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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1988
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND UKBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDREDTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
JULY 12 AND 13, 1988
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1988
For sale by the Superintendent of Documents, Congressional Sales Office
U.S. Government Printing Office, Washington. IX: 20402
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
WILLIAM PROXMIRE, Wisconsin, Chairman
JAKE GARN, Utah
ALAN CRANSTON, California
DONALD W. RIEGLE, JR., Michigan
JOHN HEINZ, Pennsylvania
WILLIAM L. ARMSTRONG, Colorado
PAUL S, SAKBANES, Maryland
CHRISTOPHER J. DODD, Connecticut
ALFONSE M. D'AMATO, New York
ALAN J. DKON, Illinois
CfflC HECHT, Nevada
PHIL GRAMM, Texas
JIM SASSER, Tennessee
CHRISTOPHER S. BOND, Missouri
TERRY SANTORD, North Carolina
RICHARD SHELBY, Alabama
JOHN H. CHAFEE, Rhode Island
BOB GRAHAM, Florida
DAVID K. KARNES, Nebraska
TIMOTHY E. WIRTH, Colorado
KENNETH A. MCLEAN, Staff Director
LAMAR SMITH, Republican Staff Director and Economist
PATRICK A. MULLOY, General Counsel
ROBERT A. JOHNSON, Chief Economist
GILLIAN GARCIA, Director of an Economic Analysis Group, GAO
(ID
CONTENTS
TUESDAY, JULY 12, 1988
Page
Opening statement of Chairman Proxmire
Opening remarks of Senator Riegle
Opening statement of Senator Sasser
1
3
64
WITNESSES
Alan S. Blinder, professor of economics, Princeton University
Fed has done an excellent job
Fiscal-monetary transition
Monetary indicators
Prepared statement
Rudiger Dornbusch, professor of economics, Massachusetts Institute of Technology
Inflation
Changes in the world trade structure
Prepared statement
Ray Fair, professor of economics, Yale University
Fed policies and political forces
Prepared statement
David D. Hale, first vice president and chief economist, Kemper Financial
Services, Inc
Weakness of the dollar
Exchange rate policy
Prepared statement
Panel discussion:
Fed can prevent recessions
Influence of international markets
Recession
External economic events
Budget deficit
Recommendations about the thrift industry
Third World debt
3
3
4
5
7
14
14
15
17
27
28
30
33
34
35
37
61
63
65
67
72
72
74
WEDNESDAY, JULY 13, 1988
Opening statement of Chairman Proxmire
Opening statements of:
Senator Dixon
Senator Chafee
'.
Senator Sasser
77
79
79
102
WITNESS
Alan Greenspan, Chairman, Board of Governors, Federal Reserve System
Economic setting and monetary policy so far in 1988
Economic outlook and monetary policy through 1989
Persistent U.S. external and fiscal imbalances
Appropriate tactics for monetary policy
Prepared statement
Response to written questions of:
Senator Proxmire
Senator Riegle
tun
80
81
81
83
85
89
124
165
IV
Response to written questions of—Continued
Senator Sasser
Witness discussion:
Living beyond our means
Rise in interest rates
Fiscal readjustment plan
Avoiding a recession at all costs
Federal Reserve policy and Third World debt
Current account deficit and import of foreign capital
Exchange rates
Discount rate
Bailout of S&L's
Gasoline tax
Page
169
100
103
109
110
Ill
113
116
118
120
121
ADDITIONAL MATERIAL SUPPLIED FOE THE RECORD
"A Way to Free Small Savers From the 'Casino Society'," by Alan S. Blinder,
Economic Watch, Dec. 8, 1986
"Risks in the Dollar's Rise," Financial Times, July 2, 1988
13
176
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1988
TUESDAY, JULY 12, 1988
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING,
AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10:15 a.m., in room SD-538, Dirksen
Senate Office Building, Senator William Proxmire (chairman of the
committee) presiding.
Present: Senators Proxmire, Riegle, Sasser, Graham, Garn,
Hecht, and Bond.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. This morning we meet to discuss the outlook for
the U.S. economy and the appropriate course for monetary policy
in the coming months. We have before the committee, a panel of
experts on monetary and macroeconomic policy: Dr. Alan Blinder,
chairman of the Department of Economics at Princeton University;
Dr. Rudiger Dornbusch, professor of economics at Massachusetts
Institute of Technology; Dr. Ray Fair, professor of economics at
Yale University; and David Hale, first vice president and chief
economist at Kemper Financial Services. Gentlemen, thank you for
appearing before us today. We certainly do need expert guidance in
these difficult times.
The U.S. economy is undergoing a profound transformation from
an economy based on consumption-led growth to an export-led
growth economy. On the one hand capacity utilization is high and
labor markets are increasingly tight. Both of these indicators suggest that inflation is beginning to reemerge. Fears of more vigorous
inflation and a precipitious decline in the dollar make easing of
monetary policy quite risky.
On the other side, huge accumulations of debt make our financial system quite fragile. Business debt, Government debt, and consumer debt, have all soared in recent years. The debt accumulation, the crisis in the Savings and Loan industry, problems of debt
service in Latin America, and the agricultural crisis combine to
raise the costs associated with a further significant rise in interest
rates.
In addition, pur Federal debt is now so large that a percentage
point increase in the interest rate can add as much as $20 billion to
the deficit over 2 years through a rise in debt service alone.
(1)
All appears calm at the moment. I fear that calm is precisely
that—momentary. The dollar is rising despite our continued massive trade deficit. The Federal Reserve has gradually raised rates
since March and the last couple of trade statistical announcements
have been good news. But what will happen when the next disappointing trade number is announced? What will happen as institutional investors begin to reallocate their assets later this summer,
each trying to beat the market to the draw before the new administration changes the course of macroeconomic policy?
Our Nation's central bank is between a rock and a hard place.
The appropriate remedy to our macroeconomic imbalance is Federal budget deficit reduction. Hopefully, the Congress and the President will find the will to address that problem very early in the
next administration. Its resolution is long overdue.
What I fear is that the overhang of problems in our economy and
the Presidential election, when all 6 members of the Federal Reserve Board are Republican Reagan appointees, will lead the Fed to
be insufficiently strong in fighting inflation. This lack of will to
face inflation at the outset will not remedy our structural problems, it will only postpone them.
Avoiding the battle against inflation will lead to a rise in prices
that will be very costly and painful to wring out of the system just
as it was in the early 1980's.
The difference is that next time we go through wrenching disinflation we will do it on the back of all the financial problems that
exist today. If the Federal Reserve does not show the resolve to
keep inflation down they will make things more comfortable temporarily, and in the long run we will all pay the price. An ounce of
prevention is, in this case, worth more than a pound of cure.
[The complete biography of the panelist follows'.]
BIOGRAPHY OF PANELISTS
Dr. Alan Blinder is the chairman of the Economics Department at Princeton University. He received his B.A. at Princeton, went to London School of Economics on a
Marshall scholarship and then returned to complete a Ph.D. at M.I-T. He is an
expert in all areas of macroeconomics, public finance, and the economics of income
distribution. His most recent book is entitled, "Hard Heads and Soft Hearts".
Dr. Rudiger Dornbusch, professor of economics at M.I.T. in Boston. He received his Ph.D. at University of Chicago. He has pioneered much of the current
thinking on international finance and open economy macroeconomics when capital
is mobile across borders. He has written the textbook entitled, "Open Economy Macroeconomics" that is a staple in every graduate student's diet. Dr. Dornbusch is a
consultant to international organizations and governments around the globe. He is
almost as internationally mobile as the financial capital that he studies.
Dr. Ray Fair, professor of economics at Yale University. He received his Ph.D.
from M.I.T. and his undergraduate training at Fresno State. He is well known as
the only macroeconomic forecaster who doesn't judgmentally fudge the results of his
model. Dr. Fair has been a pioneer in the development of economic modeling methods and is also an expert on the role of macroeconomic policy in influencing the
outcome of political elections.
David Hale is first vice president at chief economist at Kemper Financial Services
in Chicago. He has written prolifically in recent years and his work regularly appears in the magazine, The International Economy, The Wall Street Journal, and
the Financial Times. Mr. Hale was educated at Georgetown University School of
Foreign Service and holds a masters degree in economics from the London School of
Economics.
The CHAIRMAN. Senator Riegle.
OPENING REMARKS OF SENATOR RIEGLE
Senator RIEGLE. Gentlemen, we're delighted to have all of you
today and we'll start, Dr. Blinder, with you.
STATEMENT OF ALAN S. BLINDER, PROFESSOR OF ECONOMICS,
PRINCETON UNIVERSITY
Mr. BLINDER. Thank you, Mr. Chairman. I was tempted to start
by saying that these are difficult times for conducting monetary
policy, but then I concluded that I must have said that every time I
have testified on monetary policy. And probably most other witnesses have also.
I want to try to address some of the questions that were posed in
Senator Proxmire's letter to us by making just three main points.
The first is something I'm really not accustomed to saying, which
is that the Federal Reserve has on the whole done a quite splendid
job over the last several years.
The second is that the Fed will have to continue doing such a
splendid job for several more years because the transition to a
policy mix of easier money and smaller fiscal deficits has some way
to go yet.
And a third is that I think the Government should create a monetary indicator that's better than any of those mentioned in Senator Proxmire's letter by issuing indexed bonds. I will take them up
in turn, beginning with the recent performance of the Fed.
FED HAS DONE AN EXCELLENT JOB
With a few exceptions that I won't mention, the Fed has really
been doing an excellent job of sustaining a moderately paced,
steady economic expansion ever since the post recession rebound
ended around the middle of 1984. The civilian unemployment rate,
as you know, has been falling smartly since the beginning of last
year; and it's now down to the lowest level we've seen since 1974.
Furthermore, my guess is that it's also pretty close to where we'd
like it to be, that is, to the so-called natural rate of unemployment.
While getting the unemployment rate down, the Fed has also
managed to hold inflation in check and has done that despite the
falling dollar. If you look at the recent numbers on inflation, some
of which I put in table 1 which follows page 2 of any printed statement, they really show no hint at all of any acceleration of inflation.
A performance like that deserves kudos and we all hope it will
continue.
In order for it to continue, at least two potential sources of error
must be avoided over the coming months and indeed over the
coming years. The first is that the Fed must not be swayed by the
inflation hysteria that seems to sweep Wall Street about every
week or two. Speculative markets like the stock exchange and the
bond markets and the foreign exchange markets react to everything, including things that are just imagined by traders; and they
almost always overreact to these things.
The Fed has to ignore this insanity and, I'm happy to say, seems
lately to be doing so.
Second, the Fed must not again get snookered into an agreement
to support the dollar at an excessively high level, as it did in 1987.
That's obviously not a burning issue right now, with free market
forces pushing the dollar up—or let's just say with market forces
pushing the dollar up, but I can't imagine that this situation will
last very long. The longer term prognosis for the dollar must surely
be downward, not upward, a point to which I will return very
shortly.
FISCAL-MONETARY TRANSITION
The second thing I want to say something about is the fiscalmonetary transition, which has to do with the work that's cut out
for the Fed in the years coming. We're now in the midst of what
seems to be an historic transition from the Reagan-Volcker policy
mix of excruciatingly tight money and irresponsibly large budget
deficits toward a saner policy of easier money and smaller deficits.
This transition has been going on for several years now—with
greater progress, I must say, on the monetary front than on the
fiscal front. And I think it will almost surely continue through the
term of the next President and perhaps beyond that.
So far, I think many people would agree that we've managed this
transition extremely well, if slowly. I would certainly agree with
that. Table 2 which follows page 3 in the printed testimony shows
one indicator of the progress we've made to date and the distance
that we still have to travel. It does this by comparing the composition of real GNP—all the numbers in this table are percentage
shares of GNP—in 1986, when the imbalance was at its worst on
an annual basis, and the most recent quarter for which we have
data, 1988 first quarter, with 1979, which I take to be a reasonable
target of what a sensible composition of GNP for the United States
might look like.
You can see from these numbers that the combined share of consumer and government spending in GNP rose by 4.4 percentage
points between 1979 and 1986, while the investment share changed
very little. The big offsetting change, offsetting that 4.4 percent
rise, came in net exports—which swung from a rough balance to a
deficit of about 4 percent of GNP.
Now since 1986, we've moved the combined consumption and
Government share back down by about 2 percentage points, or
roughly halfway back to where we were in 1979; and we've reduced
the net export deficit by about a quarter. That last number is certainly tenuous since it's based only a single quarter, the first quarter of 1988.
And, I think by no coincidence, you can see in the memo item on
the right-hand side that the Federal deficit as a share of GNP has
come down by about a third from what it was in 1986.
So we've so far completed something between a half and a quarter of the transition we need to accomplish to get back to a reasonably balanced GNP. The rest of that job is going to be left to the
next President with the help—with considerable help—of Chairman Greenspan and the Fed.
It's obviously critical that we keep this process going. More than
likely, a continued shift toward more exports and less consumption
in GNP is going to require a continued tightening of fiscal policy
and a compensating easing of monetary policy.
Americans ought to realize that the fiscal-monetary transition
that I'm talking about will most likely bring with it not only lower
interest rates, which most Americans would welcome, but also a
cheaper dollar, which many Americans seem not to like. I don't see
how this can be avoided, especially since the foreign indebtedness
that we've been accumulating and continue to accumulate ultimately will require us to generate a trade surplus in order to pay
the interest that we will eventually owe.
To shift the pattern of world demand toward U.S. goods and services, we have to offer foreigners better prices and that's exactly
what a cheaper dollar does for us.
If the Treasury or the Fed or for that matter any other foreign
central bank blocks that adjustment process, it will be very hard
for the fiscal-monetary transition to do its necessary work in restoring the shares of GNP to what they should be.
Now let me conclude by taking up the issue of monetary indicators that was asked about in the letter.
MONETARY INDICATORS
By now I think most people would agree that, when it comes to
using Ml as a monetary indicator or target of monetary policy, the
Fed, to coin a phrase, should just say no. And I think that's exactly
what the Fed has been doing over the last several years, which is
part of the reason I applaud their performance.
I prepared two figures in the printed testimony, figures 2 and 3
which follow page 5, to illustrate this point, that is, to show that
it's so and show why this is reason to applaud the Fed's recent performance.
On figure 2, the growth rate of Ml is plotted horizontally and the
growth rate of nominal GNP is plotted vertically. The graph covers
the last 15 quarters, which is the period since the rebound from the
recession. The vertical and horizontal bars on the graph show the
average values of each variable.
Now if you look at this graph, two things are clear. One is that
monetary growth has been vastly more volatile than GNP growth.
The second is that there's absolutely no tendency in the recent
data for nominal GNP to grow rapidly when Ml grows rapidly or
to grow slowly when Ml grows slowly.
The next figure, figure 3, plots velocity growth against Ml
growth; and here you do see a very tight and inverse relationship
with an almost perfect correlation. The meaning of that tight relationship is that the Fed has managed to offset erratic movements
in velocity with timely changes in money growth, thereby stabilizing the growth rate of nominal GNP. That explains both why Ml
growth has been so volatile—because it's had to be high when velocity is falling and low when velocity is rising—and also why Ml
growth bears no relationship whatever to nominal GNP growth
over this period.
If I had constructed corresponding diagrams using M2 or the
monetary base, they would look similar to this, though a bit less
dramatic.
6
In your letter, Mr. Chairman, you inquired about some less conventional indicators like commodity prices, the exchange rate, and
the term structure of interest rates. I think each of those conveys
some useful information, but each is also influenced by a host of
extraneous factors not having to do with monetary policy.
Commodity prices are sensitive to many market-specific developments. The value of the dollar is influenced by all sorts of things
that happen both here and abroad and is also subject to speculative
bubbles. The term structure of interest rates is influenced by the
term structure of inflationary expectations.
As between those three, I personally would place the greatest
weight by far on the term structure of interest rates. In theory,
monetary policy should move short rates more than it moves long
rates, and in practice that seems to be the case. Furthermore, the
slope of the term structure is probably influenced by relatively few
nonmonetary factors.
Finally, and very importantly, econometric evidence shows that
the spread between long rates and short rates has considerable predictive power for future inflation and unemployment.
Mr. BLINDER. The last point I wanted to make is that we could
improve on the term structure of interest rates as a monetary indicator if the Congress would do one thing, which is to see to it that
some of the Federal debt was issued on an indexed basis. If the
Government would issue both bills and bonds on an indexed basis,
we could observe the term structure of real interest rates in the
financial markets, as the British now do. That is to say, we could
observe the term structure purged of the influence of inflationary
expectations. If that would be done, I think we would have a better
indicator yet.
[The complete prepared statement of Mr. Blinder follows:]
I. THE RECENT PERFORMANCE OF THE FED
Testimony of Alan S. Blinder
Professor of Economics
Princeton University
to the
Committee on Banking, Housing, and Urban Affairs
With a few exceptions, the Fed has been doing an excellent job of
sustaining a moderately-paced economic expansion since the post-recession
rebound ended In mid 1984.
The civilian unemployment rate, as you know, has been falling smartly
since January 1967 and 1s now down to its lowest level since 1974. My guess
United States Senate
1s that it is also pretty close to where we want it to be, though I hold out
July 12, 1988
the hope that we might trim off a few tenths of a point more. But, whether
the natural rate of unemployment Is 5.2% or 5.8$, it Is clear that we do not
Mr. Chairman, thank you very much for the opportunity to testify here
today. 1 was tempted to begin by saying that these are difficult times for
want any major movement of the unemployment rate right now.
While getting the unemployment rate down, the Fed has also managed to
conducting monetary policy; but then I realized that I must have said that
hold inflation in check. Figure 1, which comes from the CBOs February
every time I have testified on monetary policy. So, I Imagine, have your
report, shows what they call the stripped CPI ~ all items except food,
other witnesses.
energy, and used cars. By this measure. Inflation has been stable at around
I suppose times are always difficult.
I will try to address a few of the questions you raised In your letter by
making Just three main points. The first 1s something I am not accustomed to
saying: that the Federal Reserve has, on the whole, done a quite splendid job
for the past few years. The second 1s that the transition to a policy mix of
looser money and tighter federal budgets has some way to go yet; so the Fed
4.5S since 1983. More germane to this hearing. Inflation shows no recent
tendency toward acceleration despite falling unemployment and the falling
dollar. Table 1 below shows the last five quarterly inflation rates, measured
In two different ways. They, too, show no hint of acceleration.
This performance deserves applause. May It continue. In particular,
will need to continue its stellar performance for several more years. The
two potential sources of error must Be avoided. First, the Fed must not be
third Is that the government should create a monetary Indicator that is better
swayed by the Inflation hysteria that seems to sweep Wall Street about every
than any of the ones you mentioned in your letter by Issuing Indexed bonds.
two weeks. Speculative markets react to everything, Including things that are
Let me take up these three Issues one at a time.
just imagined, and they react too vigorously. The Fed must Ignore this
insanity. Second, the Fed must not again get Snookered Into an agreement to
support the dollar at too high a level. This 1s obviously not a burning Issue
right now, with market forces pushing the dollar up; but I cannot Imagine that
this situation will last long. The longer-term prognosis for the dollar 1s
probably downward — a point to which I will return shortly.
Figure 114.
Measures of Inflation
2. THE FISCAL/MONETARY TRANSITION
We are now 1n the midst of an historic transition from the Reagan/Volcker
mix of excruciatingly tight money and Irresponsibly large budget deficits to a
saner policy with easier money and smaller deficits. This transition has seen
going on for several years now. with greater progress on the monetary than on
tha fiscal front.
And 1t will continue through the tarn of the next
president, ana perhaps beyond. So far, we have managed tills transition
extremely well. And. as I just suggested, most of the credit must go to the
Fed; fiscal policy has been erratic.
Table 2 shows one Indicator of our progress to date and tne distance we
still have to go.
It compares the composition of real GUP 1n 1986 and tha
most recent quarter with that of 1979, which Indicates what a reasonable
target for the composition of GNP might be. I take 1986 to represent the peak
of the Imbalance and !988:1 tn show where we are now.
(One quarter does not
establish a trend, but the swing 1n net exports 1s quite recent.
Figures for
1987:4 would look similar, except for net exports.) We can see that the
combined share of consumer and government spending in GNP rose 4.4 percentage
points Detween 1979 and 1966. while the Investment snare changed little. The
big offsetting change came 1n net exports, which swurg from approximate
balance to a deficit of aBout A% of GNP. Since 1986, we have moved the
consumption and government share Oack down by 2 percentage points, or alrrost
halfway back to where we were 1n 1979, and reduced the net export deficit by
about a quarter. By no coincidence, the combined deficit of all levels of
government has also come down ba about a Quarter.
Thus we have so far completed something between a half and a quarter of
the transition we need to accomplish.
The rest of the job will be left to
3. INDICATORS OF MONETARY POLICY
Let me start with the conventional monetary aggregates.
By now I think
President Dukakis or President Bush — with the help of Chairman Greenspan.
most people agree that, when it comes to using Ml as a monetary Indicator or
It Is critical that we keep this process going. Most likely, a continued
target, the Fed should "just say no" — which is what it has been doing.
shift toward more exports and less consumption (as shares of GNP) will require
Figures 2 and 3 show dramatically why this 1s so and, by the way, also show
a continued tightening of fiscal policy and a continued loosening of monetary
why I applaud the Fed's recent performance.
policy. Both the Fed and the new administration must realize that they are
Figure 2 plots the growth rate of nominal GNP against the growth rate of
locked 1n a partnership. With unemployment now roughly where we want It, we
Ml over the last 15 quarters.
cannot welcome fiscal tightening without easier money; nor can we afford
average values of each variable. Two things are clear. First, monetary
greater monetary ease without fiscal tightening.
growth has been vastly more volatile than GNP growth.
Americans should realize that the fiscal/monetary transition will most
standard deviations Is 3.4:1.)
The vertical and horizontal lines Indicate the
(The ratio of the
Second, there 1s absolutely no tendency 1n the
likely bring with 1t not only lower real Interest rates, wtitch most of us
recent data for GNP to grow rapidly when Ml grows rapidly or to grow slowly
like, but also a cheaper dollar, which many Americans do not like.
when GNP grows slowly.
I do not
see how this can He avoided, especially since our foreign Indebtedness
ultimately will require us to generate a trade surplus to pay the Interest we
(The simple correlation between the two series 1s
actually -0.35.)
Figure 3 plots velocity growth against Ml growth over the same period.
will owe. To shift the pattern of world demand toward J.S. goods and
Here a tight Inverse relationship 1s apparent.
services, we must offer foreigners better prices — which Is just what a
-0.97.)
cheaper dollar accomplishes.
Offsetting erratic movements in velocity with timely Changes In money growth,
If the Treasury or the Fed — or, for that
(The simple correlation Is
This tight relationship shows that the Fed has succeeded 1n
matter, some foreign central bank — blocks that adjustment process, it will
thereby stabilizing the growth rate of nominal GNP. And that explains both
be hard for the fiscal/monetary transition to do Its work.
why Ml growth has been so volatile and why It bears no relationship to GNP
Nor should the combination of a cheaper dollar and lower Interest rates
be viewed as a bad outcome.
In addition to helping to rectify the trade
growth.
The fact that high Ml growth rates have recently signified sharply
Imbalance, It should provide a hospitable climate for Investment, ease the
negative velocity growth, not rapid GNP growth, would seem to disqualify Ml as
debt burdens of farmers and less developed countries, and blunt the S&L
a monetary indicator.
crisis.
(adjusted for changes In reserve requirements) look similar, though not quite
Easier money and tighter fiscal policy 1s not something to fear, but
to welcome.
so dramatic.
either lately.
Corresponding diagrams using M2 or the monetary base
Thus, these old standbys do not seem to be working very well
-Ife
-t*
-letOf,
Iff,
'..
"5
M
f rjrc 3
Vour letter enquired about less conventional Indicators such as commodity
prices, the exchange rate, and the term structure of Interest rates.
! think
Let me close by mentioning one thing Congress could do to provide all of
us with a better monetary Indicator. The main problem with interest rate
each of these conveys some useful Information about what monetary policy has
indicators, Including the term structure, 1s that Interest rates may rise for
been or should be doing. But each Is also Influenced By a host of other
two quite different reasons.
factors.
inflation, the Fed may want to tighten up.
Commodity prices are sensitive to numerous market-specific
If they rise because of higher expected
But 1f they rise because of
developments; the value of the dollar 1s Influenced by all sorts of things
greater demand for money or credit, the Fed may want to ease.
that happen both here and abroad — and 1s also subject to speculative
the nominal rate of interest rises, we cannot tell If 1t 1s the real rate of
bubbles; the term structure of Interest rates 1s Influenced By the term
Interest or the expected rate of Inflation that has risen.
structure of Inflationary expectations.
But this lack of knowledge Is self-Imposed, not inherent. We need not
Among the three, I personally would place greatest weight on the term
structure.
remain In the dark.
In theory, monetary policy should move short rates more than long
rates and, 1n practice, that seems to be true.
In a word, when
Furthermore, the slope of the
If the federal government would Just Issue Indexed
bonds, we could observe the real rate of Interest directly in the financial
markets, as the British have been able to do since 1981.
Better yet, 1f the
term structure 1s probably Influenced by relatively few nonmonetary events.
government Issued both indexed bills and Indexed bonds, we could observe the
Finally and Importantly, econometric evidence shows that the spread between
term structure of real interest rates in the markets.
long rates and short rates has considerable predictive power for future
There are other good reasons to Issue indexed bonds that have nothing to
Inflation and unemployment.
do with monetary policy. But since this Is a hearing on monetary policy, 1
But let me hasten to say that looking at any or all of these Indicators
Is a far cry from targeting on H.
Should the Fed Interpret every
will refrain from mentioning them and simply attach an old Business Week
column of mine for the record. Let me just add that there Is nothing
acceleration of commodity prices as a harbinger of Inflation? Certainly not,
difficult or mysterious about Issuing Indexed debt.
for to paraphrase an old saw, commodity prices have predicted 12 of the last
now deciding whether it will do so. I hope It will. What can be done in
five Inflations.
Annapolis ought to be doable In Washington.
Should the Fed tighten up every time the dollar drops?
I
have already answered this in the negative; we want the dollar to drop.
Should the Fed tighten every time 1t sees the term structure get steeper? No.
the term structure probably got steeper because the Fed eased up — hopefully,
for good reasons.
The state of Maryland Is
12
TABLE 1
Recent Inflation Rates
(quarterly data at seasonally adjusted annual rates)
1987:1
1987:2
1987:3
1987:4
1988:1
Consumer Price
Index
5.4
5.1
3.6
3.9
3.2
Fixed-weight
GNP deflator
4.5
4.1
3.4
3.6
3.6
TaDle 2
Snares of Real GNP (in percent)
Year Corcumptlon Investment Government Net Exports Fed. Def.
1986
66.0
17.6
20.3
-3.9
-4.e
1988:1
64.6
18.8
19.7
-3.0
-3.3
1979
62.8
18.0
19.1
0.1
0.4
'79-'B6: +3.2
-0.4
+1.2
-4.0
-5.2
'86-'B8: -1.4
+1.2
-0.6
+0.9
+1.5
Changes:
13
I Economic Watch
A WAY TO FREE
SMALL SAVERS
FROM THE
'CASINO SOCIETY'
BY ALAN S BLINDER
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Some foreign governments
issue inflation-adjusted
'indexed' bonds, which
provide a way of separating
the act of saving
from the act of gambling.
Why can't the U.S.?
ALANS E4. NDEBIS THE GCflOCH S HENTSCHLER
Of ECONOMICS AT PONCETON IWuEOSlTY
ai BUSINESS WEEK'DECEMBERS IMS
i
T
wo economists writing in the New
England Economic Review recently endorsed an idea I have
been promoting to anyone who would
listen for almost 15 years: that the U. S.
government should issue indexed bonds.
Thanks, Alicia Munnell and Joseph Grolnic. Now there are three of us.
You may be wondering what an indeied bond is. Put simply, it is a security whose real (inflation-adjusted) returns
are guaranteed against inflation. This is
done by tying interest and principal payments to a price index—hence the name.
Because of that link,, indexed bonds
make it possible tc save without betting
on inflation. Such bonds are available in
several countries—such as Britain—but
not in the U. S. So all Americans are
forced into what this magazine once
called "the casino society."
Ordinary U.S. government bonds appear to be completely safe investments.
Default is unthinkable, and the rate of
return is guaranteed if the bond ia held
to maturity. But the appearance of safety is iljusory in 3 world of unpredictable
inflation. Investors who bought 30-year
government bonds in 1956 at interest
raws of around 3ft saw unexpectedly
virulent inflation decimate their savings.
By contrast, investors who bought fiveyear government bonds in 1981 at interest rates around 15% enjoyed a bonanza
when inflation tumbled. Had those
bonds been indexed, the 1956 bond buyer
would not have been victimised by inflation, and the 1981 buyer would .not have
been rewarded by disinflation.
NO-MM mum. These two examples illustrate that indeied bonds and ordinary
bonds differ not so much in the real
returns investors expect to receive, but
rather in the riskiness of those returns.
An indeied bond is a safe investment. In
an inflationary world, an ordinary bond
is a Crapshoot
That is the main reason to favor indeied bonds: as a way of separating the
act of saving from the act of gambling.
Gamblers have ample outlets these days.
from the tables in Las Vegas to the pits
in Chicago or the trading floors of lower
Manhattan. Those who want to save
without gambling should have at least
one way to do so.
But, you will ask, aren't there already
good hedges against inflation? Sad to
say, the answer is no. For decades the
stock market was advertised as a hedge
against inflation, but research showed
this claim to be emphatically false. In
fact, stocks do about as badly as bonds
when inflation rises. Even money-market
accounts turn out to be inadequate inflation hedges.
Government indeied bonds would also
confer many important side benefit*:
• Retirees on private pension* now mu»t
worry that future inflation might erode
the purchasing power of their pension
benefits. There is no such worry with
indexed annuities, such as Social Security. But no private pension fund can commit itself to indeied payouts unless its
earnings are afeo indeied. Government
indexed bonds that could be purchased
by pension funds are the missing ingredient in the recipe for greater retirement
security.
• Becaose safer assets generally command tower rates of return in financial
markets, the government could probably
reduce its average borrowing emu by
offering indexed bonds.
• An indexed bond market would gr»
policymakers accurate and timely readings on the real interest rate, and dat
would enable them to forecast and manage the economy more effectively. A*
things stand now, economists can only
"guesstimate" the real interest rat* by
subtracting a shaky estimate of expected inflation from the observed intent*
rate. In Britain, no such gneuvork »
necessaiy. People just look up tht answer in the morning newspaper!.
Now cocoes the hard question: If indexed bond* are so wonderful, why
hasn't Will Street provided them*
One possible aniwer is that a financial
institution cannot safely issue indexed
liabilities unless it on invest in indexed
assets. Indeied government bonds
would provide those assets. My guet* it
that soon after the government nowi
its Aist indeied bonds, an outpouring of
private indexed securities would follow.
A second possible answer, of come,
is that Alicia Mmuwll, Joseph Grotnie.
and I are the only people who want to
buy indexed bond*. Skeptics point to tb*
failure of the market for consumer price
indei futures, where, since June, 1386,
bondholders who wish to hedge their inflation risks have been able to do so.
Few hare, suggesting to some people
that no one cam about such hedgfaic.
Here • a different interpretation. Futures markets are the home of gamblers, especially big-money gambtn*—
not of autious savers. Because tbe inflation rate has been so quiescent since
June. 19B5, the en futures market h*s
been a poor plats for gamblers to haw
fun. Small investors who prefer the quiet life shy away from futures markets.
which they regard aa gambung den.
If my interpretation ia correct, the potential market for government indexed
bonds, especially if they are iuued in
small denominations, is far greater than
the CM futures market indicato. Wall
Street professionals might not play
much. But Main Street amateurs probably would. Let the game begin.
ECOHCMC (HATCH
14
The CHAIRMAN. Thank you, Mr. Blinder. I want to apologize to
the panel and to Senator Garn for so patiently waiting. Unfortunately, I had to appear at another hearing this morning and testify
myself and I just couldn't get free, but I do apologize. This is an
excellent panel. We're in your debt for appearing hear today.
Mr. Dornbusch, go ahead, sir.
STATEMENT OF RUDIGER DORNBUSCH, PROFESSOR OF ECONOMICS, MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Mr. DORNBUSCH. Thank you, Mr. Chairman.
I should like to speak about two issues. One, the problem of our
policy mix today, too easy fiscal policy and a monetary policy that
has to stand by and try to avoid financial pressures; and the second
one, a dollar that is rising rather than declining. I see the main
issue for monetary policy today to be the wrong fiscal policy and I
see a serious threat that a Federal Reserve recession in view of the
rising inflation is a very, very realistic outlook for next year unless
fiscal policy changes.
INFLATION
Let me first talk of the inflation issue. I certainly do not believe
that today double digit inflation is an issue. That would be posing
the wrong question. But I do think that inflation is clearly rising. I
show in my testimony in table 1 the comparison between the 1960's
and the 1970's on page 3. The point I want to make is that all the
talk today is exactly the same as it was in 1968—the talk that inflation isn't really there, that the economy has still room to go
some though nobody knows how much. We do know that in the
1960's in the end the Federal Reserve made a recession and that
the 1970's was a period of serious deterioration.
I see the outlook, without a change in fiscal policy, to be very
much the same in the year ahead.
There is of course considerable discussion about whether in fact
inflation is there. One set of indicators, the unemployment rate,
one doesn't know at what level of unemployment inflation distinctly accelerates. Some believed it was 7, some believed it was 6, and
now some believe it is 5. But it is clear that employment costs are
rising today at sharply higher rates than a year ago and even
hourly earnings have increased significantly.
Second, we have capacity utilization, another four quarters of the
current growth rates would certainly take us to the peak of capacity utilization, so there is a second inflationary source.
The third, commodity price increases, if there should be further
ones. Of course they are very difficult to predict.
So I do see us today at the level of 1968 with the critical decision,
just as then, to shift the policy mix to have a significant tightening
of fiscal policy in order to avoid overheating of the economy; not
because of the fiscal crisis but because that is the appropriate way
to slow the growth of the economy in a situation where inflation is
clearly the big risk.
Today the dollar is rising and I consider that a very unfortunate
byproduct of the election and the wrong policy mix. The Treasury
without doubt is exploiting the markets preference for interest
15
earnings, risk-free. They have put a floor under the dollar in the
summit process and with that floor under the dollar the interest
differential in favor of the United States draws in foreign capital,
leads to dollar appreciation. In the short term, that is an attractive
policy because it cools down inflation and it looks good. It certainly
avoids that Reaganomics gets unwound in the campaign.
But from a longer run point of view, there is certainly an issue
that the dollar continues to be overvalued and that we want fiscal
tightening with a significant expansion in net exports. The 5-percent real appreciation of the dollar that we have had in the last 2
months goes exactly in the wrong direction. It creates uncertainties
about which way to go. It's the worst kind of mismanagement.
Why is the dollar going up? I think it's easy to explain. One is an
overreaction to the trade numbers. There was earlier an extraordinary pessimism. Nobody wanted to look at professional forecasts
when the trade numbers went double digit. Nobody multiplied
them by 12 when they were single digit to see that they were still
well above $100 billion.
The second reason is the agreement not to have the dollar decline which means no capital losses, just high interest rates.
And the third is the outlook for realistic possibility of a Federal
Reserve recession some day if Congress doesn't move on the budget.
In the meantime, if we take a longer run view of the U.S. external balance and the dollar, there is every reason to believe that the
dollar continues to be overvalued.
Forecasts of the U.S. current account 3 or 4 years out almost uniformly come out with numbers between $95 billion and $105 billion. There is some variation, but it's centered around $100 billion.
That means a third of the deficit will go away, two-thirds will stay.
CHANGES IN THE WORLD TRADE STRUCTURE
The reason is that we have had since 1980 significant changes in
the world trade structure. The first, newly industrialized countries
have had a shift in manufacturing of $60 billion in our trade with
them. In the 1960's and the 1970's, we equipped them with capital
goods and that made for strong trade performance here. Today,
those capital goods are at work exporting to us. That's one reason
why the dollar certainly will have to decline further.
The second is we have a large growth gap between the United
States and other industrialized countries. Cumulatively, we've
grown 13 percent more than they have. As a result, our imports
have grown much more rapidly than our exports, even assuming
the same responsiveness to demand. That gap is still there today
and it accounts for half of the trade deficit.
The third reason is that we haven't had the full devaluation. We
only have had half. It has worked extremely well on the export
side, but it has worked so far very poorly on the side of imports.
Import prices have risen relatively little in response to dollar depreciation and imports continue to be very competitive, particularly in the area of capital goods.
I show in my testimony in figure 4 the prices of capital goods in
the United States and imported capital goods. The prices of imported capital goods today are still at the level of 1980, whereas domes-
16
tic goods are 25 percent higher. So we have really had on the
import side virtually no depreciation and in capital goods we have
massive, massive loss of competitive advantage.
