<DOC> [107 Senate Hearings] [From the U.S. Government Printing Office via GPO Access] [DOCID: f:75191.wais] S. Hrg. 107- 132 FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT FOR 2001 ======================================================================= HEARING before the COMMITTEE ON BANKING,HOUSING,AND URBAN AFFAIRS UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS FIRST SESSION ON OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSU- ANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 __________ FEBRUARY 13, 2001 __________ Printed for the use of the Committee on Banking, Housing, and Urban Affairs _______ U.S. GOVERNMENT PRINTING OFFICE 75-191 WASHINGTON : 2001 ____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512ÿ091800 Fax: (202) 512ÿ092250 Mail: Stop SSOP, Washington, DC 20402ÿ090001 COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS PHIL GRAMM, Texas, Chairman RICHARD C. SHELBY, Alabama PAUL S. SARBANES, Maryland ROBERT F. BENNETT, Utah CHRISTOPHER J. DODD, Connecticut WAYNE ALLARD, Colorado TIM JOHNSON, South Dakota MICHAEL B. ENZI, Wyoming JACK REED, Rhode Island CHUCK HAGEL, Nebraska CHARLES E. SCHUMER, New York RICK SANTORUM, Pennsylvania EVAN BAYH, Indiana JIM BUNNING, Kentucky ZELL MILLER, Georgia MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware JOHN ENSIGN, Nevada DEBBIE STABENOW, Michigan JON S. CORZINE, New Jersey Wayne A. Abernathy, Staff Director Steven B. Harris, Democratic Staff Director and Chief Counsel Linda L. Lord, Chief Counsel Martin J. Gruenberg, Democratic Senior Counsel George E. Whittle, Editor (ii) C O N T E N T S ---------- TUESDAY, FEBRUARY 13, 2001 Page Opening statement of Chairman Gramm.............................. 1 Opening statements, comments, or prepared statements of: Senator Sarbanes............................................. 2 Senator Bennett.............................................. 4 Senator Miller............................................... 5 Senator Ensign............................................... 5 Senator Corzine.............................................. 5 Senator Hagel................................................ 6 Senator Stabenow............................................. 6 Senator Allard............................................... 7 Prepared statement....................................... 53 Senator Johnson.............................................. 7 Senator Bayh................................................. 8 Senator Dodd................................................. 8 Senator Reed................................................. 9 Senator Shelby............................................... 30 Senator Carper............................................... 41 Senator Schumer.............................................. 44 Senator Bunning.............................................. 53 WITNESS Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC................................. 10 Prepared statement........................................... 53 Response to written questions of: Senator Bunning.......................................... 58 Additional Material Supplied for the Record Monetary Policy Report to the Congress, February 13, 2001........ 60 A New York Times Article by Robert Rubin, ``A Prosperity Easy to Destroy,'' dated February 11, 2001............................. 92 (iii) FEDERAL RESERVE'S FIRST MONETARY POLICY REPORT TO CONGRESS FOR 2001 ---------- TUESDAY, FEBRUARY 13, 2001 U.S. Senate, Committee on Banking, Housing, and Urban Affairs, Washington, DC. The Committee met at 10:00 a.m., in room SH-216 of the Hart Senate Office Building, Senator Phil Gramm (Chairman of the Committee) presiding. OPENING STATEMENT OF SENATOR PHIL GRAMM Chairman Gramm. The Committee will come to order. Let me thank our Members for coming. This is an important hearing--The first of our new hearings on monetary policy under the Federal Reporting Act of 2000. As our colleagues and Chairman Greenspan will remember, for many years we had a semiannual report under the Humphrey- Hawkins Act, which required the Fed to report on many economic factors that are no longer as relevant in the year 2001 as they were in the 1970's. We were able to work out a bipartisan agreement to change the focus of the report and, as a result of that bipartisan effort, today, we are holding our first hearing. I want to thank Senator Sarbanes for his leadership in helping us reach a bipartisan agreement that would allow these hearings to move forward. I am also glad that we have agreed-- except under circumstances where the Banking Committee in the house of Congress that does not hold a primary hearing feels that it is necessary to have the Federal Reserve Chairman present the whole thing again--that we will have reduced four hearings a year for Chairman Greenspan down to two. Knowing that he is a busy man, trying to keep the economy strong, doing God's work in that effort, I think that is an important achievement. So, we are here today to hear a report on the American economy. In my opinion, since roughly 1982, when the Reagan program became operational, we have been virtually in a 19-year golden era in America. Not only do we have higher real incomes, not only do we have an abundance of consumer goods at lower prices and higher quality than at any other time in history, but this expansion has been so strong that people who once were considered unemployable are now viable, functioning members of the labor force. In this environment, we were able to reform welfare and require that people leave welfare and go to work, and they have done it, and have not only benefited the taxpayer with lower welfare expenditures, but, most importantly, benefited themselves by earning the dignity that comes from being self- supporting. It is hard to imagine anything more important than keeping this economic expansion going. Chairman Greenspan, as always, we look forward to hearing what you have to say and to working with you to do what we have to do to maximize the chances that this economic expansion will continue to create jobs and growth and opportunity for all of our people. And so, I want to welcome you to the Committee. Let me say to you and to our colleagues, I have to run downstairs around 10:30 to introduce a friend of mine from Texas who's been nominated to a high post. I will ask Senator Sarbanes to preside during my absence and, hopefully, by the time we allow everybody to give an opening statement, I will have had time to go down and do that and come back. But if I miss part of your statement, I will have trusty aides here listening. So let me welcome you today and recognize Senator Sarbanes. OPENING STATEMENT OF SENATOR PAUL S. SARBANES Senator Sarbanes. Well, thank you very much, Mr. Chairman. I join you in welcoming Alan Greenspan back before the Senate Banking Committee. We look forward to receiving the Federal Reserve's semiannual monetary policy report to Congress under the legislation that we were able to pass at the end of the last Congress, legislation which gave a permanent reauthorization to this semiannual monetary report, something which I understand the Fed was supportive of, and also reauthorize a number of other reports under the jurisdiction of this Committee. I want to express my appreciation to Senator Gramm for his cooperation in that effort that enabled us to resolve that issue, I think much to the advantage of everyone. These monetary policy reports and the public testimony before Congress by the Federal Reserve Board Chairman serve a critical oversight function and I am glad we are carrying it forward without interruption. Much has changed since Chairman Greenspan appeared before this Committee last July 20 to testify on the Fed's previous monetary policy report. Two months prior to that appearance, on May 16 of last year, not yet a year, the Fed completed the last and longest half-point of a series of six interest rate increases--increases--that have been initiated on June 30, 1999. Between June 30, 1999 and May 16, 2000, the Fed took the interest rates up 6 times. While many of us were searching for some visible evidence of inflation in the economy to support such a move, the Fed said they were concerned about inflationary pressures developing as a result of strong consumer demand and tight labor markets. While the Fed's Open Market Committee did not raise rates again after May 16, it maintained a position through November 15 of last year--in other words, just 3 months ago--that the economic risk continued to be weighted, and I quote them, mainly toward conditions that may generate heightened inflation pressures in the foreseeable future. It was not until the Federal Open Market Committee meeting on December 19, less than 2 months ago, that the FOMC shifted its position to the view that the economic risks were weighted, ``mainly toward conditions that may generate economic weakness in the foreseeable future.'' And of course, as we all know, thereafter, the Fed lowered interest rates half a point on January 3 and lowered interest rates another half point again on January 31. In his testimony last July 20, Chairman Greenspan also emphasized the importance of not dissipating the budget surpluses of the Federal Government. He stated--``by substantially augmenting national saving, these budget surpluses have kept real interest rates at levels lower than they would have been otherwise. This development has helped foster the investment boom that in recent years has contributed greatly to the strengthening of U.S. productivity and economic growth. The Congress and the Administration have very wisely avoided steps that would materially reduce these budget surpluses. Continued fiscal discipline will contribute to maintaining robust expansion of the American economy in the future.'' And Chairman Greenspan also stated--``I would say that anything, whether it is tax cuts or expenditure increases which significantly slows the rise in surpluses, or eventually eliminates them, will put the economy at greater risk than I would like to see it exposed to.'' Now as we all know, in his testimony before the Senate Budget Committee on January 25, just a few weeks ago, the Chairman changed all of this. Business Week said, and I now quote them in their editorial on February 19--In his Senate testimony on January 25, Federal Reserve Chairman Alan Greenspan appeared to give his blessing to massive tax cuts that extend well into the decade. Despite his caution, the predictions of budget surpluses are subject to a relatively wide range of error. His benediction--Business Week's word--his benediction changed the political climate in Washington and set off a tax cut frenzy that is now veering out of control. And earlier, with reference to that very point in that editorial, Business Week had said: ``The great tax cut stampede is on, and two things could get trampled under foot--restraint and common sense.'' Conservatives, liberals, the business roundtable and lobbyists of all kinds are demanding their fair share. A mindless, bloated, something-for-everyone tax cut may result. Before Washington gets swept away and does something that the country regrets for years to come, it might be wise to step back and consider a few simple truths. And some of those truths, I think, were outlined in a very pointed and succinct way by Alice Rivlin, the former Vice Chair of the Federal Reserve Board, as well as the former director of both CBO and OMB, who testified before the Senate Budget Committee and stated, and I quote her: I believe that the currently projected 10-year surpluses are good guesses, the best available guesses. But they are by no means guaranteed. Moreover, the 10-year horizon is too short. We need to respond now to the looming demographic pressures of the years beyond 2011. I believe committing to a massive tax cut now, especially one undertaken to counter a temporary downturn in the economy, would be short-sighted. We have time to see whether the surpluses turn out to be as large as currently projected and to debate whether public needs have priority over private spending. Ms. Rivlin also pointed out that: Since a tax reduction that overstimulates the economy is almost impossible to reverse, the likely result will be that the Federal Reserve will have to raise interest rates. If we want to promote economic growth, we would be better off with lower interest rates and tighter fiscal policy than with the opposite combination. In my view, we are at a crossroads in the conduct of fiscal policy. Over the past 8 years, the United States has maintained remarkably disciplined fiscal policy. That fiscal policy, in turn, has given the Federal Reserve the room to run an accommodating monetary policy that has allowed the economy to sustain the longest expansion in U.S. history. This economic expansion brought unemployment down to 4 percent, helped turn U.S. budget deficits into surpluses, produced an expansion in investment that has led to rising levels of productivity, which in turn has kept inflation at low levels. It is the reason the Fed had the flexibility to move quickly and aggressively last month to lower interest rates to respond to the economic slowdown. All of that could now be placed at risk. I hope we find it within ourselves to consider carefully the judgments we make in the coming months and act prudently to preserve the hard-won gains we have made over the past 8 years. Mr. Chairman, I look forward to hearing Chairman Greenspan's testimony this morning on this and other issues. Thank you very much. Chairman Gramm. Thank you, Senator Sarbanes. Senator Bennett. OPENING STATEMENT OF SENATOR ROBERT F. BENNETT Senator Bennett. Thank you, Mr. Chairman. I will try to be brief, but I could not resist noting an article that appeared today in The New York Times on the Op Ed page, that I think sounds a note that we ought to keep in mind as we get into this discussion of the economy. It is entitled, ``An Irrational Case of Dread.'' And if I may, I would like to quote a little from it. My colleague from Maryland has quoted from Business Week, maybe an unusual source from a Democrat. I will quote from The New York Times, an unusual source for a Republican. [Laughter.] He says, ``It is very hard for outsiders to believe that the United States, with housing starts at over 1.5 million units and an unemployment rate at little more than 4 percent, is in trouble.'' Why are Americans complaining about a broader economic outcome that in principle was strongly desired just a year ago? The steady drumbeat of worry over the past few months has come almost exclusively from economists who specialize in the stock market, especially the NASDAQ. There is far less gloom among the American corporate economists I speak to in nonfinancial companies, people whose main business is to advise top managers on longer-term trends that drive decisions like whether to build new factories or buy equipment. And finally, he says: Viewed from outside the country, there are a few signs of serious weakness in the American economy, just clear evidence that it has come back down to earth from a period of very fast growth before there could be real damage from a permanent rise in inflation. Only 6 months ago, most American economists still wanted to see the economy cool off. Because the Federal Reserve has done its job well by raising interest rates at the right time, there should be celebration, not trepidation. I think that is a very salutary way to greet the Chairman of the Federal Reserve Board, saying that, yes, things have slowed down a little. No, we are not going into the tank. And looking at it from the standpoint of Europe, and this particular byline is Frankfurt, U.S. economic worries look-- well, the quote is, from Europe: U.S. Economic Worries Are Hard To Fathom. Many times it is important for us when we look just at ourselves, to look around at others and see where we are in comparison to others and realize that confidence in the American economy is not a bad thing to have at this particular time. And I share that with you, Mr. Chairman, and look forward to the reactions and comments of Chairman Greenspan. Chairman Gramm. Thank you, Senator Bennett. Senator Miller. COMMENT OF SENATOR ZELL MILLER Senator Miller. I don't have any comments at this time. Maybe some questions later. Chairman Gramm. Senator Ensign. COMMENT OF SENATOR JOHN ENSIGN Senator Ensign. I will wait for questioning. Thank you. Chairman Gramm. Senator Corzine. OPENING STATEMENT OF SENATOR JON S. CORZINE Senator Corzine. Thank you, Mr. Chairman. I join my colleagues in welcoming Chairman Greenspan. I compliment you on your exceptional leadership over the years. As a former field hand in the financial services world and markets for 25 years, I could not respect your judgment, objectivity and the results more readily. But as Senator Sarbanes remarked in his opening comments, I am concerned about some of the interpretations that came out of the Budget Committee hearings. And I hope that we will have a chance today to have some clarification about some of those. As the most junior Member on this side of the aisle, I will keep my opening remarks to an irreducible minimum. But I do want to ask specific questions about specific tax cuts. Importantly, the size of those tax cuts within the fiscal framework that we face. Specifically, I hope to have some clarification whether you believe we should separate a stimulus-focused tax cut from structural tax adjustments. And under what circumstances you believe those should be scaled in, phased in, whatever term one would want to use, given the uncertainties that we may face in projecting a 10-year fiscal policy framework. But I am very, very pleased to be here and look forward to your comments. Chairman Gramm. Thank you, Senator Corzine. Senator Hagel. OPENING STATEMENT OF SENATOR CHUCK HAGEL Senator Hagel. Mr. Chairman, thank you. I would just note that, Mr. Chairman, even for your high standards, you have stimulated an unusually high degree of interest in the last few weeks, and an even more interesting degree of interpretation of what you have said. I look forward to some clarity and cogent interpretation of exactly what you said and what your intent was as you testified before our Budget Committee a couple of weeks ago. As always, we are glad you are here. Thank you. Thank you, Mr. Chairman. Chairman Gramm. Senator Stabenow. Senator Stabenow. Thank you, Mr. Chairman. OPENING STATEMENT OF SENATOR DEBBIE STABENOW Chairman Greenspan, it is a pleasure to hear your views on the economy and the budget for the second time since, as you know, I am a member of the Budget Committee and did have an opportunity to hear directly your comments just a number of days ago. As you said in your testimony before the Budget Committee, our economic performance of the past 5 to 7 years is without precedent, and I would agree. However, it is important to note, you admonished us to maintain fiscal responsibility and to pay down our national debt. I believe that somehow has gotten lost in other discussions. You also warned us about the uncertainty of a 10-year budget forecast. And while you did advocate some type of tax reduction, you also urged us to use some type of trigger mechanism to make sure that we actually pay down the national debt to its lowest possible level first. And I hope you will speak to that trigger mechanism today in your testimony. Overall, your Budget Committee testimony was balanced and prudent. But many advocates and those in elected office have highlighted only one side of your testimony, and as you know, are using it to promote a very large tax cut that would spend the entire surplus, rather than focusing on paying down the debt or other priorities, or even looking at the possibility of the slightest forecasting error. And I am looking forward to your addressing that today. I hope today's hearing will provide us an opportunity to clarify some of this confusion and to set the record straight on your message of fiscal responsibility and discipline and the importance of paying down the national debt. I think we very much need to hear your message in totality and I am looking forward to it. Thank you. Chairman Gramm. Thank you. Senator Allard. COMMENT OF SENATOR WAYNE ALLARD Senator Allard. Thank you, Mr. Chairman. I would like to make a brief comment. And I would like to just make my formal statement a part of the record. Chairman Gramm. It will be made a part of the record. Senator Allard. And just, again, welcome, Chairman Greenspan, to this Committee. I did hear your testimony before the Budget Committee. I thought it was pretty clear. I did not think there was any real confusion there. And I also found in your testimony, if you want to be vague, you can be decidedly vague and it is obvious that you are being vague. So I am looking forward to your testimony. You are going to be on a new format--focusing on monetary policy instead of the old Humphrey-Hawkins format, which, in my view, is a welcome change. Mr. Chairman, I am looking forward to your testimony. Thank you. Chairman Gramm. Thank you. Senator Johnson. OPENING STATEMENT OF SENATOR TIM JOHNSON Senator Johnson. Thank you, Mr. Chairman, and welcome to Chairman Greenspan. I will be very brief. Just a quick observation. One is that I did very much appreciate your testimony before the Budget Committee not long ago. And I would share some thoughts expressed by Senator Sarbanes and also by Senator Stabenow relative to the aftermath of your testimony before the Budget Committee. I think the message about tax reductions was heard loud and clear. The media has made much of it. And those words have been used for the promotion of that goal. I think your cautionary observations about the stimulating effect to the economy of tax cuts was not apparently heard terribly well. I think your cautionary remarks about fiscal responsibility and the uncertainty of 10-year projections on budget surpluses has not been discussed enough and it has not been heard as well as it ought to be. And I think that your observation about trigger mechanisms is something that we need to pursue further as well. I think that there is going to be a very significant tax cut enacted by this Congress. In fact, I believe that there is room within the budget for a larger tax cut for middle-class families than that which has been proposed by President Bush, but within parameters that involve less total cost for tax relief. It seems to me that it is incumbent on those of us who deal with the specifics of a budget that we use some prudence and some humility relative to the 10-year projections and that we take care to see to it that while tax relief is part of the total mix, that in fact there are adequate resources left over for education, debt reduction, defense, Social Security, Medicare, and so on, and that this be a properly balanced strategy that we embark upon here during this Congress. My fear, frankly, is that there is a greater risk of the Government backing into the bad old days of red ink--and we are not very far removed