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For release on delivery
10:30 AJM., E.S,T\
february 5r 1985

Statement by

Paul A. Volcker

Chairman, Board of Governors of the Federal Reserve System

before the

Joint Economic Committee

February 5, 1985

I am pleased to appear once again before this
Committee to discuss the economic situation.

As you knowf the

Federal Reserve will be submitting its semi-annual report on
monetary policy to the Congress in about two weeks.

My testimony

then will provide a full account of recent monetary developments
and will report on the decisions to be taken shortly by the
Federal Open Market Committee regarding money and credit
targets for 1985.

Therefore, in my prepared remarks this

morning, I will limit myself to a broader view of the
current economic setting, with some emphasis on the interrelationships between domestic and international developments.
Two years agof when the current business expansion
was just beginning, I expressed to this committee my belief
that, through a difficult period of economic and financial
adjustment, we had potentially been laying the groundwork
for sustained growth and prosperity.

I felt then, and I feel

now, that restoring and maintaining a greater sense of price
stability would be central to that effort.


Today, I think it is fair to say that bright promise
for the longer run remains.

Economic growth has in fact been

strong over the past two years, and inflation has remained
at or very close to the much lower levels reached at the start
of the recovery period*

As 1985 started, most observers have

shared the view that prospects for further growth remain good,
and expectations of stronger inflationary pressures as the
expansion period is extended, quite prevalent earlier, have
been at the least muted*
Nonetheless, clear risks and obstacles remain to making
good on our own potential both for stability and growth, and to
accomplishing that, as we must, in the context of a more prosperous

To a considerable degree, the "buts" and "ifs" are well


Yet, that intellectual understanding will be for naught

if the appropriate policy responses are lacking, whether because of
unwarranted complacency bred by current performance, because
of the inherent political difficulty of reaching the necessary
consensus, or because of some combination of the two.

The Evidence of Progress
The clearest evidence of progress toward our longrun aims lies in the combination of better than anticipated growth
and lower than anticipated inflation over the past two years.
To be sure, the current expansion began from a low level, and
unemployment has not yet been reduced to levels we have enjoyed
historically and want to regain.

But after widespread doubts

about our economic prospects, the recovery of 1983 has blossomed
into what has been one of the strongest expansions of the postwar
Real gross national product grew more than 5-1/2 percent
over the course of 1984, bringing the cumulative gain in domestic
output over the past two years to about 12 percent.

The rise in

production has been associated with an increase in employment of
more than 7 million since the end of 1982, and the unemployment
rate has fallen about 3-1/2 percentage points over that period, to
around 7-1/4 percent.

As part of that general improvement, there

has been a sharp rebound in profits and a surge in business

-4investment, factors that should bode well for our future growth

Spending for innovative, high-technology capital has

grown especially rapidly.

Productivity has grown more strongly,

although there are still important questions as to how much the
underlying trend has improved.
The recent monthly data on consumer and producer
prices continue to show only very small increases for a wide
range of goods.

For some important commodities, including

petroleum and a number of raw materials, price declines have
been more common than price increases.

Prices of most services

have continued to increase at a substantially more rapid rate


averaging 5 to 6 percent at the consumer level.

Most of our

economy today is, in fact, a "service" economy.

Those services

are generally subject less directly to competitive pressures
from overseas.

Moreover, labor intensive sectors of the

economy, such as many services, may have less opportunity for
productivity growth.

Nevertheless, the rate of price increase

for services has been significantly less than in the late
1970fs and

the first years of the 1980's.


Further improvement will be necessary in these areas
to maintain progess toward stability.

In a direct sense, that

depends in considerable part on whether the rate of nominal wage
increases continues to decline in service industries to levels
more characteristic of the rest of the economy.
With inflation down, workers generally have apparently
felt less need to press for large increases to make up for past
price increases or to stay ahead of expected inflation.
Businessmen and workers in manufacturing, mining, and construction
have also recognized that they often operate in a more competitive
and more international environment —

one in which there are

obvious perils in rising costs and prices and a premium on

The restraint on wages and costs generally need

not mean, however, reduced prospects for gains in real income.
To the contrary, the "payoff" in a growing economy, with rising
productivity and more stable prices, is more jobs and higher
real incomes for the average worker.


Success in containing inflation can help to breed further

It is indispensable to prospects for achieving and

maintaining a lower level of interest rates, which, despite
declines in recent months, have remained historically high.
Over time, expectations of greater price stability should become
increasingly woven into the fabric of household, business,
and financial decision-making.

Efficiency and productivity

should benefit as less energy is spent in the largely futile
search for ways to "beat" inflation.

Pressures for "precautionary"

wage and price increases have diminished.

