Congressional Testimony

FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1987 HEARINGS BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAffiS UNITED STATES (SENATE ONE HUNDREDTH CONGRESS FIRST SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1987 FEBRUARY 18 AND 19, 1987 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1987 For sale by the Superintendent of Documents, Congressional Sales Office U.S, Government Printing Office, Washington, DC 20402 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS WILLIAM PROXM1RE, Wisconsin, Chairman ALAN CRANSTON, California JAKE GARN, Utah DONALD W. RIEGLE, JR., Michigan JOHN HEINZ, Pennsylvania PAUL S. SARBANES, Maryland WILLIAM L. ARMSTRONG, Colorado CHRISTOPHER J, DODD, Connecticut ALFONSE M. D'AMATO, New York ALAN J- DIXON, Illinois CHIC HECHT, Nevada JIM SASSER, Tennessee PHIL GRAMM. Texas TERRY SANFORD, North Carolina CHRISTOPHER S. BOND, Missouri RICHARD SHELBY, Alabama JOHN H. CHAFEE, Rhode Island ROBERT GRAHAM, Florida KENNETH A. MCLEAN, Staff Director M. DANNY WALL, Republican Staff Director ROBERT H. DUCGEK, Chief Economist (11) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS WEDNESDAY, FEBRUARY 18, 1987 Opening statement of Chairman Proxmire Opening statements of: Senator Dixon 2 Senator D'Amato 41 Senator Heinz 71 WITNESSES Stephen Axilrod, vice chairman, the Nikko Securities Co. International, Inc.... 3 Recent evolution of monetary policy 3 Recent economic data 4 Prepared statement 7 Budgetary1 deficits 7 Trade deficit and exchange rates 7 Momentum within the private economy 8 Economic policies and attitudes abroad 9 Conclusions for monetary policy 10 Lawrence Chimerine, chairman and chief economist, Chase Econometrics 11 Slow economic growth 11 World economy is fragile 13 Prepared statement 15 Summary 15 The recovery thus far 16 The current economic situation 16 Why has the economy been so sluggish? 17 The outlook for 1987 18 Monetary policy 20 Long-term outlook 21 Policy Implications 22 "Monetary Policy Analysts Foresee Recession in "88," article in the Mone- tary Policy Forum 23 Erich Heinemann, chief economist, Moseley Securities Corp 25 Growth in high-powered money 25 Velocity 27 Prepared statement 29 Chart 1: Federal Reserve actions—1960-86 32 Chart 2: The volitility of monetary expansion 32 Alan H. Meltzer, John M. Olin Professor of Political Economy and Public Policy, GSIA—Carnegie Mellon University 33 Devaluation of the currency 34 Spending for consumption 35 Prepared statement 37 Trade and debt 37 The problem 37 Options 38 Conclusion 39 Paul Craig Roberts, William E. Simon, Chair, Political Economy, Center for Strategic and International Studies, Georgetown University 42 Growth rate of nominal GNP 42 Acceleration of Ml 43 Prepared statement 45 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Page Tables: I: Comparison of original nominal GNP assumptions with actual developments 48 II: Impact on budget deficit of unexpected collapse in nominal GNP 48 III: Quarterly rates of growth 50 IV: Levels and percent of foreign holdings of gross Federal debt and Federal debt held by the public 50 V: Federal Reserve Monetization as percent of Federal deficit 51 Chart I: Money growth rates and growth rates for the value of the dollar over selected periods, 1977-86 51 Chart II: Ml velocity 51 Chart III: FRB monetization: percent of deficit 52 Chart IV: Growth of real GNP and money supply 52 "How the Defeat of Inflation Wrecked the U.S. Budget," from the Los Angeles Times 53 "Beneath the 'Twin Towers of Debt'," from the Wall Street Journal 54 Panel discussion: Projections on the M's 55 Effect of money growth on the stock markets 56 Stop lending to other countries 58 Consumer debt 59 Third World debt 62 Inflationary potential in monetary policy 63 Corporate debt 66 J-curve 68 Need to be patient 68 Rise on import prices 70 No. 1 debtor nation , 72 Testing the outer bounds of structure 74 Broad-based consumption tax 75 Periodic recessions 76 Lower living standards in the future 78 Need to increase productivity 80 Domestic budget deficit 81 Foreign investment in American industry 82 THURSDAY, FEBRUARY 19, 1987 Opening statement of Chairman Proxmire 85 Opening statements of: Senator Garn 86 Senator Riegle 88 Senator Dixon 88 Senator Sarbanes 89 Senator Gramm 89 Senator D'Amato 90 Senator Heinz 136 Senator Shelby 92 WITNESS Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System 93 Fifth year of recovery and expansion 93 Complementary adjustments 94 Rapid growth of money aggregates 96 Rapid rate of debt 97 Inflation 98 Prepared statement 100 The economic setting 100 The broad policy approach 102 International consistency 104 The debt situation 106 Implications for U.S. policy 107 Rapid growth of money and liquidity 108 The approach to 1987 112 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Page Concluding comments 115 Witness discussion: Reporting requirements for the Fed 117 Nonbank bank and securities issues 119 Gramm-Rudman 119 $1 trillion debt by 1990 121 Bank failures 123 Activity of the stock market 125 Debtor nation from 1620 to 1914 126 Surge of protectionism 128 Rise in debt erodes confidence 129 Protectionism 130 Japanese savings rate 131 Comparison to the Japanese and the Germans 133 Fed report to the Senate 137 Letter Senator Proxmire, Chairman, Senate Committee on Banking, Housing, and Urban Affairs, from Paul Volcker, Chairman, Federal Reserve 140 Humphrey-Hawkins Act reporting requirements 142 Debt to equity swaps 165 Dangerous and unwise policy 167 Foreign exchange rate of the dollar 169 Protectionism 171 FSLIC bailout 173 Responsible economic conduct 175 Upcoming G-5 meeting 177 Korean exports 180 Baker plan 181 Trading system unfairly structured against the United States 183 Response to written questions from Senator D'Amato 184 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1987 WEDNESDAY, FEBRUARY 18, 1987 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The committee met at 10 a.m., in room SD-538, Dirksen Senate Office Building, Senator William Proxmire (chairman of the com- mittee) presiding. Present: Senators Proxmire, Riegle, Dixon, Sasser, Shelby, Graham, Heinz, Hecht, and Bond. OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. We begin this morning with the most important oversight responsibility carried by any committee of Congress, that of reviewing the monetary policy of the Federal Reserve Board of Governors. Why is this responsibility so enormously important? First, the monetary policy of the Federal Reserve and its imple- mentation have profound and far reaching effects on the economic wellbeing of our country. Second, our responsibility is dictated to us by no less an authority than the Constitution itself in article I, section 8, subparagraph 5. That provision states that only the Con- gress shall have the power, "To coin money and regulate the value thereof." During the nearly 30 years that this Senator has served on the Senate Banking Committee, there has been little doubt about the high quality of the Chairman of the Federal Reserve and their very professional staff. And there is no doubt about the remarkable abil- ity of the current Chairman or his staff. Indeed, Chairman Volcker is viewed by this Senator as one of the most talented of those giants who have so wisely guided the critical money and credit as- pects of our economy. Doubts arise not in regard to the Federal Reserve's leadership but in regard to a monetary policy that seems increasingly out of control. This Senator is concerned that the rapid growth of mone- tary reserves exceed prudence. This growth is unwise in view of the inflation potential residing in dollar exchange rate declines, energy price increases, and Federal spending imbalances. Realization of this potential accompanied with continued rapid money growth can have over time only one sure result—inflation—the result of too much money chasing too few goods. In an economy as debt bur- dened as our own is, the further consequence of an up trend in in- (1) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis flation will be a skyrocketing of interest rates, followed by a sharp economic slowdown, and rapidly increasing unemployment. To weigh these and other risks, we have with us this morning a panel of experts of international reputation. Mr. Axilrod, it is my understanding that this may be the first time that you have ap- peared before a Congressional Committee to discusss monetary policy. In light of your long professional role as the top staff official at the Federal Reserve responsbile for monetary policy develop- ment and implementation, your appearance this morning is par- ticularly significant. Two of our other witnesses, Mssrs. Erich Heinemann and Allen Meltzer, on the other hand, have served for many years on the Shadow Open Market Committee as critics of the same policies Mr. Axilrod implemented. To make this Australian Tag Team match even more exiciting, Mr. Lawrence Chimerine of Chase Econometrics comes to us as a widely respected critic of Reaganomics—the very policies Mr. Paul Craig Roberts, our last witness, in part authored and now vigorous- ly defends. Together these witnesses represent a wide range of views on monetary policy regarding both its domestic and international di- mensions. We are very fortunate to have them here this morning and look forward to the benefit of their testimony. Senator Hecht, do you have a statement you would like to make? Senator HECHT. No, thank you, Mr. Chairman. The CHAIRMAN. Senator Dixon. STATEMENT OF SENATOR ALAN DIXON Senator DIXON. I thank you. Mr. Chairman, I am pleased to be here this morning as the com- mittee begins its oversight hearings on the Federal Reserve's First Monetary Policy Report for 1987. This hearing comes at an uncer- tain time for the U.S. economy. Inflation has been low, but the latest wholesale inflation figures are up. Economic growth is low and we seem to be using only about 80 percent or less of our facto- ry capacity, yet the stock market continues to move from one all- time high to the next almost daily. The dollar has declined precipi- tously, which should help our exports, yet imports continue to grow, and our trade deficit has, at least so far, failed to show no- ticeable improvement. There also seems to be some real uncertainty as to what the Fed- eral Reserve's policy is, and what it should be. Some point to the fact that Ml, the most basic measure of the money supply, has been growing very rapidly in recent months, and argue that the Federal Reserve should keep a tighter rein on the money supply. Others, looking at the low growth in GNP, say that the Federal Re- serve should conduct monetary policy in a way that will stimulate higher rates of economic growth. They believe the fed can accom- plish this objective without reigniting the fires of inflation. The witnesses before the committee this morning are all distin- guished economists. I look forward to hearing from them on the issues I have mentioned, and on other issues related to the conduct of monetary policy. I also look forward to hearing from the Chair- man of the Federal Reserve, Paul Volcker, tomorrow. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The CHAIRMAN. Senator Shelby. Senator SHELBY. I have no opening statement, Mr. Chairman. The CHAIRMAN. Well, we'll start alphabetically with Mr. Axilrod and go right across and end up with the cleanup hitter, Mr. Rob- erts. Mr. Axilrod, go right ahead, sir. STATEMENT OF STEPHEN AXILROD, VICE CHAIRMAN, THE NIKKO SECURITIES COMPANY INTERNATIONAL, INC. Mr. AXILROD. Well, thank you, Mr. Chairman. It's somewhat daunting to be at this table after so many years of the comfort of sitting right there behind and letting other people taking the brunt. This is not as you know a simple time for monetary policy by any means. In 1979 The CHAIRMAN. May I just say—and this won't be taken out of your time—that each witness will have 10 minutes and then the red light will go on and then we'll have to terminate it. And if at the end of our hearing you would like to state anything that you would like that's been left out, you'll have 2 minutes to do that. Mr. AXILROD. Thank you. 1979 was, in some sense, was simple for monetary policy because it was clear that the objective was to con- trol inflation and what needed to be done had to be done. In 1982, it was very clear that inflation was to a reasonable degree under control and recovery from recession had to be the prime objective. More recently, objectives have been much less clearcut and the Fed has necessarily had to strike a much finer balance between the need to encourage growth and the need to contain inflation. And they have, in my view, been encouraging growth with relatively rapid expansions in money and liquidity, but I don't believe at this point excessive, and they have attempted to contain inflation by maintaining a degree of pressure on short-term interest rates. In real terms, after allowing for price increases, the level of short- term interest rates is much higher than it was in the inflationary period of the 1970's and about where it was in the less inflationary, almost noninflationary period of the 1960's. RECENT EVOLUTION OF MONETARY POLICY More recently, the evolution of monetary policy has been quite complicated by the twin deficits with which everyone is familiar— the large rise in the trade deficit and the large rise in the budget deficit. The margin of error for monetary policy has become increasingly narrowed as we move into a period when these deficits will neces- sarily be unwound. The trade deficit is going to be unwound either deliberately through acts of policy or through market developments because the world simply is not going to accept a continuing outflow of dollars of $150 billion or so a year. When a commodity gets in oversupply, its price goes down and the price of the dollar has been dropping sharply on exchange markets since early 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis At some point, this means our trade deficit will be reduced in real terms, and I think that process is beginning right now. At least the trade deficit has stopped rising, is leveling off, and I would expect it to begin declining soon. The drop in the exchange rate, then, provides an expansionary impulse to the economy but it also provides an inflationary impulse to the economy. So it's a double-edged sword, I don't have to explain to this committee, Mr. Chairman, the basic reasons for reducing the budget deficit and I will not. But I should emphasize in the context of the trade deficit that it's very important to reduce the budget deficit because that will release fi- nancial resources, it will release savings in this economy, and it will release real resources that can be shifted into the internation- al sectors. As that happens, it will reduce the potential inflationary conse- quences of the reduction in the trade deficit. It will take pressure off the balance of saving and investment and it will take pressure off our labor, plant, and product markets by releasing real re- sources through restraint on Government spending. So I regard the reduction in the budget deficit as a necessary counterpart of the reductions in the trade deficit. If the deficits are phased down together, there will be much less pressure on mone- tary policy. If the budget deficit is not reduced, for instance, there's an even greater inflationary potential in the expansion of our international sectors. The behavior of the two deficits is not the only circumstance cur- rently affecting our economy. A lot depends on whether the econo- my as a whole can be viewed as unusually strong or relatively weak. In a relatively weak economy, for example, there is less pres- sure on the budget deficit as a needed offset to the reduction in the trade deficit. One way of assessing the structure of the economy is to look at whether existing credit conditions in themselves are a propulsive force in the economy. To do that, you can't quite look at the nomi- nal level of interest rates; you have to look at the nominal level of interest rates less price increases and less expected price increases to see if in real terms interest rates are high or low. The Federal Reserve can affect short-term interest rates. Long- term interest rates are somewhat influenced by their actions but essentially depend on market attitudes. The short-term interest rate in nominal terms has been fluctuat- ing a bit recently, but it's somewhere in the 6 to 6.5 percent area. Very recently, price increases looking over a 2- or 3-month period, short term, are 3 percent or something like that. So you have a level of real short-term rates at 3 or 3.5 percent. That, as I think I mentioned earlier, is much higher than in the 1970's when we were around zero all the time and it was an inflationary period, but it's probably very close to where we were in the 1960's, which was for most of the period a noninflationary period. So I would say that there's nothing in the level of real rates at this point to act as a strong propulsive force in the economy. In practice, the question is whether they are about right or excessive- ly restraining. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Unfortunately, at this point, Mr. Chairman, I have to revert to my past as an economist and say it's not particularly clear whether they are now about right or excessively restraining. RECENT ECONOMIC DATA The recent economic data that has been coming in are not really too bad. The employment figures have been relatively strong and the new orders figures on durables have been in some sense sur- prisingly strong, although there the tax situation has complicated interpretation. I personally would expect, looking about a year ahead, that con- sumption growth will slow because the personal saving rate will probably begin rising back toward somewhat more normal levels. Moreover, I don't see in the housing market very much lift and in certain areas of nonresidential construction we are well overbuilt for many years. That simply means that basically we have to count on the inter- national sector for most of this year's economic dynamic. There, the drop in the exchange rate certainly helps. But in that respect we also do need expanding markets abroad to receive the goods which our manufacturing industry is increasingly being able to produce on a competitive basis. There is an inflationary potential, of course, in the drop in the exchange rate. And we do have plenty of liquidity in this economy to sustain that potential should it actually develop out of either the drop in the exchange rate or other forces. Inflation would reduce real interest rates and stimulate the econ- omy in the short run. But it is a very unsatisfactory way of reduc- ing real interest rates. It is very nonproductive for the long-run health of the economy, and would require strong, quick counter- vailing monetary policy action. But we don't have evidence yet of an upsurge in inflation. There is also a potential for economic weakness in current cir- cumstances, Mr. Chairman, if the turn to fiscal restraint here not be accompanied by efforts of other countries to expand through fiscal stimulation or if the basic spending forces here don't in any event have sufficient dynamism. In that case, I would expect the interest rates in the markets, the nominal interest rates, to begin declining on their own. Indeed, there are circumstances under which monetary policy itself might well take the risk this year of shifting the balance between accommodation and restraint more toward the easing side, becoming a little more willing to lead nomi- nal rates down. Stability for the dollar on exchange markets would be a sine qua non since it would stabilize inflation expectations. In such a cir- cumstance and especially in the context of a restrictive Federal fiscal policy, a tilt toward market ease rather than restraint is less likely to have the counterproductive effect of stimulating inflation- ary attitudes. But any such tilt this year, when there are doubts about the extent of inflationary potential, would also require clearer signs that real economic growth is in fact in the process of faltering. Moreover, such a tilt should be buttressed by a little more reliance Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 on the monetary aggregates, especially I would say M2 at this point, though still viewing that aggregate in the context of the whole group of money measures. I have about 1 more minute, Mr. Chairman. Under current cir- cumstances, the aggregates might in any event be given a little more prominence in policy, most particularly if the economy does not soon show indications of weakness. The essential reason is be- cause of uncertainty that market forces, as embodied in labor, goods and world commodity markets, will in and of themselves be working to reduce inflation further and because of the nonnegligi- ble risk that inflation could go higher. In a period of sharply declining inflation and inflation expecta- tions, the aggregates are not really an adequate guide to monetary policy as we have seen in recent years because of related very large and basically unpredictable changes in interest rates and attitudes toward money. But when inflation stabilizes or threatens to rise, the aggregates become a more useful guide simply in the sense that they can then act like a governor on the fuel system. I should hasten to add, however, that if we do succeed in bring- ing inflation below 3 percent on a sustained basis—and it's not clear whether that can be done in an orderly fashion or whether it will require a period of economic weakness to do so—a substantial further decline in nominal rates, both short and long term, is at some point ahead of us. That decline would have to be accommodated, if not encouraged, by monetary authorities, regardless of the behavior of the aggre- gates, if we are not to prolong the weakness unduly. Thank you. [The complete prepared statement of Stephen H. Axilrod follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Budgetary deficit I lie turned into an expansion. The deficit has caused problenB because It has Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis than they had been. begin improving. OO flue it Is not gol el al in the U.S. ha Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis here. Bnd hou Iliey cope will also Influence the U.S. eronony. Suiac cf Following the sharp drop In the dollar over Ihe past tvi> years, the expansion to keep their economies growing. They, diiil Japan it Hit <?xenpl-ir. will need to shtf: resource!, away from international iniustrieb toward domestic uses—Mhereas thf U.S. will be attempting the reuorse. Just at, othir countries a more expansive fiscal policy is needed tn help jh^.irb Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis out'—one that, for ejfample, brings price Increases thle year beyond the 3 sgbdued. That residual restrain! has been evidenced by relatively high bounds—assuming the upper llmils of the Feti targets «ere not overly Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 should haste The CHAIRMAN. Thank you very much, Mr. Axilrod. As I said, for the benefit of those who have come since then, this is the first time that somebody in your position as the top man on monetary policy for the Federal Reserve and implementing it as a staffer has ap- peared before a congressional committee and testified. I think it's very helpful to have you appear today and this fine testimony. Would like to extend our welcome to Senator Bond, formerly Governor Bond, now promoted to the exalted position of U.S. Sena- tor. We're delighted to have you with us. You have an excellent background and it's going to be great to have you on the commit- tee. We're very happy to have you. Senator BOND. Thank you, Mr. Chairman. I'm certainly looking forward to it. The CHAIRMAN. The rules are that each of the witnesses will have 10 minutes, then we'll have 5 minutes for each of the Sena- tors to question, and we'll have whatever number of rounds neces- sary. This is the one panel we have today. We go back and forth and after I question, Senator Hecht will then question and then Senator Dixon and so forth, in the order in which they arrived. Mr. Chimerine, go right ahead, sir. STATEMENT OF LAWRENCE CHIMERINE, CHAIRMAN AND CHIEF ECONOMIST, CHASE ECONOMETRICS Dr. CHIMERINE. Thank you, Mr. Chairman. I get the feeling you're trying to set an example for the Federal Reserve by limiting our time this morning so I'm going to get right into the subject be- cause I do have a lot to cover. I would like to focus on two areas. No. 1, the current economic situation; and, second, the implications for monetary policy. SLOW ECONOMIC GROWTH I think everyone in the room is well aware of the recent econom- ic performance in this country. We have had extremely slow growth now for the last 2J /2 years. As a result, the level of econom- ic conditions, in my judgment, is far from satisfactory. Many parts of the country are still experiencing recessionary conditions. People on Wall Street probably think this is the greatest boom in history, but you don't get quite the same feeling in Moline, IL or Sioux City, IA, or lots of other places that I travel to. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 It's a very mixed economic situation and, quite frankly, the health of the economy, in my view, has been consistently overstat- ed during the last several years. There have been some stronger statistics recently which are lead- ing to the view that the economy is finally starting to pick up, and that the second leg of the economic boom is finally developing. I would caution against such a conclusion. I think the recent data are distorted by tax reform related activity, and by technical problems with the data. Some industries clearly are picking up. Others, if anything, are experiencing more weakness now than they did several months ago. It is a mixed bag primarily because the economy is in transition. Some of the industries that are benefiting from the weaker dollar are doing a little bit better but retailing, construction, and others are slowing. On balance, in my view, the current economic situation basically is the same as it's been now for 2:/2 years—no evidence of reces- sion, but no meaningful evidence of an acceleration in economic growth. I think we're still stuck in this slow-growth mode that we've been in since the early summer of 1984. And, when you look at the underlying fundamentals, the appro- prate conclusion, at least in my judgment, is that this pattern of slow growth is likely to continue for several more years at least. I think the dominant factor in the outlook for the economy remains the trade situation—not only what will happen to the trade deficit itself, but the underlying causes of the trade deficit and what the solutions will do to the rest of the economy. In my judgment, the major reason we have large trade deficits in this country is because the competitive advantages and productivi- ty differentials that the United States had over the rest of the world during the 1950's and 1960's when we dominated the world economy have been narrowed dramatically. Other countries can now do the same things we can do. They can produce the same products, and in many cases of better or equal quality. They have access to the same mass production capabilities and use the same technology as we do. But of course, in many of these countries, wages are a fraction of what they are in the United States. When we dominated the world economy we raised living standards in this country by increasing wages and developing corporate structures which, quite frankly, we could afford in those days based upon the productivity differentials which existed, but they don't exist any more to the same extent. They have been narrowed dramatically and, as a result, we have become the high-cost producer in many industries and this situa- tion is fundamentally what has produced the large U.S. trade defi- cits. I think the trade deficit will eventually come down. As Steve Ax- ilrod said, it has to. The world won't keep accepting all of these dol- lars. But the problem is that the solutions that are being imple- mented right now are not cost-free solutions. Cutting wages, laying off high-wage workers, and pushing the dollar lower and lower, which are the solutions that are now taking place, will all hold back living standards and consumer spending in this country. They are already beginning to squeeze consumer purchasing power and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 we are now in the early stages of a sizable deceleration in con- sumer spending because of stagnating real incomes, high debt bur- dens, low savings, and the shift in the job mix away from high- wage jobs to low-wage jobs. Second, most companies are still trim- ming back their investment budgets—real interest rates are high; they have lots of excess capacity and they have lost the investment tax credit. Construction is coming down because of all the overbuilding. Government spending is slowing. So yes, I think we will get a modest improvement in the trade deficit. Some industries are already experiencing it. But domestic demand is slowing dramatically and, as a result, when we add it together, it is unrealistic, in my judgment, to expect an accelera- tion in overall economic growth. The components are changing, and will continue to change, but not overall grants. WORLD ECONOMY IS FRAGILE Next, I think the world economic situation is extremely fragile. We have a world economy that is growing slowly at best. Condi- tions are weakening in Japan and Germany, and in many other areas. Severe recessions are occurring in Mexico, some OPEC coun- tries and Africa. Most of the world is pursuing restrictive fiscal policies. Many countries are also pursuing restrictive monetary policies. Overcapacity exists almost everywhere. Investment is coming down and everybody seems to be engaged in competition cost-cutting, which is designed to increase their share of a stagnant pie, so to speak. As a result, I think there is a greater risk of a worldwide down- turn now than there has been in a number of years. And third, while I understand the chairman's concern about in- flation, I think the inflation risks are minimal at the moment. We are moving into a higher inflation zone because we won't be seeing the sharp decline in oil prices we had last year and because the weaker dollar is pushing up import prices. However, I don't see the conditions under which this is going to lead to a typical kind of wage-price spiral. Quite the opposite— wages are still being cut in most industries; we have massive excess capacity, both here and abroad; and commodity prices, partly be- cause of oversupply conditions and partly because of sluggish demand, are coming down again. So it seems to me the increase in inflation will be modest at best. It will take place principally from external sources—namely, the decline in the dollar and somewhat higher oil prices, and it's not the kind of inflationary spiral that I think should cause any great concern. If this setting is correct, and when you take into account a number of other factors—principally that I think the impact of monetary policy on the economy in this environment is not sym- metrical because of the high debt burdens we have and because of all the over-building and excess capacity—modest declines in inter- est rates stimulate the economy only to a very limited extent, but I think if we do the opposite—if the Fed were to tighten and push up interest rates, it would slow the economy even further. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 In fact, it has been my view in recent years, and still is, that we need lower and lower interest rates just to keep the economy in the same place, in part because real interest rates remain very high for most borrowers. Many economists measure real interest rates by adjusting interest rates for the Consumer Price Index, but as I like to joke, all of the Consumer Price Index in recent years is in col- lege tuitions. I pay those for my daughter on a regular basis. For most borrowers in this country, especially commodity produc- ers, and manufacturing companies, real interest rates remain ex- traordinarily high. They have had little or no price increases, so for them, 8 or 9 percent interest rates represents a very high real in- terest and is prohibitive in many cases for investment decisions. And, the LDC debt situation is still extremely serious. Higher in- terest rates would aggravate that. In addition, we are embarked on a process of unwinding from large Federal deficits, which is absolutely essential for the long- term health of the economy. This in the short term will be restric- tive, however, and tighter money will compound the restrictive- ness. Next, I think the basic money supply measure enormously dis- torts the growth in the money supply. It's being affected by a number of technical factors, such as deregulation and new finan- cial innovation, and thus overstates the easing of monetary policy, I think if you take all of these conditions into account, Mr. Chairman, in my judgment, it is inappropriate for the Federal Re- serve to change their relatively accommodative monetary policy and, in fact, any change that would push up interest rates in the short term is not only inappropriate but, in my judgment, is ex- tremely risky in view of the fragile nature of the economic situa- tion. I could have added to my list of reasons the fragile nature of many financial situations, especially in the view of the still serious LDC debt problem. Now having said that, Mr. Chairman, I share your concern about the long term. The 8 or 9 percent growth in M2 and M3 of recent years is both tolerable and necessary. But I would agree with you that on a 5- or 10-year horizon that may be on the high side. However, until we get Federal deficits down and reduce the pres- sure on credit markets from those deficits, and I think, as you know, we will need some tax increases to accomplish that, I think it will be very difficult to significantly reduce the growth in M2 and M3. But I do agree on a long-term horizon, that has to be implemented. My view, though, is that it is premature, and for the time being, we have to tolerate a relatively accommodative monetary posture. Thank you. [The complete prepared statement of Lawrence Chimerine, Ph.D, follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis By name is Lawrence Chimerine, and I am the Chairman and Chief Economist of Chase Econometrics. I am delighted to have this opportunity to testify before the Senate Committee an Banking, Housing and Urban Affairs on monetary policy and the outlook for CHASE the U.S. economy. In addition, I would like to address some key economic concerns and their implications for longer-term economic performance. In sum, my views are as follows: (1) Despite the fact that the current recovery is more than four years old, the recovery process has not been completed. The economy Statement By is far from being fully healthy and prosperous. (2) Despite some uptick in several recent statistics, the long period of slow and erratic growth that has been in place since mid-19B4 appears to be continuing. Thus, at this point, there is no conclusive evidence of either a major acceleration in the economy, or of a slide into recession. Lownnce Chlmarino, Ph.D Chairman and Chiaf Economis (31 Slow growth is continuing because the stimulative impact of Chase Econometric* declines in oil prices, interest rates, and the U.S. dollar, and Bala Cynwyd, Pennsylvania the boom in the stock market, are providing only modest stimulus. In addition, various negative factors are holding down economic activity. (4) The underlying fundamentals suggest that this pattern of slow growth will continue during 1987 -- in particular, slower growth in consumer spending, weakness in capital spending, cutbacks in government expenditures, and very weak construction, will combine to hold economic growth to the 2% to 2.5% range despite some Uilted State* Strata anticipated improvement in the trade deficit. i Ba W nk a in sh g i , n g H t o o m n, in D g .C e . nd Urban Affairs u (5 n > e mp Th lo e y m s e l n o t w i g s r ow l t ik h e l t y h a t t o i r s e m l a i i k n e ly cl o d s u e ri n t g o t 1 h 98 e 7 n e i a m r p l 7 i % e s l t e h v a e t l that has prevailed since early 1984. There will, however, be a modest acceleration in inflation to the near 4* range ICPI], reflecting rising import prices and higher oil prices — as a result, real Income will rise little, if at all, for most workers. Finally, I February IS, 19B7 r e e x m p a ec in t d e c r on t o i f n u t e h d i s d o y w e n a w r a r a d s p a r e r s e s s u u r l e t o o n f t s h t e i l U l .S h . i g d h o l U l . a S r . d u t r r i a n d g e the deficits, especially since economic growth in other parts of the world is likely to be very modest, which will limit the rebound in U.S. exports. (6) The ability of the Federal Reserve to conduct monetary policy has been severely hampered by a number of conflicting factors, including still enormous budget deficits, the need to continue to attract funds from overseas, the fragile financial system, the potential for higher inflation, as well as still weak economic growth. Under these circumstances, the Fed has done an admirable Job. However, it should be noted that the ability of monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis policy to produce faster economic growth is limited by the high has been highly Uneven, with many sectors still mired in debt burdens which already exist, by widespread, excess capacity and recessionary conditions. This has created major industry and overbuilding, and by other factors -- thus, it is unlikely that geographic differences which are causing severe hardships in many monetary policy can produce significantly faster economic growth in areas. the near term. In sum, the performance of the economy in recent years, *t least (7] The alow growth no« underway may in fact continue for maltf with respect to real economic growth, has been vastly overstated -- years, in part reflecting the deterioration in L.S. competitiveness the recovery in total has not been particularly strong and is far in world markets, and the enormous debt buildup in recent years. from complete-, we have experienced only marginal additional progress in completing the recovery process during the past two and one-half years; and the economy is still operating at highly unsatisfactory levels by historical standards. THE CURRENT ECONOMIC SITUATION Despite some uptick in recent statistics, the economy is still growing at a relatively slow pace, in my Judgment. The uptick in some of these recent data exaggerate strength in the economy: 1. unemployment has dropped slightly in recent months, in part The recovery which began near the end of 1962 is now more than four because of a relatively large increase in new jobs, especially in years old — this makes this recovery period one of the longest on January. However, it appears that this improvement has been record. However, the health of the economy has nonetheless been exaggerated somewhat by unreliable seasonal adjustment (actors, overstated, as evidenced by the following; particularly with respect to construction and retail trade Jobs. In particular, the increase of nearly 450,000 payroll joBs in January (11 There have been two very distinctly different parts of the included a rise of HO, 000 in construction, with the remainder In recovery period. Th« first Bighteen months (or all of 19B3 ar. retail stores, fast food chains, health care, and othsr services. However, new construction contracts have Been trending down for more than a year, so thai: the increase in construction Jobs in January will be reversed in the months ahead. Purthermota, a relatively large share of the new Jobs in services in January were part time, and were at wages well below the national average -- thus, income growth was very ine-dest despite the large increase in new jobs. And, many companies havs announced layoffs which Sjill be effective at various points during 1987 -- most of these have not yet shown up in the employment statistics. Finally, the still sluggish level of help-wanted advertising also indicates that labor vxperAenueu in IIIOBI utiiejr pu&*-l*ar iKUJvcry pvi^uua -- a<iu LUC average growth o| slightly more than 2% since 1980 is far below 2. The very strong 4.4% rise in retail Sales in December severely that experienced in previous postwar decades. distorts the underlying pattern of consumer spending: (a) The rise uas heavily concentrated in purchases of new automobiles, prior to (2| This period of extremely slow growth has taken place even the elimination of sales tax deducibility on January 1. Nonauto though the level of economic conditions has not been satisfactory. spending rose a more modest 0.9%; and eon* pre- tax-reform This reflects the fact that the 1981-82 recession followed closely purchases of furniture, appliances and other consumer durables may on the heels of a previous recession, so that economic conditions have artificially boosted sales of those goods, (bl Sales were were exttemely depressed when this recovery period r»egan. revised sharply downward for November -- thus, excluding the zigsag Therefore, virtually all measures of economic performance are still pattern of auto sales, spending was almost flat for the two months unsatisfactory. For example, the near 7% unemployment rate that combined, and have grown, much mote slowly since mid-suitnier than has prevailed during the last two years is obviously a significant during 1985 and the first half of 1986. (c} Early indications improvement over the near 11% rats of late 1982, but it is still suggest a significant tailing oft of retail activity in January — much higher tfcan st anytime in the postwar period prior to the not only vere auto sales very soft because of the high level o£ 1980s with the exception of the 1974-75 recession. "borrowed sales" in December, but many retail chains reported sluggish activity as well, especially for tiousehold durables. 131 The performance o£ tha economy during the past several years 1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3. While industrial production will continue ta grow, after the related -- in addition, orders for commercial aircraft have been almost stagnant pattern of the past two and one-half years, the very strong, but because of the long production cycle, these will rate of increase will decline significantly from the contribute very little to near-term economic activity. And orders November-December performance; (a) Auto production rose for household durables have flattened out. significantly in December -- not only will such an increase not be repeated, but significant cutbacks are likely in the months ahead. lb) Defense and space output has risen at more than an 8% annual rate since raid-summer -- recent cutbacks in appropriations for military procurement will begin to slow the growth in military output in the months ahead, (c) Utility output, while erratic on a Monthly basis, has risen at a relatively strong but unsustainable pace on average in recent months, (dl It is likely that production On balance, therefore, when erratic movements in the data, of some business equipment and consumer durables were higher in the revisions to earlier data, and the effects of tax reform are taken last two months than would have been the case because of the pre- into account, it is still premature to conclude that the overall tax-reform related activity -- this should be reversed during "-.he economy is accelerating -- this is confirmed by feedback from Chase next several months. Econometrics clients, and from more recent economic data. 4. The sharp rise in both housing starts and permits in December has raised hopes that recent declines in mortgage rates are WHY HAS THE ECONOMY BEEN SO SLUGGISH? beginning to spur a new surge in housing activity; however; fa] The The sluggishness has continued despite numerous forecasts that a December rise comes from a relatively low (and downward revised) major acceleration would take place during 1936 because of declines level in November and earlier months, (b) More than half of the in interest rates, the dollar, and oil prices, and other apparently rise was in multifamily structures, which is almost certain to be favorable factors. However, the economy has not picked up, for the reversed in coming months in view of the still enormously high (and following reasons; rising) vacancy rates in most areas, and the adverse effects of the new tax structure. (c) The overall figures were heavily influenced II] The sharp decline in interest rates that has occurred since by a surge in activity in California as builders tried to avoid late 1984 has had only a small stimulative effect on the economy higher building fees which became effective in January, (d) starts thus far, since real interest rates were extraordinarily high when were also bolstered by relatively mild weather in most of the these declines began. Thus, in effect, rate declines were country in December -- January weather was less favorable. necessary just to keep the economy in the same place, and in great part have been caused by the weak economy. The only noticeable 5. While the trade deficit did drop sharply in December, it is effect of the decline in rates has been on the housing industry premature to conclude that a significant turn has developed. This -- real interest rates for industrial companies are still so high In part reflects the fact that imports surged in November prior to that there has been virtually no impact of recent declines in the imposition of a new customs fee and prior to tar reform -- some nominal rates on capital spending plans or on inventory policies. q w e l s o u e i e o f a r t v m r h e e e t t e l h e r e o i r v o f s e f e w r n w t a r a h I s a m d s e t o p i w o o p c r n n c r o t l o u s y b m n s a o i t v b g r a s n e i l n l i m e i d y f g e s h i n t b t c t h a o l a e g s r y n a r t i o a i l b w n v n y e e s e l d t r t o i a h w n w g f e h e r D t i o d e h t c m a c r e h t e a D a m d t e t , b e c h h e e i e o r d m r r b e d d e f - o t r i - q l h . c u l e i a t a t r h r s t i T p e h s i h e r a u n c , s s l i i t , a n k h l e i o e t l m t h f p y f e o a o d r c u e r a t t r c e v o s t l f e r h i l r n f e s a e r c g o t d c e m s ited a p h c F T e e g o i h n r d g e e t p h - o i o i u r d s f m a p e p t b i a t i t d n h c o e t e n m b g s a u r o r n r e f e d d a a c s e n t d o n , d e v s p c e , h a l l r o r i o y u w n t w , s h i e i n u p t h c t u g h o h s i e l h l i d i i h n w n s z a t i g a v e n t t r e d i e o o i o s r n n n t e i g d n a r u c r d a c u s a o t e r t t w e d r e n s i a s , t n d o g h d i o e . f i a v t e p w i a r r i o l b e l n s u v l a o i i i l l o n b d u g Q e i s n e i n l e b n g s t y g s , . a l a o v i n T a f m h i d i u l b t s a o a e b , t l d l h r e e t b a h y d e y the a co b u o n v t e r , i e s s i nc ar e e i f t a l i l s i n u g n li b k e e c l au y s e t h o a f t c i u m r p r o e r n t c s y o m r o i v g e i m n e a n t t i s n . g in those f ( r 2 o ) m Th th e e ec s o h n a o r m p y de h c a l s i n n e o t i n y e t t h e e x v p a e l r u ie e n o ce f d t h a e n y d o s l i l g a n r i , f i p c r a i n m t a r b i e l n y efits because the large trade deficit reflects major deterioration of the United States competitive advantages that has occurred over many years (this will be discussed further below) -- thus, modest declines in the dollar will not solve the problem. (3) The stimulative impact of lower oil prices on the economy has been modest, at best. In great part, this reflects the fact that the United States is a large producer of oil (we produce about 70% 7. New Orders for Durable Ooods continues to see-saw — excluding o£ our own needs), so that the main benefit of declining oil prices defense, they have trended only slightly upward in recent months. has come from a decline in the price of imported oil. However, oil Furthermore, much of the recent rise was probably tax reform imports relative to GNP have fallen sharply since the early 1970s Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis [by more than 50%), reflecting that fact that we Ccoonnssuummee ttaarr lass continued increases in import penetration, which increases the energy relative to the size of tha economy than we did then,that demand for credit and tBe money supply without increasing domestic all now constitutes a smaller fraction of our total energy output; (b) declining interest rates, which have reduced the consumption than at that time, and that we produce a large opportunity costs of holding interest free or low interest deposits; fc) concerns fegajaing the sajety at deposits at various thrifts and other financial institutions, which has caused a shift of savings into Ml types of deposits: and. Id) financial Innovation and deregulation, which have created new instruments. domestic oil prices. Furthermore, because of already large current account deficits, most OPEC countries are reducing their imports of THE OUTLOOK FOR 19B7 military and manufactured goods from the United States and other I believe that the outlook is for continued subdued growth during countries, Which is offsetting part of the favorable effects of the I9S7, vith a likely rise in real GUP of 2.5% at best. This expectation is based not Only on my assessment of the recent data, bat also on the underlying fundamentals. J4) In my view, the stock market boom does not reflect either current or expected economic strength — in fact, the rise in stock (A/ As indicated earlier, consumer spending has already begun to prices is more accurately a sign of w^altneas, since it largely grow more slowly once the effects of auto incentive programs, tax reflects the sharp decline in interest rates, which in turn is a reform, etc. are smoothed out. This trend will continue through direct result of the sluggish economy. In effect, the substantial 19B7, and possibly beyond, for the following reasons; (a) There is increase in liquidity that has been pumped into the economy by the every Indication that real wfges will remain stagnant, reflecting Federal Reserve has gone primarily into financial assets rather continued cautious wage policies and an acceleration in in£latiun. than fixed assets, reflecting the lack of viable fixed Investment while slow wage growth is still most pronounced in manufacturing opportunities due in part to overcapacity, overbuilding, etc. Thus, (fully one-third of all recent union contracts have actually many companies have found it more attractive to buy up thfcic own included wags roJlbscJis), it is now spreading to other sectors as stock, or someone else's, rather than malting investments in plant well (two-tiered wage systems and the increased use of lower wage and eguipment. Furthermore, the sharp increase in the value of subcontractors are further holding down average uagest. The financial assets helo by consumers is also vastly overrated as an acceleration in inflation is coming primarily from external sources economic stimulant, since; (a) ownership of financial assets is (ratfter Chan from internal income shifts), especially from the OO concentrated among relatively high incotne fawllies with a recent increases in oil prices and sharp declines in the U.S. relatively low marginal propensity to consume, (b) most individuals dollar. Thus, even factoring in the personal tax outs which will cannot gain access to these funds because they are tied up in result from tax reform this year, real income per wocKer will grow pension accounts, and tc) many oE those who have experienced little, if at all. And, with slower growth in new jobs, and the capital gains have rolled them aver rather than using them to high concentration of those jobs in lower-than-average wage finance consumption. In addition, household debt has ris<sn occupations and industries, total real disposable income will grow dramatically during this period, with a far more widespread at only about 1.5* during 19S7. fb) It is increasingly clear that distribution across the population. consumers will be unable to continue to finance a relatively large fraction of new spending by going deeper in debt. This in part reflects the increased difficulty that many households are having in servicing existing aet)t, tVie gradual tightening in lending standards by many financial institutions, the already near-record low saving rate, and the erosion in consumer confidence in recent months, (c) Slow income growth, rising debt burdens, and lower saving rates are coming at a time when available pent-up demand, especially fci various consumer durables, has fallen — this will compound their effect. IB) The c»pit*l spending outlook remains poor. Low operating rates, the neu (less favorable) tax structure, and already high corpoiate debt ara all holding back new business investment -- the only positive might be an improvement in profit margins for those (61 Soms forecasters also predicted a surge in the economy as a companies which will have more leeway to raise prices as prices of result of sharp increases in the basic money supply during the last competing imported goods rise in response to the weaker dollar. eighteen months. However, there is currently almost no However, capital spending will lag any improvements in profits, so relationship between Ml and economic activity, reflecting1, (a* that any gains will not occur until very late in 1987 it the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis earliest. Inventory policies will also remain cautious. (particularly in those countries whose currencies have appreciated, because of the squeeze on profits being caused by their stronger (C) Despite lower interest rates, virtually all categories of public and private construction are likely to be weaker this year limit any turnaround in trade in the neat term, but suggests that than last- Even new housing activity will be down by more than 5% significant additional declines in the U.S. dollar will be needed -- in fact, total housing starts rose only slightly last year, to produce major improvements in the trade deficit in the years ahead. income growth, depressed economic conditions in some regions, a reduced number of first time buyers, overbuilding, etc. are already 2. The increase in import prices, by adding to inflation and beginning to hold down new housing construction, squeezing purchasing power (especially since imports now account for a much larger share of consumption than in the past), will ID) While the sharp drop in the dollar in recent weeks probably reduce spending for some domestically produced goods as well (the reflect^ several factors, including Increasing concerns about the income effect of the dollar decline). health at the U-S, economy, the growing likelihood of U.S. trade legislation, the rise in oil prices, the increasingly deadlocked 3. The recent sharp drop in the dollar will probably delay any U.S. political situation, and the possible departure of Fed additional cuts in tfie discount rate. Furthermore, it is unlikely Chairman Volcker, I believe the major factor is the increasing that long-term interest ratss will decline significantly from recognition that the competitive problems which exist in tha United current levels, barring a far weaker economy than now expected. States are more serious than earlier assumed (as will be discussed This reflects not only the added inflation resulting Iiom aollai declines, but also that the apparent willingness of key U.S. policy will occur during 1987, for the following reasons: <aj The makers to see an even lower dollar may cause foreigners to cut Strengthening yen has already caused a significant decline in their purchases of Treasury and other securities until the currency Japanese exports -- signs of softening German exports are also risk is reduced. Thus, the continued slow growth we envision win beginning to develop. Much of these exports would have flowed into not likely be accompanied by continued declines in long-term produced in those countries have begun to accelerate and spread constraint on growth, because even lower rates are needed to --considerably more are likely in the months ahead, fb) It appears bolster demand at this stage of the economic cycle. that Inventories o£ importeSt goods (especially automobiles) have increased recently, which will reduce new orders in the months These forces suggest that domestic demand will grow very slowly ahead. (cJ The aoureciation of the y*n and the mark will enable daring 1987 (1.5% - 2%), in contrast with the sharp tate of the United States to attain a higher share of worldwide exports to increase during tne past several yejrs. Thus, barring a monumental the Far East NIC's and the lesser developed countries. Id) Oil turn in trade, it is extremely unlikely that the economy will break imports will grow more slowly in 1987, now that inventories of crude and refined products have been built up. improvement in trade will be counterbalanced by the significant deceleration in final domestic demand already underway. And, while It should be noted, however, that the effects of declines in the industrial output may do somewhat better in 1987 than in 1986 dollar and the trade deficit an neat-term economic growth will be because of the absence of additional sharp cutbacks in oil and gas modest: activity, as well as because of the smaller trade deficit (in real terms), this Will be offset by slower growth in services as well as 1. The drop in the trade deficit will be fairly modest, because; by declines in construction. The recent boom in the stock market (aj The dollar bag not changed significantly against most will not significantly alter this pattern, primarily because the currencies other than the German Mark and the Japanese yen -- any incremental spending that is likely from the increase in household improvement in our bilateral trade deficit with these countries net worth is very small in view of the heavy concentration of will be offset at least in part by rising imparts from other ownership of common stocks among high-income individuals, and countries. [bj The impact of dollar declines "ill also be limited because of the high debt/low saving environment which already by the tact that many imported goods have no domestically produced exists- Furthermore, as not£d earlier, the (narJset appears to be counterparts, by the perception that some have higher guality than being fueled mostly by the vast amount of liguidity that has been comparable domestically produced products, and by the increased pumped into the economy by the Federal Reserve, and the channeling familiarity of American citizens with foreign produced goods. (cj of a large amount of that liquidity into stocks rather thah capital Domestic demand remains soft in the industrialized world, and very goods, commodities, real estate, etc. Finally, potentially higher weak in Mexico, most OPEC countries, and Africa -- this will limit profit margins due to the -weaker dollar are also bolstering the any improvement ift U.S. exports. In essence, worldwide economic stock market. growth is being limited by very restrictive fiscal policies in most countries, by somewhat restrictive monetary policies in many I continue to believe that there are sizable downward risks in the countries, by worldwide overcapacity, by weaksning investment near-term outlook, so that a recession sometime during 1987 or Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis early 1988 cannot be ruled out. These include the following: (a) 3. Long-term interest rates are still relatively high for most Plant closings and production cutbacks in the auto industry may be borrowers, in part because of still widespread concerns about even greater than now expected -- moreover, the loss of income and future inflation in view of the large budget and trade deficits. consumer confidence caused by these layoffs could cause weaker However, an excessively easy monetary policy could heighten these consumer spending. Ib) It is possible that the turn in the trade concerns, and actually cause even higher long-term interest rates. deficit could begin somewhat later, and/or could be somewhat slower, than now expected. fc) The change in the tax structure on 4. The Fed's policy decisions must take into account the fragile nature of the economy, as well as of the financial system. Thus, expected. any tightening designed to maintain an inflow of credit and/or to reduce inflationary expectations, could actually weaken the economy With in the short term and potentially lead to a significant downward measured by the CPI, is almost certain in 1937. This will spiral. In effect, the impact of monetary policy changes in the primarily reflect the modest increases in oil prices in recent short run is now asymmetrical -- higher rates would weaken the months (which contrasts sharply with the declines in energy prices economy considerably, but lower rates will have only limited during much of 1986), and the fact that the weakness in the dollar stimulative effects. will cause more widespread and sharper increases in the prices of imported goods. In addition, this will provide some leeway for domestic manufacturers to raise prices, especially if they are more federal spending in n shar Consumer Price Index will rise by about 4% during the course of 1987, fallowing the 1.1* increase during 1986. It should be noted Under these conditions, I give the Federal Reserve high marks for that other measures of inflation, especially the GNP price deflator its conduct of monetary policy in recent years, particularly since and the Producer Price Index, will show considerably smaller increases because they are not directly