from those days--than there is of accumulating wildly excessive surpluses 10 years down the road. I believe that while both of those are legitimate concerns, as you have expressed to us, the balancing is something that has to be done by the policymakers. And I think that the policymakers need to listen a little more carefully to the full context of your statement than was necessarily the case following your testimony to the Budget Committee. So I look forward to further elaboration and your testimony today. Chairman Gramm. Senator Bayh. OPENING STATEMENT OF SENATOR EVAN BAYH Senator Bayh. Thank you, Mr. Chairman. Harboring no illusions that we have gathered here today to listen to me, I am going to wait for the question period to express my comments. It is my hope, however, Mr. Chairman, that either in your presentation or in response to questions, you can give us some guidance in how to make decisions of great consequence in an atmosphere of substantial uncertainty, and perhaps suggest some steps that can be taken to reduce the uncertainty, thereby increasing the prospect that our decisions will be prudent ones. Thank you. Chairman Gramm. Senator Dodd. OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD Senator Dodd. Thank you, Mr. Chairman, and welcome to you, Mr. Chairman, and to the Committee. And just to underscore, I would hope today, Mr. Chairman, you might take some time to offer some clarifications, to the Budget Committee testimony. I thought it was very good testimony. But you don't control how the media reports on your testimony and what the headlines may be or may not be. But, obviously, I think for many of us here, I don't know of anyone--maybe there are people who are just adamantly opposed to any tax cuts. I think most of us believe that there is plenty of room for a tax cut in the coming years, even where there is some doubt about the size of future surpluses, but with some degree of proportionality and where it would be targeted or how it would be paid for. I hope we can have some discussion on it. There is already--the 1.6 that has been introduced, and obviously, fiscal policy has a direct bearing on monetary policy. That number is moving up. You have already had Members of Congress talking about add- ons to that that go between $500 billion and a trillion to what is already been proposed. Interest groups are lining up to express their concerns. We have watched this process over the years. It is not the first time we have been through it. And there are real dangers here that we could take what has been a very good economy--much of the responsibility for that goes to you. Your leadership over the past 8 years has been remarkable. And it is not without reason that most people attribute your leadership as the reason we have had an unprecedented economic growth and success in this country throughout its history. You really deserve a great deal of credit. And for those of us who have been around here for the past couple of decades and who have listened to the words of Yogi Berra with that deja vue all over again, there is some legitimate concern that we are back visiting the early 1980's, when similar remarks were being made about what tax cuts would do then, similar promises made about what happened on the spending side of the equation, and then to watch it all sort of evaporate, creating the mess that we saw in the late 1980's and very early 1990's. I just want to add my voice to the voices of Senators Sarbanes and Tim Johnson and others I think you will hear from today about this aspect. I know your responsibility is to talk about the overall economy. But this is such a big issue, it is so important. It has such long-term implications for our country. The opportunity to leave to the next generation a gift that none of us imagined we could ever give them, to virtually burn the national debt, the national mortgage. I cannot think of a greater gift that this generation could give to the next generation, as it grapples with the problems of the 21st Century. And we are very close to achieving that. My hope is that that would be very much on our minds as we weigh the pros and cons of the President's proposal on taxes. I thank you once again for being here and look forward to your testimony. Senator Sarbanes [presiding]. Senator Reed. OPENING STATEMENT OF SENATOR JACK REED Senator Reed. Thank you very much, Senator Sarbanes. Welcome, Chairman Greenspan. Your Budget testimony, either wittingly or unwittingly, advanced the case for a tax cut. The issue that confronts most of us today, and it is reflected in the comments of my colleagues, is the size of that tax cut. And I would hope that you could provide some specificity and some details with respect to your views in this regard. But, again, echoing my colleagues, your stewardship over the last several years has given us the opportunity to do many things, just one of which is a tax cut. We appreciate your comments on both priorities and size and other issues related to the policy choices we face ahead of us. Thank you, Mr. Chairman. Senator Sarbanes. Thank you, Senator Reed. Chairman Greenspan, we are happy to receive your statement now. OPENING STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM Chairman Greenspan. Thank you very much, Mr. Chairman. I appreciate the opportunity this morning to present the Federal Reserve's semiannual report on monetary policy. The past decade has been extraordinary for the American economy and monetary policy. The synergies of key technologies markedly elevated prospective rates of return on high-tech investments, led to a surge in business capital spending, and significantly increased the underlying growth rate of productivity. The capitalization of those higher expected returns boosted equity prices, contributing to a substantial pick up in household spending on new homes, durable goods, and other types of consumption generally, beyond even that implied by the enhanced rise in real incomes. When I last reported to you in July, economic growth was just exhibiting initial signs of slowing from what had been an exceptionally rapid and unsustainable rate of increase that began a year earlier. The surge in spending had lifted the growth of the stocks of many types of consumer durable goods and business capital equipment to rates that could not be continued. The elevated level of light vehicle sales, for example, implied a rate of increase in the number of vehicles on the road hardly sustainable for a mature industry. And even though demand for a number of high-tech products was doubling or tripling annually, in many cases new supply was coming on even faster. Overall, capacity in high-tech manufacturing industries rose nearly 50 percent last year, well in excess of its rapid rate of increase over the previous 3 years. Hence, a temporary glut in these industries and falling prospective rates of return were inevitable at some point. Clearly, some slowing in the pace of spending was necessary and expected if the economy was to progress along a balanced and sustainable growth path. But the adjustment has occurred much faster than most businesses anticipated, with the process likely intensified by the rise in the cost of energy that has drained business and household purchasing power. Purchases of durable goods and investment in capital equipment declined in the fourth quarter. Because the extent of the slowdown was not anticipated by business, it induced some backup in inventories, despite the more advanced just-in-time technologies that have in recent years enabled firms to adjust production levels more rapidly to changes in demand. Inventory-sales ratios rose only moderately, but relative to the levels of these ratios implied by the downward trend over the past decade, the emerging imbalances appeared considerably larger. Reflecting these growing imbalances, manufacturing purchasing managers reported last month that inventories in the hands of their customers had risen to excessively high levels. As a result, a round of inventory rebalancing appears to be in process. Accordingly, the slowdown in the economy that began in the middle of 2000 intensified, perhaps even to the point of growth stalling out around the turn of the year. As the economy slowed, equity prices fell, especially in the high-tech sector, where previous high valuations and optimistic forecasts were being reevaluated, resulting in significant losses for some investors. In addition, lenders turned more cautious. This tightening of financial conditions, itself, contributed to restraint on spending. Against this background, the Federal Open Market Committee (FOMC) undertook a series of aggressive monetary policy steps. At its December meeting, the FOMC shifted its announced assessment of the balance of risks to express concern about economic weakness, which encouraged declines in market interest rates. Then on January 3, and again on January 31, the FOMC reduced its targeted Federal funds rate \1/2\ percentage point, to its current level of 5\1/2\ percent. An essential precondition for this type of response was that underlying cost and price pressures remained subdued, so that our front-loaded actions were unlikely to jeopardize the stable, low inflation environment necessary to foster investment and advances in productivity. The exceptional weakness so evident in a number of economic indicators toward the end of last year--perhaps in part the consequence of adverse weather--apparently did not continue in January. But with signs of softness still patently in evidence at the time of its January meeting, the FOMC retained its sense that the risks are weighted toward conditions that may generate economic weakness in the foreseeable future. Crucial to the assessment of the outlook and the understanding of recent policy actions is the role of technological change and productivity in shaping near-term cyclical forces as well as long-term sustainable growth. The prospects for sustaining strong advances in productivity in the years ahead remain favorable. As one would expect, productivity growth has slowed along with the economy. But what is notable is that, during the second half of 2000, output per hour advanced at a pace sufficiently impressive to provide strong support for the view that the rate of growth of structural productivity remains well above its pace of a decade ago. Moreover, although recent short-term business profits have softened considerably, most corporate managers appear not to have altered to any appreciable extent their long-standing optimism about the future returns from using new technology. A recent survey of purchasing managers suggests that the wave of new on-line business-to-business activities is far from cresting. Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the 3- to 5-year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held firm at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the longer term. The same forces that have been boosting growth in structural productivity seem also to have accelerated the process of cyclical adjustment. Extraordinary improvements in business-to-business communication have held unit costs in check, in part by greatly speeding up the flow of information. New technologies for supply-chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage--virtually in real time--and can cut production promptly in response to the developing signs of unintended inventory building. Our most recent experience with some inventory backup, of course, suggests that surprises can still occur and that this process is still evolving. Nonetheless, compared with the past, much progress is evident. A couple of decades ago, inventory data would not have been available to most firms until weeks had elapsed, delaying a response and, hence, eventually requiring even deeper cuts in production. In addition, the foreshortening of lead times on delivery of capital equipment, a result of information and other newer technologies, has engendered a more rapid adjustment of capital goods production to shifts in demand that result from changes in firms' expectations of sales and profitability. A decade ago, extended backlogs on capital equipment meant a more stretched-out process of production adjustments. Even consumer spending decisions have become increasingly responsive to changes in the perceived profitability of firms through their effects on the value of households' holdings of equities. Stock market wealth has risen substantially relative to income in recent years-- itself a reflection of the extraordinary surge of innovation. As a consequence, changes in stock market wealth have become a more important determinant of shifts in consumer spending relative to changes in current household income than was the case just 5 to 7 years ago. The hastening of the adjustment to emerging imbalances is generally beneficial. It means that those imbalances are not allowed to build until they require very large corrections. But the faster adjustment process does raise some warning flags. Although the newer technologies have clearly allowed firms to make more informed decisions, business managers throughout the economy also are likely responding to much of the same enhanced body of information. As a consequence, firms appear to be acting in far closer alignment with one another than in decades past. The result is not only a faster adjustment, but one that is potentially more synchronized, compressing changes into an even shorter timeframe. This very rapidity with which the current adjustment is proceeding raises another concern, of a different nature. While technology has quickened production adjustments, human nature remains unaltered. We respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down until a renewed, more comprehensive basis for acting emerges. In its extreme manifestation, many economic decisionmakers not only become risk adverse, but attempt to disengage from all risk. This precludes taking any initiative, because risk is inherent in every action. In the fall of 1998, for example, the desire for liquidity became so intense that financial markets seized up. Indeed, investors even tended to shun risk-free, previously issued Treasury securities in favor of highly liquid, recently issued Treasury securities. But even when decisionmakers are only somewhat more risk adverse, a process of retrenchment can occur. Thus, although prospective long-term returns on new high-tech investment may change little, increased uncertainty can induce a higher discount of those returns and, hence, a reduced willingness to commit liquid resources to illiquid capital investments. Such a process presumably is now under way and arguably, may take some time to run its course. It is not that underlying demand for Internet, networking, and communication services has become less keen. Indeed, as I noted earlier, some suppliers seem to have reacted late to accelerating demand, have overcompensated in response, and then have been forced to retrench--a not-unusual occurrence in business decisionmaking. A pace of change outstripping the ability to adjust is just as evident among consumers as among business decisionmakers. When consumers become less secure in their jobs and finances, they retrench as well. It is difficult for economic policy to deal with the abruptness of a break in confidence. There may not be a seamless transition from high to moderate to low confidence on the part of businesses, investors, and consumers. Looking back at recent cyclical episodes, we see that the change in attitudes has often been sudden. In earlier testimony, I likened this process to water backing up against a dam that is finally breached. The torrent carries with it most remnants of certainty and euphoria that built up in earlier periods. This unpredictable rending of confidence is the one reason that recessions are so difficult to forecast. They may not be just changes in degree from a period of economic expansion, but a different process engendered by fear. Our economic models have never been particularly successful in capturing a process driven in large part by nonrational behavior. Although consumer confidence has fallen, at least for now it remains at a level that in the past was consistent with economic growth. And as I pointed out earlier, expected earnings growth over the longer-run continues to be elevated. If the forces contributing to long-term productivity growth remain intact, the degree of retrenchment will presumably be limited. Prospects for high productivity growth should, with time, bolster both consumption and investment demand. Before long in this scenario, excess inventories would be run off to desired levels. Still, as the FOMC noted in its last announcement, for the period ahead, downside risks predominate. In addition to the possibility of a break in confidence, we don't know how far the adjustment of the stocks of consumer durables and business capital equipment has come. Also, foreign economies appear to be slowing, which could dampen demands for exports; and, although some sectors of the financial markets have improved in recent weeks, continued lender nervousness still is in evidence in other sectors. Because the advanced supply-chain management and flexible manufacturing technologies may have quickened the pace of adjustment in production and incomes and correspondingly increased the stress on confidence, the Federal Reserve has seen the need to respond more aggressively than had been our wont in earlier decades. Economic policymaking could not, and should not, remain unaltered in the face of major changes in the speed of economic processes. Fortunately, the very advances in technology that have quickened economic adjustments have also enhanced our capacity for real-time surveillance. As I pointed out earlier, demand has been depressed by the rise in energy prices as well as by the needed slowing in the pace of accumulation of business capital and consumer durable assets. The sharp rise in energy costs pressed down on profit margins still further in the fourth quarter. About a quarter of the rise in total unit costs of nonfinancial, nonenergy corporations reflected a rise in energy costs. The 12-percent rise in natural gas prices last quarter contributed directly, and indirectly through its effects on the cost of electrical power generation, about one-fourth of the rise in overall energy costs for nonfinancial, nonenergy corporations; increases in oil prices accounted for the remainder. In addition, a significant part of the margin squeeze not directly attributable to higher energy costs probably has reflected the effects of moderation in consumer outlays that, in turn, has been due in part to higher costs of energy, especially for natural gas. Hence, it is likely that energy cost increases contributed significantly more to the deteriorating profitability of nonfinancial, nonenergy corporations in the fourth quarter than is suggested by the energy- related rise in total unit costs alone. To be sure, the higher energy expenses of households and most businesses represent a transfer of income to producers of energy. But the capital investment of domestic energy producers, and, very likely, consumption by their owners, have provided only a small offset to the constraining effects of higher energy costs on spending by most Americans. Moreover, a significant part of the extra expense is sent overseas to foreign energy producers, whose demand for exports from the United States is unlikely to rise enough to compensate for the reductions in domestic spending, especially in the short run. Thus, given the evident inability of energy users, constrained by intense competition for their own products, to pass on much of their cost increases, the effects of the rise in energy costs does not appear to have had broad inflationary effects, in contrast to some previous episodes when inflation expectations were not as well anchored. Rather, the most prominent effects have been to depress aggregate demand. The recent decline in energy prices and the further declines anticipated by futures markets, should they occur, would tend to boost purchasing power and be an impor- tant factor supporting a recovery in demand growth over coming quarters. The members of the Board of Governors and the Reserve Bank presidents foresee an implicit strengthening of activity after the current rebalancing is over, although the central tendency of their individual forecasts for real GDP still shows a substantial slowdown, on balance, for the year as a whole. The central tendency for real GDP growth over the four quarters of this year is 2 to 2\1/2\ percent. Because this average pace is below the rise in the economy's potential, they see the unemployment rate increasing to about 4\1/2\ percent by the fourth quarter of this year. The central tendency of their forecasts for inflation, as measured by the prices for personal consumption expenditures, suggests an abatement to 1\3/4\ to 2\1/4\ percent over this year, from 2\1/2\ percent over the year 2000. Mr. Chairman, I would appreciate the full comments that I have written appear in the record, and I look forward to your questions. Chairman Gramm. Mr. Chairman, thank you for your comments. I had the idea in listening to some of my colleagues that they at least perceived that you had been misquoted in your testimony before the Budget Committee. But I have noted in the past, when you thought people had misinterpretad your comment, you issued a clarification. I saw no clarification as a result of that testimony. In your opinion, were your views misconstrued? Chairman Greenspan. Mr. Chairman, I do think that because of the complexity of the issue which I addressed in the Senate Budget Committee--complex of necessity because things are changing in ways that we had not been required to evaluate previously--that a number of the reports that I saw were quite selective of the general position that I took. But I don't find that unusual. I find that sort of more general rather than otherwise. I don't know what to do about it. I just repeat myself, sometimes creating, I suspect, somewhat more complexity than is necessary. But I can only tell you what it is I believe when you ask me questions and hope for the best. Chairman Gramm. Well, let me ask you some of those questions. In listening to many people comment on where we are, I hear people talk about the need for prudence, the protection of Social Security and Medicare, uncertainty about projections. But as you are aware, last week on Thursday, the Congressional Budget Office issued their estimate as to what had happened to the 10-year projection of spending between August and January. And in that 6-month period, they concluded that Congress and the President had added $561 billion to the new projected 10-year spending. Do you find that alarming? Chairman Greenspan. I do, Mr. Chairman, as indeed I indicated in the Senate Budget Committee hearing because while I have raised issues with respect to prudence in accumulating private assets in Federal Government accounts and, hence, to the