Congressional Testimony

FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1988 HEARINGS BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDREDTH CONGRESS SECOND SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 FEBRUARY 24 AND 25, 1988 Printed for the use of the Committee on Banking, Housing, and Urban Affairs U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1988 For sale by the Superintendent of Documents, Congressional Sales Office U.S. Government Printing Office, Washington, DC 20402 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS WILLIAM PROXMIRE, 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 BOB GRAHAM, Florida DAVID K. KARNES, Nebraska TIMOTHY E. WIRTH, Colorado KENNETH A, MCLEAN, Staff Director LAM AH SMITH, Republican Staff Director and Economist PATRICK A. MULLOV, General Counsel GILLIAN GARCIA, Director of an Economic Analysis Group, GAO (II) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS WEDNESDAY, FEBRUARY 24, 1988 Page Opening statement of Chairman Proxmire 1 Prepared statement 3 Opening statements of: Senator D'Amato 6 Prepared statement 16 Senator Riegle 6 Senator Garn 9 Senator Bond 11 Senator Dixon 12 Senator Sasser 14 Senator Chafee 72 WITNESS Alan Greenspan, Chairman, Board of Governors, Federal Reserve System 18 Prepared statement 19 1987 in perspective 20 Economic outlook and monetary policy for 1988 22 The challenges ahead 26 1988 monetary policy objectives 27 Response to written questions of: Senator Proxmire 80 Senator Sasser 109 Senator Sanford 122 Witness discussion: Challenges to Fed's independence 42 Household and business debt 43 Trade deficit 45 Fed's role as to recessionary economy 55 Lower value of the dollar 57 Housing starts 67 Money supply 69 Fiscal stimulus vs. money stimulus 74 Economic report by President criticizes the Fed 76 Foreign investment 78 THURSDAY, FEBRUARY 25, 1988 Opening statement of Chairman Proxmire 129 Opening statements of: Senator Dixon 131 Senator D'Amato 133 WITNESSES Robert J. Barbera, Chief Economist, Shearson Lehman Hutton, New York, N.Y 134 Tightening of interest rates 134 Prepared statement 137 Richard N. Cooper, Professor of Economics, Harvard University 146 Opposes further weakening of dollar 146 (in) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IV Richard N. Cooper, Professor of Economics, Harvard University—Continued Pase Debt of Third World countries 146 Prepared statement 148 The current dilemmas for policy 148 The problem of medium-term adjustment 149 A long-run proposal 150 Jeffrey Sachs, Professor of Economics, Harvard University 152 Flexibility in monetary policy 152 Political business cycle and the economy 153 Prepared statement 156 Neal Soss, Chief Economist, The First Boston Corp., New York 164 Prepared statement 165 Transferring resources to foreign creditors 165 Fiscal policy 165 Inflation and financial stringency 166 Crashes and the economy 166 The monetary aggregates and monetary policy 166 Financial fragility 167 The Fed and the election 167 The Fed and foreign exchange 168 Summary 169 Panel discussion: Fed is a political institution 170 Fed as part of the Treasury 172 Import quotas 173 Mortgaging our future 175 Recession would exacerbate our problems 178 Exchange rates and monetary policy 179 Inflation and lower unemployment 181 Possible recession in 1989 , 182 A democratic administration 184 Reducing deficit will spur economic growth 185 Floating exchange rates 187 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 1988 WEDNESDAY, FEBRUARY 24, 1988 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, Garn, D'Amato, Bond, and Chafee. OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. The Federal Reserve occupies a unique position in economic policy making in this country at all times. The Fed de- termines the availability of credit. It has a profound, constant, direct influence on the level of interest rates. As we all know, the level of interest rates very largely drives this economy of ours. The Federal Reserve Board's power is always a fact of life, but this year more than in any of the 30 years I've served on this com- mittee, this year the Fed's power is especially great. The Federal Government has two primary tools in guiding the economy. They are fiscal policy—the power to tax and spend—and monetary policy, the determination of the availability of credit. Fiscal policy that is expansive that holds down taxes and pushes Federal spending can obviously stimulate the economy. Fiscal policy that is restrictive, that reduces spending and increases taxes, can certainly restrain the economy. This year the President and the Congress are observing an agree- ment to follow a fiscal policy that was locked in late last year. The President has told the country that he intends to live up to the letter of that agreement. It's quite clear that the Congress will do the same. So fiscal policy is a fixed, established, given factor. This leaves monetary policy as the only show in town and the Federal Reserve Board as the prime discretionary determinant of our future for the next 12 months or so. You tell us in your clear and incisive statement this morning that you're going to follow a path that for the time being will follow roughly the same policy the Fed has generally pursued in recent months. That is, the Fed will increase the money supply at a rate close to the present and predicted normal increase in the GNP. But you also tell us that you may have to vary this policy. You will slow the rate of monetary increase if wages, prices and (l) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis economic activity generally rise more sharply than expected. In particular, you will act if the capacity utilization rates rise sharply and unemployment continues to diminish. This language is reassuring. What is not reassuring is that you have widened the range that constitutes your goals for M2 and M3 and that you continue the policy established by your predecessor of keeping the country and the Congress in the dark about your plans for the basic monetary variable, Ml. You tell us that Ml is too er- ratic a variable to be useful because of recent changes in interest- bearing checking accounts and various transaction vehicles. The Fed and its policies are so important (and especially so this year) that this committee some 15 years or so ago requested the Fed to report to the Congress on its plans for Ml—not M2, not M3—Arthur Burns brought those in later—but Ml. We specifically requested that the report indicate not a range but a particular, spe- cific figure, as they have for instance, in Germany, I understand, for Ml. But today you give us nothing for Ml and the broadest range ever for M2 and M3. For this reason, I get the feeling you're not giving the Congress the information we should have if we are to provide the necessary congressional oversight over the Federal Reserve Board's policies. Your explanations on pages 9 and following constitute the best, concise discussion of the Ml, M2 and MS measures of monetary policy that I've read. I think they are first class. They are very con- cise, direct, and excellent. But please give us more information and a more specific goal, if you possibly can. It would also be helpful to the committee to secure an analysis from the Fed on what seems to this Senator to be an extremely se- rious overall debt problem that lies beyond even the mammoth Federal Government debt. Household debt is nearly a half trillion dollars higher than the Federal debt, yet household savings remain much lower than in the past, although there's been a modest im- provement in recent months. Business debt is substantially larger than the Federal Govern- ment's debt also and is particularly burdensome in relationship to earnings. The healthy $2.85 of debt for every dollar of earnings in 1955 for example, has swollen to a business debt of $9 of debt for every dollar of earnings today. Of course, these figures are aver- ages. Tens of thousands of our businesses are today struggling under a debt that is 15 and 20 times their earnings. It would seem that in the next recession the number of insolven- cies and bankruptcies could be very large indeed. Finally, a Fed policy that holds down interest rates tends to dis- courage savings and encourage borrowing. In the short run, this policy stimulates the economy; but not in the long run. Only the Fed among our Federal "policy making institutions has the kind of institutional basis to consider the long run. The Congress and the President are looking to the next election. Any Congress and any President have to do that. So I hope you will include the overall long-term debt problem in your monetary policy deliberations. [The complete prepared statement of Chairman Proxmire fol- lows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis OPENING HT.URMI-^r "ST MOM-.TAUV P'.'.LIC': RKT'CRT '-F |'H \ i R>U\ 'v, I L..1 v'-1 Pku'.Mi -A\L FEBKI'ARY 25, 19HH Thin morn i ng we i. ] 1 L h<*ar from Alan Greenspan, Cha i rman of the t edera1 Resprve, who is be fore the commit tee t.o discuss the first, monetary po I icy report t,r> rt)n«'i-«as for- 1988. Chairman Greenspan, I am troubled by the extent of the political pressure being put on the Fed by the Reagan Admin is t rat. i on in t.his presidential election year. One of the virtues of granting the Federal Reset-', e a greater- degree of independence from the political process than manv other agencies is to insulate your institution from the pressures to buy stimulus now and pay in inflation later. I think it is both deplorable and counterproductive for the Reagan administration to pressure you as much as they have in recent months. The evidence of political pressure on the Fed in recent mnnl hs is oven* he lining . First, on November 5 , 1987, the Wf\ ] !. St reel Journal reported on the front page that Serretarv o f tli'- Trea:—ir\ had '^ua i'an t eeiJ. Lhat he wunlii nut, I ,; t, LII t c njs t. rat.-s r i si-1 . I iio no I nccrl t ,1 remind Mr , Baker tha I i i is the Fedi? :vi 1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1 ri Dec em her , w ides pi-fad r^por ts in the press 1ft ft. no doub f. tlmt Mr. Sprinkei a.L tin.- Count' i I u!' EuunomiQ Ad\ isors wan Led the Fed to ease. Th^n, in a lutter dated January 21, 1933 Assistant Secretary of the Treasury for Economic Policy, Michael Darby sen t a letLer to the Federal Reserve Governors and to the Presidents of the Federal Reserve District Banks suggesting that real M2 was growing too slowly. The implication: Ease up on the money. Finally, The Economic Report of the President complains that money growth was too slow in 1987 and criticizes the Federal Reserve for contributing to the onset of the stock market crash in October. And the final report's substantial criticism was apparently toned down from earlier versions at the request of Secretary Baker. Chairman Greenspan, the incumbent administration often has a desire to ease money more than would be good for the economy just before the preaidental election. You and your fellow governors arti entrusted uith resisting political pressure and implementing good cconomi c po1iuv. You and your fellow governors are pnrt icu larl v vulm; ratals to th i s sort, of criticism because all i; f th(j .:iir i-"tit .401, i' rim v-; >;.*•'!•(' ^ipi>o i i;i <<\ hv t hi> Ri';i«ar: Adrn in i rf t ra t i uri . Your our f-j t-manre u L ! 1 be cl JHC 1; sum t ini-c- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis hnv-r> eatiud ;nnnc v for ^DVini: tcs-hri i o:; 1 r •;,:;-; t> n ia , vou will c:e r t ;i i n 1'.' be aeji-uscd of betid i a ij l.o poll t i.ja i. prcaiiur:;. l;ui irsuat LOUS ,s!' po 1 i. t i c;i 1 mani pu i a t i on harm hoi h vour repu t;ji t ion as chairman iind th>- rcputatiun of Lho Fed or ill Rh!si-r\'': . The administration's haranguing unnecessarily raises the cost to the Fed of making good policy. h'ere it not for your integrity, you might actually resist changing monetary pol 1C"-' i.1 hen it is. .HIS. t. i T i SM! , Cor f par of under m ining tiie credibili t > u L" the Federal Reserve. Let us hope that in the future Mr. Baker, Mr. Darby, Mr. Sprinkel and the rest of the Reagan Administration will begin to trust the Chairman and the other five governors it has appointed to make monetary policy for the country's best interest. Let us hope that they will develop greater respect for the Federal Reserve's independence and refrain from asking you to make monetary policy for the benefit of the Republican Party. That will make it easier for the Fed to implement good policy. We desperately need good economic policy. It's in such short suoply. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 The CHAIRMAN. Senator D'Amato. OPENING STATEMENT OF SENATE D'AMATO Senator D'AMATO. Thank you, Mr. Chairman. Mr. Chairman, it's good to welcome Chairman Greenspan to the committee for his first effort to explain the Fed's monetary policy report. I note that yesterday, Chairman Greenspan delivered this report to the House Banking Committee. It must have been fairly well re- ceived because the financial markets of the world which have been relatively fragile lately, remained stable. Chairman Greenspan and his colleagues at the Fed deserve con- siderable credit, Mr. Chairman, for their performance. The Fed re- sponded swiftly and I believe correctly to avert the liquidity crisis precipitated by the events of October 19 and 20. Alan, I want to congratulate you for your handling of that very, very precarious and difficult situation. In his statement today, Chairman Greenspan underscores the need to implement policies which will keep the economic expansion moving in order to avoid a recession, and I couldn't help but agree with him. In fact, this is the most forthright statement by any Fed chairman regarding the Fed's intention in relation to the contin- ued expansion of the money supply. Too often in the past, the Fed- eral Reserve has been less than explicit with regards to its inten- tion in this area and I commend you and your colleagues because I think that's important, that there be some blueprint that is laid out. Further, I hope that we can get interest rates down a bit lower because lower interest rates will prove to be a beneficial stimulus to this economy. Chairman Greenspan also rates the precarious balance between monetary growth and inflation. However, the ex- perience of the early 1980 s I believe has taught us that some infla- tion, a little inflation, accompanying monetary growth and econom- ic expansion is far better for the economy and the American people than a recession. Finally, as we've observed during our market crash hearings, the United States and foreign economies are inextricably intertwined. In his statement Chairman Greenspan discusses the prospects for domestic economic growth. However, the statement is relatively silent on the prospects for foreign economic growth and I hope, Mr. Chairman, you might be able to give us some of your insight as it relates to that area because as you know the balance of trade and the deficit is largely dependent upon the ability of foreign govern- ments to purchase U.S. goods and services. So I look forward to your statement. Again, I want to congratu- late you for your efforts and the Fed's efforts at being more straightforward with us, particularly for your actions of October 19 and 20. Mr. GREENSPAN. Thank you. The CHAIRMAN. Senator Riegle. OPENING STATEMENT OF SENATOR RIEGLE Senator RIEGLE. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Let me welcome Alan Greenspan before us today. He's a person we've all known for some time and with whom we all work closely. There are three things that I would hope you comment on today in the course of your remarks and I will ask you about them when we have the opportunity. In terms of the Federal deficit for this fiscal year that we are now in, we have so far 3-months of data that have come in. We are expecting the 4th month of data tomorrow. You may have some sense for that, but it's not public today. If you compare the deficit that we've accumulated in the first 3 months of this fiscal year to the previous fiscal year, already we have logged a 3-month deficit of $80.4 billion. The previous year through the first 3 months, the deficit was $64.6 billion. So through the first quarter of the fiscal year we are up $15.8 billion, almost $16 billion, above an actual booked deficit, and I find that a very disturbing trend. I would like to know what you make of that and where you think that's taking us. The second thing is in the President's budget submission to us, for the first time, the net interest costs in the budget which we have to of course pay each year and comes off the top, will exceed the estimated deficit itself, and we are getting into this compound interest problem where past Federal deficits are now running up the annual interest charges even at a somewhat lower level of in- terest rates to an annual operating amount that is exceeding $150 billion a year and therefore now running higher actually than the deficits themselves because many of us think the deficit probably will come in above $150 billion. So I'd like you to speak about that kind of trend if you will as well. Then finally, our debtor nation problem. And I brought a chart here that I will hope to raise with you in the question period, but as we continue to add international debt, principally driven by the very substantial trade deficit still running in the range of $160 to $170 billion a year, we are adding new international debt at the rate of about $1 billion every 2Vz days or about every 60 hours, and that figure is compounding. When I show it to you on a chart, it's a real plunge into this debtor nation circumstance that we're on. The Council of Economic Advisers the other day said: Don't worry about this mounting international debt. Even if we're headed to a trillion dollar international debt, we can take it in stride and not to be too con- cerned about it. There's even a suggestion that maybe somehow it was good for us, but at a minimum it wasn't something that we ought to lay awake nights worrying about. I find myself more and more concerned about that international debt accumulation and in turn its implications for upward pressure on interest rates and creating an ever more difficult situation for the Fed down the line. There are other implications to that as well. If you would, in the course of your comments or responses, I would hope that you would find a way to touch on those three issues. Thank you, Mr. Chairman. The CHAIRMAN. Senator Garn. Senator GARN. Thank you, Mr. Chairman. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chairman Greenspan, we are happy to welcome you here today and I am absolutely certain that no one, and certainly my col- leagues, did not come here to listen to me speak and therefore I will simply ask unanimous consent that my statement be placed in the record. [The complete prepared statement of Senator Garn follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis AS WE BEGIN THESE HEARINGS ON MONETARY POLICY, WE CANNOT DENY THE FACT THAT THE UNITED STAIRS FACES SOME FORMIDABLE ECONOMIC PROBLEMS. HIGH ON ANYONE'S LIST WOULD RE THE BUDGET DEFICIT, THE TRADE DEFICIT AND CONTINUED REGIONAL POCKETS OF RECESSIONARY CONDITIONS. AT THE SAME TIME, WE SHOULD NOT OVERLOOK THE IMPRESSIVE ECONOMIC ACCOMPLISHMENTS OF RECENT YEARS. THE U.S. ECONOMY IS NOW WELL INTO ITS SIXTH YEAR OF EXPANSION. LAST YEAR ALMOST 3 MILLION NEW JOBS WERE CREATED; AND THE UNEMPLOYMENT RATE HAS NOW FALLEN TO ABOUT 5 3/4 PERCENT. LAST YEAR CONSUMER PRICES ROSE SOMEWHAT OVER 4 PERCENT, A RATE OF INCREASE THAT IS STILL TOO HIGH BUT FAR BETTER THAN THE DOUBLE-DIGIT RATES OF INCREASE AT THE BEGINNING OF THIS DECADE. 1 SEE LITTLE TO CRITICIZE IN RECENT FEDERAL RESERVE POLICY. THE FED HAS PLAYED A MAJOR ROLE IN THE ECONOMIC ACCOMPLISHMENTS OF THIS DECADE. THE FED RESPONDED TO THE FINANCIAL- MARKET TURMOIL OF LAST FALL IN A WAY THAT LIMITED DAMAGE TO THE ECONOMY AS A WHOLE. I BELIEVE THAT THE FED'S OUTLOOK AND POLICY PRESCRIPTIONS FOR !98H ARE REASONABLE. OUR TASK IN CONGRESS SHOULD HE TO SEEK WAYS OF HELPING THE FED TO CONFRONT OUR REMAINING ECONOMIC PROBLEMS. THK, PLACE TO REGIN [S CLEARLY TO WORK ON REDUCING OUR FEDERAL DEFICIT. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 WE MAY ALSO ASSIST THE FED BY ENCOURAGING OUR TRADING PARTNERS IN THE INDUSTRIALIZED WORLD TO 1)0 THEIR PART I ti HELPING SUSTAIN THE ECONOMIC EXPANSION. THIS, OF COURSE, IS CRITIGA1, TO CONTINUING PROGRESS ON THE DEBT PROBLEMS OF MANY I.OC'S. FINALLY, I BELIEVE THAT CONGRESS H.4S A MAJOR RESPONSIBILITY FOR ASSURING THE LONG-TERM STRENGTH AND COMPETITIVENESS OF OUR NATION'S FINANCIAL ISSTITL'TIONS. IF WE DO NOT TAKE STEPS TO UPDATE OUR LAWS ON. FINANCIAL STRUCTURE, WE WILL SADDLE OUR ECONOMY WITH SEVERLY WEAKENED FINANCIAL INSTITUTIONS, AND THIS IN TURN WILL WEAKEN THE ECONOMY AS A WHOLE. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 The CHAIRMAN. Senator Bond. OPENING STATEMENT OF SENATOR BOND Senator BOND. Thank you, Mr. Chairman. That's a very difficult act to follow, but I wanted to make a very brief comment saying that as you know we all joked about the difficult job that Mr. Greenspan was undertaking when he was before this committee before, and few of us realized how difficult it would be. During the course of the hearings that we've had on the stock market crash and the activities of October 19 and 20, and afterward, there's been a lot of finger pointing among the various agencies, groups and or- ganizations before us. I think the only institution which has re- ceived praise from all quarters has been the Federal Reserve. The Fed provided liquidity, and stability for the system, and I think ev- eryone is in your debt for a job very well done. In addition to your responsibilities for the financial system, you also have the heavy responsibility of setting monetary policy during a period of turmoil and far-reaching change in our economy. The trade and budget deficits have already been mentioned and have vastly complicated the conduct of our monetary policy, and you're forced to maintain the balance of possibly higher inflation due to the weakening of the dollar against the possible damage that higher interest rates could do to the economy. Certainly we in Congress, we in the elective branch of this Gov- ernment, have limited your ability to maneuver and balance these complex forces. I'm cheered by the cautious optimism of your state- ment and I hope that we here in Congress can benefit from your guidance as to what we can do during this session to assure that that progress continues. The CHAIRMAN. Thank you, Senator Bond. Before we begin I have statements for the record from Senators Dixon, Sasser, and D'Amato. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 MR. CHAIRMAN, I AM PLEASFD TO BE HERE THIS MORNING AS THE OVERSIGHT HEARINGS AS MANDATED BY THF, HUMPHREY-HAWKINS ACT. WE AT THE OUTSF:T, r WANT TO SAY THAT i SHARK CHAIRMAN GREENSPAN'S VIEW THAT THE SETTING FOR MONETARY POLICY THIS YEAR "IS MORE THAN NORMALLY COMPLEX". IT SEEMS TO ME THAT THE OUTLOOK FOR THE ECONOMY IS MORE THAN A LITTLE UNCERTAIN, AND I AM SUKE THAT UNCERTAINTY MAKES THE FED'S JOB MUCH MORE DIFFICULT. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 Page 2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 STATEMENT OF SENATOR JIM SASSER MR. CHAIRMAN, UlllAY WE P^WF IMF F1KS1 ^ I ANNUAL RFPHRT n MONETARY POLICY HY FEDERAL RESERVE CHAIRMAN GRF.FJiSPAM. DOESN'T SEEM POSSIBLE THAT THIS IS m. fiR^HSPMi'S FIRST REPORT TO US ON THIS IMPORTANT ISSUE. HE HAS APPEARED BEFORE THE COMMITTEE ALREADY ON A NUMBER OF CRITICAL ISSUES. AND DR- GREENSPAN HAS INDEED HAH (\ GREAT HEAL W EXPERIEHC^ IH THIS AREA ALREADY. HIS ACTIONS !H ENSURING THAT T^ERC WAS ADEQUATE LIQUIDITY IH THE SYSTEM FOLLOWIf'G THE OCTOBER STOCK MARKET CRASH ARE UNIVERSALLY CREDITED WITH AVERTING MICH MORE SERIOUS ECONOMIC CONSEQUENCES- TODAY WE WILL HEAR AGAIN THAT THE LPJK BETWEEN GROWTH OF THE MONEY MEASURE Ml AND THE ECONOMY IS VERY UNCERTAIN. WE WILL HEAR Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 iF.h'iAiULY, fuii; ECnuo-'Y is :j,Fcnn;MG E'"Jir'nus,L^ COMPLEX AND INCREASINGLY INTEGRATED WITH OTHERS WORLDWIDE- IN 1HESE VOLATILE TIMES IT HAKES MORE Sf-JJSF IRAN EVER TO CONSIDER THF NUMEROUS OTHER FACTORS THAT AFEECT THE ECONOMY, RATHER THAU ADHERING RIGIDLY TO GROWTH IN THE HONEY AGGREGATE- I AM INTERESTED IN HEARING DR. GREENSPAN'S VIEWS ON OUR ECONOMIC PROSPECTS, AND WHATEVER SUGGESTIONS HE MIGHT HAVE FOR US AS TO .HOW WE SHOULD ADDRESS THE BUDGET AM1 TRADE ISSUES THAT ONTINIIE TO PLAGUE US. THAMK YOU. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 I WOULD LIKE TO WELCOME CHAIRMAN GREENSPAN TO THE COMMITTEE FOR HIS FIRST EFFORT TO EXPLAIN THE FEU'S MONETARY POLICY REPORT. YESTERDAY, CHAIRMAN GREENSPAN DELIVERED THIS REPORT TO THE HOUSE BANKING COMMITTEE AND IT MUST HAVE BEEN FAIRLY WELL RECEIVED BECAUSE THE FINANCIAL MARKETS OF THE WORLD, WHICH HAVE BEEN RELATIVELY FRAGILE LATELY, REMAINED STABLE. TO DATE, CHAIRMAN GREENSPAN AND HIS COLLEAGUES AT THE FED DESERVE CONSIDERABLE CREDIT FOR THEIR PERFORMANCE. THE FED RESPONDED SWIFTLY AND CORRECTLY TO AVERT THE LIQUIDITY CRISIS PRECIPITATED BY THE EVENTS OF OCTOBER 19TH AND 20TH. IN HIS STATEMENT TODAY, CHAIRMAN GREENSPAN UNDERSCORES THE NEED TO IMPLEMENT POLICIES WHICH WILL KEEP THE ECONOMIC EXPANSION ROLLING ALONG TO AVOID A RECESSION. IN FACT, THIS IS THE MOST FORTHRIGHT STATEMENT BY ANY FED CHAIRMAN REGARDING THE FED'S INTENTIONS IN RELATION TO THE CONTINUED EXPANSION OF THE MONEY SUPPLY. TOO OFTEN IN THE PAST THE FED HAS BEEN LESS THAN EXPLICIT WITH REGARDS TO ITS INTENTION IN THIS AREA. FURTHER, I HOPE THAT WE CAN GET INTEREST RATES DOWN A BIT LOWER BECAUSE LOWER INTEREST RATES WILL PROVE TO BE A REAL STIMULUS TO THIS ECONOMY. CHAIRMAN GREENSPAN ALSO CITES THE PRECARIOUS BALANCE BETWEEN MONETARY GROWTH AND INFLATION. HOWEVER, THE EXPERIENCE OF THE EARLY 80'S HAS TAUGHT US THAT A LITTLE INFLATION ACCOMPANYING MONETARY GROWTH AND ECONOMIC EXPANSION IS FAR BETTER FOR THE ECONOMY AND THE AMERICAN PEOPLE THAN A RECESSION. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 FINALLY, AS WE OBSERVED DURING OUR MARKET CRASH HEARINGS, THE U.S. AND FOREIGN ECONOMIES ARE INEXTRICABLY INTERTWINED. IN HIS STATEMENT, CHAIRMAN GREENSPAN DISCUSSES THE PROSPECTS FOR DOMESTIC ECONOMIC GROWTH. HOWEVER, THE STATEMENT IS RELATIVELY SILENT ON THE PROSPECTS FOR FOREIGN ECONOMIC GROWTH. I WOULD HOPE HE COULD OFFER SOME INSIGHT ON THIS TOPIC SINCE THE BALANCING OF THE TRADE DEFICIT IS LARGELY DEPENDENT UPON THE ABILITY OF FOREIGNERS TO PURCHASE U.S. GOODS. I LOOK FORWARD TO fOUS STATEMENT. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 The CHAIRMAN. Mr. Chairman, can you enlighten the committee on when the vacancy on the Federal Reserve Board is likely to be filled, when the President will nominate a Member to take that po- sition? Mr. GREENSPAN. The only thing I can see, Mr. Chairman, is that it is under active consideration by the White House and hopefully a conclusion will be reached relatively shortly. I know that noth- ing, to my knowledge, is immediately pending, but I do know there is active consideration going on. The CHAIRMAN. Fine. I'm sorry to interrupt your opportunity to read your statement. It's an excellent statement. Go right ahead. STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Mr. GREENSPAN. Thank you very much, Mr. Chairman. I will ex- cerpt from my written remarks and request that the full text be incorporated in the record. The CHAIRMAN. It will be printed in full in the record. [The complete prepared statement of Alan Greenspan follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 1988 MONETARY POLICY OBJECTIVES Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System February 23, 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 Testimony of Alan Greenspan Chairman, Federal Reserve Board Mr. Chairman, members of the Toward this end, the hederal Open Market Committee (KOMC) two weeks ago sei somewhat Committee, I appreciate this oppor- lower target ranges |<,i 1988, (.insistent with a mod- tunity to appear before you to dis- erate pace of monetary expansion this year The ranges for M2 and M!i art- 4 to 8 percent, lor debt, cuss the conduct of monetary policy we have sei a monitoring range of 7 to 11 per- cent. The annual ranges are wider than in die and the economic and financial sit- past, rcio.gnizinjf that rhe linkage helweeji nii>nt-\ uation. You have received the more and credit growth and economic pcrluiindiue lias become noticeably looser in ictcni veais formal report of the Board of Betore discussing our monet.in pnlnv plan.- ior 1988 in derail, I would likp to review w'uh vou Governors detailing the economic the developments ol ihc pas: year and financial situation and review- ing our policy actions in 1987, 1987 in Perspective The \oai 19S7 was a time ol economic transition and presenting our approach to and. like many periods of diangt, it had its dil'li- monetary policy this year. cull niiinienls. Nevertheless, cleai progress was made in achieving a healthier, more balanced eionomy. For the year as d whole, output and i-niploynn-nt e\panded stron^lv As measured bv ihe gross national produei, prodm lion mireased nearlv 1 penenl iioiii die fourth quarter of 1986 (o the luunh quditcr 19ti7. according to the Coin- ineice Department's prelirnmarv escimates. Alnmsi i million persons were added to pavrolh ovt-t this period And [he (ivilian unemplovmeni rate dropped to about 'i1', percent —the lowest level in Hns d,-< ade We achieved rhi< i-m«tli with a belter iclaium- ship between domesiu spcndmi: and domestn [iroduction (.rowih of private domeslk linal pur- chases has slowed progrcsstvelv Irom 7 ', peicent in 198:i as the econnriu i-iru-rgc(t from lecession to diioiit 1 perient lasi vear Meanwhile, real the capons ol guilds and service;, rose more than 1 i peuent o.ei die lour quar(ers of 1987. as our international crjmpetiiiveness was enhanced b> the surtoss of business and labui in nureasmg produitnitv and restramint; cost pressures In addition, ihe lower level ol the dollar on toieiim exdidiige markets, because inunh of it was noi passed (hrough into wage and other costs domes.il- calK, also helped our linns price more compon- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 lively in foreign markets and to compete with Although the aggregates from very early in the imports in the Untied Slates. The trade sector year tended to run low relative to the ranges, the improvement accounted for more than a quarter challenge as we perceived it through much of of the overall gain in GNP. 1987 was less to buoy money growth than to pre- One aspect of the improved trade situation was vent one-time price rises related to developments better balance of our economy internally, with in energy and foreign exchange markets from previously lagging sectors showing particular becoming rooted in a renewed inflation process. strength. The manufacturing sector revived in Concerns about potential inflationary pressures 1987; industrial production in manufacturing were clearly manifested in financial markets as s'jtg'dd by 5'/i percent belvreen December 1986 we\l. During the spring and again in late sum- and December 1987, and capacity utilization rose mer, inflation worries pushed up commodities to its highest level m seven years. For example, prices and long-term interest rates, and heavy output of sleel rose especially strongly, which was downward pressures on the dollar developed in the main fader in bringing capacity utilization in light of growing pessimism about the prospects for this industry from about 65 percent ai the end of significant improvement in U.S. external balances; 19M6 to above 90 percent at the end of 1987. And concerns about the financing of our external defi- olher areas of our economy that had been notably cit in turn apparently added to pressures on depressed earlier in the 1980s, such as farming, interest rates during these episodes. In view of the mining, and oil extraction, showed some signs of inflationary potential, the Federal Reserve improvement. increased somewhat restraint on reserves in both The robust growth of the economy—in combi- episodes, and in September raised the discount nation with the budgetary actions of the Congress rate from 51^ to 6 percent. and the President, and a one-time boosi from tax The balance of risks shifted following the stock reform—brought about a major reduction in the market collapse of October 19. The Federal federal budget deficit last year To be sure, the Reserve immediately modified its approach to flow of federal red ink still was heavy, but last monetary policy in light of the turbulent financial December's agreement was at least a first step in market conditions. During the crisis, the System needed actions for the future. temporarily altered its focus somewhat from On the negative side, inflation increased in reserve positions to more direct measures of 1987. This development was not altogether sur- money market pressures, and took a number of prising, given the bounce-back in energy prices steps to ensure adequate liquidity in the financial early \n the ytai and she effects on import prices system. Moreover, we encouraged some decline in of the decline in the dollar Although wage gains short-term interest rates, as a precautionary step have remained subdued, we clearly need sustained in light of the possibility that the conlraction in effort to bring about a more stable price level. financial wealth and the deterioration in consumer As you may recall, the Federal Reserve set and business confidence might lead to a signifi- ranges for monetary growth in 1987 that were cant drop-off in spending. 1/2 percentage point lower than in 19S6. We also noted that we would be conducting monetary policy with an eye toward a variety of economic indicators, including the strength of the economy, pressures on prices, and developments in interna- tional markets, as well as money growth relative to the ranges. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 These actions helped to restore a degree nl rnn- Economic Outlook and fidence in financial markets As this occurred, the Monetary Policy for 1988 Federal Reserve returned some way towald our (n (ori]luirttill(, ;,s m(.ini.tt, •arlier locus on reserve positions in the da\-to-iiav . j-Q\rf " „... ,( L „ implementation of pohcv. But 1 think ,t » la,r to ^^ „[,,;,„, CV \-^"cf sav that markets st, 1 are exhibiting a certain edg,- (o ^ ^ u^utMam ^ ness, and we can t be sure vet that norm.il mar- , ()|| ,,.,,.,,,.,. ,olv4Ui rli ket functioning has been fully restored tullowms the events of Oanber. In addition, the effects t>! the stock market events on the economy may not be tuIVy evident. Indeed, indications ol some softening in the economy as the year began, foreign exchans1" markets, led us to take a further l>rj[Lirusni tint unl small casing ^eP B f*1*1 wwks a^«. , ,s, ' In the context of a monetary pohr.\ that, tor [( . much of the ve.av needed to nmnwr infcrtiwwrv ^"^10!, .U.hough a, cur..-, , and in light of the very rapid money uu]rmilm an(| wilh ri,,^ pri, growth in 1986 and marked vanatwns in velocitv ,mm r[,t[,n, ()((llji (Il.l]lne(i in rrrent years modes, expansion o( the mone.ary (j( rf n.v nl, ((1 , amprgwes in 198, wa, viewed as atcepiable and ^ L))nuiju|. ,0 b,, Mf^ - appropnate. A, market interest rate, rose, interest of pOMC mem^. am] i>[h_ ra,PS on deposits b^ame less wmpetiliw lh,s p,,-,,,,,.,,,,' ,,,m;15,5 ls k,T ^ encouraged a shifting away from niom-tarv ,,ss<-t,, ar(((|rld ,, ,„ ._,,,, m from and growth of all «,f the monetary ^gre^.es ^ ,w_ ^ ^ li)ur(h ^ slowed sharply In addit.on. some special la.tors [hrfn ^ ]W7< ])ul hk].]v ( may also have damped money gro^h las, ve,,r. ^. ^ ^ j such as the eff,-,-,, (,1 the new tax la«, .hanjp-s m mfM f^ mdv „„, rf bank fundmg sour,es, and evolvm^ busmen prac- mj Muld .^ tices with respen to cash management anri rnm- lrl|j(](ed a(.roM [n(luslrjps :ind pensatmg balance,. M2 and MJ grew 4 and .->'-, ^ M,](;h Q, ,h(, jm ^ percent over the fo,,r quarters oi last vear. respe,- ^^^^ ^ ^mc fr(j tivdy, Icavmg them below and ju» a, the lower nf |K>[ e u( en))s of .h«r annual rangft. Ml .nrrrwcd b p^^,. !j)(. ;)nl[ci, „, adjllsl,n,.n, , Percen' , , , . ante mternallv and externalh This Debt R«*ih tJowd w ihc m«lp.»n, ot ,„ mvu|u, sj(?vt ^^ ,n dnmfstj{. d(,m rnon.tormg range The progress m reducmg thf abu. eneolnpilMinR dampwl Ra]Ils in federal Udget deticil h«rlp«l redvK* Imrro^mR and ( mud, rerfurpd n| jn,,,n[l)rv and debt issuance bv the private sector dropped |njm [(]t ^ n(.a|, year e||<] off as well. Deb. growth ,.,uld ^wcdy be charac- Rftenl ms (j| n' tld,,,ln tenzed as slow; a, <)V, per< en,, ,,jontmu.d th, mem, dn no, si.(.m [() lndicau%riv lm pattern of .n.rease, relative ,<> CNP ^ ^^ A(. r,slr[lme(1 bfhav ,„ 0, mid-1980s Although <apa. if, ,,,j|j/ati Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 in Our manufacturing sector, bottlenecks are not This change was advisable partly because the as vet a problem, and are not expected to become linkage of money to spending and income appears one if growth follows the subdued path of the to have become looser in the 1980s. As you know. Committee's outlook for real GNP. Even so, we most historical experience has suggested a fairly cannot be complacent about the potential for close relationship between spending and the quan- higher inflation; by the time an acceleration of titv of money and. over a longer run. between costs and price pressures were to become evident. mone> and prices. These relationships established the inflation process would already be- well die basis for adopting specific targets for growth entrenched of money in order to attain the ultimate goals of With its objectives in mind, as I noted earlier, macrocconomic policy the FOMC established ranges for M2 and M3 of Bu! these relationships appear to have changed 4 to 8 percent over the four quarters of 1988. considerably in the 1980s, partly reflecting the with the debt of domestic nonfmanciaJ sectors effects of deregulation, innovation, and changing expected to increase between 7 and 11 percent technology. The spectrum of stores of value is The growth ranges for money represent a extremely broad, extending from real capital, like decrease from those for 1987—bv one percentage plant and equipment and houses on the one hand, point in terms of the midpoints. This reduction is through stocks, bonds, and time deposits. :o per- viewed as another step in the longer-term process fectly liquid currency and checking accounts on of reducing targeted money growth to rates more the other hand. Both households and businesses in line with reasonable price stability. Moreover, are continually adjusting their balance sheets and the lower end of the ranges allows for the possibil- the allocation of their income flows between ity of little pickup in money growth, especially accumulation of financial assets of different sons M2, from 1987 under certain circumstances. If. and acquisitions of goods and services, for example, inflation expectations were to Transactions balances are on the edge of the strengthen, market interest rates would tend to exchange of financial claims for goods and serv- rise. and relatively .slow money growth could ices. Regulation and established practices previ- again he an appropriate policy stance. ously acted to enforce a marked separation The FOMC does not anticipate that circum- between transactions money balances and all other stances will call for such slow money growth. In balances, and supported a fairly close relationship fact, it expects some acceleration of monetary between spending and the quantity of transactions expansion in 1938, perhaps to around the middle money — as measured bv Ml—which allowed it to of the ranges. But changing circumstances could serve as a monetary policy guide Businesses and easily require a considerably different outcome. In households maintained transactions balances in recognition of the unusual degree ol uncertainty demand deposits in fairly close relation to their in the economic outlook and the large movement! spending requirements, and relied on other forms of money relative to income in recent years, we o! deposits to serve aj longer-run stores of value. have widened the specifier! ranges for monetary growth from the more traditional three percentage points to four points. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 But now deregulation and unproved mtorm,i \O\Y anounl- rnav be the most prominent tion and communications (ethnologies have e\Hinple ol this. Because ihesc .mounts are dose blurred distinctions between transactions balaiues snbsr.ir.utes lot oilier liquid instruments as a store and other assets. Businesses can move unneeded ti.r savmu.. holders ol NOW .mounts are highlv transactions bahimcs al each dav's t 'use imo svii-juvc to charges m interest rates on these I'.uvorlollars, repurchase agreenu nts. cotniiiiKi.il altci nativ e inv estrncni- 1 hcv place a larcet vol- paper, or CDs. at luile <ost. with the dion c utne ol kinds into NOW .mounts when rates mi among these instruments often depending on \leld other deposits at hanks and thrills aie iclalivelv iliiferrntials of onK a few basis points In aclcll- l»« and deposit smaller amoimr-, .,t aitualK (haw tion. firms now can maintain balances, in hvbrid don n iheckmg account balances when investment instruments like MMDAs and mone\ luiuls anil i<}>|>ortuniites are more atlia<tiv( elsewhere retrieve them nearly as easily as the\ can tiom a \\idespread (ompensating balance arr.mge regular checking account Remaining business merits lor businesses impK a stiong interc-,1 demand deposits serve importantK as balances responsiveness ol demand deposits, as well, that compensate banks lor sciviecs. and these ( hanges in maikei mleiesi rate- alter (he eain- arrangemems. too. aie evolving over time ror ings value ot these deposits to banks. with jesulr- househoLdi. NO\V account—uueresi-eainin^. ins JiS|usuueiu-. ui (In UiUi-urs ri'()uiml ui <..\m- fullv checkable deposits—are imponam savings as pensate tin bank foi a given p.id-age ot -enni's. well as l.ansauions vehides. and have contributed M2 is a broader (ollei.ion ,,l the pubh.'s liquid grealK ic the decreasing usefulness of Ml as ,1 assets, and as a consequence inlcinali/cs some ol monetary target the shifts that have plagued Ml But \U is still This process of innovation and deregulation has soiuewhai limited m its jovetage of tinam lal alfct_led tin' behavior of the monetatv aggicgatcs wealth held in liquid forms, and shift- between m a number of ways, onlv some ol whith we liillv Mi and othci financial assi'ts ma\ nor bv [hem- understand '1 o some extent it seem- sirnplv to selves irnplv (hanges in spending tcndcm ies Sudi have introduced more "noise" m the rnonev shilts have been responsive ro movements in the spending relationship In addition, though, n rail's on alrernaiive inv esrments- relative to reuirn- appe.-irs that one important consequent e has been on M2 balaiues This sensitivnv. rhough nm- 10 increase the sensitivity of the demand tor sidcrablv less than loi Ml. also seems to have monetary assets to changes m market interest increased siiue [lie laic IfTDs. perhaps as rates—at least over the shoil run While dereinjla- improved information and comrnunicatkms, teih- tion has allowed institutions to varv the rates on nnlogies have faulitaied transfer ol funds between deposits, in practice retuins on rnanv categories ot M2 asset- and those outside1 this aggregate Over deposits are adjusted sluggishlv in response ro the longer inn. OIK e rates on instruments in \1'2 changes in maiket rates, giving rise to relativelv ad|nsi to (hanges in market rates, this aggregate large swings in iniemives to hold these tends 10 grow in line with income, as u has on instruments average over the postwar period Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Inline- that hunks ,md thntts use to supplement .111 aggtvg.itc (hat i, sensitive to movement', in their u-tail deposits in order to fund credit exp.lii- inteiest i.iies Sui.li L<imvth i ould ur.ge over n sum I'nlike Ml ,ind \12. it is highlv responsive Link wide .pc. uuiii.' and Mill be <on.,i.teni wi>h e-.|jand then IjaLiiue sheets ,md whnt p.'inuulai < ir, unnl.m, es. tin: Commltlee dentied th.jt ,. .outxr, <,l funds lo ,eK on Small (liaises in modesi widening «.i 'he range, lui \1'j and M't nueiesi rate relationships 1,1,1 have ven auljM.ni- would better riKompasa dppmpn.ite monetaiv ddl nnpan.s on :he funding deiiaiinia fil iliese growth, while still pniMihinr ,i guide to polnv nisi i! in ions and ( onsequtiuk mi M.i. without I hH an.iksis aka underlies 0111 det i.ion ,m,tii: ttiain; uupln .uioiis tor iiiioine and priies not to est.ihlish a t,nget i.mtfe lot \11. UV h.i\ e Mi. ihen. is deteniiined laij;elv In th<- den- monitored llie hchii\ it.i ..1 Ml ,,iid u.ndutted hlhtli-i and til «lul tNpe the\ wish to Mjpplv to Ml\ cir-in. l)ell,un.. lelnains unexi^lained. we the inaiki-is 1 he gn.innged li.ibihties in Mil ate now behe\e th.it niosi ol its IIIHIMKL! niovenie;,t- \rr\ iliiM1 -iibstnines tor other mi>ne\ in.nkel ieLni\e to inionir m icient \e,irs i-i iittnljin.ibli- iiiknunieuts ui the jRiljlu's piintiilm \t 1 ,«id M'i. ID .1 tn-iu,!i!*-iii.-(i ASH! imv, ijiiiu- 1,11^' mlvvv^ bs umtrasi. ( ,in br' thought ol ,ts depending more , elaL-tluH dire, Ik on ;he publn \ desin- to hold the asset-. In Mew ol ihi- tiHi.n ior. our eahuhition-. sug- nuklded in llie-e ayyienales. iris-en the tetuitls on iiest th.it s,inielinni4 ''I11' •' -iev en-pen entaL;i--poiiil various .ihern.itive ni\t-stments ,is wi-11 as levels nt lange would be needed tor Ml in ordei 10 wealth and innnne li.ink. and ilintts, ol uiiirse eiuompasi the saint- range ot nni eit^inne- .is is di> s.»rs die oltemis; r;nr"i on (heir M^-t^pe ( npturi'd b> our loin-pen cntaye-pomt i,ill!!e l"i deposits in order to ,iile! i ihe quanutv ot these M_> Sudl lt wide i.inge would bo ol little use in 10 lac !)],n-ke< i.ite.. .IIHI while die M2-li«.ldmy 1111; the M.in.e ot monel.-irv pohrv -o the publu pnblu i- sensitive to aitem.itive Melds, it is not One should not < on. hide trorn this that I he ne.nK .is sen-ltlve ,i- ihe mones maiket Ilivestol- K-dei,il Reservr' is !;i\ni!.' up on rnrinel.u \ Miget Inildi,m managed halniitie. In these UfLuin- ing. We ,ire mil. The iiiikagrs between nu'llev (in stan.r. the .onnenion between Ml and M'2 ami the one hand and pn.es and -pending on ihe llie e. ono,in ie-,1- inipoi MntK or, the eltett ol o! In i- ni,i\ h;i\e loosenerl. but ih.il i- mam> .1 mieiest i.iics on ill. demand tor these aggn^atcs problem ovei the ,lnni ILIU 'ihe diain -nil exists 1 in e\.iinple. ,i moii' e\pati-ive muiietaiv polii \, \\e are eontinuim; lo -tuds ihese i i-latiotislups i nun; iaii- boosis demand tur ihese agjjregaies ,is (ould well become ughier .igani In ,iny eien> eiononiK ,uimt\ quite po riu.ian e thai, ovei ;he loiiy ism. uione\. (,i\en uiKeit,unties about how linam lal ni.irkpt in< onie. and prnes tend to move loac'.her plcs,ii,fs in !d,.i ma-, need to v.u v in response tn The FOMl". e\pe. ts to athiL-ve us aiji!"'^'1"' di.inginn umdition- in ihe euinomv n is difficult i,luges lor 1'IHH \\e will, how eve,, need to (on- tinue lo mlerpret the imolnmt; mloi m.i'ioli on ihese measuies in ht;hi ol oiher d.ita on the per- tonnrinic ot the cionoinv and pn,es. and othei indi.arois nt the nnpait of moneMr\ poll,-. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 The Challenges Ahead international competitive position, leading inevita- We face formidable challenges over 1988 and bly to more difficult and wrenching adjustments beyond in meeting national economic goals of sus- down the road. Progress toward price stability is taining growth and progress toward price stabil- the foundation on which the longest peacetime ity. Some of these relate to the short-run outlook expansion in our nation's history has been built, for the economy, as the possible effects of the and continued efforts along this line will be the slock market decline and (he build-up of inven- framework for future economic advances. tories late last year work through in 1988. Our gains in international competitiveness have But our more fundamental task remains reflected a number of factors. But we should not managing the process of restoring internal and underestimate the effects of the efforts of business external balance that is now underway This is a and labor over recent years to enhance produc- challenge that cannot be negotiated by the Federal tivity and restrain costs. And government has Reserve alone. It will require complementary and made a contribution through deregulation and consistent actions by our colleagues in the Con- through the absence of major initiatives that gress and the administration, as weD as by our would involve higher business costs major trading partners. Our adjustment process by definition has a For the United States, the most direct and counterpart for our trading partners. They must beneficial approach would be to address the prob- promote expansion in their demands and reduce lem at its major source—the f(_.Xral budget dec- trade barriers to assure active and receptive mar- eit. Reducing the deficit further would give us the kets for exports from the United States and opportunity to add to domestic saving and reduce elsewhere. dependence on foreign capita], while still The build-up of imbalances occurred over a encouraging much-needed investment spending. period of years, and has involved major adjust- Because the United States is now operating at ments to the structure of economies here and relatively high rates of resource utilization, abroad. These will not be reversed easily—but domestic demand must be restrained if our inter- they must be addressed We must resist the lure national sector is to expand without more infla- of "short-cuts", such as protectionist measures tion. In the absence of fiscal restraint, greater which would only entrench inefficiencies and pressures would be felt in financial markets, with reduce living standards at home as well as around negative consequences for investment and other the world. We can make this difficult transition, private spending. and monetary policy has a key role to play. But if While recognizing the need to supply the we are to have a chance of doing so without dislo- liquidity required to keep our economy expand- cations and detours in our national economic ing, monetary policy canno! lose sight of the need advance, we will have to work together to utilize to keep inflation pressures under control. We can- all the tools at our command not permit the price level adjustments associated with restoring external balance to feed through into a renewed inflation process. Escalating prices and costs would reverse the hard-won gam? in our Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 1988 MONETARY POLICY OBJECTIVES Summary Report to the Congress on Monetary Policv pursuant to the Full Employment and Balanced Growth Act of 1978. February 23,1988. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 Contents Section Page Monetary Policy and the Economic Outlook for 1988 2 Monetary Policy Plans for 1988 Economic Projections The Performance of the Economy during the Past Year The External Sector The Household Sector The Business Sector The Government Sector Labor Markets Price Developments Monetary Policy and Financial Markets in 1987 Behavior of Money and Credit Iinpl em en tat JOE of Monetary Policy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 Monetary Policy and the Economic Outlook for 1988 i'-, pri-ti'iH iAei (he k.ui qudi-R'is, ol ltlS7 t>ul- past several weeks. stripped most expedatioris. and [lie unrmpkn mi-til Bui while ihe Federal Re,cr\e (us had In he ic.is ild.iilr Unh Midi vxioi, a. ai;.Hiilune. nun- has noi lost sis;lit oi the potential influent e of poll. \ mi> ,]|><l nianulaummi; beiiel'iuni; uni-iderabK tiiini .ttin.ns on lonyer-term lirrul. in tin eamorm I K. expansion nl the etoiionii was benn balam ed than jii.tmem in (he l>nl,in.e <il t-M.nomu .u-isirv. atiet ,1 in I'Wi-Hfj Waije irxreases .enianird moderate and period of M-veral war. in whuh t;rt>wih ,.1 dome.d! Hnwexer. a rebound in ml prucx (ouplrd with the tio.i Over ili.it -.pan. (lie -r.icie b;ilanu' ttn.M-M in«i i-tlt-rd, (.1 (he dnll.Li-'s del line on the |>ri(es <>l tteep dflidl. and (he n,iti<i|) lie-in (t. .iin.iss a liuw nnponcd i;.>o(K «eiu nilk . pushed the 1,1(1 of pim.' ncl (.'xteinal tteljt. !( is tinpunanl TO alli>« ruutn tut intlation h.it k uji to (he 1 jx-iifin r.tin,re liv muM a n^nifnant iniprint.-iiit.-iil in our liatlu baiatRc. Ai linn • last \ e,n . '11,11 niL' tutiiiiHititiv pnst"- .ttul io« ntu-rnplm tucin. t-\ idem n\ main •ht-ntttciiis sluiip deihne. in the dollai. and bund pni i-s -14- nl nidusti> MJSK1-1--1 [1"' rl"'(i '"' 'iddt-d (aie in naletl die possibility ut ytvatei intlalnnlaii daniJeis niaintannnt; progress toward pine MabiliK \\llll lllc er(.m>m\ imn'mg to-vai<i Inglit-r' lescU t,l '['hcsf itmsidciMdoris undcriru tlif tlens.on. til the le-oime ulih/.uion. '.he K-deial RCSCIM- had to be Kederal Open Market Committee when it met tspcualK ak-n (o ihe.e and othei indn .IIIOIIN ol earlier this month to ( h.irt its moiu tarv poll. \ pifsiuK-s lhal miijlK h.nc letl t<. ,1 sisjmilt ant dep.n- str,itfi,-v lor 14HH. SIK h t on-iderati(m< also must be (uif titHii the lon^fr-nm trend toward pni e st.ilnl kept in (he ttireirtnit ;is rift mtuinukprs rkt-whrn- in it\ In ihese (in nmst.ini es. mnnetarv pnlnv was the guv rrnmmi •'"•( polK\. In patin'iilai. i riniinmin; through List (>t tobei 1 his i\as rellrrted in a moilet- resoim rs to Una in e produun iu -enham ink' pi n an ate n*f in nionev inaikt i nut-it-M ran--. whi( h in im esinirin «lnlt- bi inning abom an impio'. ed ]>,it- lurn damped growth ol ill.1 monelai \ ay«rei;,Ltes din nl nun national tr,ms,ii turns \loreo\(!. ailih \\hllf- Mi ^H-M ,11 a ji.ue equal 10 the Imic! bound (n.nal i-llori- a! binmmi; uroitei (..lnr.'im Hi poh- nl the i ,11141' "'I 1"' lt« \i,u in the [Y<l( ral Op, n .it's, dom, •malU ami nv, rnationalX will piunmtt Markei Coiiiniide, iFOMfi. M2 tt-tl -ho,t ol il. i.na«'i stabiliu in tinaiu >al maiket- and t;rc.ilfi i.tiiHf Mtei ihe plunge in (he s.,,tk maiket in uiU'iiiril and eviein.il baLnn e 10 -lie euiimrru (lu.ibei itic S\slein trunsed us efforts ]>i 1111,11 il\ on :nsmim; ,it ,(|natf 11,11 it it\ in t le , ( onoitu . am Monetary Policy Plans for 1988 .nue that 'line intcrrM ia!eb have rui-iM-tl a L'nod ' ' pa,, ot th.' use lh.il o.Min.'.l e.irlier m ]<»»: H'" 'l)»». 'I" f omnnue, .r" r.tn(r,'s ol 4 „, }i ,,.-,- How<vf'r. (ondmons in finan. lat rn.it kt-ts have vei 'eni I,,, i;nmth ..I \\2 .,n<! M'l K.vp,.ns,,,n ,,l to ie:nin ttilk it. "noiinai. and iln etlyme,. ,.l mone\ within these i;mvres \,ht,se midpoint, are on. pailKipanf Kintimi,'. it, In n lift t( d in M.latihn pcnentaye p. 11111 lowei than (hose ol the ram;es lot and i.mK .,/able u.L pie,:ua \I<,n-,,%tr, :ti,',,' have i.tsl ^'.tr would be ,-;}H-, [,,< '«. .nppci' ci "noisii. been sunn- sn;ns ol wra^n.-.. in ihr etornnm i;iowili ,1- .1 ]i,ne dial i. , OIISIM.-II' wn>, lommnctl |-.<i ntk In pard, nlai. die Ionnh (|ii,iner ot !')H7 external aduj.nneiK and progress .m-t lime io.-.ard wa. maiketl In a iharp rise in mventoiies m .1 lew }""• M.ilnln\ set -iu-s, and th.'re w, re rndu anon, ot a -la, kenim? m labo, demand eaiK iln. st'.ti X^amM -In. b.nkdiop Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 Ranges of Growth for Monetary and In light of the experience of recent years, which Debt Aggregates' have been marked by large swings in velocity, the ~~ • ' ' ~—" ranges for 1988 were widened somewhat. There is Percent change, fourth quancr TO fmmh quancr continuing "noise" in the relationship of money growth to economic activity, in addition, velocity of —_^_^-_— 198i8 ^^^_^_1_987 _^^^__ money is sensit.i ve (o changes i.n mark, et rates of' ,,„ , „ j,, ,,,, interest. This sensitivity means that even small _—_ , __ _—_ _ changes in rates, caused by variations in spending or M3 4 ID 8 5!^ tn a^ prices, can have sizable effects on the quantity of • "—' " ~ ~~ ' money the public wishes to hold Combined with an ' '" '' emit uncertain outlook for the economy and inflation, this implies that wider ranges are needed to encompass possible outcomes for monetary growth consistent Decisions regarding the ranges for money and with satisfactory economic performance in 1988. credit growth in 1988 were shaped in pan by the Thus, while the Commute? at this time expects that experience of 1987. Last February, the FOMC growth of M2 and M3 will be around the middle of established annual target ranges of 5 V? to 8 Yi per- their ranges, the outcome could differ if significant cent for both M2 and M3. both aggregates had changes in interest rates are required to counter increased mote than 9 percent in 1986, but slower unanticipated weakness in aggregate demand or an growth was expected to be continent with the Com- intensification of inflation. In carrying out policy, mittee s goal of sustaining business expansion while the Committee will continue to assess the behavior maintaining long-run progress toward price stability. of the aggregates in light of information about [he The deceleration proved sharper than anticipated. pace of business expansion and the source and and tn July, the Committee stated that growth for strength of price pressures, with attention to the per- the year around the lower ends of these ranges, or formance of the dollar on foreign exchange markets even below them, might be acceptable in certain cir- and other indicators of i.he impact of monetary cumstances. Velocity had increased in the first half policy. of the year partly under the influence of rising The FOMC will continue to monitor the growth interest rates, and the Committee agreed that if of debt in 1988. The expansion of the debt of inflation farces, *ere to exhibit renewed strength and domestic nonfinancial seciors is expected to slow interest rates were to increase further in the second somewhat from the 9 V% percent pace of 1987, to half of the year, continued slow money expansion around the middle portion of a 7 to 11 percent might be appropriate Rates did move upward again range Growth of debt however, appears likely to in the late summer, including an increase of 1/2 per- outpace that of income, as it has for the past several centage point in the discount rate to counter poten- years. Although the debt of governmental units may naJ inflation. M2 growth did in fact fall substantially not grow as rapidly as i: did last year, continued shon of the Committee's range, at 4 percent for the rapid expansion of private debt is probable, unless year, while M3 growth, at 5 !/; percent, was at the the current tide of corporate restructurings ebbs lower end of its range. The Committee decided not \o establish a range for MI in 1938 It is especially difficult to anticipate the relationship between growth in this aggregate and the performance of the economy. The character of this aggregate had been affected more than the broader monetary aggregates by deregulation, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 Economic Projections rantlv By and large, U.S. mamif.K turcrs have lei Ihe uncertainties attending the present etonorrnt sit- I he foreign <urrency prices of thru products derhnf uation are reflected in a (onsiderable range (it tore- with the depreciation of the dollar. aihu'MHC casts among Committee members and other Reserve cnhanrecl prntitahiliiv through greater \olume and Bank presidents Howevct. ihe central tendency aytjrc'.sivf eliortq to in< rcasc e(fitiC!ic\ iin<i (ontrnl langes encompass the vast inability of forecasts and (osis This enhanced rompt-tidveness is exueucd to point to giowdl in real G\P of 2 to 2 '•'; percent in uroxide a further boost to export growth ihi' year, while [he jn< reasei in die relative juices ot foreign This paie of adiMtv would be expcutcd to gener- i;oods apparentlv now in nain should <urb nnpoit dic spprei iaWc iftiiii* u> i'U)f>lmnii'j)i m rr ihe growth. As a result, some impiovement in tin- vear—about in line with labor force growth —and nation's turrent aieount baLinic i- atiti< ipau-d this die civilian unemplovment rate is pro|cned to (hange little on balamc between now and the end ot In contrast, domestic demand is e.\pecled to l(lfifl ['rues. a> measured b\ the implii 11 pine icmam relatively subdued in 19K8. as the e(onom\ deflator tor CM', are expcucd u, rise 'i', to "', % moves toward a bctier balance between domesm perrent. nor appreniaWi <!illffi-nt tr<tm chr [(,jcr Ijsj -pending and dorncsiu production. Consumei vear; (onsiirncr prices likclv will niLreasc a little demand prohablv will b<- damped to a degree bv the laster than tipe deflator Ihe <cntral tendenrv tore- los.s (it household wealth associated with the dei line Lasts emornpass the Adniimstialion s pro|ertions lor in stock prices last fall Some increase m personal real (A'P. but are a bit mon- opiimiilii on prospeds savins; iMiuld be benefit ial to the etonomv, a' it loi pruc intLinon would aid investment and help reduie oin depeii- Higher real net e\j>orls of gooiiN anit servjies are dem.e on lorcign (apital However, a seven- e.\pei ted to provide a ma|oi impetus m 1.' ^ eco- retrent hrncnt by consumers t ould have a sigmllt dtu iiomK adi.it. in 14HH As jetleded bv the japid dell.itionarv etleu. lortunatelv. the mclnation-. tiom growth ol ieal exports ol aood1- and services of more surveys ol household attitudes arc that the shaip dian li peri cm las' \e.ir. the international (oinju-u- diop m umlidciKc that ocrurred immediatelv afici ihe October shot k has been substantial reversed Houitfji; ,-KfJiiM 'thaultl pict >if> wmi'.- in I.IJIIIHH: Etunomic Project ions for 1988 FOMC Mtmbtrs tnd other FRB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 months as a result of the recent decline in mortgage depreciation is an unavoidable component of the rates. In addition, business spending on plant and process of correcting external imbalance, as an equipment should be buttressed by the desire to increase in the relative price of foreign goods build upon the progress made in regaining interna- encourages exports and discourages imports. How- tiona] competitiveness and by already high levels of ever, if we are to maintain and extend the progress rapacity utilization in a number of major industries. made in the 1980= toward price stability, it is crucial Although real GNP should rise moderately for the that business and labor continue to exercise restraint year as a whole, ihe pattern of growth may be m prite and wage behavior The forecasts of the uneven over time. An adjustment to the runup in FOMC members and other Reserve Bank presidents inventories that occurred in the fourth quarter of anticipate that such a pattern will persist through 1987 could produce relatively slow output growth this year. It is important, too, that the Congress during the first pan of the year. Such an adjustment remain mindful o( the effects of legislation on the appears in process in the auto sector, in light of cost structure of American industrv domestic automakers' current assembly schedules. The forecasts of the Federal Reserve policymakers There may also be similar patterns in a few other also assume further progress in reducing the federal sectors, but at this time there are no signs that deep budget deficit Continuing evidence of fiscal restraint cutbacks in production will be necessary is viewed as crucial in maintaining financial condi- Although no significant change is anticipated in tions that are conducive to balanced growth and to the overall pace of inflation this year, the primary an improved pattern of international transactions. It source of the rise in prices is I'1 ~'y to change. is critical that the package of deficit-reduction meas- Assuming relative stability in world oil prices, ures for 1938 and 1989 — agreed to in December—be domestic energy prices should increase only a bit fully implemented this year after their sharp rebound in 1987 How- ever, prices of non-oil imports likely will continue to rise substantially further in the wake of the decline in the foreign exchange value of the dollar in 1987, providing continuing impetus to domestic inflation. This impulse to prices associated with the dollar's Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 The Performance of the Economy during the Past Year 1'he c.ononu umipleied a fifth < onsc< nm e vear ol A mimbt i ot ,e< lor. lhal had been depressed in xpan-ion m 1'IH", with renl yioss national prodm t icieiu years be^an to show sij>ns o( impiovpineni m lereasins; aljout 'i % percent over the four quarters 1%7 The turnaround was most pronotimed in I the vear • "1 he overall cjrowtb in output noi onK mamddiL tunni;. wlieie prodiution ,,nd emplowiieni. as Beater than in I'tflfi, hul was bcttei linlanied evpe< i.ilk in i^pital ,>oods and industrial materials' ross mduMiio and returns tit the umnttv In industries, puked up shaiplv. boih in lesponse 10 Iduion, (he rise in activity supported a not yam o) Mmnger oideis In mi abroad and lo lns-lioi levels ot ore rhan three million |obs last vear, and the civil- < ajmal spendiniJ b\ domcsm prodmei- Hi-Mevci. n imempUniiieiii rale siood at ~i ii pi'rcem in Jann nnpTo\enient also was apparent in the domestn •\ of this \ear. nearU a penenlanc point below its eneri;\ xeaor. wlieie, in response to the paili.il vei a -.ear-a^o ' icunery in oil pntes. oil dnlhni! ietra(ed a .m.ill pan [)( us e.irlier pieupitons decline Hi^hei evports Real GNP ami M.ntnmrd ledei,,] -tip}>on m .^nniltiiie booMed lam-, miiime and helped filing about -ionic turinni; I he nnpiXAemcni me.ononiH (otidition. la-,1 \e,ir (oiild be tiated to the cliem ot int reased .onipeti- tu-ase in the value, ot oil imports and iisini; pines ol non-tnl imports more than offset ;m improvemeni m ie.il nel exports, and the no i.ll trade deliul "Kl- ened to almost SI61) billion m I'm? In addition. „ ot/R>r servile rranvtf mini, puihtvJ t)w i-iifn-in ,UHHI»I !'.«•: iQKi ,<m.t :»!<=, \"R>, -m: deiiut above JI60 bdlion. Altliouu'h cionnmu <utiviu lose ai a brisk pai e the pattern ot price movements ovei the past two veais re-tier ted de^ploprnem- in oil markets, where pines rehe-u dec! last vedi ..itei a sharp drop in ptices also uise sharpK t(.r some ner so»ds and. ai the producer level Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 Foreign Exchange Value of the The U.S. merchandise trade deficit widened for U.S. Dollar* i«d«. Mint, :°;i -i 1987 as a whole, but leveled off on balance in the latter part of the year The volume of imports increased, reflecting a moderate expansion in both oil and non-oil imports. Moreover, non-oil import prices moved up further in response to the continu- ing decline in the dollar through 1987, and, with oil prices also up sharply, imports rose substantially in value terms. Higher imports were matched, to a arge extent, by merchandise exports, which also grew briskly m 1987. Economic expansion abroad strengthened slightly in 1987 providing only limned support for the improvement in the U S trade position. In the other industrial countries, economic activity picked up somewhat by the middle of the year after a slow start, but on average real GNP grew less than 3 per- cent over the year The External Sector The Household Sector The dollar depreciated by 14 percent in nominal terms over the course of 198" relative lo a trade-weighted Spending by households, which had been a major average of the currencies of the other G-10 countries, contributor to growth m past yeari, slowed consider- leaving the dollar by the end ol the year at a level ably in 1987. Real consumer spending rose less than almost 4-5 percent below its February 19R5 peak and 1 percent last year, after a 4 percent gain in 1986 close to its 1980 low. The decline in the exchange value of the dollar was resisted b> substantial official Perrsonal Saving Rate intervention purchases of dollars and an apparent movement of differentials m long-term real interest rates between the United States and major foreign countries. Nonetheless, some depreciation in the dol- lar evidently was seen by participants in foreign exchange markets as a necessary element in the adjustment of the huge U S current account deficit. U.S. Real Merchandise Trade In large pan, the cutback in spending reflected smaller increases in real disposable income. Substan- tial employment growth and increases in farm and interest income fueled continued gams in nominal incomes. However, a pickup in consumer price inflation eroded much of that rise and reduced real income growth to about 2 percent last year, versus 3i/; percent in 1986. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 ,>iidn,abl< good-, whit , h«:•.%, iniiMiiei.! M, mc-c.i-,1 ,it ..bom and <, - U:(liiii !b (l;ir,,bl<-, . ,iH - [i ll honi ! 1 ' . million iinil- Wi>, i.urd iM'h liie in.-], ,,union- spending ;iai <'"li H"«" •"<>"« ."«! 'M'1 < ""'• 1.1 us ,,t M.iiMimn- ML l"H7 •„,,, ,i -.u.svm^ 1,1 II.^IM- I n'l- .nu.., iue UL:..M.-U uuu li declu.Mrd -,l,,lu,K be, m.e ,,l Inyli ,iebi bind,-,,, ol Changes in Real Business •use bcsriiiniiii,' in Apul. KMihini? aho.u II L, pei- i-ni tor tixt-d-i.iu- loans bi nnd-Oetobct AlthoLis^h nlrrc-l rate, on IIKH'UJ.IJJCS ti.ivf diopp.-d ^nbst.in- IT I l!!!.'!!l iLilli sime then the siirnul.uivi' IIIUMIL ol llui lunnc (.11 housing' d(.'tiidi«i m.i\ h,tsc brrn other lin- l.ii hi M(«k iiwrkfi losses ,ind n-dnicd uwi- iKo weakened <AC, die iia.t ,e.u as n.-ai le.onl- Vtn i-qinpnu-nt. trip yc.n bcijiin on [lie weak sule with liisl-([Urtltci spi-nriinj; down sli,,ipl\ jlter linn: Private Housin Starts ', „.' shiltrd cxpi'iidituri-s into Inic l('Mi) tu take .idvntirau »_ ot the favofitblt ireatnicnt «f inii'stiiitnt nndci [lie ^LL; iiii'fsitnciK in rtjiiipmcni rebounded shdrpli in the set ond iind third qiiarifis ot ]a-i\ irai Outldvs lor noniosideinial sifucinres jho mrm-d up tdsi \c<ir .liter a sharp drop in l«ib Much of, [h die ciHTjry SPC tor in ri-s[>oiiM.- [o lusher oil pines Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 Business inventory investment generally moved in line with sales over most of 1987, but a sharp Civilian Unemploymcnl Rate accumulalion of stocks in the fourth quarter sug- gested the possibility of excess inventory levels at some retailers. In manufacturing, inventories changed little on balance over the first half of (he year, but rose considerably in the second half as activity picked up Stockbuilding was most evident in capital goods industries, where orders and ship- ments strengthened substantially, as producers added supplies in anticipation of higher production levels. In the retail trade sector, inventories of goods other than automobiles also rose over the year, pushing the inventory-sales ratio to a relatively high level by December. The accumulation was most pronounced for home goods such as furniture and appliances and for apparel. At auto dealers, stocks generally rose m tially in the second half in response to the sharp gains 1987, and, at year-end, supplies appeared to be well in industrial production. Moreover, the expansion of above desired levels despite the prevalence of spc-tial jobs in the trade, service, and finance industries incentive programs arid production cutbacks late in remained sizable during most of 1987. Hiriiig in tht year trade and finance apparently slowed in the latter part of the year in the wake of sluggish consumer spending and the stock market crash. The Government Sector The demand for labor considerably outpaced Lasl year, there was significant progres^ toward increases m labor supply, and the civilian unemploy- reducing federal budget deficits. The FY 1987 defi- ment rate dropped nearly 1 percentage point over cit, at S150 billion, was about a third lower than the the year to 5 3/, percent at year-end—[he lowest level record level of the previous year. The Administra- since 1979 The jobless rait for adult men moved tion and Congress reached agreement on deficit down to about 4'/; percent by the end of last year, reduction actions totaling more than $30 billion in reflecting strong growth in the industrial sector. The FY 19S8 and about S46 billion in FY 1989 How- rate for adull women fell to around 4->i percent early ever, a number of factors that raised receipts and in the year, but changed lutle in the second half. lowered outlays in FY 1987 are not likely to be repealed, and—absent further legislative action — Nonfarm Payroll deficits could expand again unless there are particu- Nc' '-liajigr. mjllirr.- Employment ,r,t.>n»: uumi ran larly favorable economic circumstances. Labor Markets Employment increased three million over the 12 months of 1987, as the pickup in eionomit activity led employers to add workers at a brisk pai e In contrast to prior years when ihe labor market was characterized by sharp disparities across Seirors. the strengthening in hiring in 1987 was widespread by industn . In msinufat luring, employment edged up over the first half of the vear and then rose substan- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 CorsMimet- Prices' i.n(e.f,<; "- l''rti, llif ...crii>ii,>iL n-,iK,.i,'. in I.,hoi (l)sts piiiii.mk i,lit,!,',; m,.Jei,itf t<i:i,pei;-,UiiMi GNP !lt> [>(-[,,- .UK! pjodiu-fi pine indues sii(ii.,-sli-<l ,111 i-M-n , -li,ii]M-i- ,i(,clci.ilioii in (lines nvci l'ti!7. mvini; !o die siiinr, pi id- index was up 4-, g,< ix.nl in ihr 12 months cmlc-,1 DfinnlK'i, dlu-i .1 : [.fut-in rise in 1 "HO i lu-pi,,- dnu-i p,,,f-,ri(i(-.\. «[iidi,.nh nu hides pi i, ,-,,.( .(o.ties- tu.ilK iH'.nltiiPil^KKij, n.sf 2', iM-nenl Ms.'i-fh, \e,ir. 1 .ill.] dnipjnnt; '21, |iei<em in l''HI' I Pi lies I.,, m,inviii<hisiiialu.iiinio,hii(-,..isoiosr,(in- snl. i,1})]\ in 1<W7. In ..ddiiinn n. rli, nitif.ise ii-, ,rndf oil [iii.i-s, iO(i|)er piurs nunv tii.in tl,,nl.led irist \t-.ir, ,uid \t( el si (<tp priics were up ,)(> pelt fin To -.nine ex _ , ii-nr, ihe sli.up nst' in t(imrriii(Jil\ pikes lellfi (Mile intlu Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 Monetary Policy and Financial Markets in 1987 While the Federal Open Market Committee set tar- M2 gets for some of the monetary aggregates, it was deemed necessary to maintain a flexible approach in conducting its operations. The Committee looked at a broad range of information in judging when or if lo ad]usi its basic instruments—reserve availability and the discount rate—in response to deviations in monetary growth from expected rates. Such factors as the pace of business expansion, the strength of inflation and inflation expectations, as well as developments in exchange market', played a major role in governing the Svstem's actions In light of the behavior of these other lactors. growth in the targeted aggregates. M2 and M3. was permitted to run at or below the established ranges During episodes beginning in the spring and then again in late summer, the dollar came under sus- tained downward pressure and inflationary expecta- tions appeared to be on the rise, partially in finance purchases. The latter preference occurred in response to the dollar's wea« , rrformance With the the wake of tax reform measures which reduced the economy expanding at rates sufficient to produce ris- deducibility of nonmortgage interest payment? ing rates of resource utilization, the FOMC sought However, much of the pickup in velocity appears some firming of pressures on reserve positions and attributable to increases in the competing returns on increased the discount rate in September. When other assets, which raised the opportunity costs stuck prices collapsed in mid-October, the resulting associated with holding M2 iia^anies turmoil required that the focus of policy be on M3 was stronger than M2 over the year, expand- ensuring the liquidity of the financial system. Over ing 5H percent and ending the year at the bottom the remainder of the year, emphasis in the conduct of its 5'/2 to 8;-'i perient annual growth range. Its of open market operations shifted toward main- faster growth reflected heavv reliance bv depository tenance of" steady and somewhat easier money mar- institutions on large time deposits and on certain ket conditions to promote a return of stability lo other instruments included in M3 but not m M2. financial market; generally and to cushion the effects of the stock market decline on [he economy M3 Behavior of Money and Credit M2 increased onlv 4 percent in 1987. well below both the lower bound of us 5 w to s '•/', percent annual growth range and its more than 9 percent rate of expansion over the preceding two years The velocitv of this aggregate picked up substantially, reversing a portion of (he shaip decline thai occurred" in 1985-86. The rise m velocity mav have reflected in pan a number of special factors affecting the public's demand for M2 balances in 1987. including a much-reduced rate of saving out of income and a preference lor diawmt; upon liquid asset1. — rather than using consumer credit—to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 Until luriini. K i,il b.mks .mi! liiuli MLt nul inn- .1 r <'<,,,,! JK.MVVO dc(lm<' ;i \.-,ii ratlin I hi .h..|-|> M,'Mw,l M]) tnt-u iv-u.im*- ol \%hi.ti-'i;i>,l- man.ujctl ha- .luumi; ,il urmMli ami the abtnpl nn iiabnul in h- bihiit-. i,. mix! 11uirc .I-TI i;i-o«rli lli.ni < i ml J bf \i'l(n n\ ,i:c iniln ,,m c nl ihr in, ic.ivM .Mi-imiK to .HMHinn,nl.ilol In uri'.uK irdm i-ii ml],.us ,>l ore mm.-ini-nl" in m.irki'l inlt rest r.ncv th.it h,n rnu-it;i- .iqH.sitx I'^'-ii s,, M't t;n'«:h «.i. Mibdu,,! Ji'LttiM Icr Ml In uxriit \,-.,i- A^ Mum.",rrd li\ i'< M.I,,- '.. [)i Mr \r-,ij- ,,[],-«-ins; in S).i: t i.'dn<,-d ,,%.•!,ill \IM Jtu.'K ;.nu,i'i drx. U'l.un-n 111 1(HIT Ml i«.^ in•( rjs |,n- ttmiU .1. ,i.-, t .•-,!>.ni-i,i!i .it li.ink- .Jiul .ii>|n\u^ it' h,i\f .1 an-,m i -.•n.itix it\ i» , h.nmr- m rlltlto. slimi'd 111 ,idilill.,n li.lilk' rrlii'd h, ,IM!\ nil lllM.'M r.itl's lh.111 the Imi.ldrt ,l^"--^«*ll> iii,in,is,'ffi li.itjihdfs .ilit,tin,d lunn nniiAH sonnr. MH dcln (irdumi'-iii ninilin.iiuijl scm.i-. t;rc« r-limalK hiiuK b'liinwnl li,,in liicn u.ifiijn '''. pen cut l.i-r vc.u . finliiiK (hr vc.ir ,it 'he nuddl, ',,.,nihi-. "I thf CntniiinTfi-X iiKiniiiHiiii. i.met' i>f K m M pri ( nnuih <»l M I •,!,.«,-.1 in !.• , )»•](.'lit tn lie n-ni 11,-lit .'viiatiMun inudrratcd (ini.Md,-i,)bK In.in srn tapul I'M. pomm i.Kn-d-c po-.nl ihr pi.-Muu. 'In 1'i h j),.r,- ,,t ih,' tun [jn'Moi^ v,-.ir< Ixi! Mill vr.it. OVMDI,' n. ,i .in.ill (l.'iluu- in il.'m.nid d.'|)«'Mi. i,>-< I.IM.-I ih.m III«HM<' .nul a xh.npk U.V.M-I *-vtl,,ll-l(>li ol (Xh.'l ,lH'A.)Wt- d.'I),..,!. Ill,- ,,-i,,,if, nl Ml 111,1.'.,.r,l .ItnlllK. .lltrt Growth of Moiiev and Debl ' IVi,,'in,iG. ihan<<- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Implementation of Monetary Policy target range for Ml, given the unpredictability of During the first hall of 1987, monetary policy was the behavior of this aggregate relative to economic carried out in an atmosphere of increasing concerns activity. about the course of inflation, arising in part from For a short time after the July meeting, the dollar heavy downward pressure on the dollar. Growth of rose further, but with ihe release of trade data in the economy was bringing about noticeable increases mid-August that disappointed market participants, in resource utilization. Inflation was picking up, the dollar again came under substantial downward pressure. Long-term bond vields moved up sharply reflecting the effect of a weaker dollar on import prices as well as a rebound of oil prices from low as the dollar's weakness against a backdrop of 1986 levels When the dollar came under heavy strength in the economy spurred concerns about pressure in late March, previously tranquil credit inflation and possible firming of monetary policy. markets began to exhibit concern about the effect I Interest rates in short-term markets also increased, that declines of the dollar w'Ould have on prices. i but by lesser amounts. In light of the potential for Long-term interest rates, in particular, moved up greater inflationary pressures, in part related to strongly. In conjunction with some easing moves weakness m the dollar, the Federal Reserve sought abroad, the Federal Reserve sought somewhat to reduce marginally the availability of reserves greater restraint in the provision of reserves to the through open market operations, it also raised its banking system. Initially, this action produced discount rare hy 1/2 percentage point in early Scp- lembcr to 6 percent. After the discount-rate action, further increases in interest rates, but subsequently, financial pressures eased somewhat. In response to , interest rates rose further, especially in short-term markets. reductions in interest rates abroad, to some flatten- ing in commodity prices, and to belter news on the Stock prices, which had reached very high levels U.S. trade deficit, the dollar firmed and there was a relatiir to earnings and had been failing since mid- broad decline in interest rates, with long-term rates August, plunged on October 19 in chaotic trading falling soroewhai more rhan short-term rales. The stock market drop prompted a marked decline When the FOMC met in July to review its in interest rates as investors sought refuge in the growth ranges for money and credit, all of the perceived safety of fixed-income assets, especially monetary aggregates had decelerated considerably. Treasury securities. Although most stock indexes The weakness in monetary1 growth did not reflect recovered somewhat in the wake of the crash, finan- any evident weakness in the economy Rather, the cial markets remained turbulent, with bond and slower money growth, and accompanying strength- equity prices fluctuating widely. ening in velocity, appeared largely attributable to In a financial environment of extraordinary tur- the rise in market rates of interest fostered in pan moil and apparent fragility, the Federal Reserve by the Federal Reserve';, response to adverse shifted the emphasis in the conduct of open market developments with respect to the dollar and infla- transactions to providing reserves generously to tion. The Committee decided to reaffirm its 1987 ensure that adequate liquidity would be available to growth ranges for M2 and M31 in doing so, it antic- meet any unusual needs This action helped to calm the financial markets, although conditions remained ipated some pickup in the growth of W2 over the remainder of the year. It indicated that growth for somewhat unsettled over the rest of the vear. all of 1997, near or even below the bottom of the Earlv in 19S8, as incoming data suggested that target ranges, might he acceptable for both aggre- economic expansion over the firsi p<sr! of the year gates, depending on the behavior of their velocities mightj;? weak, bond rates dropped substantially and and other financial and economic developments, Ihe Federal Reserve sought some slight additional notably the evolving strength of inflationary pres- easing in desired pressures On reserve positions Bet- ter tr.ide news bolstered confidence in the dollar. sures The Committee also decided noi to set a and the monetary aggregates showed signs of renewed strength Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 Footnotes 1 Ml i- (Uii.n. \ h.-ld In i In- pubhi. plus Iras dels' . h,.k. plus drriwnd drp-.s.ts. plus nthi's (he<kjble d,T.i-n- Imiliiduiij mx<>ti.ib]f urdei ol «irhdi,iv.,il iNO rfiid Super \(.)\\ i jtiounrs .lunniL.ni, ir.irisli-i- " UK •• i.VISl ,(iuninis. ,ind cretin union sluir ,li,jh .i,«nniK| M2 i> Ml plti, MMna= and snull dt-nuriniurion mm dcposirs. plus Mnne\ Maikfi IVpu^n Ammii!-.. pin-- iharts in ni»tn-\ cnaikn nnitual funds urthn i)i,,n ilmsi' <)I,LV .i^wmi-m. ,ind , I'r-rfin r.vdmijlii t-umiliilJ.tr M3 is MJ plui krs-c time dc-posirs. pin- l.n^r di-miii market ITIUEII.,] iuniti rcstnt tdt t<- insiinin-.rirfl IIUCSKTS ,uid tcnain (fini Kuiodolldr rlfptmis 2 Ml M2. and \Vi inn.ipdr.nc .-lien- <>l hnuliin.n-li and MMsdiidl ad|iiitini-nl revisions m,idr in hclji-u.ii-v I")S8 Cenain i^hnua] rvdcnninon- alln tins? t.nl\ Ml were rn.uk- ,« the sinit- tune Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 The CHAIRMAN. Thank you very much, Mr. Chairman. CHALLENGE TO FED'S INDEPENDENCE Chairman Greenspan, there have been a series of challenges to the Federal Reserve's independence in recent months. As you know, we have an election coming up in 8Va months, a Presidential election and a congressional election. Every member of the Federal Reserve Board now has been appointed by the same administra- tion, by the same President. This is the first time I think since Franklin Roosevelt who served for 12 years—and I'm not even sure if Roosevelt had ever done that, because Board service is, a 14-year term. So it's an extraordinary situation, making the Board particu- larly susceptible to the appearance of this kind of pressure. The challenges I refer to were first from repeated criticisms of Federal Reserve policy by the Chairman of the Council of Economic Advisers, Mr. Sprinkel, including the latest economic report of the President, which criticized monetary policy openly. Second, Assist- ant Secretary of Treasury, Michael Darby, sent a letter with ana- lytic work on real M2 to the Federal Reserve Governors and the Presidents of the Reserve Banks just prior to the last meeting of the Federal Open Market Committee [FOMC]. I don't know of any occasion in which this direct effort to influ- ence the policy of the Open Market Committee has been so clear and so overt and the message was obvious that they wanted the Fed to ease. Chairman Greenspan, you and the members of your Board who were all appointed by the Reagan administration, demonstrated your abilities in October 1987 to the great benefit of our country when the crash occurred. Why is the Reagan administration so concerned? Do you really need so much help from the administration to figure out what poli- cies to follow? Mr. GREENSPAN. Well, all I can say, Mr. Chairman, is that when I heard about Dr. Darby's letter, I objected quite strongly. As best I can judge, he was not aware of the implications of what he was doing just prior to an FOMC meeting. I am reasonably certain that such actions will not occur in the future. It's difficult to know what to make of anybody's criticism, advice and the like that we get, and we get it from all sources. And I think it's important that we listen because the worst thing that could happen is that we would shut ourselves off from all advice, criticism from any source. I, myself, am not particularly concerned that we be unduly influ- enced by the administration. I'm not certain that they really are intent upon pressuring us. I think what's happened is they think they have really strong reasons. I must say to you that I happen to disagree with both Dr. Sprinkel and Dr. Darby on their interpreta- tion of the monetary aggregates in the last year and currently, al- though in very recent weeks Dr. Sprinkel has indicated that he is satisfied with Federal Reserve policy. But I do fully expect at some point in the future that we will have differences with people in this Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 and other administrations. I think we will have differences with economists on the outside. The only thing I hope does not happen is that the concern of our responding to political pressures gets so extraordinary that we will feel a necessity to do precisely the opposite and we could very well be taking actions which would be counter to our best judgment. That is the type of problem which concerns me more than my con- cern that the current administration will pressure us into doing things that we don't think are appropriate for monetary policy for this country. The CHAIRMAN. That's a good, solid, sensitive answer. However, I can't recall a situation in which pressure from the administration or the Congress resulted in an overreaction against the pressure that leaned so strongly against the pressure that it was against the public interest. That outstanding Chairman of the Federal Reserve Board, Arthur Burns, that may or may not have been influenced by pressure, but he followed a policy in 1972 that served the inter- ests of the administration. HOUSEHOLD AND BUSINESS DEBT Let me ask you about the point I made in my opening statement on household and business debt. Because this debt is much bigger than the Federal debt, it has very serious implications for the vul- nerability of our economy in the event of the recession which we must expect at some time. How serious is a household debt that has grown rapidly to over $2.8 trillion, and that occurs at a time when savings have dimin- ished sharply? Mr. GREENSPAN. Well, I am concerned about the issue of debt, al- though there are certain technical factors in the data which I think are creating something of an exaggeration. We have, as you know, over recent years moved currency to credit card purchases in a number of instances, and that is debt but it's very short-term debt and it's a very marginal change in patterns of purchasing. As a consequence, it is not something I worry about as much as I worry about other types of debt categories. And similarly, the decline in the published permanent savings figures reflects in part fairly substantial realized capital gains on the sales of existing homes which do not appear as savings in our regular statistics. The CHAIRMAN. How big a factor is that? Mr. GREENSPAN. I think it's a percentage point or so. It's not a small number and it's been a factor which I think accounts for part of the decline—I've forgotten exactly how much—but not a insig- nificant part of the decline in the savings rate over the last year or two. Having said all that, however, I think that the fundamental point you make, Mr. Chairman, is one which worries me a great deal in the sense that I believe that our economy is overleveraged, that we have built up debt in the business, household and financial sectors. This is a problem that we have periodically, It's not some- thing that I would consider to be of grave immediate concern, but it is certainly the case that when you have excessive debt and very Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 heavy fixed costs in the system that you have less downside flexi- bility if the economy wants to make minor adjustments. It s not something which is a short-term concern, but it is some- thing which should concern us when we look at the longer term and the process by which this economy will evolve over the next 5 or 10 years. The CHAIRMAN. Thank you very much. My time is up. Senator Bond. Senator BOND. Mr. Chairman, I was very interested in that line of questioning and I wondered if there were any further implica- tions that Mr. Greenspan might want to expand upon on the issue of the corporate debt as opposed just to personal household debt. Have we built up a corporate structure where there is so much debt and so little equity that we are likely to be losing them in undue number if there is a recession? What's the remedy? Mr. GREENSPAN. I don't want to state that we are in a severely difficult position. Remember, the debt that has been built up in most cases is voluntary. It's decided upon by corporate manage- ments. They have reasonably good judgments in virtually every case that I'm aware of as to what they can afford over the longer term, and with the exception of the merger-acquisitions which I'll get to in a minute, I don't perceive that the debt is crucially over- hanging the system. It is, nonetheless, creating a level of fixed costs within the corpo- rate business sector which is much higher than it's been and, I think, does create some difficulties. I am particularly concerned, as I've mentioned to this Committee on previous occasions, with this extraordinary amount of shift from equity to debt in our corporate balance sheets which result from a combination of very heavy purchases of company stock by the com- pany—that is buying back one's own stock—mergers, acquisitions and leveraged buyouts. It has created a fairly pronounced addition to the overall debt and at the moment I don't see any immediate falloff in that propensity. But I suspect that we will within some short period see an end to that type of pattern at least in the order of magnitudes that we've been looking at. Senator BOND. Following up on your point about mergers, I gather when the Fed reviews a contested or uncontested bank merger the Board scrutinizes financial and managerial capabilities of both institutions and looks at the public interest and competi- tiveness. Does the Federal Reserve look at any additional factors when it is a hostile takeover? Do you feel that hostile takeovers of banks could cause any public policy concerns and any other type of hos- tile takeover or any other type of financial institution merger? Mr. GREENSPAN. Well, I think hostile takeovers create some ana- lytical problems which can be overcome. It's a little more difficult to get information sometimes, but that's a technical problem and I don't think it's a particularly major issue. Let's remember when we talk about hostile takeovers, the hostili- ty is between the managements of the two organizations, not be- tween the shareholders of either. In fact, the problem that exists is that too often, in my judgment, the managements try to protect themselves from, in effect, their own shareholders, who are essen- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 tially their bosses; and I don't think that it is appropriate for us to try in any way to differentiate between so-called hostile and non- hostile takeovers. I do think, however, that we should apply in all applications the same scrutiny with respect to not only the issues you raised but also capital and a number of other implications that could arise in such mergers. But I would not, myself, draw any really significant distinction between the particular merger of a financial institution as hostile or otherwise. Senator BOND. What do you see happening to the trade deficit which we have all mentioned is too high, and are there any con- structive steps that we might take to improve the situation? Mr. GREENSPAN. I think that the trade deficit, as I have said in my formal remarks, is expected to decline moderately, but because of the nature of the data, the changes are likely to be erratic from month to month. But I think we've turned the corner and the trend is definitely down from everything we've seen. And I would suspect that if we can increase the stability of the American econo- my, reduce the Federal deficit, and essentially create the type of economic environment in which capital investment can take place which can be used for export demand, I think that we will find our- selves in a position where the difficulties that we've had in our trade accounts will pretty much be behind us. Senator BOND. Thank you, Mr. Chairman. The CHAIRMAN. Senator Riegle. TRADE DEFICIT Senator RIEGLE. Mr. Chairman, I want to follow right on in that vein if I may because when you make the comment to Senator Bond that the trade deficit seems to be getting better this is official Department of Commerce data and what it shows is our trade defi- cit through the end of 1986 is posted at a figure of about $160 bil- lion, and as the monthly figures have come in through now all of 1987 expressed on an annualized basis, we actually had a larger trade deficit, as I'm sure you know, in 1987 than we had in 1986. Now one can argue, as perhaps the implication of your comment was, that the last 2 months of data, the last of those which we just got about 2 weeks ago, means that we've finally turned the corner. I hope that's right, although I think if you look at the pattern of the data over the year and the fact that the October data was the worst in our history—$17.6 billion in 1 month—I really don't know what you hang your hat on when you say we've turned the corner on the trade situation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis U.S. MERCHANDISE TRADE DEFICIT $ in Hillions Annuallzed Rate 1987 7/ie trade deficit in 1986 was greater than the total of all the trade surpluses accumulated since World War II. 1970 1972 197-1 1976 1978 1980 1982 1984 1986 J V M A M J J A S 0 Nr D Office of Senator Donald W Riegle, Jr Source: Department of Commerce Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis U.S. MERCHANDISE TRADE BALANCE IS DETERIORATING AT AN HISTORIC RATE 100 Tile trade deficit in 1987 was greater than the total of all the trade surpluses accumulated since World ttar II. '.80 ^969 1971 1973 1975 1977 1979 19B1 1983 1985 1987 of Senator Donald W. Kiegle. Jr. Source: Department of Commerce Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 I think the trade problem is a very serious one and I want to pose a couple of questions about this, but I also want to go to the balance sheet, and that is the accumulation of international debt and the degree to which foreigners are going to continue to lend us money to finance that trade deficit. If you look at the balance sheet, again using Department of Com- merce data, what I see here is a trend line that is without prece- dent and I really don't think it's being addressed and I want to get into it not just in this round but hopefully in the second round. What this chart shows [indicating] is that we became a debtor nation in roughly 1984 for the first time since 1914. What is dis- turbing to me as I look at the trend line coming down through the end of 1986 and now we've got the four quarterly figures posted for 1987, is that we are riding this debtor nation curve at the rate—as I say, we're adding new international debt at the rate of roughly 1 billion dollars every 2V2 days. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FOR THE FIRST TIME SINCE 1914 THE U.S. IS A DEBTOR XATIOX S in Billions 1987 <£> 83 84 86 Ql Q2 Q3 Q4- Office of Senator Donald W. Riegle, Jr. Source; Deportment of Commerce Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis TOTAL FEDERAL DEBT Dollars in Trillions 0.5-4 1.5- 2.5J 1977 1978 1979 I960 1981 1982 1983 198-i 1985 3986 1987 1988 Office of Senator Donald W. Riegle, Jr. Source: Economic Report of the President Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL BUDGET DEFICIT Dollars in Billions 156 200- 221 -250 1977 1978 1979 I960 1081 1982 1983 1981 1985 1986 1987 19B8 Office of Senator Donald W. Riegle, Jr. Source: Economic Report of the President Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 Now my question really is, can this go on indefinitely? Will for- eigners continue to lend us the money to finance that huge trade deficit? Will foreign banks and foreign nations in effect continue to supply the credit that they are doing? It seems to me that at some point we run a real risk that if they should decide to draw back that we will see upward pressure on interest rates and I'm very concerned about that because the un- employment rate in Michigan now for the last month has just gone over 10 percent. We are at 10.2 percent. So this manufacturing re- covery that you speak about is very uneven. If you look at Ford Motor Co., right now they are doing very well. They've paid a large profit sharing payment to their workers. General Motors are not doing so well and paid nothing to their workers. So I find the picture to be very mixed on the manufacturing side in contrast to the rather upbeat things that you said. My question really has two parts to it here for openers. No. 1, how do we really anticipate that the rest of the world is going to be able to suddenly take this huge new volume of U.S. exports, assum- ing that we are now somehow more competitive, and do we even have the capacity to pump out huge additional amounts, but even if we do, are they prepared to buy it in very large amounts, $50 to $75 billion a year, if we're going to put much of a dent in that defi- cit? No. 2, how much longer are foreigners willing to let us live on their credit card? Is this a problem? Is it something that we just take in stride, this change in national condition; or are we headed in a direction that has some real dangers to it? Mr. GREENSPAN. Senator, let me just first take a minute to go back and say that our expectations about improving the trade defi- cit are not based on merely looking at the nominal data, but what we are impressed with is what's happening to the physical volume constituents of both imports and exports. When you look at that in the context of domestic and export prices it gives us a fairly en- couraging picture—erratic, but not one which I would find discour- aging. As I said on another occasion, I thought that that extraordinary October figure was an aberration and not anything specific to a trend; and as a consequence, I think that we have, hopefully, a little more than just merely tracing the nominal trade figures to give us some confidence that we have turned the corner. The issue of how much in the way of increased exports we can generate is an issue which clearly is a forecasting question. One of the problems that we have in this country is that the level of our exports is relatively low, especially relative to our imports, and that we therefore have a considerable way to go on the upside. In other words, we are not taking that much of a share of other coun- tries imports and that is something which at this stage strikes me as a real potential restraint. The markets in countries to whom we export are likely to be moderately better. The world economy is moving up moderately. It's sluggish but still persists in moving ahead and we think that is enough. We hope that there will be a significant turn in the ratio of imports to domestic consumption. And there is another major Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 factor which I think, would contribute to the improvement in our overall trade balance. I would expand the issue you raised with respect to the question of will foreigners continue to hold dollars. I would expand it not only in terms of will they hold the increased claims from U.S. citi- zens, which is the financing number you're looking at, but also would they be willing to continue to hold their huge block of dollar- denominated securities in both the Euro and Asian currency mar- kets, because in a sense it's one large block of funds. What we have seen in the past is that the willingness on the part of foreigners to hold dollars is very closely related to their sense of soundness of our economic policies. And as best I can judge we have the capacity to absorb—or rather to, in a sense, have foreign- ers absorb—still fairly substantial blocks of dollars provided their presumption is that this is a good place to invest directly and indi- rectly. I don't perceive there to be a significant problem out there pro- vided we have, as I say, a stable economic environment. The diffi- culty arises should there be a perception that we are going in the wrong direction. And should that happen, then I think there will be an endeavor to shift out of dollars. That could cause the types of problems which you suggest, Senator, which is all the more reason why I think it is so important that we address the budget deficit question and I think we are making progress with it. We should not forget that with all the struggles that have occurred, progress has been made, but a lot more is required to resolve the type of question which I think you are raising. Senator RIEGLE. I hope to follow up later, Mr. Chairman. The CHAIRMAN. Thank you. And congratulations on the superb charts. Senator RIEGLE. Thank you. The CHAIRMAN. Senator Shelby. Senator SHELBY. Thank you, Mr. Chairman. I hope Senator Riegle will pass that chart around because it is graphic and we will all use it at some time. The CHAIRMAN. It's very good. Senator SHELBY. Chairman Greenspan, I want to follow up on some of the areas that both Senator Bond and Senator Riegle were getting into. I think it's important, (1) as you point out, to do something about our deficits that we are creating here in the Congress each year. That's No. 1. But if we're going to have those deficits, which is not desirable—if we're going to have those deficits, we should borrow that money from our own people that's generated from savings in this country rather than the Germans and the Japanese and other blocks in the world because, as his chart points out, we are a big debtor nation now and I worry about the problem down the road of making policy; that sooner or later people in other countries will have a hold of some kind in this country and will make some type of policy. I'm not talking about monetary policy. I'm talking about political policy and economic policy. Maybe they're already doing this a little bit. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 Does that bother you, the fact that we are in hock, so to speak, a country with a gross national product like we have and one of the most dismal savings rates in the world? Mr. GREENSPAN. Well, it certainly does, Senator, and I think the concern that I would have is what tends to occur in an economy with fairly large external liabilities when we run into some diffi- culties, which we periodically do, as all economies do. It is certainly the case that the behavior of the holders of our dollar denominated assets will have a significant impact on what we do here and how we evolve our own policies and what happens to us. Senator SHELBY. Mr. Chairman, does that put us at risk some when our debt is external? Mr- GREENSPAN. Yes, it does. However, let me just comment that it's our aggregate debt—the aggregate holdings of dollar-denomi- nated securities, whether or not they are U.S. Treasury securities and whether or not we finance our Federal deficit wholly internal- ly or partly externally. The crucial issue is to what extent do we have large external dollar liabilities? We needn't go back very far in history to see the types of prob- lems we can get. Remember Britain had a very serious problem at the end of World War II with very large external sterling liabilities which it gradually unwound. But during the process it was very ob- vious that those international obligations had a very significant effect on domestic economics and politics of Britain. Senator SHELBY. Mr. Chairman, do you think it's time we took some legislative initiatives to encourage people in this country to save more money? Have you looked at that? Mr. GREENSPAN. Senator, I've been looking at that for many years and I must say to you that I am somewhat discouraged. We have had innumerable legislative initiatives. We have had many changes in our tax code, the base for which was to try to increase savings in this country. While there is some dispute on the statistics, the way I read the numbers suggests to me that we've had very little progress, that while some IRA's and other types of tax saving gimmicks have ex- hibited very large increases, as best we can judge, they were merely taken from some other pot of savings and the aggregate did not increase substantially. Senator SHELBY. The aggregate didn't change. Mr. GREENSPAN. I think it's terribly important that we try to find ways of doing this, but I must say to you, Senator, that it's something which has been rather discouraging to economists who over the years have been trying to find ways in which to do this. What we do know, however, is that in order to increase savings we've got to reduce consumption and that is difficult to do. Senator SHELBY. My time is up. The CHAIRMAN. Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. Dr. Greenspan, we are living in a time of enormous Federal budget deficits. We are all aware of that. And there is apprehen- sion I think on the part of economists across the board that the economy could be moving into a slowdown if not this year certainly next year. Indeed, that the economy could fall off into a recession that could be fairly severe. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 Now I think the great legacy of this administration is going to be that it's deprived the Congress and the American people of the tool we've used to deal with recessions and depressions since 1932, and that is the tool of economic stimulus. In other words, if we fall off into a recession in January or February of next year, we're simply not going to have the ability with these enormous deficits to engage in the economic stimulus that we have engaged in at other times when we've gotten into a recession situation. Given that scenario, it appears to me that the Federal Reserve is going to be our last resort and that last resort is going to be in the form I suppose of increasing money supply and lowering interest rates. FED'S ROLE AS TO RECESSIONARY ECONOMY What do you view as the Fed's role here in an environment in which the Congress and executive branch are deprived of our eco- nomic stimulus tool when we get into a recessionary economy? What do you view the role of the Fed being in that situation and do you agree with my assessment that we are deprived of that tool? Mr. GREENSPAN. Well, Senator, I think this may come as some- what of a surprise answer, but there's something different about the current environment and I would be inclined to say at this moment that stimulus coming from the budget side over the next several years could very well be in the context, of reducing the def- icit rather than expanding it. The reason I say that is that however one reads the numbers, the real rate of interest is higher in this country than it should be and I would contend that the budget deficit is the primary cause of that problem. If we could reduce the real rate of interest—which the Federal Reserve has very little capability of doing but can be done from the fiscal side—I think we open up a whole layer of potential effective demand in this country. So what I would suggest here is not that we try to think in terms of reducing the deficit as a fine-tuning op- eration—I don't seriously believe you can do it in that context—but I do believe that if we get the budget deficit down to a point where real interest rates fall, then actions by the Federal Reserve can become quite effective in endeavoring to forestall economic de- clines. If we are forced to try to act in a market where real interest rates are high because deficits are extraordinary, I think the abili- ty of monetary policy to function in its historic role will be cur- tailed. And as a consequence of that, I urge the Congress to address this question largely because the deficit itself limits what monetary policy can do when it is required to do something important in re- straining declines in economic activity. I don't know whether this responds to your question effectively, Senator. Senator SASSER. Well, I think it is a good response, Dr. Green- span, but I'm not quite sure that I fully understand it. I'd like to go a little further. Did I understand you to say on the front end that in seeking to reduce interest rates or to bring real interest rates down that we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 might want to engage in stimulus spending; that is, move more in the Keynesian direction or the supply side direction? Mr. GREENSPAN. I'm sorry, I thought I said reduce the deficit. In other words, let me explain what I think is involved here. At the moment, the budget deficit as best I can judge is causing an increase in the real rate of interest which is preventing capital investment from being at levels which I think it would otherwise be and probably is acting as a depressant in housing as well—two very major areas of our economy. In other words, overall effective demand in this economy is significantly lower than it could be at lower real interest rates. So what I'm saying, Senator, is that if we can find a way over the next several years to bring the budget deficit down in a perma- nent way, I think that that will, by reducing real interest rates, create an environment of potentially greater effective demand. If we do get a recession in that period—in two years or so or what- ever then monetary policy could be particularly effective in fending it off. Senator SASSER, I agree with that. Dr. Greenspan, but the thrust of my original question is how do you get from here to there. In other words, you're talking about reducing the deficit down to the point that real interest rates will follow it down, and I'm not pre- pared to disagree with you on that point; that if we did significant- ly reduce the deficit as a percentage of GNP, if we started financ- ing this deficit hopefully more internally and less externally, we would see real rates come down. But the question is, if and when we fall off into a recession, the deficit historically—and correct me if I'm wrong—almost always comes close to doubling, how can we then react to the recession by trying to come up with additional stimulation to the economy at the Federal level? Now if we fall off into a recession and the deficit get even worse, we will be deprived of a stimulus tool because of the very large deficits we have now. In fact, if we start playing the stimulus game it appears to me we are going to be driving interest rates further up because of the deficit. Mr. GREENSPAN. I agree with that, I was agreeing with what you're saying. What will be the Fed's role? I was just going to the next step. I don't disagree that there's very severe limitations, and I think it would be really counterproductive at almost any point to try to consciously expand the deficit as a countercyclical policy. Senator SASSER. My time has expired. I'd like to pursue this with you further. The CHAIRMAN. I want to pursue the deficit issue too. Mr. Chair- man, your analysis is revealing and exciting if it is correct. Few people in Congress believe that if you raise taxes and cut spending you stimulate the economy through a drop in real interest rates. If that were true, that would be marvelous. To sell that to the Con- gress and the country, would be a great achievement. Maybe we can do it, but I don't think many people believe that now. It turns Maynard Keynes on his head, doesn't it? Mr. GREENSPAN. No, I don't think it does. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 The CHAIRMAN. Ignoring the real interest rate, Keynes view was that in recessions and depressions you have to do your best to stim- ulate the economy by running a deficit deliberately. Mr. GREENSPAN. Well, Mr. Chairman, I don't think that this is particularly a bizarre point of view. I think there are a large number of economists who hold this view. The CHAIRMAN. I didn't say it would be bizarre. It's exciting. It's great. Mr. GREENSPAN. Let me put it this way. It is certainly the case that the evolution from Maynard Keynes' original notions in the mid-1930's as it evolved in the post World War II period did have much greater emphasis on expectations, especially inflationary ex- pectations, and they become critical factors in the elements of how the system works. I don't think the issue of real rates as they come into the system were fully understood, largely because we never had rates anywhere near as high as we have had in the last decade or so. The CHAIRMAN. This analysis has great appeal to me. I hope we can implement it. Turning to the Glass-Steagall reform bill for a moment, I under- stand that the Securities and Exchange Commission and the bank- ing agencies recently agreed on a compromise proposal regarding which securities activities may be conducted directly in a bank and which activities should be conducted in an SEC registered subsidi- ary or affiliate. Does the Federal Reserve Board fully support that proposal? Mr. GREENSPAN. I have been over it and I personally support it. We have not yet formally put it by the Board, but I have no reason to believe that, having spoken with them individually, that there is any dissent on that agreement. The CHAIRMAN. That's very, very reassuring. It looks as if we have on board the banking agencies, the SEC, as well as the admin- istration, and that's extraordinarily helpful. LOWER VALUE OF THE DOLLAR We have been discussing what effect of the drop in the dollar will have on our economy. I'm very concerned with what effect this may have on the European economy, given great interdependence of economies generally today. You have a situation now where I'm told that the rate of unemployment in Western Europe is 11 per- cent. It's as high as 20 percent in Spain, 19 percent in Ireland, 9.5 percent in the strongest economy in Europe—the German econo- my. If we proceed with a policy which is very attractive to us of letting the dollar go down so that we can export more, aren't we running into a situation where we're going to be adversely affected by a recession that could begin in Europe? Mr. GREENSPAN. Well, first of all, I am not an advocate myself of driving down the dollar to export more. I think it's a futile activity. In the end it doesn't work because you drive up internal U.S. costs and we will end up being noncompetitive because of rising internal costs. Japan clearly has had a remarkable capability of adjusting and has shown very little evidence of any internal weakness as a conse- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis quence of the strength of the yen vis-a-vis other currencies, espe- cially the dollar. The CHAIRMAN. My time is up. Senator Riegle. Senator RIEGLE. To follow along that line, if you look at the bilat- eral deficit with Japan for 1987 versus 1986, we've had basically no improvement, despite the big shift in the value of the dollar versus the yen and the notion that economists say that this will give us the improvement, J curve effects and other things where suddenly we will see a balance coming about. It didn't happen and it's not going to happen. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis U.S. TRADE WITH JAPAN, TAIWAN, AND KOREA ACCOUNTED FOR NEARLY FIFTY PERCENT OF U.S. TRADE DEFICIT IN 1987 (Dollars in Billions) 20 100 120 140 160 180 1980 1981 1982 Japan en 1983 <£> Taiwan Korea 1984 Others 1985 1986 1987 Office of Senator Donald W. Riegle, Jr. Source: Department of Commerce Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 The thing that bothers me about the testimony today—and I'm a great admirer of yours, as you know—is that it is very casual, very relaxed, very business as usual, and I don't detect any sense of ur- gency, despite the trend lines, despite a lot of things that have been said here today. When you talk about pumping out much higher dollar amounts of U.S. exports and being able to sell them over- seas, you've got to sell them somewhere. Somebody has to take those goods. Central and South America can't take them because they don't have any credit anymore, so they can't buy what they would like to and therefore we can't sell it. With the unemploy- ment rates in Western Europe that the chairman talks about, they're not about to put more of their people out of work to take a huge influx of American production. And out in the Pacific rim, the Japanese are the masters on the globe at practicing that kind of mercantile trade and they're not going to let the deficit come down. They're taking $5 billion a month out of this economy. That's what that $60 billion trade deficit does. I want to show you one other chart that we just made overnight so that we could have it here today for you to see. I was showing you the trade deficit before. This is again all official Government data. But this looks, Mr. Chairman, as well, that the buildup in our Federal national debt just in the last few years—look at 1981, for example. We were roughly at $1 trillion in national debt. By the end of this year, we're going to be at $2.5 trillion. Now these are big numbers. A trillion is a thousand billion. So we've left from millions to billions to trillions. But if you take that debt buildup and riding that debt accumula- tion line—and frankly this year's deficit which you didn't respond to is worse than last year's deficit through the first 3 months—but if you take that debt trend line and you imagine that one with this one [indicating] because these two are really the foundation on which the economy is performing—and so when you talk in a sense as if we can just sort of work our way through this, I have really not heard anything about how we deal with the magnitude of those trend line shifts. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis TOTAL FEDERAL DEBT Dollars in Trillions 0.5- 1.5- -2.5J 1977 1978 1979 1980 1981 1982 1983 198t 1985 1986 1987 1 Office of Senator Donald W. Hiegle. Jr. Source; Economic Report of the President Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 To come back just to the international part of it, the notion of going from this position internationally in 1982 as a creditor nation [indicating] through the end of the fourth quarter—and this data just came out and this data is our latest information—to go from here to here in roughly a 5-year period of time is a breathtaking change in national circumstance. And I think anything that sug- gests that we can keep riding this curve or somehow this curve is changing magically—where is it changing? I mean, where is the data that shows that it's changing either on this debt accumulat- tion chart or on the Federal budget deficit accumulation chart? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL BUDGET DEFICIT Dollars :n Billions 100-1 CO 150- 156 200- -250J 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 Office of Senator Donald W. Rieglc, Jr. Source: Economic Heport of the President Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 I don't see it and what I see instead is the situation—and there's a piece in this morning's Washington Post—I don't know if you know this man, John Paulus, who is the managing director and chief economist at Morgan Stanley—but he addresses this issue. He says we're in for a very major shock coming here in terms of a scal- ing down—he describes it—that American citizens are going to suffer an enormous loss of wealth because of the decline of the dollar that accompanies the effective downgrading of American means that prices of imported goods are going to go up and we're going to have a hard time selling abroad. In any event, I'll put that in the record. I don't know if you've had a chance to see it or not. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis l-'rom the JotmD.Pbutus Washington Post---Feb. 24, J988 America the Irresponsible Recently, there has been much loose utk Third, there U a risk that the American abool America's borrowing abroad being a "America now must borrow roughly $150 billion per government Witt be forced by the electorate reflection of the United SUM' attractive- to adopt economic poboe* favoring even ness as an investment tot foreigners. Noth- year from foreigners to finance its bulge in household more conamption in a vain attempt to re- ing could be lurthtT (ram the truth, given *ore the tat wealth and 10 boost the lagging the U.S. dollar's fall of more than 10 spending." Mtndard of |vk«. Sock (Aorta, of courae, percent agalnat the lading currencies dur- wadd hi bMMte they would dtacnnae the ing the past three Bwolht and ill decline of prinuryaowte of Health inaaUnert, aired a far larger amouot in the put two yeara. than 30 percent apinat mod other major deramBaaure of pofcy autonomy. Because of capkaL In the process, however, theaetAteti This depreciation in the U.S. currency, currenciea during tils period. the aiirfeaatniiofirreipnB»l)le economic poh- could came further havoc in the struggle to especially when viewed againal the back- The hteM eomple of U^. Bretpcnaibili- dea ower the paat 16 yean, Bnancbl markeM ehmiHte the trade deficit. ground of ihuply dimMuihed capital inflows 17 ia Anerica'a severe omrconaumption have taken a hanker view of certain Ameri- The world will surriv* without the Unit- from private investors, coupled with in- probtoffl, atemming from the diaparity in can economic poidaa, which they regard as ed State*1 serving alone aa the linchpin of creasing inflows from foreitji central banks fiacal policiea in the 1980*. A* * rbwlt of aef-ontend. A* a mult, our sbflity to the global financial system, a role thit most attempting to prop Dp the ffltthii dollar, ovenoMumptta, Anerka now m*t bor- Mndartaie aai independeDt courae without likely will have to be shared by a reluctant ptnpfe* that the United Staua a seen n a row roughly *1SO bjUon per year from pnUm coata hM dJowohcd. Japan, a hesitant Germany and a chastened riiky natm in which lo place funds. fonignera to finance ita bag* in houaehoM Saooad. AMcican citijens wi auffer «n United States. Moreover, it is powiMe that TheaadfactiithetoverthepiMlS yam apending which, acconling to my ealcukt- •Bomaw km o( wafch. Thededkie in the global economic growth could actually ac- America, in proving to be an unrelHbk master tion*. ii running about $150 billion abovedabr HM aceompaniM the efltoive down- celerate during the next decade if the of the global financial syiWm, ran squandered its lonf-term trend. In other words, we u a vadnf of America meana that pricea of movement toward reduced government in- , a p r ( e r m ea ie l r r f e i s n o a u n r c c i e a — l po m n r e n r d i y n . t i h ts e f w ri o n r d ld w , e to w e b th es e t n m a a ti i o n n ta in a r a e h b ig o h r r l o e w ve in l g o f f c ro o m ns u f m or p e t i i g o n n e H rs n c t e o , i H m tk po i rt m ed a n f oo t d h s a , n w 1 h 0 ic h p e n r o c w en t a c o co f un do t m fo es r t i » c w an l d v e i m f e t n b t e i r n e v e o c lu on ti o o m n ic i n a h ff i a g i h rs te c c o h n n t o in lo u g e y s OcnS HOB in Ihe market, so to spot, However, as it tintta out, the ahare of groaa national apendng, vril have to raw. In fact, from cornea to fruition. Nevertheless, rt will be a thia Batten's fraicaj hegemony in promoting product devoted to household apending cvmt tavda every 10 peroant drop la the leu hoapttiUe ptec* for America. a strong dolar had eaabted America to pur- HKe 19W has been it. or clcoe to, a datar «« add *bout ISO bHon to Annka's chase forew) gooda cheaply and to attnct pwt-World War II retort Ugh. a«cat bal not >at for oae JPMT hot fcr every capital from abroad at bargain rates. laodentatty, there b no truth to the mr la tha fabn. Moreover, tm vmatt Wat Sanity * Co. IVve achieved the diibiOMdiatinction of aaaerbon advanced by proponenta of the M eroded hecwae America wl have to pay ' 'Amending our name and, therefore, of view that foreign borrowing reflecU food •no lo bpnov abruaa n ordor to ooriMienj •wnpenlfeg our financial might, by punubf Ifcngc and tkat "•* capital fadowa have •ate kntera bt lote*r*« h * Mea MgeL UtattMary noottary pofcfea ta be IBTOa baeo and to ma»i the V£. conuaHaaept It i»M &4tcM to tay Out tie ttmU M and by implementiag In the 1980* a atimu- to capful apenaW On Uw contnry, the Ik* MotS good name In fimMUcMn hdv* bed policy, while other Mutrial ihue of CNP devoted to bualneaa find cokld neaa c&tt Ameiican* wK haiw to f«y powen tightened (heir fiacal policies •HttniHOt. at 11.8 percent in 1987, is •pward cftlOO hMon eSraper *BK to (trough tax ioercaae* and nductnM in practictBy the nme aa H m in 1980. U knport and nreJgB buiuvuf coata, a tAKRiinenl attending. Indeed, the ttinmh- there wr woader that foreitn ceatral banla aumeven In Waahingion. ttve U^. fiacal pokey hw been ao far out of have had to play an incraaamgly dominant p T n I B . . M . p . t .M M a b c* a o 1 f 9 d 8 o 2 m e H a u tk t i i p t e D h d iu - r n o f le M in fi M na i n m ci i n t g e d th e 7 5 U n p it e e r d c e S n t t a te o * f , s f u o p rd p g ly n - I haa been M penoit greater than capUal needed to stem be sbortfnJl in .si Ottn MwtrU a«kn over the •lonlfn trade In 1987, M private tamatora ppt •« yttra. A* a CMMequence of these around the worid throb their ooaee at us? Mtfe *id ^guided polkSafor the put The baa of America's {rwchke aa the 18 *att, QMOgW RM Ukn raore than 50 worifi ftuncW leader h» throe maioi impi- r*neot tfaM ON JapaneM yen ud nore catena. Fto, the Uaked State* MM «urren- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 Senator RIEGLE. But you really haven't said much today that deals with those trend lines. So the only thing I'm left to conclude is you're really not very concerned about them, at least not to the point of saying that there has to be some heightened sense of ur- gency to do some set of policy adjustments and steps to do some- thing about them because right now we're on automatic pilot. The administration is on its way out the door. They have no intention to change the policy mix. The fix is in on the budget. All those sto- ries have been written to sort of take it on through the next year. And these are the curves we're riding and I think you ought to be speaking out about it, quite frankly. Mr. GREENSPAN. Well, let me come to grips with a few of the problems. First of all, as I said before, I'm very much concerned about the issue of the Federal budget deficit. I would just want to point out there is a technical problem on the 3 month over 3 month Federal deficit comparison. My recollec- tion is that a Social Security payment that's usually paid in the be- ginning of January was paid in December, so it snowed up in the first 3 months of the fiscal year and when we see the 4 months through January we don't see that big jump. Nonetheless, I do think it is correct to presume that there will be some modest increase under existing forecasts of the Federal deficit for fiscal 1988 over fiscal 1987 and I think that is unacceptable myself. On the issue of the debt question that you're raising, Senator, I think we have to get the current account deficit down because it's basically the accumulation of the current account deficit which is engendering that net debtor position that you're showing on your chart. There are very few ways in which that can be done. Fundamen- tally, we have to reduce our demand for imports and that almost invariably means domestic consumption has got to slow and, indeed, it is slowing. We have made progress in that respect. Second, exports have to rise and, indeed, they have been rising very significantly. I realize that it is difficult to see how in the world we can get 15 percent increases in physical volume for ex- ports or even any double digit number for a while and have it ab- sorbed in the world economy. But it is true that the aggregate ratio of exports in the world to GNP is still rising. In other words, the market for goods over national boundaries is moving faster than domestic increases in demand. As a consequence of that, when we put a rising forecast in any of our models, we are required to ask where is it going and from whom is it being taken, and we are not at a point where the capac- ity of American exporters to ship abroad on an increasing trend is as yet running into any trouble of the type that you're mentioning. So all I can say, Senator, is that it is absolutely essential that we continue on the path of trying to make our external adjustments as quickly as possible to forestall the types of problems that you raise. If I seem to you to be unconcerned, it's only because we have looked at it in great detail. We know what the dangers are. We know what the nature of the problem is. I think it is an issue of concern, but I think it's far more important for us to focus on how we solve these problems. And I think at the moment we are on the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 road to solving them. I would like to see it done much more quick- ly. I sincerely trust that we don't try to do it through some quick- fix type of program which is very easy for the Congress to react to in frustration. I think that could be very counterproductive and in fact not create the solution to the problem. I have a great deal of sympathy with your concern because I am concerned as well. Senator RIEGLE. But we haven't suffered, I might say, Mr. Chair- man, from any quick fixes, as these charts show. I think we've suf- fered from sort of a no-fix problem and I have heard an awful lot of esteemed economists—and you are certainly among the highest in that rank—keep saying it's all working out, the J curve is taking effect and this thing is going to level itself out and so forth. I think you have an obligation to bring some data in here that shows that and if you can't demonstrate it, I think we're at a point where we need some far more rapid action. And that means we need a far blunter assessment of where we are and adjustments in policy rather than just stay on automatic pilot for another 12 to 18 months here and somehow hope that everything is going to correct itself. The CHAIRMAN. Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. HOUSING STARTS Dr. Greenspan, housing starts for January were at an annual level of 1.4 million units, which, as I'm sure you know, is the lowest level in 5 years. This follows a very low level for December as well, and addition- ally, building permits for January declined by 6.9 percent and building permits are considered to be the most reliable indicator of future housing starts. Now my question is, what are your expectations for housing starts in the year ahead? And I ask that question in this context. The housing industry has traditionally been on the leading edge of the business cycle either up or down and I'd like to know whether you think it's leading us up or leading us down. Mr. GREENSPAN. Well, Senator, I think the December and Janu- ary figures were a bit of an aberration. We always have trouble with those months—and February as well—because the seasonal adjustment factors which we use are very low, largely because of the usual poor weather in the north which makes construction dif- ficult. And while it's very difficult to prove, the implication is that the numbers in December and especially in January were statisti- cally low, meaning that that's not the way the market really was. Moreover, there is some evidence from homebuilders during the month of February of some quickening in the pace of sales of exist- ing homes and some renewed interest in home buying as a result of the decline in mortgage interest rates. To be sure, we don't have the data yet and the month is scarcely over, but there seems to be a somewhat better tone to the market and we would expect that starts will be climbing in the spring and into the summer months. Senator SASSER. So you don't see that as an ominous sign, that these housing starts are at the lowest level in 5 years? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Mr. GREENSPAN. No. I must say I was surprised at both the De- cember and January figures. I did not expect them to go that low. But having evaluated the data, I'm not particularly concerned that it was a trend that should worry us. Senator SASSER. Dr. Greenspan, I serve on the Senate Budget Committee and am aware of this conflict between the Congression- al Budget Office and OMB as to basic economic assumptions. Tradi- tionally—at least in recent years—the OMB assumptions have been overly rosy—when compared with the average of economic predictions. I have more confidence in CBO's numbers, but it's been suggested that the Federal Reserve ought to be the final arbiter be- tween CBO and OMB as to what should be the genuine economic assumptions to be used in formulating the budget. What say you to that, Dr. Greenspan? Mr. GREENSPAN. We thank you for your confidence. However, we would have a technical problem which rests on the difficulty that we would have in forecasting interest rates, because there is no useful budget forecast—whether by CBO or OMB—which does not embody in it their view of where they think interest rates are going. Largely because they do not have an influence on where in- terest rates are going, that is not a particular problem. But because the Federal Reserve by its nature is involved and has considerable influence on interest rates, it is very difficult for us to make fore- casts without creating market instabilities. So that if we were out there to arbitrate between CBO and OMB, we would have to make judgments about their interest rate forecasts. Senator SASSER. But the beauty of that is you could make your assumptions come true. Mr. GREENSPAN. No, I'm afraid it wouldn't because the irony of this exercise is that, if we were to forecast interest rates, the chances are the markets would create an environment which would probably make our forecast wrong. It's a very difficult situa- tion to be in, but it does preclude our capability of adjudicating be- tween OMB and CBO in an effective way. Senator SASSER. Well, I see my time has expired again. Thank you. The CHAIRMAN. Mr. Chairman, many people feel that anybody who runs for President these days is crazy because in the begin- ning of 1989 we're bound to have terrible economic problems and probably a very deep recession and maybe the first depression since the 1930's. If that happens, you could well be right in the middle of it. Some people argue that there's not much Congress or the Presi- dent can do once we move into a very deep recession or depression. What can the Federal Reserve do? They say we should have learned lessons from what the Federal Reserve did wrong in the early 1930's when it decreased the money supply and followed very conservative policies. Is there much that the Federal Reserve Board could do in the next crisis or would you be just pushing on a string, as former Chairman Martin used to say? Mr. GREENSPAN. The problem that I have in answering the ques- tion, Mr. Chairman, is that there are so many different types of severe economic contractions, all of which have differing character- istics with respect to inflation, with respect to financial stress, with respect to bankruptcies and the like, that you can't really general- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 ize in advance on what type of policy the Fed would pursue under those adverse conditions. My impression is that, should that hypothetical event ever occur, I think it would be terribly important for us to be very clear on trying to understand precisely why it occurred and what the par- ticular internal structure of the economy was doing because unless we addressed—as far as our policies were concerned—the specific form of problem that confronted us at that time, we probably could very readily provide the wrong remedy, as indeed was done, in my judgment, in the late 1920's and the early 1930's. So without actually being there and seeing in detail what that structure looks like, I don't think I can effectively answer that question. The CHAIRMAN. Do you have confidence that the Federal Reserve could substantially ameliorate and improve the situation if we went into a recession? MONEY SUPPLY Mr. GREENSPAN. I would certainly hope so. The CHAIRMAN. To get back to the issue that I raised in my open- ing statement, last year the Fed unilaterally dropped the target range for Ml. Now you come before the committee and widen the range for M2 and M3 and don't have any target range for Ml. This Senator very much disapproves of the range that we have. When Chairman Burns came before the committee, I argued with him at great length and pleaded for a single figure not a range. You not only give us a range but you widen the range. The range is now so wide that if you follow the low money growth policy and come in with a 4-percent increase, given the rate of inflation, it's quite conservative; and if you go to the 8 percent, it's very stimula- tive. So the range you give does not tell us anything about what your objective really is. Do you agree? Mr. GREENSPAN. Well, Mr. Chairman, let's take a step back to what these ranges are for and why we want to adhere to them. Our basic goal in monetary policy, as I see it, is to maximize long-term sustainable economic growth and employment in this economy. And as a necessary condition of that, we perceive the need to maintain a non-inflationary environment. What history has told us is that money and prices in the very long run are tied together. They may not be in the short run, but over the very long run they are. What we have observed in history is that if we can maintain some relatively stable set of relationships between money and income we can maintain a stable economy and stable growth and achieve long-term monetary policy objectives. It is important, however, to recognize that the objective is long- term sustainable economic growth and not the proxy, which is the monetary aggregate which we are endeavoring to use as a means— as an instrument to obtain our goal of much broader long-term eco- nomic growth. In the 1980's we began to see that the tie between money as we measured it—the specific proxies, the Mi's, the M2's, the M3's— Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 and real economic growth began to loosen. What we felt necessary to do was to loosen the tie to money because we might follow the proxy, the instrument to achieve our goal, and succeed, but fail in our goal. The best example occurred in recent years. In recent years, eco- nomic growth has been relatively stable. It has not been as high as I think we would like to have seen it obviously, but not bad. The money supply, however, has fluctuated all over the place. Had we endeavored in 1986 and 1987 and even in 1985, for example, to sta- bilize money, we would have probably temporarily distabilized our economy. I think that this condition is temporary. I think it's a function of the whole period of changing markets, deregulation, the tremen- dous extraordinary changes in telecommunications, and the whole structure of the financial system. But I think we're adjusting. Since I firmly believe that money matters, we will at some point find that the monetary aggregates are again tracking very closely with income. At that point it would be wholly appropriate and I think mandatory for us to narrow the target ranges very consider- ably. We would argue that that is inappropriate at present because we think there are special factors such that strict adherence to money—the instrument of policy—would create difficulties in at- taining our goal, which is stable, long-term economic growth. The CHAIRMAN. Then I take it you would object strongly if we were to change the law and require you to report a range of no more than 3 percent. In other words, instead of 4 to 8, it would be narrower—5 to 8 or 4 to 7, for example. You would prefer to wait until you get the kind of resolution you're talking about, is that right? Mr. GREENSPAN. I would certainly think so, Mr. Chairman. I think that it would not be appropriate for the Congress to do that. The CHAIRMAN. Since you ve discarded Ml, suppose we were to ask you then to give us a target rate for the monetary base? Mr. GREENSPAN, Well, strangely enough, we have been discussing the issue of the monetary base as a target amongst ourselves. The problem is that it has many of the characteristics of Ml and the reason it does is that the monetary base very crudely reflects currency in circulation plus commercial bank reserves. And since Ml essentially reflects currency in circulation and demand deposits and other transaction deposits, the only difference between the monetary base and Ml is reserve requirements on the transaction balances which are roughly 12 percent and the fact that there are excess reserves in our total reserve base. So what I'm saying is that the actual arithmetic shows that the monetary base, especially in the current environment, and Ml are very closely related with respect to their targeting characteristics. And my impression is that when Ml comes back into usable target- ing range, so will the monetary base, but I doubt that the mone- tary base itself will be effectively usable until Ml is also usable. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 The CHAIRMAN. I want to follow up on that but my time is up. Senator Chafee. Senator CHAFEE. I don't have any questions. Like everybody else, I've got these terrible conflicts, Mr. Chairman, so I am not able to stay. I apologize for just dropping by but I wanted to look at Mr. Greenspan's statement. Thank you very much for coming up, Mr. Greenspan. [The complete prepared statement of Senator Chafee follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 SPFFCH RY SFHATflR JOHH H. CHAFFE in SFHATF RAMKIHfi CnMMITTF.F FEDERAL RF.SFRVF MONETARY POLICY REPORT (FEBRUARY ?H MR. CHAIRMAN. 1 A*I PLEASED TO WFLCOME CHAIRMAN GREENSPAN BEFORE THE COMMITTEE THIS MORNING. THE ROLE OF THE FEDERAL RESERVF HAS BECOME INCREASINGLY IMPORTANT Iti THE L a S T DECAFF AND WILL BF CRUCIAL IN THE YEARS TO COME. THIS IS TRUE FOR TWO REASONS- FIRST, THE SCALE AND SCOPE OF MONETARY POLICY HAVE RROADFNF.n GREATLY, DI1_E TO THE RIIRGEONINfi INTERNATIONAL SECTOR, ESPECIALLY INTERNATIONAL CAPITAL FLOWS AND TRADE- N 0 LONGFR IS AMERICA A CLOJ.STFRED NATIONJ SPLENDID ISOLATION IS TRULY HfW OF THF PAST. THE FEDERAL RESERVE CAN NO LONGER MERELY CONCENTRATE ON HELPING TO CREATE A LOW INFLATIONARY PATH TO RFAL ECONOMIC GROWTH - IT MOW MUST ALSO WORRY AROIIT THE VALUE OF THE M.S. HOLLAR, A1: A FACILITATOR OF TRADE ADJUSTMENT AND A STORF. OF VALUE TO ATTRACT FOREIGN CAPITAL- SFCOND, THE FEDERAL RESERVE HAS RECENTLY HAD TO SHOULDER A PROBABLY DISPROPORTIONATE SHARF OF THE BURDEN IN BALANCING THF, INTERNAL AND EXTERNAL SECTORS. THIS HAS OCCURRED JUST WHEN ITS ROOM FOR MANEUVER HAS BECOME MORE CIRCUMSCRIBED. ALTHOUGH CONGRESSIONAL EFFORTS TO REDRESS THE FEDERAL RimGFT DEFICIT HAVE RFF.N POS ( T I VE , Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 PROGRESS MUST CONTINUE- Fnp A REDUCED DEFICIT WILL ALLOW FOR INCREASED DOMESTIC SAVINGS AND INVESTMENT AND LFSS DFPENHENCE ON FOREIGN CAPITAL . YOUR DESCRIPTION, C.HAIRMAfl fnRfF.NSPAN, OF AMERICA'S ECONOMIC PERFORMANCE IN 1Q^7 COULD PERHAPS RE LARELFO; "MODIFIED RAPTIIRF"; RUT YOUR CONCERN FOR 1'lSfi [ S WELL WARRANTED ALTHOUGH IT MUST RF A RELIEF NOT TO HAVE Ml THE MOST EAGERLY AWAITED GOVERNMENT FIGURE, YWR VIMLF.NCE TO fWOITt THE REAWAKENING Of INFLATIONARY EXPECTATIONS IS NECESSARY. YoilR MONETARY AGGRFGATE TARGETS REPRESENT YOUR REST ESTIMATE TODAY OF HOW TO ACHIEVE THF TWIN GOALS OF PRICE STABILITY AN1 ECONOMIC GROWTH. YoilR ARILITY TO STAY THAT COURSE, COMBINED WITH CONGRESSIONAL ACTION ON THE BUDGET DFFICIT, PROMISES BENEFITS FOR THIS YEAR flMD REVOND- THESE ACTIONS CAN ONLY HELP AMERICA ACHIEVE GREATER INTERNATIONAL COMPETITIVENESS. I WISH YOU WELL IN THFSE ENDEAVORS. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 The CHAIRMAN. Senator Riegle. Senator RIEGLE. Mr. Chairman, I just want to touch on some- thing that you developed earlier that we kind of went by in a hurry but I think ought to be touched on just for a moment and then I want to go into a different area myself. FISCAL STIMULUS VERSUS MONETARY STIMULUS When you engaged in that colliquy on the question of fiscal stim- ulus versus monetary stimulus and real interest rates and so forth, in effect, what I understood you to say was your interpretation of what Dr. Greenspan is saying is that if you could somehow get con- sumption down, maybe have higher taxes that led to lower real in- terest rates, that you could actually get an expansion of the econo- my and that you might in fact be able to make supply side econom- ics work with lower interest rates and, in a sense, monetary stimu- lus rather than this reliance we've seen over such a long period of time on just fiscal stimulus. If in fact anybody wants to advance that theory, I think that be- comes a very interesting concept to look at, and that is that if you're stuck with very high real interest rates that may be the thing that's limiting your growth at this point, a real spurt in growth, more than anything else. I heard Dr. Greenspan in effect say some of that today and I would be very interested myself in finding a way through this set of problems to lower real interest rates. I think that really is the key to the kind of surge that we have to make, not just by itself because we've got to jack up savings rates and we've got to get the investment going into things that improve productivity and capital formation—but lower real interest rates, it seems to me, would give us the biggest single economic surge that we could get out of the sort of monetary-fiscal policy mix, and that has not been discussed, has not been focused, but I think your observation hit on that today and I think it does open up a different way to look at this problem. I want to raise one other thing with you related to that and test it a little bit. What would happen right now, Dr. Greenspan, if the Fed acted to try to bring interest rates down? Let's say the Fed were to meet and decide that it should try under the current situa- tion to bring interest rates down, say, a full percentage point by means of using all of the internal mechanisms that the Fed has available to it with money supply and so forth? I assume that you would feel that you can't just arbitrarily push interest rates down, say, a full percentage point because you decide you want to do it or a percentage point and a half, but I'd like you to address that. If real interest rates are high, what really limits the Fed right now from embarking on a strategy that would force those interest rates down more abruptly, and if you tried to do that, what would be the problems that we might encounter? Mr. GREENSPAN. Well, let me first emphasize we're discussing a hypothetical case. Senator RIEGLE. I understand. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 Mr. GREENSPAN. You have problems if monetary policy endeav- ors to move in a manner which the markets are working against— and this would be true whether or not you try to lower rates or raise them. Take the case in which, let's say, we forced the funds rate down by 1 or 2 percentage points, which we could do. What would happen if the market were not prepared for that and in fact felt that was an inappropriate rate? Money supply would rise very sharply, inflation expectations would jump immediately, long-term interest rates—rather than following the short-term Federal funds rates down—would go up, and we would find ourselves in a situa- tion in which inflation would likely be taking hold and we would get a tremendously disruptive economy. This similar exercise would be occurring on the opposite side if interest rates were raised 1 or 2 percentage points against trends that were developing in the markets. This is the reason why we say it is so important to coordinate policies and in effect to set interrelationships to get the type of result we desire. Senator RIEGLE. May I pursue this just for 1 minute? The CHAIRMAN. Yes. Senator RIEGLE. A lot of people go back and they look at the market break on October 19 and 20, and they point to a lot of things that seem to have built up to create the change in psycholo- gy and the very sharp plunge in the market, the greatest crash in percentage terms that we'd ever had before. I find very persuasive the argument that says that the interest rate spike on long interest rates that occurred as the market was approaching on October 19, that that sudden rise in long-term rates and the very high price- earnings ratios that we had in the stock market and the widening out of the gap between the interest rate spread versus in a sense the multiples that the market was supplying created a tremendous amount of stress. If that were right, that would in a sense support the kind of an argument that you're making and that is that if in- terest rates suddenly shoot up because of inflationary expectations or because there's the perception that the Fed is flooding money in to the system unwisely and interest rates go up, you can start to see a lot of shuddering and shaking in the capital structure. I think we've just seen an example of it. We might see it again. The reason 1 pose the question—and it relates to what the chair- man has been saying and others of us have been saying today—and that is, I get the sense that the Fed doesn't have an awful lot of maneuvering room right now and, despite your adeptness in terms of managing our way through the market crash and assuming that job as you have over the last several months, that the operating range of the Fed to go very far one way or the other isn't very great and the Fed is quite hemmed in and the Fed is really quite hemmed in because of these charts that I was describing earlier. We've had a buildup of circumstance over a long period of time that I think is taking your maneuvering room down to a danger- ously small margin, in my view. Those are my words. I don't try to put those words into your mouth. But I am very uncomfortable that the maneuvering room on monetary policy has been reduced to such a small level and it worries me because it goes back to the earlier discussion—we've played the fiscal policy strategy—I think Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 the Government has gone wild in that area, and now we're to the point where we've got to balance that back the other way, move in the direction of finding how we push real interest rates down so we can get an authentic surge into our basic economy, but it seems to me we're very much out of position. You and I may have a differ- ence of opinion there because I have not heard a very persuasive case made today that says that all we really have to do is just enjoy this nice smooth transition that we're in the process of making. I don't see that happening and I think we need an active set of policy adjustments and that we need somebody like yourself speaking to that problem if that's so, and that if we talk ourselves into the notion that we can go on automatic pilot for the next 12 to 18 months because we've got an administration leaving after 8 years and a new administration coming in in the early part of 1989, that that would be a very serious miscalculation, although I think that's what's happening. I think that the view is now let's not rock the boat. Let's just ride it on through and hope for the best, although privately in the cloakroom, as the chairman will say, everybody says whoever the next President is going to be, he's going to have a very tough job at that time because a lot of these problems are just being postponed. I don't know if we can find a way to make some policy adjust- ments during this year but we should try and I want to try and I will work with you and anybody else that's willing to work to try to find a different mix to give us more maneuvering room and get us out of this I think box canyon that we've gotten into. Thank you, Mr. Chairman. ECONOMIC REPORT BY PRESIDENT CRITICIZES THE FED The CHAIRMAN. Mr. Chairman, the economic report the Presi- dent published a couple of weeks ago holds the Fed policy in the months before the stock market crash partly responsible for the market's precipitous decline. Do you agree or disagree? Mr. GREENSPAN. I disagree, Mr. Chairman. The CHAIRMAN. Why? Mr. GREENSPAN. I think that what we were looking at at the time—and I would say I subscribe to Senator Riegle's view about the effective interest rates at that time—we were confronted then by a worldwide rise in interest rates, which struck me as essential- ly reflecting a flight from currencies generally. It was an extraordi- nary period. What essentially was driving the yield-spread differentials was the 30-year Treasury bond yield, which I must say we had great difficulty understanding on a day-by- day basis at that time. I made a very extensive analysis and had many discussions with my col- leagues at various central banks around the world and a number of economist friends of mine, and I must say to you I never really fully understood—at least to my satisfaction—precisely what the driving forces for that worldwide rise in interest rates were. In my judgment, the Fed could have done very little to prevent that from happening at that time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 The CHAIRMAN. Certainly on any kind of a basis, any kind of ex- perience, the market was selling at 23 times earnings—this is ex- traordinarily high, regardless of the level of interest rates or the pattern of interest rates. Mr. GREENSPAN. Yes, I would agree with that, Mr. Chairman. What I'm saying is that even if that last surge in long-term rates did not occur, I think the market would have topped out and come down anyway because it had reached levels which in historic terms usually signaled some form of top. So I find it difficult to perceive how actions by the Federal Re- serve were a material factor in the market when, as best I can judge, there were so many other issues which would have driven the market down in any event. In other words, no matter what we did, in my judgment, the market probably would have come down at some point and probably in much the same way it did. And if one can say that, then it's very difficult to say that we had a mate- rial effect on it. The CHAIRMAN. Let me ask one final question. You said that Ml and the monetary base are closely related. Furthermore, you say that Ml was unstable in the 1980's and should not be a target. You implied that the monetary base should not be a target. Wasn't the instability in Ml related to the interest-sensitivity to deposits such as NOW accounts which are not included in the mon- etary base and to the fact that reserves and/or currency become very unstable in the 1980's? Mr. GREENSPAN. Well, in effect, Mr. Chairman, the interest sensi- tivity that affects demand deposits affects total required reserves obviously, because to the extent that we have required reserves for demand deposits they are in the total reserve number and, there- fore, in the total monetary base. So while it is true that it is somewhat less sensitive than Ml, it nonetheless captures most of the problem, largely because the vola- tility in transaction deposits as a consequence of interest sensitivity causes a virtually fixed relationship between required reserves for transaction deposits. What we find is that we mirror that instabil- ity in Ml in the required reserves part of the monetary base. The CHAIRMAN. But you can control required reserves. You can control the monetary base. Mr. GREENSPAN. Sure, we can. I'm saying that. Nonetheless, it would create the same degree of problem that would occur were we to try to control Ml. I don't deny that if we were absolutely forced to that we could get Ml to stay within a specific narrow range. My concern, however, is that there are occasions when trying to do that would destabilize the economy. The CHAIRMAN. That's exactly right. I think that perhaps there's a misunderstanding at least between you and me on what these target ranges mean. I don't think a target range means you have to meet it. I don't think that your success or failure depends upon whether you meet the range. I don't think that should ever be the case. You certainly should have flexibility. You have to have it. What we want to know is, at the beginning of a period, what you feel should be the policy and then, of course, as conditions change, if you have to modify it then you can explain why. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 So I would hope that you would consider that monetary base sug- gestion as a possibility. Thank you. Senator RIEGLE. Could I ask just one more question, Mr. Chair- man? The CHAIRMAN. Certainly. FOREIGN INVESTMENT Senator RIEGLE. I don't know if you saw Malcolm Forbes' editori- al in an issue a few weeks ago to the effect of him expressing a great concern about foreign investment in the United States, about these recycled dollars, money that used to be ours now belongs to somebody else, coming back in and picking off strategic assets of various kinds, as apart from coming in and building a manufactur- ing plant and so forth. Mr. GREENSPAN. Was he saying strategic in a national security sense? Senator RIEGLE. Well, that would have been part of it, the ques- tion of whether they were coming in and picking off a high technol- ogy company or an electronics company or somebody who's defense sensitive, but also financial services. The point he was making was broader than just that and it addressed real estate and other things. Do you have any concern at all about this money coming back in in terms of this increasing foreign investment of that kind in the United States? Mr. GREENSPAN. No, with the sole exception of national security secrets, which is a different category. What's happening is that we're shifting ownership from American to foreign. The corpora- tion remains American, it remains under our laws. It is subject to the same taxes. It is subject to all the other considerations that an American-owned organization would have. So in that sense, I'm not concerned about the form of the ownership. I think, strangely enough, there is a difference as far as these policies are concerned between whether the ownership is in real terms—that is owning real estate or a company—and owned in liquid-asset terms. The liquid-asset holding that is the external li- ability of financial claims raises a number of the issues that you raise with respect to our policies and our financial instability. But once those monies are committed to real assets, they are no longer that liquid and capable of being shifted around. And provided that the owners adhere to the laws of this land, these are creators of jobs and these are creators of prosperity. Remember that the United States was a major investor in West- ern Europe after World War II and, in my judgment, those vast in- vestments were a major factor engendering the extraordinary re- covery in Europe. We created jobs. We created technology. We cre- ated standards of living there, and I don't think we should look askance at others investing here. I mean free trade, in my judg- ment, the movement of goods and services, enhances everybody's standard of living and the free movement of capital does the same for much the same reasons. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 Senator RIEGLE. Well, Malcolm Forbes, who I would think prob- ably describes himself as a raving capitalist and is a real believ- er Mr. GREENSPAN. He's a good friend of mine. Senator RIEGLE. I know he is and when somebody like that, as opposed to a Felix Rohatyn or Robert Rice, speaks out because they are concerned about it, I think it's a significant piece of data and I've heard this from a lot of other people who would share Malcolm Forbes' general vantage point who are now concerned about this from the point of view where they see other implications to it; that if you've got mercantilist nations that are very predatory in their trading practices and you can document that, who are loaded with dollars and they come in and pick off choice assets, not just the people who design the black boxes for the Defense Department but other strategic industries—high technology, computer chip type in- dustries and so forth—that gives them a degree of operational con- trol in this country that's quite different than we have perhaps seen before and sometimes they can shut down certain things. If you're looking at a worldwide marketing scheme and a worldwide business scheme, the degree to which you do or don't produce part of that output in the United States is part of a much larger corpo- rate multinational strategy and very often a nationalistic strate- gy—what's good for the people who are domiciled in another coun- try. I think this is now an issue that we need to look at very careful- ly. I think Malcolm Forbes is not just seeing shadows on the wall here. I think this issue is now one we'd better take a look at be- cause of the charts I was describing earlier. We've put so much of our wealth, if you will, in other hands. We've gone from being a creditor to a debtor. We've exchanged equity capital for consumer goods and now the other person has taken title to the equity and they're lending it back to us in a debt form, and we're in an entire- ly different posture than we were before. And I don't think it is the same old story that we've seen in the Marshall Plan days. I wish it were. But I would like to urge the Fed to take a look at that and see if the view that some major people in the private sector are beginning to express apprehension about this has something more to it that we'd better understand while we still have some chance to do something about it. Thank you, Mr. Chairman. The CHAIRMAN. Thank you very, very much, Chairman Green- span, for a superlative performance. We're in your debt. Mr. GREENSPAN. Thank you very much. The CHAIRMAN. The committee stands adjourned. [Whereupon, at 12:05 p.m., the hearing was adjourned.] [Response to written questions of Senators Proxmire, Sasser, and Sanford follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 Chairman Greenspan's Responses to Written Questions from Chairman Proxmire in Connection with the Bearing Held on February 24, 1988 Question 1. In your written testimony, on page 6, you state: "Indeed, indications of some softening in the economy as the year began, against a backdrop of a more stable dollar in foreign exchange markets, led us to take a further small easing step a few weeks ago." Some will insinuate that the Fed's ease was acquiescence to pressure from the Reagan Administration rather than good policy. To clear the record would you please give us a precise description of the economic factors that were the most prominent influence in your decision to pase? What indications of softening in the economy did you see? Answer: As you know, the decline in the stock market and buildup in business inventories last fall were key causes for some, concern about weakness in the economy in the first part of 1988. In addition, monetary growth was weak in the latter part of 1987. During January, the incoming news gave some indications that, indeed, we might be moving toward a narked slowdown in production growth. Among the indicators were a substantial jump in initial claims for unemployment compensation and weak figures for housing activity. Fears of possible recession were re- flected in a good many private forecasts, and this kind of thinking obviously carried risks of a self-fulfilling prophecy if business decisionmafcer.1? became too gloomy. Meanwhile, inflationary pressures seemed to be in check, with favorable near-term prospects for energy prices in particular. In addition, the dollar was exhibiting greater Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 stability on exchange markets; the weakness in the dollar in the latter part of 1987 had militated against a greater adjustment in System policy to compensate for the risks to the economy associated with financial fragility in the aftermath of the stock market break. Under the circumstances prevailing in early 1988, we felt it appropriate to move to reduce modestly further the pressures on the reserve positions of depository institutions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 Question 2. Many including myself are concerned by the growth of debt in our economy. Debt to GNP ratios for all classes of borrowers have risen to very dangerous levels. Doesn't this limit the ability of the Federal Reserve to con- tract credit without causing widespread default on credit obligations? In the 1980's the ex-post real interest rate has exceeded the real GNP growth rate on average. Doesn't this imply that the debt to GNP ratio must rise? Answer; We do need to be concerned, in general, that the highly levered positions of many businesses and households might make them more vulnerable to adverse economic or financial developments. So, I share your concern about this pattern of developments over the course of the 7980s. There were some hopeful signs in the deceleration of debt growth last year, and I would hope to see that trend continue. Your observations about the arithmetic of interest rates and GNP growth is correct up to a point, but it abstracts from all considerations other than interest payments on the debt. Consider, for example, the case of the federal government alone: If the interest rate were above the GNP growth rate and the current primary deficit (that is, the total deficit, less interest payments net of the taxes paid on that interest) were zero or positive, your formula would tell us correctly that the government debt to the GNP ratio would rise; however, if there were a sufficiently large primary surplus, the ratio could be stable or declining. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 Question 3. There appear to be two schools of thought on exchange rate policy. The first group says let the dollar fall and fall a lot in a hurry. Then investors will clamor to buy dollars and U.S. interest rates will actually decline. This school claims that if we let the currency decline a great deal the expectation will be that it can only rise. They point to the experience of devaluations during the fixed exchange rate period when the rule of thumb was if you are going to do it don't undershoot. The second school believes that a gradual managed decline of the dollar is necessary because in a floating ex- change rate world expectations are unstable and a rapid fall in the dollar would create the expectation continue depreciation leading to high interest rates and an exchange rate collapse. It appears to me that a key question in exchange rate management is how actions today affect expectations of exchange rate changes in the future. Do you agree? Which of these schools of thought has the story right? Why is the right one right and the wrong one wrong? Answer; The comparison between a devaluation under a fixed exchange rate regime and a depreciation under a floating rate regime is not a simple one. In a fixed exchange rate regime, the monetary authorities of a country declare a discrete change in the currency's parity (and intervention limits). Under the Bretton Woods regime, where parity changes were very infrequent, it can fairly be stated that the rule of thumb was to make sure that the change was large enough to avoid a wide- spread expectation that a further change would be needed soon. Even so, parity changes by major industrial countries rarely were as large as 15 percent. Within the European Monetary System (EMS), where parity changes are more frequent, the changes have been smaller, generally 5 percent or less. And the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 operative rule of EMS devaluations in the 1980s has been to "underdo it" so as to maintain an anti-inflation pressure on economic policy in the higher inflation countries. Under both Bretton Woods and the EMS, parity changes required the agreement or acquiescence of the other members of the regime. Under neither system could monetary and fiscal policy among the part- ners move drastically out of line so as to build up enormous external balances; macroeconoraic policy was constrained by the agreement to maintain fixed exchange rates. Under the floating rate regime enormous imbalances were allowed to build up in the 1980s since there was no prior agree- ment to focus economic policy mainly on the exchange rate. By 1985 an international consensus had been reached that the dol- lar's exchange value was too high, but there was no agreement on how much too high. Nor is there any consensus now on the dollar's long-run equilibrium value. The purpose of the February 1987 Louvre Accord and the reaffirritation in December 1987 was to give the U.S. and foreign economies time to adjust to the cumulative substantial depreciation of the dollar that had already occurred, while recognizing the uncertainties of where the dollar's long-run equilibrium value may lie. The Federal Reserve's concern over a precipitous dollar decline has not been that the dollar would fall to zero under the influence of extrapolative expectations, but that a huge Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 decline over a very short period could disrupt financial markets generally and would certainly subject the economy to severe inflationary pressures in an environment in which still large budget deficits are making substantial net claims on our resources. The economic function of the dollar's depreciation has been to induce expenditure switching from foreign to U.S. output so as to adjust an unsustainable current account deficit. But in the context of an economy near full employment, this means that domestic absorption has to be restrained by macroeconomic policy to make room for the increase in export demand if we are not to incur an acceleration of inflation. In a context of slow reductions of the budget deficit to slow domestic spending, the faster the current account ad- justment iSjthe greater the burden on monetary policy to curtail private domestic spending. Indeed, a precipitous fall in the dollar and a very rapid adjustment of our current account deficit would require a draconian monetary tightening to reduce private spending if we were to contain total demands on the economy's resources. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 Question 4. Real interest rates have been unusually high in the U.S.in recent years. Arc real interest rates in the U.S. higher than in those countries with which it competes internationally? What are the causes of high real interest rates in the U.S.? Do you foresee real interest rates declining in the near future? What changes in public policy would help to lower real rates of interest? Answer; Real interest rates are defined as the difference between nominal interest rates and expected infla- tion. Because expected inflation cannot be measured directly, neither can real interest rates. T_f real rates are calculated assuming that expected inflation can be adequately represented by actual inflation over the immediate past, rates in the United States now are well within the range of values for major indus- trialized countries. These rates are considerably higher than in the late 1970s, when their very low level contributed to rising inflation. But they are lower than earlier in the 1980s, when restrictive monetary policy was needed to bring down infla- tion and fiscal policy was unusually expansionary. Lowering real rates further probably would require that the United States generate additional savings internally to meet our investment needs, rather than depending on foreign capital inflows. The most direct and dependable approach to this would be to lower the federal budget deficit. Although some reduction in the budget deficit has been achieved, the deficit remains quite large considering the prolonged expansion of the economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 Further reductions in the deficit, by increasing national sav- ings, would provide downward pressures on real rates and encour- age rrmch-needed capital formation. Question 5. In 1987 the Federal Reserve Board appeared to tighten monetary policy several times to arrest the decline in the exchange value of the dollar. The Fed's monetary base growth decelerated in February, May-June, and in August- September before the stock market collapse. In each of those time periods the dollar was skittish. Why not just let the dollar decline and pursue a steadier course with monetary growth? Wouldn't letting the dollar fall further cause a fall in our huge trade deficit by reducing U.S. imports, and pro- moting our exports? Answer; In the spring and the late summer of 1987, it was widely perceived--by the Federal Reserve and the market-- that inflationary expectations were increasing, partially in response to the dollar's weak performance. With the economy expanding at rates sufficient to produce rising rates of re- source utilization, the FOMC sought some firming of pressures on reserve positions and the discount rate was raised in September. It is critical that the risk of inflation be controlled and that resources be available in our economy to accommodate a shift In demand toward net exports. Otherwise, a further de- cline in the dollar's value would be counterproductive. It would not help significantly to reduce our external imbalance, but it would tend to weaken foreign growth and to exacerbate inflationary pressures in the United States. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 88 -10- Question 6. Privately many people are suggesting that the U.S. economy is going to be put into a severe recession by policymakers in 1989 just after the Presidential election. Some suggest that this is the only way to reduce the trade deficit. Does the Federal Reserve intend to contribute to putting the economy into a recession in 1989 by tightening money after the election? Are there not some very adverse consequences asso- ciated with a prolonged recession given the condition of Latin American debtors, farmers, banks, S&Ls and businesses with such high levels of debt? Does not that limit the extent of a reces- sion that policymakers could tolerate before easing up to alle- viate these maladies? Is not further exchange rate depreciation the alternative to reducing absorption by inducing a recession? Why not encourage continued growth and let the dollar fall rather than force the economy into recession? Answer: The Federal Reserve does not view a recession as being necessary to reduce the trade deficit or as being desirable in any way. Indeed, the real trade deficit has been shrinking steadily since the third quarter of 1986, albeit from an extraordinary size, over a period when the U.S. economy has been expanding at a quite satisfactory pace. The turnaround in trade was one of the princip.il contributors to U.S. economic grovth in 1987. We are optimistic that the balance of trade will continue to improve in 1988 and beyond. The effects of the drop in the dollar's value that began in 1985 do not appear, as yet, to be fully reflected in the terms of trade or, consequently, in imports and exports, but these effects should continue to unfold in coning months. The process of international adjustment is a challenging one. Achieving a better external balance without Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 increasing inflationary pressures will require a restrained pace of expansion of domestic demands. Surh restraint could best be obtained by limiting federal spending and the budget deficit, which would increase our savings and put downward pressures on interest rates, helping to sustain capital formation. This would be entirely consistent with continued expansion in our economv. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 -12- Question 7. Over the last decade economists' estimates of the so-called non-accelerating inflation rate of unemployment (NAIRU) have varied considerably. Large changes in demographic factors and sectorial dislocation may have provided good reason for these varying estimates over time. In recent months the estimates have been declining. What is your estimate of NAIRU for today and for the near future? Do you believe that the current declines in the unemployment rate imply that inflation will accelerate? Could not the presence of foreign competition increase the discipline of wage demands in light of the possi- bility of losing business to competitors offshore? Have not real wages in the United States been falling in recent years? Ts this the result of the influence of foreign competition? Answer: It should be kept in mind that the concept of the NAIRU is open to question; it is typically identified with a particular formulation of wage determination (the "expectations-augmented Phillips curve"), which may not capture all significant aspects of behavior. Even within that general analytical framework, empirical estimates of the NAIRU vary considerably among researchers. It is fair to say that most analysts believe that the NAIRU has teen declining in recent years. It is my assessment that we probably have not yet reached the level of unemployment--of general labor market tightness — that will spell a significant increase in real wage inflation. One factor in this is, as you suggest, the awareness on the parts of labor and business that the competitive reali- ties of the domestic and international marketplace will not permit cost increases to be passed through readily to prices. In effect, last year's decline in real wages is consistent with the painful fact that the reversal of the earlier runup in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 foreign exchange value of the dollar implies a deterioration in terms of trade, which must be inevitably reflected in our purchasing power. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 Question 8. Governor Johnson, in a speech at the Cato Institute in February, suggested that the Federal Reserve is now watching three new indicators in setting monetary policy: 1) the term structure of interest rates; 2) the exchange value of the dollar; 3} the price of commodities. Please discuss what variations in each of these individual indicators would imply about economic developments and how monetary policy would be used to respond to the signals sent by the indicators. Answer; Exchange rates, commodity prices, and the spread between long- and short-term interest rates are just three of the many financial and nonfinancial indicators used by the Federal Reserve to assess where the economy is headed and the effects of monetary policy. They have been among the im- portant types of information the Federal Reserve has been looking at for some time, but as confidence in the relationship of the money supply to the economy has eroded in recent years, many policymakers have been paying greater attention to other indicators — including the three cited. Interpreted together and with information provided by other variables, the three indica- tors help in the assessment of whether an adjustment of policy is needed to achieve ultimate objectives for employment and prices. Changes in these variables can reflect shifts in supply/demand balances in our economy and market expectations about prices and activity — important information for monetary policy formulation. For example, a widening of the yield Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 -15-/6" spread, a fall in exchange rates, and rising commodity prices could signal the potential for a stronger economy and potentially a pickup in inflation. A narrowing in the yield spread, a stronger dollar, and weakness in commodity prices could indicate the potential for a slowing in economic activity and possibly disinflation or deflation. How policy might react to these signals would depend on whether the trends were con- firmed by other information and whether they were considered unfavorable to the economy. For example, indication of greater strength expected in the economy would be viewed quite dif- ferently in a recession then if the economy were near full employment and in.-'lation a more immediate threat. The need for looking at a number of indicators together arises from the possibility that any one of them may be subject tn a variety of influences that could result in inappropriate policy signals. Commodity prices, for example, can reflect developments in particular markets and represent only a small component of overall business costs; the exchange rate is in- fluenced by developments overseas as well as in the United States; and the yield curve is influenced by expectations about Federal Reserve policy and shifting valuations of liquidity, as well as the outlook for the economy and prices. Even so, all three of these, when used with care, can convey to the policy- maker important information about market expectations and supply and demand conditions not only in the narrow markets in which they are determined but in the overall economy as well. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 Question 9. In your testimony you suggested that the monetary base had been considered as a target for monetary policy in light of the decision to drop Ml targets in the report to Congress. You also suggested that it was not desirable to target the monetary base. (a) Please provide the Committee with a history of the velocity of the monetary base from 1960 to January of 1988. How does the variability of base velocity compare with the variability of the velocity of Ml? (b) Please provide the Committee with data on the variability of the components of the monetary base from 1975 to the present. How does the variability of these components compare with the variability of components of Ml that are not included in the monetary base? (c) Why do you oppose establishing the monetary base as a target in lieu of the Ml target that was dis- carded last year? Answer: (a) As you know, the monetary base consists of the monetary liabilities of the Federal Reserve and the Treasury. There are two publicly available measures of rhe monetary base, one constructed by the Board and the other by the Federal Reserve Bank of St. Louis, with differences between the two measures reflecting mainly alternative treatments of vault cash. The discussions below focus on the base measure con- structed by the Board, after adjustments for changes in reserve requirements and seasonality. As measured by the Board, the base is the sum of total reserves (adjusted for changes in reserve requirements), the currency component of the money stock, and a small residual item equal to the surplus vault cash of depository institutions — that is, vault cash in excess of reserve requirements. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 Table 1 presents quarterly velocity data for the monetary base and Ml for the period 1960:Q1 through 1987:Q4, both in levels and in growth rates. Since velocity is calcu- lated as the ratio of GNP to money, velocity data are available only on a quarterly basis — the frequency at which GNP is measured. Statistics summarizing the variability of base and Kl velocity (measured as the standard deviation of velocity growth rates) are shown in Table 2 for the period 1960:Q1 through 1987:Q4, and for subperiods of this interval. The table indi- cates that over the 1960s and 1970s the variability of base velocity and variability of Ml velocity were about the same, but that over the 1980s the variability of Ml velocity nearly doubled while that of base velocity rose by considerably less, leading to a substantial increase in the variability of Ml velocity relative to that of the base. The greater variability of Ml velocity compared with base velocity over the 1980s reflects two factors: (1) that the currency component of Ml accounts for a much greater share of the base (roughly three-quarters) than of Ml (about one- quarter), and (2) that most of the increased variability in Ml velocity in the 1980s, relative to the 1960s and 1970s, can be traced to components of Ml other than currency. As shown in Table 3, the variability of the velocity of transaction deposits Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 -19- in 111 (the sum of demand deposits and other checkable deposits), which account for about three-quarters of Ml, increased sharply in the 1980s. In large part, this heightened volatility re- flected greater fluctuations in interest rates as well as the nationwide authorization of NOW accounts and other financial deregulation that increased the sensitivity of this component to movements in interest rates and to shifts in the portfolio preferences of the public. In contrast, the variability of currency velocity was little changed in the 1980s compared to earlier periods. The increased variability in transactions deposits is reflected in greater variability of the reserve components of the base. But the greater share of currency and smaller share related to deposits in the base has tended to damp the increase in the variability of base velocity relative to that of Ml. (b) Table 4 summarizes the variability of base and Ml growth rates, and the variability of components of these aggre- gates, for the period 1975rQl through 1987:Q4 and for subperiods of this interval. The table indicates that quarterly growth rates of the base tend to be appreciably less variable than those of Ml. This relationship reflects mainly the large share of the base accounted for by currency, which tends to grow more smoothly than transaction deposits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 -20- (c) The Federal Reserve does not necessarily oppose establishing growth targets for the monetary base. This issue is currently being considered within the System. We are at- tempting to evaluate whether the establishment of such targets would enhance the Federal Reserve's ability to achieve its policy goals or our ability to convey our policy intentions to the public. This involves questions about the value of the base as a forerunner of economic developments and whether its move- ments add to the information already in the broad aggregates. In large part, the base is closely related to Ml, with different weights on the various components. The heavy weight given to currency in the base significantly affects its characteristics as a policy target. For one, as noted above, its velocity is considerably less variable than that of Ml. A second charac- teristic, however, arises from the policy of the Federal Reserve, since its founding, to accommodate the public's demand for currency. Targeting the base together with accommodating currency demand would imply that, if demands for currency were weak or strong, offsetting increases or decreases in reserves might be needed, leading to multiple expansion or contraction of deposits; this could have important effects on interest rates. In any event, regardless of whether it is deemed advisable at some future date to establish monetary base growth targets, it seems likely that monetary policy would need to remain flexible Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 and that movements in all the monetary aggregates would still need to be evaluated within the broader context of other infor- mation about developments in the economy and in financial markets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 Table 1 Selected Velocity Measures Monetary Base Ml Growth Rate Growth Rate of Velocity of Velocity (annual! zed (annual! zed Period Velocity percentaae) Velocity percentage) 1960:Q1 3.689 12.1 11.966 11.8 1960:Q2 3.685 -0.4 11.931 -1.2 1960:Q3 3.674 -1.2 11.964 1.1 1960:Q4 3.642 -3.5 11.834 -4.4 1961:Q1 3.655 1.5,. 