reflect
their exposure to particular debtor countries and also reflect
the financial condition and management position of the banks.
Despite such differences, however, it is noteworthy that over
the past four years the commercial banks as a group have found
it in their overall interest to formulate financial arrangements
that provide net new money and restructuring of outstanding debt
for a wide range of borrowing countries.
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PROXMIRE—VOLCKER
Moreover, widespread expressions of support for the
Initiative announced by Secretary Baker last fall have come from
banks of all sizes and countries.
There seems to be general
agreement on the need for Secretary Baker's plan for dealing
with debt problems through a program for sustained growth
involving new loans to borrowing countries over a three-year
period from multilateral institutions and commercial banks.
Baker Initiative continues to offer the best approach for improving the ability of debtor countries to meet their international obligations while at the same time satisfying their
domestic needs for economic growth.
The
96
5
PROXMIRE--VOLCKER
Question:
Has the Fed discarded M-l?
Your statement and report indicate that M-l will be
given less attention than the other monetary aggregates.
Indeed, some observers have concluded the Fed has decided to
virtually ignore M-l as a relevant nonetary target.
For example, in the first week of July, M-l increased
by a whopping $7.4 billion or more than 1 percent. This would
produce an annual growth rate of over 50 percent if continued.
Would it be correct to conclude that the Fed is no
longer paying any attention to M-l as a monetary target?
Answej":
The Federal Reserve is placing less emphasis
on Ml as a guide for monetary policy, but the growth of this
aggregate continues to be evaluated in the conduct of policy.
The episodes of surprisingly rapid growth of Ml relative to
nominal GNP--that is, unusual declines in velocity—that have
occurred in the 1980s have raised the degree of uncertainty
surrounding the interpretation of this monetary aggregate's
behavior.
As a result, the behavior of Ml is being judged in
light of movements in the other monetary aggregates, and against
the background of developments in the economy and financial
markets more generally.
Concerning the Ml increase in the week of July 7, the
Federal Reserve statistical release in which such data are
published has indicated for some time that "special caution
should be taken in interpreting week-to-week changes in money
supply data, which are highly volatile and subject to revision."
In the subsequent week, for example, Ml fell nearly $1 billion,
highlighting the range of week-to-week changes and the pitfalls
of extrapolating weekly Ml growth.
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PROXMIBE—VOLCKER
Question: There are times when I think the concept of
velocity is a magic wand that covers up a multitude of sins by
the Federal Reserve. You refer to changes in velocity as reflecting changes in the public's demand for money balances. But
it also reflects changes in the willingness of the Federal
Reserve to supply more money balances. Indeed, a supply-side
focus on velocity leads to the conclusion that the Federal
Reserve is pursuing a dangerous and highly inflationary policy.
After all, the change in velocity is nothing more than
the difference between the growth rate of the money supply and
nominal GNP. If the Fed decides to supply a lot of new dollars
in excess of nominal GNP growth, we will see a sharp decline in
velocity as happened over the last 12 months.
How can we be sure the decline in velocity really stems
from the public's demand for more dollar balances and not to the
Fed's excessive supply?
Answer:
This is really a rather central question in
terms of the conduct of monetary policy.
Clearly, the implica-
tions for the economy are quite different if we are, in essence,
causing the supply of money to expand faster than the demand
rather than meeting a rapidly expanding demand for money associated with a falling return on money balances in an environment
of moderate growth and diminishing inflation.
Obviously, as
discussion of the events and our economic forecasts indicate, we
believe that what has been going on is more the latter than the
former.
In arriving at that judgment, we look at many bits of
information, including the patterns of money behavior.
But
prudence dictates that such a judgment must be regarded as only
tentative, and we shall remain vigilant as additional evidence
accumulates about the effects of our actions.
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PROXMIRE—VOLCKER
Question: In your statement, you mentioned that the
real economic growth rates of West Germany and other major countries have lagged behind U.S. growth rates, contributing to our
massive trade deficit. And yet, no amount of persuasion by us
seems to have been able to get these countries to pursue more
stimulative economic policies.