need to be careful about creating very substantial surpluses after the debt has been eliminated, I indicated that we could very readily fall back into a very heavy set of deficits if all of the prudence which had been built up with great difficulty over the last decade or so, I must say, and with very considerable success, is dissipated. Chairman Gramm. Obviously, if we did the same thing in the next 12 months we did in the last 6 months, we would have spent the entire Bush tax cut. So it is fair to say that you are alarmed about the decline in fiscal discipline on the spending side. Chairman Greenspan. I said so in my prepared remarks before the Budget Committee and reiterated them during the question and answer period. Chairman Gramm. Let me ask another question. Continually, the point is made--in questioning the ability of the tax cut to stimulate the economy--that because the tax cut is phased in we wouldn't be putting much money into people's pockets immediately, even if the child exemption and rate cuts were retroactive. But it seems to me that what is missed in this analysis is an understanding that consumers are rational. You have talked now for several years about a wealth effect coming from the stock market. But the reality is that wealth effect is largely in IRA's, 401(k)'s, and mutual funds that people are not going to touch until they retire 20 and 30 years from now. Yet, each quarter, as people have gotten those statements-- I know because it is happened to me--each quarter, they have looked at those numbers and said, my God, I am much richer than I thought I was. And as a result, they responded to it. So is it not true that, just as if you and I have the same income and we are young workers, but you know that you are going to inherit $100 million and I know I am going to inherit nothing, based on rational expectations, with the same income, we have greatly different spending patterns? Is it not true that if you implement a tax cut, even if they don't have the money yet, we can expect people to respond to that in their behavior, both as consumers, investors, savers, et cetera? Chairman Greenspan. Mr. Chairman, I would suspect that that is in fact the case, though I am not aware of what the evidence is with respect to how predominant that particular phenomenon is. I do know it exists on the corporate side, where you get capital appropriations moving in advance of the enactment or the implementation of a tax cut because merely knowing what the schedule of rates of return are going to be after tax has a significant impact on what one does with respect to deciding to invest or not. I don't know of any particular studies, though they may very well exist, on the issue of how individuals respond in contemplation of a tax cut. Chairman Gramm. But you do believe, based on what you have observed in the last few years, that the run-up in equity values---- Chairman Greenspan. Well, there is no question that that is indeed the case. Chairman Gramm [continuing]. Has clearly had an impact on consumption. Chairman Greenspan. But the run-up in equity values in real time actually produced a value which the individuals could see at that particular point and knew that they owned. And I am not sure how one necessarily translates that into expectations of particular tax cuts. But, obviously, when they are in place, and one contemplates their actual availability, I have no question that what you are saying is accurate. Chairman Gramm. One final question, and then I will move to my colleagues. You have not changed your position that, if we are going to do a tax cut, the most effective tax cut is an across-the-board cut, where the poorest worker and the richest worker all get a tax cut? Chairman Greenspan. Mr. Chairman, let me separate an issue here. In the Budget Committee hearings I indicated that I did not want, nor should I take a position on, any specific tax cut. And I am not and have not. It is certainly the case, as I have answered before this Committee in the past, that I think from the point of view of economic efficiency, recognizing there were other reasons to change taxes, that marginal tax rate reductions have always in my mind been the most effective way to enhance economic activity. But I was not in the Senate Budget Committee actually responding to a question which related to any particular tax recommendations that were currently in play. Chairman Gramm. Senator Sarbanes. Senator Sarbanes. Thank you very much, Mr. Chairman. Mr. Chairman, first I would like to have included in the Committee record the article by Robert Rubin that appeared in Sunday's New York Times, entitled, ``A Prosperity Easy To Destroy,'' and the first paragraph of which reads: I had not intended to get involved in the public debate on fiscal policy at this point. But I feel so strongly that a tax cut of the magnitude proposed is a serious error in economic policy that I felt a need to speak. And then goes on, I think, with a very penetrating analysis of this issue, and I commend this article to my colleagues. I think Rubin, more than any single person, is the one who helped to bring about fiscal discipline and bears a good deal of the credit for the prosperity that we have enjoyed during his tenure as the Secretary of the Treasury. Chairman Greenspan. I agree with that, Senator. Senator Sarbanes. Thank you. Chairman Greenspan. Second, I would like to quote from an article in Newsweek by their Wall Street editor, Alan Sloane, and I am just going to quote from it for a moment. A pie-in-the-sky policy. It is folly to slash taxes based on rosy budget projections that are certain to be wrong, why tax-cut fever needs to chill. And then he goes on to say--there are times when even the born contrarians among us wonder if we have taken leave of our senses or if the rest of the world has, which is how I feel about the bum's rush for getting to make huge tax right now based on iffy long-term budget projections, an economic slowdown and the supposed imprimatur of Federal Reserve Board Chairman Alan Greenspan. What is the hurry? Why not wait a while and see how the economy plays out? Treating long-term projections like they are facts is folly. For heaven's sakes, even the great Greenspan screwed up a short-term forecast last fall by not seeing that the economy was softening. That mistake is why he's cutting interest rates so sharply, an economic cardiologist trying to keep his patient from croaking. So answer me this. If the plugged-in, experienced Greenspan could not forecast the economy 4 months ahead, how can anyone think the Congressional Budget Office, or anyone, can foresee the economy 10 years ahead? Especially when the CBO, whose surplus projections are the heart of Bush's tax-cut case, regularly devotes an entire chapter in its report to the uncertainty of budget projections? History makes my case for me. Until a few years ago, experts predicted huge deficits as far as the eye could see. Now they predict huge surpluses. A year ago, the CBO projected a $3.1 trillion, 10-year surplus. Six months ago, $4.6 trillion. Last month, $5.6 trillion. Why should we treat today's numbers as right when yesterday's was so wrong? I think Senator Dodd stated this tax cut well. I think most Members of the Congress are open to doing some tax-cutting. But the question is, in what magnitude, and how is it distributed, which are obviously very, very basic questions. This tax cut now that the President has proposed, if you count in the interest cost of it, and the necessity to adjust the alternative minimum tax, is going to cost over $2 trillion. And of course, people want to add on to it, of course. Some of the leadership up here has said it should be even larger. All the interest groups are mobilizing. I used taking the cover off the punchbowl. I probably should have said, the maitre'd allowing the crowd to get at the buffet table because they all want to grab a piece of what is on the buffet table. So we are now talking of well in excess of $2 trillion. Now the Chairman asked you a question about $560 billion in spending. Chairman Gramm. In 6 months. Senator Sarbanes. I would like to ask you, don't you find a tax cut of well over $2 trillion and building all the time, do you find that alarming? Chairman Greenspan. As I said earlier, I am not going to comment on anybodys particular tax cut or structure of it. But let me just read the last paragraph of my Budget Committee testimony, which really relates to this issue. It said: But let me end on a cautionary note. With today's euphoria surrounding the surpluses, it is not difficult to imagine the hard-earned fiscal restraint developed in recent years rapidly dissipating. We need to resist those policies that could readily resurrect the deficits of the past and the fiscal imbalances that followed in their wake. I tried to stay with that position in my last testimony and trust I can maintain it today as well. I want to reemphasize as I did at the Budget Committee that I am speaking for myself on fiscal matters, except when these are cleared in detail with the Federal Open Market Committee. And the only thing that has been cleared are my monetary policy comments. So in all questions I have with respect to fiscal policy, I am on my own. I don't want to commit others. And even having said that, there is a very significant limit to which I think I ought to be engaged in. Senator Sarbanes. Do you think it is possible for the Chairman of the Federal Reserve, particularly one that has assumed kind of legendary dimensions now, to come in and make a statement and say, this is me as an individual? Chairman Greenspan. Yes, it is. Senator Sarbanes. If you weren't Chairman of the Fed and coming in as an individual, I don't know how much weight your comments would carry. But you come before us, you say--well, I am giving this as an individual. But I look at you and I see you as Alan Greenspan, an individual. But I also see you as the Chairman of the Federal Reserve and a distinguished Chairman of the Federal Reserve, who has held that position now for a great number of years. And obviously, your comments are going to be seized upon and interpreted. Someone said to me, well, maybe Alan Greenspan did not fully appreciate what the press would do with his comments. I said, you have to be kidding. Alan Greenspan is a very wily, experienced Washington hand and he obviously could anticipate what would be done with his comments, despite all the qualifiers and modifications and caveats that were in your statement. Chairman Greenspan. Senator, let me just say that I fully understand what you are saying and I don't disagree with it. But I do want to make the point because I think it is in all fairness that I am not speaking for a number of the people in the Federal Open Market Committee. I frankly do not know where they stand. But it is important for us to do that. Indeed, it is important for all of us to indicate when we are speaking for the Committee and when we are not. All of the members of the FOMC go out and make speeches and give their own views on a number of different issues. But they invariably say, ``I am speaking for myself.'' That is the only point I wish to make. I hope I succeed. If I failed, that is for you to judge. Chairman Gramm. Well, I think more people know Greenspan than know the Federal Reserve Board. So speaking for yourself does carry some weight. Senator Bennett. Senator Bennett. Thank you, Mr. Chairman. In my opening comment, I wanted to talk about confidence and I think the Chairman in his prepared remarks talked about the importance of confidence and why we can indeed have some confidence that even in this time of slowdown, the economy is not going into the tank. Therefore, it is clear we are going to turn this into a debate about taxes, and I cannot resist getting into the debate. Let me respond briefly to the article quoted where he said the projections are certain to be wrong. I will stipulate that they will be wrong. They always have been. They always will be. And there is no possible way of changing that. If I may be personal for just a moment, I made my mark in business with a reputation of being a good forecaster. And I could forecast what was going to happen in my business in my market with my customers with some certainty for about 3 months out. I was really good if I could get 6 months and, boy, if I hit it right for a year, I was a genuine hero. To forecast an $8-, $9-, $10-, $12-trillion economy 10 years in advance is beyond anybody's capability. But the point I think we have to recognize here is that just because I could not forecast accurately did not mean I did not have to make a decision. It did not mean I did not have to take a risk. It did not mean I did not have to lay out a strategic direction for the company that I headed with the best information that I had. And we as policymakers are faced with exactly the same challenge. Just because we know these forecasts are not going to be exactly right doesn't mean we must be paralyzed before our inability to make firm decisions. And the projections are certain to be wrong. They could be too high. They could be way too low. The Budget Committee has said that the surplus could be as high as $9 trillion, not $5.6. Or it could be as low as $1 trillion. And tough as it is for a businessman to be facing his shareholders and bet the company on what is going to work or what is not, it is even worse if the businessman says, since I cannot know with certainty, I won't decide. I won't make any choice. And that is a guaranteed way to fly the company right into the sea. I think we have a responsibility here, given the likelihood of very substantial surpluses, to face the question of what is going to happen to that money. And I think Chairman Gramm has said, if we do not move ahead with the tax cut, the money is going to be spent by the government and we will see fiscal restraint disappear. And we have seen it disappear over the last 6 months, and I have been part of it, as one of the appropriators. I have seen it happen in the Appropriations Committee, and the stampede to spend was almost irresistible. Mr. Chairman, I would like your reaction to this. I think you are saying that a prudent thing for us to do would be to deal with that stampede to spend by returning some of the money to the source from whence it came. We can always go back to that source if we need the money and say, we made a mistake and we need to make a mid-course correction. We have had two major tax cuts with President Kennedy and President Reagan. And in that same period of time, we have had, what, 8, 9, 10 major tax increases, one of them under President Clinton. We have demonstrated as a Congress, we know how to raise taxes. We know how to raise taxes better than we know how to cut them. So aren't you saying---- Chairman Gramm. Senator Bennett, the Democrats are disagreeing. They are saying they know how to raise them better than you do. [Laughter.] You had better put a caveat in there. [Laughter.] Senator Bennett. We won't get into that. Chairman Gramm. They are all yelling at me over here and saying, we, we, we. Senator Bennett. I will hear the heckling from the crowd and step down from my soapbox. Would you comment on that dichotomy of what happens to the surplus on the assumption from the very best sources we have that there will be a very significant one, and what it is we should be doing? Chairman Greenspan. Well, Senator, let me expand on some of the notions that you have put forth, which I think are really quite crucial to economic policy, specifically fiscal policy, and that is the fact that over the years, we have developed a budgetary process which requires us to make judgments of the future. I remember 30, 40 years ago when the so-called uncontrollables or entitlements were really very low. And the major problem that the budget process confronted was the spin- out of various different military procurement items which often lasted 2 or 3 years. But it was extraordinarily rarely the case that what the economy was doing 3 or 4 years out was wholly relevant to the budget process. That has dramatically changed in recent years in which we are making judgments which have implications 10, 20 years out, and unless we are aware of what they are and try to handle them, we are setting up a projection of fiscal policy which could very readily go awry. I was particularly impressed with the implications of what would happen, not 10 years from now, but as early, under the current services budget, as 2006. Because in 2006, if indeed the current services budget functions as a projection of what is going on in the real world--and it is one of the best estimates we could make--fully granting the very wide range of error--then we run out of Federal debt to pay down. And we end up with a situation which, if you take their numbers literally, is we are in the year 2006 with a unified budget surplus of about $500 billion, or thereabouts. If--and I underline the word if--you believe as I do that it is not a good idea to have private assets accumulated in Federal Government accounts, then the problem arises that, as of that particular point, if you wait to address it, you have to reduce the surplus by half a trillion dollars. And we may at that particular point be in a significant upswing in economic activity and confronted with the need to create a huge stimulus to the economy which could very readily destabilize the system. It is those data which led me to conclude that the issue is not one that we can readily wait for a year or two to decide how one handles that. That does not mean that one needs to act today. But I would suggest to you that the Congress needs to think about this issue well in advance of the events that are materializing. And if we are to address what is really an extraordinary event--no one would have even credibly believed 5 or 7 years ago that we would be at a point when we were running out of U.S. Treasury securities to buy back or to pay back on. We are ever more credibly moving in that direction. And the basic issue that I wished to put on the table in the Budget Committee hearing was to recognize that this is something new and it requires a wholly new set of views as to how fiscal policy is run. And the sooner it is addressed, the better. Waiting for 1 or 2 years I think is a mistake. That doesn't mean we need to do something right away with respect to it. But I do think that that issue has got to be addressed. It has very profound implications for the rest of this decade and into the next decade. And as you point out, we really have no choice but to make a forecast because not making a forecast is effectively trying to duck an issue for which we are making very major commitments. And implicit in any action that the Congress takes is a forecast. The only question is with all of its weaknesses, is it the best forecast that can be made? Or is it suboptimal, leading to suboptimal policy? And I would argue it is important that, as difficult as it is to forecast, we have no choice, as you point out, and we should do the best that we can. Senator Bennett. Thank you, Mr. Chairman. Chairman Gramm. Senator Miller. Senator Miller. Mr. Chairman, you have already answered and commented on most of the questions that I had. I would like to ask my question, though in a somewhat different way. It seems that all of us around this table are talking about fiscal restraint. We are all for fiscal restraint. But it seems to me like the definition of fiscal restraint is sort of like pornography--it is in the eye of the beholder. Some around this table see fiscal restraint as not cutting taxes too much. Others see fiscal restraint as not spending too much. And the fact of the matter is that if we have the last 4 years to look at, Congress and the President both used various tactics--namely, advanced appropriations and obligations, payment delays and emergency designations and specific legislative direction, to significantly boost discretionary spending, while at the same time remaining statutorily compliant with the spending caps enacted by the Budget Enforcement Act of 1990. If we go over what we have done the last 4 years in discretionary spending--in other words, if the current trend in discretionary spending were to continue into the future, would this not cause significant budgetary problems? Chairman Greenspan. Well, that is an arithmetical question, Senator, and I think it is more of, if I may put it that way, a rhetorical question, because, obviously, if you take the numbers which were appropriated in the last two fiscal years, and you add them, then the concerns that I have about running a unified budget surplus, accumulating private assets in Federal Government accounts, is mispositioned, if I may put it that way. Senator Miller. Thank you. Chairman Gramm. Thank you, Senator Miller. Senator Ensign. Senator Ensign. Thank you, Mr. Chairman. Actually, I have several questions. I find it interesting, though, on some of your comments, I saw a movie recently called ``Finding Forrester.'' It reminds me a little bit about when he wrote the book way in the past and then all of the people in the future tried to discern what he really meant when he said. And that seems to be what your comments always are. People try to discern what your comments truly meant when you said whatever you said. I always get a kick out of reading what people will say in tomorrow's papers about what you said today. I want to go to one question and it has to do with what Senator Miller talked about, about the way we all look at fiscal discipline. I thought that was very insightful. And it leads into one question that I had. Some have talked about triggers for, if we do have a tax cut now, that there would be some kind of trigger mechanism. When I was on the Ways and Means Committee, it seems to me that some of the trigger mechanisms that were talked about over there, some of them were destabilizing trigger mechanisms. And I would like you to address that. But also, the possibility of, if we are going to have trigger mechanisms on tax cuts, would trigger mechanisms on spending cuts also be in order? Chairman Greenspan. You know, it might not be a bad idea, Senator, if I answered your question by in fact reading what I actually said on this issue in the Budget Committee, which addresses specifically your question: In recognition of the uncertainties in the economic and budget outlook, it is important that any long-term tax plan or spending initiative for that matter, be phased in. Conceivably, it could include provisions that in some way would limit surplus-reducing actions if specified targets for the budget surplus and Federal debt were not satisfied. Now, what I am obviously referring to is the desirability of eliminating the Federal debt, which is still frankly, my first priority because I think that it has had an extraordinarily important impact on the economy, on the financial markets, on long-term interest rates, and on economic growth. The change that has occurred is we are running out of debt to retire. And