[Senate Hearing 107-627]
[From the U.S. Government Publishing Office]
S. Hrg. 107-627
RISKS OF A GROWING BALANCE OF
PAYMENTS DEFICIT
=======================================================================
HEARING
before the
SUBCOMMITTEE ON ECONOMIC POLICY
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
ON
THE BURGEONING BALANCE OF PAYMENTS DEFICIT WHICH NEARLY DOUBLED IN THE
LAST FEW YEARS, FROM $300 MILLION IN 1999 TO AN EXPECTED $500 BILLION
IN 2001
__________
JULY 25, 2001
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Martin J. Gruenberg, Senior Counsel
Amy F. Dunathan, Republican Senior Professional Staff Member
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
______
Subcommittee on Economic Policy
CHARLES E. SCHUMER, New York, Chairman
JIM BUNNING, Kentucky, Ranking Member
ZELL MILLER, Georgia ROBERT F. BENNETT, Utah
JON S. CORZINE, New Jersey JOHN ENSIGN, Nevada
DANIEL K. AKAKA, Hawaii
Kate Scheeler, Legislative Assistant
Steve Patterson, Republican Legislative Assistant
(ii)
C O N T E N T S
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WEDNESDAY, JULY 25, 2001
Page
Opening statement of Senator Schumer............................. 1
Opening statements, comments, or prepared statements of:
Senator Corzine.............................................. 10
Senator Sarbanes............................................. 11
Senator Bennett.............................................. 14
Senator Bunning.............................................. 39
WITNESSES
Robert E. Rubin, Former Secretary, U.S. Department of the
Treasury, Director and Chairman of the Executive Committee,
Citigroup, Inc................................................. 3
Prepared statement........................................... 39
Paul A. Volcker, Former Chairman of the Board of Governors,
Federal
Reserve System................................................. 5
Prepared statement........................................... 41
William Dudley, Managing Director and Chief U.S. Economist,
Goldman Sachs.................................................. 25
Prepared statement........................................... 42
Stephen S. Roach, Chief Economist and Director of Global
Economics, Morgan Stanley...................................... 28
Prepared statement........................................... 45
Additional Material Supplied for the Record
Graph of the U.S. Current Account Deficit As A Share of GDP
submitted by Senator Robert F. Bennett......................... 62
(iii)
RISKS OF A GROWING BALANCE OF PAYMENTS DEFICIT
----------
WEDNESDAY, JULY 25, 2001
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Subcommittee on Economic Policy,
Washington, DC.
The Subcommittee met at 10:05 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Charles E. Schumer
(Chairman of the Subcommittee) presiding.
OPENING STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. I would like to call the Subcommittee on
Economic Policy to order.
This is our first hearing, at least with me sitting in this
seat as Chair, and I would like to thank my colleagues and
particularly Chairman Sarbanes and Ranking Member Gramm for the
confidence they have shown in me and I will try to do the best
job I can. I would also like to thank our witnesses for coming
today. It is a very distinguished panel and I am honored that
you are willing to sacrifice your morning to be here. Your
presence today indicates the weightiness of the subject--the
balance of payments deficit.
In my view, this is probably the least explored and least
understood economic issue in Washington and the rest of the
world. In an increasingly globalized economy, no issue could be
more im-
portant or ripe for study, particularly because even those who
do
understand it, like our witnesses today, are not sure if there
is any right solution.
As we all know, the U.S. balance of payments deficit is
burgeon-
ing. Over the last 2\1/2\ years, it has risen from $320 billion
in 1999 to $500 billion this year.
A number of economists have already expressed concerns
about the sustainability of our dependence on foreign
investment. With the national savings rate dropping to around 4
percent in the last few years and the personal savings rate in
the red, the United States was forced to fund its investment
boom with foreign investment, which has generated the massive
imbalance we have today.
But like the Egypt of 1875, which through its profligate
spending became so indebted it was forced to sell its ownership
in the Suez Canal to the British, we are living beyond our
means and we cannot continue to do so, at least in the opinion
of many.
What holds for individuals apparently holds true for the
economy at large. Living beyond one's means is not sustainable
in the long run and the problem is not self-correcting.
Some economists thought that the problem would self-
correct. Over-borrowing would become a drag on the economy, as
more of the domestic GDP was allocated to foreign debt
servicing. The
slower economy would weaken the dollar and, as a result, the
United States would become less attractive to foreign
investors, but that has not happened, at least in the last
little while, the reverse has. The dollar has never been
stronger and now, more than ever, foreign investment is
descending upon the United States.
Recent gains in the Euro have been marginal and, arguably,
speculative. And as Mr. Roach notes, today foreign ownership of
U.S. Treasuries is 37 percent, U.S. corporate bonds is 46
percent, and even in the vast equities market, 11 percent.
This is a dangerous paradox. Foreign investment should be
slowing, but it is speeding up. The dollar should be getting
weaker, but it is getting stronger.
I would like to point out that our witnesses today disagree
about
whether a weaker dollar is the right solution. This
disagreement in and of itself among the most studied economists
in the United States shows how complex this is. As I see it,
this hearing is the first foray into trying to elucidate this
paradox, and in doing
so, maybe figuring out a way to overcome it. No four people
could
be better called upon to meet this challenge. There are a num-
ber of questions that I am hopeful we will get some light shed
upon today.
First, what is the primary driver of this growing
imbalance? Is it simply the result of a mismatch in the supply
of national savings and the demand for investment?
Second, is the imbalance unsustainable? I am swayed by
concerns that at some point, the imbalance will become
unsustainable. It almost seems as if a balance of payments-
induced recession is not a question of if, but when. If it is
unsustainable, will it occur gradually or is there a
possibility of a coordinated, massive withdrawal of foreign
capital that could straightjacket the economy?
Third, what are the risks to the economy? Should
international investors decide to retrench, would the United
States be at significant risk for higher interest rates, more
scarce investment sources, and a bear market?
And finally, what policies, if any, should be considered to
rectify the imbalance or mitigate the resultant risks?
I look forward to exploring these issues today. As I
mentioned, we could not have assembled a more thoughtful or
impressive panel to do so. And I am hopeful that we can begin
to come to some conclusions about what policies we should be
pursuing in order to avoid this faultline that is running
through our economy.
I want to thank our witnesses again, and I look forward to
your testimony and discussion.
Let me introduce our first two witnesses, who really need
no introduction. These gentlemen have spent much of their lives
trying to help our country, particularly in the economic
sphere.
Paul Volcker is the Former Chairman of the Board of
Governors of the Federal Reserve System. He has done an
outstanding job in that role and in subsequent and previous
roles, in a long and distinguished career in Government. Robert
Rubin, who is now the
Director and Chairman of the Executive Committee of Citigroup,
of course, has been one of the most successful Secretaries of
the Treasury that our Nation has known, following in the
tradition
of great New York Secretaries of the Treasury that began with
Alexander Hamilton.
And let me call on Mr. Rubin first, and then Mr. Volcker
for their statements.
STATEMENT OF ROBERT E. RUBIN
FORMER SECRETARY, U.S. DEPARTMENT OF THE TREASURY
DIRECTOR AND CHAIRMAN OF THE EXECUTIVE COMMITTEE
CITIGROUP, INC.
Mr. Rubin. Thank you, Mr. Chairman.
Secretary Hamilton was killed in a duel.
[Laughter.]
It struck me as you said that.
[Laughter.]
In any event, I thank you and I thank you for having us,
and it is an honor to be here with Chairman Volcker.
I think it is very useful and timely to develop further
Congressional focus on our country's current account deficit.
And thus, I think this hearing is a very good idea. I also
think, Mr. Chairman, that recent events in Genoa and elsewhere
suggest that there is a full range of issues with regard to
globalization that would merit further focus by this body.
The current account deficit, as you know, is basically the
trade deficit plus the deficit in payments, interest,
dividends, and the like. But public discussion of the current
account deficit, it seems to me at least, has become a symbol
for concern about the whole area of trade related matters. I
will briefly express my views on these matters, and related
policy issues--hopefully, that will be responsive to the
questions in your letter--as well as very summarily sketching
out an approach to the broader issues around globalization.
To begin, the United States has had remarkably good
economic conditions over the past 8 years, with far stronger
growth and far greater productivity increases than Europe or
Japan, and far lower unemployment than Europe. At the same
time, our markets have been more open to imports than Europe or
Japan, our currency has been strong, our capital markets have
been open, and our trade and current account imbalances have
grown substantially.
I have no doubt that our economy has benefited enormously
from both sides of trade, not only exports, but, even though it
is not popular to say this, also very powerfully from imports.
Imports lower prices to consumers and producers, dampen
inflation--and thereby lower interest rates--provide a critical
role in allocating our resources to the areas where our
comparative advantage is greatest, and, maybe most importantly,
imports create competitive pressure for productivity
improvement. All this is contributing greatly to our low levels
of unemployment and to rising incomes at all levels that we
have had in recent years.
The imbalance between exports and imports, which is the
core of the current account deficit, has occurred because of
vast net capital inflows from around the world into the United
States, motivated by the relative attractiveness of the United
States for investment and as a repository for capital. That
vast net inflow has allowed our consumption plus our investment
to exceed what we produce. The consequence of that vast capital
inflow has been a lower cost of capital in our country and
greater investment helping to increase productivity.
Another consequence of net capital inflow has been a strong
dollar, which has lowered cost to consumers and producers for
what we buy abroad, and created more favorable terms of
exchange
between what we sell and buy abroad. The result is lower infla-
tion, lower interest rates, higher standards of living, and
greater
productivity. The strong dollar has also helped attract capital
from abroad.
The next question is, even with our open markets--and that
was a question that you put forth, Mr. Chairman--imports and a
strong dollar being beneficial, is the imbalance itself a
problem.
While a current account deficit reduces aggregate demand,
until this year, we have had fully adequate demand and, where
additional demand is desired, monetary and fiscal policy, such
as the current tax rebate, seems to be more preferable as a
means of generating demand.
The claims against future output which worry some people
from the vast net capital inflows are like any other borrowing
or raising of equity capital--if the funds are well used for
investment, then the future contributions to growth should
exceed the cost of repayment or other forms of return to
foreign investors.
The remaining concern is that, in various ways, the current
account deficit could contribute to future instability, as, for
example, by adversely affecting confidence with respect to the
dollar or making us more vulnerable to a change in perception
abroad about our economic prospects or the soundness of our
policy regime. And it is that soundness of the policy regime
which is another reason why, at least in my judgment,
maintaining fiscal discipline is so critically important for
economic well-being. While we should be able to sustain this
deficit for an extended period because of the size and strength
of our economy, it would be desirable over time to greatly
reduce this imbalance.
There are some policy measures that could promote this
purpose and would be beneficial in other ways as well. And
there are some policy measures often more frequently advocated,
which might help reduce the current account deficit, but could
have other severe adverse economic effects and, in my judgment,
on balance, would be most unwise.
Doing whatever we can to promote structural reform and
trade liberalization in Europe and Japan would contribute to
greater growth with more attractive investment opportunities in
those areas, thus increasing our exports to those areas and
increasing investment flows to Europe and Japan. That is good
for us in many ways, including reduction of our current account
deficit, and exemplifies why it is enormously in the interest
of the United States to be strongly engaged in providing
leadership on international economic issues.
At home, increasing savings over the full business cycle
would reduce imports and reduce the inflow of capital and, in
my judgment, would be the most constructive approach to
reducing the current account deficit. While our low personal
savings rate seems to be a cultural phenomenon and, in my view
at least, there is a real question about how much net effect
some savings tax credits have, I do think carefully crafted tax
credits for subsidizing saving is a useful approach to explore
if Congress at some point revisits the recently enacted 10 year
tax cut, which itself is a significant diminution of future
national savings and, in my view, was most unsound.
Two frequently mentioned correctives for the current
account deficit that might have some impact, but on balance
would be highly detrimental to our economic well-being are
increased trade barriers and modifying our country's strong
dollar policy.
Increased trade barriers would increase prices, lessen the
comparative advantage effects that we enjoy, and reduce
competitive pressure for productivity. Also, history suggests
that if restrictive trade measures are put in place here in the
largest economy in the world, that could readily lead to
retaliatory trade measures in other countries.
Modifying our strong dollar policy could adversely affect
inflation, interest rates, and capital inflows and would lessen
the favorability of the terms of exchange that we have with the
rest of the world.
Having said all this, and this is my final point, as our
Administration made clear over the past decade, trade
liberalization, though highly beneficial on balance for
industrial and developing countries, can create dislocations,
just as technology does to a far greater degree, and there are
critically important matters, in our country and around the
globe, such as poverty and the environment, that will not be
adequately addressed by the policy regime that I have been
discussing. The demonstrators this past week in Genoa were
sometimes strident, and we certainly must condemn
violence, but there are underlying concerns about globalization
that are serious and need to be addressed. Thus, in our country
and abroad, there should be a parallel agenda to promote
productivity and equip people to deal with change, including
education, effective retraining, programs to help the poor join
the economic mainstream, environmental protection, and much
else. And in my view, the industrial nations, in their own
self-interest, should greatly increase assistance to developing
nations.
Mr. Chairman, let me conclude where I started. The current
account deficit is a complex issue that immediately leads to
the whole range of trade-related issues. I believe this
Committee performs a great service by having this hearing and
whatever other processes it employs to provide serious public
examination of these issues.
Thank you.
Senator Schumer. Thank you, Mr. Rubin.
I will now call on our Former Chairman, who has been such a
great leader for this country over many, many years, Paul
Volcker.
STATEMENT OF PAUL A. VOLCKER
FORMER CHAIRMAN OF THE BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
Mr. Volcker. Well, thank you, Mr. Chairman. I congratulate
you on assuming the Chairmanship of this Subcommittee.
I note of my personal knowledge that you have been working
in this area for, what, 20 years or something, and now in the
Senate, certainly going back into the 1980's, when I was
Chairman. And I appreciate the background and leadership you
bring. I agree with my colleague here, Secretary Rubin. I want
to congratulate you on your initiative in having this hearing.
I could probably shorten it a bit by saying, after
listening to your statement and after listening to his
statement, I will say, amen, and go home.
[Laughter.]
Senator Schumer. We never do that in the Senate.
[Laughter.]
Mr. Volcker. Well, let me just take a few minutes to read
what I have written here about the broad nature of the
challenge before us in the face of these current account and
trade deficits that have reached historically large magnitudes.
And I would mention, too, as the Secretary just mentioned,
what has been going on, looking backward, where we have had a
decade characterized by a strong dollar and a large and growing
net inflow of capital, with its counterpart of a greatly
enlarged trade and current account deficit. What has been
little appreciated, I think, is the extent to which those
developments have supported the relatively strong and well-
sustained performance of the U.S. economy.
For most of that time, the other main economic centers--
specifically, Japan and the continent of Europe--were mired in
some combination of slow growth, high unemployment, and excess
capacity. In sharp contrast, until recently, the U.S. economy
was accelerating. There was good growth in investment and
profits and a sustained high level of consumption and by the
end of the decade, as a consequence of consumption, personal
savings, as economists measure those anyway, practically
disappeared.
In those circumstances, labor markets tightened, tightened
to an extent that in the past had been associated with strong
and accelerating inflationary pressures. Yet, prices,
particularly of goods, have moved relatively little at either
the wholesale or retail level. How could those contrasting
developments be reconciled?
A key part of that explanation is that foreign capital--in
effect, the savings of other less affluent countries--has moved
strongly toward the United States. They have been attracted by
perceptions of strong growth and productivity and the powerful
attraction of the booming stock market. Along with the rising
Federal surplus, it was that foreign capital that in the
absence of personal savings, in effect, financed much of our
investment. The capital inflow has also tended to strengthen
the dollar despite the growing trade and current account
deficits. And that strong dollar, combined with the ready
availability of manufactured goods from countries function-
ing far below their economic potential, contributed importantly
to containing inflationary pressures. Now it seemed, for the
time being, a benign process: For the United States, a current
account deficit without tears; for other countries, the
American market has provided a sustaining source of demand in
an otherwise economically sluggish environment.
What is in question is what you posed for us all, Mr.
Chairman, the sustainability. Our trade and current account
deficits are now trending toward $500 billion a year, close to
5 percent of our GNP. Those are very large amounts by any past
standard for the United States. And given our weight in the
world economy, we are absorbing a significant portion of other
countries savings. With the low level of our personal savings,
and now the prospect of diminishing Federal surpluses, this
means we are dependent upon maintaining a strong inflow of
foreign funds. We have also become fully accustomed to a ready
supply of cheap goods from abroad. Both factors point to
continuing large trade and current account deficits.
For the time being, growth in most of the rest of the world
is so slow that there is no near-term prospect that the world
markets will tighten, limiting the availability of imports at
attractive prices. Moreover, the latest indications are that
the strong flow of foreign funds into the United States is
being maintained, even in the face of our economic slowdown and
stock market correction. But looking further ahead, the risks
are apparent.
We cannot assume that Japan and Europe will not at some
point resume stronger growth, and that they will then want to
employ more of their own savings at home. We would certainly
like to see stronger growth in the emerging world, which in
turn would attract more capital from the United States. Here at
home we have become less dependent on traditional ``old
economy'' manufacturing industries, but there are surely limits
as to how far we can or should countenance further erosion in
our manufacturing base.
All of this suggests that, over time, we must look toward a
narrowing of the trade and current account deficit. That will
require a revival of personal savings and maintenance of a
strong fiscal position. It may require, too, some strengthening
of the Euro and the yen relative to the dollar.
In concept, adjustments of that sort can be made over a
period of years consistent with continuing expansion in the
United States and stronger growth in the rest of the world. But
as developments in the ``high-tech'' world and stock market
have again demon-
strated, sentiment in financial markets can change abruptly and
bring in its wake strong pressures on economic activity. The
timing and degree of those changes simply cannot be predicted
with any confidence. It seems to me evident, however, that as
our trade and financial position becomes more extended, the
risk of such abrupt and potentially destabilizing pressures
increases.
