[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

                              ----------                              

                        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.
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
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