if that is indeed the case, then priorities, of necessity, must shift. But if it is not going to be happening, then we shouldn't be shifting priorities. In effect, the terminology which I employed is essentially one which tries to look at, say, the net debt of the U.S. Government to the public, which is actually the unified public debt plus a few other accrual items minus tax and loan account deposits of the Treasury, the deposits at the Federal Reserve, and a number of other types of financial assets. That is the number we are trying to bring down effectively to absolute minimums. If there were a trigger which were built into both tax and spending programs, to the extent that they were phased, it ensures that we achieve what I think should be the first priority--namely, to eliminate the debt. Senator Ensign. Getting to your whole idea about the U.S. Government owning private assets, in the future, we have all of these various trust funds that we have as debt into the future generations. When we are looking--obviously, not the subject of the hearing today, but just something to think about for the future for us when we are talking about especially the biggest liability that we will have on our books will be Social Security. If in fact we don't want to have the money set aside and earning interest some place in some kind of Federal accounts, would that not then argue, if it is a bad idea for the Federal Government to own those assets, would it not be a good idea for individuals, private accounts, similar to the Thrift Savings Plan that Federal employees have, wouldn't that be, to make sure that we have those, we don't keep building up these huge debts because a debt is a debt, regardless--as long as it is a future obligation, it is still a debt. Would that not be a way to handle that? Chairman Greenspan. One of the reasons why I thought it is important to put this issue on the table is not strictly the immediate impacts that it has with respect to policy relevant to spending and receipts. But it also has some very profound implications depending on the way the Congress comes out, on such things as trust funds within the Federal Government. And it is fairly evident to me at least that we have been able, as a number of people have argued, when we have defined contribution plans, to have them in the government. Indeed, I have a piece of it in the sense of the thrift investment accounts that the Federal Reserve employees have. But I see what I own every month. And as a consequence of that, it would be almost impossible as far as I could see for there to be political maneuvering to get that fund to invest in some Congressman's or Senator's State where a company is in difficulty and they are seeking some form of support. I would suspect if that were the case and the company's name appeared on the form, there would be an awful lot of very negative comments. And I think that is the reason why we have been able to maintain the defined contribution plans effectively in place. If the Social Security trust fund or, more exactly, if Social Security were a defined contribution program, you could build up assets in the trust fund, private assets, without the political problems that I foresee would occur if that is not the case. But I might add, parenthetically, if you are going to do that, then the question of why not put it in the private sector obviously immediately emerges. The real difficulty arises when you have defined benefit obligations of the Federal Government in which they are guaranteed annuities to various individuals in our society whose availability is wholly independent of what assets are held in the trust fund. It is an unequivocal guarantee of the Federal Government. Social Security benefits do not depend on what the rate of return on that fund is. They are irrevocable obligations as far as I can judge, even though, legally, one can argue they are not. But I perceive of no credible possibility that they are not. If that is the case, then the question arises as to the assets that are built up in these funds indeed being subject to political manipulation. I indicated in my Senate testimony I saw very little possibility that we would be able to avoid fully the accumulation of private assets and hoped that they would be put in a fund in a manner in which, because the fund would ultimately reverse, it is not an irrevocable, long-term commitment. But the ideal would be to find ways to delimit the political exposure that I think private assets held by the Federal Government would create. And it is a major issue which I think that the Congress has got to address. I will say to you, you may agree or disagree that it is desirable to have private assets in Federal Government accounts. But I don't see how the issue can be avoided. If we are effectively going toward zero debt, there is no alternative with a unified budget surplus and effectively zero debt, to accumulating private assets, claims against the private sector. I said in the Budget Committee, I view budget deficits as a preemption of private capital and, hence, an undercutting of economic growth in a quite similar manner, although I grant it is not exactly the same as having claims on private assets in the Federal Government which are subject to political decisions as distinct from private market economic ones. Senator Ensign. Thank you, Mr. Chairman. Chairman Gramm. Senator Corzine. Senator Corzine. Thank you, Mr. Chairman. I have really two areas of questions that I would like to follow up with this discussion on investments. I think the whole debate about whether we have an irrevocable obligation in Social Security is a very profound debate that has to be addressed in the context of the demographic changes that are going to occur over the next few years. But cannot we eliminate some of that political exposure by investing in index funds and things that potentially would allow for a continuation of defined benefit effort, not unlike what we see in State pension funds and other methods around the country? Chairman Greenspan. Senator, I think it helps in part. But you have to be careful with index funds because, for example, you are dealing with to a very large extent, and almost of necessity, publicly traded securities. Even if you go from, say, the S&P 500 all the way to the Wilshire 5000, you are picking up publicly traded securities and essentially discriminating against those business investments which are not publicly traded. And so, while I would certainly grant you that it is far more difficult to manipulate in any way an indexed fund, the misallocation of capital that I think occurs as a consequence of that is something that would be very wise for us to try to avoid. If the numbers were small, obviously, it is not an issue. But we are not talking about small numbers. We are talking about extraordinarily large numbers--multitrillion dollars of accumulation. And having been in Washington on and off since the late 1960's, I have seen too many potential occasions where the political pressures to use governmental funds is virtually overwhelming. So I think it is worthwhile having a discussion to see whether in fact one can credibly insulate the markets from political manipulation. My own impression is that, at the end of the day, you will fail. That is, the pressures become overwhelming, at least in my judgment. Senator Corzine. My fear is that that would change the basic nature of Social Security in that irrevocable obligation, I think is the term you used. Let me ask, with regard to the Social Security trust funds and others, which I think really tie into this purchase of, buy-down of publicly-held debt, it strikes me that, like Senator Bennett, it is hard to predict how all this world is going to work. But it looks like out just beyond that 10-year cliff, we are going to have demands on the Social Security trust fund and Medicare trust fund that are going to put us back in the red. Again, making predictions 10 years out is pretty hard. But making them out 15--we can look at the demographics and we are going to see major changes. It seems to me we are letting sort of the tail wag the dog a little bit about this short-term intermediate period when we have an obvious major fiscal demand coming down the pike that everyone generally recognizes. And it seems to me that we ought to be very cautious about how we handle the intermediate fiscal period. And shouldn't we go slow at that, both whether it is through expenditures or on tax cuts? Chairman Greenspan. Senator, I think that with the change in the underlying productivity projections, a significant alteration in the post-2011 outlook occurs. If you take some of the implications of the CBO numbers and, indeed, what I suspect is going to be the Social Security trustees' report when it comes out in March, we are going to find that we get into the year 2011 when the baby boomers just start to come on, we will see two things. We will see, as you point out quite correctly, a very marked increase in the total number of retirees and a very substantial rise in benefits. But we start 2011 with a very large Social Security surplus, and the level of the assets in the Social Security trust fund at that point engenders a rate of interest which is quite substantial. And even though the actual receipts don't go up, the extensive rise in benefits is significantly offset by the rise in interest. So, the net increase in Social Security assets continues to rise in many different ways certainly through 2020 and beyond--which means, in effect, that we do not have in that context, if you believe the numbers, a Social Security deficit and therefore, not necessarily a unified budget deficit in that forecast. But I grant you, when you get out that far, it is a very loose set of circumstances. But the presumption that we all had that it was going to be inevitable when we started to get into the baby boom retirees, that we were going to run into a very significant financing problem, which I think was the most credible forecast even 6 months ago, is subject to question. I think that it all rests on what one perceives as the appropriate productivity rate of change, the type of technologies that we are going to have. And relatively small changes in that, as you well know, have very marked effects. So I would say, rather than indicate that this is an inevitable problem, as my good friend Alice Rivlin raised, I think it is now subject to significant question. It may at the end of the day turn out that, indeed, that is not precisely as you characterized it. But I do think that what we are learning with these changing productivity numbers is a major alteration; how we view our future, how we view Social Security, how we view our fiscal affairs, have to be readdressed in this context. The Congress is going to have to make very key judgments. And ultimately, there is no one else but the Congress to basically make those judgments. As difficult as they are and as prone to error as Senator Bennett has said, which I agree, we have no choice but to make these judgments. And implicit in a judgment is a forecast. Chairman Gramm. Senator Hagel. Senator Hagel. Thank you, Mr. Chairman. Chairman Greenspan, you alluded briefly in your testimony to the global economy. In your opinion, how captive is the continued, the sustained economic growth of this economy tied to the dynamics of the global economy? Chairman Greenspan. Well, Senator, there is just no question that one of the characteristics--I should say, one of the fallouts from the remarkable changes in information technology has been a very dramatic globalization of finance. And that in turn has created a very substantial integration of the economies of the United States, Europe, and Far East in ways that had never been perceived before. So we are all interrelated with one another. And to the extent that there is general weakness abroad, it does impact us. To the extent that we are in a weak state, it affects them. And there is a general interaction. So I do think that the extent of globalization which has proceeded in the last 10 or 15 years has essentially made a world economy a realistic notion. Senator Corzine was a big player in that before he, I think, demoted himself to the Senate of the United States. Senator Hagel. That is when he had a real job. [Laughter.] You know, Mr. Chairman, that we are going to be faced with a number of decisions here in this year regarding trade relationships. Any thoughts on, as we embark on that debate, that surely will be stimulating, on the trade issue and connecting that to your comments regarding the global economy? Chairman Greenspan. Senator, I think that one of the very few things that American, indeed, European and most Asian economists, agree on is that open markets and free trade enhance the standard of living of all participants. One can look at the really quite extraordinary rise in trade as a percent of GDP in the world which necessarily implies that, on average, the proportion of imports to domestic demand is rising all over the world. And I think we all see that as a process which has been a major factor in enhancing standards of living most everywhere. And increasing evidence demonstrates that those economies which open themselves up to competition prosper, those that do not fail. Senator Hagel. Thank you. I know you prefer not to get drug back into this tax cut swamp, but let me see if I can broaden this a bit. Your testimony today, as it was before the Budget Committee a couple of weeks ago, was very complete with the balanced approach of how we continue to grow and sustain this growth, anchored by productivity. The commitments that we are continuing to take on and those commitments will grow. The prescription drug benefit plan will most likely be incorporated into Medicare. As you add in responsible monetary fiscal policy, control of spending, do you see a place for significant tax cuts as part of that effort to sustain the kind of growth that we are going to have to sustain to make good on the commitments for these out-years for the programs that we have committed our country to? Chairman Greenspan. Senator, my focus on tax cuts as such in the Budget Committee discussion was related to the issue of returning monies to taxpayers because the alternative was to employ them as private assets held in Federal Government accounts. I was not addressing the issue of the economic effectiveness of tax cuts in promoting productivity and the like. There is a long discussion which one can have with respect to that, but I was not raising that as a reason for cutting taxes. I was basically indicating that the alternative of collecting the revenues and then employing them as claims against the private sector struck me as not something which is desirable if economic efficiency in this country is our goal. Senator Hagel. Thank you. Mr. Chairman, thank you. Chairman Gramm. Senator Stabenow. Senator Stabenow. Thank you, Mr. Chairman. Once again, we appreciate your being here today with us. If I might just talk more about the tax policies that you were suggesting in terms of a trigger so that we continue to reduce our debt to the lowest possible effective Federal debt. And in speaking about a trigger, I notice that you also spoke about phasing in paying down the debt and an effective trigger for the point at which we are phasing that in and making sure that we are not going back into debt at some later point. But I wonder if you could speak to the policy that some have suggested that we make the tax cut proposed by the Administration retroactive to the beginning of this year, and whether or not that was the type of phase-in that you were referring to. Chairman Greenspan. Senator, the only purpose of the phase- in in the context of my testimony was to avoid doing nothing and then finding ourselves in, say, 2005 with the necessity of a huge reduction in a unified budget surplus, which could occur at a time when it would be wholly inappropriate to have a very large fiscal stimulus, especially of the size, the order of magnitude that we are talking about. So my notion about phasing in was to start taking actions now to endeavor to avoid having to act very abruptly in 3 or 4 years from now. But in order to make certain that it was not actions which prevented the reduction in the debt from occurring, make them contingent. That is the full nature of my argument and my concerns. How that is done or by whatever means is not something which I think I have any particular knowledge of or expertise in. But I do know that from an economic policy point of view, if the decision is made not to accumulate very large amounts of private assets, then that issue of phase-in is crucial. Senator Stabenow. Would you want to speak directly to the notion of retroactive tax cuts? Chairman Greenspan. I think I answered that in the Senate Budget Committee. It is not an issue which I have views of strongly or otherwise. I did say in the Budget Committee that it is most unlikely that if we go through a regular recession, that any tax cut can be enacted sufficiently quickly to alter the probability of whether we will indeed find ourselves in a recession. But I also pointed out that in the event--and it is a low- probability event--that we not only go into a recession, but stay there for an extended period of time, then it is better to have had lower taxes than otherwise. In short, it would be insurance against a low probability event which indeed is what insurance is essentially about. But the issue of retroactivity doesn't really phase into that period, as best I can see it. Senator Stabenow. Mr. Chairman, you spoke of 2006 as the point in which your estimation, we will have reached the effective---- Chairman Greenspan. I am sorry. This is the estimation of both OMB and CBO. Senator Stabenow. Yes. Absolutely. And I have the CBO report with me now as we look at what we expect at that point in terms of that. And you were indicating in your testimony about $500 billion that you believed would be available at that time. I am wondering if in fact that is the range that you believe that we have in which to look at tax cuts or spending or other policies of this Congress, if that number of $500 billion was stated in that context? Chairman Greenspan. Senator, these are not my estimates. For example, CBO's baseline budget projection for the fiscal year 2006 is $505 billion. The number can be higher. It can be lower. The point that I think is important is that, unless you have productivity growth very significantly below what both the previous administration's OMB or currently CBO is using, you are going to get a number of that order of magnitude. Senator Stabenow. My reason for raising that is it is my understanding from your testimony that you are not retracting your feeling about paying down the national debt. You believe that we will pay it down sooner than originally anticipated-- 2006 being the number. And that the question is, what will be available after that point? And what policies should we enact addressing that accumulation of surpluses? And I heard you indicate, as was done with CBO, that we have about $500 billion. I am assuming not to put us back into debt, that you would be suggesting that we look at that number in terms of the flexibility of our decisionmaking. Chairman Greenspan. Well, remember that $500 billion is for 1 year only, and that the notion of a current services budget is not what is legally available to the Congress to appropriate. That number is actually a larger number. Senator Stabenow. I understand. Chairman Greenspan. In other words, at this particular point, you have discretionary spending which, by definition, means that the Congress has got to enact a law to instigate it. But because there is a general presumption that these types of outlays will continuously be forthcoming--you are not going to cut the Defense Department down. You are not going to cut the Postal Service--not the Postal Service. That is the wrong example. [Laughter.] Because they are part of the off-budget problem. But you cannot cut down a number of things. And so, we make a general judgment as to what these numbers are likely to be. And it gives you what is generally called the current services budget, which is what is available if you make the assumption that discretionary spending is going to rise at, say, the rate of inflation or the rate of population, and the entitlement programs are essentially continued. That is what is available to either cut taxes or institute new programs. And what these numbers are is basically the starting point. A lot of people have argued, well, you know, there are so many different commitments. We are not going to get to these budget surpluses. And the answer is very likely we are not because they will be partly reduced by tax cuts and/or spending increases. But in order to get a framework to know where to start and how to allocate various funds, there is really no alternative but to do something such as CBO has done or OMB does. We have long-term commitments. We have to meet them. We have to make rational judgments as best we can, with all of the errors that are involved. But the process which CBO and OMB have developed I think is by far the most sensible way of going at it. Senator Stabenow. I realize I am out of time, Mr. Chairman I would just hope that Chairman Greenspan, before you leave today, that you will reiterate those policies as you say in your last paragraph of your Budget Committee testimony, that we need to resist those policies that could readily resurrect the deficits of the past. And I hope you will take the opportunity today to speak again about what those policies are for us. Chairman Greenspan. If I could just say very quickly, it is not any individual policies. It is the sum of a lot of policies which lead in that direction. Chairman Gramm. Senators, let me say that I am going to leave Senator Allard in charge here. I am going to recognize Senator Shelby. And then we will just run down the list until we run out of people. If at any point, Mr. Chairman, you want to take a break for a moment, if you will let Senator Allard know. Senator Shelby. OPENING STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you. Mr. Chairman, a lot of people seem to be a little hesitant regarding the economy as a whole. And I know it depends on how they are looking at it. But consumer confidence is very important. Is it time to hunker down--I believe that was the phrase that was used earlier. Or is it a time to be a little cautious? Or is it time to be bullish? Or what? Because what you say today and how you say it, as you well know, is going to be interpreted many, many ways. And people are looking for everything in the world out of your utterances. What would you say to the American consumer looking at the economy today, seeing lay-offs here, lay-offs here. And not in every sector but in some. Chairman Greenspan. Senator, I think that it is always important to first start with what is the longer-term outlook. Senator Shelby. Absolutely. Chairman