If that is the case, it raises serious questions about
the ability of the major countries to manage exchange rates. As
you know, a reasonable amount of economic policy coordination is
an essential precondition for reducing exchange rate fluctuations.
What is being done in the Federal Reserve and the
Treasury to strengthen the machinery for economic coordination
among the major trading nations?
Answer:
I believe the machinery for economic coordina-
tion among the major trading nations is not lacking.
U.S.
officials, both from the Treasury and the Federal Reserve, have
had for decades ongoing contact with their counterparts in the
major industrial countries, both in bilateral meetings and in
multilateral fora where ways to achieve disciplined and complementary domestic policies among the leading nations are
discussed.
While at times the direct results of these discus-
sions are not apparent, over time the awareness of the effect of
the economic performance and economic policies of each country
on others is taken into account in the formulation of policies.
What seems to be lacking now is a common judgment about
what policy actions are necessary abroad or, indeed, whether any
policy actions are necessary to yield a satisfactory growth of
domestic demand.
No policymaker can be expected to pursue poli-
cies that he or she does not deem to be in the country's own
best interest.
The further question, for the United States and
others, is whether those judgments properly take into account
the indirect influences on the world economic environment, which
in turn influence the sustainability ot domestic policies.
is in this area that methods for achieving an international
consensus are important.
It
99
RESPONSE TO WRITTEN QUESTIONS OF SENATOR RIEGLE FROM
PAUL A, VOLCKER
Question: It is widely considered that a western
economic growth rate of at least 3 percent is necessary to prevent an aggravation of the Third World's debt problems and to
head off a further rise in western unemployment.
Economists at the Organization for Economic Cooperation
and Development in Paris now doubt whether their bellwether
prediction that the world will just reach the magic 3 percent
threshold this year can now be realized. Certainly the economic
picture in Japan, Germany and the United States is not encouraging at the moment.
*
What happens to the Third World's debt problems — and how much
is that problem aggravated"if the western economic growth
rate does not reach at least 3 percent?
*
How much of a rise can we expect in western world unemployment?
Answer:
The debtor countries need a global economic
environment that will provide them the assurance that they could
earn enough export revenue with which to meet import requirements and to service their debt obligations.
I do not think 3
percent is a magical figure that must necessarily be met every
year to provide such an environment, but it is entirely true
that sustained and reasonably vigorous economic expansion in the
industrial countries over time is a key ingredient in dealing
with the debt problem.
The expansion in the major industrial
countries in the first half of the year has been disappointing,
and has made it more difficult for developing countries to earn
foreign exchange.
However, most debtor countries, with the
notable exception of the large oil exporters, have continued to
make progress in dealing with their debt problems.
That effort
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2
RIEGLE—VOLCKER
will need to be supported by more adequate growth in the
industrialized world.
Because of the relatively slow growth in foreign
industrial countries, they have made only limited progress in
reducing the high rates of unemployment that have been recorded
in recent years, and in some cases unemployment rates have
actually increased slightly.
Without an acceleration of growth
in these countries, the prospects for a significant reduction in
unemployment rates is not favorable.
Question: What happens to the United States economy if
we do not get the faster growth in key foreign economies that
you say is desirable?
Answer:
Sooner or later the U.S. external position
will have to improve.
Heavily indebted developing
also need to avoid large external deficits.
countries
The other side of
the coin is that very large surpluses of some countries cannot
reasonably continue to grow and thus provide support to their
economic expansion.
Consequently, adjustments in these external
positions must be made. It is preferable that these adjustments
'take place by increasing our exports and those of the developing
countries in the context of a healthy and growing world economy.
The alternative inight well mean that external imbalances will be
reduced in an environment of a relatively weak U.S. and world
economy, a self-defeating process.
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RIEGLE—VOLCKER
Question: In your statement you indicate that "there
is some concern over the transitional effects of tax reform
legislation."
What do you see as some of the short- and long-terra
effects of the tax reform legislation we are currently considering and how is our economy likely to be affected in the short
and longer term by passage of this legislation?
Answer:
As comprehensive a tax restructuring as is
currently being considered obviously will significantly alter
the context in which many economic decisions are made.
