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For release on delivery
9:00 A.M_.X^.S.T.
February 8 f 1985

Statement by

Paul A. Volcker

Chairman, Board of Governors of the Federal Reserve System




before the

Senate Budget Committee

February 8, 1985

I am pleased to appear once again before this Committee
to discuss the economic situation, and in that context some
implications of the budgetary choices you must make for the
economy, for financial markets, and for our international
position.

I realize the task that confronts you in dealing with

the budgetary position is extremely difficult.

Those

difficulties are matched by their significance for the
well-being of our economy and, indeed, of the world economy
generally.
Earlier this week I testified before the Joint Economic
Committee.

That testimony reviewed our economic progress, the

obstacles and risks before us, and attempted to place questions
of monetary and fiscal policy in that setting.

I have submitted

copies of that statement to the Committee and will not repeat it
this morning.
Suffice it to say that: the past two years have demonstrated highly encouraging progress toward returning the economy
to a path of sustained growth and stability.




Most observers

-2-

concur that the immediate prospects remain favorable.

But at

the same time there are large imbalances in our economic performance and points of severe strain here and abroad.

There are

particular factors helping to account for many, of those strains,
and they must be dealt with directly.

But it is also true that

most of those specific difficulties are reflected in and
aggravated by our twin deficits - - i n our budget and in our
external trading accounts.

Those two deficits are themselves

related to each other.
Until those underlying problems are adequately
addressed, we will be putting at risk our hard-won gains and the
bright promise for the future.

It is difficult for me to see a

constructive solution to those problems without going to their
source.

The implication seems to me clear -- we need to deal

effectively with the reality of an enormous budget deficit at a
time of growing prosperity and with the clear threat that, left
untended, that deficit will rise over future years even in the
context of a growing economy.




-3-

As background for your deliberations, I would emphasize
the linkage of our budgetary posture to the external side of the
economy.

The simple fact is we can no longer view our economy

in isolation from the rest of the world.

As you know, the

imbalances in our economy are most obviously manifested in our
massive trade and current account deficits, which reached about
$110 billion and $100 billion, respectively, during 1984.

It is

not a coincidence that these external deficits have developed
alongside the internal budget deficit.
That budget deficit, together with the rising
investment needed to support growth and productivity must be
financed either internally or externally.

We do not have the

capacity now or prospectively, given the size of the federal
deficit, to save enough domestically to meet those needs.
have become perforce dependent on a growing net inflow of
foreign savings to supplement our own.




We

-4-

The two tables attached to my statement illustrate the
point.

Even as domestic savings have grown, about one-quarter

of our net needs for investment and for deficit financing have
had to be met from foreign sources.

So far, that capital has

been readily available, partly because more new funds have
poured in from abroad and partly because our banks are lending
less to other countries.

That flow has had the effect of

containing pressures on interest rates and on our capital
markets, even though interest rates, as you know, have remained
high historically and relative to the current rate of inflation.
But the implications of that capital inflow are not all
favorable, and the adverse implications are mounting.

The

mirror image of a capital inflow is the trade and current
account deficits, with adverse impacts on all those industries
that look to export markets or that compete with imports.

One

effect is sizable sectors of the American economy have not
participated at all fully in the recovery.




The drain on foreign

-5-

savings and the related depreciation of their currencies
vis-a-vis the dollar, seem to be inhibiting prospects for
internally generated growth abroad.

At the same time, our

capital markets and interest rates have become hostage to a
continuing flow of foreign capital.

Over time, the interest

cost of those foreign borrowings will compound upon themselves.
A basic objective of monetary policy is, of course, to
provide enough money to sustain growth in domestic demand in a
framework of moving toward greater price stability.

Sometimes

the suggestion is made that we can go further and somehow
resolve the imbalance between domestic savings and investment by
expanding the money supply.

But printing money is not a substi-

tute for the real savings necessary to finance high levels of
investment and budget deficits simultaneously.

Excessive money

creation would be counterproductive in two respects.

To the

extent it stirred new inflationary fears, after all the progress
that has been made, those fears would sustain the level of




-6-

interest rates and even drive them higher.

By unaermining the

growing confidence in prospects for stability, it could
discourage the capital inflow on xvhich, for the time being, we
are dependent.
The Federal Reserve, the Administration and the
Congress have no magic wands to restore equilibrium and to
assure growth in one easy stroke.

Efforts must be made in a

number of directions to sustain the bright promise of the
economy.
enough.

But the key irgredient in the policy mix seems clear
Steps now toward decisive, creditable reductions in our

budget deficit? -- large enough to have ^ n impact on
.
expectations and confidence in markets -- would provide the
necessary sense of reassurance while working to alleviate the
underlying imbalance between our capacity to save and the
demands on those resources.
I am sensitive to the difficult, practical and
political decisions that must be made.




But I also know the

-7-

longer the choices are delayed, the greater the risks and the
larger the task.

As we saw in the 1970's, confidence can be a

fragile thing. It needs to be nourished and defended.
It will take action, and strong action, to get the
deficit on a downward trend.
rest.

Then growth can help to do the

And your action on the budget will help enormously in

assuring that growth can be sustained in a framework of greater
price stability.




* * * * * * *

TABLE 1
DEMANDS ON NET SAVING AND SOURCES OF NET SAVING
(Percent of gross national product)

Total

Demands on net saving
Net private
Federal budget
deficit^
investment-*-

Sources of net saving
Domestic-^

Foreign^

1974

7.0

6.2

0.8

7.2

-0.2

1975

7.1

2.7

4.5

8.3

-1.2

1976

7.6

4.5

3.1

7.9

-0.3

1977

9.0

6.6

2.4

8.3

0.7

1978

9.1

7.7

1.4

8.4

0.7

1979

7.6

7.0

0.7

7.6

0.1

1980

6.4

4.0

2.3

6.6

-0.2

1981

7.2

5.0

2.2

7.4

-0.2

1982

6.7

1.8

4.8

6.5

0.2

1983

8.2

2.8

5.4

7.2

1.0

1984(p) 11.4

6.6

4.8

8.9

2.6

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
Accounts.




TABLE 2
DEMANDS ON NET SAVING AND SOURCES OF NET SAVING
(Billions of dollars)

Total

Demands on net saving
Net private
Federal budget
investment-*deficit2

Sources of net saving
Domestic-^

Foreign4

'1974

100.4

88.9

11.5

103.3

-2.9

1975

110.6

41.3

69.3

128.8

-18.3

1976

130.8

77.7

53.1

135.9

-5.1

1977

173.4

127.5

45.9

159.7

13.6

1978

196.1

166.7

29.5

181.8

14.3

1979

184.6

168.5

16.1

182.8

1.8

1980

167.7

106.4

61.2

174.0

-6.3

1981

212.6

148.3

64.3

218.4

-5.8

1982

204.6

56.5

148.2

198.1

6.6

1983

272.6

94.0

178.6

238.7

33.9

1984(p) 419.0

242.6

176.4

324.5

94.5

p = preliminary
See table 1 for footnotes.