Greenspan. And the longer-term outlook, as I have reiterated many times, in my judgment, is undiminished in the sense that by any measure that I can see, we are only partway through one of the most remarkable periods of technological advance which is crucial to productivity growth and, indeed, to all of the deliberations we are having with respect to the budget. It really gets back to that question. What tends to happen, however, is that while the technologies change and create an accelerating environment for economic activity, as I point out in my prepared remarks we human beings react in a somewhat negative way to change when it occurs in a pronounced way. And so, it is perfectly credible to find, for example, as I think we see today, that there are a number of business people who fully perceive the longer-term profitability of these new high-tech investments as pretty much fairly accurate and achievable. But they are concerned about the uncertainty and they develop concerns about the immediate future. And even though they perceive the future in a very positive way, they tend to pull back. It is a wholly human, normal reaction. And what that does is it brings the economy down. But if indeed those underlying trends are still there, as I firmly believe, it is just a matter of time before that sort of malaise dissipates and the system comes back. If you look at American economic history, it always has those characteristics. And if we focus on the longer term, as a number of business people have and have continued to invest right through this period, it is my impression that it is they who will end up at the end of the day with the best positions in their markets to exploit over the longer run. Senator Shelby. Mr. Chairman, could you in a sense perhaps look at the economy like a long-distance race. The runners or some of the runners are going--if the economy is the runner--is going to get its second wind because they are trained for the long haul. We are in it for the long haul. And those that are in it for the long haul, which is all of us, we are going to be rewarded if we stay the course. Chairman Greenspan. I agree with that, Senator. I have no doubt that, at a minimum, the turgid economic growth which we experienced from the early 1970's through the, say, early 1990's, is not something that we are about to replicate in any sense that I can envisage over the next 10 years. Senator Shelby. Mr. Chairman, have you thought about at all, and if you haven't, maybe we can talk about it some other time, the further reduction of the capital gains rate from 20 percent to 10 percent, based on the holding period, like if you held an asset 1, 2, 3, 4, or up to 10 years, reduce it accordingly. Some economists believe that this would unburden the taxpayers who are holding onto as much as $7\1/2\ trillion in capital assets. Chairman Greenspan. Senator, that is something that this and the Finance Committee I guess are going to have to address. It is a complex issue. Senator Shelby. Very complex. Chairman Greenspan. Unlike other tax cuts, there is the obvious question of whether you lose revenue when you cut the capital gains tax. If indeed there is a capacity to unleash unrealized gains and hence to have them realized and the tax paid. There is that question, which is a crucial one because, in this particular context, where there is such a major debate with respect to fiscal responsibility, it is important to distinguish various different types of cuts and what their impact will be on revenues, as well as on the deficit or the surplus. Senator Shelby. Sure. We will talk about it again. Thank you. Senator Allard [presiding]. Senator Bayh. Senator Bayh. Thank you. And thank you, Mr. Chairman. I was struck by your dialogue with Senator Corzine that perhaps our focus on budget estimating is misplaced and instead we should focus upon the predictability and accuracy of productivity growth estimating, since that has such a profound impact upon the budget forecasts. But I suspect that may be a topic for another day. I want to just briefly go back to the comments that I made at the outset of the hearing. It seems to me that our challenge as public policymakers is to decide how best to make decisions of great consequence in an environment of inherent and substantial uncertainty. And it seems to me that the answer is to proceed with a fair amount of caution and an attempt to reduce the uncertainty in any way that we can. Senator Bennett used the analogy of a businessman making a decision and occasionally having to bet the company's future. Sometimes that is unavoidable. But when you do those kinds of things, I think you owe it to those interested in the success of the company to be as prudent as you possibly can be, and to do everything you can to make sure that your decisions are correct. You, Senator Sarbanes and others have both explicitly and implicitly mentioned the variability of the forecasts that we deal with. They varied greatly in the last 6 months. I notice that many States--and during my years as governor, we had biannual budgets. They were always inaccurate, on the upside or the downside. Many States are now going through that process. Ten-year estimating, it seems to many of us, is in reality guesswork disguised as science, it is so inherently unreliable. Considering that, it seems to me that we need to look for ways in which to reduce the uncertainty and ensure that we are making our decision based upon hard facts rather than unstable estimates. And given all that as prelude, I would like to dwell upon the idea of the trigger mechanism that has been raised by some others as perhaps one idea that can take some of the guesswork, some of the uncertainty out of our decisionmaking, and increase the probability that we are making prudent decisions. I would like to follow up on your budget testimony. You were kind enough to reread some of it here today. My understanding is that the trigger mechanism, as has been suggested, is one way to ensure that the budget will remain balanced, that we will place a premium upon paying down the debt, and therefore, increase the chances that we are being fiscally responsible. Is that your intent in floating the possibility of such an idea? Chairman Greenspan. Yes, Senator. Just remember that to the extent that the net debt goes down, that number is very close to what the unified budget surplus is. So, in a sense, you don't need to do both. In my judgment, it is far better to work off the debt numbers which are less capable of manipulation. And as a consequence of that, you get the full effect of the lower debt and the advantages of the lower debt and the savings that accrue as a consequence of the unified budget surplus. Senator Bayh. That was my understanding of the idea. I think it is commendable for those reasons. I see that Senator Ensign has reentered the room. I would just make a subsidiary point. The Senator raised the question about uncertainty, and I have occasionally heard this raised by others with regard to the trigger mechanism. I would only respond by saying that uncertainty is unavoidable and inherent in making some of these decisions. The question is not whether we will eliminate uncertainty, but whether a trigger mechanism will reduce the amount of uncertainty. And I believe that it will. My second question, Mr. Chairman, involves this. I approach the idea of a trigger mechanism as an attempt to reconcile two different strands of fiscal conservatism. The first strand believes in balancing budgets and avoiding deficits and public debt where possible. The second favors reducing taxes when the alternative to tax cuts is nonessential discretionary spending. Is my perception of the trigger mechanism as a way to reconcile these two different strands a good way to look at this? Chairman Greenspan. Well, I think the way you put it originally, Senator, is the correct one: Namely, what it tends to do is to reduce the uncertainty that is attendant upon making a decision irrevocably for an extended period of time. If you construct a mechanism which enforces an automatic revisiting of that initial decision, you effectively remove a very substantial amount of the uncertainty that is involved in it. But let me point out one issue that one must consider. Having contingent tax cuts or expenditure outlays has a downside, which is that it creates an element of uncertainty on those who are dependent on those programs, either the tax or the spending program. And what you have to do is to determine how one trades off the uncertainties that are engendered against for the people who are the recipients of those programs against the overall degree of uncertainty that is attendant upon making these types of budgetary projections. Senator Bayh. Yes. I understand we have to reconcile some of the macroeconomic uncertainty with the uncertainty created for individuals in their own decisionmaking. As someone else in the panel had previously mentioned after the tax reductions of the early 1980's, we then had nine tax increases. So it seems to me that there is some, again, inherent level of uncertainty. And what we are attempting to do is get the big picture right and then as best we can, try and limit the amount of individual uncertainty, any mechanism would create. Mr. Chairman, I just have one other question. Not surprisingly, the idea of a trigger mechanism has been the subject of some criticism. Interestingly enough, to me, it is been criticized from both those on the further left and those on the further right, suggesting that maybe we are right about where we ought to be from a public policy standpoint. Those on the left seem to be worried that a trigger would limit the ability to engage in discretionary spending in future years. Those on the right suggest that we would not get tax cuts because those on the left would engage in discretionary spending. Now, they both cannot be right. And it seems to me that in fact, what a trigger mechanism does is to establish what I would call a hierarchy of priorities. First, debt reduction, as you have pointed out. Second, a presumption that where surpluses did materialize, tax cuts could go into place. Third, that where a compelling case could be made for additional discretionary spending, such investments could be permissible. I view this as really both the left and the right being somewhat in error, that the tax cuts would go into place unless we returned to deficits and debt, which few would argue would be prudent. But that the left is also in error because spending could be considered if a compelling case could be made, as should be made to the taxpayers to justify the taking of their hard- earned resources. Is that a good way to look at this? Chairman Greenspan. Senator, let me just add something which I think is important. In order to reduce the uncertainty that the recipients of either spending programs or tax cuts have, I would assume that you would not want to reverse previous decisions. In other words, if you have, for example, taxes going down, that once they are there, they are then irreversible, in a sense. It is only the next tranche that would be affected. It would be, I think, most difficult, if not wholly inappropriate, to find that if you ran into a problem with the trigger, that you rescind previously initiated tax cuts. That would be utterly inappropriate. Senator Bayh. I agree, Mr. Chairman. And my last comment would be, I thank you for making that. The way I had envisioned this is that the first phase of the tax cut would go into place immediately and be irrevocable. And that future phases of the tax cut would go into place depending upon the realization of the surplus. So even if you did not hit it in a particular year, and it was realized in a subsequent year, then the further tax reductions would go into place. I had not envisioned in fact rolling back previously- enacted tax reductions, so thank you for raising that point and giving me the opportunity to clarify it. Thank you. Senator Allard [presiding]. Mr. Chairman, I will now take my time. I would just make an observation here at the start. Over the last two previous years, I have noticed that many of my colleagues in the Senate who feel like it is not appropriate to cut taxes, when we get toward the end of the spending year, more than willingly vote for increased spending. And that is usually in the discretionary area. I would just point out that this President here has indicated a willingness to try and reduce, hold down spending, as he moves forward, particularly the rate of growth in spending. And in recent years, discretionary spending has grown. Particularly when I look at the last budget year, last year, when we were debating this year's budget, we increased spending over a 10-year period over $500 billion. How important is it that we keep the growth of spending in line? And does rapid spending growth actually threaten any plans we may have to pay off the debt? And I may add, I think my position would be very parallel to what you are saying, is that my number-one priority is pay down the debt. Next would be cut taxes. But the least desirable would be an increase in spending. I wish you would comment on that, please. Chairman Greenspan. Senator, I think one of the really quite important advances in budgetary policy in this country occurred with the PAYGO and caps that we all early on thought were not really enforceable because a majority of both houses could basically overthrow them. The really remarkable sequence of events in the past decade or so in which those actual budgetary controls worked was a major element in restraining government outlays, producing the surpluses, and all of the great advantages that accrued from them. With the advent of surpluses, the budget controls broke down badly. And I think that if the Congress can put them back in place in an effective manner, it would be a very important public policy advance. It has only been 2 years when they have ceased to function in an effective way and hopefully, now confronted with longer- term judgments which must be made, that as a part of any budgetary process which is resurrected for the 2002 budget, some form of budget controls can be put in place replicating as close as one can to those which were really quite so effective in years past. Senator Allard. Recent numbers show we have a negative savings rate in the United States. My question is, do you view this as a threat to our prosperity? And what actions might the Congress take to reverse this trend? Is it to cut taxes or is there some other approach? Chairman Greenspan. Senator, as best we can judge, if you took a survey of the average American household and asked whether they thought they were saving inappropriately low amounts, the answer would be no. And the reason is, quite appropriately, they are looking at their 401(k)'s and a variety of other assets, all of which have risen until very recently. And the consequence of that is that they perceive that they were saving and that they would therefore spend as necessary, maintaining what they perceived as necessary for their retirement or for their children's education, or whatever. Now that the rise in household wealth has turned down, one would expect the substitution of household wealth for savings out of income would now turn in the other direction. So that most people who look at this phenomenon would expect the savings rate to move from negative to positive as a consequence of the flattening out and slight decline in the equity holdings of households. So, I don't think that I would argue that any particular policies of government are required to address that issue until we see how it all works out after the so-called wealth effect adjustment is fully embodied in the savings rate and we actually see where it is, see, in effect, where households perceive their rates are, before any policies are initiated to try to change it in a significant way. Senator Allard. Mr. Chairman, my time is expiring here. I just would ask you to conclude with one brief comment on capital gains rates. Is it appropriate at this time to look at a reduction in capital gains rates in sort of economic growth or reduction? I would like to have you comment on it. Chairman Greenspan. Senator, I think that you will find that in my past discussions before this Committee on that issue, I have always argued that capital gains taxation is a poor means of raising revenue. I think that taxes on capital of the form which that is is not something which I would consider to be an appropriate economic form of taxation. To be sure, there are noneconomic reasons for putting such a tax on, according to the vast majority of people who support it. So I would merely say to you that if you eliminate it or move it down, keep the context of what the appropriate fiscal policy overall should be in the time ahead. And I would be careful about merely getting a list of various taxes which, in the abstract, would be very nice to have, without seeing what they are relative to the whole fiscal policy outlook. Senator Allard. Thank you, Mr. Chairman. I appreciate your comments. Senator Dodd. Senator Dodd. Thank you, Mr. Chairman. And thank you again, Chairman Greenspan. You are very patient once again with your time up here. And I will try and go through some of these rather quickly. A lot of the questions have been raised. Senator Corzine's questions I think went to the heart of that issue. I think the quote you gave is that at preemptive smoothing of the glide path to zero Federal debt, is really, as I read this, that is the core of your support for a tax cut. Chairman Greenspan. Correct. Senator Dodd. And so, when I read statements that the reason for this tax cut is necessary, is to kick-start the economy, that would be an improper and unwise policy. There is nothing in this to kick-start the economy in this particular tax package. Chairman Greenspan. The problem, basically, is not what is in the package. It is really the time it takes to implement the issue, which is I think the crucial---- Senator Dodd. That is my point. Chairman Greenspan. Yes. Senator Dodd. There is nothing in the way that this is arranged that is going to kick start an economy based on--by the time it gets implemented, it is usually--it is outside the timeframe when such a kick-start might actually occur. Chairman Greenspan. Except for the low probability that any recession that might occur is prolonged. It is only under those conditions that I envisage it to be an insurance premium, in effect, because we use insurance for low probability events. And in that regard, it would act positively. But aside from that, I have not been able to find the useful means of employing it to fend off a recession. In other words, if a recession is going to happen--and I must say to you it is not happened yet--it is very unlikely to be affected one way or the other by what tax policy is going to be because the determination of a trigger as to when--I shouldn't use the word trigger--the determination of the point at which the markets determine whether we are flattening out or stabilizing or falling, that is way before the implementation of any tax cut that I can envisage happening. Senator Dodd. And you haven't changed--I mean, the definition of when a recession is occurring, is it still the classical definition of two quarters? Chairman Greenspan. It is roughly that. The only difficulty that you are going to have in these types of definitions is that when somebody examines when a recession begins, it is usually well before the economy actually breaks down. In other words, the economy will often start moving lower and a great deal of the time will then start back up. And so, that particular peak will never be discussed as the peak of the business cycle. But if it goes down and continues down, you only recognize that you are in a recession well off the peak. But in retrospect, it will always be that the beginning of the recession is supposedly at that peak. My argument is that, indeed, we really weren't in a recession in that short period. It is only when the break in confidence occurs that any meaningful definition of a recession is there. But that is not the usual definition. The usual definition, as you indicated, is any two quarters of negative economic growth. Senator Dodd. And we are not in a recession. Chairman Greenspan. At the moment we are not. Senator Dodd. And the likelihood of it is a very, very, very, very low probability. Chairman Greenspan. Well, I don't want to give probabilities. I will say, as I said at the Senate Budget Committee, that a breaking of consumer confidence or business confidence such that you get a significant erosion in economic activity is always a low-probability event. But it is of significant moment that we should take whatever actions we can to reduce the probability that it will occur. Senator Dodd. Just two quick points. I made the point at the outset of the hearing that I think virtually all the Democrats I know, and Republicans, believe that there is room in this surplus for a tax cut. Someone had the line, which I identify with, I am for as large a tax cut as we can afford, underscoring what we can afford. And that is how I feel. And I think others may share that view. I want to raise two points with you. One is, you have raised in your testimony the problems with energy, global energy issues which are looming on the horizon. Japan's economy is not recovering--you did not raise that in your testimony, at least indirectly, that that is still a serious issue given it is a major trading partner. There are issues involving global markets and how strong they will be down the road which you touched upon. The concern I have, obviously, and you raised this a bit with Senator Hagel, is there are some clouds on the horizon that raise some serious questions about the continued kind of growth of the economy? And I worry about that. I relate that to the second point, the one that my colleague from Indiana raised, the triggering mechanism. I have concerns about triggers because I think one of the values of tax cuts is to some degree the certainty of them, that there is an anticipation that occurs. And that if you start reining back in, your having trigger mechanisms, that in itself creates its own dynamic. Wouldn't it be wiser to try and come up with a tax cut proposal that was responsible and fit, rather than one that you built in a mechanism that would have to rein in, given the uncertainty that that creates in markets? Chairman Greenspan. Senator, let me just say with respect to the first part of your implied question, the very nature of the complexity of the world in which we are makes it very difficult, as I indicated in my prepared remarks, to forecast any particular recession. That does not mean that they don't happen. Obviously, they do happen. And what we try to do is, without trying to put a specific probability at any particular time, that from here forward, we are going to go into a recession. We tried that, but not with any great success. So I don't find the notion of