I don't
think anyone can predict with precision all of the ramifications
of such action; certainly I don't feel I have the necessary
expertise.
In the comment about "transitional effects" I had in
mind a number of phenomena, including the influence on business
decisions of the current uncertainty about the structure and
timing of the tax changes, and the possibilities that spending
may be shifted forward or delayed as a consequence of the
phasing in of the reform measures, among other things.
Question: There has been much concern expressed about
the impact of the Senate tax reform bill in existing real estate
partnerships, many of which have issued mortgages held by commercial banks and savings and loan associations. Has the
Federal Reserve Board conducted any studies or otherwise considered how banks and savings and loan associations could be
affected by the retroactive application of the provisions of the
Senate tax bill, including the so-called passive rule, particularly as they would apply to those partnerships with staged
payments of the equity?
Answer:
units
We are aware of the possibility that many
in the economy will be affected—some positively, some
negatively—by changes in the tax laws that they did not anticipate when they made investment and financing decisions.
It is
unlikely that any set of transition rules is going to be able to
prevent all such effects.
We do not have any specific "studies"
of the partnership rules to which you refer.
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Question: A great deal of Importance for your projections regarding future inflation and consumer spending seem to
be based on low energy prices.
Haven't we seen a bottoming out of energy prices and
aren't they far more likely to go up than down—and if they do
go up, what are the likely implications for the economy?
Answer:
I can't tell you what will be happening to the
price of oil in the months ahead, although I would agree that
the low prices reached a few weeks ago are not likely to be
sustainable over a long period of time, given the
for both consumption and exploration.
implications
If the price of crude
were to move back up moderately—as it has in recent weeks—
retail gasoline and fuel oil prices would presumably come under
upward pressure but the prices of natural gas and electricity—
competing energy sources—do not yet fully reflect the drop in
oil prices.
Obviously, if there were to be a major retracing of the
oil price decline, it would—as you suggest—sharply alter the
inflation outlook in an unfavorable direction.
The effects on
spending and output are a more complex matter, as the experience
of the first half of 1986 amply demonstrated, and much would
depend in the short run on the degree of certainty people had
about the stability of any energy price level.
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Question: How concerned are you that "the personal
saving rate has remained at an historically low level" and what
will be the likely effects of such low savings rates during the
next recession, or downturn in the business cycle?
Answe r:
I am concerned about the low personal saving
rate from a number of standpoints, including particularly the
implications for spending should income grow wore slowly or even
decline.
The low saving rate has been mirrored in an enormous
expansion of household indebtedness, which I believe is a point
of potential vulnerability for the economy generally.
One can
question whether, in such circumstances, consumer spending would
show the kind of buoyancy that it has in past recessionary
episodes.
Question: Do you expect activity in the housing market
and the strength of consumer spending to continue and possibly
accelerate in the second half of 1986?
Answer:
I think there are good reasons to expect con-
tinued strength in these areas of the economy in the near term.
Real income growth has been strong thus far this year, spending
attitudes are very favorable, judging by the survey evidence,
and interest rates have declined substantially.
However,
healthy growth in the economy over time will require a firming
in business investment and an improvement in our trade position.
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Questi_gn: In the past you and other bank regulators
have expressed considerable concern about the adverse impact of
low energy prices on banks in the Texas, Oklahoma, Louisiana and
Southwest region of the country.
*
What ca-. you tell us about the overall condition of the banks
in this area of the country since you last testified before
us on the subject on May 13th?
Answer:
Banks in the Southwest are generally con-
tinuing to operate under conditions of considerable stress.
The
problems at these banks stem primarily from the depressed condition of the energy industry.
Given the sharp further decline in
energy prices that has occurred this year, asset quality problems in energy loan portfolios have intensified.
Moreover, in
all too many cases, problems have spread increasingly to real
estate and other loans as well, reflecting in part the adverse
impact of the energy price decline on the entire economic
infrastructure of the Southwest.
Such problems have prompted many banks in the region to
add heavily to their provision for loan losses.
they have suffered poor earnings.