As borrowing and lending

horizons are lengthened, the financial structure should be
strengthened, and less "inflation insurance" will be built into
long-term interest rates.
Obstacles and Risks
After all the disappointments of the past with failed
anti-inflationary efforts, that process inevitably takes time.
Meanwhile, we cannot simply assume that inflation has been
conquered, or that we have in fact reached a new era of sustained

«- 7 —


There are still too many obstacles to permit that kind

of satisfaction.
To put it bluntly, there are large and unsustainable
imbalances in our economy, and in the world economy.

In the

midst of the overall improvement that I cited earlier, those
imbalances are reflected, for instance, in the intensity of
the strains in agriculture and in a number of other basic

There have been exceptionally high levels of

unemployment in many other industrialized countries, and,
looking ahead, too few signs of really significant improvement
in that respect.

That outlook bears on our own markets.

Moreover, the financial position of the heavily indebted
developing countries remains vulnerable, and their difficulties
can feed back on our economic outlook and financial system.
And, as I noted earlier, interest rates remain high relative
both to historical experience and to recent rates of


These difficulties arise in part out of structural
problems unique to one sector or another, and to that extent
must be addressed at that level.

The painful pressures on some

businesses, farms and financial institutions also reflect the
strain of adjusting to a less inflationary environment; when their
financial decisions had, implicitly or explicitly, been based on
expectations of accelerating inflation.

But these strains

are being aggravated by financial pressures and dislocations
related to our budgetary problems.

Until that underlying

problem is dealt with appropriately, we will unnecessarily be
putting at risk all those bright prospects for stability and
growth of which I have spoken.
The distortions in the economy are manifest in our massive
trade and overall current account deficits, which reached levels of
almost $110 billion and $100 billion, respectively, during 1984.
It is not a coincidence that those external deficits are accompanied
by an enormous internal budget deficit —

a deficit that, according

to both Administration and Congressional Budget Office estimates,

-9will tend to grow further in the absence of corrective action
even assuming healthy economic growth.
Given the deep recession and high levels of unemployment
in 1982, the sluggishness of the world economy, and the strains
on developing countries, sizable deficits in our budget and trade
accounts could and did serve an important transitional function
in helping to encourage recovery here and abroad.


the domestic deficit helped sustain and increase domestic
purchasing power, and the more favorable tax treatment for
investment helped encourage capital spending.

The growth of

our markets has probably been the single greatest expansionary
force for other countries over the past two years, and our
economy absorbed the brunt of the necessary efforts of the
heavily indebted Latin American countries ,to restore external
financial and economic equilibrium.
At the same time, the strength of the dollar in the
exchange markets, together with the ready availability of
goods from abroad, have been potent factors in damping
inflationary forces and satisfying our consumption demands.

- 10 What then, it might be asked, is the difficulty?
Why not rest content?
The answer, most fundamentally, is that economic
analysis and common sense coincide in telling us that the
budgetary and trade deficits of the magnitude we are running
at a time of growing prosperity are simply unsustainable

They imply a dependence on growing foreign

borrowing by the United States that, left unchecked, would
sooner or later undermine the confidence in our economy
essential to a strong currency and prospects for lower interest

At the same time, the hard fact is that the budget

deficit, on top of the private investment needed to support
growth and productivity, outruns our internal savings potential,
The largest and richest economy in the world has perforce
been required for the time being to draw on savings generated
abroad; in that real sense we are living beyond our means.
As we continue to draw so heavily on the world's savings,
there is a drag on internally generated expansion elsewhere,

-11feeding back on our trading prospects.

Andf the resulting

imbalances and financial strains generate political pressures,
here and abroad, for counter-productive protectionism, for
economic nationalism, and for excessive money creation that
would, if implemented, undercut and jeopardize all the progress
we have made.
The External Dimension
While much of our rhetoric still skirts the issue,
the time has passed when we can intelligently assess our
performance and our policies without considering the external
dimension —

the implications for international trade and

capital flows, exchange rates, and economic and financial
conditions elsewhere.

Like it or not, world financial markets

and economies are integrated as never before.

Over time, I

believe, we derive enormous benefits from that fact.

But it

imposes disciplines of its own.
The complications in analysis and the potential for
good or ill were amply illustrated in 1984.

As you know, the

- 12 growth of economic activity slowed abruptly during the summer
and early fall.

Following the exceptionally rapid growth

over the first half of the year, some slowdown should not have
been surprising, given the fluctuations in consumption and
inventory imbalances common as an expansion period is extended.
By year end, there was evidence once again of more positive
trends in household spending and some inventory imbalances
appeared to be at least partially corrected.
But as domestic demands slowed, the more fundamental
imbalances remained and became more obvious.