trying to say what is the probability of a recession a terribly meaningful concept because the truth of the matter is we never really know for sure what that number is because we cannot see the process by which the system breaches. But because you have that particular problem, and indeed, the international circumstances which you suggest, it is important whenever addressing economic policy, whether fiscal or monetary, to try to reduce the levels of uncertainty in policymaking for precisely the reason that we do not know at any particular point what the probabilities of a recession over X number of months will be. And I would say for those reasons, if for no other reasons, it is important to find particular fiscal policy mechanisms, whether for initiated expenditure programs or tax cuts, to find vehicles which reduce the risks which are associated with them. I think triggers have advantages. They have disadvantages. And it is got to be for the Congress to make judgments as to which outweighs the other. Senator Dodd. Some of my friends are for A, some of my friends are for B. And I am for my friends. [Laughter.] Chairman Greenspan. I fully subscribe to that point of view. [Laughter.] Senator Sarbanes. We have come to realize that. [Laughter.] Senator Dodd. Thank you. Senator Allard. Senator Reed. Senator Reed. Thank you very much, Senator Allard. Thank you, Mr. Chairman, for your testimony. Let me take up the issue of this stampede to spending that we have been witnessing in the last several years. According to the Congressional Budget Office, Federal spending as a percentage of gross domestic product has declined since 1992, from a little over 22 percent to a little over 18 percent, and that with their baseline figures, the projections for the economy and for spending, the decline is going to continue. Isn't that a more relevant way to look at the level of Federal spending than absolute increases year to year? Chairman Greenspan. Remember that goodly part of the fall in the ratio is a consequence of, one, defense expenditures coming down, two, the fact that the economy has risen so dramatically so that the denominator of the ratio has been really very impressive. But, certainly, yes, the notion of the impact of Federal spending on the economy is a function of what that ratio is. But the appropriations that one can make have very significant impacts on the forward levels of discretionary expenditures and it is quite conceivable that you can turn that ratio around quite quickly in a relatively short period of time. I think it is really quite important to think in terms of not only that ratio, but the underlying appropriations process, plus the denominator, merely what is going on in the economy, to come to conclusions on policy questions. Senator Reed. Well, I assume you are going to keep the denominator very robust. And you have done so far and we are very comfortable with that denominator. Chairman Greenspan. We certainly will endeavor to accommodate you. Senator Reed. Thank you, Mr. Chairman. Mr. Chairman, let me just take up another issue. Borrowing from Senator Dodd's phrase and your phrase, that preemptive smoothing of the glide path seems to be the operational emphasis behind your advice of cutting taxes to avoid a shock at 2005 or 2006 of a $500 billion stimulus. Chairman Greenspan. Yes. Senator Reed. There are several alternative glide paths. One is a tax cut. One is simply spending money over that time. From an economic standpoint, is there any difference? Chairman Greenspan. The only difference gets down to the question of how you view the effect of government expenditures on the economy versus tax cuts on the economy. Arithmetically, there is obviously no difference. Either one will affect it the same way. So the question really gets down to a judgment of the size of Government expenditures to the economy, coupled with the whole series of guarantees and economic preemptions which occur as a consequence of the regulatory system. In other words, there is a general sense of how much private sector resources are effectively preempted by the Federal sector, either through expenditures, guarantees, or regulatory actions. And you have to make a judgment as to whether the impact on the economy from tax cuts or Government expenditures is a plus or a minus, in addition to the noneconomic questions which obviously arise with respect to both of those issues. In other words, if you ask me from a strictly economic point of view, I have always argued and continue to argue that we are far better off when confronted with this type of situation to cut taxes rather than increase expenditures. I have always said in the next sentence that economics are not the only set, not the only criteria that are involved in making these judgments. But what I do think is required is to constrain expenditures because, in my judgment, it is very easy for expenditures to get out of hand and run up very rapidly. And that is a judgment which is based on observation on my part, as well as data. But there are others who could have different views. So I am really giving you my own point of view on that issue. But from the point of view of the question, the answer is it doesn't make any difference whether it is expenditures or taxes. Senator Reed. It seems, again, this is the difficulty you have as being both the Chairman of the Federal Reserve and being someone with very profound and insightful personal views, is that, oftentimes, your perspective is taken as sort of speaking ex cathedra about economics, when in fact, a lot of it is insights about congressional dynamics and the stickiness of cutting expenditures versus raising taxes. And I think that is sometimes confused. Chairman Greenspan. I try to make that distinction. Senator. I try to make that distinction as best I can. Sometimes I suspect I don't succeed, but I try. Senator Reed. But returning to your initial response, from a strictly tactical standpoint, tax cuts and increased expenditures will get you to that point where you do not have the fiscal shock in 2005 or 2006. Chairman Greenspan. That is correct, Senator. Senator Reed. Thank you. One of the other aspects of this debate about tax cuts is how you do it. And there has been a proposal about a rebate. In fact, if your goal is simply to eliminate the excess revenues for both economic reasons and public policy reasons, one approach is a rebate. Do you have any comments on a rebate approach, where everyone will receive a certain amount of money? Chairman Greenspan. Not really, Senator. We have had rebates in the past. Indeed, when I was chairman of the Council of Economic Advisers in 1975, we did initiate a rebate. And the purpose was to address the recession that was developing in that particular period. I don't have any comment on the appropriateness of it. The pros and cons I think are reasonably self-evident. Senator Reed. There was a suggestion by the Chairman that you were in favor of across-the-board income tax cuts. Do you have a position? Is that an accurate assessment of your view? Chairman Greenspan. It is, in the sense that I have often been asked in this Committee, when confronted with the desire to cut taxes from an economic point of view, what do I view as the most efficient means to come at the tax cuts? I have always argued that from what I can gather, marginal tax rate cuts are the superior way to come at that issue. Senator Reed. In order to ensure that the poorest workers receive the benefit as well as the richest workers, should that tax cut be refundable? Otherwise, there is a whole class of very poor workers who pay no taxes, receive no benefits, and there is equally a number of high-income taxpayers who don't work in the conventional sense. Chairman Greenspan. Well, it is a question of how you view refundable tax credits, which will often appear on the expenditure side as an outlay. As you know, the earned income tax credit, where it is unrelated to the actual tax form, is on the expenditure side. So you really cannot make the distinction. And that is a judgment that you have to make. Senator Reed. Thank you, Mr. Chairman. Senator Allard. In the Committee, where we are right now, it looks like we have Senator Carper and then Senator Schumer has just walked in. And then we will draw it to a close. Senator Sarbanes. Are we going to have a second round? Senator Allard. The Chairman had laid out earlier that he just wanted to go ahead and complete this round and then we would go ahead--I think Chairman Greenspan has a schedule and what not, that we would go ahead and adjourn. Senator Sarbanes. Well, if we have time, Mr. Chairman, I have just a couple of questions I would like to put to the Chairman before he gets away. We don't get him here that often and we would like to--I guess the phrase is, milk him for all he's worth while we have him here. [Laughter.] Senator Allard. I think if you have a couple of questions, I think that is acceptable. Senator Carper. OPENING STATEMENT OF SENATOR THOMAS R. CARPER Senator Carper. Thank you, Mr. Chairman. Chairman Greenspan, as we come to the end of this hearing, first of all, let me just thank you for being here today, for your testimony again. And maybe more important, thank you for your service to the people of our country. One of the values for me of a hearing of this nature is to find some areas where we agree on some things. And I just want to kind of go back over what I have gleaned from your testimony today and see if I have gotten it right. One of the things that I have understood you to say is that the direction of our Nation's debt and turning deficits into surpluses is something that has been a real positive for economic growth in this country. I understand you to say that economic growth in this country has slowed, but it has not tanked. And I think, to quote you, you said that the central tendency for real gross domestic product growth over the four quarters of this year is 2 to 2\1/2\ percent. I can remember a time not that long ago when 2 to 2\1/2\ percent GDP growth was actually considered pretty darn good. I have gleaned from your testimony that productivity growth continues, albeit, at a somewhat slower rate than it did over the last several years. And that the long-term prospects for economic growth over the next decade or so are actually quite encouraging. I have sensed from your testimony today that you believe inflation remains at bay. And while we always want to be cognizant of it, mindful of it, it is not now an imminent threat to our economy. I understand from your testimony today that the surplus forecasts, while they are robust in the years to come, are not always written in stone. And I think you mentioned at one point that the difference between what was forecast for deficits in 1995 and what we actually realized in surpluses in 2000, I think, the swing was about $500 billion. Chairman Greenspan. That is what I commented on at the Budget Committee, that is correct. Senator Carper. Okay. And I think I have understood you to say that, given the fact that we have some extra money on the table, extra revenues on the table, that one of the good ways to make sure that we spend the money prudently, which is left for spending, is to return some of it to the taxpayers of this country. Those are very helpful things for us to know, as we in this Committee and the Congress and the President attempt to fashion a budget, a fiscal policy for our country, budget policy for our country, and adopt changes in taxes. Where we don't agree is in the following area. If you could give me a little bit of further guidance on this, it would be helpful. First of all, if real GDP growth for the year actually turns out to be 2 or 2\1/2\ percent, the issue of whether or not we need to cut taxes at this point in time in order to stimulate the economy, or whether or not the Fed, the Federal Open Market Committee, is perfectly capable of using monetary policy, interest rate cuts, to help us ease through this slowdown and to return to a stronger growth, that question is before us. And we are going to go from here, and the Democrats, we are going to meet over lunch and try to figure out which way to go. There is some who say, no, we ought to cut taxes now. It should be retroactive. There are others who say, no, that is not appropriate. Let's let the monetary policy work and make the tax cuts phase in a bit further down the line. Any help you can give us on that point? Chairman Greenspan. Well, Senator, the position I have taken, on the basis of the experiences I have had over the years, is that recessions, when they occur, tend to more often than not be over reasonably quickly, and that the timeframe for enacting tax legislation almost invariably is longer than that. But there are some cases in which, when recessions take hold, they extend themselves. They sit there for a while and are more prolonged than you anticipate. Under that condition, which I submit is a relatively low probability, a tax cut having been in place for a period of time is good rather than bad. So what it is, as I indicated before, is it is an insurance policy. It is basically doing something against a relatively low probability outcome--that is, the protracted nature of a recession. And the usefulness of that will basically depend on what is the size of the tax cut, where is it located, and what the economic outlook is. I haven't raised that as a crucial issue because I think that the particular point that I was raising as to why I believe tax cuts are important, is to address this technical problem with respect to the accumulation of assets in the Federal government. So my argument is really quite independent of the issue of economic stimulus, though I recognize that it has certain obvious relationships to it. Senator Carper. Thank you. My only other question is this. In my little State of Delaware, we cut taxes 7 years in a row during my time as Governor, sometimes rates at the top, sometimes rates at the bottom, sometimes in between. We cut taxes for businesses and individuals. We had a four-part litmus test for tax cuts that we adopted. One of the things that we are wrestling with within our own caucus, and I presume my Republican friends are as well, is a set of core principles on which tax cuts should be based. If you will, a litmus test. The four that we used in my State were the following: One, the cuts should be fair; Two, they should promote or enhance economic growth; Three, to the extent that they can, we should simplify the Tax Code, not make it more complex; And the fourth is that the cuts should be consistent with the balanced budget and sustainable throughout the full business cycle. But those four things--fairness, promoting economic growth, simplicity, and sustainability throughout the full business cycle and consistent with a balanced budget. Really, the litmus test that we used. Can you just give us a little guidance, I know my time is expired, but just a little guidance on the kind of principles, whether Democrats or Republicans, that our tax cut policy should be based on? Chairman Greenspan. Well, I think in a very interesting way, it depends on where one starts. Going back from, say, the purview of 1995, for example, with what appeared at that point to be about a 1\1/2\ percent trend growth rate in productivity, it appeared as though the level of taxation was essentially consistent with a balanced budget over the longer run at full employment. And what has happened is that productivity growth has accelerated quite significantly, and so, the existing set of tax rates has engendered a very much more rapid rise in revenues. As I said at the Senate Budget Committee, that productivity over the past 5 to 7 years has risen at about a 3- percent rate, which is twice what it had been previously, and revenues have gone up 2\1/2\ times, the difference being that the rise in the productivity has elevated earnings, expectations, and created a permanent, higher level of asset values, which spilled over into tax liabilities when realized gains were involved, or even when they weren't. And so that what you have got at this point is, as a consequence of the acceleration in productivity, a much higher rate of receipts than one had anticipated. And so, I think the Congress is confronted with the choice of whether in fact you give back what in retrospect turned out to be an unintended excessive level of receipts, or whether those are employed for other purposes these are the key judgments which I think in this particular debate are critical, and these are political judgments. These are judgments which only the Congress can make. Senator Carper. Thank you so much. Senator Allard. The Senator from New York, Senator Schumer. COMMENTS OF SENATOR CHARLES E. SCHUMER Senator Schumer. Thank you, Mr. Chairman. And thank you, Mr. Greenspan, for your patience, as well as all your other great attributes. I would like to ask a few questions. One is, how big a tax cut is too big? One of the worries that many of us have is that we will repeat 1981. People start off with a good plan and it just snowballs. I think the way things work in Washington, when Republicans propose $2 trillion in tax cuts, and Democrats propose $1 trillion in tax cuts, you don't end up with $1.5. You end up with $3 trillion in tax cuts. I am just worried. I support deficit reduction above tax cuts. I take it you would say that that priority is reasonable. Chairman Greenspan. I would say, Senator, that we do not wish to go back into unified budget deficits. Senator Schumer. Right. So the question is, given the numbers that you have been talking about, when do we get to a level where it is too high? Chairman Greenspan. I repeat--if we project our way back into a deficit, I think it would be a mistake. Senator Schumer. And let me just ask you another question because I think there has been some miscalculation here. When you do a tax cut, is it not fair to add into that tax cut, the amount of the debt payment that will have to increase because the Government has less revenues? Chairman Greenspan. Yes. In other words, all calculations with respect to the issue of what the level of the debt will be, indeed whether you have a surplus or a deficit, has in it implicitly the level of the debt and the interest payments. Senator Schumer. Right. Chairman Greenspan. Clearly, if you alter the timeframe of any particular expenditure or tax program, it is going to affect all of those items. Senator Schumer. So just to take a hypothetical, if someone were to propose a $1.6 trillion tax cut--I don't want you to comment on a specific plan--with the decline in marginal rates, the CBO and others would say that that would increase debt service over the 10 years by $400 billion, then the fair number that the tax cut would cause would not be 1.6, but would be 2. And we can change the numbers. I just wanted to be accurate in the ratios. Chairman Greenspan. Yes. Obviously, in order to get the full accounting of any particular initiative, whether it is a tax cut or expenditure increase--what in effect you do is you take the impact of that cut or the expenditure increase and try to infer what the total effect on the budget is, including interest and debt. Senator Schumer. Right. Chairman Greenspan. But there is also a very debatable issue, which now gets to the question of whether you are doing a static estimate or a dynamic estimate. Senator Schumer. Right. Chairman Greenspan. There are going to be those who argue that those actions will impact on the tax base itself and there will be a feedback effect. And having been involved in those debates now for too many decades, it is a very difficult issue to resolve. But I think what is important is not what numbers you put on a particular program, but what are its implications. Senator Schumer. Right. Chairman Greenspan. For example, there are a lot of people who would argue that because of doing a dynamic evaluation of a tax cut, the actual net reduction will be less. Senator Schumer. Right. Although the dynamic argument in 1981 did not serve us very well. Chairman Greenspan. Dynamic arguments presupposed that expenditure cuts were to occur, which did not, plus the tax effects which you referred to. So that those projections were really off by very substantial amounts. Senator Schumer. You see, I am someone who would support a significant tax cut, but the way I look at the Bush tax cut, we are almost already in that unified deficit because it is $1.6 trillion of cuts. It is $400 billion of deficit--increased debt spending. There is $100 billion of extenders which everyone believes we are going to renew. And there is the fix of the AMT, which is $200 billion, which, again, everybody thinks we have to do. Otherwise 25 or 30 percent--this is the individual AMT. So then, if you do what the President has talked about and moved it up to March of this year because of the stimulus, you are at 2.7. Well, if the surplus is 2.6, and those things which almost everyone thinks either have to be added in by the inexorable numbers of math or just the political realities, you are already perilously close to putting us back into debt before we spend another nickel on anything else. And nobody believes--the President just called for an increase in military spending, which I think everybody would support--that we are not going to be there. I am not asking you to comment on the specifics. I know those are the ground rules. But could you comment on--is it fair for any of us to be worried that a large sweeping proposal at the beginning, without all the ramifications counted, that we get back into the debt cycle that we were in. You must have thought about that a lot. You have been one of the architects, publicly, as well as, privately, of helping us bring the debt down and to turn the deficit into surplus. And to me, you make a distinction between tax cuts and spending. I think both of those are downhill. Those are easy. Those are the id of budget politics. The superego of budget politics, the hard thing, is debt reduction. I just worry that we are going to lose that very, very quickly, as all these other factors are added in. Could you just comment on whether my worries are well- founded? What do you think about them? Chairman Greenspan. Well, Senator, if we had the ideal way to evaluate budgets and tax and expenditure programs, we would do it in what economists call a dynamic model, in which you not only calculate all the effects that you are referring to, but the interaction of all the tax and expenditure programs on what is going on in the economy as a whole and therefore, by altering the tax base, you are going to alter both expenditures and tax receipts from the initial conditions. Ideally, that is what we would like to do. Regrettably, our models have not been sufficient---- Senator Schumer. You don't have very good dynamic models. Chairman Greenspan. We don't. But the point at issue is that most dynamic models will indicate that tax cuts will engender a larger tax base. The orders of magnitude will differ and they depend very much on