The United States is already a very large net debtor
internationally, and for some time ahead will remain dependent
on foreign capital if our economy is to resume growth. We
should, and we do, export capital as our businesses and our
investors seek out prospects for the highest returns. To
finance both our current account deficit and our own export of
capital, we must import close to $3 billion worth of capital
every working day to balance our accounts. That is simply too
large an amount to count on maintaining year after year, much
less enlarging.
One way--an entirely unsatisfactory way--to approach the
need for adjustment would be to fall into extended recession or
a prolonged period of slow growth. Given that the world economy
as a whole is operating well below par, the dangers of such a
development would only be amplified.
Conversely, I do not think we can count on extending the
experience of the 1990's. That would imply further depleting
our personal savings, ever-larger external deficits, and adding
even more rapidly to our international indebtedness.
For the time being, confidence in the prospects of the U.S.
economy, its financial markets, and its currency has remained
strong, little shaken, if at all, by the generally unexpected
current slowing of growth. Our leadership in innovation, the
sense of increasing productivity and efficient management, and
the stability of our political institutions help underlie that
confidence. Those are, indeed, very precious assets. But, in my
judgment, they are no cause for complacency. The huge and
growing external deficits are a real cause for concern. They
are symptoms of big imbalances in the national economy and the
world economy that cannot be sustained.
Senator Schumer. Thank you, Mr. Chairman.
I appreciate both statements. I think they were excellent.
I hope all my colleagues will get hold of them and read them
because they are succinct and they lay out the problem and the
dilemmas that we face.
I am going to try to stick to my 5 minutes in the
questioning and go to my colleagues, and then, if we have other
questions, we will have a second round. Since this is my first
hearing, is there someone who works the clock?
Yes, good. Okay.
The first question I have is, as you just mentioned,
Chairman Volcker, this cannot go on forever. Something has to
give, and I think Secretary Rubin also alluded to that fact.
Do you think there are warning signs of unsustainability
that we could look at? I mean, if things are beginning to
break, would any economic signs be available? Will this just
happen? Is it such a new area that we could not even guess that
if X happens, that would mean it is likely that Y and Z might
occur and we ought to be at least aware of it in terms of
policy?
Mr. Volcker. Well, I am increasingly sensitive these days
to my increasing age, and I have observed these markets for
some period of time. The idea that you can project these
changes and their timing or magnitude I think is excessive. You
are not going to be able to do that.
My experience suggests that there is a real danger that
they come about suddenly. Sometimes when they come about
suddenly, it creates more difficulty in dealing with them.
Specifically, I do not see many signs, as I say in my
statement, of unsustainability at the moment, in the short run.
The capital seems to be flowing in even more generously than in
the past.
That is partly a function of a feeling that the rest of the
world is not doing very well and that we may have slowed down,
have an unforeseen slowdown--I might mention, I do not know
anybody, maybe some of your other panelists were so acute as to
project the slowdown a year ago, but there weren't many----
Senator Schumer. I think one of them was.
Mr. Volcker. Well, he was a rare observer, but right now,
given the condition in the rest of the world, given that our
stock markets have had a large adjustment, at least in the
high-tech area, we seem to have achieved that without
undermining basic confidence in the outlook. Things look okay.
But I do not think that can last. And ironically, one of the
things that could change it is much better prospects abroad.
For better or worse, we do not see those at the moment. I do
not see them in the near future. But it is an ironic fact that
one of our dangers would be good news abroad.
Senator Schumer. I find this area, there is almost a ying
and yang to everything. Something good might happen that would
help things out and at the same time, it creates something bad
that you wouldn't want to happen for other reasons.
Mr. Secretary, do you have any thoughts on that?
Mr. Rubin. I have no greater ability to predict than the
Chairman did. If I did, I wouldn't be here. I would be back
taking advantage of it.
But in any event, no, I think markets are inherently
unpredictable. I think the best thing you can do, Mr. Chairman,
is to try to have sound policy in your own country. And to me
that means sound fiscal policy and trying to work with
countries abroad to encourage growth there so that they can
gradually readjust.
Senator Schumer. The second question is for both of you.
Yesterday, when Chairman Greenspan was before our full
Committee, I asked him if he thought, given this particular
problem, that the United States should reconsider its strong
dollar policy, which we have. And he, in a rare instance,
demurred. He said that the Administration had agreed that
Secretary O'Neill would be the spokesperson on that and did not
want to say anything. In your testimony, you seem to have
somewhat different directions in this regard. Would each of you
want to comment on the idea that we--and how you keep a strong
dollar policy. This is one of the things I was trying to learn
last night and I called a number of people.
That too is a conundrum. Is it just verbiage? Are there
other things that you do other than just talk the dollar up,
talk the dollar down?
Do either of you have an opinion on how the strong dollar
policy is working and whether we should continue it, modify it,
change it?
Mr. Volcker. If you pressed me, I would have to confess
that the three words--a strong dollar policy--does not
encompass the full complexities of this situation.
Senator Schumer. Sure.
Mr. Volcker. I referred to my age earlier. I spent a long
time in the Treasury and in the Federal Reserve. And I spent
most of that time worrying about a weak dollar.
I think I am very clearly on the record of having a long
period of concern about a weak dollar. So, I do not want to be
associated with a weak dollar policy, whatever that means. I do
think I want a strong dollar in the sense of a strong and
stable American economy and a unit of currency that people can
count on.
Now if you ask me whether I think that the Euro is weak,
too weak to be sustainable over a period of time, and the yen
is too weak to be sustainable over a period of time, I think,
yes, and that will have to be corrected as part of a change in
this balance of payments situation that we are talking about. I
do not think that in any way detracts from the benefits of a
strong and a stable dollar, but it changes exchange rates.
Senator Schumer. Mr. Secretary.
Mr. Rubin. Mr. Chairman, as I said in my remarks, I think
our country has been very well served by a strong dollar policy
and I agree with Secretary O'Neill. I think that is exactly
where we ought to stay.
Senator Schumer. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Senator Schumer, I congratulate you on
your Chairmanship of this Subcommittee and your first hearing.
Great topic to review.
I am impressed by your ability to get high-quality
witnesses to come and give us insight into very difficult
issues. That was, of course, the second panel as opposed to the
first, Secretary Rubin.
[Laughter.]
The confidence that led to this tremendous inflow of
investment resources into the United States, at least in my
mind, is in part based upon the fiscal rationality that we
implemented over the last decade. Some of us are very concerned
about the erosion of that. I think I saw or heard that in
Secretary Rubin's comments.
The unfortunate personal savings rate that we have had has
been offset by these budget surpluses and we seemingly are
reversing that.
Could that be one of those sparks when those abroad realize
that this is coming about, that this external borrowing of
capital comes home to roost? How do we make the public aware of
such a risk as it accumulates? That is my first question.
I cannot help but ask, given the basis of productivity
being so heavily emphasized and how our surpluses have been
generated, whether you have any concerns about the sharp
deterioration that now is only a quarter or so old, but is so
prominent in the projections of budget surpluses and the 10
years ahead, underlying projections that led to tax cuts and
change in fiscal policy.
I have given you enough room to roam in those questions and
I would ask for comments from either of you.
Mr. Volcker. If it is directed at me, on the fiscal policy
question, I very much agree with what Mr. Rubin said about the
longer term outlook.
You can support, obviously, tax relief in the short run,
given the performance of the economy. But if we move and are
perceived to be moving in a direction over a period of time of
exhausting those nice surpluses we built up, at a time when
there are no personal savings, and if we remain with no or very
low personal savings, it would be very dangerous, I think, to
reduce the prospects of a healthy Federal surplus.
And if perceptions of that gain ground, at a time when
something else may be changing, that is the kind of thing I
think that can trigger a reversal of sentiment toward the
United States and a sharper reversal of capital inflows than we
would like to see. So, I think that is very true.
You mentioned another conundrum, I think, for anybody
concerned here as to how the public can be educated. Well,
these hearings were called and we welcome them as a means of
educating the public. But you always run the risk of, I
suppose, lighting the fire, lighting the crisis that you do not
want to see if you get too extreme in citing some of the
dangers that are very real, but they are not necessarily on the
doorstep and they are not inevitable.
I do not know how you traipse your way through that kind of
minefield, to change the metaphor a bit, and get people
educated without trying to resort to extreme statements that
might be
counterproductive.
Senator Corzine. And the productivity question, Chairman
Volcker.
Mr. Volcker. I am no expert on productivity. I have a
little difficulty getting my mind around the notion that the
world has changed completely. I think there is every reason to
believe that productivity will perform better than it did for
about 20 years when it was only 1\1/4\ percent a year, which
was abnormally low.
Whether the rather fantastic figures of the very late
1990's can be sustained, I am in a show-me posture, at least on
that.
Senator Corzine. Secretary Rubin.
Mr. Rubin. I think I would add three comments, if I may. I
agree with everything that the Chairman said.
In 1993, when serious steps were taken to reestablish
fiscal discipline, I think that had a symbolic significance
that had very substantial impact on confidence and on our
economy.
I think the 10 year tax cut cuts in exactly the opposite
direction. So, I do think it is a threat to creating deficits
on the nonentitlement side of the budget that could even reach
into the entitlement side of the budget, and I think it is a
significant adverse development with respect to confidence, or
it has the potential of being that, at least.
I do not have any wisdom on productivity, but I do think
that basing a 10 year tax cut on 10 year projections that
nobody thinks are anything other than highly unreliable, seems
to me to be quite unsound.
Senator Corzine. Thank you.
Senator Schumer. Thank you.
We are honored to have our Chairman and leader here,
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Senator Schumer. I
want to make just a few opening comments.
First of all, let me say how pleased I am to join with you
and Senator Corzine and others in welcoming Former Treasury
Secretary Rubin and the Former Federal Reserve Chairman Volcker
before the Subcommittee this morning.
I have had a long-standing interest in the subject of the
risks of a growing balance of payments deficit. In fact, two
Congresses ago, I cosponsored legislation with Senator Byrd and
Senator Dorgan to establish a trade deficit review commission.
We felt there was a need for an independent, bipartisan
commission made up of distinguished individuals of varied
backgrounds to study the nature, causes, and consequences of
the U.S. merchandise trade and current accounts deficit.
We thought that issue was poorly understood. In fact, there
was even a reluctance, I think, to discuss the trade deficit as
a potential problem for the U.S. economy. It was often ignored.
Some even
denied it was an issue.
So the commission established by Congress had Murray
Weidenbaum, the Chairman of the Council of Economic Advisers
under President Reagan, and Dimitri Poppadimitrio, who is the
President of the Levi Economics Institute up at Bard College,
as the Cochairmen.
It had six Democrats, six Republicans. They did not reach
consensus on many issues, but they did agree on one point and I
quote them: ``Maintaining large and growing trade deficits is
neither desirable, nor likely to be sustainable for the
extended future. These deficits reflect fundamental imbalances
in the American economy.''
And this is the report which they produced, entitled,
``U.S. Trade Deficit--Causes, Consequences, and Recommendations
for Action.''
I, frankly, think that we are ignoring this issue at our
peril, the continued growth in our trade and current account
deficit and, as a consequence, accumulation of large amounts of
external debt.
I think we need a good, informed public discussion about
the causes and consequences and consideration of actions we
might take to minimize the risks. For that reason, I very
strongly commend Senator Schumer for holding this hearing. We
are deeply appreciative to this panel of witnesses and the
panel that is to follow for coming this morning and giving us
their time and effort.
I am not going to go into a lot of the data, but let me
just simply note that we have gone from being the world's
largest creditor Nation to now being the world's largest debtor
Nation.
We have run these really extraordinary trade deficits year
after year, which has significantly built up our external debt.
We were a $34 billion debtor in 1987, $200 billion in 1989,
$767 billion in 1996, $1.2 trillion in 1997, and $1.5 trillion
in 1998.
As a consequence, the balance of interest, dividends and
profits paid on foreign investments in the United States versus
a return on U.S. investments abroad has turned negative.
Throughout most of the post-war period, that was positive.
We hit a high of $33 billion in 1981. In 1998, it was minus
$22.5 billion. We are the world's largest debtor and servicing
that debt has increased the U.S. deficit on current account.
Obviously, in a sense, that puts us--I think that in a
Tennessee
Williams' movie with Vivian Leigh, there is a line--dependent
on the mercy of strangers, or in the hand of strangers, or some
such line like that as I recall.
Mr. Rubin. ``Streetcar Named Desire,'' maybe.
Senator Sarbanes. Yes.
Mr. Rubin. Dependent on the generosity of strangers.
Senator Sarbanes. Dependent on the generosity of strangers.
And I think that is where we are. The economic fortunes of the
United States are partially in the hands of foreign investors
and depends on whether they are willing to increase their
investment in U.S. assets enough to offset this deficit. So, I
am extremely concerned about it.
I worked a year for Walter Heller when he was Chairman of
the Council of Economic Advisers. And in the economic report of
the President in 1962, which was Heller's first report, he
stated, and I quote him: ``The balance of payments objective
for the United States is to attain at high employment levels a
balanced position in its international accounts.'' He then
noted that this did not mean doing that each year. It does not
mean that balance must be maintained continuously. In some
years, a surplus in international payments will be appropriate.
In other years, a deficit. Do you think that this ought to be
an objective of U.S. economic policy?
Mr. Rubin. I think, Senator, it is a desirable long-term
situation. But as we were discussing before, I think this is a
very complex issue. I think that the question, at least to me,
is, what effects has the current account imbalance had? And at
least in the 1990's, it seems to me that what has really
happened is we have had these vast inflows of capital from
abroad that have financed a lot of the investment that has
created productivity.
I do agree with you that the creation of the imbalances has
the risk of possible instability at some point in the future
and it would be desirable to get back into a balance over time.
However, I think it is a question of what policies one is
thinking of in terms of getting there. If we could increase our
savings rate, that would be good. On the other hand, we just
enacted a 10 year tax cut that is the antithesis of that.
If we can encourage growth in Europe and Japan, that would
be good. That is on the good side. On the bad side, Senator, I
think if we did anything in terms of increasing trade
restrictions, that would be enormously against our self-
interest. And I at least believe that our strong dollar policy
has served us well.
So the answer is, yes, there is a problem, but some of the
cures are I think a lot worse than the disease.
Mr. Volcker. Just as a kind of historical footnote, I
suspect that Walter Heller was talking about the overall
balance of payments, not the current account. And now the
emphasis is on the current account. With the floating exchange
rate, we do not worry about the overall so much because, in
some sense, it always balances. But to get to the point, I do
not think we have to balance the current account every year. We
can probably sustain a small deficit. We sustained a small
surplus for many years. But it is a question of proportions.
And year after year, with not only a large deficit, but a
rising deficit, I think has to be unsustainable. After a while,
we can get all the international capital in the world and it is
just not going to happen.
And I might say, in your concern about being in the hands
of the generosity of foreigners, it is certainly true of
foreign lenders. It is also true that you are in the hands of
American investors. They also have feelings about confidence
and prospects. And if they begin putting money outside the
United States in greater volume, we also have a problem.
Those things tend to go together. The change in mood of the
foreign investor will probably be matched by a change in mood
of American investors.
Senator Sarbanes. Well, one of the things that concerns me
is that the debt has gotten so large, and the serving of it now
exceeds the flows into the United States, that we are in a
self-perpetuating cycle of the situation just worsening in and
of itself, let alone any further additions to it. Isn't that a
significant development, to sort of cross that line?
Mr. Rubin. I think it is, Senator. But on the other hand, I
think that one would find that, if one looked at least at the
1990's, as opposed to the 1980's, that the return on investment
that the inflows have financed exceeds the cost of repayment or
other sorts of payments abroad.
So that, in effect, it is like any other borrowing or
equity investment. I think we have actually benefited from
these flows, although we certainly have to either repay them
or, in the case of equity investments, make payments of some
sort or other.
But I think, on net, the benefits to growth have exceeded--
I guess that is one way of looking at it--that which we pay
out. I do fundamentally agree with you that there is a threat
to stability and I think the question is how do we get back?
I personally think that part of the danger in this that
causes us to do things--I was told in law school that bad facts
make bad law. And I think part of the problem here is that the
problems could lead us into directions that would be far worse
than the thing we are trying to deal with.
Senator Sarbanes. Mr. Chairman, you have been very generous
with the time.
Senator Schumer. Please continue if you have another
question.
Senator Sarbanes. No, thank you very much.
Senator Schumer. Senator Bennett.
STATEMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. Thank you, Mr. Chairman.
May I welcome you back, Mr. Secretary. I will still call
you that even though you are now earning an honest living.
[Laughter.]
Mr. Rubin. I tried to be honest when I was in office,
Senator.
[Laughter.]
Senator Bennett. Yes, you were. I will stipulate to that.
Mr. Rubin. Okay.
Senator Bennett. I will stipulate that. But it is good to
see you back and it is good to have your counsel, and we
appreciate that.
Mr. Volcker, I identify with anybody who is 6 foot 7, bald
and with white hair.
[Laughter.]
And wears glasses.
Senator Schumer. In a gray suit and a blue tie.
[Laughter.]
Senator Bennett. Yes, gray suit and blue tie.
[Laughter.]
Mr. Volcker. I am so old, Senator, I identify with any
Senator named Bennett, including your father.
[Laughter.]
Senator Bennett. Yes, indeed. Thank you. There are only a
few of us around who remember my father. He began what has now
become the Utah seat on the Banking Committee, and I am
delighted to hold it now.
Mr. Volcker. I testified before him a number of times. So
here we are.
Senator Bennett. Here we are.
Picking up on one of your comments, Mr. Volcker, going back
to Tennessee Williams for a minute, we are not, I think,
dealing with the generosity of strangers, but with the self-
interest of foreign investors. They are not taking care of us
out of a sense of generosity, but because this is the best
place for them to put their money, in their own opinion.