Throughout this

recovery, domestic purchases of goods and services have increased
faster than domestic production.

In essence, a lot of demand

generated in this country has flowed abroad through our rising
trade deficit, providing stimulus for production overseas rather
than in this country.

The increase in imports didn't seem to

matter much so long as output and employment generally were
expanding so rapidly.

But, even then important sectors of

the economy, in a real sense, did not share at all fully in

- 13 the overall recovery, with trade pressures aggravating deep-seated
structural problems.

As soon as domestic demand dropped from

the extraordinarily rapid rate of the first half of the year,
the effects of the demand slowdown on production were amplified
by the rising trade deficit*
From 1982 to the second half of 1984, the current
account deteriorated by about $100 billion, pushing us into
an external deficit equivalent to 2-1/2 to 3 percent of the

Just as for a household or business, current spending

abroad can exceed current income only to the extent that we
can draw on foreign assets or debt is increased.

As a consequence,

the United States is in the process of moving from the world's
largest creditor to the world's largest debtor.
Thus far in the expansion, the net inflow of capital
needed to finance the current account deficit has been readily
forthcoming, so much so that the dollar exchange rate has
persistently strengthened even as the U.S. current account
has deteriorated.

No single factor appears to account for

- 14 that flow.

Relatively high interest rates in this country, our

success in reducing inflation, and perceptions of political
stability and economic vitality all have contributed.


political and economic uncertainties abroad appear to have
played a part as well.
The strong flow of funds from abroad has been a key
factor helping to ameliorate financial stresses in this country,
as expansion generated large new demands for private financing
on top of the continuing Federal deficit.

Two tables attached

to my statement illustrate the point.
As indicated there, net domestic savings -- personal,
business, and state and local government —
appreciably as the economy has expanded.

have increased

The ratio of

net savings to the GNP is near the top of its historical

But those domestic savings have not been nearly

enough to finance both rising private investment and the
Federal deficit.

Those requirements, relative to the gross

national product, have risen about 4-3/4 percentage points in


the past two years to about 11-1/2 percent of the GNP. far
above past relationships.

About half of that increase was

met by higher savings from abroad.
I don't believe we can escape the conclusion that,
without the ready availability of savings from the rest of
the world, pressures on our financial markets would have been
greater and domestic interest rates would have been still higher,
at some point undermining the outlook for domestic housing
and investment.
The kind of obvious "crowding out," so widely
anticipated a year or two ago, has been avoided.

But, in a

real sense, important sectors of our economy are paying the

Those dependent on foreign markets and those

competing with imports are being "crowded."

To put the point

in perspective, the $100 billion deterioration in our current
account -- a measure of "lost" markets for U.S. producers
is equivalent in size to about two-thirds of the entire
residential housing sector.


- 16 As I emphasized earlier, viewed in a world contextf
our ability and willingness to run a sizable trade and current
account deficit during a period of strong domestic recovery
had constructive implications for others.

Butf as we look

ahead, neither we nor other countries can expect growth to
be maintained indefinitely on a shaky foundation of large and
growing trade deficits, massive capital flows to the United
States, and accelerating international indebtedness.
The visible strains in some sectors of our economy
and interest rates that have remained historically high are
clear warning signals.

Perhaps less obvious but nonetheless

real, the drain of savings from other countries to the United
States and the related tendency for their currencies to
depreciate vis-a-vis the dollar, appear to be inhibiting
more forceful policies to encourage "home grown" expansion

A healthy world economy —

for the United States —

and better export markets

are ultimately dependent on that

The dilemma is that so long as demands on our own

-17capital markets exceed our capacity to save, the stability of
our own financial markets is, in effect, hostage to a large
continuing inflow of foreign capital.
That flow, in turn, is dependent on the maintenance
of confidence in our own prospects and in our own currency.
But so long as the imbalance in our trade persists and increases,
the greater the risk that that confidence will be eroded, disturbing
our financial markets and jeopardizing our growth.

It is that

apparent inconsistency that must be confronted.
The Role of Monetary Policy
While I will be testifying with respect to Federal
Reserve policy in some detail shortly, a few general observations
about monetary policy are appropriate in this context.


policy, in most general terms, is directed toward encouraging
the process of restoring price stability while providing
enough money to support sustainable growth in demand and

Reasonable progress in those directions was made in



Indeed, the strength of the dollar, despite the larger

current account deficit, helped to reconcile strong growth in
demand over the year as a whole with restraint on prices.
But, as I indicated a few moments ago, the rising trade deficit,
as more of the domestically generated demand spilled
over abroad, clearly raises questions of the sustainability
of a process dependent on large inflows of capital.
Monetary policy can stimulate growth in the money
supply, but it cannot create the real savings necesary to
finance high levels of investment and excessive budget deficits

That depends upon all the factors inducing

individuals and businesses to save for the future.