the specification of the model itself. But, ideally, if you took the standard which I just put forth, in which whatever is done does not engender a budget deficit, a unified budget deficit, then the question is, what is the outcome of that evaluation? And I think it is a very difficult one. It raises difficult questions. I think the issues you raise are very much appropriate and to the point. The issue of static versus dynamic evaluation is really much to the point. And hopefully, over the years, we have learned a little, we have learned some, but we haven't learned enough. And I trust that in the future, we will be able to handle these issues far more facilely. But I would certainly not want to argue that the issues you are raising are inappropriate. And indeed, they are. Senator Allard. The Senator's time has expired. Senator Schumer. Thank you, Mr. Chairman. Senator Allard. And Senator Sarbanes had asked for the opportunity to ask a couple more questions, then I want to draw this to a close. Senator do you have one or two? If we are going to drag this one, maybe we would better give the Chairman an opportunity to stretch or whatever. Are you okay? Okay. Very good. Senator Sarbanes. Senator Sarbanes. The Chairman has done enough of this to know that if he stretches and comes back---- [Laughter.] You had the latter part of your statement simply included in the record and did not present it to the Committee this morning. That is the part that deals with government debt repayment and the implementation of monetary policy. I gather the conclusion I am to draw out of that section, though, is the very last sentence, which says: In summary, although a reduced availability of Treasury securities will require adjustments, in the particular form of our open market operations, there is no reason to believe that we will be unable to implement policy as required. Is that correct? Chairman Greenspan. That is correct, Senator. Senator Sarbanes. So we don't have a major worry on that score. Chairman Greenspan. We have been working on this problem for quite a while. The alternatives available to us should Treasury debt effectively go to zero, are quite numerous and we do not see any technical problems in being able to implement monetary policy. Senator Sarbanes. Now I want to ask a bit about monetary policy and fiscal policy. The Fed itself is giving us the central tendency for real GDP growth this year of 2 to 2\1/2\ percent. The blue chip economic indicators recently released a survey. They said 1 percent in the first quarter, 2 percent in the second, three percent in the third, 3\1/2\ percent in the fourth, which comes out to essentially where the Fed seems to be. Now, a tax cut, of course, would hit later. It is not going to hit right away. How much thinking is there at the Fed that it may be necessary in the future to raise interest rates in order to slow down an economy which has been overly stimulated by tax cuts? Chairman Greenspan. As I said before, Senator, what we must do is respond to the economy as it evolved. We are confronted with far more than tax cuts or tax increases or expenditure changes in endeavoring to get a view of the economy against which policy would be implemented. In a technical sense, other things equal--and I emphasize, other things equal--the greater the budget surplus, the lower interest rates would be, which is what I testified many times before this Committee, and would just repeat it. There are, however, innumerable other things going on in the economy--namely the energy difficulties, which I address in my prepared remarks, and this extraordinary change in just-in- time inventorying and the adjustment process itself, which we have to address. But before we address, we have to understand. And in that regard, the tax cut question is not a major issue, largely because its order of magnitude is not a very substantial one--it is an average tax cut. And therefore---- Senator Sarbanes. It depends on which one you are talking about. We don't know where it is going yet. Chairman Greenspan. To be sure. Senator Sarbanes. Yes. Chairman Greenspan. Of the various different tax proposals which I have heard, none of them go outside a certain range where considerations---- Senator Sarbanes. Now let me ask you because I don't want to impose on my colleagues. In early January, you took the Fed funds rate down without a meeting of the Federal Open Market Committee, as I recall. Is that correct? Chairman Greenspan. No, it is not, Senator. We actually did have a telephone conference. And we had a regular meeting and voted on the change. Senator Sarbanes. On the Federal funds, as well as the discount window, which you did a few days later? Chairman Greenspan. Correct, Senator. Senator Sarbanes. Okay. So that was not a Chairman's action under some previous authority. Chairman Greenspan. It was not. Senator Sarbanes. Now the next regularly scheduled meeting is for March 20. Chairman Greenspan. That is correct. Senator Sarbanes. But you leave open, then, I guess, on the basis of the January precedent, acting in the period between now and March 20, before a Federal Open Market Committee meeting. Chairman Greenspan. We will always have that prerogative, Senator. Senator Sarbanes. Thank you, Mr. Chairman. Senator Allard. The Senator from Connecticut. Senator Sarbanes. Can I close with just one observation? I have to put this in the record. Mr. Chairman, I am not going to ask you to answer it. But I really want to present it to you. You have argued that one reason that you have done this change in position on how high you put the priority of the debt reduction, that you see it going down to a minimum level and that this has caused you some concern. But CBO's projections last July, before you made the statements that had you on the same path as in the past, showed the public debt going to its irreducible minimum level in mid- 2007 and net debt going to zero in early 2009. Their new projections show it going to its irreducible level in late 2006 and net debt going to zero in early 2008. So the point hasn't changed very much. Chairman Greenspan. That point hasn't. But what has changed is the credibility of the productivity numbers which, as I indicated in the Budget Committee hearing and, indeed, reiterated this morning, we did not have a true test of structural productivity growth throughout this expansion period because even though we could statistically make reasonably good judgments, at the end of the day, you could not really be certain until you had a weakening in the economy and then were able to observe what happened to productivity. And so, it is the last 6 months of the year 2000 in which productivity held up far higher than any of the models based on the previous data would have indicated. It was only on seeing that that the whole notion that we were really going to reduce the debt effectively to zero became credible. Prior to then, we were dealing with projections with much larger ranges of error than we have today. Senator Allard. Senator Sarbanes. Senator Sarbanes. The 6 month period of a slowing economy is adequate to reach a conclusion that the productivity performance will track what it was in a growing and expanding economy. Is that correct? Chairman Greenspan. Obviously, it is not conclusive. It adds a very major element of evidence to the marketplace. Senator Allard. Senator Dodd. Senator Dodd. Let me just pick up on that. That is a critical point. The points that Senator Corzine raised about what happens with Social Security after the year 2010 is a legitimate issue in terms of whether or not we are actually going to be at that accumulating private assets at the Federal level, at the national level. And the second issue was the issue of productivity rates and the miracle of this new productivity. And the Economist has a piece in this February issue which I think gets to the point that Senator Sarbanes was raising. It goes on--the only possible economic justification for Mr. Greenspan's views is that the new economy has produced a productivity miracle, a permanent increase in the underlying rate of productivity, growth that is capable of being sustained through a downturn. If that were true, the public debt might indeed be paid off early and the Social Security and Medicare costs more manageable. Such a miracle may be occurring, it says, but no one is sure, and given that the downturn is only just begun, there is no strong evidence yet to justify 10 years' worth of huge tax cuts on the basis of a guess about productivity growth derived from a few quarters' figures, can only be considered, in their words, a reckless gamble. And since the tax cuts needs not be so vast, an unnecessary one. Chairman Greenspan. You want me to respond to that? Senator Dodd. Yes. Chairman Greenspan. Okay. I am not going to argue for any particular tax cut. Senator Dodd. I understand that. Chairman Greenspan. But what I do argue is that these last 6 months have been quite important because had we not gotten the type of response that we have got, then it would have raised very serious questions about the extent to which what we were dealing with was cyclical productivity and not structural. Prior to the last 6 months, to be sure, our underlying statistical evaluations lent great credibility to the notion that productivity growth had indeed accelerated from the earlier period. The last 6 months are a different type of evidence. Now I don't deny that in the event the economy weakens, that productivity could temporarily turn negative. That is not what the issue is. The issue is, granted the history of the last 10 or 15 years, what type of productivity change would you expect if there was not structural change of moment in productivity and what would you expect in the event that there was? And what I am saying is that the numbers, as crude as they are, are sufficiently persuasive that something different has happened. Now that is not the same thing as saying that we are going to get X percent of productivity for the next 10 years. That is not what I am arguing. I am just saying that if the underlying evidence is accurate, it means that the capital investments which we have put into our system over the last 7, 8 years, those capital investments have created an underlying capital stock which we now see as quite productive. And the only way you can determine that is what is the productivity of that stock. You can invest an awful lot of money irresponsibly, or whatever, and you will not be getting a return from it. What I am saying is we are now seeing that there is a return and it is suggestive of the fact that that capital stock is indeed as efficient as we suspected it was. If that is the case, then the probability of productivity growth being in excess of where it was from say, 1973 to 1995, is increasing and increasing sufficiently substantially that has made my concern about these surpluses just disappearing moot. And if you want to trace where my arguments have come from with myself, if you want to put it that way, it is trying to answer the question of can we depend upon productivity growth to generate surpluses which we don't have yet. They are on paper. And I have concluded that the changes that we have seen to date raise a sufficiently high degree of credibility without arguing it is certain, to address public policy in a different way. Senator Allard. Senator Reed. Senator Reed. Just one follow-up. Again, I am told that the Fed really relies on OMB and CBO. Do you have a different surplus number over the next 10 years that you are relying on as a result of your last statement than CBO and OMB? Chairman Greenspan. Let me put it to you this way: The numbers that I am relying on publicly are CBO and OMB. I wouldn't be had we not scrubbed the numbers ourselves and taken a close look. We get somewhat different numbers. But the point is that the numbers that OMB--this is, remember, the last administration's OMB, and current CBO--the underlying assumptions that are being employed are credible. Senator Dodd. And I assume your numbers, the Fed numbers, are higher than the 5.6. Chairman Greenspan. I don't wish to say. Senator Dodd. I have one more question, Mr. Chairman. I don't know whether my colleagues will let me address it. Senator Allard. If Senator Schumer would like to yield some time to the Senator from Connecticut. Senator Dodd. Just a quick one. I really should have raised this earlier. There was this piece--I don't know. I have so many papers in front of me here--on the bond investors who focus on Treasury auctions with the possible ending of the 30-year issuance question. I gather that the Treasury borrowing advisory committee has supported the idea of discontinuing the 30-year bonds. What effect is this going to have on the bond markets? Chairman Greenspan. We have had the 30-year bond for a long period of time and it is been a remarkable anchor in the long- term bond market and been especially important for holdings overseas as well as in the United States. In recent years, as the probability that the outstanding debt would decline rose, the 30-year bond took on a scarcity premium. And as you may recall, the interest rates came down quite appreciably. That induced significant problems with respect to the underlying benchmark status of that particular issue. Indeed if I were to think about this question, I would call Senator Corzine and ask him how he would view the particular problem because he had to deal with the particular issue of whether you are working off a 10-year benchmark or a 30-year benchmark. I think the reason why his former colleagues were advocating the elimination of the 30-year bond is that, with the reductions that have occurred, we are in a position where it no longer serves the use that it did, that the 10-year Treasury is becoming increasingly the benchmark. And there is a general presumption that if dollar- denominated issues of more than 10 years are required, that the private sector is very likely to create them. So there is no doubt that, other things equal, it would be better to have a large Treasury debt outstanding so that those of us who deal in the financial markets have easy benchmarks and easy means of pricing and funding, but, in my judgment, the value of reducing the debt to zero is so great that the costs involved to the bond community or to the Federal Open Market Committee and our System Open Market Account that the trade-off very clearly says by far the most important thing is to get the debt down, and we will handle the problem as best we can. Senator Dodd. I appreciate that. And I thank you once again for reiterating what you have now on two or three occasions this morning, this afternoon, that the primary goal is still to get that national debt down to zero. Chairman Greenspan. I have not changed my view on that in the slightest. Senator Dodd. No, I know you haven't. Chairman Greenspan. As soon as we can get it to zero, the better. And the great advantages that we have achieved as a consequence of that over the years have been really quite remarkable. Senator Dodd. I agree with you. As I said earlier, I cannot think of a better gift that we could give to a younger generation than to burn that national mortgage. Senator Allard. I would just observe at this time, for those people who are so against the debt, is running a deficit on time. Senator Schumer. Senator Schumer. I just have one final question that hasn't been asked. And I just want to get the Chairman's opinion on it, although I certainly am glad like the others to hear that debt is number one. I am worried that we are going to get away from that, as my questions before indicated, reducing debt. Credit crunch. In New York, we hear a lot of talk now about a credit crunch in various phases of the market, not just in high-yield bonds, but in other places, too. What is the outlook for credit quality and availability? Should we be concerned? What should we do? Chairman Greenspan. Senator, there were difficulties at the beginning of the year as a consequence of a very significant erosion in the latter part of December. We had problems with so-called secondary commercial paper, the so-called A2/P2 paper. We had difficulties with so-called junk bonds and the spreads were very wide. They have since come down quite appreciably. We have had, as you know, evidence of tightening credit conditions by our commercial banks. They are tightened. They have put some pressure on some borrowers. But, overall, the quality of credit is easing, if anything. And I don't consider that there are serious problems out there. There are the usual credit quality problems you have when the rates of growth fall down. But, again, we are not in a position where anything terribly worrisome is occurring. And we hope that, as this pall of uncertainty which has gripped the economy gradually dissipates, as it will eventually--I don't know when, but I know that it always has--then the markets ease up and we are back to normal. But we are nowhere near where we were at some point in 1998, which was really marginally scary. Senator Schumer. Thank you, Mr. Chairman. Senator Allard. Senator Corzine. Senator Corzine. Yes, thank you, Mr. Chairman. Remarkable display of objectivity and, I think, acumen, even on the 30-year bond, Mr. Chairman. There was one clarification that I would love to hear you comment on that you mentioned a number of times. The preference for tax cuts versus expenditures is clearly a priority that you talk about. But, certainly, there must be some expenditures--FAA computers, computer systems for wire transfers that the Fed might want at some point in time. There are instances where expenditures produce productivity that I think some clarification on how you look at that as opposed to a black and white statement. Chairman Greenspan. I think that is a very good point. I am very glad you raise it, Senator. Obviously, there are innumerable types of activities which you can engage in in which expenditure projects do have a very clear rate of return in the sense of what they can do to the economy, leaving aside the secondary issues of the broader indirect relationships like education and all of that. I would just say that it is important to scrub all expenditure programs to be sure that they are efficient, effective, and they work. There is, regrettably, too little of that in my experience. And rather than draw the line unequivocally, I do think that the weight of the evidence is very heavy on giving back taxes that you don't need rather than spend them. Having said that, there is no question that there are a lot of projects which very readily are quite desirable. The Defense budget is a crucial issue in which those types of evaluations are very important and very difficult. Senator Corzine. Thank you. Senator Allard. Okay. We will go ahead and call it to a close. I would just make the comment that it seems like we have two sets of standards--one that gets applied to tax cuts and a different standard that gets applied to spending. It will be interesting to see how our budget deliberations go as we move through the year. So we will go ahead and call the hearing to a close. [Whereupon, at 1:16 p.m., the hearing was adjourned.] [Prepared statements, response to written questions, and additional material for the record follow:] PREPARED STATEMENT OF SENATOR WAYNE ALLARD I want to welcome Chairman Greenspan. It is a pleasure to serve on both the Banking and Budget Committees where I get the opportunity to frequently hear from the Chairman. We operate today under a new format, with the Fed Chairman focusing on a report on monetary policy. This makes more sense than the old Humphrey-Hawkins format, and is a welcome change. I expect that in addition to a thorough review of monetary policy, we will also have a heated discussion of tax and budget policy. As I have stated repeatedly in these forums, I support a plan to use the surplus to pay off the national debt. However, as the Chairman pointed out during his recent Budget Committee testimony, we now have a projected surplus over the next decade that will accommodate both debt reduction and tax relief. With a nearly $6 trillion surplus, there is certainly room for a $1.6 trillion tax cut. This assumes of course that we keep Federal spending growth in check. I look forward to Chairman Greenspan's testimony. ---------- PREPARED STATEMENT OF SENATOR JIM BUNNING Mr. Chairman, I appreciate your calling this hearing and I appreciate Chairman Greenspan's willingness to come before the committee to testify today. While I am relieved Chairman Greenspan finally lowered lending rates in January, I am very concerned that the Fed's action has come too late. I believe the Nation's economy showed signs of slowing throughout the fourth quarter of last year, and I was absolutely flabbergasted the FOMC did not lower rates in December. Now we are in a period of economic slowdown that looks more and more like a recession. I do not believe this slowdown was inevitable. I do believe that the FOMC's actions can only be classified as too little, too late. I have made no secret of my concerns that the FMOC, and especially the Chairman, seems to be focusing on inflation fires that do not exist. I fear that the Chairman's preoccupation with inflation has caused the FMOC to get behind the curve. Chairman Greenspan, I realize the job you have is a very difficult one, we essentially ask you to predict the future by watching the present and researching the past. Your track record, although I have not agreed with every decision the Fed has made, is generally sound. But I believe you missed the boat on this current economic slowdown; quicker action by the FOMC may have prevented it. I believe the FOMC should drop rates further. Banks are tightening credit standards because of the fear of a worsening economy. In fact, on February 5, 2001, the Federal Reserve Board said in its January 2001 Senior Loan Officer Opinion Survey on Bank Lending Practices, ``In general, banks indicated that the most important reason for tightening standards and terms were a worse economic outlook and a reduced tolerance for risk.'' The Fed should drop rates further to pump new capital into the economy. There is no threat of inflation on the horizon; it is way past time to jumpstart the economy. As the Chairman of the Subcommittee on Economic Policy, I would like to invite the Chairman to come before our subcommittee soon to testify about the Fed's policies. I hope that you will be able to find time in your schedule to come talk to us. Once again, Mr. Chairman, I thank you for holding this hearing and I thank Chairman Greenspan for testifying. I have submitted a few questions for the record. I look forward to the Chairman's answers. Thank you Mr. Chairman. ---------- PREPARED STATEMENT OF ALAN GREENSPAN Chairman, Board of Governors of the Federal Reserve System February 13, 2001 I appreciate the opportunity this morning to present the Federal Reserve's semiannual report on monetary policy. The past decade has been extraordinary for the American economy and