And we are now faced with a borderless economy, so the same
is also true. American investors may be as friendly as
possible, but their self-interest will cause them to go
elsewhere with the speed of light on the Internet if they
decide that their money is better served some place else.
So in the borderless economy, and, frankly, I would prefer
that term to globalization, maybe because it has a slightly
different brand flavor to it and is less likely to get rocks
thrown at it when it was used in Genoa. But in the borderless
economy in which we operate now, money moves very, very freely
and it goes wherever the self-interest of the investor wants it
to go.
If we get the effect that you talked about, Mr. Rubin, that
having it here produces an increase in the overall economy that
is greater than the amount we have to pay for it, it is a good
thing for us, regardless of what the current account deficit
happens to be.
Now, I would like your comment on a chart. And unlike
Chairman Sarbanes, I have not had the time to get it blown up
big enough so everybody can see it. So all you can see are the
lines and you cannot see the numbers. You will have to trust me
on what the numbers are.
Senator Sarbanes. We are making progress just that you are
using the chart. We welcome that.
Senator Bennett. Okay. Well, I usually use them on the
floor and not in Committee.
This is the U.S. current account deficit as a share of GDP.
This is not the total deficit that you are talking about, Mr.
Chairman, but it is the current account deficit. And it is by
year and this starts in 1980 and then goes to 2000. So that is
20 years.
Now, I am not an automatic believer in cause and effect.
But you lay that chart over American economic performance and
the account deficit is positive or a surplus in 1980 and 1981.
Again in 1991. And it is overwhelmingly in a deficit, soars up
in 1984, 1985, 1986, 1987, then starts to come down.
Then when you became Secretary, Mr. Rubin, it starts going
up again. And the year of 2000, which some insisted was our
very best year, at least during the campaign season, it is at
the highest point it is in the chart. Is this sheer
coincidence? I am perfectly willing to believe that it is. Or
is the best way to solve the current account deficit to throw
the U.S. economy into a recession?
Mr. Volcker. I must point out that those years in the
1980's, I was Chairman of the Federal Reserve Board.
[Laughter.]
Senator Bennett. Okay.
Mr. Volcker. Well, as I mentioned in my statement, Senator
Bennett, you can solve this--solve is a strong word. It does
not really solve it in a fundamental way. But if the economy
goes into recession, the current account deficit will
presumably improve, particularly if you can keep the rest of
the world out of recession at the same time. That is not the
way you want to cure this.
The question is sustainability of the big deficits and what
constructive ways short of recession you can find to achieve a
more sustainable outcome.
It was widely considered, and I think appropriately so, in
those years in the 1980's that the deficit had gotten too large
and certainly a feeling at that time that the dollar had gotten
too strong. It made me very nervous that that feeling was
expressed in efforts to deliberately weaken the dollar. But,
nonetheless, it was corrected over a period of time.
I think we are not in the same situation as the 1980's, but
some elements resemble it. This period of deficits has been
longer, larger now in relation to the GNP, as your chart points
out, and it can be sustained for some time given the present
state of the world. But I do not think it can be sustained
indefinitely and the earlier we recognize that and take the
appropriate actions, the better off we are going to be.
Senator Bennett. Mr. Rubin, did you want to add something?
Mr. Rubin. Senator, I would agree with both you and Senator
Sarbanes. I do think that the capital inflows have contributed,
probably substantially, to the economic growth of the 1990's
because the financed investment that our own low savings rate
wouldn't have financed. On the other hand, it is not something
that can go on indefinitely, and as Senator Sarbanes said, it
does create at least the risk at some point of creating
instability.
I do think it would be desirable to get back toward
balance. So, I both agree with you, and yet I do think that it
is something that we need to be concerned about.
What I would not do, though, is have that lead us into
policy areas like trade restrictions that I think would be
highly adverse to our self-interest.
Mr. Volcker. I agree with this point on trade restrictions.
I just want to say that, we do not want to get so concerned
about this that we do wrong policies.
But let me make one other point about the importance of
foreign investment.
It has not only been helpful during this period, it has
also been essential to the growth of the American economy when
we haven't been saving anything. Or saving very little, anyway.
If that situation remains, we are at the mercy, if that is the
right word, of foreign investment. But we should not be in a
position that we are dependent upon foreign investment to a
degree that I believe, anyway, cannot be sustained
indefinitely. So, we therefore have to do what is necessary at
home to correct that imbalance.
Senator Bennett. What is that?
Mr. Volcker. Well, to some degree, I hope it is self-
correcting. If you think the heart of the problem, or a large
part of the problem is personal savings, when I look at the
consumption patterns of my own family, I am not sure it is
entirely self-correcting.
[Laughter.]
But the fact is that it has been, I think, pushed in part
by this extraordinary boom in the stock market. And if the boom
in the stock market is dissipated or even levels off, I think,
over time, there will be some tendency to do more personal
savings.
So far as direct Federal action is concerned, we both
express caution about the outlook of the budget. So long as
personal
savings is so low, it becomes extraordinarily important that
the
Federal Government itself be the important part of the
balancing factor, instead of foreign investment in some sense,
in maintaining a surplus on its own account which contributes
to the savings of the country.
And that is why I think both of us express concern about
the uncertainty in the current condition of the future outlook
for the budget because one of the reasons we did so well in the
1990's, in my opinion, was the combination of the foreign
inflow of capital from abroad, plus the rising Federal
deficit----
Mr. Rubin. Federal surplus.
Mr. Volcker. Federal surplus--which made up for the lack of
private savings.
Senator Bennett. Thank you, Mr. Chairman.
Senator Sarbanes. I think that is sort of the $64,000
question that Senator Bennett asked.
You both have said that it is a potentially serious problem
and it introduces an element of risk and potential volatility.
You then have warned against certain measures that you think
that people will then seize upon this in order to do, primarily
focusing on trade restrictions.
And as I understood the question, it was, well, then, given
that you say there is a problem, you do not dismiss the
problem. You accept the proposition that there is a problem.
What should be done about it?
I would like to stay with that, Mr. Chairman, and see if we
can elicit something further from you on that question.
I guess there are potentially things that could be done in
the trade area that would not equal out to restrictions. If it
is an open door here but a closed door for us over there--for
example, everyone keeps citing the trade with China. The figure
they cite when they do that is they say, well, we have $115
billion worth of trade with China. This is a big item. Then
they do not say that $100 billion of it is China sending things
to us and $15 billion of it is us sending things to China, for
a net trade deficit of $85 billion.
In percentage terms, the largest that we have of any--
actually, even in dollar terms, it is now larger than Japan,
just barely. But, of course, the Japanese figure is off of a
larger volume of trade. Only 14 percent of the United States-
China trade are our exports to China. Japan, it is 30 percent.
Europe, Canada, Mexico, it runs about 45 to 50 percent,
depending on the year. It fluctuates around in there. Now those
are very sharp differences. So let's take the Bennett question
and stay with it for a minute. What can we do about this?
Senator Schumer. Which is the $64,000 question that nobody
in all my reading has come up with a very good answer to? What
do we do?
Mr. Rubin. I think it is a complex question and there are
no easy answers. I will give you my views, for what they may be
worth.
First of all, I agree with the Chairman--increasing
national savings is probably the most important thing we can
do. But we just go in the other direction in a very substantial
way with this 10 year tax cut. I think that if Congress ever
gets to the point where it is willing to reconsider that,
number one, I think it should be made far more moderate. And
number two, I think its content should include incentives for
savings that would work, not incentives that are simply going
to shelter savings that more affluent people are already
making, but a structure that would actually work for middle-
income and lower-income people that would increase savings.
That is one thing, or two things, I suppose, I would do.
Senator Sarbanes. What would that be? Like a matching
contribution or something for lower and middle income people to
induce them to save?
Mr. Rubin. In some form or other, Senator, I think that
would have a realistic possibility of increasing savings, as
opposed to tax credits that mostly shelter more affluent
people's already existing savings that are going to occur
anyway.
But I wouldn't add that to the existing tax cut. I think if
the tax cut could be revisited, although that may not be
possible, and it would be made far more moderate, and then,
within that context, do the sort of thing that you just
mentioned, yes, I think that would be a material contribution.
Senator Sarbanes. I think that we are going to be compelled
to revisit the tax cut.
We have this situation now where they are going to work
overtime to keep their elderly wealthy parents alive until the
last year of the stepdown in the estate tax. Then, you have a 1
year window to get the estate without any taxes. And then the
next year, it sunsets. So that is going to create a lot of
interesting dynamics in families across the country.
Mr. Rubin. It is an unusual structure, Senator.
[Laughter.]
Mr. Volcker. It suggests heavy investment in respirators.
[Laughter.]
Senator Schumer. 2010.
Mr. Rubin. We should try to liberalize trade abroad. I
agree, our trade barriers are very low and they are higher
abroad. Therefore, trade liberalization is in our interest.
I personally think that we should have trade promotion
authority with appropriate terms of some sort or other. I think
a new round might make sense. I also think anything we can do
to encourage growth in Europe and Japan would make sense.
On the China situation that you mentioned, we benefit
enormously from the imports, so I wouldn't do something to
restrict those imports. But I sure as heck would try to
increase access to their markets.
Senator Schumer. Do you have anything to add to that?
Mr. Volcker. Well, you describe a pattern that one would
love to see and that ought to be encouraged by public policy by
whatever means.
You certainly would want to see more rapid growth abroad,
which would greatly assist our export position. I would like to
see the opening of the markets, too. But after watching this
for many, many years, I would not count on that being a major
influence,
although it could be helpful.
I think as we get out of this current slowdown, we
certainly want to grow again. But we want to avoid very high-
powered growth, the kind of boom and heavy pressure on our
economy because that makes us more dependent and less
sustainable.
We certainly want fiscal restraint, and so far as this low
personal savings is concerned, to change that. To change the
savings rate by fiscal policy, I have become a bit of a skeptic
over time, seeing all of these experiments in personal savings
accounts of various sorts.
If you really want to change it, I think you have to be
pretty drastic and go to a much more consumption-oriented tax
system than what we now have. And I doubt that there is any
near-term prospect of doing that.
Also as I alluded briefly to in my statement, as part of an
orderly adjustment over a period of time, I suspect you would
see some currencies that look rather depressed to me--the Euro,
the yen, the Canadian dollar--strengthen.
Some combination of these events, if they happened in a
nice, gradual kind of way, would maintain confidence during the
interim period, and over a period of time, produce a much more
sustainable position.
Senator Schumer. How do you do that in a period of floating
rates?
Mr. Volcker. Well, fiscal policy. Monetary policy is
obviously important in gauging the right degree, more or less,
of growth in the United States. There are responsibilities in
other countries that we cannot directly affect of restoring
their own growth patterns.
And as I say, I do not think the short-run outlook there is
particularly favorable. But looking ahead, a year, 2 years, 3
years, obviously, that is an important part of the solution.
Senator Schumer. I know you gentlemen have tight schedules,
but Senator Corzine had another question.
Senator Corzine. There is a changing nature of the inflow
of assets. During most of the 1990's, it was not entirely, but
heavily
direct investment. A lot of merger and acquisitions, cross-
border
activity, which has slowed dramatically.
In your judgment, is it safer or more risky for us as a
Nation to have flows that are security-denominated, if you
would, as opposed to the direct investment, which I think gets
it sometimes the description that we are in debt, when we in
fact have long-term direct investments that may have a
different nature than one where the deficit is being funded by
short-term flows of cash?
That is one question.
Then the other is another sort of technical one. What role
and how much of this benign reaction to our current account
deficits, comes because we are the reserve currency of the
world, if we
are? And are there any risks that we are not fully appreciating
and
taking into consideration? Are there changes ahead for us in
those areas?
Mr. Volcker. I will make a few remarks and then turn it
over to Mr. Rubin.
But I think, normally, you would think that direct
investment is more stable and more advantageous over time than
portfolio investment, particularly short-term portfolio
investment, which has a history of being very volatile, very
short-term oriented. Direct investment can also be reasonably
volatile, too, but probably not quite so sensitive as portfolio
investment.
Direct investment, we always argue when we are doing it
abroad, brings great management, productivity, technological
improvement.
It is interesting that in this period of time, the
foreigners have been buying up our companies more than we have
been buying up other companies. But that is a reflection I
think of the feeling that the American economy has just been
doing better and the prospects are better.
Senator Corzine. If I read the numbers right, though, that
has changed in the last 18 months.
Mr. Volcker. You are probably more familiar with the
numbers than I. And it tends to come in lumps, some very big
investments sometimes.
And the other part----
Senator Corzine. Reserve currency.
Mr. Volcker. The reserve currency. Look, I think the
feeling that the United States is a big, strong, stable country
with a relatively stable economy, a relatively stable, strong,
big, internationally used currency, makes for a kind of feeling
of safe haven when the rest of the world has not been doing
very well.
So it is both that the history of the dollar, not just the
technicalities of the reserve currency, but the fact that it is
such a widely used international currency, not just by foreign
central banks, but--the statement I guess is true that there
are more dollars circulating in Russia than there are rubles.
It may not be the only country where that relationship is
true. It just makes it a natural thing to do, so long as we are
growing, so long as our prices are reasonably stable. It is
going to be a place that benefits from difficulties in the rest
of the world. And in recent years, there have been lots of
difficulties in the rest of the world. The other side of that
coin is, if the economic prospects in the rest of the world are
perceived to improve, the capital wouldn't come in quite so
easily.
Mr. Rubin. I agree with all of that, Senator. I think the
only thing I--it is not really adding, it is just maybe
repeating--is that I believe it has been useful that the dollar
has been the reserve currency of the world. And I think it is
just one more reason why it is so important that we maintain
sound policy in this country, particularly fiscal policy,
because I think that very much influences how people around the
world view keeping their assets in our dollar-denominated
assets of one sort or another. Obviously, foreign direct
investment is more stable than portfolio capital and you are
correct about the change in flows.
Senator Sarbanes. But isn't this the problem? This is the
real dollar exchange rate in a basket of 26 currencies. There
has been a 30 percent appreciation in the dollar over the last
5 years.
Now, of course, the NAM, the Farm Bureau, the labor people
are all contacting us because of the impact of this. The
manufacturing sector is down 5 percent in this economic
slowdown. It is a very serious problem.
We still go along with, ``having a very strong dollar,''
and I understand some of the benefits that flow from that. But
there are also disadvantages that flow from this. And this sort
of marked change over a relatively short period of time, this
is 1989 back here and we have moved along like this.
But look at what has happened over the last 4 years, I
guess, in the appreciation of the dollar. Of course, that
worsens our trade
position. Now do we just accept that or should we be trying to
do something about it?
Mr. Rubin. My view, whatever it may be worth, Senator, is
that the other side of the coin is that the result is that we
have had lower inflation, lower interest rates, it has given
the Fed more room to lower rates if it so desired.
Manufacturing actually increased by--I do not have the
exact number. It is roughly 35 percent, from 1993 to 2000. Not
manu-
facturing employment because productivity increased so much.
Manufacturing increased substantially in this country, despite
our stronger currency. I actually think it is been a
substantial asset to it.
If we now have a shortfall, which we do have a shortfall of
demand, what I think we ought to do, as I said in my remarks,
is look to a fiscal and monetary policy--that is to say, tax
rebates and monetary policy--to generate the demand. I do not
think that we should modify our strong dollar policy.
Senator Sarbanes. Mr. Volcker.
Mr. Volcker. Well, I guess I would rather talk about
modifying the weak Euro policy or the weak yen policy or the
weak Canadian dollar policy because I do think that those
currencies are abnormally restrained, let me put it that way,
or unsustainably restrained, and that that, over time, I would
look for some change, which should make that chart look a
little differently, not because the dollar is weak. The dollar
strength will be maintained if we maintain the strength of our
economy. But the exchange rate might change.
The Chairman, in his opening remarks, I think said
something about this whole question gets into the question of
globalization or borderless world and what all the implications
are.
I think the volatility in these exchange rates that are
partly reflected in your chart is a very serious matter for the
world economy that deserves a lot more attention over a period
of time, and it is something that nobody has wanted to look at
for a variety of reasons. But when you have the yen or the
Euro, to take those two cases, moving by 30, 40, 50 percent,
over the course of a couple of years, you get economic
dislocations. And you get some of that economic dislocation in
Argentina because they get caught in the slipstream. It is too
complicated a subject to get into today, but I think it is a
very real problem.
Senator Schumer. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
Let's go back to my own experience in business. And I find
that the economy is much more like a business than a family.
We hear this rhetoric politically all the time--well, the
Government is like a family sitting around the kitchen table
trying to make ends meet. If you cannot get a raise down at the
factory, you are going to have to cut back on the amount of
meat you eat. And so, we have to make the budget balance. And
this is a very graphic image that every voter can respond to
and it is wholly wrong. The economy is like a business that is
constantly changing every day. Pressures are changing every
day.
I found as a businessman that the most important thing that
I could do is grow the business, that I could solve a whole lot
of my other problems if the business was constantly getting
bigger in a profitable way.
There are those of the dot-commers who think that they can
grow the top line and not pay any attention to the bottom line
and then suddenly discover that not having a bottom line is a
bit of a disadvantage.
I am biased to look at the economy through that lens and
say that as long as the economy is growing in a proper way, we
can handle the problem of account deficit. We can handle a
whole series of other problems.
If the economy is not growing and we have difficulties,
then
everything starts to come undone as well. And you talk about
the weak yen. The Japanese economy has been flat or deflating
for
10 years. Why would you want to invest in a currency that is
tied
to that?
Am I over-simplistic here when I am saying that----
Mr. Volcker. Just a little bit.
[Laughter.]
Senator Bennett. Okay. Help me out. Straighten me out. That
is why I come to these hearings, to be helped.
Mr. Volcker. Let me accept your metaphor about being in
business. What occurs to me when you say that is certainly the
importance of growth and all problems are easier to solve in a
context of growth.