affected by import prices in the basic money supply. It is important that a relatively as is the CPI. accommodative monetary policy be continued for the following reasons: (a) The relatively strong growth in HI in recent years The continuation of modest economic growth that I expect during 1987 will preclude any sizable declines in unemployment -- thus, it relationship between money growth and economic activity, which has is likely that the national unemployment rate will remain very never been very precise, has been distorted even further by the close to the current rate of slightly below 7». I do expect some surge in import penetration in the United States. In effect, the increase in manufacturing Jobs after declines in recent years -- money and credit needed to purchase imported goods are essentially this will be counterbalanced by smaller increases in the service the same as that needed to purchase domestic goods, so that the sector and by declines in construction jobs. growth in GNP will lag behind money growth when imports are rising rapidly. Furthermore, financial market deregulation in recent MONETARY POLICY years has made Ml a less reliable measure of spendable cash. The The conduct of monetary policy has been complicated enormously by a growth in other monetary aggregates have been much more moderate number of conflicting considerations: — these are probably more meaningful guides to the availability of money and credit in the current environment, (b) Despite the 1. The misguided fiscal policies of recent years, which have decline in nominal rates, real rates still remain relatively high. produced enormous budget deficits, have put additional pressure on It appears that lower rates will be necessary to maintain current the Federal Reserve to increase the supply of money, despite the economic growth rates, (c) The LDC debt crisis would be aggravated possible long-term inflationary conseijuences . Furthermore, the by higher interest rates and slower economic growth — this could Fed's policy decisions are now being complicated by the need to the short term argues for even easier monetary policy, despite the Perhaps the biggest concern is that, while a highly accommodative long-term risks. monetary posture is warranted now, it cannot t>e sustained on a long-term basis. However, large and growing Federal budget 2. In order to finance these large federal deficits and the growing deficits, the net debtor status of the United States, and the private demand for credit, it is necessary that we attract a large international debt situation, are pushing the Fed into a corner by inflow of capital from overseas. Thus, any changes in monetary policy that could cause a free-fall in the dollar could be counterproductive for the U.S. economy by discouraging foreign investment in the United States, thus pushing up interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis situation considerably healthier, even wit While efforts have been made to improve productivity and lower costs in the United States in the last several years, it seems clear they have not been enough to improve U.S. competitiveness sufficiently to bring about a sharp decline in future trade LONG-TERM OUTLOOK deficits. First, while productivity growth has accelerated in Trade Deficits and Long-Terra Growth manufacturing, aggregate productivity growth still remains It is generally expected that the U.S. trade deficit will decline disappointingly low. And, much of the improvement in productivity during the years ahead, that these declines will add between 0.5% in industry reflects layoffs, rather than benefits from the and 1% per year to average economic growth (reversing the pattern increased use of new technology or more efficiency in the during the last several years!, and that this reversal will permit manufacturing process -- this process can't be repeated overall growth to approach its near 3.51 long-term average. As indefinitely, especially since many of the employment reductions discussed earlier, I share the expectation that the trade deficit have been among managerial and nonproduction workers. Many U.S. will aoon begin to decline, and that this trend will continue over industries thus are now experiencing the worst of both worlds the long-term — in fact, such an outcome is almost essential —falling employment and continued erosion in market share. Second, because U.S. foreign debt would otherwise reach levels that would while many companies have frozen or even cut wage rates Iln be both unsustainable and potentially highly destabilizing. addition to staff reductions), wage levels remain far above those However, a decline in the trade deficit does not necessarily imply in many other countries (especially the Far East Nic's). Third, that economic growth will accelerate — it implies only that output efforts to improve efficiency and reduce costs are being growth will exceed domestic spending. implemented in Japan and other countries, offsetting some of those being made in the United States. Finally, the decline in the dollar I, in fact, believe that economic growth in the United States will thus far has had only a modest affect on U.S. competitiveness lag behind the postwar average for many years, despite a falling because it has been limited to the Japanese yen and the major trade deficit. One reason for this expectation is that a major industrialized countries in Europe. factor which produced the staggering U.S. trade deficits has been a narrowing during recent years (or elimination in some cases) of the In view of these factors, and of the continuing sluggish conditions competitive advantages that the United States enjoyed after World in many other parts of the world (which will hold down U.S. War II. These advantages resulted from the development and exports), I thus believe that a combination of additional dollar implementation of new technology, the use of more sophisticated declines (some are now happening) and slower growth in domestic mass production techniques in manufacturing, the mechanization of demand will be necessary to bring trade deficits down even modestly agriculture, etc. — they caused average productivity in the United States to far exceed that of other countries (and the gap to widen) for many years. (1) Underlying productivity trends suggest that the trade-weighted average of the dollar in real terms may have to fall to, or below, The "catching up" of the rest of the world during the last 15 years the early 1980s levels in order to produce the same degree of appears to reflect a number of factors, including the spreading of relative competitiveness which existed at that time. This trend technology throughout the world, the rebuilding of war-ravaged implies a continued upcreep in inflation as dollar declines are infrastructures in Japan and much of Europe, and investments in new increasingly reflected in higher prices for imported goods, and as and modern facilities in many other countries. However, the earlier prices of domestically-produced competing goods are raised in U.S. productivity advantages were used to raise wages and Income response. levels substantially throughout much of the economy -- these Increases in wages have now produced an enormous disparity in labor (2) Barring even sharper declines in the dollar, a long period of costs, which, when combined with differences in capital costs, can relatively slow growth in domestic demand will also be necessary to no longer be Justified by productivity differentials. This bring the U.S. trade deficit down — each 1* decline in the growth deterioration in relative U.S. competitiveness is evidenced by the of domestic demand in the United states will reduce the growth in rise in the U.S. bilateral trade deficit with Japan and some other real imports by approximately 2%, thereby cutting the trade deficit countries during the late 1970s and early 1980s — several by about $8 billion per year (on a cumulative basis). I especially temporary factors, including surges in bank-financed exports to believe that growth in consumer spending will be sluggish for many Latin America and oil-financed exports to the Middle East, as well years, reflecting the effects of cutbacks in white and blue collar as an undervalued U.S. dollar (especially in relation to European employment and wages, and declines in the value of the dollar, on currencies), temporarily bolstered our aggregate trade performance household purchasing power (real wages already are stagnating, as at that time despite the deteriorating fundamentals. When these discussed earlier). This conclusion is reinforced by data temporary factors were reversed, the U.S. trade balance began to indicating that wages and salaries among the Job losers in recent worsen rapidly — enormous budget deficits and the overvaluation of years have been above the average in most cases, and that wages for 12 13 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis a large fraction of the new Jobs that have been created have been Economic Restructuring below the average. While the increase In prices caused by dollar It is commonly argued that the United States is now going through a weakness will help bolster profits, I do not expect this to major restructuring, from a largely manufacturing to a translate into larger wage increases or employment gains for at services-based economy, in the same way that it moved from agriculture to an industrial economy earlier. Furthermore, many many companies to rebuild profit margins* economy will begin to grow more rapidly. However, the industrial Implications of the Debt Buildup revolution came about primarily because of rising productivity in An normous and unprecedented buildup of debt has occurred in the agriculture (which freed resources!, and resulted in a shifting in Uni ed States during the last five years — during this period, resources to even higher productivity manufacturing. Thus, it tot 1 nonfinancial debt has increased at a rate more than twice as added to potential long-term economic growth. f*i as nominal GNP, pushing the total debt-to-GNP ratio up sharply aftr more than 30 years of stability. The rise in debt has The restructuring now taking place is in part being forced by far outstripped the growth in domestic demand, so that the adverse diminishing competitiveness in world markets, rather than because effect of the growing trade imbalance on real output explains only Of rising productivity. Moreover, while some of this shift is now a small portion of the rise in the debt/GNP ratio. Corporations, into high value-added and productivity activities, involving the households and the Federal Government have all significantly use of new sophisticated technology, a large fraction of new jobs increased their indebtedness during this period. are in relatively low-wage, low productivity occupations and industries -- this is holding down overall productivity growth. The These high debt levels may well limit economic growth for many current restructuring is also being accompanied by an enormous years, for the following reasons: (a) Delinquency rates for buildup in corporate debt, which potentially will reduce consumer loans, and corporate defaults and bankruptcies, have competitiveness even further las discussed earlier]. Thus, I increased sharply, indicating that at least a portion of the beli economy has become overburdened. Furthermore, for the remainder of taking place will produc significantly faster growth in the next the economy, the ability to continue financing a large fraction of five or ten years. current expenditures by borrowing has diminished greatly because debt servicing has increased significantly relative to cash flow W>ng-Term Growth Prospects and household incomes, in fact, there is evidence that the buildup The combination of poor underlying competitiveness in world markets of corporate debt in recent years is now causing cutbacks in and high debt levels, combined with relatively slow productivity capital spending — this will not only prevent a stronger economy growth, the continuing loss of high-paying Jobs, and other factors, in 1987, but could actually hinder growth in the longer term. It) gugge The large buildup of debt has been used primarily to finance budget that is now underway in tne United States may continue for many deficits, consumption, and financial transactions, rather than years. In particular, since some of the factors that permitted the investment -- thus, it will not yield improvements in productivity, rise in living standards during the 1950s and 1960s are no longer competitiveness, etc. that could increase potential growth, and as favorable, since the growth in two-income families and household generate higher incomes to both service the debt and stimulate debt will slow, and since the recent low inflation rate caused by a •pending, (c) The massive accumulation of debt in recent years has rising dollar and declining oil prices will not be repeated, been financed in part by borrowing from overseas -- the increasing spending can no longer grow at anywhere near the rate of recent cost of servicing this rapidly growing foreign debt will slow long-term growth by transferring dividends and interest payments deficit reduction, so that overall economic growth will not out of the U.S. economy. accelerate significantly. In addition, the difficulty in servicing the larger volume of debt may make future recessions more steep, especially since any further POLICY IMPLICATIONS Increase in defaults and delinquencies will weaken the already While many of our current problems cannot be easily addressed by fragile financial system (bank failures continue to increase even economic policy, I would nonetheless suggest the following: though the economy is still growingl. The corporate sector is especially more vulnerable to an economic slowdown, or higher (1) Budget deficit reductions remain essential. However: la) the interest rates, because it has not only been adding debt at record ceduction should be gradual so as not to further weaken the economj levels, but it has also been redeeming equity since 1984, making it in the short term (about 125 billion per year would be reasonable, more leveraged. The risks associated with the more highly producing a targeted deficit of about tlOO billion in 1991 rather leveraged corporate sector is being exacerbated by the increased than a balanced budget]. Thus, the current Gramm-Rudman-Hollings portion of bank lending to more risky borrowers. targets should be abandoned or ignored. (b) Budget policy should be formulated to address other priorities as well. Thus, some additional funding for education, rebuilding the infrastructure, 15 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Monetary Policy forum by by , 1201 FilttEnlhSliwt.N W , WisMnslO", D C 20005 (202) 822-04B7 increases should be designed in such a vay a ey o no ur shift the tax burden avay from upper-income groups as in recent rom external sources .e., o prces an e .. oar exchange rate) will make future deficits larger than would hav been the case. (2) There is no way that our competitiveness in world markets can FOB IMMEDIATE RELEASE CONTACT: Larry Chimerine be improved with one simple policy measure. It will require a 6&7-600D thorough evaluation of our educational system, our training programs, our military expenditures, our trade laws, etc. It is imperative that this process begin as soon as possible because of the long lag before new actions begin to have a material effect. MOBETAR* POLICY ANALYSTS FORESEE RECESSION IK '88 Trade legislation should focus on improving U.S. competitiveness and opening foreign markets rather than on protectionist devices. (3) All economic and tax policy actions in the future should be Washington, February 18 — Accommodative Federal Reserve evaluated as to whether they Improve U.S. competitiveness and growth prospects before enactment. Board policies may be the only thing standing in the way of a 1988 (4) As indicated earlier, I would strongly suggest that the Fed recession, according to a recent supvey of the Monetary Policy to maintain an accommodative monetary posture in the near term, CO despite the rapid growth in the basic money supply — in fact, some Forum (MPF). easing moves would be warranted if the economy becomes more sluggish. It will be necessary to slow down the growth in money Disappointed by considerably slower than expected economic and credit on a long-term basis, however. growth In recent months, forum members predicted a scant 3 percent gain in the GNP this year and the continued unraveling of positive factors in the nation's economy. Increasingly pessimistic about prospects for the economy, Forum members, on average, believe there Is a 65 percent ohanoe for a recession in 19B8. The key factor they cited was a maasive accumulation of government, corporate and personal debt that will goods. "The news about the American economy has changed remarkably little for some time," said Lawrence Chimerine, president of the Monetary Policy Forum and chairman/chief economist for Chase Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Econometrics. "Indebtedness at home, poor competitiveneas in inflationary concerns ought not to hamper the fed from supplying world markets, weak capital spending, and the need to reduce sufficient credit to move the economy forward. enorir.oua budget deficits will both hold down economic grouch and "Any tightening by the fed would affect housing and limit our options. Under these present conditions, any change in investment related industries," said Michael Sumichraat, Senior federal reserve policy that would result in significantly higher Economic Advisor, National Association of Home Builders. "Housing interest rates could cause a sizable recession in the nest several already shows a sharp 12 percent drop in permits in January years," Chlmerine stated. foretelling a future decline in this sector," said Sumichrast. While HPF members said that the weakening dollar would have Moat of the 'orum members who were aurveyed said that Paul some beneficial effect on U.S, industry and force the nation's Volcker uas their choice for the chairmanship of the fed. The 1987 trade deficit down to about $138 billion, this trend was not group would have difficulty finding a successor if he should step expected to reverse the larger negative forces at work. down. ^ "Probably one of the most important things we should be doing The Monetary Policy Forum is a group of 26 financial, is to Insist that the West Germans and Japan start to rev up their economic and business analysts, economies with forceful fiscal stimulus," said MPF member George Perry, Senior Fellow, of the Brookings Institution. In the meantime, Forum members said, the fate of the economy appears to he in the hands of the Federal Reserve Board. The HPF Furthermore, they aaid mat the fed should he most concerned about how to avert an economic downturn rather than about too much growth of the monetary aggregates. While they expect some increase in the GNP price deflator this year, forum members said that inflation would remain well under control and that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 The CHAIRMAN. Thank you very much, Mr. Chimerine. Mr. Heinemann. STATEMENT OF H. ERICH HEINEMANN, CHIEF ECONOMIST, MOSELEY SECURITIES CORP. Mr. HEINEMANN. Thank you, Mr. Chairman. I take a somewhat different view of the current economy than my friend, Mr. Chimerine. It seems to me that we have had a solid expansion in domestic demand now throughout this business cycle from 1982. From the end of 1982 up through the most recent quar- ter, growth in /eal domestic final sales was 4.8 percent, way above the post-war average. In the last 2Va years, which Mr. Chimerine made reference to, the growth has been 3.9 percent—slower, but still above the aver- age. In the last 5 or 6 months, we have seen a sustained and quite remarkable reacceleration in growth in payroll employment. Con- sumer attitudes, as measured by the Michigan survey, continue to be quite good. We have seen growth in the leading indicators accelerate close to a 10-percent annual rate in the last 6 months or so—7 months— compared to a growth rate of only 6 percent in the year ended June 1986. So I think we've got a lot of domestic momentum in the economy at the present time. There is forward motion, and the trade deficit, which has been the principal factor inhibiting expansion I think is now clearly starting to turn around. Now in this context of solid, if unspectacular, domestic expansion and the probability of some significant improvement in our inter- national sector, we have seen a very remarkable monetary accel- eration which you made reference to, Mr. Chairman, in your open- ing statement. GROWTH IN HIGH-POWERED MONEY Over the past 2 years—actually over the past 4 years, we have seen a systematic and progressive acceleration in the growth of what I call high-powered money—the reserve aggregates most closely related to the size of the Federal Reserve System balance sheet. We have seen a progressive acceleration in the monetization of the Federal debt. Total bank reserves, according to Fed data released last Thurs- day night, averaged $56.7 billion in January. That was almost 25 percent higher than the same month a year earlier. This is not an isolated phenomenon. This progressive acceleration has been going on for a long time. The average growth in bank reserves over the last quarter of a century is somewhat less than 5 percent. So we are running close to five times the characteristic behavior of reserve expansion over the last quarter century. It seems to me that over time ripple effects from this rapid ex- pansion of liquidity will inevitably spread throughout the economy. We already see debt rising much faster than GNP and I think that process will continue. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 Prices of imported products, other than oil, are rising at a rate of about 8.5 percent at the present time. With the recent weakness in the dollar I would expect that rate of increase to accelerate. Since imported products represent about 28 or 29 percent of the goods sector of the American economy, that increase in prices of import- ed products at the wholesale level will increasingly suffuse through our domestic price structure, in my judgment. I think the risk of general reflation is rising. I think our foreign creditors, who are quite sensitive to this inflationary potential, have become and will increasingly become reluctant to lend us the roughly $3 billion per week that we must borrow in order to fi- nance our imports. They will in fact lend us what we need, but they will not lend us those sums at prices we can afford to pay. I think we will see, absent some tightening of monetary policy, further declines in the dollar. I can see significant increases in in- terest rates and I can see the threat of a recession fairly close in the future. In my judgment, Mr. Chairman, monetary growth has already reached such an extreme level that correcting the excess will inevi- tably involve a significant real economic cost. As usual, those least able to bear it will have to carry much of the burden. However, further delay in bringing monetary growth under con- trol, in my judgment, would only increase those costs. I believe very strongly the issue confronting Congress, the administration, the Federal Reserve, and the financial markets is not whether in- terest rates will rise, but when and by how much. No one wants a recession and we all recognize the structural problems that Mr. Chimerine made reference to. However, notwith- standing the short-run costs, I think the Federal Reserve should take four actions. First, take immediate steps to reduce the rate of monetary growth in the high-powered reserve aggregates most closely related to the size of the Federal Reserve System balance sheet to levels consistent with the Fed's own stated but generally ignored guide- lines for non-inflationary monetary growth. Second, I think we have to reverse the drift in Federal Reserve policy back toward interest rate targeting. We gave it up in the late 1970's on clear evidence from the Fed that using interest rates for monetary policy targets had played an important role in con- tributing to the inflation of the 1970's. But we have drifted back there. Third, I think we should establish a single target for growth in the monetary base. The base is in effect a proxy for the Federal Reserve System balance sheet. It is similar to the target which the Bundesbank, the German central bank, establishes for what they call "central bank money." We should adhere to that target over some reasonable period of time. I think it is a mistake to publish multiple policy targets and then decide ex post to focus on whichever one happens to be performing in line with preconceived ideas about the level of interest rate. I think it is wrong to establish targets and then regularly ignore them. If targets are not going to be followed, they should not be published. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 Finally, the Fed should spell out clearly for the American public what the implications of a policy of easy money and competitive de- valuation really are. Any elementary economics textbook will tell you that this policy is designed to produce a faster rate of domestic inflation and a reduction in the relative real wage in the country doing the devaluing, namely, the United States. I think we have to make plain that if inflation does not speed up and relative real wages do not decline, then we will not get the im- provement in the trade balance which we all expect. I think we have to be clear that if the external value of the dollar declines, its internal value will drop as well. That is some- thing that investors need to be very clear about. VELOCITY I do not see any empirical evidence of any permanent, long-run change in the behavior of velocity. Velocity is always very volatile. The ratio of GNP to money supply is most effectively described by the term "white noise" in the very short run. However, I see no systematic, sustained evidence that there has been a permanent change in the long-run behavior of velocity. It seems to me that the Federal Reserve in layman's terms is printing money on the theory—or perhaps it's the hope or the prayer—that no one will ever spend it. And I think that is a simplistic and dan- gerous assumption. My colleague on the Shadow Open Market Committee, Robert Rasche, has done extensive research on the behavior of velocity. I would commend his work to you. I don't know whether it's actually in final published form yet, but I would commend his work to you. His conclusion: there has been no permanent change in velocity. We have had repeated warnings in the foreign exchange markets that declining real rates in the United States suggest a diminished incentive for foreign investors to hold dollar balances at today's price. We have seen a sharply declining dollar partially offset by rising levels of central bank intervention to slow that drop. The consensus forecast in Wall Street and here also in Washing- ton suggests that the U.S. current account—a $150 billion deficit which won't change very much in nominal terms this year—can be financed readily and without disturbance if real interest rates roughly decline by half this year. The Congressional Budget Office, for example, suggests that real interest rates, using the bill rate less the current inflation rate, will be about 2.1 percent this year compared to 4,4 percent last year. I think we have clear evidence in the exchange markets that that kind of an outlook will not be acceptable to foreign investors from whom, as I noted earlier, we must borrow approximately $3 billion per week in order to finance our imports. The record of monetary policy, Mr. Chairman, has been one of great volatility in recent years. In my prepared statement I put to- gether a little table reporting the year-on-year change in money supply since 1979, picking the extremes in the curves, the tops and bottoms. In the third quarter of 1979, money growth was about 8.3 percent; second quarter of 1980, 4.3 percent; second quarter of 1981, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 9.9 percent; fourth quarter of 1981, 5 percent; third quarter 1983, 13 percent; fourth quarter of 1984, 5.4 percent; and, if current trends continue, in the first quarter this year, the growth year-on- year will be about 17.3 percent. It seems to me with this kind of a volatile record, it's very hard to assess the impact of monetary policy on the economy. It's hard to see that a strategy of monetary policy that relies on progressive- ly larger oscillations in monetary growth will lead to stable macro- economic performance. I am particularly disturbed, Mr. Chairman, that since last Sep- tember short-term interest rates have shown a modest upward bias in the face of an average month-to-month change in total bank re- serves something over 30 percent. Now something is wrong if inter- est rates go up in the face of that kind of an injection of liquidity into the banking system. This is not—and I repeat—not a short-term phenomenon. The sustained decline in interest rates since 1984 has been systemmati- cally associated with accelerated rates of expansion in all of the relevant monetary measures. When and at what level of growth in high-powered money will this process come to an end? 50 percent? 500 percent? I don't know, and we don't have much guidance from the Federal Reserve. The Fed's rhetoric against inflation is vigorous. But its actions go in the opposite direction. [The complete prepared statement of H. Erich Heinemann fol- lows:! Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Statement by £ H. ERICH HEINEHAHN Second, eliminate short-term interest rates as targets for nonetary on Banking, Housing and Urban Affairs their principal means for implementing policy. United States Senate Third. establish a target for growth in the monetary base and adhere February IB, 19S7 to it over a reasonable period of tine, say, one year. The Federal Open Market Conmittee should not publish nultiple policy targets, and then decide to focus on whichever target appears consistent with the FOMC'9 preconceived ideas about interest rates- The Fed should not establish to publish targets and subsequently disregard then. Mr. Chairman, we are neeting at a crucial point in the history of the Fourth, play fair with the American public. Let people know that the Federal Reserve System. For more than two years, the Federal Reserve - current policy of easy money and competitive devaluation has been designed to Federal Reserve data, total reserves in the American banking aysten relative real wages do not decline, then the U.S. trade balance will not averaged S56. 7-bill iaci, 23.3 percent higher than the aave noDth Isst improve. Come clean that if the external value of the dollar declines. reserves over the past 25 years was a little less than 5 percent. The background for these recommendations is straight forward: The Keep in mnd that the effective reserve requirement in the U.S. 23.8 percent rate of gain in total bank reserves over the past year was almost $36 of additional deposits and/or loans and investments- Anerica than the United States. Moreover, despite the Fed's efforts to flood the markets with noney, short-term interest rates have shown a Over time, ripple effects from this rapid expansion of liquidity will modest upward bi apread through the economy. Total debt will continue to increase nore rapidly than GNP. Prices of imported products will rise. The risk of the *3-billion per week that we need to balance our books. They will lend ua what we need, but not at a price we can afford to fay. The dollar will decline further. Interest rates will rise. Another recession will loom have been at exceptionally low levels in recent months Will the pattern of the recent past continue? Many people believe Mr. Chairman, monetary growth has already reached such an extreme so. A widespread complacency about monetary policy has developed both income velocity of money (the ratio of GNP to noney supply), has dropped. Many think it will keep on dropping. In popular terms, the Fed can print all the money it likes, but no one will spend it - at least, not to The obvious short-run costs notwithstanding, I believe the Federal unsupported by enpiricat analysis. As my colleague Robert H. Hasche nf list. Once allowance is made for the break in the cepts." In layman's language, if the Federal Deserve prints money withi Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The U.S. dafic been expanding within their anignad target range*. ID •)• Judgment, the One. the linge aluation of the CoO vaitors poured roughly *200-billion into mituel funds lait year. Much of (rom « Pro.iu r and how fast it will spread. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -5- -6- Mr. Chairman, one of government'a bedrock responsibilities - not On2 s~ This ia not , 1 repeat, not, a ahort--teru phenomenon. The auBtained honest money. "Honest no^ey," by any realistic definition, ia money with with accelerated rates of expansion in all of tbe relevant monetary MONET SUPPLY BBOHTH BATES Period Ended change "We have an Adminia tret ion, " Mr. Slocfciian added, "trbat is conducting Third Quarter 1979 8.28* currency. He have an Administration that articulated a supply-side notion Second auart*r 1930 4.31 at how you get economic growth and wealth creation no* ainply resorting to Second QuartTr 1381 9.90 international demand stimulation." Fourth, Quarter 1331 5.00 Third Quarter 1383 13.04 I hope that Mr. stockman's peasimatic assessment is not correct. Fourth Buarter 19B4 5.44 But I fear thai it may be. First Quarter 1987 17.30 (E*t.) Several years ago, Herbert Stein, former chairmkn of the President's rnl Reserve constantly running from one aide of the Council of Eeononic Advisera, took the federal Reserve to task for its of monetary policy on the econooy. The risk that we the Fed ia committed to any lang-rua objective," With due allowance for should take a broader view. Congress can maka a lasting contribution t On Peter Sternlight. ia faced with a choice on a given day between maintain- ing a defined growth path for bank reserves and a defined level of inter- than 30 percent. The Fed has hsd to flood the market with high- red noney to keep interest rates fron rising even more sharply. To us Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 mnn ACTIONS -1960-1986 1 a* 5'/i' Total Bank ,-vA / Reserves . , Vl , M A/ \ \i fj - . / Vj 5>! V / V C.j 196B 1963 19&S 1969 1972 1975 1978 1981 1984 Motes: The chart shows rates of change in total bank reserves at constant reserve ratios, The horizontal line shows the average rate of change, 1960-1986, Vertical lines show periods of recession. Source: Heinewann EconoMic Research THE VOLATILITY OF MONETfiR^ EVPANSION I960 1963 1966 1969 1972 1975 1978 1981 1984 1987 Notes: The chart shows deviations frow trend (1947-1986) in year- Qver-yea* changes in the namely-defined «oney supply (H-l), In percentage points. Vertical lines show recessions. Source; Heine«cinn Econonic Research Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 The CHAIRMAN. Thank you, Mr. Heinemann. Dr. Meltzer. STATEMENT OF ALLAN H. MELTZER, JOHN M. OLIN PROFESSOR OF POLITICAL ECONOMY AND PUBLIC POLICY, GSIA-CARNE- GIE MELLON UNIVERSITY Dr. MELTZER. Mr. Chairman, in the 25 years I have appeared before this committee and talked to you and your colleagues about monetary policy and the economy, there are few periods in my judgment which have been as critical as the current period. I want to discuss two topics with you. First, is the monetary policy which is the subject of these hearings; and, second, the prob- lems of trade and debt, a critical national issue and one which will make a great difference to the living standards of our population for years to come. Let me begin with monetary policy. In my opinion, we are back to the fast-break and slam- dunk monetary policy of the past with a vengeance. Whatever state- ments may be made to the contrary, we are printing money at a shameful rate. This policy is counterproductive. It is going to cause more prob- lems than it will solve. DEVALUATION OF THE CURRENCY Our problem is not solely with the Federal Reserve. The Treas- ury seems to know no solution except devaluation of the currency. The administration has not had the judgment to offer policies other than devaluation. It acquiesces in faster money growth in the hope that it will relieve the current problems of trade and debt. The Congress has not required disciplined monetary and fiscal policies. It has not demanded that the Federal Reserve adhere to its policy announcements. It has not insisted that the Federal Re- serve choose a target that it can control and then carry out the policies which it announces at these meetings. Elsewhere in these halls, the Congress is investigating the damage to the United States caused by our policy toward Iran that occupies the headlines. The cost to the American people of the Iran problem is small compared to the policies of inflation and devalu- ation and the effects that those policies will have on the living standards of the American people. I fully share your view, Mr. Chairman, that the hearings that you are holding are critical hearings, and the policies that you are discussing are critical, not for the short-term outlook for the econo- my, but for the longer term, for the living standards of the Ameri- can public. These policies—the policies of monetary expansion and devalu- ation—can only work to the extent that they reduce the living standards of the American public and raise the cost of consumer goods to the American public. Whatever Mr. Volcker may say about his concerns about dollar devaluation, the agency he heads has worked toward that goal and is working toward the devaluation of the dollar by printing money at an extremely rapid rate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 There is, in my opinion, no other way to explain the devaluation of the dollar, in face of the sluggish performance of the rest of the world economy compared to the U.S. economy, other than the fact that the United States is contributing to the devaluation by an ex- traordinarily high rate of monetary growth. Let me examine the policy from two aspects. First, can faster monetary growth and monetary devaluation solve the trade prob- lem? The answer is no. The problem is a real problem, not a mone- tary problem. It arises from spending, mainly for consumption, in excess of production in both the private and the public sectors. As a nation, we spend too much relative to what we produce. We borrow to pay for the excess of consumption—mainly consump- tion—leaving debts to the future that will to have to be paid out of incomes that we earn in the future. That's where the drop in the living standard will come from, In the future, we will leave a large debt and that debt will have to be paid by people working more and consuming less. In order to service our debts we must in the future produce more than we consume. Inflation can contribute to the solution, but only for a time and only by fooling people and reducing their living standards. Eventu- ally, we will pay for the inflation with a painful period of disinfla- tion that the public will demand. We will be poorer as a result of that policy. Mr. Chairman, on all sides we hear voices urging faster money growth claiming that the economy is weak. This, in my opinion, should be labeled as hokum. Faster money growth stimulates demand. Our problem is not demand. Demand and spending has grown rapidly, above the average rates of expansion for most post- war expansions, and demand continues to grow rapidly. SPENDING FOR CONSUMPTION Our problem is that we are not producing domestically the goods to satisfy that demand. We are importing them from abroad. Con- sequently, we have a large trade balance. Our problem is that we are spending most of the money that we are borrowing for con- sumption, not for investment. If we were spending more for invest- ment, we would have the resources in the future to retire the debt that we have put out and to service that debt. Because we spend mainly for consumption, we live better now at the expense of the future. Because the Government budget is devoted mainly to consump- tion and not to investment, there, too, we are borrowing to spend for consumption. We must look behind the paper veils of the deficit and the mone- tary growth to ask about the use of resources in this country. Our use of the resources is principally for consumption, which runs at a near record rate, while net investment runs at one of the lowest rates of the postwar period. Our problem is, as I have said, that we consume too much rela- tive to what we produce. We cannot solve that problem by faster money growth. Nor is it true that faster money growth can solve the problems of the farmers, the real estate operators, the oil patch, the insolvency Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 of the thrifts or the international debt. Faster inflation will be a temporary palliative, but it will bring us back the same kinds of problems that we had in the 1970's. Many of the problems to which I referred are the result of infla- tion. A high rate of inflation encouraged people to borrow and bid up the prices of assets; then a severe and rapid disinflation brought down those asset prices and left people who had invested based on the expectation of a continuously high inflation—left them holding assets which were of lower value than they had anticipated. The problems of farming, real estate and so on are largely a con- sequence of the slam-dunk monetary policies of the past 10 or 15 years, policies which are now returning. Senior policy makers brought the inflation down, in my opinion, too quickly. Once inflation was brought to the 3 to 4 percent range, they believed that the problem was largely over. That, of course, was a mistake, a mistake that has been often repeated in monetary history. The rate of increase in output prices had adjusted downward, but asset prices had not. The adjustment of farm prices, oil prices, land prices and real estate prices to the lower expected rate of inflation is the cause of many of our current problems. It is a mistake to restart inflation and to bring back the problems of inflation and drainflation 5 or 10 years from now. Having paid a high price to make part of the adjustment, it is a mistake to reverse direction, restart the inflation, and suffer an- other round of slam-dunk policies. Yet that, it appears to me, is what we are doing. Most of my written statement is concerned not with the prob- lems of inflation but with the problems of trade and debt. Mr. Chairman, we must recognize that these problems are inter- related. By the end of this decade, the United States will owe I think on a conservative estimate somewhere between $600 and $900 billion to foreigners. In 4 years, we have moved from being a net creditor position of $150 billion to a net debtor position of $200 billion or more. In 4 more years, I estimate we will add another half a trillion dollars to our foreign debt. We will be paying inter- est of $60 billion a year to service that debt. We must earn that interest by producing more than we consume. My calculations suggest that as a Nation we cannot turn the trade balance and pay the interest to foreigners that we will owe without reducing both our relative and possibly our absolute standards of living. Most likely, both. In my written comments I discuss four solutions. Each is painful. In my opinion, the least painful is to adopt policies that increase productivity. We must invest more and consume less, both publicly and privately. In my opinion, we should institute policies of this kind promptly. We should tax consumption and remove taxes from investment to reduce private consumption and increase private in- vestment. We should cut Government spending for consumption and in- crease Government spending that encourages productivity by build- ing infrastructure and helping the productivity that will promote better jobs and higher productivity in our economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 We should stabilize policies, provide greater certainty about the future. We could look to Japan as an economy which has relatively stable policies and much lower interest rates as a result of the lack of the risk premiums. There is much greater certainty in Japan about what the Government is going to do, and we might look at the fact that Japan, a nation which is consuming far less than it produces and exporting the balance, is shifting its tax rates in a direction that I think we should be shifting ours—removing taxes from investment and shifting them onto consumption. We should be doing the same and more, We should develop different and more useful approaches to the Latin American debt. I discuss some of these in my paper. The United States is a debtor country now. It cannot lend to Latin America so that Latin America can solve its problems unless we sell assets or borrow to make those loans. As a net debtor and a borrower in international markets, when we borrow to lend to Latin America that adds to the U.S. debt and the interest we must pay in the future. This is a critical period. I believe we are in danger of slipping back into the chaos of the interwar period. For 40 years, the United States used its wealth and power to provide a political, fi- nancial and trading order. Our relative wealth and power has di- minished. We are embarked on a course likely to weaken our abso- lute position. We have given little thought to who, if anyone, will provide stability in the world in which we now live. Today, we are discussing monetary policy and economic policy. But the more general subject is the world financial and trading system and further removed the political stability of the world. It is a serious mistake to sacrifice that stability, as we have, without knowing what will take its place. But that is what we are doing and we will come to regret it. Thank you, Mr. Chairman. [The complete prepared statement of Allan H. Meltzer follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis net foreign assets of nearly J150 billion, as at the end of 198S, we had net foreign debts of more than $200 billion at the end of 1986. Large borrowing will continue even or the most favorable assumption. By the end of the decade TRADE AND DEBT we will owe foreigners between S600 and $900 bilti'on, By Allan H. Heltzer These numbers seem large in an absolute Sense, and they are. The U.S. is a wealthy country, however, with assets of from $10 to $15 trillion and with gross foreign assets of H trillion ar more. Visions of U.S. citizens living Few subjects have received is nucti cement 1n recent years as the so- in hones, or working in factories and office buildings all of which are owned called twin deficits in the Federal Budget and in net exports of goods and by foreigners remain; far from reality. services. Many eCdrtomltti and most politicians po nt out the dire Still, there fl a sense of unease. We accumulated the stock of foreign consequences of the budget deficit for the future of the >conomy and of the assets over a period of 70 years. In Just four years, we have wiped out the trade deficit for the Future of domestic manufacturing. The deficits are net accumulation of several generations. filanW for Sigh Interest rates, weakness In manufacturing output and sluggish Should we he disheartened and ill at ease? Are a foreign debt and trade growth of employment at home. deficit of this sire good or bad for the economy? The answer depends not on Vet, despite the frequent discussion of these deficits for four years, mainly the size of the deficit but on how the resources obtained through the central problem has escaped attention. Few have tried to look through the borrowing and net imports are used. If our borrowing financed a high rata of paper transactions to the reality that lies below. Mad this been done, the productive Investment, the returns on the Investment would pay the interest deficits «ould appear as symptoms—not causes—of the problems of the J.S. and principal. Our future standard of living would be higher. Since economy. And. while there are no easy solutions, some of the proposed borrowing is used nalnly to finance consumption, we live better now but leave CO solutions—protection, currency devaluation, easier monetary polfcj-, general a debt to be serviced and paid in the future. At some time, we or our tai Increases—would be seen to be mistaken or less attractive-than some children will be faced with two options. available alternatives. Since our international borrowing 1s denominated in dollars, one option is to reduce the reil value of the debt by inflating faster than people now THE PROBLEM believe likely. Increased Inflation reduces the real cost of paying interest on the debt. Inflation Imposes a large cost on the foreigners who bought the The main econrmic problem is that as a nation we consume too much bonds and, as recent experience with inflation and disinflation shows, there relative to "hat we produce. The excess of spending over production shows up are large costs at home also. The precise effect on International monetary In the national accounts and affects both deficits. The government spends arrangements of anotner period of U.S. inflation cannot be predicted. A new mainly for consumption—health, welfare, most of defense spending—and very monetary arrangement may emerge, or we may return to the chaos of the 1930s. little on Investment. Privately, the share of spending for consumption The second option Is to service the debt without inflating. This remains near the highest rate we have enperlenced, while net Investment requires producing more than we consume and selling the surplus abroad to pay remains at a very low rate. To maintain spending In excess of production, we the Interest on the foreign debt. This option requires a trade surplus for sell assets and borrow abroad. The counterpart of this borrowing fs the trade the U.S. large enough to cover net interest payments attroad. Using an deficit--net Imports from abroad. For the last year, net Imports have interest rate Of 8* and a net foreign debt of $600 Sillion to 1900 billion, remained at about 2.5* of total output—about $150 billion 1n constant 1982 our trade surplus has to remain at $50 to $70 billion per year indefinitely, dollars. a larger surplus In any year would reduce the debt and future interest In the past four years, we have borrowed so much that, instead of owning Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis payments; a smaller surplus would add to the debt and raise future interest Importers from the U.S. and other debtor countries If the debts are to be payments. serviced. To Illustrate, Japanese and German trade surpluses equal to 1% of The change from net Imports of 'ISO bill Ion to net exports of $50 to $70 ttwlr 1990 output would provide only 175 billion toward any deficits and ft mi on requires a major shfft In world trade patterns and resource use. interest payments of the U.S. and other major debtors. This is about one-half Because the debt remains outstanding, the shift to a surplus must be the amount of 1990 interest payments of these debtors. permanent. A shift of this size, though large by current or past standards Is Many observers who discuss the twin deficits appear to reach conclusions not large "in comparison to the dze of the U.S. economy. A trade surplus of that are superficially similar. They urge monetary enosnslon by Germany and 160 billion by 1990 will be less than lyi >»f resl GUP In that year. Japan to lower Interest rates and stimulate demand for our exports. Others The problem cannot be solved 1> isolation, however. Me are not the only urge monetary expansion by the federal Reserve to depreciate the dollar or ijabtor. Hany other countries haire lebts that must fie serviced also, so these monetary expansion In all three countries and oerttips eKe*here. These are stop gaps, not solutions. They work by putting the bandald of additional currently close to $1 trillion. This Units our options. For example, we demand on a problem that requires adjustment of costs and prices of exports Cinr*t expect to solve-our problem by Increasing net exports to Latin American and imports. They offer short-term, not long-term, solutions. debtors unless they increase their net exports, to Europe and ftsia. dor, can The problens of trade ami debt are not mainly problems of weak demand. we continue to be a net lender to Latin America to finance their trade and Output growth In the U.S. has not been held back by weak domestic demand. development. Every dollar we lend then has to be borrowed from the rest of Consumer demand has been strong, but a large part of the demand has Been the world or earned by exporting more than we Import. satisfied by imports. Faster money growth abroad can produce a temporary There is no way to avoid the conclusion that. If the debts accumulated In spurt (n world demand, an Increase in U.S. exports and a reduction In the the seventies am) eighties are to be serviced, there must be a major change in trade deficit. But, faster coney growth abroad cinnot so We the long-term 00 trading patterns and, therefore. In ecooontc ind trading relations. The U.S. problem} of trad* and debt. And, By increasing Inflation, faster money growth must becone a large net exporter to Europe and especially to Asia. Europe and sets the stage for another period of disinflation and another round of stop tela mist becoro net Importers. The postwar strategy of export led growth to and go that will make the problem harder to solve. finance Investment in the countries if Europe, t,s1a end parts of Latin America wa( highly successful. Standards of living rose. That strategy must change to reflect the debtor position of the United States. The magnitude of the required change Is Inpresslve. Currently, the U.S. To eliminate the trade deficit and service our debt, we must lower costs exports about S£00 billion and Imports more than 1350 billion. Closing the of production relative to prices. There are four options. None offers an 9ip between exports and imports and paying the Interest on its debt is easy, attractive solution. Each dea's in a different ••aj *Uh the problems of equivalent to doubling the amount Of current exports (In constant dollars) by trade and debt. 1990, or reducing current Imports by more than one-half, or SOIK combination We car Inflate, as many now urge. Inflation lowers the value of the debt of the two. These amounts are about 10* of total current world exports and, and devalues the dollar. Ths decline in the value of tha debt transfers perhaps more relevantly, more than three tines the average trade surpluses wealth from the rest of the world but, sooner or later, Inflation raises all (with all countries) nf the two principal surplus countries--Germany and prices Including Interest rates and wages. The rise In wages and other costs Japan. Mucti of Germany's surplus is earned within the European Economic of production offsets the effect of the devaluation on trade. To reduce tne Community, while much of Japan's surplus coraes from trade with the U.S. it trade deficit permanently, we must reduce the cost of domestically produced becomes clear that these countries must become, for the first time, large net goods. Inflation not only does not solve the trade problem but, by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis encouraging consumption, it iwkes the problem worse. We can protect against imports using quotas, surcharges and perhaps tariffs. This 1 iwers spending on imports but invites retaliation and shrinks The problems of trade and debt require that we produce no's relative " tne amount of world trade, ft lower level of trade makes more difficult tne task of squeezing out S60 billion to pay interest on our foreign cebt. In the debt. The four options take different approaches to -.he :oc ?ti. addition to all the other, well advertised disadvantages of trade Inflation does little to solve tne trade problem. Devaiuatlor (in -ea' terms) restrictions, we must add that they are in a real sense counterproductive when ami protection solve the uroDlem by lowering standards of >i<ing at icme we view the trade and debt problems as a whole. reiat've to living standards abroad. None of these options work; to irc'aase Vie output and productivity. A general tai increase to reduce the bucget oe'icit years. A real .evaluation, unlike inflation, raise; prices relative to costs would raise the tax on investment to maintain government spending on of production. The rise in prices makes our eiports cheaper, our imports Consumption. This is the opposite of a policy to close the gaa between dearer. This method of adjustment, like protectionist policy, reduces Spending and production by increasing production. It is oniy oy adopt!ng standards of Jiving relative tt> foreigners and perhaps in absolute terms. We measures that increase productivity that we can hope to service our debt whi'e cannot avoid devaluation, but we shou'd avoid policies aimed at manipulating Shifting output from domestic use to exoorts without increasing frfTation and- e*c"ange rates and "talking the dollar down." without permanently reducing standards of living relative to foi-eigners and, We can increase productivity. Thsre are many ways to do this, none easy Herhaps, absolutely. Reductions in government spending on consumption, higher to accomplish. At the national level, the four most important policy changes taxes on private consumption and1 lower tdies on ini-estfflent and capital shifts In my Judgment, are: (1) without increasing taxes, shift taxation from capital resources toward Investment and raises productivity. to consumption so that tne share of consumption spending falls and the share A few numbers bring the problem irito perspective. Interest payments By 05 of capital spending rises to levels substantially above those achieved in the the end af the decade nil) be about 1>& of real output. If real output grows last twenty years; (2) reduce government spending, particularly consumption at an average rate of 2*ft to 11, per year, output per capita will rise at no spending and. If possible, shift government spending from consumption to more than 2% per yfcar. The interest payments absorb all, or most, of the productivity enhancing investments (n Infrastructure; (3} make a commitment to increase. In addition, we must eliminate the current net exports deficit of maintain these policies--and a long-term pro-growth strategy— tc reduce 2\%. uncertainty about future after tax returns to Investment. Elements of this Tliese numbers imply that per capita incomes do not rise to the <^nc ;je t-e Strategy include more deregulation, Ifss costly mean; of reducing pollution, decade, and may fall. If such a fall is to be avoided, the soticns must enforcing product liability, safety and health. (4) Shift from a policy of include more than inflation, protection and devaluation. A pro-competitive, lending to foreign debtors to a policy of encouraging repatriation of foreign pro-growth policy achieved through a permanent change in taxation must se part capita' and dsbi r-eductlon hy foreign debtors. It makes little sense for a of our policy. This policy does not avoid a reduction in current consumption, debtor country, the J.S., to borrow and sell assets to finance loans to Latin but by increasing output per worker, it assures that tfie reduction is American debtors. Instead, we should encourage Latin Americans to sell equity temporary, not permanent. in their large state sectors or to adopt policies that attract some of the There is no easy way out. Selling assets buys t'me, out something must capital held abroad by their citizens. Oe done with the Mure that *e tuy. To avoid having all =f the problem solved by permanent'y reducing the real wages of American *orke--s 3rd -^he real incomes of American consumers, through inflation, deva'uatisn and protectionist policy, we must begin, now, on a sustained effort to increase Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis productivity. A Shift of taxes from capital to consumption is an important first itep. If we could add just one-half percent to the average growth rate for the next four years, we would have 1100 billion more awaHsole for consumption, exports and investment in 1990. Much depends an our cfcclces. For the past forty years, the United States haj Nad the relative wealth and power to maintain or impose a degree of political, economic and trade stability on much of the world. We have not always succeeded; we have made mistakes; but, we Have Molded tlie return to the disorder that characterized the Interwar period, particularly the 1930s. If iie solve our problems of trade and debt by reducing our relative wealth, we move to a position of co-equal 1n a multi-centered world. Hew arrangements must develop for sharing responsibility for defense, finance, trade and the nraintenance of such ord«r li can be provided. We have done little to develop arrangements commensurate with the reduced role that our relative wealth and power will bring. If we fall to Increase productivity, sued planning Is essential to avoid a return to the uncertainties of the Intsnuar period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 The CHAIRMAN. Well, thank you very much, Dr. Meltzer. Dr. Roberts. If I could interrupt just for a minute, without objection, a state- ment by Senator D'Amato will be inserted in the record at this point, and I apologize. Go right ahead, sir. STATEMENT OF SENATOR ALFONSE M. D'AMATO I commend the chairman for inviting the witnesses to appear today, one day before Federal Reserve Board Chairman Paul Volcker is scheduled to testify. This morning's