In so doing,
From the last quarter of 1985
through the second quarter of 1986, most of the largest institutions in the region, and many of the smaller ones, have reported
at least one quarterly loss.
In the second quarter alone, three
of the largest banking organizations in the Southwest posted
losses ranging from $29 million to $281 million.
Economic problems in the Southwest are also manifested
in the number of bank failures.
Through July 25, 1986, twenty-
three banks had failed this year in Texas, Oklahoma, and
Louisiana.
These accounted for some 29 percent of total bank
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failures and 56 percent of the assets of all failed banks
throughout the nation.
The recent failure (July 14, 1986) of
First National Bank and Trust Co., Oklahoma City, Oklahoma, a
$1.6 billion subsidiary of First Oklahoma Bancorp, was the
largest failure this year and the second largest in U.S.
history.
The road ahead poses serious challenges for banks in
the Southwest.
The organizations have been facing up to these
challenges, by building loan loss reserves and by taking other
measures, but adjustment to the sharply changed economic circumstances will continue to be quite difficult.
As you know, a
strong federal support apparatus is available to cushion and
contain these strains, to protect depositors, and to avoid
secondary repercussions.
At the same time, I hope the Congress
acts this year to deal with emergency interstate bank acquisitions to help reinforce the tools available to us.
Question: Venezuela recently approved a law that would
convert into government issued bonds about $7 billion owed to
foreign creditors by private Venezuelan borrowers. The bonds
would bear a fixed annual interest rate of 5 percent, well below
the banks' cost of funds.
*
Venezuela in the past has been one of the more reliable
debtor countries and 1 #m wondering if this is the beginning
of a pattern on the part of the debtor countries to pay off
less of their debt?
Answer:
The recent action by the Venezuelan Congress
converting debt into bonds is currently being reexamined in
Venezuela.
1 am very hopeful that Venezuelan authorities will
find ways to redesign this legislation to meet the Venezuelan
objective of spreading out the debt-servicing obligations of
private Venezuelan borrowers while at the same time respecting
the rights of Venezuelan creditors in a responsible manner.
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RIEGLE—VOLCKER
Question: What, if anything, do you believe should be
the obligation of the Japanese, in light of their huge trade
surplus with the United States, and their limited spending for
defense, to increase their capital contributions to the lesser
developed indebted countries?
Answer:
By definition, a country that runs a current
account surplus also runs as a counterpart a capital account
deficit.
Thus, the huge current account surpluses that Japan
has been recording are matched by equally large net capital
outflows, to both industrial and developing countries.
Private Japanese investors, like investors everywhere,
base their investment decisions primarily on expectations of
yields and other financial arid safety considerations.
The
amount of Japanese capital flows to the developing debtor countries on the whole is determined by similar considerations.
However, Japanese banks have recognized their responsibility to
help support appropriate adjustment efforts in financially
strained developing countries, and have participated in the
various financial packages that have been arranged for individual debtor countries.
Moreover, the Japanese Government,
including entities such as Japan's Export-Import Bank, have
negotiated special lending programs to particular borrowing
countries.
Those and further efforts by a country with an
enormous current account surplus appear entirely appropriate in
reducing the disturbing effects of that surplus on the world
economy and helping to deal with particular points of strain.
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Question: In the past monetarists have been quick to
point out the relationship between growth of the economy and
growth of the money supply, but that relationship no longer
seems to be there.
*
How do you account for the confused readings we are now
getting and what are the implications for future monetary
policy of the economy's listless performance on the one hand
and the money supply's explosive growth on the other?
In terms of setting monetary policy, it seems to me
that spotting and monitoring the money that matters the most hss
become increasingly difficult.
*
How would you define the money that matters the most?
M-l? M-2? M-3? Or some new variation?
Ariswer:
Is it
A major factor boosting the growth of Ml
relative to income has been sizable declines in market interest
rates, which make it less costly—in terms of interest foregone—for the public to hold such liquid assets.
The sen-
sitivity of Ml to interest rate movements in recent years
probably has been heightened by deposit deregulation and the
spread of corporate cash management techniques.