Let me think about the headline of a certain business that
I read about in the paper coming down here this morning called
Lucent Technologies, a great growth business. People had
enormous confidence in its growth and everybody wanted its
stock and wanted to invest. And the investment flowed into
Lucent with great abandon a year or so ago and the stock price
went to, I do not know what, but some very high level.
Expectations about Lucent changed. The economy changed
somewhat. Expectations about their business changed. And you
had a drastic, to use the analogy, outflow of interest in the
stock of one, Lucent Technology, in a way that is very hard now
for it to reverse in terms of market perceptions.
In that sense, I think the dollar has some--it is not so
fragile as any individual company, but it is important what
perceptions are.
Senator Bennett. Yes. Let me step in here with a clarifying
comment. I have run public companies and I have run private
companies. And private is a whole lot more fun because you do
not run into that problem.
[Laughter.]
I am talking about the health of the company makes it
easier for you to solve problems.
Mr. Volcker. Obviously. There is no question about that.
Senator Bennett. But I accept your correction here, that
when you are running a public company, the perception of where
you are going does kind of run away from you.
And I remember once when I was invested in a stock and my
stockbroker called me and said, I think you might consider
selling a little. I said why? It is doing really well. He said,
yes, but today it hit 100 times earnings, and that strikes me
as just a little rich.
Mr. Volcker. Let me suggest to you the United States in
that sense is a public company.
Senator Bennett. That is right. And that is why I accept
your comment. Now where is our price earnings ratio? Are we too
rich or too high?
Mr. Volcker. I guess in some sense, that is what we are
talking about.
Senator Schumer. I would just tack on one final point to
Senator Bennett and all of the questions before we let you
gentlemen leave.
I guess the issue is, we have been talking before, is there
another way to deal with this problem other than recession?
That puts the cart before the horse. We are not going to
create a recession to deal with this problem. The question, and
it relates to Senator Bennett's question, is, can we continue
to grow without dealing with this problem? Or will it in
itself, with all its tentacles and ramifications, cause a
recession or a stoppage of the growth in itself because of
perception change? Because there just is not enough money now
in other places to continue to fuel the growth and we have not
dealt with the savings problem and we have
not dealt with--or we have dealt negatively, as Secretary Rubin
pointed out, with the governmental savings issue.
Sooner or later, I think what worries people is you hit a
wall. And everything seems peachy-keen and hunky-dory and
because we put ourselves in the hands of the generosity of
strangers----
Senator Sarbanes. Kindness.
Senator Schumer. Kindness. Sorry. Kindness of strangers.
Senator Bennett. Self-interest.
Senator Schumer. It is self-interest that they are doing
it. No question. But then perception all of a sudden changes
and, boom, we find ourselves twirling downward and we have less
control over how to deal with that than we have had with other
problems. Isn't that what we are worried about here?
Mr. Volcker. I think it is what we are worried about. In
dealing with the current account deficit, we deal with the
imbalances that give rise to the current account deficit.
The current account deficit is kind of a symptom----
Senator Schumer. Right. Of course.
Mr. Volcker. Of the underlying imbalance, not just in our
economy, but also in the world economy. And that is what makes
it so difficult. The kind of thing you are talking about we saw
in Thailand, we saw in Indonesia, we saw in a lot of places.
We are so much stronger, so much bigger, that that kind of
crisis is much harder to provoke, in a sense, in the United
States. So, we have, I think, still a margin of safety here,
but we have to worry about it.
Senator Schumer. It will not have the magnitude that it had
in Thailand, but it could still eat into the kind of growth
that we
have seen.
Mr. Volcker. Right.
Senator Schumer. Certainly at the margins. Maybe not.
You look skeptical, Mr. Secretary.
Mr. Rubin. No, it is not that I am skeptical, Mr. Chairman.
I guess I would just put it a touch differently.
It seems to me that what one would hope is that, for all
the reasons that we have now discussed for quite sometime, that
what you get is a gradual adjustment of the underlying balances
which then results in a gradual adjustment of the current
account deficit so that you come back into something much
closer to balance. The risk is that you have instability.
Senator Schumer. Right.
Mr. Rubin. And then it seems to me the question is what
policies do you have to maximize the probability of this more
gradual adjustment? That is what we tried to respond to Senator
Bennett on.
Senator Schumer. Macon, who was going to come here today
and could not and be on the second panel, his view is it will
all just correct itself in a nice, easy way and we do not have
to worry about it. Obviously, there is a different view among
all of us here. There is that other view out there, that it
does not matter much.
Mr. Volcker. It could, but we do not count on it.
Mr. Rubin. You maximize the probability of it by doing
sensible things.
Senator Schumer. Right. This has been a great discussion. I
think I speak on behalf of all of us that it was really
wonderful of both of you to donate your time, energy,
experience, intelligence. We have put ourselves in the hands of
the generosity of you folks--I am not going to get this right--
kindness.
Mr. Rubin. It is kindness of strangers, I think.
[Laughter.]
Senator Schumer. The kindness of you folks, and we really
appreciate it.
Mr. Volcker. It is obvious that it must be in our self-
interest.
[Laughter.]
Senator Schumer. As Senator Bennett pointed out.
Thank you very much.
Mr. Rubin. Thank you very much, Mr. Chairman.
Mr. Volcker. Thank you.
Senator Schumer. Thank you.
Let me bring the second panel up.
[Pause.]
Let me call our second panel. And again, they have not had
as much Government service, but they are equally skilled in
this area and extremely distinguished.
I think these are two gentlemen who the entire economic
world listens to. And let me introduce them after I thank the
Secretary. I will do it in alphabetical order, as we did the
previous panel.
Bill Dudley, William Dudley, whatever--I am just thinking
of something. You did not grow up in Brooklyn, did you?
Mr. Dudley. No, I did not. I have lived in Brooklyn, but I
did not grow up there.
Senator Schumer. Because there was a fellow who lived
across the street from me when I was a little boy named Billy
Dudley on East 27th Street.
Mr. Dudley. My grandfather was a minister in Brooklyn.
Senator Schumer. His name wasn't Leopold?
Mr. Dudley. No, no.
Senator Schumer. Okay. Well, there you go.
Mr. Dudley. Small world.
Senator Schumer. Yes. Yes. Everyone else is, right.
Anyway, Bill Dudley is the Chief U.S. Economist, at Goldman
Sachs. He served at the Federal Reserve Board as an economist
in the 1980's. He has a Ph.D, has his master's from the
University of California and his Ph.D there from the University
of California at Berkeley.
Stephen Roach is the Chief Economist at Morgan Stanley and
has also served at the Fed in the 1970's, has his BA from the
University of Wisconsin, his Ph.D from NYU. So, we can say that
both were at the Fed, both worked at Morgan Guaranty, and then
both left and went on to other things.
With that, let me call on Mr. Dudley first. And I may have
to excuse myself--how are we going to do this? I have to run to
the Judiciary Committee for about 5 minutes. Senator Corzine
will just take over during that time, whenever it occurs.
Mr. Dudley. Okay. Thank you.
STATEMENT OF WILLIAM DUDLEY
MANAGING DIRECTOR AND CHIEF U.S. ECONOMIST
GOLDMAN SACHS
Mr. Dudley. Thank you, Mr. Chairman. It is my pleasure to
have the opportunity to testify today and follow two very, very
distinguished members who I generally agreed with their
remarks.
The United States has a large current account deficit,
which has grown sharply in recent years. To date, it has not
proved problematic for the U.S. economy or for U.S. financial
markets. But this imbalance does create a risk. If foreign
investors' appetite for dollar-denominated assets were to
diminish, the result could be a sharp plunge in the value of
the dollar and the potential for havoc in the U.S. bond and
equity markets. So how to minimize this risk? I would suggest
three approaches.
First, shift away from the so-called ``strong dollar''
policy. It is better to make that shift now when the demand for
dollar-denominated assets is still strong and policy is
credible, rather than under duress later. The goal here would
not be to try to deliberately weaken the dollar, but to
deemphasize the dollar's value as an explicit policy goal.
Second, I would implement measures that increase the pool
of national savings. This would reduce the dependence of the
United States on foreign capital inflows.
And third, pursue policies that ensure the United States
remains an attractive market in which to invest. This would
help to keep foreign capital flowing to the United States.
Before I discuss in detail what should be done in response
to the large U.S. current account deficit, let me start with my
assessment of the causes and likely sustainability of this
imbalance.
In my opinion, the large current account deficit evident
for this country mainly reflects the disparity between the low
supply of domestic savings and the high demand for investment,
both for business and for housing.
Up to this point, the rise in the dependence of the United
States on foreign capital has not created any great
difficulties. That is mainly because foreign businesses have
been eager to increase their direct investment in the United
States and foreign investors to increase their portfolio
holdings of dollar-denominated financial assets. In fact, the
desire by foreign investors to increase their holdings of
dollar-denominated assets has been so great that it has caused
the U.S. dollar to appreciate significantly since 1995. The
strength of the dollar, in turn, has helped to sustain the
economic expansion by helping to keep inflation in check.
In general, the desire by foreign investors to increase
their investment in the United States should be viewed for what
it has been--a mark of the U.S. economy's success. Capital is
flowing here readily because the U.S. economic system has been
performing well. Many factors including credible fiscal,
monetary, and trade policies, deregulation, a flexible
financial system, and a transparent corporate governance and
accounting framework have helped to generate high productivity
growth and a healthy return on capital in the United States.
These favors have helped to encourage the flow of foreign funds
to the United States.
However, the dependence of the United States on foreign
capital inflows does create a vulnerability that needs to be
acknowledged. In particular, if the performance of the U.S.
economy were to falter on a sustained basis, the appetite for
dollar-denominated assets could decline sharply. The result
would be a sharp decline in the dollar and the risk of havoc
for U.S. financial markets. The consequence could be a vicious
circle in which dollar weakness contributed to poorer economic
performance, which, in turn, reinforced the dollar's slide.
There are three major reasons for concern.
First, as we have already heard, the U.S. current account
deficit is very large, both absolutely, and as a share of GDP.
Second, the upward trajectory of the U.S. current account
deficit evident in recent years must prove to be unsustainable
at some point. To see this, consider that a rising current
account deficit leads to greater net foreign indebtedness.
Because the interest on this debt must be paid, the increase in
debt will lead, over time, to a sharp deterioration in the net
investment income balance. Without trade improvement, that
implies an even wider current
account deficit. The result is a vicious circle of climbing
debt and
interest expense that ultimately is untenable.
Third, the risk that foreign investors lose their appetite
for dollar-denominated assets has already increased because the
performance of the U.S. economy has deteriorated sharply over
the past year. In particular, the growth rate of economic
activity and productivity has faltered and corporate profits
are contracting as the investment boom in technology has gone
bust. The budget surplus is shrinking. Put simply, the notion
of the new economy is being called into question. If the
economic rebound anticipated for 2002 disappoints, then the
demand for U.S. assets is likely to lessen.
Up to now, prospects elsewhere have also diminished.
However, if the gap in economic performance between the United
States and the rest of the world narrows in the future, then it
will become more difficult for the United States to obtain the
same huge sums of foreign capital on favorable terms, for
example, at low interest rates and a high dollar exchange rate.
Danger signs for the dollar are already visible in the
shift in the composition of foreign capital inflows, a point
raised by Senator Corzine. The proportion of capital inflows
consisting of direct investment, which is not easily reversed,
has diminished sharply this year. In contrast, portfolio
inflows, especially into corporate and agency bonds, have
increased.
The composition of these capital inflows is important. In
contrast to direct investment, exit from publicly-traded
securities is easy. Liquidation can occur quickly, with
potentially destabilizing consequences to the dollar and
financial markets. So what should be done to forestall such an
outcome?
The goal should be to pursue policies that encourage a
gradual path of adjustment--a smaller current account deficit
and an increase in the national saving rate. Three major policy
adjustments are appropriate, in my view.
First, the time has probably come to scrap the so-called
strong dollar policy. To fail to do so now, when the demand for
dollars is still strong, heightens the risk of a sharper
adjustment later. It would not be pleasant if U.S. policymakers
were forced to jettison the strong dollar policy under duress.
The loss of credibility would tend to drive up the risk premium
on dollar-denominated assets, necessitating a more painful
economic adjustment.
A strong dollar policy made sense during the investment
boom when the main risk was that the U.S. economy might
overheat. After all, during the boom, a strong dollar helped to
keep inflation in check. Now that the boom is over, the
rationale for a strong dollar has lessened, especially as the
dollar's strength is undermining the effectiveness of U.S.
monetary policy and undercutting U.S. international trade
competitiveness.
However, rather than a call for a weaker dollar, which
might provoke a sharp, destabilizing adjustment, I would shift
the emphasis away from the dollar altogether toward the
importance of having a strong and healthy economy. If the U.S.
economy performs well, then foreign capital will flow here
readily and the dollar will take care of itself.
Second, policies should be pursued that would act gradually
to raise the pool of domestic saving. This can be accomplished
in two ways. Continued discipline in terms of fiscal policy is
important. The fact is that the dependence of the United States
on foreign capital would be much greater currently if the U.S.
budget balance had not shifted sharply from deficit to surplus
over the past decade. The improvement in the budget balance has
enabled the
national saving rate to remain generally stable in recent
years,
despite a sharp fall in the personal savings rate. Not only
would slippage here reduce the pool of domestic savings, but it
also might worry foreign investors that have invested large
amounts of capital in the United States, in part, because of
the improvement in the U.S. fiscal outlook.
Although the long-term fiscal outlook for the United States
remains challenging given the impending retirement of the baby-
boom generation and the increase in life expectancy, it pales
in comparison to the challenges faced by Japan and Europe,
which have less favorable demographic trends and bigger
unfunded pension obligations. It is important that the United
States not squander its advantage in this area.
In addition, the tax code could be changed in ways that
encouraged greater domestic private savings. This might include
additional incentives to save or a more radical revamping of
the tax code to a consumption-based tax system.
Policies that raise the national savings rate would
gradually reduce the dependence of the United States on foreign
capital. Over time, this would reduce the risks of a sharp
reversal in the appetite of foreign investors for U.S. assets.
Third, policies should be pursued that ensure the United
States remains an attractive market in which to invest. This
includes lowering trade barriers, investing in education in
order to raise the quality of the U.S. labor force, and taking
steps to make the U.S. capital markets more transparent and
efficient. By creating a good environment for foreign
investment--either direct or in financial assets, this would
help to ensure that the flow of capital from abroad persists on
favorable terms to the United States.
To sum up, the large U.S. trade imbalance is worrisome. A
sharp shift in perceptions among foreign investors could lead
to a collapse in the dollar that could conceivably destabilize
the U.S. economy and global financial markets.
The best way to deal with this risk is to keep the U.S.
economy healthy through the application of prudent economic
policies. If the U.S. economy remains more productive than its
rivals and the U.S. capital markets remain deeper and more
liquid, then the flow of foreign monies to the United States
should continue relatively smoothly and easily. The current
account deficit probably would ultimately shrink, but in an
orderly way that would not disrupt the ability of the U.S.
economy and the Nation to prosper.
Thank you.
Senator Corzine. Thank you, Mr. Dudley.
It is very nice to see you, Steve. We are pleased you are
here. We would like to hear from you.
STATEMENT OF STEPHEN S. ROACH
CHIEF ECONOMIST AND DIRECTOR OF GLOBAL ECONOMICS
MORGAN STANLEY
Mr. Roach. Thank you very much. It is a pleasure to be
here, Mr. Chairman.
I have a long statement that I would simply prefer to
submit for the record and just summarize some of the
highlights.
I just want to echo the comments that were made by the
first panel, as well as by Mr. Dudley. I think the Subcommittee
is to be congratulated for having the courage to hold a hearing
on a topic that very few people understand, let alone talk
about. I really believe that our external imbalance, no matter
how you want to measure it, is a topic for serious and deep
concern in Washington.
The global economy, I think, suffice it to say, is in
trouble right now. By our estimates at Morgan Stanley, 2001
will go down
in history as a year of global recession. And it will be the
second
global recession in 4 years. This recession-prone global
economy of ours, in my opinion, reflects some serious and
worrisome imbalances in many major economies around the world.
And one of those economies is us in the United States.
I would argue that the U.S. economy at this point in time
is far more imbalanced than some of our fond recollections of
the 1990's, especially the latter half of the decade, might
otherwise lead us to conclude. And I would just cite three
imbalances, all of which have already been discussed in this
hearing this morning.
First, our negative personal savings rate. It is the first
time we have had this condition since 1933. That was not a
particularly good year in the long experience of our economy.
Second, we have a massive overhang of capital spending on
new capacity, especially in the technology area.
Third, very much a byproduct of the first two, is the topic
of this hearing--our current account deficit.
Mr. Chairman, I urge you not to treat this imbalance in our
external condition merely as a benign symptom of America's
leadership role in the global economy, or as a necessary
ingredient of
the great boom that we were able to achieve in the latter half
of the 1990's. Instead, I believe that this imbalance should
really
be taken as a sign of a Nation that has really gone to excess,
a
U.S. economy that in many important respects has lived beyond
its means.
America, as both Chairman Volcker and Treasury Secretary
Rubin indicated, is a savings-short Nation that has a voracious
appetite to spend or consume.
And yes, I think you in the Government are truly to be
commended for taking our Government budget from deficit to
surplus, from transforming the role of the public sector from a
spender into a saver. But I think, unfortunately, we as a
Nation have really squandered this opportunity by pushing our
private-sector savings rate down to historic lows in the post-
World War II period.
And so, the math is pretty straightforward here. The
national savings rate is still subpar and a savings-short U.S.
economy has had little choice other than to turn to foreign
investors to finance our investment spending.
We have had to, of course, run this record current account
deficit to attract the foreign capital that has kept the
economy on this track. And that, of course, has left us in this
very precarious place that was so vividly described--I won't
use the line again by Tennessee Williams, but it has taken to
keep the magic of our virtuous circle alive.