testimony should provide the committee with an appropriate context through which we can evaluate the content of Chairman Volcker's remarks. The testimony from today's witnesses reemphasizes several points that have been made to the committee in the past regarding the stability, or should I say the relative instability of our domestic economy. Today's testimony substantiates the assertion that eco- nomic forecasting is hardly a precise science. However, certain steps must be taken by the Congress, the President, and the Feder- al Reserve Board to ensure continued and stable economic growth. If the economy continues to grow at a moderate rate and if we are going to introduce more stability into the domestic and interna- tional economies, then Congress must address two problems that no longer loom on the horizon—these problems are at the front door. The first problem is that the Budget deficit must be reduced in a rational and least painful manner as possible. The deficit issue has become a political football with the Congress blaming the President and the President blaming a profligate Congress. Such accusations tend to exacerbate rather than resolve the problem. I am interest- ed in the testimony of Paul Craig Roberts who introduces in his testimony another culpable party in the deficit debacle—the con- duct of monetary policy by the Fed. I hope he will elaborate on this point during the hearing. I also hope each of our witnesses will offer their recommendations on how the budget deficit may be cut and whether they think Gramm-Rudman is effectively accomplish- ing its intended goals. The second problem confronting our domestic economy is the trade deficit. Frankly, I am tired of hearing the same old argu- ments about how Americans can't compete; the unions have priced American heavy industry out of the market; and America is losing its technological advantage. I believe these arguments and those advancing draconian protectionist legislation ring hollow when one takes a real look at what's happening to American industry. American Industry is at the forefront of innovation. U.S. compa- nies spend billions on innovation each year and develop new tech- nologies. However, before these new technologies can be put to practical uses, we find that our foreign competitors are using the same technologies, in practical uses, at lower costs. How can they do this? Easy, many of our competitors are stealing us blind. During our last hearing on the Federal Reserve's monetary policy report, I stated that our so-called trading partners: Steal our patents, intellectual property rights, systematically are adjudged guilty in the courts, say we're sorry, pay back penalties, continue the same thing, infringe on patents and then send the products here into the United States. Further, those harmed have limited recourse under the current legal system. At present, even Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 though your copyright may have been infringed or your patent stolen you must then demonstrate that there is substantial danger to the particular industry, before damages can be awarded. Despite the failure of the laws and trade policies pursued to date we hear, oh, yes, we're going to make changes. We've been waiting a long time for negotiations or other bilateral approaches to work. We wait in vain. It seems to me, absent any legislative action or some very real enforcement of present trade practices, the policies of the Japanese and others will not change because they lack any incentive to change. I have not changed my point of view on the subject. I should also note that Chairman Volcker supported my notion of the cause of such competitive trade imbalances and urged us to act. I am sorry to state that in the drive to make America more competitive, we and the Administration have yet to consider the steps needed to make technological piracy more punitive. I look forward to the testimony of today's witnesses and would hope they shed some light on the accuracy of the Administration's predictions about GNP growth and the chances of increased infla- tion if the Fed continues its current monetary policies. STATEMENT OF PAUL CRAIG ROBERTS, WILLIAM E. SIMON CHAIR, POLITICAL ECONOMY, CENTER FOR STRATEGIC AND INTERNATIONAL STUDIES, GEORGETOWN UNIVERSITY Mr. ROBERTS. Thank you, Mr. Chairman. Monetary targets fell into disrepute in the 1980's as Ml lost its predictive quality. I think it would be mistake to conclude from this that the targets don't matter or that money doesn't matter. To the contrary, the main reason for the large budget and trade deficits today is that the Fed followed an overly restrictive mone- tary policy in 1981 and that it had an inappropriate target in 1982, one it was forced to abandon after mid-year in order to combat a severe recession and a foreign debt crisis symbolized at the time by Mexico's inability to pay its foreign creditors. In discussing the economic outlook, many people often speak as if everything depends upon fiscal policy. This has particularly been the case in policy discussions about the U.S. budget and trade defi- cits. If belief in the primacy of fiscal policy gets out of hand, it could downgrade the importance of monetary policy and the over- sight responsibilities of this committee. In my opening remarks I provide an empirical demonstration of the power of monetary policy. Indeed, whether or not the fiscal ac- tions of Government produce the desired results depends upon whether or not the Fed conducts monetary policy in keeping with the monetary policy assumptions in the budget. GROWTH RATE OF NOMINAL GNP The key to any budget forecast is the assumption made about the growth rate of nominal GNP. If the Fed conducts monetary policy in a way that causes the inflation rate and the real economic growth rate to diverge from the assumptions or goals in the Gov- ernment's budget, the Government will collect either more or less revenues than it expected, and it will spend more or less in real terms than it intended. In the 1980's inflation fell relative to expec- tations, causing the Treasury to collect less revenues than expected Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 and causing the Government to spend more in real terms than it intended. As tables I and II in my testimony show, the conduct of mone- tary policy is resposible for about 46 percent of the buildup in public debt during the 1981-86 period. Mr. Chairman, the collapse of inflation was a good thing, but it was nevertheless hard on exporters, farmers, the energy industry, and the deficit. The powerful disinflation cut more than $2.5 tril- lion from nominal gross national product over the 1981-86 period. The budget effects of this are shown in table II. I will pass over those in the interest of time. The same unexpected disinflation that caused the budget deficit also caused the dollar's rise in value and the U.S. trade deficit. It is impossible for the inflation rate to unexpectedly drop from double- digit rates back to the low single-digit rates of the 1960's without the dollar rising in value. The Fed should have understood that it cannot simultaneously make the dollar a more desirable currency in which to hold assets and fail to meet the increased world demand for dollars without the dollar rising in value. As chart I in my testimony shows, the dollar has consistently risen with decel- eration in the growth rate of money and fallen with acceleration in the growth rate of money. The same tight monetary policy that drove down inflation and made the dollar more desirable also curtailed the supply of dollars. The result was a steep rise in the dollar's price, or exchange value. The Federal Reserve did not accommodate the higher world demand for dollars, thereby keeping upward pressure on the dol- lar's value. In 1984, the Federal Reserve again tightened, simulta- neously taking the bloom off a robust expansion in the real domes- tic economy and driving the dollar higher. In the face of the abrupt change in U.S. monetary policy and in- flation, nothing could have prevented the rise in the dollar. Indeed, not even large budget deficits, which normally depress a currency's value, could prevent the dollar from rising. Smaller deficits would have added to the confidence factor and driven the dollar even higher. ACCELERATION OF Ml Turning to the current situation, since the first quarter of 1985, money growth, as measured by Ml and total reserves, has acceler- ated. I am not convinced that these growth rates are signs of an inflationary policy, but many people have interpreted them that way and rapid money growth can explain the decline of the dollar without anything having been done about the budget deficit, which was supposed to be the cause of the high dollar. Another explanation for the dollar's decline is that a new liabil- ity has risen to take the place of double-digit inflation in depress- ing the value of the dollar. That new liability is the buildup in debt owed to foreigners as a result of the trade deficit caused by the sharp rise in the dollar's value in 1981 and in 1984. As our debtor status deepened, the dollar turned around and began falling. Mr. Chairman, to work our way out of our trade deficit requires not just a weaker dollar but an expanding world economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 We might not get one. Now that the dollar's decline is the focus of attention, the Federal Reserve is feeling pressures to raise inter- est rates to save the dollar and forestall a renewal of inflation due to rising import prices. I am not confident that the debt structure at home and in the debtor countries that owe our banks so much money is strong enough to accommodate a tightening of monetary policy. I am not confident that the economy is robust enough at this point to stand monetary tightening. There seems to be enough evidence that we are still suffering the effects of severe deflation from past monetary policy. Commodity prices have not broken out on the upside, capacity utilization is not high, and the latest Fed data show a continuing deterioration of the farm banks despite the massive federal subsidies to farmers. In general, I am somewhat skeptical the economy is strong enough at this point to stand tightening. Mr. Chairman, I have in my testimony comments about the growth of Ml and total reserves. I am not certain that these are reliable indicators for reasons that I indicate. I note the continuing decline in velocity and note that that decline is somewhat ambigu- ous because it can fall for two reasons. It's not always clear which one is the reason that is operative. I look at some other monetary indicators and see less rapid accel- eration in the growth of money than Ml indicates. I am not a monetarist, but I do believe that money matters. If monetary policy is going to be guided by money targets, they had better be the right targets, and the Fed had better hit them. Other- wise, the Government's economic goals and deficit targets are not going to be met. So far in the 1980's, the Federal Reserve has large- ly countermanded the Reagan administration's supply-side policy. The benefit of the Fed calling the shots was a more rapid than in- tended deceleration of inflation. The costs are the large budget and trade deficits and the severe debt crisis that stretches from the American farm community to the Third World. The breakdown in the monetarist relationships upon which the monetary targets are based may only be temporary. However, in view of the doubts about Ml and the actual conditions in the world economy, the Fed had best watch, for a time at least, a broader range of indicators than monetary aggregates provide. The behav- ior of commodity prices, the real growth rate of the economy, sec- toral strengths and weaknesses, consumer behavior, business confi- dence and investment, the growth of the world economy, all bear close watching. Without many signs of real strength, it could be a disastrous mistake to tighten monetary policy on the basis of Ml growth and speculation in the exchange markets that the Treasury wants a lower dollar. Mr. Chairman, That completes my opening remarks. [The complete prepared statement of Paul Craig Roberts follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Mr. Chairman, members of the Committee, monetary targets fell into disrepute in the 1980s as Ml lost its predictive quality. I think it would be a mistake to conclude from this that the targets don't matter or that money doesn't matter. To the contrary, the main reason for the large budget and trade deficits today is that the Fed followed an overly restrictive monetary policy in 1981 and that it had an inappropriate target in 1982, one that it uas forced to abandon after midyear in order to combat a severe recession and a foreign debt crisis symbolized at tha time by Mexico's inability to pay its foreign creditors. In discussing the economic outlook, many people often speak as if everything depends on fiscal policy. This has particularly been the case in policy discussions about the U.S. budget and trade deficits. If belief in the primacy of fiscal policy gets TESTIMONY BEFORE THE SENATE BANKING COMMITTEE out of hand, it could downgrade the importance of monetary policy and the oversight responsibilities of this Committee. If people FEBRUARY IS, 19B7 believe that fiscal policy is the whole ball game, they are unlikely to pay much attention to the Fed or to this Committee. Therefore, in my opening remarks I would like to give you an empirical demonstration of the power of monetary policy, indeed, whether or not the fiscal actions of government produce the desired results depends upon whether or not the Fed conducts monetary policy in keeping with the monetary policy assumptions in the budget. The key to any budget foreca the mptic Cn Paul Craig Roberts the growth rate of nominal GNP. If the Fed conducts monetary William E. Simon Chair in Political Economy policy in a way that causes the inflation rate and the real Center for S W t G ra a e 1 s o t 8 h e r 0 g i g n 0 e i g t c o t K w o a n n S n , t d U r D e I n . n e C i t t v . , e e r 2 r N n 0 s W a 0 it 0 t y i 6 onal Studies e t o r i h n c e r e o l n l a r e o g e t m s o i a s v v i l c e e r r e t g n e t v r m o r o e m n w e u n e s t e h t x ' s s p t h r e t b a a h c u n t a t e d a n g t i i t e t o o i t t , n d i s e n , t i x h v te p e e c n e r a g c g d u t e o s e e i v d d n f e . , r g r o n m a m t n h I e n d t e n h t i e t t T h w r a e w e i s l a s i l 1 s u l u 9 l m c 8 ry o 0 s p p e l t l i e t o e n o i n c d n s t f c m l o o e a o r l i t r l t i e e h o g c e n o o t r a r l f s m l l e e e o s l s i r n l s e s revenues than expected and causing the government to spend more in real terms than it intended. We have all heard a great deal about the trillion dollars that have been added to the public debt during the last six years. The Reagan Administration blames the Congress for spending too much on domestic programs, and Congress blames the President for cutting taxes too much and for spending too much on defense. These charges and counter-charges have turned the budget into a political football. Moreover, the charges are, for the most part, wrong. As Table I and Table II in my testimony demonstrate, the conduct of monetary" policy *s responsible for the lion's share of the buildup of public debt during the 1981-86 period. The unexpectedly and excessively tight monetary policy during 1981-82 expectations. Normally, administrations forecast lower inflation than occurs. However, the Reagan Administration forecast higher Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis inflation than occurred. Ironically, w&en the Administration deficit also caused the dollar's rise in value and the U.S. trade released its forecast in 1981 showing declining inflation over deficit. It is impossible for the inflation rate to unexpectedly the next five years, it was Jeered as a "rosy scenario." The drop from double-digit rates back to the low single-digit rates collapse of inflation in 1982 was not predicted by anyone, of the 1950S without the dollar rising in value. The Fed should including the Fed that caused it. have understood that it cannot simultaneously make the dollar a more desirable currency in which to hold assets and fail to meet The collapse of inflation was a good thing. But it was the increased world demand for dollars without the dollar rising nevertheless hard on exporters, farmers, the energy industry, and in value. As chart I in my testimony shows, the dollar has the deficit. The powerful disinflation cut more than 52.5 consistently risen with deceleration in the growth rate of money and fallen with acceleration in the growth rate of money. tax rsvenues by $556 billion. The same tight monetary policy that drove down inflation and I^ower than expected inflation also reduced spending relative made the dollar more desirable also curtailed the supply of to the original forecast for those outlays that are indexed to dollars. The result was a steep rise in the dollar's price, or inflation or whose costs are directly related to inflation. exchange value. The Federal Reserve did not accommodate the These costs include about two-thirds of the budget and reduced higher world demand for dollars, thereby keeping upward pressure outlays over the period By 5198 billion. on the dollar's value. in 1984, the Federal Reserve again tightened, simultaneously taking the bloom off a robust expansion The impact on outlays of a higher unemployment rate due to in the real domestic economy and driving the dollar higher. the unexpected and severe recession raised outlays by about 539 billion over the period. The debt service coats associated with In the face of the abrupt change in U.S. monetary policy and the larger than, expected deficits added $61 billion. in£lation, nothing coulfl have prevented the ris* in the dollar. Indeed, not even large budget deficits, which normally depress a When these figures are added, unanticipated disinflation currency's value, could prevent the dollar from rising. Smaller c b a i u ll s i e o d n , b y o r e x 4 c 6 e s p s e i r v c e e l n y t , ti o g f h t t h e m o tr n i e l ta li ry o n p o d l o ic l y la r a c i c n o c u r n e t a s s e f o i r n $ t 4 h 5 e 9 d d e o f l i l c a i r t s ev e w n o ul h d ig h h e a r v . e added to tne confidence factor and driven the * O > i • public debt over ISBI-BG. Since the first quarter of 1985, money growth, as measured bion by Ml and total reserves, has accelerated. 1 am not convinced forecast a cumulative deficit of 5122.5 billion for 1981-g3, we that these growth rates are signs of an inflationary policy, but have another 12 percent. And if we then add in David Stockman's many people have interpreted them that way, and rapid money $40_ billion in "unidentified spending cuts," it comes to 5120 growth can explain the decline of the dollar without anything billion for 1984-86, or another 12 percent. having been done about the budget deficit, which was supposed to be the cause of the high dollar. Altogether that accounts for $700 billion, or 70 percent of the trillion dollars. in other words, only 30 percent, or $300 Another explanation for the dollar's decline is that a new billion over the six year period, is left to be blamed on tax liability has risen to take the place of double-digit inflation cuts, defense buildup, and domestic spending. It seems to me, in depressing the value of the dollar. That new liability is the Mr. Chairnar., that it is not very productive £or Congress and the builSup in flebt o«eii to foreigners as a result of the trade deficit caused by the sharp rise in the dollar's value in 1981 them they are only responsible for 30 percent of it. I don't and in 1984. As our debtor status deepened, the dollar turned think we should send the Fed a bill for the 46 percent for which abound and began falling. it is responsible, but I do think it is tins for all of us to admit that it is impossible to unexpectedly cure inflation It got some ill-advised help along the way. At a meeting at without paying a cost. We have paid that cost, and to keep it New Mark's Plaza Hotel in September 1985, Japan and West Germany from rising we need to make a level adjustment in the budget to agreed to help reduce their trade surpluses vitfi the U.S- The bring it in line with the unexpected component in the agreement itself was Tine, but the way it was implemented was disinflation. Probably a one-year spending freeze would do the unfortunate. They drove down the value of the dollar by trick as long as it is a year during which we have a pretty good tightening their domestic monetary policies to drive up the value economy. of the yen and the mack, consequently, the Japanese econany went into recession, and West German economic growth slowed. The The same unexpected disinflation that caused the budget result was a weaker dollar but also weaker markets overseas for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis our exports. To work our way out of our trade deficit requires in velocity. The decline in velocity is itself somewhat not just a weaker dollar but an expanding world economy. ambiguous, because velocity can fall for two reasons: (1) It can fall because inflation falls and people are more willing to hold We may not get one. How that the dollar's decline is the money, and (2) it can fall because a spurt in money growth causes focus of attention, the Federal Reserve is feeling pressures to money to grow taster than nominal GHP. If velocity Has fallen because of the first reason, the double-digit Ml numbers of the of inflation due to rising import prices. I am not confident that the debt structure at home, and in the debtor countries that because of the second reason, sooner or later nominal GNP will owe our banks so much money, is strong enough to accommodate a catch up with money growth. As Chart II in my testimony shows, tightening of monetary policy. I am not confident that the the fall in velocity dates from 1981 and includes periods of economy is robust enough at this point to stand monetary monetary tightening and monetary ease (as measured by Ml). tightening. There seems to be enough evidence that we are still suffering the effects of severe deflation from past monetary policy. Commodity prices have not broken out on the upside, numbers by looking at Ml-A (demand deposits plus currency). This capacity utilization is not high, and the latest Fed data show a continuing deterioration of the farm banks despite the massive accounts. Ml-ft shows no inflationary acceleration in growth federal subsidies to farmers. There was a 30 percent increase until the second quarter of 1986, five quarters after HI turned last year in the number of farm banks with mote problem loans sharply up. It is possible that some of the growth in Hl-A than capital. The FDIC's problem-bank list now includes 615 farm simply reflects more lax management of cash balances by banks. Land values are still drifting down in most of the individuals and companies as a result of the fall in interest Midwest and the oil states. Massive federal farm payments, which rates. now exceed the value of farm output, have not yet stabilized the situation. I wouldn't think monetary tightening would be helpful Table IV shows that contrary to conventional wisdom, to the situation. foreigners are not holding a rising percentage of federal debt. Despite the large budget deficit* of the 1980s, foreigners are I wouldn't think monetary tightening would help the Third holding a significantly smaller percentage of the Federal debt World debt crisis or the loan portfolios of their U.S. creditors. than in the late 1970s. Brazil, last autumn's big political success story, is again in economic chaos, and Mexico, the big success story of two years Table V and Chart III show that during the 1980s, the Federal Reserve has monetized a much smaller percent of the interest rates. Those calling for monetary tightening had better federal deficit than during the 1970s. The claim that we have had too much money creation is not obvious in view of declining bigger subsidies, more bailouts, a weaker economy and a larger Fed monetization (as a percent) , declining foreign holdings (as a budget deficit. percent), declining inflation, and declining interest rates. The claim could nevertheless be true, but I would want to see more Concern about reflation has been caused by the increase in signs of loose money before I tightened monetary policy. HI and total reserves (Table III] . These numbers may be reliable indicators. On the other hand, some people may be reading too Mr. Chairman, members if the Committee, I am not much into them. A lot of Ml growth can be explained by deposit shifts. Far example, when multi-year CDs in savings and loans policy is going to be guided by money targets, they had better be mature, people are more likely to shift them to a NOW-account in the right targets, and the Fed had better hit them. Otherwise, a commercial banX than to roll them over. A shift in funds from the government's economic goals and deficit targets are not going H3 to Ml increases total reserves, because reserve requirements to be met. So far in the 1980s, the Federal Reserve has largely against HI deposits are higher than for M-3 deposits. If total countermanded the Heagan Administration's supply-side policy. reserves rise because of deposit shifts, it is not an indication of an expansionary monetary policy. The broader aggregate, M3, intended de ration of inflation. The costs are the large does not show an increase in money growth. Indeed, the quarterly budget and trade deficits and the severe debt crisis that stretches from the American farm community to the Third World. quarterly growth rates during 1981, 1982, 1933, and 19B4, a span that included periods of monetary tightening. The breakdown in the monetarist relationships upon which the monetary targets are based may only be temporary (see Chart IV). Moreover, rapid Ml growth is offset by a continuing decline However, in view of the doubts about Ml and the actual conditions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ny, the Fed had best watch, for a time at TftBIE II IMPACT CM EUCGET DEFICIT OF UNEXPECTED .COLtAPSE DJ MJCMM, 3)P fSBil.l Fiscal Year 1331 1282 138J 1SB4 12S5 12£6 monetary policy on the basis of Hi growth and speculation in the Impact an receipts of lower than forecasted nominal QJP exchange markets that the Treasury wants a lower dollar. "CiTunal OJP with projected grcwth of March 1981 295B.4 3319.8 3742.4 4160.6 4574.5 5005.4 Actual Ncminal Q1P 29S6.4 3139.1 3321.9 3686.3 3937.2 4163.3 Difference 28.0 -180.7 -420.S -473.8 -«37.3 -B42.1 -2526.4 Receipts effect* 6.2 -39.8 -92.5 -104.2 -140.2 -185-3 -555.8 'Marginal tax rate of 22 percent Impact on outlays of louer than forecasted inflatio TABLE I C.-1IP deflator with projected inflation Comparison of Original He of ftirth 1981 92.1 10D.1 107.4 114.0 120.3 with Actual Develocnnents Actual CWP deflator 22J, 98.S _1S2J3 106.9 110.6 OO Percent diffar<anoa .0 oitlays subject to 13B1 1332 02S3 iJSJ 1585 19B6 inflation adjustment 452.9 531.9 587.7 640.6 670.6 (percent change) Outlay effect .0 -22.9 -39.1 -56.1 -73.4 Original flssunptions nominal CMP 11.1 12. s 12.4 10.8 9.8 9.3 Inpact on outlays of higher than forecasted unenjploymsnt rati Real OIP 1.1 4.2 5.0 4.5 4.2 4.2 Off Deflator 9.9 8.3 7.0 6.0 5.4 4.9 Total Unemployment Rate Projected 7.8 7.4 6.8 6.4 6.1 5.7 Act N ua o l n i C na e l v e Q lo JP pnents 11.7 3.7 7.6 10.5 6.2 5.3 Ac D tu i a ff l erence -0 7 . .3 5 9 1 . . 0 6 10 3 .0 .2 7 1 . . 7 3 7 1. . 0 1 6 1. .9 2 Real OIF 1.9 -2.5 3.6 6.4 2.7 2.5 CMP Daflator 9.7 6.4 3.9 a. a 3.3 2.7 Outlay effect -2.2 7.6 17.2 6.1 4.5 5.3 Debt slervicecosts as*jcciated •with the above 3 -no. bill rate (actual] 14.5 11.7 a. 4 9.5 7.9 6.4 Debt service on direct deficit effect -0.6 1.4 6.4 14.7 IS. 5 21.6 Total Deficit Effect -9.0 42.1 93.2 85.9 107.1 138.8 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis NOTES OH TABLES I AND II which covers a span of the two years 1985 and 19361, Assuming Che overshoot for any one year enters Into the spending base for the next year, the figures can be The national incooe and product accounts have been rebench- cumulated. matked since the time of the original Reagan Administration economic path of March 1981, The rebenchmarkeo' series includes expanded imputations for tha underground economy. Calculation of Spending Overshoot Resulting From Thus , it La not possible to compare levels of nominal GHP Lower than Anticipated Inflation forecasted in March 19S1 with the levels that actually materialized. A nominal GNF series consistent with the 1981 Fiscal Ifear forecast was constructed by moving forward the actual FY- 1983 1984 1980 nominal GNp now carried in the accounts by the forecasted rated of increase. This secies was than compared tsoninf lation adjusted with tne actual series now being carried. outlays (Sbil.l 225.3 237.7 274.4 264.0 305.7 319.2 CEO inflation forecast over two years (%) 20.4 9.5 9.8 7.3 (annual rate) (9.6) (4.6) (4.8) (3.6) shortfall from the original path Actual inflation The lower inflation than was originally forecasted implies over two years (%> 19. T 1B.O 11. e 8.3 7.5 6.5 that outlays would have been substantially higher if the (annual rate) (9.4) (8.6) (5.7) (4.0) (3.7) (3.2) original forecast had bean met. A forecasted deflator series was constructed by the same Bathod. «.« uaad in constructing nominal GNP consistent with th* March 1981 (percentage points -0.6 scenario, and Che differentials in levels of the deflator were applied to actual outlays to derive an eatinnte at the outlay impact (Sbil.) -1.3 amounts by which outlays would have been higher under the (cumulative) original inflation assumptions. The reduced outlay effect of lover than foracaatad inflation was calenjlatad for those outlays directly affectsd by inflation by law or default: (1) indexed pragmas; (2) Health care oosts [Medicare, Calculations of the outlay effects of higher unemployment Kedicaifl, VS health care); (3) employee compensation, which rates than contained in the original forecast are tiasad on typically moves with inflation, though with some lag; and OMB rules of thumb. (4) interest; costs. Altogether, these represent about two- thirds of total outlays. These calculations do not attempt to take into account the lags between the time of differences in nominal GNP and the impact Of those differences en revenues or between the time of differences in price levels and their outlay impact. In actuality, lags exist in both cases. The calculations do not attempt to esCi.ma.te the additional interest outlays due directly to the effect of the tight monetary policy on tha real interest rate. As a proxy for Congressional anticipations, we can use Che CBo forecast of the GNP deflator made at the time o£ the budget submission for the fiscal year in question (e.g., tor FY-19S6, the CBO inflation forecast as of February 1985, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis TABLE III 4.a 7.3 -4.8 4,6 14. 5 4.9 14.0 10.5 31. H 15.2 4-3.2 17.3 59.4 16.4 Sfi.B 4.a 16.6 1.4 14.5 4.2 15.0 74.6 15.0 17.3 95.5 10. ft - I 11.7 II III IV - I II lit IV 209. S 256.3 - I II III 4.4 11. 9 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis MONEY GROWTH HATES AND GROWTH RATES FOR THE VALUE OF THE DOLLAR OVER SELECTED PERIODS, 1977-1986 = idF?nt. fhp bas Lc 50ucue Eor bjjth series is table FD-1 oE ssury Bullet Jr.. 3oth, concepts include Fe'lersl debt held by Foileral xessrJp. Foraiq". hcldmqs :)f rh<> public debt are n table OFS-J D£ the Treasury Bjlletiji. federal -isbt Tel'! ;lf. r-rDss Pe-1er.il nebt ir.cljiies •Je'jt hell "ly rhe Trust Fu Fwhral Bewrve Monetlwtion Psccsnt of fMccal Deficit [Annual Daca are Calendar ars) Qiangs in FHERAL FIB aoldinga o£ percent of DEFICIT GOV'T DEBT* Deficit M=ra; tiled 197 e 5 (= 1 0 1 1 .4 1 ) bil. { $ c 4 o . l 2 2 b ) il. " [t( 3 o 6 o .9 l * 2/col D] Chart II 1971 24.3 7.5 38.3 1 19 9 7 7 3 2 1 7 7. . 4 9 1 a. . 6 9 1 1 6 9 9 . . 9 8 M. VELOCITY 1974 19.9 7.8 64.3 1975 75.4 5.4 7.2 1976 56.6 8.2 14.5 1977 51.0 7.6 14.9 1978 44.1 9.4 21.3 1979 28. 1 9.0 32.9 1988 62.9 1.6 2.5 19B1 7B.4 9.9 12.6 1982 13B.7 8.6 6.6 1983 19*.4 14.0 7.4 1984 183.5 7.5 4.1 1985 215.6 1986 239.9 18.2 S.7 86:1 fil.2 -3.9 -£.4 :II 30. S 7.9 25.9 :III 53.9 6.0 11.1 :IV 64.3 8.2 12.7 ' U.S GoveEiraent eecuiiciea and Federal Agency obligations Changes based on tuldinga for last month of each year for annual calculations, and on holdings foe last nonth quarter for quartsrly calculatlona. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 Chart Til FRB Monetization: Percent of Deficit Calendar Years: 1970 - 1986 1970 1972 1974 1976 1978 1980 19B2 1984 1966 GROWTH OF REAL GNP AND MONEY SUPPLY (M,) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 How the Defeat of Inflation Wrecked the U.S. Budget By PAUL CRAIG ROBERTS Federal Reserve Chairman Paul A. dicted by anyone, including the Federal Volcker's unsung achievement is the de- Reserve that brought it about. The Federal struction of the budget process in the Reserve vastly overestimated the infla- United Stales. Consider first the demise tionary effect of the 1981 lax cut and. as a of the process, and then Votcker's role in result, overcompensated with an exces- bringing it about. sively tight monetary policy. The cost of The budget for fiscal 1982 was the last curing inflation faster than the Adminis- time that Congress carried out the respon- tration had planned was triple-digit budget sibilities that it gave itself in the Congres- deficits. sional Budget Act of 1974. Since then the The appropriate response to the deficit is budget process has collapsed so completely a one-year budget freeze together with that even Sen. Pete V. Domenici (R-N.M.). Federal Reserve support for a higher rate the chairman of the Senate Budget Com- of real economic growth. The combination mittee during 1981-86. has affirmed of a spending freeze and faster economic the shambles: "Deadlines are regularly growth would quickly cut the deficit and missed," "Senate rules are ignored" and terminate the speculation about U.S. eco- "the year's legislation is compressed into nomic credibility. a few major bills, each of them hundreds Even more important, it would end a of pages in length, well beyond the indi- budget impasse ihit is now five years old- vidual member'* ability to comprehend or loo long for a democracy to be immobilized influence." by such a critical operating feature as the The budget process of the United States annual budget The festering budget stale- was broken apart by the large deficits of mate between Congress and the White the 1980s, and the abandonment of budget House has produced an escalation of rhe- procedure! in turn has reduced the U.S. toric that is undermining peoples' confi- budget to the status of a political football. dence in government and creating con- Indeed, the situation today is lilUe better cerns abroad. than a shouting match between the Ad- The budget will cease to be a political ministration and Congress over who is football the day that the government responsible. The White House claims that explains to the public the effect on the the deficit is the result of Congress' refusal deficit of the unexpectedly quick victory to cut domestic spending. Congress claims over inflation. The easiest way to put the that the deficit is the result of the Admin- issue behind us is to adjust the budget to the istration's excessive tax reduction and unanticipated change in inflation with a defense buildup. Neither claim is truly one-year spending freeze. This approach correct would avoid the Tight over budget shares The "triple-digit" budget deficit of the that has stalemated the government, and 1980s has a single major cause: the un- it would pose no threat lo the Federal expected collapse of inflation. Normally. Reserve's disinflationary policy or to Pres- Administrations predict better perform- ident Reagan's tax policy. Moreover, it ance in reducing inflation than is achieved. would encourage Volcker to allow faster The Reagan Administration, however, growth by sending a signal that he would forecast worse inflation than occurred. not raise interest rates if the economy This threw the budget off. in terms of both picked up steam. revenues and spending. This approach also has the advantage at Budgets are prepared in nominal terms. being one that the public can understand So when inflation falls below the forecast, and accept. The deficit is too large to be it costs the Treasury revenues. It also handled by a rearrangemenl of budget means that spending is higher in real terms shares. People can more easily accept the than was intended. For example, if the fairness of a freeze that would not alter the government budgets for 10% inflation and relative shares of Ihe various constituen- by the end of the year inflation has fallen cies. Getting the deficit under control is the to 5%. the government ends up spending best way to assure a continuation of the far more than intended and collecting far defense buildup, because there is no guar- less revenues than expected. Every year antee that defense can win a fight over that inflation is overbudgeted adds to the budget shares or lhat higher taxes would deficit. Indeed, according to former Budget be allocated lo defense. Director David A. Stockman, the more- Once the politicians adjust the budget for rapid-than-expected decline in inflation the disinflation, they can resume the fighi cost the government a lax base equal to over budget shares. But the attempt to do half of last year's gross national product- both at once has overwhelmed the process rough ly (2,15 trillion. A solulion is al hand if the politicians arc Although it was hard on the deficit. interested in making government work. farmers, exporters and the energy indus- try, the collapse of inflation was a good Paul Craig Roberts served as asiiilanl thing overall. Nevertheless, it war. an secretory ol Ihe Trra<un/ during the first accident in the sense that il was not pre- Reagan Administration Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THU WALL STREET JCJLKNAL TUESIJAY, OCTOBER 28, 1SSIJ Beneath the Twin Towers of Debt' B> p « t. CMK. Ruwjm- decline ol Wv Inilows Indeed have risen m behavior is (lie primary reason U S. cap dollar's rise in \t\rn iifn-e.lcil the large It is tnfh fashion [o attribute the U.S. *»!«• >"" lh* outflow decline U clearly Ihe Hal outflows dried up. In other words, the deficlls and the lux cuts The ilulhr budget .md trade deficits tothe issi liu-re- u"B<n °I the large Iradc aelicll. which by U.S. has a trade deficit ami became a net snapped tack nt I9S1 iiJu-n its Ir.ide d h u e' c s l iu tD ii i is ,i n c t i n i T sn h e is s s id e b a y , c b o e n a s le ta n n t m r m ep th e e li ti p o u n b . - s d u e rp fin lu i s tio . n is a mirror Image o( the capital c fo a r p i b la e l l o I w m p a o n rt y e o r n e b ' e s c a fo u r s e e c a U s S t. . Inflation fell weighted >,iiue run- IT, t,l(,r ns iaso Is Incurred and dangerously misleading. Vet 111 is misinformation survives a free willows? A case can be made that the Reagan admlnlst ration's Inflation foiccasl fit ruse onh r.i billnui n> f;n s bilium press rind freely available statistics. short-lived business lax cut In J9B1 and the compares ivtlh whal actually materialised. from 1:3 .S billnui In IM). 1" lecenl editorials, the New York Times, tlie Washington Posl, and Ne* lie- ralu-1982 and mid-1983 raised the afier-lax forecast was released in ISKI, it w.is term ratpi iituve kiiirti-mi i.iie-j. itar.it public saw -Hie twin lowers of debi" built rate of return on real investment In the harshly crlliciied as dishonest lor ureilict- Wtnttt Uve KUHOIII> ra Vffi. \afe» ami 1*81 thus: Huge budget deficits from Ihe loss of U.S. relative to the rest of the world. Ing tailing Inflation In the f.ice of "inllu- revenues brought high Interest rales. Therefore. Instead ol jolng abroad, the tlonary tax cuts." No one expected that ac- able sign lli.it higli uiirrrsl r.itcs were Lured uy high interest rates, foreign money stayed home and Invested In equip- tual Inflation would come In far bebw the causeil by stringent motu-lfiiy policv The money (mured into Ihe U.S.. pushmi up (he ment and structures. In this case. Ihe dol- adralnlstra lion's forecast- least of ail tne federal-funds rale. aiiuitrnigJit r-iir-sd t>v dollar ,md IMHSHUJ Ihe trade deficit. The lar nee from its historic lows ol 1973-60 be- readers o[ Ihe New York Tunes and Wash Ihe Ked, wai high.'r tli.ni the inli'ii-st ink- dp fin is l,i Ned ui cause Ihe Inflation lha! cause the tax cuts Improved the Invest- ington Posl editorial pages. Yet the con- on lime term triple A < m l"T..ti- Ij-in.li fn.ni the Times and the fusi had predicted "be- Ociuiier la;s in il.n HIM) tmui ticinl«T c fr a u u t s n e a i b h r e o y a d w ." ere financed by borrowing ( U [n S bill . « u C of a dc p il i la ta rt) l Account, 19*0-8 o 5 u " U U g s l .il t o h r e e c s a iusr> tu : fl lo l'i r t I o 3S J 1 iu 1 i ( f ji 1 > S B l 2 o U II 'l I A 11 p S r I i l . i l s ll ™ il I lln li l t n li H ile iiK r.i h l d IB u S n ? ls Now comes economist David D. Hale in Uw listing* FuunialiMi's laiesl Policy me mi IMim iiu it» i™ isa. B.I>, vs. i.lT percentage points jnd in December Review to misinterpret the U.S budget dpfUIJnfkol.U.8. |tg (83 |M 19W by 3.63 percenlae.e pomls. In January d p e o f li i c c y it s a in s c " e a 1 h 3 i 8 g 1 h " l y a n e d x p a a s n k s io w n h a e r t y h e f r i sc Ih a e l Ltm capful outflow 5.4% vs. 4.0%. (The H 19 ie S1 g , a w p h e p n e a M ke r d . R a e l a 6 g .2 a ; n p * e ,, ii i - rn ln ld a g ug e u p r, o ih in > i d .. . "first experiment In global Keyneslanism" frwlIJ). M 111 121 60 24 32 CPf has continued to Overall, Interesl rates pejked in 18S1 wnh was leadme to world depression. EauhBHIdnnUltd till- budget deficj) iiiirlunieeil limn IJA pre Ca N p o it t a ic l e In th f e lo w ch s ro n F o e lo ll gy of tne eiplana- u P p liu tt i i u ] t b M lto k w d -Z3 -28 -27 as 10 « s b ' o I o K k e , ') "The Triumph v p th i e o e a u r s s s i z y l e i> e o a h f r a ' t s h v e e l e p 1 v e 9 e 8 a l 1 k e d T d e h e i l n n i li h i m . s n i l i j u ir . n i i t t d t h h e e re f i f e c e it d l im e a i p e .i] s lion: Tanuis ted to budget deficits, winch dlKnpwKT t Mhcr ol Politics." DJVid funds rate only one third ,is lugh ds n was led to high interest rates, winch led to an (inlkwi) 26 21 36 11 27 23 Stockman shows that in 1961. v I N f h a & o c e w * t s d x o i I n ' l o o l a f m t r h , S i e j. w u ir r L h e t ' i i . g c S n h . t h g C t is a a a v p p c e i i h i t a u a ro s l l . n a t o h * c h l e c o o i g t f u r y h a n d t e & tt l i i w d l e li c e e ? f i ( c l h u a it e p - . I a E n . f q V lo in S w b . n«t uplul t , t -* * -6 1 BH7 1107 HID m N j a j is e ti o , u n * n , " e t e i o p r g e e e c t i r h e « e a r f n ™ w is i n th r n p D o e l F i p c a y e r . n d I Ih ro in e m g U . o b S e n . in b L g u u d a c g n k e t e x d p i'd en m sio n u a ; , ly S |B h , s , r . ,, i 1 l blel. Halt: C«iip«i«nli may not »dd due to rounding source of the U.S. unexpected duin flat ion The few po(,,i|e Note th.ii between 1982 and 1933. when S«T« Ciaiium Dlfail^H budget deficit. Over who have tried to establish the facts haie the net identified capital inflow shifted been misinterpreted and deiided .15 saying from negative lo positive, capital luflan-s men! cllnuie In the U.S., and capital is- nominal gross national product mas' I!, 145 that "deficits don'i m.iiiei." Tlidr aieu mto toe I'.S. artoanyfell 6y W Mian. The ports dried up. As a suppty-sider t am trillion below lorecast, Mince budgets are mem Is different. Thei are sajing that change in the capital account resulted sympathetic to this case. However, i prepared In nominal lenns. the unexpected wllhoiil a pro-xniwth pilicy. debl cannol from a 171 billion fall In U.S. capital out Ironeer force Uian tax cult was operallng duUnIuttfcn not only COM il« Treasury «v be serviced or ri'iluctd. luimwin; ite fluws. not from [in Increase In capital In- on U.S. capital oulHowi. cnueB. It wiped nil spending cuts Mr. prospects for the mirhl economy In ,i flows And over Ihe I9W-B* perioU-Ihe Thai Force was Ihe unexpected collapse Stockman thought tie had achieved, trans choice of deflation "r ri<ll.itiun time when Hie story of massive foreign n the- U.S. Inllalton tale between 1900 and lormlng Ihe nominal cuU Into Increases in d m w s v P c i i a s a r o i e o e s u n u c r l e s s t f o A j n i r c r e . p m h s V D o s a l o u a y ir r l v b c m in i y k f d i g a e x F A n r e , I e d n M C d S to e o a t i o r n u r a I c t h n i l k n e c t m R h i l F e U a e o e n . s f S l c e d a . o E r s n v u c t f e d e r n o o m t n t c m h r o y , h e m ' a s b n a i u i b r c e m d r c o c g A o a h a e n d n - d t - D e n 9 h n a g 6 a 2 d n n c . e k g o i r T e . m s h M m t i I o s n o o I n d c h I o e h it e l y y e la - T c p p l e h e s r n i k e n r t e d d e c s i r n a W . g u s b o s u a e r p c n l d d r h k a , s a a c e s ti x f w c u o p e e n i e s l r d c e a a t o i n n m h f d g e e c U a n r o l v . t s p S a y - - . l q b r S a u e u u r n t g a o d e a u c g l x n m k e p g t m i t e e o t a c n v a d t t t e n e i e v r ' d f s n e a i c m f w i I d t m e h o k n o i p r l s d n n t a s f s c f l t a a p h t d c e l e o l o t o n s n d n . n 1 9 i t o , n A h 8 t g e 1 f h t . m e t e t C a a r a x u k i s b e r h b i l c o a o a u m t u w s h t s . e e e in l y s o g s . a f t t M m t h h h e e r e e . n c g u lio a o e n n n n l d n n o e o c u r w s t t t i p a o p ll u e n f l n d o l d e u t e y h l r i o i r c d a m w n i t f e d a f w i k c p e i e i n i u n l g g l b i t o i i l ' r i t s i c e s . n l y d i h b l i o o i s n o p c t n e o h if l u e e i l r s m h u s s i c e - , d y i . f a d f s u E a t i i c t l n o u t n s - oes on IVall Street and In Ihe media- there ier, to service and reuay loans. When. The explanation that attributes the Mr ftnfifijs. an rarlu Ri'tititut JVf«.s»Fii was mi ugnificinl ctiange In inflows ol Baatlon uneipeciedly collapsed, 11* bit*s Iwlns lower* ot debt la the 1981 UK cut af/lcial. lieHs fir Swian cliair in politu at capital min the U.S., but capital outflows realized that Ihey had overexposed their breaks down in Its other linkages at well. ecwmiiy nl aeon/rlma's Ceuli-r /oi sin collapsed from 1121 billion ID J21 billion, a apltal and stopped lending. This change For example, high Interesl rales and the Irinc nail lulnantHmal Stmlin Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 PROJECTION ON THE M'S The CHAIRMAN. Thank you very much, Dr. Roberts. I'm going to ask each of you to be king for a day and just give me a number in response to the first question and not any documenta- tion of it or any additional comment on it. Ml grew 16 percent last year. The question is this for each of you in turn starting with Mr. Axilrod: if you were Chairman of the Open Market Committee with six proxies in your pocket, what would you have established as the monetary growth for Ml, M2, M3 for 1986, and what would you be planning for 1987, just the numbers? Mr. AXILROD. Mr. Chairman, I would ignore Ml for 1986 and 1987. The CHAIRMAN. All right. What about M2? Mr. AXILROD. For M2, the 8.5 percent top of the range that they projected for 1987 strikes me as a tad high and I would have that at 8 percent. The CHAIRMAN. M3? Mr. AXILROD. Roughly the same, with margins of error. The CHAIRMAN. All right. Dr. Chimerine. Dr. CHIMERINE. Mr. Chairman, I would give exactly the same answer. I think Ml is irrelevant and I would target M2 and M3 in the current environment somewhere in the 8 to 9 percent range. The CHAIRMAN. All right. Mr. Heinemann? Mr. HEINEMANN. As I indicated in my statement, Mr. Chairman, I would target the monetary base—the Federal Reserve System's balance sheet. Growth in the base has accelerated approximately in the 10 to 12 percent area. My own personal preference would be to begin a systematic process of gradually reducing that growth. I would set a target for 1987 of between 7 and 8 percent. The CHAIRMAN. For the monetary base? Mr. HEINEMANN. For the monetary base. The CHAIRMAN. You have no comment on Ml, M2 or M3? Mr. HEINEMANN. I would pass on Ml. I think, as I indicated in my statement, that accelerations and decelerations in M2 and M3 are primarily a function of public portfolio decisions rather than monetary policy actions. The CHAIRMAN. So as far as the base is concerned, you said that it was at what level in 1986? Mr. HEINEMANN. As an order of magnitude, I think it's about 10 percent—a little higher than that, The CHAIRMAN. And what would be your preferred level? Mr. HEINEMANN. For 1986? The CHAIRMAN. Yes, sir. Mr. HEINEMANN. I wouldn't have allowed it to accelerate at all. The CHAIRMAN. So there would be no increase in 1986, and 1987 would be what? Mr. HEINEMANN. The question, as I understood it, sir, was what would I do from the present starting point. The CHAIRMAN. No, that wasn't quite it. I want to know what you would have done in 1986 if you had been in charge, and then what would you do for 1987? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 Mr. HEINEMANN. I see. For 1986,1 would not have allowed an ac- celeration and for 1987 I would have aimed for a moderate reduc- tion in that growth rate from the level that would have been achieved in 1986. The CHAIRMAN. Thank you. Dr. Meltzer. Dr. MELTZER. Senator Proxmire, we long ago at the Shadow Open Market Committee gave up on the aggregates for Ml because of the various shifts that have occurred. We have shifted to the mone- tary base growth rate and so I will give my statement in terms of the monetary base growth rate. In 1985, it was 8 percent. In 1986, it was 8.5 percent, accelerating at the end of the year to more than 12%. I would have not allowed the acceleration in 1986 and I would reduce the growth rate to 7 percent in 1987 on a path to return the economy toward stable prices and not be content with 3 to 5 percent inflation. The CHAIRMAN. Thank you very much. Dr. Roberts. Dr. ROBERTS. Mr. Chairman, I don't quite know what's going on here, but I find myself agreeing with Mr. Axilrod and Mr. Chimer- ine. Dr. CHIMERINE. Can I retract my answer and change it? [Laughter.] Dr. ROBERTS. I would add to that that I would watch other things other than money, which I believe the Federal Reserve Board is doing. They are forced off of the strict adherence to watching the monetary aggregates, not just because of the behavior of Ml but the monetary aggregates don't seem to—what you would expect from those growth rates don't seem to be manifest in the economy. So the Fed is watching a broad range of other factors which I be- lieve they will have to continue to do. The CHAIRMAN. Thank you, sir. EFFECT OF MONEY GROWTH ON THE STOCK MARKETS Mr. Heinemann, I would like to ask you about the connection, if any, and the extent to which there is a connection between the recent rapid money growth and the behavior of the financial mar- kets, particularly the stock markets. As we all know, there's been an enormous bull market going on all of last year and it accelerated this year. Yesterday it went up the biggest rise in history—not the biggest percentage rise by any means, but a big rise, 54 points on the Dow Jones in one day. The question is, is there a relation between recent money growth and the financial market behavior? Particularly, is there a money growth effect on the stock market that explains the recent record increases? Mr. HEINEMANN. In my judgment, Mr. Chairman, there is. In my statement I suggest that the extreme rate of liquidity creation has played a major role in fomenting the speculative atmosphere in the stock market. From my own work in the market from day to day, my regular daily contact with institutional investors, it seems to me that the liquidity effect on stock prices is very powerful. To me, the behav- ior of the stock market is one of the important signals that we are now beginning to see a shift in price expectations in this country. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 I find it difficult to believe that we will have an increase in unit volume in the economy which would generate a rise in profitability sufficient to justify the rise in stock prices. I think what the market is telling us, in effect, that investors expect—let's put it politely—some pricing flexibility. In other words, wider profit margins in nominal terms. Inflation is on the way and this will help justify the kind of aggressive bidding for eq- uities which we have seen in the recent past. The CHAIRMAN. Thank you very much. My time is up. Senator Bond. Senator BOND. Thank you very much, Mr. Chairman. I consider it quite an honor to attend my first meeting with such a distin- guished group of economists, particularly those who are using only one hand instead of the "on the one hand and on the other hand" solution, and it is very reassuring to hear such widespread agree- ment. There are a couple things that I would like to address that are slightly off the topic of your discussions today. Mr. Axilrod, for ex- ample, one of the concerns that's been expressed to some of us by those who oppose loosening of the restrictions on activities for banks is that if we allow banks to get into underwriting of govern- ment securities, et cetera, that it will limit the ability of the Feder- al Reserve to influence monetary policy directly. To what degree should we be concerned about that? Mr. AXILROD. Well, Senator, if you let banks get into the under- writing of state and local revenue bonds or corporate securities, I don't see that that will have any basic effect on the ability of the Fed to implement monetary policy, which goes through the reserve base, goes through some short-term markets, and indirectly through The CHAIRMAN. Mr. Axilrod, would you pull the microphone a little closer? It's a little hard to hear. Mr. AXILROD. My response was I don't think permitting banks— if you had decided to do that and I'm not addressing that issue—to underwrite additional securities will have any effect on the Fed's ability to implement monetary policy, which goes through a whole other route. The only conceivable adverse effect on monetary policy is if ex- panding the securities powers of banks leads to a weakening the structure of the banking system and if that makes the Fed reluc- tant to undertake the degree of tightening, for example, that might be needed under certain situations. But if you went the route of permitting banks to underwrite more securities, I assume you would do it in a way that would safeguard the core payments mechanism of the banking system relative to those banking affili- ates which might be engaged in such underwriting. Senator BOND. Thank you, sir. I might ask Dr. Roberts, in addition to your suggestions that a looser monetary policy might assist with problems in the farm economy and in the Third World debtor nations, are there other remedies which you feel should be at least sought or implemented by the Federal Government to deal with those problems? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 Dr. ROBERTS. First, let me say that I'm not sure that I recom- mended a looser policy. I was just giving many cautions against in- terpreting the current policy as loose and tightening it. As for your question, yes, there are many things you can do and I think Professor Meltzer described them and I would agree with him wholeheartedly—his entire litany of steps that we need to take to focus on being a productive economy and it's very difficult to make up with monetary policy for problems which have other causes, and I think Professor Meltzer gave a thorough litany of what those problems were and I associate myself with most of his suggestions. Senator BOND. Thank you, sir. Professor Meltzer, you indicated that we cannot continue to lend to Third World debtor nations without increasing our debt. So what would you do for the debt problems in the Third World? STOP LENDING TO OTHER COUNTRIES Dr. MELTZER. I'm glad you asked that, Senator. I think for 4 years now I've advocated a policy which, if it had been implement- ed in 1982 or 1983, would have put the debt problem behind us to a much greater extent. There are three basic steps. First, the United States should stop lending to other countries. It should request them to exchange debt for equity. They have assets that they can sell. If we continue to lend to them, we sell our assets to other people so that we can lend money to them. That doesn't seem to me to be a sensible policy for the United States. We are no longer a creditor nation. We are a debtor nation now. So the first step is we to encourage them to exchange debt for equity. Many of the governments are very concerned about of patrimo- ny. As a second step, we should encourage them to adopt policies that will repatriate their own capital so they will sell assets and equity to their own citizens. Now that isn't just a hope. We have experience with Chile and now with Mexico. We have seen that that policy can work if the local government wishes to make it work. The third step that I have urged in the past and would urge now is that exchanges of debt for equity be made at the market value of the debt. This Committee could assist a great deal if it would tell the banks that when they make those exchanges they don't have to mark all the rest of their portfolio to market. That would encour- age some steps in that direction. But the committee could also work to encourage that policy by leaning very hard on the regultors to see that that becomes the policy of the United States Government. Senator BOND. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Bond. Senator Shelby. Senator SHELBY. Thank you, Mr. Chairman. In some of your testimony I think several of you touched on the accommodative growth of the Fed as far as the monetary policy is concerned, some of it being judged prudent to now. But how much Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 longer can we go on in an accommodative stance—that is, there's a lot of money out there and the stock market some people think is an example of it now—before inflation really turns the corner on us? Mr. CHIMERINE. Can I take a crack at that, Senator? Senator SHELBY. Yes, sir. Mr. CHIMERINE. I don't think anybody can give you a precise answer. It's a matter of evaluating the relative risks and right now, in my view, the risks of a higher interest rate led downturn in the U.S. economy, perhaps spreading to the rest of the world, is so large, and so far exceeds the risks of some more inflation, that I think slowing money growth dramatically is premature at best. I wish I could tell you the exact time when we will be able to do that, but I can't. And, of course, the problem has been made more difficult by large budget deficits because the Federal Reserve is going to be under constant pressure to be accommodative in order to finance these deficits until they are reduced—not only because of the direct pressure on credit markets, but as you know, now that interest expense has become such a large item in the Federal budget, higher interest rates are just going to make future deficits even worse if they come about. So to answer your question, I can't give you an exact answer, but I think we are not at that point yet. Senator SHELBY. And does that also go because of the interna- tional debt situation? CONSUMER DEBT Mr. CHIMERINE. Yes. Not only the international debt situation, but even the domestic debt situation. I'm not sure whether it was touched upon before. Senator SHELBY. Consumer debt? Mr. CHIMERINE. Yes. We've had good growth in domestic demand in this country in recent years, but a lot of it has been financed by debt. However, demand is slowing dramatically. There is evidence that the high-debt burden is causing that slowdown, on top of stag- nant real income growth and so forth. And higher interest rates would aggravate these problems and could dramatically slow the economy further, in my judgment. Senator SHELBY. Your look at things as you're discussing now, as I read you, then the economy is not doing nearly as well as a lot of people say it is, if you look at the underpinnings of it? Mr. CHIMERINE. I agree completely. I think the underlying funda- mentals are mixed at best and, in fact, there is more reason to be concerned about the long-term health of the U.S. economy now than there probably has been in a number of years. Quite frankly, as I think most of us said here earlier, the conditions which existed 20 and 30 years ago which permitted us to significantly improve living standards in this country no longer exist. Second, we've borrowed from the future by going deeper and deeper into debt and we can't keep doing that. Third, these large budget deficits have now become counterpro- ductive. All of their factors are going to limit economic growth in the future and if monetary policy is tightened, and aggravates Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 those problems, we could have a very, very serious economic down- turn. Dr. MELTZER. Senator Shelby, may I respond to that also? Senator SHELBY. Yes, sir. Dr. MELTZER. I would like to give a different answer. First, The long record of experience is that we cannot prevent a recession by faster money growth. What we can do is postpone recessions, only to create a bigger recessions later. That's what we did in the 197Q's. "We printed money faster. We postponed the recession. We had a really ripsnorting recession because we had a high rate of inflation that the public wanted to end. So the question is not, can you prevent recessions? The answer to that is, no, you cannot prevent them. You may be able to postpone one temporarily. Second, I would like to ask: What are people betting on? The whole policy of this administration and the Federal Reserve is to devalue the dollar. That policy can only work by raising prices of imported goods relative to wages. If it raises wages as fast as it raises prices, then the policy will fail. All we will get is a nominal devaluation. We will not get a permanent solution to our trade problem. Our policy can only work by raising prices. I believe that there are better policies available, as I've said. Mr. HEINEMANN. Senator, the inflation rate as currently report- ed is very low and many people believe that inflation will continue to be very low. However, I think there are numerous signs of incip- ient price pressures, including most particularly the sharp increase in prices of imported products other than oil. I think quite apart from what expectations are in this country, foreign investors who are the critical suppliers of funds to the U.S. economy now, are concerned about the inflationary potential in U.S. monetary policy. They are becoming increasingly reluctant to lend us money at prices we can afford to pay. We are holding down the short-term interest rate at the present time, but only at the cost of a progressive acceleration in money growth. We are putting more and more money in. We're like a drug addict. We have to have a bigger fix every time in order to satisfy ourselves. Senator SHELBY. Dr. Roberts, did you want to comment? Dr. ROBERTS. Yes, Senator- I want to address this question about stock market behavior of foreigners. I believe it's correct that foreign buying of U.S. equities or stocks is now at an all-time high. It has been accelerating since the second quarter of 1985. Prior to the weakening of the dollar, for- eigners were net sellers of stocks. As the dollar has weakened, their purchases of U.S. equities have reached an all-time high. I think this is one of the reasons for the stock market's perform- ance. Another I think is since about 1984, you have had over $200 billion of equities disappear off the market due to leveraged buyouts, mergers and repurchases, and a third factor that's driving the market I think is the tax reform. As I testified at the time, one powerful impact of the tax reform that I was concerned about was to give a windfall gain to all exist- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 ing capital. When you cut the tax rates across the board, you give a windfall gain to the existing capital stock. What you see going on is the stock market repricing assets to re- flect that windfall gain. I think in view of these three factors it would be dangerous to assume that the rise in the stock market is a reflection of the Fed pumping out huge quantities of money. I wouldn't want to deny that the Fed pumping out money could cause the stock market to go up, but I think here we have three very clearcut real factors that are causing the stock market to rise. Senator SHELBY. My time is up. Mr. Chairman, thank you. The CHAIRMAN. Mr. Axilrod didn't get a chance to respond to your last question. Senator SHELBY. I would like for him to respond. I appreciate the chairman's indulgence. Mr. AXILROD. Thank you, Mr. Chairman. I think if you evaluate the monetary aggregates, you certainly shouldn't evaluate them in isolation. In the 1970's, when the mone- tary aggregates were contributing to inflation, much of that infla- tion starting in a way from oil price increases, but the monetary aggregates contributed and helped sustain it. You will also find that at the time the level of real interest rates was close to zero. That is, the nominal short-term interest rate and the rate of infla- tion were moving together. There were no real costs to stop people from borrowing. In the 1980's, we've had a very sharp growth in the monetary ag- gregates. I suspect in terms of Ml, much more than in the 1970's. The reason that hasn't contributed to inflation—there are a lot of reasons, but one very good reason—is that the level of real short- term interest rates has been relatively high. Because of that, I would not call Federal Reserve policy totally accommodative. It has been accommodative, but I think there has been a residual degree of restraint in that policy and that residual degree of restraint has kept the rate of inflation from accelerating and has kept the unem- ployment rate in this country above what we like to think as normal. Still, there hasn't been enough restraint to get the inflation rate down further. Senator SHELBY. It's been balanced up to now, but will it stay that way? Mr. AXILROD. Well, no one can really foretell the future with great certainty. The only obvious source of inflation at the moment is the drop in the dollar, and that will become more obvious if there's a very sharp drop in the dollar. The budget deficit looks like it's coming under control. If the people are disappointed in that, that would be another factor caus- ing a change in inflation expectations. Thus far, unit labor costs in our industry have been held down. It was only a 2.25-percent increase last year, so it was very low. If that is sustained, we have relatively little reason to fear a burst of inflation except out of a sharp drop in the dollar, unless the oil cartel has got a lot more power in it than I think. Senator SHELBY. Thank you. The CHAIRMAN. Senator Graham. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 THIRD WORLD DEBT Senator GRAHAM. Dr. Meltzer, you were listing three steps that you felt we should take in order to deal with the Third World debt. The last of those related to pricing the trade of debt for equity at market rates. Could you elaborate on that and what specific policies you would see as necessary in order to accomplish that? Dr. MELTZER. Well, the debt is being traded. There is a secondary market. It's not a very strong market, but from inquiries among people who are making these transactions, in the banks and so on, even quite sizable transactions are made not far from the quoted prices. To give an example, Mexican debt sells in the marketplace at about 60 cents or 65 cents on the dollar, depending upon what the prospects are. Brazilian debt was selling for somewhat higher until very recently when it may have fallen. Argentina would sell some- where like Mexico. A person who wants to invest in Mexico—for example, suppose a Mexican citizen who has sent his capital to the United States and has it invested in the United States market or in some foreign market, would like to repatriate part now. He goes to a bank and buys back the debt at the market price of the debt, brings it into Mexico and gets something close to the full face value in exchange. He makes a very large gain which gives him a great incentive to repatriate some of his capital. What the transaction achieves is to reduce the debt from the $100 billion range, in the case of Mexico or Brazil, and gradually reduces the outstanding amount. It's my estimate—a conservative estimate I believe— that if we did something on the order of 2 to 3 percent of the debt in swaps every year we could have that problem manageable at the end of 5 to 6 years, with a little bit of good fortune. What needs to be done? One of the things—by no means the only one—one of the things which inhibits those transactions is that under the current regulations banks believe that they have to mark to market all of the debt on their books and report the losses. Since they sell the debt at 60 cents on the dollar, they might have to report a loss of 40 percent of their debt on all of their holdings if they in fact made that transaction. So a lot of the transactions are being made not by using U.S. banking-owned debt but buying debt from, say, Arab banks or Third World banks and exchanging those debts for equity. I think we would be well advised to consider the policy of trying to not have mark to market all of those debts to encourage and facilitate this exchange of debt for equity. The other thing that we need to do is that we need to lean on the U.S. Government to push a policy of exchanges as an alternative to increases in World Bank quotas or increases in IMF quotas and more lending. What we need to do is encourage our Government to get out of the lending business, stop lending U.S. dollars to those countries, to encourage them to solve that problem through the marketplace in the way in which I have suggested. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Senator GRAHAM. Dr. Roberts, you referred to the importance of the expanding world economy as one of the keys to dealing with the concerns that you had outlined. What would be your comments on Dr. Meltzer's proposal as it re- lates to a means of handling Third World debt and the impact of that accommodation on general world economic expansion? Dr. ROBERTS. I think, Senator, that it's clear that it would cer- tainly help because it's very difficult for these countries to import when they can't service their debt. So I think to sell it at its market value is a good idea. It may put some hardship on the banks, but I generally favor and have proposed the same type of solution as Professor Meltzer. I think it might also help if some of the G~5 trading partners also look to the world growth rate and be sure they don't act in ways that would curtail it. If our trading partners are too tight in their exercise of policy, then we can't hardly make up the whole difference. Senator GRAHAM. No further questions. The CHAIRMAN. Mr. Heinemann, I am concerned about the syn- ergy here, the combination of expansive fiscal policy and expansive monetary policy. We have been discussing so far primarily expan- sive monetary policy. It seems to me that they work together and, together, they create a situation which in spite of the very thor- ough and able way that Mr. Chimerine described the deflationary aspects in the economy or the antiinflationary aspects, that here is something that over time and over a relatively short time is likely to give us a tremendous inflation—worse than many people have expected or talked about our having. Plus the fact, there's one other element you may want to com- ment on, and that is the monetary policy contributes to the deficit in quite a different way than I think Dr. Roberts and Mr. Chimer- ine described it in my view. What monetary policy has done is to hold down interest rates temporarily in the short run and, therefore, put less pressure on the Congress and the administration to take the kind of action that we should take to cut the deficit. What's your reaction to those two observations? INFLATIONARY POTENTIAL MONETARY POLICY Mr. HEINEMANN. Senator, I have tried to emphasize in my state- ment and in my oral remarks the concern I have about the infla- tionary potential in current monetary policy. I wonder if we will actually reach the point, though, of seeing a runaway reacceleration of inflation in the near future. I do doubt that. I think a substantially faster rate of change in prices is likely, but a runaway inflation in the near future I think is improbable for a whole host of reasons, many of them technical. But most importantly, I suspect that the process of progressive acceleration in money growth which is going on will bring the proc- ess to an end a lot sooner than we may now expect. Foreign inves- tors have concerns about what we're doing in our monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 Bank reserve growth averaged 10.6 percent in 1984, 13.6 in 1985, 20.4 last year. It was much faster than that at the end of the year. These are average month-to-month changes. As I indicated, in the last few months, reserve growth has been running over 30 percent in the context of slight increases in short- term rates. It strikes me this is a process which is starting to run out of con- trol. I do strongly believe that rates are being held down through progressive injections of liquidity. I am concerned that this boom in money growth, which will come to an end like all booms—it's a spike up and it will come down just the same way—when that hap- pens, if it comes down from a very high level, we can have very serious real shock effects on the economy. I don't think we are going to get a major new inflation in the immediate future, but the potential is there and financial markets are already giving us fair warning that the time we have left to correct policies is limited. For an equally large number of reasons, I feel that we have made a fundamental political mistake in being unwilling to impose sufficient explicit taxes to pay for the Government services that we want to consume. I think it's very hard for taxpayers to decide how big they want the Government to be if they don't really understand currently how much it's going to cost I don't view the fiscal policy actions of last year as a net tax re- duction. We shifted the incidence of explicit taxation from the indi- vidual to the corporation. I don't quite understand how that leads to a revaluation of corporate assets. It does seem to me that the total tax burden that the economy will have to bear over time has gone up because Government is bigger today than it was at earlier times. Adjusted for the stage in the business cycle, Federal spending is about 2 percentage points higher today than it was in the last busi- ness cycle at a comparable point. Government is much bigger today than it used to be and, therefore, the total explicit and implicit real tax burden is higher—not lower. I think that it will be difficult to get a political consensus on re- ducing the size of Government, assuming that's what we want to do, until we really understand what government costs. The CHAIRMAN. Thank you very much, Mr. Heinemann. I should have announced when I started, but since there are three of us questioning now we will go to a 10-minute questioning period and that leaves me with about 6 minutes. Now, Mr. Axilrod, are you comfortable with a 23-percent in- crease in monetary reserves, the base reported by Mr. Heinemann; and as one of the world's leading monetary policy experts, can you tell us unambiguously that we should not be concerned about infla- tion? Mr. AXILROD. I am not uncomfortable with that 23 percent. To explain why, can I give you an example, if you'll bear with me for just a second, through a simplified example. Suppose there were two assets in the world. One was a long-term bond and one was a deposit that bore interest and was subject to reserve requirements. Suppose at the beginning that deposit had a 5-percent interest rate and the long-term bond had a 10-percent in- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis terest rate. Then most people would be investing their money in the bond. But for one reason or another, suppose the yield on that bond dropped to 6 percent and the yield on the deposit dropped only to 4.5 percent, so that the spread became much narrower. Then a lot of people who don't like the risk of price fluctuations in the bond would say: Well, it's not worth my while to keep my money in that bond. I'll keep it in that deposit where I can get 4.5 percent and I'm not subject to big price risks. Now to support the money that is shifted to deposits, since they are subject to reserve requirements, the Federal Reserve has got to provide the reserves. You might very well get a 23-percent expan- sion in reserves at that point. The expansion is merely to accommo- date the public's desire to hold that money there. That would be, in a way, a passive role for the Federal Reserve. The active role would be for the Federal Reserve, willy-nilly to push that 23-percent increase out. Then, of course, it would be forc- ing money on the public that they didn't want; as a result, the public would probably try to spend it, with inflationary potential. So the answer to the question you raise depends on a judgment about whether the public does or does not want to hold the deposits supported by reserves as part of their longer run savings, and whether the Fed is being passive or active in adding to bank re- serves. I feel relatively comfortable that we have a more passive attitude on the part of the Federal Reserve in relation to Ml and currency, which is the main component of the base, and that it's not an infla- tion-creating attitude. I think it's not inconceivable we will have an inflation ahead, but I suspect if it comes it's going to come really from a drop in the dollar far beyond what the fundamentals call for and that is caused by loss of confidence. The CHAIRMAN. You do that on the basis of the distinction be- tween passive and willy-nilly? Mr. AXILHOD. Well, I'm trying to put it in terms that are readily understandable. The CHAIRMAN. Dr. Meltzer. Dr. MELTZER. I would say, Mr. Chairman, that one wants to be cautious about that argument. The argument that the Federal Re- serve should meet the demand for money because people want to hold it is not very different—in fact, very similar—to the argument that was made by the German central bank in the 1920's when they bought additional printing presses because there was such a large demand for currency. I don't see signs of a large increase in the demand for money in the United States. I believe that the other interpretation, the more dangerous inter- pretation, is the more reasonable interpretation of current events. And I say that because what we have seen is two things which should warn us. One is that short-term interest rates, as Mr. Hein- emann pointed out in his statement, have been rising despite mas- sive money growth. Second, we have seen a fairly substantial devaluation of the dollar in a relatively weak world economy. That is, not a weak U.S. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 economy, but a weak world economy. That's a sign that a good part of that devaluation is very likely to be nominal, not real, and the result of too much money being produced. Dr. CHIMERINE. Mr. Chairman, can I answer that? The CHAIRMAN. Go right ahead, sir. I have a question for you, but go right ahead. Dr. CHIMERINE. Why don't you ask your question and I'll try to address both together. The CHAIRMAN. All right. On page 14 of your testimony you say: The corporate sector is especially more vulnerable to an economic slowdown, or higher interest rates, because it has not only been adding debt at record levels, but it has also been redeeming equity since 1984, making it more leveraged. That's one reason you call on page 16 for a more accommodative monetary posture in the near term. My question is, is the hostile takeover phenomenon, in your view, one of the reasons for the increasing corporate debt? CORPORATE DEBT Dr. CHIMERINE. Yes, without question, I think it has accounted for a sizable part of the increase in corporate debt, but there are other reasons corporate debt has risen as well. The CHAIRMAN. Of course, there are, but is it substantial, and to the extent that there are Dr. CHIMERINE. It is a substantial part of the rise in corporate debt, but the point is is this, Mr. Chairman, it still has to be fi- nanced and a significant number of our clients, for example, are telling us that one of the reasons they are trimming their capital spending budgets is because of the increased difficulty they are having servicing that debt. So there are costs to it. It doesn't come free, and my concern is that it is going to work at the expense of near-term economic activity. And as I said earlier, I don't think the Fed can stimulate the economy very much, but my concern is, if they tighten on top of these factors, we have the chance of seeing a sizable downturn. If I might quickly make quick reference to a few of your other comments. First of all, with respect to fiscal policy, well, I think you are well aware of my concerns regarding the federal deficit for many years. We are now paying a price for them. Nonetheless, as we cut these deficits, we are implementing somewhat restrictive fiscal policies in the near term. So in the near term, it is a drag on the economy. Second, as Steve Axilrod and I mentioned earlier, I haven't found too many farmers or steel companies or energy producers who think interest rates are low right now. For a large segment of the borrowing population, particularly, the manufacturing sector and the commodity producers, real interest rates are still very high. So, from that perspective, monetary policy has not been extremely loose and easy and inflationary, and when you have real interest rates at the levels we have had in recent years. Third, if we had managed the economy based on the rapid growth in Ml in recent years, and tried to clamp down on Ml growth, as many people argued, we would be in a severe recession right now. You can't go back now and say, "Well, you're right, but Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 now let's focus on reserves, or on M2 or M3." I think some of the monetarists are doing exactly what they accuse the Federal Re- serve of doing in this respect. The truth of the matter is that the money numbers and the re- serve numbers are distorted by enormous shifts in deposits, and by rising import penetration—the demand for credit is increased just as much from imports as from domestic purchases but they don't show up in domestic GNP and, therefore, the velocity declines. The Ml numbers are just not useful. Finally, the correlation between Ml and inflation has been enor- mously overstated, even before the technical factors began impact- ing Ml. The correlation is not anywhere near as close as some people suggest. The relationship depends on underlying condi- tions—such as enormous overcapacity, wage restraints, high unem- ployement, weak commodity prices. Thus, even with the weaker dollar, and while admittedly, we have to be concerned about the potential down the road, I don't see how anyone can make now, a valid argument for tightening significantly now, because we also have to be concerned about slow growth, high unemployment, LDC debt and all the other things we've talked about. And it is a matter of balance. Last point, about the dollar. The dollar is coming down, because we have large and unsustainable trade deficits, and it is going to come down regardless of whether we tighten money growth or loosen money growth a little bit. The trade deficit is why the dollar is coming down, and it will continue to come down. As for the recent increase in interest rates, financial markets now play a guessing game with the Fed, and for a while the markets expected additional easing by the Fed. Recently, because of some recent strange statistics and because the dollar is coming down, they are questioning whether the Fed will ease, and as a result, interest rates have backed up a little bit. I don't think you can attribute the small increase in short-term rates last week, to the fact that all of a sudden, the financial mar- kets have gotten worried about the growth in Ml. Dr. MELTZER. But it isn't last week. It's over the last 6 months. Dr. CHIMERINE. Oh, it is not over the last 6 months. The CHAIRMAN. Mr. Chimerine, I vigorously disagree with you, but my time is up, and Senator Heinz now has 10 minutes. Dr. CHIMERINE. Good. I'm glad. [Laughter.] Senator HEINZ. I note from the almost, but not quite, unanimity of the panel [laughter] the age-old adage that if you took all the economists in the world and laid them end to end, they would not come to a conclusion is still true. Mr. ROBERTS. They will come to a whole bunch of different ones. Dr. CHIMERINE. That seems to be true of Congress, as well, these days. Senator HEINZ. Different ones, yes. I am particularly pleased to see that my two Pennsylvania con- stituents, Alan Meltzer and Lawrence Chimerine are still at oppo- site ends of the conclusion from time to time. You've got to make it interesting for us, but it is good to see you, even if you give me con- flicting advice. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis J-CURVE I want to ask a question about the J-curve, about trade, and about the dollar. There are a lot of people, principally those in the administration, who are saying the dollar has softened, a few other currencies have strengthened, the mass of the currencies relative to the dollar has strengthened and just wait, the solution to the trade deficit problem is just around the corner. In their view, we haven't quite yet hit the bottom of the J, but as soon as we do, it is going to shoot right up into a big lovely capital letter like we want. Is there any evidence that that is true? Who wants to take a crack at that? Dr. CHIMERINE. Well, I will, Senator. I think the best we can say so far is that the trade deficit seems to have stabilized. It has been very erratic on a monthly basis, but if you take the laset 3, 4, or 5 months on average, it looks like it has peaked out when you meas- ure it in nominal terms. If you look at it on a real basis, it looks as of the deficit has started to decline sharply. We've got some anecdotal evidence in support of that. We have seen an increase in export in a number of industries, particularly chemicals, paper, some of the other industries that compete previ- ously against Europe, where we have now become much more com- petitive, and where labor cost differentials aren't very important. Senator HEINZ. You are something of a guarded optimist, that in fact, first, the J curve exists and second, we are somewhere down there. Dr. CHIMERINE. Yes. Senator HEINZ. But where you are guarded is that your not so sure that the J isn't lying on its side. [Laughter.] Dr. CHIMERINE. No, where I am most guarded, Senator, is that I think the turnaround will be modest, partly of the J curve, partly because for other reasons. And second, that doesn't mean the econ- omy will grow more rapidly. I think the improvement in the trade deficit will come at the expense of domestic demand. Senator HEINZ. Does anybody either have a more pessimistic or more optimistic view? NEED TO BE PATIENT Mr. AXILROD. I have a view. I am not sure how you would de- scribe it as pessimistic or optimistic. I think we are moving in the right direction. I think the worst thing that we could do is lose pa- tience and seek a rapid solution to the trade problem, either through protectionism, which has very obvious structural difficul- ties or other attitudes. Those other attitudes could get reflected, if the world loses patience, or thinks we are losing patience, in a very sharp drop in the dollar. It could be sharp enough to get the trade deficit improving rapidly, but I think the other repercussions of that, the inflationary repercussions of that, the fact that a rapid improvement might come before our fiscal deficit is under control, would mean the great risk of inflation followed by recession. So I believe the best thing we can have is a degree of patience. Thus far, the world is interested in putting its money in the United States, and I can see no reason why it shouldn't, unless they sense we are losing patience. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 Dr. MELTZER. Senator, may I say one thing? Senator HEINZ. Yes. Dr. MELTZER. Incidentally, it is very good to see you again, sir. I think we have to distinguish two things between real devalu- ation and nominal devaluation. Nominal devaluation may have some advantage to us short term, but it is the real devaluation that has to carry the ball to keep the trade problem under control for the long term. I am optimistic that the trade deficit has turned. I think we need to do considerably more to get us back to some kind of reasonable position, where we are not pouring out debt. And I believe what we need to do is much more to boost production in this country by productivity-enhancing measures and to reduce consumption. Senator HEINZ. My question to you is this. How can the trade deficit ever do anything much more than stabilize, as long as most of the world's economies either are at or moving toward mercantil- ism? That is what we face in Latin American and the East Asian economies. And we all know what a mercantilist economy is. It is a one-way street. Dr. CHIMERINE. Senator, I share your concern, and I think this is one of the reasons the turnaround will be modest. We are begin- ning to see sharp declines in investment in a number of countries, especially some of the large industrialized countries, because their export industries are experiencing a profit squeeze. And historical- ly, capital goods have been our stronger export sector along with agricultural products. Furthermore, Mexico is still in terrible shape. It is very hard to export anything into Mexico, and now OPEC has been cutting back in their imports from the United States as well. This gets back to the issue of evaluating monetary policy in the insist of the underlying environment, because you are absolutely right, our ability to improve our trade deficit through faster export growth is being limited by weakness elsewhere. That probably means that we are going to get more declines in the dollar, and higher import prices, because a larger fraction of the adjustment is going to have to come on the import side. Dr. MELTZER. Senator, that leads us in the wrong direction. Whatever may be going on in the world, we are moving in the wrong direction, if we, in fact, joint them in a policy of mercantil- ism. Senator HEINZ. Oh, I agree. Dr. MELTZER. That is going to make the problem much harder for us. Senator HEINZ. I don't think there is a lot of support, I hope, for mercantilism in the United States. Dr. MELTZER. I hope that is right. Senator HEINZ. I hope we are opposed to it, although it did won- ders for us back in the 1890's. We were small, and, like other small countries are now, we could get away with it. In addition, it also built our steel industry. Let me ask this, to bring this subject back to monetary policy and the Federal Reserve's policies. At some point, a dollar that continues to drop creates, as we all know, inflationary pressures that become very powerful. How close are we to hitting that kind of sound barrier? How close are we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 coming to the drop of the dollar that will reignite inflation? It cer- tainly did do that back in 1977-78. Dr. MELTZER. Too close. Too close. That policy can only work, Senator—the only way our policy can work is by raising prices rel- ative to cost or production. That is what the policy of devaluation is. So it not possible to have one without the other. Senator HEINZ. Let me, for the sake of argument, assume Alan Meltzer is right. We know he is right, but let's assume Dr. MELTZER. Thank you. Senator HEINZ [continuing]. On his evaluation, that we are get- ting close to the inflation reignition point. Let me ask Mr. Heinemann, who's been smart. He's been very quiet. Mr. Heinemann, if you were at the Federal Reserve, if you were czar of the Reserve, and you saw inflation igniting or if you saw us about to get there, what would you do? Would you tighten monetary policy? Would you loosen it? What would you do regard- ing interest rates? Mr. HEINEMANN. One of my colleagues on the Shadow Open Market Committee and a former constituent of yours, Dr. Jerry Jordan, has promulgated one of the basic laws of economics. And Jordan's law is that the only way to prevent a hangover is not to get drunk. I think that is the only effective way to deal with the long-run inflation problem. We already see prices of imported prod- ucts at the wholesale level, other than oil, rising more than 8 per- cent, the increase year on year in the year ended September 1986 was actually about 101A percent. RISE ON IMPORT PRICES I would anticipate we will get some further acceleration in prices of imported products. Imported products, as you know, constitute almost a third of the goods sector of the American economy. I be- lieve that the policy that we are following will produce its intended result. As Dr. Meltzer said, this is a higher rate of domestic infla- tion in the United States. That is what the policy is designed to do. As far as the J curve effects that you made reference to, I fully share your concerns about mercantilism in this country or any- where else. In the very short run, we've got to remember that the dollar has been extraordinarily volatile. It went up sharply and has come down sharply. So I suspect we are seeing in the marketplace some echo effects of the past rise as well of the current decline. My friend and colleague in New York, Larry Viet of Brown Brothers, Harriman, has observed that we have an overlapping J curve effect in the market today. The echo effects of the previous overvaluation probably still influence the data. When you look at the trade data in real terms and exclude oil—which, of course, is a dollar-quoted commodity and would not be expected to respond in the short run to changes in the external value of the dollar—the trade deficit, the non-oil merchandise trade deficit in real terms seems to have hit bottom in the second quarter of 1986. Both the third and the fourth quarter were modestly better. I fully recognize that many parts of the world are showing signs of sluggish economic growth. But my sense is that the powerhouses of American industry, the GE's, for example, are becoming quite Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 successful in taking market share away from their competitors in Japan and in EEC. GE has had a sensational performance in the recent past. I happen to be a small stockholder. I am very pleased about that. Hi- tachi, a counterpart in Japan, is not doing well. They have cut ex- ecutive salaries across-the-board not very many months ago. I think this is a good metaphor for the kind of momentum which, in the short run, is beginning to build up in the trade sector. So I suppose I think we are going to get a good deal for more short-run improvement in our trade numbers than Dr. Chimerine suggests. Senator HEINZ. Mr. Chairman, my time has expired. I just ask unanimous consent that my opening statement be put in the record. The CHAIRMAN. Without objection. STATEMENT OF SENATOR JOHN HEINZ Mr. Chairman, I would like to join you in welcoming our distin- guished panel of witnesses today, in particular, Dr. Meltzer and Dr. Chimerine, who are located in the State of Pennsylvania. I look for- ward to hearing their testimony today on the state of the economy and monetary policy. At first glance, January's economic statistics reveal surprising strength despite the recent turnaround in oil prices, and reflect a reduced likelihood of a sharp slowdown in U.S. Economic activity. For example, both the producer price index and industrial produc- tion rate increased nearly one-half of 1 percent last month. Janu- ary also experienced solid gains in aggregate employment of 448,000 net new jobs, with a concomitant rise in overall personal income levels of 0.6 percent. In addition, the U.S. trade deficit declined in December to $10.7 billion, down from November's deficit of $15.4 billion. This is the smallest trade gap since the $8.1 billion deficit of March 1985. The improvement was due in large part to the substantial decline of the dollar and the associated changes in relative prices for internation- ally traded goods, resulting in nearly a 25-percent drop in imports. These are positive economic signs. In fact, they may portend better economic activity, as well as improved industrial competi- tiveness. This is especially true for the domestic manufacturing sector who may be able to recapture two lost markets, the domestic and foreign. Despite these indicators, there are other factors which concern me. For example, the healthy gains in production in the last 3 months, together with modest sales gains, have not led to surplus inventories. Automobile sales and housing starts declined last month. While the decline in these sectors may be attributable to the tax reform legislation of last year, the drop-off may also reflect other problems in these sectors. Finally, the consumer price index has risen 0.5 percent in the last 2 months, revealing the risk of in- flationary pressures. Clearly, Mr. Chairman, we are at a crossroads in terms of the country's economic and financial condition. Fed policy to cut dra- matically the short-term interest rates last year as well as better factory activity and production performance have diminished the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 recession risk. A softer pace in spending and the decline of the dollar have lessened the trade deficit. However, we still have a dis- tance to go before the economy is in balance. The dollar must decline substantially, even from its current lower level, in order to bring U.S. imports and exports back into balance and to reduce our dependence on the inflow of foreign cap- ital. While recognizing that the lower dollar is depressing the Japa- nese and German economies, we must continue to encourage their policymakers to provide the offsetting fiscal stimulus. This, in turn, will reduce the need for foreign capital inflows into the United States. Finally, and not to be ignored in this education, Mr. Chairman, it is incumbent upon us to establish policies to reduce the budget def- icit. Any meaningful trade deficit reduction will be offset in the ab- sence of a commensurate budget deficit reduction, no matter how far the dollar falls. The CHAIRMAN. Before I call on Senator Riegle, let me just say, John, I appreciated your remark about how the way to never have a hangover is not to get drunk, but that is only one way. There is another way that I am afraid some of the panelists are moving in the direction of, and that is, the way to never have a hangover is never get sober. [Laughter.] You know, the hair of the dog that bit ya. That is, unfortunately a common attribute to many people in this field. Senator Riegle. Senator RIEGLE. Thank you, Mr. Chairman. I want to say to the panelists, that I am delighted that you are here today, and I want to study carefully what you have had to say to us. The Senate Finance Committee is also meeting this morning on the revenue aspects of the budget request by the administration, so as a member of that committee, I have been involved in that. And I have just had the head of a major manufacturing company in my State come by to talk about the urgency of the trade situa- tion, a person well known to everybody in the room, who feels that more is going to have to be done before we can have a very happy or sanguine sense as to the future, notwithstanding your com- ments, Mr. Heinemann, about feeling a little bit better as a small shareholder of GE these days. NO. 1 DEBTOR NATION Let me ask this question. We have become the No. 1 debtor nation, and we have done it in a very short space of time. I have a chart that I take around with me to illustrate on a scale graph what it looks like, but the rate of descent from a creditor nation to a debtor nation looks just like the Air Mexico plane looked after its tail was sheared off and an amateur photographer took a picture of it, as it was headed for the ground. That is what that curve looks like, when you put it on a graph scale. We are adding to the net international debt at the rate of about $1 billion every 2 l/z days. Now maybe we have got sort of a miracle turnaround coming in the trade account, but I must tell you, I don't see it, not just from the Michigan point of view, I just don't see it in the numbers. Now maybe it will be there, but I can recall hearing that a year ago Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 from people who thought that it was coming, and then lo and behold, even though the dollar fell versus the yen and the mark, not much happened. In fact, what did happen was the wrong thing. The trade deficit with Japan went up substantially, though the dollar was down. Now maybe these reduced salaries at Hitachi and other places or the firm that you mentioned will start to make a difference, but we haven't seen that yet. My question is this: The New York Federal Reserve Board has now estimated that we are going to owe the rest of the world roughly $1 trillion by 1990. That is their operational estimate, the most recent one that I am familiar with. Help me size that. What does that mean, in terms of future eco- nomic prospects? Can we tolerate a buildup over that period of time of debtor nation status of $1 trillion? Can it go to $2 trillion? If we went from $1 trillion to $2 trillion over a 3- or a 5-year period, does it make any real difference? Can we continue to feel that all the foreign money that is coming to us now that is paying for all the debt that we are incurring; public, private, individual, corporate, will continue to be available, or are we reaching some kind of outer bound of these trend lines that ought to cause us to say to ourselves that we've got a very serious international balance sheet problem? That is really my question. Do we or don't we? And if we don't now, are these rates of change in these trend lines taking us to that point where we'd better treat it as an urgent matter? Let me start with you, Dr. Chimerine. You seem ready to re- spond. Dr. CHIMERINE. Yes. I think the answer to that question, Sena- tor—and by the way I just notice that I think we have scared away all the newly elected Senators, Mr. Chairman. I hope that after sit- ting through this hearing, they haven't had second thoughts. [Laughter.] But anyway, I think the answer really has two parts to it. First, how much are they willing to lend to us? At some point, they may be unwilling to lend us increasing amounts of money as they have, unless we push up our interest rates to make it more attractive for them. So that is the first question. Second, even if they are willing, even if we can continue to add to our foreign debt at $100 billion or $150 billion a year, that money is not coming free. If that $1 trillion estimate by the end of the decade is right, we are going to be seeing something in the range of $80 billion to $100 billion a year of interest and dividends leaving the country, just getting sucked out of the income structure in this country. So one way or another, it is going to reduce future living stand- ards. I think that is the real issue. It is not just the foreign debt issue. It is "What does it mean for the economy in general," for living standards, for domestic demand, for to the next generation, and so forth. All of these things are moving us in the direction, in my judgment, of holding down living standards in the years ahead. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 TESTING THE OUTERBOUNDS OF STRUCTURE Senator RIEGLE. But I still want a reflection from you and the others, is the point where we are now, the rate of change, the rate at which we are adding international debt, the $1 trillion estimate by 1990, are these cause for sufficient alarm in your mind, in terms of testing the outer bounds of structure, the international struc- ture, people's willingness to lend, to cause us to say we are doing some things now to get off those trend lines. Mr. AXILROD. Yes. In this kind of a situation, and I think Alan Meltzer earlier described it, the living standards will have to de- cline in the transition to a new period. In these circumstances, the faster you act, in a way, the better. If you let the debt get higher and higher and higher, then the tolerance of the foreigners for holding it will get less and less and less. At that point you risk a drop in the dollar that is extraordinarily sharp. It is impossible to make the domestic adjustments to move resources from purely do- mestic sectors to foreign sectors very rapidly. So if the dollar drops extremely fast, most of what you are going to get is the inflation- ary aspects of that because the real adjustments will not be coming along in time. And if the trade deficit drops very fast before we have our budget under control, then you could get the inflationary aspects in spades. So the sooner we begin making the trade adjustments the better, and I think we have begun making them. The drop in the dollar since February 1985 is certainly critical in that. But we are prob- ably at the point we could well use a little breathing space—get the budget deficit down, get the dollar stabilized, and begin making the trade adjustments gradually. I don't think we should lose patience, as long as we have the process under way. Dr. MELTZER. May I join in that? Senator RIEGLE. Yes, please. Dr. MELTZER. I spent considerable time in my testimony on that point, and I don't want to repeat all of it, but let me make two prints. First, the debt is in dollars, so that we are not in the posi- tion of Mexico or Brazil It is important to understand that, because we can try to inflate our way out of the debt. That is, we can reduce the debt by inflation, and we are, in fact, moving to some degree in that direction, I believe. The longer term problem is, of course that we are going to have, in my estimate, a minimum of 600 to 900 billion dollars' worth of debt. We are going to be paying $60 billion in interest payments by 1990 under the most fortunate of circumstances. That is going to be ll/2 percent of the GNP. Think about our problem. 4 percent of the GNP, we have to turn, in order to get the trade balance in balance. When we do that, we've got to do another 1 Vz percent, in order to get the excess of production overspending, to pay the interest on that debt. Senator RIEGLE. Right. Dr. MELTZER. Now it is almost impossible to see a increase in living standards under those circumstances over that period. The real question for the Congress is, what will happen after that. $80 or $60 billion in interest payments is more or less in the bag now. That part of the problem is the result of what we've done up to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 now. The question to be resolved is, where are we going to be in 1995, and what should we do? There is a lot that we can do now. We can make our situation in 1995 much better or much worse. The basic problem is that we are producing less than we consume, both publicly and privately. And we have to reverse that. The way to reverse it, in my opinion is, we have got to shift more funds into investment, so that the money we borrow goes into productive in- vestment, which creates productive jobs, which services some of the debt when productive jobs come on stream. We should adopt a pro- ductivity-enhancing program, and that productivity-enhancing pro- gram, in my opinion, has to have a shift in taxes I know you are not going to like to hear this, because you've just been through tax legislation. We have to shift taxes from investment to consumption. We have to shift spending, both private and public from Senator RIEGLE. Don't you mean it the other way around? You mean from consumption to investor? Dr. MELTZER. No. We have to take the taxes off of investors and put them on Senator RIEGLE. I beg your pardon. I understand. Yes. BROAD-BASED CONSUMPTION TAX Dr. MELTZER [continuing]. Consumption. That is, we need to go to a broad-based consumption tax. In my opinion, we should take all taxes off of capital. And I remind you, that is what Japan is start- ing to do. And they need that kind of stimulus far less than we do. Senator RIEGLE. You know, just as a followup to that, before the other two respond, have you done an analysis to the degree to which the tax bill actually takes effect, sort of works against us and works against the argument that you have just raised? Mr. MELTZER. Yes. It raises the cost of capital to American indus- try. All right. There are differences in the estimates of how much it raises the cost of capital to American industry, but it is moving in the wrong direction. We should be moving in the opposite direc- tion. We should be reducing the cost of capital. We should encour- age capital-intensive industry, which can produce high productivi- ty, to produce exports for the world. Senator RIEGLE. May I hear from the other two? Mr. HEINEMANN. I totally support Professor Meltzer. That was a key recommendation of the Shadow Open Market Committee at our last meeting. I very strongly believe that—and I have said this repeatedly in written material—the Tax Reform Act was upside down. It is a good law for Japan, a bad law for the United States. I strongly support Professor Meltzer's proposal that the corporate taxes be repealed and be replaced with a broad-based consumption tax. Dr. ROBERTS. At the time of the debate I made those same points, Senator. Senator RIEGLE. May I ask, just as my time expires, on this ques- tion of the build up of the international debt, are either of you very nervous about that, or do you think we can stay on these trend lines here and ride on out to that $1 trillion debt in 1990 and beyond and not suffer horrendous consequences, as a result of that? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 Dr. ROBERTS. Well, I have the feeling that there is some self-cor- recting factors there, just because the build up of the debt is not infinitely sustainable. So I sort of share the point of view of Mr. Axilrod that probably something has got to happen to turn that around. If you remember, it was only, you know, a year or two ago, that everybody was worried about the crisis of the strong dollar, and they were projecting out forever what the effects of this strong dollar was going to be and everyone was testifying the dollar could never come down until the budget deficit did. And all of that hysteria turned out to be false. So it can be mis- leading to asume that unsustainable trends can be sustained and taking how are you going to pay the cost, because probably they won't be sustained. So you may never have to pay that cost. Now if, for some reason, we manage to forever do the wrong thing and sus- tain an unsustainable trend, it is going to be bad, but I hope that people learn from this in more general ways, because when the lesser developed countries were building up massive foreign debts, it was widely interpreted as a good thing for them. And if it was so good for them, how is it so bad for us? Senator RIEGLE. You know, it is interesting—my time is up—but it seems to me a lot of what they were doing was, in a sense, in- vesting in an infrastructure, an industrial base. They were import- ing consumer goods and other things, and we are hooked on just the other side of it. We are buying the video recorders and every- thing else, and as a developed nation, carrying the free world's de- fense burden. It seems to me, we are totally out of synch with what we ought to be doing at this stage of the game. Dr. MELTZER. Right on. Dr. ROBERTS. Well, I wouldn't push that too far, because appar- ently many of those investments were not successful Senator RIEGLE. Well, I am not saying that their strategy worked for them, but that doesn't mean that the strategy that we have, if we are out of synch, is going to work for us any better. Dr. ROBERTS. I don't think that it is a strategy we have. I think it is a consequence of an unexpected, unanticipated collapse of infla- tion. The collapse of inflation that occurred was not predicted by anyone, and it set in motion these events. So I wouldn't say it is a strategy, and I think, my monetarist friends here read too much in the decline of the dollar. They see it as some sort of Government strategy to reflate. I just don't think there is a strategy like that. It is not quite clear that government has a strategy as a government. Senator RIEGLE. It sounds like it is time we had one. Thank you, Mr. Chairman. PERIODIC RECESSIONS The CHAIRMAN. Mr. Heinemann—I just have two more quick questions. First, Mr. Heinemann, what do we do in the event a re- cession comes? I get the impression that some of us feel we could avoid a recession forever. It seems to me, the price we pay for a free system is recessions periodically. We have had them historically. I don't think we can avoid them. So what do we do in the next recession? Can we follow a policy of having a $300 or a $400 billion deficit? Now Henry Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 Kaufman said we can't afford a recession. Well, we are going to have one, I think. Can we fight it by an even looser monetary policy? A 23-percent increase in monetary base isn't enough? What do we make it, 50, 100? Then what do we do? Take another drink? Mr. HEINEMANN. Senator, the business cycle has not been re- pealed. I think you are correct in implying that policies designed to prevent recessions characteristically create them. And so I think you are on the right track, totally. I think that mistakes have been made, and we have a real price to pay. I think we can begin to minimize the cost of future reces- sions by insisting on a monetary policy which is less destabilizing. The amplitude of fluctuations in money growth can be damped down over time. We can have smaller fluctuations in money growth rather than bigger ones. And over time, we can gradually minimize the real cost to the system of the inevitable ebb and flow of economic activity. I don't think we can repeal the business cycle, but we can mitigate it. As I said in my statement, I think policies that depend on pro- gressively larger perturbations in monetary growth will give us an unstable macroeconomic environment. The CHAIRMAN. Thank you very much. Now Mr. Axilrod, I would like to have you make history for us. If you answer this question, you will make history as the first former Federal Reserve official, with the kind of major monetary responsi- bilities that you had, to ever make an interest rate forecast. [Laughter.] You are in a position to do that now. You are unleashed. You are in the private sector, so you are perfectly free to tell us, what are the short- and long-term interest rates going to do over the next 6 months? Mr. AXILROD. Mr. Chairman, I will tell you that, if I may have a little preface to it, and the little preface I would like to have is sort of implicit in many of the things that have been said here already. I like to assume that we really are aiming for smaller price in- creases than the 3 to 4 percent that we have had over the last 3 or 4 years, though it was less than that last year. So I am going to assume we are aiming for that. I think, in the interim, before we get there, there is some little risk of a recession, because you can't be sure that this drop in the dollar and the re- straint in the budget are going to be so nicely phased that they will be consonent with a sort of a balanced growth. We could have, for example, a sharp drop in the dollar and not as much budget re- straint as the Congress seems to be promising. Then we might well have a little excess demand in the economy, with more upward pressure on prices. In my opinion, if that develops, it ought to be fought by the Fed in the interest of getting to lower price increases over time; in that case, interest rates will rise for a while. I don't think they will rise for very long, because I agree with Dr. Chimerine that, basically, there is not—aside from the international sectors, aside from the exchange rate drop and what that might do—there is not much real strong thrust in the economy, the reason being, real interest rates are still relatively high. Certainly, they are not very, very low. So any further rise in rates is probably going to, fairly imme- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 diately, control the economy, cause it to drop off, control the infla- tion. On the other hand, I don't think the economy is all that weak. We have made substantial productivity improvements, so I think that once inflation comes under firm control, the sort of the basic strength we have built into the economy over the past several years—for example, productivity improvements in manufactur- ing—will begin asserting itself. As a result, the economy will rela- tively promptly begin growing at near its potential. When that happens, interest rates will be a lot lower than they are now, be- cause the rate of inflation will be a lot lower than it is now. So in my personal opinion, assuming I am right, that the Fed is going to be going to aim at lowering rates of inflation over time, interest rates will be lower over the next year or two. In the inter- im, however, I want to be somewhat agnostic about rates, because no one can be absolutely certain that they won't have to go higher before they go lower. That's my view on it. The CHAIRMAN. Thank you very much. Senator Riegle has some questions on that. LOWER LIVING STANDARDS IN THE FUTURE Senator RIEGLE. Thank you. Just one other thing, and that is, several of you touched on this and maybe all of you did earlier, about the prospect of lower living standards in the future, that the crunch that we've got to work our way out of and pay off some of the bills that we have accumulated, internationally and otherwise, indicate that, as we look out, there is going to be a reduction of living standard taking place here at some point. How we distribute that is a very complex and sensitive question, or even if we can, from a policy point of view. I would like your judgement as to what kind of a downward adjustment in living standard are we apt to be looking at here, and when it is likely to come. I mean, what are the American people in store for here that may be unique in our con- temporary economic history. Certainly, you know, post-World War II history. Mr. AXILROD. It is difficult to put numbers on it, Senator Riegle, but it is coming right now. For the last 4 years or so—and I may be off a bit in my numbers—our spending in this country has grown about 11A points on average per year, more than our output. Now once we start shifting resources into the international sector—to increase export, for example—then that spending has got to come down. What we are going to be confronted with for several years ahead is output growing by whatever our potential is—say 3, 3Vg percent—and spending growing less. Depending on how fast an ad- justment to country wants to make, spending can grow, say, a half a point to one point less for several years or two or three points less for a couple of years, or we could back ourselves into a sharp recession and get the whole thing over with very promptly. But that is what we are confronted with. In Japan, for the previous 6 years, their spending grew much less than their output. They have to make the symmetrical adjustment to us, to keep the world economy growing. They've got to get their spending growing more than their output to absorb the resources Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 that the rest of the world is going to be devoting to the internation- al sector. If they don't do that, then that is something of a down- ward cast on the economy. You can't put an exact number on it, but we are in the process of reducing domestic spending now. That will occur until we are in whatever reasonable trade balance, whether it is a little surplus or little deficit that all the world and we are satisfied with. When you reach that point, then spending and output can all begin growing together, because the shift has occurred. Senator RIEGLE. Let me go right down the table. Dr. CHIMERINE. I agree, Senator, and again, it is hard to give a number but one way of measuring this phenomenon it is with real incomes or real wages. And, in my judgment, they have begun to stagnate already. We had a temporary increase in real wages last year, because of the decline in oil prices, but now that that is over, real wages are stagnating, and when you add to that the increased debt servicing for most consumers, you can make a case that the average American family will experience either stagnant or mod- estly declining living standards on average for the next 5 years or longer. It doesn't sound so bad if you already have high living standards, but the problem is, it is not equally distributed. We are seeing a number of people losing relatively high-wage jobs. Most of the new jobs we are creating are at much lower wages. I think that the boom in the stock market, you know, is making a small frac- tion of the population wealthier. Most others are not benefiting from it. So we are probably widening the income disparity or income dis- tribution disparity, but if you look at the average, I would agree that about the only thing we all agree on this morning is, at a min- imum, living standards will stagnate and probably edge lower on an average basis for the next 5 years. It is hard to measure exactly how much. Mr. HEINEMANN. I would like pass to Dr. Meltzer for the moment and then come back to something else. Senator RIEGLE. OK. Dr. MELTZER. Let me give you a ballpark estimate. Like all esti- mates by economists, it has large variation around it. We are good at some things, but forecasting isn't one of them. But let me give you a ballpark estimate and tell you how I got it, so it may help you a little bit. The economy for 100 years has grown at a rate of 3 percent a year. Population is growing at a rate of a one-half to 1 percent a year. So that gives us a base of 2 percent a year, 2 to 2l/z percent a year in growth of per capita income. Against that, we have a trade deficit of 4 percent of GNP, which we have to turn around, plus 1 Vs. percent of GNP that we are going to be paying in interest rates on my estimates, which are lower than the ones that you used. So against our 2 percent minus in per capita income, we have IVb percent for debt service plus a 4 per- cent one-time reduction in income to turn the trade balance. You only have to turn the trade balance once. But part of it is perma- nent. The debt that we have out there, we pay interest on forever. So that gives you some limits, so some idea of the ballpark esti- mate. It says we may suffer a drop or a slow increase if we close Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 the trade deficit over the period to 1990, and after that, we are going to have relatively slow growth in living standards. NEED TO INCREASE PRODUCTIVITY I agree with Dr. Chimerine that it is not going to be across-the- board. I disagree with Dr. Chimerine when he says that we are cre- ating jobs which are low-paying jobs. We always create low-paying jobs, because we create them for entry level people. We are not doing it at any greater extent in the past 5 years than we have over any other reasonable period of the time. Our problem is not to argue over the past. It is to ask how are we going to turn the prob- lem around, and the answer is, the only way that we have is, to increase productivity, so that output grows a little bit faster. Senator RIEGLE. I think the part that is different with respect to your last point is, it may well be that we have created lower wage jobs when there has been a job creation spurt. I don't know that we have seen the disappearance of the higher paying jobs at the same time. In other words, the windfall reduction or loss of high value- added, high-income manufacturing wage jobs is really, I think, an extraordinary phenomenon that is going on at the same time. Dr. MELTZER. You've seen that in the auto industry and in Pitts- burgh Senator RIEGLE. We are seeing it all over the country. Dr. MELTZER. But we are also creating- high-paying jobs. We are turning out a fair number of college graduates who are going into technical jobs. You know, all these kids who go to Wall Street, and there are large numbers of MBA graduates. There are doctors. They are going into high-paying jobs in service industries. So it is not true statistically. In fact, Bob Samuelson has a column in the Washington Post this morning that says exactly the same thing. Senator RIEGLE. I understand that, but frankly, it doesn't square with what I am seeing, not just from a Michigan point of view. Last week, we had a group in the Defense Department say that we now ought to consider direct financial subsidies to the computer and semiconductor industry in this country, because it is in trou- ble. And last year, we imported more high-technology items that we exported. I mean, we are upside down on that account, apart from cars and trucks, apart from agriculture. And it goes right on across the board. I mean, the problem that I see is exactly the Samuelson column, and if we can't get past understanding what is, in fact, happening outside, you know, textbooks that are 20 years old, I don't think we are going to deal with that problem. Dr. MELTZER. Whether you are right or I am right, the answer is going to be the same. The answer has to be the increase in produc- tivity, investment that increases productivity. Whatever we have been doing in the past, it is clear that the only way we are going to solve the problem in the future is to in- crease productivity. Senator RIEGLE. I do want to hear from Dr. Roberts and Mr. Heinemann. Dr. ROBERTS. On this topic, if Congress is to compensate for what it sees as changes in income distribution it's likely to work against Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 the measures it needs to enhance the productivity. So if Congress does its old ways, it's not likely to help the situation with regard to increasing the productivity. I agree with what's been said about the implications for our living standards of building up large foreign debt if you're not building it by building productive capacity to pay for it. So we want to be sure we build some more to do that. But population growth is about as unpredictable as anything else. It could actually decline, in which case it's not clear you would find a surplus of too many people chasing low-paying jobs. So the wild card in all that is the behavior of the population growth and I don't think any of us here can predict it. Not even people who are supposed to be able to predict it can predict it. Mr. Chairman, are you still giving us 2 minutes at the end? The CHAIRMAN. At the end, yes, sir. If you want those 2 minutes you can sure have it. Dr. ROBERTS. Can I take them now or should I wait? The CHAIRMAN. Take them now. DOMESTIC BUDGET DEFICIT Dr. ROBERTS. I want to caution against seeing in the domestic budget deficit an expansionary fiscal policy. I don't think it is an expansionary fiscal policy because it wasn't created in order to be that. It was the effect of the collapse of inflation below expecta- tions, below forecasts. So, if the domestic budget deficit is in large part a reflection of an unexpected disinflation, it would be a mistake to see it as an expansionary force in the economy. And if it is not an expansionary force and it's seen as one, it could lead to tighter monetary policy than we could really afford. Since the collapse in inflation was not anticipated, it affected the budget dramatically, I think it would have been useful if several years ago the Congress and the administration had adjusted the budget to the unexpected component in the decline of inflation. It could have done that by having a 1-year spending freeze instead of fighting over budget shares, a spending freeze would have gone a long ways toward adjusting the budget to this collapse in inflation. Because when inflation collapses unexpectedly, it doesn't bring the spending down hand-in-hand with revenues. And so the failure to make this adjustment to the unexpected disinflation has caused a lot of problems, a lot of misinterpretations, a lot of wrong solutions that are advocated that just confuse everyone and give a continued divided house and prevent any decisive action. And what I think we all agree on is that we have reached the point where we need to have some decisive action which improves the situation and, therefore, we have to fully assess the costs as well as the benefits of whatever action that we take. The CHAIRMAN. I take it, Mr. Heinemann, you passed and you wanted to come back. So you make your statement and anybody else who has a closing thought or two, preferably one, let us have it. Mr. HEINEMANN. I waive my 2 minutes. I just want to respond to Senator Riegle. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 Senator, it seems to me that in thinking about the implications of the buildup of the net U.S. foreign debt there are a couple of points that we really haven't talked about here this morning. They are obvious but I think they need to be made, FOREIGN INVESTMENT IN AMERICAN INDUSTRY One, the foreign assets in the United States are not going to stay invested in Treasury bills and Treasury bonds. They are going to move into the real economy. That's already started. And I think we need to think in political terms very thoroughly about the implica- tions of very broad-scale, widespread foreign ownership of Ameri- can industry. We need to think about the mix of production: What kind of pro- duction will be in the U.S. vis-a-vis the home country? Will it all be low end, low-value-added assembly operations or will the high- value-added manufacturing processes also occur here if the compa- ny is foreign-owned? In the auto industry, which I presume you have some concern about occasionally, my sense is that most of the foreign-owned U.S. operations are at the low end of the scheme—the assembly oper- ation. That is one broad set of concerns. I have to assume, if these num- bers are anywhere near correct, that we haven't even begun to see the beginning of the change. Now by the same token, it's fascinating to contemplate what kind of a convergence may occur between the interest of our princi- pal creditors in our export performance and our own interest in our export performance. Longer term it seems to me our creditors are interested in seeing us not try to inflate our way out of our for- eign debt. They are going to be interested in seeing our export per- formance improve just as we're interested in seeing the Brazilian export performance improve. I would not be surprised to see, for example, just taking a name out of the air, the Honda plant in Marysville, OH producing for export within a very short period of time. Chrysler now seems to be making the same point in starting to sell U.S. North American pro- duced products in Europe. They're not going to sell very many units there but Mr. lacocca is making a very important political point in doing this. That is another set of problems. I also am concerned that there may be some security issues in- volved here too that don't get much discussion. We saw during the Vietnam War that De Gaulle was able to put an enormous amount of pressure on Lyndon Johnson by withdrawing gold at the wrong time and in the wrong way. Our creditors, if they become anywhere near as big as we think they're going to become, are going to have an important voice in our political affairs—indirectly, but they are going to be there, just as we have a voice in Mexican or Brazilian or Argentinian affairs today. I think we need to think through very carefully what our longer-run role may be as a superpower if in fact we are going around the world with a tin cup asking for money all the time. The CHAIRMAN. Anybody else? Dr. CHIMERINE. Can I have part of my 2 minutes? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 The CHAIRMAN. Go right ahead. Dr. CHIMERINE. First, I'd like to register a strong disagreement with the last comment by Dr. Roberts on the cause of the budget deficit. The slowdown in inflation was a minor factor in these large budget deficits. The truth of the matter is they were caused principally by the combination of a large military buildup and large tax cuts un- matched by sufficient budget cuts elsewhere. You can blame them on somebody for not making other cuts or you can blame it on the tax cuts or whatever, but the slowdown in inflation was not the major cause. Second, I agree strongly with your comment, Senator Riegle. I didn't read the article this morning in the Post, but based on the work we've done, a relatively large fraction of the jobs that have been lost in the last several years have been high-paying jobs and a relatively large fraction of the jobs that have been created have been low-paying jobs. You can point to a few "whiz" kids on Wall Street, but there are a lot more people getting jobs in fast food restaurants or whatever at the minimum wage, and many of them part-time, than there are new jobs on Wall Street. Third, Senator Heinz asked a question before that I didn't get a chance to respond to about the implications of the decline in the dollar on inflation. Clearly, the decline in the dollar is going to add to inflation. We can't get the trade deficit down without it. The key question, though, is whether or not it's going to trigger the kind of wage-price spiral we had in the 1970's, after oil prices rose and ultimately led to the 10 or 12 percent inflation we had. Underlying conditions strongly suggest no that it won't. We can't avoid some dollar-related inflation, but as long as it doesn't feed into the wage structure, and commodity prices don't start rising, and as long as we have this cushion of a lot of excess capacity, in- flation may rise to 3 or 4 percent, but it's unlikely to approach the 7, 8 or 10 percent range. The last comment I'd like to get equal time for the Monetary Policy Forum, Mr. Chairman. You may not know this, but we have strongly advocated a position of ignoring the growth in Ml in recent years, and that if the Fed had tightened during the last sev- eral years because of the strong growth in Ml I think we probably would be in a severe recession right now. I'd like to submit for the record the latest statement of the Monetary Policy Forum on its views on monetary policy. The CHAIRMAN. Thank you very much. Anybody else want to make a comment? Dr. MELTZER. I'll take 1 minute. I think the issue before us, Sena- tor, is, as it always is, how do we maintain high productivity and low inflation or price stability in the economy. I think you're on the right track. We cannot forecast. In studying the records of forecasters—all forecasters, including my own fore- casts, Dr. Chimerine's forecasts, the Federal Reserve forecasts—the simple fact is that we cannot tell, on average, whether we're in a recession or a boom in the very quarter in which we're making the forecast. That's the record of forecasting over time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 To guide the economy by that kind of forecasting is to produce the kinds of mistakes we have made repeatedly. The Japanese don't do it. The Germans don't do it. They have much more stable policies and they have higher productivity, not entirely but partly as a result of that. We would do well if we would emulate them in that respect. I think you're on the right track and I hope you will continue with it. The CHAIRMAN. Thank you very much, Dr. Meltzer. I want to thank all of you, gentlemen. This has been one of the best panels I've heard in 30 years. It's really been very good, stimulating, dif- ferent opinions and so forth, and it provides an excellent ground- work for Chairman Volcker, who will appear tomorrow and re- spond to some of the very excellent points you have raised. Thank you. The committee stands recessed until tomorrow morning at 10 o'clock. [Whereupon, at 12:30 p.m., the hearing was recessed, to be recon- vened Thursday, February 19, 1987, at 10 a.m.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1987 THURSDAY, FEBRUARY 19, 1987 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. The committee met at 10 a.m., in room SD-538, Dirksen Senate Office Building, Senator William Proxmire (chairman of the com- mittee) presiding. Present: Senators Proxmire, Riegle, Sarbanes, Dixon, Sasser, Shelby, Graham, Garn, Heinz, Armstrong, D'Amato, Hecht, Gramm, and Bond. OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. The committee will come to order. We continue this morning with the most important of congres- sional oversight responsibilities. As I said yesterday, this is prob- ably the most important oversight hearing that any committee of Congress has inasmuch as we have a clear constitutional responsi- bility. And that is, of course, overseeing the development and im- plementation of Federal Reserve monetary policy. We have a clear and exclusive constitutional authority over the money supply. We have delegated the implementation of that au- thority to the Federal Reserve Board. We cannot and should not delegate our fundamental responsibility, however, for overseeing the implementation and direction of the Fed's action. As you know, Chairman Volcker, this Senator and, I think, the committee as a whole takes that responsibility very seriously and feels that our duties under the Constitution compel us to challenge the monetary policy which, at least this Senator believes, is inap- propriate and perhaps dangerous. Simply said, Chairman Volcker, the present rapid pace of money growth exceeds prudence. As you know, in 1985, the target range was 4 to 7 percent and you came in with a 12 percent for Ml. In 1986, last year, the target range was 3 to 8 percent. I thought it was far too large a range. We came in with 17 percent. As you know, since October, the increase has been 21 percent. On page 26 of your statement for the coming year, you tell us that we're not going to have a target, in effect, for Ml. You will monitor it; you will watch it; you will keep close to it. But as the author of the law that mandated the targeting of the aggregates, it seems to this Senator that your failure to provide a target range for Ml violates the spirit—I presume not the letter, but the spirit of the law calling for targets for the various aggre- (85) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 gates and especially Ml which is certainly fundamental, not alone and perhaps no longer the most important, but one which is signifi- cant. Current monetary growth rates are unwise in view of the infla- tionary potential inherent in the falling dollar and continued defi- cit spending. To make matters worse, we are far more vulnerable to a resurgence of inflation than we were a few years ago given our own massive consumer debt and corporate debt and our position as the world's largest debtor Nation. If foreign investors lose confidence in our price stability and withdraw their funds, interest rates will go through the roof. In the words of one former Treasury Secretary, "We will then have a re- cession that will curl your hair." "Knock the ashes off your cigar" may be more appropriate. [Laughter.] We are sensitive to the enormously complex nature of monetary policy developments. We heard a panel of five internationally known economists yesterday, including your former staff director for monetary policy, Stephen Axilrod, a man whom I know you greatly respect and admire, and who worked for you for years. The analyses and conclusions of these outstanding economists were thorough but conflicting. Certain principles of monetary economics, however, are not sub- ject to doubt. Among the most important of these is that money growth greater than nominal GNP will result in accelerated infla- tion. We are aware of the uncertainties associated with the demand for money that have caused the Fed to disregard the rapid growth of the monetary base and Ml. Nevertheless, the rough interest rate and inflation rate stability of the past several months should have also stabilized the money demand function, making the aggregates the most appropriate of the available measures of monetary ease. A look at the growth rates of any of the aggregates reveal mone- tary growth to be greater than that of nominal GNP and much greater. With debt, both domestic and international, and exchange rates in as precarious a balance as they are, the Federal Reserve has little room to maneuver. This situation is not likely to change making the best policy, in the judgment of this Senator, one in which money growth should be moderated now rather than risking the need for a drastic and destabilizing reduction later. We can joke about when to take away the punch bowl, but at risk is something far more serious than just a hangover. That risk is economic collapse, widespread personal and corporate bankrupt- cies, and rampant unemployment. At risk is the economic future of this Nation and of the world. Chairman Volcker, we appreciate your being here this morning and look forward to receiving the benefit of your testimony. Senator Garn. OPENING STATEMENT OF SENATOR GARN Senator GARN. Thank you, Mr. Chairman. As we meet here this moring to continue the first round of mone- tary policy oversight hearings for 1987, I believe that it is most im- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 portant for us to maintain a balanced view of the current state of the U.S. economy. Certainly there are problems demanding our attention. The Fed- eral budget deficits and the trade deficits are creating debt burdens that will weigh heavily on future generations. Severe sectoral prob- lems are creating economic hardship for the energy industry, for agriculture, for the real estate industry in certain parts of the country, and for many financial institutions. At the same time, we are in the midst of an historically long- term economic expansion that began more than 4 years ago. In each year of this expansion, more jobs have been created in the United States than in the combined economies of the next six larg- est industrial democracies. Most importantly, the conditions of rising inflation and rising in- terest rates that have aborted previous postwar expansions are not evident in the U.S. economy today. Thus, we have a good chance of sustaining this expansion as we work on the budget deficit, the trade deficit and the remaining sec- toral problems. The hearings that began yesterday are of critical importance be- cause of widespread concern that monetary policy may be inadver- tantly laying the groundwork for the very conditions—rising infla- tion and rising interest rates—that could put an end to the expan- sion. Growth of the Ml aggregate during 1986 at a rate of over 15 per- cent—almost double the maximum rate forseen by the Fed's own target growth range—is raising the most concern. A related issue is: How can Congress meet its monetary-policy oversight responsi- bilities if the Fed misses its announced target by such a great margin. At the same time there is also concern over a premature tighten- ing of monetary policy. Such an action also could put an end to the economic expansion. A healthy economy over the long-term requires healthy financial institutions. Today financial institutions in this country are labor- ing under some heavy burdens. Problems in certain economic sectors are creating sever difficul- ties for many banks and thrifts. These problems are compounded by Congress failure to update the outdated, decades-old financial- structure laws that do no take into account recent changes in fi- nancial markets. An end to the economic expansion brought on by misguided mac- roeconomic policies would compound the problems already facing our Nation's financial institutions. Fortunately for our financial institutions, prospects are good for sustaining economic growth with moderate inflation. The time is long overdue, however, to also overhaul our financial-structure laws in light of the ongoing changes in financial markets. This would enable our Nation's banks, thrifts and other financial insti- tutions to play their proper role as pillars of strength for our econ- omy. The CHAIRMAN. Senator Riegle. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis OPENING STATEMENT OF SENATOR RIEGLE Senator RIEGLE. Thank you, Mr. Chairman. I want to add just a point that may be somewhat different in tone than the statement that you've just made. That is that I am very uneasy about the prospect of higher interest rates right now and it seems to me that the whole question of how the monetary aggregates are managed leads very quickly to the question of whether or not we should in effect raise interest rates. I see two major dangers if that were to happen right now. One is that growth would slow down in the economy. The revenue coming into the Government would tend to be less and our budget deficit would widen out, and we've got a terribly serious problem with the Federal budget deficit anyway. I don't want to see it getting bigger because the economy in effect begins to slow down. The other side of it is, if the cost of capital, which is already very high in this country relative to our major trading partners, is driven even higher by higher interest rates, the trade deficit, which was $170 billion last year, will rise even higher. I don't want to see American business burdened with a higher capital cost today than it presently is, certainly relative to our major trading partners, and I worry about that effect of higher in- terest rates. So it's one thing I think to have a concern about how our monetary aggregates are managed and how they look in total, but I think we're walking on a tightrope here and there isn't much room for maneuvering. It seems to me, on the one hand, while we don't want to reignite inflation, in a sense, our two very dramatic problems right in front of us, the fiscal deficit and the trade deficit, are things that have to be improved and they have to be reduced, and lower interest rates—certainly not higher interest rates—is really the way, I think, to try to give us some measure of improvement in both those areas. So I would hope that comments today might reflect on these tradeoffs because they are certainly at the heart of these policy de- cisions. I thank the Chairman. The CHAIRMAN. Thank you, Senator Riegle. Next in line—we do this on the basis of who appeared in the committee first—is Senator Hecht. Senator HECHT. Thank you, Mr. Chairman. No statement. I'm just waiting to hear our distinguished witness. The CHAIRMAN. Thank you. Senator Dixon. OPENING STATEMENT OF SENATOR DIXON Senator DIXON. Thank you, Mr. Chairman. Mr. Chairman, I am pleased to be here this morning to hear the Chairman of the Federal Reserve Board, Paul Volcker, testify on the Federal Reserve's plans for the conduct of monetary policy and the Board's economic forecasts and assumptions. This is an impor- tant and sensitive? time for the ucunOniy. THe Federal Reserve has to chart a course through perilous waters.^ la void tipping the econ- omy into recesskKB^S<Amf5imifeiltH^Mrrat!onary pressures. I know Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 the Chairman's testimony will be of great value to the committee, and I look forward to hearing from him. I want to take this opportunity, however, before Chairman Volcker begins, to suggest to the administration that he should be renominated as Chairman of the Federal Reserve Board when his term expires. Paul Volcker has been an outstanding public servant. He enjoys a reputation in the financial community that is un- equaled. I do not think we can afford to lose his services to the Nation in these difficult economic times. I have had the opportunity to come to know the Chairman since I came to Washington. I have been deeply impressed by his dedica- tion to public service, and by the leadership he has provided over the course of his Government career. I know the Chairman is making a real financial sacrifice by stay- ing in Government rather than moving to the private sector, and I know it may be unfair to him to ask him to stay on. However, I hope the administration will do the right thing and ask Paul Volcker to remain as Chairman of the Federal Reserve, and I hope Paul will find it possible to accept that offer. The old Army recruit- ing posters used to say "Uncle Sam wants you"; I would para- phrase that to say "Paul, Uncle Sam still wants you." The CHAIRMAN. I certainly echo that view absolutely. Next is Senator Bond. Senator BOND. Thank you, Mr. Chairman. I am here to learn and I look forward to hearing Chairman Volcker's testimony. The CHAIRMAN. Senator Sarbanes. OPENING STATEMENT OF SENATOR SARBANES Senator SARBANES. Thank you very much, Mr. Chairman. I am pleased to welcome Chairman Volcker and I may not be able to stay for the hearing but I hope at some point he will ad- dress the difficulty we always confront that, on the one hand, he says that we need to do things about our fiscal policy—and I agree with that—on the other hand, if monetary policy moves in what may be the wrong direction, it compounds the fiscal problem. In other words, an upsurge in interest rates may lead to a downturn in the economy and a downturn in the economy will simply com- pound the fiscal problems. So we're caught once again in trying to balance those two and we obviously need the Fed to be sensitive to that as we try to work out of this situation. The CHAIRMAN. Senator Gramm. OPENING STATEMENT OF SENATOR GRAMM Senator GRAMM. Well, Mr. Chairman, let me join everybody else in welcoming you here. I think as we look back on your period of service, whenever it's over, whether it's over soon or over a long time from now, I think it's clear you will have served in a very dif- ficult period where fiscal policy was often moving in the wrong di- rection and monetary policy had to take up the slack. I have never been one who has been a Fed basher in terms of blaming the Fed- eral Reserve for all our problems. I would have to say in looking at the growth of the monetary base that I share some of the concerns of our Chairman. If it Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 weren't for the situation we face in terms of the inflation rate, if it weren't for the relative flatness of the economy, and regional weak- nesses within the economy, I would be quite concerned about the growth of Ml. On the other hand, taking those weaknesses in the economy into account and looking at the fact that M2 is not growing, I have not changed my belief that the money supply and monetary base are important. I guess my problem is trying to decide what is money. So I'm not ready to go back and throw out the money and banking textbook that the money supply is an important factor in the econ- omy. I just don't know whether it needs to be rewritten in terms of what is money. But in any case, I know you are following the monetary aggre- gates. At the current time I am not willing to say that I am alarmed. On the other hand, I think the money supply is growing very rapidly. We have worked very hard, at great sacrifice to the economy, to get the inflation genie back in the bottle, and I think it's very important that we continue to monitor what's happening. I think at the current time I am not concerned about the growth in the money supply, but I think it's something we've got to follow very closely, because if the situation should change in the economy dramatically—with the decline in the value of the dollar, obviously the price of imports is going to rise, and we're going to see an in- crease in the demand for American goods. Our trade deficit is not the result of unfair trade practices by our trading partners, which have not changed dramatically in 20 years. It's, instead, the result of the fact that the highest interest rates in the world in the last 6 years have driven up the value of the dollar and those capital in- flows have been offset by a trade deficit. As that process reverses— and it will reverse and is reversing now—at least we're beginning to see the beginnings of it—I think we are going to have to go back and look at our inflation problem, and at that point I think we're going to have to look at these monetary aggregates very closely. With that, Mr. Chairman, I appreciate your giving me time. The CHAIRMAN. Senator Armstrong. Senator ARMSTRONG. Mr. Chairman, I didn't intend to make a statement but I'm tempted to respond to Senator Gramm's observa- tions about Fed bashing. I'll just tell you, Senator, don't knock it until you've tried it. [Laughter.] I have nothing else, Mr. Chairman. The CHAIRMAN. Senators D'Amato and Heinz have requested that their statements be inserted in the record. STATEMENT OF SENATOR ALFONSE M. D'AMATO Senator D'AMATO. I would like to welcome Federal Reserve Board Chairman Volcker to the committee this morning. Due to the rumors swirling about Washington and Wall Street about the Fed's course, his appearance before us this morning is most timely. I am concerned about recent indications that the Federal Re- serve may be tightening monetary policy. For example, the in- crease in interest rates in the last week was caused by fears result- ing from the Fed's failure to inject reserves into the banking system when the Federal funds rate was well above 6 percent. The Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Fed's inaction made many market participants nervous and this was reflected in the wild, albeit short, gyrations in the short-term Treasury markets. Hopefully, Chairman Vplcker will inform us whether or not the Fed is shifting toward a tighter monetary policy or whether it is continuing to pursue the same course as Chairman Volcker indicated during his discussion of these issues before this committee on July 26, 1986. A shift to a more tightened monetary policy could have drastic results for the economy. Although monetary policy alone is not a cure all to the problems confronting our domestic economy, a tight- ening or slowing down of the growth of the monetary supply could trigger a recession. The drastic results and the budgetary impact of such a policy were articulated by Paul Craig Roberts in yesterday's hearing. While the potential inflationary impact of an increase in the monetary supply poses a threat that must be considered, the certain recession that can be triggered by drastic reductions of the monetary supply presents a peril that must be avoided. Chairman Volcker's testimony also emphasizes several points that have been made to the committee in the past regarding the stability, or should I say the relative instability of our domestic economy. Today's testimony again substantiates the assertion that economic forecasting is hardly a precise science. However, certain steps must be taken by the Congress, the President, and the Feder- al Reserve Board to ensure continued and stable economic growth. If the economy continues to grow at a moderate rate and if we are going to introduce more stability into the domestic and interna- tional economies, then Congress must address two problems that no longer loom on the horizon—these problems are at the front door. The first problem is that the budget deficit must be reduced in as rational and least painful manner as possible. The deficit issue has become a political football with the Congress blaming the President and the President blaming a profligate Congress. Such accusations tend to exacerbate rather than resolve the problem. I am interest- ed in the testimony of Paul Craig Roberts who introduces in his testimony another culpable party in the deficit debacle—the con- duct of monetary policy by the Fed. I hope he will elaborate on this point during the hearing. I also hope each of our witnesses will offer their recommendations on how the budget deficit may be cut and whether they think Gramm-Rudman is effectively accomplish- ing its intended goals. The second problem confronting our domestic economy is the trade deficit. Frankly, I am tired of hearing the same old argu- ments about how Americans can't compete; the unions have priced American heavy industry out of the market; and America is losing its technological advantage. I believe these arguments and those advancing draconian protectionist legislation ring hollow when one takes a real look at what's happening to American industry. American industry is at the forefront of innovation. U.S. compa- nies spend billions on innovation each year and develop new tech- nologies. However, before these new technologies can be put to practical uses, we find that our foreign competitors are using the same technologies, in practical uses, at lower costs. How can they do this? Easy, many of our competitors are stealing us blind. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 During our last hearing on the Federal Reserve's monetary policy report, I stated that our so-called trading partners: Steal our patents, intellectual property rights, systematically are adjudged guilty in the courts, say we're sorry, pay back penalties, continue the same thing, infringe on patents and then send the products here into the United States. Further, those harmed have limited recourse under the current legal system. At present, even though your copyright may have been infringed or your patent stolen you must then demonstrate that there is substantial danger to the particular industry, before damages can be awarded. Despite the failure of the laws and trade policies pursued to date we hear, oh, yes, we're going to make to make changes. We've been waiting a long time for negotiations or other bilateral approaches to work. We wait in vain. It seems to me, absent any legislative action or some very real enforcement of present trade practices, the policies of the Japanese and others will not change be- cause they lack any incentive to change. I have not changed my point of view on this subject. I should also note that Chairman Volcker supported my notion of the cause of such competitive trade imbalances and urged us to act. I am sorry to state that in the drive to make America more competitive, we and the administration have yet to consider the steps needed to make technological piracy more punitive. Thank you, Mr. Chair- man. STATEMENT OF SENATOR JOHN HEINZ Thank you, Mr. Chairman. It is always a pleasure to welcome Chairman Volcker, who may be setting records by making his second appearance in less than one month before the committee. Mr. Chairman, there are concerns regarding the dramatic growth in the money supply during the past year, particularly in the Ml category. Several of the witnesses yesterday expressed alarm at the fact that Ml grew 17 percent, well exceeding the Fed's target boundaries of 3 to 8 percent. They also noted that 1987 has opened with a further dramatic increase in Ml growth, again considerably ahead of Federal Reserve targets and, in fact, ahead of rates in the 1970's when inflation was at its peak. These witnesses believe the Fed is ignoring the lessons of history and planting the seeds of disaster because in the long run, the tra- ditional relationship between the supply of money and inflation will prevail. In their view, the Fed's tolerance of excess growth in Ml will trigger a sharp growth of economic activity and an early renewal of inflation. Other witnesses, while not dismissing monetarism altogether, at least questioned its import. In their view, other factors must be taken into consideration. First, they noted problems with how to define "money" for monetary policy purposes. According to them, the traditional definitions of "money1 have changed—especially in the Ml category—and that it might not be an appropriate basis for setting monetary policy. Second, and perhaps more importantly, they noted that the rela- tionship between Ml and economic growth has changed. In essence, the gross national product is simply not following Ml the way it used to. In fact, GNP has been showing only a moderate growth in recent quarters compared to the rapid growth. These witnesses pointed out that the same thing has been hap- pening in other Western countries. I think the obvious answer is the sharp decline in interest rates in recent years. Depositors are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 now willing to carry more funds in Ml form because it costs less to do so. Despite these varying views, all the witnesses suggested that the Fed's tolerance on credit could be temporary due to new develop- ments. One is the recent increase in the price of oil. While this may be a factor, it may take on lesser importance. Today's Wall Street Jour- nal reports that world oil prices have skidded to their lowest level this year. Of course, this could be temporary. Another important factor is the sharp decline in the value of the dollar relative to other currencies. This has already resulted in rising prices of imports and has the potential of leading to higher prices generally down the road. Mr. Chairman, I am not sure which of these schools of thought should prevail in the setting of monetary policy. However, I am sure that the debate about whether money should grow on a for- mula basis or whether judgment should be used in allowing money growth will continue today with Chairman Volcker's testimony. The CHAIRMAN. Mr. Chairman, I understand that you were asked to confine your remarks to 10 minutes. You've got about 38 pages. That is awful rapid reading. Mr. VOLCKER. I hadn't gotten that message, Mr. Chairman. The CHAIRMAN. Well, if you can do it in 11 or 12 minutes, we can extend it from 10, but seriously Mr. VOLCKER. Well, I wont read this whole statement, but I think you have raised some questions which I attempt to answer in the statement and I think I ought to take advantage of this oppor- tunity. The CHAIRMAN. Well, we won't run the light on you. We'll get in trouble with other people by not doing it, but we won't. Whatever time you take, I hope you can do it as rapidly as possible. STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. VOLCKER. Let me say first of all, thank you, Mr. Chairman and Senators. You have our full monetary policy report to the Con- gress. That includes a lot of details, including projections of the committee and our target ranges and so forth. I would like to take a few minutes before getting to those money supply questions by at least alluding to the broader economic setting. FIFTH YEAR OF RECOVERY AND EXPANSION You know that we are now entering into the fifth year of recov- ery and expansion and I think this is an unusual expansion in more respects in that it's been relatively long already. Among other things, at the end of this 4-year period, we find both the in- flation rate and the interest rate lower than when expansion start- ed, which is unusual in itself. And I think basically the traditional indicators of cyclical prob- lems that we have had in the past are largely absent. But I do have to emphasize that the economy is struggling with structural distortions and imbalances that for this country have little precedent. You know the facts and outline. The economic ac- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 tivity over the past 2 years has been supported very largely by con- sumption. That's been at the expense of reduced personal savings rates that by world standards were already chronically low. At the same time, the huge Federal deficit is absorbing a disproportionate amount of what savings we have in this country. We have largely escaped the adverse impacts of that for financial markets by draw- ing on capital from abroad. In 1986, the capital that we have enjoyed from abroad has actual- ly exceeded all the savings by U.S. households. The other side of that coin, however, is a massive trade and current account deficit, restraining growth in manufacturing generally and incentives for the industrial investment that we will need in the years ahead. The simple facts are that we are spending more than we produce and that we are unable to finance at home both our investment needs and the Federal deficit. Those are not conditions that are sustainable for long—not particularly when, as at present, the influx of capital from abroad cannot be traced to a surge in produc- tive investment. Sooner or later that process will stop and the only question is, how? I go over in my statement some possible approaches that I reject and say basically the only reasonable alternative is adopting a variety of measures. It's a complicated process, but it is the only promising prospect to me as opposed to protectionism or permitting inflation to rise or not dealing with the deficit. We have to draw upon a combination of policy instruments. The results are going to take time, but they will come with greater cer- tainty, and they should be consistent with maintaining growth here and abroad. They have to be consistent with price stability and with open markets and I think very broadly that is the course upon which we are embarked. And the success of that course is going to require an unusual combination of discipline, patience and international coop- eration. But the stakes are such that I don't think we have any choice, not just for the United States but for the world. I review the progress that has been made. The dollar is at much more competitive levels than it's been. We are making progress at least this year on the deficit question. I think that's going to be harder for you next year. Some of the things contributing to the reduction from a record deficit are temporary and we've got to keep that deficit coming down on an orderly course. COMPLEMENTARY ADJUSTMENTS I do spend some time in the statement pointing out the implica- tions for the world economy. We loom very large in that economy. If we move to improve our trade deficit here, it obviously has im- pacts on others. We would like to see complementary adjustments. I think the world must see complementary adjustments in the major countries with exceptionally large surpluses and that, of course, notably means Japan and Germany, both of which now are experiencing some decline in their net exports but alongside of that I think there's some evidence that their economic activity is falter- ing. They essentially have the opposite problem that we do, sus- taining internal demand while reducing the trade surplus. We're Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 going to have to diminish internal demand while seeing more demand from abroad. Certainly they don't find these changes much easier than we do. The design, nature of the measures, are going to have to be their decision, the precise timing—they are all strongly debated, but what really matters is that they do, it seems to me, have a clear responsibility for maintaining a strong momentum of growth in their economies as they absorb more imports from the rest of the world. I could make similar comments about a few of the newly indus- trialized countries. I should at least allude to the fact which is discussed in my state- ment that the international debt situation remains highly relevant to growth and financial stability around the world. I think there's been progress in that area over the past 4 years, but I think there are clear problems as well. And the fact that world growth has not been as well-maintained as we hoped makes it more difficult for them but, more precisely, right now in recent months, the process of reaching agreement on adequately supportive and timely financ- ing programs for those countries, whether by restructuring existing debts or by arranging what new loans are necessary, has conspicu- ously slowed, for a variety of reasons. I think that logjam has to be broken. Now the implications for broad U.S. policy I think are pretty clear. We have an inescapable responsibility to deal with our budget deficit. We have got to restore internal balance if we're going to restore external balance. And I don't think that responsi- bility is important just because of our own situation where we are so dangerously dependent on foreign savings, but because of a broader consideration. Progress abroad, as a practical matter, is likely to be stymied without constructive leadership from the largest and strongest nation. And if we, instead, resort to closing our markets, if we are indifferent to depreciation of our own currency, if we permit infla- tionary forces to regain the upper hand, there isn't going to be any basis for confidence in the United States, and prospects for comple- mentary action abroad or for growth in the world economy would then be dim indeed. Second, I think we have to recognize the adjustments do require a shift in financial and real resources into internationally competi- tive industry and away from consumption and Federal deficits. Without a sharp rise in overall productivity from the 1 percent or so rate characteristic of the past decade or more, I see no reason to suggest that trend will change abruptly—the recent rate of con- sumption is simply unsustainable for long. More of our growth needs to be reflected in exports and in business investment and less savings will be available to finance the Government. Now fortunately, in the manufacturing area, which is the key area of international competition, growth in productivity and re- straint on costs have been relatively strong, and that is very help- ful, but the challenge is to maintain that performance in the face of a depreciating currency. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 Now a lot of policy instruments are involved here, but let me turn to monetary policy which obviously has a critical role to play and it has a great advantage of flexibility. RAPID GROWTH OF MONEY AGGREGATES I review in the statement what you have already alluded to—you and others, Mr. Chairman—the rapid growth of the various mone- tary aggregates, particularly Ml last year. We also reduced the dis- count rate several times last year. Essentially, I think we have had a generous provision of reserves, a large expansion in money. I must emphasize that that took place in and appeared justified by an environment of restrained economic growth and declining in- flationary pressures. The latter, to be sure, was dramatically and importantly reinforced by a temporary factor—the sudden collapse of the world's most important commodity—oil. But potentially more lasting indicators of inflationary pressure— the rate of increase in workers compensation and the prices of some services that respond slowly to changes in economic environ- ment, were also trending downward. For much of the year, most commodity prices other than oil measured in dollars were falling despite the depreciation of the dollar in the exchange markets. Moreover, sizable declines in long-term interest rates seem to re- flect some easing of fears of a resurgence of inflationary pressures in the future. Nonetheless, the possibility of renewed inflation remains of con- cern both in the markets and certainly within the Federal Reserve, and I would note that one potential channel for renewed inflation- ary pressures would be an excessive fall of the dollar in the ex- change markets and at times during the past year such exchange rate considerations did prompt particular caution in the conduct of policy. Now I review in several pages here, Mr. Chairman, the analytic work that's been done quite intensively through the year to try to get a handle on this growth in the monetary aggregates. I won't take the time to review that here. It is obviously related in sub- stantial part to the declines of interest rates we've had that affects the demand for money. I hope that it reflects some greater confi- dence in money. It may, to some degree, reflect the exceptional amount of financial activity we've had in markets, but the changes in these relationships, partly growing out of institutional changes, certainly does pose new questions in setting monetary targets to help guide the conduct of monetary policy. In the broadest terms, a leveling, and even some decline, in velocity could be welcomed as an appropriate sign of growing confidence in the value of holding money during a period of disinflation. But explanations revolving around declining interest rates and greater confidence in price sta- bility beg the larger issue. Not all the increases in money can be adequately explained by interest rate relationships, nor can we be certain about what inter- est rate is appropriate. We know that confidence is hard to win and easy to lose. We need to be conscious of the fact that the effects of excessive money creation on inflation may only be evident with lags and they may be quite long. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 As a consequence, we cannot avoid relying upon a large element of judgment in deciding what, considering all the prevailing cir- cumstances, money growth is appropriate. Obviously, so far as 1986 is concerned, the Open Market Commit- tee made the judgment that relatively strong growth in the aggre- gates, and particularly Ml, could be accommodated consistent with the more basic objectives of orderly growth and price stability. Nei- ther the rate of economic growth, nor the margins of available re- sources, nor underlying cost trends, nor the movement of sensitive commodity prices suggested money growth was setting in train re- newed inflationary forces. RAPID RATE OF DEBT I must say the continuing rapid rate of debt throughout the econ- omy has raised one warning flag. In one sense, the enormous volume of purely financial activity, especially at year end but also at times earlier, reinforced other factors increasing the demand for money. But from another point of view, the ready availability of re- serves and money was also a factor facilitating that same increase in purely financial activity. The implicit dangers in that process should be clear. More lever- aging of corporations, aggressive lending to consumers already la- boring under heavy debt burdens, and less equity in homes all in- crease the vulnerability of the economy to economic risk. The fact that after 4 years of expansion many measures of credit quality are tending to deteriorate rather than improve, and that too many de- pository institutions are strained, should be warning enough. Restraining more speculative uses of credit by more restrictive monetary policy is, of course, possible. But that blunt approach in- evitably has implications for all credit and for the real economy as well as financial activity. It cannot substitute for prudent apprecia- tion of the risks in highly aggressive lending by those engaged in financial markets, reinforced and encouraged by regulatory and su- pervisory approaches sensitive to the potential problems. Now in looking at 1987, the Open Market Committee remains highly conscious of the long historical patterns that relate high rates of monetary growth over time to inflation. Consequently, in approaching 1987, it starts with the strong presumption that such growth should be moderated. Reflecting that intent, the tentative target ranges for M2 and M3 set out last July were reaffirmed. While those ranges are only slightly below those set 1 year ago, the Committee expects that the actual outcome should be much closer to the middle of the range and near to the anticipated growth in nominal GNP, assuming interest rates prove to be more stable than in recent years. While anticipating much slower growth than in 1986, the Com- mittee did not set out a specific target range for Ml. Given the de- velopments of recent years, uncertainty obviously remains about the long-term relationship between Ml and nominal GNP in today's institutional setting. That uncertainty about the trend might be encompassed by a relatively wide target range. However, the shorter term sensitivity of Ml currently to interest rates and other economic and financial variables realistically would require Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 so wide a range, or tolerance for movements outside its bounds, as to provide little guidance for the Committee's operational decisions or reliable information for the Congress or for market participants. Instead, the Committee will monitor Ml closely in the light of other information, including whether or not changes in that aggre- gate tend to reinforce or negate concerns arising from movements in M2 and M3. More broadly, the appropriateness of changes in Ml will depend upon evaluation of the growth of the economy and its sustainability and the nature of any emerging price pressures. Among important factors influencing such judgments may be the performance of the dollar in the exchange markets. I recognize the success of that approach rests on good judgment and a degree of prescience. It is justified only by the fact that set- ting out a precise Ml target—and weighing it heavily in policy im- plementation, whatever the circumstances—would run greater risks for the economy. I must also point out that the sensitivity of Ml to interest rates and other developments will not always work in the direction of relatively high growth. To the contrary, action to reduce the rate of Ml growth, promptly and substantially, would be called for in a context of strongly rising economic activity and signs of emerging and potential price pressures, perhaps related to significant weak- ness of the dollar externally. In that connection, the Committee ex- plicitly reserves the possibility, in making shorter run oeprational decisions from meeting to meeting, to use Ml along with M2 and M3 as a benchmark. Conversely, lower interest rates in a context of weak growth and further progress toward reducing inflation pressures would suggest an accommodative approach toward Ml growth. In fact, as you know, the statistical and other signals provided about economic activity and prices seldom are unambiguous or have the same directional implications for policy. In evaluating the evidence as it does appear, the Committee will naturally be sensi- tive to the desirability of maintaining the forward momentum of the economy, as well as encouraging greater price stability. Quite obviously, our task in that respect will be eased to the extent fiscal policy is consistent with the needed internal and external adjust- ments. INFLATION Finally, so far as inflation is concerned, what is critical is that the anticipated bulge in prices this year related to identifiable tem- porary external developments—oil and import prices—not be trans- lated into a broad-based cumulative upward movement. As you well know, just such a cumulative upward inflationary process started in the 1960's and then extended well over a decade into the 1980's. It was eventually brought to an end, but only with great effort and at considerable cost. The scars of that experience remain. Against that background, participants both in financial markets and in business have persistently been skeptical of prospects for lasting price stability in making investment and pricing decisions. They are bound to be alert and responsive to any sense of adverse Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 change in the underlying inflation trend, with implications for in- terest rates, exchange rates, and pricing policies. The consequences for the economy would clearly be undesirable. In effect, neither the internal nor external setting permits think- ing of trading off more inflation for more growth. Nor would infla- tion ease the problem of international adjustment. Quite to the contrary, it would both undercut some of our competitive gains and threaten the orderly inflow of funds from abroad. The implications for caution in the conduct of monetary policy are evident. Thank you, Mr. Chairman. [The complete prepared statement of Paul Volcker follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I appreciate this opportunity to review once again with this Committee the conduct of monetary policy against the background o£ economic and financial developments here and abroad. As usual, a mare detailed review of last year, of the by the federal Open Market Committee, and of the Committee's projections for economic activity and Inflation are set out in TMtiraony by the Hoard's formal Humphrey-Hawkins Report delivered to you Paul A. Volcker earlier. This morning, I want to concentrate on more general Chairman, Board of Governor* of the Federal Reserve Systc considerations underlying the policy approaches of the Federal before the Reserve. 1 will emphasize particularly how those approaches Comlttee on Banking, Bousing, and Urban Affaire must fit into a broader pattern of complementary action both in United States Senate the United States and in other countries if the common objective February 19, 1987 reached. The Economic Setting The current economic expansion — now extending into Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the absence of certain signs of cyclical excesses that often rates, after four years of expansion, ars substantially lower develop after yearK of expansion. For instance, inventories than when the recovery started. Homebuilding is being well have t?een held well within past relationships to sales, and maintained, and both capital a^ labor appear available to spending by manufacturers for plane and equipment has, if support further growth for some time without undue strain on anything, been resti-'^ined relative to prospective needs* resources. Certainly, conditions in financial markets, with While the overall rate of economic yrowth ^as been stock prices exuberant and interest rates generally as low as rather moderate since mid-1934, averaging about 2-1/2 percent at any time since the mid-1970s, appear supportive of new a ye a i*, that growth hae been -ia inta L ned despite gtriincj pressures i nvr:a ti"e nt. on sizable sectors of the economy. Oil exploration and develop" But it the traditional indicators of cyclical problems ment activity and agricultural prices have both been heavily are largely absent, it is also evident that the economy is many areas is suffering from earlier over~building. Regions for us, have little precedent. Economic activity over the past o£ the country in «hich those impacts have been particularly two years has been supported very largely by consumption- That hi large have thus regained relatively depressed. Difficult as been at the expense of reduced personal saving rates that, by those regional conditions have been, however, many of the necessary world standards, were already chronically low. At the same time, adjustments are well advanced and other areas of the economy the huge federal deficit is absorbing a disproportionate amount have been moving strongly ahead. of our limited savings. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -4- -5- For a time, we ha.