Consequently,
the relationship of Ml to economic activity, prices, and interest rates remains quite uncertain at this time, and a firm
conclusion regarding the properties of the behavior of this
aggregate in an evolving institutional and economic setting
probably will require considerably more experience.
The broader monetary aggregates, which encompass many
of the shifts between liquid and less liquid assets, have behaved more in line with their historical patterns, although they
are currently also growing somewhat faster than nominal GNP.
Both M2 and M3 are within their current target ranges, and
maintenance of growth within their ranges for 1986
and 1987 is
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believed to be consistent with a pickup in the pace of economic
activity from that of the first half of this year.
The behavior of all the traditional measures of money,
though, at times has been substantially affected by financial
innovations and deposit deregulation.
And, while research con-
tinues on alternative measures of the money stock, even with
refinements, they too probably will be subject to many of the
same influences.
In this environment, the implementation of
monetary policy has involved continuing appraisal of the relationships among all the various measures of money and credit,
their velocity trends, indicators of economic activity and
prices, as well as conditions in domestic credit and foreign
exchange markets.
So, in a sense, what "matters the most" is
not a single measure of money, but rather the monetary aggregates collectively viewed in a broader context.
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RIEGLE—VOLCKER
Question: Recently one of your fellow Board members
(Rice) gave a well-publicized speech entitled "Is Inflation
Licked?". He concluded that the answer was "No" and warned that
continued attention should be paid to this issue. He noted
among other things that apart from energy, actual inflation
rates still are in a range that, only a decade and a half ago,
were viewed as being so intolerable that they led to a program
of extensive wage and price controls.
*
What are your views on whether inflation is likely to be a
problem within the next 1 to 2 years?
Answer:
It clearly is the case that our recent, highly
favorable price performance has owed much to the extraordinary
drop in oil prices.
As those prices level off or rebound, and
as we absorb the impact of the lower dollar, some pickup in
recorded inflation is highly likely, as Is suggested by the
forecasts of the Board members and Reserve Bank presidents in
our report.
Looked at another way., a broad range of important
prices, particularly in the service area, have continued to rise
persistently, lending an underlying inflationary momentum to the
economy.
I do believe that we have made solid progress in the
fight to achieve and maintain reasonable price stability, but
recent trends provide no grounds for complacency.
Certainly the
need to build on past progress in keeping the underlying trend
of inflation down must remain a prime objective in considering
appropriate monetary policy.
By its nature, the inflationary
process tends to perpetuate itself.
The price Increases antici-
pated over the next year or two as we absorb higher impoit costs
and oil prices level off or rebound may be moderate and
temporary, but that will be true only if policy remains alert to
the danger.
110
RESPONSE TO WRITTEN QUESTIONS OF SENATOR DIXON FROM
PAUL A. VOLCKER
Question: Mr. Chairman, the conference on the tax
reform bill is now underway. Earlier this year, you expressed
your concern over efforts to tax bank loan loss reserves. Do
you continue to be opposed to taxing loan loss reserves?
Bank failures are at a record rate. The rate of return
for banks is falling, and banks are under increasing pressure to
raise more capital. Can you tell the Committee what the impact
on the banking system would be if loan loss reserves were taxed?
Answer:
As I responded to the question posed by
Senator Mattingly, the taxation of loan loss reserves could have
a negative effect on the safety and soundness of the country's
banking system.
Banks might be discouraged from maintaining
loan loss reserves as large as they otherwise might have done
under current tax law.
The elimination or restriction of the
deduction of loan loss reserve provisions could increase the
costs banks incur in establishing and maintaining such reserves.
In particular, the ability of banks to retain and attract capital would be affected adversely by the five-year recapture
provision, which would subject 1985 reserve balances to
taxation.
I have stated to the Senate Banking Committee that, as
a regulator, I am in favor of measures that will encourage banks
to build up and maintain adequate loan loss reserves because I
believe this will promote their safety and soundness.
The in-
creased taxation of loan loss reserves is inconsistent with this
objective.
As you know, however, the conference report does
change existing provisions in this respect.
@FedFRASER