But the cost here is that, right now, foreign ownership of
a lot of assets in the United States is at record levels.
Thirty-seven percent of U.S. Treasuries are owned by foreign
investors. Twenty percent of all corporate bonds are owned by
foreign investors. And I have to correct. There was an
incorrect figure and estimate in my testimony that Senator
Schumer cited. The number is 20 percent, not 46. And 11 percent
of all U.S. equities are owned by foreign investors. All of
these ratios are virtually double where they were in the mid-
1990's.
Now yesterday, in front of the full Senate Banking
Committee, Federal Reserve Chairman Alan Greenspan admitted in
a response to a question from Senator Schumer that America's
massive foreign imbalances are not a sustainable state of
affairs for the United States. He went on further to say that,
some day, something has to give.
Now as economists, our models leave us with the same
conclusion. In all of recorded history, no nation has been able
to sustain a prosperity built on a shaky foundation of subpar
domestic saving and increased dependence on foreign capital.
Yet, that is exactly the condition that we now find ourselves
in. It is an unsustainable and very worrisome state of affairs
for the United States.
What can be done? That is the--I guess Senator Schumer
called it the $64,000 question.
First of all, I do not have anything brilliant to add other
than that which has been stated. But I want to caution you in
two areas.
Number one, there is no quick-fix to this problem. I think
we must resist the temptation to find an easy way out of the
structural problems that beset both the United States and the
global economy.
I worry, for example, that if we go down the road we went
down in late 1998, by reflating through overly aggressive
monetary policy and create another boom in the United States,
that would give us exactly the same set of conditions that put
us in the place we are in today--another liquidity-induced boom
in the stock market, another binge of unnecessary capital
spending, a further plunge in the personal savings rate.
And it would also temper the urgent need for reforms around
the world and structural change that could really create better
balance in the global economy. We did that in 1998. It was not
that long ago. And here we are again, back in global recession,
for the second time in 4 years.
Number two, I would suggest that this is not a time to deal
with trade tensions on a bilateral basis. I wish Senator
Sarbanes was still here. But I am really very nervous about
viewing this as a Japan problem or a China problem, or even a
NAFTA problem. The problem is really in the mirror. We are a
saving-short economy and if we do not import from somewhere, we
will import from somewhere else. That is what is required to
attract the foreign capital. I think the options that have been
laid out by the gentle-
men that preceded me are fairly straightforward and I would
agree
with them.
I would simply underscore the following sort of three
premises that reflect my own philosophy in dealing with this
problem.
First, just recognize that we are, in fact, a Nation that
has been living beyond its means. And when that occurs, the
prudent course of events is to learn to live better within our
means. And that may mean that we cannot return to the booming
period of economic growth that we had in the latter half of the
1990's for a long time.
Second, and related to that is the belief that I think that
Chairman Volcker and Mr. Dudley expressed, and that is that
market forces will take care of the value of the dollar. I
happen to think that the dollar is over-valued. I certainly
concur that that view is arguable. But I believe strongly that
the yen and the Euro are under-valued and market forces will
take those currencies up. Currencies are relative prices. So
when one goes up, the other falls and that means the dollar,
more likely than not, will fall, and when the dollar falls,
financial markets will be, I think, taken by significant
surprise.
The third principle, and it is not a sexy one, but one that
is just absolutely critical to the whole equation, is that this
is a global problem. Our current account imbalance is a symptom
not just of our own problems, but the world itself, which has
been overly dependent on the United States as a source of
growth.
So key for us is to continue to push for reform and
restructuring amongst our trading partners so that they too can
unlock their efficiencies, grow more rapidly without hooking
themselves to the coattails of the United States.
So in closing, Mr. Chairman, I really commend you for
having the courage to hold this hearing. It is a tough and
critical issue.
I want to stress that America, in its long history, is the
leader of the global economy since the end of the World War II,
has never had a more worrisome external imbalance than it has
today. And I really urge you in the Congress--this is a wake-up
call that something needs to be done to an imbalanced U.S.
economy.
Thank you very much.
Senator Schumer. Well, thank you both.
Let me apologize to Mr. Dudley for not being here, but I am
familiar with his testimony and have read it.
Let me ask a couple of questions here.
I take it, just drawing it out, neither of you think that
this can be sustained forever. Is that fair to say?
Mr. Dudley. That is fair to say.
Senator Schumer. Okay. There are a few who do, and
Secretary Rubin was not 100 percent sure that it could not be
sustained, at least for a long time. Let me ask you the
question that I asked each of the other gentlemen. Might there
be some warning signs of unsustainability and are they upon us?
Mr. Dudley. I agree with Chairman Volcker who answered the
question. It is very, very hard to anticipate developments in
financial markets, especially in currency markets where you can
go from a virtuous cycle to a vicious cycle, very rapidly.
There is one symptom already that has become visible that
may be the leading edge of a warning, and that is the shift in
the composition of foreign capital inflows into the United
States away from foreign direct investment, which is not
readily reversed, into U.S. corporate bonds and agency bonds
and equities, publicly-traded
securities, which is very easily reversed.
So to the extent that the capital is now flowing into
assets that are more liquid, there is more risk that those
inflows could reverse more quickly. I think that that is the
only thing that I could really point to.
The second thing is that if growth in the rest of the world
picks up, that is also going to be, ironically, a little bit
problematic for the dollar in the short run because one of the
reasons why the capital has come here so readily is because the
U.S. economy has performed so well relative to its major
trading partners. And so, if we get the recovery in the rest of
the world that we actually want, one of the consequences of
that probably would be a weaker dollar.
Senator Schumer. Mr. Roach.
Mr. Roach. I think that there is no real clear set of early
warning indicators that we are going to move from a period
where the current account has been benign to where it really
turns into a destabilizing force on the U.S. economy.
What will probably occur here is that there could be a set
of conditions that could lead to a weaker dollar that could
certainly come about from improvement overseas or a loss of
confidence, for one reason or another, in foreign investors in
dollar-denominated assets. And then, when the dollar goes, it
will not be an orderly correction. The gentlemen that preceded
me were hopeful that if the dollar were to correct, that it
would be a gradual and well-managed process. Having spent an
inordinate amount of my time in the markets, if there is one
thing that I have been taught, and painfully, is that there is
no such thing as an orderly decline in extended markets.
Markets tend to overshoot. And as the dollar has overshot
to the upside, the distinct possibility is that the dollar
overshoots to the downside. Why does it do that? Because
foreign investors all of a sudden wake up and they say, the
dollar is weak and you have this horrible current account
problem.
They are paying no attention to the current account right
now because it is a capital flow story. Everyone wants a piece
of America because we have cornered the market on the so-called
productivity new economy miracle.
Well, if that miracle gets drawn into question and the
dollar goes, the current account then becomes the excuse to
take it down a lot further.
So it is a set-up. And I urge you to take it in that
regard. The markets always figure out ways to humble and
humiliate you in ways that you have not been humiliated in the
past. There is no clear set of early warning indicators that we
can focus on, but that does not mean that we should not be more
attentive than ever to this possibility.
Mr. Dudley. If I could just add one more thing, Mr.
Chairman.
Senator Schumer. Please.
Mr. Dudley. I think this whole question of how much the new
economy is real and how much of the new economy turns out to be
a mirage is critical in the outlook in terms of whether the
adjustment is gradual or precipitous.
And in that regard, things that suggest that the new
economy is real, like sustained high-productivity growth, would
makes you feel a little bit more comfortable about the outlook
that the adjustment might take place more slowly, and things
such as low productivity growth numbers, for example, what we
received in the first quarter, shrinking budget surpluses,
things of that nature, that suggest that some of the miracle
was a mirage, those would be early warning signs that would
make you a bit nervous about the outlook for the currency.
Senator Schumer. Let me ask you, Mr. Dudley, because you
were quite explicit in saying that we should not be focused on
the value of the dollar, but, rather, on other things in the
economy and let the dollar--because this is a question that I
am just learning this issue, really.
What do we do now? How much does just talking about, well,
we want a strong dollar, cause the dollar to be strong? And
what are the other policy things that we do now that explicitly
bolster the dollar that we might not do? How much of this is
talking it up in psychology and how much of it is real?
When I first came to Washington from New York, when I was a
Congressman, I would say, oh, boy, here's Washington. It is a
lot of fluff and it is a lot of hype and a lot of psychology.
But up there in the markets, they are immutable. You cannot
fool them. And the more I am around, the more I see that the
markets also are influenced by puff and hype and psychology, at
least in the short run. Can you give us some enlightenment
about this?
Mr. Dudley. I cannot give you very much enlightenment, I am
afraid.
I think, generally, for the foreign exchange markets in
particular, psychology is very important. And the reason why it
is very important is that, when currencies appreciate or
depreciate, the feedback effect on that appreciation or
depreciation in terms of real trade flows takes place very,
very slowly. There is always a very good question when you look
at any currency, where does it really belong? Where should it
truly be?
People do not really know. And so, changes in psychology
can be very, very important in changing those beliefs of where
the currency belongs in the medium- to long-run because the
feedback from changes in the currency to the real economy
happen so gradually and so slowly.
I think this is one of the problems right now with the
strong dollar policy. I think the Administration feels that
they are a little bit in a box, that if they change the strong
dollar policy in any way, the dollar will fall precipitously.
They are afraid that if that happens, they will be blamed for
that. They do not want that to happen. And so, they are sort of
sticking with the strong dollar policy. I understand that fear.
However, I think that if you do that and keep the dollar
supported on the thin air of just your belief that you want it
to be strong, the risk is that you could have a bigger
adjustment later.
So my view is, let's move away from the dollar as the focus
of policy. Let's make the focus of policy the health of the
economy. If we make the focus the health of the economy, the
dollar should over time take care of itself. So, I would argue
against propping it up on psychological factors. I do not think
that is going to gain you much in the long term.
Senator Schumer. Thank you.
I know Senator Corzine has to leave.
Senator Corzine. Thank you.
Senator Schumer. I will come back. I have a few more
questions.
Mr. Roach. I would just say, as a card-carrying economist,
I continue to this day to be truly staggered by the fact that
we, in a huge market, the world's largest and deepest market,
which is the foreign exchange markets, really condone the
setting of an asset price based on the rhetorical elements of
human beings.
Supply and demand is a very powerful force and I truly
believe that the currency will be determined by those forces
rather than by the ability of a person, whoever that person is,
to say those magic words--a strong dollar policy.
The Europeans certainly are saying the same thing about
their currency. Ultimately, the Japanese will as well. It is a
zero-sum game, so they cannot all be strong at once.
Senator Schumer. Senator Corzine.
Senator Corzine. Thank you.
I would like to follow up a little bit on that comment and
the recommendation that we should be shifting from a strong
dollar policy. I am not sure I fully understand how that gets
accomplished, what kind of methodology brings that about,
because, ultimately, supply and demand for dollars makes that
case by whatever the market price is at a given point in time.
So, I would love to hear some comments on how you go about
shifting it. I mean, you can shut up, but the fact is that it
really has been driven in part by, if not in the long run, by
the supply and demand conditions. I think we have talked today
that this is a potential for instability in financial markets
and ultimately, translation into the economy.
I am always curious about what are the shocks that we think
are the elements that bring about the change in the current
status of the market. When do people no longer want to hold on
or demand those dollars that change the context of its value?
I continue personally to believe that our foreign holders
of dollars believe we have a quality fiscal policy in place and
are expecting significant budget surpluses.
I would love your own anecdotal information on your
conversations with foreign investors about whether that is
true. And if that perception changes quickly, do we have a
potential for a shock in currency markets and a reversal of
some of the problems here.
Then, finally, I think both of you have talked about steps
that we need to take ultimately to have a strong and healthy
economy. It does not appear that we have a strong economy now.
Some might argue that it is more healthy than otherwise.
I would love to hear your current quick views on where we
are, and what do we need to do to restore a healthy economy?
Mr. Dudley. Well, Senator Corzine, how do you shift from a
strong dollar--I want to make very clear, I am not advocating a
weak dollar. I am advocating a shift in emphasis away from the
idea that our goal or policy is a given value of the currency.
I think our goal or policy should be a healthy economy and
not be so worried about where the dollar ends up. Let supply
and demand take care of it. Change the game. Let the markets
determine where the dollar should be and not have our rhetoric
enter in as an important factor.
Right now, I think rhetoric is important in the markets
because certainly people hang on Treasury Secretary O'Neill's
every word in terms of the dollar. So, obviously, the markets
view is that it is pretty important.
On the issue of the fiscal side, I agree with you 100
percent. The improvement in the U.S. fiscal position was
important both for generating more savings to finance the
investment boom that we had, but also, it was one factor that
clearly supported the demand of foreign investors for dollar-
denominated assets. Any backsliding on the fiscal side I think
would be negative in that regard.
One thing you can already see evident this year is, as the
budget surplus projections are starting to come down, we have
had a steepening of the Treasury yield curve, suggesting that
people are more nervous about the fiscal outlook now than they
were a few months ago before the passage of the Bush
Administration tax cut plan. I think staying on course on the
budget, staying the course in terms of being fiscally prudent
on the budget is very important.
One area where we have a tremendous advantage relative to
most of our major trading partners is that while we have a
Social Security problem, our Social Security problem is very,
very minor compared to the problem that you have in other
countries. And we should act to keep it that way because that
is I think something that makes the long-term fiscal outlook in
the United States quite a bit better than in, say, Europe and
Japan, which have a much greater unfunded pension liability and
much less favorable demographic trends.
Mr. Roach. I would just briefly, in response to these
questions, say three things.
In terms of shifting the policy, my strong recommendation
is simply to take the rhetoric out of the asset price. Do not
personalize the relative price of one of the most important
assets in the world.
This morning, Treasury Secretary O'Neill has an extensive
interview in the Financial Times as Treasury Secretary and
dollar spokesman articulating and personalizing his own
stylized interpretation as to why the dollar should be at a
certain level. With all due respect to the Treasury Secretary,
it is a personal view and the markets will make that judgment.
I think there is just far too much emphasis placed in rhetoric
in setting asset prices.
In terms of shocks that could cause a problem here, there
is a lot of them that you could always sort of conjure up in
your darkest moments. I have been accused of spending too much
time worrying about dark moments. So, I will not belabor those.
But I think the one that we need to think about most seriously
is really the final question, Senator Corzine, you raise, and
that is the state of the U.S. economy.
Federal Reserve Chairman Alan Greenspan reiterated
yesterday in front of the Full Committee that he is hopeful
that the U.S. economy may be forming a bottom.
What if it is not? What if this is a false bottom? What if
there is another leg down to come? And there is a good case to,
I think, worry about precisely that possibility.
The state of the global economy, as I indicated in my own
statement, poor and deteriorating as we speak. The feedback
from that will come back to crimp exports. That is another
potential source of downward adjustment in the United States
that has not even come close to fully playing out. And then,
finally, there is, I would say, the $64,000 question, Chairman
Schumer, and that is the state of the American consumer.
American consumers just hung in there. Slowed a little bit,
but basically, continues to spend, remains pretty much in
denial that anything adverse could ever happen to the Good Ship
America. What if that changes? And my guess is that there is
risk to come to the American consumer who had depleted his or
her savings balance, is overly indebted, and has also run out
of spending from the now-infamous wealth effect.
So if the consumer who is as precarious as I have ever seen
him or her, since, probably the early 1970's, throws in the
towel, that could be a shock that certainly could reverberate
into our foreign exchange markets and then all of a sudden, the
current account will matter.
Senator Corzine. Thank you.
Senator Schumer. Thank you, Senator Corzine.
I thank both of you. Let me ask you this question. I do not
know if you saw, but yesterday, I asked Chairman Greenspan
about this conundrum of interest rates, long-term, anyway, not
responding to the constant drop, I think 275 basis points, that
the Federal Reserve has done in the funds rate.
He basically said, we are not seeing anything happen
because Treasuries are being eaten up at a greater amount,
which led me to question the wisdom of the tax cut.
He actually demurred. I do not know if you saw this. He
said, please, I would ask your indulgence that I not have to
answer that question. Since I respect him, I did not push the
issue, unchar-
acteristically of me. But could it be that this is related to
the flood of foreign investment? Could it be that we do have
some form of inflation going on a little bit more here than
people think, but it is covered up because of all this foreign
money coming in, and that if it left, things would bounce up
more quickly?
Is there a relationship there? That just hit me as we were
going through this hearing. Maybe not.
Mr. Roach. I would say it is quite possible. But we are not
able to isolate and identify that with precision.
But the theory, Chairman Schumer, is that when we ask
foreign investors to fund our domestic savings shortfall, we
have to make that funding attractive to them.
Senator Schumer. Right.
Mr. Roach. Nasdaq 5,000 was all the attraction they needed.
So, they did not demand a premium on dollar-denominated assets.
Nasdaq has again--I do not know where it is today, but
yesterday, it closed back below 2,000 again. And so, suddenly,
what seemed like a sure thing to foreign investors, whether
they were buying our assets or buying our companies, is not
quite the sure thing that it was a year or a year and a half
ago.
It is perfectly appropriate under those conditions for
foreign investors to begin demanding a premium on dollar-
denominated assets, and that could well be one factor that is
keeping longer-term interest rates higher than might otherwise
be the case in a regime of Federal Reserve monetary easing.
Mr. Dudley. Mr. Chairman, my assessment is that long-term
rates are probably being held up by mainly two things.
One, the deterioration in the outlook for the Federal
budget. And two, a very strong belief that 275 basis points of
easing is going to generate a pretty healthy rebound in the
economy next year.
That is something that both Mr. Roach and I would disagree
with. We think that monetary policy is not particularly
powerful in the current environment, partly because financial
markets have not cooperated with the Fed. The stock market is
down. The dollar has appreciated. And the long-term rates have
not changed very much. But I think the markets--a lot of
investors have the belief that the economy is going to come
back very, very quickly.