11.940 3.6 1961:Q2 3.702 5.1 12.192 8.4 1961:Q3 3.754 5.7 12.354 5.3 1961:Q4 3.810 6.0 12.491 4.4 1962:Q1 3.875 6.8 12.711 7.0 1962:Q2 3.902 2.8 12.778 2.1 1962:Q3 3.954 5.4 12.867 2.8 1962:Q4 3.956 0.2 12.850 -0.5 1963:Q1 3.979 2.3 12.918 2.1 1963:Q2 3.996 1.8 12.960 1.3 1963:Q3 4.040 4.4 13.070 3.4 1963:Q4 4.060 2.0 13.114 1.3 1964:Q1 4.130 6.9 13.273 4.9 1964:Q2 4.157 2.7 13.297 0.7 1964:Q3 4.156 -0.1 13.301 0.1 1964:Q4 4.132 -2.3 13.222 -2.4 1965:Q1 4.238 10.3 13.535 9.5 1965:Q2 4.289 4.8 13.642 3.2 1965:Q3 4.336 4.3 13.767 3.7 1965:Q4 4.386 4.6 13.960 5.6 1966:Q1 4.446 5.5 14.187 6.5 1966:Q2 4.455 0.6 14.195 0.2 1966:Q3 4.546 8.2 14.300 3.0 1966:Q4 4.609 5.6 14.469 4.7 1967:Q1 4.615 0.5 14.418 -1.4 1967:Q2 4.587 -2.4 14.354 -l.fl 1967:Q3 4.583 -0.4 14.433 2.2 1967:Q4 4.5B7 0.4 14.443 0.3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 100 Table 1 (continued) Selected Velocity Measures Monetary Baae Ml Growth Rate Growth Rate of Velocity of Velocity (annual! zed (annual!zed Period Velocity percentage) percentage) 1968:Q1 4.666 6.9 14.672 6.3 1968:Q2 4.715 4.2 14.855 5.0 1968:Q3 .712 -0.2 14.858 0.1 1968:Q4 .683 -2.5 14.816 -1.1 1969:Q1 .720 3.2 r . 14.996 4.8 1969:Q2 .754 2.9 15.073 2.0 1969:Q3 .831 6.5 15.244 4.6 1969:Q4 4.832 0.1 15.114 -3.4 1970:Q1 4.831 -0.1 15.115 0.0 1970:Q2 4.669 3.1 15.106 -0.2 1970:Q3 4.695 2.2 15.144 1.0 1970:Q4 4.624 -5.8 14.928 -5.7 1971:Q1 4.945 10.1 15.276 9.3 1971:Q2 4.931 -1.2 15.258 -0.5 1971:Q3 4.935 0.3 15.219 -1.0 1971:Q4 4.947 1.0 15.252 0.9 1972:Q1 5.020 5.8 15.504 6.6 1972:Q2 5.071 4.1 15.614 2.6 1972:Q3 5.079 0.6 15.716 2.6 1972:Q4 5.117 3.0 15.817 2.6 1973:Q1 5.207 7.1 16.022 5.2 1973:Q2 5.270 4.8 16.122 2.5 1973:Q3 5.312 3.2 16.131 0.2 1973:Q4 5.414 7.7 16.292 4.0 1974:Q1 5.373 -3.0 16.102 -4.7 1974:Q2 5.448 5.6 16.068 -0.8 1974:Q3 5.510 4.5 16.078 0.2 1974:Q4 5.545 2.5 16.154 1.9 1975:Q1 5.540 -0.4 16.035 -2.9 1975:Q2 5.599 4.3 16.181 3.6 1975:Q3 5.719 8.6 16.546 9.0 1975:Q4 5.850 9.? 16.S03 6.2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 101 Table 1 (continued) Selected Velocity Measures Monetary Base Ml Growth Rate Growth Rate of Velocity of Velocity (annualized (annualized Period Velocity percentage) percentage) 1976:Q1 5.953 7.1 17.040 5.6 1976:Q2 5.964 0.7 16.979 -1.4 1976:Q3 e.on 3.1 17.038 1.4 1976:Q4 6.058 3.2 17.174 3.2 1977:Q1 6.097 2.6,. 17.362 4.4 1977:Q2 6.211 7.5 17.658 6.8 1977:Q3 6.301 5.8 17.822 3.7 1977:Q4 6.261 -2.5 17.727 -2.1 1978:Q1 6.288 1.7 17.698 -0.7 1978:Q2 6.498 13.3 18.307 13.8 1978:Q3 6.537 2.4 18.390 1.8 1978:Q4 6.643 6.4 18.643 5.5 1979:Q1 6.711 4.1 18.754 2.4 1979:Q2 6.738 1.6 18.867 2.4 1979:Q3 6.702 -2.1 18.942 1.6 1979:Q4 6.748 2.7 18.811 -2.8 1980:Q1 6.886 8.2 19.000 4.0 1980:Q2 6.990 6.0 18.658 -7.2 19BO:Q3 0.819 -9.8 18.739 1.7 1980:Q4 6.902 4.9 19.090 7.5 1981:Q1 7.179 16.0 19.752 13.9 1981:Q2 7.149 -1.6 19.689 -1.3 1981:Q3 7.224 4.2 19.963 5.6 1981:Q4 7.171 -2.9 19.876 -1.8 1982:Q1 7.039 -7.4 19.497 -7.6 1982:Q2 7.109 4.0 19.478 -0.4 1982:Q3 7.005 -5.9 19.254 -4.6 1982:Q4 6.608 -11.3 19.049 -4.3 1983:Q1 6.756 -3.1 18.917 -2.8 1983:Q2 6.770 0.9 19.012 2.0 1983:Q3 6.727 -2.5 19.063 1.1 1983:Q4 6.818 5.4 19.251 3.9 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 102 Table 1 (continued) Selected Velocity Measures Monetary Base Ml Growth Rate Growth Rate of Velocity of Velocity (annualized (annualized Period Velocity percentage? percentage) 1984:Q1 6.961 B.4 19.447 4.1 1984:Q2 7.000 2.3 19.503 1.2 1984:Q3 7.020 1.1 19.444 -1.2 1984:Q4 7.035 0.9 19.412 -0.7 1985 :Q1 6.980 -3.1 19.368 -0.9 1985:Q2 6.898 -4.7' 19.262 -2.2 1985 :Q3 6.774 -7.2 19.132 -2.7 1985:Q4 6.694 -4.7 19.007 -2.6 1966:Q1 6.658 -2.1 16.971 -0.8 1986:Q2 6.465 -11.6 18.716 -5.4 1986:Q3 6.277 -11.6 18.488 -4.9 1986:Q4 6.049 -14.6 18.094 -8.5 19B7:Q1 5.976 -4.7 17.974 -2.7 1987 :Q2 5.971 -0.5 17.942 -0.7 1987:Q3 6.065 6.3 18.030 2.0 1987:Q4 6.112 3.1 18.001 -0.6 1. Board of Governors concept. This measure is seasonally adjusted and adjusted for regulatory changes in reserve requirements. Table 2 Variability in Quarterly Growth Rates of Selected Velocity Measures (percent, annual rates) Standard Deviation of Growth Rates Monetary Base HI Period Velocity Velocity 1960:Q1-1987:Q4 4.2 5.2 1960:Q1-1969:Q4 3.6 1970:Q1-1979:Q4 3.9 3.8 1980:Q1-1987:Q4 4.6 7.0 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table 3 Variability in Quarterly Growth Rates of Selected Velocity Measures (percent, annual rates) Standard Deviation of Growth Rates Memo: Monetary Currency Component Total Residual Memo: Transaction Deposits Period Base of Ml Reserves Item Ml in Ml 1960:Q1-1987:Q4 4.2 4.0 6,.9 30.2 5..2 6..1 o CO 1960:Q1-1969:Q4 3,.5 3,.3 6,.1 29.7 3..6 3..9 1970:Q1-1979:Q4 3..9 4..1 5,.2 26.4 3..8 4.1 1980:Q1-1987:Q4 4,,6 4..1 7,7 33.5 6.9 8.6 1. The residual item is surplus vault cash of depository institutions less that part of the vault cash holdings of thrift institutions that is already included in the currency component of Ml. Although growth rates of the residual and its velocity are quite volatile, the absolute level of the residual is relatively small, about $3 billion currently compared with about $260 billion for the entire monetary base. 2. Sum of demand deposits and other checkable deposits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table 4 Variability in Quarterly Growth Rates of Selected Monetary and Reserves Aggregates (percent, annual rates) Standard Deviation of Growth Rates Memo: Monetary Currency Component Total Residual Memo: Transaction_Deposits Interval Base of Ml Reserves Item Ml in Ml 1975:Q1-1987:Q4 1.7 1.5 6.3 27.6 4.7 6.3 1975:Q1-1979:Q4 1.4 0.9 3.9 15.7 2.5 3.3 1980:Q1-198T:Q4 1.9 1.6 6.5 31.9 5.5 7.5 1. The residual item is surplus vault cash of depository institutions less that part of the vault cash holdings of thrift institutions that is already included in the currency component of* Ml. Although growth rates of the residual and its velocity are quite volatile, the absolute level of the residual is relatively small, about $3 billion currently compared with about $260 billion for the entire monetary base. 2. Sum of demand deposits and other checkable deposits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 105 Question 10. A recent Federal Reserve press release (for the FOMC meeting of December 15-16, 1987, page 10) referred to "fiscal, monetary, and trade policies by the United States and its major trading partners" that are appropriate to the realignment of the U.S. economy called for by the "unsustainable size of the current trade deficit and the rapid growth in the nation's external indebtedness." GNP data show that real ex- ports have grown recently more quickly than consumption. What further changes in the U.S. economy do you believe necessary to deal with the problem of the trade deficit? What fiscal and monetary policies do you consider desirable to pro- mote the realignment? What actions would we like the U.S.' trading partners to take to further the necessary adjustments in the U.S. and the world economies? Answer: We have a long way to go in restoring our external position to a sustainable posture. It will require continued effort to enhance the efficiency of our productive processes and the quality of our goods, and continued restraint on prices. Monetary and fiscal policies in the United States must be aimed at noninflationary growth of aggregate activity, which likely will entail a considerably slower increase of con- sumer spending than we saw earlier in the present economic expansion—so that resources will be available to support gains in net exports. Our trading partners, in contrast, must work to ensure adequate, growth of domestic demand in their economies. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 106 -23-24-- Question H. In the Wall Street Journal for Tuesday, February 23", Edouard Balladur, the finance minister of France, referred to the "anarchy of floating exchange rates" during the past 15 years. Several well-known analysts now recommend that the international financial system needs reform. Others dis- agree . In the Fed's estimation, how urgent is reform of the international financial system? Answer: Calls for reforming the international monetary system stem primarily from dissatisfaction with the wide swings in exchange rates that have occurred in recent years. However, the complexities of negotiating a new international monetary system would be immense. The issue of reforming the interna- tional monetary system has been studied repeatedly over the past 20 years in various international fora, and no political, con- ceptual, and operational consensus has emerged about the need and manner of restructuring the international monetary system. In practice, modifications in selected aspects of the international monetary system are likely to evolve through pragmatic adjustments in current arrangements. In recent years, policymakers in the major economies have concluded that there is no substitute for sound, compatible, non-inflationary policies by all major countries on a sustained basis as the most promis- ing way to achieve and maintain greater exchange rate stability. Ongoing efforts to strengthen the process of international policy coordination, as evidenced by the Louvre statement of February 1987 and the G-7 statement of last December, are directed at reinforcing this pragmatic approach to achieving greater exchange rate stability. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 107 Question 12. Many financial firms, particularly those in Texas and other energy producing and agricultural states, are currently undergoing trauma. Their survival is threatened. Do you consider that the resources of the FDIC and FSLIC funds are adequate to deal with the problems of these institutions? What do you believe is the correct public policy to deal with this situation? Answer: Many thrift institutions and commercial banks have run into serious difficulty over the current decade, re- sulting in substantial losses to the federal deposit insurance funds. The problems of the thrifts have been particularly acute relative to t.he resources of the Federal Savings and Loan Insurance Corporation (FSLIC). The large number of troubled thrift institutions, principally in Texas and California, has put a particularly severe strain on the resources of the FSLIC. Given the added resources to be obtained from the recent recapitalization of the insurance fund and the continued inflow of insurance premiums from insured institutions, the FSLIC now appears to have suf- ficient funds to permit it to begin to address many of the more serious problems in the industry. The FSLIC will undoubtedly require a further injection of capital to complete the process of resolving the problems in the thrift industry. As for the Federal Deposit Insurance Corporation (FDIC), it, too, has incurred substantial costs in resolving the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 108 -7.6- problems of troubled commercial banks—most recently, in par- ticular, in the State of Texas. In the case of the FDIC, how- ever, it managed to build up its insurance fund over the early part of the decade and thus, given the current level of the fund and prospects for a continued inflow of insurance premiums from commercial banks, it appears that it remains strong and will have sufficient resources to resolve existing and new problems that may arise in the industry. FDIC Chairman William Seidman has stated recently that the insurance fund remains healthy and is more than adequate to address the problems he foresees this year. The FDIC and the FSI.IC were established by the Congress for the express purpose of dealing with insolvent commercial banks and thrifts. As a matter of public policy, it would seem appropriate to continue to address problems in the thrift and commercial banking industry through the auspices of their offices . Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 109 Chairman Greenspan's Responses to Written Questions from Senator Sasser in Connection with the Hearing Held on February 24, 1988 Question 1. We have seen an extraordinary decline in the value ofthe dollar over the past year. In previous times, such declines in our currency value have been accompanied by rises in prices, in inflation generally. Imported goods become nore expensive and at the same time it gives a window to domestic producers to increase prices also. Why haven't we seen dramatic increases in import prices and resulting inflation? Are foreign suppliers being cautious about increasing prices — trying to preserve their market shares? Answer: There are basically two phenomena working to Unit the rise in import prices following the sharp declines in the dollar. First, production costs for foreign exporters have tended to decline, in terms of their own currencies, as prices of imported raw materials and intermediate goods have declined and as domestic prices and wages have been quite stable. Second, as you suggest, foreign exporters have been reluctant to allow their prices in the United States to rise by the full amount of the dollar's decline. In an attempt to preserve their market position as much as possible, they have preferred to see an erosion of their profit margins, which had been built up substantially over the period of the dollar's rise from 1980 to 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 110 Question 2. As you know, the central bankers of the major western countries have developed a plan to raise the capi- tal of banks dealing in international markets. By 1992, banks would have to have minimum capital of 8 percent of assets, of which 4 percent would have to be common equity and disclosed reserves. This is obviously a very good idea—capital is the best cushion against loss and the best protector of the safety and soundness of the banking system that there is. Well 1992 is only five years away and there are a great many of our banks that are pretty far away from meeting this standard. Will they make it? The recent GAO study on the repeal of the Glass-Pteagall Act says that bank holding companies that are undercapitalized have incentives to take risks that could threaten the insured bank. "Our work has shown that solvent thrifts with capital below 3% of assets tend to undertake more risky activities than do their well-capitalized peers." Indeed, the GAO is worried that the shakiest banks might be the first to take advantage of the repeal of Glass-Steagall. Do you agree that capital is the best firewall? I understand that under the Chairman's bill, S. 1886, a bank holding company has to have excess capital to have a securities affiliate. Wouldn't it nake sense to set the capital level even higher if banks get into the securities business, would it nake sense to speed up the implementation of this international capi- tal agreement? If we tied securities powers to bank capital it would be an incentive for banks to get their capital up, don't you think? Answer: Most regional and community institutions already meet or exceed the proposed capital standards by a com- fortable margin—both the interim ratios specified for 1990 and the somewhat higher ratios targeted for 1992 and beyond--and so do more than half of the large multinationals. Some of the organizations that will have to increase their capital ratios to meet the standards may find that difficult to do but we believe that, by concerted effort, most, if not all, will be able to accomplish that end over the specified phape-in period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ill With regard to undercapitalized banks being the first to take advantage of the repeal of Glass-Steagall, that is not a reasonable concern, S. 1886 specifies that bank holding com- panies will be permitted to engage in securities activities, not previously authorized for banks, in a newly established nonbank subsidiary only after obtaining the approval of the Federal Reserve Board. And, the Act prohibits the Board from granting such approval to banking organizations that do not have suf- ficient resources to adequately capitalize the securities affiliate and, at the same time, meet the capital standards set down for banking organizations. The bill also provides that a member or nonmember bank, whether it is owned by a bank holding company or independently operated, may not be affiliated with a company that engages in securities underwriting activities ex- cept as provided under the new securities affiliate provisions of S. 1886 or to the extent permitted by statute for national banks. As for the appropriate capitalization of banking organizations that wish to own a securities affiliate, it is important to keep in mind, in addressing that question, key provisions of S. 1886. Certain provisions, referred to above, require that a banking organization wishing to own a securities affiliate must be able to capitalize it in accordance with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 112 standards set down for securities firms and also meet the capi- tal standards for banking organizations, without counting the capital invested in the affiliate. Other provisions (that establish a so-called firewall) prohibit insured depositories in a holding company from lending to or investing in the securities affiliate and place other restrictions on transactions and arrangements between the securities affiliate and other elements of the holding company. The purpose of all these provisions is to protect insured depositories of holding companies from losses occurring at their securities affiliate and to gain assurance that a bank holding company will be able to serve as a source of strength for its banks and other insured depositories. Because of the requirements for separate accounting for capital in the securities affiliate and the firewall specified in S. 1886, it appears appropriate that capital standards for banking organizations be set, as contemplated by S. 1886, with- out regard to whether an organization has a securities affili- ate. Moreover, there would appear to be no reason to alter the timetable for implementing the risk-based capital standards for banking organizations simply because they are given the au- thority to establish securities affiliates. In this regard, S. 1886 provides that a bank holding company may not engage in underwriting certain corporate securities unless all of its subsidiary banks are in compliance with any applicable risk- based capital standards. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 113 Question 3. Would you please address the recent Louvre Accord on exchange rates. How do you think it is working? Does this indicate that there is a much greater level of interna- tional macroeconoraic cooperation taking place today than there was in the past. Does this give you hope that we will begin to make greater progress on the trade and budget deficits? Answer: Following the Louvre Accord of February 1987 and again following the G-7 statement this past December, the exchange value of the dollar experienced a period of relative stability. Such stability is welcome. It reflected mutually supportive economic policy actions in the United States and in other major countries, especially last spring, and more recently the recognition of progress toward reducing the U.S. trade and budget deficits. The increased degree of international cooperation in recent years and the role that has played in achieving exchange rate objectives are noteworthy. However, the ongoing process of cooperation should not obscure the underlying need for indi- vidual countries to pursue appropriate policies. In the case of the United States, a key element is that we make further pro- gress in reducing our federal budget deficit. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 114 Question 4. Commentators on the current fiscal deficit point out that a sizable portion of those deficits were incurred to finance corporate cash flow in the form of investment incen- tives provided in the 1981 tax bill (primarily accelerated depreciation). They also point out that subsequently investment in new plants and equipment declined while mergers, acquisi- tions, leveraged buyouts and buybacks skyrocketed. These investment incentives were cut back in the 1986 bill but we'll be paying for them for years to come. Some people argue that these transactions that we are financing with the deficit benefit very few people. Moreover, the deficit itself, or rather the debt, is owned by very few people. According to the Treasury, 71% of the "debt is held by 2% of U.S. households. And U.S. taxpayers are paying the owners of the debt billions o£ dollars annually in interest. Is there any way to increase the number of people that participate in this process—make ownership more widespread. I happen to think that our capital raising process would be stronger if more participated. What about ESQFS? Answer; Broad ownership of business clearly is a concept that is consonant with our economic system; it can, as you suggest, contribute to a strong capital raising process and sounder financing for our firms. I think we must be careful about utilizing tax gimmicks to encourage particular forms of investment, for they can easily cost a good deal of revenue for modest net effects. Perhaps the most important focus for policy would be to do more to remove the incentives firms now have to rely heavily on debt as opposed to equity finance. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 115 Question 5. Last Friday, Senators Proxmire, Sanford and I wrote, to you and expressed our concern about a trend that could be developing—hostile takeovers of banke. I think the najnr question in this is how it would affect the capital posi- tions of banks that are not in the best of shape anyway. In the corporate sector we have seen in the last few years an enormous number of highly leveraged hostile takeovers. If these take- overs spread to banking where many institutions are already highly leveraged against inadequate capital, it could compound existing problems, When the Federal Reserve reviews an application from a bank holding company to acquire another bank or bank holding company, capital adequacy is probably your number one concern. Correct? Do you think that the combined effect of a trend of hostile bank takeovers, and repeal of Glass-Steagall, could lead to fewer and larger financial services organizations? (I recog- nize that there are some merger limits in the Proxmire bill.) What about the combined effect of a trend toward hostile bank takeovers and the dropping of the states' restric- tions against interstate banking? What effect will that have on comnunity-oriented banks? Answer: The Board has indicated that it will apply the same financial standards in evaluating applications contested by management as it applies to negotiated mergers and acquisitions. The Board's basic policy is that banking organizations contem- plating expansion proposals maintain strong capital positions and that there should be no significant diminution of financial strength below these levels to effect major expansion proposals. Thus, as a condition of approval, the Board may require the newly combined organization to increase its capitalization above pre-acquisition levels within a reasonable period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 116 Contested acquisitions and other negotiated mergers, in part fostered by the lifting of restrictions on interstate banking, will no doubt lead to fewer and larger financial organizations. Indeed, there is already a well-established trend in this direction. To date, however, there does not seen to be an undue level of concentration in major banking markets. In fact, the number of competitors in the banking industry is still large relative to the number of competitors in most other industries. Moreover, the very changes that have accelerated the trend toward bank mergers and acquisitions also appear to have in- creased the level of intra-industry competition. For example, the removal of legislative barriers to intrastate and interstate banking which paved the way for consolidation also induced highly competitive organizations to expand into markets by open- ing new branches, establishing ATM networks, and acquiring and revitalizing marginally competitive institutions. In many cases, the new entrants brought added capacity, better service, and more attractive pricing in an effort to gain market share. As a result, competition intensified and the consumer benefited. The provision of financial services by nonbank firms also mitigates the need for concern about impact of consolida- tion within the banking industry on competition. Over the past decade, the industry's competitive position has been challenged Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 117 on many fronts. Thrift institutions have been competing more aggressively with banks, and competition from foreign banking institutions, credit unions, money market mutual funds, and other nonbank firms has intensified. In short, consolidation has reduced the number of competing commercial banking organizations and increased the concentration of commercial banking assets at larger organiza- tions. But it is far from clear that these changes have re- sulted in any lessening of competition! in fact, the intensity of competition appears to have increased. Finally, it is important to note that many community- oriented organizations have been able to meet this competitive- challenge and maintain their market positions as well as reasonably acceptable profit margins. Given their performance to date, there would appear to be no reason why community bank- ing organizations cannot continue to survive and, indeed, thrive in the years ahead. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 118 -10- Questlon 6. On pp. 6-7 you outline generally the steps the Fed took following October 19. I think the role of the Fed and its effect is a little understated. You say "the System temporarily altered its focus somewhat." It's been the impres- sion of at least some of us that the intervention was more dramatic. You say "we encouraged some decline in short-term interest rates ..." Well, the federal funds rate dropped from 7-1/2 percent to 6 percent in a day or two. I was wondering if you could review the situation again with the Committee from a monetary policy standpoint. How much liquidity was supplied to the system by the Fed following October 19? How did the Fed's response compare to normal operating procedure--how much more money was supplied? Over how long a period did the intervention last? What have been the effects in the rest of the economy? On the dollar? On inflation? Answer; The Federal Reserve provided liquidity temporarily following the stock market collapse to meet extra demands for reserves arising from two sources. One was an en- hanced demand for excess reserves by depository institutions; the other was an increased demand for required reserves to back higher levels of demand deposits and NOW accounts. In addition, the Federal Reserve undertook a measured easing of overall re- serve pressures as the balance of risks in the economy shifted in the aftermath of the crash. This easing was not as great as might have been inferred from the levels of federal funds trad- ing on particular days, which might be subject to a variety of influences. On a statement week average basis, the federal funds rate fell from 7.6 percent during the week of October 14 to 7.0 percent in the October 28 week and to 6.4 percent during the following week. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 119 Reserve needs were met through open market operations in the form of daily repurchase transactions in the market from October 20 through November 2. These operations were undertaken more frequently than usual, in order to quell market fears. The maturity of the repurchase agreements (RPs) ranged from over- night to four days, and on several days the Federal Reserve entered the market earlier than normal to reassure markets of our intentions. The unusual demands for liquidity reversed in November as the market atmosphere calmed somewhat, and the Federal Reserve open market operations accommodated the reduced demand for reserves. Trading in the federal funds market settled down in the f-3/4 percent area in the latter part of the year. There are several measures that can be used to gauge the extent of the Federal Reserve's reserve provision after the stock market decline of October 19 and its subsequent reversal. One is nonborrowed reserves—these are the reserves that are available to depository institutions without going into the discount window and are the most direct reflection of our open market operations. These reserves rose by $800 million to $58.3 billion in the two-week reserve maintenance ending November 4, the first period following the crash. They fell by around S600 million to $57.4 billion over the subsequent two maintenance periods in the latter part of the year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 120 -12- Another view of our operations can be had from looking at "net free reserves", which is the excess of reserves we sup- ply in nonborrowed form over that depository institutions need to back deposits, in the November 4 statement period, these rose to SI, 275 million from $440 million the previous two weeks, also indicating a more generous stance of reserve provision. Net free reserves dropped off to average $630 million in the next two maintenance periods. The. response of the Federal Reserve seems to have helped prevent the shock from the stock market crash from spreading throughout the financial system. Extreme fears and the accompanying demands for liquidity quickly abated. Concerns about a recession have now eased, and economic growth has continued. The decline in short-term interest rates after October 19 did place limited downward pressure on the value of the dollar, by making short-term investments In the U.S. slightly less attractive. However, the decline in the dollar was halted early this year, and in any case it did not seem to adversely affect inflationary expectations, given concerns about the economy. In fact, inflationary expectations appeared to diminish following the stock market collapse owing to the pos- sibility of a period of economic weakness or even recession caused by the drop in wealth and confidence. As the economic Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 121 expansion has been seen to be continuing at a good pace, these expectations are no longer declining, but the moderate easing by the Federal Reserve since October 21 is not expected to add to inflation pressures in our economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 122 Chairman Greenspan's Responses to Written Questions from Senator Sanford in Connection with the Hearing Held on February 24, 1988 Question 1. The U.S. Treasury is supporting a case-by-case, market-driven, menu-approach to the international- debt crisis as part of the Baker Plan. An important feature of the Plan is economic restructuring by the debtor countries in- volved, with the privatization of government enterprises a high priority. One means of privatizing while at the same time reducing the debt is through debt-to-equity swaps. A Presidential Task Force on Project Economic Justice recommends that LDC debt be restructured to encourage swaps which include employees through part-ownership of the privatized companies through stock ownership plans (ESOPs). As a regulator of the banking system, do you see any means by which we can encourage ESOPs in debt-to-equity swaps? Answer: ESOPs are useful vehicles to encourage employee participation in the success of their employer company. It would appear that ESOPs would be readily accepted only where there is broad public acceptance of the concept of private ownership of stock. The menu of options developed by the Administration includes encouraging lesser developed countries to adopt policies that will promote development of market- oriented practices in those countries. As these policies are implemented, there may be greater acceptance of private owner- ship of corporate stock and a concomitant growth in the establishment of ESOPs. With respect to establishment of ESOPs by foreign companies in which banking organizations invest through debt- for-equity swaps, the Board does not direct or dictate the business practices of these companies. It is the Board's policy that, consistent with any measures necessary to protect the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 123 banking organization's safety and soundness, the foreign com- panies in which a banking organization invests should be able to compete with other companies on an equal basis. Such companies should not be required to offer benefits that may disadvantage them vis-a-vis their competitors. If it becomes useful to pro- vide for employee participation in management or ownership in order to attract and retain employees, companies owned by U.S. banking organizations would no doubt establish ESOPs and would not be restricted from dnine so. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 124 Question 2. As you well know, a great de.al of attention is being paid to the growing level of foreign invest- ment in the U.S. along with our growing foreign indebtedness. Rome believe that foreign investment is beneficial in that it provides much needed capital for economic restructuring and industrial revitalization. Others believe that it surrenders control over our industrial base and drains our financial re- sources. What is your view of the role of foreign investment? Is there a maximum desirable level? If so, have we reached it? Given our propensity to deficit spend, coupled with the attractiveness of the U.S. to foreign capital for both economic and political stability reasons, is it indeed possible to reduce our deficit and our dependence on foreign capital? In other words, if we were to eliminate our budget deficits, wouldn't that make the U.S. an even more attractive site for foreign investment? Answer: When a nation runs a trade and current account deficit as we are, there must be a capital inflow of some sort to "finance" it. As you note, this inflow has taken the form not only of net borrowing from abroad, but also of equity in- vestments by foreigners in U.S. business. At this juncture, I think we should fake a generally positive view of such invest- ment; we are far from the point of foreign domination of American industry, and in many instances the foreign participa- tion offers the potential for the transfer of valuable techno- logical and organizational expertise that will aid our economy. You are correct in suggesting that success in eliminating our budget deficits would bolster the confidence of foreigners in our ability to manage our economic affairs, and this might--all other things equal--encourage investment in the United States. But other variables would change as well, and I Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 125 think the evidence suggests that, in the end. the restoration of better fiscal balance would be compatible — indeed, would foster — greater external balance. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 126 Question 3. Many economists believe there is a strong possibility of a recession beginning in 1989. If the LDC debt problem continues to be addressed as "business-as-usual", what will be the impact of a U.S. recession on debtor nations? What are the implications to U.S. banks holding large third world debt portfolios and the U.S. banking system? Another troublesome aspect of the third world debt problem has been capital flight, much of it winding up in the U.S. What can we do to encourage the return of capital for productive investment in the debtor nations from which it originated? Answer; The Federal Reserve does not now foresee a recession in the United States in 1988 or 1989, though we would be foolish to pretend we have perfect insight into events two year from now. However, in the event of a U.S. recession, or more importantly for debtor countries, a recession in industrial countries generally, the heavily indebted countries would be affected in several ways. On the one hand, a recession in industrial countries is likely to result in reduced demand for exports from developing countries and in a decline in commodity prices. This would adversely affect the balance of payments and growth prospects of developing countries. However, in a reces- sionary environment, world interest rates would likely fall and, as a result, interest payments on the external debt of develop- ing countries would fall. This would strengthen the balance of payments of developing countries with large amounts of floating rate debt. On balance, the net result would depend on the indi- vidual borrowing country's circumstances. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 127 The U.S. banking system would be adversely affected by a recessionary environment because the quality o£ its loan portfolio — including domestic and international loans—would tend to deteriorate. However, given the strengthened capital position of the U.S. banking system in recent years, it is now in a better position to withstand shocks that are either domes- tic or foreign in origin. Better policies in developing countries are the key to encouraging the return of flight capital. In particular, appro- priate exchange rate and interest rate policies, by providing a stable, investment climate, will help encourage residents of developing countries to repatriate capital that they have placed abroad. 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 1988 THURSDAY, FEBRUARY 25, 1988 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, Dixon, Garn, Heinz, and Hecht. OPENING STATEMENT OF CHAIRMAN PROXMIRE The CHAIRMAN. The committee will come to order. I want to thank you for your excellent statement. We look for- ward to your views of the Fed's policies. They are most helpful to us as we conduct our oversight responsibilities. International considerations have been of vital importance to this country's monetary policy in recent months. There are cur- rently great divisions of opinion concerning the appropriate level of the foreign exchange value of the dollar. With large trade surplus- es in Japan, West Germany, and Taiwan and an enormous current account deficit in this country it is hard to resist the temptation to let the dollar fall to address the problem. On the other hand, many believe that the dollar has fallen enough already, or at least it has fallen as much as it can in a short period of time without causing a recession in the countries whose currencies rise against the dollar. Many of those countries are already suffering from very high levels of unemployment and further exchange rate pressure could put them into a recession that feeds back on this country as well. A related problem is the impact on the domestic economy when monetary policy is used to defend the dollar. Some, including the Council of Economic Advisers, have suggested that monetary policy was too tight in 1987 because of efforts to defend the dollar and that tight monetary policy significantly contributed to the stock market crash in October. A third concern derives from the large accumulations of debt owed to foreigners as a result of our persistent large current ac- count deficits. Owing large amounts of debt to foreigners, who are quite sensitive to exchange rate fluctuations, appears to significant- ly alter the tradeoffs that our central bank faces when setting mon- etary policy. A look at the data for 1987 suggests that the Fed slowed the growth of the monetary base whenever downward pres- (129) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 130 sure on the dollar developed. Perhaps there is more truth than I would like to admit in economist Albert Bressand's witty remark that "the United States now has two central banks, the Federal Re- serve and the Japanese life insurance companies." Our ability to devote monetary policy to purely domestic economic consideration is compromised by the importance of foreign creditors. Finally, the effect of our monetary policy on the Latin American debtor nations is a source of concern. A rise in interest rates in- creases the cost of debt service, slows our economy and reduces our ability to import from those debtor nations. When we need to tight- en monetary policy to arrest inflationary pressures the ability of debtor nations to pay debt service to our banks is reduced. That in turn may have significant domestic repercussions. These international challenges posed for our monetary authori- ties are here to stay. I look forward to hearing our witnesses' views in this vital area of national interest. Before we start, I have statements for the record from Senators Dixon and D'Amato. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 131 FEBRUARY 25, 1988 STATEMENT OF SENATOR ALAN DIXON SENATE BANKING COMMITTEE OVERSIGHT HEARING ON THE CONDUCT OF MONETARY POLICY MR. CHAIRMAN, I AM PLEASED TO BE HERE THIS MORNING AS THE BANKING COMMITTEE CONTINUES ITS SEMI-ANNUAL MONETARY POLICY OVERSIGHT HEARINGS AS MANDATED BY THE HUMPHREY-HAWKINS ACT. WE HAVE A DISTINGUISHED GROUP OF WITNESSES BEFORE THE COMMITTEE TODAY, AND I LOOK FORWARD TO THEIR TESTIMONY. AT THE OUTSET, I WANT TO SAY THAT I WAS DEEPLY CONCERNED BY CHAIRMAN GREENSPAN'S TESTIMONY YESTERDAY ON THE EXTENT OF THE POLITICAL PRESSURE THE FEDERAL RESERVE IS GETTING FROM THE ADMINISTRATION ON ITS CONDUCT OF MONETARY POLICY. I THINK IT IS VITALLY IMPORTANT TO HAVE A SOUND, COORDINATED MONETARY AND FISCAL POLICY. THIS ADMINISTRATION, HOWEVER, HAS GIVEN US BIGGER FEDERAL DEFICITS THAN ALL OF ITS PREDECESSORS COMBINED, AND THAT Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 132 Page 2 FACT CLEARLY HAS TO ADD TO THE DIFFICULTIES THE FED FACES IN TRYING TO ACHIEVE THE KIND OF MONETARY POLICY THAT MAINTAINS THE CONDITIONS FOR SOUND ECONOMIC GROWTH WHILE NOT REKINDLING THE INFLATIONARY FIRES THAT WERE DAMPENED AT SUCH GREAT COST. IF THE CRITICISM OF THE FED IS AN ATTEMPT BY SOME IN THE ADMINISTRATION TO DIVERT ATTENTION FROM THEIR OWN STEWARDSHIP OF THE FEDERAL BUDGET, I CAN TELL THEM NOW THAT IT WILL NOT WORK. THEY WOULD BE MUCH BETTER ADVISED TO BEND THEIR EFFORTS TO SEE THAT THE EXECUTIVE BRANCH IS POING EVERYTHING IT CAN TO REDUCE THE TERRIBLE TWIN TRADE AND BUDGET DEFICITS THAT SO JEOPARDIZE OUR ECONOMIC FUTURE. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 133 STATEMENT OF SENATOR ALFONSK M. D'AMATO FEBRUARY 25, 1988 EACH OF THF, EXPERT WITNESSES BEFORE THE COMMITTEE THIS MORNING ARTICULATES THE DILEMMAS FACING BOTH THE FED, THE TREASURY AND THE CONGRESS REGARDING THE HEALTH OF THE U.S. ECONOMY. AT A TIME WHEN WE ARE EXPERIENCING THE AFTER SHOCKS OF A HUGE MARKET CORRECTION, A VOLATILITY IN THE VALUE OF THE DOLLAR, A TRADE BILL WHICH CAN HAVE MANY DETRIMENTAL EFFECTS ON THE U.S. AND WORLD ECONOMY. I BELIEVE THAT THE CONGRESS SHOULD PUT ASIDE PARTISAN DIFFERENCES AND WE SHOULD WORK WITH OUR ALLIES TO PROMOTE U.S. ECONOMIC GROWTH, WHICH TO A LARGE PART IS DEPENDENT UPON GLOBAL ECONOMIC GROWTH. TODAY'S WITNESSES RECITE THE LITANY OF DILEMMAS FACING THE NATION. ALTHOUGH THESE DILEMMAS HAVE CREATED A CLIMATE OF EXCEPTIONAL UNCERTAINTY, I BELIEVE THAT THE AMERICAN PEOPLE, AND PERHAPS THE REST OF THE WORLD IS LOOKING TO THE CONGRESS OF THE UNITED STATES FOK SOLUTIONS. THE SOLUTIONS TO THE ECONOMIC PROBLEMS CONFRONTING THE U.S. AND GLOBAL ECONOMIES ARE NOT EASILY IMPLEMENTED, NOR ARE THEY SHORT TERM IN NATURE. UNDERSTANDING THIS WE SHOULD BEGIN TO LOOK AT SOME LONG-TERM PROPOSALS SO THAT WE WON'T BE CONFRONTED WITH SIMILAR ECONOMIC DILEMMAS 10 YEARS FROM NOW. EACH OF OUR WITNESSES HAS PROVIDED SOME GUIDANCE WITH REGARD TO BOTH LONG-RUN AND SHORT- TERM SOLUTIONS. IN THE SHORT-TERM, THE FED IS IN A BETTER POSITION TO DEAL WITH ECONOMIC GROWTH THROUGH ITS CONDUCT OF MONETARY POLICY. HOWEVER, THE LONG-TERM SOLUTIONS CAN ONLY BE DEVISED AND IMPLEMENTED BV THE CONGRESS - THIS IS A RESPONSIBILITY WHICH WE CANNOT LIGHTLY TAKE. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 134 The CHAIRMAN. I'm going to ask each of you gentlemen if you would to confine your oral remarks to 10 minutes or less. We have had a chance to see your statements in advance so, we will proceed alphabetically. That's about as democratic—I like that word—an approach as we can have. So we will start with Dr. Barbera, who is the chief economist Shearson Lehman Hutton in New York. My eldest son works as a broker for Shearson Lehman. I'm very proud of the way he's done and the way the organization has done. So go right ahead. STATEMENT OF ROBERT J. BARBERA, CHIEF ECONOMIST, SHEARSON LEHMAN HUTTON, NEW YORK, NY Mr. BARBERA. Thank you, Mr. Chairman. As you said, I am Robert J. Barbera and I am the chief economist of Shearson Lehman Hutton. I would like to add that I did sit over there as a legislative assistant for economics for Paul Tsongas for several years while you were chairman. It is very interesting to sit on this side of the dais. I would like to frame my testimony in terms of answering four questions. First, were Fed officials compelled to tighten in the spring and fall of 1987? Can the Fed be held largely accountable for the October stock market crash? Was the Fed's dramatic swing toward ease immediately after the October crash appropriate? Is current Fed policy, with a slight tilt toward ease, in keeping with the Fed's disinflation bent or is the November election pre- venting the U.S. central bank from returning to its precrash bias toward tightening? TIGHTENING OF INTEREST RATES To briefly summarize my answers to these questions, I believe that consistently faster than expected U.S. economic growth in 1987, alongside bouts of rising commodity prices, dollar weakness and the flight of foreign capital from the United States, impelled the Fed to raise short-term interest rates and validate the tighten- ing of interest rates that market forces generated during these pe- riods. Had U.S. spending been reined in by budget cuts in 1987, Fed action may have been less severe, but fiscal policy moves to tighten have been most modest, leaving the job of slowing U.S. spending largely to the Fed. The second leg up for short rates in November on the heels of decidedly disappointing U.S. trade data announcements made in the summer and was to an important degree an attempt by the Fed to counteract dollar weakness. The October crash reflected not just the new higher rate structure, but, importantly, the announcement of an extraordinarily disappointing trade number in mid-October. I think the Fed then really is much less accountable for that crash than was the continued deterioration on the trade side. Once stocks crashed in the United States and quickly moving abroad, the Fed had no options. The safety and soundness of the U.S. financial system was ensured by the prompt and dramatic pro- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 135 vision of liquidity by the U.S. central bank. That infusion of liquidi- ty and the consequent sharp fall in the Fed funds was essential. Currently however, with risks to the financial system dimin- ished, the Fed appears to be tilting toward an easier policy again. Some see this as a case of election engineering. I see it as a re- sponse to a world different in two important ways from 1987. First, significant leading indicators of the U.S. economy have begun to falter. Second, the world and the Fed have been blessed by two de- cidedly better than expected trade announcements, which generat- ed a U.S. dollar bounce. Were the Fed to continue to tighten in the fact of weakening leading indicators, recession would be the clear risk. And given growing evidence that the U.S. advance right now is export-driven and therefore likely consistent with an end to the one-way—down—dollar market, recession seerns absolutely inap- propriate, election in November or not. The two tightening moves in 1987 were, in part, explicable simply based upon real economy variables: faster price increases for commodities; sharp gains for U.S. industrial activity; and rapid growth in employment. This committee, however, should also understand that bouts of dollar weakness which we saw in 1987 unquestionably also helped force the Fed to be firm. Why? Because U.S. financial markets—the markets that finance U.S. economic activity—now depend upon foreign capital. To keep that capital inflow voluntary and therefore preserve well functioning capital markets, foreigners need evidence that these inflows are temporary, or at least receding. Fed tightening, by slowing U.S. spending, promises slower import flows, better trade numbers, and, therefore, less foreign capital need in the future. The last page of my printed testimony includes some sober arith- metic. If you grant me excellent trade improvement—that is trade improvement well above what econometric models would look for— a $125 billion trade deficit this year falling to $30 billion in 1992, and the accumulated net capital need from abroad totals to $500 billion, ownership of $Va trillion of U.S. assets will be handed over to foreigners. I think that's a staggering figure, but if trade were to fail to im- prove rapidly—that is, if we had more conventional development on trade numbers—the number could approach $1 trillion by 1992. I think therein lies the world financial markets' morbid fascina- tion with U.S. trade numbers. Better than expected trade numbers allow investors around the globe to scale down their fears about future U.S. capital needs from abroad. Conversely, when those numbers disappoint they are immediate- ly translated to a worldwide announcement that U.S. addiction to foreign capital is worsening, and hence our extraordinary focus with the trade numbers and the Fed's focus with those numbers. As I see it, it was just such disappointment in the form of a much worse than expected nominal trade deficit on October 14, 1987 that burst the bubble of investors looking for receding U.S. capital needs and catalyzed the October crash. Foreign investors, all agreed, would not countenance another leg up for U.S. capital inflow needs and the investors leaped to the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 136 conclusion that a U.S. recession was the only way to curb the U.S. appetite for spending, foreign financed. U.S. stocks collapsed, foreign stocks followed. The Fed's second tightening, then, played only a small role in the stock market fall. Foreign anxiety about our trade deficit was central. Again, once stocks crashed, safety and soundness forced the Fed to leave its focus on world imbalances and confront the financial system crisis. Safety and soundness of the U.S. banking system de- manded the Fed ease and it was forthcoming. Now for the present, clearly our capital needs from abroad remain with us, but the last two trade numbers were well below expectations and they have given the dollar some bounce. More- over, we appear to be in the midst of a much needed stall for U.S. consumer spending. And taken alongside the extreme inventory overhang that U.S. retail stores are burdened with, I think it is likely that U.S. trade numbers, for some months, will show good improvement. That, as I see it, gives the Fed some breathing room. They are not consigned to lean against U.S. spending at present, as it is al- ready sagging; and it promises to deliver dividends in the form of better trade numbers. At the same time some U.S. leading indicators are flashing warn- ing signs. As is typical when Fed policy moves toward restriction, as it did in 1987, financial indicators showed the first signs of rising rates. Real money growth traditionally stalls and stock prices tumble. They certainly both did in 1987. Weakness in these leading indicators in the financial system is then typically followed by weakness in leading indicators tied more directly to the econo- my. We are now seeing that. Initial unemployment claims, though moderating from their sharp rise in January, are well above the October levels; industrial commodity prices are well off their highs; and building permits have fallen sharply for two consecutive months. The Federal Reserve Board, therefore, now confronts an economy that is not unambiguously robust. Some caution flags are waving and, again, trade improvement has lifted the dollar. Accordingly, monetary policy needs to be sufficiently accommodative to prevent the ongoing consumer pullback from devolving into recession. In that light, the modest tilt toward ease in place at present appears appropriate irrespective of political considerations. It is instructive to note that, I think, that reflecting upon the weakening U.S. lead- ing indicators, the two better than expected trade numbers, we did have a substantial decline in long-term interest rates from 9 per- cent to 8.3 percent before any move to ease by the Fed occurred. At the same time, I must point out that the Fed cannot be so stimulative as to generate a strong rebound in U.S. consumer spending. In effect, the U.S. consumer is balanced atop a knife's edge, and the U.S. Fed must work to keep the consumer in place. Thank you. [The complete prepared statement of Robert J. Barbera follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 137 Testimony Before The Senate Banking Committee, February 25, 1988 Good morning, Mr. Chairman and members of the committee. My name is Robert J. Barbera and I am the chief economist of Shearson Lehman Hutton. I would 1 ike to thank you for the opportunity to testify at these hearings. In order to frame my testimony, I have chosen to answer four questions: Here Fed officials compelled to tighten in the spring and fall of 1987? Can the Fed be held largely accountable for the October stock market crash? Was the Fed's dramatic swing toward ease immediately after the October crash appropriate? Is current Fed policy, with a slight tilt toward ease, in keeping with the Fed' s disinflation bent or is the November election preventing the U.S. central bank from returning to its precrash bias toward tightening? To briefly summarize my answers to these questions: I believe that consistently faster than expected U.S. economic growth in 1987, alongside bouts of rising commodity prices, dollar weakness and the flight of foreign capital from the U.S., impelled the Fed to raise short-term interest rates and validate the tightening of interest rates that market forces generated during these periods. Had U.S. spending been reined in by budget cuts in 1987, Fed action may have been less severe, but fiscal policy moves to tighten have been most modest, leaving the job of slowing U.S. spending largely to the Fed. The second leg up for short rates, which developed in September, followed on the heels of decidedly disappointing U.S. trade data announcements made in the summer and was to an important degree an attempt by the Fed to counteract dollar weakness. The October crash reflected not just the new higher rate structure, but, importantly, the announcement of another wildly disappointing monthly U.S. trade performance. Investor opinion in mid-October swung radically toward the notion that U.S. trade would not improve without deep U.S. recession. Fed tightening therefore played a role in the stock market's fal1, but it was a secondary one. Once stocks crashed, beginning in the U.S. and quickly movinq abroad, the Fed had no options. The safety and soundness of the U.S. financial system was ensured by the prompt and dramatic provision of liquidity by the U.S. central bank. Thus that infusion of liquidity and the consequent sharp fall in U.S. Fed funds was essential. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 138 Currently, however, with risks to the financial system diminished, the Fed appears to be tilting toward an easier policy again. Some see this as a case of election engineering. I see it as a response to a world different in two important ways from 1987. First, significant leading indicators of the U.S. economy have begun to falter. Second, the world and the Fed have been blessed by two decidedly better than expected trade announcements, which generated a U.S. dollar bounce. Were the Fed to continue to tighten in the face of weakening leading indicators, recession would be the clear risk. Given growing evidence that the U. S. advance is export-driven, and therefore likely consistent with an end to the one-way—down—dollar market, recession seems absolutely inappropriate, election in November or not. In the spring and fall of 1987, the Fed tightened. In both periods the economic backdrop was one of: rapidly rising prices for industrial commodities; strong growth for U.S. employment and industrial output; excellent gains for U.S. exporters; still hefty gains for U.S. import volumes, with rising prices; disappointing nominal trade deficits; bouts of dollar weakness; periods of foreign selling of U.S. assets; large foreign central bank intervention to absorb unwanted dollars. Clearly, then, better economic performance and rising commodity prices, in and of themselves, gave some justification for a tighter Fed. The change in the pace of U.S. economic growth was important to Fed policy. But the changing financial situation of the U.S. in the world was equally significant. The U.S. had become highly dependent on foreign capital by 1987, and once U.S. interest rates ended their incredible decline, foreign investors began to balk at supplying that capital. During 1987, the U.S. broke its two-year pattern of weak industrial production and sharp declines in industrial commodity prices, which had permitted sharp declines in U.S. long-term interest rates alongside a falling dollar. Thus, in early 1987, foreign investors faced, for the first time in two years, the prospects of an end to the explosive gains in U.S. bond prices. stronger GNP growth was raising inflation concerns and capping the bond rally. And overseas investors still faced likely hefty declines in the dollar. The prospects for large decreases in the local currency-denominated returns of U.S. assets caused a run from U.S. assets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 139 The Fed, then, faced the task of both moderating the U.S. output advance and tempering foreign investors' flight from U.S. assets. By tightening in 1987, the Fed was, I believe, attempting to do its part to help trade and the dollar and thereby restore foreign investor inflows. How can tighter Fed policy help improve the U.S. trade deficit? Simple. Higher rates slow U.S. spending, and when spending slows, spending on imports shares in the slowdown. The Fed' s second move to tighten was followed soon thereafter by the crash of 1987. Again, however, rather than holding the Fed accountable for the sharp stock market swoon, I would point the finger at the second wave of disappointing U.S. trade reports that confronted world financial markets. That second round of reports was the fundamental driver in the stock market slide. Throughout the late spring and early summer, U.S. companies across a wide array of sectors were reporting extraordinary gains in the sales of exports. In stark contrast, U.S. retailers were reporting significant sales weaknesses—a precursor, one would imagine, to a fall off in imports. Many equity investors, seeing this as bottom-up evidence of a much improved U.S. trade picture, discounted several very disappointing trade reports. The wildly disappointing trade statistics on October 14 caused investors to capitulate to the view that trade was not turning and recession was likely the only way to right U.S. trade sector woes. Perhaps the easiest assessment of appropriate Fed policy can be tied to the immediate aftermath of the U.S. and worldwide stock market crash. Once that slide occurred, financial market frailty could easily have spilled into the economy, and the U.S. and the world ran the risk of sharp economic contraction. Dramatic Fed ease was appropriate and it was forthcoming. Currently the Fed, as we see it, must ponder the following economic backdrop: U.S. exporters are enjoying explosive demand for their products. Consumer spending, however, in part reflecting last year's move to a more restrictive Fed policy, remains stagnant. These data suggest, in turn, that U.S. output advance will indeed slow in the quarters before us. Importantly, however, slack demand for consumer products promises both slower U.S. economic advance and a falloff in U.S. import inflows. Better than expected trade numbers and slower but still positive economic advance should be the rule in the months ahead. A string of better than expected trade statistics should also catalyze a healthy dollar bounce. More voluntary capital inflows can be expected in the coming months. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 140 the multiquarter poor performance for U.S. consumers has begun to temper demand for goods, both here and abroad, which should help improve U.S. trade statistics. With the U.S. export sector still minute in comparison to the U.S. consumer sector, however, consumer quiescence cannot be permitted to deteriorate into consumer contraction. U.S. leading indicators are in fact flashing such warning signs. As is typical when Fed policy moves toward restriction, leading financial indicators showed the first signs of the effects of rising rates. In 1987, real money growth stalled, and of course stock prices tumbled. Weakness in these early leading indicators is now being met by declines for leading indicators tied more directly to economic performance. Initial unemployment claims, though moderating from their sharp rise in January, are well above the October levels; industrial commodity prices are well off their highs; and building permits have fallen sharply for two consecutive months. The U.S. Federal Reserve Board, therefore, confronts an economy that is not unambiguously robust. Some caution flags are waving. And again, trade improvement has lifted the dollar. Accordingly, a monetary policy needs to be sufficiently accommodative to prevent the ongoing consumer pullback from devolving into recession. In that light, the modest tilt toward ease in place at present appears appropriate irrespective of political considerations. It is instructive to note that, reflecting upon weakening U.S. leading indicators and the dollar's bounce, U.S. long rates fell 3/4 of a percentage point from 9.1% to around 8.3% before any Fed easing took place. The Fed, then, has followed the markets toward an easier policy. At the same time, I must point out that the Fed cannot be so stimulative as to generate a strong rebound in U.S. consumer spending. In effect, the U.S. consumer is balanced atop a knife's edge, and the U.S. Fed must work to keep the consumer in place. To be sure, the task the Fed faces at present is daunting. The U.S. central bank is at once attempting both to help prevent a worldwide economic downturn and to assist in effecting a turn in U.S. trade. Again, this amounts to a policy of engineering stagnant but not sliding U.S. spending. Growth in the U.S. economy depends in turn on healthy export gains, and trade sector improvement will reflect both export advances and import declines. Export strength, however, hinges in part upon foreign central bank stimulus and consequent spending patterns abroad. Other nations must ensure sufficient demand growth abroad to absorb the slackening in demand for their products that an extended period of stagnant U.S. spending assures. In that sense, we remain hostage to foreign savers. That's a handcuff it will be difficult to slip through in the coming years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 141 and Fall of 1987. U.S. dollar decline, coincident In hnth the s »t« ^d sl.*pemg for U.S. yield curve co^ell r I S n the Fed to tighten . Laje Ian. Midway EarijMug Mid-Oct. -3.a% - U.S. dol lar' Rise for U.S." Long rates 7.4% to 9. 9.0% to 10.1% Steepening Yield*"* Curve 220 215 276 - Federal Reserve Board trade weighted dollar index, percent change. ** 30 year U S. Treasury bond yield. . ••* 30 year U.S. Treasury bond yield less interest rale on Fed Funds (in basis points). THE FED'S TIGHTENING IN 1987 OCCURRED WHILE THE ECONOMY WAS EXPERIENCING QUITE ACCEPTABLE OVERALL GROWTH. 10-1 v W Indurtrial Production (6-Month « Chute, AnnualiKd) 0- -C Bern! GHP (Quarter/Quarter * Chwif*, AmraiUnd) J--4 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 142 DURING THE FUST FBI WEEKS Of 1900. LONG RATES DECLINED WFTH STEADY FD POLICY. RECENT FED EASING FOLLOWED THE JANUARY BOND MARKET RALLY. LIKEWISE. THE FEDERAL RESERVE BOARDS SLIGHTLY EASIER STANCE HAS BEEN TAKEN WITH THE DOLLAR OFF ITS LOIS. BOTH LONG-TERM INTEREST RATE DECLINES AND THE DOLLAR'S RECENT BOUNCE DIRECTLY REFLECT TWO MONTHS OF BETTER-THAN-EXPECTED MERCHANDISE TRADE DEFICITS. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 143 CURRENT FED POLICY, WITH A SLIGHT TILT TO EASE. ALSO REFLECTS, NO DOUBT, THE DECLINE FOR U.S. LEADING INDICATORS. Financial Indicators Fell First. i •• i i ~i • [ r i rJ-160 A 9 0 H 0 J P H ItM Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 144 ANOTHER MONTHLY FALL IM THE U.S. INDEX OF LEADING INDICATORS? These Economy Related Leading Indicators Pulled the Indei Down in January. Forecast Oct . Jan. Contribuli an Initial Unemployment Claims 284 312 Bui[ding Permi ts 116.7 108.5 Vendor Performance 70 Sensitive Material Prices 1 .67 fl.84 Financial Leading Indicators, However, Bounced Back and fill Lift Ihe Index. M-2 (S2S) 2427, 4 2419.1 2420.1 2443.8 0.43 SSP 500 280.2 243.4 241 .0 250.4 0 33 The Swing Factor for the Monthly Move is Factory Orders. Should They Fall, As We Expect, The Index Hill Decline in January. Consumer Goods Orders 87.8 87.0 -.14 Capilal Goods Orders 42.0 -12.4 0.01 Index of Leading Indicators 193.3 190.2 Percent Change) -0.1 -0.2 'The initial 0,2% decline of the December index of Leading Indicators will 1 ikely he revised up to 0.3% with the next release. 1-5 -t - 1.0 J.lllll I 0.0 Index or Leidinf Indie*tors {Month/Month > Change) -1.0- - -1.0 r~~i—i 1—i 1 r~-\ 1—i 1 1—i— J F M i H J J i S O N D J FM 1M7 IBM Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 145 THE EXPLOSION OF THE US. MERCHANDISE TRADE DEFICIT IN THE EARLY 1980s WILL RECEDE IN THE LATE 1960s AND BARLY 1990s. MOREOVER, EVEN WITH AN OPTIMISTIC VIEW ABOUT TRADE IMPROVEMENT . . THE VS. CURRENT ACCOUNT DEFICIT WILL FALL MORE SLOWLY AS INTEREST AND DIVIDEND PAYMENTS ON FOREIGN-HELD ASSETS MOUNT AND . . . AS A CONSEQUENCE, NET FOREIGN INVESTMENT— THE EXCESS OF THE VALUE OF FOREIGN-OWNED VS. ASSETS COMPARED TO THE VALUE Of U.S.-OWNED FOREIGN ASSETS—WILL LIKELY EXCEED 1750 BILLION IN 1992, THIS IN TURN IMPLIES AN ADDITIONAL $500 BILLION IN NET FOREIGN PURCHASES OF US. ASSETS OVER THE 1988-1992 PERIOD. IMPORTANTLY. FOREIGN PURCHASES OF VS. ASSETS WILL EXCEED "NET FOREIGN PURCHASES" BY A •IDE MARGIN. NET FOREIGN INVESTMENT FOCUSES ON THE NEED FOR FOREIGN ASSET OWNERSHIP ABOVE THE LEVEL OF US. ASSET PURCHASES ABROAD. FROM 1980-IW2. WE ENVISION FOREIGN PURCHASES OF AN ADDITIONAL tSOO BILLION IN VS. ASSETS. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 146 The CHAIRMAN. Thank you, Dr. Barbera. Dr. Cooper is professor of economics at Harvard University and he's served with distinction as Assistant Secretary for Economic Policy in the State Department. Go right ahead, Dr. Cooper. STATEMENT OF RICHARD N. COOPER, PROFESSOR OF ECONOMICS, HARVARD UNIVERSITY Mr. COOPER. Mr. Chairman, I appreciate very much the opportu- nity to testify in these important hearings. I have provided a state- ment and, with your permission, I'd just like to emphasize several points and in the process address some of the questions that you've posed. OPPOSES FURTHER WEAKENING OF DOLLAR First, I do not share what I take to be the strong consensus among American economists that the dollar must weaken further, that the Fed or other central banks should do nothing to stop it, and if anything, they should push the dollar further down. For reasons given in my statement, I believe that a further sharp drop in the dollar may perversely enlarge rather than narrow the U.S. trade deficit over the next 12 to 18 months by creating a reces- sion in Europe and even possibly in Japan, both of which areas are economically fragile at the present time and are feeling the impact of a decline in real exports. Recession abroad would affect the United States adversely be- cause our near-term economic growth depends heavily on an im- provement in net exports and on the investment which will be in large part associated with that improvement in net exports. Now I don't want my position to be interpreted as favoring a tightening of U.S. monetary policy in order to keep the dollar from dropping. I do not. And in fact I support the course of policy that the Fed has recently been on. But the U.S. should not try to dis- suade other countries from intervening in exchange markets to prevent sharp appreciations of their currencies against the dollar which intervention incidentally involves monetary expansion in other major countries which I believe is desirable in its own right. DEBT OF THIRD WORLD COUNTRIES Second, I believe that the heavy debt of many Latin American and African countries is a continuing problem, both for the debtors and for the creditors. While it is not perhaps a threat to the world financial system, it continues to nag at the world economy acting as a costly drag on economic growth. There is no easy way out, but certainly if the world economy goes into recession or if short-term interest rates rise markedly, we will see even more debtors declin- ing to service their debts. Politically, most of them will not have the option of squeezing their economies further in order to pay in- terest on debts that were incurred 5 to 15 years ago. Third, I do not believe that the rapid growth of net U.S. foreign indebtedness per se will affect the ability of the Federal Reserve to set U.S. monetary policy. I dp believe, however, that the increasing integration of world fi- nancial markets, the increased gross indebtedness of the United Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 147 States to foreigners, and the increased ease with which Americans can invest overseas in many forms, will result in a gradual reorien- tation of U.S. monetary policy to the external environment and with greater attention being paid to "confidence" in the world fi- nancial community. The world financial community includes U.S. American partici- pants. I do not believe that foreigners are more fickle in their hold- ings of dollars than Americans are. These developments will occur via exchange rate as well as inter- est rate impact on the U.S. economy. Indeed, I see a growing ten- sion between the relative importance of the U.S. dollar in the world economy, which I suspect will continue, and the relative— and I emphasize relative—decline of U.S. output as a share of gross world product; not because the U.S. economy is doing badly but be- cause over the next 10 to 20 years other economies will grow more rapidly. For this reason, as well as because it will be desirable to reduce the influence of turbulence arising in financial markets on real business decisions, I put forward at the end of my statement what many will consider a quixotic suggestion that we should begin now to think about steps necessary to create and manage a single cur- rency for the industrialized democracies. The management arrangements could be modeled on our own Federal Reserve System, but those who would sit on the equivalent of the Transatlantic Open Market Committee would involve West- ern Europe, Canada, as well as the United States, and Japan. That sounds very radical at the present time, but in fact it repre- sents a clean solution to a number of problems which we already face and which are likely to get more acute as the years go by. I believe that a single currency for the industrialized democracies is now technically feasible, by which I mean the markets exist that could support it in a reasonably smooth way, but of course it would require a major change in our political thinking, but it's not too early to start. Thank you, Mr. Chairman. [The complete prepared statement of Richard N. Cooper follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis iranndmte rflw-tjons affprting only 125-30 billion. The only ways to make thob» rnn.srd commitments in the American system is either through tax adjus ing the formulae that nffer^t social entitlements, such that Ihe^i' hee nt values of tn f vm:!1]l thr> do] ];i -stimulu H r'fpct I .S. e\i»)rl-i neEatiM'ly, -,i*-h that the shfrt-run affect of dnilir traiji' Ijat.uice. it is noteworthy, in this connection, that U.S. forecast' pcoiion-ic et:»,i'i ri,ji-inB ISf'S Biaoc hesw veiEh: on sii improvHiicrii in net :-ts (.-,i, oti.. forer-ast of 2.3 ucn-pnt, growth, nearly KO tcr.-ent 15 utv.iic, ,I,i|wii, nr i nt l l .'lsni.1iot-p, Ihii l.S, c e o v l p : ort Broi.lh rtoes not materialize. b haris over the uot Id s-'ninmv s.: tf iir<«- [In- hed^ral Ecsci-.f Sitlem in thf inurd > conditions ir. order in preier.t tri- dr.lia bit inflatiaii in the inited Statef, Depression, allo • dr.lla Uebt-riflJeii .ie\-lanins countries trajlri be further devastated by protect ioni=t jn^tntrb, nnd could not cont.riJMJte to vvorld gn^,-th. Some ri.nBressmeri '-ill be (jimpted to threaten to withhold \otcs for the L.S.-Caji lU-uwsLoris in the UiitiilBjs Tnute Bill that he IKB,- threatens to %eto. !l >-r> lea just wliF'n [.'.fi. evoorts or** lining irell, and a IKIJ«I turnaround in the I'.S, S[.in->i!r fnr :-r-l'j, Lr« (he biidBc^r in the- l.iiited Sta'ps - 'hp ad, h« 1 H s r , i f a :, n in ] t , . s n , r n ti n f J fr T -t h . r ' - i .' [I'. k B ] i - n . . I i L . oof f rt h .] ft P h r a n ia a . rtl F ft i na 1 n 11 c ia li l o m th ar h k o e u ts s e . ' T i ' ' i i f Ihi'ir OtiM i -.r, rh. 1 .1. la^K't rtefint. EStit too •srrarn and tin ran'! a , ii f.!, •. ot i I... '. i onilrfssmrTi rai,1 tct Pi s.^] dent ni" tujJ; Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis uld publii1 del,', which to domestic residents of both countries is alreadv unt;, m! ,)i-t ably high. tin fact, West Gcirouir has at 4] percent the loues ra^io i], TA.f- Vnil^i ^1«ti^ i>i 50 -percent, and in Japan it has reached I". percent . ] Japan ^-aiits tf, avoid increasing debt by offsetting any sf iimi action through increasing new 1ji\es, notably a tax on consular speiKiin'? unhelpful!? mav actual]?1 further increase household savings in Japnn. , prnpriwi 1C offset n-ts m inconn ta.\f>s by cutting subsidies, a mm <• til surcli mi-ritnriou^ in thr mp-iuim (o lone run, hut tlin-h ™ulti rffiuce nr plirEiii>/it,- the il,-i.UL,i •-tiniiliii ansina from the proposer! ta.\ reduct 1011=. Tl., al tieh; nu Uw necessarv f Lev.! hill'_> the debt. Avr,ida!i ". The alternative will I*, r ion of the dollar, whirh IHBV >\pli to nv<>id the hsrd ( the- nevl fiie ?,"3r-, s universally desired, nt IMSI riieloricsllj. Vumljcrs are t«Jious, bit thf> are osss-r.l ial toi1 untiorsl nfirf i ng Ihe majonturfr and Ili'-rcfare the nature of the nroblex. At p-'n^si'i '. h" C'nileH ?tste= iiin^ J n^rrhanHise trado deficit of routhly Slj1' billioi , i.i'h services and reiriittijic^*i approximately in helyno?- Durina the I«st fiil> yr-ars- thp Inited States -las aiwumilated over (5TO billion in list obi igat nais to foreigners, anrl it i-t llkel! to apcumu]att> rwnrly that much agEiin during th,. i»>! ind 1HHS-1992. Thus, there will be itn-reased debt Fli year in L.S. nnt evpt-rts. grinultEirp is lik-c!y to prm ide little of the ner-egsary improve r irar^rter of fa™ prortwts, has noi.- become the second ]j.rBe=t -ho (r-.ited f<.-.<>•*.. Jani"1 nesMly prot->ct? rice and othnr aerie ts,, r.i-n^tn,- .id ion HS« [winfijl ly started in Furipc, In it i' Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Who will be or. the other sidr of this large 3.,-ing of 1200 billion in i-orid trade in manufactured goods" Developing oountriea would like to imp=tinent^ that tuined out successfully but produced goods that compel." i.it prndLicts fi-om industrialized counti-ips. There is soine merit to these •ore. Wills the currant debt situation may ease some-Jhat, net capita] inflo the same high standard: for exgjnplp, comnercial office apace in I.E. citif, vns substantially overbuilt fith the help of atrona ta>. incentives during (>i discussed. That lea\es Europe and Japan to do most of the adjusting, plus a earl) 19fiOs.; ant] Rurope hus made numeroua public inveatments, sm;h as in st- feu other countries such as Taiwan and Korea. imeslnnnt. Furl-hf.j-im.re, nvcr the decades 1960-1980 developing countries g. nt deficit*. 1 at extraordinary rates, and it is hard tc belief that inflm-'s of capita] If large surplus*^ ar** eonrontratFd in the Federal Republic of Germany, thn N • e id th e e r n l f a n a d s mp aj a o n r d U S . w S. i t c z o er r l r a e n c d ti . o n, B u e t s t p h e o c s i e a l c ly o u J n a t p r a i n e s an th d a t W r p o st u l G d e r b m e a n o y n , U h , a ^ v e o ld k * f - ^. their i-cGdCHnies over thp post decade or longer to e^-port-led firowth- The J-P Ui fulure defauirs. but sopie combination of pubiic loans and guarantees JatAn spcmft To Y,a\c started the process of adjustment , arrf the Japanp^f diArtJss publicly thp imjor structural changes that may hnvc to lAk? iilaoi" ir LjH'^jiisjdn of thf; niH^d iV.i structural change along Ihpfif lines is ini^h k-Efi altuinatjM', if world recession IB to be avoided, fill bf continued len(* the liuted SL.T.CS,. Tliat is not de?iruble t rom the American pprsDPCti\p e, interest rates, and so on, Japan and Vtest Germany rinss far in evncss of tne uiilineriess of donestie It tha ftrid invest in plant and equipment. Tlie sovemnei]!^ alisor-l: of si in-- fi-ni-th in the Jalor torn- and an aging population. The LniteH state - throiish Their budget dn'ficiTs. But larse Amnunte of is al-'i f-.i»>rieni-;ni a declinr- in the natural groi.-th of the labor f'ci-irr- fnr alinu.i, csT»^iHUy in DIP United States. Developing Ainr-j-i. .in laiKis ftiivi-, In an extent that till not tx-t-ui in nut them liu!-"H' nn t ( o l o 1 e f n 03 d i t m h in b i i ^ g i n 1 m d 1 t o e . i . o c n c f l i i a . n i t p n e u i r t I e a 1 n 9 l s S q 1 t m f a a t i n o n l d l o a e m r n n t i i h n e o g s n o t f d i i m e m l \ a i e e v t ] s e i o t d n j n n g i 3 n e . 1 n s 4 t . S ( b t i ) n i n l P c n l e r i t i o r v t n i h a e e t s i e n d h i e u 1 n b s 9 v t 8 e s c " a ta , t r o g i a r s n n a i a d s t a e t o r h d e f e , l 1 f r e 9 a a a 6 i l n r 2 l ? i n n b g a e r b u l n n f i r t i n l m J h o e a i p i H e p , n . u i . s M n i . i I m i h t o s T h i s l l - i v g i e n i s o V i u t l k i i r i i i t l l g i i l e il l L d . S i - i l t i s r a < u l l i 'o e ra m s fi i i - l Ii - . e , , a - g i u j * « - l , t u u s h w e y t h h o S i , i n i c I s w . rB 1 o s !, n , t t - g i i r n n e e r n - n r l u l e i r o t r i r i e > l b n h " y i i e d r m i i t e » e e 'l - F . . i - u v h r c n o T l o p t v l e o i g f s r o n i r - c t ^ h h l e e ^ r : i u - e n k i f v * p o n f i f i r u r t e i n w : t l t l a . . k . t n n c d d l; Slnles. For I his rea-i,,n , it mny he H ralsUke to think of hm ing to e] imiliii' .-ing cai entirely I he I'.S. current afcnun! defii-ll vilhin the ne-,1 five ypBT-i. To rh e\1.etiL lhat the rniterf .-itntes runs a deficit in the mid-1990s, the nioblem o atljustlris the utirlri st rut-t lire of trade Hill lie eased. rid Ki tJm efu] the publi investment), they Ki 1 1 tie dissi evjipttdiluie or reductions in Saves that encourage private spending, that IB, In highei budget defit-its. Thig recoranendation does not fit comfortably nth thF,l if eier<:>ne - Iniiiselinlrts and businesses na tell as gm-emments - ia ill red Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis th- i«,ssihi!i1> oi continual overshooting of exchange rsil-^, nth OVBI-I iliut inn folltn.'ed. by undervaluation, and vice vprsa. This, ryissi hi 111 o\cislvi.iling, iifrtmiw for prolonged periods, introduces a disturbing soun- inlroiut-i- Uijit from thr •.iei.-point of the busine^iman nr farmer is a uhnlly »rin!r-nri B'nji^i' of ura-crta int j into his protiuction miii investment ill anc-hor fnr thf •ii-.lem. Ratht-t-, the Federal Reserve will find itself ra-.-f frenuenllv ha. in/ to r»s,,<iii<] to intcrnationai finnnc-ial pressures, whethr-r the' n<-f radorvil 111 the Inrgr-i scheme of thinss or rait, und thess may rnr the ucalth-producing i currency for the industrial ited OtttnncriK-ifs s ing nations, arid irrdeed it invnlvp-, a mejnr lf<ir> itciFigri:} will seem to be the niajnr obateclf-; liu i* i-apiiil> ,-roding the ability of netiong to ooll&:ti>p i-rintnil. >k, mn - 1- , it 51 could be acconiDli5h«J, it umild gipat aimpljfi the iirdlilsan of coord mat ins economic policy among nations, "tour L policv could I*' aig.icJ cut in the Btard, arri fiscal polic? could proceed independent Ij , -cixiEdirwtp.]" thioi^h Ihc pn ssure of the nErketplaoe . Tl represent a wcilhy anhil ion I:,, the fulurp evolution of the industrial i ^i- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 152 The CHAIRMAN. Thank you, Dr. Cooper. That's a very interesting suggestion. Dr. Sachs, professor of economics, at Harvard University. This is Harvard day. As a Yale man, I don't know whether that's a good idea or not. You were a consultant, as I understand, with respect to Bolivia and you suggested some innovative approaches to their problems. We're delighted to have you. Go right ahead, sir. STATEMENT OF JEFFREY SACHS, PROFESSOR OF ECONOMICS, HARVARD UNIVERSITY Mr. SACHS. Thank you very much, Mr. Chairman, for the oppor- tunity to testify. I hope that despite my scholarly connection you will find some interest in the testimony. I must say I'm quite relieved, after hearing my colleague's testi- mony, I agree with most of it so we won't have to have arguments on the airplane back home, although I would have some pause about the final suggestions of one world currency which maybe we can speculate on later on. FLEXIBILITY IN MONETARY POLICY I think that both speakers already this morning have explained why this is a period of unusual complexity in monetary policy. There are a number of cross-cutting aims of monetary policy which are extremely difficult to satisfy right now. I, like the first two speakers, support the current settings of monetary policy by the Fed, but would stress and do stress throughout my testimony that there is a considerable need for continued flexibility in monetary policy. This would be a terrible time, in my view, to enter into any kind of international arrangements to peg exchange rates or to rebase the currency on the basis of a commodity standard or other such innovations, particularly because given the kinds of real eco- nomic transitions that we're aiming for in the next few years we don't really have the capacity to say very clearly what the appro- priate exchange rate will be. We just don't know enough to know what kinds of responses will occur in export and import demand and other variables which will determine the appropriate level of the exchange rate. We are in a fundamental transition I hope from domestic-led growth to export-led growth in this country, and that involves a number of tradeoffs and risks. Exports are rising right now and on the one side there is a risk that if domestic demand does not slow sufficiently the rise in exports coming from the decline of the dollar will lead to overheating of the economy. On the other hand, there are very legitimate concerns that the rise of exports will not be sufficient to match what is now projected to be a slowdown of domestic aggregate demand. So there is an unusually wide range of forecasts right now rang- ing from overheating to recession this year, which comes from the fact that we are undergoing a rather major structural change in this economy whose outcome is very hard to see on a quantitative basis, though relatively straight-forward to understand on a quali- tative basis. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 153 POLITICAL BUSINESS CYCLE AND THE ECONOMY One issue that you raised in the invitation was the question about how the political business cycle might interject itself with this delicate decision about the risk of overheating versus the risk of contraction, and I think it's a very interesting question. I do spend a couple of pages in my testimony describing that and if you could look at one of the tables in the testimony after page 3, I think that the history gives an interesting lesson actually about the political business cycle that's worth pondering. In recent research that I've been doing and others have also found the same thing, there does not seem to be any overwhelming case of a political business cycle in the sense of election year changes in monetary policy for the purpose of affecting the elec- tion. If you look in this table, for instance, you notice that the average growth rates in the fourth year of Presidential terms is approxi- mately the overall average growth rate of the economy and when one scrutinizes fairly closely the monetary policies of the various administrations in the fourth year of office or of the Fed during the fourth year of office of the various administrations you don't really see too much manipulation of monetary policy for political ends except during the term of that most political of our Presidents, President Nixon, in 1972, where we have the single case of fairly clear evidence of excessive monetary growth for the sake of the 1972 election. But more generally in our history that has not been a pattern which has played an important role. However, there is a very strong political business cycle of a dif- ferent sort which I wanted to draw your attention to, and that is that the Fed does respond to politics but not in the fourth year of Presidential terms but in the beginning of Presidential terms. And there is clearly a partisan business cycle in our country with Re- publican administrations almost invariably leading off with reces- sions. Indeed, every Republican Presidential term, save the most recent one, started out with a recession that began in the first or the 2d year of office. No Democratic term has ever started out with a recession. And when one traces the monetary policy, you do indeed find the Demo- cratic terms start out with quite expansionary monetary policy from the Fed and Republican terms start out with quite contrac- tionary monetary policies from the Fed, in my view indicating the relative priorities given to growth versus anti-inflation policies of the different political parties, and indicating that the Fed is cer- tainly not a purely autonomous institution that is not subject to po- litical change. Indeed, it does move quite strongly with the political winds, but in the beginning of presidential terms, not at the end of presidential terms. So aside from particular historical anamolies, it has not been a general pattern—the concern that you raised. Now let me say a few words about the present situation, the dif- ficulties of managing a transition from domestic-demand led growth to export-led growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 154 One point I think should be understood at the beginning. A big part of that transition, of course, involves a continuing reduction of the Federal budget deficit as a share of GNP, but strikingly, all the evidence suggests that even if we were to get the budget down to that magic number that we're aiming for of zero in 1993, that in and of itself would not even be sufficient to restore trade balance in this country, if we don't, in addition, have a rise in private sav- ings in this country because the private savings, private invest- ment balance in this country is sufficiently adverse, private savings are sufficiently low that we would be relying on foreign capital in- flows even if there weren't a Federal budget deficit right now. Our true long-term policy crisis in this country involves the pri- vate savings rate just every bit as much as it does the public sav- ings rate. Now in the short term, however, we do have the pressing public policy concern of reducing the budget deficit and managing mone- tary policy during the transition. The major problems for monetary policy, of course, are that there are great uncertainties in this transition. First, we don't really know what the strength of private demand will be, particu- larly after the collapse of the stock market last year. Export demand equations which predict how the exports should respond to movements of the exchange rate are also not performing very well now. So there are great uncertainties about the continuing strength of export demand. And finally, the inflationary risks of continuing using monetary policy are present, but once again, the traditional equations that we rely on are not performing very well. Inflation has not respond- ed as significantly as one would have expected to the falling dollar. So the guideposts for moving between these difficult positions of overheating and recession remain a matter of very good luck and considerable risk because most of the traditional quantitative guidelines that would be used simply are not up to the task at hand. I think the main implication for policy, therefore, is that mone- tary policy has to remain flexible and we should continue to avoid any adherence to firm rules either on the exchange rate or to mon- etary aggregates right now. If it does turn out that private demand falls more than is currently being forecasted, we do want to have the option of easing monetary policy and causing the dollar to go down further and we want to be able to do that without tremen- dous concern of international agreements pegging the dollar. So I think that the main policy implication right now is that the Fed is probably on the right policy course and that it should remain flexible to stay on that course if either the economy starts to overheat to be able to tighten, or if the economy actually starts to fall into recession to be able to ease monetary policy significant- ly in order to keep the economy growing, one implication of which would be a more sharp fall to the dollar than has already occurred. But that seems to me to be a risk that would be appropriate in the circumstances of a sharp slowdown in the economy and one that we want to have available to us later on. A word on the developing country debt. There is a real sense in which our monetary policy is hostage to the debt crisis right now Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 155 because a sharp rise of interest rates would do considerable damage to the prospects of the debtor countries. But as I stress in the testimony, this is an unfortunate situation because our overall debt management policy is so poor right now and so unrealistic that to hold monetary policy hostage to a very poor debt manage- ment policy is itself adding a disaster on top of a disaster. It's time to move toward a more realistic reduction of the debt burden for these countries and if we did so, then the extent to which our mon- etary policy had to reflect the concerns of the debtor countries would be substantially reduced. So the element of constraint on monetary policy vis-a-vis the Latin countries follows very closely from the fact that we are al- ready living in a very unreal debt management situation where countries are being called upon to service debts that are far beyond their steady state capacity to service. I'll stop there. [The complete prepared statement of Jeffrey Sachs follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis complicating element is the fact that the recent declines of the dollar might provoke a rise in inflation via higher import prices Testimony to the Senate Banking Committee even if the overall econony is relatively slack. Professor Jeffrey Sachs Because of the central importance of balancing a slowdown of Harvard University donestic denand with an acceleration of exports, the most February 25, 19BS inportant questions now confronting monetary policy involve the appropriate management of the exchange rate. If moietary policy is eased, the dollar will depreciate further, and export demand Mr. chairman, thank you very much for this opportunity to will be further stimulated. Tne risks of recession will thereby testify on the current management of U.S. ncnetary policy, as part be reduced, but at the possible costs of higher inflation of this Conmittee's serai-annual review of the Humphrey-Hawkins (directly through higher inport prices, and indirectly, through testimony of Chairman Greenspan. It is widely appreciated that tighter labor market conditions) . If tanetary policy is instead the uncertainties now surrounding ncnetary polity are mxre tied to a target for the exchange rate (either by unilateral Fed profound than usual, in view of the large external deficits of the policy, or in an agreement with our trading partners) , the risks U.S. economy and the financial market instabilities in the past of renewed inflation nay be reduced, but at the cost of a possible half year. Under the best of circumstances, the U.S. economy is slowdown in export growth, and a slowdown in the ecorcrry overall. in the process of a delicate transition from consumption-led growth in recent years to export-led growth in the future. Die Tne Effects of the Election Cycle cm Monetary Bslicy monetary authorities therefore have the central task of managing Before analysing the more technical aspects of the choices monetary policy (and exchange rate policy) so that escort growth facing the Fed, it is worthwhile to turn to one of the particular is fast enough to compensate for a decline in domestic demand, but concerns of the Committee: whether the choices made by the Fed not so fast as to result in an overheated economy and renewed this year are likely to be influenced in an important way by the inflation. elections. Tne historical record is, I believe, both interesting The dilemmas facing the Federal Reserve Board are perhaps and a bit surprising on this score. most simply illustrated by the fact that pundits and forecasters It is widely believed that the Federal Reserve Board tends to can't decide whether the economy is at risk of overheating, with choose policy actions in an election year in order to improve the renewed inflation, or is instead on the brink of recession. Cue Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis electoral prospects of the Administration in power (either the Rate of I3routh of GNP reelection of the president, or the election of the President's party). There are usually tuo links to the acganant: that W\ite DemocraticAdministrations House pressure can nave an important effect on monetary policy, and that these pressures are clear and overwhelming during Year election years. The enpirical evidence does supf&ri. one lit* of First Second Third Fourth this argument: the ability of the White House to influence the Truman 0.5, B.7 8.3 3-T Federal Reserve Beard actions, despite the smiceed institutional K Jo e h n n n s e o dy n 6 2 . . 