monetary policy. The synergies of key technologies markedly elevated prospective rates of return on high-tech investments, led to a surge in business capital spending, and significantly increased the underlying growth rate of productivity. The capitalization of those higher expected returns boosted equity prices, contributing to a substantial pickup in household spending on new homes, durable goods, and other types of consumption generally, beyond even that implied by the enhanced rise in real incomes. When I last reported to you in July, economic growth was just exhibiting initial signs of slowing from what had been an exceptionally rapid and unsustainable rate of increase that began a year earlier. The surge in spending had lifted the growth of the stocks of many types of consumer durable goods and business capital equipment to rates that could not be continued. The elevated level of light vehicle sales, for example, implied a rate of increase in the number of vehicles on the road hardly sustainable for a mature industry. And even though demand for a number of high-tech products was doubling or tripling annually, in many cases new supply was coming on even faster. Overall, capacity in high-tech manufacturing industries rose nearly 50 percent last year, well in excess of its rapid rate of increase over the previous 3 years. Hence, a temporary glut in these industries and falling prospective rates of return were inevitable at some point. Clearly, some slowing in the pace of spending was necessary and expected if the economy was to progress along a balanced and sustainable growth path. But the adjustment has occurred much faster than most businesses anticipated, with the process likely intensified by the rise in the cost of energy that has drained business and household purchasing power. Purchases of durable goods and investment in capital equipment declined in the fourth quarter. Because the extent of the slowdown was not anticipated by businesses, it induced some backup in inventories, despite the more advanced just-in-time technologies that have in recent years enabled firms to adjust production levels more rapidly to changes in demand. Inventory-sales ratios rose only moderately; but relative to the levels of these ratios implied by their downtrend over the past decade, the emerging imbalances appeared considerably larger. Reflecting these growing imbalances, manufacturing purchasing managers reported last month that inventories in the hands of their customers had risen to excessively high levels. As a result, a round of inventory rebalancing appears to be in progress. Accordingly, the slowdown in the economy that began in the middle of 2000 intensified, perhaps even to the point of growth stalling out around the turn of the year. As the economy slowed, equity prices fell, especially in the high-tech sector, where previous high valuations and optimistic forecasts were being reevaluated, resulting in significant losses for some investors. In addition, lenders turned more cautious. This tightening of financial conditions, itself, contributed to restraint on spending. Against this background, the Federal Open Market Committee (FOMC) undertook a series of aggressive monetary policy steps. At its December meeting, the FOMC shifted its announced assessment of the balance of risks to express concern about economic weakness, which encouraged declines in market interest rates. Then on January 3, and again on January 31, the FOMC reduced its targeted Federal funds rate \1/2\ percentage point, to its current level of 5\1/2\ percent. An essential precondition for this type of response was that underlying cost and price pressures remained subdued, so that our front-loaded actions were unlikely to jeopardize the stable, low inflation environment necessary to foster investment and advances in productivity. The exceptional weakness so evident in a number of economic indicators toward the end of last year (perhaps in part the consequence of adverse weather) apparently did not continue in January. But with signs of softness still patently in evidence at the time of its January meeting, the FOMC retained its sense that the risks are weighted toward conditions that may generate economic weakness in the foreseeable future. Crucial to the assessment of the outlook and the understanding of recent policy actions is the role of technological change and productivity in shaping near-term cyclical forces as well as long-term sustainable growth. The prospects for sustaining strong advances in productivity in the years ahead remain favorable. As one would expect, productivity growth has slowed along with the economy. But what is notable is that, during the second half of 2000, output per hour advanced at a pace sufficiently impressive to provide strong support for the view that the rate of growth of structural productivity remains well above its pace of a decade ago. Moreover, although recent short-term business profits have softened considerably, most corporate managers appear not to have altered to any appreciable extent their long-standing optimism about the future returns from using new technology. A recent survey of purchasing managers suggests that the wave of new on- line business-to-business activities is far from cresting. Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the 3- to 5-year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held firm at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the longer term. The same forces that have been boosting growth in structural productivity seem also to have accelerated the process of cyclical adjustment. Extraordinary improvements in business-to-business communication have held unit costs in check, in part by greatly speeding up the flow of information. New technologies for supply chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage--virtually in real time--and can cut production promptly in response to the developing signs of unintended inventory building. Our most recent experience with some inventory backup, of course, suggests that surprises can still occur and that this process is still evolving. Nonetheless, compared with the past, much progress is evident. A couple of decades ago, inventory data would not have been available to most firms until weeks had elapsed, delaying a response and, hence, eventually requiring even deeper cuts in production. In addition, the foreshortening of lead times on delivery of capital equipment, a result of information and other newer technologies, has engendered a more rapid adjustment of capital goods production to shifts in demand that result from changes in firms' expectations of sales and profitability. A decade ago, extended backlogs on capital equipment meant a more stretched-out process of production adjustments. Even consumer spending decisions have become increasingly responsive to changes in the perceived profitability of firms through their effects on the value of households' holdings of equities. Stock market wealth has risen substantially relative to income in recent years--itself a reflection of the extraordinary surge of innovation. As a consequence, changes in stock market wealth have become a more important determinant of shifts in consumer spending relative to changes in current household income than was the case just 5 to 7 years ago. The hastening of the adjustment to emerging imbalances is generally beneficial. It means that those imbalances are not allowed to build until they require very large corrections. But the faster adjustment process does raise some warning flags. Although the newer technologies have clearly allowed firms to make more informed decisions, business managers throughout the economy also are likely responding to much of the same enhanced body of information. As a consequence, firms appear to be acting in far closer alignment with one another than in decades past. The result is not only a faster adjustment, but one that is potentially more synchronized, compressing changes into an even shorter time frame. This very rapidity with which the current adjustment is proceeding raises another concern, of a different nature. While technology has quickened production adjustments, human nature remains unaltered. We respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down until a renewed, more comprehensible basis for acting emerges. In its extreme manifestation, many economic decisionmakers not only become risk averse but attempt to disengage from all risk. This precludes taking any initiative, because risk is inherent in every action. In the fall of 1998, for example, the desire for liquidity became so intense that financial markets seized up. Indeed, investors even tended to shun risk-free, previously issued Treasury securities in favor of highly liquid, recently issued Treasury securities. But even when decisionmakers are only somewhat more risk averse, a process of retrenchment can occur. Thus, although prospective long-term returns on new high-tech investment may change little, increased uncertainty can induce a higher discount of those returns and, hence, a reduced willingness to commit liquid resources to illiquid fixed investments. Such a process presumably is now under way and arguably may take some time to run its course. It is not that underlying demand for Internet, networking, and communications services has become less keen. Instead, as I noted earlier, some suppliers seem to have reacted late to accelerating demand, have overcompensated in response, and then have been forced to retrench--a not--unusual occurrence in business decisionmaking. A pace of change outstripping the ability of people to adjust is just as evident among consumers as among business decisionmakers. When consumers become less secure in their jobs and finances, they retrench as well. It is difficult for economic policy to deal with the abruptness of a break in confidence. There may not be a seamless transition from high to moderate to low confidence on the part of businesses, investors, and consumers. Looking back at recent cyclical episodes, we see that the change in attitudes has often been sudden. In earlier testimony, I likened this process to water backing up against a dam that is finally breached. The torrent carries with it most remnants of certainty and euphoria that built up in earlier periods. This unpredictable rending of confidence is one reason that recessions are so difficult to forecast. They may not be just changes in degree from a period of economic expansion, but a different process engendered by fear. Our economic models have never been particularly successful in capturing a process driven in large part by nonrational behavior. Although consumer confidence has fallen, at least for now it remains at a level that in the past was consistent with economic growth. And as I pointed out earlier, expected earnings growth over the longer-run continues to be elevated. If the forces contributing to long-term productivity growth remain intact, the degree of retrenchment will presumably be limited. Prospects for high productivity growth should, with time, bolster both consumption and investment demand. Before long in this scenario, excess inventories would be run off to desired levels. Still, as the FOMC noted in its last announcement, for the period ahead, downside risks predominate. In addition to the possibility of a break in confidence, we don't know how far the adjustment of the stocks of consumer durables and business capital equipment has come. Also, foreign economies appear to be slowing, which could dampen demands for exports; and, although some sectors of the financial markets have improved in recent weeks, continued lender nervousness still is in evidence in other sectors. Because the advanced supply chain management and flexible manufacturing technologies may have quickened the pace of adjustment in production and incomes and correspondingly increased the stress on confidence, the Federal Reserve has seen the need to respond more aggressively than had been our wont in earlier decades. Economic policymaking could not, and should not, remain unaltered in the face of major changes in the speed of economic processes. Fortunately, the very advances in technology that have quickened economic adjustments have also enhanced our capacity for real-time surveillance. As I pointed out earlier, demand has been depressed by the rise in energy prices as well as by the needed slowing in the pace of accumulation of business capital and consumer durable assets. The sharp rise in energy costs pressed down on profit margins still further in the fourth quarter. About a quarter of the rise in total unit costs of nonfinancial, nonenergy corporations reflected a rise in energy costs. The 12 percent rise in natural gas prices last quarter contributed directly, and indirectly through its effects on the cost of electrical power generation, about one fourth of the rise in overall energy costs for nonfinancial, non-energy corporations; increases in oil prices accounted for the remainder. In addition, a significant part of the margin squeeze not directly attributable to higher energy costs probably has reflected the effects of the moderation in consumer outlays that, in turn, has been due in part to higher costs of energy, especially for natural gas. It is likely that energy cost increases contributed significantly more to the deteriorating profitability of nonfinancial, non-energy corporations in the fourth quarter than is suggested by the energy-related rise in total unit costs alone. To be sure, the higher energy expenses of households and most businesses represent a transfer of income to producers of energy. But the capital investment of domestic energy producers, and, very likely, consumption by their owners, have provided only a small offset to the constraining effects of higher energy costs on spending by most Americans. Moreover, a significant part of the extra expense is sent overseas to foreign energy producers, whose demand for exports from the United States is unlikely to rise enough to compensate for the reduction in domestic spending, especially in the short-run. Thus, given the evident inability of energy users, constrained by intense competition for their own products, to pass on much of their cost increases, the effects of the rise in energy costs does not appear to have had broad inflationary effects, in contrast to some previous episodes when inflation expectations were not as well anchored. Rather, the most prominent effects have been to depress aggregate demand. The recent decline in energy prices and further declines anticipated by futures markets, should they occur, would tend to boost purchasing power and be an important factor supporting a recovery in demand growth over coming quarters. Economic Projections The members of the Board of Governors and the Reserve Bank presidents foresee an implicit strengthening of activity after the current rebalancing is over, although the central tendency of their individual forecasts for real GDP still shows a substantial slowdown, on balance, for the year as a whole. The central tendency for real GDP growth over the four quarters of this year is 2 to 2\1/2\ percent. Because this average pace is below the rise in the economy's potential, they see the unemployment rate increasing to about 4\1/2\ percent by the fourth quarter of this year. The central tendency of their forecasts for inflation, as measured by the prices for personal consumption expenditures, suggests an abatement to 1\3/4\ to 2\1/4\ percent over this year from 2\1/2\ percent over 2000. Government Debt Repayment and the Implementation of Monetary Policy Federal budget surpluses have bolstered national saving, providing additional resources for investment and, hence, contributing to the rise in the capital stock and our standards of living. However, the prospective decline in Treasury debt outstanding implied by projected Federal budget surpluses does pose a challenge to the implementation of monetary policy. The Federal Reserve has relied almost exclusively on increments to its outright holdings of Treasury securities as the ``permanent'' asset counterpart to the uptrend in currency in circulation, our primary liability. Because the market for Treasury securities is going to become much less deep and liquid if outstanding supplies shrink as projected, we will have to turn to acceptable substitutes. Last year the Federal Reserve System initiated a study of alternative approaches to managing our portfolio. At its late January meeting, the FOMC discussed this issue at length, and it is taking several steps to help better position the Federal Reserve to address the alternatives. First, as announced on January 31, the Committee extended the temporary authority, in effect since late August 1999, for the Trading Desk at the Federal Reserve Bank of New York to conduct repurchase agreements in mortgage- backed securities guaranteed by the agencies as well as in Treasuries and direct agency debt. Thus, for the time being, the Desk will continue to rely on the same types of temporary open market operations in use for the past year and a half to offset transitory factors affecting reserve availability. Second, the FOMC is examining the possibility of beginning to acquire under repurchase agreements some additional assets that the Federal Reserve Act already authorizes the Federal Reserve to purchase. In particular, the FOMC asked the staff to explore the possible mechanisms for backing our usual repurchase operations with the collateral of certain debt obligations of U.S. States and foreign governments. We will also be consulting with the Congress on these possible steps before the FOMC further considers such transactions. Taking such assets in repurchase operations would significantly expand and diversify the assets our counterparties could post in temporary open market operations, reducing the potential for any impact on the pricing of private sector instruments. Finally, the FOMC decided to study further the even longer-term issue of whether it will ultimately be necessary to expand the use of the discount window or to request the Congress for a broadening of its statutory authority for acquiring assets via open market operations. How quickly the FOMC will need to address these longer-run portfolio choices will depend on how quickly the supply of Treasury securities declines as well as the usefulness of the alternative assets already authorized by law. In summary, although a reduced availability of Treasury securities will require adjustments in the particular form of our open market operations, there is no reason to believe that we will be unable to implement policy as required. RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM ALAN GREENSPAN Q.1. I believe the Fed's lack of action in November and December helped ensure that we would have a recession. Now that we have a recession, how rapidly must rates be cut in order to turn around the economy? Could tax cuts alone help quickly enough to help prevent a further economic slowdown? Q.2. Why did the Fed not cut rates in November and December when economic indicators were already turning downward? Q.3. If the Fed was able to cut rates by a half-point at the emergency meeting in early January, couldn't rates have been cut even further for needed stimulus in late January? Q.4. Do the Fed's economic models need to be updated? If they did not accurately forecast the recession, then they need to be changed. If they did accurately forecast, then why didn't the Fed act? Taken together, your questions raise issues about the timing and magnitude of the Federal Reserve's response to emerging economic weakness. In the second half of 1999 and first half of 2000, overall investment demand outstripped the available savings. The imbalance that developed threatened to destabilize the economy. It drove real long-term interest rates up substantially through this period, and in order to contain the imbalances the FOMC increased its policy interest rate. After mid-2000, the rate of economic growth slowed significantly, suggesting that the adjustment toward more sustainable economic expansion was under way; long-term interest rates began to come down and financial markets took out the further Federal Reserve tightening previously thought to be necessary. Had the Federal Reserve firmed policy by less last spring or eased rates much sooner last fall, it was our judgment that we would have risked short-circuiting this needed adjustment. The likely result would have been broader and deeper imbalances that eventually would trigger a far more difficult economic correction than we are currently experiencing. In the event, the slowing in the economy late last year was greater than we or most other economic analysts anticipated. As I explained at greater length in my testimony, it appears that the rapidity and unexpected nature of the weakening owe importantly to recent advances in information technology that have enabled businesses to respond much more quickly than we anticipated to impending overhangs of inventory and plant capacity. As soon as it became evident that the economy was softening by more than was necessary to contain imbalances and foster sustainable economic expansion, we began to reduce the Federal funds rate. Because business conditions were weakening unusually rapidly, our policy shift also needed to be unusually prompt and forceful. The adjustment of the stocks of inventories and capital equipment after the unsustainable buildups of late 1999 and early 2000 is still under way, the Federal Reserve continues to watch the situation carefully to gauge the appropriate policy response. The structure of the economy is always evolving, and consequently the Federal Reserve is continuously updating its understanding of how the economy works and how policy should most appropriately respond to emerging economic and financial developments. While we use economic models fit to historical data in that process, policymaking involves looking at all available information and exercising a substantial element of judgment based on our analysis of the implications of recent trends. You also asked about the possibility that tax cuts alone could prevent further economic slowdown. As I noted in my discussion with the Senate Budget Committee, history suggests that because of unavoidable delays in passage and implementation, tax cuts rarely become effective at the time they are most needed to spur activity. That said, if tax reductions are in train in order to tailor a sensible path toward zero debt without subsequent private asset accumulation by the Federal Government, making them effective sooner rather than later could prove helpful should the current economic weakness persist. In any event, clearly, the Federal Reserve is not relying on fiscal initiatives to restore sustainable economic expansion, but is actively adjusting its policy stance to promote that objective. <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT> <GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT>