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F o r R e l e a s e on D e l i v e r y
March 8, 1989
1 2 : 0 0 Noon
C.E.T.
6 : 0 0 A.M.
E.S.T.

THE

UNITED

STATES

ECONOMY

AND F I N A N C I A L

SERVICES

INDUSTRY

By

H.

Member,

Board

of

Robert

Governors

of

Heller

the

Federal

S t a d t s p a r k a s s e Kttln
C o l o g n e , Germany
March 8, 1989

Reserve

System

THE UNITED STATES ECONOMY
AND FINANCIAL SERVICES INDUSTRY

Thank you for inviting me to talk about the United
States economy and financial services industry.

In an

increasingly interdependent world, an exchange of views
among policy makers and finance executives of different
countries can play a significant role in reducing
uncertainty and promoting global economic stability.
So I welcome this opportunity to share my views.

ECONOMIC SITUATION

As you know, the United States is enjoying one of the
longest economic expansions in its history.

Since

1983, real growth has averaged 4.2 percent, while the
unemployment rate has steadily come down to 5.4 percent
from nearly 10 percent early in the decade.

The

progress in reducing unemployment is even more
remarkable when considered in the context of an
expanding labor force.

Since 1983, the economy has

created 17 million new jobs.

1

In its early phases, the present recovery was fueled by
strong consumer demand, boosted by rising disposable
income and falling interest rates.

As consumption

spending outpaced gains in real disposable income, it
was financed in part by increased borrowing and lower
personal savings.

However, in 1987, consumption slowed

substantially, falling in line with advances in
disposable income.

Despite some acceleration in

consumption in 1988, it has not exceeded income gains.

This shift away from consumption is encouraging for a
number of reasons.

First, it is clear that as the U.S.

economy approaches full resource utilization levels,
domestic demand has to be contained if inflationary
pressures are to be prevented.

Since consumption is

the largest component of domestic demand, a slowdown in
consumption is essential.

Second, in many sectors of

the economy capacity constraints are becoming apparent
and can be alleviated only through new investment.
This requires that growth in consumption be held in
check so that resources are made available for
investment. And third, a moderation in consumer demand
should facilitate the necessary adjustment in our
external accounts through reduced import growth.

2

While consumption is moderating, investment in
producers 1 durable equipment has been strong during the
last couple of years.

Good corporate profits,

along with high capacity utilization, have provided the
primary impetus for more investment activity.

We

expect this strength in investment activity to be
maintained in the near future, as both business
confidence and capital appropriations remain buoyant.

Due to this resurgence in investment and a significant
improvement in net exports, the U.S. economy remained
strong in 1988, producing 2.7 percent growth in real
output.

Moreover, this growth occurred against the

backdrop of a serious erosion in financial wealth
stemming from the October 1987 stock market drop, a
reduction in agricultural output owing to severe
drought conditions, a stagnant construction sector,
considerable difficulties in the savings industry,
lower government purchases, and monetary restraint
through most of 1988.

This shows clearly the

impressive strength and resiliency of the American
economy.

Sustainable Growth Through Increased Potential

In view of the higher level of economic resource
utilization, the monetary policy in the U.S. has turned
3

increasingly cautious.

Excesses in aggregate demand

that do not augment the economy's productive potential
can, at the current levels of resource utilization,
lead to pressures on wages and prices which would be
costly to reverse.

Consequently, we are determined to

prevent such excesses from emerging in the first place.

But this does not mean that economic growth must be
completely stifled.

At present, the conditions that

have traditionally precipitated a recession are not
visible.

Labor market conditions, though tighter, have

not triggered a wage-price spiral.

Capacity utilization, while high, is below its previous
peak.

But further noninflationary growth requires an

expansion of capacity.

Capacity can expand only

through an increase of labor and capital resources or
their more efficient use.

The availability of labor

resources in any economy is constrained by demographic
and social factors.

On the other hand, the

productivity of labor and capital depends on the
efficient use of these resources.

Hence, the key to

high growth with price stability is high investment by
the private sector and supportive government policies.

Let me mention three policies of the American
government that have been most helpful in fostering
4

a healthy investment climate.

One, low marginal tax

rates which preserve economic incentives and rewards
for enterprising people.