0 6 5 6. . 0 8 2 * . . 7 0 H 5 . . 6 3 independence of the Fed from outside pressures (see the recent Carter 5.5 5.0 2.8 -0.3 paper by Havrilesky, 19BB, for a review of the evidence). Average 3.T 6.11 H.5 3.3 Average Cn the other hand, the historical record does not suggest any First/Second Halves 5.0 3.9 flagrant manirulatics] of Fed policies during election years for the sake of the incuitoent Administration, indeed, the "political business cycle theory", uhich predicts such manipulation, was bom Republican Administrations in the wake of the 1972 election, an election fchich raw eeems to be the <slv fairly clear case of monetary mnipulation for Tear electoral purposes. First Second Third Fourth As shown in the attached table (taken from a stuSy that I Elsenhower I 3.8 -1.2 6.7 2-1 Elsenhower II 1.8 -0.1 6.0 2.2 have recently published with Professor Alberto ftlesina, of HlHon I 2.8 -0.2 3.1. 5.1 Nixon II 5.8 -0.6 -1.2 5.1 CamegieH*!llQn University, 198B) there is no discernible pattern Reagan 2.5 -2.1 3-T 6.8 of especially rapid OJP growth during election years (th* fourth Average 3-3 -0.9 J.7 1.« year of each Administration), as a naive theory of tte political Average First/SecondHalves 1.2 tt.O business cycle would suggest. There is, however, a remarkable effect of political parties on the economy in the two years following a Presidential electicn. To the extent that political Oil shocks Suurce; Alesina and Sachs 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis variables are important in the economy, they seed to operate at Die fundamental macroeconanic policy goal that will face the the beginning of Presidential tens, not at the ena. country in the next few years, no matter which party is in office, Almost invariably, Denocratic Aiministraticns begin with is the reduction of the external deficit, a«J the ccnscwaitant boons (especially in the second year of office), nhile Republican reduction in the U.S. dependence on foreign capital inflows. In Administrations alacet invariably begin with recessions. These order to achieve a shift in the external deficit, it is required differences average out by the third and fourth years of office. that total domestic spending in the U.S. should decline relative It is remarkable to contemplate that every Republican t» OJP, in order to free up the resources that nust be devoted to Administration except the second Iteagan term began with a an increase in exports. Since the economy is already (pirating recession during the first tH3 years of office, while no near full employment, the only way to increase exports Democratic administration ewer began with a recession- In the significantly is reduce donestic demands for donestic goods, and vi«j of Alesina ana nyself, the differences betwen the Democratic thereby to free up writers and other resources to devote to export and Republican Presidencies reflect the differing (eights that the two parties put en the objectives of economic growth versus The nost reliable way to reduce domestic spending relative to inflation control, teraocratic Administrations have tended to QfP is to reduce the government budget deficit, either by oo favor growth (and employment) at the risk of higher inflation, and expenditure reductions or by tax increases, or nest likely, by a the Republican Administrations have tended to favor inflation- combination of the two. It should be noted, hcwver, tt^t even 4f fighting even at the risk of a slowdown in growth, or even a the budrfM- Deficit is virtually qjjminated . it ia likely that an recession. U .s._ gyterria f deficit will renaii^ unless nrivatn rrr+r It seems, moreover, that the differences in economic also increase performance between Administrations of the two parties can be Put another way, the U.S. external deficit is equal to the traced to differences in economic policies, particularly monetary excess of donestic investments over national savings. If policies. Huts, the Fed does seem to be susceptible to important government dissavings is reduced, thereby raising overall national partisan influence, but in ways that are more subtle than simply savings, the excess of investment over national savings will tena pjnpijig up the economy on electim eve. to fall, and the external deficit will be reduced. However, even if government dissavings are virtually eliminated, there is still Managing the Transition to Export-lad Growth likely to be an excessive of private sector investment over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis private sector savings. Tills is because our domestic savings is the fall of the dollar since 1985. Also, inport prices were mutii now extremely low, both by historical and international standards. lower than would have been predicted according to historical •OBJE, a fall talarcirg oi the external accounts will likely relation^iips, so that the effects at the weak dollar on tkmestic require a rise in private savings {or, less attractively, a fall inflation had been much less than feared. in investment) in addition to the elimination cf goverment What remains to be seen, however, is blether these breaks dissavings. with historical experience are simply ten^porary aberratiais in the The great trick for monetary policy these days is to get data {i.e. time lags in exports and import prices that are exports growing fast enough to mate up for the demand shortfall difficult to explain), or whether there are nore fundamental that might arise from the reduction in the government deficit, as structural shifts underway in the U.S. econoay. Some have argued, well as any accompanying increase in private savings that might be for example, that the dollar has to go raKSi lower than it is today achieved. The precision with which monetary policy can be because the U.S. has lost fundamental ocnipetitiveneES with the deployed in this task is limited by several factors: Asian eccranies, so that the previous basis for judging the (1) it is extremely difficult to predict accurately now the appropriate level of the D.S. exchange rate no longer apply. state of private demand and private savings, especially following the events of Black Monday; As a general strategy in such uncertain periods, I imia urge (2) it is difficult to predict the linkages of easier that we stidt with the historical experience as long as possible monetary policy to faster export growth, since both the linkage of money to the excharge rate, and of the exchange (i.e. that we continue to rely on the earlier statistical rate to exports, are difficult to gjage with precision. Statistical relationships of esqwrts to exchange rate relationships) as our guide to policy, rather than believing that changes, based on past history, have not fared well in the past year; we are always living with a new "^iecial case", requiring new (3) it is very hard today to guage the inflationary risks "special attention". Ihe normal disciplines on policyiraking tend that arise from a further decline in the dollar. Those risks are of W) sorts: a general overheating as well as the effect to fall apart if policymakers are prone to abandon earlier of a weaker exchange rate on higher import prices. The historical linkages between exchange rate changes and import guideposts every time that six months to on* year of data come a prices have tended to break down in the past year. cropper. Moreover, it is almost surely the case that ws are Thus, to appreciate the Fed's current guandry, note that the better at estimating the long-run effects of policies than their historical bases for designing exchange rate policies have been short-run effects. Technical econonists ar* alicst bound to get unreliable guides in the past year. Until very recently, export wrmg the dynamic responses of exports and imports to the exchange growth was less bouvant than would have been predicted in light of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis rate, even if they can acre reliably estiirate the long-run effects "equilibrium" value of the dollar. How strong will export growth of such policy changes. be? How inflationary will dollar depreciation be? How ouch will In this view, we stould expect two things from the fall of U.S. domestic demand slow in the coming year, and EO how fast must the dollar that has already taken place. First, export growth export growth be in order to compensate for the slowdown of should remain strong for a while even if there is no further domestic denand? H™ much progress will be made in the next significant depreciation of the dollar. This is because there is eighteen months of budget deficit reduction? All of these evidently sane remaining lagged response of export growth to the questions bear directly on the appropriate value of the dollar. exchange rate depreciations to date. Second, import prices should Since we won't know the answers to these questions except in the be expected to rise more rapidly in the coming year, since the course of tine, ue should maintain the flexibility to respond to response of ijiport prices to the dollar depreciation has so far develt^ments with changes in monetary stimulus, and charges in the been notably less than would have been anticipated from historical value of the currency. relationships. To take one case, suppose that domestic demand in 1988 turns out to be ouch Bore sluggish than currently forecasted. The To conclude this testimony, I would like to offer my appropriate response for the Fed will be to ease monetary policy, observations en the specific issues raised by Qiainnan i/i his with a resulting further depreciation of the dollar. This is for invitation to me to testify today, specifically: (1) the costs anl the straightforward reason that more donestic resources will benefits of a policy of defending the dollar on foreign exchange become available for export, without a further depreciation, the markets; (2) the constraints on monetary policy resulting from the unexpected demand slowdown would tend to result in a rise in fragility of the debtor nations; and (3) the inpact of increasing uneEployment. With depreciation, however, the incipient rise in net indebtedness of the U.S. on the conduct of monetary policy. unenployment can be absorbed into export expansion. In the event that the dollar were to be tied to the l» and C«i the Costs and Benefits of Cefending the Collar the Yen in an international arrangement, however, we would not IMs is a very poor time indeed for the U.S. to enter Into have the unlimited discretion to ease monetary policy. Nor could international agreements to support any particular value of the we enjoy the stintilative benefits of a further fall in the dollar. dollar. The whole thrust of my testiiraiy has been to suggest the We would likely enter into a rather acrimonious dispute with profound uncertainties that now revolve around the appropriate Germany and Japan ever the appropriate canton response of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis three countries to the growth slowdown. Germany and Japan would claims should usefully be converted from variable-interest-rate to tend to fear the inflationary consequences of further easing of fbted-interest-rate securities, so that the vagaries of U.S. ittietary policies, and put pressure on the U.S. to ride out the ncoetary policy would not have the effect of wiping out the debtor demand slowdown with somewhat Indited overall economic growth. Countries. The financial feasibility of such an approach, can be The Links of hfcretary policy and ICC Debt dencnstratad (see Sachs , 1987 , for some details) , as can the I have very recently testified (February 4, 1988) at length economic rationale for proaeedirg in that direction. With latin to the House Banking Committee on the state of tha debt crisis, flzerica in its k»rst financial turmoil in decades (average and I would kindly refer this Ctmoittee to that testimony for a inflation now exceeds 200 percent per year in the region! } , it is detailed discussion of ray views. Here, it should suffice to make time to face up to the shortcomings of the current ways of two sonevfliat contradictory remarks. Cn the one side, tighter managing the crisis. monetary policy clearly exacerbates the crisis, by raising interest servicing coets of the dsbtor countries and by depressing Die Inpact of Increased U.S. Net Indebtedness on Jfcnetary Policy the prices of omrtidity exports of the debtor countries, on the in a woria of high private capital ncbility, as now exists, other side, however, the whole defct crisis is being so poorly each country's monetary policies are inherently constrained by managed by the U.S. Treasury mat it makes little sense over the international factors, whether the country is a net debtor or a longer run to hold U.S. monetary policies hostage to the current net creditor country. In either case, a reductioi in domestic debt management strategy. interest rates is bound to set in motion a (rapid) process of The time has long since arrived to reduce the debt burden of portfolio adjustment leading to a depreciation of the domestic the major debtor countries through some mechanism of debt currency. A drop in the real long-term interest rate of 1 conversions, in whicii the commercial banks admit substantial percentage point tends to depreciate the real exchange rate by losses in return for having some or all of their IDC claims taken approxijiately 6 or 7 percent. TtjB big swings of the dollar in over (at a deep discount) by an intematicnal agency, such as the recent years can indeed be well explained by shifts in the U.S. Vtorld Bank. The agency, in turn, would hold the claims CHI the interest rate differential vis-a-vis our trading partners, as is debtor countries, and would reduce the debt servicing burden in shown in the attached figure, taken from Keeper and Harm, 1987. line with the ability to pay. In the debt conversim, the ICC Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FiBUre i. th, Dollar ( i O n u d t ru R n » * i l e l i n tt t ) . r v »»t FUt*t For this t«aBC*if the Knetajy 4ut±uritlflB mist «lwayB grapple •>««!. Mirth If 73 •tog with the fact that "tWnestic" nmetary policy changea uill row inAvitobly heive direct and nearly ivtantanaoua reftuxUBHioiH 01 thfi «9EttwigH rat«f the iiinrt pritv level, and •iqxeT ccnpatJltLlvenaas. A BJVB to Danaged exctiange mtaa wjulcl nat tad to chaiEe this fact: 1C would nerely tend to llait the rnngp of diacreticfi now enj^ed by the Knetory autlKritias. (Afcdttedly, if the U.S. vere at the center of a iBnacpad ayaten, 0ur direct itlClixnce over foreign nonetaiy poltclas could td onbamed. I 013 not vieu B U.S.-centered systen as a raalietic prospect, however). The fact that the U.S. la a net debtor, and OB Ixportantly, a net borrower currently, also Bane that U.S. intoroBt: rates and nonetary policy could also ba oubjast to the audits In portfolio pmtaaee of foreign iiwastors — bWh private and official. If Ritl Leng Ten* kiten»t fttU* «/ the Japanese imrastore ufclenly decide on average that thiy Otoi reopire a risk pragiiw of a feu percentage point* on U.S.- denomlnated aasets, the result ncula certainly b> a sharp rise in U.S. Interest rates and a significant alniltaneaus Cell of the dollar. Such a shift in the tsjiimd ride praaiiu in the central BBChanisn behind stejimn Harris' uell-knaun forecasts of a "hard- landing" in the warld eomv In the next tw to three yours. for feint It ia teeth (aol here history Ky be B ratnor unrellBble guide), thors la little evldance of a rising risk prendiOB on U.S. assets in the past tea years, despite the rapid huildup of U.S. dBmglnated assets In the portfolios of Japanese »» *M -ar> wealttitulderB. Die fears of a sudden uithdrouel of creditB from Sfcurce: Hooper Bud Mann (19B7), Chart 13, p. 51i. The rcil cichgnge rite 1i • CCI tdjuitid fichangf rite fur the non-U.S. G1D countrtei plus Sultierlind. Uelghtlng 1i ictordtrg to th* ihire of the country 1ri world trtde durlnj 1978-81. The long-teni Intcrctt rite 1i > government long-tin bond rite >fnus i 16-Minth, centered. Inflation rite. The 1ong>tem Interest ntt 1ndei utei the stnt weights a the real etching* rite tndei. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis the U.S. have remainedj ust that . . . fears. Foreign private investors have continued to accunulate U.S. denaninated claims at List of References a rapid rate. Jtovorents in U.S. interest rates have apparently been the result iroetly of shifts in U.S. ncnetary and fiscal Alesina, A. and J. Sadis, "Rjlitical Parties and the Business policies, and not of swings in foreign portfolio preferences. Cycle in the United States, 1948-1984", Joumal^f Ifcnev. Credit, and Banking. February 1988 HavrilesXy, T., "Monetary Itolicy Signalling fnm the Administration to the Federal Reserve", Jg^qnal pi Mnney. Credit, anri flanking February 1988 Sachs, J., "Ihe U.S. COnrercial BanXs and the Cevelcping-Country Debt Crisis", Brookinas Papers en ECcnouic Activity, 1987:2 Sadis, J. Testincr^ to the Hcuse Banking Connittee on the Developing Country Debt Crisis, February 4, 1988 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 164 The CHAIRMAN. Thank you very much, Dr. Sachs. Our last witness is Dr. Neal Soss, Chief Economist, First Boston Corporation in New York. We're delighted to have you. You're also, I understand, a former top assistant to Chairman Volcker of the Federal Reserve Board. Mr. Soss. And from Princeton. The CHAIRMAN. Well, nobody's perfect. [Laughter.] Nice to have you. Go ahead. STATEMENT OF NEAL SOSS, CHIEF ECONOMIST, THE FIRST BOSTON CORP., NEW YORK Mr. Soss. Thank you, Mr. Chairman. I appreciate the opportuni- ty to be here as well. [The complete prepared statement of Mr. Soss follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Mr. Chairman. 1 appreciate [his opportunity to testify before the Senate Banking Committee as part of the Congressional oversight of [he Federal Reserve's conduct of monetary policy. Transferring Resources to Foreign Creditors Two transitions—delicate and intertwined—challenge the American economy in the year ahead. The first is to stow output growth to a more sustainable pace after 1987's -urge The second is to base growth more heavily oil foreign demand and relatively less on domestic demand, The.se transitions are fraught with risks, and financial markets have been resonating to those risks since [he bond market collapse last spring. in iys/ pusneci me u..v economy lowaro its resource utilization Testimony by limits too fast to permit continued low-inflation expansion The question is what mec derate the pace of growth and relieve the potential inflationary pr sures Neal M. Soss The devaluation policy of recent years renewed American industry's access ro Chief Economist, The Frist Boston Corporation markets around the world, [n real terms, manufactured exports ate growing at (iouble- digit rates while imports of manufactured items are stagnating. The world wants America's output because the dollar 15 cheap. And Americans are inclined to lay claim before die to the same output because of the jobs, wages, and profit opportunities created by the OS trade boom. The confrontation between an economy moving toward full resource utili- zation and rising demands, both foreign and domestic, is a recipe for inflationary ex- Committee on Banking, Housing & Urban Affairs cesses and mounting financial stringency. The prescription over time is for policies re- strictive enough to moderate domestic demand (arid so relieve the import side (if ;he United Stales Senate trade imbalance) but stimulative enough to perpetuate the resurgence of U.S. esport competitiveness. February 25, 1988 Frijm the outset, the devaluation policy required thai resources would someday have to be shifted away from domestic use and toward the foreign sector. Somedav began to arrive in 1987, and will be with us for several years. What mechanisms can accomplish the resource transfer1* fiscal Policy Fiscal policy can play a constructive rale in this process A tighter budget— whether from higher taxes or lower expenditures— would act directly on domestic demand ,ind allow foreigners to exercise ihe first claim on America's oulput that the cheap dollar has given them. The symptoms of [he economy and the verdict of the markets sueeest that still more fiscal restraint is in order A cheap dollar and nearly full employment mean that for the first time in several years [he U S economy needs a shrinking budget deficit to sustain [he business e\pansion and stabilize financial conditions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Inflation and Financial Stringency reflect a heightened preference for liquidity rather than for the other goods and serv- ices the economy could produce' As we learned in the 197Js, inflation itself is a resource transfer mechanism. Escalat- ing prices ahead of wages (and inieresi rales) [axes away from (he domestic economy Monetary aggregates are not goals in their own right. They are important insofar some of the fruits of its labor. That margin is freed for export. In a broad sense, infla- as they shed light on current and prospective developments affecting the true goals of tion was a ceniral mechanism of the resource transfer to the oil-producing nations that economic performance—sustained growth at high levels of employment and reasonably occurred in [he Seventies. stable prices. The link between money and economic activity is velocity (nominal GNP divided by the money supply). During the 1960s and 1970s Ml velocity displayed a By contrast, inflation has remained under control so far in the 1980s despite a fairly stable trend growth of about 3% per year. Ml was used for making transactions, record-long peacetime business expansion, accompanied on average by quite high rates arid transactions are the stuff of GNP. Thus, for a given growth rate of Ml you could of money growth, and lately a sharply devalued currency. Financial market vigilantes be fairly confident that nominal GNP would grow about 3 percentage points faster. The have launched pre-emptive strikes at every inflection point in this business cycle when Fed made use of this relationship when it set growth targets for Ml. conditions threatened to overheat. While cost pressures are now trending up with iiehier labor marker and capacity utilization conditions, the demand side of inflation The historic pattern of velocity was a fundamental rationale of the Fed's mone- has had a hard time gaining momentum because of the prompt and severe bouts of tarist experiment in October 1979. The Fed would provide reserves sufficient to sup- financial instability the economy periodically experiences. Regulating the pace of busi- port only a targeted amount of Ml growth, which in turn would support only so much ness through unfettered financial markets is dangerous and messy, however, since the nominal GNP growth. Over time, it was hoped, the economy would allocate more of markets have (o make loud crashing noises to he heard by the real economy that nominal GNP to the real component and less to the inflation component. Crashes and ihe Economy Then the link changed. The earlier stable relationship of money growth to GNP growth dissolved into an erratic trend decline in velocity. By late 1982 the Fed was giv- The message to the economy in each instance has been to slow from an over-rapid ing less weight to Ml in its policy deliberations—actual Ml growth vastly overshot its pace. In particular, recession is not now required to deal with the problems of the targets m 1982, '83. '85, and '86—and the Fed didn't set an Ml target for 1987 economy or the financial system Indeed, recession now would make the problems worse. But there is no clear calibration between the degree of setback suffered in fi- In part, the change in its velocity reflects regulatory initiatives that have altered nancial markets and the cooling of demands on the economy lhat is induced. More- the composition and character of Ml. Today over one-third of the monetary assets in- over, repeated shocks have taxed the resilience of financial institutions and mecha- cluded in Ml earn interest. In 1980 less than one-twentieth did, and ihe interest rale nisms on even that small component was subject to strict limits. Since 1983 interest rate re- Crashes heighten forecasting uncertainties. Domestic demand softened in the strictions on checkable deposits held by individuals have been removed. Now the ag- fourth quarter of last year, while production momentum continued. The result was a gregate that we call Ml has both a transactions component and a large savings compo- build-up of inventory. Will production now decelerate to bring inventories into better nent. alignment with sales, or will sales pick up? The lifting of interest rate restrictions has also had an effect on the relationship The most recent statistical readings point to a remarkable (implausible?) re- of GNP and the broader monetary aggregates, M2 and M3. In general, both M2 and bound in consumer sentiment and spending only 3-4 months afler October's Black M3 velocity have become more volatile in recent years This volatility makes M2 and Monday While each of us may express assessments of how sustainable these develop- M3 less reliable monetary policy targets. ments may be, the Federal Reserve requires a higher standard of proof, for its actions The component of "money" that has been least affected by regulatory innova- not only reflect its assessment but also have an important bearing on the outcome. tions is currency—folding money and coins. Yet, even currency has misbehaved; its The Monetary Aggregates and Monetary Policy pre-1980s trend increase in velocity has given way to erratic declines in the last few years, mimicking other forms of "money." It seems likely that the harsh early-'&Gs re- cession and the long disinflationary business expansion that followed have shifted the public's desire for and use of "money" in ways that go beyond the effects of regula- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis .Significant risk remains of a sudden and perhaps exaggerated shift in liquidity preferences that would require the Fed to exercise us responsibilities as lender ol last resort. The Fed cannot pre-empt that risk by adopting a monetary posture ihat is Money is probably still sending a message about economic performance, just as chronically too easy. But a judgmentally-bascd Fed approach, by making for more sta- before. -The difference is that in Ihe "good old days" the monetarist message was deci- ble money market conditions, will lessen the risk of a renewed outbreak of financial pherable by the 3% velocity trend. The code has changed in [he last few years, and we instability on a grand scale haven't yet broken the new one. This fact does not make anyone's job any easier—not the Fed's in framing policy, not the Congress's in oversee me policy, not the market The Fed and the Election participants' in making business decisions in anticipation of economic and iinancial de- velopments As the relationships have become less stable, the Fed has given less and less The Federal Reserve System is designed to provide insulation from the biennial weight to all Ihe monetary aggregates. Currently, the monetary aggregates rank last in and quadrennial partisan pressures [hat are the lot of Congresses and Administrations the Ms! of factors that the Fed considers before adjusting short-term policy They fall Fed Governorships last 14 years, and appointments are staggered to reduce the poten- behind strength of the business expansion, inflationary pressures, and developments in liai influence of one President or political party. The four-year term of the Chairman foreign exchange markets has not been formally synchronized with the President's. The leadership and govern- Velocity is not likely to be any more predictable in 1988 than in other recent ance of the twelve Federal Reserve District Banks, including rotating voting roles on year:; The Fed will continue to set longer-range targets for monsy growth, but it is un- the Federal Open Market Committee, add further insulation from political pressures likely to react to growth that is above or below target unless business conditions and that might al times draw their primary inspiration from electoral objectives inflation pressures are confirming the signals. Financial Fragility It has often been observed that presidential elections tend not to coincide with economic recessions. There have been eight presidential elections since the emergence of a Federal Reserve unfettered by wartime and demobilization responsibilities al the end of the Korean War Only once since then, in 1960, did the election occur during Successive shocks in recent years have undermined confidence in the financial what is officially designated as a recession, while a somewhat broader standard would system, affecting the level and distribution of economic performance. The more com- recognize November 1980 as a time of severe economic turbulence, even if not techni- fortably an activity can be financed, the more of it will be undertaken—a id vice versa cally recession. Credit quality problems have hindered financing for Latin America, the oil patch and Thus, at least six (strictly speaking, seven] of the last eight elections occurred m other commodities industries, with contractionary implications for [hose sectors For a months of business expansion. For perspective, however, recall that expansion is the time, this diverted credil to support booming securities markets and regional economies normal condition of (he economy; recession is the rarity. From 1956 through 1984, [he jlong America's coasts economy grew about four-fifths of the time and suffered recession only about one month in five. Given the relative infrequency of presidential Novembers, their overlap with recession seems about what you'd expect from the "luck of the draw " If policies have been put in place with the intent of influencing election vear The nation's largest commercial banks have seen [heir credit ratings slip on av- economic performance, they have shown no systematic tendency to work. Real (ISP erage below the ratings of their largest corporate customers. Regulators of all major growth, for example, averaged ~$Vt,% in the last eight election years, well within the countries propose stricter bank capital adequacy that should induce tighter credit stan- measurement error of the economy's long-run 3% growth trend- Moreover, the record dards More prudent lending is the Iinancial synonym for more cautious spending does not reveal a 'vstematic tendency for the growth rate to accelerate in election Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis years or to decelerate thereafter. In 1968, 1972. and 1976 real GNP grew faster than it From 1955 to 1985, the fed funds rate changed on average about 160 basis had the year before; in the other five election years growth slowed. Pillowing the elec- points—sometimes up, sometimes down—from year to year. The average absolute tions of 1956. 1968, 1972, and 1984 growth decelerated, but growth sped up in the change in the funds rate in both the eight pre-election and eight post-election years has years after the other four. been about 175 basis points—substantially like all other years Except presidential years. In the last eight of those, the funds rate has changed on average only 94 basis points, less than two-thirds the norm. This behavior is not puzzling. The Fed is constituted to set it apart from the government. But the central bank is also a part of the government. On both counts, its incentives are to keep out of the public eye when the limelight is properly focused on the candidates. On the basis of past patterns, the fact that 1988 is a presidential year means the Federal Reserve will do what it otherwise would, only less so and as unob- The absence of a systematic tendency for the economy to perform differently in trusively as possible. election years does not prove that the Fed (or other policy-makers) do not try to make it otherwise. The Fed and Foreign Exchange The foreign exchange value of the dollar is one policy matter on which the Fed's inde- The monetary aggregates have been a prominent indicator of the Fed's posture pendence is deliberately circumscribed. The dollar is an instrument of foreign relations only in the period encompassing the last four presidential election years. Their record and foreign trade policies, and as such falls within the purview of the Executive. The is clouded. Ml growth accelerated by one and three-quarters percentage points in elec- Treasury Secretary has a particularly influential role in determining how much weight tion year 1972 and about one point in 1976; Ml growth decelerated by one-half per- the Federal Reserve may give the dollar in monetary policy This has been evident centage point in 1980 and four and three-quarters points in 1984. These "facts" do not throughout the G-5 (G-7) process since mid-1985 tell us about Fed motives— judgments about the best interest of the economy long-term or about the candidates short-term. More fundamental ambiguity lies in our inability to The United States is today a gargantuan debtor to the rest of the world. In the separate out of short-run changes in money stock the Fed's influence in supplying best of circumstances, even as the trade deficit shrinks in the next few years, foreign- money and that of millions of households and businesses in demanding Ml balances. ers will have to absorb several hundred billion more dollars . To induce foreigners to hold rising amounts of U.S. dollar claims—perhaps beyond the level of their demand The federal funds rate is not ambiguous. Except for quite short periods, fed for dollars—requires making American assets more attractive to them. That can happen funds trade at rates the Federal Reserve sets or condones. Fed funds behavior around by making the dollars cheaper or by making the assets (stocks, bonds, real estate and elections suggests the Fed is more apt to avoid involvement at politically sensitive businesses) cheaper. The latter is a high-risk route that could end in premature domes- times than to be active. tic recession or deflation. There is no systematic tendency for the federal funds rate to go down or up in Defending the dollar means forcing up short-term interest rates—in the extreme, election years. Fed funds were higher in election season than a year earlier in five of demonstrating a willingness to push rales high enough to provoke recession. A rising the last eight presidential years and lower in three. (Of these, the incumbent party was fe<i funds rate is no comfort to domestic financial markets, as we saw in the violently ousted twice— 1960 and 1976— and returned once— 1984.) Recognition that it takes time adverse reaction to the Federal Reserve's dollar-targeting posture last April. After see- for interest rates to influence the economy, and hence perhaps the election, leads to ing the sour outcome of defending the dollar from April to October, the relevant poli- review of the fed funds pattern before election years. Here again there seems to be no cymakers downplayed that policy in the wake of the Crash, li is unlikely that the suspicious pattern. The federal funds rale rose in five of the eight pre-election years Treasury Secretary will countenance a rerun in 1988 When the domestic economy and and fell in three (Of these, the incumbent party was ousted in 1968 and 1976 and re- inflation require higher interest rates later in 1988. the Fed will tighten policy accord- turned in 1972.) ingly, but it is unlikely to raise interest rates for the express purpose of supporting the dollar's value against the judgment of the foreign exchange market. The magnitude of Fed policy change; in election periods presents a more reveal- ing picture than their direction. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ihe dollar, insofar as exchange rales influence domestic business conditions or prices, the monetary aggregates, to the degree thai other indicators permit interpretation of the information hidden in the money supply; Once again, Mr. Chairman, I v,ant to express my appreciation ro (he Committee for the privilege of appearing hefore you today Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 170 The CHAIRMAN. Thank you, Dr. Soss. I'd like to start off with Dr. Sachs and Dr. Soss on one particular line. I'm concerned about the independence of the Federal Reserve Board and you seem to feel that, on the basis of the record, they can resist. Well, it's an entirely different situation than it's ever been now. We have for the first time in 50 years, maybe the first time ever— I'm not sure about the Roosevelt administration—I haven't been able to get it clear—but this is the first time an administration has appointed every single member of the board unanimously, all six of them. Of course, there's a seventh being appointed at any time. Also, this is an administration that has leaned very hard on the Board. I had a letter just yesterday from the Assistant Secretary of the Treasury which was, I thought, very specifically directed at the Open Market Committee. Right on the verge of their meeting, it was delivered to each member of the Open Market Committee, tell- ing him what the Treasury thought they ought to do. So I'm very much concerned about that. And I might say that Chairman Greenspan yesterday expressed some resentment of the recent efforts by the administration to influence monetary policy. I understand that former Chairman Paul Volcker is said to have written in his thesis at Princeton that the Fed should be made a part of the Treasury to promote coordination of monetary and fiscal financial policies. I think he undoubtedly changed his view as he matured. William Greider, in his recent book, "Secrets of the Temple," also suggests that the Fed should be made part of the Treasury to increase political accountability. First, Dr. Sachs, as an old Fed man, what's your view? FED IS A POLITICAL INSTITUTION Mr. SACHS. Well, I actually did not mean to leave the impression that I think that the Fed can generally resist pressures. Indeed, I think what the evidence shows is that the Fed is a political institu- tion which swings with the politics of administrations and there's a clear pattern of partisan shifts in the party that holds the White House leading to shifts in monetary policy. Historically, however, the shifts in policy have come at the begin- ning of presidential terms. There isn't that much evidence that election years per se have been manipulated by the Fed. What there is evidence, however, for is the proposition I believe that if a Democrat The CHAIRMAN. Let me just interrupt to ask—I understand that some people argue that there's a lag between the action by the Fed and the Open Market Committee and the effect on the economy, a lag of perhaps a year or so. Mr. SACHS. Right. The CHAIRMAN. So if you say "in the election year" you don't see much of a shift, shouldn't we take a look at the year before the election? Mr. SACHS. In the election year, neither do we see a shift in policy nor in effect, and in the year before we also don't see—ap- parently, we don't see enough of a shift in year 3 in order to lead Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 171 to different outcomes in year 4. In other words, the policy outcomes in year 4 are not significantly different from the outcomes in an average year in the economy. The CHAIRMAN. Well, how important actually is the independ- ence of the Federal Reserve Board? Mr. SACHS. I think that there are conflicting interests at stake. A purely independent Fed I think would be—a totally independent Fed I think would be quite problematic because there should be some democratic constraint on the institution. The CHAIRMAN. Why? Mr. SACHS. Why? The CHAIRMAN. With a democratic constraint on the institution it seems to me there would be an inflationary policy constantly. Everybody wants to have low interest rates. Everybody wants to avoid a recession. We inevitably have them but nobody ever wants them—not on his watch. It seems to me that if you're going to have a democratic effect—we have elections every 2 years—you're going to have a policy that will be less sound, less responsible, and it would seem to me there's a good argument for insulating the Fed from that democratic effect. Mr. SACHS. I think that there is an argument on the other side that having it in the Treasury would be quite problematic, but I must say that there's responsibility on both sides. The Bundesbank is probably the most independent central bank in the world and I'm not sure that that is really delivering good public policy for the German people right now. It does deliver stable prices and it's delivered significantly high unemployment rates for much of the last 15 years. And I think that there's a real problem there. We have a balance where we have some political input and we also have institutional independence. The CHAIRMAN. Right now it's a balance of living beyond our means. It's a balance which is failing to accommodate a fiscal policy which is grossly irresponsible. Mr. SACHS. Right. Living beyond our means is the one clear thing that can't be put at the doorstep of the Fed. That's a problem of Congress and the administration and not a problem of monetary policy per se. The CHAIRMAN. Well, it's a problem that monetary policy tries to compensate for. Mr. SACHS. The problem of monetary policy is that given that quite problematic fiscal policy it's extremely hard to operate be- tween the competing demands of accommodation and trying to re- strain an overheating of the economy. And I think on the whole the Fed has done a good job of walking that narrow line. I think most of the testimony this morning illustrated just how difficult it is to do that and, given how many conflicting demands there are on monetary policy, how difficult it is to find a middle ground right now. The CHAIRMAN. Dr. Soss. Mr. Soss. Well, I want to echo the sentiment about the role, if you will, of analysts or scientific kinds of approaches to assess pat- terns and to the degree that any particular instance or episode might tend to deviate from a pattern perhaps the sunlight that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 172 you've directed to the issue of a more politically oriented Fed will help to sanitize the situation. There is no question in my mind, however, that if financial mar- kets came to believe that the Federal Reserve's behavior this year or any other year was motivated by the kind of partisan political concerns that—that the markets would not take that well. FED AS PART OF THE TREASURY The CHAIRMAN. Do you specifically think the Fed should be part of the Treasury? Mr. Soss. I don't think the Federal Reserve should be part of the Treasury, no. I think we're probably better off with the kind of bal- ance that exists wherein the Federal Reserve is apart from the Government but also right here in Washington being a part of it as well. Paul Volcker's view on the question matured with age as well. Mr. COOPER. May I comment on this question? The CHAIRMAN. Dr. Cooper, I wish you would. Mr. COOPER. I think that the formalities of the relationship are less important than the established conventions and expectations. Jeff Sachs has pointed out that from a formal point of view the most independent central bank is really the Bundesbank in Germa- ny, and in two other European countries, Britain and Italy, from a formal point of view, the central bank is under control of the Treasury. The CHAIRMAN. Let me interrupt. Isn't it true that West Germa- ny has had an economic miracle? Isn't it true that that's the strongest economy in Europe? Mr. COOPER. Absolutely. The CHAIRMAN. Isn't it true on the basis of that independence that by and large over the years they've been able to avoid infla- tion? While it's true they have high unemployment now, it's lower than it is in other European countries and by and large it's been quite a success. Mr. COOPER. Mr. Chairman, with deference, this would take us in another direction. I think the U.S. economy today is in much better shape than the German economy is— much better. It's true that we have a problem with our fiscal policy at the present time. The CHAIRMAN. I'd be in better shape, too, if I took a credit card and lived on that credit card and ran up huge bills and lived way beyond my means. I'd be in great shape for a while. Mr. COOPER. But in terms of its flexibility, its innovativeness, its capacity for change, its capacity to roll with the punches, we just have much less rigidity than the German economy does. That gets us well outside the role specifically of the central bank. I don't think the German central bank can be credited with the German miracle or faulted with the rigidities of the German economy. It's just one among many features. But I would not trade places with them for a moment in terms of the fundamental soundness of the economy. I know that sounds a little odd because everyone attaches enor- mous importance to the trade position and the United States is now running a trade deficit and the Germans are running a large Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 173 trade surplus, but that is not the be all and end all of economic performance. Anyway, the point I wanted to make was that in both Britain and Italy formally the central bank is under the control of the Treasury, in the sense that at the end of the day the government can order the central what to do. But in both countries the tradi- tion has been established that the central bank will operate with a high degree of independence except perhaps in a real crunch, and people of sufficient stature have typically been appointed as gover- nors of those institutions that if they were to make a row about an order given to them by the Minister of Finance that would create a large political stink in both countries. And I think that is much more important than the formal arrangments between the institu- tions. Having said that, let me point out that there is a serious anamo- ly in the present U.S. arrangements and that is that the Federal Reserve is formally in charge of domestic monetary policy but the Treasury is formally in charge of exchange rate policy. That was an arrangement that worked perfectly well under the Bretton Woods system in which the U.S. was the passive player and we didn't intervene actively in exchange markets. That is an anomo- lous arrangement in a world of flexible exchange rates and it is one of the sources of the tensions that exist between the Treasury and the Fed today. The CHAIRMAN. Senator Hecht, Senator HECHT. No questions. The CHAIRMAN. Senator Garn. Senator GARN. Mr. Chairman, I have no questions at this time. Gentlemen, I apologize. I intended to be here earlier, but as you all know, we are having a very big markup next Tuesday on a major banking bill that Senator Proxmire and I have been working on for a long time and we had a Republican caucus going on to discuss the provisions of that bill and, as you know, caucuses sometimes last a long time. We were supposed to finish at 10 and just did. I want you to know I'm sorry for not being here, but we were not malingering. We were doing important business on the Republican side and we appreciate your testimony. The CHAIRMAN. Senator Heinz. Senator HEINZ. Mr. Chairman, I will have to make Senator Garn's speech. I, too, was at the caucus. I apologize to our wit- nesses, but I thank them for their testimony. Perhaps I'll be able to submit some questions in writing. The CHAIRMAN. Well, this is a very fine panel we have this morning. IMPORT QUOTAS I want to ask Dr. Barbera, the Wall Street Journal earlier this week reported shortages of semi-finished steel. The article blamed import quotas for contributing to the shortages and encouraging price-gouging by U.S. manufacturers. Have you observed any capacity constraints operating in the manufacturing sector? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 174 Mr. BARBERA. I think that certainly on the bottom end of the economy we've got such capacity The CHAIRMAN. I might say, if I could interrupt, Senator Heinz was elated by that news. Senator HEINZ. I said I would be elated by it if it were true. [Laughter.] Mr. BARBERA. There's ample evidence of booming demand for steel from the. United States abroad, particularly in the Far East, that we are not meeting now because of capacity constraints, I would point out, however, that there are those who are quick to jump at shortages of copper or steel and talk about running up against capacity for the entirety of the economy and then you could leap and say we're really dangerously close to a period where we should move toward recession but because of a Presidential election we're avoiding it. I really think that's a gross mischaracterization of where we are. We have shortages at the bottom end of the economy, but once you move from steel and copper and get on to higher value-added prod- ucts, in fact what we find is a great many nations producing prod- ucts looking for consumers to purchase it. Big retail inventory ex- cesses on the apparel, consumer electronic side, obviously we have a big chronic oversupply on the auto side. The Japanese are put- ting two million production capacity in the United States. They will be able to produce two million cars in the United States in 1989. It doesn't appear they are filling up the productive capacity they have in Japan with cement. So I would say that, except for the bottom end of the economy, we still have ample capacity and we're not dangerously close The CHAIRMAN. Well, I'm a little puzzled by that because they tell us that we're operating at a high level of capacity compared to our operations in the past—85 percent of capacity or something like that Mr. BARBERA. 82 percent. The CHAIRMAN. They tell us that in paper and chemicals, for in- stance, we're operating at an even higher level, 95 percent of ca- pacity. Do you think that production bottlenecks will be encoun- tered in the near future? Mr. BARBERA. I think on the bottom end of the economy, yes. I think, as I said, as you move up the value-added chain, no. I don't see it in cars. I don't see it in capital goods. I don't see it in farm machinery when I look at capacity on a worldwide basis and unem- ployment on a worldwide basis. The CHAIRMAN. Again, what industries do you consider most vul- nerable to capacity shortages? Mr. BARBERA. As I said, the very basic industries where we've had sharp deflation. In other words, primary metal industries. As you said, paper and forest products, chemicals. We're at high levels of capacity because with the big decline of the dollar for a homoge- neous commodity like that, we became wildly competitive very soon with the dollar decline and our exports have been very strong there. But once you move beyond that, I don't see those extraordi- nary capacities. The CHAIRMAN. Dr. Cooper. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 175 Mr. COOPER. Can I make a general observation? In today's world, we should address the question not of U.S. capacity or indeed ca- pacity in any other single country, but worldwide capacity. There, I would say there is worldwide excess capacity, not deficient capac- ity, in almost every industry that you can think of. The CHAIRMAN. But if you look at it that way, doesn't that mean that at least in the short run we will tend to have an even worse balance of trade? Mr. COOPER. That's what I was going to say. If we run into bottle- necks and provided we do not have import controls, we simply import the goods, and the bottleneck is broken. The bottlenecks need not be a source of inflation or constraint to production up the line, but—and here's the important qualification—we want addi- tional investment and the way you get additional investment is to have some degree of pressure on the market. If imports are coming in at higher prices, we get the supply of goods but we also get the stimulus to investment in this country. Indeed, we have seen a pickup in the last three quarters in manufacturing investment and that's what we're looking for. That's to be welcomed. The real problem is the one you put your finger to, where a bot- tleneck develops in this country and we have effective import con- trols, so that we can't relieve the pressure by drawing on the excess capacity elsewhere. The CHAIRMAN. Dr. Cooper, let me ask you about a statement by your colleague at Harvard, Robert Reich. He has an article in the most recent edition of Foreign Affairs in which he claims that our massive trade deficits of recent years have led us to become the world's largest debtor country. MORTGAGING OUR FUTURE He states in that article, "Without a surge in productivity, the present debt cannot be repaid unless we dramatically reduce our standard of living." And he further claims that so far our country has avoided being compelled to reduce the standard of living only by the steady sale to foreigners of shares in our companies and prime real estate. He claims we are, in essence, selling the house to pay the future rent. Do you share Professor Reich's views that we are in effect now selling off our assets to finance our still massive trade deficits? If so, would you state that getting our budget deficits under control is the remedy for such concern? Mr. COOPER. Well, let me say iirst that Harvard is a large and diverse institution and I don't take either credit or responsibility for everything that anyone associated with Harvard says. The CHAIRMAN. In other words, you disagree with your col- league? Mr. COOPER. Particularly with Bob Reich. Having said that, I guess I would say, stripped of the hyperbole in the quote that you read, I agree with the basic point, that we are now selling assets in order to finance an excess of consumption over output and we have been doing so since 1982. There is a risk that unless we do some- thing about getting our overall macroeconomic situation into better Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 176 balance that we will sell our assets even more cheaply than we have been up to now. The sale of assets we've made so far have not been such a bad deal for the United States actually, but it's getting worse because we're selling them more cheaply as the dollar goes down. There's one red herring in the quote you read from Reich, and that is that we don't ever have to repay this debt. We may choose to repay it but we don't ever have to repay it as long as we're a productive economy. But I agree with the fundamental proposition that we are selling assets in order to finance an excess of spending over output and that is not desirable unless we were investing the difference at very high rates of return on investment, The CHAIRMAN. I can't resist disagreeing a little bit with the ar- gument that we will never have to repay it. You say that if we have a growing economy we will never have to repay a $2.5 trillion debt. But, as it grows (and it's growing even by the rosy estimates of OMB), it's shortly going to be $3 trillion and then $4 trillion. Is there no limit? Won't we some day have to repay that? Mr. COOPER. Let me counter by giving the example of Canada, which is a country which, with the exception of a few years mostly associated with World War I and World War II, has borrowed from the rest of the world in every year of its entire existence. We don't talk about a Canadian external debt problem. We don't even think about it. The reason is that Canada has invested its bor- rowings profitably. It services its debt punctually and in fact the debt-to-GNP ratio, which is the key thing to look at, has gone down over the last 50 or 60 years, since the 1920's when it reached its peak. But the absolute amount of debt has gone up year after year. The CHAIRMAN. That's not quite true in our country, though, is it? Mr. COOPER. Well, we have gone through a period of being a net creditor, which Canada never did. After World War I we did build up assets in excess of our liabilities to the rest of the world, until 1982. The CHAIRMAN. Our ratio of debt to GNP (and of business debt to GNP and of household debt to GNP and especially of household debt to savings and of business debt to earnings) has risen. In 1955 we had what I thought was a lovely ratio of $2.85 in debt for every dollar of earnings. Today it's $9. That's a terrific difference. Mr. COOPER. I'm sorry. I was addressing your quote from Reich which had to do with external debt, not the internal debt. I was talking about the debt to the rest of the world. The CHAIRMAN. Dr. Sachs. Mr. SACHS. This is a good opportunity to disagree with both of my Harvard colleagues. The CHAIRMAN. Great. Mr. SACHS. I think first there's a semantical problem. If you say you don't have to repay the debt, it's true that you don't have to reduce the principal back down to zero, but you do have to repay the debt in the sense of servicing it. People will not lend you the money to service those accumulated debts forever and then the debt would grow at an explosive rate and eventually the lending will stop. Canada, for instance, does pay its debts in the sense of a trade balance surplus every year. It sends abroad more resources Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 177 than it imports and that's the way you pay the debt. You pay it in the annual debt servicing, which is a heavy burden. Mr. COOPER. But he said "repay." Mr. SACHS. OK. Well, that s the semantical point. You service your debts. You don't have to repay the principal, but it conies out to a real burden in any event. I think where Reich goes wrong, however, is in the magnitudes. It's a quotation without any sense of quantitative—I think the quantitative importance of these things. Our accumulated foreign debt right now is somewhere on the order of perhaps $400 billion, which is a very large amount, but we have a $4 trillion economy. That makes a debt to GNP ratio of perhaps 10 percent and a real interest servicing bill each year if we were to stabilize at that ratio of something on the order between Vz of 1 percent and 1 percent of GNP. To say that we can't afford that is a silly proposition. To say that it will be politically painful to turn from a trade balance defi- cit to a trade balance surplus is undoubtedly correct. The CHAIRMAN. That's a very, very healthy and proper correc- tion, but looking toward the future, if we continue this, it's a prob- lem. Then, there's another problem involved here. When the debt to GNP ratio increases, doesn't it limit the ability of the Federal Reserve to contract credit, diminish credit, without causing wide- spread defaults on credit obligations, driving interest rates up? Mr. BARBERA. I do think the markets have told us something in 1987 and that is that we've reached a point where we are no longer going to have the voluntary financing of that spending without clear evidence that that spending is slowing. I mean we did have two big bouts of dollar weakness in 1987 which was combined with big selling of bonds, as you said, by Japanese insurance companies. In both those instances, they were precipitated by disappointing evidence on trade which indicates a growing need rather than a de- clining need for U.S. foreign capital. I think we're already at the point where we are going to, one way or the other, see trade im- prove over the next 3 or 4 years and reduce our capital needs be- cause foreigners simply aren't going to voluntarily provide that capital. It seems to me that where you go to then is, if we're going to have economic growth over the next 3 years that stays within the disinflationary mode, let's say 2.5 percent on average the next 3 years, and if you talk about getting on a real balanced basis of something close to zero, you really don't have much in the way of room for growth on the consumer side. I would posit that that suggests that goods spending—take serv- ices out—goods spending 1988 through 1990 is going to average something like zero or 1 percent in terms of growth compared to 5 percent from 1983 through 1986. Now there's an easy way to do that. We talk about that at Shear- son in terms of voluntary quiescence. We seem to be serendipitous- ly right now in the midst of that, but if the consumer were to come back and spend strongly, I would argue, world financial markets would work to knock them down in America. The CHAIRMAN. Dr. Soss. Mr. Soss. I want to add two points on the financing of all of this. It is certainly the case that organizations as complex as a whole Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 178 economy rarely pay down the principal of debt, but there are two developments going on now that reflect how difficult it is to raise this new indebtedness. The first is that not only is the private foreign capital inflow be- coming more tenuous from time to time, but as you may have no- ticed in the Treasury's financing's of late, increasingly what we're doing is financing this budget deficit by having foreign central banks and foreign finance ministries directly buying Treasury obli- gations through the so-called foreign add-ons, which I think we can characterize as a reflection of how inadequate private foreign de- mands are for those bonds. So we are requiring a more routinized, regularized, dare I say it, IMF style financing of this budget deficit. The second thing that's going on is that we are, ourselves, experi- encing the debt for equity swaps that we have so often recommend- ed for Latin America and other debtor countries. The foreign financial inflow is not as much coming in the form of bonds or even for that matter hundred shares at a time in the stock market; it's coming in the form of 100 percent. Foreigners want control of productive assets rather than subjecting themselves to financial claims directly. RECESSION WOULD EXACERBATE OUR PROBLEMS The CHAIRMAN. Dr. Soss, your testimony suggests that the cali- bration between the degree of setbacks suffered in the financial system—the crash—and the cooling off of the real economy is miss- ing. Furthermore, you say that a recession would just make the problems worse. Is this lack of correspondence between the real and financial economies in the short run new? Didn't stocks crash in 1962 with- out precipitating a recession? Mr. Soss. That is correct, Mr. Chairman. This calibration prob- lem is not novel. It is to my mind a bit interesting to point out that we had, a relatively weak Christmas season at retail and if you at- tribute that to the crash, then I think you have to say that the crash is now behind us because January retail sales and February auto sales picture and all the rest suggests that the consumers have The CHAIRMAN. How about the Fed's vigorous lender-of-last- resort activity and their coming on hard and fast with more liquidi- ty? Mr. Soss. There are Hobson's choices that are faced from time to time and I think in that respect one can say that the Federal Re- serve had no choice but to rescue the financial system on October 20 and that doing so as effectively as they did may be why con- sumer demand in fact is rebounding so promptly. Mr. BARBERA. May I take a little bit of issue? The CHAIRMAN. Please. Mr. BARBERA. If we look at consumer demand, we are slaves to weekly and monthly numbers because both Dr. Soss and I forecast interest rate changes daily. If you look at the numbers that we've seen for January, you did have an upward revision for December Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 179 retail sales and a decent January number, so things were not quite as bad as they appeared. However, take November, December, and January retail sales and compare them with May, June, and July—in other words, 6 months percent change annualized—and we're falling The CHAIRMAN. And correct it for seasonal factors? Mr. BAEBEBA. Seasonal factors and inflation. We're falling at a 3 percent rate. So we are still below where we were in the middle of last year and I certainly wouldn't characterize consumer spending right now as robust. We also, dare I say, poll the stores on a weekly basis and Febru- ary looks fairly weak. We did have a 35-percent decline in the stock markets around the globe. The precedent for that is 1929. I think it's absolutely un- conscionable to consider that the Fed should have stuck to a tight monetary policy based on a fear about a little more inflation when you're faced with that kind of financial market fissure. Obviously it was very difficult on the brokerage industry. Some brokerage companies are no longer there that were there in Octo- ber. I worked for one. It was a difficult environment. I think the Fed had to ease money. The CHAIRMAN. Dr. Soss, does the cumulative decline in the resi- liance of our financial system limit the ability of the Fed to arrest inflation in the real economy because the cost of credit stringency has grown? Mr. Soss. I think what it does is give you periodic crashes where the financial markets themselves insist on performing the function that monetary and fiscal policies from time to time are reluctant to perform. The CHAIRMAN. Very interesting. Mr. Soss. People who were cheated out of their coupons in the 1970's have long memories. We have a financial system which from time to time gives you events like October 19 and requires the Fed to ease, and I certainly share the judgment that there was no alter- native in that episode but to do so. EXCHANGE RATES AND MONETARY POLICY The CHAIRMAN. Dr. Cooper, let me ask you a somewhat lengthy question on exchange rates and monetary policy. There appears to be two schools on exchange rate policy. The first group says let the dollar fall and fall a lot in a hurry. That school claims that if the currency declines a great deal the expecta- tion will be that it can then only rise. During the fixed exchange rate period, the rule of thumb was that if you were going to do it, don't undershoot. The second school believes that a gradual, managed decline of the dollar is necessary because, in a floating exchange rate world, an unstable and rapid fall in the dollar would create the expecta- tion of continued depreciation leading to high interest rates and ex- change rate collapse. It appears to me that a key question in exchange rate manage- ment is how actions today affect expectations of exchange rate changes in the future. Is that right? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 180 Mr. COOPER. Mr. Chairman, I belong to both of those schools of thought, depending on the circumstances. In 1985,1 was very much of the first school. I argued that the proper task was to get the dollar down and get it down very quickly and for that reason I wel- comed the Plaza Accord. I had already urged that course well before September 1985. Starting from where we start now, however, I worry very much about a sharp drop in the dollar for the reasons that I gave. I think in the short run, by which I mean 6 to 24 months, a further sharp drop of the dollar on the world economy and hence on us, the United States, would be negative, not positive, because of the heavy dependence of many other economies, especially Germany, on ex- ports. That dependence will have to change, but it will not change quickly, and it's not in our interest to shock Europeans into reces- sion. So, my judgment at the current time is to try to avoid a fur- ther drop in the dollar. Mr. COOPER. Now the market may have a different view and then somebody would have to decide my guess it would be the for- eigners in the first instance—how they want to play that. My view at the present time is conditioned by two other judg- ments that are worth making explicit. One is that I am not as cer- tain as many of my academic colleagues that the dollar actually needs to go down further. It may be so. I'm not saying it's not the case, but I'm not certain in my own mind that it does. Therefore, at the present time, I would not want to see a deliber- ate depreciation of the dollar. That judgment, in turn, is condi- tioned by a view which again differs from many American academ- ics that have spoken out on this question, that I do not think it is either necessary or possible—I actually do think it's desirable but I don't think it's necessary or possible to achieve a balanced U.S. current account by the early 1990's. I look at the adjustments that the world economy would have to make in order for us to achieve a $200 billion swing in net exports of manufactures and I cannot see that taking place politically or psychologically. For that reason, the improvement in the U.S. trade position that I target is rather less than that that other people are either implic- itly or explicitly targeting. Some of my colleagues want a current account surplus by the early 1990's, to start to repay the debt, I don't think it's in the cards and trying to force it would not serve either the United States or the rest of the world well. I do believe that the U.S. should work to get the budget deficit down at a regular steady pace, but I don't think—and in this re- spect I agree with Dr. Sachs—I don't think that by itself that will generate a current account balance in the United States, much less a surplus, in this timeframe. So for all of those reasons, I am not enthusiastic at the present time either about a sharp drop in the dollar or a further gradual drop in the dollar, although that's not to deny that one or the other might not take place as a result of market forces. The CHAIRMAN. Dr. Barbera, the Federal Reserve has been widely praised for its action—in fact, I think it's more widely praised for this than anything that's happened since Dr. Greenspan has been Chairman of the Fed—for its action in the aftermath of the stock collapse on October 19. They came right in like gangbus- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 181 ters on Terrible Tuesday with a tremendous amount of liquidity— prompt and dramatic action, as you say. Now while they did act skillfully and decisively and they really had no choice but to act, we now have kind of a moral hazard prob- lem where the financial sector will take even greater risks know- ing that the Fed will come to the rescue when danger comes and liquidity is near at hand. Mr. BARBERA. I don't think so. I think that what you had was the Fed coming in providing liquidity obviously during a period where many of the marketplaces really were, if functioning at all, func- tioning very poorly. We did have during that period some combina- tion of events that exacerbated the stock market swoon with the combination of program trading and portfolio insurance. My firm, for one, has stepped back from program trading. I don't think that simply because the Fed prevented that fissure and the extraordinary losses of the world's financial system and in the industry—they prevented that fissure from becoming a world- wide recession, that that certainly doesn't make it easy once again to increase speculation. INFLATION AND LOWER UNEMPLOYMENT The CHAIRMAN. Dr. Sachs, one of the problems that always con- cerns us very deeply is the tradeoff between unemployment and in- flation and the fact that as unemployment diminishes inflation is likely to come on. We now have a situation where unemployment is lower than it's been in 7 or 8 years. It's down to about 5.8 or 5.7 percent, depending on how you measure it. It's down at a low level. I understand that economists estimate a so-called nonaccelerat- ing inflation rate of unemployment. Some say it kicks in when un- employment gets below 6.2 percent. Then inflation comes on. Others say it's lower. Others say it changes. The estimate varies considerably. Large changes in demographic factors and sectoral dislocation may provide a good reason for these varying estimates over time. In recent months the estimates have been declining because the unemployment rate has been declining and inflation hasn't risen very sharply. What's your estimate of the so-called nonaccelerating inflation rate of unemployment today and for the near future? Mr. SACHS. Well, like many things, we don't really know, but I think that there has been relatively good success statistically with using demographically weighted unemployment rates over the past years adjusting for the composition of the labor force to include new entrants, for instance. The CHAIRMAN. Let me just interrupt. One of the problems here that you see is that up in the area where you are, up in Massachu- setts, there's a very low level of unemployment. In Texas there's a very high level of unemployment. Louisiana there's a high level of unemployment. It would seem to me that those regional factors would make a great difference. You should have a difference in the level of inflation in New England where unemployment is very low than in the South where it's higher. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 182 Mr. SACHS. And we do. Of course, if you look at housing prices in Boston compared to Texas you can see what happens with non-tra- dable goods in the economy. Prices have skyrocketed in Boston and have collapsed in the Southwest. So indeed for those goods that can't be transported easily across State boundaries you see exactly the kind of phenomena you're talking about. Overall, there is probably a small effect on the aggregate NAIUR that comes from regional mismatch and in fact some economists have tried to estimate that and I can provide for the record some of the estimates on that. I would say that there's a mainstream view among people that are in this business now that the NAIUR may have come down from somewhere around 6 percent to something like 5.5 percent, but that we're very close to the range at which a significant down- ward push on unemployment would start causing wages to rise rap- idly. Indeed, the slowdown in nominal wage growth which had been occurring every year since 1981 stopped slowing down last year and we had a slight uptake in hourly compensation in 1987 relative to 1986. So we are seeing a firming of the labor markets and I think we're around the range at which we have to be careful and we shouldn't expect another freebie of 1 percent of unemploy- ment that can be reduced without having significant inflationary consequences down the road. The CHAIRMAN. But we also have in 1988, 40 percent of organized labor contracts expiring, I understand, covering 40 percent of the workers. So it could be a year for big increases, especially in view of the fact that in many industries the real wage has not increased. Mr. SACHS. That's right. Real wages on average have declined during the Reagan term from 1981 and that's partly because there was an enormous overhang of real wages. They were too high by the time the administration came to office, given all the adverse productivity. The CHAIRMAN. How about the presence of foreign competition? Could that increase the discipline of wage demands in light of the possibility of losing business to competitors overseas? Mr. SACHS. I think that the main way that that works through the system is not directly so much as affecting the overall state of the labor market. I don't think that there's been a significant structural shift in our economy which has made the wage equation all the sudden react for a given unemployment rate differently from what it would because of the presence of foreign competition. I think the evidence is that there s a fairly stable relationship of wage inflation to lack of price change and to the demographically adjusted unemployment rate and that's a fairly good relationship that doesn't give us a lot of surprises year after year, and that sug- gests that we are in a range now where we have to be careful. POSSIBLE RECESSION IN 1989 The CHAIRMAN. Dr. Soss, privately many people are suggesting that the U.S. economy is going to be put into a severe recession by policy makers in 1989 just after the presidential election. I think that's baloney. I've never known a policy maker who had any notion of getting into a recession. By a policy maker, I mean an Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 183 elected official. Obviously, the elections come frequently and so that's not likely to happen, but some suggest that this is the only way to reduce the trade deficit. Do you agree with that? Mr. Soss. I've had over 10 years experience in public service, Senator, not quite as long as your own and not nearly as distin- guished, but I would share very strongly your sentiment that I've never known a policy maker deliberately to choose a recession if he had to face the voters. On the question of do we have to have recession in order to deal with the trade problem, I think to get back to Dr. Cooper's observa- tion that you have to be careful what you wish for. There is a limit to how fast the world economy can tolerate a shrinkage in the U.S. trade deficit because of course the counterpart to that is the shrinkage in everybody else's trade surpluses. And I don't think that we require literally a balance all that quickly and I don't think that we require literally a recession to improve conditions. Running the economy, so you don't ever need a recession, should be the real good. The CHAIRMAN. And there's some very adverse consequences as- sociated with a long recession given the condition of Latin Ameri- can debtors, farmers, banks, S&L's, and businesses with such high levels of debt. Doesn't that limit the extent of a recession that policy makers could tolerate to alleviate these matters? Mr. Soss. My own judgment, Senator, is that the financial struc- ture in that regard is not that significant to the macroeconomic problem. If the goal of policy makers is to keep the physical and other resources of the economy fully employed, there are plenty of ways to do that and I doti't think it's really a function per se of whether the capital in the real economy is reflected in claims called debt or claims called equity. The Japanese, for example, have a very much more leveraged structure in many ways than we and yet no one seems to think of their economy as at risk thereby. There are lots of other economies around the world that have less leverage than we and don't do nearly so well. So it seems to me that that is much more a matter for financial stability and for the risk that financial blowoffs can from time to time impose on the real economy than for whether the policy makers can keep the economy productive independent of the finan- cial structure. The CHAIRMAN. Now that I'm about to retire—this is my last year—I have, I think, a more objective attitude toward recession than I did when I was running for reelection. If I were running for reelection I'd be up in November and undoubtedly a recession wouldn't help any incumbent's reelection chances. But it seems to me that one of the prices you pay for a free economy are regular recessions. You don't have recessions the same way in socialist economies. We have them in a free system and that's one of the things we have to do. Recession does have the salutary effect of providing a very tough discipline in the society. It means that people have to be more prudent, more careful. They have to exer- cise more judgment. It penalizes people who don't have that pru- dence. And not only from that general standpoint but also from the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 184 standpoint of recognizing that you can't live beyond your means forever, Mr. Soss. That's another argument in the direction of the inde- pendence of the central bank. Mr. BARBERA. If I could just add one thing, I do think in terms of notion that perhaps we're due for a recession in the United States to pay for past sins. We have had an exclusive focus here on the excess of spending in the United States vis-a-vis production and the fact that we've financed that by foreign capital. I do think, though, if you turn it on its head, notwithstanding the admonition of most foreigners, we did do the world a favor. We allowed Latin America to essentially avoid default and Europe grew at about 2.5 percent, even though spending was rising at about 1.5 percent. Japan got to grow at 4 percent though spending was at 3. The CHAIRMAN. What period are you talking about? Mr. BARBERA. 1983 through 1986. And the Pacific Basin and Japan exploded, largely on the backs of our growth. I think we're done. I think it's absolutely impossible for us to perform in 1988 through 1992 as we did 1983 through 1986, but I think the risk is that there are no new volunteers in terms of the rest of the world to provide that kind of spending and that absorption of product. It seems to me that rather than the need for a U.S. recession we need a U.S. spending recession and some much better spending perform- ances abroad. The CHAIRMAN. Dr. Sachs, how enthusiastically do you endorse the views of Dr. Barbera? Mr. SACHS. I have a growing inventory of small complaints on comments in the last 5 minutes. First, I'd like to return to the Wall Street Journal statement about a recession being likely. I think it is important to point out that five of the last six Republican terms of presidencies started with a recession. No Democratic terms did, but five of the six Re- publican terms did. The CHAIRMAN. That means if we elect a Republican this year we'll have a recession in 1990? A DEMOCRATIC ADMINISTRATION Mr. SACHS. Much more likely because what will happen this year, with all likelihood, in my view, is inflation will start to rise. A Democratic President won't care so much about that and will be more interested in job creation and getting the exports growing. A Republican administration will try to clean that up in the first year and could have a conscious policy of tightening monetary policy to stabilize the dollar. That may be how it's put next year. There will be a difference in preference that will involve a real tradeoff of policy and judgment and values and people who will get hurt and who won't. Democratic administration is much more likely to lean toward job creation and continue growth of exports and I think a new Republican administration will be much more likely to say if inflation hits 6 percent we've gone far enough with the weak dollar, it's time to tighten up. So that's the way that it might be seen next year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 185 Recessions are created as a matter of policy in this country, mainly as anti-inflation policies, and I think that we may be head- ing for that cycle right now, given the 40 to 45 percent drop in the dollar. Another point I wanted to make is that I think that the debt structure is a danger. We don't have a lot of the institutions which allow us to have the kind of leveraging the Japanese firms do where you have a close special relationship between banks and firms which allow for enormously high leveraging ratios. We do have some financial instability here, particularly in the banking system, that could mean that high interest rate policy once again could have very serious real consequences, in my view. Finally, and this may be a quibble because it's past history, al- though I think it's more than a quibble, I don't think the U.S. did the world much of a favor at all in the last 7 or 8 years because while we did give them more export growth, we created enormous- ly high world interest rates. That meant that while we gave in the sense of higher exports, we took away in the sense of reduced in- vestment in those countries and, in my view, Europe was hurt much more by the reduced investments over the last few years as they sent capital here rather than investing in their own country rather than being helped on that by increased exports to the United States. Job creation in Europe was very much hurt by Reaganomics it seems to me and we contributed to the high unem- ployment in the European economies. REDUCING DEFICIT WILL SPUR ECONOMIC GROWTH The CHAIRMAN. What do you think of the point that Dr. Green- span made for us the other day that if we cut the deficit we'll spur economic growth because the real interest rate would drop and that would compensate? Mr. SACHS. I saw in the press reports that you expressed some surprise at that view. The CHAIRMAN. I sure did. It's a refreshing notion that you can do that. I'm willing to pay the price. Mr. SACHS. I actually share Dr. Greenspan's view of it, provided that he goes along and importantly accommodates our fiscal con- traction with easier monetary policy. In other words, if the policy mix in this country changes toward The CHAIRMAN. But I can't get away from the view expressed by Martin so beautifully that you can't push a string. No matter how you flood the economy with credit, if you're in a recession people are just gloomy and pessimistic about it, they won't borrow. They won't care if they pay 5 percent interest rate instead of 10 percent. Mr. SACHS. Well, I think the evidence is that if you're hanging at the end of the string because real interest rates have been so high for the last 10 years, that letting up on the string could give you some breathing space and let you start to grow again. So in my view, a shift in the policy mix toward tight fiscal and easy money will not have contractionary effects abroad but indeed could have expansionary effects abroad and would likely in my view because I think it would give an investment stimulus to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 186 Europe which is going to provide jobs there much more than the export stimulus has. What I would agree with my colleague, Professor Cooper, point, an economy has to be ready for the transition to investment led growth from export led growth. Japan is in the midst of that tran- sition now and it's very consciously in the midst of that transition. The European economies might not be consciously ready of shifting out of export industries and into domestic investment, but they will have the potential and we should give them the chance to do it by having a sharp cut in fiscal policy in this country balanced by easy money. I think the world will be much better off. The developing world, the debtors of this world, the financial structure, and the Europeans will be much better off in a low interest rate regime in the world economy. Mr. BARBERA. Your point is that a lower budget deficit would be stimulative if compensated, but not in the U.S. Mr. SACHS. Well, both. Yes, we need lower worldwide interest rates. By our interest rates coming down we will give the opportu- nity in Europe to have lower interest rates. Mr. BARBERA. I agree, but the point I'm making is based on our trade deficit, it's wrong to think that there's any combination of events that can make it easier for us to spend more. Mr. SACHS. I'm not calling for us to spend more. I'm calling for us to spend less. Mr. BARBERA. There's a opportunity to make it easier for them to spend more. Mr. SACHS. Exactly. Mr. BARBERA. I don't think that's quite what Greenspan said. The CHAIRMAN. Do you want to comment, Dr. Cooper? Mr. COOPER. I think the way to reconcile this dispute, if I can put it that way, between you and Greenspan, is to introduce the time dimension quite explicitly. At least that's the way I reconcile it in my own mind. Greenspan presented and Sachs has just agreed with what I would call the classical economic view, which is the long- term interest rate makes things all come out right in the end. But econometricians have tried for 40 years to discover the short run impact of that effect and they can't find it. And that's why I come down with you and Martin in the short run. You cannot push on a string. Lowering interest rates at the same time that you're contracting demand simply will not increase investment in the same short timeframe. There's no empirical evidence for it. During the last several years I have sat on several committees that make decisions about investments and the interest rate just doesn't figure in the calculations whether to undertake them. In the long run, there will be an impact. Where there could even be a short-run impact these days is in the liquidity constrained less developed countries. They would get immediate relief from a reduc- tion in dollar interest rates and are willing to spend more. So there you would get a relatively short-run effect. But I simply do not be- lieve that fiscal contraction accompanied by a decline in interest rates will in the same time period be offset by increased invest- ment at home or abroad. If demand goes down because of fiscal contraction, businessmen will wait before they make their invest- ment decisions, even though interest rates are lower, until they see Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 187 reasonable prospects for setting the increased production. The most promising prospect today is higher exports, but that depends on continued demand abroad. FLOATING EXCHANGE RATES The CHAIRMAN. Let me ask you one final question. In Tuesday's Wall Street Journal, Edward Balladur, the Finance Minister of France, referred to the "anarchy of floating exchange rates during the past 15 years." In your statement you referred to this system as not wholly satisfactory, although probably superior to alterna- tives available during this turbulent period. Your statement suggests that you do not join in Mr. Balladur's extreme condemnation of the system of floating exchange rates. The question is, how urgent is reform of the international finan- cial system in your estimation? Mr. COOPER. Urgent suggests an immediacy, a crisis without it, and in that sense I do not think it's urgent. However, I do think that it's highly desirable. I think we have monetary arrangements now which are not sustainable over the long run and they are going to come and zap us in one way or another if we don't get ahead of the game. So I think that it's desirable to start in a sys- tematic way to think about where we would really like the system to be 15 years from now. Fifteen years seem like a long time, but it isn't too soon to begin thinking about fundamental changes. The CHAIRMAN. You talked about a world currency. That's a marvelous thought. What reality is there here? Is it a real possibili- ty, do you think? What would be the consequences when we have an adverse balance of trade and we can't fool around with our cur- rency and compensate in that way? Mr. COOPER. Well, in the first place, just to be clear, I have not spoken of a world currency. I don t think a world currency is either desirable or necessary. What I have spoken of is a single currency in the core of the world system. The CHAIRMAN. I should have said that. Mr. COOPER. Europe, United States, and Japan. What other coun- tries do is up to them—many of them would find it convenient to peg their currencies to this currency but they would not be partici- pate directly in this system. An analogy to the United States is worth noting. We have, as you know, 12 currencies in the United States Act. Each Federal Reserve Bank issues currency. If you look in your wallet you can discover several currencies. Most people are not aware of it because these currencies trade at par and are freely interchangeable throughout the country. That system has served this country well. I do not think it's de- sirable to break New England off, even though it's booming now, and break Texas and Oklahoma off and introduce floating ex- change rates between their respective currencies. The CHAIRMAN. How about starting with a Northern Hemisphere currency? Mr. COOPER. That's up to Canada. It seems to me that that's less important for the world than to engage the major trading areas — Canada is one-tenth the size of the United States. Europe taken as a whole is equal in size to the United States, and Japan is about Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 188 half the size, so those are more important for the world monetary systems than Canada. My view stems from the fact that I think the financial side of a system with flexible rates will increasingly be a source of disturb- ance to the real side of the economy. It already has been. Since we're really interested in the real side of the economy—that's what provides people with the goods and services that determine welfare. The financial side of the economy should serve the real side of the economy. We should worry about disturbances coming from the fi- nancial side. While it has some problems, moving to a single cur- rency over the next 15 or 20 years, will have the offsetting advan- tages of eliminating a major source of uncertainty for and disturb- ances to the real economy. One reason investment has been as weak as it has been in the last 5 years is exchange rate uncertainty. Until 1986, Europeans had been doing smashingly in terms of export orders but they were not willing to invest on it because they thought that 3 marks to the dollar or even 2 marks to the dollar was a temporary and couldn't last. They turned out to be right. Now you find American firms hesitating to invest because even though their export orders are way up, there's a question of how long this can last. They're not confident. They don't accept the economists' argument that the dollar is bound to go down rather than up. Exchange rate uncer- tainty is a general dampener to more investment. The CHAIRMAN. Gentlemen, I want to thank you very, very much. This has been an excellent panel and you've certainly given me an education. The committee will stand in recess. [Whereupon, at 11:40 a.m., the hearing was adjourned.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1988, February 24). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19880225_chair_federal_reserves_first_monetary_policy

@misc{wtfs_testimony_19880225_chair_federal_reserves_first_monetary_policy,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1988},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19880225_chair_federal_reserves_first_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}