Efforts to,

in effect, paper over the difficulty by financing the huge budget
deficit by excessive money creation would surely be counterproductive.

We would undermine the growing confidence in

prospects for stability.

That confidence is a necessary

ingredient in any effort to see lower interest rates in the
years ahead.

It is also essential to maintain the flow of

capital from abroad upon which we are for the time being



In sum, I see no realistic escape from our dilemma
by reverting to inflationary monetary policies.

They could

only accelerate the disturbances we want to avoid,


without action on the budget and other frontsf the possibility
of a reduced flow of capital from abroad would, if it materialized,
constrict the flexibility of monetary policy.
The Protectionist "Solution"
The current trade imbalances and the strong
pressures on particular economic sectors certainly lead to
strong pressures for protection from affected industries.
But that approach toward "relief" is symptomatic, not

Indeed, yielding to those pressures could only

aggravate the difficulties, so long as the underlying financial
imbalances persist.
Suppose, for instance, strong protectionist measures
actually had a pronounced effect in closing our trade deficit.
Then, the capital inflow from abroad would also be reduced,
and interest rate and inflationary pressures increased.
Federal Reserve Bank of St. Louis


to one industry would be offset by greater financial

-20market pressures and damage to others.

Or f if the capital

inflows were maintained the dollar would presumably be driven
still higher, shifting the burden to exporters and unprotected
More realistically, protectionism here would be matched,
or more than matched, abroad, with devastating consequences for
world trade and growth.
A Constructive Approach
One lesson of our experience seems clear.


progress that has been made toward greater efficiency, cost
restraint and innovation needs to be continued and encouraged
by public policy in a variety of ways rather than discouraged
by a retreat into protectionism or new permanent Federal subsidies
that distort the economy and aggravate the deficit.
1 do not want to suggest all the burden of sustaining
a favorable economic climate and restoring external equilibrium
rests on the United States.

A number of industrialized

countries might reasonably review their own possibilities for

-21stimulus in the light of their high levels of unemployment
and rather sluggish growth, and they could constructively
work to remove the structural impediments to their growth.
There is too much protection of markets abroadf and the efforts
to deal with that need to be maintained.
There is no single "magic pill" to restore equilibrium
and assure growth.

But neither can there be real doubt that it

is within our capacity to take a large stepf here and now, to
ease the necessary adjustments in agriculture and industry at
home, to make us less dependent on foreign savings, to improve
trade prospects, and thus to reinforce prospects for growth
and stability.

That step would be to make decisive reductions

in our budget deficit.

Those reductions, to be credible,

should be large enough and assured enough to have an impact on
expectations and confidence, even if they cannot be fully
effective for some time.
That is, of course, by now a familiar plea —
it is no less urgent for its familiarity.


To the contrary,


the sharply increased size of our external deficit, the
tendency for the budget deficit to grow even as the economy
expands strongly, and the still high interest rates, should be
warning enough that we are on an ultimately unsustainable path.
Deficits that are relatively benign in the depths of
recession or in the early stages of recovery turn destructive
at a time of relative prosperity.
imbalances in our own economy.

They are reflected in

At the same time, our

dependence on foreign savings can only impede the prospects
for self-sustaining growth abroad —

and we cannot indefinitely

be virtually the only engine fpr world expansion.
Action now, and action large and forceful enough to
be seen to be decisive, is the constructive way to resolve
the impasse and to work toward international balance.

In the

process, it will help enormously to ensure those bright
prospects for growth and stability of which I spoke at the

(Percent of gross national product)


Demands on net saving
Federal budget
Net private

Sources of net saving






























































1984(p) 11.4





p = preliminary
1. Net private investment is the sum of business fixed investment, residential construction outlays, and the change in business inventories,
less depreciation, minus a statistical discrepancy*
2. NIA basis,
3. Domestic net saving includes personal saving, undistributed corporate
profits, and state and local government surplus.
4. Equals payments to foreigners for imports of goods and services, transfer payments, and interest paid by government to foreigners minus
receipts from foreigners for exports of goods and services.
Note: These figures exclude depreciation, which amounted to $403 billion
in 1984; including depreciation would raise both domestic investment and domestic saving.
Source: Calculations based on data from the National Income and Product

(Billions of dollars)


Demands on net saving
Net private
Federal budget

Sources of net saving






























































1984(p) 419.0





p = preliminary
See table 1 for footnotes*