Now coming back to this question of the dollar, has the
dollar's strength supressed some inflation that could come back
if the dollar were to depreciate?
Absolutely, that is a risk. However, in the current
environment, that is probably not a very big risk because the
U.S. economy has
been weak enough for long enough, that you are actually freeing
up quite a bit of slack in terms of the labor market and
industrial
capacity.
So that, yes--if the dollar were to go down, you would
probably get higher import prices and a little bit more
flexibility for U.S. producers to raise prices. But that would
be offset by the fact that the slowdown has freed up a lot of
capacity in the United States.
Senator Schumer. This is the subject of a different
hearing, which maybe we ought to have. But it seems to me what
you are saying is that this globalization, internationalization
of the world capital markets, in general, makes monetary policy
less effective than it used to be.
Mr. Roach. Absolutely. I think globalization reflects an
extraordinary new conductivity in the world through trade
flows, through capital flows. It is characterized by global
supply chains, by rapid expansion of multinational
corporations. And so, a lot of the rules that we have embraced
and understanding asset price movements, to say nothing of
reverberations from, say, the United States to non-Japan Asia,
those rules are changing before our very eyes.
So talk about a new economy, I would far prefer to have the
globalization be discussed in the context of a new economy than
the sort of Nasdaq-type bubble that has since popped.
And I think you are entirely right to draw attention to
really probing what we know about globalization, what we do not
know about globalization, and what we need to know about
globalization going forward.
Senator Schumer. Is this a consensus among practical
economists like yourselves that monetary policy is less
effective than it used to be because of globalization?
Mr. Dudley. I think there are certainly a number of people
that would agree with that statement. Both of us would agree
with that statement. I do not think it is yet a consensus view.
Senator Schumer. Gotcha. The easiest way out of this whole
conundrum we are in, of course, is to have Americans save more.
Now particularly Chairman Volcker, but even Bob Rubin, had
doubts that there was much from a policy point of view we could
do to induce savings, that most of the experiments that we have
done in terms of tax incentives and other types of things to
increase savings have not been terribly effective.
Do either of you disagree with that? Is there anything that
we could do? And what about this new idea, which I think Al
Gore had proposed, which is that, since we need to increase
savings in lower-income people, that a Federal match might do
it. Of course, you are having a dollar outflow there, too. So
tell me in general.
Mr. Roach. I would just agree with Chairman Volcker that
using fiscal policy to incent private saving is something that
history has really not spoken very kindly of. I think we have
been frustrated over the years in being able to raise the level
of savings. The best that these measures do is alter the
composition of savings, shifting it from one asset to another.
And I would actually urge you to think about our savings
shortfall in a similar context. It is not that Americans are
not saving at all. It is that American individuals have
mistakenly transferred an awful lot of their incremental
savings into the stock market. They believe that the stock
market has become a permanent new source of saving. And if that
view is correct, why should you save out of your paycheck?
The stock market is in the process of painfully pointing
out to many Americans that that premise may be flawed. And so,
I think that our system is adaptable enough to enable
individuals to rethinking their savings motives away from their
mutual funds, which are now at greater risk than they had
thought before, and back into more traditional savings
vehicles.
Mr. Dudley. I think the challenge in designing tax changes
that encourage savings is to design changes that do not allow
people just to move already-existing financial assets they have
into the new tax-favored class to take advantage of that tax
break, and not actually increase their saving. And that is
really the challenge.
I think probably what we need to think about a little bit
more is whether a shift to a consumption-based tax system is
appropriate. But, unfortunately, I think that is not very
likely politically, especially given the fact that we have now
spent most of the non-Social Security surplus.
One of the great unhappinesses to me of what has happened
in
recent months is that we had this big surplus that we could
have used to do a major revamping of the U.S. Tax Code in ways
that could have accomplished some of these goals, and we did
not
even try to take advantage of that opportunity. And I think
that
is unfortunate.
Senator Schumer. Okay. Well, I want to thank both of you
for excellent testimony, great answers.
Unlike many hearings, there has not been much heat and
there has been some light.
Thank you.
Mr. Roach. Thank you.
Mr. Dudley. Thank you.
Senator Schumer. The hearing is now adjourned.
[Whereupon, at 12:15 p.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF SENATOR JIM BUNNING
Mr. Chairman, I would like to thank you for holding this very
important hearing and I would like to thank all of our witnesses for
agreeing to testify today. This is a very important topic you have
chosen today.
I am not sure if the average American realizes how much foreign
investment we have coming in right now. Our economy is becoming
increasingly dependent on foreign investment. Without it, we would not
be experiencing even the anemic growth we have now.
Of course, we must think about the consequences of that investment.
Specifically, I am worried that the foreign money valve may get shut
off. I have heard many economists say that will not happen in the near
future, and I hope they are right. However, my fear is that we have a
rapid market change and it becomes more attractive to invest foreign
capital elsewhere.
With increased globalization, worldwide economic factors change
faster and worldwide economic changes are recognized faster. It was
only a year ago that the Nasdaq was hovering at 4,029, this morning it
opened at 1,959. If suddenly, American investment became unfashionable
and foreign capital was pulled, it would have a devastating effect on
our economy.
Of course, that leads to the question, what do we do? Well, that is
why our witnesses are here today. I eagerly await your testimony to
find out, what if anything we should do to ensure our economy does not
experience damage from the ever increasing balance of payments deficit.
I believe our economy is weak enough right now, it doesn't have to go
down any further.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF ROBERT E. RUBIN
Former Secretary, U.S. Department of the Treasury
Director and Chairman of the
Executive Committee, Citigroup, Inc.
July 25, 2001
Mr. Chairman and Members of the Subcommittee, I think it is both
useful and timely to develop further Congressional focus on our
country's current account deficit. Thus, I think this hearing is a very
good idea. Moreover, recent events in Genoa and elsewhere suggest that
the full range of issues around globalization merit great focus by this
body.
The current account deficit is basically the trade deficit plus the
deficit in net payments, including interest, dividends, and the like,
but public discussion of our deficit has, I think, become a symbol for
concern about the whole area of trade related matters. I will try to
very briefly express my views on these matters, and related policy
issues, and hopefully that will be responsive to the four questions in
the Chairman's letter outlining this hearing, as well as very summarily
suggesting an approach to the broader issues around globalization.
To begin, the U.S. has had remarkably good economic conditions over
the past
8 years, with far stronger growth and far greater productivity
increases than Europe or Japan, and far lower unemployment than Europe.
At the same time, our markets have been more open to imports than
Europe or Japan, our currency has been strong, our capital markets have
been open, and our trade and current account imbalances have grown
substantially.
I have no doubt that our economy has benefited enormously from both
sides of trade, not only exports, but, even though it is not popular to
say this, also very powerfully from imports. Imports lower prices to
consumers and producers, dampen inflation--and thereby lower interest
rates--provide a critical role in allocating our resources to the areas
where our competitive advantage is greatest, and, maybe most
importantly, create competitive pressure for productivity improvement.
All this has contributed greatly to the very low unemployment and
rising incomes at all levels.
The imbalance between exports and imports has occurred because of
vast net capital inflows from around the world into the United States,
motivated by the relative attractiveness of the United States for
investment and as a repository for capital. That vast net inflow has
allowed our consumption plus our investment to exceed what we produce.
The consequence has been a lower cost of capital in our country and
greater investment, which helped increase the rate of productivity
growth.
Another consequence of the net capital inflows has been a strong
dollar, which has lowered costs to consumers and producers for what we
buy abroad, and more favorable terms of exchange between what we sell
and buy abroad. The result is lower inflation, lower interest rates,
higher standards of living, and greater productivity. The strong dollar
has also helped attract capital from abroad.
The next question is, even if our open markets, imports and a
strong dollar are beneficial, is the imbalance itself a problem.
While a current account deficit reduces aggregate demand, in recent
years we have had fully adequate demand, and, in any case, monetary and
fiscal policy--such as the current tax rebate--are a far preferable
means of generating demand, if this is desired.
The claims against future output from the vast net capital inflows
is like any other borrowing or raising of equity capital: if the funds
are well used for investment, then the future contributions to growth
will exceed the cost of repayment or other forms of return to foreign
investors.
The remaining concern is that, in various ways, the current account
deficit could contribute to future instability, as, for example, by
adversely affecting confidence in the dollar or making us more
vulnerable to a change in perception abroad about our economic
prospects or the soundness of our policy regime--which,
parenthetically, is another reason why maintaining fiscal discipline is
so critically important for our economic well-being. While we should be
able to sustain this deficit for an extended period because of the
relative size and strength of our economy, it would be desirable over
time to greatly reduce this imbalance.
There are some policy measures that could promote this purpose and
would be beneficial in other ways as well, and there are some policy
measures that are more frequently advocated, which might help reduce
the current account deficit but could have other severe adverse
economic effects and on balance would be most unwise.
Doing whatever we can to promote structural reform and trade
liberalization in Europe and Japan would contribute to greater growth
with more attractive investment opportunities in those areas, thus
increasing our exports and increasing investment flows to Europe and
Japan. This is good for us in many ways, including reduction of our
current account deficit, and exemplifies why strongly engaging in
international economic issues is greatly in our interest.
At home, increasing savings over the full business cycle would
reduce imports and reduce the inflow of capital and would be the most
constructive approach to reducing the current account deficit. While
our low personal savings rate seems to be a cultural phenomenon--and
there is a real question about how much net effect some savings tax
credits have--I do think carefully crafted tax credits for subsidizing
saving is a useful approach to explore if Congress at some point
revisits the recently enacted 10 year tax, which is itself a
significant diminution of future national savings and, in my view was
most unwise.
Two frequently mentioned correctives for the current account
deficit that might have some impact but on balance would be highly
detrimental to our economic well-being are increased trade barriers and
modifying our country's strong dollar policy.
Increased trade barriers would increase prices, lessen the
comparative advantage effects, and reduce competitive pressures for
productivity. Also, history suggests that protectionist measures here
could lead to retaliatory trade measures in other countries.
Modifying our strong dollar policy could adversely affect
inflation, interest rates, and capital inflows and would lessen the
favorability of our terms of exchange with the rest of the world.
Having said all this, as our Administration made clear over the
past decade, trade liberalization, though highly beneficial on balance
for industrial and developing countries, can create dislocations--just
as technology does to a far greater degree--and there are critically
important matters, in our country and around the globe, such as poverty
and the environment, that won't be adequately addressed by the policy
regime that I have been discussing. The demonstrators this past week
were sometimes strident--and we must condemn violence--but there are
underlying concerns about globalization that are serious and need to be
addressed. Thus, in our country and abroad, there should be a parallel
agenda to promote productivity and equip people to deal with change,
including education, effective retraining, programs to equip the poor
to join the economic mainstream, environmental protection, and much
else. And the industrial nations, in their own self-interest, should
greatly increase assistance to developing nations.
Mr. Chairman, let me conclude where I started. The current account
deficit is a complex issue that immediately leads to the whole range of
trade-related issues, and I think that this Committee performs a great
public service by holding this hearing and whatever other processes it
employs to provide serious public examination of these issues.
PREPARED STATEMENT OF PAUL A. VOLCKER
Former Chairman of the Board of Governors
Federal Reserve System
July 25, 2001
Mr. Chairman and Members of the Subcommittee, I welcome your timely
initiative in arranging this hearing focusing on the U.S. Balance of
Payments.
Others are better equipped than I to discuss the specifics of
current developments and their significance for particular sectors of
the economy. In this short statement, I want to emphasize the broad
nature of the challenge before us as our current account deficit
reaches magnitudes with little historic precedent.
The past decade has been characterized by a strong dollar and a
large and growing net inflow of capital. The counterpart has been a
greatly enlarged trade and current account deficit. What has been
little appreciated is the extent to which those developments have
supported the relatively strong and well-sustained performance of the
U.S. economy.
For most of that time, the other main economic centers--Japan and
the continent of Europe--were mired in some combination of slow growth,
high unemployment, and excess capacity. In sharp contrast, the U.S.
economy was, until recently, accelerating. There was good growth in
investment and profits and a sustained high level of consumption. In
fact, by the end of the decade, personal savings, as the staticians
measure those savings, had practically disappeared.
In those circumstances, labor markets tightened, tightened to an
extent that in the past had been associated with strong and
accelerating inflationary pressures. Yet, prices, particularly of
goods, have moved relatively little at either the wholesale or retail
level. How could those contrasting developments be reconciled?
An important part of that explanation is that foreign capital--in
effect, the savings of other less affluent countries--moved strongly
toward the United States, attracted by perceptions of strong growth and
productivity and the powerful attraction of the booming stock market.
Along with the rising Federal surplus, it was that foreign capital that
in the absence of personal savings, in effect, financed much of our
investment. The capital inflow also tended to strengthen the dollar
despite the growing trade and current account deficits. That strong
dollar, combined with the ready availability of manufactured goods from
countries functioning far below their economic potential, contributed
importantly to containing inflationary pressures. It has seemed, for
the time being, a benign process: for the United States, a current
account deficit without tears; for other countries, the American market
has provided a sustaining source of demand in an otherwise economically
sluggish environment.
What is in question is sustainability. Our trade and current
account deficits are now trending toward $500 billion a year, or close
to 5 percent of our GDP. Those are very large amounts by any past
standard for the United States. Given our weight in the world economy,
we are absorbing a significant portion of other countries savings. With
the low level of our personal savings, and now the prospect of
diminishing Federal surpluses, this means we are dependent upon
maintaining a strong inflow of foreign funds. We have also become
accustomed to a ready supply of cheap goods from abroad. Both factors
point to continuing large trade and current account deficits.
For the time being, growth in most of the rest of the world is so
slow that there is no near-term prospect that world markets will
tighten, limiting the availability of imports at attractive prices.
Moreover, the latest indications are that the strong flow of foreign
funds into the United States is being maintained, even in the face of
our economic slowdown and stock market correction. But looking further
ahead, the risks are apparent.
We cannot assume that Japan and Europe will not at some point
resume stronger growth, and that they will then want to employ more of
their savings at home. We would certainly like to see stronger growth
in the emerging world, which in turn would attract more capital from
the United States. Here at home we have become less dependent on
traditional ``old economy'' manufacturing industry, but there are
limits to how far we can or should countenance further erosion in our
manufacturing base.
All this suggests that, over time, we must look toward a narrowing
of the trade and current account deficit. That will require a revival
of personal savings and maintenance of a strong fiscal position. It may
require, too, some strengthening of the Euro and the yen relative to
the dollar.
In concept, adjustments of that sort can be made over a period of
years consistent with continuing expansion in the United States and
stronger growth in the rest of the world. But as developments in the
``high-tech'' world and in the stock market have again demonstrated,
sentiment in financial markets can change abruptly and bring in its
wake strong pressures on economic activity. The timing and degree of
those changes simply cannot be predicted with any confidence. It seems
to be evident, however, that as our trade and financial position
becomes more extended, the risk of such abrupt and potentially
destabilizing pressures increases.
The United States is already a large net debtor internationally,
and for some time ahead will remain dependent on foreign capital if our
economy is to resume growth. We should and we do export capital as our
businesses and our investors seek out prospects for the highest
returns. To finance both our current account deficit and our own export
of capital, we must import close to $3 billion of capital every working
day to balance our accounts. That is simply too large an amount to
count on maintaining year after year, much less enlarging.
One way--an entirely unsatisfactory way--to approach the need for
adjustment would be to fall into extended recession or a prolonged
period of slow growth. Given that the world economy as a whole is
operating well below par, the dangers of such a development would only
be amplified.
Conversely, I do not think we should count on extending the
experience of the 1990's. That would imply further depleting our
personal savings, ever-larger external deficits, and adding even more
rapidly to our international indebtedness.
For the time being, confidence in the prospects of the U.S.
economy, its financial markets, and its currency has remained strong,
little shaken if at all by the generally unexpected current slowing of
growth. Our leadership in innovation, the sense of increasing
productivity and efficient management, and the stability of our
political institutions help underlie that confidence. Those are
precious assets. But, in my judgment, they are no cause for
complacency. The huge and growing external deficits are a real cause
for concern. They are symptoms of imbalances in the national economy
and the world economy that cannot be sustained.
----------
PREPARED STATEMENT OF WILLIAM DUDLEY
Managing Director and Chief U.S. Economist
Goldman Sachs
July 25, 2001
My name is William Dudley. I am the Chief U.S. Economist for
Goldman Sachs & Co. It is my pleasure to have the opportunity to
testify before the Subcommittee on Economic Policy of the Senate
Banking Committee. The views expressed in my statement are my own and
do not necessarily reflect the positions or views of Goldman Sachs.
The United States has a large current account deficit, which has
grown sharply in recent years. To date, it has not proved problematic
for the U.S. economy or the U.S. financial markets. But this imbalance
does create a risk. If foreign investors' appetite for dollar-
denominated assets were to diminish, the result could be a sharp plunge
in the value of the dollar and the potential for havoc in the U.S. bond
and equity markets.
So how to minimize this risk? I would suggest three approaches:
1. Shift away from the so-called ``strong dollar'' policy. It
is better to make that shift now when the demand for dollar-
denominated assets is still strong and policy is credible,
rather than under duress later.
2. Implement measures that increase the pool of national
savings. This would reduce the dependence of the United States
on foreign capital inflows.
3. Pursue policies that ensure the United States remains an
attractive market in which to invest. This would help to keep
foreign capital flowing to the United States.
Before I discuss in greater detail what should be done in response
to the large U.S. current account deficit, let me just start with my
assessment of the causes and likely sustainability of this imbalance.
In my opinion, the large current account deficit evident for the
United States mainly reflects the disparity between the low supply of
domestic saving and high demand for investment both in business plant
and equipment and in housing. This imbalance has developed primarily
for four reasons.