Since 1980, federal marginal

tax rates have been reduced from 80 percent to 28
percent.

Two, deregulation has created a business

environment where entrepreneurs are free to innovate.
The government focuses on establishing rules of conduct
that foster equality of opportunity for all competitors
rather than on rules that restrict competition.
And three, a monetary policy geared toward attaining
overall price stability, so that businessmen and
consumers do not have to contend with the uncertainties
attendant to an inflationary environment.

We still

envy your record in this regard but we have made
substantial progress in containing inflation in this
decade.

The policy posture in the United States in recent years
has mirrored these principles.

I am therefore

optimistic about the prospects for the continuation of
the current expansion.

In addition, I am encouraged by

the recent shifts in the composition of growth, a
significant proportion of which is now attributable to
investment activity and strong export performance.
Increased investment, especially for plant and
equipment, will augment much needed capacity and also
enhance productivity.
5

The Budget Deficit

Any discussion of the U.S. economic situation these
days is incomplete without mention of the fiscal
deficit.

The federal deficit peaked in 1986 (CY) at

$206 billion, accounting then for 5.5 percent of GNP.
Since then it has been on a downward trend, and in 1988
(CY) amounted to $138 billion, or about 3.5 percent of
GNP.

At the same time, the state and local governments

ran a surplus of about $50 billion, so that the
consolidated government deficit amounted to only 2.5
percent of GNP - about equal to the European average.
While this is an encouraging trend, the deficit is
still substantial in relation to domestic savings and
it uses up funds that are needed for private sector
investment.

Thus far, the U.S. economy has enjoyed the confidence
of foreign investors, preventing a serious private
sector "crowding out".

Foreign investors have flocked

to the U.S., not only in pursuit of higher returns, but
also because of the fundamental strength of the
American economy, the size of the market, and a
relatively unencumbered regulatory environment.
But this reservoir has its limits, even though we
believe that we are far from reaching them.
as more and more American assets are owned by
6

Moreover,

foreigners, returns to them will also accrue to
foreigners, constituting an ever increasing mortgage on
our future.

In recognition of the potentially adverse consequences
of the budget deficit, the Gramm-Rudman-Hollings
legislation was enacted which calls for a deficit of
$100 billion in fiscal 1990 and a balanced budget by
1993.

In accordance with this legislation, President

Bush has outlined a budget proposal to the Congress
calling for a $93 billion deficit in 1990.

Reflecting

domestic socio-economic concerns and the changing world
situation, budgetary priorities have been realigned.
The administration's proposal thus serves as a good
base case around which a bipartisan consensus can form.
Not only does the budget proposal conform to the
mandatory targets of the Gramm-Rudman-Hollings law, it
does so without burdening the economy with additional
taxes.

In the interest of continued health of our

economy, progress on the deficit front will be crucial
and it will be important to stick to a course which
progressively closes the fiscal gap.
action should not be expected.

However, instant

Not only is there a

detailed timetable and legislative process that has to
be followed, but any budget agreed upon would only
start to affect actual spending at the beginning of the
new fiscal year on October 1.
7

Thus, patience is in

order.

External Situation

A strong improvement in our external accounts began
last year, and despite some faltering in recent months,
the U.S. trade deficit narrowed by $33 billion in 1988.
So far, impressive gains in exports have led this
improvement, reflecting the considerably greater U.S.
competitiveness.

Our performance with respect to

relative unit labor costs and manufacturing
productivity has been positive, so there is good reason
to be optimistic that the trade deficit can be further
reduced at prevailing exchange rates.

On the import

side, the performance has been somewhat more erratic
and further moderation is needed.

In this regard, we

expect our slowing domestic demand to have beneficial
effects.

While the American trade imbalance with Germany and
Europe as a whole has been considerably reduced,
further adjustment in the global imbalances must entail
progress in the reduction of surpluses in Germany and
Japan.

Both nations continue to post ever increasing

surpluses, and, as a result, new imbalances are now
emerging in the world economy.

To quite an extent,

these deficits are concentrated in Europe, where they
8

are likely to create new tensions just as Europe is
ready to embark upon its historic integration effort.

Monetary Policy Geared Toward Price Stability

Since early 1988, Federal Reserve monetary policy has
leaned toward greater restraint in order to forestall
any pickup in inflation.