«e largely «acapad the adverts It IB not supportable politically, as the pressures consequences for financial markets of that insidious combination on our Industrial base are transmuted into demands for protection. of low saving rates and high federal deficits by drawing on Ultimately it will not be supportable from an international capital from abroad — the flow of which in 1986 actually perspective either, as the confidence that underlies the flow of exceeded all the savings by U.S. households. The other side of foreign savings will be eroded. that coin, however, is a jaaasive trade and current account Sooner or later, the process will stop. The only deficit, restraining growth in nanufactoring generally and question Is how. Incentives Cor trie Industrial tnveitnent that we will need The Broad Policy Approach tn the y«r« ahead. In concept, MB could shut Olf th* Clou ol import* by O to The simple facts are that we are/ spending more than we aggressive, broadbrush protectionist measures. But the result produce and that we are unable to finance at home both our investment would be to drive up the rate of inflation and interest rates needs and the federal deficit. Those are not conditions that are here, to damage growth abroad, and to invite retaliation. Instead of sustained and orderly growth, we would invite (com abroad cannot be traced to a surge in productive investment. world-wide recession. It'e not sustainable from an economic perspective to We could try to drive the dollar much lower — or pile up foreign debts while failing to make the Investment that complacently sit back while the market forces produce that we need both to generate growth and to earn the money to service result. But that too would undermine the hard-won gains the debts. against inflation, and would risk dissipating the flow of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis be consistent with maintaining growth here and abroad, with financial markets would be jeopardized, and export prospects markets. That is, in fact, tne course on which we are embarked. might reasonably embark upon strong austerity programs — indeed To be sure, its success will require an unusual combination sooner or later would be forced to undertake such programs. Large doses of fiscal and monetary restraint would be taken, risking I djn't think there is any real choice. respond vigorously, imports would decline, and their economies Important steps have already been taken in the needed o CO would soon resume growth on a much sounder footing. But, in the context of a sluggish growth of the world economy, for the United and the results would be problematical at best. complicated, but at the same time much more promising. He can draw upon a combination of policy instruments to epreciatic encourage the needed adjustments. Results may take time. But we have been fortunate that the initial impact on the overall pr Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis level was more than offset by falling oil and other conmodity Success in my mind will not be measured so much by whether we meet some pre-ordained arbitrary target but by wages relative to productivity, has continued to fall. whether in fact a reasonably steady downward pace in the deficit is maintained as the economy grows — and maintained aoye abroad, has been well that, it's hard to see how a sustained decline in the trade nalr deficit, 1C possible at all in the face of huge budget deficits, In reducing our current account deficit, the net capital inflow will bring net benefit to the economy. The clear implication will decline as well. That enphasizes the critical importance would be congested capital markets, higher interest rates, of moving ahead with further reductions in the federal budget deficit which absorbs so much of our own savings. The progress being made in that direction this year Inevitably, because we loom so large in the world Is heartening. But that can only be a start. The projected economy, marked improvement in our trade balance will be reduction of S40 to SSO billion this year is fron a record high matched by noticeable deterioration elsewhere. Appropriately, deficit of more than $220 billion in fiscal 1966 — more than that should take place largely in the major countries with 5 percent of the GNP — and it is being assisted by some temporary factors. Progress next year will be harder. al net effectively Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -10- unless those countries and others are able to maintain a strong IB being -- strongly debated within those countries. What is For years, those countries have been dependent Cor the measures or their enact timing, but that, at the end of the growth mainly on high and rising export surpluses. In both day, they are successful in maintaining a strong momentum of growth instances, some shift toward domestic demand was apparent in even as they absorb more imports from the rest of the world. One rianger is that, in the absence of stronger domestic That points in the needed direction. But there are also signs growth, pressures will intensify for more appreciation of their declined. At the same time, relatively high levels of unemployment Given the size of the exchange rate adjustments already made, o en and unused of inflationary pressures that they, understandably, want to Some newly industrialized countries also have clea Quite obviously, the needed reorientation c-f economic policies — essentially the complement of our own — is no Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -13- In the interests of their own citizens as consumers, as well jl action te thwart prospects for expansion, and with it the encouraging increase imports, whether by reducing tariffs, by lifting othe progress that has been made toward both more open, competitive economies and political democracy. What la needed instead is Success in these efforts, I must emphasize, will not greater access by those countries to growing markets in Europe necessarily oc primarily be measured by changes in our own and Japan as well as here. The recent changes in exchange rates bilateral trade vis-a-vis particular countries. An open competitive trading order ia by its nature multilateral, and u and others should judge equilibrium in a world-wide content. Japan. At the same time, imports by the developing world from o Oi In that connection, most of the developing world, the United States have become much more price competitive than already carrying heavy debt burdens, is in no position to a year or two ago. revalue currencies or to absorb much higher imports (from the The Debt Situation United States or from others) without more or less parallel I cannot neglect emphasizing one further continuing countries. Management of the debt problems of Latin America and some other developing countries is again at a critical stage. The exports reason Is not that progress is absent. To the contrary, most of at all. the heavily indebted countries have been growing — it for the most Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis move lower relative to exports or other measures at capacity to pay, and new financing needs have been reduced. Perhaps most the unfortunate effect of dulling a sense of urgency and cooperation progress toward liberalizing trade, opening markets, and reducing by some. I do not want to deny the progress. But to fail to carry internal economic distortions, with the World Rank playing a through on past efforts now would plainly jeopardize much of that particularly helpful role. success and threaten new strains on the financial system. Implications for U.S. Policy col Several key implications of all this for the United Impair prospects for the developing countries to find the markets States should he clear. ttiey need. More tinned, lately, in recent months, the process of reaching agreement on adequately supportive and timely financing fit what new loans are necessary, has conspicuously slowed. complexity of the individual financing programs themselves, most of which require the agreement of hundreds of banks around tne world. In some instances, policy set-backs in the borrowing Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -16- forces to regain the upper hand, then there would be no basis £ar confidence. Ln the United States. Prospects ior etteEtive that performance in the face of a depreciated currency, higher import prices, and more sizable needs for new investment to Second, we have to recognize that the needed adjustments Finally, achieving these goals in the context of into internationally competitive Industry and away from consumpt ion the capacity of any single policy instrument. Quite obviously, and federal deficits. Without a sharp rise in overall productivity monetary policy will have a critical role to play. In doing so, o 00 is simply unsustainable for long. Instead, more of our growth conflicting criteria. will need to be reflected in net exports and business investment, Rapid Growth of Money and Liquidity and leas savings will be available to finance government. Throughout 1986, monetary policy accommodated a growth and restraint on costs in the key manufacturing sectors the narrowly measured money supply — Ml -- grew at a has been relatively strong during the period of economic particularly rapid pace. The discount rate was reduced four Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -IB- -19- pressures, measured by average adjustment borrowings o£ depository the future. institutions from the Federal Reserve, was relatively low throughout Nonetheless, the possibility of renewed inflation 1986, and has remained BO since. remains of concern both in the markets and within the federal This generous provision of reserves and expansion in Reserve. One potential channel for renewed inflationary pressures noney took place in, and appeared justified by, an environment would be an encessive fall of the dollar in the exchange markets, of restrained economic growth and declining inflationary At times during the past year, such exchange rate considerations pressures. The latter, to be sure, was dramatically and prompted particular caution in the conduct of policy. The timing collapse in the price of the world's most important comtnodtty, the provision of reserves was affected; on occasion close pressure — the rate of increase in workers' compensation particularly important. and in prices of some services that respond slowly to changes More generally, intensive analytic work during the in the economic environment — were also trending downward. year suggested that much of the relatively rapid growth in the For much of the year, most commodity prices other than oil, various monetary aggregates was closely related (with lags] to measured in dollars, vere falling despite the depreciation of the rather sharp declines in market interest rates late in the dollar in the exchange markets. Moreover, the sizable 1985 and the aarly months of 1986. The responsiveness of declines in long-term interest rates seemed to reflect Borne money demand to changes in interest rates is a well established Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ause ol its composition, Ml was particularly influenced widely used by individuals are close to rates paid on competing accounts have riot declined nearly as much as market rates or Both H2 and >43 ended the year within -- hut just those on longer—term deposit accounts. Consequently, there within — their target ranges. Even so, the increases of has been a strong incentive to transfer funds to NOW (and to almost 9 percent were about as large as most earlier years, some extent savings) accounts and away from other, leas liquid when inflation and the cat* af economic growth wete higher. instruments. Demand deposits, which are largely held by businesses rapid increases in monetary growth meant that all measures of velocity (i.e., the ratio of nominal GUP to money) declined. in earlier years. In part, that was also a reflection of That was particularly evident in the case of Ml; the velocity decline of 9 percent was greater than in any year since World War II. Hh jrt attractive. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -22- since intsreat rates peaKed In 1981 and 1982. The earlier post- and easy to lose. We need to be conscious the effects of excessive money creation on inflation ma/ only trend established during a period of generally rising inflation be evident with lags — possibly quite long. and interest rates — clearly does not provide a reasonable base for judging appropriate HI growth today. Historically, there element o£ judgment in deciding what, considering all the level is historically a bit low relative to other periods of Obviously. 50 far as 1986 is concerned, the FOMC made low or declining interest rates. the judgment that relatively strong growth in the aggregates, All of this posea new questions in setting monetary and particularly Ml, could be accommodated consistent with the more basic objectives of orderly growth and price stability. broadest terras, a levelling, and even some decline, in velocity Neither the rate of economic growth, nor the margins of available could be welcomed as an appropriate sign of growing confidence resources, nor underlying cost trends, nor the movement of In the value of holding money during a period of disinflation. sensitive commodity prices suggested money growth was setting in train renewed inflationary forces. greater confidence in price stability beg the larger issue. The continuing rapid rate of debt throughout the economy Not all the increases in money can be adequately explained running far above the rate of economic growth since 1982 — has by interest rate relationships, nor can we be certain about raised one warning flag. In one sense, the enormous volume of what interest rate is appropriate. Confidence is hard to win purely financial activity, especially at year end but also at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -25- reinforced and encouraged by regulatory and supervisory for money. But approaches sensitive to the potential problems. The_flpproach to 1987 increase in financial activity. corporations, aggressive lending to consumers already laboring unde high rates of monetary growth over time to inflation. Consequently, ties in approaching 1987, it starts with the strong presumption that such growth should be moderated. Reflecting that intent, the four years of expansion, many measures of credit quality are 5-1/2 to 8-1/2 percent uere reaffirmed. while those ranges are only slightly below those set a year ago, the Committee depository institutions are strained, should be warning enough. expects that the actual outcome should be much closer to the ipated gt restrictive monetary policy is, of course, possible. But that stable blunt approach inevitably has implications for all credit and fc than in recent years. While anticipating much slower growth than in 1986, Given the developments of recent years, uncertainty obviously Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -26- -27- remains about the long-term relationship between Ml and nominal GNp. That uncertainty about the trend might be encompassed by a good judgment and a degree of prescience. It is justified only by the fact that setting out a precise Ml target — and weighing it heavily in policy implementation, whatever the circumstances — would run greater risks for the economy. tolerance for movements outside its bounds) as to provide little rates and other developments will not always work in the direction information of relatively high growth. To the contrary, action to reduce the rate of Ml growth, promptly and substantially, would be called for in a context of strongly rising economic activity and signs of emerging and potential price pressures, perhaps related to tram movements in M2 and M3. More broadly, the appropriateness economy and ita austaInability and the nature of any emerging peice pressures. flmong the important factors influencing such along with H2 and H3 as a benchmark. Conversely, lower interest judgments nay be the performance of the dollar in the exchange rates in a context of weak growth and further progress toward market a. approach toward Ml growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis That would be about about economic activity and prices seldom are unambiguous or have the same directional implications for policy. In So Ear as infl temporary external developments not be translated into a broad- forward momentum of the economy, as well as encouraging greater band cumulative upward movement. As you well know, just such a price stability. Quito obviously, our task in that respect cumulative inflationary process started in the 1960s and then will be eased to the extent fiscal policy Is consistent with the extended well over a decade into the 1930s. It wag eventually Most members believe that GNP growth of 2-1/2 to 3 percent is now likely, although a few individual members have higher or Against that background, participants both in financial lower projections. such growth should be consistent uitti continuing markets ar,fl in business have persistently been skeptical ot sizable gains in employment and a slight downward tilt in the prospects for lasting price stability in making investment and unemployment rate. Membera also agree that the rate of price pricing decisions. They are bound to Be alert and responsive increase is very likely to be greater than last year( essentially to any sense of adverse change in the underlying inflation because oil prices are expected to average higher and because trend, with implications for interest rates, exchange rates, and pricing policies. The consequences for the economy would forecasts bunch in the 3 to 3-1/2 percent area for the GNP deflator. clearly b* undesirable. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis permits thinking of trading off more inflation foe more growth. involved, and all of them have tough political decisions to competitive gains and threaten the orderly inflow of funds team make. Nor are th« key decisions entirely in the hands of governmental authorities. American industry, in particular, it. has the challenge to build upon the efforts of recsnt years and imbala pressing debt problems of their borrowers at home and abroad. from one point of view, it may seem liXe a lot to ask. Jill be amplified by tne effects on other countries. Moreov We already have achieved a long economic expansion. We have managed to combine that with progress toward price Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -32- rates. Financial markets more generally reflect renewed confidence And the broad outline o£ policies that can preserve and extend those gains are by now well known. resistance. Hut. those are also precisely the ways by which we would turn out hack to the bright promise before us. It 1* only a concerted effort here and abroad that will estend and reinforce the economic expansion, consolidate the environment in which all countries c< Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 117 REPORTING REQUIREMENTS FOR THE FED The CHAIRMAN. Thank you very much, Chairman Volcker. Chairman Volcker, let me first ask about that question that I raised with respect to your dropping Ml as far as a specific target is concerned. I want to read from the law of 1978. It says: In furtherance of the purposes of the Full Employment and Balanced Growth Act of 1978, the Board of Governors of the Federal Reserve System shall transmit to the Congress not later than February 20 and July 20 of each year and so forth, The objectives and plans of the Board of Governors and the Federal Open Market Committee with respect to the ranges of growth or diminution of the monetary and credit aggregates for the calendar year during which the report is transmitted. Now technically, the law does not spell out a definition of the monetary aggregates, although at the time it was written Congress clearly had Ml in mind. It was only at the request of Chairman Burns that the phrase "monetary aggregates" was used to allow the Fed to report on additional measures of the money supply such as M2 and M3. The fact that Congress gave the Fed leeway to include additional measures does not mean you have the authority to drop Ml from your reporting requirements. Clearly, Ml is a monetary aggregate, although economists have some dispute about its velocity. In any event, I believe the law does not give you leeway to ignore report- ing at least a range on Ml. So my question is, have you obtained an opinion from your gen- eral counsel as to whether the Fed has the authority to drop Ml from its Humphrey-Hawkins report and, if not, why didn't you seek such an opinion? Mr. VOLCKER. I think it's fair to say that our general counsel was present when many of these discussions took place and he raised no objection. I think the clear, plain language of the law as you read it does not necessarily require an Ml target range. The substance of the matter, as I tried to describe in my state- ment, is that I don't think it would be of benefit to you or to us or to the public at large to set forth either a target range so extreme- ly wide it's of no operational significance, or set out a target range and say in a variety of circumstances we would expect to be above or below it. The CHAIRMAN. Let me interrupt at that point and suggest that under those circumstances, why not ask us to change the law? Mr. VOLCKER. Well, we have not interpreted the law as requiring that in any sense, Mr. Chairman. We have set out several mone- tary and credit aggregates, as the law calls for, and we have set out the ones that in the present situation seem to us most meaningful. The CHAIRMAN. Would you dispute the notion that in 1978 when we set this forth we had Ml specifically in mind as the aggregate and then we only yielded to Chairman Burns Mr. VOLCKER. Well, I wasn't here during that discussion, but Chairman Burns, I would say, showed a little foresight in taking you away from too single-minded a devotion to Ml. The CHAIRMAN. He didn't take us as far away as you have, how- ever. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 118 Mr. VOLCKER. I compliment the Congress for recognizing his con- cerns. The CHAIRMAN. Well, he did several things to us. No. 1, he took us away from just Ml; and No. 2, he took us into a range. And the ranges, in my view, have become almost meaningless sometimes. You go from 3 to 8 percent. And then you go to 17 percent in reali- ty. But when you have that big a range, of course, it doesn't mean very much. The ranges mean very little. Mr. VOLCKER. Well, I think it doesn't mean very much when we have a range of 3 to 8 percent and end up at 15 on the basis of the ranges expressed, to be precise, which is precisely why I don't think it's a contribution to your discussions and to our discussions to set out a range in which neither we have any confidence nor would propose to you to have any confidence in. The CHAIRMAN. But the value of a benchmark, whether it's 3 to 8 or whether it's 5 or 6 or whatever it is, is that when you do vary from it we have some basis for asking why, challenging it. We have a discussion of it. Mr. VOLCKER. Right. The CHAIRMAN. When we have something as vague as saying you're going to monitor it, watch it carefully, and so forth, we don't have any basis for judging whether it's high, low or in-between or what it is. Mr. VOLCKER. Well, one can argue what is the best way of facili- tating a discussion, but I would hope we have this basis. We do have some target ranges and I have tried to set out in the state- ment some criteria which I think are appropriate for judging move- ments in Ml. That is precisely the point. If we had a cumulating expansion and evident signs and maybe even some signs that aren't conclusive of growing price pressures, a declining dollar, given the sensitivity of Ml now to these variables, a quite low rate of expansion of Ml might be appropriate. And that is what I am suggesting. It might be below any range that we would set out now and you ought to have that in mind. Conversely, if we had a situation like last year—oil prices plunging, the underlying inflation rate declin- ing, the economy rather sluggish—a rather accommodative ap- proach would be desirable. It all depends I think, given the current institutional setting, on the economic context in which you are working. The CHAIRMAN. I want to come back to that. I do want to ask one other question before my time is up. This is a hearing on monetary policy and I apologize for asking one question off the subject but it's so important and timely I must ask it. My question is on the banking bill this committee will be considering next week. It has been suggested that the FSLIC re- capitalization bill is so important that we should deal only with that item and take up other issues such as the nonbank bank loop- hole and security powers for banks at a later date. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 119 NONBANK BANK AND SECURITIES ISSUES What is your view on how urgent it is to act on the nonbank bank and security powers issues, and should we postpone action as some have suggested? Mr. VOLCKER. Well, my view is clearly that those issues are ripe for action, that they should be acted upon. Indeed, failure of the Committee and the Congress to act on those issues would be an ab- dication of your responsibilities to try to direct change in the finan- cial system in a constructive way, The CHAIRMAN. Thank you very much, Mr. Chairman. Senator Garn stepped out, so we will go to Senator Hecht. GRAMM-RUDMAN Senator HECHT. Thank you, Mr. Chairman. Mr. Volcker, you more than anyone else have been given credit for bringing down interest rates and inflation, but I think Congress in the last couple years had a part in it and my illustrious col- league from Texas I think in Gramm-Rudman in bringing the defi- cit down in deficit reduction. If we do not adhere to the Gramm-Rudman reductions in the def- icit this year, the targets, and go on a spending spree, what is this going to do to interest rates and inflation? Mr. VOLCKER. If you go on a spending spree, to take that part of the question, and the deficit doesn't decline and increases, I think it will undercut confidence in our economic prospects. I think it would be damaging from the viewpoint of the dollar. I certainly think it would increase inflationary expectations and inflation in fact, and the consequences from the money market standpoint and interest rates and economic prospects would be extremely adverse. Now whether or not you meet the exact targets that the distin- guished Senator from Texas set out, I think it's important to have those targets, I suppose, in the context of the discussion I just had with the Chairman about monetary targets, but I suppose I must make a comment similar to Ml. I think what is important is that you maintain that clear downward momentum, if I can say we have that—I'm not sure we do—but maintain the pattern at least this year of a declining deficit in a significant way, not just in 1988 but in the years beyond—are you on a trend that is what the Sena- tor from Texas had in mind that clearly deals with this problem? Whether or not you reach exactly a $108 billion deficit I don't think is in that sense the issue. Are you on a clear and sustainable downward process on the deficit? Senator HECHT. Well, the 100th Congress has only been in ses- sion roughly a month and several times on key votes—are we going to waive the Gramm-Rudman and spend more than budgeted—and I think there's a clear indication that this Congress might not adhere to these limits. Mr. VOLCKER. Well, when you say $108, that's a limit, that's a rather arbitrary number. What I would urge with all the force at my command is that you maintain the deficit reduction, assuming growth in the economy and forecasts based upon reasonable esti- mates of growth in the economy—that you maintain a strong downward momentum in the deficit. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 120 Senator HECHT. What I want to do is bring this to the business people back home that I've been associated with all my life, the people that have created all these new jobs. If we do not—let me just be specific. If we do not continue this downward holding the budget and tightening our belt, this will produce higher interest rates. Mr. VOLCKER. I think that is on a course toward fewer jobs and more inflation. Senator HECHT. Thank you. Let me just talk about a statement that Secretary Hodel made yesterday. It is possible by the year 1990 we're going to see oil lines again. We all know about the de- cline in oil production in America and the volatile Middle East. What will this do to our economy and interest rates if we are forced to pay higher prices for oil? Mr. VOLCKER. Well,, of course, it depends upon how much. We would like a situation in the oil market that I think is not—I would anyway—one that doesn't go up and down so much because that's disturbing in itself. What level of prices is the best level in some sense for a balance in supply and demand around the world that could be sustained—and I think it is a worldwide problem—is the question at issue. Clearly there is a matter of judgment here insofar as the United States is concerned as to what price maintains reasonably our own oil production, which is probably declining anyway. I think in a sense the more significant question is, because oil is a worldwide commodity, how we best keep the worldwide situation in some kind of reasonable equilibrium for the next 5 or 10 years. Senator HECHT. Of course, this is a military situation because the Middle East is militarily unstable right now. Mr. VOLCKER. True. Senator HECHT. And we have such a huge amount of proportion of oil in that that we have no guarantee. Mr. VOLCKER. The world's and our reliance on Middle Eastern oil has been going up some recently, but there's a lot of oil in the Western Hemisphere too, and there are a lot of other questions of oil policy from a security standpoint that arise here as well as to what the relative different sources of supply are and to what degree we should be relying upon different sources. I think it's clear we are import-dependent in any event and we seem to be getting more import-dependent. It's a question of how fast and then many other questions of policy as to how you best assure the supply that we are inevitably going to have to import. Senator HECHT. When you get in Washington, we call it the belt- way area, and for some reason there's always a certain amount of gloom attached to it, but then when you look at what's happening in the world markets, the stock markets particularly, there's noth- ing but expectation and what's been going on. Getting back to Congress again, if we do not hold these spending cuts down and interest rates go up, what will this do to the eco- nomic situation around the world? Mr. VOLCKER. I don't know what it will do in the short run to some of those financial markets, but it will be a decided disservice to the economic situation around the world. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 121 As I indicate in my statement, I think there are very heavy re- sponsibilities on the part of other leading economies to take appro- priate action. But I think all the lessons of history suggest that if the United States, as the world's strongest and leading economy and power, does not take actions on its own that point in the right direction so far as our own situation is concerned, we are not going to have many people following us in terms of constructive consist- ent international policies either. So you're not only talking about a failure of American policy. I think under those circumstances you're not going to get much chance for the right policies abroad and that compounds the risks for the world economy. Senator HECHT. Thank you. My time is up. The CHAIRMAN. Thank you, Senator Hecht. Senator Riegle. Senator RIEGLE. Chairman Volcker, I am very much concerned about the fact that we have become a debtor nation in the United States within the last 2 years and we are adding new international debt at the rate of about $1 billion every 2Vfe days. I have made a chart that I just want to show you here. I'll just hold it up because I think it relates very importantly to future monetary policy. It indicates that going back to 1914 we were a creditor nation without interruption and then when we crossed this line, as I say, within the last 2 years, we have gone into this debtor nation status. This chart is to scale, as you can see, both by year and in terms of billions of dollars. I'm concerned about several things, but I'm certainly concerned about the velocity of this curve in the sense Mr. VOLCKER. You should be. Senator RIEGLE. Pardon? Mr. VOLCKER. You should be. $1 TRILLION DEBT BY 1990 Senator RIEGLE. Well, I think we all should be. The New York Federal Reserve Board has estimated that by 1990 this trend is going to continue and their best estimate is that we will owe the rest of the world roughly $1 trillion based on their current projec- tions. Now my question is this. Having come into this debtor nation status, having passed Mexico, Brazil, Poland, and all the other debtor nations, when we discussed this yesterday with a panel of economists that were here and others that I've spoken to, they say there is only really two ways to get out of that kind of a debtor's hole, which of course, is getting deeper and deeper every day, and they are: to inflate our currency, and that that's been the historic way in the past for nations to dig out of an international debt situ- ation if they're in a position to do so; and to recognize that there's going to be a very substantial reduction in the United States stand- ard of living in the future. Now how that gets spread across the society is a separate question, but all five economists who were here yesterday covering a broad range of opinion were unanimous in their view that the only way to reconcile that kind of interna- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 122 tional debt is to accept the fact that we're going to have a lower standard of living in the future. Now I'd like your reaction to that. Do you see this as an urgent problem? Does it lead to those kinds of consequences, in your view? And if it does, doesn't this—whether you're running the Fed or somebody else is—doesn't this set us up for an inflationary spiral at some point in the future simply to try to reconcile that kind of a debtor nation status? I'd like your reaction to that. Mr. VOLCKER. Well, I obviously think it's a very serious problem. I think it's a total illusion to think you're going to escape it by in- flating. You may try to fool some of the people some of the time but you're not going to fool them all all of the time—that old lesson—too recently we've had inflation, and that is no orderly way out of that hole. So I think you just reject that. Although there are pressures that arise out of this situation that increase the inflationary dangers, there's no doubt about it. If that capital does not continue to flow at present and the dollar is sharp- ly affected, you have a major source of inflationary impetus. Senator RIEGLE. Are we seeing some of that now with the dollar having declined? Mr. VOLCKER. Well, you are inevitably seeing an increase in import prices. There's no way you can have this degree of deprecia- tion without import prices going up. They have not gone up nearly in proportion to the depreciation of the dollar because there was a lot of slack there, among other factors. The appreciation of the dollar was relatively recent. Profit margins were very wide. In some of the countries that export to us from which we import in the nonindustrialized world, there obviously haven't been much ex- change rate change, and until trade patterns change that's provid- ed some relief. So we have had an increase. We are having an increase in import prices. We have been somewhat shielded from the effect so far but we would expect those to be more pronounced this year. Last year they were offset by the decline in oil prices. So if you look at the total net effect, it was minus, from oil and from import prices. Assuming the oil price doesn't go down again, that won't be the case in 1987. So you do have an inflationary impact from that source and what we've got to do is absorb that without it setting off a cumula- tive inflationary movement. That I think we can do and that is our job collectively, and it's got particular implications for monetary policy. So far as reducing the standard of living is concerned, certainly it has implications for the standard of living. There is no escape from that. The increase in consumption has been practically as large as the GNP. That can't happen continuously. That has only been possible because we are importing so much. Senator RIEGLE. And paying for it with borrowed money. Mr. VOLCKER. And paying for it with borrowed money. If you're going to stop that process and deal with the debt problem, relative- ly we're going to have to export more. That will mean consumption cannot rise so fast. I don't think you have to say the standard of living is going to decline. The standard of living will not be rising as fast as it would otherwise rise. There is not doubt about that. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 123 Senator RIEGLE. Well, but if you have to pay off that foreign debt, how do you pay that off without reducing your standard of living to pay it off? Mr. VOLCKER. It depends on how long you took to pay it off and in what circumstances. If you had to pay off all that debt as fast as it was put on, yes, the standard of living might have to decline. But if we stabilize it I would be happy for a while and in time I'd like to see it paid off. The richest country in the world should be ex- porting capital, not importing capital. But doing that over a period of time, yes, means our domestic consumption cannot rise as fast as it has been rising unless we have some miraculous increase in pro- ductivity, which I don't think you should count on. Now how does that come about in an orderly way? It will come about in an orderly way by reducing the Federal deficit. Senator RIEGLE. My time is up. I hope to come back to that sub- ject. The CHAIRMAN. Senator Bond. Senator BOND. Thank you, Mr. Chairman. BANK FAILURES Chairman Volcker, in testimony before this committee we have heard a great deal about the persistent weakness in agriculture and energy. Certainly in my State, a heavy agricultural State, and In States in the oil patch we've seen this reflected in increasing number of bank failures. In testimony before this committee, FDIC Chairman Seidman has indicated that there will be a significantly higher number of bank failures this year than the 145 last year. What implications, if any, does this have for monetary policy? What, if any, actions would you propose that Congress might take to alleviate this problem either through stretching out losses over a number of years, providing some sort of partial guarantees for loan write-downs? Mr. VOLCKER. So far as the implication on monetary policy is concerned, I would read them more as longer term implications. Part of this process reflects the difficulties of adjusting to disinfla- tion. Part of it reflects—not so much in your area, but in some other areas—overexuberance in lending. I think the greatest contribution we could make to preventing those problems from arising is dealing with the inflation problem over time so that we don't have to reverse the process and get into all these squeezes. Now obviously, in the agricultural situation, there's just a world- wide problem at the moment that isn't susceptible I think to mone- tary policy or any other policy except the Government is providing $30 billion a year for the support of agriculture which indirectly obviously helps the lenders as well as the farmers themselves. So there is really rather massive Federal support being given. I do not see that the situation requires special guarantees or whatever for those banks or for their lenders, against the back- ground that the Government is providing a great deal of support to the farmers themselves. Senator BOND. You have mentioned in your testimony the great concern over the growing corporate debt load in this country. Are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 124 there steps which you might recommend to Congress that we take in terms either of requiring full financing be available before a takeover or applying margin requirements to takeovers that might responsibly inhibit the growth of that debt? Mr. VOLCKER. I don't have any recommendations of that sort now, Senator. In the area of margin requirements where we have experience, that is a question we have looked at in the past and made a rather marginal ruling that attracted a great deal of atten- tion at the time. But I don't think those margin requirements are designed to deal with this kind of takeover problem and I'm not sure that that's a tool that can be adequately used. I think we do have responsibilities, insofar as we supervise the banking system anyway, to encourage prudence in that area. And that is a very important ingredient I think in an overall approach toward the financial problems that I see not just in the corporate area but elsewhere. We have a rapid expansion in consumer credit, mortgage credit and other types of credit. So there are clear impli- cations there. I think the market itself has to look at some of its practices. Senator BOND. The Farm Credit System, as you well know, has been running up increasing losses and I understand that Federal Reserve banks are allowed to purchase Farm Credit System securi- ties. What, if any, steps would the Federal Reserve take if there were a funding crisis for the Farm Credit System? Mr. VOLCKER. Well, I think if there were that kind of liquidity crisis that you suggest, we do have some authorities to lend the money. We also have authority to buy their securities, as you say, but that is an open market authority, if I can make a distinction. Those operations should be conducted entirely with a view toward the monetary and credit base of the country. If you have a liquidity problem of that sort, the tool would be through the discount window and there is some quite limited direct authority in the Federal Reserve Act for lending to certain ele- ments of the Farm Credit System. It is quite limited. We have broader emergency powers as well. But I think fundamentally the answer to that question should not be sought simply in Federal Reserve lending—but we do have some authority. Senator BOND. There has been some speculation that the rising stock market has reflected primarily the increase in the money supply and the falling value of the dollar. Do you feel that this market rally is driven by liquidity or by basic economic facts? Mr. VOLCKER. Well, I hate to speculate upon particularly shorter term market movements and I'm not sure my understanding is any greater than the commentary you can read in the paper every day. I don't trace it to any particular recent increase in the money supply, but as I say in my statement, I think it could be argued that the rather liberal growth of the money supply this year cer- tainly was not inconsistent with more money flowing into the stock market or other areas of the financial markets. And to the extent that would be determined to be overexuberant or too much credit being created for nonproductive purposes, one Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 125 could say, well, is that one criteria for an excessive growth in the money supply? And I think that is a reasonable question. On the other hand, growth in the money supply or the general tools of monetary policy cannot single out one sector of the econo- my for restraint and if you're dealing with an overall situation that didn't seem to require more restraint you have a dilemma. That's why you have to rely upon other tools, including supervisory tools. Senator BOND. Thank you, sir. My time has expired. The CHAIRMAN. Thank you, Senator Bond. Senator Dixon. Senator DIXON. Chairman Volcker, as you know, last year the Congress thought it met the Gramm-Rudman-Hollings threshold requirements which were $144 billion or as much as $154 billion. Now, of course, it appears that the deficit will actually be over $170 billion. Instead of a $36 billion reduction this year to meet the tar- gets without raising taxes, therefore we would have to make a $60 billion cut. My question to you is, What would be the impact on the economy of that kind of a cut? In other words, is there a risk to the economy if we try to reduce the deficit too fast? Mr. VOLCKER. Yes, in theory I think you could do it too fast. I think that's more theoretical than real. I have often responded in answer to a similar question, Senator, that I really don't stay awake nights worrying about you reducing the deficit too fast, as a practical matter. [Laughter.] ACTIVITY OF THE STOCK MARKETS Senator DIXON. I'm certainly not an expert on the stock market, but I continue to be amazed at how it flourishes while we have what appears to be a recession in agricultural America, a kind of sluggish economy generally. Is what the stock market is doing a sign that things are going to get better and better, or can it be an omen that things are like they were in the 1920's? Mr. VOLCKER. Well, I'm not going to comment on the stock market specifically. But let me say that in parts of my statement I did not read, I think that we are in a both very difficult and very promising economic situation. The difficulties are obvious: the chart on debt, the big deficit, re- gional problems. Those problems can only be dealt with by both a forceful and rather complicated combination of policies. When you've got two or three things to do at the same time, I suppose that's complicated. It's not just a national problem but an interna- tional problem. That's the difficulty. But I think in fact it is also true to say that we have promise that's unparalleled at least for two or three decades. We already have 4 years of expansion. We have inflation coming down, not going up. And that will presumably be interrupted next year to some extent by the rising import prices and the higher oil prices, but the underlying trend of inflation is down. Interest rates have been moving lower after 4 years of expan- sion—or did much of last year anyway. We have the ability—we don't have big, traditional type imbalances. We've got that enor- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 126 mous trade imbalance which is more serious in some ways. But we have a chance of having a prolonged business expansion here con- sistent with greater and greater stability. We haven't had that chance for a long time and I think we have it now. We are perfect- ly capable of blowing it, but if we don't blow it but we operate cor- rectly and do these difficult things, then I think a lot of confidence is justified. But that is what's at issue. Senator DIXON. You mentioned interest rates. I've seen predic- tions that they are going to go up and predictions that they are going to go down. What's your prediction about interest rates? Mr. VOLCKER. That's a normal market situation and I am de- lighted to be in the midst of a normal market situation. Senator DIXON. Mr. Chairman, a recent story in the Washington Times stated: Mr. Volcker hinted last week that the Fed would welcome subpar economic growth this year in order to slow business and consumer spending and thus get some control on rising public and private debt. Is that story accurate and would the Fed welcome subpar eco- nomic growth? Mr. VOLCKER. Well, I didn't read that story, but it may have grown out of some testimony before the Joint Economic Committee a few weeks ago. What I said precisely was in judging progress this year, I think it is less important to worry about precisely what the growth rate is within some limits than worry about whether progress is being made on the structural adjustments that we must make. And I would repeat that statement. I think this is a year where what's critical is that we begin dealing with that trade defi- cit, that we make progress on the budget deficit, that we keep the inflation rate under good control. If those things are happening, I frankly think it's a somewhat secondary issue whether we're at the top or the bottom of these ranges that we have projected or other people have projected for economic growth. It is far more important that we are doing the things that will sustain growth into the future than that we buy another quarter's growth or even another year's growth with the implication that that's the end of the road and we have created conditions that will create a recession. That doesn't make any sense. Senator DIXON. Thank you, Mr. Chairman. My time has expired. The CHAIRMAN. Thank you, Senator Dixon. Senator Gramm. Senator GRAMM. Well, Mr. Chairman, let me say I'm sorry our distinguished colleague from Michigan has left because I can't leave one point he made unrevisited and that's the point about debt. DEBTOR NATION FROM 1620 TO 1914 Imagine that I have a great big blue and red chart that begins in 1620, and beginning in 1620 we have an unbroken train of debt as we engage in the horrors of a debtor nation from 1620 to 1914, By the logic of our distinguished colleague from Michigan, our Nation would have been filled with misery, penury and woe. And yet, from 1620 to 1914, we became the world's greatest trading nation. We Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 127 became an economic and world power and our standard of living grew faster than any nation in the history of mankind. The idea that somehow being a debtor nation is a catastrophe is absolute nonsense. What matters—and what I want to go back to is your point— what matters is what you do with the money. A lot of people have become wealthy—nations have flourished by borrowing money if they invest it productively. If, on the other hand, you go out and borrow money and blow it in on a hot weekend, you become poor quickly. I want to go back and give you a chance to basically say yes or no. Your concern about the debt is primarily what we're doing with the money, that it is funding consumption; much of that consump- tion is part of the Federal debt. Is that correct? Mr. VOLCKER. Yes. I was looking for the exact words in my state- ment to make your point. I say we are spending more than we produce. We are unable to finance at home both our investment needs and the Federal deficit. These are not conditions that are sustainable for long, not when, as at present, the influx of capital from abroad cannot be traced to a surge in productive investment. It's not sustainable from an economic perspective to pile up foreign debts while failing to make the investment that we need to gener- ate growth. Your comments remind me of a story, a true story, that I can't refrain from saying. Senator GRAMM. Make it short because the chairman is going to get me and I've got one more question. Mr. VOLCKER. It's a good story but I'll deprive you of it. The CHAIRMAN. Go ahead and tell the story and we'll give you a little more time. Mr. VOLCKER. Well, I once heard a distinguished Finance Minis- ter of a foreign country giving a litany of his current problems about balance of payments, deficits and that and all the rest. The first question he got was like yours, he said: Well, back in the 19th century your country was in debt all the time and piling up great balance of payments problems and the country was doing all right. Why didn't we ever hear about the problems? And he said, "No statistics." [Laughter.] Senator GRAMM. Also politicians who understood our problems. I'd like to go to my second question. I'd like to begin it by basi- cally defining the political problem and then ask your response to it. Every day we hear this assertion that the United States is ex- porting jobs. I could give you a thousand examples of where people say, "For every $1 billion of trade deficit we're losing 25,000 jobs. We export not goods but jobs." But yet, nowhere do I ever see any- body demonstrate that. In fact, we have since 1982 created 11.2 million new jobs, more jobs than Europe and Japan put together. Our unemployment, in the midst of this ballooning trade deficit, has gone down. And the nations that have the big trade surpluses have had unemployment go up. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 128 Now when you begin to respond in that way, invariably people say, "Yes, but we're creating jobs making hamburgers, that we're deindustrializing the economy." Yet, the fact is, from 1972-82, we lost manufacturing jobs and from 1982 to today we have gained 406,000 jobs in manufacturing. Real wages, which declined from 1972 to 1982, are rising today, so we are creating more manufactur- ing jobs. In fact, Japan and Germany are both losing manufactur- ing jobs. We are gaining manufacturing jobs. Real wages are rising, not declining. The importance of all this is that the protectionists cloak their argument in a new cloak and that cloak is sort of a lame appeal to nationalism and this assertion that we are losing jobs. SURGE OF PROTECTIONISM And I'd like as my final question—and whatever time you've got left please use it—do you see any evidence that a surge in protec- tionism, the imposition of quotas and tariffs, the limitation on trade—do you see any evidence that those proposals, if implement- ed, would create more jobs in the United States, raise real wages, raise the living standards of our people, or enhance the well-being of the working men and women of America? Mr. VOLCKER. No. If I may make—obviously, not only that, I see a threat to our prosperity and the world's prosperity. Senator GRAMM. So you would say a movement toward reducing trade through the imposition of protectionism would lower jobs, lower standards of living, and compound our economic problems? Mr. VOLCKER. Yes. I don't want that to be interpreted obviously, nor your earlier comments which I think are accurate, to mean that we don't have a very serious imbalance in our trade position that must be dealt with decisively or that, too, will bring real prob- lems. But not on the arguments that you recite and I think quite correctly refute. Senator GRAMM. Would you agree, as a final point, that the major cause of our trade deficit is the huge capital inflow that has been produced by our high interest rates? Mr. VOLCKER. There's a certain amount of chicken and egg here, but certainly the surge in capital inflow beginning some years ago is certainly related to our trade deficit, yes. And the other side of that coin is we needed the capital inflow to finance the budget defi- cit and you can't have one without the other. Senator GRAMM. And without it, all of our problems would have been worse? Mr. VOLCKER. I think given the budget deficit, the problem prob- ably would have been worse, certainly in the short run. I don't know about the long run, but in the short run it would have been worse. And you can't deal with that problem—you're either going to run much lower levels of investment, which obviously will reduce the standard of living, or you've got to run lower budget deficits. The CHAIRMAN. Thank you, Senator Gramm. Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 129 Chairman Volcker, some years ago we were talking here in this committee about the problem of the Federal budget deficit and we took the position—and I think witnesses did and perhaps you did also—that we needed to get a handle on the Federal debt and get our deficit under control. Otherwise, as the Federal Government got out and started borrowing money in the private capital market, what we would witness was a crowding out, which would drive up interest rates here in the United States. And where we all seemed to miscalculate was forgetting the free flow of capital across fron- tiers. As the debt mounted we did not see the attendant increase in interest rates; what we saw, as you have described this morning, is the financing of a large portion of this indebtedness with capital coming in from abroad—as much as 50 percent of the indebtedness financed with capital from abroad, as I recall, in fiscal year 1986; 25 percent of it being financed with capital flowing in from Japan, if memory serves me correctly. Now in your statement, Mr. Chairman, you say that this interna- tional flow will continue to be available until the confidence that underlies the flow of foreign savings will be eroded. My question to you, Mr. Chairman, is: When do we get to the saturation point? When is the confidence of foreign investors eroded to the point that they won't invest here in our deficit, and what are the signals that this is coming? Mr. VOLCKER. Well, my answer to you has to be I do not know but I don't want to find out. I think the whole essence of the prob- lem here is that we should be conducting ourselves so that we do not face that event because when it happens it's too late. And I think the problem is so evident and so clear that there is no justification for waiting until the worst happens. Even this year we are relying, mainly because the deficit is bigger, on an increas- ing flow of official capital rather than private capital. Private cap- ital isn't closing the whole current account deficit. That's not a ter- ribly happy sign in and of itself. It's not because most types of cap- ital flow have been particularly reduced—some have gone up—but as the deficit got bigger, they didn't go up by enough to provide the capital we need. And that is one maybe very early warning signal. RISE IN DEBT ERODES CONFIDENCE The rise in the debt itself obviously at some point erodes confi- dence. The decline in the dollar at some point could erode confi- dence. Now we've avoided most of that, happily. We have avoided it partly because the inflation performance, among other things, has been good. That helps undergird confidence. It would be a clear and present danger, in my judgment, with re- spect to foreign capital flows if people thought our inflation was be- ginning to get out of control again. That would be very alarming in these terms. Senator SASSER. Mr. Chairman, it's occurred to me with regard to foreign investors that they might be in the same position vis-a-vis the American economy that the FDIC and the Fed were vis-a-vis Continental Illinois. They simply can't afford to let us get into seri- ous economic trouble. They simply couldn't afford to see the Ameri- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 130 can economy go down as a result of a rapid runup in interest rates here because of unavailability of foreign capital. Would you want to comment on that? Mr. VOLCKER. Well, there doesn't seem to me to be a credible comment. The Federal Reserve and the FDIC are public institu- tions with certain responsibilities to deal with situations of that kind. When you're talking about foreign capital, you're talking about thousands and hundreds of thousands and millions of indi- viduals. Senator SASSER. If I could interrupt just a moment, one of the reasons given for coming in with a massive infusion of capital to keep Continental Illinois going was the detrimental ripple effect throughout the whole economy if we allowed it to go under. I'm not questioning the judgment on that. Mr, VOLCKER. I understand that, but that's precisely the point. You have institutions here that are charged with taking that into account. When you're dealing with a great variety of foreign inves- tors, they are not responsible for upholding the American economy. They may worry about it, but if they are worried about it what they are going to do is cut and run and not organize a rescue effort. And that's precisely the problem. Senator SASSER. And you think the Japanese would cut and run on us? Mr. VOLCKER. Well, individuals, yes. It's not the Japanese Gov- ernment. You may get some shift. Senator SASSER. They have a way of seeming to act in unison to me. Mr. VOLCKER. Well, they have more of a way of acting in unison than other people, but I think it would be a mistake to say they can act against the perceived economic incentives of all the individ- uals. Now the governments may indeed—you may get an official cap- ital inflow instead of a public capital inflow. And to some degree you probably would, but that would be a very defensive operation and not a very happy one, and how long that would last is ques- tionable, too. There will be a capital inflow, looking at it from another perspec- tive, because we're going to have to borrow the money to cover the deficit. The question is, what are the terms and conditions? What will be charged for the capital inflow, not that it's going to disap- pear. Individuals can take their money out. The collectivity cannot. But if they're not willing to put it in freely, then that has severe repercussions on the exchange rate and on the interest rate. The CHAIRMAN. Thank you, Senator Sasser. Senator Heinz. PROTECTIONISM Senator HEINZ. Mr. Chairman, I welcome Chairman Volcker once again to these hearings. I apologize for not being here at the outset. We had Secretary Baker down in the Finance Committee testifying on the administration's trade bill and I couldn't help but think about that subject in your response, Chairman Volcker, to a question asked by Senator Gramm. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 131 Senator Gramm asked if protectionism would have an effect on economic growth and standards of living and, undoubtedly, it would have an effect. But the thought that crossed my mind was this. Fifteen years ago, the Japanese had a standard of living about half of ours. Today, it's about the equal. For the last 15 years, maybe longer, the Japanese have been following a policy of unmitigated protection- ism. It has worked for them beyond anybody's expectations, per- haps even—although I don't want to underestimate them—perhaps even theirs. Why has it worked for them and why would it not work for us? Mr. VOLCKER. Japan has had a tremendous record of economic growth and productivity increases. I think my question would re- volve around how much of that was a reflection of protectionism. There are some other things going on in Japan, like a 20-percent savings rate, a very high rate of investment, big increases in pro- ductivity, and a very aggressive, disciplined, active, intelligent work force. I would look there for the explanations of the phenomena that you describe. Senator HEINZ. I think those are good explanations for a good part of their economic performance, but is that to say then that their protectionist policy has slowed them down? Mr. VOLCKER. Well, I don't know. I think at some times it may, but even to the extent that this image of a coordinated Japan ra- tionally maximizing the benefits of protectionism in their particu- lar instance by giving a chance for high productivity industries to get started and expand and all the rest—even if you give some weight to that—and I don't think that's the mainspring of their growth—Japan is still not the United States. They could get by with it. I don't think we can, in terms of retaliation and so forth. But I don't think it's the main spring of their growth. Senator HEINZ. I assume that earlier in your testimony you made the point—I hope you did if you didn't—that the United States should be doing all those other things that Japan is doing other than protectionism. Mr. VOLCKER. Many of them anyway. Senator HEINZ. Of that list, what are the two or three most im- portant ones for the United States? JAPANESE SAVING RATE Mr. VOLCKER. Japan, for instance, has had a very high savings rate. We've got a very low one. They're at the top of the interna- tional league; we're at the bottom of the international league, and there's quite a difference between the top and the bottom. I think it would be nice to have a higher savings rate. I did not have a lot of oratory about a higher savings rate because I think as a practical matter we're not going to get it. We've got a long—I'm not saying we can't go above the very low level it is today and I presume that it will, but to make a major change in the savings rate, a large structural change in our rate of savings, I frankly am not very hopeful about. We haven't saved much for 30 years in good times, bad times, under different kinds of policies, different Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 132 kinds of legislation, and I think I would be deluding you if I sug- gested to you there was some answer that you could adopt some law and that's going to have some dramatic change in the savings rate. Senator HEINZ. What you're saying, at least to me, is quite dis- tressing, even though I suspect you're right. What you're saying is, even if Congress made the tough choices to reduce the budget defi- cit, even if we found some ways to give more incentives for saving and investment, we would still be so consumer-oriented that we would never generate the savings to improve the productivity that would improve our competitiveness ever again. Now that's a very pessimistic assessment. Mr. VOLCKER. Well, let me make a distinction, a semantic distinc- tion—what we mean by savings. My comment was about private savings. What you obviously can do, that is fully within your control, to make a big difference in our overall savings is reduce the Govern- ment's dissavings. That you can do. That has been the biggest change in recent years, from a relatively balanced Government po- sition to big dissavings—in the jargon. If you want to increase the savings rate, which we must, that is where to work on it. Senator HEINZ. One last question. Let's assume we could reduce the Government's dissavings by reducing the budget deficit some- how, magically, to zero. Where would that money go? There's an assumption built into your prescription that it is going to go to cor- porate savings as opposed to individual bank accounts and then to something. I would like to believe that it would go into savings of either individuals or corporations but I don't see that happening. Mr. VOLCKER. I'd like to see it go to two places where I think it would go. One is to reduce our dissavings from abroad. We are now borrowing more abroad than all the individuals in the United States are saving. Now that's a pretty sad statistic. We are borrow- ing more from foreigners than the collective savings of all the indi- viduals in the United States. So what I would like to do is reduce the dissavings from abroad, which is the same as our trade deficit or technically the current account deficit. The other place I'd like to see some go is into investment to sup- port productivity and to support the exports that are part of the process of reducing the borrowing from abroad. Senator HEINZ. Chairman Volcker, I like those goals. Mr. VOLCKER. I don't think those goals are at all impossible. Senator HEINZ. My time has expired. Maybe we can come back. Mr. VOLCKER. Well, I just—after all, the cynical comment I made about increasing the private savings rate by fiddling around with some tax incentives or something, I don't want to be at all pessi- mistic about the possibility of reducing the government's dissav- ings. It's within your grasp and that's what will happen. The CHAIRMAN. Senator Shelby. Senator SHELBY. Mr. Chairman, I have a written statement I'd like to have included in the record. The CHAIRMAN. Without objection, it will be included in the record. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 133 COMPARISON TO THE JAPANESE AND GERMANS Senator SHELBY. Dr. Volcker, following up on the savings subject here, as far as private savings are concerned in the United States, prior to the 15 or 20 years ago—let's say 20 years ago, was the American savings rate near the Japanese or the West German sav- ings rate? Mr. VOLCKER. No, not in my memory. Senator SHELBY. When was it? Back in the 1950s or the 1940's? Mr. VOLCKER. Back before we had the statistics, I guess. I don't know. Not in my working lifetime. That's as near as I can remem- ber. Senator SHELBY. In other words, the psychology out there is not in the American to save? Mr. VOLCKER. That's right. For whatever reason, they historical- ly have had very high savings rates. My staff has given me a table going back to 1965 anyway. These are gross savings rates. Senator SHELBY, This is private savings, is it not? Mr. VOLCKER. Well, this probably includes the governments. But in any event, their savings rate was 12 percent higher than ours in 1966. Senator SHELBY. This is the Japanese you're talking about? Mr. VOLCKER. The Japanese was 12 percent higher than ours. In 1985, it was 15 percent higher than ours. Subtract out the Govern- ment deficit—I don't know what it was in 1966—you would get ba- sically no change or relatively no change. Senator SHELBY, Is the German savings rate similar to that? Mr. VOLCKER. Well, the German savings rate is currently half- way in between, but I just haven't got the private figures in front of me, but their deficit isn't all that big. Senator SHELBY. Would you furnish that to me and the commit- tee if you would, private versus Government savings rate? Mr. VOLCKER. Sure. I'm looking down the list here to find some- body—this is the gross, total, public and private—the only country I can find as low as us is Iceland, offhand—and Greece, I guess. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 134 Chairman Volcker subsequently furnished the following infor- mation for inclusion in the record of the hearing: Japanese, German, and U.S. Savings Rates Selected Years, percent of GDP Japan 1970 1965 Gross savings 31.5 40.2 31.4 private 25.6 33.1 27.2 public 5.9 7.1 4.2 Less depreciation: Net savings 18.1 26.9 17.7 private 12.7 20.2 14.2 public 5.4 6.7 3.5 1965 1970 1985 Gross savings 27.2 28.1 22.2 private 21.9 21.8 19.4 public 5.3 6.3 2.8 Less depreciation: Net savings 17.8 18.0 9.6 private 12.9 12.2 7.6 public 4.9 5.8 2.0 United States 1965 1970 1985 Gross savings 21.0 18.1 16.5 private 18..6 17.4 18.4 public 2..4 0.7 -1.9 Less depreciation: Net savings 11.2 7.5 3.7 private 10,.1 8.2 7.1 public 1.1 -0.7 . -3.4 Data are taken from OECD National Accounts. The OECD distinguishes between government current expenditure and government Investment. It thus reports greater government saving (or smaller deficit) than would be the case If government saving were measured as revenue less total government expenditure. There are additional small differences between the procedures followed in the OECD national accounts and those used in the U.S. National Income and Product Accounts. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 135 Senator SHELBY. Do you think that some type of legislation would help change that psychology of American consumers' con- sumption? Mr. VOLCKER. Well, I'm expressing some skepticism about that, given what it's practical to do. Senator SHELBY. In other words, an incentive to save? Mr. VOLCKER. You could pass a tax law and give a bonus for sav- ings and tax consumption very heavily, but I don't think you're going to do that. It would be interesting to see what results that had. I presume it would have some impact, but you have to talk I think in such extreme fashion that it is not within Senator SHELBY. A lot of money was pumped through the IRA's into the banks and thrifts. Mr. VOLCKER. A lot of money was pumped through IRA's, no doubt about it, and that I think is an illustration of what I'm talk- ing about. During most of that period when a lot of money was pumped into IRA's, the overall savings rate declined. What a lot of people were doing was shifting savings they otherwise had into IRA's because they got a tax break. Senator SHELBY. Dr. Volcker, you said earlier that we being the richest country in the world, we should be exporting capital, not importing it. To export it, we're going to have to create it. We're going to have to save it, are we not? Mr. VOLCKER. Yes. Senator SHELBY. It just begs the question. Mr. VOLCKER. Yes. Senator SHELBY. If we keep importing capital and keep consum- ing it, as Senator Gramm was alluding to, and not using it wisely for the future in developing this country—in other words, if we keep paying our national debt and our credit with it and we keep consuming in other ways, what's going to be the answer in 3 or 4 years or 10 years? Isn't the international debt situation versus ours going to be like a Third World nation? Mr. VOLCKER. Well, I think it just leads you to a dead end, and if you just continue with it, eventually Senator SHELBY. A literal dead end? Mr. VOLCKER. Well, literally in the sense—to get back to Senator Riegle—if you let it go on long enough, the actual standard of living will decline—I don't think we're in that situation yet, but if you don't repair the imbalance you eventually get in that position. Senator SHELBY. Senator Gramm was also talking about the year 1620 to 1914. During those years when we were importing capital, we were also a developing nation here and used a lot of that cap- ital as such rather than to use it for our basic consumer tastes, is that correct? Mr. VOLCKER. Yes. Again, we haven't got any statistics for that period. Senator SHELBY. And we didn't have those big Federal deficits year after year then, for the most part? Mr. VOLCKER. No, I'm sure—not only for the most part, I think we didn't have them at all during that period. We didn't have the mechanism for running federal deficits. We didn't have a Federal Government then either during part of that period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 136 Senator SHELBY. We didn't know how, did we? We didn't have the Federal Reserve then, did we? Mr. VOLCKER. We didn't have the Federal Reserve to print the money, but if you go back to 1620 we didn't have a Federal Govern- ment. Senator SHELBY. Well, that does go back quite a ways. Dropping over to one other thing, my home State of Alabama and other rural States have not shared in the coast-to-coast or bi- coast prosperity that we've had. A lot of it has been on the west coast, a lot of it on the east coast. There are distortions and struc- tural imbalances there. What is the answer for us dealing here in the Senate with some of this in the Midwest, the South, and the Northwest? Mr. VOLCKER. Well, I think that gets you into quite different policy issues than we can deal with by monetary policy. Those big depressed areas of the country are largely a reflection of either oil or agriculture and, of course, if you've got both you've got a double whammy. Both of those are similar in a way in that they are both a response I think not to specifically a U.S. problem but a world- wide relative glut of oil or agricultural products. And as you know, that raises a whole lot of issues of agricultural policy and energy policy. Take the agricultural one, which I presume is more important in Alabama Senator SHELBY. But all of this feeds into our monetary policy, doesn't it? Mr. VOLCKER. Well, it affects the environment in which mone- tary policy operates as does the relative boom let's say in New Eng- land, and you have to look at both of them. Senator SHELBY. My time has expired. Thank you, Mr. Chair- man. [The complete prepared statement of Senator Shelby follows:] STATEMENT OF SENATOR RICHARD SHELBY Senator SHELBY. Mr. Chairman, these hearings come at a time when the economy has us all perplexed. First, I want to commend Chairman Volcker for his leadership and guidance in bringing interest rates down to their lowest level in 9 years and in bringing inflation under control. Although our economy is in its fifth year of expansion, I detect warning signs on the horizon, both here and abroad, that indicate trouble ahead. Domestically, I see warning signs from an economy in transi- tion—in transition to a service economy with substantially lower wages. In this respect, I am concerned about the mounting con- sumer debt and its impact on the economy should we experience a downturn. I also see warning signs from an expansion that has been geo- graphically uneven. Recent reports indicate that we now have a bi- coastal economy and that the expansion has by-passed the citizens of middle America. Similarly, as a Senator representing a largely rural State, I am concerned about a two-tier economy. Rural areas and communities Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 137 are not experiencing economic growth. Agriculture and industries such as textiles, steel and rubber, which were once the very life blood of these communities, have fallen upon difficult times. Of course, the most serious warning sign is from the twin deficits in our Federal budget and trade with foreign countries. Internationally, I see warning signs from the Third World debt situation. Witnesses before the committee yesterday stated that our economy is controlled by external forces. While the falling dollar may give us the month-to-moiith satisfaction of a declining trade deficit, I worry that the dollar's decline threatens our standard of living. Global cost-cutting and the inherent slow-down in expan- sions abroad may thwart our hopes of economic growth fueled by exports. Again, I welcome Chairman Volcker and thank him for sharing with us his insights about the economy. The CHAIRMAN. Senator Sarbanes. Senator SARBANES. Chairman Volcker, I'm concerned by the ex- change that you had with Senator Proxmire right at the outset of the questioning period. Mr. VOLCKER. On Ml? Senator SARBANES. On the fact that you had not submitted any Ml figures. It's my understanding that this is the first time that the Fed has not done that, is that correct? Mr. VOLCKER. I believe so, yes. Senator SARBANES. So the Fed has understood the law heretofore at least to require an Ml target range? Mr. VOLCKER. No. Senator SARBANES. Well, then, why has the Fed always submit- ted the figures heretofore? Mr. VOLCKER. Because we thought it was useful and provided in- formation disciplined to ourselves, information to the public and to the Congress that was relevant. Senator SARBANES. Well, do you read the law as enabling the Fed to determine what is useful and to submit that, or that you have to, in effect, interpret the law and submit what the law requires? Mr. VOLCKER. I think the law requires us to submit some target ranges of credit and monetary aggregates. FED REPORT TO THE SENATE Senator SARBANES. No, no, I want to get an answer to my ques- tion, whether it's your view that the Fed can determine what to submit or that the Fed is supposed to determine what the law re- quires it to submit? Mr. VOLCKER. I think I'm trying to answer that question. I think we are bound to submit some monetary and credit aggregate num- bers that are presumably relevant to judging policy and relevant to the conduct of policy. Precisely what those measures are and how they are defined, as I understand it, is up to us. Senator SARBANES. Let me repeat my question again. Do you think that you are to submit what the law requires or to submit Mr. VOLCKEH. I'm trying to describe what I think the law re- quires. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 138 Senator SARBANES. OK. Very good. But your view is that you are to submit what the law requires? Mr. VOLCKER. Of course. Senator SARBANES. Now it's a question of what does the law re- quire, is that correct? Now heretofore, you have perceived the law to require that you submit Ml figures, is that correct? Mr. VOLCKER. No, not the law by the language of the law. I per- ceived that Ml was a useful, relevant aggregate to submit consist- ent with the law. When I perceive it no longer to be relevant in that respect, I don't think the law directs us to submit Ml. Senator SARBANES, Well, now, it doesn't say that. I mean, it says the objectives and plans of the Board of Governors and the Federal Open Market Committee with respect to the ranges of growth or diminution of the monetary and credit aggregates for the calendar years during which the report is transmitted and it doesn't say "as it may be deemed relevant or not by the Fed." Let me ask you this question. In preparing this report, the Mone- tary Policy Report to the Congress, pursuant to the 1978 Act, was discussion held with respect to the fact that an Ml figure was not going to be submitted? Mr. VOLCKER. Of course. It was discussed and debated on sub- stantive grounds, but I don't think we had any legal argument about it. I don't think there was any difference of opinion that it was not required by law. Senator SARBANES. That issue did not come up in the discussion at the Fed? Mr. VOLCKER. That issue did not come up. Senator SARBANES. No one raised a concern that the failure to submit this particular monetary and credit aggregate might raise— particularly in view of the fact that it had always been submitted in the past, raise a question about complying with the law? Mr. VOLCKER. As best I can recall it, as a legal matter—there was a lot of debate as a substantive matter—as a legal matter, I do not recall that question being raised. Senator SARBANES. What was the nature of the substantive debate? Mr. VOLCKER. Whether it was useful or not, whether it was useful to the committee first of all in its own operations to have it, and second of all, whether it was useful—given the answer to that question, whether it was useful to have a published Ml target. Senator SARBANES. Is it your view that the Fed could make the judgment that it would not be useful to submit any monetary or credit aggregates and then proceed not to do so? Mr. VOLCKER. No. I think with the language of the law we would be hard-pressed not to submit any, so we would look for whatever we thought was most relevant. We have changed them in the past. We have redefined Ml. We have redefined M2. We have redefined M3. We have changed the credit aggregate that we submit to you. Senator SARBANES. That's right. Mr. VOLCKER. The credit aggregate has never had the same weight as the other aggregates, although it doesn't say that in the law. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 139 Senator SARBANES. But having done that, you do then submit them? Mr. VOLCKER, Oh, yes, as we did this year. Senator SARBANES. Well, except you left out a major component which has always been submitted in the past. Mr. VOLCKER. We dropped out at one point bank credit, which had always been submitted in the past, and we dropped it once and we have never readopted it. Senator SARBANES. In having the substantive discussion, was the issue raised that the line of questioning which both the chairman and I have now directed to you might in fact come up? Mr. VOLCKER. No. Senator SARBANES. It was your assumption you could simply leave it out and no one would sort of say how come this happened? Mr. VOLCKER, I certainly expected people to say why did you leave this out as a matter of substance, and I have 10 pages before you to explain that. The CHAIRMAN. Would the Senator from Maryland yield, not on his time? Senator SARBANES. Sure. The CHAIRMAN. I want to commend the Senator from Maryland. I think it's very, very important that Congress insist that the law be obeyed to the full and I want to make a formal request, Mr. Chairman, that you have your counsel give us a strictly legal opin- ion. The committee is going to seek independent outside legal opin- ion on this. I have the greatest admiration and respect for you, as you know. I know that you want to comply with the law, but I think this is a duty that we have as the Congress to make sure that when a law is enacted that it's complied with in full by our agencies, Mr. VOLCKER. I agree with your philosophy, I would be glad to have our counsel submit such an opinion. I tell you that there was no question in my mind at any time in this procedure that we were not fully and fairly complying with the specific language and the spirit of the law. The CHAIRMAN. Thank you. Senator SARBANES. I have no further questions. I think the Chairman has been responsive to Chairman Proxmire's question and we look forward to that material. [The information referred to follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 140 Chairman Volcker subsequently furnished the following Information for inclusion in the record of the hearing: 8QARQ OF GOVERNORS FEDERAL RESERVE SYSTEM WASHINGTON, Q. C. SOSSI OAUL A. VQLCKEB April 6, 1987 CHAIRMAN The Honorable William Proxmire Chairman Committee *>n Banking, Housing and Urban Affairs United States Senate Washington, D.C. 20510 Dear Chairman Proxmire: During the course of my testimony on February 19, 1987, you raised a question about whether the Board is required by Section 2A of the Federal Reserve Act to submit a target range for Ml as part of its Semi-Annual Monetary Policy Report to the Congress. It was your view that the decision by the Federal Open Market Committee not to establish a specific target range for Ml, although ranges were provided for M2, M3, and for debt, was not consistent with the requirements of this section. You requested an opinion of the Board's General Counsel on this matter. That opinion has now been prepared and I am enclosing a copy for your review. The General Counsel has concluded that, as a matter of textual interpretation, Section 2A requires a report on the Federal Reserve's "objectives and plans" with respect to the monetary aggregates and if the Federal Reserve has not formulated "objectives and plans" with respect to one particular aggregate, it is not required to report on it. This reading of the text is supported by other provisions of Section 2A, by administrative practice and most importantly by the legislative history. 1 have paid particular attention to the legislative history because of your direct involvement in it and because I am concerned that the Federal Reserve maintain the close consul- tative relationship with the Congress that we have had in the past. I hope that you will agree with us, after going back over the history, that this relationship would not be served by our providing you with a target range for an aggregate that the Committee itself does not feel can provide a reliable quantita- tive standard for the conduct of policy at a particular point in time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 141 The Honorable William Proxmire Page Two Our concerns, I suppose, are similar to those raised with you by Chairman Burns in 1975. Those concerns were reflected in the compromise language you developed at the time speaking of both "objectives and plans" and substituting the phrase "monetary and credit aggregates" for Che "money supply". I would be glad to discuss this opinion with you further should you have ariy questions. Enclosure Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 142 BOARD OF GOVERNORS or THE FEDERAL RESERVE SYSTEM WASHINGTON, O, C. 10551 April 2, 1987 MEMORANDUM Subject; Humphrey-Hawkins Act Reporting Requirements During the course of Chairman Volcker's testimony on February 19, 1987, before the Senate Banking Committee on the Board's semiannual report to Congress provided for by Section 2A of the Federal Reserve Act, Chairman William Proxjnire requested the opinion of the General counsel of the Board on whether the Board is required by Section 2A of the Federal Reserve Act (12 U.S.C. 225a) to submit a target range for Hi as a part of this report. This question arises because, as- noted in the Board's February 19, 1987 report under Section 2A, the Federal Open Market Committee ("FOMC") elected not to establish a specific target range for Ml because of uncertainty about its underlying relationship to the behavior of the economy and its increased sensitivity to interest rate changes due to the deregulation of interest rates and other factors. The Board, in its Report, stated that the FOMC had established a range of 5-1/2 to 8-1/2 percent for M2 and M3 and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 143 -2- 8 to 11 percent for debt as the "Ranges of Growth for the Monetary and Debt Aggregates" for the period from the fourth quarter of 1986 to the fourth quarter of 1987. In addition, the Report noted that while no range had been included by the FOMC foe 1987, the POHC would continue to monitor Ml behavior carefully, assessing the growth of the aggregate in the context of other financial and economic developments. Finally, the Board reported that in the future the POMC might set more specific objectives for Ml. Section 2A of the Federal Reserve Act, as amended by the Full Employment and Balanced Growth Act of 1978 {92 stat. 1897) ("Humphrey-Hawkins"), provides in relevant part that . . . the Board of Governors of the Federal Reserve system shall transmit to the Congress, not later than February 20 and July 20 of each year, independent written reports setting forth (1) a review and analysis of recent developments affecting economic trends in the Nation; (2) the gbjectives and plans of the Board of Governora^ and the Federal Open Market Cpjnmi'ttee^ wi th^ respect to the ranges "of growth or diminution of the jggnetary and credit aggregatesFor the calendar year duringwitchthe report is transmitted. . . . Nothing in this Act shall be interpreted to require that the objectives and plans with respect to the ranges of growth or diminution of the monetary and credit aggregates disclosed in the reports submitted under this section be achieved if the Board of Governors and the Federal Open Market Committee determine that they cannot or should not be achieved because of changing conditions. . . . (Emphasis added). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 144 -3- I. ANALYSIS OF THE TEXT As a preliminary mattec, the first question that should be addressed is whether Section 2A requires the reporting of numerical ranges for the monetary and credit aggregates. On its face, the language of the statute is not entirely clear on whether numerical ranges are required. The statute provides that the Board report "objectives .and plans . . . with respect to the ranges of growth or diminution of the monetary and credit aggregates. . . ." Id. It might be argued that the only obligation of the Board is to formulate and disclose "objectives and plans" without necessarily establishing and publishing quantitative ranges for the monetary aggregates. There is nothing in the language of the quoted sentence that would prevent the Federal Reserve from formulating its objectives and plans in qualitative terms rather than assigning quantitative values. However, the last sentence of the section quoted above refers to "objectives and plans with respect to the ranges of growth oc diminution of the monetary and credit aggregates disclosed in the reports submitted under this section. . . .", Id. thus expressing a clear expectation for the disclosure of quantitative ranges of growth or diminution of the monetary and credit aggregates. Moreover, the legislative history and administrative practice support the view that Congress imposed a dual obligation on the Federal Reserve: to establish and publish ranges of growth or diminution of the monetary and credit Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 145 -4- aggregatei. and to report its objectives and plans with respect to these ranges. This conclusion is borne out by statements in the record of Congressional action on this subject. For example, the Senate cepoct on the Humphrey-Hawkins Act states that the "Federal Reserve would report its numerical monetary targets tor a fixed calendar year rather than a constantly rolling 12 month period." (S. Rep. No. 1177, 95th Cong.. 2nd Sees. (Sept. 6. 1976). p.98.) Similarly, the 'Senate Report on Resolution 133 of 1975 notes that "Discussion and disclosure of planned 'ranges of growth or diminution of the monetary and credit aggregates in the upcoming twelve months' will not eliminate all uncertainty about the future growth of the money supply and other aggregates, but it will provide reasonably reliable information about this crucial element in the economic decision making process." {S. Rep No. 38, 44th Cong.. 1st Seas. (Mar. 17, 1975} p. 7.) Moreover, the hearing record on the predecessor legislation to Section 2A. which is discussed In detail below, makes It cleat that Congress Intended that the Federal Reserve report quantitative tacget ranges foe the aggregates to provide a specific focus Cor consultations with the Federal Reserve on monetary policy. With respect to the adninlstratlve practice, following passage of Humphrey-Hawkins in October of 1973, reports wee* filed In February and July of 1979 and In February of 1980 with the House and Senate Banking Committees, and hearings were held Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 146 -5- by each Coautittee on the reportB. These reports contained numerical monetary aggregate target ranges. However, while the report filed with the House and Senate Banking Committees in July of 1980 retained the ranges contained in the February 198O report for the remainder of 1980, the report did not contain precise numerical ranges for 1981 since . . . most members [of the FOMC] believe it would be premature-at this time to set forth precise ranges for each monetary aggregate for [19611. given the uncertainty of the economic outlook and institutional changes affecting the relationships among the aggregates. (Annual Report of the Board of Governors of the Federal Reserve System, 1980, p. 52.) The absence of numerical ranges for 1981 was criticized in both Senate and House Hearings. (Hearings Before the Senate Banking Committee on the Federal Reserve's Second Monetary Policy Report for 1980, 96th Cong. 2nd Sees., July 21-22, 1980: Hearings Before the House Banking committee on the Conduct of Monetary Policy, 96th Cong. 2nd sees., July 23, 1980.) Shortly after the hearings were completed, and before the Senate Report was prepared, the Federal Reserve did submit numerical monetary aggregate ranges of growth for 1981 to Congress. (Letter dated July 29, 1980, printed in Federal Reserve Bulletin. Vol. 66, August 1980. p. 649.) Each such report filed since then has included such ranges, although as noted above the report for February 1987 did not contain a target for Ml. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 147 -6- However, this conclusion on the dual obligation to establish and publish quantitative ranges foe the monetary and credit aggregates and report on objectives and plans with respect to those aggregates still leaves the question raised by Chairman Ptoxmire unanswered. It gives no guidance on whether the obligation to report "objectives and plans with respect to the ranges and growth or dininution of the monetary and credit aggregates" requires that the Federal Reserve establish -quantitative ranges foe all of the monetary aggregates and formulate objectives and plans for all of these ranges, or whether it gives the Federal Reserve broader discretion to be selective about both the ranges and its plans and objectives with respect to those ranges. Three textual elements of Section 2A give some guidance on the question raised by Chairman Proxmire on the meaning of the statute: the literal emphasis on the Federal Reserve's objectives and plans, the absence of any definition of Monetary and credit aggregates, and the discretion to change objectives and plans in the light of changing circumstances. A. POM th« Language on Section 2A Require an Ml Target Literal construction First, read literally, it the Federal Reserve does not have "objectives and plans" with respect to a particular measure of money or credit. Section 2A does not require the inclusion ol a range for that measure in the semiannual report. When Interpreting a statute, analysis must begin with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 148 -7- the language of the statute itself. Tguehe Ross & Co. v. Redington, 442 U.S. 560, 568 (1979). The language of Section 2A only calls for the Federal Reserve to report its objectives and plans with respect to the aggregates for which it has formulated objectives and plans. If it has no such objectives or plans with respect to a particular aggregate, the statute does not require the Board to report to congress on that aggregate. B. Federal Reserve Defines the Aggregates Second, the flexibility intended by Congress in establishing the formulation of goals with respect to the ranges of growth or diminution of the monetary and credit aggregates is also reflected in the fact that Section 2A does not provide definitions of the monetary and credit aggregates. Instead, the definition of the aggregates was left to the Federal Reserve, which defines the aggregates, collects data on them and publishes the data in periodic statistical releases as well as in the Federal Reserve Bulletin. See Rettig v. Pension Ben. Guar. Corp., 744 F.2d 133 (D.C. Cic. 1984). In this connection it is also important to point out that the Federal Reserve definitions of the monetary aggregates have changed from time to tine in response to changes in an evolving financial system. At the time Humphrey-Hawkins was enacted in October of 1978 the Federal Reserve had already begun to change Ml. Immediately prior to that date Ml equalled currency plus demand deposits at commercial banks with certain Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 149 -8- adjustmenta. In October the Federal Open Market Committee began to set a target range foe M1+ which included ML and savings deposits at commercial banks, NOW accounts at all depository Institutions, credit union share draft accounts and demand deposits at mutual savings banks. In I960 all of the monetary aggregates were revised and for a period two versions of Ml. Ml-A and Ml-B, were used in order to provide a transition for the introduction of nationwide NOW accounts under the Monetary Control Act. In this new formulation. Ml-A was basically the old Ml. not Ml*, except that demand deposits held by foreign commercial banks and official Institutions, including governmental entities, were removed. Ml-B was a more comprehensive measure of transaction accounts which included, along with Ml-A, the interest bearing checkable deposits held at all depository Institutions -- NOW accounts, automatic transfer accounts, and credit union share draft accounts. In January of 1982, Ml-A was dropped and Ml-B was redefined as Ml. Because of the changing character of the aggregates in a dynamic economy It Is absolutely necessary to have flexibility to adjust the aggregates to changing circumstances. For example, if the definition of Ml was fixed at the time that Humphrey-Hawkins was enacted, today it would not include NOW accounts which have become a substitute for consumer checking accounts and would not provide a meaningful measure of the supply of transactions money. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 150 -9- Federal Reserve definition of the aggregates is entirely consistent with the intention of congress to leave formulation of goals with respect to the monetary and credit' aggregates to the Federal Reserve, and for the Congress to review them to determine their consistency with other national economic policy objectives. Where a particular measure of money or credit has become obsolete or unreliable, it would be entirely consistent 'with the" wording and intent of the statute for this measure to be removed from the definitions of the monetary and credit aggregates. It makes equally good sense, where this has occurred, to interpret the provisions of section 2A to allow the Federal Reserve to omit formulating goals with respect to the range of increase or diminution of such an aggregate even if this aggregate continued to be calculated and reported. C. Discretion to Change Objectives and Plans Third, the last sentence of Section 2A also demonstrates that Congress did not intend that the Federal Reserve should be bound by the objectives and plans stated in its report and that the Federal Reserve has discretion to depart from these objectives and plans, with the only limitation that the departure be reported to the Banking Committees at the next scheduled semi-annual consultation with the Committees, together with an explanation of the reasons for the changes in the System's objectives and plans. This provision, clarifying the Federal Reserve's discretion in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 151 -10- carrying out monetary policy, suggests that if the System has the discretion to diverge from its objectives and plans, it also has the discretion to inform the Committees that the formulation of objectives and plans for a particular measure of money or credit would not be reasonable in the circumstances. In this situation"the provision of objectives and plans for that measure of money or credit in its report to the Congress would be materially misleading, and Congress cannot be held to have intended such a result. II. THE INTENT IOJLJ3F CONGRESS This reading of the text of Section 2A is supported by the legislative history of this provision. Reference to the legislative history is particularly important in construing a statute that regulates the relationship between Congress and an administrative agency in carrying out authority delegated by the Congress, see, PPG industries. Inc. v. Harrison, 660 F.2d. 628 (5th Cir. 1981). Broadly stated, the legislative history of Section 2A demonstrates that Congress intended that the Federal Reserve inform the Congress of its "objectives and plans with respect to the ranges of growth or dininution of the monetary and credit aggregates" and left to the Federal Reserve the discretion to formulate these objectives and plans, to select the monetary aggregates that were meaningful in implementing these objective and plans, and to define the monetary and credit aggregates which were to be used in implementing these Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 152 -ii- objectives and plans. This interpretation of Section 2A emerges from the hearings on S.con.Res. 18, the predecessor to Section 2A, where the language on formulation of plans and objectives with respect to the monetary aggregates was worked out. These hearings can be best characterized as having resulted in a compromise between the desire of Chairman Burns to consult with the Congress in a general and unspecific manner without quantifying the POHC's policy objectives, and Chairman Proxmire's goal of putting a quantitative focus on Federal Reserve monetary policy for the near term future as a basis for consultations between the Federal Reserve and the congress on this policy. This history makes it clear that Chairman Proxmire was dissatisfied with the general nature of Congressional consultations with the Federal Reserve on monetary policy and wanted more than a general description of past actions and future intentions. On the other hand. Chairman Burns and the Board were deeply concerned about the impact of the Resolution on the implementation of monetary policy through Congressional limitations on Federal Reserve discretion in carrying out monetary policy. The legislative history reveals that these conflicting objectives were reconciled by the adoption of the broad and flexible concept of the Federal Reserve reporting its own goals with respect to the monetary aggregates as opposed to any specific measure of the aggregates to avoid any implication of placing a "straitjacket" Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 153 -12- ott the Implementation of monetary policy by the Federal Reserve. (Hearings before the Senate committee oa Banking, Housing and Urban Affalcs. 94th Cong. 1st Sees.. February 25 and 26. 197S. p. 46.) A. The. Derivation 9t F«4«r«l ft»«»rr» Raoortino: Requirements The key language ~ of the Humphrey- Hawkins Act oa - reporting objectives and plans cones from H. Con. Res. 133 adopted by congress on Match 24. 1975. This Resolution was initially proposed by Congressman Reuss and provided for a direction to the Federal Reserve to conduct monetary policy in the first six months of 1975 BO as to reduce interest rates. In the Senate the proposal took the form of S. Con. Res. 18, introduced by Chairman proxmlre on February 12. 1975. This Resolution directed the Federal Reserve to take appropriate action in the first half of 1975 to increase the money supply at a rate substantially higher than in recent experience and appropriate to actively promote economic c*covecy. It also required the Federal Reserve to consult with Congress at semiannual hearings before the committees on banking "about its money supply growth targets and other monetary policy actions required in the upcoming six months." Chairman Burns testified on this Resolution on February 25. 1975. and at this hearing the basic policy considerations underlying the Resolution, and the Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 154 -13- Reserve1s concerns about It, were articulated. (Heatings before the Senate Committee on Banking, Housing and Urban Affairs, 94th Con?., 1st Sees., February 25 and 26. 1975. p. 37, et. seg..) In his opening statement Chairman Burns criticized the proposed Resolution because it would result in a more detailed involvement of the Congress in the implementation of monetary policy. He summed up the Board's position in the two concluding paragraphs of his opening statement: In conclusion. Resolution 18 raises in the Board's judgment momentous issues with respect to the role of the Federal Reserve in the economic life of our Nation, whether the Federal Reserve's traditional insulation from political pressures will continue, whether resistance to Inflation may not further diminish, and whether the dollar will remain a respected currency around the world. If the Congress should seek through Resolution IB to become deeply Involved in the implementation of monetary policy, it would enter an Intricate, highly sensitive, and rapidly changing field — with consequences that could pcove very damaging to our Nation's economy. We therefore hope that this committee will consider very carefully the consequences for our national welfare that could result from adoption of this resolution. Id. at 43-44. In reply. Chairman Proxmire stressed the Importance of the Resolution as a means of providing information on which the Congress could make Intelligent judgments about the course of monetary policy without the Congress becoming involved in the details of implementation of that policy. He said that Congress as an institution "should have a voice in shaping the broad outline oC monetary policy -- not the day to day details, but the broad direction monetary policy Is taking." Id. at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 155 -14- 44. In answer to Chairman Burns' criticism that the directions contained in S.Con.Res. 18 would mean that "Congress would, in fact be malting monetary policy, and I do not think that would be wise." Id. at 45, Chairman Proxnlre noted that he wanted to 90 beyond mere consultations to provide a quantitative basis to measure Federal Reserve Intentions, but tlfat this quantitative basis would be set as the Federal Reserve's goals for the future conduct of monetary policy. Thus, Chairman Proxraire emphasized the Importance of providing additional Information on which Congress could base its analysis of Federal Reserve policy, and rejected mere consultations on the ground that he felt "very strongly that if It is going to have any real significance and meaning, we ought to have some focus." Id. at 45. However, he Indicated that in providing that focus the Federal Reserve should have broad discretion. To ensure this unfettered discretion, Proxmlre proposed that the quantitative COCUB he wanted should be based on the Federal Reserve's own goals. He said. . . . and that focus is what you intend to do. You can explain the past action of the Federal Reserve, and that is history. It is not very significant. It Is not likely to demand the attention or the understanding of the Congress. On the other hand, if you tell us what yout goals are going to be. then we have the bails on which we can focus discussion and understanding. Id,- at 46. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 156 -15- JU another point. Chairman Proxmlre answered the criticism that Congress would become too much involved in the details of monetary policy by emphasizing. You set the goals, we don't. You set the goals, we hear them, discuss the goals with you. debate them, cry to understand them, and on that basis, reach some understanding on the pact of the committee, and on the _ part of the congress as to whether or not to proceed in some other way. Id. at 46. At still another point. Chairman Burns criticized the proposal on the grounds that it would put the Federal Reserve ". . . in a s tea it jacket and we could damage our country, because we had been put in a strait jacket." Id. at 46. Again, Chairman Proxmlre replied by emphasizing that the Congress was asking for the goals to be established by the Federal Reserve which could change 1C Federal Reserve goals changed: I want to make it clear we are not asking Cor a strait jacket. Those goals are certainly goals. They are not anything that puts you la concrete. You would be perCectly able to vary from the goals, if conditions change, which they often do. Id. at 46. Finally, as the discussion proceeded. Chairman Projcmite again stressed that the proposal was focused on goals set by the Federal Reserve. He said: Furthermore, we say goals. He don1t eay this has to be the limit either way. on the way the Fed proceeds. He say that it is Che goal. Id. at 46. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 157 -16- During the remaining discussions between ChaLcman Proxmire and Chairman Bucns the dialogue turned to the issue of the narrow focus of the Resolution on a growth target with tespect to the "Money supply." Chairman Burns criticized this emphasis on reporting on the 'money supply' and noted the limited ability of the Board to achieve specific "money supply" targets. It is clear that in the context of the hearing that both Chairman Proxmire and Chair nan Burns, believed that the term "money supply" referred to Ml.!' tn response to these celticisms. Chairman Proxmire said Hell, supposing we modify the Resolution to say. "monetary aggregates." Mould that help?" Chairman Burns replied I think that would be an improvement. I would like it still better if it read "money and credit aggregates." I am sure you are Interested in the credit supply. Id,, at 47. It was obviously the intention of Chalcman Proxmire in proposing this change in language to make S.con.Res. 18 more acceptable by allowing the Federal Reserve greater flexibility !' In introducing this Resolution In the Senate. Senator PcoKalte described the money supply as publicly held currency and demand deposits. 121 Cong. Rec. s.3018 (1975). At that time, this definition of the money supply generally corresponded to the Federal Reserve's definition of Ml. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 158 -17- in setting its goals by expanding the scope of the elements that the Federal Reserve could take into account in establishing its goals. Moreover, there is no suggestion that the Federal Reserve would be bound by any mechanistic formula in setting its goals with respect to the monetary aggregates. On the contrary, the varying importance of different aggregates in different circumstances was clearly recognized. For example, as the discussion continued concerning the rate of growth in the "money supply," chairman Burns emphasized that the Hi definition of the money supply, "... made sense 50 years ago, 30 years ago, maybe 20 yeacs ago, but not today, as I have testified time and time again." ^d. at 48. He argued, and chairman Proxmire agreed, that there were numerous appropriate measures of money to take into account in formulating monetary policy. B. s. Con^ Res. 18 Modified gnd Incorporate^ Into Section 2A As a result of this discussion, S. Con. Res. 18 was modified in the senate to require semiannual consultations with both the Senate and House banking committees about the Board's and FOMC's "objectives and plans with respect to the ranges of growth or diminution of monetary and credit aggregates in the upcoming 12 months." (H. Con. Res. 133/ 94th Cong., 1st Sess. (1975)) The Resolution also provided that "nothing in this Resolution shall be interpreted to reguire that such ranges of growth or diminution be achieved if the Board of Governors and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 159 -18- the Federal Open Market Committee determine that they cannot or should not be achieved because of changing conditions." (Id.) The senate language was ultimately adopted by both the House and Senate in H. Con. Res. 133. This Resolution was then carried on essentially unchanged into the Federal Reserve Act through the Federal Reserve Reform Act of 1977 (P.L. 95-188, approved November 16, 1977, 91 Stat. 1387), with the addition of specific reporting requirements with respect to certain economic factors. This addition to the Federal Reserve Act was adopted because H.Con.Res. 133 had expired at the end of 1976, and, although Chairman Burns continued to appear before the Banking Committees as provided by the Resolution, the Congress wished to assure that "these appearances should be regularized and made businesslike by statute." (Hearings before the House Banking Committee on H.ft. 8094, The Federal Reserve Reform Act of 1977, July 18, 1977, remarks of chairman Reuss at p.2.) C. conclusions Drawn from th^j.egislatiye^ History The legislative history clarifies two important points. First, it emphasizes that Congress was looking to the Federal Reserve to formulate "goals" with respect to the ranges of growth and diminution of the monetary and credit aggregates because it did not wish to circumscribe the Federal Reserve's discretion in formulating and implementing monetary policy. The fundamental purpose was to allow Congress to better inform itself about the Federal Reserve's intentions with respect to the future course of monetary policy. To do this, congress did Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 160 -19- not establish arbitrary and objective reporting formula, but sought to continue to rely on the expertise and policy judgment of the Federal Reserve, subject to a requirement that Congress be informed about that policy in a sufficiently precise manner so as to permit a full analysis of the ^policy and its consequences. This framework Is fully consistent with not reporting on ranges for a particular aggregate Where the Federal Reserve judges that such ranges would not be useful in the formulation and implementation of policy. Second, the legislative history clarifies that the term "monetary and credit aggregates" was inserted In the statute in place of the term "money supply" because Congress recognized that the importance of the various aggregates varies and the aggregates themselves change in composition as different kinds of monetary instruments fall into di:;uBH oc new instruments rise in Importance. This emphasis on maintaining Federal Reserve discretion through the use of the Federal Reserve's own goals with respect to monetary and credit aggregates that the Congress recognized were flexible and changing provides the answer to the question calsed by Chairman Ptoxnlre. The legislative history Indicates that it a particular monetary aggregate is no longer reliable or useful as a guide for monetary policy and the Federal Reserve determines not to foraulate a goal with respect to that measure, the Congress did Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 161 -20- not require the Federal Reserve to make a report to Congress with respect to that element of the monetary aggregates. This analysis of the legislative history is also supported by the fact that the Federal Reserve has never formulated targets wtth respect to all of the monetary or credit aggregates, see, Jtettig, supra. III. FEDERAL RESERVE TARGETS DO HOT APPLE TO APE OF THE AGGREGATES If Section 2A were interpreted to require the formulation of objectives and plans with respect to each of the monetary and credit aggregates, then the Federal Reserve would have been required since 1975 to formulate goals and report them to Congress with respect to each of the monetary and credit aggregates for which the Federal Reserve maintains data. This in fact has not been the case. Although the Federal Reserve may monitor or measure a variety of monetary or credit aggregates, it has not historically established target ranges for all aggregates and included them in its reports to Congress.2/ For example, the monetary aggregate "L," total liquid assets in the hands of the public («3 plus the nonbank holdings of U.S. savings bonds, short-term Treasury securities, commercial paper and bankers 2/ Money Stock, Liquid Assets, and Debt Measures, Table 1.21, Federal Reserve Bulletin, March 1987 lists the current monetary stock and debt measures. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 162 -21- acceptances, net of money market mutual fund holdings of these assets), is regularly reported in the Federal Reserve Bulletin but no target range for this aggregate has been included in reports to Congress under Humphrey-Hawkins not has Congress requested targets for this aggregate. Similarly, the Federal Reserve does not target the debt of domestic nonfinancial sectors even though the aggregate is monitored by the Federal Reserve relative to a range expected to be consistent with ranges for money growth. In the past, the Federal Reserve has monitored ocher monetary aggregates without including them in the Humphrey-Hawkins report.J/ IV. CONCLUSION The language of Section 2A does not require reports on a particular monetary or credit aggregate if the Federal Reserve has not formulated objectives and plans with respect to such an aggregate. This literal reading of Section 2ft is supported by the last sentence of the section which contemplates that the Federal Reserve may change its plans and objectives, subject to reporting the changes to Congress. A requirement that the Board report to Congress on objectives and plans on a changing aggregate that might be abandoned within a short time would not — See, e.g^. Table 1.21, Honey Stock Measures and Components, FederaT Reserve Bulletin, January 1979 listing money stock measures H-l, M-l-f, M-2, H-3, M-4 and M-5. The February 20, 1979 Humphrey-Hawkins report projected tatgets for M-l, M-2 and M-3 but not M-4 or M-5. (Federal Reserve Bulletin, March 1979, p. 196.) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 163 -22- secve che intention of Conge ess to use the reporting requirements to provide a focus foe its review of monetary policy. Moreover, this conclusion is strengthened by the fact that Congress has not defined the monetary and credit aggregates but has left this task to the Federal Reserve. It is also supported by the fact that the Federal Reserve has never reported plans and objectives on all of the monetary and credit aggregates and such reports have not been requested by the Congress. Finally, the discretion inherent in the statutory language is borne out by the expressed intention of Congress in enacting Section 2A. It was the intention of Congress to Cuethec the monetacy policy making process by cequicing the Federal Reserve to inform the Congress of the its goals with respect to monetacy policy over the coning year in a concrete and quantitative way without limiting the discretion of the Federal Reserve in the formulation and implementation of monetary policy. This objective would not be served by an interpretation of Section 2A which would require the Federal Reserve to formulate a goal with respect to a range of increase oc diminution of a pacticulac monetary or ocedit aggregate when, in the judgment of the Federal Reserve, such a cange would not provide a reliable guide in the formulation and execution of monetary policy. Such a requirement would distort Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 164 -23- rather than improve the consultation process between the Federal Reserve and the Congress. The Federal Reserve has concluded in its February 1987 report that at this time the uncertainties about the relationship between Ml and economic performance are sufficient so as to preclude setting such ranges. Accordingly, it would not be consistent with the -text or the stated purpose of Section 2A to require the Federal Reserve to formulate and report goals with respect to Ml in connection with its monetary policy report for February 1987 because the Federal Reserve has not formulated objectives and plans with respect to this aggregate for the period of the report. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 165 The CHAIRMAN. Senator Graham. Senator GRAHAM. Thank you, Mr. Chairman. Mr. Chairman, yesterday Mr. Meltzer of Carnegie Mellon made three suggestions for dealing with Third World debt problems, with particular attention to Latin America. One was to stop U.S. lending to foreign countries and emphasize trades for debt for equity. The second was to encourage Latin American countries to repatriate their own money. And third, to swap debt for equity at market value. What would be your response to these suggestions? DEBT TO EQUITY SWAPS Mr. VOLCKER. Well, the more equity that could be sent to those countries, the better. And debt to equity swaps are one vehicle and the effectiveness depends upon the particular circumstances and times. The part that I would question is stop all lending. You're not contributing to the process I think of growth in those countries and our own interest in stable political and economic developments in those countries by simply saying stop lending. Senator GRAHAM. Implicit in his proposal is that those who hold Third World debt would agree to the writedown between its nomi- nal value and its marketplace value and in subsequent questioning Mr. Meltzer indicated that he felt that it would require actions by regulatory agencies in order to move private financial institutions towards such a proposal and would require some change in the method of asset accounting for the balance of their debt. I assume that you would be a key figure in implementing those regulatory changes. What would be your response to those sugges- tions? Mr. VOLCKER. Well, I think the description of the changes it would require suggest the difficulties—we'll arbitrarily change a few accounting procedures, we'll have to command them to write down the debts—I don't know how you do that—to market value. I assure you once you do that they will have a new market value that's less than the written down value. You don't sustain the value of the debts by writing them down and I have not thought that that's a very effective approach. Among other things, by writing them down, I suppose you mean relieving the countries of paying the debt ultimately. Depending on how much you did it, there s a question of how much they would benefit in the short run. What they need is an environment of growth, enough new money to maintain liquidity, and to pay interest, among other things. Sometimes, theoretically, you could, by not receiving the interest, provide the money. Are you creating an environment in which they can grow, return to the markets in the future, maintain open economies—these I think are the points at issue and they are very much at issue. Senator GRAHAM. What's your assessment of the current policy— I would call the Baker policy—relative to Third World debt and its effectiveness in creating an environment of growth, particularly in the context of what is happening now in Brazil? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 166 Mr. VOLCKER. There has been, viewed against history, some sig- nificant progress in Latin America in what I think are constructive directions of opening up their economies, reducing trade barriers, reducing distortions within their economies and, of course, that has accompanied a political opening as well. And I think it is quite promising. And during this period, by and large, their external debt burdens have been reduced. But we clearly have a half-full glass and if you asked it from the other direction, are there lots of problems, there are clearly lots of problems. If you ask me whether the process right now has bogged down in inability to complete some financing programs for countries, I would have to say, yes, that is true in quite a number of countries, and that is threatening to the whole process I'm very much supportive of. Now Brazil has a special kind of problem. What I am referring to in bogging down of some of these financial programs relates to countries basically that have an economic policy and have been proceeding broadly in the right direction. There are financing pro- grams that have been negotiated. Brazil is in a grave economic crisis right now. They took some constructive steps earlier in the year. They had very rapid growth for a while. They were extremely competitive, which is, I think, good overall internationally, but in recent months inflation has resumed, confidence has been lost to a considerable extent, and their trade position has deteriorated. That all obviously affects their financial position and their abili- ty to raise money and the Brazilian situation is in a very difficult stage right now after a brilliant performance for a couple of years. Senator GRAHAM. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Graham. Mr. Chairman, I want to return to the debt problem and the debt problem for the consumers, for the corporations, and for the Feder- al Government. I think on every front your monetary policy has been driving us into further debt. Let me tell you exactly why. As interest rates drop—and I realize it is unpopular for interest rates to do anything but drop, but as interest rates drop, what do they do? They provide a diminished incentive for saving. If you save, you get a lower return. As interest rates drop, you also have an increased incentive to borrow because you can borrow at a lower cost. Now while that's not the only element, it seems to me it's a clear, decisive, objective measurable element. And therefore, I think that when you criticize—and you properly do criticize the Federal Government for running such an extraordinary deficit, one reason is because we have a lesser incentive because interest rates are low and we can borrow cheaply. If interest rates were higher, the cost of the debt would be an even more spectacular and a discouraging element in our letting the deficit go up. So I think we can't escape from that effect of monetary policy on debt. We've had a spectacular drop in interest rates over the past few years. Lots of other elements and all the urging you get from the administration, from 99 percent or 95 percent of Members of Congress is keep it up, keep those interest rates down; when you do Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 167 anything else you get denounced. The American people feel the same way. But I think we have to recognize that that's the price you pay. You're going to have a lesser incentive to save. You're going to have a higher incentive to borrow for the Federal Government and for consumers and corporations. Mr. VOLCKER. I don't think the evidence is that it very much af- fects the savings rate, but leave that aside—you can argue it moves in that direction, but I accept your general point that declining in- terest rates or more money facilitates growth of debt among other things. Whether that's appropriate or not depends upon all the sur- rounding economic circumstances. And I have tried to describe our dilemma in that respect. I note in my statement that that is a potential problem, but we have to reach a judgment with some view toward that but with some view with what's going on in the real economy, what's going on in inflation, what's going on in other dimensions. We reached particular judgments last year. They may be right or wrong. We thought they were right and I continue to feel that they're right. But the consideration you mention is one factor in the equation. The CHAIRMAN. Well, I appreciate that and I only mention it be- cause I think it's been ignored. I think all these other factors have been discussed and almost nobody discusses the effect of lower in- terest rates in encouraging borrowing. Mr. VOLCKER. Well, I don't know about on the Treasury borrow- ing. The CHAIRMAN. No, no, but it's encouraging consumer borrowing and corporate borrowing. Mr. VOLCKER. There's no question about that and I explicitly say so in the statement. The CHAIRMAN. And, of course, consumer borrowing and corpo- rate borrowing is far bigger than Federal Government borrowing. DANGEROUS AND UNWISE POLICY Let me ask you this. Essentially your excuse for letting Ml grow so rapidly is that the public wants to hold more money balances and the Fed decided to accommodate that demand. It seems to me that this is an extremely dangerous and unwise policy and here's why. First of all, no one can predict very accurately what the actual demand is for money. But even assuming your estimates are cor- rect, your actions over the last two years have built up a tremen- dous amount of liquid balances in the economy. Eventually, when the money demand function shifts, those balances are going to be spent. Isn't it true that the exceedingly liberal supply of new money al- lowed by the Fed in 1985 and 1986 constitute an enormous infla- tionary threat to the economy. What happens when the public de- cides to spend all the money you've created? Will the Fed then ac- tually contract the money supply by 15 or 17 percent or whatever it was that you expanded it by? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 168 Mr. VOLCKER. Well, I think that would be rather extreme. I can't imagine the situation where that would happen, although it's theo- retically possible. But I went at some length in my statement to make precisely I think the general point that you are making; that in other economic circumstances—and I attempted to describe them—a very sharply lower growth in the money supply would be appropriate, precisely because of all the reasons you suggest. The CHAIRMAN. Well, I read your statement carefully. I didn't get that emphasis, but I'm glad you're giving it to us now. Mr. VOLCKER. Well, I refer you to page 27. The CHAIRMAN. I'm sure it's there. I don't doubt your word. Mr. VOLCKER. I don't think, it's a part I skipped over under your urgings, but I The CHAIRMAN. Let me pursue this in a different way then. Mr. VOLCKER. I just want to point out page 27 and commend it to your attention. The CHAIRMAN. What page? Mr. VOLCKER. Page 27. The CHAIRMAN. All right. Mr. VOLCKER [reading]. To the contrary, action to reduce the rate of growth of Ml promptly and substan- tially would be called for in a context of strongly rising economic activity and signs of emerging and potential price pressures, perhaps related to significant weakness of the dollar externally. The CHAIRMAN. Of course, that raises another question. It's never the time, you know. We had somebody yesterday say the way you avoid this kind of a situation we're getting into is never get drunk. And another way to do it, the way we're doing now, is to never be sober. If you're never sober, you never have a hangover. It's a hair of the dog that bit you, get another drink in the morning and you're good for the day. Mr. VOLCKER. That's not my vision. The CHAIRMAN. Well, I'm glad you don't follow that policy. Nei- ther do I. But it's sometimes a tempting policy. At any rate, let me ask you this. Over the last 12 months the money supply as measured by Ml has grown by 15 or 17 percent, depending on how you measure it, well in excess of the Fed's tar- gets. That explosion in money growth is sometimes blamed on fi- nancial deregulation and lower interest rates. That is, as interest rates come down, people shift their money from short-term liquid investment into NOW accounts. However, the demand deposit component of Ml has grown by nearly 13 percent over the last year. Of course, demand deposits pay zero interest. As a result, why wouldn't it be accurate to conclude that the ex- plosion in money growth is due to the Fed's decision to supply more money rather than an increase in the public demand for money? Mr. VOLCKER. Well, it takes both sides of the supply and demand equation to produce the result, and we supplied the reserves. But demand deposits are also affected by declines in interest rates, by at least two avenues. I'll add a third avenue. It's true they pay no interest, but most demand deposits these days are held by business- es, many of them in compensation for services provided by the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 169 bank. When the interest rate goes down, the bank says to get the same income I need a larger deposit because their return on that money has gone down. These explanations are not alternatives. They go on at the same time. The fellow who is managing his demand deposit account isn't going to manage it so carefully when the reward of taking the money out of the demand deposit and putting it in something else is reduced. And this shows up in equations over a period of time. So the direction of the movement is not at all unusual. The size of the movement is unquestionably unusual. The size of the inter- est rate decline was pretty unusual, too. In part, you may have here a phenomena of whereas more demand deposits are held by businesses—that is, a bigger propor- tion of demand deposits are held by businesses—and banks are all sharper on their costing, so you may get more responsiveness to this compensating balance phenomena that I referred to than you got earlier when a lot of individuals held demand deposits and banks and their customers may not have been so precise in their calculations. That's speculation on my part. But the direction of the tendency is clear. The third factor which is somewhat different, you have already mentioned—the obverse of that anyway. There are so many finan- cial transactions going on which in the immediate sense may re- quire some demand deposits to lubricate, that tends to pull up de- posits, too. There is one type of financial transaction which has been very active, the settlement of mortgage-backed bonds, that re- quires explicit putting of demand deposits in escrow for a while, and that activity is so big it probably has some impact. You saw this very clearly at the end of the year. This was—I don't know whether disturbing or comforting, depending on the way you look at it. There was an explosion in credit demands at the end of the year for a variety of reasons, including tax law changes, and there was a very large increase in demand deposits and the money supply generally at the same time. You had as much increase in the money supply around the turn of the year as we ordinarily get in a year and it was clearly related to an explo- sion in financial activity. Most of that has washed out. The in- crease in the money supply in February is going to be very small it looks like, and you ve had a relapse from that explosion around the year end. But that more persistent pressure from financial transactions is in there someplace. I don't think it's the major cause of the rise, but it is a third factor to put together with the others. FOREIGN EXCHANGE VALUE OF THE DOLLAR The CHAIRMAN. I'd like to ask you a question about the trade def- icit. On page 18 of the monetary policy report that accompanies your testimony the Fed says that the foreign exchange value of the dollar has declined about 40 percent against a weighted average of the currencies of the other G-10 countries since February of 1985. But on page 18 of that same report, it's noted that since early 1985 the dollar has appreciated in real terms relative to the cur- rencies of Canada and some developing countries which account for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 170 almost half of the U.S. nonpetroleum imports. In other words, we are not benefiting from the dollar decline in relation to those coun- tries with whom we do almost half of our trade. Mr. VOLCKER. Did it say that? The CHAIRMAN. I notice that the Dallas Federal Reserve Bank Mr. VOLCKER. I hope our report didn't say that last sentence. You said that we didn t The CHAIRMAN. No, no. I said that we are not benefiting from the dollar decline with those countries with whom we do almost half of our trade. That was my conclusion. Your quotation is "Since early 1985 the dollar has depreciated." Mr. VOLCKER. Your conclusion I think is wrong, and I just want to note that. The CHAIRMAN. Well, all right. What puzzles me is that the Dallas Federal Reserve, a branch of your operation, said that if you have a comprehensive weight, including Canada and the develop- ing countries and so forth, that the dollar has depreciated 5 per- cent, and that seems to be a far different situation than the 40-per- cent decline with respect to Japan and Germany and the 30 per- cent with respect to Great Britain, for example. Mr. VOLCKER. Yes, that would be quite a different situation. I am aware of the Dallas Federal Reserve's calculations. I have told them I think that they are unrealistic and misleading in terms of the economic situation. They are well aware of my view on this subject. I do not think it's a good index and I'll tell you why. It's the same observation you made. It's just nonsense to look at an exchange rate for Latin America or most of these countries before allowing for changes in prices. In the exchange rate itself, we have appreciated enormously against most of those currencies because they're having great big inflations. Even if you put it in real terms, the implication that we do not benefit in trade terms with those countries from the change in the exchange rates among the industrialized countries is simply wrong. If you have no change in the exchange rate vis-a-vis the Korean won, but our exchange rate has changed 50 percent against the Japanese yen, obviously the Koreans now have an enormous incen- tive to export to Japan instead of to us and to import from us rather than from Japan. And that's the market that is supposed to work. It doesn't make any sense for a country—take Canada—that Canada does not have a current account surplus. They have not been in a position—I'm just speaking very generally—for a major appreciation of their currency, but they certainly now have more incentive to export to Europe and Japan and less incentive to export to us and our market as a market from which to import is certainly more attractive now than it was two years ago relative to Japan and Europe. That's what these exchange rate changes are all about. Now the difficulty is that the effects may be greatly slowed down or thwarted if Japan in fact refuses to import from Korea or the Europeans don't open their markets and then these financial in- centives don't work. But that's not an exchange rate problem. That's a trade problem. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 171 The CHAIRMAN. My time is up. Senator Heinz. Senator HEINZ. Chairman Volcker, I wasn't going to talk about trade, but since you left Senator Proxmire on that note I will just ask you one quick question on trade. PROTECTIONISM This goes back to the subject of how we avoid protectionism in this country and maybe some semantics on the subject. Many of us are persuaded that the only way that we can get countries to open their markets to us is to threaten or perhaps go as far as to deny, until such time as other markets are opened to us, access to this market. It is no coincidence that this country ac- counts for roughly 22 or 23 percent of the free world's aggregate gross national product and we accept 50 to 60 percent of the free world's merchandise trade as imports. My question to you is, is it protectionist for the United States to have a law that in effect says we will deny a particular country or particular sectors of a particular country market access until that country removes the trade barriers that are denying us access— probably as a practical matter in different sectors—is that protec- tionism or not? Mr. VOLCKER. I think you're asking me a semantic question that I find difficult to deal with. Senator HEINZ. I don't know whether it's semantical or not. Mr. VOLCKER. I think there's a real issue here, don't mistake me, but I think you would say if you put up a trade barrier that's pro- tectionism, whether it's for a good purpose and for the purpose of trying to get somebody else to reduce their trade barriers so that the total in the end will not be protectionist Senator HEINZ. Let me help you a little bit with semantics. I would argue I think as a scholastic matter that protectionism, as defined, is to protect an industry and that if you're going to protect an industry in this day and age you had better have very broad comprehensive trade barriers affecting every country. Now the President has a steel import restraint program in effect on steel. It isn't working too well because there are just three coun- tries out of about two dozen—Canada happens to be one of them, Sweden and Taiwan until recently—that simply weren't participat- ing and, as a result, it hasn't had the effect the President wants it to have. So my argument would be, if you're picking on a particular coun- try with your retaliation that it is probably not protectionistic be- cause there are so many sources in this day and age of substitute products and, therefore, I really don't see your semantical problem. Do you still see it after that explanation? Have I given you cause for hope and light? Mr. VOLCKER. I don't think the real problem is what is seman- tics. The problem is whether, in the interest of a greater good, as you describe it, in breaking down the trade barriers of others this is an effective, efficient, understandable technique. And in some particular instances it may be. I certainly understand the frustra- tions that underly that approach. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 172 I would think also if it's clear enough, you could get multilateral support for that effort and that might be a test. Senator HEINZ. Let me return to a subject I wanted to pursue with you originally and that has to do with the overleveraging of the economy. Many of us today have heard you and others talk about high burden of consumer debt, the national debt, the debt we owe other countries, corporate debt, and the jury seems to be in that we are overleveraged and that entails a number of risks to our economy. Is that right? Mr. VOLCKER. Well, I, unfortunately, don't think you can say the jury is in. A lot of Wall Street doesn't seem to think so. I under- stand it's a badge of honor these days not to have Senator HEINZ. Well, as a jury of one sitting down there, what do you think? Mr. VOLCKER. I think we are in danger obviously of moving too rapidly in that direction, I have no doubt about that. Senator HEINZ. To what extent do you believe the Federal Gov- ernment's policy of insuring financial institutions against risk is a contributing—not maybe the determining factor but a significant contributing factor? Is it or is it not accurate that by providing de- posit insurance—and I'm not necessarily arguing against it, but just to understand the effect—that by providing deposit insurance, we guarantee that institutions, some of which will take bigger risks than others, will have access to funds and, therefore, by having that kind of policy, we perpetuate risk-taking through a govern- ment policy? Is that a fair statement? Is that accurate or have I missed something? Mr. VOLCKER. I'm afraid I would get maybe semantical and say we're not insuring the institution, and many institutions are fail- ing, as you know. But we are protecting depositors through the FDIC and through other events, and 1 don't think there is any doubt that in some circumstances that protection which enables in- stitutions to raise more money more freely than would otherwise be the case may contribute to risk-taking, excessive risk-taking. Senator HEINZ. Among banks or among S&L's, don't we insure deposits for the same cost, irrespective of the policy of lending of the particular institution? Mr. VOLCKER. Of the individual one, yes. Of course, as you the know, the S&L's now pay a premium. Senator HEINZ. And so we have the Continental Illinois Bank. I seem to recollect that we did a little rescue operation there. Mr. VOLCKER. I think you've got your hands on a real problem. I have not thought that the way to handle this ideally is by risk- based premiums, if that's what you're getting at. But I have no doubt in my mind you've got a problem. Senator HEINZ. I'm getting at—since I think we both understand there can be difficulties with risk-based premiums, I'm looking for a way to address the problem. Because if it's true that we are over- leveraging ourselves and putting ourselves unnecessarily into a dangerously risky position—we may not be there yet, but we can see the tunnel at the end of the light. We ought to be doing some- thing about it rather than just talking about it. Mr. VOLCKER. Well, I obviously can't disagree with that. Now this insurance only goes to depository institutions—commercial Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 173 banks, and savings and loans, leaving out credit unions for the moment, which are not a source of the problem. That is an area of the financial community that we otherwise regulate and that is part of the balance. They do get the benefits of insurance, but we're supposed to be supervising them, collectively and not just the Federal Reserve. And the supervision is supposed to obviously be alert to precisely the kind of developments that you're talking about. A lot of the leveraging in the economy is going on outside these institutions—not entirely, but in good part outside the areas that are technically covered by deposit insurance. Nonetheless, I think you have your mind on a problem that needs to be dealt with. I would say the other side of that is we've got to proceed very cautiously in this area, given the existing strains that are evident on many financial institutions. Senator HEINZ. Chairman Volcker, your admonition as to caution is well taken. I don't quarrel with that. I can't help but reflect, however, that our solution to the problem you and I have been dis- cussing is that next week we're going to hold a markup in this Committee to approve a $12 to $15 billion bailout of the Federal Savings and Loan Insurance Corporation. What we are doing is, in effect, just keeping a system afloat Mr. VOLCKER. I agree. Senator HEINZ [continuing]. That has all kinds of—is leaking des- perately and badly. And there's no institutional reform. All we're doing is we're putting more of the taxpayers' dollars beyond the premiums that that particular industry has contributed, and we have a great, wonderful and fundamentally phony way of doing it so that it doesn't show up on budget, but make no mistake, there are going to be $12 to $15 billion more allocated to the FSLIC and, correspondingly, less will be available elsewhere. So this is not an academic question. Mr. VOLCKER. I agree with that fully and I have urged before and I will again that I think this whole problem that you're raising now should be addressed by the Congress. I think it has to be ad- dressed with great care and deliberation, but I certainly hope that will be on your agenda for more comprehensive legislation when you get this immediate question out of the way. Senator HEINZ. That is a critical point. Mr. VOLCKER. What's a critical point? Senator HEINZ. Do you say to a fellow who is drowning, "I'm going to give you a life preserver and drop you off back out in the middle of the ocean and see how long that keeps you afloat," or do you tow him into shore and show him what dry land looks like and teach him to walk again? FSLIC BAILOUT The problem I have with simply passing an FSLIC bailout bill is all we do is tow these people back out in the middle of the ocean and see how long it is they can stay afloat out there without making any provisions either to lower the water level or to teach these people to swim or walk. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 174 Mr. VOLCKER. Well, what people are you talking about, the FSLIC? Senator HEINZ. The FSLIC. Mr. VOLCKER. Well, I think you are certainly throwing them a life preserver if you're talking about the FSLIC. I think that that is essential under current circumstances. This plan, as you know, is basically Senator HEINZ. But what you're saying is don't do anything about the basic problem, wait until later. How long do we have to wait? Mr. VOLCKER. I don't know, but I think a lot of difficult problems arise here that have to be carefully considered and you sure have got to wait more than a month or two, and I think the time plan you have for this program should be in the framework of a month or two, but I am not discouraging you from getting to work on the other problem. I am urging caution and care because I think it is a very diffi- cult, complicated problem. I think you ought to get to work on it. I have occasionally had some thoughts on the subject myself. I don't think you have to delay at all, and I don't think there has been any delay. I think there has been very considerable effort in the Home Loan Bank Board and the FSLIC to tighten up their regula- tory and supervisory approaches, and I think that ought to be rec- ognized. It's not quite that you're just throwing them this money and nothing has been done. Quite a lot has been done over the last few years. Senator HEINZ. Mr. Chairman, my time has expired. If I could have one additional minute, there's one followup question I would like to ask on this. The CHAIRMAN. Go ahead. Senator HEINZ. Virtually every economist and financial expert I've talked to has agreed with the proposition that nonbank banks, consumer banks, the creation of those, is a direct threat to the S&Ls. They syphon off deposits. Now I don't think it is actually fair to say that tying a closure of the nonbank bank loophole to FSLIC is actually plowing brand new turf. We passed legislation to do that about 3 years ago in the Senate. Now are you saying that we shouldn't, at the minimum, do that? Mr. VOLCKER. Quite the contrary. This issue arose before and I really think, as I said before, the failure to act in that area is an abdication. I think it has the effect that you're talking about, but I think it's a much broader issue. I was interested in noting in some newspaper column this morn- ing people upset with the grandfathering and tandem restrictions that Senator Proxmire put in the bill. They said, "My goodness, that's what it is all about. We want to cross-market all these serv- ices with our commercial firm." And, of course, that is just the issue. What kind of a banking system do you want? Do you want a banking system that's primarily devoted to cross-marketing the services of Sears Roebuck, Ford, Chrysler, and all the rest with all the problems that arise, or do you want an independent banking system? Senator HEINZ. So it is your strong view, as I understand it, that we should address those issues as part of a FSLIC recapitalization. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 175 Mr. VOLCKER. On that issue, it is my very strong view you should address along with it that issue of those particular securities powers that the Chairman has put in the bill. I think it would be a dereliction if you don't deal with those issues at this time. Senator HEINZ. Mr. Chairman, thank you. Senator Sarbanes, I thank you. You were kind enough to delay your time. The CHAIRMAN. Let me just say that I'm going to have to leave and, Senator Riegle, if you'll take over as Chairman in my absence. Senator SARBANES. Chairman Volcker, I wanted to follow along a line of questioning that Senator Heinz put to you and I thought put very well on this protectionism, and I think the one agreement I got out of all of it is that it really is a matter of semantics. I mean, various proposals for looking at this thing are brushed away by a lot of people by trying to stick that label on it, and then you can't in a sense come to grips with it. Mr. VOLCKER. If I may just interject, I think you could call that a matter of semantics. He put a very limited question, a specific re- striction, with the clear and single objective of getting the other country to remove a restriction. Senator SARBANES. Well, that's right. And I want to turn to pages 11 and 12 of your testimony where you talk about Taiwan and Korea, where you've been, in effect, so bold as to actually pick out a couple of countries. What approach is there other than the one Senator Heinz sug- gested to move these countries to deal with what you have termed a strong wall of protectionist barriers? As long as they can go along as they are, it's very much to their advantage. Mr. VOLCKER. Well, it's not entirely to their advantage and one would like to think that reason prevails at times, although I recog- nize that they're very—it's not to the advantage of particular in- dustries that are being protected in those countries. Just how that is dealt with—and you're really going to get out- side an area where I think I can be very helpful. I'm not an expert—maybe I shouldn't have mentioned Taiwan and Korea, but that involves a lot of negotiating considerations and a lot of facts that I may not be familiar with. I can understand that what Senator Heinz was talking about is one possible approach in particular selected instances. RESPONSIBLE ECONOMIC CONDUCT Senator SARBANES. Don't you think it's reasonable to assume that it's unlikely they are going to take forceful action to increase imports, whether by reducing tariffs, lifting other trade restric- tions, or by exchange rate changes, all of which of course suggest that you think their performance in those three areas fall short of responsible economic conduct—on tariffs, trade restrictions, and ex- change rates. Mr. VOLCKER. My sense is that they will and are doing something and I don't know what word I use there—I have great doubts that it's going to be sufficiently forceful. I think they are taking action. Senator SARBANES. If they perceive that their access for markets for their exports were going to be affected, it might move them Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 176 rather quickly to address these three items to which you make ref- erence. Mr. VOLCKER. That is one possibility, but those kinds of actions and threats have dangers of their own which you have to take into consideration. Senator SARBANES. That's right, but none of the other possibili- ties seem to have worked. Mr. VOLCKER. Well, I am not ready to make that sweeping judg- ment, but I understand. Senator SARBANES. Which leads me to my next question. You preface that paragraph by saying, "Some newly industrialized countries also have clear responsibilities for contributing to a better world balance." My question is somewhat broader than that. Is it your view, given the strengths of various national economies, that there are a number of countries that are not assuming their international re- sponsibilities in terms of contributing to a better world balance that's commensurate with the strength of their national economy? Mr. VOLCKER. Well, clearly, when you're talking about the imbal- ance related to trade or current accounts, you look around. We've got a big deficit. We are one of them on the deficit side. Germany, Japan, Taiwan, and Korea—Taiwan stands out more frankly than Korea. It's a little country with an enormous trade surplus and enormous reserves already accumulated. But then I think you have to look further and say, are they contributing or not depends upon their internal economic situation. Are they growing? Are there areas where they are reasonably falling short or not? Now I would say in the case of Taiwan and Korea, as I stated, that you look at those countries and their strength externally has been growing. They have room to move much more aggressively on their trade barriers now than they would have had 5 years ago. Senator SARBANES. Let me ask about Japan and West Germany, two major industrial countries who are running very large surplus- es. Do you think that a new and broader perception needs to be de- veloped on their part in terms of their responsibilities with respect to the international economy? Mr. VOLCKER. Well, I think the whole effort of the administra- tion and others has been to move clearly in that direction and I think there is a better appreciation now than perhaps a few years ago. Indeed, you see—for that reason or otherwise, you see some re- sults. Both of those countries, at least in relative terms, have had a better expansion and internal demand and some decline in their real net exports last year. That is a direction in which things I think must move and that is the direction in which things did move last year to some degree. Now one can sit here and say, as I would, that given the overall growth rates in those countries, given the amount of resources they have that are unemployed, the availability of capital and so forth— is the rate of movement optimal? Senator SARBANES. What about their responsibilities, given their surpluses, to move capital into the Third World and contribute to the possibility of the Third World being able to go on to a growth pattern? That's traditionally a responsibility the United States has Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 177 tended to assume in the post-war period. We're not in a posture to do that and, in fact, our trade deficit, if you look at it, where it has worsened most noticeably in many instances it's with respect to trade in the Third World, which before was always an offset against the deficits we were running with these very industrial countries. Now given their surpluses and their strength, why shouldn't they have a responsibility to circulate some of that to contribute towards Third World growth? Mr. VOLCKER. Well, in some kind of broad concept, that would be very helpful to see much more capital flowing from those countries to Third World countries, let's say, and we earn it back in trade instead of borrowing it ourselves. This is what it would amount to and that would be a nice outcome. In practice, I don't think you can say those countries officially— and I haven't looked at it recently in detail—are probably doing any worse, they are probably doing better than we are relatively in terms of sheer official aid. And when you talk about a kind of grand conception that you have of much bigger flows of capital out of those countries, you run against a problem that those capital outflows they have are essen- tially in private hands, and how do you redirect a private flow of capital? That basically depends upon perceptions of market incen- tive. For the government to redirect it in the kind of billions and bil- lions of dollars that you're talking about, the taxpayers in those countries and the budgets in those countries would be taking on the burden. And on the scale that you're talking about—I'm not talking about the direction, but the scale that you're talking about—I think it's simply unrealistic to think that Japan with a surplus of whatever it is—$60 or $70 billion—is going to appropri- ate $30 billion for aid to Latin America rather than some propor- tionately small amount. I just give you a practical judgment. However desirable that may be, it ain't going to happen. Senator SARBANES. What about trying to get them to work multi- laterally to accumulate resources from a number of places and, second, so that they don't tie the aid. I mean, Japan moves forward now and says, "We're going to meet our responsibility." Then they have a bilateral flow and then they tie it, which simply worsens the trade problems. Mr. VOLCKER. Those comments are very relevant. There are both some progress and some work going on, and I think it's a very rele- vant comment. Senator SARBANES. Thank you. Senator RIEGLE. Thank you, Senator Sarbanes. Mr. Chairman, three topics. You've been here quite a while and I don't want to keep you too great a length. UPCOMING G-5 MEETING Regarding the upcoming G-5 meeting, for our goals to be achieved, many of which you've talked about today, it seems to me the economies of those other nations have to grow and I'm wonder- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 178 ing what kind of growth rates you and Secretary Baker might have in mind. For example, West Germany, would we be thinking of maybe a growth rate of 3 or 4 percent, something in that range; and with respect to Japan, are we thinking about something like 4 or 5 per- cent? Where are we in terms of what it takes to make the system balance here? Mr. VOLCKER. Well, those growth rates would be very nice, but I don't want to set out a particular target. I think obviously I have some concern at least—and Secretary Baker is perfectly capable of speaking for himself—that those growth rates, particularly the growth in domestic demand, while in relative terms it has been im- proving, I would feel a lot more comfortable about the world situa- tion—I would feel a lot more comfortable about the speed of these international adjustments, if it were growing more rapidly. The latest evidence in those countries tends to be on the side of flattening growth rather than speedy growth. Senator RIEGLE. When you say the latest data, you mean within the last say quarter? Mr. VOLCKER. Yes. Senator RIEGLE. So growth may be slowing down in Japan and in Germany? Mr. VOLCKER. Well, in Germany in particular, the figures defi- nitely show a slowdown. Now you can get into all the arguments about seasonal, whether it's been a bad winter and all the rest. In Japan, I don't think they've slowed down particularly in the last few months, but it's not a very vigorous growth rate—2.5 percent or something, as I remember, which is way below Japanese stand- ards. So what I'm saying is that in these recent months I think within those countries more questions have been raised about the adequa- cy of their growth rate than earlier. I share that concern. Senator RIEGLE. Well, that's really the point of my question. In terms of balancing the international trading and financial system, you have testified here before that we are now interconnected in ways that we might not have been in years past and that's it's very important that we get corresponding adjustments that fit together. So I guess you're saying that you feel that the whole system would be better off if we could get higher rates of growth in both those countries than we are presently seeing? Mr. VOLCKER. There is no doubt about that. Now in saying that, they are going to say, "Well, don't forget, we want to safeguard our internal stability, our prices," which I have great sympathy with. I think that could be managed. They also say, "Yes, but this is a two- sided process and where is your adjustment? And you don't give us very encouraging signals about your budget deficit and we think this process ought to start with reducing your budget deficit." Well, I don't know where it should start and where it should end. They both have to be done, but I do think, as I said in my state- ment, that without them having some feeling of confidence that the United States is moving forcefully in the right direction it saps their will to take what they see is equally politically tough deci- sions to move in the other direction. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 179 And we both ought to be moving, in a sense, in opposite direc- tions. That's what would make for the international consistency I think in dealing with these adjustment problems. Senator RIEGLE. Well, you properly I think point out the role of our federal fiscal deficit. Last year it was the highest in our histo- ry, $221 billion, and maybe it's going to be substantially below that for this fiscal year that we're now in. We hope that it will be, but we won't know until all those numbers are in. I agree with your emphasis on that, but so much of the time you seem to leave out the trade deficit and the trade deficit is running at $170 billion at the same time. It seems to me that we have to move on both those problems and they're connected to one another and we've got to make progress I think very rapidly on both. Isn't that correct? Mr. VOLCKER. Yes, that is correct, and I don't think you're going to make progress on the one without making progress on the other. Senator RIEGLE. Well, that comes back to Japan. With respect to Japan, if you look at our trade deficit last year, $170 billion, the Japanese figure in terms of their surplus with us was, according to the Commerce Department, about $59 billion, by far and away the largest single part of that $170 billion deficit. And without repeat- ing all of the litany of factors, you know that the Japanese are very skillful at keeping our products and other nations' products out of their markets and so the trading system is not open both ways. Isn't it also necessary that if they're going to expand their inter- nal economies that something has got to be done about these in- credible bilateral deficits with countries like Japan? You men- tioned Korea and Taiwan and I think properly so because those are now persistent problems that are in the multibillion dollar range— about $16 billion last year with Taiwan alone. But isn't Japan going to have to find a way in their bilateral trading relationship with us either to buy more or send less so that we get this deficit down from an area of roughly $60 billion a year? Mr. VOLCKER. Well, obviously, their surplus with us is enormous and it's very hard for us to see us dealing with our general problem without a reduction in that deficit. But I think that's the wrong focus to look at it in. I think the world trading system—maybe less so—but nonetheless is still a multilateral system and where the in- dividual bilateral deficits fall out I don't think is so significant. What matters is their overall surplus. That's what I would em- phasize, their $70 billion overall surplus, and our overall deficit, rather than the bilateral one. As I indicated before, it would be greatly in our interest, as Sena- tor Sarbanes was illustrating on the capital side—but just on the trade side, if they absorbed a lot more imports from Latin America, that would give Latin America the capacity to import a lot more from us and might not affect our trade balance directly with Japan at all but it would be a remarkably constructive contribution to their overall surplus and our overall deficit. Senator SARBANES. Would the Senator yield? Senator RIEGLE. Yes, I yield. By the way, I think that's an impor- tant point. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 180 Senator SARBANES. Provided that Japan didn't tie taking more imports from Latin America to Latin America taking Japanese ex- ports, which of course they tend to do. KOREAN EXPORTS Mr. VOLCKER. I agree, which would be inconsistent with our ex- ports rising. You just mentioned Korea. Korea, of course, is right next to Japan and I read in the newspapers anyway that Korean steel is now pretty competitive in Japan and it's pretty competitive in the United States too, I guess. But it must be, given these ex- change rate changes, a very considerable incentive—just to pick out one product—cars—to sell them to Japan. But if Japan isn't going to take them, that process is thwarted. It's not a trade bar- rier against us. It's against them. Senator RIEGLE. Well, it's not only thwarted. What happens is, is that steel then basically comes to the last big market that's left, and that's here. And just with respect to cars—and cars, of course, contain a lot of steel—if you take the Hyundai, which is a very popular new Korean import, they are planning to ship about 200,000 of those in here this year but their goal 3 years down the line and their production plans in Korea are to produce and ship in here roughly 1 million cars. And it's an enormous fact of life, not just for that sector of the economy, but that is a pattern we're seeing way beyond steel and cars. Mr. VOLCKER. Well, I understand that and I suspect that those plans were made and developed over a period of time and against competitive positions that existed in part some time ago. The logic of the exchange rate changes we've had is that they should be thinking of exporting more of that planned million or whatever it is to Japan or to Europe or elsewhere and less here. Now whether that works, of course, is related to your comment— if we're the only open market, that process doesn't work. Senator RIEGLE. Well, I want to tie down two other things on this because it's important and your testimony is important. As I understand it, even though the dollar has come down sub- stantially against the yen over the last year, we really have not had any major change in currency value between our currency and the Korean currency. Is that right? Mr. VOLCKER. That's correct. I think there's been some apprecia- tion but not much. Senator RIEGLE. I think less than 1 percent. Mr. VOLCKER. Well, I'm not sure about that, but it's small anyway. I will accept your statement. It's negligible. Senator RIEGLE. Here's the point. Some will argue that what's going to happen here with the 40-percent decline of the dollar versus the yen, is that over a period of time after a lag, you'll start to see some adjustments in the trade situation unless there are just naked barriers that prevent that from happening. But with respect to Korea, if changes in currency value are not reflected in any differential way between the two countries, it seems to me we're not going to get that kind of effect in six months or sixty months. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 181 Mr. VOLCKER. Well, I think that's just plain bad economics. Ab- stracting from the trade barriers, which are very real, but just looking at the currency values, the change in relative currency rates between the United States, Europe and Japan gives Korea more incentive to export to those countries and to import from the United States without the dollar-won exchange rate changing by 1 won, or whatever the rate. Senator RIEGLE. Well, that's if they can get in those markets. Mr. VOLCKER. If they can get in them, that's right. Senator RIEGLE. But if they can't get into the markets, then they come back. Mr. VOLCKER. If they can't get into those markets, that process does not work and then you've got another set of problems. Senator RIEGLE. Two other things quickly. Citicorp seems not to want to make further loans to the LDC's at this point. At least they seem to be the one bank that is the least enthusiastic about doing so. That's what the stories say. Mr. VOLCKER. Well, the stories don't say that—just to be clear—I don't want to comment about an individual bank, but I think the stories focus on questions about what the interest rate should be, not whether they are willing to lend or not. Senator RIEGLE. I'll accept that correction. I think that's a very important point. It sounds to me as if they don't have much enthu- siasm for wanting to lend at the rates that maybe they're being en- couraged to lend at. Is that a fair summary? Mr. VOLCKER. Well, I don't know what's being encouraged or dis- couraged. It's a question of negotiations between the countries and the lenders. Senator RIEGLE. Well, let me ask a very direct question. Will the Fed pressure any of the banks to extend or increase their loans to the LDC's? BAKER PLAN Mr. VOLCKER. We have made our feelings in this general area amply clear—I do practically every time I testify—about the over- all interest that we see in this process moving forward under the broad rubric of the so-called Baker plan. It's always been under- stood that the banking community as a whole had certain responsi- bilities in that area if the plan was going to work. I don't consider that pressuring the banks. That's making a point of view known and we do it pretty clearly when we're talking to banks in groups or when I'm talking in public I say the same thing. Now that process has slowed down. It's bogged down recently and I think the atmosphere, for a variety of reasons, has under- mined the atmosphere surrounding the whole initiative and many of these programs don't require new money. Some of them are just refunding, which are usually very simple—very simple is not the right description—but considerably simpler to implement than when you're asking for sizable amounts of new money. But we've got a lot of—seven or eight countries that have been negotiating financing plans for months and none of them have been absolutely completed. Some of them are on the edge, but none of them have been conclusively completed. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 182 This is a long and frustrating process and, obviously, I would feel more comfortable if that was moving more expeditiously. Senator RIEGLE. One of the questions in my mind—and it isn't to take the argument or position of any private banking institution, but it seems to me that these loans are very much—they have a national interest component to them and it makes me wonder at what point, if banks are being pressured by events or pressured by our Government to either continue loans or extend loans or to give favorable interest rates, that if there's a public policy component to that, that maybe the Government itself ought to be extending those loans rather than go through the fiction that they are private sector loans and recognize that they are really perhaps public sector loans. Mr. VOLCKER. Well, I don't accept that the loans that the banks made were public sector loans. They were pretty eager to get into that business at one point. Senator RIEGLE. I'm talking about from here forward. Mr. VOLCKER. From here forward, I think the United States and other governments, acting either bilaterally through export credits or otherwise, and certainly acting multilaterally through the World Bank and the IMF, have a clear responsibility to support this process and, in some cases, put up new money, which, of course, is what the World Bank in particular is doing now. If you look at the Mexican program, which isn't quite tied up— it's one of those that's been caught—a very large program and a very difficult one because they were so hard-hit by the oil situation exclusively in terms of the size of the program, roughly half of the new money involved in that program comes from official sources—I think a little more than half. Senator RIEGLE. Just one other thing and this is—I don't mean for this to be an overly provocative question to you. I'm trying to get a sense as to the margins we have right now in terms of man- aging our financial problems and we've got a whole laundry list— the Federal budget deficit, the trade deficit, the working out of multilateral arrangements, Third World lending and a host of other things—monetary policy, where that fits in. The question I have in my own mind in terms of how much margin we have and the parameters we're working within—if we were to see a recession of any consequence, say, over the next 12 months, would that come at a time that would be particularly worrisome in your mind in terms of navigating our way through all of these difficult prob- lems? Is it very important for us to stay out of a recession now? We never want one, but I'm asking the question, does it pose extraordi- nary dangers? Mr. VOLCKER. I think the risks of that are inevitably greater to the extent the rest of the world is not growing on its own momen- tum with some strength, and I think the risks are inevitably great- er to the extent that the international debt problem is still there, as it obviously is. I would think the risks grow over time. I would take a somewhat different perspective if the financial system gets too highly leveraged. But the more questions there are in the world economic and financial system outside the United States, the bigger the problem potentially you have. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 183 Senator RIEGLE. I would just finish by saying, when I try to think of what would happen if we started to slip into a recession, with the Federal budget deficits rising because revenues would fall and transfer payments would Mr. VOLCKER. If I may just interrupt, that's not the part of the budget deficit 1 would worry about. I mean, really when I'm talk- ing about the budget deficit, I'm talking about reducing the budget deficit in the context of growth. Obviously, if you were in a reces- sion, the budget deficit would be affected. But what you've got to aim at is get that structural deficit under control. Senator RIEGLE. Well, you make the point I was coming to and you were ahead of me, so I'll let your point stand. Senator Sarbanes, you wanted to make an observation. Senator SARBANES. I just wanted to get one final sort of reaction from the Chairman. TRADING SYSTEM UNFAIRLY STRUCTURED AGAINST THE UNITED STATES First of all, let me say I'm not trying to lead toward any conclu- sion or any way you go about redressing the situation I'm about to set. But there's a perception I think in the Congress and in the country that the international trading system is currently struc- tured—is unfairly structured against the United States. In other words, we are being taken advantage of, that our market is much more open than other markets are to us. We had the whole prob- lem of the currency valuation which put our producers out of busi- ness because of that problem. We carry a heavy strategic responsibility, a defense strategic re- sponsibility, so we have 6 percent of our GNP going into defense and other countries have much lesser percentage so we're carrying those broad responsibilities. And that, in a sense, perhaps the United States is still operating on the premise that prevailed in the years after World War II when we were clearly the dominant economic power and, in many respects, I think made concessions to help the rest of the world grow, that that time has passed, that we're in a very different situ- ation. Now how you address it is a complicated matter and one of con- troversy. But what I'd like to get from you is whether you think the perception that the system is not now fairly structured, that the rules are not fair and need adjusting—and you can adjust them in lots of ways obviously—but whether that perception you think has some accuracy to it? Mr. VOLCKER. I would not say the rules themselves I think. I sit here and think there is some truth to the perception that in fact, at least among the major countries, we are the most open market. We obviously have the biggest defense spending and I think those perceptions are accurate. I'm not sure that they have changed dramatically. You say this was kind of built into the postwar system to some extent and if you take a long sweep—go back 30 years to the 1950's when we con- sciously almost unbalanced the system, I suspect it may be less un- balanced. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 184 But nonetheless, I share the perception that, by and large, we have more open markets. We are more welcoming of imports, whether by governmental policy or culture or whatever, and that we do carry certain burdens that other countries do not carry. I agree with that, but I'm not so sure it's changed so much in recent—I don't think that's the explanation of why our trade bal- ance is $150 billion worse than it was 4 years ago. Senator SARBANES. When Secretary Baker went to the Treasury in February 1985, he moved pretty quickly to address—at least in my judgment pretty quickly—to address the currency overvalu- ation question because it was by that fall that he had the Plaza agreement. I take it it's your view that, one, he needed to do that; and, two, that we had failed for too long to come to grips with that problem? Mr. VOLCKER. Well, I certainly think that the dollar had gotten to extremely high levels and was overvalued. It had been declining for nine months before the Plaza agreement but that gave it fur- ther impetus. But I think it's very hard to see a more balanced trade pattern emerging without a substantial realignment of the major currencies. I agree with that. Senator SARBANES. Thank you. Senator RIEGLE. Thank you, Senator Sarbanes. Thank you, Mr. Chairman. The committee is adjourned. [Whereupon, at 12:45 p.m., the hearing was adjourned.] [Response to written questions of Senator D'Amato from Paul A. Volcker follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 185 Chairman Volcker subsequently submitted the following in response to written questions from Senator D'Amato in connection with the hearing held February 19, 1987: Question 1: Mr. Paul Craig Roberts contended during the hearings that unanticipated disinflation caused by an excessively tight monetary policy accounts for $459 billion, or 46 percent, of the one trillion dollar increase in the public debt over 1981-1986. If Mr. Roberts is correct and the Federal Reserve's monetary policy contributed to the budget deficit, do you have any suggestions on how the Federal Reserve may use monetary policy to assist in deficit reduction? Answer: Characterizations of "unanticipated disinfla- tion" and "excessively tight" money are, of course, uniquely those of Mr. Roberts and have no independent analytic value. In general, however, there can be no clear answer to a question of what the deficit would have been in more inflationary condi- tions. While one might assert that the spending and revenue programs actually in place over the 1981-1986 period would have produced a smaller cumulative deficit if inflation had been greater (and all other things, including real growth), that begs a lot of obviously important questions about how Congress would have behaved in a different economic environment and whether greater inflation would have been consistent with achievement of t'ne favorable trends in real output, employment, and interest rates we experienced during the five year span. I strongly suspect that there is less than meets the eye to Mr. Roberts' claim. Whether or not Mr. Roberts is correct in his claim, I believe that the way the Federal Reserve can best contribute to deficit reduction over the long haul is the same way that it can contribute raore generally to healthy economic performance', by pursuing a monetary policy consistent with sustainable, nonin- flationary economic growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 186 Question 2: Despite claims to the contrary, the Secretary of the Treasury seems to have determined upon a level to which he intends to drive down the value of the dollar. Do you feel that there is a yen/dollar exchange rate that is too low? What are the risks for our domestic economy if the value of the dollar is driven down too far? Answer: Secretary Baker and I have agreed with finance ministers and central bank governors of other major countries that around current levels exchange rates are within ranges broadly consistent with economic fundamentals and basic policy intentions. Moreover, both Secretary Baker and I have said that a further decline in the dollar in the present circumstances could be counterproductive. It would tend to weaken economic activity abroad, by reducing demand for their exports and conse- quently by discouraging investment in new productive capacity. In this country, it could pose substantial risks of renewed inflation momentum and undermine confidence in future financial stability—developments that could jeopardize prospects for a sustained economic expansion. Instead, we should recognize that the favorable impact on our external position of the considerable decline in the dollar we have already seen will be fully realized only with a lag. We should, in the meantime, act to reduce further our federal budget deficit—while other countries provide stimulus to their economies--in order to create the domestic conditions that will accommodate the adjustment in our external position without the pressures on prices and interest rates that might otherwise occur. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 187 Question 3: One of the witnesses suggested during the hearings thatTthe dollar's decline has resulted in the Federal Reserve feeling pressured to raise interest rates "to save the dollar" and forestall a renewal of inflation due to rising import prices- Is this a correct assessment of the Federal Reserve's feelings? If the Federal Reserve were to succumb to these pressures and raise interest rates, could not this have a recessionary impact on the economy? Answer: Developments in exchange markets have been for some time among the factors considered by the Federal Open Market Committee in its monetary policy deliberations. That is because exchange rates do have implications for the U.S. economy. We have already expetienced a substantial decline in the dollar's value, and I believe in current circumstances a further sizable depreciation of the dollar could well be coun- terproductive. Officials in other countries share that view, and large-scale intervention has been undertaken to support the dollar. But in the end, confidence in the current exchange rate levels will depend upon perceptions that more fundamental poli- cies will in fact be brought to bear. I have emphasized the need for complementary changes in fiscal policies in the United States, Germany, and Japan. The conduct of monetary policy, here and abroad, will be relevant as well, and the performance of the dollar in the exchange market might become a factor bearing on our provision of reserves. There could be circum- stances in which the Federal Reserve could act to restrain the supply of reserves to resist the dollar's decline. Those Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 188 circumstances are more likely to be associated with excessive pressures on resources and a greater risk of inflation than with a recessionary situation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 189 Question 4: During the hearings, one of Che witnesses suggested that the current Gramm-Rudman deficit reduction tar- gets should be abandoned or Ignored. Do you think that the Gramm-Rudraan targets should be abandoned? What would the conse- quences be of our failure to realize these reductions on interest rates and GNP growth? Answer: Enactment of the Gramm-Rudman-Hollings Act had a positive effect in financial maikets as it bolstered confi- dence in the ability of the government to bring order to its finances and led to expectations of reduced pressures in credit markets from Treasury borrowing. Simply abandoning Gramin- Rudman-Hollings thus would appear to entail some risk of damaging sentiment. At the same time, though, I believe analysts recognize that hitting the statutory targets exactly is not what is required to solve our fiscal problem. For example, a failure to hit the prescribed number in some year might not be especially dismaying if significant action had been taken and the miss resulted from deviations of the economy from reasonable assumptions used in the budget projections; on the other hand, success in hitting the target in a particular year would not be impressive if it were achieved largely by accounting legerdemain or resort to transactions that provided one-shot improvements at the cost of longer-term problems. The important objective is meaningful and lasting reductions in the structural deficit. As long as the fiscal authorities adhere to this principle—be it through retention of Gramm-Rudman-Hollings or through some other mechanism--! believe that the financial markets will be reas- sured, interest rates likely will be lower than otherwise, and the prospects of achieving sustained, noninflationary economic growth will be enhanced. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1987, February 18). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19870219_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_19870219_chair_federal_reserves_first_monetary_policy,
  author = {Paul A. Volcker},
  title = {Congressional Testimony},
  year = {1987},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19870219_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}