First, household saving has been depressed as a consequence of the
long bull market in U.S. equities. The rise in the U.S. equity market
generated a huge increase in household net worth. This caused
households to save less out of their current income. The result has
been a sharp fall in the personal saving rate to the lowest level since
the Great Depression.
Second, investment spending on plant and equipment surged as a
consequence of technological change, which lifted productivity growth,
and the buoyant equity market, which reduced the cost of capital.
Investment spending also probably got a boost from a bit of irrational
exuberance as investors mistook profits generated from the boom for
profits that were sustainable on a long-term basis.
Third, the buoyant economy stimulated household formation and the
demand for housing, which also increased the demand for capital.
Fourth, the willingness of foreign investors to supply capital to
the U.S. also exacerbated this imbalance. The appetite of foreign
investors for U.S. assets kept the dollar strong and inflation low.
This helped to foster a more robust stock market and encouraged greater
investment.
Up to this point, the rise in the dependence of the United States
on foreign capital has not created any great difficulties. That is
mainly because foreign businesses have been eager to increase their
direct investment in the United States and foreign investors to
increase their portfolio holdings of dollar-denominated financial
assets. In fact, the desire by foreign investors to increase their
holdings of dollar-denominated assets has been so great that it has
caused the U.S. dollar to appreciate significantly since 1995. The
strength of the dollar, in turn, has helped to sustain the economic
expansion by helping to keep inflation in check.
In general, the desire by foreign investors to increase their
investment in the United States should be viewed for what it has been:
A mark of the U.S. economy's success. Capital is flowing here readily
because the U.S. economic system has been performing well. Many factors
including credible fiscal, monetary, and trade policies, deregulation,
a flexible financial system, and a transparent corporate governance and
accounting framework have helped to generate high productivity growth
and a healthy return on capital in the United States. These factors
have helped to encourage the flow of foreign funds to the United
States.
However, the dependence of the United States on foreign capital
inflows does create a vulnerability that needs to be acknowledged. In
particular, if the performance of the U.S. economy were to falter on a
sustained basis, the appetite for dollar-
denominated assets could decline sharply. The result would be a sharp
decline in the dollar and the risk of havoc for U.S. financial markets.
The consequence could be a vicious circle in which dollar weakness
contributed to poorer economic performance, which, in turn, reinforced
the dollar's slide.
There are three major reasons for concern. First, the U.S. current
account deficit is already very large, expected to reach nearly $450
billion in 2001. This is big
relative to both GDP--about 4 percent--and relative to the dollar value
of U.S. exports--about 11 percent of GDP.
Second, the upward trajectory of the U.S. current account deficit
evident in recent years must prove to be unsustainable at some point.
To see this, consider that a rising current account deficit leads to
greater net foreign indebtedness. Because the interest on this debt
must be paid, the increase in debt will lead, over time, to a sharp
deterioration in the net investment income balance. Without trade
improvement, that implies an even wider current account deficit. The
result is a vicious circle of climbing debt and interest expense that
ultimately is untenable.
Third, the risk that foreign investors lose their appetite for
dollar-denominated
assets has already increased because the performance of the U.S.
economy has
deteriorated sharply over the past year. In particular, the growth rate
of economic
activity and productivity has faltered and corporate profits are
contracting as the investment boom in technology has gone bust. The
budget surplus is shrinking. Put simply, the notion of a ``New
Economy'' is being called into question. If the economic rebound
anticipated for 2002 disappoints, then the demand for U.S. assets is
likely to lessen.
Up to now, prospects elsewhere have also diminished. However, if
the gap in economic performance between the United States and the rest
of the world narrows in the future, then it will become more difficult
for the United States to obtain the same huge sums of foreign capital
on favorable terms, for example, at low interest rates and a high
dollar exchange rate.
Danger signs for the dollar are already visible in the shift in the
composition of foreign capital inflows. The proportion of capital
inflows consisting of direct investment, which is not easily reversed,
has diminished sharply this year. In contrast, portfolio inflows,
especially into corporate and agency bonds, have increased.
For example, in the first quarter of 2001, the rate of foreign
direct investment into the United States fell to $41.6 billion, less
than half the pace of the prior three quarters. Conversely, investment
in private-sector equities and bonds increased to $147 billion, an all-
time record.
The composition of these capital inflows is important. In contrast
to direct investment, exit from publicly-traded securities is easy.
Liquidation can occur quickly, with potentially destabilizing
consequences to the dollar and financial markets. So what should be
done to forestall such an outcome?
The goal should be to pursue policies that encourage a gradual path
of adjustment--a smaller current account deficit and an increase in the
national saving rate. Three major policy adjustments are appropriate.
First, the time has probably come to scrap the so-called ``strong
dollar'' policy. To fail to do so now, when the demand for dollars is
still strong, heightens the risk of a sharper adjustment later. It
would not be pleasant if U.S. policymakers were forced to jettison the
``strong dollar'' policy under duress. The loss of credibility would
tend to drive up the risk premium on dollar-denominated assets,
necessitating a more painful economic adjustment.
A ``strong dollar'' policy made sense during the investment boom
when the main risk was that the U.S. economy might overheat. After all,
during the boom, a strong dollar helped to keep inflation in check. Now
that the boom is over, the rationale for a ``strong dollar'' has
lessened, especially as the dollar's strength is undermining the
effectiveness of U.S. monetary policy and undercutting U.S.
international trade competitiveness.
However, rather than call for a weaker dollar, which might provoke
a sharp, destabilizing adjustment, I would shift the emphasis away from
the dollar altogether toward the importance of having a strong and
healthy economy. If the U.S. economy performs well, then foreign
capital will flow here readily and the dollar will take care of itself
Second, policies should be pursued that would act gradually to
raise the pool of domestic saving. This can be accomplished in two
ways. Continued discipline in terms of fiscal policy is important. The
fact is that the dependence of the United States on foreign capital
would be much greater currently if the U.S. budget balance had not
shifted sharply from deficit to surplus over the past decade. The
improvement in the budget balance has enabled the national saving rate
to remain generally stable in recent years, despite a sharp fall in the
personal saving rate. Not only would slippage here reduce the pool of
domestic saving, but it also might worry foreign investors that have
invested large amounts of capital in the United States, in part,
because of the improvement in the U.S. fiscal outlook.
Although the long-term fiscal outlook for the United States remains
challeng-
ing given the impending retirement of the baby-boom generation and the
increase
in life expectancy, it pales in comparison to the challenges faced by
Japan and
Europe, which have less favorable demographic trends and bigger
unfunded pension obligations. It is important that the United States
not squander its advantage in this area.
In addition, the tax code could be changed in ways that encouraged
greater domestic private saving. This might include additional
incentives to save or a more radical revamping of the tax code to a
consumption-based tax system.
Policies that raise the national saving rate would gradually reduce
the dependence of the United States on foreign capital. Over time, this
would reduce the risks of a sharp reversal in the appetite of foreign
investors for U.S. assets.
Third, policies should be pursued that ensure the United States
remains an attractive market in which to invest. This includes lowering
trade barriers, investing in education in order to raise the quality of
the U.S. labor force, and taking steps to make the U.S. capital markets
more transparent and efficient. By creating a good environment for
foreign investment--either direct or in financial assets, this would
help to ensure that the flow of capital from abroad persists on
favorable terms to the United States.
To sum up, the large U.S. trade imbalance is worrisome. A sharp
shift in perceptions among foreign investors could lead to a collapse
in the dollar that could conceivably destabilize the U.S. economy and
global financial markets. The best way to deal with this risk is to
keep the U.S. economy healthy through the application of prudent
economic policies. If the U.S. economy remains more productive than its
rivals and the U.S. capital markets remain deeper and more liquid, then
the flow of foreign monies to the United States should continue
relatively smoothly and easily. The current account deficit probably
would ultimately shrink, but in an orderly way that would not disrupt
the ability of the U.S. economy to grow and the Nation to prosper.
PREPARED STATEMENT OF STEPHEN S. ROACH
Chief Economist and Director of Global Economics
Morgan Stanley
July 25, 2001
Mr. Chairman, I commend you in the Congress for looking at the U.S.
economy's problems through a global lens. America's gaping balance-of-
payments deficit is but one symptom of the stresses and strains of
globalization. The angst of Genoa is another. Yes, there are
unmistakable benefits of an increasingly integrated world economy,
especially the opportunity to bring less-advantaged developing
countries into the tent of global prosperity. But we can do a better
job in managing our collective journey. The United States is hardly an
innocent bystander in the momentous transformation that is now
reshaping the global economy. We must take a leadership role in facing
the challenges of globalization head-on. These hearings are an
important step in that direction.
The world is in the midst of what could well go down in history as
the first recession of this modern era of globalization. It is a
recession whose seeds were sown in the depth of the financial crisis of
1997-1998. Under the leadership of Treasury Secretary Rubin, the United
States played a key role in staving off what he called the world's
worst financial crisis since the 1930's. It is an honor to share this
platform with him this morning. But just as America moved aggressively
to save the world nearly 3 years ago, it has paid a steep price for
those noble efforts. That rescue mission fostered a climate that took
the U.S. economy to excess--resulting in a destabilizing asset bubble,
an overhang of excess capacity, and an extraordinary shortfall of
consumer saving. It also left the United States with its largest
balance-of-payments deficit in modern history. As you probe the
implications of America's unprecedented external imbalance, I urge you
to do so in this broader context.
A World In Recession
It has been a long march on the road to global recession. As
recently as October 2000, the global economics team that I head up at
Morgan Stanley was still calling for a 4.2 percent increase in world
GDP growth in 2001. But then a series of shocks begin to take an
unrelenting toll on our once-optimistic prognosis. First, came last
fall's spike in energy prices. Then came the most devastating blow of
all--an unwinding of the U.S. boom in information technology (IT)
spending. Another downleg in world equity markets added insult to
injury, especially in wealth-
dependent economies such as the United States. And the rest is now
history--an
inventory correction, the earnings carnage, intensified corporate cost-
cutting, and global reverberations of these largely American-made
shocks. It was only a matter of time before the world economy crossed
into recession territory.
According to IMF convention, the global economy is technically in
recession when world GDP growth pierces the 2.5 percent threshold. And
that is exactly the outcome we now anticipate. Over the past 9 months,
we have slashed our once optimistic 2001 growth estimates repeatedly
for the United States, Europe, non-Japan Asia, and Latin America. And
we have pared further our long-cautious prognosis for Japan. As a
result, we are now estimating a 2.4 percent increase in world GDP in
2001--0.4 percentage point slower than the crisis-induced outcome of
1998. Like it or not, 2001 is likely to go down in history as another
year of global recession.
This is the fifth global recession since 1970. All of these
recessions have one thing in common: They were triggered by a shock.
The global recession of 1975 was a by-product of the first oil shock.
The downturn of 1982 was driven by the shock therapy of the U.S.
Federal Reserve's anti-inflationary assault. The global recession of
1991 came about in the aftermath of another oil shock--this time the
brief spike that
led to the Gulf War. The downturn of 1998--the mildest of the lot--came
about
when a global currency crisis pushed most of East Asia into depression-
like contrac-
tions. And the global recession of 2001 certainly stems, in large part,
from America's
IT shock.
The world economy is currently about midway through a three-stage
downturn in the global business cycle. The first stage was dominated by
the abrupt about-face in the U.S. economy in the final 6 months of
2000; as recently as the middle of last year, the economy was still
surging at a 6.1 percent annual rate, whereas by year-end it had slowed
to about 1 percent. Wrenching adjustments in America's IT and corporate
earnings dynamics were at the crux of this transformation from boom to
bust. While the forecasting community was quick to lower its sights on
the U.S. economic outlook in early 2001, it was not as swift to
diagnose the second stage of this cycle--surprisingly serious
collateral damage to the broader global economy.
In retrospect, we should have seen that one coming. Courtesy of the
new connectivity of globalization--expanded trade flows, globalized
supply chains, and explosive growth of multinational corporations--the
loss of U.S. economic leadership reverberated quickly around the world.
The global trade dynamic has been especially important in transmitting
this new contagion. By our estimates, the volume of world trade
currently amounts to almost 25 percent of world GDP, essentially double
the share prevailing in the 1970's. That reflects over 30 years of 6
percent annualized expansion in global trade volumes, fully 60 percent
faster than the 3.7 percent average growth in world GDP over this same
period.
Moreover, the world's dependence on cross-border trade became even
more pronounced in the 1990's. Over the 1989 to 1997 interval, growth
in global trade averaged 2.3 times the growth in world GDP. By
contrast, over the preceding 17 years, the growth in global trade was
only 1.4 times the growth in world GDP. With global trade accounting
for a much larger portion of world GDP today than it did in the not-so-
distant past, it exerts far greater leverage over the global business
cycle. Out of that leverage has come a new strain of global contagion--
linking the world economy more closely than ever before.
But now global trade, the glue of globalization, is screeching to a
standstill. Our latest estimates point to just a 4.3 percent increase
in world trade volumes in 2001, a deceleration of 8.5 percentage points
from the record 12.8 percent increase in 2000. This outcome represents
the steepest year-to-year decline in global trade growth on record,
setting in motion a ``negative accelerator'' effect that is wreaking
havoc on industrial activity around the world. If anything, our latest
estimates may be understating the downside to global trade in 2001.
Outright declines in the first half of this year--especially in the
United States--suggest it will be a real stretch to hit our projected
4.3 percent increase for the year as a whole. That, in turn,
underscores the downside risks to our global recession forecast.
The sharp deceleration in global trade is symptomatic of a world
that had become overly dependent on the United States as the engine of
global growth. Our estimates suggest that America accounted for close
to 40 percent of the cumulative increase in world GDP in the 5 years
ending in mid-2000. The United States-led slowdown in global trade also
unmasks the world as being without an alternative growth
engine. Once the U.S. economy slowed to a crawl, it quickly became
apparent that there was no other candidate to fill to the void. The
rest of the world has tumbled like dominoes--first non-Japan Asia, then
Japan, America's NAFTA partners, and now Europe and Latin America. The
result is a rare synchronous recession in the global economy.
Alas, there is a third phase to this global downturn, one that has
yet to really play out. It will be defined by the feedback effects that
could well take an additional toll on the U.S. economy. Two such
impacts loom most prominent--the first being a likely downturn in U.S.
exports brought about by the confluence of a weakening external climate
and a strong dollar. Inasmuch as the U.S. export growth dynamic has
only just begun its descent, there is plenty of scope on the downside;
in global recessions of the past, America's real exports have declined
by anywhere from 6 percent to 20 percent.
The other shoe about to fall in the third phase of the global
downturn could well be the American consumer. This judgement is not
without controversy. But as I see it, the case against the U.S.
consumer is more compelling than at any point since the early 1970's.
Saving short, overly indebted, and wealth depleted, consumers
are about to get hit by the twin forces of layoffs and reduced flexible
compensation--the year-end payouts granted in the form of stock
options, profit sharing, and performance bonuses. Tax rebates
notwithstanding, I believe that this confluence of forces will finally
crack the denial that has kept the American consumer afloat. In my
travels around the world, the wherewithal of the American consumer is
at the top of everyone's worry list. A U.S.-dependent global economy
needs the American consumer more than ever. I fear that the world is
about to be in for a huge disappointment.
The Legacy of 1998
Alas, there is a more sinister interpretation of the events now
unfolding: I do not believe that the current global recession should be
viewed as merely the latest in a long string of isolated and unexpected
shocks. Instead, I see it as more of a by-product of the previous
crisis-induced downturn in 1998. If that view is correct, it would be
appropriate to treat these two downturns as more a continuum of a
drawn-out global business cycle--one that could well go down in history
as the world's first recession of this modern-day era of globalization.
Moreover, I would go further to argue that if the world does not get
its act together, this type of downturn could
well be indicative of what lies ahead--a more unstable and recession-
prone global
economy.
It all started in the fall of 1998. The global currency crisis that
began in Thailand had cascaded around the world, eventually leading to
Russian debt default and the related failure of Long-Term Capital
Management. The result was what Federal
Reserve Chairman Alan Greenspan dubbed an ``unprecedented seizing up of
world
financial markets.'' United States President Bill Clinton and Treasury
Secretary
Robert Rubin went even further, both calling it the world's worst
financial crisis since the Great Depression.
The Fed swung into action to save the world, leading the way with
an ``emergency'' monetary easing of 75 bp in late 1998. Other G-7
central banks more or less joined in, albeit on the their own terms and
with something of a lag. This led the Bank of Japan, which had just
about run out of basis points, to adopt its now infamous ZIRP--zero-
interest-rate policy. Europe also jumped in--belatedly, of course:
First, there was a pre-ECB coordinated rate cut in December 1998 and
then there was another 50 bp easing once the new central bank opened
its doors in early 1999. Collectively, the authorities did what they do
best--cutting official overnight lending rates in a classic
reflationary ploy.
The world economy sprang back with a vengeance that few
anticipated. The out-of-consensus ``global healing'' scenario that we
embraced in late 1998 placed us very much at odds with financial
markets that were positioned for global deflation and another year of
ever-deepening crisis and recession. But we felt that the world had
been given the functional equivalent of a massive global tax cut. It
wasn't just the monetary easing, but it was also an IMF-led liquidity-
injection of $181 billion in bailouts in Thailand, Indonesia, Korea,
Russia, and Brazil, collectively worth about 0.5 percent of world GDP.
The boost to industrial-world purchasing power brought about by cheaper
Asian-made imports was icing on the cake. A seemingly resilient global
economy accelerated sharply in the second half of 1999, and world GDP
growth spiked by 4.8 percent in 2000--the fastest such gain since 1976.
The
footprints of global healing were unmistakable. So were the perils of
its unintended consequences.