Looking ahead, there are two factors that worsen the U.S. trade
outlook. One is the dramatic trade integration in Asia between
Japan and Korea, Taiwan, Singapore, and Hong Kong. Last year,
Japanese trade with those countries doubled as each reinforces the
other's competitiveness by trading in components. The other one,
Europe in 1992, with the creation of an internal market, certainly
amounts to diverting trade from the United States.
So I conclude from all these factors on the trade side that we certainly cannot take the view that the dollar should be going up. On
the contrary, we should have no dollar targets either for monetary
policy nor for the Treasury.
I want to conclude my testimony by arguing that there's one
very important institutional change which would improve the
working of the economy. We have today a predominance of very,
very short-sighted asset markets. The upward movement of the
dollar is the very best example of speculation that is totally detached from fundamentals. A very moderate financial transaction
tax, not only on foreign exchange but also on stocks, bonds, all financial assets—extremely moderate—would discourage the very
short horizon speculation which today makes asset markets so volatile and so preponderant.
One can argue that a tax like that would simply shift business
offshore, but it's worth remembering that Switzerland does have
such a tax and is still considered the biggest financial center. So I
do think one has to start thinking about that in order to get better
functioning asset markets and for monetary policy not to become
hostage of very short run capital market movements.
Thank you.
[The complete prepared statement of Mr. Dornbusch follows:]
INFLATION AND THE DOLLAR1
Rudieer Dornbusch
admi
year there Is no excuse for stunting trade improvement by dollar a p p r e c i a t i o n .
The economy la overheating. To avoid a Federal Reserve recession and renewed
dollar overvaluation the budget d e f i c i t must come down.
f i n a n c i a l markets rightly project a c o l l i s i o n courser
r i s i n g inflation sooner
happens there are significant risks.
t i g h t e n i n g and a s h i f t in fiscal policy was the inevitable consequHm'.E' . T h i s
time around several I m p o r t a n t extra d i f f i c u l t i e s emerge:
operate over productive a c t i v i t y .
1. The Situation Today
The debate whether i n f l a t i o n is already back, around the
corner or only in the horizon makes one point clear: i n f l a t i o n is now the
where the Federal Reserve decides Co Hake a stand. Over the next ye
taking
Til* question today Is when the Federal Reserve w i l l initiate
shift toward tighter nonetery policy to slow the growth of the economy and
inflation •
Khich oust
The slowdown In the US economy which is the cure for
All these t
tightening
•Ignlf leant
poli
addltio
high le
2. The 1960s and the _Infl,tton Outlook Today
fly
the tnd of 1969,
1960s. fly 1968 the economy was precisely it E
•Unless action it taken quickly to expand Faderal tevenues. a
rapidly.
rate of nales age 25 and over. Tva
loymfnt really at the level where
economic position-- by danaglng conEtdetic* ic^ the dallar. arid by
disadvantage.
• Financing such deficits vault! increasingly strain financial
nsilwts, pushing Interest rates further above present record
highs, and threatening another financial squeeze and another
Table 1
Creeping inflation
(percent per year)
on and supply
Inflation (CPI)
(«1)
19S5
1966
1967
196B
1969
4.4
3.7
3.5
3.4
1.6
3.0
2.8
4.2
5.4
19«i
198$
1987
7.2
7.0
6.2
5.6
5.5
3.5
1.9
3.7
4 1
5.0
1988*
m^*
00
3.4
Adj. ftvg. Hourly
the year. Investment in capacity expansion, is nat Qutpwing the impact of
3.6
4.3
5.0
fi.l
6.7
3.1
2.4
2.5
3.1
4.2
(except when the dollar Is grossly overvalued). But If they should occur they
would Interact with high capacity utilization and lov unenploynent to create a
On balance the
In the unconfortable
3. The Dollar and Trade Performance
the group of partner countries Included in Che measura encompasses the highly
competitive newly Industrialized countries (SICs). By early 1986 Che dollar Has
back to Che level of competitiveness of 19BO, or to the average of the 1970s.
overvalutd dollar.
The recent upturn of the dollar and the sharp Inprovement in
rising today and whether this is desirable. Second, what are the Long run
77
H7t
10B1
prospects for U . S . trad* and ths dollar?
The Dollar Rally: Trade data are extrenely volatile and hence difficult Co
UNOIPIOYUEW (15+)
one of the reasons for the present dollar strengthr
The long run trade outlook begs the question whether the
U.S. REAL EXCHANGE RATE
t IBBO-BI-IOO]
landlr.5 BCensiio whe
In the short run this Scenario is unlikely. On Che contrary,
Treasury does not vant Co Ee* a dolla! decline that might unrivel Reagsnomic
in the niddle of the campaign. The third is the anticipation of a possible
It also would help show (In the shart run) Improving trade results. Our
The potsihiUtJ of 8 Federal aeserve tightening in 1989
dollar floor followed by a Federal Reserve recession is a situation nuch lllte
the eatly 198QK uhela the dollar «as alloved to appreciate and becone
overvalued as an anti-inflation policy.
BuC it is also clear that the dollaf appreciation that is
THE US CURRENT ACCOUNT
(PERCENT or GDP)
ourse, the undoing of the appreciation
Price
Autos
Volu
CAPITAL GOODS PRICES
(HDOt llOttl-lOO)
chose not Co pass it through Into higher dollar prices-- differed widely
export sectors.
by low cost Southeast Asian exporters notably Korea. Singapore, HongKong and
The legacy of the overvalued dollar 13 quite apparent in
Import penetration Increased in both the capital goods sector and In consumed
goods. But the Increase was very moderate compared Co the massive rise since
to
the U.S.
Desand)
JAPANESE EXPORT PRICES
(MDCt 1(85:2 - 100)
1975
1980
1987
5. It
6.9
11.6
Federal Reserve Board
14.6
37.7
and 1989 we can expect further export growth at double digit rates. When we
done . manufacturing (outside business machines) will be broadly back to the
level af 1980. gut that is performance far belo. par in a growing world
neuly Industrialized countrlas that ue comment on next.
Taiwan
Slngapo
Table 4. U.S. Manufacturing Trade with the NICS
(Billion $ U.S.)
Exports
1980
1986
55.6
49.4
Table 6
Adjustment of World Imbalances:1985-f
(Annual Average Percentage)
Export Volume
CNP
developing countries have been turned very rapidly into world class exporte
Source; OECD Economic Outlook. July 19B
THE GROWTH GAP
[LEHL Of BEAl SPENDING. 1t«0:l -1KJ)
Europe, but especially Japan, have stepped up their growth
rates of domestic demand. They are now enjoying domestic-led growth rather than
growing off the U . S . fiscal expansion. But the differential with U . S . growth
(especially in the case of Europe) continues to be far too moderate to
Lop
ajor recession) makes it app
policy ultimately tight
alnly
failure to adji
deficits.
>>- Foltev
In concluding I would like to comment briefly on the policy
to
Moreover, without a tightening of fiscal policy (bacause of the overheating of
US
t
NON-US OKD
and commodity targets seem very inappropriate
Perhaps
transactions, in stocks, bonds and foreign exchange alike. The purpose of the
Trade improvement and increased InvestmenC would then carry growth,
The basic fact of life in asset markets is that the average
professional Chinks he or she can liquidate a posIClon before a naj or turn In
evidence Co show a stable relationship between commodity prices and general
Keynes In Che General Theory (chapter 12) notes Che m a r k e t ' s pursuit of
"It might have been supposed that competition between expert
professionals, possessing judgment and knowledge beyond that of the
energies and skill of the professional Investor and speculator are
to
Of
concentrate their resources upon the holding of "liquid"
abnormal predominance which financial markets enjoy In todays economy.
entlal Co recogni
FTT tn
f an FTT
•^See M . D u r a n d and S.Blondal "Are Commodity Prices Leading Indicators of OECD Prlc
Unpublished manuscript. OECD, February 1988.
investment v i r t u a l l y unaffected.
The n a j o r obje
26
Is worth noting chat both Japau and SaiLtMclaftd do tiro
Meantime there IB not much cost in moving ahead and designing dechanlsms that
27
The CHAIRMAN. Thank you, Dr. Dornbusch.
Dr. Fair.
STATEMENT OF RAY FAIR, PROFESSOR OF ECONOMICS, YALE
UNIVERSITY
Mr. FAIR. Thank you, Senator.
In Chart 1 on the first page of my written testimony I give the
percentage change in GNP and the percentage change in the GNP
deflator by four quarter periods since 1983. There's no question, to
echo what others have said, that the economy has really had a remarkable performance in the past few years judged by GNP, inflation, as well as unemployment, which is not on this chart.
This pattern, of course, masks the changes that have taken place
in the trade deficit and the Government deficit and so forth, but if
we look simply at GNP, inflation, and unemployment, we really
have done a rather remarkable job and I would agree with Professor Blinder that the Fed should get some credit for that.
I really don't have much more to say about that, nor do I have
much to say about the mix question between monetary and fiscal
policy, which has also been touched on by others. Almost everyone
agrees that we should have in the future a tighter fiscal policy and
an easier monetary policy to offset the negative effects from the
contractionary fiscal policy, to get the Government deficit back
down.
As I said, I have nothing new to say here. I just wanted to add
one thing, which is to point out a bonus that you get when you
change the mix in this way. This bonus is what I call the interest
payments effect on the Government deficit. Because the Government debt is now so high, if you lower interest rates you get a substantial savings in Government interest payments. I ran an experiment with my econometric model where I assumed that the Fed
lowered through open market operations short-term interest rates
by a percentage point. This gradually lowers long-term rates, which
in itself is expansionary—if you lower interest rates you expand
the economy. I wanted to focus simply on the interest payments
effect, so I took an exogenous component of spending and simply
lowered it to the point where I left GNP the same as it was in the
base case. The change is thus simply a change in the interest rate,
keeping the GNP and the economy roughly the same, to see how
much this affected the Government deficit.
In the first year, there was a gain in lowering the deficit of $5.6
billion; and in the second year, $13.7 billion. So there's a substantial bonus, as I said, that one gets from an easier monetary policy.
Given that most people would want the mix to change anyway, this
is just simply icing on the cake, and the numbers are now substantial. So that any discussion that takes place on how contractionary
fiscal policy should be in the future should take this effect into account, assuming the Fed responds to offset the contractionary effects, and I see no reason it wouldn't, aside from perhaps worries
about the dollar.
28
FED POLICIES AND POLITICAL FORCES
Now let me turn finally to one of the questions Senator Proxmire
addressed in his letter. There's been concern not only by Senator
Proxmire but by many others from time to time on whether the
Fed is unduly influenced in its policies by political forces. In order
to address that question, I really need to answer two questions. The
first is, how does the economy—that the Fed has some control
over—how does the economy affect voting behavior? We really
need to answer that question first. Then, given the answer to that
question, you can ask the second question, is it advantageous then
for political parties to put pressure on the Fed to manipulate the
economy to then help them win the Presidential election?
So the first thing I focus on is the question of how does the economy affect voting behavior. Beginning about 1976, I developed an
equation that predicts votes for Presidents—the Democratic share
of the two-party vote. Not surprising to anyone in this room, the
economy does have some effect on votes for President. The econometric question that one addresses in this is how does it affect it,
which economic variables seem to be most important, and what are
the quantitative magnitudes, how much do you get out of this.
From the work I've done, the two most important economic variables seem to be the growth rate of GNP, real growth rate per
capita, between 6 and 9 months prior to the election; and the inflation rate in the 2-year period prior to the election. So the two variables are GNP growth and inflation, and the relevant time periods
seem to be for GNP growth between 6 and 9 months before the
election and for inflation about 2 years before.
On page 3 I give the past history of this equation in terms of predicting the elections, starting with 1916. The equation has a remarkable ability to predict Presidential elections I believe. The average error that this equation makes is about 3 percentage points,
and there's only one election where the error was really quite
large, which is the Johnson-Goldwater election of 1964, where the
Democrats got 61.3 percent of the vote. They were predicted to get
54.2 percent, which is an error of 7.1 percentage points. So there
was a rather large error in predicting that election, but there is
only one other case in which the error was even as large as 4 percent.
Three of the elections were predicted incorrectly. Kennedy-Nixon
in 1960, Nixon-Humphrey in 1968, and Carter-Ford in 1976. But the
errors in these cases, as you can see from page 3, were really very
small. The elections were really just too close to call, and the equation predicted them to be that way and just got the sign wrong.
The Reagan victories in both 1980 and 1984 were predicted quite
well. Again, this is easy to see from the equation. In 1980, the
growth rate was minus 5.7 percent over this period and inflation
was 9 percent. So Carter was predicted to lose by a substantial
amount. And in 1984, the growth rate was 2.7 and inflation was
3.7. Reagan had the incumbency advantage, you get some headstart
for that—and he was predicted to win again by a landslide. So you
don't really have to appeal to Reagan's personality in order to see
why he did so well in the two elections.
29
Now you can use this equation to predict 1988. In order to do
that you need to give me, or give the equation, an estimate of what
the inflation rate will be—we pretty much know that because it's
the 2-year period before—and what the growth rate will be, per
capita growth, 6 to 9 months before the election.
I've given you a table on page 4 in which you can simply choose
yourself values of what I call "g," the growth rate and "p," the inflation rate, and see what you predict. If you use a growth rate of 2
percent—remember this is per capita—and an inflation rate of 4
percent, which is roughly what my econometric model predicts, if
you look on the table you see the Democrats are predicted to get
48.2 percent of the vote, which means that the Republicans are predicted to win by 1.8 percent. This margin is within 3 percentage
points, which is the average error, and so the election is really too
close to call.
So the basic point of this is that, given what seem to be reasonable predictions now of the economy, the election seems too close to
call, although the Republicans have a slight headstart.
Now to come back to the question of the pressure on the Fed. If
what I have just outlined is in fact the way voters behave, you can
see there are obviously some advantages for a party to try to push
the Fed in one direction or another if it were irresponsible.
For example, if the Fed could be induced to increase the growth
rate of the economy to 6 percent in this year, leaving the inflation
rate at 4 percent for now because most of the inflation consequences will take place later, then the Democrats would be predicted to get 44.1 percent of the vote, which would be a substantial Republican victory, the Republicans could have some confidence that
they would win.
On the other hand, if the Democrats for some reason put pressure on the Fed to induce a recession, minus 6 percent growth or
something, then you have a substantial Democratic victory. The relationship between growth rate and vote share is about one-for-one.
For every percentage point increase in growth, the incumbent
party gains about 1 percentage point of the vote. For inflation, for
every 1 percent increase in inflation, the incumbent party loses
about a third of a percentage point, which is what's reflected in
this table.
Now to conclude, from my ivory tower at Yale, I have no inside
information about what goes on between the administration and
the Fed, but the main point is that it's really too late to try to influence the Fed. The effects of monetary policy on the economy, as
we all know, takes some time, and unless the Fed did something
really extreme between now and October, there really isn't time
left for this kind of pressure.
So I don't think that Senator Proxmire or anyone else really
needs to worry at this time about the effects on the Fed. They
maybe should have worried last year, but now it's really too late,
and so I don't see this as an important issue. I think Congress and
the administration and the Fed should get on with trying to change
the mix in the future, in 1989 and 1990, toward an easier monetary
policy and a tighter fiscal policy.
[The complete prepared statement of Mr. Fair follows:]
Housing, and Urban Affair
July 12,
dovn.
1988
If Congress and the Administration could
Ray C. Fair
Yale University
I.
The Recent U.S. Performance
The performance of the U.S. economy since 1983 has been remarkably
I have nothing nevj Co add about the mix question here.
Uhat I would
Chart 1
Four-Quarter Growth Rates In Real CNF and the CNF Deflate
In Real CUP
1983
1983
1984
1984
1984
1984
1985
1985
1985
1985
1986
1986
1986
1986
1987
1987
11
V
.1
V
1
II
V
I
11
V
in the GNF Deflator
198
198
19B
19B
198
19S
GO
o
194
198
198
198
198
198
198
193
III.
1937
I
19B8
The chart shou
Voting Behavior and the
Thl* committee and other
apid output growth in 1983, Che
all that bad.
erned from tin
tuo-party vote for the e l e c t i o n
Also, although che grouch rate in Che following table is tht
obtained using the growth rate in Che nine month period before
9f.6
CO
.517
.361
.457
412
.591
.52?
.352
.415
.446
575
.633
036 - . 0 1 6
.008
.003 - . 0 0 9 - . 0 4 2
.625
.550
.538
.524
.573
.570
.513
.023
.032 -.011
.446
.422
.456 .437
.010
.015
Growth
984
-3
.550
.539
.529
.519
2
.509
1
0
1
2
3
.499
.466
.676
.468
.456
. 12
.
.
.
.
.
<>y
i-f
«y
71
61
.516
.505
.495
.485
.475
.465
.560
.550
.540
.SJ9
.564
.553
.543
.533
.567
.557
.547
.536
. 19
. 71
. 17
. n?
.526
.516
.
.
.
.
.
09
)9
78
.
9;
a?
SB
.
71
SB
.
.506
.495
.570 . 5 7 4
.560 .564
.550 .553
.540 .543
. in
. 19
.
.
.
.4B5
.475
09
90
.
HI
78
111
5JT
.513
.502
49?
.482
If. for example, the inflation rate turns out to be 4.0 percent and the
rowth rate to be 2.0 percent, which is roughly what my model is predicting.
elections In which the win
32
Rtpub
Infla
Administration, and Che Fed should be looking ahead and worrying about the
nix in 1989 and 1990.
33
The CHAIRMAN. Thank you.
Mr. Hale.
STATEMENT OF DAVID D. HALE, FIRST VICE PRESIDENT AND
CHIEF ECONOMIST, KEMPER FINANCIAL SERVICES, INC
Mr. HALE. Thank you very much for the opportunity to testify.
I have organized my material this morning in terms of four
major points.
First, I would concur with the previous speakers that the Federal
Reserve faces a major challenge in the next couple of years inasmuch as we are now in an economic environment somewhat similar to the 1960's.
However, I would stress that in many ways the challenge facing
the Fed over the next couple of years is even greater than it was in
the late 1960's because it is now trying to conduct economic policy
and monetary policy against a framework of two major imbalances,
not simply domestic overheating.
First, as you know from previous discussion here, we currently
have a very large imbalance between savings and investment in
this country which has produced a current account deficit of $160
billion. That's not simply a record number in dollar terms; it's also
a record share of our national income, a sum of money equal to 3.5
percent of our gross national product compared to 1.5 percent back
in the 1870's and 1880's when we were a developing country.
As a result of this current account deficit and our external borrowing, we will also have by 1991-92 probably a trillion dollar external debt or foreign investment deficit which in turn will produce
a deficit on our investment account of about $60 or $70 billion. So
we're talking about a financial environment that is quite different
from anything we've known in our modern history. In fact, Chairman Greenspan is the first American Federal Reserve Chairman to
assume the office under conditions of the United States being a
large capital-importing nation.
Second, in addition to this external financial constraint, we now
have a growth rate in our real economy which is increasingly
bumping up against real constraints in terms of labor supply and
manufacturing capacity.
Let me share with you a couple of numbers to put in perspective
what these constraints look like.
Once our economy achieves full employment—and many economists believe we're almost there—its optimal noninflationary
growth rate consists of two factors—labor force growth and productivity growth. Labor force growth in this country is about 1.5 percent. Productivity growth is about 1 to 1.2 percent. As a result, our
optimal noninflationary growth rate is now around 2.5 percent.
Because of the trade deficit, because of our need to move to a
trade surplus at some point for debt servicing, we must also allocate some share of that 2.5 percent growth to reducing our trade
imbalance. I would estimate at least 0.5 and perhaps 1 percent of
GNP per annum must go for that purpose. That, in turn, leaves
about 1.5 percent for domestic spending.
Since we also have to increase the size of our capital stock in
order to generate additional capacity for exports, that means that
34
our domestic spending for consumption can only grow by about 1.2
or 1.3 percent, which would be about static in per capita terms.
That I think is a very significant challenge and my second major
point is it would be a serious mistake if we have to rely solely on
monetary policy to ration domestic demand, to ration domestic
spending in a way that we keep in a noninflationary growth projectory over the next few years. I think the previous speakers have
spoken aptly on this. Just to restate it very quickly, if we rely on
monetary policy to restrain domestic demand, to stay in this noninflationary growth path, we will have to have much higher real interest rates. Higher interest rates will in turn push up the real exchange rate. That in turn will jeopardize improvement in our trade
account and perhaps set the stage for a new current crisis in the
future.
A year ago I would have thought that simply complying with the
Gramm-Rudman program to gradually balance the budget would
be sufficient. In fact, it may be necessary for us to study the economic policies of countries like Australia and Britain, which to
deal with their trade imbalance and to maintain a low inflation
rate, felt compelled to actually go to budget surpluses. Our policy
alternative by 1991-92 may be to move in that direction more
quickly than we would have thought necessary a year ago, especially with unemployment now likely to be at 4.5 percent by the end of
1988.
Third, the instruments through which the Fed should pursue this
policy protectory must be eclectic. Again, previous speakers have
commented quite adequately on the issue of velocity shifts, changes
of money demand, and the unreliability of monetary aggregates. I
would simply amplify this by encouraging you to also ask questions
of Mr. Greenspan about how the changing value of the dollar and
possible capital flight from the United States may affect money
demand.
WEAKNESS OF THE DOLLAR
In my conversations with corporations and private investors, I
suspect the weakness of the dollar over the last 1 l/z years has further weakened the relationship between money demand, money
growth and nominal GNP, by encouraging our investors and our
corporations to put additional money into foreign currency deposits. In other countries like Britain and Germany, it's easy for the
central bank to monitor these changes in currency preferences because it's commonplace for banks in those countries to offer their
citizens the option of having their money in foreign currencies in a
retail savings account. We don't offer that option. Hence, money
here typically goes offshore. But I suspect from looking at movements that in capital flows as measured by the B.T.S. data—I cover
that in my formal testimony—that we have seen capital flight from
the United States in the last year and it is distorting the money
numbers and, therefore, is a factor which we must get a better
handle on to understand the relationship between money and GNP.
I would also concur with Alan Blinder that indexed bonds could be
a useful market test of how the market is viewing inflation, monetary policy and the risk of future price changes.
35
EXCHANGE RATE POLICY
My final point would be to focus on exchange rate policy. I believe that we need additional guidance from the U.S. Treasury and
Mr. Baker in particular on the conduct of exchange rate policy,
how our exchange rate target zones are developed, and what implications they have for policy.
In the trade bill now before the Congress, we do have an amendment or a provision which would require the Treasury to provide
regular testimony on the exchange rate. If you do not in the end
pass the trade bill, I would encourage you to separate that provision to require additional testimony on exchange rate policy and its
implications for our economy.
By convention and by custom, the exchange rate is the responsibility of the Treasury, not the central bank, but obviously conduct
of exchange rate policy has major implications for the Federal Reserve and the economy in ways which mean we cannot really separate it from monetary policy.
In addition, I believe we also must have greater disclosure in the
future of how this exchange rate policy is developed, how the
target bands are developed, what kinds of surveillance indicators
we use, what do we think are reasonable targets for our trade deficit, for capital flows, what do we think is an optimal adjustment
path for policy to try to achieve an exchange rate target and a
trade deficit adjustment.
I think we need this kind of additional information for three reasons. First, because simply focusing on the exchange rate would
itself draw attention to these other policy imbalances we must confront. That is, the tension we'll have in the next year between
fiscal policy and monetary policy. This is not a new subject or a
new theme. It's been debated over the last 4 or 5 years, but absence
of an exchange rate policy 7 and 8 years ago helped set the stage
for many of our current problems. If we had had more awareness
and more sophistication in this area, these imbalances would not
have gotten as large, in my opinion.
Second, it's very important that we provide clear signals to
American businessmen to keep investing very heavily in the tradable goods sector, especially manufacturing. We are currently experiencing a capital spending boom in manufacturing, but many businessmen still tell me they are concerned about future dollar appreciation, that there will be a repeat of what happened in the late
1970's and early 1980's of the dollar cycle which will in fact make
the investment they are now undertaking unprofitable at some
point.
If we had a more clearcut exchange rate policy and disclosure of
how things are developed, it would help to reinforce today's current
capital spending boom, which itself will lower the risk of future inflation.
Finally, I think we need additional discussion and disclosure
about exchange rate policy to lessen the fear of political manipulation of exchange rates, to lessen concerns not of our own central
bank in fact conducting policy in a way to affect our elections, but
in fact of foreign central banks conducting policy in a way which
might affect our financial markets or perceptions of the economy
36
and therefore how the electoral process here might evolve during a
period such as 1988.
Now we can put various interpretations on the conduct of monetary policy in other countries over the last year. In my testimony I
devoted a great deal of time to the issue of exchange rate intervention and how we have had exchange rate intervention over the last
year to try and stabilize our financial markets, restrain the dollar
from going too far, and preventing an upsurge in inflation and interest rates that would be destabilizing to our economy in 1988.
What concerns me here is not just the reality or what economists
might think. It's what the American public might think in 6 or 9
months time if we have a very close election this autumn and it
becomes apparent that in fact foreign economic policy was being
conducted in ways to influence our election.
Here I call your attention to an editorial in last week's Financial
Times, which addressed the dollar rally in the last couple of weeks
as being in part a political phenomenon. I'll quote it directly:
The result of the recent dollar appreciation was the export of inflation to the rest
of the world. Both this week and last, Germany has demonstrated resistance. The
spotlight now turns to Japan. The policy question in Tokyo: What price, in terms of
domestic inflation, is the Japanese Government prepared to pay to help secure the
election for Mr. George Bush?
That's the opinion of the Financial Times. There's great dissension obviously among financial economists. I think it's essential to
our long-term economic and political relationships elsewhere in the
world that we have ample description of exchange rate policy so
that the American people do not believe that we've had manipulation of the exchange rates, such beliefs would be adverse for the
maintenance of an effective exchange rate policy and also for our
strategic relationship with countries like Japan such relationships
will be critical, I would add, not only to our trade adjustment process but to maintaining world peace and prosperity well into the
1990's.
Thank you,
[The complete prepared statement of Mr. Hale follows:]
Mr. Cha
Hawking
il policy-makers,
oiio growth with
While there is nothing wrong with inporting foreign capital If ue inveat it wisely,
TBSTIHWI OH 0.3. BCOKWC ODTLOOt UK MOHBUBI POLICI
oh is:
change
Testimony for
Hearings before the
innrm stars SHU™
One Hundredth Congress
Second Session
Oversight on the Honetary Policy Report to Congress
Pursuant tn the Full Enploynent and Balanced Growth Act of 1978
Chicago
previous high of 1.5* of GNP during the late tgtn csntury when tne U.S.
country on a one hundred year round trip in tsrms
CO
Tha Balaocn of Pumtata idjnatiient Will Bf Gradual
the early i°90's, the U.S. will
for U.S. output and
It la quite likely that the fl-7 experiment^with eigtiange rate management .Hill
CO
be running at i* of GNP while foreign finis
oo
3imply becaua
Ano
adjua
ins
Why have Europe and Japan been so supportive of the dollar? They have nad several
notlves. Flrat, In gontrast to the U . S . during the period 1982-1981, thay do not
candidates favoring prot
of American military fo
ojn Europe and Asia.
Th< Jap ana
£«
B-aavy dependence upon this country for both markets and military security. In fact,
at a recent conference in Nagoya, Japan about how Japan should cope with American
at Pa* Britannlca and fifty yeara ot PHI taerlsana, in hi'it notf entered a period
International role."
imbalances is that America has a large budget deficit while Europe and Japan do
not. Nhat la leas well under-stood is that some of today's global payment Imbalances
gnarj fiscal
ography.
population la now falling by 3,000-0,000 per week. Unless there IB a major change
In birthrates or immigration, the German population will shrink from 62 million to
50 million by tha rear 2020 and to only «0 million by 2010. In Europe as a whole,
ury.
While the U.S. population la aging, the oountry has a higher birthrate and therefore
Breatep labor fsrt* gr&Jth than Europe or Japan. ExQluaing South fcrrics and Hong
with the third world. As a result, It is far more likely that tha U.S. will attract
a large immigrant population during the next feu decades than either Europe or
Japan. AS with Hong Kong, the D.S. will probably also experience a great deal of
Industrial development In areas directly adjacent to Its Border. Hhile population
la only one factor of production, large divergences in deaneraphlo behavior can
influence the direction of capital flom In a variety of vaya. An aging population
will tend to Increase Its savings rate In order to establish retlreneot funds while
a society with 4 young population will generate robuat credit denand to finance
honebuildlng and eonauaw durable purchases. Cernenjr's residential construction
industry, for exaaple, has reulned depressed In the free of falling interest rates
for several quarters because of population decline. In previous nerloda of hiatory,
countriaa with aging populations would probably have had stagnant eoonceilea and Ion
real Intareat rates. But because of the International novetwnt tcwarda financial
liberalization, coupled «lth nwt darveloaeMnta la coaputer and coamio (cations
technology, we, now have a global financial mrlntplaoe through utlch countries »itti
aftlng populations can export capital to eountrlea wita younger populations,
One could argue that the O.S. la Importing too ouch capital relative to its lav
Investaient rete and that more of It abculd be diverted to countries with even
younger populations In the third world. But a variety of structural factors.
Including pro-cspltallat eeooonlc pclioles and warlcet openeas, have caused tlxe
world's high savers to concentrate their surplua funds In Jam-lean naaeta durlna the
)9BO's.
alloy question facing the
The Foliar Challenge
While there are several structural reaaons why the 3.3. can stretch out Ita balance
of payments adjustment process and renaln a capital Inporter well into the 1990'a,
the transformation now occurring in the U.S. balance of nayawnfca will atlll pose a
aajor ohallenae to policy iskera both here and overseas. The U.S. will have to
return to trade surplua at SOM point in order to offset the growth of interest
paynenta and dividends on our internal debt and foreign Infeete»nt Sore. This,In
turn t will require tha P.3. jo davelop a, floherrent, al* of fiaanl and Btonetary
Soil a IBB for reallocating 4-5J of CMP fron dOBeatlc eenBUmption^ to eiports and
I n v e a t n a n t . '
Tee arltnaBtlo of fchla challenge is likely to work aa follows. Once a country
achieves full eaployaent. Its optical non-Inflationary growth rate consists of two
factors — labor force growth and productivity growth. Wttt tna 0.3. I»oor force
growing by 1.5) per annual and productivity expanding by 1.2% per annua, the
eoonow's ontiaai non-1 nflaelenarv real growth rate la S.t - S.7%. If we asaune
that the n.3. will hne to reduce Its reel trade daTloit by in avcnint eo.u»i to 0.5 1.01 of real GKP per annuaj over the next several years in order to achieve a trade
surplua for debt aervlolng by the nid-1990'a, doaeatla spending will be able to
expand br only 1.5 - Z.ttt per annual. Since the Inveetoent snare of OHP also Mill
hate to expand In arder to reverse ttut daaage done to the D.S. capital stock by the
exchange rate policies ef Donald Regan and Beryl Sprlokel during the early 1980'a,
aaerlcan oonauagtlon will protablv have to reBain atatle on a per capita oaals for
e,n gjteedad period of tine unless the shift In tha aoonony's ffrontn mta tomrds
aijport and Investment flv«s a aiyilfloant boo at to productivity Itself.
It is eeaenMal that the 11-3. pursue a policy xdx which does not dlacoiirage capital
spending and aavlnga egeauHe the overTHluatlen of the dollar between 1981 andll9B6
retarded investaent la~ the aconoig'a tradeabla goods industries.*s the Charts
Illustrate,Investnent In oonaerclal real estate and dosestic service InauatriBa
rose to record levels as a share cf GKF after 1932 Nftlle ran? aeatora of
atanufeaturing Industry suffered fron Invtatnent anorexia.. Indeed, the aairafacturlng
capital stoolc of the 0.3. sotually shranlt In 19BZ-B3 for the first tine In the post-
approaches full employment.
^ar6e budget deficits were
educing the
ix which ue
onomy had ample underutiliz
large
ttempting to reduc
a
the
6?.JiP' t-w
enternal deficits had been
iotjring capital stock during the n i d - I Q B C ' s , we
eficit but, unf. irtur.ately,
as charts ll-6 illustrate, the policy
•ly igaO's caused a contraction in tr.e si±e of
apital st 50k and nanj industries, Including chemicals,
jpera ting at such high utilization rates that large price
and intermediate goods. History uould suggest
ing in the industrial sector, coupled with the
is, will push the total inflation rate into the
5.0 - 5.5J range by early 1989 i
October st
triggering
steps touarda deficit reduction in the weeks after th
but was inhibited from going further by fears o
testify, though, the major thraat facing tM U.3,
reeeaalon but inflationary overheating. Despite the rt
anoopf Sue Ing '9 S3 Is not
ision myopia of_Wall Street
for a reoesalon, which would
and monetary j>olicy arc moving In
actions retire acceptance of certain traders, and
ut moat Wall
would hme been a aharp upward spllie In tmeriean Interaj
1987-1988 followed by a traditional 3lon notion correct
Monday affected the tiling of the O.S. adjustnent pr
rates during the winte
i in equity values. B
>as, not Its dlreotSoi
Fed should u
the past fow
policy Instr
Beagan adninistratlon itself during 1986 will testify, there is
_longe
aafticientlj arable felationshii. bat^Ben aonM supulv and noalnal OM7 for the Ts6 to
Hashing on capable
oil if t n e F e d e
r aspects of public polioy which
exchange rate, commodity prices
Binlnuo wage law.
Ironically,
night directly influence prlc
ch a
a ion My have contributed to the
adnlniatration spokeanan of the
riat P
n in toerican aonetary growth during the paat year by matting speeches which
ary
currency balances of Aoerioan residents, data conpiled by the Bank of International
Settlenenta showing the distribution of currency balances owned by non-oanka in the
offshore financial syateo suggests that there has been capital flight from U.S.
dollar instruoonts since 1985. lit the end of 1987, the ratio of dollar deposits
owned py non-banks to other Eurocurrency deposits was only 2,1 compared to 6.0 in
pj-oloneed period of volatile staletata in public pollc^T pould ultimately
investment and cause the econom to drift into a pertod of g&IC^pep^q
the financial tiarketa, but
vestment, ueak productivity,
198U.
en
The
included In both the Gernv
nd Japan, our population U
oaitive growth features. In contrast to
ipanding. The supply side of the Bust-lean ! onomy la also highly flexible compared
the
-ation in wages so far this year has been modest. American businessmen retain
nflienc* to invest arjo will eipanil their capital eipendiCures by 10-12J tnls
the
year. Meanwhile, non-farn siports will probably expand by 201 during '936. In
fact, the sneer size of the trade deficit la itself an argument againat recession if
vt can develop policies wfiieh nalce it poasible W us to attract external aavlngs at
reaaonable levels of interest rates. In 1987, the trade deficit uas equal t o just
under «J of OHP or twice the output lost in the average post-war recession. Hence,
si»ply elialnatlng Che trade deficit eould add about 10 points to the industrial
uhile reducing the federal deficit.
Nh.
fine tuning role designed to aehiava 6-7i nominal GMF in which raal output eipanda
y~T.11 per annun and fnflation r.Mln in a range" of 3.5 - <..H. In ihe'long-lerm.
and their poasible Impact on o
ild
example, investors believe that U.S. nQMtarv policy is too inflationarj, tMre
could be a shift of funds out of the U.S., which would depress the growth rate of
the official monetary aggregates deapite the Fed'a effort to stimulate nioney
growth. While one can only infer frox the BIS data that there has been capital
flight from the dollar, it is difficult to bellve that Treasury departments In large
corporation) as well as wealthy individuals have not baen minimizing their exposure
to dollar d«poil.tB bBcauaa of concern about the value of the currency during the
past eighteen months. Indeed, as chart 1? Illustrates, the aloudoun In 0.3. money
gictumge Bate Target Zo
abandoned because of two major defects.
trade surplus by 1992-1993.
First, the
In recent weeks, the dollar has rallied because of
foreign hand marksts this year (Oenaark, lustr-sll*, Canada, France, in* the U.S.)
greater global convergence in the_ prices of tfadeable gp
ets througl:
ally
any good arguments for establishing
adjustment after 19
ould argue that the balance of payments
would have be
still enact the provision requiring the Treasury to auaMirregular testimony about
balances ttia
groups. New
exchange rate target zones with the najor components of U.S. scononio policy
iaeri
defin
Indus
United
Treasury has been reluctant to provide auah information in the past because it was
ange
might
rally
although every government is entitled to make Its share of mistakes, the
deterioration in the conduct of the 0.3, Treasury's international econoolc policy
ompe
ong
ing that
it
inclu
mcourage more efficient resource allocation not only in this country but in the
gu.
after 19"I5, the Anerlcan people have often been uncomfortable with managed exchange
r a t e s y s t e m s because of fears that they would force this country to import
conservatives who favored maintaining nonetary links to Britain via the gold
standard and western populists who favored an autonooous domestic monetary system
baaed on bl-metallism. In 1933, Franklin Roosevelt torpedoed efforts to stabilize
Mehange rates in order to raise domestic prices and zake a clear break with Herbert
n'real' te^ms'io ustain a ^KriB? Ir'ade" /info It* an" ca
gridlock in federal
help to lessen the danger of the imerlcan people believing that a(change rates night
ing
that
olent
uphea
U.S.
o.s.
prospects,
although no one is yat calling George Bush the Hanehurlan candidate of
ty and
to
43
U.S. during (989 if
it
painful policy choices uhich 118 ahead.