One reason for the moderate

degree of price pressures in the U.S. economy has been
the commitment of the Federal Reserve to the goal of
price stability and its determination to move quickly
to prevent any acceleration in inflation.

Thus, in

recent months, as inflationary flickers appeared, we
restricted reserve availability and raised the discount
rate.

Short-term interest have risen over 3 percentage

points since last spring, and growth in the monetary
aggregates has slowed to the lower half of our monetary
target ranges.

The goal of price stability is an appropriate guide for
monetary policy, for in the long-run, it is also the
path to sustainable and stable economic growth.

In a

market economy, price stability prevents the distortion
of price signals essential for an efficient allocation
of resources.

In addition, by reducing uncertainty, it

promotes productive investment and stability in
financial and foreign exchange markets.
9

That price stability is conducive to economic growth
and efficiency is also evidenced by our historical
experience.

During the 1950s and 1960s, the industrial

countries enjoyed moderate inflation accompanied by
strong economic growth.

In the 1970s, inflation

accelerated, partly because of the oil disturbances,
but also on account of undue monetary accommodation.
The result was anemic growth in the face of high
inflation. Evidence from this period also suggests that
in countries where policies concentrated on price
stability, supply disturbances were quickly adjusted to
and the adverse consequences on the price level and
economic growth were of a short duration.
the situation was the reverse.

Elsewhere,

Throughout the 1980s,

reasonable price stability has been a primary goal for
monetary policy in the U.S.

Once again, this has also

been a period of robust economic growth.

Looking to the future, our resolve to contain inflation
and to make progress toward achieving price stability
will guide the course of monetary policy during 1989.
This implies continued restraint on the
money and credit.

expansion in

Accordingly, the Federal Reserve has

lowered the target ranges for the growth of the
monetary aggregates for 1989.
these target ranges have

Compared to last year,

been lowered by a full

percentage point to 3 to 7 percent for M2, and by 0.5
10

percent to 3.5 to 7.5 percent for M3.

The Committee

also lowered the monitoring range for the domestic
nonfinancial sector debt by 0.5 percent to 6.5 to 10.5
percent.

These reductions are in line with our

commitment to lower monetary growth over time, so that
it will be consistent with our goal of price stability.
As a matter of fact, for the last two years monetary
growth in the United States has been lower than in
Germany, and for 1989 the monetary growth path in both
countries is centered around a 5 percent target.
I believe that this underscores our mutual commitment
to price stability.

While U.S. macroeconomic policies are aimed at reducing
the internal and external imbalances and sustaining
noninflationary economic growth, serious problems have
emerged in the financial sector that demand attention.
So let me turn now to a discussion of recent
developments in the U.S. financial services industry.

DEVELOPMENTS IN THE FINANCIAL SERVICES INDUSTRY

Savings and Loans Problem

The savings and loan crisis is a major problem
confronting us in the U.S.
problem are enormous.
11

The dimensions of this

If the estimates of $85 to $105

billion in potential losses prove to be correct, it
would mean a financial burden of about $400 for every
American.

The causes of the savings and loan problem are
numerous.

They include:

the inflationary excesses of

the 1970s, followed by high interest rates and the
recession of the early 1980s; an initially very
restrictive regulation of the industry and a lax
supervision of the subsequent deregulation; increased
competitive pressures from a more dynamic and
innovative non-thrift financial sector; poor management
which was ill equipped to cope with the new competitive
environment; and outright fraudulent practices in some
cases.

For institutions that funded 30-year fixed

interest loans with short-term deposits, and whose
assets were heavily concentrated in the cyclical
housing sector, the inflation-deflation cycle of the
late 1970s and early 1980s proved to be ominous.

Their

problems were compounded when managers reacted to these
circumstances by "doubling the bet" and moving into
ever more risky assets.

Comprehensive reforms to deal with the problem have
been outlined by the President in his recent initiative
which is fully supported by the federal regulatory
agencies.
12

The President's plan encompasses several elements.
First, it fundamentally changes the way the savings and
loan industry is regulated and insured.

The Federal

Home Loan Bank Board, the savings and loan regulatory
body, is put directly under the oversight of the
Secretary of the Treasury.

The savings and loan

insurance authority, the Federal Savings and Loan
Insurance Corporation, is to be administratively
attached to the Federal Deposit Insurance Corporation the insurer for bank deposits.

While the two insuring

agencies are being merged to maximize administrative
effectiveness, the insurance funds for commercial banks
and savings and loans will not be commingled.

Premiums

from each industry will be used to support that
industry only.

Furthermore, insured bank and savings

deposits continue to be backed by the full faith and
credit of the United States government.

Second, the plan will tighten the regulatory standards
for savings and loan institutions to those applicable
to commercial banks.

As a consequence, savings

institutions will be required to double their minimum
capital.

Third, the plan will increase insurance premiums to
strengthen the financial basis of federal deposit
13

insurance.

The insurance fund for the savings and

loans will be substantially recapitalized through
higher premiums, which will rise from 0.208 percent of
deposits to 0.23 percent.

Similarly, commercial bank

deposit insurance premiums will increase from 0.083
percent to 0.15 percent by 1991 in order to boost the
financial resources of the Federal Deposit Insurance
Corporation.

Fourth, the plan will broaden enforcement authorities,
increase penalties for fraud, and increase funding for
law enforcement personnel and prosecution proceedings.

Finally, the plan will create a new private corporation
to seek a financial solution to the problem of
currently insolvent savings and loans.

This

corporation will be funded with $50 billion in capital
to deal with the ailing institutions.

Banks on Sounder Footing

It should be emphasized that the President's plan seeks
to bring the savings and loan industry to the same
degree of safety and soundness as that of commercial
banks without compromising the financial strength of
the banking system.

14

Fortunately, U.S. banks are in much better shape than
the savings and loan industry.

Under pressure from the

regulators^ they have increased their capital asset
ratios from 5 percent in the early eighties to 8
percent at present.

We have also taken steps in

conjunction with our fellOw-regulatorS abroad to
establish a comprehensive risk-based capital standard
that will be applicable to all American banks.

When

fully implemented in 1992, the new risk-based standard
will assure a risk-adjusted capital cushion of 8
percent for both on- and off-balance sheet exposures.
In effect, these standards will apply to all
internationally active banks, thereby equalizing
competitive conditions as well as safety levels.

Let me now tiirn to the potential problems posed by
the increased leveraged buy-out activity.

In recent

years, corporate restructuring in the U.S. has
proceeded at a rapid pace, as observed in considerable
mergers, acquisitions, divestitures, and leverage
buy-out activity.

The motivations for such

restructuring are many, but they primarily reflect
profitable opportunities for investors in undervalued
firms.

A potentially troublesome aspect of this,

however, is the high degree of leverage associated with
such transactions.

We at the Federal Reserve have been

especially concerned about the implications of the
15

involvement of lending institutions in highly leveraged
corporations.

Such firms are sore exposed to interest

rate risk and are vulnerable to economic downturns.
These risks in turn carry over to their creditor banks.

In order to minimize the risk to the financial system,
we have recently issued new guidelines to our bank
examiners for the evaluation of bank participation in
highly leveraged financing.

In addition to the normal

examination standards, examiners are asked to carefully
scrutinize such loans with regard to their sensitivity
to adverse economic conditions, adequacy of returns in
relation to the risk involved, sufficiency of
management control and reporting systems, and the
H

in-houseN exposure limitation procedures.

More

careful surveillance of banks' exposure in this area
will enable us to ensure that banks exercise due
prudence with respect to leveraged buy-out lending
without restricting or controlling the lending itself.

To further strengthen our banking system in the future,
we need to move on several fronts:

we need to broaden

the range of services that banks can offer to their
customers and widen the geographic base of their
operations.

These steps are needed to allow the banks

to serve their customers better and to provide new
earning sources for them.
16

As part of that process, we

recently granted banks limited powers to underwrite and
deal in corporate debt securities.

Greater geographic diversification through interstate
banking would help to insulate U.S. banks against
regional and sectoral economic problems.

We are making

considerable progress on that score, with 45 states now
permitting some kind of interstate banking, and others
are likely to do so in coming years.

The removal of

interstate banking barriers will also allow American
banks to better serve their customers on an integrated
basis at home and abroad.

As you can see, we face numerous challenges both at the
national and industry levels.

Our policies are geared

toward solving the existing problems, and to prevent
new ones from emerging.

17