The Downside of ``Global Healing''
In retrospect, global healing sowed the seeds of its own demise. It
led to a false sense of complacency on two critical fronts: First, it
created the climate that culminated in the Nasdaq bubble. The Federal
Reserve was, in effect, easing aggressively at a time when the U.S.
economy was already booming. In the midst of the Fed's emergency easing
campaign, America's real GDP surged at a 5.6 percent annual rate in the
fourth quarter of 1998. Far from faltering, the U.S. economy was on a
tear. I cannot remember when such an aggressive monetary easing had
occurred in the context of such an outsized gain in economic growth.
Although our central bank began to take back its extraordinary monetary
accommodation by mid-1999, by then it was too late--the damage had been
done. Moreover, it was compounded by the Fed's now infamous Y2K
liquidity injection of late 1999. America was on the brink of a runaway
boom. A Fed-induced, Nasdaq-led liquidity bubble gave rise to the great
IT overhang that has since wreaked such havoc on the United States and
the broader global economy. Such was the legacy of global healing.
Global healing dealt another critical blow to the world economy.
The tonic of vigorous growth dampened enthusiasm for reform. Asia rode
the coattails of the same powerful IT-led U.S. growth dynamic. Indeed,
we estimate that United States IT exports accounted for as much as 40
percent of non-Japan Asia's overall GDP growth in 2000. With growth
like that, who needs reform? Everything that was wrong had seemingly
been fixed--and quite quickly at that. At least, that was the implicit
logic throughout Asia, as banking reform was put on hold, corporate
restructuring stalled, and the old ways of crony-capitalism endured.
Global healing was a powerful antidote for the region's devastating
crisis--the cover that impeded long-overdue reforms.
The same was the case for any repair that was about to be made to
the world financial architecture. Out of the depths of the crisis of
1997-1998 came renewed commitment by the major industrial nations to
make the world a safer place for globalization. The great powers of the
world insisted they had learned a most painful lesson. Commissions were
formed--I had the pleasure of serving on one of them, sponsored by the
Council on Foreign Relations. Recommendations on architectural reforms
were put forth, only now to gather dust on bookshelves around the
world. Sadly, the power of global healing tempered the urgency of these
reforms, as well.
All this speaks of a world that has yet to come to grips with the
full ramifications of globalization. The crisis of 1997-1998 was, in
retrospect, a warning of what was to come. In increasingly connected
world financial markets, systemic risks in the emerging world loom all
the more potent--especially if the industrial world has been lagging on
its own reform agenda. The current events unfolding in Argentina, along
with the potential for a new round of contagion in Brazil and elsewhere
in Latin America, are the latest painful reminders of just such a
possibility. The quick fix of reflationary interest rate cuts is not
the panacea for a Brave New World in need of fundamental reform. It is
high time to face up to the heavy lifting that is needed to make
globalization work. Until that occurs, I suspect the global economy
will remain more recession-prone than ever.
A Fragile Global Recovery
As day follows night, recovery will, of course, come. It always
does. But the real issue is the character, or quality, of the coming
global upturn. Hope springs eternal on that score. Financial markets
are lined up on the optimistic side of the 2002 outcome--yield curves
have steepened, equity cyclicals have rallied, and next year's earnings
expectations are brimming with optimism. The risk, in my view, is that
the outcome for the United States and the broader world economy will
not conform to these optimistic expectations--that the world will
remain on a decidedly subpar growth trajectory.
Such are the realities of what has been dubbed a U-shaped world. By
definition, a U-shaped upturn is a protracted period of subpar growth.
Morgan Stanley's current baseline prognosis calls for 3 percent average
growth in world GDP in 2001-2002--an outcome fitting that description
to a tee. It depicts a world economy that falls short of its long-term
growth trend by about 0.7 percentage point per annum over this 2 year
interval. Moreover, I fear that risks could tip to the downside of the
scenario, suggesting that the world's potentially chronic growth
deficiency will become even more pronounced. In such a subpar growth
climate, the risk of a recessionary relapse is high. The world economy
will be lacking in both the leadership and the cyclical resilience that
typically cushion unexpected blows. Little wonder
the world has tipped so quickly back into recession in the aftermath of
the crisis
of 1998.
But there is a deeper and more profound meaning to this U-shaped
world. On the one hand, it reflects a worrisome imbalance in the
broader global economy--the world has simply become too dependent on
the United States. Lacking in structural reforms, the world has been
unable to unlock the efficiencies that would create new and autonomous
sources of domestic demand. Instead, on the heels of a U.S.-led boom in
global trade, the rest of the world took the easy way out--hitching
itself to surging external demand. Only through structural reform can
the global economy wean itself from excessive dependence on the
American consumer and the U.S.
IT cycle.
A U-shaped world also poses a major challenge to the United States:
America must now begin the heavy lifting that is needed to come to
grips with the painful legacy of a popped financial bubble.
Rationalizing the great IT capacity overhang is at the top of that
agenda, followed by a long overdue need to rebuild personal saving. The
bubble took America to excess, and those excesses must now be purged.
As I put the pieces of global economic recovery together, I worry most
about the quality of the coming upturn. The quality factor hinges
critically on the combination of reforms and structural change.
Unfortunately, based on recent experience, there is little ground for
encouragement.
This global recession is different. It is both the first recession
of the Information Age, as well as the first recession in the modern
era of globalization. As such, it should be viewed as a critical wake-
up call. One can only hope it will trigger structural reforms that will
rejuvenate domestic demand in the broader global economy. With any
luck, it should also force America to come to grips with many of its
own post-bubble excesses. If progress is made on those counts, a high-
quality upturn in the global economy will ensue. If, however, the world
sidesteps the challenge and squanders the opportunity for meaningful
reform, a low-quality rebound will occur. That, unfortunately, would be
a setup for an even more painful day of reckoning. The stakes are
enormous for a world now back in recession.
America's External Imbalance
The United States has shouldered a heavy burden as the
engine of global growth. Excesses have built in the structure of the
domestic economy. That is the message from the Nasdaq bubble, a
negative personal saving rate, and an outsize capacity overhang. At the
same time, America's economic and financial relationship with the rest
of the world has been stretched as never before. That is the message
from a massive balance-of-payments deficit. All this poses risks on the
dark side of the great American boom.
While there can be no mistaking the extraordinary performance of
the U.S.
economy in recent years, unfortunately, it has been built on a shaky
foundation
of increased foreign indebtedness. History demonstrates that such
external imbal-
ances cannot persist indefinitely. Something usually gives in
response--the cur-
rency, other asset prices, or the economy. Steeped in denial, few worry
of such
consequences. Therein lies a key risk for the global economy and world
financial
markets.
America's current-account deficit hit 4.4 percent of GDP in 2000,
and, by our estimates, is likely to hold near that share through 2002.
That qualifies as the widest external gap of the post-World War II
era--a full percentage point larger than the previous record of 3.4
percent in 1986-1987. We should avoid the slippery slope of looking to
our trading partners as scapegoats. Our balance-of-payments deficit
should not be viewed as an indication of a competitive assault on
American markets. It is not a Japan problem, or a China problem, any
more than it is a NAFTA problem involving Canada and Mexico.
If there is a scapegoat, it can be found in the mirror. America's
external imbalance is, instead, more a reflection of serious flaws in
the macro structure of the U.S. economy--namely, a chronic domestic
saving deficiency. From an accounting point of view, national
investment must always equal saving. Consequently, when there is a lack
of saving, one of two things has to happen: Either investment must be
reduced or an alternative source of saving must be uncovered. America
has opted for the latter of these options. A shortfall in domestically
generated saving has been augmented by an inflow of saving from
abroad--inflows that can only be attained by running a massive external
deficit.
The imbalance between domestic saving and national investment has
not come out of thin air. It is very much a hallmark of America's
bubble economy. Five years of excess returns in the U.S. stock market--
with the broad Wilshire 5,000 surging by an average 25 percent per
annum. over the 1995-1999 interval--led to serious distortions of both
consumer and business sector behavior. Consumers became convinced that
an ever-rising stock market had become a permanent new source of
saving. As a result, they drew down their income-based saving--with the
conventionally measured personal saving rate--national income accounts
basis--falling from a pre-bubble 6.6 percent in late 1994 to a negative
1.2 percent in early 2001. Why should American workers save out of
their paychecks if the stock market was automatically performing this
function? Similarly, Corporate America became convinced that IT
investment was a surefire recipe for enhanced returns in the stock
market. The IT-led investment cycle soared in response, with business
capital spending hitting a record 13.9 percent of nominal GDP in late
2000.
This juxtaposition between negative personal saving and record
investment spending was a classic recipe for an ever-deepening current
account deficit. Ironically, it occurred at precisely the moment when
the Federal Government was getting its fiscal house in order--moving
from being a dis-saver to a saver by transforming seemingly open-ended
budgetary deficits into surpluses. Indeed, Government net saving--
Federal, State, and local, combined--moved from a pre-bubble deficit of
2.8 percent of nominal GDP in the fourth quarter of 1994 to a post-
bubble surplus of 3.1 percent of GDP in early 2001. Unfortunately, this
5.9 percentage point positive swing in greater public sector saving was
more than offset by the 7.8 percentage point decline in the personal
saving rate. As a result, the net national saving rate--a broad
aggregate that includes personal, business, and public saving--stood at
only 4.8 percent in the first quarter of 2001; that is little changed
from the pre-bubble reading of late 1994 and less than half the 10
percent average of the 1960's and 1970's. Such a saving-short U.S.
economy had little choice other than to turn to foreign investors to
finance its investment boom.
In retrospect, it is not surprising that an asset bubble produced
this unstable state of affairs. Just as American consumers and
businesses came to believe that ever-ebullient equity markets had
become a new source of saving and excess return, so did foreign
investors. They became more than willing to invest in dollar-
denominated assets. Portfolio inflows surged from abroad, as did
foreign direct investment, especially through a surge of European-led
cross-border merger and
acquisition activity. Largely as a result, foreign investors currently
own 37 percent of U.S. Treasuries, 46 percent of corporate bonds, and
11 percent of equities. It was the ultimate in virtuous circles.
America's New Economy prowess won over converts at home and abroad. The
rest of the world was dying to buy a piece of the action, and so there
was little reason for foreign investors to exact a premium on dollar-
denominated assets. That is exactly what should happen in a financial
bubble--that is, until it pops.
A Venting Of Excesses
Yet, this is not a sustainable course for any nation. It depicts a
U.S. economy that is now living well beyond its means, as those means
are defined by the domestic capacity to fund its investment needs.
That, in my opinion is the painful legacy of a financial asset bubble
that took our real economy to excess. Consumers have over-spent.
Businesses have over-invested. And the United States funded these
excesses by borrowing from abroad. There is no telling when the music
will stop. The longer this state of affairs persists, the greater will
be the temptation to ignore its consequences. But the math is
straightforward: If left unchecked, an ever-widening
current-account deficit raises the debt-servicing burden of
international indebtedness to onerous levels. And an increasingly
larger share of domestically generated income will have to be exported
to offshore creditors, who, in turn, establish an ever-larger claim on
the ownership of dollar-denominated assets. An ever-widening current-
account deficit implies that foreign investors will ultimately end up
``owning'' America--unless, of course, something gives. And it usually
does.
What should give, in my view, will be the high-flying U.S. dollar.
In the interest of full disclosure, I have been wrong on the dollar for
close to a year. I felt the dollar would finally fall as the United
States veered toward recession. I also felt the current-account deficit
would exacerbate the correction, once it got going. Over the past
several years, however, the dollar call has not been driven by the
current account--instead it has been all about capital flows. The rest
of the world wanted a claim on America's New Economy prowess and has
been willing to pay up to get it. And despite the ever-widening
current-account deficit, the dollar has soared. A broad index of the
real trade-weighted value of the dollar is up 31 percent since late
1994 to a level that now stands just 12 percent short of its all-time
high in March 1985.
Like any currency, the dollar, of course, is a relative price. If
you are negative on the dollar, you have to give careful consideration
to the alternatives. This has not exactly been a year to fall in love
with yen- or euro-denominated assets. But I suspect their day is
coming. First of all, I continue to believe that the U.S. economy will
surprise on the downside. While the case for outright recession is
admittedly arguable--although one that I continue to embrace--I remain
convinced that any recovery is likely to be muted. That would most
assuredly dampen the likelihood of an earnings resurgence that would
validate the New Economy play still priced into the strong dollar.
At the same time, I believe that global investors could well begin
to flirt with
reform stories in both Japan and Europe. Indeed, the micro evidence of
corporate
reform is building in Japan. At the same time, structural change in
Europe looks
increasingly impressive--underscored by tax and cost harmonization,
improved labor-market flexibility, enhanced shareholder value cultures
brought about through cross-border merger and acquisition activity, and
ongoing deregulation. Politics remain the major impediments in both
cases, in my view. If Prime Minister Koizumi, the reformer, carries the
day in the upcoming Japanese Upper House elections,
Japan's political risk premium could start to narrow. And if European
politicians start pulling together--seemingly a stretch right now--the
euro might rise as well. The dollar could then finally be in trouble,
with its downside exacerbated by an outsized U.S. current-account
deficit.
History shows that massive current-account deficits eventually
trigger currency depreciation. The key word in this statement, of
course, is ``eventually.'' Economics often does a good job of revealing
the endgame. Timing is a different matter altogether. But the lessons
of the second half of the 1980's should not be forgotten:
A then-record current-account deficit set the stage for sharp
depreciation of the
U.S. dollar. I see no reason to believe that the endgame will be any
different this
time around.
But not only could the dollar give--so, too, could America's
current-account deficit. Usually, it takes a recession to force a major
current-account adjustment. That is what is required to reduce domestic
demand--and the import content of such spending. That was the case in
the early 1990's when the United States last dipped into a mild
recession. The current account went from a deficit of 3.4 percent of
GDP in 1987 to virtual balance in 1991--an outcome assisted by the
inflow of foreign payments that helped finance America's military
efforts in the Gulf War. If I am right and the U.S. economy slips into
a mild recession, an import-led current-account
adjustment could well be in the cards over the next year, as well.
Courtesy of the bubble-induced excesses of the 1990's, America is
still living well beyond its means. Foreign investors have been more
than willing to subsidize a profligate U.S. economy. The combination of
an overvalued dollar and a massive current-account deficit underscores
the tensions that have arisen from this state of affairs. These
distortions are not sustainable for any economy. As the U.S. economy
now begins to vent its post-bubble tensions, dollar and current-account
adjustments seem more likely than not. And, by the way, that is the
last thing most investors currently expect.
Backlash Against Globalization?
Where might this all take us? The most worrisome possibility is
that trade liberalization might give way to some form of protectionism.
To the extent that slow growth prompts mounting layoffs, the political
winds could well shift. The outcome might lead to the erection of new
competitive barriers that would supposedly shield workers from the
harsh winds of globalization. While the body politic has steadfastly
resisted this temptation, there may be a change of heart as the world
now slips into recession.
Public opinion polls reveal that U.S. workers oppose several
aspects of global-
ization--especially trade liberalization, immigration, and foreign
direct investment. (See Kenneth F. Schreve and Matthew J. Slaughter,
Globalization and the Perceptions of American Workers, published by the
Institute for International Economics, February 2001.) Even during
goods times, according to these polls, the benefits of globalization
are thought to be largely outweighed by the costs. In tougher economic
times, that resistance can only intensify.
Moreover, there is a gathering sense of anti-American sentiment
around the world. In my travels, I have heard firsthand more than one
distinguished European leader sarcastically describe globalization as
``economic integration according to American rules.'' The Asian crisis
took this resentment to a new level. Crisis-torn countries in the
region deeply resent IMF-led bailouts that sent their economies into
depression-like contractions from which many have never really
recovered. With the United States the IMF's largest shareholder and the
major architect behind the stringent bailout packages of 1997-1998,
America is blamed for much of which still ails Asia. The recent
escalation of sino-U.S. tensions underscores a different strain of this
same animosity.
In my visits to Japan I detect a similar sentiment; the logic goes
something like this: ``We followed your policy recommendations, and
look where they got us.'' Ongoing trade skirmishes between the United
States and Europe--to say nothing of the recent dispute over the GE-
Honeywell merger--are part of this same script. Fair or not, the
legitimacy of such claims is not the issue. Anti-American sentiment is
a growing problem around the world. The widening of income disparities
between rich and poor nations over the past century adds insult to
injury. Globalization is not perceived as the rising tide that lifts
all boats. Instead, it is increasingly thought of as the wedge of
disenfranchisement. In theory, globalization is all about a shared
prosperity--bringing the less-advantaged developing world into the tent
of the far wealthier industrial world. But, in reality, when there is
less prosperity to share, these benefits start to ring hollow. As the
world economy now tips into recession, the assault on globalization can
only intensify. That is the tough message from the streets of Genoa.
Mr. Chairman, if this hearing accomplishes one thing, it should
underscore America's commitment to globalization and the principles of
free trade on which it rests. Protectionism is antithetical to
everything that globalization stands for. However, if a backlash
arises, protectionism could be the gravest risk of all. While the
voices of dissent are few, they are growing louder. Yet this is not a
time to turn back the clock and single out scapegoats for a world in
recession. America's gaping current-account deficit should not be
viewed as a lightning rod for pointing fingers at our trading partners.
It is a by-product of the profound imbalances that lie at the core of
the global economy--a world that has become overly dependent on a
saving-short United States as the engine of global prosperity. Yet it
is also a by-product of an American appetite for excess--and our
willingness to rely on foreign capital to sustain that excess. It is
time to face these excesses head-on.
There is no guidebook to globalization. We are learning along the
way. It is in-
evitable that we will stumble from time to time. Fortunately, our
system is
strong enough to give us valuable feedback at critical junctures. This
is one of those wake-up calls. The world economy is back in recession
for the second time in
4 years. That, more than anything else, is an unmistakable sign of
stresses and strains in the very fabric of globalization. Don't be
tempted by the quick fix as you frame policies aimed at enhancing
United States and global prosperity. The heavy lifting of reform and
structural change is really the only way to make globalization work. We
must not squander this opportunity.
Thank you very much.