> the gold
In 1896.
but By Mr. Bush's unreported sue
Primary".
in the "G-7
of autonomy cherished by domestic policy making agencies, such 33 the Tr
the Federal Reserve.
Management of the exchange fate is by con
44
Rill Business Cycle Urwth HitM
CoMOund Mnul ntei ov«r ipuiHai ptriadi
taring Eipusiooi
1950-88:1 1170-68:1 34;2-37:3 SB:2-W:2 ilsl-WM 70:4-73:4 75il-B»!l 80:1-31:3 B2:4-88:l
Bff
Final Sain
DOMltic Final Sites
IIK Ftdffil Sptndinq....
Consuiptio
Durabln
2.7
2.7
2.B
3.0
3.0
5.0
3.4
1.1
1,1
4.1
3.?
4.2
4.9
4,2
4.1
4,1
4.4
B.I
4.1
4.2
4.4
4.6
4.4
7.1
4.4
1.9
3.7
4.7
4.1
11.4
4.1
3.9
3.B
4.0
.3.7
4.1
3.1
1,3
2.3
2.0
l.B
5,3
2.3
1.9
J.8
1.4
3.4
2.1
2.9
0.4
3.*
4.0
4.8
2.3
2.3
4.0
1.7
4.7
4.1
0.3
3.8
3.*
3.4
4.B
0.7
3.2
1.4
-1.7
5.7
1.7
i.l
f.b
2.9
10.4
B.6
7.?
9.0
4.8
t.i
B.4
4.3
1.1
-0.2
12.2
t.2
4.0
7.?
11.1
3.0
8.]
7.7
11.?
12.4
1.9
t.f
7.4
5.9
7.7
7.It
i.l
B.9
1.8
B.7
3.4
H.t
-3.1!
-1.1
4.8
2.0
i.9
-1.9
i.l
3.i
10.7
3.1
7.0
14.B 12.1
10.4
Iiportt
Km-iiil
Non-wtbutiu
Stitf I Local Sort. SotAdiag
1.3
4.B
4.1
8.T
i.3
3.7
4.1
7.3
t.3
2.1
7.0
1.7
-1.8
t.O
1.1
3.0
9.4
i.2
-1.3
1.1
12.7
14.1
20.1
-1.4
Fidiril Sovt. Spmtfinq
2.8
0.9
-3.0
-0.6
2.8
-4.9
NonduratlK
SiftitM
Businni Fiied Invntidit...
Equipimt
Structuris
R»si«ntiil Fiitt Inmtint
SingU Faitly
IWti-fnill
Eiports
ten-i^
Iton-MrchiRiliu
3.3
1.3
1.4
3.4
3.4
4.3
B.f
11.3
3.?
D«4«iM
ttnn-diftnu
Induitfiil Frttatim
GXP DHlitor
CrnfuNT Pfict Indd
Praductr Prici Indu
1.
*.l
4.4
4.3
S.O
1.1
i.4
3.7
b.l
3.3
1.3
1.7
2.2
1.1
i.i
I.l
!.4
7.3
4.2
3.0
3.1
7.T
9.4
B.3
1.3
4.2
3.5
4.2
4.4
3.B
B.I
2.3
3.7
6,4
10.4
-1.5
10.1
H.4
2.B
6.?
11.1
1.0
12.4
1S.4
9.6
3.3
1.3
3.S
2.1
O.f
2.8
J.I
7.1
-7.4
5,9
7.3
8.3
8.3
5.9
1.7
10.6
8.3
5.7
3.1
3.1
0.9
!.3
The post-1932 business expansion has been characterized by tha _strongest
growth rate of domestic demand in tha post-war period except for the expansion
which occurred during the Vietnam War.
45
It'll i it P»l I lrn>*i tun* IfttHimrr
IfW*
™"
tn-tu [v«. fralil • lit, i CM it I HT 11.14
1.11
11.11
toil I •. l-ti)l lull
I.M
-l.H
I.M
t. 1
.It
.It
t.il
.N
.11
-l.ll
.11
I.II
7.11
.11
i.n
71
l.ll
j
l.ll
- .71
-9.41
-1.11
-
1.41
!>•<* I flit twill El»l
rut i<Mk
rut
1171i 4 IITSil IfMil
FMtrtl M(*t MIC
Cnliillll M|. toli
II ill 1 LKI! tofici
litll tMHHHl Itl
cil iilSC
or
Pri-lii tort, frolit • iw i cu u i ur
L«q Inl. tmi Till / lit. l-tlll
toil lout (oil. toil
1 H r-hill Ti*H
JL, -».»
.11 -l.H "l.H
.11 -l.ll l.ll
-I.M
-l.il
-l.ll
-I.W
.11 -l.t
JL. -l.t
l.ll
I.M
-I.M
-l.ll
0.03 i.n
-i.n JJL
1. 1
IIMll Itlhl
i.n
-i.n
i.ir
-i.n
1.11
-I.M
1.11
-l.ll
-Ml
l.ll
-9.11
4.41
11.19
.11
Jt
l.H
.11
1. 1
1. I
.15
I.N - .M
-t.17
I.It
l.ll
1. 1
1
1.21
-l.ll
1.11
i.n
1.10
l.i!
.It
jB
I.I
1.1
-Ml
l.K
.1!
.11
I.I
-l.ll
5.3,
7.M
1.11
l.ll
ilj*_
I.II
-1.19
l.ll
I.N
t.il
Ml
t.n
t.n
I.IT
I.II
l.ll
l.H
1.11 i.a
-4.91
-1.11
11.19
-Ml
1.71
I.N
1.19
-1.71
19. «
4. II
Ml
-I.H
9.79
-9.4t
The above table shows Che level of various economic policy Indicators at the peaks
and ttooEha of the U.S. econony's post-war business cycles. Aa the chart illustrates,
the U.S. has never entered a recession with such a large government deficit both in
nominal terms and on a cyclically adjusted basis. Aa the ratio of long-term
government bond yields to T-bill yields utll testify, most post-war recessions also
have been preceded by yield curves which were much flatter than those which
currently prevail.
HUH iniit
4.11
l.ll
1.71
I.TI
J.It
1.11
46
6/29/8B
Savings I InvBitlent
is « I <tf MP
1980 1«1
1982 19B3 lfB4
19B! 19B6 L9B7 19B8 19B? 1990 19?1 1992
16.2 17.1 M.I 116 13.1
17.S IB.O 17.6 11.4 17.9
13.2 12.6 12.6 11.3 1!.! 13.4 13.6 11.7
16.6 16.1 15.0 15.5 15.4 15.3 1S.2 15.:
in
1 7
DcfirKiation
Bovirmcnt Surplus
Ftdiril
11. 1 11.4 12.1 11.6 11.0 10.9 10.B 10.7 10.6 10.5 10.4 10.! 10.2
-1.3 -1.0 -J.I -3.S -2.S -I.J -3.5 -2.4 -2.2 -2.1 -1.9 -1.6 -1.1
-Z.I -I.t -4.i -5.1 -*.5 -4.9 -4.B -5.4 -l.l -S.I -S.4 -1.8 -2.7
Brest Priv. DoMst. Invest
Priv. Dottstic Invest
IDDMS. Fi««d Invest
14.3
16.0
16.1
11. B
17.2
li.9
li.l
12.1
-O.I
0.5
0.3
0.0 -1.0 -2.4 -2.9 -3.4 -1.5 -1.0 -2.6 -2.3 -2.1 -2.1
0.2
0.1
0.0
Oiinqc in Bui. Inventories
Mrt Fortign InvMtiiBt
statistical diicnpucr
Addendui:
Fidinl Surplus
Exc. Social Security
Sociil Security
3.
,
n.a 1S.2
14.1 H.7 17.6
14.9 13.0 15.8
11.6 10.3 11.0
U.I
O.B -O.B -fl.2
0.2
l.B
13 J IZ.t 12.5 13.1 13.3
li.O is. a 16.0 16.1 IS. 9
15.3 15.5 13.0 15.2 15.1
11.0 10.3 9.9 10.2 10.!
9.2
0.4
1.0
1.0
0.1 -0.1 -0.1 -0.1 -0.2
0.7
0.0
13.4
13.7
15,0
10.2
13.6
15.3
15.1
10.2
13.7
15.B
1S.1
19.2
0.7
0.7
0.7
0.0
0.0
0.0
-2.2 -2.1 -4.6 -5.2 -4.5 -t.9 -4.B -1.4 -3.2 -3.2 -3,0 -2.B -2.7
-J.fl -*.0 -4.1 -4.0 -4.0 -4.0
0.4 O.B 0.9 1.0 1,2 1.3
The peraistance of large federal budget deficits will make it difficult to
reduce the nation's external deficit unless personal savings rise sharply or
private investment falls. On current policy assumptions, the current account
deficit will shrink to 2.1Z of GHP but still exceed J100 billion in 1992.
Real Net Stock of Nonrss I dan 11 a I PMvoU Capital
Manufacturing
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
Compound annual rate of growth
it.
The growth rate of the nation's manufacturing capital stock shrank in 19821983 Tor the first time In the post-war period.
87
Capacity Utilization Rates By Industry
Currant
Tola!
Manufacturing
Durables
Stone, clay, glass
Primary metals
Fabricated metals
Non-electrical machinery
Eteclrical machinery
Motor vehicles & parts
Non-aulo trans.
Instruments
83.7%
1979 Averaga
1982 Average
86 2%
72 I %
I 83.0
B1.1
82.3
84.4
82.B
79.6
77.6
80.9
87.fi
80.3
84.6
B4.I
85.0
88.6
85.5
84.2
87.3
7&2
82.8
87.3
70.3
66,8
65-1
54.2
65.4
67.0
70.6
54.3
72.1
81.8
85.7
80.4
90.fi
95.4
84.9
88.7
88.5
85.3
82.7
86.7
89.8
81.7
86.4
86.0
75.4
77.4
716
82.6
68.5
72.0
73.3
^
OD
Non-durables
Food
Textiles
Paper
Chemicals
Pelroleum
Rubber & plastics
5.
fca a result of weak manufacturing investment during th« early 1960's, the
export boom la creating capacity constraints in some industries.
Delivery
tinea rose sharply during June.
New P*E Expenditures by Business - Conraorelol k Other
QS a % of GNP
n • o i-j
Z
on
"0 • B
i- H-
(Bl
VO 3
CO
1»
0! (-
O B n 3
- D- fc <
O B It •
3.4--T-
i
70
,
71
|
72
i
73
i
74
.
75
i
76
i
77
I
78
I
79
88-1 4 88*2 based on plannod expenditures published
by the BEfl.
flcsumed
GfP gi-D»i:i
eronth iIn
1st .
A 2nd
qtr.. "•
of '<«>
;U»eQ (S.3S
J . 3 i an.n iit
j.iiu H*'
I
80
i
81
'
82
'
83
'
84
•
85
'
86
B8
2 quarter moving average
Investment in the economy's non-tradeable sectors boomed and is still growing
at healthy pace.
87
7/i/BB
CurrMCir BrtakdoMi of RtpurUni luki' EiUria) Pofitiont
m-a-m the Hoi-lak Sit tor
SMianiwal
(killiMi at U.S. loll art)
'» .
.
.
p
If 77
Liabilities
I
II
I17B
I
II
HBO
1771
I
II
I
1)82
I1BI
11
I
II
1
1984
11B3
II
11
1
If83
11
1
IfU
II
1
1187
11
I
II
'
Banks in Industrial
RtporUai. CauiUntsi
A) Foreign Currenciti
Other
Total
Ratio
43.2
41.8
12.3
57.3
16.8
7B.6
B1.7
22.7
112.4
112.3
27.?
23.3
40.2
45. S
0.4
C) Total Currnit i«
Dollars
Ottiir
Total
Ratio
17B.4
70.3
24B.f
2.3
111.3
IfS.f 204. B
3.2
43.4
40.1
13.7
41.2
17.3
84.7
18?. 8 I14.B 113.3 1?1.3 111.2 214.3
31.7 33. S 32.4
44.0
37.1
4B.O
221.3 228.3 223.7 232.2 247.2 2B0.3
4.0
3.8
33. i 41.5
43.1
14.
41. J
f7.1
104.0
207.1 224.2 243.4
71.7 (7.3
73. Z
7B.O
45.0
44.7
44.1
48.3
115.2
10?. 8
48.8
43.0
71.4
74.0
131.8 143.4
222.5 231.0 244.1
81.0 100.4 124.1
305.5 331.4 3if.B
73.2
if. 3
81. 1 14.3
154.3 163.6
71.0
116.0
187.0
238.3 261.0 24B.O 283.7 215.7 108.3 113.1
84.4
77.2
111.0 140.0 164.3 114.7 240.1
27».i 211.3 JIB.* 314.1 113.5 347.4 17f.O 423.7 460.0 303.0 554. B
3.3
1.3
1.2
1.1
1.0
2.4
2.0
1.8
l.i 1.3
J1
O.t
ECU'I
153.1 14!.? 144.5 173.0
28.1 11.4 29.8
3.7
8> DoMttic Cur rent ill
toll an
Othtr
Total
Ratio
Saurcti Bint for InterMtiwial Settltitflti
Plonetary ( Econo*ic Dept.
113.7
2S.f 10.1
140.4 IS?. 4 IBM
0.8
2.1
3.2
l.i
3.2 3.7
4.6
The sharp decline In the dollar share of offshore bank deposits owned
by non-bank investors suggests that caplcal flight from the dollar
may also have depressed the growth rate of the domestic money
aggregates. While the Fed does not collect data on domestic residents'
foreign currency balances, the protracted decline in the dollar has
probably encouraged a shift out of dollar deposits.
cn
o
Weighted Ind«x of World H3 Gro«th
X chonga year-ago
1982
13B6
Heights' U.S. 40X, U.K. 5X. Germany 231, France 7%. Japan 25X
(Thru Mar. '881
15.
while u.s. money growth declined during 196? and early 1988, It accelerated in
other countries partly because of central bank intervention to stabilize our
exchange rate.
till Itil lit) litl III! IM «il IM M i l Nil
Mil
Nit
If 11
till
ItiJ
1.1. CvtMl fccl. <uu«. ID -III -113 -Ml •!» -IM -111 -IM -IS* -IW -IM -1H
-III
-IU
-IU
-114
Mil IM. It lilHol
•ilk H I iilirmtiM
rilh 9* 1 litirmtiH
471 ]M 117
«1 304 117
Ul
111
411 Ml
UI 411
Ml
4*
H*
m
IM
H*
M
IN
HI
141
IM
Nil
Mtl
f*tl
Hi 4
lltl
Ilil
till
fill
Ilil
till
fill
Hi«
111 -IB
-l»
-|U
-111 -1*4
-141
-HI
-l«
-lit
-IU
-1»
-l»
111
Ml
til I,M7 I,HI 1,171 |,IH l,l» l,m 1,1*1 I.1H 1,171 I.M4 1,117 l,l» 1,4*4 1,411
HI I.Mi I,MI 1,111 I.1M I,U1 1,111 1,3" I.HI 1.M1 1.11' I .Ml I,Hi I,7H I,J» 1,1*1 1,U1
•m n i iitifiHiiM
vi SH MI ut ui ui Ht m u* nt i,*n i,m i,i» i,m I,M* i,m i.oj i,s» i,Mr i.tn I.IM i,iu i,m i,w i,ui i,i» i,m i,m
•itk IM t titHiMttM
III
UH
SM
Mil
5H
Ml
Mil
ill
Mil
Ul
I'll
M
I'll
W*
N*
t7l I,MI 1,114 1,191
l,W
l,4lt I,Mi I,MJ 1,141 1,141 I,t4t l,*ll 1,111 1,111 1,111 I,tU 1,111 1,*1! 1,IU
I'll III! Nil Mil Mil UK Mil Hil Nil Hi4 Mil Mil Htl Wt< IUI lltl lltl lilt 11)1 11*1 lltl Hit
U.I, CvrMl fcct. IHU«. Ill -14.* -14.1 -11.1 -IU -II.' -H.I -II.) -1.7 -1.1 1.1 1.1 -1.1 -1.1 -1.1 -I.I -1.1 1.1 I.I
1.1 5-1 1.1 1.1 1.)
1.7
M
1.1
T.I 1.1
(•til In. It l*i«w)
ritk M I ultrtMtiM
II.I
11.1
It.r
11.4
•itk H I lit Mint IM
•ilk 791 litHiMtm
ll.l
li.l
11.1
in
ll.r
».i
11.1 11.1 ».l If.l 41.3 H.I ll.t H.I 73.' 11.1 11.) H.1 21.1 M.I M.I 11.1 Il.l IM U.I lit 11.1 It.) M.I 11.7 11.1
11.1 il.f ll.l if.f 11.9 IM M.I 4).i 34.1 n.* n.i it.r n.i 14.1 n.l 11.) n.< 11.1 ».* ii.f ll.l ll.l ll.l li.l ll.l
ri» IM i uitrmdH
11.1
11.1 «,1 41,1 ll.t IM U.I IV< U.» l».l H.I H.I IS.I tl.t II. 1 11.J 11.1 tl.l tl.t II.1 II.* l*.7 11.3 l*.l
11.1 11.1 it.r 11.1 11.1 ii.i it.t ii.i ti.i M.I 11.1 u.i 11.1 »-• il.t u.i ii.i n.t IM a.i n.* n.i IM M.* 11.1 11.1 IM 11.1
MMMl rtlt »l ftplttk
16. This table shows the potential growth rate of world foreign exchange reserves IT
central banks have to finance 25*, 50K, 75* and 100* of the U.S. current account
deficit. It would be possible for central banks to finance a Bodest portion of the
current account without losing control of their domestic money supplies, but financing
on a scale equal to last year's could lead to a repeat of last October's bond market
crisis and stock narket collpaae.
Prices
energy
year.
higher
of lnter»«di«t« goods less food and
hava risen sharply during the past
Finished goods prices are trending
but at a gradual pace.
Producer Price Indexes
6 month annual rote of chanc
Intvn«diate Good* !*ss Food * Energy
lagged 6 months ( l i n e )
Finished Goods
less Food * Energy (dot)
CC
•-•I—h--r —i—t197B
1977
1978
1973
1980
1981
1982
1983
1984
1985
1986
1987
1988
Nonfinanciol Cor-por-ot* Profits *lth IVfl
Wholesale ft Retal I ( Mna)
as a X of Total Nonflnonclol
54
5E
58
60
62
64
ManufacturIng
(dot)
as o X of Total NonfInonclal
66
68
70
72
74
76
78
80
82
84
B6
88
Foreign Direct Investment !n U.S.
plus
Purchases of U.S. Corporate Equities
as a X of GNP
2.0—
B I B B
B -o
rt H »
a 3
o^
h-
0.0
63 64 65 66 67 68 59 70 71 72 73 74 75 76 77 78 79 80 81 82 63 84 85 86 67
4 qtr. moving average
Foreign direct investment and equity purchases rose sharply
during the first half of 1987, but they have receded during
recent quarters as foreigners scaled back their exposure to the
LJ. S. stock market.
Rfter-tax adj. Nonfin.
Profits as I GNP ( line
Trade weighted U.S.
dolIan (dot)
>
4.5
-150
4.0
» m i-»
1 H- i
rr o
—130
*
Hn>
Ha
K
a> 3
B
y a
ea s
i n
n
a- O » f 1
-B •< » 1
rr on
y-
:
B »
_- ft
a n *a
m
M
o> 00 V ft
» o O5 "
CD (D
2,01980
1961
1982
4 qtr. moving average
1383
4.
1984
The dollar rally of the early 1980's co-incided with a
sharp rise in the profit share of GNP resulting from tax
policy and paycuts. Now the profit share of GNP is falling,
•* C "
11. -The decline la profits c*u»d by t»x reform ha«
probably also weakened the •c.onomj'a tolertnce
for high real intireat rat«>.
Trade weighted U.S.
do I I or (dash )
>
198-1
qtr. moving overage
The rise in the profit share of GNP also increased Che economy's
Interest rate tolerance and permitted a sharp rise in real yields
foe
both short and long maturity instruments.
Ml Velocity
compound annual rate of growth
over 20 qtfs. I dot>
w » tr i
re Q, a 3-
o. o.
M- ors
e. n H-
60
62
S4
66
68
70
72
74
7B
78
80
82
84
66
88
M2 Velocity
compound onnuol rate of growth
over 20 qtrs. (dot)
over 4 qtrs. { IIne)
VI
60
62
64
66
S3
70
72
i74 "176
78
1 80
'
82
I84
186
i88
60
The CHAIRMAN. Thank you, Mr. Hale. I want to thank all you
gentlemen for excellent presentations.
Mr. Fair, as you might expect, I can't resist starting off with you
in view of the fact that you're telling us how we can predict elections and we're going to know whether Bush or Dukakis is going to
win—I should say the Dukakis-Bentsen combination versus Bush
and Kemp or whoever he picks—how they're going to make out.
It's awfully disillusioning for those of us in politics that hear
anybody, particularly a skilled professional such as you are, can
say that you can forget the personalities, you can forget all the
issues that we work so hard on and believe so deeply in, forget the
deficit, forget everything, as long as you get the combination \Vz
years before the election or 2 years before the election of relatively
stable inflation or not much change in inflation and a substantial
growth, then the election will be determined by those economic
forces without reference to either the personality or the campaign
or any of the other things that we focus on.
And I must say, on page 3, you present us with some remarkable
data that shows that in at least 14 of the 18 elections you came
very close. I would say that in 1964 it failed. Somehow Goldwater
versus Johnson was missed by 7 percent and in 1924 and in 1928
and 1944 the miss exceeded 3 percent, so that you might argue that
that wasn't too accurate.
But in all the others it was remarkably close. In 1980, for instance, you hit it exactly right on the nose and in the others you
came within 1 percent or so of predicting how it would turn out.
Now you tell us, however—boy, this is something—now you tell
us that in 1988, which is what we really are concerned about, you
can't tell us. It's too close to call. Is that right?
Mr. FAIR. Well, Senator, this is not deterministic. In any equation in economics, there are factors that we don't account for. They
are what we call error terms, things that affect, in this case, votes
that are not in the equation, that are not in the economic equation.
The CHAIRMAN. But this equation did predict 14 out of 18 elections.
Mr. FAIR. Yes.
The CHAIRMAN. And it predicted 17 out of 18 within a little over
3 percent.
Mr. FAIR. Right. On average, it makes an error of about 3 percent is what I'm saying. So that politicians should not be dismayed.
If the predicted vote is within 3 percentage points, then there's
hope because on average this is what the error is. So if I'm predicting 48.2 percent for the Republicans, that's a very close election
and there are truly other factors that affect the votes other than
the economy and that affects about 3 percent of the total.
The CHAIRMAN. But you're saying, rightly or wrongly, regardless
of how you arrived at it, that if you get the growth and inflation, it
may in the long run—the policies may be terrible—I think they are
now. They couldn't be worse. We have a terrific national debt. We
have a terrific household debt. We have an enormous business
debt. I can see nothing but grief for our economy in the future.
You're saying the public doesn't care about that. All they care
about is what's happened over the last IVa years.
61
Mr. FAIR. That's what the evidence seems to indicate, yes, that
they care about GNP growth and inflation. There's not any evidence that they care about the debt, as one can find it.
The CHAIRMAN. Now let me say one of the reasons we asked you
gentlemen to testify, of course—the principal reason—is because tomorrow we're having the Chairman of the Federal Reserve Board
testify and we wanted to get the most expert testimony we can so
that we could evaluate that testimony we're going to get tomorrow
and determine whether it's sound or whether we should criticize it
and so forth.
Now let me review what you've said very quickly. Mr. Blinder,
you have indicated that you think the Federal Reserve Board's
monetary policy is about right.
Mr. BLINDER. Yes.
The CHAIRMAN. Dr. Dornbusch, you say it's about right maybe
but it may be becoming a little too tight, slowing the economy. Is
that right?
Mr. DORNBUSCH. I'm expressing the fear that next year the Federal Reserve will feel like making a recession unless Congress
moves on the budget. All of the problems are next year, not right
now.
FED CAN PREVENT RECESSIONS
The CHAIRMAN. Well, are you telling me that the Federal Reserve somehow can prevent recessions from occurring?
Mr. DORNBUSCH. Certainly. They did last fall.
The CHAIRMAN. Well, once in a while, but are you saying that if
we have the proper Federal Reserve Board policies we will never
have another recession?
Mr. DORNBUSCH. I certainly didn't come close to saying that. But
they did last fall in a very, very critical situation do an extraordinary job avoiding a recession, yes.
The CHAIRMAN. But if we're going to have a recession, is it not
possible to argue that it's better to take the recession as soon as
possible if in taking the recession you reduce spending and increase
taxes and reduce the deficit and move the household sector and the
business sector into a more sound and stable position?
Mr. DORNBUSCH. That is exactly what I'm saying, that we should
have fiscal restraint, not recession, and not Federal Reserve recession because a Federal Reserve recession would be extremely
The CHAIRMAN. You distinguish between recessions?
Mr. DORNBUSCH. Certainly. A Federal Reserve recession tests all
the financial fragility in a particularly difficult way.
The CHAIRMAN. Mr. Fair, I don't think you made a judgment as
to the Federal Reserve Board's monetary policy.
Mr. FAIR. I said somewhere I thought they should be given substantial credit for the past performance of the economy. So basically I would agree with Alan Blinder that the Fed policy has been
about right.
I would hope, as I said, that for next year that Congress and the
administration could lower the deficit some and that the Fed would
then perhaps ease up to counter the negative effects of that on the
economy.
62
The CHAIRMAN. All right. Mr. Hale?
Mr. HALE. I would concur that the Fed has had a good policy
over the last 9 months. It began to tighten last autumn in response
to the threat of inflation and after the stock market crash it eased
very quickly. I think it pleasantly surprised the market by tightening so aggressively in the face of the resurging economy and growing inflation pressures this spring.
But I think over the next year the challenge facing the Fed because of these twin deficits, because of the need to maintain a very
modest growth rate, and also to close the very large trade deficit,
will overtax the capacity of the Fed unless it has help from fiscal
policy.
I think a monetary policy recession, as Mr. Dornbusch indicated,
would be very destructive. We have large levels of debt. We have a
serious crisis in our deposit insurance companies. We already have
a large Federal deficit. I think a recession next year is not a viable
policy option, but I'm afraid the alternative to that, if we don't get
a fiscal policy change, would be an inflation rate heading toward 6
percent and bond yields well above 10 percent.
The CHAIRMAN. You say it's not a viable policy option to have a
recession next year?
Mr. HALE. All policy choices obviously are a question of tradeoffs
and I think the tradeoffs of a recession next year would be so destructive and so destabilizing that it is not an attractive policy
choice at all.
I would rather live with 5 or 5.5 percent inflation for the next
year if we could get significant fiscal policy progress than to try
and have the Fed crunch the economy.
The CHAIRMAN. My time is up. Senator Bond.
Senator BOND. Thank you, Mr, Chairman.
It probably comes as no surprise that I don't share the chagrin
just expressed over the prospects for the parties, given the continued relatively low inflation rate and the strong growth in GNP. I
suggest that perhaps we realize that we're limited in our ability in
Congress to mess up the economy and if the people of the United
States are interested in low rates of inflation and strong growth
rates that we perhaps ought to adjust our policies to achieve those
and I particularly appreciated the comments that all of you have
made about the need for us in Congress to do something about the
deficit.
I'd like to move to a sort of related area that has interested me. I
have seen some knowledgeable economists who are saying that one
unintended effect of the increased internationalization of our debt
is the fact that the international bondholders, the people who are
putting the money into finance our excesses, are controlling interest rates and to some degree exercising through the market mechanism the role that we traditionally expect the Federal Reserve to
exercise in monetary policy.
At least one has said that this fine-tuning may prevent monetary
policy from bringing about a recession because it makes continuing
responsive changes in interest rates and money supply.
I'd like to ask if any of you have comments on that, to what
extent you think that international markets really are playing an
63
increasing role rather than the Federal Reserve in our monetary
policy.
INFLUENCE OF INTERNATIONAL MARKETS
Mr. BLINDER. Well, there's no doubt truth to the idea that bond
markets are increasingly internationalized and what goes on not
only in the United States, but also in Zurich and lots of other
places, affects our interest rates and also Switzerland's interest
rates. I think it's easy to exaggerate the effect on monetary policy.
The idea that monetary policy is now in the hands of the gnomes of
Zurich or the gnomes of somewhere else is easy to exaggerate.
To some significant extent, these people are trying to guess what
the Federal Reserve, and also the Bank of Japan, and other central
banks, are trying to do. So I think it's proper to think that the responsibility for and the authority over monetary policy still rests
with the world's central bankers and not with the world's bond
traders.
Mr. DORNBUSCH. I would add to it that the short-term interest
rates are determined by the monetary authorities. The only way
world capital markets get into the act is if the monetary authorities have exchange rate targets. Then the decline in the dollar
would force an increase in interest rates through tighter money. So
if we get exchange rate targets, then we would affect monetary
policy.
Today we are doing exactly the opposite with very strong exchange rate targets and that's behind the dollar appreciation a substitute for raising interest rates.
Mr. FAIR. I have nothing to add. I agree with that.
Mr. HALE. I would concur and again just to restate what I said in
the very beginning, we've always had some international components in interest rates but we now have more capital mobility in
the world economy than at any time since before 1914. Because of
the depression and the two world wars we had restrictions on capital mobility and the financial markets were quite insulated. I
think the current financial environment in the United States is
highly anolagous to the 1890's when we were importing capital
from Britain. In fact, if you look at our external debt in terms of
GNP you will see that Ronald Reagan and his successor will have
taken us on a 100-year roundtrip. By 1992-93, our external debt or
foreign investment here will be about 21 percent of GNP, which is
exactly what it was in the days of Grover Cleveland. In that period,
changes in foreign capital flows were a major influence on our
stock market and interest rates. In fact, all the great bear markets
of the late 19th century were grounded on exchange rate uncertainty and changes in British capital flows. As with the stock
market crash last year, 1 think again we're going to see foreign
flows are quite important for some time to come.
Senator BOND. Let me follow up on that by starting off with you,
Mr. Hale. We have all seen the stock market crash of October 1987
fail to predict the crash in the economy this year. Is there a weakening of the linkage between the financial markets, between Wall
Street and Main Street? Is this an aberration?
64
Mr. HALE. I would say that the crash was very badly interpreted
by the New York financial community back in the winter. In my
opinion we were heading for very high interest rates in the United
States because of the danger of rising inflation. Because of the
breakdown in the arbitrage system between the stock market and
the futures market, we had a compression of that financial adjustment process into a 1-day collapse called Black Monday. I believe
it's very hard to have a recession in a country that's had a big currency depreciation unless you have severely restrictive fiscal and
monetary policy. We didn't have that. I think the major error
made by Wall Street in particular last winter was not to recognize
the linkage, that in fact the real concern of the market was not
recession but inflation leading to higher interest rates triggering
recession at some point combined with the gigantic technological
accident.
Mr. FAIR. The stock market went up substantially in the first
half of 1987 and then crashed later and now has come back up
again. The net effect on consumption and spending is not that
large, looked at from more than just a 3-month period. From the
start of January 1987, the wealth effect has not been that substantial. So you wouldn't have expected much of an effect on consumption, and we certainly haven't seen it.
Mr. DORNBUSCH. I agree.
Mr. BLINDER. Let me just add one more thing. You're hearing
this with the wisdom of hindsight, to be sure, for a lot of us had
some fears in the fall. It wasn't only politicians, but also economists who had some fears about what the stock market crash
might do to the economy. With the wisdom of hindsight, however,
one thing we can see that made a big difference is that, as the
stock market fell, the bond market rose and interest rates fell.
Looking now on the investment side of the coin rather than on the
consumption side, both markets influenced the average cost of business capital. The expected effect on investment, given the adverse
movement of the stock market and the favorable movement of the
bond market, was not that great. That's not something a lot of
people were saying on October 19; but, in retrospect you can see
that was so.
Senator BOND. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you very much, Mr. Chairman.
I have an opening statement which I would like to have printed
in the record as if read.
The CHAIRMAN. Without objection, it will be printed in full in ute
record.
STATEMENT OF SENATOR JIM SASSER
Mr. Chairman, I am pleased that you are convening the committee for our biannual look at monetary policy and the state of the
economy.
I think that we are at an important point. The economy appears
to be performing at a better than expected level. And naturally we
65
are already hearing the calls for a tightening up, lest inflation rear
its head.
Well I think we need to wait on a tightening up. There is too
much fragility in the financial system. Indeed, there is too much
danger that a tightening up could eventually cause a recession.
A recession would be a disaster. The fiscal situation would be intolerable. The savings and loan crisis would reach astronomical
proportions. Any increase in rates now I remind the committee will
only exacerbate the condition of the thrifts.
So I think we need to see some solid evidence of a pick up in inflation before rates go up. Wage and price increases are moderate.
The relatively low unemployment rate does not necessarily mean
the economy is heating up.
I look forward to today's testimony.
It seems to me that given the fragility of the financial system at
the present and our fiscal imbalance that we ought to be trying to
avoid a recession almost at all costs. Quite frankly, it appears to
me that the Federal Reserve is peopled with determined inflation
fighters who see inflation where it may not be there and they could
very well trip off a recession.
We already have a fiscal deficit hovering at around $150 billion
annually and I don't see any realistic estimates of any major improvements in that. We have a thrift crisis which could cost us upwards of $60 billion to resolve. The commercial banks are carrying
large portfolios of nonperforming loans from the less developed
countries, energy loans that aren't performing, agricultural loans
that aren't performing, and the banks may soon be carrying large
portfolios of nonperforming leveraged buyout loans as well, from
what I'm reading.
Now it appears to me that a recession would greatly magnify
these problems. It would certainly make the S&L crisis much,
much worse. And I fear, when we got into this recession that Congress would have no ability, and the administration would have no
ability, to conduct a countercyclical fiscal policy because we just
wouldn't have the money. We're broke. Indeed, there probably
would be pressure to cut spending and raise revenue ala 1930-31. It
appears to me in this scenario that the Federal Reserve has an absolutely critical role. I think we need to be encouraging lower interest rates right now rather than constantly searching for the
slightest signal of an uptick inflation.
All we've been hearing in the past week is that the economy is
overheating and that interest rates need to be raised. There's speculation the Fed will up the Federal fund rates this week.
Now given the danger of recession, why don't we wait for more
solid evidence of inflation before we rein in our monetary policy?
Am I right or wrong in my assessment here? And I'd like to hear
from this distinguished panel what their views are. Why don't we
start with you, Dr. Blinder, and see what you have to say about
this observation.
RECESSION
Mr. BLINDER. Well, I very much agree with what you said, as I
tried to hint in my testimony. A recession now or next year, espe-
66
cially if induced by monetary restrictions, would indeed exacerbate
a lot of the problems that you alluded to. And I agree 100 percent
that it's pie in the sky to think that we could have a timely fiscal
offset given that the hypothetical recession we're talking about
would push the Federal budget deficit to $250 or $300 billion. So I
don't think we would get stimulus from the budget. Hence, I think
this is a scenario to be avoided. I also think there is a tendency—
I'm happy to say for a change, for I don't think it has been historically true, but for a change, the tendency to get hysterical over the
slightest indication of inflation now seems much stronger on Wall
Street than it does at the Fed. That hasn't always been the case.
But I think this particular Fed seems to be more recession-averse
than previous Boards of Governors, more so, say, than the average
over a long period of history. And hence I think we have some
reason to think, based also on their past performance, that this
group is not likely to be panicked into pushing us into a recession
at the slightest hint of inflation. I certainly think that's what they
should be doing, and I think maybe that's what they would be
doing.
Senator SASSER. Does anybody else wish to address this?
Mr. DORNBUSCH. I'd like to comment, too. I think the problems
for the Federal Reserve is to get a live economy to the next administration so they certainly must do everything to avoid a recession
in the second half of this year since that would make fiscal correction entirely impossible. After that, they have done most of the
work and the burden will be on Congress to change the fiscal policy
and if that does happen the Federal Reserve must assist with an
accommodating monetary policy that permits a slowdown but
avoids a recession. So two parts—one until Christmas by no means
recession, and after Christmas to sit on the next administration
hard. I do think we cannot say today that inflation is not the issue.
If you go back to the Economic Report of the President of the
1960's and read it year by year, you would think you were in the
1980's. We're exactly in 1968. There's absolutely no question. The
uncomfortable part is that inflation is rising so slowly that it isn't
dramatic and that one can believe there is no problem.
Mr. FAIR. Well, just quickly, we should distinguish between a recession and tight money. If it's the case that we have a big export
boom because of past falling of the dollar and the economy otherwise remains strong and fiscal policy continues to run very large
deficits, it may simply be that we are overheating because fiscal
policy is not cooperating. In that case, I would think what we
would have to have is a tight monetary policy. That doesn't have to
lead to a recession. It's just a change in the mix in the opposite
way than most of us want, but it will be a policy to try to keep the
economy from booming more than it should. That doesn't have to
imply a recession but it may in fact imply tight money.
Mr. HALE. I would just add that the Fed's current policy mode is
very much one of fine-tuning. We are not looking at a repeat of the
policies we had under Arthur Burns in 1974 and Paul Volcker in
1981 as a consequence of high inflation, you can measure that by
looking at real short term interest rates which are currently at 2
and 3 percent, which is the lowest level in this decade. I don't sense
any support either in this town or in the country as a whole for
67
severe monetary crunch because inflation is now under control, but
also, as Dr. Dornbusch indicated, the preconditions for inflation are
certainly in place and therefore this fine-tuning policy could require further moderate upward adjustments in interest rates but
the stress would be on moderate and not a repeat of the sledgehammer of 1981-82.
Senator SASSER. My time has expired. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Graham.
Senator GRAHAM. Thank you, Mr. Chairman.
There have been some traditional relationships that have been
looked at in terms of growth levels of GNP, inflation and unemployment which are balanced in order to achieve a stable economy.
These tend to infer that we are an island that is unaffected by external events, a fact which we know to be wildly inaccurate.
To what degree do we need or are we adequately incorporating
external economic events in our traditional patterns of domestic
monetary policy?
EXTERNAL ECONOMIC EVENTS
Mr. BLINDER. Well, that's a good question to ask Mr. Greenspan.
I think much more than previously everybody is keenly aware—
sometimes it seems too aware—of the sensitivity of international
capital flows. We have all been speaking about the export boom
that's going on in the United States as a very major factor in
thinking about what monetary policy should be doing now, and I
think there's every reason to think that the Fed is also thinking
about that. Should OPEC III occur any time soon—and nobody
thinks that it will—the Fed and everybody else would quickly recognize the international implications of that.
So I think our eyes are watching the right places. That's not to
say that we can predict and anticipate what's going to go on at all
perfectly in these dimensions.
Senator GRAHAM. One specific issue I heard some discussion that
if given our current 5.3 percent rate of unemployment, which is defined as almost a full employment economy, that if the gross national product rises above 2.5 or 3 percent that we may be facing
the kind of inflationary pressures that I think Senator Sasser was
concerned about.
My reservation about that analysis is that that assumes that the
additional consumption capacity which that GNP level above 2.5 or
3 percent infers is only going to be met with our own domestic
economy and if it's at full employment ergo inflation must follow.
It seems to me that that doesn't appear to adequately take into account the fact that there is the rest of the world out there which is
capable of producing products and services which could absorb that
GNP growth.
I think my question falls into the same gilt as Senator Sasser's,
that we may be searching for phantoms upon which to justify a
new surge of inflation and therefore potentially overreacting with
some unanticipated negative consequences.
Mr. DORNBUSCH. I think the policy you're advocating is exactly
what is being done now. Getting the dollar up in order to slow
down the growth of exports to have more goods available in the
U.S. economy for inflation fighting and we do that by borrowing
abroad and we can do that for 1 year or 2 or 3 or 4. If we do it long
enough you look like Mexico or Argentina. They have really fought
inflation extremely well for 5 years. Then, of course, they had the
huge collapse in the exchange rate.
I think the risk today is to use a strong dollar for inflation fighting at the cost of slowing down the trade adjustment. And that's
exactly as you describe it. You use foreign resources to fight inflation at home and there's lots out there providing we guarantee the
exchange rate.
Mr. FAIR. If we are at full employment roughly now, then domestic production can only grow at the rate of technical progress and
labor force growth, which is about 3 percent, so that we could continue without too much inflationary pressure to grow 2.5 or 3 percent domestically, but that's about it. If we want to consume more
than that, we have to do what Mr. Dornbusch said.
Senator GRAHAM. If Mr. Bush or Mr. Dukakis were to call you
and ask you to do some anticipatory planning of what they should
focus their attention on during the period from the election until
January 20 in order to be prepared to deal with the most urgent
economic issues of the new administration, what advice would you
give them?
Mr. FAIR. I think the fiscal policy needs to be contracted some, as
most of us do. So I would argue for a tax and expenditure package
that would lower the deficit substantially in the next 3 to 5 years,
something that we have been trying to do for years without much
success. I would say that's probably one of the top priorities for the
new administration.
Senator SASSER. Mr. Bush might hang up on you, Dr. Fair, if you
talk about taxes.
Mr. FAIR. I said tax and expenditure, perhaps I should have said
tax on expenditure.
Senator GRAHAM. Or in both the conjunctive and the disjunctive?
Mr. FAIR. Right.
Mr. BLINDER. I'd just like to say that most economists would say
something similar and, as you say, most politicians would hang up
on them when they say it.
Mr. HALE. I'd like to say that we obviously have to address the
fiscal problem through a 3 or 4 year program to have credibility in
the financial markets. In the absense of that credibility there will
be very severe shocks in terms of bond yields and the dollar within
weeks after the new President is elected before he even takes
office.
In addition to that, on a more positive note, I would also want to
begin negotiations with our major allies and trading partners on
redeveloping the kinds of programs we had in the late 1960's to
compensate the United States for its large international military
and political role. Before the breakdown of Bretton Woods in 1971,
this country pursued a program called the offset program with Germany, designed to compensate us for our military presence in
Europe. It encompassed, agreement by the bundesbank not to convert dollars into gold, which would create downward pressure on
the exchange rate. Second, the purchase by the bundesbank of U.S.
Treasury bonds bearing below market U.S. interest rates as a quid
69
pro quo for our defense effort. Third, additional purchases of U.S.
defense equipment by the German armed forces in preference over
British or French equipment. Finally, direct subsidies to the U.S.
military bases in the Federal Republic.
I believe the G-7 process that began under Mr. Baker 2 years ago
is now evolving inadvertently into a repeat of that offset program.
In fact, you could describe the actions of the Japanese ministry of
finance over the last year in terms of its currency intervention and
the arm twisting of Japanese life insurance companies to hold onto
our bonds even when yields are rising as a kind of informal offset
program. As stated in my initial testimony, we have to go beyond
this informal ad hoc agreement to something more substantive and
comprehensive and I think that is an essential part not only of our
adjustment process post election but also of the whole world
coming to terms with America's resource constraints and potential
overcommitment vis-a-vis its resources.
Mr. DORNBUSCH. I would like to argue also for the fiscal issue as
the main problem the next President should address and think
about early, not because we are in a fiscal crisis—we certainly
don't have one—but because the overheating of the economy at the
current rates would bring a collision course between the Federal
Reserve and the economy unless the budget gets moved. That may
be a half a year or 12 months ahead, but when it does happen, just
as in 1969, it is going to be extremely expensive because we have
vulnerability today.
I would add that there is virtually no professional economist that
disagrees except people who are advising the candidates.
The CHAIRMAN. Do they lose their professionalism because of
that?
Mr. DORNBUSCH. For them it's untimely to speak.
The CHAIRMAN. Dr. Dornbusch, supposing the next President of
the United States rolls up his sleeves and says, "Look, I've got 100
days," as Roosevelt had back in 1933, "I'm going to make them
count. I'm going to do what I think is right. I m going to, if necessary increase taxes. I'm going to cut spending. I'm going to come in
with a program that's going to cut this deficit down in a very few
years to a balanced budget.'
Do you have any confidence that the Federal Reserve Board
could then follow a policy that would not result in a recession and
a deep one?
Mr. DORNBUSCH. I'm certainly totally confident that the Federal
Reserve could do it and would do it. In fact, from the time of
Volcker it's understood that the quid pro quo of budget balancing
is that the Federal Reserve sustains growth in the economy.
The CHAIRMAN. You don't have any confidence in McChesney
Martin's observation that you can't push a string, referring to monetary policy. No matter what you do with interest rates, if you
move into a depression caused by fiscal policy or whatever, the
Federal Reserve can't make people borrow if the demand isn't
there.
Mr. DORNBUSCH. I see plenty of room on the net export side
where easier monetary policy through a gain in competitiveness
stimulates growth. We've had it this year and there's plenty of
room left. It will force foreign countries to accommodate by being
70
more expansionary and once that is seen, domestic investment will
take place.
The CHAIRMAN. Now I see Mr. Hale nodding. How about you, Mr.
Fair and Mr. Blinder, do you agree?
Mr. FAIR. I would agree with that. Remember this is not a crisis.
He's got 100 days to make a decision but it's a plan that would be
spread out over 3 or more years and that's plenty of time for the
Fed to adjust to the changing situation. There are lags and there
are some uncertainties and it may be that for a variety of reasons
one may have a slowdown, but I think that over that period of time
the Fed clearly has the ability and the will to avoid a serious recession.
The CHAIRMAN. Mr. Blinder.
Mr. BUNDER. I agree qualitatively, but I'm not quite as confident
in the Fed as Rudi Dornbusch is. He counts on the Fed much more
unequivocably than I ever would.
The other thing I want to add is that the fiscal contraction we're
talking about is not such a cataclysmic event that it's guaranteed
to tip off a recession. It's the kind of thing that can and should be
done gradually. We're probably talking about something on the
order of three quarters of a percent of GNP per year for 4 years,
something like that.
The CHAIRMAN. But what you're counting on is offsetting spending by the private sector and borrowing by the private sector at a
time when the private sector is up to its eyeballs in debt.
Mr. BLINDER. Well, some of this will be coming from foreigners
buying our goods. It's not mostly replacement by
The CHAIRMAN. Let's get into that. Mr. Hale pointed out that the
real interest rate is the lowest in this decade. Now at a time when
we do have very, very high private debt and very high business
debt and very low savings, it would seem to me that a low interest
rate policy would tend to aggravate this situation. All you do is you
shift the living beyond your means more heavily from the Government to the private sector, don't you?
Mr. BLINDER. No. I think a low interest rate policy—remember,
we're talking about compensatory monetary policy—a low interest
rate policy is going to ease all of the debt crises while a spike in
interest rates is going to exacerbate them greatly. The evidence is
that the choice between savings and consumption is very insensitive to interest rates. So we wouldn't expect any large change in
the consumption behavior of Americans.
The CHAIRMAN. That may well be, but certainly home buying,
spending on buying a home, spending on buying cars, is very sensitive to interest rate changes. If the interest rate is down, people
will borrow money and buy homes or borrow money and buy automobiles and so forth and if interest rates go up they tend to reduce
that kind of spending and dissaving. Isn't that right?
Mr. BLINDER. Yes, that's right. But I think that, given the state
of the economy we have now, which is pretty near full employment, a lot of that would be substitution from other types of savings. Prices would adjust to make it so.
The CHAIRMAN. Mr. Blinder, let me ask you this. Is it international responsible policy to reduce the value of the dollar so that
we can increase our exports and decrease our imports at a time
71
when we have 5.3 percent unemployment and in Europe it's 11 percent unemployment. They're practically at depression level in
Europe. The strongest economy in Europe, Germany, has 9.5 percent unemployment. In Ireland, it's 20 percent. In Spain, it's 19
percent. In Italy, it's 14 percent. How responsible is it for us to in
effect aggravate that kind of a situation when our unemployment
is so low?
Mr. BUNDER. Well, I think it's very responsible. I think the situation in Europe is largely the Germans' doing and not our doing. To
the extent that a further drop in the dollar, if we have a further
drop in the dollar, serves as a swift kick in the pants to the
Bundesbank, the entire world will be better off.
The CHAIRMAN. I can see how the German policy would have
that kind of effect on West Germany, but why should it have that
much of an effect on the United Kingdom and on Italy and the
other economies of Europe?
Mr. BLINDER. Because the EMS is functioning more or less as a
way to spread the German monetary policy all over Europe, because the other countries have to more or less keep their currencies on par with the mark.
The CHAIRMAN. Do you agree with that, Mr. Hale?
Mr. HALE. I would say that the bundesbank is one factor but
probably far less important than supply side factors such as labor
market rigidities in the case of Britain and France, trade union
rules, plant closure laws that make it expensive to create new jobs
and hire people. There's a whole range of labor market policies in
Europe which have been identified and amply documented in a
number of studies and books which you can get right here in Washington that explain that Europe's unemployment rate has been
rising for over a decade because of these rigidities, and monetary
policy has played a role but it's by no means the central part of the
process. I would say the German monetary policy has tried to be
responsible over the last few years in the face of barriers and problems that are out of the bundesbank's control.
Because of that supply side rigidity, I think that if we do, as it
were, export more to Europe, we in fact will create circumstances
that might lead to some policy changes that would lower unemployment. In fact, in the past year or two, the British economy has
begun to improve quite dramatically not only in terms of growth
but also unemployment because of changes in policy designed to
correct these rigidities so that their unemployment now is approaching that of the Eastern United States.
Let me just amplify your previous question. The reason we need
fiscal restraint is that we are resource constrained. None of us here
are recommending a recession. What we're recommending is a long
period of moderate growth reflecting full employment, which I
think is the ideal outcome.
The CHAIRMAN. My time is up. Senator Sasser.
Senator SASSER. Thank you very much, Mr. Chairman.
Two comments. One, Mr. Hale was indicating that we ought to
get back into an offset program with our allies around the world
where they help offset some of our military expenditures. I think
that certainly is happening, if I may comment on that—it's certainly happening with a vengeance. You have only to follow Secretary
72
Carlucci's travels to Japan and Assistant Secretary Taft's travels to
Europe to see the stipulations that have been put on the appropriations bills here in the Senate requiring increased burden sharing
on the part of our allies. So I think we're making a strong effort to
move down that road for better or worse.
BUDGET DEFICIT
One quick question. Dr. Dornbusch indicated one of his comments that he said we certainly don't have any fiscal crisis in this
country. You didn't mean to infer by that I'm sure that nonconcern
about the budget deficit and are we overly concerned here in the
Congress about budget deficits?
Mr. DORNBUSCH. Well, the Congress is certainly not sufficiently
concerned.
Senator SASSER. We say the administration is not sufficiently
concerned.
Mr. DORNBUSCH. We do not have the problem that tomorrow
morning bond buyers will not absorb what the Treasury issues in
debt. The debt income ratio is rising very, very moderately. In that
sense, there is no fiscal crisis and nothing will happen.
There is a fiscal crisis because the economy is overheating and
the right policy mix is low interest rates and a tight budget. With
that policy mix, you can have another 5 years of growth. Without
that policy mix, you will have problems and big problems from the
financial side.
Senator SASSER. Do we all agree that we would be better off with
expansive monetary policy and a tight fiscal policy.
Mr. DORNBUSCH. Yes.
Mr. BLINDER. Certainly.
Senator SASSER. While we've got all this brainpower here, Mr.
Chairman, why don't we get them to do some of our work for us.
We've got a problem here with the thrift industry. The General Accounting Office told us that their estimate of the deficit in the
FSLIC is $30 to $40 billion, when they testified here a couple weeks
ago. Now they're saying it's up an additional $10 billion. Some experts are telling us that the liability of the FSLIC could be as much
as $65 billion, whereas the best estimates of income over the next
few years is about $20 billion. So we have a little shortfall there of
somewhere in the neighborhood of $40 billion.
RECOMMENDATIONS ABOUT THE THRIFT INDUSTRY
What would these distinguished economists—what recommendations would they have to make to us or the incoming administration about what to do with regard to the thrift industry? Who's
going to pay this deficit? How should we handle it?
Mr. DORNBUSCH. If this was LDC debt, you would say the Japanese. [Laughter.]
Mr. BLINDER. I think in all likelihood, the taxpayer. The actions
Congress will take will make the taxpayer pay for a lot of it. As
you look toward the longer term, however, some reform of deposit
insurance is probably—not probably, definitely—called for. There
has been a well-documented tendency for teetering thrifts to lay off
the risks on the taxpayer by going for broke; something needs to be
73
done about that. But that in no way is going to get us out of the
current crisis.
Another way to make the point you were making is to note that
many of these thrifts would have negative net worth if they
marked their portfolios to market today. That's the legacy of the
past. That bill is, either gradually or quickly, landing in the taxpayers' lap.
Senator SASSER. Well, you know we're fresh out of cash around
here.
Mr. BLINDER. You can print it, unlike the thrifts.
Mr. HALE. I think there's no alternative but to have government
relief paid for by the taxpayers in the short term, given the magnitude of the problem. But I think this problem reflects a breakdown
in our regulatory process. There's a lot said in this town today
about financial deregulation and how it works its way through our
business sector.
Senator SASSER. I couldn't agree more.
Mr. HALE. We're going to have to create a self-funding financial
regulatory process financed by taxation on the financial sector
which employs highly sophisticated, very highly paid, elite people
who can stay on top of financial innovation or in this case the
thrift industry financial fraud, and make sure it doesn't happen
again in the 1990's. I cannot believe that over the course of the
1980's we actually reduced our Comptroller of the Currency's field
examination staff by 10 percent. The conduct of financial regulation in this country in the 1980's has been a scandal. We need institutional changes that are self-financing through industry taxation,
like we do in other industries.
Senator SASSER. One final question. My time has expired. But in
our rush to deregulate the savings and loan industry and airlines
and other matters, we've reaped a bitter harvest to a certain
extent. Are we making the same mistake in moving down the line
of deregulation of the banking industry? Does anybody on this
panel want to express an opinion on that thorny question?
Mr. HALE. There has to be deregulation because technology is
changing, the world financial marketplace is changing, and there's
no way that our banks can remain static because of the reduced
cost of trading through computerization and the movement toward
securitization globally as a consequence of these new capital asset
ratios. We cannot stay in the past.
What we need, though, as I indicated, is a new method of regulation funded in a more adequate way by taxation of the industry,
but I would add with regulatory agencies staffed by very high quality people. We can no longer have the kind of turnover, lack of professionals, that we've had in the 1980's continue into the 1990's because the scope of the problem will get larger rather than smaller
as we integrate our investment banks and our commercial banks
and as they play not only a domestic role but also a global role.
Senator SASSER. What do the academicians say about that?
Mr. FAIR. I don't have much to add. The problem with the thrifts
is that the regulation was the wrong kind; we were encouraging
risk-taking on their part. That doesn't argue necessarily that we
should stop deregulation. It just means that we want to make sure
74
whatever we do we don't impose these kind of regulations that encourage this excessive risk-taking at the expense of the taxpayers.
I would think that we should continue the deregulation at this
point.
Mr. DORNBUSCH. I would go in the same direction that you can't
stop deregulation, but at the same time you have to add an enormous amount of new regulation that takes account of the activities
that are being pursued now and much higher capital requirements
in order to discourage the speculation on the taxpayers.
Mr. BLINDER. I agree. The technology and world competition,
which are interrelated, are driving us inexorably in this direction. I
think the important thing for Congress to think of in writing new
laws is the principle—and this is a principle, not a legislative proposal—that what needs to be done is to build a wall between the
depositors and whatever kinds of equity involvement banks are
going to have. Then whatever goes on on one side of the ledger
does not jeopardize the safety of the deposits and, at the same time,
doesn't just lay off these risks on the taxpayer. That would mean
some pricing of deposit insurance to reflect the risks that are
taken, or something like that,
The CHAIRMAN. Senator Graham,
Senator GRAHAM. Going back to my question of what you would
put on the agenda for the next President during the period between the election and inauguration, what would you recommend
the new President commence planning for as it relates to the management of Third World debt?
THIRD WORLD DEBT
I noticed Hobart Rowan in the Post on Sunday had a column
which sort of did some second guessing of the recent Toronto
Summit and was more critical than the initial stories, saying effectively the summit had brushed off the difficult issues and felt that
the next summit of the new president was going to have an especially challenging time with Third World debt being the most serious and the most overlooked and unexamined and undealt with
residue of the Toronto Summit.
Mr. DORNBUSCH. I would say that certainly Third World debt is
the major issue for our financial industry and politically for the
United States. I think the trick is to find a solution that is not
squarely on the taxpayer. The taxpayer is already in, but you do
want to minimize that.
My own view is that the best way to do it—and Mexico is probably a good example—is to encourage the reinvestment of interest
payments in the debtor countries forcing them in their budgets to
actually make the payments but not to take them out in trade surpluses, but rather to reinvest them. In that way we make those
economies financially viable again and draw in repatriation of
their own capital. Then later—5, 6, 7 years, whatever—we can
start taking the money out.
If we fail to do that, then the taxpayer is in in a major way because if Mexico today, after doing everything right—except the
vote counting—does not have growth, then of course, there's a
major political issue on our border.
75
So recycling of interest payments, I think, is the most conservative way and the best economic way of handling it. Bringing in the
taxpayer is very hard to imagine given the size of the problem.
I would add, if I may, that there is today enormous diversity between countries. Brazil is messed up by poor domestic policy with
the debt problem a minor issue in their high inflation, and Mexico
by contrast all adjustments have been done. So I would not see that
there's any room for a uniform, across-the-board solution, at least
not a sensible one.
Senator GRAHAM. Any other comments?
Mr. HALE. Rudy's comments are correct. We cannot expect much
in a large country like Mexico in the face of what they just experienced in their election and also the economic challenge that will lie
ahead.
Also, I would add that the stock market itself has made a major
adjustment for these loans. The academic work suggests that the
stock market is already effectively valuing them at half their apparent book value and therefore in a sense we've already had a
major hit on bank shareholders. If we would divide up this discount
or this loss among the various parties, we could perhaps get a
benign outcome if we can get, as Rudy suggested, policies in the
beneficiaries which are encouraging growth and to developing financial markets so as to get capital transfers not just in debt but
through equity in the 1990s.
Senator GRAHAM. Thank you, Mr. Chairman.
The CHAIRMAN. Well, thank you, gentlemen, very much for an
excellent lesson on what we should do in the next 4 years. We appreciate your testimony.
[Whereupon, at 12:05 p.m., the hearing was adjourned.]
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1988
WEDNESDAY, JULY 13, 1988
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING,
AND URBAN AFFAIRS,
Washington, DC.
The committee met at 10:10 a.m. in room SD-538, Dirksen
Senate Office Building, Senator William Proxmire (chairman of the
committee) presiding.
Present: Senators Proxmire, Riegle, Dixon, Sasser, Shelby, Wirth,
Graham, Garn, Heinz, D'Amato, Hecht, Gramm, Bond, and Chafee.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
Chairman Greenspan, I apologize for my tardiness and the fact
that other members will be late. There's a vote going on on the
floor and members will come in later than they usually do.
We're looking forward eagerly to this hearing this morning. It's
a very, very important hearing for our committee and for the Congress. There are few things more critical with respect to our economy in the future than monetary policy and the policies adopted by
the Federal Reserve.
This morning Chairman Greenspan is before the committee to
discuss the outlook for the economy and monetary policy. Chairman Greenspan, the task of setting monetary policy in this high
speed world of international capital mobility is a high wire act
worthy of the great Walinda, and so far you seem to be a good rival
for Walinda.
The U.S. economy is undergoing a profound transformation from
an economy based on consumption-led growth to an export-led
growth economy. On the one hand, capacity utilization is high and
labor markets are increasingly tight. Both of these indicators suggest that inflation is beginning to reemerge. Fears of more vigorous
inflation and a precipitous decline in the dollar make easing of
monetary policy quite risky.
On the other side, huge accumulations of debt make our financial system quite fragile. Business debt, Government debt, consumer debt of all sort in recent years and by almost any measure
are very, very high. The debt accumulation, the crisis in the Savings and Loan industry, problems of debt service in Latin America
and the agricultural crisis combine to raise the costs associated
with a further significant rise in interest rates.
(77)
78
All appears calm at the moment. I fear that calm is precisely
that—momentary. The dollar is rising despite our continued massive trade deficits. The Federal Reserve has gradually raised rates
since March and the last couple of trade statistical announcements
have been good news.
What will happen when the next disappointing trade number is
announced? What will happen as institutional investors begin to
reallocate their assets later this summer, each trying to beat the
market to the draw before the new administration can change the
course of macroeconomic policy?
What I fear is that the overhang of problems on our economy
and the Presidential election, when all six members of the Federal
Reserve Board are Republican Reagan appointees, will lead the Fed
to be insufficiently strong in fighting inflation. This lack of will to
face inflation at the outset will not remedy our structural problems; it will only postpone them.
Having said that, let me say that yesterday we had four eminent
economists and experts. We chose them because we thought they
were among the most prestigious and highly respected economists
in the country and experts in monetary policy and, in general, they
gave you high marks. There were no criticisms of the conduct of
the Federal Reserve to date.
They also indicated that the book is pretty much in on monetary
policy, that there's not much you can do now that's going to have
much effect because of the lag before the election anyway.
Avoiding a battle against an overheating economy will lead to a
rise in inflation that will be very costly and painful to wring out of
the system just as it was in the early 1980's. The difference is that
next time we go through wrenching disinflation, we will do it on
the back of all the financial problems that exist today.
If the Federal Reserve does not show the resolve to keep inflation down, it will make things more comfortable temporarily, but
in the long run we will all pay the price. An ounce of prevention is,
in this case, worth a pound of cure.
The Nation's economic vitality depends upon a coherent and
stable monetary policy. To facilitate congressional oversight of the
process and to provide greater information to the public on the formation of monetary policy I encourage the Federal Reserve to
narrow the target ranges on its monetary policy projections. The
law explicitly does not require the Federal Reserve to adhere to the
publicized targets, so there's no cost to providing more precise estimates of your intentions.
At the same time, precise targets give us better information on
the Federal Reserve's intentions and a better way to measure the
performance of the central bank after the fact. Market participants
can make their plans with less uncertainty. Furthermore, at future
hearings you can come back and explain any deviations from your
projected path for monetary growth so we can all better understand this complicated process of monetary policy making.
Senator Garn.
Senator GARN. Thank you, Mr. Chairman. I have no opening
statement. I'm pleased to have Chairman Greenspan here today
and look forward to his testimony.
The CHAIRMAN. Senator Dixon.
79
Senator DIXON. I'll place my statement in the record. Thank you,
Mr. Chairman.
The CHAIRMAN. Thank you, Senator Dixon. I also have a statement from Senator Chafee to be inserted in the record.
STATEMENT OF SENATOR ALAN J. DIXON
Senator DIXON. Mr. Chairman, I am pleased to be here this
morning as the Banking Committee continues its oversight of monetary policy and other economic issues of crucial importance to our
economic future. I look forward to hearing the testimony of the distinguished Chairman of the Federal Reserve Board, Alan Greenspan.
At the moment, we seem to have a sort of "good news, bad news"
kind of economy. Unemployment is down to the lowest point in at
least 14 years, our trade deficit is finally starting to go down, and
economic growth is strong. However, persistent fears about a resurgence of inflation seemingly cannot be put to rest.
Our financial markets seem to fear every bit of economic good
news; they find the black cloud behind every silver lining. There
are those who claim that these fears are irrational, and that
strong, noninflationary, GNP growth can continue indefinitely. I
would like to believe that, but I cannot. We have serious structural
problems that we must deal with if we are to ensure a sound economic future for our economy. We must bring Federal budget deficits under control and we must address the international balance
of payments problems that have made the United States the
world's largest debtor nation.
Monetary policy cannot accomplish these tasks alone. If we continue the kind of contradictory economic policies that have characterized our recent past, then it is only a question of time before interest rates begin to rise, inflation reoccurs, and economic growth
evaporates.
We have a strong, resilient economy that is capable of tolerating
substantial abuse. But the economy's capacity to absorb the punishment caused by unwise economic policies is not limitless. The Federal Reserve cannot reverse the damage caused by past economic
mistakes by itself. The executive branch and the Congress must coordinate their efforts with those of the Fed if we are to prevent the
economic day of reckoning that we will otherwise surely face.
Thank you, Mr. Chairman.
STATEMENT OF SENATOR JOHN H. CHAFEE
Senator CHAFEE. Mr. Chairman, it is a pleasure to welcome
Chairman Greenspan back to this committee. His decisions and actions have been a helpful factor in keeping this country on an even
keel. I salute him for that.
Today's hearing, with Chairman Greenspan's commentary on
U.S. monetary policy, is very timely. For monetary policy has
become increasingly important for two reasons.
First, fiscal policy threatens to become stuck as an effective operational level of broad financial policy. If so, the hoped for benefits
achievable from significant reductions in the Federal budget deficit
80
would be minimized. This is especially true when the effect of the
Social Security surplus is noted.
Second, the growth of the international sector will constrain the
Federal Reserve's ability to focus exclusively on U.S. inflation and
interest rates. The value of the U.S. dollar and its effect on U.S.
exports and foreign imports, U.S. dollar-denominated Third World
debt, and increasing foreign ownership of U.S. Treasury securities,
will all have to be factored in. For example, higher U.S. interest
rates to counteract expected higher U.S. inflation will cause the
dollar to rise, making it more difficult for U.S. companies to export
and increasing the interest owed by developing countries on their
debt, thereby reducing their ability to import U.S. products.
What then becomes the chief priority of the Federal Reserve, especially given the probable inflexibility of fiscal policy? And what
are the Federal Reserve's obligations to foreign countries which do
not seem to be shouldering their respective obligations to keep
world trade flowing?
Fortunately, the Federal Reserve currently has some room for
maneuver, operating in an reasonably enviable environment by
recent historical standards. The United States is in the 61st month
of continuous growth, and the bouyancy of the economy is confounding even the most ardent naysayers. The unemployment rate
has fallen to 5.3%, the lowest since 1974. Inflation hovers below
4%, and the recovering U.S. dollar and low energy prices will help
keep that in check. Nevertheless, $200 billion Federal budget deficits financed abroad, $150 billion trade deficits, the potential effects
of the drought on prices—all point out that much work still remains to be done.
I look forward to the testimony of Chairman Greenspan.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator D'Amato.
Senator D'AMATO. Mr. Chairman, I'd like to take the opportunity
to raise and touch on another matter with the chairman and with
the committee as it relates to another issue. I think you know what
that issue is.
The CHAIRMAN. I sure do.
Senator D'AMATO. It's a matter of a hearing that was supposed to
be held tomorrow and was canceled, and I find it rather difficult to
understand when 14 cosponsors of a bill and this Senator having
received a promise and a commitment for that hearing, not even
being notified personally about it, and I was wondering if the chairman would reconsider. So I say I'd like to discuss that matter after
we hear the Chairman's testimony.
The CHAIRMAN. Thank you, Senator D'Amato.
Mr. Chairman, go right ahead, sir.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. GREENSPAN. Thank you very much, Mr. Chairman.
Mr. Chairman and members of the committee, I appreciate this
opportunity to review with you recent and prospective monetary
policy. I will excerpt from my prepared remarks, but request that
the full text be included in the record.
81
The CHAIRMAN. Without objection, it will be printed in full in the
record.
ECONOMIC SETTING AND MONETARY POLICY SO FAR IN 1988
Mr. GREENSPAN. The macroeconomic setting for monetary policy
has changed in some notable respects since I testified last February. At that time, the full after-effects of the stock market plunge
on spending and financial markets were still unclear. While most
Federal Open Market Committee members were forecasting moderate growth, in view of rapid inventory building and some signs of a
weakening of labor demand, the possibility of a decline in economic
activity could not be ruled out. To guard against this outcome, in
the context of a firmer dollar on exchange markets, the Federal
Reserve undertook a further modest easing of reserve pressures in
late January, which augmented the more substantial easing following October 19. Short-term interest rates came down another notch,
and with a delay helped to push the monetary aggregates higher
within their targeted annual ranges.
In the event, the economy proved remarkably resilient to the loss
of stock market wealth. Economic growth remained vigorous
through the first half of the year.
As the risks of a faltering economic expansion and further financial market disruptions diminished, the dangers of intensified inflationary pressures reemerged. Utilization of labor and capital
reached the highest levels in many years, and hints of acceleration
began to crop up in wage and price data. Strong gains in payroll
employment that continued through the spring combined with
slower growth in the labor force to lower the unemployment rate
by about 1/4 percentage point, even before the strong labor market
report for June; the industrial capacity utilization rate moved up
as well.
In these circumstances, the Federal Reserve was well aware that
it should not fall behind in establishing enough monetary restraint
to effectively resist these inflationary tendencies. The System took
a succession of restraining steps from late March through late
June. The shortest-term interest rates gradually rose to levels now
around highs reached last fall. Responding as well to the unwinding of a tax-related buildup in liquid balances, M2 and M3 growth
slowed noticeably after April.
In contrast to the shortest-maturity interest rates, long-term
bond and mortgage rates, though also above February lows, still
remain well below last fall's peaks. The timely tightening of monetary policy this spring, along with perceptions of better prospects
for the dollar in foreign exchange markets in light of the narrowing in our trade deficit, seemed to improve market confidence that
inflationary excesses would be avoided. Both bond prices and the
dollar rallied in June despite increases in interest rates in several
major foreign countries and jumps in some agricultural prices resulting from the drought in important growing areas.
ECONOMIC OUTLOOK AND MONETARY POLICY THROUGH 1989
The monetary actions of the first half of the year were undertaken so that economic expansion could be maintained, recognizing
that to do so, additional price pressures could not be permitted to
build and progress toward external balance had to be sustained.
The projections of FOMC members and nonvoting presidents indicate that they do expect economic growth to continue, and inflation
to be contained.
The 2% to 3 percent central tendency of FOMC members' expectations for real GNP growth over the four quarters of this year implies a deceleration over the rest of the year to a pace more in line
with their expected 2 to 2Vz percent real growth over 1989 and
with the long-run potential of the economy.
Although the month-to-month pattern in our trade deficit can be
expected to be erratic, the improvement in the external sector on
balance over time is expected to replace much of the reduced expansion in domestic final demands from our consumer, business,
and government sectors.
Employment growth is anticipated to be substantial, though
some updrift in the unemployment rate may occur over the next
year and a half. Capacity utilization could well top out soon, as
growth in demands for manufactured goods slows to match that of
capacity.
Considering the already limited slack in available labor and capital resources, a leveling of the unemployment and capacity utilization rates is essential if more intense inflationary pressures are to
be avoided in the period ahead. Otherwise, aggregate demand
would continue growing at an unsustainable pace and would soon
begin to create a destabilizing inflationary climate. Supply conditions for materials and labor would tighten further and costs would
start to rise more rapidly; businesses would attempt to recoup
profit margins with further price hikes on final goods and services.
These faster price rises would, in turn, foster an inflationary psychology, cut into workers' real purchasing power, and prompt an
attempted further catchup of wages, setting in motion a dynamic
process in which neither workers nor businesses would benefit. The
hard-won gains in our international competitiveness would be
eroded, with feedback effects depressing the exchange value of the
dollar. Excessive domestic demands and inflation pressures in this
country, with its sizable external deficit, would be disruptive to the
ongoing international adjustment of trade and payments imbalances.
Not only the reduced slack in the economy but also several prospective adjustments in relative prices have accentuated inflation
dangers. One is the upward movement of import prices relative to
domestic prices, which is a necessary part of the process of adjustment to large imbalances in international trade and payments. Another is the recent drought-related increases in grain and soybean
prices. It is essential that we keep these processes confined to a
one-time adjustment in the level of prices and not let them spill
over to a sustained higher rate of increase in wages and prices.
The costs to our economy and society of allowing a more intense
inflationary process to become entrenched are serious. As the experience in the past two decades has clearly shown, accelerating
wages and prices would have to be countered later by quite restrictive policies, with unavoidably adverse implications for production
and employment. The financial health of many individual and busi-
83
ness debtors, as well as of some of their creditors, would then be
threatened. The long-run costs of a return to higher inflation and
the risks of this occurring under current circumstances are sufficiently great that Federal Reserve policy at this juncture might be
well advised to err more on the side of restrictiveness rather than
of stimulus.
We believe that monetary policy actions to date, together with
fiscal restraint embodied in last fall's agreement between the Congress and the administration, have set the stage for containing inflation through next year. The central tendency of FOMC members' expectations for inflation in the GNP deflator ranges from 3
to 3% percent over this year and 3 to 4Vz percent next year.
The FOMC believes that efforts to contain inflation pressures
and sustain the economic expansion would be fostered by growth of
the monetary aggregates over 1988 well within their reaffirmed 4
to 8 percent annual ranges, followed by some slowing in money
growth over the course of next year.
The debt of nonfinancial sectors, which so far this year has been
near the midpoint of its reaffirmed 7 to 11 percent monitoring
range, is anticipated to post similar growth through year-end.
For 1989, the FOMC has underscored its intention to encourage
progress toward price stability over time by lowering its tentative
ranges for money and debt. We have preliminarily reduced the
growth range for M2 by 1 full percentage point to 3 to 7 percent.
We
have adjusted the tentative 1989 range from M3 downward by
J
/2 a percentage point to a 3l/z to 7 Vz percent range. This configuration is consistent with the observed tendency for M3 velocity over
time to fall relative to the velocity of M2; over the last decade, the
Federal Reserve's ranges frequently allowed for faster growth of
M3 than of M2. The monitoring range for domestic nonfinancial
debt for 1989 also has been lowered Vz percentage point to a tentative 6V2 to 10 Vz percent range.
The specific ranges chosen for 1989 are, as usual, provisional,
and the FOMC will review them carefully next February in light of
intervening developments. Anticipating today how the outlook for
the economy in 1989 will appear next February is difficult, and a
major reassessment of that outlook would have implications for appropriate money growth ranges for that year.
As the aggregates have become more responsive to interest rate
changes in the 1980s, judgments about possible ranges for the next
year necessarily have become even more tentative and subject to
revision.
PERSISTENT U.S. EXTERNAL AND FISCAL IMBALANCES
Despite the changes in the economic setting over the last 6
months, other features of the macroeconomic landscape remain
much the same. Most notable are the continuing massive deficits in
our external payments and internal fiscal accounts. As a nation,
we still are living well beyond our means. We consume much more
of the world's goods and services each year than we produce. Our
current account deficit indicates how much more deeply in debt to
the rest of the world we are sliding each year.
84
The consequence of this external imbalance will be a steady expansion in our external debt burden in the years ahead. No household or business can expect to have an inexhaustible credit line
with borrowing terms that stay the same as its debt mounts relative to its wealth and income. Nor can we as a nation expect our
foreign indebtedness to grow indefinitely relative to our servicing
capacity without additional inducements to foreigners to acquire
dollar assets—either higher real interest returns, or a cheaper real
foreign exchange value for dollar assets, or both. To be sure, such
changes in market incentives would have self-correcting effects
over time in reducing the imbalance between our domestic spending and income. Higher real interest rates would curtail domestic
investment and other spending. A lower real value of the dollar
would make U.S. goods and services relatively less expensive to
both United States and foreign residents, damping our spending on
imports out of U.S. income and boosting our exports.
But simply sitting back and allowing such a self-correction to
take place is not a workable policy alternative. Trying to follow
such a course could have severe drawbacks now that our economy
is operating close to effective capacity and potential inflationary
pressures are on the horizon. The time is hardly propitious to discourage investment in needed plant and equipment, to add further
impulses for import price hikes on top of the upward tendencies already in the making, or to push our export industries as well as
import-competing industries to their capacity limits.
Fortunately, we have a better choice for righting the imbalance
between domestic spending and income—one over which we have
direct control. That is to resume reducing substantially the still
massive Federal budget deficit, which remains the most important
source of dissaving in our economy. The fall in the dollar we have
already experienced over the last few years, even allowing for the
dollar's appreciation from the lows reached at the end of last year,
has set in motion forces that should.continue to narrow our trade
and current account deficits in the years ahead. The associated loss
of foreign-funded domestic investment is likely to adversely affect
overall investment unless it can be replaced by greater domestic investment financed by domestic saving. A sharp contraction in the
Federal deficit appears to be the only assured source of augmented
domestic net saving. Such a fiscal cutback should help counter
future tendencies for further increases in U.S. interest rates and
declines in the dollar, partly by instilling confidence on the part of
international investors in the resolve of the United States to address its economic problems.
In terms of Federal deficit reduction, the schedule under the
Gramm-Rudman-Hollings law is a good baseline for a multiyear
strategy, and I trust the Congress will stick with it. But we should
go further. Ideally, we should be aiming ultimately at a Federal
budget surplus so that Government saving could supplement private domestic saving in financing additional domestic investment.
The strategy for monetary policy needs to be centered on making
further progress toward and ultimately reaching stable prices.
Price stability is a prerequisite for achieving the maximum economic expansion consistent with a sustainable external balance
and high employment. Price stability reduces uncertainty and risks
85
in a critical area of economic decision making by households and
businesses.
By price stability, I mean a situation in which households and
businesses in making their saving and investment decisions can
safely ignore the possibility of sustained, generalized price increases or decreases. Prices of individual goods and services, of
course, would still vary to equilibrate the various markets in our
complex national and world economy, and particular price indexes
could still show transitory movements. Essentially, the average of
all prices would exhibit no trend over time.
In the process of fostering price stability, monetary policy also
would have to bear much of the burden for countering any pronounced cyclical instability in the economy, especially if fiscal
policy is following a program for multiyear reductions in the Federal budget deficit. While recognizing the self-correcting nature of
some macroeconomic disturbances, monetary policy does have a
role to play over time in guiding aggregate demand into line with
the economy's potential to produce. This may involve providing a
counterweight to major, sustained cyclical tendencies in private
spending, though we cannot be overconfident in our ability to identify such tendencies and to determine exactly the appropriate
policy response. In this regard, it seems worthwhile for me to offer
some thoughts on the approach the Federal Reserve should take in
implementing this longer-term strategy for monetary policy.
APPROPRIATE TACTICS FOR MONETARY POLICY
For better or worse, our economy is enormously complex, the relationships among macroeconomic variables are imperfectly understood, and as a consequence economic forecasting is an uncertain
endeavor. Nonetheless, the forecasting exercise can aid policymaking by helping to refine the boundaries of the likely economic consequences of our policy stance. But forecasts will often go astray to
a greater or lesser degree and monetary policy has to remain flexible to respond to unexpected developments.
A perfectly flexible monetary policy, however, without any guideposts to steer by. can risk losing sight of the ultimate goal of price
stability. In this connection, the requirement under the HumphreyHawkins Act for the Federal Reserve to announce its objectives
and plans for growth of money and credit aggregates is a very
useful device for calibrating prospective monetary policy. The announcement of ranges for the monetary aggregates represents a
way for the Federal Reserve to communicate its policy intentions
to the Congress and the public.
The CHAIRMAN. Mr. Chairman, I apologize. This is an excellent
statement, but it's so rare that this committee or any committee
for that matter has a quorum present that I'm going to take advantage of it. We have a number of nominees that we would like to act
on. It's very important that we act promptly, including one who
will join you on the Federal Reserve Board, John La Ware.
We also have Timothy Coyle, of California, to be an Assistant
Secretary of Housing and Urban Development; Jack Stokvis, of
New York, to be an Assistant Secretary of Housing and Urban Development; and James Werson, of California, to be a Member of the
86
Board of Directors of the National Corporation for Housing Partnerships.
Because of the urgency of this matter and because we have to
move it along as soon as we possibly can—we have had an extensive hearing, of course, on Mr. La Ware and, in my judgment, he
was very impressive and I hope that the committee can act on that
nomination now.
Senator GARN. Mr. Chairman, I would move that we act on all of
the nominees en bloc.
The CHAIRMAN. Any discussion? Any objection?
[No response.]
The CHAIRMAN. Without objection, the committee will act on the
nominees en bloc. All in favor signify by saying "Aye."
[A chorus of "Ayes."]
The CHAIRMAN. Opposed?
[No response.]
The CHAIRMAN. The nominees will be reported to the floor of the
Senate.
Senator GRAMM. Mr. Chairman.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Mr. Chairman, I'd just like to make note of the
fact that I don't think any committee chairman in the U.S. Senate
has done more than you have done to move appointments forward,
and I just want to congratulate you for it and thank you.
The CHAIRMAN. Well, thank you very much, Senator Gramm.
There's nobody who's support I'd rather have than yours, or whose
opposition I would less like to have than yours. [Laughter.]
Senator GRAMM. Then you agree with me and I appreciate it.
Senator WIRTH. Mr. Chairman.
The CHAIRMAN. Senator Wirth.
Senator WIRTH. Just let me very briefly associate myself with
Senator Gramm's remarks and also commend you on moving on
Mr. LaWare's appointment. It's a long appointment I know and I
think it's the right thing for us to do and I appreciate your stepping into that as well. Thank you very much.
The CHAIRMAN. Thank you, Senator Wirth.
Senator HECHT. Mr. Chairman, I just have a short statement on
Mr. Coyle which I'll put into the record.
The CHAIRMAN. Without objection, it will be printed in full in the
record.
Senator HECHT. Thank you.
Mr. Chairman, I would like to take this opportunity to commend
Mr. Coyle on the fine job he has done to this date and would also
like to voice my strong support for his nomination to the position
of Assistant Secretary of Housing and Urban Development. I believe he is amply qualified to fill this spot and would be an asset to
both HUD and the Nation.
Thank you, Mr. Chairman.
The CHAIRMAN. Chairman Greenspan, I apologize. Go right
ahead, sir.
Mr. GREENSPAN. Let me just say, Mr. Chairman and members of
the committee, I very much appreciate your expediting the nomination of our new Board member. I'm really sure he will serve the
country well. I think he's a first-rate appointment and hope he
87
moves through the Senate as expeditiously as he has done this
morning.
If I may continue, I just have a few more remarks to make for
the record.
The CHAIRMAN. Go right ahead.
Mr. GREENSPAN. The undisputed long-run relation between
money growth and inflation means that trend growth rates in the
monetary aggregates provide useful checks on the thrust of monetary policy over time. It is clear to all observers that the monetary
ranges will have to be brought down further in the future if price
stability is to be achieved and then maintained.
But, in a shorter-run countercyclical context, monetary aggregates have drawbacks as rigid guides to monetary policy implementation. As I discussed in some detail in my February testimony, financial innovation and deregulation in the 1980's have altered the
structure of deposits, lessened the predictability of the demands for
the aggregates, and made the velocities of Ml and probably M2
over periods of a year or so more sensitive to movements in market
interest rates.
Nonetheless, the demonstrated long-run connection of money and
prices overshadows the problems of interpreting shorter-run swings
in money growth. I certainly don't want to leave the impression
that the aggregates have little utility in implementing monetary
policy. They have an important role, and it is quite possible that
their importance will grow in the years ahead. Currently, the
FOMC keeps M2 and M3 under careful scrutiny, and judges their
actual movements relative to assessments of their appropriate
growth at any particular time. In this context, these aggregates are
among the indicators influencing adjustments to the stance of
policy. At times in recent years, we have intensively examined the
properties of several alternative measures.
An analysis of the monetary base appears as an appendix to the
Board's Humphrey-Hawkins report.
Although the monetary base has exhibited some useful properties over the last three decades as a whole, the FOMC's view is that
its behavior has not consistently added to the information provided
by the broader aggregates, M2 and M3. The committee accordingly
has decided not to establish a range for this aggregate, although it
has requested staff to intensify research into the ability of various
monetary measures to indicate long-run price trends.
Because the Federal Reserve cannot reliably take its cue for
shorter-run operations solely from the signals being given by any
or all of the monetary aggregates, we have little alternative but to
interpret the behavior of a variety of economic and financial indicators. They can suggest the likely future course of the economy
given the current stance of monetary policy.
Judgments about the balance of various risks to the economic
outlook need to adapt over time to the shifting weight of incoming
evidence; this point is well exemplified so far this year, as noted
earlier. The Federal Reserve must be willing to adjust its instruments fairly flexibly as these judgments evolve; we must not hesitate to reverse course occasionally if warranted by new developments. To be sure, we should not overreact to every bit of new information because the frequent observations for a variety of eco-
nomic statistics are subject to considerable transitory "noise." But
we need to be willing to respond to indications of changing underlying economic trends, without losing sight of the ultimate policy
objectives.
To the extent that the underlying economic trends are judged to
be deviating from a path consistent with reaching the ultimate objectives, the Federal Reserve would need to make "midcourse"
policy corrections. Such deviations from the appropriate direction
for the economy will be inevitable, given the delayed and imperfectly predictable nature of the effects of previous policy actions.
Numerous unforeseen forces not related to monetary policy will
continue to buffet the economy. The limits of monetary policy in
short-run stabilization need to be borne in mind. The business cycle
cannot be repealed, but I believe it can be significantly dampened
by appropriate policy action. Price stability cannot be dictated by
fiat, but governmental decision-makers can establish the conditions
needed to approach this goal over the next several years.
[The complete prepared statement of Mr. Greenspan follows:]
Mr. Chairman, and members of the Committee, I appreciate this opportunity to review with you recent and prospective
monetary policy and the economic outlook.
I would also like to
provide a broader perspective by discussing in some detail our
nation'a longer-term economic objectives, the overall strategy
for fiscal and monetary policies needed to reach those objectives, and the appropriate tactics for implementing monetary
Statement by
policy within that strategic framework.
The economic setting and monetary policy so far in 19SB.
Alan Greenspan
The macroeconomic aetting for monetary policy has
Chairman, Board of Governors of the Federal Reserve System
changed in some notable respects since I testified last
February.
At that time, the full after-effects of the stock
before the
market plunge on spending and financial markets were still
Committee on Banking, Housing and Urban Affairs
unclear.
While most Federal Open Market Committee members were
forecasting moderate growth, in view of rapid inventory building
of the
and some signs of a weakening of labor demand, the possibility
tJ.S. Senate
of a decline in economic activity could not be ruled out.
To
guard against this outcome, in the contest of a firmer dollar
on exchange markets, the Federal Reserve undertook a further
July 13, 1988
modest easing of reserve pressures in late January, which
augmented the more substantial easing following October 19.
Short-term interest rates came down another notch, and with a
delay helped to push the monetary aggregates higher within their
targeted annual ranges.
OO
(£5
-2-
In the event, the economy proved remarkably resilient
to the loss of stock market wealth.
the unemployment rate by about 1/4 percentage point, even before
Economic growth remained
vigorous through the first half of the year.
Continuing brisk
utilization rate moved up as well.
In part reflecting the
advances in exports, together with moderating growth in imports,
payroll tax increase, broad measures of hourly compensation
supported expansion in output, especially in manufacturing.
picked up somewhat in the first quarter.
Some strengthening alao was evident in business outlays for
range of domestic and imported industrial materials and aupplie
equipment, especially computers, and consumer purchases of
rose even more steeply than last year.
durables, including autos.
inflation has not: reflected this step-up in price increases for
Prices for a wide
Finished goods price
intermediate goods, in part as productivity gains kept unit
tioning.
labor coats under control.
Although trading volumes did not regain pre-crash
Even so, continued increases in
levels in many markets, price volatility diminished somewhat and
materials prices at the recent pace were seen as pointing to a
quality differentials stayed considerably narrower than in the
potential intensification in inflation more generally, ainco
immediate aftermath of the stock market plunge.
baaed on historical experience, such increases have tended to
In response,
the Federal Reserve gradually was able to restore its standard
show through to finished good prices.
procedure of gearing open market operations to the intended
pressure on reserve positions of depository institutions.
In these circumstances, the Federal Reserve waa well
We
aware that it should not fall behind in establishing enough
thereby discontinued the procedure of reacting primarily to day-
monetary restraint to effectively resist these inflationary
to-day variations in money market interest rates that had been
tendencies.
adopted right after the stock market break.
from late March through late June.
As the risks of faltering economic expansion and
The System took a succession of restraining steps
The shortest -term interest
rates gradually rose to levels now around highs reached last
further financial market disruptions diminished, the dangers of
fall.
intensified inflationary pressures raemerged.
buildup in liquid balances, M2 and M3 growth slowed noticeably
Utilization of
labor and capital reached the highest levels in many years, and
hints of acceleration began to crop up in wage and price data.
Responding aa well to the unwinding of a tax-related
after April.
In contrast to the shortest -maturity interest rates,
Strong gains in payroll employment that continued through the
long-term bond and mortgage rates, though alao above February
spring combined with slower growth in the labor force to lower
lows, atill remain well below last fall's peaks.
Th« tinaly
-4tightening of monetary policy this spring, along with percep-
reflecting the lagged effects of the decline in the exchange
tions of better prospects for the dollar in foreign exchange
value of the dollar through the end of last year.
markets in light of the narrowing in our trade deficit, seemed
month-to-month pattern in our trade deficit can be expected to
to improve market confidence that inflationary excesses would be
be erratic, the improvement in the external sector on balance
avoided.
over time is expected to replace much of the reduced expansion
Both bond prices and the dollar rallied in June
Although the
despite increases in interest rates in several major foreign
in domestic final demands from our consumer, business, and
countries and jumps in some agricultural prices resulting from
government sectors.
the drought in important growing areas.
Employment growth is anticipated to be substantial,
The economic outlook, and monetary policy through 1989.
though some updrlft in the unemployment rate may occur over the
next year and a half.
Capacity utilization could well top out
undertaken so that economic expansion could bo maintained,
soon, as growth in demands for manufactured goods alows to match
recognizing that to do so, additional price pressures could
that of capacity-
not be permitted to build and progress toward external balance
had to be sustained.
The projections of FQMC members and
Considering the already limited slack in available
labor and capital resources, a leveling of the unemployment and
nonvoting presidents indicate that they do expect economic
capacity utilization rates is essential if more intense infla-
growth to continue, and inflation to be contained.
tionary pressures are to be avoided in the period ahead.
The 2-3/4 to 3 percent central tendency of FOMC members' expectations for real GNP growth over the four quarters of
Other-
wise, aggregate demand would continue growing at an unsustainable pace and would soon begin to create a destabilizing
this year implies a deceleration over the rest of the year to a
inflationary climate.
pace more in line with their expected 2 to 2-1/2 percent real
would tighten further and costs would start to rise more
growth over 1989 and with the long-run potential of the economy.
rapidly; businesses would attempt to recoup profit margins with
Supply conditions for materials and labor
The drought will reduce farm output for a time, and it is
further price hikes on final goods and services.
important that nonfarm inventory accumulation slow before long,
price rises would, in turn, foster an inflationary psychology,
if we are to avoid a troublesome imbalance.
cut into workers' real purchasing power, and prompt an attempted
Still, further
gains in our international trade position should continue to
provide a major stimulus to real GNP growth through next year,
These faster
further catchup of wages, setting in motion a dynamic process in
<£>
-6-
which neither workers nor businesses would benefit.
The hard-
The costs to our economy and society of allowing a more
won gains in our international competitiveness would be eroded,
intense inflationary process to become entrenched are serioua.
with feedback effects depressing the exchange value of the
As the experience in the past two decades has clearly shown,
dollar.
Excessive domestic demands and inflation pressures in
this country, with its sizable external deficit, would be
accelerating wages and prices would have to be countered later
by qiiite restrictive policies, with unavoidably adverse impli-
disruptive to the ongoing international adjustment of trade and
cations for production and employment.
payments imbalances.
many individual and business debtors, as well as of some of
Not only the reduced slack in the economy but also
several prospective adjustments in relative prices have
accentuated inflation dangers.
One is the upward movement of
The financial health of
their creditors, then would be threatened.
The long-run costs
of a return to higher inflation and the risks of this occurring
under current circumstances are sufficiently great, that Federal
import prices relative to domestic prices, which is a necessary
Reserve policy at this juncture might be well advised to err
part of the process of adjustment to large imbalances in inter-
more on the side of restrictiveness rather than of stimulus.
national trade and payments.
Another is the recent drought-
related increases in grain and soybean prices.
It is essential
that we keep these processes confined to a one-time adjustment
gether with the fiscal restraint embodied in last fall's agreement between the Congress and the administration, have set the
in the level of prices and not let them spill over to a sus-
stage for containing inflation through next year.
tained higher rata of increase in wages and prices.
tendency of FOMC members' expectations for inflation in the GNP
Elevated
import and farm prices must be prevented from engendering
The central
deflator ranges from 3 to 3-3/4 percent over this year and 3 to
expectations of higher general inflation, with feedback effects
4-1/2 percent next year.
on labor costs.
understates this year's rate of inflation, and the comparison
A more serious long-run threat to price
But in one sense the GNP deflator
stability could come from government actions that introduced
with next year overstates the pick-up.
structural rigidities and increased costs of production.
the average price of final goods and services produced in the
Protectionist legislation, inordinate hikes in the minimum wage,
United States, or equivalently domestic value added, using
and other mandated programs that would impose costs on U.S.
current quantity weights.
producers would adversely affect their efficiency and
down in the first tjuarter by a shift in the composition of
international competitiveness.
output, especially by the surge in sales of computers whose
The deflator represents
This measure was artificially held
-9prices have dropped sharply since the 19S2 base year used for
constructing the deflator.
Indeed, if the deflator were indexed
For 1989, the FOMC has underscored its intention to
encourage progress toward price stability over time by lowering
with a 1987 base year, it would have risen appreciably faster in
its tentative ranges for money and debt.
the first quarter.
reduced the growth range for HZ by 1 full percentage point, to
Another understatement of inflation in the deflator
We have preliminarily
3 to 1 percent; last February, the FOMC also had reduced the
this year arises from its exclusion of imported goods, which ara
midpoint of the 1988 range for M2 by 1 percentage point from
not directly encompassed because they are produced abroad.
that for 1987.
In
part because import prices have continued to rise significantly
He have adjusted the tentative 1989 range for M3
downward by 1/2 percentage point, to 3-1/2 to 7-1/2 percent.
faster than prices of domestically produced goods, consumer
This configuration is consistent with the observed tendency for
price indexes have increased more than the GUP deflator.
M3 velocity over time to fall relative to the velocity of M2;
The FOMC believes that efforts to contain inflation
over the last decade, the Federal Reserve's ranges frequently
pressures and sustain the economic expansion would be fostered
allowed for faster growth of M3 than of M2.
by growth of the monetary aggregates over 1988 well within their
range for domestic nonfinancial debt for 1989 also has been
reaffirmed 4 to 8 percent annual ranges, followed by some slow-
lowered 1/2 percentage point to a tentative 6-1/2 to 10-1/2
ing in money growth over the course of next year.
percent.
M2 should
move close to the midpoint of its range by late 1988, if
depositors react as expected to the greater attractiveness of
The monitoring
The specific ranges chosen for 1989 are, as uaual, provisional, and the FOMC will review them carefully next February,
market instruments compared with liquid money balances that was
in light of intervening developments.
brought about by recent increases in short-term market rates
the outlook for the economy in 1989 will appear ne»t February is
relative to deposit rates.
difficult, and a major reassessment of that outlooK would have
M3 could end the year somewhat above
Anticipating today how
its midpoint, though comfortably within its range, if depository
implications for appropriate money growth ranges for that year.
institutions retain their recent share of overall credit expan-
Unexpectedly strong or weak economic expansion or inflation
sion.
pressures over the next six months also could have implications
The dsbt of nonfinancial sectors, which so far this year
has been near the midpoint of its reaffirmed 7 to 11 percent
for the behavior of interest rates and their prospects for 1989.
monitoring range, is anticipated to post similar growth through
The sensitivity of the monetary aggregates to movements in mar-
year-end.
ket interest rates means that the appropriate growth next year
CD
CO
-11in M2, M3, and debt could seem different next February than nov,
necessitating a revision in the annual growth ranges.
As the
incentives would have self-correcting effects over time in
reducing the imbalance between our domestic spending and income.
aggregates have become more responsive to interest rate changes
Higher real interest rates would curtail domeatic investment and
in the 1980s, judgments about possible ranges for the next year
other spending.
necessarily hive become even more tentative and subject to
U.S. goods and services relatively less expensive to both U.S.
A lower real value of the dollar would make
revision.
and foreign residents, damping our spending on imports out of
Tha persistent U.S. external and fiscal imbalances.
U.S. income and boosting our exports.
Despite the changes in the economic setting over the
But simply sitting back and allowing such a self-
last six months, other features of the macroeconomic landscape
correction to take place ia not a workable policy alternative.
remain much the same.
Trying to follow auch a course could have severe drawbacks now
Most notable are the continuing massive
deficits in our external payments and internal fiscal accounts.
that our economy is operating close to effective capacity and
As a nation, vo at ill are living well beyond our means; va
potential inflationary pressures are on the horizon.
consume much more of the norla'a goods and services each year
is hardly propitious to discourage investment in needed plant
than He produce.
and equipment, to add further impulses for import price hikes on
Our current account deficit indicates how much
more deeply in debt to the rest of the world tie are sliding each
year.
The time
top of the upward tendencies already in the making, or to push
our export industries as well as import-competing industries to
The consequence of this external imbalance will be a
steady expansion in our external debt burden in the years ahead.
tfcair capacity limits.
Fortunately, we have a better choice for righting the
No household or business can expect to have an inexhaustible
imbalance between domestic spending and income—ana over which
credit line Kith borrowing terms that stay the same as ita debt
we have direct control.
mounts relative to its wealth and income.
tially the still massive federal budget deficit, which remains
Nor can we as a
That is to resume reducing substan-
nation expect our foreign indebtedness to gro» indefinitely
the most important source of dissaving in our economy.
relative to our servicing capacity without additional induce-
in the dollar we have already experienced over the last few
ments to foreigners to acquire dollar assets--either higher rsal
years, even allowing for the dollar's appreciation from the lows
interest returns, or a cheaper real foreign exchange value for
reached at the end of last year, has set in motion forcea that
dollar assets, or both.
should continue to narrow our trade and currant account
To be aure, such changes in market
The fall
deficits
to
-13-
-12in the years ahead.
The associated loss of foreign-funded
multi-year strategy, and I trust the Congress will stick wir.h
domestic investment is likely to adversely affect overall
it.
investment unless it can be replaced by greater domestic
ultimately at a federal budget surplus, so that government
investment financed by domestic saving.
saving could supplement private domestic saving in financing
A sharp contraction in
But we should go further.
Ideally, we should be aiming
the federal deficit appears to be the only assured source of
additional domestic investment.
augmented domestic net saving.
was not a low saving, low investing economy.
Such a fiscal cutback should
Historically, the United States
From the post-
help counter future tendencies for further increases in U.S.
Civil War period through the 1920s, the United States consis-
interest rates and declines in the dollar, partly by instilling
tently saved more as a fraction of GNP than Japan and Germany,
confidence on the part of international investors in the resolve
and we saved much more as a share of GHP then than we have since
of the United States to address its economic problems.
the end of World rtar II.
A turnaround in our current domestic
saving performance is essential to a smooth reduction in our
making room for the needed diversion of more of our productive
dependence on foreign saving, and the federal government should
resources to meeting demands from abroad.
taka the lead.
Domestic demands Hill
It is also apparent that redressing our external im-
have to continue growing more slowly than our productive capacity, as seems to have been the case so far this year, if net
balances must encompass cooperative policies with our trading
exports are to expand further without resulting in an inflation-
partners.
ary overheating of the economy.
the newly industrialized economies, and the developing coun-
Absent thia fiscal restraint,
These include both the established industrial powers,
higher interest rates would become the only channel for damping
tries, whose debt problems must be worked through as part of the
domestic demands if they were becoming excessive.
international adjustment process.
If a renewed
decline in the dollar were adding further inflationary stimulus
This is the strategy that U.S. fiscal policy as well as
at the same time, upward pressures on interest rates would be
economic policies abroad should follow in most effectively pro-
even more likely.
moting our shared economic objectives.
The restrictive impact would be felt most by
The strategic role of
the interest-sensitive sectors--homebuilding, business fixed
U.S. monetary policy is implied by a clear statement of what
investment, and consumer durables.
those ultimate objectives are.
In terms of federal deficit reduction, the schedule
under the Gramra-Rudnian-Hollinga law is a good baseline for a
We should not be satisfied
unless the U.S. economy is operating at high employment with a
sustainable external position and above all stable prices.
High employment is consistent with steadily rising
that have become relatively cheap.
But essentially the average
nominal wages and real wages growing in line with productivity
of all prices would exhibit no trend over time.
gains.
in these circumstances would reflect relative scarcities of
Some frictional unemployment will exist in a dynamic
Price movements
labor market, reflecting the process of matching available
goods, and private decision-makers could focus their concerns on
workers with available jobs.
adjusting production and consumption patterns appropriately to
But every effort should be made
to minimize both impediments that contribute to structural
changing individual prices, without being misled by generalized
unemployment and deviations of real economic growth from the
inflationary or deflationary price movements.
economy's potential that cause cyclical unemployment.
By a sustainable external position, I am referring to a
The strategy for monetary policy needs to be centered
on making further progress toward and ultimately reaching
situation in which our foreign indebtedness is not persistently
stable prices.
growing faster than our capacity to service it out of national
the maximum economic expansion consistent with a sustainable
income.
Our international payments need not be in exact balance
Price stability is a prerequisite for achieving
external balance at high employment.
Price stability reduces
from one year to the next, and the exchange value of the dollar
uncertainty and risk in a critical area of economic decision-
need not be perfectly stable, but wide swings in the dollar, and
making by households and businesses.
boom and bust cycles in our export and import-competing indus-
ing price stability, monetary policy also would have to bear
tries, should be avoided.
much of the burden for countering any pronounced cyclical
By price stability, I mean a situation in which house-
In the process of foster-
instability in tBe economy, especially if fiscal policy is
holds and businesses in malting their saving and investment
following a program for multi-year reductions in the federal
decisions can safely ignore the possibility of sustained, gener-
budget deficit.
alized price increases or decreases.
some macroeconoaic disturbances, monetary policy does have a
Prices of individual goods
and services, of course, would still vary to equilibrate the
While recognizing the self-correcting nature of
role to play over time in guiding aggregate demand into line
various markets in our complex national and world economy, and
with the economy's potential to produce.
particular price indexes could still show transitory movements.
providing a counterweight to major, sustained cyclical
A small persistent rise in some of the indexes would be toler-
tendencies in private spending, though we can not be over-
able, given the inadequate adjustment for trends in quality
confident in our ability to identify such tendencies and to
improvement and the tendency for spending to shift toward goods
determine exactly the appropriate policy response.
This may involve
In this
-16regard, it aeems worthwhile for me to offer some thoughts on the
the monetary ranges will have to be brought down further in the
approach the Federal Reserve should take in implementing this
future if price staiLlity is to be achieved and then maintained.
longer-term strategy for monetary policy.
But, in a shorter-run countercyclical context, monetary
The appropriate tactics for monetary^poliCY.
aggregates have drawbacks as rigid guides to monetary policy
For better or worse, our economy is enormously complex,
implementation.
As I discussed in some detail in my February
the relationships among macroeconomic variables ate imperfectly
testimony, financial innovation and decegMlation in the 1980s
understood, and aa a consequence economic forecasting is an
have altered the structure of deposits, lessened the predict-
uncertain endeavor.
Nonetheless, the forecasting exercise can
ability of the demands for the aggregates, and made the veloci-
aid policymaking by helping to refine the boundaries of the
ties of Ml and probably M2 over periods of a year or so more
likely economic consequences of our policy stance.
sensitive to movements in market interest rates.
But fore-
casts will often go astray to a greater or- lesser degree and
Movements in
short-term market rates relative to sluggishly adjusting deposit
monetary policy has to remain flexible to respond to unexpected
rates can result in large percentage changes in the opportunity
developments.
costa of holding liquid monetary assets.
A perfectly flexible monetary policy, however, without
Depositor responses
can induce divergent growth between money and no.mir.al Gtip for a
any guideposta to steer by, can risk losing sight of the ulti-
time.
mate goal of price stability.
led the FOMC to retain the wider four percentage point ranges
In this connection, the require-
ment under the Humphrey-Hawkins Act for the Federal Reserve to
announce its Objectives «nd plans for growth of money and credit
I might add that it was partly these considerations that
for money and credit growth for this ysar and next.
Nonetheless, the demonstrated long-tun connection of
aggregates is a very useful device for calibrating prospective
money and prices overshadows the problems of interpreting
monetary policy.
shorter-run swings in money growth.
The announcement of ranges for the monetary
1 certainly don't want to
aggregatos represents a way for the Federal Reserve to
leave the impression that the aggregates have little utility in
communicate its policy intentions to the Congress and the
implementing monetary policy,
public.
it is quite possible that their importance will grow in the
And the undisputed long-run relation between money
they have an important role, and
growth and inflation means that trend growth rates in the
years ahead.
monetary aggregates provide useful checks on the thrust of
scrutiny, and judges their actual movements relative to
monetary policy over time-
assessments of their appropriate growth at any particular, time.
It is clear to all observers that
Currently, the FOMC keeps M2 and M3 under careful
-18-
-19-
In this context, these aggregates are among the indicators
noticeably faster than would have been expected from its
influencing adjustments to the stance of policy, both at regular
historical relationships with U.S. spending and interest ratea.
FOMC meetings and between meetings, as the FOMC's directive to
although the monetary base has exhibited some useful
the Federal Reserve Bank of New York's Trading Desk indicates.
properties over the last three decades as a whole, the FOMC1s
The FOMC also regularly monitors a variety of other monetary
vie« is that its behavior has not consistently added to the
aggregates.
At times in recent years, we have intensively
information provided by the broader aggregates, M2 and M3.
The
examined the properties of several alternative measures, and
Committee accordingly has decided not to establish a range for
reported the results to the Congress.
this aggregate, although it haa requested staff to intensify
These measures have
included Ml, Ml-A (Ml less NOW accounts), monetary indexes, and
research into the ability of various monetary measures to
moat recently the monetary base.
indicate long-run price trends.
An analysis of the monetary base appears as an appendix
to the Board's Humphrey-Hawkins report.
This aggregate, essen-
Because the Federal Reserve cannot reliably take its
cue for shorter-run operations solely from the signals being
tially the sum of currency and reserves, did not escape the
given by any or all of th« monetary aggregates, we have little
sharp velocity declines of other money measures earlier in the
alternative but to interpret the behavior of a variety of
1980s.
economic and financial indicators.
Its velocity behavior stemmed from relatively strong
They can suggest the likely
growth in transactions deposits compared with GNP, which was
future course of the economy given the current stance of mone-
mirrored in the reserve component of the baas.
tary policy.
In this sense,
some of the problems plaguing Ml also have, ahown through to the
base, though in somewhat muted form.
Moreover, the three-
Judgments about the balance of various risks to the
economic outlook nnad to adapt over time to the shifting weight
quarters share of currency in the base raises some question
of incoming evidence; this point La fell exemplified so far this
about the reliability of its link to, spending.
year, as noted earlier.
The high level
The Federal Reserve must be willing to
of currency holdings—5825 per nan, woman and child living in
adjust its instruments fairly flexibly as these judgments
the United States—suggests that vast, indeterminate amounts of
evolve; we must not hesitate to reverse course occasionally if
U.S. currency circulate or are hoarded beyond our borders.
warranted by new developments.
Indeed, over the last year and one half, currency has grown
overreact to every bit of new information, because the frequent
TO be sure, we should not
observations for a. variety of economic statistics are subject to
SO
00
99
-20considerable transitory "noiae".
But we need to be willing to
respond to indications of changing underlying economic trends,
without losing sight of the ultimate policy objectives.
To the extent that the underlying economic trends are
judged to be deviating from a path consistent with reaching the
ultimate objectives, the Federal Reserve would need to make
"mid-course" policy corrections.
Such deviations from the
appropriate direction for the economy will be inevitable, given
the delayed and imperfectly predictable nature of the effects of
previous policy actions.
Nunerous unforeseen forces not related
to monetary policy will continue to buffet the economy.
The
limits of monetary policy in short-run stabilization need to be
borne in mind.
The business cycle cannot be repealed, but I
believe it can be significantly damped by appropriate policy
action.
Price stability cannot be dictated by fiat, but govern-
mental decision-makers can establish the conditions needed to
approach this goal over the next several years.
100
The CHAIRMAN. Well, thank you very much, Dr. Greenspan.
Let me ask you first, is it true that because of the lags involved
the changes in monetary policy that would affect the economy,
affect interest rates, stock prices and so forth—those changes are
probably already done. They were changes that occurred in the
past and that between now and the election, that any changes in
monetary policy would not have an effect on the economy?
I ask that because Dr. Fair, a distinguished professor from Yale
University, testified that in his judgment that was the case and the
other experts yesterday seemed to agree with that judgment.
Mr. GREENSPAN. I think it is substantially true, Mr. Chairman,
that most of the effects of economic policies, specifically with respect to monetary policy, occur only with a lag.
Nonetheless, I think that there are effects which are continuing
and which could be altered should policy change in any significant
way. But those effects could be described as relatively small, compared with the effects already in place currently embodied in the
structure of policy.
The CHAIRMAN. I thought your statement was an excellent statement and you talked about something I think we have to be concerned about—living beyond our means.
LIVING BEYOND OUR MEANS
The unique thing about your statement is you didn't confine
living beyond our means to the Federal Government. We are living
beyond our means obviously. We all know that. We've talked about
it and debated it. But yours is one of the first statements from a
top official that I've heard that includes American households and
businesses. And I think that it's a very, very important point.
Not only is the Federal Government living beyond its means, but
our households are deeply in debt. Our businesses are enormously
in debt. The figures I've seen from the Federal Reserve on household debt is that it's over $3 trillion. On business debt, if you include not only corporate debt but nonincorporated business, including farms and so forth, that it's over $4 trillion. And that this is
occurring at a time when savings are low.
The reason I bring that up is that any compensatory action on
the part of the Federal Reserve to allow for the fact that we're
shrinking the Federal deficit—people have talked about how, yes,
we can encourage with lower interest rates housing and borrowing
for automobiles and so forth. It seems to me either way you do it,
you're living beyond your means and we're simply shifting the indebtedness and the obligations from the Federal Government to
the private sector.
Mr. GREENSPAN. I would, of course, generally agree with the
overall thrust of your remarks with one addition, which I think is
an important one.
We would not have particular problems if the difference between
consumption and income in our system were being financed with
equity, and if we had very effective ratios of capital to debt because
in those instances we could absorb a considerable amount of economic shock.
101
When evaluating debt, it is incomplete merely to look at the aggregate levels. It's always important to view debt relative to equity
in balance sheets. And here, even though it is certainly the case
that we have very large debts in the household sector, we also, of
course, have very substantial assets.
The CHAIRMAN. Let me interrupt in that situation, however. Isn't
it true that there's been an enormous increase in borrowing by corporations compared to raising equity, particularly in view of the
merger mania, the takeovers and so forth which have been financed largely by debt and there are certainly at least many dramatic cases of corporations that had a strong equity-debt ratio and
now have a much weaker, thinner capital-debt ratio?
Mr. GREENSPAN. Yes. In fact, that has been concerning me, as
you know, for a number of years. Long-term interest rates have
come down a great deal since their peaks in the early 1980's. But
the ratio of interest payments of the nonfinancial corporate sector
to gross cash flow has not come down, and that is another indication of the fact that instead of getting debt relief from the decline
in interest rates which occurred from the early 1980's to the most
recent period, we have essentially offset that relief by increasing
debt. The interest payments, the servicing costs, so to speak,
remain undiminished and, in my judgment, higher than I would
like to see them.
The CHAIRMAN. My time is up. Senator Garn.
Senator GARN. Thank you, Mr. Chairman.
Chairman Greenspan, increasing internationalization of world
markets—world capital markets in particular—was an important
part of passage of S. 1886, the Proxmire bill which passed the
Senate 94 to 2.
Do you still favor that legislation? It's been some 3 months now
since it passed the Senate.
Mr. GREENSPAN. Yes, I do, and the Federal Reserve Board still
does.
Senator GARN. And my next question would be, then, have you
had an opportunity to look at the St Germain draft bill?
Mr. GREENSPAN. Only cursorily, Senator.
Senator GARN. And what is your cursory opinion of the St Germain bill?
Mr. GREENSPAN. My cursory opinion is that it could probably
accept some amendments from the Senate. [Laughter.]
Senator GARN. Well, you're much more charitable with it than I
am,
I feel very strongly that if we go to conference and we do not
have a bill that looks very much like the Senate bill, that we would
probably be better off with no bill at all. I would expect that if this
happened that people would say, well, there's been another deregulation bill passed and it's good for another 6 or 7 years.
So I'm hopeful that there will be more than just some amendments by the Senate. I hope, we can come up with a bill that is
much closer to the Senate bill so that we can pass one that is significant and does not pacify certain elements for a number of years
into the future.
Would you go so far as to say that you feel that it should look
very close to what the Senate bill looks like?
102
Mr. GREENSPAN. Until I've gone beyond a cursory look, which is
really inadequate for any form of analysis, I wouldn't want to give
you any extended position. But nonetheless, I do think that at this
particular stage, speaking for my colleagues, that the Senate bill as
it stands is the type of model we would like to see evolving as this
particular piece of legislation moves forward.
Senator GARN. I would hope that when you've had an opportunity to look at it more carefully that we could have a more detailed
analysis of the bill from you and, hopefully, an expression of the
Board in general as to how they feel about the bill.
Mr. GREENSPAN. I would think we would be obliged first to communicate detailed discussions with your counterparts in the House
after we evaluate it, but after that point I'm sure we would be
more than willing to go public.
Senator GARN. News travels fast. We have no problem with that.
In your statement, you say:
A more serious long-run threat to price stability could come from government actions that introduced structural rigidities and increased costs of production. Protectionist legislation, inordinate hikes in the minimum wage, and other mandated programs that would impose costs on U.S. producers would adversely affect their efficiency and international competitiveness.
I think that's a very important statement. Would you expand
and elaborate on that particular comment?
Mr. GREENSPAN. Well, I think that what we have observed over
the years is that one can create inflationary environments by
means other than adverse monetary or fiscal policies. There are a
number of actions that can be taken which can load costs onto the
economy indirectly which have very much the same effects as inflationary monetary policies.
One thing that does concern me is that as we move toward a
period when budget restraint is going to become of necessity the
highest priority so far as economic policy is concerned, I'm concerned that we will tend to try to create a number of different economic policies through regulation or indirectly through various different types of actions which in effect move resources, increase
costs, in a way which is presumed to be hidden.
Protectionist legislation, in my judgment, is the most dangerous
form of cost increase because it gives a sense of tranquility too
often to companies which should be competing very fiercely and
will have to at some point. So I would basically argue that we must
be careful not to substitute various different forms of cost-increasing legislation merely because the vehicle which exists or has existed in the past through the Federal budget is no longer available.
Senator GARN. Thank you, Mr. Chairman. My time is up.
The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you very much, Mr. Chairman.
Mr. Chairman, I have a statement which I would like to have included in the record as if read.
The CHAIRMAN. Without objection, so ordered.
STATEMENT OF SENATOR JIM SASSER
Mr. Chairman, the committee is honored today by the presence
of the distinguished Chairman of the Federal Reserve Board. I am
103
pleased that Dr. Greenspan will give us his view of where the economy is headed.
I think Dr. Greenspan deserves great credit for his stewardship
of the Federal Reserve over the past year. Indeed, the Fed performed extraordinarily well in responding to the October stock
market crash. The Fed stepped in quickly, and reassured the marketplace by providing the liquidity needed to get us through those
seemingly desperate days.
Mr. Chairman, I am concerned, however, about the conduct of
monetary policy in the months ahead. I am afraid that some on
wall street may be a little too concerned about inflation, and too
quick to advocate a rise in interest rates.
Right now the last thing we need is a restrictive monetary
policy. The risks the economy would incur if we were to move into
a recession are far too great.
We already are running an unacceptable fiscal deficit. A rise in
interest rates, and particularly a contraction in the economy,
would only exacerbate that deficit. I note that Professor Blinder
testified yesterday that the deficit could easily go to $300 billion
were there to be a recession.
And as we all know, we are facing a crisis in the savings and
loan industry. Given the situation, a recession could easily undermine the safety and soundness of the banking system.
To put it mildly, I think the Fed will play a critical role in the
coming months. I look forward to Dr. Greenspan's testimony.
Thank you, Mr. Chairman.
Dr. Greenspan, I want to welcome you before the committee this
morning and yesterday we had the good fortune to have a panel of
very distinguished and eminent economists appear before the committee to give their views on monetary policy and generally their
views on the state of the economy.
One of those was Professor Alan Blinder, a distinguished economist from Princeton University. Dr. Blinder spoke of the speculation that the Fed might increase interest rates in the wake of the
recently announced lower unemployment rate and over concern
that the economy might be overheating.
He also indicated that the Fed should not be swayed by what he
characterized as "the hysteria that seems to sweep Wall Street
about every 2 weeks." He went on to say the speculative markets
react to everything, including things that are just imagined and
they react too vigorously and he concluded by saying, "the Fed
must ignore this insanity."
What about this speculation on a rise in interest rates and what
about Professor Blinder's comment? How significant an increase in
rates is the Fed looking at at this juncture?
RISE IN INTEREST RATES
Mr. GREENSPAN. Well, Senator, I agree with Dr. Blinder in the
sense that there is a great deal of street chatter, as we call it,
which of necessity fills up the newspapers, largely because people
discuss with each other why they are investing, why they are not
investing, sometimes based on evidence, sometimes not, sometimes
based on hunch.
104
A lot of that is actually quite useful in that we monitor it to a
very considerable degree because it tells us a good deal about what
the attitudes of the investing public and the professional investors
are.
However, that's just merely a piece of evidence so far as Federal
Reserve policy is concerned. It is an important piece of evidence because it tells us something about their expectations which one
must presume are embodied in levels of interest rates, stock prices,
exchange rates, and a variety of other things.
But I should certainly hope that we take it as that and are not
unduly swayed as though much of that is the same thing as hard
evidence about what the economy is doing at any particular time.
Our monetary policy will continue, I hope, to focus on the hard
facts of what the economy is doing and the particular positions
that the FOMC will take. Consequently, attitudes toward the various different financial variables will depend on how the Committee
views the ongoing evolution of economic developments over the
next year or year and a half.
Senator SASSER. Well, Mr. Chairman, given the fragility of the financial system at this juncture and the fiscal imbalance that we
find ourselves in, I would come down on the side of avoiding a recession almost at all costs, and I do hope that the Fed will not be
hyperreactive to any signs, real or imagined, of impending inflation. If we fall off into recession, we've got the problem of the Federal deficit. We were told yesterday that in a recessionary economy
it could run up to as high as $300 billion annually. We're saddled
here in this committee with the problem of the ailing S&L's and
we are told that the FSLIC might have liability up to $60 billion
with regard to these thrifts. If we get into a recessionary economy
the Congress and the new administration are not going to have the
ability to conduct a countercyclical fiscal policy as we've done in
times past because we simply are not going to have the wherewithal to do it, given the large budget deficit.
So that's why I'm concerned this morning, Mr. Chairman, about
the whole question of the Fed tightening monetary policy or raising rates in anticipation of some inflationary pressures. I would
urge that we not overreact to that.
I noted a day or two ago that Wall Street had reacted to the unemployment rate that is now is 5.3 percent, the lowest we have had
in 14 years. Usually that is a sign and a signal that there might be
some inflationary pressure mounting because of bidding for labor
services—there is a shortage of labor.
But when you get inside those figures, according to the Wall
Street Journal, what we find is that, unlike in the 1970's, a large
proportion of these unemployed are mature workers, as opposed to
the 1974 figures, for example, of this 5.3 figure being composed
very largely of teenage workers. Because of demographic changes,
the unemployed now are largely made up of mature workers which
would indicate that there's not the labor shortage out there that
these low unemployment figures would indicate.
That and a number of other factors lead me to at least weigh in,
Mr. Chairman, with regard to the Fed's monetary policy of not
being overreactive to signs of inflationary pressure.
That's my speech this morning.
105
The CHAIRMAN. Senator D'Amato.
Senator D'AMATO. Well, thank you, Mr. Chairman. I can quote
Senator Chafee while he's here.
Mr. Chairman, I want to tell you I'd like to associate myself with
some of the statements of my colleague, Senator Sasser. We've got
problems with FSLIC. We've got a ticking time bomb with FDIC.
Nobody wants to say that. I think we do a great mistake by the
way if this committee and staffers on this committee run around
and say, well, FSLIC has a hole of $60, $70, $80 billion. If you
really wanted to look at the international debt situation and the
commercial loan situation and add it up just like GAO went ahead
and did with FSLIC, you'd find maybe the situation will be even
more distressing. It's the faith and confidence in the system that.
we will provide the mechanism by which to work our way out that
in the fullness of time will be the only solution, not just screaming
and yelling from the highest bell tower about the problems.
I also think that Senator Sasser said something that bears repetition. I would hate to think that we're going to try to cool inflationary pressures by just simply the monetary policy of raising interest
rates. We've seen some of that in the past and I think it's been
rather disastrous. It is a very important component in that inflation factor. When you raise interest rates to the business community, to the home owner, to the user of products, it exacerbates problems as it relates to a recessionary cycle. So it's a very careful balancing act and I would hope that our Chairman—I have every confidence in him—that he is able to manage that in such a way that
we don't tilt it too much toward that high interest rate phenomena
that we saw in the past, a good deal of it which came from your
predecessor. Everybody gives him great grades. I think that he
kept that spigot on the credit closed just a little too long and
brought about a little too much pain and brought about a little too
much recession that was unnecessary. Yet we're not supposed to
say those things because we're supposed to be in the world where
we say everything is wonderful and we all do wonderful and good
jobs.
As it relates to the work of this committee, let me suggest to you
that we have an opportunity to open up the spigot to about $1V2
billion to the thrift industry that is sadly, sadly and deeply in need,
simply by lifting a restriction on the trading of Freddie Mac,
simply by taking that ban off and allowing it to proceed.
Now for whatever reason it seems to me that staff has made up
their mind—and I'll be very candid—the staff director who has
worked his way to attempt to encourage members to put in various
amendments on that legislation that has brought then concern to
other members of this committee so we can't even proceed, notwithstanding that 14 members of this committee have indicated
support for that legislative initiative. I think it's a rather sad commentary.
Now are we talking political gamesmanship or are we talking
about what we're going to do to benefit this ailing industry? Are
we talking about doing the right thing or are we talking about
some kind of obsequiousness that we have to pay in tribute to the
staff director? That's a heck of a thing for me to have to say, but
I'm sick and tired of that kind of nonsense and it's nonsense.
106
We were promised—I was promised, particularly on the floor, a
markup for tomorrow. Now that's what was made. You said, "Senator, if you don't go forward with this legislation"—then another
group of Senators are promised that they can introduce amendments and use that markup as a vehicle by which to introduce
their amendments. You want to talk about the dog in the manger,
that's exactly what that is. That's the dog in the manger and the
cow is not going to come in there to eat, and so everybody is promised something but we have the dog in the manger. I don t enjoy it.
Mr. Chairman, you may say, well, why don't we try to discuss
these things privately. Well, no one has ever made the opportunity
or the attempt. I would think that I would be owed at least that, so
I didn't have to make this public. But it seems to me that's the
only way we have to do it.
So now when this Senator looks upon other vehicles by which to
put this legislative initiative, I don't want people to be surprised. I
think that a promise that was made and accepted in good faith has
not been kept. It's unfortunate and it's wrong and it's certainly not
helping to address the problems. Let's take it on the merits. If the
legislation isn't any good, kill it, vote it down. But when you don't
have the votes, it doesn't seem to me that that's the appropriate
thing to do to exercise the kind of discretion that is placed in the
chairman and just deny that markup that was promised for tomorrow.
So I share those thoughts with you. I think some of my colleagues may agree. Some may not want to—by the way, I expressed
it in a lot less emotion than I'm generally given in regards to matters of this kind, particularly when I feel rather aggrieved.
Thank you, Mr. Chairman.
The CHAIRMAN. May I respond to the distinguished Senator from
New York? I want to thank you for your kind and gentle remarks,
kinder and gentler than they sometimes are, but I do think that in
fairness to the staff, the decision was not made by the staff.
Senator D'AMATO. He just set all the conditions, Mr. Chairman,
by which it was brought about.
The CHAIRMAN. Well, let me say that I've been insulted in a lot
of ways, but I think the worst insult would be to tell me that I
don't know what the dickens I'm doing and that the staff runs the
committee, which is what the distinguished Senator from New
York is certainly implying and that certainly isn't the case.
Let me say why we postponed this matter. During the hearings
on the Freddie Mac bill I asked Mr. Brendsel, who is the head of
Freddie Mac, the President of Freddie Mac, for legislation on how
FSLIC could share in the profits. That language has been prepared
and it's been sent to the Chairman of the Bank Board. We haven't
gotten an answer from him. The staff made at my direction repeated inquiries of the Bank Board as to its position on the bill and on
the FSLIC recapture issue. No answer has been forthcoming.
Last Monday, I asked the Bank Board in writing for its views on
the FSLIC recapture issue not later than Tuesday. We still have
not heard from the Board. If it's feasible and desirable to recapture
part of the profits for FSLIC, it's an opportunity this committee
shouldn't let slip away. FSLIC is in terrible trouble. They need that
money desperately. If they could have only several hundred million
107
dollars it would help greatly. As you know, it's either a bailout or
it raising money from the industry itself, and this is one way of
providing a little more money for FSLIC.
So in view of all that, it seemed to me that it wouldn't be responsible for the committee to proceed in the markup on Freddie Mac
without the formal views of the Bank Board.
Now this is not a cancellation. The Senator earlier— not in these
remarks, but earlier indicated that we had canceled that meeting.
We didn't cancel the meeting. We postponed the meeting. We
intend definitely to have the meeting. You said that 14 members of
the committee support your bill. That's true and I'm one of the 14,
as you know. I've said I support it.
Senator D'AMATO. That would be 15, Mr. Chairman.
The CHAIRMAN. Well, all right, then it's 15 members who support
it. I think it's a good provision.
Senator GRAMM. Let's vote.
The CHAIRMAN. But I did state on the record that I supported the
bill, but I think we ought to know what we're doing and we ought
to consider whether or not we can provide several hundred million
dollars for FSLIC as well as most of the money, three-quarters of
the money perhaps, for the S&L's. That was the reason why I postponed that, but I definitely did not cancel it. I have every intention
of having a markup on that bill, but I think we ought to do it with
the fullest knowledge we can get.
Senator GARN. Mr. Chairman.
The CHAIRMAN. Senator Garn.
Senator GARN. If I could also respond—and the Senator from
New York is well aware of this—we have had two or three private
conversations on this issue over the last day or two and so I wish to
make my statements to him public. As ranking Republican on this
committee, I was part of the decision and agreed to the postponement of the markup. I think the Senator is well aware why I felt
that way, because when we had the hearing he and I had a rather
heated discussion. It was not over the substance. I don't know
whether, Al, I'm counted in your 14 or 15, but I did state in that
hearing that I was also in favor of the legislation. So is that 16 or
am I part of the 15?
Senator D'AMATO. Sixteen.
Senator GRAMM. We'd better vote fast. [Laughter.]
Senator GARN. You didn't count very carefully then, because if
you remember, I started out our heated discussion by saying I was
in favor of your bill; but I was not in favor of rushing into it until
we had the answers to some questions. I asked all of the witnesses
very pointedly, "Will one of you answer my question?" None of
them had the answer to those questions. So that is my position. We
should move forward. The Freddie Mac stock should be freed up
and my attitude is that we ought to have the markup the week
after we come back from recess. As far as I'm concerned—and I
can only speak for myself—if at that time the Bank Board and
Freddie Mac, have not answered our questions, then we go ahead
and mark it up. We give them another 2 weeks and if they have
not answered us by then, we will go ahead and mark up the bill
and 16 of us, or however many, will vote for it.
108
The CHAIRMAN. If the Senator from Utah would yield, I agree
with that and I intend to do exactly that.
Senator D'AMATO. So I understand that the Chair is indicating
that the week we come back that we will then take this up?
The CHAIRMAN. That's correct.
Senator D'AMATO. Well, fine.
Senator GARN. I would further suggest, Mr. Chairman, the 27th,
I believe, is clear on the schedule. That's 2 weeks from today; and
if we've not had the official opinion of the Board, we will move
ahead without them.
The CHAIRMAN. The 27th is fine with me.
Senator D'AMATO. I thank the chairman and I thank the ranking
member.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
You had a ringside seat for that at no extra charge. [Laughter.]
It sounds to me in terms of what you said in going through your
statement that interest rates are probably headed up. That's what
I draw from what you presented here.
On page 7, you say explicitly that Federal Reserve policy at this
juncture might be well advised to err more on the side of restrictiveness rather than stimulus, and I think the general pattern of
events, in addition to other things you've said today, would suggest
upward pressure. When we watch what's happening to interest
rates in Great Britain, that's the sense I get.
Now if you dispute that, I think you should respond one way or
the other.
Mr. GREENSPAN. As you know, Senator, we are not in the business of forecasting rates. What we are in the business of doing is
evaluating the balance of risks. To state, as we do, that the risks
are more on the inflation upside than on the recession downside is
not to say that of necessity it will come out that way.
What we will do and what we have done is to continuously and
concurrently evaluate economic events and financial pressures as
they emerge and take actions as is appropriate to it.
We do not forecast interest rates and, in fact, we do not have implicit in our policies something which says that we will be moving
in a direction which will either move rates up or move rates down
over some protracted period. That's not the way the system functions nor do I think it should.
Senator RIEGLE. Well, let me ask you this. If interest rates tend
to be rising around the world and it seems to me they are—I think
we see pressure in that direction—we're the largest debtor nation,
so we've got more borrowing to do, unfortunately, than anybody
else. We've already had some rise in the value of the dollar and
there's a whole question as to whether it can hold that rise or goes
back down. That creates an interest rate risk to somebody that's
going to invest by lending to the United States from abroad—a currency risk, if you will, if there's reversal in the dollar value.
Why doesn t that necessarily have to push our rates up? How
can we keep our rates down if rates are rising generally?
Mr. GREENSPAN. Well, Senator, there are many more things involved in the determination of pressures which move rates one way
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or the other than either international considerations or even the
domestic economic structure.
There are so many elements involved.
Senator RIEGLE. I don't dispute that. I agree with that, but I
guess what I'm saying is, given the fact that you have this whole
mix of elements with the ones that I've just stressed, why doesn't
that upward pressure on rates inevitably cause us to have to respond in kind?
Mr. GREENSPAN. Basically, it's the word "inevitably" that I'm responding to. I don't think it is inevitable. Obviously, it is a pressure
in that direction, but there can be innumerable other things working in the other direction of greater force which would negate that.
Senator RIEGLE. What's the most hopeful one you see on the horizon that would help us keep rates down in the face of upward
pressures elsewhere?
Mr. GREENSPAN. Well, I would say, first of all, I'm not necessarily subscribing to the presumption that rates internationally are
going up. It is certainly the case that they have gone up recently.
It doesn't necessarily follow that they will continue to do so. I
know of no actions contemplated by any of my counterparts in the
international arena which necessitates that. I don't deny it is possible, it's certainly one of the innumerable credible forecasts out
there that could occur, but it may not. And it may not basically
because inflationary pressures which still are held in check may
continue to be held in check or they may begin to ease for reasons
that are not obvious at the moment.
All we can do is to try, as best we can, to monitor what's going
on on a continuous and real-time basis and try to evaluate where
the risks of mistakes are in policy. What few people realize is that
policy is perhaps more focused on what the cost is of going in direction "a" if you're wrong? We consider that all the time and that's a
major issue involved in the current period.
Senator RIEGLE. Well, let me ask you to crank one other thing
into your forward planning. I had a top official in the Government
come to see me yesterday who's in a position to be very knowledgeable, who conveyed an estimate of the size of the savings and loan
exposure of the losses that are going to have to be covered somewhere between $50 and $70 billion.
FISCAL READJUSTMENT PLAN
Your strategy here is to have a fiscal readjustment plan somewhere along the line, presumably in the next administration because there's no sign of it coming in the rest of this year. I'd like to
know how we're going to square those two things, have a fiscal readjustment plan that brings down Federal deficits, and at the same
time brings this savings and loan deficiency up into the light of
day, stops the hemorrhaging, solves it in the range of a $50 billion
problem or higher, and make all that fit together. I'd like to hear
some sense as to how you think those two things can be cross-connected here.
Mr. GREENSPAN. Well, first, Senator, I've seen those numbers—
and I've evaluated a lot of different numbers and what I am aware
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of is the fact that we have very great analytical problems with
trying to make judgments about the scope of this hole in FSLIC.
The reason we have the problem is that even though we are dealing with financial instruments—mortgages on the asset side of the
balance sheet of the S&L's largely—they are essentially at the end
of the line a nonrecourse loan against a property whose value is
deficient. I say nonrecourse in the sense that as a practical matter
it often works out that way.
The tricky problem is not in evaluating the state of those loans.
It's trying to make a judgment about the market value of all of
those properties on which those loans rest. And while there are a
lot of people who are appraisers and they look at this, until you've
got a hard evaluation over the long run, you really don't know exactly what the size of that hole is.
I think it's substantial. I don't frankly know what the specific
number is. But whatever the number, it is not a situation which, in
the event of a congressional approach to this problem, would require up front the types of numbers that you're talking about even
remotely. It is a problem which is extended over a period of time.
It is, nonetheless, an issue which I think does exacerbate the fiscal
problem and it is something which the next Congress is going to
have to confront. It's just that I'm a little bit reluctant to absorb
some of the numbers which I've seen because I know how difficult
those estimates really are. I think the ranges are much wider.
Senator RIEGLE. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gramm.
Senator GRAMM. Thank you, Mr. Chairman.
AVOIDING A RECESSION AT ALL COSTS
Dr. Greenspan, I'm sort of obsessed with this idea of avoiding a
recession at any cost and I'd like to ask you a question, going back
to your comments on page 6. As you know, we have pending before
the Congress now a series of labor provisions that range from substantial increase in the minimum wage to mandated benefits to
worker notification of plant closings and layoffs. I've seen estimates
that all of this package, if put together and adopted, would raise
the cost of job creation in the country maybe by as much as onequarter.
If your objective were to avoid a recession at all costs, to create
more jobs, more growth, more opportunity in America, would you
see the adoption of that general type of legislation as being a positive or a negative?
Mr. GREENSPAN. Negative.
Senator GRAMM. And you would say that, other things being the
same, that the adoption of that package would mean fewer jobs,
less growth, less opportunity?
Mr. GREENSPAN. Over the longer run, I would subscribe to that
statement.
Senator GRAMM. Let me talk a little bit about this whole debt
issue. It seems to me that the real question we've got to face,
whether we're talking about public debt or private debt or domestic
debt or international debt, is what was the money used for? If the
money was used to create wealth, to build new plants and equip-
Ill
ment thats one thing. It's no secret that we borrowed our way into
being a world power, since the United States was a debtor nation
from the time the first pilgrim stepped on Plymouth Rock until
about 1920.
If on the other hand the borrowing is going basically to nonproductive uses—that is, it's not creating a wealth flow that will in
turn pay off the debt and generate wealth in the process—then
debt becomes a negative factor.
So it seems to me, if you agree with that approach, that the real
question we've got to answer is, what is the private debt going to
do and what is the public debt going to do? And the thing that
bothers me about our international debt is that a lot more of it
now than ever before is going to finance the public debt, which is
primarily being generated by deficit spending and which I don't
think anybody could argue is wealth-creating. Certainly it's not
creating assets that would pay off those loans.
Do you share that concern?
Mr. GREENSPAN. It's very difficult to try to determine precisely
which item on the asset side of the balance sheet is financed by
which item on the liability side. But it is certainly the case that
our aggregate amount of external borrowing that is measured by
the current account deficit in the most recent past has been exceptionally high, as indeed our Federal deficit has been. And when one
is balancing the various different accounts one can clearly say that
there is an increasing proportion of external finance which goes directly and indirectly to finance the Federal deficit. It's not strictly
the question of how much direct Federal securities is purchased by
foreigners. That's not what I'm talking about.
But leaving that particular concept aside, I would certainly agree
that the issue of debt is crucially related to the question of whether
the employment of that debt was used to produce an asset which
will create the resources to pay both interest and principle on the
debt and more.
Senator GRAMM. Would you agree, Dr. Greenspan, that public
debt in general does not do that?
Mr. GREENSPAN. I would agree with that.
Senator GRAMM. Finally, Mr. Chairman, let me say I don't want
to get back into this debate about Freddie Mac. I think I agreed
with our colleague from New York. I think, however, that we ought
not to miss an opportunity to liberate the capital of institutions
that are capital starved. If there are legitimate concerns about it,
then we ought to move quickly to resolve them. We ought to ask
the questions and we ought to get the information, and then we
ought to move ahead if in fact there is a general consensus that
this is a good idea. We do have a very severe capital shortage in
the savings and loan industry. If we can liberate over $1 billion of
capital, I think we ought to do it.
The CHAIRMAN. Senator Graham.
Senator GRAHAM. Thank you, Mr. Chairman.
FEDERAL RESERVE POLICY AND THIRD WORLD DEBT
I would like to ask some questions relative to the Federal Reserve policy and Third World debt. Some commentators on the re-
112
cently concluded Toronto summit have suggested that the failure
to come more fully to grips with that issue was the major deficiency of the summit and that it would therefore be the first priority of
the next economic summit.
If you were preparing to advise the next Secretary of the Treasury and the next President in preparation for the economic summit
as to an evaluation of the way in which the United States has dealt
with the Third World debt to date and any changes that might be
appropriate beginning with the new administration, what advice
would you give?
Mr. GREENSPAN. Senator, when I came into office almost a year
ago, I had a number of differing notions as to how to resolve what
was clearly an extraordinarily difficult problem, and it is really
quite interesting that when you get, as I have, into the day-by-day
details and the whole financing process and the whole issue of relationships between creditors and debtors and banks and financial institutions, you begin of necessity to see where the real crucial
issues are.
The one thing that has struck me as upfront in all of this is how
important the resolution of this debt question is in general and
how necessary the solution to the problem is. The crucial initial
focus of where one starts in resolving this problem is the economic
policy actions of the debtor nations.
It's fairly obvious that if economic policies are adequate to resolve the difficulties that a lot of these debtor nations have, both
they and the international financial system will come out of this
probably strengthened, having learned basically how to deal with
this extraordinarily difficult problem.
If there are inadequate economic policies, there is no solution, of
which I am aware, that's credible over the longer run to resolve
this debt problem. I think that the most recent action in history of,
for example, Brazil, is really quite illustrative. As you know, a year
or so ago, Brazil introduced a unilateral moratorium on payments
and, in retrospect, upon relooking at what was gained from all of
that, the new finance minister, Mailson Nobrega, concluded it was
negative to Brazil's interest and immediately reversed it and endeavored to restore far more sensible policy approach. He has
moved back into very detailed discussions and very fruitful discussions with the commercial banking system.
I think that what we are learning from this process is that when
the finance ministers and various other members of the economic
team of the debtor nations look in detail at this issue, they recognize that step No. 1 is what they do. And I think that we—that is,
the United States and the next administration—should do whatever we can do to see to it that their actions are implemented in a
most productive way and in a manner which induces their creditors, who obviously want them to succeed, to be as helpful as possible.
That's essentially the process which currently is the policy of
this country. I must say to you that I think it has the highest probability of achieving more than all of the various different alternatives which I've been exposed to. Most of the alternatives require
some very large bailouts with taxpayer money, which I think
would turn out actually to be counterproductive. At the moment, I
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would recommend that we endeavor to enhance the process which
is currently in place.
Senator GRAHAM. So, in summary, your recommendation to the
next administration would be a continuation of the current policy?
Mr. GREENSPAN. Yes. It's the policy which endeavors on a caseby-case basis to recognize that the only way to get individual countries back on a basis which gives them access to the international
financial markets on a voluntary basis is to go in the direction
we're going.
My major concern is that if we fail in doing that, these debtor
nations will be out of the private markets for a generation, as they
were the last time they ran into difficulties in the 1920's. That, I
might add, would be a tragedy not only for them but for the whole
international financial system.
Senator GRAHAM. Thank you.
The CHAIRMAN. Before I recognize Senator Heinz, I ask unanimous consent that a statement by Senator Chafee appear at the beginning of the hearing before the chairman was recognized.
Senator Heinz.
Senator HEINZ. Mr. Chairman, thank you.
CURRENT ACCOUNT DEFICIT AND IMPORT OF FOREIGN CAPITAL
Chairman Greenspan, earlier you referred to our current account
deficit and this country's imports of foreign capital. You observed
that the United States is living beyond its means. We have accumulated a $400 billion debt to other countries and there are some
estimates that our debt could reach $1 trillion by the early 1990's.
Some people say that the United States is importing a lot of capital to pay for current consumption and that we cannot continue to
follow that policy. However others say those imports of capital are
really an indication of strength in the United States' economy and
that this country is an attractive place to put your money.
Which of those two views is correct?
Mr. GREENSPAN. At various different times, both of them are correct.
Senator HEINZ. What about the present?
Mr. GREENSPAN. The trouble with my answering is that the
bottom line in any short-term period is the direction of the exchange rate, and that's a topic which I think I'm probably wise to
stay away from.
Senator HEINZ. But that's the precise area I wanted you to address.
Mr. GREENSPAN. I'm delighted I fended you off in advance.
[Laughter.]
Senator HEINZ. Would you agree that today the single most important determinant of international exchange rates is the level of
interest rates in our country?
Mr. GREENSPAN. It's certainly one of the elements. I think the
more general notion I would put forth is that the exchange rate is
being determined, to a very substantial extent, by the willingness
of foreigners to hold dollar-denominated assets relative to assets denominated in other currencies. And while obviously differential in-
114
terest rates are a crucial element in that determination, it is by no
means the only element.
Senator HEINZ. In your view, what are the other key elements?
Mr. GREENSPAN. Well, I think it's interesting that when you try,
for example, to examine why the American dollar rose so sharply
from 1983 through 1985, in most of that period the real interest
rates on dollar-denominated securities were not increasing relative
to interest rates denominated in other securities.
Senator HEINZ, Were they relatively higher?
Mr. GREENSPAN. They were higher, but remember, the spread between real interest rates will determine the spread between currencies or the exchange rate, not whether it's going up or going
down.
Senator HEINZ. What you're saying then is that confidence in an
economy is another key factor.
Mr. GREENSPAN. Yes, and I think it's crucially so.
Senator HEINZ. I think there would be very few people who
would disagree with that.
There are some people who say that the United States is in dire
straits, and that we are in an irreversible economic decline. In support of that view, they cite statistics that show that real disposable
income per capita has been stagnant for 15 years or so. They also
cite our relatively poor productivity and the huge trade deficit.
In contrast there are other people who say that the economic
policies that we are following are totally sound, that these policies
are responsible for nearly 6 years of economic growth, and that we
should continue to follow those policies that have worked so well
because they will continue to work well in the future.
The former is a pessimistic view of this country. The latter is an
optimistic view of this country. Clearly, the view that foreigners
take, whether it's one or the other or someplace in between, is
quite material to where the dollar lies in international currency
values.
Which of those views comes closest to your own?
Mr. GREENSPAN. I must say I'm impressed with the improvement
in productivity which has occurred in recent years, especially in
manufacturing. The irony of that is it probably it was at least
partly the result of competitive pressures coming from abroad as a
consequence of a rise in the dollar, which in turn induced an awful
lot of endeavors on the part of manufacturing companies to pare
down in many instances what clearly in retrospect was a loaded
cost structure.
Whatever one may say about the United States in the 1970's and
the difficult periods we had in the late 1970's, the most recent
period has been really quite impressive and in one respect surprising. I don't think any of us who were in the forecasting business, as
I was as a private citizen, would, IVa years ago, have essentially
projected the developments that have emerged over the previous
times.
Senator HEINZ. Aren't there times though, when being a private
citizen felt good?
Mr. GREENSPAN. Many times.
Senator HEINZ. If you were persuaded that one view was right
and the other was wrong, would it not make a difference in the
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way the Fed conducted its policy? If you adopted the pessimistic
view, would the Fed's policy be different than if it adopted the optimistic view that I described a moment ago?
Mr. GREENSPAN. I don't think that the two views are in sufficiently constructed detail for me to then apply monetary policy to
that because I don't think
Senator HEINZ. Let me suggest a hypothesis. You may disagree
with it. I'll try and be brief because my time has expired and Senator Bond deserves his time.
If indeed the pessimistic view is correct, would it be reasonable
for the Fed to follow a policy that would allow the dollar to drift
lower in order to make our exports more competitive and imports
more expensive?
Mr. GREENSPAN. Well, merely allowing the dollar to drift lower
doesn't automatically create that phenomenon, because if in the
process a falling dollar engendered an acceleration of inflationary
forces in the United States, the cost competitiveness of American
exporters would not be improving vis-a-vis those of our foreign
competitors and could very well in the end turn out to be counterproductive. History is strewn with experiences of individual companies trying to improve their competitive position through devaluations and failed.
Senator HEINZ. Mr. Chairman, Chairman Greenspan has been
very responsive to my question. Just as a concluding comment I
would observe that it's quite remarkable that the dollar has fallen
as much as it has over the last 2 years without any resurgence of
inflation. Therefore, I'm not sure I totally understand the rationale
for Chairman Greenspan's last comment. However, I am sure that
there will be other occasions when we can pursue this matter further.
I do want to draw specifically to the Fed's attention a very significant report. This is the first part of what will be a much longer
study by the Office of Technology Assessment. It's a study that
many of us requested about 2 years ago. It was called "Paying the
Bill: Manufacturing and America's Trade Deficit."
The reason it struck me as relevant is that Chairman Greenspan
indicated that he was impressed with the improvements in America's manufacturing productivity in recent years.
This report suggests that our improvements in the manufacturing sector, while significant when compared to the 1970's are not
enough when compared with what other developed countries are
doing today. At best, we are not falling behind. At worst, there are
many areas where we are continuing to lose our competitive advantage and lead, in terms of both productivity and technological advancement.
I ask that the Fed please study this report carefully. Perhaps it's
worth further discussion and even a hearing to get Chairman
Greenspan's views and that of other experts on this report. I thank
you, Mr. Chairman.
The CHAIRMAN. Senator Bond.
Senator BOND. Thank you, Mr. Chairman. I'm always happy to
accommodate my friend from Pennsylvania in order that we can
hear the discussion that Chairman Greenspan has had with us.
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I want to follow up on the exchange rate question because it
came up yesterday in testimony by a distinguished private economist before this committee, who said that really he thought the
Fed and particularly the Treasury Department ought to be placing
more emphasis on maintaining the exchange rate within a narrow
range. Not fixing it, but keeping it in a narrow range because of
the importance of that exchange rate for fiscal and monetary
policy, the interdependence of our economy with the world economy.
He suggested that some of the problems we have seen and may
see are more likely to come because of exchange rate fluctuations.
I would appreciate your views and discussion on that issue.
EXCHANGE RATES
Mr. GREENSPAN. Well, Senator, I think that we certainly agree
that exchange rate stability is a desirable goal. It's clearly something that not only we in the United States believe but it is the
general view of the international financial community—very specifically the G-7 finance ministers and central bank governors who
are largely in charge of implementing, on a day-by-day basis, exchange rate policy for the major trading nations of the world.
There is no question that instability in the exchange rates would
create risk premium, create instabilities in other economic variables, and clearly is not something which would enhance economic
growth either for the United States or for our trading partners.
Senator BOND. I was most interested again to hear your discussions about the problem of the burden of debt going beyond the
Federal debt in our system.
What would be your suggestions with respect to tax policies to
either encourage savings or to discourage borrowing? And what
could be done to encourage an increase in personal and corporate
savings in this country, in addition to the need to balance our Federal budget?
Mr. GREENSPAN. Senator, we have over the years endeavored to
use the tax system in order to enhance savings, to basically enhance the proportion of equity to debt in the system and to largely
counter the problems which excessive debt and excessive borrowing
clearly create.
It's a slow process. I don't think we've been anywhere near as
successful as I would like to see us be. The types of things we have
to do in the tax area to significantly increase savings and discourage debt, I suspect, are very politically difficult to do.
I've concluded, as a consequence, that it is probably far easier
and, for the moment, perhaps just as productive to recognize that if
we bring the Federal deficit not only down to zero but allow it to
move into surplus, we will in fact be creating many of the very
positive things which we need to offset the excessive debt creation
that one has seen over the most recent period.
If I were to recommend a specific focus of policy which has got
the largest economic impact on this problem, it's clearly moving
toward a Federal surplus over the years as fast as we can.
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Senator BOND. Finally, with respect to that budget deficit, you
played the lead in the very important work of the commission to
fix the Social Security System.
What's the proper place for Social Security in the Federal
budget? Should it be off budget or should we be using the surplus
to pay off our other government obligations?
Mr. GREENSPAN. Senator, in a technical sense, it should be on
budget in the sense that we look at the total economic impact of
the Federal Government's activities. If one chooses to take it offbudget and focus on the non-Social Security trust fund budget and
if one endeavors to take that budget deficit—which will obviously
be larger than the current one in the unified budget deficit—down
to zero or balance, we will automatically create the type of surpluses which we will need in the aggregate unified budget system.
So whatever the Congress ultimately decides to do—and at the
moment, of course, it is scheduled to go off-budget—one should perceive of the necessity to create a surplus in the unified total budget
including Social Security funds for the type of increase in domestic
savings which I think this Nation needs.
Senator BOND. Chairman Greenspan, my sincere thanks for your
most informative testimony.
Mr. Chairman, I appreciate your indulgence and patience in allowing me to ask questions. Thank you.
The CHAIRMAN. Well, I'd be delighted to have you go on. I'll tell
you, our problem is that the Democratic Caucus is meeting right
now at 11:45 with President Dukakis and Vice President Bentsen
and, for that reason, as you can imagine, they're almost as big an
attraction as you are, but I'm going to stay here because I've got
some questions for you that I'm sure you will answer with at least
as much information as the next President and Vice President will.
Senator BOND. Mr. Chairman, would you be so kind as to ask
that pair who's defense and international policies they're going to
follow, the Governor's or the Senator's? It would be most interesting to learn. I'd be delighted to hear that discussion.
The CHAIRMAN. Well, I think they will follow the very wise policies that will come from a blending of the exchange of information
and intelligence on both sides which is very high. [Laughter.]
Chairman Greenspan, it's a delight not to have to run again for
public office, I'll tell you, because when you don't have to run
again for public office you don't have to take the position that all
Members of Congress and administrations take that we avoid a recession at all costs. We've heard that from Senator Sasser and Senator D'Amato today, two fine Senators, but I think that can get us
into a lot of trouble.
I notice you didn't indicate that. You indicated we wanted to
mitigate recessions and wanted to do all we can to make the recession as painless as possible, but that's the price you pay for a free
economy, in my view, and we're going to have to face that.
One of the things you do to get on top of the problem of excessive
debt and deficient savings it seems to me is to let interest rates
rise. That is the way it would seem to me that you penalize debt,
isn't it? We know that borrowing to buy homes, borrowing tc buy
cars is enormously sensitive to the level of interest rates.
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Mr. GREENSPAN. I think it is certainly true that mortgage interest rates do impact to a significant extent the desire on the part of
individuals to buy homes and therefore their willingness to take
out mortgage debt.
It's not clear that that's true in consumer credit in general or, as
we have observed in recent years, credit cards.
But in general, it is certainly the case that in the consumer area
that the mortgage interest rate is a crucial variable.
The CHAIRMAN. Now how about the effect of the level of interest
rates on savings? The testimony by and large has been that savings
is quite inelastic and that even if interest rates rise sharply people
are not inclined to save more. Is that correct?
Mr. GREENSPAN. I think that's correct in a general sense. Obviously, If a specific depository institution raises its interest rate, it
will gain savings. But the total is very insensitive and very inelastic to changes in interest rates.
The CHAIRMAN. Let me ask you about the discount rate. In
recent weeks, the Federal funds rate has been averaging near 75/s
percent. Yet the discount rate is only 6 percent. Ordinarily, the discount rate would be set at a level that is much closer to the shortterm money market rates.
Some are beginning to suggest that the Fed is reluctant to raise
the discount rate for fear of the impact of a rate rise on the Presidential election. Others claim that it would only send the dollar
higher.
Why has the Fed been reluctant to make an adjustment in the
discount rate that seems justified given the level of current shortterm interest rates and the implication in your testimony that they
may have to rise some more?
DISCOUNT RATE
Mr. GREENSPAN. Senator, the relationship between the Federal
funds rate and the discount rate has varied quite considerably over
the years. Spreads have been both significantly higher and significantly lower in past periods.
We have a number of instruments that can be employed to address specific problems of monetary policy and the Federal Open
Market Committee, in conjunction with the Federal Reserve Board,
makes choices about what the best mix is at any particular time.
It's been the judgment to date of the FOMC and the Federal Reserve Board that the current relationships are satisfactory.
The CHAIRMAN. Yesterday, the panel of experts who appeared
agreed with you that fiscal tightening could produce an expansion
when accompanied by monetary ease. The panelists suggested that
a substantial reason for this was that the change in the policy mix
would cause the dollar to fall and we would then experience further improvement in our trade balance and export-related investments.
Your analysis in February suggests that we would see an expansion if the deficit is reduced substantially. Today, you say that
fiscal contraction will increase confidence in U.S. policy and may
cause the dollar to rise.
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If the dollar rises and the deficit is reduced, how will an expansion result?
Mr. GREENSPAN. I'm sorry, if what?
The CHAIRMAN. If the dollar rises and the deficit is reduced, how
will that cause an economic expansion?
Mr. GREENSPAN. We're talking now about the Federal deficit?
The CHAIRMAN. That's right.
Mr. GREENSPAN. If the Federal deficit comes down, real domestic
dollar denominated interest rates are likely to fall significantly.
There is unquestionably a very substantial backlog of capital investment mainly for modernization projects that would be forthcoming in this country if real long-term interest rates declined.
And all of the various other suppressing elements in the economy would be clearly offset by that. What we don't have enough of
is net capital investment. Gross investment is quite high, but it's
relatively short-lived assets with high depreciation rates and the
trend of net capital investment to net national product has been
going down for quite a number of years. It is that which would
turn around and that which would support the economy.
The CHAIRMAN. But wouldn't that have an adverse effect on
demand? As the deficit goes down, there's less stimulus from the
Government spending.
Mr. GREENSPAN. Certainly.
The CHAIRMAN. And the relationship between taxing and spending is adverse as far as the economy is concerned and as the dollar
rises, of course, we sell less abroad and buy more from abroad.
Wouldn't that tend to overcome the modification in interest rates?
Mr. GREENSPAN. I don't necessarily think so. I think that using
the hypothetical example which we're using, the missing element
in there is precisely the reaction of domestic capital investment.
One can reduce purchasing power or effective demand from the decline in the Federal deficit and one can reduce the export demand
one could get if one hypothesizes that we lose some of that, but
that could be fully offset and more by domestic capital investment
if the combination of both of those elements brings real interest
rates down.
I'd say the conclusion of where you come out in the example is
really indeterminate without being far more specific about the various relationships that exist amongst those elements in the economy.
The CHAIRMAN. My time is up, but I get the feeling that you
seem to feel that maybe we can avoid a recession. If that happens—of course, these are the elements—reducing the deficit and
having the dollar rise it seems to me are two factors that I think in
the long run would be helpful to our economy, but I would think
we would have to go through a recession at the same time. That's
one of the things that brings interest rates down.
Mr. GREENSPAN. I would say, Mr. Chairman, that there is not
enough information, so to speak, in that hypothetical forecast to
tell me whether or not there's a recession without knowing what
domestic capital investment is, and the lower interest rates could
be a significant event in today's environment should those events
occur. I'm obviously not subscribing to that as a forecast because
that's not the way we look at things.
120
The CHAIRMAN. You're disagreeing with William McChesney
Martin and arguing that you can push a string?
Mr. GREENSPAN. I'm not aware that this is string pushing. I'm
just aware of the fact that the type of scenario that is out there,
the type of international adjustment process, can in fact be implemented over the longer run without a recession. That it can be
done is certain. That it will necessarily happen, obviously I can't
comment on.
The CHAIRMAN. Thank you. Senator Bond.
Senator BOND. I don't have as distinguished a luncheon as you do
to go to, so go ahead.
The CHAIRMAN. Some producers of export goods have claimed
that they would not invest in new capacity despite the rise in utilization rates because they did not feel confident that the dollar
would stay at its current level.
Is the rise in the dollar over the last couple of weeks going to
fuel these doubts and cause export firms to cut back on capital formation plans?
Mr. GREENSPAN. I haven't seen any evidence of that, Senator. On
the contrary, at the moment, orders for export goods are really
quite impressive.
The CHAIRMAN. Yesterday in testimony before the committee
David Hale of Kemper Financial Services suggested that the exchange rate targets be made explicit by disclosing them to the
public.
Do you support that idea?
Mr. GREENSPAN. No, I do not.
The CHAIRMAN. What are the costs of making public the target
zones for exchange rates?
Mr. GREENSPAN. I think that what would happen very quickly is
that we would engender a tremendous amount of speculation
around the targets and ultimately make the policy of implementing
them exceptionally difficult. The net result, as I would see it, would
be counterproductive.
BAILOUT OF S&I-'S
The CHAIRMAN. Now members of this committee, including the
distinguished Senator from Texas who's one of the brightest men
in the Senate, have argued that we must not under any circumstances bail out the S&L's. But I don't see that we have much
choice if things worsen because we have a promise to, of course,
pay insurance on all deposits under $100,000 which is most of the
deposits.
Some have suggested that the resolution of the S&L crisis will
entail using funds from the interest earnings of the Federal Reserve on its open market portfolio to recapitalize the savings and
loan insurance fund.
In 1987, the Fed returned to the Treasury over $17 billion. Do
you favor using these funds to recapitalize the S&L industry?
Mr. GREENSPAN. Let me just say that what we are talking about
is precisely the same as appropriations and expenditures from the
budget because to the extent that you divert funds that we earn
and return to the Treasury, receipts are lower in the total Federal
121
budget. It makes no difference so far as the Federal budget deficit
is concerned whether you do it that way—that is, take money off
the earnings of the Federal Reserve—or you expend money on the
outlay side.
The CHAIRMAN. There's a critical difference. Members of Congress don't have to vote for that appropriation. [Laughter.]
Mr. GREENSPAN. I quite agree.
The CHAIRMAN. And the President can say I can't handle these
fellows in the Federal Reserve, they're appointed and they're independent and they should be and if they want to do it that way,
then God bless them.
Mr. GREENSPAN. Without commenting on the very last remark,
I'm not certain it's good precedent or good policy.
The CHAIRMAN. Now in public statements you've supported an
increase in the gasoline tax.
Mr. GREENSPAN. That's correct.
The CHAIRMAN. I doubt that Vice President Bentsen will support
that recommendation.
Wouldn't a gas tax depress the price of energy and exacerbate
the regional depression in the oil-producing regions and wouldn't it
also make the S&L crisis worse in view of the problems in Texas
and California?
GASOLINE TAX
Mr. GREENSPAN. No, I don't think so, Mr. Chairman, because I
believe that the world price of gasoline is determined not in the
United States but in the world, and it's essentially derived from
the price of crude oil. So in the sense of the tax depressing the
price of gasoline, there's no evidence that that would happen.
It presumably would depress the demand for domestic gasoline in
the United States and in that regard, over the long run, I consider
that a plus, not a negative. Since gasoline consumption in the
United States in and of itself is a remarkably large proportion of
aggregate world oil consumption, I would assume that to the extent
that the tax lowers domestic gasoline consumption, as it would, one
can argue that, on the margin, it lowers long-term crude oil prices
and has some feedback effects here. But my suspicion is that those
numbers are really quite marginal and will have very little effect
on the oil-producing economy of the United States.
The CHAIRMAN. Chairman Greenspan, one of the statistics I'm
sure you look at in considering inflation is capacity utilization and
obviously if we move toward a higher level of capacity utilization
there's more inflationary pressures.
Dr. Cooper, of Harvard, has recommended broadening our view
there. In your testimony, you suggest that capacity utilization is
high and that this will contribute to a rise in prices in the years
ahead. At our last hearing, Dr. Cooper suggested that as long as
there were no import barriers in a sector that full capacity utilization would lead to greater imports rather than a rise in prices. Dr.
Cooper suggested that one focus on the state of global capacity utilization in the industry in question rather than on national rates of
capacity utilization.
122
Do you agree with Dr. Cooper's emphasis on global capacity utilization?
Mr. GREENSPAN. Well, only in a general way. Remember, that to
the extent you pick up imports to supply shortages in the United
States, you basically have to pay for them and one would presume
at the extreme that that would cause the dollar's exchange rate to
fall which would increase the domestic price of the imports over
time which in turn would create the same inflationary problems
that we are concerned about.
The CHAIRMAN. Of course, time is an important element here,
isn't it?
Mr. GREENSPAN. Yes.
The CHAIRMAN. How long would that time be? Would it be several years?
Mr. GREENSPAN. I don't know. Yes, it could conceivably be. However, I do think there is a different question and there is a sense in
which I would agree with Dr. Cooper. What we really are concerned about is deliverability of products by our manufacturing
producers and the way we measure that best is their ability to
supply products quickly to their customers. At the moment we
have nonaccelerating delivery lead times on materials—meaning
when customers come to the salesman for delivery they are not
being quoted excessively increasing lead times with the exception
of steel and aluminum and a few other things. But in general not.
What that is saying is that we still have adequate deliverability
capabilities in American manufacturing. Our concern is that we
will get squeezed and that will all of a sudden cause huge stretchouts in delivery lead times which is where the inflation comes
from.
The reason that we have adequate deliverability capabilities at
the moment is that, at least in part, we do have access to imports
and to products and materials from abroad. So in a certain sense,
what Dr. Cooper is arguing for already exists. My concern about
the way he put it in a generalized sense is that in the longer run it
probably doesn't work.
The CHAIRMAN. One final question. Do you favor paying interest
to banks on their required reserves?
Mr. GREENSPAN. That's a subject which gets to the whole question of interest on demand deposits and a variety of other issues. I
do think that, as I have thought over the years, we should look at
the whole question of paying interest on demand deposits. That
would bring forth the whole question of paying interest on reserve
balances. That, however, would be such a major change in the way
the Federal Reserve System functions that I think we have to give
it very considerable thought.
The CHAIRMAN. Would that have an adverse effect on the budget
deficit?
Mr. GREENSPAN. Perhaps.
The CHAIRMAN. Why not? It's money that would otherwise go
into the Treasury, wouldn't it?
Mr. GREENSPAN. In net, it could. It would depend on a number of
other things.
The CHAIRMAN. Why wouldn't it? I would think it would inevitably have that effect.
123
Mr. GREENSPAN. Well, there's no question obviously that in the
immediate short run it obviously reduces the amount of moneys
that are paid to the Treasury, but to the extent that that creates
profits in the commercial banking system, part of it gets absorbed
by the corporate income tax.
The CHAIRMAN. Well, as you know, I love the banks, but the
taxes they pay to the Federal Government are not overwhelming.
They have all kinds of ways of diminishing those taxes. Some
people tell me the tax they pay is a matter of their public relations
rather than any real requirement.
Mr. GREENSPAN. I'm not going to comment on that.
The CHAIRMAN. OK. Senator Bond.
Senator BOND. Mr. Chairman, just one last question. One of our
colleagues asked if I would inquire what impact Chairman Greenspan thinks the drought may have on the banking system. We have
had banks in trouble in our part of the country in the heartland as
a result of agricultural and commodity loans. Do you see any increased stress on agricultural lending banks that may have been
put in a precarious position from the drought?
Mr. GREENSPAN. Well, as you know, Senator, prior to the
drought, the agricultural banks were coming back quite rapidly
and doing rather well. I think this probably will stall some of the
improvement in some of the cases, but I don't see it as something
which will throw us back into the types of difficulties that we had
previously.
Senator BOND. Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Mr. Chairman. You have been
superb and I can't thank you enough for your fine testimony.
The committee will stand adjourned.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]
[Response to written questions and additional material supplied
for the record follow:]
124
Chairman Greenspan subsequently submitted the following
in response to written questions from Chairman Proxmire in
connection with the hearing held on July 13, 1988:
(Question 1; It is often suggested that cutting the
federal budget"deficit will be least painful if it is offset by
economic stimulus in some other sector of the economy. Since
early 1985 the decline in the exchange value of the dollar has
provided stimulus to export and import-competing industries.
o
According to the Federal Reserve's analysis, if the
exchange rate remains at current levels, how long
will it be before the adjustment to the decline of
the dollar since early 1985 completes propagating
through the economic system and ceases to provide
substantial stimulus to the economy?
o
According to the Federal Reserve's analysis, given
current exchange rates, at what point in time will
the current account balance begin to deteriorate
because the increment in external debt service
caused by the current account deficit begins to
exceed the improvement in the merchandise trade
deficit?
Answer;
The large net decline in the dollar's value
since early 1985 has set in motion forces that should continue,
for some time to come, the improvement in our external position
that we have been experiencing.
Conventional models of the U.S.
current account, including some of those used by the Federal
Reserve Board staff as well as other prominent models, suggest
that most of the shifts in demand for exports and imports
resulting from an exchange rate change are realized within about
two to three years.
Thus, if exchange rates were to remain
unchanged, these models suggest that the U.S. current account
might begin to deteriorate after 1990 or so, both because of
rising debt service and because the level of imports would still
exceed the level of exports, implying larger absolute increases
in imports under reasonable assumptions about other factors.
125
However, there is a wide range of uncertainty
surrounding these model results, especially given the unprecedented size of exchange rate movements.
Moreover, these
models do not even purport to capture all aspects of the process
of external adjustment.
For example, the improvement in the
competitive position of U.S. firms might well induce an increase
in productive capacity that would impact favorably on our external position.
Actions to reduce our federal budget deficit
would work In the same direction.
In short, we simply do not
know enough to predict when, if ever, the ongoing improvement in
our current account will be reversed, even at current exchange
rates.
126
-3-
Question 2: On Monday, July 19th, the New York Times
reported the results of three studies on the dynamic adjustment
of the trade balance and current account balance in the United
States in the absence of further dollar depreciation. The study
by Data Resources cited in the article suggests that the trade
deficit will stop declining in 1989 and begin to rise thereafter. The WEFA Group's study shows a similar result with both
the trade deficit and the current account deficit beginning to
widen again in the early 1990s. The third study, by the
Institute for International Economics, suggests that even without the recent appreciation of the dollar the trade deficit will
not dip below $100 billion before it begins to grow again. This
last study may be the most discouraging because it does not even
account for the recent appreciation of the dollar.
o
If one assumes that the dollar does not depreciate
further does the Federal Reserve's model predict a
result that differs markedly from the results
described in the New York Times article?
o
Absent a further decline in the dollar and a
recession, how will the United States achieve a
balanced current account in the next several years?
Answer:
Some of the models used by staff at the
Federal Reserve Board show results not unlike those of the
studies cited.
That reflects the fact that the same basic
structure underlies all of these models.
Less conventional
models that take into account a wider range of factors, including supply responses of producers, yield somewhat more
optimistic results.
Moreover, no model can take account of all
factors bearing on external adjustment.
The United States has achieved an enormous recovery in
competitiveness as a consequence of the exchange rate adjustments of the past several years coupled with continued increases
in manufacturing productivity and restrained increases in wages
and prices.
To ensure that this is sustained and results in a
127
continuing improvement in our external balances, we must act to
avoid excessive pressure on our productive capacity.
Actions to
reduce the federal budget deficit are certainly desirable in
this context.
A monetary policy like the current one, designed
to preclude additional inflationary pressures, will help also to
improve our external position.
One cannot be certain that those
policies would be sufficient to restore our external accounts to
a more sustainable configuration within the next several years,
but they could at least ensure that we continue to move in the
right direction.
128
-5-
Question 3: In a panel discussion at the February
hearings, Professor Richard Cooper of Harvard University said
the following:
"... there is a serious anomaly in the present U.S.
arrangements and that is that the Federal Reserve is
formally in charge of domestic monetary policy but the
Treasury is formally in charge of exchange rate policy.
That was an arrangement that worked perfectly well
under the Bretton Woods system in which the U.S. was
the passive player and we didn't intervene actively in
exchange markets. That is an anomalous arrangement in
a world of flexible exchange rates and it is one of the
sources of the tensions that exist between the Treasury
and the Fed today."
o
Do you agree with this statement?
o
The Federal Reserve was criticized by the
Administration in late 1987 and early 1988 for the
slow growth rate of money last year. Do you not
find that difficult to accept in light of the fact
that a significant reason for the monetary slowdown
was that the Federal Reserve was defending the dollar to live up to an exchange rate agreement made in
conjunction with the Administration in February of
1987?
Answer:
In the Federal Reserve's conduct of monetary
policy, the value of the dollar on foreign exchange markets is
an important consideration.
The exchange rate is a central
price variable in the economy, with implications both for U.S.
inflation and output and for resource shifts across sectors.
We
cannot be indifferent toward it nor can we ignore the information it may provide.
Indeed, conditions in exchange markets at
times have been accorded very high priority in our policy
decisions.
We also work closely with the Treasury in the
formulation and implementation of U.S. exchange rate policy.
Senior Treasury officials consult extensively with Federal
129
Reserve officials in a cooperative effort to ensure financial
stability, better balance in the nation's international accounts, and improved prospects for sustainable economic growth
over the long run.
During 1987, the exchange rate was given a great deal
of weight in monetary policy deliberations, but was not the
exclusive, or even the major, factor behind the rise in interest
rates and the slowing of money growth.
Instead, the major
factor was concern about a resurgence of inflation more generally.
At times during the year, soaring commodity prices and
sharp declines in the dollar and bond prices signaled the
possibility of greater inflationary dangers.
With real GNP
growing well above its long-run potential and levels of resource
utilization climbing at an unsustainable pace, the Federal
Reserve had to be especially alert to these and other indications of potential inflation pressures.
130
-7-
Question 4; In a recent book entitled, "Managing the
Dollar", by Yoichi Funabashi, the author discusses an episode
where the exchange rate between the yen and the dollar was
managed to promote the reelection of Mr. Nakasone in Japan.
Secretary Baker of the Treasury allegedly made comments on the
exchange rate to stop the yen from appreciating against the
dollar just before the Japanese elections. There is also an
insinuation that the Japanese provided a similar courtesy to the
Administration before the 1986 Congressional elections.
Mr. Hale, in a panel hearing on July 12, mentioned this in his
testimony. He also cited a Financial Times editorial on
July 2nd which espoused this view. An article in the New York
Times on the same day suggested that the dollar was being
manipulated to help George Bush. Since that time the Washington
Post and Jeffrey Garten, a New York investment banker writing in
the Hew York Times, have also expressed concern on this question.
o
Why would the Japanese or other foreign powers
prefer George Bush to Michael Dukakis?
o
Do you know of an agreement between the Japanese and
the Treasury in 1988 that is similar to the one
Mr. Funabashi described in his book? Are the
Japanese and other foreign powers capable of acting
to stabilize markets to help a Bush Administration
get elected as Mr. Hale and the press have
suggested?
Answer:
It would be inappropriate for Federal Reserve
officials to speculate about the political preferences of individuals in other countries or about their political strategies.
I know of no agreement between the Japanese and the Treasury
that is similar to the one described in Mr. Funabashi's book.
131
Ques t ion 5; In recent months Governor Johnson has
stated that tTiree indicators are helpful when assessing the
suitability of monetary policy. The behavior of an index of
commodity prices, the term structure of interest rates, and the
foreign exchange value of the dollar.
o
The December 1987 and the June 1988 issues of the
OECD Economic Outlook suggest that foreign purchases
of long-term bonds, particularly by Japanese institutional investors, occurred in 1985 and 1986. If
foreign holders sell long-term securities will not
the dollar decline at the same time that long-term
interest rates rise? What has been Che correlation
between the steepening of the term structure and the
change in the yen-dollar exchange rate in since the
end of 1986?
o
At the panel hearing on July 12, Dr. Rudiger
Dornbusch suggested that the level of commodity
prices is affected by the dollar exchange rate.
That is presumably because most commodities are
priced IB dollars and when the dollar depreciates
the demand for commodities is stimulated in the
industrial countries whose currencies have appreciated. Dr. Dornbusch claims that, "Using commodity
price-oriented monetary policy may simply amount to
a disguised exchange rate target." What is the
correlation between exchange rate changes and
changes in commodities prices?
o
Are not movements in commodity price indices, the
term structure of interest rates, and the foreign
exchange rate highly correlated? Does each convey
much information that is independent of the others?
o
In recent weeks many commodity prices have fallen,
the dollar has risen, and the term structure of
interest rates has flattened. Is that an indication
that monetary policy is becoming too tight1?
Answer:
A desired shift out of long-term U.S.
securities into foreign currency-denominated assets in response
to, say, worse-than-expected U.S. trade figures would tend to
cause U.S. long-term interest rates to rise and the dollar to
depreciate.
On the other hand, a desired shift out of long-term
132
U.S. securities into short-term dollar assets in response to,
say, an anticipated Federal Reserve tightening, would tend to be
associated with rising U.S. long-term rates and an appreciation
of the dollar.
Thus, depending on the nature of the new
information, changes in U.S. long-term rates can be associated
with either increases or decreases in the dollar's exchange
value.
The simple correlation coefficient between weekly
changes in the U.S. term structure (30-year bond minus 3-month
bills) and percentage changes in the yen-dollar exchange rate
since the end of 1986 is -.03.
The correlation of the levels is
-.33.
Changes in the dollar prices of internationally traded
commodities should, indeed, be negatively related to changes in
the dollar's exchange value since it is world (not just U.S.)
demand and supply which determines these prices.
The correla-
tion coefficient between monthly percentage changes in the
Economist commodity price index (in dollars) and monthly percentage changes in the dollar's weighted average exchange value
in terms of other G-10 currencies since 1982 is -.20.
The correlation coefficient between monthly levels of
commodity prices and the dollar's weighted average exchange
value from end-1982 is -.50; between commodity prices and the
term structure of interest rates (measured by the difference
between the yield on 30-year Treasury bonds and 3-month Treasury
133
-ID-
bills) is .08; between the term structure and the weighted
average dollar, .20.
Since none of these correlations is par-
ticularly high, it would be reasonable to conclude that each of
the three variables conveys some information not conveyed by the
others.
(Also see attached chart.)
Interpretations of the
movements in any of these indicators require a knowledge of the
surrounding circumstances and judgments of what factors lie
behind the shifts in supply and demand.
Even if these three
indicators, along with others, were all moving in a consistent
direction and all were reflecting the recent tightening of
monetary policy, that information alone could not answer the
question whether monetary policy was becoming too tight.
The
answer to that question would depend on the extent of the movement of these indicators and the strength of their relationships
to subsequent developments in the overall economy, in particular, the general price level.
Given the present risks of
inflationary pressures in the U.S. economy, we do not consider
monetary policy to be excessively tight in present circumstances.
Attachment
SELECTED INDICATORS
"Monthly
WEIGHTED AVERAGE
DOLLAR EXCHANGE
VALUE
(March 1973 -100)
CO
135
-iiQuestion 6: It is often suggested that raising
interest rates is necessary to arrest the formation of a wage
price inflationary spiral. At the same time, interest rates,
like wages, represent a cost to a business which must borrow for
working capital and fixed investment.
o
In the short run does a rise in interest rates
create "cost push" inflation just as a rise in wages
would?
o
Is it possible to generate an interest rate-price
spiral which is analogous to a vage-price spiral
whereby a rise in interest rates leads to an
increase in prices followed by an investor reaction
demanding an inflation premium in interest rates
which raises costs and prices again?
o
Would you
shows how
shares of
world war
Answer:
please provide to the Committee data which
wages, business profits and net interest
national income have evolved in the post
period?
There appears to be no compelling evidence at
the macro level of the interest rate-price effect you suggest.
Although interest costs may be an expense that businesses will
seek to cover in their pricing, the net effect of a tightening
of credit conditions that is reflected in higher interest rates
(especially higher "real" rates) appears to be a damping of
aggregate demand and of inflationary pressures.
requested are attached.
Attachment
The data you
136
Question 16
SHARES OF GROSS DOMESTIC PRODUCT FOR NONRNANCIAL CORPORATIONS
( in p e r c e n t )
EMPLOYEE COMPENSATION
r~
\
v
,
— 65
60
NET INTEREST
— B
PROFITS
[26
y\ /- ,
'
SO
\i V
\<
1946
19S3
i960
1967
1974
1901
Data description notes are included on a separate page.
19B8
137
Notes on Gross, Domestic Product of Honfinancial Corporations
Shares of Gross Domestic Product for nonfinancial corporations
are expressed in percentage terms.
Gross domestic product of nonfinancial. corporations represents
the value added of these business operations. It has accounted
for more than 90 percent of total gross domestic corporate
product and more than 55 percent of the U.S. gross national
product in recent years.
Employe* compensation includes wages and salaries plus fringe
benefits paid by nonfinancial corporations.
Net interest is the total interest paid less interest received
by nonfinancial corporations.
Domestic operations of nonfinancial firms provide for more than
three-fourths of total U.S. corporate profits.
Profits before taxes are operating profits for nonfinancial
corporations, with adjustments to value inventories and
capital at current replacement costs, but before corporate
income taxes.
Profits after taxes differ from profits before taxes by the
amount of profits taxes (including federal, state and local
income taxes levied on corporate profits).
The remaining component shares of GDP that are not depicted in
the charts (primarily, depreciation and indirect business taxes)
averaged around 20 percent of GDP in recent years.
data source:
U.S. Department of Commerce, Bureau of Economic
Analysis.
138
-12-13Question 7: It is often suggested that, given the rate
of population growth and the rate of technical progress, the
U.S. economy may overheat because demand growth will exceed the
growth of capacity. Those offering this prediction suggest that
U.S. real economic growth cannot proceed at much more than 2-2.5
percent in the years ahead. Some also suggest that in the
absence of federal budget deficit reduction interest rates will
have to be relied upon to modulate demand.
o
Are the expansion of capacity and the pace of
modernization of our capital stock independent of
the way in which aggregate demand is restrained? Do
not increases in interest rates retard capital
formation and slow down the growth of future potential output and increases in future productivity?
o
What does the Federal Reserve analysis show the
impact of a one percentage point increase in
interest rates to be on plant and equipment
investment?
Answej::
It is my view that the mix of policies in the
economy does have significant implications for the rate of capital formation and thus for the level of potential output in the
economy.
It is for this reason that I have suggested that we
should be seeking to move the federal budget toward surplus,
thereby easing financial market pressures and freeing up savings
for investment.
One cannot quantify with precision the effects of
interest rates on investment; different econometric models,
employed at the Board and elsewhere, yield different results,
and the outcome would vary depending on the circumstances.
It
is fair to say that most analysts are of the view that the
short-run response of business capital spending to changes in
interest rates is rather small, but that, over a period of a few
years, the influence of the cost of capital on such investment
is substantial.
Residential investment, of course, has a more
notable short-run interest-sensitivity.
139
-14Question 8; At the February hearing you alluded to the
difficulties that the British had after the second world war
because of their external imbalance. Some say that the U.S.
debtor status gives foreign investors influence over the setting
of monetary policy.
o
Do foreign creditors influence monetary policy any
differently than domestic creditors do?
o
Is it the debtor status or just that capital is
increasingly mobile internationally that makes the
monetary management sensitive to international
considerations?
o
Does that fact that foreign investors, particularly
Japanese institutional investors, have chosen to
invest in long-term instruments complicate the problem of monetary management, as the December OECD
Economic Outlook suggests? The Federal Reserve's
instruments of monetary policy management primarily
affect short-term interest rates don't they? How
closely linked are short-term and long-term interest
rates?
Answer:
The key factor making monetary management
sensitive to international considerations is the high degree of
international financial market integration rather than the net
debtor status, per se, of the United States.
Capital is ex-
tremely mobile internationally, and there are large gross asset
and liability positions in foreign currencies by U.S. residents
as well as large positions in dollars by foreign residents.
Gross flows into and out of currencies other than "home currencies", by both U.S. and foreign residents, are a great
multiple of net flows, and desired net positions can be very
volatile.
Both U.S. and foreign residents will likely seek to
alter their net foreign exchange exposures in response to news
140
-15-
that occasions a revision in exchange rate expectations, and
these responses will affect actual exchange rates and, to some
extent, asset prices.
Whether U.S. or foreign residents, on the
Whole, react differently to such news is a moot point.
Long-term interest rates are influenced by a wide
variety of factors, of which the portfolio preferences of a
single group of investors is only one.
Other factors, such as
anticipation of short-term rates, inflation expectations, the
perceived risk of interest rate fluctuations, real returns to
capital, and the time preferences of savers probably dominate
the setting of long-term interest rates.
Monetary policy, which
affects most directly current short-term interest rates but also
expected short-term rates and expected inflation, is a key, but
not determining, influence on long-term rates.
Short-term and
long-term rates tend to move together over time, but, given the
importance of expectations among other factors not directly tied
to current short-term rate levels, the linkage can be fairly
loose.
141
-16Question 9; In recent months we have seen a continued
rise in U.S. imports despite the decline of the dollar and the
rise in price of imports. Recent data show that the most surprising strength in imports comes from capital goods imports.
It appears that the rise in U.S. investment associated with
improvements in the export sector is leading to an increased
demand for imports.
o
Why are capital goods increasingly imported rather
than purchased from U.S. producers?
o
Since these imports are being used to provide for
improvements in the U.S. productive base presumably
they will make the economy more competitive in the
future. Should we worry about the size of our
imports if they are largely used to expand domestic
production possibilities for the future?
o
What foreign countries are producing the capital
goods that we import?
Answer:
Imports as a share of expenditures by domestic
producers of durable equipment (in constant dollars and excluding motor vehicles) edged down during the first half of this
year after having moved up throughout 1986 and 1987.
Purchases
of capital goods from domestic producers are rising very
rapidly.
In the first half of 1988, half of the increase in
value and all of the increase in the volume of imported capital
goods (1987-Q4 to 1988-Q2) can be accounted for by rising
imports of aircraft, of computers, peripherals and parts, and of
semiconductors.
Imported capital goods do not now appear to be a
problem for the U.S. capital goods industry, which is now doing
very well (after a long lean period) because of expanding markets both at home and abroad.
So long as U.S. firms in general
continue to expand their productive base, from whatever source
142
possible, the problem of servicing the debt associated with the
imports of capital goods should not be a concern either.
About three-fourths of U.S. imports of capital goods
come from industrial countries.
Western European countries
supply about 30 percent of imported capital goods, with most of
the items supplied not those showing notable increases in the
first half of 1988; the one exception was imports of aircraft
where France substantially increased its shipments of Airbuses
to the United States.
Japan supplies about 33 percent of
capital goods imports (about half of which were computers,
peripherals and parts, semiconductors, and electric generating
machinery).
Canada supplies less than 10 percent of the value
of capital goods imports.
Among developing countries, most of
the imports come from Asia.
Korea, Hong Kong, Singapore, and
Taiwan together account for nearly 20 percent of U.S. capital
goods imports (half of which are computers and parts or semiconductors).
Other countries in Asia, especially Malaysia, the
Philippines, and Thailand, are particularly important in the
production of semiconductors.
143
-18Question 10: Some analysts have suggested that there
are public policy problems associated with running a social
security trust fund surplus and a general budget deficit.
o
What are the dangers of this situation for citizens
counting on future social security benefits?
o
What policy changes would you recommend to manage
the situation?
Answer:
I believe that, for the purposes of
macroeconomic analysis, it is appropriate to look at the federal
budget including the social security surplus/deficit.
This
provides a better picture of the government's overall contribution to the flow of savings in the economy.
There is no particular danger in running a social
security surplus and a "general budget" deficit, so long as the
two net out acceptably—which I believe to be on the surplus
side, in light of our deficient level of national saving.
How-
ever, it is important to recognize that the prospective trust
fund surpluses are needed to fund social security benefits in
future years, and when the trust fund balances are later run
down, the negative effects on the government's overall fiscal
position will magnify any deficits in the remainder of the
budget.
Consequently, I think it is crucial that we keep a
close watch on the trends in both components of the budget.
144
-19Question 11: In his testimony at the panel hearing on
July 12, David Hale referred to the fact that President
Roosevelt went off of gold in 1933 to reflate the economy. Many
commentators are busy citing similarities between 1929 and 1933.
o
Is it not true that one significant difference
between the two cases derives from the fact that the
depreciation of the dollar began in 1985, two years
before the crash, and the 1933 devaluation came 3.5
years after the crash of 1929?
o
Does that not account for a large part of the
difference in post crash performance of the real
economy in the two periods?
o
What other major structural differences exist in
today's economy that would lead one to believe that
the performance of the economy in the aftermath of
the 1987 crash will differ from the experience after
the 1929 stock market crash?
Answer;
There are a great many differences between the
economic world today and that back in 1929-33.
Certainly, the
decline in the value of the dollar that has occurred since 1985
is having some highly favorable effects at present, especially
in sectors such as manufacturing that had not enjoyed as great a
measure of prosperity earlier in the current economic expansion
and that are now contributing importantly to the improvement in
our trade balance.
In terms of the basic structure of the economy, one
would have to identify in particular the differences in the
financial system safeguards that exist today as compared with
those in the earlier period.
Federal deposit insurance provides
significant protection against the kind of loss of confidence
that might cause a negative development in one segment of the
145
-20-
financial markets to create problems on a broader front; likewise, the Federal Reserve is better prepared to deal with any
liquidity shocks today, and, indeed, I believe that there is
fairly general agreement that the steps the Federal Reserve took
last fall were an important element in sustaining the strong
uptrend in economic activity in the aftermath of the stock
market break.
146
-21Question 12: In his testimony on July 12th David Hale
presented testimony on data provided by the Bank for International Settlements regarding the currency denomination of
offshore bank deposits owned by nonbanks which shows that the
proportion of total deposits in the offshore financial system
denominated in dollars has fallen quite markedly in recent
years. Mr. Hale believes that this phenomena would help to
explain the lower than normal monetary growth in the United
States and the higher than normal monetary growth abroad in
recent years.
o
Do you agree with Mr. Kale's analysis?
o
How does this show up in the U.S. monetary
aggregates?
o
Mr. Hale also suggested that retail customers in the
United States cannot be offered deposit accounts
denominated in foreign currencies. Is this true?
o
Has the Federal Reserve Board ever considered
allowing domestic banks to offer foreign currency
denominated accounts? Do U.S. banks lose business
to foreign banks because of their inability to offer
these accounts? What are the pros and cons of permitting U.S. banks to offer such accounts?
Answer;
Mr. Kale's interpretation of the data appears
to be flawed on several counts.
First, the marked decline in
the share of dollar-denominated offshore bank deposits primarily
reflects valuation effects, rather than a true shift in currency
composition.
The sharp depreciation of the dollar on balance
between the end of 1984 and late 1987 automatically would have
raised the dollar value of foreign currency deposits, even if
nonbank holders had kept the composition of their portfolios
otherwise unchanged.
After adjusting for exchange rate changes,
it appears that only about one-quarter of the recorded decline
in the dollar-denominated share of offshore deposits probably
reflected any shifting of funds.
147
-22-
While the dollar-denominated share (however measured)
declined, the level of dollar cross-border deposits continued to
rise during this period.
It increased at nearly a 7 percent
annual rate, about the same pace as overall M3.
Moreover,
another data series produced by the BIS, but not cited by
Mr. Hale, shows that dollar-denominated deposits held by
non-U.S. residents in banks in their own countries grew at
almost an 18 percent annual rate over the three years in
question.
The BIS data on cross-border holdings of deposits
include those owned both by U.S. and by foreign residents, and
thus represent a broader concept than that in our monetary
aggregates.
Narrowing it down to just those components included
in M3, cross-border bank liabilities composed perhaps 5 percent
of the broad money measure at the end of last year.
Clearly, it
would have taken an enormous shift in this small portion to have
an appreciable effect on growth of the overall monetary aggregate.
To be sure, there are other avenues through which the
aggregates could have been affected.
For example, U.S.
residents might have shifted out of domestically held deposits
into foreign-currency deposits held abroad.
But for those
wishing to adjust currency exposures, the use of options,
futures, and forward contracts is probably much less costly than
actually shifting the currency denomination and location of
148
-23-
deposits, many of which are held overseas for particular
purposes.
Finally, there is little need to resort to currency
substitution explanations for the pattern of growth in the
broader monetary aggregates over the past several years either
in the United States or elsewhere; domestic policies and macroeconomic developments can largely account for it.
It is true that the Federal Reserve has said that U.S.
offices of depository institutions should not issue deposits
denominated in foreign currencies (except at IBFs).
This policy
was first articulated in 1973 in a letter from Chairman Burns to
the Bank of America, because it was felt that providing "greater
scope for movements out of dollars into foreign currency assets
could at times pose an increased threat to the international
stability of the dollar."
It was felt also that it would be
inconsistent with the programs of restraint on capital outflows
that were in force at that time.
The policy has been reiterated
subsequently.
Financial markets have become increasingly integrated
internationally Over the years.
It has become relatively easy
for U.S. residents to acquire any foreign currency exposure they
desire.
This means that issuance of foreign currency deposits
in the United States would be likely to have a smaller and less
destabilizing impact on the dollar's value than it would have
149
-24-
earlier, but the added benefits to the U.S. Investor would be
smaller, as well.
The competitive position of U.S. banks is not
significantly affected by this policy.
Neither foreign nor U.S,
banks can issue foreign currency deposits in the United States.
150
-25Question 13; In response to a question from Senator
Heinz, you stated that, "the spread between real interest rates
will determine the spread between currencies or the exchange
rate, not whether it's going up or down."
o
Is this position borne out empirically? Is the
level of the dollar related to the real interest
rate differential? What about the so-called interest parity conditions which relate the expected
rate of change of the exchange rate to the interest
rate differential between the two currencies? Has
this relationship been reliable empirically?
o
Are changes in the real interest rate differential
correlated with changes in the exchange rate?
Answer:
There is a fairly good, broad correlation
between the level of the long-term real interest rate differential and the level of the real spot exchange value of the
dollar over the floating rate period—see attached chart.
(The
relationship between contemporaneous changes in this differential and changes in the exchange rate is not so close.)
How-
ever, both the interest differential and the exchange rate are
determined simultaneously in a general equilibrium system, and
both variables would typically react to any exogenous shock,
such as a change in monetary policy or a change in market
expectations about the long-run equilibrium exchange value of
the dollar.
An unanticipated tightening of monetary policy, for
example, would normally tend to cause both the interest differential and the exchange rate to rise.
An upward revision of
the long-run expected equilibrium exchange rate would tend to
raise the current spot value of the dollar but leave the
interest differential unchanged or even lower it.
151
-26-
The uncovered interest parity hypothesis links the
interest differential, which by arbitrage is equal to the forward exchange premium or discount, to the expected change in the
future spot exchange rate.
The forward premium has not, in
general, been a good predictor of exchange rate movements—most
of the movement in exchange rates appears to be unanticipated.
Nor has the forward rate been an unbiased predictor over extended periods of time.
The latter observations suggest that
the hypothesis of uncovered interest parity does not strictly
hold.
Attachment
152
Exchange Value of the Dollar and interest Rate Differential
fuaio MM!*, uwoh 1873 .100
Prto*-ao>»t»d
•xchvtgt vakw
ofttodoUv
teo
1*0
140
130
120
110
100
Long-term TM!
intarvst rats (fifterantial
(U.S. minus foreign)
I
I
I _]
I
I
I
I I I
IBM
NOTE; Th« «ieliing« v*lu« of ttn UA dOllv <• Hi wMgntld •v*r»g« tictiviB* vilut •gUnM ttM CunnclM <X oVwr
O-IO eeufltrtM ui'ng tB7»7t MUJ mM vAtgfH* **/uil*J frf 4U»*« con*um«r pifcM-
Tti» ai«»r»nti«t I* llw mi on Ion0-Wm U.I, go*«mm»nt bond* mlnui IM r«t« on eompvul* foreign
betn U|u%iM tor upociM intluien by A Ifrmofltn c«nWMrnoMngrrwagt of •dual CW inliuton or
«Mr* n lOQi a.
153
-27Question 14: In your testimony you state that "we have
over the years endeavored to use the tax system in order to
enhance savings to basically enhance the proportion of equity to
debt in the system..."
o
What particular tax incentives have been offered to
encourage equity issuance relative to debt issuance?
o
What further tax incentives do you believe should be
created to promote equity issuance?
Answer.-
There have been a few changes in the tax code
in recent years that, if not encouraging equity issuance, at
least have reduced the incentives for debt finance.
Perhaps the
most obvious is the phasing out of consumer interest deductions.
In many respects, however, the laws still provide substantial
incentive to leverage, and the continuing massive increases in
household and corporate indebtedness suggest that we should be
looking for ways to bring greater balance to the financial
decisionmaking process.
I do not have a specific legislative
agenda, and I recognize that any steps to address this problem
must be taken in the broader context of the effort to achieve
equity and efficiency in the tax code.
154
-28Question 15: In your testimony you suggested that the
spread between the discount rate was within a range that has
been covered by past historical experience.
o
For each year in the period from 1975 to the present
would you please provide the Committee with the
annual mean spread between the federal funds rate
and the discount rate and the maximum spread between
the monthly average federal funds rate and the
monthly average discount rate within each year.
Answer:
•Sear
Mean Spread
1975
-.43
-.90
1976
-.45
-.92
1977
.07
-.64
1978
.48
.70
1979
.91
1.99
1980
1.59
6.03
1981
2.96
6.08
1982
1.24
2.94
1983
.59
1.06
1984
1.43
2.64
1985
.41
.77
1986
.48
1.41
1987
.99
1.35
1988 (Jan. -Aug.) 1.11
1.75
Maximum (absolute) Spread
155
-29(juejtion 16; Several economists including Rudiger
Dornbusch, Lawrence Summers, and James Tobin have suggested that
this country should adopt a transfer tax on securities transactions .
o
Which of the other industrial countries currently
have such a tax? How large is the tax in each of
these countries? How are the securities markets in
each country affected? What happened to securities
markets in each of these countries at the time that
the tax was imposed? Have any countries discontinued the tax after trying it for a time?
o
Does the Federal Reserve favor adopting a securities
transfer tax in this country?
Answer;
You have raised a complex set of questions for
which I do not have the answers at present.
It may be that
other bodies that deal regularly with the subject of taxation
would be able to provide the information that you are seeking
with regard to the experience with transfer taxes in other
countries.
The Federal Reserve does not have a position on the
policy issue.
It is clear that theoreticians in the finance
field have differing views on the merits of the transfer tax
proposal, some believing that it would diminish short-run
volatility, others believing that it would reduce liquidity and
possibly enhance volatility and reduce equity values.
156
-30Question 17: In your testimony you suggest that
currency holdings are $825 per man, woman and child living in
the United States.
o
Has the Federal Reserve undertaken a study to
ascertain the whereabouts of our currency? How much
currency do you estimate is held overseas as a percent of the total? Is currency concentrated in any
one of the Federal Reserve Districts to a greater
extent than in the others?
Answer;
No large-scale study is under way to determine
where U.S. currency is being held; however, new approaches to
obtaining better estimates of currency holdings are explored
from time to time.
A comprehensive study of currency hold-
ings—even for amounts held in the United States—would be
costly, and it is unlikely that hoarders of currency and those
engaged in illegal activities would give accurate responses.
Instead, judgments regarding the amounts of currency held
domestically must be formed on the basis of infrequent surveys
of consumer holdings of U.S. currency coupled with plausible
assumptions regarding the amount of currency lost or stolen,
business needs for currency, and the requirements of individuals
engaged in illegal transactions.
Unless these surveys and
assumptions substantially understate the amounts of currency
held by consumers, this approach suggests that in excess of half
the total volume of currency outside of depository institutions
may be held abroad.
Weekly data — from the Federal Reserve's H.4.1
statistical release—are available on the amount of Federal
Reserve notes issued by each Federal Reserve district and still
157
-31-
outstanding.
As might be expected, these data display con-
siderable variation by district: New York leads with about
one-third of the total volume of notes outstanding, while
Minneapolis accounts for only about two percent.
Some caution
is appropriate in using these data to make judgments about the
concentration of currency holdings, however, because currency
issued in one district may routinely be carried or shipped
across district lines or even across national boundaries.
158
-32Cjuestion 18: In your testimony you said that "high
employment is consistent with steadily rising nominal wages and
real wages growing in line with productivity gains."
o
Would you please provide the Committee with data on
the growth of real wages and the growth of productivity on an annual basis since 1975? Have real
wages exceeded, kept pace with, or lagged behind
productivity growth in recent years?
Answer;
The data you requested are exhibited in the
attached table.
The relation between increases in real compensation and
productivity is highly variable in the short run.
Apart from
basic statistical noise associated with the difficulty in
measuring these quantities, there can be significant variation
in their relative movement because of cyclical and other
short-run economic factors.
Early in the current business
expansion, for example, real compensation gains fell short of
the percent increases in labor productivity because of a combination of labor market slack and the usual acceleration in
productivity that occurs in the initial recovery phase of an
upturn.
More recently, productivity growth has somewhat out-
stripped gains in real compensation partly because of the
effects of the depreciation of the dollar, which have shown
through in larger increases in the expenditure-price measure
conventionally used to deflate compensation than in the
output-price measure used to deflate production.
Attachment
159
CHANGES IN PRODUCTIVITY AND REAL HOURLY COMPENSATION
NONFARM BUSINESS SECTOR
(four-quarter percent change)
Year
1975
19T6
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
Productivity
3..4
1,.8
1,.5
1..1
-2,,7
1., 0
-,.6
1,,0
3..6
1,.5
1.,5
1..2
1,.9
Real Compensation
,9
3,,3
1.,0
,0
-2,.6
-1.,5
-1..2
2 ..7
.0
.1
.9
2 .9
-,.4
160
-33Questlon 19: Some analysts have suggested that the
United States should seek external financing through the
issuance of bonds denominated in foreign currencies — so-called
Reagan bonds.
o
The United States has issued foreign currency bonds
in the 1960s, so-called Roosa bonds, and again in
the 1970s, so-called Carter bonds. What was the
purpose of each of these bond issues? In retrospect
did each of these bond issuance initiatives prove to
be beneficial to the United States?
o
What are the advantages and disadvantages of issuing
debt denominated in a foreign currency? Do you
favor the U.S. government issuing foreign currency
denominated bonds in the present context?
Answer;
The Roosa bonds of the 1960s were sold to
foreign central banks.
Though denominated in foreign currency,
the U.S. Treasury received the proceeds in dollars.
The purpose
of the bonds was to redeem dollar holdings which certain foreign
central banks deemed "excessive" so as to forestall the conversion of these dollars into gold, which the United States freely
provided under the rules of the Bretton Woods system.
By
reducing the exchange risk of the foreign central banks' asset
portfolios, the notion was that these central banks would be
more willing to undertake exchange market intervention to
support the dollar.
By transferring the exchange risk from
foreign central banks to the United States the Roosa bonds were,
in essence, a substitute for U.S. exchange market intervention,
which was undertaken only minimally at that time.
Whether or
not the Roosa bonds were beneficial depends upon the counterfactual assumption.
Certainly they proved more expensive than
dollar bonds, since U.S. interest rates were lower than foreign
161
interest rates and some of the bonds were repaid only after the
dollar devaluations of 1971 and 1973.
But, to the extent that
they substituted for U.S. gold sales, the market value of gold
"saved" jumped to a great multiple of its value at the official
gold price.
The Carter bonds were issued in 1978-80 to private
market participants in Germany and Switzerland, with the
proceeds received in marks and Swiss francs.
Their purpose was
to bolster the U.S. stock of foreign currencies available to
support the dollar through U.S. exchange market intervention.
Some of the proceeds were so used, some were not required.
Those operations were, broadly speaking, profitable for the
United States as the dollar subsequently appreciated.
Generally speaking, the only purpose of issuing foreign
currency-denominated U.S. government bonds would be to finance
intervention purchases of dollars.
Unless the foreign currency
proceeds were so used, the issuance of such bonds would have no
effect on exchange markets or on the financing of the government
deficit.
But there are many alternative sources of financing
U.S. exchange market intervention—including existing balances
of foreign currencies, swap drawings, and sales of SDKs to
foreign monetary authorities.
To the extent that the proceeds
of such bond issues were not, in the event, needed for intervention, we would end up borrowing long-term and investing
short-term.
Unless short-term foreign interest rates rose
sufficiently during the holding period, we would lose money on
the spread.
162
-36Questlon 20: In recent years real interest rates have
been very high relative to historical averages. There have been
many explanations for this including the federal budget deficit,
financial deregulation, and fears of the prospect of another
bout with inflation after the experience of the late 1970s.
o
Would you please provide for the Committee data on
the decade average ex-post real interest rate of one
year maturity for each decade since the 1920s including an average for the period from 1980-1987?
o
Presumably in a world of high international capital
mobility the worldwide savings-investment balance
would determine the real interest rate. In the
1980s have the reductions in foreign government
dis-saving offset the dis-savings in the United
States associated with the rise in our federal
budget deficit as Olivier Bianchard and Lawrence
Summers suggested in a paper presented to the
Brookings Panel on Economic Activity in 1984? If
so, why have real interest rates risen in worldwide
in the 1980s? Does the key currency status of the
dollar compromise the usefulness of analyses that
utilize the global savings-investment balance
framework?
Answer:
Real
Interest Rates
Nominal
Interest Rates
1920s
3.5^
3 .5
1930s
.35
.33
- .02
1940s
-5.13
.47
5 .6
1950s
.11
2 .21
2 .1
1960s
1.74
4 .54
2 .8
1970s
-.80
7 .00
7.8
1980-87
4.42
9.02
4.6
Inflation
- .02
All figures are decade averages in percent per annum. Interest
rate quotes used are as follows: 3- to 6-month Treasury notes
and certificates in the 1920s: 3-month Treasury bills in the
1930s-1950s; and 1-year Treasury bill rates in the 1960s-1980s.
Inflation is the year-to-year change in the CPI.
163
-37Making a crude comparison of the experience of the
1970s with that so far in the 1980s shows that the general
government financial deficit in the OECD countries expanded from
an average of 1.4 percent of aggregate GNP in the 1970s to 3.3
percent in 1980-87.
Widening fiscal imbalances in both the
United States and the group of other nations contributed about
proportionately to the overall deterioration.
While these
figures cover a longer span of time than does the Blanchard and
Summers paper and have not been similarly adjusted for cyclical
and inflation influences, they nonetheless are suggestive of
increased government dissaving in the 17 member countries on
which the OECD provides data.
Certainly in the United States, the wider fiscal gap
during the 1980s has produced a macroeconomic policy mix conducive to higher real interest rates.
Ex-post real rates, while
down from earlier in the decade, remain high, perhaps in part
reflecting market participants' skepticism about the likelihood
of a significant further reduction in U.S. government dissaving.
Additional, substantial cuts in our federal deficit would undoubtedly prove constructive in paving the way for lower real
interest rates.
It should be noted that measurement of real interest
rates is problematical.
The relevant real rates for analysis
would be based on expected rates of inflation, not realized
164
-38-
movements in the price level.
In this regard, expected infla-
tion may have exceeded actual inflation through much of the
1980s, given the experience of the late 1970s, so that real
rates were somewhat lower on an gx-ante than on an gx-post
basis.
In any case, relatively high ex-post real rates did not
foreclose a sustained and vigorous economic expansion in recent
years.
Analyses that utilize the global savings-investment
balance framework can help to identify factors that are putting
upward (or downward) pressures on interest rates in general and
so can inform and guide policymakers in their efforts to support
balanced, noninflationary growth, particularly as part of the
policy coordination effort by the major industrial countries.
In this process, the dollar's status as a key currency has at
most a secondary role.
165
Chairman Greenspan subsequently submitted the following
in response to written questions from Senator Riegle in connection with the hearing held on July 13, 1988:
Question 1; There are reports that international
bankers are worried that the new capital rules announced by the
Bank for International Settlements earlier this week will further hinder their competitiveness against other financial institutions, particularly investment banks and insurers. What is
your reaction to this concern and how will the new capital rules
affect our largest money center banks?
Ansyer:
An important objective of the international
risk-based capital standard, which the Board has now adopted, is
to achieve greater convergence in the measurement and assessment
of bank capital adequacy by government supervisors in major
industrial countries.
Thus, the new standard will help to
promote competitive equality between U.S. banking organizations
and those in other countries.
As for the impact of the new
standard on the competitive position of banking organizations
vis-a-vis other financial institutions, it is generally the case
that such institutions maintain capital positions in line with
or exceeding tho&e specified by the risk-based standards.
Even
if that were not the case, however, it would not be advisable to
adjust the capital standards for banks down to the lowest common
denominator.
It should be stressed that it was the consensus
view of major industrial countries that are parties to the
international agreement that the standards are needed to help
strengthen the soundness and stability of the international
banking system.
166
-2-
Queatipn_2: OPEC'a surging oil production has resulted
in lower energy prices and of course energy prices are an important indicator of inflation. What is your projection for
energy prices throughout the remainder of this year and into the
early 1990s?
Answer;
OPEC has produced more crude oil during the
past three months than roost oil market analysts expected.
Consequently, oil prices have declined further below OPEC's
target of $18 per barrel for a select basket of crude oils.
Because of the large increase in non-OPEC oil
production during the past decade, OPEC has a large surplus of
crude oil production capacity.
Consequently, some members of
OPEC desire to produce more oil than is demanded by consumers at
current prices.
If this happens, oil prices would tend to rise
more slowly than the general price level during the next few
years.
On the other hand, other OPEC members prefer that oil
producers act cooperatively to restrict output in order to
maintain somewhat higher oil prices.
The resolution of these
differing views depends essentially on political considerations.
167
-3-
Question 3; We will have to make serious decisions
concerning the problems currently facing the S&L industry. Some
of the proposals for providing funding to clean up the mess
involve the Federal Reserve. For example, the Fed might pay
interest on bank reserves, but pay it, for the first few years,
to the FSL1C to enhance its resources. Alternatively, the
Federal Reserve might be required to accept the notes currently
being issued by the FSL1C as collateral for loans. What is your
reaction to these two proposals? What role do you see the Fed
playing in the S&L crisis?
Answer:
resources.
Clearly, the FSLIC will need additional
The amount of these additional funds will become
clearer as the FSLIC proceeds to address the problems facing it.
Congress had indicated that it intends to address this question
early in the new year.
As for whether the Federal Reserve should be called
upon to provide funding to resolve thrift industry problems, I
would point out that funding from the Federal Reserve would add
to the federal budget deficit essentially in the same way as a
budget expenditure.
Moreover, in considering such an autho-
rization one should take carefully into account that it would
mark a sharp departure from the view traditionally held in our
nation that the resources of the Federal Reserve (of the central
bank with its monetary policy responsibilities) should not be
used for special purposes and would set a dangerous precedent
for the future.
Aside from the question whether the Federal Reserve
should provide direct funding assistance to help resolve the
thrift crisis, it can play a constructive role in other ways.
168
In the event the Federal Home Loan Banks are unable to meet the
liquidity needs of troubled thrift institutions, the Federal
Reserve Banks, in their capacity as lenders of last resort,
stand ready to provide such institutions assistance at their
discount windows.
In addition, the Federal Reserve is prepared
to work with the FSLIC and the Congress in evaluating possible
ways in which additional resources might be marshalled to deal
with the problems in the thrift industry, in considering
arrangements that might be established to promote the long-run
health of the thrift industry, and in promoting harmony between
the supervisory framework to which thrift institutions and
commercial banks are subject.
169
Chairman Greenspan subsequently submitted the following
in response to written questions from Senator Sasser in connection with the hearing held on July 13, 1988:
Question 1: At the panel hearing on July 12, Dr. Ray
Fair suggested that one percentage point change in 3-month
Treasury bill interest rates, holding GNP growth constant, would
change the federal budget deficit by $5.6 billion in the first
year and $13.7 billion in the second year. The Congressional
Budget Office estimates that a one percentage point increase in
the interest rate beginning in January 1988, for all maturities,
would produce an increase in the deficit of $3 billion in fiscal
1988 CFY88), $11 billion in FY89, $16 billion in FY90, $21 billion in FY91, $26 billion in FY92, and $30 billion in FY93.
None of these estimates add in the effects of higher interest
rates depressing economic growth and thereby reducing revenues
and increasing automatic outlays. In addition, cost of living
adjustments in budget items may increase if they are based on
the consumer price index because a rise in interest costs pushes
up that index.
o
What does the Federal Reserve's analysis estimate
the dollar impact of a permanent one percentage
point increase in interest rates of all maturities
to be on each of the following over a six year
period:
A.
B.
C.
D.
E.
F.
Debt service on the national debt
Economic growth
Tax revenues
Federal government spending
The consumer price index
The federal budget deficit
Answer;
It is understandable that the OMB and CBO
prefer to give the "partial" estimates of interest rate effects,
because it really is not practical to do multi-year "general
equilibrium" simulations of the sort you are seeking without
specifying in very particular ways a great many assumptions
about policy and other variables that would significantly
influence the results.
Moreover, six years is a rather long
span of time, and the econometric models constructed by the
staff of the Board are not well designed to capture the
"supply-side" and other effects that could become important over
such an extended period.
170
-3Question 2: Japanese Bank Lending to Soviets. I have
had occasion to explore as a part of "my work on t^ie Defense
Appropriations Subcommittee the issue of burden sharing, particularly with regard to the Japanese.
In this Committee, we have the omnipresent concern
about the Third World debt crisis, and its impact on our major
financial institutions, and the issue of export policy. We need
to open markets overseas. It seems to me that the issues are
increasingly related and alarmingly so.
We have the Latin American countries scraping the
bottom of the barrel to find the foreign exchange to service
their debt. The last thing they can afford to do is to buy our
exports, so our industries and workers here suffer to some
extent.
We had hoped that the Japanese would step in and
increase assistance to the Latin American countries to get their
economies moving again. Obviously, we would like to see an
increase in lending that would relieve the pressure on our banks
and open up some opportunities for our exporters.
Well, the Japanese have increased their assistance in
Latin America to some degree. But what we see are loans tied
directly to purchases of Japanese exports. Obviously this is no
help to us.
Most alarmingly, at the same time, the Japanese banks
have dramatically increased their lending to the Soviet Bloc and
these loans are untied. They're a line of credit to be spent on
whatever the Soviets want. It sounds to me like a mockery of
the concept of burden sharing,
I have to admit that I am surprised at how little
information is available about Japanese bank lending to the
Soviets. But I strongly feel that it's an issue that this
Committee and the Fed should examine closely soon. Do you have
any information on this lending?
Answer;
Data reported by the Bank for International
Settlements (BIS) on total international bank lending to the
Soviet Bloc show a $14 billion decline in gross claims for the
1980-1984 period, followed by a $37 billion increase over the
subsequent three years.
This pattern of bank lending to the
171
Soviet Bloc reflects in part the effect of the decline in the
dollar on the dollar value of loans denominated in other currencies, which constitute a significant part of bank lending to
the Soviet Bloc.
After adjusting for exchange rate changes,
there appears to have been only a modest increase in bank lending to the Soviet Bloc in the late 1980s and, conversely, no
abrupt decline in such lending in the early 1980s.
Furthermore, data for U.S. banks indicate that their
involvement in lending to the Soviet Bloc has fallen throughout
the 1980s both in terms of dollar amounts and as a proportion of
total reported bank lending.
Unfortunately, country-by-country
creditor data for most other BIS reporting countries' banks,
including those of Japan, are not available.
Overall, the
Soviet Union's continued ability to borrow from banks appears to
be accounted for by its pursuit of conservative external financial policies.
Generally speaking. Soviet Bloc borrowing from banks
has apparently been largely untied, although anecdotal reports
suggest that recently the proportion of tied bank credits appears to have increased.
We do not have data on Japanese bank
loans to the Soviet Bloc that would enable us to say how much is
untied or whether Japanese loans have been more or less tied
than those of banks from other creditor countries.
On the other
hand, we do know there has been a strong increase in Japanese
172
official lending to Latin America.
This lending, usually con-
ducted in support of concerted lending by the international
financial institutions and the commercial banks, has been
untied.
We cannot make a comparison of Japanese bank lending
terms to Soviet Bloc and Latin American borrowers.
173
-6-
Question 3. S&L Crisis. As you probably know, the
Federal Home Loan Bank Board is now reporting that the cost of
resolving all of the problems of the insolvent thrifts is $10
billion more than they told us just last month. That puts their
estimate up to around $30 or $40 billion. However, some experts
are saying the cost could be around $65 billion. And I think
the best estimates of income to the FSLIC over the next few
years it; around $20 billion. So we will have a shortfall.
We now have talk of a taxpayer bailout and a merger of
the FD1C and FSLIC funds. Neither of these are solutions--nor
are they acceptable. Indeed, they are in effect the same thing.
Outlays by the FDIC are counted as expenditures in the budget
process, so merging the funds would only worsen the deficit, and
increase pressure for revenues from taxpayers.
What are your recommendations as to how we should
proceed? How do we pay for this mess? What's a realistic
expectation for a contribution from the thrift industry towards
reconciling the problem of the insolvent savings and loans?
With the special assessment that they're paying now, are they
already paying too much?
Answer:
It is important to emphasize the great
uncertainty that surrounds estimates of the potential losses
facing the FSLIC.
The extent of such losses will depend in
large part upon the market value of the real estate properties
that secure the mortgage loans of troubled institutions.
And,
given the huge amount of property involved, relatively small
changes in market value can have a major impact on the magnitude
of thrift industry losses.
Taking that point into account and
that real estate markets are highly unsettled in areas where
troubled institutions have made the bulk of their loans, it
should be obvious that judgments as to potential losses must be
subject to considerable error.
174
But, while there is reason to be cautious in viewing
estimates of potential loss, it is clear that the FSLIC is facing large problems which are going to be with us for some time
to come.
The Congress has indicated that it will be addressing
the important questions that you have raised concerning the
extent to which healthy thrift institutions should be required
to bear the brunt of the industry's losses early in the new
session.
The Federal Reserve will, of course, be happy to
provide whatever expertise it can when the Congress takes up
this issue.
175
Question 4; LBO Debt_as a Future Problem for Ijanks.
As you well know, b anks ^have ~dramatically in c r e a s e cT ^h eIr" 1 ending for so-called leveraged buyouts over the past few years.
Exchanging debt for equity has become the rage. Some $400
billion in new debt has been added in the last two years.
This has helped push debt-to-equity ratios of
corporations to unprecedented levels, raising a good deal of
concern that this level of debt could cause big problems for
companies when the next recession hits.
Obviously if companies are going to have problems
servicing this debt, the banks that hold it are going to be in
trouble too. Indeed, the magazine, The ^cgnomist, has called
LBO debt the next Third World debt crTsis~for banks.
What do you think about this trend? Should the Fed be
monitoring this more closely? What steps would you recommend?
Answer •. The Federal Reserve has been monitoring the
LBO and corporate leveraging trends for some time now, and both
I and my predecessor as Chairman have noted our concerns about
the risks that these developments might carry for lenders and
the economy more broadly.
The Federal Reserve, in its super-
visory capacity, has looked closely at the lending activities of
individual banking institutions and has cautioned banks more
generally that they should make certain that they examine the
prospects for LBO loans under a range of economic and financial
circumstances.
The issue of increasing leverage is one that should be
viewed from a broader perspective than its possible implications
for credit quality in the banking sector.
We do not yet fully
understand why there has been such a large increase in the use
of debt finance in the current decade, but I think it is widely
recognized that the cax system provides some incentives toward
leverage, and it would be appropriate tor the Congress to continue looking at that problem.
176
FINANCIAL TIMES
BFWCKEN HOUSE, CANNON STREET LONDON EC4 P4BY
fete^ams; Finantimo, London PS4. T&PSK: 8954871
Saturday July 2 1988
Risks in the
dollar'
,
THE MOTTO of tbc R*ann
adniUiiMMiion in lit Utt hill
year teems la be oprei naa k
dllugt. There has been little
doubt that the aftermath of pnddent Reagan would prove dtfflcult, but what Is happening it
the moment will make It KtD
man difficult than eipecud. Mr
JUH Biker, Ihe US TnuorT
Secretary, seeaa to have decided
ttuu there Is enough adjustment
of the US external account in tbt
pipeline to get the US through to
the election. The priority hu
tinted 10 the sapprettitg at
inflation.
' The result it the export of
Inflation to the rest of the world.,
Both Mi week and last. Onmany has demonstrated ml*
luce. Th* ipoilijiit Don turn* to
Japan. What price in term! of
domestic inflation ii the Japanese government prepared to pay
to help secunthe elect™ fcrltV
George Bush?
.,,, "t^"\
• The origin of the current ink
lem ii, paradojkally. Mont IK
stabilising the dollar. Being tan
worried about the extiunfMBtt
In UK medium term, the mnbaa
ttartad to look at Interait nUt
WKh the economy ibuwing nidi
greater robustness than geaealtf
expected at the beginning of -tt»
year, the dominant concern of
the US authorities had become
inflation. As a result.- .there wet
an upward drift -in ihort item
dollar intcmt ralea. MunwUle.
abort term rate* of interest
.' . A .
Changed rditlvelr utue in <0*f>
many or Japan, al lean bttn
the middteof June.™.* **•--With a larger interest rate dtfEmntlal in favour of the US md
tbe perception of UtOe downatoe
rtik in the Bhort term, money hat
ponred into the dollar. A raodwt
amount of central bank interwndon, almost entirely in Enropt,
haalalled to reverse the" ttdc, • <
USoolloofc
.
The dollar is now some 10 per
cent above its trough against the
yen pnd no less than 15 per cent
above Its low against the D-Mirk,
which is now where tt was baton
October 19 1887. The dollar')
nominal effective exchange rate
Industrial countries has appmti.'
aled Qve per cent in under three
months and now stands only 4
per cent below the pre-crash
level .
For the US authorities thii
loots quite delightful. It It
unlikely that the change in tbe
eichangt rate Hill have an
adverse effect on the balance of
payments position over the
remainder of this year. In fact,
the higher exchange rate is more
likely to improve than worsen
nomlnil drttetlt in the Mart
term. Meanwhile, the combination of a fairly tight monetary
policy and an appreciating
•n&infe rate will pul dDnmnt
in mi in on inflitton, otherwtot i
coosUermblt riii In the booytnt
,:.".' tV,
.
US iconomy. "~
pnr In* rwt of the work thlofi
loot decfderflT leu ittnctirt.
dna commodity prices wfl) rlK
in domestic currencies, Wllh
extrtrnely riptd growth In Jnui
and even Germany perforating
rathir better than anttclniUd.
tor of mQtfkn is mtvitj&a. a
tftr eiacerbated by the low*
monetary conditions In both
countries. : . .
Appreciation.'
t In MM *ub Ki traditional noon> the Bnndeibiu* tot «Md
Dnt, though In so doing tt la
realtoluit following the market.
Th» UK ham been only too gM ta
l«d the upward charge. Tin t^
tout have,
bowever, nunigiil •>
avoid an n upward movement in
tbort term Entereat rates, it Im)
y» te.m -;-r««; •
! IWh the US unwilling to kMr
tta^nn inlawt rates, and athcc
tountrist . unwUllE! .- to rada*
ih-ln very much, a muted
•ppnclitian of toe. dollar bfl
Atan-vlrtuilly inevluWe. "l*t
dttnfe In the dollar and in kNir
•ct.^ates during June remain
•oqtwhit Inflationary [or th*
net of the world and MmewiM
dldnHationary for the us, k«t
,&e «al iJuaw it an hvrfmt m
iheTIS titernal deficit In tht
?^r,S^tf vf--:- •
-. To* woriJi taden an Hkib
10 wit. aptn am art* a mo
imln laailaflM thin niiiirnd t
Bt«Ui 4gD. -The hudaciM to
aknudy much frealer *)i*n generally mliied. The US tnde baV
inc» has been improving. It it
trot,- but tbe aame bai not ban
trua «f the currant acenont.
largely became of increaHd OBW
service. In the first quarter of
MM Otf OS eamm occoma •»
in deficit to tbe tune of Itfto. up
from J34bn In tbe lut quarur of
19W, despite * tsbn unpra**ment
in the balance on merchandlBe
The US authorities carry much
of (be'blaate for the taenttal
rlfk in the medium term. Inciuie
of their unwillingness ffl carry
out ictive intervention against
tbc doDu. Tbe danger hu, bowever, been Inherent In the present Informal Approach to
eicbinge rate management, ff
there were clear rules for depredation ot eichange ntes in line
with tbe Interest rate difftrenttalt that governments want for
domestic reasons, these cmmttr-.
productive lurchet in exchange
rates could be avoided. Unfortunately, governments desire the
greatest possible discretion. If
they are unwilling to propnaa and
implement a system with batter;
articulated and more ieniibl*
rul« for intervention, perhaps
tbey deserve tbe deluge.
@FedFRASER